Principles of Economics - Perfect Competition

Perfect Competition is a market structure that follows these assumptions:

• Firms are price takers - each firm has no impact on the price in the market, they take the price the market forces set.
• Freedom of entry into the market - there are low barriers to entry so anyone could potentially set up in this market.
• Firms produce identical products - the taxi market for example, each taxi firm offers an identical product.
• Producers and consumers have perfect knowledge - both producers and consumers know everything there is to be known about the market.

However, few, if any, industries are actually perfectly competitive.

In the short run, the number of firms is fixed. In the long run, if supernormal profits are being made then new firms will enter the industry. If losses are being made, firms will leave the industry. 

Short run equilibrium of the firm:

This is what the market looks like in the short run in perfect competition. The price is Pe, and is set by the demand and supply forces. It is horizontal because firms are price takers. Due to price being constant, the red dotted line is also the average revenue, the marginal revenue and the demand for the firm as they're all the same. Qe is the amount produced by the firm because this is the amount at which profits are maximised (MC = MR). There is slight profit being made because the average revenue is higher than the average cost at the production point.

This is where the long run can be introduced. In the long run, firms see these profits being made and enter the industry. These means the industry supply increases, shifting the supply curve to the right on the left hand diagram above. Price falls, which means each firms demand falls until the point it is equal to the average cost. At this point, firms break even and make no profit. Firms will stop entering the industry now.

As far as the public interest goes with perfect competition, it has its benefits and drawbacks. The benefits are as follows:

• Firms produce at the least cost output.
• Firms that are inefficient will be forced out.
• Prices are minimised.
• Consumers determine what and how much is produced.

The drawbacks are:

• There us very little incentive to invest in new technology.
• Goods are all the same, lack of variety for consumers.

That ties up this post about perfect competition. Thank you for reading, keep checking back and sharing. Have a good day!

Sam.

Principles of Economics: Marginal Utility Theory (Microeconomics)

In this blog I'll be looking at one of the theories as to how exactly we derive the demand. This is called the marginal utility theory. All the way through this we make the assumption that consumers act and behave in a rational manner - they choose their consumption rationally and consistently. A rational consumer therefore would be one that aims to get the best value for their money. Bear that in mind and remember it as we run through this principle.

Lets start at the very basics by defining a few things. A phrase that will crop up a lot now is 'utility'. Basically, this is the term economists give to the satisfaction a consumer receives when consuming a good. Obviously, it's a totally theoretical thing as it's near on impossible to actually measure how happy or satisfied a consumer gets when consuming a good. But, for the benefit of the theory and the examples it is used. Total utility will then refer to the total satisfaction or happiness gained from all the units of the good that have been consumed. Another term here is marginal utility. This is the additional satisfaction from consuming one extra unit of a good. If i gained 10 utility from eating 6 bananas and 12 utility from eating 7 bananas then the marginal utility here would be 2 (12-10). Utility, like i said, is a very subjective thing, we have to make an assumption that it can be measured. The measurement of utility is a util. One util is one unit of satisfaction.

Marginal utility follows a diminishing pattern, the more of a good the consumer consumes the lower the marginal utility gets. This is because for every extra unit of a good consumed you won't be getting as happy until you finally reach a point at which total utility is at maximum and will only fall if any more of the good is consumed. Lets look at an example, here we have a table for the consumption of a good and the utility it gives the consumer:

This data can then be plotted onto a graph, displaying the total and marginal utility curves like this:

Before I continue, I apologise for the graphs.. I try my hardest, I'm just not a dab hand at using Paint! Anyway, here we have the total utility and the marginal utility for the table above drawn out. As you can see, marginal utility slopes downwards and total utility always starts at the origin. Total utility will peak when marginal utility is at 0. We can take any point on the total utility curve and it'll equate to the equivalent point on the marginal utility curve. For example, between 2 and 3 consumption the change in the total utility is 2 and the change in quantity consumed is 1. 2/1 = 1 of course, which if we look at the marginal curve is where MU is at 3 consumption. The general rule for that is (change in total utility) / (change in consumption) = MU. 

We can also work out what the optimum level of consumption for one good is with utility, to do this we need to measure utility with money. So utility now becomes the value people place on their consumption and marginal utility is the amount a person would pay to achieve one more unit of a good. We open up a new principle here, the marginal consumer surplus or MCS for short. This is the difference between what someone is willing to pay for one more good and what they actually pay. An equation for this would be: MCS = Marginal Utility (MU) - Price (P). Total consumer surplus (TCS) can come into play now too, this being the sum of all marginal consumer surpluses that are gained from all the good consumed. This is effectively the difference between the total utility from all units in monetary terms and the actual expenditure on them. In equation form: TCS = Total utility (TU) - Total expenditure (TE). As with most things economical, we can graph out this concept. 

The rational consumer is aiming to maximise their consumer surplus. So, on the diagram, area 1 represents the consumers total expenditure. It'd value out at P x Q. The total utility of the consumer is area 1 + area 2. As we stated above, the total consumer surplus is TU - TE so therefore area 2 on its own is the total consumer surplus. The quantity Q here maximises consumer surplus, so that is the point to consume at. Any lower quantity and consumer surplus wouldn't be maximised, any higher and consumer surplus wouldn't increase but spending would. 

