Study Notes

STUDY NOTESMICROECONOMICS

ECON 110

Dr. SULAFA HADEED

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CHAPTER 1 LIMITS, ALTERNATIVES, AND CHOICES

LECTURE NOTES

I. Definition of Economics

A. The social science that studies how individuals, institutions, and society make optimal choices under conditions of scarcity.

B. Human wants are unlimited, but the means to satisfy the wants are limited.

II. The Economic Perspective

Economists view things from a unique perspective. This economic perspective, or way of thinking has several interrelated features.

A. Scarcity and choice

1. Resources can only be used for one purpose at a time.

2. Scarcity requires that choices be made.

3. The cost of any good, service, or activity is the value of what must be given up to obtain it. (opportunity cost).

B. The above problem of scarcity and choice creates Five Fundamental

Questions in economics.

1. What goods and services will to be produced?

2. How will the goods and services be produced?

3. Who will get the output?

4. How will the system accommodate change?

5. How will the system promote progress?

C. Purposeful Behavior

1. Rational self-interest entails making decisions to achieve maximum utility. Utility is the pleasure or satisfaction obtained from consuming a good or service.

2. Different preferences and circumstances (including errors) lead to different choices.

3. Rational self-interest is not the same as selfishness.

D. Marginal Analysis: benefits and costs

1. Most decisions concern a change in current conditions; therefore the economic perspective is largely focused on marginal analysis.

2. Each option considered weighs the marginal benefit against the marginal cost.

3. Whether the decision is personal or one made by business or government, the principle is the same.

4. The marginal cost of an action should not exceed its marginal benefits.

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5. There is “no free lunch” and there can be “too much of a good thing.”

6. Conflicts between long and short-run objectives may result in decisions that appear to be irrational, when in fact they are not.

III. Theories, Principles, and Models

A. Economists use the scientific method to establish theories, laws, and principles.

1. The scientific method consists of:

a. The observation of facts (real data).

b. The formulations of explanations of cause and effect relationships (hypotheses) based upon the facts.

c. The testing of the hypotheses.

d. The acceptance, rejection, or modification of the hypotheses.

e. The continued testing with an eye toward determination of a theory, law, principle, or model.

2. Theories, principles, and models are “purposeful simplifications.”

Concept Illustration – Abstractions and Models.

3. Principles are used to explain and/or predict the behavior of individuals and institutions.

4. Terminology—Principles, laws, theories, and models are all terms that refer to generalizations about economic behavior. They are used synonymously in the text, with custom or convenience governing the choice in each particular case.

B. Generalizations—Economic principles are expressed as the

Tendencies of the typical or average consumer, worker, or

business firm.

C. “Other things equal” or ceteris paribus assumption—In order to

judge the effect one variable has upon another it is necessary to

hold other contributing factors constant. Natural scientists can

test with much greater precision than can economists. They have

the advantage of controlled laboratory experiment.

Economists must test their theories using the real world as their

laboratory.

D. Graphical Expression—Many economic relationships are

quantitative, and are demonstrated efficiently with graphs. The

“key graphs” are the most important.

E. Macroeconomics and Microeconomics

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A. Macroeconomics examines the economy as a whole.

1. It includes measures of total output, total employment, total income, aggregate expenditures, and the general price level.

2. It is a general overview examining the forest, not the trees.

B. Microeconomics looks at specific economic units.

1. It is concerned with the individual industry, firm or household and the price of specific products and resources.

2. It is an examination of trees, and not the forest.

F. Positive and Normative Economics.

1. Positive economics describes the economy as it actually is, avoiding value judgments and attempting to establish scientific statements about economic behavior.

2. Normative economics involves value judgments about what the economy should be like and the desirability of the policy options available.

3. Most disagreements among economists involve normative, value-based questions.

The Economizing Problem.

Individual’s Economizing Problem

A. Individuals are confronted with the need to make choices because their wants exceed their means to satisfy them.

B. Limited income – everyone, even the most wealthy, has a finite amount of money to spend.

C. Unlimited wants – people’s wants are virtually unlimited.

1. Wants include both necessities and luxuries (although many economists don’t worry about this distinction).

2. Wants change, especially as new products are introduced.

3. Both goods and services satisfy wants.

4. Even the wealthiest have wants that extend beyond their means (e.g. Bill Gates’ charitable efforts).

D. The combination of limited income and unlimited wants force us to choose those goods and services that will maximize our utility.

Example:

A consumer has an income of 120 KD and consumes two goods only, DVD and Books. Price of DVD is 20 KD per unit, and price of Books is 10 KD per unit.

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6543210

Units of DVD (Price= 20 KD)

Units of Books(Price=10 KD)

024681012

The Budget line: Whole Unit Combinations of DVD's and Books Attainable with an Income of 120 KD

Figure 1.1

E. Budget line

1. Definition: A schedule or curve that shows the various combinations of two products a consumer can purchase with a specific money income.

2. The model assumes two goods, but the analysis generalizes to all goods available to consumers.

3. The location of a budget line depends on a consumer’s money income, and the prices of the two products under analysis.

4. The slope of the graphed budget line is the ratio of the price of the good measured on the horizontal axis (Pb in the text) to the price of the good measured on the vertical axis (Pdvd). A change in the price of one of the goods will change the slope of the budget line and change the purchasing power of the consumer.

5. The budget line illustrates a number of important ideas:

a. Points on or inside the budget line represent points that are unattainable given the relevant income and prices. Points outside (up and to the right) the budget line are unattainable.

b. Tradeoffs and opportunity costs – the negative slope of the budget line represents that consumers must make tradeoffs in their consumption decisions; the value of the slope measures precisely the opportunity cost of one more unit of a good under analysis.

c. Limited income and positive prices force people to choose. Note that the budget line does not indicate what a consumer will choose, only what they can choose.

d. Income changes will shift the budget line. Greater income will shift the line out and to the right, allowing consumers to purchase more of both goods. Increasing income lessens scarcity, but does not eliminate it.

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Society’s Economizing Problem

A. Scarce resources

1. Economic resources are limited relative to wants.

2. Economic resources are sometimes called factors of production and include all natural, human, and manufactured resources used to produce goods and services.

B. Resource categories:

1. Land or natural resources (“gifts of nature).

2. Labor or human resources, which include physical and mental

abilities used in production.

3. Capital or investment goods, which are all manufactured aids to

Production like tools, equipment, factories, transportation, etc.

4. Entrepreneurial ability, a special kind of human resource that

provides four important functions:

a. Combines resources needed for production.

b. Makes basic business policy decisions.

c. Is an innovator for new products, production techniques,

organizational forms.

d. Bears the risk of time, effort, and funds.

D. Production possibilities tables and curves are a device to illustrate and clarify society’s economizing problem.

a. Assumptions:

1. Economy is employing all available resources (Full employment).

2. Available supply of resources is fixed in quantity and quality at this point in time.

3. Technology is constant during analysis.

4. Economy produces only two types of products.

a. While any two goods or services could be used, the example in the chapter assumes that one product is a consumer good (pizza), the other a capital good (industrial robots).

b. Consumer goods directly satisfy wants; capital goods, which are used to produce consumer goods, indirectly satisfy wants.

Types of product Production Alternatives A B C D E____________________________________Pizzas 0 1 2 3 4Robots 10 9 7 4 0

Opportunity cost of producing -- -- -- --one extra unit of pizza:

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Table (1)

(Translate the information in the above table on the following graph):

Robots

Pizzas

Graph (1.2)

b. Choices will be necessary because resources and technology are fixed. A production possibilities table illustrates some of the possible choices (see Table 1.1).

c. A production possibilities curve is a graphical representation of choices.

1. Points on the curve represent maximum possible combinations of robots and pizza given resources and technology.

2. Points inside the curve represent underemployment or unemployment.

3. Points outside the curve are unattainable at present.

d. Optimal or best product-mix:

1. It will be some point on the curve.

2. The exact point depends on society; this is a normative decision.

e. Law of increasing opportunity costs:

1. The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost.

2. Opportunity costs are measured in real terms rather than money (market prices are not part of the production possibilities model.)

3. The more of a product produced the greater is its (marginal) opportunity cost.

4. The slope of the production possibilities curve becomes steeper, demonstrating increasing opportunity cost. This makes the curve appear bowed out, concave from the origin.

5. Economic Rationale:

a. Economic resources are not completely adaptable to alternative uses.

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b. To get increasing amounts of pizza, resources that are not particularly well suited for that purpose must be used. Workers that are accustomed to producing robots on an assembly line may not do well as kitchen help.

f. Optimal allocation revisited:

Figure 1.3

1. How does society decide its optimal point on the production possibilities curve?

2. Recall that society receives marginal benefits from each additional product consumed, and as long as this marginal benefit is more than the additional cost of the product, it is advantageous to have the additional product.

3. Conversely, if the additional (marginal) cost of obtaining an additional product is more than the additional benefit received, then it is not “worth” it to society to produce the extra unit.

4. Figure 1.3 reminds us that marginal costs rise as more of a product is produced.

5. Marginal benefits decline as society consumes more and more pizzas. In Figure 1.3 we can see that the optimal amount of pizza is 200,000 units, where marginal benefit just covers marginal cost.

a. Beyond that, the added benefits would be less than the added cost.

b. At less than 200,000, the added benefits will exceed the added costs, so it makes sense to produce more.

6. Generalization: The optimal production of any item is where its marginal benefit is equal to its marginal cost. In our example, this must occur at 7,000 robots.

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Unemployment, Growth, and the Future

A. Unemployment occurs when the economy is producing at less than full employment or inside the curve (point U in Figure 1.4).

U

Figure 1.4

B. In a growing economy, the production possibilities curve shifts outward.

1. When resource supplies expand in quantity or quality.

2. When technological advances are occurring.

Figure 1.5

C. Consider This … Women, the Workforce, and Production Possibilities

1. There has been an increase in the number of women who are working. This has had the effect of shifting the production possibilities curve outward.

2. Whereas 40% of the women worked in 1965, 60% of the women are now working part time or full time.

3. There are a number of reasons for this change:

a. An increase in women’s wage rates.

b. Greater access to jobs.

c. Changes in preferences and attitudes.

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D. Present choices and future possibilities: Using resources to produce consumer goods and services represents a choice for present over future consumption. Using resources to invest in technological advance, education, and capital goods represents a choice for future over present goods. The decision as to how to allocate resources in the present will create more or less economic growth in the future.

. b

. a

Figure (1.6)

E. A Qualification: International Trade

1. A nation can avoid the output limits of its domestic production possibilities through international specialization and trade.

2. Specialization and trade have the same effect as having more and better resources of improved technology.

VIII. Economic Systems:

Economic systems differ in two important ways: a) Who owns the factors of production and, b) the method used to coordinate economic activity.

