Unit #2 The Nature and Functions of Product Markets

  • UNIT# 2:  The Nature and Functions of Product markets

    The study of the nature and functions of product markets falls into four broad areas: supply and demand models, consumer choice, production and costs, and theory of the firm .

    A well-planned AP course requires an analysis of the determinants of supply and demand and the ways in which changes in these determinants affect equilibrium price and output . In particular, the course helps students make the important distinction between movements along the curves and shifts in the curves. The course also emphasizes the impact of government policies, such as price floors and ceilings, excise taxes, tariffs, and quotas on the free-market price and quantity exchanged. 

    The concepts of consumer surplus and producer surplus should also be introduced . Students are expected to comprehend and apply the concepts of elasticity, including calculating price, cross-price, income elasticities of demand, and the price elasticity of supply.

    The next area covered in the course is the theory of consumer choice . Students should gain an understanding of the basic postulates underlying consumer choice: utility, the law of diminishing marginal utility and utility-maximizing conditions, and their application in consumer decision-making and in explaining the law of demand . By examining the demand side of the product market, students learn how incomes, prices, and tastes affect consumer purchases . Here it is important that students understand how to derive an individual’s demand curve, how individual and market demand curves are related, and how the income and substitution effects explain the shape of the demand curve .

    The third area covers production and cost analysis both in the short run and in the long run . This section begins with an introduction of the short-run production function, describing the relationship between the quantity of inputs and the quantity of output. Within the context of the production function, students should understand average and marginal products as well as the law of diminishing marginal returns. Students learn the link between productivity and costs and examine the relationships among the short-run costs: total, average, and marginal. With an introduction of the concept of cost minimization and productive efficiency, this section also includes a discussion of long-run costs and an examination of economies and diseconomies of scale, as well as returns to scale.

    The fourth area covers the behavior of firms in different types of market structures . This section begins with the definition of profits, making the distinction between accounting and economic profits, and establishing the profit-maximizing rule, using marginal analysis. In covering perfect competition, the course focuses on determining short-run and long-run equilibrium, both for the profit-maximizing individual firm

    and for the industry, and on the equilibrium relationships among price, marginal and average revenues, marginal and average costs, and profits. Students should understand the adjustment process to long-run equilibrium.

    In considering the market behavior of a monopolist, students identify and examine the sources of monopoly power and understand the relationship between a monopolist’s demand curve and its marginal revenue curve. Students learn how a monopoly’s total revenue changes along its demand curve as price varies. Having learned the behavior of monopolies and perfect competition, students should compare a monopolist’s price, level of output, and profit with those of a firm operating in a perfectly competitive market. By paying particular attention to the concept of allocative efficiency, students learn how and why competitive markets achieve an efficient allocation of resources, whereas monopolists do not. The concept of deadweight loss is a good device to show the efficiency loss due to monopoly. The model of price discrimination provides another dimension of monopoly behavior that students need to learn and understand.

    In covering oligopoly, the course stresses the interdependency of firms and their tendency to collude or to form a cartel. With a simple payoff matrix, the basic game-theory model should be used to enhance a student’s understanding of the interdependent behavior of firms in an oligopolistic market and identification of dominant strategies and Nash equilibrium.

    Finally, the course considers the market structure of monopolistic competition and highlights the importance of product differentiation and the role of advertising in the behavior of firms. The course then proceeds to examine firm behavior in the short run and in the long run and the existence of excess capacity and its implication for efficiency.