AP Microecnomics notes

UNS EDU
Microeconomics AP
Chapter 1
Basic Economic Concepts

Economics is the study of how societies use scarce resources to produce valuable commodities
and distribute them among different people.

1. Principles Are Derived At Two Levels:

 Macroeconomics: is concerned with the overall performance of the economy. Macro looks at
totals or aggregates to examine the "big picture".
 Microeconomics: is concerned with the behavior of individual entities such as markets,
firms and households. Micro looks at the "trees not the forest".

2. Economic Goals:
 Positive economics collects and presents facts. It avoids value judgments. 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.

3. Scarcity:
Scarcity is the situation that exists when they are not enough resources to meet human wants.
 Necessity vs. Wants
 Wants multiply over time with new products and incomes
 Human wants tend to be unlimited, but resources are limited
Resources in economy is anything that can be used to produce a good or service. Four types of
resources are:
 Land — All natural resources
 Fields
 Forest
 Sea
 Mineral deposits
 Gifts of nature

 Labor — Human Resources

 Manual
 Clerical
 Technical
 Professional
AP Microeconomics
 Managerial

 Capital — form the durable goods of an economy

 Factories
 Office building
 Machinery
 Tools and equipment
 Use of technology
 Use of available information

 Entrepreneurship — a particular type of human resource

 Business innovator
 Sees opportunity to make profit
 Uses unexploited raw materials
 Takes risk with new product or process
 Brings together land, labor, capital
Resource Payments — note the special terms used
Land - Rent Labor - wages and salaries Capital - Interest Entrepreneurship – Profit

Summary:
Economists deal with the problem of scarcity. Scarcity requires that people and companies make
choices. To get one thing, we often must give up another. The Opportunity Cost is the value of
the good or service forgone.

4. Production Possibility Curve:

PPC is an economic model to demonstrate opportunity costs and tradeoffs. It shows the
various combinations of goods that a society can have given its current level of resources,
technology, and trade.

Table: A B C D E
Pizza (000,000) 0 1 2 3 4
Robots (000) 10 9 7 4 0
Figure 1.1
A Points On Curve:
R B Attainable and Productively Efficient
O
B C
W
O Points Outside the
T Z Curve:
D Not Attainable
S

E Inside Curve:
PIZZA
Attainable but inefficient
Microeconomics AP
 Each point on the curve represents efficiency. The economic resources are being used to
produce the maximum amount of goods and services.

 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 law of increasing opportunity cost, defined
as within production switches from one product to another, increasing amounts of resources
are needed to increase the production of the second product. 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. A straight line would mean constant opportunity cost.

 Points inside the curve may signal unemployment or underemployment of labor and other
resources.

 Economic growth (and a movement outward of the curve) occurs because of discovering
new resources, inventing new technology, or engaging in more trade. For example, new
discoveries of raw materials (diamonds in Australia, or oil on the North Slope of Alaska),
improving the educational level or training of labor (Job Corps or company-sponsored job
training), and new technology (robots in factories or the microchip).

Figure 1.2

R Economic Growth
O
B
O
T
S

PIZZA

 Consumer Goods vs. Capital Goods:

Consumer goods directly satisfy out wants, while capital goods satisfy indirectly since they permit
more efficient production of consumer goods.
 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.
AP Microeconomics

Figure 1.3 Accelerated Growth in

future
Only modest growth Capital
Capital
goods
goods

1993
Curve Current
position

Current 1993
position Curve

Consumer goods Consumer goods

5. Economic Systems:
 Three Fundamental Questions
1. What should be produced?
2. How should it be produced?
3. For whom should it be produced?

5.1 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

5.2 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
Microeconomics AP
 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

5.3 Market
... basic questions answered by the exchanges of buyers and sellers
 Interaction of demand and supply determines the three basic questions
 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 behaviour
 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)

5.4 Mixed
... 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

6. 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.

 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.
Price 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.
AP Microeconomics

 Produce markets operate as the points of exchange between consumers who use money
incomes to buy these goods and services produced by businesses.

Figure 1.4

Land, Labor, Capital & Entrepreneurial Ability

Resource Market
Resource Money Payments

Businesses Households

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 represent the sales revenues or receipts
of the businesses.

 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 buyers and sellers.

 Scarcity plays a role in this model because households will only possess a 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.

7. Comparative advantage and specialization:

Absolute advantage is the ability to produce something more efficiently. Comparative
advantage is the ability to produce something with a lower opportunity cost. People can benefit
from voluntary trade because both parties will be specializing in what they do best, and each is
doing so at the least opportunity cost. All of the trade in the word takes place because of differing
opportunity costs – that is, because of differing comparative advantages.

