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What Economics Is
Economics is the study of how humans coordinate their wants and desires, given
the decision-making mechanisms, social customs, and political realities of the society
o
How to produce it
Coordination
Economies deal with scarcity with coercion limiting wants and increasing the
amount of work people do to fulfill them
o
This leads to the alternative definition of economics: the study of how to get
people to do things theyre not wild about doing and not to do things they are
wild about doing, so that the things some people want to do are consistent
with the things other people want to do
Cost/Benefit Analysis
o
The relevant costs and benefits to economic reasoning are the expected incremental
costs and the expected incremental benefits that result from a decision.
o
Marginal cost is the additional costs to you over and above the cost you have
already incurred
o
This means not counting sunk costs costs that have already been incurred
and cannot be recovered
Marginal benefit is the additional benefit above what youve already derived
These two concepts yield the economic decision rule: If the marginal benefits of
doing something exceed the marginal costs, do it. If the marginal costs of doing
something exceed the marginal benefits, dont do it.
Opportunity Cost
Opportunity cost is the benefit that you might have gained from choosing the nextbest alternative.
To obtain the benefit of something, you must forgo something else. The value
of this alternative is the opportunity cost.
All scarce goods must be rationed in some fashion. These rationing mechanisms are
economic forces, the necessary reactions to scarcity.
A market force is an economic force that is given relatively free rein by society to
work through the market. These forces ration by affecting prices.
o
When theres a shortage, price rises; when theres a surplus, price falls.
The invisible hand is the price mechanism, the rise and fall of prices that
guide our actions in a market.
What happens in a society can be seen as the reaction to, and interaction of, these
three forces: economic, political/legal, and social/historical forces.
Economic Insights
Theories, models, and principles must be combined with a knowledge of realworld economic institutions to arrive at specific policy recommendations
Much of economic theory deals with the pricing mechanism and how the market
operates to coordinate individuals decisions.
o
When the quantity supplied is greater than the quantity demanded, the price
has a tendency to fall.
When the quantity demanded is greater than the quantity supplied, price has
a tendency to rise.
Good economic policy analysis is objective it keeps the analysts value judgments
separate from the analysis.
o
This is the way the economy works, and if society wants to achieve a
particular goal, this is how it might go about doing so.
Positive economics is the study of what is, and how the economy works.
o
E.g. How does the market for hog bellies work? How do price restrictions
affect market forces?
Normative economics is the study of what the goals of the economy should be.
o
E.g. What should the distribution of income be? What should tax policy be
designed to achieve?
The art of economics (a.k.a. political economy) is the application of the knowledge
learned in positive economics to the achievement of the goals one has determined in
normative economics.
o
E.g. To achieve a certain distribution of income, how would you go about it,
given the way the economy works?
Economics focuses analysis on the invisible hand and how the economy would act if
only the invisible hand were present.
there is a limit to what you can achieve, given the existing institutions,
resources, and technology.
Every choice you make has an opportunity cost. You can get more of
something only by giving up something else.
The principle of increasing marginal opportunity cost says that in order to get
more of something, one must give up ever-increasing quantities of something else
o
Comparative Advantage
Efficiency
Inefficiency is getting less output from inputs that, if devoted to some other activity,
would produce more output.
Assume that the distributional effects that accompany policy are acceptable, and that
we, as a society, prefer more input
Individuals must produce those goods for which they have a comparative
advantage
How to direct individuals toward those activities in which they have a comparative
advantage?
o
When people freely enter into a trade, both parties can be expected to benefit from
the trade; otherwise, they wouldnt have entered the transaction.
o
Trade allows countries to consume past the limitations of their individual PPCs
The slope of the combined PPC is determined by the country with the lowest
opportunity cost
Outsourcing
o
Globalization
A globalized world is one where the economics of the world are highly
integrated
2 effects
The rewards for winning globally are much larger than the
rewards for winning domestically
Positive
Negative
Increased productivity
The law of one price states that the wages of workers in one country will not
differ significantly from the wages of equal workers in another institutionally
similar country
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The government must allocate and defend private property rights in order for a
market to exist
o
Private property rights are the control a private individual or firm has over
an asset
How much you get is determined by how much you give; fairness
Markets are not universally accepted as the most reasonable way to organize society
o
Arguments against markets say they bring out the worst in people
People contribute what they can and get what they need
Most economies today are distinguished by the degree to which their economies rely
on markets, not whether they are a market, capitalist, or socialist economy
The American economy can be divided into three sectors: businesses, households,
and government.
o
Businesses produce goods and services and sell them to households and
government. This is called the goods market.
Business
Businesses in the U.S. decide what to produce, how much to produce, and
for whom to produce it
Some businesses are easy to start, some require licenses, permits, etc.
