Economics Notes for IBA Sindh Foundation Program

Prepared by: Salman Ahmed Shaikh

Definition of Economics
Lionel Robbins provided one of the better definitions of mainstream economics. He wrote a
book Nature and significance of Economic science in 1932 in which he defined economics
as:

Economics is a science which studies human behavior as a relationship between
unlimited wants and limited resources which have many uses.

Following points are most important in this definition and explain why economics is said to be
the science of scarcity and choice:
1. Our wants are unlimited in relation to our resources.
2. Our resources are limited in relation to our wants.
3. Wants are unlimited but each want is different in its intensity.
4. Some wants are more intense (necessities) and some are less intense (comforts and
luxuries).
5. Our resources cannot fulfill all of our wants, so we have to make choices.
6. The choices we make are based on the assumption that our resources have alternative
uses.


Concept of Scarcity
Scarcity refers to the tension between our limited resources and our unlimited wants. For an
individual, resources include time, money and skill. For a country, limited resources include
natural resources, capital, labor force and technology.

Because our resources are limited in comparison to our wants, individuals and nations have
to make decisions regarding what goods and services they can buy and which ones they
must forgo.

Scarcity and unlimited wants force governments and individuals to decide how best to
manage resources and allocate them in the most efficient way possible.

Because of scarcity, people and economies must make decisions over how to allocate their
resources. Economics aims to study why we make these decisions and how we allocate our
resources most efficiently.


Branches of Economics: Macro and Microeconomics

Microeconomics
Microeconomics is the study of small segments of an economy. It can be defined as:

Microeconomics is the study of how individuals and businesses make decisions
about producing, exchanging, distributing and consuming particular goods and
services and the interaction of those decisions in the market.

It studies the behavior, choices and actions of individual and particular firms, industries
and households in the marketplace. Thus, we can say that it is the study of individual parts of
the economy.

Macroeconomics
The word Macro means large. It may be defined as:

Macroeconomics is the study of economics as a whole. It studies national income,
total employment, aggregate income, total production and average prices.

It studies economy in a broad way. It takes into account the totality and aggregates of
different performance variables like inflation (average price level), total employment, national
income and GDP (Gross Domestic Product).




Concept of Opportunity Cost
Opportunity cost of any action is the cost of best alternative forgone.

The opportunity cost of going to college is the money you would have earned if you worked
instead. Undergraduate students lose four years of salary while getting their degrees. They do
so because they expect to earn more during their professional career after their education
ends.

If a gardener decides to grow wheat, his opportunity cost is the alternative crop that might
have been grown instead (e.g. corn).

Put in another way, opportunity cost refers to the benefits we could have received by taking
an alternative action.


Supply & Demand
Supply and demand are one of the most fundamental concepts of economics. Demand refers
to how much (quantity) of a product or service is desired by buyers. The quantity demanded is
the amount of a product people are willing to buy at a certain price; the relationship between
price and quantity demanded is known as the demand relationship.

Supply represents how much the market can offer. The quantity supplied refers to the amount
of a certain good producers are willing to supply when receiving a certain price. The
relationship between price and how much of a good or service is supplied to the market is
known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good,
the less people will demand that good. In other words, the higher the price, the lower the
quantity demanded. The amount of a good that buyers purchase at a higher price is less
because as the price of a good goes up, so does the cost of buying that good. As a
result, people will naturally avoid buying a product that will force them to forgo the
consumption of something else they value more. The chart below shows that the curve has a
downward slope.


A, B and C are points on the demand curve. Each point on the curve reflects a direct
correlation between quantity demanded (Q) and price (P). So, at point A, the quantity
demanded will be Q1 and the price will be P1, and so on. The demand relationship curve
illustrates the negative relationship between price and quantity demanded. The higher the
price of a good, the lower the quantity demanded (A), and the lower the price, the more the
good will be in demand (C).

The Law of Supply
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward slope.
This means that the higher the price, the higher the quantity supplied. Producers supply more
at a higher price because selling a higher quantity at a higher price increases revenue.





A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and
the price will be P2, and so on.

Equilibrium
When supply and demand are equal (i.e. when the supply curve and the demand curve
intersect), then the economy is said to be at equilibrium. At this point, the allocation of goods
is at its most efficient level because the amount of goods being supplied is exactly the same
as the amount of goods being demanded.

At the equilibrium price, suppliers are selling all the goods that they have produced and
consumers are getting all the goods that they are demanding.



As you can see on the chart, equilibrium occurs at the intersection of the demand and supply
curve, which indicates no allocative inefficiency (there is no surplus or shortage). At this point,
the price of the goods will be P* and the quantity will be Q*. These figures are referred to as
equilibrium price and quantity.

Disequilibrium
Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be
allocative inefficiency.




At price P1, the quantity of goods that the producers wish to supply is indicated by Q2. At P1,
however, the quantity that the consumers want to consume is at Q1, a quantity much less
than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being
consumed. The suppliers are trying to produce more goods, which they hope to sell to
increase profits, but those consuming the goods will find the product less attractive
and purchase less because the price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is
so low, too many consumers want the good while producers are not making enough of it.




In this situation, at price P1, the quantity of goods demanded by consumers at this price is
Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1.
Thus, there are too few goods being produced to satisfy the wants (demand) of the
consumers. However, as consumers have to compete with each other to buy the good at this
price, the demand will push the price up, making suppliers want to supply more and bringing
the price closer to its equilibrium.


Shift in demand Versus Movement along Demand & Supply Curve
In Economics, the movements and shifts in relation to the supply and demand curves
represent very different market phenomena:

1. Movements along Demand Curve
A movement refers to a change along a curve. On the demand curve, a movement denotes a
change in both price and quantity demanded from one point to another on
the curve. The movement implies that the demand relationship remains consistent. Therefore,
a movement along the demand curve will occur when the price of the good changes and the
quantity demanded changes in accordance with the original demand relationship. In other
words, a movement occurs when a change in the quantity demanded is caused only by a
change in price.





Like a movement along the demand curve, a movement along the supply curve means that
the supply relationship remains consistent. Therefore, a movement along the supply
curve will occur when the price of the good changes and the quantity supplied changes in
accordance with the original supply relationship. In other words, a movement
occurs when a change in quantity supplied is caused only by a change in price, and vice
versa.



2. Shift in Demand
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied
changes even though price remains the same. For instance, if the price for a 250 ml bottle
of Pepsi was Rs 15 and price for a 250 ml bottle of Coca Cola (substitute of Pepsi) increased
to Rs 20 from Rs 15, then quantity of Pepsi demanded would increase from Q1 to Q2. There
would be a shift in the demand for Pepsi if there is change in other factors than price (like
income of the consumer, price of substitute etc). Shifts in the demand curve imply that the
original demand relationship has changed, meaning that quantity demand is affected by a
factor other than price.




When the non-price factors or determinants of demand change, there is a change in the
demand curve or a shift in the demand curve. These factors are as follows:

Population
If the population of a country increases due to an increase in immigrants or an increase in
birth rate, the market demand of various kinds of goods will increase.