Example:

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Bakery Pizza Parlor
Pastries Crusts Pastries Crusts
10 0 5 0
0 5 0 10
Opportunity Costs Opportunity Costs
1 pastry costs 1 crust costs 2 1pastry costs 2 1 crust costs 1/2
1/2 crust pastries crusts pastry

 Because the bakery can produce more pastries than the pizza parlor, the bakery has absolute
advantage in pastry production. The pizza parlor has absolute advantage in crust production.

 Both producers could produce pastries, but the bakery can produce pastries at lower
opportunity cost (0.5 crusts vs. 2 crusts). The bakery is said to have comparative advantage
in the production of pastries. Likewise, the table illustrates that the pizza parlor has the
comparative advantage in pizza crusts (0.5 pastries vs. 2 pastries).

 These producers can, and indeed should, specialize by producing only pastries at the bakery
and only crusts at the pizza parlor.

Pastries Figure 1.5

Specialization
10

50/50
7.5

5 7.5 10 Crusts

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Chapter 2
Markets and Prices

1. Demand:
 is the desire to have some good or service and the ability to pay for it.

 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:

Figure 2.1

P
Price Quantity
$5 9 $5
4 10 4
3 12 23
2 15 2 Demand
1 20 21
Q
9 10 12 15 20

1.1 Law of demand

 As the price goes down, quantity demanded goes up. This inverse relationship is called the
law of downward-sloping demand.

 In any time period, consumer will derive less satisfaction (utility) from each successive unit
of a good consumed. This is Diminishing Marginal Utility. Each successive unit brings less
utility and consumer will only buy more at lower prices.

 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.

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1.2 Change in quantity demanded
Movement along the same demand curve caused by a change in price!
P
Figure 2.2

5
4

Demand

9 10 Q

1.3 Change in demand

is a shift in the demand curve, either to the left or right. It is caused by a change in a determinant
other than the price.

P Figure 2.3
Decrease

4
Increase
D3
D2
D1
Q
9 10

1.4 Determinants of demand

 T - Consumers’ tastes and preferences: What was once perceived as useful or useless,
stylish or ugly, healthy or dangerous now can become its opposite.
 R - The price of related goods:
 Substitutes: Demand for the substitute will increase if the price of the original item rises.
 Complementary: if a decrease in the price of one good increases demand for the other good.
 I - Income:
 Normal goods: an increase in income leads to a rightward shift in the demand curve.
 Inferior goods: an increase in income leads to a leftward shift in the demand curve, since
these are usually low-quality items that people will avoid when they have more to spend.
 B - The number of buyers in the market: demand depends on the size of the market.
 E - Consumer expectations: If you expect that there will be a sharp increase in prices for a
particular goods in the near future, you may increase your demand for that good now.

2. Explanations of the Law of Demand

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2.1 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 term used for a change in the amount of a product that a consumer will
buy because the purchasing power of his or her income changes – even though the income
itself does not change.
 Substitution effect is the pattern of behavior that occurs when consumers react to a change
in the price of a good or service by buying a substitute product – one whose price has not
changed and that offers a better relative value.

2.2 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.
 Total Utility is the total amount of satisfaction or pleasure a person derives from consuming
some quantity.
 Marginal Utility is the additional utility you get from the consumption of an additional unit
of that product.
Figure 2.4

TU

TU

Unit Consumed

Total Utility increases at a diminishing rate, reaches a maximum and then declines.

MU

Unit Consumed
MU

Marginal Utility diminishes with increased consumption, becomes zero when total utility is at a
maximum, and is negative when total utility declines.

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 From the graphs above, we can conclude that when total utility is at its peak, marginal utility
is below zero. Marginal utility reflects the change in total utility so it is negative when total
utility declines.

3. Theory of Consumer Behavior

3.1 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

3.2 Utility-Maximizing Rule

 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.

For example,
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, or B, etc. will yield equal amounts of marginal utility.
MU of ProductA ΜU of Product B

Price of A Price of B

Q: How many of A and how many of B? What is the combinations of A and B that can be had with
$10?
A: 2 units of A and 4 units of B

4. Supply:
 is the amount that sellers are willing and able to sell at a particular price.

 Supply as the amount of goods and services that businesses are willing and ability to

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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 prices levels.

 Hence, a supply schedule:

Figure 2.5

P
5
Price Quantity Supply
$5 20 4
4 15 3
3 12
2
2 10
1 9 1
Q
9 10 12 15 20

4.1 Law of supply

 As the price goes down, quantity supplied 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.

4.2 Changes in quantity supplied

Movement along the same supply curve caused by a change in Price!

