REVIEW FINAL EXAM

The Price-Elasticity Coefficient and Formula

PRICE ELASTICITY OF DEMAND

Ed =

Percentage change in quantitydemanded of product X

Percentage change in priceof product X

Or equivalently…

Ed =change in quantity demanded of X

Original quantity demanded of X

Change in price of X Original price of X

Extreme CasesPRICE ELASTICITY OF DEMAND

Perfectly Inelastic Demand

Perfectly Elastic DemandP

0

P

0

D1

Ed = 0

D2Ed =

Q

Q

Q

P

D

When prices are low,

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

So is total revenue

Q

P

D

Total revenue riseswith price to a

point...TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

P

D

Total revenue riseswith price to a

point...

then declines

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Total Revenue Test

Q

P

D

Total revenue riseswith price to a

point...

then declines

InelasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

Q

P

D

Total revenue riseswith price to a

point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

InelasticDemand

Q

P

D

Total revenue riseswith price to a

point...

then declines

ElasticDemand

ElasticDemand

InelasticDemand

TR

Quantity Demanded

PRICE ELASTICITY & TOTAL REVENUE

InelasticDemand

UnitElastic

EconomicProfit

Implicit costs(including a

normal profit)

ExplicitCosts

Accountingcosts (explicit

costs only)

AccountingProfit

Ec

on

om

ic (

op

po

rtu

nit

y) C

os

ts

TOTAL

REVENUE

Profits to anEconomist

Profits to anAccountant

ECONOMIC COSTS

Law of Diminishing Returns

SHORT-RUN PRODUCTIONRELATIONSHIPS

Tota

l Pro

du

ct, T

P

Quantity of Labor

Ave

rag

e P

rod

uct

, AP,

an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

IncreasingMarginalReturns

Law of Diminishing Returns

SHORT-RUN PRODUCTIONRELATIONSHIPS

Tota

l Pro

du

ct, T

P

Quantity of Labor

Ave

rag

e P

rod

uct

, AP,

an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

DiminishingMarginalReturns

Law of Diminishing Returns

SHORT-RUN PRODUCTIONRELATIONSHIPS

Tota

l Pro

du

ct, T

P

Quantity of Labor

Ave

rag

e P

rod

uct

, AP,

an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

NegativeMarginalReturns

Algebraic Restatement of theUtility Maximization Rule

MU of product A

Price of A

MU of product B

Price of B=

UTILITY MAXIMIZING COMBINATION

8 Utils

$1

16 Utils

$2=

PRODUCTIVITY AND COST CURVES

Co

sts

(d

olla

rs)

Ave

rag

e p

rod

uct

an

dm

arg

inal

pro

du

ct

Quantity of labor

Quantity of output

MPAP

MCAVC

LONG-RUN PRODUCTION COSTSU

nit

Co

sts

Output

LONG-RUN PRODUCTION COSTS

Un

it C

ost

s

Output

LONG-RUN PRODUCTION COSTS

The long-run ATC just “envelopes”all of the short-run ATC curves.

Un

it C

ost

s

Output

LONG-RUN PRODUCTION COSTSU

nit

Co

sts

Output

long-run ATC

ECONOMIES ANDDISECONOMIES OF SCALE

• Labor Specialization• Managerial

Specialization• Efficient Capital• Other FactorsDiseconomies of ScaleConstant Returns to Scale

graphically presented...

