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What is Economics?
• The Science of Choice.
• It studies the distribution of scarce
resources among unlimited wants.
• Why do we say “scarce resources”
• labour, land, capital and entreprenourship
Economic questions:
 What goods and services should be
produced and in what quantities?
 How should they be produced?
 Who consumes the goods and services?
Self Interest vs. Social Interest
• “Could it be possible that when each and
one of us makes choices that are in our own
best interest, it turns out that these choices
are also the best for society as a whole”
• How to answer this question?
• There has been progress in some issues like:
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Privatization
Globalization
The New Economy
9/11
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Corporate Scandals
HIV/AIDS
Natural Resources
Water Shortages
Unemployment
Deficits and Debts
Economic Way of Thinking:
Choice, Tradeoff, and Opportunity Cost.
“Because the resources available are scarce,
individuals must choose among their wants,
and by doing so they face an opportunity
cost.“
“There is no free lunch.”
“Opportunity Cost is the highest-valued
alternative forgone, not all the possible
alternatives forgone”
Margins and Incentives.
“The important thing is the benefit of a bit
more or a bit less.”
– Marginal Benefit
– Marginal Cost
– The way to decide MGB = MGC
– Incentives affect these margins
• higher wages, lower prices.
There is Macro and Microeconomics:
• Macro is the study of the aggregated economy.
• Micro is the study of the components of the
economy.
What is the difference?
Imagine a football team:
– MACRO: It might be having a winning or
loosing season.
– MICRO: The statistics of the offense and the
defense.
Three important concepts:
• Normative Statements: What it ought to be,
these statements depend on values and cannot be
tested.
• More foreign aid should be given to African
countries, so they can reduce the levels of poverty.
• Positive Statements: What it is. These
statements say what is currently believed about the
way the world operates.
• Poverty levels in African countries are high.
• Ceteris Paribus!!
Resources and Wants
• Economics studies the distribution of
scarce/limited resources among unlimited
wants.
• What are those scarce/limited resources:
– Labour: Time and effort.
– Land: natural resources (air, water, surface, and minerals)
– Capital: goods that were produced and that now
are used to produce more goods. (planes,
buses, trucks, highways, production lines)
– Entrepreneurship: ideas, management.
• Also because scarcity of resources, there
are certain combinations of goods and
services that can be produced, and some
that cannot.
• The boundary between these two sets is
defined by the Production Possibility
Frontier (PPF).
• In other words, the PPF shows the different
combinations of goods and services that
can be produced, using ALL the available
resources.
Overhead transparency of Figure 2.1
• Production Efficiency
• Trade-off: give something to get something
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• Opportunity Cost: it is a ratio
The decrease in the qty produced of one good
The increase in the qty produced of another good
• Increasing Opportunity Cost: The PPF is
bowed outward because resources are not all equally productive
in all activities. Example: Football and Soccer players
Overhead transparency of Figure 2.2
– Marginal Cost: Is the opportunity cost of
producing one more unit of a good or
service. (Usually increasing)
Overhead transparency of Figure 2.3
– Marginal Benefit: Is the benefit that a
person receives from getting one more
unit of a good or service. (Usually
decreasing)
What is the difference between the two
concepts? (marginal benefit and opportunity cost)
• Both are measured in units of a good
(forgone)
• But they are different:
– Opportunity Cost of good A: how much of
good B an individual MUST forgo to get
another unit of good A.
– Marginal Benefit of good A: amount of good B
that an individual is WILLING to forgo to get
one more unit of good A.
The efficient use of resources?
Overhead transparency of Figure 2.4
Marginal Benefit = Marginal Cost
• The goods and services that are produced
are the ones that are valued the most.
Nothing more or no other good can be
produced, without giving up something that
is valued even higher.
Economic Growth:
• Defined as the expansion of production.
• What influences economic growth:
– Technological Change: better ways to produce
something
– Capital Accumulation: the growth of capital
resources.
– New Natural Resources (very rare, like oil on
the moon)
• An example:
factory example.
Figure 2.5 (page 38) and computers
Gains from Trade:
• First we need to get a couple of
concepts under our belts:
– Specialization: Concentrating on the production
of only one or some goods.
– Comparative Advantage: to be able to produce
something at a lower opportunity cost. Sometimes
depends on the characteristics of the economy
(like: geographical features)
– The best way to understand this is with an
exercise.
Gains from Trade:
• Graphs 2.7 and 2.8
• If each individual produces a combination
instead of specializing in one good, then the
benefits are less than when both agents
specialize and trade between them.
– Absolute advantage: One agent can produce more
goods than anybody else with the same
resources.
– Productivity makes some changes, but it is not
possible for anyone to have a comparative
advantage in everything.
– Dynamic Comparative Advantage: Learning by
doing.
The Market Economy: It is all about incentives
• Property Rights
• Markets
• Circular Flows in the Market Economy
– (figure 2.10)
• Coordinating Decision.
Demand and Supply: How Markets
Work?
• Prices and quantities demanded fluctuate, but in different
ways, sometimes together and other times in different
directions.
Price and Opportunity Cost:
There is a relation between them that is called a
relative price.
Demand and supply determine relative prices, and in our
studies the word price means relative price!!
DEMAND
• The good is wanted, can be afforded and there is
a definite plan to buy it.
• The quantity demanded of a good or service is
the amount that consumers plan to buy during a
given time period at a particular price.
• The quantity demanded is measured as an
amount per unit of time
DEMAND
• There are many factors that affect the buying
plans / demand:
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price of the good
prices of related goods
expected future prices
income
population
preferences
• Lets take a look at the first factor
The law of Demand: Other things remaining the
same, the higher the price of a good, the smaller is the
quantity demanded.
DEMAND
Why higher prices means lower demand?
The answer for this comes from two logical effects that
everybody knows already, but they do not know their names:
• Substitution effect: When the price of a good rises, other
things being the same, its relative price (opportunity cost) rises.
And consumers start looking for substitutes, buying less of the
original good.
• Income effect: Facing higher prices, with unchanged
income, people cannot afford to buy all the things they
previously bought. The quantities demanded of at least some
goods and services must be decreased. (Normally, the good
whose price has increased is one of those bought in smaller
quantity).
DEMAND
Demand: this term refers to the ENTIRE relationship
between the quantity demanded and the price of a good, and it
is illustrated by a demand curve and a demand schedule.
Demand Curve: It shows the relationship between the
price of a good and the quantity demanded, when all other
influences on consumers’ planed purchases remain the same.
Demand Schedule: It lists the quantities demanded at
each different price when all the other influences on
consumers’ planned purchases remain the same.
We graph the demand schedule as a demand curve with the
quantity demanded on the horizontal axis and price on the
vertical axis. (figure 3.1)
DEMAND
Quantity demanded:Refers to a point on the demand
curve, the quantity demanded at a particular price.
A Change in DEMAND: When any factor that
influences the buying plans changes, other than the
price of the good, there is a change in demand. If
demand increases, then the demand curve shifts to the
right and the quantity demanded is greater at each and
every price. (figure 3.2)
DEMAND
What factors bring a change in demand?
• Prices of related goods
– substitutes
– complements
• Expected future prices
– if good can be stored (special cases)
• Income
– normal good
– inferior good
• Population
– size
– structure
• Preferences
DEMAND
A Change in the Quantity Demanded Vs a
Change in Demand: (figure 3.3)
Movement along the demand curve shows a change in the
quantity demanded.
Shifts of the demand curve shows a change in demand.
So what happens when the factors or the price
change? (table 3.1)
SUPPLY
• The good can be produced, profit can be made
from producing it and there is a definite plan to
produce it and sell it.
• The quantity supplied of a good or service is the
amount that producers plant to sell during a given
time period at a particular price.
• The quantity supplied is measured as an amount
per unit of time
Supply
• There are many factors that affect the selling
plans / supply:
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price of the good
prices of the resources used to produced the good.
prices of related goods produced
expected future prices
number of suppliers
technology
• Lets take a look at the first factor
The law of Supply: Other things remaining the same,
the higher the price of a good, the greater is the
quantity supplied.