A. The market system:

1. There is private ownership of resources.

2. Markets and prices coordinate and direct economic activity.

3. Each participant acts in his or her own self-interest.

4. In pure capitalism the government plays a very limited role.

5. In the applied version of capitalism, the government plays a substantial role.

B. Command economy, socialism or communism:

1. There is public (state) ownership of resources.

2. Economic activity is coordinated by a central planning committee appointed by the government.

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The Circular Flow Model for a Market-Oriented System

• There are two groups of decision makers in the private economy (no government yet): households and businesses

• The market system (resource markets and product markets) coordinates these decisions.

What happens in the resource markets? a. Households sell resources directly or indirectly (through ownership of corporations).b. Businesses buy resources in order to produce goods and services.

c. Interaction of these sellers and buyers determines the price of each resource, which in turn provides income for the owner of that resource.

d. Flow of payments from businesses for the resources constitutes business costs and resource owners’ incomes.

What happens in the product markets?

a. Households are on the buying side of these markets, purchasing goods and services.b. Businesses are on the selling side of these markets, offering products for sale.c. Interaction of these buyers and sellers determines the price of each product.d. Flow of consumer expenditures constitutes sales receipts for businesses.

Circular flow model illustrates this complex web of decision-making and economic activity that give rise to the real and money flows.

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Limitations of the model:1. Does not depict transactions between businesses (inter-businesses).

2. Ignores government and the “rest of the world” in the decision-making process (we will take care of them later on).3. Does not explain how prices of products and resources are actually determine

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CHAPTER 3INDIVIDUAL MARKETS:DEMAND AND SUPPLY AND GOVERNMENT-SET PRICES

I. Markets DefinedA. A market, as introduced in Chapter 2, is an institution or mechanism that

brings together buyers (demanders) and sellers (suppliers) of particular goods and services

1. A market may be local, national, or international in scope.

2. Some markets are highly personal, face-to-face exchanges; others are impersonal and remote.

B. This chapter focuses on competitive markets with:

1. a large number of independent buyers and sellers.

2. standardized goods.

3. prices that are “discovered” through the interaction of buyers and sellers. No individual can dictate the market price.

C. The goal of the chapter is to explain the way in which markets adjust to changes and the role of prices in bringing the markets toward equilibrium.

1. Product market involves goods and services.

2. Resource market involves factors of production.

II. Demand

A. Demand is a schedule that shows the various quantities of a product that the consumers are willing and able to buy at each specific price in a series of possible prices during a specified time period.

The following is an example of a demand schedule for corn for an individual consumer buying corn per week is represented in Table 1.

Point Price per Bushel Quantity Demanded

A 5 10

B 4 20

C 3 35

D 2 55

E 1 80

B. Law of demand is a fundamental characteristic of demand behavior.

1. Other things being equal, as price increases, the corresponding quantity demanded falls.

2. Restated, there is an inverse relationship between price and quantity demanded.

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3. Note the “other things being constant” assumption refers to consumer income and tastes, prices of related goods, and other things besides the price of the product being discussed.

4. Explanation of the law of demand:

a. Common sense: People buy more of a product at a low price than at a high price. Price is an obstacle to consumers of a good, the higher the obstacle the less of the good they will buy.

b. Diminishing marginal utility: The decrease in added satisfaction that results as one consumes additional units of a good or service, i.e., the second “Big Mac” yields less extra satisfaction (or utility) than the first.

c. Income effect: A lower price increases the purchasing power of money income enabling the consumer to buy more at lower price (or less at a higher price).

d. Substitution effect: A lower price gives an incentive to substitute the lower-priced good for now relatively higher-priced goods.

C. The demand curve: (plot the points of table 1 on the following graph)

1. The curve illustrates the inverse relationship between price and quantity

P

Q

2. The downward slope of the demand curve indicates lower quantity (horizontal axis) at higher price (vertical axis), higher quantity at lower price.

D. Individual vs. market demand:

1. Transition from an individual to a market demand schedule is accomplished by adding the quantities demanded by all consumers at each of the various possible prices. If there are just three buyers the market demand is reached by adding horizontally the three individual demand curves (see table 2)

2. Market curve is horizontal sum of individual curves.

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Table (2) is the market demand for corn:

Price first buyer second buyer third buyer total quantity demand5 10 12 8 304 20 23 17 603 35 39 26 1002 55 60 39 1541 80 87 54 221

Graph the individual demand curves and the market demand curve.

E. Change in Demand:

There are several determinants of demand or the “other things,” besides price, which affect demand. Changes in determinants cause changes in demand (the whole demand schedule or the whole demand curve) which is represented by a shift in the demand curve either to right to show an increase in demand or a shift to the left to show a decrease in demand. (Show both an increase and a decrease in demand in the following graph)

P D1

D1

Q

1. The following demand shifters can lead to increase or decrease in demand as follows:

a. Tastes (T): favorable change leads to increase in demand; unfavorable change to decrease.

b. Number of buyers: more buyers lead to an increase in demand; fewer buyers lead to a decrease.

c. Income (I): more income leads to increase in demand; while less income leads to a decrease in demand for normal or superior goods. (The rare case of goods whose demand varies inversely with income is called inferior goods).

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d. Prices of related goods also affect demand.

i. Substitute goods (PS) (those that can be used in place of each other): The price of the substitute good and demand for the other good are directly related. If price of Colgate toothpaste rises, demand for Crest toothpaste increase.

ii. Complementary goods (PC) (those that are used together like tennis balls and rackets): When goods are complements, there is an inverse relationship between the price of one and the demand for the other.

iii. Unrelated (Independent) Goods. Most goods are not related. If price of potatoes change demand for cars is not affected.

e. Consumer Expectations (E): consumer views about future prices and income can shift demand. If the consumer expects higher income in the future demand will increase, and the opposite is true.

If the consumer expects higher prices of the good in the future demand will increase, and the opposite is true.

2. A summary of what can cause an increase in demand (outward

shift of the demand curve):

a. Favorable change in consumer tastes.

b. Increase in the number of buyers.

c. Rising income if product is a normal good.

d. Falling incomes if product is an inferior good.

e. Increase in the price of a substitute good.

f. Decrease in the price of a complementary good.

g. Consumers expect higher prices or higher income in the future.

3. A summary of what can cause a decrease in demand (inward shift of the demand curve):

a. Unfavorable change in consumer tastes,

b. Decrease in number of buyers,

c. Falling income if product is a normal good,

d. Rising income if product is an inferior good,

e. Decrease in price of a substitute good,

f. Increase in price of a complementary good,

g. Consumers expect lower prices or lower income in the future.

F. Review the distinction between a change in quantity demanded and a change in demand.

A change in quantity demanded is caused by a change in price of the concerned good itself and is represented by a movement from one point to another along the same demand curve. A change in demand is caused by change in any of the demand determinants and is represented by a shift of the whole demand curve. An outward shift represents increase in

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demand, while an inward shift represents a decrease in demand . Show the difference between the two on the following graphs.

III. Supply

A. Supply is a schedule that shows amounts of a product a producer is willing and able to produce and sell at each specific price in a series of possible prices during a specified time period.

1. A supply schedule portrays this such as the corn example in Table 2.

Points Price per bushel Quantity supplied

A 5 60

B 4 50

C 3 35

D 2 20

E 1 5

2. The schedule shows what quantities will be offered at various prices or what price will be required to induce various quantities to be offered.

B. Law of supply:

1. Producers will produce and sell more of their product at a high price than at a low price.

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2. Restated: There is a direct relationship between price and quantity supplied.

3. Explanation: Given product costs, a higher price means greater profits and thus an incentive to increase the quantity supplied.

4. Beyond some production quantity producers usually encounter increasing costs per added unit of output (diminishing marginal returns).

C. The supply curve:

1. The supply curve is obtained by graphing the data in the supply schedule.

2. It shows direct relationship in upward sloping curve.

(Graph the data from Table 2).

P

Q

Market supply curve is derived from individual supply in exactly the same way that market demand is derived from individual demand.

D. Determinants of supply :

1. A change in any of the supply determinants (supply shifters) causes a change in supply and a shift in the supply curve. An increase in supply involves a rightward shift, and a decrease in supply involves a leftward shift. (show increase and decrease in supply on the following graph):

S1

S1

2. Six basic determinants of supply, other than price.

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a. Resource prices (PINPUTS), a rise in resource prices will reduce profits and cause a decrease in supply or leftward shift in supply curve; while a decrease in resource prices will cause an increase in profits and cause an increase in supply or rightward shift in the supply curve.

b. Technology (Tech.), a technological improvement means more efficient production and lower costs which will cause an increase in supply or rightward shift in the curve.

c. Taxes and subsidies (T), a business tax is treated as a cost, so it decreases supply; a subsidy lowers cost of production, and so increases supply.

d. Prices of related goods—if price of a substitute good in production (PS) rises, producers might shift production toward the higher priced good, causing a decrease in supply of the original good. And if price of a complement good in production (PC) rises, producers will increase the production of the concerned good.

e. Producer Expectations (E) expectations about the future price of a product can cause producers to increase or decrease current supply.

f. Number of sellers in the market (#), the larger the number of sellers the greater the supply.

Review the distinction between a change in quantity supplied due to price changes and a change or shift in supply due to change in determinants of supply.

III. Supply and Demand: Market Equilibrium

A. Table 3 combines data from supply and demand schedules for corn.

Quantity Supplied

Price Quantity Demanded

Surplus or shortage

12,000 5 2,000

10,000 4 4,000

7,000 3 7,000

4,000 2 11,000

1,000 1 16,000

B. Find the point where quantity supplied equals the quantity demanded, and note this equilibrium price and quantity.

1. At prices above this equilibrium, note that there is an excess quantity supplied or surplus.

2. At prices below this equilibrium, note that there is an excess quantity demanded or shortage.

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C. Market clearing or market price is another name for equilibrium price.

D. On the following graph, plot the previous demand and supply schedules and graphically determine the equilibrium price and equilibrium quantity where the supply and demand curves intersect. This is an IMPORTANT point to recognize and remember. Note that it is NOT correct to say supply equals demand! The correct terminology is: quantity demanded equals quantity supplied.

E. Rationing function of prices is the ability of competitive forces of supply and demand to establish a price where buying and selling decisions are coordinated.

F. Efficient allocation – productive and allocative efficiency

1. Competitive markets generate productive efficiency – the production of any particular good in the least costly way. Sellers that don’t achieve the least-cost combination of inputs will be unprofitable and have difficulty competing in the market.

2. The competitive process also generates allocative efficiency – producing the combination of goods and services most valued by society.