Changes in Tastes
Demand for a commodity may change due to change in tastes. For example, if people shift
from motorbikes to cars for travel due to change in tastes, the demand for cars will increase
and demand for motorbikes will decrease.

Changes in Income
When the disposable income increases, the purchasing power of people also increases and
they demand more goods at the same price or even at a higher price. Conversely, decrease
in income results in decrease in the purchasing power and hence demand also decreases.

Price of Related Goods
In case of substitutes (the goods that can be used in place of other goods like tea and coffee),
if the price of the coffee decreases, the demand of coffee will increase and demand of tea will
decrease. In case of compliments (the goods that are used in combination with other goods
like cars and fuel), if the price of fuel increases, the demand of cars will decrease.

3. Shift in Supply
If the price for a 250 ml bottle of Pepsi was Rs 15 and if the price of sugar (raw material used
for soft drink) increases, then the quantity supplied would decrease from Q1 to Q2. There
would be a shift in the supply of Pepsi. Like a shift in the demand curve, a shift in the supply
curve implies that the original supply curve has changed, meaning that the quantity
supplied is caused by a factor other than price. A shift in the supply curve would occur if, for
instance, crop failure caused the sugar price to increase (which is a raw material for a soft
drink) and hence it will increase the cost of the soft drink produced. If price remains constant,
the supplier will be willing to supply less of the soft drink due to decreased profit margins with
increase in cost of production.




Equilibrium Algebra

Finding equilibrium price and quantity from inverse demand and supply function.

P = 10 0.2Qd
P = 2 + 0.2Qs
From inverse demand function, we have:
0.2Qd = 10 P
Qd = 50 5P
From inverse supply function, we have:
-0.2Qs = 2 P
Qs = 10 + 5P
Equate Qd=Qs for equilibrium


50 - 5P = -10 + 5P
10P = 60
P = 6
From demand function, we have:
Q = 50 5P
Q = 50 5(6)
Q = 20

If you want to use reduced form formula, following is the derivation for it.

Algebra of Equilibrium
Linear Functions
Q
D
= a - bP
Q
S
= c + d P
a - bP* = c+dP*
(a-c) = (b+d) P*
*
a c b d a c
Q c d c d
b d b d b d
b a
c d
b d b d








Elasticity
The degree to which a quantity demanded reacts to a change in price is the price elasticity of
demand. Elasticity varies among products because some products may be more essential to
the consumer. Products that are necessities are more insensitive (less responsive) to price
changes because consumers would continue buying these products despite price increases.

Conversely, a price increase of a good or service that is considered less of a necessity will
have responsive change in quantity demanded because the consumers could switch to cheap
alternatives (substitutes).

A good or service is considered to be highly elastic if a slight change in price leads to a sharp
change in the quantity demanded. Usually these kinds of products are readily available in the
market and a person may not necessarily need them in his or her daily life.

On the other hand, an inelastic good or service is one in which changes in price bring about
slight changes in the quantity demanded. These goods tend to be things that are more of a
necessity to the consumer in his or her daily life. E.g. food items, clothing, shelter etc.

To determine the Price elasticity of the demand, we can use this simple equation:

Elasticity = (% change in quantity demanded / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less
than one, the curve is said to be inelastic.

The demand curve has a negative slope, and if there is a large decrease in the quantity
demanded with a small increase in price, the demand curve looks flatter, or more horizontal.
This flatter curve means that the good or service in question is elastic.




Meanwhile, inelastic demand is represented with a much more upright (vertical like) curve as
quantity changes little with a large movement in price.



Degrees of Price Elasticity of Demand
We observe that for some commodities, the quantity demanded changes sharply with even a
slight change in price. But, for some other commodities, a larger change in price does not
bring much change in quantity demanded. There are different degrees of price elasticity of
demand for different products.

Perfectly Elastic Demand
When a small change in price results in quantity demanded dropping down to zero, the
elasticity is said to be perfectly elastic.

Elasiticity of Demand
0
2
4
6
8
10
0 3 6 9
Quantity Demanded
P
r
i
c
e


Perfectly Inelastic Demand
When a change in price doesnt affect quantity demanded at all and leaves it unchanged, the
elasticity is said to be perfectly inelastic. The demand for too expensive or too economical
goods is nearly perfectly inelastic.



Elasiticity of Demand
0
5
10
15
20
0 3 6 9 12
Quantity Demanded
P
r
i
c
e


Unitary Elastic Demand:
When the quantity demanded changes by exactly the same percentage as price, the demand
is said to be unitary elastic. For example, if a 10% decrease in price results in a 10% increase
in quantity demanded, the elasticity of demand is unit elastic.

Elasiticity of Demand
2.5, 2.5
0
1
2
3
4
5
0 1 2 3 4 5
Quantity Demanded
P
r
i
c
e


Elastic Demand
When the quantity demanded increases by a higher percentage than price, the demand is
said to be elastic. In other words, if a 1% change in price brings a more than 1% change in
quantity demanded, the demand is said to be elastic. The elasticity of luxurious goods is
usually elastic. The demand for products having close substitutes is also elastic.

Elasiticity of Demand
0
1
2
3
4
5
0 1 2 3 4 5 6 7 8 9 10
Quantity Demanded
P
r
i
c
e


Inelastic Demand
When the quantity demanded increases by a lower percentage than price, the demand is said
to be inelastic. In other words, if a 1% change in price brings a less than 1% change in
quantity demanded, the demand is said to be inelastic. The elasticity of necessities is usually
inelastic because we need necessities the most. The demand for products having no or fewer
substitutes is also inelastic.


Elasiticity of Demand
0
2
4
6
8
10
0 1 2 3 4 5 6 7 8 9 10
Quantity Demanded
P
r
i
c
e


Two Methods of Measuring Elasticity of Demand

There are two most commonly used methods to measure price elasticity of demand. They are
explained below:

Point Elasticity Method

It may be defined as:

The measurement of elasticity at a point on the demand curve is called point
elasticity.

The point elasticity method is used when we want to measure a small change in quantity
demanded to a very small change in price. The formula for calculating point elasticity of
demand is:

=
100
1
1 2
100
1
1 2
x
P
P P
x
Q
Q Q

=
100
100
x
P
P
x
Q
Q

=
P
P
x
Q
Q

=
Q
P
x
P
Q

Arc Elasticity of Demand

It may be defined as:

The measurement of elasticity between any two points on the demand curve.

It gives elasticity measurement between any two points lying on the demand curve
irrespective of the distance between them. Therefore, we can measure a large change in
quantity demanded and price through this method. The formula for calculating Arc elasticity of
demand is:



=
100
2
2 1
1 2
100
2
2 1
1 2
x
P P
P P
x
Q Q
Q Q

P
P
Q
Q




Factors Affecting Demand Elasticity

There are three main factors that influence price elasticity of demand:

1. The availability of substitutes - In general, the more the substitutes, the more elastic the
demand will be. For example, if the price of a cup of coffee went up by Rs 5, consumers could
replace their morning coffee with a cup of tea. This means that coffee is an elastic good
because a raise in price will cause a large decrease in demand as consumers start buying
more tea instead of coffee.

