Econ 1010 All Class Slides

Introduction and Course Overview
The Methods of Economics

The Product and Factor Markets
Determinants of Demand for an Individual

The Demand Curve for an Individual
From Individual Demand to Market Demand
Change in demand vs. Change in quantity demanded
Determinants of Supply for an Individual Supplier
The Supply Curve for an Individual Supplier
From Individual Supply to Market Supply
Change in supply vs. Change in quantity supplied
Equilibrium
The Necessity of Equilibrium
Calculating Equilibrium with Equations
EquilibriumPutting Supply and Demand

Together
The Necessity of Equilibrium
Price Floors
Price Ceilings
Calculating Equilibrium with Equations
Comparative Statics
The Three Questions
Examples
Elasticity
Price Elasticity of Demand
Elastic and Inelastic Curves
Calculating Elasticity: The Midpoint Formula
Elasticity and Slope
Other Elasticities
Cross-Price Elasticity of Demand
Income Elasticity of Demand
Price Elasticity of Supply
Determinants of Individual Demand

Price
Income
Normal goods: Goods whose demand increases when
income increases
Inferior goods: Goods whose demand decreases when
income increases
Price of Related Goods

Substitutes: Demand goes up when the price of a substitute
goes up
Complements: Demand goes down when the price of a
complement goes up
Tastes and Preferences

Expectations
Determinants of Market Demand

Price
Income
Normal goods: Goods whose demand increases when income
increases
Inferior goods: Goods whose demand decreases when income
increases
Price of Related Goods
Substitutes: Demand goes up when the price of a substitute
goes up
Complements: Demand goes down when the price of a
complement goes up
Tastes and Preferences
Expectations
Number of Buyers
Individual Demand
Lower Case q"
D
0
Market Demand
Capital Q"
D
0
The Market Demand Curve for Lattes

The Demand Function
P
QD = 24 3P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

The Demand Function
P
QD = 24 3P
P = 8 QD
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
P = 8 QD
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
P = 8 QD
P = 8 (9)
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
P = 8 QD
P = 8 (9)
=5
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

P
P
$6.00
P = 8 QD
P = 8 (18)
= 2
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6
Demand and Inverse Demand

Functions
P Numerical Demand Function: QD = 24 3P
D
0

Functions
Inverse Demand Function:
P = 8 QD
D
0

Functions
P = 8 QD
8
Slope =
D
0
24

Functions
P Parametric Demand Function: Q D a bP
a
b
a 1 D
P= Q
b b
Slope = 1/b
D
0

Functions
P General Form of Demand Function: Q D f (P)
P = f 1 (Q D )
dP
Slope =
dQ D
D
0

Increase in quantity demanded
P
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
$0.00
1.00
2.00
3.00
4.00
5.00
6.00
Qd
(Market)
24
21
18
15
12
9
6

Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good
P
$6.00
QDold
$0.00
24
$4.00
1.00
21
$3.00
2.00
18
3.00
15
4.00
12
5.00
6.00
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

held constant
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25
Incomes, Price of related goods, Expectationsall held constant

Demand curve shifts right
P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
$1.00
$0.00
Q
0
10
15
20
25

P
$6.00
QDold
QDnew
$0.00
24
28
$4.00
1.00
21
25
$3.00
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
$5.00
$2.00
P = 8 QD
$1.00
$0.00
Q
0
10
15
20
25

P
$6.00
$5.00
P = 9 QD
$4.00
$3.00
$2.00
P = 8 QD
$1.00
$0.00
Q
0
10
15
20
25
QDold
QDnew
$0.00
24
28
1.00
21
25
2.00
18
22
3.00
15
19
4.00
12
16
5.00
13
6.00
11
Increase in Quantity Demanded

P
$2.00
P QD
A
An increase in quantity
demanded is a
movement down along
the demand curve
B
$1.00
D
0
12
14
Increase in Demand
One of the non-price determinants of D changes, causing the curve to shift right
Income (Normal goods)

Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers
D2
D1
0
Decrease in Quantity Demanded

P
$2.00
P QD
B
An decrease in
quantity demanded is a
movement up along
the demand curve
A
$1.00
D
0
12
14
Decrease in Demand
One of the non-price determinants of D changes, causing the curve to shift left
Income (Normal goods)

Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers
D1
D2
0
Determinants of a Firms Supply
Price
Input Prices
Technology
Expectations
Determinants of Market Supply
Price
Input Prices
Technology
Expectations
Number of Sellers
The Market Supply Curve

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
25
Q 5.00
30
10 15 20 25 30 35 6.00
Input prices, technology, expectations and number

of sellers all held constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
P
$6.00
QS = 5P
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10 15
20 25 30
35

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
P
$6.00
QS = 5P
P = (1/5)QS
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
Q
0
10 15
20 25 30
35
Input prices, technology, expectations and number

of sellers all held constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35
Input prices, technology, expectations and number of sellers all held

constant
Increase in quantity supplied
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
S
P = (1/5)Q
4.00
20
= (1/5)10
=2
5.00
25
Q
6.00
30
10 15 20 25 30 35

constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
S
Q
P
P = (1/5)QS
(Market)
= (1/5)25
$0.00
0
=5
1.00
5
2.00
10
3.00
15
S
P = (1/5)Q
4.00
20
= (1/5)10
=2
5.00
25
Q
6.00
30
10 15 20 25 30 35

constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35

Technology, expectations and number of sellers still held
constant
Input costs increase
P
QSold QSnew
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
4.00
20
5.00
25
6.00
30
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
5.00
25
6.00
30
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

Supply curve shifts to the left
P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0
10 15
20 25 30
35

Supply curve shifts to the left
P
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q
$6.00
$5.00
$4.00
$3.00
$2.00
P = (1/5)QS
$1.00
$0.00
0
10 15
20 25 30
35

Supply curve shifts to the lefta decrease in supply
P
$6.00
P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q
P = 1 + (1/5)QS
$5.00
$4.00
$3.00
$2.00
P = (1/5)QS
$1.00
$0.00
0
10 15
20 25 30
35
Increase in Quantity Supplied

P
S
B
$3.00
$1.00
P QS
An increase in
quantity supplied
is a movement
up along the
supply curve
Increase in Supply
One of the non-price determinants of S changes, causing the curve to shift right
Technology improves
S1
Input prices
Change in expectations
S2
Number of producers
Decrease in Quantity Supplied

P
S
A
$3.00
$1.00
P QS
A decrease in
quantity
supplied is a
movement
down along the
supply curve
Q
Decrease in Supply
One of the non-price determinants of S changes, causing the curve to shift left
Technology deteriorates
S2
Input prices
Change in expectations
S1
Number of producers
Equilibrium
Point at which QS = QD
At equilibrium E = (Q*,P*),
Quantity Demanded = Quantity Supplied
P*
D
0
Q*
Disequilibrium: Getting the Price Wrong

What happens when the price is too high?
P
S
At PH, QS > QD, which results in

excess supply, or a surplus
Surplus
PH
P*
D
0
QD
Q*
QS

What happens when the price is too high?
P
S
Surplus
PH
At PH, QS > QD, which results in

excess supply
There is downward pressure on
price, and price declines toward
P*
As P falls, QD increases toward
Q*, and QS decreases toward Q*
Process stops when equilibrium
is reached, and the surplus is
eliminated
P*
D
0
QD
Q*
QS

What happens when the price is too low?
P
S
At PL, QD > QS, which results in

excess demand, or a shortage
P*
PL
Shortage
D
0
QS
Q*
QD

What happens when the price is too low?
P
S
There is upward pressure on

price, and price increases
toward P*
As P increases, QD decreases
toward Q*, and QS increases
toward Q*
P*
At PL, QD > QS, which results in

excess demand, or a shortage
Process stops when equilibrium

is reached, and the shortage is
eliminated
PL
Shortage
D
0
QS
Q*
QD
Equilibrium
At equilibrium E = (Q*,P*),
Quantity Demanded = Quantity Supplied
P*
D
0
Q*
Calculating Equilibrium from

Equations
P = 100 3QD Demand Curve
Equilibrium
D
0

Equations
P = 25 + 2QS Supply Curve
Equilibrium
D
0
Equilibrium
P*
D
0
Q*

Equations
At equilibrium,
Demand = Supply

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
100 3Q* = 25 + 2Q*

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
100 3Q* = 25 + 2Q*
5Q* = 75

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
100 3Q* = 25 + 2Q*
5Q* = 75
Q* = 15
Equilibrium
P*
D
0
Q*= 15

Equations
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
100 3Q* = 25 + 2Q*
5Q* = 75
Q* = 15

Equations
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:

Equations
Q* = 15
P* = 100 3Q* = 100 3(15) = 55

Equations
Q* = 15
P* = 100 3Q* = 100 3(15) = 55
P* = 25 + 2Q* = 25 + 2(15) = 55
Equilibrium
P*= 55
D
0
Q*= 15
Comparative Statics
Start at equilibrium
Comparative Statics
Change the value of one of the non-price
determinants of supply or demand
Comparative Statics
Change the value of one of the non-price
determinants of supply or demand
Compare the new equilibrium to the old one
Market for Compact Disks

P
Initial equilibrium is E1 = (Q1*,P1*)
Assume that the price of compact disk

players declines
What happens to equilibrium P and Q in
the market for compact disks?
P1*
E1
D
0
Q1*
Three Questions in Any Comparative Statics

Problem
Which curve shifts?

Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Problem
Which curve shifts?
Which way does it shift?

Problem
Which curve shifts?

To the right, since a fall in the price of a complement
causes demand to increase

P
S
P1*
E1
D2
D1
Q1*

Problem
Which curve shifts?

What happens to equilibrium P and Q after the

shift?

P
The demand curve shifts right
E2
P2*
P1*
The increase in demand leads to an

increase in equilibrium price and an
increase in equilibrium quantity
Note: The increase in demand leads to
an increase in quantity supplied
E1
D2
D1
Q1*
Q2*

Problem
Which curve shifts?

What happens to equilibrium P and Q after the

shift?
P* Q*
Definition of Price Elasticity of

Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price

Demand
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price

Demand
change in price
% Q D
Algebraically, eD =
% P

Demand
change in price
Q D
%Q D
QD
Algebraically, eD =
P
%P
P

Demand
change in price
Q D
D
D
%Q D
Q
P
Q
Algebraically, eD =
P
%P
Q D P
P

Demand
change in price
Q D
%Q D
Q D P
Q D P
QD
Algebraically, eD =
D
P
%P
Q P
P Q D
P
Inelastic Demand Curve

P
DI
0
Elastic Demand Curve

P
DE
0
Elasticity and the Change in QD

P
P2
P1
DE
0
DI
QEl
QIn Q1
Perfectly Inelastic Demand Curve

P
DPI
0
Perfectly Elastic Demand Curve

P
DPE
Calculating Price Elasticity of

Demand
eD =
% Q D
% P
Calculating Price Elasticity of

Demand
% Q D
eD =
% P
D
Q DNew QOld
D
QOld
= P P
New
Old
POld
Calculating eD
P
D
0
10
Calculating eD
P
6 10
10
D
6 10
QOld
FromQADNewtoB,
eD 10
=
46 2
D
10
QOld
6 2
4
PNew POld
2
24
24
POld
= .4
D
0
10
Calculating eD
P
D
Q DNew QOld
D
QOld
From PANewtoB,
POldeD
POld
6 10
10
6 10
10
6 10
42
=
244 2
24 2
= .4
D
0
10
Calculating eD
P
D
Q DNew QOld
QD
From PA toOldB,
POldeD
New
POld
6 10
66 10
10
10
62 10
=
42
44 2
24 2
= .4
10 6
6
From B to A, eD= 2 4
4
D
0
10
= 1.33
Calculating Elasticity Using the

Midpoint Formula
Q
Q
2
eD
PNew POld
PNew POld
2
Q
Q
D
New
D
New
D
Old
D
Old
Calculating eD
P
D
0
10
Calculating eD
P
6 10
10
6
6 106
Q Q
10
D
QOld
From
A to B,10
eD = 4 22
6
42
PNew POld
24
42
24
POld
2
D
New
D
Old
= .75
D
0
10
Calculating eD
P
D
Q DNew QOld
D to B,
FromQAOld
PNew POld
POld
6 10
10
6
6
4
2
2
4
2
4
eD10=
= .75
From B to A, eD=
D
0
6 10
6 10
2
42
42
2
10
Calculating eD
P
D
Q DNew QOld
D to B,
FromQAOld
PNew POld
POld
= .75
From B to A, eD=
D
0
6 10
10
6
6
4
2
2
4
2
4
eD10=
6 10
6 10
2
42
42
2
10
10 6
10 6
2
24
24
2
= .75

eD > 1
Elastic

eD > 1
eD = 1
Elastic
Unit elastic

eD > 1
eD = 1
eD < 1
Elastic
Unit elastic
Inelastic
Elasticity is Not Constant Along a Linear

Demand Curve
P
P = 100 QD
D
0

Demand Curve
P
P = 100 QD
Slope = -1 Over the

Entire Demand Curve
D
0

Demand Curve
P
P = 100 QD
80
D
0
20

Demand Curve
P
P = 100 QD
80
70
D
0
20 30
Using the Midpoint Formula, Calculate

the price elasticity of demand between
pts. A and B
P
80
70
P = 100 QD
A
B
D
0
20 30

pts. A and B
P
80
70
P = 100 QD
A
B
From A to B, eD =
30 20
30 20
2
70 80
70 80
2
= 3.00
D
0
20 30

pts. A and B
P
80
70
P = 100 QD
A
eD=3
B
From A to B, eD =
30 20
30 20
2
70 80
70 80
2
= 3.00
D
0
20 30

pts. C and D
P
P = 100 QD
A
eD=3
B
40
30
0
C
D
60 70

pts. C and D
P
P = 100 QD
A
eD=3
70 60
70 60
2
From C to D, eD = 30 40
30 40
2
= .538
40
30
0
eD=.538
D
60 70

pts. C and D
P
P = 100 QD
A
eD=3
B
eD=1
C
eD=.538

Demand Curve
P
Unit Elastic
D
0
Inelastic Curve
P
Unit Elastic
Elastic Curve
P
Unit Elastic
Rules of Thumb for Price Elasticity

of Demand
Demand for luxuries is more elastic than
demand for necessities

of Demand
Demand for a good with close substitutes is
more elastic

of Demand
more elastic
The broader the definition of a good, the less
elastic the demand
CEREAL
PRICE ELASTICITY
OF DEMAND
Post Raisin Bran
-2.5
All family breakfast cereals
-1.8
All types of breakfast cereals
-0.9

of Demand
more elastic
The broader the definition of a good, the less
elastic the demand
The longer the period of time, the more elastic
is demand
Other Elasticities
Cross-price elasticity of demand
Income elasticity of demand
Price Elasticity of supply
Cross-price elasticity of demand

Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
d for good 1
%
change
in
Q
Cross-price elast.
=
of demand
% change in price of good 2
For substitutes, cross-price elasticity > 0

(e.g., an increase in price of beef causes an
increase in demand for chicken)
For complements, cross-price elasticity < 0

(e.g., an increase in price of computers causes
decrease in demand for software)
Other Elasticities
Income elasticity of demand: measures the response
of Qd to a change in consumer income
Percent change in Qd
Income elasticity
=
of demand
Percent change in income
Remember: An increase in income causes an

increase in demand for a normal good.
Hence, for normal goods, income elasticity > 0.

