Economics All

ECONOMICS – A TO Z
GOUTAM BUCHHA
PGPSE PARTICIPANT
2009
AFTERSCHO☺OL (www.afterschoool.tk)
– DEVELOPING CHANGE MAKERS
CENTRE FOR SOCIAL ENTREPRENEURSHIP
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1
INTRODUCTION
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1
Ten Principles of Economics

Economy. . .
. . . The word economy comes from a
Greek word for “one who manages a
household.”
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TEN PRINCIPLES OF
ECONOMICS
• A household and an economy
face many decisions:
– Who will work?
– What goods and how many of them should be
produced?
– What resources should be used in
production?
– At what price should the goods be sold?
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TEN PRINCIPLES OF
ECONOMICS
Society and Scarce Resources:
– The management of society’s resources is
important because resources are scarce.
– Scarcity. . . means that society has limited
resources and therefore cannot produce all
the goods and services people wish to have.
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TEN PRINCIPLES OF
ECONOMICS
Economics is the study of how society
manages its scarce resources.
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TEN PRINCIPLES OF
ECONOMICS
• How people make decisions.
– People face tradeoffs.
– The cost of something is what you give up to
get it.
– Rational people think at the margin.
– People respond to incentives.
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TEN PRINCIPLES OF
ECONOMICS
• How people interact with each other.
– Trade can make everyone better off.
– Markets are usually a good way to organize
economic activity.
– Governments can sometimes improve
economic outcomes.
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TEN PRINCIPLES OF
ECONOMICS
• The forces and trends that affect how the
economy as a whole works.
– The standard of living depends on a country’s
production.
– Prices rise when the government prints too
much money.
– Society faces a short-run tradeoff between
inflation and unemployment.
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Principle #1: People Face Tradeoffs.
“There is no such thing as a free lunch!”
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Principle #1: People Face Tradeoffs.
To get one thing, we usually have to give up

another thing.
– Guns v. butter
– Food v. clothing
– Leisure time v. work
– Efficiency v. equity
Making decisions requires trading

off one goal against another.
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Principle #1: People Face Tradeoffs
• Efficiency v. Equity
– Efficiency means society gets the most that it
can from its scarce resources.
– Equity means the benefits of those resources
are distributed fairly among the members of
society.
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Principle #2: The Cost of Something Is
What You Give Up to Get It.
• Decisions require comparing costs and

benefits of alternatives.
– Whether to go to college or to work?
– Whether to study or go out on a date?
– Whether to go to class or sleep in?
• The opportunity cost of an item is what

you give up to obtain that item.
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Principle #2: The Cost of Something Is
What You Give Up to Get It.
LA Laker basketball
star Kobe Bryant
chose to skip college
and go straight from
high school to the
pros where he has
earned millions of
dollars.
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Principle #3: Rational People Think at
the Margin.
• Marginal changes are small, incremental

adjustments to an existing plan of action.
People make decisions by comparing

costs and benefits at the margin.
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Principle #4: People Respond to
Incentives.
• Marginal changes in costs or benefits
motivate people to respond.
• The decision to choose one alternative
over another occurs when that
alternative’s marginal benefits exceed its
marginal costs!
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Principle #5: Trade Can Make
Everyone Better Off.
• People gain from their ability to trade with
one another.
• Competition results in gains from trading.
• Trade allows people to specialize in what
they do best.
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Principle #6: Markets Are Usually a
Good Way to Organize Economic
Activity.
• A market economy is an economy that
allocates resources through the
decentralized decisions of many firms and
households as they interact in markets for
goods and services.
– Households decide what to buy and who to
work for.
– Firms decide who to hire and what to produce.
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Principle #6: Markets Are Usually a
Good Way to Organize Economic
Activity.
• Adam Smith made the observation that
households and firms interacting in
markets act as if guided by an “invisible
hand.”
– Because households and firms look at prices
when deciding what to buy and sell, they
unknowingly take into account the social costs
of their actions.
– As a result, prices guide decision makers to
reach outcomes PGPSE
thatNOTEStend to maximize the 20
welfare of society as a whole.
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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Market failure occurs when the market fails
to allocate resources efficiently.
• When the market fails (breaks down)
government can intervene to promote
efficiency and equity.
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Principle #7: Governments Can
Sometimes Improve Market Outcomes.
• Market failure may be caused by
– an externality, which is the impact of one
person or firm’s actions on the well-being of a
bystander.
– market power, which is the ability of a single
person or firm to unduly influence market
prices.
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Principle #8: The Standard of Living
Depends on a Country’s Production.
• Standard of living may be measured in
different ways:
– By comparing personal incomes.
– By comparing the total market value of a
nation’s production.
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• Almost all variations in living standards are
explained by differences in countries’
productivities.
• Productivity is the amount of goods and
services produced from each hour of a
worker’s time.
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• Standard of living may be measured in

different ways:
– By comparing personal incomes.
– By comparing the total market value of a
nation’s production.
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Principle #9: Prices Rise When the
Government Prints Too Much Money.
• Inflation is an increase in the overall level
of prices in the economy.
• One cause of inflation is the growth in the
quantity of money.
• When the government creates large
quantities of money, the value of the
money falls.
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Principle #10: Society Faces a Short-
run Tradeoff Between Inflation and
Unemployment.
• The Phillips Curve illustrates the tradeoff
between inflation and unemployment:
Inflation  Unemployment
It’s a short-run tradeoff!
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Summary
• When individuals make decisions, they
face tradeoffs among alternative goals.
• The cost of any action is measured in
terms of foregone opportunities.
• Rational people make decisions by
comparing marginal costs and marginal
benefits.
• People change their behavior in response
to the incentives they face.
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Summary
• Trade can be mutually beneficial.
• Markets are usually a good way of
coordinating trade among people.
• Government can potentially improve
market outcomes if there is some market
failure or if the market outcome is
inequitable.
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Summary
• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of
inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.
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On July 29, 2006 I was reading the Omaha World Herald. On this
Saturday morning my eye caught the car ads section. On the front
page of that section is a question and answer section by “Click &
Clack.” I do not remember their real names. They also host (used
to, anyway, and maybe they still do) a PBS radio show about cars.
I rarely read this section, but I did this day.
The first question had to do with going on a long trip in a car. The
question was about washing and waxing the car before the trip and
then washing the car along the way. The person asking the
question felt the washing would help save on gas and so the
questioner wanted information from the experts.
The experts said that yes there is some benefit to the washing, but
so little benefit that the cost of the washing and waxing would be
larger than the benefits obtained. So, from a dollars and cents point
of view the washing did not pay off.
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I was all excited about reading the story because I thought it made
sense and maybe I could use the story in my classes – so here we
are. I would like to repackage the story to make a more general
point. I will make a little diagram to aid in my story.
Benefits
Policy or action
or proposal
Costs
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The policy in the example is
Wash car before, and while on, long car trips.
The benefit(s):
Better gas mileage and thus a cost saving.
The cost(s):
The cost of the car wash.
Economics is a science that when looking at policies the focal point
is on the benefits and costs of the policy.
In our personal lives, when a policy has benefits that clearly
outweigh the costs, many people engage in what the policy
recommends.
Examples: Brushing your teeth everyday, washing your hands after
using the restroom, and thewww.afterschoool.tk
list goes on and on.
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We have government in our world. Policies are recommended in
this arena. Every policy that gets mentioned has benefits. But
every policy also has costs. Please remember this.
Is the following good social policy from an economic point of
view? Every person in northeast Nebraska should give Chuck
Parker $1 each time they drive by Dairy Queen .
Hey, businesses have policies too. Most organizations have
policies. The economic approach to viewing the world is looking
at the benefits and costs of the policy.
It seems that a lot of restaurants have a policy that if you buy a
pop you can get free refills. Is this a good business policy? The
benefits are…………………….
The costs are…………………..
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Well, here is my little story triggered by my reading the “Click &
Clack” article.
Should I make it a policy as a professor at WSC to bring in current
events and other items I find in the paper?
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Overview
In consumer theory we started with the x and y axes both referring to a good or
service, with each axis representing a different specific good. Sometimes,
though, we only want to focus on one good against everything else we could
buy.
If we think of the Y good as a composite commodity then we can say the price of
the good is $1 per unit and the commodity is really then how much we spend on
all goods except good x.
The budget line and indifference curves we saw before are essentially the same
as we saw before.
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Budget line
Y Before we said the budget line was
PxX + PyY = I, with vertical intercept
= I/Py, horizontal intercept = I/Px
and slope –Px/Py.
In the context of the composite
I commodity we have PxX + Y = I,
with vertical intercept = I (our
income amount), horizontal intercept
= I/Px still and slope = -Px
I/Px
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Utility max
With the composite good our
Y
utility max story is the same as
before except when we see
point X1 the Y point is the
amount of income we have left
after buying X1 units of X.
The point of the composite
commodity idea is we can
focus on the x good and
I – PxX1 everything else in a lumped up
amount.
X
X1
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Consumer Surplus
When consumers buy products in
the market they may pay less than
the full amount they are willing to
pay – they receive consumer
surplus.
Do you want to buy some eggs?
Who here would buy a dozen eggs for $1.59?

Who would pay $1.29?
Say the actual price of the dozen is $0.89. Do you think the
buyers would pay the $1.29 to the grocer when the grocer has
a sign out that says $0.89?
So if consumers are willing to pay, in this example, more than
$0.89, then they receive an extra benefit in the market called
consumer surplus.
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consumer surplus
Consumer surplus is an idea people I know have a hard
time accepting. Consumer surplus equals the maximum
amount you are willing to pay for an item minus what
you have to pay. It seems the hard part is
distinguishing between what you have to pay and what
you would be willing to pay.
The amount you would be willing to pay is on the

demand curve for each unit of the product. In fact the
law of demand is an expression that you are not willing
to pay as much for additional units as you did for
previous units.
The amount you have to pay is market determined.
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Willing to pay
P
24
a When the price is 24, 0 units
21 are demanded. At P=21, 1
18
b c
unit is demanded. 21 is the
d e f
maximum price this person
15
12
g h i j
would pay for the first unit.
k l m n Let’s say the market price is
10. Then the surplus on the
first unit is 11. The surplus
on the
1 2 3 4 2nd....................…,
Q
3rd....................... units is?
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willing to pay
You will notice on the previous screen at price 21, the
quantity demanded is 1. The area b + d + g + k equals
the $21 the consumer would pay for the 1st unit. The
area a is under the demand curve but not part of what
the consumer would be willing to pay for the first unit.
We will add in area a to calculate the consumer surplus.
It makes the calculation easier.
The second unit would be demanded if the price is 18.
The area e + h + i = $18. The area c is under the demand
curve but not part of what the consumer would be
willing to pay for the second unit.
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willing to pay
The point I am getting to on the previous screen is if we
add in areas like a and c, that are really not a part of what
consumers are willing to pay, we have an easier
calculation to find out what consumers are willing to pay
for a certain number of units. It is simply the area under
the demand curve out to a quantity.
P
What consumers are
willing to pay for the Q1
units
Q1 Q
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Consumer surplus again
P Say with S & D we get the
P = 10 and Q = 300.
25 Area A = .5(300)(25-10)
=2250
A Area B = 10(300)
10 = 3000
B Note consumers would be
300 Q willing to pay 3000 + 2250
for 300 units.
But the consumers only have to pay 3000 for the 300 units.
So the consumer surplus is area A and equals 2250.
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Refresher on areas
The area of a triangle is ½ of the base times the height.

The area of a rectangle, of which the square is a special case,
is the base times the height.
We use these ideas from time to time because they assist in
the development of economic ideas.
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consumer surplus again
What do consumers do with the surplus received?

They may spend it on more units of the item in question, they
may spend it on other items, or they may save it for a rainy
day.
The point here is that the surplus is useful to the consumer!
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Market Demand from
Individual Demand
In this section we want to think about market demand as the
result of adding up demands from many individuals.
Remember individual demand is the result of each
consumer going about utility maximization.
Let’s do an example with 3 people. qi is the demand from
the ith consumer. Say,
q1 = 10 - p, q2 = 15 - 2p, and q3 = 18-3p.
Often the demand is written in inverse form (where we
isolate the p term). We have
p = 10 - q1, p = 15/2 - (1/2)q2, and p = 18/3 - (1/3)q3
We usually express demand in inverse form when we want
to graph the demands in the P, Q graph. I have a graph on
the next screen with each demand in it.
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P Note at a price above 10 no one demands
any units. At a price above 7.5 only
person 1 demands units. At a price above
6 only person 1 and person 2 demand
units. If price is below 6 all three people
demand units.
The dashed line here is the market
10
demand. It is found by looking at each
price and adding the quantities each
7.5
person would demand.
6
Q
10 15 18
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To get the market demand we horizontally add the
demand from each person. This amounts to saying q1 +
q2 + q3 = Q.
We saw before the demand from each person was
q1 = 10 - p, q2 = 15 - 2p, and q3 = 18-3p.
To get the market demand we add
q1 + q2 + q3 to get (10 - p) + (15 - 2p) + (18 -3p) = (10 +
15 + 18) - (p + 2p + 3P), or
Q = 43 - 6P, but this is only true when price is less than or
equal to 6. In other words all three people demand units
when the price is less than 6.
Note if P = 1 q1 = 9, q2 = 13, q3 = 15 and Q = 37, or
if P = 2 q1 = 8, q2 = 11, PGPSE
q3 = NOTES
12 and Q = 31. 51
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Remember if the price is above 6 but
P less than or equal to 7.5 the demand
comes from only the first two people
and the demand curve is
q1 + q2 = Q = 25 - 39, and
if the price is above 7.5 the demand is
only from the first person and the
demand curve is
q1 = Q = 10 - p.
Q
So the market demand curve we have
come to know and work with is really
the addition of the demand from many
people as they have gone about
maximizing their utility.
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Price elasticity of demand
Often in economics we look at
how the value of one variable
changes when another variable
changes. The concept called
elasticity is a summary statement
about those changes.
Elasticity
The law of demand or the law of supply is a statement
about the direction of change of the quantity demanded,
or supplied, respectively, when there is a price change.
The concept of elasticity adds to these concepts by

indicating the magnitude of the change in quantity,
given the price change. The magnitude of the change is
reported in percentage terms.
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own price elasticity of demand
Ed = (% change in Q)/(% change in P)
As an example, if Ed = -2 we say for every 1 % change

in the price of the good the quantity demand changed
in the opposite direction by 2 %.
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absolute value
You may recall a function in math called the absolute value.

Basically this function makes negative values positive and
leaves positive values positive.
In the notes I will write abs( ) to mean take the absolute
value.
The own price elasticity of demand is a negative number, so
we will take the absolute value to describe some concepts
about it.
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Elasticity can have three basic
values
If abs(Ed) > 1 we say demand is elastic. This means the
% change in the Qd is greater than the % change in
price.
If abs(Ed) = 1 we say demand is unit elastic. This

means the % change in the Qd is equal to the % change
in price.
If abs(Ed) < 1 we say demand is inelastic. This means

the % change in the Qd is less than the % change in
price.
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Elasticity again
P
In the upper left of the
P1 demand curve the %
P2 change in the Qd is
greater than the %
change in the P and
thus the Ed > 1 .
Q
Q1 Q2
Without a real formal proof of the above statement, we
can see the % change in Qd is about 100 % and the %
change in P is less than 100 %. Demand is elastic here.
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Elasticity has several ranges
P
of values
In the lower right of
the demand curve the
% change in the Qd is
less than the % change
P1 in the P and thus the
P2 Ed < 1.
Q
Q1 Q2
can see the % change in Qd is less than 100 % and the %
change in P is about 100 %. Demand is inelastic here.
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Elasticity has several ranges
P
of values
In the middle of the
demand curve the %
P1 change in the Qd is
P2 equal to the % change
in the P and thus the
Ed = 1.
Q
Q1 Q2
can see the % change in Qd is about equal to the % change
in P. Demand is unit elastic here.
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Calculation point slope method
P If we know the slope of the demand

curve the elasticity at a point is found
by using the Q and P value of the
11 point and the slope in the following
way:
(P/Q)(1/slope).
Example say the slope here is -1.
The elasticity is (11/10)(1/-1) = -1.1
10 Q When we take absolute value we get
1.1. Elastic in this case.
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Own price elasticity and total
revenue changes
Total revenue (TR) is price times
quantity. Along the demand curve P
and Q move in opposite directions.
Knowledge of Ed assists in knowing
how TR will change.
Elasticity and total revenue
relationship
When we look at the collection of consumers in the
market, at this time in our study we assume each
consumer pays the same price per unit for the product.
Also at this time in our study the total expenditure of

the consumers in the market would equal the total
revenue (TR) to the sellers.
So, here we look at the whole demand side of the

market in general.
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relationship
P
TR in the market is
P1 equal to the price in the
market multiplied by
the quantity traded in
the market. In this
diagram TR equals the
Q area of the rectangle
Q1
made by P1, Q1 and
the horizontal and vertical axes. We know from math that
the area of a rectangle is base times height and thus here
that means P times Q.
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relationship
We will want to look at the change in values of a
variable and in order to do so we want to have a
consistent measure of change. In this regard let’s say
the change in a variable is
the later value minus the earlier value.
Thus if the price should change from P1 to P2, then the

change in price is
P2 - P1, or similarly if the TR should
change the change in TR is
TR2 - TR1.
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P
relationship
Now in this graph
P1 when the price is P1
a
P2 the TR = a + b(adding
areas) and if the price
b c
is P2 the TR = b + c.
Q The change in TR if
Q1 Q2 the price should fall
from P1 to P2 is (b + c) - (a + b) = c - a.
Similarly, if the price should rise from P2 to P1 the change
in TR is a - c. I will focus on price declines next.
PGPSE NOTES 66
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P
relationship
Since the change in TR
is c - a, the value of the
P1 change will depend on
a
P2 whether c is bigger or
b c smaller, or even equal
to, a. In this diagram
we see c > a and thus
Q the change in TR > 0.
Q1 Q2
This means that as the price falls, TR rises. I think you
will recall that in the upper left of the demand the demand
is price elastic. Thus if the price falls in the elastic range of
demand TR rises.
PGPSE NOTES 67
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Elasticity and TR
You will note on the previous screen that I had c - a. In
the graph c is indicating the change in TR because we
are selling more units. The area a is indicating the
change in TR when there is a price change. We have to
bring the two together to get the change in TR.
Thus a lower price has a good and a bad.

Good - sell more units.
Bad - sell at lower price.
PGPSE NOTES 68
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P
relationship
Now in this graph
when the price is P1
the TR = a + b(adding
P1 is P2 the TR = b + c.
P2 a
b c In this diagram we see
Q c < a and thus the
Q1 Q2 change in TR < 0.
I think you will recall that in the lower right of the
demand the demand is price inelastic. Thus if the price
falls in the inelastic range of demand TR falls.
PGPSE NOTES 69
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P
relationship
Now in this graph
a areas) and if the price
P2
Q c = a and thus the
Q1 Q2 change in TR = 0.
I think you will recall that in the middle of the demand the
demand is unit elastic. Thus if the price falls in the unit
elastic range of demand TR does not change.
PGPSE NOTES 70
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Elasticity and TR
P
When the price falls the quantity
demanded always rises. As the
quantity demanded rises
D
Q (because of the price change)
the TR is first rising in the
TR elastic range, levels off when
demand is unit elastic and TR
falls in the inelastic range.
Q
PGPSE NOTES 71
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Marginal revenue
Marginal revenue is defined as the change in total revenue as
the number of units cold changes. In the demand graph we
have seen that in order to sell more the price has to be
lowered. So, there is a relationship between elasticity and
marginal revenue.
If price falls and demand is elastic we know TR rises so MR
is positive.
If Price falls and demand is inelastic we know TR falls and so
MR is negative.
If price fall and demand is unit elastic we know TR does not
change.
PGPSE NOTES 72
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Other demand elasticities
There are other elasticities

besides the own price elasticity of
demand. Let’s see a few here.
demand shifters
We saw that things like taste and preference, price of other

goods, income and the number of buyers shift the demand
curve if they change. How much do they shift the demand
curve?
We use other elasticity concepts as an indication of how
much the curve will shift given a change in one of these
factors.
PGPSE NOTES 74
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cross price elasticity of demand
Edxy = % change in Qdx / % change in Py.

The bigger the value the more the demand shifts.
If the value is negative we have complements and if positive
we have substitutes.
If the absolute value is between 0 and 1 the cross elasticity is
inelastic, if = 1 unit elastic and if greater than 1 elastic.
PGPSE NOTES 75
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income elasticity of demand
Edxm = % change in Qdx / % change in M.

If the value is negative we have an inferior good and if
positive we have a normal good.
If the absolute value is between 0 and 1 the income elasticity
is inelastic, if = 1, unit elastic, and if greater than 1, elastic.
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Elasticity of supply
The elasticity of supply is used to indicate the percentage

change in the quantity supplied given a percentage change in
price.
The elasticity of supply is calculated in a manner similar to
the other elasticities we have seen and has a similar
interpretation in terms of the range of values the elasticity
might take, i.e. elastic, inelastic and unit elastic.
PGPSE NOTES 77
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Decisions under uncertainty
A Different look at Utility Theory
PGPSE NOTES 78 78
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Overview
The author says that economic decisions made under

uncertainty are essentially gambles. Let’s first look at some
gambles, and then come back to decisions under uncertainty.
Initially, our gamble will be to flip a fair coin (one where the
probability of a head is .5 and the probability of a tail is .5).
The payout will depend on which side of the coin is showing
when the coin lands at rest.
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Examples
Facts about several gambles with a fair coin:

Gamble 1 – heads means you win $100 and tails means you lose
$0.50
$100
$10000
Note what a person would lose on each gamble. Many people
would say the loses in gambles 2 and 3 make them uneasy and
they wouldn’t take those gambles.
PGPSE NOTES But, some folks out there might
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Digress – the mean
What is the mean or the average of the numbers 4 and 6? You

probably said 5 and you are right. This could be written
(4+6)/2 = (4/2) + (6/2) = (1/2)4 + (1/2)6, where
in this last form you see each number multiplied by ½. In this
context the mean is said to be a simple weighted average, with
each value weighted by ½. What would the weights be if we
wanted the average of 4, 5, and 6? 1/3! In general with n
numbers the weight is 1/n.
In other situations we may look at a weighted average (not
simple), though the weights are found in a different way.
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Back to example
The expected value of a gamble is a weighted average of the

possible payout values and the weights are the probabilities of
occurrence of each payout. We talk about EVi as the expected
value of gamble i.
EV1 = .5(100) + .5(-0.50) = 50 – 0.25 = 49.75. (Notice when
you lose the loss is subtracted out.)
EV2 = .5(200) + .5(-100) = 100 – 50 = 50
EV3 = .5(20000) + .5(-10000) = 10000 – 5000 = 5000
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Example
In our example the EV for each gamble is positive. The EV is
the highest for gamble 3. But, remember we said not many folks
would probably like it because of the uneasiness they would feel
by losing the 10000.
A couple of guys named Von Neumann (both names are just the
person’s last name) and Morgenstern created a model we now
call the expected utility model to deal with situations like this.
They indicated folks make decisions based not on monetary
values, but based on utility values. Of course the utility values
are based on the monetary values, but the utility values also
depend on how people view the world.
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Expected Utility
Say we observe a person always buying chocolate ice cream
over vanilla ice cream when both are available and both cost
basically the same, or even when chocolate is more expensive
and always when chocolate is the same price or cheaper. So by
observing what people do we can get a feel for what is preferred
over other options.
When we assign utility numbers to options the only real rule we
follow is that higher numbers mean more preference or utility.
Even when we have financial options we can study or observe
the past to get a feel for our preferences.
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Expected Utility Theory is a methodology that incorporates
our attitude toward risk (risk is a situation of uncertain
outcomes, but probabilities are known) into the decision
making process. It is useful to employ a graph like
Utility this in our analysis. In the graph we
value will consider a rule or function that
translates monetary values into utility
values. The utility values are our
subjective views of preference for
monetary values. Typically we
assume higher money values have
higher utility.
Monetary
value
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In general we say people have one of three attitudes toward
risk. People can be risk avoiders, risk seekers , or indifferent
toward risk (risk neutral).
Utility Utility values are assigned

value Risk avoider to monetary values and the
general shape for each type
Risk indifferent of person is shown at the
left. Note that for equal
increments in dollar value
Risk seeker
the utility either rises at a
decreasing rate(avoider),
constant rate or increasing
Monetary rate.
value
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Here we show a
Utility generic example with
a risk avoider. Two
monetary values of
interest are, say, X1
U(X2) and X2 and those
values have utility
U(X1) U(X1) and U(X2),
respectively
$
X1 X2
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Expected Utility
In expected utility theory we want to focus on wealth values and

utility values. Gambles will lead to adjustments in wealth.
Let’s call W the initial wealth which can always be retained if no
gamble is taken, and call the wealth at a loss X1 = W – loss, and the
wealth at a win X2 = W + win.
The expected value of wealth from a gamble is then (p1 is the
probability of a loss and p2 is the probability of a win)
EV = p1X1 + p2X2
Note we called the expected value of a gamble EV and I now have
the expected value of wealth with a gamble being EV. EV will
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value of wealth, unless otherwise stated.
Expected Utility
The following is what needs to be considered to get the expected

utility of a gamble:
1) Start with a person’s initial wealth W,
2) If the gamble is taken identify X1 and X2,
3) Assign to each wealth value in 2) the respective utility value
U1, and U2 and in a graph connect the U1 and U2 values with a
chord.
4) Calculate the expected value of wealth with the gamble EV.
5) Calculate the expected utility of the gamble as EU where EU =
p1U1 + p2U2, and find the value
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chord above the EV. 89 89
Utility
U2
EU
U1
$
X1 EV X2
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Example continued
Say utility is assigned by the function U = sqrt(wealth) and a

person has initial wealth 10000. Then for the three gambles
we had before the EU’s would be
EU1 = .5sqrt(9999.5) + sqrt(10100) = 100.248
EU2 = .5sqrt(9900) + sqrt(10200) = 100.247
EU3 = .5sqrt(0) + sqrt(30000) = 86.603
So in terms of EU’s the preferred order of gambles for this
person is gamble 1, then 2, and the 3. When we looked at
EV’s the order was 3, 2, and 1. So expected utilities of
gambles may have a different rank ordering than when
PGPSE NOTES 91 91
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Fair gambles
A fair gamble is one where the expected value of the gamble is

zero, i.e., p1(-loss) + p2(win) = -p1(loss) + p2(win) = 0.
This implies that the expected value of wealth with the gamble
is equal to the value of wealth when not gambling at all, which
you might call your certain wealth.
For fair gambles
EV = p1(W – loss) + p2(W + win)
= p1W +p2W – p1(loss) + p2(win) = (p1+p2)W + 0 = W, since
p1+p2=1.
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Risk averse fair gamble
In this graph I have the generic
Utility view of a risk lover. With the fair
gamble we have the EV and the
EU is on the chord above the EV.
If the person does not gamble
Uw
wealth will be W and the utility
EU
there is just read off the utility
function here as Uw (note a risk
averter has diminishing marginal
utility of wealth.)
X1 EV X2 wealth
=W PGPSE NOTES 93 93
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Risk Averse fair gamble
For the fair gamble we again know EV = W, but for a risk averse
person Uw > EU. Thus we can conclude risk averse folks will
not accept fair gambles.
On the next slide you can see I thickened part of the horizontal
axis and the chord connecting the two points on the utility
function associated with the wealth values under the gamble.
The probabilities of the gamble could be changed (and the
gamble would no longer be fair) and the only way the person
would accept the gamble over having the certain wealth W is if
the EV was greater than W*.
So, a risk averse person may gamble, but it has to be at favorable
odds. PGPSE NOTES 94 94
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Risk averse fair gamble
If the EV of a gamble is above
Utility W* (and is no longer a fair
gamble, but a favorable one),
then the person will end up on the
chord segment that has not been
Uw thickened and thus only then
EU have EU>Uw.
X1 EV X2 wealth
=W PGPSE NOTES 95 95
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Risk Seeker fair gamble
In this graph I have the
generic view of a risk seeker.
U
With the fair gamble we
have the EV and the EU is on
the chord above the EV.
EU If the person does not gamble
wealth will be W and the
Uw utility there is just read off
the utility function here as
Uw (note a risk seeker has
X1 EV X2 W increasing marginal
=W utility of
PGPSE NOTES
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For the fair gamble we again know EV = W, but for a risk

seeker person Uw < EU. Thus we can conclude risk seeker
folks will always accept fair gambles.
On the next slide you can see I thickened part of the horizontal
axis and the chord connecting the two points on the utility
function associated with the wealth values under the gamble.
The probabilities of the gamble could be changed (and the
gamble would no longer be fair) and the only way the person
would NOT accept the gamble over having the certain wealth
W is if the EV was less than W*.
So, risk seeker may NOTPGPSE
gamble,
NOTES
but it has to be at 97 97
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If the EV of a gamble is
below W* (and is no longer a
U
fair gamble, but an
unfavorable one), then the
person will end up on the
EU chord segment that has not
been thickened and thus only
Uw then have EU<Uw.
.
X1 EV X2 W
=W
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Risk Neutral fair gamble
U The risk neutral person

is indifferent between a
fair gamble and not
gambling at all. If odds
are switched to favorable
Uw = EU
gambles will be favored
and if switched to
unfavorable gambles
will not be taken.
X1 EV X2 W
=W
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Certainty Equivalents
In a more general sense we could talk about gambles that are fair
or unfair. The certainty equivalent of a gamble will be the sum of
money or wealth for which the individual would be indifferent
between the certain sum and the gamble. We will examine these
certainty equivalents for folks with risk aversion, neutrality and
risk seeking prefrences.
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Risk averse – certainty
equivalent
Utility
The decision maker
may have an option
that is certain. If so,
U2 the EU is simply the
EU utility along the utility
U1 curve (I called it Uw
before). So in this
diagram we see that
$ any sure bet greater
Y EV
X1 X2 than Y has an expected
utility greater than the
expected utility of the
PGPSE NOTES risky option. 101101
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Another Example
Say Utility U = square root of X, where X is a dollar amount the
person ends up with,
Then U(4) = 2 and U(16) = 4, for example.
Say a risky option will result in 4 50% of the time and 16 50%
of the time. The expected value is 10 because
.5(4) + .5(16) = 10 and the expected utility is 3 because
.5U(4) + .5U(16) = .5(2) + .5(4) = 3.
Now, if there is an option that will pay more than 9 with
certainty, than the certain option is better. So, 9 is the certainty
equivalent of this uncertain gamble. Let’s see this on the next
slide.
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U(x)
U(16)=4
U(x)
EU = 3
U(4)=2
4 9 10 16 x
Any certain option above 9 gives a utility

value greater than the expected utility of
the uncertain option.
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103103
Risk seeker – certainty
equivalent
In this graph I have the
generic view of a risk seeker.
U
With the fair gamble we
have the EV and the EU is on
the chord above the EV.
EU Y is the certainty equivalent
of the gamble. Any certain
Uw option above Y would be
preferred to the gamble
shown by the risk seeker.
X1 EV X2 W
Y
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Reducing Risk
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In a previous section we mentioned that sometimes we face an
uncertain situation with regards to monetary values. We saw
1) The expected monetary value, EV, of the uncertain situation
(what I will now call a gamble) is the sum of some numbers,
where each number is a monetary value multiplied by its
probability of occurring,
2) The expected utility of a gamble (what I will now write as
EU) is the sum of some numbers, where each number is the
utility of a monetary value multiplied by its probability of
occurring,
3) The expected utility of a gamble does not occur on the utility
function (unless the person is risk neutral), but on the chord or
line segment that connects utility values of each part of the
gamble and directly above the EV of the gamble.
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Say we have a risk lover and the gamble G
leaves Y1 p1 % of the time and Y2 p2% of the
U time.
EV =p1Y1 + p2Y2
EU = p1U(y1) + p2U(Y2)
U(Y2)
EU
U(Y1)
Y
Y1 EMV Y2
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Say we have a risk avoider and the gamble G
leavesY1 p1 % of the time and Y2 p2% of the
U time.
EMV =p1Y1 + p2Y2

U(Y2)
EU = p1U(y1) + p2U(Y2)
EU
U(Y1)
Y
Y1 EMV Y2
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On the last few slides I show you generic cases of a risk lover and
a risk avoider. You see a gamble with monetary values Y1 and
Y2, with associated probabilities p1 and p2 (where p2 = 1- p1).
I now want to show something we saw in the previous section, but
I want to be more precise in my language.
Sometimes we may have an opportunity that is known with
certainty. The utility of the opportunity will be on the utility
function for the individual and will be noted U(C).
The decision rule for choosing between a gamble and a certain
payoff is
-choose the certain option when U(C) > E[U(G)], and
-choose the gamble when U(C) < E[U(G)].
Of course, when the two arePGPSE
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Back on the slides I have some vertical dashed lines. I put them
there on purpose. I want you to think of the location as values of
a certain payoff, I now call C, and then we can see that
U(C) = EU. The payoff C is called the certainty equivalent of the
gamble.
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Say we have a risk avoider and the gamble G
leaves Y1 p1 % of the time and Y2 p2% of the
U time.
The risk premium, rp, of a

U(Y2) gamble is the EV of the
EU gamble minus the certainty
equivalent of the gamble.
U(Y1)
rp = EV - C and will always
be positive for a risk avoider.
The risk premium for a risk
lover will be negative and it
will be zero for a risk neutral
person.
Y
Y1 C EV Y2
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A Gamble of no fire insurance Say Y2 is value of property if
no fire and Y1 is the value of
U the property with a fire.
The EV = p1Y1 + p2Y2.
EU = p1u(Y1) + p2U(Y2)
U(Y2)
EU C is the certainty
U(Y1) equivalent of the
gamble.
Y
Y1 C EV Y2
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If a person buys insurance it changes the risky situation
into a certain situation.
If Y2 - C = fee paid for insurance the individual will have C
with certainty. To see this we note
If no fire the individual has Y2 - fee = C, and
If fire the individual gets restored to Y2 and has still paid
the fee so the certain property value is C.
SOOOOOO
Y2 - C is really the maximum fee the person would pay
for insurance and they would like to pay less. Y2 – C is
called the reservation price for insurance.
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Let’s take the point of view of the insurance company - and
we do not have to look at the graph here.
They pay claim of Y2 - Y1 p1% of the time and they pay 0
p2% of the time for an expected claim of
p1(Y2 - Y1) + p2(0) = p1(Y2 - Y1)
This is called the actuarially fair insurance premium -
meaning this is the minimum they have to charge to be
able to pay out all the claims.
Now look in the graph - here is an amazing result:
Y2 - EV = Y2 - (p1Y1 + p2Y2) = Y2(1 - p2) -p1Y1
= p1(Y2 - Y1), so Y2 - EV is the actuarially fair premium
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Review
Y2 - EMV = least insurance company will charge,
Y2 - C = Most person will pay,
(Y2 - C) - (Y2 - EMV) = EMV - C is the room the person
and the insurance company have to negotiate for the
insurance. Before we said EMV - C was the risk
premium and now we see it is the most the person would
pay over the actuarially fair premium to insure against
the gamble.
Now insurance companies pay out claims and pay
employees and electricity and other admin. expenses.
The company has to get some of EMV - C to pay these
expenses.
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People won’t buy the insurance if the insurance company
needs more than EMV - C to cover its other expenses
because the person would have more utility without it in
that case.
Next let’s look at how information can be beneficial in

reducing risk.
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U
situation without
information
Y1 C EMV Y2
Y
situation with
information
Y
Y1’ c’ EMV’ Y2
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On the previous slide I show two graphs. Both have the
same utility function for an individual. The top graph is a
situation where the individual has no information and the
bottom graph shows what happens when more information
is obtained.
Note more information may not eliminate risk, but it can
reduce it. Let’s study an example to show context.
Say an individual can buy a painting and if it is a real
master painting the wealth of the individual will be Y2. If
the painting is a fake the individual will lose some of his
expenditure because the painting is no big deal - wealth is
Y1. We see the certainty equivalent of the gamble is C.
Presumably the individual will buy the painting if the
certainty equivalent of the gamble is better than his wealth
by not buying the painting at all.
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Now say the person can hire a painting expert to see if the
painting is a fake or not. If the expert says the painting is a
fake then you will not buy it and will not lose on the low end.
But if it is a real painting you will have the same high end
wealth because you will buy the painting.
So information from an expert in this case gives you the
same high end value but makes your low end value better
than without information.
But, the expert is going to want to charge you for the
information. How much should you pay?
Since C’ is the certainty equivalent with information and C is
the certainty equivalent without the information, the person
would pay up to C’ - C for the information and the utility of
the person would be improved.
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Game Theory
Here we study a method for

thinking about oligopoly situations.
As we consider some
terminology, we will see the
simultaneous move, one shot
game.
Simultaneous Move, One Shot
Games
We will again assume there are only two decision makers. For
now we assume both have to make their decisions at the same
time. This is a simultaneous move game. The main point
about a simultaneous move game is that although I may know
all the information about what the other guy might do, I do not
actually see what is done before I do my thing.
Games could be sequential, where one player follows the other.
Some games have only one decision by each player involved.
Other games involve repeated rounds of play. Here we focus
on the one shot games.
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Normal Form
In the normal form of a game, information about the options of

each player is presented in a matrix. The “row” player’s
options are described in each row and the payoff is the first
number in each cell.
The “column” player’s options are described in each column
and the payoff is the second number in each cell.
Since we have a simultaneous move game each player will
choose its options without knowing what the other player will
choose. But the choice of the other player may be anticipated.
Let’s check out an example on the next few screens.
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Column player
left right
Row up a, A c, C
Player down b, B d, D
Let’s make sure we understand this table. Here we have two

players: the Row Player and the Column Player (Miller and Bud,
if you want).
This is a generic game for now and all the Row Player can do is
choose up or down (in rock, scissors, paper you can choose one
of the three, but for the Row Player here the choice is up or
down.)
The Column Player can only choose left of right.
Now, let’s say the row player picks up and the column player
picks left.
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Column player
left right
Row up a, A c, C
Now, let’s say the row player picks up and the column player
picks left just as an example to see what each would get.
If the game ended at up, left, the row player would get “a” and
the column player would get “A.”
Note all these letters usually are dollar amounts for us and can be
negative amounts. But, sometimes the letters represent other
concepts besides dollars. As an example the numbers could
represent jail time.
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Column player
left right
Row up a, A c, C
If the game ended at down, right, the row player would get “d”
and the column player would get “D.”
Caution: If as ROW Player you pick down thinking you get “b”
remember that what you get is also influenced by Column Player.
So, you could actually get “d” if the Column Player picks right.
Next we want to think about how each player should decide what
strategy to pick.
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Row player should think this way: (As the row player) I do not
know what the column player will do. But, I can look at each
option of the column player, one strategy at a time.
If the column player picks left my choices are
up a
down b
As the row player I would pick the option that has the highest
value: pick up if a > b, or pick down if a < b.
If the column player picks right my choices are
up c
down d
As the row player I would pick the option that has the highest
value: pick up if c > d, or pick down if c < d.
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For the row player the choice of strategy is up or down.
A strategy is called a dominant strategy for a player if it has a
higher payoff no matter what the other player chooses.
So, up would be a dominant strategy for the row player if both
a > b and c > d.
Down would be a dominant strategy for the row player if both
a < b and c < d.
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Example
column player
left right
Row up 10, 20 15, 8
Player down -10, 7 10, 10
The row player will think in the following way(look at each

column). If column man picks left I can have 10 if I go up and
–10 if I go down. So I will go up. If column man goes right I
can have 15 if I go up and 10 if go down. So I will go up.
In this example the row player sees it is best to go up no
matter what the column player is doing. In this sense we say
“up” is a dominant strategy for the row player.
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Example
column player
left right
Row up 10, 20 15, 8
This is the same slide as before, but I show in each column

what the ROW player will look at. If the highest value in each
column is in the same row – the person has a dominant
strategy.
Again, up is a dominant strategy here for the row player.
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Column player should think this way: (As the column player) I do
not know what the row player will do. But, I can look at each
option of the row player, one strategy at a time.
If the row player picks up my choices are

left right
A C
As the column player I would pick the option that has the highest
value: pick left if A > C, or pick right if A < C.
If the row player picks down my choices are

left right
B D
As the column player I would pick the option that has the highest
value: pick left if B > D, or pick right if B < D.
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For the column player the choice of strategy is left or right.
A strategy is called a dominant strategy for a player if it has a

higher payoff no matter what the other player chooses.
So, left would be a dominant strategy for the column player if

both
A > C and B > D.
Right would be a dominant strategy for the column player if

both
A < C and B < D.
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Example
column player
left right
Row up 10, 20 15, 8
The column player will think in the following way(look at each

row). If row man picks up I can have 20 if I go left and 8 if I go
right. So I will go left. If row man goes down I can have 7 if I
go left and 10 if go right. So I will go right.
In this example the column player does not have a dominant
strategy. What to do? If the other player has a dominant
strategy, assume he will play it and then do the best you can.
Column player should go left.PGPSE NOTES 132132
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Example
column player
left right
Row up 10, 20 15, 8
This is the same slide as before, but the column player looks at
his possibilities in each row.
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Nash Equilibrium
A set of choices by the players would be considered a Nash

equilibrium if each player would NOT want to change their
choice given the choice of the other player. The choices up
and left represents a Nash equilibrium because neither would
choose to change given the choice of the other.
The row player says – if the column player will be at left, then
it is best for me to stay at up.
The column player says - if the row player will be at up, then
it is best for me to stay at left.
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Let’s pick a different cell than up, left to see why another cell
might not be a Nash equilibrium.
Let’s look at up, right.
The row player says - if the column player is at right then I want
to stay at up (Nash Equilibrium may still be in the running).
The column player says – if the row player is up, then I want to
change from right to left.
Because the column player wants to change, the cell considered
is not a Nash Equilibrium.
Note: You look for dominant strategies before the game is
played and you see if you have a Nash equilibrium after the
game is played.
PGPSE NOTES 135135
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Applications
Here we look at several
applications. We will see a classic
example of a dilemma that can arise
in such games.
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Pricing Example
column player
low price high price
Row low price 0, 0 50, -10
Player high price -10, 50 10, 10
The numbers in the matrix represent profit. The row player

has a dominant strategy of a low price (0 is better than -10 and
50 is better than 10) and the column player has a dominant
strategy of a low price as well (similar numbers). And, low
low is a Nash equilibrium.
A dilemma that arises here is that both could be better off if

