Economics

Chapter 1 notesDefinition of EconomicsThe first thing that we should discuss is the definition of "economics." Economists generally defineeconomics as the study of how individuals and societies use limited resources to satisfy unlimited wants.To see how this concept works, think about your own situation. Do you have enough time available foreverything that you wish to do? Can you afford every item that you would like to own? Economistsargue that virtually everyone wants more of something. Even the wealthiest individuals in society do notseem to be exempt from this phenomenon.This problem of limited resources and unlimited wants also applies to society as a whole. Can you thinkof any societies in which all wants are satisfied? Most societies would prefer to have better health care,higher quality education, less poverty, a cleaner environment, etc. Unfortunately, there are not enoughresources available to satisfy all of these goals.Thus, economists argue that the fundamental economic problem is scarcity. Since there are not enoughresources available to satisfy everyone’s wants, individuals and societies have to choose amongavailable alternatives. An alternative, and equivalent, definition of economics is that economics is thestudy of how such choices are made.Economic Goods, Free Goods, and Economic BadsA good is said to be an economic good (also known as a scarce good) if the quantity of the gooddemanded exceeds the quantity supplied at a zero price. In other words, a good is an economic good ifpeople want more of it than would be available if the good were available for free.A good is said to be a free good if the quantity of the good supplied exceeds the quantity demanded at azero price. In other words, a good is a free good if there is more than enough available for everyone evenwhen the good is free. Economists argue that there are relatively few, if any, free goods.An item is said to be an economic bad if people are willing to pay to avoid the item. Examples ofeconomic bads include things like garbage, pollution, and illness.Goods that are used to produce other goods or services are called economic resources (and are alsoknown as inputs or factors of production). These resources are often categorized into the followinggroups:Land,Labor,Capital, andEntrepreneurial ability.The category of "land" includes all natural resources. These natural resources include the land itself, aswell as any minerals, oil deposits, timber, or water that exists on or below the ground. This category issometimes described as including only the "free gifts of nature," those resources that exist independentof human action.The labor input consists of the physical and intellectual services provided by human beings. Theresource called "capital" consists of the machinery and equipment used to produce output. Note that theuse of the term "capital" differs from the everyday use of this term. Stocks, bonds, and other financialassets are not capital under this definition of the term.Entrepreneurial ability refers to the ability to organize production and bear risks. Your text does not listthis as a separate resource, but instead considers it as a type of labor input. Most other introductory texts,though, list this as a separate resource. (No, your text is not wrong, it just uses a different way ofclassifying resources. I think it's better, though, to stick with the somewhat more standard classificationin this course.)The resource payment associated with each resource is listed in the table below:

Economic Resource Resource Payment

Land Rent

Labor wages

Capital interest

entrepreneurial ability profit

Rational Self-interestAs noted above, scarcity results in the need to choose among competing alternatives. Economists arguethat individuals pursue their rational self-interest when making choices. This means that individuals areassumed to select the alternative(s) that they believe will make them happiest, given the information thatthey possess at the time of the decision.Note that the term "self-interest" means something quite different than "selfish." Self-interested peoplemay donate their time to charitable organizations, give gifts to loved ones, contribute to charities andengage in other similarly altruistic activities. Economists assume, though, that altruistic people selectthese actions because they find these activities more enjoyable than available alternative activities.Economic MethodologyEconomic discussions may involve both positive and normative analysis. Positive analysis involvesattempts to describe how the economy functions. Normative economics relies on value judgments toevaluate or recommend alternative policies.As a social science, economics attempts to rely on the scientific method. The scientific method consistsof the following steps:Observe a phenomenon,Make simplifying assumptions and develop a model (a set of one or more hypotheses),Make predictions, andTest the model.If the model is rejected in step 4, formulate a new model. If the test fails to reject the model, conductadditional tests.Note that tests of a model can never prove that a model is true. A single test, however, may be used toestablish that a model is incorrect.Economists rely on the ceteris paribus assumption in constructing models. This assumption, translatedroughly as "other things constant," allows economists to simplify reality so that it may be more readilyunderstood.Logical fallaciesThe fallacy of composition occurs when one incorrectly attempts to generalize from a relationship that istrue for each individual, but is not true for the whole group. As an example of this, note that any personcan get a better view at a concert by standing (regardless of the actions of those in from of him or her). Itis incorrect, though, to state that everyone can get a better view if everyone stands.Similarly, one would commit the fallacy of composition if one were to claim that, since anyone couldincrease his or her wealth by stealing from his or her neighbors (assuming no detection), that everyonecan become wealthier if everyone steals from their neighbors.The association as causation fallacy, also known less technically as the post hoc, ergo propter hocfallacy, occurs if one incorrectly assumes that one event is the cause of another simply because itprecedes the other event. The Super Bowl example discussed in your text is a good example of thislogical fallacy.Microeconomics vs. MacroeconomicsMicroeconomics involves the study of individual economic agents and individual markets.Macroeconomics involves the study of economic aggregates.Alegbra and Graphical Analysis in Economics(This is a summary of some of the most important material in the appendix to Chapter 1.) Graphs areextensively used in economic analysis to represent the relationships that exist among economicvariables. Two simple types of relationships that may exist are direct and inverse relationships.A direct relationship is said to exist between two variables X and Y if an increase in X is alwaysassociated with an increase in Y and a decrease in X is associated with a decrease in Y. A graph of sucha relationship will be upward sloping, as in the diagram below.

A direct relationship may be linear (as in the diagram above), or it may be nonlinear (as in the diagramsbelow).

An inverse relationship is said to exist between the variables X and Y if an increase in X is alwaysassociated with a decrease in Y and a decrease in X is associated with an increase in Y. A graph of aninverse relationship will be downward sloping.

An inverse relationship may also be either linear or nonlinear (as illustrated below).

A linear relationship possesses a constant slope, defined as:

If an equation can be written in the form: Y = mX + b, then:m = slope, andb = y-intercept.

Chapter 2 notesAs noted in Chapter 1, economics is the study of how individuals and economies deal with thefundamental problem of scarcity. Since there are not enough available resources to satisfy the wants ofindividuals and societies, individuals and societies must make choices among competing alternatives.

Opportunity CostThe opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative.Let's consider a few examples of opportunity cost:Suppose that you own a building that you use for a retail store. If the next-best use of the building is torent it to someone else, the opportunity cost of using the business for your business is the rent you couldhave received. If the next-best use of the building is to sell it to someone else, the annual opportunitycost of using it for your own business is the foregone interest that you could have received (e.g., if theinterest rate is 10% and the building is worth $100,000, you give up $10,000 in interest each year bykeeping the building, assuming that the value of the building remains constant over the year --depreciation or appreciation would have to be taken into account if the value of the building changesover time).The opportunity class of attending college includes:the cost of tuition, books, and supplies (the costs of room and board only appear if these costs differfrom the levels that would have been paid in your next-best alternative),foregone income (this is usually the largest cost associated with college attendance), andpsychic costs (the stress, anxiety, etc. associated with studying, worrying about grades, etc.).If you attend a movie, the opportunity cost includes not only the cost of the tickets and transportation,but also the opportunity cost of the time required to view the movie.When economists discuss the costs and benefits associated with alternative activities, the discussiongenerally focuses on marginal benefits and marginal costs. The marginal benefit from an activity is theadditional benefit associated with a one-unit increase in the level of an activity. Marginal cost is definedas the additional cost associated with a one-unit increase in the level of the activity. Economists assumethat individuals attempt to maximize the net benefit associated with each activity.If marginal benefit exceeds marginal cost, net benefit will increase if the level of the activity rises.Therefore, rational individuals will increase the level of any activity when marginal benefit exceedsmarginal costs. On the other hand, if marginal cost exceeds marginal benefit, net benefit rises when thelevel of the activity is decreased. There is no reason to change the level of an activity (and net benefit ismaximized) at the level of an activity at which marginal benefit equals marginal cost.

Production Possibilities CurveScarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by aproduction possibilities frontier.For simplicity, it is assumed that a firm (or an economy) produces only two goods (this assumption isneeded only to make the representation feasible on a two-dimensional surface -- such as a graph onpaper or on a computer screen). When a production possibilities curve is drawn, the followingassumptions are also made:there is a fixed quantity and quality of available resources,technology is fixed, andthere are no unemployed nor underemployed resourcesVery shortly, we'll also see what happens when these assumptions are relaxed.For now, though, let's consider a simple example. Suppose that a student has four hours left to study forexams in two classes: introductory microeconomics and introductory calculus. The output in this case isthe exam score in each class. The assumption of a fixed quantity and quality of available resourcesmeans that the individual has a fixed supply of study materials such as textbooks, study guides, notes,etc. to use in the available time. A fixed technology suggests that the individual has a given level ofstudy skills that allow him or her to translate the review materials into exam scores. A resource isunemployed if it is not used. Idle land, factories, and workers are unemployed resources for a society.Underemployed resources are not used in the best possible way. Society would have underemployedresources if the best brain surgeons were driving taxis while the best taxi drivers were performing brainsurgery.... The use of an adjustable wrench as a hammer or the use of a hammer to pound a screw intowood provide additional examples of underemployed resources. If there are no unemployed orunderemployed resources, efficient production is said to occur.

The table below represents possible outcomes from each various combinations of time studying eachsubject:

# ofhoursspentstudyingcalculus

# ofhoursspentstudyingeconomics

calculusgrade

economicsgrade

0 4 0 601 3 30 552 2 55 453 1 75 304 0 85 0

Notice that each additional hour spent studying either calculus or economics results in smaller marginalimprovements in the grade. The reason for this is that the first hour will be spent studying the mostessential concepts. Each additional hour is spent on the "next-most" important topics that have notalready been mastered. (It is important to note that a good grade on an economics examination requiressubstantially more than four hours of study time.) This is an example of a general principle known as thelaw of diminishing returns. The law of diminishing returns states that output will ultimately increase byprogressively smaller amounts as additional units of a variable input (time in this case) are added to aproduction process in which other inputs are fixed (the fixed inputs here include the stock of existingsubject matter knowledge, study materials, etc.).To see how the law of diminishing returns works in a more typical production setting, consider the caseof a restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators, tables, etc.). Asthe level of labor use increases, output may initially rise fairly rapidly (since additional workers allowmore possibilities for specialization and reduces the time spent switching from task to task). Eventually,however, the addition of more workers will result in progressively smaller increases in output (sincethere is a fixed amount of capital for these workers to use). It is even possible that beyond some pointworkers may start getting in each others way and output may decline ("too many cooks may spoil thebroth...." sorry.... I couldn't resist).In any case, the law of diminishing returns explains why your grade will increase by fewer points witheach additional hour that you spend studying.The points in the table above can be represented by a production possibilities curve (PPC) such as theone appearing in the diagram below. Each point on the production possibilities curve represents the bestgrades that can be achieved with the existing resources and technology for each alternative allocation ofstudy time.

Let's consider why the production possibilities curve has this concave shape. As the diagram belowindicates, a relatively large improvement in economics grade can be achieved by giving up relativelyfew points on the calculus exam. A movement from point A to point B results in a 30-point increase ineconomics grade and only a 10-point reduction in calculus grade. The marginal opportunity cost of agood is defined to be the amount of another good that must be given up to produce an additional unit ofthe first good. Since the opportunity cost of 30 points on the economics test is a 10-point reduction in thescore on the calculus test, we can say that the marginal opportunity cost of one additional point on theeconomics test is approximately 1/3 of a point on the calculus test. (If in doubt, note that if 30 points onthe economics exam have an opportunity cost of 10 points, each point on the economics test must costapproximately 1/30th of 10 points on the calculus test -- approximately 1/3 of a point on the calculustest).

Now, let's see what happens a second hour is transferred to the study of economics. The diagram belowillustrates this outcome (a movement from point B to C). As this diagram indicates, transferring a secondhour from the study of mathematics to the study of economics results in a smaller increase in economicsgrade (from 30 to 45 points) and a larger reduction in calculus grade (from 75 to 55). In this case, themarginal opportunity cost of a point on the economics exam has increased to approximately 4/3 of apoint on the calculus exam.

The increase in the marginal opportunity cost of points on the economics exam as more time is devotedto studying economics is an example of the law of increasing cost. This law states that the marginalopportunity cost of any activity rises as the level of the activity increases. This law can also beillustrated using the table below. Notice that the opportunity cost of additional points on the calculusexam rises as more time is devoted to studying calculus. Reading from the bottom of the table up to thetop, you can also see that the opportunity cost of additional points on the economics exam rises as moretime is devoted to the study of economics.

One of the reasons for the law of increasing cost is the law of diminishing returns (as in the exampleabove). Each extra hour devoted to the study of economics results in a smaller increase in the economicsgrade and a larger reduction in the calculus grade because of diminishing returns to time spent on eitheractivity.A second reason for the law of increasing cost is the fact that resources are specialized. Some resourcesare better suited for some some types of productive activities than for other types of production.Suppose, for example, that a farmer is producing both wheat and corn. Some land is very well suited forgrowing wheat, while other land is relatively better suit for growing corn. Some workers may be moreadept at growing wheat than corn. Some farm equipment is better suited for planting and harvestingcorn.The diagram below illustrates the PPC curve for this farmer.

At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmer musttransfer resources from corn production to wheat production. Initially, however, he or she will transferthose resources that are relatively better suited for wheat production. This allows wheat production toincrease with only a relatively small reduction in the quantity of corn produced. Each additional increasein wheat production, however, requires the use of resources that are relatively less well suited for wheatproduction, resulting in a rising marginal opportunity cost of wheat.Now, let's suppose that this farmer either does not use all of the available resources, or uses them in aless than optimal manner (i.e., either unemployment or underemployment occurs). In this case, thefarmer will produce at a point that lies below the production possibilities curve (as illustrated by point Ain the diagram below).

In practice, all firms and all economies operate below their production possibilities frontier. Firms andeconomies, however, generally attempt to get as close to the frontier as possible.Points above the production possibilities cannot be produced using current resources and technology. Inthe diagram below, point B is not obtainable unless more or higher quality resources become availableor technological change occurs.

An increase in the quantity or quantity of resources will cause the production possibilities curve to shiftoutward (as in the diagram below). This type of outward shift could also be caused by technologicalchange that increases the production of both goods.

In some cases, however, technological change will only increase the production of a specific good. Thediagram below illustrates the effect of a technological change in wheat production that does not affectcorn production.

Specialization and tradeIn The Wealth of Nations, Adam Smith argued that economic growth occurred as a result ofspecialization and division of labor. If each household produced every commodity it consumed, the totallevel of consumption and production in a society will be small. If each individual specializes in the

productive activity at which they are "best," total output will be higher. Specialization provides suchgains because it:allows individuals to specialize in those activities in which they are more talented,individuals become more proficient at a task that they perform repeatedly, andless time is lost switching from task to task.Increased specialization by workers requires a growth in trade. Adam Smith argued that growingspecialization and trade was the ultimate cause of economic growth.Adam Smith and David Ricardo argued that similar benefits accrue from international specialization andtrade. If each country specializes in the types of production at which they are best suited, the totalamount of goods and services produced in the world economy will increase. Let's examine thesearguments a bit more carefully.There are two measures that are commonly used to determine whether an individual or a country is"best" at a particular activity: absolute advantage and comparative advantage. These two concepts areoften confused. An individual (or country) possesses an absolute advantage in the production of a goodif the individual (or country) can produce more than can other individuals (or countries). An individual(or country) possesses a comparative advantage in the production of a good if the individual (or country)can produce the good at the lowest opportunity cost.Let's examine an example illustrating the difference between these two concepts. Suppose that the U.S.and Japan only produced two goods: CD players and wheat. The diagram below represents productionpossibilities curves for these two countries. (These numbers are obviously hypothetical....)

Notice that the U.S. has an absolute advantage in the production of each commodity. To determine whohas a comparative advantage, though, it is necessary to compute the opportunity cost for each good. (It isassumed that the PPC is linear to simplify this discussion.)The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan, the opportunitycost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan possesses a comparative advantagein CD player production.The U.S. however, has a comparative advantage in wheat production since the opportunity cost of a unitof wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of a unit of CD players in Japan.If each country specializes in producing the good in which it possesses a comparative advantage, it canacquire the other good through trade at a cost that is less than the opportunity cost of production in thedomestic economy. For example, suppose that the U.S. and Japan agree to trade one unit of CD playersfor 1.6 units of wheat. The U.S. gains from this trade because it can acquire a unit of CD players for 1.6units of wheat, which is less than the opportunity cost of producing CD players domestically. Japangains from this trade since it's able to trade one CD player for 1.6 units of wheat while it only cost Japan4/3 of a unit of wheat to produce a unit of CD players.If each country produces only those goods in which it possesses a comparative advantage, each good isproduced in the global economy at the lowest opportunity cost. This results in an increase in the level oftotal output.

Chapter 3In this chapter, we will examine how markets determine the price of goods and the quantity sold andconsumed. A market is a set of arrangements for the exchange of a good or a service.Barter vs. marketsA barter system is a market system in which goods or services are traded directly for other goods orservices. If you agree to repair your neighbor's computer in return for his or her assistance in paintingyour house, you have engaged in a barter transaction. While a barter system may be able to functioneffectively in a simple economy in which a limited variety of goods are produced, it cannot functionwell in a complex economy that produces an extensive collection of goods and services. The primaryproblem associated with a barter system is that any trade requires a double coincidence of wants. Thismeans that trade can only take place if each person wants what the other person is willing to trade and iswilling to give up what the other person wants. In a developed economy in which a diverse collection ofgoods and services are produced, locating someone willing to make the trade that you desire may bequite difficult and costly. If you repair TVs and are hungry, you must find someone with a broken TVwho is willing to trade food for TV repairs. Because it is costly to arrange such a transaction, economistsnote that barter transactions have relatively high transactions costs.For this reason, throughout recorded history virtually all societies have used some form of money tofacilitate trade. In a monetary economy, individuals trade goods or services for money and then use thismoney to buy the goods or services that they wish to acquire. Since money can be traded for any good orservice, the use of money eliminates the need for a double coincidence of wants and lowers thetransaction costs associated with trade.Relative and nominal pricesThe opportunity cost of acquiring a good or a service under either a barter or a monetary economy maybe measured by the relative price of the commodity. The relative price of a commodity is a measure ofhow expensive a good is in terms of units of some other good or service. Under a barter system, therelative price is nothing more than the trading ratio between any two goods or services. For example, ifone laser printer is traded for 2 ink-jet printers, the relative price of the laser printer is two ink-jetprinters. Alternatively, the relative price of an inkjet printer is one-half of a laser printer in this case. In amonetary economy, relative prices can also be easily computer using the ratio of the prices of thecommodities. If, for example, a soccer ball costs $20 and a portable CD player costs $60, the relativeprice of a portable CD player is 3 soccer balls (and the relative price of a soccer ball is 1/3 of a CDplayer). Economists ague that individuals respond to changes in relative prices since these prices reflectthe opportunity cost of acquiring a good or service.In a market economy, the price of a good or service is determined through the interaction of demand andsupply. To understand how market price is determined, it is important to know the determinants of bothdemand and supply. Let's first examine the demand for a good.DemandThe demand for a good or service is defined to be the relationship that exists between the price of thegood and the quantity demanded in a given time period, ceteris paribus. One way of representingdemand is through a demand schedule such as the one appearing below:

Note that the demand for the good is the entire relationship that is summarized by this table. Thisdemand relationship may also be represented by a demand curve (as illustrated below).

Both the demand schedule and the demand curve indicate that, for this good, an inverse relationshipexists between the price and the quantity demanded when other factors are held constant. This inverserelationship between price and quantity demanded is so common that economists have called it the lawof demand:

An inverse relationship exists between the price of a good and the quantitydemanded in a given time period, ceteris paribus.

As noted above, demand is the entire relationship between price and quantity, as represented by ademand schedule or a demand curve. A change in the price of the good results in a change in thequantity demanded, but does not change the demand for the good. As the diagram below indicates, anincrease in the price from $2 to $3 reduces the quantity of this good demanded from 80 to 60, but doesnot reduce demand.

Change in demand vs. change in quantity demandedA change in demand occurs only when the relationship between price and quantity demanded changes.The position of the demand curve changes when demand changes. If the demand curve becomes steeperor flatter or shifts to the right or the left, we can say that demand has changed. The diagram belowillustrates a shift in the demand for a good (from D to D'). Notice that a rightward shift in the position ofthe demand curve is said to be an increase in demand since a larger quantity is demanded at each price.

Market demandThe market demand consists of the total quantity demanded by each individual in the market.Conceptually, the market demand curve is formed by computing the horizontal summation of theindividual demand curves for all consumers. The diagram below illustrates this process. This diagramillustrates a simple case in which there are only two consumers, Person A and Person B. Notice that thetotal quanity demanded in the market is just the sum of the quantities demanded by each individual. Inthis diagram, Person A wished to buy 10 of this commodity and person B wishes to buy 15 units whenthe price is $3. Thus, at a price of $3, the total quantity demanded in the market is 25 (=10+15) units ofthis commodity.

