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FIGURES
© Richard B. McKenzie and Dwight E.
Lee 2006
www.cambridge.org/mckenzie
Figure 2.1 Market demand for tomatoes
Demand, the assumed inverse relationship between price and quantity purchased, can be
represented by a curve that slopes down toward the right. Here, as the price falls from $11
to zero, the number of bushels of tomatoes purchased per week rises from zero to 110,000.
Figure 2.2 Shifts in the demand curve
An increase in demand is represented by a rightward, outward, shift in the demand curve,
from D1to D2. A decrease in demand is represented by a leftward, or inward, shift in the
demand curve, from D1 to D3.
Figure 2.3 Supply of tomatoes
Supply, the assumed relationship between price and quantity produced, can be represented
by a curve that slopes up toward the right. Here, as the price rises from zero to $11, the
number of bushels of tomatoes offered for sale during the course of a week rises from zero
to 110,000.
Figure 2.4 Shifts in the supply curve
A rightward, or outward, shift in the supply curve, from S1 to S2, represents an increase in
supply. A leftward, or inward, shift in the supply curve, from S1 to S3, represents a decrease
in supply.
Figure 2.5 Market surplus
If a price is higher than the intersection of the supply and demand curves, a market
surplus – a greater quantity supplied, Q3, than demanded, Q1 – results. Competitive
pressure will push the price down to the equilibrium price P1, the price at which the
quantity supplied equals the quantity demanded (Q2).
Figure 2.6 Market shortages
A price that is below the intersection of the supply and demand curves will create a
shortage – a greater quantity demanded, Q3, than supplied, Q1. Competitive pressure will
push the price up to the equilibrium price P2, the price at which the quantity supplied
equals the quantity demanded (Q2).
Figure 2.7 The effects of changes in supply and demand
An increase in demand – panel (a) – raises both the equilibrium price and the equilibrium
quantity. A decrease in demand – panel (b) – has the opposite effect: a decrease in the
equilibrium price and quantity. An increase in supply – panel (c) – causes the equilibrium
quantity to rise but the equilibrium price to fall. A decrease in supply – panel (d) – has the
opposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity.
Figure 2.8 Price ceilings and floors
A price ceiling Pc – panel (a) – will create a market shortage equal to Q2 – Q1. A price floor
Pf – panel (b) – will create a market surplus equal to Q2 – Q1.
Figure 2.9 The efficiency of the competitive market
Only those price–quantity combinations on or below the demand curve – panel (a) – are
acceptable to buyers. Only those price–quantity combinations on or above the supply
curve – panel (b) – are acceptable to producers. Those price–quantity combinations that are
acceptable to both buyers and producers are shown in the darkest shaded area of panel (c).
The competitive market is “efficient” in the sense that it results in output Q1, the maximum
output level acceptable to both buyers and producers.
Figure 2.10 Consumer preference in television size
Consumers differ in their wants, but most desire a medium-sized television. Only a few
want a very small or a large television.
Figure 2.11 Long-run market for calculators
With supply and demand for calculators at D1 and S1, the short-run equilibrium price and
quantity will be P2 and Q1. As existing firms expand production and new firms enter the
industry, the supply curve shifts to S2. Simultaneously, an increase in consumer awareness
of the product shifts the demand curve to D2. The resulting long-run equilibrium price and
quantity are P1 and Q2, respectively.
Figure 2.12 Prices in the long run
If demand increases more than supply, the price will rise along with the quantity sold –
panel (a). If supply keeps up with demand, however, the price will remain the same even
though the quantity sold increases – panel (b).
Figure 2.13 Twisted pay scale
The worker expects his productivity to rise along line A with years of service. If she starts
work with less pay than she could earn elsewhere, then her career pay path could follow
line B, representing greater increases in pay with time and greater productivity.
Figure 3.1 Constrained choice
With a given amount of time and other resources, you can produce any combination of
study and games along the curve E1 G1. The particular combination you choose will depend
on your personal preferences for those two goods. You will not choose point x, because it
represents less than you are capable of achieving – and, as a rational person, you will strive
to maximize your utility. Because of constraints on your time and resources, you cannot
achieve a point above E1 G1.
Figure 3.2 Change in constraints
If your study skills improve and your ability at the game remains constant, your production
possibilities curve will shift from E1G1 to E2G1. Both the number of chapters you can study
and the number of games you can play will increase. On your old curve, E1G1, you could
study two chapters and play four games (point a). On your new curve E2G1, you can study
three chapters and play five games (point b).
Figure 3.3 Policy trade-offs of a negative income tax
With a guaranteed income of SI1($5,000) and a break-even earned income level of
EI1($10,000), the implicit marginal tax rate on the poor is 50 percent. If policy makers
attempt to reduce the implicit tax rate by raising the break-even income level, however,
the government’s poverty relief budget will rise by the shaded area SI1ab. A higher explicit
tax burden will fall on a smaller group of taxpaying workers.
Figure 3.4 Maslow’s hierarchy of needs
The pyramid orders human needs by broad categories from the most prepotent needs on
the bottom to lesser and lesser prepotent needs as an individual moves up the pyramid.
According to Maslow, an individual can be expected to satisfy her needs in the order of
their prepotence, or will move from the bottom of the pyramid through the various levels
to the top, so long as the individual’s resources to satisfy her needs last.
Figure 3.5(a) Demand, price, and need
satisfaction
The extent to which needs are satisfied depends,
in the economists’ view of the world, on
the nature of the need’s demand and its price.
Physiological needs may indeed be more
completely satisfied than other needs, but that
may only be because physiological needs
have relatively low prices (panel (a)). But then,
as shown in this figure (panel (b)), the
price of the means of satisfying physiological
needs might be higher than the prices of the
means of satisfying safety and love needs.