PGPSE NOTES 137137
they both went with a high price.
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Prisoner Dilemma Games
The game we just saw has the characteristic that has come to be
known as the prisoners’ dilemma. When the players act
separately (competitively) the outcome is worse than if they
cooperated.
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Don’t be taken advantage of
In the pricing example each might be tempted to get together and
both charge the high price and both do better than the low price
strategy. The problem of the high, high solution is that it is not a
Nash equilibrium and thus each would have the incentive to change
to the low price strategy. Your stockholders would not want you to
be taken advantage of by a double crosser. Don’t collude here, for
it is not likely to pay off. Let’s see why.
Say you are the row player and you agree (illegally) to set prices
high with the column player. After you finish the meeting you will
note 1) if you as the row player see the column stay at a high price
the it is better for you to have a low price (this is part of why high,
high is not a Nash equilibrium), and 2) perhaps more importantly
you will note the column player also has the incentive to switch to
low (this is the other part of high, high not being a Nash
equilibrium). So, if you stayPGPSE
at high you will look bad!
NOTES 139139
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Advertising Example
column player
ad no ad
Row ad 4, 4 20, 1
Player no ad 1, 20 10, 10
Profits are in the matrix. Each player has a dominant strategy

of advertise. This outcome is a Nash equilibrium.
A similar dilemma arises here as before. No ads would be

better but each does not want to get taken advantage of in this
situation. If you don’t have ads when the other does you
won’t be on the minds of PGPSE
the consumers
NOTES
and thus you will not
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Coordination example
column player
120 volt 90 volt
Row 120 volt 100, 100 0, 0
Player 90 volt 0, 0 100, 100
In this example say you have consumer appliance

manufacturers who have the choice between making the
appliances run on 120 or 90 volt plugs. If they both do not
use the same plug they will earn less profit because
consumers will have to spend on different plugs and thus
not be willing to spend as much on the appliances. The
game has two Nash equilibria – both doing the same plug.
The next question is how do NOTES
PGPSE they get the same plug? 141141
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Coordination Example
In this example, the firms need to figure out a way to get on
the same page. Agreements to coordinate may be looked at
negatively legally, so maybe companies lobby the
government to set the standard for a product.
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Hawks and Doves
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Tastes
In economics we largely take the tastes and
preferences of the consumer to be a given piece of
information. Within that context, the consumer
attempts to maximize utility also given prices and
income. We have spent some time thinking about
how the consumer changes their actions when
income or prices change. But we leave preferences
stable.
Biologists assume (I am told) an organism’s tastes

are forged by the pressure of natural selection to
help the organism solve important problems in their
environment.
PGPSE NOTES 144
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Strategic Preference
A strategic preference helps the individual solve
important problems of social interaction and the
usefulness of having the preference depends on the
fraction of the population who share them.
What we will look at next is a model of preference
formation. The example is taken from biology, but
put into the language of economics. Note how
there are basic assumptions and then conclusions
are reached.
On to the example of hawks and doves – a model of

the taste for aggressive behavior.
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The Model
Say people are all the same except for some are
hawks (have a strong preference for aggressive
behavior) and some are doves (prefer to avoid
aggressive behavior).
Whenever two individuals come into conflict over an

important resource (food, a mate, and so on) the
hawk’s strategy will be to always fight for it while
the dove’s strategy will be to never fight.
Remember economics is about using scare

resources. Hawks may kill doves and get the
resources, but hawks might kill each other for the
resource. Doves do not fight
PGPSE NOTESeach other, but share146
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The Model
Say a food unit has 12 calories.
When two doves meet close to a food unit they

share it and each gets 6 calories.
When a hawk and a dove meet close to a food unit

the dove defers and the hawk gets all 12 calories.
When two hawks meet close to a food unit there is a

battle. The winner gets the 12 calories and the
loser gets none. Also, each spends 10 calories in
the fight. So, the winner has a net gain of 2 calories
and the loser has a net gain of -10 (sometimes
called a lose). If overwww.afterschoool.tk
time
PGPSE a hawk wins half of the147
NOTES
The Model
The average payoffs can be put in tabular form as:
Individual Y
hawk dove
Individual X hawk -4 each 12 for X, 0 for
Y
dove 0 for X, 12 for Y 6 each.
So you can see, for example, if 2 doves meet each

will get 6 calories on average.
Say h is the proportion of the population that is

hawk and thus 1-h is the proportion that is dove.
Then a hawk would meet another hawk h of the
time and the payout would be -4 and would meet a148
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dove 1-h of the time and the payout would be 12
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The Model
Similarly, the dove would have an average payoff of
Pd = h(0) + (1-h)6.
Whenever we consider a value for h, if hawk has a

higher average payoff then hawks will flourish and
doves will diminish and h will grow. For example, if
h = .5,
Ph = .5(-4) + .5(12) = 4 and Pd = .5(0) + .5(6) = 3
and thus hawks will get most of the calories and
thus they will have larger families and that trait will
grow. But, if at an h doves have a higher average
payoff then their families will grow and h will fall.
For example, if h = .75,
Ph = .75(-4) + .25(12) =
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Pd = .75(0) + .25(6)
149
Conclusion
Now, if the average payoff is the same at an h that h
will remain and the family sizes will stabilize. We
find this h by setting Ph = Pd and solving for h. We
have
h(-4) + (1-h)(12) = h(0) + (1-h)(6) and solving for x
we get
-4h + 12 – 12h = 0 + 6 -6h, or
12 – 6 = 4h + 12h – 6h, or
h = 6/10, or .6
The average payoff is 2.4 for each.
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Income and substitution
effects
Here we want to explore some more of the detail of a price
change on the demand for a good. Here is the basic idea.
Say the price of x falls. When this happens we think two
things are at work: an income effect and a substitution effect.
The income effect: If initially we buy the same amount of x
as we purchased before, since x has a lower price we will
have more of our own income left and so it will feel like we
have more income. We saw when we have more income we
want more normal and less inferior goods. So, the income
effect of a price change means if the price is lowered we
could want more or less of the good.
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The substitution effect: The sub effect is an indication that as
the price of a good falls we want more of the good and we
use it in substitution for other goods.
In economics we like to show the income and substitution
effects in the diagram of consumer utility maximization.
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change in price - optimal point
y change
Say the consumer starts out at
x1, y1. If the price of x should
fall the budget line rotates out
in a counterclockwise fashion.
y1 The dashed line above x1 is
x similar to the one in the income
x1 change diagram. Except here
we do not think the consumer
will end up to the left of the dashed line when there is a
price decline.
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change
The reason we feel the consumer will not end up to the
left of the dashed line is twofold:
when the price falls
1) at the initial amount of x purchased the consumer
feels richer and we saw this may make them buy more
or less of x(income effect of a price change),
2) x becomes relatively cheaper and we feel people
move toward now relatively cheaper products and
away from now relatively more expensive
items(substitution effect of a price change).
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change
So, the income effect means more or less x given a
price decline, and the substitution effect means more x
given a price decline.
Now if the good is an inferior good
1) the income effect says less x
2) the substitution effect says more x.
The only way we could end up to the left of the dashed

line on the previous screen is if the income effect
operating with an inferior good is larger than the
substitution effect. Economists have felt this rarely, if
ever, happens – if PGPSE
so weNOTES
call it a Giffen good. 156
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income and substitution effect
y Focusing only on good x here, say we

start at point r. With a price decline in
x this consumer would end up at point
t. But I have also shown point s. Here
is how to think about this point: after
the price fall think about the consumer
losing enough income so that the initial
utility level could be obtained.
x
r s t
PGPSE NOTES 157
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The movement from r to s highlights the substitution
effect because the consumer had the income effect of the
price change taken away. The movement from s to t is
the income effect.
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The demand curve
P
From 2 screens ago we saw a price
decline had us move from point
P1 r to t. When we put this info into
a price, quantity graph we see the
P2 demand curve is downward
sloping.
x (usually we put Q)
Q1 Q2
(r t)
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The demand curve
You and I already knew the demand curve was

downward sloping, but now we also know it is
because we think substitution effects outweigh income
effects. Plus we know at each point along the demand
curve the consumer is maximizing their utility given
the situation they find themselves in.
We also know now that at lower prices the consumer
reaches a higher level of satisfaction. This was not
always obvious along just the demand curve.
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start at point r. With a price increase in
r to s sub is how to think about this point: after
effect the price increase think about the
s to t consumer getting enough income so
income that the initial
effect utility level could be obtained.
x
t s r
PGPSE NOTES 161
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To highlight the income and substitution effects of a price
change we put in an intermediate point. Essentially what
we did was say after the price change let’s show a
hypothetical change in income to get the consumer back to
the original indifference curve that they started with.
(Lower price, take income away, higher price, give income
back.)
The movement along the original indifference curve is then
the substitution effect. Then take the income change back
out to see the income effect.
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Impact of Change in Income
Here we want to consider the

change consumers will make if
they experience a change in
income.
change in income.
Note that the budget line is a summary of the baskets of
goods that a consumer can buy. The consumer
ultimately picks the basket that is able to be purchased
and gives the individual the most satisfaction or
happiness.
For the next few slides let’s just think about the budget
line and not about consumer utility maximization.
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change in income - budget
y
change
Remember on the budget
line we are measuring the
amount of x and y the
y1 consumer can buy given
their income and given the
x fact that prices must be paid.
x1
I have illustrated one basket the consumer can buy. With
the price of x = Px and the price of y = Py the consumer
here could buy x1, y1.
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y change
There are many ways to
y2 think about how the budget
line would change given an
y1 income change, but one way
to think about it would be to
x pick a given amount of x, say
x1 x1. Before the income
change say that once x1 is bought that leaves only y1 of y.
Now if there is an income increase, after x1 is bought
that would leave more money to spend on y and thus y2
could be bought (I just say could – it may not be bought).
PGPSE NOTES 166
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change
From the previous screen we can see more y can be
bought if there is more income available, but how much
more depends on the prices of x and y and it depends on
the income change.
But, as income rises more y can be bought, given an

amount of x is bought. Thus the budget line shifts out in
a parallel fashion if income grows and by a similar logic
shifts in parallel if there is an income decline.
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change in income - optimal
point change
Now that we know how the budget changes given an
income change, let’s see how the consumer optimum
changes(given that taste and preferences do not
change).
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y point change
point a - x1, y1 gives
maximum satisfaction. Note I
have extended a line above
y1 point x1.
a
Now with more income the
x budget line shifts out. The
x1 consumer will end up either
to the right or the left of the dashed line. If the consumer
ends up to the right, more x is wanted with more income.
If the consumer ends up to the left of the dashed line
then less x is wanted when more income is obtained.
PGPSE NOTES 169
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point change
A normal good is one where that as the consumer gets
more income more of the product is demanded (or less
income means less of the good is demanded).
An inferior good is one where as the consumer gets

more income less of the product is demanded (or less
income means more of the good is demanded).
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y point change
It just so happens here that
when income went up the
consumer moves to a point
where there is more x than
y1 before. This is the case of a
a
normal good.
x
x1
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y point change
It just so happens here that
when income went up the
consumer moves to a point
where there is less x than
y1 before. This is the case of an
a
inferior good.
x
x1
Example: When you think of music CD’s are probably normal
and cassettes are probably inferior.
In general we are not sure if goods are normal or inferior until we
do a study. Here we show what happens in each case.
PGPSE NOTES 172
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y
Income consumption path
y1
a
x
x1 x2
When we look at several consumer optimum points at various
levels of income and then trace out the points with a line we
get the income consumption path. Here both goods are
normal goods. Would the income consumption path be
downward sloping if only one of the goods were inferior?
PGPSE NOTES 173
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y
Engel curve - normal good
income
I2
y1 I1
a
x x
x1 x2 x1 x2
In the right hand picture we can see an income increase
and from the left graph we take the new x, x2, and draw
it in with the new income level. The Engel curve for a
normal good is upward sloping. What about for an
inferior good?
PGPSE NOTES 174
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Budget Today or
Tomorrow
Here we study the

properties of the budget
line in the context of
consumption over time.
PGPSE NOTES 175175
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Budget Line
In the context of consumption today or consumption

tomorrow, the budget line is a bit different than in the typical
consumer behavior model.
One difference is we have consumption today (C1) on the
horizontal axis and consumption tomorrow (C2) on the vertical
axis. Another difference is the presence of an “endowment”
point. It is assumed the consumer has an initial set amount of
possible consumption today and a set amount of consumption
next period and these come from income each period, called
M1 and M2. The budget line must go through the endowment
point, but borrowing or lending (saving) can move the
consumer away from the endowment.
PGPSE NOTES 176176
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Budget Line
C tomorrow
C2
paid
back + Endowment
interest point (M1, M2)
Pay
back +
interest
C today
Lend today Borrow C1
PGPSE NOTES 177177
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Budget Line
On the previous screen the endowment point shows what the

person can have in each period.
If the person borrows - takes more today than the endowment
- then next period 1 + r must be paid back for every 1 taken
today.
If the person lends - gives some of today’s consumption up -
then next period 1 + r is received for every 1 given up today.
The slope of the budget is –(1 + r), or 1+ r in absolute value.
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Change in the interest rate
The original line has a lower

C tom. interest rate because when
New
borrowing occurs less is given
back next period, or if lending
occurs less is paid back. So, the
higher the interest rate the
steeper the curve through the
endowment point.
original
C today
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Example The endowment point here
means the income is 50000
today and 60000 tomorrow
C tomorrow (Next year). Say the interest
rate is 20%
Vertical
paid intercept.
back + Endowment
interest point (50000,
Pay 60000)
back +
interest
C today
Lend today Borrow
PGPSE NOTES
today Horizontal intercept
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Example continued
The vertical intercept means you consume nothing today and

everything next period. The 50000 this period will earn
interest and thus the total will be 50000(1.2) + 60000=120000.
The horizontal intercept means you spent all you current
income and as much as you can borrow and use next years
income to pay it off. This would be 50000 +(60000/1.2) =
100000. This horizontal intercept is the present value of
lifetime income.
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Example continued
When the interest rate is 20% and the endowment point is

(50000, 60000) the budget line can be thought of in math
form in the following ways:
1) In terms of the future C2 + 1.2C1 = 120000,
2) In terms of the present C1 + (C2/1.2) = 100000, or
3) As we do in the graph C2 = 120000 – 1.2C1.
The slope is -1.2 and means if you spend $1 today you give
up the ability to consume $1.20 next year.
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Equation for budget line
When we have endowments M1 and M2 and interest rate r
the equation for C2 and C1 is
C2 = M2 + M1(1 + r) – (1 + r)C1.
Thus,
1) If C1 = 0, C2 = M2 + M1(1 + r). This is the vertical
intercept.
2) If C2 = 0, 0 = M2 + M1(1 + r) – (1 + r)C1, or
C1 = M1 + M2[1/(1 + r)]. This is the horizontal intercept and
is called the present value of lifetime income.
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Indifference
Curves
Here we study indifference

curves in the context of
consumption over time.
PGPSE NOTES 184184
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Indifference Curves
Indifference curves in this context are basically the same as

we saw in the past. The curves slope downward, do not
cross, fill the graph (although we do not always draw many in
a graph), and are convex (meaning they get flatter as you
move down the curve.)
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Present or Future Oriented
C tom.
C today
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Present or Future Oriented
On the previous screen we have a curve for two separate
people. Each one gives up a unit of C today.
The flat curve person does not need much C tomorrow back in
return for the C today given up. This type of person is
tomorrow oriented or patient.
The steep curve person needs more C tomorrow (relative to
flat curve) in return for the C today given up. This type of
person is today oriented or impatient.
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Marginal rate of time preference
(MRTP)
The absolute value of the slope of an indifference curve at a
point is called the MRTP. The slope is change in C2 divided
by the change in C1.
If the MRTP > 1 the consumer has a positive time preference
meaning when giving up 1 unit of C1 more than 1 unit of C2
must be given back to have the same utility.
If the MRTP < 1 the consumer has a negative time preference
meaning when giving up 1 unit of C1 less than 1 unit of C2
must be given back to have the same utility.
If the MRTP =1 1 the consumer has a neutral time preference
meaning when givingPGPSE
up 1 NOTES
unit of C1 1 unit of C2 must be188188
given back to have the same utility.
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Equilibrium
Given an interest rate, we

see here the point
consumers end up at in
order to maximize their
PGPSE NOTES 189189
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A borrower
Notice at the
C tom. Endowment point endowment the
consumer’s
indifference curve
goes through the
budget steeper then
the budget- they are
willing to pay back
more than they have
to, so they borrow
C today today and become
happier than at the
PGPSE NOTES endowment. 190190
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A lender
Notice at the
C tom. endowment the
Endowment point consumer’s
indifference curve
goes through the
budget flatter than
the budget - They get
more in the future
than they require to
have the same utility
so they lend today
C today and are happier
PGPSE NOTES doing so. 191191
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Note
Both the lender and the borrower at the point of equilibrium
have the MRTP = 1+the interest rate and this is greater than
1. This means that both borrowers and lenders have positive
time preferences in equilibrium. Again, this means when
giving up 1 unit of C1 more than 1 unit of C2 must be given
back to have the same utility.
Also note that with a given interest rate some people are
lenders and some borrowers based on their preferences. Later
on we show how folks might change from being a lender to a
borrower, and vice versa, depending on changes in the
interest rate.
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Changes in
Equilibrium
Here we study how the

consumer position changes
given changes in the
interest rate.
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C tom.
Endowment point n
m
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We have seen in the past that as the interest rate falls the
budget line becomes flatter. At the highest interest rate in the
example on the previous screen, we see the individual go to
point l (and is actually a lender.) This point has a certain
amount of C today involved (as well as a certain of C tom.)
As the interest rate falls the consumer moves to point m and
then point n. So the amount of current consumption rises as
the interest rate falls.
The point here is that the demand for current consumption is a
function of the interest rate. In fact, we say as the interest rate
falls the quantity demanded for current consumption rises.
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This is the demand for

r current consumption
curve and is derived
from the graph two
l slides before this one.
m
n
C
today
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Permanent income hypothesis
Let’s consider an example where your income will 1000 in each
of two years and the interest rate will be 25%.
C2 = M2 + M1(1+r) – (1+r)C1.
a. Suppose that you save all of your money to spend next year.
How much will you be able to spend next year? This is the
same as asking on the budget what is C2 when C1 = 0? C2
would be 1000 + 1000(1.25) = 2250.
How much will you be able to spend today is like what is C1 if

C2 = 0. C1 would be 1000 + (1000/1.25) = 1800.
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b. Suppose you borrow $800 and spend $1800 today. How
much will you be able to spend next year? If C1 = 1800, C2 =
1000 + 1000(1.25) – 1800(1.25) = 0.
c. The graph is on the next slide with C1 on the horizontal and
C2 on the vertical axis. Note the vertical intercept is (0, 2250),
the horizontal intercept is (1800, 0) and the endowment point
is (1000, 1000)
The slope = (2250-0)/(0-1800) = -1.25, so the slope shows that
the price of spending $1 today means you can not spend $1.25
next year.
Note if C1= M1, then C2 = M2, and vice versa. This means
the person can have their endowment point and neither borrow
or lend.
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c2
(0, 2250)
(1000, 1000)
(1800, 0)
c1
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Say you find $400 in your desk
drawer. Your endowment today
c2 becomes 1400. How does the
budget shift?
(0, 2750) Note the new intercepts and
endowment point.
(0, 2250)
(1400, 1000)
(1000, 1000)
(2200, 0)
(1800, 0)
c1
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Say you will get $500 more in pay
next year but this year you only
c2 have 1000. Your endowment next
year becomes 1500. How does
the budget shift?
(0, 2750)
Note the new intercepts and
(0, 2250) endowment point.
The budget shifts just like in the
(1000, 1500) previous example.
(1400, 1000)
(1000, 1000)
(2200, 0)
(1800, 0)
c1
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Now say the person has
endowment 1000 and 1000
c2 initially. They consume at point A.
(0, 2750) If C1 and C2 are normal goods,
then if the endowment in period 1
rises to 400, or the endowment in
(0, 2250) period 2 rises to 500, the
individual will end up here.
A
(1400, 1000)
(1000, 1000)
(2200, 0)
(1800, 0)
c1
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In this example we see if income in period 1 goes up 40%
consumption in period 1 is not likely to go up 40%. Some
of the increase is spread out into the next year.
Similarly, if income next period goes up 50% (Say you
expect to graduate and make more money) your
consumption in period 2 is not likely to go up 50%.
Permanent income is the present value of our lifetime
income and we saw this has the horizontal intercept.
Given our preferences, permanent income is what
determines our consumption pattern. Another way to say
this is that our consumption pattern over time is influenced
not only by the income in he period in which we consume,
but by the income in every period.
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The Behavior of Consumers
Here we study an elementary view of the
economic approach to how consumers go
about spending their money – you could say
this is a model of how consumers confront the
basic economic problem.
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Consumers of goods and services face the incredible task of having to decide
how much to buy, if any, of literally thousands of items in the marketplace. In
economics we say the goal of the consumer is to maximize the utility they can
get from the goods and services that are available.
Utility here means the happiness or satisfaction that goods and services provide
for the consumer.
Let’s work with an example where there is only two goods consumers can buy –
let’s pick steak and potatoes (I pick two goods to make the example relatively
easy to work with, but others have studied this stuff and have shown the things I
point out apply when there are tons of goods and services to choose from).
Now, let’s look at something called the budget line or constraint of the
consumer. Say a consumer has $10 to spend and say a pound of steak costs
$1 and a pound of potatoes costs $1 (I made up the numbers to just get us
started – but we usually only have a certain amount to spend and we have to
pay prices for the goods and services we buy).
Can the consumer buy 20 pounds of steak? Not right now. The $10 of income
and the price of $1 per pound constrains the individual to only a maximum of 10
pounds of steak – and in this case no potatoes could be purchased if all is spent
on steak.
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Pounds of Steak Pounds of Potatoes
Each line in this table
10 0 represents a combination of
9 1 steak and potatoes the
8 2 consumer can buy. How did I
7 3 get these numbers?
6 4
Well, the amount spent on
5 5
steak plus the amount spent on
4 6
potatoes should add up to $10.
3 7
So we really have the equation
2 8
1 9 $10 = amount spent on steak +
0 10 amount spent on potatoes.
On the next screen let’s put the information into a graph. The graph will have the
quantity of steak on the horizontal axis and the amount of potatoes on the
vertical axis. Each line in the table is represented by a point in the graph.
Note the amount spent on good X is the price of X times the quantity of X taken.
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Note: From the table on the
Consumption Possibilities previous screen, the first row of
the table is the point on the
bottom right of the table.
12
10 0, 10
1, 9
8 2, 8
3, 7
6 4, 6
Pounds of Potatoes
5, 5
4 6, 4
7, 3 Then as we go down the table
2 8, 2
9, 1 we move up the line in the
0 10, 0 graph.
0 2 4 6 8 10 12
Pounds of Steak
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The economic approach to consumer behavior is based on the idea that a
consumer can evaluate how much they like each combination of goods.
Here is a way to see which basket the consumer will choose to maximize utility
given that they have $10 and each good costs $1 per unit. Start at the bottom
right basket – 10 steaks and 0 potatoes (to save on typing we assume each steak
and each potato is a pound.)
Now, the individual is getting utility from steak only at the first point. Think about
moving to point (9, 1). If the consumer moves from (10, 0) to (9,1) the consumer
will lose 1 steak, but gain 1 potato.
With this move there is
1) A loss in utility from the 1 steak that is given up,
2) A gain in utility from the 1 potato gained.
If the gain is greater than the loss, then the consumer will make the move from
(10, 0) to (9, 1). The same type of movement will be investigated between (9, 1)
and (8, 2). Move to the point (8, 2) if the second potato adds more utility than the
loss in utility from giving up the 9th steak.
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Digress: true story – my daughter JoAnn and her buddy Meg were playing one
day and I heard Meg say she liked horses more than JoAnn liked horses. Have
you every heard kids say this type of stuff? Well, anyway, in economics we
think it is hard to compare how much two different people like certain items.
BUT, we think it is very natural for a single person to compare how much they
like, or how much utility they get, from different types of items like steak and
potatoes.
Another component to our story about consumer behavior:
Notice when the consumer starts in the bottom right of the table there is a set of
10 steaks and no potatoes. We have to have a time frame in mind, so let’s say
it is a week of time. If you are like me, you like steak, but does each pound give
the same utility in a certain amount of time?
In economics we think that the more units of an item you have in a certain
amount of time the happier you probably are, but the additional units add less
and less happiness for you. The marginal utility (the utility added by another
unit) of each unit is said to diminish.
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Let’s add the concept of marginal utility to the steak and potatoes example:
Say you think about buying 10 steaks and 0 potatoes. Now compare this to 9
steaks and 1 potato. The 10th steak would have relatively low utility as far as
steak goes, because diminishing returns would have set in, and the first potato
would have relatively high utility as far as potatoes go. So, for many of us we
would take the first potato and give up the 10th steak. But maybe not every one
would. Some might just take 10 steaks and no potatoes.
Now, if a person didn’t take the first potato they are done (stick a fork in them
). They have maximized utility at (10, 0). So, when the price of steak is $1
(and when the consumer has $10 and the price of potatoes is $1) the quantity
demanded from some people will be 10 units.
Other people will move up the line in the graph because some units of potatoes
add more utility than the utility lost by having less steak. I can not predict where
any one person will end up, unless I know more about that person. But we
think each person knows where they will end up. (where does the
vegetabletarian - a person who eats only vegetables like potatoes -  end up?)
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In steak and potatoes example I had before, the price of each good was $1 and
the person had $10 to spend. Different people will have a different amount to
spend, but will always follow the same basic method as presented here
(remember this is the economic view.) The interesting thing is that although
people have different incomes (money to spend), they can face the same prices
when they shop in the same stores. When the price of each good is $1, taking
1 potato requires the person to give up 1 steak. Comparisons of the utilities
involved can take place for each person and each person can maximize their
own utility.
So, let’s say we have three people and when the price of steak is $1 we see the
demand from each of the three as
Sally – 4 pounds, Sammy – 6 pounds and Billy – 7 pounds.
The next thing we want to explore is what happens to the amount folks want
when the price of a good changes. Let’s explore a price decline to 50 cents per
pound of steak. Let’s go back to our graph, which was created with the
consumer having income of $10. Plus we will say half pounds of potatoes can
be purchased.
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Note here when the price of
Consumption Possibilities steak fell we get a new budget
line. The same maximum
amount of potatoes can be
12 bought, but now 20 steaks can
be purchased if all the money is
10
spent on steaks.
8
Pounds of Potatoes
6
4
2 When the individual gives up a
steak only half a potato can be
0 purchased. But here the same
0 5 10 15 20 25 type of comparison would
happen as before. In other
Pounds of Steak words, the 20th steak would be
given up if the utility of the first
half of potato is bigger than the
utility of the 20th steak.
PGPSE NOTES 212
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At this point in our study I hope you can accept on faith that in economics we
get the feeling that as the price of something falls people want a greater
quantity of it.
Before, when the price of steak is $1 we saw the demand from each of the
three people as
Sally – 4, Sammy – 6 and Billy – 7. So when the price is 50 cents, the demand
might be
Sally – 5, Sammy – 7 and Billy – 8.
Know, I have asked you to accept on faith that as the price of something falls a
greater quantity is demanded. Some ideas called the income effect of a price
change and the substitution effect of a price change provide some of the
reasoning for what I asked you to accept on faith.
Let’s think about a price decline. The logic behind the income effect of a price
decline is that if you buy the same amount of the good after the price decline as
you did before the price decline then you will have more money left in your
pocket. The price decline would make it seem like you got a raise in income –
hence why I wrote an income effect. Now, in the real world we might buy more
of a good if our income rises, but maybe we will buy less. It depends on the
good.
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An inferior good is one that as we get more income we want less of the good. Do
you have a good like this for you? What about cassette tapes for music? Have
you desired less when you have gotten more income? Or what about white
bread? Have you desired more of the other kinds and less white bread the more
income you have obtained? If so, these goods are inferior for you.
A normal good is one where as you get more income you want more of the good.
Maybe CD’s for music and rye bread are normal for you.
Review something: Before I mentioned that as the price of good falls I want you
to accept on faith that the amount people want will increase. Now the income
effect of a price decline says the amount will increase if the good is normal but
will decline if the good is inferior. What is the deal on the inferior good? Well I
need to mention the substitution effect.
It is thought that as the price of a good falls we will want more of it and use it as a
substitute for other things. As an example of this, as the price of gas falls we will
buy more gas to drive around instead of walking of riding our bike. (To walk or
ride your bike you need energy that comes from food, so the gas can substitute
for the food, the cheaper the gas.) So the substitution effect always says take
more when the price falls.
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Finalize our thoughts here:
Inferior good  price falls would mean the income effect says take less of
the good but the substitution effect says take more of the good. From
experience, economists have said the substitution effect is larger than the
income effect and thus when the price of a good falls people want more of it.
Normal good  price falls would mean both the income and substitution
effects say take more of the good.
On the next screen I show a typical demand curve for one person (like Sally
from before) in a graph. The curve is really the result of the individual
maximizing utility and when the price of something falls a greater amount is
desired due to the relationships known as the income and substitution
effects.
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$ - here
measuring
Price per unit
of steak
0.50
Quantity of steak
4 5
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All Else Equal
You may have noticed we tell stories in economics. Like I just told a story about
when the price of a good falls from $1 per unit to $0.50 (fity cent) most folks
demand a greater quantity of the item. As I told the story I implicitly assumed
only the price changed form $1 to $0.50. All else was assumed the same. This
means the person likes the good the same at either price and the consumer has
the same income at either price.
If a person should change how much they like a good or if their income changes
then we tell another story (just not now – maybe later).
Think back to the example developed here. When the person only had $10 to
spend and each good costs $1 per unit we can conclude, given all else is equal,
1) The consumer was limited to buying one combination of steak and potatoes in
the table, and
2) If the consumer wanted more of one good while moving along the line, then
less of the other good could be obtained.
These two conclusions are the result of scarcity that the consumer faces. We
PGPSE NOTES 217
sketch out a method the consumer might use to
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Monopoly
Here we see what a monopoly is

and its revenue potential.
Overview
Monopoly means one seller.
In perfect competition many sellers were price takers. Any

one seller could not influence the price of the product in the
market. The competitive firm could only choose what
amount to sell.
A monopoly firm will have to determine both how much to

sell and at what price. Let’s look at these ideas a little more
on the following few slides.
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p
Review
Market Q
In a market, consumers as a group are thought to want
to buy a greater quantity the lower the price. We see
this as a downward sloping demand curve.
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p $
Review
S
p* P=MR=D
D
Market Q Firm Q
In a competitive market, the market demand from consumers
interacts with market supply from many sellers and we get an
equilibrium price, like p* in the graph. At this point, since any
one firm is a small part of the market, when we look at a firm
it is a price taker. Thus, when the firm thinks about selling
another unit it can sell that unit at the same price as the
previous unit and thus MR = P for a competitive firm.
PGPSE NOTES 221
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Analogy: To think about the marginal revenue for a competitive
firm I like to think about a pop machine. Say the price of a pop is
$1.25.
Say the machine has been refilled and the pops are not chilled to
perfection and you are the first one to make a purchase. What is
the total revenue in the machine after you make your purchase?
$1.25! Since the total revenue was zero before you bought, the
change in total revenue from the sale of another unit (in this case
the first one), was $1.25. This is exactly what we mean by
marginal revenue. Marginal revenue is the change in total revenue
from changing output by 1 unit.
Now say I buy a pop right after you. The total revenue in the
machine is 1.25(2) = 2.50 and the marginal revenue is 1.25.
SO, MR = P for a competitive firm.
PGPSE NOTES 222
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Monopoly
For a monopoly firm the demand is the same as the
market demand we see in competition. The demand is
downward sloping to the right, what is called less than
perfectly elastic.
Since the monopolist is the only seller, it is natural they

face the market demand curve.
The situation of monopoly is often called imperfect

competition.
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Sources of monopoly
1) Exclusive control of an input – deBeers is an example
2) Economies of scale – the case of a natural monopoly. The idea
here is that AC can be pushed really low by one firm and it then
makes sense for only one firm to serve the market.
3) Patents – protecting inventions for a time may give monopoly
power.
4) Network economies – Microsoft Windows is an example of the
idea – once enough people use a product sometimes using another
type of product becomes less functional.
5) Granted by government
PGPSE NOTES 224
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Maximize profit
Since the monopolist is the only seller in the market,
the monopolist must decide 1) what price to charge and
2) how much to sell.
When the monopolist sells, she is worried about profit.

The goal is to maximize profit. But, in order to maximize
profit, the pattern of revenues and costs at various output
levels must be understood. The pattern of cost was the
topic of an earlier section. Now we look at the pattern of
revenue.
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p
Monopoly
6
5
D
2 3 Market Q
Here the monopoly is the only firm in the market. When
the price is 6, in this example the consumers want 2
units. Total revenue would be 12. But, this firm, if it
wants to sell 3 units has to lower the price on all units to
5. The competitive firm didn’t have to worry about
another price like the monopoly firm.
PGPSE NOTES 226
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Monopoly – marginal revenue
So, because the way consumers are in this example on the
previous screen, when P = 6, 2 units will be sold and
when the P = 5, 3 units will be sold. Total revenue would
move from 12 to 15 when the quantity moves from 2 to 3.
So, the additional revenue from the 3rd unit is $3. This is
the marginal revenue of the 3rd unit.
Note, the price to get the third unit sold is $5, but the
marginal revenue is only $3.
SO, P>MR at a quantity.
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Interpretation
When the price is lowered from 6 to 5 the amount sold
rises. In fact, the 3rd unit sold brings in 5 in revenue.
But this isn’t all we need to look at to have MR. Since the
monopolist must sell to all consumers at the same price,
the first 2 units now get sold at 5 as well. That means
revenue on those 2 units will not include $6 per unit
when the price is lowered.
Continuing with the example,
MR(of the 3rd unit) = 5 - (6-5) 2

=3
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P
interpretation
6 area c is the gain in
revenue from selling
a
more
5 b area a is the loss in
c
Q at a lower price.
2 3
Area a + b = 6 times 2= 12 = TR when P = 6
Area b + c = 5 times 3 = 15 = TR when P = 5
MR = c - a = 5 - 2 = 3
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Let’s do another example
P Q
5 0 Say this is the demand from
4 1 consumers in the market. If the
3 2 price is 5 consumers want nothing,
2 3 for instance. Let’s put TR on the
1 4 next slide.
0 5
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P Q TR
5 0 0 Total revenue is just P times
4 1 4 Q, so you should check what
3 2 6 I have here.
2 3 6 Next let’s add MR to the
1 4 4 table.
0 5 0
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P Q TR MR
5 0 0 ---- MR, marginal revenue, is
4 1 4 4 the change in TR when we
3 2 6 2 add a unit of output. Note at
2 3 6 0 Q = 0 I have the line ---
1 4 4 -2 because we have not had a
0 5 0 -4 change yet.
The MR = 4 for a Q = 1 because TR went from 0 to 4 when Q

went from 0 to 4. The MR = 2 for Q = 2 because TR went from 4
to 6 when Q went from 1 to 2.
Note: MR can become negative, in theory. Also note that P >
MR at each Q (except Q = 1, but we usually ignore this.)
PGPSE NOTES 232
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MR from areas to height
P
In the above diagram we think of
MR as area c - a and we get a
a
number.
In the bottom graph we
b c D
Q can think of the number
P as a height. Note still the
MR is lower than the price
on the demand curve.
height = MR
D On the next screen we
Q will see the whole MR
curve.
PGPSE NOTES 233
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$ Monopoly MR in a graph
I do not have a proof
for you, but you can
5 see in this diagram
that MR is also a
3 straight line that starts
at the same place as
D demand in the upper
left, but is always
below demand because
Q P>MR. Like at Q = 3,
3 MR = 3 and P = 5.
Note that a good way to draw in MR is to first draw

demand and then put MR through the Q axis halfway out
to the demand curve. I put an X at that point.
PGPSE NOTES 234
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Monopoly Pricing and Output
We study the pricing and output

decision of the monopoly firm.
Price and output decision for the
monopolist in the short run
The amount of output the monopolist should sell in the
short run is the amount where MR = MC(as long as
P>AVC), just as in the case of the competitive firm.
The price charged would then be the price on the

demand curve above the quantity where MR = MC.
(recall P = MR for firms in comp, but P>MR for the

monopolpy firm.)
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Logic of MR = MC rule
$
MC The Q = b is the Q where
MR = MC. But look at Q = a. At
that point, Q could be increased
D
and more would be added to
revenue than to cost and thus
Q profit would rise. We know this
a b c because the MR > MC for these
Q (Compare the heights of the
MR curves).
Now let’s look at a Q greater than where MR = MC,
like at point c. More has been added to cost than to
revenue and thus profit would fall. We know this
because MC > MR at this Q.
PGPSE NOTES 237
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$
What price?
MC
At Q*, where MR =
MC, P* is the price
on the demand curve
P*
consumers are
willing to pay for Q*
D and thus this is the
price charged by the
monopolist.
Q
Q*
MR
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Qualification
ATC =
$ .12
ATC Note that the ATC
AVC1 MC
is above the demand
=.11 curve, so the firm
AVC1
will lose money. In
P*= .10 AVC2 the short run, the
question is whether
AVC2 D the firm should
= .08 shutdown or
continue to operate.
20
MR Let’s go to the next
screen and say more
about this.
PGPSE NOTES 239
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continue
Note that the Q where MR = MC = 20. So, if the firm
operates at all it should make 20.
Note at Q = 20, the price on the demand curve is .10

but the ATC = .12
Now, remember ATC = TC/Q so ATC times Q = TC.
TR = P Q = .1(20) = 2
TC = ATC Q = .12(20) = 2.4
Profit = TR – TC = 2 – 2.4 = - .4
Or
Profit = (P – ATC)Q = (1 - .12)20 = -.4 The firm is
losing money.
PGPSE NOTES 240
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continue 2
If the AVC curve is AVC2 for the firm then at Q = 20 the AVC =
.08. This means the TVC = AVC Q = .08(20) = 1.6.
Thus the TR = 2 can cover the 1.6 of TVC and what is left of TR,
.4 can go to paying some of the total fixed costs. If the firm shuts
down it would have nothing going to fixed cost. So the firm should
operate.
Thus, operate if at the Q where MR = MC the P > AVC.
Note if the AVC is AVC 1 = .11 the P < AVC. The firm should
shut down. TR of 2 falls short of TVC of 2.2 and covers none of
fixed while if the firm shuts down it only has to cover the fixed
cost.
PGPSE NOTES 241
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Quiz
$
1 – not a real quiz
MC
Is this monopoly firm
earning a profit? If so,
ATC draw in the graph the
P*
rectangle that
represents the profit.
D
Q*
MR
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Quiz
$
2 not a real quiz
MC ATC Is it possible for a
monopoly to lose
AVC money?
P*
Indicate in the graph
how much this
D monopoly is losing by
indicating the loss
rectangle.
Q*
MR
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Is a monopoly guaranteed a
profit. I have a monopoly – I
make a pizza fork (not really,
but listen up). Look at the
palm of your right hand,
Thumb thumb up. When you wrap
your hand around the fork
your thumb is next to a
Palm of
button on the fork (sorry,
hand
only right handed version.).
When you press the button
A razor blade edge comes out here and you move your hand so your
thumb is now pointing left and you cut your pizza real easily.
The demand for my item is much lower than where my costs are.
PGPSE NOTES 244
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Can Monopolies charge whatever price they want? The answer
is yes, but with a qualification.
Remember consumers have a demand for the product and have
prices they are willing to pay. As long as the monopoly is
charging a price the consumers are willing to pay then they can
charge whatever they like. But if the monopoly charges too high
a price consumers will not buy at all.
OUR ECONOMIC RULE – sell Q where MR = MC, charge the
price on the demand curve above this Q (So charge whatever you
want but to profit max charge this one) and both of these ideas
are dependent on the P>AVC at this Q.
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The monopoly solution and
elasticity
Without proof I tell you that with a given demand curve and MR
curve for the monopoly, we have
MR = P (1 – F), where F = 1/absolute value of elasticity of demand.
Recall that elasticity of demand changes as we move down the
demand curve (in absolute value the number gets smaller).
Monopoly mark-up
We see the monopoly has P > MC at its profit maximizing level of
output. So the mark-up of P over MC as a percentage of the price is
(P – MC)/P.
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Mark-up and elasticity
The mark-up again is (P – MC)/P.
The profit maximization condition was MR = MC.
The MR, elasticity connection was MR = P(1 – F) = P - PF.
SO, the mark-up can be changed to
(P – MC)/P = (P – MR)/P = (P –(P – PF))/P = (P – P + PF)/P
= PF/P = 1/absolute value of elasticity of demand.
The monopoly mark-up is a function of the elasticity of demand.
Note that since we have absolute value of elasticity, the mark-up
is a positive number, and since P>MC, 1/abs <1, or abs>1. This
means the elasticity of demand will be in the elastic range for a
PGPSE NOTES 247
monopoly. www.afterschoool.tk
Compare Monopoly to
Competition
Compare monopoly with
competition
The main results here are the ideas that
----1) a monopoly firm will charge a higher price than
would occur in competition and
----2) a monopoly will sell less output than would occur
in competition.
There seems to be a notion in the world that monopolies

will charge us outrageous prices. Economics does not
settle this claim, but the science of Economics does tell
us that we get higher prices than in competition. But,
there are some willing to pay the higher price.
PGPSE NOTES 249
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P
Pc
Q
Qc
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On the previous slide we have the competitive market.
Note the demand is coming from many consumers in the
market. The demand from each person is essentially the
marginal benefit curve of each person.
Note the supply is coming from many suppliers. The
supply from each firm is basically the marginal cost curve
(that part above AVC).
Because there are so many players in the market, none has
an influence on price, so the “market” determines the price
and each buyer and seller takes the price.
Now, if the industry is monopolized, one seller would meet
all the consumers. Thus, the monopolist would see a MR
curve and treat S as a MC curve.
PGPSE NOTES 251
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If you focus your eyes on
Comparison
$ continued
the point where S = D you
S = MC see the competitive point
Pm with Pc and Qc. If you
Pc focus on the point where
MR = MC you see the
D monopoly point with Qm
and Pm (Note Pm is on
Q demand curve above
Qm Qc where MR and MC cross.).
Assume that a monopolist
comes in and buys up all
MR the firms. It then operates
where MR=MC and charges the price on the demand curve
at that Q.
PGPSE NOTES 252
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P
The graph
reproduced
a b
Pm
c d e
Pc
f g h
Q
Qm Qc
PGPSE NOTES 253
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Referring to the previous slide:
comp monop
con surp abcde ab
Prod surp fgh cdfg
So, consumers lose surplus of b, c, and e due to monopoly.
Producers gain c and d from the consumers, but lose h.
Overall, there is a deadweight loss of e and h. This loss is
a major reason why we have laws against monopoly. The
Sherman Act of 1890 is the first law in US to be against
monopoly. We have had revisions since, but basically this
law is the driving force.
PGPSE NOTES 254

