The Economic Problem

Scarcity of resources available is an essential principle that regulates the

Economic world. Society has limited resources. Resources are classified as land
(all the natural resources of the earth), labour (the human effort in the
production process) and capital (equipment and structures needed to produce
goods and services). Therefore societies cannot produce all the goods and
services people wish to have; such situation is defined as the Economic
Problem. Any society has to face the following questions in order to manage,
in the most effective way, the economic problem:
What goods and services should be produced?
How should these goods and services be produced?
Who should get the goods and services that have been produced?
Economics is the study of how society manages its scarce resources and
attempts to answer the three key questions. Limited resources imply therefore
the need to elaborate and choose the best course of action among the options
available in order to achieve the maximization of net benefit. We have in
fact to use limited resources by maximizing their impact on various aspect (E.g.
health care): while households attempt to increase utility value, firms attempt
to optimize profits. The methodology to discover the conditions for maximising
benefits are related to the cost-benefit approaches; such approaches have to
be supplemented by considerations regarding equity in the distribution of
goods and services. Equity means that benefits of resources are distributed
fairly among societys members. Cost-benefit approach and management
approach are parallel approaches regarding the intervention to correct faulty
operation of the market.
Because of limited resources, micro and macro efficiency are the most
important goals for consumers and industry. It does not exist in fact a correct
level of expenditure: in deciding what the limit to the expenditure ought to be,
we should weigh its marginal contribution (selling price per unit minus the
variable cost per unit) to utility against the marginal contribution of other
factors affecting utility and non-utility-affecting resources involved in the
flourishing process.
During the last 30 years both Demand and Supply have increased rapidly due
to economic changes (income and price increase), demographic changes, R&D
and Technological progresses and social changes.
The increase of demand with limited resources introduce an important common
dilemma in terms of economic intervention: Till where is possible to follow the
increasing demand and
absorb expenditure?; increasing demand and absorb expenditure must be
followed as long as it will be possible.
Economics
The word economy comes from a Greek word for one who manages a
household
Economics it the study of how society manages limited resources. Usually
resources are allocated through the combined actions of millions of households
and firms through a system of markets. The market economy is an economy
that addresses the three question of the economic problem through allocating
resources through decentralized decisions of many firms and householders that
interact in markets for goods and services. Moreover free markets contain
many buyers and sellers of numerous goods and services and all of them are

interested primarily in their own well-being. Nevertheless the free market is

not the best solution due to important reasons:
- Not necessary will be the respect of the needs of the population with low
income;
- Resource Allocation Model could tend to reflect preferences of people
whom can pay more than the other instead of the real needs of society.
Since economics not focus only on financial costs or benefits, do not treat
people merely as productive resources and do not treat efficiency as an
inherently good thing (ta fuck) cannot be considered as a dismal science.
The field of economics is divided into 2 subfields: Microeconomics and
Macroeconomics.
-Micro: study decision- making by households and firms and the interaction
among them in the marketplace.
-Macro: study forces and trends that affect the economy at whole.
Economists introduced 10 Principles of Economics regarding how people make
decisions, how people interact with each other and the trends and forces of the
economy as a whole.
Decision-making
The behaviour of an economy reflects the behaviour of the individuals who
make up the economy; in such matter it important to analyse 4 principles of
individual decision-making:
1) Making decision requires trading off the benefits of one goal against
those of another. To get one thing, we usually have to give up another
thing.
2) Making decision implies comparing the costs and benefits of alternative
courses of action. In such matter is important to consider the
opportunity cost of an item. The opportunity cost of an item is what
you give up to get that item (forgone opportunities) in terms of money,
time, pleasure and other benefits.
3) Making-decision implies comparing marginal changes and marginal costs.
Marginal changes are small incremental adjustments to a plan of action
while marginal costs is the change in the total cost that arises when the
quantity produced has an increment by unit.
4) In making-decisions people respond to incentives. People may in fact
change behaviour when the costs or benefits change. The decision to
choose one alternative over another occurs when that alternatives
marginal benefits exceed its marginal costs!
Interactions between people
Decisions affect not only us but other people as well. The following three
principles concern how people interact one with another:
1) Trade can be mutually beneficial: by trading with each others, people can
buy a greater variety of goods and services at lower cost.
2) Firms and households interact in the marketplace, where prices and selfinterest guide their decisions: markets are usually a good way of
coordinating trade among people. Adam Smith made the observation
that households and firms interacting in markets act as if guided by an
invisible hand. Following Smiths thought the individuals' efforts to
pursue their own interest may frequently benefit society more than if
their actions were directly intending to benefit society.
3) The Government and its legislation must regulate the markets: markets
work only if property right are enforced, consequently the governments

provide policies and courts to enforce such rights. Moreover Government

can potentially improve market outcomes if there is a situation of market
failure or if the market outcome is inequitable. Market failure may be
caused by an externality, which is the impact of one person or firms
actions on the well-being of a bystander. Market failure may also be
caused by market power, which is the ability of a single person or firm to
unduly influence market prices.
The forces and trends that affect the economy as a whole
Decisions and interactions make up the economy. The following three principles
concern the workings of the economy as a whole.
1) Productivity explains the large differences in living standards among
countries and over time. Standard of living refers to the amount of goods
and services that can be purchased by the population of a country. Its
usually measured by the inflation-adjusted income per head of the
population. Productivity is the amount of goods and services produced
from each hour of a workers time. Productivity is given by the ratio
between outputs and inputs.
2) The growth in the quantity of money printed by the government can
create a situation of inflation. Inflation is an increase in the overall of
prices in the economy. When governments create large quantities of
nations money, the value of the money falls.
3) Another result given by the increase of the amount of money in the
economy is, at least in the short-run, is a lower level of unemployment. The
curve that illustrates this short-run trade-off between inflation and
unemployment is called the Phillips curve.
The Economist as a scientist
Economists try to address their subject with a Scientifics objectivity. The economic way of thinking
involves thinking analytically and objectively following the scientific method. The economists use
abstract models to help explain how a complex, real world operates developing theories,
collecting, and analysing data to prove the theories. Economist must in fact examine and understand
how certain events and issues are related. Moreover the economist must think in terms of
alternatives and evaluate the cost of individual and social choices. One of the tasks of the
economists is make assumptions in order to make the world easier to understand. The art in
scientific thinking is deciding which assumptions to make. The economic way of thinking includes
developing abstract models from theories and the analysis of such models. The development of
abstract models can be either descriptive (reporting facts, etc.) or analytical (abstract reasoning).
Economists use models to simplify reality in order to improve our understanding of the world. Two
of the most basic economic models are:
The Circular Flow Model and The Production Possibilities Frontier.
The Circular Flow Model (1)
In the Circular Flow model the economy is simplified to include only two types of decision makers:
households and firms. Firms produce goods and services using the factors of production of labour,
land and capital. On the other hand households own the factors of production and consume goods
and services that the firms produce. The circular-flow model is a simple way to visually show the
economic transactions that occur between households and firms in the economy. Firms and
households interact in two types of market: in the market for goods and services, households are
buyers while firms are sellers while in the market for factors of production, households are sellers
and firms buyers. The households in fact sell the use of their labour, land and capital to the firms in
the markets for the factors of production; firms use these factors to produce goods and services and
consequently sell them to households. Such process is represented as an endless cycle because
households spend their money to buy good and services from firms that use such revenues to pay

