Microeconomics

Microeconomics (literally, very small economics) is the study of the economic behaviour of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labour and capital and as the ultimate consumers of the final product. It analyzes firms both as suppliers of products and as consumers of labour and capital.

Microeconomics seeks to analyze the market form or other types of mechanisms that establish relative prices amongst goods and services and/or allocates society's resources amongst their many alternative uses.

Fundamental concepts in microeconomics

Scarcity - Opportunity cost - Supply and demand - Elasticity - Consumer and producer surplus - Aggregation of individual demand to total, or market, demand

Consumer theory

Consumer Theory - Preference - Indifference curve - Utility - Marginal utility - Income

Production and pricing theory

Production, costs, and pricing - Production theory basics - X-efficiency - Factors of production - Production possibility frontier - Production function - Economies of scale - Economies of scope - Profit maximization - Price discrimination - Transfer pricing - Joint product pricing - Price points

Industrial organization

Market form - Perfect competition - Monopoly - Monopolistic competition - Oligopoly - Concentration ratio - Herfindahl index

Welfare economics

Welfare economics - Pareto efficiency - Kaldor-Hicks efficiency - Edgeworth box - Social welfare function - Income inequality metrics - Lorenz curve - Gini coefficient - Poverty level - Dead weight loss

Market failure

Market failure - Collective action - Information asymmetry - Externality - Social cost - Free goods - Taxes - Tragedy of the commons - Tragedy of the anticommons - Coase's Penguin

Financial economics

Efficient markets theory - Financial economics - Finance - Risk

International trade

International trade - Terms of trade - Tariff - List of international trade topics

Methodology

General equilibrium - Game theory - Institutional economics - Neoclassical economics - Austrian economics.

Applications and Complications

Note that opportunity cost is not the sum of the available alternatives, but rather of benefit of the best alternative of them. The opportunity cost of the city's decision to build the hospital on its vacant land is the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate.

It is important, as individuals and as societies, to compare the opportunity costs associated with various courses of action. However, some opportunities may be difficult to compare along all relevant dimensions.

Economists often try to use the Market price of each alternative to measure opportunity cost. This method, however, presents a considerable difficulty, since many alternatives do not have a market price. It is very difficult to agree on a way to place a Dollar value on a wide variety of intangible assets. How does one calculate the cost in dollars, pounds, euros, or Yen for the loss of clean air, or the loss of seaside views, or the loss of pedestrian access to a shopping center, or the loss of an untouched virgin forest? Since their costs are difficult to quantify, intangible values associated with opportunity cost can easily be overlooked or ignored.

To overcome this difficulty, economists have identified certain opportunity costs as spillover costs (or external costs). If a chemical producer dumps its waste products into a river, the company has effectively shifted part of the cost of its production onto those living downstream who like to fish. If a billboard company blocks the seaside view of passers-by, some of its gain in advertising revenue is being paid by the passers-by who enjoy natural vistas, instead of by the company's advertisers.

Typically, spillover costs are imposed by a narrower group (often called a special interest group) which benefits more quantifiably and more concretely, and they are borne by a wider group -- perhaps even the public at large -- which pays less quantifiably and less concretely. For this reason, spillover costs are most often controlled by Politics and Government regulation rather than by markets. Regulations against Pollution and building codes restricting billboard locations are examples.

Special interest groups, with a particular political or financial gain in mind, usually find incentives to underestimate or ignore the opportunity costs associated with their activities or agendas (especially when the opportunity costs are spillover costs, that can be imposed upon others), but at times such groups find incentives to overestimate them.

Another difficulty in fixing opportunity cost exists on the macroeconomic level, and is empirical in nature. Discovering the real effect of a change in production of butter specific to the production of guns in an economy as large and multifarious as, say, that of the United States, would be nightmarishly complex.

For that reason, opportunity cost is usually figured within some specific Budget of resources. For example, "If the State spends $200 million more on highways it will have $200 million less to spend on schools." Or, "If our company invests $10 million in R+D, it can't give a $1 million Christmas bonus to each of its top ten executives." Or, "If I buy fifty Lottery tickets, I won't have these two twenties and one ten left in my wallet for groceries."

Although opportunity cost can be hard to quantify, its effect is universal and very real on the individual level. The principle behind the economic concept of opportunity cost applies to all decisions, not just economic ones. The word "decide" comes from the Latin decidere, meaning "to cut off"; being the prefix de plus the root caedere, "to cut". By definition, any decision that is made cuts off other decisions that could have been made. If one makes a right turn at an intersection, she or he precludes the possibility of having made a left turn. And so forth.

Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value.

An Eternal Truth?

So, should this economy's resources be used in practice to produce 50,000,000 units of butter, there will be an opportunity cost in terms of guns. Instead of the 100,000 guns the economy could have produced, it may now only be able to produce 50,000. Conversely, should this economy's resources be used in practice to produce 75,000 guns, there will be an opportunity cost in terms of butter. Instead of the 100,000,000 units of butter the economy could have produced, it may now only be able to produce 25,000,000.

This choice can also change. But any move upward or to the right along the PPF involves an opportunity cost. (Scarcity means that cannot go above or the right of the PPF.) Any increase in gun production (a move upward) would reduce the amount of butter that can be produced, while increase in civilian production (moving to the right) would reduce the economy's ability to produce military products. On the PPF, scarcity and opportunity cost prevail.

Others argue that while it is true for most individuals that most or even all choices incur some sort of opportunity cost (i.e., that something is being given up), the concept of opportunity cost does not always apply when viewed from the societal level. Suppose that the economy starts with large amounts of unused Capital equipment and unemployed labor, as in the United States (and many other countries) in 1939. In that case, the "guns and butter" economy is inside its PPF (and not due to the production of other outputs). In this situation, it is possible to raise the employment of both capital goods and labor, raising the production of both military goods and civilian goods. In fact, the U.S. did exactly this at the onset of World War II.

This is an example of "Keynesian inefficiency" being solved by increasing Aggregate demand. More generally, if inputs are either underemployed or inappropriately employed, the production of both guns and butter can be increased by abolishing Inefficiency. In the graph, the economy moves from the "inefficient points" inside the PPF to the PPF itself.

Unfortunately, we may not always be able to get this "free lunch" because special interests often oppose such policies. They may impose institutional opportunity costs that represent more than natural or technological scarcity. Thus, we may see a price that represents political, economic, or social power rather than opportunity cost.

