ECON​ ​11​ ​LE2​ ​Reviewer​ ​(​Chapters​ ​5-8) 

● The​ ​amount​ ​of​ ​extra​ ​or​ ​marginal​ ​utility​ ​declines 

  as​ ​a​ ​person​ ​consumes​ ​more​ ​and​ ​more​ ​of​ ​a​ ​good 
● Total​ ​utility​ ​grows​ ​at​ ​a​ ​slower​ ​and​ ​slower​ ​rate  
Theory​ ​of​ ​Demand 
 
● Based​ ​on​ ​the​ ​assumption​ ​that​ ​consumers 
DERIVATION​ ​OF​ ​DEMAND​ ​CURVES 
maximize​ ​utility 
 
 
The​ ​Equimarginal​ ​Principle  
Utility 
➢ Ceteris​ ​paribus​ ​conditions: 
● The​ ​property​ ​in​ ​any​ ​object​ ​to​ ​produce​ ​pleasure​ ​or 
○ Fixed​ ​income 
happiness​ ​or​ ​to​ ​prevent​ ​pain,​ ​evil​ ​or​ ​unhappiness. 
○ Market​ ​prices​ ​of​ ​goods 
(Jeremy​ ​Bentham,​ ​English​ ​Philosopher) 
➢ States​ ​that​ ​a​ ​consumer​ ​will​ ​achieve​ ​maximum 
○ Laws​ ​should​ ​be​ ​based​ ​on​ u​ tilitarian 
satisfaction​ ​or​ ​utility​ ​when​ ​the​ ​marginal​ ​utility​ ​of 
principles​ t​ o​ ​promote​ ​the​ ​greatest 
the​ ​last​ ​peso​ ​spent​ ​on​ ​a​ ​good​ ​is​ ​exactly​ ​the​ ​same 
happiness​ ​of​ ​the​ ​greatest​ ​number.  
as​ ​the​ ​marginal​ ​utility​ ​of​ ​the​ ​last​ ​peso​ ​spent​ ​on 
 
any​ ​other​ ​good.  
Total​ ​Utility 
MU1 MU2
● The​ ​sum​ ​of​ ​all​ ​the​ ​marginal​ ​utilities​ ​up​ ​to​ ​that  P1 = P2  
point   
● Increases​ ​are​ ​more​ ​of​ ​the​ ​good​ ​is​ ​consumed   
Consumer​ ​Problem:  
Maximize​ ​utility​ ​given​ ​budget​ ​constraints 
 
Solution:  
Reallocate​ ​spending​ ​to​ ​equate​ ​marginal​ ​utilities​ ​per​ ​peso 
spent​ ​on​ ​2​ ​goods 
 
Example: 
MU1 MU2
P1 < P2  
 
➔ If​ ​the​ ​MU​ ​of​ ​good​ ​2​ ​is​ ​larger​ ​than​ ​good​ ​1,​ ​you 
 
must​ ​buy​ ​more​ ​of​ ​good​ ​2​ ​to​ ​reinstate​ ​the 
Marginal​ ​Utility 
equilibrium​ ​conditions.​ ​(More​ ​of​ ​good​ ​2,​ ​less​ ​MU 
● The​ ​additional​ ​utility​ ​you​ ​get​ ​from​ ​the 
for​ ​good​ ​2,​ ​it​ ​will​ ​then​ ​equal​ ​to​ ​the​ ​lower​ ​MU​ ​of 
consumption​ ​of​ ​an​ ​additional​ ​unit​ ​of​ ​a​ ​commodity 
ΔT U good​ ​1).  
MU = ΔQ
  ➔ If​ ​you​ ​can​ ​buy​ ​more​ ​of​ ​good​ ​2​ ​without​ ​reducing 
your​ ​consumption​ ​of​ ​good​ ​1,​ ​you​ ​must​ ​have​ ​not 
been​ ​spending​ ​all​ ​of​ ​your​ ​income.​ ​The​ ​answer, 
therefore,​ ​is​ ​in​ ​reallocation.  
 
 
 
 
 
Why​ ​are​ ​demand​ ​curves​ ​downward​ ​sloping? 
 
