Principles of Economics

This document discusses the principles of economics, including topics such as perfectly competitive markets, natural monopolies, oligopoly, and types of goods. It explains the characteristics of each market structure and their impact on pricing and output decisions. The document also explores the concept of socially efficient output and the effects of negative externalities in production.

Running head: PRINCIPLES OF ECONOMICS
Principles of economics
Name of the Student
Name of the University
Author’s Note

1PRINCIPLES OF ECONOMICS
Table of Contents
Answer 1..........................................................................................................................................2
Answer 2..........................................................................................................................................5
Answer 3..........................................................................................................................................6
Answer 4........................................................................................................................................11
References......................................................................................................................................13

2PRINCIPLES OF ECONOMICS
AR=MR
MC
Output
Price
Q
P
Answer 1
a) 1In perfectly competitive market, an entity is a price taker as other entities can easily enter
the market and manufacture the product, which is indistinguishable from other entity’s
commodities. Moreover, all the firms in perfectly competitive market sells homogenous
commodities and makes easy for them to enter the industry. These two conditions makes
it highly impossible for the entity to set the prices above market prices. However, this
makes it incredible for any entity to set its prices and turns them into price- takers. The
diagram below explains the reasons behind perfectly competitive firm as price taker.
Figure 1: Perfectly competitive firm is a price taker
Source: (As created by Author)
As the demand for the entity’s product in perfect competition is perfectly elastic,
the demand curve is drawn as horizontal line. As reflected in the figure above, based on
the firms MC (Marginal Cost), the output will be at Q where MR (Marginal
Revenue)=MC (Marginal Cost). The price takers mainly accept market price and sells
1 in Economicshelp.org, , 2019, <https://www.economicshelp.org/micro-economic-essays/marketfailure/negative-
externality/> [accessed 6 January 2019].

3PRINCIPLES OF ECONOMICS
Output
Price MC
AC
P MR=AR
E
A
B
Loss
Q
every unit at equal price where Average Revenue is equal to Marginal Revenue
(AR=MR).
b) The firm operating in perfectly competitive market makes loss in short run if average cost
(AC) exceeds average revenue (AR).2 This means that the entity is incurring losses as
each unit cost is declining short of price each unit of output. The diagram below shows
that the losses incurred by the firm is represented by the area ABPE. In this condition, the
entity might continue in producing or exit the market depending on the AVC (average
variable cost).
Figure 2: Perfectly competitive firm making short run loss
Source: (As created by Author)
3For maximizing profit in the perfectly competitive market, entities set marginal revenue
(MR) equals to marginal cost (MC). The diagram below reflects that the entity operating in
perfectly competitive market attains equilibrium at the point E because at this point both
2 K Case, R Fair & S Oster, Principles of economics, in .
3 H Daly, "A further critique of growth economics", in Ecological Economics, vol. 88, 2013, 20-24.

4PRINCIPLES OF ECONOMICS
Output
Price SMC
SAC
AR=MRP
E
D
C
Q
Economic
Profit
O
equilibrium conditions have been satisfied. Corresponding to the equilibrium point, the profit
maximizing output volume becomes OQ. The entity now attains revenue to extent of OPEQ
from the total output sale of OQ. Therefore, it incurs total production cost that is shown by
OCDQ. As revenue exceeds cost, the entity earns economic profit that is shown by the area
PEDC.
Figure 3: Perfectly competitive firm making economic profit in short run
Source: (As created by author)
` 4In the long run, the entities making abnormal profit would attract new entities in the
perfectly competitive market. This in turn would increase total supply in the industry and
thus reduce the market price. However, the new entities would stop entering the industry
once the existing entities attain zero economic profit. On the contrary, the entities making
losses in the long run might exit this market owing to not having the ability in competing
with other entities. This is in turn will enhance price in the industry. These entities would exit
4 N Mankiw, Essentials of economics, in , Australia, South-Western Cengage Learning, 2012.