Figure 2.6
P
5
Supply
4

Q
15 20

4.3 Change in supply

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is a shift in the supply curve, either to left or to right. It is caused by a change in a determinant
other than price. S1
P
S2
5 S3
4
Increase
Decrease
3

Q
15 20
Figure 2.7

4.4 Determinants of supply

 R - Resource Price: most important and most typical reason for change
 O - The price of other goods (Prices of goods that use same resources): If the price of one
production substitute rises, the supply of another substitute will decrease in order to increase
profits.
 T - Technology: new innovations in technology can reduce the average cost of production,
thus increase supply.
 T - Taxes and subsidies: taxes increase costs; subsidies lower costs.
 E - Producer expectations: If suppliers expect price to rise, they will wait to send their
goods to market. Because the price is as yet unchanged, this is a decrease in supply, which
would in turn cause price to rise. If suppliers expect price to fall, they will rush their goods to
market in hopes of getting the present high price. This increases supply, which would cause
price to fall.
 N - The number of sellers: Other things equal, the larger the number of suppliers, the greater
the market supply.

5. Equilibrium:
The prices at which both demand and supply curves intersect is the equilibrium price.

Figure 2.8
Price
Supply

p Equilibrium

Demand

q Quantity
 A market equilibrium comes at the price at which quantity demanded equals quantity

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supplied.
 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.

5.1 Changes in Supply, Demand and Equilibrium:

 Demand only changes

Figure 2.9

P P P
1 1
S S
S1
P2
Pe Pe
Pe
P2
D2
D1 D1
D1
D2
Qe Q Qe Q2 Q Q2 Q e 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

Figure 2.10

P P P S2
S1 S1
S1
S2
Pe P2
Pe Pe
P2
1
D
D1 D1

Qe Q Q e Q2 Q Q2 Q e Q

Equilibrium Supply Increases Supply Decreases

P=Pe Demand Constant Demand Constant
Q=Qe P decreases P increases
Q increases Q decreases

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 Complex Cases

Figure 2.11

P P P
S1 S1
S1

Pe Pe Pe
D1
D1 D1

Qe Q Qe Q Qe Q

Equilibrium Supply Increases Supply Decreases

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

P P
S1
S1

Pe Pe
D1
D 1 D1

Qe Q Qe Q

Supply Increases Supply Decreases

Demand Decreases Demand Increases
P _________ P _________
Q _________ Q _________

Summary:
Change in Supply Change in Demand Effect on Pe Effect on Qe
Increase Increase
Decrease Decrease
Increase Decrease
Decrease Increase

6. Consumer Surplus and Producer Surplus

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6.1 Consumer surplus, producer surplus
 Consumer surplus: A buyer's willingness to pay minus the amount of buyer actually pays.
 Producer surplus: the amount a seller is paid for a good minus the seller's cost.

Figure 2.12
Price
Consumer Surplus Supply

Equilibrium
Price

Demand
Producer Surplus

Quantity
Equilibrium quantity
 Total Surplus: the sum of consumer and producer surplus - is the area between the supply
and demand curves up to the equilibrium quantity.
Figure 2.13
Price

Supply
Deadweight loss
PB
Price without tax Tax
Ps

Demand

Quantity
Q2 Q1

 Deadweight loss: When the government imposes a tax on a good, the quantity sold falls from
Q1 to Q2. As a result, some of the potential gains from trade among buyers and sellers do not
get realized. These lost gains from trade create the deadweight loss.

7. 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.

7.1 Price elasticity of demand

Price elasticity of demand (sometimes simply called price elasticity) measures how much the
quantity demanded of a good changes when its price changes.
The price elasticity of demand is computed as:

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percentage change in the quantity demanded
Ed 
the percentage change in price

Δ in Q Δ in P
Ed  
Q P

ΔQ ΔP
Midpoint formula: E d  
(Q1  Q 2 ) (P1  P2 )
2 2
Note: use absolute values and ignore the negative sign

7.2 Interpretation of Ed
Ed>1: Elastic Demand - % Quantity demanded responds strongly to changes in price.
Ed<1: Inelastic Demand - % Quantity demanded does not respond strongly to price changes.
Ed=1: Unit Elastic - % Quantity demanded changes by the same percentage as the price.
Ed=0: Perfectly Inelastic - % Quantity demanded does not respond to price changes at all.
Ed=∞: Perfectly Elastic - % Quantity demanded changes infinitely with any change in price.

Figure 2.14

P D P P

Perfectly Inelastic Q Perfectly Elastic Q Relatively Inelastic Q

Demand Demand Demand

P P

D
D
Q Q
Relatively Elastic Unit Elastic
Demand Demand

7.3 Determinants of price elasticity of demand

 Demand tends to be more elastic ...
 If the good is a luxury
 The longer the time period

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 The larger the number of close substitutes
 If the good represents a larger share of consumer's budgets

 Demand tends to be more inelastic ...

 If the good is a necessity
 The shorter the time period
 The fewer the number of close substitutes
 If the good represents a smaller share of consumer's budgets

7.4 Elasticity Varies with Price Range

More elastic toward top left; less elastic at lower right

Note: Slope does not measure elasticity - slope measures absolute changes; elasticity measures
relative changes.