 
 
★ Diminishing​ ​marginal​ ​utility 
Law​ ​of​ ​Diminishing​ ​Marginal​ ​Utility 
○ Due​ ​to​ ​satiety 
 ○ Marshall’s​ ​reversal​ ​of​ ​the​ ​axes   Consumer​ ​Surplus  
○ See:​ ​equimarginal​ ​principle  ● The  gap  between the total utility of a good and its 
★ Substitution​ ​effect   market​ ​value  
○ Show​ ​using​ ​the​ ​equilibrium​ ​condition  ● Arises  due  to  the  fact  that  we  receive  more  than 
○ If​ ​substitute​ ​goods​ ​have​ ​different​ ​prices,  what​ ​we​ ​pay​ ​for  
higher​ ​quantities​ ​of​ ​the​ ​cheaper​ ​good​ ​will  ● A​ ​result​ ​of​ ​the​ ​law​ ​of​ ​diminishing​ ​marginal​ ​utility  
be​ ​bought​ ​compared​ ​to​ ​the​ ​more  ● Used​ ​for​ ​cost-benefit​ ​analyses  
expensive​ ​good   ○ E.g.  An  economist  would  recommend 
★ Income​ ​effect  building  a  free  road  if  its  total  consumer 
○ The​ ​change​ ​in​ ​quantity​ ​demanded​ ​that  surplus​ ​exceeds​ ​its​ ​costs. 
arises​ ​because​ ​a​ ​price​ ​change​ ​lowers 
consumer​ ​real​ ​incomes 
 
Individual​ ​to​ ​Market​ ​Demand 
● The​ ​demand​ ​curve​ ​for​ ​a​ ​good​ ​for​ ​the​ ​entire 
market​ ​is​ ​obtained​ ​by​ ​summing​ ​up​ ​the​ ​quantities 
demanded​ ​by​ ​all​ ​the​ ​consumers  
○ Individual​ ​curves​​ ​-​ ​lowercase​ ​letters​ ​(dd 
and​ ​ss)  
○ Market​ ​curves​ -​ ​ ​capital​ ​letters​ ​(DD​ ​and 
SS) 
 

 
 
 
The​ ​Paradox​ ​of​ ​Value  
➢ How  is  it  that  water,  which  is  essential  to life, has 
little  value,  while  diamonds,  which  are  not, 
command​ ​an​ ​exalted​ ​price? 
➢ The  total  utility from water consumption does not 
determine  its  price  or  demand;  rather,  it  is  the 
marginal  utility​,  ​or  the  usefulness  of  the  last 
glass​ ​of​ ​water.  
➢ Because  there  is  so  much  water,  the  lsat  glass 
sells for very little. Meanwhile, because diamonds 
 
are  scarce  and  the  cost  of  getting  extra  ones  is 
*We  pay  the  same  price  for  every  unit  of  a  good  we 
high,​ ​it​ ​is​ ​sold​ ​at​ ​a​ ​high​ ​price.  
purchase  but  we  only  pay  for what the last unit is worth on 
➢ The  more  there  is  of  a  commodity, the less is the 
the​ ​market​ ​demand​ ​curve. 
relative​ ​desirability​ ​of​ ​its​ ​last​ ​little​ ​unit.   
 
