What Economics is about

Economics- The science of scarcity; the science of how individuals and societies deal with the fact that
wants are greater than the limited resources available to satisfy those wants.

Topic Definitions
Opportunity Cost- The most highly valued opportunity or alternative forfeited when a choice is made.
Scarcity - when wants exceed our ability to satisfy
Decisions at the Margin- Decision making characterized by weighing the additional (marginal) benefits
of a change against the additional (marginal) costs of a change with respect to current conditions.
Efficiency- Exists when marginal benefits equal marginal costs
Equilibrium- Equilibrium means "at rest"; it is descriptive of a natural resting place
Ceteris Paribus- A Latin term meaning "all other things constant," or "nothing else changes."

• A condition faced by living creatures since the dawn of time

o Nog the caveman dreams of sitting in a cave full of meat, but it takes too long to make the
number of arrows needed
o Several investment bankers are allotted a designated portion of an IPO for selling to retail
customers, creating a backlog of orders.

Through study of society's response to scarcity, the field of Economics is born

Positive vs. Normative Economics

 • Positive economics- focuses upon that which is
o What is" refers to economic study based upon observable and tested phenomenon
o Cause and Effect
• Based upon collected data, we know sales will rise 10% if prices are lowered 5%
o Emphasis on reality; not opinion or conjecture
• Normative economics - is concerned with what should be
o "what should be" refers to that study concerned with advancing ideals and values
o More philosophical than empirical
• No one should pay more than 25% of their earnings in taxes
• "Why"
 Because any more than that goes against the idea of small government and a
dynamic free market.

Microeconomics vs. Macro

o Microeconomics- is concerned with the primary elements of an economy; that is, an
individual, a firm, a particular industry, or specific market
o Macroeconomics- studies the economy as a whole, firms and individuals reacting to scarcity
in the collective sense.

Micro economics
• Individual (referred to as consumer) level economic activity
• Individual Firms Behavior
o "The Firm" is generic term for a single business unit
• Industry of similar firms
• Single markets, comprised of individuals or firms within a similar business sector
Macro economics
• The economy at large
o The nation's economy
o World economic growth
• An economic market not subdivided into industry groups
• Issues may involve exchange rates, capital investment, mass labor markets, or trade.

Major concepts this course will cover

• Economics discussions frequently revolve around recurring ideas and concepts.
• The sooner you are able to understand them, the better you will understand the course material

Scarcity
• How do we better describe our response to scarcity. If there exists something capable of relieving
our cravings, then we have attained
• Utility = satisfaction of our want (good)
• The car we drive to work
• A new shirt that makes you feel stylish
• Goods = those items providing utility
• To achieved the desired utility, we expend our available resources on goods.
o These goods may be tangible or intangible
• Tangible
 Objects or specific service
• Intangible
 Happiness
 Well-being
• But if something causes us harm or dissatisfaction, we have then encountered a "BAD"
o Tangible
• Pollution
 • Sewage
o Intangible
• Pain and misery
• Goods must be produced, requiring resources
o The car won't appear by itself
• Disutility- The dissatisfaction one receives from a bad
• Bad- Anything from which individuals received disutility or dissatisfaction

• 4 TYPES OF RESOURCES
o Land (physical space; natural resources)
o Labor (talents people contribute to production process)
o Capital (Money)
o Entrepreneurship (business savvy)
• Resources are utilized in differing combinations for each and every good
 • Resources used as inputs in good production are scarce, as well. Therefore, goods can not be
produced in unlimited quantities
o Everyone wants a Filet, but there just is not enough tenderloin to go around
• How then do we determine who will receive the good, and who will not?
• Rationing Devices are introduced
o Such devices may take the form of a price, expressed in currency or exchange, or a
deterrence, such as a line
o These are naturally occurring
• EX: Someone yells "Free Spock Ears" at a Trekkie Convention. Throngs of
fanatics appear to grab a pair.
 What conditions exist, and what is likely the outcome?
• Rationing Device- a means for deciding who gets what of available resources and goods.
o Ex. Money (currency)
o Looks, "if only the pretty people were let into the game"
• Competition exists because of scarcity.

Opportunity Cost
• The highest valued alternative forfeited
• NOT the cost of your choice
• The reward lost when choosing against that which it would offer it
• "PRICE is RIGHT" Examples
o With the first spin at the wheel, you land the $1.00 spot, assuring a place in the Showcase
Showdown
o The decision of the showcase is the opportunity cost
• Teaching example
o Sleep 3 days a week
o Work on some consulting project
o Hang our at Starbucks
 • Now, neuro-surgeon Example
o Get paid very well, but must work until 5 in morning
o Sleep and rest take a higher value in my life
o Thus, the opportunity cost of teaching is likely to subside
No such thing as a Free Lunch
o All choices entail someone picking one over the other
o Resources will be spent in every action; meaning they could have been invested in an
alternative action. The result is an opportunity foregone

Cost and Benefits

• If individuals, firms, and societies are rationale, they consider only those choices providing utility - a
benefit
• And if we know all choices entail an opportunity taken or lost, then there must always be a cost
• Thus, every choice offers a cost and a benefit. As such, economic theory suggests all decisions
should be evaluated on the basis of cost-benefit analysis
• Ex.
o Should we eliminate all pollutions?
o Should I study or go to work?
o Should Progress City build a new deep water port?
• These decisions are best judged in terms of cost and benefits

Decisions Made at Margin

• If choices are evaluated on the basis of costs and benefits, then it stands to reason the following
question will frequently arrive:
• To what extent or quantity is a choice good
• The decision is made based upon whether the additional benefit continues to outweigh the additional
cost
• Think of Marginal as meaning "Additional" in economics
 • Marginal Benefits (MB)- Additional Benefits. The benefits connected to consuming an additional
unit of a good or undertaking one more unit of an activity.
• Marginal Cost (MC)- Additional Costs. The costs connected to consuming an additional unit of a
good or undertaking one more unit of an activity.

Efficiency
• Taking our analysis one step further
o If each costs and benefits are increasing marginally, then there will exist some point where
costs exceed benefit
o But before that, there is a level where MB= MC
o This intersection point is the ideal level of consumption, and is said to be "Efficient"
o In economics, the "right amount" of anything is the "optimal" or "efficient" amount and the
efficient amount is the amount for which the marginal benefits equal the marginal costs.
o Why do we want to continue exercising our choice until reaching Efficiency?
• B/c we seek to maximize Utility (benefit, satisfaction)
• If we stop before MB=MC, there remains Utility to be gained, greater than cost
o Remember, the consumer faces scarcity, and has wants greater than needs. It would be
irrational to stop attaining net positive utility when it is available
• Back to graph
Unintended Consequences
• Decisions and choices exercised may produce secondary results not intended by the deciding party
• Economists frequently discuss this concept when speaking of government policy and law
o If unemployment benefits were raised very high, more people would have less incentive to
work
• Suppose all students were told LSU would no longer require any exams. Who would study?
• Society places a value on the appearance of beauty and health. People resort to tactics that are
neither pretty nor healthy
• EX.
o Boy makes $5.15 an hour. If minimum wage gets raised to $7.50 the boy will make more, but
the unintended consequence is that the employer might not want to employ the boy anymore
 because he cannot afford it. So the unintended effect of raising minimum wage is the boy
losing his job.

Equilibrium
• Economic activity tends toward a natural level, known as an equilibrium
• A market reaches equilibrium when supply equals demand
• Prices may be set by markets seeking equilibrium
• Ex.
o Painter has a painting for sell for $5,000. Three people are willing to pay that much. Two
people are willing to pay $6,000. And one person is willing to pay $6,500. In other words, the
bidding activity of the buyers has moved the price of the painting to its natural resting place or
to an equilibrium price of $6,500.
• Look at the MC/MB graph, the third hour of studying would be equilibrum

Ceteris Paribus
• "All Other Things Held Constant" (Ceteris Paribus): The effect of a change in an assumption or
condition may only be measured if all else is equal
• The relationship between variables will be tested holding conditions ceteris paribus
• Ex.
o Romper Room, a new bar targeting freshmen who like lots of sweet drinks and fighting, is
trying to determine where the right cover charge should be set
o The manager, a 34 year old dropout who never left Tigertown, heard you took econ and asks
for your help
o What would you advise?
• Keep conditions of bar the same

Association vs. Causation

• Association events some common elements, such as timing or sequences. The events, however
closely linked, through, are independent of one another.
 • Causation occurs when one event triggers the next. There exists a relationship between events such
that the second would not exist without the first. There is a dependent relationship
• Bad analysis will lead to arguments suggesting causation when only association exists
o Examples
• Banning rap would eliminate crack use
• I started buying coke every Friday from the vending machine. They must have caught
on because the price went up
• You want to wash your car at 10:00 am and it rains at 10:30 am. Washing your car DID
NOT CAUSE THE RAIN
• If A occurs before B it does not mean it does not mean that A caused B

Group vs. Individual

• Fallacy of composition exists when it is assumed what is good or true for the individual would be
good or true for the group
o Examples
• The way to get ahead in life is to become a programmer. Let us all become programmers
• I saved a lot of money buying my car out of town. Everyone should buy out of town.
• Fallacy of composition - erroneous view that what is good or true for the individual is necessarily
good or true for the group
• Economic Example
o Some people argue that tariffs benefit certain industries by protecting them from foreign
competition. They then conclude that because tariffs benefit some industries, the economy as
a whole benefits from tariffs. This is not true.
Chapter 2
Wednesday, September 07, 2005
9:51 AM

Production Possibility Frontier

General Chapter Info.
• Following Ch. 1 the lesson in scarcity takes the next step
• Assuming limited resources are aligned in such a way that goods may be produced, there must as
well be limits to what can be produced
• In analyzing such limits and trade-offs, the PPF is a tool for comparing the production of two goods.
• Production Possibility Frontier (PPF) - Represents the possible combinations of the two goods
that can be produced in a certain period of time, under the conditions of a given state of technology
and fully employed resources.

PPF - Conditions of the Model

• Only 2 "Goods" in question
o The tradeoff of production, the give and take of choosing one versus another is the dominant
theme.
o These may be representative goods
o Examples
• Coke or Potato Chips
 Two literal goods
• Guns or Butter
 Classic example of defense versus domestic
• Fixed time duration
o The PPF addresses production capability as it exists during a specific timeframe
 o Why is the important?
• Because what may or may not be possible later is not the issue. What can be done now.
• Possible Production given the available technology and using fully employed resources
o Again, maxing out the possible level of production, the point is, what can be produced.
o Remember, the word Frontier implies what lies at the edge, or the margin. Thus, the model
examines the farthest reaching of possible output.

Opportunity Costs on the PPF

• If every choice entails selecting one option over another, whereby an opportunity cost will be
incurred, then the PPF is not different.
• Over the range of the PPF, each point represents differing levels of good X and good Y.
• Whether moving from all X, and all Y, or somewhere in between, opportunity costs arise
• In the Real World, most PPF are bowed-outward curves

• The Straight Line PPF

• Example
o Only computers and television sets are produced, the opportunity cost of one computer is one
television set. As more goods are produced, the opportunity cost between television sets and
computers is constant.
• When the frontier of production features a straight line, with a constant slope, this condition reflects
constant opportunity costs.
• Why do we say it is constant, because the forgone opportunity is the same when choosing between
any level of output
 •

The Bowed-Outward (Concave - downward) PPF: Increasing Opportunity Costs

• The reality is, most choices do not entail constant opportunity costs. The first unit of any choice
typically entails a lower opportunity cost than the last.
• The first hour of study versus the fifth.
 • Spending time watching one movie or HBO, or three in a row
• Bowed-Outward is increasing opportunity costs
Law of Increasing Opportunity Costs
• Law of increasing Opportunity Costs- As more of a good is produced, the opportunity
costs of producing that good increase.
• It addresses this phenomenon (bowed outward) by stating opportunity costs will increase as
production increases
• This concept will hold true when analyzing production, and not simply within the context of
PPF
• So, if opportunity costs rise with each unit produced, then first units produced of X will require
less units forgone of Y than the last units of X
 Because of the changing cost, the slope changes when moving through the frontier
• Thus the PPF is curved, not straight
• Why concave (curved outward) not convex (curved inward) - increasing not
decreasing opportunity costs
• Think about it, the very last good on the margin of the frontier is not the
least expensive in terms of opportunity.
• Why (for most goods) do the opportunity costs increase as more of a good is produced?
 Because people have varying abilities

In Review, Concepts within the PPF

• Scarcity - limits of production
o The PPF separates the production possibilities of an economy into two regions
• An attainable region, which consist of all points on the PPF itself and all points below it.
• An unattainable region, which consists of points above and beyond the PPF.
o Scarcity implies that some things are attainable and some are not
• Choice - the different combinations available
• Opportunity Cost - incurred with movement

Efficient vs. Inefficient Production

 • Productive Efficiency- occurs when the economy operates on the frontier, producing at the
maximum
• Productive Inefficiency- The condition where less than the maximum output is produced with the
given resources and technology. Productive inefficiency implies that more than one good can be
produced without any less of another good being produced.
• Anything less than the max is inefficient.
• On the frontier, efficient; beneath, inefficient.
o Example
• Just because you can get an A in the class, does not mean your going to
• Cannot be super efficient, can not produced more than possible

Unemployed Resources
• Should output fall beneath the frontier, then it is likely there are unemployed resources
• Something is not being utilized if attained output is less than its potential

Economic Growth
• Refers to the increased productive capabilities of an economy.
• Two factors that affect economic growth?
o Increase in the quantity of resources
o Advance in technology
• Technology- The body of skills and knowledge concerning the use of resources in
production. An advance in technology commonly refers to the ability to produce more
output with a fixed amount of resources or the ability to produce the same output with
fewer resources
• Should improved technology, increased productivity, or other business advance be gained, the effect
will be an outward (rightward) shift on the PPF
• Why, because using the same inputs, more may be produced, expanding the frontier.
Chapter 3
Monday, September 12, 2005
9:40 AM

Supply and Demand

Basic Concept
• Those who got it, and those who want it
• In a world constrained by scarcity, driven by utility seekers, there comes

into being the interaction between those who want, and those who have to
offer.
• The ensuing behavior creates the phenomenon known as a "Market".
• Market - The two sided nature of transactions, featuring an exchange

between demanders and suppliers, underlies all trade and economic

activity, today and since the dawn of intelligent man.

