EXAMINATION QUESTIONS1. Microeconomics as a science, its methodology and methods. 2. Basic problem of the organization of economic activity. 3. Production possibilities curve and rational economic choice. Opportunity cost. 4. Positive and normative analysis. 5. The nature of the demand. Demand function. The determinants of demand. 6. Market demand versus Individual demand. 7. The nature of the supply. Supply function. The determinants of supply. 8. Market supply versus individual supply. 9. Market equilibrium establishment and price of equilibrium. 10. Applied aspects of the model of demand and supply. Consequences of the government intervention in the market mechanism (by fixing the prices, taxation, subsidies). 11. Preferences, prices and income as general determinants of consumer behavior. Assumptions of consumer’s preferences. 12. Utility as the economic category. Utility functions. 13. Total and marginal utility. The law of the diminishing of marginal utility. 14. The marginal rate of substitution of goods and the slope of indifference curves. 15. Indifference curve analysis. 16. Budget constraint of a consumer 17. Consumer equilibrium. Interior and corner solutions. Consumer equilibrium means that condition, which gives him/her maximum utility from full use of income. The consumption decision of a rational consumer is motivated by the desire to maximise utility or satisfaction. But this decision is constrained by his limited purchasing power. Given the assumptions about consumer's preferences, we can draw the indifference curves showing different levels of satisfaction. Three such indifference curves, I0, I1, I2 are drawn in Figure 3.27. The budget line AB contains commodity bundles which are purchasable. The consumption bundles like a, b, c lying on the budget line AB are purchasable. The consumer will choose that commodity bundle which lie on the highest indifference curve. The consumption bundle b on indifference curve I1 is the obvious choice because the alternative commodity bundles such as a and c are located on lower indifference curve I0. The indifference curve lying above I1, such as I2. consists of commodity bundles which are not attainable with the given budget line AB. The consumption choice of b from among alternative consumption bundles maximises the utility subject to purchasing power limitations specified by the budget line. The consumer is in equilibrium at point b because he has no incentive to choose any other commodity bundle. Note that consumption choice at b contains OX0 amount of good X and 0Y0 amount of good Consider a rise in M at fixed prices. There can be five possible changes in consumption pattern: (i) both X and Y rise (ii) X rises but Y falls in such a way that the rise in P. consider the effect of a change in M on equilibrium consumption demand.consumption curves. Since the negative of the slope of the indifference curve is called MRSx.X is higher than the fall in PO' (iii) X falls and Y rises such that the rise in P.Y. In other words. the consumer can purchase more of both X and Y if M rises at fixed prices.Y is higher than the fall in P. The division of higher purchasing power among various items of consumption depends on consumer's preferences. are held constant.y and the negative of the slope of the budget line is (Px/Py). We now. We have earlier stated that the purchasing power of money income in terms of good X is (MIPX) and the purchasing power in the units of good Y is (MIPY). this does not mean that the consumer will actually increase the consumption of both X and Y. and P. the condition for equilibrium consumption choice is given by the equation written below : MUX/MUY= PX/PY 18. budget line AB is tangent to the indifference curve I. Income .X (iv) X rises but Y remains constant (v) X remains constant but Y rises. When M rises. both MIPX and MIPY rises. if P. We give below a graphical analysis of each situation . However. At the equilibrium consumption point b. the budget line have a parallel rightward shift to M1 and the new consumption choice is shown by the commodity bundle b. The initial budget line as well as income level is indicated by M0 and the corresponding consumption choice by commodity bundle a. Therefore. .31. The upward-sloping line OE is the income-consumption curve (ICC). the budget line has a constant slope. income rise leads to a rise in the equilibrium consumption of both X and Y. b starting from the origin and lying on an upward-sloping curve OE. we have a complete picture of how equilibrium consumption plan changes with the change in the level of income. The diagram shows that bundle b contains more of both X and Y than bundle a.In Figure 3. If income rises to M1. If we imagine many equilibrium consumption choices like a. Price . The budget equation can be written as M = PxX + Z or Z= -PxX + M . expenditure on all other goods equals Rs. the proportion of income spent on nonfood items increases) with the increase in income.19. Z.31.39. the consumption of a good may rise by a proportion greater than or less than the rise in income. On average. A luxury is defined as a good for which the proportion of income spent (EXIM) rises with the rise in income. The Engel curve in Figure 3. is convex from below. Price elasticity of demand. If we denote the amount of 'all. The real life Engel curve need not always be straight line.consumption curves and derivation of demand curve. I.38. 