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Thinkwell’s Microeconomics

THINKWELL’S MICROECONOMICS NOTES CHAPTER 1: INTRODUCTION TO ECONOMIC THINKING Basic Economics Ideas Defining Economics 1 Understanding the Concept of Value 2 Using Graphs Using Graphs to Understand Direct Relationships 4 Plotting a Linear Relationship Between Two Variables 5 Changing the Intercept of a Linear Function 7 Understanding the Slope of a Linear Function 8 Advanced Graphical Concepts Understanding Tangent Lines 10 Working with Three Variables on a Graph 12 Production Possibilities Understanding the Concept of Production Possibilities Frontiers 13 Understanding How a Change in Technology or Resources Affects the PPF 15 Deriving an Algebraic Equation for the Production Possibilities Frontier 17 Comparative Advantage Defining Comparative Advantage With the Production Possibilities Frontier 19 Understanding Why Specialization Increases Total Output 22 Analyzing an International Trade Using Comparative Advantage 24 CHAPTER 2: UNDERSTANDING MARKETS Demand Determining the Components of Demand 27 Understanding the Determinants of Demand 29 Understanding the Basics of Demand 31 Analyzing Shifts in the Demand Curve 33 Changing Other Demand Variables 34 Deriving a Market Demand Curve 37 Supply Understanding the Determinants of Supply 39 Deriving a Supply Curve 41 Understanding a Change in Supply vs. a Change in Quantity Supplied 43 Analyzing Change in Other Supply Variables 44 Deriving a Market Supply Curve from Individual Supply Curves 46 Equilibrium Determining a Competitive Equilibrium 47 Defining Comparative Statics 49 Classifying Comparative Statics 50 Elasticity Defining Elasticity 52 Calculating Elasticity 54 Applying the Concept of Elasticity 56 Identifying the Determinants of Elasticity 58 Understanding the Relationship Between Total Revenue and Elasticity 59

Interfering With Markets Understanding How Price Controls Damage Markets 62 Understanding the Problem of Minimum Wages in Labor Markets 64 Understanding How an Excise Tax Affects Equilibrium 66 Agriculture Economics Examining Problems in Agricultural Economics 68 CHAPTER 3: CONSUMER CHOICE AND HOUSEHOLD BEHAVIOR Utility Theory Understanding Utility Theory 71 Finding Consumer Equilibrium 72 Budget Constraints and Indifference Curves Constructing a Consumer's Budget Constraint 75 Understanding a Change in the Budget Constraint 77 Understanding Indifference Curves 79 Consumer Optimization Locating the Consumer's Optimal Combination of Goods 82 Understanding the Effects of a Price Change on Consumer Choice 85 Deriving the Demand Curve 86 CHAPTER 4: PRODUCTION AND COSTS The Basics of Production Understanding Outputs, Inputs, and the Short Run 88 Explaining the Total Product Curve 89 Drawing Marginal Product Curves 93 Understanding Average Product 95 Relating Costs to Productivity 97 Variable Costs Defining Variable Costs 98 Graphing Variable Costs 99 Graphing Variable Costs Using a Geometric Trick 101 Marginal Costs Defining Marginal Costs 103 Deriving the Marginal Cost Curve 105 Understanding the Mathematical Relationship Between Marginal Cost and Marginal Product 108 Average Costs Defining Average Variable Costs 111 Understanding the Relationship between Average Variable Cost and Average Product of Labor 112 Understanding the Relationship between Marginal Cost and Average Variable Cost 114 Total Costs Defining and Graphing Average Fixed Cost and Average Total Cost 116 Calculating Average Total Cost 118 Putting the Cost Curves Together 120 Long-Run Production and Costs Defining the Long Run 123

Determining a Firm's Return to Scale 125 Understanding Short-Run and Long-Run Average Cost Curves 127 Understanding the Difference Between Movement Along a Cost Curve and a Shift in a Cost Curve130 Isocost/Isoquant Analysis Constructing Iso-Cost Lines 131 Understanding Isoquants 134 Finding the Cost- Minimizing Combination of Capital and Labor 136 CHAPTER 5: PERFECT COMPETITION The Basic Assumptions of Competitive Markets Understanding the Role of Price 139 Understanding Market Structures 140 Finding Economic and Accounting Profit 142 Calculating Profit and Loss Finding the Firm's Profit-Maximizing Output Level 144 Proving the Profit-Maximizing Rule 147 Calculating Profit 148 Calculating Loss 149 Finding the Firm's Shut-Down Point 151 Market Supply Deriving the Short-Run Market Supply Curve 153 Relating the Individual Firm to the Market 156 Examining Shifts in the Short-Run Market Supply Curve 159 Deriving the Long-Run Market Supply Curve 160 Competitive Firms' Responses to Price Changes Examining the Firm's Long-Run and Short-Run Adjustments to a Price Increase 163 CHAPTER 6: OTHER MARKET MODELS Monopolies Defining Monopoly Power 165 Defining Marginal Revenue for a Firm with Market Power 167 Determining the Monopolist's Profit-Maximizing Output and Price 169 Calculating a Monopolist's Profit and Loss 171 Graphing the Relationship between Marginal Revenue and Elasticity 173 The Social Cost of Monopoly Determining the Social Cost of Monopoly 175 Calculating Deadweight Loss 177 Understanding Monopoly Regulation 179 Oligopoly Understanding the Kinked-Demand Curve Model 182 Monopolistic Competition Defining Monopolistic Competition 184 Understanding Pricing and Output Under Monopolistic Competition 186 Understanding Monopolistic Competition as a Prisoner's Dilemma 188 CHAPTER 7: RESOURCE MARKETS

The Derived Demand for Labor Deriving the Factor Demand Curve 189 Deriving the Least-Cost Rule 191 Analyzing the Labor Market 193 Monopsony Understanding Labor Market Power and Marginal Factor Cost 196 Capital Markets Analyzing Capital Markets 197 CHAPTER 8: MARKET FAILURES Overview of Market Failures Understanding Market Failures 199 Public Goods and Public Choice Defining Public Goods 201 Analyzing the Tax System 203 Understanding Public Choice 205 Uncertainty Understanding Expected Value, Risk, and Uncertainty 207 Understanding Asymmetric Information as an Economic Problem 209 Understanding Moral Hazards in Markets 211 Externalities Defining Externalities 212 Explaining How to Internalize External Costs 214 Explaining How to Internalize External Benefits 216 Solutions to Externalities Finding a Market Solution to External Costs 218 Finding a Negotiated Settlement to an External Cost 221 Applying the Coase Theorem 223 CHAPTER 9: INTERNATIONAL TRADE The Basics of Open Economies Determining the Difference Between a Closed Economy and an Open Economy 224 Understanding Exports in an Open Economy 226 Analyzing a Change in Equilibrium in an Open Economy 227 CHAPTER 10: EVALUATING MARKET OUTCOMES Normative Economics Measuring the Benefits of Consumption 229 Using the Demand Curve as a Measure of Benefit 231 Calculating Total Economic Value Quantifying Benefit 232 Quantifying Cost 234 Determining Total Social Cost 235 Understanding Economic Value 236 Consumer and Producer Surplus

Understanding Producer and Consumer Surplus 238 Calculating Total Economic Value 239 Market Interference and Economic Value Understanding the Effects of Price Control 241 Understanding How Price Controls Destroy Economic Value 243 Evaluating the Effects of an Excise Tax 245 Assessing the Effect of an Excise Tax on Economic Value 247 Understanding How a Tax Can Create Deadweight Loss 249 International Trade and Economic Value Evaluating the Gains from International Trade 250 Understanding the Effects of Tariffs on Consumer and Producer Surplus 252

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www.thinkwell.com [email protected] Copyright 2001, Thinkwell Corp. All Rights Reserved. Microeconomics_notes –rev 06/28/2001

Defining Economics

Ä Economics is the study of rational choice under conditions of scarcity.

Ä Opportunity cost is the best alternative that you give up when you make a choice.

Remember that scarcity is an imbalance between what people want and what is freely available. The chart on the left explains the difference between "scarce" and "not scarce." The reason that breathable air and livable space are scarce is that people want those things. The reason that garbage is not scarce is that people do not want garbage.

Rational choice means people making calculated, self -interested choices after weighing the costs and benefits of those choices. A rational agent chooses the action that is most self -satisfying.

All choices come with a cost. The real cost of choosing something is not the money you pay to get it. The real cost is the value of the next best alternative that you gave up to make the choice you did. This cost is called the opportunity cost.

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Understanding the Concept of Value

Ä A second definition of economics is the study of the creation and distribution of

value.

Ä Value is the difference between the benefit of an activity and its cost. Ä Dollars are the yardstick used to measure value.

Economic value is created when the benefits of an activity are greater than the costs of the activity. This relationship is analogous to profits in a business in which the revenues that the business gets for selling products are greater than the costs incurred in making the products.

A trade creates economic value for you if you can trade something that you have for something that you like better.

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In determining value, you can measure the benefits and the cost in dollars. The total cost is the opportunity cost because you are giving up the next best alternative to get what you want. In the graphic on the left the opportunity cost for a baker to make bread includes not only the dollar costs of the ingredients, the labor, the resources used, and the financial capital, but also the baker's entrepreneurship skills.

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Using Graphs to Understand Direct Relationships

Ä A scatter diagram is a collection of points on a graph showing the observed relationship between two variables. Each point represents an observation.

Ä A direct relationship indicates that the two variables move in the same direction; in other words, when one variable increases, the other also increases.

Ä A positive slope of a line plotted on a scatter diagram indicates a direct relationship

between the variables.

In graphing a set of observations, put one variable on each axis. In the example on the left the economist is interested in studying the relationship between consumers’ incomes and their consumption of goods and services. Plot income on the horizontal, or x-axis, and consumption on the vertical, or y-axis. Each observation is one point on the plane. For example the point on the left shows a household with an income of $30,000 and consumption of $40,000.

A scatter diagram is simply a diagram of all the observations. In the scatter diagram on the left each black dot represents the income and consumption combination for one household. If you fit a line in the diagram, you can observe the nature of the relationship. At this point you do not need to know how the line is fitted, but you should be able to see a direct relationship between the variables as represented by the line. The line on the left shows that as household income increases, consumption also increases, a direct relationship.

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Plotting a Linear Relationship Between Two Variables

Ä To plot a linear relationship between two variables, use the algebraic formula for a straight line in a plane: y = a + b(x).

Ä The formula for the slope of a line is the change in the y-axis variable divided by the change in the x-axis variable, called rise over the run.

In economics, you can plot a simple demand curve—the relationship between the price of a good and the quantity a consumer wants to buy at each price. In this example the demand curve can be plotted from a table showing how many hamburgers Bob would buy each week at various prices. The relationship described is a linear relationship between two variables because the plotted line is straight.

From algebra, recall that the formula for a straight line is y = a + b(x), where y is the price, a is the intercept on the vertical axis, b is the slope of the line, and x is the quantity. This graph shows a behavioral relationship because it describes Bob’s consumption behavior.

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The intercept of the line on the y-axis is the price at which Bob buys zero hamburgers. The slope describes Bob’s behavior when the price changes. It means that Bob increases his consumption by one hamburger for every $.50 decrease in price. You determine the slope by dividing the change in the y variable by the change in the x variable between any two points, or rise/run.

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Changing the Intercept of a Linear Function

Ä When there is a change in the consumer’s income, there is a whole new price/quantity relationship.

Ä A change in income causes a parallel shift in a demand curve. The slope remains the same but the intercept changes.

In this example, assume that Bob’s income increases from $500 per week to $600 per week. The old demand curve represents the old income level. At his new income, Bob will demand more hamburgers per week at each price. You plot a new demand curve for Bob’s new consumption behavior.

You can call this new demand curve D'. Note on the left that the slope of D' is the same as the slope of D. The only thing that has changed is the intercept.

Bob’s income may decrease to $400 per week. In that case he would change his consumption behavior and buy fewer hamburgers per week at every price. You can plot his new demand curve and call it D'', as seen on the left. Once again, the slope is the same. Only the intercept has changed, and the demand curve shifts down parallel to the original.

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Understanding the Slope of a Linear Function

Ä The slope of a linear function shows the change in one variable when the related variable changes.

Ä Slopes of the same function can change when the units of measurement change.

Ä Economists prefer to use a percentage-based measurement called elasticity as a measure of price sensitivity.

To determine the slope of a linear function, find two points on the function. Using these two points, divide the change in the y-axis variable by the change in the x-axis variable. This calculation is “rise over the run” or “rise divided by the run.” In this example, the change in the y variable is the change in the price between two points and the change in the x variable is the change in the quantity of hamburgers. The slope is -.50, meaning that for every $.50 fall in the price of hamburgers, the consumer buys one additional hamburger.

The second demand curve is much flatter. You calculate the slope in the same way as above. The flatter demand curve indicates a much greater sensitivity to price than the one above.

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If Bob’s weekly demand for hamburgers changes for some reason, he might become more price-sensitive than he was before. The slope of D is -.50, meaning that it takes a $.50 fall in the price to get him to buy one more per week. The slope of D' is -.10,meaning that it takes only a $.10 fall in price to get him to buy another hamburger per week.

Pay careful attention to the units of measurement. Changing the units on either scale can drastically change the slope. In the example on the left, the vertical axis changes from dollars to cents and the slope decreases. For this reason economists prefer a measurement called elasticity to measure a consumer's sensitivity to price changes. Elasticity is measured in percentage changes in each variable.

Note in this example that a change in units of measurement from dollars to cents changes the slope of the same demand curve. Use of elasticity, or percentage changes, would more accurately measure the consumer's sensit ivity to price changes.

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Understanding Tangent Lines

Ä A nonlinear relationship is a relationship between two variables that changes over the range of the variables' values.

Ä The slope of a nonlinear function changes at every point on it, reflecting the

changing relationship between the variables.

Ä A tangent line is a straight line that touches a nonlinear curve at any point.

If a relationship between two variables is not linear, the slope changes at different points on the curve. These variables are said to have a nonlinear relationship. To calculate the slope exactly at a single point, you will have to use calculus to take the limit. If you use the "rise over run" calculation between two points, as with a linear relationship, the slope will change at every point. For example, on the left, between output levels of four TVs and sixteen TVs, the slope is six.

Note that if you choose different points nearer the bottom of this total product curve, the slope becomes flatter. Between output levels of four TVs and nine TVs, the slope is five.

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You must use calculus to find the slope of a curvilinear line at any point. At the point you are interested in, the slope of the curve equals the slope of a tangent line at that point. On the left, if you use calculus and find the slope of the tangent line at the output level of four TVs, the slope is four. The important point is that the slope of a nonlinear function changes over the curve.

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Working with Three Variables on a Graph

Ä An isoquant is a curve showing all combinations of two variables that can be found

while holding the values of a third variable constant.

A way to represent three variables on a graph is to hold one of the variables constant and plot combinations of the other two variables. In the example on the left, the variables are latitude, longitude, and altitude. Each curve in the diagram represents a different altitude. The bottom isoquant represents all combinations of latitude and longitude at an altitude of 1000 feet; the next curve represents all combinations of latitude and longitude at 2000 feet. The curves are called isoquants, meaning "the same quantity.” Each shows all combinations of latitude and longitude at the same altitude.

To summarize, you can create an isoquant map to show three dimensions in two-dimensional space. Two dimensions are represented on the axes; the third dimension is represented as the numbers on the isoquant lines. On the left, each curve represents a single altitude level; the points on each curve represent the possible combinations of latitude and longitude for the specific altitude.

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Understanding the Concept of Production Possibilities Frontiers

Ä Efficiency means making the largest output with the limited resources available. Ä Production possibilities frontier (PPF) is a graph showing the various

combinations of output that an economy can produce with its available resources and its given technology.

Ä The production possibilities frontier shows the opportunity cost of producing goods in an economy.

You can more easily understand the concept of a production possibilities frontier (PPF) if you assume that your economy produces only two goods. With a fixed amount of resources and a fixed technology, the PPF answers the question of what is the maximum amount of output that the economy can produce. The maximum amount of production represents the maximum efficiency in the use of the limited resources.

In this example, your economy could produce 80 bushels of wheat and zero bushels of rice, or it could produce 100 bushels of rice and zero bushels of wheat. Other combinations on the curve are also possible and efficient.

Because of scarcity of resources, combinations outside the frontier, such as point S, are not obtainable. Combinations inside the curve, such as point U, are obtainable but are an ineffic ient use of resources.

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The PPF shows the opportunity cost of producing an economy’s products. The cost of producing rice is the wheat that you have to give up to produce it. At any point on the PPF, divide the change in wheat production by the change in rice production. In this example, you have to give up 2 bushels of wheat to produce the first 20 bushels of rice. Therefore the opportunity cost is one-tenth bushel of wheat for one bushel of rice.

The opportunity cost changes as you move down the PPF. At the other end, the opportunity cost of producing more rice is much higher in terms of wheat given up. Here you have to give up 1.9 bushels of wheat to get an additional bushel of rice. Once again, divide the change in wheat by the change in rice production. This procedure is sometime called dividing the rise (the change along the vertical axis) by the run (the change along the horizontal axis).

The slope of the PPF gives you the opportunity cost of producing one good in terms of the other good. It is concave and downward sloping, meaning that the opportunity cost of producing rice is increasing. The reason that the cost is increasing is that not all resources are equally suitable for producing rice and wheat. If you want to produce more rice, you may have to use drier land that would be more suitable for wheat; therefore yields would go down.

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Understanding How a Change in Technology or Resources Affects the PPF

Ä An outward shift in the production possibilities frontier (PPF) indicates an expansion in the economy caused by a change in technology or an increase in resources.

Ä An individual production shift in the PPF means that a change in technology or resources affects production of each product in different ways, creating a skewed shift.

Ä An inward shift in the PPF means that the production of both goods decreases because of a change in resources or technology.

Any movement along the PPF represents the economy’s choice about the relative amounts of each product to produce. It represents the opportunity cost of producing each in terms of the other; that is, how much of one you have to give up to get more of the other. The PPF on the left illustrates the opportunity cost of wheat in terms of rice (or rice in terms of wheat).

An outward shift represents an expansion of the production possibilities of the economy; an inward shift represents shrinkage in the production possibilities of the economy. Both of these are caused by a change in either the resources or the technology affecting production of both products. A skewed shift indicates that the change in technology or resources affects the production of each of the products in different ways, as in the far right box on the left.

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The production possibilities frontier (PPF) does not say anything about the demand for either of the products. It only addresses the supply side of the economy. In order to determine demand for the products, you will have to study consumer choice theory in economics. In a market economy, the consumer makes all the demand choices.

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Deriving an Algebraic Equation for the Production Possibilities Frontier

Ä The algebraic formula for a production possibilities frontier (PPF) shows the opportunity cost of one good in terms of the other.

Ä The reciprocal of the opportunity cost shows the opposite—the opportunity cost of the second good in terms of the first one.

Ä Concave PPFs show increasing opportunity costs. Straight-line PPFs show constant

opportunity costs.

Bernie’s PPF on the left tells us his opportunity cost of scrubbing a room in terms of how many rooms he cannot sweep. You determine this by measuring the slope, the rise divided by the run. In this case, the slope throughout the PPF is –2, meaning that in order to scrub one room, he cannot sweep two rooms. Review: The slope is "rise/run." Using the endpoints, it is 6/3 = –2. The coefficient is negative because of the inverse relationship.

By the reciprocal rule, you can reverse the axes and determine the opportunity cost of the other good. The intercepts of Bernie’s PPFs indicate the maximum amounts of sweeping and scrubbing that he could do, as shown on the vertical axes. The slope is the opportunity cost of getting more of what’s on the horizontal axis in terms of what’s on the vertical. In the example on the left, Bernie's opportunity cost of scrubbing a room is 2 swept rooms; his opportunity cost of sweeping one room is 1/2 a scrubbed room.

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Bernie’s PPF is a straight line, meaning that his resources are equally suited for either sweeping or scrubbing. His opportunity costs are constant. A PPF that is concave (far left box) indicates increasing opportunity costs. Increasing opportunity costs mean that not all resources are equally suited for the production of both goods.

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Defining Comparative Advantage with the Production Possibilities Frontier

Ä A producer has an absolute advantage in the production of a good or service when that producer can produce the service using fewer resources than other producers.

Ä A producer has a comparative advantage in the production of a good or service when that producer can produce the good or service with a lower opportunity cost.

An absolute advantage in production means that you can produce a product with fewer resources than someone else can. Anne has an absolute advantage in both sweeping and scrubbing because she can do each in less time than Bernie can.

Anne’s production possibilities schedule shows that she has a different opportunity cost than Bernie does. Her opportunity costs are one for both sweeping and scrubbing. She gives up one room swept for one room scrubbed and vice versa. Her opportunity cost for both services is always one.

Bernie’s opportunity cost of sweeping is ½ a scrubbed room; Anne’s opportunity cost of sweeping is 1 scrubbed room. Therefore Bernie has a lower opportunity cost for sweeping; he has to give up less. He has a comparative advantage in sweeping. The coefficient in front of the second term gives you the opportunity cost of the service on the horizontal axis. Using the reciprocal rule, you can see that Anne has a comparative advantage in scrubbing—she gives up less to scrub a room than Bernie does. His opportunity cost of scrubbing a room is 2 swept rooms; hers is

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only 1.

Because of their individual unit labor requirements (the amount of time it takes each to complete each task), if Bernie and Anne work independently, he can sweep and scrub 2 rooms in an hour, and she can sweep and scrub 6 rooms in an hour. By working independently, the total number of rooms that they can complete is 8 rooms.

If they decide to work together, Bernie could specialize in sweeping because his opportunity cost is only ½ room scrubbed. Anne’s opportunity cost for sweeping is 1 room scrubbed. So Bernie gives up one entire room scrubbed but adds two swept rooms.

