The Basic Principles

The Basic Principles

Business economics is defined as the study of how businesses manage scarce resources. Microeconomics is the study of the decisions of individuals, households, and businesses in specific markets, whereas macroeconomics is the study of the overall functioning of an economy such as basic economic growth, unemployment, or inflation. Scarcity in microeconomics is not the same as poverty. It arises from the assumption of very large (or infinite) wants or desires, and the fact that resources to obtain goods and services are limited.

• wants exceed resources necessary to obtain them
• therefore we must make choices
• every choice leads to a cost

Principles of Economics:

1. People face trade-offs.Every decision involves choices, and more of one good means less of another good. Income and wealth are not limitless, since there is only so much time available. Trade-offs apply to individuals, families, corporations and societies.
2. Cost of something is what you give up to get it.When we make a decision we implicitly compare the costs and benefits of our choices. Opportunity cost is whatever must be given up to obtain something. Some costs are obvious – out-of-pocket expenses; other costs are less obvious but must be included in total opportunity cost.
3. Rational people think at the margin.Basic economics assumes that people act rationally and try to act so as to gain the most benefit for themselves compared to the associated costs. Microeconomics focuses on small or marginal) changes, and it is often rational to consider the marginal rather than the average effects of decisions.
4. People respond to incentives.If rational people compare costs and benefits, then changes in either one may change decisions. An example of an incentive that people respond to, are changes in prices. In general, people are more likely to buy something if it is cheaper. If an action becomes more costly, then there is an incentive to switch to other choices. Note that all actions have substitutes.
Sometimes people will encounter emergencies with costs that are beyond the cash they have available. In these situations, they may consider getting a cash advance to ease the pressure of liquidity in the present.

Explicit costs vs. Implicit costs

The cost of something, say a business, includes both the explicity cost (usually the price) and the implicit costs. One major implicit cost is the opportunity cost. Opportunity costs includes the next best opportunity given up. Only actions have costs; if there are no choices, then there are no costs. Be aware that cost is subjective. For example, compare the psychological benefit of a new computer. Decide whether you would rather have the a vacation to Europe, or a brand new computer.
Another example is in credit card comparison. Some people might only compare the annual fees, but you should compare the added benefits and features too. Certain features may be more valuable to you and be worth the cost, while others may be more valuable to another individual.

Disagreement in Economics

Business economics is both a science and a study of policy – united by a common “way of thinking”. As a science, economists develop models and deliberately simplify accounts of how cause and effect work in some part of the economy. Based on assumptions of what is important, models are created and used to make suggestions about policy and improve basic economic outcomes. Policy involves decisions about scientific theories, personal values and particular circumstances.
Positive statements are claims about what the world is like, although they may be false. For example, "Minimum wage laws cause unemployment". Normative statements are claims about how the world ought to be, and are based on values as well as positive knowledge. For example, "The government should raise minimum wage". Economists may disagree over either positive or normative statements or both, but the great majority tend to agree over basic positive propositions. As such, most disagreements are over normative/policy issues.

Public Goods

Public goods include things such as fireworks displays, and basic research. According to basic economics, a free market is unlikely to provide enough public goods, due to the “free rider” problem. A free-rider is a person who consumes a good without paying for it. Public goods create a free-rider problem because the quantity consumed is not directly related to the amount paid. As a result:

• there may not be enough incentive to pay for public goods through individual action;
• you cannot be prevented from consuming the good even if you do not pay for it and;
• it creates an external benefit on those not involved.

Business economics state that we can decide how much of a public good to produce, by considering a cost-benefit analysis of public goods. The total benefit is equal to the total dollar value that an individual places on a given level of production of a public good. Total Cost is what we must give up to get more of the public good. These are often difficult to calculate - especially the benefits. For example, what is the benefit of saving a human life, and what is the benefit of more flowers in the downtown?
Once we decide on the benefits, then we want to provide enough of the public good to maximize net benefits. That is, total benefits - total costs. The private market will usually not produce enough of a public good. However, it is often done by government because it can compel everyone to contribute through taxes.
The problem is not that people are selfish, per se, but the free-rider problem. If some people do not voluntarily contribute, others who do contribute will feel that it is unfair and may stop contributing as well.

Common Property Resources

These resources include clean air, oil pools, congested roads, fish, whales and other wild life. The problem here is that it is hard to exclude people, but one person’s use reduces that of others'. Over-use of these resources is sometimes dramatically referred to as, "Tragedy of the Commons". This tragedy refers to the common grazing rights in medieval England, in which:

• all families could graze sheep on the common land which was collectively owned and;
• as population and number of sheep increased, common land became over-grazed.

