CFA Level I- Economics

Study Session 4“Microeconomic Analysis”

13.Demand & Supply Analysis: Introduction14.Demand & Supply Analysis: Consumer Demand15.Demand & Supply Analysis: The Firm16.The Firm & Market Structures

Definition of Market

Group of buyers

&sellers

Aware of each other

Able to agree on a

price

For Exchange of Goods

and Services

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Four Types of Market Structures

Perfect Competition

Monopolistic Competition

Oligopoly Mono-poly

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Factor that determine

market Structure

Number of Sellers in Market

Degree of product differentiation

Power of sellers in determining Price

Barriers to entry and exit

Degree of non Price Competition

Four Types of Market Structures

Perfect Competi

tion

Monopolistic Competition

Oligopoly Mono-poly

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Product Differentiation

Barriers to Entry

Pricing Power of Firm

Non price Competition

No. of Sellers

Perfect Competiton

Many

Homogen-eous

Very Low

None

None

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Demand Analysis

• There is a negative relationship between Price and Quantity Demanded

• Convention in CFA curriculum: use absolute values

• Ep =

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- (% change in Qd)

(% change in Price)

Price Elasticity of demand

Demand Analysis

Price elasticity depends on:1. Availability of substitutes2. Share of consumers budget spent on item3. Length of the time considered

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Price Elasticity of demand

ElasticEp > 1

InelasticEp < 1

Unitary ElasticEp = 1

Demand Analysis

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Price Elasticity of demand

ElasticEp > 1

InelasticEp < 1

Unitary ElasticEp = 1

Increase in Price

Result in lower TR

Increase in price

Result in Higher TR

Change in price will have no

impact on TR

Demand Analysis Two extreme case of price elasticity of demand

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Qty

Price

Qty

Price

Demand Curve

Demand Curve

Perfectly Elastic Demand Ep = Infinity

Perfectly inelastic Demand Ep = Zero

A perfectly Competitive firm is a

Price Taker

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Demand AnalysisIncome Elasticity

When Consumer income increases demand increases

Ey =

For normal goods- It’s positiveInferior goods - Negative

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(% change in Qd)

(% change in Y)

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Demand AnalysisCross Price Elasticity

Shows change in demand for product A for a change in price for Product B

Ex =

For Substitutes – PositiveFor Complements – Negative

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(% change in QdA)

(% change in Pb)

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Demand AnalysisConsumer Surplus

• Difference between value and price

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Supply Analysis

• Supply curve of Individual firm – positively Sloped

• Industry Supply curve – Positively Sloped

• As price increases, quantity supplied increases

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Supply Analysis

a firm’s short-run supply curve is the portion of the firm’s

short-run marginal cost curve above average variable cost. A firm’s long-run supply curve is the portion of the firm’s

long-run marginal cost curve above average total cost.

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Optimum Price and Output

Optimum price and output is calculated by equating demand and supply function

Important for Exams: It is possible in a perefectly competitive market , that the demand schedule of the entitre market is downward sloping

In Perefectly Competitive markets, for a Individual firm:

Price = Average Revenue = Marginal Revenue

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Optimum Price and Output Certain Basic concepts: Both MC and ATC curves are U Shaped

Demand Curve is also called as MR Curve

In perfect competition MR = P = AR

Profit is maximised when MR = MC

So for a perefectly competitive firm MR = P = AR = MC, hence economic Profit = Zero

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Average Total Cost

Quantity

PriceMarginal Cost

The point where, ATC and MC are same, ATC is lowest

Firms Demand

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Perfect Competiton

1. Demand Analysis

Price Elasicity

Cross price

Elasticity

Income Elasticity

Consumr Surplus

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Four Types of Market Structures

Perfect Competi

tionMonopol

istic Competi

tion

Oligopoly Mono-poly

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Product Differentiation

Barriers to Entry

Pricing Power of Firm

Non price Competition

No. of Sellers

Monopolistic Competition

Many

Homogen-eous

Very Low

None

None

Many

Differenti- ated

Low

Some

Advt + product Differen.

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

Demand Analysis

Each product sold in monopolistic competition is different

Demand curve for each firm is downward sloping to the right

At higher prices- Demand is more elatic

At lower prices- demand is less elastic

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

Supply Analysis

Supply curve – not represented by marginal cost curve

Imp: In monopolistic competition there is no well defied supply schedule

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

Optimal price and output

• Output is determined where MR = MC

• But the price is charged based on market demand schedule.

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Quantity

Price

Short run ATCShort run MC

Demand CurveMR

Optimal price and output

• Is imperfect competition a bad thing?

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

Factor affecting long run equilibrium

• An increase in demand will increase economic profits in the short run under all market structures.

• Positive economic profits result in entry of firms into the industry unless barriers to entry are high.

• Negative economic profits result in exit of firms from the industry unless barriers to exit are high.

Factor affecting long run equilibrium

Important concept for Exams:

Unlike long run equilibrium in perefect competition, in monopolistic competition, equilibrium position is at a higher level of average cost than the level of output that minimizes cost.

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Monopolistic Competiton

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

4. Factors affecting long

run equilibrium

Four Types of Market Structures

Perfect Competi

tion

Monopolistic Competition

Oligopoly

Mono-poly

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Product Differentiation

Barriers to Entry

Pricing Power of Firm

Non price Competition

No. of Sellers

Oligopoly

Many

Homogen-eous

Very Low

None

None

Many

Differenti- ated

Low

Some

Advt + product Differen.

Few

Homogen-eous

High

Some or

considerable

Advt + product Differen.

