Economics

GSCE A Level Economics

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Discuss whether firms in the real world set prices at profit-maximising levels.

What is the point of profit maximisation?

What other goals do firms have? Profit-satisficing, output maximisation, revenue maximisation and growth-maximisation etc. 

Conclude: Short-run, Long-run analysis

In theory, firms produce at profit-maximisation point where marginal cost (MC) equals marginal revenue (MR). However, in reality this approach is criticised as unrealistic as not only is it difficult to determine profit-maximisation levels, especially when a firm produces a large quantity of goods, firms have other objectives to achieve as well.

In reality, firms are subjected to imperfect information and hence do not have the sufficient or accurate information about their demand and supply curves to determine the exact profit-maximisation point. The changes in the tastes and preferences of consumers occur too quickly, frequently and often unpredictably for firms to react in time and estimate their profit-maximising levels. Therefore, firms often opt for easier methods of deciding their price and output, such as cost-plus pricing. It involves the firm marking up the price of the product or service from its average cost. The markup is usually arbitrary and varies according to market conditions. If the product is selling poorly, the markup could be reduced to boost sales and the converse is true as well.

Other than profit-maximisation, firms could also aim to profit-satisfice. Profit-satisficing is the situation in which decision makers in a firm set a target level of profits to be earned rather than the absolute maximum level. This is because the people running the firm may not necessarily be the people who actually own it. The owners could be shareholders who appoint a group of directors to represent them and in turn, this group of directors usually employ a professional manager to manage the firm, also known as the Chief Executive Officer (CEO). There is thus a divorce between ownership and management of the firm. While the shareholders are generally interested to maximise profits, they usually lack the information required to determine profit-maximisation point. It is also possible that managers have other objectives such as maximising revenue, output or growth because power, prestige and earnings are commonly associated with such indicators. Therefore, managers will aim to attain these goals while maintaining a satisfactory level of profits to keep the shareholders happy. 

Next, firms may also want to maximise output and revenue to maximise market share in the long run. Maximising output and revenue allows firms to increase market share even though it is at expense of short run profits. Once firms acquire a larger market share, demand for their products and services are more price inelastic, which allows them to then increase pricing power and hence maximise profits in the long. 

Firms may also aim to maximise growth. In the short run, their profits may suffer due to extensive advertising, product development through R&D and investments. However, such investments should pay off in the long run due to the expansion of the firm’s productive capacity and demand. 

Conclusion:

Given the constraints of the real world, profits devise other strategies other than simply maximising profits. Nevertheless, through these strategies, firms ultimately still aim to maximise profits earned in the long run. Over time, firms do aim to increase market power and reduce production costs so as to increase their pricing ability, all in the pursuit of maximising/earning higher profits.

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Interactions between microeconomics and macroeconomics

Consumption tax and cost-push inflation

Aim of the consumption tax was to reduce consumption

Possibly because of the negative externalities generated by the consumption of the good

However, higher costs of such goods raises cost of living for households (who consume fuel) and cost of production for firms (who also consume fuel to power their factories and processes)

Causes the AS curve to shift up, resulting in inflationary growth and cost-push inflation 

Subsidies --> Budget deficit, Pubic debt, global inequality

Aim of subsidies is to improve income inequality, give workers in certain (declining and agricultural) industries a more decent income, prevent bankruptcies 

Pressure fced from trade unions and advocacy groups that possess significant political clout

However, subsidies can be extremely costly for governments --> incur huge debts and budget deficits that may turn out to be unsustainable and unhealthy

Unnecessary protection of productively inefficient industries (protectionism) is allocatively inefficient as resources are siphoned away from more productive initiatives (like public infrastructure and education)

Negatively affects the country’s long-run growth, especially if resources are prevented from being invested in aforementioned sectors 

Exacerbates global inequality --> agricultural subsidies from the developed countries artificially depress global prices on agricultural produce, undercutting the incomes of third-world countries’ farmers and worsening global income disparity 

The accumulation of huge buffer stocks as a result from the subsidisation of agricultural production in DCs will also contribute to the worsening of global income inequality as these stocks will eventually find their way into the markets of LDCs (as food aid etc)

Act as substitutes to local agricultural produce, oftentimes cheaper substitutes --> diminishes the demand for LDCs’ domestic agricultural products and the incomes of domestic farmers 

Government intervention --> Long-run growth

Government intervention to correct market failures can confer positive externalities and contribute to the country’s potential growth

Case of education

Education is subjected to market failure, namely positive externalities and is a merit good