3. Allocative efficiency requires that there be productive efficiency. Productive efficiency can occur without allocative efficiency. Goods can be produced in the least costly method without being the most wanted by society.

4. Allocative and productive efficiency occur at the equilibrium price and quantity in a competitive market. Resources are neither over- nor underallocated based on society’s wants.

IV. Changes in Supply and Demand, and Equilibrium. Simple cases: When either demand or supply shifts while the other is held constant.

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A. Changing demand with supply held constant:

1. Increase in demand will have effect of increasing equilibrium price and quantity.

2. Decrease in demand will have effect of decreasing equilibrium price and quantity

B. Changing supply with demand held constant:

1. Increase in supply will have effect of decreasing equilibrium price and increasing quantity.

2. Decrease in supply will have effect of increasing equilibrium price and decreasing quantity.

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Complex cases—when both supply and demand shift at the same time:

A. If supply and demand change in the same direction (both increase or both decrease), the change in equilibrium quantity will be in the direction of the shift but the change in equilibrium price now depends on the relative shifts in demand or supply.

1- If both demand and supply increase equilibrium quantity will increase but the change in equilibrium price depends on the relative shifts in demand or supply.

2- If both demand supply decrease equilibrium quantity will decrease but the change in equilibrium price depends on the relative shifts in demand or supply.

B. If supply and demand change in opposite directions: (demand increase while supply decreases, or demand decrease while supply increases), the effect in price will be predictable while the effect on equilibrium quantity depends on relative sizes of shifts in demand and supply.

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1. If supply decreases and demand increases, price rises, but new equilibrium quantity depends again on relative sizes of shifts in demand and supply.

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2. If supply increases and demand decreases, price falls, but new equilibrium quantity depends again on relative sizes of shifts in demand and supply.

Government-Set Prices

A- Price Ceilings:

a. Price ceilings are maximum legal prices a seller may charge for a product or service in order to enable consumers to obtain some “essential” good or service that they could not afford at the market equilibrium price. Price ceilings are typically placed below equilibrium.

Show graphically the problem that arises when the price is set below the equilibrium price.

b. Shortages will result, since the quantity demanded will be

greater than the quantity supplied at the lower price. This presents problems to the government.

c. How should the available supply be apportioned among buyers?

Alternative methods of rationing must emerge to take the place of

the price mechanism. These may be informal (first-come, first-served)

or on the basis of favoritism. Or formal (rationing coupons) or ration

cards.

d. Black markets arise as some consumers obtain the item at the fixed

price and resell it at the higher price that many consumers are willing

and able to pay.

e. Example of price ceiling applied in the USA is in case of gasoline. Another example is Rent controls in large cities – intended to keep housing affordable but resulting in housing shortages.

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B. Price floors.

a. Price Floors are minimum prices set by government above the equilibrium price. A price at or above the price floor is legal, a price below it is not. It is adopted when society feels that free functioning of the market system has not provided a sufficient income for certain groups of resource suppliers or producers.

b. Example of price floor applied in the USA is in case of wheat. Another example: Minimum wage

Show graphically the problem that arises when the price is set below the equilibrium price.

c. Price floors result in persistent surpluses of the product, since the quantity supplied will be greater than the quantity demanded.

d. There are government policies to cope with surpluses.

1. Government may obtain agreement of the sellers to restrict supplies in exchange for the price floor, or it might try to encourage demand to increase.

2. Government may purchase the surplus if efforts to restrict supply are not successful.

e. Additional Consequences. Price Floors distort resource allocation

and causes allocative inefficiency. Resources are overallocated to the production of wheat and consumers pay higher than efficient prices for wheat-based goods. Taxpayers pay to finance the governments purchase of the surplus. Price floors may increase imports of the product and thus forces the government to impose tarrifs on imports which may cause other countries to impose their own tarrifs. Also price floors could lead to environmental damage.

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CHAPTER 6DEMAND AND SUPPLY: ELASTICITIES

I. Price Elasticity of Demand

A. Law of demand tells us that consumers will respond to a price decrease by buying more of a product (other things remaining constant), but it does not tell us how much more.

B. The degree of responsiveness or sensitivity of consumers to a change in price is measured by the concept of price elasticity of demand.

1. If consumers are relatively responsive to price changes, demand is said to be elastic.

2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic.

3. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is, they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness. A precise definition of what we mean by “responsive” or “unresponsive” follows.

C. Price elasticity formula:

Quantitative measure of elasticity, Ed = percentage change in quantity

demanded (%ΔQ)/ percentage change in price (%ΔP) .

1. Emphasis: What is being compared are the percentages changes, not the absolute changes. The reason for that is:

a. Absolute changes depend on choice of units. For example, a change in the price of a $10,000 car by $1 is very different than a change in the price of a $1 can of Pepsi by $1. The auto’s price is rising by a fraction of a percent while the Pepsi price is rising 100 percent.

b. Percentages also make it possible to compare elasticities of demand for different products.

2. Using two price-quantity combinations of a demand schedule, the percentage change in quantity is calculated by dividing the absolute change in quantity by the original quantity: (%ΔQ) = (Q2

– Q1)/(Q1). And the percentage change in price is calculated by dividing the absolute change in price by the original price: (%ΔP) = (P2-P1) / (P1). Thus, Ed = (Q2 – Q1)/(Q1) ÷ (P2-P1) / (P1). This formula for calculating the price elasticity of demand is called the point elasticity formula.

3. Note that if the other quantity and price (Q2,P2) were used as the denominator then the percentage changes would be different. The way economists deal with this problem is to use the average of the two quantities and the average of the two prices when calculating the percentage change in quantity and the percentage change in price as follows:

(%ΔQ) = (Q2 – Q1) ÷ (Q1+ Q2)/2

(%ΔP) = (P2 - P1) ÷ (P1 + P2)/2

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Thus: Ed =[(Q2 – Q1) ÷ (Q1+ Q2)/2] ÷ [(P2 - P1) ÷ (P1 + P2)/2]. And after reducing:

Ed =

(Q2 - Q1)(Q2+Q1 )

×(P1+P2 )(P2−P1)

This formula is called midpoint elasticity or arc elasticity formula, and is considered the best formula for calculating price elasticity of demand .

4. Because of the inverse relationship between price and quantity demanded, the actual elasticity of demand will be a negative number. However, we ignore the minus sign and use absolute value of both percentage changes.

5. If the percentage change in quantity is greater than the percentage change in price then the coefficient of elasticity of demand is a number greater than one (Ed > 1), this means that the quantities demanded by consumers are relatively responsive to price changes, and we say demand is elastic. Note that elastic demand does not mean consumers are completely responsive to a price change, it only means that their response is large.

6. If the percentage change in quantity is less than the percentage change in price then the coefficient of elasticity is less than one (Ed < 1), this means that the quantities demanded by consumers are relatively unresponsive to price changes, and we say that demand is inelastic. Note: Inelastic demand does not mean that consumers are completely unresponsive, it means that their response is small.

7. Note that with both elastic and inelastic demand, consumers behave according to the law of demand; that is they are responsive to price changes. The terms elastic or inelastic describe the degree of responsiveness.

8. A special case is if the percentage change in quantity is equal to the percentage change in price, then the coefficient of elasticity equals one (Ed = 1); and we say that demand is unit elastic.

9. An extreme situation is when a small price reduction would cause buyers to increase their purchases from zero to all that it is possible to obtain, then the coefficient of elasticity will equal infinity (Ed =∞); and we say that demand is perfectly elastic, and the demand curve would be horizontal.

10. Another extreme situation is if quantities demanded by consumers are completely unresponsive to changes in price (%ΔQ = 0). Then the coefficient of elasticity will equal to zero (Ed = 0); and we say

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that demand is perfectly inelastic, and the demand curve would be vertical. However this case is very rare.

D. Price Elasticity along a Linear Demand Curve

Price elasticity varies over a range of prices on the same demand curve. The following table demonstrates this.

a. Demand is more elastic in upper left portion of curve (because price is higher, quantity smaller).

b. Demand is more inelastic in lower right portion of curve (because price is lower, quantity larger).

c. Demand is unit elastic between these two portions.

d. It is impossible to judge elasticity of a single demand curve by its flatness or steepness (slope), since demand elasticity can be both elastic and inelastic at different points on the same demand curve as was shown above.

E . The Total Revenue Test is the easiest way to judge whether demand is elastic or inelastic. This test can be used in place of elasticity formula, unless there is a need to determine the elasticity coefficient.

The Total-revenue and elasticity.

Total Revenue TR: the total amount the seller receives from the sale of a product

in a particular time period. TR = P × Q.

Total revenue and the price elasticity of demand are related.

1. Elastic demand and total-revenue test:

If demand is elastic (%change in price < % change in quantity), a decrease in price will increase total revenue and an increase in price will reduce total revenue. Looking at it differently, demand will be elastic if a decrease in price results in a rise in total revenue, or if an increase in price results in a decline in total revenue. (Price and revenue move in opposite directions).

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2. Inelastic demand and total revenue test: If Demand is inelastic (%change in price > % change in quantity) a price decrease will reduce total revenue. Also a price increase will increase total revenue. Looking at it differently, demand will be inelastic if a decrease in price results in a fall in total revenue, or an increase in price results in a rise in total revenue. (Price and revenue move in same direction).

3. Unit elasticity and the total revenue test: If Demand has unit elasticity (%change in price = % change in quantity) an increase or decrease in price leaves total revenue unchanged. Looking at it differently, demand will be unit elastic if total revenue does not change when the price changes.

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The relationship between total revenue and price elasticity of demand is represented in the following table :

Total quantity (1000)

Price elasticity coefficient

total revenue

total revenue test

1 8 8000> 5 Elastic

2 7 14000> 2.6 Elastic

3 6 18000> 1.57 Elastic

4 5 20000> 1 Unit elastic

5 4 20000> .64 Inelastic

6 3 18000> .38 Inelastic

7 2 14000> .2 Inelastic

8 1 8000

The following is a graphical representation of the relationship between total revenue and price elasticity of demand represented in the above table :

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In the above graph starting from high prices if price declines total revenue increases while an increase in price leads to a decline in total revenue. This means that price and total revenue change in opposite directions confirming that demand is elastic.

Starting from low prices if price declines total revenue declines while if price increases total revenue increases. This means that price and total revenue change in the same direction confirming that demand is inelastic.

Between these two ranges changes in price is not accompanied by any change in total revenue confirming that demand is unit elastic in this region of the demand curve.

F. There are several determinants of the price elasticity of demand.

1. Substitutes for the product: Generally, the more substitutes, the more elastic the demand.

2. The proportion of income spent on the good: Generally, the larger the expenditure on the good relative to one’s budget, the more elastic the demand, because buyers will notice the change in price more.

