BASIC

MICROECONOMICS
 Saint Anthony’s College
Santa Cruz, Santa Ana, Cagayan 3514 | FAS School System

COLLEGE DEPARTMENT
============================================
SUBJECT: BASIC MICROECONOMICS
TOPICS: PRODUCER THEORY
WELFARE ECONOMICS
MONOPOLY AND OLIGOPOLY
SCHOOL YEAR/SEMESTER: 2020-2021/ 1ST SEMESTER
INSTRUCTOR: LEOMER S. TIOZON
INTRODUCTION
As we've already learned, consumers gain utility from buying goods—but
every good has to come from somewhere! Goods are produced by firms, and
analysing the decisions of firms is also central to our understanding of the economy.
In this lecture, we will learn how companies make important operation decisions.

The Producer Theory

CONTENT STANDARD:
The learners demonstrate understanding of the producer theory and its use.

LESSON OBJECTIVES:
At the end of the lesson you are expected to:
• Define what producer theory is,
• Identify the producer theory,
• Appreciate the use of producer theory.

Direction: Read carefully the following information below. Make sure to analyze
every information so that you will understand it. Please use yellow pad paper in
answering all the activities.
Just as economists have worked out a theory of consumers they have also
developed a theory of producers. This theory explains what is behind the supply
functions of markets. While this theory appears to be a general theory explaining
how an enterprise behaves, in actuality explaining the behaviour of any specific
enterprise would be too complex a problem. Some detailed studies of particular
firms such as the Ford Motor Company have been written that focus on cultural
and organizational aspects of the firm these are not the typical examples of the
economic theory of producers. But economics is not concerned with explaining the
behaviour of any specific firm; instead it is concerned with explaining the behaviour
of markets. In order to explain the behaviour of a typical firm in a market it is not
necessary to have a completely realistic and detailed model of firms. All that is
required is a model that captures the market-relevant influences of the average and
allows the individual differences to average out.
 The key concept for a firm is its cost function. The cost function gives the total
costs of the firm as a function of its level of production. Let q be the annual rate of
output of the firm. Its cost function is total costs C given as a function of q; i.e.,
C=f(q). Usually the cost function is represented as C(q). An example is shown in the
graph below.

If the producer can sell the output at a price p then the revenue received is just
the price p times the output q. The revenue as a function of q is shown in the above
graph as a green line.

The net profit for the firm is the difference between the revenue of pq and the
cost C(q). The profit is shown in the diagram above in red. A producer wants to
produce at a level where the profit is the greatest; i.e., the producer will choose a
level of consumption of x such that the profit is a maximum. Note that when the
profit is a maximum the slope of the profit function is zero. This means that at the
level of q where profit is a maximum the increase in profit from another unit of
production is zero. This is equivalent to saying that the increase in revenue from
another unit of production is exactly equal to the increase in cost of producing that
unit.

The increase in revenue from producing another unit is just the price of the
product. The increase in cost can be computed from the cost function. This increase
in cost for producing another unit is called the marginal cost of another unit. The
marginal cost may decrease with increasing output over some range but beyond
some level of production the marginal cost goes up with increasing output. The
marginal cost function is shown in the graph below.

The marginal cost function is what determines the level of output where profit is
a maximum. If the market price of the product is plotted as a horizontal line, as is
done in the above graph, then the profit-maximizing output is the output where the
price line intersects the marginal cost function. Thus where the price line intersects
the marginal cost curve gives the quantity which would be supplied at that price. If
this price and quantity data are plotted in a different graph to construct the supply
schedule for the firm one finds that the marginal cost curve is just being replotted.
In other words,

The supply curve is exactly the same as the marginal cost curve, as least for prices
above some minimum. If the price is too low the firm may find that it is most
profitable to supply zero units. This would be the case if the price is so low the firm
cannot avoid a loss. The upward sloping of the supply curve is just the increasing
marginal cost of the increasing production.
There is another cost function that is important for a producer. It is the average
cost, the total cost divided by output. The average cost function for the total cost
function shown above is shown below.

The relationship of the marginal cost curve and the average cost curve is best
seen geometrically from the total cost curve. Marginal cost corresponds to the slope
of the total cost curve. Average cost corresponds to the slope of a line drawn between
a point on the total cost curve and the origin.

When the slope of the tangent to the total cost curve is the same as the slope of
the line drawn to the origin then the marginal cost and the average cost are the
same. This point is where average cost is a minimum.

There is yet one more cost curve. If total cost is not zero when output is zero that
level of cost is called fixed cost. This would be the level of cost in factory that would
have to be paid out for maintenance, insurance, security etc.

If fixed costs are subtracted from total costs the difference is called variable costs.
Variable costs include the cost of raw materials, labour, power and so forth. If the
level of variable costs is divided by output the result is called average variable cost.
When marginal cost is equal to average variable cost then average variable cost is
at its minimum level. The three unit cost curves are shown in the graph below.