For inferior goods, income elasticity < 0.
Calculating Other Elasticities

Price elasticity of supply
% Q
eS =
% P
My Econ Lab Tricks and Tips

Behind the Demand Curve: Consumer Theory
The Two Factors Involved in a Consumers Decision
Indifference Curves
Principles of Indifference Curves
Marginal Rate of Substitution
Definition
Marginal Utility
Unusually Shaped Indifference Curves
The Other Part of the Consumers Decision Process: Budget

Constraints
Definition
Slope
Opportunity Cost
Consumer Optimum: Putting Indifference

Curves and Budget Constraints Together
Practice Problems
MyEconLab Tips and Tricks
Key Point: Do not click Submit

until you are ready to have your quiz
graded. After you click submit, you
cannot change your answer.

Key Point: Do not click Submit until you are
ready to have your quiz graded. After you click
submit, you cannot change your answer.
However, you can save your questions before
you have submitted them simply by exiting
your browserthere is no Save button or
anything.
Once you log back into MyEconLab, you will
be able to continue the quiz where you left off,
go back and change answers, etc.

Key Point: Do not click Submit until you are
ready to have your quiz graded. After you click
submit, you cannot change your answer.
Once you click Submit, however, you will
not be able to change anything, and your test
will be automatically graded.
After the due date, you can click the Review
button, and you will be able to see your answers
as well as the correct answer.
Behind the Demand Curve

P
D
0
The Two Factors in a Consumption

Decision

Decision
Tastes and preferences

Decision
Budget

Decision
Utility
Utility = happiness, satisfaction or well-being
Utility
# of Pizza
Slices
Total
Utility
Utility
# of Pizza
Slices
0
Total
Utility
0 utils
Utility
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
Utility
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
250 utils
Utility
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
250 utils
325 utils
Utility
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
250 utils
3
4
325 utils
375 utils
Utility
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
250 utils
3
4
5
325 utils
375 utils
400 utils
Utility
Marginal Utility (MU) = the additional utility you get
from one additional unit of a good or service
U
Marginal Utility of X = MU X
X
Marginal Utility
U
X
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
Marginal Utility
U
X
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
U=150
Marginal Utility
U
X
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
U=150
X=1
Marginal Utility
U
X
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
U 150
150
1
X
Marginal Utility
U
X
# of Pizza
Slices
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
150 utils
Marginal Utility
U
X
# of Pizza
Slices
0
1
2
3
4
5
Total
Utility
0 utils
150 utils
250 utils
325 utils
375 utils
400 utils
Marginal
Utility
150 utils
U 100
100
X
1
Marginal Utility
U
X
# of Pizza
Slices
Marginal
Utility
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
100 utils
150 utils
Marginal Utility
U
X
# of Pizza
Slices
Marginal
Utility
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
100 utils
75 utils
150 utils
Marginal Utility
U
X
# of Pizza
Slices
Marginal
Utility
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
100 utils
75 utils
50 utils
150 utils
Marginal Utility
U
X
# of Pizza
Slices
Marginal
Utility
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
100 utils
75 utils
50 utils
25 utils
150 utils
Utility
Marginal Utility (MU) = the additional utility you get
from one additional unit of a good or service
U
X
Diminishing Marginal Utility
When I dont have much of good X, MUX is high
When I am already consuming a lot of good X, MUX is low
Marginal Utility
U
X
# of Pizza
Slices
Marginal
Utility
0
1
Total
Utility
0 utils
150 utils
2
3
4
5
250 utils
325 utils
375 utils
400 utils
100 utils
75 utils
50 utils
25 utils
150 utils
Consumption Possibilities
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
Indifference Curves: The

Consumers Preferences
Minutes
Home
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home

Minutes
Home
90
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home

Minutes
Home
10
90
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home

Minutes
Home
45
B
A
45
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home

Minutes
Home
90
C
B
A
10
Minutes to France

Minutes
Home
C
B
A
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
100 Utils
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
100 Utils 100 Utils
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
100 Utils 100 Utils 100 Utils

Minutes
Home
C
B
A
Minutes to France

Minutes
Home
C
B
A
Indifference
curve
0
Minutes to France

Minutes
Home
C
B
A
100 Utils
0
Minutes to France
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
100 Utils 100 Utils 100 Utils
A
90 min. to
France
45 min. to
France
10 min. to
France
120 min. to
France
10 min.
home
45 min.
home
90 min.
home
90 min.
home
100 Utils 100 Utils 100 Utils 200 Utils

Minutes
Home
D
C
200 Utils
B
A
100 Utils
0
Minutes to France

Minutes
Home
I4=400 utils
I3= 300 utils
I2= 200 utils
I1= 100 utils
Minutes to France

Higher indifference curves represent higher
utility

Minutes
Home
I4=400 utils
I3= 300 utils
I2= 200 utils
I1= 100 utils
Minutes to France

utility
Indifference curves never cross
Indifference Curves Cannot Cross

Minutes
Home
A
B
C
I2= 200 utils
I1= 100 utils
Minutes to France

utility
Indifference curves usually slope downward
Upward Sloping Indifference Curve

Minutes
Home
(Good)
100 Utils
45
15
0
30
45
Minutes to France
(Bad)

utility
Indifference curves usually slope downward
Indifference curves are usually convexbowed
inward toward the origin (sometimes called
concave up)
Convexity of Indifference Curves

Minutes
Home
A
C
D
0
Indifference
curve, I1
Minutes to France

Marginal Rate of Substitution (MRS) measures
the amount of good Y you are willing to give
up to get one more unit of X

MRS measures the marginal value of one more
unit of X......that value being measured in units
of Y
Diminishing Marginal Rate of

Substitution
Minutes
Home
90
From A to B, MRS = 10
From C to D, MRS = .5
80
10
9.5
C
20
21
90
100 Utils
D
91 Minutes to France

MRS measures the marginal value of one more
unit of X......that value being measured in units
of Y
Diminishing Marginal Rate of Substitution
means that as you move down along an
indifference curve, MRS decreases

Marginal Rate of Substitution (MRS) measures the
amount of good Y you are willing to give up to get one
more unit of X
MRS measures the marginal value of one more unit of
X......that value being measured in units of Y
MU X
MRS =
MU Y

Marginal Rate of Substitution (MRS) measures the
amount of good Y you are willing to give up to get one
more unit of X
MRS measures the marginal value of one more unit of
X......that value being measured in units of Y
MU X
MRS =
MU Y
Remember the role of diminishing marginal utility
Diminishing Marginal Rate of

Substitution
Minutes
Home
90
At A: MUF is highsay 20 utils; but MUH is lowsay 2 utils

So, MRS = MUF / MUH = 20 utils / 2 utils = 10
and slope of IC at A = MRS = 10
80
B
At C: MUF is lowsay 5 utils; and
MUH is highsay 10 utils
MRS = MUF / MUH = 5 utils / 10 utils =
Slope of IC at C = MRS =
10
9.5
20
21
90
100 Utils
D
91 Minutes to France
Indifference Curves for Perfect

Substitutes
Nickels
6
I1
0
I2
2
I3
3
Dimes
Indifference Curves for Perfect

Complements
Left
Shoes
I2
I1
Right Shoes
Budget Constraint
Minutes
Home
PMin. France = 30
B
PF
PMin. HomePB = 10
H
Budget=B= $30
B
PF
Minutes to France
Budget Constraint: Vertical

Intercept
Minutes
Home
B/PH=300
PMin. France = 30
B
PF
PMin. HomePB = 10
H
Budget=B= $30
B
PF
Minutes to France
Budget Constraint : Horizontal

Intercept
Minutes
Home
B/PH=300
PMin. France = 30
PMin. HomePB = 10
B
PF
Budget=B= $30
B
PF
B/PF= 100
Minutes to France
Budget Constraint: Slope

Minutes
Home
B/PH=300
PMin. France = 30
PMin. HomePB = 10
B
PF
Budget=B= $30
Slope = PF/PH
= 30/10
=3
B
PF
B/PF= 100
Minutes to France
Budget Constraint: General Form

Y
B/PY=300
PX = Price of X
B
PY = Price
of Y
P
B
PF
B = Budget
Slope = PX/PY
B
PF
B/PX= 100
Slope of Budget Constraint

PXX + PYY = B

PXX + PYY = B
PYY = B PXX

PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X

PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY

PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run

Y
B/PY
PX = Price of X
B
PY = Price
of Y
P
B
PF
B = Budget
B
PF
B/PX

PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)

PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)
= PX/PY
Consumer Optimum
Y
Y*
IC
BC
X*
Consumer Optimum
Y
At O: Slope of IC = Slope of BC
Y*
IC
BC
X*
Consumer Optimum
Y
MRS = PX/PY
Y*
IC
BC
X*
Consumer Optimum
Y
MRS = PX/PY
MUX/MUY = PX/PY
Y*
IC
BC
X*
Consumer Optimum
Y
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
Y*
MUX/PX = MUY/PY
IC
BC
X*
Consumer Optimum
Minutes
Home
B/PH=300
PF = 30, PH = 10, B = $30

MRS = PF/PH
MUF/MUH = 30/10
Rearranging:
120
MUF/PF = MUH/PH
MUF/30 = MUH/10
For examplesatisfied if MUF = 60, MUH = 20.
IC
BC
60
B/PF=100
Minutes to France
Conditions for a Consumer

Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint

Optimum
budget constraint
Slope of IC = Slope of BC, which is equivalent
to: MUX/PX = MUY/PY
Why Cant A Be Optimal?

Minutes
Home
A
BC
I1
I2
I3
Minutes to France
Why Cant A Be Optimal?

Minutes
Home
At A, Slope of IC > Slope of BC, which

implies that MUF/MUH > PF/PH, or
MUF/PF > MUH/PH.
For example, MUF = 90, MUH = 10, so

MUF/PF = 90/30 = 3, MUH/PH = 10/10 = 1
BC
I1
I2
I3
Minutes to France
Why Cant B Be Optimal?

Minutes
Home
A
B
0
BC
I1
I2
I3
Minutes to France
Why Cant B Be Optimal?

Minutes
Home
At B, Slope of IC < Slope of BC, which

implies that MUF/MUH < PF/PH, or
MUF/PF < MUH/PH.
For example, MUF = 30, MUH = 30, so

MUF/PF = 30/30 = 1, MUH/PH = 30/10 = 3.
B
0
BC
I1
I2
I3
Minutes to France
Why Cant C Be Optimal?

Minutes
Home
A
O
C
B
0
BC
I1
I2
I3
Minutes to France
Why Cant C Be Optimal?

Minutes
Home
At C, Slope of IC = Slope of BC,

BUT C is not on the BC
O
C
B
0
BC
I1
I2
I3
Minutes to France
Why Cant D be Optimal?

Minutes
Home
A
D
O
C
B
0
BC
I1
I2
I3
Minutes to France
Why Cant D Be Optimal?

Minutes
Home
D is not affordableit is
outside the BC
D
O
C
B
0
BC
I1
I2
I3
Minutes to France
Why Cant A, B, C or D be Optimal?

Minutes
Home
Along the BC, it is only at O

that MUF/PF = MUH/PH
D
O
C
B
0
BC
I1
I2
I3
Minutes to France
Practice Questions
JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and
books cost $20 each. Each good can only be purchased in whole numbers (not
fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:
Movies
No. per Total
Marginal
Month Utility Utility MU/$
1
50
2
80
3
100
4
110
5
116
6
121
7
123
Books
No. per Total
Marginal
1
22
2
42
3
52
4
57
5
60
6
62
7
63
a. Fill in the figures for marginal utility and for marginal utility per dollar
spent for both movies and books.
JoAnnes Books vs. Movies

Question
Movies
Books
No. per Total Marginal

1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05
Practice Questions
table:
Movies
No. per Total
Marginal
1
50
2
80
3
100
4
110
5
116
6
121
7
123
Books
No. per Total
Marginal
1
22
2
42
3
52
4
57
5
60
6
62
7
63
b. Do JoAnnes preferences exhibit diminishing marginal utility for both

goods? Why or why not?

Question
Movies
Books

1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05
Practice Questions
table:
Movies
No. per Total
Marginal
1
50
2
80
3
100
4
110
5
116
6
121
7
123
Books
No. per Total
Marginal
1
22
2
42
3
52
4
57
5
60
6
62
7
63
c. Given her budget of $136, what quantity of books and what quantity of
movies will maximize JoAnnes utility? Explain how you arrived at your
answer.

Question
Movies
Books
No. per Total

Marginal
No. per Total
Marginal
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05

Question
Movies
Books
No. per Total

Marginal
No. per Total
Marginal
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05
Graphical Question on
Optimal Consumption
At her present levels of consumption of goods X and Y,
Dana is spending her entire budget, and her
MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?

Optimum
budget constraint
Optimal Consumption
MRSX,Y = 5. PX = $9 and PY = $2.

Optimum
budget constraint

Optimum
budget constraint
Slope of IC = Slope of BC
Consumer Optimum
Y
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
Y*
MUX/PX = MUY/PY
IC
BC
X*
Optimal Consumption
MRSX,Y = 5. PX = $9 and PY = $2.
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:
MUX/PX = MUY/PY
MRS = PX / PY
MRS = PX / PY
5 = PX / PY
5
9/2
Dana is not at her consumer optimum
Danas Current Consumption

Slope of IC = MRS = 5
Slope of BC = PX/PY = 9/2 = 4.5

So, Dana is at a point like A. She is
spending too much of her budget on
good Y
Dana should reallocate her budget to buy

more of good X and less of good Y
BC
I1
I2
I3
Consumer Theory (cont.)