3. Whether the product is a luxury or a necessity: Generally, the less necessary the item, the more elastic the demand.

4. The amount of time involved: Generally, the longer the time period involved, the more elastic the demand becomes.

III. Price Elasticity of Supply

A. The concept of price elasticity also applies to supply. The elasticity formula is the same as that for demand, but we must substitute the word “supplied” for the word “demanded” everywhere in the formula.

Es = percentage change in quantity supplied / percentage change

in price

As with price elasticity of demand, the midpoints formula is more accurate.

B. The time period involved is very important in price elasticity of supply because it will determine how much flexibility a producer has to adjust his/her resources to a change in the price. The degree of flexibility, and therefore the time period, will be different in different industries.

1. The market period is so short that elasticity of supply is inelastic; it could be almost perfectly inelastic or vertical. In this situation, it is virtually impossible for producers to adjust their resources and change the quantity supplied. (Think of adjustments on a farm once the crop has been planted.)

2. The short-run supply elasticity is more elastic than the market period and will depend on the ability of producers to respond to price change. Industrial producers are able to make some output changes by having workers work overtime or by bringing on an extra shift.

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Immediate time period Short run Long run

3. The long-run supply elasticity is the most elastic, because more adjustments can be made over time and quantity can be changed more relative to a small change in price. The producer has time to build a new plant.

IV. Cross and income elasticity of demand:

A. Cross elasticity of demand refers to the effect of a change in a product’s price on the quantity demanded of another product. Numerically, the formula is shown for products X and Y.

EXY = (percentage change in quantity of X) / (percentage change in

price of Y)

Ed =(Q x

2 - Qx

1)

(Q x2+Q x

1)

×(PY

1+PY

2)

(PY2−PY

1)

1. If cross elasticity is positive, then X and Y are substitutes.

2. If cross elasticity is negative, then X and Y are complements.

3. Note: if cross elasticity is zero, then X and Y are unrelated, independent products.

B. Income elasticity of demand refers to the effect of a change in a consumer’s income on the demand for this product. Numerically, the formula is shown as a percentage change in quantity demanded that results from some percentage change in consumer incomes.

EI = (percentage change in quantity demanded) / (percentage

change in income)

Ed =(Q2 - Q1)(Q2+Q1 )

×(I 1+ I 2)( I 2−I1)

1. A positive income elasticity indicates a normal or superior good.2. A negative income elasticity indicates an inferior good.

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3. Income elasticity of demand helps explain the expansion and contractions in the economy. As income grows, industries of products whose income elasticity is high expand rapidly, while those of low or negative tend to grow slowly.

Consumer Surplus1. Definition – the difference between the maximum price a consumer is (or

consumers are) willing to pay for a product and the actual price.

2. The surplus, measurable in dollar terms, reflects the extra utility gained from paying a lower price than what is required to obtain the good.

3. Consumer surplus can be measured by calculating the difference between the maximum willingness to pay and the actual price for each consumer, and then summing those differences.

4. Consumer surplus is measured and represented graphically by the area under the demand curve and above the equilibrium price. (Figure 6.5)

5. Consumer surplus and price are inversely related – all else equal, a higher price reduces consumer surplus.

The utility surplus arises because all consumers pay the equilibrium price even though many would be willing to pay more than that price to obtain the product. Consider this example

Consumer max price actual price consumer surplus

A 13 8 5

B 12 8 4

C 11 8 3

D 10 8 2

E 9 8 1

F 8 8 0

consumer surplus

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Producer Surplus

Producer Surplus

1. Definition – the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price.

2. Producer surplus can be measured by calculating the difference between the minimum acceptable price and the actual price for each unit sold, and then summing those differences.

3. Producer surplus is measured and represented graphically by the area above the supply curve and below the equilibrium price.

4. Producer surplus and price are directly related – all else equal, a higher price increases producer surplus.

Producer max price actual price producer surplus

G 3 8 5

H 4 8 4

I 5 8 3

J 6 8 2

K 7 8 1

L 8 8 0

Efficiency Revisited

• All markets that have downward slopping demand and upward slopping supply curves yield consumer and producer surplus.

• The equilibrium quantity in these markets reflect economic efficiency.

• Productive efficiency is achieved because competition forces producers to minimize their costs.

• Allocative efficiency is also achieved because the correct quantity at which MB (points on the demand curve or the maximum willingness to pay) equals MC (points on the supply curve or the minimum acceptable price). At equilibrium consumer surplus and producer surplus are maximized.

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• Allocative efficiency occurs at quantity levels where three conditions exist:

1. MB = MC

2. Maximum willingness to pay = minimum acceptable price

3. Combined consumer and producer surplus is at a maximum

Efficiency losses (deadweight loss)1.

2.

• Efficiency losses are reductions of combined consumer and producer surplus associated with underproduction (produce less than equilibrium quantity) or overproduction (produce more than equilibrium quantity).

• Underproduction : Underproduction reduces both consumer and producer surplus, and efficiency is lost because both buyers and sellers would be willing to exchange a higher quantity.

at Q2 there is a deadweight loss equals dec.

• Overproduction : Overproduction causes inefficiency because past the equilibrium quantity, it costs society more to produce the good than it is worth to the consumer in terms of willingness to pay.

• at Q3 there is a deadweight loss equals cfg.

• Since both consumers and producers are members of the society, these losses are efficiency loss or a deadweight loss

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CHAPTER 7:CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION

I. Introduction

A. People spend millions of dollars on goods and services each year, yet no two consumers spend their incomes in the same way. How can this be explained?

B. Why does a consumer buy a particular bundle of goods and services rather than others?

Examining these issues will help us understand consumer behavior and the law of demand.

Law of Diminishing Marginal Utility

A. Although consumer wants in general are insatiable, wants for specific commodities can be fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of that product. This can be illustrated with almost any item. The text uses the automobile example, but houses, clothing, and even food items work just as well.

B. Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item.

C. Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This is known as law of diminishing marginal utility.

D. The following table illustrate the relationship between total and marginal-utility.

Sandwiches Total Utility Marginal Utility

0 0

1 10

2 18

3 24

4 28

5 30

6 30

7 28

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Graph the above values of total and marginal utility:

1. Total utility increases as each additional sandwich is purchased through the first five units, but utility rises at a diminishing rate since each sandwich adds less and less to the consumer’s satisfaction. This implies that marginal utility will be decreasing but positive as long as total utility is increasing.

2. At some point, marginal utility becomes zero and then even negative at the seventh unit and beyond. If more than six sandwiches were purchased, total utility would begin to fall. This implies that marginal utility equals zero when total utility reaches the maximum and will take negative values when total utility is decreasing. This illustrates the law of diminishing marginal utility.

E. The law of diminishing marginal utility and demand.

The law of diminishing marginal utility explains why the demand

curve for a given product slopes downward. As successive units of a

product yields smaller and smaller amounts of marginal utility, so the

consumer will buy more only if the price falls otherwise it is not worth

it to buy more. This means that consumers behave in ways that make the

demand curve downward sloping.

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III. Theory of consumer behavior:

In addition to explaining the law of demand, the theory uses the law of diminishing marginal utility to explain how consumers allocate their income.

A. Consumer choice and the budget constraint:

1. Consumers are assumed to be rational, i.e. they are trying to get the most value for their money.

2. Consumers have clear-cut preferences for various goods and services and can judge the utility they receive from successive units of various purchases.

3. Consumers’ incomes are limited because their individual resources are limited. Thus, consumers face a budget constraint.

4. Goods and services have prices and are scarce relative to the demand for them. Consumers must choose among alternative goods with their limited money incomes.

B. Utility maximizing rule explains how consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility.

1. A consumer is in equilibrium when utility is “balanced (per dollar) at the margin.” When this is true, there is no incentive to alter the expenditure pattern unless tastes, income, or prices change.

2. It is marginal utility per dollar spent that is equalized; that is, consumers compare the extra utility from each product with its cost.

3. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other products.

4. The algebraic statement of this utility-maximizing state is that the consumer will allocate his fixed income in such a way that:

a. MU of product A/price of A = MU of product B/price of B = etc.

The income constraint is represented algebraically as:

b. QA× PA+ QB × PB = I

If: MU of A/price of A < MU of B/price of BThe consumer must purchase less of A and more of B till they are equal.

If : MU of A/price of A > MU of B/price of B

The consumer must purchase more of A and less of B till they are equal.

Numerical example: Suppose that a consumer purchases two products (A and

B). The utility schedules of those two products are represented in the lower table.

This consumer has a limited income of KD10. Price of product A is KD 1 while

price of product B is KD 2. Applying the two utility maximizing rules mentioned

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above to the information about this consumer the utility maximizing

combination of products A and B would be 2 units of A and 4 units of B.

Product A Product BUnits of product

Marginal Utility

Marginal utility per KD

Marginal Utility

Marginal utility per KD

1st 10 10 24 122nd 8 8 20 103rd 7 7 18 94th 6 6 16 85th 5 5 12 66th 4 4 6 37th 3 3 4 2

IV. Utility Maximization and the Demand Curve

A. Determinants of an individual’s demand curve are tastes, income, and prices of other goods.

B. Deriving the demand schedule and curve can be illustrated using the above table and considering alternative prices at which B might be sold. At lower prices, using the utility-maximizing rule, we see that more will be purchased as the price falls.

Recall from the pervious example that given tastes, income and prices of other

goods our rational consumer will purchase 4 units of product B at a price =2 KD.

If the price of B falls to 1 KD , its marginal utility per KD will double. Such that

Product A Product BUnits of product

Marginal Utility

Marginal utility per KD

Marginal Utility

Marginal utility per KD

1st 10 10 24 242nd 8 8 20 203rd 7 7 18 184th 6 6 16 165th 5 5 12 126th 4 4 6 67th 3 3 4 4

Now our consumer can purchase 4 units of A and 6 units of B to maximize his

utility. Using these data we can derive the demand schedule for good B and then

sketch a downward slopping demand curve.

Price of B Quantity of B2 41 6

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C. The utility-maximizing rule helps to explain the substitution effect and the income effect.

1. When the price of an item declines, the consumer will no longer be in equilibrium until more of the item is purchased and the marginal utility of the item declines to match the decline in price. More of this item is purchased rather than another relatively more expensive substitute.

2. The income effect is shown by the fact that a decline in price expands the consumer’s real income and the consumer must purchase more of this and other products until equilibrium is once again attained for the new level of real income.

Income and substitution effects revisited: to see the substitution effect recall that

before the price of B declined the consumer was in equilibrium when purchasing

2 units of A and 4 units of B. but after B’s price falls from KD 2 to KD 1,

MUA/PA< MUB/PB i.e., the last KD spent on B yields more utility than the last one

spent on A. This means that a switching of purchase from A to B is needed to

restore equilibrium, that is a substitution of now cheaper B for A will occur when

the price of B drops.