the factors of production provided by the households.

The Production Possibilities Frontier
The production possibilities frontier is a graph showing the various combinations of output that the
economy can possibly produce given the available factors of production and technology. This model
shows concept such as efficiency, trade-off, opportunity cost and economic growth.
Positive Versus Normative statements
When economists try to explain the world, they are considered as scientists while when they try to
change the world, they are defined as policymakers. In such matter is important to distinguish
positive and normative statements: positive statements are descriptive and make a claim about how
the world is. Therefore positive statements can be tasted and confirmed. On the other hand
normative statements are prescriptive and make a claim about how the world should be, therefore
including subjective opinions. It is important to underline that economist may disagree on both
positive and normative statements. Economists in fact may disagree about the validity of positive
statements about how the world works and especially have different values and, therefore, disagree
with normative statements about how the world should be.
Supply and Demand
Supply and demand determine the quantity of each good produced and the price at which it is sold.
Supply and demand are forces that make market economies work. A market is a group of buyers and
sellers of a particular good or service. The buyers as a group determine the demand for that product
while the sellers as a group determine the supply of the product.
Demand
A quantity demanded of any good is the amount of the good that buyers are willing and able to
purchase. Many things determine the quantity demanded, the most important is with no doubts the
price of the good itself. Other factors that influence the quantity demanded are the consumers
income, tastes and expectations. Economists usually analyse how one variable affects the others.
This principle is known as ceteris paribus (other things being equal): this principle is used to
isolate the factors which are most significant allowing to understand of how changes in one variable
affect outcomes assuming that the other variables are constant. In such matter is important to
introduce the law of demand that states that the quantity demanded falls as the price rises and rises
as the price falls. The demand schedule (2) is a table that shows the relationship between the price
of the good and the quantity demanded. The demand curve is the downward-sloping line relating
price to quantity demanded.
Market demand refers to the sum of all individual demands for a particular good or service.
Graphically, individual demand curves are summed horizontally to obtain the market demand curve
(3). As stated before the Determinants of Demand are the market price, consumer income, prices
of related goods, tastes, expectations and advertising. If any of the variables affecting demand, apart
form price, changes we recognize a change in demand; therefore the demand curve will shift either
to the right (increase in demand) or to the left (reduction un demand)(4). On the other hand if the
price of the good changes we recognize a change in the quantity demanded and consequently
recognize a movement along the demand curve (5).
Supply
The quantity supplied if any good or service is the amount that sellers are willing and able to sell.
Following the law of supply the quantity supplied rises as the price rises and falls as the price falls;
therefore the quantity supplied is positively related to the price of the good. The supply schedule
(6) is a table that shows the relationship between the price of the good and the quantity supplied. On
the other hand the supply curve is the upward-sloping line relating price to quantity supplied.
Market supply refers to the sum of all individual supplies for all sellers of a particular good or
service. Graphically, individual supply curves are summed horizontally to obtain the market supply
curve.(7) The determinants of supply are the market price, input prices, technology, expectations
and number of producers. If any of the variables affecting supply, apart form price, changes we

recognize a change in supply; therefore the supply curve will shift either to the right or to the left.
(8) On the other hand if the price of the good change we recognize a change in the quantity supplied
and consequently recognize a movement along the supply curve. (9)
Supply and demand together
Economists refer to supply and demand as market forces. If supply is greater than demand or vice
versa, then there is pressure on price to change. The situation of market equilibrium (10) occurs
when the amount consumers wish to buy at a particular good is the same as the amount sellers are
willing to offer for sale at that price. The price at this intersection is called equilibrium price while
the quantity is called the equilibrium quantity. When the market equilibrium is achieved everyone
of the market has been satisfied. The market will remain in equilibrium until something causes
either a shift in the demand curve or a shift in the supply curve. If one of these curve will shift a
situation of surplus or shortage arise:
-Surplus: when the price is above the equilibrium price, the quantity supplied exceeds the quantity
demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales,
thereby moving toward equilibrium. -Shortage: When the price is below the equilibrium price, the
quantity demanded exceeds the quantity supplied. There is excess demand or a shortage. Suppliers
will raise the price due to too many buyers chasing too few goods, thereby moving toward
equilibrium. There are three steps to analyze changes in equilibrium: Decide whether the event
shifts the supply or demand curve (or both). Decide whether the curve(s) shift(s) to the left or to the
right. Examine how the shift affects equilibrium price and quantity.
Elasticity
Elasticity is a measure of how much buyers and sellers respond to changes in market conditions.
Elasticity knowledge allows us to analyze supply and demand with greater precision.
The price elasticity of demand and its determinants
The price elasticity of demand measures how much the quantity demanded responds to a change
in price. The price elasticity of demand for any good measures how willing
consumers are to move away from the good as its price rises. Thus, reflects the
many economic, social and
psychological forces that influence consumer tastes. Price elasticity of
demand is therefore the percentage change in quantity demanded given a percent change in the price. The price elasticity of demand is computed as the
percentage change in the quantity demanded divided by the
percentage change in price. The midpoint formula is preferable when
calculating the price elasticity of demand because it gives the same answer
regardless of the direction of the change:

