Economics Intranet Module PDF

NATIONAL LAW UNIVERSITY,
ASSAM
B.A.LL.B. (Hons.) Five Years
II Year - III Semester

3.1 Economics - I
Course Compiled By:

Mr. Nayan Jyoti Pathak
Course Instructor:
Mr. Nayan Jyoti Pathak
Academic Session
(2015-16)
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ECONOMICS - I
Semester July – Nov ember

Course code 3.1
Course credit 5
Maximum marks 100
Teaching Hours Required 64
Tutorial/Presentation hours 12 – 15
Medium of instruction English
64 credit hours & 4 credit course Regular
Course Objectives
The course of Economics I which basically incorporates basics in the

subject of economics is so designed as to acquaint the students with
the knowledge of the economics. The study of economics helps us in
comprehending a wide array of issues of national as well as
international in character. Microeconomics and macroeconomics,
the base of this syllabus, helps to lay down the foundation for the
study of economics. A general understanding of microeconomics is
very essential for appreciating how a modern economy functions.
Moreov er it helps in making managerial decisions, designing public
policies etc. The course also attempts to highlight the basic
concepts pertaining to the section of macroeconomics. It consists of
various concepts dealing with the structure, behaviour, performance
of the economy as a whole. Macroeconomic models and the
economic predictions are utilized by the governments for designing
public policies. To conclude basic objectiv es are as follows:
1. To inculcate the understanding of the subject of
economics;
2. To get acquainted with the different forms of market that
exists in the real world;
3. To analyze and interpret different factors of production;
4. To understand the concept of national income and
related aspects.
5. To enable students to identify emerging issues in the
subject;
The students shall be introduced to the fundamentals of the subject

of economics and some basic theories incorporated therein. The
course, besides prov iding the conceptual fodders, intends to ignite
the curiosity of the students regarding the current problems in the
field of economics.
Teaching Methodology
The teaching methodology shall be participatory teaching with

discussions on the topics included and connected. The
students are informed in advance the topic for discussion and
the topic of project / assignment they have to prepare. The
students prepare their topics from the sources suggested to
them. The students are also encouraged to do independent
research on their respectiv e assignments. In the classroom
ev ery student is required to present his/her topic and to have
his/her doubt cleared through discussion. The teacher will be
helping and guiding the students in their pursuits of learning.
The teacher summarizes after the students have completed
their discussion, and he clarifies the doubts, if any, and answer
their queries.
Course Text Books
There are several books on basic microeconomics and

macroeconomics which may assist students study and
research. The preferred books are: Ahuja, H.L., “Advanced
Economic Theory: Microeconomic Analysis”; Chopra, P.N.,
“Micro Economics”, Maddalla, G.S. and Miller,E.,
“Microeconomic Theory and Application”, Jhingan,M.L.,
“Macroeconomic Theory”, Gardner,A.,“Macroeconomic
Theory”; Salv atore, D., “Microeconomic Theory and
Application” ; Ahuja, H.L., “Macroeconomic Theory and
Policy”, etc. There is a long list of suggested references being
attached separately at the end of course outlines. Students are
adv ised to use references from the said list for their in-depth
knowledge, project research and/or an independent research
for publications.
Course Evaluation Method
The Course is assessed for 100 Marks in total by a close book

examination system. There shall be a Mid-Semester Exam for 20
Marks and End Semester Exam for 50 Marks. 25 Marks are
allotted for the Project work and 5 Marks for attendance. The
question papers shall be designed on application based
questions.
Expected Outcomes of the Course
On completion of the Course the students are expected to

understand the nuances of each module and thereafter they shall
be in a position to understand and relate emerging topics in their
field of study. They are also expected to develop keen interest in the
topics as they are quite relevant in their practical aspects as well.
The proper understanding of the modules shall help the students
comprehend the importance of the economics underlying several
important aspects in the world.
COURSE CONTENTS
MODULE 1 [20 Teaching Hours]
Introduction
Economics: nature and scope, definitions by Adam Smith, Marshall,

Robbins and Samuelson, relationship between law and economics,
difference between microeconomics and macroeconomics
Demand and supply analysis: law of demand, change in demand

and change in quantity demanded, law of supply, elasticity of
demand and supply
Utility analysis: concept of utility, cardinal utility, law of diminishing

marginal utility, ordinal utility, indifference curv e approach, price
effect, income effect and substitution effect
Production: production function, law of variable proportions,

economies and diseconomies of scale
Costs: fixed and variable, opportunity cost, shapes of av erage and

marginal cost curves, relation between average, marginal and total
cost curves
Compulsory Readings:
1. H.l. Ahuja, Advanced Economic Theory, S. Chand Publications,

17th Rev ised Edition 2011, pp. 3-45, 97-114, 133-181, 275-317, 379-401
2. Anindya Sen, Microeconomics: Theory and Applications, Oxford

Univ ersity Press, 2011, pp. 1-140,
3. Dominick Salv atore, Principles of Microeconomics, Oxford

Univ ersity Press, 2011, pp. 1-50
4. P.N. Chopra, Micro economics, Kalyani Publishers, 2005, pp. 1-80
5. Abha Mittal, Microeconomics: Theory and Applications, Taxmann

Publications,2012, pp. 01-154.
6. G.S. Maddala and Ellen Miller, Microeconomic Theory and

Application, Tata McGraw Hill, New Delhi, 2004, pp. 1-60
Market Forms
Revenue: concept, shape of revenue curves, relation between

av erage, marginal and total rev enue curves
Markets: perfect completion and imperfect completion, monopoly,

price discrimination, monopolistic completion, price and output
determination, concept of selling costs,
Oligopoly: concept, price leadership model, concept of duopoly
Compulsory Readings

17th Rev ised Edition 2011, pp. 567-589, 646-679, 720-746, 777-795, 830-
875
2. A Koutsoyiannis, Modern Microeconomics, Macmillan Press Ltd.,

London, Second Edition, 1979, pp. 50-90
3. Robert s Pindyek, Rubinfeid, L. Daniel and l. Prem Mehta, Micro

Economics, Pearson Prentice Hall, 2011, 60-110
4. D.N. Dwivedi, Microeconomic Theory and Application, Pearson

education, New Delhi, 2005, pp. 40-90, 110-140
5. P.N. Chopra, Micro economics, Kalyani Publishers, 2005, pp. 80-
120, 130-170

Application, Tata McGraw Hill, New Delhi, 2004, pp. 40-75, 80-110
Distribution
Introduction: factors of production, land, labour, capital and

entrepreneur, features and importance
Wages: Role of trade unions and collectiv e bargaining in wage

determination, real wages and nominal wages
Rent: concept, Ricardian theory of rent, modern concept of rent,

quasi rent
Interest: concept, Keynesian theory of interest
Profit: concept, Innovation theory of profit, role of risk and

uncertainity
Compulsory Readings:

17th Rev ised Edition 2011, pp. 973-995, 1077-1098, 1099-1155

London, Second Edition, 1979, pp. 110-170
3 Robert s Pindyek, Rubinfeid, L. Daniel and l. Prem Mehta, Micro

Economics, Pearson Prentice Hall, 2011, 115-145, 160-190
4. Dominick Salv atore, Principles of Microeconomics, Oxford

Univ ersity Press, 2011, pp. 110-160, 175-210
Application, Tata McGraw Hill, New Delhi, 2004, pp. 110-135, 140-170
Macroeconomics
Macroeconomic Theory: Say’s law of market, Keynes criticisms
National Income: concept, aggregates of national income,

methods of measurement, limitations
Money: meaning, evolution, functions, types of money, high

powered money
Banking: central bank, role, commercial banks, role and functions
Compulsory Readings
1. M L Jhingan, Macro Economic Theory, Vrinda Publications (P) Ltd,

2010, pp. 251-260, 295-309, 317-344
2 K.R. Gupta, Advanced Macroeconomics Vol – I , Atlantic Publisher,

2011, pp. 30-60, 90-110
3.H.L. Ahuja, Macroeconomics Theory and Policy, S Chand and

Company Ltd., New Delhi, 2011, pp. 10-50, 60-110
4. K.C. Rana and K.N. Verma, Macroeconomic Analysis, Vishal

Publications, Jalandhar, 1998, pp. 20-60, 70-110
5. R.K. Choudhury, Public Finance and Fiscal Policy, Kalyani Publishers,

New Delhi, 2005, pp. 110-160
List of Readings:

17th Rev ised Edition, 2011
2. P.N. Chopra, Micro economics, Kalyani Publishers, 2005
Application, Tata McGraw Hill, New Delhi, 2004
London, Second Edition, 1979
5. Robert s Pindyek, Rubinfeid, L. Daniel and l. Prem Mehta, Micro
Economics, Pearson Prentice Hall, 2011
6. Anindya Sen, Microeconomics: Theory and Applications,
Oxford Univ ersity Press, 2011
7. Abha Mittal, Microeconomics: Theory and Applications,
Taxmann Publications,2012
8. M L Jhingan, Macro Economic Theory, Vrinda Publications (P)
Ltd, 2010
9. H.L. Ahuja, Macroeconomics Theory and Policy, S Chand and
Company Ltd., New Delhi, 2011
10. D.N. Dwiv edi, Microeconomic Theory and Application,
Pearson education, New Delhi, 2005
11. R.K. Choudhury, Public Finance and Fiscal Policy, Kalyani
Publishers, New Delhi, 2005
12. K.C. Rana and K.N. Verma, Macroeconomic Analysis,
Vishal Publications, Jalandhar, 1998
13. K.R. Gupta, Advanced Macroeconomics Vol – I , Atlantic
Publisher, 2011
14. V.K Patil, Modern International Macroeconomics, AL
Publishers, New Delhi, 2005
15. Soumyen Sikder, Principles of Macroeconomics, Oxford
univ ersity Press, Second Edition, 2011
16. Edward Shapiro, Macroeconomic Analysis, Galgotia
Publications, New Delhi, Fifth Edition, 2011
17. Campbell McCannell, Macroeconomics: principles,
Problems and Policies, McGrow Hill Publications, Eighteenth
Edition, 2011
18. Rudiger Dornbusch, Macroeconomics, McGrow Hill
Publications, Tenth Edition, 2005
The list of the articles included in the study material along with the authors is
outlined below:
Sl. Authors/Institutions/Web link Titles

No
1 Dr. David A. Dilts Introduction to Microeconomics
2 Joseph Whelan and Kamil Msefer Economic Supply & Demand
3 http://facweb.knowlton.ohio- Consumer Behaviour and Demand
state.edu/pviton/courses/crp6600
/Call_Holahan_03.pdf
4 Ordinal utility and the traditional theory of

Donald W. Katzner consumer demand
5 Smriti Chand The Uses or Application of Indifference
Curve Analysis
6 http://www2.palomar.edu/users/ll Monopolistic Competition
ee/ChapC20.pdf
7 Shelby D. Hunt The Theory of Monopolistic Competition,

Marketing’s Intellectual History, and the
Product Differentiation Versus Market
Segmentation Controversy
8 Brian P. Simpson Two Theories of Monopoly and
Competition: Implications and
Applications
9 John Cantwell Innovation, profits and
growth: Schumpeter and
Penrose
10 Barry W. Ickes Lecture Notes on National Income
Accounting
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INTRODUCTION
TO
MICROECONOMICS
E201
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Dr. David A. Dilts

Department of Economics, School of Business and Management Sciences
Indiana - Purdue University - Fort Wayne
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May 10, 1995

First Revision July 14, 1995
Second Revision May 5, 1996
Third Revision August 16, 1996
Fourth Revision May 15, 2003
Fifth Revision March 31, 2004
Sixth Revision July 7, 2004
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Introduction to Microeconomics, E201
8 Dr. David A. Dilts
All rights reserved. No portion of this book

may be reproduced, transmitted, or stored, by
any process or technique, without the express
written consent of Dr. David A. Dilts
1992, 1993, 1994, 1995 ,1996, 2003 and 2004
Published by Indiana - Purdue University - Fort Wayne

for use in classes offered by the Department of Economics,
School of Business and Management Sciences at I.P.F.W.
by permission of Dr. David A. Dilts
TABLE OF CONTENTS
Preface.............................................................................................................................. ii
Syllabus............................................................................................................................. iv
I. Lecture Notes
1. Introduction to Economics ...................................................................................... 2

2. Economic Problems................................................................................................ 7
3. Interdependence and the Global Economy ............................................................ 12
4. Supply and Demand ............................................................................................... 18
5. Elasticity ................................................................................................................. 29
6. Consumer Behavior................................................................................................ 33
7. Costs ...................................................................................................................... 37
8. Competition ............................................................................................................ 43
9. Monopoly ................................................................................................................ 50
10. Resource Markets .................................................................................................. 56
11. Wage Determination............................................................................................... 60
12. Epilogue.................................................................................................................. 68
II. Reading Assignments
1. Introduction to Economics ...................................................................................... 71

2. Economic Problems................................................................................................ 87
3. Interdependence and the Global Economy ............................................................ 101
4. Supply and Demand ............................................................................................... 116
5. Elasticity ................................................................................................................. 134
6. Consumer Behavior................................................................................................ 146
7. Costs ...................................................................................................................... 154
8. Competition ............................................................................................................ 165
9. Monopoly ................................................................................................................ 179
10. Resource Markets .................................................................................................. 191
11. Wage Determination............................................................................................... 200
12. Epilogue.................................................................................................................. 217
III. Appendix A
Sample Midterm Examination ........................................................................................... 222

Sample Final Examination................................................................................................. 229
IV. Appendix B
Bibliography, book list ...................................................................................................... 236
i
PREFACE
This Course Guide was developed in part because of the high cost of college
textbooks, and in part, to help organize students= studying by providing lecture notes.
This Guide was made possible because the administration of IPFW had the foresight to
make the campus= printing services available to duplicate these sorts of materials, and
provide them at cost through the auspices of the University Bookstore in Kettler Hall.
Without the active participation of both the campus duplicating services, and its most
cooperative staff, and the bookstore this would not be available.
The department, school nor the professor make anything whatsoever from this
Guide. In fact, the department=s budget and the professor=s own resources are used in
the writing of the Guide, and the numerous draft copies that are produced in the
revisions of this document. Like the sign in the Mom and Pop bait shop on Big Barbee
Lake says, “This is a non-profit organization, wasn’t planned to be B it just sorta worked
out that way.” Well, actually it was planned to be a non-profit enterprise in this particular
case.
The professor also wishes to acknowledge the fact that several students have
proposed changes, improvements, caught errors, and helped to make this document
more useful as a learning tool. Naturally, any errors of omission or commission are
those of the professor alone.
ii
Introduction & Use of Guide
This Course Guide is provided to assist students in mastering the subject matter
presented E201, Introduction to Microeconomics. The commercially available student
guides and workbooks are notoriously inadequate and are simply of little value. At
several institutions, prepared course materials are made available to students to assist
their learning. What research has been done concerning these course specific
materials, suggests that students' performances are enhanced by having access to
these types of materials. Because microeconomics is such an important foundation for
business, engineering, and the social sciences this Guide has been prepared.
The purpose of this Course Guide is fourfold. First, the course syllabus is
included in the Guide. Second, the Guide provides the student a listing of the key
concepts covered in the lectures. Third, the Guide provides students with problems and
study-guides to aid each individual in the retaining the materials presented by the text
and lecture. Fourth, sample exams are offered as self-test exercises and to give
students an idea of the level of mastery expected in this course.
Organization
The Guide is divided into eleven units, following the organization of the Tentative
Course Outline found in the syllabus. At the end of each chapters in the reading
assignments there is a section containing the key concepts developed in the chapter,
sample exam questions and a brief study guide. Also in the Guide is the course
syllabus included before the eleven sections covering the substantive portions of the
course. Following the reading assignments are the lecture notes for each chapter. The
final section of the Guide contains sample examinations, including answers.
Note to Students
There is no substitute for doing the reading assignments, attending class, and
working through the material. A teacher cannot cause a student to learn, all a teacher
can do is to organize and present the material, grades can provide a small extrinsic
reward for accomplishment, but it is the student's ability, effort, and desire that
determine how much and how well they will learn. It is hoped this Guide will help in the
learning effort.
iii
SYLLABUS
E201, Introduction to Microeconomics
Dr. David A. Dilts Department of Economics and Finance

Room 340D Neff Hall School of Business and Management Sciences
Phone 481-6486 Indiana - Purdue University - Fort Wayne
COURSE POLICIES
1. In all respects, the policies of the School, Department, IPFW and the University
shall be applied in this course.
2. Office hours will be posted on the professor's door, appointments may also be
arranged. The Professor's office is Neff 340D.
3. The following grade scale will be applied in this course for determination of final
grades:
A 100 - 90 percent
B 89 - 80 percent
C 79 - 70 percent
D 69 - 60 percent
F below 60 percent
All final grade calculations shall be rounded up. In other words, 69.01 and 69.99
percent are both considered 70 percent and will earn the student a grade of C.
4. The majority of undergraduate economics courses this professor has taught have
had average final grades that fall within the range centered on 2.0 on a 4.0 scale.
5. Course requirements:
The mid-term examination is worth 40% of the final grade, the final examination
is worth 50% of the final grade, and there will be at least three quizzes, the best
two scores on these quizzes will be worth 10% of the final grade.
A. Examinations will consist of objective items. Examinations will be

worth 100 points, and will consist of twenty multiple-choice
questions (worth four points each), and twenty true-false questions
(worth one point each).
B. Quizzes are worth twenty points each, and will consist of
iv
three multiple choice questions (four points each) and four
true false questions (worth two points each)
C. If there is a 10-point improvement on the final exam over

what was earned on the midterm, then the weights will be
change to the midterm being worth only 30 percent and the
final exam being worth 60 percent of the final grade.
6. The final examination will be given at the time and place scheduled by the
university. No exception is possible.
7. No make-up exams will be permitted. If you cannot attend class at exam

time, you must make prior arrangements to take an equivalent
examination before your classmates. Exceptions may be granted for
cases where there was no possibility for an earlier examination, i.e.,
injuries or illnesses, etc B things clearly beyond the student=s control.
8. Academic dishonesty in any form will result in a course grade of F and

other sanctions as may be authorized by the university. The over
whelming preponderance of students do not engage in dishonesty, and
the professor owes it to these students to strictly police this policy.
9. The provisions of these policies and the course objectives are subject to
testing. These policies are also subject to change at the discretion of the
professor and do not constitute a binding contract.
COURSE OBJECTIVES
This is an introductory principles of economics course that covers topics in

microeconomics. The breath of topical coverage limits the course objectives to subject
matter mastery. The course will present factual material concerning the operation of the
firm and household as well as the development of rudimentary understanding of
economic decision-making.
REQUIRED TEXT
David A. Dilts, Introduction to Microeconomics, E201. Fort Wayne: 2004, memo.
SUPPLEMENTAL TEXT
v
Campbell R. McConnell and Stanley L. Bruce, Economics, twelfth edition. New
York: McGraw-Hill. [M&B in the outline]
TENTATIVE COURSE OUTLINE
1. Introduction to Course and Economics
Dilts, Chapter 1
M & B Chapter 1
2. Economic Problems
Dilts, Chapter 2
M & B Chapter 2
3. Circular Flow
Dilts, Chapter 3
M & B Chapter 3
4. The Basics of Supply and Demand
Dilts, Chapter 4
M & B Chapter 4
5. Supply and Demand: Elasticities
Dilts, Chapter 5
M & B Chapter 20
6. Consumer Behavior
Dilts, Chapter 6
M & B Chapter 21
MIDTERM EXAMINATION
7. Costs of Production
Dilts, Chapter 7
M & B Chapter 22
vi
8. Pure Competition
Dilts, Chapter 8
M & B Chapter 23
9. Monopoly
Dilts, Chapter 9
M & B Chapter 24
10. Introduction to Resource Markets
Dilts, Chapter 10
M & B Chapter 27
11. Wage Determination
Dilts, Chapter 11
M & B Chapter 28
12. Epilogue
Dilts, Chapter 12
vii
LECTURE
NOTES
INTRODUCTION TO MICROECONOMICS
E201
1
1. Introduction to Course and Economics
Lecture Notes
1. Economics Defined - Economics is the study of the ALLOCATION of SCARCE

resources to meet UNLIMITED human wants.
a. Microeconomics - is concerned with decision-making by individual

economic agents such as firms and consumers. (Subject matter of this
course)
b. Macroeconomics - is concerned with the aggregate performance of the

entire economic system. (Subject matter of the following course)
c. Empirical economics - relies upon facts to present a description of

economic activity.
d. Economic theory - relies upon principles to analyze behavior of economic

agents.
e. Inductive logic - creates principles from observation.
f. Deductive logic - hypothesis is formulated and tested.
2. Usefulness of economics - economics provides an objective mode of analysis,

with rigorous models that are predictive of human behavior.
a. Scientific approach
b. Rational choice
2
3. Assumptions in Economics - economic models of human behavior are built upon
assumptions; or simplifications that permit rigorous analysis of real world events,
without irrelevant complications.
a. model building - models are abstractions from reality - the best model is
the one that best describes reality and is the simplest B Occam=s Razor.
b. simplifications:
1. ceteris paribus - means all other things equal.
2. There are problems with abstractions, based on assumptions.

Too often, the models built are inconsistent with observed reality -
therefore they are faulty and require modification. When a model
is so complex that it cannot be easily communicated or its
implications easily understood - it is less useful.
4. Goals and their Relations -
a. POSITIVE economics is concerned with what is;
b. NORMATIVE economics is concerned with what should be.
1. Economic goals are value statements, hence normative.
c. Economics is not value free, there are judgments made concerning what
is important:
1. Individual utility maximization versus social betterment
2. Efficiency versus fairness
3. More is preferred to less
3
d. Most societies have one or more of the following goals, depending on
historical context, public opinion, and socially accepted values :
1. Economic efficiency,
2. Economic growth,
3. Economic freedom,
4. Economic security,
5. Equitable distribution of income,
6. Full employment,
7. Price level stability, and
8. Reasonable balance of trade.
5. Goals are subject to:
a. interpretation - precise meanings and measurements will often become

the subject of different points of view, often caused by politics.
b. goals that are complementary are consistent and can often be

accomplished together.
c. conflicting - where one goal precludes, or is inconsistent with another.
d. priorities - rank ordering from most important to least important; again

involving value judgments.
6. The Formulation of Public and Private Policy - Policy is the creation of guidelines,
regulations or law designed to affect the accomplishment of specific economic
goals.
4
a. Steps in formulating policy:
1. stating goals - must be measurable with specific stated objectives to

be accomplished.
2. options - identify the various actions that will accomplish the stated
goals & select one, and
3. evaluation - gathers and analyzes evidence to determine whether

policy was effective in accomplishing goal, if not re-examine options
and select option most likely to be effective.
7. Objective Thinking:
a. bias - most people bring many misconceptions and biases to economics.
1. Because of political beliefs and other value system components

rational, objective thinking concerning various issues requires the
shedding of these preconceptions and biases.
b. fallacy of composition - is simply the mistaken belief that what is true for
the individual, must be true for the group.
c. cause and effect - post hoc, ergo propter hoc - Aafter this, because of this@
B fallacy.
1. correlation - statistical association of two or more variables.
2. causation - where one variable actually causes another.
a. Granger causality states that the thing that causes another must
occur first, that the explainer must add to the correlation, and
must be sensible.
5
d. cost-benefit or economic perspective - marginal decision-making - if
benefits of an action will reap more benefits than costs it is rational to do
that thing.
1. Focus on the addition to benefit, and the addition to cost as the basis
for decision-making.
a. Sunk costs have nothing to do with rational decision-making.
6
2. Economic Problems
Lecture Notes
1. The economizing problem involves the allocation of resources among competing
wants. There is an economizing problem because there are:
d. unlimited wants
e. limited resources
2. Resources and factor payments:
d. land - includes space (i.e., location), natural resources, and what is

commonly thought of as land.
1. land is paid rent
e. capital - are the physical assets used in production - i.e., plant and
equipment.
2. capital is paid interest
f. labor - is the skills, abilities, knowledge (called human capital) and the
effort exerted by people in production.
3. labor is paid wages
d. entrepreneurial talent - (risk taker) the economic agent who creates the
enterprise.
4. entrepreneurial talent is paid profits
3. Full employment includes the natural rate of unemployment and down time for
normal maintenance (both capital & labor). However, full production or 100%
capacity utilization cannot be maintained for a prolonged period without labor
and capital breaking-down:
7
a. underemployment - utilization of a resource in a manner, which is less
than what is consistent with full employment - using an M.D. as a practical
nurse.
4. Economic Efficiency consists of the following three components:
a. allocative efficiency - is measured using a concept known as Pareto

Superiority (or Optimality)
1. Pareto Optimal - is that allocation where no person could be made

better off without inflicting harm on another.
2. Pareto Superior - is that allocation where the benefit received by one

person is more than the harm inflicted on another. [cost - benefit
approach]
b. technical efficiency - for a given level of output, you minimize cost or

(alternatively) for a given level of cost you maximize output.
c. full employment - for a system to be economically efficient then full

employment is also required.
5. Allocations of resources imply that decisions must be made, which in turn

involves choice. Every choice is costly; there is always the lost alternative -- the
opportunity cost:
a. opportunity cost - the next best alternative that must be foregone as a

result of a particular decision.
6. The production possibilities curve is a simple model that can be used to show
choices:
a. assumptions necessary to represent production possibilities in a simple

production possibilities curve model:
8
1. efficiency
2. fixed resources
3. fixed technology
4. two products
Beer
Pizza
7. Law of Increasing Opportunity Costs is illustrated in the above production

possibilities curve. Notice - as we obtain more pizza (shift to the right along the
pizza axis) we have to give up large amounts of beer (downward shift along beer
axis).
8. Inefficiency, unemployment and underemployment are illustrated by a point

inside the production possibilities curve, as shown above. (identified
by this symbol):
a. Inefficiency is a violation of the assumptions behind the model, but do not

change the potential output of the system.
9. Economic Growth can also be illustrated with a production possibilities curve.

The dashed line in the above model shows a shift to the right of the of the curve
which is called economic growth.
9
a. The only way this can happen is for there to be more resources or better
technology.
b. Growth will change the potential output of the economy, hence the shift of
the entire curve.
10. Economic Systems rarely exist in a pure form. The following classification of
systems is based on the dominant characteristics of those systems:
a. pure capitalism - private ownership of productive capacity, very limited

government, and motivated by self-interest.
1. laissez faire - government hands-off; markets relied-upon to perform

allocations.
2. costs of freedom - poverty, inequity and several social ills are

associated with the lack of protection afforded by government.
b. command - government makes the decisions - with force of law (and

sometimes martial force)
1. Often associated with dictatorships
c. traditional - based on social mores or ethics or other non-market, non-

legislative bases
1. Christmas gift giving is tradition
d. socialism - maximizes individual welfare based on perceived needs, not

contributions; generally concerned more with perceived equity than
efficiency.
e. communism - everyone shares equally in the output of society (according

to their needs), generally no private holdings of productive resources
1. The former Soviet Union espoused communism, but also was mostly
10
command
2. Utopian movement in the U.S.
f. mixed system - contains elements of more than one system - U.S.

economy is a mixed system (capitalism, command, and socialism are the
major elements, with some communism and tradition)
1. All of the high income, industrialized economies are mixed economies
e. Even with mixed systems there are substantial variations in the amounts
of socialism, capitalism, tradition, and command exist in each example.
11
3. Interdependence and the Global Economy
Lecture Notes
1. The modern economic system is no longer the closed (i.e., U.S. only) system
upon which the debates surrounding isolationalism occurred prior to World War
II.
a. Imports and Exports are increasingly important
b. Foreign investment versus U.S. investment abroad
1. Outsourcing
2. Technological transfers
c. Balance of trade issues.
1. Current accounts (import v. exports)
2. Capital accounts (foreign investment)
2. Capitalist Ideology - The characteristics of a capitalist economy and the ideology

that has developed concerning this paradigm are not necessarily the same thing.
The elements of a capitalist ideology are:
a. freedom of enterprise
b. self-interest
c. competition
d. markets and prices
12
e. a very limited role for government
f. different countries with different views of these matters B i.e., equity v.

efficiency again.
3. Market System Characteristics - the following characteristics are typical of a

system that relies substantially on markets for allocation of resources. These
characteristics are:
a. division of labor & specialization
b. capital goods
c. comparative advantage - is concerned with cost advantages.
1. Comparative advantage is the motivation for trade among nations and

persons.
2. Terms of trade are those upon which the parties may agree and
depends on the respective cost advantages and bargaining power.
4. Trade among nations
a. the reliance upon comparative advantage to motivate trade B assuming

barter:
Belgium Holland
Tulips 400 4000
Wine 4000 400
The data above show what each country could produce if all of their
resources were put into each commodity. For example, if Holland put all
13
their resources in tulip production they could produce 4000 tons of tulips
but no wine. Assuming the data give the rate at which the commodities
can be substituted, if both countries equally divided their resources
between the two commodities, Belgium can produce 200 tons of tulips and
2000 barrels of wine and Holland can produce 200 barrels of wine and
2000 tons of tulips (for a total of 2200 units of each commodity produced
by the two countries by splitting their resources among the two
commodities). If Belgium produced nothing but wine it would produce
4000, and if Holland produced nothing but tulips it would produce 4000
tons). If the countries traded on terms where one barrel of wine was worth
one ton of tulips then both countries would have 2000 units of each
commodity and obviously benefit from specialization and trade.
b. absolute advantage for one trading partner results in no advantage to

trade.
1. LDCs often have no comparative advantage and hence the developed

countries, possessing absolute advantage have no incentive to trade (.
2. LDCB Less Developed Country - Low-income countries B 60 B (per

capita GDP of $800), middle-income countries B 75 B (per capital GDP
of $8000).
3. High income countries and developed countries (19 countries)
4. High income countries without economic development (Hong Kong,

Israel, Kuwait, Singapore, and UAE)
5. Money facilitates market activities and is necessary in complex market systems:
a. barter economy - is where commodities are directly traded without the use
of money.
1. Direct trade requires a coincidence of wants.
2. Prices become complicated by not having a method to easily measure

worth.
14
b. functions of money:
1. medium of exchange
2. store of value
3. measure of worth
c. Fiat money
1. European Gold & Silver smith receipts 15th century
2. Genghis Kahn in the 12th century in Asia B paper money
6. Foreign exchange B value of one currency versus another
a. Hard currency B U.S. dollar, British Pound, Canadian dollar, Japanese

Yen, and the Euro B general acceptability of the currency and it being
demanded as reserves by central banks
1. G-7 nations, hard currency nations; Euro predecessors France,

Germany, Italy
b. Exchange rates affect both imports and exports; and foreign investment
here, U.S. investment abroad.
1. Dollar gains strength, Imports cheaper here, exports more expensive

abroad
2. Dollar gains strength, foreign investment in U.S. more attractive
15
because dollar buys more foreigners= home currency when investment
repatriated
c. Strong dollar policy in exchange B based on interest rates, growth, and

relative strength of economy and stability of political system etc.
1. Debt and supply of currency an important factor in economic

development
7. The Circular Flow Diagram is used to show the interdependence that exists
among sectors of the economy:
a. sectors [private-domestic]
1. households
2. resource markets
3. businesses
4. product markets
b. complications
1. government
2. foreign sector
c. Model of interdependence:
16
______________________________________________________________________
____________________________________________________________________
FOREIGN SECTOR
_____________________________________________________________________
_____________________________________________________________________
Product markets are where the domestic parties obtain and sell commodities
[inside the pyramid], and the factor markets [shown with the dotted lines] are
where the domestic parties obtain and supply productive resources. The base
reads AFOREIGN SECTOR@, which indicates that the same buying and selling of
commodities and resources is not limited to just domestic parties, but can include
foreign businesses and resources as well. The circular flow diagram shows that
each of the sectors relies on the others for resources and supplies the others
commodities and resources.
17
4. Basics of Supply and Demand
Lecture Notes
1. A market is nothing more or less than the locus of exchange; it is not necessarily
a place, but simply buyers and sellers coming together for transactions.
2. The law of demand states that as price increases (decreases) consumers will
purchase less (more) of the specific commodity.
a. The demand schedule (demand curve) reflects the law of demand it is a

downward sloping function and is a schedule of the quantity demanded at
each and every price.
As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a
negative relation between price and quantity, hence the negative slope of the demand
schedule; as predicted by the law of demand.
1. utility (use, pleasure, jollies) from the consumption of commodities.
18
2. The change in utility derived from the consumption of one more unit of
a commodity is called marginal utility.
3. Diminishing marginal utility is the fact that at some point further

consumption of a commodity adds smaller and smaller increments to
the total utility received from the consumption of that commodity.
b. The income effect is the fact that as a person's income increases (or the
price of item goes down [which effectively increases command over
goods] more of everything will be demanded.
c. The substitution effect is the fact that as the price of a commodity

increases, consumers will buy less of it and more of other commodities.
3. Demand Curve
a. Price and quantity - again the demand curve shows the negative relation
between price and quantity.
b. Individual versus market demand - a market demand curve is simply an

aggregation of all individual demand curves for a particular commodity.
c. Nonprice determinants of demand; and a shift to the left (right) of the

demand curve is called a decrease (increase) in demand. The nonprice
determinants of demand are:
1. tastes and preferences of consumers,
2. the number of consumers,
3. the money incomes of consumers,
4. the prices of related goods, and
5. consumers' expectations concerning future availability or prices of

the commodity.
19
d. Changes in demand versus in quantity demanded
An increase in demand is shown in the first panel, notice that at each price there is a
greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the
solid line). The second panel shows a decrease in demand, notice that there is a lower
quantity demanded at each price along D2 (the dotted line) than was demanded with D1
(the solid line).
20
Movement along a demand curve is called a change in the quantity demanded.
Changes in quantities demanded are caused by changes in price. When price
decreases from P1 to P2, the quantity demanded increases from Q1 to Q2; when price
increases from P2 to P1 the quantity demanded decreases from Q2 to Q1.
4. The law of supply is that producers will supply more the higher the price of the
commodity.
a. Supply schedule - are the quantities supplied at each and every price.
5. Supply curve - is nothing more than a schedule of the quantities at each and
every price.
a. There is a positive relation between price and quantity on a supply curve.
b. Changes in one or more of the nonprice determinants of supply cause the

supply curve to shift. A shift to the left of the supply curve is called a
decrease in supply; a shift to the right is called an increase in supply. The
nonprice determinants of supply are:
1. resource prices,
2. technology,
3. taxes and subsidies,
4. prices of other goods,
5. expectations concerning future prices, and
6. the number of sellers.
21
A decrease in supply is shown in the first panel, notice that there is a lower
quantity supplied at each price with S2 (dotted line) than with S1 (solid line). The
second panel shows an increase in supply, notice that there is a larger quantity supplied
at each price with S2 (dotted line) than with S1 (solid line).
Changes in price cause changes in quantity supplied, an increase in price from P2 to P1

causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1
22
to P2 causes a decrease in the quantity supplied from Q1 to Q2.
6. Market equilibrium occurs where supply equals demand (supply curve intersects
demand curve).
a. An equilibrium implies that there is no force that will cause further changes
in price, hence quantity exchanged in the market. This is analogous to a
cherry rolling down the side of a glass; the cherry falls due to gravity and
rolls past the bottom because of momentum, and continues rolling back
and forth past the bottom until all of its' energy is expended and it comes
to rest at the bottom - this is equilibrium [a rotten cherry in the bottom of a
glass].
The following graphical analysis portrays a market in equilibrium. Where the

supply and demand curves intersect, equilibrium price is determined (Pe) and
equilibrium quantity is determined (Qe)
23
a. The graph of a market in equilibrium can also be expressed using a series
of equations. Both the demand and supply curve can be expressed as
equations.
Demand Curve is Qd = 22 - P
Supply Curve is Qs = 10 + P
The equilibrium condition is Qd = Qs
Therefore:
22 - P = 10 + P
adding P to both sides of the equation yields:
22 = 10 + 2P
subtracting 10 from both sides of the equation yields:
12 = 2P or P = 6
To find the equilibrium quantity, we plug 6 (for P) into either the supply or the
demand curve and get:
22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side)
7. Changes in supply and demand in a market result in new equilibria. The

following graphs demonstrate what happens in a market when there are changes
in nonprice determinants of supply and demand.
24
Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a
decrease in demand (as demonstrated in the above graph). Such decreases are
caused by a change in a nonprice determinant of demand (for example, the number of
consumers in the market declined or the price of a substitute declined). With a
decrease in demand there is a shift of the demand curve to the left along the supply
curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1
that is called an increase in demand, possibly due to an increase in the price of a
substitute good or an increase in the number of consumers in the market. When
demand increases both equilibrium price and quantity increase as a result.
Considering the following graph, movement of the supply curve from S1 (solid
line) to S2 (dashed line) is an increase in supply. Such increases are caused by a
change in a nonprice determinant (for example, the number of suppliers in the market
increased or the cost of capital decreased). With an increase in supply there is a shift of
the supply curve to the right along the demand curve, therefore equilibrium price and
quantity move in opposite directions (price decreases, quantity increases). If we move
from S2 to S1 that is called an decrease in supply, possibly due to an increase in the
price of a productive resource (capital) or the number of suppliers decreased. When
supply decreases, equilibrium price increases and the quantity decreases as a result.
That is the result of the supply curve moving up along the negatively sloped demand
curve (which remains unchanged).
If both the demand curve and supply curve change at the same time the analysis
becomes more complicated.
Consider the following graphs:
25
Notice that the
quantity remains the same in both graphs. Therefore, the change in the equilibrium
quantity is indeterminant and its direction and size depends on the relative strength of
the changes between supply and demand. In both cases, the equilibrium price
changes. In the first case where demand increases, but supply decreases the
equilibrium price increases. In the second panel where demand decreases and supply
increases, the equilibrium price decreases.
In the event that demand and supply both increase then price remains the same
(is indeterminant) and quantity increases, and if both decrease then price is
indeterminant and quantity decreases. These results are illustrated in the following
diagrams.
26
The graphs show that price remains the same (is indeterminant) but when supply and
demand both increase quantity increases to Q2. When both supply and demand
decrease quantity decreases to Q2.
8. Shortages and surpluses occur because of effective government intervention in

the market.
a. Shortage is caused by an effective price ceiling (the maximum price you

can charge for the product). Consider the following diagram that
demonstrates the effect of a price ceiling in an otherwise purely
competitive industry.
1. For a price ceiling to be effective it must be imposed below the

competitive equilibrium price. Note that the Qs is below the Qd,
which means that there is an excess demand for this commodity
that is not being satisfied by suppliers at this artificially low price.
The distance between Qs and Qd is called a shortage.
b. Surplus is caused by an effective price floor (i.e., the minimum you can
charge):
27
For a price floor to be effective, it must be above the competitive equilibrium
price. Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs
is the amount of the surplus. Minimum wages are the best-known examples of price
floors and will be discussed in greater detail in Chapter 11.
9. Supply and Demand is rudimentary, and does not exist in the real world. In most
respects the supply and demand model is the beginning point for understanding
markets. Monopoly, monopolistic competition and oligopoly are, in some
important respects, refinements from the purely competitive market. Therefore,
the basic supply and demand model may accurately be thought of as the
beginning point from which we will explore more realistic market structures.
28
5. Supply & Demand: Elasticities
Lecture Notes
1. Price Elasticity of Demand is how economists measure the responsiveness of

quantities demanded to changes in prices.
a. The elasticity coefficient is calculated using the midpoints formula

presented below:
1. Ed = Change in Qty ) Change in price

(Q1 + Q2)/2 (P1 + P2)/2
b. Elastic demand means that the quantities demanded respond more than
proportionately to changes in price; with elastic demand the coefficient is
more than one.
c. Inelastic demand means that the quantities demanded respond less than
proportionately to changes in price; with inelastic demand the coefficient is
less than one.
d. Unit elastic demand means that the quantity demanded respond

proportionately to change in prices; with unit elastic demand the coefficient
is exactly one.
2. Perfectly Elastic and Perfectly Inelastic Demand Curves
29
Notice that the perfectly elastic demand curve is horizontal, (add one more horizontal
line at the top of the price axis and it will look like an E) and the inelastic demand curve
is vertical (looks like an I).
a. Elasticity changes along the demand curve, however slope

does not. Elasticity is concerned with changes along the
curve rather than the shape or position of the curve.
3. Demand Curve and Total Revenue (total revenue = P x Q) Curve
30
In examining the above graphs, notice that as total revenue is increasing, demand is
elastic. When the total revenue curve flattens-out at the top then demand becomes unit
elastic, and when total revenue falls demand is inelastic.
4. Total Revenue Test uses the relation between the total revenue curve and the
demand curve to determine elasticity.
Consider the following numerical example:
Total Quantity Price per unit Total Revenue Elasticity
1 9 9
>+7 Elastic
2 8 16
>+5 Elastic
3 7 21
>+3 Elastic
4 6 24
>+ 1 Elastic
5 5 25
>-1 Inelastic
6 4 24
>-3 Inelastic
7 3 21
>-5 Inelastic
8 2 16
>-7 Inelastic
9 1 9
The total revenue test is simply the inspection of the data to see what happens to total
revenue. If the change in total revenue (marginal revenue) is positive then demand is
price elastic, if the change in total revenue is negative the demand is price inelastic. If
the marginal revenue is exactly zero then demand is unit elastic.
5. The following determinants of the price elasticity of demand will determine how
responsive the quantity demanded is to changes in price. These determinants
are:
a. substitutability
31
b. proportion of income
c. luxuries versus necessities
d. time
6. Price Elasticity of Supply is determined by the following time frames. The more
time a producer has to adjust output the more elastic is supply.
a. market period
b. short run
c. long run
7. Cross elasticity of demand measures the responsiveness of the quantity

demanded of one product to changes in the price of another product. For
example, the quantity demanded of Coca-Cola to changes in the price of Pepsi.
8. Income elasticity of demand measures the responsiveness of the quantity

demanded of a commodity to changes in consumers' incomes.
9. Interest rate sensitivity.
32
6. Consumer Behavior
Lecture Notes
1. Individual demand curves can be constructed from observing consumer

purchasing behaviors as we change price.
a. This is called REVEALED PREFERENCE
b. Market demand curves are constructed by aggregating individual demand

curves for specific commodities.
2. Individual preferences can be modeled using a model called indifference curve -

budget constraint and from this model we can derive an individual demand curve.
a. The budget constraint shows the consumer's ability to purchase goods.
The consumer is assumed to spend their resources on only beer and pizza. If all
resources are spent on beer then the intercept on the beer axis is the amount of beer
the consumer can purchase; on the other hand, if all resources are spent on pizza then
the intercept on that axis is the amount of pizza that can be had.
33
If the price of pizza doubles then the new budget constraint becomes the dashed
line. The slope of the budget constraint is the negative of the relative prices of beer and
pizza.
b. The indifference curve shows the consumer's preferences:
1. There are three assumptions that underpin the indifference curve,

these are:
1) Indifference curves are everyplace thick
2) Indifference curves do not intersect one another
3) Indifference curves are strictly convex to the origin
The dashed line (2) shows a higher level of total satisfaction than does the solid
line (1). Along each indifference curve is the mix of beer and pizza that gives the
consumer equal total utility.
Consumer equilibrium is where the highest indifference curve they can reach is
exactly tangent to their budget constraint. Therefore if the price of pizza increases we
can identify the price from the slope of the budget constraint and the quantities
purchased from the values along the pizza axis and derive and individual demand curve
for pizza:
34
When the price of pizza doubled the budget constraint rotated from the solid line
to the dotted line and instead of the highest indifference curve being curve 1, the best
the consumer can do is the indifference curve labeled 2.
Deriving the individual demand curve is relatively simple. The price of pizza (with
respect to beer) is given by the (-1) times slope of the budget constraint. The lower
price with the solid line budget constraint results in the level the higher level of pizza
being purchased (labeled 1for the indifference curve - not the units of pizza). When the
price increased the quantity demanded of pizza fell to the levels associated with budget
constraint 2.
Notice that Q2 and P2 are associated with indifference curve 2 and budget constraint 2,
and that Q1 and P1 result from indifference curve 1 and budget constraint 1. The above
model shows this individual consumer's demand for pizza.
35
3. Income and substitution effects combine to cause the demand curve to slope
downwards.
a. the income effect results from the price of a commodity going down
permitting consumers to spend less on that commodity, hence the same
as having more resources.
b. As a price increases, the consumer will purchase less of that commodity

and buy more of a substitute, this is the substitution effect.
c. The combination of the income and substitution effects is that an individual

(hence a market) demand curve will generally slope downward.
d. Giffin's Paradox is the fact that some commodities may have an upward
sloping demand curve. This happens because the income effect results in
less of a quantity demanded for a product the lower the price.
1. There is also the snob appeal possibility where the higher the price the
more desired the commodity is - Joy Perfume advertised itself as the
world's most expensive.
3. Utility maximizing rule - consumers will balance the utility they receive against the
cost of each commodity to arrive at the level of each commodity they should
consume to maximize their total utility.
a. algebraic restatement - MUa/Pa = MUb/Pb = . . . = Mu z / P z = 1
36
7. Costs of Production
Lecture Notes
1. Explicit are accounting costs, however, Implicit Costs are the opportunity costs of
business decisions.
a. normal profit includes an opportunity cost - the profit that could have been
made in the next best alternative allocation of productive resources.
3. In other words, there is a difference between economic and accounting

cost; accountants are unconcerned with opportunity costs.
2. Time Periods are defined by the types of costs observed. These time periods
differ from industry to industry.
a. market period - everything is fixed
b. short run - there are both fixed and variable costs
c. long run - everything is variable
3. Prelude to Production Costs in Short Run - include both fixed and variable costs:
a. the law of diminishing returns is the fact that as you add variable factors of
production to a fixed factor at some point, the increases in total output
become smaller.
b. total product is the total units of production obtained from the productive
resources employed.
37
c. average product is total product divided by the number of units of the
variable factor employed
d. marginal product is the change in total product associated with a change

in units of a variable factor
1. graphical presentation:
The top graph shows total product (total output). As total product reaches its
maximum marginal product becomes zero and then negative as total product
declines. When marginal product reaches its maximum, the total product curve
becomes flatter. As marginal product is above average product in the bottom
diagram, average product is increasing. When marginal product is below
average product, then average product is decreasing. The ranges of marginal
returns are identified on the above graphs.
38
4. Short-run costs:
a. total costs = VC + FC
b. variable costs are those items that can be varied in the short-run, i.e.,
labor
c. fixed costs are those items that cannot be varied in the short-run, i.e.,
plant and equipment
The fixed cost curve is a horizontal line because they do not vary with
quantity of output. Variable cost has a positive slope because it vary with
output. Notice that the total cost curve has the same shape as the
variable cost curve, but is above the variable cost curve by a distance
equal to the amount of the fixed cost.
d. average total costs = TC/Q
e. average variable cost = VC/Q
f. average fixed cost = FC/Q
g. marginal cost = ÎTC/ÎQ; where Î stands for change in.
39
1. The following diagram presents the average costs and marginal
cost curve in graphical form.
Notice that the average fixed cost approaches zero as quantity increases.
Average total cost is the summation of the average fixed and average variable
cost curves. The marginal cost curve intersects both the average total cost and
average variable cost curves at their respective minimums.
The following graph relates average and marginal product to average variable
and marginal cost.
Notice that at the maximum point on the average product curve, marginal cost
reaches a minimum. Where marginal cost equals average variable cost, the
marginal product curve intersects the average product curve.
40
5. Long Run Average Total Cost Curve
a. Is often called an envelope curve because it is the minimum points of all

possible short-run average total cost curves (allowing technology and fixed
cost to vary).
6. Economies of Scale are benefits obtained from a company becoming large and
Diseconomies of Scale are additional costs inflicted because a firm has become
too large.
a. The causes of economies of scale are:
1. labor specialization
2. managerial specialization
3. more efficient capital
4. ability to profitably use by-products
b. Diseconomies of scale are due to the fact that management loses control
of the firm beyond some size.
41
c. Constant returns to scale are large ranges of operations where the firm's
size matters little.
d. Minimum efficient scale is the smallest size of operations where the firm
can minimize its long-run average costs.
e. Natural monopoly is a market situation where per unit costs are minimized
by having only one firm serve the market -- i.e., electric companies.
42
8. Pure Competition
Lecture Notes
1. There are several models of market structure, these include:
a. pure competition (atomized competition, price taker, freedom of entry &

exit, no nonprice competition, standardized product)
b. pure monopoly (one seller, price giver, entry & exit blocked, unique
product, nonprice competition)
c. monopolistic competition (large number of independent sellers, pricing

policies, entry difficult, nonprice competition, product differentiation)
d. oligopoly (very few number of sellers, often collude, often price leadership,
entry difficult, nonprice competition, product differentiation)
1. all assume perfect knowledge
2. Assumptions of Pure Competition:
a. large number of agents
b. standardized product
c. no non-price competition
d. freedom of entry & exit
43
e. price taker
3. Revenue with a price taking firm:
a. average revenue and marginal revenue are equal for the purely
competitive firm because price does not change with quantity.
b. total revenue is P x Q which is the total area under the demand curve (up
to where MR = MC) for the purely competitive firm.
4. The profit-maximizing rule is that a firm will maximize profits where Marginal Cost
is equal to Marginal Revenue.
a. MC = MR
b. Where MC = MR; revenue is at its maximum and costs are at their

minimum.
5. Model of the purely competitive industry:
The purely competitive industry is the supply and demand diagram presented in
chapter 4.
44
6. Firm in Perfect Competition
a. perfectly elastic demand curve
b. Because the firm is a price taker, meaning that it charges the same price
across all quantities of output, marginal revenue is always equal to price,
and average revenue will always be equal to price. Therefore the demand
curve intersects the price axis and is horizontal (perfectly elastic).
c. Establishing price in the industry and the firm:
45
d. The price is established by the interaction of supply and demand in the
industry (Pe) and the quantity exchanged in the industry is the summation
of all of the quantities sold by the firms in the industry.
e. Economic profit for the competitive firm is shown by the rectangle labeled
AEconomic Profit@ in the following diagram:
f. The firm produces at where MC = MR, this establishes Qe. At the point
where MC = MR the average total cost (ATC) is below the demand curve
(AR) and therefore costs are less than revenue, and an economic profit is
made. The reason for this is that the opportunity cost of the next best
allocation of the firm's productive resources is already added into the
firm's ATC.
1. However, the firm cannot continue to operate at an economic profit

because those profits are a signal to other firms to enter the market
(free entry). As firms enter the market, the industry supply curve shifts
to the right reducing price and thereby eliminating economic profits.
Because of the atomized competition assumption, the number of firms
that must enter the market to increase industry supply must be
substantial.
g. A normal profit for the competitive firm is shown in the following diagram:
46
1. The case where a firm is making a normal profit is illustrated above.
Where MC = MR is where the firm produces, and at that point ATC is
exactly tangent to the demand curve. Because the ATC includes the
profits from the next best alternative allocation of resources this firm is
making a normal profit.
h. economic loss for a firm in pure competition:
i. The case of an economic loss is illustrated above. The firm produces

where MC = MR, however, at that level of production the ATC is above the
demand curve, in other words, costs exceed revenues and the firm is
making a loss.
47
j. shut-down case
1. The firm will continue to operate in the case presented in (d.)

above because the firm can cover all of its variable costs and
have something left to pay on its fixed costs - this is loss
minimization. However, in the case above you can see that the
AVC is above the demand curve at where MC=MR, therefore the
firm cannot even cover its variable costs and will shut down to
minimize its losses.
7. Pure Competition and Efficiency
a. Allocative efficiency criteria are satisfied by the competitive model.

Because P = MC, in every market in the economy there is no over- or
under- allocation of resources in this economy.
b. Technical or Productive efficiency criteria are also satisfied by the

competitive model because price is equal to the minimum Average Total
Cost.
c. This, however, does not mean a purely competitive world is utopia. There
are several problems including which are typically associated with a purely
competitive market:
1. Market failures and externalities.
48
2. Income distribution may lack fairness.
3. There may be a limited range of consumer choice.
4. Many natural monopolies are in evidence in the real world.
49
9. Pure Monopoly
Lecture Notes
1. Assumptions of Monopoly Model
a. single seller
b. no close substitutes
c. price giver
d. blocked entry
e. non-price competition
2. The Firm is the Industry and therefore faces a downward sloping demand curve,
which is also the average revenue curve..
a. If the firm wants to sell more it must lower its price therefore marginal
revenue is also downward sloping, but has twice the slope of the demand
curve.
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1. The point where the marginal revenue curve intersects the quantity
axis is of significance; this point is where total revenue is maximized.
Further, the point on the demand curve associated with where MR = Q
is unit price elastic demand; to the left along the demand curve is the
elastic range, and to the right is the inelastic range.
3. There is no supply curve in an industry which is a monopoly.
a. The monopoly decides how much to produce using the profit maximizing
rule; or where MC= MR
4. Monopolized Market
a. Economic Profit:
b. Because entry is blocked into this industry the economic profits shown
above can be maintained in the long run. The monopolist produces where
MC = MR, but the price charged is all the market will bear, that is, where
the demand curve is above the intersection of MC = MR.
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c. Economic losses
1. This monopolist is making an economic loss. The ATC is above the

demand curve (AR) at where MC = MR (the loss is the labeled
rectangle). However, because AVC is below the demand curve at
where MC = MR the firm will not shut down so as to minimize its
losses.
5. Economic Effects of Monopoly:
a. prices, output & resource allocations are not consistent with allocative and
maybe not technical efficiency criteria. With allocative efficiency consider
the following graph:
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1. The above graph shows the profit maximizing monopolist, Pm is the
price in the monopoly and Qm is the quantity exchanged in this market.
However, where MC = D is where a perfectly competitive industry
produces and this is associated with Pc and Qc. The monopolist
therefore produces less and charges more than a purely competitive
industry.
b. A monopolist can also segment a market and engage in price

discrimination. Price discrimination is where you charge a different price
to different customers depending on their price elasticity of demand.
Because the consumer has no alternative source of supply price
discrimination can be effective.
c. Sometimes a monopolist is in the best interests of society (besides the

natural monopoly situation). Often a company must expend substantial
resources on research and development. If these types of firms where
forced to permit free use of their technological developments (hence no
monopoly power) then the incentive to develop new technology and
products would be eliminated.
6. Regulated Monopoly - Because there are natural monopoly market situations it

is in the public interest to permit monopolies, but they are generally regulated.
Examples of regulated monopolies are electric utilities, cable TV companies, and
telephone companies (local).
a. A monopoly regulated at social optimum P = D = MC
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1. This firm is being regulated at the social optimum, in other words, what
the industry would produce if it were a purely competitive industry. The
price it is required to charge is also the competitive solution. However,
notice the ATC is below the demand curve at the social optimum which
means this firm is making an economic profit. It is also possible with
this solution that the firm could be making an economic loss (if ATC is
above demand) or even shut down (if AVC is above demand).
b. A monopolist regulated at the fair return P = D = AC
1. The fair rate of return enforces a normal profit because the firm must
price its output and produce where ATC is equal to demand. This
eliminates economic profits and the risk of loss or of even putting the
monopolist out of business.
c. The dilemma of regulation is knowing where to regulate, at the social

optimal or at the fair return. In reality regulated monopolies are permitted
to earn a rate of return only on invested capital and all other costs are
simply passed on to the consumer.
1. Rate regulation using, invested capital as the rate base, causes an

incentive for firms to over-capitalize and not be sensitive to variable
costs. This is called the Averch-Johnson Effect.
d. X-efficiency is where the firm's costs are more than the minimum possible
costs for producing the output. Electric companies over-capitalize and use
excess capital to avoid labor and fuel expenditures (which are generally
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much cheaper than the additional capital) - nuclear generating plants are a
good example of this.
9. Sherman Antitrust Act B monopolize or restraint trade or conspire to

monopolize a market.
a. Interstate Commerce
b. Criminal Provisions
1. Felony
c. Civil Provisions
1. Private civil suit, not criminal
2. Treble damages
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10. Resource Markets
Lecture Notes
1. Resource Market Complications:
a. Resource markets are often heavily regulated, particularly capital and

labor markets.
b. Because labor (human beings as a factor of production) and private

property are involved in resource markets there tends to be more
controversy concerning these markets.
2. The demand for all productive resources is a derived demand. By derived

demand it is meant that it is the output of the resource and not the resource itself
for which there is a demand.
a. marginal product is MP = ÎTP/ÎL where L is units of labor, (or K for

capital, etc.
b. marginal revenue product is MRP = ÎTR/ÎL
3. Demand Curve:
56
a. Because the demand for a productive resource is a derived demand, the
demand schedule for that productive resource is simply the MRP schedule
of that resource.
4. Determinants of Resource Demand:
a. productivity
b. quality of resource
c. technology
5. Determinants of Resource Price Elasticity:
a. rate of decline of MRP
b. ease of resource substitutability
c. elasticity of product demand
d. K/L ratios
6. Marginal resource cost is the amount that the addition of one more unit of a
productive resource adds to total resource costs.
a. MRC = ÎTRC/ÎL
7. The profit maximizing employment of resources is where MRP = MRC, where

MRC is the supply curve of the resource in a purely competitive resource market.
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a. resource market equilibrium
8. Least Cost Combination of all productive resources is determined by hiring

resources where the ratio of MRP to MRC is equal to one for all resources.
a. MRPlabor/MRClabor = MRPcapital/MRCcapital = ... = MRPland/MRCland = 1
b. The quantities of the resource to the left (right) of the equilibrium point is
under-utilization (over-utilization) where MRP / MRC > 1 (MRP / MRC < 1)
9. Marginal Productivity Theory of Income Distribution
a. inequality under this theory arises because of differences in the

productivity of different resources and the value of the product it produces.
b. One serious flaw in the theory is that of imperfect competition in the

product and resource markets.
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1. monopsony is one buyer of a resource (or product) and causes
factor payments below the competitive equilibrium.
2. monopoly power can also cause some goods and services to be

over-valued.
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11. Wage Determination
Lecture Notes
1. Nominal versus Real Wages:
a. Nominal wages (W) are money wages, unadjusted for the cost of living.
b. Real wages (W/P) are money wages adjusted for the cost of living (P) in
other words, what you can buy.
2. Earnings and Productivity
a. In theory an employee should be paid what she earns for the company,
MRP, however, this theory has serious flaws in practice.
b. Market imperfections, i.e., monopsony results in the earnings of workers

being paid to other factors of production.
c. Problems with measuring MRP, because of engineering complications of

technology.
3. Supply and Demand for Labor:
a. competitive labor market
60
1. The supply and demand curves for the industry are summations of the
individual firms' respective demand and supply curves. Notice that the
firm faces a perfectly elastic supply of labor curve, while the supply
curve for the industry is upward sloping just like we observed in the
product markets.
b. monopsony labor market (one buyer of labor)
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1. Notice that MRC breaks out to the right of the supply curve and is
much steeper; this is due to the pricing policy the monopolist can
employ. Also the wage and employment levels in the monopsony are
much lower than in a competitive labor market.
4. Control of Monopsony:
a. minimum wages has been one approach to the control of monopsony.
1. minimum wages under competition
2. The minimum wage acts the same as an effective price floor in

that it creates a surplus of labor -- unemployment. The distance
between Qd and Qe is the number of workers who lost jobs, and
the distance between Qe and Qs is the number of workers
attracted to this market that cannot find employment.
3. Minimum wage opponents argue that the minimum wage does

two things that are bad for the economy (and these arguments
are based on the competitive model)
b. The working poor can very easily become the unemployed poor if the
competitive model's predictions are correct.
c. Again, the government interferes with the freedom of management to

operate its firm -- thereby reducing economic freedom and increasing
costs of doing business.
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1. minimum wages in a monopsony
2. In a monopsony the wage increases with the establishment of a

minimum wage, but if the employer is rationale so too does the
employment level.
3. If the monopsony model is accurate then the conservative

argument does not hold water. Recent research results seem to
suggest the monopsony predictions are correct.
5. Unions have also be an effective response to monopsony:
a. craft union (exclusive union):
1. AFL Affiliated, organizes one skill class of employees (i.e., IBEW)
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2. Craft unions can control the supply of labor somewhat because of
the fact that they represent primarily skilled employees and have
control of the apprentice programs and the standards for
achieving journeyman status.
b. industrial union
1. CIO affiliate, organizes all skill classes within a firm (i.e., UAW)
2. The industrial union establishes the minimum acceptable wage,

below which they will strike rather than work. This approach
depends upon solidarity among the work force to make the threat
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of a strike effective.
c. There is a flaw in this analysis. Perfectly competitive labor markets are

used to illustrate the effects of two different types of unions. If labor
markets were competitive and there were not market imperfections unions
would likely not be an economic priority for workers. However, unions are
necessary in imperfectly competitive labor markets.
1. The pure craft and pure industrial union virtually no longer exist.
The AFL and CIO merged in the mid-1950s and the distinction
between the two types of unions had all but disappeared by this
time -- the exception is some of the building trades unions.
6. Bilateral Monopoly is where there is a monopsonist that is organized by a union

that attempts to offset the monopsony power with monopoly power.
a. The bilateral monopoly model is rather complex. The employer

(monopsonist) will equate MRC with demand and attempt to pay a wage
associated with that point on the supply curve. The monopolist (union) will
equate MRP' with supply and attempt extract a wage associated with that
point on the demand curve. The situation shown in this graph shows that
the competitive wage is just about halfway between what the union and
employer would impose. The wage and employment levels established in
this type of situation is a function of the relative bargaining power of the
employer and union, therefore this model is indeterminant.
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b. The indeterminant nature of this model is why industrial relations
developed as a separate field from economics (in large measure).
c. Industrial relations in the United States has been a function of the legal
environment as much as market forces.
7. Private sector labor history is a sorted affair, with distinct periods.
a. The first years (until 1932) the law in the U.S. was extremely anti-worker
and anti-union, Injunctions, anti-trust prosecution etc.
b. 1932-1935 was the Norris-LaGuardia Act and Railway Labor Act period,
and the government was neutral towards workers and unions.
c. 1935-47 Government was pro-union, pro-worker B the Wagner Act period.
d. 1947-1982 The Taft-Hartley Act period less pro-union, more balanced.
e. The post-PATCO; post-Requinst activitist court 1982 on, anti-union, anti-

worker B almost back to the pre-1932 period
8. Public Sector industrial relations more problematic.
a. Civil Service Reform Act of 1974 governs Federal Employees
1. Homeland Security Act contains negation of bargaining rights for

tens of thousands of Federal Employees
b. State employees covered by state statutes; most states have protective

legislation
1. States without protective legislation are typically southern and
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rather poor B Indiana has no protective legislation
9. Market Wage Differentials arise from several sources:
a. Geographic immobility
b. Discrimination
c. Differences in productivity
1. Ability
2. Difference in price of final product
10. Human Capital refers to the various aspects of a person that makes them
productive. Gary Becker=s book in the 1950s Human Capital earned him the
Nobel Prize, but also brought greater attention to skills and knowledge as a
determinant of income.
a. Abilities, personality, and other personal characteristics are a portion of

human capital -- many of these items are genetic, environmental, or a
matter of experience.
b. Education, training, and the acquisition of skills are human capital that is
either developed or obtained.
1. In general it is hard to separate the sources of human capital;

however, most is probably acquired.
2. In general, the higher the levels of human capital, the more

productive an employee.
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12. Epilogue to Principles of Economics
Lecture Notes
1. Changing World - Economically
a. Outsourcing B sending work out of the firm for cost cutting reasons B
generally to save labor costs.
1. Consumer incomes and production costs
2. Say=s Law B accounting identity B cost of product is factor

incomes
b. Economics and Ethics
1. Fas – ethics
2. Boni Mores - public opinion or morals
3. Lex - law
a. Law becomes dominate, but law is a constraint on the pursuit of

self-interest (same as ethics and morals)
b. Self-interest - rationality
c. Internationalization
1. Comparative advantage is the basis for trade among nations as

well as people.
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a. Natural resources
b. Technological innovation
c. Human capital
2. Language and cultural diversity important to individual and

societal success
a. The middle east and different value systems and perceptions
2. American interests and foreign policy
a. Anti-American perspectives abroad
b. Reliance on foreign sources of energy
c. Perception of imperialism versus American generosity
1. Peace Corps
2. Marshall Plan
3. Globalization and domestic changes
a. Increasingly the U.S. is a service economy
1. Goods producing comparative advantage being lost
2. Multi-national corporations
b. De-industrialization
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1. Lower incomes
2. More rapid changes
4. Parting words
a. Principles of microeconomics is a scientific framework for decision-

making.
1. Mother discipline of the business disciplines
a. Marketing, finance, production management
b. Useful in career, brings rational standards to decision-making.
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READING
ASSIGNMENTS
INTRODUCTION TO MICROECONOMICS
E201
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CHAPTER 1
Introduction to Economics
This is an introductory course in economics. As with most introductory courses

there are certain foundations that must be laid before the structure of the discipline may
be meaningfully examined. This chapter and the following two chapters will lay those
foundations -- the rudimentary definitions, and basic concepts upon which the following
ideas will be built are discussed. Further, there is a general discussion of the methods
used by economists in their analyses.
Specifically, this chapter will focus on specific definitions, policy, and objective
thinking. A discussion of the role of assumptions in model building will also be offered
as a basis for understanding the economic models that will be built in the following
chapters.
Definitions
Economics is a social science. In other words, it is a systematic examination of

human behavior, based on the scientific method, and reliant upon rigorous analysis of
that behavior. Economics is the mother discipline from which most of the business
disciplines arose. Most people have a vague idea of what the word economics means,
but precise definitions generally require some academic exposure to the subject.
Economics is the study of the ALLOCATION of SCARCE resources to meet