Of course, this example is highly simplified since there are many buyers in most real-world markets.The same principle, though would hold: the market demand curve is derived by adding together thequantities demanded by all consumers at each and every possible price.Determinants of demandLet's examine some factors that might be expected to change demand for most goods and services.These factors include:tastes and preferences,the prices of related goods,income,the number of consumers, andexpectations of future prices and income.Obviously, any change in tastes that raises the evaluation of a good will result in an increase in thedemand for a good (as illustrated below). Those who remember the short-term increases in demand thatoccurred with slap bracelets, pogs, hypercolor t-shirts, beanie babies, Tickle-Me-Elmos, etc., can attest

to the effect of changing tastes on demand. Fads will often increase the demand for a good for at least ashort period of time.

Demand will also decline if tastes change so the consumption of a good becomes less desirable. As fadsfade away, the demand for the products falls (as illustrated below).

Goods may be related in consumption as either:substitute goods, orcomplementary goods.Two goods are said to be substitute goods if an increase in the price of one results in an increase in thedemand for the other. Substitute goods are goods that are often used in place of each other. Chicken andbeef, for example, may be substitute goods. Coffee and tea are also likely to be substitute goods. Thediagram below illustrates the effect of an increase in the price of coffee. A higher price of coffee reducesthe quantity of coffee demanded, but increases the demand for tea. Note that this involves a movementalong the demand curve for coffee since this involves a change in the price of coffee. (Remember: achange in the price of a good, ceteris paribus, results in a movement along a demand curve; a change indemand occurs when something other than the price of the good changes.)

Economists say that two goods are complementary goods if an increase in the price of one results in areduction in the demand for the other. In most cases, complementary goods are goods that are consumedtogether. Examples of likely pairs of complementary goods include:peanut butter and jelly,bicycles and bicycle safety helmets,cameras and film,CDs and CD players, andDVDs and DVD players.The diagram below illustrates the effect of an increase in the price of DVDs. Note that an increase in theprice of DVDs would reduce both the quantity of DVDs demanded and the demand for DVD players.

It is expected that the demand for most goods will increase when consumer income rises (as illustratedbelow). Think about your demand for CDs, meals in restaurants, movies, etc. Is it likely that you wouldincrease your consumption of most commodities if your income increases. (Of course, it is possible thatthe demand for some goods -- such as generic foods, Ramen noodles, and other similar commodities --may decline as your income rises. We'll examine this possibility in more detail in Chapter 6.)

Since the market demand curve consists of the horizontal summation of the demand curves of all buyersin the market, an increase in the number of buyers would cause demand to increase (as illustratedbelow). As the population rises, the demand for cars, TVs, food, and virtually all other commodities, isexpected to increase. A decline in population will result in a reduction in demand.

Expectations of future prices and income are also important determinants of the current demand for agood. First, let's talk about the effect of a higher expected future price. Suppose that you have beenconsidering buying a new car or a new computer. If you acquire new information that leads you tobelieve that the future price of this commodity will increase, you are probably going to be more likely tobuy it today. Thus, a higher expected future price will increase current demand. In a similar manner, areduction in the expected future price will result in a reduction in current demand (since you'd prefer topostpone the purchase in anticipation of a lower price in the future).If expected future income rises, demand for many goods today is likely to rise. On the other hand, ifexpected future income falls (perhaps because of rumors of future layoffs or the beginning of arecession), individuals may reduce their current demand for goods so that they can save more today inanticipation of the lower future income.International effectsWhen international markets are taken into account, the demand for a product includes both domestic andforeign demand. An important determinant of foreign demand for a good is the exchange rate. Theexchange rate is the rate at which the currency of one country is converted into the currency of anothercountry. Suppose, for example, that one dollar exchanges for 5 French francs. In this case, the dollarvalue of one French franc is $.20. Notice that the exchange rate between dollars and francs is the

reciprocal of the exchange rate between francs and dollars. If the value of the dollar rises in terms of aforeign currency, the value of the foreign currency will fall relative to the dollar. This is a quite intuitiveresult. An increase in the value of the dollar means that the dollar is worth more relative to the foreigncurrencies. In this case, the foreign currencies have to be worth less in terms of dollars.When the value of the domestic currency rises relative to foreign currencies, domestically producedgoods and services become more expensive in foreign countries. Thus, an increase in the exchange valueof the dollar results in a reduction in the demand for U.S. goods and services. The demand for U.S.goods and services will rise, however, if the exchange value of the dollar declines.SupplySupply is the relationship that exists between the price of a good and the quantity supplied in a giventime period, ceteris paribus. The supply relationship may be represented by a supply curve:

or a supply schedule:

Just as there is a "law of demand" there is also a "law of supply." The law of supply states that:A direct relationship exists between the price of a good and the quantity supplied ina given time period, ceteris paribus.

To understand the law of supply, it's helpful to remember the law of increasing cost. Since the marginalopportunity cost of supplying a good rises as more is produced, a higher price is required to induce theseller to sell more of the good or service.The law of supply indicates that supply curves will be upward sloping (as in the diagram below).

Change in quantity supplied vs. change in supplyAs in the case of demand, it is important to distinguish between a change in supply and a change inquantity supplied. A change in the price of a good results in a change in the quantity supplied. A changein the price changes the quantity supplied, as noted in the diagram below.

A change in supply occurs when the supply curve shifts, as in the diagram below. Note that a rightwardshift in the supply curve indicates an increase in supply since the quantity supplied at each priceincreases when the supply curve shifts to the right. When supply decreases, the supply curve shifts to theleft.Market supplyThe market supply curve is the horizontal summation of all individual supply curves. The derivation ofthis is equivalent to that illustrated above for demand curves.Determinants of supplyThe factors that can cause the supply curve to shift include:the prices of resources,technology and productivity,the expectations of producers,the number of producers, andthe prices of related goods and services.An increase in the price of resources reduces the profitability of producing the good or service. Thisreduces the quantity that suppliers are willing to offer for sale at each price. Thus, an increase in the

price of labor, raw material, capital, or other resource, will be expected to result in a leftward shift insupply (as illustrated below).

Technological improvements and changes that increase the productivity of labor result in lowerproduction costs and higher profitability. Supply increases in response to this increase in the profitabilityof production (as illustrated below).

As in the case of demand, expectations can play an important role in supply decisions. If, for example,the expected future price of a gasoline rises, refiners may decide to supply less today so that they canstockpile gas for sale at a later date. Conversely, if the expected future price of a good falls, currentsupply will increase as sellers try to sell more today before the price declines.An increase in the number of producers results in an increase (a rightward shift) in the market supplycurve (as illustrated below).

Since firms generally produce (or, at least, are able to produce) more than one commodity, they have todetermine the optimal balance among all of the goods and services that they produce. The supplydecision for a particular good is affected not only by the price of the good, but also by the price of othergoods and services the firm may produce. For example, an increase in the price of corn may induce afarmer to reduce the supply of wheat. In this case, an increase in the price of one product (corn) reducesthe supply of another product (wheat). It is also possible, but less common, that an increase in the priceof one commodity may increase the supply of another commodity. To see this, consider the productionof both beef and leather. An increase in the price of beef will cause ranchers to raise more cattle. Sincebeef and leather are jointly produced from cows, the increase in the price of beef will also be expected toresult in an increase in the supply of leather.International effectsIn our increasingly global economy, firms often import raw materials (and sometimes the entire product)from foreign countries. The cost of these imported items will vary with the exchange rate. When theexchange value of a dollar rises, the domestic price of imported inputs will fall and the domestic supplyof the final commodity will increase. A decline in the exchange value of the dollar will raise the price ofimported inputs and reduce the supply of domestic products that rely on these inputs.EquilibriumLet's combine the market demand and supply curves on one diagram:

It can be seen that the market demand and supply curves intersect at a price of $3 and a quantity of 60.This combination of price and quantity represents an equilibrium since the quantity demanded equals thequantity supplied. At this price, each buyer is able to buy all that he or she desires and each firm is able

to sell all that it desires to sell. Once this price is achieved, there is no reason for the price to either riseor fall (as long as neither the demand nor the supply curve shifts).

If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds quantitydemanded). This situation is illustrated in the diagram below. The presence of a surplus would beexpected to cause firms to lower prices until the surplus disappears (this occurs at the equilibrium priceof $3).

If the price is below the equilibrium, a shortage occurs (since quantity demanded exceeds quantitysupplied). This possibility is illustrated in the diagram below. When a shortage occurs, producers will beexpected to increase the price. The price will continue to rise until the shortage is eliminated when theprice reaches the equilibrium price of $3.

Shifts in demand and supplyLet's examine what happens if demand or supply changes. First, let's consider the effect of an increase indemand. As the diagram below indicates, an increase in demand results in an increase in the equilibriumlevels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity (as illustratedbelow).

An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated below.)

Price ceilings and price floorsA price ceiling is a legally mandated maximum price. The purpose of a price ceiling is to keep the priceof a good below the market equilibrium price. Rent controls and regulated gasoline prices during

wartime and the energy crisis of the 1970s are examples of price ceilings. As the diagram belowillustrates, an effective price ceiling results in a shortage of a commodity since quantity demandedexceeds quantity supplied when the price of a good is kept below the equilibrium price. This explainswhy rent controls and regulated gasoline prices have resulted in shortages.

A price floor is a legally mandated minimum price. The purpose of a price floor is to keep the price of agood above the market equilibrium price. Agricultural price supports and minimum wage laws areexample of price ceilings. As the diagram below illustrates, an effective price floor results in a surplus ofa commodity since quantity supplied exceeds quantity demanded when the price of a good is kept belowthe equilibrium price.

Chapter 4In this chapter, we'll examine the operation of markets a bit more carefully. Initially, it will be assumedthat there are no barriers to the efficient functioning of markets. We'll examine what happens whenmarkets work less efficiently when we discuss Chapter 5.Market coordinationProduction in modern economies is an extremely complex activity. Consider the computer that you arecurrently using. It consists of components and raw materials that were probably made in thousands offirms located in dozens of countries. Somehow, the glass, plastic, metal, silica, and other raw materialswere all combined into the monitor, computer chips, mother board, and other components that form thiscomputer. It is interesting to note that the computer you are using contains dramatically more computingpower than the mainframe computers of 20 years or so ago. How did all of these raw materials getconverted into this computer? Well, it all happened through market processes. All but the most primitiveeconomies rely on markets to coordinate many productive decisions (yes, this was even true in theformer Soviet Union -- it has been estimated that 50% or more of all output was sold in the unofficialunderground market economy).Markets and the "three fundamental questions"All economies, no matter what their form of economic organization, must address what are known as the"three fundamental questions:"What?How?For Whom?Let's examine each of these questions.What?The first question can be rephrased as: "What mix of goods and services will be produced?" In a marketeconomy, the interaction of self-interested buyers and sellers determines the mix of goods and servicesthat are produced. Adam Smith, writing in the Wealth of Nations argued that competition among self-interested producers results in an outcome that benefits all of society. Two quotes from Smith help toillustrate this argument:It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, butfrom their regard to their self-interest. (Book I, Chapter I)[A producer,]...by directing that industry in such a manner as its produce may be of the greatest value,he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand topromote an end which was no part of his intention. Nor is it always the worse for the society that it wasno part of it. By pursuing his own interest he frequently promotes that of the society more effectuallythan when he really intends to promote it. I have never known much good done by those who affected totrade for the public good. It is an affectation, not very common among merchants, and very few wordsneed be employed in dissuading them from it. (Book IV, Chapter II)This argument suggests that competition among self-interested producers forces them to produce goodsthat satisfy consumer wants. In seeking his or her own profit, each producer attempts to produce higherquality products that better serve consumer needs. This leads to a condition of consumer sovereignty inwhich it is ultimately the consumer who determines what mix of goods and services will be produced.Some economists, such as John Kenneth Galbraith, have questioned this argument and suggest that

marketing activities by large corporations can substantially influence the pattern of consumer demand.Most economists argue, though, that while marketing methods may influence consumer demand in theshort run, consumers ultimately determine what goods and services that they will buy. Effectiveadvertising campaigns may lead to phenomena such as pet rocks and Chia Pets, but these fads aregenerally fairly short-lived.If, for whatever reason, consumers want more of a good, this results in an increase in demand. In theshort run, this increase in demand results in higher prices, increased output, and a higher level of profitfor firms in this industry. In response to these profits, however, new firms will enter the market in thelong run, resulting in an increase in market supply. This increase in supply will drive the price backdown while further increasing the quantity sold. The short-run profits generated by the increase indemand gradually disappear as the price declines. Thus, the long-run response to an increase in demandis an increase in the amount produced. (Notice how this is consistent with the concept of consumersovereignty.)How?

The second fundamental question may be more completely stated as: "How is output produced?" This question involves the determination ofthe mix of resources that are to be used to produce output. In a market economy, profit-maximizing producers will be expected to select a mix

resources that result in the lowest possible level of cost (holding the quantity and quality of output constant). New production techniqueswill be adopted only if they reduce production costs. Sellers of resources will supply them to those activities in which they are most highlyvalued. Once again, Smith's "invisible hand of the market" guides resources into their most valued uses.

For whom?This third fundamental question deals with the issue of "who gets what?" In a market economy, this isdetermined by the interaction of buyers and sellers in both output and resource markets. The distributionof income is ultimately determined by the wages, interest payments, rents, and profits that aredetermined in resource markets. Those with more highly valued land, labor, capital, and entrepreneurialability receive higher incomes. Given this distribution of income, individuals make their own decisionsconcerning how much of each good to buy in output markets.The three fundamental questions and governmentOf course, in any real-world economy, markets do not make all of these decisions. In all societies,governments influence what will be produced, how output will be produced, and who receives thisoutput. Government spending, health and safety regulations, minimum wage laws, child labor laws,environmental regulations, tax systems, and welfare programs all have a significant effect on anysociety's answers to these questions. We'll examine many of these topics in the next chapter. For now,we'll focus on a simple market economy. In this simple economy, there are three participants in theprivate sector: households, firms, and foreign countries.HouseholdA household, as defined by the Census Bureau, consists of one or more individuals that share livingquarters.Types of firmsThere are three possible types of firms:sole proprietorship,partnership, andcorporation.A sole proprietorship is a firm that has a single owner. The main advantage of this form of ownership isthat it provides the owner with autonomy (the ability to be his or her own boss). There are, though, a fewdisadvantages. Because of the high failure rate for newly founded sole proprietorships, it is difficult toacquire funds to acquire physical capital. The owners also face unlimited liability. This means that theirpersonal wealth is at risk if the business fails or is sued. While sole proprietorships are the most commonform of firm, most are very small. Sole proprietorships account for a very small proportion of total salesin the U.S. economy.Partnerships are firms in which two or more individuals share ownership. This form of businessorganization provides an advantage over sole proprietorships by allowing owners to pool their wealth,skills, and resources. The cost of this pooling of resources is some loss in autonomy for the owners. Asin the case of sole proprietorships, partnerships are subject to unlimited liability.

A corporation is a business that exists as a legal entity separate from the owners. The corporation canenter contracts, own property, and borrow money as if it were a person. The stockholders of thecorporation own the corporation. If the corporation declares bankruptcy, however, only the assets of thecorporation are at risk. The owners' personal assets are not at risk (their only loss would be the wealthused to acquire the stock). This results in a situation in which the owners only have "limited liability."Offsetting this advantage is that corporate income is subject to double taxation. Any profits received bythe corporation are subject to a corporate income tax before they are distributed as dividends to thestockholders. The dividends that are received by stockholders are taxed once again as personal incomefor the owners.As your text notes, most output in the U.S. is produced in relatively large firms. Corporations accountfor the largest component of this output.Multinational business has become increasingly important during the past several decades. Multinationalbusinesses are firms that own and operate production facilities in more than one country.International tradeDuring the past decade, there has been a substantial increase in the volume of international trade. Theinternational sector's contribution to the economy includes both imports and exports. When U.S. exportsexceed imports, a trade surplus is said to occur; a trade deficit occurs when imports exceed exports.Circular flowThe circular flow diagram below illustrates the flows of goods, services, and resources betweenhouseholds and firms. As this diagram illustrates, firms provide households with goods and serviceswhile households provide firms with the economic resources (land, labor, capital, and entrepreneurialability) that is needed to produce this output.

The monetary flows accompanying the flows of goods, services, and resources have been added to thediagram below. As this diagram illustrates, households pay for goods and services using the income theyreceive by supplying resources. The interrelationship between output and resource markets is obviousfrom this diagram. Households are able to afford goods and services only as a result of the income theyreceive from firms. Similarly, firms are only able to pay wages, interest, rent, and profits as a result ofthe revenue they receive from selling goods and services to households.

The diagram above, though is a bit of an oversimplification. Not all income received by households isspent on goods and services; some income is saved. This saving represents a leakage of spending fromthe circular flow. Fortunately, investment provides an "injection" of additional spending that offsets thisleakage. As the diagram below indicates, financial intermediaries bring borrowers and lenders. Thisallows the saving of households to become a source of finance for investment spending by firms.

The diagram above does not take international trade into account. Imports represent an additional flowof goods and services into the domestic economy while exports represent an outward flow of goods andservices. The level of net exports is equal to exports minus imports. If net exports is positive, there is anet outflow of goods and services. A negative level of net exports results in a net inflow of goods andservices. Payments for net exports will represent a net addition to the circular flow when net exports arepositive but will involve a net leakage when net exports are negative.

Chapter 5The focus of this chapter is on the role of government in the economy. Markets do not always behave asefficiently as suggested in Chapter 4. When markets result in economic inefficiency, it may be possiblefor government to correct for this market failure.Government in the circular flowYour text has an elaborate circular flow diagram (on p. 111) that adds government to the private sectorflows that were discussed earlier. This diagram is a bit too complex to recreate here, so it may be helpfulto refer to the diagram in the text. As this diagram indicates, the government collects taxes from bothhouseholds and firms and provides government services in return.To produce government services, the government buys resources from households and purchases goodsand services from firms. In return, the government provides resource payments to households andpayments for the goods and services it acquires from firms.In terms of the injections and leakages that were discussed earlier, taxes represent a leakage from thecircular flow of income while government spending represents an injection of purchasing power.Economic and technical efficiency