Demand
• Those who want, and are allocating their own scarce resources to attain,

demand
• This observed behavior has precise meaning in economics, and refers to

the following 3 Points:

o The willingness and ability of buyers to different quantities of a good
 o At different prices
o Within a specific period of time

• Those who want, but are unwilling or unable to part with resources, are not
considered demanders
o Ex.

• The 15 year old, who, in anticipation of getting a drivers license,

reads car magazines and longs for a Ferrari, is not a demander.

• The 50 year old mid-life crisis divorcee, who sells the family

vacation home and goes shopping for a car to pick up girls half his
age, is a demander.
• If a given good is known to provide utility, and is known to be the object of
demanders, who seek the utility offered, then it stands to reason the
following
o The quantity demanded will be higher when the price is lower.

• Thus we have the

• Unless both willingness and ability to buy are present, a person is not a
buyer and there is no demand.

Law of Demand
o Law of Demand - Quantity demanded is the number of units of a

good that individuals are willing and able to buy at a particular price
during some period of time.
 o The price of a good, and the quantity demanded are inversely related,
all things equal.
o This may be expressed in one of four ways:
i. Words: the definition
ii. Symbols: P(up) QD(down) : P(down) QD(up)
iii. Demand Schedule
iv. Demand Curve

Price: Absolute vs. Relative:

o Absolute Prices are reflected in monetary terms.

i. Shirt costs @10, Pants $30

o Relative Prices are given in terms of another good

i. Shirts/Pants = $10/$30 = 1/3

o Absolute price of a car would be $30,000
o Relative price of a car in terms of computers at $2,000 would be 15

30000/2000 = 15
You would give up 15 computers to buy a car
ο Relative price of a computer in terms of a care would be 1/15

2000/30000 = 1/15
A person gives up 1/15 of a car to buy a computer.
ο If absolute price rises, and nothing else changes, then the relative

price rises to.

Why quantity demanded goes down as price goes up
• Two factors are at work within the Law of Demand and the inverse

relationship between price and demand

1. Lower priced goods are substituted for goods whose prices rise.
2. Consumers may exercise choice, and are free to select other goods
offering greater perceived value
o Law of Diminishing Marginal Utility - with each unit of a good

consumed, the marginal (or additional) utility gained declines, within a

given time
• Which offers the most utility:

 The first bottle of water or the 10th?

 The first hour of study or the fifth?
o Explained a different way, with every unit consumed, the benefit

derived from each subsequent unit is less than the unit consumed right
before.
• So then, what would be most valuable, the first piece of pizza, or

the eighth?
o Therefore, if the first consumed is most valuable, and the last the least

valuable, than the same good in a small quantity will fetch a higher
price than when available in large quantities.
 o Consumers implicitly understand that something offering higher utility
is worth more than something of less. There is no need to pay higher
prices for goods available in large quantities.
• Ex

 At the grocery store, the travel size costs the most per
quantity measured, family size, the least.
 Aside from packaging costs, shelf space, etc, bulk is
cheaper because the marginal utility of the nth unit is
less. Consumers will only demand if the price is less.

The Demand Curve: Individual vs. The Market

a. The Individual Curve consists of price quantity combinations for a
single consumer.
i. For example a demand curve could show Joan's demand for cd's
b. The Marker Curve is a summation of price quantity combinations for all
consumers.
ii. For example a demand curve all buyers' demand for cd's

Change in Quantity Demanded vs. Change in Demand

• Fluctuating in the Demand Curve may be caused by
 1. Change in Quantity Demanded
2. Change in Demand
• These are not the SAME!!!!!!!!!!!!!!!!!!!!!
• Change in Quantity Demanded
o Quantity Demanded

• If Quantity Demanded = the # of units individuals are willing and

able to buy (demand) at a particular price, then….

o Change in Quantity Demanded = A movement from one point to

another point on the same demand curve caused by a change in the

price of the good (own price)
• OR
• It represents the movement from one point to another on the

same demand curve, caused by a change in price.

• Change in Demand
o Change in Demand = movement of the entire demand curve

• Demand increased at all price levels. It is not that the price

shifted, and Quantity Demanded has changed. Rather, the market

simply wants more, regardless of price
o Demand is represented by the entire curve
o A change or shift in the entire demand curve
o It can either increase or decrease
o Increase
 • An increase in demand is represented by a rightward shift
in the demand curve and means that individuals are willing
and able to buy more of a good at each and every price
• Increase in Demand = Rightward shift in Demand Curve
o Decrease
• A decrease in demand is represented by a leftward shift in

the demand curve and means that individuals are willing

and able to buy less of a good at each and every price
• Decrease in Demand = Leftward shift in Demand Curve
•

o Factors causing the shift in demand

1. Income increases or decreases
2. Taste and Preferences change
3. Priced of Related Good increased or decreases
4. The # of buyers within the market increases or decreases
5. Expectations of Future Price Change
• To better understand how a change in demand can occur, it helps to
understand the manner in which economists classify goods.
o Normal Good- a good consumers demand more of when their income

rises.
• This is the type of good most individuals imagine when discussing

"goods".
• Generally speaking, consumers will allocate more resources to this

good, if not purchasing in greater unit quantities.

• Ex.

 I may not own more homes, cars, or shirts, but the ones I do

own now cost more

o Inferior Good- a good in which consumers begin demanding less of

as their income rise.

• There exists certain goods people consume when their income is

low, or falls suddenly

• Once income rises, consumers tend to move away from such

items
• Ex

 Used cars, ramen noodles, or other low quality, relatively

inexpensive good
 There is on notable exception to an inferior good
• Whitney Houston still likes crack
o Neutral Good-Those goods for which demand does not react with
changes in income.
• Barring extremes, there is little shift in consumption of certain

goods despite differences of income

• The book suggests tooth pasts as an example. Another example

would be deodorant
 In this country at least, consumers demand relatively similar

quantities of such goods regardless of income

• Some might consider Tabasco a neutral good
o Substitutes-goods providing the same, or nearly the same utility in a
similar manner of fashion.
• The reason for distinguishing between substitute goods is often a

matter of tastes an preferences.

• These may be normal, inferior, or neutral
• Generally speaking, if the price of one differs greatly than the

other, demand will shift towards the good featuring a lower price
• Ex.

 There is little notable difference between same flavor of soft

drinks, most competition revolves on price

• As an aside, however, substitute goods are frequently marketed in

ways to prevent them from being considered either as a substitute

or a commodity
  Ex
• Bud and Miller are fairly similar. But in watching the ads,
brand association messages are intended to make
consumers fell like there exist distinct differences
o Complements- these are goods which are generally consumed jointly.
A change in demand for one will likely precipitate a similar change in
demand for the toher.
• These may be normal, inferior, or neutral
• Generally speaking, one good, if not both, are not used without

the other. Sometimes the flow goes both ways, other times, not
• Ex.

 One doesn't need cigarette lighters to smoke, but a decline in

the sales of cigarettes will lead to a decline in the sale of

lighters
 Decrease in the need for crack, will also decrease the need for

a crack pipe
 •

Factors causing the shift in demand

• Income:
o This can be for the individual or those consumers within the market
 o An increase will generally push the demand curve out of normal
goods,
• but reduce demand for inferior goods.
• Neutral goods will remain the same
• Taste and Preferences:
o The choice determinant allowing for the unique differences each

consumer exhibits. This effect also captures the phenomenon of how

consumers differentiate between goods that ostensibly serve the
same, or close to the same, purpose
o Whether consumers are motivated by seemingly trite fashion, or more

something more serious like health concerns, a change in Taste and

Preferences can and will shift demand. All goods may be effected
o A change in preferences in favor of a good shifts the demand

upward (right), vice versa

• Prices of related Goods:
o This effect upon demand is most relevant to complement and

substitute goods.
• For complements, the shift in demand will likely be in the same

direction
• For substitutes, the shift will be in opposing directions.
 o When we speak of "price chagnes", we are referring to those changes
making a pronounced effect on market dynamics. These effect demand
across all price ranges, not quantity demanded
o Ex

• Gas and SUV's. These are complement goods, when one is

consumed, so is the other. Suppose gas prices rise, all grades of

SUVs will be effected, cheap or expensive. Only those featuring
the best MPG, cheap or not, will weather the fuel crunch
• Southwest and Delta. These are substitute goods, as most

travelers show little preference for carriers outside of price. When

these engage in a price war, the other will lose market share.
o Increase in price of a substitutes, increases the demand for the

other substitute
o Increase in price of a complement, decreases the demand for

the other substitute

• Number of Buyers:
o The size of any market is related to the number of buyers. When more

are around, demand will be greater across all price levels. The reverse
is also true. This can effect all goods
• Ex

 The housing market in BR. No matter what price point,

housing is in great demand

 o More buyers, increases demand
• Expectations of Future Price:
o Consumers reacting to a belief the future price will change after their

behavior in the present. Overall demand will shift, as people await the
new price structure.
• Ex.

 When fear of interest rates hikes spread, demand for

mortgages increases.
 When consumers anticipate car rebate programs, demand

may drop until t hey are announced.

o Buyers who expect the price of a good to be higher in the

future, will buy now, increasing the demand

Supply
• Supply in economic terms, is a specific term relating to those who utilize

resources in such manner they produce goods. Like demand, there are
three key points
1. The willingness and ability of sellers to produce and offer goods, in
different quantities
2. At different prices
3. During a specific time period
• Does this mean a seller who makes only one good must offer it at different
prices?
o No, rather, they react to different prices set by the market

• Law of Supply:
o Law of Supply- The quantity of a good produced directly related to

the price, all things equal

• Thus, it the market demand for houses shifts outward, builders

will construct more new houses in response

o Just as Demand was subject to the law of diminishing marginal utility,

supply is subject to increasing opportunity costs.

• Recall the outward shaped PPF, whereby production was more

costly, in terms of opportunity, at higher levels of output

• The supply curve is upward sloping, in reaction to price, but

acknowledging that higher levels of production entail more cost.

• In other words,
• A producer will make more only if the price merits the extra

work and, ultimately, cost required

• If I'm going to work 12 hour days, there ought to be a

payout

• Supply Curve Slope:

 o Most goods feature an upward slope, reflecting opportunity costs
o Those goods are available only in a fixed quantity, however, have a
vertical slope
• Additional units can't be produced within the current timeframe
• Additional units simply can never be made

• The Market Supply Curve:

o Like Market Demand, the Market supply schedule is a summation of

individuals suppliers.
o If the market consists of Bob, Joe, and others, than the supply

schedule is their output summed together

o Supply Curves act similar to demand curves

• Movement can result from a change in quantity supplied or overall

change in supply
• As with demand, these do not mean the same thing
• Change in Quantity supplies:

 The only factor influencing a change in Qs the price of a good

- own price
• Change in Supply:

 Supply may increase or decrease in reaction to changes

effecting the market. 6 factors are said to cause such shifts in

supply (i.e. movement of the supply curve)
1.Prices
• The supply of a good is inversely related to the cost

of resources utilized in its production

• If raw material cost increases, the supply curve

will shift inward, and vice versa

2.Technology
• Advances in technology may bring about lower

production costs.
• If such changes allow more efficient production (i.e.

more units given the same resource inputs), than

producers will increase supply.
• Production is more profitable across the supply curve
• Advancement in technology causes an increase

in supply
3.Number of sellers
• More producers yields more supply. Less

suppliers yields less supply

4.Expectations of future price
• Producers will alter what they deliver to the market if

there is an expectation of changes in the future price

• If a producer thinks a higher price will be attainable

in the future, why send more product now?

 • Likewise, if the price is expected to drop, a producer
may try and capture more of the higher price now
• Again, markets react today to those events thought

to occur in the future. There is no waiting.

• If a higher price is expected, supply decreases
• If a lower price is expected, supply increases

5.Taxes and Subsidies

• Taxes have an adverse effect on supply. The more

government taxes supply, the less will come to the

market.
• Subsidies encourage production, for better for worse.

The subsidy incentivizes producers to allocate

resources beyond what market conditions might
demand.
• Simply put, less is produced of that which is taxed,

more of that which is subsidized.

