 is the study of how households

and firms make decisions and

how they interact in markets.
 What Economics Is All About
• Scarcity:  the limited nature of society’s 
resources
• Economics:  the study of how society manages 
its scarce resources, e.g.
– how people decide what to buy, 
how much to work, save, and spend
– how firms decide how much to produce, 
how many workers to hire
– how society decides how to divide its resources 
between national defense, consumer goods, 
protecting the environment, and other needs
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
• Society faces an important tradeoff:
efficiency vs. equality
• Efficiency: when society gets the most from its
scarce resources
• Equality: when prosperity is distributed uniformly
among society’s members
• Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
 Principle #2: The Cost of Something Is
What You Give Up to Get It

• Making decisions requires comparing the costs

and benefits of alternative choices.
• The opportunity cost of any item is
whatever must be given up to obtain it.
• It is the relevant cost for decision making.
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition, books, and
fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
 Principle #3: Rational People Think at the Margin

Rational people
– systematically and purposefully do the best they
can to achieve their objectives.
– make decisions by evaluating costs and benefits of
marginal changes – incremental adjustments to an
existing plan.
Example:
• When a student considers whether to go to college 
for an additional year, he compares the fees & 
foregone wages to the extra income 
he could earn with the extra year of education.
 Principle #4: People Respond to Incentives

• Incentive: something that induces a

person to act, i.e. the prospect of a reward
or punishment.
• Rational people respond to incentives.
Examples:
When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
When cigarette taxes increase,
teen smoking falls.

9
The principles of
HOW PEOPLE
INTERACT
 HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone
Better Off

• Rather than being self‐sufficient, 
people can specialize in producing one good or 
service and exchange it for other goods.  
• Countries also benefit from trade & 
specialization:
– Get a better price abroad for goods they produce
– Buy other goods more cheaply from abroad than 
could be produced at home
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
• Market: a group of buyers and sellers
(need not be in a single location)
• “Organize economic activity” means determining
– what goods to produce
– how to produce them
– how much of each to produce
– who gets them
• A market economy allocates resources
through the decentralized decisions of many
households and firms as they interact in
markets.
Principle #7: Governments Can Sometimes
Improve Market Outcomes
• Important role for govt: enforce property rights
(with police, courts)
• Market failure: when the market fails to allocate
society’s resources efficiently
• Causes:
– Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
– Market power, a single buyer or seller has
substantial influence on market price (e.g.
monopoly)
• In such cases, public policy may promote efficiency.
The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.

• The most important determinant of living

standards: productivity, the amount of goods
and services produced per unit of labor.
• Productivity depends on the equipment, skills,
and technology available to workers.
• Other factors (e.g., labor unions, competition
from abroad) have far less impact on living
standards.
Principle #9: Prices rise when the
government prints too much money.

• Inflation: increases in the general level of

prices.
• In the long run, inflation is almost always
caused by excessive growth in the quantity
of money, which causes the value of money
to fall.
• The faster the govt creates money,
the greater the inflation rate.
Principle #10: Society faces a short-run
tradeoff between inflation and unemployment

• In the short-run (1 – 2 years),

many economic policies push inflation and
unemployment in opposite directions.
• Other factors can make this tradeoff more
or less favorable, but the tradeoff is always
present.
 Assumptions & Models
• Assumptions simplify the complex world,
make it easier to understand.
• Model: a highly simplified representation
of a more complicated reality. Economists
use models to study economic issues.
Our First Model:
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
FIGURE 1:   The Circular‐Flow Diagram

Households:
 Own the factors of production, 
sell/rent them to firms for income
 Buy and consume goods & services