Now that Bernie is sweeping two more rooms, Anne can sweep two fewer and specialize in the service in which she has a comparative advantage, scrubbing. She now has time to scrub two more rooms. Recall that her opportunity cost for scrubbing is 1 swept room but Bernie's opportunity cost for scrubbing is 2 swept rooms.

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By trading and specializing, Bernie and Anne can complete 9 rooms total. She has time to scrub all 9 rooms and sweep 3. Bernie can sweep the remaining 6 rooms. Total production has increased from 8 to 9.

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Understanding Why Specialization Increases Total Output

Ä When trading partners specialize in the goods for which they have a comparative advantage, total output is greater than when the partners work independently.

Ä A trader who has a flatter production possibilities frontier, will have a comparative advantage in the production of the good on the horizontal axis.

Ä If a trader has a comparative advantage in the production of one good, he/she will have a comparative disadvantage in the production of the other.

Review from previous lectures, that Bernie has a comparative advantage in sweeping so you could have him specialize entirely in sweeping. He sweeps six rooms and scrubs zero rooms. Because Bernie has a comparative advantage in sweeping, by definition, he has a comparative disadvantage in scrubbing. Anne has a comparative advantage in scrubbing so she increases her scrubbing to nine rooms. She has a comparative disadvantage in sweeping and sweeps only three rooms. Bernie's and Anne's PPFs are depicted on the left.

By looking at the problem this way, you can see that total output has increased because of trading. You can see the totals from the chart on the left or you can examine the slope of the PPFs below.

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Note on the left that Bernie’s PPF is flatter. This means that he has a comparative advantage in the good on the horizontal axis, sweeping. It also means that he has a comparative disadvantage in the production of the good on the vertical axis, scrubbing. The information about Anne is the opposite. The point is that they will specialize and trade based on comparative advantage, not absolute advantage.

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Analyzing International Trade Through Comparative Advantage

Ä Countries will trade with each other based upon their comparative advantage in the production of their goods, not upon either country’s absolute advantage in production.

Ä Every country’s production is subject to constraints in technology and resources. Ä Trade between two countries can increase the total economic output versus what

the output would be if each acted independently .

Assume that Pakistan and Malaysia are trading partners. Each country has technology and resource constraints on the production of their two goods, wheat and rice. Assume each country has 60 workers. In Pakistan it takes two workers to produce a bushel of wheat and 3 to produce a bushel of rice. Pakistan’s opportunity cost of rice is 30/20 or 1.5 bushels of wheat given up for each bushel of rice produced. Malaysia’s opportunity cost of rice is 60/30, or 2 bushels of wheat given up for a bushel of rice. Note that Malaysia has an absolute advantage in both goods, but you should pay more attention to comparative advantage.

Plot the production possibilities frontiers (PPF) from the table or derive algebraic formulas for each country's PPF. In the two formulas the first terms are the constants; they show the maximum bushels of wheat each country can produce if rice production is zero. The negative signs indicate negative slopes. The opportunity costs of rice production in terms wheat production for each country are 2 bushels of wheat for Malaysia and 1.5 bushels of wheat for Pakistan. A straight-line PPF means that resources are equally suited for the production of wheat or rice.

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If the two countries do not trade, then each country will be forced to consume some combination of wheat and rice that is on their own PPF. Relative consumption is a matter of choice for each country but in this case you should assume that each wants to consume the combinations shown on the graph. Notice that total production for the combined economies is 35 bushels of wheat and 30 bushels of rice.

By using each country's opportunity cost, you know that Malaysia has to give up four bushels of wheat to produce two bushel of rice, and Pakistan has to give up three bushels of wheat to produce two bushels of rice, Pakistan has a lower opportunity cost for producing rice. Malaysia should specialize in wheat and Pakistan should specialize in rice and they should trade. For example, if Malaysia cuts rice production by two bushels it could increase wheat by four bushels. Pakistan could cut wheat by three bushels and increase rice by two bushels. If Malaysia trades the three bushels of wheat, for Pakistan's two bushels of rice, there is one extra bushel of wheat that was not there before.

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The two countries can increase total production by cooperating and trading. To see this idea, assume Pakistan produces all rice and zero wheat. Pakistan can produce 20 bushels of rice and zero wheat. Malaysia can produce 12 bushels of rice and uses the rest of its labor to produce wheat. Malaysia will produce wheat based on its formula for its PPF: W = 60-2R W = 60-2(12) = 36 bushels. Total output for the two economies is now 32 bushels of rice and 36 bushels of wheat. The two countries would trade but the exact terms of trade are indeterminate at this point. The main point is that total output of wheat and rice is greater than it was before trading started.

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Determining the Components of Demand

Ä Demand is the behavior of consumers in the market.

Ä The components, or determinants, of demand for a product are the price of the good, the price of substitute goods, the price of complementary goods, tastes and preferences, a consumer's income, and expectations about the future.

Ä A demand function is a mathematical relationship that predicts the quantity of a

good demanded as a function of several related factors.

Ä Ceteris paribus means “all other things equal.” It means that in a functional relationship, all factors but one are held constant.

Demand refers to the behavior of consumers in the market. Supply refers to the behavior of producers. The question that you want to answer in this example is what factors determine how much of a product that you, as a consumer, will demand. Usually the answer to this question is expressed as a demand function.

In the case of bread, the quantity of bread demanded is a function of these factors.

The demand function is expressed using symbols. You can read the function on the left as:

“The quantity of bread demanded in a particular time period is a function of the price of bread, the price of substitute goods, the price of complementary goods, tastes and preferences, household income, and expectations about the future.”

Economists like to study only one of these factors at a time. They assume that every component except the one that they want to study is constant. This assumption is called ceteris paribus which means “all other things equal.” If you hold all components constant, except the price of bread itself, you can develop a demand curve that shows the

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relationship between the price of bread and the quantity of bread demanded in a time period.

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Understanding the Determinants of Demand

Ä Demand is the behavior of consumers in the market.

Ä The components, or determinants, of demand for a product are the price of the good, the price of substitute goods, the price of complementary goods, tastes and preferences, a consumer's income, and expectations about the future.

Ä Ceteris paribus means “all other things equal.” It means that in a functional

relationship, all factors but one are held constant.

Ä A demand function is a mathematical relationship that predicts the quantity of a good demanded as a function of several related factors.

Demand refers to the behavior of consumers in the market. Supply refers to the behavior of producers. The question that you want to answer in this example is what factors determine how much of a product that you, as a consumer, will demand. Usually the answer to this question is expressed as a demand function.

In the case of bread, the quantity of bread demanded is a function of these factors.

Economists like to study only one of these factors at a time. They assume that every determinant except the one that they want to study is constant. This assumption is called ceteris paribus which means “all other things equal.” If you hold all determinants constant, except the price of bread itself, you can develop a demand curve that shows the relationship between the price of bread and the quantity of bread demanded in a time period.

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The law of demand is an observation in the real world that the quantity demanded of most goods and services exhibits an inverse relationship with its price. When the price of bread increases, the quantity demanded deceases; when the price of bread decreases, the quantity demanded increases. A complement is a product used jointly with a good or service. A change in the price of a complement causes demand for a good to change in the opposite direction. A substitute is a good that meet the same needs as the original product. A change in the price of a substitute causes demand for the original good to change in the same direction.

An increase in income increases demand for a normal good, while an increase in income decreases demand for an inferior good. Consumers’ tastes, preferences and expectations of future price changes also determine demand for a product. Tastes and preferences are simply a consumers likes and dislikes. If tastes for a product change, demand for that product changes in the same direction. Expectations about future prices cause demand in the present to change in the opposite direction from the expectation.

The determinants of demand are shown as a functional relationship. A function is simply a list of all the items that are related to demand. When economists want to hold all variables but one constant, the other ones are listed with a line above the constant factors.

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Understanding the Basics of a Demand Curve

Ä A demand schedule is a table showing the relationship between the price of a good and the quantity of the good demanded, ceteris paribus, or all other things constant.

Ä A demand curve is a graph showing the relationship between the price of a good and the quantity of the good that consumers are willing and able to purchase in a given period of time, ceteris paribus. It is the graphical representation of a demand schedule.

Ä A demand curve is downward sloping, meaning that as the price of a good falls, the quantity demanded increases and as the price of a good increases, the quantity demanded decreases. The behavior of price and quantity demanded is called the law of demand.

Ä The law of demand is observed by the substitution effect which shows consumers purchasing more substitute goods when the price of good increases, and the income effect which shows consumers purchasing less of the good when its price increases.

A demand schedule and a demand curve both show the relationship between the price of a good and the quantity demanded. The table on the left is a demand schedule; the graph on the right is a demand curve. A demand curve is downward sloping showing that there is an inverse relationship between the price of a good and the quantity demanded.

The substitution effect demonstrates the law of demand by showing that as the price of a good rises, consumers will buy more substitute goods and less of the good in question. The substitution effect is not shown on this curve on the left but is observed in the real world.

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The income effect means that an increase in the price of a good is, in effect, a decrease in a consumer’s income. The consumer will be less able to buy as much bread as before the price increase. The income effect is not shown on the curve on the left but is observed in the real world.

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Analyzing Shifts in the Demand Curve

Ä A change in the price of a good results in a change in the quantity demanded and is shown by movement along a demand curve.

Ä A change in one of the other variables that are usually held constant, results in consumers demanding more of the good at every price. This change in demand is represented as a shift in the demand curve.

Recall from the previous lecture that an increase in the price of bread means that a consumer buys fewer loaves of bread with all other variables held constant. The variable that has changed is the price of bread. This change is called a change in quantity demanded and is represented by movement along the demand curve as shown on the left. You would use the same analysis and terminology for a decrease in the price of bread.

If you allow one of the previously constant variables to change (in this case, income) you have to construct a new demand schedule and curve. In this example, household income has increased. Such an increase means that the consumer will purchase more bread at every possible price. You call this phenomenon a change in demand and show it by an outward shift in the demand curve. The new demand curve is called D' (D prime). Note: It is very important that you use the correct terminology. The example on the left is a change in demand; the previous example is a change in quantity demanded.

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Understanding Changes in Other Demand Variables

Ä Review: A change in quantity demanded is movement along the demand curve caused by a change in the price of the good.

Ä Review: A change in demand is a shift in a demand curve caused by changing a

variable other than price.

Ä Substitute goods are goods that can be purchased instead of the original good because they satisfy the same needs.

Ä Complementary goods are goods that are closely related to the original and used

with the original goods.

Ä A normal good is a good characterized by rising consumption when a consumer’s income rises.

Ä An inferior good is a good characterized by falling consumption falls when a consumer’s income rises.

Recall from previous lectures that when the price of the good itself changes, you have a change in quantity demanded; this change is represented by movement along a demand curve. At higher prices a consumer will purchase less bread than at lower prices. All other factors that influence demand are held constant.

Substitute goods are a goods that are similar to the original and that a consumer may purchase in place of the original goods. If the price of a substitute good increases, the consumer would demand more of the original product. In this example, if the price of bagels increases, the consumer would demand more bread. If the price of bagels falls, the consumer would demand less bread and more bagels at every price.

Note: This change is a change in demand; the demand curve shifts.

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Complementary goods are closely related to the original goods and often are purchased with the original. In this case, cheese is the complementary good with bread. If the price of cheese falls, the demand for bread will increase because consumers will want more cheese sandwiches. The result is a change in demand (a shift in the demand curve). Think about what will happen to the demand for bread if the price of cheese increases.

A normal good is one whose consumption increases when income increases. The demand curve for a normal good shifts out when a consumer’s income increases as shown on the left. It shifts inward when a consumer’s income decreases.

An inferior good is one whose consumption decreases when income increases and rises when income falls. The demand curve for an inferior good shifts out when income decreases and shifts in when income increases. The example on the left shows a change in demand for an inferior good (such as beans) when the consumer experiences an income reduction.

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Expectations about future prices will cause a consumer’s demand to change in the present. If the consumer expects the price of bread to fall in the future, she will demand less bread now at every price, waiting for the future to stock up on bread. As shown on the left, the consumer's demand curve shifts inward. If there is a major drought in the Midwest, she may expect future bread prices to be very high. In this case, she may stock up on bread now, and her demand curve will shift out.

To summarize: When you change any of the factors that influence demand, except price, you will cause a change in demand. The demand curve will shift in or out depending on the direction of the change in the factor.

A change in price means that there is a change in quantity demanded. This change is movement along the demand curve, as shown on the left and in the first graph on these notes.

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Deriving a Market Demand Curve

Ä A market demand curve is the horizontal summation of all individual demand curves.

Ä Any factor that can shift an individual demand curve can shift a market demand curve.

Ä A change in the number of buyers can also shift a market demand curve.

If you want to derive a market demand curve, you simply add the quantities that each consumer buys at each price. The prices on the vertical axis do not change, but the quantities on the horizontal axis are the sums of all the consumers. This is called horizontal summation.

Continue to find points on the market demand curves that are the sums of the individual quantities. Connect the points to get the market demand curve. The market demand curve on the left is labeled D.

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The market demand curve can shift just as the individual demand curves can shift. Any factor that shifts any of the individual demand curves will shift the market demand curve. Additionally, an increase or decrease in the number of buyers can shift a market demand curve. In the example on the left, only one consumer’s income changed. The change for this one consumer shifts his individual demand curve and the market demand curve because a larger quantity is demanded at each price.

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Determining the Components of Supply

Ä? The components, or determinants, of individual supply for a product are the price of the product, the price of input goods that are used to make it, the state of the industry's technology, and expectations about the future market price of the good.

Ä Profit is the difference between revenue and costs. Ä Supply is the amount of a good that a producer puts on the market for any time

period.

Ä A supply function is a mathematical representation of the quantity of a good that a producer will put on the market.

Producers will want to sell as much of a product at the highest possible price in order to maximize their profits. Profit is the difference between the revenue that producers gain from selling a product, and the cost of producing it.

The main determinants of how much of a good is supplied to the market are: 1. the price of the good 2. the price of the inputs that are used to

make it 3. the state of the industry’s technology 4. a producer’s expectations for the market

prices for the good The amount put on the market is called supply.

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The supply function is a mathematical representation of the quantity of a good supplied to the market based upon the determinants you saw above. You read the function on the left as: “The quantity of a good supplied is a function of the price of the good, the price of inputs, technology, and the expectation for future prices.”

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Deriving a Supply Curve

Ä Review: A supply function is a mathematical representation of the quantity of a good that a producer will put on the market.

Ä? A supply curve is a graph showing the relationship between the price of a good and the quantity of the good that a producer is willing and able to supply to the market in a given time period, ceteris paribus.

Ä A supply schedule is a table that shows the relationship between the price of a good and the quantity of that good supplied.

Ä The opportunity cost for a producer is what that producer has to give up to produce an additional unit.

The supply function is the basis for the supply schedule and supply curve. In setting up a supply schedule and then a supply curve, you hold constant all variables except the price of the good itself in exactly the same way you derived a demand curve.

From observations in the world, you can determine how many loaves of bread a baker will supply at each price. A supply schedule is a table showing these values. From this schedule, you create a supply curve by plotting points on a graph with the prices on the vertical axis and the quantity on the horizontal axis. Note: This curve slopes upward, meaning that as prices increase, a baker will supply more bread to the market.

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The slope of the supply curve indicates opportunity cost. In this example, the slope is increasing, which means increasing opportunity cost. Intuitively, think about the time that the baker has to spend to bake more loaves. As the baker spends more time baking, he spends less time in other activities. You will have to pay this baker more and more to entice him to bake more bread. This is the reason that the price is higher at higher levels of output.

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Understanding a Change in Supply vs. a Change in Quantity Supplied

Ä A supply curve is a collection of points representing the quantity of a good that a supplier is willing and able to offer for sale in a given time period, as a function of the good’s price.

Ä A change in quantity supplied is shown as movement along a supply curve and is a function of price.

Ä A change in supply is shown as a shift in the supply curve and is a function of a change in any of the supply variables except price.

Review the supply function on the left. Remember that when the price of the product changes, the change in quantity supplied will move from one point on the supply curve to another one—movement along the supply curve. If you change a variable other than price, you will have to construct a new supply curve. The supply curve shifts leading to a change in supply.

Assume that the price of input goods increases. Because the price of inputs is one of the constant supply factors in the supply function, a change in their prices means that suppliers will now offer fewer loaves of bread for sale at every price. You must now construct a new supply curve. The supply curve has shifted inward representing a change in supply. The new supply curve on the left is S'.

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Analyzing Change in Other Supply Variables

Ä Review: A change in the price of a good leads to a change in quantity supplied. This change is represented by movement along a supply curve.

Ä Review: A change in a variable other than price leads to a change in supply. The

supply curve shifts inward or outward.

Ä? An increase in the price of inputs causes the supply curve to shift inward. A decrease in the price of inputs causes the supply curve to shift outward.

On the left, a movement along the supply curve is called a change in quantity supplied. The only variable that is changing is the price of bread itself. All other variables are being held constant.

If you vary one of the other factors in the supply function (and hold price constant), you will get a shift in the curve. In the example here, suppose the prices of inputs (flour, labor, and so on) into bread increase. As a result, bakers will supply less bread at every price because production costs have increased, and it has become costlier to produce each loaf. The supply curve shifts inward, indicating fewer loaves supplied at every price. The new supply curve represents a change in supply.

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Using the same logic as above, the supply curve for bread would shift outward if input prices fell. Bakers would supply more loaves at every price. For each of the other variables—technology and expectations of future prices—the supply curve would shift in a similar manner. You should work through the logic using both of these variables. Show on a graph what happens if technology improves or deteriorates, or if producers expect prices in the future to increase or decrease.

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Deriving a Market Supply Curve from Individual Supply Curves

Ä The market supply curve is the horizontal summation of all producers’ individual supply curves.

Ä Any factor that can shift an individual supply curve can shift a market supply curve.

Ä A change in the number of suppliers can also shift a supply curve.

In the example on the left, you can see the supply schedules for two bakeries, Jim’s and Dan’s. To get the market supply schedule, you will need to horizontally sum the two. To do this, pick out a price then add the quantities from each bakery at this price. Do this for each price and then create a new schedule.

After creating the schedule, you should draw the market supply curve based on the horizontal summation of the individual supply curves. On the left, the market supply curve, S, is derived from the individual supply curves, SD and SJ. Note that on the horizontal axis, the quantities supplied at each price are the sum of Dan's quantity supplied and Jim's quantity supplied at each price.

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Determining a Competitive Equilibrium

Ä Excess demand in a market is a price/quantity combination in which consumers demand a greater quantity of a good than producers supply.

Ä Excess supply in a market is a price/quantity combination in which producers supply a greater quantity of a good than consumers demand.

Ä A competitive equilibrium exists when the market finds a price/quantity

combination from which there is no incentive to move.

To understand the idea of competitive equilibrium, examine this example in which there is a case of excess demand. At a price of $1.50 per loaf, consumers are demanding seven loaves, but producers want to supply only four loaves. The unsatisfied consumers then bid against each other, much like an auction, for the scarce loaves of bread.

The case of excess supply uses the same process but works in the opposite direction. At a price of $3 per loaf, seven loaves are supplied, but only three are demanded. Producers have to drop their prices until enough buyers want to purchase what is offered. Some producers may drop out of the market altogether as the price falls.

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When there is either excess demand or excess supply, a bidding process takes place in the market, much like an auction. Consumers or producers will leave or enter the market at different points. The bidding process drives the price to a point that equilibrates demand and supply. In this example the equilibrium price is $2.10 per loaf with five loaves demanded and supplied. This combination is the competitive equilibrium.

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Defining Comparative Statics

Ä Comparative statics is the study of the change in the competitive equilibrium when one of the variables affecting demand or supply changes.

When a competitive equilibrium is established, there is no incentive for the market to adjust.

Often one of the market variables changes, however, causing the competitive equilibrium to adjust. The analysis of what happens is called comparative statics.

In analyzing a change in the competitive equilibrium, you should follow the three-step process in this example. The process is shown in the box on the left. Here you assume that the price of substitute goods has increased and you want to know what happens to the competitive equilibrium quantity and price for bread. The three-step process indicates that 1. demand (buyers) is affected; 2. the demand curve shifts outward; 3. the bidding process drives the price and

quantity up.

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Classifying Comparative Statics

Ä There are a limited number of comparative statics situations to study: 1. the demand curve shifts outward; 2. the demand curve shifts inward; 3. the supply curve shifts inward; 4. the supply curve shifts outward.

Ä The bidding mechanism works differently in each situation to change the competitive equilibrium.

A demand curve can shift outward because: 1. the price of a substitute good increases; 2. the price of a complementary good falls; 3. income increases (if bread is a normal

good); 4. there are expectations of future higher

prices for bread; 5. population or number of buyers in the

market increases. On the left, the demand curve has shifted outward to D'. The new equilibrium price has increased to $2.75 per loaf and the new equilibrium quantity has increased to 6.5 loaves of bread.

The reasons for the demand curve to shift inward are the exact opposite of the reasons that cause it to shift outward. You should work through each of the events in the previous case, but in the opposite direction. Be sure to review why the bidding mechanism operates in the direction that it does. In the example on the left, the demand curve has shifted inward, decreasing the equilibrium price and quantity.

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The supply curve can shift inward causing excess demand. Reasons for this shift include: 1. The prices of input goods increase. 2. Technology in the industry worsens. 3. The number of sellers decreases. The bidding process forces the market equilibrium price up and the quantity down as on the left.

The final comparative static situation is when the supply curve shifts outward. The reasons for this outward shift are the exact opposite of those reasons that caused it to shift inward. The bidding process causes prices to fall and the quantity to increase.