o
Distribution, or getting goods where you want them when you want them, is
as important as production and is a central component of a service economy
Profit is whats left over from total revenues after all the appropriate costs
have been subtracted
Forms of Business
o
The three main forms of business are sole proprietorships, partnerships, and
corporations
These create possibilities for sharing the burden, but they also create
unlimited liability for each of the partners
Corporations are businesses that are treated as a person, and are legally
owned by their stockholders, who are not liable for the actions of the
corporate person
Households
Households are groups of individuals living together and making joint decisions,
they are the most powerful economic institution
o
Suppliers of Labor
o
The fastest-growing jobs are in the service industries and the fastestdeclining are in manufacturing and agriculture
Government
A referee setting the rules that determine relations between business and
households
An actor collecting money in taxes and spending that money on projects such
as defense and education
Government as an Actor
o
They also redistribute income through taxes and social welfare and
assistance programs
Employ over 19 million people and spend over $2.5 trillion a year
Receive most of their income from taxes and spend their revenues on
public welfare, administration, education, and roads
Federal Government
Government as a Referee
o
A free rider is a person who gets a benefit but does not contribute to
paying for the cost of that benefit
Market Failures are situations in which the market does not lead to a desired
result
Global Institutions
It is impossible to talk about the U.S. economic institutions without considering how
they integrate with the world economy
Global Corporations
They also pose a problem by evading policy through shifting its operations
between different countries
These include the UN, World Bank, World Court, and IMF
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Demand
The law of demand states that Quantity demanded rises as price falls, other things
constant. Or alternatively, Quantity demanded falls as price rises, other things
constant.
If the price of something goes up, people will tend to buy less and buy a substitute
instead
The demand curve is the graphical representation of the relationship between price
and quantity demanded.
o
It slopes downward
This qualifier places a limitation on the application of the law of demand. If the
fall in demand is a result of decreased income or some other factor, then
adjustments must be made to hold income constant.
A shift in demand is the graphical representation of the effect of anything other than
price on demand.
1. Societys income
3. Tastes
4. Expectations
Income
o
A rise in income increases the demand for normal goods. For other goods,
called inferior goods, an increase in income reduces demand.
When the price of a substitute rises, demand for the good whose price has
remained the same will rise.
Tastes
o
When the price of a good declines, the demand for its complement rises.
Changes in taste can affect the demand for a good without a change in price.
Expectations
o
If one expects his income to rise in the future, he will start spending some of it
now.
A market demand curve is the horizontal sum of all individual demand curves
o
Firms dont care who buys their goods; they only care that someone buys
them
Even if individuals dont respond to small changes in price, the market demand curve
can still be smooth and downward sloping
o
1. A demand curve follows the law of demand: When price rises, quantity falls, and
vice versa
4. The vertical axis price assumes all other prices remain the same
6. Effects of price changes are shown by movements along the demand curve.
Effects of anything else on demand (shift factors) are shown by shifts of the entire
demand curve
Supply
Thus, the analysis of the supply of produced goods has two parts
The law of supply states that Quantity supplied rises as price rises, other things
constant. Or alternatively, Quantity supplied falls as price falls, other things
constant.
A supply curve is the graphical representation of the relationship between price and
quantity supplied.
o
It slopes upward
If the amount supplied is affected by anything other than price, that is, by a shift
factor of supply, there will be a shift in supply the graphical representation of the
effects of a change in a factor other than price on supply.
Price of Inputs
o
If a firms costs rise, profits will decline, and a firm has less incentive to
supply. Thus, supply falls when the price of inputs rises.
Technology
o
Expectations
o
The market supply curve is the horizontal sum of all the individual supply curves
When a market exists where neither suppliers nor consumers collude and where
prices are free to move up and down, the forces of supply and demand arrive at an
equilibrium
o
Equilibrium quantity is the amount bought and sold at the equilibrium price
Equilibrium price is the price toward which the invisible hand drives the
market
Excess Supply
o
Price in the market falls to allow quantity demanded to meet quantity supplied
Excess Demand
o
Market price will rise to allow quantity supplied to meet quantity demanded
Price Adjusts
o
When quantity demanded is greater than quantity supplied, prices tend to rise
When quantity supplied is greater than quantity demanded, prices tend to fall
It is not a state of the world, its a characteristic of the model the framework you
use to look at the world.
Some equilibria arent good at all nuclear war and resulting mutually
assured destruction
In the real world, political and social forces are acting and pushing the price away
from the supply/demand equilibrium
Supply and demand are tools that help only when used appropriately
o
Micro v. Macro
o
The fallacy of composition is the false assumption that what is true for a
part will also be true for the whole
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The forex (foreign exchange) market determines exchange rates, or the price of one
countrys currency in terms of anothers currency
o
With price ceilings, existing goods are no longer rationed entirely by price. Other
methods of rationing existing goods arise called non-price rationing
Price Floors
E.g. minimum wage laws laws specifying the lowest wage a firm can
legally pay an employee
Excise Taxes
Quantity Restrictions
Governments often regulate markets with licenses that limit entry into a market
Quantity restrictions tend to raise price because with quantity restrictions, increases
in demand lead only to price increases
Third-Party-Payer Markets
A third-party-payer market is one where the person who receives the good differs
from the person paying for the good
o
In third-party-payer markets, equilibrium quantity and total spending are much higher
o
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Economic models differ from others. What does differentiate economists are:
The building blocks and structures of models that economists use have
evolved. Early economists used only a highly restricted set of building blocks
and a narrow set of simple formal models.
A deductive approach is one that begins with certain selfevident principles from which implications are logically
determined.
Traditional building blocks of microeconomics are the assumptions that people are
rational and self-interested
Inductive study of peoples behavior that argues that rationality and selfinterest should be broadened
These differing assumptions affect the patterns economists see in the results of their
models analysis
Predictable Irrationality
o
For behavioral economists, universality is less important than the fact that the
model captures how people actually behave
Endowment effects is the concept that people value something more just
because they have it
Traditional models provide simple and clear results, which can highlight
issues that behavioral models cannot
Types of Models
Behavioral and Traditional Informal (Heuristic Models)
Armchair Economist
Martin wants to hook up with Joan. Joan wants to hook up with Martin.