Firms Households

Firms:
 Buy/hire factors of production, 
use them to produce goods and 
services
 Sell goods & services
FIGURE 1:   The Circular‐Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
 The Market Forces of
Supply and Demand
 A market is a group of buyers and sellers of a
particular product.
 A competitive market is one with many buyers
and sellers, each has a negligible effect on price.
 In a perfectly competitive market:
 All goods exactly the same
 Buyers & sellers so numerous that no one can
affect market price – each is a “price taker”
 In
this chapter, we assume markets are perfectly
competitive.
 Demand
• The quantity demanded of any good
is the amount of the good that buyers
are willing and able to purchase.
• Law of demand: the claim that the
quantity demanded of a good falls
when the price of the good rises, other
things equal
 The Demand Schedule
Price Qty of
• Demand schedule:    of soya soya milk
a table that shows the  milk demanded
relationship between the  $0.00 16
price of a good and the  1.00 14
quantity demanded 
2.00 12
• Example:   3.00 10
GV’s demand for soya milk. 4.00 8
5.00 6
 Notice that GV’s preferences  6.00 4
obey the 
Law of Demand.  
 GV’s Demand Schedule & Curve
Price of Price Qty of soya
soya milk of soya milk
$6.00 milk demanded
$0.00 16
$5.00
1.00 14
$4.00 2.00 12
$3.00 3.00 10
$2.00 4.00 8
5.00 6
$1.00
6.00 4
$0.00
Qty of
0 5 10 15 soya milk
 Market Demand versus Individual Demand
• The quantity demanded in the market is the sum of the 
quantities demanded by all buyers at each price. 
• Suppose GV and Vince are the only two buyers in the soya 
milk market.     (Qd = quantity demanded)
Price  GV’s Qd Vince’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve for Soya Milk
Qd
P P
(Market)
$6.00
$0.00 24
$5.00 1.00 21
$4.00 2.00 18
3.00 15
$3.00
4.00 12
$2.00
5.00 9
$1.00 6.00 6
$0.00 Q
0 5 10 15 20 25
 Demand Curve Shifters:  # of Buyers

P Suppose the number

$6.00 of buyers increases.
Then, at each P,
$5.00
Qd will increase
$4.00 (by 5 in this example).
$3.00

$2.00
$1.00

$0.00 Q
0 5 10 15 20 25 30
Demand Curve Shifters: Income
• Demand for a normal good is positively
related to income.
– Increase in income causes
increase in quantity demanded at each price,
shifts D curve to the right.

(Demand for an inferior good is

negatively related to income. An increase
in income shifts D curves for inferior goods
to the left.)
Demand Curve Shifters: Prices of Related Goods
Two goods are substitutes if an increase in the
price of one causes an increase in demand for the
other.
Two goods are complements if an increase in the
price of one causes a fall in demand for the other.

Demand Curve Shifters: Tastes

Demand Curve Shifters: Expectations
Example:
If people expect their incomes to rise, their
demand for meals at expensive restaurants may
increase now.
Summary: Variables That Influence Buyers
Variable A change in this variable…

Price …causes a movement

along the D curve
# of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve
 Supply
• The quantity supplied of any good is the
amount that sellers are willing and able to
sell.
• Law of supply: the claim that the quantity
supplied of a good rises when the price of
the good rises, other things equal
 The Supply Schedule
• Supply schedule:    Price Quantity
of soya of soya milk
A table that shows the 
milk supplied
relationship between the 
price of a good and the  $0.00 0
quantity supplied.  1.00 3
2.00 6
• Example:  
3.00 9
Godwin’s supply of soya milk.
4.00 12
5.00 15
 Notice that Godwin’s supply 
6.00 18
schedule obeys the 
Law of Supply.  
 Godwin’s Supply Schedule & Curve
Price Qty of
P of soya soya milk
$6.00 milk supplied
$0.00 0
$5.00
1.00 3
$4.00
2.00 6
$3.00 3.00 9
$2.00 4.00 12
5.00 15
$1.00
6.00 18
$0.00 Q
0 5 10 15
 Market Supply versus Individual Supply
• The quantity supplied in the market is the sum of 
the quantities supplied by all sellers at each price. 
• Suppose Godwin and Jitters are the only two sellers in 
this market.     (Qs = quantity supplied)
Price  Godwin Jitters Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
Supply Curve Shifters: Input Prices

P Suppose the price

$6.00 of soya falls.
At each price, the
$5.00
quantity of
$4.00 Soya milk supplied
will increase
$3.00
(by 5 in this
$2.00 example).
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
Supply Curve Shifters: Technology
A cost-saving technological improvement has the
same effect as a fall in input prices, shifts S curve
to the right.

Supply Curve Shifters: # of Sellers

An increase in the number of sellers increases the
quantity supplied at each price, shifts S curve to the
right.

