13e

Chapter 20:
Elasticity

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Elasticity
• If a seller needs to reduce the price of a
product, how much should it be reduced?
– Reduce too little, and projected increase in sales
will not meet desired goals.
– Reduce too much, and the projected profit target
might not be achieved.
• The economic concept here is price elasticity of
demand: how much quantity demanded
changes in response to a change in price.

20-2
 Learning Objectives
• 20-01. Compute the price elasticity of demand.
• 20-02. Know the relationships between price
changes, price elasticity, and total revenue.
• 20-03. Know what the cross-price elasticity of
demand measures.
• 20-04. Know what the income elasticity of
demand tells us.
• 20-05. Know what the elasticity of supply
measures.

20-3
 Price Elasticity
• The law of demand states that quantity
demanded will increase when the price is
lowered, and vice versa.
• The critical question to be answered is how
much quantity demanded will change due to
a price change.
• Price elasticity of demand: the percentage
change in quantity demanded divided by the
percentage change in price.

20-4
 Price Elasticity
• Price elasticity of demand: the percentage
change in quantity demanded divided by the
percentage change in price.
Price elasticity (E) = % change in quantity demanded
% change in price

• A 10% increase in quantity demanded in

response to a 20% price decrease yields a
price elasticity of 0.5.

20-5
 Computing Price Elasticity
• We use the average method of computation:
– Take the quantity before and the quantity after
the price change and average them.
– Divide the average quantity into the change in
quantity to get the percentage change in
quantity.
• If quantity went from 2 to 4, then the
average is 3. The change is 2, so the
percentage change is 2/3 or 0.667.

20-6
 Computing Price Elasticity
• We do the same thing to get the percentage
change in price:
– Take the price before and the price after and
average them.
– Divide the average price into the change in price to
get the percentage change in price.
• If price went from 45 to 40, then the average is
42.5. The change is 5, so the percentage change
is 5/42.5, or 0.118.

20-7
 Computing Price Elasticity
• The % change in quantity is 0.667 and the %
change in price is 0.118.
Price elasticity (E) = % change in quantity demanded
% change in price

• We can now compute the price elasticity of

demand:
– E = 0.667 / 0.118 = 5.65
• A 1% change in price brings about a 5.65%
change in quantity demanded.

20-8
 Interpreting Elasticity
• If E > 1, demand is elastic.
– Consumer response is large relative to the price
change.
• If E < 1, demand is inelastic.
– Consumer response is small relative to the price
change.
• If E = 1, demand is unitary elastic.
– % change in quantity demanded is exactly equal to
% change in price.

20-9
Elasticity Extremes

20-10
 Determinants of Elasticity
• Necessities vs. luxuries.
– Demand for necessities is relatively inelastic.
– Demand for luxuries is relatively elastic.
• Availability of substitutes.
– The greater the availability of substitutes, the
more elastic is the product’s demand.
– No or few substitutes? Inelastic demand.

20-11
 Determinants of Elasticity
• Relative price to income.
– Demand for low-priced goods is relatively
inelastic.
– Demand for high-priced goods is relatively
elastic.
• Time.
– The more time you have to adjust to a price
change, the more elastic is your response.
– No time to adjust? Highly inelastic demand.

20-12
 Price Elasticity and Total Revenue
• The goal of sales is to receive total revenue.
Total revenue = Price x Quantity sold

– If demand is inelastic (E<1), a price rise increases

total revenue, and vice versa.
– If demand is elastic (E>1), a price rise decreases
total revenue, and vice versa.
– If demand is unitary-elastic (E=1), a price change
does not change total revenue.

20-13
 Income Elasticity
• A increase in demand for a good when
income rises is true for a normal good. Most
goods are normal goods.
• However, for some goods the demand
decreases as income rises. They are inferior
goods.
– Examples are used clothes and ramen noodles.
– As income increases, people upgrade to higher-
quality substitutes for inferior goods.

20-14
 Income Elasticity
• As income increases, people have more money
to spend. Demand for goods, in general, will
shift rightward.
– For a particular good, how much of a demand
increase will occur?
– Income elasticity of demand: % change in quantity
demanded divided by % change in income.
– Your income rises by 10%. You go to the movies
more and buy 20% more popcorn. Income elasticity
of demand for popcorn is 20% / 10% or 2.0.