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Problems of monopoly
The problems of monopoly are higher price and less output
than in competition. Moreover,
1) The higher price means those who still buy have
less money to spend on other things – c and d are surplus
areas that consumer used to have for other things but now
pays to monopoly.
2) Those who no longer buy must be worse off because

they get less than what they were at their liberty to
purchase under competition – area e represents the value of
lost output to the consumers and is part of the deadweight
loss of monopoly.
PGPSE NOTES 255

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The Competitive Firm in the
Long Run
Remember that the long run is that period of time in which all inputs to the
production process can be changed. Before, in a section on production and
cost we saw that the basic cost structure could be summarized in the following
graph. (Note, since all costs are variable the AC curve is really an AVC curve,
we just call it the AC curve.)
MC
AC
firm PGPSE NOTES 257

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The firm is still a price taker and P = D =MR = AR for the firm. The firm makes
the output level where MR = MC, as long as the P>AC. The amount of the
profit is calculated as (P – AC)times Q*, and the P and the AC are measured at
the Q* level.
MC
AC
Profit
rectangle
Q
Q*
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Here, where MR = MC, the P = AC so profit would be zero. Remember that
zero profit means that accounting profit is greater than zero if there are some
opportunity costs that are not explicit. Since at this price the firm breaks even
we say the price here is the break-even price. So when MR = MC if P = AC,
the price is called the break-even price.
Note when MC =
$ AC, AC is at its
lowest. Now at
MC break-even point, P
AC = MC and P = AC,
so MC = AC.
Q
Q*
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Here, where MR = MC, the P < AC so profit would be negative. Firms would be
better off exiting the industry.
$ The loss
MC
AC
Q
Q*
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The MC curve above the AC curve is the supply curve for the firm in the long
run. If the price line comes through at any point in this area the firm will have
positive profit and the quantity supplied will correspond with the amount on the
MC curve. If the price is any lower the firm will exit and make nothing.
MC
AC
Q
Q*
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Let’s look at an example next.
Quantity TC MC AC P Q TR TC Profit
1 10 2 10
2 15 5 7.5
3 21 6 7
4 28 7 7
5 37 9 7.40
6 48 11 8
Here is an example of Floyd’s Barbershop. Floyd operates in a
competitive environment. If he didn’t have a barbershop he
would make 8 bucks at a gas station. This cost has been
factored into his TC. So, really at Q=0 TC=8 at the
barbershop. MC = change in TC divided by change in Q,
while AC = TC/Q. PGPSE NOTES 262
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1 10 2 10 2 1
2 15 5 7.5
3 21 6 7
4 28 7 7
5 37 9 7.40
6 48 11 8
Here I have added a 2 under the P column and a 1 under the Q

column. The P and Q column is the supply curve. The supply
curve for a firm is the MC above the AC curve. But to draw
the MC curve we will follow the rule that firms produce where
P (=MR)=MC. Since the MC at Q = 1 is 2 the MC = 2 = P on
the supply curve. What is the P if Q=2? Can you fill in the
rest of these two columns? (sure you can!)
PGPSE NOTES 263
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1 10 2 10 2 1 2
2 15 5 7.5 5 2
3 21 6 7 6 3
4 28 7 7 7 4
5 37 9 7.40 9 5
6 48 11 8 11 6
Here I added the TR for the Q=1 by taking the P times Q. Can
you fill in the rest of table? (SURE you can, because, dang it,
you are good enough!)
PGPSE NOTES 264

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1 10 2 10 2 1 2 10 -8
2 15 5 7.5 5 2 10 15 -5
3 21 6 7 6 3 18 21 -3
4 28 7 7 7 4 28 28 0
5 37 9 7.40 9 5 45 37 8
6 48 11 8 11 6 66 48 18
Here I copied the TC and found profit as TR minus TC.
What have we done here? I HAVE NO IDEA!
No, really we looked at the graph on the next page.
PGPSE NOTES 265

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So, in the graph, when P = 2, MR = MC at Q=1 and profit is less than zero.
Firm really wouldn’t make this amount though, it would quit. So this part of the
MC curve is not the supply curve. Only the part above AC is the supply curve
Each row in the table can be put into this graph.
MC
AC
10 Profit=-8
2 P
Q
1
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Profits and losses
In a competitive industry it is felt the existence of profits at the
firm level will attract more firms into the industry.
This will increase supply and lower price in the market.
With a lower price firm level profit falls.
The existence of losses at the firm level will make some firms
leave the market.
This will decrease supply and raise market price.
The entry and exit of firms will stop when profit is zero. At that
point P = MC = AC.
PGPSE NOTES 267

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Competitive Industry in the
Long Run
The case of a constant cost
industry
In a constant cost industry it is assumed that
1) All firms are identical and thus all have the same identical cost
curves, and
2) Those cost curves do not change as the industry expands or
contracts (although the cost curves could change for other reasons).
The author points out that assumption 1 likely holds in industries
that do not require special skills. Fast food joints might fit the bill
here, while gourmet restaurants probably don’t.
Assumption 2 will hold in industries that are not large enough to
affect the price of any input. This means that as the number of
firms in the industry changes the price of inputs will stay the same
because the industry is not a relatively large user of the input –
other industries use the input as well.
PGPSE NOTES 269
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In competition it is assumed that in the long run any firm that
wants can enter or exit the industry. Furthermore,
If profit >0 for existing firms, more firms will enter,
If profit < 0 for existing firms, existing firms will exit, and
If profit = 0 there is no incentive for more firms to enter or
existing firms to exit.
PGPSE NOTES 270

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Useful diagram
P
D1 S1 ATC1 MC1
P1 P=MR1
Q q
Q1 q1
Market Firm
PGPSE NOTES 271
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Hey, check this out.
Produce the q where MR = MC and see what type of profit

exists by looking at (P - ATC) times Q or TR-TC at the q
mentioned.
Profit = TR – TC.
PQ = TR
ATC times Q = (TC/Q) times Q = TC
(P-ATC) times Q = PQ - (ATC times Q) = TR - TC
PGPSE NOTES 272

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Notes about diagram
Market
In the market the price is determined by the interaction
of supply and demand.
When you think about the supply curve, there are a
certain number of firms involved. You can think of this
as being the short run where the amount of capital is
fixed for each seller. In the short run, then, no new firms
can enter either because they can’t get more capital
either.
PGPSE NOTES 273

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increase demand
On the next screen you will see demand increase in the
market. Imagine consumers demand more. Then,
1) The price in the market will increase to P2,
2) The MR(price) for the firm will rise to MR2,
3) The output of the firm will expand to q2,
4) The firm will have profit given by the shaded
rectangle.
PGPSE NOTES 274

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increase demand
P D2
D1 S1 ATC1 MC1
P2 P2 = MR2
P1 P1=MR1
Q q
Q1 q1 q2
Market Firm
PGPSE NOTES 275
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demand increase
In the short run when the demand increases, existing
firms find it worthwhile to produce more, but they can
not expand the production facility, by definition, and
other firms can not enter the industry.
The profit that exists in the short run are enjoyed by the
firms in the industry. But in the long run other firms can
enter the industry, as well as have existing firms expand
their production facility. In the long run we want to note
1) what impact profit has on firms and
2) what happens to input prices.
PGPSE NOTES 276

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profit impact
In the long run positive economic profit attracts firms
to the industry. Firms will enter the industry until
profit is driven to zero.
The presence of economic losses(negative profits)
forces some firms to leave the market. Firms will exit
until the profit is zero.
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input prices
By definition in economics, resources are scarce. In the
context of increasing demand for output we want to think
about what might to the price of inputs. We consider
three cases.
1) Inputs are relatively abundant and thus there is no
increase in input prices as the demand for inputs
increases. This is called a constant cost industry.
2) Inputs are in relative short supply and thus there is an
increase in input prices as the demand for inputs
increases. This is called an increasing cost industry.
3) Inputs can be used in new ways and thus there is a
decrease in input prices. This is called a decreasing cost
industry.
PGPSE NOTES 278
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ideas to come
Now, if a firm has positive economic profit we will see
1) firms enter the market and thus market price falls, and
2) the firms cost curves may shift if input prices change.
This will have an impact on how much the supply curve
shifts.
PGPSE NOTES 279

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no change in input prices
P D2
D1 S1 S2 ATC1 MC1
P2 P2 = MR2
P1 P1=MR1
Q q
Q1 Q2 q1 q2
Market Firm
PGPSE NOTES 280
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Since there is no change in input prices in this example
profit will again be zero when the supply shifts out as far
as the new demand to return the price to P1.
Supply S1 had a certain amount of firms involved and

then some more firms entered(when profit was positive)
to give us a certain amount of firms involved with S2. So
there really is a separate supply curve for each specific
number of firms in the industry. So in the long run we
have variation in the number of firms in the industry,
depending on the level of demand.
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Long run supply curve
The long run supply curve in the market shows us the
price and quantity combinations where
1) the number of firms adjusts, and
2) profit is zero.
On the slide two screens ago we see the same price, P1,
but two levels of output, Q1 and Q2. Since input prices
didn’t change, P1 will always be the price that results in
zero profit. On the following screen you will see the
long run supply curve in the market in this constant cost
case.
PGPSE NOTES 282

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P D2
D1 S1 S2 ATC1 MC1
P2 P2 = MR2
P1 P1=MR1
Q q
Q1 Q2 q1 q2
Market long run supply Firm
PGPSE NOTES 283
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Summary
In a constant cost industry in the long run
1) The supply curve in the industry is horizontal,
2) The supply curve is horizontal at the break-even price,
3) Each firm makes the amount where MR = MC, and P = AC.
Now,
Since MR = P for firms in comp., we also conclude
P = MC and since at break-even MC =AC, P = AC.
SO, P = MR = MC = AC at the profit maximizing level of output
for each firm in the industry.
PGPSE NOTES 284

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Profit
The word profit in economics

really means economic profit.
Let’s see what this means.
Market types
Firms may operate in industries, or markets, that are

called perfect competition, monopoly, oligopoly, and
monopolistic competition.
No matter what type of market, we assume firms
attempt to maximize profit.
PGPSE NOTES 286

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Economic Costs
• Costs are accounting for the fact that
when one thing is produced alternative
goods and services are forgone.
• This is the idea of opportunity cost. When
one thing is chosen, the opportunity to do
the next best thing is forgone.
PGPSE NOTES 287

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Example where revenue is
72,000
• Explicit costs • Implicit costs
• 12,000 hired labor • 15,000 owner’s labor
• 5,000 rent • 3,000 entrepre. cost
• 20,000 materials • 4,000 inter. forgone
• 37,000 total • 22,000 total
•Accounting profit = 72,000-37,000 = 35,000

•Economic profit = 72,000-37,000-22,000 = 13,000
PGPSE NOTES 288

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Explicit cost
• In the example, the labor hired to make
pottery would then not be used to make
something else - an opportunity cost.
• These explicit costs represent payments
to nonowners of the firm.
PGPSE NOTES 289

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Implicit cost
• Costs of using owner supplied resources.
• The implicit costs represent money
payments owner supplied resources could
have earned in their next best use.
PGPSE NOTES 290

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Profit
• Accounting profit = Revenue - explicit
cost.
• Economic profit = Revenue - explicit cost -
implicit cost.
• Profit will be used in general and this will
mean economic profit. Implicit costs are
incorporated into an economic analysis.
PGPSE NOTES 291

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Profit
One last point. Since implicit costs are what owner

supplied resources would have earned in their next best
usage, we might call these costs normal profit.
SO, Economic profit = accounting profit – normal profit,
Or
Accounting profit = normal profit + economic profit.
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Perfect Competition in the
Short Run
Perfect competition
Perfect competition is a type of market defined by:
1) All firms selling essentially the same product. The
product of one firm would be a perfect substitute for the
product of another firm.
2) All firms are price takers. No individual firm can have an
influence on the market price based on how much the one
firm produces. This usually occurs when there are a large
number of firms in a market (or industry), but may happen
with relatively few firms.
(two more conditions)
PGPSE NOTES 294
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Perfect competition
3) Factors of production are perfectly mobile in the long run.

This means in the long run a firm can get rid of all its inputs
are add to what it currently has. Labor would be equally
mobile. Note: remember the short run is when at least one
input is fixed in amount for the firm.
4) Firms and consumers have perfect information.
Essentially this means if there is knowledge out there these
folks know about it.
PGPSE NOTES 295

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Supply and demand
The model of supply and demand we have already seen is

really the model of perfect competition. We will expand on
that idea and focus our attention on a typical firm in that
environment.
PGPSE NOTES 296

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Firm in SR
The firm in the short run has some inputs that are fixed and
some that are variable. The firm just accepts the market
price.
With this in mind the firms has to decide how much output
to sell to maximize profit.
Example: You can probably buy a 20 Mt. Dew at 10 places
or so in Wayne and the price is basically 1.25, right? So the
market for Mt. Dew is roughly perfectly competitive and
each store has to decide how much to sell (which means
they have to decide how much to stock on any given day).
PGPSE NOTES 297
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Totals in a graph
TR
$ TC
If you plot the TR and
TC curves the Q that
gives the greatest
distance between TR
Q and TC is the profit
Q* max level of output,
here Q*.
Profit
Next let’s turn to unit
cost and price
concepts.
Q
Q* PGPSE NOTES 298
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Revenue potential
The market demand curve is downward sloping - in the
whole market consumers will buy more at lower prices.
But, let’s say for any one firm the demand curve for the
firm’s output is horizontal. Why? Any one seller is small
relative to the market. 1) If the seller tries to charge a price
higher than the market price no one will buy from
them(because there are enough other places to buy), and
2) The seller will not charge a lower price because they can
sell all they want at the going price. The reason for this is
because they are a small part of the market and already sell
all they want at the going price.
PGPSE NOTES 299
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Revenue potential
P P
P1 d=P
D
Q
market Q
Firm
The ideas on the previous screen have the graphical

interpretation shown here. The demand curve for the
firm’s output is a horizontal line at the price that occurs in
the market(assumed here to be P1).
PGPSE NOTES 300
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Revenue potential
Since the firm in a competitive environment can not influence

the market price on its own, the firm is said to be a price taker
and this has implications for the revenue the firm can
generate from sales of units of output.
PGPSE NOTES 301

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Revenue potential
Total Revenue = TR = P times Q. For the firm here, P is a
given value.
As an example say P = 2.
Units TR
of output Notice the change in TR as
0 0 output changes is 2. This is
1 2 called the marginal revenue.
2 4
3 6 So the MR = P = firm demand
4 8 for a competitive firm.
PGPSE NOTES 302

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Revenue potential
As another example say P = 5.
Units TR
of output Notice the change in TR as
0 0 output changes is 5. Thus
1 5 marginal revenue = 5.
2 10
3 15 So the MR = P = firm demand
4 20 for a competitive firm.
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review cost concepts
$/unit MC
AC The cost curves look
this way in the short
b AVC run due to
diminishing returns.
a I picked Q = 30
Q or units arbitrarily. At this Q
30 the height of the
MC curve is the MC of this output and the height of the
AVC and AC curves have similar interpretations. AC
minus AVC equals AFC. Area a = TVC, a + b = TC
PGPSE NOTES 304
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production rule
$/unit The profit maximizing
MC
firm will choose to
produce the quantity
of output where
MR = MC(Q2 in
P = MR graph).
If the firm stops short
of the rule, like at Q1,
Q or units
Q1 Q2 Q3 then the firm
sacrifices units of output where MR > MC. In other words,
some units after Q1 add more to revenue than to cost. A
profit max. firm wouldn’t pass up this opportunity.
PGPSE NOTES 305
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production rule
If the firm produces beyond Q2, MC > MR and the firm
would thus add more to cost than to revenue on these
units. A profit maximizing firm would not want to do
this.
Now, since P = MR for the firm and since the firm goes to
the Q where MR = MC, the firm in a competitive
environment really produces where
P = MC
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operating rule
The operating rule is a qualification to the production
rule. If operating is worth it at all, follow the production
rule. Otherwise, shutdown.
Now, in the short run there are fixed costs and variable
costs. The fixed costs must be paid whether production is
0 or 1,000,000 or whatever. Variable costs must be paid
only if variable inputs are employed. It is useful to think
of hiring variable inputs only if they generate enough
revenue to pay for themselves plus pay for some of the
fixed costs.
On the next few screens I want to present cases to see
what the firm should do: operate or shutdown.
PGPSE NOTES 307
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operating rule case 1
$/unit MC
AC MR The firm is a price
P a taker - say it takes P
b AVC
This firm should
operate where
c MR = MC and make
a positive profit
Q1 Q or units
If firm operates if it shuts down
TR = a + b + c TR = 0
TC = b + c TC = TFC = b
profit = a profit = -b.
PGPSE NOTES 308
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$/unit MC
AC The firm is a price
taker - say it takes P
d MR
P
e This firm should
AVC operate where
MR = MC and have
f a loss, but not as big
Q1 Q or units as if it shutdown.
TR = e + f TR = 0
TC = d + e + f TC = TFC = d + e
profit = -d profit = -d -e.
PGPSE NOTES 309
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$/unit MC
AC The firm is a price
taker - say it takes P
g
This firm should
h AVC shutdown. Where
MR MR = MC there is
P i
too big a loss, more
Q1 Q or units than if the firm
If firm operates if it shuts down should shutdown.
TR = i TR = 0
TC = g + h +i TC = TFC = g
profit = -g -h profit = -g.
PGPSE NOTES 310
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operating rule
From these examples we can see that if the price is
everywhere below the AVC curve the firm should
shutdown. The firm will still have fixed costs to pay, but
in this case revenue not only does not pay all fixed costs,
it covers only some of variable costs. It is better to
shutdown in this case.
PGPSE NOTES 311

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firm short run supply curve
A supply curve is a curve that shows combinations of

price and quantity the firm is willing to supply. In other
words, we see the quantity the firm is willing to make
available for sale at each price.
The short run supply curve is the segment of the MC

curve that is above the AVC curve.
PGPSE NOTES 312

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firm short run supply curve
$/unit MC
AC
P
AVC
Q or units
If the price the firm accepts is above the AVC, then the MC
curve acts as the line that shows the price, quantity
relations we previously mentioned. The MC curve above
the AVC is the supply curve of the firm.
PGPSE NOTES 313
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Summary
A competitive firm will produce the Q where MR = MC, or, what
is the same thing, P = MC, so long as at this Q the P > AVC.
The supply curve for the firm in this environment is the part of
the MC curve above the AVC curve.
PGPSE NOTES 314

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Competitive Industry in the
Short Run
$/unit MC
AC MR The firm is a price
P a taker - say it takes P
b AVC
This firm should
operate where
c MR = MC and make
a positive profit
Q1 Q or units
TR = a + b + c TR = 0
TC = b + c TC = TFC = b
profit = a profit = -b.
PGPSE NOTES 316
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Profit
I copied the slide form a previous set of notes. Recall we said the firm should
produce the Q where MR = MC and have profit = (P – AC)Q.
Well PROFIT = TR – TC = P(Q) – TC(Q/Q) = (P – (TC/Q))Q = (P – AC)Q.
At the Q in the graph on the previous screen rectangle a has area (P – AC)Q.
This is the profit amount.
PGPSE NOTES 317

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We said the short run is the period of time in which at least one
input is fixed. In the industry this means the number of firms is
also fixed – firms outside the industry also can not get more of
some input and since they are not in the industry they can not
join it in the short run.
Since each firm’s supply curve is its MC curve above the AVC,
the industry supply is the sum of each firm’s MC. We call the
industry supply the horizontal sum of each firms supply because
in the graph we sum the q’s of each firm at each price.
Let’s see this on the next screen.
PGPSE NOTES 318

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P
Firm 1 Here we just

Add firm 1 onto have two firms.
firm 2 Firm 2 If more, follow
the same
principle.
Many times we
just show a
smooth upward
sloping curve
just to show the
basic idea.
PGPSE NOTES 319

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Perfect Competition in Math
Terms
Say you have a competitive market where the demand for
consumers has been added up to be
Qd = 6000/9 – (50/9)P.
Also say there are 50 identical firms, where each has the total
cost TC = 100 + 10Q + Q2.
The marginal cost for each firm would be MC = 10 + 2Q.
We know that firms that maximize profit produce the level of
output where MR = MC (as long as P>=AVC). For a
competitive firm P = MR, so MR = MC means
P = 10 + 2Q, or Q = (P – 10)/2 = .5P – 5 for each firm.
PGPSE NOTES 321

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We know the supply curve in the competitive industry is
basically the summation of the MC of each firm in the
industry. For one firm we have in our example
P = 10 + 2Q. To add across all 50 firms we re-express MC as
Q = .5P – (10/2). Now we add all 50 firms together:
Q = .5P – (10/2)
Q = .5P – (10/2) (if firms are not identical, follow this
… same basic process.)
Q = .5P – (10/2)
Qs = 25P – 250 The supply curve

or P = 1/25Q + 10
PGPSE NOTES 322
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Note the supply curve, Qs, adds up the supply curve of each
firm. .5P50 times is 25P and (10/2) 50 times is 250.
So for the supply curve we have Qs = 25P – 250.
The market price and quantity traded are determined where Qs
= Qd, so we have
25P – 250 = 6000/9 – (50/9)P, or
(225/9)P + (50/9)P = 6000/9 + 2250/9, or
(275/9)P = 8250/9, or
P = 8250/275 = 30. Plug P = 30 into either Qd or Qs to get the
quantity traded in the market. In Qs we have 25(30) – 250 =
500.
PGPSE NOTES 323

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Since the market price is 30, each firm will make
Q= (P – 10)/2 = (30-10)/2 = 10.
The profit for each firm TR – TC.
TR for a firm is P times Q, or PQ.
TR = 30(10) = 300.
TC = 100 + 10Q + Q2 for each firm in this example. So,
TC = 100 + 10(10) + 102 = 300.
Profit = 300 – 300 = 0.
PGPSE NOTES 324

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P
D1 S1 ATC1 MC1
P1 P=MR1
=30
Q q
Q1=500 Q1=10
Market Firm
PGPSE NOTES 325
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Here we have the industry P and Q where S=D and the firm output
level q where MR = MC, or we could say P = MC since P=MR.
(presumably the firms MC are above AVC, so we have profit max
P positions.)
S MC = S
P=D =MR
= AR
Industry or market firm

PGPSE NOTES 326
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Change in fixed cost
A change in the fixed cost for firms in the industry will not change the industry at
all in the short run. In the short run a change in fixed cost will just affect the
amount of profit for the firm. But it can not drive the firm out since the MC is
above the AVC. Variable costs are covered and some amount of the fixed cost
has to be covered.
In the long run we could have a very different story. But, let’s look at an analogy
to get the short run story.
The fish tank analogy. Look at the next several slides quickly, to simulate a fish
tank being filled with water.
PGPSE NOTES 327

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Hose and water
going into tank
Water level
PGPSE NOTES 328

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Hose and water
going into tank
Water level
PGPSE NOTES 329

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Hose and water
going into tank
Water level
PGPSE NOTES 330

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Hose and water
going into tank
Water level
PGPSE NOTES 331

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Wow,
this is
wild!
Hose and water
going into tank
Water level
PGPSE NOTES 332

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Here is where we get the
pay – off from the fish bowl
analogy. Given the price,
the firm looks at its revenue
as e and f filling the tank as
$/unit shown by d+e+f. Have the
MC water fill in from the bottom
AC up. Since the revenue
covers the TVC – area f -
and some of the TFC – area
d MR
P d + e – it is better to
e operate. A change in the
AVC fixed cost doesn’t change
the fact that TVC would be
f covered and some of the
fixed cost. If the firm shut
Q1
Q or units down it would have no
variable cost and all the
fixed cost to pay with no
Remember, see the revenue fill revenue. By producing, the
area f and e from the bottom up. revenue covers all the
variable and some of the
PGPSE NOTES fixed. So the firm loses333
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less.
Say variable costs rise in such a way that MC for firms rises. Here I show the MC
curve shift left. The industry supply will shift left because the industry is simply the
sum of all the firms. Market price will rise and output will fall. With a higher market
price the firm demand line = price line will rise. Where I show the industry supply,
the price means the firm would have the same level of output as before the change.
Can this be?
P S MC = S
P=D =MR
= AR
Industry or market firm

PGPSE NOTES 334
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The output for all firms in the industry can not be the same if
the output in the industry is lower. On average, output has to
fall at the firm level. If the firm shown had had slightly steeper
curves the output for the firm would have fallen. So, we see a
special case in my graph.
Demand in market rises
If demand in the market rises we would see a higher price and a
greater quantity coming out of the market. Each firm would
have more output at the higher price.
Next, we want to explore the cost of making the industry
output. The conclusion is that firms as a group will make the
industry output the cheapest that it can be made. Let’s turn to
this next.
PGPSE NOTES 335

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Refresher – What information the marginal cost curve contains.
At a quantity, the height

of the MC curve tells us
how much is added to
cost when that unit is
$ added.
The height would also tell
us how much cost would
MC
go down if that unit was
not produced.
PGPSE NOTES 336

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The output made in the market is made with the lowest cost. Let’s see how.
Normally each firm makes Q where MR = MC and since P = MR, P = MC. Say
I have power to make firms change – say I make firm 1 make 1 more unit and
to keep total output the same I make firm 2 make 1 less. Firm 1’s cost goes up
by price + something. Firm 2’s cost goes down by the price.
$ $ $
MC1 MC2
S
Q Q1 Q Q2 Q
Market – scale Firm 1 Firm 2
is larger than
each firm So price + something minus price =
something.
PGPSEMaking
NOTES firms change from what 337
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they want makes cost of market output rise.
Producer Surplus
When producers sell products in
the market they may receive more
than the amount they needed to
receive to supply a unit – they
receive producer surplus.
producer surplus
Recall that the supply curve shows various prices and
associated quantities producers would make available
for sale.
The amount they need to receive to induce them to
make available for sale units of a product are located
on the supply curve. In fact the law of supply is an
expression that they need to receive more in order to
make available additional units.
The amount actually received is market determined.
PGPSE NOTES 339

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need to receive
P Notice at P1 that only 1

S unit is supplied. P1 is
not enough of an
amount to have the 2nd
unit supplied. To get 2
units supplied, P2 is
P2 a b
required.
P1 c d e Q
1 2
PGPSE NOTES 340
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need to receive
On the previous slide we see that to get 1 unit supplied P1 was
need. P1 times 1 = P1 and is the area of the rectangle made up
of C and D. This is the amount needed to supply the first unit.
If we ignore area c we could say the area under the supply up
to 1 unit is the amount needed to get that unit supplied. You
see the area under the curve is an under-estimate of the
amount needed but it makes life easy in terms of a visual look.
Similarly area b + e = P2, the amount needed to have the
second unit supplied. If you ignore b we have just the area
under the curve.
The area under the supply curve out to a quantity is the
amount needed to supply those units.
PGPSE NOTES 341
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Producer surplus
P
With S & D we get P = 10 and
Q = 300
25 Area A = .5(300)(10 - 4)
=900
Area A + B = 10(300)
10 = 3000
A
B Area B = A + B – A
4 = 2100
300 Q
Producers actually receive A + B = 3000, but only needed

B = 2100, so the producer surplus is A = 900.
PGPSE NOTES 342

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producer surplus
What do producers do with the surplus received?

They may use it to pay off some expenses or it could be a part
of profit.
PGPSE NOTES 343

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A PART OF THE INVISIBLE
HAND
Do you see it?
There is a story in economics that competitive market outcomes
are efficient. Efficiency means two things really. What we make
we have to make it as cheaply as possible. Plus we should make
the things that people want the most.
What are some things we know?

The market supply is the supply from all firms in the market added
up.
The market demand curve is the demand from each consumer
added up.
The price and quantity traded are determined in the market.
Individual firms and individual buyers have no control over the
price. The firms and individuals are price takers.
PGPSE NOTES 345

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P
P1
B
C D
Q
Q1
PGPSE NOTES 346
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On the previous slide we see that consumer surplus plus producer
surplus equals the area A + B, and this is the result of the market
equilibrium P1 and Q1.
Inside your own head can you tell if you are willing to pay more
for good x over good y? I would say you can because you can
determine what you like!
As you compare two people can you tell who is willing to pay
more for good x? This is harder, but we think the demand curve
orders units in such a way that the first unit is demanded by the
person who values it most in terms of their willingness to pay for
it. The market price cuts off people who value the good less than
those who value it more and thus the units of the good produced
go to the people who value it most.
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Think about sellers in the market. They want to make profit,
where profit equals revenue minus cost. Can you tell between
producers which can make units cheaper? It is hard but we think
the supply curve orders units so that the first unit supplied comes
from the lowest cost producer. The market cuts off suppliers who
produce the good at too high a cost compared to those who
produce at lower cost.
So, the market is efficient because goods go to those who value
them most and are produced by the producers who can do it
cheapest.
PGPSE NOTES 348

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P
e
P1 h g
B
C D
Q
qless Q1 quamore
PGPSE NOTES 349
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Another way to think about efficiency is the total amount of
consumer and producer surplus together.
The total surplus is less when output is less than the market
outcome at Q1, like at qless. Here we would see surplus fall by
area e + h.
If output is higher than Q1, like at quamore, then we force on the
market units of the good that costs more to make than people are
willing to pay to get. This is not good.
Summary
A competitive market is most efficient because we get the most
total surplus out of it.
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Changes in Price
Here we explore the change in the

price of good x and the impact this has
on the amount of x (and y chosen).
Y
C U3
A B
U2
U1
X
L M N
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On slide 2 you see three budget lines and three indifference curves. The
budget lines are different by the price of X.
Say the consumer has $10 of income and the price of Y is $1. Then point Z
would be the situation where the consumer buys only good y and the amount
of y would be 10 units (the consumer shown won’t go to point Z, but at least it
is possible.)
Now if the price of x is $2 and the consumer spent all income on x then x
would be 5. Let’s say this is the budget from Z to L. Then if the price of x is
$1and the consumer spent all income on x then x would be 10. Let’s say this
is the budget from Z to M. If the price of x is $0.50 (50 cent), and if all income
is spent on x then x is 20. Let’s say this is the budget from Z to N.
Conclusion about budget line when price of x changes:
As price of x falls the budget line rotates counterclockwise around point Z, and
as the price of x rises the budget line rotates clockwise around point Z.
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Price consumption path
In our graph on slide two let’s focus on a price of x decline. Initially the
consumer can have utility U1 by maximizing utility at point A. Then when the
price of x falls the consumer gets more utility at point B (utility U2) and we see
in this example more x is taken because point B is to the right of point A and
this means more x.
If the price falls yet again the consumer moves to point C with more utility (U3)
and even more x.
I have drawn a line in the graph that connects all the consumer utility
maximum points at each price of x, given income and the price of y. This line
is called the price consumption path. The line is an indicator of where the
consumer will go at various levels of the price of good x.
PGPSE NOTES 354

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Demand curve we know and love
Let’s review something.
Budget ZL had the highest price of x in our story – let’s say the price is P1.
Budget ZM had the 2nd highest price of x in our story – let’s say the price is P2.
Budget ZN had the 3rd highest price of x in our story – let’s say the price is P3.
When we take the price of x at each of these levels and keep track of the
amount of x taken, we are getting the information we have always summarized
in a graph of the demand curve. The demand curve is shown on the next slide.
So, the demand curve for an individual is a result of the individuals search for
maximum utility at each price of x given their taste and preference for x (and y)
as shown by the indifference curves, given the price of y and given income.
PGPSE NOTES 355

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Price of x
P1
P2
P3
x
(quantity
of x)
PGPSE NOTES 356

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1st degree price discrimination
A form of Monopoly Power

Our story of monopoly is incomplete. We have seen the case
where the monopolist charges all customers the same amount.
This is the single price monopoly case.
Do not get me wrong, monopolies can change their price. But
once they do, the single price monopolies will charge all
consumers the same price. But, some monopolies charge
different consumers different prices. This type of monopoly is
a price discriminating monopoly.
Some folks tell us that Microsoft discriminates when it sells
Windows to the various computer makers. Some pay less than
others.
You have probably heard of cases where senior citizens pay
less, or maybe college students get to pay less. These are other
examples of discrimination.
PGPSE NOTES 358
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Why discriminate? The answer is that it may be more profitable
than charging a single price.
Can every firm with monopoly power discriminate?
Discrimination can only occur when both of the following hold.
1) The monopolist must have knowledge of how consumers
differ in their demand for the good or service. Then the
difference can be exploited.
2) Arbitrage must not be possible. Customers in the low price
market segment must not be able to sell to the customers in the
relatively high price segment.
We typically distinguish between three types of discrimination.
I will finish this section by considering price discrimination of
the 1st degree.
PGPSE NOTES 359
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Example that I will explain on
next slides
P Q TRs MRs TRd1 MRd1
11 0 0 Can’t do 0 Can’t do
10 1 10 10 10 10
9 2 18 8 19 9
8 3 24 6 27 8
7 4 28 4 34 7
6 5 30 2 40 6
5 6 30 0 45 5
4 7 28 -2 49 4
3 8 24 -4 52 3
2 9 18 -6 54 2
PGPSE NOTES 360
1 10 10 -8
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Say we have consumer demand of the form in the first two
columns of the table on the last screen. You can see the
quantity demanded rises as the price falls. TRs and MRs refer
to the total revenue and marginal revenue when we have a
single price monopoly. For example, when the price is 9, 2
units are demanded and the total revenue is 18. At a price of
10 the TRs was 10, so the additional revenue of the second unit
– what we call the marginal revenue – is 8.
Remember that when we have a single price monopoly and the
demand has the general form P = A – BQ, then the
MRs = A – 2BQ.
TRd1 and MRd1 refer to the total revenue and marginal
revenue when we have a price discriminating monopoly using
the first degree method.
PGPSE NOTES 361
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1st degree discrimination
In 1st degree price discrimination the monopoly knows what
the individual is willing to pay for each unit and is able to
extract that amount. In the example we know the individual
will pay 10 for the first unit. Since two units are demanded at
a price of 9, we know the individual is willing to pay 9 for the
second unit. So on the two units the monopoly can charge 10
for the first one and 9 for the second one.
Think about a quantity discount idea. Pay 10 for one or get 2
for 19. The TRd1 for two units is thus 19 and the MRd1 for the
second unit is 9. We follow the same idea the rest of the way
down the columns
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Note that the MRd1 and the P are the same. This is an
example that shows that the price and marginal revenue are
equal for a 1st degree price discriminator. Now if demand is
P = A – BQ, then MR = A – BQ.
The MRd1 curve is the demand curve for the 1st degree
discriminator.
Now, all businesses make the output where MR = MC, as long
as they are not losing more that the variable costs of
production.
When you look at the table in the single price case if MC is 4
all the time the monopoly will make Q = 4 and charge $7 to
each. If the MC is 4 always for a 1st degree discriminator, then
the firm will sell 7 units, one for $10, one for $9 and so on
PGPSE NOTES 363
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$
Demand of consumer
10
and MRd1
9
8
7
6
5
MC = 4 and
special case of
4
competitive
supply
Q
1 2 3 4 5 6 7
PGPSE NOTES 364
MRs
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On the previous screen we see the demand in the market. If
the market was competitive we know the MR = MC output
level is 7 because MR = P and P = MC cost at Q = 7.
Consumer surplus would be the large triangle formed by the
vertical axis, then horizontal line a $4 and the demand line.
If the market was single price monopoly we would use the
MRs line and the Q where MR = MC would be at 4 and the
price on the demand curve is 7. The consumer surplus falls to
a smaller triangle than the one before, here we have the
horizontal line at 7 as the base of the triangle. The monopoly
takes the consumer surplus that would have existed had the
market been competitive.
PGPSE NOTES 365

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Now, if the monopoly can discriminate in the first degree in
this example, then it will charge 10 for the first unit, 9 for the
second unit, on down to 4 for the 7th unit. It would not want
to sell 8 or more units because the MRd1 on those units is
less that the MC and thus take away from profit.
NOTE 1st degree discriminator
1) sells same output as in competition,
2) charges a different price on each unit and the last unit has
P = MC,
3) takes all the consumer surplus away from the consumer.
Remember consumer surplus is what consumers are willing to
pay minus what they have to pay and the 1st degree
discriminator has the ability to get them to pay their willing
PGPSE NOTES 366
amount on each unit. www.afterschoool.tk
Special way to look at 1st degree discriminator - two part tariff
A two part tariff is a special way to get the consumer to pay all
they are willing to pay for units they buy. If you think back to
the graph, the discriminator extracts all the surplus from
consumers. It can do the same thing in two steps.
1) charge a single price for all units - the competitive price -
or when P = MC,
2) charge a fee to be able to buy any units at all and make the
fee the consumer surplus that would result in competition.
We see this type of pricing in buyer clubs, country clubs and
other situations.
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3rd Price Discrimination
Third degree discrimination
The third degree price discriminator see consumers as
being in distinct groups with distinct elasticities. The key
to this method working is that buyers in one group can
not have the ability to sell to buyers in the other group.
PGPSE NOTES 369

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3 degree
rd
MC
D1 D2
MR2
MKT 1 MR1 MKT2 firm level
analysis MR
PGPSE NOTES 370
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3 degree
rd
In this situation the firm is in two markets and would

like to maximize profit. It has to decide what to charge
in each market and how much to sell in each market. We
assume here that the output is made in one location and
so there is only one marginal cost to worry about.
The way the monopolist proceeds is to
1) Figure marginal revenue at the firm level by
horizontally summing the MR in each market
2) Sell the total output where the firm MR = MC
3) take this MC value back to each market and act like a
monopolist in each market- sell where MR = MC and
charge the price on the demand curve at those Q’s
PGPSE NOTES 371