The chart on the left summarizes all of the cases in comparative statics. Because there are only four possible cases, you should work through the logic of each. Focus on what causes each and on the logic of the bidding process.

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Defining Elasticity

Ä Elasticity of demand is the percentage change in the quantity demanded that results from a given percentage change in the price. Formally, this concept is called price elasticity of demand.

Ä Elasticity of demand is the measure of how responsive buyers are to a change in price.

Ä If demand is elastic, a fall in price causes a seller’s total revenue to increase. If demand is inelastic, a fall in price causes a seller’s total revenue to decrease.

If Angie drops the price of her ice cream cones from $2 to $1, the quantity demanded increases from 20 to 30. Angie’s total revenue when the price was $2 was TR = $2.00 x 20 = $40.00. After the price change, her total revenue is TR = $1.00 x 30 = $30.00.

Barnie also has an ice cream store, but faces a different demand curve. Suppose he also decides to drop the price of ice cream cones from $2 to $1. His before and after total revenue are TR = $2.00 x 20 = $40.00 (before) TR = $1.00 x 50 = $50.00 (after). Angie's (DA) and Barnie's (DB) demand curves are depicted on the left.

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Because Angie’s total revenue fell after the price decrease, you can say that her demand is inelastic. Barnie’s demand is elastic because his total revenue increased after the price decrease. Barnie’s customers are much more responsive to a price change than Angie’s customers.

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Calculating Elasticity

Ä Review: A formal definition of elasticity of demand is “a percentage change in quantity demanded resulting from a percentage change in price.” More formally, this concept is called price elasticity of demand.

Ä The key to elasticity is that it is a unitless measure, and the exact number of units of change does not matter. Instead, elasticity is given as the ratio of the percentage changes: percentage change in quantity divided by the percentage change in price. This ratio is always expressed as an absolute value.

Ä Use the midpoint formula to calculate elasticity to ensure a uniform measure.

Using the formula in the box on the left to calculate elasticity yields inconsistent results. You get two different measures for elasticity depending on which price/quantity combination you begin with. The problem lies in determining which are the “old” price and quantity. Economists generally do not use this formula because the results can be misleading.

Economists like to use the midpoint formula. In this formula, the divisor for both the percentage change in quantity and for the percentage change in price are the midpoints between the old and new quantity and price. On the left, examine the change between points A and B. For the percentage change in quantity, divide the different quantities by 35, the midpoint between the quantities A and B ((20+50)/2 = 35). For the percentage change in price, divide the two prices by 1.5, the midpoint between the two prices (($1.00 + $2.00)/2 = 1.5).

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The midpoint formula yields uniform results no matter which point on the demand curve you use as a starting point. Note: (Price) elasticity of demand uses the absolute value of the ratio.

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Applying the Concept of Elasticity

Ä The midpoint formula for elasticity always yields consistent results.

Ä If elasticity is less than 1, demand for a product is inelastic. An inelastic demand means that customers are relatively unresponsive to changes in price. A drop in the price results in a decrease in total revenue.

Ä If elasticity of demand is greater than 1, demand for a product is elastic. An elastic demand means that customers are relatively responsive to changes in price. A drop in price results in an increase in total revenue.

Ä Unit elasticity means that the percentage change in quantity demanded is equal to the percentage change in price. A fall in price results in no change in total revenue.

Using the old formula (box on the left) to calculate elasticity from point A to point B yields an elasticity of 1, or unit elasticity . Note: Because the demand curve is downward sloping, elasticity will have a negative sign. However, economists ignore the sign and report elasticities in absolute values.

Using the old formula to calculate elasticity from B to A, yields elasticity of 1/3, or inelastic demand. If the result is greater than 1, the demand would be elastic.

Using the midpoint formula on the left to calculate elasticity from A to B yields elasticity of 3/5.

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Using the midpoint formula to calculate elasticity from B to A also yields an elasticity of 3/5, the same result as above. The beginning and ending points are irrelevant to the results. You should always use the midpoint formula to calculate elasticity because it produces uniform results.

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Identifying the Determinants of Elasticity

Ä The main determinants of a product's elasticity are the availability of close substitutes, the amount of time a consumer has to search for substitutes, and the percentage of a consumer's budget that is required to purchase the good.

Ä The demand for a product is more elastic if there are close substitutes for it, if a consumer has time to search for substitutes, or if the product requires a large percentage of a consumer's budget.

Ä Review: Elastic demand means that a fall in the price increases total revenue. Ä Review: Inelastic demand means that a fall in price shrinks total revenue.

The most important determinant of a product’s elasticity is the availability of close substitutes. If substitutes are available, customers are likely to be very responsive to changes in price. The demand is elastic. If substitutes are not available, demand is likely to be unresponsive to price changes. This demand is inelastic. The amount of time available to look for substitutes is related to the availability. If customers have a time to look for substitutes, they are likely to be more responsive to price than if they must make immediate decisions. Finally, a product that requires a large percentage of a consumer’s budget is likely to be elastic.

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Understanding the Relationship Between Total Revenue and Elasticity

Ä Review: Total revenue is price times quantity demanded: TR = P x Q. Ä Review: Elastic demand indicates price sensitivity; inelastic demand indicates

price insensitivity.

Ä When price changes, you can analyze the change in total revenue in terms of a price effect and a quantity effect. Elasticity determines which effect is greater after a change in price.

Begin this section by reviewing the formula for total revenue: TR = P x Q. The box on the left summarizes the relationship between price changes, total revenue, and elasticity : 1. With products that are price-sensitive, or elastic, a percentage change in price means a greater percentage change in quantity demanded. Total revenue and price move in opposite directions. 2. With products that are price-insensitive, or inelastic, a percentage change in price means a smaller percentage change in quantity demanded. Total revenue and price move in the same direction.

Using math shows that the relationships on the left are true.

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The mathematical relationship above is analogous to the formula for finding a change in total revenue when the price changes. The formula in the lower part of the box on the left says that the percentage change in total revenue is equal to the percentage change in price + the percentage change in quantity demanded.

Assume that the change in price is an increase. A price increase means that there will be a decrease in quantity because the demand curve is downward sloping. By manipulating the equation, you can see that the last term on the right is the formula for elasticity.

If the elasticity is less than 1, as it is here, then the product has inelastic demand. The price effect is the increase in revenue from selling the product at a higher price. The quantity effect is the decrease in revenue from the fall in quantity demanded caused by the increase in price. In this case, the price effect has dominated. The increase in price has not caused a large loss of customers. There has not been a large decrease in quantity demanded, or a large quantity effect. Therefore the increase in total revenue from the price effect is greater than the decrease in total revenue from the quantity effect.

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To summarize: If the quantity effect dominates, then elasticity is greater than 1 (demand is elastic), and total revenue and price move in opposite directions. If the price effect dominates then elasticity is less than 1 (demand is inelastic), and total revenue and price move in the same direction.

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Understanding How Rent Controls Damage Housing Markets

Ä A rent control is a government regulation that sets a maximum limit on rental prices within a housing market.

Ä Rent controls in any housing market destroy economic value by forcing buyers to engage in non-price competition to find housing, and by blocking some trades.

In a free market, demand and supply would determine the equilibrium price for housing. The free market is depicted in the far-left graph. If the government sets a rent control, say at P-bar, some suppliers will drop out of the market because their opportunity costs are greater than P-bar. After the imposition of price controls, Q-bar in the right-hand graph will be offered on the market, thus creating excess demand for the housing.

In a free market, the bidding process would force consumers to bid against each other for the available apartments, thus eliminating the excess demand. In a rent-controlled market, renters who do not get apartments must now engage in non-price competition to get the scarce apartments. They might hire apartment hunters to search the obituaries, wait in line, bribe government officials, and other such activities. All of these are nonproductive activities that do not create value.

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The result of the non-price competition is that potential renters have to pay a lot of money to find an apartment. The real cost of the rent-controlled apartment in this example becomes P’. This price is higher than the price that would occur in a free market. In a free market there is a large area of economic value, represented by consumer and producer surplus. In the controlled market, the gray area represents deadweight loss, and the striped area represents the cost of non-price competition to find an apartment.

Consumer surplus and producer surplus have shrunk to the small areas on the left. The striped area is lost economic value because of non-price competition. The triangle with the X is deadweight loss created by blocked trades caused by the rent control.

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Understanding the Problem of Minimum Wages in the Labor Market

Ä???? A minimum wage is a wage floor below which employers by law are not permitted

to pay employees.

Ä? Minimum wage laws may have unintended labor market consequences: they can actually harm the very groups that they are intended to help.

Ä? A wage (w) is the price for each unit of labor in the labor market.

On the left is a depiction of a labor market. The wage (w) is actually a price for labor. Workers could respond to higher wages in two ways: 1. There is a substitution effect, which causes

workers to work more hours because the opportunity cost of leisure has risen.

2. There is an income effect, which causes

workers to work fewer hours because they make more per hour.

Usually you assume that the substitution effect is dominant and thus, labor has an upward-sloping supply curve: as the wage increases more labor is put on the market.

Examine the graph on the left. Suppose the market establishes an equilibrium wage at W* and an equilibrium labor quantity at Q*. If the government imposes a minimum wage at Wm, there will be two unintended consequences: 1. Because of the higher cost of doing

business, firms will cut production. 2. Because capital is now relatively cheaper

than labor, firms will substitute capital for labor.

The result is unemployment in the group that the minimum wage is intended to help.

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The unemployment creates deadweight loss because of the excess supply of labor caused by the artificially elevated wage. Additionally, employers can pass along some of the increased cost of the minimum wage to their employees. For example, they could decrease benefits to compensate for the higher wage they have to pay.

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Understanding How an Excise Tax Affects Equilibrium

Ä? Review: An excise tax is a per unit tax imposed one each unit of good that is traded.

Ä An excise tax can be imposed on a seller, a buyer, or can be seen as a tax wedge.

Ä “The irrelevance of legal tax incidence” means that the results are exactly the same whether a tax is imposed on a seller or a buyer: equilibrium quantity falls and the buyer and seller each face a different price.

In a free market economy with no taxes, the market establishes an equilibrium quantity and price at the point of intersection of the demand and supply curves.

The government could impose an excise tax and make the seller pay it on every unit she sells. In this case her cost of producing each unit would increase by $2. Her supply curve would shift back by $2 at every point. The result would be a new, lower equilibrium quantity Q1. Note that the buyer pays a higher price than the seller receives. The difference is the $2 tax.

The government could require the buyer to pay the tax on each unit. In this case the buyer’s demand curve would shift down at every point by $2. The result is exactly the same as if the seller pays the tax—equilibrium quantity is less, and the price the seller receives for selling the product is less than the buyer pays.

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“The irrelevance of legal tax incidence” means that it doesn’t matter whether the tax is imposed on the buyer or the seller. The equilibrium quantity falls to Q1 and the buyer and seller each face a different price.

Another way to look at the tax is as a tax wedge. You can just view it geometrically as a wedge between what the buyer pays and what the seller receives. The equilibrium point is at the point where the $2 tax exactly fits between the curves.

The diagrams on the left summarize the three ways of looking at an excise tax. The results are the same in all of them: equilibrium quantity falls and the buyer and seller face different prices.

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Examining Problems in Agricultural Economics

Ä Agricultural markets have some special problems: low price and income elasticity and extreme variations in supply because of the weather. Ä Because of inelastic demand and variable supply, agriculture has an odd paradox: bad weather can benefit farmers and good weather can damage farmer. ÄThe government has attempted to stabilize farmers’ incomes by stabilizing prices, restricting supply, or subsidizing their incomes.

Agriculture experiences some special problems because agricultural commodities typically are price inelastic, income inelastic, and have great variations in supply because of the weather.

Price inelasticity means that total revenue and price move in the same direction. When price increases, total revenue increases; when price decreases, total revenue decreases. Farmers try to make plans based some average price that then determines an average supply curve, as shown.

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If agriculture experiences a year of bad weather, supply falls from the average, as shown on the left. Because of price inelasticity, the bad weather that caused the supply curve to shift and the resulting high equilibrium prices, farm income increases, ceteris paribus. The total revenue for farmers is the shaded area on the left.

If agriculture experiences a year of good weather, supply increases from the average, as shown on the left. Because of price inelasticity, the good weather that caused the supply curve to shift and the resulting low equilibrium prices, farm income decreases, ceteris paribus. The total revenue for farmers is the shaded area on the left.

One program that the government has relied upon in the past is price supports. The problem with price supports has been that agriculture interests have lobbied heavily to raise the “average” price of commodities. As a result, American agriculture has had chronic surpluses that the government has had to buy and store. The government has promoted exports to get rid of excess commodities and has even given away food as international aid.

Another program to help farmers maintain some income stability has been a set-aside program. In set-aside programs, farmers are paid to remove parts of their farms from production in order to restrict overall supply and raise prices. However farmers have a tendency to set aside their least productive acreage and then to farm their most productive more intensively. The result is that supply may not fall as much as intended and thus prices may not increase.

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Farmers may themselves form marketing arrangements in which they voluntarily agree to place a specific quantity of their production on the market. However these arrangements provide a strong incentive for individual farmers to cheat on the arrangement to take advantage of the higher price.

Economists prefer policies that most closely address a problem. A direct subsidization such as the one described on the left is one that economists prefer to price supports and set-aside programs.

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Understanding Utility Theory

Ä Households allocate their budgets over a wide array of goods and services by

equalizing the ratio of marginal utility to price for each good. Ä Consumption is subject to diminishing marginal utility as a household consumes

more of a good or service.

A “util” is an artificial measure of a consumer’s satisfaction from consuming a good. Economists measure total utility, or the total number of utils, a consumer receives from consuming a quantity of a good. Marginal utility is the additional utility a consumer receives from consuming an additional unit of a good.

Marginal utility is the change in total utility from consuming an additional unit of a good. On the left, the marginal utility in the second column is the change in the total utility at each additional unit as measured in the third column.

Notice that marginal utility at first increases and then decreases with each additional unit consumed. At some point, marginal utility can become negative. This example illustrates the law of diminishing marginal utility .

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Finding Consumer Equilibrium

Ä Households maximize their utility, or satisfaction, by purchasing goods and services such that they equalize utility per dollar spent for all goods.

Ä When purchasing goods and services, the typical consumer continuously reallocates

income between goods to maximize satisfaction.

Households have a limited quantity of income that they can spend on goods and services. Economists have developed utility theory to explain how consumers choose to allocate their limited incomes over a wide range of goods to maximize utility, or psychological satisfaction.

In a two-good model, consumers equalize their marginal utilities per dollar cost between the goods, as on the left.

A more general rule for utility maximization is:

MUa/Pa = Mub/Pb = …MUz/Pz

where a through z represent all possible goods.

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Assume that a consumer has a budget of $6.00 to allocate between apples and chocolate. The price of apples is $.50 each and the price of chocolate candy bars is $1.00 each. The first apple gives the consumer 8 utils of satisfaction while the first candy bar gives the consumer 10 utils. However, the consumer wants to equalize the ratio of marginal utilities per dollar, so after buying one apple and one candy bar, he sees that his marginal utility per dolla r spent on apples is greater than his marginal utility spend on candy bars. He now would want to buy another apple.

The consumer buys another apple that yields a marginal utility of 6 utils or 12 utils per dollar. The ratio for apples is still higher than the ratio for candy bars. The consumer wants to buy another apple.

The third apple gives the consumer a marginal utility of 3 utils or 6 utils per dollar. Since his marginal utility per dollar for candy bars is 10 utils, he now wants to purchase another candy bar.

The second candy bar gives the consumer a marginal utility per dollar spent of 8 utils. His ratio for candy bars remains higher than that for apples so he wants to buy a third candy bar.

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The third candy bar gives him a MU per dollar of only 5 utils. The third apple gave him a marginal utility of 3 utils each, or 6 utils per dollar. Apples now look more attractive so he buys another apple.

The fourth apple gives him a MU per dollar of 2 utils, which is less than the marginal utility per dollar of the pervious candy bar. He therefore wants to buy another candy bar.

Finally at 4 apples and 4 candy bars, the consumer has used his entire budget and has equalized his marginal utility per dollar between the two goods. The consumer has met the equilibrium condition: an extra dollar spent for one good yields the same satisfaction as an extra dollar spent for the other good.

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Constructing a Consumer’s Budget Constraint

Ä A budget constraint is a graphical representation of the limit of a consumer’s

possible choices of goods, given his or her budget.

Ä The slope of the budget constraint is the opportunity cost of buying one of the goods in terms of how much of the other good you give up.

In analyzing a consumer’s choices in the market place, you first have to construct a budget constraint for the consumer. In this example, assume that you have a consumer with an income of $12 in a period of time. Further assume that the consumer has only two goods from which to choose: toys, priced at $3 each and snacks, priced at $1 each.

To plot the budget constraint, first plot the end points. Assume that the consumer spends all the income on snacks. On the vertical axis, this means that he or she can buy 12 snack items. Now assume that the consumer spends all the income on toys. On the horizontal axis, this means he or she can buy four toys with the $12. You should now find other possible combinations of goods and connect the points.

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In the algebraic representation of the budget constraint, M is the consumer’s income, T is toys, S is snacks, PT is the price of toys, and PS is the price of snacks. This equation says that the number of snacks you buy is equal to the dollar amount you spend on snacks if you spent all your income on snacks minus the relative price of toys times the number of toys you buy.

The term in the small box on the left tells us the opportunity cost of toys in terms of how many snacks you have to give up to get one toy. The negative sign of the opportunity cost tells us that the budget constraint is downward sloping.

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Understanding a Change in the Budget Constraint

Ä A change in a consumer’s income causes the budget constraint to shift parallel to itself.

Ä A change in the price of one of the goods causes the budget constraint to pivot from one of the end points.

Assume that the consumer’s income falls to $6. The budget constraint shifts inward parallel to the original. The shift means that the consumer can buy exactly half the quantity of each good that he or she previously bought. The slope or opportunity cost, however, has not changed. If the consumer’s income were to double to $24, the budget constraint would shift outward parallel to itself, and the consumer's choices would double.

Now assume that the price of toys falls to $1.50. The consumer can now buy more toys and the same number of snacks with the budget of $12. The budget constraint pivots outward from the vertical axis to indicate more possibilities in toys. The slope or opportunity cost has changed. If the price of toys were to increase, the budget constraint would pivot inward from the vertical axis. The consumer could afford fewer toys and the same number of snacks.

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The box on the left summarizes shifts and pivots in the budget constraint. A change in income is represented by a shift in the budget constraint. A change in the price of one of the goods is represented by a pivot in the budget constraint.

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Understanding Indifference Curves

Ä An indifference curve represents combinations of goods that provide equal satisfaction.

Ä The marginal rate of substitution (MRS) is the rate at which a consumer is willing to exchange one good for the other to maintain the same level of satisfaction.

Ä Every consumer has an indifference map of curves representing different levels of satisfaction.

An indifference curve is a set of points representing combinations of goods that a consumer finds equally satisfying. In the example on the left, the goods are toys and snacks. All indifference curves slope downward. The economic meaning of downward sloping is that if you take away some of the goods on the vertical axis, you can compensate the consumer with some of the goods on the horizontal axis to maintain the consumer’s same level of satisfaction. After all, the consumer is indifferent to the combinations.

All sets of points to the northeast of the original indifference curve lie on other indifference curves. In the example on the left, combinations of goods that lie on the higher indifference curve represent more of both snacks and toys. This fact reflects the assumption that “more is better.” All points on the higher curve represent combinations that yield a greater satisfaction than any of the combinations on the lower curve.

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Recall from algebra or from the previous lectures on graphing that the slope of a curve at any point is the slope of a tangent line at that point. An indifference curve is convex, meaning that the slope decreases as you go down it.

The economic interpretation of the slope is called the marginal rate of substitution (MRS) or the rate at which the consumer is willing to trade one good for another. The MRS is large near the top of the curve. This means that at the top, this consumer has a lot of snacks and not many toys. To maintain the same satisfaction, he is willing to give up many snacks and be compensated with just a few toys.

At the lower end of the indifference curve, this consumer has a small MRS. He has a lot of toys but few snacks. To maintain his satisfaction, if he gives up one snack, he will have to be compensated with a lot of toys. Conversely, if he gives up one toy, you will not have to compensate him with many snacks.

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Each consumer has an indifference map of indifference curves in the goods space. Each indifference curve represents different levels of satisfaction. Because of the principle of “more is better,” you can say that the higher ones are preferred to the lower ones. Indifference curves do not indicate specific amounts of satisfaction. They are ordinal, meaning that one is preferred over another.

The final property of indifference curves is that indifference curves can never cross. Consider a case where indifference curves do cross at point b: D is preferred to A, and C is preferred to E because D and E are on a higher curve. But if they cross, then A = B = C. Thus, A is preferred to E, and in that case, E = B = D. This result tells us that A is now preferred to D, which contradicts the original statement.

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Locating the Consumer's Optimal Combination of Goods

Ä Review: The budget constraint shows the consumer’s opportunities for trade, or at what level the market is allowing him/her to trade. It shows the relative prices of the goods.

Ä Review: The consumer’s indifference curve map shows his/her willingness to trade. Ä The consumer’s optimal combination of goods is at the point where the budget

line is tangent to an indifference curve or where the marginal rate of substitution (MRS) is equal to the opportunity cost or relative price of the two goods, as indicated by the slope of the budget constraint.

Review: The budget constraint gives the consumer’s opportunities for trade. It represents the possibilities open to the consumer. In the graph on the left, the slope Px/Py is the relative price of toys measured in terms of snacks. It tells us that if this consumer gives up one toy, he can get three snacks.

This graph shows us the consumer’s optimal combination of snacks and toys. It is two toys and six snacks. You can determine this point by seeing that it is the one point shared by the budget constraint and the highest indifference curve that is tangent to the budget constraint. On the left, that indifference curve is U0.

