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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

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. TerminologyPrinciples, 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.

C.

D.

GeneralizationsEconomic principles are expressed as the


Tendencies of the typical or average consumer, worker, or
business firm.
Other things equal or ceteris paribus assumptionIn 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.
Graphical ExpressionMany 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, valuebased questions.
The Economizing Problem.
Individuals 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 peoples wants are virtually unlimited.
1. Wants include both necessities and luxuries (although many
economists dont 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.

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.

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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.

D. Production possibilities tables and curves are a device to illustrate and


clarify societys 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).

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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.

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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

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.

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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).

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 womens 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.
b.
c.
d.

Households are on the buying side of these markets, purchasing goods


and services.
Businesses are on the selling side of these markets, offering products for
sale.
Interaction of these buyers and sellers determines the price of each
product.
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 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

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 Demande

10

20

35

55

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 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.

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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.

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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,

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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

60

50

35

20

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

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 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.

Supply and Demand: Market Equilibrium


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

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.

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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 dont 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 societys wants.

IV.

Changes in Supply and Demand, and Equilibrium.

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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.

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 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.

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 6
DEMAND 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 (%Q)/ percentage change in price (%P) .
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
autos 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: (%Q) = (Q2
Q1)/(Q1). And the percentage change in price is calculated by
dividing the absolute change in price by the original price: (%P)
= (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 (Q 2,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:
(%Q) = (Q2 Q1) (Q1+ Q2)/2
(%P) = (P2 - P1) (P1 + P2)/2

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.

This formula is called midpoint elasticity or arc elasticity


formula, and is considered the best formula for calculating price
elasticity of demand .
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.
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.
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.
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 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.
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 (%Q = 0). Then

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.

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).

30

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.

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

total revenue test


Elastic
Elastic
Elastic
Unit elastic
Inelastic
Inelastic
Inelastic

The following is a graphical representation of the relationship between


total revenue and price elasticity of demand represented in the above
table :

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.

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.

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.

Immediate time period

IV.

Short run

Cross and income elasticity of demand:


A. Cross elasticity of demand refers to the effect of a change in a
products 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)
(Q - Q x 1 ) ( PY 1 PY 2 )
Ed x 2

(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.

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 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

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

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.

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

10

18

24

28

30

30

28

Marginal Utility

38
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 consumers
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.

39

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 B
The 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

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.

Utility Maximization and the Demand Curve


A. Determinants of an individuals 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
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
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

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 consumers 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 Bs 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 consumers 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.

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.

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 (TP/L).
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:

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.

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

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:

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 will

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

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 smallappliance 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.

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.

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.

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

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
( = TR - TC).

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

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.

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

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.

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.

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

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.

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.
.

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)

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 wont 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

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.

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.)

61
CHAPTER 10:
PURE MONOPOLY
I.

II.

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 firms 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 utilitiesgas, electric, water, cable TV, and local telephone
service companiesare 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.
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:

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.

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.
B. Price will exceed marginal revenue because the monopolist must lower
the price to sell the additional unit. The added revenue will be the

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

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.

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.

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 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.

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

66

B.

C.

D.

E.

VI.

under pure competitive conditions where price = marginal


revenue. Show on the above figure.
4. Productive efficiency is not achieved because the monopolists
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.
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.
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.
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.
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-bycase basis.

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 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).

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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 firms demand curve is highly, but not perfectly, elastic. It is more
elastic than the monopolys demand curve because the seller has many
rivals producing close substitutes. It is less elastic than in pure
competition, because the sellers 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 advertisingin 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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Oligopoly
I

II

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
interdependenteach 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.
Oligopoly Behavior: A Game Theory Overview
A. Oligopoly behavior is similar to a game of strategy, such as poker,
chess, or bridge. Each players 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 rivals pricing strategy.
C. Mutual interdependence is demonstrated by the following: RareAirs
best strategy is to have a low-price strategy if Uptown follows a highprice 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.

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.

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 marginalrevenue 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 gentlemans 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.
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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V.

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


positively and negatively.
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)