Martin is prudent and he is scared of STDs so he does not attend a
party where Joan and him expected to hook up. In his stead, Joan
hooks up with not-so-prudent Maxwell. Maxwell gives Joan AIDS all
because Martin was virtuous and did not have safe sex with Joan.
Decisions about sex may have externalities and therefore what is best
for the individuals involved may not be best for society.
That people return a $20 lampshade that was mistakenly not scanned
less often than they will return an overpayment of $20 in change
supports the assumption of purposeful behavior.
Heuristic models are very easy to modify and come to different conclusions.
Empirical Models
Empirical models are models that statistically discover a pattern in the data
Regression Models
o
Running a regression finds the line of best fit between the points plotted on a
graph of the two sets of variables
Regression models can reveal all sorts of relationships. They have been
called data-mining models but a better term for them is pattern-finding
models
Two economists can draw different conclusions from the same empirical
model
Models in which not only are the variable related, but also are the changes in
variables and the changes in changes in variables
Models in which relationships are non linear on various levels, and in which
an infinitely small change can lead to drastically different results
Game theory models are models in which one analyzes the strategic
interaction of individuals when they take into account the likely response of
other people to their actions
Modern economists, with their various frames, are less sure of the conclusion that
the market will solve every problem
o
For a modern economist, policy does not follow directly from a model
Models provide theorems results that follow logically from a model not
precepts general rules for public policy.
ED =
The price elasticity of supply is the percentage change in quantity supplied divided
ES =
Elastic: E > 1
Inelastic: E < 1
An inelastic supply means that the quantity supplied doesnt change much with a
change in price.
An elastic supply means that quantity supplied changes by a larger percentage than
the percentage change in price
Calculating Elasticities
In 2005, the city of London raised the daily toll motorists pay to drive in central
London by 46%. The increase reduced the number of motorists driving in central
London by 3%.
o
E = 3/46 = .07
The endpoint problem arises because the percentage change differs depending on
whether you view the change as a rise or a decline.
o
Economists use the average of the two end values to get around the endpoint
problem.
The relationship between elasticity and slope is the following: The steeper the curve
becomes at a given point, the less elastic is supply or demand.
On straight-line supply and demand curves, slope remains constant, but elasticity
does not.
At one point along the demand curve, between an elasticity of infinity and zero,
demand is unit elastic the percentage change in quantity equals the percentage
change in price (E = 1)
Review
Perfectly elastic
o
Elastic
o
E=1
Inelastic
o
E>1
Unit elastic
o
E=
E<1
Perfectly inelastic
o
E=0
The number of substitutes a good has affected by various factors. Several important
ones are listed.
o
The more substitutes, the more elastic the demand and the more elastic the supply
The larger the time interval considered, the more elastic is the goods
demand. There are more substitutes in the long run than the short run.
Substitutes for transportation are more difficult to find, than substitutes for
unicycle transportation.
Demand for goods that represent a large proportion of ones budget is more
elastic than demand for goods that represent a small proportion of ones
budget.
Goods that cost very little relative to ones total expenditures arent worth
spending a lot of time figuring out whether theres a good substitute.
The same general issues involving substitution are relevant when considering
determinants of the elasticity of supply. But when it comes to supply, economists
focus on time rather than on other factors because time plays such a central role in
determining supply elasticity.
The longer the time period considered, the more elastic is supply.
Knowing elasticity of demand is useful to firms when they want to know whether total
revenue will rise or fall when they change their pries.
o
If demand is elastic (ED > 1), a rise in price lowers total revenue
If demand is unit elastic (ED = 1), a rise in price leaves total revenue
unchanged
If demand is inelastic (ED < 1), a rise in price increases total revenue
With elastic demands, a rise in price decreases total revenue. With inelastic
Price discrimination
good goes up, the demand for the substitute goes up.
o
Complements are goods that are used in consumption with other goods. A fall in the
Using the theory of self-interest, two things determine what people do:
o
Price the tool the market uses to bring the quantity supplied equal to the
quantity demanded
Economists theory of rational choice is simple, it shows how pleasure and price are
related
Total utility refers to the total satisfaction one gets from consuming a product
o
Marginal utility refers to the satisfaction one gets from consuming one additional
unit of a product above and beyond what one has consumed up to that point.
o
When graphed, the marginal utility curve slopes downward, this is due to the
principle of diminishing marginal utility as you consume more of a good, after
some point, the marginal utility received from each additional unit of a good
decreases with each additional unit consumed, other things equal.
o
The analysis of rational choice is the analysis of how individuals choose goods within
their budget to maximize total utility
o
The term rational in economics means that people prefer more to less and will
make choices that give them as much satisfaction as possible
The principle of rational choice is as follows: Spend your money on those goods
that give you the most marginal utility (MU) per dollar
Thus, if
MU x MU y
, choice y would be the more rational choice in terms of
<
Px
Py
marginal utility
Simultaneous Decisions
MU
) of two goods differs
P
The utility-maximizing rule says that when the ratios of the marginal utility to price
MU x MU y
=
Px
Py
As we consume more of an item, the marginal utility we get from the last unit
consumed decreases. Conversely, as we consume less of an item, the
marginal utility we get form the last unit consumed increases.
The general principle of rational choice is to consume more of the good that provides
a higher marginal utility per dollar.