The average variable cost curve is important for determining the minimum price
at which the firm will produce any output. In the graph shown below if the price
were p0, which is below the minimum average variable cost then the price line of
p0 crosses the marginal cost curve at an output of q0. At an output of q0 the firm
would be making the maximum profit or the minimum loss that could be achieved
with any positive amount of output.

(The crossing at the point q1 does not count because the negative slope of the
marginal cost curve at that point indicates that q1 corresponds to a minimization
of profit or maximization of loss.)

If the market price is not high enough to cover the variable costs then the firm is
better off not producing. Thus at prices below the minimum average variable the
firm produces zero. The supply curve for a firm is the same as the marginal cost
curve down to the minimum average variable cost. Below that price the supply is
zero.

The area under a marginal cost curve over some range of output is the same as
the increase in total (and variable) cost over that range of outputs. The area under
the price line over a range of outputs is the change in revenue over that range of
outputs. Thus the change in profit is the same as the area between the price line
and the marginal cost curve.

Since the supply curve and marginal cost curves are the same for prices above
the minimum average variable cost then the area between the price line and the
supply curve is the change in profit for the producers over that range of outputs.
This leads to the concept of producer surplus as the area to the left of the supply
curve over some range of prices.

The Theory Production

Theory of production, in economics, an effort to explain the principles by which
a business firm decides how much of each commodity that it sells (its “outputs” or
“products”) it will produce, and how much of each kind of labour, raw material,
fixed capital good, etc., that it employs (its “inputs” or “factors of production”) it will
use. The theory involves some of the most fundamental principles of economics.
These include the relationship between the prices of commodities and the prices (or
wages or rents) of the productive factors used to produce them and also the
relationships between the prices of commodities and productive factors, on the one
hand, and the quantities of these commodities and productive factors that are
produced or used, on the other.

The various decisions a business enterprise makes about its productive activities
can be classified into three layers of increasing complexity. The first layer includes
decisions about methods of producing a given quantity of the output in a plant of
given size and equipment. It involves the problem of what is called short-run cost
minimization. The second layer, including the determination of the most profitable
quantities of products to produce in any given plant, deals with what is called short-
run profit maximization. The third layer, concerning the determination of the most
profitable size and equipment of plant, relates to what is called long-run profit
maximization.

Minimization f Short-Run Costs

The production function
However much of a commodity a business firm produces, it endeavours to produce
it as cheaply as possible. Taking the quality of the product and the prices of the
productive factors as given, which is the usual situation, the firm’s task is to
determine the cheapest combination of factors of production that can produce the
desired output. This task is best understood in terms of what is called
the production function, i.e., an equation that expresses the relationship between
the quantities of factors employed and the amount of product obtained. It states
the amount of product that can be obtained from each and every combination of
factors. This relationship can be written mathematically as y = f (x1, x2, . . ., xn; k1,
k2, . . ., km). Here, y denotes the quantity of output. The firm is presumed to
use n variable factors of production; that is, factors like hourly paid production
workers and raw materials, the quantities of which can be increased or decreased.
In the formula the quantity of the first variable factor is denoted by x1 and so on.
The firm is also presumed to use m fixed factors, or factors like fixed machinery,
salaried staff, etc., the quantities of which cannot be varied readily or habitually.
The available quantity of the first fixed factor is indicated in the formal by k1 and
so on. The entire formula expresses the amount of output that results when
specified quantities of factors are employed. It must be noted that though the
quantities of the factors determine the quantity of output, the reverse is not true,
and as a general rule there will be many combinations of productive factors that
could be used to produce the same output. Finding the cheapest of these is the
problem of cost minimization.
Activity 1
Look for someone who has a stable production business and ask them these
questions. Provide documentation while doing the activity.
 1. What product they are producing?
2. How many years they are running a production?
3. Intrigue about how their beginning.
4. What common problems do they encounter?
5. How they resolved it?

NEW IDEAS:
What did you learn about the lesson?

EVALUATION:
Imagine that you are about to run a production business, what would it be and
why? Show your step by step plan. Make it realistic considering the finance,
location and availability of the sources/materials needed.

Welfare Economics
CONTENT STANDARD:
The learners demonstrate understanding of the welfare economics and its use.

LESSON OBJECTIVES:
At the end of the lesson you are expected to:
• Define what welfare economics is,
• Identify the features of welfare economics,
• Appreciate the use of welfare economics.

What Is Welfare Economics?

Welfare economics is the study of how the allocation of resources and goods
affects social welfare. This relates directly to the study of economic efficiency and
income distribution, as well as how they affect the overall well-being of people in
the economy. In practical application, welfare economists seek to provide tools to
guide public policy to achieve beneficial social and economic outcomes for all of
society. However, welfare economics is a subjective study that depends heavily on
chosen assumptions regarding how welfare can be defined, measured, and
compared for individuals and society as a whole.