Technical efficiency is said to occur when the economy operates on the production possibilities curve. Inthis case, there are no unemployed and no underemployed resources. Economic efficiency is a moregeneral concept that occurs when any change that benefits someone would result in harm for someoneelse. Note that technical efficiency is a necessary condition for economic efficiency since a movementtoward the production possibilities curve would benefit one or more individuals.When there are no market imperfections (several types of market imperfections will be discussedbelow), markets result in a state of economic efficiency. This occurs because voluntary trade in a marketeconomy always benefits both parties to the transaction (as long as both parties have perfect informationabout the quality of the commodity being exchanged). A seller is only willing to sell something if he orshe receives more benefit from the monetary payment than from the continued possession of the itembeing sold. A buyer is only willing to buy something if he or she prefers the commodity to thealternative items that could be purchased with the monetary payment. Trade will take place in a marketeconomy until all potential gains from trade are exhausted and economic efficiency occurs.Of course, however, this only occurs when there are no imperfections that interfere with the workings ofthis "ideal" market. There are several cases in which markets will not achieve economic efficiency.Market failure may occur as the result of:imperfect information,externalities,public goods,the absence of property rights,monopoly, ormacroeconomic instability.Imperfect informationThe effect of imperfect information on economic efficiency should be fairly obvious. Buyers or sellersmay not gain from voluntary trade if they do not know the quality of the product being bought or sold. Isuspect that everyone has made at least one purchase that they regretted later. Government may correctfor this type of market failure by:requiring that product labels list ingredients,mandating warning labels on products that may be dangerous,requiring guarantees for some products (such as the "lemon law" for used cars),banning fraudulent claims and requiring "truth in advertising,"licensing workers in certain professions, andby providing public information about products.ExternalitiesExternalities are side effects of production or consumption activities that affect parties not directlyinvolved in the transaction. Positive externalities occur when parties not involved in the transactionbenefit from the transaction. Negative externalities occur when third parties are harmed. If someonepaints their house, shovels snow from the sidewalk in front of their dwelling, receives a vaccine for acontagious diseases, or removes junk cars from their lawn, positive externalities occur. Negativeexternalities occur as a result of pollution, loud music played by neighbors (assuming that you do notenjoy their choice or timing of music), fills the air with cigarette or cigar smoke, or engages in otheractivities that harm others.When positive externalities are present, those engaged in the transaction do not take into account theexternal social benefits that result from their actions. As a result, the commodity or activity thatgenerates the positive externality is underproduced in a market economy. Government may correct forthis by subsidizing the activity or issuing regulations or mandates that require a higher level of theactivity. For example, the government both subsidizes education and mandates that individuals attendschool through at least age 16. The government also subsidizes vaccines and mandates that all school-age children receive vaccines before being allowed to attend school.Negative externalities, on the other hand, result in social costs that are not taken into account by thoseengaged in the activity. In this case, markets will result in overproduction of the commodity or activitythat generates the externality. Government may attempt to correct for this by taxing the activity or byissuing regulations designed to reduce the level of the activity. Government sets limits, for example, on

the level of emissions of many chemicals and compounds that may be released into the air and water. Italso taxes cigarettes and imposes restrictions on areas in which smoking is allowed.The use of taxes or subsidies to correct for externalities is referred to as "internalizing the externality"since it involves altering the price of the commodity to reflect the external costs or benefits of theactivity.Public goodsA public good is a good that is nonrival in consumption. This means that one person's consumption doesnot reduce the quantity or quality of the good available to other consumers. Examples of public goodsinclude national defense and TV and radio signals broadcast through the air. Some public goods havesome congestion costs in which the benefits do decline a bit as the number of people consuming themrises. Town parks, highways, police and fire protection, and other similar commodities and services fitthis definition.The problem with public goods is that no individual has an incentive to pay for the good. Since it isinefficient, and not always feasible, to exclude people from consuming a public good, people canconsume it even if they do not pay for it at all. In such a situation, each person has an incentive to be a"free rider" and to let others pay for the good. The problem, of course, is that the good will be eitherunderproduced or not produced at all if the provision of such goods were left to the market.The government attempts to correct for this type of market failure by either providing or subsidizing theproduction of public goods.The absence of property rightsA related problem occurs when no one has private property rights to a good. This problem occurs in thecase of common property resources in which no individual has private property rights. When everyoneshares ownership of some resource, each individual receives all of the benefits from using the resource,but the costs are shared by everyone. Consider, for example, the case of whales, buffalo, fisheries, andsimilar resources. In each case, the whaler, hunter, or fisherman receives property rights only aftercatching and killing the animal. Each person gets the full benefit from their activity, but the cost of areduced breeding stock is shared by everyone. If you are an individual fisherman fishing in anendangered fishery, you have no incentive to reduce your individual harvest of fish because you knowthat if you do not catch an additional fish, someone else might. In such a situation, the resource isoverutilized.Governments deal with this problem by setting restrictions on consumption or by introducing propertyrights when feasible. When alligators were a common property resource in the U.S., they were hunteduntil they were threatened with extinction. The introduction of "alligator farms" in which alligators wereowned by individuals eliminated the risk of extinction since individual alligator farmers face anincentive to maintain a breeding stock for subsequent year's harvests.This "problem of the commons" (as it is also known) explains why public parks and highways oftenhave more litter than most individual's back yards, why bathrooms and commons rooms in dormitoriesare messier than those in private houses and apartments, and why many species of animals have beenhunted to extinction or threatened with extinction.MonopolyAdam Smith's "invisible hand of the market" works as a result of competition among self-interestedsellers. When monopolies are present, prices will tend to be higher and output lower than would occurunder competitive market conditions. Government may respond to this problem through antitrustenforcement, by regulating the monopoly, or by public production of the good or service.Macroeconomic instabilityThe business cycle results in periodic stages of recession in which unemployment rates rise. This resultsin a state of economic inefficiency that the government may attempt to remedy by implementing policiesdesigned to ameliorate the business cycle. (This is a topic discussed in much more detail in anintroductory macroeconomics course.)Public choice theory of governmentThe public choice theory of government suggests that government policy is made by self-interestedindividuals who are likely to work for their own interests rather than the "public interest." Advocates ofthe public choice theory argue that special interest groups will engage in "rent-seeking behavior" that isdesigned to increase their wealth at the expense of society as a whole. Many expenditures on lobbyists,

political contributions, etc. do not result in increases in output and may result in economic inefficiency ifthe lobbyists are successful in redistributing income to the groups that they represent.Microeconomic and macroeconomic policyThe government engages in both microeconomic and macroeconomic policy. Microeconomic policyinvolves policies designed to correct for imperfect information, externalities, public goods, the absenceof property rights, and monopolies. Macroeconomic policy is policy designed to enhancemacroeconomic stability and encourage economic growth. Macroeconomic policy involves the use offiscal and monetary policy. Fiscal policy involves changing government spending, taxes, and transferpayments. (Transfer payments are payments made to individuals for which no good or service isprovided in return. This category of spending includes unemployment compensation, social securitypayments, and welfare spending.) Monetary policy involves the use of changes in the money supply toaffect the level of economic activity.A budget surplus exists if tax revenue exceeds the sum of government spending and transfer payments.If the sum of transfer payments and government spending exceeds tax revenue, a budget deficit exists.Central planningAn alternative form of economic organization is provided in a centrally planned economy. In a centrallyplanned economy, the fundamental questions of what to produce, how output should be produced andfor whom should it be produced are answered (in theory) by a central planning board. With the collapseof the Soviet Union and market reforms in China, there are few economies that claim to engage incentral planning today.

Chapter 6The focus of Chapter 6 is on the concept of elasticity, a measure of the responsiveness of either quantitydemanded or supplied to a change in some other variable.Price elasticity of demandThe most commonly used elasticity measure is the price elasticity of demand, defined as:

price elasticity of demand (Ed) =

The price elasticity of demand is a measure of the sensitivity of quantity demanded to a change in theprice of a good. Notice that the price elasticity of demand will always be expressed as a positive number(since the absolute value of a negative number is always positive).Demand is said to be:elastic when Ed > 1,unit elastic when Ed = 1, andinelastic when Ed < 1.When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in quantitydemanded. If demand is unit elastic, quantity demanded will fall by 1% when the price rises by 1%. A1% price increase will result in less than a 1% reduction in quantity demanded when demand is inelastic.Suppose, for example, that we know that the price elasticity of demand for a particular good equals 2. Inthis case, we'd say that demand is elastic and would know that a 1% increase in price will cause quantitydemanded to fall by 2%.One extreme case is given by a perfectly elastic demand curve, as appears in the diagram below.Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity measurein this case is infinite (notice that the denominator of the elasticity measure equals zero). The closest weget to observing a perfectly elastic demand curve is the demand curve facing a firm that produces a verysmall share of the total quantity produced in a market. In this case, the firms is such a small share of themarket that it must take the market price as given. An individual farmer, for example, has no controlover the price that it receives when it brings its product to market. Whether it supplies 100 or 20,000bushels of wheat, the price that it received per bushel is that day's market price.

At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand curveappears in the diagram below. Note that the price elasticity of demand equals zero for a perfectlyinelastic demand curve since the % change in quantity demanded equals zero. In practice, we do notexpect to see demand curves that are perfectly inelastic. For some range of prices, the demand forinsulin, dialysis, and other such medical treatments, is likely to be close to being perfectly inelastic. Asthe price for these commodities rises, however, we would eventually expect to see the quantitydemanded fall because individuals have limited budgets.

Students considering elasticity for the first time often believe that demand is more elastic when thedemand curve is flat and less elastic when it is steep. Unfortunately, it is not quite as simple as that... Inparticular, if we consider the case of any downward sloping linear demand curve, we will see thatelasticity varies continuously along this curve. It is true that a one-unit change in price always results ina constant change in quantity demanded along a linear demand curve (since the slope is constant). Theratio of the percentage change in quantity demanded to the percentage change in price, however,changes continuously along such a curve.To see why this occurs, it is necessary to consider the distinction between a change in the level of avariable and the percentage change in the same variable. Suppose we consider the distinction bydiscussing the percentage change that results from a $1 increase in the price of a good.a price increase from $1 to $2 represents a 100% increase in price,a price increase from $2 to $3 represents a 50% increase in price,a price increase from $3 to $4 represents a 33% increase in price, anda price increase from $10 to $11 represents a 10% increase in price.

Notice that, even though the price increases by $1 in each case, the percentage change in price becomessmaller when the starting value is larger. Let's use this concept to explain why the price elasticity ofdemand varies along a linear demand curve.Consider the change in price and quantity demanded that are illustrated below. At the top of the curve,the percentage change in quantity is large (since the level of quantity is relatively low) while thepercentage change in price is small (since the level of price is relatively high). Thus, demand will berelatively elastic at the top of the demand curve. At the bottom of the curve, the same change in quantitydemanded is a small percentage change (since the level of quantity is large) while the change in price isnow a relatively large percentage change (since the level of price is low). Thus, demand is relativelyinelastic at the bottom of the demand curve.

More generally, we can note that elasticity declines continuously along a linear demand curve. The topportion of the demand curve will be highly elastic and the bottom is highly inelastic. In between,elasticity gradually becomes smaller as price declines and quantity rises. At some point, demandchanges from being elastic to inelastic. The point at which that occurs, of course, is the point at whichdemand is unit elastic. This relationship is illustrated in the diagram below.

Arc elasticity measureSuppose that we wish to measure the elasticity of demand in the interval between a price of $4 and aprice of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If we start at $5and move to $4, however, price has fallen by 20%. Which percentage change should be used torepresent a change between $4 and $5? To avoid ambiguity, the most common measure is to use a

concept known as arc elasticity in which the midpoint of the interval is used as the base value incomputing elasticity. Under this approach, the price elasticity formula becomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price risesfrom $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since Ed < 1).Elasticity and total revenueThe concept of price elasticity of demand is extensively used by firms that are investigating the effectsof a change in the prices of their commodities. Total revenue is defined as:total revenue = price x quantitySuppose that a firm is facing a downward sloping demand curve for its product. How will it's revenuechange if it lowers its price?The answer, it turns out, is somewhat ambiguous. When the price declines, quantity demanded byconsumers rises. The lower price received for each unit of output lowers total revenue while the increasein the number of units sold raises total revenue. Total revenue will rise when the price falls if quantityrises by a large enough percentage to offset the reduction in price per unit. In particular, we can note thattotal revenue will increase if quantity demanded rises by more than one percent when the price falls byone percent. Alternatively, total revenue will decline if quantity demanded rises by less than one percentwhen the price declines by one percent. If the price falls by one percent and quantity demanded falls byone percent, total revenue will remain unchanged (since the changes will offset each other). A carefulobserver will note that this comes down to a question of the magnitude of the price elasticity of demand.As defined above, this equals:

price elasticity of demand (Ed) =

Using the logic discussed above, we can note that a reduction in price will lead to:an increase in total revenue when demand is elastic,no change in total revenue when demand is unit elastic, anda decrease in total revenue when demand is inelastic.In a similar manner, an increase in price will lead to:a reduction in total revenue when demand is elastic,no change in total revenue when demand is unit elastic, andan increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demand elasticityalong a linear demand curve.

As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in theregion in which demand is unit elastic. Total revenue falls as quantity increases (and price decreases) inthe inelastic portion of the demand curve. Total revenue is maximized at the point at which demand isunit elastic.Does this mean that firms will choose to produce at the point at which demand is unit elastic? Thiswould only be the case if they had no production costs. Firms are assumed to be concerned withmaximizing their profits, not their revenue. The optimal level production can be determined only whenwe consider both revenue and costs. This topic will be extensively addressed in future chapters.Price discriminationFirms that have some control over their market price can sometimes use that control to enhance theirprofits by charging different prices to different customers. In particular, a firm engaging in pricediscrimination increases its profits by charging higher prices to those customers who have the mostinelastic demand for the product and lower prices to those customers who have a more elastic demand.In essence, this strategy involves charging the highest prices to those customers who are willing to buythe commodity at a high price and charging lower prices to those customers who are more sensitive toprice differentials.A classic example of price discrimination occurs with airline fares. There are two general categories ofcustomers: those traveling on vacations and those traveling for business purposes. It is likely that thedemand for air travel by business travelers is less sensitive to price changes than is true for those onvacation. Airlines are able to charge different prices to these two groups by offering a high base fare anda "super saver" fare that requires a weekend stay, the purchase of the tickets several weeks in advance,and similar restrictions. Since those traveling for vacation purposes are more likely to satisfy theserequirements than business travelers, airlines accomplish the goal of charging higher prices to the

business travelers with less elastic demand and lower prices to those customers with more elasticdemand who are flying for vacation purposes.The use of cents-off coupons in the Sunday newspapers is another example of price discrimination thatoffers a lower price to those customers who have more elastic demands (since low-wage workers aremore likely to be sensitive to price changes and are more likely to use coupons).Child and senior citizen discounts at restaurants and movie theaters are also examples of pricediscrimination that result in lower prices being charged to those customers with the most elastic demandfor the products.Determinants of price elasticity of demandThe price elasticity of demand is likely to be relatively high when:close substitutes are available,the good or service is a large share of the consumer's budget, anda longer time period is considered.Let's consider each of these factors.When there a large number of substitutes are available, consumers respond to a higher price of a goodby buying more of the substitute goods and less of the relatively more expensive commodity. Thus, wewould expect a relatively high price elasticity of demand for goods or services with many closesubstitutes, but would expect a relatively inelastic demand for commodities such as insulin or AZT withfew close substitutes.If the good is a small share of a consumer's budget, a change in the price of the good will have littleimpact on the individual's purchasing power. In this case, a price change will have relatively little impacton the quantity consumed. A doubling of the price of salt, for example, would not have much of animpact on a typical consumer's budget. But, when a good is a relatively large share of a person'sspending, a price increase has a larger effect on their purchasing power. To take an extreme example,suppose that a person spends 50% of his or her income on a commodity and the price doubled. It's likelythat the individual will substantially reduce their spending in response to the higher price when spendingon the good comprises a larger share of a consumer's budget. Thus, demand will tend to be more elasticfor goods that are a small share of a typical consumer's budget.Consumers often have more possibilities for substitutes for a good when a longer time period isconsidered. Consider, for example, the effect of a higher price for fuel oil or natural gas. In the short run,individuals may lower the temperature and wear warmer clothes, but are unlikely to reduce their energyconsumption by very much. Over a longer time period, however, consumers may install more energyefficient furnaces, better insulation, and more energy efficient windows and doors. Thus, we wouldexpect that the demand for either fuel oil or natural gas would be more elastic in the long run than in theshort run.Cross-price elasticity of demandThe cross-price elasticity of demand is a measure of the responsiveness of a change in the price of agood to a change in the price of some other good. The cross-price elasticity of demand between thegoods j and k can be expressed as:

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, thesign of the cross-price elasticity of demand tells us about the nature of the relationship between thegoods j and k. A positive cross-price elasticity occurs if an increase in the price of good k is associatedwith an increase in the demand for good j. As noted earlier (in Chapter 3), this occurs if and only if thesetwo goods are substitutes.A negative cross-price elasticity of demand occurs when an increase in the price of good k is associatedwith a decline in the demand for good j. This occurs if and only if goods j and k are complements.Thus, the cross-price elasticity of demand between two goods tells us whether the two goods aresubstitutes or complements. Estimates of the magnitude of the cross-price elasticity can be used by firmsin making pricing and output decisions. McDonald's Corporation, for example, might want to know thecross-price elasticity of demand between it's chicken sandwiches and its Big Macs if it is considering the

effect of a 20% decrease in the price of its Big Macs. If the cross-price elasticity of demand is 0.5, then a20% decrease in the price of its Big Mac sandwiches would result in a 10% decrease in the number ofchicken sandwiches sold. A -.9 cross-price elasticity of demand between Big Macs and french fries,though, would indicate that a 20% decrease in the price of Big Mac sandwiches would result in an 18%increase in the sale of french fries. This sort of information would be useful in determining what pricesto charge and in planning for the impact of such a price change.Income elasticity of demandThe income elasticity of demand is a measure of how sensitive demand for a good is to a change inincome. Income elasticity of demand is measured as:

As in the case of cross-price elasticity, the sign of income elasticity of demand may be either positive ornegative. A positive value for the income elasticity occurs when an increase in income results in anincrease in the demand for a good. In this case, the good is said to be a normal good. In practice, mostgoods seem to be normal goods (and therefore have a positive income elasticity).A good is said to be an inferior good if an increase in income results in a reduction in the quantity of thegood demanded. An inspection of the definition of the income elasticity of demand should make it clearthat an inferior good will have a negative income elasticity. Generic foods, used cars, and similarcommodities are likely to be inferior goods for many consumers.Another distinction that is commonly made (although not mentioned in your text at this point) isbetween luxuries and necessities. An increasing share of income is spent on luxury goods as incomeincreases. This means a 10% increase in income must be associated with a greater than 10% increase inspending on luxury goods. Using the definition of income elasticity of demand, we can see that a luxurygood must have an income elasticity that is greater than one.A smaller share of income is spent on necessities as income rises. This means that necessities have anincome elasticity that is less than one.Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is notimmediately obvious, note that an income elasticity that is greater than one must necessarily be greaterthan zero while an income elasticity that is less than zero must be less than one.) Normal goods may beeither necessities or luxuries.Price elasticity of supplyWe can also apply the concept of elasticity to supply. The price elasticity of supply is defined as:

Note that the absolute value sign is not used when measuring the price elasticity of supply since we donot expect to observe a downward sloping supply curve.A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of supply iszero when supply is perfectly inelastic. While your text suggests that the supply of Monet paintings isperfectly inelastic, this in not entirely correct. If someone offers $.50 for a Monet painting, how manypaintings are likely to be offered for sale? What is meant in the text is that, for prices above a particularthreshold, the supply curve becomes perfectly inelastic for some goods for which only a finite quantityis available. This is also true for highly perishable commodities that must be sold on the day they arebrought to market. A fisherman with no storage facilities, for example, must sell all of the fish caught atthe end of a given day at whatever price can be received.

A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply curvefacing a single buyer in a market in which there are a very large number of buyers and sellers is likely toappear to be perfectly elastic (or close to this, anyway). This will occur when each buyer is a "price-taker" who has no effect on the market price.

Economists classify time in terms of the "short run" and the "long run." The short run is defined as theperiod of time in which capital is fixed. All inputs are variable in the long run. Notice that the length ofthe short run and long run will vary from industry to industry. In the lawnmowing industry, the long runmay be as short as the few hours that may be required to buy an additional lawn mower. In theautomotive manufacturing industry, the short run may last for several years (since it takes a long time todesign and build new capital in this industry).It is expected that supply will be more elastic in the long run than in the short run since firms can expandor contract their capital in the long run. In the short run, an increase in the price of personal computersmay result in increased employment, more overtime, and additional shifts in computer factories. In thelong run, though, higher prices will lead to a larger expansion in output as new factories are built.Tax incidenceAs your text notes, the distribution of the burden of a tax depends on the elasticities of demand andsupply. When supply is more elastic than demand, consumers bear a larger share of the tax burden.Producers bear a larger share of the burden of a tax when demand is more elastic than supply.

Chapter 7This chapter provides a more detailed examination of the theory of consumer choice. The theory ofdemand is derived from this theory of choice.UtilityThe economic theory of choice is based on the concept of utility. Utility is defined as the level ofhappiness or satisfaction associated with alternative choices. Economists assume that when individualsare faced with a choice of feasible alternatives, they will always select the alternative that provides thehighest level of utility.Total and marginal utilityThe total utility associated with a good is the level of happiness derived from consuming the good.Marginal utility is a measure of the additional utility that is received when an additional unit of the goodis consumed. The table below illustrates the relationship that exists between total and marginal utilityassociated with an individual's consumption of pizza (in a given time period).

# of slices Total utility Marginal utility0 0 -1 70 702 110 403 130 204 140 105 145 56 140 -5

As the table above indicates, the marginal utility associated with an additional slice of pizza is just thechange in the level of total utility that occurs when one more slice of pizza is consumed. Note, forexample, that the marginal utility of the third slice of pizza is 20 since total utility increases by 20 units

(from 110 to 130) when the third slice of pizza is consumed. More generally, marginal utility can bedefined as:

The table above also illustrates a phenomena known as the law of diminishing marginal utility. This lawstates that marginal utility declines as more of a particular good is consumed in a given time period,ceteris paribus. In the example above, the marginal utility of additional slices of pizza declines as morepizza is consumed (in this time period). In this example, the marginal utility of pizza consumptionbecomes negative when the 6th slice of pizza is consumed. Note, though, that even though the marginalutility from pizza consumption declines, total utility still increases as long as marginal utility is positive.Total utility will decline only if marginal utility is negative. This law of diminishing marginal utility isbelieved to occur for virtually all commodities. A bit of introspection should confirm the generalapplicability of this principle.Diamond-water paradoxIn The Wealth of Nations (1776), Adam Smith attempted to formulate a theory of value that explainedwhy different commodities had different market values. In this attempt, however, he encountered aproblem that has come to be called the "diamond-water" paradox. The paradox occurs because water isessential for life and has a low market price (often a price of zero) while diamonds are not as essentialyet have a very high market price. To resolve this issue, Smith proposed two concepts of value: value inuse and value in exchange. Diamonds have a low value in use but a high value in exchange while waterhas a high value is use but a low value in exchange. Smith argued that economists could explain theexchange value of a commodity by the amount of labor required to produce the commodity. (This "labortheory of value" later served as the basis for much of Marx's critique of capitalism.) Smith did notpropose a theory to explain the use value of a commodity.Marginal analysis, however, allows us to explain both value in use and value in exchange. The diagrambelow contains marginal utility curves for both diamonds and water. Because individuals consume alarge volume of water, the marginal utility of an additional unit of water is relatively low. Since fewdiamonds are consumed, the marginal utility of an additional diamond is relatively high.

Total utility can be derived by adding up the marginal utilities associated with each unit of the good. Abit of reflection should convince you that total utility can be measured by the area under the marginalutility curve. The shaded areas in the diagram below provide a measure of the total utility associatedwith the consumption of water and diamonds. Note that the total utility from water is very high (since alarge volume of water is consumed) while the total utility received from diamonds is relatively low(because few diamonds are consumed).