But, if the price of a bread or public transport rises, then for a lower income class person, the
change in quantity demanded will not be that much. It is because necessities have inelastic
demand.

2. Amount of income available to spend on the good - If the price of a lemon sandwich biscuit
goes up from Rs 5 to Rs 6 and if the income of the consumer is sufficiently high, then the
consumer will not usually reduce his or her demand of lemon sandwich biscuits. But, for other
expensive goods, the demand could be elastic. For example, car lease payments, airline
travel etc.

3. Time - The third influential factor is time. If the price of cigarettes goes up Rs 5 per pack, a
smoker with very few available substitutes will most likely continue buying his or her daily
pack of cigarettes. This means that tobacco demand is inelastic because the change in price
will not have a significant influence on the quantity demanded. However, if that smoker finds
that he or she cannot afford to spend the expensive cigarettes every day and begins to
change the habit over a period of time, the price elasticity of cigarettes for that consumer may
become elastic in the long run.


Income Elasticity of Demand

The degree to which an increase in income will cause an increase or decrease in demand is
called income elasticity of demand, which can be expressed in the following equation:

Income Elasticity = (% change in quantity demanded/ % change in income)

If Income elasticity is greater than one, demand for the item is considered to have
high income elasticity. If income elasticity is less than one, demand is considered to be
income inelastic. Luxury items usually have higher income elasticity because when people
have a higher income, they become able to afford them and hence their demand for those
items increase.

With some goods and services, we may actually notice a decrease in demand as income
increases. These are considered goods and services of inferior quality that will be dropped by
a consumer who receives a salary increase. An example may be the increase in the demand


of branded clothing as opposed to low quality clothing. Products for which the demand
decreases as income increases have an income elasticity of less than zero.


Cross Price Elasticity of Demand

The demand for many goods is affected by the prices of other goods. It is a common
observation that various goods have close substitutes like coffee is a substitute of tea and
mutton is a substitute of beef. If a price of one substitute changes, the demand for the other
substitute is also affected. The cross elasticity of demand measures this effect. It may be
defined as:

Responsiveness of quantity demanded of one good (B) to a change in price of
another good (A)

Mathematically, it can be expressed as:

E
AB
= (% change in quantity demanded of good B/ % change in price of good A)


Elasticities

MCQs

Q#1: A perfectly inelastic demand exists if a 10 percent change in the price of good results in
a percentage change in quantity demanded that is:
a) Equal to 0.
b) Equal to 10.
c) Equal to infinity.

Q#2: A relatively elastic demand exists if a 10 percent change in the price of good results in a
percentage change in quantity demanded that is:
a) Less than 10.
b) Equal to 10.
c) Greater than 10

Q#3: A perfectly inelastic supply curve:
a) Has a relatively flat, positive slope.
b) Has a relatively steep, positive slope.
c) Is vertical.

Q#4: The elasticity of a demand curve with a constant slope:
a) Is greater than the slope.
b) Is less than the slope.
c) Increases at higher prices.

Q#5: If the price of chocolate-covered peanuts decreases 10 percent and the quantity
demanded increases 5 percent, then the numerical elasticity of demand is:
a) 0.5.
b) 1.0.
c) 2.0.

Q#6: Suppose your local public golf course increases the fees for using the golf course. If the
demand for golf is relatively inelastic, you would expect:
a) A decrease in total revenue received by the course.
b) An increase in total revenue received by the course.
c) No change in total revenue received by the course.

Q#7: There are several close substitutes for Bayer aspirin but fewer substitutes for a
complete medical examination. Therefore, you would expect the demand for:
a) Medical exams to be more elastic.
b) Medical exams to be more inelastic.
c) Bayer aspirin to be more inelastic.



Q#8: The income elasticity of demand of an inferior good is:
a) Less than 0.
b) Greater than 0.
c) Between 0 and 1.

Q#9: The cross elasticity of demand of complements goods is:
a) Less than 0.
b) Greater than 0.
c) Greater than 1.

Q#10: The burden of a tax is shifted toward buyers if:
a) Demand is perfectly elastic.
b) Demand is relatively more elastic than supply.
c) Demand is a relatively more inelastic than supply.


Worked Problems
Question 1:

Demand for a paperback Economics text is given by Q=200,000 - 300P.
The book is initially priced at Rs 300.

a. Compute the point price elasticity of demand at P= Rs 300.
b. If the objective is to increase total revenue, should the price be increased or decreased?
Explain.
c. Compute the arc price elasticity for a price decrease from Rs 300 to Rs 200.
d. Compute the arc price elasticity for a price decrease from Rs 200 to Rs 150.

Answer:

a)
At P = 300, Q = 200,000 300 (300) = 110,000
Elasticity = (Slope of Demand Function) x P/Q
Elasticity = -300 x 300/110,000 = -0.81

b)
Since demand is inelastic, price increase will increase total revenue. Hence, price must be
increased.

c)
Elasticity = (Slope of Demand Function) x (Average P/Average Q)
At P = 200, Q = 200,000 300 (200) = 140,000
Elasticity = -300 x 250/125,000 = -0.6

d)
Elasticity = (Slope of Demand Function) x (Average P/Average Q)
At P = 150, Q = 200,000 300 (150) = 155,000
Elasticity = -300 x 175/132,500 = -0.39

Question 2:

Suppose a firm sells 20,000 units when the price is $16, but sells 30,000 units when the price
falls to $14.

a. Calculate the percentage change in the quantity sold over this price range using the
midpoint formula.
b. Calculate the percentage change in the price using the midpoint formula.
c. Find the price elasticity of demand over this range of prices. State whether demand is
elastic or inelastic over this range.

Suppose Firm's elasticity of demand is constant over a large range of prices. If the price were
to fall another 4%, what should Firm predict will happen to its sales?

Answer:



a. The midpoint formula uses the average of the two quantities as the reference point for
computing the percentage change. In this example, the percentage change is (30,000
20,000)/25,000 = 0.40, or 40%.

b. The percentage change is (16 14)/15 = 0.133, or 13.3%.

c. The price elasticity of demand is the ratio of the percentage change in quantity to the
percentage change in price. In this example, E
d
= 40/13.3 = 3. Since Ed is bigger
than one, demand is elastic.

d. Since E
d
= 3, which equals the ratio of the percentage change in quantity to the
percentage change in price, this can be rearranged to determine that the percentage
change in quantity is equal to the elasticity of demand times the percentage change
in price. In this example, sales will increase by 12%. 12% = 3 x 4%.

Question 3:

Suppose a firm sells 70 units when the price is $6, but sells 80 units when the price falls to
$4.

a. Calculate Firm's revenue at each of the prices.
b. Use the total-revenue test to determine whether demand is elastic or inelastic over
this range.

Verify your previous answer by calculating the elasticity of demand using the midpoint
formula.

Answer:

a. Revenue equals price times quantity sold. At P = $6, revenue equals $420. $420 = $6
x 70. At P = $4, revenue = $4 x 80 = $320.

b. Revenue falls when the price falls, suggesting demand is inelastic over this range.

E
d
= [(80 70)/75] / [(6 4)/5] = .133/.40 = .33, or 1/3. This is less than one, verifying that
demand is inelastic.