 
GEOMETRICAL​ ​ANALYSIS​ ​OF​ ​CONSUMER​ ​EQUILIBRIUM 
  The​ ​Equilibrium​ ​Point​ ​of​ ​Tangency 
Indifference​ ​Curves  ● The​ ​point​ ​of​ ​tangency​ ​between​ ​the​ ​budget​ ​line 
● The  points  on  the  curve  represent  consumption  and​ ​the​ ​indifference​ ​curve​ ​is​ ​the​ ​highest​ ​utility 
bundles among which the consumer is indifferent;  contour​ ​that​ ​the​ ​consumer​ ​can​ ​reach.  
all​ ​are​ ​equally​ ​desirable.  ● Relates​ ​to​ ​the​ ​equimarginal​ ​principle​​ ​as​ ​this​ ​is 
○ Total  utility  is  constant  throughout  the  the​ ​point​ ​where​ ​the​ ​the​ ​ratio​ ​of​ ​the​ ​prices​ ​is​ ​equal 
curve.  to​ ​the​ ​ratio​ ​of​ ​the​ ​marginal​ ​utilities​ ​of​ ​2​ ​goods.  
● Based  solely  on  consumer  preferences,  in  Pf MUf
Pc = substitution ratio = MUc  
particular:  
○ The​ ​ability​ ​to​ ​rank​ ​preferences   
○ Say  which  combinations  give  me  as  Shifts​ ​in​ ​the​ ​Budget​ ​Line​ ​and​ ​Indifference​ ​Curves 
much  happiness  as  any  other   
combination​ ​of​ ​the​ ​two​ ​goods  ➔ Income​ ​Change 
● Bowl-shaped;​ ​convex​ ​to​ ​the​ ​origin   ◆ An​ ​income​ ​change​ ​shifts​ ​the​ ​budget​ ​line 
○ Due to the law of substitution, which says  in​ ​a​ ​parallel​ ​way. 
that  the  scarcer  the  good,  the  greater  its 
relative  substitution  value.  Its  marginal 
utility  rises  relative  to  the marginal utility 
of​ ​the​ ​good​ ​that​ ​has​ ​become​ ​plentiful. 
● The  slope  of  the  indifference  curve  tells  you  the 
marginal  rate  of  substitution  ​between  the  2 
goods,​ ​or​ ​the​ ​goods’​ ​relative​ ​marginal​ ​utilities.  

 
➔ Single​ ​Price​ ​Change 
◆ A​ ​rise​ ​in​ ​the​ ​price​ ​of​ ​a​ ​good​ ​(x​ ​axis) 
pivots​ ​the​ ​budget​ ​line​ ​inwards​ ​while​ ​a 
drop​ ​would​ ​pivot​ ​it​ ​outwards. 

 
 
*Getting​ ​more​ ​of​ ​one​ ​good​ ​entails​ ​giving​ ​up​ ​an​ ​amount​ ​of 
the​ ​other.  
   
  Deriving​ ​the​ ​Demand​ ​Curve  
  ● The​ ​demand​ ​curve​ ​can​ ​be​ ​derived​ ​from​ ​the​ ​points 
Budget​ ​Line  of​ ​tangency​ ​on​ ​the​ ​indifference​ ​curves 
● Sums​ ​up​ ​all​ ​possible​ ​combinations​ ​of​ ​the​ ​2   
goods​ ​that​ ​would​ ​just​ ​exhaust​ ​the​ ​consumer’s   
income   
  The​ ​Production​ ​Function 
 ● The​ ​maximum​ ​output​ ​that​ ​can​ ​be​ ​produced​ ​with: 
○ A​ ​given​ ​quantity​ ​of​ ​inputs 
○ Current​ ​state​ ​of​ ​technology 
● Counterpart​ ​of​ ​total​ ​utility​ ​curve​ ​in​ ​consumer 
theory  
○ If​ ​more​ ​resources​ ​are​ ​used,​ ​more​ ​output 
can​ ​be​ ​produced,​ ​but​ ​output​ ​decreases​ ​at 
a​ ​decreasing​ ​rate.  
 
Total​ ​Product 
● Total​ ​amount​ ​of​ ​output​ ​produced​ ​in​ ​physical​ ​units 
○ E.g.​ ​cavans​ ​of​ ​rice,​ ​bushels​ ​of​ ​corn,​ ​etc.  

 
Law​ ​of​ ​Diminishing​ ​Returns 
● A​ ​firm​ ​will​ ​get​ ​less​ ​and​ ​less​ ​extra​ ​output​ ​when​ ​it 
adds​ ​additional​ ​units​ ​of​ ​one​ ​input​ ​while​ ​holding 
all​ ​other​ ​inputs​ ​fixed.  
● As​ ​more​ ​of​ ​an​ ​input​ ​such​ ​as​ ​labor​ ​is​ ​added​ ​to​ ​a 
fixed​ ​amount​ ​of​ ​land,​ ​machinery​ ​or​ ​other​ ​inputs, 
the​ ​labor​ ​has​ ​less​ ​and​ ​less​ ​of​ ​the​ ​other​ ​factors​ ​to 
 
work​ ​with.  
 