ECONOMIES ANDDISECONOMIES OF SCALE

Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Constant returnsto scale

ATC decreases as Output increases

ATC is constant as Output increases

Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Diseconomiesof scale

Constant returnsto scale

ATC decreases as Output increases

ATC is constant as Output increases

ATC increases as Output increases

$200

150

100

50

0

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR

AVCATC

Economic Profit

$131.00

$97.78

MARGINAL REVENUE-MARGINAL COST APPROACH

Profit Maximization Position

$200

150

100

50

0

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR

AVCATC

Economic Profit

$131.00

$97.78

MARGINAL REVENUE-MARGINAL COST APPROACH

MR = MCOptimumSolution

Profit Maximization Position

$200

150

100

50

0

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR

AVCATC

$71.00

MARGINAL REVENUE-MARGINAL COST APPROACH

Short-Run Shut Down Point

Minimum AVCis the Shut-Down

Point

P

Q

S=MC

AVC

ATC

8

D

P

Q8000

D

S= MCs

IndustryFirm(price taker)

EconomicProfit

$111$111

SHORT-RUN COMPETITIVE EQUILIBRIUM

The Competitive Firm “Takes” itsPrice from the Industry Equilibrium

P

Q

S=MC

AVC

ATC

8

D

P

Q8000

D

S= MCs

IndustryFirm(price taker)

EconomicProfit

$111$111

SHORT-RUN COMPETITIVE EQUILIBRIUM

The Competitive Firm “Takes” itsPrice from the Industry Equilibrium

How about thelong-run?

Temporary profits and the reestablishmentof long-run equilibrium

S1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

MR

D1

An increase in demand increases profits…

MR

D1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

D2

EconomicProfits

S1

New competitors increase supply, and lowerprices decrease economic profits.

MR

D1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

D2

Zero EconomicProfits

S1

S2

Decreases in demand, losses, and the reestablishment of long-run equilibrium

S1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

D1

MR

A decrease in demand creates losses…

MR

D1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

D2

EconomicLosses

S1

MR

D1

MCATC

P

Q100

P

Q100,000

IndustryFirm(price taker)

$60

50

40

$60

50

40

PROFIT MAXIMIZATION IN THE LONG RUN

D2

Return to ZeroEconomic Profits

S1

S3

Competitors with losses decrease supply, andprices return to zero economic profits.

$200

150

100

50

0

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MRAVCATC

Economic Loss

$81.00$91.67

MARGINAL REVENUE-MARGINAL COST APPROACH

Loss Minimization Position

T

MONOPOLY REVENUES & COSTS

Do

llar

sD

oll

ars

$200

150

200

50

$750

500

250

MR

Elastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

DQ

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

TR

Q

MONOPOLY REVENUES & COSTS

Q

Do

llar

sD

oll

ars

$200

150

200

50

$750

500

250

TR

MR D

InelasticElastic

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18Q

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

A Monopolist will always operate on the Elastic Portion of the Demand Curve

Inelastic PortionMR is Negative

Profit Maximization Under Monopoly

D

MC

ATC

MR

$94

$122

Profit

MR = MC

ProfitPer Unit

OUTPUT AND PRICE DETERMINATION

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

eRemember the MR=MC Rule?

Profit Maximization Under Monopoly

D

MC

ATC

MR

$94

$122

Profit

MR = MC

ProfitPer Unit

OUTPUT AND PRICE DETERMINATION

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

What About

Loss Minimization?

Loss Minimization Under Monopoly

D

MCATC

MR

A

Pm

Loss

MR = MC

LossPer Unit

OUTPUT AND PRICE DETERMINATION

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

AVC

Qm

V

Since Pm exceeds AVC,the firm will produce

Loss Minimization Under Monopoly

D

MCATC

MR

A

Pm

Loss

MR = MC

LossPer Unit

OUTPUT AND PRICE DETERMINATION

Q

200

175

150

125

100

75

50

25

0 1 2 3 4 5 6 7 8 9 10

Pri

ce,

cost

s, a

nd

rev

enu

e

AVC

Qm

V

What are theEconomic Effectsof Monopoly?

Q

INEFFICIENCY OF PURE MONOPOLYP

DMR

S = MC

Pc

Pm

QcQm

At MR=MCA monopolistwill sell lessunits at ahigher pricethan incompetition

An industry in pure competitionsells where supply anddemand are equal

Q

INEFFICIENCY OF PURE MONOPOLYP

DMR

S = MC

Pc

Pm

QcQm

At MR=MCA monopolistwill sell lessunits at ahigher pricethan incompetition

Monopoly pricing effectivelycreates an income transfer from

buyers to the seller!