Supply Curve Shifters: Expectations

In general, sellers may adjust supply* when their
expectations of future prices change.
(*If good not perishable)
Summary: Variables that Influence Sellers
Variable A change in this variable…

Price …causes a movement

along the S curve
Input Prices …shifts the S curve
Technology …shifts the S curve
# of Sellers …shifts the S curve
Expectations …shifts the S curve
 Supply and Demand Together

P Equilibrium:
$6.00 D S
P has reached
$5.00 the level where
$4.00 quantity supplied
$3.00
equals
quantity demanded
$2.00
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
 Equilibrium price:
the price that equates quantity supplied
with quantity demanded
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00 5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
 Equilibrium quantity:
the quantity supplied and quantity demanded
at the equilibrium price
P
$6.00 D S P QD QS
$5.00 $0 24 0
$4.00 1 21 5

$3.00
2 18 10
3 15 15
$2.00
4 12 20
$1.00 5 9 25
$0.00 Q 6 6 30
0 5 10 15 20 25 30 35
 Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P Example:
$6.00 D Surplus S
If P = $5,
$5.00 then
$4.00 QD = 9 lattes
$3.00 and
QS = 25 lattes
$2.00
resulting in a
$1.00 surplus of 16 lattes
$0.00 Q
0 5 10 15 20 25 30 35
 Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00 D Surplus S Facing a surplus,
sellers try to increase
$5.00 sales by cutting price.
$4.00 This causes
$3.00 QD to rise and QS to fall…

$2.00 …which reduces the

surplus.
$1.00

$0.00 Q
0 5 10 15 20 25 30 35
 Surplus (a.k.a. excess supply):
when quantity supplied is greater than
quantity demanded
P
$6.00 D Surplus S Facing a surplus,
sellers try to increase
$5.00 sales by cutting price.
$4.00 This causes
$3.00 QD to rise and QS to fall.

$2.00 Prices continue to fall

until market reaches
$1.00 equilibrium.
$0.00 Q
0 5 10 15 20 25 30 35
 Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Example:
If P = $1,
$5.00
then
$4.00 QD = 21 lattes
$3.00 and
QS = 5 lattes
$2.00
resulting in a
$1.00 shortage of 16 lattes
$0.00 Shortage Q
0 5 10 15 20 25 30 35
 Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise,
$3.00 …which reduces the
shortage.
$2.00
$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35
 Shortage (a.k.a. excess demand):
when quantity demanded is greater than
quantity supplied
P
$6.00 D S Facing a shortage,
sellers raise the price,
$5.00
causing QD to fall
$4.00 and QS to rise.
$3.00 Prices continue to rise
$2.00 until market reaches
equilibrium.
$1.00
Shortage
$0.00 Q
0 5 10 15 20 25 30 35
 Terms for Shift vs. Movement Along Curve
• Change in supply: a shift in the S curve
occurs when a non-price determinant of supply
changes (like technology or costs)
• Change in the quantity supplied:
a movement along a fixed S curve
occurs when P changes
• Change in demand: a shift in the D curve
occurs when a non-price determinant of demand
changes (like income or # of buyers)
• Change in the quantity demanded:
a movement along a fixed D curve
occurs when P changes
 The Costs of Production

Total Revenue, Total Cost, Profit

 We assume that the firm’s goal is to maximize profit.

Profit = Total revenue – Total cost

the amount a the market

firm receives value of the
from the sale inputs a firm
of its output uses in
production
 Costs: Explicit vs. Implicit
Explicit costs require an outlay of money,
e.g., paying wages to workers.
Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.

Economic Profit vs. Accounting Profit

Accounting profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit
and implicit costs)
Accounting profit ignores implicit costs, so it’s higher
than economic profit.
 The Production Function
A production function shows the
relationship between the quantity of inputs
used to produce a good and the quantity of
output of that good.
It can be represented by a table, equation, or
graph.
Example:
– Farmer Jack grows rice.
– He has 5 hectares of land.
– He can hire as many workers as he wants.
 Example :  Farmer Jack’s Production Function

L 3,000
Q (kilos
(no. of
of rice)
workers) 2,500

Quantity of output
0 0 2,000

1 1000 1,500

2 1800 1,000

3 2400 500

4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
 Marginal Product
If Jack hires one more worker, his output rises 
by the marginal product of labor.  
The marginal product of any input is the 
increase in output arising from an additional 
unit of that input, holding all other inputs 
constant. 
Notation: 
∆ (delta) = “change in…”
Examples: 
∆Q = change in output, ∆L = change in labor
∆Q
Marginal product of labor (MPL) = 
∆L
 EXAMPLE 1: Total & Marginal Product
L
Q (kilos
(no. of
of rice) MPL
workers)

0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000
 EXAMPLE : MPL = Slope of Prod Function

L Q MPL
3,000 equals the
(no. of (kilos MPL slope of the
workers) of rice) 2,500
production function.

