Economic Theory of Production and Production Cost

Top 100 Management Theory Article

Economics Revision Article Series

Economic theory of the firm begins with theory of production. What is a firm? The essence of a firm is to buy inputs, convert them to outputs, and sell these outputs to consumers, firms or government. Therefore a firm is poised between two markets. It is a demander in factor markets. It buys the inputs required for production in factor markets (markets that supply inputs for firms). It is a supplier in market for goods and services. It has to adjust its production to satisfy the demand curve of its customers at profit.

It is assumed that the firm or the owner of the firm always strives to produce efficiently, or at lowest cost. He will always attempt to produce the maximum level of output for a given dose of inputs avoiding waste whenever possible.

Production function

The production function is the relationship between the maximum amount of output that can be produced and the inputs required to make that output. Put in other way, the function gives for each set of inputs, the maximum amount of output of a product that can be produced.  It is defined for a given state of technical knowledge (If technical knowledge changes, the amount of output will change.)

Importance of the Concept of Production Function

In an economy there will be thousands and millions of production functions because each firm will have one for each of the products that it is making. From the production function, the cost curves of a firm for each of its products can be determined.  Contribution of each factor of production i.e., land, land, capital is also determined from production functions. The price that a factor of production will command in the market will be determined by the production functions from the demand side.

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 Total, Average and Marginal Products

Total product or output is the total output produced in physical units by using a set of inputs. It is given by the product function directly.

Marginal product of an input is the extra product or output produced when 1 extra unit of that input is added while other inputs are held constant at any given set of inputs.

Average output is total output divided by total units of input. It can be calculated for each input separately also.

Law of diminishing marginal returns

It holds that the marginal product of each unit of input will decline as the amount of that input increases, holding all other inputs constant.

Returns to scale

Returns to scale reflect the responsiveness of total product when all the inputs are increased proportionately.

The scale effect can be constant returns, decreasing returns,and increasing returns.

Constant returns to scale means, if inputs are doubled output also will double.

Decreasing returns to scale means if inputs are doubled output is not doubling.

Increasing returns to scale means if inputs are doubled, output is getting more than double.

Time Horizon of Analysis

Three different time periods are used to develop theories of production and production costs

Momentary run: The period of time is so short that no change in production can take place.

Short run: The period of time in which labor and material can be changed, but all inputs cannot be changed simultaneously. Especially,  equipment and machinery cannot be fully modified or increased.

Long run: All fixed and variable factors employed by the firm can be changed.

Technology change

Technology change is said to occur when more output can be produced from the same inputs.

Example: Wide-body jets increased the number of passenger-miles per unit of input by almost 40 percent.

Technology change refers to a change in the underlying techniques of production, as when a new product is invented, an old product is improved, or a process of production is made more efficient. In  situations, if the same output is produced with fewer inputs, or more output is produced with the same inputs, the technological change would shift the production in the upward direction.

In the engineering discipline, industrial engineering branch is undertakes product industrial engineering and process industrial engineering and shifts production function in the upward direction on a continuous basis.

Analysis of Production Costs

The content above focused on theory of production quantity.  Production cost is another important attribute of firm.

Costs are important in production and supply decision making by entrepreneurs. Every dollar of cost reduces the firm's profit. The deeper reason to study costs by an economist is that supply of an item depends upon incremental or marginal cost when the price is constant. Otherwise it depends on marginal cost as well as marginal price or revenue. In all the market structures (perfect competition to monopoly) marginal cost is key concept for understanding a firm's production quantity behavior.

Concepts Related to Cost

Total Cost, Fixed Cost, Variable Cost
Marginal Cost
Average or Unit Cost, Average Fixed Cost, Average Variable Cost, Minimum Average Cost
Opportunity Cost
U-Shaped Cost Curves

Total Cost

Total cost is the cost incurred to produce a quantity of output. A total cost schedule shows the total cost for various output amounts. The total cost schedule is derived from the production function of the product for a firm. As per definition of production function and assumption of a businessman's behavior (operating at maximum efficiency and lowest cost), it will be the lowest cost for that output. But Samuelson clearly highlighted that there is hard work of the businessman involved to attain this lowest level of costs. The firm's managers have to make efforts and make sure that they are paying the least possible prices for necessary materials and supplies. The wages are to be fixed or bargained so that neither they are high to raise the firms production costs nor they are so low that sufficient labor is not there to produce as per market requirement. Also various engineering techniques are to be utilized in equipment purchase decisions, factory layout and production processes. Countless other decisions are to be made in most economical fashion.

Fixed Cost
Fixed and variable cost are categorized based on a period. Firms have to commit costs for production capacity at the start of a period and they have to incur these costs irrespective of the production output. Such committed capacity costs are termed fixed cost for a period.

Variable Cost
Variable cost is incurred when production is there and it varies with the level of output.

Marginal Cost
At each output level or at any output level, marginal cost of production is the additional cost incurred in producing one extra unit of output.

Marginal cost can be calculated as the difference between the total costs or producing two adjacent output levels. The difference in variable cost of two adjacent output levels also gives marginal cost, as fixed cost is constant for the two levels.

Marginal cost is a central economic concept with a crucial important role to play in resource allocation decisions by organizations.

Average Costs or Units Costs

Average cost or unit cost is the total cost divided by number of units produced.
Average fixed cost is total fixed cost divided by number of units produced. It keeps on decreasing as output increases.
Average variable cost is total variable cost divided by number of units produced.

Minimum Average Cost
In the average cost curve, it is normally seen that average cost initially comes down (as average fixed cost comes down) as output increases, reaches a lowest point and then starts rising. Hence on this curve there is a minimum average cost point or output level. Hence average cost curves have 'U' shape.

Choice of Inputs by the Firm

Every firm or entrepreneur has to decide how much of each input it should employ: how much labor, capital, land, energy, various materials and services.

The fundamental assumption that economists make in this context is that of cost minimization. Firms are assumed to choose their combination of inputs so as to minimize the total cost of production.

Least-cost Rule: To produce a given level of output at least cost, a firm will hire factors until it has equalized the marginal product per dollar spent on each factor of production. This implies that

Marginal product of labor/price of labor  = Marginal Product of Capital Equipment/Price of capital equipment = ...

Thus the firm will choose a factor combination or resource combination that minimizes the total cost of production.

Technology Change

References 

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition,  McGraw-Hill, 1989, Chapters 21 and 22

Online Books to be added

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Related Posts

Economics Revision Article Series - Directory

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Related Web pages

Theory of Production and Cost - Class Presentation - Stamford

http://www.stamfordonline.com.my/courses/fsb/fsbn102/FSBN102%20Week%203%20-%20Theory%20of%20Production.pdf

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Top 100 Management Theory Articles of the blog

Originally posted in
http://knol.google.com/k/narayana-rao/economic-theory-of-production-and/ 2utb2lsm2k7a/ 228


Updated on 1.7.2023,  9 November 2019, 11 December 2011

Theory of Economic Growth

Economics Concepts, Theories and Practices for Managers

Theory of Adam Smith

Adam started with the golden age where only Labor is the important factor. Nature which is represented by Land in economics is plentiful and is not a consideration. In such an company every items trades at prices to proportional to the amount of labor that is needed to produce. If labor doubles output also double as nature is not a constraint. Real wages will hold steady. If any invention increases labor productivity, real wages will rise.

Scarce Land
The next development of the theory is that as population expands, land will become scarce due to limited supply. More labor will work on the same land and hence marginal output will fall. Landowning class emerges, and they will pay subsistence wages to workers. Malthus reasoned that whenever wages were above subsistence, population would expand and drive down wages. As wages go below subsistence level, mortality and will increase and population will decline.