Figure 2.15
P
Elastic Ed>1

Unit Elastic Ed=1

Inelastic Ed<1

7.5 Total Revenue Test for Elasticity

Total revenue is the amount the seller receives from the buyer from the sale of a product;
P×Q=TR

 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.

7.6 Cross Elasticity

Cross-price elasticity of demand measures how responsive the demand for one good is to
changes in the price of another good.

The Cross Elasticity Coefficient Exy is calculated:

%  in Q d of X
E xy 
% Δ in P of Y
 If Exy is positive, then X and Y are substitute goods.

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 If Exy is negative, then X and Y are complementary goods.
 If Exy is zero, then X and Y are independent goods.

7.7 Income Elasticity

Income elasticity of demand measures how the demand for a good changes in response to
changes in income.

Income Elasticity Coefficient

% Δ in Q d
Yd 
% Δ 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.

8. Government-controlled prices

Government may set a price and it may differ from the equilibrium price that the market sets. As a
result, 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) will happen.

8.1 Price Ceilings

A maximum legal price below the equilibrium price

Figure 2.16

P S Creates a shortage since amount

demanded will be greater than
the amount supplied
Pe
Price Ceilings
Shortage
D

Qs Qe Qd Q

Examples: essential goods, rent controls, interest rates, price controls

Solutions: Black markets (underground markets)

8.2 Price Floors

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A minimum legal price above equilibrium price

Figure 2.17

P S
Surplus
Price Floors
Pe Creates surplus since the
amount supplied is greater than
the amount demanded
D

Qd Qe Qs Q

Examples: minimum wage, price supports on agricultural products

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Chapter 3
Product Market

1. Costs of Production
The relationship between the quantity of inputs (resources) a firm uses and the output produced
with them is called a production function.

1.1 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
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.

Figure 3.1

T
O
Economic
T
Profit Accounting
A
L Profit
Implicit
Costs
R
Economic E
Costs Explicit Explicit
V
Costs E Costs
N
U
E

1.2 Short run and long run

 Short run - Fixed Plant
 Period of time too brief for firm to alter is 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

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 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

1.3 Short Run Relationship

 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

TP
MP 
 Quantity of labor
 Average product: the output per unit of input, also called labor productivity
TP
AP 
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.

Figure 3.2

TP

TP

Quantity of Labor

MP

Diminishing Marginal Returns

AP

Quantity of Labor
MP
Note: the marginal product intersects the average product at its maximum average product.

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1.4 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
Variable Costs: costs which change with the level of output.
Total costs: are the sum of fixed and variable.

TFC T VC TC
AFC  A V C ATC  (OR AFC + AVC)
Q Q Q
Marginal costs: the extra or additional cost of producing one more unit of output.

 TC
M C
Q

Figure 3.3

Costs
TC
TVC

Fixed Cost

Total TFC
Cost Variable Cost

Q
Costs
MC
 AVC declines initially, then
reaches a minimum, then
ATC increases (a U-shaped curve)
AVC  ATC will be U-shaped curve
 MC declines sharply, reaches a
minimum and then rises sharply
because of diminishing returns.

AFC
Q

Note: The MC of producing any unit of output is only the additional variable cost that will be
incurred for the production of that one unit.
MC intersects with AVC and ATC at minimum points.
 When MC<ATC, ATC is falling
 When MC>ATC, ATC is rising

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 There is no relationship between MC and AFC.

1.5 Short and long run costs

Costs are related to types of adjustments a firm can make - "time" is a factor.

Figure 3.4
ATC

Economies Constant Returns Diseconomies

of scale of scale s of scale
Q

 Economies of scale (down-sloping 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 (up-sloping portion) - caused generally by the difficulty of
efficiently controlling a firm's operations as it becomes a large-scale producer.

2. Characteristics of Markets
Purely Monopolistic Oligopoly Pure Monopoly
Competitive Competitive
Number of firms Numerous Large number of A few large A single producer
businesses businesses businesses
Type of Product Homogeneous Differentiated Homogeneous or Unique; no
Differentiated substitutions
Ability to Set None. Price-taker Some. The degree More. Sellers can Most. Seller is only
Price of product act as monopoly source of produce
differentiation will setting price or and can act like
affect the ability of sellers can act price maker.
the seller to set independently and
price. ability to set price
is determined by
differentiation.
Product None. Products are Varies depending Varies. Some None. Product is
Differentiation identical. on the industry industries may be unique.
identical; others
may be
differentiated.

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Ease of Entry Relatively easy to Relatively easy to Difficult. High Very difficult.
start a new business start a new business Startup costs

3. Perfectly Competitive
A competitive market is one with many sellers trading identical (homogeneous) 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.

3.1 Demand as seen by a perfectly 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.

Figure 3.5
$
P = MR because each
additional sale brings
the price as revenue -
never more, never
less.
P D=MR

Quantity Demanded (sold)

3.2 Profit Maximization in the short run

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.