Figure 3.5(b)
Figure 5.1 The economic effect of an excise tax
An excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2.
The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase,
$0.20, however, will not cover the added cost to the producer, $0.25.
Figure 5.2 The effect of an excise tax when demand is more elastic than supply
If demand is much more elastic than supply, the quantity purchased declines significantly
when supply decreases from S1 to S2 in response to the added cost of the excise tax.
Producers will lose $0.20; consumers will pay only $0.05 more.
Figure 5.3 The effect of price controls on supply
If the supply of gasoline is reduced from S1 to S2, but the price is controlled at P1, a
shortage equal to the difference between Q1 and Q2 will emerge.
Figure 5.4 The effect of rationing on demand
Price controls can create a shortage. For instance, at the controlled price P1, a shortage of
Q2 - Q1 gallons will develop. By issuing a limited number of coupons that must be used to
purchase a product, the government can reduce demand and eliminate the shortage. Here,
rationing reduces demand from D1 to D2, where demand intersects the supply curve at the
controlled price.
Figure 5.5 The conventional view of the impact of the minimum wage
When the minimum wage is set at Wm (and the market clearing wage is Wo),
employment will fall from Q2 to Q1; simultaneously, the number of workers who are
willing to work in this labor market will expand from Q2 to Q3. The market surplus is then
Q3 - Q1.
Figure 5.6 An unconventional view of the impact of the minimum wage
When the minimum wage is raised to Wm, a surplus is created equal to Q3 - Q1. As a
consequence, employers can be expected to respond to the surplus by reducing fringe
benefits or increasing work demands on workers. The supply curve of labor contracts,
reflecting the greater wage the workers will demand to compensate for the reduction in
fringe benefits or increase in work demands. The employers’ demand for labor increases,
reflecting the higher wage they are willing to pay workers in terms of money wages who
get fewer fringe benefits or work harder and produce more.
Figure 5.7 Marginal benefit versus marginal cost
The demand curve reflects the marginal benefits of each loaf of bread produced. The supply
curve reflects the marginal cost of producing each loaf. For each loaf of bread up to Q1, the
marginal benefits exceed the marginal cost. The shaded area shows the maximum welfare
that can be gained from the production of bread. When the market is at equilibrium (when
supply equals demand), all those benefits will be realized.
Figure 5.8 External costs
Ignoring the external costs associated with the manufacture of paper products, firms will
base their production and pricing decisions on the supply curve S1. If they consider external
costs, such as the cost of pollution, they will operate on the basis of the supply curve S2,
producing Q1 instead of Q2 units. The shaded area abc shows the amount by which the
marginal cost of production of Q2 – Q1 units exceeds the marginal benefits to consumers. It
indicates the inefficiency of the private market when external costs are not borne by
producers.
Figure 5.9 External benefits
Ignoring the external benefits of getting flu shots, consumers will base their purchases on
the demand curve D1 instead of D2. Fewer shots will be purchased than could be justified
economically – Q1 instead of Q2. Because the marginal benefit of each shot between Q1
and Q2 (as shown by demand curve D2) exceeds its marginal cost of production, external
benefits are not being realized. The shaded area abc indicates market inefficiency.
Figure 5.10 Is government action justified?
Because of external costs, the market illustrated produces more than the efficient output.
Market inefficiency, represented by the shaded triangular area abc, is quite small – so small
that government intervention may not be justified on economic grounds alone.
Figure 5.11 Market for pollution rights
Reducing pollution is costly (see table 5.1). It adds to the costs of production, increasing
product prices and reducing the quantities of products demanded. Therefore firms have a
demand for the right to avoid pollution abatement costs. The lower the price of such rights,
the greater the quantity of rights that firms will demand. If the government fixes the
supply of pollution rights at ten and sells those ten rights to the highest bidder, the price of
the rights will settle at the intersection of the supply and demand curves – here, about
$1,500.
Figure 6.1 External and internal coordinating costs
As the firm expands, the internal coordinating costs increase as the external coordinating
costs fall. The optimum firm size is determined by summing these two cost structures,
which is done in panel (b) of the figure.
Figure 6.A1 Fringe benefits and the labor market
If fringe benefits are more valuable to workers and impose a cost on the employers, the
supply of labor will increase from S1 to S2 while the demand curve falls from D1 to D2. The
wage rate falls from W1 to W2, but the workers get fringe benefits that have a value of ac,
which means that their overall payment goes up from W1 to W3.
Figure 7.1 The law of demand
Price varies inversely with the quantity consumed, producing a downward sloping curve
such as this one. If the price of Coke falls from $1 to $0.75, the consumer will buy three
Cokes instead of two.
Figure 7.2 Market demand curve
The market demand curve for Coke, DA+B, is obtained by summing the quantities that
individuals A and B are willing to buy at each and every price (shown by the individual
demand curves DA and DB).
Figure 7.3 Elastic and inelastic demand
Demand curves differ in their relative elasticity. Curve D1 is more elastic than curve D2, in
the sense that consumers on curve D1 are more responsive to a given price change (P2 to
P1) than are consumers on curve D2.
Figure 7.4 Changes in the elasticity coefficient
The elasticity coefficient decreases as a firm moves down the demand curve. The upper half
of a linear demand curve is elastic, meaning that the elasticity coefficient is greater than
one. The lower half is inelastic, meaning that the elasticity coefficient is less than one. This
means that the middle of the linear demand curve has an elasticity coefficient equal to one.
Figure 7.5 Perfectly elastic demand
A firm that has many competitors may lose all its sales if it increases its price even slightly.
Its customers can simply move to another producer. In that case, its demand curve is
horizontal, with an elasticity coefficient of infinity.
