AP Microeconomics

Chapter One p. 3-13

Economics: social science concerned with the efficient use of limited or scarce resources to achieve
maximum satisfaction of human material wants.

• Economic perspective: a unique way of thinking about economic issues

√ Scarcity and Choice √ Rational Behavior √ Marginal Thinking: Costs and Benefits

• Why Study Economics?

“The ideas of economists and political philosophers, both when they are right and when they
are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.
Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually
the slaves of some defunct economist.” John Maynard Keynes (1883-
1946)
√ Economics for Citizenship
Well-informed citizens will vote intelligently
Well-informed politicians will choose wisely among alternatives
√ Professional and Personal Application
Businessmen need an understanding of economy
Problems are examined from social rather than personal viewpoint

Economic Methodology
POLICIES
Policy economics is concerned with controlling or influencing
economic behavior or its consequences.

THEORETICAL ECONOMICS
Theoretical economics involves generalizing about
economic behavior.

THEORIES FACTS
Developing hypotheses which are Gathering facts and testing hypotheses
then tested against facts against the facts to validate theories
Deductive Method Induction Method

Descriptive Economics
√ Based on facts—observable and verifiable behavior of certain data or subject matter
√ Economists examine behavior of individuals and institutions engaged in the production,
exchange, and consumption of goods and services.

Economic Principles (laws, models)

√ Task of analysis is to systematically arrange, interpret, and generalize upon facts
√ Principles and theories bring order and meaning to facts by tying them to together, putting
them in correct relationship to one another and generalizing.
√ Principles are expressed as the tendencies of typical or average consumers, workers, or
business firms
√ Generalizations
• “Other things equal” assumption—controlling all variables except one
• Abstractions—do not mirror the complexity of real world
• Graphic Expressions—models used to show theory

1
Policy Economics
√ Applied Economics that recognizes the principles and data which can be used to formulate
policies.
√ Determining a course of action to resolve a problem or to further a nation’s economic goals

Steps in Policy Economics

State the goal A clear, specific statement • Every able-bodied individual
should have opportunity to work
Determine the policy options List specific policies to • Fund vocational training
achieve goal with an programs in high schools and
assessment of possible junior colleges
effects • Create job training and subsidy
to business firms willing to take
on new workers
Implement and Evaluate the Monitor steps in • Survey statistics on employment
policy which was selected implementing the policy • Do follow-up on job placements
initiatives taken and training programs

Principles Are Derived At Two Levels:

Macroeconomics: economy as a whole and its basic subdivisions such as government,
business and households. Macro looks at totals or aggregates to examine the “big picture”.
Microeconomics: looks at specific units or segments of the economy, a particular firm or
household. Micro looks at the “trees not the forest”.

ECONOMIC GOALS
• POSITIVE economics collects and presents facts. It avoids value judgments—”just the facts,
madam”! Positive economics concerns WHAT IS—what the economy is really like.

• NORMATIVE economics involves value judgments about what the economy should be like or which
policies are best. Normative economics embodies subjective feelings about WHAT OUGHT TO
BE—examining the desirability of certain conditions or aspects of the economy.

• GOALS are general objectives that we try to achieve. The nation’s policy makers use these goals so
that they can make better use of scarce resources. Goals make it easier to determine the tradeoffs
involved in each choice.
√ Economic Growth—increase in the production capacity of the economy to increase the
standard of living
√ Full Employment—provide suitable jobs for all citizens willing and able to work
√ Economic Efficiency—maximum satisfaction of wants with the available but scarce resources
√ Price-level Stability—stable price level avoiding inflation and deflation
√ Economic Security—providing for those unable to earn an income
√ Economic Freedom—guarantee that consumers, workers and business owners have freedom
in economic activity
√ Equitable Distribution of Income—ensure that no citizen faces stark poverty while others
enjoy extreme luxury
√ Balance of trade—seek a reasonable balance of trade with the world

• Complementary goals when one goal is achieved, some other goal or goals will also be
realized. For example, the achieving of Full Employment means elimination of low incomes and
economic insecurity.
• Conflicting goals some goals are mutually exclusive. Economic Growth may be in conflict
with Economic Equity; some argue that efforts to achieve greater equal distribution of income may
weaken incentives to work, invest, innovate and take business risks, all of which promote rapid
Economic Growth. Establishment of Job Security may lessen strive for high productivity.

2
AP Microeconomics
Chapter Two p. 23-25
Foundation of Economics:
• Social Science concerned with how resources are used to satisfy wants—the economizing problem.
• Study of how people and countries use their resources to produce, distribute and consume goods and
services.
• An examination of behavior related to how goods and services are acquired.
• A study of how people decide who will get the goods and services.
Scarcity:
• Society’s material wants are unlimited and unsatiable; economic resources are limited or scarce.
√ Demand for goods and services exceeds the supply
• Material wants means that consumers want to obtain products that provide utility.
√ Necessity vs. wants √ Wants multiply over time with new products and incomes
√ Human wants tend to be unlimited, but human, natural, and capital resources are limited
• Resources are materials from which goods and services are produced. Four types of resources are:
√ Land —All Natural Resources √ Labor— Human Resources
• Fields • Manual
• Forests • Clerical
• Sea • Technical
• Mineral deposits • Professional
• Gifts of nature • Managerial
√ Capital—Means of production √ Entrepreneurship— a particular type of
• factories • business innovator human resource
• office buildings • sees opportunity to make profit
• machinery • uses unexploited raw materials
• tools and equipment • takes risk with new product or process
• use of technology • brings together land, labor, capital
• use of available information
• Resource Payments—note the special terms used
Land-Rent Labor-wages and salaries Capital-Interest Entrepreneurship-Profit

Economic Efficiency—Using limited resources to derive the maximum satisfaction and usefulness
• Full employment and full production must be realized to achieve this goal
Full Employment Full Production
√ All available resources used √ Resources used to maximize satisfaction
√ Employment for all willing √ Allocative Efficiency–resources used to produce
and able society’s most wanted goods & services.
√ No idle capital √ Productive Efficiency–goods & services are produced
√ No idle arable land in least costly ways.

Think About This!

1. Evaluate: “If resources were unlimited and freely available, there

would be no subject called Economics”.

2. Analyze: “Wants are not insatiable. I can prove it. I get all the
coffee I want to drink every morning at breakfast”.

3
AP Microeconomics
Chapter Two p. 25-34

Production Possibility Tables and Curves

• PPC is an economic model to demonstrate opportunity costs and tradeoffs. The curve diagrams
the various combinations of goods/services an economy can produce when all productive resources are
employed. • There are 4 assumptions regarding the model:
√ Efficiency: full employment and productive efficiency
√ Fixed Resources: no more available, but they are shiftable
√ Fixed Technology: state of technology does not change in the period
√ Two Products: producing just two products (hypothetical, of course)
• Necessity of Choice is created. Limited Resources means a Limited Output.
TABLE: A B C D E
PIZZA (000,000) 0 1 2 3 4
ROBOTS (000) 10 9 7 4 0
Points on the curve:
A Attainable & Efficient
B with these resources
R
o
W
b C
o Points outside curve:
t Not Attainable
F D with these resources
s
Points inside curve: √ See page 26 for a Key
Inefficiency Graph Quiz!
E
Pizza

• Each point on the curve represents some maximum output of any two products. Limited
resources (or supplies of the specific resource to produce the goods shown) will make any combination
lying outside of the curve unattainable.
• Choice is reflected in the need for society to select among the various attainable
combinations lying on the curve.
• The concave shape of the curve implies the notion of opportunity costs, defined, as some
amount of one good must be sacrificed to obtain more of the other. The amount of robots, which must be
foregone or given up to get another unit of pizza, is the opportunity cost of that unit. The slope of the PPC
curves becomes steeper as we move from A to E. The reason lies in the fact that economic resources are
not completely adaptable. This curved line shows the adaptability and increasing opportunity cost. A
straight line would mean constant opportunity cost.
• Points inside the curve may signal unemployment or underemployment of labor and other resources.
• Points outside the curve are unattainable with the available resources. More resources or higher
productivity is needed to the curve to include those points outside the curve.

• Economic growth (and a movement outward of the

R curve) occurs because of expanding resource supplies,
o improved resource quality, and technological advances.
b These stimuli might include new discoveries of raw
o materials (diamonds in Australia, or oil on the North Slope
t of Alaska), improving the educational level or training of
s labor (Job Corps or company-sponsored job training), and
new technology (robots in factories or the microchip).
Pizza

4
• Allocative Efficiency (or determining the best or optimal output-mix) will relate to the concept of
Marginal Cost versus Marginal Benefit.
MC
MC
The point where MC=MB is
& allocative efficiency since neither
underallocation or overallocation
MB of resources occurs.
MB
Q
• Consumer Goods vs. Capital Goods:
Consumer goods directly satisfy our wants, while capital goods satisfy indirectly since they permit
more efficient production of consumer goods.
√ Think about what a nation must sacrifice in terms of its consumer good consumption
(opportunity costs) in order to be able to add to its capacity (by currently producing capital goods) in the
future.
• A current choice favoring more consumer goods will result in only a modest movement to the
right in the future.
• A current choice to produce a greater portion of capital goods with the available resources
can result in a greater rightward movement in the future.
Current
F G F G Position
u o u o
t o t o
u d Current u d
r s Position r s
e e

Present Present
Goods Goods
Current position favoring present Current position favoring future
goods results in only moderate goods results in accelerated
growth growth

Think About This!

1. Examine the eight applications on pages 33-34 and think about the movements of the PPC.
2. Explain the effects on the PPC from these situations:
a. standardized test scores of high school students decline greatly
b. unemployment falls from 9 to 6 % of the labor force
c. Defense spending is reduced to allow government to spend more on health care
d. Society decides it wants compact discs rather than new tools for factories
e. A new technique improves the efficiency of extracting copper from ore
f. A maturing of mini baby boom generation (born 1976-1982) increases the size of the nation’s
workforce

5
AP Microeconomics
Chapter Two p. 34-35

Economic Systems
TRADITIONAL
…decisions based on the past
• tied to methods of trial and error
• same products and production methods used as in the past
• jobs passed down through generations
• questions answered by custom, habit, religion or law
• change comes slowly, often with opposition
• war, climate, or outside force can cause change
• choices are limited; people do things “the way they were done in the past”
• people find it hard to believe other methods exist
• family is important social structure
Examples: (though slowly changing) North American Eskimos, Navajo Indians

COMMAND
… central planners answer the basic questions
• planners have power to make decisions for society as a whole
• decisions are answered by planners’ needs and wishes
• planners decide how many workers, who gets what job, and production goals
• wages and distribution system are determined by planners
• poor planning can cause shortages and surpluses; choice is often limited
• punishment and reward are the incentives to workers
• change can be quick without little opposition
• poor worker morale though fear is a motivator
• right to make decisions is based on political power
Examples: North Korea and Cuba

MARKET
… basic questions answered by the exchanges of buyers and sellers
• interaction of demand and supply determines the what? how ? for whom?
• no real overall central planning
• self-interest is guiding principle
• no single person or group determines what is best for society
• “an invisible hand” directs that the best interests of society are met when people compete to achieve
individual self-interest
• profit motive determines producer behavior
• capitalism is a type of market system in which private individuals and firms own the resources
• components are: private property, freedom of exchange, competition and profit motive.
Example: USA (though it really is a mixed market system)

MIXED SYSTEMS
… elements of market, command and traditional are used in various economic
activities
• government acts as stabilizer of economic activity and provider of goods and services
• large unions and large corporations can manipulate the market
• authoritarian capitalism mixed high government control and private property in Nazi Germany
• Market socialism of China mixes extensive government ownership of resources and capital but
reliance on free markets for distribution
• Sweden’s mixed market allows for government redistribution of income through high tax rates.
• Japanese economy relies on cooperation and coordination between government and businesses.

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AP Microeconomics
Chapter Two p. 35-37

The Circular Flow Model

• Economists use the circular flow diagram to show the high degree of economic
interdependence in our economy. Money flows in one direction while goods, services, and the
factors of production flow in the opposite direction.
• This simple circular flow model shows two groups of decision-makers—households (or
individuals) and businesses. (Later government will be added). The coordinating mechanism which
brings together these decisions is the market system.
• Resource (or factor) markets operate as the points of exchange when individuals sell their
resources (land, labor, capital, and entrepreneurial ability) to businesses in exchange for money
incomes. Businesses will demand these resources to produce goods and services. Prices paid for the
use of resources are determined in this market, and will create the flow of rent, wages, interest and profit
income to the households. Examples are hiring of workers by a business firm, savings and investments
in stocks and bonds. Here the money incomes would be interest and dividends.

• Product markets operate as the points of exchange between consumers who use money
incomes to buy these goods and services produced by businesses. Money income itself does not have
value, since money must be used in exchange for the goods and services that satisfy our wants.

Land, Labor, Capital & Entrepreneruial Ability

Resource Market
Resource Money Payments

See Key
graph on
Businesses page 36 of Households
text.

Money Payments for goods and services

Product Market

Goods and Services

• Households create the demand for goods and services, while businesses can fill the
demand with the supply that they produce with the resources sold. The interaction of demand for
goods and services with the supply of available products determines the price for the products. The
flow of consumer expenditures represents the sales revenues or receipts of the businesses. Examples
are the retail stores and other outlets for products.
• Individuals or households function as both providers of resources and as consumers
of finished products. Businesses function as buyers of resources and sellers of finished products.
Each group of economic units both buys and sells.
• Scarcity plays a role in this model because households will only possess limited amounts
of resources to supply to businesses, and hence, their money incomes will be limited. This limits their
demand for goods and services. Because resources are scarce, the output of finished goods and
services is also necessarily limited.
• Limitations to this model include:
√ Intrahousehold and Intrabusiness transactions are ignored. √ Government and the financial
markets are ignored. √ The model implies constant flow of output and income; the fact is that these
flows are unstable over time. √ Production expends resources and human energy and can cause
environmental pollution.
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AP Microeconomics
Chapter 4 p. 61-67

Capitalism
• There really is no generally acceptable definition of “capitalism”. A market system is
sometimes described as being based on capitalism, a system in which private citizens own the
factors of production. A market economy is based on free enterprise, because businesses are allowed
to compete for profit with a minimum of governmental interference.

• Both terms—capitalism and free enterprise —describe the US Economy. Our economy is
often defined as MIXED MARKET due to the role that government plays. In the US, individuals are
free to exchange their goods and services, use their resources as they wish, seek jobs of their own
choosing, and own and operate businesses. A Free Enterprise system is on in which business can be
conducted freely with only limited government interference.