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3 degree
rd
The firm sells where MC = MR1 = MR2 or in words the

firms sells the amount of output where the MC is equal
to the marginal revenue in each market.
Mathematically this is similar to a multiplant

monopoly, except here we sum across MR’s, not MC’s.
PGPSE NOTES 372

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Let’s do a problem
P = 6 – Q in one group and P = 8 – Q in the other. Marginal
revenues in both will be
MR = 6 – 2Q and MR = 8 – 2Q.
To add these two together we need to put them in Q form:
Q = (6/2) – (1/2)MR and Q = (8/2) – (1/2)MR.
So at the firm level we have
Q = 7 – 1MR, or MR = 7 – Q.
Say MC is constant at 4. Then at the firm level sell where
MR = MC, or 7 – Q = 4, or sell a total of 3 units. How much
to sell in each market?
PGPSE NOTES 373
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Since MC = 4
In P = 6 – Q,
MR = 6 – 2Q = 4 = MC, so Q = 1 and price from the
demand is 5.
In P = 8 – Q,
MR = 8 – 2Q = 4 = MC, so Q = 2 and price from the
demand is 6.
Note that MC is a constant in this example. We would
follow the same pattern if MC was not a constant.
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The task we just completed could be bipassed if we had
information about demand elasticities. Without proof I tell
you
MR = P(1 – [1/E]) = P([E – 1]/E), where E is the absolute
value of the elasticities.
Since MR = MC for firms, this would mean
MC = P([E – 1]/E) or
P = (E/[E-1])MC
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3 degree
rd
Say MC is $6 for a firm (constant MC). Say in market 1

the elasticity –4 and in market 2 it is –2. Notice market 1
folks are more responsive to price.
The firm will sell where MR = MC in each market, so in
market 1 we have
P = [-4/1 – 4]6 = 8 and in market 2 P = [-2/1-2]6 = 12.
Take these prices back to each market, plug into the
demand to get the amount to sell and figure profit in
each market. Note the market with lower elasticity is
charged more. Why? They do not respond as much to
price changes
PGPSE NOTES 376
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Let’s review the economic story about price
discrimination.
1st degree – we can get the maximum each is willing
to pay on each unit
2nd degree – (I didn’t cover) we have two groups and
we can get what each is willing to pay on each unit
(almost).
3rd degree – we have two groups and in each group
we have to charge each the same amount in their
group – kind of like a single price monopoly in each
PGPSE NOTES 377
group. www.afterschoool.tk
Price Supports
Here are two examples of

government intervention in a
market.
price floor
The downward
arrow is here to
suggest price
P can not get
below Pf.
S1 A price floor is a
minimum legal price.
Pf The government
a b c enacts one when it is
P1 felt the market price
d e
is too low. So an
D1 effective legal
minimum must be
Q above the
Qd Q1 Qs equilibrium price so
price can not get
down to P1.
PGPSE NOTES 379
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price floor
With the price floor we see:
1) higher price Pf,
2) lower quantity demanded - from Q1 to Qd. This is

really also the amount traded. The amount traded has
fallen because sellers can only sell what buyers buy.
3) Higher quantity supplied - Q1 to Qs.
4) surplus = Qs - Qd.
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One thing we notice with the floor is a surplus is created.
What happens to the goods that are made and not
purchased?
Maybe the government will buy them – the government
would have to pay (Qs – Qd)times Pf to buy the surplus.
Maybe the government will ask producers not to make
them.
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price ceiling
P
S1 A price ceiling is a
maximum legal price.
The government
enacts one when it is
is too high. So an
Pc effective legal
D1
maximum must be
below the
The upward Q equilibrium price.
arrow is here to Qs Q1 Qd
suggest price can Price can then not
not get above Pc.
legally get to P1.
PGPSE NOTES 382
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price ceiling
With the price ceiling we see:
1) lower price Pc,
2) lower quantity supplied - from Q1 to Qs. This is really

also the amount traded. The amount traded has fallen
because buyers can only buy what sellers sell.
3) Higher quantity demanded - Q1 to Qd.
4) shortage = Qd - Qs.
PGPSE NOTES 383

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price ceiling
P This screen is a repo of a
S1 previous screen.
Imagine you are sitting
at P1, do it! Where do
you look for the ceiling?
P1 Down! Why not up?
Pc
D1 A ceiling above P1
would cause a surplus
The upward Q and we know with a
arrow is here to Qs Q1 Qd surplus the price will
suggest price can
not get above Pc. fall. It would fall to P1.
Price ceilings above equilibrium are not binding
PGPSE NOTES 384
Or are not effective!
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Production
In this section we want to explore ideas
about production of output from using
inputs. We will do so in both a short run
context and in a long run context.
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Production function
Here we will assume output is made with the inputs
capital and labor. K = amount of capital used and L =
amount of labor. The production function is written in
general as Q = F(K, L),
where Q = output,and F and the parentheses are general
symbols that mean output is a function of capital and
labor.
The output, Q, from the production function is the
maximum output that can be obtained form the inputs.
PGPSE NOTES 386386

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Time Frame
In production, we have said that firms have the ability to use both
capital and labor.
When you consider the fact that capital is basically the production
facility – the building, equipment, machines and the like – you
can get the feeling that it is probably less easy to change the
capital than it is to change the amount of labor used.
When you look at how long it takes to change the amount of
capital in production, during that time when capital can not be
changed in amount the time period of production is said to be the
SHORT RUN. When all inputs can be changed we are in the
LONG RUN.
PGPSE NOTES 387387

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Example
Say production of units of output follow the function

Q = 2KL. This means output is the multiplication of 2, the
units of capital used, and the units of labor used. You can
probably envision a table of numbers that puts units of labor
across the top, units of capital down the side and inside the
table is the output amount.
For example if we went down 1unit of capital and over to 2
units of labor and we would have output Q = 2(1)(2) = 4
PGPSE NOTES 388388

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Long run
Capital On a curve we have different
combinations of L and K
that give the same amount of
output. Curves farther out in
the northeast direction have
more output. Later we will
say more about what the
firm uses as a guide to
choice of position in the
graph. The position chosen
will have implications for
the amount of labor
Labor demanded.
PGPSE NOTES 389389
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Short Run
Capital
In the short run the
firm would have a
given amount of
capital, say K* here.
Production would
K* occur along the
dotted line.
Labor
PGPSE NOTES 390390
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Short run/long run
The notion of a fixed or variable input is related to the
time frame of production.
The short run is that period of time when at least one
input is fixed in amount.
The long run is that period of time in which all inputs
are variable.
As an example of this consider fast food in Wayne.
About any store in town could remodel and increase
floor space in about 3 months. So after 3 months we
have the long run, all inputs can vary - even floor space.
But less than three months is the short run because there
is only so much floor space to use.
PGPSE NOTES 391391
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example Say Q = 2KL. In short
run say K=1.
Capital Then if L = 1, Q = 2 and

if L = 2, Q = 4, and
if L = 3, Q = 6, and so
on.
K=1
Q=6
Q=4
Q=2
Labor
1 2 3 and so on
PGPSE NOTES 392392
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Short run production function
Units of Typically in the short run we
output Q use the graph here instead of
the previous one. We put the
variable input on the horizontal
axis and the output amount on
the horizontal axis. Implicitly
we have the capital amount
fixed at a level when we draw
the short run production
function.
Labor
amount
PGPSE NOTES 393393
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Short run production function
example Q = 2KL
Units of If K = 1 we have the production
output Q function Q = 2L. Some points
would be if L = 1 Q = 2,
If L=2, Q=4 and so on. The
graph is on the left here
4
2
12 Labor
amount
PGPSE NOTES 394394
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Short run Production example
Q = sqrt(KL) when K = 4
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General short run example
Units of Here is a general short run
output Q production function. Notice 1)
if labor input =0 output = 0, 2)
initially output grows at an
increasing rate when labor input
rises, then 3) output grows at a
decreasing rate (called
diminishing returns), and 4)
finally more labor may even
make output start to decline.
Labor
amount
PGPSE NOTES 396396
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Malthus and diminishing returns
It has been suggested that enough production processes in the

short run exhibit diminishing returns that we should take it
seriously.
Malthus argued way back in late 1700’s that because of
diminishing returns we would eventually starve to death. The
fixed land (which places us in the short run) would eventually
not be able to add food production at the rate at which the
population increased.
In our model labor is the only variable input. In the real world
there are many variable inputs. Technology has increased so
much that Malthus has not been proven right, yet. Will he ever
PGPSE NOTES 397397
be proven right? Only time will tell (but I think NOT!)
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General example continued
In the general example, the relationship between the
labor used and the total product (TP), or output Q, is
called the short run production function. Behind the
scenes we assume there is a given amount of capital.
The marginal product of labor (MPL)is the additional
output forthcoming from the additional unit of labor.
Note that as the units of labor increases the marginal
product first increases, but then begins to diminish after
more labor is employed.
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example continued
The marginal product curve has the pattern it does
because of the way the fixed input is used. Remember
that the variable input is used in conjunction with only
so much of the fixed input.
In the beginning, as more labor is added, specialization
of labor can occur and increasing returns to labor can
result, but eventually as more labor is added there will
be less of the fixed input to work with and thus
additions to output have to diminish.
The way output changes as the variable input is
changed, with a given amount of a fixed input, is
summarized with the phrase diminishing marginal
product.
PGPSE NOTES 399399
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Example continued
The average product of labor (APL)is for each amount of labor

the output produced divided by the labor amount.
The average product mimics, or follows, the marginal product. It
is just a math thing.
Next let’s look at some graphs.
Definitions
APL = Q/L
MPL = change in Q / change in L
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TP and MPL, APL
TP or Q Marginal Product and Average

Product
2500
2000 400
Total Product of Output
1500 300
200
MP and AP
1000
500 100
0 0
0 5 10 15 -100 0 5 10 15
Quantity of Labor Quantity of Labor
APL curve
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Notes about MPL and APL
Note
2) When the MPL is above the APL the APL rises.
3) When the MPL is below the APL the APL falls.
4) The APL continues to rise while the MPL is falling only
when the MPL is above the APL.
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APL from the graph of TP
I have reproduced the
Units of
general short run production
output Q
function, also called the
total product, TP, curve. I
have also put out a “ray”
line through the origin.
Note at L1 we get Q1. The
Q1 APL = Q/L so at the point
shown APL1 = Q1/L1.
Also note as you go along
L1 the ray line from the origin
So the slope of the ray Labor
to the TP the slope of the
from the origin to the amount
PGPSE NOTES 403403
ray
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APL from the graph of TP
Note 1) as labor is first

Units of
increased the ray lines are
output Q
moving from right to left
and since the slopes are
getting bigger the APL is
rising, 2) at L* the ray is
tangent to the TP curve and
Q1 we can see the APL is at a
maximum, and 3) beyond
Y* the ray lines have less
steep slopes and thus APL
L1 L*
Labor is falling.
amount
PGPSE NOTES 404404
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MPL from the graph of TP
The MPL is the change in
Units of
output divided by the
output Q
change in labor. The MPL
of an amount of labor is
really the slope of the TP
curve at the level of L used.
A way to see the slope is to
Q1 look at the slope of the
tangent line at that point
L1
Labor
amount
PGPSE NOTES 405405
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MPL from the graph of TP
Crazy graph, I know.

Units of
Before L* the tangent lines
output Q
have slopes that get bigger.
But when the curve
switches from increasing at
an increasing rate to
increasing rate at a
Q1 decreasing rate it is before
L*. So MP reaches it peak
and begins to diminish
before AP has reached its
L1 L*
Labor peak. At L* MP = AP.
amount
PGPSE NOTES 406406
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Marginal analysis
It has been said economics is a science of marginal analysis.

With this in mind, we see later MPL is the more interesting
idea.
As an example of this, firms might ask, should another
economist be hired?
By the way, when Q = 2KL and if K = 1, for example, we are
in the short run. The APL = Q/L = 2L/L = 2, a constant, and
MPL=2 as well.
You have to read pages 272-275 for a great example of why we
focus more on margins than averages in economics.
PGPSE NOTES 407407
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Long Run - isoquants
In the long run all inputs can be varied. On the next slide you
see what we call an isoquant. Along the curve the amount of
output is the same, but we have different combinations of K
and L.
Again say Q = 2KL. To get one isoquant you pick a level of
output. Say we pick Q = 100. Then we have
100 = 2KL. Since capital is on the vertical axis we might re-
express this function as
K = 100/2L = 50/L. If L = 1 K =50 to get Q = 100. If L = 2 K
= 25 to get Q = 100. Isoquants have properties similar to
indifference curves for consumers.
PGPSE NOTES
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408408
Marginal Rate of Technical
Substitution - MRTS
Capital
slope = Change in K
Change in L
On the next slide I

will refer to a change
with the use of a
triangle.
Labor
The MRTS = absolute value of the slope.
PGPSE NOTES 409409
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MRTS
The slope of the curve at a point is

K/ L
Now, if the marginal product of an input is defined as the
change in output divided by the change in the input, the slope
can be manipulated to be:
K Q and since K = 1
L Q Q MPK
So the slope is MPL/MPK and is called the MRTS (in absolute
value) and it is a measure of the rate at which inputs can be
substituted and output remains the
PGPSE NOTES same.
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410410
A few slides back I showed an isoquant. I also put a tangent
line at a point on the curve. The slope of a curved line at a
point is really the slope of a tangent line at the point.
You will notice that as you move along the curved line from
left to right that the slope of a tangent line gets smaller (in
absolute value).
Isoquants for perfect substitutes in production will be straight,
downward sloping from right to left, lines.
Isoquants for perfect complements are L shaped. The
production process is often called a fixed proportion process.
An example would be you need a computer and a computer
operator in many cases.
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LR – returns to scale
Remember in short run at least one input is fixed in amount. In

LR all inputs can vary.
Returns to scale is idea that if all inputs are increased by a
proportionate amount what happens to the amount of output.
Since all inputs are changed it is a long run concept.
Example: We might be interested what would happen to
output if all inputs were doubled.
It is not a done deal that if all inputs are increased in the same
proportion that output will grow by that same proportion. But
if it does the we say there are constant returns to scale.
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LR – returns to scale
If inputs are all increased by a proportionate amount and the

resulting output grows by more than this proportion, then
increasing returns to scale exists.
If inputs are all increased by a proportionate amount and the
resulting output grows by less than this proportion, then
decreasing returns to scale exists.
A given production function may exhibit each of these returns
to scale at different ranges of output, with increasing returns
happening first, then constant and finally decreasing returns
happening.
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NOTE
Returns to scale is a long run concept when changing all inputs in
the same proportion.
Diminishing returns is a short run concept when at least one input
is fixed in amount and another input is changed in amount.
The two ideas are really not related in any general way.
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Production and Costs in the
Short Run
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Overview
In this section we want to
1) Think about how production might occur and change
as different amounts of inputs are used in the
production process, and
2) Translate the production data into cost data. In other
words, we will want to understand how the cost of
producing various units of output might change as
different amounts of inputs are used.
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Fixed/variable inputs
Inputs can be classified as either fixed or variable.
A variable input is one that can be changed as the level

of output is changed .
A fixed input is one that can not be changed as the level
of output is changed.
We often think of labor as a variable input and capital or

land as a fixed input.
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Short run/long run
are variable.
PGPSE NOTES 418
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example to illustrate some ideas
Quantity of L TP or Q MPL APL
0 0
1 5 5 5
2 12 7 6
3 21 9 7
4 28 7 7
5 33 5 6.6
6 36 3 6
7 37 1 5.285714
PGPSE NOTES 419
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example continued
In the example, the relationship between the labor used
and the total product (TP) is called the short run
production function. Behind the scenes we assume there
is a given amount of capital.
The marginal product of labor is the additional output
forthcoming from the additional unit of labor. Note the
first unit of labor has a marginal product of 5.

the third unit of labor is employed.
PGPSE NOTES 420

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example continued
product.
PGPSE NOTES 421
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The average product of labor is for each amount of labor the
output produced divided by the labor amount.
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TP and MPL, APL
TP or Q Marginal Product and Average Product of

Labor
40
35 10
30
8
Total Product or Quantity
25
of output
20 6 MPL
MPL, APL
15 4 APL
10
2
5
0 0
0 2 4 6 8 0 2 4 6 8
Units of labor given an amount of capital Units of labor
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Note
PGPSE NOTES 424

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short run costs
In the short run we will consider the fixed and variable
costs of production and how they change as more of the
variable input is used.
Definitions:
Total cost (TC) = Total variable cost(TVC) + Total fixed
cost (TFC).
Marginal cost(MC) = (change in TC)/(change in output).
where change in output = 1 when possible.
Average cost (AC) = TC/Q.
Average variable cost(AVC) = TVC/Q.
Average fixed cost(AFC) = TFC/Q.
Note that in the short run fixed costs must be paid
whether output is zero or 100,000 units.
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example
Let’s take the production example we had before and
translate the production data into cost data. Say the cost
of capital is $50 and the cost of labor is $15 per unit.
The next screen shows the continuation of our example.
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example to illustrate some
ideas
Q VC FC TC AVC AFC AC MC
5 15 50 65 3 10 13 3
12 30 50 80 2.5 4.17 6.67 2.14
21 45 50 95 2.14 2.38 4.52 1.67
28 60 50 110 2.14 1.79 3.93 2.14
33 75 50 125 2.27 1.52 3.79 3
36 90 50 140 2.5 1.39 3.89 5
37 105 50 155 2.84 1.35 4.19 15
PGPSE NOTES 427
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COST Curves
Totals Averages and Marginal
200 16
14
150 12 AVC
VC 10
AFC
Costs per unit

Dollar cost
100 FC 8
AC
TC 6
50 4 MC
2
0 0
0 10 20 30 40 0 10 20 30 40
OUTPUT OUTPUT
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Idealized graph of per unit costs
in the short run
$/unit
AC
AVC
MC
Q
Note AVC and AC equal MC when AVC and AC are at
their minimum values.
PGPSE NOTES 429
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When you look back at slide nine at the marginal product and
average product curves note that the horizontal axis is measuring
labor units used and the curves are inverted u-shaped curves.
When you look back at slide 14 at the marginal cost and various
average cost curves note that the horizontal axis is measuring
output units and the curves are u-shaped curves.
There is a relationship between these two graphs
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The marginal cost of production is the change in total cost divided
by the change in output.
The marginal product of labor is the change in output divided by
the change in labor.
MC = ▲TC/▲Q, and MPL = ▲Q/▲L, so
MC = ▲TC/(MPL ▲L) = price labor/MPL.
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Supply, Demand and
Equilibrium
Price per A basic diagram
unit or
$/unit or
just P In this chapter we want to
B ultimately work with a
diagram like the one here.
A The diagram will be our
C
PA representation of a market
for a product during a
Quantity per period of time -
unit of time or like the market
origin QA for cups of
Q
coffee per day.
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observation, theory
In the real world we could observe on a given day the

price of a cup of coffee and see how many cups are sold.
Point A in the diagram on the previous screen, for
example, has QA being observed in combination with
price PA.
We have a theory that the observed combination
represented by the point is a point where the supply and
the demand for the product are equal - a notion that
economists call an equilibrium point.
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change
We know prices and quantities change over time - like
from point A to point B - and we have a theory about
this as well. We will see changes in P and /or Q result
from changes in economic variables that cause supply
and/or demand to shift.
But the points we see in the diagram are points where
supply and demand are equal - perhaps after shifts.
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explore
In this chapter we want to explore
1) concepts of demand,
2) concepts of supply,
3) the interaction of supply and demand - equilibrium,
and
4) the application of taxation in a market for a product.
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Demand
Demand, in general, refers to how much of a product
consumers want during a particular time period. The
amount consumers want is influenced by
1) the price of the product,
2) the consumer desire or taste and preference for the
product,
3) the level of prices of other goods,
4) the level of consumer income, and
5) the level of sales taxes or subsidies.
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The law of demand
The law of demand is our summary statement about how
the price of a product influences how much we want. The
law is a statement that the price and quantity demanded
are inversely related.
In a later chapter we will see why economists think the
law of demand holds true, but for now we will accept this
notion.
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Change in demand
If any of the items from our list from 2 to 5 should change,
then we say there is a change in demand. Economists
treat items 2 through 5 differently than the price item. If
the price should change we say there is a change in the
quantity demanded.
The logic behind this difference is the desire to use graphs

as an aid to economic understanding. The graphs used
most often are of only two dimensions. Q and P are the
two primary variables of interest. Other variables may be
of interest and so a different term is used to indicate those
situations.
PGPSE NOTES 439
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change in demand in a graph
P
As a consumer if you think about
D1 D2 items 2 through 5 in our earlier list,
P1 when you see those items as being
stable you then have a certain demand
P2 for the product. In a graph this means
Q you demand curve is located at a
Q1 Q2 certain place. Let’s say yours is at D1.
If the price should fall from P1 to P2 the movement from
Q1 to Q2 is called a change in the quantity demanded -
we move along the curve. If an item from our list 2 to 5
should change(and we started at P1) the movement from
Q1 to Q2 is called a change in demand - the curve shifts.
PGPSE NOTES 440
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A sales tax on consumers
Except for the sales tax, we will wait until chapter 4 to
really work through our list of concepts that influence
how much of a product you and I want to buy.
Say that at a certain time there is no
P sales tax on an item. Then if the
price is P1, Q1 is the quantity
P1 demanded. We will consider a
sales tax one where the consumer
D1 pays a tax directly to the
government.
Q
Q1
PGPSE NOTES 441
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With a sales tax not only does the consumer have to pay
the merchant, but money must be sent to the government
as well. The amount paid to the merchant is called the
price of the product. The amount the customer
ultimately takes out of their pocket for the product is the
price plus the tax.
Your first inclination, when I say the product now has a
lump sum tax of 10 cents per unit on it, would be to say
the demand curve should shift up by 10 cents - P is paid
to the merchant and the tax is added on and paid to the
government. Let’s look at how we really want to handle
this situation.
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Without a sales tax the amount the consumer pays the
merchant and the amount taken out of pocket are the
same. What really matters to the consumer is how much is
taken out of the pocket.
Say P1=50 cents and Q1=2 cups of coffee per day. Then
before a tax the consumer is willing to pay $1 per day for
coffee.
Now say a tax of 10 cents per cup is imposed on the
consumer. But the consumer wants 2 cups of coffee when
$1 comes out of the pocket. With this tax the only way this
is going to happen is if the price per cup is now 40 cents.
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This doesn’t mean the seller will lower the price to 40
cents!!! It just means the consumer will not demand 2
cups unless the price is 40 cents per cup.
Thus the demand curve shifts DOWN by the amount of
the tax. In our analysis we like to draw the demand curve
both before and after the tax.
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effect of sales tax on the
D1 = demand curve
demand curve
before tax P
D2 = demand curve after
tax
Note Pbt = Pat +tax

1) If Pbt is the price before
Pat
the tax the quantity D1
demanded would be Q1. D2
2) With the tax Q1 will Q
only still be demanded if Q1
the price is Pat. Then the consumer will still only have to take
out of their pocket Pbt for Q1.
PGPSE NOTES 445
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Supply
Supply, in general, refers to how much of a product
sellers want to make available during a particular time
period. This amount is influenced by
2) the level of costs of inputs to production,
3) the level of technology in production, and
4) the level of an excise taxes.
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Law of supply
The law of supply is the statement that the price and the
quantity supplied are positively related.
We will see about why this is the case later, but let’s just
accept this statement for now.
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Change in supply
If items 2 thru 4 in our list should change the supply curve
will shift and we say there has been a change in supply.
Note a decrease in supply is a leftward movement of the
supply curve. The amount supplied is measured
horizontally, i.e., rightward and leftward.
P S2
S1
S2 represents a lower
supply.
Q
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excise tax
An excise tax is a tax on the seller of a product. We treat
the tax as a cost of doing business. If there is no tax the
seller will offer Q1 for sale when the price is P1. In other
words the seller is indicating they need P1 to supply Q1.
P
S1
P1
Q
Q1
PGPSE NOTES 449
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excise tax
If a lump sum excise tax is imposed then the seller still
needs to get P1 for their own efforts in order to supply
Q1. This means the price in the market will have to be P1
plus the tax to supply Q1. Thus the supply curve shifts
up by the amount of the tax.
P
S2
P2 = S1
P1 + tax
P1
Q
Q1
PGPSE NOTES 450
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Something seems weird about the sales tax and the excise tax
when I compare the two.
The sales tax is paid by the consumer. So prices on the
demand curve WILL NOT include the sales tax because
consumers know after they take the item they will also have
to pay the tax to the government. But, consumers only want
to pay a certain amount for a good or service, regardless of
taxes or not.
The excise tax is paid by the producer. So prices on the
supply curve WILL include the excise tax because after the
suppliers get the money they have to send some on to the
government and the suppliers still need to get the amount
they want for the item sold.
PGPSE NOTES 451
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Equilibrium
Equilibrium in a market is a situation where
1) Buyers can buy all they want at the price considered
and
2) Sellers can sell all they want at the price considered.
If both situations do not occur there is a force for change

in the market. Equilibrium is the absence of a force for
change.
Equilibrium in a market occurs where supply and

demand cross.
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Equilibrium
P
D1
S1 Any price above P1 is not
equilibrium because sellers
can only sell the amount
P1 buyers will buy and above
P1 there is a surplus so
sellers have a force for
change - lower the price.
Qd Q1 Qs
At the higher price the quantity supplied is greater than the
quantity demanded and since you can only sell what buyers
buy, Qs – Qd is a surplus.PGPSE NOTES 453
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Equilibrium
P
D1
S1 Any price below P1 is not
equilibrium because buyers
can only buy the amount
P1 sellers will sell and below P1
there is a shortage. So,
buyers have a force for
change - raise or bid-up the
price.
Q1
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Change in Equilibrium
Steps to analysis
1) start out at initial equilibrium,
2) see a condition change - item 2 to 5 on demand
and/or 2 to 4 on supply change,
3) Shift the appropriate curve the appropriate direction,
4) at initial price note if excess supply or demand
results,
5) move to the new equilibrium point, and
6) compare the new equilibrium with the initial
equilibrium.
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effect of sales tax on the market
S1 = supply curve
D1 = demand curve before tax P
D2 = demand curve after tax S1
P1, Q1 = initial equil.
P2, Q2 = new equil. P2 + tax
P1
Note
1) Q2 < Q1 - lower output P2 D1
2) P2 < P1 - lower market price D2
3) Consumer pays P2 to the seller and Q2 Q1 Q
pays a tax on each unit purchased to the government,
the total paid per unit is P2 + tax.
PGPSE NOTES 456
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effect of sales tax on the market
4) Tax = P2 + tax - P1 + P1 - P2
Amount of
Amount of increase in per unit decrease in the
pay out made by the per unit amount
consumer. seller receives.
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effect of excise tax on the
S1 = supply curve before tax
market
D1 = demand curve P
S2 = supply curve after tax S2 S1
P1, Q1 = initial equil.
P3, Q2 = new equil. P3
P1
Note
1) Q2 < Q1 - lower output P3 - tax D1
2) P3 > P1 - higher market price
3) tax = P3 - P1 + P1 - P3 + tax Q2 Q1 Q
= P3 – P1 + P1 – (P3 – tax)
decrease in amount seller keeps
increase in amount paid
after the tax, per unit
by consumer on per unit basis
PGPSE NOTES 458
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Comparing excise and sales
tax
If the excise tax and the sales P
tax are of the same amount, S2 S1
but only one is imposed,
we would end up at Q2.
Pd
Pd is what consumers take Ps
out of pocket, Ps is what sellers
keep and Pd - Ps is the tax(all D1
D2
on a per unit basis). Q
Q2 Q1
The economic incidence of a marketplace tax is independent of
its legal incidence. In other words, sales or excise taxes have the
same real impact on the market.
PGPSE NOTES 459
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Hey you ever heard of a wedgie, or what is sometimes called
a herman? Well, I am not going to talk about that now. I
wanted to talk about a wedge. In our supply and demand
graph we have seen that when a per unit tax is imposed on
the buyer the demand shifts down by the amount of the tax
and when a tax is imposed on the seller the supply shifts up
by the amount of the tax.
This vertical line here is the amount of

the tax. I have shown my right hand
as well because I am going to push the
line with my hand into a supply and
demand graph on the next few slides
and WEDGE the tax into the S & D
curves. Here goes.
PGPSE NOTES 460
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P
S
D Q
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P
S
D Q
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P
S
D Q
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So, you can see by the graph, when we wedge the tax into
the graph we can see either the demand shifts down by
this amount or the supply shifts up by this amount. We
end up at the same market quantity and our story is the
same as before.
P
S
D Q
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The budget constraint
Consumers need income to buy
goods and they must pay prices.
These features limit what the
consumer can have.
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Budget constraint or budget line
◆ The budget constraint for an individual

shows combinations of x and y that can be
attained given a certain income and assuming
prices must be paid for the goods.
◆ The constraint will be a line in a graph where
the amount of x is measured horizontally and
the amount of y is measured vertically.
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If I = the consumer income in dollars

Px = the price per unit of x
Py = the price per unit of y
x = the amount of x the consumer buys
y = the amount of y the consumer buys,
then the amount the consumer buys is
I = (Px)(x) + (Py)(y) or y = (I)/(Py) - [Px/Py](x)
Note if x = 0, y = I/Py and if
y = 0, x = I/Px and the slope of the line is - (Px)/(Py).
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Budget constraint
(0, I/PY) -Px/Py This is the slope – a negative

number.
x
(I/Px, 0)
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Budget constraint
The slope of the budget
y line is - Px/Py. Say x = a
bag of chips and y = a can
of pop. If Px = $1/bag and
Py = .50/can, then
2 - Px/Py = -($1/bag)
($.50/can)
1 = - 2 cans/bag
x
The slope of the budget line indicates that if one bag of
chips is given up, 2 cans of pop can be obtained in the
market. This occurs at every point on the budget line
when prices remain constant in relation to the amount
bought.
PGPSE NOTES 469
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slope
Note on the previous screen that the slope of the budget line
is telling us about how much good x is valued in the market
in relation to good y.
This implies that the slope of the budget is indicating the
market rate of substitution of good x for good y.
The slope of the budget is the relative price of x.
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Example
Say a consumer has $20 bucks to spend and good x costs $5 per
unit and good y costs $4 per unit.
The graph of the budget line would be
y
The slope is -5/4 =

(0, 5)
-1.25. This means
that if 1 x is given up
1.25 y can be
obtained.
x
(4, 0)
PGPSE NOTES 471
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NOTE
Sometimes a question in the book will have something about

showing me a graph. Instead of having you draw the graph
electronically you can just tell me about both intercepts and the
slope of the line. That way you do not have to draw the graph.
PGPSE NOTES 472

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Indifference curves
Indifference curves represent a
summary of the consumer’s taste
and preferences for various
products.
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There is no accounting for the taste of the consumer.
Consumers like what they like(various things influence
what they like - advertising, customs...). Consumers
derive utility or happiness by consuming goods and
services. In economics we summarize the likes or tastes
of the consumer by using indifference curves.
An indifference curve shows different combinations of

goods that give the same level of utility to the consumer.
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Diagram used in analysis
good y
The amount
of good y a
consumer
may have is
measured
vertically
good x
The amount of good x is measured on the horizontal
axis.
This type of diagram is used extensively when
considering the behavior of consumers.
PGPSE NOTES 475
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Indifference curves - definition
◆ As mentioned earlier, an indifference curve

shows various combinations of goods that
yield some specific level of utility or
satisfaction for the individual.
y
This is one type of
A indifference curve. We
assume the
individual is equally happy
B at point A or B or any other
point on the indifference
x curve.
PGPSE NOTES 476
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Indifference curves - feature 1
◆ We assume more goods are preferred to less

and thus indifference curves slope downward
to the right.
y Say the individual is at
the point in the middle
2 1 of the graph. Keep this
in mind as we explore
the following screens.
3 4
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◆ If the individual is at the point in the

diagram, then all those points in area 1 and
on the boundary are more preferred because
those points have either more of both items or
more of one and the same amount of the
other item compared to the point chosen.
◆ Points in area 3 and the boundary are less
preferred to the point in the diagram because
the point chosen has more of both items.
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◆ An individual may think that points in areas

2 and 4 are preferable, less preferred or
equally desirable to the point indicated.
◆ Since areas 2 and 4 are the only ones that
could have a point of indifference to the one
chosen, the indifference curves must have
negative slope.
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slope
In economics we often use graphs and with graphs you can

look at the concept called slope. Often in economics the idea
of slope will have an economic interpretation. Let’s review
the idea of slope.
Slope = rise/run.
With a curve that slopes downward from left to right the
slope is a negative number.
With a curve that slopes upward from left to right the slope is
a positive number.
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y
Say the consumer is at
point A. If the
consumer gives up one
B unit of x, m units of y
m must be given back to
A hold the consumer at a
constant level of utility.
x You could say the

consumer is willing to
1 trade 1 unit of x to get m
units of y.
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◆ The shape of the indifference curve on the

previous screen is said to be convex.
◆ Part of the reason for this is that it is assumed
that the amount of good y one receives in
return for one unit of x depends on how
much of each the individual starts out with.
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y
You can tell that point A has
less x than at B. As the
A
individual takes even one less
unit of x from either point A or
B B, some y must be given in
return.
But more is given in return if
point A is the initial point.
x
The point is the less you have of something(like x at
point A compared to point B), the more of other things
you must be given in return to compensate for the loss of
the one unit, assuming the same level of utility is
PGPSE NOTES 483
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◆ The marginal rate of substitution(MRS) is the amount
of y given in return for the one unit of x, while
maintaining the same level of utility.
◆ We can think of the MRS as a fraction:
◆ MRS=absolute value of
(change in y)/(change in x) .
◆ In this sense, the MRS is the absolute value of the
slope of the curve at various points. Note the slope
changes from point to point. In absolute value the
fraction gets smaller the farther down the curve one
moves. This is another way of saying the curve gets
flatter.
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feature 2
In general, it is assumed that consumers value additional units

of a good less and less the more they have of the good. (Or
you could say when consumers give up good x they require
more and more of good y the less of good x they start with.)
The indifference curve gets flatter.
This notion is summarized with the phrase – diminishing
marginal rates of substitution.
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y Indifference curves - feature 3
Indifference Map
Every point in the graph
has one, and only one,
indifference curve running
through it.
Curves farther out from
the origin have more
utility.
x So, the consumer can
compare every bundle and
make a determination of
preference or indifference.
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Indifference curves for an

individual do not cross. Say they
did, like in this diagram. Then
C individual would be
A indifferent to A and B,
B indifferent to A and C,
and thus by logic should be
indifferent to B and C.
x
But C has more of both goods compared to B and thus C

is preferred to B. So the curves can not cross for an
individual. Transitivity of preferences holds.
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◆ Different people can have different general

shapes of indifference curves. Some are
relatively steep and some are relatively flat.
◆ On the next slide I will put two peoples’
indifference curves and they will cross.
Before we said one individual’s curves could
not cross.
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y
Mr. A
Mr. B
x
Note how Mr. A has a steeper curve than Mr. B. From the
point where the curves cross if both give up a unit of
x, note how Mr. A has to be given more y to
make up for the loss of x than Mr. B. Mr. A is said to have
a relatively strong preference for x because he needs much
more y in return for the one unit of x given up.
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A math example of a utility function might be
U = sqrt(XY) – this means utility is a function of the square root of
the product of the amount of x and the amount of y a person would
get.
To get an indifference curve pick a value of U. Let’s say U = 4.
Then some points on the indifference curve would be
X Y
16 1
1 16
4 4
8 2
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indifference curve when U = 16
20
15 1, 16
10 y
Y
2, 8
5 4, 4
8, 2 16, 1
0
0 5 10 15 20
X
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Utility maximization
The goal of the consumer is to
maximize utility given the budget
constraint. Let’s see what that
means.
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y
I show the budget line here
again. What the consumer
attempts to do is find the
point on the budget line that
will give the maximum
utility. I show some arrows
to get you to think about
moving up and down the
line in this search.
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Here I present a few ideas we think hold in the world and then we see
how they show up in the graph.
The consumer wants to maximize the utility, or happiness, that can be
achieved when consuming goods and services.
At a given level of happiness the consumer will always give up a unit
of a good if on the other good in the market an amount greater than
required to maintain the given level of utility is returned. The
consumer will also be happier than at the start. As an example, say
you are willing to take 0.9 Cokes to give up a Pepsi, and you would
be as happy. If in the market when you give up a Pepsi you get 1
Coke back you then you would give up the Pepsi and be happier.
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A related idea is that
At a given level of happiness the consumer will always take
another unit of a good if on the other good in the market an amount
less than required to maintain the given level of utility must be
given up.
As an example, say you will take another hamburger if you give up
2 hotdogs. If the market only requires you to give up1.5 hotdogs,
the you would take the hamburger and you would be happier.
Note: Remember that because of the shape of the indifference
curves that the amount you are willing to give up of a product (or
an amount you would take) depends on how much you already
have and thus changes along the indifference curve.
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Utility Maximization
◆ The individual would like to get to the

highest indifference curve possible, but the
budget constraint restricts the individual’s
options to the budget line.
◆ On the next slide let’s see what is the best the
individual can do. But, before we do
remember 1) indifference curves summarize
how consumers are willing to trade off good
x for y, and 2) the budget line shows how the
consumer can trade off good x for good y.
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y Utility Maximization
Because of the budget

c line u3 can not be
a u3
reached
u2
b u1
u1 can be reached at
points c and b, but even
x more utility would be
obtained if the individual
went to point a on u2.
The utility associated with u2 is the maximum this person

can achieve given their income and the prices they face.
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x
Note why b from the previous screen was not the best
point. To give up a unit of x and maintain the same
utility the person needed to get back a certain amount of
y. But the market actually gives back more y
than the individual requires. This trade is beneficial.
The individual would thus give up the unit of x
and be happier for the trade.
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c
x
Note why c from two screens ago was not the best
point. To take a unit of x and maintain the same
utility the person is willing to give up a certain amount of
y. But the market actually requires the individual
to give up less. This is a beneficial trade. The individual
would thus take the unit of x and be happier for the
trade.
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a b
c final analysis, the individual maximizes utility
In the
when the indifference curve is tangent to the budget line.
Tangent means equal slopes.
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Consumer Surplus
When consumers buy products in
the market they may pay less than
the full amount they are willing to
pay – they receive consumer
surplus.
Do you want to buy some eggs?
Who here would buy a dozen eggs for $1.59?

Who would pay $1.29?
Say the actual price of the dozen is $0.89. Do you think the
buyers would pay the $1.29 to the grocer when the grocer has
a sign out that says $0.89?
So if consumers are willing to pay, in this example, more than
$0.89, then they receive an extra benefit in the market called
consumer surplus.
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consumer surplus
Consumer surplus is an idea people I know have a hard
time accepting. Consumer surplus equals the maximum
amount you are willing to pay for an item minus what
you have to pay. It seems the hard part is
distinguishing between what you have to pay and what
you would be willing to pay.
The amount you would be willing to pay is on the

demand curve for each unit of the product. In fact the
law of demand is an expression that you are not willing
to pay as much for additional units as you did for
previous units.
The amount you have to pay is market determined.
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Willing to pay
P
24
a When the price is 24, 0 units
21 are demanded. At P=21, 1
18
b c
unit is demanded. 21 is the
d e f
maximum price this person
15
12
g h i j
would pay for the first unit.
k l m n Let’s say the market price is
10. Then the surplus on the
first unit is 11. The surplus
on the
1 2 3 4 2nd....................…,
Q
3rd....................... units is?
PGPSE NOTES 504
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willing to pay
You will notice on the previous screen at price 21, the
quantity demanded is 1. The area b + d + g + k equals
the $21 the consumer would pay for the 1st unit. The
area a is under the demand curve but not part of what
the consumer would be willing to pay for the first unit.
We will add in area a to calculate the consumer surplus.
It makes the calculation easier.
The second unit would be demanded if the price is 18.
The area e + h + i = $18. The area c is under the demand
curve but not part of what the consumer would be
willing to pay for the second unit.
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willing to pay
The point I am getting to on the previous screen is if we
add in areas like a and c, that are really not a part of what
consumers are willing to pay, we have an easier
calculation to find out what consumers are willing to pay
for a certain number of units. It is simply the area under
the demand curve out to a quantity.
P
What consumers are
willing to pay for the Q1
units
Q1 Q
PGPSE NOTES 506
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Consumer surplus again
P Say with S & D we get the
P = 10 and Q = 300.
25 Area A = .5(300)(25-10)
=2250
A Area B = 10(300)
10 = 3000
B Note consumers would be
300 Q willing to pay 3000 + 2250
for 300 units.
But the consumers only have to pay 3000 for the 300 units.
So the consumer surplus is area A and equals 2250.
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Refresher on areas
The area of a triangle is ½ of the base times the height.