Consumer Optimum (Review)
Changes in the Budget
Effect on the Budget Constraint
Effect on Consumer Optimum
Normal Good
Inferior Good
Changes in Prices
Effect on the Budget Constraint
Income and Substitution Effects
Deriving the Demand Curve

Why does the Demand Curve Slope Down?
Consumer Optimum
Y
Y*
IC
BC
X*
Consumer Optimum
Y
Y*
IC
BC
X*
Consumer Optimum
Y
MRSX,Y = PX/PY
Y*
IC
BC
X*
Consumer Optimum
Y
MRSX,Y = PX/PY
MUX/MUY = PX/PY
Y*
IC
BC
X*
Consumer Optimum
Y
MRSX,Y = PX/PY
MUX/MUY = PX/PY
Rearranging:
Y*
MUX/PX = MUY/PY
IC
BC
X*

Optimum
budget constraint
Slope of IC = Slope of BC, which is equivalent
to: MUX/PX = MUY/PY

Y
B/PY
PX = Price of X
B
PY = Price
of Y
P
B
PF
B = Budget
Slope = PX/PY
B
PF
B/PX
Budget Constraint: Example

Minutes
Home
B/PH=300
PMin. France = 30
PMin. HomePB = 10
B
PF
Budget=B= $30
Slope = PF/PH
= 30/10
=3
B
PF
B/PF= 100
Minutes to France
A Change in Budget
What if the prices of calls stay the same, but
consumers budget for phone calls doubles?
Effect of a change in budget

on slope of BC
Minutes
Home
PMin. France = 30
PMin. HomePB = 10
B
PF
New Budget=B=
$60
Will the slope of the
Budget Constraint
Change?
B
PF
Minutes to France
Slope doesnt change with a change

in budget
Minutes
Home
PMin. France = 30
PMin. HomePB = 10
B
PF
New Budget=B=
$60
Slope = PF/PH
B
PF
= 30/10
=3
Minutes to France
Slope doesnt change with a change

in budget
Minutes
Home
PMin. France = 30
PMin. HomePB = 10
B
PF
New Budget=B=
$60
Slope = PF/PH
B
PF
= 30/10
What does change

when the budget
changes?
=3
Minutes to France
When budget increases, budget

constraint shifts right: Vertical and
horizontal intercepts increase
Minutes
Home
B/PH=600
PMin. France = 30
PMin. HomePB = 10
B
PF
New Budget=B
B/PH=300
= $60
B
PF
B/PF=100
B/PF= 200
Minutes to France
When budget decreases, budget

constraint shifts left: Vertical and
horizontal intercepts decrease
Minutes
Home
B/PH=300
PMin. France = 30
PMin. HomePB = 10
B
PF
New Budget=B
B/PH=180
= $18
B
PF
B/PF=60
B/PF= 100
Minutes to France
A Change in Budget
What happens to consumers calls to France and
calls home when the budget for phone calls
increases?
Consumer Optimum When Budget Doubles if Calls

to France and Calls Home are Normal Goods
Minutes
Home
B/PH=600
PF = 30, PH = 10, B = $30, B = $60

Calls to France and Calls Home are Normal
Goods
Old Optimum = O = 50 min. to France
150 min. Home
New Optimum = O = 120 min. to France
240
150
240 min. Home
O
O
IC
BC
BC
50
120
IC
IC
B/PF=200
Minutes to France
What Do We Know About the

Phone Calls Now?
Minutes
Home
B/PH=600
240
150
PF = 30, PH = 10, B = $30, B = $60
IC
BC
50 75
IC
BC
B/PF=200
Minutes to France
What Do We Know About the

Phone Calls Now?
Minutes
Home
B/PH=600
PF = 30, PH = 10, B = $30, B = $60

Calls Home are Normal Goods (QD when B)
Calls to France are Inferior Goods
240
150
(QD when B)
IC
BC
50 75
IC
BC
B/PF=200
Minutes to France
What Do We Know About the Two

Goods Now?
Minutes
Home
B/PH=600
240
150
PF = 30, PH = 10, B = $30, B = $60
O
IC
BC
BC
50
120
IC
B/PF=200
Minutes to France
What Do We Know About the Two

Goods Now?
Minutes
Home
B/PH=600
PF = 30, PH = 10, B = $30, B = $60

Calls to France are Normal Goods
Calls Home are Inferior Goods
240
150
O
IC
BC
BC
50
120
IC
B/PF=200
Minutes to France
Effects of a Price Change:

PH to 15
Minutes
Home
B/PH=300
PF = 30, PH = 15, B = $30

What happens to the Budget Constraint?
BC
B/PF=100
Minutes to France

PH to 15
Minutes
Home
B/PH=300
PF = 30, PH = 15, B = $30
BC
What happens to the Budget Constraint?

It pivots around the horizontal interceptthe
vertical intercept moves down
Slope changes from PF/PH = -.3/.1= -3
to PF/PH = -.3/.15 = -2
B/PH=200
BC
B/PF=100
Minutes to France
A Change in Prices
What happens to consumers optimum
consumption bundle when the price of calls
home goes up to 15?

PH to 15
Minutes
Home
B/PH=300
PF = 30, PH = 15, B = $30

Optimum bundle moves from O to O, with
fewer minutes home, and fewer minutes to
France.
BC
B/PH=200
BC
IC
IC
B/PF=100
Minutes to France
What Happens to the BC

if PF to 10?
Minutes
Home
B/PH=300
PF=30, PF = 10, PH =10, B = $30

Budget constraint pivots around the vertical
intercepthorizontal intercept increases
BC
BC
B/PF=100
B/PF=300
Minutes to France
What Happens to the Consumer

Optimum if PF to 10?
Minutes
Home
B/PH
PF = 10, PH = 10, B = $30
IC
BC
IC
BC
B/PF
Minutes to France
Substitution and Income Effects when PF Goes

Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
These are
always
opposite

Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
These are
always
opposite

Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
These are
always
opposite
These are
always the same
if both goods are
normal

Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
These are
always
opposite
These are
always the same
if both goods are
normal

Minutes
Home
B/PH
PF = 10, PH = 10, B = $30
IC
BC
IC
BC
B/PF
Minutes to France

Down
Calls Home
Substitution
Effect
Income
Effect
Combined if IE > SE
Effect if SE > IE
Calls to
France
Comments
These are
always
opposite
These are
always the same
if both goods are
normal

Minutes
Home
B/PH
PF = 10, PH = 10, B = $30
IC
BC
IC
BC
B/PF
Minutes to France

Minutes
Home
300
180
120
PF by 30
IC
IC
BC
BC
20
50
60
100
Minutes to France

Minutes
Home
Calls to France
SE: O O
200
by 5
Calls Home
by 80
O
SE
120
PF by 30
IC
IC
BC
BC
55
60
Minutes to France

Minutes
Home
Calls to France
SE O O
200
180
IE
by 5
Calls Home
by 80
IE O O
O
SE
120
PF by 30
IC
IC
BC
BC
20
55
60
Minutes to France

Minutes
Home
200
180
Calls to France
IE
SE O O
by 5
IE O O
by 35
Calls Home
by 80
SE
120
PF by 30
IC
IC
BC
BC
20
55
60
Minutes to France

Minutes
Home
Calls to France
200
180
IE
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
SE
120
PF by 30
IC
IC
BC
BC
20
55
60
Minutes to France

Minutes
Home
Calls to France
200
180
IE
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
SE
Net
120
PF by 30
IC
IC
BC
BC
20
55
60
Minutes to France

Minutes
Home
200
180
Calls to France
IE
SE
Net
120
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
Net Effect
O O
PF by 30
IC
IC
BC
BC
20
55
60
Minutes to France

Minutes
Home
Calls to France
200
180
IE
SE
Net
120
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
Net Effect
by 40
O O
PF by 30
IC
IC
BC
BC
0 20
55
60
Minutes to France

Minutes
Home
Calls to France
200
180
IE
SE
Net
120
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
Net Effect
by 40
by 60
O O
PF by 30
IC
IC
BC
BC
0 20
55
60
Minutes to France

Minutes
Home
Calls to France
200
180
IE
SE
Net
120
Calls Home
SE O O
by 5
by 80
IE O O
by 35
by 20
Net Effect
by 40
by 60
O O
(SE > IE)
PF by 30
IC
IC
BC
BC
0 20
55
60
Minutes to France

Y
As PX goes down, optimum moves
from O to O to O
PX=P1
IC1
X1
Demand Curve
P
P1
X1

Y
from O to O to O
PX=P1
O
O
PX=P2
X1 X2
IC2
IC1
Demand Curve
P
P1
P2
X1
X2

Y
from O to O to O
PX=P1
O
IC3
PX=P2
IC2
PX=P3
X1 X2 X3
IC1
Demand Curve
P
P1
P2
P3
0
X1
X2
X3
Demand Curve
P
P1
P2
P3
0
D
X1
X2
X3
Demand Curve
P
P1
P2
P3
0
D
X1
X2
X3
Why Does the Demand Curve Slope

Down?

Down?
(1) The good is normal, so the SE
and IE work in the same direction
Substitution and Income Effects when

PF Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

PF Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments

PF Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments

Down?

Down?
What if the good is inferior?
Substitution and Income Effects when PF

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
if IE > SE
if SE > IE
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
if IE > SE
if SE > IE
Comments
When P,
SE always
makes Q
If IE>SE, PF
and QD goes
downthis is a
Giffen Good
Giffen Goods vs. Inferior Goods

All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods

For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE
Demand Curve for a Giffen Good

IE > SE, so as P, QD
P
D
Demand Curve for an Inferior Good

for which SE > IE
P
D
0

Down?
(2) The good is inferior, but the
SE outweighs the IE
Why Does the Demand Curve Slope Down?

(Review)
Choice Under Uncertainty
Probability and Expected Value

Expected Utility
Attitudes Toward Risk
Insurance

Down?

Down?

PF Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

PF Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments

PF Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments

Down?

Down?
What if the good is inferior?

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments

Goes Down
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect
Calls to
France
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
if IE > SE
if SE > IE
Comments
When P,
SE always
makes Q

Goes Down
Calls Home
Calls to
France
Substitution
Effect
Income
Effect
Combined
Effect
if IE > SE
if SE > IE
Comments
When P,
SE always
makes Q
If IE>SE, PF
and QD goes
downthis is a
Giffen Good

All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods

For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE
Demand Curve for a Giffen Good

IE > SE, so as P, QD
P
D
Demand Curve for an Inferior Good

for which SE > IE
P
D
0

Down?
(2) The good is inferior, but the
SE outweighs the IE
Expected Value
Expected Value (EV)
= Probability of Outcome 1 Value of Outcome 1
+ Probability of Outcome 2 Value of Outcome 2
+ .......
+ Probability of Outcome N Value of Outcome N
Expected Value
Example
Lottery with
Outcome 1: Win $10,000
Outcome 2: Win
$0
P(1) = .1
P(2) = .9
EV = Probability of Outcome 1 Value of Outcome 1

= (.1) ($10,000) + (.9) (0)
= $1,000
Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
EV(Option I) = 1 $2,000 = $2,000
Option II: Internet start-up

50% chance of making $1,000
EV(Option I) = 1 $2,000 = $2,000

EV(Option II) =
EV(Option I) = 1 $2,000 = $2,000

EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500
Expected Utility
Expected Utility (EU)
= Probability of Outcome 1 Utility from Outcome 1
+ Probability of Outcome 2 Utility from Outcome 2
+ Probability of Outcome 3 Utility from Outcome 3
+ .......
+ Probability of Outcome N Utility from Outcome N
Expected Value vs. Expected Utility

EV(Option I) = 1 $2,000 = $2,000

EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500

EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500
EU(Option II) = .5 U($1,000) + .5 U($4,000)
EU and the Summer Jobs Example

EU(Option I) = 1 U($2,000) = $2,000

EU(Option II) = .5 U($1,000) + .5 U($4,000)
= $2,500
Take Option II only if:

EU(Option II) > EU (Option I)
Three Attitudes Toward Risk
Risk Aversion
Risk Aversion Diminishing

Marginal Utility of Money
Risk Aversion: Diminishing

Utility
Money

Utility
U(4,000)
U(2,500)
EU
U(1,000)
1,000
EV = 2,500
4,000
Money

Utility
U(4,000)
U(2,500)
EU
U(1,000)
1,000
CE
2,500 = EV
4,000
Money
Three Attitudes to Risk and the Relation of

EV to CE
Risk Aversion: CE < EV
Risk Aversion
Risk Neutrality

Risk Neutrality Constant Marginal
Utility of Money
Risk Neutrality: Constant

Utility
U(4,000)
U(2,500)
U(1,000)
1,000
EV = 2,500
4,000
Money

Utility
U(4,000)
U(2,500)
= EU
U(1,000)
1,000
EV = 2,500
4,000
Money

Utility
U(4,000)
U(2,500)
= EU
U(1,000)
1,000
EV = 2,500
= CE
4,000
Money

EV to CE

Risk Neutrality: CE = EV
Risk Aversion
Risk Neutrality
Risk Loving

Risk Neutrality Constant Marginal
Utility of Money
Risk Loving Increasing Marginal
Utility of Money
Risk Loving: Increasing

Utility
U(4,000)
EU
U(2,500)
U(1,000)
1,000
2,500=EV
4,000
Money
Risk Loving: Increasing

Utility
U(4,000)
EU
U(2,500)
U(1,000)
1,000
2,500=EV
CE 4,000
Money

EV to CE

Risk Neutrality: CE = EV
Risk Loving: CE > EV

EV to CE
Risk Averse: CE < EV
Risk Neutral: CE = EV
Risk Loving: CE > EV
Insurance Example
Income = $30,000
10% chance of becoming ill, and having
$20,000 in medical bills
EV of her income = .9 ($30,000)
+.1 ($10,000)
= $28,000
Insurance Example for a RiskAverse Person

Utility
U(30,000)
EU = U(27,000)
U(10,000)
Max willing to pay for

insurance = H CE
10K
CE=27K 28K = EV
30,000
Money
Behind the Supply Curve: Producer Theory

Production Function
Economies of Scale
Marginal Product vs. Economies of Scale
Economies of Scope
Firms Costs
Total, Average and Marginal Costs
Fixed and Variable Costs
Practice Problem on Calculating Costs

Short-run vs. Long-run Costs
Production Function
The Production Function
The production function shows the relationship
between quantity of inputs used to make a
good and the quantity of output of that good.
q=f(K, L, X)
Example: q = 2K + 3L + 4X
When K = 4, L = 2 and X = 1, q = 18
Production Function
The Production Function
The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output of that good.
q=f (K, L, X)
Example: q = 2K + 3L + 4X
When K = 4, L = 2 and X = 1, q = 18
Cobb-Douglas Form of the

Production Function
q AK L
Returns to Scale
q = f (K, L, X)
What happens when K, L and X double?
Constant Returns to Scale
(CRTS)
If output more than doubles Increasing Returns to Scale
(IRTS)
If output less than doubles Decreasing Returns to Scale
(DRTS)
Example: q = f (K, L, X) = 2K + 3L + 4X
K = 4, L = 2, X = 1 q = 18
Double K, L and X to K = 8, L = 4, X = 2;
Now q = 36 = 2q
Output doubled when inputs doubled CRTS
If output doubles
Returns to Scale and the Cobb-Douglas

Form of the Production Function
q f ( K , L) AK L
q f (2 K , 2 L)
A(2 K ) (2 L)
A2 K 2 L

