Long term decisions

All inputs are variable, ACL= 𝑇𝐶𝐿/𝑄𝐿 , if the increase in TCL is x and increase in Q is x++ then the
company is observing economies of scale (increased market power, departmentalization, technology)
decision to expand is justifiable.

If increase in TCL is x and inc in Q is x- - then the company is observing diseconomies of scale and
shouldn’t expand or should downsize.

Economic vs. Accounting Equation

Accounting equation is about profit and loss, revenue minus expenses of any explicit expense such as
rent, equipment, salaries and wages, interest.

Economic equation adds implicit cost to explicit cost mainly the opportunity cost which is cost of 2nd best
option forgone. Economic Profit/loss= Revenue- Accounting Expenses- Foregone cost (foregone rent,
foregone salary, foregone interest and normal profit) . Economic equation is showed mainly in projected
income statement.

Types of Economic profit

+ve= Abnormal Economic Profit

-ve= Economic loss

Break even= 0

At break even firms are earning normal profit.

Types of Markets

1. Perfect Competition:
• large number of sellers
• homogeneous product
• no barriers to entry
• impossible pricing competition
• price takers as per market conditions (supply and demand curve)

2. Monopolistic Competition
• Many firms
• Differentiated product
• No barriers to entry
• Price competition possible based on differentiation
• Price setters due to differentiation
 3. Oligopoly
• Small number of firms compete dominating the market
• Homogeneous or differentiated product
• Difficult barriers of entry
• High market concentration
• Price setter due to market power
• Price competition is impossible due to game theory

4. Monopoly
• One seller dominates the market
• No substitutes
• High barriers of entry
• Price setters

Pricing decision according to each market

Perfect Competition

Goal: maximize profit

2 Approaches to what quantity to produce

1st Compare TR &TC

If TR↑> TVC↑ keep producing till reach Q max once reached Qmax TR ↑< TVC ↑ due to law of
diminishing returns.

2nd Compare MR &MC

Profit maximization quantity is when MR= MC in perfect competition Qmax is when P=MR=MC

If MC<MR the firm can increase profit by producing more units.

If MC>MR, the firm should reduce output to maximize profit.

How to deal with economic loss?

Permanent Exit the market usually a long-term decision

Minimize loss

1. When AVC<P< AC, the company would continue operating at loss as they make enough revenue
to cover their variable cost and little surplus to cover a portion of the fixed cost. If they shut
down they whole amount of fixed cost would be an economic loss.
2. When AVC=P <AC, the company is indifferent whether to operate or not as their revenues are
enough to cover the variable cost and their loss would be the whole amount of the fixed costs
causes of operating would be for instance higher costs to reenter the market
3. When P<AVC<AC, the company’s revenue isn’t enough to cover the variable cost and producing
more units adds to their losses, the company in the short run should shut down temporarily and
minimize their losses to the fixed cost only. On the long run the company should exit the market.
Long term equilibrium for perfect competition

Over a long period of time, prices that enable firms to earn above-normal profit would induce other
firms to enter the market, and prices below the normal level would cause firms to leave the market.
At the state of long-term equilibrium all market players are only generating normal profit and no
entry or exit happens in the market.

Firms should either be lucky or good to enter a perfect competition market.

Luck Early Entry/ favorable market conditions/ unexpected increase in demand: The earlier the
firm enters a market, the better its chances of earning above-normal profit (assuming a strong
demand in this market).

Good Cost Management: As new firms enter the market, firms that want to survive and perhaps
thrive must find ways to produce at the lowest possible cost, or at least at cost levels below those of
their competitors.

Firms that find themselves unable to compete on the basis of cost might want to try competing on
the basis of product differentiation instead, although this is extremely difficult in this type of market
and if successful, they move into another type of market (monopolistic competition or oligopoly)

Imperfect Competition (Monopolistic Competition and Oligopoly)

The case for monopolistic competition is the same for perfect competition when it comes to
production level, profit maximization quantity is when MR=MC. Pricing however depends on their
point of differentiation from the competition. Due to low barriers of entry, on the long run if they are
earning abnormal economic profit then the market attracts new players which lead to shift in the
demand curve down and to the left and companies only earn normal profit on the long run.

Competition among players is a non-price competition, they compete based on non-price

determinants of demand.

Adding extra cost to gain advantage

1. Product Development is continuous to keep earning abnormal profit, it gives them competitive
edge and allows abnormal profit temporarily until competition imitates. Innovation is costly but
it increases total revenue. Perceived or real innovation translates into marginal benefit that the
consumer is willing to pay.
2. Marketing costs are fixed costs,
a. AFC ↓ as Q↑ marketing costs increases AFC at any point but it doesn’t affect MC, marketing
efforts are profitable and successful if they increase the demand for the product.
b. Signaling quality to uninformed audience by spending millions on advertising to signal
quality.
c. Branding: companies incur branding establishment costs for signaling so consumers know
what to expect.
 Case of Oke and Coke

Coke spends millions, people think it must be good, they try it and like it and keep buying it if
because it is truly good.

Oke spends millions, people think it must be good, they try it and it turns out to be bad they stop
buying it.

If Oke knows it is bad they don’t bother to waste money on advertising.

If Coke knows its product is good, they spend millions to deliver the message.

Oligopoly

Two measures of concentration to determine competitiveness

1. Four Firm concentration, take market share of top four firms in the industry if ∑ Mkt share is
higher than 50% then this market is oligopoly
2. HHI index, sum of squared of the highest 50 market share, if HHI< 1500, highly competitive
market, if 1500< HHI< 2500 the market is of moderate competition, if HHI> 2500 then the
market is highly concentrated and oligopoly.