The area of a rectangle, of which the square is a special case,
is the base times the height.
We use these ideas from time to time because they assist in
the development of economic ideas.
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consumer surplus again
What do consumers do with the surplus received?

They may spend it on more units of the item in question, they
may spend it on other items, or they may save it for a rainy
day.
The point here is that the surplus is useful to the consumer!
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Cost in Math Form and Perfect
Competition in Math Form.
Say we have a cost function of the general form
TC = f + aQ + bQ^2 + dQ^3, where the sign ^ means raise to a
power.
Note the term f has no Q “hooked” on to it so f represents fixed
cost, and all the terms with a Q are part of variable cost:
TFC = f = total fixed cost
TVC = aQ + bQ^2 + dQ^3 = total variable cost.
Now, it is possible that a, b, and d are positive or negative, or
even 0.
Looking at averages we have
AFC = f/Q, AVC = (aQ + bQ^2 + dQ^3)/Q = a + bQ + dQ^2,
And ATC = AFC + AVC = TC/Q.
PGPSE NOTES 511
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To get the marginal cost from a TC of the form
TC = f + aQ + bQ^2 + dQ^3, you have
MC = a + 2bQ + 3dQ^2.
Example 1 TC = 100 + Q^2

Note f = 100 and a=0, b=a, and d =0.
AFC = 100/Q, AVC = Q and MC = 2Q.
Say this firm operates in a perfectly competitive market where the

price is $10.
From my notes the production rule says go to the quantity where
P = MC, so 10 = 2Q, or Q = 5. The operating rule says only do
this if P > AVC. Here AVC = Q and at Q = 5 AVC = 5 and thus
P is > AVC. SO the best thing to do is make Q=5.
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Profit = TR – TC = PQ – [TC/Q]Q = [P – ATC]Q
Here I used a trick that TC times 1 written as Q/Q gives [TC/Q]Q
= ATCQ.
Thus, profit = [P – ATC]Q.
In our problem we have [10 – 25]5 = -75. So, the best this firm
can do is lose 75. But, note if it shut down it would still have
fixed cost of 100 that would have to be paid. So, it is better off
operating in the short run while it has the 100 fixed cost.
Example 2 – same cost, but say the price in the market is 20. (note
this problem is not exactly like demo problem 8-1)
Produce Q where P = MC: 20 = 2Q, or Q = 10.
Make sure P > AVC: AVC here is 10, so with P > AVC operate.
Profit = [20 – 20]10 = 0. PGPSE NOTES
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513
Demand in Mathematical
Terms
Here we want to look at the
presentation of demand in math
terms so that we can use the
concept in making decisions.
Review
We know that how much of a product consumers want

depends on
2) the consumer desire or taste and preference for the
product,
3) the level of prices of other goods,
4) the level of consumer income,
5) the number of consumers in the market.
In a general mathematical sense we may summarize this with
the following
Qx = f(Px, Py, T, M, N) .
PGPSE NOTES 515
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general math form
On the previous screen
Qx = the amount people want of good x,
f means is a function, note the parentheses here is not a
multiplication sign,
Px = the price of good x, Py = the price of good y,
T = a measure of consumer taste, M = consumer income,
N = a measure of the number of consumers in the market.
So, the amount people want depends on or is a function of
these influences listed in parentheses.
PGPSE NOTES 516
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Linear demand
A linear demand curve might be of the form

Qx = a0 + axPx + ayPy + aMM.
Note the a’s with subscripts just means we have a number here.
Many books use the greek letter alpha here. The a’s may be
positive or negative.
As an example say we have
Qx = 1000 - 3Px + 4Py - .01M
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Linear demand
Now if Px = 1, Py = 1 and M = 50,000

Qx = 1000 – 3(1) + 4(1) - .01(50,000)
= 1000 – 3 + 4 – 500
= 501.
Once we have the from and coefficient values of the
relationship between the variables we can make “predictions”
about how much people want based on the value of prices and
income and other variables.
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Market demand
The market demand is the demand from each individual

added together. Say in a market we have two buyers. The
demand from each is
Q = 10 – 1P, and Q = 20 – 2P, respectively. (you will notice
I only have the price term listed. All the other influences are
captured in the Q intercept.)
Now, if the price is $1 per unit, the demand is 9 and 18,
respectively. So the market demand is 27. Here is how we
add the demand functions of each individual to get the
market demand : (next screen)
PGPSE NOTES 519
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Market demand
Q = 10 – 1P Notice on the left side on the addition I

Q = 20 – 2P did not put 2Q. The reason is due to the
notation used. The Q for each person is
Q = 30 – 3P personal, but I just used Q. You can see
at a price of 1 the Q is not the same for
each person. (We just did this last
screen.)
Notice the market demand curve Q = 30 – 3P does add up the

demand from each individual at a given price. If P = 1 we
have a market demand of 27 (= 9 + 18).
PGPSE NOTES 520
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Inverse Demand curve
We just saw a market demand curve of

Q = 30 – 3P. I could rewrite this as P = 30/3 – (1/3)Q. When
written with P on the left we call the demand curve the inverse
demand curve. We write it this way because in a graph we
typically have the price on the vertical axis and so the equation
follows that convention. In general we write
P = A – BQ.
(Note: do not add individual demand curves when written in
inverse form – you do not get what you want.)
PGPSE NOTES 521
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Nonlinear demand
Demand may not be a linear function. A popular nonlinear

form takes the form
Qx = cPxBxPyByMBMHBH. An example would be
Qx = 10Px-1.2Py3M.5H.3 . An interesting thing about this
form is if you take the natural log (sometimes written Ln)of
each side you get
log Qx = 10 – 1.2 log Px + 3 log Py + .5 log M + .3 log H .
This nonlinear demand is said to be linear in logs.
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Natural log
On the previous screen you see we have the amount demanded
in the form of a natural log. To get the value in the terms you
and I are used to you would take the value given and make it
the exponent of the term e.
Microsoft excel has the the function ln to put values into
natural log form. To get out of natural log form use the exp
function.
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Qualitative Independent
Variables
Sometimes called Dummy
Variables
In the simple and multiple regression we have studied so far the
dependent variable, y, and the independent variable(s), x(s) have
been quantitative variables. But the regression can be used with
other variables. We will study the case where
The dependent variable, y, is quantitative,
One (or more, in general) independent variable is quantitative,
and,
One independent variable is qualitative.
Remember that a qualitative variable is of the type where
different values for the variable are just categories. Some
examples include gender and method of payment (cash, check,
credit card).
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An example
y = the repair time in hours. The company provides maintenance
and it would like to understand why the repair time takes as long
as it does. With an understanding of repair time maybe it can
schedule employee hours better or improve company performance
in some other way.
x1 = the number of months since the last repair service was
performed. The idea is that the longer since the last repair the
more that will be need to be done. The is a quantitative variable.
x2 = the type of repair service needed. In this example there are
only two types of repairs – electrical and mechanical.
So, the company has clients that need repairs and the company is
exploring what accounts for the time it takes to make a repair.
PGPSE NOTES 526
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On the next slide I have a graph where two quantitative variables
are on the axes. The two ovals represent the “cloud” of data
points. Here the points suggest a positive relationship between
months since last repair and repair time. Of course, we will have
to test if this is the real case or not, but the graph suggests that is
the case.
I have two ovals because it is thought that maybe each type of
repair has a different impact on repair time. The different ovals
represent what is happening for each type of repair and here I am
suggesting that there is a difference in repair time for each level
of repair type. Here we will also do a test to see if the different
types of repair lead to different repair times.
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Repair time
Months since last

repair
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The model
Here the regression model is
y = Bo +B1x1 + B2x2. When we estimate the model we use data
on y and x1 and x2. Here we make the data for x2 special. We
will say that x2 = 0 if the data point is for a mechanical repair and
x2 = 1 if the data point is for an electrical repair.
Now, when we look at the model for the two types of repair we
get the following: When x2=0
y = Bo + B1x1 + B2(0) = Bo + B1x1, and when x2 = 1,
y = Bo + B1x1 + B2(1) = Bo + B2 + B1x1. The impact of
creating x2 as a 0, 1 variable is that when the value is 0 we have
one line and when the value is 1 we have another line with a
different intercept. The intercept is Bo with the mechanical repair
PGPSE NOTES 529
and the intercept is Bo + B2 with the electrical
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repair.
PGPSE NOTES 530
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Getting and interpreting the results:
The previous slide has the Excel printout for this regression
model. The interpretation starts with the F test. The null is that
both B1 and B2 are equal to zero. Here the F stat is 21.357 with
a p-value (Significance F) = .001. Then we would reject the null
with alpha as small as .001 (certainly we reject at alpha = .05)
and we go with the alternative that at least one of the beta’s is not
equal to zero. In other words, as a package the x’s exhibit a
relationship with the y variable.
The next step is to do the t tests on each slope value B1 and B2
(even here we tend to ignore the test on Bo because we typically
do not have much data with all the x’s = 0) separately. Here the
p-values on both have values less than .05 so we reject the null
and conclude each variable has an impact on y.
PGPSE NOTES 531
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Repair time
Electrical y = (.9305 + 1.2627) + .3876x1
Mechanical y = .9305 +.3876x1
.9305 +
1.2627
.9305
Months since last

repair
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On the previous slide I reproduced the graph I had before, and I
added the equations for repair time under each value of x2.
When x2 = 0 we have the line for mechanical types of repair.
When x2 = 1 we have the line for electrical types of repair.
Ultimately the difference in the two lines here is in the intercept.
But, the slope of each line is the same. This means that months
since the last repair has the same impact on repair under either
type of repair. Since b2 = 1.2627 (really since we rejected the
null that B2 = 0) the electrical line has a higher intercept. We can
use each equation to predict repair time given the value of
months since last repair, and given the type of repair. Of course,
if the type is mechanical we use the mechanical line and we use
the electrical line for the electrical type.
The next thing we would do is evaluate R square. Here the value
is .8592 and this indicates PGPSE
that just over 85% of the variation in533
NOTES y
is explained by the x’s. www.afterschoool.tk
The qualitative variable
In our example we had a qualitative variable with two categories.
Note we added 1 x variable for this 1 qualitative variable. The
reason is because the 1 variable had 2 categories. Now if the 1
qualitative variable has 3 categories we would have to have 2 x
variables. Say we had mechanical, electrical and industrial repair
types. We would need x2 and x3 variables, in addition to repair
time, x1.
With 3 categories we would have 3 lines.
When x2 = 0 and x3 = 0 the intercept would be Bo for the
mechanical line.
When x2 = 1 and x3 = 0 the intercept would b Bo + B2 for the
electrical line (assuming the tests had us reject the null).
When x2 = 0 and x3 = 1 the intercept would be B0 + B3 for the
industrial line.
PGPSE NOTES 534
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In general, if the 1 qualitative variable has k categories, we add
k-1 x’s. When all the x’s are zero we have intercept Bo and the
line represents the equation for 1 of the categories and then the
other x’s account for the change from Bo the other k-1 category
values have.
Summary
1 qualitative variable would have k lines associated with it
(assuming tests reject Ho) and we add k-1 x’s of the 0,1 type to
account for all the k categories. 1 category is made the “base”
category and its line will have intercept Bo and the other
categories will have intercept Bo + Bt, where the t would be
different for each case of the other categories on the variable.
PGPSE NOTES 535

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The budget constraint
Consumers need income to buy

goods and they must pay prices.
These features limit what the
consumer can have.

shows combinations of x and y that can be
attained given a certain income and assuming
prices must be paid for the goods.
◆ The constraint will be a line in the graph we
saw before – you know the one, the one
where the amount of x is measured
horizontally and the amount of y is measured
vertically.
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If I = the consumer income in dollars

Px = the price per unit of x
Py = the price per unit of y
x = the amount of x the consumer buys
y = the amount of y the consumer buys,
then the amount the consumer buys is
I = (Px)(x) + (Py)(y) or y = (I)/(Py) - [Px/Py](x)
Note if x = 0, y = I/Py and if
y = 0, x = I/Px and the slope of the line is - (Px)/(Py).
PGPSE NOTES 538

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Budget constraint
(0, I/PY) -Px/Py This is the slope – a negative

number.
x
(I/Px, 0)
PGPSE NOTES 539

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Budget constraint
The slope of the budget
y line is - Px/Py. Say x = a
bag of chips and y = a can
of pop. If Px = $1/bag and
Py = .50/can, then
2 - Px/Py = -($1/bag)
($.50/can)
1 = - 2 cans/bag
x
The slope of the budget line indicates that if one bag of
chips is given up, 2 cans of pop can be obtained in the
market. This occurs at every point on the budget line
when prices remain constant in relation to the amount
bought.
PGPSE NOTES 540
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slope
Note on the previous screen that the slope of the budget line
is telling us about how much good x is valued in the market
in relation to good y.
This implies that the slope of the budget is indicating the
market rate of substitution of good x for good y.
Remember the indifference curve slope was indicating how
much of good x a person was willing to give up to get more
of good y.
The slope of the budget is the relative price of x.
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Introduction
Introduction
What is managerial economics going to do for you?

Among other things, by studying this course you will gain
insight into
pricing and output decisions by firms,
input mix and production choices by firms, and
government intervention in markets.
Note economics is a science where decisions in the presence of

scarce resources are studied.
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Assume
In economics it is assumed that individuals have objectives

and goals in mind that guide their actions. For example,
businesses attempt to maximize profit and consumers attempt
to maximize utility.
What would a manager of a social service agency have as an
objective?
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Economic Profit
When the term profit is used in

economics it is usually a short
way of saying economic profit.
Let’s see what this means.
Example
Say I am planning to open my own entertainment
establishment, called Parker’s Pool Hall. I will have explicit
costs for the pool tables, pinball machines, labor and electric I
use.
Say these explicit costs add up to $10,000 a year. If the
revenue to the firm is $60,000 a year, the accounting profit
(revenue – explicit costs) is $50,000.
How do you think I would feel if I gave up a job where I made
$40,000 a year and I could have rented out the building where
the pool hall is located for $15,000?
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Implicit costs
Notice the $60,000 in revenue pays the explicit costs of

$10,000, pays me the $40,000 I gave up in a job, and only
pays $10,000 of the $15,000 in forgone rent.
I end up short $5,000 (I always end up short – slow too!) in
the entertainment business, compared to what I was doing
before.
The forgone income and rent are examples of implicit costs
that economists incorporate into the analysis of profit.
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Profit
Economic profit = accounting profit – implicit costs

= total revenue – explicit costs – implicit
costs
= total revenue – total costs
= profit.
Costs mean all explicit and implicit costs and in economics
the term cost really means opportunity cost, or what is given
up in a course of action.
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Profits can be a guiding light!
Resource owners (those having land, labor, capital or
entrepreneurial ability) like to make money. When an industry is
earning profits (economic profits), resource owners get the
message that maybe they should move resources to the industry.
In this sense profits are seen as a mechanism that moves
resources to areas that have higher value than where resources
are currently being used.
As a manager of business you may get criticized that profits are
ugly and outrageous, but profits serve the role of allocating
resources to the highest valued use. This is a good thing if you
want the world’s resources to go to the place where they are
valued most (in terms of willingness to pay).
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Industry Profit and Five Forces
Michael Porter, a writer of business topics, has put down on paper
some ideas about what factors influence the profit an industry can
sustain. The following is a listing and brief summary of those ideas.
-Entry – the ability of others to get into an industry will impact the
overall level of profit. If barriers to entry can be erected than perhaps
profits can be maintained.
-Power of input suppliers – unique inputs tend to be able to get more
out of firms and thus influence the level of profits.
-Power of Buyers (of the output) – If there are a few “high-volume”
customers they may be able to get low prices and thus drive profits
down.
-Industry rivalry – rivalry pertains to influences that exists among the
firms within the industry. The greater the rivalry, the lower the
PGPSE NOTES 550
profits. www.afterschoool.tk
-Substitutes and Compliments – The relationship products have
with other products can also influence profit levels. The author
points out that Microsoft makes more on operating systems
(because it sells more units) when hardware is cheaper and thus
more folks can buy computers.
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Understanding Markets
Who are the players in the market

system and what influence do
they have on price?
Transactions – two sides
Every transaction has two sides – the buying side and the
selling side. Other names used are the consumer and producer
sides.
A market is where the consumer and the producer interact.
The consumer would like to PAY LOW PRICES (given all
else the same).
The producer would like to RECEIVE HIGH PRICES.
In every transaction there is a struggle between the desires of
producers and consumers in terms of the market price. The
market is a mechanism that balances out the two desires.
PGPSE NOTES 553
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Bargaining Power
The power that consumers and producers have over the price is
influenced by relationships that exist between
consumer and producer
consumers and other consumers, and
producer and other producers.
Let’s explore these ideas on the next few screens, OK?
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Consumer-Producer Rivalry
Consumers like to pay low prices, but consumers can not offer
too low of prices because eventually producers would not
make the good available.
Producers like high prices, but producers can not require too
high of prices because eventually consumers would not
purchase the good.
The market price is the price that balances out the opposing
forces.
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Consumer-Consumer Rivalry
Consumers like to pay low prices. But in a world of scarcity
(wants being greater than resources available to satisfy all
those wants) consumers are pitted against each other in an
attempt to capture the goods and services they want. This
leads consumers to BID-UP prices in the presence of a
relatively large amount of consumers.
Think about professional sports. Owners are the frontline
consumers of the athletes. Years ago when one owner had the
right to resign the player forever the player received much less
than occurs in a world a free agency.
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Producer-Producer Rivalry
Producers like high prices. But, if there are many producers
of a product then each, in an attempt to gain buyers, will tend
to lower the price to attract those consumers from other
producers.
Think about fast-food establishments in an area. As a casual
observation, it seems to me the more producers you have in an
area, the lower the prices. This may take affect by using
coupons or other special deals, but the producers try to get
your business.
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Prices
Later in the course we will think about why prices turn out
the way they do, and the rivalry among producers and
consumers and among themselves will play a key role.
A topic like this is often called price theory within the
economics community because a primary concept of study is
the price of products.
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Time Value of Money
Decisions made today have
consequences today and in the
future. The time value of money
concept is an aid in evaluating the
future in terms of today’s value.
Time line
Now 1 2 3 4 5 n
Now is time zero, or when the decision is made. Each
following number is an “end of period” concept. We
have the end of the first period, end of the second period
and so on until the end of the nth period.
PGPSE NOTES 560
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Interest Rate Growth
If you have $1 today and can earn an interest rate of 10% by
the end of the first year then you will have $1.10.
The$1.10 is calculated as the amount you start the period with
plus the product of what you start the period with times the
rate of interest that period.
If F is the amount at the end of the period, P is the amount at
the beginning of the period and i is the rate of interest during
the period, then in general we have
F = P + Pi = P(1 + i).
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Growth in general
If you start out with P and wait one period at rate i we just saw
you have F = P(1 + i). Now, if you again earn i, by the end of
the second period you would have
F = P(1 + i) + P(1 + i )i (start period with + start period with times i)
= P(1 + i)(1 + i)
= P(1 + i)2.
In general, at the end of n periods, you have
F = P(1 + i)n.
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Present Value
The present value concept uses the growth process we just

studied, but the focal point is the present. As an example,
what amount do you need today if you want $1.10 at the end
of the period and you can earn 10% during the period. You
need P = F / (1 + i) = 1.10 / (1 + .1) = $1.00
In general if you want to have F n periods from now and you
can earn i each period , then today you need
P = F / (1 + i)n.
Note, the present value of an amount today would mean n = 0
and so P = F because anything raised to the power zero equals
1. PGPSE NOTES 563
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Discount Rate
The present value P of a future amount F n periods from now

at interest rate i is
P = F / (1 + i)n.
The interest rate i in this context is often called the discount
rate. It is the rate at which we “discount” future values to
place them in terms of today’s value.
Do not confuse this with the discount rate in the context of
monetary policy. The Federal Reserve charges banks the
“discount rate” when those banks borrow from the Fed.
PGPSE NOTES 564

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Example
say you are offered the opportunity to get paid $1 at the end of
the first period and another $1 at the end of the second period.
You know you can earn 10% over the next two years. The
catch is that to get the pay-outs you have to give up $1.50.
Should you do it?
The present value of the future payments is
{1 / (1 + .1)} + {1 / (1 + i)2}
= {1/1.1} + {1/1.21}
= .91 + .83 (rounding to two digits)
=1.74.
Since the future stream of payments has a present value of
$1.74 you should do it. You basically trade $1.50 for $1.74.
What a deal! PGPSE NOTES 565
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Net Present Value
The net present value of an opportunity is the present value of
all the benefits of the opportunity minus the present value of
all the costs of the opportunity.
On the last screen, the NPV of the opportunity was
$1.74 - $1.50 = $0.24.
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Apply NPV
Rules for behavior

2) Take an opportunity if the NPV > 0.
3) Choose the opportunity among competing choices that
has the highest NPV (firms maximize profit).
4) The value of the firm is the net present value of the future
profit stream.
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Caution
Much of what we will do in this course is think about what to
do in one period and we will think about the rules of behavior
in that context. It seems we will ignore the time value of
money. We are not ignoring the concept.
As an example, we will think about how much a firm should
produce this period. Should it make 1, 2, 3, or more units this
period? This period it should make the profit maximizing
amount. The rules we come up with for this type of decision
can be used in any time period. There is no time dimension in
much of what we do. BUT, if there is a time dimension, use
the time value of money!
PGPSE NOTES 568
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Marginal Analysis
A major tool or way of thinking in
economics is marginal analysis.
Basically, the tool says to get to
the “optimal” position think about
the next move.
Driving Analogy
Did you drive 100 mph today?
When you think about driving there are benefits and costs.
Benefits: it can be exhilarating, you get there quicker so you
can stay where you are longer and enjoy that situation, and
there are probably more.
Costs: risk of injury, penalties for driving over speed limit,
and there are probably more.
Many choose to drive instead of walk because the benefits of
driving outweigh the costs. But how fast should we drive?
PGPSE NOTES 570
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Driving Analogy
Now think about increasing the speed at which you drive 1

mph at a time, please (). We usually don’t even think about
it out of the driveway until we hit the speed limit. Then we
start to think about cops in the area giving tickets, how fun it
is to push the exhilarator (accelerator), the injuries that might
happen, etc…
As we push our total speed higher and higher, the economic
way of thinking would have use write down the marginal
benefit and marginal cost of each mile per hour faster. Drive
a mile per hour faster if the marginal benefit is at least as
great as the marginal cost.
PGPSE NOTES 571
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General Analysis
We will see more later, but essentially it is thought that the

marginal benefits of an activity decline the more we do of the
activity and the marginal costs of an activity rise the more we
do of an activity. With this in mind, on the next screen I will
have a graph with MB and MC on the vertical axis, while on
the horizontal axis I will have the TOTAL amount of the
activity.
So, while we increase the total activity on the horizontal axis,
on the vertical axis we measure the marginal benefit and cost
of the additional unit.
PGPSE NOTES 572

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Graphical Interpretation
MB,
MC MC
go don’t MB
amount or Q
Q*
PGPSE NOTES 573
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Activity Rule
Engage in an activity up to the point where the marginal

benefit equals the marginal cost. The logic here is that people
are maximizers – they want the most benefit net of costs.
Q* is the optimal amount in the graph. Before this point each
unit added has a MB > MC and so adding these units adds
more to benefit than cost and makes the total net higher.
Always add a unit if MB > MC on that unit. If more than Q*
is done then on those units the MB < MC and thus the net
amount is lowered. We do not want that.
You will notice that when the Q* unit was added MB = MC.
Nothing on the net was added or lost. But our rule is go to
PGPSE NOTES 574
point where MB = MC. www.afterschoool.tk
Calculations of marginal amounts
Total Revenue is price times quantity.
Marginal revenue is the typical benefit we have for firms in a
market. MR is the change in total revenue when we change
output, usually by one unit.
MR = Change TR divided by change in output.
Marginal cost is the change in total cost divided by the change in
output.
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In this chapter we want to explore ideas about production of
output from using inputs and then look at how much that
production will cost.
Isoquants
An isoquant is a curve or line that

has various combinations of
inputs that yield the same amount
of output.
Production function
Here we will assume output is made with the inputs
capital and labor. K = amount of capital used and L =
amount of labor. The production function is written in
general as Q = F(K, L),
where Q = output,and F and the parentheses are general
symbols that mean output is a function of capital and
labor.
The output, Q, from the production function is the
maximum output that can be obtained form the inputs.
Two screens from now we will see some isoquants.

Note: on a given curve L and K change while Q is fixed.
PGPSE NOTES 577
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Time Frame
In production, we have said that firms have the ability to use both
capital and labor.
When you consider the fact that capital is basically the production
facility – the building, equipment, machines and the like – you
can get the feeling that it is probably less easy to change the
capital than it is to change the amount of labor used.
When you look at how long it takes to change the amount of
capital in production, during that time when capital can not be
changed in amount the time period of production is said to be the
SHORT RUN. When all inputs can be changed we are in the
LONG RUN.
PGPSE NOTES 578

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Long run
Capital On a curve we have different
combinations of L and K
that give the same amount of
output. Curves farther out in
the northeast direction have
more output. Later we will
say more about what the
firm uses as a guide to
choice of position in the
graph. The position chosen
will have implications for
the amount of labor
Labor demanded.
PGPSE NOTES 579
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Short Run
Capital
In the short run the
firm would have a
given amount of
capital, say K* here.
Production would
K* occur along the
dotted line.
Labor
PGPSE NOTES 580
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Marginal Rate of Technical
Substitution - MRTS
Capital
slope = Change in K
Change in L
On the next slide I

will refer to a change
with the use of a
triangle.
Labor
PGPSE NOTES 581
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MRTS
The slope of the curve at a point is

K/ L
Now, if the marginal product of an input is defined as the
change in output divided by the change in the input, the slope
can be manipulated to be:
K Q and since K = 1
L Q Q MPK
So the slope is MPL/MPK and is called the MRTS (in absolute
value) and it is a measure of the rate at which inputs can be
substituted and output remains the
PGPSE NOTES same.
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582
A few slides back I showed an isoquant. I also put a tangent
line at a point on the curve. The slope of a curved line is really
the slope of a tangent line.
You will notice that as you move along the curved line from
left to right that the slope of a tangent line gets smaller (in
absolute value).
PGPSE NOTES 583

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Short Run
Overview
In this section we want to
1) Think about how production might occur and change
as different amounts of inputs are used in the
production process, and
2) Translate the production data into cost data. In other
words, we will want to understand how the cost of
producing various units of output might change as
different amounts of inputs are used.
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Fixed/variable inputs
Inputs can be classified as either fixed or variable.
A variable input is one that can be changed as the level

of output is changed .
A fixed input is one that can not be changed as the level
of output is changed.
We often think of labor as a variable input and capital or

land as a fixed input.
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Short run/long run
are variable.
PGPSE NOTES 587
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Note here that as K = 2,
Short run if L = 1, Q = 76 and
Capital if L = 2, Q = 248, and

if L = 3, Q = 492, and
so. On the next slide I
show this information
and more. Note: the
numbers are made up
K=2
and not based
Q = 492 on any specific
Q = 248 mathematical
function.
Q = 76
Labor
1 2 3 and so on
PGPSE NOTES 588
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Quantity of L TP or Q MPL APL
0 0
1 76 76 76
2 248 172 124
3 492 244 164
4 784 292 196
5 1100 316 220
6 1416 316 236
7 1708 292 244
8 1952 244 244
9 2124 172 236
10 2200 76 220
11 2156 -44 196
PGPSE NOTES 589
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example continued
In the example, the relationship between the labor used
and the total product (TP), or output, is called the short
run production function. Behind the scenes we assume
there is a given amount of capital.
The marginal product of labor is the additional output
forthcoming from the additional unit of labor. Note the
first unit of labor has a marginal product of 76.

the third unit of labor is employed.
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example continued
product.
PGPSE NOTES 591
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The average product of labor is for each amount of labor the
output produced divided by the labor amount.
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TP and MPL, APL
TP or Q Marginal Product and Average

Product
2500
2000 400
Total Product of Output
1500 300
200
MP and AP
1000
500 100
0 0
0 5 10 15 -100 0 5 10 15
Quantity of Labor Quantity of Labor
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Note
PGPSE NOTES 594

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short run costs
In the short run we will consider the fixed and variable
costs of production and how they change as more of the
variable input is used.
Definitions:
Total cost (TC) = Total variable cost(TVC) + Total fixed
cost (TFC).
Marginal cost(MC) = (change in TC)/(change in output).
where change in output = 1 when possible.
Average cost (AC) = TC/Q.
Average variable cost(AVC) = TVC/Q.
Average fixed cost(AFC) = TFC/Q.
Note that in the short run fixed costs must be paid
whether output is zero or 100,000 units.
PGPSE NOTES 595
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example
Let’s take the production example we had before and
translate the production data into cost data. Say the
fixed costs is $1000 per unit of capital and we had two
units before in our example, and the cost of labor is $400
per unit.
The next screen shows the continuation of our example.
PGPSE NOTES 596

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QL Q MPL APL TFC TVC TC
0 0 2000 0 2000
1 76 76 76 2000 400 2400
2 248 172 124 2000 800 2800
3 492 244 164 2000 1200 3200
4 784 292 196 2000 1600 3600
5 1100 316 220 2000 2000 4000
6 1416 316 236 2000 2400 4400
7 1708 292 244 2000 2800 4800
8 1952 244 244 2000 3200 5200
9 2124 172 236 2000 3600 5600
10 2200 76 220 2000 4000 6000
11 2156 -44 196 2000 4400 6400
PGPSE NOTES 597

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QL Q MPL APL TFC TVC TC AFC AVC ATC MC
0 0 2000 0 2000
1 76 76 76 2000 400 2400 26.32 5.26 31.58 5.26
2 248 172 124 2000 800 2800 8.06 3.23 11.29 2.33
3 492 244 164 2000 1200 3200 4.07 2.44 6.5 1.64
4 784 292 196 2000 1600 3600 2.55 2.04 4.59 1.37
5 1100 316 220 2000 2000 4000 1.82 1.82 3.64 1.27
6 1416 316 236 2000 2400 4400 1.41 1.69 3.11 1.27
7 1708 292 244 2000 2800 4800 1.17 1.64 2.81 1.37
8 1952 244 244 2000 3200 5200 1.02 1.64 2.66 1.64
9 2124 172 236 2000 3600 5600 0.94 1.69 2.64 2.33
10 2200 76 220 2000 4000 6000 0.91 1.82 2.73 5.26

PGPSE NOTES 598
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COST Curves
Total cost curve
7000 Costs per unit

6000
Dollars of Cost
5000 TFC
4000
3000
TVC 35
2000 TC 30
1000
0 25
0 1000 2000 3000 20
Dollars per unit

TP or Q or output 15
10
5
0
0 500 1000 1500 2000 2500
Quantity of Output
PGPSE NOTES 599

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Idealized graph of per unit costs
in the short run
$/unit
AC
AVC
MC
Q
Note AVC and AC equal MC when AVC and AC are at
their minimum values.
PGPSE NOTES 600
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When you look back at the marginal product and average product
curves note that the horizontal axis is measuring labor units used
and the curves are inverted u-shaped curves.
When you look back at the marginal cost and various average cost
curves note that the horizontal axis is measuring output units and
the curves are u-shaped curves.
There is a relationship between these two graphs. When you move
to the right by adding labor in the one graph you are moving to the
right in the other by having output increased.
PGPSE NOTES 601

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How much output should the firm make? How much of the
variable labor should be hired?
At this stage of our study we can say in general that additional
units of output should be made if the additional revenue on those
units is at least as great as the cost on those units. Even if the
additional revenue is equal to the additional cost nothing has
been lost, so we say produce units until the marginal revenue
equals the marginal cost. Now, if we assume all the units are
sold at the same price, then the additional revenue per unit sold
is the price of the output. In this case MR = P.
PGPSE NOTES 602

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The marginal cost of production is the change in total cost divided
by the change in output.
The marginal product of labor is the change in output divided by
the change in labor.
MC = ▲TC/▲Q, and MPL = ▲Q/▲L, so
MC = ▲TC/(MPL ▲L) = price labor/MPL.
So MR = MC implies P of output = price labor/MPL on the last
unit of output made or on the last unit of labor hired. This can also
be seen as
P of output times MPL = price labor.
So a rule of thumb is make output until MR = MC, or from a
different point of view, hire labor up to the point where the value of
the marginal product, VMP (this is P of output times MPL) = the
wage (the price of labor). www.afterschoool.tk
PGPSE NOTES 603
P
outpu
QL Q MPL APL TFC TVC TC AFC AVC ATC MC t Wage VMP
0 0 2000 0 2000
5
1 76 76 76 2000 400 2400 26.32 5.26 31.58 .26 3 400 228
2
2 248 172 124 2000 800 2800 8.06 3.23 11.29 .33 3 400 516
1
3 492 244 164 2000 1200 3200 4.07 2.44 6.5 .64 3 400 732
1
4 784 292 196 2000 1600 3600 2.55 2.04 4.59 .37 3 400 876
1
5 1100 316 220 2000 2000 4000 1.82 1.82 3.64 .27 3 400 948
1
6 1416 316 236 2000 2400 4400 1.41 1.69 3.11 .27 3 400 948
1
7 1708 292 244 2000 2800 4800 1.17 1.64 2.81 .37 3 400 876
1
8 1952 244 244 2000 3200 5200 1.02 1.64 2.66 .64 3 400 732
2
9 2124 172 236 2000 3600 5600 0.94 1.69 2.64 .33 3 400 516
PGPSE NOTES 604
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10 2200 76 220 2000 4000 6000 0.91 1.82 2.73 .26 3 400 228
On the previous slide assume price of output is $3 per unit, and the
wage is $400.
Note 9 units of labor is desired because VMP is at least as great as
the wage, but not on 10 units.
Also, 2124 units of output should be made, but not more because P
of output is at least as great as the MC, but not on more units.
PGPSE NOTES 605

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Long Run
The long run
• The long run is the time frame longer or
just as long as it takes to alter the plant.
• Thus the long run is that time period in
which all inputs are variable.
PGPSE NOTES 607

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Isocost lines
An isocost line includes all possible combinations of
labor and capital that can be purchased for a given
total cost.
In equation form the total cost is
TC = PLL + PKK,
where TC = Total cost,
PL= the wage rate,
L = the amount of labor taken,
PK = the rental price of capital, and
K = the amount of capital taken. This equation
can be re-expressed as
K = TC/ PK - (PL/ PK) L.
PGPSE NOTES 608
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example
As an example say labor is $6 per unit and capital is
$10 per unit. Then if we look at a total cost of $100
we see various combinations of inputs:
L = 10 and K = 4 or
L = 0 and K = 10 or
L = 16.67 and K = 0, amoung others.
On the next screen we can view the isocost line in a

graph.
PGPSE NOTES 609

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graph of isocost line
K
This is the isocost line

at $100. If we wanted
to see higher costs we
would shift the line out
in a parallel shift and a
lower cost we have a
shift in.
L
PGPSE NOTES 610

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K cost and output
On this slide I want to
concentrate on one
level of output, as
summarized by the
K1 isoquant. Input
combination L1, K1
K2 could be used and have
cost summarized by
K* 4th highest isocost
L shown. L2, K2 would
L1 L2 L* be cheaper, and L*, K*
is the lowest cost combination of inputs to produce the given
level of output. Here the cheapest cost of the output occurs
PGPSE NOTES 611
at a tangency point between an isocost and isoquant.
www.afterschoool.tk
K cost and output
On this slide I want to
concentrate on one
level of cost, as
summarized by the
isocost line. Input
combination L1, K1
K1 could be used and have
this cost but more
K* output would be
L obtained if L*, K* were
L1 L* used.
Here, the most output for a given cost occurs at a
tangency point.
PGPSE NOTES 612
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cost and output
On the last two screens we have seen the tangency of
an isoquant and isocost line shows either
1) the cheapest way to produce a certain level of
output, or
2) the most output that can be obtained for a given
amount of cost.
These two things are different sides of the same coin
and profit maximizing firms would be expected to
reach the tangency positions in the long run.
PGPSE NOTES 613

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Tangency
In the long run when a firm is able to change all inputs we
see the firm will go to a point where the slope of an isocost
line is tangent to a isoquant. This means the slopes are equal.
Thus, slope of isocost = (PL/ PK) = MRTS = slope of
isoquant.
Remember we said MRTS can be shown to be the ratio of
marginal products of labor to capital. Thus
PL/PK = MPL/MPK means MPK/PK = MPL/PL. This is a
statement that the “bang for the buck” should be the same
for both inputs. In other words the additional output for
each input per dollar spent should be equal across inputs
when all is said and done.
PGPSE NOTES 614
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If you happen to be at a point where the ratios are not equal
take more of the input that has the higher ratio because its
marginal product will diminish with a greater amount taken.
You will probably have to take less of the other input.
PGPSE NOTES 615

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K Expansion path
Once we have a unit
cost of capital and
labor we can draw
many isocosts, each
one that is farther out
has a higher cost. We
can see the tangency of
each isocost with an
isoquant (output level).
L
In the long run the firm will be at one of the points of
tangency. When connect all those points we have the
expansion path. In the long run the firm will be on the
PGPSE NOTES 616
expansion path. www.afterschoool.tk
The Short Run and the Long Run and seeing the connection
between the two.
The exception to reaching the tangency in the long run would
be the short run when the amount of some input can not be
changed to reach the tangency. In the long run all inputs can
be changed in amount and thus the tangency point could be
reached.
PGPSE NOTES 617

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K short run
Here the cheapest way
to produce the output
level as depicted in the
isoquant would be to
K1 hire L*, K*. But the
firm has committed to
K2 having K1 units of
capital. Thus the cost
K* of this output is
L indicated by the fourth
L1 L2 L* highest isocost line.
We could follow K1 out and see costs of other levels of
output(by putting in more isoquants).
PGPSE NOTES 618
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As you follow along K1 maybe one output level will occur
where that short run point is exactly the same as the long run
point. In that one case the cost level is the same in both the
short run and the long run.
Remember the output level shown on the previous screen in
the short run with K1 has a higher cost to produce that
output than would occur in the long run.
So, in the long run, you make the cost of a certain level of
output the lowest by not only adjusting labor to the right
amount but capital to the right amount. But, if in the short
run you are not at the right amount of capital then you will
produce the output at a higher cost because in the short run
you are stuck at a certain level of capital.
PGPSE NOTES 619
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On the next slide I have two short run average cost
curves. Each one represents the average cost with
different amounts of the fixed input capital. SO, maybe
ATC1 could have 1 unit of capital and ATC2 could have
two units of capital. There really should be lots more of
these curves but I show two to get to the next point.
If output will be less than Q in the long run, then in the
short run costs might be too high if we have two units of
capital. But, in the long run capital would be switched to
1 unit. Similarly, output above Q has lowest cost when
made with two units of capital.
PGPSE NOTES 620

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To
ATC
get Long Run Graphs
ATC2
ATC1
Q
Q
PGPSE NOTES 621

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Long Run continued
• When we switch from one unit of capital to
two units, we have the long run because
all inputs are then variable.
• But with the two units we would have short
run curves for that level of capital.
• Now we have two sets of cost curves, one
for one unit of capital and one for two units
of capital.
PGPSE NOTES 622
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Interpretation
• If output is going to be less than Q1 in the
long run then only one unit of capital
would be wanted because those units
would be produced cheapest with one unit
of capital.
• Greater than Q1 would be produced
cheapest with two units of capital.
PGPSE NOTES 623

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Interpretation
• The long run curve is parts of the short
run curves. For each range of output the
long run curve is the segment of the short
run curve that is the lowest, representing
the cheapest way to produce that range of
output in the long run. The final long run
curve is smooth. Let’s see.
PGPSE NOTES 624

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Smooth long run curve
ATC
Each point on the long run curve is really just a point off the
lowest short run curve at a level of output.
PGPSE NOTES 625
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Reason for long run shape
• The long run cost curve is said to be u -
shaped, just as in the short run, but for a
different reason. In the short run we had
diminishing returns. In the long run we
have economies of scale.
PGPSE NOTES 626

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Reason continued
• The basic idea of economies of scale is
that at least for a while when the plant size
is increased the average cost curve is
pushed down, implying average costs are
lowest in a bigger plant. It may be that
further increases in plant size push the
average cost curve back up. This would
technically be called diseconomies of
scale.
PGPSE NOTES 627
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Long Run
• Another way to view the long run is to
think about different short run situations
and put them together. Think of a short
run with one capital unit. Think of one
with two capital units, and so on.
• We would have a similar table of
numbers and graphs as we did in the
short run example when only one unit of
capital was available.
PGPSE NOTES 628
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Some Additional Cost
Concepts
The author suggests that a good function to represent total cost has
the general form
TC = f + aQ + bQ^2 + cQ^3,
Where the key ^ means raise to power,
f represents fixed cost,
Q represents the level of output that can vary, and
a, b, and c are numbers, sometimes called constants.
The average cost (AC OR ATC) = TC/Q = f/Q + a + bQ + cQ^2,
the average variable cost is a + bQ + cQ^2, the average fixed cost is
f/Q and the marginal cost = a + 2bQ + 3Q^2.
PGPSE NOTES 630