KEY TAKEAWAYS

• Welfare economics is the study of how the structure of markets and the
allocation of economic goods and resources determines the overall well-being
of society.
• Welfare economics seeks to evaluate the costs and benefits of changes to the
economy and guide public policy toward increasing the total good of society,
using tools such as cost-benefit analysis and social welfare functions.
• Welfare economics depends heavily on assumptions regarding the
measurability and comparability of human welfare across individuals, and
the value of other ethical and philosophical ideas about well-being.
Understanding Welfare Economics
Welfare economics begins with the application of utility theory in
microeconomics. Utility refers to the perceived value associated with a particular
good or service. In mainstream microeconomic theory, individuals seek to maximize
their utility through their actions and consumption choices, and the interactions of
buyers and sellers through the laws of supply and demand in competitive markets
yield consumer and producer surplus.

Microeconomic comparison of consumer and producer surplus in markets under

different market structures and conditions constitutes a basic version of welfare
economics. The simplest version of welfare economics can be thought of as asking,
"Which market structures and arrangements of economic resources across
individuals and productive processes will maximize the sum total utility received by
all individuals or will maximize the total of consumer and producer surplus across
all markets?" Welfare economics seeks the economic state that will create the
highest overall level of social satisfaction among its members.

Pareto Efficiency
This microeconomic analysis leads to the condition of Pareto efficiency as an ideal
in welfare economics. When the economy is in a state of Pareto efficiency, social
welfare is maximized in the sense that no resources can be reallocated to make one
individual better off without making at least one individual worse off. One goal of
economic policy could be to try to move the economy toward a Pareto efficient state.

To evaluate whether a proposed change to market conditions or public policy will

move the economy toward Pareto efficiency, economists have developed various
criteria, which estimate whether the welfare gains of a change to the economy
outweigh the losses. These include the Hicks criterion, the Kaldor criterion, the
Scitovsky criterion (also known as Kaldor-Hicks criterion), and
the Buchanan unanimity principle. In general, this kind of cost-benefit analysis
assumes that utility gains and losses can be expressed in money terms. It also
either treats issues of equity (such as human rights, private property, justice, and
fairness) as outside the question entirely or assumes that the status quo represents
some kind of ideal on these type of issues.

Social Welfare Maximization

However, Pareto efficiency does not provide a unique solution to how the economy
should be arranged. Multiple Pareto efficient arrangements of the distributions of
wealth, income, and production are possible. Moving the economy toward Pareto
efficiency might be an overall improvement in social welfare, but it does not provide
a specific target as to which arrangement of economic resources across individuals
and markets will actually maximize social welfare. To do this, welfare economists
have devised various types of social welfare functions. Maximizing the value of this
function then become the goal of welfare economic analysis of markets and public
policy.

Results from this type of social welfare analysis depend heavily on assumptions
regarding whether and how utility can be added or compared between individuals,
as well as philosophical and ethical assumptions about the value to place on
different individuals' well-being. These allow the introduction of ideas about
fairness, justice, and rights to be incorporated into the analysis of social welfare,
but render the exercise of welfare economics an inherently subjective and possibly
contentious field.

Activity 1
Of all the existing business here in Sta. Ana, which do you think determines the
overall well-being of society? Why? Expound and justify your answer.

NEW IDEAS:
What did you learn about the lesson?

EVALUATION:
If given the chance to establish your own business, what type of business would it
be and why? Consider the overall well-being of the people of Sta. Ana.

Monopoly and Oligopoly

CONTENT STANDARD:
The learners demonstrate understanding of the Monopoly and Oligopoly its use.

LESSON OBJECTIVES:
At the end of the lesson you are expected to:
• Define what Monopoly and Oligopoly are,
• Identify the differences of Monopoly and Oligopoly,
• Appreciate the use of Monopoly and Oligopoly.

Monopoly vs. Oligopoly: An Overview

A monopoly and an oligopoly are market structures that exist when there is
imperfect competition. A monopoly is when a single company produces goods with
no close substitute, while an oligopoly is when a small number of relatively large
companies produce similar, but slightly different goods. In both cases, significant
barriers to entry prevent other enterprises from competing.

A market's geographical size can determine which structure exists. One company
might control an industry in a particular area with no other alternatives, though a
few similar companies operate elsewhere in the country. In this case, a company
may be a monopoly in one region, but operate in an oligopoly market in a larger
geographical area.