2 AK L

2 q
Returns to Scale and the Cobb-Douglas

Form of the Production Function

q f (2 K , 2 L) 2
1 f (2 K , 2 L) 2q
CRTS
1 IRTS
1 DRTS
Returns to Scale
vs. Marginal Product
Returns to Scale: What happens to output when
all inputs are changed. . . . .
By the same proportion
Simultaneously
Marginal product: What happens to output when
one input is changed. . . . .
By itself
Holding all other inputs constant
Product Transformation Curve

Product Transformation Curve
The product transformation

curve describes the different
combinations of two outputs
that can be produced with a
fixed amount of production
inputs.
The product transformation
curves O1 and O2 are bowed
out (or concave) because
there are economies of scope
in production.
product transformation curve
Curve showing the

various combinations of two different outputs
(products) that can be produced with a given set of
inputs.
Economies of Scope
economies of scope Situation in
which joint output of a single firm is
greater than output that could be
achieved by two different firms when
each produces a single product.
diseconomies of scope Situation in

which joint output of a single firm is
less than could be achieved by
separate firms when each produces a
single product.
Economies of Scope
To measure the degree to which there are economies of
scope, we should ask what percentage of the cost of
production is saved when two (or more) products are
produced jointly rather than individually.
degree of economies of scope (SC)

Percentage of cost savings resulting when
two or more products are produced jointly
rather than Individually.
Economies of Scope: Example

Banks have introduced other financial products like
mutual funds, brokerage services, etc., because they
can integrate these services with their more traditional
banking operations.
Let service 1 be checking accounts, and
service 2 be brokerage
So, q1 is the number of checking accounts,
and q2 is the number of brokerage accounts

Let service 1 be checking accounts, and
service 2 be brokerage
So, q1 is the number of checking accounts,
and q2 is the number of brokerage accounts
If checking accounts are offered exclusively
and alone by banks, say C(q1) = $5 per
account
If brokerage accounts are offered exclusively and
alone by brokerage firms, say C(q2) = $10 per
account

C(q1) = $5 per account
C(q2) = $10 per account
C(q1,q2)=$8 per account.
So, SC, the degree of economies of scope,
would equal:
C (q1 ) C (q2 ) C (q1 , q2 )
SC
C (q1 , q2 )
$5 $10 $8
$8
7
.875
8
SC > 0
economies of scope are present
SC < 0
diseconomies of scope are present
Short Run vs. Long Run

short run Period of time in which
quantities of one or more production
factors cannot be changed.
long run Amount of time needed
to make all production inputs
variable.
fixed input Production factor that
cannot be varied.
Average and Marginal Products

average product Output per unit
of a particular input.
marginal product Additional output
produced one additional unit of an
input.

average product Output per unit
of a particular input.
q
Example: average product of labor
L
q
average product of capital
K

marginal product Additional output
produced from one additional unit of
an input.
q
Example: marginal product of labor
L
q
marginal product of capital
K
Production with One Variable Input

(Labor)
Amount
of Labor (L)
Average
Product (q/L)
Marginal
Product (q/L)
Amount
of Capital (K)
Total
Output (q)
10
10
10
10
10
10
30
15
20
10
60
20
30
10
80
20
20
10
95
19
15
10
108
18
13
10
112
16
10
112
14
10
108
12
10
10
100
10

The total product curve in (a) shows

the output produced for different
amounts of labor input.
The average and marginal products
in (b) can be obtained (using the
data in the table on the previous
slide) from the total product curve.
At point A in (a), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average product
of labor is 20, which is the slope of
the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope
of the line 0C.

(continued)
To the left of point E in (b), the

marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point
at which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.

(Labor)
law of diminishing marginal returns
Principle that as the

use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.
The Effect of Technological

Improvement
Labor productivity (output

per unit of labor) can
increase if there are
improvements in technology,
even though any given
production process exhibits
diminishing returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.
Total Cost
Total Cost = TC = the total cost of producing q
units of output
Example: TC = 10q
q
TC
0
0
1
10
2
20
3
30
4
40
Graph of Total Cost Curve

q
0
1
2
3
4
TC
0
10
20
30
40
TC
TC=10q
Total Cost
Example: TC = q3 + 2q2 + 3q + 5
TC
TC
Average Cost
Average Cost = AC = TC/q
Example: Average Cost

Example: TC = 10q AC = 10q/q = 10
$/unit
10
AC=10
Example: Average Cost

Example: TC = q3 + 2q2 + 3q + 5
AC = q2 + 2q + 3 + 5/q
$/unit
AC
Marginal Cost
Marginal Cost = MC = TC / q
= cost of producing an
additional unit of ouput
Example: Marginal Cost

Example: TC = 10q MC = 10
$/unit
10
MC=AC=10
Example: Marginal Cost

Example: TC = q3 + 2q2 + 3q + 5
MC = 3q2 + 4q + 3
$/unit
MC
Relationship Between Marginal Cost

and Average Cost
$/unit
MC>AC AC is rising
MC
AC
MC<AC AC is falling
MC=AC AC is flat
Summary of Costs
Total
Total
Average
Marginal
Fixed
Variable
Summary of Costs
Total
Total
TC
Average
Marginal
Fixed
Variable
Summary of Costs
Total
Fixed
TC
TFC=costs
that do not
vary with q
Total
Average
Marginal
Variable
Total Fixed Cost

Example: TC = q3 + 2q2 + 3q + 5
TC
TFC = 5
TC
5
q
Summary of Costs
Total
Fixed
Variable
TC
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
Total
Average
Marginal
Total Variable Cost

Example: TC = q3 + 2q2 + 3q + 5
TVC
TVC = q3 + 2q2 + 3q
TVC
Cost Equations
TC = TFC + TVC
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
TFC=costs
that do not
vary with q
Variable
TVC=costs
that do vary
with q
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
TFC=costs
that do not
vary with q
AFC=TFC/q
Variable
TVC=costs
that do vary
with q
Average Fixed Cost

$/unit
AFC
q
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
Variable
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
AFC=TFC/q
AVC=TVC/q
Cost Equations
AC = AFC + AVC
Relationship Between Average Cost

and Average Variable Cost
$/unit
AC
AVC
AFC
q
Summary of Costs
Total
Total
TC
Average
AC = TC / q
Marginal
MC = TC/q
Fixed
Variable
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
AFC=TFC/q
AVC=TVC/q
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
Variable
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
AFC=TFC/q
AVC=TVC/q
MC = TC/q MFC=TFC/q
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
Variable
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
AFC=TFC/q
AVC=TVC/q
MC = TC/q MFC=TFC/q
=0
Summary of Costs
Total
Total
TC
Average
Marginal
AC = TC / q
Fixed
Variable
TFC=costs
that do not
vary with q
TVC=costs
that do vary
with q
AFC=TFC/q
AVC=TVC/q
MC = TC/q MFC=TFC/q MVC=TVC/q

=0
=MC
Cost Equations
MC = MFC + MVC
= 0 + MVC
= MVC
The Family of Cost Curves

$/unit
MC
AC
AVC
AFC
q
Cost Equations
TC = TFC + TVC
AC = AFC + AVC
MC = MFC + MVC
= 0 + MVC
= MVC
Long-run vs. Short-run Costs

Long-Run Average and
Marginal Cost
When a firm is producing at

an output at which the longrun average cost LAC is
falling, the long-run marginal
cost LMC is less than LAC.
Conversely, when LAC is
increasing, LMC is greater
than LAC.
The two curves intersect at A,
where the LAC curve
achieves its minimum.
Long-run vs. Short-run Costs

long-run average cost curve
(LAC) Curve relating average cost
of production to output when all
inputs, including capital, are
variable.
short-run average cost curve

(SAC) Curve relating average cost
of production to output when level of
capital is fixed.
long-run marginal cost curve

(LMC) Curve showing the change in
long-run total cost as output is
increased incrementally by 1 unit.
Long-run vs. Short-run Cost Curves

Long-Run Cost with
Economies and Diseconomies
of Scale
The long-run average cost

curve LAC is the envelope of
the short-run average cost
curves SAC1, SAC2, and
SAC3.
With economies and
diseconomies of scale, the
minimum points of the shortrun average cost curves do
not lie on the long-run
average cost curve.
Revenue Concepts
Short-run Equilibrium for a Perfectly
Competitive Firm
The Shut-Down Rule
Long-run Equilibrium for a Perfectly

Competitive Firm
Accounting Profit vs. Economic Profit

Entry
Exit
Long-run Supply Curve
Revenue Concepts
Total Revenue (TR) = p q, where p is the price
per unit and q is the number of units sold
Revenue Concepts
Example: A gas station sells 1000 gals. of gas
at $3.00 per gallon.
TR = $3,000
Revenue Concepts
Example: A gas station sells 1000 gals. of gas
at $3.00 per gallon
TR = $3,000
Average Revenue (AR) = TR/q = (p q) / q =
p; so AR is just a fancy name for price
\
Revenue Concepts
Total Revenue (TR) = p q, where p is the price per unit and q
is the number of units sold
Example: A gas station sells 1000 gals. of gas at $3.00 per
gallon.
TR = $3,000
Average Revenue (AR) = TR/q = (p q) / q = p; so AR is just a
fancy name for price
Marginal Revenue (MR) =TR/ q = the additional revenue
received from selling the last unit
Example: The 110th widget is sold for $40; so TR = 40, q=
1, so the MR of the 110th unit = 40.
Perfect Competition:
Three Conditions
Many buyers and sellers
Complete information
Well-specified property rights
Characteristics of
Perfectly Competitive Firm
Homogeneous products
Ease of entry and exit
Price-taking behavior
How Price is Determined for a

P
Market
P*
P*
Firm
P*

P
Market
P*
P*
Firm
P*= D

P
Market
P*
P*
Firm
P*= D = AR

P
Market
P*
P*
Firm
P*= D = AR = MR
Profit
Profit = = TR TC
Profit Maximization Condition

For continuous quantities, produce that q for
which MR = MC
Determining the Profit-Maximizing

Quantity
P
P*
MC
MR (=P*= D = AR)
At q*, MR = MC
q*
Why Cant qA Be the ProfitMaximizing Quantity?

P
MC
P*
MR (=P*= D = AR)
At q*, MR = MC
q* qA
Why Cant qA Be the ProfitMaximizing Quantity?

P
MCA
P*
MC
At qA, MC > MR
A
MR (=P*= D = AR)
At q*, MR = MC
q*
qA
Why Cant qB Be the ProfitMaximizing Quantity?

P
MCA
MC
At qA, MC > MR
P*
A
MR (=P*= D = AR)
At q*, MR = MC
B
qB
q*
qA
Why Cant qB Be the ProfitMaximizing Quantity?

P
MCA
MC
At qA, MC > MR
P*
MR (=P*= D = AR)
At q*, MR = MC
At qB, MR > MC
B
MCB
qB
q*
qA
Profit Maximization Condition

For continuous quantities, produce that q for
which MR = MC (derived from calculus)
For discrete quantities, produce the highest q
for which MR MC
Finding the profit-maximizing

quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
q TC
0
1
2
3
4
5
6
100
150
170
190
240
300
380

quantity
given in the table.
The market-determined
price of digital toilet
paper is $65
q TC
0
1
2
3
4
5
6
100
150
170
190
240
300
380

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80

quantity
given in the table.
paper is $65
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
Profit
Profit = = TR TC
Profit
Profit = = TR TC
= q (TR/q TC/q)
Profit
Profit = = TR TC
= q (TR/q TC/q)
= q (AR AC)
Profit
Profit = = TR TC
= q (TR/q TC/q)
= q (AR AC)
= q (p AC)
Showing the Firms Profits

Graphically
P
MC
AC
P*
P = MR = AR
q*

Graphically
P
MC
AC
P*
P = MR = AR
O
P AC at q*
q*

Graphically
P
MC
AC
P*
P = MR = AR
O
P AC at q*
Profits
q*
What if at q*, AC > P

P
P*
MC
AC
P = MR = AR
q*
What if at q*, AC > P

P
MC
AC
At q*, AC > P, so
P*
q*
P AC < 0
Showing the Firms Losses

Graphically
P
MC
AC
O
P*
Losses
At q*, P AC < 0
so the firm is
making losses
q*
Deriving the Firms Supply Curve

P
MC
P4*
O4
P3*
P2*
P1*
O3
O2
O1
q1* q2* q3* q4*
Deriving the Firms Supply Curve

P
MC
P4*
O4
P3*
P2*
P1*
O3
O2
O1
q1* q2* q3* q4*
What if the Firm is Losing Money?

P
MC
AC
O
P*
Losses
At q*, P AC < 0
so the firm is
making losses
q*
Should the Firm Shut Down?

Profits from continuing to operate at q*

= TR TC

= TR TC
= TR TFC TVC

= TR TC
= TR TFC TVC
Profits from shutting down

= TR TC
= TR TFC TVC
= TR TC

= TR TC
= TR TFC TVC
= TR TC
= 0 TFC TVC

= TR TC
= TR TFC TVC
= TR TC
= 0 TFC TVC
= 0 TFC 0

= TR TC
= TR TFC TVC
= TR TC
= 0 TFC TVC
= 0 TFC 0
= TFC
Shut Down Condition: Shut Down

If.......
Profits if shut down > Profits if produce at q*

If.......
-TFC
> TR - TFC - TVC

If.......
-TFC
> TR - TFC - TVC
0
> TR - TVC

If.......
Profits if shut down
-TFC
0
TVC
> Profits if produce at q*

> TR - TFC - TVC
> TR - TVC
>
TR

If.......
-TFC
0
TVC
TVC/q

> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q

If.......
-TFC
0
TVC
TVC/q
AVC

> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q
>
AR

If.......
-TFC
0
TVC
TVC/q
AVC
AVC

> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q
>
AR
>
P
Should the firm shut down?

given in the table.
Assume the marketdetermined price of
digital toilet paper falls to
$25: Should the firm
shut down?
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80

given in the table.
Assume the marketdetermined price of
digital toilet paper falls to
$25: Should the firm
shut down?
q TC MC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80

q TC MC TFC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
100
100
100
100
100
100
100

q TC MC TFC TVC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
100
100
100
100
100
100
100
0
50
70
90
140
200
280

q TC MC TFC TVC AVC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
100
100
100
100
100
100
100
0
50
70
90
140
200
280
50
35
30
35
40
46.67

q TC MC TFC TVC AVC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
100
100
100
100
100
100
100
0
50
70
90
140
200
280
50
35
30>25
35
40
46.67

Yesat q*, P*<AVC
q TC MC TFC TVC AVC
0
1
2
3
4
5
6
100
150
170
190
240
300
380
50
20
20
50
60
80
100
100
100
100
100
100
100
0
50
70
90
140
200
280
50
35
30>25
35
40
46.67
The Firms Supply Curve

$/unit
MC
AC
AVC
From the Firms Supply Curve to the

Market Supply Curve
Assume there are 1000 identical firms
Price
(a) Individual Firm