These concepts of total and marginal utility can be used to resolve Adam Smith's diamond-waterparadox. When Adam Smith was referring to "value in use," he was actually referring to the concept oftotal utility. Exchange value, on the other hand, is tied to how much someone is willing to pay for anadditional unit of the commodity. Because diamonds are expensive, individuals consume few diamondsand the marginal utility of an additional diamond is relatively high. Since water is not very costly toacquire, people consume more water. At this high level of consumption, the marginal utility of anadditional unit of water is relatively low. The price that someone is willing to pay for an additional unitof a good is related to its marginal utility. Because the marginal utility of an additional diamond ishigher than the marginal utility associated with an additional glass of water, diamonds have a highervalue in exchange.Consumer equilibriumHow can the concept of marginal utility be used to explain consumer choice? As noted above,economists assume that when an individual is faced with a choice among feasible alternatives, he or shewill select the alternative that provides the highest level of utility. Suppose that an individual has a givenincome that can be spent on alternative combinations of goods and services. A utility maximizingconsumer will select the bundle of goods at which the following two conditions are satisfied:MUA/PA = MUB/PB = ... = MUZ/PZ, for all commodities (A-Z), andall income is spent.The first of these conditions requires that the marginal utility per dollar of spending be equated for allcommodities. To see why this condition must be satisfied, suppose that the condition is violated. Inparticular, let's assume that the marginal utility resulting from the last dollar spent on good X equals 10while the marginal utility received from the last dollar spent on good Y equals 5. Since an additionaldollar spent on good X provides more additional utility than the last dollar spent on good Y, a utility-maximizing individual would spend more on good X and less on good Y. Spending $1 less on good Ylowers utility by 5 units, but an additional dollar spent on good X raises utility by 10 units in thisexample. Thus, the transfer of $1 in spending from good Y to good X provides this person with a netgain of 10 units of utility. As more is spent on good Y and less on good X, though, the marginal utilityof good Y will fall relative to the marginal utility of good X. This person will keep spending more ongood Y and less on good X, though, until the marginal utility of the last dollar spent on good Y is thesame as the marginal utility of the last dollar spent on good X.The first condition listed above is sometimes referred to as the "equimarginal principle."The reason for the assumption that all income is spent is because this relatively simple model is a single-period model in which there is no possibility of saving or borrowing (since there are no future periods inthis simple model). Of course, a more detailed model can be constructed which includes suchpossibilities, but that is a topic left for more advanced microeconomics classes.When the two conditions above are satisfied, a state of consumer equilibrium is said to occur. This is anequilibrium because the individual consumer has no reason to change the mix of goods and services

consumed once this outcome is achieved. (Unless, of course, there is a change in tastes, income, orrelative prices.)The example on pages 163-165 of your textbook provides a very good discussion of how this concept ofconsumer equilibrium can be used to explain the mix of goods and services consumed. Be sure that youunderstand the decision process described in the text and summarized in Table 2 on p. 164.Consumer equilibrium and demandThe concept of consumer equilibrium can be used to explain the negative slope of a consumer's demandcurve. Suppose that an individual is initially buying only two goods, X and Y. At a point of consumerequilibrium:

and all income is spent. Let's consider what happens if the price of good X rises. An examination of theequation above indicates that the marginal utility per dollar spent on good X will fall when the price ofgood X rises. To restore a consumer equilibrium, the individual will increase his or her consumption ofgood Y and reduce his or her spending on good X. This change in the mix of goods consumed is calledthe substitution effect. When good X becomes relatively more expensive, the quantity of good Xdemanded falls as a result of the substitution effect.In addition to this substitution effect, there is also an income effect that occurs when the price of a goodchanges. Since good X has become more expensive in this example, the individual can no longer affordthe original combination of goods X and Y. This income effect results in a reduction in the quantitydemanded for all normal goods. If good X is a normal good, the substitution and income effects bothwork together to reduce the quantity of good X demanded.A careful reader will note that there is a possibility that an inferior good may have an upward slopingdemand curve if the income effect is larger in magnitude than the substitution effect. A good thatexhibits such a demand curve is called a Giffen good. (This type of good is named after an economistwho believed that he had found evidence that indicated that the quantity of potatoes demanded increasedin Ireland when the price rose during the Irish Potato Famine - more careful later analysis indicated thatGiffen's evidence was flawed.) In practice, though, no one has found reliable evidence of a Giffen good.Thus, it is probably fairly safe to assume that demand curves are downward sloping. This will, of course,unambiguously be expected to occur for normal goods.Consumer surplusAn individual buys a good only if the purchase is expected to makes the person better off (or at least noworse off). In general, the total benefit received from the purchase of a commodity is expected to exceedthe opportunity cost. This provides consumers with a net gain from trade, referred to as consumersurplus. Let's examine this concept in more detail.Suppose that an individual buys 10 units of a good at a price of $5. The diagram below illustrates thispossibility.

As the diagram below indicates, the first unit of this good costs $5, but this individual would have beenwilling to pay a price of up to $9 for this first unit of this good. In this case, the consumer receives agood that he or she values at $9 by giving up only $5. Thus, the first unit of the good generates $4 inconsumer surplus. In the diagram below, the benefit received from the first unit of the good is the sum ofthe two shaded areas (notice the height of this rectangle equals the price the person is willing to pay - $9- while the base equals 1, thus the area of the rectangle equals $9) The cost of this first unit of the good($5) is given by the green shaded area. The blue shaded area at the top of the graph represents theconsumer surplus ($4) received from the first unit of this good.

More generally, the total benefit from consuming 10 units of this good is the entire area under thedemand curve (as illustrated by the blue shaded area in the diagram below).

The total cost of consuming 10 units of this good at a price of $5 is $50. This is represented by the greenshaded rectangle in the diagram below.

The consumer surplus received by this consumer is the difference between the total benefit and totalcost. This is represented by the red shaded area in the diagram below. As noted above, the consumersurplus represents the consumer's net benefit from engaging in voluntary trade.

Indifference curves

Consumer choice can also be explained through the use of indifference curves. An indifference curve isa graph of all combinations of goods that provide a given level of utility. The diagram below contains anindifference curve for two goods, X and Y.

Any two points on an indifference curve generate the same level of utility. Thus, the diagram belowindicates that this person would be indifferent if faced with a choice between the combinations of goodsrepresented by points A and B. Points that lie above and to the right of an indifference curve provide ahigher level of consumption of each good than points on an indifference curve. Because of this, suchpoints provide a higher level of utility than points on the indifference curve. Thus, point C would bepreferred to either point A or B (or any other point on the indifference curve Uo). Points that lie belowand to the left of the indifference curve (such as point D) provide a lower level of utility. Therefore, thisindividual would prefer the bundle of goods represented by point A if faced with a choice between thebundles of goods represented by points D and A.

An indifference curve crosses through each and every point in this diagram. Thus, an infinite number ofindifference curves exist for these two goods. Two additional indifference curves, corresponding to thelevels of utility received at points C and D have been added to the diagram below.

It is assumed that individuals attempt to place themselves on the highest level of utility that they canachieve, given the constraints that they face. Let's examine the budget constraint facing individuals.Budget constraintLet's consider the budget constraint facing an individual who has a fixed level of income (I) that can beused to buy two goods (X and Y) at fixed prices (PX and Py). The budget constraint facing this individualcan be expressed as:

A graph of this budget constraint appears below. The intercepts of this budget constraint on each axisequals income divided by the price of the good represented on the axis (this can be demonstrated quiteeasily using basic algebra).

As your text illustrates on p. 182, changes in income will result in a parallel shift in the budget constraintwhile changes in the prices of goods X and Y will affect the slope of the budget constraint.Consumer equilibrium and indifference curvesIndividuals maximizing utility subject to their budget constraint attain the highest possible level ofutility at a point of tangency between their budget constraint and an indifference curve. In the diagrambelow, this occurs when the individual consumes X* units of good X and Y* units of good Y. Whileother points on the budget constraint, such as point A, are feasible, they provide a lower level of utility.Points such as point B provide a higher level of utility, but are not feasible. It is not possible to attain ahigher level of utility than Uo without violating the budget constraint (and there are laws that preventpeople from acquiring more goods than they can pay for...).

Chapter 8During the first weeks of the course, we examined how a market economy functioned. The past twoweeks have focused on the behavior of consumers in more detail. We'll be focusing on the supply side ofthe economy for the next two weeks. This week, we begin by discussing the determinants of productioncosts.ProductionThe total amount of output produced by a firm is a function of the levels of input usage by the firm. Inthe short run, a simplified version of this relationship is provided by a firm's total physical product(TPP) (also known more simply as total product) function. This function captures the relationship thatexists between the maximum level of output that can be produced by a firm and its level of labor use,holding other inputs and technology constant. (Remember, the short run is defined to be the period oftime in which capital cannot be changed.) The table below contains an example of a possible totalproduct function.

A careful inspection of the table above indicates that output initially increases more rapidly as the levelof labor use increases, but ultimately increases by smaller and smaller increments. In the exampleillustrated above, output even declines at higher levels of labor use (note that output declines from 275to 270 when the level of labor use increases from 40 to 45). Economists argue that equal increases in thelevel of labor use will ultimately result in progressively smaller increases in output in virtually allproduction processes. This is a consequence of the law of diminishing returns that was first introducedin Chapter 2 of your text.The relationship between the level of input use can also be represented through the average physicalproduct (APP) of labor. The average physical product is defined as the ratio of total physical product tothe quantity of labor. The average physical product for the firm described above has been added to thetable below. Notice how the value of APP is equal to the ratio of TPP to the quantity of labor in eachrow of this table. As in this example, economics expect that the APP may initially rises but willultimately decline as a result of the law of diminishing returns. The average physical product of labor iswhat is meant when economists talk about labor productivity. So, when you hear references to rising ordeclining labor productivity, you'll now know that they're talking about changes in APP.

The marginal physical product (MPP) (also know more simply as just marginal product), is anotheruseful and important concept. MPP is defined as the additional output that results from the use of anadditional unit of a variable input, holding other inputs constant. It is measured as the ratio of the changein output (TPP) to the change in the quantity of labor used. In mathematical terms, this can be expressedas:

The table below continues the estimated MPP for each of the reported intervals. Be sure that youunderstand how the MPP is computed from the information contained in the first two columns of thistable. For example, consider the interval between 10 and 15 units of labor. Note that since TPP increases

by 60 (from 120 to 180) when the quantity of labor increases by 5, the MPP of labor in this intervalequals 60/5 = 12.

As the table above indicates, the MPP is positive when an increase in labor use results in an increase inoutput; the MPP is negative when an increase in labor use results in a decrease in output.The TPP, APP, and APP curves can also be illustrated using a graph. The diagram below contains agraph of a possible TPP curve. As was true in the table above, this diagram suggests that output initiallyrises more rapidly as labor use increases. Beyond some point, however, TPP starts to rise by less andless with each additional unit of labor. It is possible (as in the example here) that TPP may eventuallyfall when too many workers are present (yes, the old "too many cooks spoil the broth" cliché applieshere again....).

The diagrams below illustrate the APP and MPP curves associated with this TPP curve. As in the tableabove, APP initially rise and then falls. MPP rises in the range in which TPP is increasing at a morerapid rate and declines in the range in which TPP increases at a declining rate. MPP equals zero at thepoint at which TPP reaches a maximum and is negative when TPP declines.

As the diagram above indicates, the MPP and APP curves intersect at the maximum level of APP. Thereason for this is relatively intuitive. For levels of labor use below Lo, MPP is greater than APP. Thismeans that an additional workers adds more to output than the average worker is producing. In this case,the average has to increase. An analogy is quite useful here. Suppose that your grade in a class at anypoint in time is formed by taking the average of all of the grades that you have achieved up to that pointin time. If your score on an additional test (this may be thought of, quite appropriately in many cases, asa "marginal grade") exceeds your average average, your average grade will rise. Using similarreasoning, if your marginal grade is less than your average grade, your average will decline. In the samemanner, the average physical product of labor will decline when the marginal physical product of laboris less than the average physical product of labor.An inspection of the diagram above indicates that APP increases whenever the level of labor use is lessthan Lo. APP declines, however, when the level of labor use is greater than Lo. Since APP increases upto this point and declines after this point, APP must reach a maximum when Lo workers are employed(at the point at which MPP = APP).Total CostsIn the short run, total costs (TC) consist of two categories of cost: total fixed costs and total variablecosts. Total fixed costs (TFC) are costs that do not vary with the level of output. The level of total fixedcosts is the same at all levels of output (even when output equals zero). Examples of such fixed costsinclude rent, annual license fees, mortgage payments, interest payments on loans, and monthlyconnection fees for utilities (note that this last category includes only fixed monthly charges, not theportion of utility fees that varies with the level of use). Total variable costs (TVC) are costs that varywith the level of output. Labor costs, raw material costs. and energy costs are examples of variable costs.Variable costs are equal to zero when no output is produced and increase with the level of output.The table below contains a listing of a hypothetical set of total fixed cost and total variable costschedules. As this table indicates, total fixed costs are the same at each possible level of output. Totalvariable costs are expected to rise as the level of output rises.

As the table below indicates, we can use the TFC and TVC schedules to determine the total costschedule for this firm. Note that, at each level of output, TC = TFC + TVC.

The diagram below contains a graph of a total fixed cost curve. Since total fixed costs are the same at alllevels of output, a graph of the total fixed cost curve is a horizontal line.

The total variable cost curve increases as output increases. Initially, it is expected to increase at adecreasing rate (since marginal productivity increases initially, the cost of additional units of outputdecline). As the level of output rises, however, variable costs are expected to increase at an increasingrate (as a result of the law of diminishing marginal returns). The diagram below contains a possible totalvariable cost curve.

Since total cost equals the sum of total variable and total fixed costs, the total cost curve is just thevertical summation of the TFC and TVC curves. The diagram below illustrates this relationship.

Average and marginal costsAverage fixed cost (AFC) is defined as: AFC = TFC / Q. An average fixed cost schedule has been addedto the diagram below. Note that average fixed costs always decline as the level of output increases.

Average variable cost (AVC) is defined as: AVC = TVC / Q. An average variable cost schedule hasbeen added to the table below. It is expected that average variable costs will initially decrease as outputincreases but will eventually increase as output continues to rise. The reason for the eventual increase inAVC is the law of diminishing returns discussed above. If each additional worker adds progressivelyless additional output, the average cost of the additional output must eventually increase.

Average total cost (ATC) is defined as: ATC = TC / Q. The table below includes an ATC schedule. Notethat ATC can also be measured as: ATC = AVC + AFC (since TC=TFC+TVC, TC/Q = TFC/Q +TVC/Q).

In addition to these average cost measures, it is also useful to measure the cost of an additional unit ofoutput. The cost of an additional unit of output is called marginal cost (MC). Marginal cost can bemeasured as:

A marginal cost schedule has been added to the table below. Be sure that you understand how marginalcost is computed in this table. Consider, for example, the interval between 10 and 20 units of output. Inthis case, total costs increase by 20 (from 40 to 60) when 10 additional units of output are produced, soin this interval, marginal cost is 20/10 = 2.

We can also represent these average and marginal cost relationships using diagrams. The diagram belowcontains a graph of a typical AFC curve. Note that AVC declines as output increases.

The diagram below contains a graph of the ATC, AVC, and MC curves for a typical firm. Note that thevertical distance between the ATC and the AVC curve is equal to AFC (since AFC+AVC=ATC). It isalso useful to observe that the MC curve intersects the AVC and the ATC curves at their respectiveminimum points. To see this, note that whenever marginal costs are less than average costs, the averagecost must decline. Similarly, when marginal costs exceed average costs, the average must rise. Thus, theMC curve must cross each of these average cost curves at their respective minimum points.

Long-run costsIn the long run, all inputs are variable. As the firm changes the amount of capital it uses, it will shiftfrom one short-run averate total cost curve (SRATC) to another. The diagram below illustrates thisrelationship. As a firm acquires more capital, the minimum point on it's average total cost curve isassociated with a higher level of output. Thus, in this diagram, SRATC4 represents a firm with arelatively high level of capital while SRATC1 represents a firm with a low level of capital.

The long-run average total cost curve (LRATC) represents the lowest level of average cost that canoccur in the long run at each possible level of output. It is assumed that firms producing any given levelof output in the long run would always select the size of firm that has the lowest short-run average totalcosts at that level of output. In the diagram above, a firm would select a level of capital that places it onthe short-run average total cost curve SRATC2 if it were to produce Qo units of output. (Notice that thecosts of producing this level of output would be higher with either a smaller or a larger firm.)It is often argued that the long-run average cost curves has a shape similar to the diagram below. At lowlevels of output, it is suggested that economies of scale result in a decrease in long-run average costs asoutput increases. Economies of scale are factors that result in a reduction in LRATC as output rises.These factors include gains from specialization and division of labor, indivisibilities in capital, andsimilar factors. Diseconomies of scale, factors that result in higher levels of LRATC as output increase,are believed to be important at high levels of output. These factors include the increased cost ofmanaging and coordinating a firm as the size of the firm rises. Constant returns to scale occur whenLRATC does not change when the firm becomes larger or smaller. It is believed that this happens over arelatively large range of output (as illustrated in the diagram below).

The diagram above also illustrates the concept of minimum efficient scale (MES). The minimumefficient scale of a firm is the lowest output level at which LRATC are minimized. As we'll see in laterchapters, the MES is important in determining the market structure for a particular output market.Competition among firms forces firms to produce at a level of output at which LRATC is minimized. Ifthe MES is large, relative to the quantity of output demanded in a market, only a small number of firmscan profitably coexist. If, for example, the MES is 10,000 and a quantity of only 20,000 units of outputis demanded, at most two firms can survive in the market. We'll return to this topic in later chapters.

Chapter 9During this week, we'll examine how firms determine the profit-maximizing level of output. As part ofthis discussion, we'll also examine differences among perfectly competitive, monopolisticallycompetitive, oligopoly, and monopoly markets.Profit maximizationEconomists assume that firms select prices and output levels that maximize their profits. Wheneconomists discuss profits, however, they are referring to the concept of economic profit defined as:

Economic profit = total revenue - all economic costsAs you should recall from our discussion of the material in Chapter 2, economic costs include allopportunity costs, regardless of whether these costs are explicit or implicit. An explicit cost is a cost inwhich a payment is actually made. An implicit cost, on the other hand, is a cost in which no moneychanges hands. An example may help to illustrate this distinction. Suppose that you borrow money froma bank to acquire capital to open a business. In this case, the interest payments on the loan would be anexplicit cost. If, on the other hand, you use your own savings to finance this capital, you do not have topay interest to someone else for the use of these funds. In this case, however, the opportunity cost wouldbe the implicit cost of the interest that you could have received had you placed this money in an interest-bearing asset instead of buying this capital.Note that economic costs are different than accounting costs. Accounting costs, for the most part,include only explicit costs. (The only exception is that accounting cost includes a measure ofdepreciation, which is an implicit cost. But, even in this case, the accounting measure of depreciation isbased on the historical price of capital, and not based on its opportunity cost.) The reason for thisdistinction, of course, is that accounting systems are designed to provide a record of a firm's receipts andexpenditures. For such a record to be meaningful to tax authorities and the owners of a firm, each receiptand expenditure must be accompanied by some verifiable record of transactions. Implicit costs are notdirectly observed (and provide no "receipts" that can be used to verify accounts.)Since economic costs include both implicit and explicit costs while accounting costs consist (almostexclusively) of explicit costs, economic costs are virtually always greater than accounting costs. Thedifference between between these two measures of cost is the opportunity cost of resources supplied bythe firm's owner. The opportunity cost of these owner-supplied resources is called normal profit. Asyour text notes, the owners of corporations (the shareholders) must receive a rate of return on their stockthat is equivalent to what they could receive if their next-best alternative. So, normal profit (or "normalaccounting profit" as your text defines it) is an economic cost that is not counted as an accounting cost.Accounting profit is defined as:Accounting profit = total revenue - all accounting costsA comparison of the definitions for economic and accounting profits indicates that accounting profitswill virtually always exceed economic profits. Let's take a simple example. Suppose that the owner of afirm could receive $90,000 a year using the labor, capital, and other resources that she uses to operateher own business. If she receives $70,000 in accounting profits, she would actually have suffered$20,000 in economic losses, since she is earning $20,000 less than she could receive with an alternativeemployment of these resources.If the owners of a firm economic profits, this means that they are receiving a rate of return on the use oftheir resources that exceeds that which can be received in their next-best use. In this situation, we'dexpect to see other firms entering the industry (unless barriers to entry exist).If a firm is receiving economic losses (negative economic profits), the owners are receiving less incomethan could be received if their resources were employed in an alternative use. In the long run, we'dexpect to see firms leaving the industry when this occurs.If the owners of a typical firm receive zero economic profits, this means that they are receiving anincome that is just equal to what they could receive in their next-best alternative. In this case, therewould be no incentive for firms to either enter or leave this industry. Be sure to understand that zeroeconomic profits occur only if the owners are receiving accounting profits equal to normal profit.Marginal Revenue and Marginal CostLet's consider what happens to a firm's profits when it produces an additional unit of output. Recall thatits economic profits are defined as:Economic profit = total revenue - economic costsWhen a firm produces an additional unit of output its revenue rises (in all practical situations) and itscosts rise as well. Profits rise if revenue rises by more than costs and fall if costs rise by more thanrevenue. The additional revenue resulting from the sale of an additional unit of output is called marginalrevenue (MR). As noted in Chapter 8, the additional cost associated with the production of an additionalunit of output is marginal cost (MC).Let's consider a firm's decision about whether to produce more or less output. If marginal revenueexceeds marginal cost, the production of an additional unit of output adds more to revenue than to costs.