Figure 3.6

TC TR

Greatest Profit

Q demanded (sold)

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Profit-maximizing rule: the firm can maximize its profits where MR=MC.

Figure 3.7
ATC
$ MC
MC $
ATC
ATC AVC
P AVC
P
D D
ATC

Q q Q
q

Profit maximization Loss Minimization

3.3 Shutdown position

If MR<ATC, the firm will sustain losses. However, there is a range in which it still pays the firm
to continue production. As long as the firm's MR>AVC, the firm should continue in operation,
even if the MR<ATC. Because the firm is able to cover its AVC and part of its FC. The shutdown
point is the point when MR falls below the firm's minimum AVC. At this point the firm's
revenues do not cover variable costs, and it will be economic for the firm to cease production and
sustain only fixed costs.

Figure 3.8
Classic Shut-Down Position

P MC P
ATC S
AVC
C

Q Q
Firm Industry

 Any price below the minimum AVC as in the Shutdown position will force the firm to shut
down (point a)
 At a price of P2 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 MC crosses the ATC (P4) shows the break-even point for the firm (point d).
Here the total revenue covers the total costs (including normal profits)
 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.

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Figure 3.9

Costs and Revenues

MC
ATC
e
P5 MR5
d
P4 MR4
AVC
P3 c
MR3

b
P2 MR2
a
P1 MR1

Q1 Q2 Q3 Q4 Q5 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.
Since the MC above the AVC is the Supply curve, it can shift when costs change.

Figure 3.10

P MC1
& MC2
ATC1 In this case of a decrease in
C
AVC and hence ATC, the MC
ATC2
moves to MC2 and shows that
the Quantity increases to Q2.
AVC1
AVC2

Supply shifts to right to show a decrease in costs.

3.4 Firm and Industry

The firm's price is determined by the market price. Market price is determined by the demand and
supply for a particular product. Profit-maximizing output is found where MR=MC=P.

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3.5 Profit maximization in the Long Run
 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)

How Economic Profits for a Firm will Disappear in Long Run

Figure 3.11

P P S1
MC
S2
ATC
P1
P=MR
M M
AVC P2
D

Q2 Q1 M Q Q

Firm Industry

How Economic Losses for a Firm will Disappear in Long Run

Figure 3.12
S2
P ATC MC P S1

M P=MR
M

D
Q Q
Q 1 Q2
Firm Industry

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 are attracted
 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

Summary:
So in the long run, the purely competitive firm will produce an output where the

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MR=MC=minimum ATC. This will be the long run equilibrium position There will be no
economic profit only the normal profit.

Figure 3.13

P MC
ATC

Pe
P=D=MR=AR

Q
Qe

3.6 Short-run and long-run Supply curve

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.

Figure 3.14

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.

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Long-run industry supply curve is up-sloping.

Figure 3.15

P
S

3.7 Pure Competition and Efficiency

Figure 3.13 shows that a purely competitive firm cannot earn economic profit in the long run; it
can earn normal profit.

 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.

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附表：Summary of Approaches to Determining the Profit-Maximizing Output

Total Revenue-Total Cost Marginal Revenue-Marginal Cost

Should the Firm produce? YES, if TR exceeds TC or if YES, if price is equal to, or
TC exceeds TR by some greater than minimum AVC.
amount less than fixed cost.
What quantity should be TR over TC is a maximum or Produce where MR or price
produced to maximize where the excess of TC over equals MC.
profit? TR is a minimum (and less
than total fixed costs).
Will production result in YES, if TR exceeds TC. YES, if price exceeds ATC.
economic profit? No, if TR exceeds TR. No, if ATC exceeds price.

4. Monopoly
4.1 Monopoly characteristics
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 non-price competition, generally advertising
 Blocked entry - barriers to entry created by monopolist or government

4.2 Barriers to entry

 Economies of scale: Costs
Large Scale production is efficient
 Public Utilities: natural monopolies
 Competition is impractical, inconvenient, or unworkable
 Natural monopoly is a monopoly that arises because a single firm can supply a good or
service to an entire market at a smaller cost than could two or more firms. When a firm is a
natural monopoly, it is less concerned about new entrants eroding its monopoly power
because would-be entrants know that they cannot achieve the same low costs that the
monopolist enjoys because, after entry, each firm would have a smaller piece of the market.
 Natural monopoly is the extreme example in which market demand curve intersects the long
run ATC where the ATC is still declining.
 Legal Barriers: patents and licenses
 Patents awarded by government to encourage research
 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.
 Ownership of Raw material
 Using the concept of private property rights, ownership of necessary material can block
others

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 Pricing and other Strategic Barriers
 Lowering price or aggressive advertising
 Aggressive Cutthroat tactics:
 Product disparagement
 Pressure on resource supplier
 Aggressive price cutting
 Dumping

4.3 Unregulated Monopoly

 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.
 If demand is down-sloping, so is Marginal Revenue.
Figure 3.16

Elastic
P

P1 In the Elastic range, TR is

Inelastic
rising, hence MR is positive.
P2
In the Inelastic range, TR is
falling, and MR is negative.
D

Q
Q1 Q2
MR

The monopolist will operate in the elastic portion of the demand curve since in the inelastic
region, it must lower price. Recall that total revenue test that TR will decline if a product
demand is inelastic.