Supply
(b) Market Supply

Price
MC
Supply
$2.00
$2.00
1.00
1.00
100
200
Quantity (firm)
100,000
200,000 Quantity (market)
Long-Run Firm Equilibrium

P
Market
S
$/unit
Firm
P*
P*
MC
P*= MR = D
q*
Long-Run Firm Equilibrium: At q*,

economic profits = 0
P
Market
S
$/unit
Firm
MC
AC
P*
P*
P*= MR = D
q*
At q*, P*= MC = AC,
so P* AC = profits = 0
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Accounting Costs
Accounting Costs
Labor
Accounting Costs
Accounting Costs
Labor
Raw materials
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
$ 500
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
$ 500
$1000
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
$ 500
$1000
$ 200
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
Total Accounting Costs
$ 500
$1000
$ 200
$1700
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
$ 500
$1000
$ 200
$1700
Accounting Costs are Explicit Costs
Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
$ 500
$1000
$ 200
$1700
Accounting Costs are Explicit Costs
Accounting profit = TR Accounting

Costs
Accounting Profit
Accounting Costs
Labor
Raw materials
Equipment
$ 500
$ 1000
$ 200
$ 1700
Accounting profit = TR Accounting

Costs
Say TR = $5,000; then-accounting profit = $5,000 $1,700 = $3,300
Economic Costs
Implicit Costs
Foregone salary
Foregone interest
Total implicit costs
costs
$ 4,000
$
15
$ 4,015
Economic Costs
Implicit Costs
Foregone salary
Foregone interest
costs
$ 4,000
$
15
$ 4,015
Total Economic Costs

= Total explicit (accounting) costs + Total implicit
costs
Economic Costs
Implicit Costs
Foregone salary
Foregone interest
costs
$ 4,000
$
15
$ 4,015

costs
= $1,700 + $4,015
Economic Costs
Implicit Costs
Foregone salary
Foregone interest
costs
$ 4,000
$
15
$ 4,015

costs
= $1,700 + $4,015
= $5,715
Economic Profits
Total Economic Costs = $5,715
Economic Profits
Economic Profit = TR Total Economic Costs
Economic Profits
= $5,000 $5,715
Economic Profits
= $5,000 $5,715
= $715
Economic Profits < Accounting Profits


= TR (Explicit Costs + Implicit Costs)

= TR Explicit Costs Implicit Costs

= (TR Explicit Costs) Implicit Costs

= Accounting Profits Implicit Costs

= Accounting Profits Implicit Costs
The Family of Cost Curves Capture

Economic Costs, not just Accounting
Costs
$/unit
MC
AC
AVC
AFC
q
At q*, economic profits are 0 if the

market is in LR equilibrium
P
Market
S
$/unit
Firm
MC
AC
P*
P*
P*= MR = D
q*
At P1, a typical firm is making

economic profits
P
Market
S
Firm
$/unit
P1
P1
MC
AC
P*= MR
Profits
Q1
q1
Firms enter, shifting S curve to the right

and lowering the equilibrium price
P
Market
S
Firm
$/unit
S
P1
P2
P1
P2
MC
AC
P2= MR
Profits
D
Q1 Q2
q2 q1
Eventually, entry lowers the market

price to P***=min AC, lowering economic
profits to 0; then entry ceases
P
Market
S
$/unit
Firm
S
S
P1
P2
P3
P1
P2
P3
P***= MR
D
Q1 Q2 Q3
MC
AC
q3 q2 q1
When a typical firm in a perfectly

competitive market is making economic
profits:
>0

profits:
> 0 Entry occurs

profits:
> 0 Entry occurs Number of firms

profits:
Supply

profits:
Supply Supply curve shifts R

profits:
P*

profits:
P*, Q*

profits:
P*, Q*, to 0
At P*, a typical firm is making

economic losses
P
Market
$/unit
Firm
MC
AC
P*
P*
D
Q*
Losses
q*
Firms exit, shifting S curve to the left

and raising P*
P
Market
$/unit
S
MC
AC
P2
P2
P1
P1
D
Q2 Q1
Firm
Losses
q1 q2
LR equilibrium is restored when P increases

to P3, no more firms exit, and a typical firm is
making 0 economic profit
P
Market
S
S
$/unit
Firm
MC
AC
P3
P2
P1
P3
P2
P1
D
Q3Q2Q1
q1q2q3

losses:
<0

losses:
< 0 Exit occurs

losses:
< 0 Exit occurs Number of firms

losses:
Supply

losses:
Supply Supply curve shifts L

losses:
P*

losses:
P*, Q*

losses:
P*, Q*, to 0
LR Equilibrium
P
Market
S
$/unit
Firm
AC
P*
P*
MC
P*= MR = D
D
q*
Q
P*LR = min AC for a typical firm
All firms make 0 economic profit
Perfectly Elastic Supply Curve

P
SSR
P*
LR
SLR
In the LR, S is perfectly elastic at the
min of AC for a typical firm; there is
only one possible price:
P*LR = min AC
Comparative Static Exercise: Toner

Market Starts in LR Equilibrium
P
Toner Market
S
$/unit
Toner Firm
MC
AC
P*
P*
P*= MR = D
D
Q*
q*
Price of Laser Printers Goes Down

P
Toner Market
S
$/unit
Toner Firm
MC
AC
P*
P*
P*= MR = D
D
Q*
q*
Demand for Toner Goes Up

P*, Typical Firm Makes Profit
P
Toner Market
S
$/unit
P2
P1
P2
P1
Toner Firm
MC
AC
Profits
D
D
Q1 Q2
q1 q2
Entry causes S to shift R, P* to

min AC, and economic profits return to 0
P
Toner Market
S
$/unit
Toner Firm
AC
P2
P1
P2
P1
MC
D
D
Q1 Q2 Q3
q1 q2
Monopoly
Conditions for Monopoly

Sources of Monopoly
Demand and Marginal Revenue for a Monopoly
Profit Maximization for a Monopoly
Monopoly Power and Elasticity
Measures of Monopoly Power
Sources of Monopoly Power
Monopoly
Price Discrimination
First Degree
Second Degree
Third Degree
Monopolistic Competition
Product Differentiation
Attributes of a monopolistically competitive
market
Profit Maximizing Quantity
Long-run Equilibrium
Summary of Market Structure:

Perfect Competition
Perfect
Competition
Number of Firms
Very many
Output of Different Identical

Firms
View of Pricing
Price taker
Barriers to Entry/
Exit
No
Output and Pricing MR = MC = P

q* at min AC
SR Profit
Positive, zero,
or negative
LR Profit
Zero
Advertising
Never
Types of Market Structure

Number of Firms
Many
Firms
One
Firm
Monopoly
Tap water
Cable TV
Identical
Products
Perfect
Competition
Wheat
Milk
(1)One Seller
(1)One Seller
(2)Barriers to Entry
Sources of Monopoly
Sources of Monopoly
Govt grant of a monopoly

Sole ownership of a scarce resource
Natural monopoly
Patents and copyrights
Average Cost for a Natural

Monopoly
$/unit
AC
Q
Demand Curve for a Perfectly

Competitive Firm vs. Demand Curve for
a Monopoly
P
P*
Perfectly
Competitive Firm
$/unit
Monopoly
D=AR=P*
Demand Curve for a Perfectly

Competitive Firm vs. Demand Curve for
a Monopoly
P
P*
Perfectly
Competitive Firm
$/unit
Monopoly
D=AR=P*
Marginal Revenue for a Perfectly

Competitive Firm vs. Marginal Revenue
for a Monopoly
P
P*
Perfectly
Competitive Firm
$/unit
Monopoly
D=MR=AR=P*
Marginal Revenue for a Perfectly

Competitive Firm vs. Marginal Revenue
for a Monopoly
P
P*
Perfectly
Competitive Firm
$/unit
Monopoly
D=MR=AR=P*
MR
q
D
Q
Marginal Revenue for a Monopoly:

An Example
$/unit
Nickelback
CDs per Day
$20
D
10
TR
$20
10
$200

An Example
$/unit
Nickelback
CDs per Day
$20
D
10
11
TR
$20
10
$200

An Example
$/unit
Nickelback
CDs per Day
$20
$19
D
10
11
TR
$20
10
$200

An Example
$/unit
Nickelback
CDs per Day
$20
$19
TR
$20
10
$200
$19
11
$209
D
10
11
MR

An Example
$/unit
Nickelback
CDs per Day
$20
$19
TR
$20
10
$200
$19
11
$209
D
10
11
MR
$9

An Example
$/unit
Nickelback
CDs per Day
$20
$19
TR
$20
10
$200
$19
11
$209
$9
D
10
11
MR
$9
Firm gains $19 from 11th unit.

but gets $1 less on each of
the previous 10 units, so:
MR = $19 $10 = $9

An Example
$/unit
Nickelback
CDs per Day
$20
$19
$9
TR
$20
10
$200
$19
11
$209
$9
$18
12
$216
$7
D
10
11
12
MR

An Example
$/unit
Nickelback
CDs per Day
$20
$19
$9
TR
$20
10
$200
$19
11
$209
$9
$18
12
$216
$7
$7
10
11
12
MR

An Example
$/unit
Nickelback
CDs per Day
$20
$19
$9
TR
$20
10
$200
$19
11
$209
$9
$18
12
$216
$7
$7
10
11
12
MR
MR
Marginal Revenue for a Monopoly

$/unit
Monopoly
MR
D
Q
Marginal Revenue and Average

Revenue
Consider a firm facing the following demand curve:
P=6Q
TOTAL, MARGINAL, AND AVERAGE REVENUE
PRICE (P)
QUANTITY (Q)
TOTAL
REVENUE (R)
MARGINAL
REVENUE (MR)
AVERAGE
REVENUE (AR)
$6
$0
$5
$5

Quantity for a Monopoly
P
MC
MR
At Q*, MR = MC
MR
QMon
What is the monopoly price?

P
MC
MR
At Q*, MR = MC
MR
QMon

P
MC
MR
At Q*, MR = MC
MR
QMon

P
MC
PMon
MR
At Q*, MR = MC
MR
For a monopoly,
MR<P at Q*
QMon
Profit Maximization for a Monopoly

PROFIT IS MAXIMIZED WHEN
MARGINAL REVENUE
EQUALS MARGINAL COST
Q* is the output level at
which MR = MC.
If the firm produces a smaller
outputsay, Q1it sacrifices
some profit because the
extra revenue that could be
earned from producing and
selling the units between Q1
and Q* exceeds the cost of
producing them.
Similarly, expanding output
from Q* to Q2 would reduce
profit because the additional
cost would exceed the
additional revenue.
A Monopoly Has No Supply Curve

SHIFTS IN DEMAND
Shifting the demand curve shows
that a monopolistic market has no
supply curvei.e., there is no
one-to-one relationship between
price and quantity produced.
In (a), the demand curve D1 shifts
to new demand curve D2.
But the new marginal revenue
curve MR2 intersects marginal
cost at the same point as the old
marginal revenue curve MR1.
The profit-maximizing output
therefore remains the same,
although price falls from P1 to P2.
In (b), the new marginal revenue
curve MR2 intersects marginal
cost at a higher output level Q2.
But because demand is now more
elastic, price remains the same.
Monopoly with Profits

P
MC
MR
MR
QMon

P
MC
PMon
MR
MR
QMon

P
MC
AC
PMon
MR
MR
QMon

P
MC
AC
PMon
P AC at QMon
AC
MR
MR
QMon

P
MC
AC
PMon
AC
Profits
P AC at QMon
MR
MR
QMon
Monopoly with Losses

P
MC
AC
PMon
MR
MR
QMon

P
MC
AC
AC
PMon
MR
MR
QMon

P
MC
AC
AC
PMon
P AC < 0
MR
MR
QMon

P
MC
AC
AC
PMon
Losses
P AC < 0
MR
MR
QMon
Profit and Profit Maximization:

A Numerical Example
Cost Function: C (Q ) 50 Q 2
Demand: P(Q ) 40 Q
Part (a) shows total revenue TR, total cost C, and
profit, the difference between the two.
Part (b) shows average and marginal revenue
and average and marginal cost.
Marginal revenue is the slope of the total revenue
curve, and marginal cost is the slope of the total
cost curve.
The profit-maximizing output is Q* = 10, the point
where marginal revenue equals marginal cost.
At this output level, the slope of the profit curve is
zero, and the slopes of the total revenue and
total cost curves are equal.
The profit per unit is $15, the difference between
average revenue and average cost. Because 10
units are produced, total profit is $150.

An Example
$/unit
Nickelback
CDs per Day
$20
$19
TR
$20
10
$200
$19
11
$209
$9
D
10
11
MR
$9
Firm gains $19 from 11th unit.

but gets $1 less on each of
the previous 10 units, so:
MR = $19 $10 = $9
ASTRA-MERCK PRICES PRILOSEC

In 1995, Prilosec, represented a new generation of
antiulcer medication. Prilosec was based on a very
different biochemical mechanism and was much
more effective than earlier drugs.
By 1996, it had become the best-selling drug in
the world and faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only about
30 to 40 cents per daily dose.
The price elasticity of demand, ED, should be in the range of roughly
1.0 to 1.2.
Setting the price at a markup exceeding 400 percent over marginal
cost is consistent with our rule of thumb for pricing.
MARKUP PRICING: SUPERMARKETS TO

DESIGNER JEANS
Although the elasticity of market demand for food is
small (about 1), no single supermarket can raise its
prices very much without losing customers to other
stores.
The elasticity of demand for any one supermarket is
often as large as 10. We find P = MC/(1 0.1) =
MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11 percent
above marginal cost.
Small convenience stores typically charge higher prices because its customers
are generally less price sensitive.
Because the elasticity of demand for a convenience store is about 5, the
markup equation implies that its prices should be about 25 percent above
marginal cost.
With designer jeans, demand elasticities in the range of 2 to 3 are typical.
This means that price should be 50 to 100 percent higher than marginal cost.
price discrimination Practice of charging
different prices to different consumers for
similar goods.
If a firm can charge only one price
for all its customers, that price will
be P* and the quantity produced
will be Q*.
Ideally, the firm would like to
charge a higher price to
consumers willing to pay more
than P*.
The firm would also like to sell to
consumers willing to pay prices
lower than P*, but only if doing so
does not entail lowering the price
to other consumers.
In that way, the firm could earn
additional profits by selling to
consumers represented by region
B of the demand curve.
First degree price discrimination
First-Degree Price Discrimination

reservation price Maximum price
that a customer is willing to pay for a
good.
first-degree price discrimination
Practice of charging each customer
her reservation price.
First-Degree Price Discrimination

Perfect Price Discrimination
The additional profit from
producing and selling an
incremental unit is now the
difference between demand
and marginal cost.
Second degree price discrimination
Second-Degree Price Discrimination

second-degree price discrimination Practice of
charging different prices per unit for different quantities
of the same good or service.
block pricing Practice of charging different prices for
different quantities or blocks of a good.