MU x MU z
>
, consume more of good x
Px
Pz
MU y MU z
o When
, consume more of good y
>
Py
Pz
MU x MU y MU z
o When
, you are maximizing utility
=
=
Px
Py
Pz
o
When
this rule is met, the consumer is in equilibrium; the cost per additional unit of
When
utility is equal for all goods and he consumer is as well off as it is possible to be
Thisrule does not say that the rational consumer should consume a good until its
marginal utility reaches zero because consumers dont have enough money to buy
all they want
o
Consumers have budgets and they do the best they can under that constraint
The law of demand in relation to the principle of rational choice: when the price of a
good goes up, the marginal utility per dollar goes down. Thus, if we are initially in
equilibrium as a consumer and the price of a good goes up, we no longer are and we
choose to consume less of that good.
o
If
MU x MU y
MU x MU y
and the price of good x goes up, then
=
<
Px
Py
Px
Py
To satisfy our utility-maximizing rule so that our choice will be rational, we must
somehow raise the MU we get from the good whose price has risen. According the
If the price of a good rises, youll increase your total utility by consuming less
of it.
There is a certain ambiguity with the changes in nominal prices and their precise
effects on how much quantity demand will change.
o
When the relative price of a good goes up, the quantity purchased of
that good decreases (even when youre given money to compensate
for the price increase)
According to the principle of rational choice, if there is diminishing marginal utility and
the price of supplying a good goes up, you supply more of that good.
Opportunity Cost
Opportunity cost is essentially the marginal utility per dollar you forgo from the
consumption of the next-best alternative.
o
To say
MU x MU y
, is to say that the opportunity cost of not consuming
>
Px
Py
Some behavioral economists are questioning whether tastes are given or shaped by
society.
Conspicuous Consumption
Utility Maximization
The ultimatum game is a game where the first person only gets the money if the
other person accepts the offer. If the second person does not accept, they both get
nothing
o
A status quo bias is where an individuals actions are very much influenced by the
current situation, even when that reasonably does not seem to be very important to
the decision
Nashs realization was that each person, acting in his or her own best
interest, will not necessarily arrive at the best of all possible outcomes; Adam
Smith is wrong.
The central element of the modern economic way of thinking is strategic thinking
o
Where does game theory fit into the modern economists modeling method?
o
Bob Solow: You look at a problem; you create a simple model that captures
its essence you empirically test how well that model fits the data, and if it fits,
you use that model as a guide to understanding the problem and devising a
solution.
Game theory offers a new set of models with which to approach economic issues.
o
They can be better tailored to fit the actual problem and are more flexible than
the standard models of economics
A different game theory model must be developed for each different situation
and each different set of assumptions
Rather than one model with one equilibrium solution, game theory had many
models with multiple equilibrium solutions
A payoff matrix is a table that shows the outcome of every choice by every player,
given the possible choices of all the other players.
Cheap talk is communication tat occurs before the game is played that carries no
cost and is backed up only by trust, and not any enforceable agreement
o
Informal game theory (often called behavioral game theory) relies on empirical
observation, not deductive logic alone, to determine the likely choices of individuals.
It looks at how people actually think and behave and is thus empirically based.
Informal game theory proves a framework for approaching questions rather than
providing definite answers
Informal game theory is used to explore what rationality is and the nature of
individuals utility functions.
o
If people feel someone is being unfair, people will reduce their own income to make
that person pay
Framing Effects
Framing effects are the tendency of people to base their choices on how the choice
is presented
Behavioral economics provides a more nuanced view of human behavior than does
standard economics
The Importance of the Traditional Model: Money Is Not Left on the Table
Just because people dont act as the traditional economic model predicts doesnt
mean that the traditional assumption and model are irrelevant
o
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A firm is an economic institution that transforms factors of production into goods and
services. Firms:
Some firms are virtual firms, which dont produce anything but they simply
subcontract out all production
The firm plays the same role in the theory of supply that the individual does in the
theory of demand
o
When determining that to include in total revenue and total costs, accountants
focus on explicit revenues and explicit costs because they must have
quantifiable measures to go into a firms income statement.
Economists include both explicit and implicit costs and revenues into their analysis
o
Total revenue is the amount a firm receives for selling its product or
service plus any increase in the value of the assets owned by the firm
In the long run, all inputs are variable; in the short run, some inputs are fixed.
worker, other inputs constant. Marginal product is how much additional output will be
forthcoming if the number of workers changes.
Average product is output per worker. Workers average product is the total output
variable input is added to an existing fixed input, eventually the additional output one
gets from that additional input is going to fall.
o
under consideration
Average Total Cost, Average Fixed Cost, and Average Variable Cost
Average total cost (average cost) equals total cost divided by the quantity
produced
o
ATC =
Also,
TC
Q
AFC =
FC
Q
AVC =
VC
Q
Marginal Cost
Marginal cost is the most important cost a firm considers when deciding how much to
produce
Marginal cost is the increase (decrease) in total cost from increasing (decreasing)
the level of output by one unit
The MC curve goes through the minimum point of the ATC curve and AVC
curve. Each of these curves is U-shaped. The AFC curve slopes down
continuously
As output increases, the same fixed cost can be spread over a wider
range of output, so average fixed cost falls
In the short run, output can be raised only by increasing the variable
input. But as increasing variable inputs are added to a fixed input, the
law of diminishing marginal productivity enters in. Marginal and
average productivities fall and marginal and average costs rise.