20-15
 Cross-Price Elasticity
• Suppose the price of candy in the theater falls.
How would this affect the sales of popcorn?
– Candy and popcorn are substitutes for each other.
– Lower-priced candy will see an increase in quantity
demanded. Also, the demand for popcorn will
decrease. But by how much?
• Cross-price elasticity of demand: the % change
in quantity demanded of X divided by the %
change in price of Y.
20-16
 Cross-Price Elasticity
• Cross-price elasticity of demand: the %
change in quantity demanded of X divided
by the % change in price of Y.
– If popcorn sales declined 20% when the candy
price dropped 10%, the cross-price elasticity of
demand for popcorn is -20 / -10 or Ex = +2.0, a
relatively elastic response.
– Note that the sign is significant. When goods are
substitutes, cross-price elasticity is positive.

20-17
 Cross-Price Elasticity
• Cross-price elasticity of demand: the %
change in quantity demanded of X divided
by the % change in price of Y.
– If popcorn sales declined 20% when the movie
admission price increased 10%, the cross-price
elasticity of popcorn is -2.0, a relatively elastic
response.
– Again the sign is significant. When goods are
complements, cross-price elasticity is negative.

20-18
 Cross-Price Elasticity
• Substitute goods: goods that can replace
each other; when the price of good X rises,
the demand for good Y increases, and vice
versa, ceteris paribus.
• Complementary goods: goods frequently
consumed in combination; when the price of
good X rises, the demand for good Y
decreases, and vice versa, ceteris paribus.

20-19
 Elasticity of Supply
• The law of supply states that an increase in
price causes an increase in quantity supplied.
But how much more will be produced as the
price rises?
• Elasticity of supply: the % change in quantity
supplied divided by the % change in price.
– If it is highly elastic, producers are very responsive
to a price change.
– If it is highly inelastic, producers do not have much
of a response to a price change.

20-20
 13e

Chapter 21:
The Costs of Production

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 The Costs of Production
• Before anyone can consume to satisfy wants
and needs, goods and services must be
produced.
• Producers are profit-seeking, so they aim to
produce a salable product at the lowest cost
of resources used.
– Many times this means producing overseas.

21-2
 The Costs of Production
• However, costs are not the only consideration.
Productivity is also important.
– Paying $10 an hour to typist A who types 90 words
a minute is a lot cheaper than paying $2 an hour to
typist B who types 10 words a minute.
• Exercise: Compare the cost of words per hour
in the example above.
– A: 5,400 words/$10 = 540 words/$1
– B: 600 words/$2 = 300 words/$1

21-3
 Learning Objectives
• 21-01. Know what the production function
represents.
• 21-02. Know how the law of diminishing
returns applies to the production process.
• 21-03. Describe how the various measures of
cost are related.
• 21-04. Discuss how economic and accounting
costs are different.
• 21-05. Understand (dis)economies of scale.

21-4
 The Production Function
• Production function: a technological
relation-ship expressing the maximum
quantity of a good attainable from different
combinations of factor inputs.
– In other words, how much can we produce with
the land, labor, and capital available?
– We will consider the land to be a fixed amount.
So we can vary only the labor and the capital.

21-5
 The Production Function
• In order for labor to produce, it needs land
and capital. With neither, production is zero.
• With fixed land and capital, adding more
labor will increase production.
– First, at a rapid rate as the added workers put
the capital to full use.
– Later, more workers will not add as much new
production as workers overwhelm the available
capital.

21-6
 The Production Function
• The productivity
of any factor of
production (e.g.,
labor) depends on
the amount of
other resources
(e.g., capital)
available to it.

21-7
 The Production Function
• Note that when capital is fixed, as labor
increases, output increases but ultimately at
a slower rate. Ultimately output maxes out
and begins to decline.
– The measure of this added output as labor
increases is marginal physical product (MPP).

21-8
Marginal Physical Product (MPP)

21-9
 Diminishing Marginal Returns
• Law of diminishing returns: the marginal
physical product of a variable input declines
as more of it is employed with a given
quantity of other (fixed) inputs.
– Added output begins to decrease and ultimately
goes negative as more and more workers are
added with no increase in capital.

