Download Thinkwell`s Microeconomics

Thinkwell’s Microeconomics
THINKWELL’S MICROECONOMICS NOTES
CHAPTER 1: INTRODUCTION TO ECONOMIC THINKING
Basic Economics Ideas
Defining Economics
Understanding the Concept of Value
1
2
Using Graphs
Using Graphs to Understand Direct Relationships
Plotting a Linear Relationship Between Two Variables
Changing the Intercept of a Linear Function
Understanding the Slope of a Linear Function
4
5
7
8
Advanced Graphical Concepts
Understanding Tangent Lines
Working with Three Variables on a Graph
10
12
Production Possibilities
Understanding the Concept of Production Possibilities Frontiers
Understanding How a Change in Technology or Resources Affects the PPF
Deriving an Algebraic Equation for the Production Possibilities Frontier
13
15
17
Comparative Advantage
Defining Comparative Advantage With the Production Possibilities Frontier
Understanding Why Specialization Increases Total Output
Analyzing an International Trade Using Comparative Advantage
19
22
24
CHAPTER 2: UNDERSTANDING MARKETS
Demand
Determining the Components of Demand
Understanding the Determinants of Demand
Understanding the Basics of Demand
Analyzing Shifts in the Demand Curve
Changing Other Demand Variables
Deriving a Market Demand Curve
27
29
31
33
34
37
Supply
Understanding the Determinants of Supply
Deriving a Supply Curve
Understanding a Change in Supply vs. a Change in Quantity Supplied
Analyzing Change in Other Supply Variables
Deriving a Market Supply Curve from Individual Supply Curves
39
41
43
44
46
Equilibrium
Determining a Competitive Equilibrium
Defining Comparative Statics
Classifying Comparative Statics
47
49
50
Elasticity
Defining Elasticity
Calculating Elasticity
Applying the Concept of Elasticity
Identifying the Determinants of Elasticity
Understanding the Relationship Between Total Revenue and Elasticity
52
54
56
58
59
Interfering With Markets
Understanding How Price Controls Damage Markets
Understanding the Problem of Minimum Wages in Labor Markets
Understanding How an Excise Tax Affects Equilibrium
62
64
66
Agriculture Economics
Examining Problems in Agricultural Economics
68
CHAPTER 3: CONSUMER CHOICE AND HOUSEHOLD B EHAVIOR
Utility Theory
Understanding Utility Theory
Finding Consumer Equilibrium
71
72
Budget Constraints and Indifference Curves
Constructing a Consumer's Budget Constraint
Understanding a Change in the Budget Constraint
Understanding Indifference Curves
75
77
79
Consumer Optimization
Locating the Consumer's Optimal Combination of Goods
Understanding the Effects of a Price Change on Consumer Choice
Deriving the Demand Curve
82
85
86
CHAPTER 4: PRODUCTION AND COSTS
The Basics of Production
Understanding Outputs, Inputs, and the Short Run
Explaining the Total Product Curve
Drawing Marginal Product Curves
Understanding Average Product
Relating Costs to Productivity
88
89
93
95
97
Variable Costs
Defining Variable Costs
Graphing Variable Costs
Graphing Variable Costs Using a Geometric Trick
98
99
101
Marginal Costs
Defining Marginal Costs
Deriving the Marginal Cost Curve
Understanding the Mathematical Relationship Between Marginal Cost and Marginal Product
103
105
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
Calculating Average Total Cost
Putting the Cost Curves Together
116
118
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
Understanding Isoquants
Finding the Cost- Minimizing Combination of Capital and Labor
131
134
136
CHAPTER 5: P ERFECT COMPETITION
The Basic Assumptions of Competitive Markets
Understanding the Role of Price
Understanding Market Structures
Finding Economic and Accounting Profit
139
140
142
Calculating Profit and Loss
Finding the Firm's Profit-Maximizing Output Level
Proving the Profit-Maximizing Rule
Calculating Profit
Calculating Loss
Finding the Firm's Shut-Down Point
144
147
148
149
151
Market Supply
Deriving the Short-Run Market Supply Curve
Relating the Individual Firm to the Market
Examining Shifts in the Short-Run Market Supply Curve
Deriving the Long-Run Market Supply Curve
153
156
159
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
Defining Marginal Revenue for a Firm with Market Power
Determining the Monopolist's Profit-Maximizing Output and Price
Calculating a Monopolist's Profit and Loss
Graphing the Relationship between Marginal Revenue and Elasticity
165
167
169
171
173
The Social Cost of Monopoly
Determining the Social Cost of Monopoly
Calculating Deadweight Loss
Understanding Monopoly Regulation
175
177
179
Oligopoly
Understanding the Kinked-Demand Curve Model
182
Monopolistic Competition
Defining Monopolistic Competition
Understanding Pricing and Output Under Monopolistic Competition
Understanding Monopolistic Competition as a Prisoner's Dilemma
184
186
188
CHAPTER 7: RESOURCE MARKETS
The Derived Demand for Labor
Deriving the Factor Demand Curve
Deriving the Least-Cost Rule
Analyzing the Labor Market
189
191
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
Analyzing the Tax System
Understanding Public Choice
201
203
205
Uncertainty
Understanding Expected Value, Risk, and Uncertainty
Understanding Asymmetric Information as an Economic Problem
Understanding Moral Hazards in Markets
207
209
211
Externalities
Defining Externalities
Explaining How to Internalize External Costs
Explaining How to Internalize External Benefits
212
214
216
Solutions to Externalities
Finding a Market Solution to External Costs
Finding a Negotiated Settlement to an External Cost
Applying the Coase Theorem
218
221
223
CHAPTER 9: INTERNATIONAL TRADE
The Basics of Open Economies
Determining the Difference Between a Closed Economy and an Open Economy
Understanding Exports in an Open Economy
Analyzing a Change in Equilibrium in an Open Economy
224
226
227
CHAPTER 10: EVALUATING MARKET OUTCOMES
Normative Economics
