ECONOMICS REVISION

MACROECONOMICS
Is generally the study of individuals and business decisions.  With regards to the allocation of resources & price of goods and services  Also means taking account of taxes and regulations created by the government Focuses on Supply and Demand and other forces that determine price levels seen in the economy Utility (individual benefit) total satisfaction received from consuming a good/ service Decisions made based on competition in the market Opportunity Cost- cost of an alternative in order to pursue a certain action Marginal utility Total utility Market failure and competition.

MACROECONOMICS
Studies the behaviour of the economy as a whole and not just on specific companies but entire industries and economies. Looks at economy wide phenomena; such as GDP and how it is affected by changes in unemployment, national income, rate of growth & price levels. Try to forecast economic conditions to help consumers/ firms/ governments make better decisions Customers want to know how easy it is to find work/ cost of goods/services in the market/cost of borrowing. GDP Unemployment Inflation Demand & disposable income Monetary policy Fiscal policy

DEMAND
Price depends on what objectives companies are trying to meet. (revenue maximisation/ profit maximisation) A graph showing the relationship between price and quantity demanded over a given period of time. Fundamental concept, backbone of a market economy. Refers to how much of a product or service is desired by buyers. Quantity demanded is the amount people are willing to buy at a certain price.

Demand Curve
Shows quantities of a good/ service that will be demanded over a period of time at each possible price that might exist. Helps explain buyers behaviour If price changes we mover up or down the curve. At low prices demand rises as price falls and quantity increases At high prices demand may become zero as price rises and quantity falls.

Shows change in consumers behaviour/ change in relationship between the price and quantity

SHIFTS; Occurs when a goods quantity demanded or supplied changes even though price remains the same.

MOVEMENTS; Refers to a change along a curve Denotes a change in both price and quantity demanded from one point to another on the curve. Implies demand relationship remains consistent. Movement occurs when a change in quantity demanded is caused ONLY by a change in price & vice versa.

Determents of Demand
Tastes and fashion (Advertising) Expectations Substitute goods Complementary goods (cars and petrol) Income; Normal goods/luxury goods/inferior goods.

Law of demand
The quantity of a good demanded in a given period of time will fall as price rises and will rise as price falls, other things may be equal. I.e. if the price of a good rises the quantity demanded will fall.

Supply
Time is important to supply as you cant always adjust supply quickly when a change in demand/price occurs. Need to identify whether the change will be permanent/ temporary. Demonstrates qualities that will be sold at a given price

Unlike demand relationship shows an upward slope. The higher the price the higher the quantity Producers supply more as a higher price means more revenue as more is sold.

Equilibrium
When supply & demand are equal the economy is said to be at equilibrium At this point allocation of goods is at its most efficient as the amount of goods supplied is exactly the same as the amount of goods being demanded. At a given price suppliers are selling all the goods that they are demanding In real life, this is just a theory, hence why prices constantly change in relation to fluctuations in demand & supply.

Disequilibrium
Occurs when price and quantity is not equal. Excess supply (price is set too high) Excess demand (price set below equilibrium price.

Elasticity (lectures)
Price elasticity of demand: The demand for a good may respond to a change in its price Demand may increase, decrease, remain the same. Percentage change in the demand for a good resulting from a 1% change ( + or - ) in its price. FORMULA:
% change in quantity demanded / % change in price

When EP < 1 demand is inelastic or unresponsive to change in price When EP > 1 demand is unit/ unitary and a change in price results in an equal change in demand.

Consumer expenditure & total revenue.

Can be used to illustrate the effect of changing price on consumer expenditure. FORMULA: Total sales / Total revenue Shows whether elastic / inelastic TOTAL EXPENDITURE / REVENUE = PRICE * QUANITITY (area under demand curve.) Therefore when demand is elastic a price fall results in expenditure or total revenue rising. If price goes up revenue falls.

Income elasticity of demand

Measures responsiveness of demand to changes in consumers real income. DETERMINANTS. No. of closeness of substitutes (the more substitutes the more elastic demand will be) Time Market definition Amount of income available to spend on good CROSS PRICE ELASTICITY OF DEMAND Examines substitutes/ complementary goods price changes The responsiveness of demand for one good to a change in the price of another
% change in quantity demanded of a good X / % change in price of good Y

Price discrimination
Consumer surplus = the benefit gained by being willing to pay more for a product than they actually have to pay First degree discrimination;

Seller charges buyer the highest price he or she is willing to pay for a commodity (car sales, Auctions) Second degree discrimination; Firm charges according to how much is consumed, charge higher for the first few units then charge lower after that. (electricity/ gas, telephones) Third degree discrimination; Consumers put in separate markets. (age/ location/ ) charged different prices.

