Download CHAPTER 3 Where Prices Come From: The Interaction of Demand

CHAPTER 3 Where Prices Come From: The Interaction of Demand and Supply
3.1 The Demand Side of the Market
a. Demand schedules and demand curves
A demand schedule is a table that shows a negative relationship between the price and the quantity
demanded of a good. The table in Figure 3-1 is a demand schedule.
Quantity demanded is the amount of a good that a consumer is willing and able to buy at a given price.
A demand curve is a curve that shows a negative relationship between the price of a good and its quantity
demanded.
Demand Schedules and Demand Curves
FIGURE 3-1
A Demand Schedule and
Demand Curve
As the price changes, consumers
change the quantity of energy
drinks they are willing to buy. We
can show this as a demand
schedule in a table or as a demand
curve on a graph.
The table and graph both show that
as the price of energy drinks falls,
the quantity demanded rises.
When the price of energy drinks is
$3.00, consumers buy 60 million
cans per day. When the price drops
to $2.50, consumers buy 70 million
cans.
Therefore, the demand curve for
energy drinks is downward sloping.
Market demand is the demand of all consumers of
a given product. Figure 3-1 shows a market
demand. It has a downward slope, or as price
decreases quantity demanded increases.
b. The law of demand
The law of demand states that as the price of a
product falls its quantity demanded increases and
vice versa while holding other things constants
(this is the ceteris paribus assumption).
c. What explains the law of demand?
There are two effects that affect the quantity
demanded of a good when its own price changes.
These two effects are the substitution effect and the income effect and act simultaneously.


Substitution effect: It is the change in quantity demanded of a good due to a change in its own
price, which makes the good more or less expensive relative to its substitutes.
Income effect: it is the change in quantity demanded of a good that results from the effect that a
change in the good’s own price has on the purchasing power of the consumer.
d. Holding everything else constant: The Ceteris Paribus condition
It means, for example, that when we analyze the relationship between price and quantity demanded of a
product, other variables are assumed to remain unchanged. An increase or a decrease of demand is given
by a shift of the demand curve. A change in quantity demanded is given by movements along the demand
curve.
e. Variables that shift market demand
An increase in the quantity of a product that consumers want to buy at a given price causes the demand
curve to shift to the right, an increase in demand. A decrease in the quantity of a product that consumers
want to buy at a given price causes the demand curve to shift to the left, a decrease in demand.
Income. Changes in the quantity that consumers want to buy may be due to changes in income. An
increase in income may increase the quantity of a product that consumers want to buy and vice versa.


Normal good is a good for which its demand increases when income increases and decreases
when income decreases, e.g. luxury goods.
Inferior good is a good for which its demand decreases when income increases and increases
when income decreases.
Prices of related goods. Goods and services that can serve the same purpose are substitutes, e.g. coffee
and tea. Therefore, if good X is a substitute for good Y, an increase in the price of good X will cause the
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demand curve of good Y to shift to the right. But, a decrease in the price of good X will cause the demand
curve of good Y to shift to the left. Complements are goods and services that are consumed together, e.g.
consumption of coffee and cream. If good X is a complement for good Y, an increase in the price of good
X will cause the demand curve of good Y to shift to the left. But, a decrease in the price of good X will
cause the demand curve of good Y to shift to the right.
Tastes are about consumers preferences that affect consumers’ decisions when buying a product. Tastes
can be affected by advertising and may cause the demand curve to shift to the right.
Population and demographics is about how the size of the population and the characteristics of the
population regarding age, race, and gender affect the demand for a product.
Expected future prices are about consumers’ perception on either increases or decreases of a price of a
good. If consumers believe the price of a good will decrease they can decrease current demand, but if they
believe that price of a good will increase they can increase current demand.
f. A change in demand versus a change in quantity demanded
A change in demand occurs when the demand curve shifts. This is caused when a variable such as income
changes. A change in quantity demanded is a movement that occurs along the demand curve when the
own price of a good changes. These two scenarios are shown in Figure 3-3.
3.2 The Supply Side of the Market
Quantity supplied is the amount of a good a firm is willing and able to supply at a given price. The
quantity supplied of a good will increase when the good’s price increases, holding everything else
constant. The quantity supplied of a good will decrease when the good’s price decreases, holding
everything else constant.
a. Supply schedules and supply curves
A supply schedule is a table that shows a positive relationship between the quantity supplied of a product
and its own price. The table below shows the
supply schedule and the graph shows the supply
Supply Schedules and Supply Curves
curve.
FIGURE 3-4
A Supply Schedule and Supply Curve
b. The law of supply
As the price changes, Red Bull, Monster
Energy, Rockstar, and the other firms
producing energy drinks change the quantity
they are willing to supply. We can show this
as a supply schedule in a table or as a supply
curve on a graph.
The supply schedule and supply curve both
show that as the price of energy drinks rises,
firms will increase the quantity they supply.
At a price of $2.50 per can, firms will supply
90 million cans. At a price of $3.00, firms will
supply 100 million cans.
The law of supply states that an increase in the
price of a product will cause an increase in its
quantity supplied, holding everything else constant.
A change in the product’s own price causes a
change in the quantity supplied, which is a
movement along the supply curve. A change in a
factor that affects the willingness of firms to supply
a product will cause a change in supply, which is a
shift of the supply curve. Thus, if a firm increases
the quantity supplied of a product at a given price the supply curve will shift to the right. If a firm
decreases the quantity supplied of a product at a given price the supply curve will shift to the left.
c. Variables that shift market supply
The most important variables are: prices of inputs, technological change, prices of substitutes in
production, number of firms in the market, and expected future prices.
Changes in the prices of inputs cause the supply curve to shift because it affects costs of production. An
increase in input prices shifts the supply curve to the left. A decrease in input prices shifts the supply
curve to the right.
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Technological change is about positive and negative technological changes. Positive technological
change occurs when a firm is able to increase production with the same amount of inputs. This would be
due to an increase in either worker productivity or machine productivity, so that costs of production will
decrease and more of the product can be supplied at a given price. As a result, the supply curve will shift
to the right. Negative technological change occurs when a firm decreases production of a product given
an amount of inputs, which can be the result of either wars or natural disasters. Costs of production
increases and the supply curve shifts to the left.
Prices of substitutes in production affect the quantity supplied of a product. When the price of a product
decreases, firms will reduce production of this product and increase production of its substitutes at the
given prices. So, the supply curve for each of the substitutes will shift to the right.
The number of firms in the market affects the quantity supplied of a product. An increase in the number of
firms will increase the supply of a product and shift the supply curve to the right. A decrease in the
number of firms will decrease the supply of a product and shift the supply curve to the left.
Expected future prices affect how much of a product is produced. If a firm expects the price of its product
will increase in the future, it may reduce current production and then increase it in the future.
d. A change in supply versus a change in quantity supplied
A change in supply occurs when the supply curve shifts. This is caused when a variable such as the price
of an input changes. A change in quantity supplied is a movement that occurs along the supply curve
when the own price of a good changes.
3.3 Market Equilibrium: Putting Demand and Supply Together
FIGURE 3-7
Market Equilibrium
Where the demand curve crosses
the supply curve determines market
equilibrium.
In this case, the demand curve for
energy drinks crosses the supply
curve at a price of $2.00 and a
quantity of 80 million cans.