At the tangency point (2,6) the MRS (the slope of the indifference curve) is equal to the slope of the budget constraint.

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Consider a point at which the MRS<3, as on the left. At this point the consumer is willing to give up a toy for fewer than three snacks. But why should he? The market as represented by his budget constraint will let him get three snacks for that toy.

This consumer will continue to trade until he gets to the equilibrium point at which MRS = Px/Py = 3.

At the point on the left, MRS>3. Here the consumer is willing to give up more than three snacks for one toy. Because he only has to give up three snacks to get the toy, he trades until MRS = Px/Py = 3.

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Note: Pay attention to the difference between tangency and intersection: In the graph at the left, the lower indifference curve intersects the budget constraint twice, but is tangent to U0 only once. The point of tangency determines the optimal point for the consumer.

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Understanding the Effects of a Price Change on Consumer Choice

Ä When the price of one of the goods changes, the budget constraint shifts and the consumer's optimal combination of goods changes.

Using the example from the previous lecture, assume that the price of toys falls from $3.00 each to $1.50 each, as illustrated on the left. The consumer now has a new budget constraint. The old one has shifted on its vertical axis (it shifts on the axis because the price of only one item has changed).

The consumer now has a new optimal combination on a higher indifference curve. With his budget of $12, and the lower price of toys, he can maximize his satisfaction by purchasing four toys and six snacks. The optimal combination is always found at the point where the budget constraint is tangent to an indifference curve, that is, where MRS = Px/Py.

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Deriving the Demand Curve

Ä Review: A demand curve is a graph showing the relationship between the price of

a good and the quantity demanded of that good, all other things being equal.

Ä The demand curve for a good is derived by finding the consumer’s optimal combination at various prices.

Using the example of snacks and toys, find the consumers optimal choice when the price of the toy is $3. Under the goods space graph (the top graph on the left) plot a price/quantity combination on a graph. Make sure that the quantity scale is the same as the upper graph. In this case, at a price of $3, the consumer demands two toys.

Now change the price of toys to $1.50 each. The consumer now has a new optimal combination on a new indifference curve (the upper graph on the left). He now chooses four toys at the new price. Draw a dotted line to the point on lower graph showing four toys at $1.50 each. You now have two points on a demand curve.

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When you have two or more points, you simply connect them to get a demand curve, as shown at left. A demand curve is a record of the consumer’s choices of a product at various prices.

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Understanding Output, Inputs, and the Short Run

Ä Output (also called total product) is the amount of product a firm can produce with a given set of inputs.

Ä Inputs are resources that a firm uses to produce a final product.

Ä The short run is a period of time during which a firm can change only one (or a few) input(s). The inputs that can be changed in the short run are called

To answer the question of how much a firm will produce, you need to understand the three concepts on the left.

Output (also called total product) is the amount of product a firm can produce with a given amount of input. One way of representing output is by making a schedule to show the output that can be produced with each level of input. In the schedule on the left, the output is TVs, and the input is number of workers.

Usually a firm is making decisions in the short run, a period of time during which it can change only one input. The example on the left assumes that labor is a variable input that can be changed in the short run. You assume that technology and all other inputs cannot be changed in the short run.

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Explaining the Total Product Curve

Ä The total product (TP) curve graphically explains a firm’s total output in the short run. It plots total product as a function of the variable input, labor.

Ä Marginal product (MP) of labor is the change in output generated from adding one more unit of the variable input, labor.

Ä The shape of the total product curve is a function of teamwork, specialization, and using the variable input with the fixed inputs.

The total product (TP) curve represents the total amount of output that a firm can produce with a given amount of labor. As the amount of labor changes, total output changes. The total product curve is a short-run curve, meaning that technology and all inputs except labor are held constant. This assumption is the familiar ceteris paribus rule. In the example on the left, you plot output/labor combinations from the total product schedule. The vertical axis is output and the horizontal axis is labor.

The S-shaped total product curve has economic meaning. At the lower end, where labor and output are low, the curve is convex. Convexity means that as labor is added, the production of TVs is increasing at an increasing rate. This phenomenon is a function of teamwork and specialization: as more workers are added at low production levels, they can specialize in tasks and more efficiently use the fixed inputs.

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In the middle production range, the slope of the total product curve gets flatter, and the curve becomes concave. Concavity means that the production of TVs is increasing but at a decreasing rate. The economic interpretation of concavity is that as workers are added, there is less and less specialization available and that the workers are less and less efficient in using the fixed inputs.

Finally, the total product curve hits a maximum point after which output decreases with each additional worker. After the maximum, additional employees are nonproductive and unable to use the fixed inputs efficiently. In fact, employees may be getting in each other’s way and hindering production, causing total product to decrease.

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The marginal product (MP) of labor is the change in total product that results from a one-unit change in labor. In the example on the left, the second worker adds eight TVs to TP, the third one adds twenty TVs, the fourth one adds ten TVs, the fifth one adds five TVs, the sixth one adds three TVs, the seventh one adds one TV, and the eighth worker causes production to fall by one TV. The S-shaped TP curve reflects the schedule on the far left.

In the convex area of the TP curve, teamwork and specialization lead to increased productivity. Additional workers very efficiently use the available fixed inputs.

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In the concave portion, production increases at a decreasing rate because additional employees are less able to use the plant and other fixed inputs efficiently.

At some point, total product hits a maximum. After the maximum, additional labor becomes inefficient, and output falls.

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Drawing Marginal Product Curves

Ä The marginal product (MP) curve reflects changes in total product (TP) and is drawn using the same horizontal axis.

You can draw the marginal product curve below the total product curve using the same horizontal axis. On the left, labor is the horizontal axis for both curves. Because the MP curve is derived from the TP curve, it reflects the information in the TP curve. For example, when the slope of the TP curve is increasing, MP is increasing because of specialization and teamwork.

In the middle range where TP is increasing at a decreasing rate, MP is positive but falling. Remember that MP represents the change in TP. TP is increasing, but the rate at which it is increasing is falling. MP is that rate.

At the point where TP is at its maximum, MP = 0, the point at which it crosses the x-axis. After this point, MP is actually negative, meaning that TP is falling.

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The shape of the MP curve follows the above description. You can draw the curve by finding the change in total product for each unit of labor and graphing those points under the TP curve.

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Understanding Average Product

Ä Average product (AP), also called average product of labor (APL), is total product (TP) divided by the total quantity of labor. It is the average amount of output each worker can produce.

Ä The average product curve and marginal product (MP) curve intersect at the maximum average product.

Average product of labor (APL) is a measure of how much each worker produces, on average. You simply divide total product by the number of employees. The shape of the AP curve on the left indicates that AP initially rises to a maximum and then falls as additional workers are added.

The lower graph on the left depicts the exact relationship between the AP curve and the marginal product (MP) curve. When AP is rising, it is below MP; when AP is falling it is above MP. Therefore, MP intersects the AP curve at the maximum AP.

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The intuitive explanation for the relationship between MP and AP is that MP represents the contribution of an additional worker. If that worker adds more to total output than the average, then the average is pulled up. At some point, an additional worker starts adding less than the average to TP, so the average starts coming down. On the graph on the left, the decrease in AP occurs when the fifth worker is hired.

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Relating Costs to Productivity

Ä Productivity and costs are inversely related. As productivity increases, a firm’s costs fall, and vice versa.

Ä Productivity means the quantity of goods produced from each hour of an employee's time.

A firm’s costs are inversely related to productivity. In the example on the left, assume that one worker can produce 1/4 of a television in a day. It takes four workers to produce one TV. Productivity is 1/4 and costs are the payment to 4 workers. This is the inverse relationship. If productivity were to increase to 1/2 of a TV per worker, costs would decrease by 1/2.

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Defining Variable Costs

Ä Variable costs (VC) are costs that change with the amount of output being produced. In the case of labor, variable costs are wages times the number of workers for a given time period and a given output level.

Ä Wage is a payment to an employee for labor services.

To calculate the variable costs (VC) for producing a product, you need two pieces of information: 1. the amount of labor needed to produce a

given amount of output 2. the wage that you have to pay to get that

amount of labor In the graph at left, a firm chooses where on the TP curve it wants to produce, finds the amount of labor required for that TP level, and multiplies the labor by the market wages.

Use the schedule on the left. Assume that the wage rate is $1000 per week for each worker. If you choose to produce 20 TVs per week, you will need two workers. In this case, VC = $1000 x 2 = $2000 per week. If you want to produce 40 TVs per week, then VC = $1000 x 4 = $4000 per week. Note: A firm could choose to produce amounts other than those listed at left. In these cases, it could hire “partial workers,” or part-time employees.

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Graphing Variable Costs

Ä Variable costs (VC) can be graphed by plotting variable cost and different outputs on a two-dimensional graph.

Ä Inefficient points are excluded from the graph. The inefficient points are those in which additional workers cause total product to fall.

You can graph the variable cost (VC) curve by simply creating a graph with output on the horizontal axis and VC on the vertical axis, as on the left. Use the schedule that you created in the previous lecture and plot points.

At some point the VC curve starts going backward. This point is excluded from the VC curve because it means that adding more labor actually reduces output. No rational firm would produce at that level because to do so would be inefficient.

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Refer to the graph on the left: At the maximum output, you just extend the VC curve vertically. The interpretation is that adding more labor will not produce more output. You are at the maximum that can possibly be produced in this case.

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Graphing Variable Costs Using a Geometric Trick

Ä To graph variable costs (VC), you can reverse the axes of the total product (TP) curve and multiply the number of workers by the dollar cost.

Ä The variable cost (VC) curve is a reflection of the total product curve.

To graph a variable costs (VC) curve, find points on the horizontal axis of the total product (TP) curve associated with particular output levels on the vertical axis. When you find the numbers of workers, you can easily get the variable costs by multiplying the numbers of workers at each output by the wage cost. In the example on the left, the wage is $3000 for three workers who are producing 10 televisions a week: 3 x $1000 = $3000

To create the variable cost curve, reverse the axes of the total product curve and turn the number of workers into dollars by multiplying the number of workers at each output level by the wage rate. In this example, the vertical axis is now dollars, and the horizontal axis is total product.

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The VC curve becomes a reflection of the total product curve, as on the left.

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Defining Marginal Costs

Ä Marginal cost (MC) is the cost incurred by producing one additional unit of a good.

To calculate marginal cost (MC), first find two points on the total product schedule and find the difference in output. For example, on the left the change in TP between the first two boxes is eight TVs. This is the change from two to ten TVs.

Next, find the difference in variable costs (VC) when increasing production from two to ten TVs. Then divide that amount by the difference in the TV production. $1000 = Change in variable costs.

8 = Change in production. $1000/8 = $125 = MC. $125 is the cost for one more unit of output.

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If you continue to find MC for each increase in production, you get an entire range of marginal costs. Note that in the lower ranges, marginal costs are decreasing. As you add workers, teamwork and specialization reduce the cost for producing another unit. At some point, however, there are too many workers. They crowd the workplace and inefficiently use the fixed inputs. MC increases. Changes in MC are always the result of changes in productivity.

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Deriving the Marginal Cost Curve

Ä You can derive the marginal cost (MC) curve by finding points on the graph and plotting.

Ä The marginal cost curve is a mirror of the marginal product (MP) curve.

Ä Another way to draw a marginal cost curve is to find the slope of the variable cost (VC) curve at several points, and plot those points below the variable cost curve.

To graph a marginal cost (MC) curve, plot the costs associated with various outputs that you derived from the previous lecture. Plot the MC on the vertical axis and the total product on the horizontal axis. You can connect the points because the points you found are not all the possible MC and TP combinations. The graph represents MC at each level of output.

If you flip the MC curve over and change the MC axis to labor, you have the marginal product (MP) curve. It is possible to change MC to number of workers, as in the example on the left, because MC is simply the dollar value of a number of workers. It does not change the shape of the graph. The two graphs are mirror images of each other because productivity and costs have a reciprocal relationship. Marginal cost is falling when marginal product is rising.

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Marginal cost (MC) is rising when marginal product is falling. The intuition for this idea is that marginal product falls after a certain number of workers are hired. Additional workers are less and less able to produce as much as the previous ones because the workplace becomes more congested. Therefore, to produce more TVs, the firm has to hire more of these less productive workers, who have to be paid, thereby increasing costs for each additional TV.

Another way to derive the MC curve is to plot it under the variable cost curve. The VC curve shows the increasing variable costs associated with each output level. By definition, MC is the slope of the variable cost curve at any point.

The most important point on the VC curve is the inflection point where the slope of the VC curve is smallest. At the inflection point, the slope changes from concave to convex.

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The inflection point becomes the lowest point on the MC curve. The MC curve is decreasing up to that point, and increasing after it.

By graphing the MC curve using the VC curve, you can clearly see the relationship between the two. The MC curve is the slope of the VC curve at every point.

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Understanding the Mathematical Relationship Between Marginal Product and Marginal Costs

Ä Marginal product (MP) and marginal cost (MC) can be thought of as mathematical reciprocals of each other.

Review: Marginal product (MP) is the addition to total product from hiring one more worker. Review: Marginal cost (MC) is the addition to total costs from producing one more unit. Review: Marginal cost and marginal product are inversely related.

To understand how marginal cost and marginal product are inversely related, you should work through the mathematical proof on the left. Review: Wage is the money paid to each worker in a given unit of time. You will find that MC = W/MP. If you understand this relationship, you can see that MC and MP are really reciprocals of one another.

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An intuitive explanation of the relationship between MP and MC is: If a worker can produce 1/4 of a TV in a day, then you need 4 workers to produce one TV in a day. If the market wage is $1000, you can calculate marginal cost by using the formula W/MP.

The marginal cost is W/MP or $1000/(1/4) = $4000, as shown on the left. Remember that the wage is fixed at $1000 per worker per week and that the marginal product is 1/4 of a TV per worker per week.

Marginal product and marginal costs are mirror images of each other: When marginal product is rising because of teamwork and cooperation, marginal cost is falling.

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When marginal product reaches a maximum, marginal cost is at a its minimum. When MP is falling because of congestion in the workplace, marginal cost is rising.

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Defining Average Variable Costs

Ä Average variable cost (AVC) is the variable cost per unit of total product (TP).

Ä To calculate AVC, divide variable cost at a given total product level by that total product. This calculation yields the cost per unit of output.

Ä AVC tells the firm whether the output level is potentially profitable.

Review: Variable cost (VC) is the wage cost required to produce a given level of output, or the wages paid times the number of workers at each output level. To calculate average variable cost (AVC) at each output level, divide the variable cost at that level by the total product. You will get an average variable cost for each output level. For example, on the left at five workers, the VC of $5000 is divided by the TP of 45 to get an AVC of $111.

Examine the chart on the left: AVC is a guide to show the firm whether a certain output level is profitable. If the AVC is greater than the price of the product, there would be no potential profit. However, if AVC is lower than the price, the firm could make a profit. (Profitability also has to do with fixed costs, which are not covered here.) In the example on the left, the market price for a TV is $150. If the firm has only variable costs, any output level at which AVC<$150 would be profitable.

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Understanding the Relationship Between Average Variable Cost and Average Product of Labor

Ä Review: The average product (AP) of labor is total product (TP) divided by the number of workers. It measures total product or output per worker. The average product of labor is written as average product (AP) of labor or AP(L).

Ä Review: Average variable cost (AVC) is variable cost (VC) divided by total product (TP). It measures labor cost per unit of output.

Ä APL and AVC have an inverse relationship with each other.

You should first understand the mathematical relationship between AVC and AP. In the proof on the left, L is the number of employees and W is the wages paid to each employee. Because AVC is VC divided by TP, you can rewrite AVC as (wages x labor)/TP and divide both the numerator and the denominator by labor. The new denominator is the AP(L). This proof tells you that AVC is the wages paid divided by the APL.

To see how productivity and costs are inversely related, look at the graphics on the left. If wages are $1000 per worker, and one worker can produce 1/4 of a TV, then it will require four workers to produce each TV. AVC will be $4000---the amount of VC needed to produce one TV. However, if productivity increases to 1/2 TV per worker, it will take only two employees per TV, and AVC falls to $2000.

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On a graph, you can see the relationship between APL and AVC. When APL is rising, the firm does not have to hire as many workers to build its TVs. Therefore, AVC must come down because AVC = (wages x labor)/TP.

At some point, APL reaches a maximum and AVC reaches a minimum. After that point, APL falls because additional workers are less able to efficiently produce TVs. AVC must rise because the firm has to hire more and more workers to produce more TVs.

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Understanding the Relationship between Marginal Cost and Average Variable Cost

Ä Review: Marginal cost (MC) is the cost of producing an extra unit of output.

Ä Review: Average variable cost (AVC) is the cost of labor per unit of output produced.

Ä When MC is below AVC, MC pulls the average down. When MC is above AVC, MC is pushing the average up; therefore MC and AVC intersect at the lowest AVC.

You should understand the exact relationship between marginal cost (MC) and average variable cost (AVC). Because MC is the cost of producing the next unit, when it is below AVC, AVC must be falling. AVC falls because MC is the cost of the next unit produced; therefore, when the next unit costs less than the average, it must be pulling the average down. You can see this geometrically on the left.

By the same logic, when MC is above AVC, it is pushing the average up so AVC must be rising. When the marginal unit costs more than the average, the average has to increase. By definition, then, the MC curve intersects the AVC curve at the minimum point on the AVC curve. At the intersection, MC and AVC are equal.

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If you flip the AVC and MC curves over, they become APL and MP curves. Once again, productivity and costs are mirror images of each other.

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Defining and Graphing Average Fixed Cost and Average Total Cost

Ä The short run is a brief period of time during which only one input can be varied.

Ä Fixed inputs are inputs in the production process that do not change with changes in output. Examples are machinery and factories.

Ä Variable inputs are inputs that can be changed when output changes. Usually labor is the only variable input.

Ä Total fixed costs (FC) are short-run costs that that do not vary with output.

Ä Average fixed costs (AFC) are fixed costs divided by total output.

Ä Average variable costs (AVC) are variable costs divided by total output.

Ä Average total costs (ATC) are the summation of AFC and AVC.

All firms have fixed inputs in the short run. The fixed inputs are usually the factory and equipment, and the variable input is labor. To produce output, firms have to combine fixed and variable inputs, as the graphic on the left indicates.

Average fixed cost (AFC) is total fixed cost (FC) divided by total product. Total fixed costs do not vary with output, but average fixed costs decrease as total product (TP) increases. Geometrically, AFC becomes a rectangular hyperbola. In other words, as output approaches infinity, AFC approaches zero. On the left is the AFC curve showing that it decreases as output increases.

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To graph average total costs (ATC), you must get the vertical summation of AFC and AVC. Add the two at each output level and plot the points as shown on left.

The ATC curve lies above the other two because it is the summation of AFC and AVC. On the left, you can see that it is U-shaped like the AVC curve.

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Calculating Average Total Cost

Ä Average total cost (ATC) is total cost (TC) divided by total product (TP): ATC = TC/TP.

Ä A second method for calculating ATC is to separate TC into fixed costs (FC) and variable costs (VC), divide each of those by total product and add them: ATC = FC/TP + VC/TP.

Average total cost (ATC) can be calculated for every level of production by adding variable cost and fixed cost and dividing the total by that level of output, as done on the left. The ATC in the example is $11,000/2 = $5500.

The second method for calculating ATC is to separate TC into its two components, VC and FC, divide each of those by TP, and add them as on the left.

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The formulas on the left summarize the two methods for calculating ATC.

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Putting the Cost Curves Together

Ä The average cost curves summarize unit costs and productivity . The costs curves are mirror images of the productivity curves.

Ä The important average cost curves are average fixed cost (AFC), average variable cost (AVC), and average total cost (ATC). Each of these is calculated by dividing the appropriate cost by total product (TP):

AFC = FC/TP AVC = VC/TP ATC = (VC + FC)/TP.

Ä The marginal cost (MC) curve is below the average cost curves when the average cost curves are falling and above the average cost curves when they are rising.

Review: Recall from the cost lectures that the cost curves summarize productivity. When productivity is rising, cost is falling. The curves on the left summarize the reciprocity of the average product (AP) of labor curve to the average variable cost (AVC) curve and average total cost (ATC) curve. Note: In the graph on the left, the ATC curve lies above the AVC curve, but it is unlabeled.

In the decreasing portion of the average cost curves on the left, costs fall because

1. increasing output is spreading the fixed costs over more units; thus, average fixed—and therefore average total—costs are falling;

2. additional workers are increasingly productive.

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In the increasing portion of the total cost curves on then left, costs are increasing because additional workers are less productive than the previous ones. Even though fixed costs (FC) remain the same, the variable costs (VC) are increasing at an increasing rate. It is the increasing variable costs that force the average up.

The vertical difference between the ATC curve and the AVC curve is the area between the two curves. This area is AFC. Note on the left that as production increases, the AFC shrinks. This shrinkage occurs because fixed costs are being spread between more units, but variable costs are increasing. Remember: ATC = FC/TP + VC/TP.

In the rising portion of the ATC curve, AVC is increasing faster than AFC is falling, thus pushing the ATC curve up.

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Marginal cost (MC) is the cost of producing another unit of output; that is, it is the cost of the additional labor required to produce another unit. When AVC and ATC are falling, MC must be below the average cost curves. When AVC and ATC are rising, MC must be above the average cost curves. Therefore, MC intersects the average cost curves at the average cost curves’ minimum points. If you are having trouble understanding the relationship between marginal costs and average costs, remember that marginal costs are the cost of the next unit. If the next unit costs less than the average of the previous units, it pulls the average down; if it costs more than the previous units, it pushes the average up.