UNLIMITED human wants. In other words, economics is the study of human behavior
as it pertains to material well-being. The key words in this definition are in all capital
letters. Because there are a finite number of resources available, the fact that human
want exceed that (are unlimited) then the resources are scare relative to the want for
them. Because there are fewer resources than wants there must be allocation
mechanism of some sort – markets, government, law of the jungle, etc.
Robert Heilbroner describes economics as the "Worldly Philosophy." A "Worldly

Philosophy" is concerned with matters of how our material or worldly well-being is best
served. In fact, economics is the organized examination of how, why and for what
purposes people conduct their day-to-day activities, particularly as it relates to the
accumulation of wealth, earning an income, spending their resources, and other matters
concerning material well-being. This worldly philosophy has been used to explain most
rational human behavior. (Irrational behavior being the domain of specialties in
sociology, psychology, history, and anthropology.) Underlying all of economics is the
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base assumption that people act in their own perceived best interest (at least most of
the time and in the aggregate). Without the assumption of rational behavior,
economics would be incapable of explaining the preponderance of observed economic
activity. As limiting as this assumption may seem, it appears to be an accurate
description of reality.
In 1776 Adam Smith penned An Inquiry into the Nature and Causes of the
Wealth of Nations. With its publication, capitalism was born, from the ashes of the
mercantilist system that preceded it. Smith described an economic system of cottage
industries and relatively unfettered pursuit of self-interest, and how that unfettered
pursuit of self-interest could result in a system that distributed its limited resources in an
efficient fashion.
Adam Smith’s view of self-interest and exchange
An Inquiry in the Nature and Cause of the Wealth of Nations, Adam Smith, New York:
Knopf Publishing, 1910, p. 14.
. . . In almost every other race of animals each individual, when it is grown to

maturity, is entirely independent, and in its natural state has occasion for the
assistance of no other living creature. But man has almost constant occasion for the
help of his brethren, and it is in vain for him to expect it from their benevolence only.
He will be more likely to prevail if he can interest their self-love in his favour, and
show then that it is for their own advantage to do for him what he requires of them.
Whoever offer to another a bargain of any kind, proposes to do this. Give which I
want, and you shall have this, which you want, is the meaning of every such offer;
and it is in this manner that we obtain from one another the far greater part of those
good office which we stand in need of. It is not from the benevolence of the butcher,
the brewer, or the baker that we expect our dinner, but from their regard to their own
interest. We address ourselves, not to their humanity but to their self-love, and never
talk to them of our necessities but of their advantages. . . .
Adam Smith, Wealth of Nations. New York: Alfred A. Knopf, 1991, p. 13.
Experimental economics, using rats in mazes, suggests that rats will act in their
own best interest (incidentally, Kahneman won a Noble Prize for this sort of research –
it is serious business, not just fun and games like it sounds). Rats, it was discovered,
prefer root beer to water. The result is that rats will pay a greater price (longer mazes
and electric shocks) to obtain root beer than they will to obtain water. Therefore it
appears to be a reasonable assumption that humans are no less rational – as Adam
Smith postulates in his view of how we might best obtain our dinner.
Most academic disciplines have evolved over the years to become collections of
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closely associated scholarly endeavors of a specialized nature. Economics is no
exception. An examination of one of the scholarly journals published by the American
Economics Association, The Journal of Economic Literature, reveals a classification
scheme for the professional literature in economics. Several dozen specialties are
identified in that classification scheme, everything from national income accounting, to
labor economics, to international economics. In other words, the realm of economics
has expanded over the centuries that it is nearly impossible for anyone to be an expert
in all aspects of the discipline, so each economist generally specializes in some narrow
portion of the discipline. The decline of the generalist is a function of the explosion of
knowledge in most disciplines.
In general, economics is bifurcated by the focus of the analysis – that is, there
are two bundles of issues that are examined by economists. These bundles of issues
are considered together, by the level of the activity upon which the analysis is focused.
Economics is generally classified into two general categories of inquiry, these two
categories are: (1) microeconomics and (2) macroeconomics.
Microeconomics is concerned with decision-making by individual

economic agents such as firms and consumers. In other words, microeconomics is
concerned with the behavior of individuals or groups organized into firms, industries,
unions, and other identifiable agents. The focus of microeconomics is on decision-
making, and hence markets. Microeconomics is the subject matter of this course
(E201).
Macroeconomics is concerned with the aggregate performance of the

entire economic system. That is, the performance of the U.S. economy or, in a more
modern sense, the global economy. The issues of unemployment, inflation, economic
development and growth, the balance of trade, and business cycles are the topics that
occupy most of the attention of students of macroeconomics. These matters are the
topics to be examined the course that follows this one (E202).
Methods in Economics
Economists seek to understand the behavior of people and economic systems

using scientific methods. These scientific endeavors can be classified into two
categories of activities, these are: (1) economic theory and (2) empirical economics.
Theoretical and empirical economics are very much related activities, even though
distinguished here for simplicity of presentation.
Economic theory relies upon principles to analyze behavior of economic

agents. These theories are typically rigorous, mathematical representations of human
behavior with respect to the production or distribution of goods and services in
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microeconomics – and the aggregate economy in macroeconomics. A good theory is
one that accurately predicts future human behavior and can be supported with
evidence.
Nobel Prize Winners in Economic Science
1969 J. Tinbergen (Netherlands); R. Frisch (Norway)

1970 P.A. Samuelson (USA - Indiana)
1971 S. Kuznets (USA, Soviet Union)
1972 J. R. Hicks (United Kingdom); K. J. Arrow (USA)
1973 W. Leontief (USA)
1974 F. A. Hayek (Austria, USA); K. G. Myrdal (Sweden)
1975 T. Koopmans (USA); L. Kantorovich (Soviet Union)
1976 M. Friedman (USA)
1977 B. Ohlin (Sweden); J. Meade (United Kingdom)
1978 H. A. Simon (USA)
1979 T. W. Schultz (USA); A. Lewis (United Kingdom)
1980 L. R. Klein (USA)
1981 J. Tobin (USA)
1982 G. J. Stigler (USA)
1983 G. Debreu (USA)
1984 R. Stone (United Kingdom)
1985 F. Modigliani (Italy, USA)
1986 J. Buchanan (USA)
1987 R. M. Solow (USA)
1988 M. Allais (France)
1989 T. Haavelmo (Norway)
1990 H. Markowitz (USA); M. Miller (USA); W. Sharpe (USA
1991 R. H. Coase (United Kingdom, USA)
1992 G. S. Becker (USA)
1993 R. W. Fogel (USA); D. C. North (USA)
1994 R. Selten (Germany); J. C. Harsanyi (USA); J. F. Nash (USA)
1995 R. E. Lucas (USA)
1996 J. A. Mirrlees (United Kingdom); William Vickery (Canada, USA)
1997 R. C. Merton (USA); M. S. Scholes (USA)
1998 A. Sen (India, United Kingdom)
1999 R. A. Mundell (USA)
2000 J. J. Heckman (USA); D. L. McFadden (USA)
2001 G. A. Akerlof (USA); A. M. Spence (USA); J. E. Stiglitz (USA - Indiana)
2002 D. Kahneman (USA, Isreal); V. L. Smith (USA)
Economic theory tends to be a very abstract area of the discipline. Mathematical

modeling was introduced into the discipline early in the eighteenth century by such
scholars as Mill and Ricardo. In the middle of the twentieth century, an economist, Paul
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Samuelson, from M.I.T., published his book, Mathematical Foundations of Economic
Analysis, and from the that point forward, economic theory was to become heavily
mathematical – gone were the days of the institutionalists from the mainstream of
economic theory. (Incidentally Paul Samuelson won the Nobel Prize for Foundations,
and he is a Hoosier, Stiglitz is also from Indiana, and both are from Gary, Indiana).
The above table presents a list of those who have won Nobel Prizes in Economic
Science. Notice that the overwhelming majority of these persons are Americans – two
of whom are from Indiana, and several are from the University of Chicago. It is also
interesting to note that one must be living to receive the Nobel Prize; so many famous
economists who met their end before receiving the prize will not be listed. Further, it is
also interesting to note that the Nobel Prize in Economic Sciences is the newest of the
prizes, beginning with Tinbergen’s award in 1969.
Empirical economics relies upon facts to present a description of

economic activity. Empirical economics is used to test and refine theoretical
economics, based on tests of economic theory.
The area referred to as econometrics is the arena in economics in which

empirical tests of economic theory occurs. The area is founded in mathematical
statistics and is critical to our ability to test the veracity of economic theories.
Theory concerning human behavior is generally constructed using one of two

forms of logic – inductive logic or deductive logic. Most of the social studies, i.e.,
sociology, psychology and anthropology typically rely on inductive logic to create theory.
Inductive logic creates principles from observation. In other words, the

scientist will observe evidence and attempt to create a principle or a theory based on
any consistencies that may be observed in the evidence.
Economics relies primarily on deductive logic to create theory. Deductive logic

involves formulating and testing hypotheses. In other words, the theory is created,
and then data is applied in a statistical test to see if the theory can be rejected.
Often the theory that will be tested comes form inductive logic or sometimes
informed guess-work. The development of rigorous models expressed as equations
typically lend themselves to rigorous statistical methods to determine whether the
models are consistent with evidence from reality. The tests of hypotheses can only
serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused
on rejecting hypotheses and those that fail to be rejected over large numbers of tests
generally attain the status of principle.
However, examples of both types of logic can be found in each of the social
sciences and in most of the business disciplines. In each of the social sciences it is
common to find that the basic theory is developed using inductive logic. With increasing
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regularity standard statistical methods are being employed across all of the social
sciences and business disciplines to test the validity and the predictability of theories
developed using these logical constructs.
The usefulness of economics depends on how accurate economic theory

predicts human behavior. In other words, a good theory is one that is an accurate
description of reality. Economics provides an objective mode of analysis, with rigorous
models that permit the discounting of the substantial bias that is usually present with
discussions of economic issues. The internal consistency brought to economic theory
by mathematical models of economic behavior provides for this consistency. However,
no model is any better than the assumptions that underpin that model. If the
assumptions are unrealistic, so too will be the models' predictions.
The objective mode of analysis is an attempt to make a social study more

scientific. That is, a systematic analysis of rational human behavior. “Rational” is a
necessary component of this attempt. It is the rationality that makes behavior
predictable, and what most economists don’t like to admit is without this underlying
premise, economics quickly falls into a quagmire of irreproducible results and disjointed
theories.
The purpose of economic theory is to describe behavior, but behavior is

described using models. Models are abstractions from reality - the best model is the
one that best describes reality and is the simplest (the simplest requirement is called
Occam's Razor). Economic models of human behavior are built upon assumptions; or
simplifications that allow rigorous analysis of real world events, without irrelevant
complications. Often (as will be pointed-out in this course) the assumptions underlying
a model are not accurate descriptions of reality. When the model's assumptions are
inaccurate then the model will provide results that are consistently wrong (known as
bias).
One assumption frequently used in economics is ceteris paribus which means

all other things equal (notice that economists, like lawyers and doctors will use Latin for
simple ideas). This assumption is used to eliminate all sources of variation in the model
except those sources under examination (not very realistic!).
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Economic Goals, Policy, and Reality
Most people and organizations do, at least, rudimentary planning, the purpose of
planning is the establishment of an organized effort to accomplish some economic
goals. Planning to finish your education is an economic goal. Goals are, in a sense, an
idea of what should be (what we would like to accomplish). However, goals must be
realistic and within our means to accomplish, if they are to be effective guides to action.
This brings another classification scheme to bear on economic thought. Economics
can be again classified into positive and normative economics. Positive economics is
concerned with what is; and normative economics is concerned with what should
be. Economic goals are examples of normative economics. Evidence concerning
economic performance or achievement of goals falls within the domain of positive
economics.
The normative versus positive economics arguments begs the question of

whether economics is truly a value free science. In fact, economics contains numerous
value judgments. Rational behavior assumes that people will always behave in their
own self-interest. Self-interest is therefore presented as a positive element of behavior.
In fact, it is a value judgment. Self-interest is probably descriptive of the majority of
Americans’ behaviors over the majority of time, however, each of us can think of
instances where self-less behavior is observed, and is frequently encouraged.
Efficiency is a measurable concept, and is taken as a desirable outcome.

However, efficiency is not always desirable. Equity or fairness is also something prized
by most people. The efficiency criterion in economics is not always consistent with
equity; in fact, these two ideas are often in conflict.
Economics also generally assumes that more is preferred to less by all

consumers and firms. However, there are disposal problems, distributional effects, and
other problems where more may not be such a good thing. Obesity is a result of more,
but a bad result. Pollution, poverty, and crime may also be examined as more begetting
problems.
Most nations have established broad social goals that involve economic issues.
The types of goals a society adopts depends very much on the stage of economic
development, system of government, and societal norms. Most societies will adopt one
or more of the following goals:
(1) economic efficiency,
(2) economic growth,
(3) economic freedom,
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(4) economic security,
(5) an equitable distribution of income,
(6) full employment,
(7) price level stability, and
(8) a reasonable balance of trade.
Each goal (listed above) has obvious merit. However, goals are little more than
value statements in this broad context. For example, it is easy for the very wealthy to
cite as their primary goal, economic freedom, but it is doubtful that anybody living in
poverty is going to get very excited about economic freedom; but equitable distributions
of income, full employment and economic security will probably find rather wide support
among the poor. Notice, if you will, goals will also differ within a society, based on
socio-political views of the individuals that comprise that society.
Economics can hardly be separated from politics because the establishment of

national goals occurs through the political arena. Government policies, regulations, law,
and public opinion will all effect goals and how goals are interpreted and whether they
have been achieved. A word of warning, eCONomics can be, and has often been used,
to further particular political agendas.
The assumptions underlying a model used to analyze a particular set of

circumstances will often reflect the political agenda of the economist doing the analysis.
An example liberals are fond of is, Ronald Reagan argued that government deficits
were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes --
thereby spurring economic growth, therefore more income that could be taxed at a
lower rate and yet produce more revenue. Mr. Reagan is often accused, by his
detractors, of having a specific political agenda that was well-hidden in this analysis.
His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to
make his tax cuts for rich acceptable to most of the voters. (Who really knows?)
Conservatives are fonder of criticizing the Clinton administration’s assertions that the
way to reduce the deficit was to spend money where it was likely to be respent, and
hence grow the economy and the result was more tax revenues, hence eliminate the
deficit. Most political commentators, both left and right, have mastered the use of
assumptions and high sounding goals to advance a specific agenda. This adds to the
lack of objectivity that seems to increasingly dominate discourse on economic problems.
On the other hand, goals can be public spirited and accomplish a substantial
amount of good. President Lincoln was convinced that the working classes should have
access to higher education. The Morrell Act was passed 1861 and created Land Grant
institutions for educating the working masses (Purdue, Michigan State, Iowa State, and
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Kansas State (the first land grant school) are all examples of these types of schools).
By educating the working class, it was believed that several economic goals could be
achieved, including growth, a more equitable distribution of income, economic security
and freedom. In other words, economic goals that are complementary are consistent
and can often be accomplished together. Therefore, conflict need not be the
centerpiece of establishing economic goals.
Because any society's resources are limited there must be decisions about which
goals should be most actively pursued. The process by which such decisions are made
is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to
the least important. Prioritizing of goals also involve value judgments, concerning which
goals are the most important. In the public policy arena prioritizing of economic goals is
the subject of politics.
Policy
Policy can be generally classified into two categories, public and private policy.
The formulation of public and private policy is the creation of guidelines, regulations, or
law designed to effect the accomplishment of specific economic (or other) goals.
Public policy is how economic goals are pursued. Therefore, to understand goals one
needs to understand something of the process of formulating policy.
Business students will have an in depth treatment of policy making in

Administrative Policy (J401) and the School of Public and Environmental Affairs requires
a similar course in some of its degree programs. For students in other programs the
brief treatment here will suffice for present purposes.
The steps in formulating policy are:
1. stating goals - must be measurable with specific stated objective to be

accomplished.
2. options - identify the various actions that will accomplish the stated
goals & select one, and
3. evaluation - gather and analyze evidence to determine whether policy

was effective in accomplishing goal, if not reexamine options and
select option most likely to be effective.
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Both the public and private policy formulation process is a dynamic one.
Economic goals change with public opinion and with achievement. Step 1 involves the
value statement of setting goals. Step 2 involves selecting the appropriate model and
the options associated with that model to accomplish the specified goal. The final step
involves gathering evidence and the appropriate analysis to determine whether the
policy needs revision. The process of formulating policy is therefore a loop, and
requires continuous monitoring and revising.
The major difference between public policy and private policy is that private
policy is not subject to democratic processes. The Board of Directors or management
of a company will decide what goals are to be accomplished and what policy options are
best used to do so. Often private policy is made behind closed-doors without public
accountability, even though there are often public costs imposed. The strength of public
policy is created in the open, with public debate, and often has the force of law (and not
just company rules and regulations).
Objective Thinking
Most people bring many misconceptions and biases to economics. After all,
economics deals with people's material well-being – a very serious matter to most.
Because of political beliefs and other value system components rational, objective
thinking concerning various economic issues fail. Rational and objective thought
requires approaching a subject with an open-mind and a willingness to accept what ever
answer the evidence suggests is correct. In turn, such objectivity requires the shedding
of the most basic preconceptions and biases -- not an easy assignment.
What conclusions an individual draws from an objective analysis using economic

principles, are not necessarily cast in stone. The appropriate decision based on
economic principles may be inconsistent with other values. The respective evaluation
of the economic and "other values" (i.e., ethics) may result in a conflict. If an
inconsistency between economics and ethics is discovered in a particular application, a
rational person will normally select the option that is the least costly (i.e., the majority
view their integrity as priceless). An individual with a low value for ethics or morals may
find that a criminal act, such as theft, as involving minimal costs. In other words,
economics does not provide all of the answers; it provides only those answers capable
of being analyzed within the framework of the discipline.
There are several common pitfalls to objective thinking in economics. Among the
most common of these pitfalls, which affect economic thought, are: (1) the fallacy of
composition, and (2) post hoc, ergo prompter hoc. Each of these will be reviewed, in
turn in the following paragraphs.
The fallacy of composition is the mistaken belief that what is true for the
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individual must be true for the group. An individual or small group of individuals may
exhibit behavior that is not common to an entire population. For example, if one
individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an
obvious fallacy of composition. Statistical inference can be drawn from a sample of
individuals, but only within confidence intervals that provide information concerning the
likelihood of making an erroneous conclusion (E270, Introduction to Statistics provides a
more in depth discussion of confidence intervals and inference).
Post hoc, ergo prompter hoc means after this, hence because of this, and
is a fallacy in reasoning. Simply because one event follows another does not
necessarily imply there is a causal relation. One event can follow another and be
completely unrelated, this is simple coincidence. One event can follow another, but
there may be something other than direct causal relation that accounts for the timing of
the two events. For example, during the thirteenth century people noticed that the black
plague occurred in a location when the population of cats increased. Unfortunately,
some concluded that the plague was caused by cats so they killed the cats. In fact, the
plague was carried by fleas on rats. When the rat population increased, cats were
attracted to the area because of the food supply. The rat populations increased, and so
did the population of fleas that carried the disease. This increase in the rat population
also happened to attract cats, but cats did not cause the plague, if left alone they may
have gotten rid of the real carriers (the rats, therefore the fleas).
Perhaps it is interesting to note that in any scientific endeavor there is a basic

truth. Simple answers to complex problems are appealing, abundant, and often
wrong. This twist on Occam’s razor is true. Too often the desire to have a simple
solution will blind individuals, and public opinion to the more complex and often more
harsh realities. One must take great care to assure that this simple trap does not befall
one in their search for truth, because not all truth is simple.
Policy is fraught with danger. Failure to anticipated the consequences of certain

aspects of policy may cause results that were neither intended nor anticipated by the
policy-makers; this is referred to as the law of unintended consequences.
The following box presents an excellent historical example of the law of

unintended consequences.
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Law of Unitended Consequences “The Legend of Pig Iron”
(David A. Dilts, Indiana Policy Review, Vol. 1, No. 5, pp. 28-29.)
Many a cliché seems to center on pork. The head of the household is
supposed to " put bacon on the table," "pork barrels," and politicians are frequently
accused of being in too close a proximity. It only seems fitting that one more story
concerning pork should be brought to your attention.
During World War II, farmers in the corn belt argued that regulation of the
price of pork had no effect on the war effort, and that they should be permitted to sell
their commodities without government interference. The farmers brought political
pressure to bear on the Congress and our representatives to deregulate the price of
pork. The end result was to shut down the steel mills in Gary.
Shut down our steel mills? How could this be?
Since it is not intuitively obvious how this happened, I'll explain. In 1942, there
had been a change in management in the Philippines. And, as luck would have it, we
didn't have good trade relations with the new management -- the Japanese.
Therefore we did not have access to Manila fibre, necessary in making everything
from rope to battleships. We had not yet developed synthetic fibre and therefore has
to rely on the fibre previously available. That fibre was hemp.
Now hemp grows in the same places, under the same climatic conditions as
does corn. Corn is what hogs eat. And because corn was not being grown in the
Midwest, the farmers sought alternative feed for the increased number of hogs they
were raising. (Remember, increased price results in a larger quantity supplied.)
Oats, wheat and barley were available from the Great Plains region. The problem
was shipping it to where the hogs were raised in the Corn Belt of the Lower Midwest.
In their search for transportation, the farmers found that railroads were
regulated and reserved for military and heavy industry; trucks needed gasoline and
rubber, both in short-supply; and airplanes were being built almost exclusively for
military purposes.
This left the farmers without a ready source of domestic transportation for the
needed grain. But they eventually found a source of shipping that was neither
regulated nor controlled, because it was international in nature -- the iron-ore barges
on the Great Lakes.
They bid up the price and the barges started hauling oats to the pigs and
stopped hauling ore to the Gary steel mills. And there you have it:
Without the requisite iron ore the steel mills could not produce; they were
actually shut down for a period as a direct result of deregulating the price of pork.
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Statistical Methods in Economics
The use of statistical methods in empirical economics can result in errors in

inference. Most of the statistical methods used in econometrics (statistical examination
of economic data) rely on correlation. Correlation is the statistical association of
two or more variables. This statistical association means that the two variables move
predictably with or against each other. To infer that there is a causal relation between
two variables that are correlated is an error. For example, a graduate student once
found that Pete Rose's batting average was highly correlated with movement in GNP
during several baseball seasons. This spurious correlation cannot reasonably be
considered path-breaking economic research.
On the other hand, we can test for causation (where one variable actually causes
another). Granger causality states that the thing that causes another must occur
first, that the explainer must add to the correlation, and must be sensible. As with
most statistical methods Granger causality models permit testing for the purpose of
rejecting that a causal relation does not exist, it cannot be used to prove causality
exists. These types of statistical methods are rather sophisticated and are generally
examined in upper division or graduate courses in statistics.
As is true with economics, statistics are simply a tool for analyzing evidence.
Statistical models are also based on assumptions, and too often, statistical methods are
used for purposes for which they were not intended. Caution is required in accepting
statistical evidence. One must be satisfied that the data is properly gathered, and
appropriate methods were applied before accepting statistical evidence. Statistics do
not lie, but sometimes statisticians do!
Objectivity and Rationality
Objective thinking in economics also includes rational behavior. The underlying

assumptions with each of the concepts examined in this course assumes that people
will act in their perceived best interest. Acting in one's best interests is how rationality is
defined. The only way this can be done, logically and rigorously, is with the use of
marginal analysis. This economic perspective involves weighing the costs against the
benefits of each additional action. In other words, if benefits of an additional action will
be greater than the costs, it is rational to do that thing, otherwise it is not. Too often
people permit the costs already paid to influence their decision-making, and hence they
are lead astray by not focusing on the margin.
The problem with rationality is perception. Often what people believe is in their
own self-interest may not be. (Remember the Pig Iron example). Education and the
gathering of information helps to make perceptions more accurate views of reality. In
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other words, the more we can eliminate our biases and faulty perceptions, the more
likely we are to act in our own interest. However, there are costs associated with
information gathering and with education, therefore rationality may be costly.
KEY CONCEPTS
Economics
Microeconomics
Macroeconomics
Economic Theory v. Empirical Economics
Inductive v. Deductive Logic
Usefulness of Economics
Occam’s Razor
Rationality
Assumptions in Economics
Ceteris Paribus
Simplification for rigor’s sake
Positive v. Normative Economics
Economic Goals
Policy Formulation
Objective Thinking
Fallacy of Composition
Post hoc, ergo propter hoc fallacy
Causation v. Correlation
Granger Causality Tests
Cost-Benefit Perspective
85
STUDY GUIDE
Food for Thought:
Most people have their own opinions about things. How might opinions be of
value? Explain.
Compare and contrast deductive logic with inductive logic.
What evidence can statistical analysis provide? Critically evaluate this evidence
and explain the role of empirical economics in developing economic theory.
Sample Questions:
Multiple Choice:
Which of the following is not an economic goal?
A. Price Stability
B. Full Employment
C. Economic Security
D. All of the above are economic goals
If we provide school lunches for children from households with incomes below the
poverty level, and finance the school lunch program with an increase in taxes on
incomes in excess of $100,000, these actions are likely to:
A. Promote stability but reduce growth

B. Promote equality but reduce freedom
C. Promote efficiency but reduce equality
D. Promote efficiency but reduce security
True/ False:
Non-economists are no less or more likely to be biased about economics than they are
about physics or chemistry. {FALSE}
Assumptions are used to simplify the real world so that it may be rigorously analyzed.
{TRUE}
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CHAPTER 2
Economic Problems
The purpose of this chapter is to introduce you to several basic economic

principles that will be useful in understanding the costs, markets, and the materials to
follow in subsequent chapters. This chapter will examine scarcity, factors of production,
economic efficiency, opportunity costs, and economic systems. In this chapter the first
economic model will also be developed, the production possibilities frontier (or curve).
The Economizing Problem
Economics is concerned with decision-making. An economic decision is one that

allocates resources, time, money, or something else of use or value. The fundamental
question in economics is called the economizing problem. The economizing problem
follows directly from the definition of economics offered in Chapter 1. The economizing
problem involves the allocation of resources among competing wants. The
economizing problem exists because there is scarcity. Scarcity arises because of two
facts; (1) there are unlimited human wants, but (2) there are limited resources available
to meet those wants. In other words, scarcity exists because we do not have sufficient
resources to produce everything we want. Perhaps at some date in the future, a
utopian world may be obtained where everyone's desires can be fully satisfied -- most
economists probably hope that will not happen in their lifetimes because of their own
self-interest.
Economists do not differentiate between wants and needs in examining scarcity.

Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the
need of a starving child for food in the aggregate. However, in a realistic sense, social
welfare and the implications of needs versus wants are partially addressed later in this
chapter in the discussions offered for allocative efficiency and economic systems.
The concept of scarcity is embedded in virtually every analysis found in

economics. Because there is scarcity there is always the question of how resources are
allocated and the effects of allocations on various economic agents. Each decision
allocating resources to one use or economic agent is also, by necessity, a decision not
to allocate resources to an alternative use.
To fully understand the idea of scarcity, each of its components must be

mastered. The following section of this chapter examines resources. The next sections
will examine economic efficiency, opportunity costs and allocations, before proceeding
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to the production possibilities model and economic systems.
Productivity is the key
Head to Head (Lester Thurow, New York: William Morrow and Company, Inc., 1992,
p. 273.)
If the "British disease" is adversarial labor-management relations, the

"American disease" is the belief that low wages solve all problems. When under
competitive pressure, American firms first go the low-wage nonunion parts of
America and then on to succession of countries with ever-lower wages. But the
strategy seldom works. For a brief time lower wages lead to higher profits, but
eventually other with even lower wages enter the business (low wages are easy to
copy), prices fall, and the higher profits generated by lower wages vanish.
The search for the holy grail of high profitability lies elsewhere -- in a relentless
upscale drive in technology to ever-higher levels of productivity -- and wages. Since
rapid productivity growth is a moving target and therefore hard to copy, high long-run
profits can be sustained. But to get the necessary human talent to employ new
technologies, large skill investments have to be made. High wages have to be paid,
but paradoxically high wages also leave firms with no choice but to go upscale in
technology. High wages and high profits are not antithetical -- they go together.
Resources and factor payments
The resources used to produce economic goods and services (also called
commodities) are called factors of production. These resources are the physical
assets needed to produce commodities. The way that these resources are combined to
produce is called technology. For example, a man with a shovel digging a ditch is one
technology from which ditches can be obtained. Another technology that can produce
the same commodity as a man with a shovel is a backhoe and an operator -- the
former is more labor intensive, and the latter is more capital intensive.
Land is a factor of production. Land includes space, natural resources, and

what is commonly thought of as land. A building lot, farm land, or a parking space is
what people normally think of when they think of land. However, iron ore, water
resources, oil, and other natural resources obtained from land are also one dimension
of this factor of production. Another, perhaps equally important dimension, is space.
The location of a building site for a business is an important consideration. For
example, a retail establishment may succeed or fail because of location, therefore
location is another important aspect of the resource called land. The factor payment
that accrues to land for producing is rent.
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Capital includes the physical assets (i.e., plant and equipment) used in the
production of commodities. Often accountants refer to capital as money balances
that are earmarked for the purchase of plant or equipment. The accounting view of
capital is not the physical asset envisioned by economists (in reality the difference is
one of a future claim (the accountant's view) and a present stock of capital (the
economist's view) and is not trivial). Capital receives interest for its contributions to
production.
There is one important variation on capital. Economists also called the skills,
abilities, and knowledge of human beings as human capital. Human capital is a
characteristic of labor. Human capital can be acquired (i.e., education) or may be
something inherent in a specific individual (i.e., size, beauty, etc.). This subject will be
examined in more depth in Chapters 10 and 11.
Labor includes the broad range of services (and their characteristics)

exerted in the production process. Labor is a rather unique factor of production
because it cannot be separated from the human being who provides it. Human beings
also play other roles in the economic system, such as consumer that complicates the
analysis of labor as a productive factor. The amount of human capital possessed by
labor varies widely from the totally unskilled to highly trained professionals and highly
skilled journeymen. Labor also includes hired management, and the lowest paid janitor.
Labor is paid wages for its contribution to the production of commodities.
Entrepreneur (risk taker) is the economic agent who creates the enterprise.
Entrepreneurial talent not only assumes the risk of starting a business, but is generally
responsible for innovations in products and production processes. The vibrancy of the
U.S. economy is, in large measure, due to a wealth of entrepreneurial talent. This
factor of production receives profits for its contribution to output.
To obtain the maximum amount of output from the available productive resources
an economic system should have full employment. Full employment is the utilization
of all resources that is consistent with normal job search and maintenance of
productive capacity. Full employment includes the natural rate of unemployment,
which economists estimate to be between four and six percent (unemployment due to
job search and normal structural changes in the economy). Empirical evidence
suggests that about 80% capacity utilization is consistent with the natural rate of
unemployment. When the economy is operating at rates consistent with the natural rate
of unemployment it is producing the potential total output. However, full production,
100% capacity utilization involves greater than full employment and cannot be
maintained for a prolonged period without labor and capital breaking-down.
Underemployment has been a persistent problem in most developed economies.
Underemployment results from the utilization of a resource that is less than what is
consistent with full employment. There are two ways that underemployment manifests
itself. First, individuals can be employed full time, but not making use of the human
89
capital they possess. For example, in many European countries it is not uncommon for
an M.D. to be employed as a practical nurse. The second way that underemployment is
typically observed is when someone is involuntarily a part-time employee rather than
employed full-time in an appropriate position.
Economic Efficiency
Economic efficiency consists of three components; these are: (1) allocative

efficiency, (2) technical or productive efficiency, and (3) full employment. For an
economy to be economically efficient all three conditions must be fulfilled.
Allocative efficiency is concerned with how resources are allocated. In a

perfectly competitive economy, without institutional impediments, monopoly power, or
cartels the markets will allocate resources in an allocatively efficient manner. Allocative
efficiency is measured using a concept known as Pareto Optimality (or Superiority in an
imperfect world).
Pareto Optimality is that allocation where no person could be made better-

off without inflicting harm on another. A Pareto Optimal allocation of resources can
exist, theoretically, only in the case of a purely competitive economy (which has never
existed in reality). What is of practical significance is a Pareto Superior allocation of
resources. A Pareto Superior allocation is that allocation where the benefit received by
one person is more than the harm inflicted on another. [cost - benefit approach]
Technical or productive efficiency is a somewhat easier concept. Technical

efficiency is defined as the minimization of cost for a given level of output or
(alternatively) for a given level of cost you maximize output. In other words, for an
economic system to be efficient, each firm in each industry must be technically efficient.
Again, a technically efficient operation is difficult to find in the real world. However,
most profit-maximizing firms (as well as government agencies and non-profit
organizations) will at least have technical efficiency as one of its operational goals.
For an economic system to be economically efficient then full employment is also

required. Due primarily to the business cycles, no economic system can consistently
achieve full employment. The U.S. economy typically has one (during recoveries) to
four percent (during recessions) unemployment above that associated with the natural
rate of unemployment. We will return to this topic in the discussions of market
structures in Chapters 8 and 9.
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Allocative Efficiency
The Economics of Welfare, fourth edition (A. C. Pigou, London: Macmillan Publishing
Company, 1932, p. 89.)
. . . Any transference of income from a relatively rich man to a relatively poor man
of similar temperament, since it enables more intense wants to be satisfied at the
expense of less intense wants must increase the aggregate sum of satisfaction. The
old "law of diminishing utility" thus leads securely to the proposition: Any cause which
increases the absolute share of real income in the hands of the poor, provided that it
does not lead to a contraction in the size of the national dividend from any point of
view, will, in general, increase economic welfare.
Pigou states the basic proposition of Pareto Superiority in the real world; an
application of income re-distribution. The “transference of income from a relatively rich
man to a relatively poor man of similar temperament” making one less poor, and the
other less rich, results in an application of the principle of diminishing marginal utility
and, hence, allocative efficiency. In other words, the cost-benefit approach on the
margin. We take the last dollar from those with less value for that dollar and add that to
those more desperate for an additional dollar of income. Not only is this allocatively
efficient, but there are those who would argue that this is also fair.
Economic Cost
Economic cost consists of two distinct types of costs: (1) explicit (accounting)
costs, and (2) opportunity (implicit) costs. Explicit costs are direct expenditures in the
production process. These are the items of cost with which accountants are concerned.
An opportunity cost is the next best alternative that must be foregone as a result
of a particular decision. Rather than a direct expenditure, an opportunity cost is the
implicit loss of an alternative because of a decision. For example, reading this chapter
is costly, you have implicitly decided not to watch T.V. or spend time doing something
else by deciding to read this chapter. Every choice is costly; that is, there is an
opportunity cost. Economic costs are dealt with in greater detail in Chapter 7.
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Production Possibilities
The production possibilities frontier (or curve) is a simple model that can be used
to illustrate what a very simple economic system can produce under some restrictive
assumptions. The production possibilities model is used to illustrate the concepts of
opportunity cost, productive factors and their scarcity, economic efficiency
(unemployment etc.) and the economic choices an economy must make with respect to
what will be produced.
There are four assumptions necessary to represent the production possibilities in

a simple economic system. The assumption which underpin the production possibilities
curve model are: (1) the economy is economically efficient, (2) there are a fixed number
of productive resources, (3) the technology available to this economy is fixed, and (4) in
this economy we are going to produce only two commodities. With these four
assumption we can represent all the combinations of two commodities that can be
produced given the technology and resources available are efficiently used.
Consider the following diagram:
Beer
Pizza
Along the vertical axis we measure the number of units of beer we can produce
and along the horizontal axis we measure the number of units of pizza we can produce.
Where the solid line intersects the beer axis shows the amount of beer we can produce
92
if all of our resources are allocated to beer production. Where the solid line intersects
the pizza axis indicates the amount of pizza we can produce if all of our resources are
allocated to pizza production. Along the solid line between the beer axis and the pizza
axis are the intermediate solutions where we have both beer and pizza being produced.
The reason the line is curved, rather than straight, is that the resources used to
produce beer are not perfectly useful in producing pizza and vice versa. The dashed
line represents a second production possibilities curve that is possible with additional
resources or an advancement in available technology.
Increasing Opportunity Costs is illustrated in the above production possibilities

curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have
to give up large amounts of beer (downward move along beer axis). In other words, the
slope of the production possibilities curve is the marginal opportunity cost of the
production of one additional unit of one commodity, in terms of the other commodity.
Inefficiency, unemployment, and underemployment are illustrated by a point

inside the production possibilities curve, as shown above. A point consistent with
inefficiency, unemployment, or underemployment is identified by the symbol to
the inside of the curve.
Economic growth can also be illustrated with a production possibilities curve.

The dashed line in the above model shows a shift to the right of the curve. The only
way this can happen is for there to be more resources or better technology and this is
called economic growth. It is also possible that the curve could shift to the left (back
toward the origin -- the intersection of the beer axis with the pizza axis), this could result
from being forced to use less efficient technology (pollution controls) or the loss of
resources (racism or sexism).
Economic Systems
Production and the allocation of resources occur within economic systems.

Economic systems rarely exist in a pure form and the pure forms are assumed simply
for ease of illustration. The following classification of systems is based on the dominant
characteristics of those systems.
Pure capitalism is characterized by private ownership of productive capacity, very

limited government, and motivated by self-interest. Laissez faire means that
government keeps their hands-off and markets perform the allocative functions within
the economy. This type of system has the benefit of producing allocative efficiency if
there is no monopoly power, but this type of system tends towards heavy market
concentration left unregulated. There are substantial costs associated with pure
capitalism. These costs include significant loses of freedom, poverty, income inequity
93
and several social ills associated with the lack of protections afforded by stronger
government. What is perhaps the saving grace, is that pure capitalism does not exist in
the course of economic history. Pure capitalism exists only in the tortured minds of
economists, and pages of the Wealth of Nations.
In the following box, Thorstein Veblen discusses his view of capitalism and the
“struggle” associated with the pursuit of self-interest in a system marked with private
interests.
The Struggle
The Theory of the Leisure Class, Thorstein Veblen, New York: Penguin Books, 1899,
pp. 24-25.
Wherever the institution of private property is found, even in a slightly developed

form, the economic process bears the character of a struggle between men for the
possession of goods. It has been customary in economic theory, and especially
among those economists who adhere with least faltering to the body of modernised
classical doctrines, to construe this struggle for wealth as being substantially a
struggle for subsistence. Such is, no doubt, its character in large part during the
earlier and less efficient phases of industry. Such is also its character in all cases
where the “niggardliness of nature” is so strict as to afford but a scanty livelihood to
the community in return for strenuous and unremitting application to the business of
getting the means of subsistence. But in all progressing communities an advance is
presently made beyond this early stage of technological development. Industrial
efficiency is presently carried to such a pitch as to afford something appreciably more
than a bare livelihood to those engaged in the industrial process. It has not been
unusual for economic theory to speak of the further struggle for wealth on this new
industrial basis as a competition for an increase in the physical comforts of life, –
primarily for an increase of the physical comforts which the consumption of goods
affords.
In command economies the government makes the allocative decisions. These

decisions are backed with the force of law (and sometimes martial force). Political
freedom is the antitheses of a command economy. Even though political and economic
freedom could result in a reasonable allocation, but rarely will command economies be
associated with democratic forms of government. Examples, of these types of systems
abound, Nazi Germany, Chile, the former Soviet Union are but a few examples.
Traditional economies base allocations on social mores or ethics or other non-

market, non-legislative bases. For example, Iran is an Islamic Republic and the
allocation of resources is heavily influenced by religious precepts. The purest forms of
traditional economies are typically observed in tribal societies. In the South Pacific and
certain South American Indian tribes, the allocation of resources is determined by
94
traditions, only some of which are based in their religion. Many of these traditions
developed because of economic constraints. For example, the tradition that some
native tribes in the Arctic had of putting their elderly out of the community to starve or
freeze may seem barbaric, but because of the difficulty in obtaining the basic
requirements of life, those that could not contribute, could not be supported. Hence a
tradition that arose from economic constraints.
Socialism generally focuses on maximizing individual welfare for all persons

based on perceived needs, not necessarily on contributions. Socialist systems are
generally concerned more with perceived equity rather than efficiency. The basic idea
here is that when there is assurance of economic security then society in general is
better-off. Sweden, Denmark, Norway and Iceland have systems that have large
elements of socialism. Each of these three countries have been reasonably successful
in maintaining relatively high levels of productivity and standards of living.
Communism is a system where everyone shares equally in the output of society

(according to their needs), at least theoretically. Generally, there is no private holdings
of productive resources, and government is a trustee until such time as what is called
"Socialist Man" fully develops (where the individual is more concerned with aggregate
welfare than individual gain). The former Soviet Union was not a communist society as
perceived by Karl Marx in Das Kapital. However, examples of communist societies
exist on small community levels. Both New Harmony, Indiana and Amana, Iowa were
utopian communist systems that were probably more in keeping with Marxist ideals, but
without the political implications and in very limited scope.
Division of Labor – and possibly society
Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996,
pp.19-20.
. . . People read snippets of Adam Smith, the few phrases they teach in school.
Everyone reads the first paragraph of The Wealth of Nations where he talks about
how wonderful the division of labor is. But not many people get to the point hundreds
of pages later, where he says that division of labor will destroy human beings and
turn them into creatures as stupid and ignorant as it is possible for a human being to
be. And therefore in any civilized society the government is going to have to take
some measures to prevent division of labor from proceeding to its limits.
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Virtually all economic systems are mixed systems. A mixed system is one that
contains elements of more than one of the above pure systems. The U.S. economy is a
mixed system, with significant amounts of capitalism, command, and socialism. The
U.S. economy also has some very limited amounts of communism and tradition that
have helped shape our system. Much of the political controversies concerning the
budget deficit, social security, and the environment focuses on the what the appropriate
mix of systems should exist in our economic system.
Most developed economies are mixed systems. As a society grows and

becomes more complex, simple pure examples of economic systems are incapable of
handling the demands placed on them. Complexity generally requires elements of
command, socialism and capitalism to properly allocate resources and produce
commodities. This is no more evident in the troubles being experienced in the former
Soviet Union and in China. As these economies attempt to modernize and develop, the
policy makers have discovered the utility of market systems for many economic
decisions.
Estranged Worker
The Economic & Philosophic Manuscripts of 1844, Karl Marx, New York: International
Publishers, 1964, p. 107-8.
The worker become all the poorer the more wealth he produces, the more his
production increases in power and size. The worker becomes an even cheaper
commodity the more commodities he creates. With the increasing value of the world
of things proceeds in direct proportion the devaluation of the world of men. Labor
produces not only commodities: it produces itself and the worker as a commodity –
and this in the same general proportion in which it produces commodities.
This fact expresses merely that the object which labor produces – labor’s
product – confronts it as something alien, as a power independent of the producer.
The product of labor is labor which has been embodied in an object, which has
become material: it is the objectification of labor. Labor’s realization is its
objectification. In the sphere of political economy this realization of labor appears as
loss of realization for the workers; objectification as loss of the object and bondage to
it; appropriation as estrangement, as alienation.
Developed economies are generally high income economies, because the

production processes tend be capital intensive, and focused on high value-added
products. An economy that has a per capita GDP of $8000 or more is a high income
economy. Less developed economies fall into two categories, middle income $8000 to
$800, and low income economies or those below $800. Low income economies are
concentrated in South Asia, and Africa South of the Sahara. Middle income economies
are in the Middle East, Eastern Europe and Latin America. The majority of the world’s
96
population, over half, live in low income economies.
Perhaps the greatest economic issue facing the current generation is what can
be done to bring the low income economies into meaningful participation in the global
economy. The poverty of the low income economies is a serious matter without any
other issue. AIDS, malaria, and a host of other health problems are associated with the
poverty in these nations. Perhaps more importantly, with rising incomes in these parts
of the world come several benefits globally. As income rise in low income countries,
cheap labor is no longer a cause for outsourcing from the high income, industrialized
parts of the world. Further, as income rise, so too does the demand for goods and
services. The often used cliché “a rise tide makes all boats float higher” is exactly the
case in these nations emergence into full participation in the global economy. More
concerning these issues will be offered later in this book.
KEY CONCEPTS
Economizing problem
Scarce Resources
Unlimited Wants
Resources and Factors Payments

Land - rent
Labor - wages
Capital - interest
Entrepreneurial Talent - profits
Full Employment
Underemployment
Economic Efficiency
Allocative Efficiency
Technological Efficiency
Full Employment
Opportunity Cost
Implicit vs. Explicit Costs
Production Possibilities Frontier (or Curve)

Growth
Inefficiency
Law of Increasing Opportunity Costs
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Economic Systems
Pure capitalism
Command
Tradition
Socialism
Communism
Mixed Systems
Developed vs. Less Developed Economies

High Income
Middle Income
Low Income
Globalization
STUDY GUIDE
Food for Thought:
What is the economizing problem? What, precisely does scarcity have to do with this?
Explain.
Draw a production possibilities curve that illustrates a one-to-one trade-off between the
two goods, what would cause such a production possibilities curve? Explain.
Compare and contrast the various economic systems? Is a mixed system best?
Explain.
Differentiate between explicit and implicit costs. Is this differentiation important in

economic decisions? Explain.
98
Sample Questions:
Multiple Choice:
Which of the following factors of production are not properly matched with their factor
payments?
A. Land - profits
B. Labor - wages
C. Capital - interest
D. All are properly matched
Unemployment can be illustrated with a production possibilities curve. Which of the

following illustrates unemployment?
A. A shift to the left of the curve

B. A shift to the right of the curve
C. A point on the inside of the curve
D. A point on the outside of the curve
Which of the following is an implicit cost of your obtaining a college education if you go
to school exclusively?
A. Tuition
B. Books and supplies
C. Income lost from a job you didn’t take
D. All of the above
The U.S. economy is closest to which of the following economic systems?
A. Mixed
B. Pure Capitalism
C. Pure Command
D. None of the above
TRUE-FALSE
A laissez faire, purely capitalistic economy will always result in economically efficient
distributions of resources. {FALSE}
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If the assumption of a fixed technology is relaxed in the production possibilities curve
model, then the exact position and shape of the curve will be impossible to show using
a single line. {TRUE}
The former Soviet Union was an example of pure Communism and the Swedish
economy an example of pure socialism. {FALSE}
Opportunity cost is an example of an implicit cost. {TRUE}
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CHAPTER 3
Interdependence and the Global Economy
This chapter begins with a discussion of the interdependence of nations in the

modern global economy before proceeding to a discussion of capitalist ideology. The
characteristics of a market based economic system, and the motivation for international
trade will then presented before offering a discussion of the role of money in a global
economic system. The final section of this chapter develops the circular flow diagram
that illustrates interdependence within a global economy.
Open Economic System
The modern economy of most nations is no longer a closed-localized system.

Virtually every nation on earth has some sort of relations with other nations. The extent
to which an economic system is involved in economic relations with other countries is
the degree to which that economy is open. Foreign economic relations involves the
importation and exportation of goods and services. When you buy a Toyota you are
having economic relations with Japan. When you work for Philips (Aero-Quip etc.) you
are having economic relations with Holland (Philips is a Dutch company). Over the past
three decades our reliance on foreign produced goods has become increasingly
important to our standard of living. On the other hand, foreigners have become
increasingly reliant on American goods. Without trade among nations then everyone
would suffer the loss of goods they desire that must be imported.
Foreign investment in the United States has been and continues to be an

important component of our economic development. From the very beginnings of the
United States European countries, i.e., France, Britain and Germany have heavily
invested in the United States. In the Nineteenth Century the motivation was that the
U.S. was far from the turmoil of the repeated European wars (Napoleon etc.) and
investment here was protected by the expanse of the two Oceans on our east and west.
As our institutions developed and became more secure, investment was attracted by
the safety offered by our financial institutions and government regulations. At the same
time, American industry sought to move into markets they presently served only by
exportation.
Controversy abounds concerning international economic relations. The

outsourcing of jobs abroad has real costs for the affected households and is a source of
discontent among workers who have lost their jobs to foreign competition (more
concerning this will discussed in chapter 12). In many cases these job loses are simply
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employers taking advantage of very low income populations in poor countries – with all
of the social and political ills associated with economic exploitation. Over the next
several decades these issues will take a more central place in political debate, and
concerns over the social responsibility of business.
Technology transfers are also controversial. There are currently bands on the
transfer of certain technologies that have implications for national defense. However, in
general, technology transfers is the exportation of ideas, knowledge and equipment that
may permit less fortunate nations to more adequately participate in the global economic
system.
The United States is presently experiencing large deficits in our balance of

payments. The balance of payments is the net investment abroad (capital accounts)
plus the net exports (current accounts) of the United States. If the balance of payments
is positive, ignoring investment (capital accounts) for the moment, that means we are
exporting more than we are importing. With the capital accounts that means we invest
more abroad, than foreigners invest in the U.S. Together, if the balance of payment is
negative, that means the net of the capital and current accounts is a negative number
(i.e., we invest less abroad than foreigners invest here, and we import more than we
export).
Capitalist Ideology
Ideology is defined by Webster’s Dictionary as: that system of mental

philosophy which exclusively derives our knowledge from sensation. Webster’s
also appropriately defines capitalism as: An economic system characterized by
private ownership of natural resources and means of production. However, what
our system is, and what ideology has grown up around the system are two different
things. We have a mixed system, which includes a significant amount of market
allocation mechanisms, but it is not a pure capitalist system. Further, what Adam Smith
envisioned for capitalism is in many respects very much different from the more radical
proponents of capitalism would have us believe is the ideal system. One should
remember that a mixed system evolved for a reason, and that the ideology ought not
taint the wonders of that system and the standard of living it provides.
The following box is an excerpt from Adam Smith’s Wealth of Nations which
clearly and unambiguously examines the idea of social welfare, with respect to the
pursuit of individual welfare. Bear in mind Adam Smith was the father of capitalism as
you read this excerpt.
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Individual Self-Interest and Social Welfare
An Inquiry into the Nature and Causes of the Wealth of Nations (Adam Smith, New
York: Random House, Modern Library editions, 1937 [original published 1776] Book
IV, Ch. 2)
Every individual necessarily labours to render the annual revenue of the

society as great as he can. He generally, indeed, neither intends to promote the
public interest, nor knows how much he is promoting it. By preferring the support of
domestic to that of foreign industry, he intends only his own security; and by directing
that industry in such a manner as its produce may be of the greatest value, he
intends only his own gain, and he is in this, as in many other cases, led by an
invisible hand to promote an end which was no part of his intention. Nor is it always
the worse for society that it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually than when he really intends
to promote it. I have never known much good done by those who affected to trade
for the public good. It is an affectation, indeed, not very common among merchants,
and very few words need be employed in dissuading them from it.
Capitalist ideology is therefore what we wish to perceive it to be, rather a

dispassionate observation of some characteristics of a our economic system. The
characteristics of a market system are dispassionate observations about markets and
their operation. Therefore capitalist ideology is different than the characteristics of a
market system.
The characteristics of a capitalist economy are familiar to anyone who has

grown up in western industrialized countries. The elements of a capitalist ideology are:
(1) freedom of enterprise, (2) self-interest, (3) competition, (4) markets and
prices, and (5) a limited role for government.
Freedom of enterprise, self-interest and a limited role for government are related
characteristics of capitalist ideology. By limiting government participation in the
economy it is thought that economic freedom to pursue one's self-interest increases –
hence government participation is often called “interference.” To the extent that
government limits the freedom of enterprise, there is merit to this argument. However,
there are often problems associated with the pursuit of self-interest. One of the primary
problems with this aspect of the ideology is it is based on the assumption that the power
to limit people's self-interest comes only from government. There is also a significant
amount of potential to limit economic freedom by predatory behaviors from the private
sector. For example, large businesses running small ones out of business to obtain a
monopoly to permit prices to increase.
Again, assuming that monopoly power is not exerted over otherwise competitive
markets, the competition among producers in a market economy will approximate a
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Pareto Optimal (see Chapter 2) allocation of resources. Competition does provide for
alternate sources of supply that generally increases quality and keeps prices in check.
The market system is largely responsible for our high standard of living and the ability
to effectively respond to changes in the global economy.
Maybe the best example of the benefits that arise from a capitalist economy is
the U.S. automobile industry. In the 1970s the U.S. car producers did not have effective
competition, and their prices increased as the quality of U.S. built cars declined. The
Japanese entered the U.S. markets and successfully competed with the U.S.
manufacturers. This caused the U.S. manufacturers to significantly increase the quality
of their products and keep their prices in check. By 2004 many of the top ten vehicles in
quality according to consumer reports are U.S. automobiles. Consumer Guide’s
Recommended List for 2004:
(http://auto.consumerguide.com/auto/new/index.cfm)
lists fifteen foreign built vehicles (14 of which are Japanese name plates) and eighteen
American vehicles as best buys for 2003. This is a significant benefit from competition
that is fundamental to capitalism.
However, capitalism has its drawbacks. Poverty, high rates of litigation, pollution,
crime and several other social problems are associated with freedom and limiting
government's role. There is a broad range of legitimate roles for government in a
capitalist economy. As social responsibility by producers and consumers declines, the
legitimate roles of government generally expand.
Worse still, over the past three or four years, businesses in the U.S. have been
rocked by scandals. The accounting and analyst frauds at Enron, WorldCom, Health
South, and an array of brokerage firms and investment banks, have illustrated that the
ethic of self-interest is hardly a reasonable basis for an economic system – without
some countervailing forces. Self-interest, without government, or at least effective
government regulation, may produce results that are extremely harsh for those without
the resources to defend themselves. Therefore there is a strong need not only for a
strong ethic of honest and forthright dealings, but also governmental regulation to
proscribe the worst abuses.
For the tendency of capitalism toward monopoly and market power to be held in
proper balance government must have a significant role. The exact magnitude of the
role of government in a free economy has always been controversial, but there is little
doubt of its potential for positive outcomes. President Bush, during his first election
campaign argued that he envisioned American society becoming "kinder and gentler"
society. This reference was for the need for certain elements of socialism to provide
limited assurance for the disabled, the elderly, and children freedom from poverty. In
the years since George Bush, it seems that neither Democrats nor Republicans shared
the first President Bush’s vision. Mixed economic systems are the response to the
104
drawbacks of capitalism.
Not all people accept our view of the proportions of market activity that should be
in evidence in a mixed economy. The Europeans and major Asian economies have far
more socialism than we do. On the other hand, many of the Less Developed Countries
permit far more free enterprise than we do. Whatever the proportions, two things are
certain. First, no two societies are alike in their mix of allocative mechanisms, and
second the mix evolves and changes over time with the societies the system serves.
Market System Characteristics
The characteristics of the market system is both practically and intellectually

different than capitalist ideology. The characteristics of the market system are those
things upon which the operationalization of markets depend to decide what is produced
and how it will be allocated. The characteristics of a typical of market system are: (1)
the division of labor & specialization, (2) significant reliance on capital goods,
and (3) reliance on comparative advantage. These characteristics have significant
interactions and together are responsible for the competitive well-being of most market
system economies.
In market economies the competition among producers requires high levels of

technical efficiency, which, in turn, requires labor to become specialized and focused on
narrow aspects of a particular production process. By dividing tasks into small
components people become better at repetitive movements and therefore their
efficiency increases. As efficiency increases, cost per unit declines.
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Division of Labor and Production
York: G. P. Putnam and Sons, 1877 (original published 1776) Book II, Chapter V.)
To take an example . . . from a very trifling manufacture; but one in which

the division of labour has been very often taken notice of, the trade of the pin-maker;
a workman not educated to this business (which the division of labour had rendered a
distinct trade), nor acquainted with the use of machinery employed in it (to the
invention of which the same division of labour has probably given occasion), could
scarce, perhaps, with his utmost industry make one pin in a day, and certainly could
not make twenty. But in the way in which this business is now carried on, not only
the whole work is a peculiar trade, but it is divided into a number of branches, of
which the greater part are likewise peculiar trades. One man draws out the wire,
another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for
receiving the head; to make the head requires two or three distinct operations; to put
it on, is a peculiar business, to whiten pins is another; it is even a trade by itself to put
them into the paper; and the important business of making a pin is, in this manner,
divided into about eighteen distinct operations, which in some manufactories, are all
performed by distinct hands, though in others the same man will sometimes perform
two or three of them. I have seen a small manufactory of this kind where ten men
only were employed, and where some them consequently performed two or three
distinct operations. But though they were poor, and therefore indifferently
accommodated with the necessary machinery, they could, when they exerted
themselves, make among them about twelve pounds of pins in a day. There are in a
pound upwards of four thousands pins of middling size. Those ten persons,
therefore, could make among them upwards of forty-eight thousand pins in a day.
Each person, therefore making a tenth part of forty-eight thousand pins, might be
considered as making four thousand eight hundred pins in a day. But if they had all
wrought separately and independently, and without any of them having been
educated to this peculiar business, they certainly could not each them have made
twenty, perhaps not one pin in a day.
Because of the need to compete, capital is typical used where it is less costly.
Capital can be substituted for labor in many production processes and significantly
reduce per unit costs of production.
Comparative Advantage and Trade
However, comparative advantage is somewhat more complicated. Comparative

advantage is the motivation for trade among people (and nations). Terms of trade are
106
those upon which the parties may agree and depends on the relative cost advantages
of trading partners and their respective bargaining power.
Interdependence and Comparative Advantage
York: Random House, Modern Library editions, 1937 [original published 1776] Book
IV, Ch. 2)
. . . It is the maxim of every prudent master of a family, never to attempt to make at

home what it will cost more to make than to buy. The taylor does not attempt to
make his own shoes, but buys them of the shoemaker. The shoemaker does not
attempt to make his own clothes, but employs a taylor. The farmer attempts to maler
neither the one nor the other, but employs those different artificers. All of them find it
for their interest to employ their whole industry in a way in which they have some
advantage over their neighbors, and to purchase with a part of its produce, or what is
the same thing, with the price of a part of it, whatever else they have occasion for.
What is prudence to the conduct of every private family, can scarce be folly in
that of a great kingdom. If a foreign country can supply us with a commodity cheaper
than we ourselves can make it, better buy it of them with some part of the produce of
our own industry, employed in a way in which we have some advantage.
Consider the following illustration:
Texas Florida
Cows 1000 100

Oranges 100 1000
The data above show what each state could produce if all of their resources were
put into each commodity. For example, if Texas put all their resources in cattle
production they could produce 1000 cows but no oranges. Assuming the data give the
rate at which the commodities can be substituted, if both states equally divided their
resources between the two commodities, Texas can produce 500 cows and 50 oranges
and Florida can produce 50 cows and 500 oranges (for a total of 550 units of each
commodity produced by the two states together). If Texas produced nothing but cows it
would produce 1000, and if Florida produced nothing but oranges it would produce
1000). If the countries traded on terms where one orange was worth one cow then both
states would have 500 units of each commodity and obviously benefit from
specialization and trade. In this example notice that oranges are relatively expensive.
Trade between industries and individuals also arises from comparative
107
advantage. However, barter (direct trading of commodities) becomes increasingly
difficult as an economic system becomes more complex. Barter requires a
coincidence of wants, it does no good to have apples if you want oranges and the only
people who have oranges hate apples. No transaction will occur under this scenario
unless a third-party can be found that has a commodity that both original trading parties
value and who accept both apples and oranges. Therefore, as complexity rises, so does
the need for the ability to conduct business without reliance on barter, therefore the
need for money.
TRADE SUMMARY - U.S. Department of Commerce, International Trade

Administration
(billions of dollars)
Year Total Exports Total Imports Balance of Trade
2000 $1064.2 $1442.9 –$378.7

2001 998.0 1356.3 – 358.3
2002 971.7 1407.3 – 435.7
2003 (est) 988.8 1489.2 – 501.4
Money in an Economic System
Money facilitates market activities and is necessary in complex market systems.

With money people can avoid the problems associated with coincidence of wants.
Among, these problems is the pricing of commodities. Prices stated in the terms of all
possible trading goods makes it difficult to determine what anything costs. In barter
economies hours are spent in negotiating for even simple transactions, these hours are
resources that could have been spent on other activities (therefore the hours of
negotiations are the opportunity cost of a money economy).
The functions of money include; (1) medium of exchange, (2) store of value,
and (3) a measure of worth. Because money is acceptable as a form of payment for
all commodities, barter is no longer needed. Money can be easily stored in a tin can or
bank account, so commodities need not be stored and can be purchased when needed.
Because money is acceptable in virtually all transactions, prices can be stated in terms
of dollars or yen thereby simplifying transactions substantially. In other words, money is
the grease that lubricates any complex economic system.
108
Fiat money is what is common in modern economic systems. Fiat money is
money that is defined as legal tender by either a government or some
organization with the authority to define legal tender. In the United States the
Federal Reserve System issues Federal Reserve Notes, which serve as the legal
tender for the United States. The currency used here is backed by nothing except the
faith of the general public that this money will be acceptable by everyone else with
whom you could have an economic transaction.
President Nixon in 1971 took the United States off of the gold standard. Up to
that point of time the value of the dollar was expressed in some fixed ratio to the
commodity – gold. The end result was the dollar had become seriously over-valued,
and something had to be done so that American exports could resume to our trading
partners. When the U.S. abandoned the gold standard gold went from less than forty
dollars an ounce, to over $1000 an ounce in a matter of weeks. Thus illustrating the
folly of pegging one’s currency to the value of some commodity.
Fiat money is not a new idea. Some European historians identify the first use of
fiat money in Europe resulting from gold and silver smiths issuing their customers
receipts for gold or silver left in their care. The receipts were commands over that gold
and silver, and began to trade as easily as the commodity itself, to the extent that the
parties to the transaction knew of the smith and the note bearer. This trade in receipts
dates back to the mid-fifteenth century. Hence, in this case the value of money is based
on some mutual trust between the principles to these transactions.
The first recorded use of fiat money, however, dates to three hundred years
earlier in Asia. Because of the shortage of gold and silver to run the Mongol Empire,
Genghis Kahn began to issue orders, in writing, that the written order was to be given
deference as a specific amount of gold or silver. Genghis was known to a be no-
nonsense sort of guy, and the violation of his decrees were clearly unhealthy acts,
therefore these orders were the first fiat money recorded in history, and not backed by
anything save the martial might of the Mongol Army. Perhaps, in retrospect, it is better
that currency be acceptable on economic grounds, than under threat of violence from a
government.
Foreign Exchange
International economic relations also depend, in large measure, on monetary

issues. You are unlikely to accept the Turkish Lire in payment for your wages in this
country, simply because you can’t easily use that money to buy anything. You want
U.S. dollars in payment for your services, because you can easily spend the dollar.
Countries act the same way you do. There are currencies that virtually everyone
accepts as payment, and those widely accepted currencies are called hard currency.
109
The currency of the big, developed, high income economies are the hard currencies –
U.S. dollar, Japanese Yen, Canadian dollar, British pound and the E.E.U.s’ Euro.
Prior to the Euro, there were seven countries whose currencies were considered
hard currencies. In addition to the U.S., Japan, Canada, and the United Kingdom, the
French Franc, German Mark, and Italian Lire were also considered hard currencies.
These seven nations are called the G-7 countries because the size and strength of their
economies made them the leading economic forces on the planet, and their currencies
the most accepted.
The relative value of currency is called the exchange rate. For example, one
U.S. dollar may buy 109 Japanese Yen but only .85 Euros. It is these currency
exchange rates that, in large measure, determine net exports and foreign investment in
the U.S.
As the dollar gains strength, i.e., goes from 109 Yen to the dollar to 120 Yen to
the dollar, then imports are cheaper. If at 110 Yen to the dollar a particular Japanese
car costs $20,000 that is also 2.2 million Yen. If the dollar gains strength, and it can
now purchase 125 Yen per dollar, then that 2.2 million Yen car is only $17,600. As can
be readily seen the strong dollar give the American consumer an advantage in buying
imports. If the dollar becomes weak then that advantage turns to disadvantage. Going
back to the example above, if the 2.2 million Yen vehicle was available at $17,600 at
125 Yen per dollar, the additional cost of $2400 would be observed if the dollar could
only purchase 110 Yen.
The same sort of analysis applies to American exports. With an expensive dollar
it is hard to sell American goods abroad. If the Mexican Peso will buy 10 cents we may
be able to sell some goods in Mexico, however if the dollar becomes stronger and
Mexicans can only get 5 cents per peso, we will observe a marked decline in exports to
Mexico.
Currency also impacts foreign investment. If our Mexican friends invest 2 million
pesos in the U.S. when the peso buys 10 cents ($200,000), and then suddenly the peso
becomes worth 25 cents ($500,000) the foreign investor just made 250% on his
investment simply because the U.S. dollar weakened with respect to the Mexican peso.
On the other hand, if the Mexican investor bought dollars at 25 cents per peso and over
a year the dollar fell to 10 cents per peso, his investment went from $500,000 to only
40% of his original investment. In other words, foreign investment becomes more
attractive with strength in the host countries’ currency.
A strong dollar policy means that the government will undertake policies that will
increase the value of the dollar with respect to other currencies. Contractionary fiscal
and monetary policies are typically associated with strong dollar policy and is properly
the subject of the next course (macroeconomics). Strength a nation’s currency is
typically a reflection of its strong economy and institutions. The relative supply and
110
demand for a currency will also impact the currency exchange rates.
Strong dollar policies promote the importation of goods and services from
abroad, and foreign investment in our domestic enterprises. On the other hand, a weak
dollar policy promotes the exportation of goods and services abroad, and U.S.
investment overseas. Often, the international aspects of domestic monetary and fiscal
policies are less important than political consideration in the U.S. or policy consideration
concerning unemployment or inflation. However, one must always remember that
lobbyists and special interest groups are quick to point-out to policy makers the
advantages and disadvantage of either policy for their constituents back home.
The Circular Flow Diagram
The circular flow diagram is used to show the interdependence that exists among
sectors of the economy. The diagram illustrates that there are several collections of
similar economic agents, called sectors. Households provide resources to government
and business and consume the outputs of these other sectors. The markets in which
land, labor, capital, and entrepreneurial talent are sold are called resource markets.
The markets in which the output of business and in some cases government is sold are
called product markets.
To this point, the circular flow diagram is relatively simple. However, when a
foreign sector or substantial governmental sector is added it becomes more
complicated. It is not unusual for a modern economy to have substantial participation in
both the product and resource markets from both foreigners and governments
(sometimes even foreign governments).
Consider a relatively simple open-economy, trade and foreign investment occurs.

