Survey of Economics: Principles,

Applications and Tools

Eighth Edition

https://www.pearson.com/mylab

Course ID: chakroun54908

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 1

Introduction: What Is
Economics?

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Chapter Outline
1.1 What Is Economics?
1.2 The three economic questions: What, How and Who?
1.3 The Economic Way of Thinking
1.4 Microeconomics Verus Macroeconomics

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1.1 What Is Economics?

Economics: The study of choices when there is scarcity.

Scarcity: The resources we use to produce goods and
services are limited.

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Some Examples of Scarcity and Trade-
offs
• You have a limited amount of time. Each hour on the job
means one less hour for study or play.
• A city has a limited amount of land. If the city uses an acre
of land for a park, it has one less acre for housing, retailers,
or industry.
• You have limited income this year. If you spend $17 on a
music CD, that’s $17 less you have to spend on other
products or to save.

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The Five Factors of Production (1 of 2)
Factors of Production: The resources used to produce
goods and services; also known as production inputs or
resources.
Natural Resources: Resources provided by nature and
used to produce goods and services.
Labor: Human effort, including both physical and mental,
used to produce goods and services.

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The Five Factors of Production (2 of 2)
Physical Capital: The stock of equipment, machines,
structures, and infrastructure that is used to produce goods
and services.
Human Capital: The knowledge and skills acquired by a
worker through education and experience and used to
produce goods and services.
Entrepreneurship: The effort used to coordinate the factors
of production—natural resources, labor, physical capital, and
human capital—to produce and sell products.

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1.2 The Three Key Economic
Questions: What, How, and Who?
The choices made by individuals, firms, and governments
answer three questions:
1. What products do we produce?
2. How do we produce the products?
3. Who consumes the products?

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Economic Models
Economists use economic models to explore the choices
people make and the consequences of those choices.
Economic model: A simplified representation of an
economic environment, often employing a graph.

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Positive versus Normative Analysis
Most modern economics is based on positive analysis:
Positive Analysis: Answers the question “What is?” or
“What will be?”
A second type of economic reasoning is normative in
nature:
Normative Analysis: Answers the question “What ought
to be?”

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Table 1.1 Comparing Positive and
Normative Questions
Positive Questions Normative Questions
• If the government increases the • Should the government
minimum wage, how many workers increase the minimum wage?
will lose their jobs?
• If two office-supply firms merge, will • Should the government block
the price of office supplies increase? the merger of two office-supply
firms?
• How does a college education affect • Should the government
a person’s productivity and earnings? subsidize a college education?
• How do consumers respond to a cut • Should the government cut
in income taxes? taxes to stimulate the
economy?
• If a nation restricts shoe imports, who • Should the government restrict
benefits and who bears the cost? imports?

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1.3 The Economic Way of Thinking
List the four elements of the economic way of thinking.
“The theory of economics does not furnish a body of settled
conclusions immediately applicable to policy. It is a method
rather than a doctrine, an apparatus of the mind, a technique
of thinking which helps its possessor draw correct
conclusions.”
John Maynard Keynes, The Collected Writings of John
Maynard Keynes, Volume 7

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Use Assumptions to Simplify
Economists use assumptions to make things simpler and
focus attention on what really matters.
We have to be careful to make the right assumptions and
simplifications.

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Isolate Variables—Ceteris Paribus
Economists often consider how one variable changes in
isolation, in order to see how its changes affect other
variables.
Variable: A measure of something that can take on
different values.
Ceteris Paribus: The Latin expression meaning that other
variables are held fixed.

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Think at the Margin
How will a small change in one variable affect another
variable, and what impact will that have on people’s
decision-making?
Marginal Change: A small, one-unit change in value

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Rational People Respond to Incentives
A key assumption of most economic analysis is that people
act rationally, that is, in their own self-interest.
This does not mean that people are only motivated by self-
interest, but instead that this is their primary motivation.
Rationality implies that when the payoff (benefit) to doing
something changes, people will change their behavior to
make their payoff as large as possible.

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1.4 Microeconomics Vs Macroeconomics

The field of economics is divided into two categories:

macroeconomics and microeconomics.
Macroeconomics: The study of the nation’s economy as a
whole; focuses on the issues of inflation, unemployment, and
economic growth.

Microeconomics: The study of the choices made by

households, firms, and governments, and how these choices
affect the markets for goods and services.

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Using Macroeconomics to Understand
Why Economies Grow
The world economy has been growing in recent decades,
averaging about 1.5 percent higher per capita income per
year.
Why do some countries grow much faster than others?
Macroeconomics will help us understand why.

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Using Macroeconomics to Understand
Economic Fluctuations
All countries, even those where per capita income is
generally rising, experience economic fluctuations,
including periods where the economy temporarily shrinks.
What options do governments have to moderate these
fluctuations?
And should they do so?

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Using Macroeconomics to Make
Informed Business Decisions
A manager who studies macroeconomics will be better
equipped to understand the complexities of interest rates
and inflation, and how they affect the firm.
Should a firm borrow money now at a fixed interest rate?
Or wait a while, hoping interest rates will fall?

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Using Microeconomics to Understand
Markets and Predict Changes
One reason for studying microeconomics is to better
understand how markets work and to predict how various
events affect the prices and quantities of products in
markets.
For example, how would a tax on beer affect:
1. The price of beer?
2. How many people buy beer?
3. How many people are likely to drink and drive?

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Using Microeconomics to Make
Personal and Managerial Decisions
On the personal level, we use economic analysis to decide
how to spend our time, what career to pursue, and how to
spend and save the money we earn.
Managers use economic analysis to decide how to produce
goods and services, how much to produce, and how much to
charge for them.

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Using Microeconomics to Evaluate
Public Policies
We can use economic analysis to determine how well the
government performs its roles in the market economy.
For example, prescription drugs are protected from being
copied because of government patents.
If we shortened patent lengths, we may get cheaper generic
drugs sooner; but fewer drugs may get developed because
of the decreased profitability of drug development.
Microeconomics can help evaluate the best policy here.

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Key Terms
Ceteris paribus Marginal change
Economic model Microeconomics
Economics Natural resources
Entrepreneurship Normative analysis
Factors of production Physical capital
Human capital Positive analysis
Labor Scarcity
Macroeconomics Variable

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1A.1 Using Graphs
Economists use several types of graphs to present data,
represent relationships between variables, and explain
concepts.
Although it is possible to do economics without graphs, it’s
a lot easier with them in your toolbox.

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Figure 1A.1 Graphs of Single Variables

Left: Pie Graph for Types of Recorded Music Sold in the United States
Right: Bar Graph for U.S. Export Sales of Copyrighted Products

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Figure 1A.2 Time Series Graph

A time series graph shows how the value of a variable changes

over time. In the right panel, the vertical axis is truncated,
indicated by the double hash marks on the y-axis. This
exaggerates the fluctuations in the data.
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Figure 1A.3 Basic Elements of a Two-
Variable Graph
One variable is measured along
the horizontal, or x, axis, while
the other variable is measured
along the vertical, or y, axis.
The origin is defined as the
intersection of the two axes,
where the values of both
variables are zero.
The dashed lines show the
values of the two variables at a
particular point.

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Graphing Two Variables
The slope of a line relating two variables on a graph indicates
whether they have a positive or negative relationship.
Positive relationship: A relationship in which two variables
move in the same direction.
Negative relationship: A relationship in which two variables
move in opposite directions.

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Figure 1A.4 Relationship between
Hours Worked and Income
There is a positive
relationship between work
hours and income, so the
income curve is positively
sloped.
The slope of the curve is
$8: Each additional hour of
work increases income by
$8.

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Computing the Slope
Income
Slope 
Work hours

Vertical difference between two points rise

Slope  
Horizontal difference between two points run

Slope of a curve: The vertical difference between two points (the rise)
divided by the horizontal difference (the run).
In general, if the variable on the vertical axis is y and the variable on the
horizontal axis is x, we can express the slope as:

y
Slope 
x

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Figure 1A.5 Movement Along a Curve
versus Shifting the Curve
To draw a curve showing the
relationship between hours worked
and income, we fix the weekly
allowance ($40) and the wage ($8
per hour).
A change in the hours worked
causes movement along the curve,
for example, from point b to point c.
A change in any other variable shifts
the entire curve. For example, a $50
increase in the allowance (to $90)
shifts the entire curve upward by
$50.
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Figure 1A.6 Negative Relationship between
CD Purchases and Downloaded Songs
There is a negative relationship between
the number of CDs and downloaded
songs that a consumer can afford with a
budget of $360.
The slope of the curve is −$12: Each
additional CD (at a price of $12 each)
decreases the number of downloadable
songs (at $1 each) by 12 songs.
Vertical difference
Slope 
Horizontal difference
120  240  120
    12
20  10 10
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Figure 1A.7 Nonlinear Relationships (1 of 2)
There is a positive and nonlinear
relationship between study time
and the grade on an exam. As
study time increases, the exam
grade increases at a decreasing
rate.
For example, the second hour of
study increased the grade by 4
points (from 6 points to 10 points),
but the ninth hour of study
increases the grade by only 1 point
(from 24 points to 25 points).

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Figure 1A.7 Nonlinear Relationships (2 of 2)
There is a positive and nonlinear
relationship between the quantity of
grain produced and total production
cost. As the quantity increases, the
total cost increases at an increasing
rate.
For example, to increase production
from 1 ton to 2 tons, production cost
increases by $5 (from $10 to $15) but
to increase the production from 10 to
11 tons, total cost increases by $25
(from $100 to $125).

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1A.2 Computing Percentage Changes
and Using Equations
To compute a percentage change, we divide the change in
the variable by the initial value of the variable, and then
multiply by 100:

New value  initial value

Percentage change   100
Initial value

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Application 3: The Perils of
Percentages (1 of 2)
In the 1970s, the government of Mexico City repainted the
highway lane lines on the Viaducto to transform a four-lane
highway into a six-lane highway.
• The government announced that the highway capacity had
increased by 50% (equal to 2 divided by 4).
• Unfortunately, the number of collisions and traffic fatalities
increased, and one year later the government restored the
four-lane highway and announced that the capacity had
decreased by 33% (equal to 2 divided by 6).

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Application 3: The Perils of
Percentages (2 of 2)
This anecdote reveals a potential problem with using the
simple approach to compute percentage changes. Because
the initial value (the denominator) changes, the computation
of percentage increases and decreases are not symmetric.
There is a solution to this problem: using the midpoint
method for percentage changes:

New value  initial value

Percentage change   100
Average value

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Using Equations to Compute Missing
Values (1 of 2)
It will often be useful to compute the value of the numerator
or the denominator of an equation. For example, if we know
the change in work hours, and the slope of the line relating
change in income and change in work hours:
Income
Slope 
Work hours

Work hours  Slope  Income

Income  Work hours  Slope

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Using Equations to Compute Missing
Values (2 of 2)
Income  Work hours  Slope

Then, if you work seven extra hours, and the slope of this
line is $8 per hour, then your change in income is:

Income  7 hours  $8per hour

Income  $56

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Key Terms (Appendix)
Negative relationship
Positive relationship
Slope of a curve

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 2

The Key Principles of

Economics

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Chapter Outline
2.1 The Principle of Opportunity Cost
2.2 The Marginal Principle
2.3 The Principle of Voluntary Exchange
2.4 The Principle of Diminishing Returns
2.5 The Real-Nominal Principle

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2.1 The Principle of Opportunity Cost
Apply the principle of opportunity cost.
Economics is all about making choices; to make good
choices, we must compare the benefit of something to its
cost.
Opportunity Cost: What you sacrifice to get something.
“There is no such thing as a free lunch”

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Application 1: The cost of doing business

Jack left a job paying $60,000 per year to

start his own florist shop in a building he
owns. The market value of the building
is $80,000. He pays $30,000 per year for
flowers and other​ supplies, and has a bank
account that pays 5 percent interest. What is
the economic cost of​ Jack's business?

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The Cost of Military Spending
The war in Iraq cost the United States an estimated $1
trillion. Each $100 billion could:
• Enroll 13 million preschool children in the Head Start
program for one year.
• Hire 1.8 million additional teachers for one year.
• Immunize all the children in less-developed countries for
the next 33 years.

The true cost of the war was its opportunity cost: what the
United States sacrificed for it.

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Figure 2.1 Scarcity and the Production
Possibilities Curve (1 of 3)
Production possibilities
curve: A curve that shows
the possible combinations
of products that an
economy can produce,
given that its productive
resources are fully
employed and efficiently
used.

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Figure 2.1 Scarcity and the Production
Possibilities Curve (2 of 3)
The production
possibilities curve
illustrates the principle of
opportunity cost for an
entire economy.
An economy has a fixed
amount of resources. If
these resources are fully
employed, an increase in
the production of wheat
comes at the expense of
steel.

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Figure 2.1 Scarcity and the Production
Possibilities Curve (3 of 3)
Each additional 10 tons of
wheat requires sacrificing
progressively more steel—
50 tons from a to b, 180
tons from c to d.
Some resources are better
suited for steel production,
and some are better suited
to wheat production.

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Figure 2.2 Shifting the Production
Possibilities Curve
An increase in the quantity
of resources or
technological innovation in
an economy shifts the
production possibilities
curve outward.
Starting from point f, a
nation could produce more
steel (point g), more wheat
(point h), or more of both
goods (points between g
and h).

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2.2 The Marginal Principle
Apply the marginal principle.
We rarely make all-or-nothing choices. Economists tend to think
in marginal terms: the effect of a small or incremental change.
Marginal benefit: The additional benefit resulting from a small
increase in some activity.
Marginal cost: The additional cost resulting from a small
increase in some activity.
The marginal principle: Increase the level of an activity as long
as its marginal benefit exceeds its marginal cost. Choose the
level at which the marginal benefit equals the marginal cost.

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Application 2: Hiring people

1) The table below shows the marginal benefit that Khaled earns from keeping his store
open one more hour. Khaled has a marginal cost of $40 per hour. Khaled stays open
20 hours.

a) Do you think Khaled’s decision to stay open 20 hours is optimal? Why? (1 mark)
b) How many hours do you advise Khaled to stay open? Why? (2 marks)
2.3 The Principle of Voluntary Exchange
Apply the principle of voluntary exchange.
Why would two people trade with one another?
Because each believes that what they receive is worth
more to them than what they give.
The principle of voluntary exchange: A voluntary
exchange between two people makes both better off.
Example: When you work, you trade your time for money.
The money is more valuable than the time to you, and your
time is more valuable than the money to your employer.

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2.4 The Principle of Diminishing
Returns
Apply the principle of diminishing returns.
You run a small copy shop with one copying machine and
one worker, who can copy 500 pages per hour.
You add another worker, but output increases to only 800
pages per hour, not doubling to 1,000.
Why? They now share the copier, so each is less productive.
The principle of diminishing returns: Suppose output is
produced with two or more inputs, and we increase one input
while holding the other input or inputs fixed. Beyond some
point—called the point of diminishing returns—output will
increase at a decreasing rate.
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Why Do Diminishing Returns Occur?
Diminishing returns occurs because one of the inputs to the
production process is fixed.
When a firm can vary all its inputs, including the size of the
production facility, the principle of diminishing returns is not
relevant.
If you doubled both the number of workers and equipment,
output ought to double also—or maybe more than double, if
specialization is beneficial.

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Application 4: Fertilizer and Crop Yields
Adding fertilizer to a field
increases its production; but
this is subject to diminishing
returns.
Why? The other inputs to the
production process are fixed,
such as the field itself, the rain,
the sunlight, etc. Each
additional bag of fertilizer is
progressively less productive.
Some representative numbers
are on the next slide.
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Table 2.1 Fertilizer and Corn Yield

Bags of Nitrogen Fertilizer Bushels of Corn per Acre

0 85
1 120
2 135
3 144
4 147

The first bag of fertilizer increases production by 35

bushels, but subsequent bags of fertilizer increase
production by less and less.

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2.5 The Real-Nominal Principle
Apply the real-nominal principle.
Most modern money is not inherently valuable, but is
valuable because of what it will buy.
The real-nominal principle: What matters to people is the
real value of money or income—its purchasing power—not
its face value.
Nominal value: The face value of an amount of money.
Real value: The value of an amount of money in terms of
what it can buy.

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Table 2.2 The Real Value of the
Minimum Wage, 1974–2015
Blank 1974 2015
Minimum wage per hour $2.00 $7.25
Weekly income from minimum wage 80 290
Cost of a standard basket of goods 47 236
Number of baskets per week 1.70 1.23

Between 1974 and 2015, the federal minimum wage increased

from $2.00 to $7.25.
Was the typical minimum-wage worker better or worse off in
2015?
We can apply the real-nominal principle to see that the value of
the minimum wage has actually decreased over this time period.
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Application 5: Repaying Student Loans
Suppose you finish college with $40,000 in student loans and
start a job that pays a salary of $50,000 in the first year. In 10
years, you must repay your college loans. Which would you
prefer, stable prices, rising prices, or falling prices?
Hint: The nominal value of the loans will not change, even as
prices change.

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Key Terms
Marginal benefit
Marginal cost
Opportunity cost
Production possibilities curve
Nominal value
Real value

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 3

Demand, Supply, and

Market Equilibrium

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Chapter Outline
3.1 The Demand Curve
3.2 The Supply Curve
3.3 Market Equilibrium: Bringing Demand and Supply
Together
3.4 Market Effects of Changes in Demand
3.5 Market Effects of Changes in Supply
3.6 Predicting and Explaining Market Changes

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4.1 The Demand Curve
Describe and explain the law of demand.
In this chapter, we will develop the model of demand and
supply—the most important tool of economic analysis.
We will assume markets are perfectly competitive,
implying that individual sellers are so small they cannot
affect the market price.
Perfectly competitive market: A market with many buyers
and sellers of a homogeneous product and no barriers to
entry.

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Consumers and Demand
How much of a particular product are consumers willing to
buy during a particular period? We call this the quantity
demanded.
Quantity demanded: The amount of a product that
consumers are willing and able to buy.
What alters the amount consumers are willing to buy? We
divide this into two categories:
• The price of the product
• Everything else!

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Figure 3.1 The Individual Demand
Curve (1 of 4)
The table shows how
many pizzas a consumer
will buy at a selection of
prices. This is a demand
schedule.
Demand schedule: A
table that shows the
relationship between the
price of a product and the
quantity demanded,
ceteris paribus.

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Figure 3.1 The Individual Demand
Curve (2 of 4)
We plot each of the price-
quantity pairs on the graph;
joining those points gives
the individual demand
curve for pizza.
Individual demand curve:
A curve that shows the
relationship between the
price of a good and quantity
demanded by an individual
consumer, ceteris paribus.

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Figure 3.1 The Individual Demand
Curve (3 of 4)
The demand curve slopes
downward; this is so typical,
we call it the law of demand.
Law of demand: There is a
negative relationship between
price and quantity demanded,
ceteris paribus.

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Figure 3.1 The Individual Demand
Curve (4 of 4)
As price rises from $8 to $10,
the consumer buys 3 fewer
pizzas. This is a change in
quantity demanded.
Change in quantity
demanded: A change in the
quantity consumers are willing
and able to buy when the price
changes; represented
graphically by movement along
the demand curve.

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Figure 3.2 From Individual to Market
Demand
Adding quantity demanded by each consumer at each price
gives us the market demand curve.
Market demand curve: A curve showing the relationship
between price and quantity demanded by all consumers,
ceteris paribus.

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Application 1: Young Smokers and the
Law of Demand
As price decreases, the quantity of
cigarettes demanded increases for
two reasons:
• People who already smoke,
choose to smoke more; and
• Some (mostly young) people start
smoking.

Keeping cigarette prices high, or

increasing them with taxes, is one way
that governments try to discourage
young people from starting smoking.

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3.2 The Supply Curve
Describe and explain the law of supply.
How much of a particular product are firms willing to produce
and sell during a particular period? We call this the quantity
supplied.
Quantity supplied: The amount of a product that firms are
willing and able to sell.
What alters the amount firms are willing to sell? We divide this
into two categories:
• The price of the product
• Everything else!

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Figure 3.3 The Individual Supply
Curve (1 of 4)
The table shows how many
pizzas a firm will sell at a
selection of prices. This is a
supply schedule.
Supply schedule: A table
that shows the relationship
between the price of a
product and the quantity
supplied, ceteris paribus.

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Figure 3.3 The Individual Supply
Curve (2 of 4)
We plot each of the price-
quantity pairs on the graph;
joining those points gives the
individual supply curve for
pizza.
Individual demand curve: A
curve that shows the
relationship between the price
of a good and quantity supplied
by an individual firm, ceteris
paribus.

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Figure 3.3 The Individual Supply
Curve (3 of 4)
The supply curve slopes upward; this
is so typical, we call it the law of
supply.
Law of supply: There is a positive
relationship between price and
quantity supplied, ceteris paribus.
There are some prices below which
the firm would not provide any pizzas;
for this firm, the minimum supply
price appears to be $2.
Minimum supply price: The lowest
price at which a product will be
supplied.