In this case, a firm is expected to increase its level of production to increase its profits. If, instead,marginal cost exceeds marginal revenue, the production of the last unit of output costs more than theadditional revenue generated by the sale of this unit. In this case, firms can increase their profits byproducing less. So, a profit-maximizing firm will produce more output when MR > MC and less outputwhen MR < MC. If MR = MC, however, the firm has no incentive to produce either more or less output.In fact, the firm's profits are maximized at the level of output at which MR = MC.Since marginal revenue is such an important part of a firm's decision concerning how much output toproduce, it should be examined in greater detail. (We already examined marginal cost last week.)Marginal revenue is defined as:

If a firm faces a perfectly elastic demand curve, the price of the good is the same at all levels of output.In this case, marginal revenue is simply equal to the market price. Suppose, for example, that corn sellsfor $1 per dozen. The marginal revenue received by a farmer from the sale of an additional dozen ears ofcorn is simply the price of $1. This possibility is illustrated in the diagram below.

Suppose, however, that a firm faces a downward sloping demand curve. In this case, it must lower theprice if it wishes to sell additional units of this good. In this case, marginal revenue is less than the price.Let's use an example to see why this is true. Consider the situation described in the diagram below.When the price is $6, the firm can sell 4 units of output while receiving a total revenue equal to $6 x 4 =$24. If it wishes to sell the 5th unit of output, it must lower the price to $5. Its total revenue in this casewill equal $25. Marginal revenue in this case equals: change in total revenue / change in quantity = $1 /1 = $1. As this example illustrates, marginal revenue will always be less than the price of the good whenthe firm faces a downward sloping demand curve. This is because the firm has to lower the price not juston the last unit sold but instead on all units that it sells. In this case, the firm received an additional $5 inrevenue from the same of the 5th unit, but it lost $4 in revenue when it lowered the price on the first 4units by $1. Thus, total revenue increased by only $1 when the 5th unit is sold.

The diagram below illustrates the relationship that exists between the marginal revenue curve and thedemand curve. The demand curve provides the price that can be charged at each level of output. Sincewe know that MR is less than the price, the marginal revenue curve must lie below the demand curve.Using the results from the chapter on elasticity, we can also note that marginal revenue is positive in theelastic section of the demand curve (since a price decrease results in an increase in total revenue in thiscase), is zero when demand is unit elastic (since total revenue remains unchanged when the price fallswhen demand is unit elastic) and is negative when demand is inelastic (since total revenue declineswhen the price falls in this portion of the demand curve.)

Table 1 on p. 223 in your text provides a good numerical example of the computation of marginalrevenue. Be sure that you understand how the marginal revenue column is computed in this table.Profit maximizationThe diagram below illustrates the profit-maximizing levels of price and output for a firm facing adownward sloping demand curve. As noted above, the profit-maximizing level of output occurs at thepoint at which MR = MC. This occurs at an output level of Qo, the level of output at which the MR andMC curves intersect. The price that firms can charge to sell this much output is given by the demandcurve. In this example, the price equals Po.

The shaded area in the diagram above represents the level of economic profits recveived by this firm.Note that the height of this rectangle equals the difference between the price of the good and averagetotal cost. This vertical distance is equal to the profit received per unit of output. The base of therectangle is equal to the quantity of output sold by the firm. The area of this rectangle (the shaded area)equals the profit per unit of output x the number of units of output. This product is equal to totaleconomic profit.Alternative market structuresThe basis market structures that we'll be examining over the next several weeks include: perfectcompetition, monopoly, monopolistic competition, and oligopoly. Let's examine the definingcharacteristics of each market structure. Perfect competition is characterized by:a very large number of buyers and sellers,easy entry,a standardized product, andeach buyer and seller has no control over the market price (this means that each firm is a price taker thatfaces a horizontal demand curve for its product).A monopoly market is characterized by:a single seller producing a product with no close substitutes,effective barriers to entry into the market, andthe firm is a price maker, also called a price searcher because it faces a downward sloping demand curvefor its product (in fact, note that this demand curve is the market demand curve).One special type of monopoly is a natural monopoly, a monopoly that arises because of the existence ofeconomies of scale over the entire relevant range of output. In this case, a larger firm will always be ableto produce output at a lower cost than could a smaller firm. The pressure of competition in such anindustry would result in a long-run equilibrium in which only a single firm can survive (since the largestfirm can produce at a lower cost and can charge a price that is less than the ATC of smaller firms).Under a monopolistically competitive market:there is a large number of firms,the product is differentiated (i.e., each firm produces a similar, but not identical, product),entry is relatively easy, andthe firm is a price maker that faces a downward sloping demand curve.In an oligopoly market:a small number of firms produce most output,the product may be either standardized or differentiated,there are significant barriers to entry, andrecognized interdependence exists (i.e., each firm realizes that its profitability depends on the actionsand reactions of rival firms).Most output is produced and sold in oligopoly and monopolistically competitive industries.

Chapter 10This week, we'll examine how price and output is determined in a perfectly competitive market. Aperfectly competitive market is characterized by:many buyers and sellers,identical (also known as homogeneous) products,no barriers to either entry or exit, andbuyers and sellers have perfect information.In particular, there are so many buyers and sellers for the product in a perfectly competitive market thateach buyer and seller is a price taker.Demand curve facing a single firmThe diagram below illustrates the relationship between the market and an individual firm. Theequilibrium price is determined by the interaction of market demand and market supply. Since the outputof each firm is such an infinitesimally small share of this total output, no individual firm can affect themarket price. Thus, each firm faces a demand curve for its product that is perfectly elastic at the marketprice.

Profit maximizationAs discussed last week, a firm maximizes its profits by producing the level of output at which marginalrevenue equals marginal cost. (If you're not comfortable with the concepts of marginal revenue andmarginal cost, it would be useful to review last week's material.) As noted in the module accompanyingChapter 9, marginal revenue is defined as:

In a similar manner, marginal cost is defined as:

As noted last week, marginal revenue equals the market price for a firm facing a perfectly elasticdemand curve. The diagram below illustrates this relationship.

Marginal and average total cost curves have been added to the diagram below. As this diagram indicates,a profit-maximizing firm will produce at the level of output (Qo) at which MR = MC. The price, Po, isdetermined by the firm's demand curve.

At an output level of Qo, the firm faces average total costs equal to ATCo. Thus, it's profit per unit ofoutput equals Po - ATCo (= revenue per unit or output - total cost per unit of output). Economic profitsare equal to: profit per unit x # of units of output. An inspection of the diagram below should confirmthat economic profits equals the area of the shaded rectangle (notice that the height of this rectangleequals profit per unit of output and the base equals the number of units of output).

If a firm is receiving economic profits, the owners are receiving a return on their investment that exceedsthat which they could receive if their resources had been used in an alternative occupation. In this case,existing firms will stay in the market and new firms will enter the market. We'll discuss the effects ofthis entry on price and output in more detail below.Loss minimization and shutdown ruleSuppose that P < ATC at the level of output at which MR = MC. Will the firm continue operations? Todetermine this, we have to compare the firm's loss if it stays in business with its loss if it shuts down. Ifthe firm decides to shut down, it's revenue will equal zero and its costs will equal its fixed costs.(Remember, fixed costs must be paid even if the firm shuts down.) Thus, the firm receives an economicloss equal to its fixed costs if it shuts down. It will stay in business in the short run even if it receives aneconomic loss as long as it's loss is less than its fixed costs. This will occur if the revenue received bythe firm is large enough to cover its variable costs and some of its fixed costs. In mathematical terms,this means that the firm will stay in business as long as:TR = P x Q > VCDividing both sides of the above expression by Q, we can write this condition in an alternative form as:P > AVCWhat this means in practice, is that the firm will stay in business if the price is greater than averagevariable cost; the firm will shut down if the price is less than average variable cost. Consider thesituation illustrated by the diagram below. In this case, losses are minimized at the level of output atwhich MR = MC. This occurs at an output level of Q'. Since the level of average total cost (ATC')exceeds the market price (P'), this firm receives economic losses. Since the price is greater than AVC,however, this firm will choose to stay in business in the short run.

If the firm illustrated above were to shut down, it would lose its fixed costs. The shaded area in thediagram below equals the firm's fixed costs (to see this, note that the height of this rectangle equals thefirm's AFC and the base equals Q -- therefore, the shaded area equals AFC x Q = TFC). A comparisonof the firm's losses if it shuts down (the shaded area in the diagram below) with its losses if it continuesto operate in the short run (the shaded area in the diagram above) indicates that this firm will receivelower losses if it decides to remain in business in the short run.

So, this discussions should suggest that the shut down rule for a firm is: shut down if P < AVC. In thelong run, of course, firms will leave the industry if economic losses are received (remember, there are nofixed costs in the long run.)Break-even priceIf the market price is just equal to the minimum point on the ATC curve, the firm will receive a level ofeconomic profits equal to zero. In this case, the owners of the firm are receiving a rate of return on all oftheir resources that is just equal to that which they could receive in any alternative employment. Whenthis occurs, there is neither an incentive to enter or leave this market. This possibility is illustrated in thediagram below.

If the price drops below AVC, the firm will shut down. This possibility is illustrated in the diagrambelow. The green shaded area equals the firm's fixed costs (its losses if it shuts down). The loss if itcontinues operations, however, equals the combined blue and green shaded areas. As this diagramsuggests, a firm's economic losses are lower when it shuts down if P < AVC.

Short-run supply curveSo far, we have observed that a perfectly competitive firm will produce at the point at which P = MC, aslong as P > AVC. The diagram below indicates that at prices of Po, P1, P2, and P3, this firm wouldproduce output levels of Qo, Q1, Q2, and Q3, respectively. A bit of reflection should convince you thatthe MC curve can be used to determine the quantity of output that this firm will supply whenever P >AVC. Since the portion of the MC curve that lies above the AVC curve indicates the quantity of outputsupplied at each price, it is the firm's short-run supply curve. In general, a perfectly competitive firm'sshort-run supply curve is the portion of its marginal cost curve that lies above the AVC curve. This isillustrated by the darker and thicker portion of the MC curve in the diagram below.

Long RunIn the long run, firms will enter the market if positive economic profits are received and will leave themarket if economic losses are realized. Let's think about the consequences of such entry and exit.Suppose that the current equilibrium price in a market results in economic profits for a typical firm. Inthis case, firms enter the market and the market supply curve shifts to the right. As market supplyincreases, the equilibrium price falls. This process will continue until firms no longer have an incentiveto enter the market. As the diagram below indicates, a typical firm will receive zero economic profits inthis long-run equilibrium situation.

Suppose instead that a typical firm is receiving an economic loss. In this situation, firms will leave theindustry in the long run. As they exit, the market supply curve shifts to the left and the equilibrium pricerises. Firms will continue to leave until the market supply curve has shifted enough so that a typical firmreceives zero economic profits (as illustrated in the diagram above).Thus, as the above diagram illustrates, a long-run equilibrium is characterized by the receipt of zeroeconomic profits by a typical firm. This means, of course, that the owners of a typical firm receiveaccounting profits just equal to normal profit.Long-run equilibrium and economic efficiencyThis long-run equilibrium condition has two desirable efficiency properties:P = MC, andP = minimum ATC.The equality between P and MC is important for society because the price reflects society's marginalbenefit from the consumption of the good while the marginal cost reflects the social marginal cost of

producing the good (in the absence of externalities). At the competitive equilibrium, society's marginalbenefit just equals society's marginal costs. Society's net benefit from the production of each good ismaximized when social marginal benefit equals social marginal cost.Production at minimum average cost means that society is producing each good at the lowest possiblecost per unit. This, obviously, is also a desirable property.Economic efficiency occurs when both of the above conditions are satisfied.Consumer and Producer SurplusWe had discussed the concept of consumer surplus earlier. As noted in the section on demand andutility, consumer surplus is equal to the net benefit that consumers receive from the consumption of agood. It occurs because the marginal benefit from each unit of the good exceeds the marginal cost up tothe point until the last unit is consumed. Producer surplus is defined in a similar manner as the netbenefit received by producers from the sale of a good. It occurs because P = MC only for the last unitproduced. Up to that point, the marginal cost of producing the good is below the price received by thefirm.In the diagram below, the yellow shaded region equals the amount of consumer surplus, while the blueshaded region represents producer surplus. The net benefit to society, also known as the "gains fromtrade," equals the sum of these two areas.

Chapter 11This week, we'll examine how price and output is determined in a monopoly market. A monopolymarket is characterized by:a single seller,no close substitutes, andeffective barriers to entry.Monopoly marketsBarriers to entry may exist for three reasons:economies of scale,

actions by firms, and/oractions by the government.If economies of scale exist throughout the relevant range of output, large firms can produce output at alower cost than can smaller firms. The diagram below illustrates this possibility. When an industry ofthis sort begins to develop, there may be many small firms. Suppose, for example that all of the firmshave the average total cost curve labeled "ATCo." If one of them becomes larger than the others, though,it can produce output at a lower cost per unit (as illustrated by the curve ATC'). This allows the largerfirm to sell its output at a lower price (such as P') at which smaller firms will experience economiclosses. (Note that the smaller firms would receive zero economic profit if the price were Po. At a priceof P' the smaller firms would receive economic losses and the larger firm would receive zero economicprofits.)

In this situation, the smaller firms will eventually be forced to either leave the industry or merge withother firms to become at least as large as the current largest firm. As firms keep growing (either throughinternal expansion or by buying up smaller firms), their average costs continue to decline. Smaller firmscontinue to disappear until eventually only one large firm remains. Such an industry is referred to as anatural monopoly since the long-run outcome of the competitive process is the creation of a monopolyindustry.The concept of "natural monopoly" in the U.S. was first used to explain the early development of thetelephone industry in the U.S. In the early years, most cities had several telephone companies competingto offer telephone service. To call all of the other people who had phones in a given city, people mighthave to subscribe to 3 or 4 telephone services (since they were not initially interconnected). By virtue ofits patents and head start, though, the Bell Company was larger than most of its competitors. To see whythis provided an advantage, note that once a company pays for the right-of-way and places telephonepoles and wires on a given street, the cost of adding an additional customer (on that street) is fairlysmall. The company that acquires the most customers faces lower average costs. This is why AT&T wasable to offer lower prices then its competitors. AT&T bought up these companies when they were nolonger profitable. Since the government recognized that it would be more costly to have many smalltelephone companies, it chose to allow AT&T to operate as a regulated monopoly in which thegovernment regulated the prices that could be charged for telephone services. (The government chose tobreak up AT&T in the latter part of the 20th century because the introduction of microwave and satellitetransmissions of telephone signals and digital switching networks were believe to have eliminated someof the economies of scale that were present under the earlier technology.)One way in which firms may acquire monopoly power is by acquiring exclusive ownership of a rawmaterial. As your text notes, a single family in New Mexico controls most of the known supply ofdesiccant clay. Firms can also raise the sunk costs associated with entry into an industry to helpdiscourage entry by new firms. Sunk costs are costs that cannot be recovered upon exit from an industry.These sunk costs include things like the advertising expenditures needed to ensure brand-namerecognition. If a firm spends a large amount of money on advertising, new firms in the industry will

have to spend a similar amount to counteract this advertising spending. While investments in buildingscan be (at least partly) recovered if a firm leaves the industry, it cannot recover it's sunk costs. Thesecosts represent a cost of exit that must be taken into account by firms considering entry into an industry.If all costs were recoverable on exit, firms would be quite willing to enter to receive even just temporaryshort-run profits. If they know that they'd lose a large amount in the form of sunk costs, though, they'dbe much more cautious about entering an industry. Large sunk costs are also difficult to finance. (Aproblem experienced by John DeLorean when he attempted to enter the automotive manufacturingindustry.... His methods of financing the high sunk costs of this industry were not well received by thelegal authorities...)Patents and licenses provide two types of barriers to entry that are created by the government. Whilepatent protection is necessary to ensure that there are sufficient incentives for firms to engage in researchand development expenditures, it also provides the patent holder with some degree of monopoly power.This is how Polaroid has been able to maintain it's long-term monopoly of the instant film business.A local monopoly is a monopoly that exists in a specific geographical area. In many regions, there isonly a single company providing local newspapers (at least on a daily basis). In Syracuse, for example,the Syracuse Newspapers company is the only local newspaper (note that this company publishes boththe Post-Standard, a morning newspaper, and the Herald American, an afternoon paper).Demand, AR, MR, TR, and elasticityThe demand curve facing a monopoly firm is the market demand curve (since the firm is the only firm inthe market). Since the market demand curve is a downward sloping curve, marginal revenue will be lessthan the price of the good (this relationship was discussed in some detail in Chapter 9). As noted earlier,marginal revenue is:positive when demand is elastic,equal to zero when demand is unit elastic, andnegative when demand is inelastic.These relationships are illustrated in the diagram below. As this diagram illustrates, total revenue ismaximized at the level of output at which demand is unit elastic (and MR = 0). It might be tempting toassume that this is the best output level for the firm to produce. This would be the case, though, only ifthe firm's goal is to maximize it's revenue. A profit- maximizing firm must take its costs as well as itsrevenue into account in determining how much output to produce.

As in all other market structures, average revenue (AR) is equal to the price of the good. (To see thisnote that AR = TR/Q = (PxQ)/Q = P.) Thus, the price given by the demand curve is the average revenuethat the firm receives at each level of output.As discussed in Chapter 9, any firm maximizes its profits by producing at the level of output at whichmarginal revenue equals marginal cost (as long as P > AVC). For the monopoly firm described by thediagram below, MR = MC at an output level of Qo. The price that this firm will charge is Po (the pricethat the firm can charge for this level of output given by the demand curve). Since the price (Po) exceedsaverage total cost (ATCo) at this level of output, the firm receives economic profit. These monopolyprofits, though, differ from those received by a perfectly competitive firm in that these profits willpersist in the long run (due to the barriers to entry that characterize a monopoly industry).

Of course, it is possible that a monopoly firm may experience losses. The diagram below illustrates thispossibility. In this diagram, the firm receives economic losses equal to the shaded area. Since price isabove AVC, though, it will continue operations in the short run, but will leave the industry in the longrun. Note that the ownership of a monopoly does not guarantee the existence of economic profits. It isquite possible to have a monopoly in the production of a good that few people want....

A monopoly firm will shut down in the short run if the price falls below AVC. This possibility isillustrated in the diagram below.

Those who have not studied economics often believe that a monopolist is able to choose any price that itwishes and that it can always receive higher profits by raising its price. As in all other market structures,though, the monopolist is constrained by the demand for its product. If a monopoly firm wishes tomaximizes its profit, it must select the level of output at which MR = MC. This determines a uniqueprice that will be charged in this industry. An increase in the price above this level would reduce theprofits received by the firm.Price discrimination and dumpingFirms operating in markets other than those of perfect competition are able to increase their profits byengaging in price discrimination, a practice in which higher prices are charged to those customers whohave the most inelastic demand for the product. Necessary conditions for price discrimination include:the firm cannot be a price taker,the firm must be able to sort customers according the their elasticity of demand, andresale of the product must not be feasible.The diagram below illustrates how price discrimination may be used in the market for airline travel.Those flying for vacation purposes are likely to have a more elastic demand than those who fly forbusiness purposes. As the diagram below indicates, the optimal price is higher in for business travelersthan for vacation travelers. Airlines engage in price discrimination by offering low price "super saver"fares that require a weekend stay and that tickets be purchased 2-4 weeks in advance. These conditionsare much more likely to be satisfied by individuals traveling for vacation purposes. This helps to ensurethat the customers with the most elastic demand pay the lowest price for this commodity.

Other examples of price discrimination includes daytime and evening telephone rates, child and seniorcitizen discounts at restaurants and movie theaters, and cents-off coupon in Sunday newspapers. (Besure to understand why each of these is an example of price discrimination.)When countries practice price discrimination by charging different prices in different countries, they areoften accused of dumping in the low-price countries. Predatory dumping occurs if a country charges alow price initially in an attempt to drive out domestic competitors and then raises the price once thedomestic industry is destroyed. While it is often claimed that predatory dumping occurs, the evidence onthis is rather weak.Comparison of perfect competition and monopolyThe left-hand side portion of the diagram below illustrates the consumer and producer surplus that isreceived in a perfectly competitive market. The right-hand side portion of the diagram illustrates the lossin consumer and producer surplus that results when a perfectly competitive industry is replaced by amonopoly. As this diagram indicates, the introduction of a monopoly firm causes the price to rise fromP(pc) to P(m) while the quantity of output falls from Q(pc) to Q(m). The higher price and reducedquantity in the monopoly industry causes consumer surplus to fall by the trapezoidal area ACBP(pc).This does not all represent a cost to society, though, since the rectangle P(m)CEP(pc) is transferred tothe monopolist as additional producer surplus. The net cost to society is equal to the blue shaded triangleCBF. This net cost of a monopoly is called deadweight loss. It is a measure of the loss of consumer andproducer surplus that results from the lower level of production that occurs in a monopoly industry.