Neoclassical Growth Model

Neoclassical growth accepts the fixed amount of land, but now the growth drivers are labor, capital and technological progress. If capital increases relative to labor, labor productivity will increase. Capital is the great variety of durable tangible goods used to make other goods. For modeling purpose, it is assumed to be homogeneous and total capital is approximated by constant dollar value of capital stock in an economy.

Capital deepening occurs when the supply of capital grows more rapidly than the labor force. In the absence of technological change, capital deepening will produce a growth of output per worker, of the marginal product of labor, and of wages;
As capital deepening goes on occurring,  it will lead to diminishing returns on capital and a consequent decline in the real interest rate till there is no incentive to create further capital. This theory prophesies a better living condition for the masses in contrast to the limited land held by landlords theory.

In history or economic history, we witnessed technological progress whereby capital produced by the same inputs is giving more units of output in combination with the same amount of labor. Hence, capital productivity increases and labor productivity also increases and wages expand in the presence of technological progress.

Growth accounting

Growth in out can be decomposed into three separate sources, growth in labor, growth in capital and technological progress.


References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Updated  4 July 2021,   23.12.2012
Pub 11 Dec 2011
Source:
http://knol.google.com/k/  narayana-rao/   theory-of-economic-growth/2utb2lsm2k7a/242#

Capital, Interest and Profits - Review Notes

Economics Concepts, Theories and Practices for Managers

Capital

Capital consists of those durable produced goods that are in turn used as productive inputs for further production.

There are three major categories of capital goods: structures (factories), equipment (machine tools) and inventories(goods on the shelfs of retails stores).

Investing in capital goods involves indirect or roundabout production. An item to catch fish can be made by spending time which can be used to catch fish with hands. There is an opportunity cost here. But investment of time or the opportunity cost is made in a capital good because it allows more consumption in the future than the opportunity cost.

Interest

The rate of return on capital is the annual net income (rentals less expenses) per dollar of invested capital.

In a world free or risk, inflation and monopoly, the competitive rate of return on capital would be equal to the market interest rate. In a world of different risk for different assets, return on capital is the sum of market interest rate plus risk premium. Market interest rate for zero risk assets is a benchmark. The presence of risk indicates that return on capital is not constant every period. If fluctuates and from past data, an expected return and variability of return can be established.

Profit

Profits are defined as the difference between total revenues and total costs.

From the total revenue all expenses (wages, salaries, rents, materials, interest, excise taxes, and the rest are deducted. The residual amount is termed as profit. The profits go the enterpreneur.

1. Profits are implicit returns

If the enterpreneur does not charge the business for his labor, his capital and land and profit will be an implicit return to his factors of production.

2. Profits as a reward for risk taking

If the revenues of the business are charged with the implicit returns - what remains is a reward for risk taking.

3. Profit as monopoly returns




References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Knols - 237 profit

Updated on 3 July 2021

First pub 11 Dec 2011 Transferred from Knol to this blog.

Wages and the Labor Market - Samuelson and Nordhaus - Review Notes

Online MBA Management Theory Handbook 

Wages - Questions

How wages are determined in a market economy?
How wages are determined under competitive conditions?
How imperfect competition (that results when unions or government regulation limits the supply in the labor market) will affect wage rates and employment?

In perfectly competitive equilibrium, if all people and jobs were exactly alike, there would be no wage differentials. The equilibrium wage rate would be determined by supply and demand.

Demand for Labor from Entrepreneurs

The demand for labor is determined by labor's marginal product. The marginal productivity of labor depends upon the quality of labor itself, quantity and quality of cooperating factors of production, and technology of the economy. The quality of labor inputs refers to the basic literacy, higher education, training and skills of the labor force. The quality and quantity of the cooperating factors refers to the capital employed in the economy. Production and managerial methods refer to the technology.

Supply of Labor

Labor supply means the number of man days that people of an economy are will to put in job related activities in agricultural activities or manufacturing and mining activities or service activities. The population size and the pattern of time spending by the people determine the labor supply. How wage rates affect the pattern of spending by time people?

As wages rise, there are two opposite effects on the supply of labor.

Substitution effect tempts each worker to work longer due to high pay for each hour of work. Income effect reduces the need to work as higher wages mean that workers can afford more leisure time to enjoy good things in life.

Wage Differences across Groups and Individuals

We find substantial differences in wages as there is no uniformity in people or jobs.

References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989


Originally posted in
http://knol.google.com/k/narayana-rao/wages/   2utb2lsm2k7a/235


Updated 4 July 2020
11 December 2011

The Economic Theory of Entrepreneurship - Model - Introduction, Assumptions and Propositions

The Economic Theory of Entrepreneurship - Model - Introduction,  Assumptions and Propositions - Version 1

27 October 2018
Prof. Narayana Rao K.V.S.S.

Introduction

Economic theory is developed on the basis of four factors of production. The four factors are land, labor, capital and entrepreneurship.  The factors are owned by some or other persons in the economy at a given point of time. In every period of production, these four factors participate and the production output of the period is distributed to them according to the contracts that they make at the beginning of the production period.

Land and capital are tangible assets separate from persons and they can be given to others. Labor and entrepreneurship are attached to persons and their use implies participation of persons.

Entrepreneur enters into a contract with the owners or holders of land, capital and labor and acquires the required amount to participate in his plan of production. Entrepreneur distributes the proceeds of rewards after the production period is over and sales takes place and the consumers pay him the exchange value.  The way entrepreneurship is described or modeled in the economic theory, implies that there is an active credit market through which entrepreneurs acquire other factors of production.

All owners of factors of production have to survive till they get returns from production and exchange process. Hence, we need to assume that there is enough consumption goods stock with the owners of production to consume during the production cycle.

Entrepreneur tasks.

1. Should be able to come out with a production and exchange plan that is feasible at expected value level and satisfies the desires of owners of factors of production and consumers.

2. He must create trust in the owners of factors of production so that they provide their goods and services on credit to him.

3. He must have trust in potential customers so that he gives his produce on credit to them.

4. He must have the ability to collect exchange value  from the customers to whom he sold his produce on credit.

What are the questions to be answered by the economic theory of entrepreneurship?

1. Supply of entrepreneurship services.
2. Demand for entrepreneurship services.
3. Reward to entrepreneurship.
4. Growth and decline of entrepreneurship services
5. Role of entrepreneurship in economic growth of society.

Managerial Tasks of an Entrepreneur

Management theory has application in the economic theory of entrepreneurship.  Entrepreneurs have to undertake managerial tasks to successfully complete the cycle of entrepreneurship. The cycle of entrepreneurship is  -----------  Production and Exchange Plan - Communication of the Plan to  Owners of Factors of Production - Acquisition of Factors of Production - Execution of Production Process - Communication of Product/Service Information in the Market - Selling - Collection of the Exchange Value - Payment to Owners of Factors of Production. 

The Cycle of Entrepreneurship

Production and Exchange Plan - Communication of the Plan to  Owners of Factors of Production - Acquisition of Factors of Production - Execution of Production Process - Communication of Product/Service Information in the Market - Selling - Collection of the Exchange Value - Payment to Owners of Factors of Production.

Bibliography - The Economic Theory of Entrepreneurship

Nash, S. J.,
Thesis title : On entrepreneurship : a critique of the economic theories of entrepreneurship
School of Economics, University of Queensland, 1987-01-01
https://espace.library.uq.edu.au/view/UQ:222083


Formaini, Robert L.
The Engine of Capitalist Process: Entrepreneurs in Economic Theory
Economic and Financial Review, Fourth Quarter 2001, Federal Reserve Bank of Dallas


Khalil, Elias
Entrepreneurship and Economic Theory
Munich Personal Repec Archive
October 2016
https://www.researchgate.net/publication/24114234_Entrepreneurship_and_Economic_Theory/download


Rocha Very Caterina
The Entrepreneur in Economic Theory: From an Invisible Man Toward a New Research Field.
FEP Working Papers, No. 459, May 2012
School of Economics and Management, University of Porto.