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Figure 3.3 The Individual Supply
Curve (4 of 4)
As price rises from $8 to $10,
the firm is willing to provide 100
more pizzas. This is a change
in quantity supplied.
Change in quantity supplied:
A change in the quantity firms
are willing and able to sell when
the price changes; represented
graphically by movement along
the supply curve.

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Why Is the Individual Supply Curve
Positively Sloped?
A higher price encourages the firm to increase its output by
purchasing more materials and hiring more workers.
Even if the new materials are more expensive, or the new
workers are more costly or less productive, the firm is willing to
incur those higher marginal costs to sell at higher prices.
• This is consistent with the marginal principle: increase the
level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit
equals the marginal cost.
The price is the marginal benefit; the supply curve shows the
firm’s marginal cost of production.

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Figure 3.4 From Individual to Market
Supply
Adding quantity supplied by each firm at each price gives
us the market supply curve.
Market supply curve: A curve showing the relationship
between price and quantity supplied by all firms, ceteris
paribus.

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Figure 3.5 The Market Supply Curve
with Many Firms
A perfectly competitive
market has hundreds of
firms rather than just two.
In the case of many firms,
the market supply curve
will be smooth rather than
kinked.
In this graph, we assume
there are 100 firms
identical to Lola’s.

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Why Is the Market Supply Curve
Positively Sloped?
There are two reasons why the market supply curve is
positively sloped. As the market price increases,
1. Individual firms increase output by purchasing more
materials and hiring more workers; and
2. New firms enter the market, encouraged by the higher
price.

As with the individual supply curve, the market supply curve

shows the marginal cost of production, this time for the
market as a whole.

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Application 2: Sheep, Wool, and the
Law of Supply
In the 1990s, the world
price of wool decreased
by about 30%. The law
of supply suggests wool
output would decrease.
It did; wool-exporting
countries like New
Zealand converted land
to more profitable uses,
like dairy farming,
forestry, and wine
production.

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3.3 Market Equilibrium: Bringing
Demand and Supply Together
Explain the role of price in reaching a market
equilibrium.
A market is an arrangement that brings buyers and sellers
together. These buyers and sellers jointly determine prices
and quantities traded.
Market equilibrium: A situation in which the quantity
demanded equals the quantity supplied at the prevailing
market price.
When a market is in equilibrium, there is no pressure on the
price to change.

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Figure 3.6 Market Equilibrium (1 of 3)
At the market equilibrium
(point a, with price = $8 and
quantity = 30,000), the
quantity supplied equals the
quantity demanded.
Everyone willing to pay $8
receives a pizza for that
price; and every pizza firms
are willing to produce at $8
gets sold.

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Figure 3.6 Market Equilibrium (2 of 3)
At a price below the equilibrium
price ($6), there is excess
demand—the quantity demanded
at point c exceeds the quantity
supplied at point b.
Excess demand: A situation in
which, at the prevailing price, the
quantity demanded exceeds the
quantity supplied.
This mismatch causes the price of
pizza to rise; firms will realize they
can raise the price and still sell all
the pizzas they planned to sell.
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Figure 3.6 Market Equilibrium (3 of 3)
At a price above the equilibrium price
($12), there is excess supply—the
quantity supplied at point e exceeds
the quantity demanded at point d.
Excess supply: A situation in which
the quantity supplied exceeds the
quantity demanded at the prevailing
price.
This mismatch causes the price of
pizza to fall; firms will realize they
cannot sell all of their pizzas at the
prevailing price, and will start
undercutting one another.

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Application 3: Shrinking Wine Lakes
The European Union guarantees
minimum prices for agricultural
products like grapes. These
above-equilibrium prices
encourage overproduction, which
the EU guarantees to buy.
Recent reforms have reduced
(and in some cases eliminated)
these price guarantees, resulting
in shrinking excess “wine lakes”
and “butter mountains.”

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3.4 Market Effects of Changes in
Demand
Describe the effect of a change in demand on the
equilibrium price.
Market equilibrium occurs when the quantity supplied equals
the quantity demanded.
Changes in the demand side of the market can affect the
equilibrium price and the equilibrium quantity.

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Figure 3.7 Change in Quantity Demanded
Versus Change in Demand (1 of 2)

Panel (A) shows a change in price causing a change in quantity

demanded, a movement along a single demand curve.
A decrease in price causes a move from point a to point b, increasing
the quantity demanded.

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Figure 3.7 Change in Quantity Demanded
Versus Change in Demand (2 of 2)

Panel (B) shows a change in demand caused by changes in a variable

other than the price. This shifts the entire demand curve.
An increase in demand shifts the demand curve from D1 to D2.
Change in demand: A shift of the demand curve caused by a change in
a variable other than the price of the product.
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Increases in Demand Shift the Demand
Curve (1 of 3)
What could cause the demand curve to increase (shift to the
right)? Anything other than a price decrease that makes
consumers want to buy more of the good. Some examples:
• An income change: Consumers buy more vacations and
new cars when their income increases. We call these
normal goods. But consumers buy less of some goods (like
second-hand clothing, or ramen noodle packets) when their
income increases: these are inferior goods.
Normal good: A good for which an increase in income
increases demand.
Inferior good: A good for which an increase in income
decreases demand.
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Increases in Demand Shift the Demand
Curve (2 of 3)
More examples:
• Increase in the price of a substitute good: Tacos and pizza are
substitutes: when the price of tacos rise, some consumers switch
to buying pizzas instead.
• Decrease in the price of a complementary good: Pay-per-view
sports events and pizza are complements: when the price of a
pay-per-view event falls, more consumers watch it, and buy more
pizza to consume with it.
Substitutes: Two goods for which an increase in the price of one
good increases the demand for the other good.
Complements: Two goods for which a decrease in the price of
one good increases the demand for the other good.

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Increases in Demand Shift the Demand
Curve (3 of 3)
Even more examples:
• Increase in population: More people means more
potential pizza consumers.
• Shift in consumer preferences: Consumers might
decide the like for pizza more than they used to. A
successful pizza advertising campaign might increase
the demand for pizza.
• Expectations of higher future prices: If consumers
learn pizza prices will rise next week, they might buy
more pizzas this week, and fewer next week.

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Table 3.1 Increases in Demand Shift
the Demand Curve to the Right

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Figure 3.8 An Increase in Demand
Increases the Equilibrium Price (1 of 2)
An increase in demand shifts
the demand curve to the right:
At each price, the quantity
demanded increases.
At the initial price ($8), there is
excess demand, with the
quantity demanded (point b)
exceeding the quantity
supplied (point a).
The excess demand causes
the price to rise, and
equilibrium is restored at point
c.
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Figure 3.8 An Increase in Demand
Increases the Equilibrium Price (2 of 2)
The result of the increase
in demand: the equilibrium
price rises to $10, and the
equilibrium quantity of
pizzas rises to 40,000
pizzas per month.
Generally, we predict an
increase in demand will
increase the equilibrium
price and increase the
equilibrium quantity.

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Table 3.2 Decreases in Demand Shift
the Demand Curve to the Left

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Figure 3.9 A Decrease in Demand
Decreases the Equilibrium Price (1 of 2)
A decrease in demand shifts the
demand curve to the left: At each
price, the quantity demanded
decreases.
At the initial price ($8), there is
excess supply, with the quantity
supplied (point a) exceeding the
quantity demanded (point b).
The excess supply causes the
price to drop, and equilibrium is
restored at point c.

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Figure 3.9 A Decrease in Demand
Decreases the Equilibrium Price (2 of 2)
The result of the decrease in
demand: the equilibrium price
falls to $6, and the equilibrium
quantity of pizzas falls to
20,000 pizzas per month.
Generally, we predict an
decrease in demand will
decrease the equilibrium price
and decrease the equilibrium
quantity.

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Application 4: Craft Beer and the Price
of Hops
Between 2012 and 2017,
U.S. craft beer production
increased more than 30%.
Craft beer brewers
increased their demand for
ingredients, including hops.
As a result of the demand
increase, the equilibrium
price of hops rose
substantially: from $3.17 to
$5.92 per pound.

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3.5 Market Effects of Changes in Supply
Describe the effect of a change in supply on the
equilibrium price.

Market equilibrium occurs when the quantity supplied equals

the quantity demanded.
Changes in the supply side of the market can affect the
equilibrium price and the equilibrium quantity.

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Figure 3.10 Change in Quantity
Supplied versus Change in Supply (1 of 2)

Panel (A) shows a change in price causing a change in quantity

supplied, a movement along a single supply curve.
An increase in price causes a move from point a to point b,
increasing the quantity supplied.

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Figure 3.10 Change in Quantity
Supplied versus Change in Supply (2 of 2)

Panel (B) shows a change in supply caused by changes in a variable

other than price. This shifts the entire supply curve.
An increase in supply shifts the entire supply curve from S1 to S2.
Change in supply: A shift of the supply curve caused by a change in a
variable other than the price of the product.
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Increases in Supply Shift the Supply
Curve
What could cause the supply curve to increase (shift to the right)?
Anything other than a price increase that makes firms want to provide
more of the good. Some examples:
• A decrease in input costs: If wages or the cost of materials go down,
production becomes more profitable, so firms expand.
• Technological advance: New technologies can make production more
profitable and hence encourage expansion.
• Government subsidy: A payment from the government will also make
production more profitable also.
• Expected future prices falling: A firm that learns prices will fall next
month will try to sell more at current higher prices.
• Number of producers: More firms mean more production.

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Table 3.3 Changes in Supply Shift the
Supply Curve Downward and to the Right

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Figure 3.11 An Increase in Supply
Decreases the Equilibrium Price (1 of 2)
An increase in supply shifts
the supply curve to the right:
At each price, the quantity
supplied increases.
At the initial price ($8), there
is excess supply, with the
quantity supplied (point b)
exceeding the quantity
demanded (point a). The
excess supply causes the
price to drop, and equilibrium
is restored at point c.

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Figure 3.11 An Increase in Supply
Decreases the Equilibrium Price (2 of 2)
The result of the increase in
supply: the equilibrium price
falls to $6, and the equilibrium
quantity of pizzas rises to
36,000 pizzas per month.
Generally, we predict an
increase in supply will
decrease the equilibrium price
and increase the equilibrium
quantity.

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Table 3.4 Changes in Supply Shift the
Supply Curve Upward and to the Left

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Figure 3.12 A Decrease in Supply
Increases the Equilibrium Price (1 of 2)
A decrease in supply shifts
the supply curve to the left.
At each price, the quantity
supplied decreases.
At the initial price ($8), there
is excess demand, with the
quantity demanded (point a)
exceeding the quantity
supplied (point b). The
excess demand causes the
price to rise, and equilibrium
is restored at point c.

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Figure 3.12 A Decrease in Supply
Increases the Equilibrium Price (2 of 2)
The result of the decrease in
supply: the equilibrium price
rises to $10, and the
equilibrium quantity of pizzas
rises to 24,000 pizzas per
month.
Generally, we predict a
decrease in supply will
increase the equilibrium price
and decrease the equilibrium
quantity.

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Simultaneous Changes in Demand and
Supply
What happens to the equilibrium price and quantity when
both demand and supply increase?
It depends on which change is larger.
• If the effect on demand is larger, then the overall change
will “look like” the change in demand.
• If the effect on supply is larger, then the overall change
will “look like” the change in supply.

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Figure 3.13 Market Effects of Simultaneous
Changes in Demand and Supply

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Application 5: The Harmattan and the
Price of Chocolate
The harmattan is a dry, dusty
wind from the Sahara desert.
Each year it sweeps through
cocoa plantations in Ghana and
Ivory Coast, drying coca pods
and decreasing yields.
In 2015, the harmattan was
longer than usual (14 days rather
than the usual 5 days) so crop
yields were lower than usual; the
decrease in supply caused world
cocoa prices to rise in 2015.

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3.6 Predicting and Explaining Market
Changes
Use information on price and quantity to determine what
caused a change in price.
Using our demand and supply model, we have shown how
equilibrium prices are determined, and how changes in demand
and supply affect equilibrium prices and quantities.
When demand changes, both equilibrium price and quantity
change in the same direction as demand changes: increasing or
decreasing.
When supply changes, the equilibrium quantity changes in the
same direction as the supply change, but equilibrium price
changes in the opposite direction.
The table on the next slide summarizes this.
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Table 3.5 Market Effects of Changes in
Demand or Supply
Change in Demand How does the equilibrium How does the equilibrium
or Supply price change? quantity change?
Increase in demand Increase Increase

Decrease in demand Decrease Decrease

Increase in supply Decrease Increase

Decrease in supply Increase Decrease

We can use this knowledge to predict how prices and quantities will
change in response to a demand or supply change.
We can also use this knowledge “in reverse”: if we know the price and
quantity of a product both rose or fell, we should expect a change in
demand caused the changes.
Conversely, if the price and quantity of a product moved in opposite
directions, we should infer a change in supply occurred.

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Application 6: Why Did Drug Prices
Fall? (1 of 2)
“Do you know what’s happened to the price of drugs in the
United States? The price of cocaine, way down, the price of
marijuana, way down. You don’t have to be an expert in
economics to know that when the price goes down, it means
more stuff is coming in. That’s supply and demand.”
Ted Koppel, host of the ABC news program Nightline

Was Koppel right? That is, do falling drug prices prove the
U.S. government’s “war on drugs” was failing, and the
supply of illegal drugs was increasing

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Application 6: Why Did Drug Prices
Fall? (2 of 2)
There are two possible explanations:
• Koppel’s hypothesis: supply rose, resulting in lower prices
and higher quantities.
• The alternative: demand fell, resulting in lower prices and
lower quantities.
According to the U.S. Department of Justice, during this time
of falling prices, drug consumption actually decreased.
• This suggests the alternative explanation is more likely to
be correct.

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Key Terms
Change in demand Law of supply
Change in quantity demanded Market demand curve
Change in quantity supplied Market equilibrium
Change in supply Market supply curve
Complements Minimum supply price
Demand schedule Normal good
Excess demand Perfectly competitive market
Excess supply Quantity demanded
Individual demand curve Quantity supplied
Individual supply curve Substitutes
Inferior good Supply schedule
Law of demand

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 4

Elasticity: A Measure of
Responsiveness

Slides in this presentation contain

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Chapter Outline
4.1 The Price Elasticity of Demand
4.2 Using Price Elasticity
4.3 Elasticity and Total Revenue for a Linear Demand Curve
4.4 Other Elasticities of Demand
4.5 The Price Elasticity of Supply
4.6 Using Elasticities to Predict Changes in Prices

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4.1 The Price Elasticity of Demand
List the determinants of the price elasticity of demand.
Price elasticity of demand (Ed): A measure of the
responsiveness of the quantity demanded to changes in price;
equal to the absolute value of the percentage change in quantity
demanded divided by the percentage change in price.
percentage change in quantity demanded
Ed 
percentage change in price
Suppose that when the price of milk increases by 10%, the
quantity demanded of decreases by 15%:

percentage change in quantity demanded 15%

Ed    1.5
percentage change in price 10%

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Computing Percentage Changes and
Elasticities
Computing elasticities requires computing percentage
changes.
We can compute percentage changes via the initial-value
method or the midpoint method.
• The initial-value method is easier.
• The midpoint method is more accurate.
In this text, we use the initial-value approach in order to
concentrate on the economic intuition rather than the math.
A comparison of calculations using the two methods is on
the next slide.

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Table 4.1 Computing Price Elasticity
with Initial Values and Midpoints
Blank Blank Price Quantity

Data Initial $20 100

Blank New 22 80

Blank Blank Price Quantity

$2 divided by $20, times 100 = 10% negative 20 divided by 100, times 100 = negative 20%
Computation with Percentage change $2 20
10%   100 20%    100
Initial-value method $20 100
the absolute value of, negative 20% divided by 10%, = 2.0 Blank
Blank Price elasticity of 20%
2.0 
demand 10%
Blank Blank Price Quantity
$2 divided by $21, times 100 = 9.52% negative 20 divided by 90, times 100 = negative 22.22%
Computation with Percentage change $2 20
9.52%   100 22.22%   100
midpoint method $21 90
22.22%
the absolute value of negative 222.22% divided by 9.52% = 2.33
Blank Price elasticity of 2.33  Blank
demand 9.52%

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Price Elasticity and the Demand Curve
Price elasticity of demand and the slope of the demand
curve are related.

percentage change in quantity demanded

Ed 
percentage change in price
rise change in price
Slope  
run change in quantity

Roughly, a greater price elasticity of demand means a

shallower slope, and a smaller price elasticity of demand
means a steeper-sloped demand curve.

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Figure 4.1 Elasticity and Demand
Curves (Panel A)
Elastic demand: The
price elasticity of
demand is greater than
one, so the percentage
change in quantity
exceeds the percentage
change in price.
Example goods:
restaurant meals, air
travel, movies.

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Figure 4.1 Elasticity and Demand
Curves (Panel B)
Inelastic demand:
The price elasticity of
demand is less than
one, so the
percentage change in
quantity is less than
the percentage
change in price.
Example goods: milk,
salt, eggs, coffee,
cigarettes.

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Figure 4.1 Elasticity and Demand
Curves (Panel C)
Unit elastic demand: The
price elasticity of demand is
one, so the percentage
change in quantity equals
the percentage change in
price.
Example goods: housing,
juice.

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Figure 4.1 Elasticity and Demand
Curves (Panel D)
Perfectly inelastic
demand: The price
elasticity of demand is
zero.
In this extreme case, the
quantity demanded does
not change when the price
changes. This could only
happen if there were no
possible substitutes for the
good, say insulin for
diabetics.

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Figure 4.1 Elasticity and Demand
Curves (Panel E)
Perfectly elastic
demand: The price
elasticity of demand is
infinite.
In this extreme case,
buyers will buy as much
as sellers can offer at
the given price. When a
seller provides a tiny
fraction of output for the
market, this may be a
good assumption.

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Elasticity and the Availability of
Substitutes
The key factor in determining the price elasticity of demand for a
particular product is the availability of substitute products.
• For diabetics, there is no substitute for insulin, so the demand
for insulin is inelastic.
• For cereal-eaters, there are many substitutes for cornflakes, so
the demand for cornflakes is elastic.
Adjustment to price changes is easier over time. So the price
elasticity of demand tends to be greater in the long run than in the
short run.
• If gasoline prices rise, you can do little about it in the short run.
• In the long run, you can move, change cars, etc.

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Table 4.2 Price Elasticities of Demand
for Selected Products (1 of 2)
Price Elasticity of
Blank
Product Demand
Inelastic Salt 0.1
Food (wealthy countries) 0.15
Weekend canoe trips 0.19
Water 0.2
Coffee 0.3
Physician visits 0.25
Sport fishing 0.28
Gasoline (short run) 0.25
Eggs 0.3
Cigarettes 0.3
Food (poor countries) 0.34
Shoes and footwear 0.7
Gasoline (long run) 0.6
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Table 4.2 Price Elasticities of Demand
for Selected Products (2 of 2)
Price Elasticity of
Blank
Product Demand
Unit Housing 1.0
elastic Fruit Juice 1.0
Automobiles 1.2
Elastic Foreign travel 1.8
Motorboats 2.2
Restaurant meals 2.3
Air travel 2.4
Movies 3.7
Specific brands of coffee 5.6

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Other Determinants of the Price
Elasticity of Demand
1. Elasticity is higher for goods that take a relatively large part of a
consumer’s budget.
– A 10% increase in the price of gum is unlikely to change the
quantity of gum demanded by much.
– But a 10% increase in the price of cars would have a large
effect.
2. Goods that are necessities have lower elasticities of demand;
goods that are luxuries have higher elasticities of demand.
– Food demand is inelastic in both rich and poor countries.
– Demand for air travel is elastic (though for some it may be
inelastic, say for travel to a funeral).

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Table 4.3 Determinants of Elasticity

Demand is relatively Demand is relatively

Factor elastic if … inelastic if …
Availability of There are many There are few
substitutes substitutes. substitutes.
Passage of time a long time passes. a short time passes.
Fraction of consumer is large. is small.
budget
Necessity the product is a the product is a
luxury. necessity.

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Application 1: The Elasticity of Demand
for Public Transit
When the price of a city bus
or subway ride increases,
what is the price elasticity of
demand for public transit?
• In the short run (one to two
years) it is 0.40: relatively
inelastic.
• In the long run it is 0.80:
close to unit elastic.