21-10
 Resource Costs
• The sales manager wants to maximize sales
revenue.
• The production manager wants to minimize
production costs.
• The business owner wants, instead, to
maximize profit.
• There is no reason to expect these three
goals to occur at the same output.

21-11
Resource Costs

21-12
 Resource Costs
• As MPP decreases with added workers, we
continue to pay the added workers, but we get
less added product with each added worker.
• Therefore, the cost per added product
increases as MPP declines.
• Marginal cost (MC): the increase in total cost
associated with a one-unit increase in
production.

21-13
 Marginal Cost (MC)
Change in total cost
Marginal cost (MC) =
Change in output

• When MPP decreases, MC must increase,

and vice versa.
• For any production with fixed capital, the
MC curve will fall at low levels of production
but will rise sharply at higher levels when
diminishing marginal returns set in.

21-14
 Dollar Costs
• Total cost (TC): the market value of all
resources used to produce a good or service.
• Fixed cost (FC): costs of production that
don’t change when the rate of output is
altered.
• Variable cost (VC): costs of production that
change when the rate of output is altered.
Total Costs = Fixed costs + Variable costs
TC = FC + VC

21-15
 Fixed Costs
• Payments for the fixed inputs.
• Includes the cost of basic plants and
equipment.
• Must be paid even if output is zero.
• Do not increase as output increases.

21-16
 Variable Costs
• Payments for the variable inputs.
• Include the costs of labor and raw materials.
• At zero output, these costs are zero.
• As output increases, variable costs increase
rapidly at first, then more slowly, and finally
very fast as the firm approaches maximum
capacity.

21-17
 Average Costs
• Average total cost (ATC): total cost divided by the
quantity of output in a given time period.
– ATC = TC / q
• Average fixed costs (AFC): total fixed cost divided by
the quantity of output in a given time period.
– AFC = FC / q
• Average variable cost (AVC): total variable cost
divided by the quantity of output in a given time
period.
– AVC = VC / q

21-18
Characteristics of the Cost Curves
• Falling AFC: as output increases, AFC decreases
rapidly. Any increase in output will lower AFC.
• U-shaped AVC: AVC decreases at first, hits a
minimum, and then rises as output increases
(as a result of diminishing returns).
• U-shaped ATC: at low output, falling AFC
dominates and ATC decreases. As output
increases, rising AVC begins to dominate. ATC
hits a minimum, then begins to rise.

21-19
 Minimum Average Cost
• The output at which ATC switches from being
dominated by AFC to being dominated by
rising AVC is the point where average costs are
minimal.
– It is at this output where the firm can produce at
the lowest cost per unit...
– … and where the firm minimizes the amount of
resources being used.
– However, this amount of output is not necessarily
the output where profit is maximized.

21-20
 Marginal Cost (MC)
Change in total cost
Marginal cost (MC) =
Change in output

• Diminishing returns in production cause MC to

increase as output increases.
• After a brief drop in MC at low output, MC rises
rapidly as output increases.
• As MC rises, it intersects ATC at its minimum
point.
• ATC decreases when MC<ATC.
• ATC increases when MC>ATC.
21-21
 Economic vs. Accounting Costs
• Accountants count only dollar costs of
production – that is, the explicit costs.
– Explicit costs: a payment made for the use of a
resource.
• Economists add the value of all other resources
used in production, including resources not
paid for in dollars.
– Implicit costs: the value of resources used in
production, even when no direct payment is made.

21-22
 Economic vs. Accounting Costs
Economic cost = Explicit costs + Implicit costs

• Explicit costs can be identified by the

accountant with a paper trail denominated in
dollars.
• Implicit costs are the cost of resources for
which no payment is made – that is, the
opportunity cost of using those resources. They
can be identified only by the entrepreneur.

21-23
 Long-Run Costs
• The short run is characterized by fixed costs.
– In the short run, the plants and equipment are
fixed.
– The objective is to make the best use of those fixed
inputs while making the production decision.
• In the long run, we can change the plants and
equipment.
– Long run: a period of time long enough for all
inputs to be varied.
– There are no fixed costs in the long run. All costs
are variable.