The following diagram illustrates this relatively simple economic system. The
interdependence in the sectors is represented by the flows in both the resource and
factor markets. Resources flow from household to both the government and
businesses. Private goods and services flow from the businesses to households and
government, and public goods and services flow from the government to both
households and businesses. The triangle representing these domestic sectors rests on
a foundation called the foreign sector. Foreign households, business, and even
governments (in limited ways) participate in the flows that would otherwise have been
purely domestic if the economy was a closed economy.
111
_____________________________________________________________________
FOREIGN SECTOR
_____________________________________________________________________
As can be easily observed the government provides public goods and services to
both businesses and households and receives resources and private goods and
services in return; the business sector sells commodities to households and households
provide resources to businesses. This is the nature of interdependence.
112
KEY CONCEPTS
Capitalist Ideology
Freedom of Enterprise
Self-Interest
Competition
Markets and Prices
Limited Role for Government
Market System Characteristics

Division and Specialization of Labor
Capital Goods
Comparative Advantage
Barter
Coincidence of Wants
Functions of Money
Medium of exchange
Store of Value
Measure of Worth
Foreign Exchange
Balance of Payment
Current Account
Capital Account
Exchange Rates
Imports and Exports
Foreign Investment
Circular Flow Diagram

Interdependence
Sectors
Foreign Sector
113
STUDY GUIDE
Critically evaluate capitalist ideology? How does this differ from market characteristics?
Explain.
Explain the role of money in a modern economic system. Does this simplify or
complicate matters? Explain.
Develop the traditional circular flow diagram and illustrate the interdependence between
the sectors. Add the government and the foreign sectors, how does this complicate
matters? Explain.
The following two commodities are produced by Tennessee and Kentucky:
Sour Mash Whiskey Bourbon
Tennessee 5,000 500
Kentucky 500 10,000
Assuming free trade and that each state wishes to consume as much of each
commodity as possible, what will each state produce? What will the terms of trade be?
Explain the role of currency exchange rates in international trade. What cause these
exchange rates to change?
Sample Questions:
Multiple Choice:
114
Which of the following is not a function of money?
A. Store of value
B. Measure of worth
C. Medium of exchange
D. All of the above are functions of money
Barter is a system that historically existed since the beginnings of time. Why has barter
been displaced by more modern systems?
A. Coincidence of wants makes exchange complicated

B. Coincidence of wants no longer exists in the world’s economy
C. Gold and silver are now in plentiful supply so that money can be used
If the dollar gains value with respect to the Euro what would we expect to observe?
A. U.S. imports increase, foreign investment in the U.S. increases

B. U.S. exports decrease, foreign investment in the U.S. decreases
C. U.S. imports decrease, U.S. investment abroad increases
True - False
The circular flow model demonstrates that there is interdependence between the
sectors but does not identify how the sectors are interdependent. {FALSE}
Comparative advantage derives from having an ability to produce some commodity at a

lower cost than a potential trading partner. {TRUE}
The majority of the countries in the world are high income, developed countries.
{FALSE}
115
CHAPTER 4
The Basics of Supply and Demand
The purpose of this chapter is to develop one of the most powerful methods of
analysis in the economist's tool kit. In this chapter we will develop the model of a simple
market – supply and demand (the industry in pure competition – discussed further in
Chapter 8). The demand schedule and supply schedule will be developed and put
together to form the analysis of a market. The market presented here is the starting
point for the analysis of all market structures.
Markets
A market is nothing more or less than the locus of exchange, it is not necessarily
a place, but simply buyers and sellers coming together for transactions. Transactions
occur because consumers and suppliers are able to purchase and sell at a price that is
determined through the free interaction of demand and supply.
Adam Smith, in the Wealth of Nations, described markets as almost mystical

things. He wrote that the interaction of supply and demand "as though moved by an
invisible hand" would determine the price and the quantity of a good exchanged. In fact,
there is nothing mystical about markets. If competitive, a market will always satisfy
those consumers willing and able to pay the market price and provide suppliers with the
opportunity to sell their wares at the market price. To understand the market, one need
only understand the ideas of supply and demand and how they interact.
Demand
The law of demand is a principle of economics because it has been consistently

observed and predicts consumers’ behavior accurately. The law of demand states
that as price increases (decreases) consumers will purchase less (more) of the
specific commodity, ceteris paribus. In other words, there is an inverse relationship
between the quantity demanded and the price of a particular commodity. This law of
demand is a general rule. Most people behave this way, they buy more the lower the
price. However, everyone knows of a specific individual who may not behave as
predicted by the law of demand, but remember the fallacy of composition -- because an
individual or small group behaves contrary to the law of demand does not negate it.
116
The demand schedule (demand curve) reflects the law of demand. The demand
curve is a downward sloping function (reflecting the inverse relationship of price to
quantity demanded) and is a schedule of the quantity demanded at each and every
price.
Price
P1
P2
Demand
Q1 Q2 Quantity
As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a
negative relation between price and quantity, hence the negative slope of the demand
schedule; as predicted by the law of demand.
Consumers obtain utility (use, pleasure, jollies) from the consumption of

commodities. Economists have long recognized that past some point, the consumption
of additional units of a commodity bring consumers less and less utility. The change in
utility derived from the consumption of one more unit of a commodity is called marginal
utility. The idea that utility with the amount added to total utility will decline when
additional units are consumed past some point has also the status of principle. This
principle is called diminishing marginal utility.
Because consumers make rational choices, that is they act in their own self
interest, there are two effects that follow from their attempts to maximize their well-being
when the price of a commodity changes. These two effects are called the; (1) income
effect, and (2) the substitution effect. Together these effects guarantee a downward
sloping demand curve.
The income effect is the fact that as a person's income increases (or the
price of item goes down [which effectively increases command over goods] more
of everything will be demanded. The income effect suggest that as income goes
down (price increases) then less of the commodity will be purchased.
117
The substitution effect is the fact that as the price of a commodity
increases, consumers will buy less of it and more of other commodities. In other
words, a consumer will attempt to substitute other goods for the commodity that became
more expensive. The substitution effect simply reinforces the idea of a downward
sloping demand curve.
The demand schedule can be expressed as a table of price and quantity data, a
series of equations, or in a downward sloping graph. To this point, our discussion has
focused on individuals and their behavior. Assuming that at least a significant majority of
consumers are rational, it is a simple matter to obtain a market demand curve. One
needs only to sum all of the quantities demanded by individuals at each price to obtain
the market demand curve.
Changes in the price of a commodity causes movements along the demand

curve; such movements are called changes in the quantity demanded. If price
decreases, then we move down and to the right along the demand curve; this is an
increase in the quantity demanded. If price increases, then we move upward and to left
along the demand curve, this is a decrease in the quantity demanded. Remember, (it is
important) such changes are called changes in the quantity demanded because the
demand curve is a schedule of the quantities demanded at each price.
Movements of the demand curve itself, either to the left or right are called
changes in demand. A change in demand is caused by a change in one or more of
the nonprice determinants of demand. A shift to the right of the demand curve is called
an increase in demand; and a shift to the left of the demand curve is called a decrease
in demand.
The nonprice determinants of demand are; (1) tastes and preferences of

consumers, (2) the number of consumers, (3) the money incomes of consumers, (4)
the prices of related goods, and (5) consumers' expectations concerning future
availability or prices of the commodity.
If the tastes and preferences of consumers change they will shift the demand
curve. If consumers find a commodity more desirable, ceteris paribus, then an increase
in demand will be observed. If consumer tastes wane for a particular product then there
will be a shift to the left of the demand (a decrease in demand).
An increase in the number of consumers or their money income will result in a

shift to the right of the demand curve (an increase in demand). A decrease in the
number of consumers or their income will result in a shift of the demand curve toward
the origin (a decrease in demand). Consumers will also react to expectations
concerning future prices and availability. If consumers expect future prices to increase,
their present demand curve will shift to the right; if consumers expect prices to fall then
we will observe a decrease in current demand.
118
The prices of related commodities also effect the demand curve. There are two
classes of related commodities of importance in determining the position of the demand
curve, these are (1) substitutes, and (2) complements. A substitute is something that is
alternative commodity, i.e., Pepsi is a substitute for Coca-Cola. A complement is
something that is required to enjoy the commodity, i.e., gasoline and automobiles. If the
price of a substitute increases, then the demand for our commodity will increase. If the
price of a substitute decreases, so too will the demand for our commodity. In other
words, the price of a substitute and the demand for our commodity move in the same
direction. For complements, the price of the complement and the demand for our
commodity move in opposite directions. If the price of a complement increases, the
demand for our commodity will decrease. If the price of a complement decreases, the
demand for our commodity will increase.
Increase in Demand Decrease in Demand
Price Price
D2
D1 D2 D1
Quantity Quantity
An increase in demand is shown in the first panel, notice that at each price there is a
greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the
solid line). The second panel shows a decrease in demand, notice that there is a lower
quantity demanded at each price along D2 (the dotted line) than was demanded with D1
(the solid line).
119
Changes in Quantity Demanded
Price
P1
P2
Demand
Q1 Q2 Quantity
Movement along a demand curve is called a change in the quantity demanded.

Changes in quantities demanded are caused by changes in price. When price
decreases from P1 to P2 the quantity demanded increases from Q1 to Q2; when price
increases from P2 to P1 the quantity demanded decreases from Q2 to Q1.
Supply
The law of supply is that producers will supply more the higher the price of the
commodity. The supply curve is an upward sloping function showing a direct
relationship between prices and the quantity supplied. In other words, the supply curve
has a positive slope that shows that as price increase (decreases) so too does quantity
supplied.
As with the demand curve a change in the price will result in a change in the
quantity supplied. An increase in price will result in an increase in the quantity
supplied, and a decrease in price will result in a decrease in the quantity supplied.
Again, this is because the supply curve is a schedule of the quantities supplied at each
price.
Changes in one or more of the nonprice determinants of supply cause the supply
curve to shift. A shift to the left of the supply curve is called a decrease in supply; a shift
to the right is called an increase in supply. The nonprice determinants of supply are; (1)
resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5)
expectations concerning future prices, and (6) the number of sellers.
When resource prices increase, supply decreases (shifts left); and when
120
resource prices decrease, supply increases (shifts right). If a more cost effective
technology is discovered then supply increases, increases in taxes cause the supply
curve to shift left (decrease). An increase in a subsidy effects the supply curve in the
same way as a cut in taxes, an increase in supply.
If the price of other goods a producer can supply increases, the producer will
reallocate resources away from current production (decrease in supply) and to the
goods with a higher market price. For example, if the price of corn drops, a farmer will
supply more beans.
If producers expect future prices to increase, current supply will decline in favor
of selling inventories at higher prices later. In other words, supply will decrease (a shift
to the left, and exactly the opposite response will occur if producer expect future prices
to be lower. If the number of suppliers increases, so too will supply, but if the number of
producers declines, so too will supply.
Decrease in Supply Increase in Supply

Price Price
S2 S1
S1
S2
Quantity Quantity
A decrease in supply is shown in the first panel, notice that there is a lower quantity
supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel
shows an increase in supply, notice that there is a larger quantity supplied at each price
with S2 (dotted line) than with S1 (solid line).
121
Changes in Quantity Supplied
Price Supply
P1
P2
Q2 Q1 Quantity
Changes in price cause changes in quantity supplied, an increase in price from P2 to P1

causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1
to P2 causes a decrease in the quantity supplied from Q1 to Q2.
Market Equilibrium
Market equilibrium occurs where supply equals demand (supply curve intersects
demand curve). An equilibrium implies that there is no force that will cause further
changes in price, hence quantity exchanged in the market. This is analogous to a
cherry rolling down the side of a glass; the cherry falls due to gravity and rolls past the
bottom because of momentum, and continues rolling back and forth past the bottom
until all of its' energy is expended and it comes to rest at the bottom - this is equilibrium
[a rotten cherry in the bottom of a glass].
122
Price and Value
Principles of Economics, 8th edition (Alfred Marshall, London: Macmillan Publishing

Company, 1920, p. 348.)
. . . We might as reasonably dispute whether it is the upper or the under blade of a

pair of scissors that cuts a piece of paper, as whether value is governed by utility or
cost of production. It is true that when one blade is held still, and the cutting is
effected by moving the other, we may say with careless brevity that the cutting is
done by the second; but the statement is not strictly accurate, and is to be excused
only so long as it claims to be merely a popular and not a strictly scientific account of
what happens.
The following graphical analysis portrays a market in equilibrium. Where the

supply and demand curves intersect, equilibrium price is determined (Pe) and
equilibrium quantity is determined (Qe)
Price Supply
Pe
Demand
Qe Quantity
The graph of a market in equilibrium can also be expressed using a series of

equations. Both the demand and supply curve can be expressed as equations.
Demand Curve is Qd = 22 - P
(Notice the negative sign in front the price variable, indicating a downward sloping
function)
123
Supply Curve is Qs = 10 + P
(Notice the positive sign in front of the price variable, indicating an upward sloping
function)
The equilibrium condition is Qd = Qs
(For this market to obtain equilibrium, the quantity demanded must equal the quantity
supplied in this market)
Therefore:
22 - P = 10 + P
adding P to both sides of the equation yields:
22 = 10 + 2P
subtracting 10 from both sides of the equation yields:
12 = 2P or P = 6
To find the equilibrium quantity, we plug 6 (for P) into either the supply or
demand curve and get:
22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side)
The system of equations approach to solving for equilibrium gives a specific

number for price and for quantity. Unless the numbers are specified along the price
axis and the quantity axis, the graph does not yield a specific number for price and
quantity. However, the graph provides a visual demonstration of equilibrium which may
aid learning.
Changes in supply and demand in a market result in new equilibria. The

following graphs demonstrate what happens in a market when there are changes in
nonprice determinants of supply and demand.
124
Change in Demand
Price Supply
P1
P2
D2 D1
Q2 Q1 Quantity
Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a

decrease in demand (as demonstrated in the above graph). Such decreases are
caused by a change in a nonprice determinant of demand (for example, the number of
consumers in the market declined or the price of a substitute declined). With a
decrease in demand there is a shift of the demand curve to the left along the supply
curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1
that is called an increase in demand, possibly due to an increase in the price of a
substitute good or an increase in the number of consumers in the market. When
demand increases both equilibrium price and quantity increase as a result.
Considering the following graph, movement of the supply curve from S1 (solid
line) to S2 (dashed line) is an increase in supply. Such increases are caused by a
change in a nonprice determinant (for example, the number of suppliers in the market
increased or the cost of capital decreased). With an increase in supply there is a shift of
the supply curve to the right along the demand curve, therefore equilibrium price and
quantity move in opposite directions (price decreases, quantity increases). If we move
from S2 to S1 that is called an decrease in supply, possibly due to an increase in the
price of a productive resource (capital) or the number of suppliers decreased. When
supply decreases, equilibrium price increases and the quantity decreases as a result.
That is the result of the supply curve moving up along the negatively sloped demand
curve (which remains unchanged).
125
Changes in Supply
S1
Price
S2
P1
P2
Demand
Q1 Q2 Quantity
If both the demand curve and supply curve change at the same time the analysis
becomes more complicated. Consider the following graphs:
Increase in Demand Decrease in Demand

Decrease in Supply Increase in Supply
Price Price
D2 S2
D1 S1
S1
P2 S2
P1 P1
P2 D1
D2
Q Quantity Q Quantit
Notice that the quantity remains the same in both graphs. Therefore, the change
in the equilibrium quantity is indeterminant and its direction and size depends on the
relative strength of the changes between supply and demand. In both cases, the
equilibrium price changes. In the first case where demand increases, but supply
decreases the equilibrium price increases. In the second panel where demand
decreases and supply increases, the equilibrium price decreases.
In the event that demand and supply both increase then price remains the same
126
(is indeterminant) and quantity increases, and if both decrease then price is
indeterminant and quantity decreases. These results are illustrated in the following
diagram
Increase in Supply Decrease in Supply s.
and in Demand and in Demand
Price Price
D2 D1
D1
D2
P P
S2
S1 S2 S1
Q1 Q2 Quantity Q2 Q1 Quantity
The graphs show that price remains the same (is indeterminant) but when supply
and demand both increase quantity increases to Q2. When both supply and demand
decrease quantity decreases to Q2.
Shortages and Surpluses
There is some rationale for limited government intervention in a free market

economy. Perhaps the most powerful rationale for limited government arises from the
effects of price controls in competitive markets. Shortages and surpluses can only
result because by having some sort of price controls in the market.
For example, the Former Soviet Union had a centrally planned economy and the
government decided what would be produced and for what price that production would
be sold. The government also was the sole employer and paid very low wages,
therefore prices were also controlled at below market equilibrium levels. The result was
that whenever any commodity was available in the market, there were long lines
observed at any store with anything to sell, prices were low but there was nothing to buy
(shortages). The popular Russian immigrant comedian, Yakov Simirnov, summed-up
the plight of the working class consumer in Russia prior to break-up of the Soviet Union.
He said, "In Russia we used to pretend to work, but that was alright, the government
only used to pretend to pay us!"
127
Shortage is caused by an effective price ceiling (the maximum price you can
charge for the product). Effective, in this sense, means that the government can and
does actively enforce the price ceiling. With the exception of the Second World War,
there is little evidence that the government can effectively enforce price ceilings.
Consider the following diagram that demonstrates the effect of a price ceiling in an
otherwise purely competitive industry.
SHORTAGE
Supply
Price
Pe
Price Ceiling
Demand
Qs Qe Qd Quantity
For a price ceiling to be effective it must be imposed below the competitive

equilibrium price. Note that the Qs is below the Qd, which means that there is an excess
demand for this commodity that is not being satisfied by suppliers at this artificially low
price. The distance between Qs and Qd is called a shortage.
It is interesting to consider the last time that wage and price controls were
attempted during the Carter administration. These short-lived price ceilings resulted in
producers technically complying with the price restrictions, but they frequently changed
the product. For example, warranties were no longer included in the sales price, service
was extra, delivery was extra, and where possible, the product was reduced in size. For
example, in the previous administration’s failed wage and price controls (Nixon) candy
bars were made smaller and they put fewer M & Ms in the package and the price for
these treats was not changed – effectively cutting costs, but not price, hence increasing
the profit margin without raising the price of the candy. The lesson is simple, if
government is going to control prices, they must be prepared to control virtually all other
aspects of doing business.
Surplus is caused by an effective price floor (minimum you can charge):
128
SURPLUS
Price Supply
Price Floor
Pe
Demand
Qd Qe Qs Quantity
For a price floor to be effective it must be above the competitive equilibrium price.
Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the
amount of the surplus. Minimum wages are the best known examples of price floors
and will be discussed in greater detail in Chapter 11.
Implicit in these analyses is the fact that without government we could have
neither shortage or surplus. In large measure, the suspicion of government is because
it has the power to create these sorts of peculiar market situations. Even with the
power of government to enforce law, the only way that a shortage or surplus could
occur is if the price ceiling or the price floor were effective.
Markets and Reality
As intuitively pleasing as these analyses are, they are only models, and these
models are based on assumptions that are not very good approximations of reality. In
Chapter 8 the analysis of a purely competitive market is offered. What this chapter
presents is the industry in pure competition, which is based on assumptions that do not
exist in reality. The assumptions are (1) perfect information about all past, and future
prices, (2) no barriers to entry or exit from the market, (3) no non-price competition
(advertising etc.), (4) atomized competition (so many suppliers and consumers that
none can appreciably affect price or quantity), and (5) there is a standardized product
(corn is corn is corn). If all of these assumptions accurately represent reality, then the
firm must sell at whatever price is established in the industry. To sell at a lower price
denies the firm revenue it could have otherwise earned, and to sell at a higher price
would mean the firm could sell nothing. In other words, the competitive industry impose
price discipline on all of the firms that together comprise that competitive industry.
129
Part of the controversy in almost any discussion of microeconomic activity is
whether the results of policy can be predicted by the simple supply and demand model.
Often the results of the simple supply and demand diagram are not bad rough
approximations of reality – but remember that it is only a rough approximation – based
on assumptions that are not very accurate depictions of reality. However, more often
imperfect market models are more accurate approximations of reality – because one or
more the assumptions underpinning those models more accurately reflects reality. One
must be careful in applying these models, and in policy debates concerning these
models. To the extent that the assumptions are not fulfilled, then the results may not be
accurate.
The real value of the simple supply and demand model is to provide a beginning
point for coming to understand how markets really work. In most respects the simple
supply and demand model is little more than the beginning point for constructing one of
the more realistic market models. Pure monopoly, monopolistic competition and
oligopoly are, in some important respects, refinements from the purely competitive
market model.
KEY CONCEPTS
Market
Equilibrium
Law of Demand
Demand schedule
Utility
Marginal Utility
Diminishing Marginal Utility
Income Effect
Substitution Effect
Demand Curve
Determinants of Demand
Tastes & Preferences
Number of Consumers
Money Income of Consumers
Prices of Related Goods
Substitutes
Complements
Expectations
130
Change in Demand v. Change in Quantity Demanded
Price changes v. Non-price determinant changes
Law of Supply
Supply Schedule
Supply Curve
Determinants
Resource prices
Technology
Taxes & Subsidies
Prices of other goods
Number of Sellers
Expectations
Change in Supply v. Change in Quantity Supplied

Price changes v. Non-price determinant changes
Shortage and Surplus
Price Floor and Price Ceiling
STUDY GUIDE
Food for Thought:
Demonstrate what happens to a market equilibrium when: (1) demand increases, supply
increases, (2) demand decreases, supply decreases, (3) demand increases, supply
decreases, and (4) demand decreases, and supply increases. Do the same exercise
showing only the demand curve increasing and decreasing and only the supply curve
increasing or decreasing.
Demonstrate the effects of a price floor: (1) above the competitive equilibrium, and (2)
below the competitive equilibrium.
131
Repeat exercise 2, using a price ceiling.
Using the system:
Qd = Qs, where Qd = 124 - 4P and Qs = -16 + 3P
What is the equilibrium price and quantity exchanged in this market? What would
happen if there were a price floor of 6 imposed in this market? If 6 was a price ceiling
would that change your answer? If so, how and why?
Sample Questions:
Multiple Choice:
If a minimum wage were imposed below the competitive equilibrium what would we
expect to observe in the effected labor markets?
A. An excess demand for labor

B. People being attracted by the higher wage cannot find jobs and some who were
employed will lose their jobs, but those remaining employed will have a higher
wage
C. There will be unemployment created by people losing jobs, but there will be no
new employees attracted to this labor market.
D. Nothing will be caused by the introduction of this minimum wage
If there is an increase in demand and an increase in the quantity supplied in a product

market what should be observed?
A. Price increases, quantity exchanged is indeterminant

B. Price decreases, quantity exchanged is indeterminant
C. Price decreases, quantity exchanged decreases
D. Price increases, quantity exchanged increases
132
True - False
If the price of Pepsi-Cola increases we should expect the demand for Coca-Cola
increase, ceteris paribus. {TRUE}
If consumers expect the price of computers to increase in the near future there should
be an increase in the quantity demanded observed. {FALSE}
133
CHAPTER 5
Supply & Demand: Elasticities
The purpose of this chapter is to extend the supply and demand analysis
presented in the previous chapter. Specifically, this chapter will develop the methods
employed by economists to measure consumer responsiveness to price changes -- the
price elasticity of demand. Other topics examined in this chapter are the price elasticity
of supply, cross-elasticities, the income elasticity of demand and the interest elasticity of
demand.
Price Elasticity of Demand
The price elasticity of demand is how economists measure the responsiveness of

consumers to changes in prices for a commodity. In other words, as price increases
(decreases), the quantity demanded by consumers will decrease (increase). The
relative proportions of the changes in price and the respective quantities demanded are
the responses of consumers and are referred to as the price elasticity of demand. It is
this consumer responsiveness that is the subject of this chapter.
Business decisions concerning prices are not always a simple matter of adding
some margin to the cost of production of the commodity (cost-plus pricing). Suppliers
will wish to obtain the most revenue the market will bear from the sales of their products
– in other words, maximize their profits. It is therefore necessary for business to have
some idea of what the market will bear, and that is where the price elasticity of demand
enters the picture in business decision-making.
There are three methods that are used to measure the price elasticity of demand,
these are; (1) the price elasticity coefficient (midpoints formula), (2) the total revenue
test, and (3) a simple examination of the demand curve. Each of these will be
examined in turn, in the following paragraphs.
Elasticity Coefficient
The elasticity coefficient is a number calculated using price and quantity data
to determine how responsive consumers are to changes in the price of a commodity.
The elasticity coefficient may be calculated in two distinct ways. Point elasticity is
134
measuring responsiveness at a specific point along a demand curve. The other
method is using the mid-point of the difference in the price and the mid-point in the
difference of the quantity numbers. Because the midpoints formula cuts down on the
confusion of which prices and quantities are to be used, it is the only coefficient we will
use in this course.
The price elasticity coefficient (midpoints) is calculated using the midpoints

formula:
Ed = Change in Qty ÷ Change in price

(Q1 + Q2)/2 (P1 + P2)/2
Calculating the elasticity coefficient will yield a specific number. The value of that
number provides the answer as to whether demand is price elastic or price inelastic.
Elastic demand means that the consumers' quantities demanded respond (more than
proportionately) to changes in price; with elastic demand the coefficient is more than
one. Inelastic demand means that the consumers' quantities demanded do not respond
very much to changes in price; with inelastic demand the coefficient is less than
one. Unit elastic demand means that the consumers' quantity demanded respond
proportionately to change in price; with unit elastic demand the coefficient is exactly
one.
What this equation states is illustrated in the graph below. The midpoint between
price one (P1) and price two (P2) is labeled Midpoint along the price axis and M on the
quantity axis.
Price
P1
Midpoint
P2
Demand
Quantity
Q1 M Q2
135
On the graph this number is the difference between Q1 and Q2 divided by the
distance between the origin and the point labeled M on the quantity axis for the
numerator and the difference between P1 and P2 divided the distance between the
origin and the point labeled midpoint on the price axis for denominator. The ratio of the
numerator to the denominator on this graph is the same number yielded by the
equation.
Examining the demand curve can also provide clues concerning the price
elasticity of demand. A perfectly vertical demand curve indicates that the quantity
demanded will be exactly the same, regardless of price. This type of demand curve is
called a perfectly inelastic demand curve. A perfectly horizontal demand curve
indicates that consumers will have almost any quantity demanded, but only at that price.
This is called a perfectly elastic demand curve. Perfectly unit elastic demand curves
are not linear, they have slopes that vary across ranges.
Perfectly elastic demand Perfectly inelastic demand
Price Price Demand
Demand
Quantity Quantity
Perfectly Elastic and Perfectly Inelastic Demand Curves
There is a trick to remembering inelastic and elastic demand. Notice in the
above graphs that the perfectly elastic demand curve is horizontal, (add one more
horizontal line at the top of the price axis and it will look like an E). The perfectly
inelastic demand curve is vertical (looks like an I). If you have problems remembering
the concept of inelastic or elastic demand you need only draw the curves above and
observe what happens to the quantity demanded when the price changes. In the case
of perfectly inelastic demand consumers will buy exactly the same quantity of a product
without regard for its price. In the case of a perfectly elastic demand curve, if producers
raise the price of the product, then they will sell nothing.
Slope and elasticity are two different concepts. With linear demand curves,
elasticity changes along the demand curve, however its slope does not. Elasticity is
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concerned with responses in one variable to changes in the other variable. The slope
of the curve is concerned with values of the respective variables at each position along
the curve (i.e., its' shape and direction).
Demand Curve and Total Revenue (total revenue = P x Q) Curve
Price
Elastic Unit
Demand
Inelastic
Quantity
Total
Revenue
Total Revenue
Quantity
The total revenue curve in the bottom graph is plotted by multiplying price and quantity
to obtain total revenue and then plotting total revenue against quantity. In examining
the above graphs, notice that as total revenue is increasing, demand is elastic. When
the total revenue curve flattens-out at the top then demand becomes unit elastic, and
when total revenue falls demand is inelastic. In other words, moving from left to right on
the demand curve, as price and total revenue move in the opposite direction demand is
price elastic, and when price and total revenue move in the same direction demand is
price inelastic.
The total revenue test uses the relation between the total revenue curve and the
demand curve to determine the price elasticity of demand. In general, price and total
revenue will move in the same direction of the demand is price inelastic (hence
consumers are unresponsive in quantity purchased when price changes) and move in
opposite directions if price elastic (consumers’ quantities being responsive to price
changes).
137
Consider the following numerical example:
_____________________________________________________________________
_____________________________________________________________________
Table 1: Total Revenue Test

_____________________________________________________________________
Total Quantity Price per unit Total Revenue Elasticity

_____________________________________________________________________
1 7 7
>+5 Elastic
2 6 12
>+3 Elastic
3 5 15
>+1 Elastic
4 4 16
>-1 Inelastic
5 3 15
>-3 Inelastic
6 2 12
>-5 Inelastic
7 1 7
_____________________________________________________________________
_____________________________________________________________________
Marginal revenue is the change in total revenue due to the a change in

quantity demanded. The total revenue test relies on changes in total revenue
(marginal revenue) to determine elasticity. If the change in total revenue (marginal
revenue) is positive the demand is price elastic, if the change in total revenue is
negative the demand is price inelastic. If the marginal revenue is exactly zero
then demand is unit elastic.
The following determinants of the price elasticity of demand will determine how
responsive the quantity demanded by consumers is to changes in price. The
determinants of the price elasticity of demand are; (1) substitutability of other
commodities, (2) the proportion of income spent on the commodity, (3) whether
the commodity is a luxury or a necessity, and (4) the amount of time that a
consumer can postpone the purchase.
If there are no close substitutes then the demand for the commodity will be price
inelastic, ceteris paribus. If there are substitutes then consumers can switch their
purchasing habits in the case of a price increase, but if there are no substitutes then
138
consumers are more likely to buy even if price goes up. For example, if the price of
Pepsi goes up, then certain consumers will buy Coke, if the price of Coke has not
increased, hence the demand for Pepsi is likely to be elastic.
All other things equal, the higher the proportion of income spent for the
commodity more price elastic will be the demand. Most home owners are familiar with
how this determinant works. The demand for single family dwellings is likely to be more
elastic than the demand for apartments, because a higher proportion of your income will
be spent on housing when you own your home.
Commodities that are viewed as luxuries typically have price elastic demand, and
commodities that are necessities have price inelastic demand. There is simply no
substitute for a insulin, if you are an insulin dependent diabetic. Because insulin is a
necessity for which there is no substitute, the demand will be price inelastic.
Time is an important determinant of price elasticity. If a price changes, it may

take consumers a certain amount of time to discover alternative lifestyles or
commodities to account for the price change. For example, if the price of cars
increases, a family that planned to buy a car may wait for their income or wealth to
increase to make buying a new car viable alternative to continuing to drive an older
vehicle. In other words, the longer the time frame for the decision to purchase the more
price elastic the demand for the commodity.
Price Elasticity of Supply
The price elasticity of supply measures the responsiveness of suppliers to

changes in price. The price elasticity of supply is determined by the following time
frames; (1) market period, (2) short-run, and (3) long-run. The more time a producer
has to adjust output the more elastic is supply.
The time frames for producers will be discussed in more detail in Chapter 7 as
they pertain to a firm's cost structure. However, it is important to understand the basic
idea behind this classification of time as it relates to price elasticity. The market period
is defined to be that period in which the producer can vary nothing, therefore the supply
is perfectly inelastic. The long-run is the period in which the producer can vary
everything, therefore the supply is perfectly elastic. The short-run is the period in which
plant and equipment cannot be varied, but most other factors' usage can be varied,
therefore it depends on a producers capital - intensity as to how elastic supply is at any
particular point.
139
Other Elasticities
There are three other standard applications of the elasticity of demand. The
cross elasticity of demand, the income elasticity of demand, and the interest rate
elasticity of demand. Each of these will be examined, in turn, in the remaining
paragraphs of this chapter.
The cross elasticity of demand measures the responsiveness of the

quantity demanded of one product to changes in the price of another product.
For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi.
Cross elasticity of demand gives an indication of how close a substitute or complement
one commodity is for another. This concept has substantial practical value in
formulating marketing strategies for most products.
For example, as the price of coke increases, then consumers may purchase
proportionately more Pepsi products. In such a case, the cross elasticity of demand of
Pepsi to the price of coke would be termed elastic. The equation for the cross elasticity
of demand described here is presented below.
Ed = Change in Qty pepsi ÷ Change in price coke

(Q1 Pepsi + Q2 Pepsi)/2 (P1 coke + P2 coke)/2
The income elasticity of demand measures the responsiveness of the

quantity demanded of a commodity to changes in consumers' incomes. This is
typically measured by replacing the price variable with income (economists use the
letter Y to denote income) in the midpoints formula. Again, in business planning the
responsiveness of consumers to changes in their income may be very important.
Housing and automobiles, as well as, several big ticket luxury items have demand that
is sensitive to changes in income. The income elasticity formula is presented below.
Ed = Change in Qty ÷ Change in income

(Q1 + Q2)/2 (Y1 + Y2)/2
Often interest rates will also present a limitation on a consumer’s quantity of

demand for a particular commodity. As with income, often big ticket items are very
sensitive to interest rates on the loans necessary to make those purchases. With the
record low mortgage rates in the Spring of 2003 the quantity demanded for housing,
both new and existing homes, witnessed dramatic increases.
140
The automobile companies rarely reduce prices for their vehicles, but rather, GM,
Ford and Chrysler will offer incentives. Rebates, which are temporary reductions in
price, and attractive financing rates are the hooks offered to get the consumer in the
showroom and into the new car. In May of 2003 all of the American producers were
offering zero percent financing on all but a very few of their vehicles, and even some of
the European and Japanese producers were following suite with either very low rates,
or zero percent financing. The interest rate elasticity formula is (where interest rate is
“r”):
Ed = Change in Qty ÷ Change in interest rate

(Q1 + Q2)/2 (r1 + r2)/2
These analyses are important to businesses in determining what issues are

important to the successful sales of their products. There are industries that have not
been particularly good at understanding the notions of cross elasticity or price elasticity
– the airlines in particular, and many of these firms have suffered as a result. The
bankruptcies of United Airlines and US Air being excellent examples. The automobile
companies have been, in some measure, forced into the financing business because of
the interest rate sensitivity of consumers. By offering financing the car companies are,
essentially, maintaining some modicum of control over one important aspect of their
business.
Interest rate sensitivity can also be understood from another perspective. The
total cost of a commodity is not just its price, but also what must be paid to borrow
money to purchase that item. With modern views of instant gratification, it is rare for
someone to save to purchase a house, or any other big ticket item, what is more
common is to borrow the money, buy the item, and make installment payments.
Therefore the interest charges are a part of the total cost of acquiring that big ticket item
– hence consumer sensitivity to interest rates when buying a house or a car.
It is also noteworthy, that purely competitive firms are price takers, and it is the
imperfectly competitive firm that has a pricing policy. What is often referred to as
“pricing power” in the business press, means the ability to take advantage of the price
elasticity of demand or one of the other elasticities examined here – hence implying
some market structure, hence market power not otherwise identified in the model of
pure competition.
141
KEY CONCEPTS
Price Elasticity of Demand

Elasticity coefficient
Elastic Demand
Perfectly Elastic Demand
Inelastic Demand
Perfectly Inelastic Demand
Unitary Elasticity
Total Revenue Test

Price and Total Revenue
Marginal Revenue
Determinants of Price Elasticity

Substitutability
Proportion of Income
Luxuries v. Necessities
Time
Elasticity of Supply
Time periods
Market period
Short-run
Long-run
Cross Elasticity of Demand
Income Elasticity
Interest Rate Sensitivity
Pricing Power
142
STUDY GUIDE
Food for Thought:
List and explain the determinants of the price elasticity of demand and of supply.
What are the income and cross elasticities of demand? Why might they be useful?
Explain.
3. Consider the following data:
Price Quantity Total Revenue Marginal Revenue
1 2000 2000
2 1900 3800
3 1750 5250
4 1550 6200
5 1250 6250
6 900 5400
7 400 2800
8 100 800
Calculate the marginal revenue for each change in price. Perform a total revenue test
and determine the ranges of price elastic and price inelastic demand. Draw the demand
curve and the total revenue curve and show these ranges thereon.
Using the data in question 3 above calculate the price elasticity coefficient moving from
price of 3 to a price of 4; from a price of 5 to a price of 6.
143
Explain what the price elasticity of demand is and why it is of interest in examining
markets. Might it be useful in the airline industry? Why?
Sample Questions:
Multiple Choice:
Which of the following is a determinant of the price elasticity of demand?
A. Proportion of income spent on commodity

B. Price of complements
C. Number of consumers
Where is the range of unit price elasticity of demand for the following demand curve?
Price Quantity
8 3
7 4
6 5
5 6
4 7
3 8
A. From price 8 to price 6

B. From price 6 to price 5
C. From price 5 to price 3
D. From price 7 to price 4
Calculate the elasticity coefficient from the data above for the interval where price
changes from 8 to 7. That coefficient is:
A. 0.47
B. 1.00
C. 2.14
144
True - False:
The longer the period the more suppliers can adjust to price changes, hence the greater
the price elasticity of supply. {TRUE}
The income elasticity of demand shows whether a product has a close substitute or
complement. {FALSE}
The maximum point on the total revenue curve correlates with the elastic range of the
demand curve. {FALSE}
145
CHAPTER 6
Consumer Behavior
The purpose of this chapter is to refine the income and substitution effects
introduced in Chapter 4. This chapter will also introduce the idea of Giffin’s Paradox,
consumer equilibrium, and the utility maximization rule. The appendix to this chapter
also introduces you to indifference curves and budget constraints to analyze consumer
behavior.
Income and Substitution Effects Revisited
The income and substitution effects combine to cause the demand curve to slope
downwards as was discussed earlier in Chapter 4. In fact, an individual consumer's
demand curve can be rigorously derived using concepts from intermediate
microeconomics (E321) called indifference curves which illustrate, graphically, the
income and substitution effects. For students who are interested, it is recommended
that you take E321, Intermediate Microeconomics; or at a minimum go through the
appendix to this chapter.
The results of the indifference curve analysis (presented in the appendix to this
chapter) can be described in words. The income effect results from the price of a
commodity going down having the effect of a consumer having to spend less on that
commodity, hence the same as having more resources. However, as price increases,
the consumer will purchase less of that commodity and buy more of a substitute, this is
the substitution effect. It is the combination of the income and substitution effects, and
their relative strength, that causes an individual (hence generally a market) demand
curve to slope downward. However, there is an interesting exception to this general
rule -- Giffin's Paradox.
Giffin's Paradox is the fact that some commodities may have an upward
sloping demand curve. Such commodities are called inferior products. (Not
necessarily because of quality problems with the product, but because the analysis is
inferior -- not generalizable to all commodities). This happens because the income
effect results in a lesser demand for a product. (In other words, the income effect
overwhelms the substitution effect).
There are at least two types of goods that often exhibit an upward sloping
demand curve. One is necessity for very poor people and the other is one for which a
high price creates a snob effect. Each case will be reviewed, in turn, in the following
paragraphs.
146
Price Demand
with Giffin’s
Paradox
P1
P2
Quantity
In the diagram above notice that as price is decreased from P1 to P2 the quantity
demanded decreases, hence snob appeal may go down from the loss of a prestigiously
high price – consumers who value the product simply because it is high priced leave the
market as the price falls. As price increases from P2 to P1 poor people can’t afford
other more luxurious items therefore they have to buy more of the very commodity
whose price wrecked their budgets.
In the case of poor people who experienced the price of necessity increasing,
their limited resources may result in their buying more of the commodity when its price
increases. For example, if the price of rice increases in a less developed country,
people may buy more of it because of the pressure placed on their budget prevents
them from buying beans or fish to go with their rice. To maintain their caloric intake rice
will be substituted for the still more expensive beans and fish.
The other situation is where a luxury is involved. There is the snob appeal
possibility where the higher the price, the more desired the commodity it. Often people
will drive expensive cars, simply because of the image it creates. If the car is extremely
expensive, i.e., Rolls Royce, the snob effect may be the primary motivation for the
purchase. This also works with less expensive commodities. For example, Joy
Perfume advertised itself as the world's most expensive to attract consumers that their
marketing surveys indicated would respond to the snob effect.
147
Consumer Equilibrium
Incentive and Economic Welfare
Principles of Economics, 8th ed. (Alfred Marshall, London: Macmillan Publishing

Company, 1920, pp. 15-16.)
. . . If then we wish to compare even physical gratifications, we must do it not

directly, but indirectly by the incentives which they afford to action. If the desires to
secure with of two pleasures will induce people in similar circumstances each to do
just an hour's extra work, or will induce men in the same rank of life and with the
same means each to pay a shilling for it; we they may say that those pleasures are
equal for our purposes, because the desires for them are equally strong incentives to
action for persons under similar conditions.
Rational behavior was defined as economic agents acting in their self interest. It
is the idea of rational behavior that permits the rigorous examination of economic
activity. Without rationality, our analyses fail to conform with the basic underlying
assumption upon which most of economics is based.
Consumers (when acting in their own self interest) will generally attempt to maximize
their utility, given some fixed level of available resources and income with which to
purchase goods and services. The utility maximizing rule is that consumers will balance
the utility they receive from the consumption of each good or service against the cost of
each commodity they purchase, to arrive at how much of each good they need to
maximize their total utility.
The algebraic restatement of the rule:
MUa/Pa = MUb/Pb = . . . = MUz/Pz
When the consumer reaches equilibrium each of the ratios of marginal utility to
price will be equal to one. If any single ratio is greater than one, the marginal utility
received from the consumption of the good is greater than the price, and this means the
consumer has not purchased enough of that good. Therefore the consumer must
purchase more of that good (causing price to increase and marginal utility to go down to
the point they are equal), where MU > P. If the ratio is less than one, where MU< P,
then the consumer has purchased too much of the commodity (price is larger than the
marginal utility received from the commodity) and needs to cut back.
Whether consciously or not, rationality requires each individual consumer to

allocate their resources in such a manner as to meet the restrictions of the above
148
equation that is when the consumer is said to be in equilibrium. In reality, a consumer is
always seeking those levels, but because of changing prices and changing preferences,
it is understood that the consumer is always seeking, but never quite at equilibrium.
APPENDIX TO CHAPTER 6
Utility and Demand Curves
The material in this appendix is not subject to testing and will not be included on
any of the examinations or quizzes. It is provided simply to demonstrate how an
individual demand can be derived.
The demand curve is dependent on the individual consumer's tastes and

preferences, as was shown in Chapter 5. Therefore we can derive an individual
demand curve using what we have learned about utility in this chapter.
Individual preferences can be modeled using a model called indifference curve -

budget constraint and from this model we can derive an individual demand curve.
A consumer's budget constraint is a mapping of the ability to purchase goods and

services. We assume that there are two goods and that the budget constraint is linear.
The following budget constraint shows the consumer's ability to purchase goods, beer
and pizza.
Budget Constraint
Beer
Pizza
The consumer is assumed to spend their resources on only beer and pizza. If all
resources are spent on beer then the intercept on the beer axis is the amount of beer
the consumer can purchase; on the other hand, if all resources are spent on pizza then
the intercept on that axis is the amount of pizza that can be had.
149
If the price of pizza doubles then the new budget constraint becomes the dashed
line. The slope of the budget constraint is the negative of the relative prices of beer and
pizza.
An indifference curve is a mapping of a consumer's utility derived from the

consumption of two goods, in this case beer and pizza. There are three assumptions
necessary to show a consumer's utility with an indifference mapping. These three
assumptions are: (1) every point in the positive/positive quadrant is associated with
exactly one indifference curve (every place thick), (2) indifference curves do not
intersect (an indifference above another shows greater utility unequivocally), and (3)
indifference curves are strictly convex toward the origin (bow toward the origin).
The following indifference curve shows the consumer's preferences:
Beer
2
1
Pizza
The dashed line (2) shows a higher level of total satisfaction than does the solid
line (1). Along each indifference curve is the mix of beer and pizza that gives the
consumer equal total utility.
Consumer equilibrium is where the highest indifference curve they can reach is
exactly tangent to their budget constraint. Therefore if the price of pizza increases we
can identify the price from the slope of the budget constraint and the quantities
purchased from the values along the pizza axis and derive and individual demand curve
for pizza:
150
Beer
2 Pizza
2 1
When the price of pizza doubled the budget constraint rotated from the solid line
to the dotted line and instead of the highest indifference curve being curve 1, the best
the consumer can do is the indifference curve labeled 2.
Deriving the individual demand curve is relatively simple. The price of pizza (with
respect to beer) is given by the (-1) times slope of the budget constraint. The lower
price with the solid line budget constraint results in the level the higher level of pizza
being purchased (labeled 1for the indifference curve - not the units of pizza). When the
price increased the quantity demanded of pizza fell to the levels associated with budget
constraint 2.
Price
P2
P1
Quantity
Q2 Q1
Notice that Q2 and P2 are associated with indifference curve 2 and budget
constraint 2, and that Q1 and P1 result from indifference curve 1 and budget constraint
1. The above model shows this individual consumer's demand for pizza.
151
KEY CONCEPTS
Revealed preference
Utility
Budget Constraint
Indifference Curves
Income Effect
Substitution Effect
Giffin’s Paradox, Inferior goods
Consumer Equilibrium
STUDY GUIDE
Food for Thought:
What is utility and diminishing marginal utility? Explain.
In detail, explain the utility maximization rule? Critically evaluate this concept.
How is a market demand curve derived? What does this have to do with indifference
curves and budget constraints?
152
Sample Questions:
Multiple Choice:
Which of the following describes the utility maximization rule? (where MU is marginal
utility and P is price)
A. MUa/Pa = MUb/Pb = . . . = MUz/Pz

B. Total MU = Total P
C. MUa = MUb = . . . = MUz
D. None of the above describe the rule
True - False:
The law of diminishing marginal utility states that total utility will become negative as
more units of a commodity are consumed. {FALSE}
Typically, the income and substitution effects combine to cause a downward sloping
demand curve. {TRUE}
153
CHAPTER 7
Costs of Production
The purpose of this chapter is to examine the production costs of a firm. The first
section develops the economic concepts of production necessary for understanding the
cost structure of a firm. The second section presents the models of short-run costs.
The final section develops the long-run average total cost curve and discusses its
implications for the strategic management of a business.
Production and Costs
The reason that an entrepreneur assumes the risk of starting a business is to

earn profits. The fundamental assumption in the theory of production is that a rational
owner of a business will seek to maximize the profits (or minimize the losses) from the
operation of his business. However, before anything can be said about profits we must
first understand costs and revenues. This chapter will develop the basic concepts of
production costs.
An economist's view of costs includes both explicit and implicit costs. Explicit
costs are accounting costs, and implicit costs are the opportunity costs of an allocation
of resources (i.e., business decisions). Accountants subtract total cost from total
revenue and arrive a total accounting profits. An economist, however, would include in
the total costs of the firm the profits that could have been made in the next best
business opportunity (e.g., the opportunity cost). Therefore, there is a significant
difference in how accountants' and economists' view profits B economic profits versus
accounting profits.
For the purposes of economic analysis, a normal profit includes the cost of the
lost opportunity of the next best alternative allocation of the firm=s resources. In a purely
competitive world, a business should be able to cover their costs of production and the
opportunity cost of the next best alternative (and nothing more in the long-run). In an
accounting sense there is no benchmark to determine whether the resource allocation
was wise. Instead various financial ratios are used to determine how the firm has done
with respect to similarly situated companies.
154
Time Periods Revisited
As was discussed briefly in the section of elasticity of supply in Chapter 5, time

periods for economic analysis are defined by the types of costs observed. These time
periods differ from industry to industry, and will differ by the technology employed
between firms. Again, these time periods are; (1) the market period, (2) the short-run,
and (3) the long-run.
In the market period, all costs are fixed costs (nothing can be varied). In the
short-run, there are both fixed and variable costs observed. Generally, plant,
equipment, and technology are fixed, and things like labor, electricity, and materials can
still be varied. In the long-run everything is variable. That is, the plant, equipment, and
even the business into which you put productive assets can all be changed. In the
long-run, even the country in which the business is located can be changed. Because
everything is fixed in the market period, this period is of little interest in economic
analysis. Therefore, economists typically begin their analysis of costs with the short-run
and proceed to examine the operation of the firm and the industry. The long-run is of
interest because it is also the planning horizon for the business.
Production
Another view of the short-run cost structure is that fixed costs are those that must
be paid whether the firm produces anything or not. Variable costs are called variable
because they increase or decrease with the level of production. Therefore to
understand short-run costs, you must first understand production.
Total product or total output is the total number of units of production obtained
from the productive resources employed. Average product is total product divided by
the number of units of the variable factor employed. Marginal product is the change in
total product associated with a change in units of a variable factor of production.
As a firm increases its output it normally makes more efficient use of its available
capital. However, with a fixed level of available capital as variable factors are added to
the production process, there is a point where the increases in total output begin to
diminish. The law of diminishing returns is the fact that as you add variable
factors of production to a fixed factor, at some point, the increases in total output
begin to become smaller. In fact, it is possible, at some point, that further additions in
the units variable factors to a fixed level of capital could actually reduce the total output
of the firm. This is called the uneconomic range of production. In reality, most firms
come to realize that their total additions to total output diminish, long before they begin
to experience negative returns to additions to their workforce or other variable factors.
155
The following diagram provides a graphical presentation of total, average, and
marginal products for a hypothetical firm.
The top graph shows total product. After total product reaches its maximum
marginal product where marginal product changes from positive to negative (first
derivative is zero, second derivative is negative). When the total product curve reaches
its maximum, increased output results in negative marginal product. The maximum on
the marginal product curve is also associated with the first inflection point (the
acceleration or where the curve becomes steeper) on the total product curve. The
ranges of marginal returns are identified on the above graphs.
The beginning point in developing the cost structure of a firm is to examine total
costs in the short run. Total costs (TC) are equal to variable costs (VC) plus fixed costs
(FC).
TC = VC + FC
Variable costs are those costs that can be varied in the short-run, i.e., the cost of
hiring labor. Fixed costs are those costs that cannot be varied in the short-run, i.e.,
plant (interest). Therefore, total costs consist of a fixed component and a variable
component.
These relations are presented in a graphical form in the following diagram:
156
The fixed cost curve is a horizontal line. These costs are illustrated with a
horizontal line because they do not vary with quantity of output. The variable cost curve
has a positive slope because it varies with output. Notice that the total cost curve has
the same shape as the variable cost curve, but is above the variable cost curve by a
distance equal to the amount of the fixed cost. This is because we added fixed cost
(the horizontal line) to variable cost (the positively sloped line).
From the total, variable and fixed cost curves we can obtain other relations.
These are the marginal cost, and the total, variable, and fixed costs relation to various
levels of output (averages).
Average total cost (ATC) is total cost (TC) divided by quantity of output (Q),
average variable cost (AVC) is variable cost (VC) divided by quantity of output (Q), and
average fixed cost (AFC) is fixed cost (FC) divided by quantity of output (Q). Marginal
cost (MC) is the change (denoted by the Greek symbol delta), in total cost (TC) divided
by the change in the quantity of output (Q).
157
These relations are presented in equation form below:
ATC = TC/Q
AVC = VC/Q
AFC = FC/Q
MC = ÎTC/ÎQ; where Î stands for change in.

The following diagram presents the average costs and marginal cost curve in
graphical form.
Please notice that the average fixed cost approaches zero as quantity increases.
This occurs because a constant is being divided by increasingly large numbers.
Average total cost is the summation of the average fixed and average variable cost
curves. Because average fixed cost approaches zero, the difference between average
variable cost and average total cost also approaches zero (the difference between ATC
and AVC is AFC). The marginal cost curve intersects both the average total cost and
average variable cost curves at their respective minimums. In other words, as marginal
cost is below average total (and average variable) cost the average function is falling to
meet marginal cost. As marginal cost is rising above the average function then average
158
total (and average variable) cost are increasing.
The following graph relates average and marginal product to average variable
and marginal cost.
Notice that at the maximum point on the marginal product curve, marginal cost
reaches a minimum. Where marginal cost equals average variable cost, the marginal
product curve intersects the average product curve. In other words, the cost structure
of the firm mirrors the engineering principles giving rise to the firm=s production, hence
its costs.
This presents some interesting disconnects from how business is presently

evolving. The high compensation levels of executives seems to not reflect the actual
output of their labors. In other words, the costs of production seemingly fail to account
for the history of the 21st century thus far. As it turns out, these issues can be explained
by neo-classical economics, and will be in Chapters 10 and 11.
The Long Run Average Total Cost Curve
In the long-run all costs are variable. In other words, a firm can vary its plant,
equipment, technology and any of the factors that were either fixed or variable in the
short-run. Therefore, anything that is technologically feasible is available to this firm in
the long-run. Further, any short-run average total cost curve (consistent with any size of
operation) could be selected for use in the long-run.
159
The long-run average total cost curve (LRATC) is therefore a mapping of all
minimum points of all possible short-run average total cost curves (allowing technology
and all factors of production (i.e., costs) to vary). The enveloping of these short-run
total cost curves map all potential scales of operation in the long-run. Therefore, the
LRATC is also called the planning horizon for the firm.
The following diagram illustrates a LRATC:
The shape of the LRATC is dependent upon the available resources and
technology that a firm can utilize to produce a given commodity. The downward sloping
range of the LRATC is due to economies of scale, the upward sloping range of the
LRATC is due to diseconomies of scale, and if there is a flat range at the minimum point
of the LRATC this is called a range of constant returns to scale.
Economies of scale are benefits obtained from a company becoming large and
diseconomies of scale are additional costs inflicted because a firm has become too
large. The causes of economies of scale are that as a firm becomes larger it may be
able to utilize labor and managerial specialization more effectively, capital more
effectively, and may be able to profitably use by-products from its operations.
Diseconomies of scale result from the organization becoming too large to effectively
manage and inefficiencies developing.
Constant returns to scale are large ranges of operations where the firm's size
matters little. In very capital intensive operations that must cover some peak demand,
the size of the firm may matter very little. Several public utilities, such as electric
generating companies, telephone company, and water and sewer service have
160
relatively large ranges of constant returns to scale.
Where the LRATC curve reaches its minimum, this is called the minimum
efficient scale (size of operation). Minimum efficient scale is the smallest size of
operations where the firm can minimize its long-run average costs. Minimum efficient
scale varies significantly by commodity produced and technology. For example, the
minimum efficient scale in agriculture in the Great Lakes area for dairy operations is
relatively small (in the $200,000 range). Minimum efficient scale for wheat farmers in
the Great Plains may be as large as $1,000,000.
There is an interesting implication of the LRATC analysis. There are instances

where competition may be an unrealistic waste of resources. A natural monopoly is a
market situation where per unit costs are minimized by having only one firm serve the
market.
Minimum efficient scale is the point on the LRATC where it reaches its minimum.
If that happens to be at the beginning of a long range of constant costs, it is the first
point (on the left of the range) where costs are at their minimum. Remember, that
technical efficiency requires that a firm produce at where it has attained minimum total
long-run costs.
Where minimum efficient scale is very large for capital intensive operations, it
may be more cost effective to permit one company to spread its fixed costs over a very
large number of consumers, rather than have several competing firms suffer the fixed
costs of a minimum efficient scale and have to share a customer base. There are
several industries that are very capital intensive and require large initial investments to
operate. These types of firms are frequently natural monopolies. Railroads, electric
generating companies, and air lines requires tens of millions of dollars in fixed costs.
KEY CONCEPTS
Explicit v. Implicit Costs

Opportunity Costs
Economic v. Accounting Costs
Normal Profit
Next Best Alternative
Time Periods of Analysis

Market Period
Short-run
161
Long-run
Law of Diminishing Returns
Total, average, and marginal product
Short-run Costs
Total costs
Average Total
Average Fixed
Average Variable
Marginal
Long-run average total cost

Economies of Scale
Diseconomies of Scale
Minimum efficient scale
Planning Horizon
Natural Monopoly
STUDY GUIDE
Food for Thought:
Complete the following table then draw the relevant curves from the data (fixed cost is
$200).
Total Total Total Average Average Average Marginal

Product Variable Costs Costs Fixed Cost Variable Cost Total Cost Cost
0 0 ___ ___ ___ ___
1 20 ___ ___ ___ ___ >
2 38 ___ ___ ___ ___ >
3 58 ___ ___ ___ ___ >
4 64 ___ ___ ___ ___ >
5 76 ___ ___ ___ ___ >
6 93 ___ ___ ___ ___ >
7 114 ___ ___ ___ ___ >
8 139 ___ ___ ___ ___ >
162
Give the algebraic expression of each of the short run average cost curves and explain
(in words) what each means and what its relation is to total product.
Explain, in detail, why normal profit is included in average total costs?
Draw a LRATC demonstrating diseconomies, economies and constant returns to scale.

Explain why each range of the LRATC curve is observed. What does this have to do
with planning? Explain.
Sample Questions:
Multiple Choice:
Which of the following does the marginal cost curve NOT intersect at its minimum?
A. Average variable cost

B. Average total cost
C. Average fixed cost
D. Average fixed cost plus average variable cost
Which of the following is not a potential cause of economies of scale?
A. Ability to use by-products

B. Specialization of labor
C. Efficient use of capital
D. All of the above are potential causes of economies of scale
163
True - False
When marginal cost is below average variable cost, average variable cost must be
rising. {FALSE}
Long Range Average Total Cost reaches its minimum where short run marginal cost is
equal to LRATC. {FALSE}
Economic costs include implicit costs, whereas accounting costs do not. {TRUE}
Marginal costs are the change in costs associated with the addition of one more unit of
output. {TRUE}
164
CHAPTER 8
Pure Competition
Chapter 4 developed the supply and demand diagram. The simple supply and
demand diagram is the model of a perfectly competitive industry. That model will be
revisited and extended in this chapter.
The purpose of this chapter is to introduce models of the firm that are not purely
competitive. After a brief introduction to imperfectly competitive models we will turn our
attention to the purely competitive industry and firm. In particular, this chapter will
develop the model of the perfectly competitive firm, examine its relation to the industry,
and then offer some critical evaluation of this important paradigm.
Firms and Market Structure
There are several models of market structure. In the product market, the two
extremes are perfect competition and pure monopoly. This chapter will examine pure
competition and the following chapter examines monopoly. However, there are
intermediate market structures. These intermediate market structures are oligopoly and
monopolistic competition.
The assumptions in pure competition are:
(1) there is atomized competition (a large number of very small suppliers

and buyers relative to the market),
(2) there is complete freedom of entry and exit into and from this market,
(3) there is no nonprice competition,
(4) suppliers offer a standardized product, and
(5) firms in this industry must accept the price determined in the industry.
Purely competitive firms and industries do not exist in reality. Probably as close
as the real world comes to the competitive ideal is agriculture, during the period in which
this industry was dominated by the relatively small family farms prior to World War II.
165
The assumptions in pure monopoly are:
(1) there is one seller that supplies a large number of independent buyers,
(2) entry and exit into this market is completely blocked,
(3) the firm offers unique product,
(4) there is nonprice competition (mostly public information advertising),

and
(5) this firm is a constrained price dictator.
Pure monopolies abound in reality, including public utilities and manufacturing

firms producing products protected from competition by patents or copyrights. A
monopolist will produce less than a competitive industry and charge a higher price,
ceteris paribus.
The assumptions underlying the model of a monopolistically competitive industry

are:
(1) a relatively small number of sellers compared to pure competition, but

this number can still be large, in some cases a few hundred
independent sellers,
(2) pricing policies exist in these firms,
(3) entry into this market is generally somewhat difficult,
(4) there is substantial nonprice competition, mostly designed to create

product differentiation, at least some of which is spurious.
Numerous industries are properly characterized as monopolistic competition.