Quantity of output
0 0 2,000
1000
Notice that
1 1000 MPL diminishes
1,500
800 as L increases.
2 1800 1,000
600 This explains why
3 2400 the
500 production
400
4 2800 function
0
gets flatter
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
 Why MPL Diminishes
Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has
less land to work with and will be less productive.
In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
 EXAMPLE : Farmer Jack’s Costs

• Farmer Jack must pay $1000 per month

for the land, regardless of how much rice
he grows.
• The market wage for a farm worker is
$2000 per month.
• So Farmer Jack’s costs are related to how
much rice he produces….
 EXAMPLE 1: Farmer Jack’s Costs
L Q
Cost of Cost of Total
(no. of (kilos
land labor Cost
workers) of rice)

0 0 $1,000 $0 $1,000

1 1000 $1,000 $2,000 $3,000

2 1800 $1,000 $4,000 $5,000

3 2400 $1,000 $6,000 $7,000

4 2800 $1,000 $8,000 $9,000

5 3000 $1,000 $10,000 $11,000
 EXAMPLE 1:  Farmer Jack’s Total Cost Curve
$12,000
Q (kilos Total
of rice) Cost $10,000

$8,000

Total cost
0 $1,000
$6,000
1000 $3,000
$4,000
1800 $5,000
$2,000
2400 $7,000
$0
2800 $9,000 0 1000 2000 3000
3000 $11,000 Quantity of rice
 Marginal Cost
• Marginal Cost (MC) 
is the increase in Total Cost from 
producing one more unit: 

∆TC
MC =
∆Q
 EXAMPLE :  Total and Marginal Cost
Q
Total Marginal
(kilos
Cost Cost (MC)
of rice)

0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3000 $11,000
 Why MC Is Important
• Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce
more or less wheat?
• To find the answer, Farmer Jack needs to
“think at the margin.”
• If the cost of additional wheat (MC) is less than
the revenue he would get from selling it,
then Jack’s profits rise if he produces more.
 Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of
output produced.
– For Farmer Jack, FC = $1000 for his land
– Other examples:
cost of equipment, loan payments, rent
• Variable costs (VC) vary with the quantity
produced.
– For Farmer Jack, VC = wages he pays
workers
– Other example: cost of materials
• Total cost (TC) = FC + VC
EXAMPLE : Marginal Cost

Q TC MC $200 Marginal Cost (MC)

Recall,
is $175
the change in total cost from
0 $100
$70 producing
$150 one more unit:
1 170
50 $125 ∆TC
MC =
Costs
2 220 ∆Q
40 $100
3 260 Usually,
$75 MC rises as Q rises, due
50 to diminishing marginal product.
4 310 $50
70 Sometimes (as here), MC falls
5 380 $25
100 before rising.
6 480 $0
140 (In other0 examples,
1 2 3 MC 4 may
5 6be 7
7 620 constant.) Q
EXAMPLE : Average Fixed Cost

Q FC AFC Average
$200 fixed cost (AFC)
0 $100 n/a
is$175
fixed cost divided by the
quantity
$150 of output:
1 100 $100
AFC
$125 = FC/Q

Costs
2 100 50
$100
3 100 33.33
Notice
$75 that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed
$50
5 100 20 costs over a larger and larger
$25
number of units.
6 100 16.67 $0
7 100 14.29 0 1 2 3 4 5 6 7
Q
EXAMPLE : Average Variable Cost

Q VC AVC Average
$200 variable cost (AVC)
is$175
variable cost divided by the
0 $0 n/a
quantity
$150
of output:
1 70 $70
AVC
$125 = VC/Q