By subsidising the consumption and production of education, not only solves the inherent allocative inefficiency in the micro-market, but also improves labour mobility and productivity, which in turn contributes positively to the productive capacity and potential growth of the macroeconomy

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Macroeconomic Tradeoffs

Inflation vs Unemployment

Achieving full employment requires AD to move along the upward sloping portion of the AS curve, leading to higher prices ie Inflation

Inverse relationship between inflation and unemployment

Inflation vs Long-run Growth

Curbing inflation using policies that reduce consumption and investments and hence AD slows down capital accumulation which is vital for long run growth (CMP)

CFP which reduces government spending to bring down AD and hence demand-pull inflation reduces government investments on R&D, human capital development and infrastructure which all contribute to long-run growth

CFP also necessitates the raising of taxes which deters private investments due to lower net returns --> less investments impede capital accumulation and hence long-run growth

Internal stability vs External stability

BOP surplus: potentially lead to an increase in money supply which eventually finds its way into the economy and cause demand-pull inflation and asset bubbles

BOP deficit: contraction in the economy’s money supply, lower AD, output and employment

Long-run growth vs Equity

Reducing income inequality involves making the tax structure more progressive and raising income taxes

However, this creates a disincentive to work and invest, impeding capital accumulation and long-run growth

On the flip side, achieving long-run growth through the lowering of direct taxes is likely to worse income distribution and exacerbate income inequality 

Another argument is that without sufficient economic growth, there won’t be sufficient tax revenues available for the government to spend on income redistribution 

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Choice between Monetary and Fiscal Policy

Inflation

Monetary policy

Political viability

More politically viable to raise interest rates compared to raising taxes and cutting G

No limit to which interests rates can be raised but Government spending can only be reduced to a certain extent beyond which social services will be severely compromised 

Politically unpopular to raise taxes when households are ALREADY suffering from inflation

Time lag

Time lags associated with MP much less than FP

Enables rising prices to be curbed more quickly

Reinforcement through exchange rate (flexible only)

raising interest rates causes currency to appreciate --> fall in export/external demand reinforces contraction in internal demand

However, for countries who manage their exchange rates, only fiscal and supply-side policies can be used to fight inflation 

Unemployment

Choice is dependent on the severity of the economic downturn

Mild economic downturn: Monetary Policy

Interest insensitivity hasn’t set in 

Time lag is also reduced 

Crowding out is avoided

Can avoid incurring government debt

Severe economic downturn: Fiscal Policy

Tax and interest insensitivity likely to have set in --> lowering interest rates will have minimal impact on consumption and investments

Direct injection into the circular flow of income --> there is at least a direct initial boost in AD which is hopefully sufficient to turn the economic situation around

Crowding out is also unlikely in this scenario since private demand for loanable funds would be weak given bleak economic prospect --> likely to have a large pool of idle funds for the government to borrow to finance its increased spending 

Countries with fixed exchange rates/capital control can concurrently use MP and FP so that their effects can reinforce one another to maximise results 

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Government Debt

Balanced budgets and budget surpluses are generally considered healthy for the economy. They are sustainable and do not generate long term problems for the country.

Budget surpluses can be channelled to fund budget deficits

Government can accumulate budget surpluses as reserves/savings that can be used to manage future problems 

On the other hand, a budget deficit is a cause for concern. While small, temporary budget deficits are not too worrisome as they can be financed by future budget surpluses, large, long-term budget deficits are harmful to economies. 

Government deficits are financed through 1) drawing on reserves 2) borrowing 3) printing money

Drawing on reserves is usually the first option

It does not generate any side effects on the economy

The next best alternative is to borrow from private firms and households (pubic debt) by issuing government bonds 

This increases the demand for loanable funds and hence interest rates --> curbs private consumption and investment [crowding out effect]

In the SR, lower consumption and investments by private sector reduces AD

In the LR, reduced investments slow down the rate of capital accumulation and potential growth (AS) is hindered

Continued borrowing results in the accumulation of pubic debt, which restricts the ability of the government to function and leads to social and economic instability

Inability to pay back debts will severely tarnish the government’s credibility such that private firms and entities are unwilling to purchase more government bonds 

The only option left is to print money to monetise the debt

However, such a move will lead to severe demand-pull inflation due to excessive money supply growth (and corresponding drop in interest rates)

Why is national debt BAD?