Only at this point is the quantity of
energy drinks consumers are willing
to buy equal to the quantity that Red
Bull, Monster Energy, Rockstar, and
the other firms are willing to sell: The
quantity demanded is equal to the
quantity supplied.
Figure 3-7 shows demand and supply together.
Demand and supply intersect at point E, the market
equilibrium. Equilibrium price is $2.00 and
equilibrium quantity is 80 million cans per day.
Hence, point E shows that the quantity that
consumers are willing to buy equals the quantity
that producers are willing to sell. This market (the
market for energy drinks) is assumed to be
competitive since there are many buyers and many
sellers (about 80 firms).
a. How markets eliminate surpluses and shortages
At the price of $2.50, there is a surplus of 20 million cans of energy drinks (90 million minus 70 million =
20 million). That is, quantity demanded (70 million) is less than quantity supplied (90 million). The
surplus makes firms to reduce the price of energy drinks so that quantity demanded increases. As the price
decreases, quantity demanded increases while quantity supplied decreases until demand and supply meet
at market equilibrium. At the price of $1.00, however, there is a shortage of 40 million cans of energy
drinks (100 million minus 60 million = 40 million). That is, quantity supplied (60 million) is less than
quantity demanded (100 million). The shortage makes firms to raise the price of energy drinks so that
quantity demanded decreases. As price increases, quantity demanded decreases while quantity supplied
increases until demand and supply meet at market equilibrium.
b. Demand and supply both count
This means that market equilibrium price is determined by the intersection of demand and supply.
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3.4 The Effect of Demand and Supply Shifts on Equilibrium
a. The effect of shifts in supply on equilibrium
This is shown in Figure 3-9. The supply curve has
shifted to the right from S1 to S2. This is because
Coke added Full Throttle (a new product) to the
energy drink market. The increase in supply causes
a surplus of energy drinks at the price of P1. The
decrease in price from P1 to P2 eliminates the
surplus and the equilibrium quantity increases
from Q1 to Q2. On the contrary, an exit of a firm
from the energy drink market will cause a shift of
supply to the left, so that equilibrium price will
rise and equilibrium quantity will fall.
FIGURE 3-9
The Effect of an Increase in
Supply on Equilibrium
If a firm enters a market, as Coca-Cola
entered the market for energy drinks when it
launched Full Throttle, the equilibrium price
will fall, and the equilibrium quantity will rise:
1. As Coca-Cola enters the market for
energy drinks, a larger quantity of energy
drinks will be supplied at every price, so
the market supply curve shifts to the right,
from S1 to S2, which causes a surplus of
cans at the original price, P1.
2. The equilibrium price falls from P1 to P2.
3. The equilibrium quantity rises from Q1 to
Q2.
b. The effect of shifts in demand on equilibrium
This is shown in Figure 3-10. The demand curve
has shifted to the right from D1 to D2. The
increase in demand causes a shortage of energy
drinks at the price of P1. The increase in price
from P1 to P2 eliminates the shortage and the
equilibrium quantity increases from Q1 to Q2. On
the contrary, a decrease in the price of colas (a
substitute product) will cause a shift of the
demand curve for energy drinks to the left, so that
equilibrium price and quantity will both fall.
FIGURE 3-10
The Effect of an Increase in
Demand on Equilibrium
Increases in income will cause the
equilibrium price and quantity to rise:
1. Because energy drinks are a
normal good, as income grows,
the quantity demanded increases
at every price, and the market
demand curve shifts to the right,
from D1 to D2, which causes a
shortage of energy drinks at the
original price, P1.
2. The equilibrium price rises from
P1 to P2.
3. The equilibrium quantity rises
from Q1 to Q2.
c. The effect of shifts in demand and supply over time
If both demand and supply shifted to the right, but the shift in demand is larger than the shift in supply.
Hence, the equilibrium price increased. If, again, both demand and supply shifted to the right, but the
shift in supply is larger than the shift in demand. Hence, the equilibrium price decreased.
Table 3-3 summarizes the effects of shifting demand and supply over time on the price and equilibrium
quantity. The red entry in the table shows that the shifts of demand and supply to the right cause an
increase in equilibrium quantity, whereas the equilibrium price may increase or decrease.
TABLE 3-3
How Shifts in Demand and Supply Affect
Equilibrium Price (P) and Quantity (Q)
DEMAND CURVE
UNCHANGED
DEMAND CURVE
SHIFTS TO THE RIGHT
DEMAND CURVE
SHIFTS TO THE LEFT
SUPPLY CURVE
UNCHANGED
SUPPLY CURVE
SHIFTS TO THE RIGHT
SUPPLY CURVE SHIFTS
TO THE LEFT
Q unchanged
P unchanged
Q increases
P decreases
Q decreases
P increases
Q increases
P increases
Q increases
P increases or
decreases
Q increases or
decreases
P increases
Q increases or
decreases
P decreases
Q decreases
P increases or
decreases
Q decreases
P decreases
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CHAPTER 6 Elasticity: The Responsiveness of Demand and Supply
Elasticity measures the response of an economic variable (e.g., quantity demanded) to changes in another
economic variable (e.g., price).
6.1 The Price Elasticity of Demand and its Measurement
Price elasticity of demand is the percentage change in quantity demanded of a product due to some
percentage change in its price.
a. Measuring the price elasticity of demand
Price elasticity of demand is calculated as:
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Price elasticity of demand is always negative. That is, when the price of a product decreases the
denominator will be negative, and as a result, quantity demanded will increase and the numerator will be
positive, so price elasticity of demand will be negative. For an increase in price, the denominator will be
positive while the numerator will be negative, so price elasticity of demand will be negative. However,
the absolute value of the price elasticity of demand is used to compare elasticities.
b. Elastic demand and inelastic demand
Elastic demand: It happens when the absolute value of the price elasticity of demand is greater than 1.
Or, the percentage change in quantity demanded is greater than the percentage change in price. For
example, if a 10% decrease in price of bagels is associated with a 20% increase in its quantity demanded
then
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
20%
= −2
−10%
Hence, demand for bagels is “elastic”.
Inelastic demand: It happens when the absolute value of the price elasticity of demand is less than 1. Or,
the percentage change in quantity demanded is less than the percentage change in price. For example, if a
10% decrease in price of wheat is associated with a 5% increase in its quantity demanded then
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
5%
= −0.5
−10%
Hence, demand for wheat is “inelastic”.
Unit elastic demand: It happens when the absolute value of the price elasticity of demand is equal to 1.
Or, the percentage change in quantity demanded is equal to the percentage change in price. For example,
if a 10% decrease in price of corn is associated with a 10% increase in its quantity demanded then
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
10%
= −1
−10%
Hence, demand for corn is “unit elastic”.
c. An example of computing price elasticities
Assume that you are a gas station owner, and that you are interested in reducing the price of gas. Initially,
in figure 6-1, you are at point A: A sale of 1,000 gallons/day and a price of $3.00/gallon. Then, if you
reduce the price to $2.70, on demand curve D1 sales increase to 1,200 gallons/day (a movement from A
to B), while on D2 sales increase to 1,050 gallons/day (a movement from A to C). Therefore, elasticity of
demand for gas has affected the response in quantity demanded. Hence, among these three points, D1 is
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elastic and D2 is inelastic. D2 is inelastic between point A and C, and D1 is elastic between point A and
B.
