UGC-NET Study Material: Economics Harbour PDF

UGC-NET STUDY MATERIAL PART-1 (SECOND EDITION) ECONOMICS HARBOUR We Teach How to Reach Success!!!...

UGC-NET STUDY MATERIAL PART-1 (SECOND EDITION) ECONOMICS HARBOUR We Teach How to Reach Success!!! CONTENTS 1. Micro-Economics 2. Macro-Economics 3. Development Economics 4. International Economics 5. Econometrics 6. Statistics 7. Mathematical Economics 8. Game Theory Contact Information:- www.economicsharbour.com; [email protected] Mobile No.: +917837587648  MICRO-ECONOMICS Part 1- a Notes by Economics Harbour Notes by Economics Harbour www.economicsharbour.com Page 0  Micro-Economics Micro-Economics NOTESBYECONOMICSHARBOUR CONCEPT OF DEMAND The concept of demand was given by Alfred Marshall in 1890s in his book “Principles of Economics”. According to him, the demand can be represented by following words: 1. Desire 2. Willingness 3. Ability to pay for the commodity 4. Price of the commodity 5. Time Demand is a flow concept. Difference between “Demand Changes” and “Quantity Demanded Changes” Demand Quantity Changes Demanded Changes Due to any other factor like income, tastes and preferences, prices of Due to change in price. substitutes or complements, etc. Law of Demand The law of demand was given by Alfred Marshall. It is a partial equilibrium analysis and states that there is an inverse relationship between price of the commodity and the quantity demanded of it. Demand Curve: It is the graphical presentation of the law of demand Demand Schedule: It is the tabular presentation of the law of demand. Demand curve and demand schedule do not tell us what the price is, it only tells us how much quantity of the good would be purchased by the consumer at various possible prices. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 1 Micro-Economics Market Demand: It is the horizontal summation of individual demands. It is affected by the population levels. Market demand curve is flatter as compared to the individual demand. Reasons for downward sloping demand curve 1. Law of Diminishing Marginal Utility: The law was given by Alfred Marshall and it states that “as the consumer consumes more and more of a good, the marginal utility derived from each successive unit keeps on decreasing. 2. Income effect: Decrease Increase Increase in Increase in in Real Purchasing in price Income power demand 3. Substitution effect: Marshall explained the downward sloping demand curve with the aid of substitution effect alone; he ignored the income effect on price change. Good becomes Consumption Decrease in cheaper as price compared to and demand others increases 4. Different uses of a commodity Decrease in Commodity Demand price put to increases different uses 5. Size of the market Decrease in More Demand people will price be attracted increases Exceptions to the Law of Demand 1. Veblen Effect: Goods having prestige value. Veblen propounded the doctrine of conspicuous consumption. Under this case, the prestige value of a commodity is associated with its price. This implies, higher the price of the commodity, more will be the prestige derived from it. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 2  Micro-Economics 2. Giffen goods: The concept was given by Robert Giffen. According to him, for giffen goods there is a positive relationship between price and quantity demanded, that is, as price decreases, quantity demanded of it also decreases. Inferior Goods The demand curve for a giffen goods is an upward sloping curve. Giffen goods Giffen goods 15 10 Price 5 0 0 2 4 6 Units 3. Ignorance 4. Expectations 5. War Bandwagon Effect: It arises because individuals demand commodities because others are doing so, or in simple words, it is in fashion. Snob Effect: It arises due to the desire to purchase a commodity having prestige value so as to look different or exclusive than others. Factors Determining Demand Factor Relation with the Demand 1. Tastes and Preferences of Demand + Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 3 Micro-Economics 2. Income of the people + 3. Change in the price of Related Goods Substitutes (+) Complements (-) 4. Advertising Expenditure + 5. Number of customers in the market + 6. Future Expectations about the price + Increase or Decrease in Demand Leads to shift in the demand curve. Caused by Shift Factors of Demand (Factors other than price) Expansion or Contraction of Demand Leads to movement in the demand curve. Caused due to price. Demand for Durable goods Durable goods can be stored, hence the prices are not volatile. Consumption can be postponed. Derived Demand It is the demand for goods which are used to produce other goods. Example Labour. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 4  Micro-Economics ELASTICITY OF DEMAND The concept of elasticity of demand was given by Marshall. Elasticity of demand measures the responsiveness or change in demand due to factors like price, income, price of related goods, etc. The differences between quantity demanded and elasticity of demand are: Demand Elasticity of demand It is qualitative in nature. It is quantitative in nature. It gives directions to where the demand will It tells about the extent of change in demand go with the change in price. due to change in price. Kinds of Elasticity 1. Elasticity of Substitution (Es) : 𝑸𝒙 𝑸𝒙 ∆( )/( ) 𝑸𝒚 𝑸𝒚 Es = ∆𝑴𝑹𝑺𝒙𝒚/𝑴𝑹𝑺𝒙𝒚 Where: x = Good 1, y = Good 2, MRSxy = Marginal Substitution of good x for good y Good MRSxy Es Perfect Substitutes Constant Infinity Perfect Complements Zero Zero In case of high elasticity of substitution, it is easy to change the proportion and there is not much change in marginal rate of substitution. 2. Price elasticity Price elasticity = (-) (∆𝑸/𝑸) (∆𝑷/𝑷) Price elasticity is the proportionate change in quantity demanded divided by the proportionate change in price. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 5 Micro-Economics Degrees of Price Elasticity: Ep < 1 Ep = 1 15 25 20 10 Price 15 Price 10 5 5 0 0 0 5 10 15 0 2 4 6 Quantity Quantity EP =  Ep > 1 11 21.0 10 20.5 9 Price Price 8 20.0 7 19.5 6 5 19.0 0 5 10 15 20 25 0 2 4 6 Quantity Quantity EP = 0 50 40 30 Price 20 10 0 19.0 19.5 20.0 20.5 21.0 Quantity Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 6  Micro-Economics Measurement of Price Elasticity of Demand ∆𝑸 (𝑸 ) a. Proportionate or Percentage Method: (-) ∆𝑷 ( ) 𝑷 b. Point Elasticity Method = 𝑳𝒐𝒘𝒆𝒓 𝑺𝒆𝒈𝒎𝒆𝒏𝒕 𝑼𝒑𝒑𝒆𝒓 𝑺𝒆𝒈𝒎𝒆𝒏𝒕 ∆𝑸𝟏 ( )) 𝒒𝟏+𝒒𝟐 c. Arc Elasticity Method = ∆𝑷/(𝑷𝟏+𝑷𝟐) It is used when price and quantity changes are somewhat large. 