Study Notes
Study Notes
Study Notes
STUDY NOTES
MICROECONOMICS
ECON 110
Dr. SULAFA HADEED
CHAPTER 1
LIMITS, ALTERNATIVES, AND CHOICES
LECTURE NOTES
I.
II.
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.
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
3
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.
B.
C.
D.
4
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.
The Budget line: Whole Unit Combinations of DVD's and Books Attainable with
Units of DVD
(Price= 20 KD)
6
5
4
3
2
1
0
Units of Books
(Price=10 KD)
0
2
4
6
8
10
12
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 consumers 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.
6
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.
Societys 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.
7
b. Consumer goods directly satisfy wants; capital goods, which are
used to produce consumer goods, indirectly satisfy wants.
Types of product
A
B
____________________________________
Pizzas
0
1
Robots
10
9
Opportunity cost of producing
one extra unit of pizza:
Production Alternatives
C
D
2
7
--
3
4
--
E
4
0
--
--
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.
8
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.
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
9
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.
10
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).
Figure 1.4
Figure 1.5
11
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.
12
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
13
14
CHAPTER 3
INDIVIDUAL MARKETS:
DEMAND AND SUPPLY AND GOVERNMENT-SET PRICES
I.
Markets Defined
A. 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
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
Quantity Demande
10
20
35
55
80
15
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 higherpriced 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.
16
Table (2) is the market demand for corn:
Price
5
4
3
2
1
first buyer
second buyer
third buyer total quantity demand
10
12
8
30
20
23
17
60
35
39
26
100
55
60
39
154
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).
d. Prices of related goods also affect demand.
17
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 demand,
18
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
Quantity supplied
60
50
35
20
19
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
S1
20
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 goodsif 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.
Price
Quantity
Demanded
12,000
2,000
10,000
4,000
7,000
7,000
4,000
11,000
1,000
16,000
Surplus or
shortage
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.
21
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.
IV.
22
Simple cases: When either demand or supply shifts while the other is held
constant.
A. Changing demand with supply held constant:
1. Increase in demand will have effect of increasing equilibrium price
and quantity.
23
Complex caseswhen 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.
24
1. If supply decreases and demand increases, price rises, but new
equilibrium quantity depends again on relative sizes of shifts in
demand and supply.
25
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.
26
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.
27
CHAPTER 6
DEMAND AND SUPPLY: ELASTICITIES
I.
28
Thus: Ed =[(Q 2 Q1) (Q1+ Q2)/2] [(P2 - P1) (P1 + P2)/2]. And
after reducing:
(Q - Q1 ) ( P1 P2 )
Ed 2
(Q 2 Q1 ) ( P2 P1 )
4.
5.
6.
7.
8.
9.
29
the coefficient of elasticity will equal to zero (Ed = 0); and we say
that demand is perfectly inelastic, and the demand curve would be
vertical. However this case is very rare.
30
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.
31
The relationship between total revenue and price elasticity of demand
is represented in the following table :
Total quantity
(1000)
1
Price
elasticity
coefficient
>
>
2.6
>
1.57
>
>
.64
>
.38
>
.2
total
revenue
8000
14000
18000
20000
20000
18000
14000
8000
32
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 ones 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.
33
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.
Short run
(Q x 2 Q x 1 ) ( PY 2 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
consumers 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)
(Q - Q1 ) ( I 1 I 2 )
Ed 2
(Q 2 Q1 ) ( I 2 I 1 )
1. A positive income elasticity indicates a normal or superior good.
Long run
34
2. A negative income elasticity indicates an inferior good.
Consumer Surplus
1. 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
A
13
8
B
12
8
C
11
8
D
10
8
E
9
8
F
8
8
consumer surplus
5
4
3
2
1
0
consumer surplus
35
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
G
H
I
J
K
L
max price
3
4
5
6
7
8
actual price
8
8
8
8
8
8
producer surplus
5
4
3
2
1
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.
36
1. MB = MC
2. Maximum willingness to pay = minimum acceptable price
3. Combined consumer and producer surplus is at a maximum
37
CHAPTER 7:
CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION
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.