People did not reduce their use, because social and private incentives differed. Each individual’s best move is to get as much of the resource as possible before it is gone. The social optimum is to restrict use. The problem is that each individual creates a negative externality by reducing amount available to others. A few possible solutions were:

1. Custom or regulations could put a maximum on how much each family could use the resource;
2. They could have internalized the externality by auctioning off rights to graze and;
3. They could have created private property rights.

Property Rights

Economists realize that property rights are very important for efficient use of resources. When an individual owns and controls the resource, they have an incentive to increase its value. When everyone owns a resource, or rather, no one owns the resource, there is no one to charge for use, or who can attach a price. An example of such, is air that we breath.
For some goods we can establish property rights, like the pollution permit. For other goods, like national defence or clean air, the government can improve the outcome by regulating or providing the product.

Monopolistic Competition

Monopolistic competition has characteristics of both competition and monopoly. Similar to competition, it has many firms, and free exit and entry. Similar to monopoly, the products are differentiated and each company faces a downward sloping demand curve. Since the company has a differentiated product, it is like a monopolist and faces a negatively-sloped demand curve. In the short-run,

• marginal revenue is always less than demand
• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity

The short-run equilibrium in monopolitic competition is the same as for a monopolist, and businesses may make positive, zero, or negative profits in the short run.

Long Run Equilibrium

In the long run, entry and exit are both possible. If profit is greater than zero, businesses will enter, and each company's market share will fall because of more variety. As a result, each company’s demand curve will decrease, along with price and quantity. If profit is less than zero, businesses will exit, and each company’s market share will increase. This will cause the remaining companies' demand curves to increase, along with the price and quantity.
If profit is equal to zero, there will be no entry into or exit from the industry. In the long run, all the companies' economic profits must be zero.

Monopolistic Competition and Welfare

Let's compare a company in monopolistic competition with a company in perfect competition, where both are in a long-run equilibrium. In both cases, profit equals zero. The two main differences between the two are:

1. Excess Capacity
   • companies in perfect competition produce where ATC is at a minimum (efficient scale)
   • companies in monopolistic competition produce where quantity of output is smaller, and on a downward sloping part of ATC (excess capacity)
   • could increase capacity and lower average costs
2. Make-up Over Marginal Cost
   • for a competitive firm, price = marginal cost
   • for a monopolistic competition firm, price > marginal cost
   • there is a mark-up above MC even though the firm makes zero profits

Efficient Outcomes and Externalities

When price is greater than marginal cost, the value that consumers place on the last unit is greater than the cost, so the good is under-produced. This leads to a deadweight loss like a monopolist. The number of businesses in the industry may be inefficient, and each time a new business enters, it creates externalities such as,

• Product Variety Externality - consumers get a wider choice of products, and an increase in consumer surplus which is a positive externality
• Business-Stealing Externality - this is a negative externality whereby other businesses lose customers

Since companies do not take these into account, there are no guarantees that there is an optimum number of them in the industry. This means that there may be too few or too many products available on the market.

Product Differentiation through Advertising

Companies that wish to differentiate products often use advertising. Advertising is common with differentiated consumer products, and much less common with homogeneous goods. Forms of advertising include television, radio, direct mail, billboards, etc. Advertising has a wide range of costs and benefits.
One cost of advertising, is that it may be mostly aimed at manipulating tastes of consumers without conveying any useful information. Advertising may also try to create differentiation within products that are actually very similar. Also, advertising tries to make demand curves less elastic, and impedes competition. This then leads to a high markup over marginal cost.
Some benefits to advertising, is that it does convey some useful information such as prices, new products, locations, etc. Advertising may also foster competition by giving more information on pricing and availability. Advertising may also be a “signal of quality”, because willingness to spend money to advertise products may be a sign that the company has confidence in its quality. This makes it rational for consumers to try such products even if content of ads is minimal.

Oligopoly Market Structure

Between the definitions of perfect competition and pure monopoly lie oligopolies and monopolistic competition. An oligopoly is where there are a few sellers with similar or identical products, such as hockey skates (Bauer, CCM). Monopolistic competition has many companies with similar but not identical products. Each firm has monopoly power over what it produces, but products are close substitutes, such as cigarettes, CDs, and computer games. Examples of oligopolies include crude oil businesses and auto manufacturers.
The main key to behaviour in an oligopoly, is that companies must take into account what other companies will do. In perfect competition, firms are price-takers and can ignore other firms. In a monopoly, there is only one firm, and it does not take into account what competitors will do. Oligopolists are torn between:

1. cooperating to increase profits by obtaining the monopoly outcome, or;
2. competing to try to gain an advantage over competitors.