The market demand curve for a good can be derived from the individuals demand curves. The individuals demand curve is the MU curve for the good. So the market demand curve for a good is the sum of all individual MU curves. It's shape depends entirely on the rate that MU falls in general for the individuals. A shift could occur if, for example, the price of a substitute good rises the MU will rise because people will desire the original good more instead of the higher priced substitute. 

This theory for working out the optimal consumption of one good does have it's limitations:

• A change in consumption will affect the MU of both substitute and complimentary goods and also effect income left over to spend.
• Money itself doesn't have a constant MU.
• Income rising means extra money meaning each pound will bring less satisfaction.
• We cannot literally use money in an absolute sense to measure utility. ]

It's more appropriate to measure the optimal consumption of goods in combination, two goods in the example. This involves finding the equi-marginal price. This is where the consumer gets the highest utility from a level of income, which is where the ratio of the MUs of the two goods is equal to the ratio of the price. In equation form this would be (MU of good A) / (MU of good B) = (Price of good A) / (Price of good B). 

...And exhale. That's me done, the basics of marginal utility and how it can be used to derive demand. A lot in one go I know, but you'll get the hang of it. My next post on the principles of economics will be focused on indifference curves. Thanks for reading guys, have a good night!

Sam. 

Principles of Economics: Supply (Microeconomics)

*Disclaimer: I'm fully aware of the fact that I've already written a post on supply. However, I've decided to cover it again now I know more on the subject and can give a better coverage.* 

Okay, I'll dive straight into this one with the main principle of supply: 'When the price of a good rises, the quantity supplied will also rise'. Now, it's all well and good just stating that, however we need to know the reasons why this happens. Let's look at three of them:

• Beyond a certain level of production for the producer costs are likely to rise at a quicker rate than previously. This could be due to having to pay overtime to staff members or increased maintenance costs for machinery. Either way, the quantity supplied by producers will only rise if the price rises so that it becomes efficient for them to raise their costs.
• A more basic reason now: The higher the price of the good, the more profitable it is for the firm. In general terms this theory holds true. Most firms have an aim of profit maximisation, so therefore they'll increase supply when the price rises to maximise profits.  Both of these two points are short term reasons as to why supply rises when price increases.
• A long term reason is because when price rises in an industry new firms are encouraged to join the market with the hope of profit. This increase in firms will increase the supply to the market. 

Here we have a very basic graphical presentation of the supply curve. A supply curve shows us the supply schedule. Supply schedule refers to the amount producers are able to and willing to produce at different prices at a set point in time, it is normally shown in a table and can then be presented in a graph like the one above. The supply curve will generally slope upwards from left to right, to show that the higher the price the higher the supply will be. Obviously, price elasticity of supply plays a part in the steepness of the slope but I'll get on to that point in a few blog post times, I'm keeping it very basic here. 

As with demand, there are many factors apart from just price that affect the supply of a good to the market. These are the main ones:

• Production cost - Higher costs mean less profits means less supply and vice versa. This can be because of a change in the input prices (wages, raw materials), government policy (subsidies, taxation), organisation changes or technology changes.
• Nature - This can include the weather, disease, natural disaster. Basically things that are out of human control.
• Aims of the producer - The supply of a firm aiming to maximise profit will be different to a firm aiming for sales maximisation. Therefore different producer aims will cause varying levels of supply. 
• Expectations - If prices are expected to rise, producers will hold onto stock in anticipation of this rise meaning supply will fall. This works the opposite way for if prices are expected to fall.
• Number of suppliers - Simply put, more producers means more supply, less producers means less supply. 
• Profitability of alternatives - If a substitute in supply is more profitable, supply for the good in question may fall. Alternatively, if a substitute in supply is less profitable, the good in questions supply may rise as the producer re-diverts resources. 
• Profitability of goods in joint supply - Goods that are produced together mean if the profitability of the joint good rises then the supply of the good in question may also rise. Works the opposite way too.

As with demand, there can either be a movement along the supply curve or a shift in the supply curve. 

A change in price will mean a movement along the supply curve. So, the supply curve will stay at the initial place of 'Supply 1' on the diagram and the point supplied will just move up or down that curve. If any of the other determinants of supply stated above change then we can expect a shift in supply. A shift to the right, 'Supply 1' to 'Supply 2' on the diagram, shows an increase in supply. A shift to the left, 'Supply 1' to 'Supply 3' on the diagram, shows a decrease in supply. A movement along the curve is known as a change in the quantity supplied whereas a shift in the supply curve is known as a change in supply.

There we have it, a recap on the basics of supply. Next to come in terms of principles of economics will be marginal utility theory, so stay tuned for that! Thanks for reading and have a good day.

Sam. 