Elasticity Summary
The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

. Summary
A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. Elasticity = (% change in quantity / % change in price)

Summary
If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

Utility
Underlying Demand & supply curve is concept of utility which represents the advantage or fulfilment a person receives from a good or service Abstract concept rather than a concrete, observable quantity. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility corresponds to the person's level of consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption.

Utility continued;
Although total utility usually increases as more of a good is consumed, marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. There is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. Total utility will increase at a slower pace as an individual increases the quantity consumed.

Utility continued
The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more.

Firms and Costs

All firms must pay attention to its level of costs and the structure of costs. High costs relative to revenue is bad for profit PROFIT = REVENUE COST Variable costs = varies with the level of production Fixed costs = independent of level of production

The law of diminishing marginal returns

A law of economics stating that as the number of employees increases the marginal product of an additional employee will at some point be less than the marginal product of the previous employee. (adding additional units of an input to a productive process will yield less additional output per unit.)

Productivity
Economic measure of out per unit of input. (inputs include labour & capital) Output measured in revenues/ other GDP components. Can be examined collectively (across whole economy) or viewed by industry to examine trends in labour growth, wage levels.
MARGINAL PRODUCTIVITY = change in output / change in variable output.

Shot run analysis

S costs = s fixed costs + s variable costs SAC = STC / Output STC = SAC per unit produced * output MARGINAL COSTS MC= change in TC resulting from increasing or decreasing output by 1 unit.

Cost curves
The short run marginal cost curve will at first decline then go up at some point and will intersect the average total cost and average variable cost curves at their minimum points. The AVC curve will decrease then increase The FC will decrease as additional units are produced and will continue to decline. ATC will decline as fixed costs are spread over a larger number of units, but will increase as MC increase due to the law of diminishing returns.
The law of diminishing returns state that as one production input is added , all other types of input remain the same, at some point production will increase at a diminishing rate.

Long term output

All factors variable
ECONOMIES of scale; In long run, firms are able to cut costs through mass production Means goods can be produced at a lower cost per good, as the quantity produced increases. DISECONOMIES of scale; Complexity of managing large organisations, lack of communication, industrial relations problems, boring repetitive jobs. A situation where economies of scale no longer work for a firm.

Supply
Firms decisions; Assuming price is known a firm has to decide whether to carrying on producing goods or shut down, or if it continue to produce how much of that product do they need. Assume the firm is a product maximiser; PROFIT = (price SRATC) * output If price is high say price > SRATC (profit is positive) then its ok to produce If price < SRATC (price not high) and there are some losses need to check if SRAVC < profit < SRATC If it is then ok to produce If price < SRAVC not ok to produce.

Supply
As long as price covers average variable cost you stay in business, otherwise SHUTDOWN. As long as price > marginal cost firms can keep increasing output Stop when price = marginal cost

Supply Curve
Slopes increase from left to right Shows a direct relationship If the price of a good increases, suppliers increases the quantity supplied. Movement along the supply curve is a result of a change in price Shift along the curve us a result of changes induced by determinants of supply other than price.

Determinants of Supply
The cost of production; If costs rise production becomes less profitable at any price so firms forced to cut back on production. If costs fall firms will increase production of goods and services. Unpredictable events (natural disasters) Expectations of future price changes.

Market Structure and profit maximisation

Profit = revenue costs Firm is a profit maximiser therefore making a profit is the one thing everyone has in common. Total revenue = price * quantity Average revenue = TR / Q sold
Marginal revenue =change in TR resulting from increasing sales by 1 unit

Profit is maximised at the point where MR = MC

Continued
Market spectrum; perfect competition; Oligopoly; monopoly
Characteristics Number of Firms Market Share Perfect Competition Many Monopolistic Competition Many Oligopoly Monopoly A few large, many small May be large/ Relatively large Differentiated One

Small

Small

All

Product

Homogeneous

Differentiated

Differentiated

Entry Barriers Price

None

Low

May be high

High

Taker

Maker

Maker/ interdependent

Maker

Profit - short run - long run

Abnormal Normal

Abnormal Normal

Abnormal Abnormal

Abnormal Abnormal

Perfect Competition
Its competition of the highest intensity High number of buyers and sellers Firms are price takers Identical products (Homogenity of products) Free entry, free exit A single firm cannot influence the market price MR = AR = P Therefore the best strategy is to find best output at the prevailing market price. Perfect knowledge of price, quality and cost No single buyer/ seller is powerful enough to influence the market price.