• The list of characteristics of Capitalism:

Private property Freedom of Enterprise and Choice
Role of Self-Interest Competition
Markets and Prices Limited Government
• Consider:
√ What incentives does private property give people?
√ What about rights of inheritance?
√ Is self-interest really selfishness?
√ Are there social advantages in freedom to choose?
√ What is government’s limited role? Legal framework? Regulation of business?
Protection of consumer? Subsidizing production? Protection from foreign trade or
unfair competition?

• The other characteristics include:

Extensive use of Capital Specialization and Efficiency
Division of Labor Use of Money
• Consider:
√ What if the labor force in unskilled?
√ What if there are no real regional, occupational, or resource specializations?
√ Why does money place an important role in a large economy?

• The market economy is very popular because of a concept called Voluntary Exchange.
Who benefits when you buy something—you or seller? As long as the transaction involves dual
benefit, the exchange will take place.
• The market system is a means of communicating and implementing decisions
concerning allocation of the economy’s resources.

Think About This!

1. Evaluate these statements
a. The capitalistic system is a profit and loss economy.
b. Competition is the indispensable disciplinarian of the market system.

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AP Microeconomics
Chapter 4 p. 67-74

Competitive Market System

The theory of Capitalism must have some guidance if society desires to get what it wants in
terms of goods and services. The Competitive Market System functions mostly efficiently because it
relies on its answers to the Five Fundamental Questions—ideas driven by the economizing problem
of scarcity:
1. How much of a society’s resources should be used?
√ How much is a macro question!
2. What is to be produced?
√ Driven by costs—all costs including non-monetary opportunity costs
√ Driven by profits—normal and economic profits
√ Profits are signals to new firms to enter an industry to “catch the profits”
√ Losses are signals to firms to exit an industry to “cut their losses”
√ Consumer Sovereignty means that consumer demand drives the market because
ultimately they pay and use their dollar votes to alert the sellers what is demand.
3. How is that output to be produced?
√ Organizing production covers three areas:
* How should resources be allocated among industries?
* What specific firms should do the producing?
* What combinations of resources—what technology should each firm employ?
√ Most efficient production will mean use of available technology (combinations of
resources) and the prices of the needed resources.
√ Most efficient production is the least cost method.
4. Who is to receive the output?
√ Prices perform a rationing function in the distribution of goods and services.
√ Distribution to those willing and able to purchase depends on the income of buyers.
√ Size of Income depends on supply and prices in the resource market and the quantity
of resources the buyer possess.
5. Can the system adapt to change?
√ Markets are dynamic because demand and supply are constantly changing. Consumer
demand shifts with tastes, incomes, and prices of other goods. Supply changes as the
quantity of resources changes
√ Price perform a guiding function as it directs firms to see the changes that occur in
both demand and supply.
√ Market system provides incentive for technological progress which lowers consumer
prices and make more efficient use of resources. Entrepreneurs use their “dollar
votes” for capital goods to spur these gains from technology.

In summary:
• Adam Smith’s idea of the “invisible hand” in The Wealth of Nations means that there
is a unity between private and social interests.
• Businesses use the most efficient means of production by choosing the least-cost
combination of resources in their pursuit of profit.
• Consumers allocate their limited income to best satisfy their own self-interest expressed as
utility.
• Efficiency, incentives and freedom are the essential virtues of the market system.

9
AP Microeconomics
Chapter 6 p. 107-110

Specialization and Comparative Advantage

Specialization and trade increases the productivity of a nation’s resources and allows for
larger total output.

Why do people trade?

√ Both parties gain. Just as individual specialize so do nations and the result is greater output and
income.
√ Why does a school hire a teacher who has a degree in teaching? To gain the greatest benefit for
the students in their educational pursuit. The teacher teaches to satisfy a need for income and to gain a
good feeling about the employment.
√ Why does the U.S. import bananas? U.S. farmers could grow bananas but it would be very
expensive. They gain more by growing wheat and trading for bananas. Our resources are better suited to
growing wheat so we specialize.

What is comparative advantage?

√ Comparative Advantage is the ability to produce an item at a lower
opportunity cost. Resources are scarce, so that one can only produce more of one
product by taking the resources away from another.
√ Example with data:
Chipland and Entertainia are the two nations that currently produce their own Computer Chips and CD Players.
Production without Trade
Product Chipland Entertainia
1 Computer Chip 5 hours 24 hours
1 CD Player 10 hours 12 hours
Total 15 hours 36 hours

Note that Chipland uses less time (15 hours) to produce both and Entertainia uses more time (36 hours)
to produce both. Chipland enjoys an Absolute Advantage, an ability to produce an item with fewer resources.
Why would Chipland care about trade?

Opportunity Cost of production

Chipland Entertainia
1 Computer Chip 1/2 CD Player 2 CD Players
1 CD Player 2 Computer Chips 1/2 Computer Chip
The table shows that Chipland has a comparative advantage in Computer Chip production while
Entertainia has the comparative advantage in the production of CD Players.
These nations can benefit from trade.
Production With Trade
Chipland Entertainia
1 Computer Chip for Chipland 5 hours 1 CD Player for Entertainia 12 hours
1 Computer Chip for Entertainia 5 hours 1 CD Player for Chipland 12 hours
Total 10 hours 24 hours

In summary:
Specialization based on comparative advantage improves global resource allocation. The
same total inputs of world resources and technology result in a larger global output.

10
AP Microeconomics
Chapter 3 p. 42-53

Markets and Prices

Product Markets:
√ A product market is the different transactions through which finished goods and services are
exchanged for consumption expenditures.
√ In the circular flow diagram, the flow of products from businesses to consumers constitutes the
product market.
√ Businesses are the suppliers of the products and households are the demanders for the products.
Sellers of consumer goods and services meet those who want to buy finished goods and services.

Factor Markets:
√ A factor market involves businesses and the resources they need to purchase to produce goods
and services.
√ In the consumer flow diagram, the resources owned by households are exchanged with
businesses for income.
√ Businesses are the demanders of the resources and households are the suppliers of the
resources. The sellers of land, labor, capital and entrepreneurship meet the people who need their
resources.

In both markets, buyers and sellers determine certain price and certain quantity that are
mutually acceptable.

DEMAND
√ Demand is one side of a product or factor market.
√ The buyers (business in factor, households in product) exhibit both willingness and ability to
purchase goods and services. Their willingness and ability to purchase vary in response to price.
√ Demand is a record of how people's buying habits change in response to price. It is a
whole series of quantities that consumers will buy at the different prices level at which they will
make these purchases.
√ Hence, a demand schedule:
PRICE QUANTITY
P
$ 5 9 $5
4 10
3 12 4
2 15
1 20 3
Next, a demand curve can be 2
Demand
derived. The axes of the graph are
price (vertical) and quantity 1
(horizontal). Each price and
quantity pair becomes a pair of 9 10 12 15 20 Q
coordinates for a demand curve.

Foundation of the Law of Demand

√ For most goods and services, demand tendencies are predictable. As the price goes down,
quantity goes up. This inverse relationship is called the law of downward -sloping demand.
√ Three arguments to apply for the reasoning behind this law are:
• Price is an obstacle to most and it makes sense to buy less at higher prices. The fact of “sales” is
the key.
• In any time period, consumer will derive less satisfaction (utility) from each successive unit of a
good consumed. This is Diminishing Marginal Utility. Marginally, that is, each successive unit brings less
utility and consumer will only buy more at lower prices.

11
 • At higher prices, consumers are more willing and able to look for substitutes. The substitution
effect suggests that at a lower price, consumers have the incentive to substitute the cheaper good for the
more expensive.
• A decline in the price of a good will give more purchasing power to the consumer and he can buy
more now with the same amount of income. This is the income effect.

Changes in Quantity demanded: Movement along the same demand curve caused by a change in Price!
P
$5 As the price changes, the quantity demanded
among the horizontal axis changes.
A movement from $5 to $4 causes the
4 Quantity demanded to move from 9 to 10
3 units.
2
Demand
1

9 10 12 15 Q 20
Change in Demand: The introduction of new price-quantity pairs on a demand schedule caused by a
change in one or several demand determinants. The entire demand curve moves (left or right) to a new
position because a different demand schedule was written.

P Now notice that a larger quantity is available

$5 than before at $5—15 units. This means that
buyers have changed their thinking about
price-quantity combinations.
4 Decrease
3
Increase
2
D3
1 D2
1
D
9 10 12 15 20 Q
What causes these changes?
Non-price determinants of demand are:
1) Income--having more or less to spend affects individual demand schedules. For normal goods, an
increase in income leads to a rightward shift in the demand curve. For inferior goods, an increase in
income leads to a leftward shift since these are usually low-quality items that people will avoid when they
have more to spend.
2) Utility (taste)--the use that a good or service provides can easily change and affect demand. What was
once perceived as useful or useless, stylish or ugly, healthy or dangerous now can become its opposite.
3) Complementary goods--the linkage of products' demand because they "work" with each other can
affect demand for each
4) Substitutes--when the prices of or preference for a substitute changes, demand for both products will
change.
5) Number of buyers --demand depends on the size of the market.
6) Price Expectations of Buyers—purchases may be postponed or rushed dependent on the expectations
of future price changes

12
SUPPLY
√ Supply is also one side of a product or factor market.
√ The sellers (business in product, households in factor) are selling finished goods or resources.
√ Supply is the amount of goods and services that businesses are willing and able to
produce at different prices during a certain period of time. Supply is a record of how business's
production habits change in response to price. It is a whole series of quantities that businesses
will offer at the different price levels.
√ Hence, a supply schedule:
PRICE QUANTITY P
$ 5 20 $5
4 15
3 12 4
2 10
1 9 3
Next, a supply curve can be 2
Supply
derived. The axes of the graph
are price (vertical) and quantity 1
(horizontal). Each price and
quantity pair becomes a pair of 9 10 12 15 20 Q
coordinates for a supply curve.

√ For most goods and services, supply tendencies are predictable. As the price goes down,
quantity offered decreases. From a business perspective, profit-seeking activities by businesses are
logical. Hence, sellers will pull back from a market where prices are low. This direct relationship is
called the law of upward-sloping supply.

Changes in Quantity supplied: Movement along the same supply curve caused by a change in Price!
P As the price changes, the quantity supplied
$5 among the horizontal axis changes.
4 A movement from $5 to $4 causes the
Quantity supplied to move from 20 to 15
3 units.
2 Supply
1

9 10 12 15 20 Q
Change in Supply: The introduction of new price-quantity pairs on a supply schedule caused by a change
in one or several supply determinants. The entire supply curve moves (left or right) to a new position
because a different supply schedule was written.
S1 Now notice that a larger
P S2 quantity is available than
$5
Decrease S 3 before at $3—20 units.
Increase This means that sellers have
4 changed their thinking
3 about price-quantity
combinations.
2
1

9 10 12 15 20 Q

13
What causes these changes?
The non-price determinants of supply are:
1) Production Costs--most important and most typical reason for change. The price of ingredients and
other capital goods, rent or labor could rise of all. New technology could make productions more or less
expensive. The law could relate to minimum wage or taxes.
2) Prices of Goods that use same Resources—a demand for a specific resource is increased when other
producers bid up the price in response to increased demand for their product
3) Change in Technology—new innovations in capital resources can change the average cost of
production.
4) Taxes and Subsidies—taxes increase costs; subsidies lower costs.
5) Future Price Expectations--producers' confidence in the future, difficult to quantify or justify
6) Numbers of Sellers--businesses enter and exit a market regularly based on a variety of reasons. More
or less producers will affect the supply of the product.
7) Time needed for Production—in market period, no additional product can be produced quickly; in
short run, only variable costs can be changed to produce more; in long run all costs are variable and any
amount of new resources can be added.

ACHIEVING EQUILIBRIUM
The prices at which both demand and supply curves intersect is the equilibrium price.

Supply See Key Graph p.

P 54 in text.
r
i
c p Equilibrium
e

Demand

q Quantity

√ Equilibrium is the price toward which market activity moves.

√ If the market price is below equilibrium, the individual decisions of buyers and sellers will
eventually push it upward. If the market price is above equilibrium, the opposite will tend to happen.
√ Depending on market conditions, immediately or in the future, price and quantity will move
toward equilibrium as buyers and sellers intuitively and logically carry out the laws of demand
and supply.

• The ability of the competitive forces of demand and supply to establish a price at
which selling and buying decisions are consistent is called the
Rationing Function of Prices.

14
AP Microeconomics
Chapter 3 p. 53-58

Changes in Supply, Demand and Equilibrium

Demand Only Changes

1
S P S1 P S1
P
P2

pe pe pe

D2 P 2
1
D1 D D1
D2
Qe Q2 Q Q2 Qe Q
Qe Q

Equilibrium Demand Increases Demand Decreases

P = Pe Supply Constant Supply Constant
Q = Qe √ P increases √ P decreases
√ Q increases √ Q decreases

Supply Only Changes

S2
S1 P S 1
P S1
P S P 2
2

pe pe pe

P2
D 1
D1 D1

Qe Q Qe Q2 Q Q2 Qe Q

Equilibrium
P = Pe Supply Increases Supply Decreases
Q = Qe Demand Constant Demand Constant
√ P decreases √ P increases
√ Q increases √ Q decreases

15
Complex Cases— you draw the scenarios given and show the effect on P
and Q! Be careful to change D and S by the same distance—remember this
is the theory! Be aware of Prices or Quantity Change as Indeterminate!
P S1 S1 P S1
P

pe pe pe

D1 D1 D1

Qe Q Qe Q Qe Q

Equilibrium Demand Increases Demand Decreases

P = Pe Supply Increases Supply Decreases
Q = Qe P _________ P _________
Q _________ Q _________

P S1 S1
P

pe pe

D1 D1

Qe Q Qe Q
Demand Decreases Demand Increases
Supply Increases Supply Decreases
P _________ P _________
Q _________ Q _________

This chart will summarize the effects on Pe and Qe

Change in Supply Change in Demand Effect on Pe Effect on Qe
Increase Increase

Decrease Decrease

Increase Decrease

Decrease Increase

16
AP Microeconomics
Chapter 20 p. 404-413

Elasticity
√ is a measure of how much buyers and sellers respond to changes in market
conditions.
√ allows us to analyze supply and demand with greater precision.