• More taxes, less supply
• More subsidies, more supply

6.Government Restrictions
• Regulation has a negative effect upon supply
• The supply curve will shift inward with

increasing government restrictions

 • The more arduous the regulation, the more
producers begin to curtail (reduce the duration)
production or drop out entirely of the market
•

Supply - And - Demand

• "Two great tastes that taste great together"
• Before we plunge into this joint scenario, a few terms are in order
1. Surplus vs. Shortage
• Surplus- a condition existing when quantity supplied is greater

than quantity demanded

• Shortage- Quantity supplied is less than quantity demanded

2. Equilibrium vs. Disequilibrium

• Equilibrium- A market is said to have reached equilibrium when

demonstrating a price/quantity combination from which there is

no tendency for either buyers or sellers to move away. No
shortage or surplus exists. Those that want to buy can do so;
those who sell can do alike as well
• Disequilibrium- a market experiencing either a shortage or

surplus condition
• Graph

 Shortage under, surplus over

3. Equilibrium Price vs. DisEq. Price

• Equilibrium Price- The price at which the quantity demanded will

equal the Quantity Supplied

• Disequilibrium Price- Any price which results in Quantity

Demanded differing from the Quantity Supplied

 4.Equilibrium Quantity- The quantity corresponding with equilibrium
price.
• At this level, there exists an equal number of units demanded by

willing and able buyers as there are units supplied by willing and
able producers. The amount produced is the amount sold -no
leftover unit and no let out buyers.
• Auctions: the search for Equilibrium - Live
o Ex: The government is auctioning off lease territory.

• There are numerous areas available, and t here is a quantity of

demanders
• The final price must ensure all are sold
• How will this work
• The Search For Equilibrium
o Markets don't necessarily have readily apparent supply and demand

graphs for all concerned to readily see the equilibrium point.

o Rather, the natural equilibrium is found through transaction

experience.
o This process may be ongoing, as a single market is not insulated from

other markets or worldly events.

• The Search for Equilibrium in Action:
o Recall, demand and supply curves stem from schedules
 • Therefore, we know the quantities, both demanded and supplied,
at play given varying price levels.
o The graph, turn, is a physical representation of market forces.

Movement on a graph has its basis in the numerical schedule

o At a level where demand and supply are not equal, and a surplus or

shortage results, the price will face pressures to increase or decrease

until balance arises.
• A market where the Supply Exceeds Demand
o Numerically, suppliers are producing more goods than for which there

is demand. At the current price, goods will remain unsold

o Consumers simply do not generate the necessary utility to justify

allocating resources for this good at such a level

o With excess inventory, suppliers will begin lowering the price
o Buyers are enticed to consume more, increasing demand
o The price will continue falling until there is no more surplus

• A market where Supply exceeds Demand

o With falling price, suppliers sell excess inventory, but also have less

incentive to continue producing at the higher level. The resulting

equilibrium quantity will be less units produced, but consumers will
actually attain more units.
o Graphically this show as follows:
 o Leftward movement along the supply curve; Rightward movement
along the demand
o Along both demand and supply, the movement lowers the relative

locations, reflecting the decreasing price.

o Movement continues until the curves intersect

• A market where Demand Exceeds Supply

o Numerically, demanders seek more goods than what is available for

sale. At the current price, supply is exhausted before all buyers have
consumed
o Suppliers will not produce more units because the price does not

justify allocating more resources for production

o With excess demand, consumers are willing to pay more
o Suppliers are enticed to produce more, increasing supply
o The price will continue rising until there is no more shortage.
o With rising price, suppliers produce more units for sale. At the higher

level, however, some consumers either demand less units, or no longer

demand entirely. The resulting equilibrium quantity will be less units
demanded, but again, consumers will actually attain more units than
at the original price.
o Graphically this is shown as follow
o Rightward movement along the supply curve
o Leftward movement along the demand curve
 oAlong both demand and supply, movement raises the relative price
• Movement to Equilibrium, Explained by Price
o For each unit produced

• Producers must receive a minimum price;

• Consumers will only pay a maximum price
o Exchange will continue between Producers and Consumers until the

price required to stimulate production exceeds the price consumers are

willing to pay.
o As demonstrated earlier, the market will force a movement toward

equilibrium price and quantity

o At this equilibrium price, there are more units actually sold then at the

other inefficient prices. Given these units sell at a price both greater
than the producers minimum, and less than the consumers maximum,
both the consumer and the producers achieve a benefit
o The difference is referred to as the "Surplus"
o Consumer's Surplus- the difference between the Max. buying price

and the price actually paid

o Producers Surplus- the difference between the price actually

received and the minimum selling price

o Total Surplus- the combined surplus gained by both the consumer

and the producer

o Conceptually, economist consider this a surplus because the Consumer
buyers units for less than what they were willing to pay, and producers
receive a price greater than what they were willing to receive
• Ex.

 I would have paid up to $20 for a large pizza. But because the
market set an equilibrium price of $14. I saved $6. This
savings represents the surplus gained
• Price Controls:
o Arbitrary mechanisms by which the government sets a price, despite

whatever level market force might achieve.

o Price Ceiling- the maximum pricing level permitted. No trade may

occur above this price

o Price ceilings can create shortages if the maximum allowed price

is below the market equilibrium

o Producers will react to the ceiling by producing less units than

they would have if the higher price were allowed

o Consumers pay less, but are now forced to contend with fewer

available goods
o Nonprice Rationing Devices result, adding inefficiency to the

process of attaining goods. These may include lines and acts of

appeasement
o Price Floor- the minimum pricing level permitted. No trade may occur

below this price

Price floors create a surplus of the given good
Producers will react to the floor by producing more units than they
would have if the lower price were allowed
Consumers must pay more, and in turn, demand less
 The producers seek to sell at the floor price, but no one wants to
buy the quantity. The result is few overall exchanges

Chapter 5
Wednesday, September 21, 2005
10:13 AM

Elasticity of Demand
Price Elasticity of Demand
• When discussing Consumer reactions to price changes, and the subsequent

change in Quantity Demanded, the question will arise: if price changes by a

given percentage, how will demand change
• Price elasticity of demand answers such a question by measuring the

responsiveness of QD to changes in price

• Elasticity of Demand is represent as ED
• ED= Percentage Change in Quantity Demanded
Percentage Change in Price
• The formula is expressed as: Delta Qd
Qd average
Delta P
P average
• Using the numbers taken from the Demand schedule, the price elasticity of
demand may be calculated
• Price elasticity is measured point by point
• If ED = 2, means that the % change in QD will be 2 times as much as the
% change in price
o Therefore if price change is 5% then quantity demanded will change

10%
o If 10, then quantity demanded will be 20

• Economist speak in terms of ABSOLUTE VALUE, so ignore negative signs

 • Price Elasticity of Demand- A measure of the responsiveness of quantity
demanded to changes in price

Elasticity is Not Slope

• Slope and demand elasticity is not the same thing

From Perfectly Elastic to Perfectly Inelastic Demand

• Elastic Demand- The percentage change in quantity demanded is greater

than the percentage change in price. Quantity Demanded changes

proportionately more than price changes
o Elastic Demand is when the numerator is greater than the

denominator
o Ed > 1
o Percentage Change in QD > Percentage change in Price
o 20/10 = 2

• 2 is greater than 1 therefore it is elastic

• Inelastic Demand- The percentage change in quantity demanded is less
than the percentage change in price. Quantity Demanded changes
proportionately less than price changes
o Inelastic Demand is when the numerator is less than the

denominator
o Ed < 1
o Percentage Change in QD < Percentage change in Price
o 4/10= 2/5

• 2/5 is less than one therefore it is Inelastic

• Unit Elastic Demand- The percentage change in quantity demanded is
equal to the percentage change in price. Quantity Demand changes
proportionately to price changes
o Unit Elastic demand is when the numerator equals the

denominator
o Percentage Change in QD = Percentage change in Price
o Ed = 1
o 10/10 = 1

• 1 is equal to 1, therefore it is Unit Elastic Demand

• Perfectly Elastic Demand- A small percentage change in price causes an
extremely large percentage change in quantity demanded. (From buying all
to buying nothing)
o Ed = ∞
o When quantity demanded is extremely responsive to changes in price
o For example, buyers are willing to buy all units of a sellers good at

$5.00 per unit, but nothing at $5.10. Perfectly Elastic Demand

• Perfectly Inelastic Demand- Quantity demanded does not change as
price changes
o Ed = 0
o Quantity demanded is completely unresponsive to changes in price

then demand is perfectly inelastic

o For example, buyers are willing to buy 100 units of good X at $10

each, and if price rises to $11 each, then buyers will still buy a 100
units
 • Perfectly Elastic and Perfectly Inelastic Demand Curves
o In the real world, there are no demand curves that are perfectly elastic

or perfectly inelastic at all prices

o They are representations of the extreme limits
o A few real world demand curves do approximate the perfectly elastic

and inelastic demand curves

Price Elasticity of Demand and Total Revenue (Total Expenditure)

• Total Revenue (TR)- price times quantity sold
o Example

• If a hamburger stand sells 100 hamburgers a day at $1.50, then

total revenue would be $150

 • An increase in price, can make total revenue, increase, decrease,
or remain constant
 Whether total revenue rises, falls, or remains constant after a

price change depends on whether the percentage change in

quantity demanded is less than, greater than, or equal to the
percentage change in price
 Thus, price elasticity of demand influences Total Revenue
• Elastic Demand and Total Revenue
o Because quantity demanded falls, or sales fall off, by a greater

percentage than the percentage rise in price, total revenue decreases

o In short, if demand is elastic, a price rise decreases total revenue
o If demand is elastic, a price fall increases total revenue
o Demand is Elastic: P (up) -> TR (down)
o Demand is Elastic: P (down) -> TR (up)

• Inelastic Demand and Total Revenue

o If demand is inelastic, a price rise increases total revenue
o If demand is inelastic, a price fall decreases total revenue
o Demand is Inelastic: P (up) -> TR (up)
o Demand is Inelastic: P (down) -> TR (down)
o If demand is inelastic, price and total revenue are directly related

• Unit Elastic Demand

 o If demand is Unit Elastic, a rise or fall in price leaves total revenue
unchanged
o This may be expressed:

• (up) P -> TR
• (down) P -> TR
• Price Elasticity on Straight Line Demand Curve:
o Varies from highly elastic to highly inelastic
o A straight line may feature a constant slope, where the trade off

between price and QD remains the same

o The elasticity, however, does not remain constant, because the

percentage value of the tradeoff is changing

o Thus within the same straight line demand curve, there can be a range

of elasticity above 1, and a range below

 o Total revenue is at its peak when Ed = 1

• Given the following:

o Elasticity demonstrates consumer sensitivity to price changes
o Both elastic and inelastic results appear within the same curve
o Total revenue is impacted differently when price changes if demand is

elastic or inelastic
• Then it stands to reason we can easily determine how to adjust price along
the demand curve in such a way that TR is maximized

• Determinates of Price Elasticity of Demand:

1.Number of Substitutes
2.Necessities versus luxuries
3.Percentage of a budget spent on the good
4.Time
• Substitutes: the more substitutes for a good, the more sensitive
consumers will be to a price change
o More substitutes for a good, the higher the price elasticity of demand
o The fewer substitutes for a good, the lower price elasticity of demand
o The more broadly defined the good, the fewer the substitutes

• Ex.
  There are more substitutes for Economic Textbooks, than for
textbooks
 More substitutes for Coke a Cola, than for softdrinks
o The more narrowly defined the good, the greater the substitutes
o If one can move in and out of a particular type of good, attaining

similar utility, the decision to consume will be largely influenced by

price
o If there aren't many substitutes available, with little alternative to

provide the same utility, there is less reaction to price changes

o A good with a broad definition will have fewer substitutes than a good

having a narrow definition

o A category of goods will not prove as readily interchangeable as one

good within the category

• Necessities Vs. Luxuries:
o More a good is considered a luxury (a good that we can do without)

rather than a necessity (a good we can't do without), the higher the

price elasticity of demand
• Ex

 It is easier to cut back on jewelry, than on medicine that

keeps you alive

 o Consumers are more sensitive to price changes of luxuries than
necessities. It is easier to forgo something we desire than something
we need
o Thus, luxuries will generally feature a greater price elasticity of

demand
• Good's Relation to Overall Budget:
o Consumer price sensitivity is greater for those goods commanding the

highest allocation. Price increases for these goods could have dire
consequences on a budget.
• If rent increased by 50%, one would be very concerned
• If the price of a movie concession increases, the change is not so

significant
o Buyers are (and thus quantity demanded is) more responsive to price

the larger the percentage of their budgets that goes for the purchase
of a good
o The greater the % of one's budget that goes to purchase a good, the

higher the price of elasticity of demand; the smaller the % of one's

budget that goes to purchase a good, the lower price elasticity of
demand
• Time:
o As time passes, you have more time to find substitutes, or to change

your lifestyle, etc.

 o The more time that passes (since the price change), the higher the
price elasticity of demand for the good; The less time that passes, the
lower the price elasticity of demand for the good
o With less time available, the less there exists an opportunity to react
or change.
o Consumers have more ability to change behavior due to a price
increase as more time is allowed
o The price elasticity of demand increases with time

Cross Elasticity of Demand:

