Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College © 2004 Thomson Learning/South-Western.

Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College
© 2004 Thomson Learning/South-Western

What is Microeconomics?
The study of the allocation of scarce resources among alternative uses Microeconomics The study of the economic choices individuals and firms make and how those choices create markets

Economic Models Simple theoretical descriptions that capture the essentials of how the economy works Used because the “real world” is too complicated to describe in detail Models tend to be “unrealistic” but useful While they fail to show every detail (such as houses on a map) they provide enough structure to solve the problem (such as how a map provides you with a way to solve how to drive to a new location)

The Production Possibility Frontier
A graph showing all possible combinations of goods that can be produced with a fixed amount of resources Figure 1.1 shows a production possibility frontier where the good goods are food and clothing produced per week At point A, 10 units of food and 3 units of clothing can be produced

FIGURE 1.1: Production Possibility Frontier
Amount of food per week A 10 B 4 Amount of clothing per week 3 12

The Production Possibility Frontier
At point B, 4 units of food can be produced and 12 units of clothing Without more resources, points outside the frontier are unattainable This demonstrates a basic fact that resources are scarce

Opportunity Cost The cost of a good or service as measured by the alternative uses that are foregone by producing the good or service

Opportunity Cost Example
As shown in Figure 1.1, if the economy produces one more unit of clothing beyond the 10 that it produces at point A, the amount of food produced decreases by 1/2 from 10 to 9.5 Thus, the opportunity cost of one unit of clothing is 1/2 unit of food at point A

Amount of food per week Opportunity cost of clothing = ½ pound of food A 10 9.5 Amount of clothing per week 3 4

Opportunity Cost Example
Figure 1.1 also shows that the opportunity cost of clothing is much higher at point B (1 unit of clothing costs 2 units of food) The increasing opportunity costs of producing even more clothing is consistent with Ricardo’s and Marshall’s ideas of increasing marginal cost

Amount of food per week Opportunity cost of clothing = 2 pounds of food B 4 2 Amount of clothing per week 12 13

Amount of food per week Opportunity cost of clothing = ½ pound of food A 10 9.5 Opportunity cost of clothing = 2 pounds of food B 4 2 Amount of clothing per week 3 4 12 13

APPLICATION 1.1: Do Animals Understand Economics?
Nature provides examples of where animals have scarcity affect their choices Birds of prey recognize a trade-off between spending time and energy in one area and moving to another location To avoid using too much energy, animals will leave an area before the food supply is exhausted

Uses of Microeconomics
While the uses of microeconomics are varied, one useful way to categorize is by types of users Individuals making decisions regarding jobs, purchases, and finances Businesses making decisions regarding the demand for their product or their costs Governments making policy decisions regarding laws and regulations

APPLICATION 1.2: Is It Worth Your Time to Be Here?
The typical U.S. college student pays about $18,000 per year in tuition, fees, and room and board charges. One might conclude then, that the “cost” of 4 years of college is about $72,000. A number of studies have suggested that college graduates earn more than those without such an education.

APPLICATION 1.3: Saving Blockbuster
The largest video rental company incurred a huge financial loss primarily because of the high price of first-run movies A large part of the “price” of the movie to the customer was not finding the movie in stock. Blockbuster reached an agreement to guarantee availability and reverse its losses.

APPLICATION 1.4: Microsoft and Antitrust
The central issue of this case is whether or not Microsoft is illegally “monopolizing” various segments of the software industry in violation of the Sherman Antitrust Act. MIT professor Franklin Fisher suggests that the real danger is allowing Microsoft to dominate the internet browser market which would eliminate competition.

APPLICATION 1.4: Microsoft and Antitrust
MIT professor Richard Schmalensee argues that Microsoft has not acted like a monopoly in the pricing of the Windows operating system The judge’s decision will have to try to strike a balance between the operating system monopoly and the ability of Microsoft to be innovative

The Basic Supply-Demand Model
A model describing how a good’s price is determined by the behavior of the individual’s who buy the good and the firms that sell it. Economists argue that market behavior can generally be explained by this model that captures the relationship between consumers’ preferences and firms’ costs.