Gunter, Frank R.
A Simple Model of Entrepreneurship for Principles of Economics Courses
Expanded version of the article published in the Journal of Economic Education, Vol. 43, No. 4, 2012, pp. 1-11.




Tiryaki, Ahmet
Theories of Entrepreneurship: A Critical Overview
Paper avaiable on Web/Internet


Campagnollo, Gilles, & Vivel, Christel
The Foundations of the Theory of Entrepreneurship in Austrian Economics - Menger, Bohm-Bawerk on entrepreneur

International Trade Theory and Issues

Economics Concepts, Theories and Practices for Managers

International trade is going on for ages. There are conventional reasons for the existence for trade among kingdoms or nations.

Conventional Sources of international trade:

1. Diversity in conditions of production

Tropical reagions are suitable for certain products and temperate regions are suitable for certain other products.

2. Decreasing costs due to scale

Due economies of scale, a country which has taken lead in production of a product can increase scale of production and reduce costs further. Thus other countries may buy that product from this country lower cost of production.

3. Differences in tastes

The people of a country may have taste for a product and for the shortfall in the availability of their country may import from another country.

Unconventional Reason: The principle of comparative advantage

Each country will specialize in the production and export of those goods that it can produce at relatively low cost. This principle is unconventional because, this proposition brings out the idea that even though one country is absolutely more productive or efficient in all the items compared to another country, it is better off by exporting items in which it has relatively higher productivity advantage and importing products in which it has relatively lower advantage.

This makes trade between a developed and developing country possible.

The principle was first explained by David Ricardo.

Illustration: USA is a unit of food costs 1 hour of labor and a unit of clothing costs 2 hours of labor.
In Europe, one unit of food costs 3 hours of labor and a unit of clothing costs 4 hours of labor.
This means that  1 unit of food is equal to 0.5 units of cloth in USA.
1 unit of food is equal to 3/4 units of cloth in Europe.
Cloth is exported to USA and food is bought with it till relative prices are equal. Let us say relative price become equal at 2/3. It means in USA 1 unit of food buy 2/3 units of cloth. In Europe also one unit of food is equal to 2/3 times of cloth.

In the situation of after trade, the USA persons have to spend only 2 and half hours to get 1 unit of food and one unit of cloth. Earlier, before trade he has to spend 1 hour for food and two hours for cloth. So he is better of.

Similarly the European needs to spend only 6 and 2/3 hours for 1 unit of food and 1 unit of cloth instead of 7 hours. So he is also better of.


Absolute and Comparative Advantage
genehayward
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References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989


Updated 8 July 2017,  23.12.2012, 11 December 2011

Exchange Rates: Markets Regulation and International Financial System

Economics Concepts, Theories and Practices for Managers

International trade is beneficial as it increases real wages. This idea is based on the benefits of trading based on comparative advantage. But payments in international trade are based on two different currecies. A person in USA has to pay a British seller pounds to buy goods. It means a US person has to first buy pounds using his dollars. The number of dollars a US citizen has to pay for each pound is the exchange rate for pound expressed in terms of dollar.

On 24.12.2012, one pound requires 1.62 dollars. Any US person who wants pounds has to buy pounds at this exchange rate.

How are there rates (exchange rates) determined?

For foreign exchange also there are markets like there are markets for various commodities. The markets operate on the basis of demand and supply for a currency. The demand for British pounds with respect to dollars come from the people who want to buy  British goods, services and assets. Supply of pounds come from British people who want to buy US goods, services and assets. The equilibrium price for the currency is at the intersection of these two curves at any point in time.

Changes in Demand Curve

The demand for British pounds from US citizens can change due to various reasons. Like, if there is better substitute produced locally in US itself, the demand for British item may go down and consequently, the demand for British pound will go down. The demand curve will shift to the left and exchange rate for Pound will go down.

The balance of supply and demand for foreign exchange determines the foreign exchange rate of a currency. It can fluctuate day by day and period by period.


When a country's foreign exchange rate has declined relative to that of another country, we say that the domestic currency has depreciated while the foreign currency has appreciated.

Government try to regulate exchange rates. When a country's official exchange rate (or policy rate) is lowered we say that the currency has undergone a devaluation.

Three major exchange rate systems are the gold standard, pure floating exchanged rates and managed floating exchange rates.


References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Introduction to Exchange Rates and Forex Markets

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Jason Welker

Updated 8 July 2017, 11 December 2011

Economic Model Based on Ekatma Manav Darshan (Integral Humanism)

First Published on 24 January 2016, 1.52 pm (Indian Standard Time)




|Self Interest, Others' Interests, Freedom subject to Principles of Dharma|
| (Kama),        (Moksh)                 (Dharma)                                               |






                                                       Leads to



| Individual learning,  Individual Activity, Increase in Knowledge,  Innovation, Major Adventures|
|     (Dharma),                 (Karma)                   (Jnana)                                         (Rajayogic ventures|


                                                        In turn leads to

|Growth in Wealth, Social stability, Socially Committed People|
|  (Artha,                                                     (Bhakti)                     |

Ideas for enlarging the model.

In the intermediate step we can include activities of  Consumers and Social Sector Organizations, Government and Political Parties, Business Organizations and Trade Unions. Thus we identify and brings activities of people in the society into the model.

Bhakti can be interpreted commitment to the society, commitment to the organizations and to the people managing the organizations. Commitment will come only when people take care of desires of other people (stakeholders) apart from their own.


Reference

Self Interest: The Economist's  Straight Jacket
Robert Simons, Professor, Harvard Business School
Working Paper, 2015
http://www.hbs.edu/faculty/Publication%20Files/16-045_2276e3cd-ab73-4ee8-b494-59488e6e1f0b.pdf





Deendayal Upadhyaya - Biography and Philosophy - Integral Humanism




POSTULATES OF HINDUTVA THEORY OF ECONOMIC DEVELOPMENT - Intergral Humanism - Subramanian Swamy
http://guide-india.blogspot.com/2016/01/postulates-of-hindutva-theory-of.html

A “postulate” (noun) is a statement that someone claims to be true and upon which
further discussion is based.
http://www.capitalism21.org/wp-content/uploads/2011/09/IMN-Paper-9-Postulates.pdf

Towards a Framework for a Hindu Economic Model
By Lall B. Ramrattan, Ph.D., UC Berkeley Extensionhttp://dharmacivilization.com/2012/11/towards-a-framework-for-a-hindu-economic-model/



Updated 26 Jan 2016, 24 Jan 2016

Alternative Economic Systems - Review Notes

The system described in detail by Samuelson is Mixed Capitalist Economy.

This is the economic system of advanced democracies of world today. It accounts for 60 percent of world income.

Marxism and socialism are important alternative economic systems.

Development or Evolution of Economic Thought

Aristotle wrote on economic issues also.

First systematic thinkers were mercantilists of the 17th and 18th centuries. They advocated the accumulation of gold and silver to improve the military and economic power of a state.

David Hume (1711-1776) showed how gold inflow would eventually end up raising prices rather than output. Physiocrats put forward arguments against mercantile thought excesses and argued that agriculture is the only source of economic surplus.

Modern economic claims its roots to 'The Wealth of Nations' by Adam Smith published in 1776.

T.R. Malthus (1766-1834) enuniciate the iron law of wages.

David Ricardo (1772-1823) believed that there were basic errors in Smith's analysis and attempted to provide alternative ideas. He wrote Principles of Political Economy and Taxation in 1817.