 
Marginal​ ​Product 
➢ Diminishing  returns  are  a  key  factor  in explaining 
● Extra​ ​output​ ​produced​ ​by​ ​an​ ​extra​ ​unit​ ​of​ ​input 
why  countries  in  Asia  are  so  poor  -  living 
used,​ ​other​ ​inputs​ ​held​ ​constant. 
standards  in  crowded  countries  are  so  low 
 
because  there  are  so  many  workers  per  acre  of 
land. 
➢ Diminishing  returns  may  not  hold  for  all  levels  of 
production.  The  very  first  inputs  of  labor  may 
actually​ ​show​ ​increasing​ ​marginal​ ​products​ ​(MP).  
 
Returns​ ​to​ ​Scale 
● The  effects  of  scale  increases  of all inputs to the 
quantity​ ​produced.  
○ Constant​ ​returns​ ​to​ ​scale  
■ A  change  in  all  inputs  leads  to  a 
  proportional​ ​change​ ​in​ ​output. 
  ○ Increasing​ ​returns​ ​to​ ​scale  
Average​ ​Product  ■ Also​ ​called​ ​economies​ ​of​ ​scale 
● Total​ ​product​ ​or​ ​total​ ​units​ ​of​ ​output​ ​divided​ ​by  ■ An  increase  in  all  inputs leads to 
total​ ​units​ ​of​ ​input​ ​used.  a  more  than  proportional 
T otal U nits of Output increase​ ​in​ ​all​ ​outputs. 
T otal U nits of Input  
○ Decreasing​ ​returns​ ​to​ ​scale 
 
 ■ A  balanced  increase  of all inputs  ○ Extra​ ​or​ ​additional​ ​cost​ ​of​ ​producing​ ​1 
leads  to  a  less  than  proportional  extra​ ​unit​ ​of​ ​output 
increase​ ​in​ ​total​ ​output.   ○ The​ ​slope​ ​of​ ​the​ ​TC​ ​curve 
■ Scaling  up  may  eventually  reach  ○ Note:​ ​MC​ ​curve​ ​is​ ​also​ ​the​ ​firm’s​ ​supply 
a  point  beyond  which  curve​ ​for​ ​values​ ​above​ ​AVC.  
inefficiencies​ ​set​ ​in.   M C = ΔT C
ΔQ  
 
Short​ ​Run​ ​and​ ​Long​ ​Run   
 
❖ Short​ ​Run 
➢ A  period  in  which  firms  can  adjust 
production  by  changing  variable  factors 
such  as  materials  and  labor  but  cannot 
change​ ​fixed​ ​factors​ ​such​ ​as​ ​capital. 
❖ Long​ ​Run 
➢ A  period  sufficiently  long  that  all  factors 
including​ ​capital​ ​can​ ​be​ ​adjusted. 
 
 
 
The​ ​Firm’s​ ​Problem 
● The​ ​firm​ ​wants​ ​to​​ ​maximize​ ​profit​ ​subject​ ​to​ ​a 
cost​ ​constraint.    
○ Profit​ ​=​ ​Total​ ​Revenue​ ​-​ ​Total​ ​Cost 
● Equivalently​ ​stated,​ ​the​ ​firm​ ​wants​ ​to​ ​minimize 
cost​ ​subject​ ​to​ ​an​ ​output​ ​constraint.  
● It​ ​is​ ​facing​ ​GIVEN​ ​resources,​ ​and​ ​the​ ​prices​ ​of 
factor​ ​inputs.  
● It​ ​operates​ ​in​ ​2​ ​markets​ ​-​ ​goods​ ​and​ ​factor 
markets. 
 