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4.2 Using Price Elasticity
Use price elasticity of demand to predict changes in quantity and
total revenue.
If we have values for two of the three variables in the elasticity formula,
we can compute the value of the third. The three variables are:
• the price elasticity of demand itself,
• percentage change in quantity, and
• the percentage change in price.
Specifically, we can rearrange the elasticity formula:
percentage change in quantity demanded
Ed 
percentage change in price
percentage change in quantity demanded
 percentage change in price  Ed
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Predicting Changes in Quantity
Suppose you are running a campus film series, and you
know the price elasticity of demand for tickets is 2.0.
If you raise prices by 15%, how many fewer tickets will you
sell?
percentage change in quantity demanded
 percentage change in price  Ed
 15%  2.0
 30%

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Price Elasticity and Total Revenue
Firms use the concept of price elasticity to predict the effects
of changing their prices.
Total revenue: The money a firm generates from selling its
product.
Suppose a firm increases the price of its product. Two things
happen:
• Good news: it gets more money for each product sold.
• Bad news: it sells fewer products.
The extent of the “bad news” depends on the price elasticity
of demand for the firm’s product.

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Table 4.4 Price and Total Revenue with
Different Elasticities of Demand
Blank Elastic Demand: Ed = 2.0 Blank
Price Quantity Sold Total Revenue
$10 100 $1,000
11 80 880
Blank Inelastic Demand: Ed = 0.50 Blank
Price Quantity Sold Total Revenue
100 10 $1,000
120 9 1,080

When elasticity is high, the “bad news” is large, and total

revenue falls.
When elasticity is low, the “bad news” is small, and total
revenue rises.
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Table 4.5 Price Elasticity and Total
Revenue

Blank Blank Elastic Demand: Ed > 1.0

If price … Total Because the percentage change in
revenue … quantity is …
  Larger than the percentage change in price.
  Larger than the percentage change in price.
Blank Blank Inelastic Demand: Ed < 1.0
If price … Total Because the percentage change in
revenue … quantity is …
  Smaller than the percentage change in
price.
  Smaller than the percentage change in
price.

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Using Elasticity to Predict the Revenue
Effects of Price Changes (1 of 2)
1. Market v s Brand Elasticity:
ersu

The demand for a specific brand of a product is more elastic

than the demand for the product.
Raising the price of all coffees would increase coffee revenue;
but raising the price of one brand would decrease revenue for
that brand.
2. Bus Fares and Deficits:
Public bus systems almost always run a deficit.
But demand is typically inelastic.
If fares were raised, the “good news” (more revenue per rider)
would dominate the “bad news” (fewer riders), so total fare
revenue would increase, potentially eliminating the deficit.

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Using Elasticity to Predict the Revenue
Effects of Price Changes (2 of 2)
3. A Bumper Crop is Bad News for Farmers:
An unusually large crop of soy beans increases the number of
bushels of soy beans for sale (good news).
But the price decreases, because of the increased supply (bad
news).
But demand is inelastic, so the bad news dominates the good
news: a bumper crop results in lower overall revenues.
4. Antidrug Policies and Property Crime:
Antidrug policies raise the price of drugs. But demand for drugs
is inelastic, so total spending on drugs increases.
This increases property crime, as drug addicts commit crime to
obtain money for drugs.

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Application 2: Vanity Plates and the
Elasticity of Demand
Virginia has the highest ratio of
vanity license plates: over 10% of
vehicles have them.
Why? Because the price is so low,
$10 per year.
If Virginia wanted to raise more
revenue from vanity license plates,
it should raise its price: the price
elasticity of demand is only 0.26.
• A 100% increase in price would
decrease quantity demanded
only 26%.

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4.3 Elasticity and Total Revenue for a
Linear Demand Curve
Explain how the price elasticity of demand varies along a linear
demand curve.

It is often useful to represent the demand for a product with a linear

demand curve.
• A linear demand curve—a straight line—has a constant slope, but
that does not mean that it has a constant elasticity of demand.
In fact, the price elasticity of demand decreases as we move downward
along a linear demand curve.
• On the upper half of a linear demand curve, demand is elastic.
• On the lower half of the curve, demand is inelastic.
• At the midpoint of a linear demand curve, demand is unit elastic.

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Figure 4.2 Elasticity and Total Revenue
along a Linear Demand Curve (Panel A)

The slope of this demand curve is −$2 per unit quantity. We

will use this in the table on the next slide to compute the
elasticity at three points: e, u, and i (elastic, unit elastic,
and inelastic).
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Table 4.6 Elasticity of Demand along a
Linear Demand Curve
A B C D E F
Percentage Change Percentage
Starting Change Change in in Change in Elasticity of
Point in Price Price Quantity Quantity Demand
e: Elastic ‒$2 $2 $2 over $80 =
negative
+1 1 over110 = 10% absolute value of 10% over
10%
 2.5%
negative 2.5%  10% 4
negative 2.5% = 4.
$80 10 2.5%
u: Unit ‒$2 $2
negative $2 over $50 =
+1 1 over125 = 4%. absolute value of 4% over
4%
 4%
negative 4%.  4% 1
negative 4% = 1.
elastic $50 25 4%
i: inelastic ‒$2 $2
negative $2 over $20 =
+1 1 over 40 = 2.5%
1 absolute2.5%
value of 2.5% over
 10%
negative 10%  2.5% negative 10% = 0.25 0.25
$20 40 10%

The slope of −$2 per unit quantity means each increase in quantity of 1
(column D) is associated with the price decreasing by $2 (column B).
The elasticity is lower at greater quantities (lower prices): a large
percentage change in price induces a smaller quantity change.
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Figure 4.2 Elasticity and Total Revenue along
a Linear Demand Curve (Both Panels)
Since elasticity varies along the
linear demand curve, so does
the total revenue:
• When demand is elastic,
lowering price raises total
revenue.
• When demand is inelastic,
raising price raises total
revenue.
• When demand is unit elastic,
total revenue is maximized.

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Application 3: Drones and the Lower
Half of a Linear Demand Curve
Suppose a firm that produces hobby
drones (for civilian use) has a linear
demand curve for its product, with a
vertical intercept of $800. The firm
currently charges a price of $300.
Should the firm raise its price? Yes!
1. The price is below the midpoint of
the linear demand curve, so
raising price would increase
revenue.
2. It would need to make fewer
drones, so its costs would fall.

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4.4 Other Elasticities of Demand
Define the income elasticity and cross-price elasticity
of demand.
Price elasticity of demand measures the responsiveness of
consumers to changes in the price of a particular good.
But demand depends on other variables too; we can obtain
an elasticity for those variables, by seeing how quantity
demanded responds to changes in those other variables.
We will examine the effects of income and the prices of
related goods.

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Income Elasticity of Demand
Income elasticity of demand: A measure of the responsiveness
of demand to changes in consumer income; equal to the
percentage change in the quantity demanded divided by the
percentage change in income.

percentage change in quantity demanded

Ei 
percentage change in income

If a 10% increase in income increases the quantity of books

demanded by 15%:

percentage change in quantity demanded 15%

Ei    1.5
percentage change in income 10%

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Cross-Price Elasticity of Demand
Cross-price elasticity of demand: A measure of the
responsiveness of demand to changes in the price of another
good; equal to the percentage change in the quantity demanded
of one good (X) divided by the percentage change in the price of
another good (Y).

percentage change in quantity of X demanded

E xy 
percentage change in price of Y

If a 20% increase in the price of bananas (B) increases the

quantity of apples (A) demanded by 5%:

percentage change in quantity of A demanded 5%

E AB    0.25
percentage change in price of B 20%
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Table 4.7 Income and Cross-Price
Elasticities for Different Types of Goods
This elasticity Is Positive for … Is Negative for …
Income elasticity Normal goods Inferior goods

Cross-price elasticity Substitute goods Complementary goods

Recall inferior goods are ones we buy less of as our income

rises, resulting in a negative income elasticity of demand.
• Normal goods—ones we buy more of as our income rises—
have a positive income elasticity of demand.
Substitutes are bought in place of one another: when the price of
one rises, the demand for the other increases (a positive cross-
price elasticity).
• Complements work the other way: when the price of one rises,
we buy less of the other—a negative cross-price elasticity.
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How Are These Elasticities Useful?
During a recession, incomes fall (or rise slowly).
• If you operate a retail store and know the income elasticity of
demand for your product and how incomes are changing, you
can predict how sales of your product will change.
A supermarket sells many products. When ordering for the
produce department of a supermarket, suppose you know
bananas will be on sale.
• If you know the price change for the bananas, and the cross-
price elasticities for other products, you can predict how much
more or less you will sell of the other products, and order
accordingly.

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Application 4: I Can Find That
Elasticity in Four Clicks!
The USDA has a web site
that provides estimates of
demand elasticities (own-
price, income, or cross-
price) for hundreds of food
products, and for dozens of
countries.
Check it out:
https://data.ers.usda.gov/
reports.aspx?ID=17825

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4.5 The Price Elasticity of Supply
List the determinants of the price elasticity of supply.
We can also use elasticity do measure the responsiveness
of firms to changes in prices.
Price elasticity of supply: A measure of the
responsiveness of the quantity supplied to changes in price;
equal to the percentage change in quantity supplied divided
by the percentage change in price.

percentage change in quantity supplied

Es 
percentage change in price

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Figure 4.3 The Slope of the Supply
Curve and Supply Elasticity

As with demand curves, a steeper slope means a smaller price

elasticity of supply, and a shallower slope means a greater price
elasticity of supply. For panel A,

percentage change in quantity supplied 2%

Es    0.10
percentage change in price 20%
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What Determines the Price Elasticity of
Supply?
The price elasticity of supply is determined by how rapidly
production costs increase as the total output of the industry
increases.
• If the marginal cost increases rapidly, the supply curve is
relatively steep and the price elasticity is relatively low.
• Consider the pencil industry: increasing output is unlikely
to increase input costs much, so the supply curve will be
quite flat, with a high price elasticity of supply.

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The Role of Time: Short-Run versus
Long-Run Supply Elasticity
The supply curve is positively sloped because of two
increases to an increase in price:
• Short run: A higher price encourages existing firms to
increase their output by purchasing more materials and
hiring more workers.
• Long run: New firms enter the market and existing firms
expand their production facilities to produce more output.

Greater quantity changes will result from a given price

change in the long run: a greater price elasticity of supply.

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Extreme Cases: Perfectly Inelastic
Supply and Perfectly Elastic Supply
For some goods and services, there is only a fixed amount of the
good or service available: a perfectly inelastic supply.
Perfectly inelastic supply: The price elasticity of supply equals
zero.
Land is a good example: as Will Rogers said, “The trouble with land
is that they’re not making it anymore.”
For other goods and services, the marginal cost of production may
not change as we provide one more unit. These have a perfectly
elastic supply.
Perfectly elastic supply: The price elasticity of supply is equal to
infinity.

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Figure 4.4 Perfectly Inelastic Supply
and Perfectly Elastic Supply

In Panel A, the quantity supplied is the same at every price, so the

price elasticity of supply is zero.
In Panel B, the quantity supplied is infinitely responsive to changes
in price, so the price elasticity of supply is infinite.
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Predicting Changes in Quantity
Supplied
We can rearrange the formula for price elasticity of supply as we
did for price elasticity of demand:

percentage change in quantity supplied

Es 
percentage change in price
percentage change in quantity supplied
 percentage change in price  Es

If the elasticity of supply is 0.80 and price rises by 5%:

percentage change in quantity supplied

 percentage change in price  Es  5%  0.80  4%

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Application 5: The Short-Run and Long-
Run Elasticity of Supply of Coffee
Suppose the price of coffee beans
rises.
In the short run, farmers will use
more fertilizer and water, and more
labor, to obtain greater output per
bush.
In the long run, they will also plant
more bushes, resulting in a greater
output increase for the same size
price increase—greater price
elasticity of supply in the long run.

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4.6 Using Elasticities to Predict
Changes in Prices
Use demand and supply elasticities to predict changes
in equilibrium prices.
When demand or supply changes, we can use a simple
demand-and-supply graph to predict whether the equilibrium
price will increase or decrease.
But we might want to do better: predicting how much the
equilibrium price will change.
• Demand and supply elasticities can help us to make this
prediction.

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The Price Effects of a Change in
Demand
Suppose the demand for milk increases. Immediately, there
is an excess demand for milk. We know the price will rise to
eliminate the excess demand.
What would make the resulting increase in price relatively
small?
1. A small increase in demand (so the amount of excess
demand is small).
2. Highly elastic demand (so the quantity demanded
changes a lot in response to a price change).
3. Highly elastic supply (so the quantity supplied changes a
lot in response to a price change).

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Figure 4.5 An Increase in Demand
Increases the Equilibrium Price
Demand increases by 35 million
gallons; perhaps a new trade
deal sends 35 million gallons
overseas.
The supply elasticity is 2.5 and
the demand elasticity is 1.0.
A 10% increase in price will
increase quantity supplied by
25% (25 million) and decrease
quantity demanded by 10% (10
million), eliminating the excess
demand.

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Predicting the Change In Equilibrium
Price
More generally, we can use the following formula:

percentage change in demand

percentage change in equilibrium price 
Es  Ed

In our example:

35%
percentage change in equilibrium price 
2.5  1.0
35%

3.5
 10%

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The Price Effects of a Change in Supply
Let’s work through a similar exercise for a change in supply.
Suppose the supply of shoes decreases. Immediately, there is an
excess demand for shoes. We know the price will rise to eliminate
the excess demand.
What would make the resulting increase in price relatively small?
1. A small decrease in supply (so the amount of excess demand is
small).
2. Highly elastic demand (so the quantity demanded changes a lot
in response to a price change).
3. Highly elastic supply (so the quantity supplied changes a lot in
response to a price change).

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Figure 4.6 An Increase in Demand
Increases the Equilibrium Price
The supply of shoes falls by 30
million pairs; perhaps a
protectionist government
introduces import restrictions.
The supply elasticity is 2.3 and
the demand elasticity is 0.7.
A 10% increase in price will
increase quantity supplied by
23% (23 million) and decrease
quantity demanded by 7% (7
million), eliminating the excess
demand.
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Finding the Change In Equilibrium Price
More generally, we can use the following formula:

percentage change in supply

percentage change in equilibrium price 
Es  Ed

In our example:

 30% 
percentage change in equilibrium price    
 2.3  0.7 
 30% 
  
 3.0 
 10%

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Application 6: A Broken Pipeline and
the Price of Gasoline (1 of 2)
In 2003, a pipeline break
decreased the supply of
gasoline to the city of Phoenix
by 30%.
The equilibrium price
increased only 40%; with a
short-run demand elasticity of
demand for gasoline of 0.2, a
price increase of 150% would
have been necessary to
eliminate the excess demand
if there were not supply
adjustment.

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Application 6: A Broken Pipeline and
the Price of Gasoline (2 of 2)
What actually happened? Gasoline was diverted to Phoenix via a
different pipeline: quantity supplied increased in response to the high
prices.
Suppose the price elasticity of supply was 0.55:

percentage change in supply

percentage change in equilibrium price  
Es  Ed
 30% 
  
 0.55  0.20 
30%

0.75
 40%

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Key Terms
Cross-price elasticity of demand Perfectly inelastic demand
Elastic demand Perfectly inelastic supply
Income elasticity of demand Price elasticity of demand (Ed)
Inelastic demand Price elasticity of supply
Perfectly elastic demand Total revenue
Perfectly elastic supply Unit elastic demand

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 5

Production Technology
and Cost

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Chapter Outline
5.1 Economic Cost and Economic Profit
5.2 A Firm with a Fixed Production Facility: Short-Run Costs
5.3 Production and Cost in the Long Run
5.4 Examples of Production Cost

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5.1 Economic Cost and Economic Profit
Define economic cost and economic profit.
A firm’s objective is to maximize its economic profit:
economic profit  total revenue  economic cost
Economic profit: Total revenue minus economic cost.
Economic cost: The opportunity cost of the inputs used in the
production process; equal to explicit cost plus implicit cost.
The economic cost is the entire opportunity cost of production:
whatever must be sacrificed in the course of production.
Explicit cost: A monetary payment.
Implicit cost: An opportunity cost that does not involve a
monetary payment.

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Table 5.1 Economic Cost versus
Accounting Cost
blank Economic Cost Accounting
Cost
Explicit: monetary payments for labour, $10,000 $10,000
capital, materials
Implicit: opportunity cost of 5,000 -
entrepreneur’s time
Implicit: opportunity cost of funds 2,000 -
Total 17,000 10,000

Accountants calculate profit and cost differently from economists. Their

purpose is to account for flows of money. Economists are interested in
questions like “should this firm continue to operate?” which require
considering implicit costs as well as flows of money.
Accounting cost: The explicit costs of production.
Accounting profit: Total revenue minus accounting cost.

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Application 1: Opportunity Cost and
Entrepreneurship
A homeowner is considering
renting out his or her home
through Airbnb, earning $90 for a
typical two-night stay.
While that may sound like a nice
payoff, it fails to account for the
opportunity cost of the
homeowner’s time:
• Emails to arrange the stay
• Cleaning up after guests leave

The economic profit will be much less than $90.

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5.2 A Firm with a Fixed Production
Facility: Short-Run Costs
Draw the short-run marginal-cost and average-cost
curves.

Consider first the case of a firm with a fixed production

facility.
Suppose you have decided to start a small firm to produce
plastic paddles for rafts.
Before we can discuss the cost of production, we need
information about the nature of the production process.

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Figure 5.1 Total-Product Curve (1 of 2)
Total-product curve: A
curve showing the
relationship between the
quantity of labor and the
quantity of output produced,
ceteris paribus.
Marginal
For the first two workers, Quantity of Product of
output increases at an Labor Output Produced Labor
increasing rate because of 1 1 1

labor specialization. 2 5 4
3 8 3
Marginal product of labor: 4 10 2
The change in output from 5 11 1
one additional unit of labor. 6 11.5 0.5

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Figure 5.1 Total-Product Curve (2 of 2)
Diminishing returns
occurs for three or more
workers, so output
increases at a decreasing
rate.
Diminishing returns: As
Marginal
one input increases while Quantity of Product of
the other inputs are held Labor Output Produced Labor
fixed, output increases at 1 1 1

a decreasing rate. 2 5 4
3 8 3
4 10 2
5 11 1
6 11.5 0.5

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Short-Run Total Cost
In the short-run analysis of costs, we divide production costs
into two types, fixed cost and variable cost.
Fixed cost (FC): Cost that does not vary with the quantity
produced.
Variable cost (VC): Cost that varies with the quantity
produced.
Short-run total cost (TC): The total cost of production when
at least one input is fixed; equal to fixed cost plus variable
cost.

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Figure 5.2 Short-Run Costs: Fixed Cost,
Variable Cost, and Total Cost

The short-run total-cost curve shows the relationship between the

quantity of output and production costs, given a fixed production
facility.
Short-run total cost equals fixed cost (the cost that does not vary
with the quantity produced) plus variable cost (the cost that varies
with the quantity produced).
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Table 5.2 Short-Run Costs (1 of 2)
1 2 3 4 5 6 7 8 9
Labor Output Fixed Variable Total Average Average Average Marginal
Cost Cost (V Cost (TC) Fixed Variable Total Cost (M
(FC) C) Cost (AF Cost (AV Cost (AT C)
C) C) C)
0 0 $100 $0 $100 - - - -
1 1 100 50 150 $100.00 $50.00 $150.00 $50.00
2 5 100 100 200 20.00 20.00 40.00 12.50
3 8 100 150 250 12.50 18.75 31.25 16.67
4 10 100 200 300 10.00 20.00 30.00 25.00
5 11 100 250 350 9.09 22.73 31.82 50.00
6 11.5 100 300 400 8.70 26.09 34.78 100.00

The table shows a variety of measures of cost for the firm.

Average fixed cost (AFC): Fixed cost divided by the quantity produced.
Average variable cost (AVC): Variable cost divided by the quantity
produced.

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Table 5.2 Short-Run Costs (2 of 2)
1 2 3 4 5 6 7 8 9
Labor Output Fixed Variable Total Average Average Average Marginal
Cost Cost (V Cost (TC) Fixed Variable Total Cost (M
(FC) C) Cost (AF Cost (AV Cost (AT C)
C) C) C)
0 0 $100 $0 $100 - - - -
1 1 100 50 150 $100.00 $50.00 $150.00 $50.00
2 5 100 100 200 20.00 20.00 40.00 12.50
3 8 100 150 250 12.50 18.75 31.25 16.67
4 10 100 200 300 10.00 20.00 30.00 25.00
5 11 100 250 350 9.09 22.73 31.82 50.00
6 11.5 100 300 400 8.70 26.09 34.78 100.00

Short-run average total cost (ATC): Short-run total cost divided by

the quantity produced; equal to AFC plus AVC.

TC FC VC
ATC     AFC  AVC
Q Q Q
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Figure 5.3 Short-Run Average Costs
The short-run average-total-cost
curve (ATC) is U-shaped.
• As the quantity increases, fixed
costs are spread over more
units, pushing down the ATC.
• As the quantity increases,
diminishing returns eventually
pull up the ATC.