Different prices are charged

for different quantities, or
blocks, of the same good.
Here, there are three blocks,
with corresponding prices P1,
P2, and P3.
There are also economies of
scale, and average and
marginal costs are declining.
Second-degree price
discrimination can then make
consumers better off by
expanding output and
lowering cost.
Second degree price discrimination
Third degree price discrimination
Third-Degree Price Discrimination

third-degree price discrimination Practice of
dividing consumers into two or more groups with
separate demand curves and charging different
prices to each group.
Third-Degree Price Discrimination:

Creating Consumer Groups
If third-degree price discrimination is feasible, how
should the firm decide what price to charge each
group of consumers?
1. We know that however much is produced, total
output should be divided between the groups of
customers so that marginal revenues for each
group are equal.
2. We know that total output must be such that the
marginal revenue for each group of consumers
is equal to the marginal cost of production.
Third-Degree Price Discrimination:

Creating Consumer Groups
Third-Degree Price Discrimination
Consumers are divided into two

groups, with separate demand
curves for each group. The
optimal prices and quantities
are such that the marginal
revenue from each group is the
same and equal to marginal
cost.
Here group 1, with demand
curve D1, is charged P1,
and group 2, with the more
elastic demand curve D2, is
charged the lower price P2.
Marginal cost depends on the
total quantity produced QT.
Note that Q1 and Q2 are chosen
so that MR1 = MR2 = MC.
Price Discrimination and Coupons

Coupons provide a means of price
discrimination.
Studies show that only about 20 to 30
percent of all consumers regularly
bother to clip, save, and use coupons.
Rebate programs work the same way.
Only those consumers with relatively
price-sensitive demands bother to send
in the materials and request rebates.
Again, the program is a means of price
discrimination.
Price Discrimination and Coupons

Price Elasticities of Demand for Users versus Nonusers of Coupons
PRICE ELASTICITY
Product
Nonusers
Users
Toilet tissue
0.60
0.66
Stuffing/dressing
0.71
0.96
Shampoo
0.84
1.04
Cooking/salad oil
1.22
1.32
Dry mix dinners
0.88
1.09
Cake mix
0.21
0.43
Cat food
0.49
1.13
Frozen entrees
0.60
0.95
Gelatin
0.97
1.25
Spaghetti sauce
1.65
1.81
Creme rinse/conditioner
0.82
1.12
Soups
1.05
1.22
Hot dogs
0.59
0.77
Price Discrimination and Air Fares

Travelers are often amazed at the variety of fares available for round-trip
flights from New York to Los Angeles.
Recently, for example, the first-class fare was above $2000; the regular
(unrestricted) economy fare was about $1700, and special discount fares (often
requiring the purchase of a ticket two weeks in advance and/or a Saturday
night stayover) could be bought for as little as $400.
These fares provide a profitable form of price discrimination. The gains from
discriminating are large because different types of customers, with very
different elasticities of demand, purchase these different types of tickets.
Elasticities of Demand for Air Travel
FARE CATEGORY
Elasticity
First Class
Unrestricted Coach
Discounted
Price
0.3
0.4
0.9
Income
1.2
1.2
1.8
Summary of Market Structures:

Perfect Competition and Monopoly
Number of Firms
Perfect
Competition
Monopoly
Very many
One

Firms
--
View of Pricing
Price taker
Price maker
Barriers to Entry/
Exit
No
Yes

q* at min AC
MR = MC
P > MC
q* below pt. of min AC
SR Profit
Positive, zero,
or negative
Positive, zero,
or negative
LR Profit
Zero
Positive
Advertising
Never
Sometimes: PR Type

Number of Firms
One
Firm
Many
Firms
Type of Products
Differentiated
Products
Identical
Products
Monopoly
(Chapter 15)
Monopolistic
Competition
(Chapter 17)
Perfect
Competition
(Chapter 14)
Tap water
Cable TV
Household Goods
Movies
Wheat
Milk
A monopolistically competitive market has two key
characteristics:
1. Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect substitutes.
Cross-price Elasticity of Demand

Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
d for good 1
%
change
in
Q
Cross-price elast.
=
of demand
% change in price of good 2
For substitutes, cross-price elasticity > 0

(e.g., an increase in price of Diet Pepsi causes an increase in
demand for Diet Coke)
For perfect substitutes, cross-price elasticity

For close (but not perfect) substitutes, cross-price elasticity is
high but not infinite
A monopolistically competitive market has two key
characteristics:
1. Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect
substitutes.
In other words, the cross-price elasticities of demand are
large but not infinite.
2. There is free entry and exit: It is relatively easy for new firms
to enter the market with their own brands and for existing
firms to leave if their products become unprofitable.
Monopolistic Competition as a
Hybrid Market Structure
Many sellers
Like perfect
competition
Free entry and exit
Downward sloping demand Like
monopoly
curve
Product differentiation (Unlike perfect competition)
Demand curve much more elastic than
monopoly
MONOPOLISTIC COMPETITION IN THE MARKETS

FOR COLAS AND COFFEE
The markets for soft drinks and coffee illustrate the
characteristics of monopolistic competition. Each
market has a variety of brands that differ slightly
but are close substitutes for one another.
TABLE 12.1
ELASTICITIES OF DEMAND FOR COLAS AND COFFEE

BRAND
Colas
RC Cola
Coke
Ground coffee
ELASTICITY OF DEMAND
2.4
5.2 to 5.7
Folgers
6.4
Maxwell House
8.2
Chock Full o Nuts
3.6
With the exception of RC Cola and Chock Full o Nuts, all the colas and
coffees are quite price elastic. With elasticities on the order of 4 to 8,
each brand has only limited monopoly power. This is typical of
monopolistic competition.

Quantity for a Monopolistically
Competitive Firm
P
MC
MR
At QMC,MR = MC D
MR
qMC
Determining the Price for a

Monopolistically Competitive Firm
P
MC
PMC
MR
At QMC,MR = MC D
MR
qMC

Making Profits in the Short Run
P
MC
AC
PMC
AC
MR=MC
P AC at QMC
Profits
MR
qMC
As firms enter, a monopolistically

competitive firms demand decreases,
and its demand curve shifts left
P
MC
AC
MR
MR
In the Long Run, a Monopolistically

Competitive Firms Profits are Zero
P
MC
AC
PMC=AC
min AC
MR=MC
MR
qMC
When a typical firm in a monopolistically

profits:
>0

profits:
> 0 Entry occurs

profits:

profits:
Demand for product of incumbent
firms

profits:
firms
Demand curve of incumbent firms
shifts left

profits:
firms
shifts left
qMC goes down to point where P = AC

profits:
firms
shifts left
qMC goes down to point where P = AC
Economic profits are 0
Is this firm making profits or losses?

P
AC
MC
PMC
MR=MC
MR
qMC

Making Losses
P
AC
MC
AC
PMC
Losses
P AC < 0
MR=MC
MR
qMC
As firms exit, a monopolistically

competitive firms demand increases,
and its demand curve shifts right
P
AC
MC
MR
MR
In the Long Run, a Monopolistically

Competitive Firms Profits are Zero
P
MC
AC
PMC=AC
min AC
MR=MC
MR
qMC

losses:
<0

losses:
< 0 Exit occurs

losses:

losses:
Demand for product of remaining
firms

losses:
firms
shifts right

losses:
firms
shifts right
qMC goes up to point where P = AC

losses:
firms
shifts right
qMC goes up to point where P = AC
Economic profits are 0
Monopolistic versus Perfect

Competition
(a) Monopolistically Competitive Firm
(b) Perfectly Competitive Firm

Price
Price
MC
MC
AC
AC
Markup
P
P = MR
(demand
curve)
MC
MR
Quantity
produced
Efficient
scale
Demand
Quantity
At equilibrium:
P > MC
q < q at min AC
Quantity produced =
Efficient scale
Quantity
At equilibrium:
P = MC
q = q at min AC
Summary of Market Structures

Perfect
Competition
Monopolistic
Competition
Monopoly
Very many
Many
One

Firms
Differentiated
--
View of Pricing
Price taker
Price maker
Price maker
Barriers to Entry/
Exit
No
No
Yes
q* at min AC
MR = MC
P > MC
MR = MC
P > MC
SR Profit
Positive, zero,
or negative
Positive, zero,
or negative
Positive, zero,
or negative
LR Profit
Zero
Zero
Positive
Advertising
Never
Always
Sometimes: PR Type
Number of Firms
Oligopoly
Four-four concentration ratios
The Cournot Model
The Stackelberg Model

Number of Firms
One
Firm
Few
Firms
Many
Firms
Type of Products
Differentiated
Products
Monopoly
(Chapter 15)
Oligopoly
(Chapter 16)
Monopolistic
Competition
(Chapter 17)
Tap water
Cable TV
Tennis balls
Crude oil
Household Goods
Movies
Identical
Products
Perfect
Competition
(Chapter 14)
Wheat
Milk
Measuring Market Concentration

Four-firm concentration ratio: the
percentage of the markets total output supplied
by its four largest firms.
The higher the concentration ratio, the less
competition.
Oligopoly is a market structure with high
concentration ratios.
Concentration Ratios in Selected U.S. Industries

Industry
Video game
consoles
Tennis balls
Credit cards
Batteries
Soft drinks
Web search
engines
Breakfast cereal
Cigarettes
Greeting cards
Beer
Cell phone service
Autos
Concentration
ratio
100%
100%
99%
94%
93%
92%
92%
89%
88%
85%
82%
79%
Oligopoly
Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
Strategic behavior in oligopoly:
A firms decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making
decisionsstrategic interdependence
Game theory: the study of how people behave
in strategic situations.
Oligopoly
In monopolistic competition:
Many firms
Free entry and exit
In oligopoly:
Few firms (High concentration ratios)
Barriers to entry
Sources of Barriers to Entry

in Oligopoly
Natural barriers:
(inherent in basic market structure)
Scale economies
Patents or limited access to a technology
Need to spend money to establish name recognition
and market reputation
Strategic actions by incumbent firms:

Examples
Excess capacity
q > q which maximizes profit
(p < p consistent with profit maximization)
Equilibrium in Oligopoly
vs. Other Market Structures
In perfect competition, monopoly, and
monopolistic competition:
Firms find profit-maximizing q where MR = MC
Any other firms in the market can be ignored
In oligopoly:
Strategic interdependence
Optimal decisions about p, q, or anything else
depend on competitors decisions
Sohow do we find equilibrium?
Equilibrium in Oligopoly
Regardless of market structure, equilibrium is
where a firm is doing the best that it can, and has
no incentive to change output or price
In oligopoly, a firm also does the best that it can
in equilibrium . . . . . .
. . . . given what its competitors are doing
Cournot Model
Researches on the Mathematical
Principles of the Theory of Wealth
(1838)
Antoine Augustin Cournot

(1801 - 1877)
First introduced concepts of functions

and probability into economics
First to conceive the idea of supply and
demand as a function of price
First to draw supply and demand curves
First to analyze oligopoly
Cournot Model
Assumptions:
Two firms
Homogeneous good
Firms know the market demand curve
The two firms decide simultaneously how
much to produce
Each firm treats the output of its competitors
as fixed
Cournot Model
Market Demand: P = 75 2Q
Total Cost: TC = 10 + 3Q
Marginal Cost: MC = 3
Cournot Outcome
Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qFqL
MRL = 75 4qL 2qF = MC = 3
75 4qL 2qF = 3 4qL = 72 2qF
* = 18 q
q
F
L
Cournot Model
Total Cost: TC = 10 + 3q
Cournot Outcome
Firm F: TRF = PqF= (75 2Q)qF
= 75qF 2(qL + qF)qF
= 75qF 2qLqF 2qF2
MRF = 75 2qL 4qF = MC = 3
75 2qL 4qF = 3 4qF = 72 2qL
* = 18 q
q
L
F
Cournot Model
Firm Ls Reaction Function: qL* = 18 qF
Firm Fs Reaction Function: qF* = 18 qL
Find qL*: qL*= 18 qF*
= 18 (18 qL*)
= 18 9 + qL*)
qL*= 9
qL*= 12
Find qF*: qF*= 18 (12)
qF*= 12
Cournot Model
qL* = qF* = 12
Q* = qL* + qF* = 24
P* = 75 2Q*
= 75 2(24)
P* = 27
TRL= TRF= P*qL*= P*qF* = (27)(12) = 324
TCL= TCF= 10 + 3qL* = 10 + 3qF* = 10 + 3(12) = 46
ProfitsL= ProfitsF = 324 46 = 278
Cournot Model: Another Example

Duopolists face the following market demand curve: P = 30 Q
MC1 = MC2 = 0
Total revenue for firm 1: R1 = Pq1 = (30 Q)q1
then MR1 = R1/q1 = 30 2q1 q2
Setting MR1 = 0 (the firms marginal cost) and solving for q1, we find:
Firm 1s reaction curve:
q1 15 1 q2
2
By the same calculation, Firm 2s reaction curve:

Cournot equilibrium:
q1 q2 10
Total quantity produced: Q q1 q2 20
q2 15 1 q1
2
Cournot Model
If the two firms collude, then the total profit-maximizing
quantity can be obtained as follows:
Total revenue for the two firms: R = PQ = (30 Q)Q =
30Q Q2, then MR = R/Q = 30 2Q
Setting MR = 0 (the firms marginal cost) we find that
total profit is maximized at Q = 15.
Then, q1 + q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will
produce half of the total output:
q1 = q2 = 7.5
Cournot Model
Duopoly Example
The demand curve is P

= 30 Q, and both
firms have zero
marginal cost. In
Cournot equilibrium,
each firm produces 10.
The collusion curve
shows combinations of
Q1 and Q2 that
maximize total profits.
If the firms collude and
share profits equally,
each will produce 7.5.
Also shown is the
competitive
equilibrium, in which
price equals marginal
cost and profit is zero.
Stackelberg Model
Cournot: The two firms make their output decisions
simultaneously
Stackelberg Model
Cournot: The two firms make their output decisions
simultaneously
Stackelberg: One of the firms can set its output first
Stackelberg Model
Two firms: A leader and a follower
Leader produces quantity qL
Follower produces quantity qF
What would be the outcome if one of the firms
(firm L, the leader) sets its output first?
Stackelberg Model
Firm L sets its output first
Stackelberg Model
Firm F then sets its output based on firm Ls output
Stackelberg Model
Firm L takes firm Fs reaction into consideration when
it sets its output first
Stackelberg Model
Firm L takes firm Fs reaction into consideration when
it sets its output first
Since firm F sets output after firm L, it treats firm Ls
output as fixedjust like in the Cournot model
Stackelberg Outcome
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3
2qL*= 36
qL*= 18
Stackelberg Outcome
qF*= 18 qL*
qL*= 18
qF*= 18 (18)
qF*= 9
Stackelberg Outcome
qL* = 18
qF* = 9
Q* = qL* + qF* = 27
P* = 75 2Q*
= 75 2(27)
P* = 21
TRL= P*qL*= (21)(18) = 378
TCL= 10 + (3)(18) = 64
TRF= P*qF* = (21)(9) = 189