The position of the PPF is not static. It shifts outward (upward and/or to the right) when an economy's ability to produce increases, i.e., an increase in the aggregate number of guns and butter that can be produced. This can happen if the availability of resources (factors of production) increases, or if technology or management skills improve. Few if any of these changes are "free": for example, increasing the amount of capital goods requires sacrifice of current consumption. Thus, there is a clear opportunity cost. Some shifts may be inexpensive, however, as with some technological change.

The PPF shifts inward when an economy's ability to produce decreases, reflecting a decrease in the aggregate number of military and civilian goods that can be produced. This is possible due to some major disaster, such as hurricanes or military invasion. The PPF of the Roman Empire probably shifted inward due to the "barbarian" invasions and the end of regular law and order.

In microeconomic Theory, the partial equilibrium supply and demand economic model originally developed by Alfred Marshall attempts to describe, explain, and predict changes in the Price and quantity of goods sold in competitive markets. The model is only a first approximation for describing an imperfectly competitive market. It formalizes the theories used by some economists before Marshall and is one of the most fundamental models of some modern economic schools, widely used as a basic building block in a wide range of more detailed economic models and theories. The theory of supply and demand is important for some economic schools' understanding of a Market economy in that it is an explanation of the mechanism by which many Resource allocation decisions are made. However, unlike General equilibrium models, supply schedules in this partial equilibrium model are fixed by unexplained forces.

Assumptions and definitions

Mainstream economics does not assume A priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard. In such cases, economists may attempt to find policies that will avoid waste; directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing" markets to enable efficient trading where none had previously existed. This is studied in the field of Collective action.

Demand

The shape of the aggregated demand curve can be Convex or concave, possibly depending on income distribution, as shown in this paper: /essays/consumers.htm

Supply

Simple supply and demand curves

The slope of the demand curve (downward to the right) indicates that a greater quantity will be demanded when the price is lower. On the other hand, the slope of the supply curve (upward to the right) tells us that as the price goes up, producers are willing to produce more goods. The point where these curves intersect is the equilibrium point. At a price of P producers will be willing to supply Q units per period of time and buyers will demand the same quantity. P in this example, is the equilibrating price that equates supply with demand.

In the figures, straight lines are drawn instead of the more general curves. This is typical in analysis looking at the simplified relationships between supply and demand because the shape of the curve does not change the general relationships and lessons of the supply and demand theory. The shape of the curves far away from the equilibrium point are less likely to be important because they do not affect the market clearing price and will not affect it unless large shifts in the supply or demand occur. So straight lines for supply and demand with the proper slope will convey most of the information the model can offer. In any case, the exact shape of the curve is not easy to determine for a given market. The general shape of the curve, especially its slope near the equilibrium point, does however have an impact on how a market will adjust to changes in demand or supply. (See the below section on elasticity.)

It should be noted that on supply and demand curves both are drawn as a function of price. Neither is represented as a function of the other. Rather the two functions interact in a manner that is representative of market outcomes. The curves also imply a somewhat neutral means of measuring price. In practice any currency or commodity used to measure price is also the subject of supply and demand.

Effects of being away from the equilibrium point

Now assume that individual firms have the ability to alter the quantities supplied and the price they are willing to accept, and consumers have the ability to alter the quantities that they demand and the amount they are willing to pay. Businesses and consumers will respond by adjusting their price (and quantity) levels and this will eventually restore the quantity and the price to the equilibrium. In the case of too high a price and oversupply (seen in the diagram at the left), the profit-maximizing businesses will soon have too much excess inventory, so they will lower prices (from P1 to P) to reduce this. Quantity supplied will be reduced from Qs to Q and the oversupply will be eliminated. In the case of too low a price and undersupply, consumers will likely compete to obtain the good at the low price, but since more consumers would like to buy the good at the price that is too low, the profit-maximizing firm would raise the price to the highest they can, which is the equilibrium point. In each case, the actions of independent market participants cause the quantity and price to move towards the equilibrium point.

Demand curve shifts

Conversely, if the demand decreases, the opposite happens. If the demand starts at D1 and then decreases to D0, the price will decrease and the quantity supplied will decrease-a contraction in supply. Notice that this is purely an effect of demand changing. The quantity supplied at each price is the same as before the demand shift (at both Q0 and Q1). The reason that the equilibrium quantity and price are different is the demand is different.

Supply curve shifts

See also: Induced demand

Market 'clearance'

Elasticity

An important concept in understanding supply and demand theory is elasticity. In this context, it refers to how supply and demand change in response to various stimuli. One way of defining elasticity is the percentage change in one variable divided by the percentage change in another variable (known as arch elasticity because it calculates the elasticity over a range of values, in contrast with point elasticity that uses differential calculus to determine the elasticity at a specific point). Thus it is a measure of relative changes.

Often, it is useful to know how the quantity supplied or demanded will change when the price changes. This is known as the Price elasticity of demand and the Price elasticity of supply. If a monopolist decides to increase the price of their product, how will this affect their sales revenue? Will the increased unit price offset the likely decrease in sales volume? If a government imposes a Tax on a good, thereby increasing the effective price, how will this affect the quantity demanded?

If you do not wish to calculate elasticity, a simpler technique is to look at the slope of the curve. Unfortunately, this has units of measurement of quantity over monetary unit (for example, liters per Euro, or battleships per million Yen), which is not a convenient measure to use for most purposes. So, for example, if you wanted to compare the effect of a price change of Gasoline in Europe versus the United States, there is a complicated conversion between gallons per Dollar and liters per euro. This is one of the reasons why economists often use relative changes in percentages, or elasticity. Another reason is that elasticity is more than just the slope of the function: It is the slope of a function in a coordinate space, that is, a line with a constant slope will have different elasticity at various points.

Let's do an example calculation. We have said that one way of calculating elasticity is the percentage change in quantity over the percentage change in price. So, if the price moves from $1.00 to $1.05, and the quantity supplied goes from 100 pens to 102 pens, the slope is 2/0.05 or 40 pens per dollar. Since the elasticity depends on the percentages, the quantity of pens increased by 2%, and the price increased by 5%, so the elasticity is 2/5 or 0.4.

Since the changes are in percentages, changing the unit of measurement or the currency will not affect the elasticity. If the quantity demanded or supplied changes a lot when the price changes a little, it is said to be elastic. If the quantity changes little when the prices changes a lot, it is said to be inelastic. An example of perfectly inelastic supply, or zero elasticity, is represented as a vertical supply curve. (See that section below)

Elasticity in relation to variables other than price can also be considered. One of the most common to consider is Income. How would the demand for a good change if income increased or decreased? This is known as the Income elasticity of demand. For example, how much would the demand for a luxury car increase if average income increased by 10%? If it is positive, this increase in demand would be represented on a graph by a positive shift in the demand curve, because at all price levels, a greater quantity of luxury cars would be demanded.