SUPPLY
Why higher prices means greater supply?
The answer comes from a well known term, increasing
marginal cost. As the quantity produced of any good
increases, the marginal cost of producing the good
increases.
So, when the price increases, producers are willing to
incur in higher marginal costs to increase production.
The higher price brings forth an increase in the quantity
supplied.
SUPPLY
Supply: this term refers to the ENTIRE relationship between
the quantity supplied and the price of a good, and it is
illustrated by a supply curve and a supply schedule.
Supply Curve: It shows the relationship between the price
of a good and the quantity supplied, when all other influences
on producers’ planed sales remain the same.
Supply Schedule: It lists the quantities supplied at each
different price when all the other influences on producers’
planned sales remain the same.
We graph the supply schedule as a supply curve with the
quantity supplied on the horizontal axis and price on the
vertical axis. (figure 3.4)
SUPPLY
Quantity supplied:Refers to a point on the supply curve,
the quantity supplied at a particular price.
A Change in SUPPLY: When any factor that
influences the selling plans changes, other than the
price of the good, there is a change in supply. If supply
increases, then the supply curve shifts to the right and
the quantity supplied is greater at each and every price.
(figure 3.5)
SUPPLY
What factors bring a change in supply?
• Prices of productive resources
• Prices of related goods produced
– substitutes in production
– complements in production
• Expected future prices
• Number of producers
– size
– structure (could be)
• Technology
SUPPLY
A Change in the Quantity Supplied Vs a Change
in Supply: (figure 3.6)
Movement along the supply curve shows a change in the
quantity supplied.
Shifts of the supply curve shows a change in supply.
So what happens when the factors or the price
change? (table 3.2)
MARKET EQUILIBRIUM (figure 3.7)
• Equilibrium price
Price at which the quantity demanded equals the quantity
supplied
• Equilibrium quantity
Quantity bought and sold at the equilibrium price.
• Price is what regulates the market
• price as a regulator
• price adjustments
MARKET EQUILIBRIUM (figure 3.7)
• A shortage forces the price up
• A surplus forces the price down
• The best deal available for buyers and sellers
In equilibrium, buyers pay the highest price
they are willing to pay for the last unit bought
and sellers receive the lowest price at which
they are willing to supply the last unit sold.
MARKET EQUILIBRIUM (figure 3.8 and 3.9)
A Change in Demand: There is a shift (left or right) of the
demand curve, and there is an increase or decrease in the
quantity supplied. But there is no change in supply, the supply
curve does not move!.
• If the demand increases, both price and quantity supplied increase
• If the demand decreases, both price and quantity supplied decrease
A Change in Supply: There is a shift (left or right) of the supply
curve, and there is an increase or decrease in the quantity
demanded. But there is no change in demand, the demand curve
does not move!.
• If the supply increases, price falls and quantity demanded increases
• If the supply decreases, price rises and quantity demanded decreases
MARKET EQUILIBRIUM (figure 3.10 and 3.11)
If both, demand and supply, change:
– Change in the same direction:
• If both increase: the quantity increases and price increases, decreases
or remains constant
• if both decrease:the quantity decreases and price increases, decreases
or remains constant
– Change in opposite direction:
• If demand decreases and supply increases: the price falls and
quantity increases, decreases or remains constant
• if demand increases and supply decreases: the rice rises and the
quantity increases, decreases or remains constant
– Some examples
MARKET EQUILIBRIUM
A Mathematical Note:
Demand and Supply Curves: The equation of the lines
Demand
P = a - bQd
Supply
P = c + dQs
What information is contained in these two expressions?
What is a, b, c and d?
MARKET EQUILIBRIUM
Solving a system of equations: two equations for two
unknown variables.
A simple Example:
P = 800 - 2Qd (this is the _______ curve,
P = 200 + 1Qs (this is the _______ curve,
why? ____________)
why? ____________)
Solving the system we get: P* and Q* (* means equilibrium)
Elasticity
The elasticity is a unit free measure of responsiveness,
and there are many kinds of elasticities that are used in
economics:
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Price elasticity of demand
Cross elasticity of demand
Income elasticity of demand
Elasticity of supply
Why does it matter? (some examples and figure 4.1)
Price Elasticity of Demand
• This is a units free measure of the responsiveness of the
quantity demanded of a good to a change in its price when all
other influences on buyers’ plans remain the same.
• Why do we use a units free measure?
• How to calculate the price elasticity of demand (figure 4.2):
– We want to get a relation between percentage changes of quantity
demanded and percentage changes in price (so this is a ratio).
Price Elasticity of demand = % change in Quantity demanded
% change in price
NOTE: The changes in price and quantity demanded are expressed as
percentage changes of the average price and the average quantity, we do
it to get a more precise measurement. We ignore the minus sign, because
we are interested in the magnitude of the price elasticity of demand (we
use the absolute value)
Price Elasticity of Demand
Inelastic or elastic demand, what is this??? (figure 4.3)
This is just a simple way of expressing the degree of responsiveness of the
demand towards price changes.
– Perfectly elastic demand: price changes but quantity does not, elasticity is 0.
– Unit elastic: percentage change in price is equal to the percentage change in
quantity demanded, so the elasticity is equal to 1.
– Inelastic demand: between the two above, the percentage change in price is
greater than the percentage change in quantity demanded, so the elasticity is
between 0 and 1.
– Perfectly elastic demand: quantity demanded changes by an infinite amount
in response of a tiny price change, so the elasticity is equal to infinite.
– Elastic demand: this is between unit elastic and perfectly elastic, and it
means that the percentage change in quantity demanded is greater than the
percentage change in price, so the price elasticity is greater than 1.
Elasticity Along a Straight Line: An Example (figure 4.4)
Price Elasticity of Demand
Another way to look at this is from the revenue generated by the
sale of a good, this is call the Total Revenue Test. (figure 4.5)
•
If demand is elastic, a 1 percent price cut increases the quantity demanded sold by
more than 1 percent and total revenue increases.
•
If demand is unit elastic, a 1 percent price cut increases the quantity by 1 percent
and total revenue does not change.
•
If demand is inelastic, a 1 percent price cut increases the quantity demanded by
less than 1 percent and total revenue decreases.
Your expenditure and your elasticity
If your demand is inelastic, then a 1 percent price cut increases the quantity you
buy by less than 1 % and your expenditure on the item decreases.
For unit elastic and elastic it is very straight forward, the first one doesn’t change
your expenditure on the item, while the later increases it.
Price Elasticity of Demand
What influences the Elasticity of Demand?
• Closeness of substitutes
• It depends on how we define them.
• Necessities (Inelastic)
• Luxuries (Elastic)
• Proportion of income spent on the item
• It is just like saying: size matters doesn’t it. (cars and candies)
• Time elapsed since a price change
• give me some time and I will find another thing that looks like that or
can be used for the same thing.
Cross Elasticity of Demand (figure 4.7)
This is a measure of responsiveness of the demand for a
good to a change in price of a substitute or complement,
other things remaining the same.
Cross Elasticity of demand = % change in Quantity demanded
% change in price of a substitute
or complement
NOTE: The cross elasticity is positive for substitutes and
negative for complements.
Income Elasticity of Demand (do graphs)
This is a measure of responsiveness of the demand for a
good to a change in income, other things remaining the
same.
Income Elasticity of demand = % change in Quantity demanded
% change in income
NOTE: The income elasticity can be positive or negative:
» Greater than one: income elastic, normal good.
» Between zero and one: income inelastic, normal good.
» Less than zero: inferior good
Elasticity of Supply
• Measures the responsiveness of the quantity supplied to a
change in the price of a good when all other influences on
selling plans remain the same.
• How to calculate the elasticity of supply (figure 4.9):
– We want to get a relation between percentage changes of quantity
supplied and percentage changes in price (so this is a ratio).
Elasticity of supply = % change in Quantity supplied
% change in price
Degrees of Elasticity of Supply: (figure 4.10)
• Perfectly elastic
• Unit elastic
• Perfectly elastic
Elasticity of Supply
What influences the elasticity of supply?
