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Study Guide – Unit II (Chapters 18, 20-24, 26)
Big Picture: The Microeconomics of Product (and Resource) Markets extends the
discussion of supply and demand to include “price elasticity,” a measure of consumers’ and
producers’ responses to price changes; it then analyzes markets in which government sets
maximum or minimum prices. It also examines the behavior of producers with regard to the
influence of production costs, product demand, product prices and revenue on setting levels
of output. Next, it examines the characteristics of the four basic market models, pure
competition, monopolistic competition, oligopoly and pure monopoly. Finally, it looks at wage
determination and the role labor supply, demand and productivity play in determining wages
and earnings.
Big Ideas:
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Elasticity measures the degree to which price changes affect quantity demanded or
quantity supplied: Price elasticity of demand measures consumer response to price
changes, while price elasticity of supply measures producers’ ability to respond to price
changes:
o If consumers are relative sensitive to price changes, demand is elastic; if they
are relatively unresponsive, demand is inelastic.
o Elasticity of supply depends on the ease of shifting resources between
alternative uses.
The amount of a product a firm is willing to supply depends on production costs—the
prices and productivity of the resources essential to production—and the price the product
will bring in the market. Production costs include variable, fixed and marginal costs. In
the long run, as firms get larger, they can profit from economies of scale.
Industries are grouped into four models based on their market structures:
o Pure competition: a large number of independent firms producing a
standardized product, in which no single firm can influence market price.
o Pure monopoly: a sole producer of a commodity for which there are no close
substitutes, in which market entry is effectively blocked. Except for regulated
monopolies, pure monopolies have negative economic effects
o Monopolistic competition: many firms offering elastic products, differentiated
through advertising; these firms have limited control over price, and entry is
relatively easy. The goal of these firms is to shift demand within a niche market
to the right, resulting in higher prices and a larger market share.
o Oligopoly: characterized by the presence of few firms, each having a significant
faction of the market. Barriers to entry exist and collusion is possible.
Oligopolists emphasize nonprice competition through advertising, since they
usually have the money.
Not all pages will be covered, though you should be familiar with all terms listed below.
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There is a critical relationship between labor productivity and real wages. Wage
differentials are explained by the differences among worker characteristics, job
characteristics and lack of worker mobility.
Essential Questions (some or all of these questions will be on the Unit Exam):
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The laws of supply and demand act on producers’ and consumers’ decisions in the
marketplace. Yet, different products and/or services vary in their sensitivity to changes in
price:
o Summarize the main determinants of price elasticity of demand and supply;
o Analyze why governments apply excise taxes to liquor and gasoline and not on
restaurant meals or basketball shoes;
o Using the ideas of consumer surplus and producer surplus, explain why
competitive markets are efficient—e.g., why below- or above-equilibrium levels of
output are inefficient, according to these two sets of ideas.
The text claims that “Costs exist because resources are scarce, productive, and have
alternative uses. When society uses a combination of resources to produce a particular
product, it forgoes all alternative opportunities to use those resources for other purposes.
The measure of the economic cost, or opportunity cost, of any resource used to
produce a good is the value or worth the resource would have in its best alternative use”
[emphasis in original]. Answer two (2) of the following:
o Explain why, in the long run, there are no fixed costs and why, similarly, the law of
diminishing returns doesn’t apply;
o Using the concepts of economies and diseconomies of scale, explain the shape of
a firm’s long-run ATC curve, and what bearing the shape of the long-run ATC curve
can have on the structure of an industry;
o Describe why business managers consider marginal cost (MC) a better indicator of
a firm’s efficiency than total cost (TC) or average total cost (ATC).
“Pure monopoly exists when a single firm is the sole producer of a product for which there
are no close substitutes.” Answer two (2) of the following:
o Describe the major barriers to entry into an industry, explaining how each barrier
can foster either monopoly or oligopoly;
o Assume that a pure monopolist and a purely competitive firm have the same unit
costs; contrast the two with respect to (a) price, (b) output, (c) profits, (d( allocation
of resources, and (e) impact on the distribution of income;
o Some propose that natural monopolists should be allowed to determine their profitmaximizing outputs and prices and then government should tax their profits away
and distribute them to consumers in proportion to their purchases from the
monopoly. Explain why this proposal may or may not be as socially desirable as
requiring monopolists to equate price with marginal cost or average total cost.
o Explain why unregulated, non-natural monopolies are “bad” for society.
