Microeconomics

Assignment on History of Economic (ECN 202) BERNARD OKPE Reg. No./Group/Level: Department & Faculty: Economics & Social Sciences Question 1: With the aid of a diagram, show the Equilibrium position of the Monopolist in a short run Question 2: Differentiate between Partial and general equilibrium point ANSWER1: With the aid of a diagram, show the Equilibrium position of the Monopolist in a short run Introduction Monopoly is a market structure characterized by a single seller of a unique product with no close substitutes. This is one of four basic market structures. The other three are perfect competition, oligopoly, and monopolistic competition. As the single seller of a unique good with no close substitutes, a monopoly has no competition. The demand for output produced by a monopoly is the market demand, which gives monopoly extensive market control. The inefficiency that results from market control also makes monopoly a key type of market failure. Monopoly is a market in which a single firm is the only supplier of the good. Anyone seeking to buy the good must buy from the monopoly seller. This single-seller status gives monopoly extensive market control. It is a price maker. The market demand for the good sold by a monopoly is the demand facing the monopoly. Market control means that monopoly does not equate price with marginal cost and thus does not efficiently allocate resources. Characteristics of monopoly The four key characteristics of monopoly are: 1. Single Supplier: First and foremost, a monopoly is a monopoly because it is the only seller in the market. The word monopoly actually translates as "one seller." As the only seller, a monopoly controls the supply-side of the market completely. If anyone wants to buy the good, they must buy from the monopoly. 2. Unique Product: A monopoly achieves single-seller status because the good supplied is unique. There are no close substitutes available for the good produced by a monopoly. 3. Barriers to Entry: A monopoly often acquires and generally maintains single seller status due to restrictions on the entry of other firms into the market. Some of the key barriers to entry are: (1) government license or franchise, (2) resource ownership, (3) patents and copyrights, (4) high 1|Page start-up cost, and (5) decreasing average total cost. These restrictions might be imposed for efficiency reasons or simply for the benefit of the monopoly. 4. Specialized Information: A monopoly often possesses information not available to others. This specialized information comes in the form of legally-established patents, copyrights, or trademarks. Other characteristics includes: Price Maker, on-price Competition, etc Short-run Conditions for the equilibrium of a monopoly In the Short-Run, the monopoly firm attains equilibrium when its profits are maximized or losses are maintained. Like the competitive equilibrium, this analysis can also be discussed in terms of the total revenue-total cost approach and the marginal revenue cost approach. 1. MC = MR 2. MC curve cuts MR curve from below Total Revenue-Cost Approach In the figure 1 below TC is the total cost curve showing a constant rise in the total costs as output increases. TR is the total revenue curve which goes on rising to begin with, then flattens and latter on slopes downward, showing fall in total receipts after a given point. The monopolist will maximize his profits at that output where the difference between TR and TC is the greatest. This will be the level at which the slopes of TR and TC curves equal. Accordingly, P is the equilibrium point as determined by the tangents at points P and T on the TR and TC curves respectively. A and B are the break-even points where TR = TC. To the left of A right of B, the monopolist is incurring losses because TC > TR. Thus his maximum profits will be PT and he will sell OM output at MP Price. Figure 1: Total Revenue-Cost Approach Marginal Revenue-Marginal Cost Approach In the short-run, the monopolist can change the price as well as the quantity of the product. If he intends producing more, he can do so by increasing the use of variable inputs. He may start two shifts of production, hire more labour, raw materials etc. but he cannot change his fixed plant and equipment. On the other hand, if he wants to restrict his output, he may dispense with certain workers, work less hours and use less of the variable factors. In any case, his price cannot be below 2|Page the average variable costs. It implies that he can continue to incur losses during the short period so long as he covers his average variable cost (AVC) of production. Price is determined when: 1. P > SMC = MR, and 2. The SMC curve cuts the M curve from below. It is at this equilibrium point that profits are maximized or losses are minimized. Super-normal or Abnormal profits From the figure 2 below, SAC whose and SMC are the short-run average and marginal revenue curves respectively AVC is the average variable cost curves. D/ AR is the demand curves (the average revenue curves) whose corresponding marginal revenue curve is MR. The short-run monopoly equilibrium is at point E where the SMC curve cuts the MR curve from below. The monopolist sells OM output at MP (=OB) price. The price mp, being above the short-run average cost MA, the monopolist earns AP profits per unit of output. Thus total monopolist profit are AP * CA=CAPB. AV>P Figure 2: Supernormal Abnormal profit Normal profits In figure 3 the short-run equilibrium of the monopolist is shown when he earns only normal profits. The equality of SMC curve and MR Curve at this level of output, the monopolist earns normal profits. The monopoplist knows that any level of output other than OM would bring losses because the SAC curve would be higher than the AR curve. That