Necessities versus Luxuries, availability of close substitutes, definition of the

market and time Horizon are what determine the price elasticity demand. In
fact necessities tend to have relatively inelastic demands while luxuries have
elastic demands. Good with close substitutes tend to have more elastic
demand because it is easier for consumers to switch from that good to others.
Defined markets tend to have more elastic demand that broadly defined
market. Goods tend to have more elastic demand over longer time horizons.
The demand is known as inelastic when the quantity demanded does not
respond strongly to price changes (Price elasticity of demand is less than one).
On the other hand the demand is known as elastic when the quantity
demanded responds strongly to changes in price (price elasticity of demand is
greater than one).
Because the price elasticity of demand measures how much quantity

demanded responds to changes in the price, it is closely related to the slope of

the demand curve. The flatter the demand curve that passes through a given
point, the greater the price elasticity of demand. The steeper the demand
curve that passes through a given point, the smaller the price elasticity of
demand. In the extreme case of zero the elasticity demand is perfectly
inelastic. In such condition the quantity demanded does not respond to price
changes and the demand curve is vertical. (11) On the other hand when the
demand curve is flatter and flatter represents greater decrees of elasticity. In
such condition the demand is known as perfectly elastic and the demand
curve becomes horizontal due to the fact that the quantity demanded changes
infinitely with any change in price (12). Finally when the quantity demanded
changes by the same percentage as the price the demand is known as unit
elasticity.
Elasticity and total revenue
Total revenue is the amount paid by buyers and received by sellers of a good,
computed as the price of the good per the quantity sold: TR = P x Q
With an inelastic demand curve, an increase in price leads to a decrease in
quantity that is proportionately smaller. Thus, total revenue increases. With an
elastic demand curve, an increase in the price leads to a decrease in
quantity demanded that is proportionately larger. Thus, total revenue
decreases.
The Income elasticity of demand
The income elasticity of demand measures how the quantity demanded
changes as consumer income changes. It is computed as the percentage
change in the quantity demanded divided by the percentage change in income

The Cross-Price Elasticity of Demand is a measure of how much the

quantity demanded of one good responds to a change in the Price of another
good, computed as the percentage change in quantity demanded of the first
good divided by the percentage change in the price of the second good.

Normal and inferior goods

Higher income raises the quantity demanded for normal goods but lowers
the quantity demanded for inferior goods. Normal goods have positive
income elasticities because quantity demanded and income change in the
same direction. On the other hand inferior goods have negative income
elasticities because the quantity demanded and income move in opposite
directions.
The price elasticity of supply and its determinants
The price elasticity of supply measure of how much the quantity supplied of a
good responds to a change in the price of that good. Price elasticity of supply is
the percentage change in quantity supplied resulting from a per cent change in
price. Supply of a good is said to be elastic if the quantity supplied responds
substantially to changes on the price while it is said inelastic if the quantity

supplied responds only slightly to changes in price (05 slides 31-32).

Supply is usually more elastic in the long run, is smaller firms or industries,
firms who present greater mobility of factors of production and relative easy
inventory. The price elasticity of supply is computed as the percentage
change in the quantity supplied divided by the percentage change in
price:

There are three steps to analyze the application of elasticity:

1) Examine whether the supply or demand curve shifts.
2) Determine the direction of the shift of the curve.
3) Use the supply-and-demand diagram to see how the market equilibrium
changes.
The theory of consumer choice
The consumer theory analyzes consumer behaviour aimed at obtaining the
maximum utility in the presence of a budget constraint. Therefore the theory of
consumer choice examines the trade-off people face in their role as consumers.
When making trade-offs, there are some assumptions that can be made
about consumers: more is preferred to less, buyers are rational and seek to
maximize their utility and consumers act in self-interest and do not consider
the utility of others. The budget constraint shows what combination of goods
the consumer can afford given his income and the prices of the goods. The
essential element of the behaviour of consumer choice is whether a basket has
been considered more useful than another (no matter how much). The term
utility refers to the satisfaction derived from the consumption of a certain
quantity of a product. Utility is an ordinal concept: it can be measured by
ranking but there are limitation to such ranking; utility in fact cannot have any
meaningful arithmetic operations performed on it. The utility function describes
the consumers preferences: it assigns a numerical value to every possible
consumption bundle: the favourite baskets receive
greater numbers: highest the curve, higher the value. Moreover we need to
distinguish between total utility and marginal utility. Total utility is the
satisfaction that consumers gain form consuming a product. On the other hand
the marginal utility of consumption is the increase in utility that a consumer
gets form an additional unit of that good. The more of the good the consumer
already has, the lower the marginal utility provided by an extra unit of such
good.
Preferences
The consumers preferences allow him to choose among different bundles. The
model of preferences has certain assumptions: the consumer theory is based
on three axioms:
- The axiom of transitivity: Given three baskets of goods (X, Y and Z), if the
consumer prefers X to Y and Y to Z, then he also prefers X to Z. This is also true
in the case of "indifference" between baskets (if the consumer is indifferent
between X and Y and is also indifferent between Y and Z, it will also be
between X and Z).
- The axiom of reflexivity: Each basket is desirable as much as himself. (?)
- The axiom of completeness: An ordering of preferences is complete if it
allows the consumer to classify all possible baskets of goods and services, in
order to still be able to make a choice between the baskets available.