Adam Smith and the Invisible Hand
Adam Smith ( ) saw prices as the force that directed resources into activities where they were most valuable Prices told both consumers and firms the “worth” of the good. Smith’s somewhat incomplete explanation for prices was that they were determined by the costs to produce the goods.

Adam Smith and the Invisible Hand
Since labor was the primary resource used, this led Smith to embrace a labor-based theory of prices. If catching deer took twice as long as catching a beaver, one deer should trade for two beaver (the relative price of a deer is two beaver’s). In Figure 1.1(a), the horizontal line at P* shows that any number of deer can be produced without affecting the relative cost

FIGURE 1.2(a): Smith’s Model
Price P* Quantity per week

David Ricardo and Diminishing Returns
David Ricardo ( ) believed that labor and other costs would rise with the level of production for example, as new less fertile land was cultivated, it would require more labor This increasing cost argument is now referred to as the law of diminishing returns

David Ricardo and Diminishing Returns
The relative price of a good could be practically any amount, depending upon how much was produced The level of production represented the quantity the country needed to survive In Figure 1.2(b), as the needs of the country increase from Q1 to Q2 prices increase from P1 to P2

FIGURE 1.2(b): Ricardo’s Model
Price P1 Q1 Quantity per week

FIGURE 1.2(b): Ricardo’s Model
Price P2 P1 Q1 Q2 Quantity per week

FIGURE 1.2: Early Views of Price Determination
Quantity per week Q1 Q2 Quantity per week (a) Smith model ’ (b) Ricardo model ’

Marginalism and Marshall’s Model of Supply and Demand
Ricardo’s model was unable to explain the fall in the relative prices of good during the nineteenth century so a more general model was needed Economists argued the willingness of people to pay for a good will decline as they have more of it

People will be willing to consume more of a good only if the price is lower The focus of the model was on the value of the last, or marginal, unit purchased Alfred Marshall ( ) showed how the forces of demand and supply simultaneously determined price

In Figure 1.3, the amount of a good purchased per period is shown on the horizontal axis and the price of the good is shown on the vertical axis The demand curve shows the amount people want to buy at each price and is negatively sloped reflecting the marginalism principle

The upward sloping supply curve reflects the idea of increasing cost of making one more unit of a good as total production increases Supply reflects increasing marginal costs and demand reflects decreasing marginal usefulness

FIGURE 1.3: The Marshall Supply-Demand Cross
Price Supply Demand Quantity per week

Market Equilibrium In Figure 1.3, the demand and supply curve intersect at the market equilibrium point P*, Q* P* is the equilibrium price: The price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good

FIGURE 1.3: The Marshall Supply-Demand Cross
Price Demand Supply . P* Equilibrium point Quantity per week Q*

Market Equilibrium Both demanders and suppliers are satisfied at this price, so there is no incentive for either to alter their behavior unless something else happens Marshall compared the roles of supply and demand in establishing market equilibrium to the two blades of a pair of scissors working together in order to make a cut

Nonequilibrium Outcomes
If something causes the price to be set above P*, demanders would wish to buy less than Q* while suppliers would produce more than Q* If something causes the price to be set below P*, demanders would wish to buy more than Q* while suppliers would produce less than Q*

Change in Market Equilibrium: Increased Demand
Figure 1.4 shows the case where people’s demand for the good increases as represented by the shift of the demand curve from D to D’ A new equilibrium is established where the equilibrium price has increased to P**

FIGURE 1.4: An increase in Demand Alters Equilibrium Price and Quantity
per week

Change in Market Equilibrium: decrease in Supply
In Figure 1.5 the supply curve has shifted leftward reflecting a decrease in supply brought about because of an increase in supplier costs (say an increase in wages) At the new equilibrium price P** consumers respond by reducing quantity demanded along the Demand curve D

FIGURE 1.5: A shift in Supply Alters Equilibrium Price and Quantity
Quantity per week