is AC=P or P=AC Figure 3: Normal Profit Losses (Figure 4.1= Minimum Loss, Figure 4.2= Total Short-down) 3|Page Figure 4.1 shows a short-run situation in which the monopolist incurs minimum loss. As usual, the equilibrium point E is determined by the quality of SMC and MR. But the monopolist price MP, as fixed by demand conditions, does not cover the short-run average cost of production PA. It just average variable cost MP, represented by the tangency of the demand curve D and the AVC curve at point P. PA is thus per unit loss which the monopolist incurs. Total losses are equal to BP * PA=BPAC. That is AV>P but AVCP, AVC>P. Figure 4.1 Minimum Losses Figure 4.2 Total Short-down ANSWER to Question 2: Differentiate between Partial and general equilibrium point THE CONCEPT OF EQILIBRIUM The word „equilibrium‟ is derived from the Latin words equilibrium which means equal balance. Its use in economics is imported from physics. In physics, it means a state of even balance in which opposing forces or tendencies neutralize each other. Prof. Stigler defines equilibrium in this sense in these words. An equilibrium is a position from which there is no net tendency to move, we say net tendency to emphasize the fact that it is not necessarily to state of sudden inertia but may instead represent the cancellation of power forces to illustrate, in figure 6 the supply curve S intersects the demand curve D at E which Is the equilibrium point, and OP1 and OQ represent thee equilibrium price-quantity combination. Figure 5: Equilibrium Point If for some reason, price falls below the equilibrium price to OP2‟ the quantity demanded will increase and quantity supplied will diminish, i.e. P 2d> P2S. Forces will set in, which will tend to 4|Page push the price back toward the equilibrium; position E.Similarly, a price above the equilibrium level to OP1 will increase the supply and reduce the demand, P1s1> P1d1 and it will instantly be brought back to E. Partial Equilibrium Partial or particular equilibrium analysis, also known as microeconomic analysis, is the study of the equilibrium position of an individual, a firm an industry or a group of industries viewed in isolation. It is a market process for the determination of product prices and factors prices in which one or two variables are discussed, other things remaining equal (ceteris paribus). In the words of Prof. Stigler: “ A partial equilibrium is one which is based on only a restricted range of date, a standard example is price of single product, the price of all other product being held fixed during the analysis.” The Marshallian economics is mostly a study in partial equilibrium analysis. Partial equilibrium analysis is concerned with two types of economic problems. 1. First those pertaining to only particular aspect of the economic behavior of a certain individual, firm or industry. For instance, it may limit itself to market for a single product where its price, the technique of production, and the amount of factor used in its production are into consideration, while all other factors affecting it are assumed to constant. 2. Second, It studies only the first-order consequence of the economic events it analysis. It ignores the effects on the price of other commodities brought about by the product being analysis and in turn secondary influences of the former on the product. 1. The equilibrium condition of an individual We may briefly study the equilibrium condition of an individual, a firm, an industry and a factor. A consumer is in equilibrium when he spends his money income on different goods and service in such a way that he gets the maximum satisfaction. The conditions are (1) The marginal utility of each good is equal to its price (P), i.e. MUA = MUB = ….. PA PB = MUN PN (2) The consumer must spend his entire income (Y) on the purchase of goods, Y=pAQA +pB QB +…+ PNQN. It is assumed that his taste, preference, money income and price off the goods he wants to buy are given and constant. 2. The equilibrium condition of a firm In figure 6 a firm is in equilibrium when it has no tendency to change its output. I8n the short-run it equalizes its marginal revenue with marginal cost and in the long-run it satisfied the conditions of full equilibrium, LMC=MR=AR=LAC at it minimum. Thus, it earns only normal profits and has no tendency to leave the industry. In the analysis of the firm, the given data are the techniques of production, the prices of its product and of the factors. This is showed below diagrammatically. 5|Page Figure 7 firm equilibrium 3. The equilibrium condition of an industry In figure 6 an industry is in equilibrium when all its firms are earning normal profits and there is no tendency for the existing firms to leave or for new firms to enter it. In the market for a single product, only one price rule at a time which the quantity which the consumer wish to buy exactly equals the quantity being produced by the different firms. Each firm in the industry sells its product at the ruling market price and produces that level of output where its marginal cost equals marginal revenue. In the short-Run, its can produce even at a price less than its average costs of production, but in the long-run the price must equal its minimum long-run average costs (LAC) of production.2 Figure 8 Industry equilibrium 4. The equilibrium condition of a factor of production In figure 7 a factor of production (land, labour, capital, or organization) is in equilibrium when it is employed in its highest paid employment so that its income is maximized. It is a position where its price equals its marginal revenue product. At this price, it has no incentive to offer more Or less of its service and not to seek employment elsewhere. Thus, there is one price for the factor which rules throughout the market