4.4 Output and Price Determination for Unregulated Monopoly

Figure 3.17
P
MC

Pm
ATC
Unit
Cost
D
MR
Qm Q

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 Note that the MR=MC rule is used to determine the output quantity.
 The MR=MC quantity line is drawn upward to where it intersects with the demand curve
to find the price.
 Total economic profit is: (P-ATC)×Q
 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 (=TR-TC)

4.5 Economic Effects of Pure Monopoly

 Price and Output Efficiency
Figure 3.18
P MC P MC

Pm ATC

Pc

D D
MR Q
Qc Q
Qm

Perfect competitive Industry Pure Monopoly

 See Figure 3.18 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.

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 perfectly competition.

4.6 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:

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 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

 Example:
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"

 Reason: 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.

Figure 3.19

P P
MC MC

D
D MR
MR
Q Elastic Demand Q
Inelastic Demand

 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)

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Figure 3.20
Monopolist with Single Price Monopolist with Perfect Price Discrimination

P P
CS
Deadweight loss
MC MC

Q Q
Quantity sold Quantity sold

4.7 Regulated Monopolies

 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 costs curve at a point
where the average cost is still falling.
 The relationship between market demand and costs is such that low unit costs presumes
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.

Figure 3.21

P&C

MC
Fair Return
Pm
P=ATC
Pfr f
r
Pso
Socially optimum
D P=MC
MR
Q
Qm Qfr Qso

 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 figure 3.21.
 At this point r the monopolist must produce Qso since MR (Pso) = MC since the demand
curve has become perfectly elastic since the monopolist can not charge above Pr.

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 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
since misallocation of resources is tolerated.

5. 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
 Preferences:
 Product Quality and Attributes
 Location
 Services offered
 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

5.1 Price and Output Determination

Figure 3.22 Short-run Profits
MC Firms enter to seek
the economic profit;
ATC eventually each firm
Profit holds a smaller share
of the demand, but
D those firms that can
keep cost low can be
MR
profitable.
Q

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P/C MC Short-run Losses
ATC With less favorable
Loss demand or higher
costs, firms minimize
losses and some exit
D helping the market to
find equilibrium.
MR

 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.
 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.

P/C Figure 3.23

MC
ATC

MR
Q

Complications:
 Some firms can achieve product differentiation that others cannot – location, patents are
examples
 There may be high financial barriers because of product differentiation.

5.2 Economic Efficiency

- neither productive or allocative efficient since P ≠ MC pr P ≠ minimum ATC

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Figure 3.24

MC Price MC
Price ATC
ATC
P
P=MR=D

MC
MR D

Quantity Efficient Quantity

Quantity Quantity produced
produced Scale = Efficient Scale

Excess capacity

5.3 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 Is advertising an important determinant of the
and increase economies of scale levels of output and employment?

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

6.1 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 non-price 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

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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.

6.2 Measures of Industry Concentration

 Concentration ratio – percentage of total industry sales accounted for by the four largest
firms in the industry
 When four firms control 40 or more of the market, the industry is considered
oligopolistic – one-half of all US manufacturing industries are oligopolistic.
 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 large firms
 Larger the index number, the greater the market power within an industry

6.3 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
 Three models – needed for university of oligopolies and complications of interdependence
Kinked demand: Noncollusive Oligopoly

Figure 3.25
P/C P/C MC1
D2
P
P
D2 MC2
MR2

MR2

D1 D1

q Q q MR1 Q
MR1

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The slope of the noncollusive ologopolist’s demand curve and marginal revenue curve will
depend on whether rivals will match or ignore price changes. Parts of the two demand and MR
curves are used to “kink” the curves to show the differences in pricing strategies.

 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
 Covert Collusion: Electrical Equipment Conspiracy
 Tacit Collusion: Gentlemen’s agreement

 Price Leadership
 Type of implicit understand to coordinate prices without outright collusion.
 One firm is dominant and initiates price changes which other follow

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Chapter 4
Factor Market

1. Why Study Resource Pricing?

 Money Income: resources are major source
 Resource Allocation: price allocate scarce resources
 Cost minimization: best combination of resources will be most efficient
 Policy issues: the unequal distribution of income, etc.