How Economists Verify Theoretical Models
Two methods are used Testing Assumptions: Verifying economic models by examining validity of the assumptions on which they are based Testing Predictions: Verifying economic models by asking if they can accurately predict real-world events

Testing Assumptions One approach would be to determine if the assumptions are reasonable The obvious problem is that people have differing opinion regarding reasonable Empirical evidence can also be used Results of such methods have had problems similar to those found in opinion polls

Testing Predictions Economists, such as Milton Friedman argue that all theories require unrealistic assumptions The theory is only useful if it can be used to predict real-world events Even if firms state they don’t maximize profits, if their behavior can be predicted by using this assumption, the theory is useful

Models of Many Markets Marshall's model of supply and demand is a partial equilibrium model: An economic model of a single market To show the effects of a change in one market on others requires a general equilibrium model: An economic model of a complete system of markets

APPLICATION 1.5: Economics According to Bono
The Spring 2002 trip to Africa by the Irish rock star Bono and U.S. Treasury Secretary Paul O’Neill sparked much interesting dialogue about economics Bono claimed that recently enacted agricultural subsidies in the U.S. were harming struggling farmers in Africa

APPLICATION 1.5: Economics According to Bono
In Figure 1 U.S. farm subsidies reduce the world price of this crop from P* to P**. Exports from this African country fall from QS – QD to Q’S – Q’D

Figure 1: U.S. Subsidies Reduce African Exports
QD Q’D Q’S QS Q

The Positive-Normative Distinction
Distinction between theories that seek to explain the world as it is and theories that postulate the way the world should be To many economists, the correct role for theory is to explain the way the world is (positive) rather than the way it should be (normative) Positive economics is the primary approach of the text

APPLICATION 1.6: Do Economists Ever Agree?
Many jokes and popular opinion suggest that economists do not agree on many issues This belief arises primarily because people fail to distinguish between positive and normative issues As Table 1 shows, there is much agreement regarding positive issues but much less agreement with normative issues

TABLE 1: Percentage of Economists Agreeing with Various Propositions in Three Nations

Theory of Choice The interaction of preferences and constraints that causes people to make the choices they do

Utility The pleasure, satisfaction, or need fulfillment that people get from their economic activity. To identify all of the factors that affect utility would be virtually impossible Much economic analysis is based on the ceteris paribus assumption.

Ceteris Paribus Assumption
In economic analysis, holding all other factors constant so that only the factor being studied is allowed to change Other factors are held constant so that we may choice is a simple setting that isolates the economic factors that affect behavior

Utility from Consuming Two Goods
In this chapter we assume that a person receives utility from the consumption of two goods “X” and “Y” which we can show in functional notation by The other things that appear after the semicolon are assumed to be held constant.

Measuring Utility Two problems make it difficult to measure utility directly. Because the real-world is constantly in flux, the ceteris paribus assumption is difficult to impose. There is no unit of utility measurement. However, it is possible to do a fairly complete job of studying choices without having to measure utility.

Assumptions about Utility
Basic Properties of Preferences Preferences are complete : The assumption that an individual is able to state which of any two options is preferred. Preferences are transitive: The property that if A is preferred to B, and B is preferred to C, then A must be preferred to C.

Application 2.1: Can Money Buy Health and Happiness?
The relationship between health and income has been intensely studied Virtually all of these studies conclude that people who have higher incomes have better health People with higher incomes tend to report that they are happier than are those with lower incomes.

More Is Better: Defining an Economic “Good”
An economic good is one that yields positive benefits to people. Thus, more of a good is, by definition, better. This is shown in Figure 2.1 where all points in the darkly shaded area are preferred to the amounts of X* of good X and Y* of good Y. Movement into the shaded area is unambiguously better since the person gets more of one good without the loss of another.

FIGURE 2.1: More of a Good Is Preferred to Less
Quantity of Y per week ? Y* ? Quantity of X per week X*

Voluntary Trades and Indifference Curves
The areas marked with question marks in Figure 2.1 are difficult to compare to X*, Y* since they involve more of one good but less of another. Trading one good (such as money) for another good (such as a candy bar) is the essence of demand.