at any time. Moreover, the quantity of the factors which its owners willing to sell at the ruling price must equal the quantity which the entrepreneneur are willing to hire. Figure 9: Equilibrium of factor of production (using capital & Labour) 6|Page Assumptions of partial equilibrium 1. This partial equilibrium analysis of the market assumes that the price of the product is given and constant for consumers. Their incomes, tastes, habits and preference also remain constant. For the firms, the price of the productive resources of the product and of other related products is known, and constants. Factors of production are easily available to the industry at known and constant prices in accordance with the techniques of production, in use. If there is any change, say in consumer‟s tastes or techniques of production, the producer consumer plans are revised and e1quilibrium is re-established, thought at a new level. 2. The analysis of the market for a factor assumes that the price of the products which the factor helps in producing is known and constants and the price and quantities of all other factors are also given and constant. Moreover, factors of production are perfectly mobile between occupation and places. In the short-run, a factor may be earning less than it marginal revenue product, but in the long-run its price must equal the marginal revenue products at all places and in all employments. 3. The analysis discuss above relates to a perfectly competitive market which can also be extended to monopoly, monopolistic competitive, oligopoly, and monopsony markets Advantages of partial equilibrium Partial equilibrium analysis possesses certain advantage. 1. It helps us in analyzing the cause of a change in the price of product or service. Similarly the cause of a change in the behaviors of an individual, a firm or an industry can be understood. 2. This method helps in predicting the consequence of change in the behaviors and plans of the market participants. The consequences of interferences by the state in the working of the market system can also be analylized. For example what are the effects of an exercise duty on the price, output, sales, and profits, etc on cotton textiles fall within the ambit of the partial equilibrium analysis. 3. For an understanding of the general working of the economic system which involves it is an indispensable tool of analysis for the solution of practice problems. By concentrating on a limited and narrow range of economic subjects and by reducing the field of enquiry to or two variables, it makes the economic problem simple and intelligible. 4. The interdependence of economic variable, partial equilibrium analysis acts as a stepping stone. Without it, we cannot understand and analysis general equilibrium analysis. Limitation of partial equilibrium But partial equilibrium analysis has limitations. 1. It is confined to one particular field, it be an individual, a firm or an industry and ignores the study of the economy. 2. If unrealistic assumptions which separate the study of a specific market from the rest of the economy are dropped, partial equilibrium analysis breaks down. 3. It fails to explain the consequences of an economic disturbance in the market that leads to supply and demand changes, moving from one market to another and thus initiating second, third and higher order waves of change in the entire economy. 7|Page 4. Partial equilibrium analysis is incompetent to study interrelation of all parts of the economy. General Equilibrium General equilibrium analysis is an extensive of a number of economic variables, their interrelation and interdependence for understanding the working of the economic system as a whole. It brings together the cause and effect sequences of changes in prices and quantities of commodities and service in relation to the entire economic. An economy can be in general equilibrium only if all consumers, all firms, all industries and all factors-services are in equilibrium simultaneously and they are interlinked through commodity and factor prices. As Stigler has said: “The theory of general equilibrium of interrelationship among all parts of the economy.” Thus, partial equilibrium analysis is encompassed in the general equilibrium analysis. General equiliorium exists when all prices are in equilibrium; each consumer spends his given incomes in a manner that yields him the maximum satisfaction; all firms in each industry are in equilibrium at all prices and outputs; and the supply and demand for productive resources are equal at equilibrium prices. Assumptions of General Equilibrium The general equilibrium analysis is based on the following assumptions: 1. 2. 3. 4. 5. 6. 7. 8. 9. There is perfect competition both in the commodity and factor markets. Tastes and habits of consumers are given and constant Incomes of consumers are given constant. Factor of production are perfectly mobile between different occupation and places. There are constant returns to scale. All firms operate under identical cost conditions. All unit of a productive service are homogeneous. There are no changes in the techniques of production. There is full employment of labour and other resources. Working Of the General Equilibrium System Given these assumptions, the economy is in a state of general equilibrium when the demand for every commodity and service is equal to the supply for it. It implies perfect harmony of the decisions made by all the market participants. The decisions of the consumers for the purchase of each commodity must be in perfect accord with the decision of producers for the production and sale of each commodity. Similarly, the decision of owners for selling each factor service must be in perfect harmony with the decisions of their employers. It is only when the decision of buyers of goods and services fit in perfectly with the decision of sellers that the market is in general equilibrium. Given the tastes, preferences and aims of the consumers in the economy, the quality of each commodity demanded depends not only on its own price but also on the price of each other commodity available in the market. Thus, each consumer maximizes his satisfaction relative to prices ruling the market. For him marginal utility of each commodity equals its price. 