These industries include computer manufacturers, software manufacturers, most retail
industries, and liquor distillers. In general, monopolistic competitors produce less than
pure competitors but more that pure monopolists, and charge prices that also fall
between competition and monopoly. In general, the graphical analysis of a monopolistic
competitive industry is identical to a monopoly, except the demand curve is somewhat
more elastic than the monopolists'.
166
The assumptions upon which the model of oligopoly are founded are:
(1) that there are few sellers (generally a dozen or less), these firms often
collude or implicitly cooperate through such practices as price
leadership,
(2) entry into this market is generally difficult,
(3) there is normally very intensive non price competition in an attempt to

create product differentiation, often spurious.
Examples of oligopolies abound, the U.S. automobile industry, the soft-drink

industry, the brewing industry, segments of the fast-food industry, and airplane
manufacturers. Oligopoly will generally produce less than monopolistic competitors and
charge higher prices, if price leadership or other collusive arrangements exist an
oligopoly may be a close approximation to a pure monopoly.
All of these market structures also assume perfect knowledge concerning

present and future prices (by both producers and consumers) and all other information
relative to the operation of the market, i.e., product availability, quality etc. This perfect
knowledge assumption is not realistic, however, it does little violence to the models
because people typically learn very quickly in aggregate, and hence there expectations
approximate perfect knowledge over large numbers of persons.
The Purely Competitive Firm
Total, average and marginal product were developed with the various cost curves
in Chapter 7. The missing piece of the puzzle is revenue. Because a purely competitive
firm sells its output at the one price determined in the industry, price does not change as
the quantity sold increases. In other words, the demand curve is horizontal, or perfectly
elastic. The result is that average revenue is equal marginal revenue, and both of these
are equal to price. Further , total revenue is P x Q which is the total area under the
demand curve for the purely competitive firm.
A firm is assumed to be rationally managed and therefore it will attempt to

maximize its profits. The profit maximizing rule is that a firm will maximize profits where
marginal cost (MC) is equal to marginal revenue (MR). The reason for this is relatively
simple. There is still a positive amount of revenue that can be had in excess of costs of
the firm produces at a quantity less than where MC = MR. If a firm produces at a
quantity in excess of where MC = MR, the firm adds more to its costs than it receives in
revenues. Therefore the optimal, or profit maximizing level of output is exactly where
MC = MR.
167
The model of the purely competitive industry is the simple supply and demand
diagram you mastered in Chapter 4. The simple supply and demand diagram is a
representation of the aggregation of a large number of independent firms and
consumers. This model is revisited below:
Supply
Price
Pe
Demand
Qe Quantity
The firm in perfect competition is just one of thousands that are summed to arrive
at the industry levels of output and price. Because of the atomized competition, it a firm
charges a higher price that the industry it will sell nothing because consumers can
obtain exactly the same commodity at a lower price elsewhere. If the firm charges a
price lower that the price established in the industry it is irrational and will lose revenue
it could have otherwise had. Therefore, a firm operating in a perfectly competitive
industry has no choice save to sell its output at the industry established price. Because
the firm sells at the single price established in the industry it has a perfectly elastic
demand curve. (In other words, it is horizontal and not downward sloping).
168
The demand curve for the perfectly competitive firm is illustrated below:
Price
D = MR = AR = P
Quantity
Because the firm is a price taker, meaning that it charges the same price across all
quantities of output, marginal revenue is always equal to price, and average revenue
will always be equal to price. Therefore the demand curve intersects the price axis and
is horizontal (perfectly elastic) at the price determined in the industry.
Establishing the price in the industry is simply setting the equilibrium in the
familiar supply and demand diagram, and that is the price at which the firm is obliged to
sell its output. The following diagram illustrates how this is done:
Industry Firm in Competition

P
Pe
D=MR=AR
Q Q
169
Again, the price is established by the interaction of supply and demand in the
industry (Pe) and the quantity exchanged in the industry is the summation of all of the
quantities sold by the firms in the industry. However, this yields little information save
what price will be charged and what quantity the industry produce. To determine what
each firm will produce and what profits each firm will earn, we must add the cost
structure (developed in the previous chapter).
Economic profits are total revenues in excess of total costs. Remember from
Chapter 7, that profits from the next best alternative allocation of resources is included
in the total costs of the firm. In this short-run it plausible that some firms in pure
competition can exact an economic profit from consumers, but because of freedom of
entry, the economic profit will attract new firms to the industry, hence increasing supply,
and thereby lowering price and wiping out the short-run economic profits.
The following diagram adds the costs structure to the purely competitive firm’s
demand curve and with this information it is possible to determine the profits that this
firm makes:
MC
Price
ATC
AVC
Economic Profits D=MR
Qe Quantity
The firm produces at where MC = MR, this establishes Qe. At the point where
MC = MR the average total cost (ATC) is below the demand curve (AR) and therefore
costs are less than revenue, and an economic profit is made. The reason for this is that
the opportunity cost of the next best allocation of the firm's productive resources is
already added into the firm's ATC.
However, the firm cannot continue to operate at an economic profit because

those profits are a signal to other firms to enter the market (free entry). As firms enter
the market, the industry supply curve shifts to the right reducing price and thereby
eliminating economic profits. Because of the atomized competition assumption, the
number of firms that must enter the market to increase industry supply must be
170
substantial. The following diagram illustrates the purely competitive firm making a
normal profit:
MC
Price ATC
AVC
D=MR
Qe Quantity
The case where a firm is making a normal profit is illustrated above. Where MC
= MR is where the firm produces, and at that point ATC is exactly tangent to the
demand curve. Because the ATC includes the profits from the next best alternative
allocation of resources this firm is making a normal profit.
A firm in pure competition can also make an economic loss. The following
diagram shows a firm in pure competition that is making an economic loss:
MC
ATC
Price
AVC
Economic Losses
D=MR
Qe Quantity
The case of an economic loss is illustrated above. The firm produces where MC
= MR, however, at that level of production the ATC is above the demand curve, in other
words, costs exceed revenues and the firm is making a loss.
171
Even though the firm is making a loss it may still operate. The relation of
average total cost with average revenue determines the amount of profit or loss, but we
to know what relation average revenue has with average variable cost to determine
whether the firm will continue in business. In the above case, the firm continues to
operate because it can cover all of its variable costs and have something left to pay at
least a part of its fixed costs. It is shuts down it would lose all of its fixed costs,
therefore the rational approach is to continue to operate to minimize losses. Therefore,
the profit maximizing rule of producing at where MC = MR is also the rule to determine
where a firm can minimize any losses it may suffer.
In sum, to determine whether a firm is making a loss or profit we must consider

the relation of average total cost with average revenue. To determine whether a firm
that is making a loss should continue in business we must consider the relation between
average variable cost and average revenue. The following diagram illustrates the shut-
down case for the firm making a loss:
MC ATC
Price AVC
AVC SAVED BY SHUT- DOWN

D=MR
Qe Quantity
In the case above you can see that the AVC is above the demand curve at where
MC=MR, therefore the firm cannot even cover its variable costs and will shut down to
minimize its losses. If the firm continues to operate it cannot cover its variable costs
and will accrue losses in excess of the fixed costs. If the firm shuts-down, all that is lost
is the fixed costs. Therefore the firm should shut-down in order to minimize its losses.
What may not be intuitively obvious is that this analysis determines the industry
supply curve. Because firms cannot operate along the marginal cost curve below the
average variable cost curve, the firm’s supply curve is its marginal cost curve above
average variable cost. To obtain the industry’s supply curve one needs only sum all of
the firms’ marginal cost curves about their average variable cost curves.
172
Pure Competition and Efficiency
Allocative efficiency criteria are satisfied by the competitive model. Because P =

MC, in every market in the economy there is no over- or under- allocation of resources
in this economy. This is because the cost of production for the last unit of production is
what determines supply, and that cost of production includes only the engineering costs.
However, this result is obtained only if all industries in that economic system are purely
competitive. This is the contribution of the models of distribution created by economists
working in the marginalists traditions. The problem is that this is economic theory that is
not necessarily supported by empirical evidence.
Additionally, the technical or productive efficiency criteria are also satisfied by the
competitive model because price is equal to the minimum average total cost. In the
real world the ideal of technical efficiency is rarely attained. However, this criteria
provides a useful benchmark to use in measuring how well a firm is doing with respect
to minimizing costs for a specified level of total output.
As you may recall from the definition of economic efficiency, allocative and
technical efficiency are only two of the three necessary and sufficient conditions for
economic efficiency. The third condition necessary for economic efficiency is full
employment. If full employment is also in evidence then a purely competitive world is
economically efficient.
A few economists writing about economic problems through the past three
decades have focused their analyses narrowly on the competitive models. Conclusions
from the competitive models are straightforward and fairly simple, hence accessible to
the population in general. These models suggest that economic utopia is found only by
returning to a purely competitive world. However, as Adam Smith himself, notes there
was never a point at which competition was observed, let alone, was the general rule.
This illustrates a very important point about economics. While it is true that there
is a Nobel Prize in Economic Science, economics is not a science in the same vain that
physics or chemistry is. Economics relies on assumptions upon which to build models
to analyze material goods and their production and distribution. However, the
assumptions may reflect value judgments (biases) more than what the analyst believes
reflects the state of nature in the real world. Therefore, economics is not value free, as
many would posit.
173
Criticism of Pure Competition as a Mode of Analysis for the Real World.
In theory, the purely competitive world is utopia. There are several problems that
are not excluded by meeting the assumptions behind the competitive models. As
wealth increases, predation could easily develop and monopoly power could be gained
by the occasional ruthless businessman, especially in cases where government has
been significantly limited. Public goods and other commodities may not be available
through competitive industries because of the lack of a profit potential. The competitive
economic models are motivated by the suppliers seeking to maximize profits, and
without the profit motive, there can be no market.
Further because of technical efficiency requirements, externalities such as

pollution, work environment safety, and other such problems are likely to arise because
of the constraint imposed on the firms by the price being determined by the industry.
Without strong government and appropriate regulations to protect the environment or
workplace, it is unlikely that any private incentive system could impose sufficient
discipline upon producers to properly internalize the costs of production that can be
allowed to flow to the public in general.
The distribution of income may lack equity or even technical efficiency. In a

purely competitive world, workers will be paid the value of what they contribute to the
total output of the firm. If the product they produce is not highly valued then some
workers could be paid very low wages, even though the human capital and effort
requirements are substantial. For example, a mathematician or a physicist may be paid
less than a baseball player or musician – even though the value of what the
mathematician or physicist is far greater than the athlete’s contribution. This type of
result often creates substantial social problems, i.e., alienation, occasionally resulting in
alienation, crime, drug abuse, and in the developing world even political instability.
If all industries are purely competitive there be consumer dissatisfaction because

each firm offers a standardized product. This standardization might very well result in a
substantial loss of consumer choice. For example, if the soft drink industry was purely
competitive, the product offered might well be a single cola, someplace between Coca-
Cola and Pepsi-Cola, and might very well suite nobody’s tastes and preferences.
The present state of technology simply requires the existence of many natural
monopolies. The problems with natural monopolies are that under-production occurs at
too high of a market price for the product. This misallocation of resources results in an
insufficient amount of some commodities, with an excess of resources available to other
products, and prices that are not specifically determined by the actual costs of
production. Even so, if the natural monopolies are properly regulated at something near
a competitive price, then the damage to the economy may be minimized. This issue will
be discussed in greater detail in the following chapter (Chapter 9, Monopoly).
174
It is frequently mused that if you teach a parrot to say “supply and demand” you
have created a feathered economist. Perhaps the simplicity of this is appealing,
however, supply and demand reflects, at best, a very superficial understanding of a
modern economic system. One must be very careful in critically evaluating the
assumptions that underpin an economic model, and the agenda of those who propose a
particular mode of analysis. Economics, is not pure science, and it is not value free as
many would lead you to believe.
Distributive Acquisition
The Place of Science in Modern Civilization and Other Essays, Thorstein Veblen,
New York: Memo, 1919, p. 183.
. . . The normal economic community, upon which theoretical interest has converged,
is a business community, which centers about the market, and whose scheme of life
is a scheme of profit and loss. Even when some considerable attention is ostensibly
devoted to theories of consumption and production, in these systems of doctrine the
theories are constructed in terms of ownership, price and acquisition, and so reduce
themselves to doctrines of distributive acquisition. . . .
As one can see, Thorstein Veblen was very suspicious of economic theories of
the time as being little more that an apology for self-interest of the rich and powerful
posing as markets. However, Adam Smith was also suspicious of the real world
solutions of his time, to wit:
175
Liberty?
An Inquiry into the Nature and Causes of the Wealth of Nations. Adam Smith, New
York: Knopf Publishing, 1910, pp. 106-107.
Such are the inequalities in the whole of the advantages and disadvantages of
the different employments if labour and stock, which the defect of any of the three
requisites above mentioned must occasion, even where there is most perfect liberty.
But the policy of Europe, by not leaving things at perfect liberty, occasions other
inequalities of much greater importance.
It does this chiefly in the three following ways. First by restraining the
competition in some employments to a smaller number than would otherwise be
disposed to enter into them; secondly by increasing it in others beyond what it
naturally would be; and, thirdly, by obstructing the free circulation of labour and stock
both from employment to employment and from place to place.
Adam Smith suspicious of the motivations of businessmen, and craftsmen in the

pursuit of their own self-interest. He witnessed the monopolization of many markets in
Scotland and in England, and he had also been the Director of the world’s largest
monopoly of the time the East India Company. Adam Smith, therefore, had first hand
experience with the early beginnings of monopoly and knew their potential for evil.
Smith was not only an advocate of competition, but knew that competition is what
provided the consumer with alternatives in the marketplace, and hence an ability to
choose among various suppliers. It is this consumer ability to choose, that motivated
Smith’s view that capitalism would produce socially beneficial results – and monopoly
power is a threat to those results. (Hence the invisible hand)
KEY CONCEPTS
Market Structures
Pure Competition
Pure Monopoly
Oligopoly
Monopolistic Competition
Industry v. Firm
Profit Maximizing Rule
MC = MR
Economic v. Normal profits
176
Shut down analysis
Problems with competition

income equity
market failures
limitations on choice
Smith’s Invisible Hand

Consumer choice
STUDY GUIDE
Food for Thought:
Outline and critically evaluation the assumptions underpinning the purely competitive
model.
Why is the profit maximizing (loss minimizing) point where Marginal Cost equals
Marginal Revenue? Explain, fully.
Draw each of the following cases of the firm in pure competition: (1) long-run profit
maximizing, (2) short-run, economic profit, (3) short-run, economic loss, and (4) shut
down point.
177
Sample Questions:
Multiple Choice:
A purely competitive firm’s short-run supply curve it its marginal cost curve, for all:
A. Quantities of output
B. Output where marginal cost exceeds minimum average total cost
C. Output where marginal cost exceeds minimum average fixed cost
D. Output where marginal cost exceeds minimum average total cost
If all of the firms producing a commodity in a purely competitive market are required to
adopt antipollution devices that increase their costs of production (even though it cleans
up the air), one would expect:
A. The demand for the product to decrease

B. The market supply curve to shift to the left
C. The long-run economic profits of the individual firms to decrease
D. The short-run economic profits of the individual firms to decrease
True - False
If all industries within an economy were pure competitors, the economy would be
economically efficient. {TRUE}
Oligopoly is an industry with a large number of suppliers, but few buyers. {FALSE}
178
CHAPTER 9
Pure Monopoly
The purpose of this chapter is to examine the pure monopoly model in the
product market. Because monopolies are price givers, there are significant differences
between monopolies and competitive firms, these differences will be examined in details
in this chapter. Once the monopoly model is mastered, it will be critically evaluated.
Further, the rate regulation of monopolies will be examined and critically evaluated.
The Assumptions of Monopoly Revisited
The assumptions upon which the monopoly model is based were presented in
Chapter 8. However, a quick review of those assumptions is worthwhile here. The
assumptions of the monopoly model are:
(1) there is a single seller (or a few sellers who collude, hence a cartel),
(2) the single seller offers a unique product,
(3) entry and generally exit are blocked,
(4) there is non-price competition, and
(5) the monopolist dictates price in the market.
As will become quickly apparent, the differences in the assumptions that

underpin the monopoly and purely competitive models make for very different analyses.
Further, the difference in assumptions also creates substantially different results in
price and output between the two models.
The Monopoly Model
In the purely competitive analysis, there were two different models, one model for
the industry, in which the interaction of supply and demand established the market price
and quantity. The second model was that of the firm, the firm faced a perfectly elastic
demand curve, in which demand, price, average revenue and marginal revenue were all
the same. However, in the analysis of a monopoly there is but one model. The firm, in
monopoly, is the industry (by definition). Because the firm is the industry it therefore
179
faces a downward sloping demand curve, which is also the average revenue curve for
the firm (hence the industry).
If the firm wants to sell more it must lower its price therefore marginal revenue is also
downward sloping, but has twice the slope of the demand curve. Remember when you
lower price the average revenue falls, but not as fast as the marginal, and if the average
revenue is a linear (as it is here, which is smooth, and continuously differentiable) the
there is a necessary relationship between the slope of the average and marginal
functions.
Price
El
as
ti c
Ra
ng
e
In
ela
st i
cR
an
ge
Marginal Demand
Revenue
Quantity
The point where the marginal revenue curve intersects the quantity axis is of
significance; this point is where total revenue is maximized. Further, the point on the
demand curve associated with where MR = Q is the point on the demand curve of unit
price elastic demand; to the left along the demand curve is the elastic range, and to the
right is the inelastic range (see Chapter 5 for a review of the relation between marginal
revenue and price elasticity of demand).
Unlike the purely competitive model here is no supply curve in an industry which
is a monopoly. The monopolist decides how much to produce using the profit
maximizing rule; or where MC = MR. In this sense, the monopolist is a price dictator,
in that it is the cost structure, together with the change in total revenue with respect to
change in quantity sold that directs the monopolist’s pricing behavior, rather than the
interaction of the monopolist’s supply schedule, with the demand schedule of
consumers (demand curve). With this information we can discover more about the
monopoly model.
A monopolist can make an economic profit. An economic profit is that margin

above average cost which is in excess of that necessary to cover the next best
alternative allocation of the firm’s assets. As you recall from Chapter 8, in pure
180
competition if there is an economic profit, that profit is a signal to other assets to enter
the market. Because there are no barriers to entry into a purely competitive industry,
the supply curve increase (shifts right) as these newly attracted resources enter the
market – hence driving down the market price in the industry, and eliminating the
economic profit.
One of the objections to pure monopoly is that there is closed entry. A

monopolist making an economic profit can do so as long as the cost and revenue
structure permit, perhaps permanently. The self-correcting advantages from pure
competition are lost because of these barriers to entry.
Price
Pe MC
Economic ATC
Profit
MR
Qe Quantity
The above diagram shows the economic profits that can be maintained in the long run
because of the barriers to entry into this industry. The monopolist produces where MC
= MR (where MC intersects MR), but the price charged is all the market will bear, that
is, the price on the demand curve that is immediately above the intersection of MC =
MR. The rectangle mapped out by the ATC, the indicator over the price index, the
origin, and Qm are the total costs, the rectangle mapped out by the demand curve, QM,
the origin, and Pm is the total revenue, and the difference between these rectangles is
economic profits.
On the other hand, there is nothing in the analysis that requires any given
monopolist will be profitable. In fact, a monopolist can operate at an economic loss, the
same as a competitive firm can.
The following diagram shows a monopolist that is unfortunate enough to be

operating at an economic loss.
181
Price MC
ATC
Economic Loss AVC
Pe
MR
Qe Quantity
This monopolist is making an economic loss. The ATC is above the demand
curve (AR) at where MC = MR (the loss is the labeled rectangle). However, because
AVC is below the demand curve at where MC = MR the firm will not shut down so as to
minimize its losses. The firm can pay back a portion of its fixed costs by continuing to
operate at this level because the AVC is still below the demand curve. As you will
remember from the discussion in Chapter 8, when AVC is above the demand curve the
firm should shut down to prevent throwing good money after bad.
The Effects of Monopoly
There are several implications of the monopoly model; many of which lead to
criticisms of monopoly on issues of both technical and allocative efficiency. The prices
and output determined in the monopoly are not consistent with allocative efficiency
criteria. In monopoly there are too many resources allocated to production of this
product, for which we receive too little output as illustrated by comparison with the
competitive solution, the dotted line (discussed below). Consequently, because of the
barriers to entry, the price for this product is too high – hence allocatively inefficient.
Consider the following diagram of a pure monopoly making an economic profit, in

this case:
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Price
Pm MC
Economic ATC
Profit
Pc
MR
Qm Qc Quantity
The above graph shows the profit maximizing monopolist, Pm is the price the
monopoly commands in this market and Qm is the quantity exchanged in this market.
However, where MC = D is where a perfectly competitive industry produces and this is
associated with Pc and Qc. The monopolist therefore produces less and charges more
than a purely competitive industry.
A monopolist can also segment a market and engage in price discrimination.

Price discrimination is where you charge a different price to different customers
depending on their price elasticity of demand. Because the consumer has no
alternative source of supply price discrimination can be effective. This practice
enhances the allocative inefficiency. When a consumer must pay more for a product,
simply because of the monopoly power in the market, less of the consumers’ incomes
are available to purchase other commodities. The end result is even more resources
flow into the monopolist’s coffers, and out of other industries – hence even more
inefficient allocations of productive resources.
This does not mean that monopolists are pure evil – in an economic sense.
Sometimes a monopolist is in the best interests of society (besides the natural
monopoly situation). Often a company must expend substantial resources on research
and development (i.e., pharmaceutical firms). If these types of firms were forced to
permit free use of their technological developments (hence no monopoly power) then
the economic incentive to develop new technology and products would be eliminated –
hence economic irrationality would have to prevail for the technological progress we
have come to expect in the beginning of the twenty-first century.
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Regulated Monopoly
Because there are natural monopoly market situations it is in the public interest
to permit monopolies, but traditionally in the United States they are regulated with
respect to price. The purpose of the rate regulation was to ensure that the public would
not suffer price gouging as a result of the monopoly position of the firms. Examples of
regulated natural monopolies are electric utilities, cable TV companies, and telephone
companies (local).
Throughout the 1980s and 1990s, up through 2002, there was substantial
deregulation of the power industry, cable TV industry, and telecom. In the 1980s ATT
was broken-up into several local telecom companies, i.e., Verizon, Southwestern Bell,
Ameritech, and US West, among other, the long lines company (ATT) and Bell Labs
(Lucent). The idea was to permit competition in long distance and local service. What
happened was far different. The local providers had much invested in microwave
towers, switches, and telephone lines – there would be charges permitted for the use of
these assets by competitors, and what resulted was poorer service, at higher prices in
most areas. In the summer of 2001, California consumers got a taste of what Enron
could do in selling power to local public utilities. Consumers were victims of
unscrupulous business practices that resulted in billions of dollars in overcharges that
cannot be recovered.
The problem with regulating the prices that monopolists can charge is that there
are several competing goals that can be accomplished through rate regulation. If
allocative efficiency is the goal, then the monopolist should be constrained to charge a
price where MC = D or the social optimum. If technical efficiency is the goal then
some argue that the monopolist’s minimum total cost should be the basis for the rate
regulation. If we are concerned about consistently and reliably having the product of the
monopolist available, at a reasonable price, then it might be more sensible to regulate
the monopolist to charge a price at where ATC = D, or the fair rate of return. So
regulatory agencies have alternatives as to where to regulate any monopolists within
their jurisdiction. The potential prices at which a monopolist could be regulated,
and the potential results of those price levels, is called the dilemma or regulation.
This dilemma has presented the opportunity for considerable debate about whether
rate regulation is appropriate, and if so, what sorts of regulation should occur.
Consider the following diagram, this is a monopolist that is being regulated at the
social optimum (MC = D):
184
Price
MC
ATC
Pr
MR
Qr Quantity
This firm is being regulated at the social optimum, in other words, what the
industry would produce if it were a purely competitive industry. The price it is required
to charge is also the competitive solution. However, notice the ATC is below the
demand curve at the social optimum which means this firm is making an economic
profit. It is also possible with this solution that the firm could be making an economic
loss (if ATC is above demand) or even shut down (if AVC is above demand).
Consider the following diagram of a monopolist that is being regulated at the fair
rate of return:
Price
MC
ATC
Pr
D
MR
Qr Quantity
The fair rate of return enforces a normal profit because the firm must price its
output and produce where ATC is equal to demand. This eliminates economic profits
and the risk of loss or of even putting the monopolist out of business. Virtually every
185
state public utility commission relies on this model to regulate their electric companies
and other public utilities.
Regulation and It’s Problems
Regulation is not a panacea. There are problems with rate regulation. In our
litigious society, the legal proceedings involved in rate regulation are not inexpensive for
any of the parties involved, the state, public interest groups, and the firm. Because of
the closeness of the legal advocates, economists, and others involved in the litigation of
rate cases, there has been accusations that the public utility commissions have been
over-taken by the industries they regulate. The capture theory of regulation is that
the retired executives, and economists and lawyers who have made their mark
defending utilities have been appointed to public utility commissions, thereby
allowing the utilities to regulate themselves. While there have been instances
where conflicts of interest have been noted, this “capture theory of regulation” probably
overstates the relations between the industries regulated and the public utility
commissions in most jurisdictions.
Rate regulation using invested capital as the rate base cause an incentive for
firms to over-capitalize and not to be sensitive to variable costs of production. This is
called the Averch-Johnson Effect. Electric companies, and other utilities are permitted
to earn a rate of return only on invested capital. Therefore, given a choice, the utilities
will invest in expensive (sometimes overly-expensive) capital to maximize the base
upon which they can earn a rate of return. By using too much capital and not enough
variable factors, there firms are generally technologically inefficient, and thereby also
allocatively inefficient.
In the management literature there is come discussion of “organizational slack.”

Organization slack is simply excess capacity in the organization, and it is often touted
as giving management flexibility. However, economists have observed the same
inefficienies, with different conclusions. X-efficiency is where the firm's costs are
more than the minimum possible costs for producing the output. Electric
companies over-capitalize and use excess capital to avoid labor and fuel expenditures
(which are generally much cheaper than the additional capital) - nuclear generating
plants are a good example of this of this type of planned inefficiency. However, there is
another issue with public utilities and x-efficiency. Electricity is not something that is
easily stored, and therefore the relevant demand for electricity is the peak demand on
the system.
Because public utilities must plan for peak load demands on the system, most of
the time electric companies are operating at some fraction of total capacity. To smooth
this peak out and make more consistent use of “slack” electric utilities, particularly in
Europe, price their power at different rates taking into consideration the peaks and
troughs in demand – higher rates in the peak times, lower rates in the troughs. This is
186
referred to as peak load pricing.
Monopoly
Essentials of Economic Theory. John Bates Clark, New York: Macmillan Publishing
Company, 1907, pp. 375-77.
. . . No description could exaggerate the evil which is in store for a society given
hopelessly over to a regime of private monopoly. Under this comprehensive name
we shall group the most important of the agencies which not merely resist, but
positively vitiate, the action of natural economic law. Monopoly checks progress in
production and infuses into distribution an element of robbery. It perverts the forces
which tend to secure to individuals all that they produce. It makes prices and wages
abnormal and distorts the form of the industrial mechanism . . . Prices do not conform
to the standards of cost, wages do not conform to the standard of final productivity of
labor, and interest does not conform to the marginal product of capital. The system
of industrial groups and sub-groups is thrown out of balance by putting too much
labor and capital at certain points and too little at others. Profits become, not
altogether a temporary premium for improvement, – reward for giving to humanity a
dynamic impulse, – but partly the spoils of men whose influence is hostile to
progress.
187
APPENDIX TO CHAPTER 9
STATUTORY PROVISIONS AND GUIDELINES

OF THE ANTITRUST DIVISION1
Sherman Antitrust Act, 15 U.S.C. §§ 1-7
§ 1 Sherman Act, 15 U.S.C. § 1
Trusts, etc., in restraint of trade illegal; penalty
Every contract, combination in the form of trust or otherwise, or conspiracy, in

restraint of trade or commerce among the several States, or with foreign nations, is
declared to be illegal. Every person who shall make any contract or engage in any
combination or conspiracy hereby declared to be illegal shall be deemed guilty of a
felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000
if a corporation, or, if any other person, $350,000, or by imprisonment not exceeding
three years, or by both said punishments, in the discretion of the court.
Monopolizing trade a felony; penalty
Every person who shall monopolize, or attempt to monopolize, or combine or

conspire with any other person or persons, to monopolize any part of the trade or
commerce among the several States, or with foreign nations, shall be deemed guilty of
a felony, and, on conviction thereof, shall be punished by fine not exceeding
$10,000,000 if a corporation, or, if any other person, $350,000, or by imprisonment not
exceeding three years, or by both said punishments, in the discretion of the court.
Trusts in Territories or District of Columbia illegal; combination a felony
Every contract, combination in form of trust or otherwise, or conspiracy, in

restraint of trade or commerce in any Territory of the United States or of the District of
Columbia, or in restraint of trade or commerce between any such Territory and another,
or between any such Territory or Territories and any State or States or the District of
Columbia, or with foreign nations, or between the District of Columbia and any State or
States or foreign nations, is declared illegal. Every person who shall make any such
contract or engage in any such combination or conspiracy, shall be deemed guilty of a
felony, and, on conviction thereof, shall be punished by fine not exceeding $10,000,000
1
Statutory material is current as of January 1997.
188
if a corporation, or, if any other person, $350,000, or by imprisonment not exceeding
three years, or by both said punishments, in the discretion of the court.
Jurisdiction of courts; duty of United States attorneys; procedure
The several district courts of the United States are invested with jurisdiction to
prevent and restrain violations of sections 1 to 7 of this title; and it shall be the duty of
the several United States attorneys, in their respective districts, under the direction of
the Attorney General, to institute proceedings in equity to prevent and restrain such
violations. Such proceedings may be by way of petition setting forth the case and
praying that such violation shall be enjoined or otherwise prohibited. When the parties
complained of shall have been duly notified of such petition the court shall proceed, as
soon as may be, to the hearing and determination of the case; and pending such
petition and before final decree, the court may at any time make such temporary
restraining order or prohibition as shall be deemed just in the premises.
Bringing in additional parties
Whenever it shall appear to the court before which any proceeding under section
4 of this title may be pending, that the ends of justice require that other parties should
be brought before the court, the court may cause them to be summoned, whether they
reside in the district in which the court is held or not; and subpoenas to that end may be
served in any district by the marshal thereof.
Forfeiture of property in transit
Any property owned under any contract or by any combination, or pursuant to

any conspiracy (and being the subject thereof) mentioned in section 1 of this title, and
being in the course of transportation from one State to another, or to a foreign country,
shall be forfeited to the United States, and may be seized and condemned by like
proceedings as those provided by law for the forfeiture, seizure, and condemnation of
property imported into the United States contrary to law.
§ 7 Sherman Act, 15 U.S.C. § 6a (Foreign Trade Antitrust Improvements Act of 1982)
Conduct involving trade or commerce with foreign nations
Sections 1 to 7 of this title shall not apply to conduct involving trade or commerce
(other than import trade or import commerce) with foreign nations unless--
(1) such conduct has a direct, substantial, and reasonably foreseeable effect--
189
(A) on trade or commerce which is not trade or commerce with foreign nations, or
on import trade or import commerce with foreign nations; or
(B) on export trade or export commerce with foreign nations, of a person
engaged in such trade or commerce in the United States; and
(2) such effect gives rise to a claim under the provisions of sections 1 to 7 of this
title, other than this section.
If sections 1 to 7 of this title apply to such conduct only because of the operation of
paragraph (1) (B), then sections 1 to 7 of this title shall apply to such conduct only for
injury to export business in the United States.
"Person" or "persons" defined
The word "person", or "persons", wherever used in sections 1 to 7 of this title

shall be deemed to include corporations and associations existing under or authorized
by the laws of either the United States, the laws of any of the Territories, the laws of any
State, or the laws of any foreign country.
KEY CONCEPTS
Monopoly
Economic Profits
Comparisons with pure competition
Economic efficiency induced by monopoly
Rate Regulation
Social Optimum
Fair Rate of Return
Proce Discrimination
Averch-Johnson Effect
Dilemma of Regulation
X-efficiency
Sherman Antitrust Act
190
Study Guide
Food for Thought:
Compare and contrast the monopoly model with the purely competitive model.
Critically evaluate the social optimum and fair rate of return theories of rate regulation of
monopolies.
Develop and explain the monopoly model, showing an economic profit, a normal profit,
and an economic loss. Can there be maintained in the long-run? Explain.
Sample Questions:
Multiple Choice:
An unregulated monopolist when compared with a purely competitive industry will:
A. Produce more, and charge more

B. Produce more, and charge less
C. Produce less, and charge more
D. Produce less, and charge less
Which of the following statements is true of an unregulated monopolist?
A. Price is less than marginal cost

B. Price is more than average revenue
C. Price is more than marginal revenue
D. Price is set where the monopolist chooses regardless of cost
191
True - False
Society would be unambiguously better-off without monopolists. {FALSE}
A monopolist can maintain an economic profits in the long-run, because there are
substantial barriers to entry into its markets. {TRUE}
192
Chapter 10
Resource Markets
To this point the discussion of markets has focused on product markets. The
purpose of this chapter is to examine the other set of markets identified in the circular
flow diagram – factor markets. The markets to be examined in this chapter are those
where firms purchase productive resources (in other words, factors of production).
Resource Market Complications
Over the course of modern American economic history there have been market
failures, serious social problems, and other difficulties that have resulted in certain
resource markets becoming heavily regulated. In particular, capital and labor markets
have been the focus of substantial regulation.
2001 was the beginning of one series of accounting and brokerage scandals
after another. Many of these scandals were from conflicts of interest, resulting in 2003
beginning to witness the regulation of financial markets in the U.S. The late 1990s
witnessed the abuse of managerial trust by high ranking executives in awarding
themselves very high compensation levels, while laying-off productive employees, and
cutting wages and benefits for those who performed the work of the organizations. By
2003 these abuses have not yet been addressed by re-regulation, but as these
becoming increasing problematic re-regulation will occur.
The United States seems to go through cycles where regulation and de-
regulation ebb and flow. Resultant depressions and recessions, give way to more
active government involvement in factor markets, and as things seemingly progress
political pressure for de-regulation and the results of that political pressure set the stage
for another round of economic difficulties. If history is instructive then market ups and
downs are the natural order of things in a mixed economy.
Because labor (human beings as a factor of production) and private property are
involved in resource markets there tends to be more controversy concerning these
markets than is true of normal product markets. However, this controversy also serves
to make resource market extremely interesting.
193
Resources
Head to Head, Lester Thurow, New York: William Morrow and Company, Inc., 1992,
p. 40.
Historians trace much of America’s economic success to cheap, plentiful, well-

located raw materials and farm land. America did not become rich because it worked
harder or saved more than its neighbors. A small population lived in a very large,
resource-rich environment. Natural resources were combined with the first
compulsory public K-12 education system and the first system of mass higher
education in the world. Together they gave America an economic edge. While
Americans may not have worked harder, they were better skilled and worked
smarter. Once rich, America also found it easy to stay rich.
New technologies and new institutions are combining to substantially alter

these four traditional sources of competitive advantage. Natural resources
essentially drop out of the competitive equation. Being born rich becomes much less
of an advantage that it used to be. Technology get turned upside down. New
product technologies become secondary; new process technologies become primary.
And in the twenty-first century, the education and skills of the work force will end up
being the dominant competitive weapon.
Derived Demand
The demand for all productive resources is a derived demand. By derived

demand it is meant that it is the output of the resource and not the resource itself
for which there is a demand by its employer. In other words, the demand for any
factor of production is the schedule of the value of its marginal productivity.
The marginal product (MP) of a productive resource is the change in total output
where ▵TP (▵ means change) attributable to the employment of one more unit of that
productive resource ▵L, in this case change in labor.
marginal product is MP = ▵TP/▵L where L is units of labor, (or K for capital,

etc.)
The marginal revenue product of labor (MRP labor) is MRP labor = ▵TR/▵L
where ▵TR is the change in total revenue attributable to the employment of one more
193
unit of that resource:
MRP = ▵TR/▵L
The demand for a productive resource comes from the business sector and the
supply of that productive resource comes from the households (see Chapter 3). This is
exactly the opposite of what happens in the product market, where consumers are from
the households and the suppliers are from the business sector.
Because the demand for a productive resource is a derived demand, the demand
schedule for that productive resource is simply the MRP schedule for that resource by
the firm. The following diagram presents a demand curve (MRP schedule) for a
productive resource. Notice, if you will, this demand schedule is downward sloping and
is therefore for an industry is pure competition.
Resource
Price
D = MRP
Quantity of Resource
The determinants of resource demand are:
(1) productivity of that specific resource,
(2) quality of resource (i.e., education, etc.), and
(3) the technology in which the resource will be employed.
194
As with product markets as the price of the resource changes so does the
quantity demanded, that is, that causes shifts along the demand curve. If, on the other
hand, a change in one of the non-price determinants of demand occurs then the
demand curve will shift either left (decrease) or right (increase). If the productivity of a
resource increases so too will its demand. Likewise if the quality of the resource
declines, so too will its demand. If a change in technology occurs that requires less of a
particular resource, the demand for that resource will also decline.
The non-price determinants of supply are pretty much factor of production

specific. The supply of labor depends are several issues, but is basically the willingness
and ability of persons to work, these issues are among the topics of labor economics
(E340). The supply of capital depends on several issues, such as investor expectations
and the life of plant and equipment, capital supply is dealt with in greater detail in
finance (F301).
The determinants of resource price elasticity are:
(1) the rate of decline of MRP,
(2) the ease of resource substitutability,
(3) elasticity of product demand, and
(4) capital-labor ratios for the specific firm.
The greater the rate of decline of the MRP schedule the more inelastic the
demand for the factor production, and the lesser the rate of the decline in MRP the more
elastic the demand for the factor. If it is difficult to substitute one factor for another the
demand will be relatively inelastic for the factor with few substitutes. The more price
elastic the demand for the product, the more elastic will be the demand for the factor of
production, and the more inelastic the demand for the product, the more inelastic will be
the demand for the factor of production. Capital-labor ratios concern the technology
used by the firm. The more intensely a factor is used the more inelastic its demand, all
other things equal, and the less intensely the factor is used in a given technology the
elastic the demand for the factor.
The supply side of the market is the marginal resource cost side of the market.
Marginal resource cost (MRC) is the amount that the addition of one more unit of a
productive resource (▵L) adds to total resource costs (▵TC), which is:
195
MRC = ▵TRC/▵L
The supply curve of a factor production in a purely competitive market is simply
the MRC curve for that factor. In general, the industry supply curve for a factor of
production is upward sloping just like the supply curve in a purely competitive product
market.
The profit maximizing employment of resources is where MRP = MRC, where

MRC is the supply curve of the resource in a purely competitive resource market and
MRP is the demand curve for a purely competitive resource market. Consider the
following diagram:
Resource Supply = MRC

Price
Demand = MRP
Q Quantity of Resource
The equilibrium resource price and the quantity of the resource employed is
determined by the intersection of the supply curve (MRC) and the demand curve (MRP).
This equilibrium is similar to that found in the product market. Unless one of the non-
price determinants of demand or supply change neither the supply nor demand curves
will shift. Further, if there is a change in price, then all that happens is a movement
along the curve, i.e., a change in the quantity demanded or a change in the quantity
supplied of this factor of production.
Least Cost Combination of Resources and Technology
Marginal analysis also lends insight into the best technology that can be
employed. Best, in this case, being judged by the most technologically efficient. The
least cost combination of all productive resources is determined by hiring resources to
the point where the ratio of MRP to MRC is equal to one for all resources.
196
MRP /MRC labor labor = MRP /MRC
capital capital = ... = MRP /MRC
land land =1
If the ratio of MRP to MRC for a productive resource is greater than one, then
you have hired too little of that productive factor. Hiring more of that factor results in
moving down the MRP curve and up the MRC curve until you reach the equilibrium level
of employment. If the MRP to MRC ratio is less than one, then you have hired too much
of that productive factor. Hiring less of that factor results in moving down the MRP
curve and up the MRC curve until you reach the equilibrium level of employment. See
the following diagram:
The equilibrium level employment is identified as Qe and the equilibrium price

level is Pe in the above diagram. The dashed line to the left of the equilibrium identifies
the “too little level of employment” and the need to move up the MRP and down the
MRC to arrive at an equilibrium price for this factor. The dashed line to the right
identifies the “too much level of employment” and the need to move down the MRP and
up the MRC to arrive at an equilibrium price for this factor or production.
Marginal Productivity Theory of Income Distribution
Price MRC=supply
Pe
MRP=demand
Quantity of
Too little Qe Too Much Resource
Economic freedom (see Chapter 1, economic goals) has both positive and
negative implications. During the 1980s and most of the 1990s, the average worker in
the United States has experienced a decline in real wages, which results in a lowering
197
of the standard of living. At the same time executive salaries and entertainers’ incomes
have enjoyed historically high levels. The distribution of income in this country critically
depends on the factor markets and when those factor markets are encumbered by
serious market imperfections there is inefficiency that results in people losing what they
earn (exploitation in the factor market) and people obtaining income they did not earn
(economic rents in the form of stock options, salaries, etc.)
The marginal productivity of resource markets has important implications for

economic welfare. In a world of purely competitive markets any observed inequality in
income arises simply because of differences in the productivity of different resources
and the value of the product that resource produces. However, in a world with both
purely competitive markets and monopoly power in some product and factor markets we
will observe misallocations of resources as discussed in the monopoly chapter, and in
the following chapter. The monopolist charges too much and produces too little,
resulting in higher consumer prices and depressed wages in the factor markets for other
businesses. Both results have negative implications for allocative efficiency and for
workers who may be disadvantaged by such markets.
Employers can exercise substantial monopoly power in the factor markets, and
often do. Where there is one employer or a small number of employers, especially
when they collude to depress wages, this has the effect of giving the employer an
exploitable market imperfection that has negative implications for allocative efficiency
and any workers caught in such a market. This market power resulting from the
described imperfection is called monopsony. Monopsony is one buyer of a resource
(or product) and cause factor payments (or prices) to be below the competitive
equilibrium.
Monopoly power in the product market will also impact the factor markets.
Remember that the derived demand for a factor of production arises because the MRP
schedule facing an employer is the demand curve for a factor of production. MRP is the
change in total revenue due to the employment of one more unit of a resource. If the
product is over-priced because it is sold in a monopolized market, then the MRP for that
factor is too high. This results in some goods and services being over-valued and the
factors that produce them being paid too much.
Professional athletes are a prime example of this exercise of monopoly power.

Professional sports franchises are exempted from the anti-trust laws in the United
States, but they are textbook examples of monopolies. The end result is that their
products have become very much 0ver-priced and because their industry is highly labor
intensive, the professional athletes are paid a large multiple of their true MRPs. Worse
yet, this misallocation of resources results in consumers paying too much for tickets to
sporting events, and too much for the products the athletes endorse in advertising. The
allocation of resources to this industry also has a depressing effect on wages in other
industries (after all there are limited resources).
198
KEY CONCEPTS
Derived Demand
Marginal Product, Marginal Physical Product
Marginal Revenue Product, Resource Demand

Determinants
Productivity
Quality of Resource
Technology
Elasticity Determinants
Rate of Decline of MRP
Ease of Resource Substitutability
Elasticity of Product Demand
K/L Ratios
Marginal Resource Cost, Resource Supply
Least Cost Combination of Resources

Technology
Marginal Productivity Theory of Income Distribution

Monopoly power
Monopsony in the resource market
STUDY GUIDE
Food for Thought:
Fully explain the profit maximizing rule for employing resources and the least cost
combination of resources rule.
Using the following data complete the following table and derive a demand curve for
labor (price of output is $2 per unit):
199
Workers Total Product Marginal Product MRP
1 22
2 42
3 60
4 76
5 90
6 102
7 112
8 120
9 126
Fully explain the concept of derived demand.
Illustrate a resource market and compare and contrast it with a product market.
Sample Questions:
Multiple Choice:
Which of the following is the decision rule to determine the optimal combination of
productive factors?
A. MRP = MRP = ... = MRP = 0

labor capital land
B. MRP = MRP = ... = MRP = 1

labor capital land
C. MRP /MRC = MRP /MRC = ... = MRP /MRC = 0

labor labor capital capital land land
D. MRP /MRC = MRP /MRC = ... = MRP /MRC = 1

An increase in the productivity of a factor of production will typically increase the

demand for that factor. Which of the following is associated with an increase in the
demand for a factor of production?
200
A. A person's acquisition of human capital
B. An increase in the price of a complementary factor
C. A decrease in the price of a factor of production that is a substitute for the factor
under consideration
D. All of the above will cause an increase in the demand for a factor of production
True-False:
Monopsony is one buyer of a commodity in the market. {TRUE}
The MRP slopes downward in an imperfectly competitive (resource) market serving an

imperfectly competitive product market because the MP diminishes and the price of the
output must be lowered to sell more. {TRUE}
201
CHAPTER 11
Wage Determination
This chapter is focused on the labor market. The model of the purely competitive
firm's labor market will be developed. Once the competitive model has been completed,
the model of a monopsony in the labor market will be developed. These models will be
used to analyze minimum wages and unionization.
Wages and Labor Supply
Labor cannot be separated from the human being who provides it. The result of
the inseparability of labor from the people who provide it, is that the wage for the last
hour worked must be equal to the utility lost from the use of that hour for leisure
activities (all other activities except work.) Further, because labor is provided by people
who are also consumers, the wage variable (the price of labor in a labor market) is
somewhat more complicated than prices in product markets.
Workers offer their services in the labor market for the standard of living that their
wages will provide for them and their households. Therefore, the nominal wage (money
wage) unadjusted for the cost of living; or W, means very little in determining the
quantity of labor supplied in a factor market. The relevant wage variable is the real wage
rate, which is the money wage (W) adjusted for the cost of living or price level (P); or
W/P.
In theory (in the competitive labor market) an employee should be paid what she
earns for the company. What the employee contributes to the revenues of the firm is
the marginal revenue product, MRP (the marginal physical product (MPP) times the
price of the product produced (P) – MRP = MPP x P). In a perfectly competitive world
this is what is supposed to happen. In a competitive labor market the wage is
determined in the industry. The firm faces a perfectly elastic supply of labor curve. The
equilibrium wage and level of employment is then determined by the intersection of the
factor's MRP with the factor's marginal resource cost, MRC.
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Firm Industry
Supply
W/P W/P
Supply = MRC
W W
Demand = MRP
Demand
Q Quantity Q Quantity
In this analysis of a firm in a perfectly competitively market, the supply and

demand curves for the industry are summations of the individual firms' respective
demand and supply curves. Notice that the firm faces a perfectly elastic supply of labor
curve, while the supply curve for the industry is upward sloping just like that observed in
the product markets.
Monopsony in the Labor Market (one buyer of labor)
Unfortunately, the real world is not one of perfectly competitive labor markets.
Factor markets are generally imperfect, and labor markets are generally monopsonies
or contain elements of monopsony power in the hands of employers. A monopsony is
one buyer of something. The monopsony model is based on the assumption that
there is one employer, or a group of employers that collude, they purchase standardized
labor, and the supply side of the market is competitive. Therefore, the monopsonist is a
price giver in this labor market. The result is that the employer has a pricing policy. If
the employer wishes to hire more labor he must raise the wage to attract the labor
necessary to obtain the labor required. Therefore the monopsonist faces an MRC that
is to the left of the supply curve and has twice the slope of the supply curve.
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MRC
W/P Supply
Wm
Demand = MRP
Qm Quantity of Labor
Notice, however, that the monopsonist does not have to pay the wage
associated with the MRC's intersection with the demand curve. The employer equates
MRC with MRP to determine the least cost level of employment and then imposes the
lowest wage the market will bear, that being the point on the supply curve associated
with the intersection of MRP and MRC. Also notice that the wage and employment
levels in the monopsony are much lower than that in a competitive labor market.
Control of Monopsony
It is clear that monopsony in the labor market is not consistent with allocative
efficiency and has the effect of withholding significant amounts the employees' MRP
from them, that becomes profits, advertising, charitable expenditures, or payments to
other factors that did not earn those payments. It is clear that such reallocations are
inconsistent with both equity and efficiency and have been the focus of numerous public
policies attempting to thwart such misallocations based purely on market power.
One approach to the control of monopsony has been the imposition of minimum
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wages. This approach is focused on controlling the worst effects of monopsony in the
sense of inequitable redistributions from the working poor to the firms. A minimum
wage does little to correct monopsony inefficiencies in all by the lowest paying
occupations.
What is interesting is that some economists argue that the minimum wage is a
source of unemployment and inefficiency. To prove their point they argue the minimum
wages' effects under the assumptions of a purely competitive labor market. Consider
the following diagram.
Supply = MRC
W/P
Minimum Wage
Pe
Demand = M
Qd Qe Qs Quantity of Lab
The minimum wage acts the same as an effective price floor in that it creates a
surplus of labor -- unemployment. The distance between Qd and Qe is the number of
workers who lost jobs, and the distance between Qe and Qs is the number of workers
attracted to this market that cannot find employment. This analysis is exactly correct
under these assumptions. However, remember the minimum wage was established to
offset market power possessed by employers whose wage policies worked to the
detriment of the working poor -- i.e., the monopsonist. To the extent that there may be
some labor markets that approximate a competitive labor markets, the minimum wage
creates unemployment. However, purely competitive markets, either product or factor,
exist only in the pages of textbooks.
If minimum wages are analyzed in the context of the monopsony model for which
the policy was intended the results obtained are far different than those of the
competitive model. This is an example of how an analysis that has been passed-off as
positive economics is really a normative model. If we assume competitive labor
markets, we are making a normative statement, because only imperfectly competitive
markets can be described in the real world.
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MRC
W/P Supply
Minimum
Wm
Demand = MRC
Qm Quantity of Labor
In a monopsony, the wage increases with the establishment of a minimum wage,

but if the employer is rationale so too does the employment level as the employer slide
back up the supply curve towards the competitive equilibrium. In the monopsony model
there are no negative employment effects of the minimum wage unless it is established
above the intersection of MRC with MRP.
What the employment effects of the minimum wage are is an empirical question.
Most of the research done concerning minimum wage effects have focused on the
hospitality industry, in particular fast-food restaurants. This is one of the lowest paying
industries in the U.S. economy and most recent research findings suggest either no
employment effects or marginal positive gains in employment associated with the
minimum wage. However, most of this research suffers from significant data problems.
Earlier studies in a broader range of industries have generally found no employment
effects, and the few studies where the data were competently gathered tend to confirm
the monopsony power that requires market intervention.
In most industrialized countries the approach to controlling monopsony power

has been to establish collective bargaining or co-determination as a matter of public
policy and to provide legislation protecting organizational and collective bargaining
rights for workers. Unions have the potential of being an effective response to restore
allocative efficiency in the case of monopsony in the labor market. The Harvard
Business School studies published recently indicate that unions effects in the U.S. have
been to restore much of the efficiency lost due to monopsony.
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Unions in a Competitive Market
Again, there a group of economists who will rely on the use of the competitive
model to illustrate the evils of unionization. The most common analyses are to sub-
divide unions into two classes, craft and industrial unions and show their effects in an
otherwise competitive industry.
A craft union is one that was AFL affiliated (before the AFL-CIO merger in 1956),
organizes one skill class of employees (i.e., IBEW) and is termed an exclusive union.
Consider the following diagram.
Union Target Supply

W/P Supply = MRC
Demand = MRP
Quantity of Labor
Craft unions could control the supply of labor somewhat because of the fact that
they represented primarily skilled employees and had control of the apprentice
programs and the standards for achieving journeyman status. Because unions are the
ones that train the skilled labor it is presumed that they can restrict the supply of labor
within their craft and drive up wages. This is true, if we are willing to assume that
unions could organize perfectly competitive industries.
An industrial union is one that was a CIO affiliate (before the AFL-CIO merger in
1956), organizes all skill classes within a firm (i.e., UAW), and is called an inclusive
union. An industrial union's bargaining power arises from what is called solidarity, its
ability to strike and withhold all labor from an employer (bearing in mind that a strike is
also a costly venture for a union). Again, consider the following model of an industrial
union in an otherwise competitive labor market.
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Supply
W/P
Wc
Demand = MRP
Qu Qc Quantity of Labor
The industrial union establishes the minimum acceptable wage to the workers it
represents, below which they will strike rather than work. This approach depends upon
solidarity among the work force to make the threat of a strike effective. Assuming, that
a strike can be effective within the legal and economic environments in which the union
and management operate.
The serious flaw in this analysis is the market model used to analyze unions
makes little sense. Perfectly competitive labor markets are used to illustrate the effects
of two different types of unions. If labor markets were competitive and there were not
market imperfections unions would likely not be an economic priority for workers.
However, unions are necessary in imperfectly competitive labor markets.
Further, it is interesting to note that the pure craft and pure industrial unions
virtually no longer exist. Originally, the International Brotherhood of Teamsters
represented primarily drivers and warehouse workers. Today, the Teamsters represent
a wide range of employees working in most occupations and industries in the U.S.
economy. Since the American Federation of Labor (AFL) and Congress of Industrial
Organizations (CIO) merged in the mid-1950s, the distinction between the pure craft
union has all but disappeared -- the exception are some locals of the traditionally
skilled-trades unions in the building trades (i.e., International Brotherhood of
Carpenters, International Brotherhood of Electrical Workers, the Bricklayers, the
Glaziers, and the Laborers International Union). Most unions today are more consistent
with the old model of industrial unions.
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Unions and Monopsony
Unions
The Theory of the Labor Movement (Selig Perlman, New York: Augustus M. Kelley,
Reprints of Economics Classics, 1970, [original published 1928] pp. 198-99.)
In the evolution of the psychology of the American wage earner, the fruition of
this "job and wage conscious" unionism and its eventual mastery of the whole field
meant a final and complete rupture with the old "producing classes" point of view,
which saw the road to economic democracy in a restoration to the individual, or to
intimately associated groups of individuals, of access to economic opportunity in
land, marketing, and credit; this opportunity once restored, competition alone would
suffice to preserve it all around. This philosophy, as already noted, had issued from
the typically American premise of an existing abundance of opportunity for every
industrious person, -- an abundance, however, which conspiring monopolists have
artificially converted into scarcity. The predominance of the "anti-monopoly" point of
view in the American labor movement down to this time actually denoted a mental
subordination of the wage earner to the farmer, a labor movement in the grip of a
rural ideology. In contrast, the ideology of the American Federation of Labor was
both an urban and a wage earner's ideology. It was based on a consciousness of
limited job opportunities, -- a situation which required that the individual, both in his
own interest and in that of a group to which he immediately belonged, should not be
permitted to occupy any job opportunity except on the condition of observing the
"common rule" laid down by his union. The safest way to assure this group control
over opportunity, though also a way so ideal that only a union as favored as the
printers' was able to actualize it entirely, -- was for the union, without displacing the
employer as the owner of his business and risk taker, to become the virtual owner
and administrator of the jobs. Where such an outright "ownership" of the jobs was
impossible, the union would seek, by collective bargaining with the employers, to
establish "rights" in the jobs, both for the individual and for the whole group, by
incorporating, in the trade agreement, regulations applying to overtime, to "equal
turn", to priority seniority in employment, to apprenticeship, and so forth. Thus the
industrial democracy envisaged by this unionism descended from Marxism was not a
democracy of individualistic producers exchanging products under free competition,
with the monopolist banished, but a highly integrated democracy of unionized
workers and of associated employer-managers, jointly conducting an industrial
government with "laws" mandatory upon the individual.
As with the minimum wage, the appropriate analysis is where there is a problem,
in the imperfect labor markets. If we assume a monopsony, rather than a perfectly
competitive market, we again arrive at a far different set of results. When a monopsony
exists, working conditions and compensation levels are allocatively inefficient resulting
in an employee's desire for a voice in their working conditions and a method to offset
the monopsony power that binds them to wages below the competitive equilibrium.
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These are the types of conditions that result in employees attempting to form unions for
purposes of collective bargaining. Not only in this country, but in Europe and Asia too,
where the industrialized nations have higher proportions of union organization.
The most common approach to monopsony control is to attempt to offset the

monopsony power of the employer by creating a countervailing power on the supply
side of the market. To offset monopsony power, unions attempt to approximate a
monopoly, which theoretically should neutralize the monopsony. This addition of a
monopoly on the supply side to a monopsony is called bilateral monopoly. The
MRC
Supply
W/P
Monopsonist
Monopolist
Pure Competition
Demand = MRP
MRP'
Quantity of Labor
following diagram shows a monopsony that has been confronted by a monopoly.
The bilateral monopoly model is rather complex. The employer (monopsonist)
will equate MRC with demand and attempt to pay a wage associated with that point on
the supply curve. The monopolist (union) will equate MRP' (MRP' occurs because now
the union also has a pricing policy and must lower price to sell more labor) with supply
and attempt extract a wage associated with that point on the demand curve. The
situation shown in this graph shows that the competitive wage is just about half-way
between what the union and what the employer would impose. The wage and
employment levels established in this type of situation is a function of the relative
bargaining power of the employer and union, therefore this model is indeterminant. The
theory is that if the union and employer have equal bargaining power, the results of their
collective bargaining should approximate the competitive labor market solution and
restore allocative efficiency in these markets.
The academic significance of the indeterminant nature of this model is the lack of
an ability to predict wages and employment levels is why industrial relations developed
as a separate field from economics (in large measure). In fact, marginal analysis has
210
not yet evolved to such an extent that it can successfully explain collective bargaining
results. Therefore, the mix of social sciences, jurisprudence, and marginal analysis
that marks modern industrial relations is because of the need to have greater
explanatory power than marginal analysis alone can provide.
The following box provides the language of Section 7 of the National Labor
Relations Act, which is commonly called the Employee Bill of Rights. This statute
applies to preponderance of private sector employees in the United States:
Employee Bill of Rights
Section 7, National Labor Relations Act – 49 Stat. 449 (1935) as amended
Employees shall have the right to self-organization, to form, join or assist labor
organizations, to bargain collectively through representatives of their own choosing,
and to engage in other concerted activities for the purpose of collective bargaining or
other mutual aid or protection, and shall also have the right to refrain from any or all
such activities except to the extent that such right may be affected by an agreement
requiring membership in a labor organization as a condition of employment as
authorized in section 8(a) (3).
Labor History
The United States has a labor history that is not a particularly bright spot in our
democratic traditions. Up to 1932 the U.S. government actively persecuted unions and
their members. The first labor law case in the U.S. involved cordwainers, and the
application of the criminal conspiracy doctrine to skilled workers Philadelphia
Cordwainers (1806). This British common law doctrine was applied to unions until
1842, when three things happened. First, the House of Commons outlawed the use of
this doctrine against unions in England. Second, in the United States a judicial decision
made it difficult to apply the doctrine to unions. In the Commonwealth v. Hunt (Mass.
Sup. Crt.) decision Chief Justice Shaw ruled that unions were not criminal
organizations, per se. He reasoned that if unionists were to be convicted of a criminal
conspiracy there would be evidence required to prove that the purposes of the union
were to violate some established criminal proscription. Third, employers discovered a
preventative, rather than curative measure. The use of an injunction prevented, rather
than prosecuted unions after they were already established and operating. Prevention
was to the employers advantage because remedies for unionization often occurred long
after the fact of a successful organizing campaign.
Injunctions are court orders that require someone to do something or to refrain

from doing something. An injunction can be issued only in the case where irreparable
211
damage will occur in its absence. The violation of an injunction is punishable as
contempt of court. The use of labor injunctions has a long, and sorted history in the
United States. Because jurists came from the propertied class they often permitted their
biases to interfere in the proper exercise of their obligations.
There are literally hundreds of examples of courts issuing injunctions interfering

with union activities without evidence in support of the employer's request, or where
evidence was clearly not competent, or where the injunction prohibited any and all union
activities (blanket injunctions). Frequently, unions and their representatives were not
given an opportunity to even be present in court when the petition for the injunction was
first heard (a temporary restraining order) and the restraining order was converted to a
permanent injunction without a hearing.
Perhaps, worse still, workers in the coal fields (and elsewhere) were often
required to sign "Yellow-dog" contracts before they were hired. The "Yellow-dog"
contract was an instrument where an employee agreed that they would neither join nor
associate themselves with unions (and if they did they by so doing resigned their
position with the company). Courts, particularly in southern and Midwestern states,
enforced these so-called contracts with injunctions. The Congress finally banded the
use of labor injunctions and made "Yellow-dog" contracts unenforceable in 1932 with
the passage of the Norris-LaGuardia Act.
In 1890, the American economy was being overrun by massive monopolies that
had become fairly anti-social. The Sherman Act was passed in 1890 to break the power
of these giant businesses or trusts. Unfortunately, the anti-trust laws were not brought
to bear against monopolies unless their conduct was totally unreasonable (i.e.,
Standard Oil, Amstar, American Tobacco). However, these anti-trust laws were
routinely used against organized labor to prevent or punish labor unions. In 1914, the
Congress passed amendment to the Sherman Act (Clayton Act) to remove judicial
interpretations that union could fall under the provisions of the Sherman Act. Again, the
courts ignored the law, and finally in 1932 these issues were not made subject to
judicial inquiry, unless a product market was effected or there was clear evidence of
union misconduct.
In 1932, the Congress enacted the first of the federal statutes designed to bring
reason to labor-management relations in the United States. The first law passed was
the Norris-LaGuardia Act and President Hoover (a conservative Republican) signed it
into law. This act outlawed the use of injunctions against unions, the requirement that
an employee sign a Yellow-Dog contract, and limited the use of the anti-trust laws
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(Title I, Section 1, National Labor Relations Act, as amended)
Findings and Policies
The denial by some employers of the right of employees to organize and the
refusal by some employers to accept the procedure of collective bargaining lead to
strikes and other forms of industrial strife or unrest, which have the intent or the
necessary effect of burdening or obstructing commerce by (a) impairing the
efficiency, safety, or operation of the instrumentalities of commerce; (b) occurring in
the current of commerce; (c) materially affecting, restraining, or controlling the flow of
raw materials or manufactured or processed goods in commerce; or (d) causing
diminution of employment and wages in such volume as substantially to impair or
disrupt the market for goods flowing from or into the channels of commerce.
The inequality of bargaining power between employees who do not possess

full freedom of association or actual liberty of contract, and employers who are
organized in the corporate or other forms of ownership association substantially
burdens and affects the flow of commerce, and tends to aggravate recurrent
business depressions, by depressing wage rates and the purchasing power of wage
earners in industry and by preventing the stabilization of competitive wage rates and
working conditions within and between industries.
against unions. 1932-1935 was the only period in U.S. history that the government was
neutral towards unions.
In 1935, the National Labor Relations Act (N.L.R.A.) was passed making
collective bargaining the public policy of the United States. The N.L.R.A. was amended
several times. The major amendments occurred in 1947 (Taft-Hartley), 1959
(Landrum-Griffin), and the health care amendments of 1974. Until 1981, the federal
government fostered peaceful labor-management relations and enforced the provisions
of the N.L.R.A. in a more or less neutral way. Beginning in 1981 we returned to pre-
1932 days, without the violence.
The purposes of the N.L.R.A. was to foster peaceful labor-management relations

and to maintain a reasonable balance between the power of unions and management
so that society benefits. Yet, the politics involved in these matters have resulted in a
rather unpredictable body of labor law that seems to change with changes in U.S.
administrations. This is called the pendulum theory, Democrats seem to support
collective bargaining and pro-worker legislation, Republicans seem to support
management and government non-involvement (and there are notably exceptions to
political party or individual candidate association with one side or the other).
To foster peaceful labor-management relations there must be a balance of

bargaining power between unions and management. The theory behind the N.L.R.A.
213
was to permit free and equal negotiations to solve the monopsony problem in the
nation's labor markets. Because atomized competition could not be enforced without
substantial disruption to the economic system, the equalization of bargaining power was
thought to approximate the competitive solution in a manner similar to that
demonstrated by the bilateral monopoly model's results.
Of the world's industrialized nations, the United States has among the most
peaceful labor relations. Nations such as England, Italy, and France have far more
strikes and lost work time due to strikes than does the United States. Even Germany
and Japan generally experience more lost time due to strikes than does the United
States. However, compensation levels, and the extent of worker rights in the United
States, lags far behind most of the rest of the industrialized world. This situation seems
to be worsening over time. As Lester Thurow observes in his book, Head to Head, (pp.
204-06) the standard of living in the United States has steadily fallen since 1980. By
1988 the United States was eighth in the world in per capita purchasing power in the
global economy. As of the summer of 1995 the purchasing power of American family's
dollars had dropped out of the top ten among the world's industrialized nations (this is
strikingly similar to the 1920s).
Public sector employees have fared no better than private sector employees.
After a series of Federal Executive Orders extending collective bargaining rights to
employees and the Postal Reorganization Act extending the N.L.R.A. to postal
employees, the Congress passed the Civil Service Reform Act of 1974 which extending
bargaining right by statute. However, much of this was negated for several
classifications of Federal employees with the passage of the Homeland Security Act,
which once again placed certain Federal Employees in a position where they have no
statutory protection to organize and bargain.
State and local employee bargaining rights have some piece-meal. Thirty-eight
states have collective bargaining laws protecting state employees. Only the old
Confederate, and some poor western states, and Indiana do not have such statutes to
protect these bargaining rights.
Wage Differentials
Market structure alone does not account for all of the variations in wages and
employment. Market wage differentials arise from several other sources, including, (1)
the variations in geographic immobility within segments of the U.S. labor force,. (2) the
continuing racial and gender discrimination evident in the U.S. social fabric, and (3)
differences in productivity that arise from abilities of workers.
The abilities, skills, and characteristics of workers that add to their productivity is
called human capital. Abilities, personality, and other personal characteristics are a
214
portion of human capital -- many of these items are genetic, environmental, or a matter
of experience. Education, training, and the acquisition of skills are human capital that is
either developed or obtained. In general, it is hard to separate the sources of human
capital, however, most is probably acquired.
There are significant wage differentials to be observed by sector of the economy.