If two bundles yield the same utility the consumer is said to be indifferent
between them. We can represent these preferences as indifferences curves. An
indifference curve shows consumption bundles that give the consumer the
same level of satisfaction. Indifferences curves have certain property that
reflect preferences:
- Higher indifference curves are preferred to lower ones: consumers
prefer more of something to less of it. Higher curves represent larger quantities
of goods than lower ones. It follow that curves more are moved upwards and to
the right, the greater the satisfaction level corresponding to these.
- They have a negative slope.
- Never intersect.
- Are convex to the origin of the axes.
The term perfect complements refer to those goods that are used jointly in a
fixed proportion. A significant example of perfect complements is given by
products like the shoes. Increase the amount of only one of the two goods, for
example right shoes, NOT increases the utility of the consumer. The
indifference curves of these goods are right angles (13).
The consumers optimal choices
The consumer will seek to maximize utility subject to the constraint of a limited
income. The consumer chooses the point on his budget constraint the lies on
the highest achievable indifference curve. The point at which the indifference
curve and the budget constraint touch is called the optimum. The optimum
represents the best combination of consumption of bundles available to the
consumer. To identify the optimal choice, the condition of tangency between
the indifference curve and the budget line is not needed if the indifference
curves are angled or if there is an optimal border (is consumed only one good).
Changes in income
Suppose that income increases. We know that if income increases there is a
parallel shift of the budget constraint with the same slope of the initial budget
line because the relative price of the two goods has not changed. The increase
in income means there is an incentive for the consumer to reallocate his
spending decisions to increase utility and choose better combination of goods.
In other words, the consumer can now reach a higher indifference curve. The
consumer reallocates income until he reaches a new optimum known as new
optimum. If a consumer wants more of a good when his income rises, we call it
normal good. On the other hand if a consumer buys less of a good when his
income rises, we call it inferior good (14). Moreover its important to
introduce luxury and necessary goods:
Luxury goods demand increases more than proportionally with income while
necessary good s demand increases less than proportionally with income.
Income-consumption curve represents the set of optimal choices at different
levels of income (if income is greater, the budget line moves parallel in the
upper right)(15). In such matter the Engel curve is a line showing the
relationship between demand and levels of income.
Changes in price
When the price of a product changes the consumers budget constraint pivots
and changes slope. How such change in the budget constraint alters the
consumption of goods depends on the customers preferences. Usually
ordinary good s demand increases with decreasing of price while Giffen
good s demand increases in terms of quantity when its price rises. Giffen
goods therefore violate the law of demand. Giffen goods are inferior goods for

which the income effect dominates the substitution effect. Thus, they have
demand curves that slope upward.
The effect of a change in price can be broken down into an income effect and
substitution effect: income effect refers to the change in consumption that
results when a price change moves the consumer to a higher or lower
indifference curve while the substitution effect refers to the change in
consumption that results when a price change moves the consumer along a
given indifference curve to a point with a new marginal rate of substitution.
In such matter is important to underline the Slutsky equation according to
which the overall change in demand is the sum of the effect of income and
substitution effect. However situations can change depending on the type of
goods that we face.

Costs (22)
All firms incur costs as they make the goods and services that they sell. Firms costs are a key
determinant of its production and pricing decisions. In such matter is important to underline the
importance of the opportunity cost: The opportunity cost of an item is what you give
up to get that item. Economists in fact when speak about firms costs of
production they include the opportunity cost related to the production of goods
and services. A firms cost of production includes explicit costs and implicit
costs: explicit costs involve a direct money outlay for factors of production
while implicit costs do not involve a direct money outlay.
The production function
The quantity of goods and services a firm produces per hour depends on the
number of workers: The production function shows the relationship between
quantity of inputs used to make a good and the quantity of output of that good.
In such matter it is important to take into consideration the marginal product
that refers to the increase in the quantity of output obtained from an additional
unit of that input. The marginal product is given by the change in total
product divided per the change in quantity of factor. There may be
situations in which the marginal product of an input declines as the quantity of
the input increases; such property is known as diminishing marginal
product. In certain circumstances in fact when the number of workers
increases the efficiency of the production process decreases. The slope of the
production measures the marginal product of a worker. As the number of
workers increases, the marginal product declines, and the production function
becomes flatter (16).
The relationship between the quantity a firm can produce and its costs is
graphically represented by the total-cost curve (17). Such relationship is the
most determinant aspect that determines pricing decisions. Cost of production
can be divided into two types of cost:
Fixed costs are those costs that do not vary with the quantity of output
produced. Fixed costs incur even if the firm produces nothing at all; they
include for example rent and salaries.
On the other hand variable costs are those costs that do change as the firm
alters the quantity of output produced and include especially raw materials.
The Total costs (TC) is given by the sum between the Total variable costs(TVC)
and the total fixed cost (TFC): TFC+TVC=TC. It follows that the average total
costs is given by the sum of average fixed costs and average variable cost:
AVC+AFC= ATC. The average fixed costs is given by the fixed costs divided

by the quantity of output while the average variable costs is given by the
variable costs divided by the quantity of output. Thus average costs can be
determined by dividing the firms costs by the quantity of output produced and
refers to the cost of each typical unit of product. The average fixed cost will
tend to "0" with the increasing amount produced, while will assume maximum
value in correspondence with the minimum production. The function of the
overall average cost will present, therefore, a "U" form as the sums of the
two previous curves. Marginal cost (MC) measures the amount of total cost
that rises when the firm increases production by one unit. Marginal cost is
given by the change in total cost divided by the change in quantity
(DeltaTC/DeltaQ). The marginal cost has some properties:
- The MC of the first unit of output produced will be equal to its average
variable cost, since the variable costs are zero if theproduction is nothing.
-The cost of each additional unit is less than the calculated average up to that
point, in the case of average costs increasing.
-The MC is higher than the average variable cost in the case of increasing
variable costs
AFC, AVC, ATC and MC can be graphically represented (18) and usually
presents the following properties:
- Marginal cost rises with the amount of output produced (reflects the
property of diminishing marginal product).
- The average total-cost curve is U-shaped: At very low levels of output,
average total cost is high because fixed cost is spread over only a few units.
Average total cost declines as output increases. Average total cost starts rising
because average variable cost rises substantially.
- The bottom of the U-shape occurs at the quantity that minimizes average
total cost. The quantity of output that minimizes average cost in known as
efficient scale.
The marginal-cost curve crosses the average-total-cost curve at the efficient
scale.
Costs in the short and long run
For many firms, the division of total costs between fixed and variable costs
depends on the time horizon being considered. Managers in the making
decision process in fact must consider both the short run and the long run.
While the short time is the period of time in which some factors of production
cannot be changed, the long run is the period of time in which all factors of
production can be altered. Because many costs are fixed in the short run but
variable in the long run, a firms long-run cost curves differ from its short-run
cost curves (19).
Economies and diseconomies of Scale (20)
There are 3 effects related to the production in the long-run:
- Economies of scale occur when long-run average total cost declines as
output increases. In this situation the proportionate increase in output is
greater than the proportionate increase in total cost.
- Diseconomies of scale occur when long-run average total cost rises as
output increases. When the proportionate increase in total cost is greater thant
the proportionate increase in output the firm is said to experience decreasing
returns to scale.
- Constant returns to scale occur when long-run average total cost does not
vary as output increases.
Profit