20. we see that the consumption of X rises by the same proportion as the rise in income.. implying that X/M rises as M rises. The Engel curve shows the equilibrium consumption of one of the two goods as a function of income. 21. the proportion of income spent on food decreases (i.e. Engel curves. we draw the Engel curve as a straight line through the origin in Figure 3. other goods' by Z and price per unit of Z by Re. prices remaining unchanged. By plotting M on the horizontal axis and X on the vertical axis. A necessity is defined as a good for which (EXIM) falls as income rises. when income rises. If we take drawn in Figure 3. In general. Cross –price elasticity of demand. in case of backward bending supply curve the supply curve will have a segment on which Ex is negative. The value of elasticity of supply can be calculated by the formula: Ex= Percentage change in the quantity supplied / Percentage change in price This may be expressed as: Ex=(ΔQ/Q) / (ΔP/P) = (ΔQ/ ΔP) x (P/ Q) Elasticity of supply is positive since the supply curve slopes upwards from left to right. However. 23. Income elasticity of demand. 24. Supply elasticity.22. Price elasticity of supply measures the degree of responsiveness of quantity supplied of a commodity to change in its own price. Types: Periods of Supply Elasticity . 42.run cost. Production with two variable inputs. Isoquants and their characteristics. 41. Long . 32. The competitive firm’s demand curve. 38. 37. The nature and features of perfectly competitive markets. . Total Revenue and profit of the firm. Marginal revenue – marginal cost approach: profit maximization. 30. 29. Total. 39. is zero.). 36. Accounting. A perfectly competitive firm and market supply curve in the short-run. Economies and diseconomies of scale.run cost. Total revenue – total cost approach. (b) Short run: In the short run supply can be varied with the limit of the present fixed assets (buildings.(a) Momentary: In the momentary period or the very short run supply is fixed and E. Short . Long-run equilibrium in perfectly competitive firm. MRTS. The production function. average and marginal product of a variable input and the interdependence between them. 31. Thus E. 25. Production with one variable input. 34. 44. Optimal combination of input factors for a firm. Returns to scale. Accounting and Economic costs. Determinants of increasing and decreasing returns to scale. in the short run is generally low. economic and normal profit. machines. 40. etc. 35. 33. Constant returns to scale. 43. 28. losses minimization and shut-down decisions. The cost function. (c) Long run: In the long run all factors may be varied and firms may enter or leave the industry. The Nature of production costs. 26. Explicit and implicit costs. Applied aspects of the theory of elasticity. Isocost lines and their characteristics. 27. 47. Price discrimination in possible only if the monopoly firm can divide buyers in dependence with their demand elasticity and if the reselling of its goods are impossible. Price discrimination under monopoly. and when he decide to modify the quantity supplied. By knowing the reservation price. The power of the monopoly firm depends on the available substituents of this good and on the market quota of the firm.45. Pure monopoly and its properties. it has to minimize the price. the monopoly firm has to modify the production volume or the selling price. - 2nd degree price discrimination – consist in the setting of the same price for all consumers. 46. Social price of monopoly. and this action hasn’t any link with the cost differences. 49. 50. The marginal consumer is the one whose reservation price equals to the marginal cost of the product. Monopoly demand. Short-run profit maximization and losses minimization by monopoly firm. though. but differ in relation with the quantity purchased. Monopoly power. Marginal revenue curve for a monopolist. 51. The demand for a monopolist product. Larger quantities are . The monopoly power consist in the capacity of the firm to set the price of its products at a higher level as marginal cost. and thus transform the consumer surplus into revenues. the practice of collusive tendering could reduce the market efficiency. in this case. Perfect price discrimination can be only if the monopoly firm knows the consumer demand curve and sell each unit of good at the demand price (at the higher price which the consumer is able to buy a certain quantity of goods). modifying the supply quantity. the seller is able to sell the good or service to each consumer at the maximum price he is willing to pay. So the price is higher than marginal revenue and higher than marginal cost. There are 3 types of price discrimination: - Perfect price discrimination (1st degree) – suppose that for each particular buyer it will set a particular price. which means that there is no deadweight loss. Monopoly total revenue and its maximization. When trying to maximize the profit. The difference between selling price and marginal cost can be used to evaluate the monopoly power. 