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Sometimes firms make more than one type of good and one type of
cost function to represent the total cost of making both goods would
be
TC = f + aQ1Q2 + Q1^2 + Q2^2.
The marginal cost with respect to Q1 would be
MC1 = aQ2 + 2Q1, and with respect to Q2
MC2 = aQ1 + 2Q2.
PGPSE NOTES 631

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Economies of Scope.
This is when you buy Scope in a really big bottle. 
Economies of scope are present whenever it is less costly to
produce a set of different goods in one firm than it is to produce
that set in two or more firms.
Example of two goods in the set. Add up the cost of good 1 in
one firm and the cost of good 2 in another firm then subtract the
cost from making both in one firm.
PGPSE NOTES 632

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In notation form we have
TC(Q1, 0) + TC(0, Q2) – TC(Q1, Q2).
If this expression > 0 we have economies of scope,
If < 0 we have diseconomies of scope, and
If = 0 we do not have economies of scope.
The degree of scope economies is
Sc = {TC(Q1, 0) + TC(0, Q2) – TC(Q1, Q2)} / TC(Q1, Q2).
Why do scope economies exist?
Particular outputs share common inputs. Example: advertising
diet coke with lemon twist also helps classic coke because the
brand names are the same.
PGPSE NOTES 633
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Cost complementarities – when increasing the production one
good it lowers the marginal cost of producing the other good.
Example: Say a multiproduct firm has
TC = 100 -0.5Q1Q2 + Q1^2 + Q2^2
In terms of scope economies
If Q2 = 0 TC1 = 100 + Q1^2 and if Q1 = 0 TC2 = 100 +Q2^2,
Then TC1 + TC2 – TC = 100 + .5Q1Q2 which >0 for Q1 and
Q2 greater than 0. So economies of scope exist.
In terms of cost complementarities
MC1 = -.5Q2 + 2Q1 so if Q2 goes up MC1 goes down, and
MC2 = -.5Q1 + 2Q2 so if Q1 goes up MC2 goes down. Thus
there are cost complementarities.
PGPSE NOTES 634
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If in the example on the previous screen if the firm divested
itself of product 2 its cost would become
TC = 100 +Q1^2 and its MC would be 2Q1. This MC is more
than under the case of cost complementarity.
PGPSE NOTES 635

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Chapter 6
The Organization of the Firm

Last chapter we said the firm works to make output as cheap as
possible. There we focused mainly on transforming inputs to output.
Here we add to more ideas:
1) The firm must obtain the inputs in the least costly way, and
2) The firm must ensure that maximum effort is given by all
involved in the firm. (Is maximum 100%? Probably not, we would
all go bonkers. But, maximum is a high level of effort.)
Some guide named Ronald Coase has a story called “Nature of the
Firm.” In the story he basically said a firm will internalize an
operation if it is cheaper than doing the operation external to the
firm. This chapter is based on this story.
PGPSE NOTES 637

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Methods of Getting Inputs
1) Spot Market – buyers and sellers meet in the open market, make
a deal and move on. There is no formal relationship between the
buyer of the input and the seller.
2) Have a contract – have a formal agreement between the buyer
and the seller.
3) Vertically Integrate – As a maker of output you also make your
own inputs.
Transaction Costs
When getting an input, firms incur costs in excess of the actual
amount paid to the input supplier. These costs include searching for
sellers, negotiating terms of trade and other investments and
expenditures required to get and use the input.
PGPSE NOTES 638
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Some investments firms make are specialized in nature. An
example would be where as a supplier you have to have a certain
knowledge base and that knowledge is only required by 1 buyer.
Transaction costs may be high with specialized investment
because of
1) Costly bargaining to hammer out details
2) Underinvestment – supplier may buy less than best tools to do
the job because supplier can not be sure buyer of input will be
around long enough for input supplier to get most out of the
tools.
3) Opportunism
Example: Buyer of an input likes to specify that supplier has
“quality” inputs. Moreover, the buyer spends $10 investigating
the supplier to make sure itPGPSE
is okay. After the investigation the 639
NOTES
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the input for $100, on this new buyer it may try to get between $100
and 110 because the supplier knows the buyer can buy the input
elsewhere at $100, but it will also have to spend $10 to varify the
other seller has quality.
Problems of Spot Exchange
If acquisition of input requires substantial specialized investments
there is likely to be high bargaining costs. Perhaps opportunism
and underinvestment would happen as well.
As we look at the world around us specialized inputs are probably
not traded much on the spot market.
Problems of contracts
Contracts may overcome underinvestment and opportunism, but the
negotiation costs could be high.
PGPSE NOTES 640
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Problem of vertical integration
Vertical integration overcomes the costs of negotiating with a
middleman, but it increases the degree of complexity of the
organization.
Author suggestion:
If an input is not very specialized buy it on the spot market. If an
input is specialized contract when bargaining is not very complex.
Otherwise, vertically integrate.
PGPSE NOTES 641

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Owner –Manager Problems
Many firms have managers who run the firm, but the managers
are not the owners of the firm. The manager likes income (and
will get it if the owners are happy), but the manager also likes
leisure. Owners don’t like the managers having too much leisure.
The situation described here is 1 type of Principal – Agent
problem. The general problem is an agent working on behalf of
the principal has interests that differ from the principal and thus
agents may not always do what is in the best interest of the
principal.
Ways the owner-manager problem may be overcome
1) Give managers pay incentives so that they act like owners.
2) Managers may recognize if they earn a good reputation as a
good manager then they can advance in the company or become a
“free agent” and make morewww.afterschoool.tk
money later.
PGPSE NOTES 642
3) Managers may be motivated by the possibility that if they under-
perform the company will be overtaken by new owners who will
replace them with new managers.
Manager-worker problem
Another principal-agent problem occurs between managers and
workers. The manager is now the principal. How does the manager
get the worker to not shirk (take too much leisure)?
Ways to overcome the problem
1) Profit sharing for workers.
2) Revenue sharing like tips and wages.
3) Piece rates – you get paid by how much you produce.
4) Time clocks and spot checks.
PGPSE NOTES 643
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So, there you go. We have explored some issues that deal with the cost of doing
business. The hope is that if we are sensitive to these issues than perhaps we
can have the firm produce its output level at the lowest possible cost.
PGPSE NOTES 644

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The Nature of Industry
Later we will study industries called perfect competition,
monopoly, monopolistic competition, and oligopoly. The
differences in these industry types has to do with factors such as
how many sellers there are in the industry, or market, technology
and cost consideration, demand conditions and how easy it is to
enter an industry.
Let’s explore some of these topics next.
PGPSE NOTES 646

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Measuring Market Structure
Concentration ratios
In the real world of business we see the number of firms varies
from industry to industry. In an attempt to find a numerical
measure to indicate which industries are more like monopoly –
one firm - and which are more like perfect competition – many
firms, concentration ratios were devised.
Concentration ratios typically use sales as the concept used in
the numerical measure.
PGPSE NOTES 648

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Concentration ratios
CRn is the sales added across the n largest firms in an industry
divided by the total industry sales(and then multiply the
result by 100 to be in percentage terms). For example, CR4
is the sales of the 4 largest firms added together divided by
total sales in the industry(generally, more than 4 firms).
Examples
d) Monopoly industry –> CR4 = 100,
e) Industry with 4 firms of equal size (25% of sales for each)
-> CR4 = 100.
Can you tell which of the examples above has only one firm by
just looking at the CR4? Of course not!
PGPSE NOTES 649
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More examples:
b) 10 firms, each with 10% of market -> CR4 = 40,
c) 4 firms, each with 10%, and 30 firms, each with 2% ->
CR4 = 40.
Here we have two examples of industries where the CR4 is the
same. But we see the remaining firms after the top 4 are
very different in each example. You would see this by
looking at the CR8, but not all the time. So, another measure
has been added and the measure considers all the firms in an
industry. The measure is the HHI
PGPSE NOTES 650

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Herfindahl-Hirschman Index – HHI
To get the HHI we need the market share of each firm in
percentage terms. Then we square the market share of each
firm. After this, simply add the squared market share of
each firm to get the final number.
Examples
• Monopoly -> HHI = 1002 = 10,000. This is as big as you
can get.
• 4 firms with 25% each -> HHI = 252 + 252 + 252 + 252 =
2500
• 10 firms each with 10% -> HHI = 10 times 102 = 1000.
• 4 firms with 10%, 30 firms with 2% -> HHI = 4 times 102
plus 30 times 22 = 400PGPSE
+ 120NOTES
= 520. 651
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Another way to get this is to take the market shares in fractional
terms, square each share, add them all up and multiply by 10000.
HHI
The closer the HHI is to 10,000 the more the industry is like a
monopoly. The closer to 0 the more the industry is like a
competitive industry.
Issues with CR4 or HHI
How do we define a market? At issue is how narrow or broad do
we define the industry. Is aluminum foil and waxed paper in the
same market? What about that plastic wrap that gets all stuck
together before you cover the food? Should that be included with
the aluminum foil and waxed paper?
The issue raised has to be settled before we can even calculate the
PGPSE NOTES 652
CR4 or the HHI. www.afterschoool.tk
The Census Bureau looks at firms that have similar production
processes and considers them to be in the same market. But, this
method may not be useful if consumers do not consider different
products with similar production processes to be substitutes for
each other.
The cross price elasticity of demand
The cross price elasticity of demand is defined as the percentage
change in the demand for good x given the percentage change in
the price of good y.
Example
If the price of Pepsi (and only Pepsi in this example) goes up we
would expect the demand for Coke to rise. So the cross price
elasticity of demand is positive for substitutes and we would
expect goods in the same market to have a high numerical value
PGPSE NOTES 653
for the cross price elasticity.
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Geography
Most studies have considered concentration ratios for the
country. Local ratios need to be considered.
If you look at the services of real estate agents, then
concentration ratios at the national level are probably small.
But, in many towns there is only one agent. Local ratios could
be large.
Ratios at the national level do not include foreign firms that
actually compete. This means that some industries will appear
more concentrated toward monopoly when, in fact, if you
include the foreign firms the ratios would be lower.
PGPSE NOTES 654

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Vertical integration
Goods and services are the end of a process of transforming
inputs into those goods and services. Just think of a loaf of
bread. The wheat needed to be grown. Then the wheat is sent
on to millers. The miller sends on the “stuff” to the baker.
From the baker the item might go to a distributor and then the
retailer. The more that one firm is involved in all stages of the
production process, the more vertically integrated the firm is
said to be.
With this in mind, there are some industries that are not
vertically integrated and this would suggest low
concentration. But this could be misleading because all the
firms in the “stream” of production are tied to the main
product.
PGPSE NOTES 655
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The authors of our text use the example of Coke and Pepsi.
There are many bottlers around the country and this leads to low
concentration. But in the soft drink industry you and I know
Coke and Pepsi are the dominant players.
So, what have we done here? We listed numerical measures of
concentration designed to show what type of market structure an
industry might have. Plus, we indicated some ideas we need to
be aware of as we look at these measures.
PGPSE NOTES 656

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http://www.usdoj.gov/atr/public/guidelines/horiz_book/toc.html
The link above is to a web site at the Department of Justice

dealing with horizontal mergers – companies in the same line
of business. Note section 1.5.
Market Conditions
Firms in an industry will have a demand for its product, while

at the same time there is a demand for the product from all the
firms as a group. With each there is an elasticity of demand.
The Rothschild index is the elasticity of the total market - Et
divided by the elasticity of the firm - Ef.
If there are not many substitutes for a firm’s product you would
expect the index to be 1 and if there are many substitutes you
would expect the index to PGPSE
be closer
NOTESto 0. 657
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Entry into Industry
Major League Baseball has a specific barrier to entry into the
league. You have to get the approval of the other owners in the
league. This is a significant barrier.
Patents may limit the number of firms that can operate in an
industry, as can capital requirements.
The notion of a barrier to entry is significant because if there is
an ability to restrict others then maybe existing firms can enjoy
long term profits without fear of others stepping in and taking
some of those profits.
PGPSE NOTES 658

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Lerner Index
Lerner Index
L = (P – MC)/P. This is a measure of the exercise of monopoly
power.
In perfect Comp. the L = 0 because (as we will see) P = MC.
The Lerner Index = 0 in competition and is larger for

Monopoly situations. The term P – MC is often called the
Monopoly mark-up.
By math we see
LP = P – MC, or MC = P – LP = (1 – L)P, or
P = [1/(1 – L)]MC, 1/(1 – L) is the mark-up factor. If L = 1
MC = P.
PGPSE NOTES 660

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As a manager, this current section is designed to have you look at
the world around you and observe some things. In the future you
will learn about models of the world so you can put into
perspective what you are observing. Along the way you will
learn about rules of behavior. Behavior in this sense is what price
should you charge for your services and what output level should
you attempt to sell.
PGPSE NOTES 661

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Cost of Living
cost of living
On the next several slides we want to explore the
economic concept called the cost of living. We typically
look at a price index to help us understand the cost of
living.
In order to do this let’s first think about some examples of
consumer optimum points.
Say that you have income of $20, the price of x is $3, the
price of y is $4.
Now if you spent all of your income on x you could buy
6 2/3 x or if you spent all your money on y you could buy
5 y. Note that each time an additional unit of x is
purchased, 3/4 of a y must be given up.
PGPSE NOTES 663
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cost of living
y
From the previous screen I
have taken information about
the budget line and have
drawn in the budget line. Plus
(0, 5) I have added the fact that when
(4, 2)
the consumer faces this budget
line they end up purchasing
x the basket (4, 2).
(6 2/3, 0)
We know that when the consumer ends up at point (4, 2)
the are as happy as they can be at this time. In fact they are
at a point of tangency between the budget line and their
highest possible indifference curve.
PGPSE NOTES 664
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cost of living
y
In this diagram you can see the
optimum point for the
consumer.
(0, 5) (4, 2)
x
(6 2/3, 0)
PGPSE NOTES 665

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cost of living
Now let’s say that there are
y some changes in the world. The
price of x becomes 4(it used to be
3), and the price of y becomes
2(used to be 4). Now the new
budget line would have:
(0, 5) 1) if all income(no change in this
(4, 2)
example) is spent on y, 10 y
could be bought.
x 2) 5 x could be bought if all is
(6 2/3, 0) spent on x.
In this example the original optimum point could also be
purchased at the new prices: (4)(4) + (2)(2) = 20.
PGPSE NOTES 666

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y
cost of living
In this diagram I put just the new
new and the old budget lines. Note
that the same original basket can
be purchased under either set of
prices. With the new budget we
know the consumer will not end
up to the right of the original
basket because any of those
old baskets on the new budget could
x
have been purchased by the consumer under the old set of
prices, but the consumer didn’t buy them. Therefore, they
could not have been preferred
PGPSE NOTES to the basket. 667
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y cost of living
When I put in the indifference
new curve tangent to the old budget
line you can see the individual
will not end up at the original
basket under the new budget
because it isn’t tangent there
now. You know the consumer
will not end up on the new
old
x
budget line way up in the upper left - also left of the
indifference curve. Those points are less preferred
because they have to be on a lower indifference curve.
PGPSE NOTES 668
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cost of living
We conclude that in this
y example the consumer will
actually end up on a higher
indifference curve at the later
prices compared to the earlier
prices. Thus, the consumer is
(0, 5) happier under the new prices
(4, 2)
than under the old prices.
x
Note this is a special
(6 2/3, 0)
example because the
consumer can buy the same
basket under either set of
prices.
PGPSE NOTES 669
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cost of living
Now in this example we had original basket
x = 4 and y = 2.
Under the original prices of Px = 3, Py = 4 the cost of
living at the original basket was (3)(4) + (4)(2) = 20.
The consumer price index looks at the cost or ‘price’ of a

basket of goods over time. If we look at the original
basket and original prices in this example we see the cost
of living is 20.
Now the new prices are Px = 4, Py = 2. The cost of the

original market basket is still 20 = (4)(4) + (2)(2).
PGPSE NOTES 670
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cost of living
In this example the consumer price index would show no
change in consumer prices.
What is interesting about this example is that although one
price went up and one went down, the original basket cost
stayed the same- no CPI change - BUT the level of
happiness for the consumer went up.
In this sense you could say that the CPI is a misleading
indicator of the cost of living. It measures the cost of a
basket of goods - not the cost of a level of happiness. Since
the consumer ends up happier in our example (at the same
cost), the cost of having the original happiness went down.
Thus, the CPI overstates the cost of maintaining a given
level of happiness. PGPSE NOTES 671
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steak and potatoes
potatoes
Note in this example
the order of preference
for the baskets of goods
(steak, potatoes)
(2, 2) is preferred to
(1, 1)
steak
PGPSE NOTES 672

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steak and potatoes
potatoes
Now say in some year
Ps = $2 and Pp = $1
and the consumer has
$4 of income. The
budget line is drawn in
and the optimum for
the consumer is 1
steak, 2 potatoes.
steak
PGPSE NOTES 673

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steak and potatoes
potatoes
In a later year let’s say
prices change such that
steak is lowered to $1
and potatoes rise to $2.
The new budget line is
the dashed line.
Note at the new prices

steak
more steak is bought when steak is at a lower price and
less potatoes are bought when potato prices went up.
PGPSE NOTES 674
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steak and potatoes
Also note on the previous screen that after the price
change the consumer is better off.
Now let’s look at the original basket (as is done with the
consumer price index). At the old prices the basket cost
$4. Under the new prices the basket costs $5. We can see
from the consumer preferences that this old basket is less
preferred than the new basket.
The consumer price index would indicate a 25% increase
in prices and the consumer is still better off. Why?
PGPSE NOTES 675

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steak and potatoes
The CPI follows the cost of fixed basket of goods over
time.
Consumers do not buy a fixed basket of goods over time.
They tend to shift to goods that have prices lowered and
away from goods that have had price increases.
In this regard the CPI overstates the true impact of
inflation. It measures inflation of a fixed basket of
goods. What would really be good is to look at the cost
of buying a fixed level of happiness. This method can
not be devised. So we live with a measure that has
problems and recognize what those problems are.
PGPSE NOTES 676

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Price changes and total
revenue changes
relationship
When we look at the collection of consumers in the
market, at this time in our study we assume each
consumer pays the same price per unit for the product.
Also at this time in our study the total expenditure of

the consumers in the market would equal the total
revenue (TR) to the sellers.
So, here we look at the whole demand side of the

market in general.
PGPSE NOTES 678

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Elasticity and total revenue (TR)
relationship
P
TR in the market is
P1 equal to the price in the
market multiplied by
the quantity traded in
the market. In this
diagram TR equals the
Q area of the rectangle
Q1
made by P1, Q1 and
the horizontal and vertical axes. We know from math that
the area of a rectangle is base times height and thus here
that means P times Q. The rectangle here is TR.
PGPSE NOTES 679
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relationship
We will want to look at the change in values of a
variable and in order to do so we want to have a
consistent measure of change. In this regard let’s say
the change in a variable is
the later value minus the earlier value.
Thus if the price should change from P1 to P2, then the

change in price is
P2 - P1, or similarly if the TR should
change the change in TR is
TR2 - TR1.
PGPSE NOTES 680
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P
relationship
Now in this graph
P1 when the price is P1
a
b c
Q The change in TR if
Q1 Q2 the price should fall
from P1 to P2 is (b + c) - (a + b) = c - a.
Similarly, if the price should rise from P2 to P1 the change
in TR is a - c. I will focus on price declines next.
PGPSE NOTES 681
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P
relationship
Since the change in TR
is c - a, the value of the
P1 change will depend on
a
P2 whether c is bigger or
b c smaller, or even equal
to, a. In this diagram
we see c > a and thus
Q the change in TR > 0.
Q1 Q2
This means that as the price falls, TR rises. I think you
will recall that in the upper left of the demand the demand
is price elastic. Thus, if the price falls in the elastic range of
demand, TR rises.
PGPSE NOTES 682
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Elasticity and TR
You will note on the previous screen that I had c - a. In
the graph area c is an indication of the change in TR
because we are selling more units. The area a is an
indication the change in TR when there is a price
change. We have to bring the two together to get the
change in TR.
Thus a lower price has a good and a bad.

Good - sell more units.
Bad - sell at lower price.
PGPSE NOTES 683

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P
relationship
Now in this graph
the TR = a + b(adding
P1 is P2 the TR = b + c.
P2 a
Q c < a and thus the
Q1 Q2 change in TR < 0.
I think you will recall that in the lower right of the
demand the demand is price inelastic. Thus, if the price
falls in the inelastic range of demand, TR falls.
PGPSE NOTES 684
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P
relationship
Now in this graph
a areas) and if the price
P2
Q c = a and thus the
Q1 Q2 change in TR = 0.
I think you will recall that in the middle of the demand the
demand is unit elastic. Thus, if the price falls in the unit
elastic range of demand, TR does not change.
PGPSE NOTES 685
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Okay, let’s see if you understand this section.
If the price of a product falls will the firm lose revenue?
In general we say the answer depends on what the elasticity of
demand is for the product. Revenue will be lost only if the
demand is inelastic and the price falls. If you like to memorize
stuff, here is a table for you:
Call this symbol the
Demand is P P no change symbol.
Elastic TR TR
Unit elastic TR TR
Inelastic TR TR
PGPSE NOTES 686

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Income and substitution
effects
Here we want to explore some more of the detail of a price
change on the demand for a good. Here is the basic idea.
Say the price of x falls. When this happens we think two
things are at work: an income effect and a substitution effect.
The income effect: If initially we buy the same amount of x
as we purchased before, since x has a lower price we will
have more of our own income left and so it will feel like we
have more income. We saw when we have more income we
want more normal and less inferior goods. So, the income
effect of a price change means if the price is lowered we
could want more or less of the good.
PGPSE NOTES 688

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The substitution effect: The sub effect is an indication that as
the price of a good falls we want more of the good and we
use it in substitution for other goods.
In economics we like to show the income and substitution
effects in the diagram of consumer utility maximization.
PGPSE NOTES 689

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y change
x1, y1. If the price of x should
fall the budget line rotates out
in a counterclockwise fashion.
y1 The dashed line above x1 is
x similar to the one in the income
x1 change diagram. Except here
we do not think the consumer
will end up to the left of the dashed line when there is a
price decline.
PGPSE NOTES 690

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change
The reason we feel the consumer will not end up to the
left of the dashed line is twofold:
when the price falls
1) at the initial amount of x purchased the consumer
feels richer and we saw this may make them buy more
or less of x(income effect of a price change),
2) x becomes relatively cheaper and we feel people
move toward now relatively cheaper products and
away from now relatively more expensive
items(substitution effect of a price change).
PGPSE NOTES 691

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change
So, the income effect means more or less x given a
price decline, and the substitution effect means more x
given a price decline.
Now if the good is an inferior good
1) the income effect says less x
2) the substitution effect says more x.
The only way we could end up to the left of the dashed

line on the previous screen is if the income effect
operating with an inferior good is larger than the
substitution effect. Economists have felt this rarely, if
ever, happens. PGPSE NOTES 692
www.afterschoool.tk

start at point r. With a price decline in
is how to think about this point: after
the price fall think about the consumer
losing enough income so that the initial
utility level could be obtained.
x
r s t
PGPSE NOTES 693
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The movement from r to s highlights the substitution
effect because the consumer had the income effect of the
price change taken away. The movement from s to t is
the income effect.
PGPSE NOTES 694

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The demand curve
P
From 2 screens ago we saw a price
decline had us move from point
P1 r to t. When we put this info into
a price, quantity graph we see the
P2 demand curve is downward
sloping.
x (usually we put Q)
Q1 Q2
(r t)
PGPSE NOTES 695

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The demand curve
You and I already knew the demand curve was

downward sloping, but now we also know it is
because we think substitution effects outweigh income
effects. Plus we know at each point along the demand
curve the consumer is maximizing their utility given
the situation they find themselves in.
We also know now that at lower prices the consumer
reaches a higher level of satisfaction. This was not
always obvious along just the demand curve.
PGPSE NOTES 696

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start at point r. With a price increase in
r to s sub is how to think about this point: after
effect the price increase think about the
s to t consumer getting enough income so
income that the initial
effect utility level could be obtained.
x
t s r
PGPSE NOTES 697
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To highlight the income and substitution effects of a price
change we put in an intermediate point. Essentially what
we did was say after the price change let’s show a
hypothetical change in income to get the consumer back to
the original indifference curve that they started with.
(Lower price, take income away, higher price, give income
back.)
The movement along the original indifference curve is then
the substitution effect. Then take the income change back
out to see the income effect.
PGPSE NOTES 698

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Impact of Change in Income
Here we want to consider the

change consumers will make if
they experience a change in
income.
change in income.
Note that the budget line is a summary of the baskets of
goods that a consumer can buy. The consumer
ultimately picks the basket that is able to be purchased
and gives the individual the most satisfaction or
happiness.
For the next few slides let’s just think about the budget
line and not about consumer utility maximization.
PGPSE NOTES 700

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y
change
Remember on the budget
line we are measuring the
amount of x and y the
y1 consumer can buy given
their income and given the
x fact that prices must be paid.
x1
I have illustrated one basket the consumer can buy. With
the price of x = Px and the price of y = Py the consumer
here could buy x1, y1.
PGPSE NOTES 701

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y change
There are many ways to
y2 think about how the budget
line would change given an
y1 income change, but one way
to think about it would be to
x pick a given amount of x, say
x1 x1. Before the income
change say that once x1 is bought that leaves only y1 of y.
Now if there is an income increase, after x1 is bought
that would leave more money to spend on y and thus y2
could be bought.
PGPSE NOTES 702
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change
From the previous screen we can see more y can be
bought if there is more income available, but how much
more depends on the prices of x and y and it depends on
the income change.
But, as income rises more y can be bought, given an

amount of x is bought. Thus the budget line shifts out in
a parallel fashion if income grows and by a similar logic
shifts in parallel if there is an income decline.
PGPSE NOTES 703

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point change
Now that we know how the budget changes given an
income change, let’s see how the consumer optimum
changes(given that taste and preferences do not
change).
PGPSE NOTES 704

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y point change
point a - x1, y1 gives
maximum satisfaction. Note I
have extended a line above
y1 point x1.
a
Now with more income the
x budget line shifts out. The
x1 consumer will end up either
to the right or the left of the dashed line. If the consumer
ends up to the right, more x is wanted with more income.
If the consumer ends up to the left of the dashed line
then less x is wanted when more income is obtained.
PGPSE NOTES 705
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point change
A normal good is one where that as the consumer gets
more income more of the product is demanded (or less
income means less of the good is demanded).
An inferior good is one where as the consumer gets

more income less of the product is demanded (or less
income means more of the good is demanded).
PGPSE NOTES 706

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y
Income consumption path
y1
a
x
x1 x2
When we look at several consumer optimum points at various
levels of income and then trace out the points with a line we
get the income consumption path. Here both goods are
normal goods. Would the income consumption path be
downward sloping if only one of the goods were inferior?
PGPSE NOTES 707
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y
Engel curve - normal good
x
x2
y1 x1
a
x income
x1 x2 I1 I2
In the right hand picture we can see an income increase
and from the left graph we take the new x, x2, and draw
it in with the new income level. The Engel curve for a
normal good is upward sloping. What about for an
inferior good?
PGPSE NOTES 708
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Note that the second graph on the previous slide had income on
the horizontal axis and the quantity of x on the vertical. This is
different than most graphs you have probably seen in econ.
Mrs. Engel’s boy thought this idea up – to study how changes in
income change our consumption patterns.
PGPSE NOTES 709

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Indifference curves
Indifference curves represent a

summary of the consumer’s taste
and preferences for various
products.
De gustibus non est
disputandum
There is no accounting for the taste of the consumer.
Consumers like what they like(various things influence
what they like - advertising, customs...). Consumers
derive utility or happiness by consuming goods and
services. In economics we summarize the likes or tastes
of the consumer by using indifference curves.
An indifference curve shows different combinations of

goods that give the same level of utility to the consumer.
PGPSE NOTES 711

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Diagram used in analysis
good y
The amount
of good y a
consumer
may have is
measured
vertically
good x
The amount of good x is measured on the horizontal
axis.
This type of diagram is used extensively when
considering the behavior of consumers.
PGPSE NOTES 712
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Indifference curves - definition
◆ As mentioned earlier, an indifference curve

shows various combinations of goods that
yield some specific level of utility or
satisfaction for the individual.
y
This is one type of
A indifference curve. We
assume the
individual is equally happy
B at point A or B or any other
point on the indifference
x curve.
PGPSE NOTES 713
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◆ We assume more goods are preferred to less

and thus indifference curves slope downward
to the right.
y Say the individual is at
the point in the middle
2 1 of the graph. Keep this
in mind as we explore
the following screens.
3 4
PGPSE NOTES 714

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◆ If the individual is at the point in the

diagram, then all those points in area 1 and
on the boundary are more preferred because
those points have either more of both items or
more of one and the same amount of the
other item compared to the point chosen.
◆ Points in area 3 and the boundary are less
preferred to the point in the diagram because
the point chosen has more of both items.
PGPSE NOTES 715

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◆ An individual may think that points in areas

2 and 4 are preferable, less preferred or
equally desirable to the point indicated.
◆ Since areas 2 and 4 are the only ones that
could have a point of indifference to the one
chosen, the indifference curves must have
negative slope.
PGPSE NOTES 716

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slope
In economics we often use graphs and with graphs you can

look at the concept called slope. Often in economics the idea
of slope will have an economic interpretation. Let’s review
the idea of slope.
Slope = rise/run.
With a curve that slopes downward from left to right the
slope is a negative number.
With a curve that slopes upward from left to right the slope is
a positive number.
PGPSE NOTES 717

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y
Say the consumer is at
point A. If the
consumer gives up one
B unit of x, m units of y
m must be given back to
A hold the consumer at a
constant level of utility.
x You could say the

consumer is willing to
1 trade 1 unit of x to get m
units of y.
PGPSE NOTES 718
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◆ The shape of the indifference curve on the

previous screen is said to be convex.
◆ Part of the reason for this is that it is assumed
that the amount of good y one receives in
return for one unit of x depends on how
much of each the individual starts out with.
PGPSE NOTES 719

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y
You can tell that point A has
less x than at B. As the
A
individual takes even one less
unit of x from either point A or
B B, some y must be given in
return.
But more is given in return if
point A is the initial point.
x
The point is the less you have of something(like x at
point A compared to point B), the more of other things
you must be given in return to compensate for the loss of
the one unit, assuming the same level of utility is
PGPSE NOTES 720
obtained. www.afterschoool.tk
◆ The marginal rate of substitution(MRS) is the amount
of y given in return for the one unit of x, while
maintaining the same level of utility.
◆ We can think of the MRS as a fraction:
◆ MRS=absolute value of
(change in y)/(change in x) .
◆ In this sense, the MRS is the absolute value of the
slope of the curve at various points. Note the slope
changes from point to point. In absolute value the
fraction gets smaller the farther down the curve one
moves. This is another way of saying the curve gets
flatter.
PGPSE NOTES 721

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feature 2
In general, it is assumed that consumers value additional units

of a good less and less the more they have of the good. (Or
you could say when consumers give up good x they require
more and more of good y the less of good x they start with.)
The indifference curve gets flatter.
This notion is summarized with the phrase – diminishing
marginal rates of substitution.
PGPSE NOTES 722

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Indifference Map
Every point in the graph
has one, and only one,
indifference curve running
through it.
Curves farther out from
the origin have more
utility.
x So, the consumer can
compare every bundle and
make a determination of
preference or indifference.
PGPSE NOTES 723

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Indifference curves for an

individual do not cross. Say they
did, like in this diagram. Then
C individual would be
A indifferent to A and B,
B indifferent to A and C,
and thus by logic should be
indifferent to B and C.
x
But C has more of both goods compared to B and thus C

is preferred to B. So the curves can not cross for an
individual. Transitivity of preferences holds.
PGPSE NOTES 724
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◆ Different people can have different general

shapes of indifference curves. Some are
relatively steep and some are relatively flat.
◆ On the next slide I will put two peoples’
indifference curves and they will cross.
Before we said one individual’s curves could
not cross.
PGPSE NOTES 725

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y
Mr. A
Mr. B
x
Note how Mr. A has a steeper curve than Mr. B. From the
point where the curves cross if both give up a unit of
x, note how Mr. A has to be given more y to
make up for the loss of x than Mr. B. Mr. A is said to have
a relatively strong preference for x because he needs much
more y in return for the one unit of x given up.
PGPSE NOTES 726
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A math example of a utility function might be
U = sqrt(XY) – this means utility is a function of the square root of
the product of the amount of x and the amount of y a person would
get.
To get an indifference curve pick a value of U. Let’s say U = 4.
Then some points on the indifference curve would be
X Y
16 1
1 16
4 4
8 2
PGPSE NOTES 727
2 8 www.afterschoool.tk
indifference curve when U = 16
20
15 1, 16
10 y
Y
2, 8
5 4, 4
8, 2 16, 1
0
0 5 10 15 20
X
PGPSE NOTES 728

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Budget
Here we explore the combinations

of income and leisure the
individual can obtain
Budget constraint

shows combinations of income and leisure
that can be attained.
◆ The constraint will be a line in a diagram
where we put the hours of leisure on the
horizontal axis and income on the vertical
axis. When an individual takes more leisure
here we are assuming that less time is spent
as labor.
PGPSE NOTES 730

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Budget constraint
This budget line

income
is drawn assuming
the wage rate is $1.
(0, 24) In one day, one
could have 24 hours
of leisure and no
income, or no leisure
leisure and $24 income, or
any other combo on
(24, 0)
the line.
PGPSE NOTES 731

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Budget constraint
income Note how the slope

of the budget line is
(0, 24) the negative of the
wage rate. For
every unit of leisure
given up, $1 would
be earned as income.
leisure
slope=(change in inc)
(24, 0) (change in leis.)
=1/-1= -1 = -wage.
PGPSE NOTES 732

www.afterschoool.tk
(0, 48)
Budget constraint
income If the wage should rise,

to say $2 per hour, the
(0, 24) budget constraint
rotates clockwise. The
point on the vertical
axis now has to indicate
$48 in income if one
leisure
worked all day.
(24, 0) The slope of the new
budget is - $2.
PGPSE NOTES 733

www.afterschoool.tk
Budget constraint
income
(0, 24)
nonlabor income
leisure
(24, 0)
If the individual has nonlabor income, the budget line shifts
up by the amount of nonlabor income. The slope remains
as was - remember the slope is the negative of the wage rate.
PGPSE NOTES 734
www.afterschoool.tk
Let’s come up with the equation for the budget constraint.
The dollar volume of income – y - we can undertake is
made up of our income from work and any nonlabor
income we have. If the wage is w, h is the number of hours
we work, and the nonlabor income is Z, then
y = wh + Z.
PGPSE NOTES 735

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y = wh + Z
Say T = 24 hour day, then the amount spent in work is 24
minus the time spent in leisure (l). So,
y = w(24-l) + Z
Note:
1) If l=0, meaning all time is spent working, y = 24w + Z.
2) If l = 24, meaning all time spent in leisure, y = Z.
3) If Z = 0, meaning no nonlabor income, y = w(24-l)
PGPSE NOTES 736

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Budgets when wage = $2
70
60
50
Income
40 budget V= 0
30 budget V = 10
20
10
0
0 10 20 30
Leisure
Note here that when the nonlabor income changed the

budget shifted out in a parallel fashion.
PGPSE NOTES 737

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The budget line represents the most of income and leisure
the individual can get. The individual can be inside the
budget, but not outside it (meaning farther out in the
northeast direction from the budget.)
Next we will bring together the budget line and the
indifference map for an individual and explore what the
connection is between the two.
PGPSE NOTES 738

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To Supply Labor or Not to
Supply Labor
This is the question to which we
turn.

highest indifference curve possible (because
then they would maximize utility – that is the
utility they can obtain), but the budget
constraint restricts the individual’s options to
the budget line.
individual can do.
PGPSE NOTES 740

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income Utility Maximization

c line, u3 can not be
a u3
reached
u2
b u1
leisure more utility would be
obtained if the individ.
can achieve given the wage rate.
PGPSE NOTES 741

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C Utility Maximization
L
point. To give up a unit of leisure and maintain the same
income. But the market actually gives back more income
than the individual requires for the same level of utility.
This trade is beneficial. The individual would thus give
up the unit of leisure and be happier for the trade.
PGPSE NOTES 742
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c
point. To take a unit of leisure and maintain the same
income. But the market actually requires the individual
would thus take the unit of leisure and be happier for the
trade.
PGPSE NOTES 743
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a b
In the
when the MRS=wage(this means the indifference curve is
tangent to the budget line).
Distance cb is the amount of labor this individual would
supply. Distance ad is the amount of income they would
have.
PGPSE NOTES 744
www.afterschoool.tk
At the same wage, why two people supply different amounts of
A workaholic is a person with a labor
relatively weak preference for leisure
because little income is needed to give up
Note the solid line indiff.
a unit of leisure
curve is for the
workaholic. At the
workaholics optimal
point, the leisure lover
finds it beneficial to take
on more leisure because
or their willingness to
Note that at each persons give up much more
optimal point inccom to get more
MRS=wage. leisure than the market
requires.
PGPSE NOTES 745
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Changes in wage and the
work decision
here we explore the income and
substitution effects of a wage
change.
Change in the wage rate
b Before the wage rate increase

c the person does best at point
a. After the wage rate
d increase the individual will
a
be happier but what is not
clear is if 1)they will work
more, as they would at area b, 2) they work the same

amount as, as at point c, 3) they work less, as at area d.
Economic theory does not indicate which move will be
preferred for any individual, but we have some general
rules called the income effect and the substitution effect
that help us understand which move a person makes.
PGPSE NOTES 747
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Income effect
◆ The basic idea of the income effect is that as

the wage rate rises(falls), even if the person
worked the same amount as before the wage
increase, they would have more income.
Now when people obtain more income they
tend to want more goods and services(at least
those kinds we call normal). Leisure is one of
those goods we would like more of and this
pulls the person toward area d on the
previous screen.
PGPSE NOTES 748

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income
Income effect in a graph
The way we look at the income

effect is to not change the wage,
but to give the person more
(nonlabor) income and see how
they react. Since we assume
leisure is a normal good the
leisure
person will take more leisure.
PGPSE NOTES 749

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Substitution effect
◆ The basic idea of the substitution effect is that

as the wage rate rises, the price of leisure
rises. As the price of anything rises you and I
tend to look for something else in substitution
for the thing that has had an increase in price.
◆ This means we would want less leisure as the
price of leisure(the wage rate) rises. On slide
2 this means we would move more toward
area b.
PGPSE NOTES 750

www.afterschoool.tk
income Substitution effect in a graph
Start out on the

indifference curve tangent
to the budget line above
point j. An increase in
the wage rotates the
budget clockwise. Now if
we take away non-labor
in the amount so that the
k j leisure person ends up with the
same utility with which
sub. effect is from j to k. they started, then we
would be at the point
above k – a tangency.
PGPSE NOTES 751
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income income effect in a graph
To see the income effect

we start at point k and
give back income so that
we are on the new wage
budget line.
If the income effect had

us move to this area of
k j leisure the budget, a place that
could, in theory,
happen, then the income effect would be stronger than the
substitution effect and the person would want more leisure as
the wage rose.
PGPSE NOTES 752
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Change in the wage rate again
b The graph here is the same one

c as on slide 2. At the initial
wage a is still the best point for
d the person.
a
After the wage increase:
Area d will be where the individual ends up if the income

effect is stronger than the opposing sub. effect. Area b
will be where the individual ends up if the income effect
is weaker than the sub. effect. An the individual will end
up at point c if the two forces are equal.
PGPSE NOTES 753

www.afterschoool.tk
Supply curve of labor
wage
In this diagram we see the
person supplys more
labor at higher wages.
This would be like ending
up at point b in the
previous diagram.
labor supply
PGPSE NOTES 754

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Supply curve of labor with a backward bend
wage
Here the backward
bend of the supply
curve is the result of a
wage increase moving
the individual to area d
on slide 8. We think
this only happens when
the wage is already
labor supply fairly high.
PGPSE NOTES 755

www.afterschoool.tk
Nonparticipation and other
examples in the labor market
Nonparticipation - not in the labor market
income The flat budget

Note: I1 I2 I3 I4 line implies the
1)nonlabor amount of inc.
income is given up for one
available more unit of
2) Wage is leisure is low.
relativiely low A
hours
24
Starting at point A, if the person thinks of “buying”
another unit or leisure, the amount they are willing to pay is
higher than what they have to pay. So they buy another unit.
This moves the person down to a point of all leisure.
PGPSE NOTES 757
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Starting at a
Nonparticipation - not in the labor market
the person has
utility I1.
income
They would
give up ac to I1 I2 I3 I4
get one more
unit of leisure
and be as a
happy. But b
A
they only have
c
to give up ab. hours
The individual 24
takes another Analogy time: say you are truly willing to
unit of leisure give up $10 for something. But you only
and is happier have to give up, say $5. You do it and are
for it happier.PGPSE NOTES 758
www.afterschoool.tk
So, for the person on the previous slide, the wage in the
market is so low that the individual is willing to give up
income and take leisure up to the point that they do not
work at all.
PGPSE NOTES 759