Another elasticity that is sometimes considered is the Cross elasticity of demand, which measures the responsiveness of the quantity demanded of a good to a change in the price of another good. This is often considered when looking at the relative changes in demand when studying complement and substitute goods. Complement goods are goods that are typically utilized together, where if one is consumed, usually the other is also. Substitute goods are those where one can be substituted for the other, and if the price of one good rises, one may purchase less of it and instead purchase its substitute.

Cross elasticity of demand is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For an example with a complement good, if, in response to a 10% increase in the price of fuel, the quantity of new cars demanded decreased by 20%, the cross elasticity of demand would be −20%/10% or, −2.

Vertical supply curve

In the short run near vertical supply curves are even more common. For example, if the Super Bowl is next week, increasing the number of seats in the stadium is almost impossible. The supply of tickets for the game can be considered vertical in this case. If the organizers of this event underestimated demand, then it may very well be the case that the price that they set is below the equilibrium price. In this case there will likely be people who paid the lower price who only value the ticket at that price, and people who could not get tickets, even though they would be willing to pay more. If some of the people who value the tickets less sell them to people who are willing to pay more (i.e., scalp the tickets), then the effective price will rise to the equilibrium price.

The graph below illustrates a vertical supply curve. When the demand 1 is in effect, the price will be p1. When demand 2 is occurring, the price will be p2. Notice that at both values the quantity is Q. Since the supply is fixed, any shifts in demand will only affect price.

Other market forms

Where there are both few buyers or few sellers, the theory of supply and demand cannot be applied because both decisions of the buyers and sellers are interdependent-changes in supply can affect demand and vice versa. Game theory can be used to analyze this kind of situation. (See also Oligopoly.)

The supply curve does not have to be linear. However, if the supply is from a profit-maximizing firm, it can be proven that supply curves are not downward sloping (i.e., if the price increases, the quantity supplied will not decrease). Supply curves from profit-maximizing firms can be vertical, horizontal or upward sloping. While it is possible for industry supply curves to be downward sloping, supply curves for individual firms are never downward sloping.

Standard microeconomic assumptions cannot be used to prove that the demand curve is downward sloping. However, despite years of searching, no generally agreed upon example of a good that has an upward-sloping demand curve has been found (also known as a giffen good). Non-economists sometimes think that certain goods would have such a curve. For example, some people will buy a luxury car because it is expensive. In this case the good demanded is actually prestige, and not a car, so when the price of the luxury car decreases, it is actually changing the amount of prestige so the demand is not decreasing since it is a different good (see Veblen good). Even with downward-sloping demand curves, it is possible that an increase in income may lead to a decrease in demand for a particular good, probably due to the existence of more attractive alternatives which become affordable: a good with this property is known as an Inferior good.

An example: Supply and demand in a 6-person economy

• Alice is willing to pay $10 for a sack of potatoes.
• Bob is willing to pay $20 for a sack of potatoes.
• Cathy is willing to pay $30 for a sack of potatoes.
• Dan is willing to sell a sack of potatoes for $5.
• Emily is willing to sell a sack of potatoes for $15.
• Fred is willing to sell a sack of potatoes for $25.

There are many possible trades that would be mutually agreeable to both people, but not all of them will happen. For example, Cathy and Fred would be interested in trading with each other for any price between $25 and $30. If the price is above $30, Cathy is not interested, since the price is too high. If the price is below $25, Fred is not interested, since the price is too low. However, at the market Cathy will discover that there are other sellers willing to sell at well below $25, so she will not trade with Fred at all. In an efficient market, each seller will get as high a price as possible, and each buyer will get as low a price as possible.

Imagine that Cathy and Fred are bartering over the price. Fred offers $25 for a sack of potatoes. Before Cathy can agree, Emily offers a sack of potatoes for $24. Fred is not willing to sell at $24, so he drops out. At this point, Dan offers to sell for $12. Emily won't sell for that amount so it looks like the deal might go through. At this point Bob steps in and offers $14. Now we have two people willing to pay $14 for a sack of potatoes (Cathy and Bob), but only one person (Dan) willing to sell for $14. Cathy notices this and doesn't want to lose a good deal, so she offers Dan $16 for his potatoes. Now Emily also offers to sell for $16, so there are two buyers and two sellers at that price (note that they could have settled on any price between $15 and $20), and the bartering can stop. But what about Fred and Alice? Well, Fred and Alice are not willing to trade with each other, since Alice is only willing to pay $10 and Fred will not sell for any amount under $25. Alice can't outbid Cathy or Bob to purchase from Dan, so Alice will not be able to get a trade with them. Fred can't underbid Dan or Emily, so he will not be able to get a trade with Cathy. In other words, a stable equilibrium has been reached. A supply and demand graph could also be drawn from this. The demand would be:

• 1 person is willing to pay $30 (Cathy).
• 2 people are willing to pay $20 (Cathy and Bob).
• 3 people are willing to pay $10 (Cathy, Bob, and Alice).

The supply would be:

• 1 person is willing to sell for $5 (Dan).
• 2 people are willing to sell for $15 (Dan and Emily).
• 3 people are willing to sell for $25 (Dan, Emily, and Fred).

Supply and demand match when the quantity traded is two sacks and the price is between $15 and $20. Whether Dan sells to Cathy, and Emily to Bob, or the other way round, and what precisely is the price agreed cannot be determined. This is the only limitation of this simple model. When considering the full assumptions of perfect competition the price would be fully determined, since there would be enough participants to determine the price. For example, if the "last trade" was between someone willing to sell at $15.50 and someone willing to pay $15.51, then the price could be determined to the penny. As more participants enter, the more likely there will be a close bracketing of the equilibrium price.

It is important to note that this example violates the assumption of perfect competition in that there are a limited number of market participants. However, this simplification shows how the equilibrium price and quantity can be determined in an easily understood situation. The results are similar when unlimited market participants and the other assumptions of perfect competition are considered.

Decision making

However, this framework, once called "Homo economicus", has for decades been the focus of unease even by those who apply it. Milton Friedman once defended the idea by saying that inaccurate assumptions could produce accurate results. Alfred Marshall was careful to differentiate the tendency to maximize happiness with maximizing economic well-being. The limits of rationality have been the subject of intense study, for example, Herbert Simon's model for "Bounded rationality", which was awarded a Nobel Prize in 1978. More recently, irrational behavior and imperfect information have increasingly been the subject of formal modeling, often referred to as behavioral economics, for which Daniel Kahneman won a Nobel Prize in 2002. An example is the growing field of Behavioral finance, which combines previous theory with Cognitive psychology.