Price elasticity of demand

√ is the responsiveness of consumers to a change in the price of a product
√ The price elasticity of demand is computed as:
Ed = percentage change in the quantity demanded
the percentage change in price.
Q and P are the
Ed = ∆ in Q ÷ ∆ in P original amounts
Q P
√ Be sure to use absolute values and ignore the — sign; useful for comparing
different products.
√ Interpretation of Ed:
• Inelastic Demand —‰ Quantity demanded does not respond strongly to
price changes. Ed: is less than one.
• Elastic Demand—‰ Quantity demanded responds strongly to changes in
price. Ed: is more than one.
• Perfectly Inelastic—‰ Quantity demanded does not respond to price
changes at all.
• Perfectly Elastic—‰ Quantity demanded changes infinitely with any change
in price.
• Unit Elastic—‰ Quantity demanded changes by the same percentage as the
price. Ed: is equal to one.

√ Demand tends to be more elastic . . .

• if the good is a luxury.
• the longer the time period.
• the larger the number of close substitutes.
• the more narrowly defined the market.
√ Demand tends to be more inelastic . . .
• if the good is a necessity.
• the shorter the time period.
• the fewer the number of close substitutes.
• the more broadly defined the market.
√ Elasticity Varies with Price Range—more elastic toward top left; less elastic
at lower right P
Elastic Ed > 1 Slope does not measure
Elasticity—slope measures
absolute changes; elasticity
Unit elastic Ed = 1 measures relative changes.

Inelastic Ed >1

17
 Total Revenue Test for Elasticity
√ Total Revenue is the amount the seller receives from the buyer from the sale of a
product; P x Q = TR
√ Elasticity and total revenue are related; observe the effect on total revenue when
product price changes
• In 1992 people purchased about 20 million videos of Walt Disney’s
Beauty and the Beast at a price of about $25.

P
Total Revenue (A &
B) was $500 million.

$25
A B

20 Q
• Suppose the price increases, causing Q to drop.
P
$30 Now TR is A & C and is
C equal to $360 million.

A B

12 Q

√ If demand is elastic, then a decrease in price will increase total revenue; an increase
in price will decrease total revenue.
√ If demand is inelastic, then a decrease in price will reduce total revenue; an increase
in price will increase total revenue.
√ If demand is unit elastic, any change in price will leave total revenue unchanged.
Unit
T
o
t I
a E n
l l e
a Total Revenue
l Curve
R s a
e t s
v i t
e c i
n c
u
e
Quantity Demanded

18
AP Microeconomics
Chapter 20 p. 415-416

Cross Elasticity
√ measures how sensitive consumer purchases of one product (such as X) are to a
change in the price of some other product (say Y)
√ The Cross Elasticity Coefficient Exy is calculated:
Exy = % ∆ in Qd of X
% ∆ in P of Y
√ If Exy is positive, then X and Y are substitute goods.
√ If Exy is negative, then X and Y are complementary goods.
√ If Exy is zero, then X and Y are independent goods
√ Examples:
• Business firms worry about the effect of their demand when other firms
change their price.
• Governments consider in mergers that the products may be substitutes
for each other and hence competition may be decreased by the merger
agreement.

Income Elasticity
√ How responsive consumer purchases are to income changes is measured by
Income Elasticity of Demand.
√ Income Elasticity Coefficient
Yd = % ∆ in Q d
% ∆ in Y (income)
√ For most goods, changes in income and changes in quantity purchased on directly
related such that the coefficient has a value greater than zero. We call these goods “normal
goods.”
√ In other instances, people purchase less of some goods as their incomes increase.
These are called “inferior goods” and they have a negative coefficient.
√ Examples:
• This measurement helps to explain expansion and contraction of industries
in US; growth in the economy aids industries with high-income elasticity, like autos,
housing, and restaurant meals. Those industries not sensitive to income changes
(agriculture) will be slower in their expansion.

Think About This!

• Does Bus Transportation have a positive or negative Income Elasticity?

• Economists have observed that spending on restaurant meals declines more during
economic downturns than does spending on food to be eaten at home. How might this
concept explain this phenomenon?

• Is food in general positive or negative Income Elasticity? Are there exceptions?

19
AP Microeconomics
Chapter 20 p. 417-421

Government-controlled prices:
√ Not all markets are allowed to function freely. Government may set a price and
it may differ from the equilibrium price that the market sets.
√ This action will interfere with the “clearing function” which equilibrium
conditions create. A shortage (as in the case of a price that is below equilibrium) or a
surplus (as in the case of a price that is above equilibrium) is the result of these government
price setting actions.
• Economic behavior does not change when price floors and ceilings are set. People
will continue to make their best choices as they respond to the changes that alter
the costs and benefits of the decision. Since people make decisions usually in
predictable ways, we can predict consequences of the price-setting laws.

Price Ceilings
√ A maximum legal price below the equilibrium price
S √ Creates a shortage since amount demanded
P will be greater than the amount supplied
pe
CEILING
shortage D

Qs Qe Qd Q
√ Examples: essential goods, rent controls, interest rates, price controls
√ Read examples p. 417-419
√ Solutions to alleviate shortage?
• First-come/first-served • favoritism
• Rationing • black markets

Price Floors
√ A minimum legal price above equilibrium price
√ Supported by authority like government
S
P surplus
FLOOR
pe
Creates surplus since the amount supplied
D is greater than the amount demanded

Qd Qe Qs Q
√ Examples: minimum wage, price supports on agricultural products
√ Solutions to alleviate surplus?
• Government give-away programs • Incentive not to plant crops

22
 A Variety of Demand Curves showing different elasticities
P P
D

An increase
in price D
leaves Qd
unchanged At any price above
the Price noted, Qd is
unlimited.

Perfectly Inelastic Q Perfectly Elastic Q

Demand Demand
Ed = 0 Ed = Infinity

P P
% change in Qd is
% change in Qd is greater than %
less than % change change in P
in P

D
D

Relatively Inelastic Q Relatively Elastic Q

Demand Demand
Ed < 1 Ed > 1

D
% change in Qd is
equal to % change in
P

Unit Elastic Demand Q

Ed = 1

20
 A Variety of Supply Curves showing different elasticities
S
P P

An increase
in price S
leaves Qs
unchanged At any price above
the Price noted, Qs is
unlimited.

Perfectly Inelastic Perfectly Elastic Supply

Supply Q Es = Infinity Q
Es = 0

P S P
S

% change in Qs is
less than % change % change in Qs is
in P greater than %
change in P

Relatively Inelastic Q Relatively Elastic Q

Supply Supply
Es < 1 Es > 1

P
S

% change in Qs is
equal to % change in
P

Unit Elastic Supply Q

Es = 1

21
AP Microeconomics
Chapter 21 p. 424-425

Explanations of the Law of Demand

1. The Income and Substitution Effect combine to make a consumer able and willing to
buy more of a specific good at a low price than at a high price.

• Income effect is the Impact of a change in the price of a product has on a consumer’s real
income and consequently the quantity of the produce demanded.

• Substitution effect is the Impact of a change in the product’s price has on its relative
expansiveness, and consequently on the quantity demanded.

2. Law of Diminishing Marginal Utility can be stated as the more a specific product
consumer obtain, the less they will want more units of the same product.

• Utility is want-satisfying power— it is the satisfaction or pleasure one gets from

consuming a good or service. This is subjective notion. How?
• Total Utility is the total amount of satisfaction or pleasure a person derives from
consuming some quantity
• Marginal Utility is the EXTRA satisfaction a consumer realizes from an additional unit of
that product.

T
o
t Total Utility increases at a
a TU diminishing rate, reaches a
l maximum and then
u declines.
t
i
l
i
t Unit Consumed
y
M Marginal Utility diminishes
a with increased consumption,
r becomes zero where total utility is
g at a maximum, and is negative
I when Total Utility declines.
n
a
l

U
MU See Key Graph p. 427
t
in Text.
I
l Unit Consumed
I
t When Total Utility is at its peak, Marginal Utility is below zero.
y Marginal Utility reflects the change in total utility so it is negative when
Total Utility declines.

23
AP Microeconomics
Chapter 21 p. 428-431

Theory of Consumer Behavior

Consumer Choice and Budget Restraints
• Rational Behavior—derive the greatest satisfaction
• Preferences—based on marginal utility
• Budget Restraints—money income is limited
• Prices—signal scarcity, consumer must compromise

Utility-Maximizing Rule—Consumer Equilibrium

• The consumer’s money income should be allocated so that the last dollar spent on each
product purchased yields the same amount of marginal utility.
• The rational consumer must compare the extra utility with its added cost.

Utility-Maximizing with Income of $10

Units Product A $1 Product B $2
MU or utils MU/$ MU or utils MU/$
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2

Allocation Rule: consumer will maximize satisfaction when he allocates money income so
that the last dollar spent on A, on B, etc. will yield equal amounts of marginal utility.
MU of Product A = MU of Product B
Price of A Price of B
How many of A and how many of B? What is the combinations of A and B that can be
had with $10?
Answer: 2 units of A and 4 units of B
MU of Product A = MU of Product B
Price of A Price of B
8 = 16
$1 = $2

Think About this!

√ Reading the applications and extensions on page 432-435 including the Last Word, think
in terms of marginal utility and consumer choice.

√ In the last decade or so there has been a dramatic expansion of small retail convenience
stores (7-Eleven, Qt’s, Casey’s for example), although their prices are generally higher than those
at large supermarkets. Can you explain their success?

24
AP Microeconomics
Chapter 22 p. 444-446

Costs of Production
√ All firms incur costs and those costs help determine how much a firm will
produce as well as how high the price of the good or service will be. The area of economics
which deals with production and pricing decisions firms make as well as other conditions in
markets is called Industrial Organization.

What are Costs?

The goal of a firm is to maximize its Profits. Profits are Total Revenue
minus Total Costs. Total Revenue is Price times Quantity.

• ECONOMIC COSTS—payments a firm must make, or income it must pay to resource

suppliers to attract those resources from alternative uses. This would mean all the
opportunity costs.
• EXPLICIT payments to outsiders for labor, materials, services, fuel,
transportation services, power, etc. Usually means an outlay of money.
• IMPLICIT costs of self-owned, self-employed resources

ACCOUNTING PROFIT ECONOMIC PROFIT

Revenues — Explicit Costs Revenue—Explicit and Implicit Costs

Economic Profit is often called “the pure profit”. It keeps the entrepreneur in place
and is the real reward for the risk-taking aspect of Entrepreneurship.

Short Run—FIXED PLANT

√ Period of time too brief for firm to alter its plant capacity
√ Output can be varied by adding larger or smaller amounts of labor, materials, and
other resources.
√ Existing plant capacity can be used more or less intensively

Long Run—VARIABLE PLANT

√ Period of time extensive enough to change the quantities of ALL resources
employed, including plant capacity.
√ Enough time for existing firms to dissolve and exit the industry OR for new firms
to form and enter the industry.

25
AP Microeconomics
Chapter 22 p. 447-450

Short Run Relationships

Terms
√ Total Product
• total quantity or total output of a good produced
√ Marginal Product
• extra output or added product associated with adding a unit of a variable
resource
• change in total product OR ∆ in TP
change in labor input ∆ in labor input
√ Average Product
• the output per unit of input , also called labor productivity
• equals total product
units of labor

Law of Diminishing Returns

√ as successive units of a variable resource are added to a fixed resource beyond
some point the extra or the marginal product will decline
√ if more workers are added to a constant amount of capital equipment, output will
eventually rise by smaller and smaller amount.

(1) Units (2) (3) (4) TP

of a Total Marginal Average
variable Product Product Product
resource ∆ in 2 / ∆ in 1 2 / 1
(labor)
TP
0 0 -----
1 10 10 Increasing 10
15 Marginal Returns
2 25 12.5
3 45 20 Diminishing 15 See Key Graph
15 Marginal p. 449 in Text
4 60 15
10 Returns
5 70 14
5
6 75 0 Negative 12.5
7 75 -5 Marginal 10.71 Quantity of Labor
8 70 Returns 8.75
MP
Note that the marginal product intersects Increasing
the average product at its maximum Marginal Returns
Negative
average product. Marginal Returns

When the TP has reached it maximum, Diminishing

the MP is at zero. Marginal
Returns AP
As TP declines, MP is negative.

Quantity of Labor
MP

26
AP Microeconomics
Chapter 22 p. 450-455
Short Run Costs
√ FIXED COSTS costs which in total do not vary with changes in the output; costs which
must be paid regardless of output; constant over the output
examples—interest, rent, depreciation, insurance, management salary
√ VARIABLE COSTS costs which change with the level of output; increases in variable
costs are not consistent with unit increase in output; law of diminishing returns will mean more
output from additional inputs at first, then more and more additional inputs are needed to add to
output; easier to control these types of costs
examples—material, fuel, power, transport services, most labor
√ TOTAL COSTS are the sum of fixed and variable. Most opportunity costs will be
fixed costs.
√ PER UNIT OR AVERAGE COSTS can be used to compare to product price
AFC = TFC/ Q AVC = TVC/Q ATC = TC/Q (or AFC + AVC)
√ MARGINAL COSTS the extra or additional cost of producing one more unit of output;
these are the costs in which the firm exercises the most control
MC = Change in TC / Change in Q

• AFC declines as output increases • AVC declines initially, then reaches a

P/C MC ATC minimum, then increases (a U-shaped
curve)
• ATC will be U-shaped as well
AVC • MC declines sharply, reaches a
minimum and then rises sharply.
AFC • MC intersects with AVC and ATC at
minimum points
See Key Graph Q √ When MC < ATC, ATC is falling
p. 454 √ When MC > ATC, ATC is rising
There is no relationship between MC and AFC

SHORT AND LONG RUN COSTS

√ COSTS are related to types of adjustments a firm can make—“time” is a factor.
A
T
C Economies Diseconomies of
of Scale Scale

Constant Returns
to Scale

Q
√ Economies of scale (downsloping portion)—as plant size increases a number of
factors will lead, for a time, to average costs declining. Labor specialization, managerial
specialization, efficient capital and certain other kinds of cost like “start-up” and advertising.
√ Constant Returns to Scale—long run-costs due not change
√ Diseconomies of Scale (upsloping portion)—caused generally by the difficulty of
efficiently controlling a firm’s operations as it becomes a large-scale producer.