FIGURE 6-1
Next, we compute the price elasticity of demand
Elastic and Inelastic Demand
for D1 as follows. The decrease in price from $3 to
Curves
Along D , cutting the price from $3.00
$2.7 means that a 10% decrease in price is
to $2.70 increases the number of
gallons sold from 1,000 per day to
associated with a 20% increase in quantity
1,200 per day, so demand is elastic
between point A and point B.
demanded. Then,
Along D , cutting the price from $3.00
to $2.70 increases the number of
20%
gallons sold from 1,000 per day only to
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
= −2
1,050 per day, so demand is inelastic
between point A and point C.
−10%
1
2
However, if we compute price elasticity of demand
for an increase in price from $2.7 to $3 the result
will be different. The increase in price from $2.7 to
$3 means that an 11.1% increase in price is associated with a 16.7% decrease in quantity demanded.
Then,
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
−16.7%
= −1.5
11%
Hence, there is not a consistent result for price elasticity of demand on D1 between point A and B. We
need a single value for price elasticity of demand.
d. The midpoint formula
The midpoint formula gives only one value for price elasticity of demand between two points on a
demand curve. The formula is defined as
(𝑄2 − 𝑄1) (𝑃2 − 𝑃1)
÷
𝑄1 + 𝑄2
𝑃1 + 𝑃2
(
) (
)
2
2
where Q1 and P1 are initial quantity and price, and Q2 and P2 are the final quantity and price. Now, by
applying the midpoint formula to figure 6-1, we get, for demand curve D1
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
(1200 − 1000) (2.70 − 3.00)
18.2
÷
=
= −1.7
1000 + 1200
3.00 + 2.70
(
) (
) −10.5
2
2
Notice that this value is in between the two values we computed in section ‘c’ above. And, we see that D1
is price elastic between point A and B.
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
Next, we apply the midpoint formula to demand curve D2
(1050 − 1000) (2.70 − 3.00)
4.9
÷
=
= −0.5
3.00 + 2.70
1000 + 1050
−10.5
(
)
(
)
2
2
Hence, D2 is price inelastic between point A and C.
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑 =
e. When demand curves intersect, the flatter curve is more elastic
Elasticity is not the same as slope. Elasticity is calculated based on percentage changes between quantity
demanded and prices, while the slope is calculated based on changes in quantities and prices. However, if
two demand curves intersect, as in Figure 6-1, then the flatter (smaller slope in absolute value) demand
curve is more elastic, while the steeper (larger slope in absolute value) demand curve is more inelastic.
f. Polar cases of perfectly elastic and perfectly inelastic demand
Perfectly inelastic demand: It occurs when quantity demanded does not change due to a price change, and
price elasticity of demand equals zero. This is represented by a vertical line. An example is the drug
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insulin. Diabetics require some daily amount of insulin, so a decrease or increase in price of insulin will
not affect diabetics’ daily requirements of insulin, and as a result, quantity demanded for insulin will not
change. If some diabetics are not able to buy insulin at the higher price, then demand will not be perfectly
inelastic or completely vertical.
Perfectly elastic demand: It occurs when quantity demanded is infinitely responsive to a change in price,
and price elasticity of demand equals infinity. This is represented by a horizontal line. In this case, an
increase in price will make quantity demanded to be zero.
6.2 The Determinants of the Price Elasticity of Demand
The key determinants of price elasticity of demand are: availability of close substitutes, passage of time,
luxuries versus necessities, definition of the market, and the share of the good in the consumer’s budget.
Availability of close substitutes: It is the most important determinant of price elasticity of demand.
Therefore, a product with relative more substitutes has a more elastic demand. For this product, when its
price increases, quantity demanded can decrease a lot because consumers have some other alternatives
(e.g., pizzas vs. burgers or hot dogs). On the contrary, a product with relative fewer substitutes has a less
elastic demand. For this product, when its price increases, quantity demanded can decrease a little because
consumers have few alternatives (e.g., gasoline).
Passage of time: It refers to the length of the period of time while the new the price is available. The
longer this period the more elastic the demand of a product becomes. For example, consumers will require
some time to switch from eating chicken once a week to twice a week when the price of chicken
decreases. So, the longer the lower price is available the more time consumers have to adjust their
consumption pattern and the more elastic the demand for chicken will be.
Luxuries versus necessities: Usually, luxuries have more elastic demand relative to necessities. For
example, bread is a necessity and has an inelastic demand, while tickets to a concert are a luxury and have
an elastic demand.
Definition of the market: It is about consumers’ demand of a product in a relatively narrow market. For
example, demand for gasoline at a particular gas station may be elastic. That is, if price increases at a
particular gas station consumers can buy gasoline at another gas station where gas is cheaper. Then,
demand of gas at the former gas station is elastic. The more narrowly the market is defined the more
elastic demand will be. However, the demand for gasoline as a product is inelastic.
Share of a good in a consumer’s budget: Products with a smaller share in a consumer’s budget are likely
to have less elastic demand than products with a larger share. Consider consumer spending on table salt
which has a very small share in consumers’ budget, then even a doubling of the price of salt will not
cause a small reduction in the quantity demanded. But, for houses, cars and furniture, which have a big
share in consumers’ budget, an increase in price will cause a big reduction in quantity demanded.
6.3 The relationship Between Price Elasticity of
Demand and Total Revenue
FIGURE 6-2
The Relationship between Price
Elasticity and Total Revenue
When demand is inelastic, a cut in price will decrease
total revenue. in panel (a), at point A, the price is $3.00,
1,000 gallons are sold, and total revenue received by the
service station equals $3.00 × 1,000 gallons, or $3,000.
At point B, cutting price to $2.70 increases the quantity
demanded to 1,050 gallons, but the fall in price more than
offsets the increase in quantity. As a result, revenue falls
to $2.70 × 1,050 gallons, or $2,835.
When demand is elastic, a cut in price will increase
total revenue.
In panel (b), at point A, the area of rectangles C and D
is still equal to $3,000.
At point B, the area of rectangles D and E is equal to
$2.70 × 1,200 gallons, or $3,240. In this case, the
increase in the quantity demanded is large enough to
offset the fall in price, so total revenue increases.
For an inelastic demand, price and total revenues
moves in the same direction. That is, when price
increases total revenue increases, but when price
decreases total revenue decreases. For an elastic
demand, price and total revenues moves in the
opposite direction. That is, when price increases
total revenue decreases, but when price decreases
total revenue increases.
Figure 6-2 above shows the relationship between
price elasticity and total revenue. Panel (a) shows
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a demand curve for gasoline that is inelastic between
point A and B. Total revenue at point A is $3,000.
The increase in revenue of $135 is less than the lost
in revenue of $300. Hence, the reduction in price
caused total revenue to decrease to $2,835. Panel (b)
shows a demand curve for gasoline that is elastic
between point A and B. Total revenue at point A is
$3,000. The increase in revenue of $540 is greater
than the lost in revenue of $300. Hence, the reduction in price caused total revenue to increase to $3,240.
IF DEMAND IS . . .
THEN . . .