Duopolies and Cartels

A duopoly is when there are only two businesses in a market. Their best outcome is to cooperate and agree to restrict output to the monopoly quantity, where price is greater than margical cost, and profit is maximized. A great example of a duopoly is Coca-Cola and Pepsi Co. Usually, a duopoly trying to maximize profits will produce more than a monopolist but less than a competitive industry. Duopolies come from collusion where firms agree to share output and set prices such as in a cartel.
A cartel is a group of companies acting in unison, such as OPEC. If the competing companies cannot agree, then they may end up with the competitive position with profits equal to zero. Cartels are known to restrict output quantities in order to raise prices, and consequently profits.

Size of an Oligopoly and the Market Outcome

Generally, the more companies in the industry, the harder it is to form a cartel and to enforce it. As the number of companies increases, the more the industry resembles a competitive outcome, since each company has a smaller effect on the outcome. The mentality where each company tends to think only of its own profits and strategic behaviour is reduced. Each company will increase production as long as price is greater than marginal cost. As the number of companies increases, we tend to move towards a perfectly competitive outcome.

Game Theory and Prisoners' Dilemma

Game theory is the study of how people behave in strategic situations (i.e. when they must consider the effect of other people’s responses to their own actions). In an oligopoly, each company knows that its profits depend on actions of other firms. This gives rise to the "prisoners’ dilemma".
The prisoners' dilemma is a particular game that illustrated why it is difficult to cooperate, even when it is in the best interest of both parties. Both players select their own dominant strategies for shortsighted personal gain. Eventually, they reach an equilibrium in which they are both worse off than they would have been, if they could both agree to select an alternative (non-dominant) strategy.

Monopoly Companies

A monopoly is a single producer of a product which does not have close substitute. A monopoly is characterized bybarriers to entry. Sources of a monopoly include:

• Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers diamond monopoly).
• Exclusive Right Given by Government - patents, copyrights, franchises (pharmaceutical companies, research, authors).
• Falling Average Total Cost - making one company more efficient than others (also known as a natural monopoly), arising from economies of scale over the relevant range of output.
• Public Utilities - electricity, cable television. and water provision.

Pricing and Production Decisions

A monopoly is a large enough business to influence its own price, such that it is the price setter rather than taker, unlike a perfectly competitive market where each firm faces a perfectly elastic demand curve. A monopoly faces a downward-sloping demand curve and the market demand is the company’s demand. Monopolists are still constrained by the negative relationship between price and quantity demanded. With fraud becoming more widespread, it's important to do a criminal background check prior to engaging in business activities.

Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower its price. There are two effects on total revenue (profit x quantity):

1. Output effect - gains more revenue because it sells more.
2. Price effect - gains less revenue because it gets less from each unit sold because of the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total revenue, even though the company sells more. What determines value of MR? It depends on whether the fall in price is larger than the increase in quantity. In other words, it depends on the elasticity of demand. Note that MR = P [1-1/abs. E].
When E > 1, MR > 0 because output effect > price effect
When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect
Therefore, the monopolist will never produce in the inelastic portion of the demand curve since MR < 0. A straight-line demand has elasticity that varies from zero to infinity. Assuming a linear demand curve P = a-bQ, the MR curve for a straight line will:

• be a straight line with the same intercept and;
• have twice the slope of the demand curve (i.e. it is zero at the halfway point of the demand curve).

Profit Maximization

Recall that the objective of a business is to maximize profits. As such, a company should produce where profit is at a maximum. In marginal terms,

1. If MC < MR, producing 1 more unit will add more to TR than to TC, so the monopoly should increase quantity.
2. If MC > MR, producing 1 more unit will add more to TC than to TR, so the monopoly should decrease quantity.
3. Only when MR = MC (and MC cuts MR from below) is profit maximized.

A monopolist will generally produce less than a socially efficient level of output, and charge too high a price. Are the above normal profits of monopoly a social cost? Not usually, since profit is still part of surplus but has been transferred from consumers to producers. Social cost arises from inefficiently low output which leads to the dead weight loss. However, if the monopolist uses some of its normal profits to lobby in order to maintain a monopoly (rent seeking), then this can be a welfare cost to society.