One of his major achievements was to analyze the laws of income distribution in a capitalist economy.

John Stuart Mill wrote his classic 'Principles of Political Economy'.

Economics developed a branch with the writings of Marx, Capital (1867, 1885, 1894). But the tradition of Adam Smith and David Ricardo was continued by W.Stanley Jevons, Carl Menger, and John Maynard Keynes.

The Keynesian Revolution

The great depression made Keynes to come out with General theory of Employment, Interest, and Money (Macmillan,1936). Economists were inspired to understand why wages and prices tend to be sticky, why nominal variables like money have real impacts, and how government fiscal and monetary policies affect the macroeconomy.


Criticism of Capitalistic System by Some Economists  (Characterised as Dissent from Left by Samuelson)

John Kenneth Galbraith: Wrote American Capitalismm, The Affluent Society, and the New Industrial State.

Todays economies are directed by large bureaucracies and perfectly competitive markets do not exist.
Consumers are not masters of their own minds. Advertising shapes preferences.
Public sector is starving and private sector is flourishing. Parks, roads, and bridges etc. are not built adequately and maintained properly.

MIT's Lester Thurow, Harvard's Robert Reich, and others argued for redesigning the work place on cooperative rather than competitive lines.

One important suggestion of this group of economists is introduction of profit sharing in place of fixed wages. MIT's Martin Weitzman has analyzed this type of system According to him profit sharing system,will result in lower marginal cost of labor.

Marxism

Marx's advocated labor theory of value. what gives value to a product is the amount of direct labor and indirect labor embodied in it. In the capitalist system, profit is earned by paying only part of the labor value to the workers. As capital goes on accumulating, profits fall and capitalist pay less and less to workers and make them live a subsistence life.

Socialism

Socialists believed that the role of private property should be reduced and key industries should be run by government.





References

Paul Samuelson and William D. Nordhaus, Economics, 13th Edition, McGraw-Hill, 1989

Originally posted in
http://knol.google.com/k/narayana-rao/alternative-economic-systems/2utb2lsm2k7a/241




Updated 20 January 2016, 11 Dec 2011



INVITATION FOR SEMINAR ON   “EKATMA MANAV DARSHAN AS A PRACTICAL ALTERNATIVE”

In view of the birth centenary year of Pt. Deendayal Upadhyaya, (Propounder of Ekatma Manav-vad), Deendayal Prerana Kendra and Ekatma Prabodh Mandal have organized a seminar on Ekatma Manav Darshan as per details below:

Theme: EKATMA MANAV DARSHAN AS A PRACTICAL ALTERNATIVE

Place: SHRIRAM VYAYAMSHALA HALL, OPP.GADAKARI RANGAYATAN, THANE WEST

Time: WEDNESDAY, 10TH FEBRUARY 2016, 4.30 TO 7.45 PM

Session 1: Ekatma Manav Darshan & Capitalism by Dr. KVSS Narayana Rao
Session 2: Ekatma Manav Darshan & Globalization by Dr. Varadraj Bapat
Session 3: Ekatma Manav Darshan – In Practice by Dilip Kelkar
Session 4: Samarop: DR. SATISH MODH,  Director, Vivekanand Institute of Mgt, Chembur

DEENDAYAL PRERANA KENDRA 2/27 Kalpana Sahaniwas, Sahyog Mandir Path, Naupada, Thane (W)

EKATMA PRABODH MANDAL (Activity of Ekatma Vikas Samiti, Public Trust) B105 Vatsalyadeep, Krantiveer Phadke Marg, Mulund East, Mumbai 400081 Tel: 25639654, Email: ekatmaprabodh at the rate gmail.com

Interesting Quotations by Adam Smith - From The Wealth of Nations

In the progress of society, philosophy or speculation becomes, like every other employment, the principal or sole trade and occupation of a particular class of citizens. Like every other employment too, it is subdivided into a great number of different branches, each of which affords occupation to a peculiar tribe or class of philosophers; and this subdivision of employment in philosophy, as well as in every other business, improves dexterity, and saves time. Each individual becomes more expert in his own peculiar branch, more work is done upon the whole, and the quantity of science is considerably increased by it.  (I.1.9)

The improvements in agriculture and manufactures seem likewise to have been of very great antiquity in the provinces of Bengal in the East Indies, and in some of the eastern provinces of China; though the great extent of this antiquity is not authenticated by any histories of whose authority we, in this part of the world, are well assured. In Bengal the Ganges and several other great rivers form a great number of navigable canals*56 in the same manner as the Nile does in Egypt. In the Eastern provinces of China too, several great rivers form, by their different branches, a multitude of canals, and by communicating with one another afford an inland navigation much more extensive than that either of the Nile or the Ganges, or perhaps than both of them put together. It is remarkable that neither the antient Egyptians, nor the Indians, nor the Chinese, encouraged foreign commerce, but seem all to have derived their great opulence from this inland navigation. (I.3.7)


Every prudent man in every period of society, after the first establishment of the division of labour, must naturally have endeavoured to manage his affairs in such a manner, as to have at all times by him, besides the peculiar produce of his own industry, a certain quantity of some one commodity or other, such as he imagined few people would be likely to refuse in exchange for the produce of their industry. (I.4.2)

Many different commodities, it is probable, were successively both thought of and employed for this purpose. In the rude ages of society, cattle are said to have been the common instrument of commerce; and, though they must have been a most inconvenient one, yet in old times we find things were frequently valued according to the number of cattle which had been given in exchange for them. (I.4.3)

In all countries, however, men seem at last to have been determined by irresistible reasons to give the preference, for this employment, to metals above every other commodity. (I.4.4)

Different metals have been made use of by different nations for this purpose. Iron was the common instrument of commerce among the antient Spartans; copper among the antient Romans; and gold and silver among all rich and commercial nations. (I.4.5)



As soon as stock has accumulated in the hands of particular persons, some of them will naturally employ it in setting to work industrious people, whom they will supply with materials and subsistence, in order to make a profit by the sale of their work, or by what their labour adds to the value of the materials. In exchanging the complete manufacture either for money, for labour, or for other goods, over and above what may be sufficient to pay the price of the materials, and the wages of the workmen, something must be given for the profits of the undertaker of the work who hazards his stock in this adventure. The value which the workmen add to the materials, therefore, resolves itself in this case into two parts, of which the one pays their wages, the other the profits of their employer upon the whole stock of materials and wages which he advanced. He could have no interest to employ them, unless he expected from the sale of their work something more than what was sufficient to replace his stock to him; and he could have no interest to employ a great stock rather than a small one, unless his profits were to bear some proportion to the extent of his stock. (I.6.5)

The profits of stock, it may perhaps be thought, are only a different name for the wages of a particular sort of labour, the labour of inspection and direction. They are, however, altogether different, are regulated by quite different principles, and bear no proportion to the quantity, the hardship, or the ingenuity of this supposed labour of inspection and direction. They are regulated altogether by the value of the stock employed, and are greater or smaller in proportion to the extent of this stock. (I.6.6)

The market price of any particular commodity, though it may continue long above, can seldom continue long below, its natural price. Whatever part of it was paid below the natural rate, the persons whose interest it affected would immediately feel the loss, and would immediately withdraw either so much land, or so much labour, or so much stock, from being employed about it, that the quantity brought to market would soon be no more than sufficient to supply the effectual demand. (I.7.30)


In that original state of things, which precedes both the appropriation of land and the accumulation of stock, the whole produce of labour belongs to the labourer. He has neither landlord nor master to share with him. (I.8.2)



Book I, Chapter IX
Of the Profits of Stock

It may be laid down as a maxim, that wherever a great deal can be made by the use of money, a great deal will commonly be given for the use of it; and that wherever little can be made by it, less will commonly be given for it.*51 According, therefore, as the usual market rate of interest varies in any country, we may be assured that the ordinary profits of stock must vary with it, must sink as it sinks, and rise as it rises. The progress of interest, therefore, may lead us to form some notion of the progress of profit. (I.9.4)

Book I, Chapter X
Of Wages and Profit in the Different Employments of Labour and Stock


Book I, Chapter XI
Of the Rent of Land


I shall conclude this very long chapter with observing*217 that every improvement in the circumstances of the society tends either directly or indirectly to raise the real rent of land, to increase the real wealth of the landlord, his power of purchasing the labour, or the produce of the labour of other people. (I.11.255)



Book II
Of the Nature, Accumulation, and Employment of Stock




II.1.3
There are two different ways in which a capital may be employed so as to yield a revenue or profit to its employer.