The gap between ATC and AVC is

the average fixed cost (AFC).

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Short-Run Marginal Cost
Short-run marginal cost (MC): The change in short-run
total cost resulting from a one-unit increase in output.
TC change in TC
MC  
Q change in output

One worker produces 1 paddle, with total cost $150.

Two workers produce 5 paddles, with total cost $200.

TC $200  $150 $50

MC     $12.50
Q 5 1 4

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Figure 5.4 Short-Run Marginal and
Average Cost
The marginal-cost curve (MC) is
negatively sloped for small
quantities of output, because of
the benefits of labor
specialization, and positively
sloped for large quantities,
because of diminishing returns.
The MC curve intersects the
average-cost curve (ATC) at the
minimum point of the average
curve.
At this point ATC is neither
falling nor rising.

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Table 5.3 Marginal Grade and Average
Grade
Labor Marginal Number of Grade Grade Point Average
Grade Courses Points
3.0  27 / 9
3.0 = 27 over 9
Starting point - 9 27
2.8  28 / 10
2.8 = 28 over 10
Marginal grade < GPA D 10 28 = 27+1
Marginal grade = GPA B 10 30 = 27+3 3.0  30 / 10
3.0 = 30 over 10

Marginal grade > GPA A 10 31 = 27+4 3.1

3.1 over
= 31 31/1010

To illustrate the relationship between marginal and average, suppose

you have a B (3.0) average after 9 classes, and are waiting for the
grade for the 10th to come in.
The 10th is your marginal grade; your GPA is your average grade.
• If the 10th grade is less than your GPA, your GPA will fall.
• If it is equal to your GPA, your GPA will stay the same.
• If it is greater than your GPA, your GPA will rise.

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Application 2: The Rising Marginal
Cost of Crude Oil
The first 40 million barrels of oil
produced worldwide per day
have a marginal cost less than
$10 per barrel; oil costs little to
extract in the Middle East and
Russia.
The next 25 million barrels cost
about $20 per barrel, from more
expensive offshore rigs and oil
sands projects.
Higher quantities see the
marginal cost rise quickly, for
Arctic drilling, biodiesel, etc.
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5.3 Production and Cost in the Long
Run
Draw the long-run marginal-cost and average cost curves.
The long run is defined as the period of time over which a firm is
perfectly flexible in its choice of all inputs.
• In the long run, a firm can build or modify a production facility
such as a factory, store, office, or restaurant.

The key difference between the short run and the long run is that
there are no diminishing returns in the long run.
• Diminishing returns occur because workers share a fixed
production facility.
• In the long run, a firm can expand its production facility as its
workforce grows.
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Expansion and Replication
Suppose our paddle-production firm was producing 10 paddles
per day, with a total cost of $300 per day—an average cost of
$30 per paddle.
If we wanted to double production, we could do so in our old
facility; but the workers would be cramped, and average costs
would rise.
Another option: build another identical workshop, to replicated
our already successful production methods.
The cost to produce, when we can flexibly change our facilities,
is the long-run total cost.
Long-run total cost (LTC): The total cost of production when a
firm is perfectly flexible in choosing its inputs.

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Figure 5.5 Expansion and
Replication (1 of 2)
Initially (up to point b) the short-run
and long-run total cost curves are the
same; while average costs are falling,
replication is not useful.
Long-run average cost (LAC): The
long-run cost divided by the quantity
produced.

Labor 1 Capital 2 Output 3 Labor 4 Long-Run Total 5 Long-Run Average

Cost Cost (LTC) Cost (LAC)
1 $100 1 $ 50 $150 $150
2 100 5 100 200 40
4 100 10 200 300 30
8 200 20 400 600 30
12 300 30 600 900 30

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Figure 5.5 Expansion and
Replication (2 of 2)
Once we exhaust our gains from
specialization, we can replicate and
achieve constant returns to scale.
Constant returns to scale: A
situation in which the long-run total
cost increases proportionately with
output, so average cost is constant.

Labor 1 Capital 2 Output 3 Labor 4 Long-Run Total 5 Long-Run Average

Cost Cost (LTC) Cost (LAC)
1 $100 1 $ 50 $150 $150
2 100 5 100 200 40
4 100 10 200 300 30
8 200 20 400 600 30
12 300 30 600 900 30

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Long-Run Marginal Cost
If we achieve constant returns to scale by replication, each
additional batch of output costs the same as the ones
before, so the long-run marginal cost is constant also.
Long-run marginal cost (LMC): The change in long-run
cost resulting from a one-unit increase in output.
We may be able to do even better—say, by combining two
workshops into a single larger workshop. Then the long-run
marginal cost would be falling.

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Reducing Output with Indivisible Inputs
While replication will often allow us to increase production and keep
average costs the same, we often cannot decrease production with the
same result.
Many inputs cannot be divided—they must be all-or-nothing.
Indivisible input: An input that cannot be scaled down to produce a
smaller quantity of output.
• For example, to produce up to 10 paddles per day, perhaps we need
one plastic mold; we cannot have half a mold.
• Similarly, a hospital cannot buy half an MRI machine, and a railroad
company can’t build half a set of tracks.
• This helps to explain why long-run average costs are often high for
small quantities.

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Scaling Down and Labor Specialization
Another problem with getting smaller is that we cannot
benefit as much from labor specialization.
• In our paddle-production example, if we cut down to just
a couple of workers, each would have to perform many
tasks. With more workers, they could specialize.
• Similarly a large hospital benefits from size by having
specialist surgeons, radiologists, etc. A small hospital
could have one person perform multiple roles, but they
would likely not be as productive; or it could contract
some roles out, at higher cost.

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Economies of Scale
The foregoing examples help to explain why larger firms can
enjoy economies of scale.
Economies of scale: A situation in which the long-run
average cost of production decreases as output increases.
Eventually we will likely exhaust all possible economies of
scale.
Minimum efficient scale: The output at which scale
economies are exhausted.

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Diseconomies of Scale
Could a firm get so big, its average cost actually starts to rise?
Diseconomies of scale: A situation in which the long-run average
cost of production increases as output increases.
Diseconomies of scale could occur because of:
• Coordination problems: Organizing a large operation with many
layers of management may be difficult to do effectively.
• Increasing input costs: A firm could get so big that it may be
forced to pay higher prices for its inputs. For example, a large
coal-fired power plant may have to source coal from far away,
with higher delivery costs than a small power plant would face.

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Figure 5.6 Actual Long-Run Cost Curves for
Aluminum, Truck Freight, and Hospital Services
Different industries can
have dramatically different
long-run average cost
curves.

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Short-Run Versus Long-Run Average
Cost
Why is the firm’s short-run average-cost curve U-shaped,
while the long-run average-cost curve is L-shaped?
• The difference between the short run and long run is a
firm’s flexibility in choosing inputs.
In the long run, a firm can increase all of its inputs, scaling up
its operation by building a larger production facility.
• As a result, the firm will not suffer from diminishing returns.

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Application 3: Indivisible Inputs and
the Cost of Fake Killer Whales
Sea lions off the Washington coast
threaten some fish species with
extinction and threaten commercial
fisheries.
One innovative idea: build big
plastic killer whales, on roller-
coaster-like rails, to scare off the
sea lions.
The cost for the first fake whale
would be $16,000: $11,000 for the
plastic mold, and $5,000 for labor
and materials; each extra whale
would cost only $5,000.

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5.4 Examples of Production Cost
Provide examples of production costs.
In this section we will look at actual production costs for
several products:
• Electricity from wind turbines
• Music videos
• Solar and nuclear power

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Table 5.4 Wind Turbines and the
Average Cost of Electricity
blank Small Turbine Large Turbine
(150 kilowatt) (600 kilowatt)
Purchase price of turbine $150,000 $420,000
Installation cost $100,000 $100,000
Operating and maintenance cost $75,000 $126,000
Total Cost $325,000 $646,000
Electricity generated (kilowatt-hours) 5 million 20 million
Average cost (per kilowatt-hour) $0.065 $0.032

A large wind turbine is more expensive, but also more cost-effective:

installation and maintenance costs are relatively low for the large turbine,
considering the much higher output of electricity.
A wind turbine company would experience economies of scale as it moved
from small to large turbines.
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Figure 5.7 Average-Cost Curve for an
Information Good
A music video is an
information good; almost
all of its cost is in the initial
production, and the
marginal cost of
reproduction is essentially
zero.
The average cost will fall
for all reasonable
quantities.
A similar cost structure
exists for other products
distributed online.

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Solar Versus Nuclear: The Crossover
In 1998, the cost of electricity produced with solar technology
was $0.32 per kilowatt-hour (Kwh), vs $0.07 per Kwh for
nuclear.
Over the last 20 years, the cost for electricity from nuclear
power plants has increased to about $0.16 per Kwh, because
the cost of building reactors has increased
Meanwhile the cost from solar has decreased: $0.21 per Kwh
in 2005, and $0.16 per Kwh in 2010.
As further innovations happen in the solar industry, it is likely
that solar energy costs will continue to fall: solar has crossed
over to being more cost-effective than nuclear.

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Table 5.5 The Language and
Mathematics of Costs (1 of 3)
Type of Cost Definition Symbols and
Equations
Economic cost The opportunity cost of the inputs used -
in the production process; equal to
explicit cost plus implicit cost
Explicit cost The actual monetary payment for inputs -
Implicit cost The opportunity cost of inputs that do not -
involve a monetary payment
Accounting cost Explicit cost -

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Table 5.5 The Language and
Mathematics of Costs (2 of 3)
Type of Cost Definition Symbols and
Equations
Short-Run Costs blank blank
Fixed cost Cost that does not vary with the quantity FC
produced
Variable cost Cost that varies with the quantity produced VC
Short-run total cost The total cost of production when at least one TC = FC + VC
input is fixed
MC = Delta TC over Delta Q
Short-run marginal The change in cost from a one-unit increase MC  TC / Q
cost in output
AFC = 
AFC FCFC /Q
over Q
Average fixed cost Fixed cost divided by the quantity produced
Average variable Variable cost divided by the quantity produced AVC  VC / Q
AVC = VC over Q

cost
Short-run average Short-run total cost divided by the quantity ATC = AFC + AV
total cost produced C

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Table 5.5 The Language and
Mathematics of Costs (3 of 3)
Type of Cost Definition Symbols and
Equations
Long-Run Costs blank blank
Long-run total cost The total cost of production when a firm is LTC
perfectly flexible in choosing its inputs
LAC =LTC
LAC LTCover /QQ
Long-run average Long-run total cost divided by the quantity
cost produced
Long-run marginal The change in long-run cost resulting from a LMC  LTC / Q
LMC = Delta LTC over Delta
Q
cost one-unit increase in
output

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Key Terms
Accounting cost Implicit cost
Accounting profit Indivisible input
Average fixed cost (AFC) Long-run average cost (LAC)
Average variable cost (AVC) Long-run marginal cost (LMC)
Constant returns to scale Long-run total cost (LTC)
Diminishing returns Marginal product of labor
Diseconomies of scale Minimum efficient scale
Economic cost Short-run average total cost (ATC)
Economic profit Short-run marginal cost (MC)
Economies of scale Short-run total cost (TC)
Explicit cost Total-product curve
Fixed cost (FC) Variable cost (VC)

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
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restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 6

Perfect Competition

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Chapter Outline
6.1 Preview of the Four Market Structures
6.2 The Firm’s Short-Run Output Decision
6.3 The Firm’s Shut-Down Decision
6.4 Short-Run Supply Curves
6.5 The Long-Run Supply Curve for an Increasing-Cost
Industry
6.6 Short-Run and Long-Run Effects of Changes in Demand
6.7 Long-Run Supply for a Constant-Cost Industry

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6.1 Preview of the Four Market
Structures
Distinguish between four market structures.
Our next four chapters will explore how firms make decisions in
different types of markets.
First, we will look at perfectly competitive markets.
Perfectly competitive market: A market with many sellers and
buyers of a homogeneous product and no barriers to entry.
In such a market, there are hundreds or even thousands of firms
selling homogeneous products. Each firm is a price taker.
Price taker: A buyer or seller that takes the market price as given.

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Features of a Perfectly Competitive
Market
Here are the five features of a perfectly competitive market:
1. There are many sellers.
2. There are many buyers.
3. The product is homogeneous.
4. There are no barriers to market entry.
5. Both buyers and sellers are price takers.

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Figure 6.1 Monopoly Versus Perfect
Competition (1 of 2)

When studying firm behavior, we distinguish between the

market demand curve and the firm-specific demand curve.
Firm-specific demand curve: A curve showing the
relationship between the price charged by a specific firm and
the quantity the firm can sell.
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Figure 6.1 Monopoly Versus Perfect
Competition (2 of 2)

A monopolist is the only firm in its market; so it faces the

entire market demand curve.
A perfectly competitive firm takes the market price as given;
it can sell as much as it would like at the market price, and
would sell nothing if it charged a higher price.
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The Other Three Market Structures
Over the coming chapters, we will discuss:
• Monopoly: A single firm serves the entire market, with
barriers to entry preventing new firms entering and
breaking the monopoly.
• Monopolistic Competition: Many firms serve the market
with nonidentical products. Firms can enter and exit the
market.
• Oligopoly: Only a few firms are in the market, because of
economies of scale or because government policies limit
the number of firms.

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Table 6.1 Characteristics of the Four
Market Structures
Perfect Monopolistic
Characteristics Competition Competition Oligopoly Monopoly
Number of firms Many Many Few One
Type of product Homogeneous Differentiated Homogeneous or Unique
differentiated
Firm-specific Demand is Demand is Demand is less Firm faces market
Demand curve perfectly elastic but not elastic than demand demand curve
Elastic perfectly elastic facing
monopolistically
competitive firm
Entry conditions No barriers No barriers Large barriers from Large barriers from
economies of scale economies of scale
or government or govern-ment
policies policies
Examples Corn, plain T- Toothbrushes, Air travel, Local phone
shirts music stores, automobiles, service, patented
groceries beverages, drugs
cigarettes, mobile
phone service

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Application 1: Wireless Women in
Pakistan
In Pakistan, phone service is now
provided by thousands of “wireless
women,” entrepreneurs who invest
$310 in wireless phone equipment, a
sign, and a stopwatch.
They sell phone service to their
neighbors, earning about $2 per day.
Why so little? The market is close to
perfectly competitive: easy entry, a
standardized good, and a large
number of suppliers.

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6.2 The Firm’s Short-Run Output
Decision
Explain the short-run output rule and the break-even
price.
How much output should an individual firm produce?
We assume a firm’s objective is to maximize economic
profit: total revenue minus economic cost.
Our example for the remainder of this chapter will be a firm
that produces plain t-shirts, a relatively generic product with
many firms producing essentially identical competitive
products.

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The Total Approach: Computing Total
Revenue and Total Cost
One way to decide how much to produce is to compute the
economic profit for different quantities, and choose the
quantity that generates the highest profit.
A firm in a perfectly competitive market sells all output for the
same price—the market price.
• Total revenue equals the price of the product times the
quantity sold.

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Table 6.2 Deciding How Much to
Produce When the Price Is $12
1 2 3 4 5 6 7 8 Marginal
Output: Shirts Fixed Variable Total Total Profit = T Marginal Cost (MC)
per Minute (Q) Cost (F Cost (VC) Cost Revenue (TR) R −TC Revenue =
C) (TC) Price
0 $17 $0 $ 17 $0 −$17 Blank Blank
1 17 5 22 12 −10 $12 $5
2 17 6 23 24 1 12 1
3 17 9 26 36 10 12 3
4 17 13 30 48 18 12 4
5 17 18 35 60 25 12 5
6 17 25 42 72 30 12 7
7 17 34 51 84 33 12 9
8 17 46 63 96 33 12 12
9 17 62 79 108 29 12 16
10 17 83 100 120 20 12 21

Profit is maximized at a quantity of 7 or 8 shirts: $33. When this

happens, we assume the firm produces the larger quantity.

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Figure 6.2 Using the Total Approach to
Choose an Output Level
Economic profit is shown by
the vertical distance between
the total-revenue curve and
the total-cost curve.
To maximize profit, the firm
chooses the quantity of
output that generates the
largest vertical difference
between the two curves.

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The Marginal Approach
The other way for a firm to decide how much output to
produce relies on the marginal principle: Increase the level
of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal
benefit equals the marginal cost.
The marginal benefit of production is the marginal revenue.
Marginal revenue: The change in total revenue from selling
one more unit of output.
For a perfectly competitive firm, the price doesn’t change as
it sells more; so
marginal revenue  price
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Figure 6.3 The Marginal Approach to
Picking an Output Level (1 of 4)

The marginal principle tells us that the firm will maximize its
profit by choosing the quantity at which price equals marginal
cost. This occurs at point a.
economic profit  price  average cost   quantity produced
economic profit   $12  $7.875   8  $4.125  8  $33
The shaded area shows this economic profit.
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Figure 6.3 The Marginal Approach to
Picking an Output Level (2 of 4)

If the firm produced less—say, 6 shirts—it would make less profit.

• The extra revenue from the 6th and 7th shirts would be $12.
• The extra cost from the 6th and 7th shirts would be less than
$12.
• So producing the 6th and 7th shirts increases profit.

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Figure 6.3 The Marginal Approach to
Picking an Output Level (3 of 4)

If the firm produced more—say, 9 shirts—it would make less

profit.
• The extra revenue from the 9th shirt would be $12.
• The extra cost from the 9th shirts would be greater than $12.
• So producing the 9th shirt decreases profit.

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Economic Profit and the Break-Even
Price
The marginal cost curve is positively sloped.
If the price rose, the marginal revenue (price) line would
move upward, and intersect the marginal cost curve at a
higher quantity.
• This is the law of supply in action: higher price results in
higher quantity supplied.

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Figure 6.3 The Marginal Approach to
Picking an Output Level (4 of 4)

If price fell to $7, the marginal revenue line would intersect the marginal
cost curve at point c: a quantity of 6 shirts.
At this quantity, the average total cost is also $7, so the firm would make
zero economic profit: it would break even.
Break-even price: The price at which economic profit is zero; price
equals average total cost.

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Application 2: The Break-Even Price for
Switchgrass, A Feedstock for Biofuel
Switchgrass is a perennial grass
native to U.S. plains states.
Farmers can grow it for biofuel.
Suppose the alternative crop for
farmers to grow is alfalfa, which
earns $120 per acre. Switchgrass
yields 3 tons per acre, so the
opportunity cost of growing
switchgrass is $40 per ton.
Explicit costs (capital, labor, etc.)
total $36 per ton; so the break-
even price for switchgrass is $76
per ton.
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6.3 The Firm’s Shut-Down Decision
Explain the shut-down rule.

When prices are high and the firm is making a profit, everything is
easy: just choose the quantity that yields the highest profit.
What about when prices are so low the firm cannot make a profit?
Should the firm continue to operate at a loss, or shut down?
• It may seem obvious that the firm should shut down if it’s making
a loss, but this is a short-run decision: the firm has some fixed
costs.
• So even if it shuts down, it will still make a loss.
• The right choice will make the loss as small as possible.

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Table 6.3 Deciding How Much to
Produce When the Price Is $4 (1 of 2)
1 2 3 4 5 6 7 8
Output: Fixed Variable Total Total Profit = Marginal Marginal
Shirts per Cost Cost (V Cost (T Revenue (T TR − TC Revenue = Cost (MC)
Minute (Q) (FC) C) C) R) Price
0 $17 $0 $17 $0 −$17 Blank Blank
1 17 5 22 4 −18 $4 $5
2 17 6 23 8 −15 4 1
3 17 9 26 12 −14 4 3
4 17 13 30 16 −14 4 4
5 17 18 35 20 −15 4 5

Because the firm cannot do anything about its fixed costs, the
decision of whether to shut down comes down to variable costs:
• Operate if total revenue > variable cost
• Shut down if total revenue < variable cost

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Table 6.3 Deciding How Much to
Produce When the Price Is $4 (2 of 2)
1 2 3 4 5 6 7 8
Output: Fixed Variable Total Total Profit = Marginal Marginal
Shirts per Cost Cost (V Cost (T Revenue (T TR − TC Revenue = Cost (MC)
Minute (Q) (FC) C) C) R) Price
0 $17 $0 $17 $0 −$17 Blank Blank
1 17 5 22 4 −18 $4 $5
2 17 6 23 8 −15 4 1
3 17 9 26 12 −14 4 3
4 17 13 30 16 −14 4 4
5 17 18 35 20 −15 4 5

Producing 3 or 4 shirts, the firm’s total revenue is greater than its

variable cost, so it should produce rather than shut down.
• Notice that for these quantities, the loss is smaller than the loss
from producing 0 shirts.