I.
Sandwiches
Total Utility
10
18
24
28
30
30
28
Marginal Utility
38
Graph the above values of total and marginal utility:
39
III.
40
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
Units of
product
1st
2nd
3rd
4th
5th
6th
7th
Marginal
Utility
10
8
7
6
5
4
3
Product B
Marginal
utility per KD
10
8
7
6
5
4
3
Marginal
Utility
24
20
18
16
12
6
4
Marginal
utility per KD
12
10
9
8
6
3
2
IV.
Marginal
Utility
10
8
7
6
5
4
3
Product B
Marginal
utility per KD
10
8
7
6
5
4
3
Marginal
Utility
24
20
18
16
12
6
4
Marginal
utility per KD
24
20
18
16
12
6
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
2
1
Quantity of B
4
6
41
42
CHAPTER 8
THE 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 owners 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.
II.
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.
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
43
attributable to each additional resource unit (marginal product) will
decline.
1. The following table presents a numerical example of the law of
diminishing returns.
44
We can conclude the following from the above table and graphs:
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
inputsworkers in this caseare 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. Thats why
sometimes this law is called the law of variable proportions.
III.
TFC
TVC
TC
AFC
AVC
ATC
MC
1000
1000
1000
100
1100
1000
100
1100
100
1000
160
1160
500
80
580
60
1000
210
1210
333.3
70
403.3
50
1000
260
1260
250
65
315
50
1000
300
1300
200
60
260
40
1000
360
1360
166.7
60
226.7
60
1000
455
1455
143
65
208
95
1000
560
1560
125
70
195
105
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
45
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:
46
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
47
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.
48
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 smallappliance industries are examples.
49
CHAPTER 9
PURE 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 sellers product is identical to its competitors.
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 sellers 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.
50
Individual firm
The industry
B. Definitions of average, total, and marginal revenue:
1. Total revenue is the price multiplied by the quantity sold (TR =
PQ).
2. Average revenue is the share of each unit sold in the total revenue:
(TR/Q) = [(PQ)/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
III.
AR, MR
51
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-revenuetotal-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
TR
TFC
TVC
TC
210
1000
1000
-1000
210
1000
100
1100
-890
420
1000
160
1160
-740
630
1000
210
1210
-580
840
1000
260
1260
-420
1050
1000
300
1300
-250
1260
1000
360
1360
-100
1470
1000
455
1455
15
1680
1000
560
1560
120
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
52
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.
T.R
T.C
Profit
T.R
T.C
*Q
D. Marginal-revenuemarginal-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.
53
Q
AFC
AVC
ATC
MC
(P=210)
-1000
1000
100
1100
100
-890
500
80
580
60
-740
333.3
70
403.3
50
-580
250
65
315
50
-420
200
60
260
40
-250
166.7
60
226.7
60
-100
143
65
208
95
15
125
70
195
105
120
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
54
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.
M.C.
A.T.C
.
d
P2
c
Q2*
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.
55
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 its 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.
56
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
180
10
-100
60
-1000
40
-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.
57
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 totalsupply 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.
58
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 firms 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)
59
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)
VI.
(B)
(C)
60
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.
61
CHAPTER 10:
PURE MONOPOLY
I.
II.
62
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 worlds nickel reserves, and DeBeers of South Africa controls
most of worlds 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
Microsofts Internet Explorer. U.S. courts ruled this action illegal.
III.
63
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
TR
TC
VC
MR
MC
ATC
AVC
40
50
38
38
56
38
-18
36
72
66
34
10
34
102
80
30
14
22
32
128
98
26
18
30
30
150
120
22
22
30
28
168
146
18
26
22
26
182
176
14
30
24
192
210
10
34
-18
22
198
248
38
-50
-50
64
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.
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 PAVC) , the less-than-profitable monopolist
65
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.
66
B.
C.
D.
E.
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:
67
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 profitmaximizing 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).
68
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.
69
70
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:
71
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.
72
Oligopoly
I
II
73
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 .
IV.
74
V.