𝑨𝑹 d. Revenue Method (e) = (𝑨𝑹−𝑴𝑹) e. Total Expenditure Method: Evolved by Marshall Situation  in Price  in Qty  in Elasticity of Expenditure demand A   Constant Ed = 1 (Unitary elastic) Ed>1 (Greater B   Increases than unity) C   Decreases Ed < 1 (Less than unity) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 7 Micro-Economics 3. Income Elasticity: It is the responsiveness of change in quantity Income demanded due to change in income elasticity levels. Income elasticity = ∆𝐐/𝐐 ∆𝐘/𝐘 Normal Good Inferior goods (ey) > 0 (ey) < 0 Luxuries Necessities (ey) > 1 0 < ey < 1 Engel curve: Engel curve is the graphical presentation of relationship between income and quantity demanded. a. Necessities Necessities 40 30 Income 20 10 0 0 2 4 6 8 Quantity b. Luxuries: Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 8  Micro-Economics Luxuries 20 15 Income 10 5 0 0 2 4 6 Quantity c. Inferior goods Inferior Goods 20 15 Income 10 5 0 0 2 4 6 Quantity 4. Cross Elasticity of Demand measures the degree of responsiveness of change in the demand for one good in response to the change in price of another good. 𝐏𝐫𝐨𝐩𝐨𝐫𝐭𝐢𝐨𝐧𝐚𝐭𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐪𝐮𝐚𝐧𝐭𝐢𝐭𝐲 𝐝𝐞𝐦𝐚𝐧𝐝𝐞𝐝 𝐨𝐟 𝐗 Ec = 𝐏𝐫𝐨𝐩𝐨𝐫𝐭𝐢𝐨𝐧𝐚𝐭𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐭𝐡𝐞 𝐩𝐫𝐢𝐜𝐞 𝐨𝐟 𝐠𝐨𝐨𝐝 𝐘 𝚫𝐐𝐱 𝐏𝐲 Ec = 𝚫𝐏𝐲 * 𝐐𝐱 Qx = Quantity Demanded of Good X Py = Price of Good Y Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 9 Micro-Economics Goods Cross Elasticity Substitutes Positive Complements Negative Unrelated Zero Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 10  Micro-Economics THEORIES OF DEMAND 1. Cardinal or Marshallian Analysis Cardinal school is the oldest school in case of theories of demand. According to them, the characteristics of utility are: a. Subjective b. Reflects the satisfaction level derived from a commodity. c. It is based on introspection d. Measured in relative terms e. It is ethically neutral, that is, cannot associate features of good or bad. Concept of Utility was originally given by Bentham, however, it was formally introduced by Jevons. He defined utility as the power of a commodity or service to satisfy human wants. Assumptions of cardinal analysis are as follows: a. Utility can be measured. b. Consumer is rational c. Money is a measuring mode of utility. d. Marginal utility of money is constant: The concept of Marginal Utility of money was given by Daniel Bernoulli. e. Utilities are additive in nature. f. Utilities are independent. g. It is based on introspection. Theories under Marshallian Analysis a. Law of Diminishing Marginal Utility: It is also known as Gossen’s First law. Law of Diminishing Marginal Utility states that as the consumer consumes more and more of a commodity, the marginal utility derived on consuming each additional unit keeps on declining. Before going into details, we should know some important concepts: Total Utility (TU): Total utility is the total satisfaction achieved after consuming all the units of a particular commodity. In other words, it is the sum of marginal utilities of each successive unit of consumption. o TU = ⅀MUX Marginal Utility (MU): Marginal Utility is the additional or incremental utility achieved after consuming additional unit of a commodity. Therefore, it can be formulated as: ∆𝐓𝐔 o MUx = ∆𝐐 Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 11 Micro-Economics Marginal Utility curve is simply the slope of the total utility curve. Diminishing Marginal Utility 40 TU Point of Statiation 30 MU TU, MU 20 10 Point of satiation 0 2 4 6 8 10 -10 Quantity This law operates to: Achieve maximum satisfaction Goods are not perfect substitutes. The law of diminishing marginal utility depends on the following factors: Total wants of a human are unlimited but it is possible to satisfy each single want. Different goods are not perfect substitutes for each other. Marginal utility of the money is constant. In this law, marginal utility of money and tastes and preferences are generally taken to be stable. However, if they change, then marginal utility curve will shift accordingly. Significance of Law of Diminishing Marginal Utility It explains the relationship between demand and price. It explains the paradox of value. Marginal utility determines the price of a commodity and not the total utility. More availability of Less durability Low Price the commodity Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 12  Micro-Economics b. Law of Equi-Marginal Utility: It is also known as Gossen’s Second Law. The law states that the marginal utility derived should be equal to that derived from the last rupee spent. 𝐌𝐔𝐱 𝐌𝐔𝐲 𝐌𝐔𝐤 MUm = = =.......... = 𝐏𝐱 𝐏𝐲 𝐏𝐤 The law is more associated with the consumer’s equilibrium. Consumer will reach the equilibrium point when: In case of single good: MUx = Px In case of several goods: MUm = (MUx/Px) = MUy/Py = …… Criticisms of Marshallian Analysis a. Not practical b. Utilities cannot be measured c. Marginal utility of money cannot be constant. d. Marshall ignored the income effect. Therefore, he was unable to decompose price effect into income effect and substitution effect. e. He was unable to explain giffen paradox. 2. Ordinal or Hicksian Analysis Utilities cannot be measured. Assumptions of the theory: a. Utilities can be ranked. b. Consumer is rational. c. Indifference curve is based on weak ordering, that is, it considers both preferences and indifference. d. The consumption follows a transitive pattern. e. Completeness: If we have two goods, there would be some kind of relationship between them (either preferred to or indifference). f. Continuity: The consumption follows a smooth continuous curve which can be drawn. g. Diminishing Marginal Rate of Substitution: MRSXY = ∆Y/∆X = MUx / MUY Note: MRSXY is also the slope of Indifference curves. h. Dominance/Non-satiety/monotonicity: More will always be preferred to less. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 13 Micro-Economics Indifference curves The convex shape of IC shows diminishing MRS. Indifference Map: Set of ICs Why the MRS is decreasing? Want of the good is satiable. Goods are imperfect substitutes of each other. Properties of Indifference curve a. Downward sloping curve b. Convex to the origin. c. Two indifference curves never intersect. d. Higher indifference curve means higher satisfaction. Shapes of Indifference Curves are: a. Substitutes: Perfect Substitutes 6 4 Good Y 2 0 0 2 4 6 Good X b. Perfect Complements: Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 14  Micro-Economics Perfect Complements 15 10 Good Y 5 0 0 1 2 3 4 5 Good X c. When one commodity is a good and other is a bad: Bad is a good which gives disutility after consumption. 