– Resource substitution possibilities
– Time frame for the supply decision:
» Momentary supply
» Lon run supply
» Short run supply
Efficiency and Equity
More with less may not be more efficient.
An allocation is said to be efficient if the
goods and services produced are the ones
that are valued the most.
Efficiency has something to do with value,
and value is related to feelings
Is the current situation fair?
Efficiency
Do you remember these terms?
• Marginal Benefit: is the benefit that a person receives from
consuming one more unit of a good or service and it is
measured as the maximum amount that a person is willing
to pay for one more unit of it. (usually decreasing)
• Marginal Cost: is the opportunity cost of producing one
more unit of a good or service and it is measured as the
value of the best alternative forgone. (usually increasing)
• Inefficient Allocations: if marginal benefit exceeds marginal
cost or if the opposite happens.
• Efficient Allocations: marginal benefit equals marginal cost.
(figure 5.1)
Consumer Surplus
• What do we mean with the term value of the good
or service?
It is simply the marginal benefit of a good or service.
Recall that the marginal benefit can be expressed as the
maximum price that people are willing to pay for another
unit of the good or service. And this willingness
determines the demand for the good or service.
And also recall that a demand curve tells us the quantity
of other goods and services that people are willing to
forgo to get an additional unit of a good.
So we can conclude that a demand curve is a marginal
benefit curve. (figure 5.2)
Consumer Surplus
If people buy something for less than it is worth to
them, they receive a consumer surplus. (figure 5.3)
Consumer surplus = the value of the good - the price paid for it
Producer Surplus
• What do we mean with the term cost of
producing the good or service?
It is simply the marginal cost, the minimum price
that producers must receive to induce them to
produce another unit of the good or service, this
minimum acceptable price determines supply.
A supply curve tells us the quantity of other good
and services that sellers must forgo to produce
one more unit of the good or service.
So we can conclude that a supply curve is a marginal
cost curve. (figure 5.4)
Producer Surplus
When a firm sells something for more than it costs to
produce, the firm obtains a producer surplus. (figure
5.5)
Producer surplus = price of a good - opportunity cost of producing it.
Efficient Competitive Markets?
Why do we say, that markets are efficient when
marginal cost equals marginal benefit? (figure 5.6)
• It maximizes the consumer and producer surplus.
• Any other allocation than the one in equilibrium
puts the forces of supply and demand to work and
the equilibrium allocation will be the final result.
• Resources are allocated efficiently (where they
create the greatest possible value)
The invisible hand is working!!
Efficient Competitive Markets?
Obstacles to efficiency:
– Price ceilings and floors: incorrect quantities (chpt.6)
– Taxes, subsidies and Quotas: distortions on market prices
(example: prices received by producers are lower than those
paid by buyers) (chpt.6)
– Monopoly: larger profits, wrong quantity supplied (chpt. 12)
– Public goods: the free rider problem (chpt. 16)
– External costs and external benefits:
– External costs: is a cost not borne by the producer but borne by
other people.
– External benefit: benefit that accrues to people other than the buyer
of a good.
In consequence we have overproduction or
underproduction
Efficient Competitive Markets?
And this two problems decreases the total surplus
(producer surplus plus consumer surplus).
• Figure (5.7)
• Deadweight loss: is the decrease in consumer surplus
and producer surplus that results from an inefficient
level of production.
The deadweight loss is borne by the entire society, it is
a social loss.
Fair Competitive Markets?
• It is not fair if the result is not fair.
– Utilitarianism
– The big tradeoff
– Make the poorest as well off as possible
• a bigger piece of a smaller pie can be less than a smaller piece of a
bigger pie.
• It is not fair if the rules are not fair.
– The symmetry principle: Behave toward other people in the way you expect
them to behave toward you.
– The two basic rules for fairness:
• The state must enforce laws that establish and protect private property.
• Private property may be transferred from one person to another only by
voluntary exchange.
Acquisition of Customers:
Utility and Demand
• Why some things are more expensive than others, even
when the ones that are cheap are the ones that we need
the most?
• What makes the demand for some goods price elastic,
while the demanders for others is price inelastic?
Household Consumption Choices
These are delimited by two things mainly:
• Consumption possibilities (figure 7.1): Consumers have a
certain amount of income to spend and cannot influence
the prices of good and services that they buy.
• THE BUDGET LINE IS A CONSTRAINT ON CHOICES. (IT TELLS
WHAT CAN BE AND WHAT CAN NOT BE AFFORDED)
• Preferences: How do consumers distribute their incomes?
Well it depends on what they like and what they do not, in
other words their “PREFERENCES”
• Economists use the term of UTILITY to describe PREFERENCES
• The benefit that a persons derives from the consumption of a good or
service is called UTILITY. (abstract concept!!)
UTILITY (table 7.1)
• TOTAL UTILITY: Total benefit that a persons derives from
the consumption of goods and services. It depends on the
level of consumption, more generally means more utility.
• MARGINAL UTILITY: Is the change in total utility that
results from one unit increase in the quantity of a good
consumed. (figure 7.2)
• Marginal Utility is positive but diminishes as the consumption of the
good increases (again you get tired of the goods)
• That is why we have DIMINISHING MARGINAL UTILITY
MAXIMIZING UTILITY
• The Household’s income and the prices she/he faces limit
her/his choices, and her/his preferences determined the
amount of utility that she/he gets from each affordable
combination. But the main objective is to choose the
combination that MAXIMIZES UTILITY!.
• Just find out what is the total utility of each combination and
choose the one that gives the highest number and that will
be the best the consumer can do given the prices and
her/his income. (table 7.2)
• CONSUMER EQUILIBRIUM: Is a situation in which a
consumer has allocated all his or her available income in
the way that, given prices and income, maximizes his or
her utility.
MAXIMIZING UTILITY
• EQUALIZING MARGINAL UTILITY PER DOLLAR SPENT:
“Total utility is maximized when all the consumer´s
available income is spent and when the marginal utility
per dollar spent is equal for all goods”
Marginal Utility from X =
Price of X
Marginal Utility from Y
Price of Y
EXAMPLE
TABLE 7.3 AND FIGURE 7.3
“As always, if the marginal utility of the last dollar spent
on X exceeds the marginal utility per dollar spent on Y,
buy more X and less of Y. (VICEVERSA)”
Predictions of Marginal Utility
• After a change on prices or income, to find the new utility
maximizing combination follow the next three steps:
– Determine the new combinations that exhaust new
income at the new prices.
– Calculate the marginal utilities per dollar spent.
– Determine the combination that makes the marginal
utilities per dollar spent on X and Y equal.
Predictions of Marginal Utility
Change in Prices:
• If price of X falls:
• Table 7.4
• Figure 7.4
• If price of Y rises
• Table 7.5
• Figure 7.5
• This tells us that:
– When price of a good rises, the quantity demanded of the good
decreases.
– When the price of one good rises, the demand for another good
that can serve as a substitute increases.
Predictions of Marginal Utility
• If income increases
• Table 7.6
• This tells us that:
– With more income the consumer always buys more of a normal
good and less of an inferior good.
• Table 7.7: A summary.
Individual and Market Demand
• Marginal Utility theory explains how an individual household
spends its income and enables us to derive an individual
household’s demand curve.
• Before during the first part of the course we used market
demand curves
• But Market demand can be derived from individual demand
curves (figure 7.6)
“The market demand is the horizontal sum of the
individual demand curves and is formed by adding the
quantities demanded by each individual at each price”
Efficiency, Price and Values
• Consumer Efficiency and Consumer Surplus
“Marginal benefit is the maximum price that a
consumer is willing to pay for an extra unit of a god or
service when utility is maximized”
• The paradox of Value: Everything comes from the equality
of the marginal utilities per dollar spent.
POSSIBILITIES,
PREFERENCES AND CHOICES
• Why do changes in prices or income change demand and
quantity demanded?
• Here we will study what effects do these changes have,
how and why?