Figure 7.6 Increase in demand
When consumer demand for low-rise pants increases, the demand curve shifts from D1 to
D2. Consumers are now willing to buy a larger quantity of low-rise pants at the same price,
or the same quantity at a higher price. At price P1, for instance, they will buy Q3 instead of
Q2. And they are now willing to pay P2 for Q2 low-rise pants, whereas before they would
pay only P1.
Figure 7.7 Decrease in demand
A downward shift in demand, from D1 to D2, represents a decrease in the quantity of
low-rise pants consumers are willing to buy at each and every price. It also indicates a
decrease in the price they are willing to pay for each and every quantity of low-rise pants.
At price P2, for instance, consumers will now buy only Q1 low-rise pants (not Q3, as before);
and they will now pay only P2 for Q1 low-rise pants – not P3, as before.
Figure 7.8 Network effects and demand
As the price falls from P3 to P2, the quantity demanded in the short run rises from Q1 to Q2.
However, sales build on sales, causing the demand in the future to expand outward to, say,
D2. The lower the price in the current time period, the greater the expansion of demand in
the future. The more the demand expands over time in response to greater sales in the
current time period, the more elastic is the long-run demand.
Figure 7.9 Choosing between housing and bundles of other goods
The budget line in Six Mile is A1H1 with an income of $100,000. The budget line in La Jolla
is A1H3 with the same income. If the employer were to offer the engineer a salary of
$152,000, which covers the additional cost of housing, the engineer’s budget line would be
the thin line cutting A1H1 at a. Hence, the engineer could choose combination b and be
better off than in Six Mile. This means that the employer can offer the engineer less than
$152,000.
Figure 7A.1 Derivation of an indifference curve
Because the consumer prefers more of a good to less, point a is preferable to point c, and
point b is preferable to point a. If a is preferable to d but e is preferable to a, then when we
move from point d to e, we must move from a combination that is less preferred to the one
that is more preferred. In doing so, we must cross a point – for example, f – that is equal in
value to a. Indifference curves are composed by connecting all those points – a, f, i, and so
on – that are of equal value to the consumer.
Figure 7A.2 Indifference curves for pens and books
Any combination of pens and books that falls along curve I1 will yield the same level of
utility as any other combination on that curve. The consumer is indifferent among them. By
extension, any combination on curve I2 will be preferable to any combination on curve I1.
Figure 7A.3 The budget line and consumer equilibrium
Constrained by her budget, the consumer will seek to maximize her utility by consuming at
the point where her budget line is tangent to an indifference curve. Here the consumer
chooses point a, where her budget line just touches indifference curve I1. All other
combinations on the consumer’s budget line will fall on a lower indifference curve,
providing less utility. Point c, for instance, falls on indifference curve I2.
Figure 7A.4 Effect of a change in price on consumer equilibrium
If the price of pens falls, the consumer’s budget line will pivot outward, from B1P1 to B1P2.
As a result, the consumers can move to a higher indifference curve, I2 instead of I1. At the
new price, the consumer buys more pens, twenty-two packs as opposed to fifteen.
Figure 7A.5 Derivation of the demand curve for pens
When the price of pens changes, shifting the consumer’s budget line from B1P1 to B1P2 in
figure 7A.4, the consumer equilibrium point changes with it, from a to c. The consumer’s
demand curve for pens is obtained by plotting her equilibrium quantity of pens at various
prices. At $5 a pack, the consumer buys fifteen packs of pens (point a). At $3 a pack, she
buys twenty-two packages (point c).
Figure 7A.6 Budget line: cash grants vs. education subsidies
If the price of education is reduced by an in-kind subsidy, a family’s budget line will pivot
from H3E3 to H3E5. The family will move from point a to point b, where it can consume
more food and housing. If the family is given the same subsidy in cash, its budget line will
move from H3E3 to H4E4. Because the relative price of housing is lower on H4E4 than on
H3E5, the family will choose a point such as d over b. Because b was the family’s preferred
point on H3E5, but it prefers d to b on H4E4 which allows the purchase of b, we must
presume that it also prefers cash to a food subsidy.
Figure 7B.1 Upward sloping demand?
A good might have an upward sloping range, as described in panel (a), given that a price
increase might convey greater value to consumers. However, there must be some higher
price that will cause sales to contract, since many consumers will no longer be able to buy
the good. This means that the demand curve must go beyond some price, P3 in panel (b),
must bend backwards and, thus, must have a downward sloping range. The downward
sloping range of the curve in panel (b) is the relevant range. If the seller is at combination
b, then there is some combination such as d in the downward sloping range of the entire
demand curve that is more profitable than combination b.
Figure 7B.2 Demand including irrational behavior
If irrational consumers demand Q1 cigarettes no matter what the price, but rational
consumers take price into consideration, market demand will be D1. The quantity
purchased will still vary inversely with the price.
Figure 7B.3 Random behavior, budget lines, and downward sloping demand curves
If a number of buyers are faced initially with budget line A1B1 and behave randomly, they
will buy an average quantity of A2B2. If the price of A increases while the price of B
decreases, the budget line pivots on a, causing buyers to purchase on average more of B
(B4) and less of A (A4). Thus, quantity changes in the direction predicted by the law of
demand (in spite of the absence of rational behavior).
Figure 7B.4 Random behavior and the demand curve as a “band”
If buyers randomly purchase anywhere from Q1 to Q2 when the price is P1 and anywhere
from Q2 to Q3 when the price is P2, then they will tend to increase their average quantity
purchased from Q4 to Q5 when the price falls from P1 to P2.
Figure 8.1 Rising marginal cost
To produce each new watercolor, Jan must give up an opportunity more valuable than the
last. Thus the marginal cost of her paintings rises with each new work.