Average total cost initially falls faster and then rises more slowly than
average variable cost.
The Relationship between the Marginal Cost and Average Cost Curves
Marginal and average reflect a general relationship that also holds for
MC and AVC
This part is best understood by reading pages 285-289 in the text book
Review
Costs
Marginal cost
MC = TC
Total cost
TC = FC + VC
TC
Q
Fixed cost
Cost that is already spent and cannot be recovered. It exists only in the short
run.
FC
AFC =
FC
Q
Variable cost
VC
AVC =
VC
Q
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Firms have many more options in the long run than in the short run
o
To make their long-run decisions, firms look at the costs of the various inputs and the
technologies available for combining those inputs and seeing which has the lowest
cost
Technical efficiency in production means that as few inputs as possible are used to
produce a given output
o
Many production processes can have equal technical efficiencies, but their
economic efficiencies distinguish some from others
The shape of the long-run cost curve is due to the existence of economies and
diseconomies of scale
o
Economies of Scale
Diseconomies of Scale
Diseconomies of scale could not occur if production relationships were only technical
relationships
o
The same technical process could be used over and over again at the same
per-unit cost.
In reality, production relationships have social dimensions that effect the production
process:
o
Larger firms have to have more and more people devoted to simply
monitoring employees
Team spirit is the feelings of friendship and being part of a team that
bring out peoples best efforts
Constant returns to scale are where long-run average total costs do not change
with an increase in output
Together, economies of, constant returns to, and diseconomies of scale contribute to
the U-shaped curve of long-run average total costs
If firms can make and sell more at lower per-unit costs they can make more profits
Envelope Relationship
Since long-run costs are variable and short-run costs arent, long-run costs will
always be less than or equal to short-run cost at the same level of output
o
In the short run, all expansion must be done by increasing only the variable
input. This constraint must increase average cost (or at least not decrease it)
compared to what the average cost would have been if the firm had planned
to initially produce that level.
This envelope relationship comes from the fact that the long-run average total cost
curve is an envelope of short-run average total cost curves
The more options you have to choose from, the lower the costs of production.
When there are economies of scale and you have chosen an efficient plant size for a
given output, your short-run average costs will fall as you increase production.
o
Pg 302
The expected price of a good must exceed the opportunity cost of supplying the good
for a good to be supplied
Economies of scope are when the costs of producing products are interdependent
so that its less costly for a firm to produce one good when its already producing
another
Learning by doing means that as we do something, we learn what works and what
doesnt, and over time we become more proficient at it
o
Many firms estimate that worker productivity grows 1-2% p.a. due to learning
by doing
Many Dimensions
Real-world economic decisions have many dimensions besides the single dimension
of output in the standard model
Unmeasured Costs
Accountants calculations dont take into account the time and effort that the
owner inputs
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Perfect Competition
A price taker is a firm or individual who takes the price determined by market
supply and demand as given
The term large means sufficiently large so that any one firms output
compared to the market output is imperceptible and what one firm does has
no influence on what other firms do
Complete Information
o
Firms and consumers know all there is to know about the market prices,
products, and available technology
Firms can have many goals, but for perfect competition, firms must seek
maximum profit and only profit. The people who make the decisions must
receive only profits and no other form of income from the firms.
The stated conditions are enormously strong and rarely meet simultaneously,
however theyre necessary for a perfectly competitive market to exist. When they do
meet, they create an environment in which each firm, following its own self-interest,
will offer goods to the market in a predictable way.
Recall the definition of supply: a schedule of quantities of goods that will be offered
to the market at various prices.
o
In almost all other market structures, firms arent price takers; they are price
makers.
The second condition the number of firms is large is necessary so that firms have
no ability to collude (operate in concert to reap more benefits)
Conditions 3-5 are closely related to the first two; they make it impossible for any firm
to forget about the hundreds of other firms
Condition 6 tells a firms goals; without these, we wouldnt knowhow firms would
react when faced with the given price
Marginal Cost
o
If the conditions for perfect competition hold, then a firms supply curve will be
that portion of the firms short-run marginal cost curve above the AVC curve
The demand curve for an industry is downward-sloping, but the demand curve for the
firm is horizontal (perfectly elastic)
The price a firm can get is determined by the market supply and demand
curve
Firms will increase their output in response to an increase in market demand, even
though that increase in output will cause price to fall and can make all firms
collectively worse off. But in perfect competition firms dont act collectively.
Since profit is the difference between total revenue and total cost, the effect of
change in output on profit is determined by marginal revenue and marginal cost.
o
Marginal cost (MC) the change in total cost associated with a change in
quantity
Marginal Revenue
Since a perfect competitor accepts the market price as a given, marginal revenue is
simply the market price.
The Marginal revenue curve and demand curve are the same for a perfect
competitor
Profit Maximization: MC = MR
If marginal revenue does not equal marginal cost, a firm can increase profit by
changing output
The upward-sloping portion of the marginal cost curve fits this definition
Because the marginal cost curve tells us how much of a produced good a firm will
supply at a given price, the marginal cost curve is the firms supply curve; MC=S
Maximizing profit means maximizing total profit, not profit per unit
Total revenue and total cost curves can also be used to determine the profitmaximizing level of output
o
Total profit is maximized where the vertical distance between total revenue
and total cost is greatest. At that output, marginal revenue (the slope of the
total revenue curve) and marginal cost (the slope of the total cost curve) are
equal
Marginal cost is all that is needed to determine a competitive firms supply curve
The P=MR=MC demonstrates how much output a competitive firm should produce to
maximize profit, however it does not tell us how much profit the firm makes
Profit is determined by total revenue minus total cost at the point where MR=MC
Find point where MC=MR, this point marks the quantity that the firm will
produce
After finding the profit-maximizing quantity, drop a vertical line down to the
horizontal axis. Find the ATC at that output level and extend a line from the
ATC to the Y-axis (price).