While some of this is explainable by human capital, and geographic region of the
country, much of this differential has to do with the value of the products the labor is
producing. Consider the following table:
Weekly Earnings - Bureau of Labor Statistics (in current dollars)
Year U.S. Economy Manufacturing Construction Retail Trade
1999 456.78 579.63 672.13 263.61

2000 474.72 597.79 702.68 273.39
2001 489.40 603.58 720.76 282.35
2002 505.13 625.77 732.16 297.26
2003(est) 513.47 635.66 751.29 297.44
The average weekly hours in the U.S. economy for calendar year 2002 was just
over 34 hours per week. These data do not include fringe benefits provided such as
health insurance, etc.
KEY CONCEPTS
Nominal v. Real Wages
Competitive Labor Market

Industry
Firm
Monopsony
Minimum Wages
In competition
In monopsony
Craft Unions
Industrial Unions
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Bilateral Monopoly
Wage Differentials
Geographic immobility
Discrimination
Productivity Differences
Human Capital
STUDY GUIDE
Food for Thought:
Compare and contrast the real with the nominal wage. Do these distinctions have any
bearing on motivation? Explain.
Develop the monopsony model and build in the union response to monopsony.
Develop the two models of unions in otherwise competitive labor markets. Critically
evaluate these models.
Outline and explain the theory of human capital and how it relates to labor earnings.
216
Sample Questions:
Multiple Choice:
A monopolist in an otherwise competitive labor market will cause (as compared with the
competitive labor market):
A. Employment to increase, wages to decrease

B. Employment to decrease, wages to decrease
C. Employment to increase, wages to increase
D. Employment to decrease, wages to increase
Which of the following best describes a union that organizes only a specific skill group,
relies on apprentice programs to influence the supply of labor and is often called an
exclusive union?
A. An industrial union
B. A CIO affiliate
C. A craft union
True -False:
Bilateral monopoly is an indeterminant model, which gave rise to a need for better
models to explain labor-management relations. {TRUE}
Human capital is concerned with the characteristics of labor that contribute to its
productivity. {TRUE}
217
CHAPTER 12
Epilogue to Principles of Microeconomics
Changing World
Throughout this course, the focus has been on standard microeconomic analysis.
However, the subject matter has been primarily focused on ideas that are, in the main,
at least vaguely familiar. With the controversies about outsourcing and about corporate
corruption, it should be clear that the world is changing rapidly. A stroll through almost
any retail establishment will also make clear that the U.S. economy is rapidly becoming
very internationalized. Before closing this course, it is necessary to make a few points
about this changing economic world.
Outsourcing
There are several issues involved in the outsourcing of production in the U.S.
economy. Outsourcing is an activity designed to cut the costs of production. This has
two significant implications. First, the costs of production decline, which normally
results in higher profit margins to the firm, with few implications for the pricing of the
output. Normally, when something is outsourced it is a method used to cut labor costs.
Perhaps one of the best examples of this outsourcing has been the movement to India
of much of the computer software industry and a significant part of customer services
for computer purveyors. This action was taken to cut costs, but that same cost cutting
has implications for consumer incomes.
Consumers, for the most part, in this country have the resources to consume
because they are also workers who earn a wage. In the principles of macroeconomics,
you will study something called Say=s Law. Say=s Law says that the value of output
produced is generally equal to the incomes earned in that production B hence just
enough to buy that output in a closed system. When outsourcing results in the loss of
income to workers, they consume less, in turn, reducing other people=s income, which
has the effect of further depressing incomes, and hence demand.
Clearly, and unambiguous, the interdependence (circular flow) that exists in a

modern economic system means that consumption and production costs are the
opposites sides of the same coin. What may be a good idea in terms of technical
efficiency may actually harm allocative efficiency and / or full employment.
218
Economics and Ethics
Morality and ethics are strong motivations to behavior. However, economists

assume that rationality is a function of demonstrable self-interest. That means, material
well-being B greed if you will. The acceleration of corporate scandals through the early
part of this century seems to suggest a disregard for issues other than material well-
being by many people who were in positions of authority in several major companies
(Enron, Worldcom, Tyco etc.) Self-interest when measured purely in dollars and cents
will often give rise to unethical, immoral, and perhaps even illegal conduct.
Ethics and morality are self-imposed (or societal) constraints without the binding
authority of law. People may very well do what is right, because it is the proper thing to
do. However, the proper thing is too often less binding than what is the most personally
profitable. Faced with these decisions, it should come as no surprise that a society will
have crises in ethics and morals when faced with decisions concerning their economic
well-being. CEOs stealing from the companies they direct are clearly wrong, but there
are also many shades of gray. A CEO making tens of millions of dollars, when his
contributions to the firm=s productivity are a small fraction is not as clear as stealing
directly, but perhaps the difference is in gradient only.
Clarence Updegraff (Arbitration and Labor Relations, Washington, D.C.: Bureau

of National Affairs, Inc., 1972) describes the relationship of ethics with public opinion
and law:
In all systems of primitive law, three elements of social control

invariably seem to make early appearances. In the Roman law, these
social controls were designated as fas, boni mores, and lex. The weakest
of these in the beginning of the historical period was lex, or law. In all
legal systems that truly develop to maturity it comes to be the dominate
factor, but fas, the ethical or religious teaching, and boni mores, public
opinion (or literally good morals) always remain important factors. The
judge comes to deal almost entirely with law. At any rate, it dominates his
technique of decision. . . .
Notice that economic self-interest is not mentioned. However, look around you
and see how economic self-interest is the dominate factor in ruling a person=s conduct.
It is the fas, boni mores, and lex that are the constraints on a person=s pursuit of their
economic self-interest. Personal embarrassment may restrain greed, but the probability
of being caught, and doing jail time is a far greater restrain on unbridled greed for most
people.
219
One ought not to become confused. Microeconomics provides decisional tools in
making efficient decisions. Microeconomics, however, cannot substitute for what is
ethical, moral or legal. As a scientific approach to resource allocation, economics has
much to offer, but as a philosophy of what is right, moral, or decent, it falls far short.
Internationalization
It is clear that the days of the United States remaining safe, secure and isolated
by two oceans is long gone. The United States is part of a global economic system,
and there is much that can be gained or lost by how we conduct our role on the world
economic stage. The United States has a current dominate role, militarily and
economically, but as any student of history knows, such dominate roles are never
permanent. Egypt, Greece, Rome, Persia, the Mongol Empire, and the British Empire
all rose and most had economic sources of their failing.
Free trade, tolerance, and a continuing development and reliance on

comparative advantage are what provide for economic success. Technological
innovation, natural resources, and human capital can provide significant comparative
advantages in the production of commodities for trade internationally. It is upon these
issues that the fate of the U.S. depends.
As cultural barriers to economic activity, tolerance and understanding become

evident; Americans will have to learn what values dominate in other cultures, and what
constraints exist. Americans will also find that they will need to learn other languages to
be able to work and trade in foreign lands. With the advances in communications,
transportation, and the increased demands on natural resources, it is clear this
economy will become increasingly internationalized. It is how we learn to deal with this
internationalization, and how well we prepare for it that will determine our economic
success, as both individuals and as a society.
The work-world in the future of most college students today is far different from
what confronted their parents. Immigration of workers into the United States, and
significant foreign investment assures that greater cultural diversity will be in evidence.
Greater understanding of the world=s religion, ethnic diversity, and cultural backgrounds
will be absolutely essential if one never leaves the State of Indiana.
Much of the conflict in the Middle East today can be traced to failures to
understand cultural differences. Because of this country=s inability to be independent
and self-sufficient in energy, this critical area of the world will continue to be very
important to our economic well-being.
American interests abroad generally mean business interests, and generally

multi-national firms. The love that most people had for the United States, outside of this
220
country has been seriously mitigated over the past couple decades. Whatever the
reason, just as business becomes more focused on the global economy, the global
economy is becoming a more challenging place. The great generosity (i.e., Peace
Corps, the Marshall Plan etc.) endeared us to a large portion of the world. It will be a
challenge to regain this sort of love and respect from countries that are now mistrustful.
Finally, the economic environment in the U.S. is uncertain. The de-

industrialization of the U.S. economy portends potentially hard economic times. Lower
incomes, less economic security, and requirements on the work force to be far more
adaptive may result the loss of comparative advantage in many markets, if we don=t rise
to the task. Education, investment, and determination will undoubtedly make our future
bright, but there is competition, and we must not become complacent.
Parting Words
The principles of economics provide a rudimentary guide to decision-making on

the margin. One of the hallmarks of sound economic reasoning is marginal analysis.
While most people find it difficult to ignore Asunk@ costs, it is often these very same sunk
costs that lead people astray in deciding what to do next. It is hoped that this course
will help make you think more like an economist, and act more rationally in your
decision-making.
Economics is also the mother-discipline for the academic areas, roughly referred
to as business administration. A solid foundation microeconomics is going to make
marketing, production management, and finance far easier to master and apply. Price
elasticity of demand (and other elasticities) is much of the subject matter in marketing,
marginal analysis will again become central in the methods you use in production
management, and finance is concerned primarily with capital markets. Therefore,
microeconomics will follow throughout your academic career if you are a business major
and throughout your real world career if you make decisions.
221
Sample Examinations
1. Sample Midterm Examination
2. Sample Final Examination
222
Sample Midterm Examination
Answers are found at the end of this section.
Multiple Choice (4 points each):
1. Which of the following factors of production are NOT properly matched with their
factor payments?
A. Capital - interest
B. Land - profits
C. Labor - wages
D. All are properly matched
2. Which of the following terms means "all other things equal"?
A. Post Hoc, Ergo Propter Hoc

B. Fallacy of Composition
C. Ceteris Paribus
3. Economic growth can be illustrated with the use of a production possibilities

curve:
A. By a shift to the left of the curve

B. By a shift to the right of the curve
C. By a point on the inside of the curve
D. By a point on the outside of the curve
4. A small developing country in Central America has an economy that exhibits the
following characteristics: (1) exchange occurs through markets, (2) private
property is permitted, but there is also a large public sector, (3) what will be
produced is decided by the government and the operation of markets, and (4)
there is also a strong social desire to maintain the status quo.
A. This is definitely a capitalist system

B. This is definitely a command system
C. The economy is most likely a mixed system
D. It is impossible to tell what type of economic system this is from the
information given
223
5. If Kansas can produce either 400 tons of wheat or 100 tons of corn and
Nebraska can produce 300 tons of corn or 200 tons of wheat then it makes
sense for the two states to specialize and trade. Which of the following
accurately states the amount of grain that will be produced (assuming corn and
wheat can be produced in constant ratios) and the terms of trade?
A. Kansas will produce 0 wheat and 100 tons of corn, Nebraska will produce
300 tons of wheat and 0 corn, the terms of trade will be between 1.5 and 4
tons of corn per ton of wheat.
B. Kansas and Nebraska will produce the amounts shown in the stem of the
question and the terms of trade will 4 tons of corn for 6 tons of wheat.
C. Kansas will produce nothing but 400 tons of wheat and Nebraska will
produce nothing but 300 tons of corn, the terms of trade, assuming equal
bargaining power, will be probably be 4 tons of wheat for 3 tons of corn.
D. We cannot tell what the terms of trade will be from the information, but
there is no advantage to trade between Nebraska and Kansas.
6. Which of the following is a characteristic of a market economy?
A. Limited role for government

B. Competition
C. Freedom of Choice
D. Specialization of Labor
7. If there were a decrease in demand and a decrease in supply, what would we

expect to observe in a purely competitive market?
A. price will increase, quantity exchanged is indeterminate

B. price will decrease, quantity exchanged is indeterminate
C. price is indeterminate, and quantity exchanged will increase
D. price is indeterminate, and quantity exchanged will decrease
8. The recent flooding in the upper Midwest destroyed a significant proportion of the
corn crop. However, it has been discovered that corn oil is far better in keeping
cholesterol within acceptable limits than was once believed. What would we
expect to observe in the market for corn?
A. price is indeterminate, and quantity exchanged will increase

B. price is indeterminate, and quantity exchanged will decrease
C. price will increase, quantity exchanged is indeterminate
D. price will decrease, quantity exchanged is indeterminate
224
9. If the supply curve shifts left and there is also an increase in demand what
happens to equilibrium price and quantity?
A. Price increases, quantity is indeterminate

B. Price decreases, quantity is indeterminate
C. Price is indeterminate, quantity increases
D. Price is indeterminate, quantity decreases
10. The term "scarcity" in economics refers to the fact that:
A. No country can yet produce enough to satisfy completely everybody's

wants for everything
B. It is impossible to produce to too much of any particular good
C. Even in the richest country some people go hungry
D. Everything costs money
11. A city government regulates taxi fares. It also limits the number of taxicabs
(through licensing), and has not changed the limit on cabs for many years. At
one time vacant taxis were scarce and hard to find; but when the city increased
the allowable fares 25 percent, vacant taxis suddenly became plentiful. The
result is BEST explained by the economic principle of:
A. A negatively sloped, downward sloping demand curve

B. Specialization & division of labor
C. Increasing marginal cost
D. Public goods
12. "The compact disk player has literally revolutionized the recording industry with
its state-of-the-art sound, clarity, durability, and the fact that it costs less than
cassette tape players." Assuming that compact disks and cassette tapes are
substitutes, how will the equilibrium price and equilibrium quantity of cassette
tapes be affected?
A. Equilibrium price increases, quantity decreases

B. Equilibrium price decreases, quantity increases
C. Equilibrium price and quantity will both increase
D. Equilibrium price and quantity will both decrease
225
13. Which of the following is a function of money?
A. Investment
B. Store of value
C. Bartering for goods
D. All of the above are functions of money
14. If the quantity demanded of Pepsi Cola goes up, and its supply increases what
will happen in the market for Pepsi?
A. Price is indeterminate, quantity increases

B. Price goes up, quantity is indeterminate
C. Price goes down, quantity goes up
15. Which of the following describes the utility maximization rule? (where MU is
marginal utility and P is price)
A. MUa/Pa = MUb/Pb = . . . = Mu z/Pz = 1

B. Total MU = Total P
C. MUa = MUb = . . . = MUz
D. None of the above describe the rule
16. A local airline charges $500 to fly (round-trip) to Louisville, Kentucky. Over the
past three months, while the $500 fare has been in effect each of the two daily
flights have averaged 10 passengers. During last summer, the carrier ran a sale
and charged $300 for a round-trip to Louisville; during the six weeks of the sale,
the airline averaged 20 passengers per flight. What is the coefficient of price
elasticity?
A. 0.76
B. 1.00
C. 1.20
D. 1.33
17. Which of the following is a determinant of the price elasticity of demand?
A. Whether a luxury or necessity

B. Price of complements
C. Number of consumers
D. All of the above are
226
18. Where is the range of unit elasticity for the following demand curve?
Price Quantity
8 3
7 4
6 5
5 6
4 7
3 8
A. From price 8 to price 6

B. From price 6 to price 5
C. From price 5 to price 3
D. From price 7 to price 5
19. With perfectly inelastic demand, then if supply increases:
A. Price remains the same, quantity increases

B. Price remains the same, quantity decreases
C. Price increases, quantity remains the same
D. Price decreases, quantity remains the same
20. The price of Pepsi decreased from .50 to .40 and the quantity demanded
increased from 100 million to 150 million. Which of the following statements are
true?
A. Quantity demanded decreased

B. Demand is elastic
C. Demand increased
D. None of the above is true
True/False (1 point each)
1. A laissez faire economy will always result in economic efficiency.
2. Business sell to households in the resource markets, but households sell to

businesses in the product markets.
3. If the prices of Fords decrease, we should expect the demand for Chevrolet to
227
decrease, ceteris paribus.
4. If the price of MacDonald's Cheeseburgers increases, we would expect the

demand for Coca-Cola to decrease, ceteris paribus.
5. Correlation can only test whether two variables are statistically associated, it
cannot test for causation.
6. The circular flow diagram illustrates that there is interdependence in modern

industrialized economic systems.
7. Giffin's paradox states that a demand curve can only be downward sloping if
consumers have a limited income.
8. An increase in the quantity demanded of a good can occur because consumers

expect the price of that good to increase in the near future.
9. A price ceiling imposed above the competitive equilibrium will result in a

shortage.
10. The demand curve slopes downward because of the income and substitution
effects.
11. The United States is the example of a laissez faire, capitalist economy.
12. Microeconomics is concerned with decision-making within the firm, household or

on the individual level, but macroeconomics is concerned with the behavior of the
entire economic system.
13. Economic goals are complementary with one another, but may be conflicting with
other social goals.
14. The quantity supplied of a commodity will increase if we increase an ad valorem

tax on the commodity.
15. A price floor established above a competitive equilibrium will cause a surplus.
16. The income effect results from consumers having more resources available to
purchase everything, if the price of one good decreases.
17. The maximum point (where it is goes flat or from increasing to decreasing) in the
total revenue curve is associated with the unitary range in the demand curve.
18. The price elasticity of demand is the slope of the demand curve.
228
19. The law of diminishing marginal utility states that some consumers experience
less utility from the consumption of a commodity than do other consumers.
21. When total revenue and price move in the same direction, demand is price
inelastic; when they move in opposite directions demand is price elastic.
Answers:
Multiple Choice: True/False:
1. B 11. A 1. F 11. F
2. C 12. D 2. F 12. T
3. B 13. B 3. T 13. F
4. C 14. C 4. T 14. F
5. C 15. A 5. T 15. T
6. D 16. D 6. T 16. T
7. D 17. A 7. F 17. T
8. C 18. B 8. F 18. F
9. A 19. D 9. F 19. F
10 A 20. B 10 T 20. T
229
Sample Final Examination
Answers are given at the end of the section
Multiple Choice (4 points each)
1. In a purely competitive market, the firm will take the price established in the
industry. The question that the firm must answer is what quantity it will offer in
the market. The firm makes this decision based on which of the following
criteria?
A. Where average total cost is equal to average revenue

B. Where the marginal cost is equal to marginal revenue
C. Where the industry supply curve is equal to the demand curve
D. The firm cannot "decide" where to produce, this is imposed by the industry
equilibrium
2. A perfectly competitive firm's short-run supply curve is its marginal cost curve:
A. For all output where marginal cost exceeds minimum average variable
cost
B. For all output where marginal cost exceeds minimum average total cost
C. For all output where marginal cost exceeds minimum average fixed cost
D. For all quantities of output
3. A newspaper reports, "COFFEE GROWERS' MONOPOLY BROKEN INTO

SEVERAL COMPETING FIRMS." If this is true, we would expect the coffee-
growing industry to:
A. decrease output and increase price

B. increase output and decrease price
C. use more capital goods and hire fewer workers
D. use fewer capital goods and hire more workers
4. To regulate a monopolist at the social optimum implies:
A. We risk forcing the monopolist to make a loss

B. We will approximate a purely competitive market solution
C. The point where the social optimum is obtained is where P = D = MC
D. All of the above are true
230
5. An unregulated monopolist when compared with a purely competitive industry
will:
A. Produce more, and charge more

B. Produce more, but charge less
C. Produce less, but charge more
D. Produce less, and charge less
6. Which of the following is the decision rule to determine the optimal combination
of productive factors?
A. MRP /MRC = MRP /MRC = ... = MRP /MRC = 0

B. MRP /MRC = MRP /MRC = ... = MRP /MRC = 1

C. MRP = MRP = ... = MRP = 0

labor capital land
D. MRP = MRP = ... = MRP = 1

labor capital land
7. Which of the following is a nonprice determinant of the demand for a factor of

production?
A. Product Demand
B. Resource productivity
C. Quality of the Resource
D. All of the above are nonprice determinants of the demand for a factor
8. The demand for capital for a firm that can easily automate its production
operations (all other things equal) can be characterized as:
A. Price elastic
B. Price inelastic
C. Demand is increasing
D. Demand is decreasing
9. Which of the following is true of the minimum wage?
A. If we assume a monopsony in the labor market, then there are likely no

employment effects of the minimum wage as long as it's imposed below
the monopsonist=s desired wage rate.
B. If it is imposed above the competitive equilibrium, there will be
unemployment as a result of the minimum wage.
C. If it is imposed below the competitive equilibrium, it will not be a binding
constraint on the market.
D. All of the above are true.
231
10. A monopsonist in an otherwise competitive labor market will cause (as compared
with the competitive labor market):
A. Employment to increase, wages to decrease

B. Employment to decrease, wages to decrease
C. Employment to increase, wages to increase
D. Employment to decrease, wages to increase
11. A craft union is characterized by all but which of the following?
A. Changes supply by manipulation of apprentice programs

B. Cause a kink in the supply curve at the minimum acceptable wage
C. Organizes only one skill group of employees and was associated with the
AFL
12. In a small Ohio community, we have only five employers who pay wages within a
narrow range that is basically acceptable to each of the employers. The
employees believed that the wage they received was below the competitive
equilibrium so they unionized. The effects of this unionization in the small
community was:
A. A higher wage, but with increased employment

B. A higher wage, but with decreased employment
C. The wage didn't change, but there was increased employment
D. We simply do not know because the underlying economic model is
indeterminant
13. If we have a monopolist that provides electrical service to a community and it is

observed that the monopolist charges, what is viewed by most people as
excessive rates, we may wish to regulate the monopolist. If we were to regulate
the monopolist at competitive equilibrium we have regulated the monopolist at:
A. The social optimum (allocatively optimal)

B. At where marginal cost is equal to average revenue
C. At a point where there is a greater quantity than would be observed at the
monopoly rate
14. Which of the following is not an assumption of the pure competition model?
A. The is only public relations type non-price competition

B. There are no barriers to entry or exit
C. There is a standardized product
D. All of the above are
232
15. Because of the underlying assumptions of the purely competitive model, all of the
following are true, but one, which of the following is not true of competition?
A. Economic profits are a signal for new firms to enter the market
B. Purely competitive industries are economically efficient
C. Competitive firms= are guaranteed a profit at where MC=MR
16. Which of the following does the marginal revenue curve intersect at their
minimum?
A. Short run average total cost

B. Total cost in the short run
C. Long Run Average Total Cost
17. What are the causes of economies of scale?
A. Ability to use by-products

B. Ability to use specialized management
C. Use of specialized capital goods in production
D. All of the above
18. Which of the following is an implicit cost to a business?
A. The costs that are associated with factors of production that can be varied
in the short-rum
B. The forgone opportunity for the business to engage in the current activity
C. Any and all costs to the firm that are termed accounting costs
19. Which of the following is true?
A. TC - MC = VC
B. AVC + TC = FC
C. AFC + AVC = ATC
D. MC + MR = profits
20. Fixed costs:
A. Exist only in the long run

B. Exist only in the market period
C. Are the difference between variable cost and total cost
D. Are only opportunity costs in the long run, but implicit costs in the short run
233
True/False (1 point each)
1. Other things equal, a monopolist will produce less, at a higher price than a
competitive firm will.
2. Oligopoly is an industry with a large number of suppliers, but few buyers.
3. Society would be unequivocally better off without monopolists.
4. X-inefficiency occurs when a firm's actual costs of producing any output are
greater than the minimum possible costs.
5. Price discrimination occurs when a firm can segment the market and charge
different prices, which do not necessarily reflect the costs of production.
6. The MRP slopes downward in an imperfectly competitive (resource) market

serving an imperfectly competitive product market because the MP diminishes
and the price of the output must be lowered to sell more.
7. The demand for a factor of production in a competitive factor market is the MRP
schedule for that factor, and this is why we refer to the demand as being a
derived demand.
8. Human capital is concerned with the characteristics of labor that contribute to its
productivity.
9. Labor offers its services for the nominal wage and the determinants of demand
for labor are basically utility maximizing decisions within the household.
10. The marginal revenue curve in a monopoly model has exactly half the slope as
the demand curve.
11. The supply curve in a monopoly is the marginal cost curve above average fixed
costs.
12. The lower the value of the commodity produced, the lower the wage earned by
labor, ceteris paribus.
13. In a purely competitive industry, supply is the summation of all the firms= marginal
cost curves above average variable cost.
14. The shut down point is where the firm cannot cover its fixed costs of operation.
234
15. A firm in pure competition has a horizontal demand curve, which is also equal to
the marginal revenue, and average revenue curves.
16. Long run average total cost curve is also referred to commonly as a planning
horizon.
17. An economic profit cannot be maintained in the long run in monopoly, but can be
in pure competition.
18. In the market period, all costs are variable, in the short-run there are both fixed
and variable costs and in the long run all costs are fixed.
19. The cost structure of the firm is unrelated to the theory of production in pure
competition.
20. The average fixed cost increases as the marginal cost curve is above it.
235
Answers:
Multiple Choice: True/False:
1. B 11. D 1. T 11. F
2. A 12. D 2. F 12. T
3. B 13. D 3. F 13. T
4. D 14. A 4. F 14. F
5. C 15. C 5. T 15. T
6. B 16. A 6. T 16. T
7. C 17. A 7. T 17. F
8. A 18. B 8. T 18.T
9. D 19. C 9. F 19. F
10 B 20. C 10 F 20. F
236
APPENDIX B
SELECTED BIBLIOGRAPHY
(BOOK LIST)
Becker, Gary, Human Capital: A Theoretical and Empirical Analysis. Chicago: University
of Chicago Press, 1993
Friedman, Milton, Essays in Positive Economics. Chicago: University of Chicago Press,

1994.*
Friedman, Milton and Rose D. Friedman, Capitalism and Freedom. Chicago: University
of Chicago Press, 1972.
Galbraith, John Kenneth, The Great Crash of 1929. New York: Houghton - Mifflin,
Company, 1997.*
Heilbroner, Robert L., The Worldly Philosophers, seventh edition. New York: Simon and
Schuster, 1999.*
Higham, Charles, Trading with the Enemy: The Nazi-American Money Plot - 1933-1949.
New York: Barnes and Nobel Books, 1983.
Hilgert, Raymond L. and David A. Dilts, Cases in Collective Bargaining and Industrial
Relations, tenth edition. New York: McGraw-Hill / Irwin, 2002.
Manchester, William, The Arms of Krupp: 1587-1968. New York: Bantam Books, 1970.*
Marx, Karl, Das Kapital, New York: International Publishers, Incorporated, 1982.*
McConnell, Campbell R. and Stanley Brue, Principles of Economics, sixteenth edition,

New York: McGraw-Hill / Irwin, 2004.
North, Douglas C. Economic Growth in the United States: 1790-1860. Seattle: DIANE
Publishing Co., 2003.
Rahnama-Moghadam, Mashaalah, Hedayeh Samavati and David A. Dilts, Doing

Business in Indebted Less Developed Countries. Westport, Conn: Greenwood
Publishing Group, 1995.
237
Schumpeter, Joseph A., Business Cycles. New York: Porcupine Press, Incorporated,
1982.
Sloane, Arthur A. and Fred Witney, Labor Relations, eleventh edition. Englewood Cliffs,
N.J.: Prentice-Hall, 2003.
Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations. New
York: Everyman=s Library - Alfred A. Knopf, Inc. 1991 (first published 1776).*
Steinbeck, John, Grapes of Wrath. New York, Penguin Books, 2002.*
Stiglitz, Joseph E., Globalization and its Discontents. New York: W. W. Norton &
Company, 2003.*
Thurow, Lester, The Future of Capitalism. New York: Penguin Books, Inc., 1997.*
Thurow, Lester, Head to Head New York: Warner Books, Inc., 1993.
Terkel, Studs, Working. New York: Ballantine Books, 1974.*
Tuchman, Barbara, A Distant Mirror: The Calamitous Fourteenth Century. New York:
Random House, 1979.*
Veblen, Thorstein, The Theory of the Leisure Class, New York: Penguin Books, 1967
(first published 1899)
* denotes classic, must read sometime while you are still in school
238
D-4388 1
ECONOMIC SUPPLY & DEMAND
by
Joseph Whelan
Kamil Msefer
Prepared for the
MIT System Dynamics in Education Project
Under the Supervision of
Professor Jay W. Forrester
January 14, 1996
Copyright ©1994 by MIT
Permission granted to copy for non-commercial educational purposes
D-4388 3
Table of Contents
1. ABSTRACT 4
2. INTRODUCTION 5
3. CONVENTIONAL SUPPLY AND DEMAND 6
3.1 I NTRODUCTION 6
3.2 DEMAND 6
3.3 SUPPLY 8
3.4 I NTERACTION BETWEEN SUPPLY AND DEMAND 9
4. A SYSTEM DYNAMICS APPROACH TO SUPPLY AND DEMAND 12
4.1 I NTRODUCTION 12
4.2 DEMAND 13
4.3 SUPPLY 15
4.4 I NTERACTION BETWEEN SUPPLY AND DEMAND 18
5. TESTING THE MODEL 20
5.1 I NCREASE IN DEMAND 21
5.2 DESIRED INVENTORY COVERAGE 23
5.3 P RICE C HANGE D ELAY 24
5.4 F URTHER EXPLORATION 26
6. SOLUTIONS TO EXERCISES 27
6.1 I NCREASE IN DEMAND 27
6.2 DESIRED INVENTORY COVERAGE 29
6.3 P RICE C HANGE D ELAY 30
7. APPENDIX 32
7.1 M ODEL EQUATIONS 32
7.2 T YPICAL MODEL BEHAVIOR 34
4 D-4388
1. ABSTRACT
The main purpose of this paper is to discuss supply and demand in the framework
of system dynamics. We first review classical supply and demand. Then we look at how
to model supply and demand using system dynamics. Finally, we present a few exercises
that will improve understanding of supply and demand and help improve system
dynamics modeling skills.
D-4388 5
2. INTRODUCTION
This paper emerged as an attempt to use system dynamics to model supply 1 and
demand. Classical economics presents a relatively static model of the interactions among
price, supply and demand. The supply and demand curves which are used in most
economics textbooks show the dependence of supply and demand on price, but do not
provide adequate information on how equilibrium is reached, or the time scale involved.
Classical economics has been unable to simplify the explanation of the dynamics
involved. Additionally, the effects of excess or inadequate inventory are often not
discussed.
In the real world, the market price is affected by the inventory of goods held by
the manufacturers rather than the rate at which manufacturers are supplying goods. 2 If
the manufacturers are supplying goods at a rate equal to the consumer demand, the static
classical theory would propose that the market is in equilibrium. However, what if there
is a tremendous surplus in the store supply rooms? The manufacturers will lower the
price and/or decrease production to return inventory to a desired level.
This paper introduces a model that incorporates elements from classical
economics as well as several real-world assumptions. This model will be used to
examine some of the interactions among supply, demand and price.
1 Supply and production are very similar terms and are often used interchangeably.
2Low, Gilbert W. (1974). Supply and Demand in a Single-Product Market (Exercise Prepared for the
Economics Workshop of the System Dynamics Conference at Dartmouth College, Summer 1974)
(Department Memorandum No. D-2058). M.I.T., System Dynamics Group.
6 D-4388
3. CONVENTIONAL SUPPLY AND DEMAND
3.1 Introduction
This section deals with supply and demand as sometimes taught in high-school
economics classes. The following descriptions of supply and demand assume a perfectly
competitive market, rational consumers, and free entry and exit into the market.
Economists also make the simplification that all factors other than price which affect the
quantity of goods sold and purchased are held constant. Economists argue that this is a
valid assumption because changes in price occur much more quickly than changes in
other factors that may affect supply or demand. Examples of these other factors include
changes in taste, changes in the state of the economy and long-term changes in
production capacity (such as the construction of a new factory).
3.2 Demand
Demand is the rate at which consumers want to buy a product. Economic theory
holds that demand consists of two factors: taste and ability to buy. Taste, which is the
desire for a good, determines the willingness to buy the good at a specific price. Ability
to buy means that to buy a good at specific price, an individual must possess sufficient
wealth or income.
Both factors of demand depend on the market price. When the market price for a
product is high, the demand will be low. When price is low, demand is high. At very
low prices, many consumers will be able to purchase a product. However, people usually
want only so much of a good. Acquiring additional increments of a good or service in
some time period will yield less and less satisfaction.3 As a result, the demand for a
product at low prices is limited by taste and is not infinite even when the price equals
zero. As the price increases, the same amount of money will purchase fewer products.
When the price for a product is very high, the demand will decrease because, while
consumers may wish to purchase a product very much, they are limited by their ability to
buy.
The curve in Figure 1 shows a generalized relationship between the price of a
good and the quantity which consumers are willing to purchase in a given time period.
This is known as a simple demand curve.
3 This behavior toward aquiring additional increments of a good is called diminishing marginal utility.
D-4388 7
Demand Limited by
ability to buy
Price
Demand Limited
by taste
Rate of Purchase
Figure 1: Demand Curve4
This curve shows the rate at which consumers wish to purchase a product at a given
price.
The simple demand curve seems to imply that price is the only factor which
affects demand. Naturally, this is not the case. Recall the assumption made by
economists that the other factors which influence changes in demand act over a much
larger time frame. These factors are assumed to be constant over the time period in
which price causes supply and demand to stabilize.
4 The reader should note that the convention in economic theory is to plot the price on the vertical axis and
the rate of purchase on the horizontal axis.
8 D-4388
3.3 Supply
Willingness and ability to supply goods determine the seller’s actions. At higher
prices, more of the commodity will be available to the buyers. This is because the
suppliers will be able to maintain a profit despite the higher costs of production that may
result from short-term expansion of their capacity 5.
In a real market, when the inventory is less than the desired inventory,
manufacturers will raise both the supply of their product and its price. The short-term
increase in supply causes manufacturing costs to rise, leading to a further increase in
price. The price change in turn increases the desired rate of production. A similar effect
occurs if inventory is too high. Classical economic theory has approximated this
complicated process through the supply curve. The supply curve shown in Figure 2
slopes upward because each additional unit is assumed to be more difficult or expensive
to make than the previous one, and therefore requires a higher price to justify its
production.
Price
Supply
Figure 2: Supply Curve
At high prices, there is more incentive to increase production of a good. This graph
represents the short-term approximation of classical economic theory.
5Short-term expansion can be achieved by giving workers overtime hours, contracting to an outside source,
or increasing the load on current equipment. These types of changes increase per-unit supply costs.
D-4388 9
3.4 Interaction Between Supply and Demand
Demand is defined as the quantity (or amount) of a good or service people are
willing and able to buy at different prices, while supply is defined as how much of a good
or service is offered at each price. How do they interact to control the market?
Buyers and sellers react in opposite ways to a change in price. When price
increases, the willingness and ability of sellers to offer goods will increase, while the
willingness and ability of buyers to purchase goods will decrease. To illustrate more
clearly how the market works, we will look at the following example from the clothing
industry.
Table 1 is called a schedule of demand and supply. For each price, it indicates
how much clothing is demanded by the consumers per week, and how much clothing is
supplied per week. Notice that as price decreases, demand increases and supply
decreases. Eventually demand exceeds supply.
10 D-4388
Demand and Supply Schedules
Price Quantity Quantity

Demanded Supplied
(per week) (per week)
---------------------------------------------------------------
$50 10 100
$45 14 97
$40 18 94
$35 22 89
$30 28 84
$25 35 77
$20 45 68
$15 57 57
$10 73 40
$5 100 0
Table 1: Demand and Supply Schedules

For each price, the schedule above indicates the quantity (in articles per week) of clothing
demanded and supplied.
The market will reach equilibrium when the quantity demanded and the quantity
supplied are equal. At $15, supply and demand are equal at 57 articles of clothing per
week. To better understand the dynamics involved, suppose that one article of clothing
was selling for $30. Producers would be willing to supply 84 articles of clothing per
week, but consumers would only be buying 28 articles per week. As a result, the
producers would have excess inventory piling up very quickly. In order to get their
inventory back to the desired level, the suppliers would have to decrease production and
reduce the price. Eventually, the quantity demanded and quantity supplied meet at 57
articles per week at a price of $15.
D-4388 11
$50
Dem
ply
Sup
and
Price per article of Clothing ($)
$40
$30
$20 Equilibrium Point
Equilibrium Price
Equilibrium
$10
Quantity
$0
0 20 40 60 80 100
Quantity of Clothing per week
Figure 3: Demand and Supply Curves
These curves were plotted from the data for the clothing market included in Table 1.
Figure 3 plots the demand and supply curves from the data in Table 1. Notice that
at $15 the supply and demand curves meet.
12 D-4388
4. A SYSTEM DYNAMICS APPROACH TO

SUPPLY AND DEMAND
4.1 Introduction
Classical economic theory presents a model of supply and demand that explains
the equilibrium of a single product market. The dynamics involved in reaching this
equilibrium are assumed to be too complicated for the average high-school student.
Economists hold the view that price determines both the supply and the demand.
Equlibrium economics defines only the intersection of the supply and demand curves, not
how that intersection is reached.
On the other hand, system dynamicists believe that the availability of a product,
rather than its rate of production, affects the market price and demand. This means that
the inventory (or backlog) of a product is a major determinant in setting price and
regulating demand. This model is a hybrid of both views in that it introduces the
dynamic effects of inventory into a model that generally replicates the economists’ static
explanation of supply and demand.
To explore the dynamics of supply and demand we will use the clothing market as
an example. Because of a very aggressive marketing campaign, demand for clothes has
increased. How will the suppliers and consumers react?
To study the behavior of the market, we will look at its three major components:
supply, demand, and price. There will be a series of exercises to help you understand the
model. We will first look at consumer demand.
D-4388 13
4.2 Demand
Demand
inventory
shipments
demand
demand price schedule

desired inventory
~
price
Figure 4: Demand Sector
Demand in this model obeys one simple rule. It is the demand as dictated by the
demand price schedule. The demand price schedule is a demand curve that indicates
what quantity consumers are willing to buy at a given price. The demand directly affects
two things. First, it determines the outflow to the inventory stock of the suppliers. This
model assumes that the rate of shipments from the inventory is equal to the demand.
Additionally, the demand sets the size of the supplier’s desired inventory.
14 D-4388
Figure 5 shows the simple demand curve used in the demand price schedule
graphical function. This curve is somewhat different from the curve shown in Figure 1.
Because STELLA and system dynamics standard practice require the input to a graphical
function to be on the horizontal axis, it was necessary to reverse the axes. In the curve
shown in Figure 5, price is on the horizontal axis instead of the vertical. As discussed
earlier, the curve shows that consumers are willing to buy more if the price is lower.
Figure 5: Demand Price Schedule

This curve is a simple demand curve from classical economics with the axes reversed.
D-4388 15
4.3 Supply
Below is the supply sector of the model. To simplify the model, we combined the
inventories of all the suppliers into one large inventory. The inflow supply represents the
total production of goods to inventory. The outflow to this stock, shipments, is equal to
the demand.
Supply
Demand
inventory
supply shipments
demand
inventory ratio
~ demand price schedule

supply price schedule desired inventory
~
desired inventory coverage
price
Figure 6: Supply Sector
In Section 3 (Conventional Supply and Demand, page 8) there was no discussion

of inventory. Basic classical economic theory does not specifically address the effects of
excess or inadequate inventory. This model includes these effects. The inventory stock
represents the total quantity of clothing in the warehouses of all suppliers.
The shipments flow is equal to the weekly demand for clothing. Desired
inventory is the quantity of clothing the suppliers would like to have in inventory. The
suppliers like to have enough inventory to cover several weeks of demand. Therefore,
desired inventory is the product of desired inventory coverage and demand. The
inventory ratio is the ratio of inventory to desired inventory. The inventory ratio will be
used to determine price later in the modeling process.
16 D-4388
Before clothes can be stored in the warehouses, they need to be produced. The
supply flow is determined by the supply price schedule. The supply price schedule is a
supply curve which indicates how much the producers are willing to produce for each
price they receive in the market. The source for this relation is the supply curve provided
by classical economic theory6. As with the demand curve, the axes must be reversed so
that price can be an input to the graphical function. The curve used in the supply price
schedule is shown in Figure 7 below.
Figure 7: Supply Price Schedule

This curve was derived by taking the simple supply curve from classical economics and
reversing the axes. This curve shows the rate of production for a given price.
Below a certain price, the incentive to produce is zero because manufacturers
cannot cover the costs of production. As the price rises above that cutoff, supply will
increase rapidly. At higher prices, the additional cost of increasing the supply begins to
outweigh the benefits of selling at a higher price. As the supply rate continues to
6 The reader should note that this curve is being used in place of more complictated dynamic structure.
There is no real-world causal relation between the price and the supply rate of a product. The information
contained in the graph is an approximation for the behavior that would be produced by including structure
which includes the effects of varying production capacity and employment.
D-4388 17
increase, it takes larger and larger increases in the market price to justify further increases
in supply.
18 D-4388
4.4 Interaction between Supply and Demand
Supply
Demand
inventory
supply shipments
demand
inventory ratio
~ demand price schedule

supply price schedule desired inventory
~
desired inventory coverage
Price
desired price
effect on price
price change delay price
change in price
Figure 8: Price Sector

Price affects supply and demand as determined by the supply price schedule and
the demand price schedule. When price is high, demand is low and supply is high. When
price is low, demand is high and supply is low. We assumed that the only direct action
by a manufacturer to bring inventory to the desired level is to vary price.
The action of the suppliers to regulate the price based on the inventory ratio is
shown in Figure 9. Recall that the inventory ratio is defined as the ratio of inventory to
desired inventory.
D-4388 19
Figure 9: Effect on Price graphical function

When there is excess inventory, the price is lowered and when there is inadequate
inventory, the price is raised.
The graphical function shown in Figure 9 represents the action of suppliers to

regulate their inventory. When inventory is below the desired inventory, then the
inventory ratio is less than one. The graph in Figure 9 shows that an inventory ratio less
than 1 gives a value for effect on price that is greater than one. This causes the price to
increase. The increase in price causes the supply to increase and the demand to decrease
through their respective price schedules and brings the inventory closer the desired value.
Multiplying the output of the effect on price converter and actual price returns desired
price.
Price was modeled as a stock because prices cannot change instantaneously.
People do not have immediate and exact information on the supply (inventory) and
demand of the commodity in question. Additionally, when the information becomes
available, it takes time to make a decision about changing the price.
5. TESTING THE MODEL
Putting the model together, we get the following:
ma supply A 6
[.I:] Demand /\ 8
inventory
demand
desired price
price change delay
Figure 10: The complete Supply and Demand model

D-4388 21
At this point, you may wish to build the STELLA model of supply and demand.
The exercises that follow do not require you to run the model, but you may wish to
perform some simulations of your own. The complete model equations are included in
the appendix, beginning on page 33.
You will analyze three scenarios in this section. The first scenario will be a base
case run to observe the response of the model to a step increase in demand. Then you
will analyze how the behavior of the system varies from the base case when you change
the desired inventory coverage and the price change delay. Solutions start on page 28.
5.1 Increase in Demand
For the base case run, assume the following conditions:

• initial price = $15 per article of clothing
• desired inventory coverage = 4 weeks
• price change delay = 15 weeks
#1: What should inventory be in order for the system to be in equilibrium? (Hint: look
at the supply price schedule and the demand price schedule) _______________________
Discuss your reasoning below.

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
#2: Assume that the system is in equilibrium. Price and inventory remain the same
until the tenth week, at which time there is a permanent increase in demand of 10 units.
(At each price, the consumer demand is 10 articles per week higher.) What are the new
equilibrium values for price and inventory? ____________________________________
22 D-4388
#3: Draw below what you think will happen to inventory in response to an increase in
demand.
1 : invent ory
4 0 0 .0 0
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
Explain your reasoning:

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
D-4388 23
5.2 Desired Inventory Coverage
We will now explore the response of the system to an increase in demand for
different values of the desired inventory coverage (the number of weeks of desired
inventory coverage). Presently desired inventory coverage is 4 weeks and the system is
in equilibrium. The response of the system to a step increase in demand with desired
inventory coverage = 4 weeks is shown below.
#4: If we change desired inventory coverage to 6 weeks, how would the system react
to the same increase in demand? On the graph below, draw the expected behavior.
#5: Now, draw on the same graph what you expect the behavior of inventory will be if
desired inventory coverage is equal to 2 weeks and there is an increase in demand.
1 : invent ory
4 0 0 .0 0
1
1
1
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
24 D-4388
5.3 Price Change Delay
We are now ready to discuss the effect of varying the price change delay. The
delay obviously affects how quickly the price changes, and in the following exercises we
will see how well you can predict the behavior of price when that delay is modified.
#6: Currently, the price change delay is 15 weeks. Assuming everything else remains
unchanged (system in equilibrium), would price or inventory change over time if the
delay is suddenly shortened? __________________
Why or why not?

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
#7: Would you expect the system to reach equilibrium more quickly when the price
change delay is equal to 30 weeks or 15 weeks? ____________

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
D-4388 25
The graph below shows the response of the system to a step increase in demand when the
price change delay is 15 weeks.
#8: If the price change delay is changed to 5 weeks, how would the system react to an
increase in demand? On the graph below, draw the expected behavior of price.
#9: Now, draw on the same graph what you expect the behavior of price to be if price
change delay is changed to 30 weeks and there is an increase in demand.
1 : price
2 0 .0 0
1
1 7 .5 0
1
1
1 5 .0 0 1
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks

________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
________________________________________________________________________
26 D-4388
5.4 Further Exploration
Naturally, no system dynamics model is ever complete. We believe that the

model presented is adequate for the purposes of this paper, but there are many
possibilities for enhancing it. One possibility is to include the effect of available
inventory on demand. The current model assumes that if a product is not currently
available, the consumer will simply place an order and wait for the product to arrive,
creating negative inventory, or backlog. You may also wish to include structure for
increasing the capacity of the supplier. This would allow for increased production
without raising the per-item cost. You could also experiment with the dynamics of a non
durable good market (i.e., food). The possibilities are unlimited and it will help enhance
your modeling skills.
D-4388 27
6. SOLUTIONS TO EXERCISES
6.1 Increase in Demand
#1: In equilibrium, all stocks must remain constant. The price will remain constant
when the inventory ratio is one. Therefore, in equilibrium, the inventory is equal to the
desired inventory. By looking at the supply and demand curves contained in the
graphical functions of Demand Price Schedule and Supply Price Schedule we can see that
the equilibrium price is $15 when demand and production both equal 57 articles of
clothing per week. Since the desired inventory coverage is 4 weeks, the equilibrium
inventory is 228 articles of clothing.
#2: An increase in demand of 10 articles of clothing per week means that the demand
curve in the demand price schedule is shifted up by 10. An easy way to figure out the
new equilibrium price is to plot the supply curve and the new demand curve on the same
graph and find the intersection. Doing this shows that the new equilibrium price will be
about $17 with production and demand slightly less than 62 articles per week. The new
equilibrium inventory is then 62*4 or 248 articles of clothing.
28 D-4388
1 : invent ory
4 0 0 .0 0
1
1
1
1
2 0 0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
Figure 11: Step in Demand

Inventory decreases at first due to increased demand. It then overshoots and oscillates to
a new equilibrium.
#3: The increase in demand causes the desired inventory to immediately shoot up by
40 articles of clothing (10 articles per week * 4 weeks of coverage). At the same time,
inventory begins to drop because shipments are higher than supply. These cause the
inventory ratio to drop, resulting in an increase in price. The price increase causes the
demand to fall and supply to increase allowing the inventory to catch up to the desired
inventory. However, the price continues to rise until the inventory has overshot its
equilibrium value. At this point the inventory ratio becomes positive, causing the price to
begin falling. Although the price is falling, it remains above its equilibrium value
causing the inventory to continue increasing beyond its equilibrium. Eventually, the
price falls below the equilbrium price and causes the inventory to begin decreasing, but
the inventory again overshoots and the system oscillates to its new equilibrium with
inventory equal to about 248. A graph of this behavior is shown in Figure 11.
D-4388 29
6.2 Desired Inventory Coverage
#4 & #5: The desired inventory coverage affects the size of the desired inventory.
The response of the system to an increase in demand was very different for the three
values of desired inventory coverage. When the desired inventory coverage was 2
weeks, the inventory seemed to exhibit sustained oscillation. As the coverage was
increased to 4 and 6 weeks, the reaction to an increase in demand was smaller and
stabilized more quickly. This behavior shows that there is a tradeoff when considering
the size of inventory coverage. When the desired inventory coverage is high, inventory
remains fairly stable and is not greatly affected by changes in demand. Unfortunately,
maintaining a large inventory can be costly. Lower values for desired inventory coverage
are less costly to maintain, but react dramatically to changes in demand. Figure 12 shows
the model runs for desired inventory coverage equal to 2, 4 and 6 weeks. (Curves 1, 2
and 3 respectively.)
1 : invent ory 2 : invent ory 3 : invent ory
4 0 0 .0 0
3 3 3
2
2
2
2 0 0 .0 0 2
1 1 1
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
Figure 12: Change in desired inventory coverage

Variations in desired inventory coverage have a large effect on the behavior of the
system. Higher coverage allows the inventory to maintain stable, but is costly to
maintain.
30 D-4388
6.3 Price Change Delay
#6: The price change delay does not affect the equilibrium state of the model. This
delay only comes into effect when the price is changing. Any change in the price change
delay will not affect the model if it is already in equilibrium.
#7: When the model is knocked out of equilibrium, the price change delay affects
how it approaches its new equilibrium. When the price change delay is short (5 weeks),
the price changes rapidly and overshoots its equilibrium value. The price also converges
on its equilibrium quickly. As the price change delay increases (15 weeks and 30
weeks), the changes are more gradual, the overshoot smaller and the equilibrium takes
longer to reach.
D-4388 31
#8, #9: The graphs below show the reaction of price to an increase in demand when the
price change delay is 5, 15 and 30 weeks.
1: price
20. 00
17. 50
1 1 1
5 Weeks
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
1: price
20. 00
1
17. 50
1 15 Weeks
1
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
1: price
20. 00
17. 50
30 Weeks
1
1
15. 00 1
0. 00 50. 00 100. 00 150. 00 200. 00
Weeks
Figure 13: Variations in price change delay

32 D-4388
7. APPENDIX
7.1 Model Equations

Demand Sector
demand = demand_price_schedule+step(10,10)
DOCUMENT: This is the rate at which consumers wish to purchase clothing from the
company. The step function is used to jar the system out of equilibrium.
UNITS: shirts per week
demand_price_schedule = GRAPH(price)
(5.00, 100), (10.0, 73.0), (15.0, 57.0), (20.0, 45.0), (25.0, 35.0), (30.0, 28.0), (35.0, 22.0),
(40.0, 18.0), (45.0, 14.0), (50.0, 10.0)
DOCUMENT: This is based on the simple demand curve. At some particular price, the
consumers are willing and able to purchase clothing at a certain rate; the lower the price,
the higher the demand.
Price Sector
price(t) = price(t - dt) + (change_in_price) * dt

INIT price = 15
DOCUMENT: Price is modeled as a stock in order to model the delays inherent in
changes in price.
UNITS : dollars per shirt
INFLOWS:
change_in_price = ((desired_price)-price)/price_change_delay
DOCUMENT: Change in price can be either positive or negative depending on
the effect_on_price. If the effect_on_price > 1, then price will increase. If the
effect_on_price < 1, then the price decreases. If effect_on_price = 1, price
remains same. Price changes slowly, so we divide the change by
price_change_delay.
UNITS: price/week or ($/shirt)/week
desired_price = effect_on_price*price
DOCUMENT: This is the equilibrium price as set by the inventory_ratio. The actual
price will reach this value after a delay specified by the price_change_delay.
UNITS: dollars per shirt
price_change_delay = 15
DOCUMENT: Prices do not change instantaneously. This value determines how
quickly price can change.
UNITS : weeks
D-4388 33
effect_on_price = GRAPH(inventory_ratio)
(0.5, 2.00), (0.6, 1.80), (0.7, 1.55), (0.8, 1.35), (0.9, 1.15), (1, 1.00), (1.10, 0.875), (1.20,
0.75), (1.30, 0.65), (1.40, 0.55), (1.50, 0.5)
DOCUMENT: This graphical function regulates price change. When the inventory >
desired_inventory then the inventory_ratio is >1 and price must be reduced. When the
inventory ratio is <1, price must be increased.
UNITS: dimensionless
Supply Sector
inventory(t) = inventory(t - dt) + (supply - shipments) * dt

INIT inventory = desired_inventory
DOCUMENT: Inventory is the stock of produced clothing in the company's warehouse.
UNITS: shirts
INFLOWS:
supply = supply_price_schedule
DOCUMENT: The price supply schedule is based on a classical short-term
supply curve. The company uses this algorithm to set a desirable supply rate for a
given price. This curve is being used in lieu of more complitated dynamic
structure.
UNITS = shirts per week
OUTFLOWS:
shipments = demand
DOCUMENT: This is equal to the demand. The shipments deplete the
inventory.
desired_inventory = demand*desired_inventory_coverage
DOCUMENT: Desired inventory is how much inventory the suppliers would like to
have. It is calculated as how many weeks worth of demand they would like to store in
inventory.
UNITS: shirts
desired_inventory_coverage = 4
DOCUMENT: This value sets how many weeks of demand the suppliers would like to
keep in inventory.
UNITS: weeks
inventory_ratio = inventory/desired_inventory
DOCUMENT: This is the ratio of inventory to desired inventory.
UNITS: dimensionless
supply_price_schedule = GRAPH(price)
(0.00, 0.00), (5.00, 0.00), (10.0, 40.0), (15.0, 57.0), (20.0, 68.0), (25.0, 77.0), (30.0, 84.0),
(35.0, 89.0), (40.0, 94.0), (45.0, 97.0), (50.0, 100)
DOCUMENT: This is a short-term supply curve. At higher prices there is more
incentive to produce, more producers can enter the market, etc. This is why this curve
points upward as price increases.
UNITS: shirts per week.
34 D-4388
7.2 Typical Model Behavior
These graphs represent the behavior of the model set up with the values in the
equations listed above. The model is initialized in equilibrium and there is a step increase
in demand of 10 units/week after 10 weeks.
1 : invent ory 2 : desired invent ory 3 : invent ory rat io

4 0 0 .0 0
3 .0 0
2 1
2 1 2
2
1
1
2 0 0 .0 0
1 .5 0
3 3 3
3
0 .0 0
0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
1 : shipment s 2 : supply
7 0 .0 0
2
1 2
1
2
6 0 .0 0 2 1
5 0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
D-4388 35
1 : price 2 : desired price

3 0 .0 0
2 0 .0 0
1 2
1 1
2
2
1
1 0 .0 0
0 .0 0 5 0 .0 0 1 0 0 .0 0 1 5 0 .0 0 2 0 0 .0 0
Weeks
The Uses or Application of
Indifference Curve Analysis
by Smriti Chand Economics
The Uses or Application of Indifference Curve Analysis!
The indifference curve technique has come as a handy tool in economic analysis. It has freed the theory
of consumption from the unrealistic assumptions of the Marshallian utility analysis. In particular,
mention may be made of consumer’s equilibrium, derivation of the demand curve and the concept of
consumer’s surplus.
The indifference curve analysis has also been used to explain producer’s equilibrium, the problems of
exchange, rationing, taxation, supply of labour, welfare economics and a host of other problems. Some
of the important problems are explained below with the help of this technique.
(1) T he Problem of Ex change:
With the help of indifference curve technique the problem of exchange between two individuals can be
discussed. We take two consumers A and В who possess two goods X and Y in fixed quantities
respectively. The problem is how can they exchange the goods possessed by each other. This can be
solved by constructing an Edgeworth-Bowley box diagram on the basis of their preference maps and the
given supplies of goods.
In the box diagram, Figure 12.28, Оa is the origin for consumer A and Оb the origin for consumer В (turn
the diagram upside down for understanding). The vertical sides of the two axes, Oa and Ob, represent
good Y and the horizontal sides, good X. The preference map of A is represented by the indifference
curves I1a, I2 a and I3 a and B’s map by I1b, I2b and I3b indifference curves. Suppose that in the
beginning A possesses ObYb units of good Y and Ob Хb units of good X. В is thus left with ObYb of Y
and Ob Xb of X. This position is represented by point E where the curve I1a intersects I1b.
Suppose A would like to have more of X and S more of Y. Both will be better off, if they exchange each
other’s unwanted quantity of the good, i.e. if each is in a position to move to a higher indifference curve.
But at what level will exchange take place? Both will exchange each other’s good at a point where the
marginal rate of substitution between the two goods equals their price ratios.
This condition of exchange will be satisfied at a point where the indifference curves of both the
exchangers touch each other. In the above figure P, Q and R are the three conceivable points of
exchange. A line CC passing through these points is the “contract curve” or the “conflict curve”, which
shows the various positions of exchange of X and Y that equalise the marginal rates of substitution of
the two exchangers.
If exchange were to take place at point P then consumer S would be in an advantageous position
because he is on the highest indifference curve I3b. Individual A would, however, be at a disadvantage
for he is on the lowest indifference curve I1a. On the other side, at point R, consumer A would be the
maximum gainer and S the loser. However, both will be at an equal position of advantage at Q. They can
reach this level only by mutual agreement otherwise the point of exchange depends upon the bargaining
power of each party. If A has better bargaining skill than S, he can push the latter to point R.
Contrariwise, if В is more skillful in bargaining he can push A to point P.

(2) Effects of Subsidy on Consum ers:
The indifference curve technique can be used to measure the effects of government subsidy on low
income groups. We take a situation when the subsidy is not paid in money but the consumers are
supplied cereals at concessional rates, the price-difference being paid by the government. This is
actually being done by the various state governments in India. In Figure 12.29 income is measured on the
vertical axis and cereals on the horizontal axis.
Suppose the consumer’s income is OM and his price-income line without subsidy is MN. When he is
given subsidy by supplying cereals at a lower price, his price -income line is MP (it is equivalent to a fall
in the price of cereals). At this price-income line, he is in equilibrium at point E on curve I1 where he buys
OB of cereals by spending MS amount of money. The full market price of OB cereals is MD on the line MN
where the curve lotouches.
The government, therefore, pays SD amount of subsidy. But the consumer receives cereals at a lower
price. He does not receive SD amount of subsidy in cash. If the money value of the subsidy were to be
paid to him in cash, they would receive MR amount of money. The equivalent variation MR shows that in
the absence of the subsidy, a cash payment would bring the consumer on the same indifference curve,
which makes him as better off as the subsidy.
But the value of the subsidy MR to the consumer is smaller than the cost of the subsidy DS to the
government. It reveals the fact that the consumer is happier if he is paid the subsidy in cash rather than
in the E S form of subsidised cereals. In this case, the cost of subsidy to the exchequer will also be less.
It points out to another interesting result. When the income of the consumer is raised by giving him cash
subsidy, he will buy less cereals than before. In Figure 12.29 at the equilibrium point C, he buys OA of
cereals which are less than OB when he was getting them at the subsidised price. This is what
the government actually wants.