Future revenue/welfare is used to finance/repay the debt

By doing so, less funds are available for the government to spend on other areas or sectors/services

Compromises on current welfare as well

Governments may also need to raise taxes to finance their debts, leaving the general population with less disposable income and lower purchasing power 

Exacerbates income inequality/ inequality in general

Government debt redistributes income from taxpayers to bondholders who are often the rich as they are the ones who can afford to buy government bonds

Tarnishes the government’s credibility and investor’s confidence

In the long run, excessive public debt reduces investor’s confidence and causes capital flight --> as the economy suffers lower investments, its tax base and hence, tax revenue is further reduced

Why national debt isn’t necessarily bad?

Debt is used to finance government investments rather than government consumption

Government investments expand the economy’s productive capacity which may instead generate more than enough output and income in the future to repay the debt. Future welfare is enhance instead of diminished.

Debt is purchased by the country’s own citizens --> internal debt

The economy does not suffer net losses in welfare 

Funds are merely being redistributed from the tax payers to the bondholders

E.g. of Japan for the past 20 years whose sovereign debt has been financed from domestic savings 

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Limitations of Fiscal Policy

Government debt--> govt has to borrow from the future to finance current budget deficit --> less available funds for social services and infrastructural development 

Dependence on the size of the economy's multiplier --> the smaller the multiplier, the costlier and less effective EFP is to fight unemployment 

Case of Singapore

Lacks natural resources --> high marginal propensity to import

High rates of savings (CPF) --> high marginal propensity to save

Therefore, overall high marginal propensity to withdraw and a SMALL INJECTION MULTIPLIER 

Small domestic economy --> Singapore’s AD is very much reliant on net exports 

Therefore, domestic fiscal stimulus is unlikely to have a huge impact in boosting AD in times of a recession

Why does Singapore still use fiscal policy then?

Government spending in times of economic hardship is aimed at maintaining firms’ productive capacity to reduce the number of layoffs

At the same time, government spends on direct transfers to households to help the poor (especially) to tide through the economic downturn rather than to raise private demand 

Overall, fiscal policy in Singapore is aimed at engendering supply-side effects 

Crowding out effect --> government borrows in order to finance a budget deficit --> increase demand and hence price of loanable funds --> increase interest rates --> deters private firms and households from consumption and investment 

The decline in demand stemming from lower private consumption and investment could offset the increase in government stimulated increase in AD, thereby reducing the efficacy of fiscal policy

--> appreciation of exchange rate --> curbs net exports --> diversion of private demand towards public demand 

Time lag: government needs time to decide how much to inject into the economy, how to distribute budget etc 

Tax insensitivity: despite tax cuts, firms and households are still unwilling to invest because of dire economic outlook. Households, for fear of future pay cuts and retrenchment, are more likely to save

Fiscal policy is hence not very effective in times of a recession or when economic outlook is extremely buoyant 

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Limitations of Expansionary Monetary Policy

Interest insensitivity renders it futile, especially in times when economic prospects are very bleak 

Monetary policy alone is not enough to counter a SEVERE economic downturn

Liquidity trap--> interest rates are already so low that any further reduction does not have any impact on consumption and investment 

Risk of asset bubbles--> if they were to burst, they could trigger another round of recession. Decrease in interest rates --> increase in liquidity which finds its way into stock and property markets --> speculative demand inflates the price of assets --> when prices become so high that they eventually become unaffordable to buyers, demand and hence price starts to fall precipitously--> triggers successive rounds of selling as speculators try to offload assets before their prices drop even further 

Economists have argued against the sue of expansionary monetary policy because of tis impact on asset markets which arguably generates even more macroeconomic instability over time

Exchange rate-centered monetary policy boosts AD by raising net exports --> devaluation of currency--> rise in export competitiveness --> fall in import demand 

But imported inflation resulting from the depreciation of domestic currency --> imported inflation --> potentially offset any export competitiveness country has gained in the first place + domestic consumers and firms will also suffer from inflated food and fuel prices 

Exchange rate depreciation involves the selling of domestic currency to the forex market --> liquidity will usually find its way back into domestic markets--> may trigger asset bubbles or demand-pull inflation

Case of Singapore

High dependence on imports due to the lack of natural resources --> sudden depreciation of the S$ causes severe imported inflation

affects households and firms directly (increased prices of food and fuel)

imported inputs become more pricey as a result --> raise production costs and product prices

Small domestic market, export-oriented --> Singapore is highly dependent on export demand (external demand) --> sudden appreciation of S$ causes Singapore’s AD to plummet, triggering a recession 

Given the aforementioned considerations, MAS would rather manage Singapore’s exchange rate rather than domestic interest rates as the former has a GREATER IMPACT ON MACROECONOMIC STABILITY COMPARED TO THE OTHER 

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Economic Growth

Barriers to economic growth for developing countries

Economic growth is the increase in real output of an economy and is usually measured in terms of GDP.