The assumed decline in price of B increases the consumer’s real income, such

that he can spend more on A or B or both. Now he can purchase 2 extra units of A

and B using the same income. This is the income effect.

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CHAPTER 8THE COST OF PRODUCTION

LECTURE NOTES

I. Economic costs are the payments a firm must make, or incomes it must pay, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. A. Explicit costs are payments to owners of resources which the firm

buys from the resource market. This would include cost of the raw material bought, wages of labor employed, salaries of accountants and clerks employed, rent paid for land and offices rented from their owners and payments for energy and utilities.

B. Implicit costs are the money payments the self-employed resources could have earned in their best alternative employments. This would include forgone interest, forgone rent, forgone wages, and forgone income for resources which belong to owners of the firm.

C. Normal profits are considered an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities self-employed.

D. Economic or pure profits are total revenue less all costs (explicit and

implicit including a normal profit). Accounting profits are total

revenue less explicit costs.

E. The short run is the time period that is too brief for a firm to alter the resources which determine its plant capacity. Such resources are equipment, machinery, buildings, storage and highly qualified management. These resources are called fixed resources and they cause the plant size to be fixed in the short run. The cost of using these fixed resources represent previous commitments of the firm and thus does not change in the short run and are called short run fixed costs. Such costs would include rent, interest on loans, salaries of higher management, maintenance and insurance payments. However the firm can alter some resources which affect the size of its total product, such as labor, raw materials, energy and utilities and these resources are called variable inputs. Short run variable costs are the costs of using these variable inputs and would include wages, price of raw materials, and costs of utilities used for production in a fixed plant. Short-run total costs are made up of fixed costs plus variable costs.

F. The long run is a period of time long enough for a firm to change the quantities of all resources employed, including the plant size, and so all inputs are variable in the long-run. This means that in the long run costs are all variable costs, including the cost of varying the size of the production plant and they are all variable costs.

II. Short-Run Production Relationships

A. Short-run production reflects the law of diminishing marginal returns (product) which states that as successive units of a variable resource (labor) are added to a fixed resource, beyond some point the product

41

attributable to each additional resource unit (marginal product) will decline.

1. The following table presents a numerical example of the law of diminishing returns.

2. Total product (TP) is the total quantity, or total output, of a

particular good produced.

3. Marginal product (MP) is the rate of change in total product resulting from each additional input of labor (ΔTP/ΔL).

4. Average product (AP) is the total product divided by the total number of workers (TP/L).

5. Illustrate on the following graph the relationship between marginal, average, and total product concepts as follows:

We can conclude the following from the above table and graphs:

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a. As the marginal product is the rate of change in total product, at the beginning, when total product is increasing at an increasing rate marginal product will be increasing. When total product is increasing at a decreasing rate marginal product will be decreasing. When total product reaches the maximum, marginal product is zero. When total product declines, marginal product is negative.

b. When marginal product is greater than average product, average product will be increasing. When marginal product is less than average product, average product will be decreasing. And marginal product equals average product when average product reaches the maximum.

B. The law of diminishing returns assumes all units of variable inputs—workers in this case—are of equal quality. Marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available. That’s why sometimes this law is called the law of variable proportions.

III. Short Run Production Costs

A. Fixed, variable and total costs are the short-run classifications of costs; The following table illustrates their relationships.

B.

Q TFC TVC TC AFC AVC ATC MC

0 1000 0 1000 - - - -

1 1000 100 1100 1000 100 1100 100

2 1000 160 1160 500 80 580 60

3 1000 210 1210 333.3 70 403.3 50

4 1000 260 1260 250 65 315 50

5 1000 300 1300 200 60 260 40

6 1000 360 1360 166.7 60 226.7 60

7 1000 455 1455 143 65 208 95

8 1000 560 1560 125 70 195 105

9 1000 720 1720 111.1 80 191.1 160

10 1000 900 1900 100 90 190 180

11 1000 1090 2090 99.9 99.1 190 190

12 1000 1300 2300 83.3 108.7 192 210

13 1000 1600 2600 76.9 123.1 200 300

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1. Total fixed costs (TFC) are those costs whose total does not vary with changes in short-run output and must be paid even if output is zero.

2. Total variable costs (TVC) are those costs which change with the level of output. They include payment for raw materials, fuel, power, transportation services, most labor, and similar costs.

3. Total cost is the sum of total fixed and total variable costs at each level of output (TC) = (TFC) + (TVC).

On the following graph plot all the above costs:

B. Per unit or average costs :

1. Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will decline as output rises.

2. Average variable cost is the total variable cost divided by the level of output (AVC = TVC/Q). AVC first declines as quantity increases, reaches a minimum then it increases. AVC is represented by a U shaped curve.

3. Average total cost is the total cost divided by the level of output (ATC = TC/Q), sometimes called unit cost or per unit cost. ATC first declines as quantity increases, reaches a minimum then it increases. ATC is represented by a U shaped curve.

Note that ATC also equals AFC + AVC.

4. AVC reaches a minimum before ATC. ATC curve falls above AVC curve. And the vertical distance between the two equals AFC.

C. Marginal cost is the additional cost of producing one more unit of output (MC = TC/Q).

1. Marginal cost can also be calculated as MC = TVC/Q.

2. Marginal decisions are very important in determining profit levels. Marginal revenue and marginal cost are compared.

3. Marginal cost is a reflection of marginal product and diminishing returns. When marginal product is increasing, MC will be decreasing. When diminishing returns begin, the marginal cost

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will begin its rise. And MC reaches its minimum when MP reached its maximum.

4. The marginal cost is related to AVC and ATC. These average costs will fall as long as the marginal cost is less than either average cost. As soon as the marginal cost rises above the average, the average will begin to rise. MC intersects both curves at their minimum.

Students can think of their grade-point averages with the total GPA reflecting their performance over their years in college, and their marginal grade points as their performance this semester. If their overall GPA is a 3.0, and this semester they earn a 4.0, their overall average will rise, but not as high as the marginal rate from this semester. But if in this semester they earn a less than 3.0 then their overall average will fall.

D. Cost curves will shift if the resource prices change or if technology or efficiency change.

Plot the above cost curves on the following graph (AFC, AVC, ATC, MC):

IV. In the long-run, all production costs are variable, i.e., long-run costs reflect changes in plant size and industry size can be changed (expand or contract).

A. Illustrate different short-run cost curves for five different plant sizes on the following graph

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B. The long-run ATC curve shows the least per unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size.

C. Economies or diseconomies of scale exist in the long run.

1. Economies of scale or economies of mass production explain the downward sloping part of the long-run ATC curve, i.e. as plant size increases, long-run ATC decrease, For example, if a 10 percent increase in all resources result in a 25 percent increase in output, ATC will decrease.

a. Labor and managerial specialization is one reason for this.

b. Ability to purchase and use more efficient capital goods also may explain economies of scale.

c. Other factors may also be involved, such as design, development, or other “start up” costs such as advertising and “learning by doing.”

2. Diseconomies of scale may occur if a firm becomes too large as illustrated by the rising part of the long-run ATC curve. For example, if a 10 percent increase in all resources result in a 5 percent increase in output, ATC will increase. Some reasons for this include distant management, worker alienation, and problems with communication and coordination.

3. Constant returns to scale will occur when ATC is constant over a variety of plant sizes. For example, if a 10 percent increase in all resources result in a 10 percent increase in output, ATC will remain constant.

D. Both economies of scale and diseconomies of scale can be demonstrated in the real world. Larger corporations at first may be successful in lowering costs and realizing economies of scale. To keep from experiencing diseconomies of scale, they may decentralize decision making by utilizing smaller production units.

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Minimum efficient scale

• The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs in the long run.

• The firms in some industries realize this at a small plant size: apparel, food processing, furniture, wood products, snowboarding, and small-appliance industries are examples.

• In other industries, in order to take full advantage of economies of scale, firms must produce with very large facilities that allow the firms to spread costs over an extended range of output. Examples would be: automobiles, aluminum, steel, and other heavy industries. This pattern also is found in several new information technology industries.

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CHAPTER 9PURE COMPETITION

I. Pure Competition: Characteristics and Occurrence A. The characteristics of pure competition:

1. Many sellers, which means that there are enough sellers such that a single seller has no impact on price by its decisions alone.

2. The products in a purely competitive market are homogeneous or standardized; each seller’s product is identical to its competitor’s.

3. Individual firms must accept the market price; they are price takers and can exert no influence on price.

4. Freedom of entry and exit means that there are no significant obstacles preventing firms from entering or leaving the industry.

5. Pure competition is rare in the real world, but the model is important because:

a. The model helps analyze industries with characteristics similar to pure competition, such as wheat market in North America, or international financial markets.

b. The model provides a context in which to apply revenue and cost concepts developed in previous chapters.

c. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world.

B. There are four major objectives to analyzing pure competition.

1. To examine demand from the seller’s viewpoint,

2. To see how a competitive producer responds to market price in the short run,

3. To explore the nature of long-run adjustments in a competitive industry, and

4. To evaluate the efficiency of competitive industries. II. Demand from the Viewpoint of a Competitive Seller

A. Distinguishing demand:

1. The individual firm will view its demand as perfectly elastic since they must take the market price no matter what quantity they produce and sell.

2. The perfectly elastic demand curve is a horizontal line at the prevailing market price.

3. The demand curve is not perfectly elastic for the industry, it is a regular downward sloping market demand curve.

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Individual firm The industry

B. Definitions of average, total, and marginal revenue:

1. Total revenue is the price multiplied by the quantity sold (TR = P×Q).

2. Average revenue is the share of each unit sold in the total revenue: (TR/Q) = [(P×Q)/Q] = P. This means that AR is equal to the price per unit for each firm in pure competition.

3. Marginal revenue is the change in total revenue due to an increase in total product by one extra unit (MR= ∆TR/∆Q = P). This means that MR is also equal to the unit price in conditions of pure competition. MR is also equal to the slope of the TR curve.

TR AR, MR

III. Profit Maximization in the Short-Run:

A. In the short run the firm has a fixed plant size and maximizes

profits or minimizes losses by adjusting output to the given market price. Note: The firm has no control over the market price.

Profits are defined as the difference between total costs and total revenue (π = TR - TC).

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B. Three questions must be answered.

1. How much should the firm produce in order to maximize profit or minimize loss?

2. What will be the amount of profit or loss?

3. If there is loss, should the firm continue to produce or should it shut down?

There are Two Approaches to determining the firm equilibrium level of output where profit is maximized or loss is minimized:

C. The total - revenue—total - cost approach.

An example of this approach is shown in the following table. Note that the costs are the same as for the firm in the table given in the previous chapter.