1.1 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

For example, the demand for labor: pure competitive in the sale of the product
Units of Total Marginal Product Total Marginal
Resource Product Product Price Revenue Revenue
(Output) Product
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

Figure 4.1

Under pure competition, the price

Wage
is constant, so the diminishing
Rate
productivity is the sole reason why
D = MRP the demand curve is downsloping.

Quantity of labor

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Figure 4.2

Wage In imperfect competition, price is not

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

Quantity of labor

1.2 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 profit-maximizing 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.

1.3 Determinants of resource demand

 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 inputs Increase in the price of capital
Substitution effect Output effect Combined effect
Substitutes in Labor substituted for Production costs up, output DL increases if the
production capital goes down, and less of both substitution effect
capital and labor used exceeds the output
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

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

1.4 Elasticity of resource demand

The sensitivity of producers to changes in resource price is measured by the elasticity of resource
demand

% change in resource quantity

Erd =
% 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:
 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
 Elasticity of produce 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

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 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.

2. 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?

2.1 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 of capital

Price of labor Price of capital
For example,
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
Answer:
3 labor = 6/8
2 capital = 9/12

2.2 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.
MRP MRP
 1
PL PC
For example, see the table above, when hiring 5 labor and 3 capital, profit is maximized.

3. Labor, wages, and Earning

 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

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wages.
Nominal wage is the amount of money received per hour, per day or whatever the time frame.
 Sometimes called gross earnings. (wage rate × 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 is relatively high compared to international wages.
 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

3.1 Purely competitive labor market

In this market,
 Large number of firms hiring a specific type of labor
 Numerous qualified, independent workers with identical skills
 Wage take 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.

For example, pure competition in the hire of labor

Unit of Wage rate Total labor Marginal
When the resource price is
labor cost resource
given to the firm, their
cost (MRC)
MRC is constant and is
0 $6 $0
equal to the wage rate.
1 $6 6 $6
Each new worker adds his
2 $6 12 $6
wage rate to the total wage
3 $6 18 $6 cost.
4 $6 24 $6
5 $6 30 $6
6 $6 36 $6

For the firm, MRC is perfectly elastic and MRP is downsloping. Firms will find it profitable to

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hire labor up to the point at which MRP=MRC. The firm gets their price from the market
equilibrium of demand and supply of labor.

Figure 4.3
Wage rate Wage rate
S

S=MRC WC
WC

D=MRP D=ΣMRP

qc Quantity Qc Quantity

Individual Firm Labor Market

3.2 Monopsony Model

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 quantity of workers it
hires.

For example,
Unit of Wage rate Total labor Marginal
labor cost resource
cost (MRC)
0 $5 $0
1 $6 6 $6
2 $6 14 $8
3 $7 24 $10
4 $8 36 $12
5 $10 50 $14
6 $11 66 $16
Decision to employ more or fewer workers will affect the wage rate; the firm will have to pay a
higher wage to obtain more labor. This makes the supply curve upsloping. Each point indicates
the wage rate (cost) per worker which must be paid to attract that corresponding quantity of
workers.
MRC Figure 4.4
Wage rate
S
b

Wc a
Wm c
MRP
Q
Qm Qc

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The employer’s MRC curve lies above the labor S curve since it must pay all workers the higher
wage when it hires the next worker the high rate to obtain his services. Equating MRC with MRP
at point b, the monopsonist will hire Qm workers, and pay wage rate Wm.
Note that the q and w are below the Qc and Wc amounts.

Question: why not pay a wage rate noted by point b?

Answer: This firm does not have to do so since the labor supply is willing to accept less as
indicated by the S curve.

4. Three Union Models

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

4.1 Demand – Enhancement Model

raising the demand for labor causing wages to rise and quantity of labor to increase.
Figure 4.5

Wage rate S

WM
WC
D2
1
D
QC QM Quantity of labor
A union can increase labor demand by changing one or more of the determinants of labor
demand:
1) increase product demand - advertising the product, political action to increase production
2) Increase productivity - joint labor - management committees
3) Change prices of other inputs - support of minimum wage legislation, prevent declines in labor
decline through actions to raise the price of other inputs.

4.2 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.
Figure 4.6

Wage rate S2
S1
WM
WC
D

QC QM Quantity of labor
Craft union (exclusive unionism) include workers sharing a specific skill who act together to

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force employers to hire them. They employ restrictive membership – long apprenticeship, high
fees, limits on new members – and hence, cause the supply of labor to decrease.
 Occupational licensing is also used to protect consumers but has the same effect by
restricting the supply of labor. Some 600 occupations are now licensed in the US.

4.3 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.
Figure 4.7

Wage rate S
a b e
Wm
Wc

D
Q m Qc Quantity of labor
In inclusive industrial unions, wages are above the competitive wage rate and the quantity of
labor is less than would have been with competitive model.
 Point e show a quantity of workers greater than competitive model. This causes a surplus of
workers, which should lower wages. But, union workers will refuse to work for lower wages
acting collectively and employers contractually cannot pay less.