The new model of information and decision making focuses on asymmetrical information, when some participants have key facts that others do not, and on decision making based not on the economic pressures but on the decisions of other economic actors. Asymmetrical information and behavioral dynamics lead to different conclusions: in a world of asymmetrical information, markets are generally not efficient, and inefficiencies grow up as means of hedging against information. While not yet universally accepted, it is increasingly influential in policy, for example, the writing of Joseph Stiglitz and financial modeling.

History of supply and demand

During the late 19th century the marginalist school of thought emerged. This field mainly was started by Stanley Jevons, Carl Menger, and Léon Walras. The key idea was that the price was set by the most expensive price, that is, the price at the margin. This was a substantial change from Adam Smith's thoughts on determining the supply price.

Finally, most of the basics of the modern school theory of supply and demand were finalized by Alfred Marshall and Léon Walras, when they combined the ideas about supply and the ideas about demand and began looking at the equilibrium point where the two curves crossed. They also began looking at the effect of markets on each other. Since the late 19th century, the theory of supply and demand has mainly been unchanged. Most of the work has been in examining the exceptions to the model (like oligarchy, transaction costs, non-rationality).

Criticism of Marshall's theory of supply and demand

Keynesian economics also runs counter to the theory of supply and demand. In Keynesian theory, prices can become "sticky" or resistant to change, especially in the case of price decreases. This leads to a market failure. Modern supporters of Keynes, such as Paul Krugman, have noted this in recent history, such as when the Boston housing market dried up in the early 1990s, with neither buyers nor sellers willing to exchange at the price equilibrium.

Gregory Mankiw's work on the irrationality of actors in the markets also undermines Marshall's simplistic view of the forces involved in supply and demand.

Special Cases of a Supply Curve

In Economics, elasticity is the ratio of the incremental percentage change in one variable with respect to an incremental percentage change in another variable. Elasticity is usually expressed as a positive number (i.e., an Absolute value) when the sign is already clear from context.

Generalised cases

Figure 1: Illustrations of Perfect Elasticity and Perfect Inelasticity.

[image] [image]
Generalised cases of elasticity are frequently used in discussions that characterise circumstances for which detailed information is not available and/or irrelevant to the discussion. There are five such cases of elasticity.

• E = 0 Perfectly inelastic. This special case of elasticity is represented in the figure to the right above. Any change in P will have no effect on Q.
• E < 1 Inelastic. The proportional change in Q is less than the proportional change in P.
• E = 1 Unit elasticity. The proportional change in one variable is equal to the proportional change in another variable.
• E > 1 Elastic. The proportional change in Q is greater than the proportional change in P.
• E = infinity Perfectly elastic. This special case of elasticity is represented in the figure to the left above. Change in P is zero, so elasticity is infinite.

Mathematical definition

The general formula for elasticity (the "y-elasticity of x") is:

E x,y =

percent change in x –––––––––––––––––––––––––– percent change in y

or, more formally,

E x,y =

∂ ln(x) –––––––––––– ∂ ln(y)

=

∂ x ––––––– ∂ y

y –– x

A common mistake for students of economics is to confuse elasticity with slope. Elasticity is the slope of a curve on a Loglog graph only, not on a regular graph (taking into account whether the independent variable is on the horizontal or the vertical axis). Consider the information in figure 2--this is a special case which illustrates that slope and elasticity are different. In the above example the slope of S1 is clearly different from the slope of S2, but since the rate of change of P relative to Q is always proportionate both S1 and S2 are unit elastic (i.e. E = 1).

Importance

The concept of Elasticity was also an important component of the Singer-Prebisch thesis which is a central argument in Dependency theory as it relates to Development economics.

This page deals with the various forms of economic surplus, including producer, consumer, government, and social/total surplus. For information about a budget surplus, see budget deficit.

If the Government intervenes, using, for example, a tax or a subsidy, then the graph of supply and demand becomes more complicated and will also include an area that represents government surplus.

Combined, the consumer surplus, the producer surplus, and the government surplus (if present) make up the social surplus or the total surplus. Total surplus is the primary measure used in Welfare economics to evaluate the efficiency of a proposed policy.

A basic technique of Bargaining for both parties is to pretend that their surplus is less than it really is: sellers may argue that the price they asks hardly leaves them any profit, while customers may play down how eager they are to have the article.

In national accounts, Operating surplus is roughly equal to distributed and undistributed pre-tax Profit income, net of depreciation.

In Heterodox economics, the economic surplus denotes the total income which the Ruling class derives from its ownership of society's (productive) assets, which is either reinvested or spent on consumption.

In Marxian economics, the term surplus may also refer to Surplus value and Surplus labour.

Consumer theory relates preferences, indifference curves and budget constraints to consumer demand curves.

Indifference curves and budget constraints

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Income effect and Price effect deal with how the change in price of the commodity changes the consumption of the Good

Price effects

To maximize the utility with the reduce budget constraint, BC1, the consumer will re-allocate consumption to reach the highest available indifference curve which BC1 can touch. As shown on the diagram below, that curve is I1, and therefore the amount of good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift from X2 to X1. The opposite effect will occur if the price of Y decreases causing the shift from BC2 to BC3, and I2 to I3.

[image]

If this shifts are repeated with many different prices for good Y, a demand curve for good Y can be constructed. If the price for good Y is fixed and the price for good X is varied, a demand curve for good X can be constructed. The below diagram explains this for good y.

[image]

Income effect

[image]

Depending on the indifference curves the amount of a good bought can either increase, decrease or stay the same when income increases. In the diagram below, good Y is a normal good since the amount purchased increased as the budget constraint shifted from BC1 to the higher income BC2. Good X is an Inferior good since the amount bought decreased as the income increases.

[image]

Substitution effect

[image]

To download a free software to make your own experiments with consumer choice, substitution and income effects you may go to: /essays/consumertheory.htm

The demand for various commodities by individuals is generally thought of as the outcome of a utility-maximizing process. The interpretation of this relationship between price and quantity demanded of a given good is that, given all the other goods and constraints, this set of choices is that one which makes the consumer happiest.