Q P TR TFC TVC TC π

0 210 0 1000 0 1000 -1000

1 210 1000 100 1100 -890

2 420 1000 160 1160 -740

3 630 1000 210 1210 -580

4 840 1000 260 1260 -420

5 1050 1000 300 1300 -250

6 1260 1000 360 1360 -100

7 1470 1000 455 1455 15

8 1680 1000 560 1560 120

9 1890 1000 720 1720 170

10 2100 1000 900 1900 200

11 2310 1000 1090 2090 220

12 2520 1000 1300 2300 220

13 2730 1000 1600 2600 130

1. The profit or loss can be established by subtracting total cost from total revenue at each output level.

2. In the short run, the firm should produce that output at which it maximizes its profit (positive difference between TR and TC) or minimizes its loss (negative difference between TR and TC).

Graphical representation of the top case (economic profits) is shown in the following Figure.

3. Firms should produce if the difference between total revenue and total cost is profitable, or if the loss is less than the fixed cost.

50

T.R

T.C

4. The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. Then, by shutting down its loss will just equal those fixed costs.

Profit

Q*

D. Marginal - revenue—marginal - cost approach

A. MR = MC rule states that the firm will maximize profits or minimize losses by producing the output where marginal revenue equals marginal cost in the short run.

Two features of this MR = MC rule are important.

a. Rule works for firms in any type of industry, not just pure competition.

b. In pure competition, price = marginal revenue, so in purely competitive industries the rule can be restated as the firm should produce that output where P = MC, because P = MR.

B. At equilibrium level of output the firm measures profits or losses by comparing P and ATC (or comparing TR and TC).

a. If P > ATC (TR >TC), the firm will be making positive economic (abnormal) profit.

b. If P = ATC (TR=TC), the firm will be making only a normal profit.

c. If P < ATC (TR<TC), the firm will be making negative economic profit or loss.

C. In case of loss, should the firm continue production or should it shut down?

Price must exceed or equal minimum-average-variable cost (TR ≥TVC) or the firm will shut down.

T.C

T.R

Q

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Q AFC AVC ATC MC P Π (P=210)

0 - - - - -1000

1 1000 100 1100 100 -890

2 500 80 580 60 -740

3 333.3 70 403.3 50 -580

4 250 65 315 50 -420

5 200 60 260 40 -250

6 166.7 60 226.7 60 -100

7 143 65 208 95 15

8 125 70 195 105 120

9 111.1 80 191.1 160 170

10 100 90 190 180 200

11 99.9 99.1 190 190 220

12 83.3 108.7 191.667 210 220

13 76.9 123.1 200 300 130

1- Applying the rule on the above Table (1):

a. Determining the equilibrium output if price is 210:

MC = MR at unit 12. Therefore, the firm should produce 12 units to maximize profits or minimize loss.

b. Measuring profit:

The level of profit can be found by multiplying ATC (192) by the equilibrium quantity, 12 to get TC ($2300) and subtracting that from total revenue which is $210 x 12 or $2520. Profit will be 2520-2300= $220 when the price is $210. Profit per unit could also have been found by subtracting ATC ($191.667) from P or AR ($210) which gives profit per unit ($18.333), and then multiplying by 12 to get total profit $220. The above figure portrays this situation graphically.

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M.C.

A.T.C.

d

2- When price falls to P2 = 190, comparing P and MC, equilibrium output level will equal 11 units. The firm will be making normal profits (P: 190 = ATC :190) or (TR:2090 = TC:2090). This is called the break even point, and the price which is equal to minimum ATC is called break even price.

P2

o c

3- When price falls to 180, comparing P and MC, the equilibrium output equals 10 units. Here P:180 is less than ATC:190, or (TR:1800 is less than total cost:1900). The firm is facing loss $10 per unit produced (Total loss= 10 x 10= 100) (or:TR- TC=-100). Should the firm continue producing or should it shut down its operations? From the previous table, at this level of output P is greater than AVC (TR >TVC), which means that the revenues generated from production can pay all variable costs (the costs associated with production in the short run) and some revenues will still be left to pay part of FC. Therefore the firm will be minimizing its loss by continuing to produce because the loss (100) will be equal to part of FC only, while if it stops production loss will be all of FC (1000). So the firm should not shut down.

4- When price falls to $60, comparing P and MC, the equilibrium output level is 6 where P = MC.

Here the firm is facing a loss because P (60) < ATC (226.7), and the loss per unit produced = (60-226.7 = 166.7) and total loss equals (166.7 x 6 = 1000).

Should the firm continue producing or should it shut down its operations? From the previous table, at this level of output P is equal to AVC (TR =TVC= 360), which means that the revenues

Q2*

b

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generated from production can pay all variable costs only (the costs associated with production in the short run). This means that the firm will be losing all its FC if it continues to produce. If it stops production loss will also be equal to FC. So the firm would be indifferent to producing or shutting down when P = AVC.

5- If price falls to $40, the equilibrium output for the firm is 5, but at this level of output P < AVC (TR<VC). If the firm continues to produce, it will be losing all the FC plus part of the VC, while if it shuts down, it will lose only it’s FC. Therefore to minimize its losses the firm should shut down.

From the above cases, the firm will continue to produce although it is facing a loss as long as the price is greater than or equal to AVC, but it will shut down when price is less than AVC. Therefore, price 60 (equal to minimum AVC) is called shutdown price, and minimum AVC is referred to as shutdown point.

This means that the firm in the short run can continue to produce although there is a loss as long as the loss is not greater than FC. Put differently, the maximum loss the firm tolerates and still continues to produce is FC.

E. Marginal cost and the short - run supply curve:

1. From the above tables when price was 210, the firm will produce 12 units. When price falls to 190, the firm will produce 11 units. At price of $180 the firm will produce 10 units. And when price is $60 the firm will produce 6 units. And if price falls below 60 (minimum AVC) the firm will stop producing.

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The above set of product prices and corresponding quantities supplied constitutes the supply schedule for the competitive firm which can be represented by the following table for the four set of prices and quantities.

P QS Total Profit

210 12 220

190 11 0

180 10 -100

60 6 -1000

40 0 -1000

The above table confirms the direct relationship between product price and quantity supplied which was identified in chapter 3. Note that the firm will not produce at price less than 60, and that economic profit is higher at higher prices.

3. Since a short-run supply schedule tells how much quantity will be offered at various prices, this identity of marginal revenue with the marginal cost tells us that the marginal cost above AVC will be the short-run supply curve for this firm.

4.

3. Short run supply curve for the industry is the sum of individual supply (MC) curves.

F. Changes in prices of variable inputs or in technology will shift the marginal cost or short-run supply curve.

1. For example, a wage increase would shift the marginal cost (supply) curve upward.

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2. Technological progress would shift the marginal cost (supply) curve downward.

3. Using this logic, a specific tax would cause a decrease in the supply curve (upward shift in MC), and a unit subsidy would cause an increase in the supply curve (downward shift in MC).

G. Determining equilibrium price for a firm and an industry:

1. Total-supply and total-demand data must be compared to find most profitable price and output levels for the industry. (See Table 21.7)

2. Figure 21.7a and b shows this analysis graphically; individual firms supply curves are summed horizontally to get the total-supply curve S in Figure 21.7b. If product price is $111, industry supply will be 8000 units, since that is the quantity demanded and supplied at $111. This will result in economic profits similar to those portrayed in Figure 21.3.

3. Loss situation similar to Figure 21.4 could result from weaker demand (lower price and MR) or higher marginal costs.

H. Firm vs. industry: Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price.

V. Profit Maximization in the Long Run

A. Several assumptions are made.

1. Entry and exit of firms are the only long-run adjustments.

2. Firms in the industry have identical cost curves.

3. The industry is a constant-cost industry, which means that the entry and exit of firms will not affect resource prices or location of unit-cost schedules for individual firms.

.

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B. Basic conclusion to be explained is that after long-run equilibrium is achieved, the product price will be exactly equal to, and production will occur at each firm’s point of minimum average total cost (break even point). The model is one of zero economic profits, but note that this allows for a normal profit to be made by each firm in the long run.

1. If economic profits are being earned, firms enter the industry,

which increases the market supply, causing the product price to move downward to the equilibrium price where zero economic profits (normal profits) are earned ( Show on the figure).

Single firm Industry

5. If losses are incurred in the short run, firms will leave the industry; this decreases the market supply, causing the product price to rise until losses disappear and normal profits are earned (Show on the figure).

Single firm Industry

C. Long-run supply for a constant cost industry will be perfectly elastic; the curve will be horizontal. In other words, the level of output will not affect the price in the long run.

1. In a constant-cost industry, expansion or contraction does not affect resource prices or production costs.

2. Entry or exit of firms will affect quantity of output, but will always bring the price back to the equilibrium price.

(Show on figure A)

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D. Long-run supply for an increasing cost industry will be upward sloping as industry expands output.

1. Average-cost curves shift upward as the industry expands and downward as industry contracts, because resource prices are affected.

2. A two-way profit squeeze will occur as demand increases because costs will rise as firms enter, and the new equilibrium price must increase if the level of profit is to be maintained at its normal level. Note that the price will fall if the industry contracts as production costs fall, and competition will drive the price down so that individual firms do not realize above-normal profits ( Show on figure B).

E. Long-run supply for a decreasing cost industry will be downward sloping as the industry expands output. This situation is the reverse of the increasing-cost industry. Average-cost curves fall as the industry expands and firms will enter until price is driven down to maintain only normal profits (figure C).

(A) (B) (C)

VI. Pure Competition and Efficiency

Whether the industry is one of constant, increasing, or decreasing costs,

the final long-run equilibrium will have the same basic characteristics.

A. Productive efficiency occurs when there is no excess capacity where P = minimum AC; at this point firms must use the least-cost technology or they won’t survive.

B. Allocative efficiency occurs where P = MC, because price measures the benefit that society gets from additional units of good X, and the marginal cost of this unit of X measures the sacrifice or cost to society of other goods given up to produce more of X. Under pure competition this outcome will be achieved.

1. If price exceeds marginal cost, then society values more units of good X more highly than alternative products the appropriate

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resources can otherwise produce. Resources are underallocated to the production of good X.

2. If price is less than marginal cost, then society values the other goods more highly than good X, and resources are overallocated to the production of good X.

3. Efficient allocation occurs when price and marginal cost are equal. Under pure competition this outcome will be achieved.