To determine maximum profit, you must first determine what output the firm
will choose to produce by seeing where MC equals MR and then determine
the ATC at that quantity by dropping a line down to the ATC curve
ATC at the profit-maximizing position is below the price, thus making profit
When the ATC is below the marginal revenue curve, the firm makes a
profit
When the ATC is above the marginal revenue curve, the firm incurs a
loss
To determine maximum profit, first determine what output the firm will choose
to produce by seeing where MC=MR, and then extending a line to the ATC
curve
The supply curve of a competitive firm is the MC curve where it is above the AVC
curve. If a firm is operating above AVC, there is no point of shutting down. The fixed
costs are sunk costs and the firm must pay them regardless of whether it produces
or not. The firm only considers the variable costs, as long as it covers its variable
costs, it pays to keep on producing.
The shutdown point is the point below which the firm will be better off if it
temporarily shuts down than it will if it stays in business
In the short run when the number of firms in the market is fixed, the market supply
curve is the horizontal sum of all the firms marginal cost curves, taking account of
any changes input prices that might occur
o
As the short run evolves into the long run, the number of firms in the market is
variable and the market supply curve shifts to the right because more firms are
supplying the quantity indicated by the representative marginal cost curve
In the long run, firms can enter and exit the market
o
Thus, in the long run only the zero profit equilibrium (shown on pg 329) can
exist
Firms cant make economic profit or economic loss in the long run because of
the entry and exit of firms
If there are economic profits, firms will enter the market, shifting the
market supply curve to the right. As market supply increases, the
market price will decline and reduce profits for each firm. Firms will
continue to enter the market until economic profit is eliminated
Normal profit is the amount the owners of business would have received in the
next-best alternative
o
A market in equilibrium that experiences an increase demand. Firms are making zero
profit because theyre in long-run equilibrium. If demand increases, firms will see the
market price increasing and will increase their output until theyre once again at a
position where MC=P.
Chapter 15 - Monopoly
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Monopoly is a market structure in which one firm makes up the entire market
Natural barriers - unique ability to produce what other firms cant duplicate
Technological barriers the size market can support only one firm
A competitive firm is too small to affect price so it does not take into account the
effect of its output decision on the price it receives (price taker)
o
MR=Market price
A monopolistic firm takes into account that its output decision can affect price; its
marginal revenue is not its price
In competitive markets the firms do not act in the interest of the firms collectively
o
A Model of Monopoly
Pricing
o
Equilibrium output for the monopolist, like equilibrium output for the
competitor is determined by the MC=MR condition, but because the
monopolists marginal revenue is below its price, its equilibrium output is
different from the competitive market
Profit is determined by subtracting ATC from average revenue (P) at that level of
output and multiplying by the chosen output
o
Price is given by the demand curve (at the Quantity where MR=MC)
Because monopolies charge a price that is higher than marginal cost, peoples
decisions dont reflect the true cost to society. Price exceeds marginal cost. Because
price exceeds marginal cost, peoples choices are distorted, they choose to consume
less of the monopolists output and more of some other output than they would if
markets were competitive.
o
The marginal cost of increasing output is lower than the marginal benefit of
increasing output, so theres a welfare loss
Examples
Natural Ability
o
A firm might have unique abilities that make it more efficient than all other
firms
Economies of Scale
o
Occurs when the technology is such that indivisible set up costs are
so large that average total costs fall within the range of possible
outputs
The public does not like the income distributional effects of monopoly
Monopolistic competition is a market structure in which there are many firms selling
differentiated products and few barriers to entry
Oligopoly is a market structure in which there are only a few firms and firms explicitly
take other firms likely response into account
Many sellers
o
Differentiated products
o
The goods sold arent homogenous, each firm has a monopoly on the good it
sells
This means that for monopolistic competitors market share is a valid concern
Goals of Advertising
Shifting the demand curve to the right and making it more inelastic
Characteristics of Oligopoly
There are a small number of firms in the industry, so that, in any decision a firm
makes, it must take into account the expected reaction of other firms
o
Mutual interdependence
There is no single model because an oligopolist can decide on pricing and output
strategy in many possible ways
The Cartel model of oligopoly is a model that assumes that oligopolies act as
if they were monopolists that have assigned output quotas to individual
member firms of the oligopoly so that total output is consistent with joint profit
maximization
Dominant firm cartel model- a single large firm makes pricing and
output decisions and smaller, fringe firms follow
Since other firms can enter the market, cartels encourage technological
advances to retain their monopoly
If a firm increases its price and the firm believes that other
firms wont go along, its perceived demand curve is very
elastic. It will lose a lot of business
Thus the demand curve has a kink and MR curve has a gap
A model of oligopoly in which barriers to entry and barriers to exit, not the
structure of the market, determine a firms price and output decisions.