4.4 Bilateral Monopoly Model

Figure 4.8

Wage rate MRC

S
Wu
Wc

Wm
D
Qw = Q m Qc Quantity of labor

 A monopsonist seeks to hire Qm (where MRC = MRP) and pay wage rate Wm corresponding
to Qw on the labor supply curve S.
 The inclusive union it faces seeks the above equilibrium wage Wu . The actual outcome
cannot be predicted by economic theory. Collective bargaining will be the vehicle used to
reach consensus.

 Wage Differentials:

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Wage differences based on work abilities, educational level, non-monetary differences in jobs &
market imperfections.

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Chapter 5
Government and Market

1. 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, 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 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 good – no effective way to exclude
individuals

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 Classic example is a lighthouse – 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 goods and service since private sector may tend to
underallocate resources for their production
 Medical care and public housing are examples.
 Allocation of resources to public 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.
 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 non-exhaustive since they do not use resource and hence, do not
produce any output.
 Tax

2. 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

Figure 5.1

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 incurring to an individual or group- third party - which is external to the market
transaction )

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Figure 5.2

P St
Spillover Costs
S

Q0 Qe Q

Overallocation of resources when external costs are present and suppliers are shifting some of
their costs onto the 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 firm enjoys S curve and Qe (optimal output). This means resources are overallocated to the
production of this product.

Figure 5.3

P S
Spillover benefits

Dt
D

Qe Q0 Q
Underallocation of resources when external benefits are present and the market demand curve
reflects only the private benefits understating the total benefits. Market demand curve and market
supply curve yield Qe. This output will be less than Q0 shown by the intersection of Dt and S with
resources being 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

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Figure 5.4

P St
Spillover Costs
S

T D

Q0 Qe Q

 Correcting for the Spillover Costs

Difference between Q0 and Qe is the overallocation. This can be corrected by direct controls or by
imposing a specific tax T that raises the firm's marginal costs and shifts its supply curve from S to
ST.

Figure 5.5

P St
Spillover benefits

Dt
D

Qe Q0 Q

 Correcting for the Spillover benefits

Difference between Q0 and Qe is the underallocation of resources. This can be correct by a subsidy
to consumers (demand side to push back to Dt) or a subsidy to producers (supply side to S to the
right of St). These shifts will move to Q0.

Figure 5.6

Supply of
P per ton
rights
$200

$100 D 2000

D 1996
Q of rights

 Market for Externality rights:

 Determine "rights" (supply is fixed)
 Demand is downsloping; demand will increase over time as human and business populations
increase
 Equilibrium price for "rights" will be intersection of demand and supply
 Firms are either encouraged to reduce or eliminate it based on their costs and the price of the

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right
 Rights can be bought and sold; conservation groups can "buy" up rights to control spillover
costs

Summary
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

3. 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 bahavior in which are costly to the
other party.
 Divorce insurance example
 Car insurance and your "cautious" bahavior?
 Medical malpractice insurance and doctor bahavior?
 Guaranteed contracts for professional athletes?
 Unemployment compensation and employee bahavior?
 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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4. 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 problem 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 taxpayers incomes.
Type Definition Applications
progressive  Average rate increases as income Personal Federal Income Tax
increases Marginal tax rates between 15
 Claims a larger absolute amounts AND a and 39.6%
larger percentage of income as income Tax deductions like homo
rises mortgage and bond interest
 Bears down most heavily on the rich exemption erode progressively
proportional  Average rate remains the same regardless Corporate Income Tax
of the size of income Flat rate of 35%
Some argue that this tax is
passed to consumers
regressive  Average rate declines as income increases Sales taxes
 Takes smaller and smaller proportion of Larger portion of poor person's
income as income increases income exposed to tax; rich
 May or may not take a larger absolute can avoid by saving some
amount of income as income expands income
Payroll taxes
Apply to only a fixed absolute
amount of income
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

 Tax incidence
Refers to the manner in which the actual payment of a tax is "shared" between suppliers (firms)

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and
consumers of a taxed good. The incidence of a tax in a particular market depends upon the type of
tax that it is and the respective elasticities of supply and demand in that market.

Figure 5.7
St
P
Elastic supply
Inelastic demand
S
Price buyers
pay
Price without tax tax
Price sellers
receive D

When supply is more elastic than demand, the incidence of the tax falls more heavily on buyers
than on sellers.

Figure 5.8 St

P S
Inelastic supply
Elastic demand

Price buyers
pay
Price without tax
tax

Price sellers D
receive
Q

When demand is more elastic than supply, the incidence of the tax falls more heavily on sellers
than on buyers.

Summary:
 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 the taxes. In the new equilibrium, buyers pay more for
the good, and sellers receive less.

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