Figure 8.2 The law of diminishing marginal returns
As production expands with the addition of new workers, efficiencies of specialization
initially cause marginal cost to fall. At some point, however – here, just beyond two bushels
– marginal cost will begin to rise again. At that point, marginal returns will begin to
diminish and marginal costs will begin to rise.
Figure 8.3 Costs and benefits of fishing
For each fish up to the fifth one, Gary receives more in benefits than he pays in costs. The
first fish gives him $4.67 in benefits (point a) and costs him only $1 (point b). The fifth
yields equal costs and benefits (point c), but the sixth costs more than it is worth. Therefore
Gary will catch no more than five fish.
Figure 8.4 Accident prevention
Given the increasing marginal cost of preventing accidents and the decreasing marginal
value of preventing the accidents, c or 5 accidents will be prevented.
Figure 8.5 Total, average, and marginal product
curves
The total product curve shows how output
changes when the amount of the variable input,
labor, changes. Total product rises first at an
increasing rate (0–five workers), then at a
decreasing rate (five–fifteen workers), before
declining (beyond fifteen workers). The
marginal and average product curves reflect what
is happening to total product. Marginal
product rises when total product is rising at an
increasing rate and falls when total product
is rising at a decreasing rate. Marginal product is
positive when total product is rising and
negative when total product is falling.
Figure 8.6 Marginal costs and maximization of
profit
At price P1 (panel (a)), this firm’s marginal
revenue, represented by the area under P1 up to Q1,
exceeds its marginal cost up to the output level of
Q1. At that point total profit, shown in panel (b),
peaks (point a). At price P2, marginal revenue
exceeds marginal cost up to an output level of Q2.
The increase in price shifts the profit curve in panel
(b) upward, from TP1 to TP2, and profits peak at b.
Figure 8.7 Market supply curve
The market supply curve (SA+B) is obtained by adding together the amount producers A
and B are willing to offer at each and every price, as shown by the individual supply curves
SA and SB. (The individual supply curves are obtained from the upward sloping portions of
the firms’ marginal cost curve.)
Figure 9.1 Total fixed costs, total variable costs, and total costs in the short run
Total fixed cost does not vary with production; therefore, it is drawn as a horizontal line.
Total variable cost does rise with production. Here it is represented by the shaded area
between the total cost and total fixed cost curves.
Figure 9.2 Marginal and average costs in the short run
The average fixed cost curve (AFC) slopes downward and approaches, but never touches,
the horizontal axis. The average variable cost curve (AVC) and the total variable cost curve
are mathematically related to the marginal cost curve and both intersect with the marginal
cost curve (MC) at its lowest point. The vertical distance between the average total cost
curve (ATC) and the average variable cost curve equals the average fixed cost at any given
output level. There is no relationship between the MC and AFC curves.
Figure 9.3 Economies of scale
Economies of scale are cost savings associated with the expanded use of resources. To
realize such savings, however, a firm must expand its output. Here the firm can lower its
costs by expanding production from q1 to q2 – a scale of operation that places it on a lower
short-run average total cost curve (ATC2 instead of ATC1).
Figure 9.4 Diseconomies of scale
Diseconomies of scale may occur because of the communication problems of larger firms.
Here the firm realizes economies of scale through its first short-run average total cost
curves. The long-run average cost curve begins to turn up at an output level of q1, beyond
which diseconomies of scale set in.
Figure 9.5 Marginal and average cost in the long run
The long-run marginal and average cost curves are mathematically related. The long-run
average cost curve slopes downward as long as it is above the long-run marginal cost
curve. The two curves intersect at the low point of the long-run average cost curve.
Figure 9.6a Individual differences in long-run average cost curves
The shape of the long-run average cost curve varies according to the extent and persistence
of economies and diseconomies of scale. Firms in industries with few economies of scale
will have a long-run average cost curve like the one in panel (a). Firms in industries with
persistent economies of scale will have a long-run average cost curve like the one in
panel (b), and firms in industries with extensive economies of scale may find that their
long-run average cost curve slopes continually downward, as in panel (c).
Figure 9.6b
Figure 9.6c
Figure 9.7 Shifts in average and marginal cost curves
An increase in a firm’s variable cost (panel (a)) will shift the firm’s average total cost curve
up, from ATC1 to ATC2. It will also shift the marginal cost curve, from MC1 to MC2. Production
will fall because of the increase in marginal cost. By contrast, an increase in a firm’s fixed
cost (panel (b)) will shift the average total cost curve upward from ATC1 to ATC2, but will
not affect the marginal cost curve. (Marginal cost is unaffected by fixed cost.) Thus the
firm’s level of production will not change.
Figure 9A.1 Single isoquant
A firm can produce 100 pairs of jeans a day using any of the various combinations of labor
and machinery shown on this curve. Because of diminishing marginal returns, more and
more machines must be substituted for each worker who is dropped.
Figure 9A.2 Several isoquants
Different output levels will have different isoquants. The higher the output level, the higher
the isoquant.
Figure 9A.3 Finding the most efficient combination of resources
Assuming that the daily wage of each worker is $100, and the daily rental on each sewing
machine is $20, an expenditure of $600 per day will buy any combination of resources on
isocost curve IC1. The most cost-effective combination of labor and capital is point a, three
workers and fifteen machines. At that point, the isocost curve is just tangent to isoquant
IQ2, meaning that the firm can product 150 pairs of jeans a day. If the firm chooses any
other combination, it will move to a lower isoquant and a lower output level. At point b (on
isoquant IQ1), it will be able to produce only 100 pairs of jeans a day.
Figure 9A.4 The effect of increased expenditures on resources
An increase in the level of expenditures on resources shifts the isocost curve outward from
IC1 to IC2. The firm’s most efficient combination of resources shifts from point a to point c.