Actual growth is economic growth (increase in real output) that has already been experienced by the country.

Potential growth refers to the increase in a country’s productive capacity which shifts the economy’s AS curve rightwards over time. i.e. Long run growth achieved.

Short-run economic growth can be realised just by an increase in AD, but long-run economic growth requires increase in the country’s AS/potential growth.

Developing countries

Low income per capita

Low or semi-skilled workforce

Financial sectors less developed 

Primary industries or labour intensive manufacturing 

Lack of savings and investments (raises quantity of capital)

Hampers capital accumulation and hence potential growth

Low per capita income --> people unable to invest because of low disposable income with most of it being used to fulfil basic needs

Low tax revenues --> government unable to spend on essential infrastructure needed to attract FDIs and support the growth of the economy

Problems acquiring finances due to inept financial sectors --> problems investing --> hampers potential growth

Political instability, crime, corruption --> deterrent forces which repel FDIs

Low technological development (raises quality of capital)

Country must invest sufficiently in innovation and R&D to result in improvements in the quality of capital

Lack of technological developments and R&D --> unable to improve quality of capital --> low potential growth

R&D requires too high a set-up cost for developing countries to afford

Requires high expertise --> developing countries are short on thi because most of their workers are low-semi-skilled 

Lack of mature IPR regulations and enforcement --> firms deterred from engaging in R&D

Lack of investment in human capital (quality of labour)

Slow increase in labour productivity --> low potential growth

Developing countries are not short on labour, but the workers often receive low education --> lower productivity

Government budget constraints--> difficult to subsidise and provide training programmes

Typically do not put priority in training because it takes away workers from work and imposes costs on both firms & workers

Benefits of economic growth to developing countries

Increased material standards of living --> rise in AD --> rise in incomes assuming population growth doesn’t exceed output growth

More output --> higher demand for goods and services--> more employment opportunities generated --> surplus of workers averrable will  unlikely result in demand-pull inflation 

Increased incomes --> increased savings --> can be used for investments in capital --> raising the country’s productive capacity OR increase tax revenues --> government can spend more on human capital developmental programmes, infrastructure and R&D --> facilitates potential growth

Enables better redistribution of incomes --> channelled from the rich to the poor without making the rich worse off in absolute terms --> less likely to resist --> government can go ahead with this policy which is all the more important as the country transits from a labour-intensive to a skill or knowledge-based economy (inequality tends to worsen during this stage)

Costs of economic growth to developing countries

Potential growth --> current consumption has to be sacrificed --> LDCs are already poor and have many unfulfilled needs --> may mean having less food in what may already be very little to start with

Environmental degradation. Industrialisation, urbanisation --> destruction of habitats, pollution, exposure of people to contaminated water and air --> particularly when LDCs often lack formal and strict environmental regulations 

Depletion of natural resources if there is a lack of planning --> growth is only short-term as the resources are finite

Increasing income inequality --> arises when country experiences a structural shift from primary & secondary sector to a territory sector which i more skills and knowledge oriented --> those who are unable to assimilate and catch up with the rising industries become structurally unemployed --> exacerbates income inequality

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Alternate theories of firms

Profit satisficing: decision makers for a firms aim for a targeted level of profit rather than maximisation level

Shareholders want to maximise profit but they lack information about exactly how much maximum profit is

Managers may be more interested in achieving higher revenue, output or growth because his/her power, prestige and earning are often tied to these indicators, thus the manager will aim to maximise these objectives while maintaining a satisfactory level of profit to keep the shareholders happy

To maximise revenue, produce at point where MR=0 --> can earn supernormal profits

To maximise output, produce at AC=AR --> earn normal profits 

Long-run profit maximisation

Maximising long-run profits may be at the expense of short-run profits

Maximising revenue or output increases firm’s market share which reduces the firm’s price elasticity of demand in the long-run, increases pricing power and hence profits

Growth maximisation involves a firms to incur extra costs in aspects of advertising, investments and product development, going that it will pay off in the future with the resulting expansion in the firm’s demand and capacity

Imperfect information 

In reality it is difficult to determine the profit-maximisation point MC=MR

In the real world imperfect information is the norm

Cost plus pricing --> average cost of producing a good is calculated and a mark-up is attached to determine selling price 

Mark-up is varied depending on the sales of the product

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Market Structure Issues

Collusion

Occurs amongst oligopolistic competitive firms because there are only a small number of firms

It is the act of jointly determining the price or output in the market by a small number of firms