Principles of Economics: Demand (Microeconomics)

*Disclaimer: I'm fully aware of the fact that I've already written a post on demand. However, I've decided to cover it again now I know more on the subject and can give a better coverage.*

Basically, I'm back to cover a very basic principle of microeconomics: Demand. Demand refers to the amount consumers can and are able to purchase of a good or service, 'can and able' being a very important part. Note that a consumers want for a good should not be included in demand. I'm sure everyone wants a flashy sports car on their drive yet the true demand of that good will be very small. Glad we got that out of the way. The demand of a good in a market plays a pivotal role in determining the price. For this, demand must interact with supply and the point at which they meet can be called the 'market output' or the 'equilibrium output'. This is displayed on a graph which I'll do a post about in a few days. The price at this 'equilibrium output' is called the 'market price' or the 'equilibrium price' which is essentially the price consumers have to pay for the good and the price suppliers are selling at.

It's important for me to point out here also that when looking at demand we assume that we're operating in a market of perfect competition. This basically means that in the market there are an abundance of consumers and producers and therefore they have no control over prices. We call them price takers. The size of each producer is too small and there is too much competition from other firms that it would be impossible for them to raise prices and still make sales. Perfect competition is the closest theoretical example to most real-world markets and therefore we use it in our examples.

Let's now look at the relationship between the demand and the price of a good or service. The law of demand is as such: 'When the price of a good rises, the quantity demanded will fall'. This occurs for two reasons:

1. The good/service will cost more than substitute goods. Other similar products will be comparatively cheaper and therefore demand for the good will fall as consumers start to purchase the substitute. For example, a Playstation 3 could be said to be a substitute good for an Xbox 360. Therefore, if the price of the Xbox 360 were to rise then the demand for it would fall as consumers move over to purchase the comparatively cheaper Playstation 3. This is called the 'substitution effect' of a rise in price.
2. People will feel poorer. A rise in the price of a good means people will effectively be able to afford less of the good which makes them seem less well-off, or poorer. This is known as the 'income effect' of a price rise. 

Obviously it occurs the other way also; if the price of a good falls then the quantity demanded will rise. We'll consider the following example, theoretical figures for the monthly coffee demand:

Now, if we were to plot the demand curve for this data it would look something like this:

A typical demand curve would look like this, if real data is being used. The curve you can see slopes downwards from left to right, also called a negative slope, as when the price falls the quantity demanded rises. In most cases, however, real figures aren't used, it's just theoretical. In these cases the demand curve will just be a straight line sloping down from left to right. Remember that we still use the term 'curve' when the line is straight. 

Apart from the price of a good, the demand for a product is also determined by other factors. These are as follows:

• Tastes - The more desirable a good the more it will be demanded and vice versa. This is often affected by advertisements, fashions and what other consumers are purchasing. 
• Quantity and Price of Substitute Goods - If a substitute good has a higher price then demand for the good in question will be higher. If the substitute good has a lower price then the demand will be lower for the initial good.
• Quantity and Price of Complimentary Goods - This works in the opposite way to above. Complimentary goods are products that are consumed together, examples would be cars and petrol or DVD players and the actual DVDs. If the complimentary good's price rises you can expect the demand for the good in question to fall and vice versa. 
• Income - This one is fairly obvious. As people's incomes rise, so does their spending power and therefore demand for 'normal' goods will rise. With this, demand for 'inferior' goods will fall. When we say 'inferior' goods we are talking about things such as supermarket own brand foods. 
• Distribution of Incomes - This determinant is a little more ambiguous. If wealth was re-distributed from the rich to the poor, then demand for luxury items would rise as the poorer people would be able to buy these goods for the first times. It works in the opposite way too, if the poor in society get poorer then the demand for 'normal' goods will fall as the demand for 'inferior' goods should rise. 
• Expectations - Last but not least, people's expectations. Everyone speculates, and if the speculation is that the price of a good is set to rise in the near future then we can expect demand to rise in the short term. If the price is expected to fall we'd expect demand to fall as people hold out until the lower price arrives. 

When we put together a demand curve, we do it assuming that all other things are remaining equal and this is known as ceteris paribus. Nothing but the price changes and when the price changes it results in a movement along the curve. A movement along the curve is different to a shift of the curve, which is very important to remember. When any other determinant of demand changes the curves will shift. A movement along means the demand curve remains the same but the demand just moves to a different point on that curve. A shift means a new demand curve, where at each price a different amount is demanded. 

This is the same demand curve we used earlier, but here we can see that the demand curve has shifted. At each price a different amount of coffee is being demanded. This occurs when a non-price determinant of demand changes. That's probably the hardest basic principle of demand to grasp, but here it is summed up:

• A change in price results in a movement along the demand curve.
• A change in a non-price determinant results in a shift  of the demand curve.

If the change in the determinant of demand causes a rise in demand then the demand curve will shift to the right. If the change in the determinant causes a fall in demand then the demand curve will shift to the left.
The proper names for these two principles are as follows:

• A shift in the demand curve is called a change in demand.
• A movement along  the demand curve is called a change in the quantity demanded.

And that is pretty much that, the principles of demand. The hardest part here is probably differentiating between a movement a long and a shift in the demand curve, however you can pick it up rather quickly. Feel free to comment if you feel i missed something out or something is incorrect. Thanks for reading!

Sam.