• Cross Elasticity of Demand - A measurement capturing the change in

QD of Good A to price changes in Good B

• This is helpful for two Reasons:

i. Determines if two goods are complements or substitutes

ii. Helps to determine the impact on demand if the price changes for
other relevant goods
• Cross Elasticity of Demand
o Ec = (% Change in QD of Good A) / (% Change in price of Good B)
o If Ec > 0 than the goods are considered substitutes
• The % change in quantity demanded for good A moves in the

same direction as the percentage change in price of Good B

o If Ec < 0 than the goods are considered complements
 • When the % change in quantity demanded for good A and the %
change in price of Good B move in the opposite direction
• Once determining if Good A is a substitute or compliment for Good B, the
number indicates the strength of the underlying relationship (the further
away from zero)
• The larger the number, greater or less than zero, the change in quantity
demanded will be more pronounced
• Income Elasticity of Demand:
o Income Elasticity of Demand- Measures the responsiveness of
quantity demanded to changes in income
o Designed to measure changes in QD given changes in income
• Recalling normal or inferior goods, and goods thought to be

inelastic or elastic, this formula helps measure the relationship

between income and quantity demanded
o EY = (% Change in QD) / ( % Change in Income)
o If EY > 0 then Normal good
• A good whose demand, and thus quantity demanded, increases,

given an increase in income

• Variables in the numerator and denominator move in the same

direction for a normal good

o If EY < 0 than Inferior good
 • Income Elastic- Should EY > 1 than QD is changing at a rate greater than
income. Elastic demand as it relates to income
• Income Inelastic: Should EY < 1 , then QD is changing at a rate less
than income. Inelastic demand as it relates to income
• Income Unit Elastic- Should EY = 1 , then QD is changing at the same
rate as income. Unitary elastic demand as it relates to income

Elasticity of Supply
• Price Elasticity of Supply- measures the responsiveness of quantity

supplied to changes in price

• As with the Quantity Demanded, the Quantity Supplied reacts to changes in

price
• Price Elasticity of Supply measures the responsiveness of the QS to

changes in price
• ES = (% Change in QS) / (% Change in Price)

• Elastic Supply- Should ES > 1, than QS is changing at a rate greater than

price. Elastic behavior
• Inelastic Supply- Should ES < 1, then QS is changing at a rate less than
price. Inelastic behavior
• Unit Elastic- Should ES = 1 , than QS is changing at the same rate as
price. Unitary elastic behavior

• The Extremes:
o Perfectly Elastic- Should ES = ∞, then the smallest of price changes

will generate an infinite change in QS

• This is vary rare
o Perfectly Inelastic- Should ES = 0, then changes in price changes
will generate no change in QS
 • The longer the period of adjustment to a change in price, the higher the
price elasticity of supply
• The Price Elasticity of Supply will become more pronounced as time for
reaction increases. As producers have more time to make production
changes, their ability to respond increases

Taxes and Elasticity

• Government may place a tax on either a producer or consumer, but the

laws of supply and demand determines who actually pays

• Who pays the tax is actually determined by how responsive both the

consumer and supplier are to changes in price

• If buyers and sellers are equally responsive, they may split the tax,

regardless upon who it is actually placed

• Those who are perfectly inelastic in either demand or supply pay the full

tax, absorbing it from the other

• Those who are perfectly elastic in either demand or supply pay no tax,

shifting it to the other

• The more elastic the demand, the smaller the percentage of the tax will be

paid for by the buyer

Chapter 6
Thursday, October 06, 2005
9:41 AM

Consumer Choice
Utility Theory
• Utility- a measure of satisfaction, happiness, or benefit that results from

the consumption of a good

• Util- an artificial construct used to measure utility
• If utility is a measure of satisfaction, then it may be analyzed further:
o Total Utility - total satisfaction received when consuming a quantity

of goods
• Example

 First unit = 10 utils

 Second unit = 8 utils
 Third unit = 7 utils
 Total Utility = 25 utils
 o Marginal Utility- additional utility received from consuming an
additional unit of a good
• MU = (∆ TU) / (∆ Q)

 TU = total utility
 Q = quantity consumed of a good
• Q is usually equal to one
• Law of Diminishing Utility
o Law of Diminishing Utility-The marginal utility (downward sloping)

gained with every equal successive unit consumed will decline as

consumption increases
o On the scale of wants, the first unit is desired most urgently; the last,

least urgently
• Total utility can increase as marginal utility decreases
• Interpersonal Utility Comparison- comparing the utility one person
derives from a good with the utility another person derives from consuming
the same good
o It is impossible to quantify and objectively make this comparison

• Diamond-Water Paradox- marginal utility determines price. The

observatioion that those things that have the greatest value in use
sometimes have little value in exchange and those things that have little
value in use sometimes have the greatest value in exchange
 o While a good may have a high total utility, value is derived from the
marginal utility
o Plentiful goods offer little marginal value, because they are consumed
in high quantities
• What's another glass of water
o Rare goods offer high marginal value, because they are consumed in
low quantities
• How often do you come across a diamond

Consumer Equilibrium and Demand

• Consumers reach equilibrium once achieving the same marginal utility per

dollar for all goods within their basket

• If good A offers more marginal utility than good B, the consumer will

increase A and decrease B

• This new consumption level changes the MU for both A and B - increasing

MU for B; Decreasing MU for A

• This shifting of consumption - More Good A. Less Good B - will continue

until the MU per dollar spent on A and B is the same

• Thus: (MUA/PA) = (MUB/PB)
• Consumer Equilibrium occurs once the MU per dollar is the same for all

goods purchased
• Changing consumption levels thereafter will only reduce the utility attained
 • Recall the Law of Demand - the QD increases when price decreases
• In terms of MU, a change in price will alter the MU per dollar a consumer
receives
• If price decreases, the MU per dollar increases. This creates an imbalance
in the MU per dollar across the basket of goods
• To correct, more of the good will be purchased

Chapter 8
Monday, October 10, 2005
10:01 AM

Production and Costs

The Firm's Objective: Maximizing Profit
• A firm engages in business activity with the objective of attaining the

highest possible profit

• Its not about

1. The People Who Work Here

2. Our Grandfather's Name
3. Doing what's right, one customer at a time
4. Any other warm and fuzzy notion
• Businesses failing to understand this prime objective will soon be failing -
period
• Profit maximization helps determine resource allocation and directs
business decisions
• Profit: Total Revenue - total cost
o Total Revenue = price of a good * quantity sold of the good

• Explicit Cost: Costs incurred involving actual exchange and monetary

payments
• Implicit Cost: Costs representing the value of resources utilized in
production, but for which no actual payment is made
o Similar concept as Opportunity cost

• Accounting Profit : Total Revenue - Explicit Costs

o Here, the business is analyzed only in terms of actual costs, not

including the cost of forfeited alternatives

• Economic Profit: Total Revenue - Explicit & Implicit Costs
o The business profit accounts for the actual costs accrued through

operation, and also recognizes the costs of alternate uses for the
resources employed
o It is usually lower than accounting profit

• Why are there 2 ways for Measuring Profit?

o Accounting Profit measures the operation
o Economic Profit measures the opportunity
 • A firm might make a positive accounting profit, but its resources might still
be better employed elsewhere
• If the firm shows negative economic profit, the company should redirect its
efforts
• However, it is sufficient for a firm to attain only an accounting profit, and
zero economic profit
• Normal Profit: the condition whereby the firm earns positive accounting
profit and zero economic profit
o Here, the firm is doing at least as well as some other opportunity using

the same resources

Production
• The production of goods requires resources, or, inputs.
o These may be either

1. Fixed Inputs: those resources whose quantity can not be

changed with changes in output
2. Variable Inputs: resources whose quantity may be changed
with changes in output
• The timeframe of production operations may be viewed either as the "Short

Run" or "Long Run"

• Short Run: a time horizon in which some production inputs remain fixed
o Ex
 • A factory may be able to order more raw goods, and hire new
employees, but can't change the factory plant size
• Long Run: a time horizon whereby all inputs may be considered variable
o Ex

• Given a 5 year outlook, Acme can change every aspect of its

production, including all leases and factory layouts

• Short Run Production

o Understating that Short Run production entails variable and fixed

inputs, consider two broad categories of inputs: labor and capital

o Labor may be modified on short notice, and is a variable input. Capital

changes require more planning, and are considered fixed

• Marginal Product and Marginal Costs

o Marginal Product (MP) or Marginal Physical Product (MPP): The

change in output given a marginal change in one variable input, all

else equal
• Thus, if there are two inputs, capital and labor, with only labor

being variable, than the Marginal Product will focus upon labor
change
• With more complex examples featuring numerous variable inputs,

there would be a Marginal Product for each

o Marginal Product Formula
• MP = (∆ Q) / (∆ L)

 Q = to the change in output

• In quantifying the Marginal Product, all other inputs to production

are held constant

o Law of Diminishing Marginal Returns: As the quantity of a variable
input increases, and are combined with the fixed inputs, the marginal
product of the variable input will decline
• Just as Marginal Utility declines for consumers, an input will not

deliver a constant increase in Marginal Product

• Again, think of the proportional benefit a variable input can offer

given there exist fixed inputs

 Ex
• If Joe runs a copy center with 5 copiers, what good would

100 employees be for him?

• If a factory has fixed floor space, then there will exist a

point where additional employees are less productive

o Fixed Costs: those costs that do not vary with output. Such costs are
incurred even if producing 0 units. Generally associated with fixed
inputs
o Variable Costs: those costs that vary with output. These are
generally incurred when utilizing variable inputs
o Total Cost (TC): In terms of production, this includes both fixed and
variable costs
• TC = TFC + TVC
o Marginal Cost (MC): the change in total cost given a unit change in
output. Captures both variable and fixed costs
• MC = (∆ TC / ∆ Q)
• The low point on the MC Curve is when diminishing marginal

return sets in
 o The behavior MP and MC exhibit are related
o For every added input, there is both an added measure of output and
an added cost
o Given that variable inputs suffer diminishing returns, then the MP will
rise then fall following the increasing and decreasing productivity
o MC will reflect the same increase and decrease in productivity
o Production costs, as measured by MC capture the cost side of changes
in the productivity measured by MP
o When productivity rises, marginal costs will decrease.
o When productivity declines, marginal costs increase
o Thus, MP and MC move in related, but opposite directions
o As the MP curve rises, the MC curve falls; As the MP curve falls, the MC
curve rises

• Average Productivity
o Average productivity measures the quantity level of output per variable

input
• Whereas MP measures the output per additional unit, average

productivity is considering the total quantity in terms of total

inputs
 AP of Labor = Q/L
o There are various ways to measure cost:
• Average Fixed Cost (AFC): a measurement of total fixed costs
in terms of quantity of output
 AFC = TFC / Q
 The AFC curve continually declines
• Average Variable Cost (AVC): Total variable cost divided by
quantity of output:
 AVC = TVC /Q
 Understanding that TVC = VC * # of inputs
• So if ABC employs 10 workers @ 50$ each, then TVC =

50 * 10 = 500
 The AVC curve declines and then rises
• Average Total Cost: a measurement of total costs (FC + VC) in
terms of quantity of output
 ATC = TC / Q
 ATC = AFC + AVC
• The ATC curve falls and then rises
•
o The behavior of the MC curve is related to the shape of the AVC and
ATC curves
• Understand that averages are effected with each new observation

included within the average

 Ex
• If the average of 10 units is 100, and the 11th is 150,

this will have the effect of raising the average

• This is an example of the Average-Marginal Rule
• Average-Marginal Rule- the marginal unit will raise the average

if it is greater than the average magnitude; the marginal unit will

decrease the average if it is less than the average magnitude
 Marginal < Average, then average decreases
 Marginal > Average, then average increases
• MC works upon the AVC and ATC curves the same way

 MC < AVC, or MC < ATC, then the curves will slope

downward
 MC > AVC, or MC > ATC, then the curves will slope

upward
•

 In Graph A
• In Region 1, the MC < AVC, so AVC is declining
• In Region 2, the MC > AVC, so AVC is inclining
 In Graph B
• In Region 1, the MC < ATC, so ATC is declining
• In Region 2, the MC > ATC, so ATC is inclining

• There is no relationship between AFC and MC

• Therefore, if it is understood that:
  MC drives the movement associated with the AVC and ATC
• And MP and MC move in related (through opposite directions)
• Then a relationship may be drawn between MP and

cost (AVC and ATC)

 Thus, the relationship between production and cost can be defined
• Explained Again:
 If productivity is increasing / decreasing, then MP is increasing /

decreasing, which in turn causes the MC to decrease / increase

 A change in MC will cause the AVC and ATC to decrease/increase

when the marginal magnitude is greater than the average

magnitude
• Sunk Cost: Costs occurring in the past which can not be altered in the
present, and are, therefore irrecoverable
 Ex.
• Tuition
• Once a student has paid their tuition and the semester

has begun, they can not get a refund

• The cost can not be recovered. Nothing may be sold

or traded to get the tuition back

• How should a student view any decision to drop out?