Consumption Possibilities
• The budget line, again!! (figure 8.1)
• Divisible goods and indivisible goods
• The budget line “equation”:
Expenditure = Income
PxQx + PyQy = Y
Qx= (Y/Px) - (PyQy/Px)
• Real Income
• Relative Price
• Change in Prices and Changes in Income (figure 8.2)
Preferences and Indifference
Curves
• A preference Map: this is based on the assumption that
people can sort all the possible combinations of goods into
three groups: preferred, not preferred and indifferent.
• Indifference Curve: is a line that shows combinations of
goods among which a consumer is indifferent. (figure 8.3)
Marginal Rate of Substitution
(MRS): (figure 8.4)
• Is the rate at which a person will give up good y (measured
on the y-axis) to get more of good x (measured on the xaxis), and at the same time remain indifferent. It is
measured by the slope of the indifference curve.
– Steep curve, high substitution
– Flat curve, low substitution
• Diminishing Marginal Rate of Substitution
• Degree of Substitution (figure 8.5)
– Close substitutes: easily substituted for each other.
– Complements:can not be substituted for each other at all.
Predicting Consumer Behavior
• Assume we start at equilibrium (huh!!)
– What is equilibrium here?!! (figure 8.6)
• Is on her budget line
• Is on her highest attainable indifference curve
• Has a marginal rate of substitution between y and x equal to the
relative price of y and x.
• What happens when prices change? (figure 8.7)
• Find the demand curve.
• What happens when income changes? (figure 8.8)
• Income effect
• Less consumption of all goods (if they are normal goods), remember
that income changes switch the demand curve!!
Substitution and Income Effect
• Substitution Effect: is the effect of a change in price on
the quantity bought when the consumer (hypothetically)
remains indifferent between the original and the new
situation.
• Income Effect: is the effect of a change in income on
consumption.
• Analysis of figure 8.9 (very important!!!)
• The case of inferior goods: remember that the income
effect is negative in this case!!
Work and Leisure Choices
• Using this model to explain the labor supply:
• More work means more income
• Figure 8.10
• The labor supply curve
• Higher wage has both a substitution effect and an income effect
ORGANIZING PRODUCTION
• A Firm is an institution that hires productive resources and
that organizes those resources to produce and sell goods
and services.
• The main goal of any firm is to maximize profit.
• To measure profits, first we need to review one concept that
we have been using before (Opportunity Cost) and
understand 4 new ones (Explicit Costs, Implicit Costs,
Economic Depreciation, Cost of owner’s resources)
Opportunity Cost
• The opportunity cost of any action is the highest-valued
alternative forgone.
• The firm’s opportunity costs are:
– Explicit Costs: are paid in money. Money that could have been used in
something else.
– Implicit Costs: when it forgoes an alternative action but does not make a
payment.
• Using own capital (because it could be rented to another firm), this is also
called the implicit rental rate of capital, which is made up of:
– Economic Depreciation: change in the market value of capital over time.
– Interest forgone: the funds used to buy own capital could have been used
in something different and they would have yielded a return.
• Using owner’s time and financial resources:
– Usually the entrepreneurial ability, the return on entrepreneurship is profit
and the average return for supplying entrepreneurial ability is called
normal profit, and this is a part of a firm’s opportunity cost because it is the
cost of a forgone alternative, like running another firm.
Economic Profit and Economic
Accounting
• The Economic Profit is simply the result of the next
subtraction: Total Revenue - Opportunity Cost
• Where the Opportunity Cost is equal to the sum of its
implicit costs and explicit costs.
• Economic Accounting (table 9.1)
• How do firm’s achieve their objective of profit maximization:
– By answering the five questions:
•
•
•
•
•
What goods to produce
How to produce them
How to organize and compensate managers and workers
How to market and price its products
What to produce itself and what to buy from other firms
But how do firms answer this
questions?
• The must take in to account their constraints, which are:
– Technology Constraints:
• A technology is any method of producing a good or service. It includes
the detailed designs of machines, the layout of the workplace and the
organization of the firm. You can produce up to a certain amount with
the current technology!!
– Information Constraints:
• We never have enough information about the present and future
buying plans of customers and competitors and suppliers.
– Market Constraints
• What each firm can sell, the price it can obtain the resources that it
can buy and the prices it pays form them are constrained by the
willingness to pay of its customers, by the prices and marketing efforts
of other firms, but the willingness of people to work and invest in the
firm.
Technology and Economic Efficiency
• Technological Efficiency: When a firm produces a given
output by using the least inputs. (table 9.2)
• Economic Efficiency: When a firm produces a given output
at lest cost. (table 9.3)
• A Technologically Inefficient method is never economically
efficient!!
• Technological efficiency depends only on what is feasible,
economic efficiency depends on the relative cost of
resources
Information and Organization
• Command Systems: A method of organizing productions
that uses a managerial hierarchy
• Incentive Systems: Instead of keeping a very close eye on
workers, the managers use a market-like mechanism inside
the firm, creating compensation schemes that will induce
workers to perform in ways that maximize profit. The case
of supervision Vs no supervision and the effect on costs!
• Mixing the systems: Use commands when it is easy to
monitor performance or when a small deviation from ideal
performance is very costly, and use incentives when
monitoring performance is either not possible or too costly.
Information and Organization
• Principal Agent Problem: is the problem of devising
compensation rules that induce an agent to act in the best
interest of a principal. (the brokerage house example, the
extra hours example and the bank tellers example)
• Coping with the principal agent problem:
– Ownership: Give them a piece of the pie!!
– Incentive pay: Pay related to performance
– Long Term-Contracts: maximize profit over a sustained period.
• These three ways of coping with the principal agent
problem give rise to different types of business
organization.
Information and Organization
• Types of Business Organization:
– Proprietorship: single owner, with unlimited liability
– Partnership: two or more owners who have unlimited liability
– Corporation: Firm owned by one or more limited liability
stockholders, limited liability means that the owners have legal
liability only for the value of the initial investment.
• Pros and Cons of Different Types of Firms:
– Table 9.4
Market an the Competitive Environment
• Some are highly competitive, with profits hard to come by,
some are almost free from competition and firms earn large
profits. Some markets are dominated by fierce advertising
campaigns in which each firm seeks to persuade buyers
that it has the best products, and some markets display a
warlike character.
• Economist identify four market types: (table 9.6)
–
–
–
–
Perfect competition (identical product)
Monopolistic Competition (differentiated product)
Oligopoly (either identical or differentiated product)
Monopoly (No close substitutes)
How to determine Market Type in
Reality?
• We have what is called the Measures of Concentration:
– The four-firm concentration ration: Is the % of the value of sales accounted
by the four largest firms in an industry (0 for perfect competition to 100 for
Monopoly)
– The Herfindahl-Hirschman Index: Is the square of the % market share of
each firm summed over the largest 50 firms (or summed over all the firms
if there are fewer than 50) in the market.
• In perfect competition the HHI index is small and large for monopoly.
• In the 80´s the Federal Trade Commission used it to classify markets and said
that a market with an HHI between 1000 and 1800 is regarded as a
competitive market and an HHI higher than 1800 is regarded as as being uncompetitive.
– Figure 9.2 for the US Economy.
– Limitations of Concentration Measures
• Geographical scope of the market
• Barriers to entry and firm turnover
• Correspondence between a market and an industry.
Markets and Firms
• Market coordination
• Why Firms?
– Transaction Costs
– Economies of Scale
– Economies of Scope
– Economies of Team Production
OUTPUT AND COSTS
• All firms must decide how much to produce and how to
produce it.
• How do firms make these decisions?
• First, the objective is to maximize profits, but to do that the
firms must decide the quantity to produce, the quantities of
resources to hire and the price at which sell the output.
• Decisions about the quantity to produce and the price to
charge depend on the type of market in which the firm
operates. But decisions about how to produce a given
output do not depend on the type of market. These
decisions are similar for all firms in all type of markets.
Decision Time Frames
• The actions that a firm can take to influence the relationship
between output and cost depend on how soon the firm
wants to act.
– The short run: is the time frame in which the quantities of some resources
are fixed. For most of the firms, the fixed resources are the firm’s buildings and
capital. (the management organization and the technology it uses are also
fixed in the short run) We call the collection of fixed resources, the firm’s plant.