Explicit collusion 

Where oligopolistic firms formally gather to fix prices or output

Formal collusive oligopoly = cartel

OPEC --> consists of 12 countries which controls about two-thirds of the world’s oil supply

Caused several supply shocks, notably one in 1973 (an oil embargo in protest to the US for openly supporting Israel) and 1979 (due to the Iranian war)

Tend to break down --> cheating of cartel members by not adhering to the allocated quotas as it could have been too restrictive

To succeed, the following conditions must be fulfilled:

Combined market share of the firms in the cartel needs to be sufficiently large

Demand for the commodity must be price inelastic --> rising price will lead to increased revenue

Product must be homogenous so a standard price can be agreed upon

Production methods and costs must be similar --> or else members with significantly production costs can drive out their competitors 

Supply needs to be stable 

Tacit collusion

Where firms cooperate informally by following a price leader

Price leader is often the dominant firms --> largest market share, highest capacity, strongest branding and largest economies of scale

Smaller firms are willing to follow the leader rather than unilaterally lowering their prices, for fear of angering the dominant firm and potentially being driven out of the market

Barometric price leader --> a leader agreed by the other firms to be the best predictor and adaptor to changing, market conditions

Occurs when that one firms is able to consistently predict market trends accurately --> it gains credibility\

In the absence of a leader, firms simply follow whoever changes prices first or take turns being the leader firm

Could result in leadership break down when business is poor

Price war in desperate times 

Price wars

Occurs when a collusion breaks down --> firms retaliate by slashing prices --> successive rounds of price cuts triggered --> heavy losses incurred throughout the market

Reasons for price wars

Intention to punish the rival who caused the break down of the collusion

Raise barriers to entry and deter potential firms from entering the market --> demonstration of market power 

Short-term price slashed could be primarily to meet sales targets pr raise revenue to overcome cash flow problems 

Short-lived

The only beneficiaries are consumers --> lower prices, discounts 

Price discrimination

Definition: Firms charging different prices for the same product to different buyers for reasons not associated with the differences in costs.

Firm is a price-setter

Different buyers must have different price elasticities of demand 

Firm must be able to segment the market

There should be limited seepage (or else people would buy the good at a lower price from a black market)

First degree --> the buyer is charged the maximum price that he/she is willing to pay for the good

Requires seller to know the demand curve of each buyer --> impossible in reality due to imperfect information

Closets situation in reality is that the seller of a shop in a small area knows each and every one of his buyers well enough to know their demand curve

Unrealistic but still necessary to analyse impact of price discrimination on distribution of profits, equity and efficiency

Firm is able to lower the price of the last unit without having to lower the prices of all previous units

Consumers do not enjoy any consumer surplus at all --> consumer welfare has been transferred t the producers --> in equitable if those affected are poor

However, price discrimination results in allocative efficiency because output and price is now at the point where DD=MC

Price discrimination is also beneficial to firms when demand is so low that the good is not commercially-viable if only a single price was charged

Cross-Subsidisation: what was an initially non-existent market becomes economically viable as welfare is being channeled from the richer consumers to the poorer ones 

Second degree --> buyers are charged progressively less for each subsequent blocks of output AKA block pricing where the size of each block does not have to be the same

Producer receives higher producer surplus if he engages in 2nd degree price discrimination versus when he simply charges a single price at MC=MR

Less extreme compared to 1st degree because consumers still benefit from some consumer surplus

Firms use 2nd degree rather than 1st degree price discrimination in reality

Administratively simpler, less complicated 

Electively efficient because they produce at the point where MC=DD

Generates less profits than 1st degree 

More equitable than 1st degree

Cross-subsidisation can also occur 

Third degree --> buyers are segmented into two o more different markets and then charged different prices for each market

Goal is also to maximise profits

Firm charges the market with more price elastic demand a higher price than the market with more elastic demand

Most common form of price discrimination

NOTE: Need to juxtapose the curves of 2 markets with the curve of the horizontal summation of them, then compare the size of profits

Size of firms

Measuring inputs

Number of workers

Value of physical assets --> likely to be inaccurate as their values can appreciate or depreciate with time

Market capitalisation (if firm is listed on the stock market) --> prone to fluctuations and instability

Measure outputs

Physical output

Not useful when making cross-industry comparisons

Total revenue or market share

Growth of firms

Horizontal integration--> firms on the same stage of production merge to form a single entity

Vertical integration--> firm of one stage of production combines with a firm of another stage of production

Forward--> firm integrates with another firm in the previous stage of production

Backward --> firm integrates with another firm in the next stage of production

Conglomerate integration--> when firm merges or acquires another firm from a totally different industry

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Monopolistic Competition

A market where there is a large number of small firms each selling a differentiated product.