BECAUSE . . .
elastic
an increase in price
reduces revenue
the decrease in quantity demanded is
proportionally greater than the increase in price.
elastic
a decrease in price
increases revenue
the increase in quantity demanded is
proportionally greater than the decrease in price.
inelastic
an increase in price
increases revenue
the decrease in quantity demanded is
proportionally smaller than the increase in price.
inelastic
a decrease in price
reduces revenue
the increase in quantity demanded is
proportionally smaller than the decrease in price.
unit-elastic
an increase in price does
not affect revenue
the decrease in quantity demanded is
proportionally the same as the increase in price.
unit-elastic
a decrease in price does
not affect revenue
the increase in quantity demanded is
proportionally the same as the decrease in price.
For a unit elastic demand, total revenue is unaffected when price either increases or decreases.
a. Elasticity and revenue with a linear demand curve
Elasticity is not constant
along most demand
curves. Panel (a) in Figure
FIGURE 6-3
6-3 shows a linear demand
Elasticity Is Not Constant
for rentals of DVDs.
Along a Linear Demand Curve
Along this demand curve,
The data from the table are plotted in
a decrease of $1 in the
the graphs. Panel (a) shows that as we
move down the demand curve for DVD
price of DVD rentals
rentals, the price elasticity of demand
declines. In other words, at higher
causes an increase in
prices, demand is elastic, and at lower
prices, demand is inelastic.
quantity demanded of 2
Panel (b) shows that as the quantity of
DVDs per month. Also,
DVDs rented increases from zero,
revenue will increase until it reaches a
when price is high and
maximum of $32 when 8 DVDs are
rented.
quantity demanded is low,
As rentals increase beyond 8 DVDs,
demand is elastic. That is,
revenue falls because demand is
inelastic on this portion of the demand
the percentage change in
curve.
quantity demanded is
larger than the percentage
change in price. But, when
price is low and quantity
demanded is high, demand is inelastic. In this case, the percentage change in quantity demanded is
smaller than the percentage change in price. In panel (b), when quantity demanded is between 0 and 8, a
decrease in price will increase total revenue. This is the case when demand is elastic. However, when
quantity demanded is between 8 and 16, a decrease in price causes total revenue to decrease. This is the
case when demand is inelastic.
Elasticity and Revenue with
a Linear Demand Curve
b. Estimating price elasticity of demand
In order to estimate price elasticity of demand for a product, the product’s demand curve needs to be
known. Firms have used market experiments to calculate price elasticity of demand for a new
product. Firms try different prices and observe the changes in quantity demanded.
8
6.4 Other Demand Elasticities
a. Cross price elasticity of demand
It is the percentage change in quantity
demanded of one good due to some percentage
change in the price of another good.
TABLE 6-4
Summary of Cross-Price
Elasticity of Demand
IF THE
PRODUCTS ARE . . .
THEN THE CROSS-PRICE
ELASTICITY OF DEMAND
WILL BE. …
substitutes
positive
complements
negative
EXAMPLE
Two brands of digital
music players
Digital music players and
song downloads from
online music stores
𝐶𝑟𝑜𝑠𝑠 − 𝑝𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑
=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑜𝑛𝑒 𝑔𝑜𝑜𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑛𝑜𝑡ℎ𝑒𝑟 𝑔𝑜𝑜𝑑
If the two goods are substitutes, then crossprice elasticity of demand will be positive. But,
if the two goods are complements, then cross-price elasticity of demand will be negative. For unrelated
goods, cross-price elasticity of demand will be zero. Table 6-4 is a summary of cross price elasticity.
unrelated
Digital music players and
peanut butter
zero
b. Income elasticity of demand
It is the percentage change in quantity
demanded of one good due to some percentage
change in income.
TABLE 6-5
Summary of Income
Elasticity of Demand
IF THE INCOME ELASTICITY
OF DEMAND IS . . .
THEN THE GOOD IS . . .
EXAMPLE
positive but less than 1
normal and a necessity.
Bread
positive and greater than 1
normal and a luxury.
Caviar
negative
inferior.
High-fat meat
𝐼𝑛𝑐𝑜𝑚𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑑𝑒𝑚𝑎𝑛𝑑
=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒
For normal goods income elasticity of demand is positive and greater than 1. For inferior goods income
elasticity is negative. Table 6-5 is a summary of income elasticity.
6.6 The Price Elasticity of Supply and its Measurement
a. Measuring price elasticity of supply
Price elasticity of supply is the percentage change in quantity supplied due to some percentage change in
price. Price elasticity of supply is calculated as:
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑠𝑢𝑝𝑝𝑙𝑦 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑠𝑢𝑝𝑝𝑙𝑖𝑒𝑑
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
Price elasticity of supply is always positive since supply is upward sloping. Then, if price elasticity of
supply is greater than 1, then supply is elastic. If price elasticity of supply is less than 1, then supply is
inelastic. If price elasticity of supply is equal to 1, then supply is unit elastic.
b. Determinants of the price elasticity of supply
The increase in quantity supplied of a product as its price increases will determine whether supply is
inelastic or elastic. In some cases, the length of the period of time can determine whether supply is elastic
or inelastic. For example, a pizza parlor cannot increase its pizza production on any one night using the
ingredients on hand. However, during a period of one or two days, the pizza parlor can buy more
ingredients. If the period of time gets longer, for example some months, the pizza parlor can hire more
cooks and install additional ovens. Hence, the supply curve for pizzas and most products will be inelastic
if measured over a shorter period of time, but the supply for pizzas and most products will be more elastic
if measured over a longer period of time. However, there are some products that do not follow this rule.
The production of these products involves a fixed supply of an input. An example is the production of
wine which can depend on a specific grape variety, but if the land where that grape can be grown is
9
already used for vineyards, then the supply of that wine will be inelastic even over a longer period of
time.
c. Polar cases of perfectly elastic and perfectly inelastic supply
Perfectly inelastic supply: It occurs when quantity supplied does not change due to a price change, and
price elasticity of supply equals zero. This is represented by a vertical line. Over a short period of time the
supply of some goods and services may be perfectly inelastic. An example is parking service. A parking
lot may have a fixed number of parking spaces, and if demand increases, the parking price may rise, but
the number of parking spaces will not increase. However, if demand increases over a longer period of
time the number of spaces may increase.
Perfectly elastic supply: It occurs when quantity supplied is infinitely responsive to price, and price
elasticity of supply equals infinity. This is represented by a horizontal line. In this case, a very small
increase in price will cause a very large increase in quantity supplied.
d. Using price elasticity of supply to predict changes in price
Figure 6-5 shows the demand for parking space at a beach resort. In panel (a), point A is a typical summer
weekend. Point B is the new equilibrium due to an increase in demand on the Fourth of July. Because
supply is inelastic, there is a large increase in price from $2 to $4 but a small increase in quantity supplied
from 1200 to 1400 spaces.
Using Price Elasticity of Supply to Predict Changes in Price
FIGURE 6-5
Changes in Price Depend on the
Price Elasticity of Supply
In panel (a), Demand Typical represents the typical demand
for parking spaces on a summer weekend at a beach
resort. DemandJuly 4 represents demand on the Fourth of
July.
Because supply is inelastic, the shift in equilibrium from
point A to point B results in a large increase in price—
from $2.00 per hour to $4.00—but only a small increase
in the quantity of spaces supplied— from 1,200 to 1,400.