Price Discrimination

Price discrimination is selling the same good to different customers/markets at different prices. Examples include movie tickets, airline tickets, and discount coupons. In order to practice price discrimination, there must be easy to separate customer into groups. These groups are determined based on their elasticities to demand. The company must also be able to prevent resales between groups, as well as arbitrage, which is buying where a good is cheap and selling where it is expensive.
Price Discrimination can increase the profit of monopolies, since they can charge a higher price to those with less elastic demand, and a lower price to those with more elastic demand. In this manner, a business does not have to lower prices to all buyers in order to sell more goods.

Perfect Competition

In competitive markets there are:

1. Many buyers and sellers - individual firms have little effect on the price.
2. Goods offered are very similar - demand is very elastic for individual firms.
3. Firms can freely enter or exit the industry - no substantial barriers to entry.

Competitive firms have no market power. Recall that businesses are trying to maximize profits, and Profit = Total Revenue (TR) - Total Cost (TC).

Revenue in a Competitive Business

Businesses in competitive markets take the market price (P) as given (price takers). How much does the business receive for a typical unit is known as the "average revenue" (AR) and is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is constant. How much additional revenue does the firm get if it sells one additional unit? To answer this question, we take a look at "marginal revenue" (MR) which is equal to the change in TR divided by the change in quantity. Note that this too is equal to price, so the marginal revenue is constant as well, and is equal to average revenue.

Profit Maximization

To maximize profit, we need to know the revenue and costs of the business. Profit is maximized when marginal revenue = marginal cost, and marginal cost is rising. To see why, recall that marginal revenue is the additional revenue from 1 additional unit. Marginal cost is the additional cost from 1 additional unit.
When MR > MC, revenue is increasing faster than costs and the firm should increase production. When MR < MC, revenue from the additional unit is less than additional cost, and the firm should decrease production. As such, A firm maximizes profits when MR = MC.
So what happens to output at various prices? Since MC is upward sloping, as price increases, quantity produced will increase too. As price falls, quantity produced falls. In each case, the marginal cost curve determines how much the firm is willing to produce at each price, so it translates into the supply curve.

Shutting Down a Company (temporary)

A company is considered to have shut down, if it temporary ceases production but keeps fixed capital. A company has exit the industry when it has made a permanent decision to leave the industry. The decision to temporarily shut down a business depends on a few factors. Recall that ATC = AVC + AFC. So average fixed cost is the vertical distance between average variable cost and average total cost.
Now if a business shuts down, its total revenue becomes zero, and its total cost equals the fixed cost. So the company should continue producing its product, as long as it covers its variable costs. This way, total revenue is greater than total variable cost, because losses are then less than TFC. Basically, shut down when P (AR = MR) < AVC, to minimize the losses and so the company's short-run supply curve = MC curve above AVC. The firm therefore produces where profit equals marginal cost.
Another way to put this is that sunk costs are sunk. Fixed costs are sunk, and therefore cannot be recovered by shutting down in the short run. The decision to continue producing depends on revenues and variable costs. If average revenue is greater than average variable cost, then the business should continue to produce. It is rational to continue producing, so long as AVC < P < ATC.

When to Leave An Industry (permanent)

A business should leave the industry when revenue is less than cost of operating in the long run. In other words, exit if total revenue is less than total cost (P < ATC). In competitive markets, a company will make zero economic profits in the long run. If companies are making more than zero economic profits, it will encourage other firms to enter the industry to share in these profits. In other words, enter if total revenue is greater than total cost (P > AC). If companies are making zero economic profits, there is no entry and no exit, which is a long run condition.

Market Structures-Costs and Production

Firms are defined as economic organizations that purchase inputs and sell outputs. We will assume that a firm's objective is to maximize profits. Let's take a look at some equations relating to costs.
Profit = Total Revenue (TR) - Total Costs (TC)
Total Revenue = Price x Quantity Sold
Total Costs = Sum of all opportunity costs related to the production process
Opportunity Costs = Explicit Costs + Implicit Costs
Explicit costs of production include:

• wages and salaries to employees
• costs of raw materials
• taxes

Implicit costs of production include:

• value of time of owner/entrepreneur
• opportunity cost of financial capital invested in the firm i.e. interest rate foregone

"Economic profit" is the difference between total revenue and total cost, where total cost includes both explicit and implicit costs. In contrast, "accounting profit" is the difference between total revenue and explicit cost. For example: A dancer gives dancing lessons for $20 per hour. Instead, he could be performing on stage for $30 per hour. What is the economic profit of performing on stage?
Total costs = $0 (explicit cost) + $20 (implicit cost)
Economic Profit = $30 (TR) - $20 (TC)
Recall that supply is primarily determined by the productivity of inputs, and the cost of the inputs. The production functions show the relationship between quantity of inputs and the quantity of output.
The short run refers to a period in which at least one input (usually capital) is fixed. The short run production function shows a relationship between total output and inputs, when one input is varied and one is fixed. This is also referred to as the total product (TP). Average product (AP) is the average production per unit of variable input, and is equal to TP/L, where L is labour (the variable input). Marginal product (MP), shows the change in total output when input changes by one unit. Therefore, MP is the slope of the total product curve, and thus shows the productivity of labor.