The economic goal of the firms is to maximize profits. Total Revenue of the
firm refers to the amount that the firm receives for the sale of its output while
the Total Cost to the amount that the firm pays to buy inputs. It follows that
profit is given by the difference between total revenue and total cost.
In such matter we can distiniguish between the economic profit and the
accounting profit. The economic profit is measured by an economist as the
firms total revenue minus all the opportunity costs (explicit and implicit) of the
production process. On the other hand accountants measure the firms
accounting profit as the firms total revenue minus the firms explicit costs.
When total revenue exceeds both explicit and implicit costs, the firm earns
economic profit. Because the accountant ingores the implicit costs, accounting
profit is usially larger than economic profit.
Isoquants and isocosts
Firms attempt to maximize output or minimize costs taking into consideration a
constraint of limited factor inputs. Different firms have different ratios of factor
inputs (land, labour and capital) in the production process. Such differences are
more relevant in different industries, but still present even within the same
industry. Firms can utilize their factors of production in different ways to
produce any given output; obviously the objective of any firm is to maximize
output at minimum cost: the use of isocost and isoquant lines provide a
model to help conceptualize such process. In this model the firm analyze
different combinations of factors which yield the same amount of output
(isoquants) and the budget available to pay those factors of production
(isocosts).
Isoquants
The production isoquant(23) is a function which represents all the possible
combinations of factor inputs that can be used to produce a given level of
output. the set of all combinations of inputs exactly sufficient to produce a
given amount of output is said isoquant. The Isoquant is similar to the
indifference curves for the consumer, with the only difference that the
Isoquants are characterized by the amount of output produced, while the
indifference curves indicate the level of utility from consumption. Any
substitution of input will have an effect on the shape and position of the
isoquants. Firms will often look at the option of substituting capital for labour by
making staff redundant and investing instead in new equipment. It is importan
to underline that substituting one factor for another will incur costs. The Slope
of the Isoquant represents the marginal rate of technical substitution
(MRTS). This is the rate at which one factor input can be substituted for another
at a given level of output. In such matter is important to take into consideration
the concept of marginal product (above!).
Isocost
A business has to take into consideration the obvious fact that factor inputs
cost money (wages, energy, materials). Isocost lines (24) take the cost of
factor inputs into consideration. An isocost line shows the different combination
of factor inputs which can be
purchased with a given budget.
Cost minimization
In order to achieve pofit maximization is necessary to follow a cost
minimization approach. Given the inputs, firms have to find the most efficient
way to produce a certain level of output: through the isocost strainght line,
firms are able to indetify all the combinations of input availabe to produce the

fixed amount of output at some cost. The slope of the isocost line is equal to
the ratio between the prices of the inputs used. Tallest straight isocst lines
correpsond to highest costs. Cost minimization is achieved when the isocost
straight line is low as possible. the manufacturer can reduce costs by moving
along the curve of isoquant up to touch the lower isocost curve.
The behaviour of producer
In order to carry out the activities in the most efficient way, the producer has to
take into consideration precincst, production factors, production function
and competitive market where the firm operates.
Analyze the firms precincst is concerned with studying firm behavior
examining the technical constaints to which it is subjected .
The production factors can be classified as land, work, capital and raw
materials. Work refers to any human effort in the production process while the
term land refers to the set of natural resources used in production. Capital can
be divided into physical capital (machinery, manufacturing plants) and
financial capital (money used to finance the company) The economic system,
given the scarcity of resources, it is not able to realize a "endless" production;
furthermore, the presence of the technological constraints implies that only
certain combinations of inputs allow to produce a defined amount of output.
The optimal combinations of the production set lie on the production
function (2!), which indicates the maximum production obtainable from an
economic system, given the technological knowledge and a given amount of
input.
Competitive market
A market in which there is only one supplier has no competition as consumers
have no choice, but a market where there are many suppliers gives consumers
the opportunity of making a
chice based on quality, value for money, price and so on. Therefore
competition refers to a situation where there are rivals in production who allow
the consumer to make a choice. In a competitive market, where the price is
determined by the meeting of demand and supply, the quantity produced will
depend only on the amount required. The presence of 4 elements generate
competition:
- More than one firm offers the same or a similar product there is competition
- Competition manifest itself where substitutes exist. (E.g. gas and electricity
are separate markets, but there is the opportunity for consumers to substitute
gas cooker for electric ones)
- The closer the degree of substitutability the greater will be the competition
that exist;
- Firms may influence the level of competition through the way they build
relationships with consumers, encourage purchasing habits, provide levels of
customer service etc.
At the extreme end of the competitive scale is a perfectly competitive
market. Such market has serveral characteristics:
- There are many buyers and sellers in the market (Atomization market)
- Homogeneity of the product offered: the good is not replaceable; this
means that the other goods available do not allow to satisfy the same need;
- Transparency: everyone has access to all available information and in
particular to market prices and conditions of sale.
- The absence of barriers to entry: each operator is free to come and go
from the market

- Firms have to accept the price determined by the market as a whole, no

individual firm in fact can influence supply and price. Firms are referred to as
being price takers. Each seller can sell all he wants at the going price, he
has little reason to charge less, and if he charges more buyers will go
elsewhere (Sovereignty of the consumer). Therefore all consumers will have the
same marginal utility, while producers, will have the same rate of technical
substitution.
Total, average and marginal revenue for a competitive firm (25)
Total revenue is proportional to the amount of output and is given by selling
price times the quantity sold. TR = (P X Q). On the other hand the average
revenue is given by the total revenue divided by the amount of output and tell
how much revenue a firm receives for the typical unit sold. In perfect
competition, average revenue equals the price of the good
AR
= Price. Moreover the marginal revenue is the change in
(Price Quantity)
=
Quantity
total revenue from the sale of each additional unit of output (MR =TR/ Q).
Profit Maximization (26)
Firms in competitive markets try to mazimize profit, which equals total revenue
minus total cost. This means that the firm will want to produce the quantity
that maximizes the difference between total revenue and total cost. A long as
marginal revenue exceeds marginal cost, increasing the quantity produced
adds profit. On the other hand when marginal revenue is lower than marginal
cost there is the need to decrease the quantity produced. Moreover profit
maximization occurs at the quantity where marginal revenue equals marginal
cost.
Short-run and long-run decisions - Shut down and exit
A shutdown refers to a short-run decision not to produce anything during a
specific period of time because of current market conditions. In the short-run
the competitive firms supply curve is its marginal cost curve above average
variable cost. Thus the portion of the marginal-cost curve that lies above
average variable cost is the competitive firms short-run supply curve. If
the price falls below the average variable cost, the firm should shut down its
activities (27).
Exit refers to a long-run decision to leave the market. In the long-run, the
competitive firms supply curve is its marginal cost curve above avarege total
cost. Thus the competitive firms long-run supply curve is the portion of its
marginal-cost curve that lies above average total cost. If the price falls below
the AVT the firms should exit the market (28).
The short-run and long-run decisions differ because most firms cannot avoid
their fixed costs in the short run but can do so in the long run. That is, a firm
that shuts down temporarily still has to pay its fixed costs, whereas a firm that
exits the market saves both its fixed and its variable costs. The shutdown and
exit decisions are made in situation where:
- Total revenue is lower than variable cost
- Total revenue divided per quantity is lower than variable cost divided per
quantity
- Price is lower than the avarage variable cost.
(A firm should enter the market if has the opposite situation)
The firm considers its sunk costs when deciding to exit, but ignores them when

