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Microeconomics
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Production Possibilities
Frontier Supply and demand In economics, supply and demand describe market relations between prospective sellers and buyers of a good. The supply and demand model determines price and quantity sold in the market. The model is fundamental in microeconomic analysis of buyers and sellers and of their interactions in a market. It is also used as a point of departure for other economic models and theories. The model predicts that in a competitive market, price will function to equalize the quantity demanded by consumers and the quantity supplied by producers, resulting in an economic equilibrium of price and quantity. Fundamental theory Strictly considered, the model applies to a type of market called perfect competition in which no single buyer or seller has much effect on prices and prices are known. The quantity of a product supplied by the producer and the quantity demanded by the consumer are dependent on the market price of the product. The law of supply states that quantity supplied is related to price. It is often depicted as directly proportional to price: the higher the price of the product, the more the producer will supply, ceteris paribus. The law of demand is normally depicted as an inverse relation of quantity demanded and price: the higher the price of the product, the less the consumer will demand, cet. par. "Cet. par." is added to isolate the effect of price. Everything else that could affect supply or demand except price is held constant. The respective relations are called the 'supply curve' and 'demand curve', or 'supply' and 'demand' for short. The laws of supply and demand state that the equilibrium market price and quantity of a commodity is at the intersection of consumer demand and producer supply. Here quantity supplied equals quantity demanded (as in the enlargeable Figure), that is, equilibrium. Equilibrium implies that price and quantity will remain there if it begins there. If the price for a good is below equilibrium, consumers demand more of the good than producers are prepared to supply. This defines a shortage of the good. A shortage results in the price being bid up. Producers will increase the price until it reaches equilibrium. Conversely, if the price for a good is above equilibrium, there is a surplus of the good. Producers are motivated to eliminate the surplus by lowering the price. The price falls until it reaches equilibrium. Supply schedule For a given firm in a perfectly competitive industry, if it is more profitable to produce at all, profit is maximized by producing to where price is equal to the producer's marginal cost curve. Thus, the supply curve for the entire market can be expressed as the sum of the marginal cost curves of the individual producers.[2] Demand schedule Just as the supply curves reflect marginal cost curves, demand curves be described as marginal utility curves. The main determinants of individual demand are the price of the good, level of income, personal tastes, the price of substitute goods, and the price of complementary goods. The shape of the aggregate demand curve can be convex or concave, possibly depending on income distribution. Changes in market equilibrium
Demand curve shifts
People increasing the quantity demanded at a given price is be referred to as an increase in demand. Increased demand can be represented on the graph as the curve being shifted right, because at each price point, a greater quantity is demanded, as from the initial curve D1 to the new curve D2. An example of this would be more people suddenly wanting more coffee. In the diagram, this raises the equilibrium price from P1 to the higher P2. This raises the equilibrium quantity from Q1 to the higher Q2. In standard usage, a movement along a given demand curve can be described as a "change in the quantity demanded" to distinguish it from a "change in demand," that is, a shift of the curve. In the example above, there has been an increase in demand which has caused an in increase in ( (equilbrium) quantity. The increase in demand could also come from changing tastes, incomes, product information, fashions, and so forth. Conversely, if the demand decreases, the opposite happens: a lefward shift of the curve. If the demand starts at D2 and then decreases to D1, the price will decrease and the quantity will decrease&mdash. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q1 and Q2). The reason that the equilibrium quantity and price are different is the demand is different. At each point a greater amount is demanded (when there is a shift from D1 to D2).
When the suppliers' costs change for a given output, the supply curve shifts in the same direction. For example, assume that someone invents a better way of growing wheat so that the cost of wheat that can be grown for a given quantity will decrease. Otherwise stated, producers will be willing to supply more wheat at every price and this shifts the supply curve S1 to the right, to S2—an increase in supply. This increase in supply causes the equilibrium price to decrease from P1 to P2. The equilibrium quantity increases from Q1 to Q2 as the quantity demanded increases at the new lower prices. Notice that in the case of a supply curve shift, the price and the quantity move in opposite directions. Conversely, if the quantity supplied decreases at a given price, the opposite happens. If the supply curve starts at S2 and then shifts leftward to S1, the equilibrium price will increase and the quantity will decrease. This is purely an effect of supply changing. The quantity demanded at each price is the same as before the supply shift (at both Q1 and Q2). The reason that the equilibrium quantity and price are different is the supply changed. There are only 4 possible movements to a demand/supply curve diagram. The demand curve can move to the left and right, and the supply curve can also move only to the left or right. If they do not move at all then they will stay in the middle where they already are.