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Defining the Long Run

Ä The long run is a time period in which there are no fixed inputs and therefore no fixed costs . All inputs can be varied.

Ä In the long run, a firm faces two decisions: (1) the cost-minimizing technique that it wants to use and (2) the scale or size of operation that it will use.

Ä A capital-intensive technology is one that uses more capital relative to labor .

Ä A labor-intensive technology is one that uses more labor relative to capital.

In the short run, almost all the manufacturing inputs are fixed. The only variable one is labor. In the long run, the firm has enough time to vary all inputs including, factory, equipment, machinery, tools, and such. In the long run, there are no fixed inputs.

In the long run, the firm can choose either a capital-intensive technology or a labor-intensive technology. The choice depends on the relative costs of the two. In the short run, the firm can only add or eliminate labor, its variable input.

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In the long run, the firm also gets to choose the size of its operation. This is called the scale. It can build new factories or open new offices or close some operations. In the short run, scale is fixed.

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Determining a Firm's Returns to Scale

Ä If a firm’s output increases by the same percentage as the increase in its inputs, it has constant returns to scale.

Ä If a firm’s output increases by a greater percentage than the percentage increase in

its inputs, it has increasing returns to scale.

Ä If a firm’s output increases by less than the percentage increase in its inputs, it has decreasing returns to scale.

In the short run, a firm can increase output only by increasing labor. In the long run, a firm can change the techniques of its operation by increasing labor, tools, equipment, and/or its factory.

A firm that increases all its inputs by some percentage and then the subsequent output increases by the same percentage is said to have constant returns to scale. For example, if a firm doubles its employees and its other inputs, and then output doubles, it has constant returns to scale. The example on the left shows constant returns to scale. Constant returns to scale describe many firms in the economy because firms replicate previous work.

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A firm that is able to increase output by a greater percentage than the percentage increase in its inputs is said to have increasing returns to scale. In the example on the top left, the firm doubles its inputs but output triples. The opposite case is when a firm has decreasing returns to scale. Doubling inputs results in a less-than-doubled output as on the lower left. Economists believe that this may happen when employees start trying to get special treatment for themselves or their group and become less productive.

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Understanding Short-Run and Long-Run Average Cost Curves

Ä The long-run average cost (LRAC) curve is a U-shaped curve that shows all possible output levels plotted against the average cost for each level.

Ä The LRAC is an “envelope” that contains all possible short-run average total cost (ATC) curves for the firm. It is made up of all ATC curve tangency points. All ATC curves are short-run curves.

Ä The point of efficient scale is the point on the long-run average cost (LRAC) curve where average cost for a firm is at the minimum.

In the long run, all inputs are variable. The long-run average cost (LRAC) curve shows all possible outputs in the long run. On the left, at the point where the LRAC curve has zero slope, the firm is experiencing constant returns to scale. In the decreasing part of the LRAC, long-run average costs are falling so the firm is experiencing increasing returns to scale. In the increasing part of the LRAC curve, where costs are increasing, the firm experiences decreasing returns to scale.

Each output point on the LRAC curve represents a particular combination of capital and labor . Remember that in the long run, a firm can change both capital and labor. Each output level on the LRAC curve represents a combination of capital and labor that is possible in the long run. In the short run, capital is frozen at a particular level.

The LRAC curve is an “envelope” containing all possible short-run cost curves. Each average total cost (ATC) curve represents a manufacturing scale where the only way to increase output is to hire more workers. It is for this reason that the ATC curve lies above the LRAC curve except at one point of tangency. The point of tangency is the cost minimizing point for that level of output.

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1

The short-run ATC curves represent different scales of plant that cannot be changed in the short run. They are all above the LRAC because firms have less flexibility in the short run and costs are higher. Each tangency point is the cost-minimizing point for that level of output.

The LRAC for most firms is U-shaped reflecting first, increasing returns to scale; at some point constant returns to scale; and finally, decreasing returns to scale. On the left, you can see the shape of the LRAC.

On the LRAC, there is at least one point where a tangent line has a slope of zero. This is the point where long-run average costs are at the lowest for the firm. On the left, the tangent line is horizontal at the point on the LRAC curve where the slope is zero.

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The output and cost combination where the firm is experiencing constant returns to scale is called the point of efficient scale. In the long run, the firm can do no better than this combination because at no other point in the long run can its average, or per unit cost, become less.

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Understanding the Difference between Movement Along a Cost Curve and a Shift in a Cost Curve

Ä The firm moves along its cost curves only when the product price increases or decreases.

Ä If any other variable—for example, rent on capital or labor costs—changes, the

firm moves to short-run cost curves on the same long-run average cost (LRAC) curve.

The firm adjusts output by movement along its cost curves only when the product price changes. Any other variable change means that the short-run cost curves shift.

Technically, short-run curves do not shift. As the firm moves from one output level to another along the LRAC, the firm actually moves to a new set of short-run cost curves. For example, on the left, if the firm experiences an increase in the cost of labor or rent for capital, it would move to a new point on the LRAC and operate in the short run on a new average total cost (ATC) curve. If technology changes, the whole set of curves, including the LRAC, shifts up or down.

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Constructing Isocost Lines

Ä An isocost line is a line that represents all combinations of a firm’s factors of

production that have the same total cost. Ä Factors of production are generally classified as either capital (K) or labor (L).

Ä Wage (W) is the price a firm has to pay for labor and rent (r) is the price it has to pay for capital.

Ä The slope of an isocost line represents the cost of one factor of production in terms of the other.

Ä Rational firms want to minimize costs; that is, they want an isocost line close to the origin.

You can represent the total costs of production with an isocost line. The isocost line is a firm’s budget constraint when buying factors of production. To calculate the isocost line for a firm, begin with the total cost equation, TC = (W x L) + (r x K) and solve for K. W= wages, L =labor, r = the rent (what you pay for the use of capital), and K = capital.

In the example on the left, if the firm’s budget is $100 and the rent (r) for each unit of capital (K) is $10, then the vertical intercept is the total cost (TC) expressed only in terms of capital. In other words the entire budget is spent on capital and nothing is spent on labor.

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Similarly, the horizontal intercept is the point at which the entire budget is spent on labor. The TC is expressed only in terms of labor. The isocost line represents all combinations of capital and labor that have the same total cost. Therefore, any values of capital and labor that the firm can choose must satisfy the equation on the left that you previously derived.

Then slope of the isocost line is W/r or the relative price of the inputs. W/r is the opportunity cost of labor; that is, it tells the firm how many units of capital it has to forego to get another worker.

Because isocost lines are determined by the budget, any change in a firm’s total budget would cause the budget to shif t in or out, as shown on the left. An outward shift represents an increase in the budget (right graph), and an inward shift represents a decrease in the budget (left graph). The middle graph on the left shows the original isocost line.

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The slope of the isocost line represents the relative prices of the inputs, labor and capital. When the price of one changes relative to the price of the other, the line does not shift, but the slope changes.

In the lower panel on the far left, the price of capital has increased relative to labor, making labor relatively cheaper. In the lower far right graph, the price for labor has increased making labor relatively expensive. The middle graph is the original isocost line.

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Understanding Isoquants

Ä A production technology is the way a firm combines labor and capital to produce output. A firm may use labor-intensive technology, meaning that it relies more heavily on human labor than on capital, or it may use capital-intensive technology, meaning that it relies more heavily on capital than human labor.

Ä An isoquant is a graph showing combinations of capital and labor that a firm can

use to produce a given output.

Ä The marginal rate of technical substitution (MRTS) is the amount of capital a firm needs to substitute for one unit of labor to produce the same amount of output.

A firm could choose many different combinations of capital and labor that could produce a given quantity. For example, on the left, suppose this firm decides to produce 12 TVs per week. It could combine capital and labor in any of the combinations on the schedule on the left to produce 12 TVs a week.

By putting labor on the horizontal axis and capital on the vertical, you can plot some points and connect them to form an isoquant. Points near the top of the curve represent capital-intensive technology and points near the lower end represent labor-intensive technology.

The slope of an isoquant at any point is the slope of a tangent line at that point. The slope is called the marginal rate of technical substitution (MRTS). It tells the firm how much capital is needed to replace a unit of labor to maintain the output. On the left, it is rise over run and tells us the MRTS necessary to continue producing 12 TVs. At the point illustrated, the MRTS is 2/2 = 1.

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The most important point to remember about the slope is that there is a diminishing marginal rate of technical substitution. Near the top, where the MRTS is high, labor is scarce and capital is abundant. To replace a worker, the firm must use a lot of capital. At the lower end, the MRTS is low. Labor is abundant and capital is scarce. It takes just a little capital to replace one worker in order to maintain the same output.

A firm can choose different output levels that require different combinations of inputs. For example, on the left, if the firm wanted to produce 24 TVs, its new isoquant would look similar to the higher one.

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Finding the Least-cost Factor Combination

Ä A firm chooses a capital-labor combination that minimizes its total cost of

production.

Ä The exact combination of capital and labor that a firm would choose depends on the relative prices of capital and labor.

Ä If the relative prices of capital and labor change, the firm substitutes away from the relatively more expensive factor.

Ä In the short run the firm can only change its labor and cannot choose the least-cost combination of capital and labor.

The slope of the isocost line is the relative price of capital and labor. In the example on the left, the price of labor is $10, and the price of capital is $30. The slope of the isocost curve is the fraction wage/rent or $10/$30 = –1/3. The curve slopes downward so it has a negative sign. Recall: Rent is the price paid for capital; the wage is the price paid for labor.

The firm chooses the output level that it wants and then finds the least-cost combination of capital and labor to produce that output. In the example on the left the firm chooses to produce 12 units of output and finds the combination of factors of production at the point where the slope of the isocost curve is tangent to the isoquant line that represents 12 units. In this example the firm chooses six units of labor and two units of capital at a total cost of $120.

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The firm could choose another combination of capital and labor to produce the same output, but any other combination would not be the cost-minimizing combination. For example the firm could choose 12 units of labor and one unit of capital to produce 12 units of output. This combination of capital and labor would cost the firm $150.

Suppose that the relative price of capital and labor changes. If the price of labor increases more than the price of capital, the slope of the isocost curve changes, and the firm chooses a new combination of factors to produce the output. In the example on the left, the firm substitutes in the direction of the factor that has become relatively less expensive and away from the factor that has become relatively more expensive.

If the firm wants to increase its output to 24 units, it can increase only its labor in the short run. The amount of its capital is fixed. To produce 24 units in the short run, it must use the two units of capital that it previously used and increase labor to 12 units. As you can see on the left, this is not the least-cost combination because the isocost curve is not tangent to the isoquant.

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In the long run the firm can adjust labor and capital and find the least-cost combination of factors. The firm finds the tangency point on the desired isoquant. Note that long-run costs are always less than short-run costs because a firm has the flexibility to adjust both capital and labor.

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Understanding the Role of Price

Ä???? The difference between a firm’s total revenue (TR) and total costs (TC) is

profit. Total revenue for firm is dependent upon the product’s price.

Ä ?Competitive firms are called price takers. This means that they have to accept their product’s price as set by the market. They are unable to influence the price.

Ä ?Firms that have market power are called price setters. They are able to influence their product’s price because of the power they have in the market.

An underlying assumption in economics is that firms are interested in profit maximization. For all profit-maximizing firms Profit = TR-TC, where TR = product price x quantity sold. Therefore, price plays a key role in profit maximization. This concept is graphically illustrated on the left.

Competitive firms are price takers because each firm has such a small share of the market that it cannot influence the price. Firms with market power are price setters in that they have a large share of the market and can influence the price of the product.

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Understanding Market Structures

Ä Monopoly, monopolistic competition, and oligopoly are three types of market structure that exercise market power because certain barriers to entry exist in the market.

Ä A market that is described as perfect competition has no barriers to entry, many price-taking firms, and homogeneous products.

A monopoly is an industry in which only one firm supplies the entire market. If a monopoly is to continue, there must bb must significant barriers to entry for other firms. Some barriers to entry are copyrights, patents, sole ownership of a strategic resource, government licenses, and a cost structure that creates a natural monopoly.

Monopolistic competition and oligopoly are two market structures that also exist and maintain market power. Monopolistic competition is a market in which firms try to carve up a market among themselves by trying to slightly differentiate similar products. Oligopolies are markets in which a few firms try to watch each other, then to strategically react to what other firms do.

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A market characterized by perfect competition is one that has many firm, no barriers to entry, price-taking behavior (no one firm can influence the price). Each individual firm in the market faces a perfectly elastic (horizontal) demand curve; it can sell all it can produce at the market price, but if it tries to raise the price, it will lose all its sales.

For perfect competition to exist, the market must exhibit the assumptions listed on the left. In the real world, perfect competition rarely exists but firms often behave in a way that is similar to the model. Economists use the model to predict behavior.

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Finding Economic and Accounting Profit

Ä Economic and accounting profits differ from each other in the way that each defines costs: accounting uses only explicit costs, but economics calculates opportunity costs. Ä Sunk costs are unrecoverable coasts that should not effect current decisions.

Economists and accountants look at costs very differently. Accountants account for only explicit costs, or those costs for which a monetary payment must be made. Economics account for opportunity costs as well as explicit costs. Because of the two ways of examining costs, accounting and economic profit are different. Recall that total revenue minus total costs equals profit. TR-TC = profit

Accounting costs are only those costs that the firm explic itly pays for. They are costs that the firm must write checks for. To calculate accounting profit, the firm finds its total revenue and subtracts its explicit costs. Accounting does not account for the opportunity costs of the resources.

Economic profit is always less than accounting profit because it has to add in opportunity costs. In the example on the left, the firm’s explicit costs are embedded in the opportunity cost. Economic profit is all profit greater than the opportunity costs. Economic profit is also called rent.

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Sunk costs are unrecoverable costs that a firm expends on a project. Economists argue that sunk costs should never enter into current decisions.

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Finding the Firm’s Profit-Maximizing Output Level

Ä A competitive firm uses the following production rule to maximize profits: the firm's

profit-maximizing output level is where its marginal cost (MC) just equals the product price and where marginal cost is increasing; that is, the MC curve is sloping upward.

Ä A competitive firm is one that can produce any quantity that it wants without influencing the market price. When a firm cannot influence the price, it is called a price taker.

Ä Marginal revenue (MR) is the change in total revenue that results from a change in output.

For a competitive firm, marginal revenue (MR) is the product price. Because marginal revenue is the change in total revenue resulting from a change in output, it must be the price of the product. Anytime the firm sells its product, its revenue increases by the amount of the price that it sold the product for. Competitive firms are price takers so the price defines the firm’s marginal revenue. In the example on the left, the TV firm must sell its TVs at the market price of $500. Five hundred dollars is the marginal revenue that the firm receives for each TV.

In the lower graph you can plot the price as a straight line at $500. Recall from previous lectures that the slope of the total cost (TC) curve is marginal cost. The three important points to plot are the point of inflection where the slope of TC is zero and the two points where MC equals price.

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The firm wants to produce at the point that maximizes profit. From the upper graph, the profit-maximizing output is y* because that is the point at which the distance between total revenue and total cost is greatest and total revenue is greater than total cost. Find y* on the lower graph and follow the vertical line to y* on the upper one. You can tell the same story from the bottom graph but using the marginal cost/price terminology. At y*, marginal cost equals marginal revenue, or price, and MC is increasing.

To see why the profit-maximizing output is y*, examine the graph on the left. Recall that marginal revenue is the same as the product price. If the firm were to produce at a level greater than y*, each new TV would bring in only $500 in revenue but the cost of producing it would be greater than $500. In this case, MC > M, so the firm would cut production back to where the cost of producing the TV is equal to the revenue the TV brings it.

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Similarly if the firm were to produce at a level where MC < MR, it could improve its profits by increasing output. Each new TV would bring in $500 but cost less than $500 to produce. Note that the firm would never produce at yt. At that output, although MC = MR, MC is decreasing and TC > TR, it is the point of maximum loss, not maximum profit.

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Proving the Profit-Maximizing Rule

Ä Review: The firm’s profit-maximizing output rule is to produce at the point

where marginal cost (MC) equals price and MC is increasing.

Ä The firm must compare the price to average total cost (ATC) to determine if it actually is profitable.

Using the TV example from the previous lecture, note on the left that as long as MC is less than price, the firm’s profitability increases as the firm’s production increases. When MC exceeds price beginning at 49 units, profit starts to fall. The maximum loss occurs at two units which is also a point where MC = price. Howeve,r at this output level, the second condition is not met: MC is decreasing, not increasing.

Once the firm has found the profit-maximizing output level, it can then compare the price with the average total cost (ATC) at that level to determine if it is actually making a profit or if it is suffering a loss. If the price exceeds the ATC at the profit-maximizing output, the firm is profiting. If the ATC is greater than the price, the firm has a negative profit or loss. Recall that the price of TVs is $500. When ATC is $333, the profit per TV is $500 - $333 = $167. Total profit is $167 x 48 TVs = $8016.

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Calculating Profit

Ä A profitable, competitive firm divides its total revenue (TR) between its variable

cost (VC), its fixed costs (FC), and its profit.

Recall the cost curves from previous lectures. On the left you see the set of cost curves for the TV firm. The firm will produce at y* where the price of $500 equals marginal cost and marginal cost is increasing. For this firm the box created by P and y* is the firm’s total revenue. Total revenue is the price times the quantity or P x y*.

Total revenue for the firm can now be divided between the factors of production that are entitled to receive it; that is, the total revenue is distributed to profits, variable costs (VC) paid to the workers, and fixed costs (FC). Each box in the graph represents one of these factors. First draw a box from y* to the AVC curve, then to P1. This box represents the part of TR that goes to variable cost. VC is the lower box. Similarly the next box in the layer is the TR going to fixed costs. This area is the area between the AVC curve and the ATC curve. FC is the middle box. Because price is above ATC at the output level, the firm is profitable. The profit is the top box on the left. Recall that profit is total revenue minus total cost and is VC + FC. Profit is the upper box.

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Calculating Loss

Ä If the market price of a firm’s product falls below average total cost (ATC), the

firm will have a negative profit or loss.

Ä A firm experiencing a loss will continue to operate as long as the price is above average variable costs (AVC).

Recall from the previous lecture that the TV firm was facing a market price of $500 for a TV. At that price the firm was making a profit because the price was greater than average total cost (ATC). Now suppose that the market price falls to $300 per TV. The firm’s costs curves are depicted on the left. Note that this price is less than ATC at the output level y*.

You can find total revenue (TR), variable costs (VC), and fixed costs (FC) as before. However, in this example the profit region has collapsed, and the price is somewhere between ATC and AVC. Recall that ATC – AFC = AVC. If ATC = $350 and the price per TV is $300, then the firm is experiencing a loss of $50 per TV.

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When the firm faces a loss, it can choose either to shut down the operation or to keep operating. The shut-down point is this: if the price covers at least AVC, the firm should continue to operate. The reason they should continue to operate is that fixed costs are incurred even if they are shut down. If the firm is at least covering variable costs and possibly some of the fixed cost, they should continue to operate. The graph on the left shows that this firm is covering variable costs and some of the fixed costs when the price is $300.

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Finding the Firm’s Shut-Down Point

Ä Review: ?If the firm’s product price is above average variable cost (AVC), it will

continue to operate even if it is experiencing a loss.

Ä If the firm’s product price falls below AVC, it will shut down. The price at which marginal cost (MC) equals average variable cost (AVC) is called the shut-down point.

Ä The marginal cost (MC) curve above the firm’s AVC is its short-run supply (SS)

curve.

From the previous example of the TV firm, assume that the product price falls to P on the left graph. The firm’s total revenue is now the black box in the small graph on the far left. The firm produces at y* where its AVC = MC. At the price and output combination on the left, the firm is only covering its variable costs. It is experiencing a loss equal to its fixed costs. However, at p and y* it is indifferent to shutting down because if it shuts down, it will incur the fixed costs anyway.

Assume now that the price falls below AVC. The firm’s total revenue now is not covering all its variable costs and the firm is losing its fixed costs. The firm can minimize losses by shutting down. By shutting down it loses only its fixed costs which it incurs whether it is operating or not. If it continues to operate, it will lose fixed costs and a portion of variable costs. The point at which the price equals AVC is called the shut-down point.

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Because the firm will operate at any level above the AVC curve where its marginal cost is equal to the product price, the marginal cost curve above the AVC curve is also the firm’s short-run supply (SS) curve, labeled SS on the left.

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Deriving the Short-run Market Supply Curve

Ä The short-run market supply (SS) curve assumes that (1) firms are price takers, (2) each produces where the product price equals its marginal cost (MC) (when MC is increasing), and (3) each firm will shut down if the product price is less than its average variable cost (AVC).

Ä The short run-market supply curve is derived by horizontally summing each firm’s

short-run supply curve. It tells us the amount of product that producers will offer for sale at any given price.

In the example on the left, assume that there are three firms in a market for a good and that each has a different AVC schedule. Because the firms are price takers and cannot influence the market price, they all have to accept the price P as given. On the graphs, P is below each firm’s minimum AVC so each firm will shut down. In this case, there will be no market supply curve at all.

In the far left graph, price rises to P1, and the first firm, which has the lowest AVC, begins producing. At P1, it will produce y∗1. You can move horizontally to the far right graph and plot this combination of points. If the product price continues to rise, the first firm will produce more output by moving along its MC curve. Its MC curve is its supply curve. In the far right graph, you can plot these additional points for firm 1.

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If the product price reaches P2, the second firm would enter the market because it could now cover its AVC. In the second graph on the left, the second firm begins producing y*2 at P2. You plot that point on the graph on the far right in the box on the left. Like the first firm, the second firm moves along its MC curve as the price rises. Its MC curve becomes its supply curve, creating other price/quantity combinations, which are plotted on the market supply graph.