C. The firm earns only normal profits where P = AC which guarantees equitable distribution of income.

D. Allocative efficiency implies maximum consumer and producer surplus.

a. Consumer surplus is the benefit buyers receive by having the market price less than their maximum willingness to pay (as also seen in Chapter 18).

b. Producer surplus is the benefit sellers receive by having the market price greater than their minimum willingness to accept for payment.

c. Combined consumer and producer surplus is maximized at equilibrium (see Figure 21.12b).

d. Any quantity less than equilibrium would reduce both consumer and producer surplus (reducing the green and blue areas of Figure 21.12b)

e. Any quantity greater than equilibrium would occur with an efficiency loss that would subtract from combined consumer and producer surplus.

Dynamic Adjustments.

This market has the ability to restore efficiency when disrupted by

changes in the consumer tastes, resource supplies or technology.

Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs.

“The invisible hand” (introduced in Chapter 2) works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. (Assumes private goods with no externalities.)

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CHAPTER 10:PURE MONOPOLY

I. Pure Monopoly: An Introduction

A. Definition: Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.

B. There are several characteristics that distinguish pure monopoly.

1. There is a single seller so the firm and industry are synonymous.

2. There are no close substitutes for the firm’s product.

3. The firm is a “price maker,” that is, the firm has considerable control over the price because it can control the quantity supplied.

4. Entry into the industry by other firms is blocked.

5. A monopolist may or may not engage in non-price competition. Depending on the nature of its product, a monopolist may advertise to increase demand.

C. Examples of pure monopolies and “near monopolies”:

1. Public utilities—gas, electric, water, cable TV, and local telephone service companies—are pure monopolies.

2. Monopolies may be geographic. A small town may have only one airline, bank, etc.

D. Analysis of monopolies yields insights concerning monopolistic competition and oligopoly, the more common types of market situations.

II. Barriers to Entry Limiting Competition:

The factors that prohibit firms from entering an industry are called barriers to entry. In pure monopoly there are strong barriers to entry which effectively block all potential competition. The barriers can be any of the following:

A. Economies of scale constitute one major barrier. This occurs where the lowest unit costs and, therefore, lowest unit prices for consumers depend on the existence of a small number of large firms or, in the case of a pure monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Graph:

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1. Public utilities are known as natural monopolies because they have economies of scale in the extreme case where one firm is most efficient in satisfying existing demand.

2. Government usually gives one firm the right to operate a public utility industry in exchange for government regulation of its power.

3. The explanation of why more than one firm would be inefficient involves the description of the maze of pipes or wires that would result if there were competition among water companies, electric utility companies, etc.

B. Legal barriers to entry into a monopolistic industry also exist in the form of patents and licenses.

1. Patents grant the inventor the exclusive right to produce or license a product for seventeen years; this exclusive right can earn profits for future research, which results in more patents and monopoly profits.

2. Licenses are another form of entry barrier. Radio and TV stations, airline companies, taxi companies are examples of government granting licenses where only one or a few firms are allowed to offer the service.

C. Ownership or control of essential resources is another barrier to entry.

1. International Nickel Co. of Canada controlled about 90 percent of the world’s nickel reserves, and DeBeers of South Africa controls most of world’s diamond supplies.

2. Aluminum Co. of America (Alcoa) once controlled all basic sources of bauxite, the ore used in aluminum fabrication.

3. Professional sports leagues control player contracts and leases on major city stadiums.

D. Monopolists may use pricing or other strategic barriers such as selective price-cutting and advertising.

1. Dentsply, manufacturer of false teeth, controlled about 70 percent of the market. In 2005 Dentsply was found to have illegally prevented distributors from carrying competing brands.

2. Microsoft charged higher prices for its Windows operating system to computer manufacturers featuring Netscape Navigator instead of Microsoft’s Internet Explorer. U.S. courts ruled this action illegal.

III. Monopoly demand is the industry (market) demand and is therefore a downward sloping curve.

A. Our analysis of monopoly demand makes three assumptions:

1. The monopoly is secured by patents, economies of scale, or resource ownership.

2. The firm is not regulated by any unit of government.

3. The firm is a single-price monopolist; it charges the same price for all units of output.

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B. Price will exceed marginal revenue because the monopolist must lower the price to sell the additional unit. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output (Table and Figure).

P Q TR TC VC MR MC ATC AVC π

40 0 0 50 0 -50

38 1 38 56 38 6 -18

36 2 72 66 34 10 6

34 3 102 80 30 14 22

32 4 128 98 26 18 30

30 5 150 120 22 22 30

28 6 168 146 18 26 22

26 7 182 176 14 30 6

24 8 192 210 10 34 -18

22 9 198 248 6 38 -50

1. In the above figure shows the relationship between demand, marginal-revenue, and total-revenue curves.

2. The marginal-revenue curve is below the demand curve, and when it becomes negative, the total-revenue curve turns downward as total-revenue falls.

C. The monopolist is a price maker. The firm controls output and price but is not free of market forces, since the combination of output and price that can be sold depends on demand. For example, the above table shows that at $38 only 1 unit will be sold, at $36 only 2 units will be sold, etc.

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D. Price elasticity also plays a role in monopoly price setting. The total revenue test shows that the monopolist will avoid the inelastic segment of its demand schedule. As long as demand is elastic, total revenue will rise when the monopoly lowers its price, but this will not be true when demand becomes inelastic. At this point, total revenue falls as output expands, and since total costs rise with output, profits will decline as demand becomes inelastic. Therefore, the monopolist will expand output only in the elastic portion of its demand curve.

IV. Output and Price Determination

A. Cost data is based on hiring resources in competitive markets, and it is assumed that the resource prices remain constant for the monopolist who buys them.

B. The MR = MC rule will tell the monopolist where to find its profit-maximizing output level. This can be seen in the above table. The same outcome can be determined by comparing total revenue and total costs incurred at each level of production.

The following figures show short-run possible equilibrium situations for a monopoly firm.

C. Long run equilibrium: Unlike the purely competitive firm, the pure monopolist can continue to receive economic profits in the long run. Although losses can occur in a pure monopoly in the short run as was shown above ( as long as P≥AVC) , the less-than-profitable monopolist

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will shutdown in the long run, meaning that the firm should make economic profit (P>ATC).

D. The pure monopolist has no supply curve because there is no unique relationship between price and quantity supplied. The price and quantity supplied will always depend on location of the demand curve.

E. There are several misconceptions about monopoly prices.

1. Monopolist cannot charge the highest price it can get, because it will maximize profits where total revenue minus total cost is greatest. This depends on quantity sold as well as on price and will never be the highest price possible.

2. Total, not unit, profits is the goal of the monopolist, he seeks to maximize his total profits and not per unit profit. In the above table compare the profit per unit at its maximum and at the profit-maximizing output of 5 units. Once again, quantity must be considered as well as unit profit.

3. The monopolist could sometimes make only normal profit in the long run and not economic profit.

V. Evaluation of the Economic Effects of a Monopoly

A. Price, output, and efficiency of resource allocation should be considered.

1. Monopolies will sell a smaller output and charge a higher price than would competitive producers selling in the same market, i.e., assuming similar costs. Show in the above figure what is the price and the output for the competitive producer and the monopolist

2. Monopoly price will exceed marginal cost, because it exceeds marginal revenue and the monopolist produces where marginal revenue and marginal cost are equal. The monopolist charges the price that consumers will pay for that output level.

3. Allocative efficiency is not achieved because price (what product is worth to consumers) is above marginal cost (P >MC: opportunity cost of product). Ideally, output should expand to a level where price = marginal revenue = marginal cost, but this will occur only

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under pure competitive conditions where price = marginal revenue. Show on the above figure.

4. Productive efficiency is not achieved because the monopolist’s output is less than the output at which average total cost is minimum. This means there is excess capacity in pure monopoly.

5. The efficiency (or deadweight) loss is also reflected in the sum of consumer and producer surplus equaling less than the maximum possible value.

B. Income distribution is more unequal than it would be under a more competitive situation. The effect of the monopoly power is to transfer income from the consumers to the business owners. This will result in a redistribution of income in favor of higher-income business owners, unless the buyers of monopoly products are wealthier than the monopoly owners, which is not the case in most cases.

C. Cost complications may lead to other conclusions.

1. Economies of scale may result in one or two firms operating in an industry experiencing lower ATC than many competitive firms. These economies of scale may be the result of spreading large initial capital cost over a large number of units of output (natural monopoly) or, more recently, spreading product development costs over units of output, and a greater specialization of inputs.

2. X-inefficiency may occur in monopoly since there is no competitive pressure to produce at the minimum possible costs.

3. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain government-granted monopoly privileges. Such rent-seeking may entail substantial costs (lobbying, legal fees, public relations advertising, etc.), which are inefficient.

D. Technological progress and dynamic efficiency may occur in some monopolistic industries but not in others. The evidence is mixed.

1. Some monopolies have shown little interest in technological progress.

2. On the other hand, research can lead to lower unit costs, which help monopolies as much as any other type of firm. Also, research can help the monopoly maintain its barriers to entry against new firms.

E. Assessment and policy options:

1. Although there are legitimate concerns of the effects of monopoly power on the economy, monopoly power is not widespread. While research and technology may strengthen monopoly power, overtime it is likely to destroy monopoly position.

2. When monopoly power is resulting in an adverse effect upon the economy, the government may choose to intervene on a case-by-case basis.

VI. Price discrimination occurs when a given product is sold at more than one price and the price differences are not based on cost differences.

A. Price discrimination can take three forms:

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1. Charging each customer in a single market the maximum price he or she is willing to pay.

2. Charging each customer one price for the first set of units purchased, and a lower price for subsequent units.

3. Charging one group of customers one price, and another group a different price.

B. Conditions needed for successful price discrimination:

1. Monopoly power is needed with the ability to control output and price.

2. The firm must have the ability to segregate the market, to divide buyers into separate classes that have a different willingness or ability to pay for the product (usually based on differing elasticities of demand).

3. Buyers must be unable to resell the original product or service.

C. Examples of price discrimination:

1. Airlines charge high fares to executive travelers (inelastic demand) than vacation travelers (elastic demand).

2. Electric utilities frequently segment their markets by end uses, such as lighting and heating. (Lack of substitutes for lighting makes this demand inelastic).

3. Long-distance phone service has higher rates during the day, when businesses must make their calls (inelastic demand), and lower rates at night and on week-ends, when less important calls are made.

4. Movie theaters and golf courses vary their charges on the basis of time and age.

5. Discount coupons are a form of price discrimination, allowing firms to offer a discount to price-sensitive customers.

6. International trade has examples of firms selling at different prices to customers in different countries.

D. Graphical Analysis:

1. Most price discrimination separates the market into two (sometimes more) groups of customers. This is shown in the software example depicted by Figure 22.8.

2. Because the demand curves for software for students and small businesses differ, so will their MR curves and the profit-maximizing prices and quantities for each group.