Monopoly
The firm is the whole industry; e.g. National lottery, Microsoft No close substitutes Firm controls the market, price setter not price taker Can change revenue in 2 ways; By changing output or price. +ves; Economies of scale, Profit used for R & D and investment, Innovation & new products -ves; Generally high price, low volume, Possibility of high inefficiency and high costs due to lack of competition (there are some exceptions)

Barriers to entry
Legal (patents) or Regulatory (Licences) Patent rights, threat of take over, threat of price war, Brand loyalty, Economies of scale, lower production costs. In some instances, economies of scale exist so that there is a tendency toward a natural monopoly - one firm can provide the good most efficiently. One traditional example is the distribution of electrical power to a local community. Duplication of power lines within a community would increase overall costs. With natural monopolies, government policy to encourage more entrants may not make sense.

Continued
Social Welfare = consumer surplus + producer surplus * consumer surplus: difference between price that consumers are willing to pay and what they finally pay * firms interest: Producer surplus, difference between the price the company is willing to sell at and the actual price received. Optimal stopping point in monopoly is MR = MC As the monopolist does not know exactly how much consumers are willing to buy at particular prices, it must "search" for the optimum price.

Effects of monopoly
BAD, produces less leaving opportunities unexploited. Causes deadweight loss. Not profitable for a monopolist to produce up to the socially optimum point. Moving away from monopoly allows greater social welfare Reduce deadweight loss by: Market method (encourage competition) or Regulatory method (regulating the monopolies output choice directly.) Government should encourage competition Break monopolies engaged in unfair practices Competition commission is a regulatory body who does this

*All firms want to be in the top right box, worst place is the bottom left box.

Input and output markets

Where should the firm be?

Input market

Output market

Perfect competition Low revenues, High Low costs revenues,

Perfect competition

Monopoly

Low costs
Monopoly Low revenues, High revenues, High costs High costs

Oligopoly
Duopoly (2 firms) Oligopoly (several firms) Firms are price setters Each firm is aware that its actions or decisions will influence its rivals actions or decisions. (strategic interdependence)

Prisoners dilemma (Game theory.)

Branch of applied mathematics and economics dealing with choices made under conflict and uncertainty. Predicts solutions to a game, like problems, tells us what strategies the player should take in equilibrium of a given game. John Nash suggested an equilibrium concept called Nash equilibrium, helps us understand the outcomes of a game no matter how complex. Strategy is a decision rule over actions. Pure strategy; player prefers to play one action over the other Mixed strategy; When a player is uncertain between two possible actions. Dilemma; whether to compete or be nice Competition erodes everyones profit Tit for tat approach; I will be nice if you are to me

Shot run Monopolistic competition

Some markets characterised by product differentiation: Reduces strategic interdependence By developing brand loyalty small monopolies can be created around the brand. Competition will still exist. Monopoly power can be created through brand loyalty.

Long run monopolistic competition

Each firm still decides on its output by the MR = MC rule Create their own rival goods/ brands to pre-empt potential competition or entry, increases profit. Potential competition rather than actual competition keeps the price down. Have strong incentives to collude because while acting together they can restrict output and set prices so that economic profits are earned.

Market Failure
Private efficiency is achieved where; MB (marginal benefit) = MC (marginal cost) Given to companies through independent action of companies and individuals. Social efficiency : MSB = MSC Where; MSB (marginal social benefit) MSC (marginal social cost)

Externalities
Costs and benefits of production or consumption experienced by society, but not by producers or consumers themselves. +ve externalities; technological development, immunisation -ve externalities; pollution, noise. Production externalities make social and private marginal costs diverge. Consumption externalities make social and private marginal benefits diverge

Social efficiency in production

MSB = MSC this is the only point where production is optimal. Where MSB > MSC there is scope to produce more as higher benefits are added by producing an extra unit as compared to extra costs. Where MSB < MSC there is scope to reduce production, as the benefit of extra production is lower than the cost of the extra product.