Some economists argue that the threat of potential competition may encourage monopoly firms toproduce more output at a lower price than the model presented above suggests. This argument suggeststhat the deadweight loss from a monopoly is smaller when barriers to entry are less effective. Fear ofgovernment intervention (in the form of price regulation or antitrust action) may also keep prices lowerin a monopoly industry than would otherwise be expected.A related point is that it is unreasonable to compare outcomes in a perfectly competitive market withoutcomes in monopoly market that results from economies of scale. While competitive firms mayproduce more output than a monopoly firm with the same cost curves, a large monopoly firm producesoutput at a lower cost than could smaller firms when economies of scale are present. This reduces theamount of deadweight loss that might be expected to occur as a result of the existence of a monopoly.On the other hand, deadweight loss may understate the cost of monopoly as a result of either X-inefficiency or rent-seeking behavior on the part of monopolies. X-inefficiency occurs if monopolieshave less incentive to produce output in a least-cost manner since they are not threatened withcompetitive pressures. Rent-seeking behavior occurs when firms expend resources to acquire monopolypower by hiring lawyers, lobbyists, etc. in an attempt to receive governmentally granted monopolypower. These rent-seeking activities do not benefit society as a whole and divert resources away fromproductive activity.Regulation of natural monopoly

As noted above, a monopoly firm can produce at a lower cost per unit of output than could any smallerfirms in a natural monopoly industry. In this case, the government generally regulates the price that amonopoly firm can charge. The diagram below illustrates alternative regulatory strategies in such anindustry. If the government leaves the monopolist alone, it will maximize its profits by producing Q(m)units of output and charging a price of P(m). Suppose, instead, though, that the government attempts toemulate a perfectly competitive market by setting the price equal to marginal cost. This would occur at aprice of P(mc) and a quantity of output of Q(mc). Since this is a natural monopoly, though, the averagecost curve declines over the relevant range of output. If average costs are declining, marginal costs mustbe less than average costs (this relationship between marginal and average costs was discussed in detailin Chapter 9). Thus, if the price equals marginal costs, the price will be less than average total costs andthe monopoly firm will experience economic losses. This pricing strategy could only exist in the longrun if the government subsidized the production of this good.

An alternative pricing strategy is to ensure that the owners of the monopoly receive only a "fair rate ofreturn" on their investment rather than monopoly profits. This would occur if the price were set at P(f).At this price, it would be optimal for the firm to produce Q(f) units of output. As long as the ownersreceive a fair rate of return, there would be no incentive for this firm to leave the industry. Roughlyspeaking, this is the pricing strategy that regulators use in establishing prices for utilities, cable services,and the prices of other services produced in regulated monopoly markets.

Chapter 12In this chapter, we'll examine how price and output is determined in oligopoly and monopolisticallycompetitive markets. Let's begin with a discussion of monopolistic competition.A monopolistically competitive market is characterized by:many buyers and sellers,differentiated products, andeasy entry and exit.The monopolistically competitive market is similar to perfect competition in that there are many buyersand sellers who can enter or leave the market easily in response to economic profits or losses. Amonopolistically competitive firm, though, is similar to a monopoly in that it produces a product that isdifferent from that produced by all other firms in the market. The restaurant market in New York Cityprovides a good example of a monopolistically competitive market. Each restaurant has its own recipes,decor, ambiance, etc. but also must compete with many other similar restaurants.Because each firm produces a differentiated product, it won't lose all of its customers if it raises itsprices. Thus, a monopolistically competitive firm faces a downward sloping demand curve for itsproduct. As noted in Chapters 8 and 10, whenever a firm faces a downward sloping demand curve, its

marginal revenue curve lies below its demand curve. The diagram below illustrates the relationship thatexists between a monopolistically competitive firm's demand and marginal revenue curves.

While the diagram above seems similar to the demand and marginal revenue curves facing a monopolist,there is a critical difference. In a monopolistically competitive market, the number of firms changes asfirms enter or leave the industry. When new firms enter the market, the customers are spread over alarger number of firms and the demand for each firm's product declines. An increase in the number offirms also tends to result in an increase in the elasticity of demand for each firm's products (sincedemand is more elastic when more substitutes are available). The diagram below illustrates the shift in atypical firm's demand curve that occurs when additional firms enter a monopolistically competitivemarket.

Short-run and long-run equilibrium in monopolistically competitive marketsLet's examine the determination of short-run equilibrium in a monopolistically competitive outputmarket.The diagram below illustrates a possible short-run equilibrium for a typical firm in a monopolisticallycompetitive market. As with any profit-maximizing firm, a monopolistically competitive firmmaximizes its profits by producing at a level of output at which MR = MC. In the diagram below, thisoccurs at an output level of Qo. The price is determined by the amount that customers are willing to payto buy Qo units of output. In the example below, the demand curve indicates that a price of Po will becharged when Qo units of output are sold.

In a monopoly industry, economics profits could persist indefinitely due to the existence of barriers toentry. In a monopolistically competitive industry, however, the existence of economic profits results inthe entry of additional firms into the industry. As additional firms enter, the demand for each firm'sproduct will fall and become more elastic. This reduction in demand, though, results in a reduction in thelevel of economic profit received by a typical firm. Entry into the market continues until a typical firmreceives zero economic profits. This possibility is illustrated in the diagram below.

The diagram above depicts a monopolistically competitive firm in a state of long-run equilibrium. Thisfirm maximizes its profit by producing an output level of Q'. The equilibrium price is P'. Since the priceequals average total cost at this level of output, a typical firm receives a level of economic profit equal tozero. This long-run equilibrium situation is often referred to as a "tangency equilibrium" since thedemand curve is tangent to the ATC curve at the profit-maximizing level of output.

In the short run, a monopolistically competitive firm may receive economic losses in the short run. Thispossibility is illustrated in the diagram below. While each firm will continue operations in the short run,firms will leave the industry in the long run. As firms leave, the demand curves facing the remainingfirms will shift to the right and become less elastic. (To see this, note that when firms leave the industry,the remaining firms will receive some of the customers that used to purchase the commodity at the firmsthat have left the industry.) Exit from the industry will continue until economic profits again equal zero(as illustrated in the diagram below).

Monopolistic competition vs. perfect competitionAs noted in Chapter 10, perfectly competitive markets result in economic efficiency since P = MC andfirms produce at the minimum level of ATC. The diagram below compares price and output levels forperfectly competitive and monopolistically competitive firms. As this diagram suggests, a perfectlycompetitive firm produces output at a price (Ppc) that is less than the price that would be charged by amonopolistically competitive firm (Pmc). A perfectly competitive firm will also produce a larger quantityof output (Qpc) than would be produced by a monopolistically competitive firm (Qmc).

Because monopolistically competitive firms produce at a level of cost that exceeds the minimum level ofATC, they are less efficient than perfectly competitive firms. This efficiency loss, however, is a cost thatsociety must bear if it wishes to have differentiated products. One of the costs of having variety inrestaurants, clothing, most types of prepared foods, etc., is that average production costs will be higherthan they would be if a homogenous product were produced.It should be noted, though, that the larger the number of firms in the market, the more elastic will be thedemand for each firm's product. As the number of firms grows very large, the demand curve facing amonopolistically competitive firm will approach the perfectly elastic demand curve that is faced by aperfectly competitive firm. In such a situation, the efficiency cost of product differentiation will berelatively small.In the short run, monopolistically competitive firms may receive economic profits by successfullydifferentiating their product. Successful product differentiation, however, will soon be copied by otherfirms. It is expected that such profits will disappear in the long run. Advertising campaigns may raise theprofits of a firm in this industry in the short run, but will successful advertising campaigns will lead tosimilar efforts by other firms in the industry.As your text notes, monopolistically competitive firms in the same industry often locate near each otherin communities as a result of their attempts to appeal to the median customer in a geographic region.This is why we often see car dealerships and fast-food restaurants locating near each other on aparticular street.OligopolyAn oligopoly market is characterized by:a small number of firms,either a standardized or a differentiated product,recognized mutual interdependence, anddifficult entry.Because there are few firms in an oligopoly industry, each firm's output is a large share of the market.Because of this, each firm's pricing and output decisions have a substantial effect on the profitability ofother firms. Furthermore, when making decisions concerning price or output, each firm has to take intoaccount the expected reaction of rival firms. If McDonald's lowers the price of their Big Macs, forexample, the effect on their profits would be very different if Burger King responded by lowering theprice on their Whopper sandwiches by a larger amount. Because of this mutual interdependence,oligopoly firms engage in strategic behavior. Strategic behavior occurs when the best outcome for oneparty is determined by the actions of other parties.The kinked demand curve model describes a situation in which a firm assumes that other firms willmatch its price reductions but will not follow price increases. As your text notes, the optimal strategy insuch a situation is frequently to leave the price at the current level and to rely on nonprice competitionrather than price competition.

There is little evidence, though, that the kinked-demand curve model accurately describes the behaviorof oligopoly firms. Instead, economists generally rely on game-theory models to describe outcomes inoligopoly markets. Game theory attempts to explain strategic behavior by examining the payoffsassociated with alternative choices by each participant in the "game." A possible situation that can beanalyzed by game theory is whether each firm in a 2-firm oligopoly should maintain a high or a lowprice. In such a situation, the highest level of combined profits may be received if each firm charges ahigh price. Either firm, however, could increase its profits by offering a low price if the other firmcontinues to charge a high price. If both firms charge a low price, combined profits are lower than ifthey both charged a high price.Participants in a game face a relatively simple choice when a dominant strategy exists. A dominantstrategy is one that provides the highest payoff to an individual for each and every possible action oftheir rivals. In the oligopoly pricing decision described above, the dominant strategy is to offer a lowerprice. To see this, suppose that you are making this decision and do not know what the other firm willdo. If the other firm charges a high price, you can receive the highest profits by undercutting this firm'sprice. On the other hand, if the other firm charges a low price, the best strategy for you is again to chargea low price (if you charge a high price when the other firm offers a low price, you will receive largerlosses). In this case, if this game is played only once, each firm would be expected to charge a low priceeven though their combined profits would be higher if they both charged a high price. If collusion ispossible (and enforceable), though, both firms may charge a high price.The oligopoly pricing decision described above is an example of a general type of game known as aprisoners' dilemma. Under the traditional prisoners' dilemma game, two prisoners are arrested and heldseparately. When they are interrogated, each is offered a reduced sentence if he or she provides evidenceagainst the other party. The dominant strategy in this situation is to confess since for each possibleaction chosen by the other party, the prisoner receives a lighter sentence by confessing. The prisoners'dilemma model is used in a wide variety of academic disciplines to explain individual behavior instrategic situations.Not all strategic situations result in a dominant strategy. It becomes much more difficult to predict theoutcome of a game when no dominant strategy exists.The analysis of strategic decision making, though, becomes much more complex when they are playedrepeatedly by the same players. In the case of the prisoners' dilemma, even though each individual maygain in a single case by confessing, both prisoners will have a wealthier life of crime if neither of themconfesses and provides evidence against the other. If they know that they will engage in further crimesin the future, they will be less likely to confess. By not confessing, they are able to attain a higher levelof lifetime income. In the case of oligopolies, each firm has an incentive to undercut the prices chargedby other firms in any given time period. Each firm, though, realizes that if it charges a lower price now,the other firm may respond by charging lower prices in the future. The threat of future retaliation mayencourage firms to maintain high prices in each time period.The situations described above involve noncooperative games in which participants could not worktogether to mutually decide on outcomes. If oligopoly firms are free to collude and jointly determinetheir prices and output levels, they would be able to attain a higher combined level of profits. In the U.S.collusion of this sort is illegal. While it is illegal for firms to officially meet and determine prices andoutput levels, it is perfectly legal for them to charge the same high prices as long as they didn't meet todetermine the prices. Firms may be able to achieve outcomes equivalent to the collusive outcome byengaging in a price-leadership situation in which one firm sets the price for the industry and the otherfirms follow that firms' price changes. Other facilitating practices such as cost-plus/markup pricing mayalso result in an equivalent outcome. (Cost-plus or markup pricing occurs when firms determine theretail price of a commodity as a given multiple of the wholesale price - if there is a 50% markup, a goodthat costs the firm $10 to acquire will be sold for $15.) If all firms use the same markup percentage, theywill all tend to charge the same price. Manufacturers of goods often facilitate this practice by posting"recommended retail prices" on the products.Cartels are legal in some countries. Under a cartel arrangement, firms engage in explicit collusivebehavior. One problem with cartels, though, is that any individual firm can increase its profits bycheating on the agreement. For this reason, most cartels have not been lasted very long.Imperfect information

One complicating factor in markets is that buyers and sellers do not always possess perfect informationabout the characteristics of the products that they are buying and selling. Brand name identification isimportant in many oligopoly and monopolistically competitive markets because a seller that wishes toremain in business has an incentive to produce a high quality product. Customers are often willing topay a higher price for a product produced by an established firm rather than buying a product from afirm that they do not recognize. Product guarantees are also used by firms as a signal of product quality.One problem caused by imperfect information is the adverse selection problem. The adverse selectionproblem occurs when those who willing to agree to a transaction are selling a lower-quality product thanis typical in the population as a whole. A classic example of the adverse selection problem occurs in themarket for used cars. Once a car is driven off the lot, its value declines rather dramatically. The reasonfor this is that individuals who are stuck with "lemons" are more likely to sell their cars in the used-carmarket than those who purchased reliable vehicles. Because buyers cannot always determine whether acar is a good used car or a "lemon" the price of all used cars is lower because of the lower averagequality of the used cars that are offered for sale.Another example of the adverse selection problem occurs in the market for insurance. If there are norestrictions on who is eligible to purchase a health insurance or life insurance policy, those whopurchase them are disproportionately those individuals who are more seriously ill. Because of this, thecost of insurance policies offered to the general public is much higher than the cost of insurance that isprovided to all employees in a firm or all students at a college.Moral hazard is another problem that results from imperfect information. Moral hazard occurs when theexistence of a contract causes one party to alter his or her behavior from the behavior that wasanticipated by the other party at the time the contract was agreed to. Medical insurance provides anexample of the moral hazard problem since the existence of insurance encourages individuals toconsumer more medical services than would otherwise be consumed.

Chapter 13In this chapter, we'll discuss government policy toward business, with particular attention on antitrustlaws.Two explanations for government intervention in markets are:public interest theory, andcapture theory.Public interest theory suggests that the government takes actions that are designed to correct for marketfailure. This view suggests that the government undertakes actions that are designed to improve thewelfare of society as a whole. Those who believe in the capture theory, though, argue that governmentactions transfer wealth across individuals and groups in society. The capture theory suggests that specialinterests receive the benefits from government intervention in the economy. Advocates of this positionsuggest that even regulatory agencies charged with serving the public interest will eventually be"captured" by the firms that they regulate.AntitrustThe measure of market concentration that is used by the U.S. Justice Department is the Herfindahl indexdefined as the sum of squared market shares (expressed as a percentage) of all of the firms in anindustry. In a pure monopoly, this would equal 10,000. If there are 100 equal sized firms in an industry,

the Herfindahl index would equal 100. The Justice Department argues that an industry in which theHerfindahl index is less than 1,000 is highly competitive. A Herfindahl index between 1,000 and 1,800indicates that an industry is moderately competitive. An industry is said to be highly concentrated if theHerfindahl index exceeds 1,800.The basis of antitrust law in the United States is the Sherman Antitrust Act of 1890. This act prohibitedfirms from engaging in activities that were "in restraint of trade." Initially, this act was not used to breakup many monopolies, though, because it did not define what activities were illegal. The Clayton Act of1914 (and subsequent amendments), however, provided a list of activities that were held to be violationsof antitrust law. In particular, the Clayton Act prohibited firms from engaging in price discriminationdesigned to reduce competition and from engaging in exclusive dealing and tieing contracts that limitedcompetition.Initially, courts followed the "rule of reason" that suggested that size alone is not evidence of a violationof antitrust law. This changed with the Alcoa case of 1945 that held that size, per se, is sufficientevidence of antitrust violation. By the 1980s, though, the Justice Department and subsequent courtdecisions had effectively returned to the earlier "rule of reason."RegulationDuring the earlier years of these industries, the U.S. regulated the trucking, airline, and railroadindustries. The rationale behind the regulation was that it was needed to prevent "destructivecompetition" that would result in the failure of these new industries that had relatively high fixed costs.In the 1970s, however, the airline and trucking industries were deregulated. Transportation costs in theseindustries fell rather substantially.As your text notes, the government also engages in a variety of social regulatory activities.

Chapter 14Government and Market FailureThis chapter addresses the major types of market failure that provides an economic rationale forcorrective governmental action:externalities,common property resources,public goods, andasymmetric information.ExternalitiesExternalities are side effects of production or consumption that impose costs on or provide benefits tothird-parties who are not directly involved in the activity. Positive externalities are side-effects thatprovide benefits to one or more third-parties, while negative externalities harm others.If someone paints their house, shovels snow from the sidewalk in front of their dwelling, receives avaccine for a contagious diseases, or removes junk cars from their lawn, positive externalities occur.Negative externalities occur as a result of pollution, loud music played by neighbors (assuming that youdo not enjoy their choice or timing of music), cigarette or cigar smoke, or any other activities that peopleengage in that harm others.

In earlier chapters, you learned that the optimal level of consumption for a good occurs at the point atwhich the price of the good equals the consumer's private marginal benefit from the good. You alsoshould recall that, in a perfectly competitive market, a firm will produce output at the point at which P =MC (where MC includes only the firm's private marginal costs). Thus, we know that, at a competitiveequilibrium, private marginal benefit (as reflected in the demand curve) must equal private marginal cost(as represented by the supply curve). If there are no externalities, social marginal cost will equal privatemarginal cost (since no costs are imposed on others) and social marginal benefit will equal privatemarginal cost.When negative externalities are present, the social marginal cost exceeds the private marginal cost tothose who are engaged in the activity that generates the externality. In this case, competitive markets,left to themselves, will result in a level of production at which the social marginal cost exceeds thesocial marginal benefit associated with the activity. In this case, society would be better off if the levelof the activity was reduced. The presence of negative externalities results in overproduction.One of the most commonly used examples of a negative externality is pollution. If firms are able topollute the air, water, or soil without any costs, they will not take these external costs into account whenformulating their production plans.Social marginal benefits exceed private marginal benefits when positive externalities are present. Sincepeople do not take external benefits into account when weighing their own private benefits and costs,social marginal benefits exceed social marginal cost at their optimal level of the activity. Thus,competitive markets will underproduce those activities that generate positive external benefits.Consider, for example, the case of a vaccine. When you receive a vaccine, you not only protect yourselffrom the virus, you also protect those with whom you come into contact from contracting the virus fromyou. Suppose that you would receive $10 in benefits by receivng the vaccine and those around youwould (in total) receive $4 in benefits from your consumption of the vaccine. If the vaccine cost $12(including the cost of time), it would not be optimal for you to consume this (since your private benefitis less than your private cost) even though it the gains to society outweigh the social cost of providingyou with the vaccine.Solutions to externality problemsOne method of dealing with externalities is to impose a tax (in the case of a negative externality) orprovide a subsidy (in the case of a positive externality). If the tax (or subsidy) is set at the level of themarginal external cost (or marginal external benefit), individuals will select the optimal level of theactivity since thgeir own costs and benefits now reflect social costs and benefits. This method ofcorrecting for the presence of an externality was first suggested by A. Pigou, and is known as a Pigoviantax (or subsidy). This type of approach is said to "internalize the externality" by converting an externalcost or benefit into an internal cost or benefit.An alternative method of dealing with externalities is the use of government regulations. Restrictions onpollution emissions, mandatory schooling requirements, laws banning driving whil intoxicated, andsimilar laws all attempt to correct for the presence of externalities.In recent decades, marketable pollution permits have been introduced as an alternative to emissionrestrictions for several pollutants. Firms must buy permits to emit spoecific quantities of these pollutantsinto the air or water. The advantage of this system over the use of taxes or regulations is that it providesa more efficient reduction in pollution. Those firms that face lower costs of reducing pollution have anincentive to reduce pollution by more than those firms that find pollution reduction more costly. In thiscase, society attains a given reduction in total emissions at a lower opportunity cost than would occur ifall firms were forced to reduce emissions to the same level.The Coase theorem suggests that, as long as property rights are well established and there are notransaction costs, private bargaining may correct for the presence of externalities. In practice, however,the existence of transaction costs makes it unlikely that an efficient outcome will occur in the absence ofgovernment intervention.Common property resourcesA common property resource is one for which no individual has private property rights. When everyoneshares ownership of a resource, each individual receives all of the benefits from using the resource, butthe costs are shared by everyone. Consider, for example, the case of whales, buffalo, fisheries, andsimilar resources. In each case, the whaler, hunter, or fisherman receives property rights only after