(3) T he Problem of Rationing:
The indifference curve technique is used to explain the problem arising from various systems of
rationing. Usually rationing consists of giving specific and equal quantities of goods to each individual
(we ignore families because equal quantities are not possible in their case).
The other, rather liberal, scheme is to allow an individual more or less quantities of the rationed goods
according to his taste. It can be shown with the help of indifference curve analysis that the latter scheme
is definitely better and beneficial than the former.
Let us suppose that there are two goods rice and wheat that are rationed, the prices of the two goods are
equal and that each consumer has the same money income. Thus, given the income and price -ratios of
the two goods, MN is the price-income line. Rice is taken on vertical axis and wheat on the horizontal
axis in Figure 12.30.
According to the first system of rationing, both consumers A and В are given equal specific quantities of
rice and wheat, OR + OW. Consumer A is on indifference curve Ia and В is on lb. With the introduction of
the liberal scheme each can have more or less of rice or wheat according to his taste. In this situation, A
will move from P to Q on a higher indifference curve Ia1. Now he can have ORb of rice + OWa of wheat.
Similarly, В will move from P to R on a higher indifference curve Ib1 and can buy ORb of rice + OWb of
wheat. With the introduction of the liberal scheme of rationing both the consumers derive greater
satisfaction. The total quantity of goods sold is the same.
For when В buys more quantity of wheat WW b, he purchases less quantity of rice RRb and when A buys
RRb more of rice, he purchases WW less of wheat. Thus, the governmental aim of controlled distribution
of goods is not disturbed at all rather there has been a better distribution of goods in accordance with
individual tastes.
(4) Index Num bers: Measuring Cost of Liv ing:
The indifferent curve analysis is used in measuring the cost of living or standard of living in terms of
index numbers. We come to know with the help of index numbers whether the consumer is better off or
worse off by comparing two time periods when the income of the consumer and prices of two goods
change.
Suppose a consumer buys only two goods X and Y in two different time periods 0 and 1 and he spends
his entire income on them in the two periods. It is also assumed that the consumer’s tastes and quality of
the two goods do not change.
Suppose the initial budget line is AB in the base period 0 and the consumer is in equilibrium at point P
on the indifference curve Io in Figure 12.31. The new budget line in period 1 is CD which passes through
point P, on the new indifference curve I1. Both the combinations P and P1 lie on the original budget line
AB.
Therefore, they have the same cost. But combination P is on the higher indifference curve IQ than
combination P1. However, the consumer cannot have combination P at the new price (P,) in period 1.
Thus he chooses combination P, on the lower indifference curve I1and is worse off in period 1 than in the
base period 0. This shows that his standard of living has decreased in period 1 as compared with period
0.
(5) T he Supply of Labour:
The supply curve of an individual worker can also be derived with the indifference curve technique. His
offer to supply labour depends on his preference between income and leisure and on the wage rate. In
Figure 12.32 hours of work and leisure are measured on the horizontal axis and income or money wage
on the vertical axis. W2L is the wage line or income-leisure line whose slope indicates wage rate (w) per
hour. When the wage rate increases, the new wage line becomes W 3L and the wage rate per hour-also
increases and similarly for the wage line W 3 L.
As the wage rate per hour increases, the wage line becomes steeper. When the worker is in equilibrium
at the tangency point E1 of wage line W1L and indifference curve I1, he earns E1L1 wage by working L1L
hours and enjoys OL1 of leisure. Similarly, when his wage increases, to L1, he works for longer hours
L2 L and with E3 L3 wage increase, he works for still longer hours L3 L and enjoys lesser and lesser
leisure than before. The line connecting the points E1E2 and E3 is called the wage-offer curve.
The supply curve of labour can be drawn from the locus of the equilibrium points E1E2and But the wage-
offer curve is not the supply curve of labour. Rather, it indicates the supply curve of labour. To derive the
supply curve of labour from the wage-offer curve given in Figure 12.32, we draw the wage-hour schedule
in Table 12.6.
Table 12.6: Wage-Hour Schedule:

Equilibrium Point Wage Rate Per Hour Hours Worked
E1 OW1/OL = w1 L1L
E2 OW1/OL = w2 L2L
E3 OW1/OL – w3 L3L
On the basis of the above schedule, the supply curve of labour is drawn in Figure 12.33 where the wage
rate per hour is plotted on the vertical axis and hours worked (or supply of labour) on the horizontal axis.
When the wage rate is W1 labour supplied is OL1. As the wage rate rises to W1and labour supplied
increases to OL2 and OL1 respectively. The wage-labour combination points E1E2 and E3 trace out the
supply of labour curve SS1. The SS1 curve is positively sloping upwards from left to right which shows
that when the wage rate increases, the worker works for more hours.
This attitude of the worker is the result of two forces: one, the substitution effect, and two, the income
effect of the wage increase. When the wage rate increases, the tendency to work longer hours increases
on the part of the worker in order to earn more. It is as if leisure has become more expensive. So the
worker has a tendency to substitute work for leisure. This is the substitution effect of the wage increase.
Further, when the wage rate increases, the worker becomes potentially better off, he has a feeling of
satisfaction and gives preference to leisure over work. This is the income effect of the wage increase. In
the figure, as the wage rate increases from W1 to W2, hours worked increase from OL1 to OL2 and to
OL1. This is because the substitution effect of wage increase is stronger than the income effect.
Backward-Sloping Supply Curve of Labour:
At some higher wage rate if the wage rate increases further, the worker may work for lesser hours and
enjoy more leisure. This case is illustrated in Figure 12.34. When the income of the worker increases
progressively from E1L1 to E2L2 and to E3L3, hours worked may decline at some level of income. At the
equilibrium point E1 hours worked are L1L and they increase to L2L at the equilibrium point E2, when his
income rises to E2L2, from E1L1. But further increase in income to E3 L3 leads to the reduction in hours
worked to E3L3 from L2L. The worker now increases his leisure hours from OL2 to OL3.
The corresponding supply curve of labour is drawn in Figure 12.35 which is backward slopping. Taking
the substitution effect and the income effect of the wage increase up to the wage rate W 2, the
substitution effect is stronger than the income effect. So the supply curve of this worker is positively
sloped from S to E2.
At the wage rate W2 the substitution effect exactly equals the income effect and the SS1curve is vertical
at point E2. As the wage rate increases above W2, the income effect is stronger than substitution effect
and the supply curve is negatively sloped in the region E2S1 which shows that the worker gives
preference to leisure over work. In the figure, when the wage rate increases to W 3 the worker reduces his
hours worked from OL2 to OL3 and thus enjoys L2L3 of leisure.
(6) T he Effect of Incom e T ax v s. Ex cise Duty :
The indifference curve technique helps in considering the welfare implications of income tax vs. excise
duty or sales tax. Whether an income tax hurts the tax payer more or an excise duty of an equal amount?
Let us take a taxpayer who is required to pay, say Rs. 4000 annually either as income tax or as excise tax
on a commodity X. It is further assumed that he will continue to buy the commodity even after the
imposition of the duty when its price goes up.
In Figure 12.36 the money income of the taxpayer is shown along the vertical axis. He has OM of income
and his original price-income line, before the tax is levied, is MN. He is in equilibrium at point В on the
indifference curve I1.
For MA quantity of X, he spends AB. Now when the excise duty on commodity X is levied, its price rises
so that his price-income line shifts to MN1 where he is in equilibrium at point С on the I1 curve. As a
result of the tax, he buys ML quantity of X and spends LC on it. But at the original price, this quantity ML
would have cost him LS. Thus SC is the amount of tax which he pay for it.
If an equal amount of tax is raised by the government through income tax instead, the taxpayer’s income
would be reduced by MT (=SC). He moves to a lower line TR on the indifference curve I3, at point D. Since
the indifference curve I3 is higher than I2 the income tax equivalent to an excise duty places the taxpayer
in a favourable position.
(7 ) T he Sav ing Plan of an Indiv idual:
The indifference curve technique can also be used to study the saving plan of an individual. An
individual’s decision to save depends upon his present and future income, his tastes and preferences for
present and future commodities, their expected prices, on the current and future rate of interest, and on
the stock of his savings.
As a matter of fact, his decision to save is influenced by the intensity of his desire for present goods and
future goods. It he wants to save more, he spends less on present goods, other things being equal. Thus
saving is, in fact, a choice between present goods and future goods. This is illustrated in Figure 12.37
with the help of indifference curves.
Let PF1 be the original price-income line of the individual where he is in equilibrium at point S on the
indifference curve I.
Given the price of the present and future goods, the income of the consumer, his tastes and preferences
for the present and the future, and the rate of interest, he buys OA of the present goods and plans to
save so much as to have OB of goods in the future.
Suppose there is a change in his preferences. What will be the effect of such a change on the
consumer’s saving plan? If his preference for the present goods increases, his price-income line will
move to P1F so that he is in equilibrium at point Q on I1 He now buys OA, present goods and thus saves
less for the future goods. As a result, the purchase of the future goods will fall from OB to OB1. On the
other hand, if in his estimation the value of future consumption increases, his price -income line will
move to P1F where he will be in equilibrium at point R on L curve. He will, therefore, save more and thus
reduce his consumption of present goods to OA2 in order to have OB2 future goods. Similar effects can
be traced if the rate of interest changes, other things remaining constant.

real-world economics review, issue no. 67
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Ordinal utility and the traditional theory of consumer

demand 1
Donald W. Katzner [University of Massachusetts/Amherst, USA]
Copyright: Donald W. Katzner, 2014

You may post comments on this paper at
http://rwer.wordpress.com/comments-on-rwer-issue-no-67/
In an earlier issue of this Journal, Jonathan Barzilai, in a paper entitled, “Inapplicable

Operations on Ordinal, Cardinal, and Expected Utility” [see reference 2], has raised important
issues regarding ordinal utility, and correctly clarified the meaning of the general notion of
ordinality in terms of the mathematical theory of measurement. In that process, he has also
subjected the traditional theory of consumer demand to serious attack. Barzilai's assault on
traditional consumer theory, which is based on the mathematical theory of measurement, is
useful because it brings to the fore the fact that, for economists, there is a second notion of
ordinal utility, older than and independent of the mathematical-theory-of-measurement
concept, and which is the relevant one for the traditional theory of consumer demand. That
older approach seems to have had widespread acceptance among economists before the
newer mathematical approach was known to them. The essence of Barzilai's attack consists
of the claims that:
1. The function values of the utility function in that theory are ordinal and cannot,
according to the mathematical theory of measurement, be subjected to arithmetic
operations. This means that, since the reckoning of derivatives requires subtraction
and division of function values, the derivatives of the ordinal utility function cannot be
calculated. Marginal utilities, then, cannot exist, and hence the Lagrange-multiplier
derivation of demand functions and their properties from constrained utility
maximization is logically flawed and erroneous.
2. Both Hicks in Value and Capital [4] and Samuelson in his Foundations of Economic
Analysis [11] base their discussions of the theory of consumer demand on
differentiable, ordinal utility functions and the method of Lagrange multipliers. Their
arguments too are, as a consequence of (1), logically flawed and erroneous. Since
subsequent development of the theory has taken the same tack, the traditional theory
of consumer demand as it was then and as it stands today is invalid.
The purpose of this paper is to demonstrate that these claims are based on a
misunderstanding of the theory of consumer demand and the work of Hicks and Samuelson,
and that the conclusion that that theory is logically flawed and invalid is unjustified. The
misunderstanding arises in that, contrary to what is ordinarily done, Barzilai wants to use the
theory-of-measurement notion of ordinal utility as the basis for the traditional theory of
consumer demand.
I. Ordinal utility
One of the issues raised by Barzilai has to do with the meaning of the phrase “ordinal utility.”
Barzilai's approach is taken directly from the mathematical theory of measurement which
provides, among other things, the technical requirements for constructing measures (e.g.,
Pfanzagl [9]). To describe what is involved in measurement from this perspective, consider
1
The author would like to thank Roberto Veneziani for his support and help in preparing this paper.
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ordinal in contrast with cardinal measurment. Let A be a set of objects, say, sticks of chalk.
Suppose the relation longness orders the elements of A in that some sticks are seen to have
more longness than others. Suppose also that one is able to “operate” on them in the sense
of “combining longnesses” by lining up any two sticks end to end. An ordinal measure
transforms longness into units of length. The ordinality guarantees that sticks with greater
longnesses are assigned greater lengths when measured. A cardinal measure ensures
additionally that when two sticks are lined up end to end, the length of the combined stick is
the sum of the lengths of each separately.
From the perspective of the mathematical theory of measurement, the question of whether it
is possible to measure utility ordinally or cardinally has to do with the kind of scale upon which
the elements of the function values of the utility function are measured. In that context, let A
be a collection of objects, say vectors or baskets of commodities, capable of providing what,
for lack of a better term, may be called “pleasure” to the consumer. The set A is merely a
general assemblage to be used as the basis for constructing a scale on which pleasure is
measured in units of, say, utils. Assume that some ordering relation orders the objects of A by
pleasure. Under certain technical restrictions on that ordering, 2 there exists an ordinal scale
for measuring pleasure. When a utility function is present and when its function values are
taken to be ordinally measured in this sense, the functions maps baskets of commodities into
measured pleasure recorded as quantities of utils.
Now suppose that a combining operation is also defined on A that characterizes the means
by which the pleasure in any two objects is to be consolidated into the pleasure of the
combination. Then under additional, technical conditions, 3 the existence of a cardinal scale is
assured and the pleasure obtained from any combination of two objects is measured in utils
as the (possibly weighted) sum of the amounts of pleasure afforded by each separately.
Thus Barzilai's notion of ordinal utility requires a conceptual framework in which there is a
direct connection to an underlying ordering of objects by pleasure. His definition of “ordinal
space,” over which the function values of his ordinal utility function range, is a follows: “An
ordinal space A is a set of objects equipped only with the relations of order and equality” [2, p.
99]. As suggested above, the objects of A can be vectors or baskets of commodities. The
order and equality relations he is referring to may be either the order and equality relations in
the space A based on pleasure, or the greater-than and equal-to relations among the real-
number quantities of utils in the space, U, of utility-function values. The two spaces are
related by a function, the ordinal utility function, mapping the former into the latter that
impresses on U the pleasure structure, and only that structure, of A. For him, the ranges of all
ordinal utility functions are ordinal spaces.
Faithfully adhering to this notion of ordinality, Barzilai cannot permit arithmetic operations to
be employed among quantities of utils. At first, this seems rather strange because quantities
of utils are expressed as numbers and numbers can always be added, subtracted, multiplied,
and divided. But what he most likely means here is that, although arithmetic operations can
be applied to these numbers, they have no significance in terms of the underlying structure of
pleasure described above. This is because, since utility values are only ordinal and not
cardinal, there is no operation of combination in that underlying structure that will give
meaning to the adding together (or the subtracting) of the quantities of utils of two objects. In
2
See Pfanzagl [9, p. 75].
3
Ibid., pp. 97-98.
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[1, p. 61], Barzilai refers to what he sees as the logical necessity of having arithmetic
operations, when they are to be employed, meaningfully represented in terms of the
underlying pleasure structure as the “Principle of Reflection”.
In any case, it is on the basis of the mathematical-theory-of-measurement approach to ordinal

utility that Barzilai concludes that the theory of consumer demand, including the arguments of
Hicks and Samuelson, are flawed. The flaw arises in that, because the utility function is
ordinal, the arithmetic operations needed to define the utility-function derivatives necessary in
characterizing the relevant first-order constrained-utility maximization conditions cannot be
supported by the Principle of Reflection. However, Barzilai's approach to ordinal utility, which
is correct if one strictly adheres to the general notion of ordinality derived from the
mathematical theory of measurement, is not the approach to ordinal utility taken by the
traditional theory of consumer demand or by Hicks and Samuelson in their presentations of it.
In these latter contexts, pleasure plays no role in relation to utility values. Indeed, utility values
are not measures, in the theory-of-measurement sense, of anything. Rather the ordinal utility
function is simply a numerical, differentiable 4 representation of a preference ordering (that
includes the possibility of indifference and) that has no relation to any underlying pleasure
structure. The starting point of the traditional theory of consumer demand is this preference
ordering. That ordering is, perhaps, based on a judgment that, for some unspecified reasons,
various baskets are better or no worse than others. Such a judgment need have nothing to do
with pleasure and certainly has no connection to any underlying pleasure structure of the sort
required by Barzilai.
The only meaning attributed to the ordinal utility representation of the preference ordering in
the traditional theory of consumer demand is that if basket of commodities b is preferred to
basket of commodities c, then the utility value assigned to b is greater than that assigned to c;
and if the two baskets are indifferent, they are assigned the same utility value. The utility
function values have no intrinsic meaning other than the information they provide concerning
preferences. That is, the utility function contains exactly the same information as, and is an
equivalent way of expressing the preference ordering. There is no underlying pleasure
structure, and no necessity to have that structure and its properties, and only that structure
and those properties, reflected in the meaning of, and in operations on, the utility function’s
values. The fact that this function is often referred to as ordinal is not a reference to the notion
of ordinality invoked by the mathematical theory of measurement and employed by Barzilai. 5
Of course, such a utility representation is not unique. Any increasing transformation of it (e.g.,
cubing) provides another utility function that represents the same preference ordering in the
same sense as that of the original representation. And this implies that marginal utilities,
although calculable, have no meaning with respect to the specified preference ordering.
Applying an increasing transformation to the utility function changes the marginal utilities too.
(Since the utility function has no relation to an underlying pleasure structure, neither do the
marginal utilities.)
4
Actually, twice, continuous differentiability is often assumed.
5
In some of my earlier work (e.g., Katzner [6, pp. 49-50]), the distinction between these two approaches
to ordinal utility and the fact that economists subscribe to the one that eschews any reference to an
underlying pleasure structure is obscured. Barzilai's paper has led me to clarify the matter here.
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Indifference surfaces are defined in terms of the indifference relation that is included in the
preference ordering. 6 A utility function is not required to characterize them. Assuming
differentiability, their “slopes” (partial derivatives), referred to as (the negatives of) marginal
rates of substitution, are the rates at which the consumer can substitute at the margin one
good for another and remain on the same indifference curve. Even though those slopes can
be expressed in terms of the ratio of meaningless marginal utilities, they depend only on the
indifference relation – not the specific utility function employed. Increasing transformations of
the utility function change the marginal utilities, but not their ratio. Meaningful marginal utilities
are not needed to characterize marginal rates of substitution.
The arguments of Hicks and Samuelson take this perspective on ordinal utility. In the
mathematical appendix of Value and Capital [4, pp. 305-306], Hicks first derives the first-order
conditions for constrained maximization of the utility function using the method of Lagrange.
Then, when commenting on the “ordinal character of utility” in the section of the mathematical
appendix with that title, Hicks asserts that, “The equilibrium conditions [first-order
maximization conditions] … for the consumer … do not depend upon the existence of any
unique utility function” and the fact that they appear in terms of marginal utilities is only “… the
most convenient way to write them” [4, p. 306]. In the text itself he states: “The quantitative
concept of utility is not necessary in order to explain market phenomena,” and in reference to
the theory of consumer demand: “We start off from the indifference map alone; nothing more
can be allowed” [4, p. 18]. Hicks then goes on in the text to show how the theory of consumer
demand can be set out in non-mathematical terms without any reference to a utility function.
On p. 19, Hicks acknowledges that although the notion of marginal utility has no meaning, the
ratio of marginal utilities does. The word “ordinal” does not appear on these pages. The facts
that the word “ordinal” is used only once (as quoted above) in the mathematical appendix as
part of the title of a section, and that it appears in the index in reference to pp. 17 and 18
without actually appearing in the text on pp. 17 and 18, suggests that Hicks used it only as an
afterthought, perhaps to bring his work more in line with the latest terminology in vogue at the
time. There is nothing to suggest an underlying pleasure structure and a concept of ordinal
utility similar to that of the theory of measurement invoked by Barzilai. Indeed, if there were,
then his attack on Hicks would be fully justified.
Samuelson [11] uses the phrase “ordinal preference field” on p. 93. He explains what he
means by this on p. 94: “For any two combinations of goods [baskets of commodities or
vectors x and y] … it is only necessary that the consumer be able to place them in one of the
following categories: (a) x preferred to y, (b) y preferred to x, [or] (c) x and y equally preferred
or indifferent. For convenience, we may attach a number to each combination; this is
assumed to be a continuous differentiable function.” 7 In relating utility values to the preference
ordering, he then gives the exact same statement of the non-mathematical-theory-of-
6
Let the space of commodities X be the collection of all nonnegative baskets of goods. A preference
ordering ≥x is a binary relation defined on X that is reflexive and transitive. (Definitions of the latter two
terms appear in n. 8 below.) The (strict) preference relation > x and the indifference relation = x are
separated from the combined preference-indifference relation ≥ x as follows: In the case of (strict)
preference, for all x ′ and x ′′ in X, x ′ > x x ′′ if and only if x ′ ≥ x x ′′ and it is not the case that
x ′′ ≥ x x ′ . And, with regard to indifference, for all x ′ and x ′′ in X, x ′ = x x ′′ if and only if both
x ′ ≥ x x ′′ and x ′′ ≥ x x ′ .
7
I have taken a slight liberty here in changing Samuelson’s mathematical notation.
4
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measurement meaning of the concept of ordinal utility representation as provided here. Once
again, there is nothing to suggest anything that would indicate a concept of ordinality similar
to Barzilai's. Samuelson's approach to the theory of demand is similar to that of Hicks
presented in the mathematical appendix of Value and Capital.
There is further evidence in the literature suggesting that Hicks and Samuelson were not
confused about the notion of ordinality they employed, and were thinking of that concept only
as a representation of a preference ordering – not in terms of the mathematical theory of
measurement conceptualization as claimed by Barzilai. In a 1985 volume called Abstract
Measurement Theory, Narens [8] traces the history of Barzilai’s mathematical-theory-of-
measurement approach to measurement. On p. 5 Narens says, “The view that measurement
consists in specifying homomorphisms of some qualitative (or empirical) structure into a
numerical one [i.e., the mathematical-theory-of-measurement or Barzilai approach] is called
the representational theory of measurement, and since the late 1950s it has gained
widespread support among measurement theorists.” Indicating that the representational
theory of measurement found its way outside of the measurement theory world also in the
1950s, Luce and Narens write [7, p. 220], “More than anyone else, Suppes brought to the
attention of non-mathematicians this axiomatic style of studying the measurement of
attributes.” And the papers of Suppes they cite in this regard appeared starting in the 1950s.
Before the 1950s, the common notion of ordinal scales seems to have been that described by
Stevens [12, p. 679] in 1946: “The ordinal scale arises from the operations of rank ordering…
any ‘order-preserving’ transformation will leave the scale form invariant .” He goes on to
say that, “In the strictest propriety the ordinary statistics involving means and standard
deviations ought not to be used with these scales, for these statistics imply a knowledge of
something more than the relative rank-order of data. On the other hand, for this ‘illegal’
statisticising there can be invoked a kind of pragmatic sanction: In numerous instances it
leads to fruitful results.”
Given today’s knowledge of the matter, one may question that such results are, in fact, fruitful.
But, in any case, Stevens is not saying that arithmetic operations are not legitimate with
ordinal numbers; only that the results obtained when calculating means and standard
deviations of ordinal data, which require the use of arithmetic operations, should be used with
care. Care should be taken because applying an increasing transformation to the data will not
change the meaning of the data but may change the results of the calculation.
Now Hicks was writing about the theory of consumer demand in the 1930s and Samuelson in
the 1930s and early 1940s. (Samuelson’s Foundations was completed in 1941 but, due to
World War II, not published until 1947.) This suggests that the illegitimacy of applying
arithmetic operations to ordinal numbers in the mathematical-theory-of-measurement context
was not known to them, and that their attitudes toward ordinal numbers were likely to be
similar to the non-algebraic approach of Stevens rather than the homomorphism approach of
Barzilai. That is, as with many other scholars both in and outside of economics at the time, it
would probably not have occurred to them that the application of arithmetic operations to
ordinal numbers might be improper since their vision of ordinality had only to do with the fact
that applying increasing transformations to ordinal numbers yields new numbers having the
same informational content as the old. From the Hicks-Samuelson perspective then, there
would be nothing wrong in using the term 'ordinal' in conjunction with their order-preserving
utility function. After all, order-preserving functions arise from rank orderings and order-
preserving transformations have no impact on the underlying ordering – properties similar to
those described for ordinal numbers in the first quotation cited from Stevens above. Thus it
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seems that Hicks and Samuelson were not using ordinality in the sense of Barzilai and
were thinking of the utility function simply as an order-preserving representation of a
preference ordering.
II. Consumer demand functions
As indicated in the quotations and discussion attributed to Hicks above, the traditional theory
of consumer demand can be stated in its entirely omitting reference to utility of any
kind. Without becoming too deeply involved in technicalities, here is one mathematical
account of it:
Begin with a preference ordering defined among commodity baskets (vectors) in the non-
negative orthant of Euclidean space (the space of commodities) that is reflexive, transitive,
total, increasing, and strictly convex. 8 Assume that through each basket of commodities in
that space there is a continuous indifference surface defined in terms of the indifference
relation (mathematically characterized in n. 6 above).
Now every vector of (strictly) positive prices and income determines a budget set, B, defining
the collection of baskets available to the consumer for purchase. Budget sets are compact. 9
Consider one such vector of prices and income and hence a specific set B. For each basket x'
in that set there is another set, C', of all baskets preferred or indifferent to x'. The intersection
of the latter set (which is closed because indifference surfaces are assumed continuous) and
the budget set, B ∩ C', is also compact. Two baskets x' and x'' on the same indifference
surface yield the same intersection B ∩ C'. The collection of all sets of the form B ∩ C', one
set corresponding to each basket x' in the budget set, has the finite intersection property,
namely that the intersection of every non-empty finite sub-collection of the collection of all
sets of the form B ∩ C' is non-empty. It follows that 10 there exists a basket x0 in the budget set
that is contained in all sets of the form B ∩ C'. That basket is unique in the budget set and
(strictly) preferred to all other baskets in it. Loosely speaking, x0 is the “most preferred” basket
in the budget set B.
It turns out that under the assumptions on preferences stated above, a continuous (not
necessarily differentiable) utility representation of the preference ordering exists. That utility
functions is sometimes called ordinal. But it is not ordinal in the sense of the mathematical
theory of measurement and of Barzilai. Rather, it is ordinal in the sense of being a
representation of a preference ordering. In terms of such a utility function, the basket that is
(strictly) preferred to all other baskets in the budget set can be said to maximize utility subject
to the budget constraint. But, of course, that utility function and the constrained maximization
8
A relation such as ≥ x is reflexive when x ≥ x x for all x in the space of commodities X. It is transitive
if x ′ ≥ x x ′′ and x ′′ ≥ x x ′′′ imply x ′ ≥ x x ′′′ , for all x ′ , x ′′ , and x ′′′ in X. And it is total provided that,
for all x ′ and x ′′ in X, either x ′ ≥ x x ′′ or x ′′ ≥ x x ′ . The relation ≥ x is increasing whenever

x ′ ≠ x ′′ and x ′ ≥ x ′′ (in terms of inequality and greater-than-or-equal-to among Euclidean vectors)
implies x ′ > x x ′′ for all x ′ > 0 and x ′′ > 0 , where > x is defined in n. 6 above. It is strictly convex if
θx ′ + (1 − θ ) x ′′ > x x ′ for all x ′ > 0 and x ′′ > 0 such that x ′ = x x ′′ and 0 < θ < 1.
9
A set is compact is if it is closed (i.e., contains all of its limit points) and bounded.
10
See, for example, Hall and Spenser [3, p. 68].
6
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of it is irrelevant in, and imposes no additional restrictions on, the preceding derivation of the
most preferred basket in each budget set B.
Consumer demand functions are now defined as that function that relates to each price-
income vector, the basket of commodities that is (strictly) preferred to all other baskets in the
budget set as determined above by the specified price-income vector. All of the standard
properties of demand functions, such as homogeneity of degree zero and continuity, can now
be proved. Even without a utility function or its differentiability if one is in view, demand
functions may still be differentiable and, where they are, the well-known negative definiteness
and symmetry properties follow. 11 Clearly, then, the theory of consumer demand does not
need to rely on a utility function differentiable or otherwise for its logical viability. 12
Of course, there is little doubt that the theory of consumer demand has its limitations and can
be subjected to justifiable criticisms. But that it contains logical flaws of the sort described by
Barzilai is not one of the latter.
References
1. Barzilai, J., “Preference Function Modelling: The Mathematical Foundations of Decision Theory.” In
Trends in Multiple Criteria Decision Analysis, M. Ehrgott, J.R. Figueira, and S. Greco eds. (Boston:
Springer, 2010), Ch. 3
2. Barzilai, J., “Inapplicable Operations on Ordinal, Cardinal, and Expected Utility,” Real-World
Economics Review, 2013 issue # 63, pp. 98-102.
3. Hall, D.W., and G.L. Spenser II, Elementary Topology (New York: Wiley, 1955).
nd
4. Hicks, J.R., Value and Capital, 2 ed. (Oxford: Claredon Press, 1939).
5. Katzner, D.W., Static Demand Theory (New York: Macmillan, 1970).
6. Katzner, D.W., An Introduction to the Economic Theory of Market Behavior: Microeconomics from a
Walrasian Perspective (Cheltenham: Elgar, 2006).
7. Luce, R.D. and L. Narens “Fifteen Problems Concerning the Representational Theory of
Measurement,” in P. Humphreys, ed., Patrick Suppes: Scientific Philosopher, v. 2 (Dordrecht:
Kluwer, 1994).
8. Narens, L., Abstract Measurement Theory, (Cambridge: MIT Press, 1985).
nd
9. Pfanzagl, J., Theory of Measurement, 2 ed. (Würzburg-Vienna: Physica-Verlag, 1971).
10. McKenzie, L., “Demand Theory without a Utility Index,” Review of Economic Studies, 24 (1957),
pp.185-189.
11. Samueslson, P.A., Foundations of Economic Analysis (Cambridge: Harvard University Press, 1958).
12. Stevens, S.S., “On the Theory of Scales of Measurement,” Science, v. 103, no. 2684, Friday, June 7,
1946, pp. 677-680.
Author contact: dkatzner@econs.umass.edu
___________________________
SUGGESTED CITATION:
Donald W. Katzner, “Ordinal utility and the traditional theory of consumer demand”, real-world economics review,
issue no. 67, xx May 2014, pp. 130-136http:/www.paecon.net/PAEReview/issue67/Katzner67.pdf
You may post and read comments on this paper at: http://rwer.wordpress.com/comments-on-rwer-issue-no-67/
11
See, for example, Katzner [5, pp.110-112].
12
An account of the theory of consumer demand similar to that presented here has been given by
McKenzie [10].
7
1
How to Study for Chapter 20 Monopolistic Competition
Chapter 20 introduces the tools for analyzing the behaviors of companies in monopolistic
competition.
1. Begin by looking over the Objectives listed below. This will tell you the main points you
should be looking for as you read the chapter.
2. New words or definitions and certain key points are highlighted in italics and in red color.
Other key points are highlighted in bold type and in blue color.
3. You will be given an In Class Assignment and a Homework assignment to illustrate the main
concepts of this chapter.
4. There are a few new words in this chapter. Be sure to spend time on the various definitions.
Go over the graphs very carefully. They will be very important throughout the remainder of
the course.
5. The teacher will focus on the main technical parts of this chapter. You are responsible for
the cases and the ways by which each case illustrates a main principle.
6. When you have finished the text, the Test Your Understanding questions, and the
assignments, go back to the Objectives. See if you can answer the questions without looking
back at the text. If not, go back and re-read that part of the text. When you are ready, take
the Practice Quiz for Chapter 20.
Objectives for Chapter 20 Monopolistic Competition
At the end of Chapter 20, you will be able to answer the following:
1. Explain how a company in monopolistic competition would determine the profit-

maximizing quantity and price.
2. Show the graph for a company in monopolistic competition
3. Explain what will result in monopolistic competition if a company is earning economic
profits. Show this on the graph.
4. Explain what will result in monopolistic competition if a company is earning economic
profits. Show this on the graph.
5. Explain what will happen to a company in monopolistic competition if there is a decrease in
demand for the product. Apply this analysis to the case of movie theaters.
6. Explain what will happen to a company in monopolistic competition if there is a decrease in
a fixed cost of production or a variable cost of production. Apply this analysis to the case
of movie theaters.
7. Compare the performance of monopolistically competitive and purely competitive industries.
Why do monopolistically competitive companies have "excess capacity" in the long-run?
8. Explain what is meant by “creative destruction”.
9. Using the computer industry as an example, explain both how monopolistically competitive
companies operate and also the process of “creative destruction”.
10. What is an “experience good”? How is it marketed differently than other goods?
Chapter 20 Monopolistic Competition (latest revision July 2004)
In Chapter 16, monopolistic competition was defined as an industry with one seller (i.e., a
monopoly) of a very narrowly defined product. The demand for this product is very elastic
because there are many close substitutes for it. The close substitutes provide the competition.
2
Examples given included Coca Cola, McDonalds, and personal computers. In essence,
monopolistic competition has four main characteristics:
1. One seller of a narrowly defined product (such as Diet Coke)

2. Many close substitute products --- the products of the competitors are
differentiated
3. Good information on the part of buyers and sellers
4. Relatively easy entry and exit from the industry.
Monopolistic competition is the way that most actual competition occurs. In most cases
where there is sufficient competition, the products of the various competitors are
differentiated. Supermarkets sell dozens of brands of cereal, ice cream or frozen yogurt, soaps,
toothpaste, and so forth. Companies spend billions of dollars in advertising, trying to
differentiate their products from those of their competitors. There are several reasons that this
product differentiation is so common. First, and most obvious, is the fact that the tastes of
different people are different. In some cases (for example aspirin), there are no actual
differences between the products. But people perceive that there are real differences. For
example, one coffee company ran a series of commercials showing that customers in fancy
restaurants could not tell the difference between their instant coffee and fresh coffee. Yet, most
buyers still prefer the fresh coffee to instant coffee. Some prefer coffee strong while others
prefer it weaker. Some prefer it sweeter while others dislike sweet coffee. Companies try to
produce for all of these different preferences. Second, there are differences in income that
cause people to buy different goods and services. For this reason, sellers will sell color
television sets that range in price from $300 to several thousands of dollars. And the Honda
Motor Company produces Civics, Accords, and the Acuras.
Decision Making with Monopolistic Competition
Let us examine the graph for a company in a monopolistically competitive industry as shown
on the next page. Notice that the demand for the company’s product is very elastic (flat).But it
is not horizontal. For example, Coca Cola can raise its price above its competitors’ prices and
still be able to sell Coca Cola. However, if it raises its prices very much, the quantity it sells
could fall dramatically. Because an increase in price causes the quantity demanded to fall, the
demand curve is downward-sloping. And as we saw in Chapter 18, since the demand curve is
downward-sloping, the marginal revenue must be below the demand curve. This is the
same situation as in any “monopoly” --- that is, in any situation in which the company has some
ability to affect its price. The only difference between the demand curve facing a seller in
monopolistic competition and the demand curve facing the seller in pure monopoly is that the
demand curve for monopolistic competition is very elastic (because there are many substitute
goods). The goal of the company is to maximize profits. We know that this occurs where the
marginal revenue equals the marginal cost (point a). The company produces quantity Q1.
Going up from point a to the demand curve (point b) shows that the price is P1. Finally, we
calculate the profits as (price minus average total cost) times the quantity --- the rectangle
bcde. There is no industry supply curve here. Each company must be considered separately.
There is no way to add up hamburgers, pizzas, and tacos.
3
Monopolistic Competition with Economic Profits

$
Marginal Cost
Average Total Cost
e b
Demand1
d f c
a Demand2
Marginal Revenue2
Marginal Revenue1
0 Q2Q1 Quantity
Explanation. Since the demand is downward-sloping, the marginal revenue is below the demand
curve. This is the same situation as in any “monopoly” --- that is, in any situation in which the
company has some ability to affect its price. The goal of the company is to maximize profits. This
occurs where the marginal revenue equals the marginal cost (point a). The company produces
quantity Q . Going up from point a to the demand curve (point b) shows that the price is P . Finally,
1 1
we calculate the profits as (price minus average total cost) times quantity --- the rectangle bcde. In
the long run, competing companies would enter. The company would perceive that new competitors
were taking away its business. The demand for its product would fall (shift left). As it did, the
economic profits would fall. When the economic profits fell to zero, there would be no reason for
new competitors to enter. The situation is called “long-run equilibrium” (point f)
4
So far, the situation looks similar to that of a pure monopoly. But there is one big difference.
The company shown in the graph on Page 3 is making economic profits. This attracts new
competitors. In monopolistic competition, there are no barriers to entry. The new competitors
come in to compete with this company, often producing slightly different products. How do we
show this on the graph? We cannot show an increase in supply because there is no industry
supply curve. We must show this as the company would perceive it. What the company would
perceive is that the new competitors were taking away its business. The demand for its product
would fall (shift left). As it did, the economic profits would fall. When the economic profits
fell to zero, there would be no reason for new competitors to enter. The situation, shown in the
graph above, is called “long-run equilibrium” (point f). The number of competitors will then
remain unchanged until something occurs to change demand or costs.
The graph below shows the same situation, except that the company is making an economic
loss. The economic profits are still given by the rectangle bcde. However, since the price is less
than the average total cost, the economic profit is negative (loss). In the long-run, companies
will leave --- i.e., they will stop producing the product. They may go out of business altogether.
Or they may just stop producing this product and shift to another. How do we show this on the
graph? If this company stays in business and its competitors leave the business, the company
will perceive an increase in demand for its product. Those who bought from the former
competitors will now buy from this company. The increase in demand reduces its economic
losses. When the economic losses reach zero, there is no reason for companies to leave the
business. Long-run equilibrium has been reached (point f). The adjustment here may take
longer than the adjustment when there are economic profits. Each company will resist leaving
the business, hoping that the others will leave first. However, eventually some will have to leave
the business and long-run equilibrium will be reached.
Case: Premium Ice Cream
The changes in demand noted above can be illustrated with the case of premium ice cream.
Premium ice cream is ice cream with at least 13% butterfat content, giving it the thick, creamy
texture and superior taste to regular ice cream. The first company to market premium ice cream
was Pillsbury, marketing it under the name Haagen Daz. The demand for the product was very
high. As a result, the company was making considerable economic profits. As would be
expected, many new companies began producing this product. All of the new competitors made
products slightly different from Haagen Daz (perhaps the only difference was in the customers’
minds). Ben and Jerry produced chunky premium ice cream. Swensens not only produced
premium ice cream but also opened stores to sell it. Baskin and Robbins, which had previously
sold only in their stores, began to package their products. Others, such as Dreyers, and Breyers
(Kraft) appeared. For each individual company, the demand for its product fell as buyers bought
more from competitors. The demand continued to fall until the economic profits were zero.
Some years after the product came onto the market, it became known that a large amount of
fat in the diet is unhealthy. The demand for premium ice cream fell. As a result, companies
began to experience economic losses in the production of premium ice cream. As would be
expected, companies then reduced their production of premium ice cream. In this case, they did
not leave the frozen dessert business altogether. They simply shifted to other products such as
frozen yogurt and fat-free ice cream. With fewer facilities being devoted to premium ice cream,
the demand for any one producer rose (as there were fewer competitors). Economic profits
returned to zero.
5
Monopolistic Competition with Economic Losses

$
Average Total Cost
Marginal Cost
f
d c
e b Demand2
Demand1
Marginal Revenue1
Marginal Revenue2
0 Q1Q2 Quantity
Explanation. Since the demand is downward-sloping, the marginal revenue is below the demand
curve. This is the same situation as in any “monopoly” --- that is, in any situation in which the
company has some ability to affect its price. The goal of the company is to maximize profits. This
occurs where the marginal revenue equals the marginal cost (point a). The company produces
quantity Q . Going up from point a to the demand curve (point b) shows that the price is P . Finally,
1 1
we calculate the profits as (price minus average total cost) times quantity --- the rectangle bcde. In
this case, this is an economic loss. In the long run, companies would leave the industry. The
company would perceive that, with fewer competitors, it would have more business. The demand for
its product would rise (shift right). As it did, the economic profits would rise. When the economic
profits rose to zero, there would be no reason for new competitors to leave. The situation is called
“long-run equilibrium” (point f)
6
Case: Movie Theaters
A similar situation occurred for movie theaters. In the mid-1970s, assume that movie theaters
were in long-run equilibrium with economic profits of zero. Then, there was a large decrease
in the demand for movie theaters. The reason, of course, was the invention and spread of the
Video Cassette Recorder as well as the video rental store. This allowed people to rent movies
and see them at home. As the demand for movies fell, the quantity produced would fall as would
the price. The economic profits fell below zero (see the graph on the previous page). In this
situation, one would expect many theaters to go out of business. And indeed many did.
However, there is another response they could make --- find a way to produce at a lower cost
so as to make sufficient profits even with the decrease in demand. Movie theaters did this by
forming into large units of very small theaters --- the multiplex that is familiar to anyone who
attends movies. First of all, this lowered costs by allowing a spreading of the fixed costs. The
building is being used more intensively when people are in ten different parts of it watching ten
different movies. If there were only one movie showing in a large theater, many seats might be
empty. Also, the multiplex allows more efficient use of labor. Only one or two people are
needed to sell tickets or to sell food items. Ushers and people to clean can work in one theater
while the other ones are being used. These cost savings are reductions in both fixed and variable
costs. The decrease in fixed cost is a shift down in the average total cost. The decrease in the
variable cost is a shift down in both average total cost and marginal cost. The costs continue to
decrease until the economic profits rise back to zero.
Test Your Understanding

1. Show on a graph (like the one above) the result of the decrease in demand for movie theaters that
resulted from the invention, and subsequent popularity, of the Video Cassette Recorder. Show what
would occur in the short-run. Then, show what would occur in the long-run. Explain the changes you
made. In each case, what happens to the quantity of movie theater seat sold, the price of movies, and the
economic profits of movie theaters?
2. The movie theaters responded to the Video Cassette Recorder by moving into large multiplex theaters.
At first, six or eight theaters would be found in one structure. Now, twenty or thirty theaters may be
found in one structure. The purpose of doing this is to lower costs so as to regain profitability. The
building is used more efficiently if many parts of it are showing different movies. The workers, ticket
takers, ushers, cleaners, etc. can also be used more efficiently. In each case, is the reduction in the cost
a reduction in a fixed cost or in a variable cost? Show the results of these cost reductions on the same
graph --- in both the short-run and the long-run. In each case, what happens to the quantity of movie
theater seat sold, the price of movies, and the economic profits of the movie theaters?

1. Consider the fast food industry, including companies such as Wendys, Burger King, Taco Bell, and so forth.
First, explain why this industry would be considered monopolistic competition.
2. The company under consideration is Taco Bell. Taco Bell spends a large amount of money on advertising. The
purpose of the advertising is to increase the demand for Taco Bell products and to make that demand more inelastic
(that is, to have fewer real substitutes). Assume that the advertising succeeds in doing this. Show the new demand
and marginal revenue on the graph for Taco Bell, assuming you begin in long-run equilibrium.
3. The advertising is a cost of production. Is it a fixed cost or a variable cost? Why? Show the change in the cost
curves on the same graph.
4. Explain what will result in the short-run to the quantity of Taco Bell products produced, the prices of them, and
the economic profits of Taco Bell. Finally, explain what will result in the long-run.
7
Comparing Monopolistic Competition and Perfect Competition
Since monopolistic competition is much more common than perfect competition, it is

important to examine the list of benefits to society to see if they still pertain. Return to the list of
benefits to society from perfect competition in Chapter 17.
First, in perfect competition, all companies earned economic profits of zero in the long-
run. Do they do so in monopolistic competition? The answer, of course, if “yes” and for the
same reason. In both cases, when companies are earning economic profits above zero, new
competitors will continue to enter until the economic profits have been reduced to zero. In both
cases, companies can earn economic profits in the short-run. But if these do not last very long,
they are socially desirable because they motivate companies to enter industries whose products
are desirable, to find ways to lower costs, and to find improvements to products. Economic
profits will be zero in the long-run in any case in which there are no barriers to entry.
Second, companies in perfect competition achieved productive efficiency. In the short-

run, this meant that they produced the quantity being produced as cheaply as possible. That
would also occur for companies in monopolistic competition, as they also desire to maximize
their profits. In the long-run, productive efficiency meant that each company would produce that
quantity for which average total cost is at its minimum. The least possible is sacrificed for the
production of each unit of the product. Does this result occur in monopolistic competition? Just
looking at the long-run equilibrium in the graphs above indicates that it does not. The facts that
demand is downward sloping and that the price equals the average total cost (when economic
profits equal zero) require that the quantity produced in the long-run equilibrium is less than
the quantity for which average total cost is at its minimum. The company is said to have
excess capacity. Why is this so? Remember that the average total cost falls because of the
spreading of the fixed cost (that is, the cost of the capital goods). Companies in monopolistic
competition will not produce enough to take full advantage of the spreading of the fixed cost.
If they produced a greater quantity, the cost of producing per unit would be lower. However,
they do not produce a greater quantity because doing so would reduce their economic profits
(if they produced more, the marginal revenue would be less than the marginal cost).
There are many illustrations of this excess capacity. Walk into a supermarket at noon. You
will observe eight or nine cash registers. However, only one or two are open. The others are
excess capacity. You will also observe much freezer space with few customers. This too is
excess capacity. Walk into the branch of a bank in the morning. You will observe several teller
positions. However, only one or two are open. This phenomenon of increased cost per unit
due to excess capacity is common to companies in monopolistic competition. This increased
cost per unit explains why companies in monopolistically competitive industries, such as
supermarkets and banks, are frequently the subject of horizontal mergers (two or more
competing companies coming together into one company). The takeovers of Lucky by American
Stores (Alpha Beta), which was later taken over by Albertsons, or of Vons by Safeway, or of
Home Savings Bank by Washington Mutual are just a few examples. Mergers were discussed in
Chapter 10.
Third, companies in both perfect competition and monopolistic competition have incentives
to find ways to lower costs over time. The incentive in both cases is increased economic profit --
- in the short-run. However, only companies in monopolistic competition have incentives to
“improve” the product. In perfect competition, products are identical and all buyers know this.
8
In monopolistic competition, differentiating products is the main competitive strategy.

Remember that an “improvement” occurs only if buyers prefer the product more and are more
likely to buy it.
Finally, companies in perfect competition achieve allocative efficiency. Exactly the

“right” quantity of each good and service is produced. We know that this occurs when the price
is equal to the marginal cost. Does allocative efficiency occur in monopolistic competition? An
examination of long-run equilibrium in either graph above shows that it does not. The company
maximizes its profits at the quantity for which the marginal revenue equals the marginal cost.
But, because the demand is downward-sloping, the price is greater than the marginal revenue.
This means that the price must be greater than the marginal cost for a monopolistically
competitive company. Too little of the product is being produced (allocative inefficiency).
Society would benefit from having more of the product produced; however, the company would
lose profits if it produced more of the product (because the marginal revenue would be less than
the marginal cost).
In summary, companies in monopolistic competition realize all of the same benefits to

society as companies in perfect competition --- except for two. They generate economic profits
of zero in the long-run. The short-run economic profits that can be earned will motivate
socially desirable behaviors by the businesses. They provide incentives to be cost efficient in
the short-run, to find ways to reduce costs over time, and to find ways to “improve” the
product. The two exceptions are that monopolistically competitive companies do not produce
at the lowest possible cost per unit (they have excess capacity) and that they produce too little
of the good from the point of view of society as a whole (allocative inefficiency). However,
they do confer one additional advantage to society that companies in perfect competition do not.
They provide an endless variety of products. Since consumers’ tastes and incomes are
different, it is likely worth it to have the great variety of choices and to suffer the burdens of
excess capacity and allocative inefficiency.
Monopolistically competitive industries are in a constant state of flux. Companies are always
trying to gain a short-run advantage by finding ways to produce at a lower cost or by finding
products that consumers like more. Entrepreneurship is the most important factor of
production in monopolistically competitive industries. The dominant company of today may be
replaced very soon by a company that no one has yet heard of. The process --- labeled “creative
destruction” by the famous economist Joseph Schumpeter --- is central to the dynamics of a
market economy. This entrepreneurial drive to gain short-run profits seems to be the most
important reason for the creation of great wealth in countries that rely basically on markets. This
is illustrated in the following case.
Case: The Personal Computer Industry
The modern computer was actually born during World War II. The first American computer
was the ENIAC, designed to calculate artillery tables. It was an incredibly large device,
weighing 30 tons and containing 18,000 vacuum tubes. From that time until the early 1980s, the
main computer was the mainframe computers used by businesses and universities. These were
very large, requiring most of the space in an air conditioned room, and were very expensive.
Over 60% of all mainframe computers were sold by IBM. Other large producers were Sperry
Rand, Burroughs, and Honeywell. Sperry Rand (which actually produced the first mainframe
9
computer) and Burroughs later merged to form Unisys.

The first step in the creation of the personal computer was the development of the
microprocessor on a silicon chip by Intel in 1968. Once it had created the microprocessor, Intel
had all of the ingredients necessary to produce a personal computer. However, Intel saw no
practical application for such an invention. It saw the microprocessor as useful only for such
items as calculators and traffic lights. The only interest in personal computers at the time came
from a group of hobbyists. These young people had learned how to use and program the
mainframe computers. This became their passion. Since gaining time on a mainframe computer
was difficult, they yearned for a computer they could use at home. The first such personal
computer was invented in 1975 by Ed Roberts, who worked for a calculator company in New
Mexico. Called the Altair 8800 (named after a star used in the Star Trek series), it was designed
only for the hobbyist. It was expensive and came in a kit that one had to assemble oneself. Very
few were sold. Since computers work through thousands of circuits which are either “on” or
“off”, the Altair needed a way of relating the activities on the keyboard to the “on” or “off”
positions of the circuits. Two young hobbyists, Bill Gates and Paul Allen of Seattle, devised a
version of the computer language BASIC for the Altair. (BASIC stands for Beginners All-
Purpose Symbolic Instruction Code.) BASIC was a simple and commonly used language to
program large mainframe computers. With this language, which was loaded into the Altair using
paper tape, hobbyists could develop games and word processor applications for the Altair.
In California, several of the young computer enthusiasts belonged to a club, called the
Homebrew Club. To impress their friends, two of the club members, Steve Wozniak and Steven
Jobs, built a primitive computer, which they called Apple. They then improved it into the Apple
II, a packaged computer that did not have to be assembled by the purchaser. The Apple II was a
big improvement in that Wozniak had engineered it so that far fewer microprocessor chips were
needed. Granted funding from venture capitalist Arthur Rock, Apple was formed as a private
company marketing the Apple II. Until the end of the 1970s, the market was still limited to
computer enthusiasts. But then, in 1979, Dan Bricklin and Bob Frankston of the Harvard
Business School developed the first electronic spreadsheet, VISICALC, for use on the Apple II.
The spreadsheet was desired greatly by businesses, especially on Wall Street. Sales of Apple II
soared. In 1980, Apple went public (that is, it sold its shares on the market to anyone who
wished to buy them). With the sales of the stock, Steven Jobs was worth over $100,000,000 by
age 23. The situation for Apple is shown in the graph below. The economic profits of Apple
encouraged market entry by such companies as Atari, Osborne, and Radio Shack.
10
Case of Apple Computer

Marginal Cost
Average Total Cost
e b
Demand1
d f c
a Demand2
Marginal Revenue2
Marginal Revenue1
Q2Q1 Quantity
Explanation: The high demand and the virtual monopoly of personal computer is depicted above. The
economic profits (bcde) are very large. This attracts new producers to make a similar product. In the
Apple case, the main new competitor was IBM.
The rise in the sales of Apple II caught the attention of IBM, who feared a great loss in their
sales of mainframe computers. Anytime a company is earning large economic profits, it can
expect to find new potential competitors. IBM had one main advantage: it was greatly trusted
by businesses. Business represented the largest potential market for personal computers. But
IBM had one great disadvantage: its decision-making processes were very slow. IBM made the
decision to go into the personal computer business in 1980. It estimated that it would take four
years for it to produce a computer if it produced all or most of the components, as Apple had. To
expedite the process, IBM abandoned its traditions and decided to purchase components from
other companies (called “open architecture”). For example, the microprocessor chips were
purchased from Intel. The computer language was to be BASIC and was purchased from a new
11
company called Microsoft that had been started by Bill Gates and Paul Allen. The operating
system (the internal navigator that tells the computer how to store files, how the keyboard is
connected to the screen, and so forth) was also to be purchased. The logical seller was Gary
Kildall, who had developed an operating system for the personal computer called CPM. In one
of those great turns of history, Kildall treated IBM representatives in a manner they considered a
snub. IBM then turned to Bill Gates, asking to purchase both the computer language and the
operating system. At the time, the business of Microsoft was computer languages; Microsoft did
not have an operating system to sell. But Microsoft saw the advantage to itself of linking with
IBM who were so highly esteemed by businesses. So it looked around and found an operating
system that had been developed by Tim Patterson for a small company called Seattle Computer
Products. This system was adapted from (very similar to) CPM and was called QDOS (the quick
and dirty operating system). Seattle Computer Products was short of cash. So Microsoft bought
QDOS for $50,000, changed the name to MS-DOS (Microsoft Diskette Operating System), and
licensed (not sold) MS-DOS to IBM. Finally, IBM purchased the rights to a spreadsheet that had
been developed by Lotus Corp. of Massachusetts called “Lotus 1-2-3”. The IBM was marketed
through Sears and Computerland stores. The only components that IBM produced for itself was
the RAMBIOS, a chip that connects the hardware with the software. The new IBM personal
computer came on the market in August of 1981 and was an instant success, quickly reaching
30% of the market by 1984. However, the demand for Apple computers did not fall as one would
expect. The introduction of the IBM had increased the market for personal computers so greatly
that some of the increase actually spilled over to Apple.
The huge economic profits still being earned by Apple and now being earned by IBM should
attract competitors. And this is exactly what occurred. It was relatively easy for outsiders to
produce machines very similar to the IBM. All of the components could be purchased except
one. The operating system could be leased from Microsoft. In one of the major mistakes in
business history, IBM had allowed Microsoft to maintain control of the MS-DOS operating
system. It had never considered that Microsoft could lease the system to anyone else since, at
the time, there were no other companies to lease to. The first main competitor for IBM was
Compaq. It developed its RAMBIOS through a process known as “reverse engineering” (take
the IBM RAMBIOS, take it apart to see how it works, and then develop one that is similar
without violating the patent). Others, such as AST and Dell, also became competitors to IBM.
They were known as “IBM clones” because all of the software for IBM personal computers
would work on their personal computers. The clones reduced the demand for Apple and IBM
personal computers, causing the prices of them and the economic profits to fall. The clone
companies were able to operate with very low fixed costs since they were buying most of their
components. As a result of the low cost of production of the clones, the prices of personal
computers fell at the rate of 30% every six months.
To restore its “monopoly” position, IBM changed its strategy. It decided to develop its own
operating system and also to produce personal computers by producing all of the components
itself. This was the OS/2. To develop the operating system for the new OS/2, IBM asked
Microsoft to write the code. IBM and Microsoft had worked closely together before. But the
OS/2 was designed to eliminate the market for clones. This clone market was the market in
which Microsoft had made most of its profits from the leasing of MS-DOS. Microsoft faced a
conflict of interest. To keep MS-DOS competitive, Microsoft worked on the OS/2 for IBM and
at the same time poured its resources into the main improvement to MS-DOS, to be known as
“Windows”. Windows was introduced in 1990 and was immediately the industry success. The
decision not to use Windows was another major business mistake by IBM. IBM responded by
12
breaking off its relationship with Microsoft. In doing so, IBM became an also-ran in the
personal computer business. IBM returned to its origins --- being a profitable and dominant
producer of mainframe computers. In 1980, the share value of IBM stock was over 3,000 times
that of Microsoft. Today, the share value of Microsoft is greater. The key to the success of
Microsoft came form its ability to exploit opportunities (some would say ruthlessly). Microsoft
had not invented MS-DOS; however, it profited the most from it. And Microsoft did not invest
nor develop Windows. That story takes us back to Apple.
Actually, that story begins in 1971 with Xerox. Fearing that the computer would create a
“paperless office” and hurt its business in photocopying, Xerox created the Palo Alto Research
Center (PARC) near Stanford University, hiring 58 of the best people in the country in the area
of computers and giving them complete freedom to develop computer applications for the future.
Most of the functions that computer users today take for granted were developed at Xerox
PARC. However, the Xerox Corporation did not see any business benefit to them and therefore
did not develop them into products. Had it done so, Xerox could have dominated the entire
personal computer industry and been at least ten times its current size. Instead, many of the
researchers at Xerox PARC patented their applications and formed their own businesses to
develop them. They are now multi-millionaires. One person who visited Xerox PARC and saw
the immediate benefit was Steven Jobs of Apple. He was most interested in the Graphical User
Interface (GUI) which had been developed there. This is the system which allows the users to
tell the computer what to do by clicking a mouse (which had actually been invested in the 1960s)
on representational figures on the screen. Apple had been hurt by the IBM personal computer (it
lost market share, even though its sales of computers rose). The IBM used software that did not
run on Apple computers. Apple had tried to improve on the Apple II, but its computers either
were too expensive or did not work well enough. Apple would now risk the company on a new
computer incorporating the Graphical User Interface --- the MacIntosh. It would also hire as its
Chief Executive Officer (CEO) John Scully, formerly CEO at Pepsi-Cola, to help promote sales
of Apple computers to businesses. To make the MacIntosh successful, Jobs needed applications
that would be popular. For this, he turned to Bill Gates at Microsoft. Until this time, Microsoft
had not produced applications. The new MacIntosh, with Microsoft applications such as Word
and Excel 1-2-3 included, was launched with great fanfare in 1984. Initially, sales were very
low. The applications were not as numerous as those for the IBM and the price was much too
high (more than twice the price of the IBM). MacIntosh needed a market niche.
One of the problems with computers at the time was that the Dot Matrix printer could not
print exactly what was on the screen. One of the researchers at Xerox PARC had developed a
laser printer and printer software that could print exactly what was on the screen. He started a
company to market this product, called “Adobe”. Apple then bought almost 20% of the stock of
Adobe in a deal that allowed Apple to use the software. Apple had found its niche in the market
--- desktop publishing. MacIntosh would become the computer of choice for almost any creative
business. The result was a large increase in the demand for MacIntosh computers. By 1987,
Apple was selling one million MacIntosh computers per year. Apple saw itself as a “monopoly”;
it assumed that its product was so good that buyers would pay a premium price. Apple believed
that there was no good substitute. Of the high price of $2,000 that Apple charged, about $1,000
was pure economic profit. Given that MacIntosh was so much better than the other personal
computers of the time, it should have come to dominate the market. But it failed to realize that
high economic profits will always invite competition. That competition was to come from Bill
Gates at Microsoft.
13
Gates saw the MacIntosh as a threat to his “cash cow”: the MS-DOS that was included with
each IBM compatible personal computer (the clones). To defend the market position of MS-
DOS, he launched Windows 1.0 (which worked on top of MS-DOS). This was gradually
improved until Windows 3.0 was launched in 1990. Windows 3.0 made the IBM personal
computer almost as easy to use as the MacIntosh. It sold 30 million copies in just one year.
Apple believed that Microsoft had been copying features of the MacIntosh and sued in court.
The case lasted six years. Eventually, Apple lost its case. After losing the case, Apple struggled
to maintain profitability for several years. Gates went on to launch the next version of Windows
--- Windows 95 --- in 1995, combining the operating system and the graphical user interface into
one package. Windows 95 was a major success in the marketplace and Microsoft is an
extremely profitable company. A slight improvement, Windows 98, came out in 1998. Then
came Windows 2000 and Windows XP and so forth.
The difference in the competitive strategies of the companies shows the nature of competition
under monopolistic competition. Apple chose to keep the design of the MacIntosh to itself,
refusing to license the technology to others. It feared licensing its technology to a cheaper
producer because the MacIntosh had a gross markup of 55%. In effect, Apple was greedy. It
paid dearly for this. Apple was vertically integrated, meaning that it produced the computer and
the software. Microsoft was not. Microsoft’s strategy was to link itself to the main hardware
producers --- IBM and also Apple. In each case, it sought to carve out a dominant market share
for its product. In the case of operating systems, its product became the industry standard (see
Chapter 19). Software applications were largely written for MS-DOS and then for Windows.
This made computer buyers more likely to buy the computers that had these operating systems.
(Path dependence is described in Chapter 19.) Since IBM compatible computers had these
operating systems and sold large numbers of computers, software manufacturers desired to write
applications for them --- a virtuous circle for Microsoft. Microsoft cannot be credited with
developing original ideas or even particularly good products. However, Microsoft was better
than anyone in recent memory at exploiting the ideas of others. Therein lies the key to the
success of one of the greatest stories in American business history.
The case of the personal computer industry also illustrates the drive to continually improve
products that is the hallmark of monopolistic competition. In recent years, Microsoft
developed a World Wide Web browser (Internet Explorer) to compete with the industry leader,
Netscape. It entered the entertainment business by joining into alliances with Steven Spielberg
in a movie studio (Dreamworks) and with NBC in a cable television station (MSNBC). Steven
Jobs, after being forced from Apple, sold his Apple stock and used the money to fund a
successful movie animation studio (Next). Apple itself was a company in trouble; it is tried to
restore itself to profitability through an alliance with IBM (called Taligent) to develop a more
advanced operating system and through an alliance with IBM and Motorola to develop the Power
PC. In 1996, Apple bought Next and brought back Steven Jobs. Apple's profitability returned in
1998 with the introduction of the iMac. IBM restructured itself into thirteen autonomous
divisions which make components. These divisions often sell the components on the open
market, a radical departure from the methods of IBM in previous years. Workstations (personal
computers linked together in a network, first developed by Sun Microsystems) allow companies
to replace their mainframe computers with personal computers and thereby save large amounts
of money. Laptop computers today contain the processing power that required mainframe
computers a generation ago. And many others are presently developing new innovations for the
coming world of the information superhighway. Entrepreneurial drive has led not only to better
14
products but also to lower prices. Over the period of the 1980s and early 1990s, personal
computer prices fell at a rate of 32% annually. In no industry has the assault of “creative
destruction” been more evident.
*Test Your Understanding*

In the chapter, the history of the personal computer industry is developed as an example of monopolistic
competition. In the graph below, depict the history of IBM as related in the chapter. Assume that the
personal computer industry is monopolistic competition. The graph below shows the situation as of 1980.
It assumes that the company is in long-run equilibrium, with economic profits of zero. Go through the
chapter and show on the graph all of the events that relate to IBM. Consider the decision to enter
the personal computer industry, the entry of the “clones”, the development of the OS/2, the
development of Microsoft Windows, and the alliances with Apple. In each case, explain why you
made the changes that you did and also what resulted for the company. (You may need to redraw the
graph so that your graph does not become too crowded)
$
Marginal Cost
Average Total Cost
Demand1980
Marginal Revenue1980
0 Q1980 Quantity for IBM
Internet Assignment
1. The personal computer industry is a monopolistically competitive industry. Find the homepages of
some of the leading companies in this industry. You may focus on any aspect of this industry that you
wish. Go to the web pages of any of the large number of companies that produce either hardware or
software. Discuss some of the ways that these companies attempt to differentiate their products. Is the
product differentiation real or imagined?
2. The text considers the computer industry up to about 1995. The text says that, in monopolistic
competition, there should be a continual effort to “improve” the product and to lower the costs of
production. From your perusal of the homepages, find examples of “improving” the product (and also of
lowering the costs of production, if you can) that occurred from 1996 to 2004.
15
Case: Experience Goods
In Chapter 1, it was stated that modern economic thinking begins with the assumption that
people are rational. I know what is best for me and you know what is best for you. This
knowledge then determines our buying decisions. But for certain goods or services, this
assumption has to be modified. These are called “experience goods” because people must
experience them first before knowing whether they want them or not. Do you want today’s
edition of the Wall Street Journal? If you have not seen the edition, you really have no way of
knowing. It may contain articles you don’t care at all about. Or it may provide exactly the
information you need to become financially secure for the rest of your life. Only when you
know what the edition contains, when you have experienced it, can you decide if you want it or
not. Until 1990, I could not figure out why I would ever spend thousands of dollars for a
computer. What would I do with it that I really wanted to do? Now, I have three computers and
cannot figure out how I ever lived without one.
There are many examples of “experience goods”. Most entertainment products are
experience goods. Most new products are experience goods. And, as the example of the Wall
Street Journal illustrates, most information goods are experience goods. The problem with
experience goods is that people will be very reluctant to buy the product until they know what
it is but will not know what it is until they buy it. This has presented a problem for the sellers of
these products.
The sellers’ responses have depended on the type of product they produce. Those companies
that produce physical products have long responded to this problem by giving away free
samples. Those sellers that produce popular music have put the music on radio. Hearing a new
song allows you to know if you like it. But it is not convenient to wait until the radio DJ decides
to play it. If you like it, you will want the CD for yourself. An interesting example concerns a
former teacher. In the late 1980s, she created shows with Barney the Dinosaur as her main
character. She could produce the shows easily and get the tapes to stores on consignment. But
her problem was how to get people to buy them? Her response was to send free videos to day
care centers and preschools. The kids liked Barney and wanted to see Barney at home. As they
say, the rest is history. The purple dinosaur is now a major part of American life.
Similar behaviors have been common for software products. McAfee Associates was a
company selling a program to detect and fix computer viruses. It offered its product free over
the World Wide Web. Its revenues came from upgrades and additional services. In less than ten
years, it became a multi-billion dollar company. Adobe offers its pdf reader free over the
Internet. Once many people have downloaded it, Adobe makes its revenue by selling programs
that provide the ability to write in the pdf format. Netscape gave away its World Wide Web
browser, Navigator, for free over the Internet. When you go to Netscape Navigator, you are
taken to the company’s Netcenter. The company earns revenue by selling advertising on
Netcenter. The search engines, Yahoo and Google, operates in the same manner.