40 30 Good 20 10 0 0 2 4 6 8 Bad d. Circular Indifference Curve: Circular Indifference curve is when the consumer tries to reach an optimal point between two goods. Closer is the consumer to the point of bliss, more will be the satisfaction. Budget Constraint PxQx + PyQy = Money Income Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 15 Micro-Economics Budget Constraint 6 4 Good Y 2 0 0 2 4 6 Good X When there is a change in income levels, it leads to shift in the budget line. When there is a change in prices, it will lead to the movement in the budget line. Consumer Equilibrium Assumptions: 1. Given indifference map 2. Fixed income 3. Prices are given and constant 4. Goods are homogenous and divisible. Consumer Equilibrium 10 Indifference Curve 8 Budget Line Consumer Equilibrium Good Y 6 4 2 0 0 2 4 6 8 Good X At the point of equilibrium, Second Order Condition: At the point of tangency, indifference curve should be convex to the origin. MRSXY = MUX / MUY = (-) PX / PY Conditions for consumer equilibrium First Order Condition: MRSXY = MUX / MUY = (-) PX / PY Notes by Economics Harbour (2nd Edition) www.economicsharbour.co m Page 16  Micro-Economics Engel Curves Engel Curves show the relationship between income of the consumer and the quantity demanded of a good by him. The shape of the indifference curves are as follows: Necessities Luxuries 60 50 40 40 Income Income 30 20 20 10 0 0 0 2 4 6 8 0 2 4 6 8 Quantity Quantity Inferior Goods When X is a Neutral Good 40 40 30 30 Income Income 20 20 10 10 0 0 0 2 4 6 8 1.90 1.95 2.00 2.05 2.10 2.15 Quantity Quantity Income Effect To trace the income effect, we have an Income Consumption curve which shows the changes in consumer equilibrium with changes in income. We had classified the goods into normal good and inferior goods on the basis of changes in consumption due to changes in income. Normal goods are those whose consumption increases with increase in income, while inferior goods are those whose consumption decreases due to increase in income. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 17 Micro-Economics In this case, both the commodities are normal goods. However, it is possible that one good be inferior and the other may be inferior. Then in that case our income consumption curve will be a backward bending curve. In the diagram below, the commodity X is an inferior good. Substitution Effect Substitution effect traces the changes in consumption of commodities when the relative prices change. In case of tracing the substitution effect, we keep the real income as constant so that we can know the relative change in the prices. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 18  Micro-Economics Substitution effect is always negative. This implies that a fall in the relative price, increases the demand for the commodity. Substitution effect is given by: 1. Hicks Substitution Effect: Under this method, the price changes are in tune with the changes in money income so that the consumer is neither worse off nor better off, that is, he remains on the same indifference curve. The amount by which money income changes is known as the compensating variation in income. 2. Slutsky Substitution Effect: It is also known as the cost-difference method. It is a better method as compared to hicks’ because it was built on the available data and is more mathematical. Under this method, the consumer moves on a higher indifference curve, that is, the consumer is over compensated. The consumer has the opportunity to buy the original bundle or go on the higher indifference curve. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 19 Micro-Economics Price Fall Price Rise S.E.Slutsky > S.E.Hicks S.E.Slutsky < S.E.Hicks I.E.Slutsky < I.E.Hicks I.E.Slutsky > I.E.Hicks Price Effect Price effect is the change in demand due to change in the price of the commodity, other things remaining the same. To trace the changes in price effect, we have price consumption curve. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 20  Micro-Economics PCC Curve Price Elasticity (ep) Whether the goods are related or not PCC Ep < 1 Cross Elasticity < 0 40 Goods are complementary 30 Good Y 20 10 0 0 2 4 6 8 Good X PCC Ep > 1 Cross Elasticity > 0 30 Goods are subsitutes 20 Good Y 10 0 0 2 4 6 8 Good X PCC Ep = 1 Cross Elasticity = 0 10.6 10.4 10.2 Good Y 10.0 9.8 9.6 9.4 0 2 4 6 8 Good X Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 21 Micro-Economics Goods are unrelated Goods Price Effect Income Effect Substitution Effect Normal Goods Negative Positive Negative Inferior Goods Negative (I.E. S.E.) Negative Negative Benefits of Ordinal Theory of Demand 1. It decomposes price effect into substitution effect and income effect. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 22  Micro-Economics 2. Explains the positive relationship between quantity demanded and price in case of giffen goods. Compensated Demand Curve: Considers only substitution effect. Real income remains constant. While studying consumer surplus, compensated demand curve is better. 3. Revealed Preference Theory: The theory was given by Samuelson in 1938. It is a form of ordinal ranking and is based on the concept of strong ordering. The theory is behaviour based and the choice of the consumer reveals the preference. Assumptions of the theory are: a. Consistency: If A is chosen over B, then B won’t ever be chosen if A is still available. b. Transitivity d. Income will be fully spent. c. Choice is always made e. More is preferred to less. Direct Revealed Preference Direct Revealed Preference 10 IC1 8 IC2 A Good Y 6 4 B 2 0 0 2 4 6 Good X A will always be preferred to B hence revealing the property of consistency. Indirect Revealed Preference In this case more than two goods are involved. For example, if A is preferred to B, and B is preferred to C, then A is indirectly preferred to C. Weak Axiom of Revealed Preference (WARP) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 23  Micro-Economics WARP 10 P1 8 P2 A Good Y 6 4 2 B 0 0 2 4 6 Good X B will be chosen on P1 set of prices because A becomes unaffordable. On the other hand, the strong axiom of revealed preference (SARP) is just the generalisation of weak axiom. Criticisms 1. Samuelson ignores the possibility of indifference in consumer’s behaviour. 2. Considers only single act of choice. 