27
AP MicroEconomics
Chapter 23 p. 467-468
Characteristics of Markets
Purely Monopolistic Oligopoly Pure Monopoly
Competitive Competitive

Number of Very large number Large number of A few large A single producer
firms of businesses businesses businesses
Type of Standardized Differentiated Standardized or Unique; no
Product Differentiated substitutions
Ability to Set None. Market Some. The degree of More. Sellers can Most. Seller is
Price determines price differentiation will act as monopoly only source of
and the seller is the affect the ability of setting price or product and can
Price Taker. the seller to set sellers can act act like Price
price. independently and Maker.
ability to set price
is determined by
differentiation.
Product None. Products are Varies depending on Varies. Some None. Product is
Differentiation identical. the industry. industries may be unique.
Differences may be identical; others
subtle. may be
differentiated.
Ease of Entry Relatively easy to Relatively easy to Difficult. High Very difficult.
start a new start a new business start-up costs. Significant
business. barriers to entry.
AP Microeconomics
Chapter 23 p. 468-477

A Competitive Market is one with many sellers trading identical (standardized)

products so that each buyer and seller is a price taker. There are no barriers so firms can
freely enter and exit the industry and there is not non-price competition.

Demand as seen by a Purely Competitive Firm

√ PC firms are price takers; they are one firm among thousands and they have no effect on
the price—they are price-takers. These firms must accept the price predetermined by the market.
√ Technically, the demand curve of the individual firm is perfectly elastic—the firm
cannot obtain a higher price by restricting its output; it does not have to lower its price to increase
sales.
1 2 3 4 The Revenue of a Competitive
Quantity Price Total Marginal Firm
Revenue Revenue √ These firms want to maximize
profits by finding the output that gives
Q P Q x P ∆ TR / ∆ Q the most profit (TR—TC).
0 $131 0 $131 √ The firm is a price taker and hence
1 $131 $ 131 $131 will only be able to sell its product at the
given price. They can sell any or none of
2 $131 262 $131 the product for the given price.
3 $131 393 $131 √ This table shows that in columns
4 $131 524 $131 1 and 2. The Total Revenue derived is
shown in Column 3.
5 $131 655 $131 √ Marginal Revenue is the change in
6 $131 786 $131 total revenue from an additional unit sold in
7 $131 917 $131 Column 4.
8 $131 1048 $131
9 $131 1179 $131
10 $131 1310 $131

Price TR
&
Revenue

P = MR because each
additional sale brings the
price as revenue—never more,
never less.

$131 D = MR

Quantity Demanded (sold)

29
Profit Maximization in the Short Run
Total Revenue, Total Cost Approach
√ A PC firm can maximize its profits only by adjusting its output. In the short run, only
variable costs can be changed, not fixed costs.
√ Profit is the difference between TC and TR. See the data in this table.
1 2 3 4 5 6
Quantity Total Total Total Total Profit or
Fixed Variable Costs Revenue Loss Profit is
Costs Costs maximized at
Q Q x P TC FC+VC TR TR—TC 9 units of
output where
0 $100 $0 $100 $0 $—100
$299 is earned.
1 $100 90 190 131 —59 Total Costs are
2 $100 170 270 262 —8 $880; Total
3 $100 240 340 393 53 Revenue is
4 $100 300 400 524 124 $1179.
5 $100 370 470 655 185
6 $100 450 550 786 236
7 $100 540 640 917 277
8 $100 650 750 1048 298
9 $100 780 880 1179 299
10 $100 930 1030 1310 280

T T
C R
T
R
P=$131
$1179
Greatest Profit
$880

9
Q demanded (sold)

Think About This!

√ Why does the purely competitive firm not sell above the market price?

√ Why does the purely competitive firm not sell below the market price?

30
Profit Maximization in the Short Run
Marginal Revenue, Marginal Cost Approach
√ Marginal Analysis as noted in Chapter 1 is a better, more precise approach to discovery of
the profit maximizing output.
√ The MR=MC rule will determine the profit maximizing output. Observe the data in the
table:
1 2 3 4 5 6 7
Quantity Average Average Average Marginal Price= Profit
Fixed Variable Total cost Marginal or
Costs Costs Costs Revenue Loss
Q AFC AVC ATC MC P=MR TR—T
C
0 $—100
1 $100 $90 $190 $90 $131 —59
2 50 85 135 80 $131 —8
3 33.33 80 113.33 70 $131 53
4 25 75 100 60 $131 124
5 20 74 94 70 $131 185
6 16.67 75 91.67 80 $131 236
7 14.29 77.14 91.43 90 $131 277
8 12.50 81.25 93.75 110 $131 298
9 11.11 86.67 97.78 130 $131 299
10 10 93 103 150 $131 280

√ Note here that the firm can maximize its profits where MR = MC. This is the point
of intersection.
√ This determines the output of 9 units. This position also determines the Price of $131
and the cost per unit of $97.78. This is per unit profit of $33.22. That makes the total profit $299.
√ This is the short run since there is an AVC curve shown.

P Se Key Graph p. MC
475 MR=MC
ATC

P=$131 P=MR=AR
Profit
ATC= AV
$97.78 C

$97.78

Q
Q=9
%

31
Loss Minimizing for the Competitive Firm
√ Is there a situation that a firm will choose to produce at a loss?
√ The firm will produce at any output for which it covers all of its variable costs even if it
does not cover its fixed costs. Think about the reason why?

• Suppose the price dropped to $81, but the costs were the same. MR now is $81 and MC is the
same for each quantity of output. The firm will choose to produce 6 units and lose $64, because it
would lose $100 if it chose to produce none. Six units will result in the minimum loss under these
price conditions.

1 2 3 4 5 6 7
Quantity Average Average Average Marginal Price= Profit
Fixed Variable Total cost Marginal or Loss
Costs Costs Costs Revenue
Q AFC AVC ATC MC P=MR TR—T
C
0 $—100
1 $100 $90 $190 $90 $81 —109
2 50 85 135 80 $81 —108
3 33.33 80 113.33 70 $81 —97
4 25 75 100 60 $81 —76
5 20 74 94 70 $81 —65
6 16.67 75 91.67 80 $81 —64
7 14.29 77.14 91.43 90 $81 —73
8 12.50 81.25 93.75 110 $81 —102
9 11.11 86.67 97.78 130 $81 —151
10 10 93 103 150 $81 —220

ATC
ATC=$91.67 MC
P

AV
LOSS C
P=$81 P=MR=AR

MR=MC

Q=6 Q

How long will the firm choose to produce at a loss? As long as it covers
its variable costs and at least some of its fixed costs!

32
 Shut Down Case
√ Drop the price to $71 and find that no quantity can bring enough revenue to cover cost
ATC
MC
P

AV
C

P=$71
P=MR=AR

MR=MC

Q
√ The price of $71 is below every ATC. There is no level of output at which the firm can
produce and realize a loss smaller than its total fixed costs of $100.

1 2 3 4 5 6 7
Quantity Average Average Average Marginal Price= Profit or
Fixed Costs Variable Total Costs cost Marginal Loss
Costs Revenue
Q AFC AVC ATC MC P=MR TR—TC
0 $—100
1 $100 $90 $190 $90 $71 —119
2 50 85 135 80 $71 —128
3 33.33 80 113.33 70 $71 —127
4 25 75 100 60 $71 —116
5 20 74 94 70 $71 —115
6 16.67 75 91.67 80 $71 —124
7 14.29 77.14 91.43 90 $71 —143
8 12.50 81.25 93.75 110 $71 —182
9 11.11 86.67 97.78 130 $71 —241
10 10 93 103 150 $71 —320

Think About This

√ Why is the equality of marginal revenue and marginal cost essential for profit
maximization in all market structures?

√ Explain why price can be substituted in the MR=MC rule when an industry is purely
competitive.

33
AP Microeconomics
Chapter 23 p. 478-480

Marginal Cost and SR Supply Curve—Purely competitive firm

√ Any price below the minimum AVC as in the Shutdown case (below $74.00) will
force the firm to shutdown. (such as point a)
√ At a price of $74.00 a firm will just cover the AVC, yet still lose the Fixed Cost.
Here the firm would be indifferent as to operating or not. (point b)
√ A price where the MC crosses the ATC (about 91.00) shows the break-even point
for the firm (point d). Here the total revenue covers the total costs (including normal profit).
√ At any MC point above the ATC, profits will be generated. (such as point e).
√ Each of the various MR=P=D intersection points indicates a possible production price
and corresponding quantity. These points locate the supply curve of the competitive firm.

See Key Graph ATC

p. 479 in Text

MC
C
o e
P5 Break-even Point MR5
s Normal Profit
t AVC
d
s
P4 MR4
&
R
e c MR3
v P3 Shutdown Point
e b
n MR2
u P2
a
e MR1
P1
s

Q1 Q2 Q3 Q4

Quantity supplied
√ Because nothing will be produced at any price below the minimum AVC, we
conclude that the portion of the firm’s MC curve which lies above its AVC curve is
the SHORT-RUN SUPPLY CURVE.

√ Because of the law of diminishing returns, marginal costs eventually rise as more
units are produced. So…a PC firm must get higher and higher prices to entice it to
produce additional units of output.
√ Higher product prices and marginal revenue encourage a PC firm to expand
output. As it expands, its MC rises as a result of the law of diminishing returns. At some
now greater output, this higher MC now equals this higher P=MR and profit is
again maximized but at a greater output.

34
Supply Curve Shifts
√ Supply shifts for the reasons stated in Chapter 3, among them changes in costs
and technology. Since the MC above the AVC is the Supply curve, it can shift when costs
change.
P MCMC ATC 1
& 1
2
ATC 2
C In this case of a decrease in
AVC and hence ATC, the
AVC1
AVC2 MC moves to MC2 and
shows that the Quantity
increases to Q2

Q1 Q2 Q
Supply shifts to right to
show a decrease in costs.

Summary of Approaches to Determining the

Profit Maximizing Output

Total Revenue-Total Cost Marginal Revenue-Marginal Cost

Should the YES, if TR exceeds TC or YES, if price is equal to, or
Firm produce? if TC exceeds TR by some greater than minimum than
amount less than fixed cost. AVC.

What quantity TR over TC is a maximum or Produce where MR or price equals MC.

should be where the excess of TC over
produced to TR is a minimum (and less
maximize than total fixed costs).
profit?

Will production YES, if TR exceeds TC. YES, if price exceeds ATC

result in NO, if TC exceeds TR. NO, if ATC exceeds price.
economic
profit?

Think about This!

√ Why would a firm ever want to produce an output on which it takes a loss?

35
AP Microeconomics
Chapter 23 p. 481-484
Firm and Industry
√ Market price is determined by the demand and supply for a particular product. In
the discussion above, the firm was the price taker—taking it from the market.
√ To determine the market equilibrium price, and output, the total supply data must be
used with the total demand data. This is the industry data.
1 2 3 4
Q S single firm total Q S Product Price Total QD
1000 firms
10 10000 $ 151 4000
9 9000 131 6000
8 8000 111 8000
7 7000 91 9000
6 6000 81 11000
0 0 71 13000
0 0 61 16000
Profit Maximization in the Long Run
• Assume:√ Only adjustment in this analysis is the entry and exit of new firms
√ All firms have identical cost curves
√ Industry is cost-constant (entry and exit will not affect resources prices)
• Conclusion:
√ When long-run equilibrium is achieved, product price will be exactly equal to
minimum ATC and production will occur at that level of output.
√ Why? • Firms want profits • When prices rise, profit appear—new firms enter
• Increased supply will drive price back down to minimum ATC.
• When prices fall, losses result and firms will exit
• Decreased supply will result in price moving back to min. ATC
Ø In the short run, firms can earn economic profits if the price from the market is above
the average total cost. The gray shaded area on the firm graph is the profit. The output is
found where MR=MC, and the price come from the market.
MC
ATC
P S P MR=MC

Pe MR=P=D
AVC

Qe Q q Q

Market Firm

36
 Ø In the short run, firms can earn suffer losses if the price is below the total average
cost. Perhaps the price in the market falls (as in this example, demand falls) or costs for the firm
rise. They will continue to operate if the price is greater than the average variable costs. In the
short run, variable costs can be changed to affect changes in this loss situation.
MC
ATC
P S P

MR=MC
Pe MR=P=D

MR2=P2=D
AVC
2
D
D
Qe Q q Q

Market Firm

Ø If the price falls below the average variable costs at all levels of output, the firm must
shut down since it cannot even cover its fixed costs. Price has fallen in the market or the
firm’s costs have risen. In this example, new firms enter and force the firm to shut down.
MC

S ATC
P P
S2
Pe MR=P=D

MR2=P2=D
D
Qe Q Q

Market Firm

37
Ø In the long run, after all the changes in the market (more demand for the product, firms
entering in search of profit, and then firms exiting because economic profits are gone), long
run equilibrium is established. In the long run, a purely competitive firm earns only normal
profit since:
MR=P=D+MC at the lowest ATC
Both Allocative and Productive efficiency!

MC
P ATC

Pe P=D=MR=AR

Qe Q

38
AP Microeconomics
Chapter 23 p. 484-490
Short run supply curves are derived from the MC portion above the AVC. In the
long run, the supply curve has industry characteristics based on the influence that changes
in the number of firms in the industry have on the costs of the individual firms.

Long-Run Supply for Constant -Cost Industry

√ Entry of new firms does not affect resource prices. Graphically, the position of
the long-run average cost curves of individuals firms does not change.
√ Why? When the industry’s demand for resources is small in relation to the total
demand for those resources. This is most likely in industries that employ unspecialized
resources which are being demanded by many other industries.
√ The long-run supply curve of a constant-cost industry is perfectly elastic.
P

D3 D1 D2

Q3 Q1 Q2 Q

Long-Run Supply for Increasing-Cost Industry

• Average cost curves shift upward as the industry expands and downward when the
industry contracts. Entry of new firms will bid up resource prices and raise unit cost.
• This happens in industries using specialized resources whose initial supply is not
readily augmented. They are using a significant portion of some resource whose total
supply is not readily increased.
• Result: Two- way squeeze on profits
√ New entry will increase supply, lowering price
√ average cost curve will shift upward
• Long -run industry supply curve is upsloping.

P S

D3 D1 D2

Q3 Q1 Q2 Q

Think About This!

√ Is there the possibility of a long run supply curve for a decreasing cost industry?
√ What would be its characteristics?