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Reservation wage
The wage implied by this

budget is tangent to the
indiff. curve at the 24
leisure point. This is the
highest wage at which the
individual chooses not to
work.
A wage just a wee bit
higher would be the lowest
wage at which the
individual would work.
You could say the reservation wage is the value of leisure because
if the wage is higher, then leisure will be given up.
PGPSE NOTES 760
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Retirement
Let’s consider a retirement plan
that pays individual a certain
amount - provided they do not
work any hours. Their budget
is the horizontal line at a.
a At various wage rates we see
how much leisure the individual
would have with the same
income as in retirement.
If the indiff. curves are relatively steep, as in graph, people
retire. They are willing to give up much income in
exchange for more leisure. If indiff. curves are relatively
flat, (workaholics, remember)people may work, even at
lower total pay compared to retirement income.
PGPSE NOTES 761
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Standard workday - 8 hour shift and underemplolyent
income
Say a company will only let
employees work 8 hour days.
Point a has 16 hours of leisure
and thus 8 hours of work.
The person involved
would like less leisure, but
b a can not get to point b because
of the employer restriction.
leisure This implies the worker is
underemployed.
PGPSE NOTES 762

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Standard workday - 8 hour shift and uoveremploymentt
Point a has 16 hours of leisure,

the amount an employer may
require. The person involved
would like more leisure. This
implies the worker is
overemployed.
a b
PGPSE NOTES 763

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Premium pay versus straight pay
◆ You may be familiar with the concept of

getting paid time and a half if you work
overtime. This is called premium pay. This
changes the budget line to have a kink like
below:
PGPSE NOTES 764

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◆ Once the person decides how much they

want to work given the overtime pay, we can
think of another pay scheme that gives them
one wage for all hours, but they could have
same pay as with the overtime scheme.
At point a the individual has a certain
a income level and this could occur from
either budget line.
PGPSE NOTES 765

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Under the overtime payment

plan the person wants to work
amount implied by point a.
If a standard one rate is paid, the

person could work the same
hours and receive the same pay,
but they find it better to work
less.
a b The employer would have to
offer a really high wage and thus income to get the worker
to work as much as under the overtime pay scheme.
PGPSE NOTES 766
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Price ceiling
This is an example of government

intervention in a market.
price ceiling
P
S1 A price ceiling is a
maximum legal price.
The government
enacts one when it is
is too high. So an
Pc effective legal
D1
maximum must be
below the
The upward Q equilibrium price.
arrow is here to Qs Q1 Qd
suggest price can Price can then not
not get above Pc.
legally get to P1.
PGPSE NOTES 768
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price ceiling
With the price ceiling we see:
1) lower price Pc,
2) lower quantity supplied - from Q1 to Qs. This is really

also the amount traded. The amount traded has fallen
because buyers can only buy what sellers sell.
3) Higher quantity demanded - Q1 to Qd.
4) shortage = Qd - Qs.
PGPSE NOTES 769

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full economic price
On the previous slide I mentioned in point 1 that the price
falls. But, let’s think some more about this. Since there is a
shortage at the lower price, some method needs to be worked
out to decide who gets to buy the items. Maybe people wait
in line after having arrived early. This is costly. Consumers
will actually pay, by waiting, up to the price on the demand
curve above the point of trade with the price ceiling. We see
this on the next slide.
So, the market price falls with a ceiling, but with the
shortage created consumers end up “spending more.” Maybe
another way they pay is having to bribe the sellers by paying
the full Pf to the sellers.
PGPSE NOTES 770
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Full price
P
S1 Consumers will
a spend up to Pf to
Pf get the item since
b c at Qs, the amount
P1
d e sellers will make
Pc available, the price
f D1 on the demand
curve is Pf.
Q
Qs Q1 Qd
PGPSE NOTES 771

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Note on the previous screen
Before that ceiling was imposed consumer surplus was the areas
a+b+c and producer surplus was d+e+f.
After the ceiling the full price consumers pay is Pf and they only
get Qs units. So their surplus ends at only a. Consumers lost b
and c. If the consumers bribed sellers, as I mentioned before, the
at least area b is lost to the consumer but gained by the seller.
Area c though is totally lost to the consumer.
Similarly the sellers will lose out on e because with the ceiling
less is sold.
Areas c and e are called the deadweight loss of the ceiling because
they used to be captured by the participants and are then lost to all
because less units are traded.
PGPSE NOTES 772
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price ceiling
P This screen is a repo of a
S1 previous screen.
Imagine you are sitting
at P1, do it! Where do
you look for the ceiling?
P1 Down! Why not up?
Pc
D1 A ceiling above P1
would cause a surplus
The upward Q and we know with a
arrow is here to Qs Q1 Qd surplus the price will
suggest price can
not get above Pc. fall. It would fall to P1.
Price ceilings above equilibrium are not binding
PGPSE NOTES 773
Or are not effective!
www.afterschoool.tk
Utility maximization
The goal of the consumer is to

maximize utility given the budget
constraint. Let’s see what that
means.
y
I show the budget line here
again. What the consumer
attempts to do is find the
point on the budget line that
will give the maximum
utility. I show some arrows
to get you to think about
moving up and down the
line in this search.
PGPSE NOTES 775

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Here I present a few ideas we think hold in the world and then we see
how they show up in the graph.
The consumer wants to maximize the utility, or happiness, that can be
achieved when consuming goods and services.
At a given level of happiness the consumer will always give up a unit
of a good if on the other good in the market an amount greater than
required to maintain the given level of utility is returned. The
consumer will also be happier than at the start. As an example, say
you are willing to take 0.9 Cokes to give up a Pepsi, and you would
be as happy. If in the market when you give up a Pepsi you get 1
Coke back you then you would give up the Pepsi and be happier.
PGPSE NOTES 776

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A related idea is that
At a given level of happiness the consumer will always take
another unit of a good if on the other good in the market an amount
less than required to maintain the given level of utility must be
given up.
As an example, say you will take another hamburger if you give up
2 hotdogs. If the market only requires you to give up1.5 hotdogs,
the you would take the hamburger and you would be happier.
Note: Remember that because of the shape of the indifference
curves that the amount you are willing to give up of a product (or
an amount you would take) depends on how much you already
have and thus changes along the indifference curve.
PGPSE NOTES 777

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highest indifference curve possible, but the
budget constraint restricts the individual’s
options to the budget line.
individual can do. But, before we do
remember 1) indifference curves summarize
how consumers are willing to trade off good
x for y, and 2) the budget line shows how the
consumer can trade off good x for good y.
PGPSE NOTES 778

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c line u3 can not be
a u3
reached
u2
b u1
x more utility would be
obtained if the individual

can achieve given their income and the prices they face.
PGPSE NOTES 779
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x
point. To give up a unit of x and maintain the same
y. But the market actually gives back more y
than the individual requires. This trade is beneficial.
The individual would thus give up the unit of x
and be happier for the trade.
PGPSE NOTES 780
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c
x
point. To take a unit of x and maintain the same
y. But the market actually requires the individual
would thus take the unit of x and be happier for the
trade.
PGPSE NOTES 781
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a b
In the
when the indifference curve is tangent to the budget line.
Tangent means equal slopes.
PGPSE NOTES 782

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Determinants of elasticity of
demand
Different products have different
elasticity values. It is thought
there are factors that lead to
certain elasticity values.
Different elasticities
P
We see the same price change along
both curves, but the flatter curve has a
greater quantity response. If you
worked out the elasticity, you would see
the flatter curve is more elastic than the
steep curve in any price range.
PGPSE NOTES 784

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Determinants of elasticity
• Some determinants are
– The number of substitutes a product has,
– The % of the consumer budget the item costs,
– Time.
PGPSE NOTES 785

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# of Subs.
• The more substitutes an item has the
more likely the quantity demanded will
respond to a price change.
• Thus, the more subs. there are the greater
the elasticity.
PGPSE NOTES 786

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% of consumer budget
• The greater the % of your budget the greater is the
elasticity.
Let’s use milk as an example. Milk purchases by the
typical consumer likely takes a relatively small
percentage of the budget for a consumer. Changes
in the price elicit almost no change in the quantity
demanded.
A few years back the government taxed yachts and this
raised the price of yachts. The Gov thought rich
people would go on buying. Many buyers though
said I’ll keep my current yacht longer because this
increase is too much of my budget. The price
change had a significant on the quantity demanded.
PGPSE NOTES 787

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Time
• The longer the time period since the price
change, the more elastic demand tends to
be. To a certain extent because the
longer time since the price change the
more time we have to find substitutes.
With home heating fuels if the price goes
up in short term we buy but in long term
we buy less and wear a sweater or search
for other methods.
PGPSE NOTES 788

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Elasticity from mathematical
demand curves
Before we saw linear and
nonlinear demand curves. We
return to them to get elasticity
values from them.
Linear demand
A linear demand curve might be of the form

Qx = a0 + axPx + ayPy + aMM.
To evaluate the price elasticity of demand from a certain point
on the demand curve you would need to have a Px and Qx
point to start from. The elasticity is then axPx / Qx
As an example say we have
Qx = 1000 - 3Px + 4Py - .01M and we start at
Px = 1 and Q = 300. Then around the price = 1 the
Ed = -3(1)/300 = -.01 PGPSE NOTES 790
www.afterschoool.tk
Linear demand
Cross price and income elasticities are found in a similar way.

Note: take the coefficient of the relevant term, multiply by the
original value of the relevant price or income and divide by the
starting quantity.
Say when Py = 2 Qx = 400. From the previous screen, the
cross price elasticity would be 4(2)/400 = .02  so we have an
example of substitutes.
PGPSE NOTES 791

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Nonlinear demand
Demand may not be a linear function. A popular nonlinear

form takes the form
Qx = cPxBxPyByMBMHBH. An example would be
Qx = 10Px-1.2Py3M.5H.3 . An interesting thing about this
form is if you take the natural log (sometimes written Ln)of
each side you get
log Qx = 10 – 1.2 log Px + 3 log Py + .5 log M + .3 log H .
This nonlinear demand is said to be linear in logs.
PGPSE NOTES 792

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Nonlinear demand
When the nonlinear demand is written in natural log form the
coefficients in the equation are themselves elasticities. From
the previous screen the price elasticity of demand is –1.2, the
cross price elasticity is 3, and the income elasticity is .5.
So from the previous screen good x is elastic in the range
investigated, is a normal good and in regard to good y is a
substitute.
PGPSE NOTES 793

www.afterschoool.tk
Other demand elasticities
There are other elasticities

besides the own price elasticity of
demand. Let’s see a few here.
demand shifters
We saw that things like taste and preference, price of other

goods, income and the number of buyers shift the demand
curve if they change. How much do they shift the demand
curve?
We use other elasticity concepts as an indication of how
much the curve will shift given a change in one of these
factors.
PGPSE NOTES 795

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cross price elasticity of demand
Edxy = % change in Qdx / % change in Py.

If the value is negative we have complements and if positive
we have substitutes.
If the absolute value is between 0 and 1 the cross elasticity is
inelastic, if = 1 unit elastic and if greater than 1 elastic.
PGPSE NOTES 796

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income elasticity of demand
Edxm = % change in Qdx / % change in M.

If the value is negative we have an inferior good and if
positive we have a normal good.
If the absolute value is between 0 and 1 the income elasticity
is inelastic, if = 1, unit elastic, and if greater than 1, elastic.
PGPSE NOTES 797

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applied problem
Say the cross price elasticity for Coke with respect to the
price of Pepsi is 1.7. This means for every 1% Pepsi raises
price the demand for Coke will go up 1.7%.
Say Coke exec’s hear Pepsi is going to raise price by 2.5%.
How much will Coke exec’s expect demand to rise?
1.7 = 1.7= x/2.5 or x = 1.7(2.5) or 4.25%
PGPSE NOTES 798

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Elasticity of supply
The elasticity of supply is used to indicate the percentage

change in the quantity supplied given a percentage change in
price.
The elasticity of supply is calculated in a manner similar to
the other elasticities we have seen and has a similar
interpretation in terms of the range of values the elasticity
might take, i.e. elastic, inelastic and unit elastic.
PGPSE NOTES 799

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Monopoly Pricing and Output
We study the pricing and output

decision of the monopoly firm.
Price and output decision for the
monopolist in the short run
The amount of output the monopolist should sell in the
short run is the amount where MR = MC(as long as
P>AVC), just as in the case of the competitive firm.
The price charged would then be the price on the

demand curve above the quantity where MR = MC.
PGPSE NOTES 801

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Logic of MR = MC rule
$
MC The Q = b is the Q where
MR = MC. But look at Q = a. At
that point, Q could be increased
D
and more would be added to
revenue than to cost and thus
Q profit would rise. We know this
a b c because the MR > MC for these
Q.
MR
Now let’s look at a Q greater than where MR = MC,

like at point c. More has been added to cost than to
revenue and thus profit would fall. We know this
because MC > MR at this Q.
PGPSE NOTES 802
www.afterschoool.tk
$
What price?
MC
At Q*, where MR =
MC, P* is the price
on the demand curve
P*
consumers are
willing to pay for Q*
D and thus this is the
price charged by the
monopolist.
Q
Q*
MR
PGPSE NOTES 803

www.afterschoool.tk
$
Qualification
ATC Note that the ATC
AVC1 MC
is above the demand
AVC1 curve, so the firm
will lose money. In
P* AVC2 the short run, the
question is whether
AVC2 D the firm should
shutdown or
continue to operate.
Q*
MR Let’s go to the next
screen and say more
about this.
PGPSE NOTES 804
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continue
If the real AVC is AVC1, then the firm should not
follow the MR = MC rule. At this level of output, P <
AVC. It should not operate at all and lose less money
by not operating than if it tried to operate.
The situation is that only some of the variable costs

are being covered and none of the fixed costs are
being covered. The firm should not operate and only
lose its fixed cost.
PGPSE NOTES 805

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continue 2
If the real AVC is AVC2, then the firm should operate,
even though there is still a loss. The P > AVC, and this
means the revenue from operating covers all of the
variable costs and some of the fixed costs. This is
better than not operating and losing all the fixed costs.
Note that in the long run if ATC > P (at the Q where
MR = MC) the monopoly will continue to lose money and
should in that case cease operating.
PGPSE NOTES 806

www.afterschoool.tk
Quiz
$
1 – not a real quiz
MC
Is this monopoly firm
earning a profit? If so,
ATC draw in the graph the
P*
rectangle that
represents the profit.
D
Q*
MR
PGPSE NOTES 807

www.afterschoool.tk
Quiz
$
2 not a real quiz
ATC
MC Is it possible for a
monopoly to lose
AVC money?
P*
Indicate in the graph
how much this
D monopoly is losing by
indicating the loss
rectangle.
Q*
MR
PGPSE NOTES 808

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Monopoly
Here we see what a monopoly is

and its revenue potential.
Overview
Monopoly means one seller.
In perfect competition many sellers were price takers. Any

one seller could not influence the price of the product in the
market. The competitive firm could only choose what
amount to sell.
A monopoly firm will have to determine both how much to

sell and at what price.
PGPSE NOTES 810

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p $
Review
S
P=MR=D
D
Market Q Firm Q
In a competitive market, the market demand curve
represents the demand of all consumers in the market. At
the equilibrium price in the market, the firm must merely
sell what it wants at this price. The firm is a price taker
and we say the demand for a firm is horizontal or perfectly
elastic.
PGPSE NOTES 811
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Monopoly
For a monopoly firm the demand is the same as the
market demand we see in competition. The demand is
downward sloping to the right, what is called less than
perfectly elastic.
Since the monopolist is the only seller, it is natural they

face the market demand curve.
The situation of monopoly is often called imperfect

competition.
PGPSE NOTES 812

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Maximize profit
Since the monopolist is the only seller in the market,
the monopolist must decide what price to charge and
how much to sell.
When the monopolist sells, she is worried about profit.

The goal is to maximize profit. But, in order to maximize
profit, the pattern of revenues and costs at various output
levels must be understood. The pattern of cost was the
topic of an earlier chapter. Now we look at the pattern of
revenue.
PGPSE NOTES 813

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Market demand
P
In the market, the way
142 consumers will take a
greater quantity demanded
132 is to have a lower price in
the market.
Q As an example, if the price
3 4 in the market is 142,
consumers will have a
quantity demanded of 3. But the quantity demanded
will be 4 when the price is 132.
PGPSE NOTES 814

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Marginal revenue
Marginal revenue is the change in total revenue when
there is a change in output. Let’s continue with the
example we introduced before.
If the P = 142, Qd = 3 and TR = 426.

If the P = 132, Qd = 4 and TR = 528.
Thus, the marginal revenue(MR) of the 4th unit is 102.
The price needed to get the 4th unit was 132, but the MR
is only 102. Why the difference between P and MR? (It
wasn’t like that for the competitive firm.)
PGPSE NOTES 815

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Interpretation
When the price is lowered from 142 to 132 the amount
sold rises. In fact, the 4th unit sold brings in 132 in
revenue. But this isn’t all we need to look at to have MR.
Since the monopolist must sell to all consumers at the
same price, the first 3 units now get sold at 132 as well.
That means revenue on those three units will not
included 10 per unit when the price is lowered.
Continuing with the example,
MR(of the 4th unit) = 132 - (142-132) 3

= 102
PGPSE NOTES 816

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P
interpretation
142 area c is the gain in
a
more
132 b area a is the loss in
c
Q at a lower price.
3 4
Area a + b = 142 times 3 = 426 = TR when P = 142
Area b + c = 132 times 4 = 528 = TR when P = 132
MR = c - a = 132 - (142-132)(3) = 102
PGPSE NOTES 817

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When P = 132, Qd = 4.
When P = 122, Qd = 5.
When P = 132, TR = ...................

When P = 122, TR = ...................
So the 5th unit is sold when P = 122, but the MR of the
5th unit = ...........................................
Again we see P>MR.
PGPSE NOTES 818

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MR from areas to height
P
In the above diagram we think of
MR as area c - a and we get a
a
number.
In the bottom graph we
b c D
Q can think of the number
P as a height. Note still the
MR is lower than the price
on the demand curve.
height = MR
D On the next screen we
Q will see the whole MR
curve.
PGPSE NOTES 819
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$ Monopoly MR in a graph
I do not have a proof
for you, but you can
132 see in this diagram
that MR is also a
102 straight line that starts
at the same place as
D demand in the upper
left, but is always
below demand because
Q P>MR. Like at Q = 4,
4 MR = 102 and P = 132.
Note that a good way to draw in MR is to first draw

demand and then put MR through the Q axis halfway out
to the demand curve. I put an X at that point.
PGPSE NOTES 820
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Multiplant Monopoly
Here we study the situation where

a monopoly sells in one market
but makes the output in two
facilities.
multiplant monopolist
The type of monopolist we will consider here is one
that produces output in two facilities, but sells the
output in one market.
The questions we want to answer are:
1) How much output to sell in the market,
2) What price to charge in the market,
3) How much of the total output should come from
each of the facilities?
PGPSE NOTES 822

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firm level marginal cost
Each facility will have a marginal cost schedule. The
first unit of output out of each facility will have a MC
value, of course. Say the first plant has a MC = 3 for the
first unit and plant 2 has a MC = 4 for the first unit.
The first unit the firm sells should come form plant 1.
Now say the second unit from plant 1 has a MC = 3.5.
The second unit the firm sells should come from plant 1
as well. If the third unit from plant 1 has a MC = 4.25,
then the third unit the firm should sell should be the
first unit from plant 2.
In a graph this is accomplished by horizontally adding
the plant level MC’s to get the firm level MC.
PGPSE NOTES 823
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Firm level marginal cost
$ MC firm
MC1 MC2
equal
PGPSE NOTES 824

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decision time
$ MC firm
Pm
MC1 MC2
MR
Q1 Q2 Q = Q1 + Q2
PGPSE NOTES 825

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analysis
The firm will sell the level of output where firm level
MC = MR,
charge the price on the demand curve at this level of
output,
recognize the MR at the optimal Q is a firm level MR
now and each plant should produce the amount where
MR = MC.
Since the firm level MR drives the revenue side of
things, don’t sell additional units that have higher MC
than MR. Thus plants have MC’s that are equal and
also equal to MR.
PGPSE NOTES 826

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In general, when the inverse demand is
P = A – BQ, the MR is
MR = A – 2BQ.
Example: Say demand is P = 70 – 0.5Q, then MR = 70 – Q.
Note in the example that B = 0.5 and 2B = 2(0.5) = 1.
So, this is just a rule you will use in working with a

monopoly. You have to put the demand in this inverse
form to apply the rule.
PGPSE NOTES 827

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Decision in Math Terms
Say we have demand in inverse form of

P = 40 – Q.
Plus say the total cost in each plant is (with subscripts)
TC1 = Q1 + Q12,
TC2 = 4Q2 + 0.5Q22.
The MR for the firm is: MR = 40 – 2Q. The MC at each
plant is MC1 = 1 + 2Q1,
MC2 = 4 + Q2.
PGPSE NOTES 828
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Decision in Math Terms
There are several ways we could proceed at this time to
answer the questions we set out above. I have chosen
the path that is consistent with using the graph we saw
before. Next you will see a crucial step.
Re-express each MC in Q form as
MC1 = 1 + 2Q1, as Q1 = .5 MC1 - .5
MC2 = 4 + Q2, as Q2 = MC2 – 4.
Now, the Q’s add up to Q and on the right side we add
to get Q = 1.5MC – 4.5 (you ignore the
subscripts on the MC terms and add them together.)
PGPSE NOTES 829
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Output and Price for the Firm
Re-express the MC for the firm as

MC = (2/3)Q + 3. We have MR = 40 – 2Q. Thus the
level of output to maximize profit occurs where MR =
MC and we have
40 – 2Q = (2/3)Q + 3, or Q = 37(3/8) = 13.875. The price
to charge is on the demand curve
P = 40 – 13.875 = 26.125. Note at the optimal level of
output the MR = 40 – 27.75 = 12.25.
PGPSE NOTES 830

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Production in each plant
The MC in each plan, again, is
MC1 = 1 + 2Q1,
MC2 = 4 + Q2.
With MR = 12.25 at the optimal output, set each MC =
12.25 to see how much to make in each plant:
Plant 1  1 + 2Q1 = 12.25, or Q1 = 5.625 and
Plant 2  4 + Q2 = 12.25, or Q2 = 8.25.
Note the two Q’s add up to what we saw before.
PGPSE NOTES 831

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Profit
The profit for the firm is 258.1875.

Find this by looking at the TR and TC in each plant.
PGPSE NOTES 832

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Demo problem 8-6
P = 70 - .5Q is demand,
So MR = 70 – Q because of rule we saw before.
Say MC1 = 3Q1 and MC2 = Q2. Then
Q1 = [1/3]MC1 and Q2 = MC2.
Q1+ Q2 = Q 4/3MC and MC = [3/4]Q
Make the Q where MR = MC, so
70 – Q = [3/4]Q, or 70 = [7/4]Q, or Q = 40. Set this Q into
the demand to get the price P = 70 -0.5[40] = 50. The value
of MR at Q = 40 is 30 so in each plant MR = MC gives
In plant 1 30 = 3Q1, or Q1 PGPSE
= 10 NOTES
and in Plant 2 30 = Q2. 833
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Multiple Regression
Here we add more independent

variables to the regression.
In this section I focus on sections 13.1,
13.2 and 13.4
Let’s begin with an example of simple linear regression. A
trucking company is interested in understanding what is going on
with the time the drivers are on the road. Travel time is the
dependent variable. It seems that travel time (how long it takes to
make the days deliveries) would be influenced by miles traveled,
the independent variable.
I have the simple regression results from such a study on the next
slide.
PGPSE NOTES 835

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Note the estimated equation is
y (time) = 1.27 + .068x(miles).
The p-value on the slope coefficient (miles line) is
.0041 and since it is less than .05(say that is
alpha we use) we reject the null of a zero slope
Miles time (hours)
and conclude there is a relationship between
miles driven and travel time.
R square = .66 and thus 66% of the variation in y
is explained by x.
PGPSE NOTES 836

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So, we had a significant relationship between x and y and the r-
square was .66. This r square is not bad, but the company may
think that with only 66% of the variation in travel time explained
by miles driven, maybe other variables will explain the
variability as well. Another variable that could explain the travel
time is the number of deliveries that are made.
In a multiple regression we can add another variable to the initial
X variable we had included.
In Excel you just include in the definition of X two (or more
columns) variables Note you may want to have the Y variable in
the last column of the right or the first column on the left because
the X’s need to be included together in contiguous columns. I
have a multiple regression output on the next slide.
PGPSE NOTES 837

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PGPSE NOTES 838
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Math form
The multiple regression form of the model is:
Yi = B0 + B1 x1 + B2x2 + … + e,
where
B0 is the Y intercept of the line, Bi is the slope of the line in terms
of xi, and e is an error term that captures all those influences on Y
not picked up by the x’s. The error term reflects the fact that all
the points are not directly on the line.
So, we think there is a regression line out there that expresses the
relationship between x’s and Y. We have to go find it. In fact we
take a sample and get an estimate of the regression line.
PGPSE NOTES 839

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When we have a sample of data from a population we will say in
general the regression line is estimated to be
Ŷi = b0 + b1 x1 + b2x2 + …, where the ‘hat’ refers
to the estimated, or predicted, value of Y.
Once we have this estimated line we are right back to algebra. Ŷ

values are exactly on the line.
Now, for an each value of x we have data values, called Y’s, and
we have the one value of the line, called Ŷ.
This part of multiple regression is very similar to simple
regression. But our interpretation will change a little.
PGPSE NOTES 840

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From the multiple regression output we see the coefficients section
means the estimated regression line is estimated to be
Ŷ = -.8687 + .0611x1 + .9234x2.
From the simple regression we had
Ŷ = 1.2739 + .0678x1. You will note the variable x1 does not have
the same value in each case.
In the simple regression case the .0687 is the increase in the mean
value of Y for each unit increase in x1, but we could not control all
the other factors at work in influencing Y. In the multiple case the
.0611 is the increase in the mean value of Y when x1 increases by
1, but we have controlled for the influence that x2 has on Y by
including x2 in the equation.
Each slope or net regression coefficient measures the mean change
in Y per unit change in the particular x, holding constant the effect
PGPSE NOTES 841
of the other x variable. www.afterschoool.tk
Problem 3 page 471
a) The formal model is
Y = Bo + B1(foreimp) + B2(Midsole) + e and the estimates
equation is
Ŷ = -0.027 + 0.791X1 + 0.605X2.
b) Since the p-value on each slope is less than alpha = .05
(something I saw more about later), we can interpret each slope
separately in the following way.
For each unit increase in foreimp, the mean value of Y increases by
0.791, holding constant the value of midsole. For each unit
increase in midsole, the mean value of Y increases by 0.605,
holding constant the valuePGPSEof foreimp.
NOTES 842
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Multiple Regression
Interpretation
Correlation, Causation
Think about a light switch and the light that is on the electrical
circuit. If you and I collect data about someone flipping the
switch and the lights going on and off we would be able to say
that there is correlation from a statistical point of view. In fact,
you and I know we can say something even stronger. We can say
in this case there is causation.
In the world of business (and other areas) we want to find
relationships between variables. We would hope to find
correlation and if we have a compelling theory maybe we could
say we have causation.
PGPSE NOTES 844

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Example
Say we are interested in crop yield on a farm. What variables are
correlated with crop yield? You and I know the amount of water
has been shown to have an impact on yield, as has fertilizer and
soil type, among other things. In a multiple regression setting, if
Y = yield,
x1 = water amount, and x2 = amount of fertilizer, the a multiple
regression would be of the form
Y = Bo +B1x1 + B2x2 + e and our estimated regression would be
of the form
Ŷ = bo +b1x1 + b2x2.
PGPSE NOTES 845

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r square
r square on the regression printout is a measure designed to
indicate the strength of the impact of the x’s on y. The number
can be between 0 and 1, with values closer to 1 meaning the
stronger the relationship.
r square is actually the percentage of the variation in y that is
accounted for by the x variables. This is also an important idea
because although we may have a significant relationship we may
not be explaining much. From the yield example the more
variation we can explain then the more we can control yield and
thus feed the world, perhaps. Or maybe in business setting the
more variation we can explain the more profit we can make.
PGPSE NOTES 846

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F Test
In a multiple regression, a case of more than one x variable, we
conduct a statistical test about the overall model. The basic idea
is do all the x variables as a package have a relationship with the
Y variable? The null hypothesis is that there is no relationship
and we write this in a shorthand notation as
Ho: B1 = B2 = … =0. If this null hypothesis is true the equation
for the line would mean the x’s do not have an influence on Y.
The alternative hypothesis is that at least one of the beta’s is not
zero, written H1: not all Bi’s = 0. Rejecting the null means that
the x’s as a group are related to Y.
The test is performed with what is called the F test. From the
sample of data we can calculate a number called the F statistic and
use this value to perform the test. In our class we will have F
calculated for us because it is a tedious
PGPSE NOTES calculation. 847
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F
Under the null hypothesis the F statistic we calculate from a

sample has a distribution similar to the one shown. The F test
here is a one tailed test. The farther to the right the statistic we
get in the sample is, the more we are inclined to reject the null
because extreme values are not very likely to occur under the null
hypothesis. In practice we pick a level of significance and use a
critical F to define the difference between accepting the null and
rejecting the null.
PGPSE NOTES 848

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Area we make = alpha
F
Critical F
To pick the critical F we have two types of degrees of freedom to

worry about. We have the numerator and the denominator degrees
of freedom to calculate. They are called this because the F stat is a
fraction.
Numerator degrees of freedom = number of x’s, in general called k.
Denominator degrees of freedom = n – k – 1, where n is the sample
size. As an example, if n = 10 and k = 2 we would say the degrees
of freedom are 2 and 7 where we start with the numerator value.
You would see from a book the critical F is 4.74 when alpha is .05.
Many times the book also hasPGPSE
information
NOTES for alpha = .025 and .01.
849
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PGPSE NOTES 850
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Area we make = alpha =.05
here
F
4.74 here
In our example here the critical F is 4.74. If from the sample we get
an F statistic that is greater than 4.74 we would reject the null and
conclude the x’s as a package have a relationship with the variable
Y.
On the previous slide is an example and the F stat is 32.8784 and so
the null hypothesis would be rejected in that case.
PGPSE NOTES 851

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here
F
4.74 here 32.8784
P-value
The computer printout has a number on it that means we do not even
have to look at the F table if we do not want to. But, the idea is
based on the table. Here you see 32.8784 is in the rejection region.
I have colored in the tail area for this number. Since 4.74 has a tail
area = alpha = .05 here, we know the tail area for 32.8784 must be
less than .05. This tail area is the p-value for the test stat calculated
from the sample and on the computer printout is labeled Significance
F. In the example the value is .0003.
PGPSE NOTES 852
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SOOOOOOO,
Using the F table,
Reject the null if the F stat > critical F in the table, or
If the Significance F < alpha.
If you can NOT reject the null then at this stage of the game there
is no relation between the x’s and the Y and our work here would
be done. So from here out I assume we have rejected the null.
t tests – After the F test we would do a t test on each of the slopes
similar to what we did in a simple linear regression case to make
sure that each variable on its own has a relationship with y. There
we reject the null of a zero slope when the p-value on the slope is
less than alpha. The t test for each regression coefficient is
equivalent to testing for the contribution of each independent
variable. PGPSE NOTES 853
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Multicollinearity
Can you say multicollinearity? Sure you can. Let’s all say it
together on the count of 3. 1, 2, 3 multicollinearity! Very good
class, now listen up!
Multicollinearity is an idea that volumes have been written
about. We want to have a basic feel for the problem here.
You and I want x variables that help explain Y. The reason is so
that we can predict and explain movement in Y. As an example,
if we can predict and explain crop yield maybe we can make
yield higher so that we can feed the world!
So, we want x’s that are correlated with Y. This is a good thing.
But, sometimes the x’s will be correlated with each other. This
is called multicollinearity. The problem here is that sometimes
we can not see the separatePGPSE
influence
NOTES
an x has on Y because the854
other x’s have picked up the influence due to their correlation.
www.afterschoool.tk
From a practical point of view multicollinearity could have the
following affect on your research. You reject the null hypothesis
of no relationship between all the x variables and Y with the F test,
but you can not reject some or all of the separate t tests for the
separate slopes. Don’t freak out (yet!).
Let’s think about crop yield. Some farmers have water systems.
The more it rains in a summer the less water the farmers directly
apply. (Okay, maybe I am ignorant here and farmers here can use
all the water they can apply – its an example.) If you included
both inches of rain and water applied there is a correlation between
the two. This may make it difficult to see the separate impact of
either the rain or the water from the system.
If the x’s (the independent variables) have correlations more
extreme than .7 or -.7 then multicollinearity could be a problem
PGPSE NOTES 855
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PGPSE NOTES 856
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Problem 4 page 471, problem 14
page 476 and 26 on page 481
On the previous slide I have an Excel printout.
a)The model for the problem is
Cost = Bo + B1(sales) + B2(# of orders) + e and the estimates line
is Ŷ = -2.728 + 0.0471X1 + 0.0119X2.
b) For each unit increase in sales, the mean value of Y
increases by 0.0471, holding constant the # of orders. For
each unit increase in# of orders, the mean value of Y
increases by 0.0119, holding constant the value of sales.
c) While the value for bo = -2.728 we really do not look at it for
much meaning because in the data there are no sales values = 0
and no # of orders = 0. This is like extrapolation we saw before –
PGPSE NOTES 857
this is risky to interpret outside the range of the values of the x’s.
www.afterschoool.tk
d) To predict we use Ŷ = -2.728 + 0.0471X1 + 0.0119X2 and note
the data for sales use 400 because data is in thousands. So, we have
Ŷ = -2.728 + .0471(400) + .0119(4500) = 69.662.
(Not doing e and f)
Prob 14
a) The critical value of F with 2 and 21 degrees of freedom is 19.45.

Our Fstat from the printout is 75.13 so we can reject Ho: B1=B2=0
and conclude that there is a significant relationship between the x’s
and the Y variable.
b) The p-value here is the value under the heading Significance F
and has value 3.0429E-10. The E-10 part means move the decimal
10 places to the left. Thus the p-value is 0.00000000030429 which
is way less than alpha so we can reject the null and conclude the
same thing we did in part a.
PGPSE NOTES 858
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c) r2 or R square = .8759 and means that 87.59% of the variation in
costs is explained by the variation in sales and the variation in the
number of orders.
d) Not doing
Prob 26
Not doing a
b) Note the p-values for both sales and # of orders are both less than
alpha = .05 so each variable makes a significant contribution to the
model and both should be included in the model.
PGPSE NOTES 859

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Multiple Regression
Interpretation
Correlation, Causation
Think about a light switch and the light that is on the electrical
circuit. If you and I collect data about someone flipping the
switch and the lights going on and off we would be able to say
that there is correlation from a statistical point of view. In fact,
you and I know we can say something even stronger. We can say
in this case there is causation.
In the world of business (and other areas) we want to find
relationships between variables. We would hope to find
correlation and if we have a compelling theory maybe we could
say we have causation.
PGPSE NOTES 861

www.afterschoool.tk
Example
Say we are interested in crop yield on a farm. What variables are
correlated with crop yield? You and I know the amount of water
has been shown to have an impact on yield, as has fertilizer and
soil type, among other things. In a multiple regression setting, if
y = yield,
x1 = water amount, and x2 = amount of fertilizer, the a multiple
regression would be of the form
y = Bo +B1x1 + B2x2 + e and our estimated regression would be
of the form
y hat = bo +b1x1 + b2x2.
PGPSE NOTES 862

www.afterschoool.tk
F Test
In a multiple regression, a case of more than one x variable, we
conduct a statistical test about the overall model. The basic idea
is do all the x variables as a package have a relationship with the
y variable? The null hypothesis is that there is no relationship and
we write this in a shorthand notation as
Ho: B1 = B2 = … =0. If this null hypothesis is true the equation
for the line would mean the x’s do not have an influence on y.
The alternative hypothesis is that at least one of the beta’s is not
zero. Rejecting the null means that the x’s as a group are related
to y.
The test is performed with what is called the F test. From the
sample of data we can calculate a number called the F statistic and
use this value to perform the test. In our class we will have F
calculated for us because it is a tedious
PGPSE NOTES calculation. 863
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F
Under the null hypothesis the F statistic we calculate from a

sample has a distribution similar to the one shown. The F test
here is a one tailed test. The farther to the right the statistic we
get in the sample is, the more we are inclined to reject the null
because extreme values are not very likely to occur under the null
hypothesis. In practice we pick a level of significance and use a
critical F to define the difference between accepting the null and
rejecting the null.
PGPSE NOTES 864

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Area we make = alpha
F
Critical F
To pick the critical F we have two types of degrees of freedom to

worry about. We have the numerator and the denominator degrees
of freedom to calculate. They are called this because the F stat is a
fraction.
Numerator degrees of freedom = number of x’s, in general called p.
Denominator degrees of freedom = n – p – 1, where n is the sample
size. As an example, if n = 10 and p = 2 we would say the degrees
of freedom are 2 and 7 where we start with the numerator value.
You would see from a book (maybe page 672 of a stats book) the
critical F is 4.74 when alpha is .05.NOTES
PGPSE Many times the book also has865a
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table for alpha = .025 and .01.
PGPSE NOTES 866
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here
F
4.74 here
In our example here the critical F is 4.74. If from the sample we get
an F statistic that is greater than 4.74 we would reject the null and
conclude the x’s as a package have a relationship with the variable
y.
On the previous slide is an example and the F stat is 32.8784 and so
the null hypothesis would be rejected in that case.
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here
F
4.74 here 32.8784
P-value
The computer printout has a number on it that means we do not even
have to look at the F table if we do not want to. But, the idea is
based on the table. Here you see 32.8784 is in the rejection region.
I have colored in the tail area for this number. Since 4.74 has a tail
area = alpha = .05 here, we know the tail area for 32.8784 must be
less than .05. This tail area is the p-value for the test stat calculated
from the sample and on the computer printout is labeled Significance
F. In the example the value is .0003.
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SOOOOOOO,
Using the F table,
Reject the null if the F stat > critical F in the table, or
If the Significance F < alpha.
If you can NOT reject the null then at this stage of the game there
is no relation between the x’s and the y and our work here would
be done. So from here out I assume we have rejected the null.
T tests
After the F test we would do a t test on each of the slopes similar
to what we did in a simple linear regression case to make sure that
each variable on its own has a relationship with y. There we reject
the null of a zero slope when the p-value on the slope is less than
alpha.
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Multicollinearity
Can you say multicollinearity? Sure you can. Let’s all say it
together on the count of 3. 1, 2, 3 multicollinearity! Very good
class, now listen up!
Multicollinearity is an idea that volumes have been written
about. We want to have a basic feel for the problem here.
You and I want x variables that help explain y. The reason is so
that we can predict and explain movement in y. As an example,
if we can predict and explain crop yield maybe we can make
yield higher so that we can feed the world!
So, we want x’s that are correlated with y. This is a good thing.
But, sometimes the x’s will be correlated with each other. This
is called multicollinearity. The problem here is that sometimes
we can not see the separatePGPSE
influence
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an x has on y because the870
other x’s have picked up the influence due to their correlation.
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From a practical point of view multicollinearity could have the
following affect on your research. You reject the null hypothesis
of no relationship between all the x variables and y with the F test,
but you can not reject some or all of the separate t tests for the
separate slopes. Don’t freak out (yet!).
Let’s think about crop yield. Some farmers have water systems.
The more it rains in a summer the less water the farmers directly
apply. (Okay, maybe I am ignorant here and farmers here can use
all the water they can apply – its an example.) If you included
both inches of rain and water applied there is a correlation between
the two. This may make it difficult to see the separate impact of
either the rain or the water from the system.
If the x’s (the independent variables) have correlations more
extreme than .7 or -.7 then multicollinearity could be a problem
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r square
r square on the regression printout is a measure designed to
indicate the strength of the impact of the x’s on y. The number
can be between 0 and 1, with values closer to 1 meaning the
stronger the relationship.
r square is actually the percentage of the variation in y that is
accounted for by the x variables. This is also an important idea
because although we may have a significant relationship we may
not be explaining much. From the yield example the more
variation we can explain then the more we can control yield and
thus feed the world, perhaps. Or maybe in business setting the
more variation we can explain the more profit we can make.
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Price Floor
This is another example of

government intervention in a
market.
price floor
The downward
arrow is here to
suggest price
P can not get
below Pf.
S1 A price floor is a
minimum legal price.
Pf The government
a b c enacts one when it is
d e
is too low. So an
D1 effective legal
minimum must be
Q above the
Qd Q1 Qs equilibrium price so
price can not get
down to P1.
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price floor
With the price floor we see:
1) higher price Pf,
2) lower quantity demanded - from Q1 to Qd. This is

really also the amount traded. The amount traded has
fallen because sellers can only sell what buyers buy.
3) Higher quantity supplied - Q1 to Qs.
4) surplus = Qs - Qd.
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One thing we notice with the floor is a surplus is created.
What happens to the goods that are made and not
purchased?
Maybe the government will buy them – the government
would have to pay (Qs – Qd)times Pf to buy the surplus.
Maybe the government will ask producers not to make
them.
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Public Goods
A public good is one that is nonrival and nonexclusionary in
consumption.
Nonrival means that when you consume the good it does not
diminish the availability for me to consume the good. An example
would be radio signals. When turn on your radio it does not stop
me from doing the same and listening to the same station.
Nonexclusionary means that when the good is provided no one can
be excluded from consuming it. Once radio waves are out there
they are out there for all.
Most goods and services we have (implicitly) considered this term
are private goods that do not have the characteristics mentioned
here.
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Demand
In the private good case we said the market demand was the
horizontal summation of each individual’s demand. The logic
there was that at a given price each consumer decided how much
to consume on there own.
For the public good, all consumers consume the same amount,
although each may be willing to pay a different amount for
additional units of the good. Constructing the demand for a public
good then is NOT the horizontal sum. It is the vertical sum. This
means that at each quantity we have to see how much in total
consumers as a group are willing to pay.
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Say the demand for each of three people is, respectively,
p1 = 30 – q1, p2 = 30 – q2, p3 = 30 – q3(note we have identical
demands, although this may not always be the case).
As a private good you add the demands horizontally by first re-
expressing the demands in “Q” form, like
q1 = 30 – p1, q2 = 30 – p2, q3 = 30 – p3, and then total demand is
Q = q1 + q2 + q3 = 90 – 3p.
Note if p = 1 the total market demand is 87 and each individual will
demand 29 units.
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In the public good case the total demand is
P = p1 + p2 + p3 = 90 – 3q.
Note if q = 1 the total amount folks are willing to pay is 87 and each
person is willing to pay 29.
$
90
30
Total demand
Q
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Each individual’s demand
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Say that each unit of the public good and be supplied at a MC = 54.
Note that each individual alone does not value even 1 unit enough
to cover the MC. But, as a group, the three have evaluations of the
product above or equal to the MC up to 12 units. We see this by
setting 90 – 3q = 54, or q = (90 – 54)/3= 12.
$ 12 units is considered the