Figure 10.1 Demand curve faced by perfect competitors
The market demand for a product (panel (a)) is always downward sloping. The perfect
competitor is on a horizontal, or perfectly elastic, demand curve (panel (b)). It cannot raise
its price above the market price even slightly without losing its customers to other
producers.
Figure 10.2 Demand curve faced by a monopolistic competitor
Because the product sold by the monopolistically competitive firm is slightly different from
the products sold by competing producers, the firm faces a highly elastic, but not perfectly
elastic, demand curve.
Figure 10.3 The perfect competitor’s production decision
The perfect competitor’s price is determined by market supply and demand (panel (a)). As
long as marginal revenue (MR), which equals market price, exceeds marginal cost (MC),
the perfect competitor will expand production (panel (b)). The profit maximizing
production level is the point at which marginal cost equals marginal revenue (price).
Figure 10.4 Change in the perfect competitor’s market price
If the market demand rises from D1 to D3 (panel (a)), the price will rise with it, from P1
to P3. As a result, the perfectly competitive firm’s demand curve will rise, from d1 to d3
(panel (b)).
Figure 10.5 The profit maximizing perfect competitor
The perfect competitor’s demand curve is established by the market clearing price
(panel (a)). The profit maximizing perfect competitor will extend production up to the point
at which marginal cost equals marginal revenue (price), or point a in panel (b). At that
output level – q2 – the firm will earn a short-run economic profit equal to the shaded area
ATC1P1 ab. If the perfect competitor were to minimize average total cost, it would produce
only q1, losing profits equal to the darker shaded area dca in the process.
Figure 10.6 The loss minimizing perfect competitor
The market clearing price (panel (a)) establishes the perfect competitor’s demand curve
(panel (b)). Because the price is below the average total cost curve, this firm is losing
money. As long as the price is above the low point of the average variable cost curve,
however, the firm should minimize its short-run losses by continuing to produce where
marginal cost equals marginal revenue (price or point b in panel (b)). This perfect
competitor should produce q1 units, incurring losses equal to the shaded area P1ATC1ab.
(The alternative would be to shut down, in which case the firm would lose all its fixed
costs.)
Figure 10.7 The long-run effects of short-run profits
If perfect competitors are making short-run profits, other producers will enter the market,
increasing the market supply from S1 to S2 and lowering the market price from P2 to P1
(panel (a)). The individual firm’s demand curve, which is determined by market price, will
shift down, from d1 to d2 (panel (b)). The firm will reduce its output from q2 to q1, the new
intersection of marginal revenue (price) and marginal cost. Long-run equilibrium will be
achieved when the price falls to the low point of the firm’s average total cost curve,
eliminating economic profit (price P1 in panel (b)).
Figure 10.8 The long-run effects of short-run losses
If perfect competitors are suffering short-run losses, some firms will leave the industry,
causing the market supply to shift back from S1 to S2 and the price to rise, from P1 to P2
(panel (a)). The individual firm’s demand curve will shift up with price, from d1 to d2
(panel (b)). The firm will expand from q1 to q2, and equilibrium will be reached when price
equals the low point of average total cost P2, eliminating the firm’s short-run losses.
Figure 10.9 The long-run effects of economies of scale
If the market is in equilibrium at price P1 in panel (a) and the individual firm is producing
q1 units on short-run average total cost curve ATC1 (panel (b)), firms will be just breaking
even. Because of the profit potential represented by the shaded area ATC1P2ab, firms can
be expected to expand production to q3, where the long-run marginal cost curve intersects
the demand curve (d1). As they expand production to take advantage of economies of
scale, however, supply will expand from S1 to S2 in panel (a), pushing the market price
down toward P1, the low point of the long-run average total cost curve (LRATC in panel
(b)). Economic profit will fall to zero. Because of rising diseconomies of scale, firms will not
expand further.
Figure 10.10 The efficiency of the competitive market
Perfectly competitive
markets are efficient in
the sense that they equate
marginal benefit (shown
by the demand curve in
panel (a)) with marginal
cost (shown by the
supply curve in panel (a).
At the market output
level, Q1, the marginal
benefit of the last unit
produced equals the
marginal cost of
production. The gains
generated by the
production of Q1 units
– that is, the difference between cost and benefits – are
shown by the shaded area in panel (a). The perfectly
competitive market is also efficient in the sense that the
marginal cost of production, P1, is the same for all firms
(panels (b) and (c)). If firm X were to
produce fewer than its efficient number of units, qx, firm
Y would have to produce more than its efficient number,
qy, to meet market demand. Firm Y would be pushed up
its marginal cost curve, to the point at which the cost of
the last unit would exceed its benefits. But competition
forces the two firms to produce to exactly the point at
which marginal cost equals marginal benefit, thus
minimizing the cost of production.
Figure 10.11 Supply and demand cobweb
Markets do not always move smoothly toward equilibrium. If current production decisions
are based on past prices, price may adjust to supply in the “cobweb pattern” shown here.
Having received price P1 in the past, farmers will plan to supply only Q1 bushels of wheat.
That amount will not meet market demand, so the price will rise to P4 – inducing farmers
to plan for a harvest of Q3 bushels. At price P4, however, Q3 bushels will not clear the
market. The price will fall to P2, encouraging farmers to cut production back to Q2. Only
after several tries do many farmers find the equilibrium price–quantity combination.
Figure 10A.1 A contestable market
The market is composed of three firms, each producing output q*, which minimizes average
costs. Total industry output is Q* = 3q*. Any attempt by the three firms to reduce output
and increase market price will lead to entry by new firms and the dissipation of profits.