1. The Grateful Dead were a band who made most of their money from touring, rather than from selling
records or CDs. While most performers prevent anyone from taping their live performances, the Grateful
Dead encouraged people to tape their concerts. Explain why it would be beneficial for them to encourage
fans to tape their live performances.
2. Linux is an operating system that is a competitor to Windows. The code for Windows is a very closely
guarded secret. But the code for Linux is available over the Internet free to anyone who wants it. Explain
why Linux would give away its product.
16
Practice Quiz on Chapter 20
1. Which of the following is a characteristic of monopolistic competition?

a. many close substitutes b. good information c. low barriers to entry d. all of the above
2. Which of the following will result in monopolistic competition in the long-run?

a. excess capacity c. zero economic profits
b. allocative inefficiency d. all of the above
3. If a company in monopolistic competition is earning economic profits in the short run,

a. new sellers will enter, reducing the demand for this company’s product
b. sellers will leave, raising the demand for this company’s product
c. new sellers will enter, decreasing the marginal cost
d. new sellers will enter raising the demand for this company’s product
4. Assume a company in monopolistic competition begins in long-run equilibrium. Then, there is a decrease in
demand for the product. Which of the following will occur in the short-run?
a. the quantity sold will rise b. profits will fall c. the price will rise d. all of the above
5. Taking the situation in the previous question, what will result in the long-run?
a. sellers will leave the industry c. economic profits will fall below zero
b. the price charged will fall d. all of the above
6. Assume a company in monopolistic competition begins in long-run equilibrium. Then, there is a decrease in a
fixed cost of production. Which of the following will occur in the short-run?
a. the quantity sold will rise b. profits will rise c. the price will rise d. all of the above
a. sellers will enter the industry c. economic profits will fall to zero
8. Assume a company in monopolistic competition begins in long-run equilibrium. Then, there is a decrease in a
variable cost of production. Which of the following will occur in the short-run?
a. the quantity sold will rise b. profits will rise c. the price will fall d. all of the above
a. sellers will enter the industry c. economic profits will fall to zero
10.The constant drive to improve products in order to gain short-run profits is called
a. creative destruction b. allocative efficiency c. excess capacity d. rents
Answers: 1. D 2. D 3. A 4. B 5. A 6. B 7. D 8. D 9. D 10. A
Journal of Macromarketing
31(1) 73-84
The Theory of Monopolistic Competition, ª The Author(s) 2011
Reprints and permission:
sagepub.com/journalsPermissions.nav
Marketing’s Intellectual History, and the DOI: 10.1177/0276146710382119
http://jmk.sagepub.com
Product Differentiation Versus Market
Segmentation Controversy
Shelby D. Hunt1
Abstract
Edward Chamberlin’s theory of monopolistic competition influenced greatly the development of marketing theory and thought in
the 1930s to the 1960s. Indeed, marketers held the theory in such high regard that the American Marketing Association awarded
Chamberlin the Paul D. Converse Award in 1953, which at the time was the AMA’s highest honor. However, the contemporary
marketing literature virtually ignores Chamberlin’s theory. The author argues that the theory of monopolistic competition
deserves reexamining on two grounds. First, marketing scholars should know their discipline’s intellectual history, to which
Chamberlin’s theory played a significant role in developing. Second, understanding the theory of monopolistic competition can
inform contemporary marketing thought. Although our analysis will point out several contributions of the theory, one in partic-
ular is argued in detail: the theory of monopolistic competition can contribute to a better understanding of the ‘‘product differ-
entiation versus market segmentation’’ controversy in marketing strategy.
Keywords
Chamberlin, marketing strategy, product differentiation, market segmentation
As research specialization has increased, . . . knowledge outside Despite the theory’s defeat in economics, the theory of
of a person’s specialty may first be viewed as noninstrumental, monopolistic competition (hereafter, TMC) influenced greatly
then as nonessential, then as nonimportant, and finally as the development of marketing theory and thought in the 1930s
nonexistent. to the 1960s (Dixon and Wilkinson 1989; Grether 1967). That
Wilkie and Moore (2003, 142). is, TMC was influential at the end of marketing’s ‘‘second era’’
and the beginning of its ‘‘third era’’ (Wilkie and Moore 2003).2
In 1927, a young doctoral student completed his dissertation For example, in his argument that progressive differentiation of
in economics at Harvard; in 1933, the dissertation was pub- products and services is the key to defining the values created
lished as a book. The student was Edward Hastings Chamber- by marketing, Alderson acknowledges that ‘‘this step-by-step
lin; the book was The Theory of Monopolistic Competition. The differentiation of an economic good is the essence of the eco-
theory was proposed as ‘‘a general theory, designed to replace nomic process as recognized by Chamberlin’’ (Alderson
that of generalized pure competition (of Marshall or Walras, for 1957, 70). In addition, in discussing his functionalist approach,
instance) as a point of departure and as a basis for analysis of Alderson (1957, 101) maintains that the ‘‘substance of the
the entire economy’’ (Chamberlin 1951, 343; italics in origi- functionalist approach is very similar to what Chamberlin
nal). In light of its ‘‘replacement’’ thesis, economists vigor- implied by monopolistic competition.’’ As a third example,
ously debated the theory in the 1930s to the 1950s: ‘‘During Alderson (1965, 184) notes that ‘‘this writer has drawn upon
a relatively short period of time (1926-41), monopolistic com- E. H. Chamberlin for the treatment of differential advantage
petition theory dominated international economic science, . . . although the term has never been used by Chamberlin.’’
[but] there were technical difficulties in the mathematical mod-
eling of monopolistic competition . . . [that] made it unattrac-
tive in a science that was being formalized and extended into 1
Jerry S. Rawls College of Business Administration, Texas Tech University,
general equilibrium’’ (Keppler 1994, 3, 7). By the mid- Lubbock, TX, USA
1950s, the debate’s verdict was in: advocates of perfect compe-
Corresponding Author:
tition had won, and those promoting the theory of monopolistic Shelby D. Hunt, Department of Marketing, Jerry S. Rawls College of Business
competition as a starting point for analyzing competition had Administration, Texas Tech University, Lubbock, TX 79409, USA
been ‘‘defeated’’ (Stigler 1957, 17).1 Email: shelby.hunt@ttu.edu
73
74 Journal of Macromarketing 31(1)
Theorists in marketing’s second and third eras held TMC in micromarketing thought, one contribution is argued in detail:
such high regard that Chamberlin received the American Mar- TMC can contribute to a better understanding of the ‘‘product
keting Association’s Paul D. Converse Award in 1953, which differentiation versus market segmentation’’ controversy in
at the time was the AMA’s highest honor. The citation stated: marketing strategy.
The author intersects with macromarketing in at least three
You have been selected by our national jury of scholars to ways. First, he contributes to marketing’s intellectual history
receive this award for your contribution to the advancement and the history of both marketing practice and marketing
of theory in marketing, primarily through your development thought has long been considered an important component of
of The Theory of Monopolistic Competition. Although you macromarketing. Indeed, this journal institutionalized history
probably consider the study a development of economic as a part of macromarketing with the establishment of the mar-
thought, it has had a major impact on marketing thinking. . . . keting history section in 1998. Second, the author addresses the
Such effects widen through the years and the influence of an nature of competition, specifically monopolistic competition,
idea is seen in the direction it gives to research, to thought, to and the subject of competition has long been associated with
practice, and to the philosophy of men. (Grether 1967, 307)
macromarketing. Again, this journal institutionalized ‘‘compe-
tition and markets’’ as an important part of macromarketing
Contrary to the citation’s prediction, the influence of Chamber-
with the establishment of a separate section in 1998. Third, the
lin’s TMC on marketing has not ‘‘widened through the years,’’
author is macro in that it discusses product differentiation in
nor is there evidence that it has given ‘‘direction’’ to research,
association with marketing systems that are characterized by
thought, or practice. Indeed, a citation analysis (Web of Sci-
heterogeneous, intra-industry demand and heterogeneous,
ence, 1981 to present) for ‘‘E.H. Chamberlin’’ and ‘‘market-
industry supply. That is, product differentiation has conse-
ing’’ conducted by the author finds only twenty-five
quences for marketing systems, as stressed in macromarketing
citations. Furthermore, of the marketing-related articles citing
by Hunt (1981) and Layton (2009).
Chamberlin, less than a dozen are in marketing journals. In
The author begins the analysis with an overview of the ori-
short, the contemporary marketing literature virtually ignores
gins, assumptions, and formal structure of the Chamberlin’s
Chamberlin’s TMC. Therefore, the conclusion of Dickson and
TMC. Then, he discusses the debate in economics concerning
Ginter (1987, 2) that Chamberlin’s TMC has been ‘‘over-
TMC and the impact of TMC on marketing.
looked’’ still stands.
Chamberlin’s TMC joins other works in being highly influ-
ential in marketing’s intellectual development, yet virtually The Development of the Theory of
ignored in contemporary marketing theory and thought. Con- Monopolistic Competition
sider Wroe Alderson. At the beginning of the‘‘era three’’ of
Chamberlin’s development of TMC was prompted by several
Wilkie and Moore (2003), Alderson was judged to be ‘‘without
considerations. Appendix H, in Chamberlin (1962), highlights
doubt the most influential marketing theorist in recent times’’ three: (1) his analysis of the problem of setting railway rates,
(Grether 1967, 315) and at the era’s end, a survey of marketing which he studied when he was a graduate student at the Univer-
academics ranked Alderson as the number one contributor to sity of Michigan, (2) his observation that many industries con-
the development of marketing thought (Chonko and Dunne tain firms whose products are heterogeneous, and (3) his
1982). Furthermore, scholars in the current era now laud recognition that the economics literature of his time provided
Alderson as ‘‘unquestionably the pre-eminent marketing theor- no clear explanation of how industry prices settled at the point
ist of the mid-twentieth century’’ (Wooliscroft, Tamilia, and of equilibrium between supply and demand. However, he
Shapiro 2006, xvii). However, Alderson’s work is seldom used laments, misconceptions concerning the origins, and nature
as a foundation for (or even cited in) contemporary marketing of TMC contributed to the confused nature of the debate over
research, which leads Wooliscroft, Tamilia, and Shapiro 2006 the theory’s merits.
(2006) to (1) develop a historical perspective on Alderson, the Some writers maintained that TMC was developed as a
person, (2) provide commentaries on, and extensions of, response to the depression of the 1930s. However, Chamberlin’s
Alderson’s work, and (3) argue that Alderson’s work ‘‘continues (1933) Theory of Monopolistic Competition was first written as a
to provide ... many important conceptual building blocks . . . PhD thesis at Harvard in 1927, before being shortened to book
which contemporary marketing scholars can use in their efforts form six years later. He revised it seven times, with the last edi-
to improve both the theory and practice of marketing’’ (xviii). tion bearing a 1962 copyright. Therefore, TMC was developed
The author argues that Chamberlin’s TMC, like the work of prior to the great depression and ‘‘is without reference to any
Alderson, deserves reexamining on two grounds. First, as Jones particular period of business, either good or bad’’ (Chamberlin
and Keep (2009) and E. H. Shaw (2009) point out, marketing 1962, 293). Other commentators argued that TMC was an attack
scholars should know their discipline’s intellectual history, to on Marshall, but Chamberlin (1962, 316) pointed out that TMC
which Chamberlin’s TMC played a significant role in develop- ‘‘was an attack, but not on Marshall, but on the theory of perfect
ing. Second, understanding TMC can inform contemporary competition . . . [and] those who simply regard ‘competitive’
marketing thought. Specifically, though our analysis will point and ‘monopolistic’ as separate categories, with different princi-
out several ways TMC can inform both macromarketing and ples in each case and a clear line of distinction between them.’’
74
Hunt 75
Still others viewed TMC as a form of imperfect competition. analysis of Robinson’s ‘‘wrong turning.’’ As Mongiovi
But, Chamberlin (1951, 343) saw it as ‘‘not a theory of ‘imper- (1992, 964) recounts, ‘‘The despair that marked the final years
fections’ in any sense.’’ of her [Robinson’s] life was due not only to the discipline’s
Although the author focuses on TMC, it should be noted that indifference to her message [that equilibrium analysis is a des-
Joan Robinson’s (1933) theory of imperfect competition was ert], but also to her rising doubts about whether the method she
also much debated in the 1930s–1940s, often in conjunction endorsed could in fact help to explain processes in historical
with Chamberlin’s theory of monopolistic competition. As time.’’ Joan Robinson’s despair is understandable.3
Chamberlin (1962, 207) points out, ‘‘imperfect [competition] For TMC, a common, if not the most common, form of com-
and monopolistic competition have been commonly linked petition is characterized by ‘‘product differentiation,’’ which
together as different names for the same thing.’’ However, his implies a form of competition that contains elements of both
1962 edition devoted an entire chapter (Chapter IX) to discuss- competition and monopoly. As he put it, his dissertation and
ing the differences between the theories of monopolistic com- book sought to develop ‘‘a hybrid theory of monopoly and
petition and imperfect competition. The chapter ‘‘reaffirm[s] competition’’ (1962, 296). The first edition’s preface main-
the nature of monopolistic competition as a composite of tained that ‘‘economic theory is often remote and unreal, not
monopoly and competition, calling attention here to a funda- because the method is wrong, but because the underlying
mental difference between Mrs. Robinson’s conception of the assumptions are not as closely in accord with the facts as they
problem and my own’’ (191). Specifically, ‘‘this concept of a might be’’ (Chamberlin 1933/1962, xi). What, then, are the
blending of competition and monopoly [in monopolistic com- assumptions of TMC?
petition] is quite lacking in Mrs. Robinson’s Imperfect Compe-
tition’’ (205; italics in original).
That is, for Chamberlin, but not for Robinson, the fact that Assumptions
an industry is characterized by product differentiation implies
The first assumption of TMC is that the theory applies to those
that there is a form of competition (monopolistic competition)
industries in which there is product differentiation, which he
that is a blend of competition and monopoly. Indeed, in the
defines very carefully:
very first chapter of Robinson (1933, 17), she defines a com-
modity as a ‘‘consumable good, arbitrarily demarcated from A general class of product is differentiated if any significant
other kinds of goods, but which may be regarded for practical basis exists for distinguishing the goods (or services) of one
purposes as homogeneous within itself.’’ She then goes on to seller from those of another. Such a basis may be real or fan-
define what a demand curve is and then to use ‘‘motor cars’’ cied, so long as it is of any importance whatever to buyers, and
as an example of a ‘‘commodity’’ that has a single, industry leads to a preference for one variety of the product over another.
demand curve. For Chamberlin’s TMC, in contrast, assuming Where such differentiation exists, even though it be slight, buy-
that the motor car industry can be viewed as producing a homo- ers will be paired with sellers, not by chance and at random (as
geneous commodity for the ‘‘practical purpose’’ of generating under pure competition), but according to their preferences.
an industry demand curve is totally contrary to the theory’s (Chamberlin 1962, 56)
emphasis on the consequences of product differentiation in real
industries. In fact, Chamberlin (1954b) actually uses the motor TMC’s second assumption is that product differentiation is the
car industry as a prototypical example of the kind of industry state of affairs in an industry that results from both heteroge-
for which it is theoretically (and practically) impossible to draw neous demand (i.e., differences in buyers’ preferences) and het-
an industry demand curve. To those who insist that the motor erogeneous supply (i.e., differences in what firms choose to
car industry should produce a homogeneous product, produce or are capable of producing). TMC recognizes that het-
Chamberlin (1954a, 259) asks, ‘‘if we are to imagine a purely erogeneous demand alone is not sufficient to result in product
competitive automobile industry, will its homogeneous product differentiation. Firms may be unaware of demand heterogene-
be Packards, Plymouths, or Peugeots?’’ ity, collude to ignore demand heterogeneity, or be required by
There is also an interesting sidenote on the debate in eco- state fiat to produce a homogeneous product.
nomics concerning Robinson’s theory of imperfect competi- Recall that Chamberlin maintained that problems in eco-
tion. As early as the 1950s, Robinson (1951, vii-viii) was nomic theory result ‘‘not because the method is wrong.’’ There-
lamenting that, instead of the Marshallian, evolutionary pro- fore, TMC’s third assumption is that the method appropriate for
cess approach that she could have adopted, her static–equili- economic analysis is that of static equilibrium, with its reliance
brium analyses represented a ‘‘wrong turning.’’ Because, she on mathematics and geometric reasoning. We should be mind-
pointed out, the neoclassical approach lacked a ‘‘comprehensi- ful that, in the 1920s and 1930s, the neoclassical research tra-
ble treatment of historical time,’’ the ‘‘theoretical apparatus dition had not yet ‘‘hardened’’ (Lakatos 1978) around static
[was] useless for the analysis of contemporary problems in the equilibrium analysis and general equilibrium theory (Nelson
micro and macro spheres’’ (Robinson 1979, 58). Accordingly, and Winter 1982; Weintraub 1984), and many economists were
she later pleaded for ‘‘getting economic theory out of the desert still advocating a Marshallian, dynamic, biological metaphor,
of equilibrium and into fruitful fields’’ (Robinson 1980, xiv). evolutionary approach to economic theory. Indeed,
Loasby (1991) provides an extensive and very sympathetic Chamberlin’s selection of equilibrium analysis and his
75
development of the equilibrium firm (as a complement to Mar- equilibrium position poses a challenge because each firm’s
shall’s industry equilibrium) furthered the static–equilibrium product ‘‘has distinctive features and is adapted to the tastes
approach to economics. Historians note that Chamberlin’s and needs of those who buy it, . . . [which] lead to wide diver-
selection of equilibrium analysis contributes to explaining gences in the curves of cost of production, and buyers’ prefer-
‘‘why, how and when Marshall’s use of the biological analogy ences account for a corresponding variety of demand curves’’
was suppressed and eventually eliminated from economics’’ (81). His ‘‘solution’’ is to assume that the demand and cost
(Foss 1994). curves for all group members are identical, which he charac-
TMC’s fourth assumption is that monopolistic competition terizes as a ‘‘heroic assumption’’ (1962, 82).
is to be judged using perfect competition (or ‘‘pure’’ competi- Given identical demand and cost curves for a group of
tion in Chamberlin’s terminology) as the reference.4 Because monopolistically competitive firms, Chamberlin (1962) argues
perfect competition leads to a Pareto-optimal allocation of that the surplus profit of the group’s members that stems from
scarce resources in the face of unlimited human wants, perfect their higher prices (compared with perfect competition) attracts
competition is the ‘‘gold standard.’’ That is, perfect competi- new entrants to the group. The total quantity sold by the group
tion is the standard to be used because perfect competition is, must then be divided among more producers, which shifts each
well, perfect. firm’s demand curve to the left. Consequently, each firm’s
Nelson and Winter (1982) note that economic theory can profit maximizing price increases and quantity produced
divided into two types: (1) ‘‘appreciative theory,’’ the informal decreases. Therefore, at the group equilibrium point (where
theoretical discussion that one finds at the beginning and end of there is no further entry or exit of firms, no further price–quan-
typical journal articles in economics and (2) ‘‘formal theory,’’ tity adjustments), each firm’s demand curve is tangent to its
the equations in the middle of the articles that are considered by total cost curve. At this group equilibrium price and quantity,
the neoclassical economics’ research tradition to be each arti- all surplus profits have been competed away, but ‘‘the price
cle’s major contribution. Accordingly, Chamberlin’s TMC has is inevitably higher and the scale of production inevitably
both formal and informal theories. We begin with the formal smaller under monopolistic competition than under pure com-
theory. petition’’ (1962, 88).
Chamberlin (1962) then extends his analysis to other wel-
fare implications of monopolistic competition. As to product
TMC’s Formal Theory quality, he argues that it will be ‘‘inevitably somewhat infer-
ior’’ (99). As to the factors of production, because excess pro-
Chamberlin (1962, 74-81) begins developing his formal theory
ductive capacity has no ‘‘automatic corrective,’’ the ‘‘surplus
by analyzing the circumstances that must prevail for an individ-
capacity is never cast off and the result is high prices and
ual monopolistic firm to be in equilibrium. He draws a down-
waste’’ (109). As to whether labor is exploited in the sense of
ward sloping demand curve for the firm, a U-shaped total
receiving less than the value of its marginal product, as argued
cost curve, a downward sloping marginal cost (MC) curve, and
by Robinson (1933), ‘‘all factors are necessarily ‘exploited’
a U-shaped marginal revenue (MR) curve.5 He next assumes
. . . [for] it would be impossible for employers to avoid the
firms to be profit maximizers and points out that the profit max-
charge of ‘exploitation’ without going into bankruptcy’’ (183).
imizing quantity occurs where MC ¼ MR. He then directs the
TMC’s formal theory paints a dismal picture of the welfare
reader to the demand curve and shows that the profit maximiz-
implications of the monopolistic competition spawned by het-
ing quantity occurs at a price that exceeds MR. Because under
erogeneous demand and supply. Compared with perfect com-
pure (perfect) competition MC ¼ MR ¼ Price, he concludes:
petition’s homogeneous demand and supply, prices are
higher, quantities produced are lower, excess capacity is per-
[T]he effect of monopoly elements on the individual’s adjust-
manent, products produced are inferior, and all factors of pro-
ment . . . is characteristically to render his price higher and his
scale of production smaller than under pure competition. This is duction are exploited.
the result of the sloping demand curve, as compared with the
perfectly horizontal one of pure competition. No matter in what TMC’s Informal Theory
position the demand curve is drawn, its negative slope will
define maximum profits at a point further to the left than if it The vigorous debate over TMC in the 1930s and 1940s did not
were horizontal, as under pure competition. This means, in gen- lead Chamberlin to change or modify his formal theory nor did
eral, higher production costs and higher prices. (Chamberlin it shake his conviction that a static equilibrium method of anal-
1962, 77-78) ysis was appropriate. However, the debate did prompt him to
develop additional informal theory, which he presented in a
Chamberlin (1962, 81-100) turns next to the issue of competi- new and final Chapter IX in the 1946 and succeeding editions
tion from substitutes and, again, focuses on the static–equili- of his book. He then supplemented the informal theory in his
brium situation. He posits that each monopolistic firm later articles (Chamberlin 1950, 1951, 1954a, 1954b).
belongs to a group of competitors and he seeks to determine the Recall that Chamberlin had consistently used pure (perfect)
nature of such group equilibria (which parallel the customary competition as the standard against which monopolistic com-
industry equilibria). However, determining a group’s petition would be compared. His later analyses led him to
76
Hunt 77
conclude: ‘‘[The concept of] ‘free enterprise’ has too long been of no consequence merely because they are both a part of the
loosely identified with . . . ‘perfect’ or ‘pure’ competition . . . ‘newspaper industry.’ The general principle of free choice in
The explicit recognition that product is differentiated brings the spending of one’s income includes not only freedom to vary
into the open the problem of variety and makes it clear that the proportions between the larger categories of food, shelter,
pure competition may no longer be regarded as in any sense etc., but freedom also to express a market demand for Smith’s
an ‘ideal’ for purposes of welfare economics’’ (1962, 214; ita- sausages if one believes them superior to Jones’s. (Chamberlin
lics in original). Indeed, he pleads mea culpa: ‘‘I must plead 1954a, 260)
guilty myself to having done what is here held to be meaning-
less’’ (1951, 349). In Chapter IX of his book and his subsequent
articles, he develops numerous arguments—informal the-
ories— to justify not only his conclusion that perfect competi- Economics and TMC
tion is in no sense ideal but also that the very concepts industry As previously noted, Chamberlin failed to achieve his objective
and commodity represent nothing less than a ‘‘snare and delu- of developing a theory to replace perfect competition as a point
sion’’ (Chamberlin 1950, 86). of departure for economic analysis. However, four aspects of
Chamberlin’s arguments against using perfect competition the debate that resulted in TMC’s defeat are of interest here.
as a competitive ideal can be placed into two general cate- First, all participants in the debate agreed that static equili-
gories: (1) heterogeneous, intra-industry supply is natural, not brium methodology—as developed in Chamberlin’s ‘‘formal’’
artificial, and (2) heterogeneous, intra-industry demand is nat- theory—was the appropriate procedure. Although Marshall
ural, not artificial. As to the first category, Chamberlin (1962, ([1890] 1949) gave equal prominence to both evolutionary and
214) points out that every supplier is necessarily unique in its mechanistic (i.e., static–equilibrium) metaphors, by 1950 the
physical location: ‘‘Retail shops, for example, could not all evolutionary metaphor had been abandoned in economics (Foss
be located on the same spot.’’ He also argues that there are nat- 1991), and the neoclassical research tradition ‘‘hardened’’
ural ‘‘[p]eculiarities of any individual establishment which can- (Lakatos 1978) around static equilibrium, profit-
not be duplicated . . . [such as] reputation, skill, and special maximization, firms-are-cost-curves, perfect competition, and
ability . . . [that result in] returns which cannot be reduced the language of mathematics. Marshall’s evolutionary,
by others moving in to share them’’ (1962, 112). Finally, het- dynamic approach was dismissed in mainstream economics
erogeneity of supply is natural because it is a direct response as his ‘‘prattle about the biological method’’ (Samuelson
to heterogenous demand: ‘‘Commodities are differentiated 1967, 112; italics added).
. . . partly in response to differences in buyers’ tastes, prefer- Consequently, in mainstream economics, the term ‘‘compe-
ences, locations, etc., which are as much a part of the order tition’’ lost its Adam Smith roots concerning the rivalry
of things within any broad class of product as they are between between and among firms. ‘‘Competition’’ became synon-
one class of product and another’’ (Chamberlin 1962, 213; ita- ymous with ‘‘perfect competition,’’ which is why the adjective
lics in original). That is, one reason for the differences between perfect is often dropped in academic discourse as redundant
Cadillacs and Fords is that some consumers desire luxury auto- with, simply, competition (Hunt 2000). For example, readers
mobiles and have the incomes to buy them, while others desire should note that Chamberlin (1962, 296) himself calls monopo-
more economical transportation. listic competition ‘‘a hybrid theory of monopoly and competi-
As to heterogeneous, intra-industry demand being natural: tion,’’ instead of a hybrid theory of monopoly and perfect
‘‘Differences in tastes, desires, incomes, and locations of buy- competition.
ers, and differences in the uses which they wish to make of Second, the debate’s participants ignored, dismissed, and
commodities all indicate the need for variety’’ (Chamberlin rejected Chamberlin’s ‘‘informal’’ theory. Specifically, they
1962, 214). Such differences are natural because, he stresses, ignored his appeal that economic theory needs a new standard
‘‘human beings are individuals’’ (1950, 86). Therefore, product for evaluating welfare effects because ‘‘pure competition may
differentiation is neither ‘‘the reprehensible creation by busi- no longer be regarded as in any sense an ‘ideal’ for purposes
nessmen of purely fictitious differences between products of welfare economics’’ (Chamberlin 1962, 214; italics in orig-
which are by nature fundamentally uniform’’ (1950, 87), nor inal). Furthermore, participants provided no answer to his
‘‘an optical illusion based upon ignorance, . . . imperfect famous question: ‘‘if we are to imagine a purely competitive
knowledge, . . . [or] irrational preferences’’ (1950, 88). automobile industry, will its homogeneous product be
Instead, the belief that consumers would prefer homogeneous, Packards, Plymouths, or Peugeots?’’ (Chamberlin 1954a,
intra-industry goods were it not for consumers’ ignorance, irra- 259). Keppler’s (1994) review of the debates over TMC con-
tionality, and susceptibility to the wiles of advertising is eco- tains no analysis of Chamberlin’s argument against the use of
nomic arrogance: perfect competition as the ideal, no answer to Chamberlin’s
Packards–Plymouths–Peugeots question. Even Bishop’s
Diversity is the natural consequence of the system of demands, (1967) discussion of the welfare effects of monopolistic com-
in the same sense as is any variety whatever in the output of the petition, which is in a volume ‘‘in honor’’ of Chamberlin and
economic system . . . A preference for the New York Times TMC (1) starts from the position that Pareto-optimality is ideal,
over the Daily Record is not to be dismissed as irrational or (2) focuses on the problem of determining the ‘‘optimal product
77
variety,’’ and (3) concludes that, for monopolistic competition, ‘‘informal’’ theory of TMC. That is, neither side agrees with
there are ‘‘practical limitations standing in the way of any Chamberlin that perfect competition is ‘‘in no sense ideal.’’
thoroughgoing application of . . . ideal welfare principles’’ Furthermore, neither side sees any benefit to allowing consu-
(263). mers, as Chamberlin puts it, to prefer—and purchase—Pack-
Third, the debates over TMC became intertwined with the ards over Plymouths or Smith’s sausages over those of Jones.
controversies concerning the philosophy of economic science Therefore, it is no surprise that the standard treatment of TMC
(the ‘‘realism’’ of assumptions issue) and the extent to which in economics’ textbooks is:
government should intervene in the economy by means of reg-
ulation and legislation. In this debate, the two sides are often In the end, we can conclude only that monopolistically compet-
considered to be the ‘‘Chicago school’’ versus the ‘‘Harvard itive markets do not have all the desirable welfare properties of
school.’’ Thus, Stigler ([1949] 1983), of the Chicago school, perfectly competitive markets. That is, the invisible hand does
writes that monopolistic competition fails the crucial test for not ensure that total surplus is maximized under monopolistic
viable economic theories. For him, this test is that the theory competition. Yet because the inefficiencies are subtle, hard to
must make interesting and accurate predictions: measure, and hard to fix, there is no easy way for public policy
to improve the market outcome. (Mankiw 1998, 370)
The purpose of the study of economics is to permit us to make In short, allowing consumers to prefer and purchase Packards
predictions about the behavior of economic phenomena under over Plymouths or Smith’s sausages over those of Jones is a
specified conditions. The sole test of the usefulness of an eco- problem because allowing consumers the freedom to choose
nomic theory is the concordance between its predictions and the introduces ‘‘inefficiencies’’ in the economy.
observable course of events. Often a theory is criticized or
rejected because its assumptions are ‘‘unrealistic.’’ . . . This
is a most unreasonable burden to place upon a theory: the role Economics and TMC: An Evaluation
of description is to particularize, while the role of theory is to
Although it might have been reasonable to assume in the 1930s
generalize. (Stigler [1949] 1983, 319)
and1940s that the primary effect of heterogeneity of supply in
Friedman’s (1953) famous essay expanded Stigler’s discussion most industries is that it introduces ‘‘inefficiencies,’’ it is not a
and claimed that the ‘‘relevant question to ask about the reasonable position in the twenty-first century. Schumpeter
‘assumptions’ of a theory is not whether they are descriptively (1950, 106, 110; italics added) was prescient:
‘realistic,’ but whether they are sufficiently good approxima-
What we have got to accept is that it [the imperfect competition
tions for the purpose in hand’’ (15).6 That is, the key question
of large corporations] has come to be the most powerful engine
is whether a theory’s assumptions are ‘‘close enough’’ to the
of . . . the long-run expansion of total output . . . In this respect,
real world that it can make accurate predictions. For the
perfect competition is not only impossible but inferior, and has
Chicago school, perfect competition is argued to be close not title to being set up as a model of regulation of industry . . .
enough to real-world competition and, therefore, is to be pre- It is therefore quite wrong . . . to say . . . that capitalist enter-
ferred over TMC. Furthermore, for the Chicago school, govern- prise was one, and technological progress a second, distinct fac-
ment intervention in the economy is to be avoided because tor in the observed development of output; they were essentially
those firms that do not act in accordance with perfect competi- one and the same thing, as . . . the former was the propelling
tion (e.g., do not profit maximize) will be selected out in the force of the latter.
evolutionary process of competition.
In contrast, the ‘‘Harvard school’’ believes that TMC Since the time of Schumpeter (1950), studies of innovation
showed that existing competition in existing economies is routinely stress the role of profit-oriented firms in industries
imperfect, which provides grounds for significant government characterized by heterogeneous supply. Studies of innovations
intervention to correct imperfections. For example, Samuelson in industries such as machine tools (Rosenberg 1963), aircraft
(1967) argues that ‘‘Chicago writers are simply wrong in deny- (Constant 1980), synthetic chemicals (Freeman 1982),
ing that . . . reality will falsify many of the important qualita- metallurgy (Mowery and Rosenberg 1989), and semiconductors
tive and quantitative predictions of the [perfectly] competitive (Dosi 1984) all support the view that the pursuit of increased
model’’ (108).7 Indeed, ‘‘free enterprise can lead to greater profits in ‘‘monopolistically’’ competitive industries prompts
inefficiency than either monopoly or ideal planning or a per- innovations. To those who cling to the view that innovations and
fectly competitive configuration . . . [and it is not the case] that technological progress are exogenous to competition, Grossman
the wastes of imperfect competition under laissez-faire are and Helpman (1994, 32) ask ‘‘What would the last century’s
small, or preferable to what would result from some govern- growth performance have been like without the invention and
ment interferences’’ (125, 136). Therefore, for the Harvard refinement of methods for generating electricity and using radio
school, TMC provides theoretical justification for government waves to transmit sound, . . . and without the design and
intervention. development of products like the automobile, the airplane, the
Readers should note that neither the Chicago school nor the transistor, the integrated circuit, and the computer?’’ They
Harvard school acknowledges any legitimacy to the believe the answer to their query is obvious.
78
Hunt 79
In short, the existence of intra-industry heterogeneity of ‘‘increasing differentiation of commodities,’’ there is still much
supply in industries characterized by product differentiation and confusion as to what product differentiation is and how it
monopolistic competition is not a problem to be solved because relates to market segmentation. As Dickson and Ginter
of ‘‘inefficiencies.’’ Rather, its existence is a desirable situation (1987) point out, some marketing articles and texts describe
to be recommended because it prompts the innovations that pro- product differentiation and market segmentation as alternative
mote increases in productivity and economic growth. For Romer strategies, while others see product differentiation as a comple-
(1994, 11, 14), a leading scholar of economic growth, ‘‘it is obvi- ment or a means to implement a strategy of segmentation.
ous in retrospect that endogenous growth theory would have to Furthermore, when marketers distinguish between ‘‘differen-
introduce imperfect [monopolistic] competition, . . . [which tiated’’ and ‘‘undifferentiated’’ strategies, ‘‘the potential for
implies] the passing of perfect competition.’’ (See Hunt [1997] misunderstanding is exacerbated . . . [because] where product
for how resource-advantage theory provides a theoretical foun- differentiation is discussed as an alternative to market segmen-
dation for endogenous growth models.) tation, it is described as being an undifferentiated marketing
strategy’’ (Dickson and Ginter 1987, 1; italics added). Since the
documentation of the problem by Dickson and Ginter, the con-
Marketing and TMC fusion concerning product differentiation and market segmen-
Because (1) marketing scholars should know their discipline’s tation continues, with some marketers attempting to resolve the
intellectual history (Jones and Keep 2009; E. H. Shaw 2009) controversy by maintaining that differentiation is both an alter-
and (2) Chamberlin’s TMC played a significant role in devel- native to and a means to implement a segmentation strategy
oping marketing theory and thought, then (3) contemporary (Schnaars 1998).
marketers should know the history and characteristics of TMC. Therefore, the product differentiation controversy in mar-
Indeed, Chamberlin’s TMC, through its impact on Alderson keting centers on what product differentiation is and whether
and others, such as Fisk and Dixon (1967) and Narver and it is an alternative or complement to market segmentation.
Savitt (1971), provides a foundation for the assumptions of het- Chamberlin’s TMC, we argue, can inform marketing thought
erogeneous, intra-industry demand and supply, both of which by (1) showing how the confused status of product differentia-
are staples of contemporary marketing theory and thought tion versus market segmentation came about and (2) suggesting
(e.g., Hunt and Morgan 1995). insights for resolving the controversy.
In addition, TMC’s stress on the desirability of allowing
consumers the freedom to choose from among the market Smith (1956) and the Product Differentiation
offerings of marketplace rivals accords well with the Controversy
marketing concept, as well as the market orientation of
many firms (e.g., Kohli and Jaworski 1990; Slater and The concept of product differentiation entered the modern
Narver 1994). Furthermore, recall that TMC’s recognition marketing literature in Smith’s (1956) classic article, for which
that heterogeneity of supply is natural in macromarketing he received the Paul D. Converse Award in 1981.8 Although
systems (Layton 2009) because there are natural ‘‘[p]eculia- (1) A. W. Shaw’s (1916) use of ‘‘market contours’’ was an
rities of any individual establishment which cannot be early academic forerunner of what is now called ‘‘market seg-
duplicated . . . [such as] reputation, skill, and special ability mentation’’ in marketing, and (2) Wheeler (1935) used the term
. . . [that result in] returns which cannot be reduced by ‘‘segment’’ in library studies to indicate groups of consumers in
others moving in to share them’’ (Chamberlin 1962, 112). the 1930s, and (3) Hollander and Germain (1992) trace the
Therefore, TMC can be viewed as one of the forerunners—along actual practice of market segmentation to at least as early as the
with Penrose (1959)—of the resource-based and competence- 1880s, it was Smith’s seminal article that prompted the stream
based views of strategy (e.g., Aaker 1995; Barney 1991; Day and of literature that has resulted in market segmentation being a
Nedungadi 1994; Heene and Sanchez 1996; Wernerfelt 1984). In key component of marketing strategy (Dibb 1995, 2001; Dibb
addition, Hunt (2000) acknowledges the contribution of and Simkin 2009; Hooley and Saunders 1998). Indeed, market
Chamberlin to the development of resource-advantage theory, segmentation strategy is ‘‘one of the most widely held theories
which is argued to be toward a general theory of marketing. To in strategic marketing’’ (Piercy and Morgan 1993, 123), is
macromarketing and micromarketing theory and thought, TMC ‘‘considered one of the fundamental concepts of modern mar-
offers all these contributions. keting’’ (Wind 1978, 317), is ‘‘the key strategic concept in mar-
Here, we focus on the contributions of TMC to marketing keting today’’ (Myers 1996, 4), and is one of the basic
strategy. Specifically, we argue that TMC has the ability to ‘‘building blocks’’ of marketing (Layton 2002, 11). Essentially,
inform a key issue in marketing strategy, which we label ‘‘the the thesis of market segmentation strategy is that, to achieve
product differentiation vs. market segmentation’’ controversy. competitive advantage and, thereby, superior financial perfor-
mance, firms should identify segments of demand, target spe-
cific segments, and develop specific marketing ‘‘mixes’’ for
The Nature of the Product Differentiation Controversy each targeted market segment (Hunt and Arnett 2004).
Although the concept ‘‘differentiation’’ in marketing traces at Notice, however, that Smith (1956) considers market seg-
least back to Shaw’s (1912) observation that there is an mentation to be an alternative to product differentiation. What,
79
then, for Smith, is product differentiation? At the outset, we industry demand and supply are natural. In addition, it would
note that Smith mentions that the source of his article was ‘‘the imply that product differentiation strategy is an alternative to
work of Robinson and Chamberlin’’ (3).9 In addition, Smith’s market segmentation strategy. As evidence of this interpreta-
(1978, 1982) two retrospects acknowledge the influence of tion, note that Smith (1956, 5) maintains that the purpose of
Alderson, who, in turn, gave much credit to Chamberlin. There- product differentiation strategy is ‘‘to establish firm market
fore, we might expect that Smith would adopt Chamberlin’s positions and/or to insulate their business against price compe-
definition, which focuses on the state of affairs in an industry tition.’’ Call this first interpretation the ‘‘resisting homogene-
characterized by different consumer preferences for different ity’’ view, which accords well with the neoclassical
suppliers’ products, which are based on ‘‘real or fancied’’ dif- economics’ view.
ferences in those products.
Furthermore, recall that at the time of Smith’s writing, A second interpretation of Smith (1956). There is a second
Chamberlin had already developed his informal theory argu- interpretation of Smith’s product differentiation strategy that
ment that product markets are ‘‘fundamentally heterogeneous’’ can be inferred from his ‘‘bending the will of demand to the
(Chamberlin 1954b, 33). Summarized succinctly, this argu- will of supply.’’ The second interpretation is that in most
ment is that because in most industries (1) heterogeneous, industries (1) heterogeneous, intra-industry demand is natural
intra-industry demand is natural (i.e., consumers in, say, the and (2) heterogeneous, intra-industry supply is natural, but
automobile market, have different tastes, preferences, incomes, (3) as a matter of corporate strategy, a firm may decide to
and use requirements) and (2) heterogeneous, intra-industry ignore the heterogeneity of demand and (4) produce and mar-
supply is natural (i.e., individuals and firms in, say, the automo- ket a single, standardized product, which it then (5) promotes
bile industry have different skills and capabilities), then vigorously. In such an interpretation, ‘‘bending the will of
(3) products will be differentiated in most industries (including demand to the will of supply’’ is not to tilt or slant a firm’s natu-
the automobile industry), and therefore (4) the concept of the rally occurring, horizontal demand curve. Rather, it is to ignore
industry demand curve in economics represents a ‘‘snare and all the naturally occurring, tilted, or slanted demand curves fac-
delusion’’ (Chamberlin 1950, 86). ing the firm and treat the marketplace as if it were a single,
Although Smith (1956) could have followed Chamberlin’s homogeneous market. Call this second interpretation the
lead, he did not. Instead, he defines, ‘‘In its simplest terms, ‘‘ignoring heterogeneity’’ view.
product differentiation is concerned with the bending of the There is much in Smith’s (1956) article that supports the
will of demand to the will of supply, . . . securing a measure ‘‘ignoring heterogeneity’’ interpretation. Note that Smith
of control over the demand for a product by advertising or pro- recognized that most industries have ‘‘a diversity in supply’’
moting differences between a product and the products of com- that results from differences in producers’ ‘‘specialized or
peting sellers, ... [which] result[s] in prices that are somewhat superior resources’’ (1956, 3). In addition, note that Smith
above the equilibrium levels associated with perfectly compet- maintains that ‘‘the strategy selected may consist of a program
itive market conditions’’ (Smith 1956, 5). designed to bring about the convergence of individual market
demands for a variety of products upon a single or limited
An interpretation of Smith (1956). One interpretation of offering to the market’’ (1956, 3; italics in original). Further-
Smith’s classic article is that it agreed with the winner’s side more, he maintains that through ‘‘product differentiation . . .
of the TMC debate in economics. That is, it accepted the stan- variations in the demands of individual consumers are mini-
dard, neoclassical argument: because in most industries mized or brought into line by means of effective use of appeal-
(1) homogeneous, intra-industry demand is ‘‘close enough’’ ing product claims designed to make a satisfactory volume of
to being natural (and any observed differences in tastes, prefer- demand converge upon the product or product line being pro-
ences, and use requirements are artificial, contrived, and result- moted, . . . [which is] the marketing counterpart to standardiza-
ing from advertising), and (2) homogeneous, intra-industry tion and mass production in manufacturing’’ (1956, 3). Indeed,
supply is ‘‘close enough’’ to being natural (i.e., individuals and product differentiation ‘‘seeks to secure a layer of the market
firms in the factor markets are relatively uniform as to their cake, whereas one who employs market segmentation strives
skills and capabilities), then (3) the natural state of affairs in to secure one or more wedge-shaped pieces’’ (1956, 5).
most industries is that products will be homogenous, and there-
fore (4) efficiency will be maximized.10 Indeed, as economics’
historians have noted, ‘‘under monopolistic competition . . .
Toward Resolving the Controversy
prices are, as it were, two steps higher . . . because selling costs The preceding warrants, I argue, two conclusions. First, there
must be added, and . . . because the demand curve is tipped are more passages in Smith (1956) that support the ‘‘ignoring
from the horizontal’’ (Kuhn 1970, 194). heterogeneity’’ interpretation of Smith’s argument than there
Therefore, Smith’s ‘‘bending the will of demand to the will are that coincide with the ‘‘resisting homogeneity’’ view.
of supply’’ can be interpreted as a firm in an industry taking its Therefore, the ‘‘ignoring heterogeneity’’ view dominates the
naturally occurring, horizontal demand curve and artificially ‘‘resisting homogeneity view.’’ Second, there clearly is a strat-
tipping, tilting, or sloping it downward. Such an interpretation egy that is consistent with the ignoring heterogeneity view.
would imply that Smith believed that homogeneous, intra- This strategy would entail: (1) ignore the various market
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Hunt 81
segments, (2) treat the marketplace as a whole, (3) produce a freedom to choose from among the different market offerings
single, standardized product, and (4) try to ‘‘bend the will of of marketplace rivals accords well with the theory and strategy
[heterogeneous] demand’’ by convincing a significant share underlying both the marketing concept and the market orienta-
of consumers to purchase the product that one chooses to pro- tion. It also accords well with what we now know from the eco-
duce. Note that some firms may, indeed, decide to ignore het- nomics of economic growth literature about how monopolistic
erogeneity and promote heavily a single version of a product competition promotes the increases in productivity required for
when, for example, tailoring different products for different economic growth. Furthermore, TMC’s recognition that hetero-
market segments is viewed as too costly. Note also that the geneity of supply is natural may be viewed as a forerunner of the
strategy would properly be considered an alternative to market resource-based and competence-based views of strategy. All
segmentation. these contributions warrant the incorporation of TMC into mar-
The preceding implies that Smith’s (1956) article did keting theory and thought.
describe two alternative strategies, but his labeling of the strate- The author shows how TMC can also inform a key issue in
gies was problematic. Indeed, the label ‘‘product differentia- marketing strategy, the product differentiation controversy.
tion’’ was a ‘‘relatively poor choice’’ (Hollander and Germain Based on TMC and the preceding analysis, several recommen-
1992, 109) for signifying the standardized product strategy dations are supported. First, ‘‘product differentiation’’ or ‘‘the
implied by firms’ ignoring heterogeneity in demand. This is product in an industry is differentiated’’ should be used to refer
because producing a single product contradicts a portion of the to the state of affairs in an industry characterized by heteroge-
clear English meaning of joining ‘‘product’’ with ‘‘differentia- neity of demand and supply, in which ‘‘buyers will be paired
tion.’’ That is, any phrase containing product and differentiation with sellers, not by chance and at random (as under pure com-
should involve products or product versions that are in some petition), but according to their preferences’’ Chamberlin 1962,
ways different. The academic usage of terms may differ from the 56). This state of product differentiation should not be consid-
usage of words in conversational English, but it is bad form for ered an ‘‘imperfection,’’ but a key component of a kind of com-
academic usage to contradict conversational English. Contra- petition that, because of its association with the innovations
dictions invite confusing communications—as it has in the prod- that result in increases in productivity and economic growth,
uct differentiation versus market segmentation controversy. has positive welfare implications.
If ‘‘product differentiation’’ fits poorly the strategy embo- Second, ‘‘product differentiation’’ is not an alternative to
died in the ignoring heterogeneity interpretation, what is a bet- market segmentation. Indeed, one should avoid using ‘‘product
ter label? Consider products as bundles of attributes, as argued differentiation’’ in conjunction with ‘‘strategy.’’ Rather, ‘‘prod-
by Lancaster (1979) and the multiattribute models in consumer uct differentiation’’ may be used to describe a portion of the
behavior (e.g., Fishbein and Ajzen 1975). Essentially, the strat- process by which a market segmentation strategy is implemen-
egy embodied in the ignoring heterogeneity interpretation con- ted. That is, in a market segmentation strategy, firms tailor their
sists of producing one particular bundle of attributes that may market offerings for particular market segments, which then
fit no market segment well but may fit multiple market seg- results in products being ‘‘differentiated’’ in the marketplace.
ments adequately. Given the emphasis placed on promotion However, using ‘‘product differentiation’’ as a means of
by Smith, such a strategy might be described as a promotion- describing the implementation of a market segmentation strat-
enhanced, standardized product strategy, and it might be best egy should probably be avoided because it invites confusion.
labeled a ‘‘mass market’’ strategy. In these terms, it is the mass That is, many readers who have read Smith’s (1956) famous
market strategy that Smith (1956) viewed as prevalent in his article or have been exposed to the standard, economics,
time and that he was arguing against. Furthermore, Smith pro- ‘‘resisting homogeneous demand’’ interpretation of Smith’s
vides ample evidence as to how he would compare the relative position will be confused when ‘‘differentiation’’ is used to
merits of a market segmentation strategy versus a mass market identify firms that tailor their market offerings for particular
(i.e., promotion-enhanced, standardized product) strategy. For market segments.
him (1956, 6), ‘‘market segmentation . . . will not be denied.’’ Third, the label ‘‘mass market’’ strategy can be used to iden-
Half a century later, his view still holds. tify those firms whose strategy is to resist the natural heteroge-
neity of demand in the marketplace by vigorously promoting a
standardized product. That is, they choose not to engage in a
Conclusion market segmentation strategy, despite the fact that ‘‘market
Chamberlin’s theory of monopolistic competition, like the work segmentation may be regarded as a force in the market that will
of Alderson, deserves revisiting. Marketing scholars should know not be denied’’ (Smith 1956, 6). Again, the academic usage of
their discipline’s intellectual history, to which Chamberlin’s terms should not directly contradict the common meaning of
TMC significantly contributed. Chamberlin’s TMC, through its terms in standard, conversational English, and ‘‘differentia-
impact on Alderson and others, provides a foundation for the tion,’’ if it implies anything, implies that a firm is not producing
assumptions of heterogeneous, intra-industry demand and hetero- a standardized product for the marketplace.
geneous, intra-industry supply, both of which are staples of con- Chamberlin’s TMC warrants a place in contemporary macro-
temporary macromarketing and micromarketing theory and marketing and micromarketing theory and thought. Indeed, mar-
thought. In addition, TMC’s view that allowing consumers the keting theory and thought can be enriched by incorporating the
81
theory of monopolistic competition. Consistent with the 9. Consistent with many works published in the Journal of
admonitions of Wilkie and Moore (2003), significant benefits Marketing in the 1950s, Smith (1956) does not cite specific works
accrue to marketing in era four when scholars acknowledge the of Chamberlin, only ‘‘Chamberlin.’’
contributions of those in eras one, two, and three. Perhaps, more 10. Readers should note the use of the word ‘‘most’’ in the standard
importantly, benefits accrue when marketing scholars under- neoclassical argument. As a reviewer points out, there are, indeed,
stand how the contributions of those in previous eras shaped the some markets that are close enough to being homogeneous that
contours of contemporary theory and thought. industry demand and supply curves are meaningful. For more
on this issue, see Hunt (2000, 197-9). For a discussion of the use
Acknowledgments of ‘‘close enough’’ in antitrust, see Hunt and Arnett (2001).
The author thanks Roy Howell (Texas Tech University), three anon- References
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84
Journal of Applied Business and Economics vol.11(2)
Two Theories of Monopoly and Competition: Implications and Applications
Brian P. Simpson
National University
This paper addresses the claim that monopolies arise naturally out of the free market. I show by
comparing and contrasting two theories of monopoly—economic and political monopoly—that
this is not true. This paper also demonstrates that the two theories of monopoly have their
separate roots in two opposite theories of competition: perfect competition and competition as
rivalry. I show that only one of these theories of competition accurately describes the nature of
competition in an economy. In addition, I show how these different theories of competition and
monopoly are derived from diametrically opposed political philosophies: collectivism and
individualism. I illustrate how perfect competition and economic monopoly have undermined
economists’ understanding of the actual nature of both competition and monopoly. As a part of
my investigation of these very different theories of competition and monopoly, I apply them to
show how, depending on which theories one accepts, one will come to very different conclusions
about when monopoly power does or does not exist.
INTRODUCTION
It is often claimed that a free market leads to large firms gaining monopoly power and being
able to restrict the output of the goods they produce to arbitrarily raise their prices (see
Gwartney, et al., 2000, pp. 126-127 for a typical statement of this point). This alleged monopoly
power is said to lead to greater economic inefficiency, a lower productive capability, and a lower
average standard of living. Hence, it is said the government must step in to restore competition,
such as through the antitrust laws. In this paper, I show that this claim is based on an invalid
view of competition and monopoly. I show that the free market leads to the most intense
competition that is possible in any industry and that deviating from a free market, with some
form of government interference in the name of allegedly making competition more intense,
actually decreases the intensity of competition that exists in the economy and thus decreases the
level of economic efficiency, the productive capability, and the standard of living. This paper is
based on chapter two of my book Markets Don’t Fail! (Simpson, 2005, pp. 31-57).
ECONOMIC VERSUS POLITICAL MONOPOLY
There are two concepts of monopoly that exist and they do not provide an equally good
understanding of monopoly. The concept accepted by most economists today is the one that is
deficient, and it is the acceptance of this invalid concept of monopoly that leads them to
(incorrectly) believe that monopolies arise out of the free market. The concept of monopoly
accepted by most economists today is known as the economic concept of monopoly. This
concept says a monopoly exists when there is only one supplier of a good, with no close
substitutes, in a given geographic region (see Arnold, 2001, p. 528 for a typical exposition of this
concept). The concept that provides a sound understanding of monopoly is known as the political
concept of monopoly. This concept says that monopolies arise from the government’s initiation
of physical force to reserve a market or a portion of a market to one or more sellers. My
discussion of the political and economic concepts of monopoly is based on the discussion of
these concepts in the book Capitalism: A Treatise on Economics (Reisman, 1996, pp. 376-377
and 389-392).
The economic concept of monopoly focuses on the number and size of firms in an industry. It
says the smaller the number of firms in an industry, and the larger those firms are, the more
monopoly power that exists in that industry. It says monopoly power can arise naturally out of
the market simply by firms becoming the only firm in an industry. Based on this concept, the
greater the market share a firm has the greater its monopoly power. The political concept focuses
on the restriction of competition by the government and says monopoly power can be held by
many small producers against just one or a few large producers, or can be held by one large
producer against other, smaller producers. The political concept says as long as a firm is being
protected from competition by the government—no matter what its size—then that firm has
monopoly power.
As examples, Microsoft, Wal-Mart, and the United States Postal Service (USPS) are
considered monopolies based on the economic concept due to their large size and market share in
their respective markets. However, of the three, only the USPS is a monopoly based on the
political concept. Only it has achieved dominance in its market through protection from
competition by the government. In fact, not only are Microsoft and Wal-Mart not monopolies
based on the political concept, they are actually victims of monopolies. Wal-Mart has force
initiated against it by local governments (in favor of smaller retailers) in the form of ordinances
that put a maximum limit on the square footage of retail stores in certain locations. These
ordinances are designed to keep Wal-Mart out by making the size smaller than what Wal-Mart
considers necessary to make it worth it for Wal-Mart to open a store in an area. This is a case of
a larger number of smaller firms (i.e., local grocery and other retail stores) gaining and using
monopoly power to protect themselves from competition from a larger and more efficient rival.
Microsoft has had force initiated against it through the antitrust laws (in favor of such
companies as Sun Microsystems and Netscape [the latter now being a part of America Online]).
These laws initiate force and thus prevent voluntary trade by, for instance, limiting the market
share of some firms in particular industries and preventing some firms from merging (see
Simpson, 2005, pp. 67-72 for more on how the antitrust laws create political monopolies).
Microsoft is a case of firms using monopoly power to protect themselves from a competitor that
produces better products and is more effective at selling those products.
The main problem with the economic concept of monopoly is that it groups together firms
that have achieved their dominant positions through voluntary trade (i.e., by outdoing their rivals
through competition), such as Wal-Mart and Microsoft, with firms or organizations that have
achieved their dominant or sole-supplier positions through the government’s initiation of
physical force (i.e., by the government protecting them from competition), such as the USPS. It
does so based on the characteristic that these two types of firms or organizations both have a
large market share in their industry. By doing this, it ignores how these firms came to acquire
their dominant positions.
These two situations should not be grouped together because the ways in which the
companies have achieved their dominant positions are diametrically opposed to each other. The
case based on voluntary trade is a part of competition and the one based on the government’s use
of force is an act of restricting competition. That is, the former case is a part of the rivalrous act
of firms building a product and trying to get individuals to voluntarily buy it. This is what
competition in an economic system is all about. Anything that results from this process does not
create monopoly power because it is part of the competitive process. The latter case is a situation
in which one or more firms are prevented from building and selling a product. This is why it
represents a restriction of competition and therefore creates monopoly power.
For example, Wal-Mart has achieved its dominant position in the retail industry by being
relentlessly competitive. It does everything possible to keep its costs and prices low, such as
using an extremely efficient inventory control system and requiring its vendors to keep their
costs as low as possible and pass the savings on to Wal-Mart. If a company cannot match Wal-
Mart’s costs and prices—if it cannot handle the competition—it will be difficult for it to survive.
Of course, many have not, as Wal-Mart has driven many companies out of business.
The same cannot be said of the Post Office. It has become the sole deliverer of first-class mail
because it is legally protected (by the Constitution) from others competing in the delivery of such
mail (some have tried and have been stopped, see Friedman, 1990, p. 288 for an example). The
government not only forcibly prevents others from delivering first-class mail, it forces taxpayers
to subsidize the Post Office. If taxpayers were not forced to subsidize the Post Office and the
delivery of first-class mail was performed under free competition, there are a number of
companies that would probably enter the field (such as Federal Express and United Parcel
Service) and drive the Post Office out of business (unless it became more efficient and provided
higher quality service). The case of Wal-Mart and the Post Office are complete opposites
because the former involves competition and voluntary trade while the latter involves protection
from competition and the prevention of voluntary trade.
Because monopoly is a concept used to identify situations where competition is absent or
restricted, one cannot use it to identify situations that are the result of competition, such as when
firms achieve dominant positions by producing and selling better products. By grouping together
situations that are the result of competition with situations that are the result of restrictions of
competition, the economic concept obliterates a crucial difference and leads people to
inappropriately identify when monopolies do or do not exist; that is, when competition is
actually restricted or not.
Having a large market share is not essential to whether a firm has monopoly power or not.
However, because the economic concept focuses on this characteristic—as if it is the essential
characteristic of monopoly—it leads to arbitrary and contradictory conclusions as to whether
firms are monopolies or not. For instance, the economic concept leads to claims that no firm is a
monopoly and all firms are monopolies, depending on how broadly or narrowly one defines a
good. Further, it leads to claims that a firm both is and is not a monopoly.
For example, if one defines a good by brand names (such as Chevrolet or Ford), every firm is
a monopoly because each firm is the only seller of its brand-name product. However, if one
broadens his definition of a good and, continuing with the same example, considers the good
“automobile” or, expanding it further to, “mode of transportation” then neither Chevrolet nor
Ford is a monopoly and no other firm is a monopoly either. This is the case because all producers
of automobiles compete with each other, as well as with other modes of transportation, such as
trains, buses, and airplanes. This example can be applied to any industry (see Reisman, 1996, p.
390 for a similar example).
Depending on how one defines a good, what one person says is a monopoly and what another
says is a monopoly could be quite different. One could say that no business is a monopoly and all
businesses are monopolies, or that a firm both is and is not a monopoly. Because of this, the
economic concept is meaningless. It is a subjective concept because it can be used in an arbitrary
manner to say whether a monopoly exists or not.
One might object to my claim here by saying that two brands of automobiles with similar
types of vehicles are really close substitutes and therefore not, in fact, monopolies based on the
economic concept. However, if one puts forward this argument, one misses the point I am
making. It is true that those who embrace the economic concept of monopoly believe that the
criteria of whether products are close substitutes should be used as the basis to determine
whether a single supplier of a good, and therefore a monopoly, exists. But I am not arguing about
what basis we should use to determine whether a producer is a single supplier of a good. I am
saying that we should not use the “single supplier” criteria at all as the basis for determining
whether competition is restricted and thus whether a monopoly exists. Whether a firm is a single
supplier of a good is not essential to whether competition exists or not. That is why the economic
concept of monopoly leads to arbitrary and contradictory claims with regard to who is a
monopoly.
The arbitrary nature of the economic concept of monopoly has been illustrated eloquently in
the Microsoft antitrust case. Here, different economists have given contradictory answers to the
question of whether Microsoft is a monopolist. They do so based on their different opinions
concerning what the relevant market is for Microsoft’s products and therefore how large of a
market share Microsoft has (Maurice and Thomas, 2002, pp. 482-483). The arbitrary nature was
also seen in the court decisions made in the Microsoft case. Here, U.S. District Court Judge
Thomas Penfield Jackson ruled Microsoft was a monopoly and ordered the breakup of the
company, while a Federal Appeals Court reversed the breakup order. Contradictory conclusions
inevitably result when a concept is not defined based on the essential characteristics of the
concept (see Rand, 1990, pp. 40-54 and Peikoff, 1991, pp. 96-105 for a discussion on the proper
method of defining concepts).
There is no confusion, contradictions, or inappropriate classifications based on the political
concept. Any producer or producers that are protected by the government from competition are
monopolists, whether through government issued licenses, tariffs, quotas, exclusive franchises,
subsidies, or government owned enterprises. This is a valid concept because it is not subjective
and arbitrary who is a monopolist; it is objective. One cannot claim that a firm both is and is not
a monopoly based on the political concept. A firm either has monopoly power or it does not.
Further, one does not lump firms that have achieved their dominant position through voluntary
trade, such as Wal-Mart and Microsoft, with organizations that have achieved their dominant
position through the initiation of physical force, such as the Post Office.
Based on a proper understanding of what a monopoly is, one can say that Microsoft and Wal-
Mart do not have any monopoly power because they are not protected from competition in any
way by the government. More significantly, one can say that monopolies do not arise naturally
out of the free market. The only time a monopoly exists is when the government interferes with
the free market using the initiation of physical force to protect some firm or firms from
competition. Below I will show that it is only when a firm possesses monopoly power based on
the political concept that the standard negative effects associated with monopoly arise. Only then
will a firm be able to arbitrarily restrict its output to raise its price. Only then will it produce in a
much more inefficient manner. This is so because only then is competition actually restricted.
PERFECT COMPETITION
“Economic monopoly” stems from the theory of competition that most economists accept and
is known as “perfect competition.” The five standard characteristics of a “perfectly competitive”
industry are insignificant barriers to entry and exit, a large number of small producers,
homogenous products, “perfect information,” and price-taking firms (see Arnold, 2001, p. 501
for a typical presentation of these characteristics). It helps in understanding any concept to
concretize what the concept means or implies in reality. By doing this, one can see whether a
concept makes sense based on the facts or whether a concept is absurd and meaningless. By
concretizing “perfect competition” I will show that the latter applies to it. My critique of perfect
competition is based on criticisms presented in Individualism and Economic Order (Hayek,
1948, pp. 92-106) and Capitalism: A Treatise on Economics (Reisman, 1996, pp. 430-432).
First, consider the idea that all products must be the same to have perfect competition. What
does this imply? It implies that there is no competition with respect to differentiation in quality
and style. This means that if perfect competition is to exist, firms cannot try to make their
product different from or better than their rivals’ products. Therefore, this concept of
“competition” actually excludes one major aspect of competition. Furthermore, there would be
no variety in the types of goods that exist. As one can easily observe in the marketplace,
competition has the exact opposite effect.
Second, what about the idea that an industry must have a large number of small firms in order
to be considered perfectly competitive? This excludes competition by companies to drive their
costs down and gain a competitive edge over their rivals by achieving economies of scale. This is
probably one of the most intense aspects of competition in the marketplace. If every industry was
composed of a large number of small firms, costs in many industries would be higher, and this
would lead to a lower productive capability and standard of living. Again, this is the exact
opposite result that is achieved by competition.
Third, what about the idea that an industry must have insignificant barriers to entry and exit to
be perfectly competitive? This ignores a crucial distinction between two types of barriers to entry
that one must consider when assessing whether competition exists: natural and government
imposed barriers. Natural barriers, such as high capital requirements, brand loyalty, or
knowledge about how to produce a good, are a part of competition and voluntary trade. For
example, a firm gains customer loyalty by producing a product customers like so much that they
will not easily switch to a different brand.
Government imposed barriers impede competition and voluntary trade and are achieved
through the initiation of physical force. They are achieved by the government forcibly preventing
some firms from competing (such as through granting government franchises, as in the case of
electric or cable television utilities), making it harder for some to compete (such as through
tariffs, quotas, and licenses), or by providing an artificial advantage to some companies (through
subsidies). These types of barriers restrict competition.
By ignoring the fundamental distinction between these two types of barriers to entry, perfect
competition lumps these two fundamentally different things together and says when any barriers
exist competition is lessened. This means it lumps together industries such as the New York City
taxicab industry, which has substantial government barriers, and the computer hardware
manufacturing business, which has high capital requirements, and says both of these industries
lack competition because of these barriers. However, this could not be farther from the truth. The
computer business is extremely competitive because of the high capital requirements, and thus
low costs, that have been achieved in that industry. Achieving these low costs has been a part of
the competitive process in this industry. Whereas competition is restricted in the New York City
taxicab business because of the extremely expensive government required medallion one must
have to be in the business legally (costing about $400,000 to $500,000 for each medallion!),
which forcibly keeps many potential competitors out of the business.
Fourth, what about the idea that perfect information must exist for an industry to be perfectly
competitive? This is blatantly absurd. Perfect information implies that humans must be
omniscient in order for competition to exist. However, part of competition is competition
concerning information and knowledge. Competition to gain knowledge about what methods of
production to use, competition to gain knowledge about customers (such as through focus group
studies), and competition among firms to disseminate information about themselves (such as
through advertising) are all important aspects of competition. By assuming that we must have
perfect information to have an allegedly perfect form of competition, again, a major component
of competition is excluded.
Fifth, what about the idea that perfectly competitive firms are price takers? This characteristic
ignores the fact that many firms set their prices based on costs of production they can achieve.
Firms compete intensely by continuously driving their costs down, setting a lower price, and thus
gaining a competitive advantage over their rivals. Hence, in requiring firms to be price takers,
perfect competition excludes another aspect of competition.
Perfect competition, as economists often admit, does not exist anywhere in reality. Sometimes
it is claimed that agricultural industries, such as wheat farming, come closest to being perfectly
competitive because the products are close to being identical and the farmers take whatever price
they can get for their products in the commodity markets. However, even these industries fail to
meet the standard in many ways. First, it takes a large amount of capital to get into the
agricultural business (think of all the land and sophisticated machinery one must possess).
Second, perfect information most certainly does not, and cannot, exist in farming or any other
industry (think of all the knowledge about agriculture one must have to be a successful farmer).
Third, because of the high capital and knowledge requirements needed to get into the farming
business, significant barriers to enter the business exist.
As F. A. Hayek recognized, perfect competition is not a form of competition at all; it actually
means the absence of all competition (Hayek, 1948, pp. 92 and 96). Under perfect competition,
there is no competition to differentiate one’s product, no competition to gain economies of scale
and drive one’s costs down, and no competition to gain or disseminate information. It is not a
valid concept because it has nothing to do with the actual nature of competition and exists no
where in reality.
In addition, nothing is improved by the use of the terms “oligopoly” and “monopolistic
competition.” These are terms that are based on the invalid concepts of economic monopoly and
perfect competition and are used to identify varying degrees of alleged monopoly power.
Monopolistic competition is used by contemporary economists to describe situations in which
firms have small differences in their products (such as in the grocery business or with regard to
gasoline stations) and thus begin to violate the characteristics of perfect competition. The
concept says monopoly power begins to exist when small differences arise. This means it is
thoroughly rooted in the notion that the “sole-supplier” criteria should be used in determining
whether monopoly power exists. It merely identifies firms that are not yet sole suppliers, but
have some of the characteristics that begin to move them in that direction.
Oligopoly is a term used by contemporary economists to identify industries that have a few
firms in the industry that have most of the market share in the industry (such as the automobile
industry or the steel industry). The concept is based largely on the number and size of firms in
industries and identifies industries in which the degree of alleged monopoly power is somewhere
between monopolistic competition and a “pure” economic monopoly. Since it is based on the
economic monopoly/perfect competition view of competition and monopoly, it must also be
discarded. Neither “oligopoly” nor “monopolistic competition” provide us with any better
understanding of the nature of competition and monopoly or the competitive nature of the
industries they categorize because they are both based on invalid views of competition and
monopoly.
A good concept of competition is one based on rivalry. This says that “to compete” one must
try and outdo one’s competitors in production and voluntary trade. It means a firm tries to
differentiate its product, drive its costs down and set a lower price, advertise, and drive its
competitors out of business by getting customers to voluntarily switch to its product. This
provides one with a good understanding of how competition actually takes place in an economic
system.
How does this relate to the discussion on monopoly? The economic concept of monopoly is a
corollary of perfect competition. That is, if one accepts that competition is most intense in an
industry that has a large number of small producers each producing identical products, then
monopoly exists when there is only one producer of a good with no close substitutes. In order to
reject this invalid concept of monopoly, one must also reject perfect competition. Likewise, to
fully embrace a proper understanding of monopoly—political monopoly—one must have a
proper understanding of competition. That is, one must understand the competition that takes
place in an economic system is a rivalrous process that occurs between producers who attempt to
get people to voluntarily purchase their products. The opposite of this is when production and
voluntary trade is restricted through the initiation of physical force. This is identified by the
political concept of monopoly.
THE PHILOSOPHICAL BASIS OF PERFECT COMPETITION AND ECONOMIC

MONOPOLY
The philosophical basis for why many economists accept the validity of perfect competition
and economic monopoly is provided by egalitarianism and collectivism, ideas that many
economists embrace. Egalitarianism is the belief that people should be the same in all respects.
We should all have the same amount of income, the same opportunities, abilities, etc. For
example, if I possess some greater ability than others, I should some how “give up” some of my
ability and “give it” to others. Maybe, the egalitarians might say, I should hold back so as not to
make others look worse and feel bad about their lack of talent. Or maybe I should spend less
time developing my own talent and more time helping less talented individuals develop their
skills. Others should do the same in the areas where they have superior ability. The alleged ideal
is a society in which everyone is equally talented and no one is superior to any other person at
anything.
The type of world that would exist if everyone was exactly the same is the bizarre world of
perfect competition. For instance, under perfect competition, no one would have an advantage in
the information he possesses because producers would all have perfect information. Likewise,
everyone would produce identical products, no one would have a cost advantage because firms
would all be the same small size, and all businesses would receive the same price that prevails in
the market. Perfect competition is an egalitarian ideal. And if this is the competitive ideal then
being different (especially superior) in any way would create some element of (economic)
monopoly. Differences between competitors stand in opposition to egalitarianism. Therefore, if
one takes egalitarianism seriously, he will end up believing it is beneficial to have all competitors
exactly the same, and consider it harmful when one competitor has an advantage, in any way,
over the rest.
One might argue regarding my point about egalitarianism that most (and maybe even all)
advocates of egalitarianism do not advocate everyone being exactly the same, but rather believe
that we should merely eliminate some of the inequality that currently exists in the world. This
might be true but does not deny my point that egalitarianism provides the philosophical basis for
perfect competition. Here I am not concerned whether economists embrace egalitarianism
consistently or not. I am concerned with the nature of the idea. Whether egalitarianism is the
basis for perfect competition does not depend on whether economists embrace it consistently.
What matters is the nature of egalitarianism and perfect competition. Based on their
characteristics, it is easy to see that egalitarianism provides the philosophical basis for perfect
competition.
The problem with egalitarianism is that it is not a proper standard by which to judge anything.
Economically, implementing egalitarian policies would lead to a lower average standard of
living (Reisman, 1996, pp. 145-146) by sacrificing the productive to the unproductive through
such schemes as the progressive income tax and the inheritance tax. Morally, such a standard is
an abomination because it stands in opposition to the requirements of human life. It prevents the
individual from being the beneficiary of his own actions by morally requiring the individual to
be a rightless servant to the needs of others (Rand, 1971, pp. 152-186). This is a thoroughly
collectivist idea because it says individuals must live for others. If people are to survive and
flourish, they must be free to pursue their rational self- interests; they must not be sacrificed to
the needs and whims of others.
Moreover, perfect competition is an attempt to wipe aside the individual’s role in competition.
This is another way in which perfect competition is a collectivist idea. It says, in essence, that
producers should mindlessly stamp out the same products and serve customers (Ridpath, 1999,
pp. 178-179). It says individual differences should play no role in competition and, in fact, any
differences are to be condemned as alleged monopoly power. What this theory forgets is that
competition occurs between individuals.
Just as economic monopoly and perfect competition are based on egalitarianism and
collectivism, political monopoly and competition as rivalry are based on individualism. These
latter fully recognize the role of the individual in competition by recognizing that competition
takes place between individuals. They recognize that individuals possess different skills and
financial resources and that these differences are a part of the competitive process. They
recognize that each individual has a right to his own life and should live it to further his own well
being and happiness, which includes outdoing others in the rivalrous process of economic
competition.
Ultimately, to reject perfect competition and economic monopoly, one must reject
egalitarianism and collectivism. Likewise, to embrace a proper theory of competition and
monopoly, competition as rivalry and political monopoly, one must embrace an individualist
political philosophy.
BARRIERS TO ENTRY
To gain a better understanding of competition and monopoly, it will help to go through some
specific examples to see what actually does and does not constitute a monopoly. To do this, I
will discuss a few specific types of barriers to entry and assess them based on the political
concept of monopoly.
Patents, Copyrights, and Trademarks