3. For each segment of the market the monopolist will set output and price according to the MR = MC rule.

4. Firms realize greater profits, and students benefit from lower prices. Small businesses face higher prices and consume less.

E. Price discrimination is common, and only illegal when the firm is using it to lessen or eliminate competition (see Chapter 30 for more on that topic).

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VII. Regulated Monopoly

A. This occurs where a natural monopoly or economies of scale make the presence of one firm desirable.

B. In regulated monopoly market, a regulatory commission may attempt to establish the legal price for the monopolist that is equal to marginal cost at the quantity of output chosen. This is called the “socially optimal price” because it achieves allocative efficiency.

C. However, setting price equal to marginal cost may cause losses, because public utilities must invest in enough fixed plant to handle peak loads. Much of this fixed plant goes unused most of the time, and a price = marginal cost would be below average total cost. Regulators often choose a price equal to average cost rather than marginal cost, so that the monopoly firm can achieve a “fair return” and avoid losses. (Recall that average-total cost includes an allowance for a normal or “fair” profit.)

C. The dilemma for regulators is whether to choose a socially optimal price, where P = MC, or a fair-return price, where P = AC.

P = MC is most efficient but may result in losses for the monopoly firm, and government then would have to subsidize the firm for it to survive.

P = AC does not achieve allocative efficiency, but does insure a fair return (normal profit) for the firm.

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CHAPTER11: MONOPOLISTEC COMPETITION .

I. Monopolistic Competition, Characteristics and occurrence.

A. Monopolistic competition refers to a market situation in which a relatively large number of sellers offer similar but not identical products.

1. Each firm has a small percentage of the total market.

2. Collusion is nearly impossible with so many firms.

3. Firms act independently; actions of one firm are ignored by the other firms in the industry.

B. The firms offer similar but not identical products.

C. Product differentiation and other types of non-price competition give the individual firm some degree of monopoly power that the purely competitive firm does not possess.

1. Product differentiation may be physical (qualitative).

2. Services and conditions accompanying the sale of the product are important aspects of product differentiation.

3. Location is another type of differentiation.

4. Brand names and packaging lead to perceived differences.

5. Product differentiation allows producers to have some control over product prices.

D. Advertising is a type of non-price competition and is used in this market in order to make consumers aware of the product differences. If successful, it will make the demand curve shift to the right and become less elastic.

E. Similar to pure competition, under monopolistic competition firms can enter and exit these industries relatively easily. Trade secrets or trademarks may provide firms some monopoly power.

F. Examples of real-world industries that fit this model are: barber shops, grocery stores, tailor shops, clothing stores, furniture shops, restaurants, dry cleaners, hotels, and many other examples.

II. Monopolistic Competition: Price and Output Determination

A. The firm’s demand curve is highly, but not perfectly, elastic. It is more elastic than the monopoly’s demand curve because the seller has many rivals producing close substitutes. It is less elastic than in pure competition, because the seller’s product is differentiated from its rivals, so the firm has some control over price.

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The larger the number of rivals and the weaker the product differentiation, the greater the price elasticity of demand and the closer monopolistic competition will be to pure competition.

B. Equilibrium situation in the short-run:

The firm will maximize profits or minimize losses by producing where marginal cost and marginal revenue are equal, as was true in pure competition and monopoly. The different possible situations of equilibrium facing the firm in this market in the short run are similar to those in the previous two markets, and the graphical illustration is similar to those in the case of pure monopoly.

C. In the long - run , the firm earns a normal profit only, that is it will break even.

1. Firms can enter the industry easily and will if the existing firms are making an economic profit. As firms enter the industry, this decreases the demand curve facing an individual firm as buyers shift some demand to new firms; the demand curve will shift until the firm just breaks even.

2. If firms were making a loss in the short run, some firms will leave the industry. This will raise the demand curve facing each remaining firm as there are fewer substitutes for buyers. As this happens, each firm will see its losses disappear until it reaches the break-even (normal profit) level of output and price.

3. Complicating factors are involved with this analysis. Sometimes the firm might continue to make economic profits in the long run due to one of the following reasons:

a. Some firms may achieve a measure of differentiation that is not easily duplicated by rivals (brand names, location, etc.) and can realize economic profits in the long run.

b. There is some restriction to entry, such as financial barriers (differentiation and advertisement costs) that exist for new small businesses, so economic profits may persist for existing firms.

c. Long-run below-normal profits may persist, because producers like to maintain their way of life as entrepreneurs despite the low economic returns.

III. Monopolistic Competition and Economic Efficiency

1. Price exceeds marginal cost in the long run, suggesting that society values additional units that are not being produced, meaning there is allocative inefficiency or under-allocation of resources. The gap between price and marginal cost for each firm creates an efficiency (or deadweight) loss industry-wide.

2. Firms do not produce at the lowest average-total-cost level of output which means there is excess capacity or productive inefficiency.

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3. The firm produces a smaller output than under perfect competition and sets its price higher than under perfect competition.

4. The firm will realize only normal profits (P=ATC), then there will be equal distribution of income.

5. Average costs may also be higher than under pure competition, due to advertising and other costs involved in differentiation.

IV. Monopolistic Competition: Product Variety

A. A monopolistically competitive producer may be able to postpone the long-run outcome of just normal profits through product development and improvement and advertising. This will increase costs but at the same time increase demand, which might compensate for the added costs and leads to increased profits.

B. Compared with pure competition, this suggests possible advantages to the consumer.

1- Developing or improving a product can provide the consumer with a diversity of choices to satisfy the diverse tastes.

2- Product differentiation is the heart of the tradeoff between consumer choice and productive efficiency. The greater number of choices the consumer has, the greater the excess capacity problem.

C. The monopolistically competitive firm keeps changing three factors—product attributes, product price, and advertising—in seeking maximum profit.

1. This complex situation is not easily expressed in a simple economic model such as Figure 23.1. Each possible combination of price, product, and advertising poses a different demand and cost situation for the firm.

2. In practice, the optimal combination cannot be readily forecast but must be found by trial and error.

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OligopolyI Characteristics and Occurrence

A. Oligopoly exists where a few large firms producing a homogeneous or differentiated product dominate a market.

1. There are few enough firms in the industry that firms are mutually interdependent—each must consider its rivals’ reactions in response to its decisions about prices, output, and advertising.

2. Some oligopolistic industries produce standardized products (steel, zinc, copper, cement), whereas others produce differentiated products (automobiles, motorcycles, light bulbs, batteries, cigarettes, detergents, greeting cards, ).

B. Barriers to entry:

1. Economies of scale may exist due to technology and market share.

2. The capital investment requirement may be very large.

3. Other barriers to entry may exist, such as patents, control of raw materials, preemptive and retaliatory pricing, substantial advertising budgets, and traditional brand loyalty.

C. Although some firms have become dominant as a result of internal growth, others have gained this dominance through mergers.

D. Measuring industry concentration (Table 14.2):

1. Concentration ratios are one way to measure market dominance. If the concentration ratio is greater than or equal to 40%, then it is considered an oligopoly.

2. The Herfindahl index is another way to measure market dominance. It measures the sum of the squared market shares of each firm in the industry, so that much larger weight is given to firms with high market shares.

3. Concentration tells us nothing about the actual market performance of various industries in terms of how vigorous the actual competition is among existing rivals.

II Oligopoly Behavior: A Game Theory Overview

A. Oligopoly behavior is similar to a game of strategy, such as poker, chess, or bridge. Each player’s action is interdependent with other players’ actions. Game theory can be applied to analyze oligopoly behavior. A two-firm model or duopoly is usually used.

B. Figure 14.3 illustrates the profit payoffs for firms in a duopoly in an imaginary athletic-shoe industry. Pricing strategies are classified as high-priced or low-priced, and the profits in each case will depend on the rival’s pricing strategy.

C. Mutual interdependence is demonstrated by the following: RareAir’s best strategy is to have a low-price strategy if Uptown follows a high-price strategy. However, Uptown will not remain there, because it is better for Uptown to follow a low-price strategy when RareAir has a low-price strategy. Each possibility points to the interdependence of the two firms. This is a major characteristic of oligopoly.

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D. Another conclusion is that oligopoly can lead to collusive behavior. In the RareAir/Uptown example, both firms could improve their positions if they agreed to both adopt a high-price strategy. However, such an agreement is collusion and the two firm will form a monopoly which is a violation of most countries’ anti-trust laws.

E. If collusion does exist, formally or informally, there is much incentive on the part of both parties to cheat and secretly break the agreement. For example, if RareAir can get Uptown to agree to a high-price strategy, then RareAir can sneak in a low-price strategy and increase its profits.

III . Three oligopoly models are used to explain oligopolistic price-output behavior. (There is no single model that can portray this market structure due to the wide diversity of oligopolistic situations and mutual interdependence that makes predictions about pricing and output quantity precarious.)

A. The kinked-demand model assumes a noncollusive oligopoly. (See Key Graph 14.4)

B. Cartels and collusion agreements constitute another oligopoly model. (See Figure 14.5)

1. To maximize profits, the firms collude and agree to a certain price. Assuming the firms have identical cost, demand, and marginal-revenue data the result of collusion is as if the firms made up a single monopoly firm.

2. A cartel is a group of producers that creates a formal written agreement specifying how much each member will produce and charge. The Organization of Petroleum Exporting Countries (OPEC) is the most significant international cartel.

3. There are many obstacles to collusion:

a. Differing demand and cost conditions among firms in the industry;

b. A large number of firms in the industry;

c. The incentive to cheat;

d. The attraction of potential entry of new firms if prices are too high; and

e. Antitrust laws that prohibit collusion.

C. Price leadership is a type of gentleman’s agreement that allows oligopolists to coordinate their prices legally; no formal agreements or clandestine meetings are involved. The practice has evolved whereby one firm, usually the largest, changes the price first and, then, the other firms follow.

IV. Oligopoly and Advertising

A. Product development and advertising campaigns are more difficult to combat and match than lower prices.

B. Oligopolists have substantial financial resources with which to support advertising and product development.

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C. Advertising can affect prices, competition, and efficiency both positively and negatively.

V. The economic efficiency of an oligopolistic industry is hard to evaluate.

A. Allocative and productive efficiency are not realized because price will exceed marginal cost and, therefore, output will be less than minimum average-cost output level (Figure 14.5).

B. The economic inefficiency may be lessened because:

1. Foreign competition has made many oligopolistic industries much more competitive when viewed on a global scale.

2. Oligopolistic firms may keep prices lower in the short run to deter entry of new firms.

3. Over time, oligopolistic industries may foster more rapid product development and greater improvement of production techniques than would be possible if they were purely competitive. (See Chapter 12)

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