Principles of Economics

This document provides study material and solved assignments on Principles of Economics. It covers topics such as perfectly competitive market, natural monopoly, oligopoly, and more. The document explains the characteristics and equilibrium conditions of different market structures and discusses the concepts of efficiency and profit maximization. It also explores the classification of goods and the levels of output in competitive and socially efficient scenarios.

Running head: PRINCIPLES OF ECONOMICS
PRINCIPLES OF ECONOMICS
Name of the Student
Name of the University
Author Note

1PRINCIPLES OF ECONOMICS
Table of Contents
Answer 1:...................................................................................................................................2
a..............................................................................................................................................2
b..............................................................................................................................................3
Answer 2:...................................................................................................................................4
a..............................................................................................................................................4
b..............................................................................................................................................5
Answer 3:...................................................................................................................................7
a..............................................................................................................................................7
b..............................................................................................................................................7
c..............................................................................................................................................8
d..............................................................................................................................................9
Answer 4:.................................................................................................................................10
a............................................................................................................................................10
b............................................................................................................................................10
References:...............................................................................................................................12

2PRINCIPLES OF ECONOMICS
S
D
D1
Price Price
P
O
Output Output
Market Price taker firm
Q
Answer 1:
a.
In a perfectly competitive market, firms are price taker as none of them can change
the market price. New firms can enter into the market without any restrictions and each of
them sells similar products. Therefore, each firm possesses a very small portion of the entire
market. According to the characteristic of this market, each firm and each consumer has
perfect knowledge of others (Cowell, 2018). If one of them change price then other firms can
also change accordingly in order to earn higher profit. Therefore, market price remains stable
at equilibrium level. The following diagram represents this situation accordingly.
Figure 1: Price taker firm in a perfectly competitive market
The above figure represents the equilibrium condition of a perfectly competitive
industry. The market receives its equilibrium price when demand and supply equate with
each other. At this price, each firm set their demand curve, which is a horizontal straight line.

3PRINCIPLES OF ECONOMICS
AC
E
Market Firm
Price Price
O
Output Output
P1
P0
C
Q2Q1
D
S1
S2
MC
MR0
MR1
b.
In short-run, a perfectly competitive firm incur loss or earn economic profit.
However, this firm earns only normal profits in long-run. This happens as firms can enter or
exit freely. In short run, firms may earn economic profit and this further can attract others to
enter into the market gradually (Currie, Peel & Peters, 2016). On the contrary, firms can incur
loss in short run and this further may lead some existing firms to exit from the market. As a
result, those firms, who earn normal profit, remain into the market.
Figure 2: Short-run and long-run condition of a perfectly competitive firm
The above figure represents both short-run and long-run condition of a perfectly
competitive firm. Initially, the firm makes short-run loss by CP1 amount. In this situation, the
supply curve of the firm is S1. However, the firm tends to decrease its supply to avoid loss.
As a result, the curve shifts leftward from S1 to S2. Therefore, in long-run the firm will earn
normal profit only at P0 price, where marginal cost, average cost and marginal revenue
equate with each other. Some firms may leave the market to avoid such losses. On the

4PRINCIPLES OF ECONOMICS
contrary, a firm may increase its supply or other firms may enter into the market for
increasing supply when existing firms enjoy economic profit in short-run.
Answer 2:
a.
The situation “natural monopoly” occurs when s firm performs in the entire industry.
Due to higher fixed costs, it becomes impossible for other firms to enter into the market for
conducting the same business. Moreover, natural monopoly may arise due to unique raw
materials or technology that more than one firm cannot use. The firm that operates in this
situation is called natural monopolist (Lim & Yurukoglu, 2018). If other firms enter into the
market to compete then costs and prices will increase significantly. This situation can be
described with a suitable diagram where the average cost curve decreases continuously as
firm produces more output. At each level of output, the firm experiences increasing returns to
scale. One of the chief examples of natural monopoly is British Telecom that builds and
maintains the telecommunications network of the United Kingdom.

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LRAC
Economies of scale
Costs
Output
Figure 3: Natural Monopoly
The diagram represents the condition of a natural monopoly. Due to increasing return
to scale, the long run average cost (LRAC) decreases as production increases. As production
increases, the economies of scale decreases and this further helps the economy to produce
efficiently.
b.
To evaluate the performance of a firm, the concept of efficiency is required. This
concept also measures the performance of the market as well entire economy. Technical
efficiency means how much output a firm can produce by using a given input. This input can
be either a machine or a worker or combined of more two inputs (Stiglitz & Rosengard,
2015). The firm can maximise technical efficiency through maximising output when inputs of
the firm is given. Therefore, it can be said that a profit maximising monopoly is technically
efficient. The following figure represents a profit maximising condition of a technically
efficient monopolist.

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MR
Costs and revenue
Output
AR
O
ATC
MC
P
C
Q
Figure 4: profit maximising condition of a technically efficient monopolist
The above diagram represents profit maximising condition of a firm when it is
technically efficient. Through using limiting inputs, the firm maximises its output efficiently
and consequently earns excess profit. The difference between P and C represents excess
profit that the monopolist earns in technically efficient way.