8|Page Each consumer is assumed to spend his entire income on consumption, so his expenditure equals his income. His income, in turn, depends on the prices at which he is selling his productive services. In other words, a consumer earns by selling his productivity services he owns. Thus, the demand of consumers for the various commodities depends upon their prices and the prices of services. Let us take the supply side. Given the market structure, the state of technology and the aims of firms, the price at which a commodity sells depends on it costs of production. The costs of production, in turn, depend on the quantities of the various productive services employed and the prices paid for them. Assuming constant return to scale and identical cost condition for all firms, each producer will produce and sell that quantity of output at which the demand price for the commodity equals both the minimum average cost and the marginal cost. The equilibriums of the commodity market is illustrate in figure 8.1 the market is in equilibrium at point E where the market demand and supply curves D and intersect. It determines OP price at which OQM quantity of the product is bought and sold in Figure 10.1: The equilibriums of the commodity market the market. There being identical cost conditions, each firm in the market produces and sells the commodity at the given price OP. It is in equilibrium when MC=MR and AC=AR at point E1 producing OQ unit of the commodity, as shown in figure 8.2. If, say, there are 1OO firms in the market each producing 60 unit of the commodity, the total production will be 6000 (=100*60) units This analysis inter alia can be extended to all commodity being produced in the economy. Like the quality of demand and supply of commodities, the equality of demand and supply of factor services is also essential for the general equilibrium system. Figure 10.2 The equilibrium of the factor market The demand for productive service comes from the producers and supply from the consumers. Given the state of technology and profit maximization objective of the producers, the quantity of a factor used in producing a commodity depends on the relationship between the prices of that and of all other factors and on the prices of commodities. Each producer maximimised his profits relative to the ruling factors prices by employing the various factors in such proportions and quantities that their marginal revenue productivities are equal to their prices. Since there is full employment in the 9|Page economy, the markets for factors are in equilibrium when the total quantities of factors offered and the total quantities employed are equal, The equilibrium of the factor market is illustrated in figure 8.3 where the price of a factor OP and its quantity ON are determined in the market by the interaction of its demand and supply curves D and S at point E. Panel (B) shows that the supply of factor to individual firm is perfectly elastic and is the same as marginal cost of factor, MFC. The firm will employ units of the factor at the given factor price OP where MFC=MRP and AFC=ARP to the firm. Such an equilibrium point is E at which it employs OM unit of the factor. If there are 10identical cost firms and each employs 100 unit of the factor, the total market demand and supply of this factor will be 1000 units in the market. This analysis can be extended to the economy as a whole. Thus, the economy is in general equilibrium when commodity prices make each demand equal to its supply and factor prices make the demand for each factor equal to its supply so that all product markets and factor market are simultaneously in equilibrium. Such a general equilibrium is characterized by two condition in which set of prices in all product and factor market is such that 1. all consumer maximized their satisfactions and all producers maximized their profits; and 2. all market are cleared which means that the total amount demanded equals the total amount supplied at a positive price in both the product and factor market. To explain it, we begin with a simple hypothetical economic where there are only two sectors, the household and the business. The economic activity takes s the form of flow of goods and service between these two sectors and monetary flow between them. These two flows, called real and monetary, and are in figure 8.4 where the product market is shown n the lower portion and the factor market in the upper portion. In the product market, consumers purchase goods and services from producers while in the factor market, consumer receive income from the former for providing services. Thus consumers purchase all goods and services provided by producers and make payments to the latter in lieu of these. The producers, in turn, make payments to consumers for the service rendered by the latter to the business-wage payment labour services interest for capital supplied, etc. Thus payments go around in a circular manner from producers to consumers and from consumer to producers, by arrows in the outer portion of the figure. Figure 10.3 Simple hypothetical economic where there are only two sectors, the household and the business They also are also flows of goods and services in the opposite direction to the money payment flows. Goods flow from the business sector to the household sector to the business sector in the factor market, as shown in the inner portion of the figure. These flows are linked by product price and factor prices. The economy is in general equilibrium when a set of prices is allowed at which the magnititude of income flow from producers to consumers I equal to the magnititude of the money expenditure from the consumers to producers. 