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Figure 6.4 The Shut-Down Decision and
the Shut-Down Price (1 of 2)
When the price is $4, marginal
revenue equals marginal cost at
four shirts (point a).
At this quantity, average cost is
$7.50, so the firm loses $3.50 on
each shirt, for a total loss of $14.
Total revenue is $16 and the
variable cost is only $13, so the
firm is better off operating at a
loss rather than shutting down
and losing its fixed cost of $17.

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Figure 6.4 The Shut-Down Decision
and the Shut-Down Price (2 of 2)
To determine whether to operate
or shut down, compare the price
to the average variable cost.
• Operate if price > AVC
• Shut down if price < AVC
The shutdown price, shown by
the minimum point of the AVC
curve, is $3.00.
Shut-down price: The price at
which the firm is indifferent
between operating and shutting
down; equal to the minimum
average variable cost.

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Fixed Costs and Sunk Costs
We ignore the fixed cost in the short run—the cost of the
facility—because we assume it is a sunk cost.
Sunk cost: A cost that a firm has already paid or
committed to pay, so it cannot be recovered.
It is often psychologically difficult to put sunk costs out of
your mind when making decisions, but it is an essential
element of good decision making.

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Application 3: Shutting Down a Coal
Mine
In early 2018, the 4 West
coal mine in West Virginia
shut down.
The price of coal had
decreased from $140 per
ton to roughly $61 per ton.
Some firms could continue
to operate at that price,
because their costs were
lower; but $61 per ton was
below the shut-down price
for 4 West.
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6.4 Short-Run Supply Curves
Explain why the short-run supply curve is positively
sloped.
Now we’re ready to explore short-run supply curves for the
individual firm and for the whole market.
Short-run supply curve: A curve showing the relationship
between the market price of a product and the quantity of
output supplied by a firm in the short run.
Short-run market supply curve: A curve showing the
relationship between the market price and quantity supplied
in the short run.

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Figure 6.5 Short-Run Supply Curves
(Panel A)
When the price is below
the shut-down price ($3
for this firm), the firm
produces no output.
For any price above the
shut-down price, the firm
will choose the quantity at
which price equals
marginal cost, so we can
read the firm’s quantity
supplied directly from its
marginal-cost curve.

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Figure 6.5 Short-Run Supply Curves
(Panel B)
In Panel B, there are 100
identical firms in the market,
so the market supply at a
given price is 100 times the
quantity supplied by the
typical firm.
At a price of $7, each firm
supplies 6 shirts per minute
so the market supply is 600
shirts per minute (point f).

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Figure 6.6 Market Equilibrium

In Panel A, the market demand curve intersects the short-run market

supply curve at a price of $7.
In Panel B, given the market price of $7, the typical firm satisfies the
marginal principle at point b, producing six shirts per minute. The $7
price equals the average cost at the equilibrium quantity, so economic
profit is zero, and no other firms will enter the market.

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Application 4: Short-Run Supply
Curve for Cargo
Consider the supply of shipping
service.
• At low freight rates, only the most
efficient ships operate, and they
economize on fuel by traveling at a
relatively low speed.
• As freight rates increase, less
efficient ships join the fleet, and
ships can afford to travel faster
(and burn more fuel), so the
amount of shipping service offered
increases.

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6.5 The Long-Run Supply Curve for an
Increasing-Cost Industry
Explain why the long-run industry supply curve may be
positively sloped.
We have dealt with the short run; now we move on to the
long run, a period long enough that firms can enter or leave
the market.
What will the long-run market supply curve look like?
Long-run market supply curve: A curve showing the
relationship between the market price and quantity supplied
in the long run.

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An Increasing-Cost Industry
We start with the case of an increasing-cost industry:
Increasing-cost industry: An industry in which the average cost
of production increases as the total output of the industry
increases; the long-run supply curve is positively sloped.
Why positively sloped?
• Increasing input price: As the industry grows, it competes with
other industries for scarce inputs, raising their price, and hence
the break-even price in the industry.
• Less productive inputs: A small industry uses only the most
productive inputs, but as it grows it will be forced to use less
productive inputs.

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Table 6.4 Industry Output and Average
Production Cost
Number of Industry Shirts per Total Cost for Average Cost
Firms Output Firm Typical Firm per Shirt
100 600 6 $42 $7
200 1,200 6 60 10
300 1,800 6 78 13

As the number of firms increases, the total cost for the

typical firm increases (because of higher input prices and
less productive inputs).

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Figure 6.7 Long-Run Market Supply
Curve

This allows us to form the long-run market supply curve for

this industry.
As price rises, production for the existing firms is more
profitable; new firms enter the market, raising the cost until
profits fall back down to the zero economic profit level.
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Examples of Increasing-Cost
Industries: Sugar and Apartments
If the price of sugar is only 11 cents per pound, sugar production
is profitable only in areas with low production costs—the
Caribbean, Latin America, Australia, and South Africa.
• As price rises, more countries would begin to produce sugar:
some countries in the European Union, and eventually the
United States.
The market for apartments is another increasing-cost industry.
• Many communities restrict the land available for apartments with
zoning laws.
• As the industry expands, housing firms bid up the price of land.
Input prices rise, which is justifiable only if the price the
apartments can rent for is higher.
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Application 5: Chinese Coffee
Growers Obey the Law of Supply
Pu’er is a southern
Chinese city famous for its
tea, but gaining a
reputation for coffee also.
As world coffee prices
doubled from 2009 to
20012, farmers cleared
hillside to double the
acreage of coffee.

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6.6 Short-Run and Long-Run Effects of
Changes in Demand
Describe the short-run and long-run effects of changes
in demand for an increasing-cost industry.
We now consider what happens in perfectly competitive
markets when demand increases.
The general idea is this:
• The increase in demand makes output prices higher.
• In the short run, existing firms produce more in response to
the higher prices.
• In the long run, new firms enter the market; the increase in
competition helps to lower the price.
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Figure 6.8 Short-Run Effects of an
Increase in Demand

In panel A, an increase in demand for shirts occurs. In the short

run, this is served only by existing firms, with the market
equilibrium changing to point b.
In panel B, we see that at the higher price, the typical firm now
makes positive economic profit: price > ATC.

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Figure 6.9 Short-Run and Long-Run
Effects of an Increase in Demand
In the long run, firms can
enter the industry and build
more production facilities, so
the price eventually drops to
$10 (point c).
The large upward jump in
price after the increase in
demand is followed by a
downward slide to the new
long-run equilibrium price.

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Application 6: The Upward Jump and
Downward Slide of Blueberry Prices
In the late 2000s, blueberry demand
increased ~72%.
Price increased from $1.44 per pound in
2005 to $1.85 per pound in 2007.
• In the short run, supply is limited, and
the increased demand bid up the price.

By 2010, production had increased by

almost 50%, bringing the price back
down under $1.50 per pound.
• This suggests the blueberry industry
is approximately a constant-cost
industry.

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6.7 Long-Run Supply for a Constant-
Cost Industry
Describe the short-run and long-run effects of changes
in demand for a constant-cost industry.
In a constant-cost industry, the prices of inputs such as
labor, land, and materials do not change as the output of the
industry increases.
This happens when the industry uses a relatively small
amount of the available labor, land, and materials, so events
in the industry do not change the prices of these inputs.
Constant-cost industry: An industry in which the average
cost of production is constant; the long-run supply curve is
horizontal.

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Figure 6.10 Long-Run Supply Curve for
a Constant-Cost Industry

For the candle industry, the cost per candle is constant at

$0.05, so the supply curve is horizontal at $0.05 per candle.
At any higher price, firms would enter the candle industry in
droves, pushing the price back down to $0.05 per candle.
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Figure 6.11 Hurricane Andrew and the
Price of Ice

In 1992, Hurricane Andrew struck the southeastern United States.

Millions of people were without electricity, so they turned to ice to
cool and preserve food.
The jump in price prompted entrepreneurs to bring ice to the area;
this increase in the number of firms pushed the price back down.
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Application 7: The Upward Jump and
Downward Slide of Blueberry Prices
In the 2000s, the demand for margarine
decreased.
Total U.S. consumption of margarine
halved, but the price barely changed. How
could this be?
• Firms saw the decrease in demand, and
switched production away from
margarine.
• As the total output of the margarine
industry decreased, the prices of inputs
didn’t change.
• So the cost of producing margarine, and
hence the price, stayed constant.

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Key Terms
Break-even price Perfectly competitive market
Constant-cost industry Price taker
Firm-specific demand curve Short-run market supply curve
Increasing-cost industry Short-run supply curve
Long-run market supply Shut-down price
curve
Sunk cost
Marginal revenue

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Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 7

Monopoly and Price

Discrimination

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Chapter Outline
7.1 The Monopolist’s Output Decision
7.2 The Social Cost of Monopoly
7.3 Patents and Monopoly Power
7.4 Price Discrimination

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7.1 The Monopolist’s Output
Decision
Describe and explain a monopolist’s output decision.
In this chapter we will examine the production and pricing decisions
of a monopoly.
Monopoly: A market in which a single firm sells a product that does
not have any close substitutes.
Some sort of barrier to entry exists to maintain the monopoly; and
the lack of competition gives the monopolist a large degree of
market power.
Barrier to entry: Something that prevents firms from entering a
profitable market.
Market power: The ability of a firm to affect the price of its product.

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Barriers to Entry
What sort of barriers to entry can exist?
• Patent: The exclusive right to sell a new good for some period of time.
• Network externalities: The value of a product to a consumer increases
with the number of other consumers who use it.
• Licensing policies, where the government chooses a single firm to sell a
particular product.
• Control of a key resource, like DeBeers with diamonds or Alcoa with
aluminum.
• Natural monopoly: A market in which the economies of scale in
production are so large that only a single large firm can earn a profit.

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Figure 7.1 The Demand Curve and the
Marginal-Revenue Curve (1 of 2)
(2) Quantity (3) Total Revenue (4) Marginal Revenue
MR = Delta TR over Delta Q
(1) Price (P) Sold (Q) (TR = P × Q) MR = ΔTR / ΔQ

$16 0 0 -
14 1 $14 $14
12 2 24 10
10 3 30 6
8 4 32 2
6 5 30 −2
4 6 24 −6

Marginal revenue equals the price for the first unit sold, but is less
than the price for additional units sold.
To sell an additional unit, the firm cuts the price and receives less
revenue on the units that could have been sold at the higher price.
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Figure 7.1 The Demand Curve and the
Marginal-Revenue Curve (2 of 2)
A key feature of monopoly
is that the marginal
revenue is less than the
price; this results from the
downward-sloping firm-
specific demand curve.
Contrast this with perfect
competition, where the
horizontal firm-specific
demand curve led the
marginal revenue to be
equal to the price.

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A Formula for Marginal Revenue
With a straight-line demand curve:
marginal revenue  new price  (slope of demand curve  old quantity )
We can think of selling an additional unit as having both
good news and bad news:
• Good news: we receive revenue equal to the price of the
unit we sell (the new price).
• Bad news: to sell more, we had to reduce the price—not
just for the next unit, but for all units. This decreases
revenue by however much we had to drop the price by
(the slope of the demand curve) multiplied by how
many units we were already selling (the old quantity).

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Using the Marginal Principle
The three-step process explaining how a monopolist
picks a quantity and how to compute the monopoly profit
is as follows:
1. Find the quantity that satisfies the marginal principle,
that is, the quantity at which marginal revenue equals
marginal cost.
2. Using the demand curve, find the price associated
with thea monopolist’s chosen quantity.
3. Compute the monopolist’s profit. The profit per unit
sold equals the price minus the average cost, and the
total profit equals the profit per unit times the number
of units sold.

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Figure 7.2 The Monopolist Picks a
Quantity and a Price (1 of 2)
(1) (2 ) (3) (4) (5) (6) (7)
Price (P) Quantity Marginal Marginal Total Revenue Total Cost Profit
Sold (Q) Revenue Cost (TR = P × Q) (TC) (TR − TC)
$18 600 $12 $4.00 $10,800 $5,710 $5,090
17 700 10 4.60 11,900 6,140 5,760
16 800 8 5.30 12,800 6,635 6,165
15 900 6 6.00 13,500 7,200 6,300
14 1,000 4 6.70 14,000 7,835 6,165
13 1,100 2 7.80 14,300 8,560 5,740
12 1,200 0 9.00 14,400 9,400 5,000

A firm patents a new drug that cures the common cold.

• At a quantity of 600, the marginal revenue ($12) is greater than the
marginal cost ($4) so the firm increases profit by increasing production.
• At a quantity of 900, marginal revenue equals marginal cost, so profit is
maximized.
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Figure 7.2 The Monopolist Picks a
Quantity and a Price (2 of 2)

We can see the profit on the graph at the quantity of 900:

Profit  profit per unit  quantity
Profit   price  ATC   quantity
Profit   $15  $8   900
Profit  $6,300
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Application 1: Marginal Revenue from
a Baseball Fan
We expect Major League Baseball teams
to choose the quantity—number of fans—
to set MR = MC.
The cost of an additional fan is essentially
zero.
But for the typical team, the marginal
revenue from tickets is negative: teams
could make more ticket revenue by raising
price.
Why? Teams gain additional profit from
concessions and merchandise, making up
for the lost revenue.

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7.2 Patents and Monopoly Power
Identify the trade-offs associated with a patent.
One source of monopoly power is a government patent that
gives a firm the exclusive right to produce a product for 20
years.
The patent encourages innovation through the promise of the
reward of monopoly power.
The increased innovation may be worth the deadweight loss
of the resulting monopoly.

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Incentives for Innovation
Suppose a firm is considering developing a new arthritis drug.
• The cost of research and development will be $14 million.
• The estimated annual economic profit from a monopoly will
be $2 million.
• Other firms will be able to copy the drug in three years.
Without the promise of patent protection, the firm will not
develop the drug—it could not recoup its cost.
• The possible consumer surplus from the drug would
disappear.

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Trade-Offs from Patents
All else equal, more competition is almost always desirable.
• Under monopoly, total surplus will be lower.
• But if the product would not be developed, the outcome for
society would be worse.
Is the patent for the drug good for society?
• No one knows in advance whether a particular product
would be developed without a patent, so the government
can’t be selective in granting patents.
• In some cases, patents lead to new products, although in
other cases, they merely prolong monopoly power.

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Application 2: Bribing the Makers of
Generic Drugs
When a patent expires, new firms
enter the market; the resulting
competition for consumers
decreases prices and increases
quantities.
The former patent holders dislike
this, and sometimes use illegal
means to prevent competition.
• In 2003, the Federal Trade
Commission found two drug
makers had paid $60 million in
bribes to keep lower-priced
generic drugs off the market.

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7.3 Price Discrimination
Identify the trade-offs associated with a patent.
So far we have always assumed a firm charges the same
price to all its customers.
However a firm may be able to engage in price
discrimination:
Price discrimination: The practice of selling a good at
different prices to different consumers.

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Conditions for Price Discrimination
In order to engage in price discrimination, firms need:
1. Market power: The firm must have some control over its
price.
2. Different consumer groups: Groups of consumers that
differ in their willingness to pay for the product, along with
the ability to distinguish these groups.
3. Resale is not possible: Otherwise a low-price consumer
could resell to a high-price consumer, circumventing the
price discrimination.

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How to Price Discriminate
Firms commonly engage in price discrimination by finding
consumers who are not willing to pay the regular price, and
offering them a discount. Examples include:
• Discounts on airline tickets
• Discount coupons for groceries and restaurant meals
• Manufacturers’ rebates for appliances
• Senior citizen or student discounts

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Figure 7.3 The Marginal Principle and
Price Discrimination

To engage in price discrimination, the firm divides potential

customers into two groups and applies the marginal principle
twice—once for each group.
Using the marginal principle, the profit-maximizing prices are
$3 for seniors (point b) and $6 for nonseniors (point d).
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Price Discrimination and the Elasticity
of Demand
Elasticity of demand helps to explain why price
discrimination can increase profits.
For a high price elasticity group (Ed > 1), decreasing price
will increase revenues: the firm gains a lot of customers
when it decreases price a little.
For a low price elasticity group (Ed < 1), increasing price will
increase revenues: the firm loses few customers when it
increases price.

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Example: Movie Admission versus
Popcorn
Why do senior citizens pay less than everyone else for
admission to a movie, but the same as everyone else for
popcorn?
• Seniors have a lower willingness to pay for both movies
and popcorn.
• But admission cannot be traded from one consumer to
another, while popcorn can.

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Example: Hardback versus Paperback
Books
Why are hardback books so much more expensive than
paperback books?
• The cost difference between the two is small, about 20%
higher for hardbacks, so that doesn’t explain the price
difference.
• Publishers use different editions to price discriminate: the
hardback edition comes out first, and is bought by the most
eager readers. The paperback edition comes out later,
priced to gain profit from the casual (and more price-
sensitive) audience.

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Application 3: Refillable Soda Bottles
and Price Discrimination
In some countries, customers can
purchase cola in either a refillable or
a disposable bottle.
The refillable bottle receives a 20%
discount—much more than the
actual cost difference.
People who use the refillable format
are more price sensitive, so
customers sort themselves into
groups for price discrimination.
The price discrimination increases
both firm profits and consumer well-
being.

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Key Terms
Barrier to entry
Market power
Monopoly
Natural monopoly
Network externalities
Patent
Price discrimination

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
Copyright

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
destroy the integrity of the work and is not permitted. The work
and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.

Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly

Copyright © 2012 Pearson Prentice

Copyright © 2012Hall. All rights
Pearson reserved.
Prentice Hall. All rights reserved.
8-1
 CHAPTER

Market Entry, Monopolistic

Competition, and Oligopoly
8
During the recession that started in 2008, some industries
actually experienced increases in demand that caused market
entry – new firms entered the markets.

PREPARED BY
Brock Williams
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly

APPLYING THE CONCEPTS

1 How does brand competition within stores affect prices?

Name Brands versus Store Brands

2 What does it take to enter a market with a franchise?

Opening a Dunkin’ Donuts Shop

3 What are the effects of market entry?

C3PO and Entry in the Market for Space Flight

4 What signal does an expensive advertising campaign send

to consumers?
Advertising and Movie Buzz

5 How do firms conspire to fix prices?

Marine Hose Conspirators Go to Prison

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

8-3
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly

APPLYING THE CONCEPTS

6 How do patent holders respond to the introduction of

generic drugs?
Merck and Pfizer Go Generic

7 What is the rationale for regulating a natural monopolist?

Public versus Private Waterworks

8 When does a natural monopoly occur?

Satellite Radio as a Natural Monopoly

9 Does competition between the second- and third-largest

firms matter?
Heinz and Beech-Nut Battle for Second Place

10 How does a merger affect prices?

Xidex Recovers Its Acquisition Cost in Two Years
Copyright © 2012 Pearson Prentice Hall. All rights reserved.
8-4
CHAPTER 8 Market Entry, Monopolistic Competition,
Market Entry, Monopolistic
Competition, and Oligopoly and Oligopoly

●monopolistic competition
A market served by many firms that
sell slightly different products.

The term, monopolistic competition, actually conveys the two key

features of the market:

• Each firm in the market produces a good that is slightly different from
the goods of other firms, so each firm has a narrowly defined
monopoly.

• The products sold by different firms in the market are close

substitutes for one another, so there is intense competition between
firms for consumers.

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8-5
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.1 THE EFFECTS OF MARKET ENTRY

MARGINAL PRINCIPLE
Increase the level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit equals the
marginal cost.

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8-6
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.1 THE EFFECTS OF MARKET ENTRY (cont’d)

FIGURE 8.1 Market Entry Decreases Price and Squeezes Profit

(A) A monopolist maximizes profit at point a, where marginal revenue equals marginal cost. 300 toothbrushes
at a price of $2.00 (point b) and an average cost of $0.90 (point c). Profit of $330 is shown by the shaded
rectangle.
(B) Entry of a second firm shifts the firm-specific demand curve for the original firm to the left. The firm
produces only 200 toothbrushes (point d) at a lower price ($1.80, shown by point e) and a higher average cost
($1.00, shown by point f). Profit, shown by the shaded rectangle, shrinks to $160.

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8-7
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.1 THE EFFECTS OF MARKET ENTRY (cont’d)

Entry Squeezes Profits from Three Sides

Entry shrinks the firm’s profit rectangle because it is squeezed from three
directions.
The top of the rectangle drops because the price decreases.
The bottom of the rectangle rises because the average cost increases.
The right side of the rectangle moves to the left because the quantity
decreases.

Examples of Entry: Stereo Stores, Trucking, and Tires

Empirical studies of other markets provide ample evidence that entry

decreases market prices and firms’ profits. In other words, consumers
pay less for goods and services, and firms earn lower profits.

Copyright © 2012 Pearson Prentice Hall. All rights reserved.

8-8
CHAPTER 8
Market Entry, Monopolistic APPLICATION 1
Competition, and Oligopoly

NAME BRANDS VERSUS STORE BRANDS

APPLYING THE CONCEPTS #1: How does brand
competition within stores affect prices?