Cost​ ​Concepts 
➢ Total​ ​Cost  
○ Represents​ ​the​ ​lowest​ ​total​ ​expense 
needed​ ​to​ ​produce​ ​each​ ​level​ ​of​ ​output​ ​q.  
TC = FC + V C    
➢ Fixed​ ​Cost  ➢ Average​ ​Cost​ ​or​ ​Unit​ ​Cost 
○ Expenses​ ​that​ ​are​ ​paid​ ​out​ ​even​ ​if​ ​no  ○ Total​ ​cost​ ​per​ ​unit​ ​of​ ​output​ ​or​ ​unit​ ​cost 
outputs​ ​are​ ​produced  ○ The​ ​sum​ ​of​ ​the​ ​average​ ​fixed​ ​cost​ ​and 
○ Unaffected​ ​by​ ​variation​ ​of​ ​output  average​ ​variable​ ​cost 
○ “Overhead”​ ​or​ ​“sunk”​ ​costs  AC = TC
➢ Variable​ ​Costs  Q  
○ Expenses​ ​that​ ​vary​ ​with​ ​the​ ​level​ ​of   
output  ➢ Average​ ​Fixed​ ​Cost​ ​(AFC) 
○ The​ ​jump​ ​in​ ​TC​ ​between​ ​2​ ​outputs​ ​is​ ​the  ○ Since​ ​total​ ​fixed​ ​cost​ ​is​ ​constant, 
same​ ​as​ ​the​ ​jump​ ​in​ ​VC.  dividing​ ​it​ ​by​ ​an​ ​increasing​ ​output​ ​gives​ ​it 
➢ Marginal​ ​Cost  a​ ​steadily​ ​falling​ ​curve.  
 ○ As​ ​a​ ​firm​ ​sells​ ​more​ ​and​ ​more​ ​output,​ ​it 
can​ ​spread​ ​its​ ​overhead​ ​cost​ ​to​ ​more 
units.  
AF C = FQC  
 
➢ Average​ ​Variable​ ​Cost​ ​(AVC) 
○ Variable​ ​cost​ ​divided​ ​by​ ​output 
VC
AV C = Q  

 
The​ ​Relation​ ​between​ ​Average​ ​Cost​ ​and​ ​Marginal​ ​Cost 
➔ MC​ ​>​ ​AC,​ ​AC​ ​is​ ​pulled​ ​up 
➔ MC​ ​<​ ​AC,​ ​AC​ ​is​ ​pulled​ ​down 
➔ MC​ ​=​ ​AC,​ ​AC​ ​is​ ​neither​ ​rising​ ​nor​ ​falling​ ​nad​ ​is​ ​at 
its​ ​minimum.​ ​Hence,​ ​at​ ​the​ ​bottom​ ​of​ ​a​ ​U-shaped 
AC,​ ​MC​ ​=​ ​AC​ ​=​ ​MINIMUM​ ​AC.  
 
 
*Remember​ ​story​ ​about​ ​the​ ​average​ ​height​ ​of​ ​people​ ​in​ ​a 
Factors​ ​that​ ​Determine​ ​the​ ​Cost​ ​Curves 
room.  
● Factor​ ​prices 
*MC​ ​always​ ​cuts​ ​the​ ​AC​ ​curve​ ​at​ ​the​ ​minimum​ ​point.  
● Firm’s​ ​production​ ​function 
 
 
 
Diminishing​ ​Returns​ ​&​ ​U-Shaped​ ​Cost​ ​Curves 
 
● For​ ​U-shaped​ ​cost​ ​curves,​ ​cost​ ​falls​ ​in​ ​the​ ​initial 
phase,​ ​reaches​ ​a​ ​minimum​ ​point,​ ​and​ ​begins​ ​to 
rise.  
○ If​ ​cost​ ​curves​ ​did​ ​not​ ​eventually​ ​turn​ ​up, 
perfect​ ​competition​ ​would​ ​break​ ​down.  
● Diminishing​ ​returns​ ​lead​ ​to​ ​rising​ ​marginal​ ​costs 
because​ ​each​ ​additional​ ​unit​ ​of​ ​labor​ ​has​ ​less 
capital​ ​to​ ​work​ ​with.  
 
 diminishing​ ​returns,​ ​thereby​ ​returning​ ​the 
ratio​ ​back​ ​into​ ​equality.  
 