“Most markets in the U.S. economy fall between the two poles of pure competition and
pure monopoly….Most firms have distinguishable rather than standardized products and
have some discretion over the prices they charge. Competition often occurs on the basis
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of price, quality, location, service, and advertising. Entry to most real-world industries
ranges from easy to very difficult but is rarely completely blocked”:
o Compare the elasticity of the monopolistic competitor’s demand with that of a pure
competitor and a pure monopolist;
o Explain why monopolistically competitive firms frequently prefer non-price
competition to price competition;
o Explain why there is so much advertising in monopolistic competition and oligopoly:
how such advertising helps consumers and promotes efficiency, and why it might
be excessive at times.
“Technological advance is evidenced by new and improved goods and services and new
and improved production or distribution processes.” And today, many economists
consider technical advances as “an integral part of capitalism,” not a “random, external
force to which the economy adjusted.” Answer two (2) of the following:
o Based on the following table, answer the questions that follow:
Amount of R&D (millions)
$10
20
30
40
50
60
Expected Rate of Return on R&D (%)
16
14
12
10
8
6
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If the interest-rate cost of funds is 8 percent, what will be the optimal amount
of R&D spending for this firm?
 Explain why $20 million of R&D spending will not be optimal.
 Why won’t $60 million be optimal either?
o Explain how research by universities and government affects innovators and
technological advance, and why some university researchers might be becoming
more like entrepreneurs and less like “pure scientists.”
o Make a case that neither pure competition nor pure monopoly is conducive to a
great deal of R&D spending and innovation—why oligopoly might be more
favorable to R&D spending and innovation than either pure competition or pure
monopoly.
Unit Summary:
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Price elasticity of demand is a measure of the responsiveness or sensitivity of quantity
demanded to changes in the price of a product—e.g., the degree to which a change in price
affects quantity demanded... When quantity demanded is relatively responsive to a price change,
demand is said to be elastic; when it is relatively unresponsive, demand is said to be inelastic:
o Demand is elastic when the percentage change in quantity is greater than the
percentage change in price;
o Demand is inelastic when the percentage change in quantity is less than the
percentage change in price;
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Demand elasticity is not the same at all prices;
One way to test the demand elasticity of a product is the total revenue test:
 When demand is elastic, a decrease in price will increase total revenue and an
increase in price will decrease total revenue;
 When demand is inelastic, a decrease in price will decrease total revenue and
an increase in price will increase total revenue;
o The price elasticity of demand for a product depends on the number of good
substitutes for the product, its relative importance in the consumer’s budget, whether
it is a necessity or a luxury and the period of time under consideration.
Price elasticity of supply is a measure of the sensitivity of quantity supplied to changes in the price
of a product:
o Supply will tend to be more price inelastic in the short run than in the long run.
Price ceilings and price floors set by gov’t prevent price from performing its rationing function—
that is, reach equilibrium:
o A price ceiling results in a shortage of the product, may bring about formal rationing
by gov’t and a black market, and causes a misallocation of resources;
o A price floor creates a surplus of the product, and may induce gov’t to take measures
either to increase the demand for or to decrease the supply of the product.
In money terms, the costs of using resources are an opportunity cost: the payments a firm must
make to the owners of resources to attract these resources away from their best alternative
opportunities for earning incomes.
In the short run the firm cannot change the size of its plant and can vary its output only by
changing the quantities of the variable resources it employs.
In the long run, all the resources employed by the firm are variable resources, and therefore all
its costs are variable costs.
As the firm expands its output by increasing the size of its plant, average total cost tends to fall at
first because of the economies of large-scale production, but total cost begins to rise because
of the diseconomies of large-scale production.