In many stores, nationally advertised brands share the shelves with store brands.
The introduction of a store brand is a form of market entry—a new competitor for a
national brand—and usually decreases the price of the national brand.

The classic example of the price effects of store brands occurred in the market for
light bulbs:

• In the early 1980s, the price of a four-pack of General Electric bulbs was about
$3.50.
• The introduction of store brands at a price of $1.50 caused General Electric to
cut its price to $2.00.
• In markets without store brands, the General Electric price remained at $3.50.

For a wide variety of products—laundry detergent, ready-to-eat breakfast cereals,

motor oil, and aluminum foil—the entry of store brands decreased the price of
national brands.

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8-9
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.2 MONOPOLISTIC COMPETITION

Under a market structure called monopolistic competition, firms will

continue to enter the market until economic profit is zero. Here are the
features of monopolistic competition:

• Many firms.

• A differentiated product.

●product differentiation
The process used by firms to
distinguish their products from the
products of competing firms.

• No artificial barriers to entry.

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8-10
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.2 MONOPOLISTIC COMPETITION (cont’d)

When Entry Stops: Long-Run Equilibrium

FIGURE 8.2
Long-Run Equilibrium with
Monopolistic Competition

Under monopolistic competition,

firms continue to enter the market
until economic profit is zero.

Entry shifts the firm specific

demand curve to the left.

The typical firm maximizes profit at

point a, where marginal revenue
equals marginal cost.

At a quantity of 80 toothbrushes,
price equals average cost (shown
by point b), so economic profit is
zero.

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8-11
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.2 MONOPOLISTIC COMPETITION (cont’d)

Differentiation by Location

FIGURE 8.3
Long-Run Equilibrium with
Spatial Competition

Book stores and other retailers

differentiate their products by
selling at different locations.

The typical book store chooses

the quantity of books at which
its marginal revenue equals its
marginal cost (point a).

Economic profit is zero

because the price equals
average cost (point b).

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8-12
CHAPTER 8
Market Entry, Monopolistic APPLICATION 2
Competition, and Oligopoly

OPENING A DUNKIN’ DONUTS SHOP

APPLYING THE CONCEPTS #2: What does it take to
enter a market with a franchise?

One way to get into a monopolistically competitive market is to get a

franchise for a nationally advertised product.

Table 8.1 shows the franchise fees and royalty rates for several franchising
opportunities. The fees indicate how much entrepreneurs are willing to pay
for the right to sell a brand-name product.

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8-13
 TRADE-OFFS WITH ENTRY AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.3 MONOPOLISTIC COMPETITION

Average Cost and Variety

There are some trade-offs associated with monopolistic competition.

Although the average cost of production is higher than the minimum,

there is also more product variety.

When firms sell the same product at different locations, the larger the
number of firms, the higher the average cost of production.

But when firms are numerous, consumers travel shorter distances to get
the product.

Therefore, higher production costs are at least partly offset by lower

travel costs.

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8-14
 TRADE-OFFS WITH ENTRY AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.3 MONOPOLISTIC COMPETITION (cont’d)

Monopolistic Competition versus Perfect Competition

 FIGURE 8.4
Monopolistic Competition
versus Perfect Competition

(A) In a perfectly competitive

market, the firm-specific
demand curve is horizontal at
the market price, and marginal
revenue equals price.

In equilibrium, price = marginal

cost = average cost.

Equilibrium occurs at the

minimum of the average-cost
curve.

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8-15
 TRADE-OFFS WITH ENTRY AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.3 MONOPOLISTIC COMPETITION (cont’d)

Monopolistic Competition versus Perfect Competition

 FIGURE 8.4 (cont’d.)

Monopolistic Competition
versus Perfect Competition

(B) In a monopolistically
competitive market, the firm-
specific demand curve is
negatively sloped and marginal
revenue is less than price.

In equilibrium, marginal
revenue equals marginal cost
(point b) and price equals
average cost (point c).

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8-16
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
APPLICATION 3

C3PO AND ENTRY IN THE MARKET FOR SPACE FLIGHT

APPLYING THE CONCEPTS #3: What are the effects of market entry?

Entry into a market increases the competition for consumers, leading to lower prices
and profit. Once the shuttle program ends, the Russian Space Agency will charge the
monopoly price of $47 million per flight.

The C3PO (Commercial Crew & Cargo Program) should stimulate competition and
result in lower prices

• NASA expects cheaper more flexible rockets

• Price should drop to about $20 million per flight

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8-17
 ADVERTISING FOR PRODUCT
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.4 DIFFERENTIATION

Celebrity Endorsements and Signaling

An advertisement that doesn’t provide any product information may actually

help consumers make decisions.

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8-18
CHAPTER 8
Market Entry, Monopolistic APPLICATION 4
Competition, and Oligopoly

ADVERTISING AND MOVIE BUZZ

APPLYING THE CONCEPTS #4: What signal does an
expensive advertising campaign send to consumers?

For another example of signaling from advertising, consider movies:

• A movie distributor may produce several movies each year but advertise
just a few of them.
• Although there are few repeat consumers for a particular movie, there is
word-of-mouth advertising, also known as “buzz”: People who enjoy a
movie talk about it and persuade their friends and family members to see
it.
• An advertisement that gets the buzz started could pay for itself.
• In contrast, a distributor won’t expect much buzz from a less-appealing
movie, so advertising won’t be sensible.
In general, an expensive advertisement sends a signal that the movie
will generate enough word-of-mouth advertising to cover the cost of
the advertisement.

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8-19
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.5 WHAT IS AN OLIGOPOLY?

●concentration ratio
The percentage of the market output
produced by the largest firms.

An alternative measure of market concentration is the Herfindahl-Hirschman

Index (HHI). It is calculated by squaring the market share of each firm in the
market and then summing the resulting numbers.

An oligopoly—a market with just a few firms—occurs for three reasons:

1 Government barriers to entry.

2 Economies of scale in production.
3 Advertising campaigns.

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8-20
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.5 WHAT IS AN OLIGOPOLY?

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8-21
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA

●duopoly
A market with two firms.

●cartel
A group of firms that act in unison,
coordinating their price and quantity
decisions.

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8-22
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)

profit = (price − average cost) × quantity per

FIGURE 8.5 firm
A Cartel Picks the Monopoly Quantity
and Price

The monopoly outcome is shown by

point a, where marginal revenue equals
marginal cost.

The monopoly quantity is 60

passengers and the price is $400.

If the firms form a cartel, the price is

$400 and each firm has 30 passengers
(half the monopoly quantity).

The profit per passenger is $300 (equal

to the $400 price minus the $100
average cost), so the profit per firm is
$9,000.

●price-fixing
An arrangement in which firms conspire to fix prices.
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8-23
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)
 FIGURE 8.6
Competing Duopolists
Pick a Lower Price

(A) The typical firm

maximizes profit at point a,
where marginal revenue
equals marginal cost. The
firm has 40 passengers.

(B) At the market level, the

duopoly outcome is shown
by point d, with a price of
$300 and 80 passengers.

The cartel outcome, shown

by point c, has a higher
price and a smaller total
quantity.

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8-24
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)

Price-Fixing and the Game Tree

●game tree
A graphical representation of the consequences
of different actions in a strategic setting.

 FIGURE 8.7
Game Tree for the Price-
Fixing Game

The equilibrium path of the

game is square A to square C
to rectangle 4: Each firm picks
the low price and earns a
profit of $8,000.

The duopolists’ dilemma is

that each firm would make
more profit if both picked the
high price, but both firms pick
the low price.

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8-25
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)

Price-Fixing and the Game Tree (pickup)

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8-26
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)

Equilibrium of the Price-Fixing Game

●dominant strategy
An action that is the best choice for a
player, no matter what the other
player does.

●duopolists’ dilemma
A situation in which both firms in a
market would be better off if both
chose the high price, but each
chooses the low price.

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8-27
 CARTEL PRICING AND THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.6 DUOPOLISTS’ DILEMMA (cont’d)

Nash Equilibrium

●Nash equilibrium
An outcome of a game in which each
player is doing the best he or she can,
given the action of the other players.

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8-28
 OVERCOMING THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.7 DUOPOLISTS’ DILEMMA

Low-Price Guarantees

●low-price guarantee
A promise to match a lower price of a competitor.

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8-29
 OVERCOMING THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.7 DUOPOLISTS’ DILEMMA (cont’d)

Low-Price Guarantees
 FIGURE 8.8
Low-Price Guarantees Increase Prices

When both firms have a low-price guarantee, it is impossible for one firm to underprice the other. The only
possible outcomes are a pair of high prices (rectangle 1) or a pair of low prices (rectangles 2 or 4).

The equilibrium path of the game is square A to square B to rectangle 1. Each firm picks the high price
and earns a profit of $9,000.

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8-30
 OVERCOMING THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.7 DUOPOLISTS’ DILEMMA (cont’d)

Repeated Pricing Games with Retaliation for Underpricing

Repetition makes price-fixing more likely because firms can punish a firm that
cheats on a price-fixing agreement, whether it’s formal or informal:

1 A duopoly pricing strategy.

Choosing the lower price for life.

2 A grim-trigger strategy.
●grim-trigger strategy
A strategy where a firm responds to underpricing by choosing a
price so low that each firm makes zero economic profit.

3 A tit-for-tat strategy.

●tit-for-tat
A strategy where one firm chooses whatever price the
other firm chose in the preceding period.

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8-31
 OVERCOMING THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.7 DUOPOLISTS’ DILEMMA (cont’d)

Repeated Pricing Games with Retaliation for Underpricing

 FIGURE 8.9
A Tit-for-Tat Pricing Strategy (cont’d)

Under tit-for-tat retaliation, the first firm (Jill, the square) chooses whatever price the second firm
(Jack, the circle) chose the preceding month.

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8-32
 OVERCOMING THE
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.7 DUOPOLISTS’ DILEMMA (cont’d)

Price-Fixing and the Law

Under the Sherman Antitrust Act of 1890 and subsequent

legislation, explicit price-fixing is illegal.

It is illegal for firms to discuss pricing strategies or

methods of punishing a firm that underprices other firms.

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8-33
CHAPTER 8
Market Entry, Monopolistic APPLICATION 5
Competition, and Oligopoly
MARINE HOSE CONSPIRATORS GO TO PRISON
APPLYING THE CONCEPTS #5: How do firms
conspire to fix prices?

In 2007, the U.S. government discovered a seven-year conspiracy to fix the price
of marine hose, which is used to transfer oil from tankers to onshore storage
facilities.

• The case ultimately led to fines and prison sentences for the employees of
several marine-hose firms and for a person paid by the firms to coordinate the
price-fixing scheme.
• The executives were arrested after a meeting in Houston in which they
allocated customers to different members of the cartel and fixed prices.
• Each firm in the cartel agreed to submit artificially high bids for customers
allocated to other firms, a practice known as bid rigging.

There is some evidence that prison sentences are more effective than fines in
deterring business crimes such as price fixing.

In the United States, people convicted of price fixing regularly offer to pay bigger
fines to avoid prison.

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8-34
 THE INSECURE MONOPOLIST
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.8 AND ENTRY DETERRENCE

The Passive Approach

 FIGURE 8.10
Deterring Entry with Limit
Pricing

Point c shows a secure

monopoly, point d shows a
duopoly, and point z shows the
zero-profit outcome.

The minimum entry quantity is 20

passengers, so the entry-
deterring quantity is 100 (equal to
120 – 20), as shown by point e.
The limit price is $200.

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8-35
 THE INSECURE MONOPOLIST AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.8 ENTRY DETERRENCE (cont’d)

Entry Deterrence and Limit Pricing

The quantity required to prevent the entry of the second firm is computed
as follows:

deterring quantity = zero profit quantity − minimum entry quantity

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8-36
 THE INSECURE MONOPOLIST AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.8 ENTRY DETERRENCE (cont’d)

Entry Deterrence and Limit Pricing

 FIGURE 8.11
Game Tree for the Entry-Deterrence Game

The path of the game is square A to square C to

rectangle 4. Mona commits to the entry-deterring
quantity of 100, so Doug stays out of the market.

Mona’s profit of $10,000 is less than the monopoly

profit but more than the duopoly profit of $8,000.

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8-37
 THE INSECURE MONOPOLIST AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.8 ENTRY DETERRENCE (cont’d)

Entry Deterrence and Limit Pricing

●limit pricing
The strategy of reducing the price
to deter entry.

●limit price
The price that is just low enough to
deter entry.

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8-38
CHAPTER 8
Market Entry, Monopolistic APPLICATION 6
Competition, and Oligopoly
MERCK AND PFIZER GO GENERIC?
APPLYING THE CONCEPTS #6: How do patent holders
respond to the introduction of generic drugs?

Between 2006 and 2011 many top-selling branded drugs will lose their patent
protection. Producers of generic versions will enter markets with hundreds of
billions of dollars in annual sales.

There are two way companies are responding to this increased competition.

• Companies are producing their own versions of generic drugs

• They are cutting the prices of branded drugs to compete with the generic
versions.

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8-39
 THE INSECURE MONOPOLIST AND
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.8 ENTRY DETERRENCE (cont’d)

Examples: Microsoft Windows and Campus Bookstores

Microsoft picks a lower price to discourage entry and preserve its monopoly.
If your campus bookstore suddenly feels insecure about its monopoly
position, it could cut its prices to prevent online booksellers from capturing
too many of its customers.

Entry Deterrence and Contestable Markets

●contestable market
A market with low entry and exit
costs.

When Is the Passive Approach Better?

Entry deterrence is not the best strategy for all insecure monopolists.

Sharing a duopoly can be more profitable than increasing output and cutting
the price to keep the other firm out.
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8-40
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.9 NATURAL MONOPOLY

Picking an Output Level

MARGINAL PRINCIPLE
Increase the level of an activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal benefit equals the
marginal cost.

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8-41
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.9 NATURAL MONOPOLY (cont’d)

Picking an Output Level

 FIGURE 8.12
A Natural Monopoly Uses the
Marginal Principle to Pick
Quantity and Price

Because of the indivisible input of

cable service (the cable system),
the long-run average-cost curve is
negatively sloped.

The monopolist chooses point a,

where marginal revenue equals
marginal cost.

The firm serves 70,000

subscribers at a price of $27 each
(point b) and an average cost of
$21 (point c). The profit per
subscriber is $6 ($27 – $21).

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8-42
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.9 NATURAL MONOPOLY (cont’d)

Will a Second Firm Enter?

 FIGURE 8.13
Will a Second Firm Enter the
Market?

The entry of a second cable

firm would shift the demand
curve of the typical firm to the
left.

After entry, the firm’s demand

curve lies entirely below the
long-run average-cost curve.

No matter what price the firm

charges, it will lose money.
Therefore, a second firm will
not enter the market.

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8-43
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.9 NATURAL MONOPOLY (cont’d)

Price Controls for a Natural Monopoly

 FIGURE 8.14
Regulators Use Average-Cost
Pricing to Pick a Monopoly’s
Quantity and Price

Under an average-cost pricing

policy, the government chooses
the price at which the demand
curve intersects the long-run
average-cost curve—$12 per
subscriber.

Regulation decreases the price

and increases the quantity.

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8-44
CHAPTER 8
Market Entry, Monopolistic APPLICATION 7
Competition, and Oligopoly
PUBLIC VERSUS PRIVATE WATERWORKS
APPLYING THE CONCEPTS #7: What is the rationale
for regulating a natural monopoly?

In the early part of the nineteenth century, public water works

could not keep up with rapidly growing demand, so cities allowed
private companies to provide water.

However, problems with competing private wager providers

caused cities to switch back to public systems

The British determined that water distribution is a natural monopoly and

allowing competition hurts rather than helps public access to water.

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8-45
CHAPTER 8
Market Entry, Monopolistic APPLICATION 8
Competition, and Oligopoly

SATELLITE RADIO AS A NATURAL MONOPOLY

APPLYING THE CONCEPTS #8: When does a natural
monopoly occur?

In 2008, the nation’s only two satellite radio providers, Sirius Satellite Radio and XM
Satellite Radio, merged into a single firm. Together the two firms had 14 million
subscribers, each paying $13 per month for dozens of channels, most of which are
free of advertisements. Both firms were losing money as they struggled to get
enough subscribers to cover their substantial fixed costs.

The proposed merger needed to be approved by the U.S. Department of Justice and
the Federal Communication Commission.

Two years later, the new firm, Sirius XM, earned its first quarterly profit of $14.2
million, compared to a loss one year earlier of $245.8 million.

The merger transformed two unprofitable firms into a single profitable firm.

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8-46
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY

●trust
An arrangement under which the
owners of several companies transfer
their decision-making powers to a
small group of trustees.

Breaking Up Monopolies

One form of antitrust policy is to break up a monopoly into several smaller

firms. The label “antitrust” comes from the names of the early conglomerates
that the government broke up.

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8-47
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)

Blocking Mergers

●merger
A process in which two or more firms
combine their operations.

A horizontal merger involves two firms producing a similar product, for

example, two producers of pet food.

A vertical merger involves two firms at different stages of the production

process, for example, a sugar refiner and a candy producer..

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8-48
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)
Blocking Mergers
 FIGURE 8.15
Pricing by Staples in Cities with and without Competition

Using the marginal principle, Staples picks the quantity at which marginal revenue equals marginal cost.
In a city without a competing firm, Staples picks the monopoly price of $14.
In a city where Staples competes with Office Depot, the demand facing Staples is lower, so the profit-
maximizing price is only $12.

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8-49
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)

Merger Remedy for Wonder Bread

In some cases, the government allows a merger to happen
but imposes restrictions on the new company.

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8-50
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)

Regulating Business Practices: Price-Fixing, Tying, and

Cooperative Agreements

●tie-in sales
A business practice under which a
business requires a consumer of one
product to purchase another product.

●predatory pricing
A firm sells a product at a price below
its production cost to drive a rival out
of business and then increases the
price.

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8-51
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)

The Microsoft Cases

In recent years, the most widely reported antitrust actions have

involved Microsoft Corporation, the software giant.

In the case of United States v. Microsoft Corporation, the judge

concluded that Microsoft stifled competition in the software industry.

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8-52
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly
8.10 ANTITRUST POLICY (cont’d)

A Brief History of U.S. Antitrust Policy

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8-53
CHAPTER 8
Market Entry, Monopolistic APPLICATION 9
Competition, and Oligopoly

HEINZ AND BEECH-NUT BATTLE FOR SECOND PLACE

APPLYING THE CONCEPTS #9: Does competition
between the second- and third-largest firms matter?

In 2001, H.J. Heinz Company announced plans to buy Milnot Holding Company’s
Beech-Nut for $185 million. The merger would combine the nation’s second- and
third-largest sellers of baby food, with a combined market share of 28 percent. The
combined company would still be less than half the size of the market leader,
Gerber, with its 70 percent market share.

The FTC successfully blocked the merger, based on two observations:

• Most retailers stock only two brands of baby food, Gerber and either
Heinz or Beech-Nut. After the merger, the Heinz brand would
disappear, leaving Beech-Nut as a secure second brand on the shelves
next to Gerber. The elimination of competition for second place would
lead to higher prices.

• The smaller the number of firms in an oligopoly, the easier it is to

coordinate pricing. In a market with two firms instead of three, it would
be easier for the baby-food manufacturers to fix prices.

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8-54
CHAPTER 8
Market Entry, Monopolistic APPLICATION 10
Competition, and Oligopoly
XIDEX RECOVERS ITS ACQUISITION COST IN TWO YEARS
APPLYING THE CONCEPTS #10:
How does a merger affect prices?

In 1981 the FTC brought an antitrust suit against Xidex Corporation for its
earlier acquisition of two rivals in the microfilm market.

Xidex increased its market share from 46 percent to 71 percent.

• Price on one type of microfilm increased by 11 percent.

• Price on the other type increased by 23 percent.

• Xidex recovered it acquisition cost in two years.

Xidex agreed to license its microfilm at bargain prices to other firms

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8-55
CHAPTER 8
Market Entry, Monopolistic
Competition, and Oligopoly KEY TERMS

cartel limit pricing

concentration ratio merger
contestable market monopolistic competition
dominant strategy Nash equilibrium
duopolists’ dilemma oligopoly
duopoly predatory pricing
game theory price-fixing
game tree product differentiation
grim-trigger strategy tie-in sales
low-price guarantee tit-for-tat
limit price trust

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8-56
Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 9

Imperfect Information,
External Benefits, and
External Costs

Slides in this presentation contain

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Chapter Outline
9.1 Adverse Selection for Buyers: The Lemons Problem
9.2 Responding to the Lemons Problem
9.3 Adverse Selection for Sellers: Insurance
9.4 Insurance and Moral Hazard
9.5 External Benefits and Public Goods
9.6 The Efficient Level of Pollution
9.7 Taxing Pollution
9.8 Traditional Regulation
9.9 Marketable Pollution Permits

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9.1 Adverse Selection for Buyers: The
Lemons Problem
Explain the notion of adverse selection for buyers.
In this chapter, we explore the circumstances under which
the decisions of individuals do not promote the social
interest:
• Imperfect information: Either buyers or sellers do not
know enough about the product to make informed
decisions.
• External benefits: The benefits of a product are not
confined to the person who pays for it.
• External costs: The cost of producing a product is not
confined to the person who sells it.