II.1.4
First, it may be employed in raising, manufacturing, or purchasing goods, and selling them again with a profit. The capital employed in this manner yields no revenue or profit to its employer, while it either remains in his possession, or continues in the same shape. The goods of the merchant yield him no revenue or profit till he sells them for money, and the money yields him as little till it is again exchanged for goods. His capital is continually going from him in one shape, and returning to him in another, and it is only by means of such circulation, or successive exchanges, that it can yield him any profit. Such capitals, therefore, may very properly be called circulating capitals.

II.1.5
Secondly, it may be employed in the improvement of land, in the purchase of useful machines and instruments of trade, or in suchlike things as yield a revenue or profit without changing masters, or circulating any further. Such capitals, therefore, may very properly be called fixed capitals.


Book II, Chapter II
Of Money Considered as a particular Branch of the General Stock of the Society, or of the Expence of Maintaining the National Capital


Book II, Chapter III
Of the Accumulation of Capital, or of Productive and Unproductive Labour



Book IV

IV.9.3
Mr. Colbert, the famous minister of Lewis XIV. was a man of probity, of great industry and knowledge of detail, of great experience and acuteness in the examination of public accounts, and of abilities, in short, every way fitted for introducing method and good order into the collection and expenditure of the public revenue. That minister had unfortunately embraced all the prejudices of the mercantile system, in its nature and essence a system of restraint and regulation, and such as could scarce fail to be agreeable to a laborious and plodding man of business, who had been accustomed to regulate the different departments of public offices, and to establish the necessary checks and controls for confining each to its proper sphere.

The industry and commerce of a great country he endeavoured to regulate upon the same model as the departments of a public office; and instead of allowing every man to pursue his own interest in his own way, upon the liberal plan of equality, liberty, and justice, he bestowed upon certain branches of industry extraordinary privileges, while he laid others under as extraordinary restraints.


Mr. Quesnai, who was himself a physician, and a very speculative physician, seems to have entertained a notion of the same kind concerning the political body, and to have imagined that it would thrive and prosper only under a certain precise regimen, the exact regimen of perfect liberty and perfect justice. He seems not to have considered that, in the political body, the natural effort which every man is continually making to better his own condition is a principle of preservation capable of preventing and correcting, in many respects, the bad effects of a political œconomy, in some degree, both partial and oppressive. Such a political œconomy, though it no doubt retards more or less, is not always capable of stopping altogether the natural progress of a nation towards wealth and prosperity, and still less of making it go backwards. If a nation could not prosper without the enjoyment of perfect liberty and perfect justice, there is not in the world a nation which could ever have prospered. In the political body, however, the wisdom of nature has fortunately made ample provision for remedying many of the bad effects of the folly and injustice of man, in the same manner as it has done in the natural body for remedying those of his sloth and intemperance. (IV.9.28)




Online copy of the book
http://www.econlib.org/library/Smith/smWN19.html#firstpage-bar

Ch. 22: COST CURVES - Summary - Intermediate Microeconomics - Varian

Ch. 22: COST CURVES

Topics in the chapter

22.1 Average Costs
22.2 Marginal Costs
22.3 Marginal Costs and Variable Costs
22.4 Cost Curves for Online Auctions

22.5 Long-Run Costs
22.6 Discrete Levels of Plant Size
22.7 Long-Run Marginal Costs





The cost curve is an important geometric construction in economics.  Cost curves can be used to depict graphically the cost function of a firm and  to study the determination of optimal output choices.

Different types of cost curves

(1) Total cost: c(y) = cv(y) + F



cv(y)= variable costs

F= Fixed costs



(2) Average costs: c(y)/y



 =                 +

AC        AVC AFC

Average Average Average

costs variabel fixed

costs costs






Example: c(y) = y3- y2 + 4y + 12



(3) Marginal costs: the derivative of the cost curve

dc(y)/dy = dcv(y)/dy



c’(y)

MC is the change in cost due to change in output

MC equals AVC at zero output

MC goes through minimum point of AC and AVC





(4) Area under MC-curve gives the total Variable Costs



cv(y)=

example: MC=y2



Intuitively: MC-curve measures the cost of each

additional unit,

so adding up MCs gives the variable costs.



Long run and short run



(1) Average costs


(2) Marginal costs

Important Points

22.1 Average Costs

1. Average costs are composed of average variable costs plus average fixed
costs. Average fixed costs always decline with output, while average variable
costs tend to increase. The net result is a U-shaped average cost
curve.

22.2 Marginal Costs

2. The marginal cost curve lies below the average cost curve when average
costs are decreasing, and above when they are increasing. Thus marginal
costs must equal average costs at the point of minimum average costs.



3. The area under the marginal cost curve measures the variable costs.

4. The long-run average cost curve is the lower envelope of the short-run
average cost curves

Ch. 1. The Market - Summary - Intermediate Microeconomics - Varian

The Market



1.1 Constructing a Model


Example of an economic model — The market for rented apartments is discussed in this book.


1. Models are simplifications of reality. From the real situation many complicated issues are ignored and only few important issues are considered for analysis using models.
2. For example, we assume all apartments are identical (In reality they are not)
3. Some are close to the university, others are far away
4. Rental price of outer-ring apartments is exogenous — determined outside the model (we are not analyzing)
5. price of inner-ring apartments is endogenous — determined within the model (We want to analyze and find out.)


1.2 Optimization and Equilibrium

 Two principles of economics

1. Optimization principle — people choose actions that are in their interest. They want to buy a specific quantity of goods at various prices to increase benefit to them
2. Equilibrium principle — Market prices adjust so that people who want to buy can buy and people who want to sell can sell the quantities of their choice. Thus the intentions of buyers and sellers become consistent with each other with varying prices and quantities.


1.3 The Demand Curve
Constructing the demand curve

1. Find the rent each person is willing to pay and draw a graph in descending order with rent on the y axis.

2. If there are large numbers of people, this curve can become a smooth curve. Otherwise it will be a step curve.


Reserve Price: Economists call a person’s maximum willingness to pay for something that person’s reservation price. The reservation price is the highest price that a given person will accept and still purchase the good.


1.4 The Supply Curve

Supply curve

1. depends on time frame
2. but we’ll look at the short run—when supply of apartments
is fixed.


1.5 Market Equilibrium
Equilibrium
1. when demand equals supply
2. price that clears the market


1.6 Comparative Statics
Comparative statics
1. how does equilibrium adjust when economic conditions change?
2. “comparative” — compare two equilibria
3. “statics” — only look at equilibria, not at adjustment
4. example — increase in supply lowers price;
5. Complicated example — convert somee rental apartments into  condos which can be  purchased by renters; no effect on price;

1.7 Other Ways to Allocate Apartments
 Other ways to allocate apartments
1. discriminating monopolist
2. ordinary monopolist
3. rent control

1.8 Which Way Is Best?
Comparing different institutions

1. need a criterion to compare how efficient these different
allocation methods are.