Law of Diminishing Marginal Utility

Law of diminishing marginal utility explains a basic fact of life that whenever we consume
something in sequence without break, we get less satisfaction from it with each successive
unit consumed. The law may be stated as:

The additional utility derived from consuming more quantities of a commodity
diminishes with each additional unit of consumption.

Explanation
This law can be explained with a schedule and a graph. We take example of consumption of
mangoes. The total utility and marginal utility derived from each unit of consumption is listed
in the following schedule. The table shows that with each additional unit of mango consumed,
the marginal utility or additional utility decreases.

Units of Mangoes Total Utility Marginal Utility
0 0 0
1 7 7
2 11 4
3 13 2
4 14 1
5 14 0
6 13 -1

The total utility and marginal utility curves are graphically expressed as:



Law of Diminishing Marginal Utility
-2
0
2
4
6
8
10
12
14
16
0 5 10
Quantity of Mangoes
U
t
i
l
i
t
y
Total Utility
Marginal Utility


Note that the total utility is maximum when marginal utility is zero.


Difference between Short Run and Long Run

Short Run Long Run
It is the time period in which at least the
quantities of one input are fixed while the
quantities of other inputs can be varied.
It is the time period in which the quantities of
all the inputs (fixed or variable) can be
increased.


Law of Diminishing Marginal Returns
It may be stated as:

Increasing the quantities of one input while keeping all other inputs constant, the total
output increases at a decreasing rate with each unit of input added.

Explanation
When fixed resources are used to their capacity, adding variable inputs while fixed resources
are kept constant, the productivity of each additional input or its marginal product decreases.
Therefore, increasing the variable factor gives more output at a decreasing rate. This law can
be explained by a schedule and a graph.

Fixed Factor (Land) Labor Total Product Marginal Product
5 1 20 20
5 2 45 25
5 3 65 20
5 4 80 15
5 5 90 10

Law of Diminishing Returns
0
3
6
9
12
15
18
21
24
27
30
0 1 2 3 4 5 6
Labor
M
a
r
g
i
n
a
l

P
r
o
d
u
c
t





Returns to Scale

Suppose the inputs are capital or labor in a production process, and we double each of these
(m = 2). We want to know if our output will more than double, less than double, or exactly
double. This leads to the following definitions:

Increasing Returns to Scale
When the inputs are increased by m and the output increases by more than m.

Constant Returns to Scale
When the inputs are increased by m and the output increases by exactly m.

Decreasing Returns to Scale
When the inputs are increased by m and the output increases by less than m.


Factors of Production

In a market based economy, we can classify factors of production as follows:
1. Land with natural resources.
2. Labor.
3. Capital.
4. Entrepreneur.

Below, we try to present details of our proposed classification.

Land with natural resources It includes all things of value which are naturally occurring
goods such as soil, minerals, land etc and that are used in the creation of different products.
The payment for the use of those resources in fixed supply is rent. When these are sold, their
compensation is profit.

Labor Providing physical or mental exertion by way of contract for consideration in the form
of wage or salary. It does not include entrepreneurial labor as the compensation for
entrepreneurial labor is the residual outcome of the productive activity and contains an
element of risk and uncertainty.

Capital Stock - It includes human-made goods or produced means of production. These are
goods which are used in the production of other goods. These include machinery, tools and
buildings. The payment for the use of those resources in fixed supply is interest as capital
also includes financial capital.

Entrepreneur It refers to an economic entity, natural person or corporation (juristic person),
which undertakes the ultimate responsibility for the production process. It undertakes the
responsibility to bear losses (if any) and is entitled to the entire residual positive economic
outcome after interest on capital and rent on land and wages have been paid.


Fixed Costs and Variable Costs

Fixed Cost
Fixed cost is the cost that is independent of the output level. It remains same at each level of
Output. Changes in output level do not affect fixed cost. It is represented as a horizontal curve
on the graph. Fixed cost curve is shown below:


Fixed Cost and Total Cost
0
5
10
15
20
25
30
35
40
0 2 4 6
Output
C
o
s
t
Fixed Cost
Total Cost


Average Fixed Cost
It is total fixed cost per unit of output. It always decreases with the increase in the level of
output. With the increase in output, the fixed cost is distributed over many units. That is why;
average fixed cost curve always decreases.

Variable Cost
It is the cost of all the variable inputs. It increases as the output increases. At zero level of
output, there is no variable cost.
Variable Cost
0
10
20
30
40
50
60
0 2 4 6
Output
V
a
r
i
a
b
l
e

C
o
s
t
Variable Cost


Average Variable Cost
It is total variable cost per unit of output. It decreases initially and then it starts to increase
with the increase in output. It serves as a minimum compensation for Firm when it is incurring
losses. Firm will shut down operations if it is not able to cover its average variable cost.


Types of Variable Cost Functions

Let us say KESC gives us this electricity price slab as follows:

1 200 Units Rs 18/unit
200 500 Units Rs 20/unit
500 1,000 Units Rs 30/unit

Based on this data, if Firm uses these levels of electricity, then variable cost will be increasing
at an increasing rate.

100 units Total bill = 18 x 100 = 1,800
500 units Total bill = 20 x 500 = 10,000
1000 units Total bill = 30 x 1,000 = 30,000





Let us say PTCL gives us this internet price slab as follows:

1MB 3 MB Rs 1,000
4MB 7 MB Rs 1,500
7MB 10 MB Rs 1,700

Based on this data, if Firm uses these levels of electricity, then variable cost will be increasing
at a decreasing rate.

1MB Total bill = 1,000
4MB Total bill = 1,500
7 MB Total bill = 1,700



Suppose a supplier supplies plastic to the dollar company for its pens at a rate of Rs 2 per
unit. In this case, total variable cost will be an upward sloping curve, but a straight line with a
constant slope.


Production & Cost Analysis

Fill the other two columns, Average Cost & Marginal Cost

Labor Input Total Cost Average Cost Marginal Cost
0 100
1 120 =120/1 = 120 =(120-100)/(1-0) = 20
2 170 =170/2 = 85 =(170-120)/(2-1) = 50
3 250 =250/3 = 83.33 =(250-170)/(3-2) = 80
4 350 =350/4 = 87.5 =(350-250)/(4-3) = 100
5 500 =500/5 = 100 =(500-350)/(5-4) = 150

Fill the two other columns, Average Product and Marginal Product.