Aggregate, or market, demand curves represent the sum of these individual demand curves. An important question is whether market demand curves can also be thought of as being generated by a utility-maximization process. Does the aggregated demand curve show how to optimise the total utility (happiness) of society? Does it show how to optimise something else? The answer to these questions is no; market demand curves generally have no utility interpretation.

Moreover, even if market demand curves could mathematically be rationalized by a utility function; they still cannot be economically rationalized as generating an overall welfare index. There are several reasons for this

1. Each person's individual total utility gleaned from purchases depends on the size of his or her budget, but the Distribution of wealth (and thus her budget) is a separate (free) variable in the aggregation. In other words, changing the distribution of wealth (such as giving needy people more resources) will produce a different total for society's utility.
2. Each person's demand curve is a function of his or her budget, so that if the distribution of wealth changes (by changing the distribution of prices and thus salaries, and so on), all of the individual demand curves change. The aggregate effect of such a change is not simple unless all the consumers have wealth-independent consumption patterns --- that is, unless the pauper and the billionaire spend the same fraction of their budgets on each item.

Markets cannot be claimed to select an optimum in the sense of the greatest total utility of society; indeed, there is not even general agreement on how total utility should be defined. However, under strictly competitive conditions, market outcomes do represent a Pareto optimum.

It has been known since at least 1953 (Gorman, W.M., Community Preference Fields, Econometrica, 21: 63-80) and 1982 (Shafer, W. and Sonnenschein, H., Market demand and excess demand functions, in K. J. Arrow and M. D. Intriligator (eds), Handbook of Mathematical Economics (Vol. II), North-Holland, Amsterdam) that no reasonable assumptions can circumvent these problems.

This article is about "utility" in economics and in game theory. For utility companies and similar concepts, see Public utility. For utilities in computers, see Computer software. See also Utility (patent)

In Economics, utility is a measure of the happiness or satisfaction gained from a good or service.

The concept is applied by economists in such topics as the Indifference curve, which measures the combination of a basket of commodities that an individual or a community requests at a given level(s) of satisfaction. The concept is also used in utility functions, social welfare functions, Pareto maximization, Edgeworth boxes and contract curves. It is a central concept of Welfare economics.

The doctrine of Utilitarianism saw the maximisation of utility as a moral criterion for the organisation of society. According to utilitarians, such as Jeremy Bentham (1748-1832) and John Stuart Mill (1806-1876), society should aim to maximise the total utility of individuals, aiming for 'the greatest happiness for the greatest number'.

Utility theory assumes that humankind is rational. That is, people maximize their utility wherever possible. For instance, one would request more of a good if it is available and if one has the ability to acquire that amount, if this is the rational thing to do in the circumstances.

Cardinal and ordinal utility

Utility was originally viewed as a measurable quantity, so that it would be possible to measure the utility of each individual in the society with respect to each good available in the society, and to add these together to yield the total utility of all people with respect to all goods in the society. Society could then aim to maximise the total utility of all people in society, or equivalently the average utility per person. This conception of utility as a measurable quantity that could be aggregated across individuals is called cardinal utility.

Cardinal utility quantitatively measures the preference of an individual towards a certain commodity. Numbers assigned to different goods or services can be compared. A utility of 100 units towards a cup of vodka is twice as desirable as a cup of coffee with a utility level of 50 units.

The concept of cardinal utility suffers from the absence of an objective measure of utility when comparing the utility gained from consumption of a particular good by one individual as opposed to another individual.

For this reason, Neoclassical economics abandoned utility as a foundation for the analysis of economic behaviour, in favour of an analysis based upon preferences. This led to the development of tools such as indifference curves to explain economic behaviour.

In this analysis, an individual is observed to prefer one choice to another. Preferences can be ordered from most satisfying to least satisfying. Only the ordering is important: the magnitude of the numerical values are not important except in as much as they establish the order. A utility of 100 towards an ice-cream is not twice as desirable as a utility of 50 towards candy. All that can be said is that ice-cream is preferred to candy. There is no attempt to explain why one choice is preferred to another; hence no need for a quantitative concept of utility.

It is nonetheless possible, given a set of preferences which satisfy certain criteria of reasonableness, to find a utility function that will explain these preferences. Such a utility function takes on higher values for choices that the individual prefers. Utility functions are a useful and widely used tool in modern economics.

A utility function to describe an individual's set of preferences clearly is not unique. If the value of the utility function were to be, e.g., doubled, squared, or subjected to any other strictly monotonically increasing function, it would still describe the same preferences. With this approach to utility, known as ordinal utility it is not possible to compare utility between individuals, or find the total utility for society as the Utilitarians hoped to do.

Utility functions

For example, suppose a consumer's consumption set is X = {nothing, 1 apple, 1 orange, 1 apple and 1 orange, 2 apples, 2 oranges}, and its utility function is u(nothing) = 0, u(1 apple) = 1, u(1 orange) = 2, u(1 apple and 1 orange) = 4, u(2 apples) = 2 and u(2 oranges) = 3. Then this consumer prefers 1 orange to 1 apple, but prefers one of each to 2 oranges.

In microeconomics models, there are usually a finite set of L commodities, and a consumer may consume an arbitrary amount of each commodity. This gives a consumption set of R ^L ₊ , and each package x ∈ R ^L ₊ is a vector containing the amounts of each commodity. In the previous example, we might say there are two commodities: apples and oranges. If we say apples is the first commodity, and oranges the second, then the consumption set X = R ² ₊ and u(0, 0) = 0, u(1, 0) = 1, u(0, 1) = 2, u(1, 1) = 4, u(2, 0) = 2, u(0, 2) = 3 as before. Note that for u to be a utility function on X, it must be defined for every package in X.

A utility function u : X → R rationalizes a preference relation <= on X if for every x, y ∈ X, u(x) <= u(y) If and only if x <= y. If u rationalizes <=, then this implies <= is complete and transitive, and hence rational.

In order to simplify calculations, various assumptions have been made of utility functions.

• CES (constant elasticity of substitution) utility is one with constant relative risk aversion
• quasilinear utility
• homothetic utility

Expected utility

Restricting to the discrete choice context, let L : X → [0,1] be a simple lottery such that L (x _i ) = p _i , where p _i is the probability that x _i is won. We may also consider compound lotteries, where the prizes are themselves simple lotteries.

The expected utility theorem says that a von Neumann-Morgenstern utility function exists if and only if the agent's preference relation >= on the space of simple lotteries satisfies four axioms: completeness, transitivity, convexity/continuity (also called the Archimedean property), and independence.