In panel (b), supply is elastic. As a result, the
shift in equilibrium from point A to point B
results in a smaller increase in price and a
larger increase in the quantity supplied.
An increase in price from $2.00 per hour to
$2.50 is sufficient to increase the quantity of
parking supplied from 1,200 to 2,100.
Panel (b) shows an elastic supply. This may be because the resort has some available land that can be
used for parking during periods of high demand. Hence, point B represents a smaller increase in price and
a larger increase in quantity supplied. Price increases from $2 to $2.5 which is enough to increase
quantity supplied from 1,200 to 2,100 parking spaces. Thus, knowing the price elasticity of supply helps
us to predict the change in price due to either an increase or decrease in demand.
10
CHAPTER 10 Technology, Production, and Costs
10.1 Technology: An Economic Definition
Technology is the process firms use to transform inputs into output. The technology of a firm depends on
factors such as managers’ skills, worker’s training, and the speed and efficiency of its machinery and
equipment. For example, the technology of a pizza parlor depends on the capacity of the ovens, the cooks,
how the manager motivates the workers, and how the manager has arranged the facility to promote a
faster production of pizzas.
Technological change is the increase in a firm’s level of output using a given quantity of inputs. Positive
technological change can occur when a manager rearranges the factory floor or the layout of a retail store
in order to increase production and sales. Or, workers can participate in a training program which will
allow them to be more productive. Technological change can also be negative; a hurricane can destroy the
firm’s facilities so the firm’s output will fall.
10.2 The Short Run and the Long Run in Economics
Short run represents a period of time in which at least one input is fixed.
Long run represents a period of time in which a firm is able to vary the amounts of all inputs, adopts new
technology, and increases or decreases the size of its physical plant.
a. The difference between fixed costs and variable costs
Total costs are the costs of all the inputs used to produce a given level of output.
Variable costs are the costs of the inputs that vary (variable inputs) as output varies. Examples of variable
inputs are labor, electricity, raw material, etc.
Fixed costs are the costs of the inputs that do not vary (fixed inputs) as output varies. Examples of fixed
costs are leases on factory or retail space, insurance payments, advertising expenses, etc.
Total costs = Fixed Costs + Variable Costs
or, TC = FC + VC
b. Implicit costs versus explicit costs
Opportunity cost is the highest valued alternative that we need to give up to undertake another alternative.
Explicit cost occurs when money is required to pay for some inputs.
Implicit cost means that spending money is not required to pay for some inputs.
Table 10-1 shows implicit and explicit costs for Jill
Johnson’s pizza parlor. The red entries are explicit costs
Interest payments on loan to buy pizza ovens
10,000
while the blue ones are implicit costs. Implicit costs are
Electricity
6,000
Lease payment for store
24,000
the salary of $30,000 Jill had to give up to manage her
Foregone salary
30,000
own pizza restaurant; the $3,000 in foregone interest
Foregone interest
3,000
Economic depreciation
10,000
since she withdrew $50,000 from her bank account; and
Total
$151,000
the $10,000 in economic depreciation. Economic
depreciation is the decrease in value of the investment of the $50,000 in tables, chairs and other physical
capital at the beginning of the year, so at the end of the year the value of this capital will be $40,000.
Pizza dough, tomato sauce, and other ingredients
Wages
$20,000
48,000
11
c. The production function
Assume that Jill uses only labor and ovens to produce pizzas. So, in the short run she cannot add more
ovens, increase the size of the restaurant, or redesign the layout of the restaurant. She can only change the
amount of labor hired (number of workers) in order to change the quantity of pizzas produced.
A Production function shows the relationship between inputs and the maximum output that can be
produced. The production function represents the firm’s technology. The first three columns of Table 102 shows the relationship between workers, ovens and pizzas produced weekly.
Table 10-2 Short-run production and costs at Jill Johnson’s restaurant
QUANTITY
OF WORKERS
QUANTITY
OF
PIZZA OVENS
QUANTITY OF
PIZZAS
PER WEEK
COST OF
PIZZA OVENS
(FIXED COST)
0
2
0
$800
1
2
200
2
2
450
3
2
4
2
5
6
COST PER
COST OF
TOTAL COST
PIZZA
(AVERAGE
WORKERS
OF PIZZAS
(VARIABLE COST)
PER WEEK
TOTAL COST)
—
$0
$800
800
650
1,450
$7.25
800
1,300
2,100
4.67
550
800
1,950
2,750
5.00
600
800
2,600
3,400
5.67
2
625
800
3,250
4,050
6.48
2
640
800
3,900
4,700
7.34
d. A first look at the relationship between production and cost
Table 10-2 shows costs of production. Assume that Jill borrowed money from a bank to buy two ovens,
so her fixed cost per week is $800 (the cost of the loan). Variable cost is the amount paid in wages to her
workers. Average total costs are total costs divided by total output. Then, if 600 pizzas are produced at the
cost of $3,400, ATC is $3,400/600=$5.67.
10.3 The Marginal Product of Labor and the Average Product of Labor
Marginal product of labor is the increase in output due to hiring an additional unit of labor (a worker).
Table 10-3 shows marginal product of labor at Jill’s restaurant.
Table 10-3 The marginal product of labor at Jill’s restaurant
Hiring the first worker increases output
from zero to 200 pizzas per week. That
0
2
0
—
1
2
200
200
is, 200 pizzas is the marginal product
2
2
450
250
of labor for the first worker. Hiring the
3
2
550
100
second worker increases output by 250
4
2
600
50
5
2
625
25
pizzas per week which is the marginal
6
2
640
15
product of labor for the second worker.
Output increases because of the division of labor and specialization.
QUANTITY
OF WORKERS
QUANTITY
OF PIZZA OVENS
QUANTITY
OF PIZZAS
MARGINALPRODUCT
OF LABOR
a. The law of diminishing returns
The law of diminishing returns states that increasing the amount of an input while holding another input
fixed will cause the marginal product of the variable input to decrease. Table 10-3 shows that marginal
12
product of labor begins to decrease when the third worker is hired. If labor continues to be added while
the number of ovens is fixed, marginal product of labor will become negative and output will decrease.
b. Graphing production
Panel (a) in figure 10-2 below
shows the production function for
FIGURE 10-2
Jill’s restaurant. It plots the values
Total Output and the
Marginal Product of Labor
in columns 1 and 3 of table 10-3.
In panel (a), output increases as
more workers are hired, but the
Panel (b) shows the marginal
increase in output does not occur
at a constant rate.
product of labor. It plots the values
Each additional worker hired after
the third worker causes production
in columns 1 and 4 of table 10-3. In
to increase by a smaller amount
than did the hiring of the previous
panel (a), output increases at an
worker.
In panel (b), the marginal product
of labor is the additional output
increasing rate until the second
produced as a result of hiring one
more worker. The marginal product
worker is hired. After the second
of labor rises initially because of
the effects of specialization and
worker is hired, output increases at
division of labor, and then it falls
due to the effects of diminishing
a decreasing rate. In panel (b),
returns.
marginal product of labor increases
until the second worker is hired,
and it decreases when the third worker is hired because of diminishing return effects.