Indifference Curves A curve that shows all the combinations of goods or services that provide the same level of utility. In Figure 2.2, the horizontal axis measures the quantity of soft drinks consumed by the individual per week while the vertical axis measures the quantity of hamburgers consumed per week.

Indifference Curves The curve U1 in Figure 2.2 includes all combinations of hamburgers and soft drinks that yield the same level of utility. Point A, with 6 hamburgers and 2 soft drinks, has the same utility as point B, 4 burgers and 3 drinks. Since all points on the curve yield the same utility, the person has no reason to prefer one point over another.

FIGURE 2.2: Indifference Curve
Hamburgers per week A 6 B 4 3 C D 2 U1 Soft drinks per week 2 3 4 5 6

Points Above an Indifference Curve
In Figure 2.2, points such as E are above (to the northeast) of U1. Since E has more of both goods than point C, E is preferred to C (more is better). Because of transitivity, E is preferred to any point on U1. Points above an indifference curve are preferred to points on the curve.

Hamburgers per week A 6 B 4 E 3 C D 2 U1 Soft drinks per week 2 3 4 5 6

Points Below an Indifference Curve
In Figure 2.2, points such as F are below (to the southeast) of an indifference curve. Point C is preferred to point F since it contains more of both goods. Because of transitivity, all points on U1 are preferred to point F. Points on an indifference curve are preferred to points below it.

Hamburgers per week A 6 B 4 E 3 C D F 2 U1 Soft drinks per week 2 3 4 5 6

Movements Along an Indifference Curve
The negative slope of an indifference curve shows that, if a person must give up some hamburgers, the only way he/she can be as happy as before is if they get more soft drinks. In Figure 2.2, in giving up one hamburger to go from point B to point C means that the person receives one soft drink to compensate him or her.

The Slope of an Indifference Curve
In Figure 2.2, going from point A to point B, the person willingly gives up two hamburgers to gain one soft drink since they are equally happy at either point. The slope of U1 is approximately -2 between points A and B since hamburgers decline by two units to gain one unit of soft drinks.

Indifference Curves and the Marginal Rate of Substitution
Marginal Rate of Substitution (MRS): The rate at which an individual is willing to reduce consumption of one good when he or she gets one more unit of another good. Also, the negative of the slope of an indifference curve. The MRS between points A and B on U1 in Figure 2.2 is (approximately) 2.

Diminishing Marginal Rate of Substitution
On indifference curve U1 in Figure 2.3 the person is willing to only give up one hamburger to gain one more soft drink between points B and C. Between points C and D, the consumer is only willing to give up ½ a hamburger to gain one more soft drink.

FIGURE 2.3: Balance in Consumption Is Desirable
Hamburgers per week A 6 B G 4 3 C D 2 U1 Soft drinks per week 2 3 4 6

Diminishing Marginal Rate of Substitution
The MRS diminishes along an indifference curve moving from left to right. This reflects the idea that consumers prefer a balance in consumption. Point G in Figure 2.3 reflects a bundle that is “between” points A and D. Since it is above U1 point G is preferred to any bundle on the indifference curve.

Indifference Curve Maps
Since every combination of hamburgers and soft drinks must yield some level of utility, every point must have one (and only one) indifference curve passing through it. An indifference curve map shows the utility an individual obtains from all possible consumption options. Figure 2.4 shows three of the infinite number of indifference curves in the map.

Labeling Indifference Curves
Since utility can not be measured, the labeling of indifference curves has no meaning except to indicate that utility increases from U1 to U2 and then to U3 in Figure 2.4. In any indifference curve map, all we can assume is that utility increases as we move to higher indifference curves.