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Answer 3:
a.
In a market, oligopoly occurs when limited number of firms sell homogeneous
product. This market structure has two types, which are collusive and non-collusive. The
chief characteristic of this type of market is mutual interdependency among firms
(Matsumura & Okamura, 2015). This happens as each firm considers the reaction of rival
firms at the time of implementing price and output policy. This process makes a firm highly
dependent on others.
The auto industry can be considered as an oligopoly market, where interdependence
can be observed among various automobile manufacturing companies, such as Ford, General
Motors and Chrysler. Ford set its price and output strategy considering the reaction of GMC
and Chrysler.
b.
In a oligopoly market, a rival’s responses regarding the kinked demand curve depends
on some assumptions. Firstly, rivals will reduce price level and responses with the price cut
strategy. Secondly, rivals ignore the strategy of price increase. If one firm increases prices for
its product, other firms will not follow this (Head & Spencer, 2017). From these assumptions
it can be said that oligopolistic firms can protect and maintain their market share. Rivals firms
react asymmetrically with the strategy of price changes of other firms.

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MR
Costs and revenue
Output
AR
O
ATCMC
P
C
Q
c.
The long-run monopolistic competitive market:
Figure 5: Monopolistic Competitive Market in Long-run
The above figure represents the long-run condition of a monopolistically competitive
market. In this market, the firm earns normal profit only during long-run as other firms can
enter or exit from the market freely (Bertoletti & Etro, 2016). This characteristic can be
observed in a perfectly competitive market as well. However, some features of a monopoly
firm can also be observed. For this, the demand curve slopes downward.

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Price, Costs
Output
O
P MR=AR
AC
MC
Q
The long-run perfectly competitive market:
Figure 6: Perfectly Competitive Market in Long-run
The above figure represents a perfectly competitive market in representing the long-
run situation. In this condition, no firm can earn economic profit or cannot incur any losses
(Hayek, 2016). Each firm earns normal profit only as marginal revenue becomes equal with
marginal cost and average cost curves.
d.
The monopolistically competitive firm can be superior to a perfectly competitive firm
if the former one can earn excess profit. As the firm experiences a downward slopping
demand curve, it can charge any price like a monopolistic firm. On the contrary, the perfectly
competitive firm cannot earn economic profit, as it acts as a price-taker. However, the
monopolistically competitive firm can be inferior to a perfectly competitive firm as well
(Mahoney & Weyl, 2017). This is because firms under monopolistically competitive market

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incur losses. However, a perfectly competitive firm cannot experience such possibilities, as it
cannot influence market price.
Answer 4:
a.
Three types of goods classified by Economists are private goods, public goods and
club goods. Each type of goods has some characteristics considering two key concepts rivalry
and excludability. Private goods are rival and excludable by nature. This means only one
consumer consumes a private good. An example of this type of good is foods (Benson, 2017).
Public goods are non-excludable as well as non-rival. This implies many consumers can
purchase this item at the same time. Public Park is an example of public good. Club-goods,
on the contrary, have the nature of both private good and public good. This type of goods is
excludable though non-rival by nature. Cable television can be considered as club goods.
b.
i) The profit maximising level of output of the competitive firm is 7. At this level of
output, price per unit of output becomes equal with marginal private costs of that firm (Van
Oort, 2017). According to the concept, a competitive firm can maximise its profit when
marginal cost equates with marginal revenue.
ii) The socially efficient level of output is 5. At the level, marginal social benefit (MSB)
becomes equal with marginal social costs.
iii) The marginal pollution costs increase as the firm produces products, which create
negative externalities. According to the cost theory, production cost increases at a decreasing
rate then reaches to minimum point and then starts to increase at an increasing rate (Kaplan &

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Menzio, 2016). This implies that after a certain level of product, the starts to produce
pollution by large amount.

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References:
Benson, B. L. (2017). Are Roads Public Goods, Club Goods, Private Goods, or Common
Pools?. In Explorations in Public Sector Economics (pp. 171-213). Springer, Cham.
Bertoletti, P., & Etro, F. (2016). Monopolistic competition when income matters. The
Economic Journal, 127(603), 1217-1243.
Cowell, F. (2018). Microeconomics: principles and analysis. Oxford University Press.
Currie, D., Peel, D., & Peters, W. (Eds.). (2016). Microeconomic Analysis (Routledge
Revivals): Essays in Microeconomics and Economic Development. Routledge.
Hayek, F. A. (2016). The meaning of competition. Econ Journal Watch, 13(2), 360-373.
Head, K., & Spencer, B. J. (2017). Oligopoly in international trade: Rise, fall and
resurgence. Canadian Journal of Economics/Revue canadienne d'économique, 50(5),
1414-1444.
Kaplan, G., & Menzio, G. (2016). Shopping externalities and self-fulfilling unemployment
fluctuations. Journal of Political Economy, 124(3), 771-825.
Lim, C. S., & Yurukoglu, A. (2018). Dynamic natural monopoly regulation: Time
inconsistency, moral hazard, and political environments. Journal of Political
Economy, 126(1), 263-312.
Mahoney, N., & Weyl, E. G. (2017). Imperfect competition in selection markets. Review of
Economics and Statistics, 99(4), 637-651.
Matsumura, T., & Okamura, M. (2015). Competition and privatization policies revisited: the
payoff interdependence approach. Journal of Economics, 116(2), 137-150.

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Stiglitz, J. E., & Rosengard, J. K. (2015). Economics of the public sector: Fourth
international student edition. WW Norton & Company.
Van Oort, F. G. (2017). Urban growth and innovation: Spatially bounded externalities in the
Netherlands. Routledge.