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Demand Analysis

There are three basic pricing startegies in oligopily

1. Pricing interdependence2. cournot assumptions3. Nash Equilibrium

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Demand Analysis

1. Pricing interdependence Competitors will match a price reduction but ignore a

price increase Therefore given a price:

If Price Decreased Price elasticity Less If price Increased price elasticity is Higher Which results in a Kinked Demand Curve

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Quantity

Price

Demand Curve

Demand Analysis

2. Cournot Assumption Each firm will determine it’s profit maximising

production level, Assuming, that other firms output will not change.

Two Implications: Output is greater than monopoly, but lower than

perfect competition. Price is lower than monopoly, but not as low as with

perfect competition.

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Demand Analysis

3. Nash Equilibrium Nash Equilibrium presents when two or more

participant, in a non –cooperative game have no incentive to deviate from their respective strategies

none of the oligopolist can increase its profits by unilaterally changing its pricing strategy.

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Nash Equilibrium in Duopoly Market

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B High Price- 600

A High Price- 1000

B Low Price-700

A High Price- 600

B Low Price-140

A Low Price- 100

B High Price-0

A Low Price- 160

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Supply Analysis

• No well defined supply curve

• Level of output where MC = MR

• Price will determined based on Demand Curve

• Generally a firm with more than 40% market share is called as dominant firm in oligopoly

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Supply Analysis

• Without collusion, dominant firm will beome price maker

• It has also been seen that supremacy comes from Cost leadership

• And therefore price followers rather charge a price higher than dominant firm, if they charge a lower price, it follows the risk of a price war.

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Optimum Price and output

• There’s no single optimum point

• In case of kinked demand curve, the kink is the optimim point but model fails to identify the point

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Factors affecting long run equilibrium

Long run economic profits are possible

History has proven that pricing wars should be avoided.

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Oligopoly

1. Demand Analysis

Pricing interdepend

ence

Nash Equilibri

um

Cournot Equilibri

um

2. Supply Analysis

3.Optimum price and

output

4. Factors Affecting Long

run Equilibrium

Four Types of Market Structures

Perfect Competi

tion

Monopolistic Competition Oligopoly

Mono-poly

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Product Differentiation

Barriers to Entry

Pricing Power of Firm

Non price Competition

No. of Sellers

Monoply

Many

Homogen-eous

Very Low

None

None

Many

Differenti- ated

Low

Some

Advt + product Differen.

Few

Homogen-eous

High

Some or

considerable

Advt + product Differen.

One

Uniqueproduct

Very High

considerable

Advertising.

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Introduction Sources of monopoly power

Patent Control over critical resources used for prodn

Government controlled authorisation ( Natural monopolies)

Network effect

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Demand Analysis Demand curve for a monopoly firm is downward sloping

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Supply Analysis

A monopoly does not have a well defined supply curve

Output- Profit maximising – MR= MCPrice- Derived from demand curve

( Same as Monopolistic competition and Oligopoly)

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Optimal price and output

Relationship between MR and price elasticity MR = P (1 – 1/Ep)

Since for a monopoly MR = MC, we can extend the equation by saying

MR = MC = P (1 - 1/Ep)

If a Monopolist know its MC ( lets asssume 50), if it observes price elasticity to be ( 1.5), then he can caluclate the optimum price to be charged. 150

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Optimal price and output Regulated monopoly

1. In perfect competition P = MR = MC, but for a regulated monopoly it will be unfair to set a price of perefect competition

Because its LRAC will be higher than perfect competition

Solution:- subsidize the difference between LRAC and P of Competitive firm for each unit sold

2. Set a price where LRAC equals AR( regualatory solution is between pure a monoply and perfect competition)

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Price DiscriminationAnd Consumer Surplus

• First Degree price Discrimination– When a monopolist extracts entire consumer Surplus

• Second Degree Price Discrimination–Monopolist uses quantity purchased to establish how

much consumer values the product– So he will sell small quantities at less prices– Large qunatities at higher prices

• Third Degree price Discrimination- -- Customers are seggregated by demographic or other traits

Two part Tariff pricing

Lets say, a consumers demand for a yoga Club is Qd = 30 – 5p, the MC per visit to the club is $2 . Calculate maximum monthy membersheep fees to be

charged to the consumer?

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Monopoly

1. Demand Analysis

2. Supply Analysis

3.Optimal price and Output

5. Factors affecting long run equilibrium

4.Price Discrimination& Consumer Surplus

Factors affection Long Run Equilibrium

Unregulated monopoly can produce economic profits in the long run

For regulated monoply , P can be kept at MC but it should be supported by subsidy

National ownership of monoply is another solutionFranchise the monopolistic firm through bidding war

Monopolist are not always inefficient- beacuase regulation , economies of scale, or threat of entry- might give consumers better price than perfect competition

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Factors affection Long Run Equilibrium

Unregulated monopoly can produce economic profits in the long run

For regulated monoply , P can be kept at MC but it should be supported by

subsidy National ownership of monoply is another solution Franchise the monopolistic firm through bidding war

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Four Types of Market Structures

Perfect Competi

tion

Monopolistic Competition Oligopoly Mono-

poly

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Identification of market structure

• Compute price elasticity

Highly elastic- intense competition

Highly inelastic high Concentration

Identification of market structure

• A concentration ratio for N firms is calculated as the percentage of market sales

accounted for by the N largest firms in the industry and is used as a simple measure of market structure and market power.

Two Disadvantages:1. Does not quantify market power2. Tends to be unaffected by mergers

Identification of market structure

• Herfindahl-Hirschman Index • Measure of concentration is calculated as the sum of

the squared market shares of the largest N firms in an industry and better reflects the effect of mergers on industry concentration.

Disadvantages:1. Does not quantify market power

Identification of market structure

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