deciding whether to shut down. Sunk costs are costs that have already been
committed and cannot be recovered. Supply in a Competitive Market
We can examine a market with a fixed number of firms as well as a market in
which the number of firms can change as old firms exit the market and new
firms enter. Both cases are important: over short periods of time it is often
difficult for firms to enter and exit, so the assumption of a fixed number of firms
is appropriate. But over long periods of time, the number of firms can adjust to
changing market conditions.
The short- run: Market supply with a Fixed number of firms (29)
Market supply equals the sum of the quantities supplied by the individual firms
in the market.
For any given price, each firm supplies a quantity of output so that its marginal
cost equals price. As long as price is above AVC, the firms marginal cost curve
is its supply curve. In fact the market supply curve reflects the individual
firms marginal cost curves.
The long- run: Market supply with entry and exit (30)
Decisions about entry and exit a market depend on the incentives facing the
owners of existing firms and the entrepreneurs who could start new firms. The
entry of new firms will expand the number of firms, increase the quantity of the
good supplied, and drive down prices and profits. On the other hand the exit of
firms will reduce the number of firms, decreasing the quantity of the good
supplied, and drive up prices and profits. At the end of this process of entry and
exit, firms that remain in the market must be making zero economic profit.
The process of entry & exit ends only when price and average total cost are
driven to equality. Profit is equal to both marginal and averege total cost. The
.arginal cost and average total cost are equal only when the firm is operating at
the minimum of averege total cost (firms efficient scale). The long-run
equilibrium in fact must have firms operating at their efficient scale. In the
presence of positive profits other firms would, in
fact, encouraged in entering the market. In a market characterized by free
entry, profits
are almost null (if there were positive profits other firms would have an
incentive in entering the market).
Equilibrium in Perfect Competition Market
The situation of market equilibrium (10) occurs when the amount consumers wish to buy at a
particular good is the same as the amount sellers are willing to offer for sale at that price. Thus the
competitive equilibrium (or General) is achieved when the total amount of each asset that every
consumer is willing to buy at market prices is equal to the total amount available to the buyers. The
price at this intersection is called equilibrium price while the quantity is called the equilibrium
quantity. When the market equilibrium is achieved everyone of the market has been satisfied.
The market will remain in equilibrium until something causes either a shift in the demand curve or a
shift in the supply curve. If the price is lower than the equilibrium price, the demand exceeds
supply; in such situation the producers have more demand than they can satisfy, thus they shall
consider the advantageous of increase the price of goods. Conversely, if the price were higher than
the equilibrium price, the offer would be greater than the demand, so sellers will tend to reduce their
prices to attract more buyers. Graphically, the balance is still represented by the intersection of the
supply curve of the market with the demand curve of the market. The balance of the market is the
lowest price that companies can practice without a loss. The quantity produced in
competitive equilibrium will be that in correspondence of which marginal
revenue is equal to marginal cost and price, as the marginal revenue coincides
with the price. If this condition is not possible to increase profit by varying the

quantity produced.
Under the conditions of perfect equilibrium there are no further incentives to
the
exchange: the gains of utility or product that could be achieved would be null.
This situation is typical of a market monoproduct characterized by a high
number of
companies that produce a quantity of output negligible (insignificante)
compared to the quantity exchanged in the market.

Monopoly
When the market does not present the characteristics of the perfect
competition, we say that firms are operating under imperfect competition.
Firms which operate under the imperfect competition are able to differentiate
their product in order to influence the price. We define the situation where a
firm is able to raise the price and not lose its sales to rivals as market power.
Monopoly is the form of market characterized by the offer concentrated in the
hands of a single undertaking, which can affect the price by the amount which
decide to sell. A monopoly therefore is a market structure with only one firm;
even though firms can exercise monopoly power by being the dominant firm in
the market. A firm is considered a monopoly either if it is the sole seller of its
product or if its product does not have close substitutes.
We define a monopoly firm as price maker. The monoply company in
contrast to what happens in perfect competition will not accept the price given
by the market because able to influence it. Monopoly company will usually
choose the price levels and output that maximize its total profit. Monopolist will
manage both outputs quantity and price depending on the choices of
consumers in terms of the amount that consumers are willing to buy at a given
price. Monopolist can therefore either fix the price and let consumers decide
the corresponding quantity or fix the amount of quantity to sell and let
consumers decide what price to buy it. A monopy can remain the only seller in
its market because other firms cannot enter the market and compete with. The
funamental cause of monopoly is therefore the barriers to entry in it. A
barrier to entry exists where there is something that pervents a firm from
entering the market. Barriers to entry have four main sources:
1) A key resource is owned by a single firm: Nowadays economies are
large and resources are owned by many people. Therefore monopolies rarely
arise for this reason
2)The government gives to a single firm the exclusive right to produce
some good or service: governments may grant a monopoly because in the
public interest. The patent and the copyright laws are two examples of how
the government create a monopoly: the patent confers to the owner the
right to prevent anyone else making or using an inventation or
manufacturing process without permission. On the other hand the
copyright refers to the right an individual or organization has to own things
created in the same way as physical objects to pervert others form copying
or reproducing such creation.
3) The cost of prodcution makes a single producer more efficient than a
large number of producers: an industry is a natural monopoly when a
single firm can supply a good or service to an entire market at a smaller cost
than could two or more firms. A natural monopoly arises when there are
economies of scale over the relevant range of output.