Costs
2 120 60
$100
3 160 53.33 As$75
Q rises, AVC may fall initially.
4 210 52.50 In most cases, AVC will
$50
eventually rise as output rises.
5 280 56.00 $25
6 380 63.33 $0
7 520 74.29 0 1 2 3 4 5 6 7
Q
EXAMPLE : Average Total Cost

Q TC ATC AFC AVC Average total cost

(ATC) equals total
0 $100 n/a n/a n/a
cost divided by the
1 170 $170 $100 $70 quantity of output:
2 220 110 50 60 ATC = TC/Q
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29
EXAMPLE : Average Total Cost

Q TC ATC $200
Usually,
$175
as in this example,
0 $100 n/a
the ATC curve is U-shaped.
$150
1 170 $170
$125
2 220 110

Costs
$100
3 260 86.67
$75
4 310 77.50 $50
5 380 76 $25
6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57
Q
EXAMPLE : The Various Cost Curves Together

$200
$175
$150
ATC
$125
AVC
Costs
$100
AFC
MC $75
$50

$25
$0
0 1 2 3 4 5 6 7
Q
EXAMPLE : Why ATC Is Usually U‐Shaped

As Q rises: $200

Initially, $175
falling AFC $150
pulls ATC down. $125

Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
Efficient scale: $25
The quantity that
$0
minimizes ATC. 0 1 2 3 4 5 6 7
Q
 EXAMPLE : ATC and MC
When MC < ATC, $200 ATC
ATC is falling. $175
MC

When MC > ATC, $150

ATC is rising. $125

Costs
$100
The MC curve
crosses the $75

ATC curve at $50

the ATC curve’s $25
minimum. $0
0 1 2 3 4 5 6 7
Q
Costs in the Short Run & Long Run
Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones).
In the long run, ATC at any Q is cost per unit
using the most efficient mix of inputs for that
Q (e.g., the factory size with the lowest ATC).
 EXAMPLE : LRATC with 3 factory Sizes
Firm can choose
from 3 factory Ave
Total
sizes: S, M, L.
Cost ATCS ATCM
Each size has its ATCL
own SRATC
curve.
The firm can
change to a
different factory Q
size in the long
run, but not in the
short run.
 EXAMPLE : LRATC with 3 factory Sizes
To produce less
than QA, firm will Ave
choose size S Total
in the long run. Cost ATCS ATCM
ATCL
To produce
between QA
and QB, firm will LRATC
choose size M
in the long run.
To produce more Q
than QB, firm will QA QB
choose size L
in the long run.
 A Typical LRATC Curve
In the real
ATC
world, factories
come in many
sizes, LRATC
each with its
own SRATC
curve.
So a typical
LRATC curve Q
looks like this:
 How ATC Changes as 
the Scale of Production Changes
Economies of ATC
scale: ATC falls
as Q increases. LRATC

Constant returns
to scale: ATC
stays the same
as Q increases.
Q
Diseconomies of
scale: ATC rises
as Q increases.
 How ATC Changes as
the Scale of Production Changes
Economies of scale occur when increasing
production allows greater specialization:
workers more efficient when focusing on a
narrow task.
– More common when Q is low.
Diseconomies of scale are due to
coordination problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
– More common when Q is high.
 Firms in Competitive Markets
Characteristics of Perfect Competition
1. Many buyers and many sellers.
2. The goods offered for sale are largely the
same.
3. Firms can freely enter or exit the market.

 Because of 1 & 2, each buyer and seller is

a “price taker” – takes the price as given.
 The Revenue of a Competitive Firm
• Total revenue (TR)  TR = P x Q

TR
• Average revenue (AR) AR = = P
Q

• Marginal revenue (MR): MR =
∆TR
The change in TR from  ∆Q
selling one more unit. 
Calculating TR, AR, MR
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n/a

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
79
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a
$10
1 $10 $10 $10
Notice that  $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
80
MR = P for a Competitive Firm
A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue to
rise by P, i.e., MR = P.
MR = P is only true for 
firms in competitive markets.
 Profit Maximization
• What Q maximizes the firm’s profit?
• To find the answer, “think at the margin.”
If increase Q by one unit, revenue rises by
MR, cost rises by MC.
• If MR > MC, then increase Q to raise
profit.
• If MR < MC, then reduce Q to raise profit.
 Profit Maximization
(continued from earlier exercise)

Profit = 
At any Q with Q TR TC Profit MR MC
MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2 
5 50 45 5
 MC and the Firm’s Supply Decision
Rule:  MR = MC at the profit‐maximizing Q.