catching and killing the animal. Each person gets the full benefit from their activity, but the cost of areduced breeding stock is shared by everyone. If you are an individual fisherman fishing in anendangered fishery, you have no incentive to reduce your individual harvest of fish because you knowthat if you do not catch an additional fish, someone else might. In such a situation, the resource isoverutilized.Governments deal with this problem by setting restrictions on consumption or by introducing propertyrights when feasible. When alligators were a common property resource in the U.S., they were hunteduntil they were threatened with extinction. The introduction of "alligator farms" in which alligators wereowned by individuals eliminated the risk of extinction since individual alligator farmers face anincentive to maintain a breeding stock for subsequent year's harvests.This "problem of the commons" (as it is also known) explains why public parks and highways oftenhave more litter than most individual's back yards, why bathrooms and commons rooms in dormitoriesare messier than those in private houses and apartments, and why many species of animals have beenhunted to extinction or threatened with extinction.Public goodsA public good is a good that is nonrival in consumption. This means that one person's consumption doesnot reduce the quantity or quality of the good available to other consumers. Examples of public goodsinclude national defense and TV and radio signals broadcast through the air. Some public goods havesome congestion costs in which the benefits do decline a bit as the number of people consuming themrises. Town parks, highways, police and fire protection, and other similar commodities and services fitthis definition.The problem with public goods is that no individual has an incentive to pay for the good. Since it isinefficient, and not always feasible, to exclude people from consuming a public good, people canconsume it even if they do not pay for it at all. In such a situation, each person has an incentive to be a"free rider" and to let others pay for the good. The problem, of course, is that the good will be eitherunderproduced or not produced at all if the provision of such goods were left to the market.The government attempts to correct for this type of market failure by either providing (or subsidizing theproduction of) public goods.Asymmetric informationAsymmetric information is said to exist when one party to a contract has more information than theother party. Among the problems associated with asymmetric information are:adverse selection, andmoral hazard.Adverse selectionAn adverse selection problem occurs when the average "quality" of one of the participants in atransaction is of lower quality than in the population. A classic example occurs in the market for usedcars. As noted by George Akerlof, the value of a car declines substantially once the car has beenpurchased by its original owner. The reason for this is that a 1-year old used car that is offered for sale isof lower quality than a typical 1-year old used car. If 1% of new cars are "lemons," it is quite possiblethat 50% of one-year old used cars might be "lemons." The reason is that those who bought high-qualitycars are more likely to keep them while those who ended up with lower-quality cars are more likely totry to sell them.Asymmetric information occurs in this case because the buyer of a used car has less information aboutthe true quality of the car than does the seller. The equilibrium price of a 1-year old used car reflects theaverage value of these cars. Those who try to sell high-quality used cars end up with the same price thatsellers of "lemons" receive since buyers cannot tell them apart.As noted in your text, markets for insurance and loans also experience adverse selection problems.The government may attempt to correct for adverse selection by requiring product warranties. Insurancecompanies require physical exams as a condition for receiving health or life insurance as a way ofdealing with adverse selection. Banks and other financial intermediaries use credit reports to reduce theadverse selection problem. Brand-name loyalty is one method by which consumers may avoid adverseselection problems.Moral hazard

A moral hazard problem occurs when one of the party to a transaction has an incentive to alter theirbehavior in a manner detrimental to the other party once a contract is formed. Insurance, for example,generates a moral hazard problem since the individual with the insurance has less incentive to avoid theevents for which they are insured against.Copayments and deductibles are by insurance companies to reduce the moral hazard problem.

Government failureThe government consists of many individuals who may attempt to maximize their own utility rather thanserving the general "social interest." "Logrolling" in legislatures may lead to higher spending than isoptimal. Rent-seeking behavior may result in policies being pursued that provide large benefits to asmall group but small damage to the vast majority of the population.

Chapter 15In this chapter, we'll examine how employment and resource prices are determined in resource markets.As noted earlier, there are four basic categories of resources: land, labor, capital, and entrepreneurialability. The associated resource payments for these resources are:

Resource Resource Paymentland rentlabor wagescapital interestentrepreneurial ability profit

Rent, wages, and interest are determined in the markets for land, labor, and capital. The entrepreneurs,though, are residual claimants who receive profits, the revenue that is left over after all other factors ofproduction have been paid.

The relationship between output and resource markets is described by the circular flow diagram that wehad examined in the early part of this course. This diagram illustrates the very importantinterdependence between output and resource markets. Firms purchase resources in resource markets sothat they can produce the output that is sold in the output markets. Because of this, we say that thedemand for resources is a derived demand that is derived from the demand for final output. The demandfor autoworkers, for example, increases when the demand for automobiles rises.

The circular flow diagram above also illustrates another point that should be remembered: householdsare the source of supply in the resource market and firms are the source of demand. Note that these rolesare the opposite of the roles played by both households and firms in the output market.Market demand and supply of resourcesThe diagram below illustrates the market demand and supply curves for a resource market. The demandcurve is downward sloping since a reduction in the price of a resource increases a firm's willingness andability to pay for the resource. The quantity of a resource supplied rises as the price of the resource risessince the owners of the resource will transfer the resource to the most highly-valued alternative. As thediagram below suggests, a market equilibrium occurs at the level of resource price at which quantitydemanded equals quantity supplied.

Let's examine the resource demand and supply relationships in more detail.Market demandThe elasticity of resource demand is defined as:

The price elasticity of demand for a resource is expected to be higher when:the price elasticity of demand for the final product is relatively high,this resource accounts for a relatively large share of the firm's total costs,there are many substitutes for the resource, anda longer time period is considered.Let's consider why the price elasticity of demand for the final product affects the price elasticity ofresource demand. Resource demand is more elastic when the quantity of the resource demanded declinesby a larger amount when the price of the resource declines. Let's examine how a change in the resourceprice affects the quantity of the resource demanded. As the price of the resource rises, marginal andaverage total costs will increase. This increase in costs results in a higher equilibrium price of theproduct being sold. As the price of the product rises, the quantity of the product demanded declines.Since the demand for resources is a derived demand, this decline in the quantity of the productdemanded results in a reduction in the quantity of resources demanded. When the price elasticity ofdemand for the final product is relatively large, there will be a larger reduction in the quantity of thefinal product demanded (and therefore a larger reduction in the quantity of resources demanded) whenthe price of a product rises in response to an increase in resource price. Be sure to think through thechain of causality rather carefully to understand the relationship between the price elasticity of demandfor the product and the price elasticity of resource demand.The resource's share in total costs affects the elasticity of resource demand in a similar manner. Whenthe price of the resource rises, the effect on marginal and average total costs will depend upon theresource's share in total costs. If a resource comprises 10% of total costs, a doubling of the price of theresource would result in a 10% increase in total costs. If the resource accounts for only 1% of the firm'scost, a doubling of it's price will raise the firm's costs by only 1%. Thus, a change in the price of theresource will have a larger effect on the cost of and the price of the final product when the resource is alarger share of total costs. In this situation, the quantity of output sold will decline by more, as will thequantity of the resource demanded. Thus, resource demand is more elastic when the resource accountsfor a larger share of total costs.Firms will reduce the employment of a resource by a larger amount when many substitute resources areavailable. Thus, resource demand is more elastic when there are more substitutes.Since it takes time for firms to alter their production methods, an increase in the price of a resource willhave a larger effect in the long run when there are more possibilities for substitution. Thus, resourcedemand will be more elastic when a longer time period is considered.Let's examine those factors that will cause the demand for a resource to shift.The demand for a resource will increase when:the price of the product increases,the productivity of the resource rises,the number of buyers rises,the price of a substitute resource rises,the price of a complementary resource falls, and/orthe firm possesses high levels of other resources.In determining how many workers (or units of another resource) to employ, a firm weights the benefitsfrom employing the resource against the cost. An additional worker will be hired only if the additionalbenefit exceeds the additional cost. The benefit the firm receives from adding additional workers is therevenue generated from the sale of the output produced by the workers. An increase in the price of theproduct or the productivity of the workers raises the marginal benefits associated with hiring workers.Thus, labor demand will increase when the price of the output sold rises or the productivity of theworkers rises. An equivalent argument applies to other resources.Since the market demand curve for a resource is constructed by adding together the demand curves forall of the firms in a resource market, an increase in the number of firms will increase the market demandfor the resource.Substitute resources are used in place of each other (such as assembly line welders and robotic welders).If one of these resources becomes more expensive, firms will replace the more expensive resource withthe relatively less expensive resource. Complementary inputs are inputs that tend to be used together.Computer-controlled production equipment and computer technicians are likely to be complementary

inputs. If one of these inputs becomes more expensive the demand for the complementary input willdecline.If a firm has a high level of some input, the productivity of other inputs will increase. A firm possessinga large amount of capital, for example, may find that its workers are more productive than workers infirms where the workers have fewer tools to assist their work. In this case, an increase in capital mayresult in an increase in the demand for labor.Market SupplyAs your text notes, the price elasticity of resource supplied is given by:

The price elasticity of supply is greater when there are many alternative uses for the resource and alonger time period is considered. Workers who can work in many occupations will be reduce thequantity of labor supplied by more if their wage falls than would workers who do not have manyalternative employments. Since it takes time for workers to retrain and acquire information about otherlabor markets, a larger change in the quantity of labor supplied will occur in response to a wage changewhen a larger time period is considered.The earnings of a resource that has a perfectly inelastic supply curve is called economic rent. Economicrent represents a payment in excess of the opportunity cost of supplying a resource. If a firm has aperfectly inelastic supply curve, the same amount of the resource is available even if the price is zero.Thus, any payment receives by this resource constitutes economic rent. The earnings of a resourcepossessing a perfectly elastic supply curve are called transfer earnings. Transfer earnings are paymentsthat equal the opportunity cost of supplying a resource. When a resource has a perfectly elastic supplycurve, the price of the resource is the same in all alternative employments in this market. Thus, allearnings are transfer earnings. In the more typical case of a resource with an upward sloping marketsupply curve, the resource receives a mix of economic rent and transfer earnings.Resource supply shifts in response to changes in tastes, changes in the number suppliers and changes inthe price of the resource in alternative uses.Price ceilings and price floorsAs noted above, an equilibrium in a resource market occurs when the quantity supplied equals thequantity demanded. If an effective price floor is introduced (such as a minimum wage law) that keepsthe price above the equilibrium, a surplus will occur (since quantity supplied exceeds quantitydemanded). In the labor market, this surplus takes the form of unemployed workers. This possibility isillustrated in the diagram below. Note that quantity supplied exceeds quantity demanded when a pricefloor is introduced at a price equal to Pf.

The diagram below illustrates the effect of an effective price ceiling. When the price is kept below theequilibrium (as at Pc in this diagram), quantity demanded exceeds quantity supplied and a shortageoccurs.

Individual firm demandA firm will hire an additional unit of a resource if this increases its profits. Recall that economic profitequals:economic profit = total revenue - total costWhen the level of resource use rises, both total revenue and total cost rise. Economic profit will increaseif total revenue rises by more than total cost.The additional revenue that results when the level of resource use rises by one unit is called the marginalrevenue product (MRP) of the resource. Marginal factor cost (MFC) is defined as the additional costassociated with a one-unit increase in resource use. A little bit of reflection should convince you that it isoptimal for the firm to:increase the level of resource use when MRP > MFC, andreduce the level of resource use when MRP < MFC.An optimal level of employment occurs at the level of resource use at which MRP = MFC.Marginal revenue product can be expressed as:MRP = MR x MPPwhere MR (marginal revenue) equals the additional revenue resulting from the sale of an additional unitof output and MPP (marginal physical product) is the additional output that results from the use of anadditional unit of the resource. Suppose, for example, that you wished to compute the marginal revenueproduct of labor that occurs when MR = $3 and MPP = 4. In this case, the use of an additional unit oflabor results in the production of an additional 4 units of output. Since revenue increases by $3 when anadditional unit of output is sold, total revenue will increase by $12 (= $3 x 4 units of output) when anadditional worker is employed. In the special case of a perfectly competitive output market, MRP = P xMPP since MR = P (where P is the market price of the product). (In the case of perfectly competitiveoutput markets, the MRP curve is sometimes referred to as the VMP - the "value of the marginalproduct.")The diagram below illustrates a possible MRP curve. This curve is downward sloping as a result of thelaw of diminishing returns. As you recall, the law of diminishing returns states that as the level ofresource use rises, holding other resources constant, the MPP of the resource ultimately declines. Whileit is possible that the MPP of the resource may initially increase (as illustrated in the diagrams in thetext), a profit-maximizing firm will only employ resources in the range in which MPP is decreasing.Thus, only the downward sloping portion of the MRP curve is illustrated below. (In the case ofimperfectly competitive markets, MR will also decline as the level of resource use rises - since MRdeclines when output increases in imperfectly competitive markets.)

If the resource market is perfectly competitive, each firm faces a perfectly elastic resource supply curve.The diagram below illustrates this relationship. The market price of the resource is determined by theinteraction of market demand and supply. Since each firm is a price taker in a perfectly competitiveresource market, each firm faces a resource supply curve that is perfectly elastic at the equilibriumresource price.

Since each firm is a price taker in a perfectly competitive resource market, the additional cost that resultsfrom the use of an additional unit of the resource is just equal to the resource price. Thus, the marginalfactor cost curve is horizontal at the market price of the resource in such a market. Two possible MFCcurves are illustrated in the diagram below.

As the diagram above suggests, the optimal level of employment occurs at the level of resource use atwhich MRP = MFC. When the level of marginal factor costs is given by the MFC curve, the optimallevel of resource use is Qo. If MFC increases to MFC', the optimal level of resource use will fall to Q'. Abit of reflection should convince you that at any given level of resource price (= MFC), the MRP curvedetermines the quantity of the resource that is demanded by a firm. Since the MRP curve determines thequantity of resource demanded at each level of the resource price, it serves as the firm's resource demandcurve.Monopsony resource marketsThe situation is a bit more complex in the case of a monopsony resource market, a market in which thereis only a single buyer for a resource. An example of a monopsony labor market is a small "companytown" in which there is only a single employer in a particular labor market. In some communities, ahospital may be the only employer of nurses, medical technologists, and radiologists. While there arefew pure monopsonies, many firms have some degree of monopsony power. Let's examine what thisentails.A monopsony firm faces the entire upward sloping resource supply curve. The labor supply curve in thediagram below illustrates such a possibility. In this example, the firm must pay a wage of $6.00 an hourwhen 8 workers are hired and must raise the wage to $6.20 to induce the ninth worker to work for thefirm. Of course, when the ninth worker is hired at this higher wage, the firm will have to raise the wagesof the first eight workers to $6.20. Because of this, the cost of adding a 9th worker each hour is the$6.20 that is paid to this worker plus a $.20 increase in the wage rate of the first 8 workers (costing thefirm $1.60 each hour in wage increases to these workers). Thus, the marginal factor cost of adding the9th worker equals $7.80.

Multiple resourcesThe discussion above applies to the optimal level of employment of any resource, considered by itself. Acost-minimizing firm selects a mix of resources at which the ratio of the MRP to the MFC is the samefor all resources. This condition guarantees that the marginal revenue generated by the last dollar spenton each resource is the same for all resources.

Chapter 16In this chapter, we'll examine the labor market in more detail. Since we discussed resource demand in afair amount of detail in Chapter 15, let's start by examining labor supply.OverviewIndividuals have a fixed amount of time that is available for work or leisure activities. If an additionalhour is spent at work, then one less hour is available for alternative uses. The opportunity cost of an hourof leisure time is the wage that is given up by consuming this leisure. Thus, an increase in the wage rateraises the opportunity cost of leisure time and results in a substitution effect that reduces leisure time andincreases hours worked. A wage increase, however, also raises the worker's real income and results in anincrease in the amount of leisure the individual wishes to consume (assuming that leisure is a normalgood). This second effect, called an income effect, tends to increase the quantity of leisure time andreduces time spent at work when the wage increases.Individuals will work more when the wage rate increases if the substitution effect outweighs the incomeeffect. As the diagram below indicates, an individual's labor supply curve will be upward sloping for therange of wage rates in which the substitution effect is larger in magnitude than the income effect. Whenthe wage is high enough, though, it is generally argued that the income effect will eventually outweighthe substitution effect and the labor supply curve will become backward bending (as in the top portion ofthe diagram below).

The market labor supply curve is the horizontal summation of the labor supply curves for all individualsin a labor market. Even though individuals may have backward-bending labor supply curves, it isexpected that the market labor supply curve will be upward sloping. One reason for this result is thatindividuals will not enter the labor force unless the wage is above a particular threshold value (theindividual's "reservation wage"). As the wage rate rises, more individuals enter the market, offsettingany reduction in the quantity of labor supply that may occur as a result of backward-bending laborsupply curves on the part of some individuals. The diagram on p. 366 in your text illustrates thisconcept.An equilibrium in the labor market occurs at the wage at which quantity demanded equals quantitysupplied. In the diagram below, this occurs at a wage level of w* and an employment level of Q*.

Wage differentialsLet's examine some of the reasons for wage differentials across individuals and across occupations.Jobs differ in terms of the level of risk, stress, educational requirements, physical effort, etc. Whenworkers choose jobs, they do so on the basis of all characteristics of the job, not just the wage. Supposethat two occupations are initially perceived as equivalent in all characteristics, including the wage. Ifnew evidence is dscovered that indicates that one job has a higher risk of an work-related injury, thenthe supply of labor will decrease in the risky occupation and increase at the safer occupation as workersmove from the risky job to the safer job. As this migration of labor occurs, wages will fall in the saferoccupation and rise at the riskier occupation. This migration will continue until the wage differentialbetween the two jobs is just large enough to compensate for the difference in risk. The equilibrium wagedifferential between the risky and the safer occupations is called a compensating wage differential since

it compensates individuals for differences in job risk. This compensating wage differential is equal to theadditional wage payment that must be made to the last worker hired at the risky job to induce him or herto accept the additional risk.The diagram below illustrates the compensating wage differential that is associated with job risk. In thisexample, the compensating wage differential equals Wr - Ws (the wage difference between the risky andthe safer occupation).