48. Price discrimination consists in firm application of different prices for different unities of the same product. So the profit is equal to the sum of consumer surplus and producer surplus. Examples of where this might be observed are in markets where consumers bid for tenders. The seller produces more of his product than he would to achieve monopoly profits with no price discrimination. Another coefficient used to calculate the monopoly power is the elasticity coefficient of the demand in relation with the price. Monopolistically competitive markets have the following characteristics: . Thus. . This type of market is distinctive for clothes. Short-run equilibrium under monopolistic competition. and each of them has a small share on the market and a limited control over the price.available at a lower unit price. or non-linear pricing. This allows the supplier to set different prices to the different groups and capture a larger portion of the total market surplus. food production and others. and others. each with their own "unique" product or in pursuit of positive profits. 52. - In third degree price discrimination. This assumption implies that there are low start up costs. is a time period . 53. shoes production. by the individual customer's identity. quantity "discounts". no sunk costs and no exit costs. services. Monopolistic competition is an intermediary type of market which combines elements of monopoly market and those of the market with perfect competition as high competition and an insignificant part of monopoly power. where the attribute in question is used as a proxy for ability/willingness to pay. .There are few barriers to entry and exit. On the market there isn’t an interdependence between firms and when one of them decide something about the price and production volume.Firms don’t take care on the competitors’ reactions. Each firm has a unique role as a seller of a certain quantity of goods. sellers are not able to differentiate between different types of consumers. Additionally to second degree price discrimination. where bulk buyers enjoy higher discounts. is a means by which suppliers use consumer preference to distinguish classes of consumers. .There are different products which don’t represent perfect substituents of goods offered by other firms. the suppliers will provide incentives for the consumers to differentiate themselves according to preference. it doesn’t mind about the competitors’ reactions. Any firm unable to cover its costs can leave the market without incurring liquidation costs. Monopolistic Competition is a market structure featuring few large and many small firms. fairly low entry barriers similar goods and relatively high competition.There are many producers. Monopolistic competition and its properties. furniture. placement. In the long run there are no entry and exit costs. package. price varies by attributes such as location or by customer segment. There are numerous firms waiting to enter the market. or in the most extreme case. As above. This is particularly widespread in sales to industrial customers. The differentiation of the goods can appear through its quality. possessing a certain market power. who own the monopoly in a narrow specialized field. The short-run. there are no abnormal profits because of the features of Monopolistic competition. the goods are similar enough to ensure that competition will always remain high.in which at least one factor of production is fixed and firms can usually gain some abnormal profit. because MC is the cost of producing an one more of the good and MR is the revenue of selling one more good and their meeting point is the most efficient production. The long-run period is when all factors of production are variable. ACs (average cost of producing one good at this quantity) and the AR curve (average revenue curve) is the abnormal profit the firm makes. AR is equivalent to the demand curve and is the average revenue the firm makes per item sold. Finally. fairly low entry barriers similar goods and relatively high competition. Long-run equilibrium under monopolistic competition. 54. equilibrium is created in the short run. The firm produces where marginal cost (MC) and marginal revenue (MR) curves meet. This means that the shaded area between Ps. low entry barriers mean new firms will enter the market and further add competition. The firm will produce quantity Qs at price Ps. . There are a few large firms. Producing at this point ensures the highest amount of profit. Monopolistic Competition is a market structure featuring few large and many small firms. In the long run. Thus. but many small firms that will compete for profit and thus drive the price down. Also. Firms in a monopolistically competitive market are price setters. The LRMC describes the cost of producing one more of the good when no factors of production are fixed over the long run. In terms of economic efficiency.This price exceeds the firm's marginal costs and is higher than what the firm would charge if the market was perfectly competitive. meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. or long run average cost curve. 