KEY TAKEAWAYS

• A monopoly occurs when a single company that produces a product or service

controls the market with no close substitute.
• In an oligopoly, two or more companies control the market, none of which
can keep the others from having significant influence.
 • Anti-trust laws prevent companies from engaging in unreasonable restraint
of trade and transacting mergers that lessen competition.1
Monopoly
A monopoly exists in areas where one company is the only or dominant force to sell
a product or service in an industry. This gives the company enough power to keep
competitors away from the marketplace. This could be due to high barriers to
entry such as technology, steep capital requirements, government regulation,
patents or high distribution costs.

Once a monopoly is established, lack of competition can lead the seller to charge
high prices. Monopolies are price makers. This means they determine the cost at
which their products are sold. These prices can be changed at any time. A monopoly
also reduces available choices for buyers. The monopoly becomes a pure monopoly
when there is absolutely no other substitute available.

Monopolies are allowed to exist when they benefit the consumer. In some cases,
governments may step in and create the monopoly to provide specific services such
as a railway, public transport or postal services. For example, the United States
Postal Service enjoys a monopoly on first class mail and advertising mail, along with
monopoly access to mailboxes.

Oligopoly
In an oligopoly, a group of companies (usually two or more) controls the market.
However, no single company can keep the others from wielding significant influence
over the industry, and they each may sell products that are slightly different.

Prices in this market are moderate because of the presence of competition. When
one company sets a price, others will respond in fashion to remain competitive. For
example, if one company cuts prices, other players typically follow suit. Prices are
usually higher in an oligopoly than they would be in perfect competition.

Because there is no dominant force in the industry, companies may be tempted to

collude with one another rather than compete, which keeps non-established players
from entering the market. This cooperation makes them operate as though they
were a single company.

In 2012, the U.S. Department of Justice alleged that Apple (AAPL) and five book
publishers had engaged in collusion and price fixing for e-books. The department
alleged that Apple and the publishers conspired to raise the price for e-book
downloads from $9.99 to $14.99.3 A U.S. District Court sided with the government,
a decision which was upheld on appeal.4

In a free market, price fixing—even without judicial intervention—is unsustainable.

If one company undermines its competition, others are forced to quickly follow.
Companies that lower prices to the point where they are not profitable are unable
to remain in business for long. Because of this, members of oligopolies tend to
compete in terms of image and quality rather than price.
Legalities of Monopolies vs. Oligopolies
Oligopolies and monopolies can operate unencumbered in the United States unless
they violate anti-trust laws. These laws cover unreasonable restraint of trade;
plainly harmful acts such as price fixing, dividing markets and bid rigging;
and mergers and acquisitions (M&A) that substantially lessen competition.

Without competition, companies have the power to fix prices and create product
scarcity, which can lead to inferior products and services and higher costs for
buyers. Anti-trust laws are in place to ensure a level playing field.

In 2017, the U.S. Department of Justice filed a civil antitrust suit to block
AT&T's merger with Time Warner, arguing the acquisition would substantially
lessen competition and lead to higher prices for television programming. However,
a U.S. District Court judge disagreed with the government's argument and approved
the merger, a decision that was upheld on appeal.6

The government has several tools to fight monopolistic behaviour. This includes
the Sherman Antitrust Act, which prohibits unreasonable restraint of trade, and
the Clayton Antitrust Act, which prohibits mergers that lessen competition and
requires large companies that plan to merge to seek approval in advance. Anti-trust
laws do not sanction companies that achieve monopoly status via offering a better
product or service, or though uncontrollable developments such as a key competitor
leaving the market.

Examples of Monopolies and Oligopolies

A company with a new or innovative product or service enjoys a monopoly until
competitors emerge. Sometimes these new products are protected by law. For
example, pharmaceutical companies in the U.S. are granted 20 years of exclusivity
on new drugs. This is necessary due to the time and capital required to develop and
bring new drugs to market. Without this protected status, firms would not be able
to realize a return on their investment, and potentially beneficial research would be
stifled.

Gas and electric utilities are also granted monopolies. However, these utilities are
heavily regulated by state public utility commissions. Rates are often controlled,
along with any rate increases the company may pass onto consumers.

Oligopolies exist throughout the business world. A handful of companies control

the market for mass media and entertainment. Some of the big names include The
Walt Disney Company (DIS), ViacomCBS (VIAC) and Comcast (CMCSA). In the
music business, Universal Music Group, Sony Entertainment and Warner Music
Group all have a tight grip on the market.

Activity 1
What is the difference between of Monopoly and Oligopoly? Show an authentic
example of the following.

NEW IDEAS:
What did you learn about the lesson?

EVALUATION:
This is your free gift! Relax and prepare for examination. Good luck and God bless
you all!

References:
https://www.sjsu.edu/faculty/watkins/prodtheo.htm
https://www.britannica.com/topic/theory-of-production
https://www.investopedia.com/terms/w/welfare_economics.asp
https://www.investopedia.com/ask/answers/121514/what-are-major-
differences-between-monopoly-and-oligopoly.asp