Labor Input Total Product Average Product Marginal Product
0 0
1 12 =12/1 = 12 =(12-0)/(1-0) = 12


2 28 =28/2 = 14 =(28-12)/(2-1) = 16
3 36 =36/3 = 12 =(36-28)/(3-2) = 8
4 42 =42/4 = 10.5 =(42-36)/(4-3) = 6
5 46 =46/5 = 9.2 =(46-42)/(5-4) = 4

Fill the other two columns, Average Variable Cost & Average Fixed Cost

Quantity Total Cost AVC AFC
0 400
1 480
2 800
3 1,200
4 1,800
5 2,600

TC = TFC + TVC
At Zero quantity, TVC=0
TC = TFC when TVC=0
AVC = TVC/Q
AFC = TFC/Q
ATC = TC/Q
ATC = AVC + AFC

Quantity Total Cost TFC TVC AVC AFC
0 400 400 0
1 480 400 =480 - 400 TVC/Q TFC/Q
2 800 400 =800 - 400 TVC/Q TFC/Q
3 1,200 400 =1,200 - 400 TVC/Q TFC/Q
4 1,800 400 =1,800 - 400 TVC/Q TFC/Q
5 2,600 400 =2,600 - 400 TVC/Q TFC/Q


Economies of Large Scale Production

The benefits obtained through large scale production are called economies of large scale
production. There are several advantages of large scale production. Broadly speaking, we
divide these benefits as internal economies and external economies of large scale production.

1. Internal Economies
The economies of large scale production benefiting an organizations internal structure are
referred to as internal economies of large scale production. Some of the internal economies
that firms enjoy through large scale production are as follows:

a) Technical Economies
Advancement in technology is the most important tool to reduce cost of production and
increase productivity. But, new and improved technology is introduced after heavy investment
in research and development. A large scale producer can afford research and development
spending and achieve increase in productivity which reduces cost of production.

b) Administrative Economies
In a large scale firm, each major task is performed by a specialized department. Therefore, a
businessperson has to worry only about the policy matters because he can pass on the work
to his supervisors who are specialized in managing a particular task better.

c) Commercial Economies
A firm needs raw materials to produce output. A large scale firm needs more inputs to
produce more outputs. It has to purchase raw materials in large quantities to produce more
output. A large scale firm can obtain raw materials at a cheaper price if it buys them in large
quantity. Therefore, the cost of production decreases.






d) Financial Economies
To operate any business activity, a firm needs finance. A large scale firm has a generally
greater reputation than a small scale firm. Because of its reputation, a large scale firm can
obtain finance from banks and also purchase raw materials on credit.

e) Risk Bearing Economies
No business is without a risk. To operate any business, one needs to take risk. But, taking
risks also depends on risk bearing capability of a firm. A large scale producer or a firm has a
greater risk bearing capacity than a small scale firm. It can take greater risks and run
successfully through a financial crisis because of adequate capital.

2. External Economies
The economies of large scale production benefiting an organizations external environment
are referred to as external economies of large scale production. Some of the external
economies that firms enjoy through large scale production are as follows:

a) Reduced cost of production
Since a large scale firm can spend a huge amount on research and development, it has a
better chance of achieving advancements in technology and reducing cost of production
through increased productivity. Therefore, a large scale firm can reduce the price to increase
the demand of its products and still earn a higher profit on its products.

b) Establishment of supporting industries
A large scale firm can become its own supplier. It can produce equipments and raw materials
itself which it used to purchase from other firms. It can reduce the cost of production because
a firm producing its own supplies will not have to pay profit to other firms.

c) Establishment of subsidiary industries
A large scale producer can use wasted output to produce some useful by-products. This way,
it will earn more profit and will be able to use its resources optimally.

d) Availability of trained manpower
A large scale firm can hire more trained workers for each department because it can pay the
higher salaries for getting specialized workers. But, the benefit obtained from specialization
and division of labor is much more than the extra cost of hiring trained manpower.

e) Better prospects of market leadership
Since a large scale producer can reduce its cost of production, it can transfer this benefit to its
customers by charging them a lower price. This way, it will be able to maintain better
customer relationships and gaining the market share.


Diseconomies of Scale

The diseconomies are the disadvantages arising to a firm or a group of firms due to large
scale production.

Internal Diseconomies of Scale
If a firm continues to grow beyond the optimum capacity, the economies of scale disappear
and diseconomies will start operating. For instance, if the size of a firm increases, after a
point, managing Firm becomes difficult which will increase the average cost of production of
that firm. This is known as internal diseconomies of scale.

External Diseconomies of Scale
If the size of Firm increases beyond a limit, it will create diseconomies in production which will
be common for all firms in a locality. For instance, the growth of an industry in a particular
area leads to high rents and high costs of utilities. These are the external diseconomies as
this affects all Firms in the industry located in that particular region.


Economic & Business Profit

Q1. After working as a head chef for years, Jared gave up his $60,000 salary to open his own
restaurant last year. He withdrew $50,000 of his own savings that had been earning 4%


interest and borrowed another $100,000 from the bank at a rate of 5%. As the restaurant
space he was leasing had no separate office, Jared converted his basement apartment into
office space. He had previously rented the apartment to a student for $300/month. The
following table summarizes his operations for the past year.

Total sales revenue $590,000

Employee wages $120,000
Materials $350,000
Interest on loan $5,000
Utilities $10,000
Rent $25,000

Total explicit costs $510,000

a. What is Jared's accounting profit?
b. Suppose Jared could have used his talents to run a similar kind of business instead.
If he values his entrepreneurial skill at $10,000 annually, find Jareds total implicit
costs

What was Jared's economic profit last year?

Solution

a. Jared's accounting profit is the difference between total sales revenue and his explicit
costs, or $80,000 in this example. $80,000 = $590,000 $510,000.
b. Implicit costs include his foregone wages ($60,000), the value of his entrepreneurial
skill ($10,000), foregone rent on the apartment ($3,600 = 12 x $300) plus the
foregone interest on his savings ($2,000 = .04 x $50,000). These total $75,600.
Jared's total economic cost, explicit plus implicit, was $585,600 = $510,000 + $75,600. His
economic profit is the difference between revenue and economic cost, or $4,400 (= $590,000
$585,600).

Q2. An IBA graduate turns down a job offer of 720,000 a year & starts his own business.

He will invest Rs. 1,200,000 of his own money which has been in a bank account earning 6%
interest per year.

He also plans to use a building he owns in Karachi that has been rented for Rs. 20,000 per
month.

Revenue in the new business during the 1st year was Rs. 3,000,000 while other expenses
were:

Advertising Rs. 75,000
Taxes Rs. 60,000
Employees Salaries Rs. 500,000
Supplies Rs. 50,000

Required: Calculate Accounting Profit and Economic Profit
Solution:

Total Revenue = Rs 3,000,000
Total Explicit Costs = Advertising Cost + Taxes + Salaries + Supplies
Total Explicit Costs = Rs 685,000

Business Profit = Total Revenue - Total Explicit Costs
Business Profit = 3,000,000 685,000 = 2,315,000

Total Implicit (Opportunity) Costs = Job Income + Rent Income + Interest Income
Total Implicit (Opportunity) Costs = 720,000 + (20,000x12) + (0.06 x 1,200,000)
Total Implicit (Opportunity) Costs = 720,000 + 240,000 + 72,000
Total Implicit (Opportunity) Costs = 1,032,000



Economic Profit = Total revenue Total Explicit Costs total Implicit Costs
Economic Profit = 3,000,000 685,000 1,032,000 = 1,283,000


Basic Characteristics of Market Structures

Perfect Competition
There are large number of buyers and sellers.
Buyers and sellers are price takers.
Products are homogenous or identical with no differentiation.
There are no barriers to entry and exit.
Buyers and sellers are perfectly informed of the market conditions.