TCF= 10 + (3)(9) = 37
ProfitsL= 378 64 = 314
ProfitsF= 189 37 = 152
Cournot vs. Stackelberg Outcomes

Cournot Outcome
Stackelberg Outcome
qL* = 12
qL* = 18
qF* = 12
qF* = 9
Q* = qL* + qF* = 24
Q* = qL* + qF* = 27
P* = 27
P* = 21
ProfitsL= 278
ProfitsL= 314
ProfitsF= 278
ProfitsF= 152
Steps in Solving for

Stackelberg Equilibrium
1. Find followers reaction function
Find Followers Reaction Function

Total Cost: TC = 10 + 3Q
Firm F: TRF = PqF= (75 2Q)qF
= 75qF 2(qL + qF)qF
= 75qF 2qLqF 2qF2
MRF = 75 2qL 4qF = MC = 3
75 2qL 4qF = 3 4qF = 72 2qL
qF* = 18 qL

2. Find leaders TR function (which will include
a qF term)
Find Firm Ls TR Function

= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF

a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
Substitute for qF
in leaders TR function

= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2

a qF term)
leaders TR function
4. Find leaders MR function
Find Leaders MR Function

= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL

a qF term)
leaders TR function
5. Set leaders MR = MC
Set MRL = MC
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3

a qF term)
leaders TR function
6. Solve for qL*
Solve for qL*

= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3
2qL*= 36
qL*= 18

a qF term)
leaders TR function
6. Solve for qL*
7. Substitute qL* into followers reaction function
Substitute qL*
into Expression for qF*
qF*= 18 qL*
qL*= 18
qF*= 18 (18)

a qF term)
leaders TR function
6. Solve for qL*
8. Solve for qF*
Solve for qF*

Firm F:
qF*= 18 qL*
qL*= 18
qF*= 18 (18)
qF*= 9

a qF term)
leaders TR function
6. Solve for qL*
8. Solve for qF*
9. Find Q* = qL* + qF*
Find Q*
qL* = 18
qF* = 9
Q* = qL* + qF* = 27

a qF term)
leaders TR function
6. Solve for qL*
8. Solve for qF*
10. Substitue Q* in demand function to find P*
Find P*
qL* = 18
qF* = 9
Q* = qL* + qF* = 27
P* = 75 2Q*
= 75 2(27)
P* = 21

a qF term)
leaders TR function
6. Solve for qL*
8. Solve for qF*
10. Substitue Q* in demand function to find P*
Oligopoly and Game Theory

Bertrand Model
Game Theory
Prisoners Dilemma
Dominant Strategies
Repeated Games
Bertrand Model
Competition based on setting prices
not quantities (like Cournot)
Two variants:
Homogeneous goods
Differentiated goods
Bertrand Model
with Homogeneous Products
Market demand curve: P = 30 Q
Q = q 1 + q2
MC1 = MC2 = 3
Good is homogeneous Buyers only care
about price
Outcome: Both firms will charge $3
Total output will be Q = 27 q1 = q2 = 13.5
1 = 2 = 0
Bertrand Model
with Differentiated Products
Firm 1s Demand: Q1 = 12 2P1 + P2
Firm 2s Demand: Q2 = 12 2P2 + P1
TFC = $20
TVC = 0
1 = P1Q1 20 = 12P1 2P12 + P1P2 20

1 / P1 =12 4P1 + P2 = 0
Firm 1s reaction curve: P1 = 3 + P2
Bertrand Model
with Differentiated Products
To find the Nash Equilibrium:
P1 = 3 + P2
= 3 + (3 + P1)
3 3 4 116 P1
1516 P1 15 4
P1 4
Nash Equilibrium in a Bertrand

Model with Differentiated Products
P1
Firm 2s
reaction curve
Firm 1s
reaction curve
$4
Nash
Equilibrium
$4
P2
What if Firm 1 and 2 Could Collude?

1 = 12P1 2P12 + P1P2 20
2 = 12P2 2P22 + P1P2 20
T = 24P 4P2 + 2P2 40
= 24P 2P2 40
T / P = 24 4P = 0
P* = 6
T = 24(6) 2(62) 40
T = 32 1 = 2 = 16
Components of a Game
Players
Example: Coke and Pepsi
Players
Strategies for Each Player

Example: Spend a little (small) or a lot
(large) on advertising
Prisoners Dilemma Situation

Pepsis Spending
On Advertising
Small
Cokes
Spending on
Advertising
Small
Large
Large
Players
Strategies for Each Player

Example: Spend a little (small) or a lot
(large) on advertising
Payoffs

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Large
Small
C = +8
Large

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Large
Small
C = +8
P = +8
Large

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Large
Small
C = +8
P = +8
Large
C = 2

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Large
Small
C = +8
P = +8
Large
C = 2
P = +13

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Nash Equilibrium
Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Equilibrium if Players Could Collude

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Cokes Dominant Strategy

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Pepsis Dominant Strategy

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Outcome of the Game

Pepsis Spending
On Advertising
Cokes
Spending on
Advertising
Small
Small
C = +8
P = +8
Large
C = 2
P = +13
Large
C = +13
P = 2
C = +3
P = +3
Repeated Games
repeated game Game in which actions are taken and payoffs
received over and over again.
PRICING PROBLEM
Firm 2
Firm 1
Low price
High price
Low price
10, 10
100, 50
High price
50, 100
50, 50
Suppose this game is repeated over and over againfor example, you and
your competitor simultaneously announce your prices on the first day of every
month. Should you then play the game differently? 13.8
TIT-FOR-TAT STRATEGY
In the pricing problem above, the repeated game strategy that works best is the
tit-for-tat strategy.
tit-for-tat strategy Repeated-game strategy in which a player responds in
kind to an opponents previous play, cooperating with cooperative opponents
and retaliating against uncooperative ones.
Welfare Economics
Consumer, Producer, and Social Surplus

Pareto Optimality
Welfare Analysis of a Price Ceiling
Welfare Analysis of a Price Floor
Nobody Buys the Surplus
Government Buys the Surplus
Welfare Analysis of a Monopoly

Welfare Analysis of Taxes
What Does
Consumer Surplus Measure?
Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount they
actually pay for it, measures the benefit that
buyers receive from a good as the buyers
themselves perceive it.
Consumer Surplus
Consumer Surplus
= Value to buyers Amount paid by buyers
Price and Consumer Surplus:

Consumer Surplus at Price P1
Price
A
Consumer
surplus
P1
Demand
Q1
Quantity
Price and Consumer Surplus:

Consumer Surplus When Price
Goes Down from P1 to P2
Price
A
Initial
consumer
surplus
P1
P2
C
B
Consumer surplus
to new consumers
F
D
E
Additional consumer
surplus to initial
consumers
Q1
Demand
Q2
Quantity
What Does Producer Surplus

Measure?
Producer surplus, the amount that sellers
receive for a good over and above the minimum
for which they are willing to sell the good. The
minimum for which they are willing to sell the
good is their marginal cost, and is given by
their supply curve.
Producer Surplus
Consumer Surplus
= Value to buyers Amount paid by buyers
Producer Surplus
= Amount received by sellers Cost to sellers
Price and Producer Surplus:

Producer Surplus at Price P1
Price
Supply
P1
B
Producer
surplus
A
0
Q1
Quantity
Price and Producer Surplus:

Producer Surplus When Price
Goes Up from P1 to P2
Price
Supply
Additional producer
surplus to initial
producers
P2
P1
E
F
B
Initial
producer
surplus
Producer surplus
to new producers
A
0
Q1
Q2
Quantity
Social Surplus
Social surplus
= Consumer surplus + Producer surplus
Consumer Surplus, Producer

Surplus and Social Surplus
Price
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
Demand
C
0
Equilibrium
quantity
Quantity
Consumer Surplus, Producer

Surplus and Social Surplus
Price A
Supply
Consumer
surplus
Social
Equilibrium
price
E
Producer
Surplus
surplus
Demand
C
0
Equilibrium
quantity
Quantity
Efficiency
Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.
The Omniscient Planner

P
V(1)
V(2)
V(3)
C(Q*+1)
V(Q*) =C(Q*)
V(Q*+1)
C(3)
C(2)
C(1)
Q* Q*+1
Pareto Efficiency
(or Pareto Optimality)
A situation in which nobody can be made better
off without making somebody else worse off
First Fundamental Welfare Theorem

Any market equilibrium will be Pareto Efficient
Efficiency vs. Equity

In addition to market efficiency, a social
planner might also care about equity the
fairness of the distribution of well-being among
the various buyers and sellers.
Welfare Analysis of Price Ceiling

P
S
P*
PC
Shortage
D
0
QS
Q*
QD

P
S
Before Price
Ceiling
A
P*
CS
B
D
PS
SS
PC
E
D
0
QS
Q*
QD
After Price
Ceiling
Change

P
S
Before Price
Ceiling
A
P*
CS
B
D
A+B
PS
SS
PC
E
D
0
QS
Q*
QD
After Price
Ceiling
Change

P
S
Before Price
Ceiling
A
P*
B
D
CS
A+B
PS
C+D+E
SS
PC
E
D
0
QS
Q*
QD
After Price
Ceiling
Change

P
S
Before Price
Ceiling
A
P*
B
D
PC
CS
A+B
PS
C+D+E
SS
A+B+C
+D+E
E
D
0
QS
Q*
QD
After Price
Ceiling
Change

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
CS
A+B
A+C
PS
C+D+E
SS
A+B+C
+D+E
E
D
0
QS
Q*
QD
Change

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
CS
A+B
A+C
PS
C+D+E
SS
A+B+C
+D+E
E
D
0
QS
Q*
QD
Change

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
CS
A+B
A+C
PS
C+D+E
SS
A+B+C
+D+E
A+C+E
E
D
0
QS
Q*
QD
Change

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
Change
CS
A+B
A+C
+CB
PS
C+D+E
SS
A+B+C
+D+E
A+C+E
E
D
0
QS
Q*
QD

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
Change
CS
A+B
A+C
+CB
PS
C+D+E
CD
SS
A+B+C
+D+E
A+C+E
E
D
0
QS
Q*
QD

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
Change
CS
A+B
A+C
+CB
PS
C+D+E
CD
SS
A+B+C
+D+E
A+C+E
BD
E
D
0
QS
Q*
QD

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
Change
CS
A+B
A+C
+CB
PS
C+D+E
CD
SS
A+B+C
+D+E
A+C+E
BD
E
D
0
QS
Q*
QD
SS = B D

P
S
A
P*
B
D
PC
Before Price
Ceiling
After Price
Ceiling
Change
CS
A+B
A+C
+CB
PS
C+D+E
CD
SS
A+B+C
+D+E
A+C+E
BD
E
D
0
QS
Q*
QD
SS = B D
DWL = SS = (BD)
Q =B+D
Price Ceilings: Sources of Even

Higher DWL
Who ends up with the available
output?
Price Ceilings: Sources of Even Higher

DWL
Rent Control Example
P
QD = 200
QS = 120
$1000
$950
Shortage = 80
$800=
$700
$600 PC
=
P*
Shortage
D
0
100
QS
QD

Higher DWL
output?
Lines

Higher DWL
output?
Lines
Corruption/Black Markets
Welfare Analysis of a Price Floor

P
S
Surplus
PF
P*
D
0
QD
Q*
QS
Welfare Analysis of a Price Floor:

Govt. Does Not Buy Surplus
P
S
PF
Surplus
A
B
P*
G
H
F
F
D
QD
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
CS
PS
P*
After Price
Floor
SS
H
F
F
D
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
After Price
Floor
SS
H
F
F
D
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
After Price
Floor
G+H
SS
G
H
F
F
D
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
+G+H
H
F
F
D
QD
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
+G+H
H
F
F
D
QD
SS A+B+C
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
B+H
+G+H
H
F
F
D
QD
SS A+B+C
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
G
F
B+H
A+B+H
F
D
QD
+G+H
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
G
F
BC
B+H
A+B+H
F
D
QD
Change
+G+H
After Price
Floor
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
G
F
BC
B+H
+BG
A+B+H
F
D
QD
Change
+G+H
After Price
Floor
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
G
F
BC
B+H
+BG
A+B+H
CG
F
D
QD
Change
+G+H
After Price
Floor
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
SS A+B+C
G
F
BC
B+H
+BG
A+B+H
CG
F
D
QD
Change
+G+H
After Price
Floor
Q*
QS

P
S
PF
Surplus
A
B
P*
G
H
F
F
D
QD
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
CS
PS
P*
Gov
H
F
SS
D
0
QD
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
H
F
SS
D
0
QD
After Price
Floor
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
G+H
Gov
G
H
SS
F
D
After Price
Floor
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
G
H
G+H
---
SS
F
D
After Price
Floor
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
G
H
G+H
---
SS A+B+C
+G+H
D
0
After Price
Floor
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
G
H
G+H
---
SS A+B+C
+G+H
D
0
After Price
Floor
QD
Q*
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
H
F
G+H
QD
B+C+D+G
+H
SS A+B+C
F
Q*
---
+G+H
After Price
Floor
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
H
F
QD
B+C+D+G
+H
---
C D E
F G
SS A+B+C
F
Q*
G+H
+G+H
After Price
Floor
QS
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
H
F
B+C+D+G
+H
---
C D E
F G
+G+H
QD
Q*
QS
G+H
SS A+B+C
After Price
Floor
A+B+H
E F
Change

P
S
PF
Surplus
A
B
Before
Price
Floor
CS A+B+C
PS
P*
Gov
H
F
QD
Q*
B C
---
C D E
F G
+G+H
QS
A
B+C+D+G
+H
Change
G+H
SS A+B+C
After Price
Floor
A+B+H
E F

P
S
PF
Surplus
A
B
Before
Price
Floor
PS
Gov
H
F
Change
B C
G+H
B+C+D+G
+H
+B+C+D
---
C D E
F G
CS A+B+C
P*
After Price
Floor
SS A+B+C
+G+H
QD
Q*
QS
A+B+H
E F

P
S
PF
Surplus
A
B
Before
Price
Floor
PS
Gov
H
F
Change
B C
G+H
B+C+D+G
+H
+B+C+D
---
C D E
F G
C D E
F G
CS A+B+C
P*
After Price
Floor
SS A+B+C
+G+H
QD
Q*
QS
A+B+H
E F

P
S
PF
Surplus
A
B
Before
Price
Floor
PS
Gov
H
F
Change
B C
G+H
B+C+D+G
+H
+B+C+D
---
C D E
F G
C D E
F G
A+B+H
E F
C E
F G
CS A+B+C
P*
After Price
Floor
SS A+B+C
+G+H
QD
Q*
QS