There are lo barriers to entry and each firm possesses insignificant market share, meaning that individual firm’s decisions do not have significant impact on its competitors, enabling them to market independent decisions, unlike oligopolies.

Product differentiation can be done in 2 ways -- real differences and imaginary differences.

Real differences refer to the differentiation of the product in terms of tis physical attributes. Imaginary differences refer to the creating of brand loyalty and packaging to lure/persuade consumers to buy the firm’s products.

Due to product differentiation, monopolistic competitive firms have price-setting ability i.e. market power. Perfect information and knowledge about the product and production techniques are unimportant for monopolistic competition because the product is differentiated and also, such concepts only apply in principle and not in reality.

Price setting ability (market power) --> demand curve resembles that of a monopoly (AR half the gradient of the MR curve)

Short run performance: able to earn sub, normal and supernormal profits. Will still continue production if it is able to cover variable costs but will shut down if it is unable to cover AVC.

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Oligoply

A market that is dominated by a small number of large firms, each possessing a significant market share. 

Examples: Supermarket industry in Singapore is an oligopoly --> supermarkets are owned by 3 big firms namely Dairy Farm Group, Sheng Shiong and NTUC; similar for the petrol industry, firms are owned by 4 large firms namely SPC, Caltex, Esso-Mobil and Shell

Small number of firms due to high barrier to entry preventing firms from entering even when there are supernormal profits to be made in the long run. Barriers to entry can either be natural or artificial. Natural being large economies of scale and artificial being aggressive advertising, licensing and product proliferation.

Oligopolies have the liberty to sell homogenous of heterogenous products.

Due to large market share, oligopolies have price setting abilities even if they are selling homogenous products or are subjected to perfect pricing information. Their large market share can be attributed to 2 things : product differentiation and imperfect information.

A key characteristic of oligopoly is mutual interdependence or rivalry which refers to a situation where firms have to consider the reactions of its competitors when making decisions. Due to the condition of a small number of large firms each possessing significant market share, decisions made by one firm is likely to have a large impact on the other firms in the market. Therefore firms tend to react to one another’ decision and cannot make independent business decisions and has to factor in the reactions from its rivals. The degree of rivalry is estimated by the concentration ratio.

Due to an oligopoly’s characteristic of mutual interdependence, its demand curve is kinked. In the event that an oligopolistic firm lowers its price, other firms in the similar market are likely to lower theirs as well for fear of losing a large portion of the sales. 

Above the current market price, the firm’s demand curve is flatter, meaning that it is more price elastic. As a firm increases its price, consumers switch away and buy the similar product from other oligopolistic firms who are less likely to increase prices to stay competitive and increase sales. Therefore, above the market price, demand is more responsive to price increase, and the curve is therefore much flatter.

On the other hand, when the firm reduces its price, the other oligopolistic firms will likely reduce their prices in order to stay competitive, hence the resulting change in output from the price decrease is likely to be less than proportional. Hence the demand curve below the market price is more price inelastic.

Criticisms of the kinked demand curve:

Does not explain how the equilibrium price and output is established in the first place

Does not determined where the next kink will be should the initial equilibrium price and output be disturbed

Model also does not account for how firms react if their demand curves shifted

The kinked demand curve is therefore an incomplete model which only explains one aspect of oligopolistic behaviour.

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Production & Cost

Production is a process of using resources to make goods and services to satisfy human wants.

Costs are incurred when firms buy factors of production. Eg rent, wages, interests and utility bills.

Explicit costs are costs that involve monetary transactions. They include rents, wages, interests, utility bills and expenditure on raw materials

Implicit costs are costs that c=do not involve monetary transactions because they involve inputs that are owned by the firm

Economists usually measure both explicit and implicit costs so that they know the total opportunity cost of production.

Short run refers to the decision timeframe where at least one factor of production is fixed. The firm’s ability to produce is constrained by that fixed factors which are usually assumed to be land or capital.