Monopoly
There is only one seller.
A single seller is a price setter.
A single seller has a complete control over price.
There are no close substitutes available.
There are no competitors in the market.

Oligopoly
There are few producers.
Products may be identical or differentiated.
Producers have some control over price.
Firms advertise their products to create demand for them.

Monopolistic Competition
There are a large number of sellers.
Products are differentiated (either real or perceived differences).
None of the sellers has a large share of the market.
Sellers have some control over price.
Firms advertise their products to create demand for them.


Equilibrium in Short Run under Perfect Competition

A firm under perfect competition faces a horizontal demand curve. It means that demand of its
products is perfectly elastic. If it increases the price of its product by even a smaller quantity,
the demand for its products will immediately drop down to zero. Since the products are
homogenous and every firm is a price taker, the price remains constant and is equal to
marginal revenue at each level of quantity sold.

P = Average Revenue = Marginal revenue

The competitive firm will be in equilibrium at a point where its marginal cost is equal to
marginal revenue. Firms equilibrium at different points determine whether Firm is incurring
losses or earning profits and whether it should continue operations or shut down. Following
cases determine Firms performance.

Cases of Equilibrium
If the marginal revenue intersects marginal cost at a point above average cost, the
competitive firm will enjoy supernormal profits.

If the marginal revenue intersects marginal cost where it also equals average cost, the
competitive firm will enjoy normal or zero economic profits (including sellers
compensation for efforts).

If the marginal revenue intersects marginal cost at a point below average total cost but
above average variable cost, the competitive firm is incurring losses but it will not shut
down because it is able to cover the variable cost and a part of fixed cost. By shutting
down at a point above average variable cost, it will incur a greater loss than from
continuing operations.



If the marginal revenue intersects marginal cost at a point below average variable cost,
Firm will minimize losses by shutting down.




Equilibrium in Long Run under Perfect Competition

A perfectly competitive firm in the long run is in equilibrium at a point where marginal revenue
intersects marginal cost at a point where it also equals minimum average total cost. Therefore
at this point,

P = Marginal Revenue = Marginal Cost = Minimum Average Cost

If there are short run profits or losses in different industries operating under perfect
competition, then short run profits will attract entry and short run losses will induce exit. Entry
and exit will be constantly happening across industries until there is zero economic profit in all
industries. Unless that happens, entry or exit can benefit firms. With no barriers to entry and
exit, any short run profits and losses will be wiped out in long run in competitive markets.

It also implies that in the long run, Firm can only survive if it can cover its minimum average
total cost (AVC as well as AFC). Therefore, zero economic profit point is the long run
equilibrium point of a perfectly competitive firm.



In the long run, perfect competition has both productive efficiency and allocative efficiency.
Productive efficiency implies producing the profit maximizing level of output most cheaply.
Allocative efficiency implies producing the kind of goods in such quantities for which the price
the consumers are willing to pay equals the marginal cost of production. If people are willing
to pay a price for a good for which P=MC, then, it will be produced by the competitive firms.








Mathematical Proofs Related to Market Structures

Proof of P=MC
TP = TR - TC
TP = PQ - TC
dTP/dQ =d/dQ(P.Q) d/dQ(TC)=0

Taking first derivative with respect to Q is same as calculating slope of a function.
Slope of TR is MR and slope of TC is MC.
dTR/dQ reads as change in TR with respect to change in Q, which is MR.
dTC/dQ reads as change in TC with respect to change in Q, which is MC.

dTP/dQ= P - MC=0
Since P=MR in perfect competition
P = MC
Numerical Proof of MR<P

0 1 2 3 4 5 6
$142
132
122
112
102
92
82
D
A monopolist is
selling 3 units at
$142
To sell 4, price must
be lowered to $132
All customers
must pay the same
price
TR increases $132
minus $30 (3x$10)
$102 becomes a
point on the MR
curve
Try other prices to
determine other
MR points
Gain = $132
Loss = $30
The Constructed Marginal Revenue Curve
Must Always Be Less Than the Price
MR
Price and Marginal Revenue
Marginal revenue is less than price
10-8


Mathematical Proof of MR<P
P = a bQ
TR = PQ
TR = (a - bQ)Q
TR = aQ bQ
2
MR = a 2bQ
We have, P = a bQ
MR = a 2bQ
So, MR<P Since intercept is same and bQ > - 2bQ

Proof of Ep/Unit = P ATC
EP = TR TC
EP = PQ TC Divide by Q
EP/Q = P ATC


Profit Maximization under Monopoly
In Monopoly,

There is only one seller.
A single seller is a price setter.
A single seller has a complete control over price.
There are no close substitutes available.
There are no competitors in the market.



A monopolist can restrict output and produce much lower output even if Average Total Cost
(ATC) is declining further. By restricting output due to non-availability of substitutes, the
Monopolist can set its own price and has the most control over prices than any other
competition.

Green Rectangle is the economic profit region. Equilibrium takes place where MR=MC. Qm is
the equilibrium level of output and Pm is the equilibrium level of price.




Profit Maximization under Monopolistic Competition

In Monopolistic Competition,

There are a large number of sellers.
Products are differentiated (either real or perceived differences).
Sellers have some control over price.
Firms advertise their products to create demand for them.

In monopolistic competition, there are limited barriers to entry. So, when a differentiated
product is offered exclusively by one innovating firm, it may get short run profits, but, imitation
and adaptation will decrease the capability to earn short run profits and with more firms
offering the good for sale, demand for Firm that has economic profit in the short run will go
down and profits are beaten down to zero in the long run.

A monopolistically competitive firm confronts a downward-sloping demand curve for its output.
Modest changes in the output or price of any single firm will have no perceptible influence on
the sales of any other firm. The relative independence of monopolist competitors means that
they do not have to worry about retaliatory responses to every price or output change.
Another characteristic of monopolistic competition is the presence of low barriers to entry.

In the figure below, purple rectangle is the economic profit region. Equilibrium takes place
where MR=MC. Qa is the equilibrium level of output and Pa is the equilibrium level of price.





With low barriers to entry, new firms will enter the market if there is economic profit. Economic
profit is the difference between total revenues and total economic costs (including explicit
costs and implicit costs).

When firms enter a monopolistically competitive industry, the market supply curve shifts to the
right. The demand curves facing individual firms shift to the left. In the long run, there are no
economic profits in monopolistic competition as shown in figure below.




Price Discrimination

Price discrimination exists when sales of identical goods or services are transacted at
different prices. Price discrimination can only be a feature of monopolistic and oligopolistic
markets, where market power can be exercised. In perfect competition, price discrimination is
not possible because perfectly competitive firm does not have a price setting ability.

Price discrimination can be used by educational institutions, charging higher prices from rich
students and lower prices from poor students. They offer programs like self-finance schemes,
so that if rich students want, they can get admission in universities. The higher fees taken
from these students are used to pay scholarships to the needy students. Price discrimination
can be used by medical institutions, charging higher prices from rich patients and lower prices
from poor patients. Other examples include airline fares, restaurant food packages, telecom
companies call and SMS packages.