It must be stressed that monopoly power exists only when the government initiates physical
force to reserve a market or a portion of a market for one or more sellers. Based on this, patents,
copyrights, and trademarks do not create monopolies, even though they are often thought to do
so based on the economic concept of monopoly simply because they create an entry barrier.
Patents, copyrights, and trademarks protect intellectual property from being used by others
without the owner’s consent. Just as the government must use retaliatory force to protect, say, a
grocer’s inventory (i.e., physical property) from being stolen by others, it must do the same with
intellectual property (such as protecting the use of an invention with a patent, the use of an
author’s book with a copyright, and the use of brand names and logos with trademarks).
Protecting patented devices, copyrighted material, and trademarks is similar to protecting any
other property that a person owns.
There are some differences between protecting intellectual property and physical property that
I will not discuss here. For instance, there are time limits on the protection of some intellectual
property (such as patents and copyrights), while there are none on physical property. But the
essential point that protecting intellectual property is similar to protecting physical property
remains valid. For a discussion on why differences in protecting the two types of property exist,
see the book Capitalism: The Unknown Ideal (Rand, 1967, pp. 130-134).
The protection of patents, copyrights, and trademarks helps to increase efficiency, quality,
and the supply of goods by making it possible for those who create wealth or develop a good
reputation to profit from it. Patents provide the ability and incentive to develop new inventions or
make improvements on old ones. Copyrights provide the ability and incentive to produce higher
quality written matter. Trademarks provide a strong incentive to maintain quality by making it
possible for a company to gain from the reputation it has built. These are the exact opposite
effects of a monopoly.
Monopolies decrease economic efficiency, quality, and the supply of goods because they
violate individual rights by protecting producers from competition. Economic competition can
only take place within the context of voluntary trade, and the latter can only exist when people
are protected from the initiation of physical force, i.e., when individual rights are protected
(Simpson, 2005, pp. 7-9). This is what patents, copyrights, and trademarks do; they are a part of
what makes competition possible.
Based on a proper understanding of monopoly, not protecting patents, copyrights, and
trademarks would constitute a monopoly. It would be the establishment of a monopoly of the
dull and incompetent by forcibly depriving the intelligent and competent of the benefit of their
intelligence and competence. Such a situation would constitute an act of the initiation of force by
the dull and incompetent, sanctioned by the government, to gain access to things they could have
never created and thus to obtain a portion of a market they could have never gained access to on
their own through voluntary trade. (Reisman, 1996, pp. 388-389)
Economies of Scale
Gaining efficiencies through economies of scale does not constitute a monopoly, although it
is often believed to do so based on the economic concept of monopoly (Reisman, 1996, p. 376).
Economies of scale are achieved through intense competition to drive costs down through the
accumulation of capital, the acquisition of knowledge, and the efficiencies in production and
improvements in quality that can be gained based on this foundation. Potential entrants to an
industry, if they want to compete successfully, must be able to achieve the low costs of
production that those currently in the industry have already achieved.
If the government provided new firms with the capital and knowledge to compete (this latter,
perhaps, by requiring existing companies to provide their trade secrets to new entrants), this
would constitute a monopoly of those who have not earned the capital and knowledge against
those who have. The government would be initiating force against existing companies to force
them to provide newcomers with their trade secrets, or against taxpayers to provide newcomers
with funds to purchase capital goods. In either case, this would lead to a lower productive
capability. It would either take away the ability and incentive for firms to acquire more
knowledge (since it is likely firms would be forced to provide that knowledge to newcomers), or
it would take away the financial incentive to be efficient and produce products that consumers
demand (since newcomers could obtain funds from taxpayers instead of having to raise funds
from investors through voluntary means).
Sole Control of a Resource

Gaining sole control of a resource does not constitute a monopoly if it is achieved through
voluntary trade. Remember, a monopoly does not depend on having only one producer of a
good; it depends on whether competition is forcibly restricted. If someone had the foresight to
buy up the total supply of a resource, this is an achievement that is based on the ability of the
person buying the resource. Such an acquisition is based on voluntary trade and does not
constitute a restriction of competition (in fact, it is a part of competition). Further, recognizing
and developing uses for a particular resource take great ability. Such activities help to increase
the productive capability of the economic system. This can be seen in the case of the aluminum
industry where, up through the mid-twentieth century, Alcoa controlled virtually the entire
supply of land that contained Bauxite ore, a chemical from which aluminum is made. Without
Alcoa’s efforts to discover better ways to produce and use aluminum, the development of the
aluminum industry, and industries that are heavily dependent on aluminum (such as the aircraft
industry), would probably have developed in a much slower fashion.
Taking away resources from someone, if acquired through voluntary trade, would violate
individual rights and constitute a monopoly. It would be a monopoly of those who did not have
the means and ability to acquire the resources through voluntary trade against those who did.
This would decrease economic efficiency and the productive capability of the economic system
because firms would have less ability and incentive to acquire and develop uses for resources in
the future.
Network Effects
Network effects are said to lead to monopoly power because they create switching costs and
allegedly lead to “lock- in effects” and “path dependency.” For instance, it is often said that
people can get locked into an inferior standard or product just because it was the first one to gain
a significant market share. Therefore, it is claimed that it may be impossible even for superior
goods to unseat an inferior “network good.” This has been alleged to occur with such goods as
the typewriter, the VCR, computer operating systems, and computer software, among others.
Even if lock-in and path dependency existed, they would not create a monopoly as long as the
widely-accepted standard was established based on voluntary trade. However, Stan Liebowitz
and Stephen Margolis have shown that lock- in and path dependency do not exist. For instance,
with respect to the typewriter it is claimed that the allegedly inferior QWERTY keyboard (named
for the letters on the top left-hand side of the keyboard) has maintained its popularity simply
because it was the first one to be widely used and that an allegedly superior late comer, the DSK
(or Dvorak) keyboard, has not been widely used because of the early success of the QWERTY
keyboard. The DSK was said to be superior because the arrangement of the keys allegedly made
it possible to type faster. The claim by supporters of the “network effect” monopoly argument is
that no one learns how to use the DSK keyboard because DSK keyboards are hard to find and
DSK keyboards are hard to find because no one learns how to use them. However, a detailed
study of the history of the keyboard shows (1) that the QWERTY keyboard faced intense
competition during the late-nineteenth century, when the battle occurred to establish the
standard, and it emerged from that competition as one of the better keyboards, and (2) that the
DSK keyboard offers no clear advantage over the QWERTY keyboard. The lock-in/path
dependency tales in other industries fall victim to a similar fate. (Liebowitz and Margolis, 1999,
pp. 11-14, 19-46, 120-129, and 163-200)
With regard to switching costs, although they do exist in some industries, they are simply a
part of the competitive process with which firms must deal. They are facts of economic reality
that are not to be bewailed simply because they are not in agreement with one’s arbitrary desires.
One cannot wish an aspect of the nature of reality (including the nature of competition) out of
existence. One can only accept it. The people who bemoan the nature of competition and wish
for an alternative (whether “perfect competition” or the absence of switching costs) are guilty of
attempting to rewrite reality. They think that reality is deficient simply because it is not as they
wish it to be. They think it is perfectly valid to pine for the elimination of something that cannot
be erased, i.e., to wish for an “alternative” reality (see Rand, 1982, p. 30 and Peikoff, 1991, pp.
26-30 for more on the fallacy of rewriting reality).
If the government was to interfere to help a firm overcome switching costs, this would create
monopoly power, even if the firm it was helping had a better product and would eventually
dominate the market without the government’s help. The government might initiate physical
force against taxpayers to force them to subsidize the firm with the new product or the
government might somehow restrict the competitive ability of existing firms. While the existence
of switching costs as such does not lead to inefficiency and the acceptance of inferior standards,
government interference to help firms overcome switching costs does. For example, if firms are
subsidized, it causes the firms to be more inefficient because they can rely on funds expropriated
from taxpayers to cover their costs. Hence, they will less likely be concerned with keeping their
costs down. In addition, help from the government for companies with inferior products will help
those companies to achieve a greater market share than they otherwise would be able to. Also,
when the government helps firms with superior products, this creates a monopoly by helping
those firms to achieve a dominant position in a quicker fashion than they otherwise would be
able to through the competitive process.
CONCLUSION
As one can see, monopolies are not created by the free market. They are created only by
government interference into the free market; they are created when the government gives some
firm(s) special privileges over others through the initiation of physical force. A free market
economy is intensely competitive and is typically more so the larger the firms in an industry are
and the fewer the number of firms that exist in an industry.
There are numerous practical implications for the ideas discussed in this paper. They require a
radical re-assessment of the competitive nature of the U.S. economy. They require a radical re-
interpretation of the antitrust laws as well. Typically, those laws are seen as anti- monopoly.
However, these laws are based on the invalid concepts of perfect competition and economic
monopoly. When seen in the light of the valid concepts of competition as rivalry and political
monopoly, one comes to a radically different conclusion regarding the antitrust laws. One sees
them as undermining competition and voluntary trade and thus creating monopoly. To make the
economy more competitive, these laws must be abolished. The implications for the ideas
discussed in this paper with regard to the antitrust laws are discussed in detail in chapter 3 of
Markets Don’t Fail! (Simpson, 2005, pp. 63-72).
REFERENCES
Arnold, R.A. (2001) Economics 5th ed., Cincinnati, OH: South-Western College Publishing.
Friedman, M. and R. (1990) Free to Choose: A Personal Statement, San Diego, CA: Harcourt
Brace Jovanovich, Publishers.
Gwartney, J.D., Stroup, R.L., and Sobel, R.S. (2000) Economics: Private and Public Choice 9th
ed., Fort Worth, TX: The Dryden Press.
Hayek, F.A. (1948) Individualism and Economic Order, Chicago: The University of Chicago
Press.
Liebowitz, S.J. and Margolis, S.E. (1999) Winners, Losers, & Microsoft: Competition and
Antitrust in High Technology, Oakland, CA: The Independent Institute.
Maurice, S.C. and Thomas, C.R. (2002) Managerial Economics 7th ed., New York: McGraw-
Hill.
Peikoff, L. (1991) Objectivism: The Philosophy of Ayn Rand, New York: Meridian.
Rand, A. (1990) Introduction to Objectivist Epistemology 2nd ed., New York: Meridian.
Rand, A. (1982) Philosophy: Who Needs It, New York: Signet.
Rand, A. (1971) The New Left: The Anti-Industrial Revolution, New York: Signet.
Rand, A. (1967) Capitalism: The Unknown Ideal, New York: Signet.
Reisman, G. (1996) Capitalism: A Treatise on Economics, Ottawa, IL: Jameson Books.
Ridpath, J.B. (1999) The Philosophical Origins of Antitrust. In Richard E. Ralston, ed. Why
Businessmen Need Philosophy, Irvine, CA: Ayn Rand Institute Press.
Simpson, B.P. (2005) Markets Don’t Fail!, Lanham, MD: Lexington Books.
gareth.jones Section name
School of Economics
Innovation, profits and

growth: Schumpeter and
Penrose
by
John Cantwell
2000/2001
427
Henley Business School

University of Reading
Whiteknights
Reading
RG6 6AA
United Kingdom
www.henley.reading.ac.uk
Innovation, Profits and Growth: Schumpeter and Penrose
by John Cantwell*
*Professor John Cantwell

Department of Economics
University of Reading
PO Box 218, Whiteknights
Reading RG6 6AA, UK
Tel.: +44 (0)118 9875123
Fax: +44 (0)118 9750236
E-mail: J.A.Cantwell@reading.ac.uk
2
1. Introduction
In this paper the Schumpeterian theory of profits and growth through innovation is revisited and
recast, with explicit reference to the changing institutional form of innovation during the twentieth
century. It is shown how many clues for the restatement and modernisation of Schumpeter's
approach can be found in Edith Penrose's theory of the growth of the firm, her 1959 book having
benefitted from her reading of what for our purposes are the crucial aspects of Schumpeter (1943).
The paper has three parts following this introduction. Section 2 sets out an evolutionary or
institutional account of how profits are created through innovation, which is contrasted with the
standard interpretation of Schumpeter’s theory found in the literature. It is argued that the standard
interpretation does not do justice to Schumpeter’s theory, but that the original theory requires
adaptation in any case to better reflect the means by which capitalist institutions have promoted
innovation during and beyond the twentieth century. The third section reviews Penrose's work on the
growth of the modern firm, demonstrating how she incorporated Schumpeter's insights into her
thinking, and explaining how her approach provides a link between Schumpeter's theory and the
modern institutional form of innovation in the large firm. The remainder of the paper in section 4
illustrates and elaborates upon the argument through some evidence on the changing form of
innovation in large firms in the major industrialised countries during a first phase roughly from 1900
to 1970, and a more recent phase from around 1970 onwards.
It is contended that innovation has relied on the creation of technological or social capability,
through problem-solving or learning activities principally within (and between) large firms. The
development of new products and processes is the outcome of a path-dependent building upon
established capabilities and achievements, by the critical revision of emergent new products or
methods and the search for relevant novelty. This insight into the form of innovation is an amalgam
of the conclusions of the work of Usher (1954) and Rosenberg (1976, 1982, 1994) on the history of
technology, Nelson and Winter (1982) on the evolutionary theory of economic change, as well as
Penrose’s (1959) theory of the growth of the firm. Thus, innovation depends upon the generation of
feasible new capabilities, the operation of which adds new value to the existing circular stream of
income, and thereby creates new profits and higher income.
By contrast, the standard interpretation of Schumpeter’s theory of profits through innovation

focuses upon the quasi-monopoly positions developed in markets by entrepreneurial firms that enjoy
first mover advantages. This common approach to Schumpeter’s theory renders it understandable
within the conventional framework of market-based analysis, in which institutions are discussed only
3
with regard to their role in the process of economic exchange, primarily through markets (or with
reference to a hypothetical alternative market in the case of transactions within firms). Since the
leading innovators establish a temporary monopoly within some output (product) or input (process)
markets they obtain ‘super’ profits from innovation, typically associated with higher output prices
and lower input prices or costs. But this brings us back to issues of the distribution of the circular
flow of income, a flow that is sustained through markets, rather than the question of how that flow
can be increased over time as new value-generating activities are added into the stream. In other
words the standard treatment reduces the means by which profits can be earned through innovation
to a matter of the capacity for static appropriability through the exercise of market power, and hence
analytically no different to any other kind of ‘normal’ profits. The relevant markets may be new, but
their newness is significant only for its relationship to the scope for temporary monopolies. The
distinctiveness of Schumpeter’s notion of adding to the existing circular flow of income is lost.
Schumpeter’s (1934) original theory of innovative profits emphasised the role of

entrepreneurship (his term was entrepreneurial profits) and the seeking out of opportunities for novel
value-generating activities which would expand (and transform) the circular flow of income, but it
did so with reference to a distinction between invention or discovery on the one hand and innovation,
commercialisation and entrepreneurship on the other. This separation of invention and innovation
marked out the typical nineteenth century institutional model of innovation, in which independent
inventors typically fed discoveries as potential inputs to entrepeneurial firms. After his early work on
entrepreneurship, Schumpeter became only too aware of the rise of in-house corporate research and
development (R&D) in large firms in the twentieth century, to the extent that the literature now
distinguishes his ‘Mark I’ model of innovation from his ‘Mark II’ model in which innovation was
envisaged as a more routinised process within large firms (Phillips, 1971). The Mark I model is
associated with Schumpeter (1934) originally published in 1911, and the Mark II model with
Schumpeter (1943). Indeed, this shift in Schumpeter’s thinking towards the role of large
oligopolistic firms as the key agents for innovation might be thought to reinforce the conventional
interpretation of his earlier theory of innovative profits, since these large firms certainly exercise
market power, and in what has become known as the 'Schumpeterian hypothesis' Schumpeter himself
is now widely believed to have thought in terms of a link running from market power to the extent to
which resources are devoted to innovation. However, I argue here that the so-called 'Schumpeterian
hypothesis' which links profits based on market power with innovation is a misunderstanding of
Schumpeter (1943) which is due to an attempt to recast his insights from within what he labelled
traditional theory; and that Schumpeter himself did not revise his earlier theory of profits when
4
advancing his Mark II model, but in fact reiterated his view of the distinctiveness of profits from
innovation as opposed to market power, although without working through the implications of
endogenous innovation in large firms for his theory.1 In any case, recent empirical research has cast
doubt upon the alleged association between market power, firm size and innovation, and suggests
that smaller firms may be highly innovative as well, especially through their interactions with large
firms in the same industry (Pavitt, Robson and Townsend, 1987; Audretsch, 1995). In other words,
the critical contribution of large firms to modern innovation may lie instead in their creation of novel
technological capability run by skilled teams and developed through their continual problem-solving
activity, which becomes a resource for other firms with which they cooperate as well as for
themselves (Loasby, 1998). This alternative perspective returns us to Schumpeter’s original
emphasis on creating new value-generating activities as a means of searching for higher profits from
innovation, as opposed to statically maximising profits by appropriating higher rents from an existing
income stream.
In section 3 of the paper it is argued that Penrose (1959) relied on an approach to profits and
innovation in the firm that implicitly embodies the most important elements of Schumpeter's original
theory (that is, the elements which are most important for our purposes), and she explicitly
incorporated the role of in-house research and development and endogenous innovation in large
firms. As such, she helps us to link together these two aspects and from that vantage point to expand
upon Schumpeter's theory of innovation, profits and growth for a modern institutional setting. What
is more, as is perhaps better known and is referred to in other chapters, she anticipated the recent
approach to technological change and the firm with her resource-based perspective on corporate
growth. Hence, we can trace to Penrose the foundations of the approach taken here, which aims to
connect Schumpeter's theory of innovation, profits and growth to the changing institutional reality of
innovation since the start of the twentieth century.
In the final section 4 we relate our discussion to some evidence of recent studies on the changing
institutional form of innovation over the last hundred years. By understanding how profits are
created from innovation in an alternative evolutionary way through corporate learning and search
processes, it can be appreciated how innovative profits are of steadily rising significance relative to
the more traditional kind of profits derived from market power, given the way in which capitalist
institutions have evolved during the twentieth century through to today. In the first phase or
1
My attention was called to this by Richard Nelson's presentation in the plenary session 'Joseph Schumpeter 50 years
on' at the International J.A. Schumpeter Society conference held in Manchester in June 2000, in which he argued that
5
paradigm in about the first three-quarters of the twentieth century, science-based innovation in large
scale production facilities (as documented by Chandler, 1990) depended upon the capabilities that
were associated with the rise of in-house corporate R&D in large industrial firms. Large firms
became the key actors in combining the processes of invention and innovation, each individual firm
being technologically specialised in a way that reflected the specific profile of corporate
technological competence that it accumulated through cumulative path-dependent learning
processes. An inter-company variety of capabilities gradually extended the reservoir of social
capability for innovation, and hence broadened the foundations for the creation of profits through
innovation.
In the most recent phase or paradigm from the latter part of the twentieth century onwards,
science-based innovation has been combined with information and communication technologies in
computerised and flexible production facilities. Large firms have remained the key actors in the
accumulation of technological capabilities, but in an institutional context that now emphasises the
economies of scope to be obtained from the fusion of interrelated capabilities, and a new role for the
internationalisation of economic activity. Between firms this has taken the form of a growing
number of inter-company alliances for the purposes of promoting innovation. Within large firms in-
house R&D is increasingly directed to the emergent benefits of corporate technological
diversification through novel and more complex combinations, and to the development of
technological competence through internal international company networks. These latter
international corporate networks for innovation mark a change in the institutional character of
multinational firms in terms of how they innovate and organise their R&D. While in the past the
internationalisation of firms was mainly a matter of the internationalisation of their markets and
hence supporting through adaptation the wider exploitation of their established technological
competences, it is now also becoming a matter of the internationalisation of their ability to create
technological competences through the combination of geographically distinct lines of innovation.
Of course, the greater scope for establishing such international research-based networks has
depended upon organisational innovation and new types of managerial capabilities, as stressed by
scholars of business strategy. The emergence of institutions that can accommodate successful
international integration of corporate innovation implies a shift away from obtaining profits through
the exploitation of established capabilities through new positions of market power abroad, towards
the creation of innovative profits by building new capabilities through knowledge exchanges and
there was no evidence of what has subsequently become known as the 'Schumpeterian hypothesis' to be found in
Schumpeter's own writings.
6
cooperative learning, and thereby utilising cross-border networks for the establishment of new value-
generating activities. These recent changes have further reinforced the growing relative importance
of innovative profits of the original Schumpeterian or Penrosian kind, when the conceptualisation of
innovative profits is suitably reinterpreted to fit the current institutional conditions for innovation.
2. Schumpeter's theory of profits through innovation revisited

Schumpeter (1934) relied on a distinction between two realms of economic analysis, and
corresponding to these realms are two different means for creating profits. The first realm is
grounded on the circular flow of income, and this is the realm of traditional economic theory focused
upon the determination of prices and quantities in the markets that link together the flows of inputs
and products. In this realm the economy is most easily analysed as either stationary or as growing at
a steady state in the form of a simple reproduction of at least some existing elements of the economy
on an expanded scale. Profits derive from positions of market power (some might say from market
imperfections), since in perfectly competitive conditions profits would be driven to zero. However,
Schumpeter (1943) argued that perfectly competitive markets had never existed and would never
exist, so comparisons with this hypothetical state are unhelpful. So let us suppose that there is some
irreducible degree of market power inherent in every market in practice, which is then associated
with positive 'normal' profits (in equilibrium, leaving aside issues of recession or declining demand
and the like). In this traditional context of price and quantity setting in the realm of circulation or
markets, an increase in profits to values above the 'normal' must be attributed to a rise in the degree
of market power. Now when profits are achieved through the market-based adjustment of prices and
quantities by firms that possess the market power to do so, then it is appropriate to use the
conventional apparatus for the analysis of profit maximisation and optimisation by rational economic
agents. This is the sphere of most mainstream or orthodox economic analysis.2
The second realm is that of novelty-creating economic activity which generates new sources of
value-adding productive endeavour, and which disturbs the circular flow of income. In this realm
growth must be understood as an inherently disruptive rather than as a smooth process, which the
later Schumpeter (1943) termed 'creative destruction' (although this term is also often
misunderstood, as the disruption referred to relates to the circular flow and established market
structures, but the creative process itself is likely to be cumulative and incremental, as argued below
and by Cantwell and Fai, 1999). Profits derive from creating new fields of productive activity, given
7
that there is an inertia in the wages of the firms responsible, such that their wage costs only rise with
a lag. A traditional theorist might reply here that such profits are still conditioned on the fact that
markets do not adjust instantaneously (wages being bid up immediately in the labour market to
match higher productivity), but the source of the profits is the creative process that added new value
to the income stream - and this type of departure from a hypothetical absence of any kind of market
power is highly socially beneficial, since everyone enjoys higher income in the long run as a result.
Following successful innovation workers do earn higher wages on average, but only high enough to
leave room as well for a return as well to the creation of a collective social capability, which is jointly
exercised especially in large firms, and does not initially accrue to the individuals that make up an
innovating firm's team. The value created by the collective operation is greater than the sum of the
parts, and the individuals concerned could not appropriate a higher return on their own particular
knowledge or contribution were they to set up independently, so in this sense there is no market
failure or departure from rational behaviour. The increase in profits over and above the 'normal' are
not in this case due to an increase in the degree of market power at a given point in time, but rather
are due to a continual process of creating new value-adding activities. It is a process of incessant
change and improvement despite a tendency within markets for such profits to be subsequently
whittled away (were there no further change) through technological competition. The elements of
market power in the position of an innovating firm are not the source of the new value, but are rather
a coincidental by-product (when viewed from the perspective of the realm of circulation) of the
uneven character of the creative process (which stems principally from the realm of production).
Given the uncertain and the experimental nature of the process of innovation which follows a course
of trial and error including an inevitability of some mistakes (Nelson and Winter, 1982), this second
category of profits is best characterised analytically in a framework of a search for higher profits, and
not within the standard framework of profit maximisation strictly interpreted (even if stylised as 'long
run' profit maximisation, since this is not achievable as a behavioural strategy in the context of
experimentation).
These two different realms of profits, which correspond to two different realms of economic
analysis with alternative focuses of attention and corresponding methodologies, can be linked as well
with two different functions of the firm, as discussed by Penrose (1959) in the early sections of her
book. The firm is in part a price and output decision-taker, in which guise it can earn higher profits
through increasing its degree of market power, but the firm is also a device for innovation, problem-
2
It might be noted in passing that it is also the sphere of a lot of non-orthodox economic analysis, such as that of
Marxists that emphasise the market power of multinational firms, or neo-Ricardians that emphasise the bargaining
strengths of capitalists as against workers.
8
solving and cumulative learning in production, the incentive for which is to generate higher profits
through creating new areas of social or productive capability. While Schumpeter suggested that the
first realm of the market-based allocation of resources and coordination could be left to the closed
system of Walras and his own contribution was focused instead mainly on the second realm of
innovation, for her part similarly Penrose suggested that the first realm could be left to the
conventional theory of the firm which was thus set apart from her separate theory of the growth of
the firm ("so long as it cultivates its own garden and we cultivate ours", Penrose, 1959, p.10) (see
Loasby, 2000).
It turns out that both the common misunderstandings of Schumpeter's two primary arguments to
which we referred earlier can be reduced to attempts to recreate his contentions about the source of
innovative profits and their relationship to market power within the framework and constraints of the
first realm of analysis, when they can only be properly and fully comprehended when placed in their
original and more appropriate context of the second realm. His theory of innovative profits depends
upon creating new fields of productive endeavour to add to and restructure the established circular
flow of income and cannot be understood by means of a simple reference to the building of
temporary positions of market power within that circular flow. Likewise, Schumpeter's view that
when areas of market power are the occasional effects of a continuous stream of innovation from
within large firms such monopolistic positions in the market are an incidental by-product and not the
source of innovative profits, became inverted in the so-called 'Schumpeterian hypothesis' which held
that market power is the cause of innovation by providing resources and safeguarding against the
potential downside of risk-taking activity. The attribution of the latter idea to Schumpeter (1943)
seems to come from a misreading of his Chapter 8 on Monopolistic Practices, in which his criticisms
of the notion of perfect competition and its inconsistency with a regime of innovation and creative
destruction were taken as an advocacy of the benefits of market power and imperfect markets for
innovation, when viewed through the lens of conventional market-based analysis. Instead,
Schumpeter's real point was that the very intellectual framework which gave rise to the hypothetical
concept of perfect competition as an extreme point on a spectrum of market structures was
misplaced when it comes to the analysis of innovation, but this point could hardly be absorbed by
those whose objective it was to try and introduce reference to the scope for innovation within the
confines of the traditional analysis of market structure and resource allocation. His idea was simply
too revolutionary to be taken on board, and so it could only be accommodated partially and hence in
the process in a misleading fashion.
9
So in order to better understand and appreciate the significance of Schumpeter's own view let us
allow him to speak for himself. First of all, it is important to understand the context which was set
for his chapter on Monopolistic Practices by the preceding Chapter 7 on The Process of Creative
Destruction. In a quotation that is now well known amongst evolutionary economists, as part of an
effort to show the need for the analysis of a process in its own right and not through the device of
comparative statics, Schumpeter says:
"The essential point to grasp is that in dealing with capitalism we are dealing with an
evolutionary process. It may seem strange that anyone can fail to see so obvious a fact which
moreover was long ago emphasised by Karl Marx."3 (Schumpeter, 1943, p. 82.)
The profits that derive from evolutionary processes over time can be best characterised as the
outcome of profit-seeking activities, in contrast to the strict notion of profit maximisation which
better describes the profits that result from coordinating activities at a given point of time and with
given technology; and over the longer term innovative profits are probably more important:
"A system - any system, economic or other - that at every given point in time fully utilises its
possibilities to the best advantage may yet in the long run be inferior to a system that does so at no
given point in time, because the latter's failure to do so may be a condition for the level or speed of
long-run performance." (Schumpeter, 1943, p. 83.)
Crucially, in order to understand how to interpret Schumpeter's subsequent discussion of
monopolistic practices (which follows immediately in his book), he goes on to argue that when
monopolistic positions are created through innovation they are not intentionally profit-maximising
despite any appearance of being so since they are merely one aspect of a wider process of
transformation, and so innovation requires competition to be analysed in a fundamentally different
framework:
3
In turn, in order to understand the context for this remark it should be recalled that the first four chapters of
Schumpeter's book were devoted to an appraisal of Marx, from which there are three points worth noting for our
purposes. First, Schumpeter draws a contrast between the evolutionary Marx as an economist and the revolutionary
Marx as a sociologist, and believed that it was possible to isolate the evolutionary economic aspects of his work: "To
say that Marx, stripped of phrases, admits of interpretation in a conservative sense is only saying that he can be taken
seriously" (Schumpeter, 1943, p. 58). Although Schumpeter's view runs against the whole tenor of twentieth century
Marxism, perhaps it might be more readily accepted today. Second, Schumpeter criticises Marx's supposed solution to
the question of the origins of profit (surplus value) through the concept of a market for labour power in place of the
conventional labour market. But in doing so Schumpeter focuses his attack on Marx's use of this device to explain the
creation of absolute surplus value through lengthening the working day or increasing the intensity of work; while
arguably the more significant application was how Marx explained the creation of relative surplus value through
productivity-raising innovation, and hence introduced the distinction between the two types of profit emphasised by
Schumpeter himself. Third, indeed, just as Marx learned much through an intense criticism of Ricardo (as noted by
Schumpeter), so Schumpeter appears to have learned much from his detailed critique of Marx, and this is reflected in
his own theory of innovation which incorporates many of Marx's insights (on which see Rosenberg, 1976, 1982,
1994). Just as Marx took the parts of Ricardo that he needed and critically demolished the redundant parts that didn't
fit with his argument, so Schumpeter did the same with Marx.
10
"In other words the problem that is usually being visualised is how capitalism administers existing
structures, whereas the relevant problem is how it creates and destroys them.........However, it is still
competition within a rigid pattern of invariant conditions, methods of production and forms of
industrial organization in particular, that practically monopolizes attention. But in capitalist reality as
distinguished from the textbook picture, it is not that kind of competition which counts but the
competition from the new commodity, the new technology, the new source of supply, the new type
of organization...." (Schumpeter, 1943, p. 84.)
Schumpeter claims that with innovation output expands despite restrictive practices, unlike in the
conventional account of the effect of monopoly, but this is not because these restrictive practices are
themselves the source of the incentive to innovate. In this context the motive for restrictive practices
is to facilitate further learning and inter-company knowledge transfer in an environment of rapid
change, within which such practices provide some temporary stability so as to be able to introduce
new products or processes more gradually (in an evolutionary and path-dependent fashion, learning
in the process) and hence more effectively, so as to raise the longer term growth of output. Thus, any
monopolistic price and output decisions in a changing market are a coincidental (and transitory)
source of profits, and should be distinguished from the profits due to innovation as such:
"Thus it is true that there is or may be an element of genuine monopoly gain in those
entrepreneurial profits which are the prizes offered by capitalist society to the successful innovator.
But the quantitative importance of that element, its volatile nature and its function in the process in
which it emerges put it in a class by itself. The main value to a concern of a single seller position that
is secured by patent or monopolistic strategy does not consist so much in the opportunity to behave
temporarily according to the monopolistic schema, as in the protection it affords against temporary
disorganization of the market and the space it secures for long-range planning." (Schumpeter, 1943,
pp. 102-103.)
This is a quotation which we can be sure does not appear in orthodox references to the
'Schumpeterian hypothesis', since it disputes the so-called 'Schumpeterian hypothesis' and challenges
the very notion of analysing innovation as the outcome of the degree of market power associated
with one particular kind of market structure as opposed to another. Schumpeter does then go on to
show how the hypothetical regime of perfect competition would be even less desirable with respect
to technological dynamism, but he did so in the context of a thorough critique of the conventional
market structure framework as a whole, rather than (and indeed explicitly not) to associate
innovative profits with market power. From here, in what would become a link with Penrose,
Schumpeter argued that the large firm was more an innovator and an organizational device for
11
learning beyond being a price and quantity decision taker, and within innovation (much more clearly
than in his first book) he stresses the centrality of technological change in production:
"What we have got to accept is that it [the large-scale establishment or unit of control] has come
to be the most powerful engine of that [economic] progress and in particular of the long-run
expansion of total output not only in spite of, but to a considerable extent through, this strategy
which looks so restrictive when viewed in the individual case and from the individual point of
time....Was not the observed performance due to that stream of inventions that revolutionized the
technique of production rather than the businessman's hunt for profits? The answer is in the negative.
The carrying into effect of those technological novelties was of the essence of that hunt."
(Schumpeter, 1943, pp. 106 and 110.)
So we have seen that far from abandoning his earlier theory of innovative profits in his analysis of
the later phase of trustified capitalism, Schumpeter reasserted that theory and continued to draw a
clear conceptual distinction between the profits which are due to the market power of monopolistic
or oligopolistic firms and the profits they earn from their capacity to innovate, and indeed to insist on
the priority of the latter over the former. However, in this event the original theory was in need of
extension in order to accommodate the significance of inter-company technological cooperation as
well as competition, and the blurring of the distinction between innovation and imitation to which
Schumpeter continued to adhere, but which is by now more obviously unsustainable (since with
greater technological complexity imitation requires the related absorptive capacity that comes from
innovation, and innovation always incorporates some elements of imitation). In this respect the
problem with the original formulation of the theory is that it stresses the need to identify the original
sources of innovation as opposed to subsequent imitation in order to determine the distribution of
innovative profits, with the initial leaders (innovators) earning the higher share. It is true that a useful
recent literature has continued in this tradition to distinguish between 'Schumpeter Mark I' and
'Schumpeter Mark II' technological regimes, according to whether innovations are introduced mainly
by new entrants or by established firms (Malerba and Orsenigo, 1995; Breschi, Malerba and
Orsenigo, 2000). Yet moving beyond this to link innovation with the distribution of profits and
growth across firms, a drawback of Schumpeter's approach is that the first mover in a successful
innovation does not always perform best.
Empirical evidence indicates that among large firms technological leaders tend to retain
leadership positions from one phase of development to another (they are the companies specialised in
the fields of technological opportunity), but at the level of the industry innovative profits and
technology-based growth is highest the faster that other firms catch up (Cantwell and Andersen,
12
1996). This suggests that innovative profits are created by 'followers' and not just by 'leaders'. What
is more, the technological leaders are not in general the firms that earn the highest profits within the
industry or experience the most rapid growth (Teece, 1992; Andersen and Cantwell, 1999). Now
none of this need be a problem once we accept that although social capability is created through
internal learning processes within firms such learning is interactive and involves continuous
exchanges of knowledge, whether through deliberate cooperation in learning or independent
exchanges through licensing, imitation or the like (Cantwell and Barrera, 1998). Defining innovation
to be what is new to a firm with its own differentiated area of expertise or what is new to a particular
local context rather than as something new to the world as a whole (Nelson, 1993), the most
effective corporate innovators are not necessarily the technological leaders whose expertise is
focused on the leading edge fields as such. They may be other firms that have found the most
productive industrial applications of the leading edge technologies, which applications themselves
require further innovation and other supporting capabilities - linked in part to the process of critical
revision of new technologies which enhances their workability and effectiveness, as emphasised by
Usher (1954) and Rosenberg (1982).
This line of argument is now entirely intelligible in terms of the most recent literature on the
evolutionary approach to technological change which has stemmed from the work of Nelson and
Winter (1982) and Rosenberg (1982), and in the process rediscovered the contribution of Penrose
(1959). In the evolutionary theory of technological change innovation is always context-specific and
localised, and so requires the cost of further innovation to be transferred into some other context, but
the cost or difficulty of subsequent innovation depends upon the initial degree of technological
relatedness or complementarity between the activities (Cantwell and Barrera, 1998), and upon the
degree of absorptive capacity in the recipient or imitating firm (Cohen and Levinthal, 1989). When
firms have a higher degree of technological complementarity between their profiles of specialisation
they will each have a greater absorptive capacity with respect to taking advantage of the knowledge
being created by the other, and so they will be better able to mutually make use of technology-based
alliances and the external capabilities that can be accessed through inter-firm cooperation (Cantwell
and Colombo, 2000). In the network of inter-company interaction in innovation the greatest profits
are likely to accrue to the firm with the best fit between initial capabilities and the new field of
opportunity, as opposed to the firm that first initiates a new line of innovation. The greatest benefits
go not to the 'first to discover' or the 'first to commercialise' a core technology with important
implications, but rather to firms whose social capabilities are best adapted to absorb and to further
develop and entrepreneurially to apply the new lines of innovation that emerge from the areas of
13
greatest technological opportunity to novel contexts and in new combinations with other branches of
(and perhaps more traditional) technology.
According to this view Schumpeter's theory of innovative profits should be retained, but his
underlying theory of innovation needs to be strengthened in the modern institutional context. It is not
necessarily technological leaders that become the best innovators, let alone the only innovators, but
rather the firms that succeed in making the most effective combinations between new and old
technologies and uncovering the most conducive new fields of application. Actually, abolishing the
hard distinction between innovation and imitation only goes to reinforce Schumpeter's point about
the distinctiveness of innovative profits which has been stressed above. Innovative profits should not
be understood as the returns to the temporary positions of monopolistic market power enjoyed by
first movers, but rather represent a return to the creation of the social capability that enables firms to
experiment with new technological combinations and solve the problems that arise in doing so, and
hence to learn and to innovate in production successfully.
3. Penrose on profits, growth and path-dependent learning in large firms

Penrose identified herself clearly with those such as Schumpeter that were mainly interested in
the second realm above of innovation, productive experimentation and novel creativity, rather than in
the first realm of coordination, exchange and market power. She focused on innovation as the source
of profits, which would be achieved through learning to develop new applications of the current
resource base of the firm, as opposed to profits due to the market positioning of the firm or the rents
achieved through market power. So like Schumpeter before her and Nelson and Winter
subsequently, Penrose stylised the firm as a profit-seeker rather than as a profit-maximiser. She
argued that in the most successful and longest standing firms (on which her attention was
concentrated) profits were typically desired for the sake of the firm itself, to facilitate a stream of
continued longer-term profit creation through the expansion of the firm, by developing and taking
advantage of the opportunities provided by the firm's capabilities or resources. Thus, she claimed
that the goals of profit-seeking and raising through appropriate investment the long run rate of
growth of the firm became equivalent, since each was derived from the innovative adaptation and
extension of the firm's resource base. Echoing Schumpeter's view that innovation is the only reliable
basis for longer-term corporate growth as distinct from the shorter-term gains that might be made
from monopolistic practices or market power she states:
14
"Examples of growth over long periods which can be attributed exclusively to such protection
[market power] are rare, although elements of such protection are to be found in the position of
nearly every large firm." (Penrose, 1959, p. 113.)
While acknowledging that the firm could create new opportunities through marketing and
advertising by better exploiting its established competence as well as through the development of
new technological competence, Penrose suggested that such a strategy is only feasible within its
existing market areas. To diversify into new areas of specialisation requires the appropriate
technological base to do so. In other words she asserted the ultimate primacy of the realm of
productive and technological competence over that of exchange and selling relationships, since
purely market exploiting activity works only within the confines of an established market area, and so
must sooner or later run up against limits. Like Schumpeter she contrasted the attainment of a
monopolistic market position and technological progressiveness as conceptually alternative (although
in practice quite possibly correlated) routes to profitability and corporate survival. She argued that
the seeking of the innovative profits needed for longer-term survival led to a wider range of
diversification based on the underlying technological complementarity or relatedness of activities:
"Firms....'specialize'....in a much wider sense than the logic of industial efficiency [cost
minimisation and price competition] would suggest, for the kind of 'specialization' they seek is the
development of a particular ability and strength in widely defined areas which will give them a special
position vis-à-vis existing and potential competitors. In the long run the profitability, survival and
growth of the firm does not depend so much on the efficiency with which it is able to organize the
production of even a widely diversified range of products as it does on the ability of the firm to
establish one or more wide and relatively 'impregnable' bases from which it can adapt and extend its
operations in an uncertain, changing and competitive world." (Penrose, 1959, p. 137.)
Hence, Penrose had little use for her purposes for the standard model of the firm as a price and
output decision-taker (the coordination-based theory of the firm), which was not designed for the
analysis of a firm that is free to internally vary the kind of products it produces as it grows and to
innovate by creating from within new products and processes (as in the capabilities-based approach
to the firm, which she effectively initiated). She remarked:
"...we will be dealing with the firm as a growing organization, not as a 'price-and-output decision
maker' for given products...." (Penrose, 1959, p. 14.)
She goes on to explain how the very nature of the social capabilities of the firm as embodied in
its organisational structure is transformed as the technological base of the firm is expanded and
increased in complexity. She was especially interested in large successful firms not because she
15
believed them to be representative of the population of firms as a whole (indeed she was careful to
distinguish between the two), but rather because it is these large firms that encapsulate a repository
of competence for the economy of which they are part, which today we might refer to as social
capability but which she termed administrative organisation. Penrose spent some time discussing the
relationship between the productive competence of firms and market demand, acknowledging of
course that external changes in the structure of demand may be responsible for growth opportunities.
However, as noted above she argued that a firm which lacked an adequate technological base would
lack the capability to diversify, while conversely a firm with a strong degree of technological
competence would find its opportunities for expansion likely to be so prevalent that it would have to
choose carefully between many different possibilities of action. Indeed, in a view that anticipates
quite well the later Cohen and Levinthal (1989) argument about the role of absorptive capacity, she
emphasised that the very ability to perceive opportunities in the firm's external environment
(including new market opportunities) depended upon the initial capabilities and resources of the firm:
"I have placed the emphasis on the significance of the resources with which a firm works and on
the development of the experience and knowledge of a firm's personnel because these are the factors
that will to a large extent determine the response of the firm to changes in the external world and
also determine what it 'sees' in the external world." (Penrose, 1959, pp. 79-80.)
In this context Penrose referred as well to Schumpeter's contention that new products may be
forced on consumers by the initiative of entrepreneurs where the latest fashion or model comes to be
desired in its own right, but this is not necessary to understand why she wished to focus on the firm
as a repository of capabilities or resources as opposed to the coordination functions of the firm.
Rather she believed that innovation-based profitability and growth is essential to the firm's longer-
term survival, that it is 'built into' or inherent in the characteristics of every successful firm, and hence
that the firm can be most usefully depicted as a device for learning and the posing and solving of new
problems in its field of expertise and production. New products and processes are in her view created
through learning from the established resources and technological base of the firm, by extending and
adapting it for novel purposes:
"Consequently if we can assume that businessmen believe there is more to know about the
resources they are working with than they do know at any given point in time, and that more
knowledge would be likely to improve the efficiency and profitability of their firm, then unknown and
unused productive services [from existing resources] immediately become of considerable
importance, not only because the belief that they exist acts as an incentive to acquire new
knowledge, but also because they shape the scope and direction of the search for knowledge .... both
16
an automatic increase in knowledge and an incentive to search for new knowledge are, as it were,
'built into' the very nature of firms possessing entrepreneurial resources of even average initiative.
Physically describable resources are purchased in the market for their known services; but as soon as
they become part of a firm the range of services they are capable of yielding starts to change. The
services that resources will yield depend on the capacities of the men using them, but the
development of the capacities of men is partly shaped by the resources men deal with. The two
together create the special productive opportunity of a particular firm." (Penrose, 1959, pp. 77-79.)
Indeed, Penrose began her book by remarking that there are forces inherent in the nature of firms
that induce expansion even if all external conditions remain unchanged, and that the internal
interaction between inherited resources and managerial perception is a dynamic process which
encourages continuous corporate growth, but which constrains the achievable rate and direction of
growth. From all this the centrality to her perspective of capabilities, corporate learning and
innovation is quite clear, and as with Schumpeter conceptually separate from issues of market power
or other aspects of the exchange and coordination of established products or activities. What is
interesting here is not just her linking of Schumpeter's second realm of innovative profits to the
resource-based theory of growth of the firm, but also the way in which as a result she depicted the
direction of corporate learning and growth as a path-dependent resource-constrained process. In this
respect she anticipated current ideas on the evolutionary approach to technological change, and in
particular the notions of corporate technological trajectories (Dosi, 1982), corporate technological
diversification (Pavitt, Robson and Townsend, 1989; Granstrand and Sjölander, 1990; Grandstrand,
Patel and Pavitt, 1997) and corporate coherence in diversification (Teece, Dosi, Rumelt and Winter,
1994). Anticipating as well the argument of Cantwell and Fai (1999) that since innovation is rooted
principally in internal learning within the firm, technological competence evolves gradually and
changes much less dramatically than the composition of downstream products or markets, Penrose
claimed that each successful firm had a continuity which was provided by its capabilities or
resources:
"In practice the name of a firm may change, its managing personnel and its owners may change,
the products it produces may change, its geographical location may change, its legal form may
change....[yet] the identity of the firm can be maintained through many kinds of changes, but it
cannot survive the dispersal of its assets and personnel nor complete absorption in an entirely
different adminstrative framework. .... The general direction of innovation in the firm (including
innovation in production) is not haphazard but is closely related to the nature of existing
resources...and to the type and range of productive services they can render. .... The Schumpeterian
17
process of 'creative destruction' [of established products] has not destroyed the large firm; on the
contrary, it has forced it to become more and more 'creative' [in the adaptation and application of its
capabilities]. .... ...when it [a firm] develops a specialized knowledge of a technology which is not in
itself very specific to any particular kind of product...it [research] enables at least the large firms to
turn aside the process of 'creative destruction' and to thrive on the novelty which might otherwise
have destroyed them." (Penrose, 1959, pp. 22-23, 84, 106 and 115.)
As was argued that has now actually occurred at the start of this paper, from here Penrose was
led to forecast that there would be an increasing impetus to innovation as the basis for profits
(innovative profits, as opposed to profits due to market power) as the role of technological
competition rises. However, at the same time she noted that greater technological competition would
compel firms to specialise in a narrower range of basic areas of production, since resources would be
increasingly tied up in continual innovation which would restrict the rate at which they can diversify
their fundamental activities (Penrose, 1959, pp. 106-107). This was a remarkable anticipation of the
modern trend towards corporate technological diversification or more properly a restructuring of
diverse technological capabilities around the clusters of greatest interrelatedness (Cantwell and
Santangelo, 2000), accompanied by greater product concentration (less diversification across
products or lines of business activity). However, as was more appropriate to the historical period in
which she herself was writing, and to the earlier stages of large firm growth, Penrose tended to stress
how technological diversification would in general facilitate and support greater product
diversification:
"There is no reason to assume that the new knowledge and services [from corporate exploration
and research] will be useful only in the production of a firm's existing products; on the contrary, they
may well be useless for that purpose but still provide a foundation which will give the firm an
advantage in some entirely new area." (Penrose, 1959, pp. 114-115.)
As has now been described in a detailed historical survey by Chandler (1990), and as Penrose had
observed from her own collection of case study evidence, for most of the twentieth century large
firms grew through a combination of technological diversification from their initial resource base
linked to related product diversification, or what Chandler later depicted as the interlinkage between
the economies of scale and scope. Penrose indicated as well that the greater market spread that
accompanied technological diversification through innovation from within the resource base of the
large firm may entail either product diversification or geographical diversification. Hence, industrial
diversification or internationalisation could be considered substitutes for a particular firm at a given
point in time given the resource constraint upon its overall rate of growth (see Cantwell and
18
Piscitello, 2000, for a discussion of how this relationship later shifted from one of substitutability to
one of complementarity). However, it should be underlined that for Penrose the substitutability
between different types of new market entry was not a result of her trying to focus on the realm of
market exploitation rather than competence creation (selecting between alternative ways of
exploiting a given competence), but was on the contrary the outcome of her focus upon the nature of
competence creation in the specific historical context in which she was writing, at which time any
diversification of the basic market area(s) of the firm tended to require a supporting diversification of
the firm's technological base. This emphasis upon capability formation from the resource base of the
firm rather than market exploitation should already be clear from what has been said of Penrose's
central focus upon the firm as a device for innovation and knowledge creation rather than as a means
of coordinating established activities. However, she believed that the scope of feasible technological
diversification would not only regulate the degree of market spread, but a move into markets that
require a complementary technological base may result in positive feedbacks to further innovation. If
there were no such feedbacks the long-term rationale for common ownership in the firm would be
weak and the character of the investment association between the parts of the enterprise would be
qualitatively different than in a coherent corporate group:
"...expansion by acquisition does not necessarily, or perhaps even usually, mean that a firm is
entering a field for which it would otherwise have no qualifications. Acquisition is often a profitable
process precisely because the firm has peculiar qualifications in the new field. .... In some cases [of
exceptions in which foreign subsidiaries operate independently of their parents]...the acquisition of
foreign subsidiaries should be treated...simply as an investment akin to investments in financial assets
[as a portfolio rather than as a direct investment]" (Penrose, 1959, p. 129 and 193.)
Thus, Penrose asserted the need for coherence in the technological and productive activities of
the firm from the perspective of the capacity to continue to innovate and grow as a combined
organisation, although not necessarily from the perpective of the pure realm of coordination, which
may be instead essentially a financial perspective. By thinking in terms of feedbacks to subsequent
growth perhaps Penrose also to some extent anticipated the notion of intra-firm networks of
competence creation, but at least at an international level for cross-border innovative feedback to
become fully effective was to wait for the new historical phase of integrated multinational firms only
from around 1980 onwards (Cantwell, 1989; Cantwell and Piscitello, 2000).
4. The changing institutional form of innovation

19
Something has already been said of the way in which the institutional conditions for innovation in
large firms have shifted since Schumpeter's day, and to some extent since Penrose's early
contribution as well, although she said much which anticipated these changes. The import of this
shift in institutional regime has been to reinforce the significance of innovative profits as against the
profit and growth strategies associated with market power. Hence, the arguments of Penrose and
Schumpeter are still more relevant today than at the time they were writing, once their essential
themes are related to the modern context. The two major reasons why innovative profits are now
even more relatively important are first that innovation has been increased in what modern
Schumpeterians such as Freeman (1987) have termed a new techno-economic paradigm, and with a
greater intensity of international competition positions of protected market power are increasingly
under threat; and second, the firm must now rely on more complex combinations of related
technologies to serve even more narrowly defined product markets, so relative to some given level of
cost of the innovative development of resources the opportunities for establishing downstream
monopolistic positions are reduced in this way as well. A by-product of these changes is that inter-
company cooperation between large firms is increasingly motivated by the need for mutual
technology-based exchanges and coordinated learning relative to the more traditional collusion to
secure jointly exercised positions of market power.
Taking a step back for a moment, in the first phase of the growth of large firms that ran up until
about 1970, as described by Chandler (1990) there was an interleaving between the economies of
scale and scope. Large firms grew by diversifying their technological base, and in the process
diversified their product markets in similar proportion, and together this combined diversification
supported a rise in the scale of output. An essential plank behind this process was the rapid growth
of in-house corporate R&D in the largest firms, as stressed by Schumpeter, which improved their
innovative search activities, and their capacity for problem-solving and learning in an age in which
acience and technology began to become more interdependent with one another. Using the patents
that large firms are granted from these problem-solving activities, we can trace their individual
profiles of technological specialisation (Cantwell, 1993; Cantwell and Fai, 1999; Cantwell, 2000).
What emerges from these studies is that these patterns of corporate technological specialisation are
differentiated and firm-specific, that groups from common countries of origin have certain country-
specific features in the form of their expertise, and that the profiles of specialisation persist over time,
reflecting a path-dependent technological accumulation or corporate technological trajectories.
One other aspect of this empirical evidence on the history of corporate innovation patterns is
worth emphasising in particular. This is the relationship between the degree of diversity of
20
technological activity in the firm and the overall scale of technological effort, the latter serving as a
proxy as well for the scale of output of the firm since the various measures of size tend to be
correlated across firms. It is well established that the degree of diversification rises with size, and we
can plot a size-diversification relationship across large firms (size is measured by the total number of
patents granted, and diversification by the reciprocal of the coefficient of variation across sectors in
the index of corporate technological specialisation - see eg. Cantwell and Santangelo, 2000). Now
the interesting point is that whether we are working with firms (Cantwell and Fai, 1999) or at the
level of countries (Cantwell and Vertova, 1999) for most of the twentieth century the size-
diversification frontier didn't shift very much. That is, most growth took the form of the joint
achievement of increased scale and greater scope through a movement along the frontier, as
diversification and growth went hand in hand, a statistical confirmation of the case study conclusions
of Penrose and Chandler. However, in more recent times the size-diversification frontier has shifted
quite markedly (Cantwell and Santangelo, 2000), which shows how the relationship between
technological diversification and growth has become less simple than in the past. For firms the size-
diversification frontier has tended to shift upwards (so the average extent of technological
diversification controlling for size has risen), but it has also shifted rotationally so that the very
largest firms have tended to reduce the diversity of their technological profiles. There is now an
impetus for firms to achieve a minimum threshold degree of technological diversification to take
advantage of greater interrelatedness, but the combinations constructed by the firm must also be
coherent enough to focus upon potential linkages in which interrelatedness or technological
complementarity is at its highest. At the level of countries instead the size-diversification frontier has
shifted downwards, which shows that on average countries have increased the extent of their
technological specialisation for any given size (Cantwell and Vertova, 1999). This is likely to be due
to the effects of internationalisation of activity, leading locations to become more focused in their
efforts while the largest firms span more technological fields and more geographical areas.
The increasing significance for firms of technological interrelatedness and fusion is one aspect of
the historical shift mentioned earlier as having been termed a new techno-economic paradigm
(Freeman and Perez, 1988). In this context a techno-economic paradigm is a system of scientific
and productive activity based on a widespread cluster of innovations that represent a response to a
related set of technological problems, relying on a common set of scientific principles and on similar
organisational methods. The old paradigm until around 1970 was based on energy and oil-related
technologies, and on mass production with its economies of scale and specialised corporate R&D.
In recent years this has gradually been displaced by a new paradigm grounded on the economies of
21
scope as distinct from scale, and derived from the interaction between flexible but linked production
facilities, and a greater diversity of search in R&D. Individual plant flexibility and intra-company
network linkages both depend upon the new information and communication technologies (ICT).
Part of the reason for the increased extent of technological interactions within and between firms
lies in the more sophisticated modern system of production as well in the more intensive linkages
between science and technology in the current techno-economic paradigm, which relies on flexibility
through computerisation and diversity through new combinations drawing upon a wider range of
disciplines. Firms increase the returns on their own R&D through suitably adapting their underlying
tacit capability so that they can absorb and apply the complementary knowledge acquired from other
locations or from other firms more intensively in their own internal learning process. Technological
diversification and internationalisation have become positively related in more internationally
integrated multinational corporations (MNCs) since around 1980 (Cantwell and Piscitello, 2000).
Apart from the rise in technological interrelatedness, the potential opportunities for cross-border
learning within MNCs have been enhanced by an increased take-up of ICT technologies (Santangelo,
1999). ICT specialisation seems to amplify the firm’s technological flexibility by enabling it to fuse
together a wider range of formerly separate technologies. In this sense, in the current ICT-based
paradigm government intervention is better geared towards the promotion of cross-firm and cross-
border knowledge flows (presuming that firms follow the model of a continually interactive search
for better methods and improved products, and hence a search for higher profits through
experimental innovation in the fashion of Schumpeter and Penrose); rather than to provisions to
protect the monopolistic and separate exploitation of knowledge by those that have independently
invested in its creation (which could be more easily represented through an underlying model of
static profit maximisation by firms through the exercise of market power) (Cantwell, 1999). Yet as
stressed above, the theory of innovative profits needs revising in this era of greater technological
interrelatedness in which firms must not only sustain an adequate spread of coherent in-house
diversification but must be able to access other related capabilities through partnerships. It is not
leadership in ICT as such that is likely to count for most, but rather the capacity to blend ICT with
other technologies as a means of fusing them together and creating new combinations.
However, the creation of technology may be locationally concentrated or dispersed according to
the degree of complexity embedded in it. Some kinds of technologies are geographically easily
dispersed, whilst the uncodified character of others makes cross-broader learning within and across
organisations much more difficult. Thus, although multinationals have shown a greater
internationalisation of their R&D facilities recently, it depends upon the type of technological activity
22
involved. The development of science-based fields of activity (eg. ICT, biotechnology and new
materials) and an industry’s core technologies appear to require a greater intensity of face-to-face
interaction (Cantwell and Santangelo, 2000). Nonetheless, it may sometimes still be the case that
science-based and firm- and industry-specific core technologies are dispersed internationally. The
main factors driving the occasional geographical dispersion of the creation of these kinds of
otherwise highly localised technologies are either locally embedded specialisation which cannot be
accessed elsewhere, or company-specific global strategies that utilise the development of an
organisationally complex international network for technological learning (Cantwell and Santangelo,
1999).
The more typical pattern of international specialisation in innovative activity within the MNC is
for the development of technologies that are core to the firm’s industry to be concentrated at home,
while other fields of technological activity may be located abroad, and in this sense the
internationalisation of research tends to be complementary to the home base. Thus, when science-
based technology creation is internationally dispersed it is most often attributable to foreign
technology acquisition by the firms of ‘other’ industries - for example, chemical industry MNCs
developing electrical technologies abroad, or electrical equipment MNCs developing specialised
chemical processes outside their home countries (Cantwell and Santangelo, 1999, 2000; Cantwell
and Kosmopulou, 2001).
Evidence has now emerged that the choice of foreign location for technological development in
support of what is done in the home base of the MNC depends upon whether host regions within
countries are either major centres for innovation or not (termed ‘higher order’ or ‘lower order’
regions by Cantwell and Iammarino, 1998, 2000). Whereas most regions are not major centres and
tend to be highly specialised in their profile of technological development, and hence attract foreign-
owned activity in the same narrow range of fields; in the major centres much of the locally-sited
innovation of foreign-owned MNCs does not match very well the specific fields of local
specialisation, but is rather geared towards the development of technologies that are core to the
current techno-economic paradigm (notably ICT) or earlier paradigms (notably mechanical
technologies) (Cantwell, Iammarino and Noonan, 2001). The need to develop these latter
technologies is shared by the firms of all industries, and the knowledge spillovers between MNCs and
local firms in this case may be inter-industry in character. Thus, ICT development in centres of
excellence is not the prerequisite of firms of the ICT industries, but instead involves the efforts of the
MNCs of other industries in these common locations.
23
It may also be the case that the development of the capability to manage a geographically
complex international network lies in a firm’s specialisation in ICT. The opportunities created for the
fusion of formerly unrelated types of technology through ICT has made feasible new combinations of
activities, the best centres of expertise for which may be geographically distant from one another.
The enhanced expertise in ICT seems to provide a company with greater flexibility in the
management of its geographically dispersed network, and an enhanced ability to combine distant
learning processes in formerly separate activities. If this is the case for manufacturing companies in
general, it is all the more true for electrical equipment and ICT specialist companies. Affiliate
networks are increasingly used to source new technology. Accordingly, global learning has become
an important mechanism for corporate technological renewal within MNCs.
The key importance of ICT to the now more complex management of innovation in MNCs is that
it enables firms to better exploit their corporate technological diversification across national
boundaries (Cantwell and Piscitello, 2000), owing to the role of ICT as a means of combining fields
of knowledge creation that were previously kept largely apart (or what Kodama, 1992, terms
technology fusion). However, while this use of ICT has led many smaller firms to extend the breadth
of their technological diversification to create new combinations, in some of the very largest MNCs
the extent of technological diversification has been reduced, so as to better focus on the most
promising possible combinations from amongst the broader initial dispersion of innovative activity
that such companies have inherited from the past (Cantwell and Santangelo, 2000). Thus, we find
some convergence in the average degree of technological diversification across large firms, including
amongst others in the pharmaceutical industry (Cantwell and Bachmann, 1998).
Freeman and Perez (1998) had argued that in the latest techno-economic paradigm ICT has
become a 'carrier branch' or a 'transmission belt' for the transferal of innovation across sectors,
analogous to the role played by the capital goods sector in the mechanisation paradigm in the
nineteenth century (Rosenberg, 1976). Company evidence now suggests more than this that ICT has
become also a core connector of potential fields of technological development within firms (or
between firms in technology-based alliances) that facilitates the technological fusion of a formerly
disparate spread of innovative activity. Thus, while in the past the machine-building industry simply
passed knowledge of methods from one field of mechanical application to another, ICT potentially
combines the variety of technological fields themselves and so increases the scope for wider
innovation. Hence, innovation has become a still more central part of corporate development in the
ICT age. Internationalisation through the MNC to connect together in a network related streams of
locationally specialised innovation, in-house technological diversification and inter-company
24
technology-based alliances, and the corporate development and application of ICT have become
intertwined in a new era of innovative capitalism. The perspective of Penrose and Schumpeter on
innovation, profits and growth in the large firm has not only stood the test of time, but provides a
crucial theoretical backdrop to the analysis of this modern form of innovative and international
capitalism.
25
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NATIONAL LAW UNIVERSITY,

B.A.LL.B. (Hons.) Five Years

II Year - III Semester

Course Compiled By:

Semester July – Nov ember

The course of Economics I which basically incorporates basics in the

The students shall be introduced to the fundamentals of the subject

The teaching methodology shall be participatory teaching with

There are several books on basic microeconomics and

Course Evaluation Method

The Course is assessed for 100 Marks in total by a close book

On completion of the Course the students are expected to

MODULE 1 [20 Teaching Hours]

Economics: nature and scope, definitions by Adam Smith, Marshall,

Demand and supply analysis: law of demand, change in demand

Utility analysis: concept of utility, cardinal utility, law of diminishing

Production: production function, law of variable proportions,

Costs: fixed and variable, opportunity cost, shapes of av erage and

1. H.l. Ahuja, Advanced Economic Theory, S. Chand Publications,

2. Anindya Sen, Microeconomics: Theory and Applications, Oxford

3. Dominick Salv atore, Principles of Microeconomics, Oxford

5. Abha Mittal, Microeconomics: Theory and Applications, Taxmann

6. G.S. Maddala and Ellen Miller, Microeconomic Theory and

MODULE 2 [14 Teaching Hours]

Revenue: concept, shape of revenue curves, relation between

Markets: perfect completion and imperfect completion, monopoly,

Oligopoly: concept, price leadership model, concept of duopoly

1. H.l. Ahuja, Advanced Economic Theory, S. Chand Publications,

2. A Koutsoyiannis, Modern Microeconomics, Macmillan Press Ltd.,

3. Robert s Pindyek, Rubinfeid, L. Daniel and l. Prem Mehta, Micro

4. D.N. Dwivedi, Microeconomic Theory and Application, Pearson

6. G.S. Maddala and Ellen Miller, Microeconomic Theory and

MODULE 3 [15 Teaching Hours]

Introduction: factors of production, land, labour, capital and

Wages: Role of trade unions and collectiv e bargaining in wage

Rent: concept, Ricardian theory of rent, modern concept of rent,

Interest: concept, Keynesian theory of interest

Profit: concept, Innovation theory of profit, role of risk and

1. H.l. Ahuja, Advanced Economic Theory, S. Chand Publications,

2. A Koutsoyiannis, Modern Microeconomics, Macmillan Press Ltd.,

3 Robert s Pindyek, Rubinfeid, L. Daniel and l. Prem Mehta, Micro

4. Dominick Salv atore, Principles of Microeconomics, Oxford

MODULE 4 [15 Teaching Hours]

Macroeconomic Theory: Say’s law of market, Keynes criticisms

National Income: concept, aggregates of national income,

Money: meaning, evolution, functions, types of money, high

Banking: central bank, role, commercial banks, role and functions

1. M L Jhingan, Macro Economic Theory, Vrinda Publications (P) Ltd,

2 K.R. Gupta, Advanced Macroeconomics Vol – I , Atlantic Publisher,

3.H.L. Ahuja, Macroeconomics Theory and Policy, S Chand and

4. K.C. Rana and K.N. Verma, Macroeconomic Analysis, Vishal

5. R.K. Choudhury, Public Finance and Fiscal Policy, Kalyani Publishers,

1. H.l. Ahuja, Advanced Economic Theory, S. Chand Publications,

Sl. Authors/Institutions/Web link Titles

4 Ordinal utility and the traditional theory of

7 Shelby D. Hunt The Theory of Monopolistic Competition,

Dr. David A. Dilts

May 10, 1995

8 Dr. David A. Dilts

All rights reserved. No portion of this book

1992, 1993, 1994, 1995 ,1996, 2003 and 2004

Published by Indiana - Purdue University - Fort Wayne

1. Introduction to Economics ...................................................................................... 2