39
Pure Competition and Efficiency
MC
P ATC

Pe P=D=MR=AR
P = MC = minimum ATC
(normal profit only)

Qe Q
This triple equality shows that a purely competitive firm cannot earn
economic profit in the long run; it can earn normal profit.
In terms of efficiency, two types emerge from this diagram.
Allocative Efficiency
√ Resources are allocated among firms and industries to obtain the particular mix of
products most wanted by consumers
√ The money price of any product is society’s measure or index of the relative
worth of that product at the margin. Hence, the MC of producing a product is the value, or
relative worth of the other goods the resources used could otherwise have produced.
√ P = MC is efficient
√ The money price of any product is really the measure of its Marginal Benefit
(MB); the purely competitive firm P equals the MC. But, at times…
• P>MC underallocation of resources to this product: society values
additional units of this product more highly than alternative ones that the resources could
produce. MB<MC
• P < MC overallocation of resources to this product: society is
sacrificing products it would value higher than the ones being produced with the available
resources: MB>MC

Productive Efficiency
√ Each good must be produced in the least costly way
√ When firms produce most efficiently, they will do so at the least cost point.
√ For consumers, this is desirable; firms must use the best available (least cost)
technology or they will not survive.
√ P = minimum AC

Dynamic Adjustment
√ A change in demand or supply will disrupt the allocative efficiency and change the
alignment of resource use. This is will have an effect on price, output and profit.
Expansion and contraction of the industry will eventually move to a new output and cost
structure so that P=MC and allocation efficiency is restored.

“Invisible Hand”
√ It organizes the private interests of producers in a way that is in accord with
society’s interest in using scarce resource efficiently.

40
Qualification for the Purely Competitive Firms
√ Market Failures: Spillovers and Public Goods
• Firms in seeking profits will only produce at the efficient level if they can
generate said profit. A big “IF”!
• Some goods will never be produced by private interest, hence the need for
public goods. These cannot be priced or shared consumption of one the characteristics.
√ Economies of Scale
• We assumed that PC firms operated at their optimal size.
• Not all firms are large enough to be efficient; their optimum size is larger
then their operation.
√ Technological Advance
• Some economists argue that PC firms do not have incentive for research
and development since they earn no economic profit in the long run.
√ Range of Consumer Choice
• Pure competition means standardized products; imperfect competition
offers diversification of product lines, varying quality and styles—more choice.

Think About This!

√ Why is the equality of marginal revenue and marginal cost essential for
profit maximization in all market structures?

√ Why can price be substituted for marginal revenue in the MR=MC rule
when an industry is purely competitive?

41
AP Microeconomics
Chapter 24 p. 493-98

Monopoly characteristics and Barriers to Entry

Monopoly exists when a SINGLE firm is the sole producer of a product for which there
are no close substitutes.
√ single seller—industry and firm synonymous
√ no close substitutes—unique product; no reasonable alternative
√ price maker—firm exercises considerable control over price
√ some degree of nonprice competition, generally advertising
√ blocked entry—barriers to entry created by monopolist or government
Examples:
I. Government-owned monopolies—TVA power, municipal water
II. Regulated monopolies—gas, electric, water, cable, phone
III. Private Unregulated monopolies—De Beers Diamond Syndicate,
Professional Sports Leagues
IV. Local monopolies—airline, bank, movie, bookstore
Importance of Monopoly
√ 5 to 6 % of domestic output √ study will lead to better understanding
of other types of imperfect competition
Barriers to entry:
1. Economies of Scale: Costs
√ Large Scale Production is efficient
2. Public Utilities: natural monopolies
√ Competition is impractical, inconvenient, or unworkable
√ Natural Monopoly is the extreme example in which market demand
curve intersects the long run ATC where the ATC is still declining.
P/C More on this later.

ATC

Q
3. Legal Barriers: patents and licenses
√ patents awarded by government to encourage research; historically,
patents were for 17 years, 1995 GATT agreement made it standard 20 years
worldwide.
√ Licenses given to guarantee safety or limit competition so that economic
profit can be earned in order for the product to be provided by the private
sector.
4. Ownership of Raw material
√ Using the concept of private property rights, ownership of necessary
material can block others
5. Pricing and Other Strategic Barriers
√ lowering price or aggressive advertising
√ Aggressive Cutthroat tactics:
• product disparagement
• pressure on resource supplier
• aggressive price cutting
• dumping

42
AP Microeconomics
Chapter 24 p. 498-501
Unregulated Monopoly
Assumptions:
√ Monopoly status secured by patents, economies of scale or resource ownership
√ Firm is not regulated
√ The firm is a single-price monopolist charging the same for all units of output.
Demand Curve:
√ Firm is the industry so it can dictate price, but demand is not perfectly elastics, so the
demand curve is downsloping.
1 2 3 4 5 6 7 8
Quantity Price Total Marginal Average Total Marginal Profit
Revenue Revenue Total Cost Cost or Loss
Costs
Q P=AR PxQ=TR MR FC+VC TC MC TR—T
C
0 $172 $0 $100 $100 $—100
1 162 162 162 190 190 90 —28
2 152 304 142 135 270 80 34
3 142 426 122 113.33 340 70 86
4 132 528 102 100 400 60 128
5 122 610 82 94 470 70 140
6 112 672 62 91.67 550 80 122
7 102 714 42 91.43 640 90 74
8 92 736 22 93.75 750 110 —14
9 82 738 2 97.79 880 130 —142
10 72 720 -18 103 1030 150 —310

√ Why does unregulated monopoly face a downward sloping Demand Curve? To

sell more of his goods, the monopolist knows that he must lower his price. This puts a constraint of
his ability to profit from his market power. This is why a monopolist does not charge the highest
price he wants! Instead he charges the highest price he can!

P √ If Demand is
downsloping, so is
$142, 3 units Marginal Revenue.
$142 Loss = $30
$132, 4 units Observe the data and see that
$132 the marginal revenue is
below the price.
√ When selling 4 units at
D $132, he gains $132 in
marginal revenue though he
must subtract the $30 he lost
Gain = $132 by lowering the price.
√ So…the marginal revenue
of the 4th unit is $102.

3 4 Q

43
AP Microeconomics
Chapter 24 p. 501-504

Output and Price Determination for Unregulated Monopoly

√ Using the revenue and cost data given in the last pages, we can construct a graph
for an unregulated monopoly.

P See Key Graph

p. 502
MC

$122 P ATC
Profit
$94 Unit
Cost MR=MC

D
Q
5 MR Q
√ Note that the MR=MC rule is used to determine the output quantity of 5 units.
√ The MR=MC quantity line is drawn upward to where it intersects with the
demand curve to find the price.
√ Total economic profit is: Per unit profit ($122—94) times Quantity (5) —$140
√ There is no supply curve for the pure monopoly firm; there is no unique
relationship between price and quantity supplied. The monopolist does not equate price
with marginal cost so it is possible for different demand conditions to bring different prices
for the same output.

Steps for Graphically determining profit-maximizing output, price and economic

profit for pure monopoly
Step 1 Use the MR=MC rule to determine output.
Step 2 Extend the vertical line upward from the quantity to the
demand curve to determine the price.
Step 3 Use one of two methods to determine the economic profit
√ Per unit profit times quantity = Economic profit
√ Total cost of output = ATC times Q
Total revenue of output = P times Q
TR—TC = Economic profit

Misconceptions
√ Not Highest price—selling at prices higher than MR=MC output will yield
smaller than maximum total profit.
√ Total not Unit Profit—seeking the most profit not the most per unit profit.
Monopoly Losses?
√ Not immune from changes in demand, or higher resource costs.
√ Look at data to show that the example given losses money at 8 units and greater.

45
AP Microeconomics
Chapter 24, p. 504-507

Economic Effects of Pure Monopoly

• Price and Output Efficiency

P S=MC P MC
pm

pc P=MC=min ATC p
c MR=MC
D
MR D
qc Q qm qc Q
Purely competitive Industry Pure Monopoly
√ See here that a pure monopolist will charge a higher price and a lower
quantity is sold. Note that costs are identical since the MC curve is in the same
position.
√ In Pure Monopoly, P > MC and P > minimum ATC.

• Income Distribution
√ Contributes to inequality in income distribution by “levying a private tax”
on consumers to obtain economic profit.
√ These profits are not widely distributed because corporate stock ownership is
largely concentrated in the hands of upper-income groups. Thus these firms and their
owners tend to be enriched at the expense of the consumer.

• Cost Complications
√ In the diagram, costs are identical, yet the costs of a monopolist may vary:
• Economies of scale—reduced output may result in inefficiencies that
would cause the firm to have a higher ATC than its minimum.
• X-inefficiency—occurs when a firm’s actual cost of producing an output is
greater than its lowest possible cost of producing it. Monopolistic firms tend more
to X-inefficiency; no rivals are pushing them to lower cost, and entry barriers are usually
greater than in pure competition.
• Rent-Seeking Expenditures—rent-seeking involves cost associated with
maintaining the monopoly so as to earn the greatest economic profits. This is part of the
higher costs.
• Technological Advance—most economists feel that pure monopolist are
not technology progressive because of absence of competitors and their tendency to be slow
to change.

• Policy Options
What should society do about monopoly?
√ Anti-trust litigation can thwart monopoly firms if they are grossly inefficient
√ Regulation of natural monopoly
√ Technology advance may solve the problem without government action.

46
AP Microeconomics
Consumer Surplus

Welfare Economics… the study of how the allocation of resources affects economic
well being. The equilibrium of demand and supply in a market maximizes total benefits
received by buyer and seller.

Consumer Surplus…a buyer’s willingness to pay minus the amount the buyer actually
pays.

• If four people, John, Paul, George and Ringo show up at an Elvis auction, each has a
limit that they are willing to pay for the Elvis album to be sold.
Buyer Willingness to pay As bidding reaches $80, three of the
John $100 buyers are not willing to pay more than
this amount. John pays $80 and gets the
Paul 80 album.
George 70 John gains a consumer surplus of $20
Ringo 50 ($100 - 80)
Consumer Surplus measures the benefit to buyer by participating in a market.
• Now, let’s assume that two identical Elvis albums are available for sale, and no one
buyer wants more than one, and the two will sell for the same price.
Where does the bidding stop? $70
What is the consumer surplus of the two bidders? $30 for John and $10
for Paul—a total of $40.

Using Demand Curve to Measure Consumer Surplus

Price Buyers Quantity Demanded
More than $100 None 0
$80 to $90 John 1
$70 to $80 John and Paul 2
$50 to $70 John, Paul and George 3
$50 or less John, Paul, George and 4
Ringo
P A
The triangle ABC is the
Consumer Surplus if p1 is the
p1 B C price and q1 is the quantity.

D
1
q Q

47
 P A

p1 B Initial C
Additional
New
p 2 F
D E

D
1 2
q q Q
• Triangle ABC is the initial consumer surplus
• Rectangle BCDE is the additional consumer surplus for the
initial customer.
• Triangle CEF is the consumer surplus for the new consumer

Using Supply Curve to Measure Producer Surplus

Producer surplus…the amount a seller is paid for a good minus the seller’s cost.
We can use a similar analysis as demand and consumer surplus to see the producer
surplus.
P S P D E F S
p2 Additional New
1 A C 1 A
p p
Initial C
B B

q1 Q q1 q2 Q
The triangle ABC is the • Triangle ABC is the initial
Producer Surplus if p1 is producer surplus
the price and q1 is the • Rectangle ADEC is the additional
quantity. producer surplus for the initial
producer
• Triangle CEF is the producer
surplus for the new producer
P
S
Consumer
Surplus
pe
Producer Surplus

D
qe Q
48
AP Microeconomics
Chapter 24 p. 507-510

Price Discrimination
√ Selling a given product for more than one price and these price differences
are not justified by cost differences.
√ Three conditions are realized:
• Seller must be a monopolist or at least have some degree of monopoly
power (ability to control output and price)
• Seller must be able to segment the market so that each has a different
willingness and ability to pay for the product (based on different elasticities
of demand)
• Original purchaser cannot resell the product or service. This suggests that
service industries are especially susceptible to price discrimination
√ Examples: think of elastic vs. inelastic demand
• Telephone service reduced rates in evening and weekend
• Electric utilities raise rates during peak use
• Movie Theater Rush hour rates
• Golf courses green fees
• Bulk discounts for shipping on RR
• Airline tickets bought in advance or family rates vs. business rate
• Hotel and restaurant discounts to seniors
• In international trade, the practice is called “dumping”.
√ Consequences:
• Higher profits for discriminating monopolists (some buyers will be willing and
able to buy at the MR=MC price)
• Larger output by discriminating monopolists (marginal revenue and price are now
equal since the reduced price applies to only the additional units sold not the prior,
and the monopolist will now find it profitable to produce more)

P MC
Single price Monopolist
……produces output where
P ATC MR=MC at Q and sells that
Q at P. Profit is shown in the
Unit shaded rectangle.
Cost

D
Q M Q
R
Perfectly Discriminating P
Monopolist ……D=MR MC
because it does not cut
price on preceding units to
sell more output. The ATC
profitable output is Q2
which is greater than the Minimum
single monopolist. The Unit Cost
profit is the shaded area.
D=MR
QMR
Q1 Q2

49
 √ Elasticity of Demand …is the reason some buyers will pay more. The more
inelastic the demand, the higher price that can be charged by the seller. Think about the
elasticity of demand and the cause of it in each of the examples above.
MC
MC

P Inelastic Elastic
Demand: Demand
Higher P
price
D
D

MR MR

Think About This!

√ Is there any fairness to this idea of price discrimination?

√ Comment on the desirability of price discrimination from the viewpoint of the

seller.

50
AP Microeconomics
Chapter 24 p. 510-512

REGULATED MONOPOLIES
• Most natural monopolies are regulated.
√ In certain lines of production, existing technology may be such that a firm must
be a large-scale producer in order to realize the lowest unit costs of production.
√ This suggests that, given demand, a small number of producers who are efficient
and large-scale will be needed. Existing mass-production economies would be lost with
more producers.
√ Because of heavy fixed costs, the demand curve will cut the average cost curve at a
point where the average cost is still falling.
√ The relationship between market demand and costs is such that low unit costs
presume usually one producer.
√ The application of MR=MC for the unregulated monopolist would allow for a
substantial economic profit. Further, price exceeds marginal costs which indicates
misallocation of resources.

P&C

Pm Fair Return
P=ATC

Pf r f ATC

r MC
Ps o
Socially Optimum
D P=MC
MR
Qm Qf r Qs o Q

√ An unregulated monopoly would charge Pm and produce output Qm.

√ Socially optimal price: P=MC

• To achieve allocative efficiency, the legal ceiling price for monopoly should be
where P=MC. This is point r as noted on diagram.
• At this point r the monopolist must produce Qs o since MR(Ps o ) =MC since the
demand curve has become perfectly elastic since the monopolist can not charge
above Pr
• Allocative efficiency is attained when production takes place where Pr =MC. This
may result in losses, and shown in this case.