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Asymmetric Information
Asymmetric information: A situation in which one side of
the market—either buyers or sellers—has better information
than the other.
How can asymmetric information can produce problems?
• The side with less information cannot make good buying or
selling decisions.
• Because of this, they may be reluctant to buy or sell at all,
which hurts the side with more information also.

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Uninformed Buyers and Knowledgeable
Sellers
Suppose there are two types of used cars: low-quality
“lemons” and high-quality “plums.” They sell together in a
single mixed market.
Mixed market: A market in which goods of different
qualities are sold for the same price.
The price of used cars in this market will be based on:
1. How much is a consumer willing to pay for a plum?
2. How much is a consumer willing to pay for a lemon?
3. What is the chance that a used car purchased in the
mixed market will be of low quality?

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Figure 9.1 All Used Cars on the Market
Are Lemons (1 of 2)

Suppose a consumer values a plum at $4,000 and a lemon

at $2,000.
If he guesses there is a 50–50 mix of plums and lemons on
the market, he is willing to pay $3,000; but if he offers
$3,000, 80% of the cars will be lemons.
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Figure 9.1 All Used Cars on the Market
Are Lemons (2 of 2)

This would lead the consumer to offer less; but now an

even lower fraction of cars available are plums.
The equilibrium in this market is that all cars offered for
sale are lemons, and the price is $2,000.

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Table 9.1 Equilibrium with All Low-
Quality Goods
blank Buyers Initially Equilibrium:
Have 50–50 Pessimistic
Expectations Expectations
Demand Side of Market blank blank
Amount buyer is willingness to pay for a lemon $2,000 $2,000
Amount buyer is willingness to pay for a plum $4,000 $4,000
Assumed chance of getting a lemon 50% 100%
Assumed chance of getting a plum 50% 0%
Amount buyer is willing to pay for a used car in $3,000 $2,000
mixed market
Supply Side of Market blank blank
Number of lemons supplied 80 45
Number of plums supplied 20 0
Total number of used cars supplied 100 45
Actual chance of getting a lemon 80% 100%

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Equilibrium with All Low-Quality Goods
The domination of the used car market by lemons is an
example of the adverse-selection problem.
Adverse-selection problem: A situation in which the
uninformed side of the market must choose from an
undesirable or adverse selection of goods.
The asymmetric information in the market generates a
downward spiral of price and quality, in this case until all
cars on the market are lemons.

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A Thin Market: Equilibrium with Some
High-Quality Goods
The result that all cars on the market are lemons occurs
because no plum-seller is willing to sell at the value of a
lemon.
If the minimum supply price of plums were lower (below
$2,000 in this example), then some cars sold would be
plums. The result is a thin market:
Thin market: A market in which some high-quality goods
are sold but fewer than would be sold in a market with
perfect information.

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Figure 9.2 The Market for High-Quality
Cars (Plums) Is Thin

If buyers are pessimistic and assume that only lemons will be

sold, they are willing to pay $2,000 for a used car. At this price, 5
plums are supplied (point a), along with 45 lemons (point b).
This is not an equilibrium because 10% of consumers get plums,
contrary to their expectations.
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Table 9.2 A Thin Market for High-
Quality Goods
Blank Initial Equilibrium:
Pessimistic 75–25
Expectations Expectations
Demand Side of Market Blank Blank
Amount buyer is willing to pay for a lemon $2,000 $2,000
Amount buyer is willing to pay for a plum $4,000 $4,000
Assumed chance of getting a lemon 100% 75%
Assumed chance of getting a plum 0% 25%
Amount buyer is willing to pay for a used car in $2,000 $2,500
mixed market
Supply Side of Market Blank Blank
Number of lemons supplied 45 60
Number of plums supplied 5 20
Total number of used cars supplied 50 80
Actual chance of getting a lemon 90% 75%

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Predictions from the Lemons Problem
The lemons model makes two predictions about markets with
asymmetric information.
1. The presence of low-quality goods in a market will at least
reduce the number of high-quality goods in the market and
may even eliminate them.
2. Buyers and sellers will respond to the lemons problem by
investing in information and other means of distinguishing
between low-quality and high-quality goods.

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Evidence of the Lemons Problem
In studies of the market for used trucks:
1. For trucks less than 10 years old, the ones sold on the
used market are about as reliable as ones retained by
owners.
2. For older trucks (about 1/3 of transactions), the
probability of requiring engine and transmission repairs
is much higher for those that are sold on the used
market.

The problem of information asymmetry appears to be more

severe for older trucks.

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Application 1: Are Baseball Pitchers
Like Used Cars?
After playing for six years, MLB
players can become free agents.
Free-agent pitchers who change
teams get injured more: 28 days
per season, v s 5 for players who
ersu

stay with their original team.

Adverse selection helps to explain
this: original teams will be more
willing to part with an injury-prone
“lemon” baseball player than with a
healthy “plum.”

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9.2 Responding to the Lemons Problem
Discuss the possible responses to adverse selection
for buyers.

There are strong incentives for buyers and sellers to solve the
lemons problem.
• In our car market example, consumers are willing to pay a
high price if they can be guaranteed a “plum.”
• Similarly, sellers benefit from a higher sale price if they can
demonstrate their car is high quality.
In this section, we will examine some ways of overcoming
the lemons problem.

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Buyers Invest in Information
Buyers may be able to pay for information about the
product they want to buy.
In the market for lemons, a buyer could:
• Take the car to a mechanic to learn more about it.

• Obtain a report on the history of the car, say from

Carfax.com.

• Learn more about the likely reliability, say by reading

Consumer Reports publications on repair histories of
car models.

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Consumer Satisfaction Scores from
Angie’s List and eBay
Asymmetric information also exists when purchasing
services. How can you know if your mechanic or plumber is
high quality? Or if an unknown seller online is trustworthy?
• Angie’s list was created in 1995 to solve this problem,
collecting reviews of local businesses.
• eBay and other online marketplaces collect reviews of
sellers and make those available, to help reduce the
information asymmetry between buyers and sellers.

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Guarantees and Lemons Laws
Sellers can credibly signal to buyers that their product is
high quality by offering money-back guarantees or repair
warranties.
Governments can also help to increase the ability of
buyers to trust sellers by creating “Lemons Laws,”
protecting consumers against unusually poor products.
• In the new car market, such laws sometimes require
manufacturer to buy back cars with recurring problems.

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Application 2: Regulation of the
California Kiwifruit Market
The sweetness level of kiwifruit
cannot be determined by customers
before purchase; producers know it
but buyers don’t, an asymmetric
information problem.
In 1987, California producers
implemented a federal marketing
order: fruit must meet a minimum
maturity standard.
Within a few years, kiwifruit prices
went up as buyers could trust the
product they were buying.

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9.3 Adverse Selection for Sellers:
Insurance
Explain the notion of adverse selection for sellers.
Sometimes, buyers can be more knowledgeable than
sellers, when they are buying a service but the seller does
not know how expensive it will be to provide the service.
The best example of this is insurance markets:
• Auto insurance sellers have limited information about
your driving ability and habits.
• Health and life insurance companies have limited
information about your overall health and lifestyle.

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Health Insurance
What is the insurance company’s average cost per customer? To
determine the average cost in a mixed market, we must answer
three questions:
• What is the cost of providing medical care to a high-cost person?
• What is the cost of providing medical care to a low-cost person?
• What fraction of the customers are low-cost people?

There is asymmetric information in the insurance market because

potential buyers know from everyday experience and family
histories what type of customer they are, either low cost or high
cost.

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Figure 9.3 All Insurance Customers
Are High-Cost People
A high-cost customer
requires $6,000 worth of
care, while a low-cost
customer requires $2,000.
If the insurance company
assumes a 50–50 mix, it
charges $4,000; but this is
not an equilibrium, because
too many high-cost
customers buy insurance.

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Table 9.3 Equilibrium with All High-Cost
Consumers
50–50 Equilibrium: Pessimistic
Blank Expectations Expectations
Supply Side of Market Blank Blank
Cost of serving a high-cost customer $6,000 $6,000
Cost of serving a low-cost customer $2,000 $2,000
Assumed fraction of high-cost customers 50% 100%
Assumed chance of low-cost customers 50% 0%
Expected average cost per customer (price) $4,000 $6,000
Demand Side of Market Blank Blank
Number of high-cost customer 75 40
Number of low-cost customers 25 0
Total number of customers 100 40
Actual fraction of high-cost customers 75% 100%
Actual average cost per customer $5,000 $6,000

In the equilibrium, relatively few people buy health insurance, and

they are all high cost: an adverse-selection problem.
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Responding to Adverse Selection in
Insurance: Group Insurance
Insurance companies use group insurance plans to diminish
the adverse-selection problem.
By enrolling all the employees of an organization in one or
two insurance plans, they ensure that all workers, not just
high-cost people, join the pool of consumers.
Prices are then usually set by experience rating.
Experience rating: A situation in which insurance
companies charge different prices for medical insurance to
different firms depending on the past medical bills of a firm’s
employees.

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The Uninsured
One implication of asymmetric information in the insurance
market is that many low-cost consumers who are not
eligible for a group plan will not carry insurance.
The Affordable Care Act (ACA) tried to solve this problem
with the individual mandate, requiring U.S. residents to
obtain health insurance.
• Changes to the law were passed in 2017 ending the
individual mandate.
• The Congressional Budget Office (CBO) estimates that
this will increase the uninsured population by 15 million
by 2026.

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Other Types of Insurance
The same logic of adverse selection applies to the markets
for other types of insurance.
• Homeowners know more than home insurers about the
state of repair of their homes.
• Individuals know more about their family history of illness
than life insurance companies.

Insurance companies can try to reduce this information

asymmetry, say by requiring home inspections or physical
exams.

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Application 3: Genetic Testing and
Adverse Selection
The cost of genetic testing
continues to decrease, giving
consumers insights into their
ancestry and future health.
If you test positive for APOE4, a
mutation of a gene related to
increased risk of Alzheimer’s,
would you be more willing to buy
long-term care insurance?
• A recent study showed those
who knew they had the gene
were 2.3–5.8 times more likely
to buy that insurance.

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9.4 Insurance and Moral Hazard
Explain the notion of moral hazard.
Another problem of asymmetric information is that people who are
insured against the consequences of their actions may change their
behavior in undesirable ways.
• Someone with auto insurance may drive less safely.
• A student guaranteed a good grade may not study hard to learn
class material.
• A worker who will be paid regardless of performance may not put
in high effort at work
Moral hazard: A situation in which one side of an economic
relationship takes undesirable or costly actions that the other side
of the relationship cannot observe.

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Insurance Companies and Moral Hazard
Insurance companies use various measures to decrease
the moral-hazard problem.
For example, many insurance policies have a
deductible—a dollar amount that a policyholder must pay
before getting compensation from the insurance
company.
• Deductibles reduce the moral-hazard problem because
they shift to the policyholder part of the cost of a claim
on the policy.

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Deposit Insurance for Savings and
Loans
When you deposit money in a Savings and Loan (S&L), the
S&L will invest the money, loaning it out and expecting to
make a profit when loans are repaid with interest.
• For S&L managers, pursuing high-risk, high-reward
investments could be beneficial: succeed and obtain large
financial rewards, fail and lose your job, and move on to the
next company.
• Because consumer deposits are protected by FDIC
insurance, consumers have little incentive to insist on safe
S&L investment practices.

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Savings and Loans in the 1980s
Recognizing this moral hazard problem, the federal
government has historically limited S&Ls to relatively safe
investments.
• In the 1980s, the government loosened investment
restrictions. Managers engaged in risky behaviors, and
taxpayers bailed out failed S&Ls at a cost of about $200
billion.

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Application 4: Car Insurance and Risky
Driving
Do people really drive less
safely when they have car
insurance?
When a state makes car
insurance compulsory,
collisions and the number of
traffic deaths increase.
• A 1% decrease in the share
of uninsured drivers
increases traffic fatalities by
2%.

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9.5 External Benefits and Public Goods
Define a public good and the free-rider problem.
Writing and enforcing laws and regulations are important
activities that take place within governments.
In this section, we focus on another aspect of government:
provision of, and decisions about, goods with external
benefits.
External benefit: A benefit from a good experienced by
someone other than the person who buys the good.

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Public Goods and the Free-Rider
Problem
Suppose a new dam will provide $50 in benefit to each of
1,000 residents, while costing $20,000 to build.
The dam is an example of a public good; it is nonrival in
consumption (one person benefiting from it does not prevent
another person from benefiting from it) and nonexcludable
(impractical to exclude people who do not pay).
• Examples include national defense, space exploration, the
preservation of endangered species, and fireworks shows.

Public good: A good that is available for everyone to

consume, regardless of who pays and who doesn’t; a good
that is nonrival in consumption and nonexcludable.
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Free Riders
Suppose, we were to build the dam only if people volunteered
to pay for it. Would you pay, knowing you would benefit from
this public good regardless of whether you paid?
Free rider: A person who gets the benefit from a good but
does not pay for it.
Private goods do not have the free-rider problem because we
can stop people from benefiting from the good if they do not
pay for it.
Private good: A good that is consumed by a single person or
household; a good that is rival in consumption and excludable.

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Public Goods and Public Provision
Governments often provide public goods as a solution to the
free-rider problem.
• Governments can force people to pay for the good through
taxation.

Be careful: just because a good is provided by the

government, does not necessarily make it a public good.
• For example, public housing is a private good: it is both
rival in consumption and excludable.

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Behavioral Economics and Free Riding
Some economic experiments investigate the extent of free
riding.
• In one experiment, participants decide how much of their
private funds to contribute to a public good, helping out the
other participants by more than their own cost.
• Participants tend to start out contributing to the public good,
but contribute less and less over time; that is, they free ride
more as time goes on.

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Overcoming the Free-Rider Problem
Some organizations are successful at getting people to
contribute rather than free ride. Successful strategies
include:
• Giving contributors private goods such as coffee mugs,
books, musical recordings, and magazine subscriptions.
• Arranging matching contributions.
• Appealing to a person’s sense of civic or moral
responsibility.

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Application 5: Clearing Space Debris
NASA estimates there are
about 300,000 pieces of
“space debris” orbiting the
earth, each large enough to
destroy an orbiting satellite.
Cleaning up the space debris
is a public good subject to the
free-rider problem:
• If one nation clears space
debris, the benefits are
shared by all.

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Application 6: Global Weather
Observation
Weather information gathered by
one country has external benefits
for other countries.
The United States has taken the
lead in encouraging cooperation
and sharing of data collected by
different organizations around the
world.
The National Oceanic and
Atmospheric Organization was able
to predict the El Niño weather
pattern in 1997–98, saving the
California economy over $1 billion.

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9.6 The Efficient Level of Pollution
Use the marginal principle to describe the efficient level
of pollution.
In an earlier chapter, we saw that one condition for market
efficiency is that there are no external costs in production.
• External costs will lead to market failure: markets will fail to
allocate resources efficiently.

How can we deal with situations in which there are large

external costs, such as pollution costs?
• The consequences for our environment if we fail to account
for these external costs of production may be dire.

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Using the Marginal Principle
Caring about pollution does not mean eliminating all
pollution.
Recall the marginal principle: increase the level of an
activity as long as its marginal benefit exceeds its
marginal cost. Choose the level at which the marginal
benefit equals the marginal cost.
Pollution and other external costs make the marginal cost
of production higher. This alters the optimal level of many
activities, though the ideal reduction depends on the
balance of benefits and costs.

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Costs and Benefits of Pollution
Abatement
Instead of considering the pollution-producing activity, it
is convenient to consider a new good: pollution
abatement, or the reduction in pollution.
• Pollution abatement has costs: resources (land, labor,
and capital) will be used in the abatement process.
• Pollution abatement has benefits: better health,
increased enjoyment of the natural environment, and
lower production costs (e.g., for farmers gaining
access to clean water).

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Figure 9.4 Efficient Abatement and
Coase Bargaining (1 of 4)
With no abatement, 500 tons
of waste is produced.
The marginal cost of
abatement rises as more
waste is abated; similarly, the
marginal benefit falls.
The ideal amount of
abatement is 300 tons: 200
tons of waste will still be
formed.

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Coase Bargaining
Under some circumstances, an external-cost problem can be
resolved through bargaining among the affected parties.
The Coase bargaining solution, named after economist
Ronald Coase, applies to a situation when:
• There is a small number of affected parties, and
• The transactions costs of bargaining are relatively low.

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Figure 9.4 Efficient Abatement and
Coase Bargaining (2 of 4)
If we started with 500 tons of
waste, the people who would
benefit from waste abatement
could pay the polluting firm to
reduce waste.
They value 1 ton of waste
reduction at $21, while
reducing pollution by that 1 ton
costs the firm only $3.
They could bargain for some
price in the middle, making
both better off.
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Figure 9.4 Efficient Abatement and
Coase Bargaining (3 of 4)
Similarly, if we started with
full waste abatement
(pollution is banned), the
firm would offer $13 to be
allowed to produce 1 ton of
waste.
Because the benefit to the
rights-holders of that last 1
ton of pollution abatement
is only $1, the parties can
again agree on a mutually
beneficial trade.

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Figure 9.4 Efficient Abatement and
Coase Bargaining (4 of 4)
In either case, the process
can continue until point e is
reached: the efficient
outcome.
The Coase bargaining result
does not depend on who is
assigned the property rights
as long as those property
rights are well defined.
If many parties are involved,
however, bargaining may
break down.
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Application 7: Reducing Methane
Emissions
Methane is a greenhouse gas
that contributes to global
warming.
Determining the cost of methane
abatement is not too hard; the
problem is determining the
benefit.
How much will reducing methane
by particular amounts reduce
adverse climate effects?
• The uncertainty makes forming
good public policy difficult.

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9.7 Taxing Pollution
Describe the role of taxation in promoting efficient environmental
policy.

The economic approach to pollution is to get producers to pay for the

waste they generate, just as they pay for labor, capital, and materials.
One way of doing this is with a tax on pollution.
Private cost of production: The production cost borne by a producer,
which typically includes the costs of labor, capital, and materials.
External cost of production: A cost incurred by someone other than
the producer.
Social cost of production: Private cost plus external cost.
Pollution tax: A tax or charge equal to the external cost per unit of
pollution.

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Figure 9.5 The Firm’s Response to an
SO2 Tax
The efficient outcome is 6 tons
of abatement; at that level, the
marginal cost of abatement just
equals the marginal benefit.
To achieve this, we can set the
tax per ton to be the same as
the marginal benefit ($3,500).
The firm will abate pollution as
long as it can do that more
cheaply than paying the tax.

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Figure 9.6 The Effects of SO2 and NOx
Taxes on the Electricity Market

A tax on pollution raises the firm’s cost of production, shifting

the supply curve upward; the tax is an additional cost the firm
has to pay when it produces.
The tax is shifted forward to consumers, who pay a higher
price, and consequently choose to consume less.
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Figure 9.7 Responses to SO2 and NOx
Taxes on Electricity Generation

Firms can also adjust their production process to avoid the

pollution tax. Electricity generators switch to low-sulfur coal
and alternate energy sources.
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Example: A CO2 Tax
A tax on carbon dioxide-producing fuels could help reduce or avoid
global warming caused by greenhouse gases.
A tax of $30 per ton of CO2 would add $0.27 per gallon to the price
of gasoline, $1.60 per 1,000 cubic feet of natural gas, and $63 per
short ton of coal.
How would this help the environment?
• People would drive less and buy more energy-efficient vehicles.
• Higher home energy costs would encourage better home
insulation and reduced electricity consumption.
British Columbia implemented such a tax; since 2008, fuel
consumption in the province decreased by 4.5%.

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Application 7: Washing Carbon Out of
the Air
One option to address the
problem of CO2 in the
atmosphere is large machines
to wash CO2 out of the air.
With current technology, the
cost of carbon washing is $200
per ton.
As costs fall, this may become
an effective alternative to the
cost of avoiding CO2 emission.