Short run costs are either fixed or variable costs

Fixed costs are costs incurred even if output is zero [eg rent] because once a contract is negotiated, the firms has to pay for the stipulated time period regardless of the number of output it produces

Variable costs are costs that vary with output. [e.g. raw materials cost] As more goods are produced, more raw materials are needed, and the costs of more inputs rises correspondingly

Marginal costs refers to the increase in total cost arising from the production of one additional unit of output --> (change in total costs)/(change in total output)

Since fixed costs do not vary with output, changes in marginal cost must be due to the changes in variable costs that arises when producing an extra unit of output --> Marginal cost = (change in total variable costs)/(change in total output)

Law of diminishing returns states that as more of a variable factor is added to a fixed factor, the addition to output eventually declines. When diminishing returns sets in, an additional unit of output will cost more to produce as a higher amount of the VC is required

Average variable cost refers to the total variable costs incurred per unit of output --> AVC = (total variable costs)/(total output)

Relationship between the average and marginal

If marginal = average --> average remains unchanged

If marginal > average --> average rises

If marginal < average --> average falls

Average Fixed Costs is the total fixed costs incurred per unit of output --> AFC = (total fixed costs)/(total output)

Curve is downward sloping because total fixed cost is spread over more and more output AKA spreading of overheads 

Average Total Costs is the total cost incurred per unit output --> (total costs)/(total output)

Since the ATC is the sum of AFC and AVC, the shape of the ATC curve is determined by the shapes of the the AFC and AVC curves

Long run refers to the decision timeframe where all inputs can be varied.By definition, all factors of production are variable in the long run.

The short run and long run timeframe varied from industry to industry.

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Monopoly vs Perfectly Competitive Firm

Monopoly is a market where there is only 1 seller of a product with no close substitutes.

Perfect competition refers to a market where there is a large number of small firms, each with an insignificant market share, selling a homogenous product.

In terms of price and output...

Perfectly competitive market charge a lower price but produces more output. On the other hand, a monopoly charges a higher price but produces fewer output than PC firm => society is worse off with monopoly

However, with substantial economies of scale, the monopoly is able to produce equal or more output at an equal to lower price than perfectly competitive firms => society is better off with a monopoly than PC

Natural monopoly arises when the economies of scale is SO large that it is cheaper for ONE firm to supply the market compared to 2 or more firms as the market is only big enough to support one firm. In this case, not only is it better for society, it is also the most feasible market structure though government regulation or nationalisation may be required to further improve society’s welfare

In terms of efficiency, innovation, equity and range of products...

Profit-maximising monopoly will charge P>MC which is higher than the equilibrium price P*, producing Qm which  is < than equilibrium output Q* --> negative welfare generated due to the underproduction of goods. On the other hand, perfectly competitive firms, being price takers, will set price P=MC which coincides with the equilibrium price. Therefore, perfectly competitive firms are more allocatively efficient than monopoly.

For a perfectly competitive firm, staying productively efficient is not just a matter of maximising profits, but more importantly a matter of survival, because with low barriers to entry, these firms constantly face the risk of being driven out of the market by competitive rivals. With that being said, perfectly competitive firms are productively efficient, producing at the Minimum Efficient Scale (MES). On the other hand, with the total absence of competition, a monopoly can afford to be X-inefficient because the pressure to minimise cost is less pressing. The monopoly tends to spend more than what is necessary, turning out to be X-inefficient. Monopolies do not always nor do they have to produce on the MES in order to survive, and even if it does it is usually purely coincidental. Therefore, perfectly competitive firms are more beneficial to society in that they are more productively efficient than monopoly.

In terms of choice of products, a monopoly ‘s product can be differentiated and may even have a few models of the same product if it engages in product proliferation. In contrast, there is no product variety in the case for perfectly competitive firms as products are assumed to be homogenous. 

In terms of innovation, a monopoly is more likely to engage in it. This is because monopoly is able to earn supernormal profits in the long-run and have the extra funds to spend on innovating their products and improving production techniques and technology. On the other hand, perfectly competitive firms can only earn long run normal profits, and since there is assumed to be perfect information and knowledge in a perfectly competitive market, there is no incentive to engage in innovation as it can be easily copied by other firms. 

Conclusion: Which is better for society?

Conditions for a perfectly competitive firm are very strict as the model was developed as a theoretical benchmark where all other markets can be compared against. Conditions like product homogeneity and perfect information/knowledge is impractical, unrealistic and very rare.

Natural monopolies do exist in real life. They are usually the most desirable and feasible market structure in those circumstances.

To only have perfectly competitive firms in society is unrealistic and is not always the best. Monopoly does have its benefits and strength while the perfectly competitive firms have their own weaknesses. In reality, society should have a mix of different types of firms to cater to the diverse needs and wants of society.

[golbscimonoceym]

Economies and diseconomies of scale

Internal economies of scale are reaped from 0 to Q along the falling portion of the firm’s LRAC.