Total Product Function

A very key assumption, is that of the diminishing marginal product (or diminishing marginal returns). If we add more and more of the variable input(s) and there is at least one fixed input, then eventually the MP of the variable input will decline. The TP curve will flatten out as the quantity of the variable input increases. Therefore, MP may rise initially, but it must fall (TP is increasing but at a decreasing rate).

Product and Cost curves

To go from production to cost, we assume that the costs of inputs are fixed (i.e. a firm can hire all the labour it wants at the going wage). Cost are divided into two broad categories:

• Fixed costs - costs that do not vary with output, such as cost of plant or some fixed inputs
• Variable costs - costs that vary with output, such as cost of labour or other variable inputs.

Total costs (TC) is the sum of Total Fixed Costs (TFC) and Total variable Costs (TVC). Graphically, TFC is represented by a horizontal line since costs are fixed. The total cost eventually gets steeper as more is product is produced. Average cost (AC) is how much a typical unit costs and is equal to TC divided by number of units produced. Mathematically we have,
AC = (TFC + TVC)/Q = AFC + AVC
AFC: average fixed costs
AVC: average variable costs
Note that AFC will constantly fall as output increases. AVC will fall and then increase due to diminishing returns. Marginal Cost (MC) is the change in total cost divided by change in output, and addresses the question: how much will it cost to produce one additional unit of output?

Market Failures and Externalities

Principle of Economics #7: Governments can sometimes improve market outcomes. Markets do many things well. With competition and no externalities, markets will allocate resources so as to maximize the surplus available. However, if these conditions are not met, markets may fail to achieve the optimal outcome. This is also known as "market failure".

Externalities

In previous analysis, we assumed that all goods consumed or produced have been private, in the sense that one individuals consumption or production of a good does not affect the other. When our actions impact on those not directly involved, an externality exists. As one individual's behaviour increases or decreases, another's satisfaction or profit changes as well. It can have a positive or negative effect on a third-party not directly involved with the buyer or seller of the transaction. These costs (or benefits) are not included in the cost curve faced by the decision makers.
Examples of externalities:

• A smoker annoys others with second hand smoke.
• A gardener delights a neighbour with his beautiful garden.
• A pulp mill pollutes the air and water in town.
• A perfume wearer gives a friend an allergic reaction.

Negative Externalities

When economic agents not directly involved, negative externalities can exist, such as pollution. A free market tends to over-produce the good which produces a negative externality, and under produce those with positive externality. If we include costs borne by everyone, then we get social costs, which are the total costs of production no matter who bears them. We say that the total cost is equal to private costs plus external costs.
Negative externalities result in a lower free-market output. In order to make the market produce the optimal amount, we must impose a tax. This is called "internalizing the externality", and forces those involved to account for external costs. There are also externalities in "consumption", when consumption has costs for persons other than those actually consuming the product. Examples of these are cigarettes and second-hand smoke, and drinking alcohol and car accidents.

Positive Externalities

Not all externalities are negative. Some create benefits to those not directly involved. Such is the case with "technology spillover", where new inventions benefit those beyond the inventors.
Some have argued that governments should subsidize research and development, since it will have positive externalities to everyone else. Another method is to allow patents to give monopoly rights to new inventions for a period of time, and encourage such activity. Without this method, there could be an under investment in research. Positive externalities in production means that social cost is less than private cost, and more of the good should be produced than will occur in a free market.
There may also be positive externalities in consumption, such as education. In this case, the social value is greater than the private value

Solution to Externalities

Externalities lead to an inefficient quantity of production and consumption. This can be remedied by either private arrangements or public policy. Externalities can be dealt with by:

1. Moral codes and social sanctions
2. Voluntary organizations - charitable groups, lobby groups
3. Internalization - when activities with complementary externalities are merged into one firm, thus eliminating the externality
4. Contracts - parties through negotiation can agree as to how to regulate the externality

Coase Theorem

If parties can bargain without cost over the allocation of resources, then the private market can always solve the problem of externalities. It can allocate resources efficiently, irrespective of how the law assigns responsibility for damages. Earlier before Coase, it was argued that the source of the externality should be penalized. It is now recognized that the party that can deal with the externality at least cost should do exactly that.