Completeness and transitivity are discussed supra. The Archimedean property says that for simple lotteries L ₁ >= L ₂ >= L ₃ , then there exists a 0 <= p <= 1 such that the agent is indifferent between L ₂ and the compound lottery mixing between L ₁ and L ₃ with probability p and (1-p), respectively. Independence means that if the agent is indifferent between simple lotteries L ₁ and L ₂ , the agent is also indifferent between L ₁ mixed with an arbitrary simple lottery L ₃ with probability p and L ₂ mixed with L ₃ with the same probability p.

Independence is probably the most controversial of the axioms.

Daniel Bernoulli has shown how the personal utility vary with the personal degree of Risk aversion, itself linked to the initial wealth situation of the person.

Discussion and criticism

In Economics, marginalism is the theory that economic value results from marginal utility and Marginal cost (the Marginal concepts). Marginalism is the notion that what is most important for decision making is the marginal or last unit of consumption or production. For example, one automobile is very useful for getting around. An additional automobile might be useful in case the first is being repaired, or for spare parts, but it is not as useful as the first. A third automobile has even less utility than the first two. Given the price of cars, one would not expect many people to own three cars because the benefit they receive on the third car would be unlikely to exceed the price.

The theory of marginal utility was independently developed around 1870 by William Stanley Jevons in England, Carl Menger in Austria and Leon Walras in Switzerland. HH Gossen had also posited a connection between value in exchange and marginal utility, but it was ultimately popularised by the three European economists. These advances in economic thought are known as the Neoclassical Revolution (or Marginal Revolution).

Theories of Value

Diamond-water Paradox

Cost of Production

The origins of marginalism come from Ricardo's theory of land-rent, in which the price of land depends on the productivity of the least productive land in cultivation-the marginal land. Thus, all else equal, as the demand for agricultural crops increases, the price of land rises as farmers move to less productive land.

Subjective Value

Those who endorse subjective value theory (including mainstream modern economists) believe it is a refutation of intrinsicist value theories, such as the Labor theory of value, which is a cornerstone of Marxism. Behavioral economics theorists explicitly seek to research and model how subjective Framing of decisions affects the value an individual places on goods and outcomes.

Carl Menger and Eugen von Böhm-Bawerk, members of the Austrian School of economics, took subjective value further, developing the theory of marginalism.

Marginal Utility

The Austrian economist Eugen von Böhm-Bawerk gave probably the most memorable description of the marginal theory of value, one often used by economics textbooks. Loosely translated it is:

A pioneer farmer had five sacks of grain, with no way of selling them or buying more. He had five possible uses: as basic feed for himself, food to build strength, food for his chickens for dietary variation, an ingredient for making whisky and feed for his parrots to amuse him. Then the farmer lost one sack of grain. Instead of reducing every activity by a fifth, the farmer simply starved the parrots as they were of less utility than the other four uses, in other words they were on the margin. And it is on the margin, and not with a view to the big picture, that we make economic decisions.

Diminishing marginal utility refers to the marginal utility of each additional unit of a good having less value than the previous unit. For example, the marginal utility of an additional slice of bread to a person with few slices will be great. But the marginal utility of an extra slice of bread to a person with many slices will be small.

Diminishing marginal utility is a very common assumption in economics, but it is not universally assumed. It corresponds to convexity of the indifference curves.

Marginalism and Schools of Economic Thought

Neo-classical Economics

Austrian School

Austrian economists formulated the law of marginal utility in a period when psychologists were much interested in the Weber-Fechner law of sensation. The Weber-Fechner law states that in order that the intensity of a sensation may achieve an Arithmetic progression, the stimulus itself must achieve a Geometric progression. For example, in a quiet environment, humans will notice even a small increase in noise level, but when the given noise level is already loud, humans will need a much larger increase in order to perceive a difference.

Von Wieser's seminal essay on "Natural Value" appeared in 1889. In 1890, the American psychologist William James wrote his Principles of Psychology and offered an interpretation of the Weber-Fechner law that may also shed a lot of light on marginal utility in von Weiser's sense. James saw the Weber-Fechner law as a rough generalization as to the friction in the neural machinery.

"If our feelings [of weight, sight, sound, etc.] resulted from a condition of the nerve molecules which it grew ever more difficult for the stimulus to increase, our feelings would naturally grow at a slower rate than the stimulus itself," he wrote. "An ever larger part of the latter's work would go to overcoming the resistances, and an ever smaller part to the realization of the feeling-bringing state."

Whatever the neurological basis, the result of diminishing marginal utility is that rather than having a lot of one good or a lot of another one, one prefers having some of both. In the case of perfect substitutes this result does not apply (since the two products are essentially the same), in the case of perfect complements it applies most.

Marxist School

Some economists strongly influenced by the Marxian tradition such as Oskar Lange, Wlodzimierz Brus, and Michal Kalecki have attempted to integrate the insights of classical Political economy and neo-classical economics. Important reasons for this were that Marx lacked a sophisticated theory of prices, and neo-classical economics lacked a theory of the social frameworks of economic activity.

Marxists often criticise capitalism for its "Commodity fetishism" or the "illusions created by competition" arguing that capitalists dominate the working class and exploit them. They argue that although individual economic visions and decision-making play a role in Marx's theory, he thought that it was necessary to understand the totality of capitalist social relations (in volume I of his Das Kapital) before it was possible to understand this consciousness and action (in volume III of that book). Some Marxists argue that on one level there is no conflict between marginalism and Marxism: one could employ a marginalist theory of supply and demand within the context of a "big picture" understanding of capitalist exploitation of labor.

Income, generally defined, is the money that is received as a result of the normal business activities of an individual or a business. For example, most individuals' income is the money they receive from their regular paychecks.

In business and accounting, income (also known as Profit or earnings) is, more specifically, the amount of money that a company earns after paying for all its costs. To calculate a company's income, it starts with its amount of Revenue, deducts all costs, including such things as employees' salaries and Depreciation, and the number that results is its income, which may be a negative number. This money is typically reinvested in the business, paid in Corporate tax and used to pay the owners (the shareholders) a Dividend.