REGULATED MONOPOLY

Q

D

MR

MCATC

PP

rice

an

d C

ost

sMR = MC

Fair-Return Price

Socially-OptimumPrice

Qm Qf Qr

Dilemma of RegulationWhich Price?

Pm

Pf

Pr

D

MR

MC

P3 = A3

ATC

Pri

ce a

nd

Co

sts

Q3

Quantity

Long-Run EquilibriumPrice is Not= Minimum

ATC

Price MC

MONOPOLISTIC COMPETITIONAND EFFICIENCY

MONOPOLISTIC COMPETITIONAND EFFICIENCY

• Not Productively Efficient Minimum ATC

• Not Allocatively EfficientPrice MC

• Excess CapacityGraphically…

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High Low

Up

tow

n’s

Pri

ce S

trat

egy

RareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High Low

Up

tow

n’s

Pri

ce S

trat

egyRareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

GreatestCombined

Profit

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

y

RareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

IndependentActions

StimulateResponse

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

y

RareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

IndependentActions

StimulateResponse

Gravitatingto the

Worst Case

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

yRareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

CollusionInvites aDifferentSolution.

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

yRareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

CollusionInvites aDifferentSolution.

OLIGOPOLY BEHAVIORA Game-Theory Overview

High

Low

High LowU

pto

wn

’s P

rice

Str

ateg

y

RareAir’s Price Strategy

BA

DC

$12 $15

$12 $6

$6 $8

$8$15

But, theincentiveto cheat

is very real.

CollusionInvites aDifferentSolution.

Non-LaborCosts

LaborCosts

PURELY COMPETITIVE LABORMARKET EQUILIBRIUM

Labor Market

S

D = MRP( mrp’s)

Wc

(1000)

Individual Firm

S = MRC

d = mrp

Wc

Quantity of Labor

Wa

ge

Ra

te (

do

llars

)

Quantity of Labor

($10)

(5)

$10 $10 $10 $10 $10 $10

IncludesNormalProfit

Non-LaborCosts

LaborCosts

IncludesNormalProfit

Labor Market

S

D = MRP( mrp’s)

Wc

(1000)

Individual Firm

S = MRC

d = mrp

Wc

Quantity of Labor

Wa

ge

Ra

te (

do

llars

)

Quantity of Labor

($10)

(5)

$10 $10 $10 $10 $10 $10

Marginal ResourceCost (MRC) will be

constant and equal toresource price(the wage rate)

PURELY COMPETITIVE LABORMARKET EQUILIBRIUM

Wa

ge

Ra

te (

do

llars

)S

Quantity of Labor

MONOPSONISTICLABOR MARKET

In monopsonyMRC lies above

the supply curve.

Wa

ge

Ra

te (

do

llars

)

MRP

S

Wm

Quantity of Labor

MRC

Qm

MONOPSONISTICLABOR MARKET

MRP = MRC

Qm units oflabor hired

Wa

ge

Ra

te (

do

llars

)

MRP

S

Wm

Quantity of Labor

MRC

Wc

Qm Qc

The competitivesolution would

result in a higherwage and greater

employment.

MONOPSONISTICLABOR MARKET

P

Q

$ 9 7

5

3

1

0 1 2 3 4 5

DC

S

OPTIMAL AMOUNT OF A PUBLIC GOOD

Yields theoptimum amount

of the public good

MB = MC

20 40 60 80 100

100

80

60

40

20

0

Percent of Families

Per

cen

t o

f In

com

e Perfect Equality

CompleteInequality

Lorenz Curve (actual distribution)

Area betweenthe lines shows

the degree ofincome inequality

THE LORENZ CURVE

Lorenz curveafter taxes and

transfers