----------------------------------------------------------------------------------------------------------------- Elasticity Often, it is useful to know how the quantity demanded or supplied will change when the price changes. This is known as the price elasticity of demand and the price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a tax on a good, thereby increasing the effective price, how will this affect the quantity demanded? If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve. Unfortunately, this has units of measurement of quantity over monetary unit (for example, liters per euro, or battleships per million yen), which is not a convenient measure to use for most purposes. So, for example, if you wanted to compare the effect of a price change of gasoline in Europe versus the United States, there is a complicated conversion between gallons per dollar and liters per euro. This is one of the reasons why economists often use relative changes in percentages, or elasticity. Another reason is that elasticity is more than just the slope of the function: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points. Elasticity in relation to variables other than price can also be considered. One of the most common to consider is income. How would the demand for a good change if income increased or decreased? This is known as the income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded. Another elasticity that is sometimes considered is the cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute. Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be -20%/10% or, -2. ----------------------------------------------------------------------------------------------------------------- Utility The doctrine of utilitarianism saw the maximization of utility as a moral criterion for the organization of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximize the total utility of individuals, aiming for "the greatest happiness for the greatest number". In neoclassical economics, rationality is precisely defined in terms of imputed utility-maximizing behavior under economic constraints. As a hypothetical behavioral measure, utility does not require attribution of mental states suggested by "happiness", "satisfaction", etc. Utility is applied by
economists in such constructs as the indifference curve, which plots
the combination of commodities that an individual or a society requires
to maintain a given level of satisfaction. Individual utility and
social utility can be construed as the dependent variable of a utility
function (such as an indifference curve map) and a social welfare
function respectively. When coupled with production or commodity
constraints, these functions can represent Pareto efficiency, such
as illustrated by Edgeworth boxes and contract curves. Such efficiency
is a central concept of welfare economics. Net output, sometimes called netput is a quantity, in the context of production, that is positive if the quantity is output by the production process and negative if it is an input to the production process. Marginal cost
In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs. It is a general principle of economics that a (rational) producer should always produce (and sell) the last unit if the marginal cost is less than the market price. As the market price will be dictated by supply and demand, it leads to the conclusion that marginal cost equals marginal revenue. These general principles are subject to a number of other factors and exceptions, but marginal cost and marginal cost pricing play a central role in economic definitions of efficiency.
----------------------------------------------------------------------------------------------------------------- Externalities ----------------------------------------------------------------------------------------------------------------- Profit maximization Diminishing returns ----------------------------------------------------------------------------------------------------------------- Monopoly Monopoly should be distinguished from monopsony, in which there is only one buyer of the product or service; monopolies often have monopsony control of a sector of a market. Likewise, monopoly should also be distinguished from the phenomenon of a cartel. In a monopoly a single firm is the sole provider of a product or service; in a cartel a centralized institution is set up to partially coordinate the actions of several independent providers (which is a form of oligopoly). A government-granted monopoly, or legal monopoly is sanctioned by the state, often to provide a greater reward and incentive to invest in a risky venture. The government may also reserve the venture for itself, which is called a government monopoly. If a monopoly is not protected from competition by law, then it is subject to competitive forces. However, with enough market share, a company or group can partially plan and control the market through strategic product updates or lower prices - potential competition can be thwarted, while demand for the dominant company's output can be preferentially developed. Hence, within free economies, planned sub-economies can arise. Primary characteristics
of a monopoly Significant Barrier of Entry: If a company has a monopoly on a good or service, it becomes prohibitively difficult for other firms to enter the industry and provide the same good or service. No close substitutes: Monopoly is not merely the state of having control over a product; it also means that there are no close substitutes available that fill the same function as the monopolized good. Price maker: Because a single firm controls the total supply in a pure monopoly, it is able to exert a significant degree of control over the price by changing the quantity supplied.