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9.8 Traditional Regulation
Explain the superiority of taxation over traditional
regulation.
Although the economic approach to pollution is to get
polluters to pay for the waste they generate, governments
often take a different approach.
• Under a traditional regulation policy, the government tells
each firm how much pollution to abate and what
abatement techniques to use.
Why might is this not ideal?
• We are likely to be able to achieve the same reduction in
pollution at a lower cost using other methods.
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Table 9.4 Uniform Reduction Versus
Pollution Tax
blank blank Abatement cost Abatement cost

blank Marginal Uniform Abatement Pollution tax = $3,000 per ton

Abatement cost policy
Low-cost firm $2,000 $2,000 $4,000

High-cost firm $5,000 $5,000 $ 0

Total Blank $7,000 $4,000

Suppose, we want to achieve 2 tons of pollution abatement. Two firms emit 2 tons of
pollution each.
Using a uniform abatement policy, we would require both the low-cost and high-cost
firms to reduce pollution by 1 ton.
• The total cost of abatement is $7,000.

If we tax pollution instead, the high-cost firm will not reduce pollution at all, choosing to
pay the tax.
• The low-cost firm will abate 2 tons of pollution, costing $4,000.

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Command and Control
Command-and-control policies specify maximum amounts
of pollution and mandate particular pollution reduction
technologies.
Economists discourage command-and-control approaches:
• Requiring the same technology for all firms is unlikely to be
efficient when firms differ in their production technology.
• Even worse, there is no incentive to improve beyond the
mandated technology.

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Market Effects of Pollution Regulations
Why do governments use these policies, when:
• Uniform abatement policies are inefficient, ignoring firm-
specific costs of reducing pollution.
• Command-and-control policies discourage innovation.
One reason is predictability: we are more able to predict the
amount of waste generated.
• Using a pollution tax, firms will choose how much pollution
to abate, and this may not match the government’s goals.

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Lesson from Dear Abby: Options for
Pollution Abatement
A reader wrote to columnist “Dear Abby” Van Buren, asking
how to deal with pollution from their neighbor’s wood-burning
stove. The reader had offered $500 to the neighbors to
remove the stove, but they refused.
Other readers offered some sub-$500 ideas, including:
• Buy the neighbors a pollution-reducing stove add-on
• Pay the neighbors to hire a chimney sweep
• Purchase an air purifier for the reader’s own home
The lesson: by getting creative, we may be able to find a
lower-cost solution to pollution problems.

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Application 9: Options for Reducing CO2
Emissions from International Shipping
International shipping is responsible
for about 3% of global CO2
emissions.
Some ways to reduce CO2
emissions:
• Switch from diesel to gas-powered
engines: $20 per ton
• Reduce speed and increase fleet
size: $90 per ton
• Install fixed sails and wings to tap
wind power: $105 per ton

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9.9 Marketable Pollution Permits
Describe the virtues of marketable pollution permits
and the factors that determine their price.

One new approach to environmental policy is the use of

marketable pollution permits, sometimes called
pollution allowances.
Marketable pollution permits: A system under which the
government picks a target pollution level for a particular
area, issues just enough pollution permits to meet the
pollution target, and allows firms to buy and sell the
permits; also known as a cap-and-trade system.

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Voluntary Exchange and Marketable
Permits
Making pollution permits marketable is sensible because it
allows mutually beneficial exchanges between firms with
different abatement costs.
• This is another illustration of the principle of voluntary
exchange: A voluntary exchange between two people
makes both people better off.
A firm with a low cost of pollution abatement would sell its
permits (i.e., abate more pollution); a firm with a high cost of
pollution abatement would buy those permits.
• This system uses market forces to discover which firms
have the lowest cost of pollution abatement.

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The Clean Air Act (1990) and the SO2
Cap-and-Trade Program
The Clean Air Act (1990) established a system of marketable
pollution permits for SO2.
• Firms received permits equal to 50–70% of their previous
pollution levels.
• Over time, the number of permits would decrease, in order
to encourage innovation in pollution abatement.
A report from the National Acid Precipitation Assessment
Program showed the permit system lowered the cost of
abatement by 15–20%.
In 2011, courts invalidated the program, and by 2012, it was
no longer an important force in pollution reduction.
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Figure 9.8 The Market for Pollution
Permits
A similar system for smog pollutant
permits was created in the Los
Angeles basin.
Again, the number of permits shrunk
over time, eventually allowing only
30% as much pollution as at the start
of the program.
• This created incentives for
innovation in pollution abatement,
since the demand for pollution
abatement technologies would rise
over time.

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Application 10: The Price of CO2
Permits in the European Union
The EU designed an Emissions
Trading System (ETS) to serve
as a market for CO2 permits.
The number of permits was not
designed to shrink fast enough,
however, resulting in falling
prices for the permits—resulting
in low incentives for innovation.
2017 reforms are expected to
decrease the supply of permits.

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Key Terms
Adverse-selection problem Moral hazard
Asymmetric information Pollution tax
Experience rating Private cost of production
External benefit Private good
External cost of production Public good
Free rider Social cost of production
Marketable pollution permits Thin market
Mixed market

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Copyright

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Survey of Economics: Principles,
Applications and Tools
Eighth Edition

Chapter 10

The Labor Market and

the Distribution of
Income

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Chapter Outline
10.1 The Demand for Labor
10.2 The Supply of Labor
10.3 Labor Market Equilibrium
10.4 The Distribution of Income and Public Policy

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10.1 The Demand for Labor
Explain why competition generates wages equal to marginal
revenue product.
Most of our work so far has been on the markets for final goods and
services.
In this chapter, we examine the market for one of the factors of
production: labor.
• We can use a labor demand and supply model to investigate why
wages are different for different types of people, and in different
occupations.
• We will also look at recent changes in the distribution of income
and the effects of government tax and transfer policies.

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Labor Demand by an Individual Firm in
the Short Run
Labor demand is a derived demand, derived from the
demand for the products that workers produce.
Consider a perfectly competitive firm producing rubber
balls and selling them for $0.50 each. The firm decides
how many people to hire using the marginal principle:
• Increase the level of an activity as long as its
marginal benefit exceeds its marginal cost. Choose
the level at which the marginal benefit equals the
marginal cost.

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Table 10.1 Using the Marginal Principle
to Make a Labor Decision
(1) (2) (3) (4) (5) (6)
Workers Balls Marginal Product of Price Marginal Revenue Marginal Cost
Labour Product of Labour (MRP) When Wage = $8
1 26 26 $0.50 $13 $8
2 50 24 0.50 12 8
3 72 22 0.50 11 8
4 92 20 0.50 10 8
5 108 16 0.50 8 8
6 120 12 0.50 6 8
7 128 8 0.50 4 8
8 130 2 0.50 1 8

Marginal product of labor: The change in output from one additional unit
of labor.
Marginal-revenue product of labor (MRP): The extra revenue generated
from one additional unit of labor; MRP is equal to the price of output times
the marginal product of labor.

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Figure 10.1 The Marginal Principle and
the Firm’s Demand for Labor (1 of 2)

The MRP curve is also the short-run demand curve for labor:
Short-run demand curve for labor: A curve showing the
relationship between the wage and the quantity of labor
demanded over the short run, when the firm cannot change its
production facility.
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Figure 10.1 The Marginal Principle and
the Firm’s Demand for Labor (2 of 2)

The firm chooses how many workers to hire (demand) based on

the marginal cost (the wage) and the marginal benefit (the MRP).
To form the market labor demand for labor in the short run, we
add up the number of workers demanded by each individual firm
at each wage.
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Figure 10.2 An Increase in the Price of
Output Shifts the Labor-Demand Curve (1 of 2)

Long-run demand curve for labor: A curve showing the

relationship between the wage and the quantity of labor demanded
over the long run, when the number of firms in the market can
change and firms can modify their production facilities.

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Labor Demand in the Long Run
The long-run demand curve for labor slopes downward for two
reasons:
1. The output effect: when wages are higher, the price of output
will be higher; less output will be demanded, and hence fewer
workers also.
2. The input-substitution effect: when wages are higher, firms
can substitute toward other inputs.
Output effect: The change in the quantity of labor demanded
resulting from a change in the quantity of output produced.
Input-substitution effect The change in the quantity of labor
demanded resulting from an increase in the price of labor relative
to the price of other inputs.
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Figure 10.2 An Increase in the Price of
Output Shifts the Labor-Demand Curve (2 of 2)

Labor demand is a derived demand, deriving from the demand for

the product.
If consumers are willing to pay a higher price for the product, the
firm will supply more, and hence labor demand will be higher.

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Short-Run Versus Long-Run Demand
How does the short-run demand curve for labor compare to
the long-run demand curve? There is less flexibility in the
short run because
1. Firms cannot enter or leave the market
2. Firms cannot modify their production facilities.

As a result, the demand for labor is less elastic in the short

run.
• That means the short-run demand curve is steeper than
the long-run demand curve.

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Application 1: Marginal Revenue
Product in Major League Baseball
In 2018, the average salary in Major
League Baseball (MLB) was $4.5
million. Are players really worth that
much?
A team will pay $4.5 million for a
player only if the player’s marginal
revenue product (MRP) is at least
$4.5 million.
• How could it be so high? Fans are
more willing to pay to watch
winning teams; and they purchase
more merchandise when teams
win.
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10.2 The Supply of Labor
Explain why an increase in the wage could increase,
decrease, or not change hours worked
How many hours of labor will be supplied at each wage?
When we speak of a labor market, we are referring to the
market for a specific occupation in a specific geographical
area.
Consider the supply for nurses in the hypothetical city of
Florence. The supply question is, “How many hours of
nursing services will be supplied at each wage?”

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The Individual Labor-Supply Decision:
How Many Hours?
The decision of how much to work is how much leisure time to sacrifice
for money. The price of leisure is the wage.
As the wage increases:
1. Leisure becomes more expensive, so workers substitute away from
it; but
2. Workers have higher incomes, so they consume more normal
goods—including leisure!

Substitution effect for leisure demand: The change in leisure time

resulting from a change in the wage (the price of leisure) relative to the
price of other goods.
Income effect for leisure demand: The change in leisure time resulting
from a change in real income caused by a change in the wage.

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An Example of Income and Substitution
Effects
Suppose each nurse in Florence initially works 36 hours per week
at an hourly wage of $10 and the wage increases to $12.
1. Lester works fewer hours. If Lester works 30 hours instead of
36 hours, he gets 6 hours of extra leisure time and still earns
the same income per week ($360 = 30 hours × $12 per hour).
2. Sam works the same number of hours. If Sam continues to
work 36 hours per week, he gets an additional $72 of income
($2 per hour × 36 hours) and the same amount of leisure time.
3. Maureen works more hours. If Maureen works 43 hours
instead of 36 hours, she sacrifices 7 hours of leisure time but
earns a total of $516, compared to only $360 at a wage of $10
per hour.

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The Market Supply Curve for Labor
Now consider the market supply curve for nursing labor in
Florence. As wages rise:
1. Hours worked per employee is hard to predict, but unlikely to
change much.
2. Some workers will switch to nursing from other occupations.
3. Some workers will migrate to Florence for the higher pay.

So overall the market supply curve for labor will slope

upward.
Market supply curve for labor: A curve showing the
relationship between the wage and the quantity of labor
supplied.
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Application 2: Bike Messengers and
Revenue Sharing in Zurich
A bike messenger in Zurich earns 40% of
their employer’s revenue from deliveries.
A study investigated how they would
respond to a higher wage: 50% revenue
share instead. What happened?
• Messengers worked 40% more shifts.
• They pedaled a little slower each shift,
but made a little more money because
of the higher revenue share.
• Combining these two, their incomes
increased from 1,200 francs to 2,000
francs.
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10.3 Labor Market Equilibrium
Explain why wages differ across occupations and
levels of human capital.
We can now consider a labor market equilibrium: a situation
where there is no pressure to change the wage because the
amount of work demanded is equal to the amount of work
supplied at the prevailing wage.
After this, we will consider a number of reasons why people
earn different amounts.

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Figure 10.3 Supply, Demand, and Labor
Market Equilibrium
At the market equilibrium
shown by point a, the wage is
$15 per hour and the quantity
of labor is 16,000 hours.
The quantity supplied equals
the quantity demanded, so
there is neither excess
demand for labor nor excess
supply of labor.

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Figure 10.4 The Market Effect of an
Increase in Demand for Labor

An increase in the demand for nursing services shifts the demand

curve to the right, moving the equilibrium from point a to point b.
The equilibrium wage increases from $15 to $17 per hour, and the
equilibrium quantity increases from 16,000 hours to 19,000 hours.
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The Market Effects of the Minimum
Wage
In 2012, the federal minimum wage was $7.25 per hour.
What are the trade-offs associated with the minimum wage?
For restaurant workers and restaurant diners, there is good
news and bad news:
• Good news for some restaurant workers: those who keep
their jobs at the higher minimum wage.
• Bad news for some restaurant workers: those who lose
their jobs or have their hours cut.
• Bad news for diners: increased wages are passed on in
higher meal prices.

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Figure 10.5 The Market Effects of a
Minimum Wage
The market equilibrium is shown
by point a: The wage is $6.05
per hour, and the quantity of
labor is 50,000 hours.
A minimum wage of $7.25
decreases the quantity of labor
demanded to 49,000 hours per
day (point b).
Although some workers receive
a higher wage, others lose their
jobs or work fewer hours.

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Variation in Wages across Occupations
Why do some jobs pay more than others? Generally, because
the supply of labor in those jobs is low. Why?
• Few people with the required skills (e.g., to play
professional baseball)
• High training costs (e.g., to become a medical doctor)
• Undesirable working conditions (e.g., working third shift)
• Danger (e.g., crabbing in Alaska)
• Artificial barriers to entry (e.g., licensing requirements for
beauticians)

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Figure 10.6 The Equilibrium Wage When
Labor Supply Is Low Relative to Demand
If supply is low relative to
demand—because few
people have the skills,
training costs are high, or
the job is undesirable—the
equilibrium wage will be
high.

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The College Premium
College graduates earn more than those without college
degrees—on average 72% more in 2015. Why?
1. College students learn useful skills: the learning effect.
2. College students demonstrate by completing college that
they can manage time and work hard: the signaling
effect.
Learning effect: The increase in a person’s wage resulting
from the learning of skills required for certain occupations.
Signaling effect: The information about a person’s work
skills conveyed by completing college.

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The Gender Pay Gap
A 2016 study showed the typical woman earned about 82% as
much as the typical man, compared with 62% in 1976. Why?
1. Human capital: In the past, women had less education than
men; though this is no longer true.
2. Work experience: In 1981, the average man had seven more
years of work experience; by 2011, the gap was only 1.4 years.
3. Industry and occupational mix: Women are overrepresented
in lower-wage industries, and jobs within those industries.

The factors above explain about 62% of the gender pay gap,
leaving about 38% unexplained.

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Racial Discrimination
Blank Male Female
African American 76% 83%
Hispanic 67% 77%

The table shows the fraction of a corresponding average white

worker’s full time pay that African American and Hispanic workers
received in 2016.
A portion of the differences can be attributed to productivity
differences; but a recent study concluded that racial discrimination
probably accounts for about a 10% pay gap.
This gap is not identical across the earnings distribution: it appears
to be small or nonexistent for high-skill and very low-skill workers.

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Labor Unions and Wages
Labor union: A group of workers organized to increase job
security, improve working conditions, and increase wages and
fringe benefits.
In the United States in 2017, about 1 in 9 wage and salary
workers belongs to a union, down from 1 in 3 in the 1950s.
Union workers earn about 10–20% of nonunion workers in typical
jobs. Firms respond to the higher wages by hiring fewer workers.
Unions try to combat this with practices like featherbedding.
Featherbedding: Work rules that increase the amount of labor
required to produce a given quantity of output; may actually
decrease the demand for labor.

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Effects of Unions
Practices like featherbedding tend to reduce output,
raising production costs and increasing prices for
consumers.
Unions have some potential benefits also, like facilitating
communication between management and workers, and
decreasing turnover.
• The decreased turnover resulting from unions is
estimated to reduce costs for firms by 1–2%.

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Immigration and Labor Markets
A substantial fraction of the U.S. labor force was born in other
countries.
A naïve labor supply-based argument would conclude that adding
immigrant workers would decrease the wage of native workers,
because they compete for the same jobs. But:
1. Immigrants are often complements to, rather than substitutes
for, native labor (because of different skill sets etc.).
2. Increased production by immigrants benefits consumers.
3. Immigrants tend to locate in large cities where labor productivity
is relatively high—because demand for labor is high.

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Figure 10.7 Percentage of Workers Who Are
Foreign Born for Different Education Levels

Immigrants to the United States are more likely to be very high or

very low education, compared with the native population.

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Results of Recent Immigration Studies
From dozens of studies over the period 1990–2010, we learn:
• Immigrants have relatively small effects on wages of native
workers overall, neither consistently positive nor negative.
• Because many immigrants are low-skill/education, low-skill
native workers do receive a negative effect on wage due to
immigration.
• Immigrants are substitutes for one another also: increased
immigration hurts the wages of earlier immigrants.

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Application 3: The Value of a Statistical
Life
By examining how much more
people require to work in risky jobs
than safer ones, economists can
estimate how much people value
their own lives.
Suppose working on a skyscraper
pays more than working on the
ground by $6,000, and carries a
0.001 higher risk of death.
We would conclude 0.001 of a life
is worth $6,000; so 1 life is worth
$6,000,000.
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10.4 The Distribution of Income and
Public Policy
Describe the effects of government policies on poverty
and the distribution of income.
In 2016, the median household income in the United States
was $59,039.
But some households earn much more or much less than
others.
There are three key reasons for inequality:
1. Differences in labor skills and effort
2. Luck and misfortune
3. Discrimination
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Figure 10.8 Distribution of Market
Income and After-Tax Income, 2013

The figure shows the distribution of income before (green bars)

and after (purple bars) accounting for government transfers and
federal taxes.
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Table 10.2 Changes in Income for
Different Quintiles, 1979 – 2013
Change in Bottom 20 Middle 60 Percent Next 19 Percent (quintile Top 1
Average Percent (quintiles 2, 3, 4) 5 without top 1%) percent
Income (quintile 1)
Before tax 39% 32% 65% 187%
(market)
After tax 46% 41% 70% 192%

Over the last several decades, the distribution of income has

become more unequal.
• The largest income gains were experienced by households at
the top end of the income distribution.
Over this time, the college premium doubled, and the advanced-
degree premium increased also.
• The dropout penalty almost doubled.
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Changes in the Distribution of Income
What explains these changes?
• Technological change: advances in technology like
computers have complemented high-skill workers, making
them more productive; but reduced the demand for low-skill
workers.
• Increased international trade: Trade has facilitated the
export of goods produced in the United States with high-skill
labor; but it has allowed import of goods that low-skill
workers in the United States would have produced
previously.

Economists have not yet reached a consensus on the relative

importance of these two factors.

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Table 10.3 Poverty Rates for Different
Groups, 2016
A household in the United States Characteristic Poverty Rate in 2010
is classified as poor if it does not All Races 12.7%
receive at least three times as White 11.0

much income as it would take to Black 22.0

Hispanic 19.4
feed the family.
Asian 10.1
In 2016, 40.6 million people were Type of Family Blank
below the poverty line. Married couple 5.1
Female-headed household 26.9
Some government programs
Age Blank
provide assistance to the poor.
Under 18 years 18.0
Means-tested program: A 65 years and older 9.3
program that restricts eligibility to Education Blank

people or households with less College graduates 4.5

High-school graduates 13.3
than a specified maximum wealth
High-school dropouts 24.8
or income.

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1996 Welfare Reform
In 1996, the overhaul of federal antipoverty programs ended
decades of policy based on the notion that low-income families
are entitled to cash and in-kind assistance.
Most programs became administered by states as Temporary
Assistance for Needy Families (TANF). Further,
• A recipient must participate in work activities, defined as
employment, on-the-job training, work experience, community
service, or vocational training.
• After a total of 60 months of cash assistance (consecutive or
nonconsecutive), assistance stops. States can allow
exceptions to the 60-month rule for up to 20% of recipients.

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Earned Income Tax Credit
The government also provides assistance to low-income
households through the tax system.
• The earned income tax credit (EITC) is an earnings
subsidy for low-income households that is determined by
the number of children in the household.
• For the fiscal year 2018, federal spending on the EITC
was $64 billion, which was more than twice the spending
on TANF.
Economists believe the EITC results in significant increases
in workforce participation and decreases in poverty.

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Application 4: Earned Income Tax
Credit and Child Health
Economists used differences in
state tax credit programs to
estimate that:
1. The EITC increased the use
of private health insurance
2. An increase in the value of a
state EITC decreases the
chance a child is in fair or
poor health, and increases
the chance a child is in
excellent health.

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Key Terms
Featherbedding Marginal-revenue product of
labor (MRP)
Income effect for leisure
demand Market supply curve for labor
Input-substitution effect Means-tested programs
Labor union Output effect
Learning effect Short-run demand curve for
labor
Long-run demand curve for
labor Signaling effect
Marginal product of labor Substitution effect for leisure
demand
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Copyright

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