FIGURE 2.4: Indifference Curve Map for Hamburgers and Soft Drinks
per week A 6 H 5 B G 4 U3 3 C U2 D 2 U1 Soft drinks per week 2 3 4 5 6

Application 2.2:Product Positioning in Marketing
One practical application of utility theory is marketing is the positioning of products in comparison with competitors. Assume consumers have preferences for taste and crunchiness in breakfast cereal as represented by U1 in Figure 1.

Application 2.2:Product Positioning in Marketing
If points X and Y represent competitors, positioning, a cereal at point Z would increase utility to consumers. If competitors have similar costs, this should offer good market prospects for the new cereal.

FIGURE 1: Product Positioning
Taste X Z U1 Y Crunchiness

Illustrating Particular Preferences
In Figure 2.5(a) the good on the vertical axis (smoke grinders) is useless so that the consumers only gains utility from more of the good on the horizontal axis (food). In Figure 2.5(b) the good on the vertical axis is an economic bad (houseflies) so the consumer only gets more utility from consuming less of the bad.

FIGURE 2.5: Illustrations of Specific Preferences
Smoke Houseflies grinders per week per week U 1 U 2 U 3 U 1 U 2 U 3 10 Food per week 10 Food per week (a) A useless good (b) An economic bad Gallons Right shoes of Exxon per week per week 4 U 4 3 U 3 2 U 2 1 U 1 U 1 U 2 U 3 Gallons of Mobil 1 2 3 4 Left shoes per week per week (c) Perfect substitute (d) Perfect complements

Particular Preferences
In Figure 2.5(c) the two goods are perfect substitutes in that the consumer views them as essentially the same. In this example the MRS = 1. In Figure 2.5(d) the two goods are perfect complements in that they must be used together (like left and right shoes) to gain utility.

Utility Maximization: An Initial Survey
Economists assume that when a person is faced with a choice among several possible options, he or she will choose the one that yields the highest utility- utility maximization. Economists assume that people know their own minds and make choices consistent with their preferences.

Choices are Constrained
People are constrained in their choices by the size of their incomes. Of the choices the individual can afford, the person will choose the one that yields the most utility.

A Simple Case When choosing to allocate income between two goods (e.g. hamburgers and soft drinks) the consumer will: spend his or her entire income on the two goods, and choose a combination of goods for which the marginal rate of substitution between the two goods is equal to the ratio of their prices.

A Simple Case Since both goods (and only these goods) provide more utility with increased consumption the consumer will spend his or her entire income on the goods. The only other alternative is to throw the income away which does not increase utility.

Equality of MRS with the Ratio or Prices
Suppose the individual is currently consuming where MRS = 1. Assume the price of hamburgers is $1 and the price of soft drinks is $.50. This yields a price ratio (PH/PS) of ($.50/$1) = ½.

Equality of MRS with the Ratio or Prices
The person could give up one hamburger (freeing $1) and purchase one soft drink using $.50. Since his or her MRS =1, the person would be just as happy as before but would now have an additional $.50 to spend which would enable him or her to increase utility. The only way utility can not be increased further is when MRS = price ratio.

Graphic Analysis of Utility Maximization
An individual’s budget constraint is the limit that income places on the combinations of goods and services that a person can buy. In Figure 2.6 the individual has a fixed amount of income that can be spend on two goods, X and Y.

Budget Constraint from Figure 2.6
If all income is spent on X, Xmax can be purchased. If all income is spent on Y, Ymax can be purchased. The line joining Xmax and Ymax represents the various mixed bundles of good X and Y that can be purchased using all income.

FIGURE 2.6: Individual’s Budget Constraint for Two Goods
Quantity of Y per week Xmax Quantity of X per week

Quantity of Y per week Ymax Xmax Quantity of X per week

Quantity of Y per week Ymax Income Not affordable Affordable Xmax Quantity of X per week

Budget Constraint The downward slope of the budget line reflects the fact that more X can be purchased only if less Y is purchased. If Y is expensive relative to X the line will be relatively flat. If Y is relatively inexpensive compared to X the line will be relatively steep.

Budget Constraint Algebra
Assume an individual has I dollars of income to spend on goods X and Y. Suppose the price of X is Px and the price of Y is PY. The total amount spent on X and Y are Px·X and PY·Y respectively.