1.9 Pareto Efficiency


an allocation is Pareto efficient if there is no way to make
some group of people better off without making someone else
worse off.
if something is not Pareto efficient, then there is some way
to make some people better off without making someone else
worse off.
if something is not Pareto efficient, then there is some kind
of “waste” in the system.


1.10 Comparing Ways to Allocate Apartments

Checking Pareto efficiency of different methods
1. free market — efficient
2. discriminating monopolist — efficient
3. ordinary monopolist — not efficient
4. rent control — not efficient


1.11 Equilibrium in the Long Run
In long run supply will change
We have to  examine efficiency in this context as well.


Important Points

1. Economics proceeds by making models of phenomena of interest. Models are simplified representations of reality and using these models our questions of interest can be answered.

2. Economists are guided by  two important principles. The optimization principle, which
states that people typically try to choose what’s best for them, and by the equilibrium principle, which says that prices will adjust until demand (quantity demanded at the price) and supply (quantity sellers are willing to sell at that price) are equal.

3. The demand curve measures how much people wish to demand at each price, and the supply curve measures how much people wish to supply at each price.

4. An equilibrium price is one where the amount demanded equals the amount supplied.

5. The study of how the equilibrium price and quantity change when the underlying conditions (conditions that change demand curves and supply curves) change is known as comparative statics.

6. Markets  and plans are analyzed on the basis of Pareto efficiency. An economic situation is Pareto efficient if there is no way to make some group of people better off without making some other group of people worse off. The concept of Pareto efficiency can be used to evaluate different ways of allocating resources either based on markets or central planning.

Ch. 26. Monopoly Behavior - Summary - Intermediate Microeconomics - Varian

26. Monopoly Behavior




If a firm has some degree of monopoly power, it can use  complicated pricing and marketing strategies to earn profits higher than that of firms in competitive market. It can try to differentiate its product from the products sold by its competitors to create extra preference for its product in the market thus enhance its market power even further than that allowed by technology alone.
In this chapter the topic of  how firms can enhance and exploit their market power is explained.

26.1 Price Discrimination

Selling different units of output at different prices is called price discrimination. Three kinds of price discrimination are recognized.


First-degree price discrimination means that the monopolist sells different units of output for different prices and these prices may differ from person to person. This is also termed as the case of perfect
price discrimination.


In second-degree price discrimination,  the monopolist sells different units of output for different prices, but every individual who buys the same amount or quantity of the good pays the same price. The prices differ across the units of the good bought, and not across people. A  simple  example
of this is bulk discounts or discount for higher quantity.

In third-degree price discrimination,  the monopolist sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This means he quotes the same price to a buyer irrespective of the quantity bought. Also this can occur across categories of persons, For example,  senior citizens’ discounts, student discounts come under this type of discrimination. .


26.2 First-Degree Price Discrimination

A producer who is able to perfectly price discriminate will sell each unit of the good at the highest price it will command, that is, at each consumer’s reservation price. Since each unit is sold to each consumer at his or her reservation price for that unit, there is no consumers’ surplus generated in
this market; all the surplus goes to the producer.


26.3 Second-Degree Price Discrimination

Second-degree price discrimination is also known as the case of nonlinear pricing, since it means that the price per unit of output is not constant but depends on how much you buy.

26.4 Third-Degree Price Discrimination

Two different consumer groups or markets are offered different prices.

The market with the lower elasticity of demand will have higher price. This is because, an elastic demand provide more profit as price is decreased.  A firm that price discriminates will therefore set a low price for the price-sensitive group and a high price for the group that is relatively price insensitive. In this way it maximizes its overall profits.


26.5 Bundling
26.6 Two-Part Tariffs
26.7 Monopolistic Competition
26.8 A Location Model of Product Differentiation
26.9 Product Differentiation
26.10 More Vendors


Important Points


1. A monopolist has  an incentive  to engage in price discrimination of some sort.

2. Perfect price discrimination involves charging each customer a different take-it-or-leave-it price. This is a Pareto efficient allocation. (But consumer surplus will be low in this allocation)

3. If a firm can charge different prices in two different markets, it will tend to charge the lower price in the market with the more elastic demand (because elastic demand gives more profit on reducing price).

4. If a firm can set a two-part tariff, and consumers are identical, then it will generally want to set price equal to marginal cost and make all of its profits from the entry fee.

5. The industry structure known as monopolistic competition refers to a situation in which there is product differentiation, so each firm has some degree of monopoly power, but there is also free entry so that profits are driven to zero.

6. Monopolistic competition can result in too much or too little product differentiation in general.


________________________
________________________



max         p1(y1)y1 + p2(y2)y2 − c(y1 + y2).
y1,y2

The optimal solution must have
MR1(y1) = MC(y1 + y2)
MR2(y2) = MC(y1 + y2).

That is, the marginal cost of producing an extra unit of output must be equal to the marginal revenue in each market.

________________________

________________________

Ch. 25. Monopoly - Summary - Intermediate Microeconomics - Varian

25. Monopoly


In this chapter we  consider an industry structure when there is only one firm in the industry—a monopoly.

A monopoly would recognize that it can influence the market price by its choice of supply quantity and choose that level of price and output that maximized its overall profits.


The difference

Perfect competition: All firms are price takers

Monopoly: The monopolist decides market output and price



24.1 Maximizing Profits

B. Profit maximization

(1) =TR(y)-TC(y)

max  when =0

MR-MC=0  MR = MC



Marginal revenue Marginal cost





(2) TR(y) = p(y)*y

MR(y)= p(y)*1+ y

Note:

Perfect competition: MR=price

For a monopolist: MR  price. Why?



(3) Examples


24.4 Inefficiency of Monopoly

 Ineffiency of monopoly



24.6 Natural Monopoly

Natural monopoly - theory of regulation





(1) Definition: Decreasing AC

MC < AC Why?



(2) Examples of natural monopolies

Railroad tracks

Utilities etc



(3) No regulation: MC=MR

fig.



MR  price  MC  price

Efficient ressource use when MC=price.

Why?



(4) Regulation regimes

(a) Price=MC

 Price< AC

 Need to subsidise the monopolist

 Note: Efficiency loss by taxation

(b) Price=AC

 =0

 Efficiency loss?


24.7 What Causes Monopolies?




Important Points


1. When there is only a single firm in an industry, we say the market is a monopoly market and the firm is a monopolist.

2. A monopolist operates at a point where marginal revenue equals marginal cost to get maximum profit for him.. Hence a monopolist charges a price (average price) that is a markup on marginal
cost.  The price or  the size of the markup depends on the elasticity of demand.

3. The monopoly market will produce an inefficient amount of output. The size of the inefficiency can
be measured by the deadweight loss—the net loss of consumers’ and the producer’s surplus.

4. A natural monopoly occurs when a firm cannot operate at an efficient level of output  as per the with marginal cost analysis without losing money. Hence they are to be allowed to operate in a market that has monopoly features and hence allows it to fix price to get profit.  Many public utilities come under the category of  natural monopolies  and are therefore regulated by the government.


5. Whether an industry is competitive or monopolized depends in part on the nature of technology. If the minimum efficient scale is large relative to demand, then the market is likely to be monopolized because only limited number of firms can be in the market and operate at the efficient scale. But if the minimum efficient scale is small relative to demand, there is room for many firms in
the industry, and  a competitive market structure may emerge.

Ch. 16. Equilibrium - Summary - Intermediate Microeconomics - Varian

16. Equilibrium

In this chapter we will describe how to use these market demand curves to determine the equilibrium market price (Refer 1.5 Market Equilibrium).

We will not study in detail, but give some examples of equilibrium analysis—how the prices adjust
so as to make the demand and supply decisions of economic agents compatible. In order to do so, we need to introduce  briefly the other side of the market—the supply side.