The "natural monopoly"
problem An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). The word is derived from the Greek for few sellers. Because there are few participants in this type of market, each oligopolist is aware of the actions of the others. Oligopolistic markets are characterised by interactivity. The decisions of one firm influence, and are influenced by the decisions of other firms. Strategic planning by oligopolists always involves taking into account the likely responses of the other market participants. This causes oligopolistic markets and industries to be at the highest risk for collusion. Oligopoly
Oligopoly is a common market form. As a quantitative description of oligopoly, the four-firm concentration ratio is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. Using this measure, an oligopoly is defined as a market in which the four-firm concentration ratio is above 40%. For example, the four-firm concentration ratio of the supermarket industry in the United Kingdom is over 70%; the British brewing industry has a staggering 85% ratio. In the U.S.A, oligopolistic industries include accounting & audit services, tobacco, beer, aircraft, military equipment, motor vehicle, film and music recording industries. In an oligopoly, firms operate under imperfect competition and a kinked demand curve which reflects inelasticity below market price and elasticity above market price, the product or service firms offer, are differentiated and barriers to entry are strong. Following from the fierce price competitiveness created by this sticky-upward demand curve, firms utilize non-price competition in order to accrue greater revenue and market share. Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may collude to raise prices and restrict production in the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. Firms often collude in an attempt to stabilise unstable markets, so as to reduce the risks inherent in these markets for investment and product development. There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be a real communication between companies) - for example, in some industries, there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership. In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater than when there are more firms in an industry if for example the firms were only regionally based and didn't compete directly with each other. ----------------------------------------------------------------------------------------------------------------- Game theory The field of game theory came into being with the 1944 classic Theory of Games and Economic Behavior by John von Neumann and Oskar Morgenstern. A major center for the development of game theory was RAND Corporation where it helped to define nuclear strategies. Game theory has played, and continues to play a large role in the social sciences, and is now also used in many diverse academic fields. Beginning in the 1970s, game theory has been applied to animal behaviour, including evolutionary theory. Many games, especially the prisoner's dilemma, are used to illustrate ideas in political science and ethics. Game theory has recently drawn attention from computer scientists because of its use in artificial intelligence and cybernetics. In addition to its academic interest, game theory has received attention in popular culture. A Nobel Prize–winning game theorist, John Nash, was the subject of the 1998 biography by Sylvia Nasar and the 2001 film A Beautiful Mind. Game theory was also a theme in the 1983 film WarGames. Several game shows have adopted game theoretic situations, including Friend or Foe? and to some extent Survivor. The character Jack Bristow on the television show Alias is one of the few fictional game theorists in popular culture.[1] Although some game theoretic analyses appear similar to decision theory, game theory studies decisions made in an environment in which players interact. In other words, game theory studies choice of optimal behavior when costs and benefits of each option depend upon the choices of other individuals. Applying game theory to procedures and organisation in real life is often called gaming the system. This has a negative connotation and usually implies disingenuous behaviour. Infinitely long games
The focus of attention is usually not so much on what is the best way to play such a game, but simply on whether one or the other player has a winning strategy. (It can be proven, using the axiom of choice, that there are games — even with perfect information, and where the only outcomes are "win" or "lose" — for which neither player has a winning strategy.) The existence of such strategies, for cleverly designed games, has important consequences in descriptive set theory. Application and challenges
of game theory Political science For early examples of game theory applied to political science, see the work of Anthony Downs. In his book An Economic Theory of Democracy (1957), he applies a Hotelling firm location model to the political process. In the Downsian model, political candidates commit to ideologies on a one-dimensional policy space. The theorist shows how the political candidates will converge to the ideology preferred by the median voter. For more recent examples, see the books by George Tsebelis, Gene M. Grossman and Elhanan Helpman, or David Austen-Smith and Jeffrey S. Banks. Game theory provides a theoretical description for a variety of observable consequences of changes in governmental policies. For example, in a static world where producers were not themselves decision makers attempting to optimize their own expenditure of resources while assuming risks, response to an increase in tax rates would imply an increase in revenues and vice versa. Game Theory inclusively weights the decision making of all participants and thus explains the contrary results illustrated by the Laffer Curve. Economics and business