10 | P a g e Its Limitations The general equilibrium analysis of economy has several limitations. 1. Firstly, it is based on a number of unrealistic assumptions which are contrary to actual condition prevailing in the world. Perfect competition, the very basis of this analysis, is a myth. 2. Secondly, it is static analysis. All consumers and producers in this analysis consume and produce the product day in and day out without any time-lag. Their tastes, preferences, and aims are the same, and their economic decision is in perfect harmony with each other. In it reality, nothing of this sort happens. Producers are as consumers never act and think alike. Changes are taking place continuously in tastes and preferences. There are no constant returns to scale and two factor services are homogeneous. Thus cost condition differs from producer to producer. Since the given conditions are continuously changing, the moment towards general equilibrium is ever thwarted and its attainment has ever remained a wishful ideal. 3. Lastly, Prof, Stigler regards general equilibrium as a misnomer. According to him, no economic analysis has ever been general in the sense that it considers equilibrium studies as more inclusive than partial equilibrium studies, never that they are complete. Moreover, the more general the analysis, the less specific its content must necessarily be. Uses of General Equilibrium Analysis:The general equilibrium analysis possesses some important uses also 1. A picture of economy equilibrium. It presents a picture of private enterprise economy in equilibrium, where consumers are attuned to a position of maximum satisfaction and the producers to that of maximum profits. There is no wastage of resources. All are fully of employed. Economic efficiency is at its maximum so that economic welfare of the community is maximized. Thus its help understanding the determinants of the pattern of an economy. 2. To understand the working of economic system. Even otherwise, the theory is a schematic point of departure from which, by removing certain unwarranted assumptions, the actual working of economic system can be understood. We can know whether the economy is working efficiently, or wealthier there is any discordancy in it smooth function. The problem of disequilibrium and the restoration of equilibrium can be studied with the help of this analysis. 3. To understand the complex problem of the market. The general equilibrium analysis further helps in predicting the consequence of an autonomous economic event. Suppose the demand for commodity X rise which may leads to a rise in it price. These, in turn, reduce the prices of substitute and raise the prices of complements. These may thus reduce the demand for X somewhat. The demand for X may be further affected if the prices of productive service also tend to rise. Thus the general equilibrium analysis aids in understanding the nature of the complex chains of relationship of the market on a step-by-step basis. 4. To understand the working of the pricing process. The general equilibrium analysis is also useful in explaining the function of prices in the economy. As relative price change, three main decisions are made for the entire economy: What to produce and how much to produce, how to produce, and who will buy them when the commodity are produce. These decision are made by individual producers and consumers because each commodity and service they wants to 11 | P a g e produce, sell and buy, has a price that reacts to changes in their demand and supply. The general equilibrium analysis helps in integrating a variety of individual decisions affected by price changes. 5. To understand input-output Analysis. The main importance of general equilibrium analysis in its providing the conceptual basis for the input-output analysis developed by Leontief. In this analysis which is regarded as an outstanding variant of the general equilibrium analysis, the house and industries are related in an invisible interdependent system of input and output of the economy. This analysis is being increasingly used for planning the economic development backward regions and countries. 6. Basis of modern monetary and welfare economics. In recent years, general equilibrium analysis has been extended to monetary theory and welfare economics thereby making them more realistic fields of economic study. Reference Material 1. Arrow, K. J., and Hahn, F. H. (1971). General Competitive Analysis, San Francisco: Holden-Day. 2. Arrow K. J. and G. Debreu (1954). "The Existence of an Equilibrium for a Competitive Economy" Econometrica, vol. XXII, 265-90 3. Black, Fischer (1995). Exploring General Equilibrium. Cambridge Mass: MIT Press. pp. 318. ISBN 0262023822 4. 5. 6. Debreu, G. (1959). Theory of Value, New York: Wiley. Eaton, Eaton and Allen, "Intermediate Microeconomics" Chapters 13 and 18. Eatwell, John (1987). "Walras's Theory of Capital", The New Palgrave: A Dictionary of Economics (Edited by Eatwell, J., Milgate, M., and Newman, P.), London: Macmillan. 7. Geanakoplis, John (1987). "Arrow-Debreu model of general equilibrium," The New Palgrave: A Dictionary of Economics, v. 1, pp. 116–24. 8. Georgescu-Roegen, Nicholas (1979). "Methods in Economic Science", Journal of Economic Issues, V. 13, N. 2 (June): 317-328. 9. Grandmont, J. M. (1977). "Temporary General Equilibrium Theory", Econometrica, V. 45, N. 3 (Apr.): 535-572. 12 | P a g e