Graphing Production
c. The relationship between marginal and average product
The average product of labor is total output divided by total labor. If Jill hires 4 workers to produce 600
pizzas, then average product of labor is 600/4 = 150. The relationship between average and marginal
product of labor is: Average product of labor is the average of the marginal product of labor. Using the
marginal product of labor for the first, second and third workers from table 10-3, we can calculate the
average product of labor for these three workers as
If marginal product of labor is greater than average product of labor, then average product of labor must
be increasing. If marginal product of labor is less than average product of labor, then average product of
labor must be decreasing. Marginal product of labor equals average product of labor when average
product of labor is a maximum.
10.4 The Relationship between Short-Run Production and Short-Run Cost
a. Marginal Cost
Marginal cost is the change in total cost due to producing an extra unit of output. Marginal cost is
calculated by dividing the change in total cost by the change in total output. That is,
MC 
ΔTC
ΔQ
13
b. Why are the marginal and average cost curves U shaped?
In figure 10-4, marginal cost decreases at first and then increases. This gives marginal cost the U-shape
form.
Why Are the Marginal and Average
Cost Curves U Shaped?
FIGURE 10-4
Jill Johnson’s Marginal Cost and Average
Total Cost of Producing Pizzas
We can use the information in the table to
calculate Jill’s marginal cost and average total
cost of producing pizzas.
For the first two workers hired, the marginal
product of labor is increasing. This increase
causes the marginal cost of production to fall. For
the last four workers hired, the marginal product
of labor is falling. This causes the marginal cost of
production to increase. Therefore, the marginal
cost curve falls and then rises—that is, has a U
shape—because the marginal product of labor
rises and then falls.
As long as marginal cost is below average total
cost, average total cost will be falling. When
marginal cost is above average total cost,
average total cost will be rising.
The relationship between marginal cost and
average total cost explains why the average total
cost curve also has a U shape.
The table in the figure shows that
marginal product of labor is rising for
the first two workers. However,
marginal cost for the pizzas produced
by these workers is decreasing. On the
contrary, marginal product of labor
decreases for the last four workers
while marginal cost of their produced
pizzas increases. Hence we conclude
that: when marginal product of labor
is increasing, marginal cost is
decreasing; but, when marginal
product of labor is decreasing,
marginal cost is increasing.
Because Jill pays the same $650 to each additional worker she hires, marginal cost of the pizzas produced
by each new worker depends on the amount of pizzas produced by each new worker. If each new
worker’s output is increasing marginal cost will decrease, but if each new worker’s output is decreasing
marginal cost will increase.
Therefore, we can also conclude that: Marginal cost of production decreases and then increases, because
marginal product of labor increases and then decreases. And this makes marginal cost to be U-shaped.
The relationship between marginal cost and average total cost is as follows. When marginal cost is below
average total cost, average total cost decreases. When marginal cost is above average total cost, average
total cost increases. Marginal cost and average total cost are equal when average total cost is a minimum.
Hence, average total cost is U-shaped because marginal cost is U-shaped.
c. Graphing cost curves
Average total costs: It is total costs divided by total output.
ATC = TC/Q
Average fixed costs: It is fixed costs divided by total output.
AFC = FC/Q
Average variable costs: It is variable costs divided by total output.
AVC = VC/Q
Also, ATC = AFC + AVC.
14
Figure 10-5 shows Jill’s cost of production. An explanation about this figure follows.



The MC, ATC, and AVC curves are all U-shaped. Marginal cost intersects (or equals) ATC and
AVC at their minimum points. When MC is below ATC and AVC, both ATC and AVC decrease.
When MC is above ATC and AVC, both ATC and AVC increase.
AFC is decreasing. This is because as output increases, fixed costs are divided by a larger amount
of output.
AVC and ATC get closer as output increases. This is because AFC decreases as output increases.
FIGURE 10-5
Costs at Jill Johnson’s
Restaurant
Jill’s costs of making pizzas are
shown in the table and plotted in
the graph. Notice three important
facts about the graph:
(1) The marginal cost (MC),
average total cost (ATC), and
average variable cost (AVC)
curves are all U-shaped, and the
marginal cost curve intersects
both the average variable cost
curve and average total cost
curve at their minimum points.
(2) As output increases, average
fixed cost (AFC) gets smaller and
smaller.
(3) As output increases, the
difference between average total
cost and average variable cost
decreases.
10.6 Cost in the Long Run
In the long run there are not fixed costs, all costs are variable costs. Hence, total cost equals variable cost,
and average total cost equals average variable cost.
a. Economies of scale
Long-run average cost curve: It shows the lowest cost of production of certain amount of output in the
long run, when all inputs are variable.
Economies of scale: It is the decrease of long run average costs because of increasing output.
15
CHAPTER 11 Firms in Perfectly Competitive Markets
Three key characteristics of any industry:



Number of firms.
The similarity of the product produced by the firms in the industry.
The level of easiness for new firms to enter the industry.
These three characteristics allow industries to be classified into four market structures. These market
structures are shown in Table 11-1 - The four market structures.
MARKET STRUCTURE
CHARACTERISTIC
PERFECT
COMPETITION
MONOPOLISTIC
COMPETITION
OLIGOPOLY
MONOPOLY
Number of firms
Many
Many
Few
One
Type of product
Identical
Differentiated
Unique
Ease of entry
High
High
Identical or
differentiated
Low
Examples of
industries
• Growing Wheat • Clothing Stores
• Apples
• Restaurants
• Manufacturing
computers
• Manufacturing
automobiles
• First-class
mail delivery
• Tap water
Entry blocked
11.1 Perfectly Competitive Markets
Three conditions that define a competitive industry:



There are many buyers and many firms, and they are small relative to the market.
The product sold in the market is identical.
There are not barriers to entry the market.
An example of a perfect competitive market is the market for organic apples. This market has many
producers, and many buyers. Each producer and consumer represents a very small part of the market.
There are not barriers to entry to this market. An apple is an identical product. These circumstances do not
allow apple producers to affect the market price of organic apples.
a. A perfect competitive firm cannot affect the market price
In a perfectly competitive market, price is determined by the interaction of market demand and market
supply. Producers and sellers have to accept the market price if they want to participate in this market.
Producers and sellers cannot affect the market price.
A Price taker is a seller or a buyer who does not have power to change the market price of a product. The
competitive firm is a price taker. It cannot sell its product at a higher price than that of the market price,
but it can sell any amount of its product at the market price. A wheat producer is also an example of a
producer who behaves as a price taker. A wheat producer will not affect the wheat price either by
increasing or decreasing his wheat production. Also, a consumer behaves as a price taker when she buys
small amounts of a product relative to the market size for that product. Thus, the consumer has no power
to change the market price of the product.
16
b. The demand curve of a perfectly competitive firm
The demand curve for a perfect competitive firm is a horizontal line through the market price. This is
shown in Figure 11-2(b). We see that the wheat producer can sell either 6,000 bushels or 15,000 bushels
without changing the market price. Thus, the producer is a price taker.
The farmer demand is different from the market demand for wheat. Figure 11-2 shows the market demand
curve in panel (a) and the farmer demand curve in panel (b). The market price for wheat is determined in
panel (a), which is the price taken by our wheat producer. Note that the quantity supplied by the farmer to
the market is very small relative to the market quantity, and that is why the farmer has no power to
change the price.