55. The difference between the quantity of products which correspond with the minimum level of long-run average cost and the quantity of products offered by the firm in conditions of long-run equilibrium is called excess capacity of firm production . Monopolistic competition and economic efficiency. there is no abnormal profit. Regardless of whether there is a decline in producer surplus. In these types of markets. in the long run. It also means that producers will supply goods below their manufacturing capacity. or long run marginal cost curve. which shows them average cost of producing one good at this quantity over the long run. the firm produces where the LRMC. Because the LRAC curve is above the AR curve. in the long run.In this diagram. This quantity is less than what would be produced in a perfectly competitive market. the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus. Monopolistically competitive markets are less efficient than perfectly competitive markets. equilibrium is acquired. firms that are in monopolistically competitive markets behave similarly as monopolistic firms. and the marginal revenue curve meets. Excess capacity. That point is. equivalent to the LRAC. Thus. Excess capacity. the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve. Both types of firms' profit maximizing production levels occur when their marginal revenues equals their marginal costs. as the average cost of the good equals the average revenue of the good. So in case of equilibrium for long-run activity of perfect competition.56. economic profit become equal with 0 (zero) when the price is equal with minimum total average costs for long period (P=LRACmin). In conditions of monopolistic competition. . doesn’t permit the existence of economic profit for a long period of time. In conditions of monopolistic competition. P=LRMC=LRACmin. firms offer differentiable goods. and unique goods offered by pure monopoly firms. but the price level is higher as in case the products are offered by firms from perfect competition. 57. free entrance on the market. Because the price is always bigger than marginal revenue. The firm modify the price until MR=MC. in conditions of equilibrium the price will be higher than marginal cost. Monopolistic competition. The equilibrium of the firm from monopolistic competition resembles (se aseamana) with the equilibrium in the monopoly situation through the idea that prices are higher than marginal costs. Consumers buy goods at the minimum possible level of price. prices are lower as in case the products are offered by a monopoly firm. Because here exist barriers to enter the market.advertising is informative. So. In perfect competition market. in conditions of monopolistic competition. consumers are imposed to pay higher prices for differentiate goods. The role of advertizing in the monopolistic competition Some of the arguments in favor of advertising are . in case of monopoly market. pure monopoly and perfect competition: comparative analysis. the price in long-run can be higher than average costs.advertising increases sales and permits economies of scale. . The profit gained by firms attract in this field other firms and maintain the prices at a lower level than in case of existence of a monopoly firm. in contradiction to homogeneous ones offered by firms from perfect competition market. In monopolistic competition industry. The prices reflect minimum average costs for one unit of production and marginal cost. advertising increases sales and contributes to economic growth. but no more beyond that. offer different products and place an emphasis on nonprice competition. . those of automobiles. product or advertising. Usually three. those of steel. The small number of firms let oligopolies to set prices and output levels. breakfast cereal. .advertising raises the cost curve. Oligopoly is a situation on the market where exist a limited number of producers (more than one) and a big number of consumers. Sometimes the cost of capital is too high and other times. . Patents and brand loyalty are also barriers of entry into an oligopolistic market. or standardized. e. and . -Strategic Behavior: self-interested behavior that takes into account the reactions of others -Mutual interdependence: profit doesn't depend entirely on its own price and strategies Relatively high entry barriers. tires. Some oligopolistic industries offer homogenous. output. . Oligopoly and its properties.g. four. 58. to some extent. or five firms occupy the market Homogenous or differentiated products. because there are rival firms. .. Some of the arguments against advertising are . lead. such as advertising. electronics. However. industrial alcohol. .the economies of scale are illusory. products. copper.advertisers may use their influence to bias the media. oligopolies must take note at how they react to its change in price. ownership and control of the raw materials is a factor.g.advertising is not a productive activity. .advertising supports the media. e. zinc. Other industries. but still mutually interdependent.advertising is used as an entry barrier.advertising is not informative but competitive. Any new firms would have too small a market share and would have to produce at too high a price. Price maker.advertising increases competition and lowers prices. The main characteristics of oligopoly are: A few large producers. Entry barriers exist that allow a handful of firms to achieve economies of scales.