Price Wars
Firms utilize the strategy of pushing down price to drive the other firm
out of business
Consists of six digits with each successive digit specifying a subgroup of the
initial two digit sector
Concentration Ratio the value of sales by the top firms of an industry stated
as a percentage of total industry sales
The Cartel model fits best with these empirical measurements because it
assumes that the structure of the market (the number of firms) is directly
related to the price a firm charges
The Contestable market model gives less weight to the empirical estimates
because a market structure that looks highly oligopolistic could actually be
highly competitive
If firms are profit maximizers they arent just concerned with short-run profit;
most are concerned with long-run profit.
Expenditures on reputation and goodwill (to be perceived as good citizens) can increase long-run profit,
even if they reduce short-run profit
In the real world the decision makers income is often a cost of the firm
Managers incentives
Self-interested decision makers have little incentive to hold down their pay, which is a
cost of the firm.
o
Incentive-Compatible Contract- the incentives of each of the two parties to the contract are made to
correspond as closely as possible
Self-interested managers are interested in maximizing the firms profit only if the structure of the firm
requires them to do so
Often other intermediate goals become the focus of the firm (ex: growth of sales)
Lazy monopolist- firms that do not push for efficiency, but merely enjoy the position
they are already in
o
Results in X-Inefficiency- firms operating far less efficiently than they could technically
These firms are in monopoly positions
The standard model avoids dealing with monitoring problems by assuming the owner of the firm makes all
the decisions
Competitive pressure can be generated by a Corporate takeover- in which a firm or group of individuals
issues a tender offer (that is, offers to buy up the stock of a company) to gain control and install its own
manager
Managers lose perks or even their jobs with takeovers so they will often preventively
restructure the company
Restructuring incurs debt so even more pressure is placed on the management to operate efficiently
Rare
Our laws and social values and customs simply do not allow perfect competition to
work because government emphasizes other goals besides efficiency
Firms collude and restrict entry into the market in order to increase
profits (in self interest)
For a Monopoly to exist it must prevent other firms from entering the market,
which is nearly impossible
Reverse Engineering
Natural monopolies often have high profits, which gives other firms an
incentive to research alternate ways (new technologies) of supplying the
product
They are allowed to make a normal return but no economic profit and thus have no incentive to keep
costs down, resulting in X-Inefficiency
Monopolies are expensive to create and maintain, thus firms will buy
monopoly power until the marginal cost of such power equals the marginal
benefit.
Technology
Natural outcome of specialization due to the increased knowledge gained in specialization that allows a
breakthrough
Some market structures are more conducive to growth than others (they provide
more incentives)
They also make no economic profit and thus may not be able to acquire the funds needed to devote to
R&D
The promise of gaining market power provides the incentive to fund research
in new technologies
However, in Monopolistic competition, long-term economic profit is zero so the gained market power will
eventually deteriorate
Typical oligopolistic firms have continual economic profit and can thus fund R&D
Also spurred on by the belief their competitors are doing so, and the desire to gain
an edge on said competitors
Network Externalities lead to the development of Industry standards (such as AC vs. DC)
Standards and Winner-take-all industries
Network externalities increase the likelihood that the industry becomes a winnertake-all industry.
Network externalities increase the need for an industry standard, benefitting the firm whose standard is
accepted.
First-Mover Advantage
o
Firms will be willing to incur large losses in order to set the industry standard
Technological Lock-In
The market might not gravitate toward the most efficient standard, yet
be maintained by the First mover advantage.
Technological lock-in when prior use of a technology makes the adoption of subsequent technologies
difficult
This does not, however, merit government interference because this would slow or stop the competitive
process and make society worse off
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The labor market is a factor market in which individuals supply labor services for
wages to other individuals and to firms that demand labor services
o
If the invisible hand were the only force operating in the labor market, wages
would be determined entirely by supply and demand; this is not the case
The incentive effect is how much a person will change his or her hours worked in
response to a change in the wage rate
o
Normal relationship: The higher the wage, the higher the quantity of labor
supplied
Over the last century, real wages in the U.S. rose significantly, but average number
of house worked per person fell.
o
This is counter to the logic that opportunity cost of leisure rises as wages rise
Higher incomes, however, make people richer and richer people can afford more to
choose more leisure
Societal and political programs reward the needy with less expenses/taxes
o
Individuals opportunity cost of working determine individuals supply curves and the
amounts of people entering and leaving the labor force
The higher the wage, the lower the quantity of labor demanded
When people are self-employed, the demand for the labor is the demand for the
product or service they supply
When a person isnt self-employed, determining the demand for labor isnt as direct
o
Theres 2 steps: Consumers demand products from firms; firms then demand
labor
Labor is a derived demand the demand for factors of production by firms, which
depends on consumers demands
Land, labor, and capital are the traditional factors of production along with
entrepreneurship labor that involves high degrees of organizational skills,
concern, oversight responsibility, and creativity
o
Factors that shift the demand curve for labor will put pressure on the equilibrium
price to change
o
If the price of a machine that is used in production rises, then demand for
labor (a substitute) would shift right and the wage would rise
Supply and demand forces greatly influence wages, but do not determine them
o
Real-world labor markets are filled with individuals/firms that resist market
forces of supply and demand
When theres only one buyer of labor, with each worker hired, the equilibrium wages
of the next one rise
o
The marginal factor cost the additional cost to a firm of hiring another
worker is above the supply curve
A union monopoly is where workers organized together that allows them to act as if
there were only a single seller
The union will have the incentive to act like a monopoly and increase its members
wages
o
The wage that the union sets wouldnt be below the competitive wage, it would be
above it
Bilateral Monopoly
A bilateral monopoly is a market with only a single seller and single buyer
The equilibrium wage will between that of the monopsonist wage and the union
monopoly power wage; the equilibrium quantity will be between the monopsonist
quantity and union monopoly power quantity
Efficiency Wages
o
Efficiency wages are wages paid above the going market wage to keep
workers happy and productive
On average women are paid les than men and blacks are often directed into lowerpaying jobs
Institutional Discrimination
o
When the structure of the job makes it difficult/impossible for some groups to
succeed, there is institutional discrimination
A union shop is a firm in which all workers must join the union
The share distribution of income is the relative division of total income among
income groups
Social Security
Progressive taxation
Defining Poverty
The poverty threshold is the income below which a family is considered to live in
poverty
o
The poverty line is seen as too high and too low by various groups based on
observations on prices of food, etc.