The price a firm charges and its output of that product depend only on the demand for and the
cost of producing it, but on the character of the market.
The models of the markets are pure competition, pure monopoly, monopolistic competition
and oligopoly.
A firm selling its product in a purely competitive industry cannot influence the price and is a price
taker.
A firm will maximize profits when marginal revenue (MR) equals marginal costs (MC) at an output
level where price is greater than average total cost.
Pure monopoly: a market structure in which a single firm sells a product for which there are no
close substitutes:
o Monopoly firms are price makers;
o In monopolies, the following barriers to entry exist:
 Economies of scale;
 Legal restrictions through patents and licenses;
 Ownership or control of essential resources;
 Pricing and other practices, such as price cuts, ad campaigns, producing
excess capacity.
o Pure monopoly has the following effects on the economy:
 They charge a higher price and produce less output than in a more competitive
industry;
 It contributes to income inequality in the economy;
 The legal fees, lobbying and public-relations expenses to obtain and /or
maintain monopoly status add nothing to output, but increase costs;
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It’s not likely to be technologically progressive, since there’s no incentive to do
so;
o Policy options to deal with monopoly include use of antitrust laws and breakup of firms,
and the regulation of price, output and profits.
Monopolistic competition, found in many industries, has the following characteristics:
o The relatively large number of sellers means that each has a small market share, there
is no collusion, and firms take actions that are independent of each other;
o They exhibit product [nonprice] differentiation: different attributes, services to
customers, brand names, packaging, etc.
o Entry into or exit from the industry is relatively easy;
o In addition to price competition, monopolistically competitive firms also use nonprice
competition in the form of product differentiation, new-product development and
advertising.
o Product differentiation means consumers will be offered a wide range of types, styles,
brands, and quality variants of a product;
Oligopolies are composed of a few firms that dominate an industry and sell a standardized or
differentiated product:
o They control price, though there is also mutual interdependence, because firms must
consider the reactions of rivals to any changes;
o Barriers to entry, plus mergers, help explain the existence of oligopoly;
o Concentration of the industry can be measured by either concentration ratios or the
Herfindahl index.
o Oligopoly often leads to overt or covert collusion among firms to fix prices or coordinate
pricing; overt collusion can include cartels.
o These firms often avoid price competition, but since they have greater financial
resources, they do engage in nonprice competition through product development and
advertising.
Technological advance involves the development of new and improved products and new and
improved ways of producing and distributing products.
Technological advance involves a three-step process:
o Invention – the discovery of product or process, which is encouraged by the granting
of patents;
o Innovation – the first successful commercial use of a new product or method or the
creation of a new form of business; this can involve innovation of products (product
innovation) or methodologies (process innovation);
o Diffusion – the spread of an innovation through imitation or copying.
The optimal amount of R&D (research and development) depends on the marginal benefit and
marginal cost of R&D activity; the greatest profit from R&D will be reached when the marginal
benefit equals the marginal costs:
o Sources for financing firms’ R&D activities are banks, bond issues, retained earnings,
venture capital, etc. A firm’s marginal cost of these funds is the interest rate;
o A firm’s marginal benefit of R&D is its expected profit (or return) from the last dollar
spent on R&D;
o The optimal amount of R&D in a marginal-cost and marginal-benefit analysis is the
point where the interest-rate cost-of-funds (marginal-cost) curve and the expected-rateof-return (marginal-benefit) curve intersect. R&D expenditures can be justified only if
the expected return equals or exceeds the cost of financing it;
o Firms may use a fast-second strategy by imitating the innovator, rather than spending
R&D money on invention, resulting in the imitation problem;
o Taking the lead in innovation could offer firms several protections and potential
advantages:
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Patents limitation imitation and protect profits;
Copyrights and trademarks reduce direct copying;
The time lags between innovation and diffusion give innovators time to make
substantial economic profits;
 There is potential purchase of innovating firm by larger firm at high price;
 Brand names may provide major marketing asset.
o Technological advances, however, do enhance economic efficiency.