There are three forms of price discrimination.
Charge each customer max willingness to pay
Charge one price for first unit and a lower price for subsequent units
Charge different customers different prices





Game Theory

In Game Theory analysis, we try to find out the optimal choice for a player (Oligopolist) given
the choices by other player (competitor or rival). Such interdependent decision making is the
hallmark of Oligopoly markets. We follow these steps in solving the problem.

Player is an oligopolist in game theory. Payoff is an outcome of a certain action by a player.
Payoff matrix is a table showing all possible actions that can be taken by each player with
their payoffs. Dominant Strategy is the optimal strategy for player regardless of what the other
player does.

1) Find dominant strategy for each player separately. If each player has a dominant
strategy in the game, each would select the dominant strategy and game will have
dominant strategy equilibrium.

2) If only one player has a dominant strategy, then the player with dominant strategy will
play the dominant strategy. That is rule of the game. If dominant strategy exists for
player A, then player A would select the dominant strategy. The other player, player B
will select the optimal choice that exists for him, given the choice taken by player A.

Example 1: Payoff Matrix for an Advertising Game (in 000s PKR)
Firm B
Advertise Dont Advertise
Firm A Advertise (4,3) (5,1)
Dont Advertise (2,5) (3,2)

To solve this game, we first have to check whether each or one of the player has a dominant
strategy. By advertising, Firm A would earn an increase in profit of Rs 4,000 when Firm B also
advertises and Rs 5,000 when Firm B does not advertise. By not advertising, Firm A would
only earn an increase in profit of Rs 2,000 when Firm B advertises and Rs 3,000 when Firm B
also does not advertise. So, regardless of what Firm B does, Firm A earns higher profits by
advertising. So, Firm A has dominant strategy, which is to advertise.

Next, we check whether Firm B also has a dominant strategy. By advertising, Firm B would
earn an increase in profit of Rs 3,000 when Firm A also advertises and Rs 5,000 when Firm A
does not advertise. By not advertising, Firm B would only earn an increase in profit of Rs
1,000 when Firm A advertises and Rs 2,000 when Firm A does not advertise. So, regardless
of what Firm A does, Firm B earns higher profits by advertising. So, Firm B has dominant
strategy, which is to advertise.

Both Firms will play their dominant strategies, hence, there will be equilibrium at (4,3) when
both advertise.

Example 2: Payoff Matrix for an Advertising Game (in 000s PKR)
Firm B
Advertise Dont Advertise
Firm A Advertise (4,3) (5,1)
Don Advertise (2,5) (6,2)

To solve this game, we first have to check whether each or one of the player has a dominant
strategy. By advertising, Firm A would earn an increase in profit of Rs 4,000 when Firm B also
advertises and Rs 5,000 when Firm B does not advertise. By not advertising, Firm A would
earn an increase in profit of Rs 2,000 when Firm B also advertises and Rs 6,000 when Firm B
also does not advertise. Firm A does not have a dominant strategy.

Next, we check whether Firm B has a dominant strategy. By advertising, Firm B would earn
an increase in profit of Rs 3,000 when Firm A also advertises and Rs 5,000 when Firm A does
not advertise. By not advertising, Firm B would only earn an increase in profit of Rs 1,000
when Firm A advertises and Rs 2,000 when Firm A does not advertise. So, regardless of what


Firm A does, Firm B earns higher profits by advertising. So, Firm B has dominant strategy,
which is to advertise.

Rule of the game is to follow the dominant strategy, if it exists. Firm A knows that Firm B has
a dominant strategy, which is to advertise. If Firm B will play its dominant strategy, Firm A will
earn increase in profits of Rs 2,000 by not advertising and Rs 4,000 while advertising. Hence,
Firm A will also advertise. There will be equilibrium at (4,3) when both advertise. This
equilibrium is Nash Equilibrium. Nash Equilibrium occurs where each player chooses optimal
strategy, given the choice by other player. Each dominant strategy equilibrium is a Nash
Equilibrium, but not every Nash Equilibrium is dominant strategy equilibrium.

Example 3: Payoff Matrix for Prisoners Dilemma (in Years)
Individual B
Confess Dont Confess
Individual A Confess (5,5) (0,10)
Don Confess (10,0) (1,1)

Essence of this kind of problem is that both players do not cooperate or cannot cooperate.
Since they cannot cooperate, they choose their dominant strategies which make them worse
off than if they had cooperated. Its application is widespread. Two firms in a duopoly (a type
of oligopoly) could enter into price wars to beat the competition and reduce their prices to
such a level that eventually they charge the price which would have prevailed in a perfect
competition.

Even though, there are two firms, but the competition could still from the point of view of price,
give the same result as that of a perfect competition. That is very beneficial for society. That is
why, Competition Commission of Pakistan is an authority which ensures that there is no
hidden cooperation among oligopolists. In Pakistan, Cement sector has seen tacit
collusion/cooperation. Sugar mills have also behaved in similar way.

To solve this game, we first have to check whether each or one of the player has a dominant
strategy. By confessing, Individual A would get a sentence of 5 years when the Individual B
also confesses and goes free when the Individual B does not confess. By not confessing,
Individual A would get a sentence of 10 years when the Individual B confesses and 1 year
when the Individual B also does not confess. So, regardless of what Individual B does,
Individual A has a dominant strategy to confess.

Next, we check whether Individual B has a dominant strategy. By confessing, Individual B
would get a sentence of 5 years when the Individual A also confesses and goes free when the
Individual A does not confess. By not confessing, Individual B would get a sentence of 10
years when the Individual A confesses and 1 year when the Individual A also does not
confess. So, regardless of what Individual A does, Individual B has a dominant strategy to
confess.

Both individuals will play their dominant strategies, hence, both will confess and get a
sentence of (5,5) years. This is not the best outcome for them. If they have both not
confessed, they will have got only the sentence for 1 year. But, What if the other does line of
thinking forces them to choose an action which is worst for them, but good for society.
Detectives convict criminals through this. Competition Commission of Pakistan by disallowing
collusion enables competition in the market and which results in price wars and this result in
firms charging lower prices at such a level that they would be equal to prices charged if there
was perfect competition. Consumers benefit through this, else if oligopolists cooperate easily,
they can earn monopoly like profits.

Example 4: Price Competition & Prisoners Dilemma (in 000s Rs.)
Firm B
Low Price High Price
Firm A Low Price (2,2) (5,1)
High Price (1,5) (3,3)

To solve this game, we first have to check whether each or one of the player has a dominant
strategy. By lowering price, Firm A would get an increase in profit of Rs 2,000 when Firm B
also charges low price and Rs 5,000 when Firm B charges high price. By keeping high price,
Firm A would get an additional profit of Rs 1,000 when Firm B charges low price and Rs 3,000


when Firm B also charges high price. So, regardless of what Firm B does, Firm A has a
dominant strategy to charge low price.

Next, we check whether Firm B has a dominant strategy. By lowering price, Firm B would get
a increase in profit of Rs 2,000 when Firm A also charges low price and Rs 5,000 when Firm
A charges high price. By keeping high price, Firm B would get an additional profit of Rs 1,000
when Firm A charges low price and Rs 3,000 when Firm A also charges high price. So,
regardless of what Firm A does, Firm B has a dominant strategy to charge low price.