Figure 11.1 The monopolist’s demand and marginal revenue curves
The demand curve facing a monopolist slopes downward, for it is the same as market
demand. The monopolist’s marginal revenue curve is constructed from the information
contained in the demand curve (see table 11.1).
Figure 11.2 Equating marginal cost with marginal revenue
The monopolist will move toward production level Q2, the level at which marginal cost
equals marginal revenue. At production levels below Q2, marginal revenue will exceed
marginal cost; the monopolist will miss the chance to increase profits. At production levels
greater than Q2, marginal cost will exceed marginal revenue; the monopolist will lose
money on the extra units.
Figure 11.3 The monopolist’s profits
The profit maximizing monopoly will produce at the level defined by the intersection of the
marginal cost and marginal revenue curves: Q1. It will charge a price of P1 – as high as
market demand will bear – for that quantity. Because the average total cost of producing Q1
units is ATC1, the firm’s profit is the shaded area ATC1P1ab.
Figure 11.4 The monopolist’s short-run Losses
Not all monopolists make a profit. With a demand curve that lies below its average total
cost curve, this monopoly will minimize its short-run losses by continuing to produce at the
point where marginal cost equals marginal revenue (Q1 units). It will charge P1, a price that
covers its fixed costs, and will sustain short-run losses equal to the shaded area P1ATC1ab.
Figure 11.5 Monopolistic production over the long run
In the long run, the monopolist
will produce at the intersection
of the marginal revenue
and long-run marginal cost
curves (panel (a)). In contrast
to the perfect competitor, the
monopolist does not have to
minimize long-run average
cost by expanding its scale of
operation. It can make more
profit by restricting production
to Qa and charging price Pa.
In panel (b), the monopolist
produces at the low point of
the long-run average cost
curve only because that
happens to be the point at which marginal
cost and marginal revenue curves
intersect. In panel (c), the monopolist
produces on a scale beyond the low point of
its
long-run average cost curve because demand
is high enough to justify the cost. In each
case, the monopolist charges a price higher
than its long-run marginal cost.
Figure 11.6 The comparative efficiency of monopoly and competition
Firms in a competitive market will tend to produce at point b, the intersection of the
marginal cost and demand curves (with the price, or marginal benefit given by the height
of the demand curve). Monopolists will tend to produce at point c, the intersection of
marginal cost and marginal revenue, and to charge the highest price the market will bear:
Pm. In a competitive market, therefore, the price will tend to be lower (Pc) and the
quantity produced greater (Qc) than in a monopolistic market. The inefficiency of
monopoly is shown by the shaded triangular area abc, the amount by which the benefits of
producing Qc - Qm units (shown by the demand curve) exceed their marginal cost of
production.
Figure 11.7 The costs and benefits of expanded production
If the monopolist expands production from Qm to Qc in panel (a), consumers will receive
additional benefits equal to the area bounded by QmabQc. They will pay an amount equal
to the area QmcdQc for those benefits, leaving a net benefit equal to the shaded area abdc.
To expand production, the monopoly must incur additional production costs equal to the
area QmcbQc in panel (b). It gains additional revenues equal to the area QmcdQc, leaving a
net loss equal to the shaded area cbd. Thus, expanded production helps the consumer but
hurts the monopolist.
Figure 11.8 Price discrimination
By offering customers one can of beans for $0.30, two cans for $0.55, and three cans for
$0.75, a grocery store collects more revenues than if it offers three cans for $0.20 each. In
either case, the consumer buys three cans. But by making the special offer, the store earns
$0.15 more in revenues per customer.
Figure 11.9 Perfect price discrimination
The perfect price-discriminating monopolist will produce at the point where marginal cost
and marginal revenue are equal (point a). Its output level, Qc is therefore the same as that
achieved under perfect competition. But because the monopolist charges as much as the
market will bear for each unit, its profits – the shaded area ATC1P1ab – are higher than the
competitive firm’s.
Figure 11.10 Imperfect price discrimination
The monopolist that cannot perfectly price-discriminate may elect to charge a few different
prices by segmenting its market. To do so, it divides its market by income, location, or
some other factor and finds the demand and marginal revenue curves in each (panels (a)
and (b)). Then it adds those marginal revenue curves horizontally to obtain its combined
marginal revenue curve for all market segments, MRm (panel (c)). By equating marginal
revenue with marginal cost, it selects its output level, Qm. Then it divides that quantity
between the two market segments by equating the marginal cost of the last unit produced
(panel (c)) with marginal revenue in each market (panels (a) and (b)). It sells Qa in market
A and Qb in market B, and charges different prices in each segment. Generally, the price
will be higher in the market segment with the less elastic demand (panel (b)).
Figure 11.11 The effect of price controls on the monopolistic production decision
In an unregulated market, a monopolistic utility will produce Qm kilowatts and sell them for
Pm. If the firm’s price is controlled at P1, however, its marginal revenue curve will become
horizontal at P1. The firm will produce Q1 – more than the amount it would normally
produce.
Figure 11.12 Taxing monopoly profits
Theoretically, a tax on the economic profit of monopoly will not be passed on to the
consumer – but taxes are levied on book profit, not economic profit. As a result, a tax shifts
the first marginal cost curve up, from MC1 to MC2, raising the price to the consumer and
lowering the production level.
Figure 11A.1 Construction of the linear marginal revenue curve
The marginal revenue curve always starts at the intersection of the vertical axis and any
demand curve. However, for a linear demand curve, the marginal revenue curve must slope
downward under the demand curve, splitting the horizontal distance between the vertical
axis and every point on the demand curve. The marginal revenue curve must cut the
horizontal axis at the point below the middle of the linear demand curve, or where the
elasticity coefficient equals one.