√ Fair Return Price: P=AC

• Since public utilities must be ready for the peak uses and hence incur heavy fixed
equipment costs. The market demand curve cuts the marginal cost at a point to the
left of the marginal-cost-average-total-costs intersection so that the socially optimal
price is below AC. Losses would result in the long run.
• To solve the dilemma, most regulatory agencies establish a “fair-return” price.
This is noted by point f were price equals the AC and will allow the monopolist to
break even, though some misallocation of resources is tolerated.

51
AP Microeconomics
Chapter 25 p. 516-522

Monopolistic Competition
Market situation in which a relatively large number of small producers are
offering similar but not identical products.
√ Each firm has small percentage of total market
√ Collusion (concerted action by firms to rig price and production output) is not likely
√ No feeling of mutual interdependence (each firm makes its own decisions without
consideration of reaction by rival firms
√ Product Differentiation causing buyers to pay higher price to satisfy those
preferences:
• Product Quality and Attributes • Services offered
• Location • Brand Names & Packaging
• Some control over price
√ Easy entry and exit—economies of scale small and low capital requirements
√ Non Price Competition
• Trademarks • Advertising • Brand Names
√ Examples: Retail, light manufacturing (table on p. 518)

Price and Output Determination

√ The demand curve faced by MC seller is highly but not perfectly elastic. There
are many substitutes, but there are not perfect since product differentiation is high. The
amount of price elasticity will depend on the number of rivals and the degree of product
differentiation.
√ Short run profits and losses—using MR=MC rule if the firm’s price is above the
ATC, then profit; if firm’s price is below the ATC, then loss. Firms will enter to gain
profits and firms will exit to avoid losses.
MC
ATC MC
P/C P/C ATC
PROFIT
D
MR=MC LOSS MR=MC

MR D
MR
Q Q
SHORT RUN PROFITS SHORT RUN LOSSES
Firms enter to seek the economic With less favorable demand or
profit; eventually each firm holds a higher costs, firms minimize
smaller share of the demand, but losses and some exit helping the
those firms that can keep costs market to find equilibrium.
low can be profitable.

52
√ Long Run Equilibrium
…after profits and losses, the equilibrium will be established where there will be no
economic profits, just the normal profits. The ATC is tangent to the Demand curve at the
point where MR=MC. Price exceeds the minimum ATC and exceeds MC. There is
underallocation of resources to the production; consumers do not get the product at the
lowest possible price.
See Key Graph MC
p. 519 in text ATC
Complications:
P/C
• Some firms can achieve
product differentiation that
others cannot—location,
D patents are examples
MR=MC • There may be high financial
barriers because of product
differentiation.
MR

√ Economic Efficiency—neither productive or allocative efficient

since P ≠MC or P≠ minimum ATC
MC
ATC
P/C P ≠MIN ATC

P≠MC
D

MR

Q
Excess Capacity
Advertising:
GOAL: √ To increase market share √ To create customer loyalty
Case for Advertising Case Against Advertising
• Provides information • Persuades rather than inform
• Supports communication industry • Diverts human and property resources from other
areas
• Stimulant to product development • Significant external costs
• Promotes competition • Tends to be self-canceling
• Promotes full employment by inducing high • Promotes the growth of monopoly
levels of consumer spending
• Successful advertising can expand production and • Is advertising an important determinant of the
increase economies of scale levels of output and employment?

53
AP Microeconomics
Chapter 25 p. 522-538

Oligopoly
A relatively small number of firms producing either homogeneous (standardized) or
differentiated products dominate the market

Characteristics
√ Few large producers—vague term generally meaning 2-4 firms that dominate an industry
√ Homogeneous (industrial products like steel, zinc, copper, etc) or differentiated products
(consumer products like autos, tires, household appliances, etc.). Differentiated oligopolies will
engage in more nonprice competition.
√ Control over price with mutual interdependence—some monopoly pricing power but
each oligopoly must consider how its rival will react to any change in its price, output, product
characteristics or advertising.
√ Entry barriers
• Economies of scale are substantial and attained if large production capacity and output.
• The level of demand will dictate how many firms are needed. The desire to lower cost
will force firms to grow larger and will come at the expense of the other competitors.
• Ownership of patents will be a barrier
• Large advertising budgets to move demand upward are costly.
• Ownership or control of raw materials will give monopoly power
• Urge to merge for greater profit will aid firms in internal growth.

Measures of Industry Concentration

√ Concentration ratio–percentage of total industry sales accounted for by the four largest
firms in the industry (Table 25-2, p. 524)
• When four firms control 40 or more of the market, the industry is considered
oligopolistic—one-half of all US manufacturing industries are oligopolisitic.
• Shortcomings— pertains to entire nation, some markets are localized; does not show
interindustry competition or import competition; does not show actual market performance in
terms of degree of competition and technological progress
√ Herfindahl Index helps to show dominance of major firm
• sum of the squared percentage market share of all firms in the industry
• greater weight is given to larger firms
• larger the index number, the greater the market power within an industry (See Table 25-2,
p. 524)

Oligopoly Behavior
Pricing behavior has the characteristics of a game of strategy—game theory.
√ Mutual Interdependence–situation in which the actions of one firm can and will affect the
fortunes of another
• expectation of reaction—match a price decrease but ignore a price increase
• collusive tendencies—cooperation among rivals can result in profits and/or smaller losses;
“price wars” are good for consumer but not for seller.
• unpredictability of reaction—incentive to cheat

54
√ Profit Payoff for two-firm oligopoly (a duopoly)
• Two firms: RareAir and Uptown • Two pricing strategies: High and Low
• Profit earned will depend on the strategy it chooses and the strategy its rival chooses.
• Each lettered cell of this four-cell payoff matrix represents one combination of a RareAir strategy
and an Uptown strategy and shows the profit that combination would earn for each firm.

Cell A Cell B Cell C Cell D

High(U) High(U) Low(U) Low(U)
High(R) Low(R) High(R) Low(R)
Uptown $ 12 $6 $ 15 $ 8
RareAir 12 15 6 8
• Oligopoly firms can increase profits and affect rival's profit by changing their pricing
strategy. This is mutual interdependence.
√ If Uptown chooses High, it earns $ 12M only if RareAir chooses High.
√ If Uptown chooses High and RareAir chooses Low, RareAir will capture more of the market
and earn $ 15 M while Uptown only gets $ 6M.
• If either firm chooses the low price strategy—Cell C for Uptown and Cell B for RareAir, each
could increase profits.
√ Uptown to $ 15M (Cell C) or RareAir to $ 15M (Cell B).
√ But…note in Cell C, RareAir reduces its profits to $ 6M and in Cell B, Uptown would reduce its
profits to $ 6M.
√ The high priced firm would be better off it adopted the low-price strategy. (Cell D). Both
firms would reap profits of $ 8M.
√ So…movement from Cell A ($12M for both) to Cell D ($8M for both) is the effect!
• Oligopoly firms can benefit from collusion— cooperation among rivals. The two firms
could decide together to establish the high pricing strategy and each earn $12M. There is temptation
to cheat since the extra profit possible if you trick your rival is present by with low price strategy.

√ Three models—needed for diversity of oligopolies and complications of interdependence

• Kinked Demand: Noncollusive Oligopoly

P/C Rivals ignore

price increase P/C D2 MC 1
p p 2
MR MC 2
D2 See Key Graph
p. 528
Rivals match MR 2
price decrease
D1
1
D
q Q q Q
MR 1 MR 1

The slope of the noncollusive oligopolist’s demand curve and marginal revenue curve will
depend on whether rivals will match or ignore price changes. Parts of the two demand curves
and MR curves are used to “kink” the curves to show the differences in pricing strategies.
Don’t worry about these curves. They seem to be currently out of favor, but are offered to
show that demand and supply and the relationships of MC and MR are important in oligopoly.

55
• Collusive Oligopoly
√ Cartels— agree on production limits and set a common price to maximize profits as if
each were acting like a unit of a single monopoly.
• Overt Collusion: OPEC example p. 531
• Covert Collusion: Electrical Equipment Conspiracy p. 531
• Tacit Collusion: Gentlemen’s agreements
• Price Leadership
√ type of implicit understanding to coordinate prices without outright collusion.
√ one firm is dominant and initiates price changes which others follow

• ECONOMIC EFFICIENCY:
√ Traditional View–acts like monopoly (higher price, lower output); no productive or
allocative efficiency; some view it worse than monopoly because government tends to
discourage monopoly development
√ Qualifications:
• Increased foreign competition—breaking down price leadership and bringing more
competitive pricing
• Limit pricing—low prices are an entry barrier and benefits consumers
• Technological advance—large economic profit is used for R&D and barriers give
some assurance that money for R&D is well spent.

56
AP Microeconomics
Chapter 27 p. 564-569

• Why Study Resource pricing?

√ Money Income: resources are major source
√ Resource Allocation: prices allocate scarce resources
√ Cost Minimization: best combination of resources will be most efficient
√ Policy Issues: the unequal distribution of income, etc.
• Marginal Productivity Theory of Resource Demand
√ Derived Demand—demand for resources is derived from the products which
those resources help produce.
√ Marginal Revenue Product (MRP)—Demand for resource depends on
• productivity of resource
• market value or price of good produced
The demand or labor: pure competition in the sale of the product
Units of Total Marginal Product Total Marginal
Resource Product Product Price Revenue Revenue Product
(Output)
MP P TR MRP
0 0 $2 $ 0
1 7 7 $2 14 $ 14
2 13 6 $2 26 12
3 18 5 $2 36 10
4 22 4 $2 44 8
5 25 3 $2 50 6
6 27 2 $2 54 4
7 28 1 $2 56 2
√ MRP is the increase in total revenue resulting from the use of each additional
variable input (like labor)
• The MRP curve is the resource demand curve. Location of curve depends
on the productivity and the price of the product.
• MRP is demand schedule
Wage √ Under pure competition, the price is
Rate constant, so the diminishing productivity is
the sole reason why the resource demand
curve is downsloping.

D=MRP
Quantity of labor

In imperfect competition, price is not

Wage constant, so the resource demand curve
Rate slopes downward because marginal
product diminishes and product price falls
as output increases

D=MRP
Quantity of labor

57
 The demand for labor: Imperfect Competition in the sale of the product
Units of Total Marginal Product Total Marginal
Resource Product Product Price Revenue Revenue Product
(Output)
MP P TR MRP
0 0 $ 2.80 $ 0
1 7 7 $ 2.60 18.20 $ 18.20
2 13 6 $ 2.40 31.20 13.00
3 18 5 $ 2.20 39.60 8.40
4 22 4 $ 2.00 44.00 4.40
5 25 3 $ 1.85 46.25 2.25
6 27 2 $ 1.75 47.25 1.00
7 28 1 $ 1.65 46.20 -1.05
• Marginal Resource Cost (MRC)
√ MRC is the increase in total cost resulting from the employment of each
additional unit of a resource; so for labor, the MRC is the wage rate.
• MRP=MRC is the rule.
√ It will be profitable for a firm to hire additional units of a resource up to the point
at which that resource’s MRP is equal to its MRC. (Compare this to the MR=MC rule in
terms of the market models of the previous chapters. Recall that it was profitable to produce
the output that added revenue until the added cost was greater.)

58
AP Microeconomics
Chapter 27 p. 569-574
Determinants of Resource Demand (location of demand curve MRP)
√ Changes in Product Demand
• Recall Derived Demand—changes in Demand for the product produced
by the resource will cause change in the resource demand in the same direction
√ Changes in Productivity
• Quantities of other resources used—adding capital to labor raises
productivity more than if labor is added to labor
• Technological Progress—the better the quality of the capital, the greater
the productivity of the labor used with it
• Quality of the variable resource— improvements in the quality of the
resource will raise its marginal productivity and hence raise demand
√ Changes in Prices of Other Resources
Relationship of Increase in the price of capital (2)
inputs (1)
Substitution Effect Output Effect (b) Combined Effect (3)
(a)
Substitutes in Labor substituted for Production costs up, output DL increases if the substitution
production capital goes down, and less of both effect exceeds the output
capital and labor used effect; DL decreases if the
output effect exceeds the
substitution effect
Complements in No substitution of Production costs up, output DL decreases
production labor for capital goes down, and less of both
capital and labor used

Real World Applications: p. 572

√ Restaurant Workers √ Defense Personnel
√ Computer-related workers √ Contingent Workers

Examples of Determinants of Labor Demand

Determinant Examples
Change in product • Gambling increases in popularity, increasing the demand for
demand workers at casinos
• Consumers decrease their demand for leather coats, decreasing the
demand for tanners
Change in • An increase in the skill level of glassblowers increases the demand
productivity for their services.
• Computer-assisted graphic design increases the productivity of and
the demand for graphic artists
Changes in the price • An increase in the price of electricity increases the cost of
of another resource producing aluminum and reduces the demand for its workers.
• The price of security equipment used by businesses to protect
against illegal entry falls, decreasing the demand for nigh guards
• The price of telephone switching equipment decreases, greatly
reducing the cost of telephone service, which in turn increases the
demand for telemarketers.

59
Elasticity of Resource Demand
The sensitivity of producers to changes in resource price is measured by the
elasticity of resource demand.

Erd = % change in resource quantity

% change in resource price
Erd > 1 elastic Erd = 1 unit-elastic Erd < 1 inelastic

Factors that determine the sensitivity of producers to changes in

resource prices: Elasticity of Resource Demand
• Rate of MP decline:
√ if MP of labor declines slowly as it is added to a fixed amount of capital, the
MRP, (demand curve for labor) will decline slowly and tend to be highly elastic; a small
decline in the price of a resource will yield a relatively large increase in the amount
of labor demanded.
√ if MP of labor declines sharply, the MRP (labor demand curve) will decline
rapidly and hence tend to be inelastic; a relatively large decline in the wage rate will be
accompanied by a very modest increase in the amount of labor hired.
• Ease of Resource Substitutability
√ the larger the number of good substitute resources available, the greater the
elasticity of demand for a particular resource
√ wood substitutes and aluminum
√ use airline pilots, railroad crews and truck drivers as example of time element
• Elasticity of Product Demand
√ the greater the elasticity of product demand, the greater the elasticity of resource
demand; derived demand is reason
√ recall the elasticity of demand curves for resources by perfect and imperfect
competitors
• Labor Cost-Total Cost Ratio
√ the larger the proportion of total production cost accounted for by a resource,
the greater will be the elasticity of demand for that resource.

60
AP Microeconomics
Chapter 27 p. 574-578

Optimum combination of Resources

Consider two interrelated questions: What is the least combination of resources and
what is the combination of resources that will maximize a firm’s profit?