Compensating wage differentials may be expected to exist for any job characteristic that is valued eithernegatively or positively by workers. Ceteris paribus, wages will be higher in those occupations that areless pleasant and will be lower in those occupations that are more pleasant.As noted earlier, an individual's human capital is a measure of his or her productive capacity.Individuals that are more productive receive higher wages. Investments in education, training, or healthcare will be expected to increase an individual's stock of human capital. Thus, as your text indicates,earnings increase with both education and years of work experience.There are two types of human capital: general human capital and firm-specific human capital. Generalhuman capital raises an individual's productivity in more than one firm. Firm-specific human capitalraises an individual's productivity only in his or her current job. The education that individual's receivein elementary, secondary, and post-secondary educational institutions increases an individual's stock ofgeneral human capital. Training about specific production processes, policies, or procedures used at aspecific firm increases an individual's stock of firm-specific human capital. Since firm-specific humancapital increases a worker's productivity only in the current firm, it provides a return only if the workerremains with the firm. To help encourage long-term attachment to the firm, earnings tend to risesubstantially with the worker's tenure in the firm.Team productionOne of the problems that firms experience is that in many production processes it is difficult to assessthe contributions of individual workers. A team production process is said to occur when managers canobserve the joint output produced by a group of workers but not the individual contributions of eachworker. In such situations, job categories are defined in which each job category has a specified wagerate.Choice of majorOne of the major determinants of the income of college graduates is the choice of a college major.Economists argue that students make this choice by weighing the all of the expected costs and benefitsassociated with each major. One of the major factors in this decisions in the level of net benefitsanticipated for alternative career paths.DiscriminationGender and racial discrimination are common phenomena in most economies. Economists say thatdiscrimination occurs when a worker's wage is based positively or negatively on some factor other thanmarginal revenue productivity. Economists note that discrimination may be the result of one of thefollowing forms of personal prejudice:employer prejudice,

worker prejudice, orconsumer prejudice.Employer prejudice occurs when employers are willing to pay a higher price for the groups they favor.In this situation, a profit-maximizing firm that does not discriminate will be able to hire the victims ofthis discrimination at a lower wage than the favored groups. This means that firms that discriminate onthe basis of employer prejudice will have higher costs and lower profits. Gary Becker has argued thatthis type of prejudice will be eventually eliminated by the pressures of competition in reasonablycompetitive markets (since firms that do not discrimimate against workers can charge a lower price andremain profitable).Worker prejudice occurs when workers who are prejudiced are willing to accept lower wages to avoidassociation with some other group of workers. The cost of this type of prejudice is expected to be borneby these workers (in the long run, at least).Consumer prejudice occurs when consumers are willing to pay a higher price for products that areproduced or sold by workers from the groups that they favor. This type of discrimination may persistindefinitely, even though it imposes a cost on those who discriminate.Statistical discriminationAnother source of discrimination is a phenomenon known as statistical discrimination. Employers do nothave perfect information about the productivity or reliability of workers who apply for positions with thefirm. College graduates applying for positions in a given occupation often have similar resumes, similarletters of recommendation, and have even learned to dress alike and answer questions alike during theirinterviews (through their planning with career placement offices at their colleges). Firms having to makedecisions on hiring in this situation will often judge people based on the average productivity that theyhave observed for workers with similar characteristics in the past. If, for example, that they haveobserved that graduates of College X have been more productive than graduates from College Y, they'dbe more likely to hire someone from College X if two people with other equivalent characteristicsapplied.Since women and older workers, on average, have historically had higher quit rates than males in theirmid-20s, women and older workers may be the victims of statistical discrimination in jobs in which thefirm provides costly training programs (since it is more profitable to select workers who will remainwith the firm for an extended period of time). Firms that rely on statistical discrimination will makesome mistakes, but will be more profitable - on average - than firms that do not engage in this practice.This type of discrimination is particularly difficult to eliminate since it is a profitable practice for theemployer. On the bright side, the effect of statistical discrimination on women should lessen as femalelabor force participation rates rise and quit rates decline.Occupational segregationStatistical discrimination, combined with societal norms and prejudice, often leads to crowding in someoccupations in which there are a large number of women or minorities. Jobs such as nurse, health careaide, secretary, and elementary teacher are occupations that are disproportionately filled by women.Since the supply of labor is relatively large in these occupations, the equilibrium wage tends to berelatively low. Predominately male occupations such as engineering, computer programming, andphysicians, tend to be less "crowded" and have higher wages. This gender difference in the mix ofoccupations is referred to as "occupational segregation."CEO pay packagesCEOs in large U.S. firms receive salaries that are dramatically above those of other managers in thefirm. This may be the result of market failure caused by a separation between ownership and control inlarge corporations. It may also be the result of a "tournament" in which the promise of a very large prizeto the most successful managers provides an incentive for lower-level managers to work hard to achievethis position. The frequent relocation of managers may also be indicative of this "tournament" processsince firms may wish to examine how managers perform in different market settings. (These frequentmoves may also be simply due to the short-term productivity boost that often occurs when newmanagers are brought into a new position.)Superstar effectsAnother phenomenon that is often observed in real-world labor markets is that a small number ofworkers in an occupation receive salaries that are dramatically above those of other workers. Star actors,

athletes, musicians, lawyers, etc. often receive salaries that are dramatically above those of otherworkers in these occupations. The main reason for this is that these "superstars" provide a return to thefirm that is much larger than that generated by other actors, athletes, musicians, lawyers, etc. These"superstars" fill more theater seats, stadium seats, etc. than do other with less star quality.Antidiscrimination lawsThe Civil Rights Act of 1964 made it illegal for employers to discriminate on the basis of race, color,religion, sex, or national origin (except for cases where there is a legitimate reason for such policies -such as the employment of religious leaders by a church, mosque, synagogue, etc.) Two standards ofdiscrimination have evolved: disparate treatment and disparate impact. Disparate treatment occurs whenpersonnel and employment practices are adopted that treat individuals in the same way without regard togender, race, or religion. One criticism of this standard is that it tends to perpetuate the effects of pastdiscrimination. Even if all workers are given the same chances of promotion in a seniority system,minorities and women may not be employed for a long time at the top of th hierarchy if they had beendiscriminated against for a long period of time. The disparate impact standard is based on the outcomesof a policy, rather than the policy itself. This stricter standard requires that the effects of pastdiscrimination be remedied. Court decisions have frequently gone back and forth between these twostandards.Comparable worthComparable worth pay schemes attempt to base wages on the characteristics of a job rather than on amarket equilibrium. It involves an attempt to provide equal pay for "comparable" jobs. Economists aregenerally opposed to comparable worth pay systems because they raise the wage above the equilibriumin low-wage markets (creating a labor surplus) and below the equilibrium in high-wage markets(creating a labor shortage).UnionsUnions provide another explanation for wage differentials. In at least some cases, unions operate in alabor market that may be characterized as a bilateral monopoly, a situation in which a single buyernegotiates price with a single seller. The diagram below illustrates the monopsony outcome in theabsence of a union. The level of employment occurs at the point at which MRP = MFC and the wage isdetermined by the supply curve at this level of output (as discussed a few chapters back). In thisexample, the monopsony firm would hire Lm workers and pay a wage of Wm.

Suppose, however, that a union negotiates a wage of Wu. At this wage, the supply firm facing the firm isnow perfectly elastic at this wage and the firm's marginal factor cost equals the wage (Wu). Thus, thefirm will still hire Lm workers, but will pay a higher wage (as illustrated in the diagram, below).

If the union and firm negotiate a wage between Wm and Wu, the level of employment will actuallyincrease (since the MFC is lower - even though the wage is higher). Employment will decline if thenegotiated wage exceeds Wu.In perfectly competitive labor markets, the introduction of a union will result in higher wages but lessemployment in unionized firms (as illustrated by the diagram on p. 403 of your text). This will result inunemployed workers if all firms in the labor market are unionized. If the union does not cover all firmsin the industry, some of the workers who lose there jobs in the unionized sector will shift to nonunionfirms. This increases the supply of labor in nonunion firms and lowers the wage received by nonunionworkers.Until 1947, unions were sometimes able to negotiate a closed shop arrangement under which only unionworkers can be hired. This arrangement became illegal under the Taft-Hartley Act of 1947. Since then, amore common arrangement is the union shop in which the firm may hire either union or nonunionworkers, but all workers must join the union after employment. Unions have also attempted to increasethe demand for union workers by supporting:child labor laws and mandatory education requirements (eliminating competition from low-wage childworkers),restrictions on immigration,barriers to entry in certain occupations (such as licensing requirements for plumbers and electricians,andother actions that increase the demand for union workers (such as ad campaigns encouraging consumersto "look for the union label" or "buy American").In some cases, unions have been accused of "featherbedding," a practice in which union contractsmandate the employment of more workers than are needed in a firm. Union contracts in the railroadindustry long required that firemen be employed on each train. The original job of these firemen was tomaintain the temperatures of the coal furnaces used for the steam engines. There was no need for suchworkers, though, on the diesel engines that were used later.The effect of minimum wage laws is quite similar to the effect of a union. In competitive markets, aminimum wage law reduces employment. In monopsony labor markets, it will increase the wage butmay cause employment to increase, decrease, or remain the same. What matters is the real value of theminimum wage, not it's nominal value. Over time, the purchasing power of a given minimum wagedeclines. In response, however, Congress and the President have often passed new minimum wage lawsthat raise the value. Typically, the increase restores the real minimum to its earlier level. The realminimum wage had not changed very much, on average, from its inception until 1990. Since then, thereal minimum wage has declined substantially.

Chapter 17In this chapter, we'll examine the market for capital and the determinants of technological change.Capital

Capital consists of the buildings and machinery that are used to produce output. Be sure to not confusethis definition of capital with the concept of "financial capital," the funds that are used to purchasecapital. Capital differs from the other factors of production in that capital is produced using all of theother factors of production. The production of capital involves a process of roundabout production inwhich society uses some of its resources today to produce capital instead of commodities intended forimmediate consumption. Thus, the production of capital requires that society forgoes currentconsumption. To acquire this capital, society must engage in saving. This saving makes it possible toengage in capital investment that enhances society's future productive capacity.The demand for capital is tied to the marginal revenue product of capital. Additional capital is acquiredas long as the marginal revenue product of capital exceeds the marginal factor cost of capital. Whenpurchasing capital, though, firm's must take into account the revenue generated by capital over its entireproductive life. Since capital tends to last for a relatively long period of time, the calculation of themarginal revenue product requires taking into account revenue generated in the relatively distant futureas well as revenue generated in the more immediate future.Since $1,000 in revenue received in 10 years is worth less than $1,000 in revenue received today, it isnecessary to find a some way of comparing benefits received in different time periods. This calculationcan be done by determining the present value of these payments. The present value of any future balanceis the amount that must be given up today to receive that balance at the specified future date. Forexample, the present value of $1,000 received in 5 years would equal the amount of money that youwould have to deposit in an interest-bearing asset today so that you would have $1,000 in 5 years. As aresult of interest accumulation, the present value of this payment will be substantially less than $1,000.In particular, the present value of a payment of $K received in T years in the future is given by:

where r is the market interest rate.As the formula above suggests, the present value of any given future balance will be less when thepayment is received in the more distant future or when the interest rate is higher. To see this intuitively,note that a smaller current balance will have to be given up today to reach the specified future value ifinterest accumulates for a longer period of time (T increases) or more interest is received each year (rincreases).For a given interest rate, the demand curve for capital is the present value of the stream of marginalrevenue product generated at each possible level of capital. Holding other resources constant, themarginal revenue product of capital is expected to fall (in each time period). Thus, we would expect thatthe demand curve for capital will be a downward sloping curve, as in the diagram below).

Since the demand curve for capital is tied to the present value of the marginal revenue product streamgenerated by capital, an increase in the interest rate results in a reduction in demand (since the present

value of the future revenue generated by capital declines when the interest rate rises). Thus, the demandcurve for capital shifts to the left (declines) when interest rates rise (as illustrated below).

The supply of capital is provided by firms that manufacture capital goods. As in other markets, anincrease in the price of capital induces firms to supply a larger quantity of capital. Thus, the capitalsupply curve is upward sloping. As the diagram below indicates, an increase in the market interest rateresults in a reduction in the equilibrium quantity of capital sold.

Technological changeFirms also acquire more recent technology when they buy capital. New computers are substantiallyfaster than older ones. New furnaces are more energy efficient than old furnaces.... and so on. Thistechnological change makes it possible for a firm to produce more output from each unit of inputs.Technological change may be the result of either basic or applied research. Basic research is researchthat is solely designed to create new knowledge. Applied research is research conducted for a specificpractical application. Successful applied research activities result in the development of new productionmethods or products. Basic research is generally sponsored by universities, the government, and privatefoundations. Applied research and development are generally undertaken by firms.As Figure 6 in your text indicates, technological change not only lowers costs, it also may eitherincrease or decrease the extent of the economies of scale that exist in an industry.One issue associated with the adoption of new technologies is the possibility of path dependence. Pathdependence occurs when an "industry standard" is established as a result of the dominance of the firstcompany that introduces a product. It is often argued that once an initial standard receives widespreadacceptance, it is difficult for better systems to be adopted. It should be noted that most economists have

found little empirical evidence to support the path dependence argument. The most commonly citedstory is the adoption of the QWERTY typewriter design. Many people argue that the DVORAKkeyboard layout is better as a result of a single typing test several decades ago. What is generallyignored is that this typing test was sponsored by the inventor of the DVORAK keyboard and was notsuccessfully duplicated despite numerous trials.....Financial capitalThe financial instruments that firms use to finance capital purchases are called financial capital. Stocks,bonds, and similar instruments are examples of financial capital.Owners of stock receive two types of return: dividends and capital gains. Dividends are profits that aredistributed to the owners of stock. Capital gains occur when the value of stock rises over time. Theannual return on stock consists of dividends plus capital gains.Coupon bonds are corporate bonds that provide a fixed coupon payment each year (twice a year,actually). This coupon payment provides the holder of the bond with an annual interest payment that is afixed proportion of the face value of the bond. The entire value of the bond is paid back at the bond'smaturity date. Since the price of the bond can be above or below the bond's face value, the yield on abond also comes about through both coupon payments and capital gains (note that for either stocks orbonds, negative capital gains - also known as capital losses - are not uncommon). As the price of a bondrises, it's yield declines (since the coupon payment and payment at maturity are fixed). Thus, there is aninverse relationship between bond prices and bond yields.For the sake of completeness, we should also briefly discuss discount bonds. Discount bonds do notprovide coupon payments, but are instead sold at a price below the face value. The difference betweenthe purchase price of the bond and its value when it is sold provides a yield to the bond holder.Government bonds (such as Treasury bills, Treasury bonds, and savings bonds) are discount bonds.Risky bonds provide a higher average yield than safer bonds since financial investors will only holdriskier financial assets if they receive a risk premium that is large enough to induce them to accept theadditional risk.As your text notes, economic profits are equal to accounting profits minus the cost of equity capital.Positive economic profits occur when the level of profits exceed the dividend payments that must bemade to stockholders. Stock prices are expected to rise in response to higher expected profits.

Chapter 18In this chapter, we'll examine natural resource markets and environmental policy.Natural resources can be divided into two categories: nonrenewable resources and renewable resources.Nonrenewable resources (also known as exhaustible resources) have a finite supply that is depleted asthe resource is consumed. Fossil fuels provide an important example of a nonrenewable resource.Renewable resources can be replenished by producers. Examples of renewable resources include:timber, land, agricultural products, cows, etc. Let's first examine the market for nonrenewable resources.

As with any other commodity, the equilibrium price and quantity for a nonrenewable resource isdetermined by the interaction of demand and supply. A larger quantity of the resource is supplied todaywhen the current price is higher. More oil wells will be drilled, for example, when the price of oil ishigher. Firms will shift to other fuel sources, though, and the quantity of oil demanded will decline whenthe price of oil rises. This is illustrated in the diagram below.

As the supply of the resource is depleted over time, the cost of extracting the resource will rise (since thelowest cost sources will be used first) and the supply curve will shift to the left. In response to thisreduction in supply, the equilibrium price will rise and the quantity consumed will decline (as illustratedbelow).

The owner of a nonrenewable resource faces a choice between supplying the resource today, or selling itat a higher price in the future. The owner will supply more today if the rate of increase in the price overtime is less than the market interest rate (since the owner can take the proceeds from the current sale andreceive a future value greater than the price that would have been received if the resource was notextracted until the following period). Since many producers would increase current supply (and reducefuture supply), the current price will fall and the future price will rise until the rate of price increaseequals the market interest rate. (If the difference in price is greater than the market interest rate, currentsupply will fall while future supply will increase until the rate of growth in the price is equal to themarket interest rate.)The situation for renewable resource is even simpler. In any given time period, the price is determinedby the interaction of demand and supply. An exceptionally large harvest results in higher prices, lessconsumption, and increased production of the commodity in the future.

Environmental problemsAs noted earlier in the course, markets allocate resources efficiently when the price reflects all of themarginal costs and benefits associated with an activity. Market failure occurs when externalities arepresent. Environmental pollution is an example of a negative externality in which the marginal socialcost of the activity exceeds the marginal private cost. Thus, in a market equilibrium, too much of theunderlying activity occurs (since the marginal social costs exceeds the marginal social benefit at themarket equilibrium). This relationship is represented in the diagram that appears on p. 450 in your text.The government may attempt to correct for this market failure through the use of taxes or regulations(such as those specifying emission standards).A related environmental problem is caused by the absence of private property rights for commonproperty resources. As noted earlier in the class, the lack of private property rights in fisheries, etc. willbe expected to result in overfishing.The Coase theoremThe Coase theorem suggests that the assignment of property rights may correct for the presence ofexternalities if there are no transactions cost. If, for example, the right to pollute is assigned to a firm,then those who wish to have cleaner air may bargain with the firm to reduce it's emissions in return for amonetary payment. In practice, though, such bargaining is not costless and there are public goodsproblems associated with such negotiations (i.e., individuals would have an incentive to be free riders).International aspectsSince the problem of pollution is global, attempts to correct for it must have a global dimension. TheKyoto accords represent an attempt to move in such a direction.

Chapter 19In this chapter, we'll examine some of the economic issues associated with aging, social security, andhealth care.Economics of the familyIn recent decades, economists have devoted a great deal of attention to understanding the economics ofthe family. One area of particular interest is the decision of households to have children. In developedeconomies, children provide consumption benefits for their parents (well... except when they areteenagers). Children provide labor services on family farms and provide old-age security for theirparents in less developed economies.The diagram below contains a simple demand and supply diagram that may be used to explain thenumber of children selected by a household. The demand curve is expected to be downward sloping as aresult of the law of diminishing marginal utility. The supply curve may initially slope downward sincethe marginal cost of a 2nd child may be lower than that of a first child since cribs, clothing, toys, andother items may be used more than once. Since raising children is a time-intensive activity, though, it isexpected that the marginal cost will ultimately increase (since the opportunity cost of time increases as

more time is taken away from other activities). An optimal quantity of children occurs at the point atwhich the demand and supply curves intersect.

World War II had a very substantial impact on child bearing. After the war, men and women who hadbeen separated by the war were able to have children that would, under other circumstances, have beenborn in earlier years. The rapid increase in income that accompanied the end of the Great Depressionmade it easier for households to afford new homes and to raise children. This lead to a dramatic increasein fertility during the years between 1946 and 1961.From the 1960s onward, though, fertility rates declined. One of the major reasons for this is the increasein female wage rates and labor market opportunities. Higher wages and improved job opportunities formarried women substantially raised the opportunity cost of having children. (In the diagram above, thiswould be indicated by a reduction in the supply curve for children.) As wage rates for married womenhave continued to increase, fertility levels have remained substantially lower than in earlier periods.Rising divorce rates and increased educational attainment by women, have also helped to maintain lowfertility levels.Aging and Social SecurityThe large baby-boom generation, combined with low fertility rates in recent decades, have resulted in apotential problem for the social security system. As the baby-boom generation retires, there will besubstantially fewer workers supporting each Social Security recipient. This problem is exacerbated byincreased longevity resulting from improvements in medical care. The problems associated with thefuture of the social security system are covered in a fair amount of detail on the web page on SocialSecurity that I've constructed for South-Western College Publishing. Click here to jump to this site.Health CareHealth care expenditures in the U.S. have increased quite dramatically in recent years. HMOs andsimilar arrangements have been created in response to these rising health care costs. The issues andproblems associated with health care are covered on a health care reform web page that I've written forSouth-Western College Publishing. Click here to go to this site.

Chapter 20In this chapter, we'll examine some of the economic issues associated with income distribution andpoverty.Income DistributionIn a pure market economy, income is determined by the resource payments that individuals andhouseholds receive in resource markets. The level of wages, interest, rent, and profits that are receivedare determined by resource prices in resource markets and the quantity and quality of the resources thatare owned by individuals and households. Those households with the most valuable bundles ofresources receive the highest income. The quantity of land, capital, and human capital (to some extent),is partly determined by the income that was received by past generations of the family. This system ofincome determination can result in a quite unequal distribution of income.The extent of income distribution in an economy is often represented using a Lorenz curve. To constructa Lorenz curve, individuals (or households) are ranked from highest to lowest according to income. TheLorenz curve illustrates the proportion of total income that is received by the poorest x% of thepopulation (where x is allowed to vary between 0 and 100). The diagram below contains a possibleLorenz curve.

For the country represented by the green Lorenz curve in the above diagram:the poorest 20% of the population receives 7% of the economy's total income,the poorest 40% of the population receives 18% of the economy's total income,the poorest 60% of the population receives 32% of the economy's total income,the poorest 80% of the population receives 52% of the economy's total income, andthe poorest 100% of the population (the entire population) must receive 100% of the economy's totalincome.If each person had an identical income, the Lorenz curve for society would correspond to the line ofincome equality in the diagram above. The greater the distance between the Lorenz curve and the line ofperfect equality, the greater the level of income inequality. In the diagram below, Country B's incomedistribution is more unequal than that of Country A.

PovertyA household is considered to be in a state of poverty if its income is less than the amount that is requiredto provide a nutritious diet. The level of income required to place a household above the poverty levelvaries with geographical location and household size (as well as with the ages of household members -teenagers eat more than 2-year olds). Federal poverty statistics are based on a measure of totalhousehold income that includes earnings and any cash transfers received by the household. Transferpayments are defined as any payment for which no good or service is provided in return. Examples ofcash transfers include social security benefits, unemployment compensation, and disability payments.Households also receive transfers in the form of goods of services. These transfers are called in-kindtransfers. Examples of in-kind transfers include food stamps and housing subsidies. Both cash and in-kind transfers reduce the degree of income inequality in the U.S. economy.Income inequality in the U.S. had fallen steadily in the U.S. until the 1980s as a result of povertyprograms and economic growth. Income inequality increased in the 1980s and during the early 1990s.It is important to note that a substantial portion of those living in poverty remain in poverty for longperiods of time. As your text notes, poverty is more common for:the youngest and oldest members of society,those with relatively low levels of education and training,members of racial minority groups, andfemale-headed households.Government antipoverty programs include the cash and in-kind transfer programs above, as well as theuse of progressive tax systems that impose lower tax rates on low-income groups.The distribution of income in an economy is also affected by its tax structure. Taxes as a share ofincome rise under progressive taxes, remain constant under proportional taxes, and decline under aregressive tax system. Federal and most state income taxes systems are progressive. Sales taxes and thesocial security tax are regressive (sales taxes are regressive because high income individuals spend asmaller share of their income and save more, social security taxes are regressive at high levels of incomebecause they are capped at a specified income level).The labor supply disincentives existing under the U.S. welfare system and the earned income tax credit(a form of negative income tax) are discussed on the web page on workfare that I've created for South-Western College Publishing. Click here to visit this page.