21-24
 Long-Run Average Costs
• In the long run, a firm
can build a plant of any
desired size.
• As plant size gets
larger, each plant’s ATC
curve has a lower
minimum point.
• In this case, building a
larger plant would
lower production
costs.
21-25
 Long-Run Average Costs
• There are unlimited
options.
• One option delivers
the lowest ATC.
• It is at this point
where the long-run
marginal cost curve
intersects the long-
run average total
cost curve.
21-26
 Economies of Scale
• Economies of scale: reductions in minimum
average costs that come through increases
in the size (scale) of plants and equipment.
– Larger plants reduce minimum average costs.
– Greater efficiency may come from
• Specialization vs. multifunction workers.
• Mass production vs. small batch mode production.

21-27
 Diseconomies of Scale
• If the plant size gets too big, however, long-
run average costs begin to rise, creating
diseconomies of scale.
– Operating efficiency may be reduced.
– Worker alienation may increase.
– Rigid corporate structures emerge.
– Off-site management may be unresponsive.
• Bigger isn’t always better.

21-28
 13e

Chapter 22:
The Competitive Firm

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Competition and Profits
• All firms are in business to make a profit.
• Their profit opportunities are limited by the
amount of competition they face.
– Little competition, easier to be profitable.
– Lots of competition, much more difficult.

22-2
 Learning Objectives
• 22-01. Know how profits are computed.
• 22-02. Know the characteristics of perfectly
competitive firms.
• 22-03. Know how a competitive firm
maximizes profit.
• 22-04. Know when a firm will shut down.
• 22-05. Know the difference between
production and investment decisions.
• 22-06. Know what shapes or shifts a firm’s
supply curve.

22-3
 The Profit Motive
• The expectation of profit is the basic incentive
to produce.
– Profit: the difference between total revenue and
total cost.
• The profit motive encourages firms to produce
the goods and services that consumers desire,
at prices they are willing to pay.
– What will happen to a firm if it produces goods that
no consumers want or are willing to pay for?

22-4
 Is the Profit Motive Bad?
• Some think so. Some believe
– It results in inferior products at higher prices.
– It leads to pollution, restricted competition, and an
unsafe workplace.
• Reality:
– It encourages firms to produce products customers
desire at prices they are willing to pay.
– It causes markets to adapt to changing economic
conditions and customer preferences.

22-5
 Economic vs. Accounting Profits
• Economists include all costs in economic costs,
both implicit costs and explicit costs.
• Accountants include only explicit costs.
• Profit equals total revenue minus total costs.
– Economic profit, then, is smaller than accounting
profit because more costs are subtracted:
Economic profit = Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs only
Economic profit = Accounting profit – Implicit costs

22-6
 Normal Profit
• Normal profit: the opportunity cost of capital.
– The owner could have invested these resources
elsewhere. If the opportunity cost is a lost return of
10%, then the owner will expect at least a 10%
return in this business, preferably higher.
– Normal profit is equivalent to an implicit cost.
– It is earned if economic profit is zero, which, maybe
surprisingly, is the typical case.
• A productive activity reaps an economic profit
only if it earns more than its opportunity cost.

22-7
 Entrepreneurship and Risk
• The entrepreneur will go into business only if
the prospect of earning more there is greater
than the alternative use of resources.
– The owner expects a return of more than a normal
profit.
– There is no guarantee of profit. Thus the owner is
willing to undertake the risk of suffering economic
losses.
– The inducement to face this risk is the potential for
economic profit.

22-8
 Market Structure

• Market structure: the number and relative size

of firms in an industry.
• The market structures range from monopoly at
one extreme to perfect competition at the other
extreme. Most real-world firms are along the
continuum of imperfect competition.
22-9
 A Survey of Market Structures
• Perfect competition: a market in which no
buyer or seller has market power.
• Monopolistic competition: many firms, a
little market power.
• Oligopoly: a few firms, considerable market
power.
• Duopoly: two firms.
• Monopoly: one firm only.

22-10
 Perfect Competition
• Characteristics:
– Many firms compete for consumer purchases.
– The products of each firm are identical.
– Low entry barriers make it easy to get into the
business.
– No firm has any market power, thus they cannot
manipulate the price. They are price takers.
– Each firm’s output is small relative to the total
market amount.