The payoffs of the game are generally taken to represent the utility of individual players. Often in modeling situations the payoffs represent money, which presumably corresponds to an individual's utility. This assumption, however, can be faulty. A prototypical paper on game theory in economics begins by presenting a game that is an abstraction of some particular economic situation. One or more solution concepts are chosen, and the author demonstrates which strategy sets in the presented game are equilibria of the appropriate type. Naturally one might wonder to what use should this information be put. Economists and business professors suggest two primary uses. Game theory has been put to several uses in philosophy. Responding to two papers by W.V.O. Quine (1960, 1967), David Lewis (1969) used game theory to develop a philosophical account of convention. In so doing, he provided the first analysis of common knowledge and employed it in analyzing play in coordination games. In addition, he first suggested that one can understand meaning in terms of signaling games. This later suggestion has been pursued by several philosophers since Lewis (Skyrms 1996, Grim et al. 2004). In ethics, some authors have attempted to pursue the project, begun by Thomas Hobbes, of deriving morality from self-interest. Since games like the Prisoner's Dilemma present an apparent conflict between morality and self-interest, explaining why cooperation is required by self-interest is an important component of this project. This general strategy is a component of the general social contract view in political philosophy (for examples, see Gauthier 1987 and Kavka 1986).[4] Other authors have attempted to use evolutionary game theory in order to explain the emergence of human attitudes about morality and corresponding animal behaviors. These authors look at several games including the Prisoner's Dilemma, Stag hunt, and the Nash bargaining game as providing an explanation for the emergence of attitudes about morality (see, e.g., Skyrms 1996, 2004; Sober and Wilson 1999). History of game theory
Although Cournot's analysis is more general than Waldegrave's, game theory did not really exist as a unique field until John von Neumann published a series of papers in 1928. While the French mathematician Borel did some earlier work on games, Von Neumann can rightfully be credited as the inventor of game theory. Von Neumann was a brilliant mathematician whose work was far-reaching from set theory to his calculations that were key to development of both the Atom and Hydrogen bombs and finally to his work developing computers. Von Neumann's work in game theory culminated in the 1944 book The Theory of Games and Economic Behavior by von Neumann and Oskar Morgenstern. This profound work contains the method for finding optimal solutions for two-person zero-sum games. During this time period, work on game theory was primarily focused on cooperative game theory, which analyzes optimal strategies for groups of individuals, presuming that they can enforce agreements between them about proper strategies. In 1950, the first discussion of the prisoner's dilemma appeared, and an experiment was undertaken on this game at the RAND corporation. Around this same time, John Nash developed a definition of an "optimum" strategy for multiplayer games where no such optimum was previously defined, known as Nash equilibrium. This equilibrium is sufficiently general, allowing for the analysis of non-cooperative games in addition to cooperative ones. Game theory experienced a flurry of activity in the 1950s, during which time the concepts of the core, the extensive form game, fictitious play, repeated games, and the Shapley value were developed. In addition, the first applications of Game theory to philosophy and political science occurred during this time. In 1965, Reinhard Selten introduced his solution concept of subgame perfect equilibria, which further refined the Nash equilibrium (later he would introduce trembling hand perfection as well). In 1967, John Harsanyi developed the concepts of complete information and Bayesian games. Nash, Selten and Harsanyi became Economics Nobel Laureates in 1994 for their contributions to economic game theory. In the 1970s, game theory was extensively applied in biology, largely as a result of the work of John Maynard Smith and his evolutionary stable strategy. In addition, the concepts of correlated equilibrium, trembling hand perfection, and common knowledge[6] were introduced and analysed. In 2005, game theorists Thomas Schelling and Robert Aumann followed Nash, Selten and Harsanyi as Nobel Laureates. Schelling worked on dynamic models, early examples of evolutionary game theory. Aumann contributed more to the equilibrium school, developing an equilibrium coarsening correlated equilibrium and developing extensive analysis of the assumption of common knowledge.
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