• Long Run Production & Costs

o Recall, in the long run, there are no fixed inputs, thus no fixed costs.
All costs are variable
• Therefore, only total costs are considered
• Long Run Average Total Cost is utilized in determining the proper

level of inputs given a level of output

o LRATC reveals the lowest unit cost of production at a given level of
output
• Theoretically, the LRATC is comprised of numerous SRATC's

reflecting incrementally small changes in plant size

• The bottom of each SRATC represents production at its most cost

efficient
o The grouping of SRATC into a LRATC begins to resemble one giant
SRATC. The shape begins to tell something about production
o Long-Run Average Total Cost Curve (LRATC): a curve that shows
the lowest (unit) cost at which the firm can produce any given level of
output
o Economies of Scale: A condition whereby unit inputs may be
increased by X percent and output increases by a greater percent.
Because productivity is rising, unit costs decrease
o When output levels are low, one can witness Economies of Scale,
increasing inputs, and lowering production costs
o All good things don't last forever
o Constant Returns to Scale: Exist when inputs are increased by some
percentage and output increases by an equal percentage, causing unit
costs to remain constant
o Constant returns to scale occur next within the LRATC.
• Here an X percent increase in inputs leads to the same X percent

increase in output. Unit costs remain the same because

productivity has not changed
o Further along the LRATC, one reaches :
• Diseconomies of Scale: exist when inputs are increased by

some percent and output increases by a smaller percentage,

causing unit cost to rise
• Diseconomies of Scale, where inputs are increased by X percent,

and output increases by less than X percent. Productivity is

declining, thus unit costs are beginning to rise
o In reviewing the LRATC in its entirety, and observing the areas where
one experiences Economies of Scale, Constant Returns to Scale, and
Diseconomies of Scale, there is a point which can be observed:
o The Minimum Efficient Scale: a scale of operation producing at the
lowest level of output at which ATC are minimized
o Where will this Minimum Point reside?
• Wherever Constant Returns to Scale first begin to Occur
•

• Shifts in Cost Curves

o Both Long Run and Short Run Curves can be impacted by external

factors. During prior analysis, these were held constant

1.Taxes
 Taxes will increase costs for the firm. An output tax will raise

variable costs, causing

• An upward shift in AVC and ATC curves reflecting higher

costs
 An upward shift in the MC curve
•

 Taxes do not affect fixed costs and therefore cannot affect

average fixed costs

2.Input Prices
 Input Prices: Shifts in Variable Input Prices
 Changing variable input prices will create changes in the costs

of production
 Rising variable costs will shift the relevant cost curves

(ATC,AVC,MC) upwards, whereas declining costs will shift the

curves downward
3.Technology
 Changes in technology introduce either or both
• Increased input efficiency
• Lower input prices

 Both of these will bring about reduced variable costs

 Shifts downward the AVC, ATC, and MC curves

Chapter 9
Monday, October 17, 2005
10:07 AM
 Perfect Competition

• Market Basics
o Market Structure: The environment and setting in which a particular

firm operates. This has great influence upon pricing and output
decisions
• 4 kinds of Market Structure

 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
o Chapter 9 will study Perfect Competition
o Every Firm must answer the following

• What price to charge

• How many units to produce
• How many resource inputs should be purchased

• Perfect Competition:
• Perfect Competition: a theory of market structure based on four

assumptions: There are many sellers and buyers, sellers sell a

 homogeneous good, buyers and sellers have all relevant information,
and there is easy entry and exit from the market
• A market structure based upon 4 key Assumptions
1.Many sellers and many buyers interact within a large
market - no one seller or buyer corners the market or
maintains any power
• Each firm services only a very slight percentage of the market

2.Each firm produces a homogeneous product. There exist no

real differences amongst brands
♣ This means each firm sells a product that is indistinguishable

from all other firm's products in a given industry

♣ Buyers are indifferent to the sellers of the product

3.Buyers and Sellers have all relevant information about

Prices, Quality, Sources of Supply, etc.
♣ They know everything that relates to buying, producing, and

selling a product
4.Firms have easy entry and exit. There are no barriers to
entry such as high investment costs or government
regulations
 Supplies are Price Takers:
 Price Taker: a seller that does not have the ability to control the
price of the product it sells, it takes the price determined in the
market
 "A perfectly competitive firm"
 A firm is a price taker if it finds itself one among many firms
where its supply is small relative to the total market supply, and it
sells a homogenous product, in an environment where buyers and
sellers have all relevant information
 Within this market structure, no one can influence the price set by
market force. They accept the market price
 Recall, there are many firms, producing an indistinguishable
product - no one can set price
 Any firm raising price will suffer from no demand. Any firm
lowering the price will forfeit profit - they already sell what can be
produced, and will not set the market
 Demand Curve is Horizontal (Perfectly Elastic):
• Recall Downward Sloping Demand Curves - these were for the
Market, not a single Firm
• Perfectly Competitive Firms sell at Equilibrium Price
 Why?
• B/c the firms sells a homogenous product, its supply is

small relative to the total market supply, and all buyers

 are informed about where they can obtain the product at
the lower price
• If a firm is a price taker, they do not have the poor to influence

price, thus demand for their good is perfectly elastic

• Because the Firms Demand Curve represents the price the firm

receives, it also serves as the Marginal Revenue:

 MR: the change in Total Revenue (TR) resulting from the sale

of one additional unit of output

• MR = (∆ TR / ∆ Q)
• Theory represents the pure essence of Perfect Competition
• Some markets may display many, but not all, characteristics
completely
• So long as the particular market approximates those assumptions, it
may behave as if it were a perfectly competitive market
• For a Perfectly Competitive Firm, Price = Marginal Revenue

(P=MR)
 Therefore the marginal revenue curve for the perfectly

competitive firm is the same as its demand curve

 Look above at the graph
• Short Run Perfect Competition
♣ If the firm is a price taker, and Price = Marginal Revenue, then

how much will the firm produce

♣ Profit Maximization Rule: suggest the firm will produce at a
level of output such that MR = MC
 In other words, the Firm will produce up until that point when

one more unit will cost more for the firm to produce than it
will receive given the price
♣ If MR = MC, then any other level means:
 At a lower output level, MR > MC, and the firm is giving up

potential profit by not producing more

 At a higher output level, MR < MC, and it is costing the firm

to produce at this higher level

♣ When P = MC, then the resources utilized in the production are
valued at least at that price
 Thus, consumers value the product more than the raw

materials to make the product, but not at an output beyond P

= MC
 In perfect competition, profit is maximized when P =

MR = MC
•

 Resource Allocative Efficiency- the situation that exists when

firms produce the quantity of output at which price equals
marginal cost: P = MC
 A perfectly competitive firm is resource Allocative efficient
 Resource Allocative Efficiency is said to occur when output ensures
P = MC
 That is, the resources would not be better employed in the
production of some alternative good
♣ When will production Occur?
 Market Prices at different levels will influence the decision of a

producer to operate or not

 Simply because a producer loses money does not mean it will

shut down
 There are 3 scenarios to Review

1.Price is greater than the Average total cost

• When P > ATC, then the firm should produce until P

= MC. Once here, the firm will profit maximized

• Thus when P > ATC, the firm will produce, and may

attain profit
• If price is above average total cost for the

perfectly competitive firm, the firm maximizes

profits by producing the quantity of output at
which MR = MC
2.Price is Below Average Variable Cost:
• When P < AVC, total revenue is not only less than

the TC, but is also less than the variable cost

 • Therefore, should the firm produce, the price it
receives won't cover the cost of the inputs used in
production
• Thus, the firm will NOT produce when P < AVC,

because it loses more money by producing than

being idle
3.Price is Below Average Total Cost, but higher than
Average Variable Cost
• When P > AVC, the firm will receive a price greater

than the cost of the raw materials and other inputs

• Although P < ATC, which includes both variable and

fixed costs, the firm will lose more money by being

idle than producing at a loss
• In other words
• If the firm went idle, it would incur no variable

costs, but lose all of its fixed costs

• When P > AVC, the firm covers all the variable costs,

plus it is able to cover some of its fixed costs, thus

covering more costs by producing then being idle
• P > AVC -> Firm produces
• P < AVC -> Firm shuts down
•
• For the firm:
• Short-Run (Firm) Supply Curve: the portion of the firm's

marginal cost curve that lies above the average variable cost
curve
• The short run Supply curve is simply the portion of its marginal

cost curve lying above the AVC

• Why?
• Recall, production will target the output level where MC = MR

(which in turn equals price). Thus, the firms supply curve will
follow the MC curve

•
 • For the Market:
• Short-Run Market (Industry) Supply Curve: the horizontal

"addition" of all existing firms' short run supply curves (SRSC)

• The Short Run Supply Curve represents a summation of all

existing firms' SRSCs

• Recall the Individual and the Market Demanded Schedules, where

market demand was derived through simple addition, the Market

SRSC is formed in similar fashion
• Having now demonstrated the formation of a firm - based and market
- based supply curve, it is possible to understand why supply curves
are upward sloping
• Everything follows the upward sloping MC curve, formed in such a
shape due to the Law of Diminishing Marginal Returns

• Long Run Perfect Competition

 In a Long-Run scenario, there are some additional conditions and

assumptions
 Before, however, understand that in a competitive market firms may

come and go. The number of firms present in the short run may differ
from the long run.
• Why
 • Because a market where firms attain economic profit will
attract new firms. The market might attract so many firms
that some are now unprofitable.
 One might view the market as having a surplus or shortage of firms,
and that over time, an equilibrium will be reached
 Once reached, no firm will attain economic profit
 Conditions of LR Competitive Equilibrium
• Economic Profit is Zero
• P = MC = SRATC = LRATC
• As mentioned previously, a different price would either create

profit or loss environments. LR Equilibrium implies there is no

incentive for firms to enter or exit. Thus, in the LR profit will
be zero
• Firms are producing a quantity level of output where P =

MC
• No firm has any incentive to change plant size. Thus,

SRACT = LRACT where P = MC

• Recall the LRATC consisting of numerous SRATCs. In LR

equilibrium, the firm has attained the ideal plant size, where
the SRATC = LRATC
•

 Productive Efficiency- a condition attained when a firm produces at

the lowest possible per unit cost (lowest ATC)
• Not only is the condition more efficient for the firm, but for society

as well. Efficient firms utilize less resources, which in turn might

be used in the production of other goods
 Long Run Market meets increased Demand
• What will happen to the market:

1. Obviously if there is an increase in demand, the initial change

will be a higher price and a higher output. The demand curve
shifts out
• The existing firms supply the increased production, and

will receive the higher price. This price level creates

economic profit
2. The lure of economic profit attracts new firms to enter the
market. The presence of the new companies creates an
increase in supply. The supply curve now shifts out
• With the new level of supply, the price level falls, and the

original existing firms begin backing down production to

levels witnessed before the new demand
 Thus, an increase in demand brings temporary profits, taken away by
new firms entering the market. The new Equilibrium Output is now
higher, but the new price level depends upon whether the industry is
known as:
• Increasing Cost
• Decreasing Cost
• Constant Cost
 Constant Cost Industry: Average total costs do not change as
industry output increases or decreases when firms enter or exit the
market
• Thus a CC Industry facing an increase in demand will eventually

deliver greater output at the same price

• The Long Run Supply Curve is Flat
♣ Increasing Cost Industry: Here, Average Total Costs
increase/decrease with the changes in output resulting from firms
entering/exiting the market. Higher output yields higher costs.
• Therefore, and IC cost industry will deliver higher output to meet

increased demand, but will do so at a higher price

• The Long Run Supply curve is upward sloping
♣ Decreasing Cost Industry- In this scenario, average total costs are
decreasing/increasing as output increases/decreases with the new
firms entering/leaving the industry. Higher output yields lower costs
• An increase in demand will result in a higher output with a lower

price
• The Long Run Supply Curve is downward sloping
•

 When firms enter an industry chasing profits, prices will fall as the
market becomes more competitive. The industry, itself, might achieve
greater economies of scale as more production influences the cost of
inputs
• Ex.
• Over time, Demand for PCs drives the cost of computer chips

down
  Long Run (Industry) Supply Curve (LRS): graphic representation
of the quantities of output that the industry is prepared to supply at
different prices after the entry and exit of firms is completed

Chapter 10
Monday, October 24, 2005
10:04 AM

Monopoly

• Theory of Monopoly
o Monopoly: a theory of market structure based on three assumptions:

There is one seller, it sells a product for which no close substitutes

exist, and there are extremely high barriers to entry
o Theory has 3 Primary Assumptions

1.There is one seller, and the firm is the industry

  Opposite of the Competitive Market, where many firms
compete and offer an indistinguishable product. Here one firm
is the sole source
2.Seller offers a product having no close substitute
 Consumers have little in the way of substitutes. What can one

reasonably sub for water, electricity, sewer, etc?

3.Barriers
 Understanding the Barriers
a. Public Franchise: a right granted to a firm by gov't that
permits the firm to provide a particular good or service
and excludes all others from doing the same
• Ex
• U.S. Postal Service

b. Patents encourage companies to invest in R&D. Original

and innovative products and services which arise from
invention may be offered to market free from competition
• The patent denies competitors any way of copying

the product without fear of lawsuit

c. Licensing restricts competition. Governments enact a
licensing process as a method of both regulation and
market control. The process can be tailored in such a way
that it limits the number of firms in a market
 Economies of Sale: Certain industries are only profitable
when the level of output is extremely high. Thus, a new firm
must create a very large operation if they are to have any
chance at succeeding. The new entrant might then face two
possibilities
a. First, there exists high risk when entering a market
requiring such a large initial build-up
b. Secondly, multiple firms producing at high levels would
create supply at high levels causing price drops. This
might endanger the profitability of all the firms
• Natural Monopoly: The condition where economies of

scale are so pronounced that only one firm can survive

• Ownership of Needed Resources:
o A firm may create a monopoly over a market if it takes ownership of

the inputs. No competitor can buy the inputs needed to make the
product.
Aluminum made from bauxite
Diamonds

• Government vs Market Monopolies

o A government monopoly is created via some action (described earlier)

creating the legal barrier to entry.