5PRINCIPLES OF ECONOMICS
until other firms again make normal profit. Thus, all firms in the long run under perfectly
competitive market attain normal profit.
Answer 2
a) 5Natural monopoly arises when most efficient entities in the sector is one. This is a kind
of monopoly that exists owing to high start- up costs of doing business in particular
sector. A firm is called natural monopolist when it can supply the specific commodity or
service to the market at low unit cost than what other competing entities could attain.
However, the firms average cost (AC) declines over certain range of production, which
satisfies the market demand.
One example of natural monopoly is tap water. One firm providing water pipes
and sewers network as it involves high capital cost to set up national network of sewage
as well as pipe systems. For having two varied entities providing water would not make
any sense since AC can be high in comparison with one entity as well as one network.
However, there might be inconvenience of having two entities operate to set up water
pipes. This is explained in the figure below-
Figure 4: Natural monopoly
5 J Sloman, K Norris & D Garratt, Principles of economics, in .

6PRINCIPLES OF ECONOMICS
Source: ()
The above diagram shows that if an entity in water industry produces 10000 units, then it
might attain lowest AC at 9 pound. If in case there are three entities manufacturing 3000 units,
then they will have AC at 17 pound. Thus, optimal number of entities in this sector would be
one.
c) The profit maximizing monopoly firm is not always technically efficient as it produces
output that is less than output of minimum ATC (average total cost). X-Inefficiency
might arise as there is no competitive pressure of producing at minimum cost. In
particular, price that monopoly charges is higher than MC (marginal cost) of production
that violates efficiency condition where P=MC. A monopoly entity is inefficient as it has
market control and thus face negative slope demand curve. A monopolist might charge
high price prevents output and reduce welfare as price rise decreases consumer surplus.
Answer 3
a) One of the vital features of oligopoly is interdependence wherein each seller must be
cautious in respect of any action undertaken by competing entities. As there are less
sellers in the oligopoly market, if any entity makes change in price or the promotional
scheme, other entities in the sector must comply with it in order to remain competitive.
Therefore, every entity remains alert in others action and also plans counterattack in order
to escape turmoil. Moreover, change in price by one entity evokes reaction from other
entity operating in this market. Hence, there is interdependence among sellers in respect
of their price- output policies. For example, car market is mainly dominated by few

7PRINCIPLES OF ECONOMICS
Output
MC
P
Q
ARMR
Cost and Price
Output
Cost and price
MC
Q
P
Other entity
will follow if
price are cut
Firms will not follow
if price increase
entities. Change in vehicle by any single entity might induce other entities in making
changes in its respective vehicles.
b) The assumptions concerning rival responses underlying kinked demand curve are given
below-
 Rivals would match cut in price
 Rivals would ignore increase in product price.
One example is price war between the rival entities that happens under kinked demand
curve framework. The supermarket industry in UK is having price wars where the entities in the
market are attempting to take short – term benefit and gain additional market share. This is show
in the figure below-
Figure 5: Price war between rival firms
Source: (Author’s creation)

8PRINCIPLES OF ECONOMICS
Output
Price LMC
LACPm
Pp
AR
MR
Qm Qp
F
AR=MR
E
N
c) In the long run, perfect competition comes closer to monopolistic competition as freedom
of entry and exit permits the entity to enjoy normal profit. This is shown in the diagram
below-
Figure 6 : Long run equilibrium situation under monopolistic competition and perfect
competition
Source: (Author’s creation)
Long run equilibrium is attained at the point E where long run marginal cost
(LMC) equals to long run marginal revenue (LMR). The equilibrium output is obtained at
OQm, where AR (Average revenue) equals AC (Average cost). The entity attains normal
profit by selling OQm output at price OPm. A monopolistically competitive firm operates
to the left of minimum point of AC curve. As LRAC lies above AR curve, there occurs
no abnormal profit because the AC equals AR of product. 6Long run equilibrium under
perfect competition is attained at the point where MR=MC=AR=AC. Due to perfectly
6 "The Long-Run Equilibrium of the Firm under Perfect Competition", in Your Article Library, , 2019,
<http://www.yourarticlelibrary.com/economics/perfect-competition/the-long-run-equilibrium-of-the-firm-under-
perfect-competition/37115> [accessed 6 January 2019].