Since all income must be spent on either X or Y we have Amount spent on X + Amount spent on Y = I or

Solving equation 2.3 for Y, so that it is expressed in the standard form for a linear equation, we have

Equation 2.4 shows that if all income is spent on Y, I/PY will be purchased, and if all income is spent on X, I/PX will be purchased. The slope of the budget line (-PX/PY) represents the opportunity cost of X in terms of foregone Y.

Utility Maximization An individual can afford all bundles of X and Y that fall within the budget constraint represented by the shaded area in Figure 2.6. Point A is affordable but not all of the consumer’s income would be spent. Point B is affordable but is not on the highest indifference curve that can be reached by the consumer.

FIGURE 2.7: Graphic Demonstration of Utility Maximization
Hamburgers per week B Income A U1 Soft drinks per week

Utility Maximization Point D is on a higher indifference curve than C, but is not affordable given the budget constraint. Point C, where the consumer chooses X*, Y* is the point that is affordable that lies on the highest indifference curve, so it represents utility maximization.

Hamburgers per week B D Income U3 A U1 Soft drinks per week

Hamburgers per week B D Income U3 Y* C U2 A U1 X* Soft drinks per week

Utility Maximization At point C all income is spent.
At point C indifference curve U2 is tangent to the budget line so that the or

APPLICATION 2.3: Ticket Scalping
When rationed by some means other than prices often a secondary market such as ticket “scalping” occurs. Since Super Bowl tickets are rationed at one per consumer, the individual maximizes utility at point B in Figure 1, but would be happier if he or she could be at point A purchasing 4 tickets.

APPLICATION 2.3: Ticket Scalping
The person would be willing to pay a great deal (measured by the vertical distance between points C and D in Figure 1) to a ticket scalper for a second ticket. Most economists view ticket scalping as voluntary activity that improves the welfare of both parties, even though many laws have been passed to stop these types of sales.

FIGURE 1: Rationing of Tickets Leads to Scalping
Other goods B C Income D A U2 U1 1 2 3 4 5 Super Bowl tickets

Numerical Example of Utility Maximization
Assume the individual can choose between hamburgers (Y) and soft drinks (X) whose prices are PY = $1.00 and PX=$.50. The individual has $10.00 to spend (I). The individual gets measurable utility from X and Y as follows

Using The Model of Choice
Table 2.1 lists several possible ways that this person can spend the $10.00 on hamburgers and soft drinks and the level of utility associated with each choice. The choice of 5 hamburgers and 10 soft drinks yields the most utility as is also demonstrated graphically in Figure 2.8.

Using the Model of Choice
The utility maximization model can be used to explain many common observations. Figure 2.8 shows people with the same income still consume different bundles of goods.

FIGURE 2.8: Differences in Preferences Result in Differing Choices
Hamburgers per week Hamburgers per week Hamburgers per week U2 U1 U2 U0 U1 U0 U2 U1 Income 8 Income Income U0 2 Soft drinks per week Soft drinks per week Soft drinks per week 4 20 16 (a) Hungry Joe (b) Thirsty Teresa (c) Extra-thirsty Ed

Using the Model of Choice
Figure 2.9 shows the four indifference curve maps with a budget constraint and the utility maximizing choice labeled E. Panel (a) shows that people will not buy useless goods and (b) shows they will not buy bads. Panel (c) shows that people will buy the least expensive of the two perfect substitutes while (d) shows that perfect complements will be purchased together.