 • Public franchises, patens, or gov't licenses
o Market monopolies do not rely upon law to keep away entrants, but
may come about from market conditions or contractual arrangements.
• Such as economies of scale and exclusive ownership of resources

• Pricing and Output

o Recalls firms engaged in Perfect Competition were price takers.
o Monopolists are Price Searchers

• Price Searcher: a seller that has the ability to control to some

degree the price of the product it sells

• Price Searchers are able to exert some control over the price of

their product. After all, they control supply. They can not dictate
perfectly, though, as consumers still maintain control over
demand.
• Because the Monopolist (M) is not a price taker, demand is

downward sloping, not flat.

• To sell more, M lowers price
• Thus, price does not equal Marginal Revenue, a key distinction
o Monopolist Supply and Demand is not separated into Firm or

market specific views. There exists only one firm, who provides
the single source for the product.
 • Thus, for the monopolist, the firm supply and demand is the same
as the market.
o If price is greater than MR, and the Price determines the quantity
demanded, then logic dictates the Demand Curve (which plots p and
quantity demanded) will lie above the MR curve.
o When D is flat, P=MR. When D is downward sloping, then P>MR.
• Thus, at zero output, both D and MR have the same point of

origin. With output, the gap between D (which is P) and MR

widens.
o M will profit maximize, as did the firms in a competitive market. Just
like those firms, M will target the level of output where MC = MR.
• Only this time, M attains a pricing level higher than would be

achieved in a competitive market.

 Thus, because P>MC, the production is NOT resource

Allocative efficient.
•
•

• Pricing and Output

o M will Profit Maximize, as did the firms in a competitive market. Just

like those firms, M will target the level of output where MC = MR

 • Only this time, M attains a pricing level higher than would be
achieved in a competitive market
• Thus, b/c P > Mc, the production is NOT resource Allocative

Efficient
o Though M can exert some control over Price, M is not guaranteed a
profit
• Given that MR = MC, and the P > MR, this level will only produce a

profit if P > ATC

• Those M's witnessing P < ATC will suffer Loss
•
• Maximizing Revenue Vs. Maximizing Profit
• The level at which TR is highest does not always yield the highest

profit. Profit is the difference of TR and TC

• There, conceivably, may be P and Q combinations yielding higher TR,

but at output levels with high TC

• A firm will always pick profit over TR
• Why is this relevant NOW?
• B/c a M has the power to target levels of price and output where

costs are such that profit may by maximized

• There may exist other price and output combinations yielding

greater TR and Q, but offer less profit

• The only scenario where maximized TR will yield maximum profit is

when there are no variable costs

♣ Why?

 B/c variable costs introduce a shifting cost structure. When

there exists only fixed costs, cost does not change over a
range of output

• Perfect Competition and Monopoly

 o If PC and M represent the opposite ends of market structure, it is
important to note the key differences:
i. For the Perfectly Competitive firm, D = P = MR
 For Monopolist, D = P but > MR
ii. The perfectly competitive firm charges a price equal to
marginal cost; the monopolist charges a price greater than
marginal cost
 Both PC and M set output where MR = MC
• But for the PC firm, this sets P = MC
• For M, recall P > MC

• Consumer Surplus levels vary by Market Structure

• Recall that CS is the area beneath the Demand curve but above the

current price
 This represents pricing levels some consumers might have been

willing to pay, but did not

 In a PC market, P = MR = MC
 In M, P > MC
• Therefore M markets produce lower consumer surplus then PC markets

 This result is logical, if unfortunate for consumers

•

• There can exist market situations where there is either a monopoly,

or no service at all
• Should no firm offer any output. Then there will exist zero consumer

surplus
• If some firm offers some output, even at a price level higher than PC

would create, some output is better than none

 • Thus, M is preferred to nothing

• Why Monopoly may be Bad??

o If PC creates a larger consumer surplus than M, there exists a loss

should the market structure not be PC

o Deadweight Loss of Monopoly- defines the net value difference
between quantity attained from M and what quantity could have been
attained via PC. The "value" in question here is the value to buyers
over and above the suppliers costs
o Therefore, with M, consumers receive less and pay more than what
they might find with the supply generated in a competitive market
o Greater output is produced under perfect competition than
under monopoly
•

• The Rent Seekers

o Rent Seeking: actions of individuals and groups who spend resources

to influence public policy in hope of redistributing (transferring) income

to themselves from others.
o Having studied PC and M, it is clearly obvious that M maintains and

enviable market position

o M commands a market structure whereby it is able to extract surplus
and profit, transferring income to itself from others
o With competition, no firm would have this power
o Obviously, then, some will seek this power
o Those individuals and firms who seek to manipulate markets in search
of this power are known as "Rent Seekers"
o My Opinion:
• These folds are most despicable, using political leverage and

undue influence to gain such power through distortions of public

policy
o Who can become a rent seeker, some examples
• A politician who doles out gov't contracts and favorable regulation

to political supporters. The "rent" is the support extracted in

exchange for gov't favor
• The firm or industry who lobbies, gives to PACs, and works behind

the scenes to win concessions buried deep within the tax code.
o No one simply gives away M POWER
• Rent seekers try and attain through surly methods this power
• That effort, in turn, is forever squandered
• What might the world attain with thousands of lobbyists and tax

attorneys not seeking rents

• The Inefficient Monopoly
o Competition makes participants run strong and lean
o Monopoly allows for inefficiency - who else is going to come along?

Giving rise to:

• X-inefficiency- a condition where costs rise and organizational

management suffer as the lack of competition removes the

pressure to keep costs low and maintain a sound firm
• That is, M runs fat and laze

• Price Discrimination
o Price Discrimination: occurs when the seller charges different prices

for the product it sells and the price differences do not reflect cost
differences
o So far, it has been assumed all products are sold for the same price
o What if the firm had the power to segment who paid what?
o Price discrimination occurs when a seller charges different prices for

the same product, and these in no way reflect differences in cost

o Perfect Price Discrimination:

• For each unit produced, the seller can charge the highest price

each consumer is willing to pay

• There would be no consumer surplus under this scenario. The

consumer pays at their reservation price level

 • Under this scenario P = MR, b/c each unit carries its own price
o Second Degree Price Discrimination:
• The seller charges a uniform price per unit to all consumers, but

for a given quantity. The price declines per unit as the quantity
purchased increases
• The Buy in Bulk rationale
o Third Degree Price Discrimination:
• The seller charges different prices to different markets or to

different groups of consumers.

• Ex.

 Senior citizens discount

 New Customer discount
 Sun tan oil is marked up at company stores near beaches
o Why price discriminate? - Maximize revenue
o Which M stands to gain more, the firm who charges one price, or the
firm who can perfectly price discriminate?
• The firm that perfectly price discriminate

o Conditions of Price Discrimination

i. Seller must exercise some control over price (that is that have
some ability to be a price searcher)
 ii. Seller must have some way of distinguishing amongst buyers
willing to pay different prices
iii. The transactions costs associated with arbitrage are too high to
enable reselling, such that any chance of forming some secondary,
market is eliminated
 The old people don't stand outside and sell the "Early Bird

Special" to the young

 Arbitrage: buying a good at a low price and selling the good

for a higher price

o The Perfect Price Discriminator attains an output where: P = MC,
similar to the result of PC
• Why is this good - b/c more quantity is produced
• Why does this happen? Recall, here P = MR, and where do firms
target output, where MR = MC
•
•
Chapter 11
Friday, November 04, 2005
9:40 AM

Monopolistic Competition, Oligopoly, and Game Theory

• Monopolistic Competition (MC)

• Monopolistic Competition: a theory based on three assumptions;

many sellers and buyers, firms producing and selling slightly

differentiated products, and easy entry and exit
• Having now studied the pure cases of Perfect Competition and

Monopoly, Monopolistic Competition (MC) is a market structure more

commonly encountered.
• In any typical market, there may exist elements of both monopoly and

perfect competition, which is the environment MC will address.

• MC defined: a market structure based upon 3 primary
assumptions:
1. Many sellers and buyers
2. Each firm produces a slightly differentiated product.
 Such differentiation may be attributed to branding,
marketing, proximity to consumer, credit terms, etc.
3. Firms enjoy easy entry and exit
 no barriers to competition.
• Examples of MC include retail clothing, computer software,

restaurants, and service stations

• Given the aforementioned assumptions, it can be said:
• The firms face competitors, and must practice vigilant business

management.
• Were they to become careless, competitors would take their place.

Should the market prove very profitable, new firms will likely
enter.
• However, given there will exist differentiation, there are times

when the firm will be the sole supplier for a segment of

consumers.
 Why and how?
• Supposing Bob’s Exxon lies somewhere rural off I-10.
 • There may be many places to find gas, and Exxon
has numerous substitutes.
• But within 15 miles, there are no other gas stations.
• Flights out of BR.
• There are numerous airlines, and almost all serve

the major markets.

• Yet for any given route, only one might have a direct

flight.
 Thus, when consumers have specific needs, they might find

there is only one firm offering what they really want.

• This differentiation allows the firms within MC to be Price

searchers, not price takers.

 Firms maintain pricing power as a result of minute

differences.
• The Monopolistic Competitor's Demand Curve
• If the PC firm faced perfect elasticity, where the good sold had many

perfect substitutes
• The PC demand curve reflected such and was horizontal.
• M was the sole supplier, and elasticity was low, because there were no

perfect substitutes
• The M demand curve was downward sloping.
 • MC, then, is somewhat between the two. There are substitutes, but
not perfect ones. Some elasticity, but not perfect either.
• Therefore, the Demand Curve for MC will be downward sloping.

 It is certainly not horizontal, but may not be as steep

as what M enjoys.

• The Relationship Between Price and Marginal Revenue for a

Monopolistic Competitor
• If MC encounters a downward sloping demand curve, then it must

lower price to sell more quantity.

• This works in similar fashion to M.

 Therefore, D = P, but P does not = MR. P > MR.

• Output, Price, and Marginal Cost for the Monopolistic Competitor

• Like both PC and M, MC will target output where MR = MC.
• Thus, MC can attain profits in the short run. Likewise, it can also

suffer losses.
 This depends upon ATC.
•

• Will there be Profits in the Long Run?

• Over the Long Run, however, MC will not likely enjoy profit.
• Recall the assumptions of many firms and ease of entry. These

conditions will allow new entrants seeking profit, as is the case in PC.
• This is not absolute, however, but depends greatly on the market

specifics and the closeness of substitutes.

 • Ex. If Bob’s Exxon is raking in profit somewhere off I-10, one
would expect many new service stations to open over a LR
timeframe. Gas has many substitutes, almost perfect in nature.
Economic Profit would likely disappear.
• Designer fashion brands might encourage many knock-offs, but
there would be few real substitutes for say, a Hermes handbag or
Kiton suit. Economic profit would likely continue, albeit in a
diminished capacity.

•
• Excess Capacity: What is it, and is it "Good" or "Bad"?
o Excess Capacity Theorem:- a monopolistic competitor in equilibrium

produces an output smaller than one that would minimize its cost of
production
• Recall, the lowest unit cost of production occurs at the bottom of

the ATC curve. In perfect competition, the firm will provide output
where P = MC, but also where MC = ATC
• Even in the LR, the firm will not be producing where ATC is lowest
o Why?

• Because the downward sloping demand curve exists

• The monopolistic competitor operates at excess capacity as

a consequence of its downward sloping demand curve

o Were it not for differentiation, the firm would have no pricing power,

and the demand curve would be flat

o B/c of differentiation, the demand curve is downward sloping, and will

not lie tangent with ATC

o Thus in both SR and LR, the firm retains excess capacity
•

• The Monopolist Competitor and Two Types of Efficiency

o Thus, the firm is inefficient for two reasons

i. Price is greater than MC. This implies it is not Resource

Allocative Efficient
 ii. The firm is not productive efficient b/c it does not charge a price
equaling ATC

• Oligopoly
o Given the pure markets, PC and M, there are those structures which lie

somewhere in between
• MC is a dynamic market, where ease of entry will likely eliminate

any chance of long run profit

• Should the barriers to entry be high, however, a different market

structure might arise - oligopoly

o Market Structure featuring 3 primary assumptions:

• Few sellers and many buyers. The sellers are independent, yet

they are influenced by one another. The interdependence is a key

characteristic of oligopoly
• Significant barriers to entry exist. Primarily, economies of scale

are present, whereby a new entrant must build a very large

operation from the start
• Products may be differentiated or homogenous. B/c of the first

two points, the product need not be unique in order for it to be for
consumers to find less choice
o Examples of such a market

• Automobiles:
  There will likely never be another newly formed domestic
manufacturer. The products are somewhat differentiated. The
marketing and sales methods, production, and labor relations
of one greatly influences the others
• Gasoline

 The product is relatively homogenous, and consumers

frequently interchange brands. Even given existing firms, new

refineries are rare, and their construction will face numerous
barriers
o As one should expect, the oligolopist is a price searcher, and will
enjoy a downward sloping demand curve
o The level of production should be chosen where MR = MC
o Concentration Ratio will help determine whether or not a market
should be labeled as an oligopoly
• Concentration Ratio: the percentage of industry sales (or

assets, output, labor force, or some other factor) accounted for by

x number of firms in the industry
• The % of sales (or assets, market share, output, labor, etc) within

an industry attained by X number of firms

• Example

 If the 4 biggest airlines accounted for 80% of all air travel,

one might say the 4 Firm Concentration Ration would be 80%

 • Concentration ratios may be utilized to better answer questions
about the marketplace
• As one might expect, industries such as airlines, automobiles,
gasoline, are oligopolies. At one time, the big three TV networks
maintained this market structure

• Oligopoly - Pricing and Output

o Oligopoly may come in many forms - three will be discussed

1. Cartel Theory: the firms supplying the market behave as if they

were one firm. The cartel acts as an organization to control output
and maintain price levels in such a way as to maximize revenue
 The object of this arrangement is long - run profit
 Whereas a competitive market would witness output where P

= MC, the cartel will constrict output to where MR = MC

 The price level at this output is higher, as are the profits the

firm will enjoy

•

•
• It can, however, be difficult to enact a Cartel, even if the benefits seem obvious at
first glance.
1. Forming a cartel may be outright illegal in some countries.
 The organizational effort and cost must be borne by the members, but some

may “free ride”.