9PRINCIPLES OF ECONOMICS
elastic AR curve, tangency arises between AR and AC at minimum point of AC. This is
shown in the figure by dotted AR=MR curve by the competitive entity. Equilibrium is
achieved at the point F in which LMC=LMR=AR at lowest point of LAC. Thus, the
competitive output is obtained at OQp and corresponding price is OPp. Hence, it can be
seen that monopolistically competitive output is lesser than perfectly competitive output.
d) 7Under monopolistic competitive market, price of the product is higher than the price of
product under perfectly competitive market in long run as the firm under perfect
competition extends output up to that point where AC is lowest, which is that optimum
output in the perfect competition. This is shown in the figure below- The perfect
competitive entity is at equilibrium point M in which MC = MR. At the point, AR = AC
to LAC at the minimum point. The equilibrium price is OP and equilibrium output is
ON. in the monopolistic competition, entity is in equilibrium position at the point K in
which MC=MR. in this case, equilibrium price is OP and output is ON1.
Figure 7: monopolistic competition is superior than perfect competition
Source: ()
On the contrary, output under monopolistic competition is less than that under perfect
competition. In long run, equilibrium position in perfect competition occurs at MC=MR=
7 K Tyagi, "Chapter 2: Principles of Micro-Economics Part-III", in SSRN Electronic Journal, , 2013.

10PRINCIPLES OF ECONOMICS
AC=AR while equilibrium position under monopolistic competition occurs under
MC=MR. Hence, perfect competition is superior than monopolistic competition.
Answer 4
a) The three major types of goods are-
 Material and non- material-Material goods are tangible while non- material goods are
intangible. Examples of material goods-cloth, machines, cars and non- material goods
include- actors, doctors etc. Material good is divided into two types- economic and
non- economic. Economic goods are those that have price and its supply is less
relating to its demand. For example- scarce land and is able to produce commodities.
Non- economic goods are free goods that have any price or unlimited in supply. For
example- air, water.
 Intermediate goods-It is termed as input as the product sold by one entity to another
for resale. These goods are transformed to produce final goods. For example, cotton
to yarn.
 Final goods- These goods are not used for further manufacture but only for personal
consumption. For instance, water provided by corporation to industrial undertaking.
b) i) Profit maximizing level of output occurs when P= MC. For this firm operating under
perfect competition, profit maximizing level is 7units where P=MC.

11PRINCIPLES OF ECONOMICS
Output
Price
P1
P
Q Q1
S=MPC
MSC
D=MPC=MSB
Figure 8: Negative externality in production
Source: (Author’s creation)
The above diagram show that output is at Q1 where demand equals supply. This
is socially inefficient as at Q1, SMC>SMB. However socially inefficiency occurs where
SMC=SMB.
ii) Socially efficient output occurs when MSB equals to MSC. In this case, the firm’s
socially efficient output level is at 5 units where MSB=MSC=100.
iii) As the environment becomes less able in coping with extra amount of pollution.

12PRINCIPLES OF ECONOMICS
References
"The Long-Run Equilibrium of the Firm under Perfect Competition". in , , 2019,
<http://www.yourarticlelibrary.com/economics/perfect-competition/the-long-run-equilibrium-of-
the-firm-under-perfect-competition/37115> [accessed 6 January 2019].
Daly, H, "A further critique of growth economics.". in Ecological Economics, 88, 2013, 20-24.
Economicshelp.org, , 2019,
<https://www.economicshelp.org/micro-economic-essays/marketfailure/negative-externality/>
[accessed 6 January 2019].
Mankiw, N, Essentials of economics. in , Australia, South-Western Cengage Learning, 2012.
Sloman, J, K Norris, & D Garratt, Principles of economics. in .
Tyagi, K, "Chapter 2: Principles of Micro-Economics Part-III.". in SSRN Electronic Journal, ,
2013.