The wage rate received by a specific type of labor depends on the demand for the supply of that
labor and the competitiveness of the market in which that type of labor is hired.
Differences in wages exist for three reasons:
o Workers are not homogeneous and have different skills, abilities and training;
o Jobs vary in difficulty and attractiveness, meaning that higher wages may be necessary
either to attract skilled labor or to compensate for less desirable aspects of some jobs;
o Workers are not perfectly mobile, and some areas may simply pay more.
Unit II Terms:
Price elasticity of demand
Midpoint formula
Elastic demand
Inelastic demand
Unit elasticity
Perfectly inelastic demand
Perfectly elastic demand
Total revenue (TR)
Total-revenue test
Price elasticity of supply
Market period
Short run
Long run
Cross elasticity of demand
Income elasticity of demand
Consumer surplus
Producer surplus
Efficiency losses (“deadweight
losses”)
Economic (opportunity) cost
Explicit costs
Implicit costs
Normal profit
Economic profit
Total product (TP)
Marginal product (MP)
Average product (AP)
Law of diminishing returns
Fixed costs
Variable costs
Total cost
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
Economies of scale
Diseconomies of scale
Constant returns to scale
Minimum efficient scale (MES)
Natural monopoly
Pure competition
Pure monopoly
Monopolistic competition
Oligopoly
Imperfect competition
Price taker
Average revenue
Total revenue
Marginal revenue
Break-even point
MR = MC rule
Short-run supply curve
Long-run supply curve
Constant-cost industry
Increasing-cost industry
Decreasing-cost industry
Productive efficiency
Allocative efficiency
Barriers to entry
Simultaneous consumption
Network effects
X-inefficiency
Rent-seeking behavior
Price discrimination
Socially optimal price
Fair-return price
Monopolistic competition
Product differentiation
Nonprice competition
Excess capacity
Oligopoly
Homogeneous oligopoly
Differentiated oligopoly
Strategic behavior
Mutual interdependence
Concentration ratio
Inter-industry competition
Import competition
Herfindahl index
Game-theory model
Collusion
Kinked-demand curve
Price war
Cartel
Tacit understandings
Price leadership
Technological advance
Very long run
Invention
Patent
Innovation
Product innovation
Process innovation
Diffusion
Start-ups
Venture capital
Interest-rate cost-of-funds curve
Expected-rate-of-return curve
Optimal amount of R&D
Imitation problem
Fast-second strategy
Inverted-U theory of R&D
Creative destruction
Wage rate
Nominal wage
Real wage
Purely competitive labor market
Monopsony
Minimum wage
Wage differentials
Marginal revenue productivity
Noncompeting groups
Human capital
Compensating differences
Incentive pay plan
Short-Answer Questions—some or all will be used as short-answer questions on the exam:
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Summarize the price elasticity of demand in terms of the change in total revenue when price
changes.
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Summarize the factors which together determine the price elasticity of demand for a product?
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Explain what determines the price elasticity of supply of an economic good or service?
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What if the government institutes a price floor? Illustrate the economic consequences with a
graph.
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Judge what type of adjustments a firm can make in the long run that it cannot make in the short
run
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Distinguish between a fixed cost and a variable cost.
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Summarize what is meant by economies of scale and some of the more important factors that
explain its existence?
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Assess the causes diseconomies of large scale?
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Explain to a small company why economies of scale are a barrier to entry?
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Cite examples of how patents and licenses create barriers to entry.
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Define product differentiation, and design a method by which a product can be differentiated?
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Identify the ways in which product differentiation and product development may offset the
economic inefficiency associated with monopolistic competition.
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What are the essential characteristics of an oligopoly, and how does oligopoly differ from pure
competition, pure monopoly and monopolistic competition?
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Explain the price leadership model and the leadership tactics oligopolistic firms use.
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Use a marginal-cost and marginal-benefit graph to illustrate how the firm decides on the optimal
amount of research and development.
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Support the notion that a firm’s revenues and profits can be increased through product innovation.
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Design a rationale by which innovation might create or reduce monopoly.