• That is, one firm may not pay the dues to join the club, but can reap all

the benefits by following their model.

2. Cartel policy can be difficult to formulate.
  Members must not only reach some decision by vote or consensus, but they
must be willing to abide by those results.
• Should cartel members vary greatly in scale, coherent policy is much
more difficult to reach.
3. Entry of new firms.
 The cartel will have a difficult time blocking new firms from the market.
• A free market will represent little to stand in the way of those having the

ability and means to enter the market.

• Regulation and government control will frequently provide these

barriers.
4. Cheating.
• Once the cartel is formed, and an output level with subsequent pricing targets

is announced, then each member has the incentive to cheat.

• Recall, the LR output in a competitive market would offer no profit. The LR

output in a cartel will offer profit, but only by controlling output, So if one
member cheats in a controlled environment, they will enjoy even greater
profits.
• If all cheat, then the LR will resemble competition.
• The individual firm faces a horizontal demand curve, because the cartel sets the price.
Each firm does not control price.
• So, here, if one firm cheats, it can sell more oil at the cartel set price, and make even
greater profit.
• Thus, we see both incentive to create a cartel, and the incentive each firm has to cheat on
the agreement once the cartel has formed.

•
 • If oligopoly presents a market structure with few sellers, situations may arise where
one of the few is dominant.
• That is, there may be X number of sources, but only on firm is large enough to

really impact the market. This one firm’s output represents such a significant share
of the overall market that changes will impact price.
• Further, because this one firm has such power, it will take the lead in setting price

while others will follow.

• Oligopoly – Price Leadership

• Price Leadership Theory: – the dominant firm is a Price searcher, while the other,

smaller firms are price takers, accepting what the dominant has set.
• Note, however, the Dominant Firm does not operate in complete isolation from the fringe

firms. Rather, the dominant firm observes their behavior, and thereafter decides a pricing
strategy.
• How does this work?
• 1. The DF (Dominant Firm) determines how the market would operate without its

presence. It finds where the equilibrium price and quantity would reach. At this
point, however, the DF is excluded.
• 2. For the DF to enter the market therefore, it must introduce output available at a

lower price. At the current Eq, all output is sold, Only a lower price will trigger
additional Q demanded.
• 3. Given that only lower priced goods will create room for the DF, it then

determines a demand curve based upon all prices below the existing Eq price.
 Because it is taken after, DF’s demand curve is often called the “Residual Demand
Curve.”
• 4. After setting a demand curve of the lower prices, the DF selects a production
level where MR = MR.
• 5. When the DR introduces this new supply into the market, the price falls to the
level it targeted. After all, consumers will only move out of an Eq with a lower
price.
• 6. The fringe firms produce less output, and target their production where P = MC.
Why, because they are price takers, and witness a flat demand curve.
 •

Chapter 12
Monday, November 28, 2005
4:05 PM
 Government and Product Markets (Antitrust and Regulation)

Antitrust
• If monopoly situations give rises to:

1.Reduced Output Levels

2.Higher Prices
3.Deadweight Loss
• Then it may be argued that the gov't should seek ways to limit or prevent

their development
o Some believe this on theoretical grounds, others may point to specific

instances where companies circumvent the free market

• Antitrust Law: Legislation passed for the stated purpose of controlling

monopoly power and preserving and promoting competition

o An area of law specifically focused on the prevention of monopolies.

The legislation is aimed at promoting free and fair competition

o These attempts at reform were known as "Antitrust", meaning they are

aimed at any company, or group of companies, that may act as a

monopoly
o How can a group of separate entities act like a monopoly???

• Example

 Supposing there are many suppliers of oil and many train

lines for shipping. But to one large geographic area, only one
 oil company and one rail line serviced customers. Through
whatever means, they have established a corner on the
market, creating a monopoly

The Sherman Act (1890)

• 1st major piece of Antitrust Legislation
• Two Major Provisions

1.All corporate arrangements having an intent to restrain trade

will be declared illegal
2.Those individuals involved with such efforts would be charged
with a misdemeanor
• Trust- A combination of firms that come together to act as a monopolist

The Clayton Act (1914)

• In certain instances where the effect may lessen competition or create a

monopoly, the following practices could be ruled illegal

1.Price discrimination
• Charging different customers different prices for the same product

where the price differences are not related to cost differences

2.Exclusive contracting
• Selling to a retailer on the condition that the retailer not carry any

rival products
 3.Tying contracts
• Arrangements whereby the sale of one product is dependent on

the purchase of some other products

4.Acquisition of competitor's stock
• If the acquisition reduces competition

5.Interlocking Boards of Directors

• An arrangement whereby the directors of one company sit on the

board of directors of another company in the same industry

The Federal Trade Commission Act (1914)

• In 1914 a new gov't authority was formed to provide constant watch - The

Federal Trade Commission (FTC)

o This agency was formed to help decide what is fair and what is not

The Robinson-Patman Act (1936)

• Protect small stores from competitive effects of large chains

The Wheeler-Lea Act (1938)

• Empowers the FTC to contend with false and deceptive advertising

Celler-Kefauver Antimerger Act (1950)

 • Bans the creation of monopoly through acquisition of the target's assets, if
not the target's stock
o Bans mergers that occur as a result of one company acquiring the

physical assets of another company

Concentration Ratios
• Herfindahl Index: Measures the degree of concentration in an industry. It

is equal to the sum of the squares of the market shares of each firm in the
industry
o Herfindahl Index = (S )2 + (S )2 + … + (S )2
1 2 n
• A measure intended to gauge the level of competitiveness within an

industry
o The Justice dept. may bring antitrust actions if the index rises by a set

formula

Antitrust and Mergers

• Three basic types of mergers

1.Horizontal
2.Vertical
3.Conglomerate
• Horizontal Merger: a merger between firms that are selling similar

products in the same market

 o Ex
• If company A and B produce cars. If they merge to a single
ownership then it would be a horizontal merger
• Vertical Merger: a merger between companies in the same industry but
at different stages of the production process
o Stated differently, a vertical merger occurs between companies where

one buys something from the other

• Ex

 Suppose company C, which produces cars, buys tires from

company D. If these two companies combined under single

ownership then it would be a vertical merger
• Conglomerate Merger: a merger between companies in different
industries
o Ex

• If company E, in the car industry, and company F, in the

pharmaceutical drug industry, combined under single ownership

then it would be a conglomerate merger

Network Monopolies
• Network Good: a good whose value increases as the expected number of

units sold increases

o Ex
• A Telephone, you buy a telephone in order to network with other
people. If only 1 other person had a telephone then you wouldn't
want one, it only has value when you expect thousands of people
to buy it
o This value may be completely irrespective of investment or the
underlying asset
• Example

 What would hold more value ?

• An established nationwide network or Fiber Optics
o Antitrust Policy For Networks
• It becomes very likely that a dominant system may take a share

of business so great that it would be considered a monopoly under

any other circumstance
 However; gov't looks more for predatory behavior than simply

share of market
• Why?
• Obviously there are certain networks where it would

be inefficient to have numerous competitors

 Innovation may be stifled if the dominant network has too

much invested in a system, or faces too great a cost for

change
  Lock-In Effect: Descriptive of the situation where a
particular product or technology becomes settled upon as the
standard and is difficult or impossible to dislodge as the
standard

Regulation
• Recall that some monopolies form b/c the environment will be unprofitable

for more than one firm

• Natural monopolies are said to be those which arise from very large

economies of scale
o The cost are such that if there were more than one firm, none would

be profitable and all would leave the market

• Thus, natural monopolies are allowed (power, water, etc.) but are

generally highly regulated

• Graphically, we can see a natural monopoly form when the

additional firm would face ATC severely higher than existing firms
• The idea is to attain a position where resource allocative efficiency

occurs, such that P = MC

• However; in order to increase output, either one firm can be

regulated, or one will operate at a loss (which is

unsustainable)
•
•
Regulating the Natural Monopoly
1.Price Regulation
2.Profit Regulation
3.Output Regulation
• Price Regulation: if we know M will typically price where MR = MC,
regulators will instead seek a price where D = MC
o Unfortunately for the firm, ATC are such that this level will lead to

losses
o This yields a high output level, but firm loses

• Profit Regulation: here gov't prefers M earn zero economic profits.

Regulators would then mandate a price which equals ATC
o This is known as average cost pricing
o With such regulation, though, the firm has no incentive to control

costs. It will simply let cost rise and petition regulators to allow a
greater price
•
• Output Regulation: gov't mandates the level of output
o Here, M will enjoy some economic profit. Knowing it has no

competition, M can increase profit by lowering cost, regardless of the

effect on product
o The easiest way to lower cost is to reduce the quality, not become a

better managed company

o Thus regulators will struggle with ensuring the company delivers on its

promise to serve
• Difficulties with regulation frequently center around the unintended
consequences
 o Regulated monopolies are typically slow to innovate. They may have
no incentive to control cost
o Utilities may over-invest in infrastructure (itself lacking proper cost

controls) knowing the consumer will be around for 30 years to pay for
it
• If utilities can pass on costs of resources, then they have less incentive to
adapt and change
o Consumers are typically at odds with regulated monopolies

• Government regulators have little financial incentive to be monitor in the

most efficient and effective way possible
o Information gaps can create less than perfect gov't analysis
o Regulatory Lag: the time period between when a natural monopoly's

costs change and when the regulatory agency adjusts prices for the
natural monopoly
• Ex

 Suppose the rates your local gas company chares customers

are regulated. The gas company's costs rise, and it seeks a

rate hike through the local regulatory body

Theories of Regulation
 • Given regulators are individuals who do not operate in a vacuum, and are
subject to many interest and pressures, there exists theories which
attempt to explain the regulator's behavior
1. Capture Theory of Regulation: no matter what the original intent
and purpose of a regulatory agency may be, over time, the agency will
become "captured" by the special interest and elements of the
targeted industry
2. Public Interest Theory: Here, the idealistic view of a regulator
holds. That is, the regulator has the incentive to look after the public,
and will perform as intended
3. Public Choice Theory of Regulation: the regulators are incentivized
to act according to their own interests. This is similar to a profit
motive, but here, the regulator seeks power, authority, and a greater
budget

Chapter 13
Tuesday, November 29, 2005
5:34 PM

Factor Markets
Factors
• Factors of production experience supply and demand similar to that of

finished products
• Why do firms purchase factors?
o To produce products to sell

• The demand for a factor is often the result of increased demand for a

finished good
o Derived Demand: Demand that is the result of some other demand

• Ex.

 If the demand for reproduction furniture increases, then the

demand for skilled craftsmen will increase

o Marginal Revenue Product: the additional revenue generated by

employing an additional factor unit

• Method 1:

 MRP = Δ TR / Δ QF (quantity of factor)

• Method 2:

 MRP = MR x MPP
• An important thing to notice. MR can be constant or change

depending on whether a firm is a price taker or price searcher

o Differing levels of MRP may be plotted, producing the MRP curve

• This curve will represent the firm demand for a factor

 •

o Value Marginal Product: literally the value of the MP

• Defined as

 VMP = Price x MPP

 • This offers a dollar measure of what an additional factor unit will
produce
• Question?
 Does VMP = MRP?
• It does only in competitive market structures, where

MR is constant
• When P > MR, VMP will be > MRP

•
o Marginal Factor Cost- additional cost incurred when employing an
additional factor unit
• MFC = Δ TC / Δ QF
o Factor Price Taker- a firm able to buy all of a factor needed, at a
price set by the market (equilibrium). The Firm will face a horizontal
supply curve
 •

So given there is MRP and MFC, a firm can now decide how many units
of a factor to utilize
• Intuitively, one might say that a factor unit would be increased until

the benefit is outweighed by the cost

  Specifically, a firm will continue using a factor until the marginal
revenue product equals the Marginal Factor Cost

Most situations will not involve one factor, but a variety that will be
consumed in different quantities
o Least Cost Rule: helps determine a combination of factors which will

help minimize cost

• This will work much the same as when individuals evaluate

consumption based upon marginal utility per dollar

• MPPL/PL = MPPK/PK
 • Here, dollars are allocated per factor based upon their marginal
product. The balance will occur when the firm continues buying
one factor until the MPP to price ratio is the same.