Measuring the Benefits of Consumption
Using the Demand Curve as a Measure of Benefit
229
231
Calculating Total Economic Value
Quantifying Benefit
Quantifying Cost
Determining Total Social Cost
Understanding Economic Value
232
234
235
236
Consumer and Producer Surplus
Understanding Producer and Consumer Surplus
Calculating Total Economic Value
238
239
Market Interference and Economic Value
Understanding the Effects of Price Control
Understanding How Price Controls Destroy Economic Value
Evaluating the Effects of an Excise Tax
Assessing the Effect of an Excise Tax on Economic Value
Understanding How a Tax Can Create Deadweight Loss
241
243
245
247
249
International Trade and Economic Value
Evaluating the Gains from International Trade
Understanding the Effects of Tariffs on Consumer and Producer Surplus
250
252
Page 1 of 253
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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Page 6 of 253
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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Page 9 of 253
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 variable s 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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Page 11 of 253
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 twodimensional 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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Page 14 of 253
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 onetenth 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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Page 16 of 253
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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Page 18 of 253
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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Page 19 of 253
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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Page 19 of 253
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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Page 21 of 253
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 giv en 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. Pakis tan 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. T he
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 pric e.
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, S D
and S J. 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 wh ich 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 rentcontrolled 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, la bor has an upwardsloping 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 W m,
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/P a = Mub/P b = …MUz/P z
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 consum er’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 down ward 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 toy s. 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 = P x/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 inpu
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 xaxis. 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 laborintensive 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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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.
1
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 laborintensive 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 C
? ompetitive 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 F
? irms 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 y t.
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 profitmaximizing 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 profitmaximizing 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 shutdown 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.
`
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 longrun 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 longrun 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 y 1s. 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 shortrun 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 longrun 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 maxim um, 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 Q 0. 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 profitmaximizing 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 profitmaximizing 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 = MP K/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:
$10,000 $10,000
+
= $9,524 + $9,070 = $18,594 I
(1 + .05) (1.05) 2
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 monopolistically 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 consum er 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 riskaverse.
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 riskinclined 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 highquality 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, coinsurance (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 precis ely
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 Y
? ou 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 S D.
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 = Q SD - 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 cos t 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 Q T 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 Q 1, 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 maximiz e 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'D D. French
producers will start producing more at Q'S D
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.
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