They are cost savings that arise when a firm expands output --> gains in efficiency when a larger scale enables specialisation of factors and processes

Plant economies --> arise due to technical improvements in production processes (technological improvements)

Multistage production

Principle of increased dimensions

Specialisation & division of labour

Factor indivisibility

By-product economies (putting waste to good use)

Firm economies --> improvements in operations lie management, administrative and distribution 

Organisational economies (specialisation in roles -> efficiency gains)

Marketing economies (by increasing range of products)

Financial economies (perceived to be financial more stable and hence obtain funding at lower interest rates)

Spreading of various overheads (R&D, advertisements, rental, cost of legal services all spread over a larger volume of output)

Risk-bering economies --> by diversifying its markets

Internal diseconomies of scale are reaped after output Q along the rising portion of the LRAC.

Organisational diseconomies --> too large, to difficult and cumbersome to manage

Staff problems --> staff turnover, low morale, low labour productivity

Marketing diseconomies --> widened distance from customer base, additional marketing costs incurred to bridge info gaps

External economies of scale refer to costs savings enjoyed by a firm due to the growth of the industry. Movement of the entire LRAC vertically downwards.

Economies of concentration --> supporting services and extensive linkages, shared infrastructure from agglomeration 

Economies of information --> sharing knowledge, mutual cooperation in R&D, less duplication of efforts

Economies of disintegration --> outsourcing benefits supporting firms

External diseconomies of scale refer to additional cots incurred when the industry grows too big. Graphically represented by the vertical upward shift of the entire LRAC curve.

Increased demand for raw materials --> higher prices

Land becomes increasingly scarce --> higher rents

Increased transportation costs --> congestion and increased demand for transport services 

[golbscimonoceym]

Internal & External value of currency

Internal value refers to the purchasing power of a currency --> how much goods and services can be consumed per unit of the currency in the domestic market

External value refers to how much foreign currency can one unit of domestic currency purchase --> i.e exchange rate 

Inflation --> internal value of currency to drop --> exports become more expensive but imports become more relatively cheaper --> increase in quantity of imports and decrease in quantity of exports --> importing more foreign goods causes supply of domestic currency in the forex market to increase --> putting downward pressure on domestic currency --> decrease in the currency’s external value

Increase in external value (appreciation of currency) --> exports become more expensive while imports become cheaper --> quantity exported drops while quantity of imports rise --> fall in net exports and therefore a fall in AD --> AD shifts down ALSO appreciation of domestic currency --> imported inputs an consumption goods to become cheaper --> hence shifting AS curve vertically downwards as well --> general price levels decreases --> fall in the currency’s internal value 

[golbscimonoceym]

Singapore’s Exchange rate policy

Context of Singapore: Singapore is a small country with no natural resource. Thus it is dependent on imports for its exports and basic consumption needs like food and fuel. Singapore also has a small domestic population, so it has to rely on exports and external demand to achieve high economic growth. Given SG’s dependency on trade, SG has chosen to manage her exchange rate. 

In doing so, SG has relinquished control over her interest rates and domestic money supply due to her position as an international financial hub, which requires her to allow free capital mobility. i.e Singapore is unable to use monetary policy in times of need.

Singapore uses a managed float exchange rate in which her exchange rate is allowed to float between two undisclosed bands, which are meant to prevent speculative demand. The S$ is measured against a basket of currencies of the key trading partners and competitors of Singapore and each of them are accorded different weightage depending on the extent of trade dependence Singapore has with that country. The composition of that basket of foreign curries is reviewed and revised timely to reflect and keep up with changes in Singapore evolving trade patterns. The band in which the exchange rate is allowed to float is allowed to widen or narrow according to prevailing market conditions.

Main aim of the managed float is to fight imported inflation, instead of gaining export competitiveness. Singapore is a country which lacks natural resources and relies heavily on imported inputs for domestic consumption as well as export. By allowing her currency to appreciate slightly within the band, imported inputs are arguably cheaper, causing food, fuel and exports to be cheaper. This also helps Singapore’s households and firms to better cope with inflationary pressures.

MAS does not depreciate the S$ to boost export competitiveness because export competitiveness is likely to be eroded by relatively more expensive imported inputs with a depreciated currency.

Mas controls fluctuations in Singapore’s currency so as to maintain exchange rate and macroeconomic stability. Nevertheless, the S$ is still allowed to flow market conditions in the long run while being moderately undervalued so that the resulting BOP surpluses result in the accumulation of foreign currency reserves which are vital for when there is a need to adjust the exchange rate and finance imports in time of crisis. Also, the BOP surplus resulting from the slightly depreciated S$ is necessary to generate money supply growth in order to fuel Singapore’s long-run economic growth.