Equal​ ​Product​ ​Curves​ ​/​ ​Isoquants 
❖ Shows​ ​you​ ​different​ ​combinations​ ​of​ ​2​ ​factors​ ​of 
production​ ​that​ ​produce​ ​the​ ​same​ ​amount​ ​of 
output 
❖ The​ ​shape​ ​of​ ​the​ ​isoquant​ ​is​ ​convex​ ​to​ ​the​ ​origin 
due​ ​to​ ​the​ ​law​ ​of​ ​diminishing​ ​marginal 
productivity 
➢ As​ ​one​ ​input​ ​is​ ​increased​ ​while​ ​all​ ​other 
inputs​ ​are​ ​held​ ​constant,​ ​the​ ​MP​ ​of​ ​the 
varying​ ​input​ ​will​ ​start​ ​declining​ ​after 
some​ ​point.  
❖ The​ ​slope​ ​of​ ​the​ ​isoquant​ ​is​ ​the​ ​marginal​ ​rate​ ​of 
technical​ ​substitution​ ​(like​ ​MRS​ ​in​ ​consumer 
theory) 
 

 
 
The  region  of  increasing  marginal  product  corresponds  to 
falling  marginal  costs,  while  the  region  of  diminishing 
returns​ ​implies​ ​rising​ ​marginal​ ​costs. 
 
Least-Cost​ ​Rule  
● To  produce  a  given  level  of  output  at  the  least   
cost,  a  firm  should  buy  inputs  until  it  has  Equal-Cost​ ​Lines​ ​/​ ​Isocosts 
equalized  the  marginal product per peso spent on  ❖ How​ ​much​ ​will​ ​it​ ​cost​ ​to​ ​produce​ ​a​ ​given​ ​level​ ​of 
each​ ​input.   output? 
MP1 MP2
P1 = P2   ➢ Note​ ​that​ ​there​ ​are​ ​different 
  combinations​ ​of​ ​the​ ​2​ ​inputs​ ​that​ ​can​ ​be 
  used​ ​to​ ​produce​ ​the​ ​same​ ​level​ ​of​ ​output  
Substitution​ ​Rule  ❖ Slope​ ​of​ ​the​ ​curve 
● If​ ​the​ ​price​ ​of​ ​one​ ​factor​ ​falls​ ​while​ ​all​ ​other  ➢ Price​ ​of​ ​X​ ​input​ ​/​ ​Price​ ​of​ ​Y​ ​input  
factor​ ​prices​ ​remain​ ​the​ ​same,​ ​the​ ​firm​ ​will​ ​profit   
by​ ​substituting​ ​the​ ​now-cheaper​ ​factor​ ​for​ ​other 
factors​ ​until​ ​the​ ​marginal​ ​products​ ​per​ ​dollar​ ​are 
equal​ ​for​ ​all​ ​inputs. 
○ E.g.​ ​ ​A​ ​fall​ ​in​ ​the​ ​price​ ​of​ ​labor​ ​will​ ​raise 
the​ ​ratio​ ​MPL/PL​ ​above​ ​the​ ​MP/P​ ​ratio 
for​ ​other​ ​inputs.​ ​By​ ​employing​ ​more 
labor,​ ​it​ ​will​ ​lower​ ​the​ ​MPL​ ​by​ ​law​ ​of 
 ● Key​ ​assumptions:  
○ Firms​ ​maximize​ ​profits 
○ Firms​ ​are​ ​atomistic​ ​and​ ​are​ ​price-takers 
○ Firms​ ​sell​ ​homogeneous​ ​products 
○ Firms​ ​cannot​ ​affect​ ​market​ ​price 
● The​ ​firm’s​ d​ d​​ ​demand​ ​curve​ ​looks​ ​completely 
horizontal​ ​or​ ​infinitely​ ​elastic. 

 
Shifts​ ​in​ ​Isocosts 
➔ If​ ​the​ ​price​ ​of​ ​one​ ​factor​ ​of​ ​production​ ​changes 
so​ ​that​ ​the​ ​ratio​ ​of​ ​prices​ ​is​ ​no​ ​longer​ ​the​ ​same, 
the​ ​equal​ ​cost​ ​line​ ​will​ ​pivot.  
➔ A​ ​change​ ​in​ ​TC​ ​(firm’s​ ​budget)​ ​would​ ​cause​ ​the 
isocost​ ​to​ ​move​ ​in​ ​a​ ​parallel​ ​way. 
 