FIGURE 11-2
The Market Demand for
Wheat versus the Demand
for One Farmer’s Wheat
In a perfectly competitive market,
price is determined by the
intersection of market demand
and market supply.
In panel (a), the demand and
supply curves for wheat intersect
at a price of $4 per bushel.
An individual wheat farmer like
Farmer Parker cannot affect the
market price for wheat.
Therefore, as panel (b) shows,
the demand curve for Farmer
Parker’s wheat is a horizontal
line.
11.2 How a firm Maximizes Profit in a Perfectly Competitive Market
We assume that the competitive firm maximizes profits. So, profit is given by total revenues minus total
costs:
Profit = TR – TC.
a. Revenue for a firm in a perfectly competitive market
Assume that a wheat farmer produces 10 bushels of wheat a year. Table 11-2 shows Farmer Parker’s
total revenue, average revenue and marginal revenue at the price of $4.
NUMBER OF
BUSHELS
(Q)
MARKET PRICE
(PER BUSHEL)
(P)
TOTAL
REVENUE
(TR)
$4
4
4
4
4
4
4
4
4
4
4
$0
4
8
12
16
20
24
28
32
36
40
0
1
2
3
4
5
6
7
8
9
10
AVERAGE
REVENUE
(AR)
$4
4
4
4
4
4
4
4
4
4
MARGINAL
REVENUE
(MR)
$4
4
4
4
4
4
4
4
4
4
Average revenue (AR) equals total revenue
divided by the quantity sold. Or, AR = TR/Q
= (P×Q)/Q=P.
Marginal revenue (MR) is the change in total
revenue due to selling an extra unit of a
product. Or,
𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 =
, or 𝑀𝑅 =
∆𝑇𝑅
.
∆𝑄
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Table 11-2 also shows that price equals both marginal revenue and
average revenue (P = MR = AR). This is a characteristic of a perfect competitive market.
17
b. Determining the profit maximizing level of output
Profit depends both on revenues and costs. Table 11-3 shows data on revenues and costs of production of
wheat. Profit is shown in column four. Maximum profit equals $7.5 when output equals 6 bushels of
wheat. But, for output levels above six bushels, profit decreases. This is because marginal cost increases
after the sixth bushel is produced.
Table 11-3 Farmer Parker’s profit from wheat farming
QUANTITY
(BUSHELS)
(Q)
0
1
2
3
4
5
6
7
8
9
10
TOTAL
REVENUE
(TR)
TOTAL
COST
(TC)
PROFIT
(TR-TC)
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
$2.00
5.00
7.00
8.50
10.50
13.00
16.50
21.50
28.50
38.00
50.50
-$2.00
-1.00
1.00
3.50
5.50
7.00
7.50
6.50
3.50
-2.00
-10.50
MARGINAL
REVENUE
(MR)
MARGINAL
COST
(MC)
—
$4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
—
$3.00
2.00
1.50
2.00
2.50
3.50
5.00
7.00
9.50
12.50
Figure 11-3 shows two procedures to calculate profits. Panel (a) shows that we can calculate profits using
total revenues and total costs. Then, total profit is a maximum when the vertical distance between total
revenue and total cost is a maximum. That relationship is reached when output is 6 bushels. Panel (b)
shows that we can also calculate profit using marginal revenue and marginal cost. In this case, maximum
profit is reached when output is 6 bushels. Increasing production above 6 bushels decreases total profit. In
panel (b) the revenue curve is the same as the demand curve.
Therefore, by using Table 11-3 and Figure 11-3 we can conclude that:


The largest difference between total revenue and total cost determines the maximizing level of
output.
The maximizing level of output is also determined when MR = MC.
FIGURE 11-3
The Profit-Maximizing Level of Output
In panel (a), Farmer Parker maximizes his
profit where the vertical distance between
total revenue and total cost is the largest.
Panel (b) shows that Farmer Parker’s marginal revenue
(MR) is equal to a constant $4 per bushel.
Farmer Parker maximizes profits by producing wheat up to
the point where the marginal revenue of the last bushel
produced is equal to its marginal cost, or MR = MC.
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11.3 Illustrating Profit or Loss on the Cost Curve Graph
Profit can also be expressed in terms of average total cost (ATC). The procedure is as follows. Profit is
equal to total revenues minus total costs. And, revenue is equal to price times total quantity. Then we
have the following relationship:
Profit = TR – TC, or Profit = (P ×Q) – TC.
Dividing the last equation by Q, we get
𝑃𝑟𝑜𝑓𝑖𝑡 (P × Q) TC
=
−
= 𝑃 − 𝐴𝑇𝐶
𝑄
𝑄
𝑄
The last equation indicates that profit per unit equals price minus average total costs. Next, by
multiplying the last equation by Q, we get total profits.
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 − 𝐴𝑇𝐶) × 𝑄
This equation indicates that total profit equals the product of total output and the difference between price
and average total cost.
a. Showing profits on a graph
FIGURE 11-4
The Area of Maximum
Profit
Figure 11-4 shows profits
calculated based on the
relationship between price,
average total cost and total
output. The green rectangle
shows profit calculated using
the area of the rectangle. That
is, profit equals Q times (PATC).
A firm maximizes profit at the
level of output at which
marginal revenue equals
marginal cost.
The difference between price
and average total cost equals
profit per unit of output.
Total profit equals profit per
unit multiplied by the number
of units produced. Total profit
is represented by the area of
the green-shaded rectangle,
which has a height equal to
(P - ATC) and a width equal
to Q.
Illustrating When a Firm Is Breaking Even or Operating at a Loss
FIGURE 11-5
A Firm Breaking Even and a Firm Experiencing Losses
b. Illustrating when a firm is
breaking even or operating at
a loss
Does the firm make profit when
marginal revenue equals
marginal cost? The answer to
this question depends on the
relationship between price and
marginal cost.
In panel (a), price equals average total cost, and
the firm breaks even because its total revenue will
be equal to its total cost. In this situation, the firm
makes zero economic profit.



In panel (b), price is below average total cost, and the firm
experiences a loss. The loss is represented by the area of
the red-shaded rectangle, which has a height equal to
(ATC - P) and a width equal to Q.
There are three possible
outcomes:
If P > ATC, the firm makes profits.
If P = ATC, the firm breaks even (zero profits).
If P < ATC, the firm loses money.
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Figure 11-4 above shows the first possibility. Figure 11-5 shows the second and the third possibility. In
figure 11-5, panel (a) shows the case when the firm breaks even. In this case P = ATC, total revenue
equals total costs and economic profit is zero. In panel (b), P < ATC, total revenue is less than total cost
and profit is negative or the firm has losses.
11.4 Deciding Whether to Produce or to Shut Down in the Short Run
There are two choices for a firm that faces losses in the short run. One is to continue producing, and the
other is to stop producing by shutting down temporarily.
However, if the firm decides to shut down temporarily, say for a month, the firm still has to pay for the
fixed costs (e.g., the monthly rent on the building). Fixed costs will be the loss to the firm if the firm stops
producing temporarily. Fixed cost is the maximum loss the firm will accept, and the firm will shut down
if producing will cause a loss greater than the fixed cost.