To increase output in the short run, a firm must increase the quantity of
variable inputs it uses. Labor is usually the variable input.
– The long run: is the time frame in which the quantities of all resources can
be varied. That is, the long run is a period in which the firm can change its
plant and the amount of labor that is used.
– Long run decisions are not easily reversed, short run decisions are
easily reversed, these is the result of the cost of buying a new
plant, these are called the sunk costs.
Short Run Technology Constraint
• To increase output in the short run a firm must increase the
quantity of labor employed
• As usual we can analyze the relation between production
and labor with the following concepts: (Table 10.1)
– Total Product: Total quantity produced
– Marginal Product of Labor: is the increase in total product that
results from a one unit increase in the quantity of labor employed.
First increases and then begins to decrease
– Average Product of Labor: Total product divided by the quantity of
labor employed.
First increases and then begins to decrease
Product Curves (figure 10.1 and 10.2)
• Total Product: it is similar to the Production Possibility Frontier, it
separates the attainable from the unattainable. And points on the curve
are technologically efficient.
• Marginal Product: The height of this curve measures the slope of
the total product curve at a point. We plot the marginal product at the
midpoint because it is the result of going from x1 units of labor to x2 units
of labor.
• Increasing Marginal Returns: these occur when the marginal product
of an additional worker exceeds the marginal product of the previous
worker.
• Diminishing Marginal Returns: these occur when the marginal
product of an additional worker is less than the marginal product of the
previous worker. They arise from the fact that more and more workers
are using the same capital and working in the same space.
• Law of Diminishing Returns: As firms uses more of a variable
input, with a given quantity of fixed inputs, the marginal product of the
variable input eventually diminishes
Product Curves (figure 10.3)
• Average Product: The marginal product curve, cuts the
average product curve at the point of maximum average
product. So, for employment levels where the marginal
product exceeds average product, average product is
increasing. This is a LOGICAL result, right? A very good
example is the Marginal Grade and GPA.
Short Run Cost
• To produce more output in the short run, a firm must
employ more labor, which means that it must increase its
costs.
• As always we can analyze the costs with the following
concepts:
• Total Cost
• Marginal Cost
• Average Cost
Short Run Cost
• TOTAL COST: Is the cost of all the productive resources
that a firm uses, including the cost of land, capital, labor
and the cost of entrepreneurship, which is normal profit.
• Total Cost is divided in two: (figure 10.4)
– Total Fixed Cost: Cost of all fixed inputs, it is horizontal because
total fixed cost does not change when output changes.
– Total Variable Cost: Cost of all the firm’s variable inputs.
• The vertical distance between the TVC and TC curve is
total fixed cost.
• Total Variable Cost and Total Cost increase at a decreasing
rate at small levels of output and then begin to increase at
an increasing rate as output increases, to understand this
we need to take a look at marginal cost.
Short Run Cost
• MARGINAL COST: is the increase in total cost that results
from a one unit increase in output. We calculate it by the
increase in total cost divided by the increase in output.
• The Marginal Cost curve is “U” shaped because of the Law
of Diminishing Returns!, which tells us that each additional
worker produces a successively smaller addition to output,
so to get an additional unit of output, ever more workers are
required. (figure 10.5)
• The marginal cost curve tells us how total cost change as
output changes.
Short Run Cost
• AVERAGE COST:
– Average Fixed Cost: Total fixed cost per unit of output. Slopes
downward.
– Average Variable Cost: Total variable cost per unit of output. “U”
shaped
– Average Total Cost: Total cost per unit of output. “U” shaped.
• The Marginal Cost curve intersects the average variable
cost curve and the average total cost curve at their
minimum points.
• The distance between ATC and AVC is equal to the AFC
and it shrinks as output increases, since AFC declines with
increasing output.
Short Run Cost
• Cost Curves and Product Curves (figure 10.6)
– what are the relations?
• Shifts in the Cost Curves:
– Technology
– Prices of Productive Resources.
Long Run Cost
• In the long run, a firm can vary both the quantity of labor
and the quantity of capital.
• Long run cost is the cost of production when a firm uses the
economically efficient quantities of labor and capital, there
are no fixed costs in the long run.
• The behavior of the long run cost depends on the firm’s
production function, which is the relationship between the
maximum output attainable and the quantities of both labor
and capital.
Long Run Cost
• Diminishing Returns, happen at each level of capital
utilization.
• Diminishing Marginal Product of Capital: Diminishing
returns also occur as the quantity of labor increases.
Marginal product of capital is the change in total product
divided by the change in capital when the quantity of labor
is constant.
• Short run cost and Long Run Cost. (table 10.3 and figure
10.7)
• Each short-run average total cost curve is U shaped
• For each short-run average total cost curve, the larger the plant, the
greater is the output at which average total cost is a minimum.
Long Run Cost
• The economically efficient plant size for producing a given
output is the one that has the lowest average total cost.
• The Long run average cost curve: is the relationship
between the lowest attainable average total cost and output
when both the plant size and labor are varied.
(Figure 10.8)
• The Long run average cost curve is derived from the short
run average total cost curves.
Long Run Cost
• Some more concepts that we need to know:
– Economies of Scale: are features of a firm’s technology that lead to falling
long run average cost as output increases. When economies of scale are
present the LRAC curve slopes downward. The percentage increase in output
exceeds the percentage increase in all inputs; the main source of economies
of scale is greater specialization.
– Diseconomies of Scale: are features of a firm’s technology that lead to
rising long-run average cost as output increases. When diseconomies of scale
are present the LRAC curve slopes upwards. The percentage increase in
output is less than the percentage increase in all inputs; the main source of
diseconomies of scales is the difficulty of managing a very large enterprise.
– Constant Returns to Scale: are features of a firm’s technology that lead
to constant long-run average cost as output increases. When constant returns
to scale are present, the LARC curve is horizontal. The percentage increase in
output equals the percentage increase in inputs.
– Minimum Efficient Scale: is the smallest quantity of output at
which long-run average cost reaches its lowest level and as we will
see it plays a role in determining market structure.
PERFECT COMPETITION
• How does competition affect prices and profits?
• What causes some firms to enter and industry and others
to leave it?
• What are the effects on profits and prices of new firms
entering and old firms leaving an industry?
Competition
• Perfect Competition is an industry in which:
–
–
–
–
Many firms sell identical products to many buyers
There are no restrictions on entry into the industry
Established firms have no advantage over new ones
Sellers and buyers are well informed about prices.
• How Perfect Competition Arises
– If the minimum efficient scale of a single producer is small relative
to the demand for the good or service
– If each firm is perceived to produce a good or service that has no
unique characteristics so that consumers do not care which firm
they buy from
NOTE: Minimum efficient scale is the smallest quantity of output at which long
run average cost reaches its lowest level.
Competition
• Economic Profit and Revenue: (figure 11.1)
• Economic Profit = Total Revenue - Total Cost
– Total Revenue = Q*P
– Total Cost = the opportunity cost of production, which includes normal
profit.
– Marginal Revenue: is the change in total revenue that results from a one
unit increase in the quantity sold.
• In Perfect Competition Marginal Revenue = Price !!!
Firm’s Decisions in Perfect Comp.
• The revenue curves summarize the market constraints
faced by a perfectly competitive firm. Firms also have a
technology constraint which is described by the product
curves.
• Short Run Decisions:
• Whether to produce or to shut down
• If the decision is to produce, what quantity to produce.
• Long Run Decisions:
• Whether to increase or decrease its plant size
• Whether to stay in the industry or leave it.
Firm’s Decisions in Perfect Comp.
• Profit Maximizing Output: (figure 11.2)
A Perfectly competitive firm maximizes economic profit by choosing
its output level.
• We can look at the Total Revenue (TR) and the Total Cost
(TC) and see where does the firm gets the highest
economic profit.
• An output where TR = TC, is called a break-even point, the firm’s
economic profit is zero, but because normal profit is part of total cost,
the firm makes normal profit at a break-even point.
• Graphically, economic profit is measured by the vertical distance
between the total revenue and total cost curves.
• The profit curve is at a maximum when TR exceeds TC by the largest
amount!.