16.1 Supply

A. Supply curves -

Measures amount suppliers want to supply at each price

How do we derive supply curves:

Technology

Minimize costs - producing y units

Factor demand

Cost function

Firms supply when marginal cost =price

Aggregate supply fn.: S(p)

Inverse supply fun: Ps(q)



B. Demand curves





Measures amount consumers want to buy at each price

How do we derive demand curves:

Preferences

Max. utility - budget restriction

Individual demand

Aggregate individuals demand function: D(p)

Inverse demand function: Pd (q)







16.2  Equilibrium

(1) Competitive market - each agent price taker



(a) Many small agents

(b) A few agents who think that the others keep fixed prices



(2) Example:



Demand: q= 5-p Supply: q = -2 + p



Inverse d.: p=5-q Inverse s.: p=2+q



16.3  Two special cases of Market Equilibrium



(1) Vertical supply

Perfectly inelastic supply

Example:

Short run supply of apartments



(2) Horizontal supply

Perfectly elastic supply



Example:

When a small country imports goods from the

world market, the country won’t influence the market

price. Supply is horizontal.


16.4 Inverse Demand and Supply Curves


16.5. Comparative statics (Refer 1.6 Comparative Statics)



(1) What happens with (q*, p*) when Supply (or Demand) changes?



Shift the Supply curve (or Demand), and get a new
equilibrium.



(2) Example: tax per unit: t.

New supply curve: Ps + t



New equilibrium when Pd = Ps+ t

Ch. 15. Market Demand - Summary - Intermediate Microeconomics - Varian

15. Market Demand

Analysis of Elasticity


In this chapter, we see how to add up individual choices to get total market demand.
Once the market demand curve is obtained, we examine some of its properties, such as the relationship between demand and revenue (elasticity).



15.1 From Individual to Market Demand

To get M.D. - add up individual demands



Add horizontally


X1(p1, p2, m1, m2 ... mn) =





Often think of market behaving like a single individual



(1) The "representative consumer model"



(2) Not true in general, but a reasonable assumption for this course



15.5 Elasticity

Elasticity

(1) Measures responsiveness of demand to price

(2)  E =  (the own price elasticity)

(a) E < 0: Normal goods

(b) E> 0: Giffen goods

(c)  > 1 Elastic

(d)  < 1 Inelastic

(c) (d)

----------------1-------------0-------------------

(a) (b)



(3) Example: Linear demand



q= a-bp

Eq,p=(-b)=



Note: Elasticity is in the linear case a function of p and q

(4) Demand curve with constant elastisticity

q= Apa (e<0. Why?)

E= a

(5) "Tendency":



Goods with many close substitutes - elastic demand



Goods without close substitutes - inelastic demand



15.7 Elasticity and Revenue

How does revenue change when you change price?



(1) Revenue= quantity x price

R=qp



dR/dp = q + p(dq/dp)



dR/dp > 0 when  < 1. Why?

Inelastic demand - 1 % price increase leads to less than 1% reduction in quantity sold.



dR/dp < 0 when  > 1.



Monopolist: Maximizes R when

  = 1



(2) Example: q(p) = 30 - 2q





G. Some other elasticities


15.11 Income Elasticity


(1) Income elasticity

Eq,m =

Eq,m > 0 Normal good

Eq,m < 0 Inferior good







(2) Cross price elasticity

E q,p2 =



Good 1 and 2 are substitutes if

E q,p2 > 0



Good 1 and 2 are complementary goods if

E q,p2 < 0


Important Points

15.1

1. The market demand curve is simply the sum of the individual demand
curves.

2. The reservation price measures the price at which a consumer is just
indifferent between purchasing or not purchasing a good.

15.2

3. The demand function measures quantity demanded as a function of
price. The inverse demand function measures price as a function of quantity.
A given demand curve can be described in either way.

15.5 Elasticity

4. The elasticity of demand measures the responsiveness of the quantity
demanded to price. It is formally defined as the percent change in quantity
divided by the percent change in price.

15.6

5. If the absolute value of the elasticity of demand is less than 1 at some
point, we say that demand is inelastic at that point. If the absolute value
of elasticity is greater than 1 at some point, we say demand is elastic at
that point. If the absolute value of the elasticity of demand at some point
is exactly 1, we say that the demand has unitary elasticity at that point.

15.7

6. If demand is inelastic at some point, then an increase in quantity will
result in a reduction in revenue. If demand is elastic, then an increase in
quantity will result in an increase in revenue.

15.9

7. The marginal revenue is the extra revenue one gets from increasing
the quantity sold. The formula relating marginal revenue and elasticity
is MR = p[1 + 1/ ] = p[1 − 1/| |].

15.10

8. If the inverse demand curve is a linear function p(q) = a − bq, then the
marginal revenue is given by MR = a − 2bq.

9. Income elasticity measures the responsiveness of the quantity demanded
to income. It is formally defined as the percent change in quantity divided
by the percent change in income.

29. Game Theory - Summary - Intermediate Microeconomics - Varian

29. Game Theory


29.1 The Payoff Matrix of a Game
29.2 Nash Equilibrium
29.3 Mixed Strategies
29.4 The Prisoner’s Dilemma
29.5 Repeated Games
29.6 Enforcing a Cartel
29.7 Sequential Games
29.8 A Game of Entry Deterrence


Game theory is concerned with the general analysis of strategic interaction.

In this chapter we discuss the basics of the subject and explore how it works and how it can be used to study economic behavior in oligopolistic markets.


Game Theory
Game theory studies strategic interaction, developed by von Neu-
mann and Morgenstern around 1950


How to depict payoffs of game from different strategies
1. two players
2. two strategies
3. example

Dominant strategy
Each person has a strategy that is best no matter what the
other person does
Nice when it happens, but doesn’t happen that often

Nash equilibrium
1. what if there is no dominant strategy?
2. in this case, look for strategy that is best if the other player
plays his best strategy
3. note the “circularity” of definition
4. appropriate when you are playing against a “rational” oppo-
nent
5. each person is playing the best given his expectations about
the other person’s play and expectations are actually con-
firmed
6. example


7. Nash equilibrium in pure strategies may not exist.

8. but if allow mixed strategies (and people only care about
expected payoff), then Nash equilibrium will always exist

Prisoner’s dilemma
1. 2 prisoners, each may confess (and implicate other) or deny
2. gives payoff matrix

3. note that (confess, confess) is unique dominant strategy
equilibrium, but (deny, deny) is Pareto efficient
4. example: cheating in a cartel
5. example: agreeing to get rid of spies
6. problem — no way to communicate and make binding agree-
ments


Repeated games
1. if game is repeated with same players, then there may be
ways to enforce a better solution to prisoner’s dilemma
2. suppose PD is repeated 10 times and people know it
a) then backward induction says it is a dominant strategy to
cheat every round
3. suppose that PD is repeated an indefinite number of times
a) then may pay to cooperate
4. Axelrod’s experiment: tit-for-tat

Example – enforcing cartel and price wars

Sequential game — time of choices matters

I. Example: entry deterrence
1. stay out and fight
2. excess capacity to prevent entry — change payoffs
3. see Figure 29.7.
4. strategic inefficiency


29.1 The Payoff Matrix of a Game

1. A game can be described by indicating the payoffs to each of the players
for each configuration of strategic choices they make.

2. A dominant strategy equilibrium is a set of choices for which each
player’s choices are optimal regardless of what the other players choose.

29.2 Nash Equilibrium

3. A Nash equilibrium is a set of choices for which each player’s choice is
optimal, given the choices of the other players.