Figure 11A.2 Construction of the nonlinear marginal revenue curve
The marginal revenue curve for a nonlinear demand curve is obtained by imagining linear
demand curves tangent to every point on the nonlinear demand curve and finding the
midpoint between the vertical axis and the imagined linear demand curves.
Figure 12.1 Monopolistic competition in the short run
As do all profit maximizing firms, the monopolistic competitor will equate marginal
revenue with marginal cost. It will produce Qmc units and charge price Pmc, only slightly
higher than the price under perfect competition. The monopolistic competitor makes a
short-run economic profit equal to the area ATC1Pmcab. The inefficiency of its slightly
restricted production level is represented by the shaded area.
Figure 12.2 Monopolistic competition in the long run
In the long run, firms seeking profits will enter the monopolistically competitive market,
shifting the monopolistic competitor’s demand curve down from D1 to D2 and making it
more elastic. Equilibrium will be achieved when the firm’s demand curve becomes tangent
to the downward sloping portion of the firm’s long-run average cost curve Qm. At that
point, price (shown by the demand curve) no longer exceeds average total cost; the firm is
making zero economic profit. Unlike the perfect competitor, this firm is not producing at the
minimum of the long-run average total cost curve Qm. In that sense, it is underproducing,
by Qm - Qmc2 units. This underproduction is also reflected in the fact that the price is
greater than the marginal revenue.
Figure 12.3 The oligopolist as monopolist
With fewer competitors than the monopolistic competitor deals with, the oligopolist faces a
less elastic demand curve, Do. Each oligopolist can afford to produce significantly less (Qo)
and to charge significantly more Po than the perfect competitor, who produces Qc, at a
price of Pc. The shaded area representing inefficiency is larger than that of a monopolistic
competitor.
Figure 12.4 The oligopolist as price leader
The dominant producer who acts as a price leader will attempt to undercut the market
price established by small producers (panel (a)). At price P1 the small producers will supply
the demand of the entire market, Q2. At a lower price – Pd or Pc – the market will demand
more than the small producers can supply. In panel (b), the dominant firm determines its
demand curve by plotting the quantity it can sell at each price in panel (a). Then it
determines its profit maximizing output level, Qd, by equating marginal cost with marginal
revenue. It charges the highest price the market will bear for that quantity, Pd, forcing the
market price down to Pd in panel (a). The dominant producer sells Q3 – Q1 units, and the
smaller producers supply the rest.
Figure 12.5 A duopoly (two-member cartel)
In an industry composed of two firms of equal size, firms may collude to restrict total
output to Qm and sell at a price of Pm. Having established that price–quantity combination,
however, each has an incentive to chisel on the collusive agreement by lowering the price
slightly. For example, if one firm charges P1, it can take the entire market, increasing its
sales from Q1 to Q2. If the other firm follows suit to protect its market share, each will get a
lower price, and the cartel may collapse.
Figure 12.6 Long-run marginal and average costs in a natural monopoly
In a natural monopoly, long-run marginal cost and average costs decline continuously, over
the relevant range of production, because of economies of scale. Although the long-run
marginal and average cost curves may eventually turn upward because of diseconomies of
scale, the firm’s market is not large enough to support production in that cost range.
Figure 12.7 Creation of a natural monopoly
Even with declining marginal costs, the firm with monopoly power will produce at the
point where marginal cost equals marginal revenue, making Qm units and charging a price
of Pm. Unless barriers to entry exist, however, other firms may enter the market, causing
the price to fall toward P1 and the quantity produced to rise toward Q1. At that price–
quantity combination, only one firm can survive – but without barriers to entry, that firm
cannot afford to charge monopoly prices. At a price of P1, its total revenues just cover its
total costs. Economic profit is zero.
Figure 12.8 Underproduction by a natural monopoly
A natural monopolist that cannot price discriminate will produce only Q1 megawatts – less
than Q2, the efficient output level – and will charge a price of P1. If the firm tries to produce
Q2, it will make losses equal to the shaded area, for its price (P2) will not cover its average
cost (AC1).
Figure 12.9 Regulation and increasing costs
If a natural monopoly is compensated for the losses it incurs in operating at the efficient
output level (the shaded area P1ATC1ba), it may monitor its costs less carefully. Its cost
curves may shift up, from LRMC1 to LRMC2 and from LRAC1 to LRAC2. Regulators will then
have to raise the price from P1 to P2, and production will fall from Q1 to Q2. The firm will
still have to be subsidized (by an amount equal to the shaded area P2ATC2dc), and the
consumer will be paying more for less.
Figure 12.10 The effect of regulation on a cartelized industry
The profit maximizing cartel will equilibrate at point a and produce only Qm units and sell
at a price of Pm. In the sense that consumers want Qc units and are willing to pay more
than the marginal cost of production for them, Qm is an inefficient production level. Under
pure competition, the industry will produce at point b. Regulation can raise output and
lower the price, ideally to Pc, thereby eliminating the dead-weight welfare loss that is
equal to the shaded triangle abc and which results from monopolistic behavior.
Figure 13.1 Shift in demand for labor
The demand for labor, as with all other demand curves, slopes downward. An increase in
the demand for labor will cause a rightward shift in the demand curve, from D1 to D2. A
decrease will cause the leftward shift, to D3.
Figure 13.2 Shift in the supply of labor
The supply curve for labor slopes upward. An increase in the supply of labor will cause a
rightward shift in the supply curve from S1 to S2. A decrease in the supply of labor will
cause a leftward shift in the supply curve, from S1 to S3.
Figure 13.3 Equilibrium in the labor market
Given the supply and demand curves for labor S and D, the equilibrium wage will be W1
and the equilibrium quantity of labor hired Q2. If the wage rate rises to W2, a surplus of
labor will develop, equal to the difference between Q3 and Q1.