Firm’s Decisions in Perfect Comp.
• As always we could also look at this with the Marginal
Analysis (figure 11.3)
• Marginal Revenue = Marginal Cost
 Max. Econ. Profit
• Marginal Revenue > Marginal Cost
 Sell more
The extra revenue from selling one more unit exceeds the extra cost
incurred to produce it. The firm makes an economic profit on the
marginal unit.
• Marginal Revenue < Marginal Cost
 Decrease output
The extra revenue from selling one more unit is less than the extra cost
incurred to produce it. The firm incurs an economic profit loss on the
marginal unit.
Firm’s Decisions in Perfect Comp.
• The firm’s short run supply curve (figure 11.5)
– It shows how the firm’s profit maximizing output varies as the market price
varies, other things remaining the same.
– Temporary Shot down: In the short run Total Fixed Cost can not be avoided, if
a firm shuts down it produces no output and it incurs in a loss equal to total
fixed cost.
• Shot down point: is the output and price at which the firm just covers its total
variable costs.
– The short run supply curve: if the price is above the minimum average
variable cost, the firm maximizes profit by producing the output at which
marginal cost equals price. We can determine the output produced at each
price from the marginal cost curve.
– The short run Industry supply curve: it shows the quantity supplied by the
industry at each price when the plant size of each firm and the number of firms
remain constant. It is the sum of the quantities supplied by all firms in the
industry at that price. (figure 11.6)
Output, price, and profit in Perfect
Competition
• Short Run Equilibrium: Industry demand and industry
supply determine the market price and industry output.
• A Change in Demand: these type of changes bring
changes to the short run industry equilibrium. (figure 11.7)
• Profit and Loses in the Short run (figure 11.4)
– If price exceeds average total cost, a firm makes an economic
profit.
– If price is less than average total cost, a firm incurs an economic
loss.
– If price equals average total cost, a firm breaks even, but it makes
normal profit.
Output, price, and profit in Perfect
Competition
• Long Run Adjustments: Industry adjust in two ways.
1 Entry and exit (figure 11.8)
– Temporary economic profit or temporary economic loss, like the win or
loss at a casino, do not trigger entry or exit. But the prospect of persistent
economic profit or loss does.
– Entry and exit influence price, the quantity produced and the economic
profit.
» Economic profit is a signal for new firms to enter the industry.
- As new firms enter and industry, the price falls and the
economic profit of each existing firm decreases.
» Economic loss is a signal for some firms to exit the industry.
- As firms exit and industry, the price rises and the
economic loss of each remaining firm decreases.
Output, price, and profit in Perfect
Competition
2 Changes in plant size (figure 11.9)
– A firm changes its plant size if, by doing so, it can lower its costs and
increase its economic profit.
• Long Run Equilibrium: it occurs in a competitive industry
when economic profit is zero (when firms earn normal
profit).
Changing Tastes and Advancing
Technology
• Permanent changes in Demand:
• Why do these happen?
• What are the effects in the equilibrium price, quantity and number
of firms in the market?
• Adjustment process:
– (Figure 11.10)
• Technological Change:
• It takes time
• Adjustment process:
– Two forces are at work in an industry undergoing technological change. Firms
that adopt the new technology make an economic profit. So there is entry by
new-technology firms. Firms that stick with the old technology incur economic
losses. They either exit the industry or switch to the new technology. As oldtechnology firms disappear and new technology firms enter, the price falls and
the quantity produced increases. Eventually, the industry arrives at a long-run
equilibrium in which all firms use the new technology and make a zero
economic profit.
Changing Tastes and Advancing
Technology
• Some important concepts:
– External Economies: these are factors beyond the control of an
individual firm that lower it costs as the industry output increases.
– External Diseconomies: are factors outside the control of a firm that
raise the firm’s costs as industry output increases.
– NOTE: With no external economies or diseconomies a firm’s cost remain
constant as the industry output changes.
– Long Run Industry Supply curve: shows how the quantity supplied by
an industry varies as the market price varies after all the possible
adjustments have been made. The slope of this curve is affected by the
existence of external economies or diseconomies (figure 11.11)
– Constant slope if none are present
– Upward sloping if external diseconomies are present
– Downward sloping if external economies are present.
Competition and Efficiency
• Efficient Use of Resources: this happen when we produce the
goods and services that people value most highly. If someone can
become better off without anyone else becoming worse off, resources
are not being used efficiently.
• Choices, Equilibrium and Efficiency. (figure 11.12)
– Choices:
• Consumers allocate their budgets to get the most value possible out of them. And we derive a
consumer’s demand curve by finding how the best budget allocation changes as the price of a
good changes.
• Competitive firms produce the quantity that maximizes profit. And we derive the firm’s supply
curve by finding the profit maximizing quantity at each price.
– Equilibrium:
• quantity demanded = quantity supplied
• price paid = consumer’s marginal benefit
• price received = producers marginal cost
– Efficiency:
• In absence of external benefits and external costs, competitive markets are in equilibrium,
when resources can not be reallocated to increase value.
Competition and Efficiency
• Efficiency of Perfect Competition
• Perfect competition achieves efficiency if there are no external benefits
or external costs. But there are three main obstacles to efficiency:
» Monopoly: Restricts output below its competitive equilibrium
» Public Goods: If left to competitive markets, too small a quantity
would be produced.
» External Costs and External Benefits: the quantity is efficient in the
market, but it harms or benefits other markets or society.
MONOPOLY
Market Power
• This is the ability to influence the market and in particular the market
price, by influencing the total quantity offered for sale.
• Monopoly: is an industry that produces a good or service for which
no close substitute exists and in which there is one supplier that is
protected from competition by a barrier preventing the entry of new
firms.
• How Monopoly arises:
• No close substitute
• Barriers to entry
– Legal Barriers
» Public Franchise, government license, patent and copyright
– Natural Barriers (figure 12.1): a firm can supply the entire market at a lower price
than two or more firms can.
Market Power
• Monopoly Price Setting Strategies:
– Price discrimination:
Which means that a firm sells different units of a good or service
for different prices. When a firm price discriminates, it looks as if it
is doing its customers a favor, but in fact it is charging them the
highest possible price for each unit sold and making the largest
possible profit.
– Single price:
Selling each unit of output for the same price to all of its
customers.
Single Price Monopoly’s Output
and Price Decision
• Price, Total Revenue and Marginal Revenue analysis.
– Total Revenue (TR): price times quantity sold
– Marginal Revenue (MR): is the change in total revenue resulting
from a one unit increase in the quantity sold.
– Different from the marginal revenue of perfect competition, why?
» In a Monopoly, since there is only one supplier, changes in quantity affect the price.
So as the supplier satisfies one more unit demanded the price will fall (figure 12.2),
notice that we are not talking about the quantity supplied, just quantity demanded.
• Marginal Revenue and the Price Elasticity of Demand
(figure 12.3).
• Elastic Demand
• Unit Elastic Demand
• Inelastic Demand.
– This analysis tells us that profit maximizing monopolies never produce an output in the
inelastic range of its demand curve. Why?
Single Price Monopoly’s Output and
Price Decision
• Output and Price Decision: (figure 12.4 and table 12.1)
– A monopoly, like a competitive firm, maximizes profit by
producing the output at which marginal cost equals marginal
benefit, in fact ALL FIRMS MAXIMIZE PROFIT WHEN
MARGINAL BENEFIT EQUALS MARGINAL COST!!
– For the monopoly, once we get that the quantity that will
maximize profit is for the quantity that makes Marginal Revenue
equals Marginal Cost, then we can see that price will be set
higher than Marginal Cost, given the consumers willingness to
pay for that quantity.
– By following this strategy the monopolist earns economic profits,
which in the competitive market would be the signal for the entry
of new firms, but in this case there are barriers for entry that
permit the existence of economic profits.
Single Price Monopoly Vs. Perfect
Competition
• How would you compare these two types of markets?
– Quantities? Price? How? (figure 12.5)
• A single-price monopoly, restricts its output and charges a higher price.
– Efficiency? (figure 12.6)
• By restricting output, then we have an underproduction, you must know how to solve
this one, right? …. Hint: consumer and producer surplus in addition to the deadweight
loss!!