Least-Cost​ ​Tangency 
● The​ ​optimal,​ ​or​ ​cost​ ​minimizing​ ​position​ ​of​ ​the   
firm​ ​comes​ ​at​ ​the​ ​point​ ​of​ ​tangency​ ​between​ ​the  Competitive​ ​Supply  
isoquant​ ​and​ ​the​ ​isocost.   ● Comes​ ​at​ ​the​ ​output​ ​where​ ​marginal​ ​cost​ ​equals 
● The​ ​ratio​ ​of​ ​the​ ​marginal​ ​products​ ​of​ ​any​ ​2​ ​inputs  price​ ​(P​ ​=​ ​MC) 
must​ ​equal​ ​the​ ​ratio​ ​of​ ​their​ ​factor​ ​prices.   ● At​ ​the​ ​maximum-profit​ ​point,​ ​the​ ​last​ ​unit 
MP1 W1 produced​ ​brings​ ​in​ ​an​ ​amount​ ​of​ ​revenue​ ​exactly 
MP2 = W2  
equal​ ​to​ ​the​ ​unit’s​ ​cost. 
  ○ What​ ​is​ ​the​ ​extra​ ​revenue​?​ ​Price​ ​per​ ​unit 
Where​ ​W​ ​=​ ​prices​ ​of​ ​inputs  ○ What​ ​is​ ​the​ ​extra​ ​cost​?​ ​Marginal​ ​cost 
  ● This​ ​implicates​ ​that​ ​diagrammatically​,​ ​a​ ​firm’s 
marginal​ ​cost​ ​curve​ ​is​ ​also​ ​its​ ​supply​ ​curve. 
 

 
   
Perfect​ ​Competition 
  

 
 
  Market​ ​Supply 
  ● Obtained​ ​by​ ​adding​ ​horizontally​ ​all​ ​the​ ​supply 
The​ ​Shutdown​ ​Rule  curves​ ​of​ ​the​ ​individual​ ​producers​ ​of​ ​that​ ​good.  
● The​ ​shutdown​ ​point​ ​is​ ​when​ ​revenues​ ​just​ ​cover   
variable​ ​costs​ ​or​ ​where​ ​losses​ ​are​ ​equal​ ​to​ ​fixed  Short​ ​Run​ ​vs.​ ​Long​ ​Run​ ​Equilibrium 
costs.​ ​(P​ ​=​ ​AVC,​ ​intersection​ ​of​ ​MC​ ​and​ ​AVC).    
○ For​ ​prices​ ​above​ t​ he​ ​shutdown​ ​point  ❖ Short​ ​Run 
(above​ ​AVC​ ​but​ ​below​ ​AC),​ ​the​ ​firm  ➢ Output​ ​changes​ ​must​ ​use​ ​the​ ​same​ ​fixed 
should​ ​produce​ ​along​ ​its​ ​MC​ ​curve  amount​ ​of​ ​capital 
because​ ​even​ ​though​ ​it​ ​would​ ​be​ ​losing  ❖ Long​ ​Run 
money,​ ​it​ ​would​ ​lose​ ​more​ ​money​ ​by  ➢ Capital​ ​and​ ​all​ ​other​ ​factors​ ​are​ ​variable 
shutting​ ​down.​ ​It​ ​would​ ​gain​ ​negative  ➢ Free​ ​entry​ ​and​ ​exit​ ​of​ ​firms​ ​into​ ​and​ ​from 
profits.   the​ ​industry 
○ For​ ​prices​ ​below​​ ​the​ ​shutdown​ ​point   
(below​ ​AVC),​ ​the​ ​firm​ ​will​ ​produce 
nothing​ ​at​ ​all.​ ​By​ ​shutting​ ​down,​ ​it​ ​will 
lose​ ​only​ ​its​ ​fixed​ ​costs.  
 
Zero​ ​Profit​ ​Point 
● When​ ​P​ ​=​ ​AC  
● MR​ ​=​ ​MC 
 

 
 
 
 
Special​ ​Cases​ ​of​ ​Competitive​ ​Markets 
 
❖ Constant​ ​Cost 
➢ E.g.​ ​Textile​ ​production 

 
 
Pareto​ ​Efficiency 
  ● Occurs  when  no  possible  reorganization  or 
❖ Increasing​ ​Costs​ ​and​ ​Diminishing​ ​Returns  distribution  can  make  anyone  better  off  without 
making​ ​someone​ ​else​ ​worse​ ​off.  
● One  person’s  satisfaction  or  utility  can  be 
increased​ ​only​ ​by​ ​lowering​ ​someone​ ​else’s​ ​utility. 
 