22-11
Market Demand vs. Firm Demand

Although the entire market has a typical downward-

sloping demand curve, the individual firm perceives its
demand curve to be horizontal.
22-12
 A Firm’s Demand Curve
• Why horizontal?
– The firm is a price taker. It will charge only the
market price.
– If it raises its price, nobody will buy.
– If it lowers its price, it will sell out, but it can do that
at the market price.
– It can sell increased quantities at the market price.
• If you draw a line for any quantity at the
market price, the line will be horizontal.

22-13
 The Production Decision
• There are no pricing decisions. Firms take
the market price.
• There are no quality decisions since all
products are identical.
• The only decision left is how much to
produce.
– This is the production decision.

22-14
 The Production Decision
• A firm’s goal is to
maximize profits, not
revenues.
• Profit equals total
revenue (price X
quantity) minus total
costs.
• The goal is to find the
output that maximizes
profits.
• Is h that output?

22-15
 The Production Decision
• Never produce a unit
of output that yields
less revenue than it
costs.
• Marginal revenue
(MR) is equal to price,
the added amount
received from selling
one more unit.
MR = Change in total revenue
Change in output

22-16
 The Production Decision
• As output increases,
marginal cost (MC)
increases, squeezing the
profit from the added
units.
• Compare P to MC:
– If P>MC, we add to profit
by selling that one.
– If P<MC, we make a loss
by selling that one.
– If P=MC, we make no
profit or loss on that one.

22-17
 Profit Maximization Rule
• For perfectly competitive firms,
– If P > MC, increase output and profits will grow.
– If P < MC, decrease output and losses will go away.
– If P = MC, produce this output because it is the
quantity at which profits are maximized.
• Profit maximization rule:
– Produce at that rate of output where marginal
revenue (MR = P) equals marginal cost (MC).

22-18
 Graphical Look at Profit Maximization
• Here we relate ATC
and MC to P=MR.
• To maximize profits,
choose the quantity
related to point b.
That is where MR=MC.
• Note that it is not the
same as maximum
profit per unit (point a)
or maximum revenues
(point c).
22-19
 The Shutdown Decision
• Shutting down the firm does not eliminate
all costs.
– Fixed costs must be paid even if all output
ceases.
– If a firm makes losses, it cannot pay all its fixed
costs and its variable costs.
– The firm will lose less by shutting down
(output=0) if losses from continuing production
exceed fixed costs.
22-20
 The Shutdown Decision

• Always set P=MR=MC to maximize profits or minimize losses.

• If prices fall below ATC, a loss is made.
• The firm should not shut down until the price falls below AVC. When this
happens the firm can’t pay its labor and suppliers, so shutting down is the
best option.
22-21
 The Investment Decision
• Investment decision: the decision to build, buy,
or lease plants and equipment or to enter or
exit an industry.
– The shutdown decision is a short-run decision.
– Investment decisions are long-run.
– Fixed costs are the owners’ investment in the
business. They must generate enough revenue to
recoup the investment.
– Investment will occur if the anticipated profits are
large enough to compensate for the effort and risk.

22-22
 Determinants of Supply
• A producer will increase output only if profits
are increasing. Conversely, a producer will
decrease output if profits are decreasing.
• Each of these determinants affects a producer’s
willingness and ability to supply a product:
– The price of factor inputs.
– Technology.
– Expectations.
– Taxes and subsidies.

22-23
 The Short-Run Supply Curve
• The supply curve shows the quantity a
producer is willing to supply at each price.
• The profit maximization rule leads us to the
short-run supply curve.
– At each price, the producer sets output where
MR=MC.
– The producer resets this output when price
changes.
• Raise the price, produce more.
• Lower the price, produce less.
• The marginal cost curve is the firm’s short-run
supply curve.
22-24
 Supply Shifts
• If any determinant of supply changes, the
supply curve shifts.
– A change that lowers costs will cause the supply
curve to shift right.
– A change that raises costs will cause the supply
curve to shift left.

22-25
 Tax Effects
• Raising property taxes.
– Fixed costs and total costs rise, but MC does not. So
there is no change in the production decision.
• Raising payroll taxes.
– Variable costs and total costs rise, but MC rises also.
The MC curve will shift upward to the left, and
production output will be decreased.
• Raising profit taxes.
– Neither fixed nor variable costs are changed. But
owners receive less return and may reduce
investment in new business.

22-26