Figure 13.4 The effect of nonmonetary rewards on wage rates
The supply of labor is greater for jobs offering nonmonetary benefits – S2 rather than S1.
Given a constant demand for labor, the wage rate will be W2 for workers who do not
receive nonmonetary benefits and W1 for workers who do. Even though wages are lower
when nonmonetary benefits are offered, workers are still better off; they earn a total wage
equal, according to their own values, to W3.
Figure 13.5 The effect of differences in supply and demand on wage rates
In competitive labor markets, higher demand for labor (D2 in panel (a)) will bring a higher
wage rate. A higher supply of labor (S2 in panel (b)) will bring a lower wage rate.
Figure 13.6 The competitive labor market
In a competitive market, the equilibrium wage rate will be W2. Lower wage rates, such as
W1, would create a shortage of labor, and employers would compete for the available
laborers by offering a higher wage. In pushing up the wage rate to the equilibrium level,
employers impose costs on one another. They must pay higher wages not only to new
employees but also to all current employees, in order to keep them.
Figure 13.7 The marginal cost of labor
The marginal cost of hiring additional workers is greater than the wages that must be paid
to the new workers. Therefore the marginal cost of labor curve lies above the labor supply
curve.
Figure 13.8 The monopsonist
The monopsonist will hire up to the point at which the marginal value of the last worker,
shown by the demand curve for labor, equals his or her marginal cost. For this
monopsonistic employer, the optimum number of workers is Q2. The monopsonist must
pay only W1 for that number of workers – less than the competitive wage level, W2.
Figure 13.9 The employer cartel
To achieve the same results as a monopsonist, the employer cartel will devise restrictive
employment rules that artificially reduce market demand to D2. The reduced demand
allows cartel members to hire only Q2 workers at wage W1 – significantly less than the
competitive wage, W2.
Figure 13.10 Menu of two-part pay packages
By varying the base salary and the commission rate, employers can get salespeople to
reveal more accurately the sales potential of their districts. A salesperson who believes that
the sales potential of his district is great will take the income path that starts at a base
salary of S3. The salesperson who doesn’t think the sales potential of his district is very
good will choose the income path that starts at S1.
Figure 14.1 The political spectrum
A political candidate who takes a position in the “wings” of a voter distribution, such as D1
or R1, will win fewer votes than a candidate who moves toward the middle of the
distribution. In a two-party election, therefore, both candidates will take
middle-of-the-road positions, such as D and R.
Figure 14.2 Bureaucratic profit maximization
Given the demand for police service, D, and the marginal cost of providing it, MC, the
optimum quantity of police service is Q2. A monopolistic police department interested in
maximizing its profits will supply only Q1 service at a price of P2, however. (A monopolistic
bureaucracy interested in maximizing its size would expand police service to Q3.)
Figure 15.1 Gains from the export trade
Opening up foreign markets to US producers increases the demand for their products, from
D1 to D2. As a result, domestic producers can raise their price from P1 to P2 and sell a larger
quantity, Q3 instead of Q2. Revenues increase by the shaded area P2bQ3Q2aP1. The more
price-elastic or flatter the supply function (S), the larger the change in quantity and the
smaller the change in price.
Figure 15.2 Losses from competition with imported products
Opening up the market to foreign trade increases the supply of textiles from S1 to S2. As a
result, the price of textiles falls from P2 to P1, and domestic producers sell a lower quantity,
Q1 instead of Q2. Consumers benefit from the lower price and the higher quantity of
textiles they are able to buy, but domestic producers, workers, and suppliers lose.
Producers’ revenues drop by an amount equal to the shaded area P2aQ2Q1bP1. Workers’
and suppliers’ payments drop by an amount equal to the shaded area Q2abQ1. Starting at
point c, a tariff or tax equal to ad is levied, shifting the supply curve from S2 to S1. In an
industry whose costs are increasing, the increase in price from P1 to P2 in the importing
country is less than the increase in the tariff (ad), because a price fall in the exporting
country absorbs some of the burden of the duty.
Figure 15.3 Effects of tariff protection on individual industries: case 1
If neither the textiles nor the automobile industry obtains tariff protection, the economy
will earn its highest possible collective income (cell I), but each industry has an incentive to
obtain tariff protection for itself. If the textiles industry alone seeks protection (cell II), its
income will rise while the auto industry’s income falls. If the auto industry alone seeks
protection, its income will rise while that of the textiles industry falls. If both obtain
protection, the economy will end up in cell IV, its worst possible position. Income in both
sectors will fall.
Figure 15.4 Effects of tariff protection on individual industries: Case 2
In this case, the auto industry gains from tariff protection, even if both sectors are
protected (cell IV). The textiles industry’s income falls from $20 (cell I) to $17 (cell IV), but
the auto industry’s income rises from $30 (cell I) to $31 (cell IV). Thus the auto industry has
no incentive to agree to the elimination of tariffs.
Figure 15.5 Supply and demand for euros on the international currency market
The international exchange rate between the dollar and the euro is determined by the
forces of supply and demand, with the equilibrium at E. If the exchange rate is below
equilibrium, say at ER1, the quantity of euros demanded, shown by the demand curve, will
exceed the quantity supplied, shown by the supply curve. Competitive pressure will push
the exchange rate up. If the exchange rate is above equilibrium, say, ER3, the quantity
supplied will exceed the quantity demanded and competitive pressure will push the
exchange rate down. Thus the price of a foreign currency is determined in much the same
way as the price of any other commodity.
Figure 15.6 Effect of an increase in demand for euros
An increase in the demand for euros will shift the demand curve from D1 to D2, pushing the
equilibrium from E1 to E2. At the initial equilibrium exchange rate ER1, a shortage will
develop. Competition among buyers will push the exchange rate up to the new equilibrium
level, ER2.