√ Least—Cost Rule
• The cost of any output is minimized when the marginal product (MP) per
$’s worth of each resource is the same.
MP of labor
= MP
Price of laborPrice
of capital
of capital
Labor Price=$8 Capital Price=$12
Q TP MP TR MRP Q TP MP TR MRP
0 0 $0 $0 0 0 $0 $0
1 12 12 24 24 1 13 13 26 26
2 22 10 44 20 2 22 9 44 18
3 28 6 56 12 3 28 6 56 12
4 33 5 66 10 4 32 4 64 8
5 37 4 74 8 5 35 3 70 6
6 40 3 80 6 6 37 2 74 4
7 42 2 84 4 7 38 1 76 2

Example: For 50 units of output # of units is given since cost is the issue!

MPL = MPC 3 labor 6/8

PL PC 2 capital 9/12

√ Profit Maximization Rule

• When hiring two resources in competitive markets, a firm realizes the profit-
maximizing combination of resources when each input is employed up to the point at which
its price equal its MRP.
# of units is not given since profit
MRP = MRPC = 1 is the issue.
PL PC
Example: 5 labor 8/8
MRP L = MRP C 3 capital 12/12
PL PC

√ Can a firm be least cost and profit maximizing?

Least cost Profit maximizing
5 labor 4/8 8/8
3 capital 6/12 12/12

How many units?

5 labor produce 37 3 capital produce 28 = 65 units of output

61
AP Microeconomics
Chapter 28 p. 581-589

Labor, Wages and Earnings

√ Labor means 1) blue and white-collar workers, 2) professional workers, 3)
owners of small businesses who provide their labor in operating.
√ Wages and wage rates are the price paid for labor. Wage is said to mean some
wage rate per unit of time. Weekly or monthly salaries, bonuses, royalties, commissions are
also forms of wages.
√ Nominal wage is the amount of money received per hour, per day or whatever
the time frame. Sometimes called gross earnings. (wage rate x time worked)
√ Real wage is the quantity of goods and service a person can obtain with nominal
wages; purchasing power of nominal wages often measured in take-home pay.
General Level of Wages
√ Wages differ among nations, regions, occupations and individuals. The general
level of wages is a composite concept that includes average wages of all workers.
Wages in the US are relatively high compared to international wages. This demand
for labor in advanced economies is quite large relative to the supply of labor.
√ Demand for labor depends on Productivity:
• Plentiful capital—total capital available per worker in US is about
$90,000
• Access to abundant natural resources—domestic or imported, the
US has arable land, minerals, and sources of energy. The growth of
agriculture is a good example of abundant land and capital.
• Advanced Technology—use of technologically superior equipment
and scientific study and research.
• Labor quality—high living standards in health and education give us an
edge over others
• Intangible factors—efficiency and flexibility of management,
business, social and political environment, vast size of market.
Purely Competitive Labor Market
In a purely competitive market:
√ large number of firms hiring a specific type of labor
√ numerous qualified, independent workers with identical skills
√ Wage taker behavior—no ability to control wage on either side
Market Demand: sum of labor demand curves of the individual firms—their MRP curves
Market Supply: assume no union, slopes upward because as a group, the firms must pay
higher wage rates to obtain more workers; workers have some alternatives.
The supply of labor:
Pure competition in the hire of labor
Unit of Wage Total Marginal
Labor Rate Labor Resource
Cost Cost When the resource price is
—MRC given to the firm, their MRC is
0 $6 $0 constant and is equal to the
1 $6 6 $6 wage rate. Each new worker
2 $6 12 $6 adds his wage rate to the total
3 $6 18 $6 wage cost.
4 $6 24 $6
5 $6 30 $6
6 $6 36 $6

62
For the firm, MRC (S) is perfectly elastic and MRP is downsloping. Each firm will
find it profitable to hire labor up to the point at which MRP=MRC. The firm’s get
their price from the market equilibrium of demand and supply of labor.
S
Wage
Wage See Key Graph Rate
Rate p. 586

Wc S=MRC Wc

D=MRP
D=mrp ∑ mrp’s
qc Qc Quantity
Quantity
Individual Firm Labor Market

For the firm, the shaded area is total wage cost; the triangle above the shaded
area is the nonlabor cost, or payments to the suppliers of other resources.

Monopsony Model
This is a market in which an employer of resources has monopolistic buying
(hiring) power. One major employer or several acting like a single monopsonist in a labor
market. In this market:
√ single buyer of a specific type of labor
√ labor is relatively immobile—geography or skill-wise
√ firm is “wage maker” —wage rate it must pay varies directly with the # of
workers its hires
Unit of Wage Total Marginal Decision to employ more or fewer
Labor Rate Labor Resource workers will affect the wage rate; the firm
Cost Cost will have to pay a higher wage to
—MRC obtain more labor. This makes the
0 $5 $0 supply curve upsloping. Each point
1 $6 6 $6 indicates the wage rate (cost) per worker
2 $7 14 $8 which must be paid to attract that
3 $8 24 $10 corresponding # of workers.
4 $9 36 $12
5 $10 50 $14
6 $11 66 $16 The employer’s MRC curve lies
above the labor S curve since it must
MRC
Wage pay all workers the higher wage
S when it hires the next worker the
Rate
high rate to obtain his services.
b Equating MRC with MRP at
point b, the monosponist will hire
Wc a Qm workers and pay wage rate Wm .
Note that the q and w are below
Wm the Qc and W c amounts.
c MRP

Qm Qc Q
Why not pay a wage rate noted by point b?
This firm does not have to do so since the labor supply is willing to accept
less as indicated by the S curve.
63
AP Microeconomics
Chapter 28 p. 590-600

Three Union Models

The most important goal of union activity is to raise wages.

√ Demand-Enhancement Model—raising the demand for labor causing wages to

rise and quantity of labor to increase.
Wage • A union can increase labor demand
Rate S by changing one or more of the
determinants of labor demand:
1) increase product
demand—advertising the product,
political action to increase production,
Wu “featherbedding”
2) increase productivity—joint
Wc D2 labor-management committees
3) change prices of other
D1 inputs—support of minimum wage
legislation, prevent declines in labor
Qc Qu Q of L decline through actions to raise the price
of other inputs.

√ Exclusive or Craft Union Model—reducing the supply of labor through the use
of restrictive membership policies causing higher wages but lower quantity of labor.
• Craft unions (exclusive unionism)
Wage S2 include workers sharing a specific
Rate S1 skill who act together to force
employers to hire them. They employ
restrictive membership—long
apprenticeship, high fees, limits on new
members—and hence, cause the supply
Wu of labor to decrease.
• Occupational licensing is also used to
Wc protect consumers but has the same
D effect by restricting the supply of labor.
Some 600 occupations are now licensed
in the US.
Qc Qu Q of L

64
 √ Inclusive or Industrial Union Model—imposing a wage rate above the
competitive rate causing the supply curve to be perfectly elastic in part of its range. This
means that employers are forced to accept the wage or no labor is made available—workers strike.
By agreeing to the union’s wage demand, individual employers are wage takers. When they equate
MRC = MRP, they are in the perfectly elastic range. Employers here are in a competitive
market for labor.
• In Inclusive Industrial unions,
Wage Wages are above the competitive
Rate wage rate and the quantity of labor
S is less than would have been with
competitive model.
• Point e show a quantity of workers
a b e greater than competitive model.
Wu This causes a surplus of workers,
which should lower wages. But,
Wc union workers will refuse to work
D for lower wages acting collectively
and employers contractually cannot
pay less.
Qu Qc Q of L

Wage Increases and Unemployment

√ Union members earn on average 10 to 15% more than nonunion members do
√ Both types of unions do reduce quantity of labor
√ Growth of economy and Elasticity of demand for labor are two ways to raise
employment caused by union action.

Bilateral Monopoly Model

A monopsonistic employer seeks a lower wage rate that is demanded by an
inclusive union. This is “monopsony in labor vs. monopoly in business” or “big labor vs.
big business”!
• A monosponist seeks to hire Qm
Wage MRC (where MRC =MRP) and pay wage rate
Rate W m corresponding to Qw on the labor
S supply curve S.

• The inclusive union it faces seeks

the above equilibrium wage rate Wu .
Wu The actual outcome cannot be predicted
by economic theory. Collective
Wc bargaining will be the vehicle used to
D reach consensus.
Wm

Qu=Q m Qc Q of L

65
Wage Differentials
• Table 28-3 p. 595 shows wage differences based on work abilities, educational level,
non-monetary differences in jobs & market imperfections.
• Figure 28-9 shows how education levels affect individual annual earnings.
• Non-Monetary aspects of work can lead to a compensating difference in wages. “Dirty”
jobs or those that have hazardous elements may not attract all possible workers so compensating
differences illicit higher wages.
• Market imperfections include lack of job information, geographic immobility, effect of
unions and government policies and discrimination. These differences result in a difference in
wage payments.

Pay for Performance: Principal Agent Problem

√ Problem arises when workers (as agents) shirk their responsibilities and provide less than
expected work effort. Firms want to motivate workers in some way to raise productivity.
√ Piece rates, commissions, royalties, bonuses, profit sharing, and efficiency wages are
designed to improve productivity by overcoming the principal agent problem.
√ There are negative side effects of these measures: poor quality, predatory sales practices,
interference in team oriented work, free-riders, and lack of new ideas.

66
AP Microeconomics
Chapter 29 p. 603-606

Economic Rent…price paid for the use of land and other natural resources, which are
completely fixed in supply.
• Perfectly inelastic supply since land
has no production costs; it is a “free and S
nonproductive gift of nature.” Its
quantity does not change with price (a R
few exceptions) e D1
n
• Changes in demand will determine the
t D2
amount of rent.
• Several factors influence this demand: D3
√ price of the product grown on the land
√ the productivity of the land Acres of land
√ the prices of other resources combined D4
with the land

• Land is viewed as surplus since there is no incentive function to provide more supply,
• Some argue it should be taxed away, since it is unearned. Some argue that it should be
nationalized or owned by the government.
• Differences in land productivity result from differences in the land itself. These account for
the varying amount of rent to allocate land to its most productive use.
• Economic rent is a surplus payment above that needed for society to gain the use of the
resource, but individual firms do need to pay rent to attract land resources away from
alternative uses, and so rent is a cost for firms.

67
AP Microeconomics
Chapter 29 p. 606-611

Interest…price paid for the use of money, usually viewed as the money that must be paid
for the use of one dollar for one year.

• Interest is stated as a percentage as required by the Truth in Lending Act of 1968.

• Money itself is not a resource. It is used to acquire capital goods, so by borrowing money or
using money, businesses are buying the use of real capital goods.
S • Interest rate is determined in Money Market.
i% • Demand consists of Transaction and Asset demands;
it is downsloping because at lower interest rates,
businesses are willing to borrow more.
i% • Supply is upsloping because at higher interest rates,
D consumers will be induced to save more and spend
less.
Q Q of loanable funds

• Investment decisions are related to rates of interest and rates of return. Businesses will be
willing to invest in capital goods when their expected return exceeds the cost of borrowing.

• Nominal interest rates are stated in current dollar values; real interest rates are expressed in
constant or inflation-adjusted dollars. Businesses are worried about real interest rates.

• Range of interest rates:

√ Varying degrees of risk (riskier loans carry higher rates)
√ Differing maturity dates (longer-term loans carry higher rates)
√ Size of loan (larger amount of loan have lower rates)
√ Taxability (some interest earned is tax-free, so interest paid would be lower)
√ Market imperfections (monopoly power in market may raise rate)

• Pure Rate of Interest: best defined in terms of the long-term virtually risk-free securities such
as the US government 30-year Treasury Bond. The rate in August 2001 was 5.5%.

• Role of Interest is important since it affects both levels and the types of investment
undertaken. Level of investment is inversely related to the rate of interest.

• Interest rates ration money capital to those who are willing to pay for it, so…capital is
allocated to its more productive and profitable uses.

68
AP Microeconomics
Chapter 29 p. 612-615

Economic Profits…what remains of a firm’s total revenue after the explicit and implicit
costs are subtracted.

• Profit are the reward for the entrepreneur-for risk-taking, for innovation, for creative ways
of combining resources.
√ Normal profit is the minimum required to retain the entrepreneur.
√ Economic profits are above the normal and act as the incentive to take risks.

• Economic profits occur in a dynamic, ever-changing economy as the reward to the

entrepreneur, but they also accrue to those with monopoly power in the market.

• Expectation of profit encourages firms to invest and expand output and production. They
allocate resources to those ventures that are profitable—a signal that society’s needs and wants
for being met.

Income Shares

Functional Distribution of Income

Interest
Corporate 7%
Profit
12%
Rent
2%

Proprietor's
Income
8%
Wages &
Salaries
71%

• Wages are dominant type, and if proprietor’s income is added, the percentage rises even
higher.
• Historically, corporate profit has grown as a share over time as that form of business
organization grows. Industry has changed from land-capital intensive to labor-capital intensive to
labor-service intensive.

69
AP Microeconomics
Chapter 5 p. 84-97
Economic Functions of Government
√ Legal and Social Framework—provides legal framework and services needed
for a market economy to function efficiently.
• sets “rules of the game” governing business relationships such as contract
enforcement
• services like police powers, weights and measures, and system of money
• agencies that protect consumer and regulate businesses
√ Maintaining Competition—actions that encourage competition in order to
promote efficiency to provide low prices and an adequate quantity of goods for
consumers
• Regulation and ownership controls
• Anti-monopoly laws
√ Redistribution of Income—providing for those unable to do so themselves
• transfer payments such as welfare, SS payments, food stamps; unemployment compensation
• market intervention such as price controls or price supports
• sharing the wealth of the nation through income based taxation
√ Reallocation of Resources—measures to correct over- and under-allocation
of resources
• Spillovers occur when some of the costs or the benefits of the good or service are passed on to
parties other than the immediate buyer or seller.
• spillover costs
√ production or consumption costs inflicted on a third party without compensation
√ pollution of air, water are examples
√ Supply moves to right producing a larger output that is socially desirable—
overallocation of resources
√ Legislation to stop/limit pollution and specific taxes (fines) are ways to correct
• spillover benefits
√ production or consumption costs conferred on a third party or community at large
without their compensating the producer
√ education, vaccinations are examples
√ Market Demand, reflecting only private benefits moves to left producing a smaller
output that society would like—underallocation of resources
√ Legislation to subsidize consumers and/or suppliers and direct production by
government are ways to correct
√ Provider of Public Goods and Services—providing goods and services
to society that the private sector is not willing or able to provide
• private goods are subject to exclusion principle—those unable or unwilling to pay
do not get the product.
• public goods are indivisible—cannot be sold to individual buyers
• exclusion principle does not apply to public goods—there is no effective way to exclude
individuals
• classic example is a lighthouse—free-rider problem emerges. Who pays? Who benefits?
• Quasipublic Goods—goods and services produced and delivered in such a way that the exclusion
principle applied even though the private sector could offer
√ Often, government will provide these g/s since private sector may tend to underallocate
resources for their production
√ Medical care and public housing are examples.
• Allocation of resources to public and quasipublic goods—government spending, taxing policies,
and manipulating interest rates are the ways government can shift resource use.
√ Stabilization—helping the private economy achieve full employment of
resources and stable prices.