4) A firm is avle to gain control of other firms and erect barriers to make
harder for new firms to compete.
Monopoly versus competition (31) (Summary 36)
The key difference between a competitive firm and a monopoly is the
monopolys ability to influencethe price of its output. A competitive firm takes
the price of its output as given by market conditions. By contrast, because a
monopoly is the sole producer in its market, it can alter the price of its good by
adjusting the quantity it supplies to the market. A competitive firm sells a
product with many perfect substitutes, therefore the demand curve that any
one firm faces is perfectly elastic (horizontal demand curve). The firm has
therefore no market power. By contrast, because a monopoly is the sole
producer in its market, its demand curve is the market demand curve
(downward-sloping demand curve). If the monopolist raises the price of its
good, consumers buy less of it. Looked at another way, if the monopolist
reduces the quantity of output it sells, the price of its output increases.
Monopoly optimal condition- Profit Maximization (32)
The optimal condition that must occur so that the monopolist maximizes profit
is that Marginal Revenue equals the Marginal Cost. A monopoly
maximizes profit by producing the quantity at which marginal revenue equals
marginal cost. It then uses the demand curve to find the price that will induce
consumers to buy that quantity.
If Marginal Revenue was higher than the Marginal Cost, the company would
have convenience to increase the amount of output produced: In fact, the
revenue increase would offset the increased costs.
Conversely, if marginal revenue is less than the marginal cost, the firm would
get a higher profit by reducing the output produced. First case of optimal
condition:
The only point in which the company has no incentive to vary the amount of
output produced is the point where MR equals MC. The condition of
optimization is actually the same as for the competitive company with the only
difference that in the perfect competition market MR is equal to the market
Price. The effect that is generated, in monopoly, with a variation of the output
produced is twofold: if the firm increases the quantity produced, on the one
hand the revenue increases, of the other part the price reduces and, therefore,
all the quantity output will be sold at a lower price. Second case of optimal
condition:
A different way of identifying the optimal choice for the monopolist is assumed
that the company can choose the price and quantity, in respect of the bond
demand. If the monopolist wants to sell a greater amount of output will reduce
the price, but the lower price will apply not only to the additional quantities
produced and sold, but to all units produced. While in competition a firm which
practices a lower price than that charged by all businesses deprive them of the
entire market. In a position of monopoly the company already has the entire
market demand, lowering the price must be considered that the effect will be
to reduce the price of all units sold.
Monopoly revenue
The total revenue equals the quantity sold times the price. A monopolists
marginal revenue is always less than the price of its good. Because a monopoly
is the sole producer in its market,
it faces a downwards sloping demand curve for its product.

When a monopoly drops the price to sell one more unit, the revenue received
from previously sold units also decreases. When a monopoly increases
production by 1 unit, it
causes the price of its good to fall, which reduces the amount of revenue
earned on all units produced As a result, monopolys MR is always below the
price of its good.
When a monopoly increases the amount it sells, it has two effects on total
revenue (P x Q). The output effect: more output is sold, so quantity is higher
increasing total revenue. The price effect: price falls decreasing total revenue.
While for a competitive firm, price equals marginal cost P = MR = MC, for a
monopoly firm, price exceeds marginal cost
P > MR = MC. Profit equals total revenue minus total costs. The monopolist
will receive economic profits as long as price is greater than average total cost.
Profit = TR - TC
Profit = (TR/Q - TC/Q) x Q
Profit = (P - ATC) x Q (33)
In monopoly the consumer will pay a higher price than competitive conversely
the producer practicing a higher price will increase its profits. Consequently,
there will be a change in producer surplus and a change in consumer surplus:
the producer surplus is the amount seller is paid minus the cost of production
while the consumer surplus is the amount a buyer is willing to pay for a good
minus the amount the amount the buyer actually pays for it.
Pareto-efficieny
Pareto efficiency occurs if it is not possible to reallocate resources in such a
way as to make one person better without making anyone else worse. Markets
are all about trading and, as we have seen, the demand curve tells us
something about the benefit consumers receive from allocating their income in
a particular way, and the supply curve the benefit to suppliers of offering goods
for sale
The Welfare Cost of Monopoly
In contrast to a competitive firm, the monopoly charges a price above the
marginal cost. From the standpoint of consumers, this high price makes
monopoly undesirable. On the other hand from the standpoint of the owners of
the firm, the high price makes monopoly very desirable. We have noted that
the equilibrium of supply and demand in a competitive market is not only a
natural outcome but a desirable one. The invisible hand of the market leads to
an allocation of resources that makes total surplus as large as it can be.
Because a monopoly leads to an allocation of resources different from that in a
competitive market, the outcome must, in some way, fail to maximize total
economic well-being.
The efficient level of output (34)
Total surplus in the market would be maximized at the level of output where
the demand curve and marginal cost curve intersect. Below this level, the
value of the good to the marginal buyer (as reflected in the demand curve)
exceeds the marginal cost of making the good. Above this level, the value to
the marginal buyer is less than marginal cost.
The deadweight lost (35)
The fact that the market outcome under monopoly is different to that under
conditions of perfect competition means there is a deadweight loss
associated with monopoly. Comparing the company competitive and
monopolistic that it appears that in monopoly the output produced is lower and
price higher, than those applied in competition. If we wanted to measure the