FIGURE 2.9: Utility-Maximizing Choices for Special Types of Goods
Smoke Houseflies grinders per week per week U 1 U 2 U 3 U 1 Income U 2 Income U 3 E E 10 Food per week 10 Food per week (a) A useless good (b) An economic bad Gallons Right shoes of Exxon per week per week E Income U 3 E 2 U 2 U 1 U 1 U Income 2 U 3 Gallons of Mobil 2 Left shoes per week per week (c) Perfect substitute (d) Perfect complements

APPLICATION 2.4: The Sad Tale of Willie and His Uncle
Figure 1 shows Willie’s choice between “sin” (i.e. smoking, drinking, and gambling) on the X-axis and his spending on everything else on the Y-axis. Willie would prefer to consume at point A—which involves some sin along with other things Willie’s uncle is offering him point B

FIGURE 1:Willie’s Utility and His Uncle’s Promises
Other Goods Budget constraint B C A U3 U2 U1 Sin

APPLICATION 2.5: Quantity Discounts and Frequent-Flier Programs
When consumers receive quantity discounts or have to pay excessive use fees, the budget line is no longer straight. In Figure 1, the consumer pays regular price for good X up to XD but receive a quantity discount beyond that as shown by the flatter budget line after consuming XD.

APPLICATION 2.5: Quantity Discounts and Frequent-Flier Programs
Since the consumer is indifferent between points A and B, a slightly larger discount would cause the consumer to reach a higher indifference curve by using the discount. All major airlines use frequent-flier programs that provide such quantity discounts and enable the airlines to gain revenues on seats that otherwise would remain empty.

FIGURE 1: Kinked Budget Constraint Resulting from a Quantity Discount
Quantity of Y per period A B U1 X0 Quantity of X per period

Composite Goods A Composite Good is obtained by combining expenditures on several different goods whose relative prices do not change into a single good for convenience in analysis. This is a common graphing procedure that is used when many goods are involved but you want to study one good.

Individual Demand Curves
Chapter 3 Individual Demand Curves © 2004 Thomson Learning/South-Western

Individual Demand Curves
This chapter studies how people change their choices when conditions such as income or changes in the prices of goods affect the amount that people choose to consume. This chapter then compares the new choices with those that were made before conditions changed The main result of this approach is to construct an individual’s demand curve

Demand Functions If we knew a person’s preferences and all the economic forces that affect his or her choices, we could predict how much of each good would be chosen. This summarizes this information in a demand function: a representation of how quantity demanded depends on prices, income, and preferences.

Demand Function The three elements that determine the quantity demanded are the prices of X and Y, the person’s income (I), and the person’s preferences for X and Y. Preferences appear to the right of the semicolon because we assume that preferences do not change during the analysis.

Homogeneous Demand Function
Individual demand functions are homogeneous since quantity demanded does not change when prices and income increase in the same proportion. The budget constraint PXX + PYY = I is identical to the budget constraint 2PXX + 2PYY = 2I. Graphically the lines are the same.

Changes in Income When a person’s income increase, while prices remain the same, the quantity purchased of each good might increase. This situation is shown in Figure 3.1 where the increase in income is shown as the budget line shifts out from I1 to I2 to I3. The slope of the budget lines are the same since the prices have not changed .

FIGURE 3.1: Effect of Increasing Income on Quantities of X and Y Chosen
Quantity of Y per week Y1 U1 I1 Quantity of X per week X1

Quantity of Y per week Y2 U2 Y1 U1 I1 I2 Quantity of X per week X1 X2

Quantity of Y per week Y3 Y2 U3 U2 Y1 U1 I1 I2 I3 Quantity of X per week X1 X2 X3

Changes in Income In response to the increase in income the quantity of X purchased increases from X1 to X2 and X3 while the quantity purchased of Y also increases from Y1 to Y2 to Y3. Increases in income make it possible for a person to consume more reflected in the outward shift in the budget constraint that allows an increase in overall utility.

Normal Goods A normal good is one that is bought in greater quantities as income increases. If the quantity increases more rapidly than income the good is called a luxury good as with good Y in Figure 3.1. If the quantity increases less rapidly than income the good is called a necessity good as with good X in Figure 3.1.

APPLICATION 3.1: Engel’s Law
One important generalization about consumer behavior is that the fraction of income spent on food tends to decline as income increases. This finding was discovered by Prussian economists Ernst Engel ( ). Table 1 show Engel’s data with Table 2 showing recent data for U.S. consumers.