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The story is the same for the third firm. When the product price reaches its AVC, it begins production, as shown in the third graph. As usual, plot points in the market supply graph as the firm moves up its MC curve.

In this example, with only three firms the market supply curve looks a little strange. There are jumps in it where each firm enters the market.

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In a real competitive market there would be many firms with many points of entry. The short-run market supply curve would become smoother so that it can be depicted as on the left.

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Relating the Individual Firm to the Market

Ä The individual firm is a captive of the overall market, and its economic profitability is determined by market price.

Ä A firm makes a short–run economic profit if the price of its product is greater than its minimum average total cost.

Ä Firms respond to price changes by increasing or decreasing output using its marginal cost (MC) curve as a guide, or by entering or exiting the market.

Ä Economic profit is total revenue (TR) minus total costs (TC).

In the graphs on the left, the market supply and demand are summarized with the cost curves for an individual firm. The cost curves summarize the firm’s technology and input costs, while the market supply and market demand curves are the summations of the behavior of all consumers and suppliers. The market supply curve is the summation of each individual firm’s marginal cost (MC) curve. Note: The values on the vertical axes, P and $, are the same values. They show the market prices and thus the revenue that a firm would get for selling one unit.

Examine the graphs on the left. If the market price is P*, track that value to the graph on the right side to show the revenue that the firm would get at that price. In this example, P* covers the firm’s variable costs, as shown by the lower shaded box, and the firm’s fixed costs, as shown by the upper shaded box. The firm is covering all costs at output y*, but is not making economic profit.

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Now assume that there is a change in demand that causes the market demand curve to shift up, as illustrated on the left. In this case, the bidding process on both sides of the market will push the market price up.

The firm now can bring in more revenue and hire more workers, even if those workers are not as productive as the previous workers. We know they are not as productive because MC is increasing. But with the new, higher price the firm can afford to cover a higher marginal cost (MC). In the right-hand graph, the extra box shows that the firm is now making an economic profit. The new price is higher than its total costs (TC).

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Economic profit occurs only in the short run. Because firms are now making profits, two economic events happen: 1. existing firms start producing more

because the new price justifies expanded output;

2. firms that had previously shut down start production.

Firms increase quantity supplied to the point where P = MC. On the right hand graph on the left, firms are producing where P∗1 = MC.

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Examining Shifts in the Short-Run Market Supply Curve

Ä The short-run market supply curve is the summation of all firms’ supply curves above the shutdown point and is the short-run marginal cost (SMC) curve

Ä The short-run market supply curve can shift to the right (an increase in supply) in

response to (1) existing firms acquiring new capital and (2) new firms entering the market.

In a competitive market, the short-run market supply curve is the summation of all individual firms’ supply curves above the shutdown point, and is the same as the short-run marginal cost (SMC) curve. The market supply curve can shift because (1) existing firms’ supply curves shift, and (2) new firms may enter the market in response to economic profits in the industry. In the example on the left, consider the first reason. If a firm acquires new capital, its marginal product (MP) of labor increases. Labor becomes more productive. When labor becomes more productive, the firm’s marginal costs fall because marginal costs are the reciprocal of MP. The firm’s short-run supply (SS) curve then shifts to the right, and thus, the market supply curve shifts because the market supply curve is a sum of the individual supply curves.

The market supply curve can also shift because new firms may enter the industry in response to economic profits. If new firms enter, the market supply curve will shift to the right. You can use the same logic to work through a decrease in supply caused either by existing firms disposing of capital or firms leaving the industry.

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Deriving the Long-Run Market Supply Curve

Ä The long-run supply (LS) curve gives information about the size of an industry

and the nature of costs in that industry. Ä Costs in industries are characterized by increasing, constant, or decreasing

costs, depending on the behavior of long-run costs as firms enter the industry in response to increased demand.

To understand how to derive a market supply curve, consider first an industry where there is long-run equilibrium at price P0 and market quantity of ye. There is no incentive for any firm to change its behavior. Each firm is covering its opportunity costs but no firm is making economic profit. The market on the left is such an industry.

Now consider an increase in demand in this industry. If demand shifts from D to D’, there will be an increase in price and an increase in quantity supplied in the far left graph. In response to short-run profits, new firms start entering the market and the short-run supply (SS) curve starts shifting to the right.

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It is possible that in this the industry, as new firms enter and SS shifts to the right, the long-run costs for all firms in the industry rise. The rise in costs is attributable to firms bidding for a scarce resource. For example, if this were the trucking industry, qualified drivers may be in short supply and firms would have to bid up the wages to attract them. An industry such as this is called an increasing cost industry.

In an increasing cost industry, the market price rises to P1 at the intersection of the new demand curve and the new short-run supply curve. By connecting the old and new equilibrium points, you derive the long-run supply (LS) curve. As on the left, the long-run supply curve (LS) has a positive slope, reflecting the increasing costs.

Another type of industry is one in which long run costs remain constant as market demand and supply change. This industry is a constant cost industry and is depicted on the left. The LS curve has zero slope at the original market price, reflecting the industry’s constant costs.

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A final example is on the left. It is the decreasing cost industry. As new firms enter and begin production, costs for all firms in the industry may actually decrease. The LRAC shifts down, a new market price is established, and the derived LS curve is down sloping.

The chart on the left summarizes the long-run supply market (LS) curves for increasing, constant, and decreasing cost industries.

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Examining the Firm's Long-Run and Short-Run Adjustments to a Price Increase

Ä A price increase for a competitive firm’s product produces different responses in the short run and in the long run.

Ä In the short run, a firm increases output by moving along its short-run cost curves to

the output level where price equals short-run marginal cost (SMC), P = SMC.

Ä In the long run, the competitive firm has the flexibility to change all its inputs and increases output further to the point where price equals long-run marginal cost, P = LMC.

Ä With the increased price the firm is able to make an economic profit in both the short run and long run, but the profit is higher in the long run.

Using the trucking firm example, the firm faces short-run and long-run cost curves. The long-run curves are always lower than the short-run curves because in the long run, the firm has more flexibility to change the combination of capital and labor . In the short run, the firm can vary only labor if it wants to change output. In the example on the left, if market price for the firm’s product is P0, the firm is breaking even: it is making zero economic profit.

Assume now that the market price rises to P1. The firm’s short run response to the price increase is to increase output to y1s. The output level the firm chooses is where MR = P = SMC. (Recall for a competitive firm MR = P.) The firm is now making an economic profit, as shown by the shaded area on the left. Profit is the area above the ATC curve.

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In the long run the firm has the option of increasing output to y1L where MR= P = LMC. It would prefer the long-run output level at the new price because long-run profits are greater than in the short run. In the long run, the firm would buy additional trucks as well as hire more drivers because it has the flexibility to alter all inputs to achieve the profit-maximizing output level.

To summarize the firm’s long-run and short-run response to a price increase: 1. the firm increases output in both the long

run and the short run, but the long run increase is greater;

2. the firm realizes an economic profit in

both the long run and the short run, but the long run profit is greater.

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Defining Monopoly Power

Ä A monopoly is one firm supplying 100 percent of a product to a specific market.

Ä A monopoly can appear in a market when one firm owns the entirety of a resource, when operation is large relative to the size of the market.

A monopoly is different from a competitive firm in that there is only one producer of a product. The firm then has some degree of market power in that it can set the price for its product. Recall that a competitive firm is a price taker. Although monopolies are rare in the world, there are a few. One kind of monopoly is one in which a firm owns all of a specific resource. At one time DeBeers Diamond Cartel owned all of the world’s diamond mines. Another example is sole ownership of restaurant space in an airport.

Ä

Another type of monopoly is one created by a government granting a right to sole ownership by way of patents and licenses: In the United States and other countries, inventions are granted patents for up to 14 years. A patent is a right to exclusive ownership of the production of the product. Government can also grant rights to one company to provide a particular service by granting an exclusive license.

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Sometimes a natural monopoly exists in a market when the scale of efficient operation is large relative to the market. If a firm’s long-run average cost curve is continuously downward sloping, or is downward sloping over a large output level, only one firm can efficiently provide a good or service. One example of this type is an electric company. In a specific market, it is efficient for only one firm to build power plants and put up lines.

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Defining Marginal Revenue for a Firm with Market Power

Ä Marginal revenue (MR) is the change in total revenue (TR) that a firm gets

from selling one more unit of its product.

Ä For a monopolist, marginal revenue is always less than price because to sell an additional unit of its product, a firm has to lower the price not only for the marginal unit but for all units.

Ä Average revenue (AR) is the total revenue divided by output. AR is the per unit revenue, and for a monopolist it is always the price.

In the example on the left, assume that the firm has a monopoly restaurant at an airport. It can sell different quantities of meals at different prices, as shown in the two far left columns. It has a down-sloping demand curve. You then multiply P x Q at each point to get total revenue (TR). Marginal revenue (MR) is the change in total revenue at each price/output combination.

There are some things that you should remember about the MR/TR relationship: 1. TR increases for awhile then begins to

decrease. At first, as the price falls, the firm sells more dinners that more than compensate for the lower price, but later the additional meals do not make up for lost revenue from selling all of them at a lower price.

2. When TR is maximum, MR is zero. 3. When MR becomes negative, TR is falling.

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From the production schedule on the previous page, you can draw a demand curve which tells you the quantity sold at any given price. The demand curve is also called the average revenue (AR) curve. Average revenue is total revenue/quantity. For a monopolist, average revenue is the same as the product price.

The most important concept to remember in this lesson is that marginal revenue is always less than the price for a monopolist. The marginal revenue curve is depicted on the left. The reason that it is less than the price at all output levels is that if the firm wants to sell more dinners, it has to lower the price for all customers. For a competitive firm, marginal revenue is always the price because one additional sale increases total revenue by the price. For a monopolistic firm, total revenue changes by something less than the price because when it lowers the price, it has to lower it for all customers.

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Determining the Monopolist’s Profit-Maximizing Output and Price

Ä A monopolist maximizes profit by producing at an output level at which marginal

revenue (MR) equals marginal cost (MC) but will charge a price as determined by the firm’s demand curve.

A firm that is the sole producer of a product and has zero costs will want to maximize its total revenue. On a graph, it would try to maximize the size of the total revenue rectangle on the left. To maximize revenue it would produce at an output level where the marginal revenue curve crosses the horizontal axis of the graph or where MR = 0. The price it charges is the price on the demand curve at that level of output.

When a monopolist produces a product and has to deal with production costs, it wants to maximize profits not revenue. Because profits are total revenue minus total costs, the monopolist will produce up to the point at which marginal revenue (MR) = marginal cost (MC) and find the price at that level on the demand curve. On the left the firm with costs produces at Q*m because at that point, additional sales begin adding more to costs than they do to revenue. The market price at that output is P*m so price is greater than marginal revenue.

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The economic intuition for choosing to produce at the point where MR = MC is this: as long as the firm can add more to total revenue from an additional unit than is subtracted from total revenue by its production, the firm will produce it. After the point where MR = MC, the additional cost of the marginal unit is greater than the revenue it brings in.

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Calculating a Monopolist’s Profit or Loss

Ä A monopolist calculates its profit or loss by using its average cost (AC) curve to

determine its production costs and then subtracting that number from total revenue (TR).

Recall from previous lectures that firms use their average cost (AC) to determine profitability. Average cost in this example is average total cost (ATC). Profit for a firm is total revenue minus total cost (TC), and profit per unit is simply price minus average cost.

To calculate total revenue for a monopolist, find the quantity it produces, Q*m, go up to the demand curve, and then follow it out to its price, P*m. That rectangle is total revenue. Next find the output level on the average cost curve and go to the vertical axis from the AC curve. The portion of the total revenue rectangle that represents production costs is the striped section on the left. The firm’s profit is the small rectangle on the top of the total revenue rectangle. It is TR-TC.

If the monopolist’s average cost is greater than the price of its product, the firm would suffer a loss. In the right-hand graph, the firm’s average cost curve is greater than price, and it is losing money. Total cost is AC* x Q*m, but total revenue is only P*m x Q*m, so TC>TR.

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Graphing the Relationship Between Marginal Revenue and Elasticity

Ä For firms with market power, there is a specific relationship between marginal

revenue (MR) and elasticity: if the firm faces an elastic demand curve, a small change in price will result in positive marginal revenue. If the firm faces an inelastic demand curve, a small change in price will result in negative marginal revenue.

Recall from the previous lecture that a firm with market power faces a downward-sloping demand curve so when price falls, quantity demanded increases. Recall also from prior lectures that a competitive firm faces a perfectly elastic demand curve and must take the market price as given. In the graph on the left, assume that the firm, a monopolist, lowers the price of its product from P0 to P1. Quantity demanded increases to Q1 from Q0. If you recall that total revenue is P x Q, examine the boxes on the left. The original box is bounded by P0 out to the demand curve and down to Q0. This box is the original total revenue. After the price decrease, the small box at the top is the loss of revenue resulting from a lower price on each unit sold but the larger box on the right is the gain in revenue from selling more units.

For the monopolist, whether the gain in revenue from selling more units is greater than the loss in revenue from selling them at a lower price depends on the elasticity of demand for the product. You can see from the left that by using the boxes, you can derive the elasticity of demand for this product.

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The monopolist’s marginal revenue (MR) is intimately related to elasticity. If the firm faces an elastic demand curve, a small change in price means a large change in sales. If demand is inelastic, a change in price means a small increase in sales. Geometrically, examine the boxes on the left. Box 1 is the gain in revenue from selling more units. Box 2 is the loss in revenue from selling at a lower price. If box 1 is larger than box 2, the product has an elastic demand. If box 2 is larger, the demand is inelastic.

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Determining the Social Cost of Monopoly

Ä The result of having a monopolistic market as opposed to a competitive market is

restricted output and a higher price.

Ä Monopoly creates a social cost, called a deadweight loss, because some consumers who would be willing to pay for the product up to its marginal cost (MC), are not served.

In a monopoly, there is no supply curve because monopolists are price setters and not price takers. In the graph on the left, the MC curve is not the firm’s supply curve. In a competitive market, firms have to passively take the market price as given. The supply curve describes the quantities they will put on the market at any given price. If the firm is a monopoly it does not need that information because it is setting the price.

In a competitive market, marginal cost tells us the social cost of producing a product, and the demand curve tells us the social benefit of producing the product. The competitive price/output is determined where marginal cost intersects the demand curve, as on the left. Recall from previous lectures that at the competitive price/output combination social value is maximized.

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Recall from the monopoly lectures that a monopolist restricts the output to the point at which MC = MR and increases the price to what the market will bear. The result of a monopoly is restric ted output and higher price.

Because of the monopolist’s restriction of output, you can see that there are people who would be willing to pay up to the marginal cost who are not being served. The reduced output is the difference between Qc - Qm. The shaded area in the graph on the left represents the loss of economic value from a monopoly The loss is called deadweight loss.

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Calculating Deadweight Loss

Ä? Review: Deadweight loss is the social benefit that is lost when a monopolist

operates at its profit-maximizing output/price combination.

Ä? Monopolies create deadweight loss by producing lower output and charging a higher price than what a competitive market would produce and charge.

Ä Monopolists must often engage in rent-seeking behavior to maintain their monopoly positions.

Graphed on the left is a competitive firm’s market for restaurant meals at an airport. Assume that the marginal cost for each meal is $3 (as shown on the vertical axis) and that that price represents the social cost of producing each meal. Assume also that each point on the demand curve represents consumers’ reservation prices. In a competitive market, the equilibrium price is $3, and the firm will sell five meals.

The competitive market is creating $13 in economic value. The economic value is seen on the left as the total of the difference between each customer’s reservation price and the marginal or social cost of the meal. To calculate consumer surplus, you simply sum the differences up to the point at which another unit adds no more economic value. In this case, there is no producer surplus. All economic value is in the form of consumer surplus.

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Now assume that the firm selling meals at the airport is a monopolist. The socially beneficial output and price is not the monopolist’s profit-maximizing output and price. In fact, at $3 and five meals, the firm is making zero economic profit. The monopolist’s profit-maximizing output is two meals at $7 each. The monopolist’s profit at that output is TR – TC = $14.00 - $6.00 = $8.00.

When there are monopoly profits, society loses the economic value of the triangular shaded area on the left. This is value that is gained when this market is a competitive market because it represents customers who are willing to pay for meals but are not served. In this case, the deadweight loss is $3 because the monopoly has created only $10 in economic value as opposed to the $13 created under competition.

Another loss of economic value occurs under monopoly: because the monopolist has economic profit, other firms will want a franchise. (Recall that economic profit is any revenue greater than average costs.) To protect its monopoly, the firm has to engage in non-price competition, or rent-seeking behavior . Rent-seeking activities are those that involve political lobbying, bribery, or other non-price activities that will ensure continuation of the monopoly. These activities are another form of social loss.

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Understanding Monopoly Regulation

Ä? Governments may regulate monopolies by breaking them up, by forcing them to

use average cost (AC) or marginal cost (MC), or by buying the patents and auctioning off licenses to produce.

Ä A patent is a government-granted right to have a monopoly on an invention or process for a certain number of years. It is a legal and economic incentive to invent.

Because of the deadweight loss created by monopolies, governments often try to break them up, as happened with telephone companies. The problem with this approach is that economies of scale make small firms inefficient and high-cost. In the case of pharmaceutical companies, small firms could not afford the high cost of research and development. If average cost is continuously down-sloping, it is not possible for a firm to get to large.

A monopoly would choose to produce at the point at which its marginal revenue equals its marginal cost, then go to the demand curve to determine its price. The competitive price would be the one at which the firm’s marginal cost (MC) equals its price at the intersection of its demand curve. As shown on the left, the competitive price is lower and output is higher.

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Another way that governments may regulate monopolies is to tell them what price to charge. Many governments force monopolies to price their product at average cost (AC). This pricing scheme does eliminate part of the deadweight loss, and it is usually easy for firms to calculate their average cost. However, some monopolies may intentionally overstate their costs, and there is no real incentive to innovate and operate efficiently.

Another regulation method is to force monopolies to price at marginal cost, which is the competitive price. However, if average costs are higher than marginal costs, the firm would face a loss if it had to price at marginal cost. It is also difficult for firms to estimate marginal cost.

The picture on the left summarizes the main regulatory actions and their drawbacks against what an unregulated monopoly would do.

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A new proposal recently advocated by some is for the government to buy a patent from companies and then auction licenses for smaller companies to produce the products. The advantage of this proposal is that economies of scale would allow large firms to conduct the research but allow competition into the production.

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Understanding the Kinked-Demand Curve Model

Ä The kinked-demand model explains price stickiness in some oligopolies: if a firm raises its price, other firms do not follow; if a firm lowers its price, other firms follow. Ä The model has been criticized because it does not explain how the original equilibrium is reached and it does not match empirical studies in most oligopolies.

The kinked-demand curve was developed by economist Paul Sweezy to explain oligopoly behavior.

Examine the graph on the left. If firm A is an airline and charges $200 for a ticket, it can sell 10,000 tickets. Assume firm A tries to raise its price. Its demand curve at prices above $200 looks like the one on the left. It is very elastic above $200, so it loses market share when it raises price because the other firms do not raise their prices.

Assume now that firm A lowers its price below $200. Other firms match the price decrease so firm A gains little market share. The demand curve is inelastic at prices less than $200. The result is a kink in the demand curve at the original price.

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Because of the down sloping demand curve, the marginal revenue curve lies below the demand curve. There is a gap in marginal revenue at the original price. At this point, the firm experiences a sharp drop in MR when it lowers the price.

You can find the output/price combination that the firm produces and sells for by putting in the marginal cost curve. The MC curve is usually within the gap.

The model is logically consistent but does not explain the original price and does not match empirical evidence. This model is one of several models used to explain oligopoly.

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Defining Monopolistic Competition

Ä Monopolistic competition is a market form in which firms draw some features

from monopolies and some from competitive markets.

Ä? Monopolistic competitors use advertising to create product differentiation so they can exercise market power.

A market described as monopolistic competition is one that has many firms, each trying to create mini-monopolies. Firms try to create product differentiation to separate their similar products from other similar products. Monopolistic competition is a blend of competitive and monopoly pricing: price is generally somewhere between a competitive price and a monopoly price.

Firms spend a large amount of advertising to persuade buyers that their products are not perfect substitutes for other similar products. They often develop brand loyalty to the extent that lower prices of other products cannot attract the firm’s loyal customers. The firm can create some market power if it can persuade buyers that its product is distinct.

Firms create product differentiation by advertising and by introducing a slight difference in its product. Monopolistically competitive firms are slightly less efficient than competitive firms but lead to more variety in the market.

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Understanding Pricing and Output Under Monopolistic Competition

Ä? In monopolistic competition, firms make price/output decisions as if they were a

monopoly. In other words, they will produce where marginal revenue equals marginal cost.

Ä? Free entry into the market may ultimately shrink the economic profits of

monopolistically competitive firms.

To understand how a monopolistically competitive firm determines its output and prices, assume that there is a single fast food restaurant in a market, as on the left. This monopolistically competitive firm will price its product at the point at which marginal cost equals marginal revenue. It is behaving as a monopolist. The firm is realizing economic profits because the price is greater than average cost.

However, as in a competitive market, there is free entry into the market so other firms will enter the market enticed by the economic profits. The firm’s average costs may increase, and ultimately economic profits may disappear. For a monopolistic competitor, the economic profits may shrink but not completely disappear.

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Monopolistic competition is like a monopoly in that the firms try to price at the point where MR = MC, but it is like a competitive market in that free entry may eliminate economic profits. The advantage of monopolistic competition is more variety in the market.

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Understanding Monopolistic Competition as a Prisoner’s Dilemma

Ä? Monopolistically competitive firms are often in a prisoner’s dilemma, with

each firm using advertising expenditures as the basis for “cheating.”