70
Circular Flow adding government to the picture.
Land, Labor, Capital & Entrepreneruial Ability to bs and govt

Resource Money Payments paid by bs. and govt

Bs. Taxes Taxes

Businesses Government Households

Subsidy Transfers

Money Payments for goods and services from

government and households

Goods and Services for Households and Government

• All the government flow suggest ways that the government can stabilize
the economy:
√ To stimulate the economy, increase government spending and/or reduce taxes;
increase transfers and subsidies.
√ To fight inflation, raise taxes and/or reduce spending; decrease transfers and
subsidies.
Government Finance
• Government Purchases are exhaustive since they use resources directly and are
part of the domestic output.
• Transfer payments are nonexhaustive since they do not use resource and hence, do
not produce any output.
• Government purchases have been about 20% of domestic production for past 35
years and transfer payments now equal about 33% of domestic production having increased
as a % over the past 35 years.
• Federal Finance:
√ Expenditures: figure 5-7 on p. 93—38% goes to pensions and income security
√ Revenues: figure 5-7 p. 93—80% of revenue comes from personal
income tax and payroll tax.
• Personal Income Tax is a progressive tax (those with higher incomes pay a larger
percentage of their income. Higher rates are applied in bracket to higher incomes. The
marginal tax rate is the rate at which the tax is paid on each additional unit of taxable
income. Average tax rates give a better picture of the tax burden; it is the total tax paid
divided by the total taxable income.

71
 Federal Personal Income Rates, 1997
for married couple filing a joint return
(1)Total Taxable Income (2)Marginal (3)Total Tax (4)Average
tax % paid on highest Tax %
income bracket 3÷1

$1 to $41,200 15.0 $6,180 15.0

$41,201 to $99,600 28 $22,532 22.6
$99,601 to $151,750 31 $38,699 25.5
$151,751 to $271,050 36 $81,647 30.1
Over $271,050 39.6

• Payroll tax is the social security contribution based on wages and salaries. Two
compulsory Federal programs are financed: social security and Medicare. The payroll tax
is assessed on both workers and employer equally. In 1998, the rate was 7.65% on first
$68,400 or earnings and 1.45% on all additional earnings.
• Corporate Income Tax is levied on a corporation’s profit. The rate is 35% for
most corporations.
• Sales and excise taxes on commodities or on purchases such as alcoholic
beverages, tobacco, and gasoline. The Federal government does not levy a general sales tax.

72
AP Microeconomics
Chapter 30 p. 625-631
Market Failures
• Failure of the market to bring about the allocation of resources that best satisfies the wants
of society
• Results in either over- or underallocation of resources dedicated to the production of a
particular good or service
• Caused by either externalities (spillover) or information problems
P
S
No externalities involved:
No benefits or costs beyond those to consumer
Qe is efficient allocation equilibrium
D
Qe
Q
• Externalities failures: (cost or benefit accruing to an individual or group—third party—which
is external to the market transaction)
Overallocation of resources when external costs are present
St Spillover and suppliers are shifting some of their costs onto the
P Costs
S community, making their marginal costs lower. The supply
does not capture all the costs with the St curve understating
total production costs. By shifting costs to the consumer, the
D firm enjoys S curve and Qe., (optimum output ). This means
Qo Qe Q resources are overallocated to the production of this product.

P Underallocation of resources when external benefits are

St
Spillover present and the market demand curve reflects only the private
Benefits benefits understating the total benefits. Market demand curve and
D D market supply curve yield Q . This output will be less than Q
t e o

Qe QO shown by the intersection of Dt and St with resources being

Q
underallocated to this use.

Correcting for Spillovers or Externalities:

√ Individual bargaining: Coase Theorem — government role is to encourage
bargaining; property rights must be defined; a compelling incentive emerges for the parties to find
ways to solve failure since both have opportunity costs.
√ Liability rules and lawsuits: government role is to establish framework of laws
which define property rights and protect them from damage done by other parties; private lawsuits
are judged from that framework
√ Direct controls: legislation that sets limits on activity (clean air acts, etc.); raises
the private marginal costs of producing
√ Specific taxes: producers must decide to pay tax or expend funds to develop
substitutes
√ Subsidies and Government Provision: payments to buyers, to producers, or
the government provides the product

73
 St Spillover
P Costs Correcting for the Spillover Costs
S
Difference between Qo and Qe is the
T overallocation. This can be corrected by direct
D controls or by imposing a specific tax T that
raises the firm’s marginal costs and shifts its
Qe supply curve from S to St.
Qo Q

P
St Correcting for the Spillover Benefits
Spillover
Benefits Difference between Qo and Qe is the underallocation
of resources. This can be corrected by a subsidy to
D Dt consumers (demand side to push back to Dt ) or a
subsidy to producers (supply side to S’ to the right
Qe QO of St ). These shifts will move to Qo.
Q

Market for Externality Rights:

Supply • Determine “rights” (supply is fixed)
of • Demand is downsloping; demand will increase over
$200 rights time as human and business populations increase
• Equilibrium price for “rights” will be intersection of
demand and supply
$100 D • Firms are either encouraged to reduce or eliminate it
P
per D 2000 based on their costs and the price of the right .
ton 1996 • Rights can be bought and sold; conservation groups
can “buy” up rights to control spillover costs
Q of rights

Society’s Optimal Amount of Externality Reduction

M
C
The optimal amount of externality
Society’s reduction occurs at Q where society’s
MB marginal cost and marginal benefit of
& Socially
Optimum reducing the negative externality are
MC equal. Reduction of the negative
Amount
externality beyond Q will reduce
economic efficiency by overallocating
resources to control.
MB

Amount of Abatement
Q

74
 Problem Resource allocation Ways to Correct

Spillover Costs Overallocation of Resources Individual Bargaining

Negative Externalities Liability rules and lawsuits
Tax on Producers
Direct Controls
Market for Externality rights
Spillover Benefits Underallocation of Resources Individual Bargaining
Positive Externalities Subsidy to consumer
Subsidy to producer
Government Provision

Think About This!

√ Read “A Closer Look at Pollution” (pages 631-635). Relate the law of conservation of
matter and energy to the air pollution problem and the solid waste disposal problem. What is the
“tragedy of the commons” as it relates to pollution?

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AP Microeconomics
Chapter 30 p. 636-640

Information failures: unequal knowledge possessed by the parties to a market transaction

Sellers’ side: √ Gasoline market — legal system of weights and measures

√ Licensing of doctors — qualifying tests and licensing

Buyers’ Side: √ Moral Hazard Problem — tendency of one party to alter behavior in
which are costly to the other party.
Divorce Insurance example
Car Insurance and your “cautious” behavior?
Medical Malpractice insurance and doctor behavior?
Guaranteed contracts for professional athletes?
Unemployment Compensation and employee behavior?
FDIC insurance and risky loans?

√ Adverse Selection Problem — information know by the first party is not

known by the second and as a result, the second party incurs major costs.
Those in poorest health want the best medical insurance
A person hiring an arsonist wants to buy fire insurance

√ Workplace Safety — lack of knowledge on job safety

Workplace Safety has a cost
Unsafe workplaces will need to pay high wages to attract
workers

Government can intervene by:

…Providing workers with safety information
…Mandate that employers give workers good information
…Establish standards and force firms to abide

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AP Microeconomics
Chapter 31 p. 650-652

Apportioning the Tax Burden

• The benefits-received principle holds that government should assess taxes on

individuals according to the amount of benefits they received, regardless of their income.
Gasoline tax is the best example since the tax collected goes directly into the fund to finance
highway construction and repair. Two problems arise—how to determine who really
benefits and this principle cannot be applied to income redistribution programs.
• The ability-to-pay principle holds that people should be taxed according to
their income or wealth regardless of the benefits received from government. Those with
higher income has a diminishing marginal utility for the goods they buy since their incomes
allow them to buy more things to satisfy their wants. A low-income buyer places a higher
utility on each good he purchases since he has less to spend. Problems—what is fair?—a
larger tax total or a higher rate on higher income levels?

• Taxes are classified as progressive, proportional or regressive depending on

the relationship between tax rates and taxpayer incomes.

Type Definition Applications

Progressive • Average rate increases as Personal Federal Income Tax
income increases √ Marginal Tax rates between 15 and
• Claims a larger absolute 39.6 %
amounts AND a larger √ Tax deductions like home mortgage
percentage of income as income and bond interest exemption erode
rises progessiveness of the tax
• Bears down most heavily on
the rich
Proportional • Average rate remains the sameCorporate Income Tax
√ flat rate of 35%
regardless of the size of income
√ some argue that this tax is passed
to consumer
Regressive • Average rate declines as Sales Taxes
income increases √ Larger portion of poor person’s
• Takes smaller and smaller income exposed to tax; rich can avoid
proportion of income as income by saving some income
increases Payroll Taxes
• May or may not take a larger √ Apply to only a fixed absolute
absolute amount of income as amount of income
income expands √ SS tax—7.65% of $72000
√ Excludes non-wage income
Real Property Tax
√ Poor spend a larger portion of their
income for housing
√ Owners of rental property “pass”
tax onto tenants

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AP Microeconomics
Chapter 31 p. 652-57

Taxes
When government imposes a tax on a good, who pays the tax? The way the burden of
a tax is distributed is the incidence of the tax. The true tax incidence seldom falls entirely on the
party on whom the government levies the tax. In many instances, someone else collects the tax and
sends the proceeds to the government.

How taxes on buyers affect market outcomes?

What if a tax is imposed on the buyer ice cream cones? Demand Curve shifts down and
equilibrium quantity falls. The price sellers receive is reduced. The price buyers pay (including the
tax) rises to an amount greater than the equilibrium price. Even though the tax is levied on
buyers, buyers and sellers share the burden.
Price
buyers P
S
pay
Price w/o tax

Price sellers D1
receive
D2
Q

How taxes on Sellers Affect market Outcomes

What if a tax is imposed on the seller of ice cream cones? Supply Curve shifts up and
equilibrium price increases while equilibrium quantity falls. The price sellers receive after paying
the tax is reduced. The price buyers pay rises to an amount greater than the equilibrium price.
Even though the tax is levied on sellers, buyers and sellers share the burden.
S2
Price
buyers P
S1
pay
Price w/o tax

Price sellers D1
receive

Q
Two lessons:
• Taxes discourage market activity. When a good is taxed, the quantity of the good sold is
smaller in the new equilibrium.
• Buyers and sellers share the burden of taxes. In the new equilibrium, buyers pay more for
the good, and sellers receive less.

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 • Elasticity and Tax Incidence St Elastic Supply
Inelastic
Price S Demand
buyers pay

Tax 1. When supply is

more elastic than
Price w/o tax demand…
Price 2. the incidence of the
sellers tax falls more heavily
receive on buyers…
D 3. than on sellers.

P
Price S Inelastic Supply
buyers Elastic Demand
pay
Price w/o 1. When demand is
tax Tax more elastic than
supply…
Price D 2. the incidence of
sellers
the tax falls more
receive
heavily on sellers…
3. than on buyers.

Efficiency Loss of a tax

St
S
The efficiency loss
P Tax paid by arises from the
consumer decline in output as
noted by the quantity
Efficiency decrease as the St
Loss of the curve shifts to the
Tax left.

Tax paid by
producer D

79
The probable incidence of taxes

Type of Tax Probable Incidence

Personal Income Tax The household or individual on which it is levied
Corporate Income Tax Some argument:
firm on which it is levied
tax is shifted in whole or part to the consumer
Sales Tax Consumer who buy taxed products
Specific Excise Tax Consumers & producers each share depending on their
elasticities
Property Tax Owners in the case of land and owner-occupied residences;
Tenants in the case of rental property
Consumers in the case of business property

American Tax Structure

• Federal tax structure: income tax is progressive though the payroll tax is regressive.

• State and Local structure: property tax and sales tax is largely regressive; state income tax less
progressive than Federal
Combined Tax System: the American Tax Structure is deemed to be slightly progressive, only
slightly redistributing income from the wealthy to the poor.

Think About This!

√ Read about Tax Reform on pages 657-58 and think about the feasibility of using a VAT
or Flat Tax to replace our current tax on income.

80
AP Microeconomics
Chapter 34 p. 701-707
Distribution of Personal Income
• Average family income in 1996 was $56,674.
Personal Income Class % of all families in
this class
Under $10,000 7.6
$10,000 to $14,999 6.1 This table shows that
$15,000 to $24,999 13.5 there is considerable
$25,000 to $34.999 13.5 income inequality.
$35,000 to $49,999 17.1
$50,000 to $74,999 21.3
$75,000 to $99,999 10.0
$100,000 and over 10.3
100.0
• Causes of growing inequality:
Greater demand for highly skilled workers
Demographic changes
International trade, immigration and a decline in union membership

The Lorenz curve—another way to depict inequality

%
of Perfect
I Equality
N
C
O
Lorenz
M
E Curve (actual
distribution)
% of FAMILIES

If income were distributed perfectly equally, the Lorenz curve would be the straight-
line diagonal shown. The extent to which the actual income distribution varies from
the line of perfect equality is the measure of inequality.
The greater the distance of the curve from the line of equality, the more unequal the
distribution. The extreme would be a line following the horizontal axis to the right until it meets
the right vertical axis and then turns upward along that axis. The Lorenz curve can be used to
compare changes in the curve over time or to compare income distributions across
countries.
• Government significantly redistributes income from higher to lower income
households through taxes and transfers.
• The distribution of personal income is significantly more equal after taxes and
transfers. Because the American tax system is only modestly progressive, transfer payments
are the most important method of redistribution. They account for more than 75% of the
income of the lowest quintile. The Lorenz curve will move inward toward equality with these
influences.

81