3. The theory does not account for Giffen’s paradox. Difference beween Indifference Curve and Revealed Preference Indifference Curve Revealed Preference Uses real income for estimating the level of Uses real income for estimating the purchasing satisfaction. power. Fundamental Theorem of Consumption The theorem was given by Samuelson. It states that price and quantity will be negatively related if we have positive income effect of demand. In case of indifference curve analysis, real income is used in the sense of level of satisfaction. In case of revealed preference, real income is used in the sense of purchasing power. 4. Hicks’ Logical Ordering This theory is the revised version of Hicks’ own theory in his work “A Revision of Demand Theory” in 1956. He was influenced by Samuelson’s work and hence used econometrics in his theory, keeping the original assumption that utility is ordinal in nature. The changes from his past theory were: Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 19 Micro-Economics a. He gave up indifference curve because it is limited to only two goods. b. He gave up the assumption of continuity. c. The difference between weak ordering and strong ordering was very clearly done in this theory. d. He also considered money. 5. Consumer Behavior Under Uncertainty The theory was propounded by Neumann and Morgenstein and is commonly known as N-M Utility Index. They have considered the role of both risk and uncertainty. Assumptions: a. Axiom of complete ordering: If we have two lotteries, either there should be a relationship of preference or indifference between them. b. Transitiveness c. Continuity d. Reflexivity: A good is indifferent between the two events having same outcome. e. Axiom of Independence: Suppose there are two lotteries, L1 = P1 (A,B) and L2 = P2 (C,B) If A is preferred to C, then L1 will be preferred to L2. f. Axiom of unequal probabilities: if in the above example, P 1 > P2, then L1 will be preferred to L2. g. Axiom of Compound lotteries: A lottery can also be the combination of two lotteries, for example, L1 = P1 (A,B) and L2 = P2 (L3, L4) h. Axiom of dominance or monotonicity: It implies that more is preferred to less. i. Local non-satiation: If there is even a minute difference between the two lotteries, consumer will be able to make out that difference. Expected value of a lottery The expected value of a lottery can be calculated using the weighted sum of the lotteries with probabilities acting as weights. E(L) = P1(A) + (1-P1)(B) Expected Utility of a lottery Expected utility of a lottery can be calculated using the weighted sum of the utilities associated with the outcomes with probabilities acting as weights. E(U(L)) = P1 (U(A)) + (1-P1)(U(B)) It reflects the uncertain income. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 20  Micro-Economics However, U(E(L)) = U[P1 (A) + (1-P1)(B)] shows certain income. Risk Averse 20 Total Utility 15 Marginal Utility Total Utility 10 5 0 2 4 6 8 -5 Income For a risk averse person, U[E(L)] is greater than E[U(L)] and marginal utility of money is falling. Risk Lover 30 Total Utility Marginal Utility 20 TU, MU 10 0 0 2 4 6 Income For a risk lover, U[E(L)] is less than E[U(L)] and marginal utility of money is rising. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 21 Micro-Economics Risk Neutral 6 Total Utility Marginal Utility 4 TU, MU 2 0 0 2 4 6 Income For a risk neutral person, U[E(L)] is equal to E[U(L)] and marginal utility for money is constant through all income levels. Risk premium is to protect the risk averse person to avoid risk. Measures of risk aversion: Two measures of risk aversion were given by Arrow and Pratt. a. Absolute measure: It is measured using the formula: [-U’’(W)/U’(W)] where W is a measure of wealth [-U’’(W)/U’(W)] is positive Risk Averse [-U’’(W)/U’(W)] is negative Risk Lover [-U’’(W)/U’(W)] is zero Risk Neutral b. Relative measure: It helps in comparing the attitude of workers towards risk and is measured using the formula W*RA Where RA is the relative attitude towards risk. Some other theories related to Consumer’s behaviour towards risk a. Bernoulli’s hypothesis: The theory assumes that majority of the population is risk averse and hence marginal utility of money is declining. For the risk averse person, the effect of gain received from the lottery will be less than the effect of loss incurred and hence he will never choose a 50- 50 probability. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 22  Micro-Economics b. Friedman-Savage Hypothesis: According to this theory, the marginal utility will not be constant over the entire range, that is, it will both increase and decrease. The attitude of the consumer would depend on whether the marginal utility of money is increasing or decreasing. Friedman-Savage Hypothese 40 (-) Total Utility of Money 30 (+) 20 (-) 10 0 0 5 10 15 20 Income c. Markowitz Theory: According to his theory, there can be both risk lovers as well as risk averse individuals. The marginal utility of money will not be constant over the entire range. However, in his theory, small increases or decreases in income will increase the marginal utility of money but large changes in income will always lead to decrease in marginal utility of money. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 23 Micro-Economics Markowitz Hypothesis 25 Marginal Utility of Money 20 15 10 5 0 0 5 10 15 20 Income d. St. Petersburg Lottery/Paradox: The paradox states that when the number of participants are less, then this might lead to infinite expected value. In the case, an individual will always accept the lottery. Investor Choice Problem Budget constraint will be an upward sloping line because there is a positive trade-off between risk and return. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 24  Micro-Economics PRODUCTION THEORY A production function shows the technical relationship between the inputs and outputs. Q=f(L,K) Assumptions of production function are: 1. State of technology is assumed to be constant. 2. Production function is with reference to a particular period of time. Production function 1 factor variable, others fixed All factors variable (Law of variable prop. (Returns to scale of because proportion inputs, LR Law) varies, SR law) TP = Total output produced AP= TP/L MP= TP/L Shifts in TP curve  in level of fixed TP increases input fixed input Output Elasticity of an Input 𝑶𝒖𝒕𝒑𝒖𝒕 𝑬𝒍𝒂𝒔𝒕𝒊𝒄𝒊𝒕𝒚 𝒐𝒇 𝒍𝒂𝒃𝒐𝒖𝒓 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒖𝒕𝒑𝒖𝒕 𝑴𝑷𝑳 = = 𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒍𝒂𝒃𝒐𝒖𝒓 𝑨𝑷𝑳 Law of Variable Proportions/Returns to a Factor It is a short run theory in which there is atleast one factor which is fixed, that is, it cannot change. Thus, this law deals with the changes in the factor proportions. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 25 Micro-Economics Beyond a certain point, the MP of the factor would diminish. Assumptions :- (1) Tech is fixed and constant (2) Some inputs should be ript constant (3) Various factors can be combined to produce a product. Stages of Law of Variable Proportions The stages of law of variable proportions can be defined as: Law of Variable Proportions 30 Stage 1 Stage 2 Stage 3 Total Product Average Product 20 Marginal Product TP,MP,AP 10 0 5 10 15 Units -10 Stage 1: Increasing returns to a factor Under this stage the marginal product increases, reaches maximum and starts decreasing. The stage ends where the average product reaches maximum. In this stage MP of the fixed factor is negative. Reasons for Stage 1 are: 1. Indivisibility of factors 2. Scope for specialisation and hence increase in efficiency. The fixed factor is efficiently utilised in this stage. Stage 2: Diminishing returns to a factor Under this stage, the marginal product decreases, average product starts falling. The stage ends when marginal product reaches zero. Reasons for Stage 2 are: 1. Scarcity of fixed factor 2. Indivisibility of fixed factor 3. Imperfect substitutability of factors: This reason was given by Joan Robinson stating that elasticity of substitution is not equal to infinity. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 26  Micro-Economics Stage 3: Negative Returns to a Factor Under this stage, the marginal product of the variable factor becomes negative as a result of which the total product starts falling. Reason for Stage 3: 1. Variable factor is in excess of fixed factor. Therefore, the most optimal stage of production is stage 2. A point to remember here is that in stage 1, the marginal product of fixed factor is negative because it is in excess of the variable factor. On the other hand, in stage 3, the marginal product of a variable factor is negative because it is in excess of the fixed factor. Isoquants/Equal Product Curves/Iso-Product Curves Isoquants is the locus of various combinations of input producing the same level of output. Properties of Isoquants are: a. Downward sloping curve b. Convex to the origin. c. Two isoquants never intersect. d. Higher isoquants means higher level of production. MRTS Slope of isoquants No of units of capital gives up to get me unit of labour, output to be the same. Diminishing is nature (Convexity) If isoquant is concave linear, the optimum production would be at a corner solution Elasticity of Substitution 1. Perfect substitutes: Marginal Rate of technical substitution is constant and elasticity of substitution is equal to infinity. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 27 Micro-Economics Perfect Substitutes 6 4 Input Y 2 0 0 2 4 6 Input X 2. Perfect Complements: Marginal rate of technical substitution is zero and elasticity of substitution is also equal to zero. Perfect Complements 15 10 Input Y 5 0 0 1 2 3 4 5 Input X Technical Coefficient It is the amount of factor required to produce a given level of output. For example, 100 units – 25 labour 1Unit – 25/100 0.25-technical coefficient Homogenous Production Function Q=f(x,y) Q=f,(mx, my) Q=mf(x,y) Homogenous of degree 1: linearly homogenous function All factors increase in same prop, thus implying, Constant Returns to Scale Types of Production Functions 1. Linearly Homogenous Production Function Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 28  Micro-Economics Q = f(L,K) If we multiply the production function with a constant say m, Q = f(mL, mK) Taking m to be common, we get; Q = m.f(L,K) Q= m.Q Anything raise to the power m, gives us the degree of homogeneity. 2. Cobb-Douglous Production Function It was given in 1928 and is represented as follows: Q = ALαKβ Where: Q = Output level, A = State of Technology, L = Labour, K = Capital, α = Share of Labour in production, β = Share of capital in production The features of C-D production function are: Linearly Homogenous Production Function Constant Returns to Scale Elasticity of Substitution is equal to one α tells the output or production elasticity of labour, β tells the output or production elasticity of capital and they both are constant. α+β=1 Constant Returns to Scale α+β>1 Increasing Returns to Scale α+β 0 Ϩ = Distribution Parameter; 0 < Ϩ < 1 ϱ = Substitution parameter Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 29 Micro-Economics Elasticity of Substitution = 𝟏 (𝟏+𝛠) Ridge Lines: Ridge lines are the locus of points where marginal productivity of atleast one factor is zero. Isoclines: Isoclines is the locus of points in which marginal productivity of inputs is kept constant. There are two ridge lines A and B. At A, the marginal productivity of capital is zero and points above A show negative marginal productivity of capital. At B, the marginal productivity of B is Zero and is negative at all points below it. The optimum stage of production is the region between the two ridge lines and hence is called the region of economic production. Returns to Scale It is a long run law in which all the factors are variable in nature and factor proportions do not change. All inputs will be varied by the same proportion. Technological Change Technological Change Process Innovations Product Innovations (New technique of (New Product) production) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 30  Micro-Economics Endogenous technological change Brought about within the firms through R&D Type of Technical Change 1. Neutral technical change 2. Labour saving technical change: capital bias. 3. Capital Saving technical change Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 31 Micro-Economics Stages of Returns to Scale 1. Constant Returns to Scale: Under this, the change in proportion of inputs is equal to the change in proportion of outputs. Isoquants are equi-distant. 2. Decreasing Returns to Scale: Under this, the change in proportion of inputs is greater than the proportionate change in outputs. The distance between the isoquants keep increasing. 3. Increasing Returns to Scale: Under this, the change in proportion of inputs is less than the change in proportion in outputs. The distance between the isoquants would keep decreasing. Reasons of Increasing, Decreasing or Constant Returns to Scale are explained by the Economies of Scale. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 32  Micro-Economics Economies of Scale (Output expansion's impact on the costs) Internal Economies External Economies of Scale of Scale (Firm Based) (Industry Based) Real Economies: Real economies are experienced when we reduce the quantity purchased of our physical inputs. Pecuniary Economies: Pecuniary economies are experienced when we purchase large quantities of physical inputs so that the overall price paid is less. For example, wholesale prices. Diseconomies of Scale Diseconomies of Scale (Disadvantage due to expansion of output) Internal Diseconomies of External Diseconomies Scale of Scale Caused By: 1. Management issues, 2. Caused by: 1. Burden on Co-ordination problem, 3. storage and transportation Technical Failures Under Constant returns to scale, the economies and the diseconomies are equal to each other. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 33 Micro-Economics Relationship between Returns to Scale and Returns to a factor Returns to Scale When Capital is held constant Constant Returns to scale Returns to a factor say MPL will diminish when capital is held constant. Decreasing Returns to scale Returns to a factor MPL will diminish at a rapid pace. Increasing Returns to scale There can be two possibilities: 1. If there are strong increasing returns to scale then returns to a factor MPL will increase. 2. If there is a slight increasing returns to a scale then returns to a factor MPL will decrease. Multi-product Firm Production Possibility Frontier: It is the combination of two goods which can be produced given the technology or level of resources. Iso-Revenue line: It is the locus of points of combination of two goods produced which generate equal revenue. Equilibrium Producer's Equilibrium 25 20 Equilibrium Good 2 15 10 PPC 5 Iso-Revenue Line 0 A 0 2 4 6 8 Good 1 Slope of PPC is the Marginal Rate of Product Transformation (MRPT) which is increasing because different resources are suited to produce different goods. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 34  Micro-Economics 𝐌𝐂𝐱 MRPTXY = 𝐌𝐂𝐲 Equilibrium point will occur where 𝐌𝐂𝐱 𝐏𝐱 MRPTXY = = 𝐌𝐂𝐲 𝐏𝐲 For a firm producing single output, equilibrium will occur at the point of tangency of isoquant and the iso- revenue line Producer's Equilibrium 20 15 Capital 10 Equilibrium 5 0 0 2 4 6 8 Labour Expansion Path: It is the locus of point of revenue maximisation. It is also known as scale line because it tells how firms change their scale of production. Expansion Path 25 PPC 2 20 PPC 1 Good 2 15 Expansion Path 10 5 0 0 2 4 6 8 Good 1 Price Effect In case of production theory, the price effect is the sum of output effect and substitution effect. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 35 Micro-Economics In case when factors of production are substitutable, then substitution effect is greater than the output effect implying that, if price of labor decreases, then labor would be used more as compared to the other input. In case the goods are complementary, then output effect is more than the substitution effect implying that with decrease in price of labor, more of both factors will be used. Important terms: 1. Technical Efficiency: It implies maximizing the output with given inputs. 2. Economic Efficiency: It implies minimizing the cost to produce a given level of input. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 36  Micro-Economics COST THEORY “In Economics, cost of production has a special meaning. It is all of the payments or expenditures necessary to obtain the factors of land, labour, capital and management required to produce a commodity. It represents money costs which we want to incur in order to acquire the factors of production.” Gulhrie & Wallace Cost = f (Output) In short run, we assume one factor of production to be variable and rest all are fixed. In the long run, we assume technology and prices to be constant. Shift Factors: These are the factors shifting the cost function other than the output. In the long run, technology and prices are the shift factors while in the short run, the fixed factors are considered to be the shift factors. Types of Cost 1. Explicit Cost: It is also known as the accounting cost, private opportunity cost. These costs are out of the firm or cost of hiring a factor of production. 2. Implicit Cost: Also known as the imputed cost. These are the prices of owned services and are included in the average cost. 3. Economic Cost: It is the sum of explicit and implicit cost. 4. Opportunity Cost: It is the cost of next best alternative and is a part of implicit cost. It is also known as transfer earnings. 5. Historical Cost: It is the original price of the factor of production when bought in the past. It is irrelevant in the production process. 6. Sunk Cost: It is a kind of historical cost which cannot be recovered. Even sunk costs are not relevant to decision making. Note: Economic Profits = Total Revenue = Economic Costs Total Cost = Total Fixed Cost + Total Variable cost Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 37 Micro-Economics Average Cost = Average Fixed Cost + Average Variable Cost Marginal cost is the change in Total cost represented as follows MC = TCN – TCN-1 or MC = TVCN – TVCN-1 Relationship between Average Cost and Marginal Cost Average Cost and Marginal Cost 30 AC MC 20 AC, MC 10 0 0 2 4 6 8 Units When AC is falling, marginal cost is falling more than AC. When AC is minimum, AC = MC When AC is rising, MC rises more than AC Long Run Costs Long Run Costs are less than or equal to short run costs, and are hence flatter as compared to the short run costs. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 38  Micro-Economics Long Run Average cost curve is also known as the planning curve. Plants are used at less than full capacity at point left to the minimum point and are used at more than full capacity at points right to the minimum point. The optimum plant size is when it operates at minimum LAC. Recent Developments in the Cost Theory 1. Saucer Shaped LAC Saucer Shaped LAC 15 10 LAC 5 0 0 5 10 15 Units The shape is such due to the reserve capacity. 2. L-Shaped or continuously falling LAC curve Continuously Falling LAC curve 15 10 LAC 5 0 0 2 4 6 8 Units Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 39 Micro-Economics The reasons for continuously falling LAC curve are: a. Economies of Scale b. Technological Progress 3. Learning Curve: This was given by Kenneth Arrow. It includes the concept of learning by doing. It states that the increase in cumulative output leads to decline in per unit cost due to learning by doing. Economies of Scope: Joint production of a good is more efficient than the separate production by two firms producing the same good. Diseconomies of Scope: Joint production is less than the individual production. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 40  Micro-Economics MARKET STRUCTURES Market Structure Perfect Monopoly Monopolistic Oligopoly Competition Competition Collusive Non- Oligopoly collusive Essentials of a Market 1. Commodity 2. Existence of buyers and scales 3. Place 4. Communication b/w buyers and scales – 1 price Form of No. of Nature of Price Price control Ease of entry product elasticity Market Firms Perfect Large Homogenous Infinity Zero Free Competition Imperfect competition a) Large Differentiated Large Some Free Monopolistic (close competition substitutes) b) pure Few Homogenous Small Some Limited oligopoly (cout product differentiation) c) Few Differentiated Small Large Limited Differentiated (close subsist.) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 41 Micro-Economics (with product diff.) (3) Monopoly One Unique out Very small Very large Strong close subst. barrows to entry 1. Perfect Competition: Features of perfect competition are: a. Large number of buyers and sellers. b. Free entry and exit. c. Perfect information. d. No transport cost. e. Homogenous Product It is important to understand the difference between perfect and pure competition. Perfect competition is a wider concept and is perfect in all contexts. On the other hand, pure competition is a narrower concept in which there is freedom from monopoly errors and freedom from entry and exit. Price Determination Industry Demand and Supply analysis Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 42  Micro-Economics Time element Marshall gave the concept and he divided time on the basis of response of supply (1) Market period /very short time period – supply fixed and there are no adjustments (2) Short period – Expand output with given equipment No change in plants or given capital. (3) Long period – New entry and exit New plants/abandon old ones Full adjustment of all factors and all costs. Demand curve of a Product facing a Perfectly Competitive Firm 1. No control over price 2. Raises price lose all customs 3. Sall any qty at that price Under Perfect Competition, MR = AR = Price Short Run Equilibrium Two conditions need to be satisfied for attaining the equilibrium level: a. Marginal Cost (MC) = Marginal Revenue (MR) b. MC should cut MR from below Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 43 Micro-Economics Short Run Equilibrium 15 AR=MR= Price AR, MR, Price, MC MC 10 5 Equilibrium 0 0 2 4 6 8 10 Quantity a. Super Normal Profits: Super normal profits occur when AR > AC b. Normal Profits Normal Profits occur when AR = AC Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 44  Micro-Economics c. Losses Losses occur when AR < AC Shut Down Point (P ≤ Average Variable Cost (AVC)) Long run Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 45 Micro-Economics In the long run, a perfectly competitive industry earns only normal profits, that is, Price = AR = MR = LMC = LAC = SAC = SMC Long Run Equilibrium (Industry): Conditions for equilibrium are: a. Every firm is at its equilibrium point, that is, price = MC. b. No new firms enter or exit the industry. Overall, Price = Marginal Cost = Long Run Marginal Cost. When these conditions are satisfied with equality between demand and supply, then it is called full equilibrium. Supply Curve (Short Run): It is the upward sloping part of MC above the minimum point of AVC. Supply Curve (Long Run): It is the upward sloping part of MC above the minimum point of AC. Industry curve can be upward/downward/horizontal sloping. It would be determined by net change in Economies and Diseconomies of Scale. Economic efficiency (Perfectly Competitive Market) Resources efficiently used; maximum possible satisfaction. Important points: a. A perfectly competitive firm does not quit the industry even if it incurs losses in the short run because they can’t alter the fixed capital equipment in the short run. As a result, they will have to incur the losses equal to fixed cost even when they shut down. Thus, they continue production in the short run even when they incur losses. b. A perfectly competitive firm is in business even when economic profits are zero because economic profits include the opportunity costs. So at zero economic profits, firms still earn a return on capital invested. So at zero economic profits, the firms still earn a return on the capital invested. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 46  Micro-Economics Consumer surplus :- Price consumers are wailing to pay- what they actually pay Producer’s surplus :- Mkt price at which sellers sell min price they are willing to sell. Criticism Maximising total economic surplus is not a good measure of equity. May not be fair/equitable Hence social well being cannot be measured 2. Monopoly Features: a. Single seller b. No close substitutes c. Legal or natural barriers to prohibit the entry of new firms. d. Affects no other seller by its own action. e. Firm and industry are one single entity. f. The demand curve in case of a monopolist is a downward sloping curve. Sources/Causes of Monopoly 1. Patents or copy rights – especially in case of new products 2. Control over essential raw materials example in case of OPEC 3. Grant of franchise by the Government. example MTNL in Delhi 4. Natural Monopoly:- Such kind experiences significant economies of scale, that is, continuous falling AC implying output large enough to meet the entire market demand. 5. Advertising and Brand loyalties of the Established firms. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 47 Micro-Economics Types of Monopoly: The distinction was given by Chamberlin Monopoly Pure Monopoly Ordinary Monopoly (Single Seller, no substitutes, cross elasticity = 0, price (Single Seller, the good elasticity = 1. Thus Total produced has substitutes, revenue remains constant. cross elasticity is low.) Natural Monopoly: It experiences economies of scale and the average cost is diminishing in nature. It is one big optimum sized firm. Legal/Statutory Monopoly: The government provides the legal status through patents or copyrights. Price and Marginal Cost under Monopoly Price difference from MC = f (Price elasticity at that point on AR curve) Smaller the elasticity, greater the difference between price and MC. Therefore, Monopoly price = f (MC, Price elasticity) Where, Monopoly price and MC are positively related, and Price elasticity and Monopoly price are negatively related. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 48  Micro-Economics Monopoly Equilibrium And price Elasticity of Demand Monopolist will never be in when ep < 1 We know, MR = AR [(e-1)/e] So when e < 1, MR becomes negative, implying a fall in total revenue. So it will not be rational for the monopolist to operate at a point where Marginal revenue is negative. Monopoly Equilibrium in case of Zero Marginal cost. Zero Marginal Cost Monopolist has to decide the output where total revenue will be maximum At maximum total revenue, Marginal revenue = 0, computing the elasticity = 1. Therefore, when the marginal cost is zero, monopolist operates at the point where price elasticity of demand is equal to one. Average revenue is decreasing because more can be sold at lower price. MR is below AR because its fall is twice the fall of AR. Therefore, Price is more than marginal cost. Cost curves remain the same. There is no supply curve in monopoly. No unique price-quantity relationship. Short Run: Conditions of equilibrium 1. MR = MC 2. MC should cut MR curve from below In short run, a monopolist can earn super-normal profits, normal profits or can even incur losses. The diagrammatic representation would be as follows: 1. Super Normal Profits: Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 49 Micro-Economics 2. Normal Profits: 3. Losses Long Run: In the long run, a monopolist earns only super normal profits because there are no barriers to entry. Conditions for equilibrium: a. Short run Average cost = Long run Average Cost (LAC) b. Marginal Revenue = Long Run Marginal Cost = Short run Marginal Cost c. Price > LAC Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 50  Micro-Economics Difference between Perfect Competition and monopoly PC Monopoly Price Longer Higher Quantity Higher Longer Monopolist does not have a unique supply curve because a shift in demand will lead to change in output/price. Monopoly, Resource Allocation & Social welfare - No economic efficiency - Dead weight loss. Drawback of Monopolies 1. Restriction of output to charge higher prices 2. Management slack – due to absence of competition 3. Do not make adequate expenditure on R&D Monopoly regulation a. Price regulation Price Regulation MC Pricing AC Pricing (Price is charged (Price is charged equivalent to the equivalent to AC) MC) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 51 Micro-Economics According to the diagram above, a monopolist would charge P m price. However, if government regulations are imposed, then the price charged would be lower. According to the MC pricing, the price charged would be Pg1 increasing the quantity to Qg1. While in case of AC pricing, the price charged would be Pg2 and quantity further increasing to Qg2. b. Taxes: Taxes Specific Tax (It will affect both MC and AC. If Lump Sum Tax specific tax increases, price increases and entire burden falls (It only affects on AC. Only profits on the consumers. would be reduced and there is no change in quantity and price) It is not a good way to regulate a monopoly. ) Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 52  Micro-Economics Price Discrimination: Price discrimination is an act of charging different prices from different consumers for the same good. It can either be systematic or unsystematic. Conditions necessary for price discrimination: a. There is no interaction between the two markets. b. Goods cannot be commuted between the two markets. Degrees of price discrimination a. First Degree of Price Discrimination: Features: Extreme form of price discrimination. Extracts entire consumer surplus. Marginal Revenue curve also becomes the demand curve. Marginal Revenue = Price Each consumer is charged his respective reservation price. It is also the ‘Take it or leave it’ strategy. Overall, 1. Extreme form because it extracts all consumer surplus, 2. MR = AR = P- Price charged is equal to what each consumer can pay for an incremental output. Second and third degree Price Discrimination are known as Imperfect Price Discrimination. Imperfect Price Discrimination- Why? a) Impractical to change each and every customer diff price b) firm does not know the reservation price of each customers. b. Second Degree of Price Discrimination: Features: It is applicable to a particular section of goods. Goods can be divided into different parts. Goods included are either recorded or billed or metered. c. Third Degree of Price Discrimination: Features: Different prices are charged in different markets depending on the elasticities. Example: Dumping. It is possible when the elasticities between the two markets are different. Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 53 Micro-Economics In case of the diagram below, the elasticity of demand is low in case of market segment 1 and thus price charged is higher. In case of the second market, the demand is quite elastic, as a result, the price charged is lower. When is price discrimination possible? 1. Nature of the commodity – in terms of transference like a 2. Long distance or tariff bankers – P.D. is possible 3. Legal sanction 4. Ignorance and laziness of burgers Condition of Price Discrimination 1. No interaction between 2 markets. Consumers should not be able to interact 2. Goods cannot be commuted between two markets. Under which market, price discrimination is possible? 1. Perfect competition- Not possible 2. Monopolistic competition- Some (Strong brand loyalty) 3. Monopoly – Yes Equilibrium for a discriminating monopolist Conditions are: a. Aggregate MR = MC b. MC = MRA = MRB Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 54  Micro-Economics Inter temporal price discrimination Separating customers with different demand functions into different groups which leads to charging diff. prices at different points of time. Peak load pricing:- Charge high prices at peak times because capacity constrain to cause MC to be high Two part tariff:- Consumers are charged both entry of usage fees. Degree of Monopoly Power: The monopoly power determines the extent to which a monopolist has control over either prices or quantities. Measures of Monopoly Power: a. Performance based: It is an outcome of the use of the monopolists’ ability. Elasticity of Demand: Monopoly power is the inverse of elasticity of demand. 1 MP = E d Lerner’s Measure: P − MC or P − MR or 1 P P Ed Greater the difference between price and marginal cost, greater will be the lerner’s measure and thus greater will be the monopoly power. Cross Elasticity of demand: The measure was given by R.Triffin and thus it is also known as Triffin’s Measure. Monopoly power is determined by how many substitutes does the good has. More the number of substitutes, less will be the monopoly power. Therefore, monopoly power is measured by taking the inverse of cross elasticity of demand. 1 Monopoly Power = e c Notes by Economics Harbour (2nd Edition) www.economicsharbour.com Page 55 Micro-Economics P − LAC Bain’s rate of return: P Hig