The soft drink industry is a monopolistically competitive industry. If Coke and Pepsi split this market, they could find themselves in prisoner’s dilemma over advertising. If they could split the market with no advertising, the profits would be $5 million each. However if either one or both want to advertise, the cost would be $3 million each. In this example, if one advertises and the other does not, the total profit would be $7 million ($10 million - $3 million). If they both advertise, each gets a profit of only $2 million.

If the two companies are prohibited from colluding, then advertising is the dominant strategy for each. For example, from Coke’s perspective, it will advertise no matter what Pepsi does. Its potential profit is either $2 million or $7 million, depending on what Pepsi does.

Although the best outcome is for the firms to split the market and earn $5 million each, this outcome is unstable in the face of uncertainty and the illegality of collusion. The most stable outcome for both companies is to advertise because there is no way to enforce cooperation.

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Deriving the Factor Demand Curve

Ä A firm’s demand for a factor of production, such as labor, is a derived demand. That demand is derived from the demand for the product that the factor produces. Ä The profit-maximizing rule says that a firm in a perfectly competitive firm hires labor up to the point at which marginal revenue product (MRP) equals the wage. Ä The marginal revenue product [in a perfectly competitive firm, MRP is called value of the marginal product (VMP)] is marginal revenue times marginal product.

On the left, notice that the marginal revenue of a perfectly competitive firm is the same as the product price. Marginal revenue is the change in total revenue from hiring an additional unit of labor. Marginal product is the change in output that the additional unit of labor produces. By multiplying the two terms, you get MRP, which represents the addition to the firm’s total revenue from an additional worker. Notice: VMP is the same as MRP. VMP is the term used for perfectly competitive firms, but some economists never use the term VMP and simply use MRP at all times. l

Notice the table on the left. VMP (also called MRP) is calculated by multiplying the marginal product of labor by the product price. The product price for this competitive firm is $100. The VMP is the addition to the firm’s total revenue that each additional worker produces. If the wage rate is given, then the VMP (MRP) curve becomes the firms labor demand curve.

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The firm hires as long as each additional worker adds more to total revenue than the cost, which is the wage. This profit-maximizing rule is another way of saying the firm produces where MC = MR.

To see the profit-maximizing rule, examine the derivation on the left. The derivation shows that the profit-maximizing rule, W= VMP is equivalent to the rule MC = MR, since MR is the same as price for a perfectly competitive firm.

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Deriving the Least-Cost Rule

Ä In the long run, when all resources are variable, a cost-minimizing firm employs

resources in a combination that equalizes the ratio of a resources marginal product to its price with the same ratio of all other resources.

Ä If a firm employs only labor and capital, it can minimize its costs by employing these two resources in a combination such that MPL/PL = MPK/PK.

Assume that a firm uses only labor (L) and capital (K) to produce TVs. If it can buy a unit of labor for $10 and a unit of capital for $5, it needs to figure out how much of each to buy to minimize its costs.

Assume that marginal product of labor is six TVs and the marginal product of capital is 2 TVs. If the firm spends $10 on labor it can get 6 additional TVs; if it spends $10 on capital it gets 4 additional TVs.

MPL/PL = 6/$10 > MPK/PK = 4/$10

The firm should reallocate its budget toward labor.

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When the firm reallocates its budget, MP of capital will rise. Assume it rises to 3 TVs. The firm can then equalize the ratios at 1 unit of labor and 2 units of capital.

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Analyzing the Labor Market

Ä Profit-maximizing firms hire labor as long as each additional unit of labor increases the firm’s total revenue more than the unit of labor increases costs. ÄThe supply of labor is determined by households in response to wages and can have both substitution and income effects. Ä Equilibrium wage and quantity demanded change in response to shifts in either supply or demand.

The demand for labor is a firm’s MRP curve. The graph shows the relationship between the wage rate and the quantity of labor that a firm demands. The curve slopes downward because of diminishing marginal product. Recall that MRP = MR x MP. As MP falls, MRP has to fall.

The slope of the MRP is related to elasticity of demand for labor. When the demand for labor is highly elastic, a small change in the wage rate causes a large change in the quantity of labor demanded, as on the left.

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If the demand curve (MRP) is inelastic, as on the left, a large increase in the wage rate causes a small change in the quantity of labor demanded. Recall: elasticity of demand for labor equals % change in quantity of labor demanded/% change in the wage rate.

The demand for labor can also shift if there are changes in technology or capital increases labor productivity or the price of the firm’s product increases. If the price of the firm’s product increases, each employee would now add more to the firm’s total revenue than before, because MR = P.

To get the market demand for labor, horizontally sum the demand curves for each firm in the market. However, to analyze a change in the market wage rate, examine the box on the left. Notice that the analysis is not exactly the same as analyzing a change in price in a product market because the MRP for each firm curve shifts.

Because households tradeoff between labor and leisure, the may be subject to both the income effect and the substitution effect. The substitution effect predicts that as wage rates increase, households supply more labor, substituting more labor for leisure. The income effect predicts that as wage rates increase above a certain point, households may want to forgo more income for more leisure time. This would create the backward-bending part of the labor supply curve.

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The substitution effect usually is stronger than the income effect, so the labor supply curve is almost always depicted as on the left. The labor supply curve can shift if households decide that they prefer to work more than have leisure at any wage rate. The shift on the left is an increase in labor supply. The supply curve could also decrease.

The labor market is much like any other competitive market. The wage rate, on the vertical axis is the price for labor. The market establishes an equilibrium wage rate and quantity of labor supplied.

If the demand for labor were to shift, the market would establish a new equilibrium wage rate and quantity supplied. On the left, the demand for labor has increased increasing the equilibrium wage rate and increasing the equilibrium quantity.

The supply of labor could also shift as on the left. Once again, the labor market establishes a new equilibrium wage and quantity.

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Understanding Labor Market Power and Marginal Factor Cost

Ä A monopsony is a labor market characterized by having a single buyer of the

resource. Ä In monopsony labor markets, employers must raise the wages of all previously hired

employees in order to attract new employees into the market. Ä A monopsonist hires labor up to the point at which MRP = MFC.

In competitive labor markets, firms can pay each employee in the labor market his/her reservation wage, or the minimum wage that that employee will accept. In a monopsony, or a market with a single employer, the firm must raise the wages of all previously hired employees in order to hire an additional one. Therefore, the firm’s marginal factor cost, or the added cost of hiring an additional employee, is greater than the wage. As on the left, the MFC curve lies above the supply curve.

Recall: Marginal revenue product (MRP) is MR x MP. MRP is the addition to total revenue that the additional employee adds to the firm. In a competitive product market, the MRP is called the value of the marginal product, VMP. The firm hires the quantity of labor such that its MRP = MFC; the MRP is its demand for labor curve. Note: The wage rate paid by the firm is the rate indicated by the intersection of the MRP and the supply curve. That rate is the rate that will induce the chosen quantity of labor to enter the labor market.

Some firms have power in the labor market and power in the product market where they sell their products. These firms face three problems that are listed on the left.

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Analyzing Capital Markets

Ä Firms choose the amount of capital they want to purchase by using a process similar to the one they use to purchase labor. Ä Firms decide whether to buy a certain piece of capital by comparing the internal rate of return (IRR) with the market rate of interest. Ä A firm has a demand curve for capital based on the market rate of interest and the internal rate of return.

A firm’s capital items are items like its factory, tools, and equipment. A firm’s capital is separate from its labor involves a different decision. Recall that labor is apart of variable costs and changes with output. Capital usually represents fixed costs and do not change with output. The characteristic of capital is its durability, that is, it has a long life.

Suppose a firm can buy a factory that can produce an income stream every year. The present value of that future income stream is the discounted value of the income stream, using the market rate of interest. For example: Suppose that from a machine, you get a net income stream (benefits minus costs) of $10,000 for two years. Assume that the market rate of interest is 5%. Also assume that at the end of 2 years, the machine has no value and must be scrapped. The present value of the income stream is:

2

$10,000 $10,000$9,524 $9,070 $18,594

(1 .05) (1.05)+ = + =

+I

The firm will compare the cost of the machine with the present value to determine if it should buy the machine.

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Closely related to present value is the internal rate of return (IRR). The IRR is the discount, or interest, rate that makes the present value of the income stream equal to the price of the factory. Suppose a firm knows the price of a project ($200,000) the yearly cash flow ($10,000) and the life of the project. We want to know the value of r that would allow us to take $10,000 out per year.

If this factory costs $200,000 and the value of r is 5%, the firm compares the IRR with the market rate of interest. If the market rate is less than 5%, the firm should buy the factory. If the market rate of interest is greater than 5%, the firm should not buy the factory. It should buy bonds or some other investment that is paying 5%. In other words, the IRR is the rate of return generated by the factory. the firm compares the IRR with alternative investments to make a decision.

The firm can derive a demand curve for capital based on the market rate of interest. As the market rate of interest falls, the firm finds more and more projects that have a higher IRR than the market. Therefore at lower interest rates, the firm will choose to build or buy more projects.

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Understanding Market Failures

Ä? A market failure is any situation in which the free market fails to deliver maximum

economic value.

Ä? Market failures may occur because of wealth effects, externalities, market power, or asymmetric information.

Recall from the lectures on normative economics that a free market creates maximum economic value at the point where the supply and demand curves intersect. In a free market, the supply and demand curves represent the social costs and social benefits associated with any good or service. A market failure may occur in any situation where the demand and supply curves do not reflect social benefit and social cost The following problems analyzed below may lead to market failure.

With very poor people, the reservation prices of some products do not really reflect the value these people may place on them. Their low income is driving the value they place on these products and makes the reservation price an unreliable measure of benefits. This effect is a wealth effect.

A second cause of market failure is an externality. An externality is a cost or benefit imposed on other people who are not part of the trade. Demand and supply curves generally reflect private benefits and costs but often do not reflect true social cost and benefits produced by externalities.

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A third cause of market failure is market power. A monopoly, an oligopoly, or a monopo-listically competitive firm will artificially drive up price by making it scarce. In these markets, the economic value that is created is less than the maximum created in a free market.

A fourth cause of market failure is asymmetric information creating adverse selection or moral hazards. A free market assumes that buyers and sellers have perfect information. When they do not, the values imputed to demand and supply curves are not accurate measures of value.

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Defining Public Goods

Ä Public goods are goods that, once provided, are non-excludable. Problems with public goods are the tragedy of the commons and the free-rider problem. Ä To derive a demand for a public good, economists vertically sum each consumer’s demand and then try to find a method to allocate the demand for the public good.

All goods can be classified using the matrix on the left. Private goods are exclusive goods: once a consumer consumes the goods, other consumers are excluded from the consumption of the good. Public goods are goods from which other consumers cannot be excluded. Rival goods mean that there is a limited quantity and one person’s consumption reduces or eliminates the consumption of others.

Public goods are subject to two special problems: (1) the free rider problem and (2) the tragedy of the commons. The solution to these problems is to try to make a market for the public good and to get consumers to pay for the public good.

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In private markets, it is possible to determine a horizontally sum the demands of each consumer in the market to a market demand. You choose various prices and add up the quantity demanded at each price.

For public goods, you have to vertically sum each consumers demand. The public good has a given quantity so vertical summation is the amount that each consumer would be willing to pay for the given quantity of the public good. On the left, assume that the only one streetlight is provided. Each consumer receives a different benefit and would be willing to pay the benefit that he/she receives.

Consumers should be willing to pay for the benefit they get but it is often difficult to determine those benefits. Usually society has to impose a tax to pay for public goods. The tax may not be the same as each consumer’s benefit.

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Analyzing the Tax System

Ä The government imposes taxes on citizens to pay for public goods. It can tax income, wealth or consumption. ÄTaxes may be proportional, progressive, or regressive depending on the percentage of total income collected. ÄThe marginal tax rate is the rate that individuals pay on each additional dollar of income; the average tax rate is the ratio of total taxes paid to income.

An income tax is a tax on a person’s income.

A wealth tax is a tax on wealth, such as a property tax or capital gains tax. A consumption tax is a sales tax on items that consumers purchase.

Taxes can be defined by the distribution of the tax burden, called the tax incidence. A proportional tax is a tax in which everyone pays the same percentage of his or her incomes as tax.

A progressive tax is one in which a taxpayer pays a higher percentage of his income as his income rises.

A regressive tax is one in which taxpayer pays a lower percentage of his income as his income rises.

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The marginal tax rate is the tax rate that one pays on each additional dollar of income. Marginal tax rate is defined as the change in taxes divided by the change in income, as on the left. The average tax rate is a taxpayer’s total taxes divided by her total income, as on the left. In the example, the taxpayer has an income of $50,000 and is exempt from income tax on the first $20,000 of income

Assume now that there is a taxpayer with an income of $500,000. If you work through the algebra, as on the left, you can see that this taxpayer’s average rate is 24%. His tax rate has increased as his income has increased. This system is a progressive tax system.

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Understanding Public Choice

Ä In public choice theory, economists assume that people behave in their own self-interest in the market for public goods as well in the market for private goods. Ä Public choice theory predicts that majority voting will yield inefficient outcomes by failing to account for intensity of preferences. Ä The impossibility theorem suggests that there is no method of aggregating individual preferences into social choices that will yield consistent results.

With private markets, we can express the intensity of our preferences by bidding against each other for scarce resources. The method of voting for public goods is for each voter to have one vote. This method may not yield the socially optimal result.

For example, suppose a city is asking voters to build a park. There are three voters in the city. To pay for the park, the city would tax each voter $100. The first voter judges his benefit to be $110; the second voter judges his benefit to be $105; the third voter judges her benefit to be $75. The total societal benefit is less than the cost. Economists would say that this park should not be built because it is an inefficient use of resources.

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The impossibility theorem says that we cannot come up with a method of ordering individual preferences that yield consistent results. In choosing public goods, it is possible to manipulate election outcomes to achieve desired ends. The way to achieve a goal is to have pair-wise elections and always run your preferred project against something it can beat. Examine on the left the ordered preferences of three voters for three public goods.

Assume that you are a public official that wants the public TV station. The first thing to do is hold an election between the streetlight and the park. Voter 1 prefers the park to the streetlight, voter 2 prefers the park to the streetlight, and voter 3 prefers the streetlight to the park. The streetlight is eliminated in this pair-wise election.

You now hold an election with the TV station running against the park. Voters 2 and 3 prefer the TV station to the park, so the TV station wins. By using voters’ preferences, the desired outcome is achieved.

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Understanding Expected Value, Risk, and Uncertainty

Ä The expected value of a risk is equal to the sum of each probability times the

potential payoff.

Ä You can model uncertainty on the basis of willingness to risk loss or gain. Individuals or institutions can be classified as risk-neutral, risk-inclined, or risk-averse.

In studying uncertainty, you always have to begin with the expected value of an outcome: the expected value of any outcome is the sum of the odds of each outcome times the value of that outcome. Assume that in a coin toss, you could win a $2 bet on heads. The expected value of the gamble is found by the formula on the left. That value is $1. The expected value is the average outcome if you played this exact game repeatedly.

You want to now ask how much someone (or some institution) would be willing to pay to play this game. A risk-neutral person would pay only $1, the expected value; a risk-inclined person would pay more than $1; a risk-averse individual would pay less than $1.

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The analysis of risk behavior has applications in financial markets, insurance, and sales.

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Understanding Asymmetric Information as an Economic Problem

Ä? Asymmetric information means that one party in a transaction has more

knowledge about the quality of a product than the other party.

Ä? The asymmetric information problem differs from uncertainty in that under uncertainty, both parties have equal information and can calculate the expected value of the outcome.

Ä? The economic problem with asymmetric information is adverse selection. Adverse selection means that buyers try to protect themselves from poor quality by paying a lower price than the expected value of a quality product, and thus driving high-quality products off the market.

On the left you can see used cars, some of which are gems (high-quality cars) and lemons (poor-quality cars). If buyers and sellers both have perfect information, the gem will sell somewhere between the buyer’s and the seller’s reservation prices. Economic value is created. Lemons create no economic value and will not be sold at all.

Assume that 50% of cars are gems and 50% are lemons, but neither buyers nor sellers know which ones are gems or lemons. In this uncertain situation, buyers and sellers would determine the expected value of the transaction. A risk-neutral buyer would pay up to $5,000 for a car. A risk-neutral seller would find expected value of ½ x $8,000 + ½ x $0=$4,000. The car would sell somewhere between $4,000 and $5,000 .

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Under asymmetric information the seller knows which cars are gems and which are lemons.

With asymmetric information, the market for high-quality vehicles disappears because buyers understand that the seller knows which vehicles are gems and which are lemons. This problem is called adverse selection. To protect themselves against lemons, buyers are not willing to pay a high enough price to attract the gems, so sellers withdraw the gems from the market. The result is that only lemons appear on the market.

There are some ways to solve the problem of asymmetric information. One solution is “lemon busters.” These businesses are services that buyers hire to inspect products for quality. Another solution is guarantees from sellers regarding the quality of the product.

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Understanding Moral Hazards in Markets

Ä? A moral hazard in a market occurs when one of the parties to a transaction takes

some unobservable action after the transaction that benefits only him/her.

Ä? The most common example of a moral hazard is in insurance markets where a policyholder may buy a policy and then cause a loss that is payable under a policy.

One example of a moral hazard is insurance. Individuals or institutions could buy a policy and then report a loss that didn’t happen or inflate the value of lost property to collect a large benefit from the insurance company.

Insurance markets may break down because insurance companies may not want to insure certain properties or individuals because of the moral hazard. They partially solve this problem by returning some of the risk to the insured party in the form of deductibles, collateral, co-insurance (companies split the risk), or monitoring (periodically observing the risk).

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Defining Externalities

Ä? An externality is any external cost or external benefit from a transaction that

can be passed on to any person or group who is not a party to the transaction. The demand and supply curves do not accurately reflect social benefits or costs when externalities are present.

An external cost is a transaction cost that is borne by persons outside the transaction. The examples on the left involve some forms of pollution in which the producer of the pollution is able to pass part of the cost to others. In the case of an external cost, the social costs exceed the private costs.

A transaction may generate external benefits rather than external costs. For example, if a teacher gets a flu shot, he/she gets immunity, but the people in the teacher’s class also get benefits in that they may not get infected from the teacher. In this case, the social benefits exceed the private benefits.

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When externalities are present you cannot rely on the market to maximize economic value. When external costs are present, otherwise unprofitable transactions may become profitable. When external benefits are not accounted for, some otherwise beneficial transactions may become unprofitable.

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Explaining How to Internalize External Costs

Ä? The true social costs of a transaction are the sum of its private cost and external cost.

Ä It is possible to internalize an externality by using the principle of the second best which says that you correct a market failure by the method that most precisely corrects for the original problem.

It is possible to internalize an externality. In the example on the left, assume that a box manufacturer has private costs of $.50 to produce a box, and there is a buyer that is willing to pay $5 for the box. The transaction will take place although the true social cost is not reflected in the transaction. The social cost in this case is the pollution the boxmaker creates.

One way to calculate an external cost is to consider the cost of correcting the problem. If a firm is polluting the environment, you could calculate cost in several ways, but the most reasonable calculation is to find the least expensive method of correcting it. This cost is the external cost. The true social cost then is private cost plus external cost.

In analyzing the demand/supply model for boxes, there will be a point at which the true social costs outweigh the social value (as reflected in a consumer’s reservation price). Normative economics tells us that this transaction should not take place. But it will take place because the firm is externalizing the external costs and the transaction remains profitable.

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One way to internalize the externality--that is, to force the firm to internalize the true social cost--is to use the principle of the second best. This principle says that you use any method to correct the market failure that most precisely corrects for the original problem. This correction could be a tax on the producer, forcing the producer to pay the medical bills of those affected, or making the producer clean up the externality.

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Explaining How to Internalize External Benefits

Ä? An external benefit of a transaction is a benefit that accrues to someone who is not a party to the transaction.

Ä???? A market failure can occur when the true social benefits of a transaction are greater than the private benefit. A transaction that is socially beneficial may not take place because the private benefits are not great enough to induce the decision maker to complete the transaction.

Ä? It is possible to internalize this external benefit with a subsidy to the decision maker. A subsidy is a payment to the decision maker to increase the private benefit.

Ä? You can solve the market failure using the principle of the second best.

The true social benefit of a transaction is the private benefit plus the external benefit. In the example on the left, getting a flu shot may have a social value of $5 and a private cost of $2 for an individual. The individual’s private benefit in this example is the same as his cost, $2. It is the amount he is willing to pay. The external benefit is that other people do not get infected with the flu when one person gets a shot.

At some point, the private costs will exceed the private benefits and a decision maker will decide not to get the shot. In the example on the left, this individual only values the shot at $1. Her cost is $2 so the transaction will not take place. However, the shot should be given if external benefits are taken into account.

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The principle of the second best says that the best method to solve the market failure is to use the one that most precisely corrects the problem. To correct this market failure, society wants to internalize the externality so that the transaction will take place. Society can do this by giving a subsidy to the decision makers to increase the private benefit to the point at which it equals the true social benefit.

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Finding a Market Solution to External Costs

Ä ?You can use a demand/supply model to analyze a market failure caused by an

external cost.

Ä? One solution to a market failure caused by an externality is through a per-unit tax on the individual firm causing the externality.

Ä? A better method for solving the problem is to create a market for the right to create an external cost. This method is a more direct use of the principle of the second best.

External costs cause problems in markets because they cause social benefits and social costs to diverge from each other. In the example on the left, the market would produce four units with a market price of $2.50. However, if there are external costs in this market, you can draw a new supply curve called marginal social cost (MSC) that captures all social costs. If all social costs are captured, the producer would produce only three units at $3.