P
S
PF
Surplus
A
B
Before
Price
Floor
PS
Gov
H
F
After Price
Floor
Change
B C
G+H
B+C+D+G
+H
+B+C+D
---
C D E
F G
C D E
F G
A+B+H
E F
C E
F G
CS A+B+C
P*
DWL = C+E+F+G
SS A+B+C
+G+H
QD
Q*
QS
Monopoly vs. Perfect Competition

P
MC
PMon
PPC
MR
MR
QMon QPC

P
MC
A
PMon
PPC
B
D
C
E
MR
MR
QMon QPC

P
MC
Perfect
Competition
PMon
PPC
CS
PS
C
E
MR
MR
QMon QPC
Monopoly
SS
Change

P
MC
Perfect
Competition
PMon
PPC
CS
PS
C
E
MR
MR
QMon QPC
Monopoly
A+B+C
SS
Change

P
MC
Perfect
Competition
PMon
PPC
CS
A+B+C
PS
D+E
C
E
MR
MR
QMon QPC
Monopoly
SS
Change

P
MC
Perfect
Competition
PMon
PPC
CS
A+B+C
PS
D+E
SS
A+B+C
+D+E
C
E
MR
MR
QMon QPC
Monopoly
Change

P
MC
PMon
PPC
Perfect
Competition
Monopoly
CS
A+B+C
PS
D+E
SS
A+B+C
+D+E
C
E
MR
MR
QMon QPC
Change

P
MC
PMon
PPC
Perfect
Competition
Monopoly
CS
A+B+C
PS
D+E
B+D
SS
A+B+C
+D+E
C
E
MR
MR
QMon QPC
Change

P
MC
PMon
PPC
Perfect
Competition
Monopoly
CS
A+B+C
PS
D+E
B+D
SS
A+B+C
+D+E
A+B+D
C
E
MR
MR
QMon QPC
Change

P
MC
PMon
PPC
Perfect
Competition
Monopoly
Change
B C
CS
A+B+C
PS
D+E
B+D
SS
A+B+C
+D+E
A+B+D
C
E
MR
MR
QMon QPC

P
MC
PMon
PPC
Perfect
Competition
Monopoly
Change
CS
A+B+C
B C
PS
D+E
B+D
+B E
SS
A+B+C
+D+E
A+B+D
C
E
MR
MR
QMon QPC

P
MC
PMon
PPC
Perfect
Competition
Monopoly
Change
CS
A+B+C
B C
PS
D+E
B+D
+B E
SS
A+B+C
+D+E
A+B+D
C E
C
E
MR
MR
QMon QPC

P
PMon
PPC
DWL = C + E
MC
Perfect
Competition
Monopoly
Change
CS
A+B+C
B C
PS
D+E
B+D
+B E
SS
A+B+C
+D+E
A+B+D
C E
C
E
MR
MR
QMon QPC

P
PMon
PPC
DWL = C + E
MC
Perfect
Competition
Monopoly
Change
CS
A+B+C
B C
PS
D+E
B+D
+B E
SS
A+B+C
+D+E
A+B+D
C E
C
E
MR
MR
QMon QPC
Quantity Supplied with a

$1 Per Gallon Tax
QS
Price
10,000
$1.00
12,500
$1.50
15,000
$2.00
17,500
$2.50
20,000
$3.00
22,500
$3.50
25,000
$4.00
Price with Tax

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
15,000
$2.00
17,500
$2.50
20,000
$3.00
22,500
$3.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
17,500
$2.50
20,000
$3.00
22,500
$3.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
$3.00
17,500
$2.50
20,000
$3.00
22,500
$3.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
$3.00
17,500
$2.50
$3.50
20,000
$3.00
22,500
$3.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
$3.00
17,500
$2.50
$3.50
20,000
$3.00
$4.00
22,500
$3.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
$3.00
17,500
$2.50
$3.50
20,000
$3.00
$4.00
22,500
$3.50
$4.50
25,000
$4.00

$1 Per Gallon Tax
QS
Price
Price with Tax
10,000
$1.00
$2.00
12,500
$1.50
$2.50
15,000
$2.00
$3.00
17,500
$2.50
$3.50
20,000
$3.00
$4.00
22,500
$3.50
$4.50
25,000
$4.00
$5.00
Tax on Producers
P
S + Tax
$4.00
S
Tax
$3.00
20,000
Tax on Producers
P
S + Tax
$3.00
S
$1=Tax
PC
$1=Tax
$2.00
PP
D
QTax 15,000
Quantity Demanded with a

$1 Per Gallon Tax
QD
Price
20,000
$1.00
17,500
$1.50
15,000
$2.00
12,500
$2.50
10,000
$3.00
7,500
$3.50
5,000
$4.00
Max willing to
pay with $1 tax

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
15,000
$2.00
12,500
$2.50
10,000
$3.00
7,500
$3.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
12,500
$2.50
10,000
$3.00
7,500
$3.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
$1.00
12,500
$2.50
10,000
$3.00
7,500
$3.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
$1.00
12,500
$2.50
$1.50
10,000
$3.00
7,500
$3.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
$1.00
12,500
$2.50
$1.50
10,000
$3.00
$2.00
7,500
$3.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
$1.00
12,500
$2.50
$1.50
10,000
$3.00
$2.00
7,500
$3.50
$2.50
5,000
$4.00

$1 Per Gallon Tax
QD
Price
Max willing to
pay with $1 tax
20,000
$1.00
$0
17,500
$1.50
$.50
15,000
$2.00
$1.00
12,500
$2.50
$1.50
10,000
$3.00
$2.00
7,500
$3.50
$2.50
5,000
$4.00
$3.00
Tax on Consumers
P
$3.00
$1=Tax
$2.00
D
D with Tax
10,000
Tax on Consumers
P
S
PC
Tax
$2.00
E
Tax
PP
D
$1.00
D with Tax
0
QTax
15,000
Tax Incidence
P
S with Tax
S
PC
Tax
P*
PP
D
D with Tax
0
QTax
Q*
The Burden of a Tax

P
S with Tax
S
PC
Tax
P*
Burden on consumers = PC P*
Tax
Burden on producers = P* PP
Wedge
Tax
PP
D
D with Tax
0
QTax
Q*
Consumers Bear More of the Burden of

the Tax
P
S
Tax
Burden on consumers
P*
Burden on producers
Tax Wedge
PC
is greater than
PP
D
QTax Q*
Consumers Bear All of the Burden of

the Tax
P
S + Tax
S
PC
Tax
= Tax
Burden on consumers
Burden on producers = P* PP = 0
PP= P*
D
0
QTax= Q*
Consumers bear the entire burden
Consumers Bear All of the Burden of

the Tax
P
S + Tax
Tax
PC
PP=
Burden on consumers
= Tax
P*
Burden on producers = P* PP = 0
Consumers bear the entire burden
D
0
QTax
Q*
Producers Bear More of the Burden of

the Tax
P
Burden on consumers
Tax
P*
Burden on producers
Tax Wedge
PC
PP
is less than
QTax Q*
Producers Bear All of the Burden of the

Tax
P
S
Burden on consumers = PC P* = 0
PC= P*
Tax
Burden on producers = P* PP = Tax

Burden on producers
Producers bear the entire burden
PP
D with Tax
0
QTax= Q*
Producers Bear All of the Burden of the

Tax
S+Tax
S
PC= P*
Burden on consumers = PC P* = 0
Tax
Burden on producers = P* PP = Tax

Burden on producers
Producers bear the entire burden
PP
QTax
Q*

P
S with Tax
S
PC
Tax
P*
PP
D
D with Tax
0
QTax
Q*

P
A
PC
Before
Tax
P*
CS
After Tax
PS
Gov
SS
PP
F
0
D
QTax
Q*
Change

P
A
PC
Before
Tax
P*
CS A+B+C
After Tax
PS
Gov
SS
PP
F
0
D
QTax
Q*
Change

P
A
PC
Before
Tax
P*
CS A+B+C
After Tax
PS D+E+F
Gov
SS
PP
F
0
D
QTax
Q*
Change

P
A
PC
Before
Tax
P*
CS A+B+C
After Tax
PS D+E+F
Gov
---
SS
PP
F
0
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
CS A+B+C
After Tax
PS D+E+F
Gov
---
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
CS A+B+C
PS D+E+F
Gov
After Tax
---
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
CS A+B+C
PS D+E+F
Gov
After Tax
---
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
CS A+B+C
PS D+E+F
Gov
After Tax
---
B+D
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
CS A+B+C
PS D+E+F
Gov
---
B+D
SS A+B+C
A+B+D+F
+D+E+F
PP
F
0
After Tax
D
QTax
Q*
Change

P
S
A
PC
Before
Tax
P*
After Tax
Change
CS A+B+C
B C
PS D+E+F
Gov
---
B+D
SS A+B+C
+D+E+F
PP
F
0
A+B+D+F
D
QTax
Q*

P
S
A
PC
Before
Tax
P*
After Tax
Change
CS A+B+C
B C
PS D+E+F
D E
Gov
---
B+D
SS A+B+C
+D+E+F
PP
F
0
A+B+D+F
D
QTax
Q*

P
S
A
PC
Before
Tax
P*
After Tax
Change
CS A+B+C
B C
PS D+E+F
D E
B+D
+B+D
Gov
---
SS A+B+C
+D+E+F
PP
F
0
A+B+D+F
D
QTax
Q*

P
S
A
PC
Before
Tax
P*
After Tax
Change
CS A+B+C
B C
PS D+E+F
D E
B+D
+B+D
A+B+D+F
C E
Gov
---
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*

P
DWL = C + E
A
PC
Before
Tax
P*
After Tax
Change
CS A+B+C
B C
PS D+E+F
D E
B+D
+B+D
A+B+D+F
C E
Gov
---
SS A+B+C
+D+E+F
PP
F
0
D
QTax
Q*
Three Conditions for Perfect Competition

Asymmetric Information
Adverse Selection
Market Unraveling
Remedies
Screening
Signaling
Moral Hazard
Principal-Agent Problem
Auto Depreciation

1. Many buyers and sellers

2. Complete informationwell informed buyers
and sellers

and sellers
3. Well-specified property rights

Violations: Monopoly and Imperfect
Competition
and sellers

Competition
and sellers
Violations: Externalities; Public goods

Competition
and sellers
Violations: Asymmetric information
Violations: Externalities; Public goods
Problems Arising from Asymmetric

Information
Adverse selection

Information
Adverse selection
Occurs prior to a market transaction

Information
Adverse selection
Moral hazard

Information
Adverse selection
Moral hazard
Occurs after a market transaction

Information
Adverse selection
Moral hazard
Principal-agent problem
A variant of moral hazard

Information
Adverse selection
Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of the
(better informed) possible trading partners

Information
Adverse selection
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)
Auto Depreciation
The lemon dilemma

The Economist, Oct. 11, 2001
Numerical Example of Adverse

Selection
Max price
offered by
buyers
Peaches
Lemons
Min price
wanted by
sellers

Selection
Max price
offered by
buyers
Peaches $20,000
Lemons
Min price
wanted by
sellers

Selection
Max price
offered by
buyers
Peaches $20,000
Lemons
Min price
wanted by
sellers
$17,000

Selection
Max price
offered by
buyers
Peaches $20,000
Lemons $10,000
Min price
wanted by
sellers
$17,000

Selection
Max price
offered by
buyers
Min price
wanted by
sellers
Peaches $20,000
$17,000
Lemons $10,000
$ 8,000

Selection
Max price
offered by
buyers
Min price
wanted by
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000

Selection
Max price
offered by
buyers
Min price
wanted by
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%

Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
Max buyer is willing to offer for any given car?

Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
Max buyer is willing to offer for any given car
= 1/2 ($20,000) + 1/2 ($10,000) = $15,000

Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
The maximum a buyer is willing to offer for
any given car ($15,000) is less than the
minimum ($17,000) that the seller of a peach
wants for his car

Selection
Max price Min price
offered by wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
The maximum a buyer is willing to offer for any given
car ($15,000) is less than the minimum ($17,000) that
the seller of a peach wants for his car
Result: Peaches will disappear from the market, and
only lemons will be sold

Information
Adverse selection
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)
Market for insurance
Market for credit
Remedies for Adverse Selection

Market screeningprocess by which an
uninformed party attempts to gather
information about the product or service offered
by the informed party

Market screeningprocess by which an
uninformed party attempts to gather
information about the product or service offered
by the informed party
Examples

Market signaling

Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell

Signal must be effective in distinguishing
between different levels of quality

Signal will be more costly for a low-quality
producer than for a high-quality producer

Examples

Examples
Branding

Examples
Branding
Guarantees and Warranties

Market signalingprocess by which an informed
party sends signals to uninformed parties conveying
information about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing between
different levels of quality
Signal will be more costly for a low-quality producer
than for a high-quality producer
Examples
Branding
Guarantees and warranties
Education

Examples
Branding
Education
Signals on the job

Examples
Branding
Education
Signals on the job
Reputation

Market signalingprocess by which an informed party sends
signals to uninformed parties conveying information about the
quality of the product or service theyre trying to sell
Signal must be effective in distinguishing between different
levels of quality
Signal will be more costly for a low-quality producer than for a
high-quality producer
Examples
Branding
Education
Signals on the job
Reputation
Gifts

Information
Moral hazard

Information
Moral hazard
Definition: the tendency of a transaction to change
peoples incentives and therefore their behavior

Information
Moral hazard
Examples
On the job

Information
Moral hazard
Examples
Insurance market
On the job
Two conditions necessary for a principal-agent
problem
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent
problem
(2) Divergent interestsprincipal and agent must
have different interests or goals
problem
(2) Divergent interestsprincipal and agent must
have different interests or goals
Examples and Remedies

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Econ 1010 All Class Slides

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Introduction and Course Overview

The Methods of Economics

Determinants of Demand for an Individual

EquilibriumPutting Supply and Demand

Calculating Equilibrium with Equations

Determinants of Individual Demand

Price of Related Goods

Tastes and Preferences

Determinants of Market Demand

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

Demand and Inverse Demand

Demand and Inverse Demand

Demand and Inverse Demand

Demand and Inverse Demand

Demand and Inverse Demand

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant

Increase in Quantity Demanded

Income (Normal goods)

Decrease in Quantity Demanded

Income (Normal goods)

Determinants of a Firms Supply

Determinants of Market Supply

The Market Supply Curve

The Market Supply Curve

Input prices, technology, expectations and number

The Market Supply Curve

The Market Supply Curve

The Market Supply Curve

Input prices, technology, expectations and number

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held

Increase in quantity supplied

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held

Increase in quantity supplied

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held

Increase in quantity supplied

The Market Supply Curve

The Market Supply Curve

The Market Supply Curve

The Market Supply Curve

The Market Supply Curve

The Market Supply Curve

Initial equilibrium is E1 = (Q1,P1)