All public companies are required to provide Financial statements on a quarterly basis. The statement of income is an important part of this. Some companies also provide a more rosy financial report of their income, with Pro forma reporting, or, EBITDA reporting. Pro forma income is an estimate of how much the company would have earned without including the negative effect of exceptional "one-time events", supposedly in order to show investors how much money the company would have made under normal circumstances if these exceptional, one-time events had not occurred. Critics charge that, in most cases, the "one-time events" are normal business events, such as an acquisition of another company or a write off of a cancelled project or division, and that pro forma reporting is an attempt to mislead investors by painting a rosy financial picture. Besides that, when discussing results with analysts and shareholders CEOs and CFOs have a tendency to do even more "hypothetical accounting". EBITDA stands for "earnings before interest, taxes, depreciation, and amortisation", and is also criticised for being an attempt to mislead investors. Warren Buffett has criticised EBITDA reporting, famously asking, "Does management think the tooth fairy pays for capital expenditures?"

It is common for some other companies, such as real estate investment trusts, to present reports using a standard called FFO, or funds from operations. Like EBITDA reporting, FFO ignores depreciation and amortization. This is widely accepted in the industry, as Real estate values tend to increase rather than decrease over time, and many data sites report Earnings per share data using FFO.

In Economics, income is the constraint to unlimited Consumer purchases. Consumers can purchase a limited number of goods. The basic equation for this is I = Px × x + Py × y, where Px is the price of good x, x is the quantity of good x, and I is the income (Py and y are similar to Px and x). If you need to examine more than two goods, you can add more on. This equation tells us two things. First, if you buy one more of good x, you get Px/Py less of good y. Here, Px/Py is known as the rate of substitution. Secondly, if the price of x changes, then the rate of substitution changes. This causes demand curves to slope down.

The distribution of income within a society can be measured by the Lorenz curve and the Gini coefficient.

National income, measured by statistics such as the Net National Income (NNI), measures the total income of all individuals in the economy. For more information see Measures of national income and output.

In Economics, profit maximization is the process by which a firm determines the Price and Output level that returns the greatest Profit. There are several approaches to this problem. The total revenue -- total cost method relies on the fact that profit equals revenue minus cost, and the Marginal revenue -- Marginal cost method is based on the fact that total profit in a perfectly competitive market reaches its maximum point where marginal revenue equals marginal cost.

Basic Definitions

Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, Venture capital and personal funds.

Average cost and revenue are defined as the total cost or revenue divided by the amount of units output. For instance, if a firm produced 400 units at a cost of 20000 USD, the average cost would be 50 USD.

Marginal cost and revenue, depending on whether the Calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the Derivative of cost or revenue with respect to quantity output. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to Linear interpolation. Calculus is capable of providing more accurate answers if Regression equations can be provided.

Total Cost-Total Revenue Method

There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product.

Marginal Cost-Marginal Revenue Method

If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams.

Modes of Operation

A firm is said to be making an economic profit when its average total cost is less than the price of the product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.

A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.

If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it was to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose equivalent of its entire fixed cost.

If the price is below average variable cost at the profit-maximizing output, the firm is said to be in Shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost.

Perfect competition is a Model in economic Theory. It describes a hypothetical Market form in which no producer or consumer has the Market power to influence prices in the market. This would lead to an outcome which is efficient, according to the standard definition in economics (Pareto efficiency). The analysis of perfectly competitive markets provides the foundation of the theory of Supply and demand.

Assumptions of perfect competition

1. Atomicity -- there are a large number of small producers and consumers on a given market, each so small that its actions have no significant impact on others, firms are price takers.
2. Homogeneity -- that goods and services are perfect substitutes.
3. Perfect and complete information -- all firms and consumers know the prices set by all firms.
4. Equal access -- all firms have access to production technologies, and resources (including Information) are perfectly mobile.
5. Free entry -- any firm may enter or exit the market as it wishes (see Barriers to entry).

In such a Market, the Price would move instantaneously to Equilibrium.

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Results of a Perfectly Competitive Market

In contrast to a Monopoly or Oligopoly, it is impossible for a firm in perfect competition to earn Abnormal profit in the long run, that is to say that a firm cannot make any more money than is necessary to cover its losses. If a firm is earning abnormal profit in the short term, this will act as a trigger for other firms to enter the market. They will compete with the first firm, driving the market price down until all firms are earning normal profit.

Examples of Perfect Competition

Perhaps the closest thing to a perfectly competitive market would be a street market with many small stalls selling identical smallholding-sourced food produce. As perfect competition is a theoretical absolute, there are no examples of a perfectly competitive market.

This article is about the state of a player in Economics. For the Parker Brothers board game, see Monopoly (game).

In Economics, a monopoly (from the Greek monos, one + polein, to sell) is defined as a persistent Market situation where there is only one provider of a kind of product or service. Monopolies are characterized by a lack of economic Competition for the good or service that they provide and a lack of viable substitute goods.

Monopoly should be distinguished from Monopsony, in which there is only one buyer of the product or service; it should also, strictly, be distinguished from the (similar) phenomenon of a Cartel. In a monopoly a single firm is the sole provider of a product or service; in a cartel a centralized institution is set up to partially coordinate the actions of several independent providers (which is a form of Oligopoly).

Forms of monopoly

Legal monopoly

An example of a "de jure" monopoly is AT&T, which was granted monopoly power by the US government, only to be broken up in 1982 following a Sherman Antitrust suit.

Natural monopoly

A natural monopoly is a monopoly that arises in industries where economies of scale are so large that a single firm can supply the entire market without exhausting them. In these industries competition will tend to be eliminated as the largest (often the first) firm develops a monopoly through its cost advantage. In these industries monopoly may be more economically efficient than competition, although because of potential dynamic efficiencies this is not necessarily clear-cut.

Natural monopoly arises when there are large capital costs relative to variable costs, which arises typically in network industries such as Electricity and Water. It should be distinguished from network effects, which operate on the demand side and do not affect costs. Counter-intuitively, the case of a monopolization of a key source of a Natural resource is not considered a natural monopoly, because it is based on the running down of Natural capital rather than the amortization of an investment in physical or Human capital.

Whether an industry is a natural monopoly may change over time through the introduction of new technologies. A natural monopoly industry can also be artificially broken up by government, although (eg Electricity liberalization, eg Railtrack) the results are at best mixed. Advocates of free markets, such as libertarians, assert that a natural monopoly is a practical impossibility, and, given that a monopoly is a persistent rather than a transient situation, that there is no historical precedent of one ever existing. They say that the idea of "natural monopoly" is mere theoretical abstraction to justify expanding the scope of government, and that it in the case of nationalization or deprivatization it is the government intervention itself that creates a monopoly where one did not actually exist.