HHI is a more accurate representation as squaring the market share gives more weight to high
market share holders.

Pricing in Oligopoly market

Mutual interdependencies: firms in such market are carefully watching their competitors when
it comes to pricing. Firms might be tempted to form alliances to set prices and limit supplies, it is
illegal, nevertheless, alliances don’t last due to game theory.

Models of Oligopoly

Kinked Demand Curve: competitor would follow price decrease but will unlikely follow price
increase. Pepsi and Coke for example, if Pepsi decreases the price from $10 to 9$ hoping for
increase in the quantity demanded, Coke will follow suit and both of them would lose the
chance to make economic profit at the price that consumers were already willing to pay at $10
as the elasticity of the demand wouldn’t make the quantity demanded increase by more than
change in price.

If price increase the competitor as a close substitute wouldn’t follow suit as increase in price
would cause quantity demanded to decrease and consumers would buy Coke.

Companies with huge market share in Oligopoly don’t engage in price wars as it is harmful for
both firms

Dominant firm model (Market leader)

Due to the size of the leading firm, they have significant cost advantage over smaller firms,
consequently they set their own price and smaller firms become price takers. The large firm here
acts as monopoly and smaller firms are in a perfect competition situation.
The Game theory and Duopoly

The theory is developed to understand strategic interdependent decisions made by firm

competing in a duopoly. Both firms collude secretly to fix price and decrease supply to gain more
profit. Strategies are either comply and cheat and there are 2*2 outcomes, both comply, both
cheat, COMPLYxCHEAT, CHEATxComply.

Pay off Matrix

Nash Equilibrium: The quantity and price are those of a competitive market, and the firms earn normal
profit!!!
Macroeconomics

Production

Expenditure Employment

Income

Production (Measured by GDP or GNP)

GDP: Gross domestic product is the market value of all final goods and services produced in a country in
a given time period. GDP focuses on what is being produced.

Measuring GDP

Nominal GDP: Q*P of the year pf production focuses on current prices to show how prices grow.

Real GDP: Qyear *Preference year with focus on how production grew.

𝑅𝐺𝐷𝑃23 = 𝑄^23 ∗ 𝑃^18

𝑅𝐺𝐷𝑃24 = 𝑄^24 ∗ 𝑃^18
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝐺𝑟𝑜𝑤𝑡ℎ 𝑅𝑎𝑡𝑒 = (𝑅𝐺𝐷𝑃24 − 𝑅𝐺𝐷𝑃23)/𝑅𝐺𝐷𝑃23
To understand if economic growth rate is healthy or not it must be compared against population growth
rate.

GDP Per Capita is a measure of productivity of the country

𝐺𝐷𝑃 𝑝𝑒𝑟 𝐶𝑎𝑝𝑖𝑡𝑎 = 𝐺𝐷𝑃/𝑝𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

GNP: Gross national product focuses on who makes the product rather than what and where

𝐺𝑁𝑃 = 𝐺𝐷𝑃 + 𝐼𝑛𝑐 𝑟𝑒𝑐𝑖𝑒𝑣𝑒𝑑 𝑏𝑦 𝐸𝑔𝑦𝑝𝑡𝑖𝑎𝑛 𝑎𝑏𝑟𝑜𝑎𝑑

− 𝐼𝑛𝑐 𝑟𝑒𝑐𝑖𝑒𝑣𝑒𝑑 𝑏𝑦 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑜𝑚𝑝𝑎𝑛𝑖𝑒𝑠
GNP per capita is an accurate metric for indicating standard of living.

Business Cycles:

periodic but irregular up-and-down movement of total production and other measures of economic
activity.

Every business cycle has two phases Expansion (GDP ↑) and Recession (GDP ↓)

And two turning points peak and trough

Employment

#𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Measured by unemployment rate =
𝑙𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒
To be counted as unemployed, a person must be in one of the following three categories:

1. Without work but has made specific efforts to find a job within the previous four weeks

2. Waiting to be called back to a job from which he or she has been laid off

3. Waiting to start a new job within 30 days

4. not institutionalized.

Unemployment can be classified into three types:

Frictional unemployment: permanent and healthy phenomenon of a growing economy.

Structural unemployment: changes in technology and foreign competition that change the skills needed
to perform jobs or the locations of jobs.

Cyclical unemployment: higher than normal unemployment at a business cycle trough and lower than
normal unemployment at a business cycle peak. (Highest concern from economic point of view)
Inflation

• Dynamic process of continuous increase in the general price level index (CPI)
• A persistently rising price level is called inflation.
• A persistently falling price level is called deflation.

CPI measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods
and services, CPI basket is based on a Consumer Expenditure Survey, which is undertaken infrequently.

Low, steady, and anticipated inflation or deflation is not a problem.

Unpredictable inflation or deflation is a problem because it

a. Redistributes income and wealth

b. Lowers real GDP and employment
c. Diverts resources from production

Inflation High when the price level is rising rapidly and Low when the price level is rising slowly.

If prices are constant the inflation is zero, if prices are decreasing the inflation is negative (deflation)
𝐶𝑃𝐼 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟 − 𝐶𝑃𝐼 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 = 𝑥 100
𝐶𝑃𝐼 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟
Two types of Inflation

Demand pull: when the economy is heating up towards expansion and people are getting paid more so
they buy more.

Cost push: when the cost of production rises and MC of producers increase, worse type of inflation.