– Redistribution of Surpluses:
some consumer surplus goes to the monopoly
– Rent seeking: (figure 12.7)
– Buy a Monopoly
– Create a Monopoly
NOTE: The average total cost curve, which includes the fixed cost of rent seeking, shifts upward
until it just touches the demand curve, economic profit is zero, now there is more deadweight loss!!
Price Discrimination
• Price discrimination is charging different prices for a single
good or service because of differences in buyer’s
willingness to pay and not because of differences in
production costs.
• To be able to price discriminate, a monopoly must:
• Identify and separate different buyers type.
• Sell a product that cannot be resold.
• At first sight it appears that price discrimination is against
all logic, why?
• Well, instead of decreasing profits it is actually increasing them, nice
trick right?
Price Discrimination
• Price Discrimination and Consumer Surplus:
– What would happen if we could sell each unit at the exact price that
the consumer of that unit is willing to pay, what would happen to
consumer surplus in this case?
• Discrimination Among Units of a good: Charges each buyer a different
price on each unit of a good bought. (usually this does not happen,
because discounts reflect the lower costs of production! Huh? , what?
• Discrimination Among Groups of Buyers: Price discrimination on the
basis of age, employment status, or some other EASILY distinguished
characteristic. (Now, this is what usually happens!)
– How do profits behave under this new context? (figure 12.8 and
12.9)
– An extreme case, Perfect Price Discrimination (figure 12.10)
Price Discrimination Monopoly Vs.
Perfect Competition
• Efficiency and Rent seeking with price discrimination.
– So, perfect price discrimination achieves efficiency!!
• The more perfectly the monopoly can price discriminate, the
closer its output gets to the competitive output and the more
efficient is the outcome
• It is as efficient as perfect competition, but it is not as good, why?
» Consumer surplus
» Rent seeking activities waste resources
Monopoly Policy Issues
• If it is so bad, why does it exists? Do we do anything about
it?
• Yes, there are laws that actually limit monopoly power and regulate the
prices that monopolies are permitted to charge, but monopoly also
brings some benefits: what??? HOW??
– Incentives to innovation
» Do innovations come faster with monopolies or with competition, well
we can not tell, but one thing is for sure the process of diffusion is
faster, new firms jump in the wagon faster.
– Economies of Scale and Scope:
» Where significant economies of scale or scope exist, it is usually
worth putting up with the monopoly and regulating its prices.
Monopoly Policy Issues
• Regulating Natural Monopoly* (figure 12.11)
– Profit maximization: Marginal Revenue = Marginal Cost
– But for efficiency, an efficient regulator would like to have Marginal
Benefit = Marginal Cost, which is the same as setting price equals
Marginal Cost. This is called the Marginal Cost pricing rule, and it gives
us an efficient outcome but the natural monopoly is incurring an
economic loss.
• A way to fix this is to price discriminate, charging higher prices to some
consumers and the marginal cost to others.
• Another way is know as the two part tariff: fixed with variable fees.
• Government subsidies, but these would require a tax from somewhere
else, and these taxes cause a deadweight loss in that market, so at the end
we would try to minimize the total deadweight loss.
• Follow the average cost pricing rule: The outcome is better for consumers
than with the unregulated case. (the firm earns normal profit.
Monopolistic Competition
and Oligopoly
• Coupons, fliers and price wars, what do they mean and
why do the exist?
• What are the decisions of the firms under these market
structures?
• How deep is our knowledge and understanding of these
markets?
MONOPOLISTIC COMPETITION
• Sometimes firms are competitive, but not as fiercely so as
perfect competition firms. In this type of market firms
posses some market power to set their prices, just as
monopolies do!
• The characteristics of this type of market:
–
–
–
–
Large number of firms
Differentiated product
Competition on product quality, price and marketing
Free entry and exit.
MONOPOLISTIC COMPETITION
• Implications of having a large number of firms:
– Small market share
– Ignore other firms
– Collusion is impossible
• Product differentiation
• Competing in:
– Quality
– Price: because of product differentiation, a firm in monopolistic
competition faces a downward-sloping demand curve. (like
monopoly!!)
– Marketing: convince that yours is better.
• Free entry and exit, implies that there are no economic
profits in the long run (incentives to go in or out exist)
Decisions and results.
• SHORT RUN
• The marginal revenue curve is derived in the same way as in the single price
monopolist case! (figure 13.2)
• In the short run the firm behaves as a single price monopolist, it produces the quantity
at which marginal revenue equals marginal cost and then charges the highest price
possible for this quantity.
• Economic Profit and Economic Loss in the Short Run. (figures 13.2 and 13.3)
• LONG RUN
• Zero economic profits!!
• What is the adjustment process? (figure 13.4)
• Efficiency (figure 13.5)
• Marginal Cost equals marginal benefit, but in this market, even though the firms make
zero economic profit in the long run equilibrium, the monopolistically competitive
industry produces an output at which price equals average total cost, but exceeds
marginal cost, so there is an excess capacity in the long run equilibrium.
• Output capacity: is the output at which average total cost is a minimum.
• The firms could sell more by lowering their prices, but they would incur losses.
• This market structure is inefficient, just like monopoly, but the inefficiency arises from
the product differentiation, so this loss must be weighed against the gain of greater
product variety.
Product Developing and Marketing
• Innovation and Product Development:
– Innovation is a necessity if a firm wants to enjoy economic profit
• Imitations
– Innovations increase the firm’s demand temporarily.
– Is Innovation efficient? Isn’t it just a waste of resources?
• Marketing
– Convince and emphasize the product differentiation, even if the
differences are small.
– What about the total costs of the firm? Do they increase with the
expenditures in marketing campaigns? What kind of costs are
they?
– If advertisement increases the quantity sold by a large amount,
then it can lower the average total cost. So what? (figure 13.5)
Product Developing and Marketing
• Selling Costs and Demand
– The Mark Up
– The effects on elasticity of demand
• Advertising to Signal Quality
• Brand Names
• Efficiency and Advertising of Brand Names
OLIGOPOLY
• Characteristics:
• Small number of firms
• Natural or legal barriers to entry
• Decisions depend on the decisions made by other firms
• The current models:
• Natural Oligopoly
• Kinked demand curve model (figure 13.11)
– If the firm raises its price, others will not follow.
– If it cuts its price, so will the others.
– The kink in the Demand curve causes a break in the marginal revenue
curve.
• Dominant firm oligopoly (figure 13.12)
– When one firm has a big cost advantage (the dominant one) over the
other firms and produces a large part of the industry output.
• These models do not match what is happening out there, so the new
fashion in economics is the use of Game theory to explain these type
Game Theory
• It is used to analyze strategic behavior (behavior that takes
in to account the behavior of others and the mutual
recognition of interdependence).
• Game theory seeks to understand oligopoly as well as
other forms of economics, political, social and even
biological rivalries.
• What must exist in order to have a game?
• The prisoners’ dilemma:
–
–
–
–
–
–
–
–
rules
strategies
Payoffs: Payoff matrix
Equilibrium
Nash Equilibrium
Dominant strategy equilibrium
The Dilemma
A Bad outcome
A better “economics” example
• An Oligopoly Price-Fixing Game: “The Duopoly example”
– Collusive agreement: “Cartel”
• Strategies: Comply and Cheat
• Actions: There are four of them
– Cost and Demand conditions (figure 13.13)
– If they collude (figure 13.14)
– If one firm cheats on a collusive agreement (figure 13.15)
– If both firms cheat (figure 13.16)
A better “economics” example
– If both firms cheat (figure 13.16)
– The payoff matrix (Table 13.2)
– Equilibrium
A better “economics” example
– Research and Development Game (Table 13.3)
– John Nash and Adam Smith: The Game of Chicken (Table 13.4)
– Repeated Games: The opportunity to penalize
– Cooperative Equilibrium: players make and share the monopoly profit.
– How to make this happen? (Table 13.5)
» Tit for tat Strategy
» Trigger strategy
– Price Wars
Two other Oligopoly games
• Sequential entry games: Contestable
Markets:
• Danger of the existence of entry incentives.