Social efficiency in consumption

MSB = MSC is the only point where consumption is optimal. Where MSB > MSC there is scope to consume more, towards an increased utility, as opposed to the cost of the extra product consumed. Where MSB < MSC there is scope to reduce consumption, as the utility from consuming an extra product is lower than the cost.

Market failure
All circumstances in which market equilibrium is inefficient. 4 fundamental reasons why markets fail:
 Monopoly (market functions inefficiently)  Externality (market can sometimes lead to disasters)  Asymmetric information and uncertainty (2nd hand car purchases can go wrong)  Public good (market rarely provides public goods such as roads.)

Monopoly
To reduce dead weight loss of a given monopoly government must regulate it. To prevent future monopoly the competition commission oversees activities such as mergers, price setting behaviour and activities of regulated industries. ASYMETRIC INFORMATION; Market for lemons, (2nd hand cars) where the seller knows the quality but the buyer can not be certain. Vulnerable to selling products of an unknown quality. Regulations such as MOTs boost buyers confidence.

Continued
Uncertainty; Stock markets are a good example, Rumours, news, political events can trigger heavy selling of stocks, or run on the banks. These markets have a peculiar feature, individuals can choose a side, either buy or sell. If most people suddenly sell market will crash. Public goods; Good or service characterised by non-rivalry and nonexcludability which are attributes preventing it from being provided by the market. Free market fails to provide public good, because the market cannot price it properly.

The tragedy of the commons

Described a dilemma in which multiple individuals acting independently in their own self interest can ultimately destroy a shared resource even where it is clear that it is not, in anyones long term interest for this to happen.

Externalities as a form of market failure.

The need of equating marginal benefits and costs, options at hand are;  Compensation mechanism (coase theorem)  Government Intervention  Need of clearly defined property rights in order to negotiate efficient level of externality (usually efficient at a level different from zero.) OTHER TYPES OF MARKET FAILURE;      Labour & geographical / occupational mobility Constantly moving equilibrium points in real markets Artificial barriers to entry enhance immobility Negative goods over consumed (smoking / gambling) Merit goods consumption too low.

Intervention to address market failure

Taxes and subsidies Property rights changes Prohibitions and regulation behaviour Price control Providing information Direct provision of goods and services.

Business Growth strategies

Argument that growth is pursued in order to increase profitability implies: Enhancement of total revenue and/or Decrease in total costs Consequence: as total costs and total revenue move apart, profit maximising and maximum profit increase. Some firms want to live beyond their owners lifetime, some dont.

Types of growth
Horizontal; Keep repeating core operations; Companies spend a lot of time exploring new markets Vertical growth; Acquire retail outlets, input supplying firms. Diversification; Diversify into other markets All 3 strategies are profit enhancing The one that is right depends on the firm & how competitive the market structure is. There are +ves and ves to every strategy Firms use a bit of all 3

Horizontal growth
The expansion of the core business of a company. Observed over time within a given geographic area; organic growth. Generally involves mergers and acquisitions +ves; economies of scale, market growth Mergers/ acquisitions are likely to bring cost reduction Economies on fixed inputs such as management will be exploited after rationalising the cost structure. Increase in production brings learning curve effects, learning to cut costs by avoiding mistakes. -ves; decrease in competition when growth is due to mergers & acquisitions Loss of jobs = socially bad

Vertical growth
Results from the act of integrating along the vertical chain of production. Strong quality concern and high scope for cost reduction lead to vertical growth.

Vertical integration; To avoid monopoly in the input market, a firm can buy an input manufacturing firm elsewhere and bring its production cost down. Most often manufacturers buy various inputs from a network of suppliers. For many products a complex task : whole network must work coherently 2 problems; transaction costs & hold up problem Transaction costs are additional or hidden costs other than the price paid in any transaction.

Diversified Growth
Diversification = venturing out in two or more unrelated markets. Reasons; Technological: Economies of scope, costs will fall with adding more products. Risk reduction; e.g. strengthening brand name

Flexible manufacturing and mass customisation

Term flexible manufacturing technology or lean production covers a range of manufacturing technologies that are designed to; Reduce set up times for complex equipment Increase utilisation of individual machines through better scheduling Improve quality control at all stages of the manufacturing process.