Both individuals will play their dominant strategies, hence, both will charge lower price and
earn additional profit of Rs 2,000 each. This is not the best outcome for them. If they have
both charged high price, they will have got additional profits of Rs 3,000 each. But, What if
the other does line of thinking forces them to choose an action which is worst for them, but
good for society. Consumers benefit through this, else if oligopolists cooperate easily, they
can earn monopoly like profits.

Example 5: Pricing Game with a Threat
Firm B
Low Price High Price
Firm A Low Price (2,2) (2,1)
High Price (3,4) (5,3)

From the above example, it should be clear that equilibrium will occur at (3,4). Firm A has a
dominant strategy to charge high price. Firm B has a dominant strategy to charge lower price.
Given the low price charged by Firm B, Firm A will charge higher price to earn more profits.

Example 6: Entry Deterrence (Uncredible Deterrent)
Firm B
Enter Do Not Enter
Firm A Low Price (4,-2) (6,0)
High Price (7,2) (10,0)

This is an example of barriers to entry. From the above example, it should be clear that
equilibrium will occur at (7,2) and Firm B will enter the market. Firm A will not be able to stop
Firm B from coming into the market.

Firm A has a dominant strategy to charge high price. Firm B does not have a dominant
strategy. But, given the high price charged by Firm A, Firm B will enter the market since by
entering; it earns positive profits if Firm A is going to play its dominant strategy, which is to
charge a high price.

Example 7: Entry Deterrence (Credible Deterrent)
Firm B
Enter Do Not Enter
Firm A Low Price (4,-2) (6,0)
High Price (3,2) (8,0)

This is an example of barriers to entry. Equilibrium will occur at (6,0) and Firm B will not enter
the market. Firm A will be able to stop Firm B from coming into the market.

Firm A does not have a dominant strategy. Firm B does not have a dominant strategy either.
No firm has a dominant strategy. But, the objective of Firm A is to stop Firm B from entering
the market.

By charging high price, Firm A will not be able to stop Firm B from entering the market and if
Firm B enters, the profit of Firm A will also shrink. By charging low price, Firm A will be able to
stop Firm B from entering the market and if Firm B does not enter, the profit of Firm A will also
increase. Equilibrium will occur at (6,0).

Application: In industries, where initial infrastructure cost is very high, new entrants will not
be able to survive by charging low prices. Pakistan produces steel, but does not produce cars
from scratch. It is because cars produced by Japan are less costly. Hence, Japanese car


makers are able to charge lower prices and still be profitable, but, for Pakistani firms, it is not
possible to compete at low prices.

Example 8: International Competitiveness (First Mover Advantage)
Firm B
Enter Not Enter
Firm A Enter (-10,-10) N
Not Enter (0,100) (0,0)

Sometimes, in industries, where initial infrastructure cost is very high and market is so small,
the costs could only be kept low at higher level of output. If market is small and if both firms
enter into a small market, then each will have to incur high fixed costs initially. As a result,
they both could be in loss. It is because with both firms in the market, the costs are borne by
them separately, but their market share will be distributed from the same pie. Customer won
by one firm is customer lost by the other firm.

If both firms do not enter market, they earn nothing and lose nothing. If both simultaneously
enter, both lose. In such cases, one firm could look for first mover advantage. Firm which
enters first, earns all the profits. But, since firms do not know about others and since they
have to incur fixed costs which will be not be a reversible action, they tend to hesitate. In such
cases, they seek subsidies from the government and the confirmation that if they enter the
market, government will not allow the other firms to enter.

Application: Many multinationals come to Pakistan with this pact with government that
government will not allow others to come and compete.

Q1. Pricing Game
Firm B
Low Price High Price
Firm A Low Price (10,10) (80,5)
High Price (5,80) (50,50)

Required Identify dominant strategies for both players (if any). Find Nash Equilibrium &
Cartel Equilibrium. Does this game have prisoners dilemma.

Solution
A has a dominant strategy in charging low price. B has a dominant strategy in charging low
price as well. Dominant strategy equilibrium as well as Nash equilibrium is {(A,B)=(LP,LP)}.
Equilibrium outcome is {(A,B)=(10,10)}. Cartel equilibrium is {(A,B)=(50,50)}. This game has
prisoners dilemma. Cartel solution is more welfare enhancing to both players.

Q2. Entry Deterrence

Potential Entrant
Enter Not Enter
Large Oligopolist High Price (50,20) (150,0)
Low Price (70,-10) (130,0)

Required Find the outcome of game. Briefly explain your reasoning. Does this game have
credible deterrence?

Solution
Both players do not have any dominant strategy. Hence, their actions cannot be pre-
determined. If the large oligopolist wants to deter entry, then, he needs to create a credible
threat of charging low price. By installing more capacity and announcing discount packages, it
can create a credible threat in the mind of the potential entrant. If potential entrant believes in
that threat, then it will not enter and the game will end with large oligopolist charging low price
and potential entrant not entering the industry.







Market Concentration

Oil Exploration Daily Sales (in Rs.) Automobile Sector Daily Sales (in Rs.)
OGDC 25,000,000

PSMC 15,000,000
POL 12,000,000

IMC 60,000,000
PPL 3,500,000

Deewan Motors 5,000,000
Mari 5,500,000

Atlas 40,000,000
PARCO 8,000,000

Hino 50,000,000
Total 54,000,000

Total 170,000,000

Required

a) Calculate Four Firm Concentration Ratio for Oil exploration & Automobile sector.
b) Calculate Herfindahl Index for Oil exploration & Automobile sector.
c) Based on answer in part a) which industry is more competitive.
d) Based on answer in part b) which industry is more competitive.

Solution

Industry Oil Exploration
Oligopolist Daily Sales Four Firm Contration Ratio Market Share % (Si) (Si
2
)
OGDC 25,000,000 46.3000 2144
POL 12,000,000 Market Share of 4 largest firms 50,500,000 22.2200 494
PPL 3,500,000 Total Market Share 54,000,000 6.4800 42
Mari 5,500,000 10.1900 104
PARCO 8,000,000 Ratio= 41,000,000/44,000,000 0.94 14.8100 219
Total 54,000,000
HI S
1
2
+S2
2
+S3
2
+S4
2
+S
5
2
HI 3003
Industry Automobiles
Oligopolist Daily Sales Four Firm Contration Ratio Market Share % (Si) (Si
2
)
PSMC 15,000,000 8.8200 78
IMC 60,000,000 Market Share of 4 largest firms 165,000,000 35.2900 1245
Deewan 5,000,000 Total Market Share 170,000,000 2.9400 9
Atlas 40,000,000 23.5300 554
Hino 50,000,000 Ratio= 41,000,000/44,000,000 0.97 29.4100 865
Total 170,000,000
HI S
1
2
+S
2
2
+S
3
2
+S
4
2
+S
5
2
HI 2750
Which industry is more competitive as per HI Ans. Automobiles.
Which industry is more competitive as per 4-Firm Ratio Ans. Oil Exploration