29.4 The Prisoner’s Dilemma

4. The prisoner’s dilemma is a particular game in which the Pareto efficient
outcome is strategically dominated by an inefficient outcome.

5. If a prisoner’s dilemma is repeated an indefinite number of times, then
it is possible that the Pareto efficient outcome may result from rational
play.

6. In a sequential game, the time pattern of choices is important. In these
games, it can often be advantageous to find a way to precommit to a
particular line of play.

http://www.powershow.com/view1/19fc23-ZDc1Z/Hal_Varian_Intermediate_Microeconomics_Chapter_Twenty-Eight_powerpoint_ppt_presentation

http://home.cerge-ei.cz/kalovcova/files/EconII.pdf



https://www.sites.google.com/site/richvanweelden/teaching/winter12

http://www.econ.ucsb.edu/~deacon/Econ100APublic/econ100a.htm

Ch. 28. Oligopoly - Summary - Intermediate Microeconomics - Varian

28. Oligopoly

Oligopoly
A. Oligopoly is the study of the interaction of a small number of
firms
1. duopoly is simplest case
2. unlikely to have a general solution; depends on market struc-
ture and specific details of how firms interact

28.1 Choosing a Strategy
B. Classification of theories
1. non-collusive
a) sequential moves
1) quantity setting — Stackelberg
2) price setting — price leader
b) simultaneous moves
1) quantity setting — Cournot
2) price setting — Bertrand
2. collusive

28.2 Quantity Leadership

C. Stackelberg behavior
1. asymmetry — one firm, quantity leader, gets to set quantity
first
2. maximize profits, given the reaction behavior of the other
firm
3. take into response that the other firm will follow my lead
4. analyze in reverse
5. firm 2
a) maxy2 P(y1 + y2)y2 − c(y2)
b) FOC: P(y1 + y2) + P′(y1 + y2)y2 = c′(y2)
c) solution gives reaction function, f2(y1)
6. firm 1
a) maxy1 P(y1 + f2(y1))y1 − c(y1)
b) FOC: P(y1 + f2(y1)) + P′(y1 + f2(y1))y1 = c′(y1)
c) see Figure 26.2.
7. graphical solution in Figure 28.4.
D. Price-setting behavior
1. leader sets price, follower takes it as given
2. given p1, firm 2 supplies S2(p1)
3. if demand is D(p), this leaves D(p1) − S2(p1) for leader
4. hence leader wants to maximize p1y1 − c(y1) such that y1 =
D(p1) − S2(p1)
5. leader faces “residual demand curve”

28.5 Simultaneous Quantity Setting

E. Cournot equilibrium — simultaneous quantity setting
1. each firm makes a choice of output, given its forecast of the
other firm’s output
2. let y1 be the output choice of firm 1 and ye
2 be firm 1’s beliefs
about firm 2’s output choice
3. maximization problem maxy1 p(y1 + ye
2)y1 − c(y1)
4. let Y = y1 + ye
2
5. first-order condition is
p(Y ) + p′(Y )y1 = c′(y1)
6. this gives firm 1’s reaction curve — how it chooses output
given its beliefs about firm 2’s output
8. look for Cournot equilibrium — where each firm finds its
expectations confirmed in equilibrium
9. so y1 = ye
1 and y2 = ye
2

28.6. Example of Cournot
1. assume zero costs
2. linear demand function p(Y ) = a − bY
3. profit function: [a − b(y1 + y2)]y1 = ay1 − by2
1 − by1y2
4. derive reaction curve
a) maximize profits
b) a − 2by1 − by2 = 0
c) calculate to get y1 = (a − by2)/2b
d) do same sort of thing to get reaction curve for other firm
5. look for intersection of reaction curves

28.9 . Bertrand – simultaneous price setting
1. consider case with constant identical marginal cost
2. if firm 1 thinks that other firm will set p2, what should it set?
3. if I think p2 is greater than my MC, set p1 slightly smaller
than p2
4. I get all the customers and make positive profits
5. only consistent (equilibrium) beliefs are p1 = p2 = MC


28.10 . Collusion
1. firms get together to maximize joint profits
2. marginal impact on joint profits from selling output of either
firm must be the same
3. max p(y1 + y2)[y1 + y2] − c(y1) − c(y2)
4. P(y1 + y2) + P′(y1 + y2)[y1 + y2] = c′(y1) = c′(y2)
5. note instability — if firm 1 believes firm 2 will keep its output
fixed, it will always pay it to increase its own output
6. problems with OPEC
7. if it doesn’t believe other firm will keep its output fixed, it
will cheat first!

Ch. 24: INDUSTRY SUPPLY - Summary - Intermediate Microeconomics - Varian

Ch. 24: INDUSTRY SUPPLY


In Ch. 23, We have seen how to derive a firm’s supply curve from its marginal cost curve. In a market,  there will typically be many firms. So the supply curve the industry presents to the market will be the sum of the supplies of all the individual firms. In this chapter,  we learn how develop the
industry supply curve and make decisions based on it.

23.1 Short Run Industry Supply


A. Industry supply: Sum of the MC curves

(1) S(p) =



(2) Example:

Firm 1:            Firm 2:

c(y)= 2y2 +3          c(y)= 3y2 +3

MC= 4y                 MC=6y

P=4y                 P=6y

S1(p)= p/4         S2(p)= p/6

Market Supply: S(p) = S1+ S2= p/4 + p/6 = (10/24)p





B. Equilibrium in the short run



(1) Look for point where D(p) = S(p)



(2) can then measure profits ()of firms





C. Short run and long run supply



(1) If profits > 0, entry of new firms in the long run



(2) If any firm have identical cost structure, then

      Price in long run = minimum of AC-curve







D. Economic rent



(1) If no factors are scarce: Long run supply curve: Horisontal



P= minAC



All firms have Zero Profits

(no factors of production are "paid" more than its value,

i.e. the opportunity cost of the factor)



(2) What if some factors (of identical quality) are scarce in the long run? Because:

(a) licences/patents

(b) raw materials, land



(3) Entrants (new firms) will have higher costs



(4) "Old" firms will still have economic rents, because price won’t be as low as their minimum AC.

Ch. 23: FIRM SUPPLY - Summary - Intermediate Microeconomics - Varian

Ch. 23: FIRM SUPPLY

 In this chapter we derive the supply curve of a competitive firm from its cost function using the model of profit maximization.

We first  describe the alternative market environments in which a firm has to operate. But in this chapter we concentrate on pure competitive market only.


23.1 Market Environments

A. Firms face two sorts of constraints



(1) Technological - summarized in cost function



(2) Market constraints - how will

consumers and
other firms
react to a given firm’s choice



B. Assumption: Pure/perfect competition



(1) Price takers - takes market prices as given,

i.e. outside of any particular firms control

Example - if many "relatively" small firms


Demand curve facing a competitive firm




C. Supply decision of competitive firm



(1) maxy py- c(y)





(2) first order condition: Price = MC

p = c’(y)



(3) second order condition: c’’(y)  0

i.e. only upward-sloping part of MC-curve matters



(4) check that it is profitable to operate at all

revenue > Variabel Costs

py > cv(y)



p > cv(y)/y

price > Average Variable Costs



D. Example

c(y) = 2y2 + 3

cv(y) + F



[ Supply: Si(p) = 0.25p ]





E. Producer’s Surplus (PS)



(1) PS is defined to be Revenue - Variabel costs

py - cv(y)



(2) Since cv(y) = area under MC-curve



(3) PS = area above MC-curve





F. Long run supply



(1) L= Long Run



(2) LAVC = LAC Why?



No costs are fixed in the long run

i.e.  All costs are variable in the long run



(3) Long Run Supply more elastic than Short Run Supply



Demand Supply



ED =  ES =

[ES,L > ES,S]