90 socially optimal level of
output. These units are valued
as much or more as what it
MC = 54
cost to make the units.
30 Note each person would pay
18 18 for each of the 12 units,
while they would be willing to
Q pay more than 18 on some of
12 PGPSE NOTES
those units so each person 882
gets
Consumer surplus = .5(30 – 18)12 = 72, for a total of 3(72) = 216.
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Let’s think about one of the three saying they have no value from
the public good (which is untrue, but how can we know for sure?).
The demand would then only be p = 60 - 2q and set equal to MC =
54 we would have solution q = (60 – 54)/2 = 3. So only 3 units of
the public good would be provided. The two who pay would each
pay 27 per unit ( p = 30 – 3) and each would have consumer
surplus = .5(30 – 27)3 = 4.5 for a total from the 2 = 9.
Now, the one who said they have no need for the public good
actually gets a benefit or consumer surplus = .5(30 – 27)3 + 27(3)
= 85.5. The individual has an incentive to be a free rider because
they benefit more (85.5 to 72), while as a group the total consumer
surplus is smaller (216 to 94.5).
Each individual may chose to be a free rider and then no units of
the good will be produced.
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The logic of this lesson suggests that there is a legitimate reason
for the government to tax to raise funds to provide some public
goods. Of course, there will probably always be debate on which
public goods the government should provide.
Demonstration problem 14-4 is a neat problem in that our work
environment might sometimes be a situation where folks will be
free riders. The example there is that workers what a more
desirable work environment. Maybe the workers want the
parking lot to look better and so they may plant shrubs. Some
may really get value from the shrubs but not want to pay.
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Regression
A review and summary of our work up to this
time with some examples – the examples are
on the Excel file listed on the web right below
this file – Please be sure to hit the tabs for
sheets 1, 2 and 3.
The model
When we look at two quantitative variables we often wonder if
the two variables are related in some way. As an example I am
sure you are aware of the relationship between the weight of a
person and the amount of calories they ingest each day. Given all
other factors being at a certain level, the more calories the higher
the weight.
Now, in general when y is the dependent variable and x is the
independent variable, we say the relationship between the
variables is of the form
y = Bo + B1x
and we note that it could be the case that B1 = 0 and therefore
there is no relationship between the two variables.
So, our basic question is, are the NOTES
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related?
The following is the progression of ideas you may want to
follow as you investigate the relationship between two variables.
1) We take a sample from the larger population because it is
often time consuming and expensive to do a census.
2) Create a scatterplot of the data and even include the estimated
regression line. The plot gives us our first glimpse of the
relationship between the variables. Caution, we can not rely on
the graph alone.
If the points in the plot are upward sloping from right to left we
say there is a positive relationship. If the points are downward
sloping we say there is a negative relationship and if there is no
slope we say there is no relationship.
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3) Run the regression and get the estimated regression line, which
we note in general as
y hat = bo + b1x and bo and b1 are read off an Excel regression
output under the coefficients section.
4) The null hypothesis is that even if the sample has a scatterplot
suggesting a relationship we will say there is no relationship and
thus Ho: B1 = 0. The alternative is that there is a relationship of
some kind and thus Ha: B not equal to 0. (We typically do a two-
tailed test here.)
If the p-value on the slope > alpha we can not reject the null
hypothesis and we conclude there is no relationship between the
variables. Our analysis would be over. But, if the p-value <
alpha we reject the null hypothesis and conclude there is a
relationship between the variables in the population.
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In our examples on the accompanying Excel program you see that
examples 1 and 2 suggest we reject the null if alpha = .05 and we
can not reject the null on example 3. Our work would be done with
example 3. So, on example 3, even tough the sample suggests a
positive relationship, there is not enough evidence in this case to
suggest the relation is different from B1 = 0.
5) r2 (read r squared of r square) is the percentage of the variation
in the y variable that is explained by the x variable.
Why is this important? The y variable is usually one we are very
interested in – like college graduates starting salary – and as we
look across individuals we notice not everyone gets the same
starting amount – there is variability. r2 as a number is a measure of
the % of the variation in y that is explained by the x variable. The
value of r square ranges from 0 to 1 and the closer the value is to 1
the stronger is the relationship between the variables.
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6) r and the sign of b1
Remember we are really concerned with the population
relationship. We take a sample and test the null of no relationship.
If we reject the null we say there is a relationship. What kind of
relationship is there? We go with what the sample suggests is the
relationship.
In example 1 we had a negative value of b1 and so we would say
there is a negative relationship. In example 2 we had a positive b1
and we would say there is a positive relationship. (Remember in
example 3 we concluded there was no relationship.)
The correlation coefficient r is the square root of r square and can
also be used to assess the strength of the relationship. The r can
range from -1 to 1, but if you calculate it by taking the square root
of r square from the Excel output you would think it ranges from 0
to 1. You would have to takePGPSE
the NOTES
square root of r square and give890it
resulting value the same sign as the slope estimate.
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The closer the value or r to -1 or 1 suggests a stronger relationship
between x and y. For example 1 we would have a negative r and
for example 2 we would have a positive r.
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The Basics of Regression
Remember back in your prior school daze some algebra? You
might recall the equation for a line as being y = mx + b. Or
maybe you had the form y = a + bx. Maybe you even had
another form. Did you?
Notice how the y term is on the left of the equal sign. It looks
like y is all by itself, but actually it is called the dependent
variable. The value of y depends on the value of x. x is the
independent variable.
On the right side the variable x has a coefficient with it called
the slope. The slope can be negative or positive, or even zero.
The term that is on the right with no x hooked to it is called the
y-intercept, or intercept for short. The intercept can be positive,
negative or zero.
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y
This
height is
called the x
intercept.
Here I show three different lines with the same
intercept. But, different lines could have different
intercepts. Intercepts can even be negative.
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y 2 Say we move from a dot
1 one unit away in the x
The dot direction. The slope
on the then tells us how far we
line is have to go in the y
represented ? direction to get back to
by an x 1 the line.
value and
a y value.
3 x
Note on the upward sloping (to the right) curve when we went over to
the right on x we have to go up on the y variable. On the flat line we
wouldn’t move in the y direction at all, and on the downward sloping
line we would move down toPGPSE
the line.
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Now, in algebra, we might have a specific line with the form
y = 60 + 5x. Then we can say, when
x= y=
0 60
5 65
6 70
7 75 and so on. In algebra every point fits exactly on the
line.
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Now, let’s use an example to see how what we have just been
thinking about is related to statistics. Say a chain of pizza joints
has stores in many college towns. And say it is wondering if the
sales in these towns are related to the size of the college in terms
of student population.
Sales would be the y variable because sales are thought to
depend on the population. The student population would be the
x variable.
On the next screen I have data from 10 of the stores. Note each
row is a store and we have on each line the population and the
sales. Then we put each store as a dot in the scatter diagram.
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Restaurant Population Sales
1 2 58
2 6 105
3 8 88 250
4 8 118
5 12 117 200
6 16 137
7 20 157
150
8 20 169
Sales in $1000's
9 22 149
100
10 26 202
50
Do the dots fit 0

exactly on a line like 0 5 10 15 20 25 30
in algebra? No, but Population in 1000's
maybe a line can be
put into the data so
that the line can be used to represent the data.
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Math form
It is thought that in the population the variable x and y are
related in the following general form:
y = B0 + B1 x + e,
where
B0 is the y intercept of the line, B1 is the slope of the line, and
e is an error term that captures all those influences on y not
picked up by x. The error term reflects the fact that all the
points are not directly on the line.
So, we think there is a regression line out there that expresses

the relationship between x and y. We have to go find it. In
fact we take a sample and get an estimate of the regression
line.
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Later we will see a method to get an estimate, but for now say we
have the method.
When we have a sample of data from a population we will say in
general the regression line is estimated to be
^
y = b0 + b1 x, where the ‘hat’ refers to the
estimated value of y.
Once we have this estimated line we are right back to algebra. y

hat values are exactly on the line.
Now, for an each value of x we have data values, called y’s, and
we have the one value of the line, called y hat.
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At each x a deviation, or residual is the data value minus the y hat
value. The method we use to find the line is called the (ordinary)
least squares method.
From the data of our example I tell you the least squares method
gives the equation
y hat = 60 + 5x (look like the algebra you saw before?)
Now, go back to the slide with the data. Create a y hat, or values
of y on the line, column (you don’t have too, but think about it).
You get this column by taking the population values for x in each
row and plug into the line to get the y hat. The difference
between the sales values and the y hat values are the deviations to
which I refer.
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ordinary least squares
The typical method used to pick the line through the data is
called the ordinary least squares line. This method is the one
that minimizes the sum of squared deviations of the data points
to the line. The line has desirable properties(not proven here):
1) It is unbiased - if many samples were taken, the average of
the intercepts and slopes from the samples would be the
population intercept and slope.
2) It is consistent - ‘large’ samples would give the population
intercept and slope as well.
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One last point in this section. When you see the scatterplot
like the one I had before, you should look at the pattern in
the dots.
Look at the dots from left to right. 1) if the dots go up hill,
suggesting a positive slope, you should get the feel that the
sample suggests the relationship between the variables is
then beginning to look like a positive relationship – this
means the two variables tend to move in the same direction.
The means higher values for x go with higher values for y.
2) If the dots go down hill the sample is suggesting there is a
negative relationship between the variables. 3) If the dots
are flat the sample is suggesting there is no relationship
between the variables.
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More Regression Information
PGPSE NOTES 905
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On the previous slide I have an Excel regression output.
The example is the pizza sales we saw before.
The first thing I look at is the coefficients. See cell b28 has
the word coefficient. We take the information below and
write the equation as
y hat = 60 + 5x. This is the estimated regression equation.
The intercept is 60 and the slope is 5.
Remember x = population of students and y = sales.
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Hypothesis test about the population slope B1.
Remember we have taken a sample of data. In this context we
have taken a sample and estimated the unknown population
regression.
Our real point in a study like this is to see if a relationship exists
between the two variables in the population. If the slope is not
zero in the population, then the x variable has an influence on
the outcome of y. Now, in a sample, the estimated slope may or
may not be zero. But the sample provides a basis for a test of
the true unknown population slope being zero.
For the test we will use the t distribution.
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The t-distribution
At this stage of the game I am going to have you accept some
of the following without much proof.
The t-distribution is like the normal except for two notable
features. 1) t-distributions tend to be wider (show more
variability) than z distributions. 2) the t-distribution does not
have one standard like the normal distribution. Each t-
distribution is unique, based on its degrees of freedom.
Admittedly, degrees of freedom is a term without much
meaning to you, but in the context of simple regression equals
the sample size minus 2.
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Many books have t-tables. Or you could do a Google search. Go
to the upper tail area being .025. If you run down the column
with your finger you will notice at the bottom the number 1.96.
So, when the degrees of freedom is really large, the t is like the z.
But, with other degrees of freedom on the t-distribution, you have
to go out farther than 1.96 to get to .025 in the upper tail. This is
what I mean be t-distributions being wider.
The t-values in this table are critical values for tests of
hypotheses.
Back to our hypothesis test about the slope. The null hypothesis
is that B1 = 0, and the alternative is that B1 is not equal to zero.
Since the alternative is not equal to zero we have a two-tailed test.
Our example has a sample size of 10, so the degrees of freedom is
8. A level of significance of .05 means we want .025 on each side
for a two tail test. From t-table
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t is 2.306. 909
Back on the computer output we see the calculated t in cell d30.
The t stat from the sample is the slope divided by the standard
error. Notice the t is 8.6167. Since this is bigger than the
critical t we reject the null and conclude the slope is not zero in
the population. Thus in the population of all company stores,
sales are influenced by populations of students in the college
towns.
Excel prints the p-value for the test. For the slope we have
2.55E-05. E notation of the form E-05 means move the decimal
in the number 5 places to the left. So our p-value is 0.0000255.
This is a two-tailed p-value. Since this is less than .05, it is an
alternative way to reject the null hypothesis. This method can
be used without looking at the t-table.
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In cells f30 and g30 you have the 95% confidence interval for the
slope. The interval is (3.6619, 6.3381). So you can be 95%
confident the true unknown population slope is in this interval.
A few slides back I wrote ,” From the t-table the critical t is
2.306.” The margin of error in the confidence interval is the
critical value times the standard error: (2.306 ).5803 = 1.3381 for
an interval for the slope 5 – and + 1.3381.
In cell b17 you see the R square value of 0.9027. Sometimes
this is called r2, and its real name is the coefficient of
determination. The coefficient of determination is a statistic used
to see how well the data points “hug” the regression line. The
value can be anywhere from 0 to 1. If all the data points actually
touch the line then R square would be 1. If the value is 0 the
points are not close to the line at all.
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The square root of the coefficient of determination is the
correlation coefficient ( called r). Remember the correlation
coefficient was an indicator of the direction and strength of the
relationship between two variables.
The correlation coefficient could be anywhere from minus 1 to
1. Negative values meant a negative relationship and positive
values meant a positive relationship. There we said the closer to
1 or minus 1 the stronger the relationship.
If R square = 1, r = 1 and the relationship is as strong as you can
get.
If R square = .9, r = .94 and you still have a pretty strong
relationship.
If R square = .5, r = .71 and you would still be in the strong
relationship neighborhood.
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Well, in this section I have tried to go over some of the basic
regression ideas. The point again is that we are studying two variables
together and trying to establish if the two variables are related or not.
Why should we care if two variables are related? As a person in
business it might help the bottom line. As another example, say it can
be established that the size of the advertising budget has an impact on
sales. This could help us determine the right size budget.
I have a claim that one day I will try to back up by using regression. I
claim that recycling of paper makes states in the country have less
trees. Each state probably recycles a different number of pounds of
paper and has a certain amount of tree population growth or
destruction. With tree population as the dependent variable, I would
expect the slope coefficient on pounds of paper recycled to be
negative. In other words, the more recycling, the less trees. (ITS an
econ story, but anyway.) Regression can be used in social policy
analysis. Anyway, that’s allPGPSE
for now.
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Hypothesis test of the slope
Y y
X x
Null hypothesis Alternative hypothesis
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ON the previous slide I have two graphs with some points in each (ignore the
ovals for now, please). Imagine there are more points in the same basic area as
those shown.
Now, we use stats to help us understand the world and in the context of
regression we think variables are related. Examples would be that income
depends on years of school, or weight depends on net calories consumed, or
gpa depends on hours studied per week.
IN each example the thinking is that one variable changes value from one person
to the next because each person does not have the same value of another
variable – not all people have the same income because not all people have the
same years of schooling.
There is a tradition in statistics to say initially that there is no relationship
between two variables (even if our research and theorizing suggests there is).
The null hypothesis is then that the slope of a regression line between the two
variables is zero. This would mean the data are the graph on the left.
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In stats we take a sample from a population and make calculations – here we
calculate the regression coefficients. We take a random sample, which means
every data point has an equal chance of being picked.
Now if you look at the graphs again and this time look at the ovals. Say the ovals
represent the data points that make it in our sample. If you just focus on the
ovals could you tell which graph the data came from? No, both samples suggest
a positive relationship between x and y.
Now in regression we assume the slope in the population is zero and use the
sample slope as a basis for a test of hypothesis about the population slope.
Under the hypothesis of a zero slope if the slope we get has a low probability of
occurring then we reject the null and conclude the population slope is not zero.
Look back at the graph on the left. Could we get a random sample that would
only include points in the oval? Yes we could, but is seems more likely the
random sample would include other points, like in upper left. So we have a low
probability of getting the sample and thus the slope. When we have a low
probability result (.05 is chosen as low) we reject the null and conclude the
population is probably more like the alternative.
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An example
Airline Percentage on time Complaints
Southwest 81.8 0.21
Continental 76.6 0.58
Northwest 76.6 0.85
US Airways 75.7 0.68
United 73.8 0.74
American 72.2 0.93
Delta 71.2 0.72
America West 70.8 1.22
TWA 68.5 1.25
Here is some data on airlines. We have the percentage of flights on time and
the number of complaints per 100,000 passengers.
What do you think happens to the number of complaints the greater the
percentage of flights on time? I would think the complaints would fall.
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1.4
1.2
1
Complaints per 100,000
0.8
passengers
complaints
0.6
0.4
0.2
0
65 70 75 80 85
% on time
The scatterplot suggests higher the % on time the lower the number of
complaints per 100,000 passengers.
PGPSE NOTES 920
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SUMMARY
OUTPUT
Regression Statistics
Multiple R 0.882607408
R Square 0.778995837
Adjusted R Square 0.747423814
Standard Error 0.160817904
Observations 9
ANOVA
df SS MS F Significance F
Regression 1 0.638118768 0.638118768 24.67361157 0.001624211
Residual 7 0.181036788 0.025862398

Total 8 0.819155556
Standard
Coefficients Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%
Intercept 6.017831995 1.052259699 5.718960823 0.000721093 3.529634972 8.506029019 3.529634972 8.506029019
% on time -0.0704144 0.01417572 -4.967253927 0.001624211 -0.103934628 -0.036894173 -0.103934628 -0.036894173
PGPSE NOTES 921

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ON the previous screen I put a circle around the coefficients on the bottom left
of the screen. We use them to write the equation as
y hat = 6.02 – 0.07x, where y = complaints per 100,000 passengers and x is
% of flights on time.
Just to the right of the circle I have a rectangle around the t stat and p-value
for the slope. Since the p-value is less than .05 we can reject the null
hypothesis of a zero slope and we conclude that the percentage of flights on
time has an influence on the number of complaints per 100,000 passengers.
Since the slope is negative we would say the more flights on time means less
complaints.
IN the rounded rectangle on the previous page toward the top left you see the
R-square. You really only what to look here after you see the slope is not
zero. When the slope is not zero the R-square tells us the percent of the
variation in y explained by the x variable. Here this means that 77.9% of the
variation in complaints is explained by the % of flights on time. This is a good
R-square. Can you think of what else would lead to complaints? Maybe bad
snacks on the flight, or rude flight attendants.
PGPSE NOTES 922

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Excel and Regression
PGPSE NOTES 924
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On the next screen you can see I typed in the data for an
schooling / income study. I even put in labels in the first
row.
PGPSE NOTES 925

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PGPSE NOTES 926
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On the main menu at the top, go to the tools option. When you
click on tools you want to see the tool called data analysis. Excel
does not always show this option. If you do not see data
analysis, hit the Add-Ins option. From the pop-up menu there
check the Analysis Toolpak.
When this is completed you should be able to go back to tools on
the menu at the top and hit data analysis. You would then see a
screen similar to what comes next in these slides. You will have
to scroll down in the list to get to “regression.”
PGPSE NOTES 927

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PGPSE NOTES 928
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On the next screen you will see what excel asks you to put in
to get the regression results.
PGPSE NOTES 929

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PGPSE NOTES 930
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For the example I had on slide 4,
For the Input y range put b1:b6, the cells the data is in.
(y is the dependent variable – the variable I am most interested
in understanding.)
For the Input x range put a1:a6.
(x is the variable we think will help us predict and explain y.)
Check labels box. (Only check the labels box if you have a label
in the data set like I do.)
Check confidence level box - keep at 95%
Check output range and a9 in open box. (I like to have the output
next to the data set. You can go to a new worksheet if you
want.)
PGPSE NOTES 931
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When you say ok to the regression dialog box Excel will do its
thing and have the results highlighted. Keep the results highlighted,
but you will need to adjust the column widths to be able to read the
output. Open the Format menu, choose ‘column’ and select ‘autofit
selection.’
Then un-highlight the cells and look at your results.
If you print the results you may want to change the page to
landscape.
Sometimes in the output you will see a number followed by E and
some other stuff. E-06 means take the number given and move the
decimal place six places to the left. Similarly, E+06 means move
the decimal 6 places to the right.
PGPSE NOTES 932

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Duopoly again
Here we look at the Stackelberg

leader/follower model
The Cournot model was a simultaneous game in the sense that
each player did not know what the other did before their own
action.
The Stackelberg duopoly model is sequential in that one player
will act, the other will see the action and then act.
As an example, let’s use the same demand and cost conditions as
we used in the Cournot example:
P = 100 – 2Q, or = 100 - 2(q1 + q2), and MC = 10 for both.
Firm 1 is the leader in the example. There are industries where
we have leaders. In cars it is still probably GM. What about in
software? Computer Chips?
PGPSE NOTES 934

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Firm 1 being the leader thinks that with the market demand firm
2 will take what ever part of the market firm 1 leaves behind. In
the sense of Cournot, firm 1 understands that firm 2 has a best
response function indicating what firm 2 should make. As before
in the Cournot case, the best response function firm 2 has is
found by:
MR = MC for firm 2, giving
100 - 2q1 - 4q2 = 10, or q2 = (90/4) - (2/4)q1,
Firm 1 then thinks that since firm 2 will follow in this way I (firm
1) will put this into the demand and see what is my best option
where MR = MC.
PGPSE NOTES 935

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P = 100 - 2q2 - 2q1, is market demand
P = 100 – 2[ (90/4) - (2/4)q1 ]- 2q1, by sub. of q2 from firm 2,
= 55 - q1.
Firm 1 MR = MC is then
MR = 55 – 2q1 = 10 = MC, or
q1 = 22.5.
Then the follower will have
q2 = (90/4) - (2/4)22.5 = 11.25. Total output in the market is
33.75 and thus the market price is (from the demand curve)
100 – 2(33.75) = 32.5.
PGPSE NOTES 936

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Summary:
P Q profit
Monopoly 55 22.5 1012.5
P. Comp 10 45 0 for each firm
Duopoly - Cournot 40 30 450 for each firm
Doupoly – Stack. 32.5 33.75 506.25 for leader
253.13 for foller
So, the Stackelberg Duopoly leads the industry closer to the
competitive solution than did the Cournot solution. This
seems ironic because usually, when we have one leader firm,
the leader gets criticized. But here it leads to better result,
short of competition. PGPSE NOTES 937
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Supply and Demand
In economics we use a model of supply and demand in an attempt to
understand market outcomes for a good or service. Of particular interest are
two basic questions:
1) What determines the price of a product, and
2) What determines the quantity of a product sold.
Before I get into this I want to present something totally different. I want to
talk about the weather. In particular, I want to talk about the highest
temperature in Wayne, Nebraska on each and every day. At the bottom I
have a graph of the highest temperature on each day for the year 2006 (I
made up the data, but do you think it covers the basic idea?)
Highest
temperature on the
day
PGPSE NOTES
Day of 939
JFMAMJJAS the year
O www.afterschoool.tk
ND
Notes about graph:
1) The long term we see the highest temperature occurred
sometime in July or August.
2) When you look at any three or four day period (a shorter
time frame than the whole year) you see ups and downs of
the highest temperature.
Why does the highest temperature each day follow the
pattern I have shown?
The accepted answer comes from the science areas of
astronomy and physics. In these sciences there are
theories about how the earth is tilted and how it rotates
around the sun. These ideas provide us with our
understanding of the pattern of daily high temperatures.
PGPSE NOTES 940

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Now, instead of thinking about the weather we could consider a
market. There is a market for corn, wheat, Mt. Dew in a 20 ounce
bottle, Microsoft stock, and many more. Some folks use a graph
similar to the one I had with the weather example. The vertical
axis variable may be the price of the product or the quantity
(number of units) of the product traded.
Our study of supply and demand is the scientific way folks go
about explaining the pattern of price movements and/or quantity
traded movements.
When we study supply and demand we use a different graph than
the one I have used so far. But it is related. Let’s turn to that
graph next.
PGPSE NOTES 941

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Price, P Along this axis we measure the price
per unit of a product. At the bottom we
start at zero and move our way up.
Along this axis we measure quantity in

units of a good or service. On the left
we start at zero and as we go right we
go to larger amounts.
Quantity, Q
PGPSE NOTES 942

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Price, P
We could look at any point in

the graph and at that point we
can get a feel for the quantity
at that point and the price at
that point. This point would
correspond to the other graph
in that this point is for a certain
day. On other days we could
be a a different point and we
want to build a theory of that
Price movement.
at the
point
Quantity, Q
Quantity at the point

PGPSE NOTES 943
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Price, P
In economics,
often times the
only point you
need to focus
your attention on
is where two
curves cross.
Quantity, Q
PGPSE NOTES 944

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Price, P If a curve should shift
– here the demand
shifts – you can focus
your attention on the
new intersection.
D2
D1
Quantity, Q
PGPSE NOTES 945

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Price, P
2) Note here that after the

curve shifted, we will move
along the new demand
curve and call the
movement a change in
the quantity demanded.
D2
1) Note here that when the D1
demand shifted we would
say it shifted because of a
change in demand Quantity, Q
PGPSE NOTES 946

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So, we have gotten warmed up to the model of supply and
demand. Now we want to look at
1) The demand side of the market,
2) The supply side of the market,
3) The interaction of supply and demand and how these
determine the price in the market and the quantity traded in
the market, and
4) Changes in supply and demand and how that leads to price
and quantity traded changes.
PGPSE NOTES 947

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P
Demand in general refers to how much of a
product consumers want to buy. In the
graph here you should note two things.
1) The demand curve is downward sloping
as you look at the graph from left to right,
and
D
2) The demand curve is in a certain position
or location that could change. Q
Let’s think about each of these points in more detail.

When we say the demand curve is downward sloping we say this is a reflection
of the law of demand. The law of demand is a statement that when the price of
the product changes the quantity demanded moves in the opposite direction.
So, if the price should rise, the quantity demanded will fall, and if the price
should fall the quantity demanded will rise.
Law of Demand – Price and quantity demanded are

inversely related. PGPSE NOTES 948
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Let’s consider one more thing about the law of demand.
Let’s take an example from our life. Any music CD costs
about 15 bucks, give or take a few $’s. At that price you
and I could probably buy more than we do, but we would
have to give up other things (like milk and cookies, what
were you thinking?) to get even more CD’s. In order to get
us to demand an even greater quantity the price has to be
lowered and we therefore do not have to give up as much
of the other things we enjoy.
It works the other way as well. If the price becomes higher
we have a lower quantity demanded because at the higher
price we have to give up too much of other things we like
and so we reduce our quantity demanded for the CD’s.
PGPSE NOTES 949

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P
In the graph at P1, although folks
could probably buy more of the
P1
product, quantity demanded is
only Q1 because folks have
decided they do not want to give
D
up other things to get more of Q.
Q1 Q
But, If the price was lower than P1 you see there would be
movement down the demand curve. Some folks would say
that since they do not have to give up as much other stuff
to get more units here, they are happy to demand a greater
quantity.
So, the price of the product is a major determinant of how
much of a product consumers want. But there are other
PGPSE NOTES 950
things that have an influence as well.
www.afterschoool.tk
P
A few slides back I mentioned
that we need to pay attention to
P1
the position or location of the
demand curve and that maybe
the location could change.
D
Q1 Q
What I now want to make explicit is that Q1 was
demanded at P1 with the understanding that other things
that influence demand are held constant. If these other
things should change then at P1 the amount people want
could change and the demand would shift.
Let’s go back to our CD example. We said if the price
was P1 folks would demand Q1 units. But, if people get
more income it is likely they can afford more things and
PGPSE NOTES 951
thus the demand for CD’s would shift to the right.
www.afterschoool.tk
So, on the previous slide we see the demand curve would
shift right when a people’s income would go up. Similarly
we would expect the demand curve would shift left if
people’s income should fall.
People’s income is a factor that leads the demand curve to
be in a certain location. This means if income should
change the demand curve will shift to a new location.
Other factors that lead to a shift in the demand include the
price of related goods, consumer taste and preference, and
the number of consumers in the market.
On the next slide is a table that will list how the demand
curve will shift given a change in a factor of demand. Note
the table does not include the price of the product itself. If
the price changes there is a movement along the demand
curve and we say there isPGPSE
a change
NOTES
in the quantity 952
demanded. www.afterschoool.tk
Factor of demand change demand shifts to
Income increase for normal good right
Income decrease for normal good left
Income increase for inferior good left
Income decrease for inferior good right
Complementary good price increase left
Complementary good price decrease right
Substitute good price increase right
Substitute good price decrease left
Increase in consumers in market right
Decrease in consumers in market left
Please note that when a factor changes in such a way that

demand shifts to the right we could also say demand has
increased and if a factor changes in such a way that
demand shifts to the leftPGPSE
we could
NOTES
also say demand has 953
decreased. www.afterschoool.tk
P
Supply in general refers to how much of a
product producers want to sell. In the graph
here you should note two things. S
1) The supply curve is upward sloping as
you look at the graph from left to right, and
2) The supply curve is in a certain position
or location that could change.
Q
Let’s think about each of these points in more detail.

When we say the supply curve is upward sloping we say this is a reflection of
the law of supply. The law of supply is a statement that when the price of the
product changes the quantity supplied moves in the same direction.
So, if the price should rise, the quantity supplied will rise , and if the price
should fall the quantity supplied will fall.
Law of Supply – Price and quantity supplied are directly, or

positively, related. PGPSE NOTES 954
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Let’s consider the story about why the supply curve is
upward sloping. Production of a good or service takes
time and producers have lots of things they would like to
do. When the price of a good is low producers look at their
options and conclude at a low price that they will make a
few units but then do something else because there is not
a big payoff to production. But, if the price is higher they
do not mind giving up other things to produce here
because they will get more for their efforts.
PGPSE NOTES 955

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P
In the graph at P1, although
producers could probably make S
more of the product, quantity
supplied is only Q1 because P1
producers have decided they do

not want to give up other things
Q
to make more of Q. Q1
But, If the price was higher than P1 you see there would be
movement up the supply curve. Some producers would
say that since they get more for producing this item they
give up doing other stuff and they are happy to supply a
greater quantity of this good.
So, the price of the product is a major determinant of how
much of a product producers want to make. But there are
other things that have anPGPSE
influence
NOTES as well. 956
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P
A few slides back I mentioned
that we need to pay attention to
the position or location of the S
supply curve and that maybe the P1
location could change. What I
now want to make explicit is that
Q1 was supplied at P1 with the Q
Q1
understanding that other things that influence supply are
held constant. If these other things should change then at
P1 the amount producers want to make could change and
the supply would shift.
As an example, say the company is making candy and the
price of sugar, a major input to the product, goes up. Then
at P1, since it costs more to make a unit of candy, the
producer will make less because there is less profit to be
made per unit. Producers would
PGPSE NOTES rather
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do something else.
957
So, on the previous slide we see the supply curve would
shift left when the price of an input to the production process
went up. Similarly the supply curve would shift right when
the price of an input falls.
The price of an input is a factor that leads the supply curve

to be in a certain location. This means if the input price
should change the supply curve will shift to a new location.
Other factors that lead to a shift in the supply include the
state of technological sophistication used in production (what
I call the state of technology), the number of sellers and the
price sellers expect to see in the future.
On the next slide is a table that will list how the supply curve
will shift given a change in a factor of supply. Note the table
does not include the price of the product itself. If the price
changes there is a movement along the supply curve and
we say there is a change in theNOTES
PGPSE quantity supplied. 958
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Factor of supply change supply shifts to
Input price increase left
Input price decline right
Increase in state of technology right
Decrease in state of technology left
Increase in expected future price left
Decrease in expected future price right
Increase in producers in market right
Decrease in producers in market left
Please note that when a factor changes in such a way that

supply shifts to the right we could also say supply has
increased and if a factor changes in such a way that supply
shifts to the left we could also say supply has decreased.
PGPSE NOTES 959

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Price, P
Now that we
S have considered
supply and
demand
separately we
will bring the two
together and
see how buyers
and sellers
interact in a
market.
D
Quantity, Q
PGPSE NOTES 960

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Price, P
Notice at this
S1 price P1 the
quantity
demanded
equals the
quantity
P1 supplied.
D1
Quantity, Q
Q1
PGPSE NOTES 961

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Price, P
Notice that
S1 when you look
at any price
above where the
Pa curves cross,
like at Pa, the
quantity
supplied is
greater than the
quantity
demanded – a
D1 surplus
Quantity, Q
Qd Qs
PGPSE NOTES 962

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Price, P
Notice that
S1 when you look
at any price
below where the
curves cross,
like at Pb, the
quantity
supplied is less
Pb than the quantity
demanded – a
shortage
D1
Quantity, Q
Qs Qd
PGPSE NOTES 963

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Notice on the previous three slides that I have put the
subscript 1 on the labels for the supply and demand
curves. I do this to have you understand that when we
consider the interaction of supply and demand we initially
have supply and demand located in place because the
factors that can shift these curves are fixed at a certain
level for the time being. Later these curves can shift, but
for now we have them fixed in place.
Theory of Price Change
1) When the price is above P1 in our graphs from the
previous slides we see Qs > Qd, meaning we have a
surplus. All buyers at this price (as recognized by the
amount on the demand curve) would get to buy, but not all
sellers would get to sell. This surplus of items means
some sellers have an incentive to change. They would
PGPSE NOTES 964
lower the price so that they do not have
www.afterschoool.tk any left over items.
2) When the price is below P1 in our graphs from the
previous slides we see Qs < Qd, meaning we have a
shortage. All sellers at this price (as recognized by the
amount on the supply curve) would get to sell, but not all
buyers would get to buy. This shortage of items means
some buyers have an incentive to change. They would bid
up the price in an attempt to get the item.
3) When the price is P1 we see Qs = Qd. All buyers and
sellers are able to buy and sell, respectively, what they want
at this price. Neither group has an incentive to change.
Item 3) here defines equilibrium in the market. Take this to
mean you should focus your attention on were the curves
cross. But items 1) and 2) help us understand why the price
will change when conditions in the world change. Let’s turn
to this next.
PGPSE NOTES 965
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Price, P For any market
story this is
where you mind
S1 should be, on
this graph with
all the
knowledge you
have in these
P1
notes. Slides 16
and 22 mention
how supply or
demand could
D1 change.
Quantity, Q
Q1
PGPSE NOTES 966

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Price, P Here we have a
demand
D2 increase. Slide
S1 16 should
remind you how
a demand
increase can
happen. Note at
P1
the initial price
P1 Qs = Q1 but
demand is now
Qd.
D1
Quantity, Q
Q1 Qd
PGPSE NOTES 967

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Price, P At P1, since Qd
> Qs, we have a
D2 shortage and
S1 with a shortage
the price will
rise. The price
P2 will rise to P2.
P1
D1
Quantity, Q
Q1 Qd
PGPSE NOTES 968

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Price, P Note as the
price rises due
D2 to the shortage
S1 both a) the
quantity
supplied rises
P2 from Q1 to Q2
and b) the
P1
quantity
demanded falls
from Qd to Q2.
The shortage is
D1 gone.
Quantity, Q
Q1 Qd
Q2
PGPSE NOTES 969
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Let’s summarize what is on the last 4 slides.
1) We have the market at some starting point. Note the
equilibrium price and quantity traded, P1 and Q1.
2) The demand increases creating a shortage.
3) The shortage means the price will rise.
4) The shortage is eliminated because with the higher
price the a) quantity supplied rises and b) the quantity
demanded falls (from the new higher level).
Overall, the increase in demand resulted in
1) An increase in the market price, and
2) An increase in the quantity traded in the market.
PGPSE NOTES 970

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Price, P From this
starting point
let’s now look at
S1 the story of a
supply increase.
P1
D1
Quantity, Q
Q1
PGPSE NOTES 971

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Price, P Here we have a
supply increase.
Slide 22 should
S1 remind you how
a supply
S2
increase can
happen. Note at
the initial price
P1
P1 Qd = Q1 but
supply is now
Qs.
D1
Quantity, Q
Q1 Qs
PGPSE NOTES 972

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Price, P At P1, since Qs
> Qd, we have a
surplus and with
S1 a surplus the
price will fall.
S2
The price will fall
to P2.
P1
P2
D1
Quantity, Q
Q1 Qs
PGPSE NOTES 973

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Price, P Note as the
price falls due to
the surplus both
S1 a) the quantity
supplied falls
S2
from Qs to Q2
and b) the
quantity
P1
demanded rises
P2 from Q1 to Q2.
The surplus is
gone.
D1
Quantity, Q
Q1 Qs
Q2 NOTES
PGPSE 974
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Let’s summarize what is on the last 4 slides.
1) We have the market at some starting point. Note the

equilibrium price and quantity traded, P1 and Q1.
2) The supply increases creating a surplus.
3) The surplus means the price will fall.
4) The surplus is eliminated because with the lower price

the a) quantity demanded rises and b) the quantity supplied
falls (from the new higher level).
Overall, the increase in supply resulted in

1) An decrease in the market price, and
PGPSE NOTES 975
2) An increase in the quantity traded in the market.
www.afterschoool.tk
What have we learned? Among other things
1) The price and quantity traded in a market are
determined by the interaction of supply and demand.
2) The price and quantity traded in a market will change if
there is a change in supply or demand.
PGPSE NOTES 976

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ECONOMICS – A TO Z

Ten Principles of Economics

“There is no such thing as a free lunch!”

To get one thing, we usually have to give up

Making decisions requires trading

• Decisions require comparing costs and

• The opportunity cost of an item is what

• Marginal changes are small, incremental

People make decisions by comparing

• Standard of living may be measured in

Who here would buy a dozen eggs for $1.59?

The amount you would be willing to pay is on the

The area of a triangle is ½ of the base times the height.

What do consumers do with the surplus received?

The concept of elasticity adds to these concepts by

Ed = (% change in Q)/(% change in P)

As an example, if Ed = -2 we say for every 1 % change

You may recall a function in math called the absolute value.

If abs(Ed) = 1 we say demand is unit elastic. This

If abs(Ed) < 1 we say demand is inelastic. This means

P If we know the slope of the demand

Also at this time in our study the total expenditure of

So, here we look at the whole demand side of the

Thus if the price should change from P1 to P2, then the

Thus a lower price has a good and a bad.

There are other elasticities

We saw that things like taste and preference, price of other

Edxy = % change in Qdx / % change in Py.

Edxm = % change in Qdx / % change in M.

The elasticity of supply is used to indicate the percentage

The author says that economic decisions made under

Facts about several gambles with a fair coin:

What is the mean or the average of the numbers 4 and 6? You

The expected value of a gamble is a weighted average of the

Utility Utility values are assigned

In expected utility theory we want to focus on wealth values and

The following is what needs to be considered to get the expected

Say utility is assigned by the function U = sqrt(wealth) and a

A fair gamble is one where the expected value of the gamble is

For the fair gamble we again know EV = W, but for a risk

U The risk neutral person

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Any certain option above 9 gives a utility

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EMV =p1Y1 + p2Y2

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The risk premium, rp, of a

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Next let’s look at how information can be beneficial in

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Here we study a method for

In the normal form of a game, information about the options of

Let’s make sure we understand this table. Here we have two

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The row player will think in the following way(look at each

This is the same slide as before, but I show in each column

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If the row player picks up my choices are

If the row player picks down my choices are

A strategy is called a dominant strategy for a player if it has a