Like most economic statistics, poverty statistics should be used with care
General morale
The U.S. has less income inequality than most developing countries but more
income inequality than many developed countries
Wealth is the value of the things individuals own less the value of what they
owe
A static concept
A flow concept
The U.S. has socioeconomic classes with some mobility among classes. This
is not to say such classes should exist, just that they do.
Economists used to see the class structure as a pyramid, with a large lower
class, a smaller middle class, and an even smaller upper class
However, now the class structure is more like a pentagon with the
middle class being the largest
Radical economists emphasize the control that the upper class has
over the decision process
Peoples acceptance of the U.S. economic system is based not only on what
the distribution of income is but also on what people thing it should be and
what they consider fair
Different philosophies hold very different normative views on how incomes should be
distributed if at all
Fairness has many dimensions and it is often difficult to say what is fair and what
isnt
People will change their behavior in response to changes in taxation and income
redistribution programs
o
Often, politics (instead of value judgments) plays a central role in determining what
taxes an individual will pay
Poor people are discouraged from voting feeling one vote cant make a
difference
A progressive tax is one in which the average tax rate increases with income
A proportional tax is one in which the average rate of tax is constant regardless of
income level
A regressive tax is one in which the average tax rate decreases as income
increases
In the 1940s, the federal personal income tax was made highly progressive.
But since then, the rates have become less progressive.
State and local governments get most of their income from the following
sources:
Social Security
o
Public Assistance
o
Unemployment Compensation
o
Housing Programs
The invisible hand framework says that if markets are perectly competitive,
they will lead individuals to make voluntary choices that are in societys
interest
When conditions arent met to ensure that the invisible hand guides private actions
towards social good, market failure occurs
o
Market failure is a situation in which the invisible hand pushes in such a way
that individual decisions do not lead to socially desirable outcomes
Externalities
Public goods
Imperfect information
Externalities
Externalities are the effects of a decision on a third party that are not taken into
account by the decision maker
o
Negative externalities occur when the effects of a decision not taken into
account by the decision maker are detrimental to others
Positive externalities occur when the effects of a decision not taken into
account by the decision maker are beneficial to others
When there are externalities, the marginal social cost differs from the marginal
private cost
o
The marginal social cost includes all them marginal costs that society bears
or the marginal private costs of production plus the cost of the negative
externalities associated with that production
The distance between the two marginal cost curves (social vs. private) is the
additional marginal cost of the externality
The vertical distance between the two (MC [or supply]) curves at a
given quantity is the MC of the externality
Positive externalities make the marginal private benefit below the marginal social
benefit
o
The distance between the two marginal benefit curves (social vs. private) is
the additional marginal benefit of the externality
1) Direct Regulation
2) Incentive Policies
3) Voluntary Solutions
Direct Regulation
Direct regulation is when the amount of a good people are allowed to use is directly
limited by the government
o
Direct regulation is not efficient achieving a goal at the lowest cost in total
resources without consideration as to who pays those costs
o
Direct regulation does not take into account that the costs of reducing
consumption may differ among individuals
Incentive Policies
More efficient than a regulatory solution as the person for whom the
reduction is lest costly cuts consumption the most
An efficient tax equals the additional cost imposed on society but not taken
into account by the decision maker
With such a tax, the cost the suppliers face is the social cost of
supplying the good. With the tax, the invisible hand guides the traders
to equate the marginal social cost to the marginal social benefit and
the equilibrium is socially optimal
Voluntary Reductions
The optimal policy is one in which the marginal cost of undertaking the policy
equals the marginal benefit of that policy
o
If a policy isnt optimal, resources are being wasted because the savings from
reducing expenditures on a program will be worth more than the gains that
will be lost from reducing the program
Public Goods
A public good is a good that is nonexclusive (no one can be excluded from its
benefits) and nonrival (consumption by one does not preclude consumption by
others)
o
Governments generally provide goods with public aspects as private businesses will
not supply them without transforming them into a mainly private goods
The market demand curve represents the marginal social benefit of a good
While the market demand curve for a private goods is the horizontal
sum of all the individual demand curves, the market demand curve of
a public good is the vertical sum. This is because the quantity of the
good supplied is not split up; the full benefit of the total output is
received by everyone
Goods can be non rival but highly excludable and vice versa
Informational Problems
These have a problem of their own; they can slow down the economic
process. E.g. FDA
A Market in Information
o
The bureaucratic nature of government intervention does not allow fine tuning
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