At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q P1 MR
to raise profit.
At Q1, MC = MR.
Q
Changing Q Qa Q1 Qb
would lower profit.
 MC and the Firm’s Supply Decision

If price rises to P2,

then the profit- Costs
maximizing quantity MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any P1 MR
price.
Hence,
Q
Q1 Q2
the MC curve is the 
firm’s supply curve.
A Firm’s Short‐run Decision to Shut Down
Cost of shutting down: revenue loss = TR
Benefit of shutting down:
cost savings = VC (firm must still pay FC)
So, shut down if TR < VC
Divide both sides by Q: TR/Q < VC/Q
So, firm’s decision rule is:

Shut down if  P < AVC
 A Competitive Firm’s SR Supply Curve
The firm’s SR 
supply curve is 
the portion of  Costs
its MC curve 
MC
above AVC.
If P > AVC, then
firm produces Q ATC
where P = MC. AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q
 A Firm’s Long‐Run Decision to Exit
• Cost of exiting the market:
revenue loss = TR
• Benefit of exiting the market:
cost savings = TC (zero FC in the long run)
• So, firm exits if TR < TC
• Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC
 A New Firm’s Decision to Enter Market
• In the long run, a new firm will enter the
market if it is profitable to do so: if TR >
TC.
• Divide both sides by Q to express the
firm’s entry decision as:

Enter if  P > ATC
 The Competitive Firm’s Supply Curve

The firm’s 
LR supply curve is  Costs
the portion of  MC
its MC curve 
above LRATC.
LRATC

Q
Example
Identifying a firm’s profit
A competitive firm
Determine 
this firm’s  Costs, P
total profit. MC

Identify the  P = $10 MR
area on the  ATC
graph that 
$6
represents 
the firm’s 
profit.
Q
50
91
Answers

A competitive firm
Costs, P
Profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50
92
Example
Identifying a firm’s loss

Determine  A competitive firm
this firm’s  Costs, P
total loss,  MC
assuming AVC
< $3.
ATC
Identify the 
area on the  $5
graph that 
P = $3 MR
represents 
the firm’s loss.
Q
30
93
Answers

A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30
94
 Market Supply: Assumptions
1) All existing firms and potential entrants
have identical costs.
2) Each firm’s costs do not change as other
firms enter or exit the market.
3) The number of firms in the market is
– fixed in the short run
(due to fixed costs)
– variable in the long run
(due to free entry and exit)
 The SR Market Supply Curve
As long as P ≥ AVC, each firm will produce
its profit-maximizing quantity, where MR =
MC.
Recall from Chapter 4:
At each price, the market quantity supplied
is
the sum of quantities supplied by all firms.
 The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

 Entry & Exit in the Long Run
In the LR, the number of firms can change
due to entry & exit.
If existing firms earn positive economic
profit,
– new firms enter, SR market supply shifts right.
– P falls, reducing profits and slowing entry.
If existing firms incur losses,
– some firms exit, SR market supply shifts left.
– P rises, reducing remaining firms’ losses.
 The Zero‐Profit Condition
• Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
• Zero economic profit occurs when P = ATC.
• Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
• Recall that MC intersects ATC at minimum
ATC.
• Hence, in the long run, P = minimum ATC.
Why Do Firms Stay in Business if Profit = 0?

Recall, economic profit is revenue minus

all costs – including implicit costs, like the
opportunity cost of the owner’s time and
money.
In the zero-profit equilibrium,
– firms earn enough revenue to cover
these costs
– accounting profit is positive
 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
 A monopoly is a firm that is the sole seller
of a product without close substitutes.

The key difference:

A monopoly firm has market power, the
ability to influence the market price of the
product it sells. A competitive firm has no
market power.

Oligopoly: only a few sellers offer similar or

identical products.
Monopolistic competition: many firms sell
similar but not identical products.
 Comparing Perfect & Monop. Competition
Perfect Monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-
D curve facing firm horizontal
sloping

Sample Questions