At the original market price and output, you can see that there is a divergence between the marginal social cost and the marginal social benefit, as represented by the demand curve.

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The result of producing four units is a deadweight loss, as depicted by the striped triangle in the graph.

Using the principle of the second best, you want to internalize the externality. One way to internalize it is with a per-unit tax on the product, in this case a per-unit tax on each box. The per-unit tax will push the supply curve up to capture all costs. The producer will then produce the output that maximizes economic value, three units.

However, a per-unit tax is only an approximation of a solution because the problem in this example is not boxes but pollution. A more efficient way to solve the market failure is charge a tax for polluting. A pollution tax follows the principle of the second best in that it directly attacks the original problem, pollution.

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The way to calculate the pollution tax is to create a market for the right to pollute. The rights could be bought and sold by anyone including environmental groups. Those firms that want to pollute would have to buy the rights on the market. This method is a more efficient method for internalizing an externality because an externality is really a missing market.

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Finding a Negotiated Settlement to an External Cost

Ä???? An external cost can sometimes be settled by negotiation between the party creating the cost and the party having to bear the external cost.

Ä? The party bearing the cost can sometimes pay the source to cease the behavior that creates cost. Total economic value may be greater than would be if the cost were borne.

Ä The economic basis for the negotiated settlement is called the Coase theorem after Nobel Prize winner Ronald Coase.

Suppose that there is a box maker and a brewer in a community. There is a lake between them. The box maker uses the lake to dump pollution from its factory, but the brewer needs clean water from the lake as the major input for beer. Further assume that the price (benefit) for a box is $.50 and the price (benefit) for a beer is $1. It costs the box maker $.25 to prevent the pollution, but if it decides to pollute, it costs the brewer $.50 to clean the water to brew beer. If the box maker pollutes and the brewer cleans it, the total economic value created is $1: $.50 to the box maker and $.50 to the brewer.

Given the scenario above, the two firms could negotiate a settlement that increases economic value. The brewer could pay the box maker $.25/box to prevent the pollution. The box maker would still realize a net of $.50 from each box, the brewer would get $.75 from each box, and total economic value is now $1.25.

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Ownership of the lake is irrelevant in the creation of economic value under the negotiated settlement. Whether the brewer or the box maker owns the lake, the cost to prevent the pollution is less than the cleanup.

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Applying the Coase Theorem

Ä???? The Coase theorem says that sometimes the parties involved in an externality

have no basis for negotiating a settlement based on relative costs. In this case, no settlement will take place and the externality will continue.

Ä? If other parties are recipients of the externality, the government may step in and force a solution to the externality.

Suppose from the previous example that the costs are reversed between the box maker and the brewer. If it now costs the box maker $.50 to prevent the pollution and the brewer only $.25 to clean the water, the negotiated settlement will not take place. The box maker will pollute and the brewer will clean the water. The total economic value then will be the box maker’s profit and the brewer’s profit: $.50 + $.75 = $1.25. There is no loss of value from the negotiated settlement.

A review of the Coase theorem is on the left. The key point is that there must be a negligible cost for the two parties to negotiate. If other parties are affected, the negotiation costs may become high.

The only corollary to the Coase theorem is this: if third parties are bearing part of the external cost, there may be a justification for a government-imposed solution to the problem. For example, if there are swimmers who use the lake, it may be less expensive for government to impose a solution.

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Determining the Difference between a Closed Economy and an Open Economy

Ä Imports are goods purchased from other countries. Exports are domestically produced goods that are sold to consumers in other countries.

Ä A closed economy is one that has no exports or imports.

Ä An open economy is one that has exports and imports.

In a closed economy , the market equilibrium price and quantity would be determined at the intersection of the demand and supply curves. In a closed economy, begin with demand and supply curves, but indicate that they are domestic supply and demand by using the symbols DD and SD. The world price line, Pw, shows us that French farmers and consumers of pommelos take the price as given; they have no influence over the world price. Note here that the world price is lower than the domestic price.

Using the graphs in this example, we see at the world price French farmers would be willing to produce only QSD, but French consumers would be willing to buy QDD. Recall from the previous lectures that this is a case of excess demand. Think about what would happen in France if it remained a closed economy. French consumers would not get the quantity of pommelos they want at the lower world price.

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France, however, is an open economy—it allows imports into the country. Imports are the difference between the quantity demanded domestically and the quantity supplied domestically. In studying open economies or international trade, you will want to focus on the volume of exports and imports.

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Understanding Exports in an Open Economy

Ä Exports are domestically produced products that are sold to consumers in other countries.

In this example, assume that France has a comparative advantage in the production of wine. If France were a closed economy , the domestic price for wine would be P*. If the world price is above the domestic price, French winemakers would be selling their wine to French consumers at a price less than the one they would receive if France were an open economy.

Now assume that France is an open economy and that winemakers can export their wine. At the world price of Pw, French winemakers will want to produce QSD, but French consumers demand QDD. There is now excess supply in the economy. If France is an open economy, winemakers can export the excess supply at the world price. Total exports at Pw = QSD - QDD.

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Analyzing a Change in Equilibrium in an Open Economy

Ä A change in one of the variables other than price, such as income, will cause a change in the equilibrium price and equilibrium quantity in an open economy.

Ä A change in a demand determinant affects an open economy differently from a closed economy.

Ä? Review: A closed economy is one that has no exports or imports. An open

economy is one that has exports and imports.

Review: In analyzing a change in equilibrium, in an open economy you should follow the three-step process that you previously studied for a closed economy: 1. identify which side of the market is affected; 2. identify how the change will affect the curve; 3. analyze what happens to the equilibrium quantity and price. In the example on the left, assume that France experiences an increase in personal income. The first question to ask is, “Who will be affected by a change in income?” The answer is “buyers,” or the demand side of the market.

The next question that you would ask is, “Which curve shifts and which way?” The answer is the demand curve shifts out. There is an increase in demand for pommelos at every price.

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Finally, you will need to ask, “What happens to the equilibrium price?” In a closed economy, the equilibrium price increases after an increase in demand, but in an open economy, equilibrium price does not change. The price is given and stays constant at the world price. In this example, French income increased and French demand for pommelos increased, but the price stayed the same. The excess demand is filled by more importation of pommelos.

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Measuring the Benefits of Consumption

Ä Value is the difference between the benefits and the costs of an activity.

Ä Reservation price is the maximum price you would pay to have a good or service.

Ä The private benefits of consumption are those benefits accruing only to the consumer.

Ä Wealth effects are the effects of a person’s income (or lack of income) on the measurement of his or her private benefit.

Ä External benefits are the benefits of consumption that may go to persons other than the consumer.

In economics, value is the difference between the benefits and the cost of any activity.

Your reservation price is usually considered to be a good measure of the benefit you receive from consuming a good. However, if your income affects how much you will pay, the reservation price may not accurately reflect your benefit. Economists often assume that there are no wealth effects.

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External benefits may also affect the measurement of value. In this example, if you receive a flu shot and your reservation price is $5, this price will not reflect the entire benefit. There is a private benefit from getting a flu shot and an external benefit to others from your receiving a shot. Again, economists often assume that external benefits do not exist because the existence of external benefits would skew the measurement of value.

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Using the Demand Curve as a Measure of Benefit

Ä Normative economics is the study of “what should be” in economic activities.

Ä From the normative perspective, the demand curve can indicate the benefit from the next unit of consumption.

Ä Using the normative interpretation, social benefit can be determined by summing all private benefits.

Ä? Review: Private benefits of consumption are those benefits accruing only to the individual consumer.

The usual interpretation of a demand curve is to determine the quantity demanded at each price as on the left. Under this interpretation the demand curve indicates that at the market price of $2.10, five loaves of bread are demanded.

In normative economics, you may want to judge the benefit from each unit of consumption. If so, the demand curve must be interpreted differently.

From the normative perspective, the private benefit from consuming the next unit is measured as the price at that point on the demand curve. In the example on the left, the private benefit from consumption of the fifth loaf of bread is $2.10 because $2.10 is someone’s reservation price. Social benefit is the sum of all the private benefits.

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Quantifying Social Benefit

Ä Review: A consumer's reservation price is a measure of an individual consumer’s private benefit. The reservation price is the maximum price an individual would pay for a good.

Ä To quantify the social benefit to society of the consumption of a product, you sum each consumer’s private benefit.

Ä Normative economics interprets the area under the demand curve as total social benefit.

Ä Marginal social benefit is the benefit from the consumption of the next unit of the good.

In this example using loaves of bread, the demand schedule on the left shows the quantities demanded at various prices. From the normative perspective, the schedule shows six reservation prices that can be interpreted as the private benefits of consumption for six consumers. Each consumer's reservation price is the marginal social benefit from the consumption of that loaf of bread. Five dollars for the first loaf is someone’s reservation price. Four dollars is the second consumer's reservation price. From the normative perspective, $5 represents the benefit from the first loaf of bread, and $4 represents the private benefit from the second loaf of bread.

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Each loaf of bread has a reservation price for someone. To get the total social benefit of producing bread, you sum each consumer’s reservation price. In the example on the left, the social benefit of the first five loaves of bread is the sum of the consumers' reservation prices: $5.00+$4.00+$3.00+$2.50+$2.10=$16.60

Normative economics interprets the area under the demand curve as the total social benefit society gets from consuming bread. In the graph on the left, the shaded area under the demand curve is the total benefit from consuming bread. The underlying assumption is that there are no wealth effects and no external benefits.

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Quantifying Social Cost

Ä? A seller's reservation price is the minimum price at which a seller would offer a unit of a good for sale in a market.

Ä To quantify the total social cost of producing a good, sum all the producers' reservation prices.

Ä Marginal social cost is the social cost incurred from producing the next unit of a

good.

Normative economics is concerned with the social benefits and social costs of producing goods and services. The sum of each seller’s reservation price is a good measure of the total social cost of producing a good if: 1. there are no wealth effects on the part of

sellers; 2. all costs are private; that is, there are no

external costs.

In analyzing cost, you examine the supply curve. The normative economics interpretation is to begin with the last unit supplied, then find the seller’s reservation price. Normative economics interprets this as the social cost of producing that unit. This cost is called the marginal social cost.

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Determining Total Social Cost

Ä Total social cost is the sum of each seller’s reservation price.

Each seller has a reservation price. To determine the total social cost of producing a product, you have to sum the sellers’ reservation prices. In the example on the left, the total social cost of producing five loaves of bread is: $.40 + $.60 + $1 + $1.50 + $2.10 = $5.60.

Normative economists describe total social cost as the area under the supply curve. On the left is a graphical view of the summation that you did above. Review: This interpretation of total social cost assumes no wealth effects and no external cost.

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Understanding Total Economic Value

Ä Total economic value is the difference between the total social benefit and the total social cost.

To determine the total economic value of producing a product, find the difference between each unit’s social benefit and the social cost, and sum the differences. In the example on the left, the social benefit of the first unit is $5 and the social cost is $0.40. The social value of this unit is $4.60.

The sum of the differences between social benefit and social cost of each of the first five units is: $4.60+$3.40+$2.00+$1.00+$0=$11.00. Eleven dollars is the total economic value of producing five loaves of bread. The social value of the fifth unit is $0. The fifth unit is society’s break-even point where social benefit and social cost are equal. At the sixth unit, social costs are greater than benefits, and at the fourth unit, social benefits are greater than social costs.

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Graphically, the total economic value is represented by the area between the demand and supply curves. If society produces five loaves of bread, the total social value is the sum of the difference between each unit’s social benefit and its social cost. The total economic value is $11 for the first five loaves of bread.

Note that if society produces more than five units, the social costs begin to exceed the social benefits, resulting in economic loss. From a normative perspective, society should not produce more than five loaves of bread.

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Understanding Producer and Consumer Surplus

Ä Consumer surplus is the difference between the consumer’s reservation price—what he/she would be willing to pay for a product—and what he/she actually has to pay for it.

Ä Producer surplus is the difference between the price a producer receives from a product and the reservation price, or the price he/she would have accepted.

Ä? Review: Total economic value for each unit is the difference between the consumer's and the producer's reservation prices.

In the example on the left, suppose that the first loaf of bread sells for $2.10. The consumer surplus is $2.90: reservation price minus actual price, or $5.00 - $2.10 = $2.90. The producer surplus is $1.70: actual price minus reservation prices or $2.10 - $.40 = $1.70.

The total economic value is the difference between the consumer’s reservation price and the producer’s reservation price.

The total economic value is not necessarily divided equally between producers and consumers. The division of this value depends on the price of the product. The price of the product depends on the competitive equilibrium price and quantity, as determined by the forces of supply and demand.

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Calculating Total Economic Value

Ä You calculate total economic value by adding consumer surplus to producer surplus.

To find total economic value, you must first solve for the equilibrium price and quantity. In this example, you are given a formula for the supply and demand curves. The formula for the demand curve describes consumer behavior; the formula for the supply curve describes producer behavior.

Next you must algebraically solve for P* and Q*, the equilibrium price and quantity. Use the substitution method shown on the left.

The consumer surplus is the area under the demand curve and above the price, the shaded area on the left. To calculate consumer surplus, you must use the formula for the area of a triangle: CS = 1/2 bh or 1/2 (40)(100 – 60) = $800

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Producer surplus is above the supply curve and under the price line, the dark shaded area in the diagram on the left. Producer surplus is calculated in the same way as consumer surplus: PS = 1/2 bh or 1/2 (40)(60-20) = $800.

Total economic value in this example is consumer surplus plus producer surplus or $1600.

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Understanding the Effects of Price Controls

Ä A price control or price ceiling is a government regulation setting a maximum price that sellers may sell a product for.

Ä Non-price competition describes methods other than price that buyers may have to use to obtain a scarce product, such as standing in long lines to buy a valued product.

Ä Rent-seeking behavior means expending resources in nonproductive ways to get a larger share of the economic pie for oneself at the expense of others.

Suppose the market has a seller willing to sell one loaf of bread for as low as $1, and a buyer is willing to pay up to $5 for it. There is a potential economic value of $4 if the trade occurs. If the government were to set a price ceiling of $2 on loaves of bread, the trade would still occur. The seller would gain producer surplus of $1, and the buyer would gain consumer surplus of $3. The price ceiling has no effect, as shown on the left.

However, if the government sets a price ceiling at $.50 a loaf, trade would be blocked because that price would not cover the seller’s opportunity cost. The only way that trade could occur would be by illegal means. You can see in the graph on the left that the price ceiling of $.50 is below the sellers reservation price.

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With price controls, the buyers have to engage in non-price competition to determine who gets the bread. One type of non-price competition is rent seeking behavior. Rent-seeking behavior is using resources in a nonproductive way to gain an advantage for oneself. The winner will be the one who can expend the most resources to get the bread.

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Understanding How Price Controls Destroy Economic Value

Ä Review: A price control or price ceiling is a government-set maximum price that sellers may charge for a particular product.

Ä A price control in a market destroys economic value by blocking potential trades.

Ä Price controls force buyers to engage in non-price competition and rent-seeking behavior in order to compete for the scarce products.

Examine the small market for bread on the left. Assume that there are three buyers trying to buy one loaf each and three sellers selling one loaf each, all with different reservation prices. You can see from the diagram that the market equilibrium price would be $3.50 and three loaves of bread. By summing the difference between the market price and each reservation price, you can determine the total economic value created in this market: $3.00 + $2.00 + $0 = $5.00.

Assume now that the government imposes a price control on the bread and sets the maximum price at $2. Now two sellers will drop out of the market because $2 will not cover their opportunity costs. The three buyers now must engage in non-price competition to get the one remaining loaf.

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Buyer A will win the competition because he will expend enough resources to drive the other two buyers out of the market. The buyer with the highest reservation price wins the non-price competition because he can outspend the others. When he has spent $2 in economic value, both of the other buyers will have reached or exceeded their reservation prices.

Now the total economic value has shrunk to $2 because the buyer has had to engage in expensive and wasteful behavior. The price control has destroyed $3 of economic value. In the absence of the price control, total economic value was $5, as shown in the first panel.

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Evaluating the Effects of an Excise Tax

Ä Review: Total economic value is the sum of the consumer surplus, producer surplus, and tax revenue.

Ä Total economic value is the area on a demand and supply graph between the demand and supply curves, up to the last unit traded.

Ä? Review: Deadweight loss is the lost economic value that a tax causes when it

blocks trades.

Ä When an excise tax is imposed, deadweight loss is created, equilibrium quantity and total economic value fall, and producers and consumers face different prices.

An excise tax can block some trades. On the left an excise tax is imposed and a tax wedge is placed between the demand and supply curves. The area of deadweight loss represents blocked trades. The tax blocks all trades between QT and Q*. Note that the price the seller receives is less than the price the buyer pays. The difference is the $2 excise tax.

Geometrically, total economic value is represented by the area between the demand and supply curves, up to the last unit traded. Total economic value is the sum of the consumer surplus, the producer surplus, and the tax revenue. The tax revenue is part of the total economic value, but it goes to the government. Deadweight loss is not part of the total economic value because it represents blocked trades.

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In comparing the results of trade in a free market (no excise tax) and one with a tax, note the diagram on the left. The tax causes the equilibrium quantity to fall from Q* to Q1, the buyers’ price has increased from P* to PD, and the sellers’ price has fallen from P* to PS.

Because of the tax, total economic value is less than it would be in a free market. Economists are concerned with the trade that is blocked because of an excise tax. The striped area in the right-hand graph is the deadweight loss or the lost economic value from blocked trades.

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Assessing the Effect of an Excise Tax on Economic Value

Ä An excise tax is a per unit tax imposed on each unit of a good that is traded.

Ä A tax wedge is the difference between what a buyer pays for a good and what a producer gets for it. The difference is caused by the imposition of the tax.

Review: From the previous example with bread, the first unit creates economic value of $4.60 because the seller’s reservation price is $.40 and the buyer’s reservation price is $5. The total economic value from this transaction is the difference between the two reservation prices.

Now suppose the government decides to impose an excise tax of $2 on this loaf of bread. Also assume that the buyer has agreed to pay $3.50 for this loaf of bread. The seller will get only $1.50 for this loaf. Consumer surplus in this instance is $1.50, and producer surplus is $1.10. The tax revenue of $2 goes to the government and is called a tax wedge.

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The excise tax affects the distribution of the economic value that the trade created. Economists always want to maximize the creation of value but have no opinion, except as private citizens, about the distribution of that value. In the example above, the government receives $2 of the value created from the trade.

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Understanding How a Tax Can Create Deadweight Loss

Ä Deadweight loss is the lost value, or the economic value that is not created, when a tax policy imposes burdens on buyers and/or sellers to the extent that trade will not occur.

This example shows how an excise tax can create a deadweight loss because it creates a situation in which trade will not occur. Assume that a buyer is willing to pay $3.50 for a loaf of bread, and a seller has a reservation price of $2, the price at which he will sell the bread. Without a tax, $1.50 worth of economic value is created. If the government imposes a $2 per loaf tax, a tax wedge would be created with the result that neither party could pay it, nor would trade occur.

If the producer were to pay the tax, he would have to charge $4 for the bread to cover his opportunity cost and the government ‘s tax. The consumer is unwilling to pay $4. If the consumer pays his reservation price of $3.50, $2 of this has to go to the government. Only $1.50 would go to the seller. The seller is unwilling to put the bread on the market at this price—it is less than his reservation price. In this example, no trade takes place, and the lost economic value is deadweight loss.

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Evaluating the Gains from International Trade

Ä Review: A closed economy is one that has no exports or imports.

Ä Review: An open economy is one that has exports and imports.

Ä In a closed economy , domestic quantity and domestic price entirely determine producer surplus and consumer surplus.

Ä With international trade there is a loss of producer surplus but a larger compensating gain of consumer surplus, resulting in a net gain in economic value.

In a closed economy , equilibrium price and equilibrium quantity determine consumer surplus and producer surplus. Remember in a closed economy, all of the product (in this example, pommelos in France) are produced domestically. Imports are not allowed, so the world price is irrelevant.

If France allows imports, consumers can buy all the pommelos they want at the lower, world price. They will now buy QDD at a price of Pw. The new price is lower than the domestic price, and the amount of pommelos demanded is higher than before. Note on the left that the area of consumer surplus is larger than in a closed economy. Consumer surplus is now the area between the demand curve and the price line, PW.

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Because consumers are paying a lower price and buying more imported pommelos, there is a loss of producer surplus, but the loss is smaller than the gain in consumer surplus.

The net gain in total economic value from international trade is the area of the dark triangle in the graph on the left. In this example, French consumers are the winners in the trade for pommelos. There is a net gain in total economic value from international trade.

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Understanding the Effects of Tariffs on Consumer and Producer Surplus

Ä A tariff is a per-unit tax imposed on goods imported from outside the country.

Ä A tariff imposed on imported goods causes a net loss in total economic value. It amounts to a tax on consumers and a subsidy to producers.

Suppose that France imposes a tariff on pommelos. In the graph on the left, the new tax will push the price to French consumers up to Pw + T. They will now demand Q'DD. French producers will start producing more at Q'SD

because they can now get the new higher price. Note that the area representing consumer surplus has shrunk by the area between PW and PW + T.

The lost consumer surplus is represented by areas 1,2,3, & 4.

You will need to analyze what happened to the lost consumer surplus. Area 1: This area is regained as additional producer surplus caused by French producers producing more pommelos and at a higher price. Area 2: This area is deadweight loss caused by lost production of other crops that are more suitable for French climate and soil. Area 3: This is the tax revenue produced by the tariff. It does not represent a loss of value. Area 4: This is deadweight loss caused by lower consumption at higher prices. In the end, French consumers pay a higher price and consume fewer pommelos, but

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French producers capture producer surplus from consumer surplus.

thinkwell’s microeconomics - florida gulf coast...

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