Labor Market
• Labor Market: the labor market is a unique factor given the many

dynamics involved.
• The demand curve for labor will reflect the price of the good

produced.
• Should the price fall, the demand curve will shift left.
• Should the price increase, the demand curve will shift right,

reflecting a higher demand for labor

•

• Market Demand for Labor

• Unlike other market demand schedules, the market demand for

labor is not simply a horizontal summation of each firm’s labor

demand.
• There is a two fold effect in place with labor demand. Because it is

a factor, higher labor costs will shift the production curve and
causes price increases in the market. The MRP will shift
accordingly.
• The double effect of:
1. A change in wage
2. A change in product price
• Makes a simple horizontal summation incorrect
Elasticity of Demand for Labor
• Elasticity of Demand for Labor: The percentage change in the

quantity demanded of labor by the percentage change in the wage

rate.
• Ex: If wages rise 20%, and employment drops 30%, the EL for

labor is 1.5
• Recall when E>1, this is known as elastic, when E<1 this is

inelastic.
• EL = (% Change in quantity demanded of Labor) / (%

Change in wage rate)

• 3 Factors influencing Elasticity of Demand for Labor:
• The ED for Product that Labor Produces:

 Simply put, the greater the ED for a given product, the

greater the ED for the labor producing the product.

• Ratio of Labor Costs to Total Costs:

 When labor cost is a small percentage of total cost, the ED for

labor will be low. When labor cost is a larger percentage of

total costs, then the ED for labor will be high.
• Number of Substitute Factors:

 Should there exist a high number of substitutes for labor in

the production of a good, then the ED for labor will be high.

Market Supply of Labor:
• As one should expect, the market supply of labor is upward sloping. The

higher the wage rate, the greater the amount of labor units (hours, days,
etc.) individuals are willing to contribute.

•
• Individual Labor Supply:
• A single person will have two opposing forces acting upon them as a

result of a change in wage. It would be wrong to think of a person

simply working more given a higher wage:
1.Substitution Effect
2.Income Effect

• Substitution Effect:
• Given a higher wage for working, an individual may elect to

allocate more time working and less time for leisure. Because the
monetary reward for work has increased, the relative leisure
derives is now worth less.
• Income Effect:
• Given there is a higher wage, some may opt to work less, and are

content making the same or slightly higher overall income.

• Shifting the Labor Supply:

• Recall, a wage rate change will create change in quantity demanded. The
entire supply curve may, however, shift when acted upon by
1. Wages in other Labor Markets (or simply, effects of other
markets).
 • Should outside markets witness great fluctuations, than the
market under review will be impacted
• Examples might include demand swings (the tech boom in the

90's)
2.Other aspects of a labor sector
• Certain labor markets may enjoy appeal or disfavor.
• No one seeks work that is socially frowned upon, unless the

dynamics of the labor market create demand for those jobs.

Likewise, health issues may arise
• Ex

 No one wants a job in a dangerous, dirty, cold place.

 They would rather a job that is indoors, with longer lunch

breaks, and access to a company gym

Putting Supply and Demand Together

Why Wage Rates Differ:
• Should 4 primary conditions hold, there should be little expectation of long

run wage differentials across markets. Over time ,workers would flow in
and out of markets until a balance is achieved.
1.Demand for all labor skills is the same
2.There exist no special, non-income considerations
3.The labor force is homogeneous, and training costs are
negligible
4.All labor is mobile at zero cost
 • Obviously, these conditions are almost completely unrealistic in practice.
However, the failure to maintain said conditions explain why wage rates
may differ across sectors and markets
• Demand and Supply for Labor will differ across markets

Why Demand and Supply Differ in Different Labor Markets

Demand for Labor
 1. Like any other factor, the demand for labor is derived from the demand for
product it produces.
o B/c each product market is different, so will the corresponding demand

for labor
2. Each individual works differently, impacting their own MPP.
o As such, demand for labor may differ person to person

• Supply of Labor

1. There do exist certain positive or negative characteristics associated with

job sectors (nonpecuniary).
o This will have a tendency to attract more or less attention to the field

2. Supply reflects those who are willing and able to perform the given task
3. Training costs may deter some who have natural ability from attaining
necessary knowledge and skills
4. Geography can create wage differentials.
o Less desirable or hard to reach locales may require higher wage levels

Marginal Productivity Theory

• Firms in competitive or perfect product and factor markets will pay factors

their marginal products

• Here are the conditions

1. Given a firm is a factor price taker, then MFC is constant. Thus MFC =
P, or MFC = W (if labor)
 2. The firm will attain a factor in a quantity where MFC = MRP (where the
factor cost equals its Marginal Revenue of the product)
3. Given these equations, then we can set the following
• If W = MFC, and MFC = MRP then MRP = W

4. Should the firm be perfectly competitive (a price taker, not a price

searcher) then MRP = VMP
• Recall that competitive firms witness constant MR b/c the price

never changes
5. Finally, if MRP=VMP, and MRP=W, then VMP=W
• Why does this really mean anything?
o In competitive environments, wages are equal to the contribution
Chapter 15
Wednesday, November 30, 2005
10:19 AM

Income and Poverty

Income Distribution
• When studying income distribution, the overall personal income as it
spread about the population
• As we all know, some earn more income than others
o That is, they receive a greater distribution

• Income may be studied before or after taxes, and with or without transfer
payments
o Transfer Payments: payments to individuals without expectation of

goods or services in return (welfare checks, disability payments, etc)

o In-kind Transfer Payments: transfer payments made not in cash,

but in the form of a good (food stamps, housing vouchers, Medicaid,

etc.)
• Ex Ante Distribution: income distribution before taxes and transfer
payments
• Ex Post Distribution : Income distribution after taxes and transfer
payments
• What is the individual (personal) income, therefore?
o Income = (labor income + asset income + transfer payments) -

taxes
o Not everyone will receive transfer payments, and not everyone will pay

taxes
• The effects of age on income.
 o As every one knows, people have a tendency to earn more as their
career develops. This trend will continue, if at different rates.
Eventually, people retire, and they will begin receiving social security
and possibly earn investment income, hold part-time positions, etc.

Lorenz Curve
o A graph of income distribution expressing the relationship between the

cumulative percentage of households and the cumulative percentage

of income
o A straight line will reflect an equal income distribution;
o A bowed line reflects inequality
o This graph is a visual tool for examining income distribution
Gini Coefficient
• Gini Coefficient: this measures the degree of inequality
o Gini = ( Area between line of Perfect Equality and Lorenz
curve) / (Entire Triangle Under Line of Perfect Equality)
o How the Gini Coefficient Works
• If the Lorenz curve provides a graphical representation of income

distribution, the Gini Coefficient offers a numerical measure to

help better determine the degree of inequality
• Why?

 B/c comparing Lorenz curves which are close but not equal

becomes an exercise in graphics

• The Gini Coefficient ranges between 0 and 1

 Perfect equality = 0
 Perfect Inequality = 1
• The larger the GINI coefficient , the higher the degree of income

inequality and the smaller the Gini coefficient, the lower the
degree of income inequality
• The Gini Coefficient can't tell us what is happening in different

quintiles
o One Caveat: the Lorenz curve can show what is happening in the
various quintiles. The Gini only refers to the entire distribution, so no
determination can be made about specific quintiles using the Gini
alone
Why income inequality?
1.Innate Abilities and Attributes
• Individuals are not all born with the same innate abilities and

attributes; People vary in intelligence, looks, and creativity they

possess
2.Work and Leisure
• More work means less leisure

3.Education and Training

 •Investment in "Human Capital"; like going to college
4.Risk Taking
• Different people have different attitudes toward risk

5.Luck
• When individuals can't explain what is happing to them

6.Wage Discrimination
• Exists when individuals of equal ability and productivity, as

measured by their MRP, are paid different wage rates by the same
employer

Income Differences
• When studying the differences which may exist with income, one can

typically trace the root causations back to these six factors

• Coupled with the issues discussed in CH. 13, of supply and demand for

labor, this helps better explain why two graduates of the same college,
with the same major might experience entirely different lifetime
earnings
• Some degree of income inequality occurs b/c individuals are innately

different and make different choices.

• However, some degree of income inequality is also due to factors

unrelated to innate ability or choices, such as discrimination or

luck
Normative Standards of Income Distribution
• Marginal Productivity Normative Standard:
o Recall the marginal productivity theory, where the labor factors should

be paid their marginal revenue products

• This theory holds that people should be paid their marginal

revenue products
o Here, an individual's income is based entirely upon their contribution.

There is no equalization of wages, collective bargaining, minimum

wage, etc.
o You earn what you produce. All incentives exist to be more productive

• Absolute Income Equality Normative Standard:

o Here, a perfect equal distribution is offered to all
o The basic theory involves the notion of utility and diminishing marginal

utility.
o Taking from wealthy does not reduce utility by the same magnitude as

it is gained when redistributing the poor

• The poor will gain more utility from additional dollars than the

wealth have lost. Thus,, societal utility is higher

• Rawisan Normative Standard:
o Here the concept revolves around knowing or not knowing where one

fits in the income distribution

 o "Veil of Ignorance" : The imaginary veil or curtain behind which a
person is ignorant of their income distribution

•
Poverty:
o Absolute definition vs. Relative definition

• Absolute: any family earning less than "X" per year is poor
• Relative: Those in the bottom 10% are poor
o The U.S. uses absolute terms, but inflation adjusted
 o Poverty Income Threshold Line:
• Aka the Poverty Line - the income level below which people are

considered to live in poverty

Chapter 17
Monday, December 05, 2005
10:05 AM

Externalities, Public Goods, and Asymmetric Infomation

Market Failure and Externalities

o There will be occasions when markets produce unintended or

undesirable outcomes
o Market Failure: a situation in which the market does not provide the

ideal or optimal amount of a particular good

• These occur under 3 different situations listed below
o 3 Areas of Focus

• Externalities
• Public Goods
• Asymmetric Information
Externalities
• The side effects which may arise through the production and

consumption process. Third parties, not market participants, generally

bear the majority of the costs or benefits
• Cost and Benefits of Activities
• Negative Externality: exists when a person's or group's actions cause a

cost (adverse side effect) to be felt by others

 Market actions or behavior producing an adverse side effect.
 Pollution is the primary example and second hand smoking
• Positive Externality: exists when a person's or group's actions cause a

benefit (beneficial side effect) to be felt by others

o Positive Externalities might include beautification projects,

architecture, and public safety

Marginal Cost and Benefits of Activities
o When measuring the overall impact of an activity, one should consider

the Marginal Social Costs

• MSC = Marginal Private Costs (MPC) + Marginal External

Costs (MEC)
• Supposing President Bush loved to travel in the US. He sent at

least 3 days of the week flying Air Force Once through major
national airports. What would be the MSC?
 They would shut down airports
o Likewise, overall impact is incomplete without benefits.
• MSB = Marginal Private Benefits (MPB) + Marginal External

Benefits (MEB)
• Comparing the MSC and MSB can give offer an overall outlook on

the costs and benefits of an individual's or groups actions

Social Optimality of Efficiency Conditions
o Once considering the MSC and MSB, an optimal level of production or
activity will occur when these are equal
• Socially Optimal Amount of output has occurred where MSC =

MSB
Three Categories of Activities
 All activities may be categorized whether there are:
• No externalities

 MEC = 0 and MEB = 0

 Therefore, MSC = MPC and MSB = MPB
• Negative but not positive

 MEC > 0 and MEB = 0

 Therefore, MSC > MPC and MSB = MPB
• Positive but not negative

 MEB > 0 and MEC = 0

 Therefore, MSB > MPB and MSC = MPC
• As mentioned earlier, externalities may result from almost any action. In
terms of basic econ, we will also witness them in both production and
consumption
• Everyone can understand the externalities of production, but some are

less clear on consumption - smoking is one of the better examples

• Diagramming Negative Externalities:
• Should a negative externality exist which is not reflected within the cost it
will diagrammed as follows:
♣ Demand = Marginal Private Benefits
♣ Supply = Marginal Private Costs

 Should the MSC > MPC, then a negative externality exists for which

supply has not properly accounted. The supply curve will exist father
outward, and overproduction will result
• The Socially Optimal Output would capture MSC, and the supply curve

would shift inward, raising price and reducing output

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• Should the MSB > MPB then a positive externality exits that demand is
not fully exploiting. The demand curve lies further inward than it should,
and the resulting output level is less than what the Socially Optimal level
might suggest
• If MSB were to be captured, demand would shift rightward, raising

price which would spur greater production, increasing output

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• When analyzing the difference between the market output level and the
Socially Optimal point, a comparison must be drawn between the benefits
and costs of moving from Q2 (socially optimal) to Q1 (market output)
• This difference will form a triangle, representing the net social cost of

market failure (negative externalities), or the lost social benefit of

market failure (positive externalities)
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• Key Point:
• The Socially Optimal Point is only preferred if the benefits of Q2

outweigh the costs to move there

• This is why some pollution may be preferred to no pollution.
  The costs of some pollution is less than the costs it will require to
eliminate all pollution

Internalizing Externalities
• It is possible to capture the externality into cost-benefit calculations
o Internalizing Externalities is a process by which those who create the

externality include such costs or benefits, borne by third parties, into

their own private calculations
• What will motivate such an action?
• Persuasion:
o PR campaigns, public or private pleading, debates, etc. Here, the

externality generating is not simply made aware, but the public

recognition makes it socially difficult to continue
• Ignorant carelessness is regarded differently than willful disregard. Ex:

"I'm sorry, I didn't know we were keeping you awake," versus, "I'm sorry,
we're really enjoying ourselves and have no plans of stopping"
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