Mass customisation
Implies that a firm may be able to customise its product range to suit the needs of different customer groups without bearing a cost penalty.

Where to produce?
Country factors; Favourable economic, political and cultural conditions, including relative input costs Regulations affecting foreign investment and are very important. Expectations about future exchange rates crucial. Technological factors; Type of technology a firm uses in its manufacturing can affect location decisions The level of fixed costs, its minimum efficient scale (MES), its flexibility Product Factors; Question of whether the product serves its universal needs Since few national differences in consumer tastes and preferences for some products the need for local responsiveness is reduced. Increase in attractiveness of concentrating manufacturing in a central location.

Vertical integration (Make)

Associated with low costs Facilitates investments in highly specialised assets Protects proprietary technology Facilitates the scheduling of adjacent processes.

Lowering costs; If firm is more efficient at a specific production activity than any other enterprise, may pay a firm to continue manufacturing a product / component part in house. Facilitating specialised investments Benefits of manufacturing components in house are greatest when highly specialised assets are involved, when vertical integration is necessary, when the firm is more efficient than external suppliers at performing a particular activity.

+ves of buying
Gives firm more flexibility Helps drive down firms cost structure Helps firm to capture orders from international customers Switch between suppliers.

Business Objectives
We assume businesss to be profit maximisers -ves; alternatives to profit maximising Sales maximisation Growth maximisation Satisficing behaviour These are the managerial theories if the firm

Short run profit maximisation

Output determined where MR = MC Related issues; Assumes owner controls the business (no separation of ownership and control) Assumes that cost and demand (revenue) curves are known- no uncertainty

Problems with profit maximisation

Firms unlikely to know their demand and marginal revenue functions Firms operate under conditions of uncertainty Development of large limited liability companies & the separation of ownerships and control. (atomisitic shareholding, owners delegate control to managers.) Conflicting objectives Information assymetry

In PLCs (public limited companies)

A) shareholders owners (interested In profit) B) managers / directors (company size) C) profit remains a constraint on managers

Sales maximisation
Aggressive strategy Captures the market early on, steals business from rivals Common misunderstanding claims that if sales increase so do profits But laws of diminishing returns are in operation with costs increasing with output resulting in falling profits. Sales growth is a poor indicator of overall performance of a company

Growth Maximisation
Managers may be empire builders over profit maximisers The size & rate of growth of the company may be excessive from profit maximisers point of view Rapid growth may put company in a stronger position than its rivals (can achieve economy of scale therefore reducing costs, achieve a higher market share which will achieve greater pricing power.) May be seen as a profit maximiser in the long run.

..
Goal Setting = companys goals may reflect interests of the top manager. Target Setting = whoever has greater power in the company is likely to have greater influence over company targets. Managers may fail to meet targets but still achieve an acceptable level of performance. Satisficing = attainment of an acceptable level of performance; decision making strategy which attempts to meet criteria for adequacy, rather than to identify an optimal solution.

Principal Agent Model

Its a response to managerial theories Argues firms DO maximise profits They explain; the parties in the model, the agency problem, possible solutions to the agency problem. Particpants; A) principles of quoted companies (PLCs) (shareholders who provide the capital, want profit maximisation.) B) Agents; (appointed or hired, by the principle to run the company for them (directors) assume the agent represents the principles best interest. Agent signs contract aligns interest of principles and agents.) Agents have other aims (salary / prestige and perks)

Possible solutions
Monitor agents actions Executive director compensation (incentives for agents) (traditionally; pay = basic salary + bonus) Stock options as a solution! Individuals have the option to purchase shares therefore if a manager takes up this option & buys shares in the company it acts as an incentive to ensure company profits increase. Higher profits are reflected in the share price. Managers are encouraged to take risks and make appropriate investment.

Regulating competition through government intervention

Competition : low prices, high quantity Government intervention towards high competition; competition policy, privatisation / deregulation. Competition v.s. monopoly The need for competition policy Perfect competition v.s. monopoly power; compare price, output, profit from point of consumer not firm. Monopolies may be good, its the misuse of market power that is the problem. Regulatory framework is necessary to protect the public.

UK policy 1998 competition act

Restrictive practices Any practice that presents, restricts or distorts competition is illegal . Deals with collusive behaviour, collusive tendering, price fixing.