If total revenue is greater than variable cost, the firm can reduce its fixed cost losses by continuing its
output production. That is, the firm can use the amount of revenue in excess of variable cost to cover part
of the fixed costs. Hence, it will be better to continue producing rather than shutting down.
The fixed cost is a sunk cost. A sunk cost is a cost that has been paid and cannot be recovered. Therefore,
if revenues are greater than variable cost, it is better for the firm to continue producing.
a. The supply curve of a firm in the short run
The marginal cost curve is the supply curve of the competitive firm. Remember that the competitive firm
produces the level of output where MR = MC. And, because marginal revenue equals price, the firm will
produce the output level where P = MC. However, if total revenue is less than variable cost then firm will
shut down production. That is,
Total Revenue < Variable Cost, or (P × Q) < VC.
Dividing (P × Q) < VC by Q we get,
P < AVC
This is the rule for shutting down production. If price is less than average variable cost, then is better for
the firm to shut down because the loss will be less. Thus, marginal cost is the supply curve for the firm
only when price is equal or greater than average variable cost. Figure 11-6 shows the supply curve for
the firm in the short run. It also shows the minimum point for the average variable cost curve, which is
the shutdown point.
FIGURE 11-6
The Firm’s Short-Run
Supply Curve
For any given price, we can
determine the quantity of output
the firm will supply from the
marginal cost curve. In other
words, the marginal cost curve is
the firm’s supply curve.
The firm will shut down if the price
falls below average variable cost.
The marginal cost curve crosses
the average variable cost at the
firm’s shutdown point. This point
occurs at output level QSD.
For prices below PMIN, the supply
curve is a vertical line along the
price axis, which shows that the
firm will supply zero output at
those prices. The red line in the
figure is the firm’s short-run supply
curve.
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b. The market supply curve
in a perfectly competitive
industry
FIGURE 11-7
Firm Supply and Market Supply
We can derive the market supply curve by adding up the quantity that each firm in the market is
willing to supply at each price. In panel (a), one wheat farmer is willing to supply 15,000 bushels
of wheat at a price of $4 per bushel.
If every wheat farmer supplies the same amount of wheat at this price and if there are 167,000
wheat farmers, the total amount of wheat supplied at a price of $4 will equal 15,000 bushels per
farmer 167,000 farmers = 2.5 billion bushels of wheat.
The market supply is the sum
of the quantity supplied by
each firm to the market at the
different prices. The market
supply is derived from each
firm’s marginal cost. The
marginal cost curve for one
wheat farmer is shown in panel
(a) of Figure 11-7. Hence, if
each framer supplies this
amount and there are 167,000
farmers, the total amount of
wheat supplied at the price of
$4 will be:
15,000 bushels per farmer × 167,000 farmers = 2.5 billion bushels of wheat.
Panel (b) shows the market supply for wheat. At the price of $4, quantity supplied is 2.5 billion bushels of
wheat.
11.5 “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the
Long Run
a. Economic Profit and the Entry or Exit Decision
Assume that Ann Moreno decides to become an organic apple producer. She has saved $100,000 and
borrowed $900,000. This money allowed her to own a farm to produce apples. Also, assume that if Ann
would have kept the money in a saving account that paid 10 percent, she would have earned $10,000 per
year. This $10,000 is the opportunity cost of Ann’s apple business. We also assume that $10,000 is the
minimum amount that Ann needs to make as returns from her investment in order to stay in the industry
in the long run. Table 11-4 below shows Ann’s cost of producing apples.
The table shows that implicit
costs are given by the $10,000
that represents the opportunity
costs of investing in the farm and
IMPLICIT COSTS
the $30,000 in salary that Ann
Foregone salary
$30,000
would make if she would have
Opportunity cost of the $100,000 she has invested in her farm
$10,000
Total cost
$125,000
decided to manage someone
else’s farm. Total costs are
$125,000. Assume that the price of a box of apples is $15 and that Ann produces 10,000 boxes, then total
revenue will be $150,000 and economic profit will $25,000. Therefore, Ann has covered the opportunity
costs of her investment and has also made an additional profit of $25,000.
EXPLICIT COSTS
Water
Wages
Organic fertilizer
Electricity
Payment on bank loan
$10,000
$15,000
$10,000
$5,000
$45,000
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Economic profit leads to entry of new firms. Assume that other farmers who use conventional methods
to grow apples are breaking even. So, they can become producers of organic apples and make some
economic profit. So, if more farmers enter the organic apple market seeking to earn economic profit, the
market supply will shift to the right. Panel (b) of Figure 11-8 shows that producers will continue entering
the market until market supply shifts from S1 to S2.
At the new market supply (S2), price per box has decreased to $10. At this new price, Ann decreases
production to 8,000 boxes. We have also assumed that all farmers have the same costs. The new price is
Ann’s new demand curve; and at this new demand, Ann and the other producers are breaking even.
Because economic profit is zero, the entering of farmers to the market stops. Ann will stay in the market
because she is still making the $10,000 that represents the opportunity costs of her investment.
Economic Profit Leads to Entry of New Firms
FIGURE 11-8
The Effect of Entry on Economic Profits
Economic losses lead to exit. Assume that consumers prefer to buy conventionally grown apples rather
than organic apples. This will cause a decrease in the demand for organic apples. Panel (a) in Figure 11-9
shows that market demand shift from D1 to D2 and that price falls from $10 to $7 per box. Panel (b)
shows that at the price of $7, Ann will produce even less output and experience an economic loss. If the
price is above average variable cost, she will continue producing in the short run. But, in the long run, if
Ann is not able to cover average total cost, she will have to exit the market for organic apples and switch
to produce apples using conventional methods.
22
FIGURE 11-9
The Effect of Exit on Economic Losses
Panel (c) shows that market supply shifts to the left (from S1 to S2) because some firms are exiting the
market. This causes price to increase to $10. Panel (d) shows that at the price $10 the firms that remained
in the market are breaking even.
23
b. Long-run equilibrium in a perfectly competitive market
Long-run competitive equilibrium occurs because of the entry and exit of firms which causes the
competitive firm to be breaking even.
Long run average cost shows the minimum cost of production in the long run. So, in the long run
competition pushed price down to the minimum point on the long run average cost curve.
c. The long run supply curve in a perfectly competitive market
An increase in demand can cause price to increase above the $10, which will create economic profit. This
profit will attract additional producers to the market, supply will shift to the right and price will fall to
$10. This is shown in panel (a) of Figure 11-10.
Figure 11-10. The long run supply curve in a perfectly competitive industry
Panel (b) shows that a decrease in demand (the shift from D1 to D2) causes price to fall to $7, some firms
will face economic losses and will exit the market. The exit of firms decreases supply (the shift from S1
to S2) and price rises to $10, so losses are eliminated
The long run supply curve is the horizontal line labeled SLR. It is the horizontal line at the price of $10
which is the price at which the typical firm is breaking even. This price level represents the minimum cost
on the long run average cost curve. Therefore, we can conclude that in the long run, the competitive
market will supply the quantity of a product consumers demand at a price that equals the minimum point
on the long run average cost curve.
However, since the long run price equals the lowest point on the typical firm long run average cost, any
factor that causes either an increase or decrease in long run average cost will either increase or decrease
price. Thus, if treating apples trees against some diseases cost $2, the long run supply curve will shift up
by $2.
24