Local monopoly

Monopolistic competition

Industries which are dominated by a single firm may allow the firm to act as a near-monopoly or "De facto monopoly", a practice known in economics as Monopolistic competition. Common historical examples arguably include corporations such as Microsoft and Standard Oil (Standard's market share of refining was 64% in competition with over 100 other refiners at the time of the trial that resulted in the government-forced breakup). Practices which these entities may be accused of include Dumping products below cost to harm competitors, creating Tying arrangements between their products, and other practices regulated under antitrust law.

Large corporations often attempt to monopolize markets through Horizontal integration, in which a parent company consolidates control over several small, seemingly diverse companies (sometimes even using different branding to create the illusion of marketplace competition). Such a monopoly is known as a Horizontal monopoly. A magazine publishing firm, for example, might publish many different magazines on many different subjects, but it would still be considered to engage in monopolistic practices if the intent of doing this was to control the entire magazine-reader market, and prevent the emergence of competitors.

A monopoly arrived at through Vertical integration is called a Vertical monopoly. A common example is vertical integration of Electricity distribution with Electricity generation, which is common because it reduces or eliminates certain costly risks.

Coercive monopoly

A coercive monopoly is one that arises and whose existence is maintained as the result of any sort of activity that violates the principle of a Free market and is therefore insulated from competitive forces that would otherwise be a potential threat to its superior status. The term is typically used by those who favor laissez-faire capitalism.

Economic analysis

Primary characteristics of a monopoly

• Single Seller

A pure monopoly is an industry in which a single firm is the sole producer of a good or the sole provider of a service. This is usually caused by a blocked entry.

• No Close Substitutes

The product or service is unique in ways which go beyond brand identity, and cannot be easily replaced (a monopoly on water from a certain spring, sold under a certain brand name, is not a true monopoly; neither is Coca-Cola, even though it is differentiated from its competition in flavor).

• Price Maker

In a pure monopoly a single firm controls the total supply of the whole industry and is able to exhert a significant degree of control over the price, by changing the quantity supplied. In subtotal monopolies (for example diamonds or petroleum at present) a single organization controls enough of the supply that even if it limits the quantity, or raises prices, the other suppliers will be unable to make up the difference and take significant amounts of market share.

• Blocked Entry

The reason a pure monopolist has no competitors is that certain barriers keep would be competitors from entering the market. Depending upon the form of the monopoly these barriers can be economic, technological, legal (basic patents on certain drugs), or of some other type of barrier that completely prevents other firms from entering the market.

Monopolistic pricing

If a monopoly can only set one price it will set it where Marginal cost (MC) equals Marginal revenue (MR) as seen on the diagram on the right. This can be seen on a Supply and demand diagram for the firm. This will be at the quantity Qm and at the price Pm. This is above the competitive price of Pc and with a smaller quantity that the competitive quantity of Qc. The profit the monopoly gains is the shaded in area labeled profit.

As long as the Price elasticity of demand (in Absolute value) for most customers is less than one, it is very advantageous to increase the price: the seller gets more money for less goods. With an increase of the price the price elasticity tends to rise, and in the optimum mentioned above it will for most customers be above one. A formula gives the relation between price, marginal cost of production and demand elasticity which maximizes a monopoly profit:

P ––– MC

=

1 –––––––––––– 1 + 1 / e

(known as Lerner Index).

The economy as a whole loses out when monopoly power is used in this way, since the extra profit earned by the firm will be smaller than the loss in consumer surplus. This difference is known as a Deadweight loss.

Calculating monopoly output

The monopoly's profit is its total revenue less its total cost. Let the price it sets as a market response be a function of the quantity it produces (Q) P (Q) and let its cost function be as a function of quantity C (Q). The monopoly's revenue is the product of the price and the quantity it produces. Hence its profit is:

 Π  = P (Q).Q - C (Q)

Taking the first order derivative with respect to quantity yields:

d Π  ––––– dQ

= P '(Q).Q + P (Q) - C '(Q)

Setting this equal to zero for maximisation:

d Π  ––––– dQ

= P '(Q).Q + P (Q) - C '(Q) = 0

d Π  ––––– dQ

= P '(Q).Q + P (Q) = C '(Q)

i.e. marginal revenue = marginal cost, provided

d 2  Π  –––––––– dQ 2

= P (Q).Q + (Q+1).P '(Q) +P (Q) - C (Q) < 0

(the rate of marginal revenue is less than the rate of marginal cost, for maximisation).

This procedure assumes that the monopolist knows exactly which is the demand function. For a discussion on a monopolist who does not know it, see /essays/monopolist.htm where a free software is available as well.

Monopoly and efficiency

It is also often argued that monopolies tend to become less efficient and innovative over time, becoming "complacent giants", because they don't have to be efficient or innovative to compete in the marketplace. Sometimes this very loss of efficiency can raise the potential value of a competitor enough to overcome market entry barriers, or provide incentive for research and investment into new alternatives. The theory of contestable markets argues that in some circumstances (private) monopolies are forced to behave as if there were competition, because of the risk of losing that monopoly to new entrants, or because of the availability in the longer-term of substitutes in other markets. For example, a Canal monopoly in the late eighteenth century United Kingdom was worth a lot more than in the late nineteenth century, because of the introduction of railways as a substitute.

Some argue that it can be good to allow a firm to attempt to monopolize a market, since practices such as dumping can benefit consumers in the short term; and once the firm grows too big, it can then be dealt with via Regulation. (This is a rather optimistic view of how effectively regulation can substitute for competition.) When monopolies are not broken through the open market, often a government will step in to either regulate the monopoly, turn it into a publicly-owned monopoly, or forcibly break it up (see Antitrust law). Public utilities, often being natural monopolies and less susceptible to efficient breakup, are often strongly regulated or publicly-owned. AT&T and Standard Oil are debatable examples of the breakup of a private monopoly. When AT&T was broken up into the "Baby Bell" components, MCI, Sprint, and other companies were able to compete effectively in the long-distance phone market and started to take phone traffic from the less efficient AT&T.

Historical examples

Salt

In Economics, a market failure is a situation in which markets do not efficiently organize production or allocate goods and services to consumers (for example, a failure to allocate goods in a way some see as socially or morally preferable). To economists, the term would normally be applied to situations where the inefficiency is particularly dramatic, or when it is suggested that non-market institutions would provide a more desirable result. On the other hand, to many, market failures are situations where market forces do not serve the perceived "Public interest". Here, the focus is on the economists' theories of market failure.

Economists use model-like theorems to explain or understand such cases. The two main reasons that markets fail are:

• the inadequate expression of costs or benefits in prices and thus into microeconomic decision-making in markets.
• sub-optimal market structures

In Economics, information asymmetry occurs when one party to a transaction has more