Producer​ ​Surplus 
➔ Area​ ​between​ ​the​ ​price​ ​line​ ​and​ ​the​ ​SS​ ​curve 
➔ Includes  the  rent  and  profits  to  firms and owners 
of​ ​specialized​ ​inputs​ ​in​ ​the​ ​industry  
➔ Indicates  the  excess  of  revenues  over the cost of 
production 
   
❖ Fixed​ ​Supply​ ​and​ ​Economic​ ​Rent  Economic​ ​Surplus 
➔ Welfare  or  net  utility  gain  from  production  and 
consumption​ ​of​ ​a​ ​good 
➔ Consumer​ ​surplus​ ​+​ ​Producer​ ​surplus 
 

 
❖ Backward-Bending​ ​Supply​ ​Curve 
➢ E.g.​ ​Labor 
 

 
 
 
 
Efficiency​ ​of​ ​Competitive​ ​Equilibrium  causes  consumers  to  buy  less  of  such 
● It  maximizes  the  economic  surplus  available  in  goods  than  they  would  under  perfect 
the  industry.  For  this  reason,  it  is  economically  competition and consumer satisfaction is 
efficient.   reduced.  
● If​ ​P​ ​=​ ​MU​ ​=​ ​MC,​ ​then​ ​the​ ​allocation​ ​is​ ​efficient.   ➔ Externalities 
○ P​ ​=​ ​MU  ◆ Side  effects  of  production  or 
■ Consumers  choose  food  consumption  are  not  included  in  market 
purchases  up  to  the  amount  prices.  
where​ ​P​ ​=​ ​MU.  ● E.g.  Environmental  effects  of 
○ P​ ​=​ ​MC  factories  
■ As  producers,  each  person  is  ◆ Positive​ ​externalities​ ​also​ ​exist. 
supplying  food  to  the  point  ● E.g.  Inoculation  of  persons  who 
where  the  price  of  food  equals  are  affected by disease; this also 
the​ ​MC​ ​of​ ​the​ ​last​ ​unit​ ​of​ ​food.   benefits  those  who  would  have 
■ Price  is  then  the  utils  of  been​ ​infected. 
leisure-time  satisfaction  lost  ➔ Imperfect​ ​Information 
because  of  working  to  grow  that  ◆ The  invisible-hand  theory  assumes  that 
last​ ​unit​ ​of​ ​food.  buyers  and  sellers  have  complete 
○ MU​ ​=​ ​MC.   information  about  the  goods  that  they 
■ Utils  gained  from  the  last  unit  of  buy​ ​and​ ​sell.  
food  consumed  exactly  equal  to  ● E.g.  When  products  actually 
the  leisure  utils  lost  to  produce  contain​ ​poisonous​ ​materials 
that​ ​last​ ​unit​ ​of​ ​food.   ◆ This  is  where  government  intervention  is 
  important,  in  order  to  identify  areas 
*​The  marginal gain to society from the last unit consumed  where  informational  deficiencies  are 
equals  to  the  marginal  cost  to  society  of  that  last  unit  economically​ ​significant.  
produced;​ ​thus,​ ​a​ ​competitive​ ​equilibrium​ ​is​ ​efficient. 
 
Marginal​ ​Cost​ ​in​ ​Efficiency 
● For  any  goal-oriented  organization,  efficiency 
requires  that  the  marginal  cost  of  attaining  the 
goal​ ​should​ ​be​ ​equal​ ​in​ ​every​ ​activity.  
● In  a  market,  an  industry  will  produce its output at 
minimum  total  cost  only  when  each  firm’s  MC  is 
equal​ ​to​ ​a​ ​common​ ​price.  
● Only  when  marginal  costs  are  equalized  can  we 
squeeze  the  maximum  from  our  scarce 
resources. 
● A  competitive  economy  is  efficient  only  when 
marginal  private cost equals marginal social cost, 
and​ ​when​ ​both​ ​equal​ ​marginal​ ​utility.  
 
Market​ ​Failures 
 
➔ Imperfect​ ​Competition 
◆ When  firms  have  some  control  over  the 
price,  they  can  raise  the  price  of  the 
product  above  their  marginal  cost.  This