overall loss of efficiency due to the monopoly, we should jointly measure the
loss of the consumer and the producer. The demand curve reflects the value of
the good to consumers, as measured by their willingness to pay for it. The
marginal cost curve reflects the costs of the monopolist. Thus, the socially
efficient quantity is found where the demand curve and the marginal cost curve
intersect. Below this quantity, the value to consumers exceeds the marginal
cost of providing the good, so increasing output would raise total surplus.
Above this quantity, the marginal cost exceeds the value to consumers, so
decreasing output would raise total surplus. The efficient outcome would be
where the demand curve intersects the marginal cost curve where P = MC.
The monopolist chooses the profit maximizing output where the marginal
revenue and marginal cost curves intersect but this is not the same as the
socially efficient output where the demand and marginal cost curves intersect.
The monopolist usually produces less than the socially efficient quantity of
output. We can also view the inefficiency of monopoly in terms of the
monopolists price. Because the market demand curve describes a negative
relationship between the price and quantity of the good, a quantity that is
inefficiently low is equivalent to a price that is inefficiently high. When a
monopolist charges a price above marginal cost, some potential consumers
value the good at more than its marginal cost but less than the monopolists
price. These consumers do not end up buying the good. the area of the
deadweight loss triangle between the demand curve and the marginal cost
curve equals the total surplus lost because of monopoly pricing. The
deadweight loss caused by monopoly is similar to the deadweight loss caused
by a tax.
Natural monopoly
As stated before the monopolistic market may be formed by natural reasons
(eg mineral water spring), for statewide initiative (eg tobacco) or for
circumstances legalized in fact (eg patents) or for purposes of general interest.
In certain circumstances the price of the monopolist is equal to the marginal
cost; therefore the profit could be negative due to the high fixed and very low
marginal costs. Consequently, if the company were to be compelled to produce
at the market price would suffer losses, because, not able to cover its fixed
costs. For this reason, natural monopolies are usually regulated or managed
directly by the State. In certain cases the State intervenes and sets the
price (equal to the average cost) that the company, providing the public
service, can impose. On the other hand sometimes the State manages this
service directly by providing a subsidy to the company that allows to company
to produce according to the criterion of equality between price and marginal
cost. The state provides subsidy in situation related to high fixed costs as well
as situation of inefficient management.
Public policy toward monopolies
We have seen that monopolies, in contrast to competitive markets, fail to
allocate resources efficiently. Monopolies produce less than the socially
desirable quantity of output and, as a result, charge prices above marginal cost
(inefficiency). Policymakers in the government can respond to the problem of
monopoly in one of four ways, by:
1) Trying to make monopolized industries more competitive
2) Regulating the behaviour of the monopolies
3) Turning some private monopolies into public enterprises
4) Doing nothing at all.

Trying to make monopolized industries more competitive:

All industrialized countries have process for legally prohibiting activity by firms
with market power that are against the public interest. This is variously referred
to as anti-trust law and anti-trust policy and also as competition law and
competition policy. Two important antitrust law are : Sherman Antitrust Act
(1890) that reduced the market power of the large and powerful trusts of that
time period and Clayton Act (1914) that strengthened the governments
powers and authorized private lawsuits. Competition legislation covers three
main areas:
- Acting against cartels and cases where businesses engage in restrictive
business practices which prevent free trade.
- Monitoring and supervising acquisitions and joint ventures.
- Banning pricing strategies which are anti-competitive such as price fixing,
predatory pricing, price gouging and so on.
Regulating the behaviour of the monopolies
Another way in which the government deals with the problem of monopoly is
by regulating the behaviour of monopolists. This solution is common in the
case of Natural Monopolies, such as utility companies like water, gas and
electricity companies. These companies are not allowed to charge any price
they want; in fact government agencies regulate their prices. One might
conclude that the price should equal the monopolists marginal cost. If price
equals marginal cost, customers will buy the quantity of the monopolists
output that maximizes total surplus, and the allocation of resources will be
efficient. Nevertheless monopolies have declining avarege total cost. When the
average total cost is declining, marginal cost is less than average total cost. If
regulators are to set price equal to marginal cost, that price will be less than
the firms average total cost, and the firm will lose
money. Instead of charging such a low price, the monopoly firm would just exit
the industry.
Turning some private monopolies into public enterprises
The third policy used by the government to deal with monopoly is public
ownership. That is, rather than regulating a natural monopoly that is run by a
private firm, the government itself can run the monopoly itself. All industry
owned by the government is called a Nationalized
industry. This solution is common in many EU countries, where Government
owns and operates utilities such as the telephone, water and eletric companies.
Doing nothing at all
Each of the foregoing policies aimed at reducing the problem of monopoly has
drawbacks. As a result, some economists argue that it is often best for the
government not to try to remedy the inefficiencies of monopoly pricing.
According to George Stigler Government can do nothing at all if the market
failure is deemed small compared to the imperfections of public policies.
Price Discrimination
We have shown that the monopolist produces an inefficient level of output as
the production of an additional unit of output would decrease the price of all
output produced. In many cases firms try to sell the same good to different
customers for different prices, even though the costs of producing for the two
customers are the same. This practice is called price discrimination. Price
discrimination is not possible when a good is sold in a competitive market; a
firm to price discriminate in fact it must have market power.
Monopolistic competition

Markets that have some features of competition and some features of

monopoly. This market structure is called monopolistic competition. In this
market, on the one hand there is a manufacturer that has exclusive rights and
has the power to determine the price, but on the other hand, companies
compete trying to attract customers with the price or the type of product.
Monopolistic competition describes a market with the following attributes:
1) Many sellers: There are many firms competing for the same group of
customers.
2) Product differentiation: Each firm produces a product that is at least slightly
different from those of other firms, either physically different or perceived as
different by consumers. The firm is able to have some control over the extent
to which it can differentiate its product from its rivals. More effective is the
differentiation, the greater the monopoly power of that company. Therefore,
rather than being a price taker, each firm faces a downwards sloping demand
curve.
3) Free entry. Firms can enter (or exit) the market without restriction. There
are no constraints that prevent new companies to enter this market. This
situation will lead to a change in the firm's demand curve following the entry of
other firms in the market. In fact, at each price, the number of products that
the firm can sell decreases as the number of firms entering the market. The
demand curve will become also more elastic: if more companies produce
products more and more similar, freedom of entry will bring a little at a time to
annul the profit of each firm. Thus, the number of firms in the market adjusts
until economic profits are driven to zero.

Firms Stay in Business with Zero Profit

Firms stay in business with zero profit are characterized by the fact that the
proit equals total revenue minus total cost . Nevertheless is important to
underline that opportunity costs are included in the total cost. In the zero-profit
equilibrium, the firms revenue compensates the owners for the time and

money they expend to keep the business going. A nil profit does not mean that
a company disappears, but simply that it ceases to expand (Samuelson,
Nordhaus, 1996).
Increase in Demand in the Short Run
An increase in demand raises price and quantity in the short run. Therefore
firms earn profits because price now exceeds average total cost. The
marginal firm is the firm that would exit the market if the price were any
lower.