• The HHI signal is wrong?
• The Entry deterrence Game (figure 13.17)
– Payoffs
– Equilibrium
Economic Theory of the Government
• The economic theory of the government explains the
economic roles of governments, the economic choices
that they make, and the consequences of those choices.
• The government roles:
– Establish and maintain property rights and set rules for the
redistribution of income and wealth.
– Provide mechanisms for allocating scarce resources when the
market economy results in inefficiencies (Market Failures)
Economic Theory of the Government
Economic problems that governments and public
choices address:
1.
2.
3.
4.
5.
Monopoly and Oligopoly – Regulation and Antitrust laws
The provision of Public Goods
The use of Common Resources
Externalities
Income redistribution
Economic Theory of the Government
Monopoly and Oligopoly Regulation:
Government intervenes in monopoly and oligopoly
markets to influence prices, quantities produced,
and the distribution of the gains from economic
activity in two main ways:
– Regulation
– Antitrust Law
Economic Theory of the Government
Economic Theory of Regulation: There is always
demand and supply.
– Demand for regulation
– Supply for regulation
– Equilibrium: Social Interest Theory Vs. Capture
Theory
Economic Theory of the Government
•
The Cable Company Example (A Natural
Monopoly)
– Regulation in the Social Interests:
Marginal Cost = Price
•
•
Marginal Cost Pricing Rule (figure 14.2)
Average Cost Pricing Rule (figure 14.3)
– Rate of Return Regulation: It is already part of
the opportunity cost for the natural monopoly
•
Inflating Cost (figure 14.4)
Economic Theory of the Government
– Price Cap Regulation: A surprising result of an
effective price ceiling. (Why???) (figure 14.5)
•
Cartel Regulation: An Example (figure 14.6)
– Social Interest
– Capture Theory
– Cases
Economic Theory of the Government
•
Antitrust Law
– Policy Debates
•
•
•
Resale price maintenance
Tying arrangements
Predatory Pricing
– The Microsoft Case
– Merger Rules
– Social Interest
Economic Theory of the Government
•
Externalities
– Positive Production Externalities
– Negative Production Externalities
– Positive Consumption Externalities
– Negative Consumption Externalities
Economic Theory of the Government
• Production and Pollution how much?
–
–
–
–
Taking into account all costs (private and external)
Figure 15.3
Property Rights (Figure 15.4)
The Caose theorem
• Government actions in the face of
external costs (figure 15.5)
Economic Theory of the Government
•
Positive Externalities: An Example
– Education
– Figure 15.6
– Figure 15.7
•
Government actions in the face of external
costs (figure 15.8)
– Public provision or Private subsidies
Economic Theory of the Government
•
Provision of Public Goods
– Classification of Goods (figure 16.1)
– The Free Rider Problem and the problem of the
commons
– The benefit of a public good and the free rider
problem (figure 16.2)
•
•
•
•
Individual Marginal Benefits
Economy’s Marginal Benefits
Economy’s marginal benefit vs. market demand
The efficient quantity of a public good (figure 16.3)
Economic Theory of the Government
– The efficient quantity of a public good (figure
16.3)
– Private provision Vs. Public Provision
•
Common Resources
– The original problem
– A current example (Table 16.1)
•
•
Over fishing
Efficient use of the commons
– Property rights
– quotas
DEMAND AND SUPPLY IN
RESOURCE MARKET
• Why do differences in wages exist?
• How do return on savings influence the allocation of
savings across the many industries and activities that use
our capital resources?
• What causes the differences in the cost of the land?
Resource Prices and Income
• Goods and services are produced using the four economic
resources: labor, capital, land and entrepreneurship.
• Incomes are determined by resource prices and the
quantities used.
–
–
–
–
the wage rate for labor
the interest rate for capital
the rental rate for land
the rate of normal profit for entrepreneurship
• Because the price - quantity relation exist, then we can use
the usual law of demand and supply to analyze the
resource markets.
Labor Market
• The demand for labor is a derived demand, since it
depends on the quantity that is produced.
• Maximizing profit behavior: marginal benefit = marginal
cost
– We have: Marginal revenue earned by hiring one more worker = marginal cost of that worker.
– The change in total revenue that results from employing one or unit of labor is called the
marginal revenue product of labor. (table 14.1)
• You have marginal revenue and marginal product so multiply them to get the marginal
revenue product. (marginal revenue per worker)
• Diminishing Marginal Revenue product is caused by the characteristic of decreasing
marginal product!
Labor Market
• The labor demand curve:
• A firm’s marginal revenue product curve is also its demand for labor
curve!!
• If the wage rate is less than the marginal revenue product a firm
benefits if it hires one more unit of labor
• if the wage rates is higher than the marginal revenue product a firm
can increase its profit by employing one fewer worker.
• Then MRP = W is the profit maximizing condition.
• So we have two profit maximizing conditions: MRP = W and
MR = MC, what is the connection? (table 14.2)
• Changes in the demand for labor: (table 14.3)
• Movements along the demand curve for labor
• Shifts in the demand curve for labor
Labor Market
• Market demand of labor
• Elasticity of demand for labor: it measures the
responsiveness of the quantity of labor demanded to the
wage rate.
• It depends on:
– labor intensity of the production process
» the greater the degree of labor intensity, the more elastic is the
demand for labor.
– elasticity of demand for the product
» the greater is the elasticity of demand for the good, the greater larger
is the elasticity of demand for the labor used to produce it.
– substitutability of capital for labor
Labor Market
• The supply of labor
•
•
•
•
•
Substitution effect
Income effect
Backward-bending supply of labor curve
Market supply of labor
Changes in the supply of labor:
– Adult population
– Technological change and capital accumulation in home production
• Market Equilibrium (figure 14.2)
Labor Market
• Wage differentials (figure 18.7)
– The demand for High-Skilled and LowSkilled labor
– The Supply of High-Skilled and Low-Skilled
labor
– Wage Rates of H-S and L-S labor
• Do Education and training pay?
• Inequality explained by Human Capital
Differences
Labor Market
• Trends in Inequality Explained by Human
Capital trends (figure 18.8)
• Discrimination
– A simple setup (figure 18.9)
– Counteracting forces
– Differences in the degree of specialization
Capital Markets
• Through this market the firms get the financial resources to
buy physical capital resources. These financial resources
come from saving, and the price of capital, which adjusts
the market, is the interest rate.
• Demand for capital:
– If the marginal product of capital exceeds the cost of capital, then
the firm buys more capital. The problem is that the payment of
capital must be made today but the revenue comes in the future.
– To solve this problem, the firm must calculate the present value of
the future marginal products and compare this value to the existing
cost of capital and make the decision.
Capital Markets
• Discounting and Present Value
• The savings example:
next period value = deposit * (1+r)
two periods ahead value = next period * (1+r)
= [deposit * (1+r)] * (1+r) = deposit * (1+r)^2
• So the future value in the t-th period is equal to
future value in the t-th period = deposit * (1+ r)^t
• Moving terms around we can get the present value
Present value = deposit = [future value in the t-th period] / (1+r)^t
Capital Markets
• Net present Value (NPV) = Present Value - Cost
• If the NPV exceeds the cost then buy the capital.
• The effect of higher interest rates.
• The example of Taxfile’s Investment Decision (table 14.5)
• Demand curve for capital:
– Law of demand
– Changes in demand
• Population growth
• Technological change
Capital Markets
• The Supply of Capital
– It results from people’s decision to save money and these are
determined by:
• income
• expected future income
• interest rate
– Supply curve of capital
• changes in the supply of capital
• Equilibrium in the Capital Markets (figure 14.6)
Land and Exhaustible Natural
Resource Markets
• All natural resources are called LAND, and they fall in to
two categories:
– Nonexhaustible (land, rivers, lakes and rain)
– Exhaustible (oil, coal and natural gas)
– The supply of a Nonexhaustible natural resource: it is perfectly
inelastic (figure14.7)
– The supply of an exhaustible natural resource: perfectly elastic
(figure 14.8)
– Price and Hotelling Principle