TABLE 1: Percentage of Total Expenditures of Various Items in Belgian Families in 1853

TABLE 2: Percentage of Total Expenditures by U. S
TABLE 2: Percentage of Total Expenditures by U.S. Consumers on Various Items, 2000

Inferior Goods An inferior good is one that is bought in smaller quantities as income increases. In Figure 3.2 as income increases from I1 to I2 to I3, the consumption of inferior good Z decreases. Goods such as “rotgut” whiskey, potatoes, and secondhand clothing are examples of inferior goods.

FIGURE 3.2: Indifference Curve Map Showing Inferiority
Quantity of Y per week Y1 U1 Z1 I1 Quantity of Z per week

Quantity of Y per week Y2 U2 Y1 U1 I2 I1 Z2 Z1 Quantity of Z per week

Quantity of Y per week Y3 U3 Y2 U2 Y1 U1 I1 I2 I3 Z2 Z1 Z3 Quantity of Z per week

Changes in a Good’s Price
A change in the price of one good causes both the slope and an intercept of the budget line to change. The change also involves moving to a new utility-maximizing choice on another indifference curve with a different MRS. The quantity demanded of the good whose price has changed changes.

Substitution Effect The part of the change in quantity demanded that is caused by substitution of one good for another is called the substitution effect. This results in a movement along an indifference curve. Consumption has to be changed to equate MRS to the new price ratio of the two goods.

Income Effect The part of the change in quantity demanded that is caused by a change in real income is called the income effect. The price change also changes “real” purchasing power and consumers will move to a new indifference curve that is consistent with this new purchasing power.

Substitution and Income Effects from a Fall in Price
As shown in Figure 3.3, when the price of good X falls, the budget line rotates out from the unchanged Y axis so that the X intercept lies father out because the consumer can now buy more X with the lower price. The flatter slope means that the relative price of X to Y (PX/PY) has fallen.

Substitution Effect from a Fall in Price
The consumer was originally maximizing utility at X*, Y* in Figure 3.3. After the fall in the price of good X, the new utility maximizing choice is X**, Y**. The substitution effect is the movement on the original indifference curve to point B.

FIGURE 3.3: Income and Substitution Effects of a Fall in Price
Quantity of Y per week Y* U1 X* Quantity of X per week

Quantity of Y per week Old budget constraint Y* B New budget constraint U1 X* XB Quantity of X per week Substitution effect

Quantity of Y per week Old budget constraint Y** Y* U2 B New budget constraint U1 X* XB X** Quantity of X per week Substitution effect Income effect Total increase in X

Substitution Effect from a Fall in Price
If the individual had to stay on the U1 with the new price ratio, the consumer would choose B since that is the point where the MRS is equal to the slope of the new budget line (shown by the dashed line). Staying on the same indifference curve is the same as holding “real” income constant. The consumer buys more good X.

Income Effect The movement from point B to X**, Y** results from the increase in purchasing power. Because PX falls but nominal income (I) remains the same, the individual’s “real” income increases so that he or she can be on utility level U3. The consumer buys more good X.

The Effects Combined Using the hamburger-soft drink example from Chapter 2, suppose the price of soft drinks falls from $.50 to $.25. Previously the consumer could purchase up to 20 soft drinks, but now he or she can purchase up to 40. This price decrease shifts the budget line outward and increases utility.

The Effects Combined If the consumer bought his or her previous choice it would now cost $7.50 so that $2.50 would be unspent. If the individual stayed on the old indifference curve he or she would equate MRS to the new price ratio (consuming 1 hamburger and 4 soft drinks). This move is the substitution effect.

The Effects Combined Even with constant real income the consumer will buy more soft drinks since the opportunity cost of eating a burger in terms of the soft drinks forgone is now higher. Since real income has increased the person will choose to buy more soft drinks so long as soft drinks are a normal good.

Substitution and Income Effects from an Increase in Price
An increase in PX will shift the budget line in as shown in Figure 3.4. The substitution effect, holding “real” income constant, is the move on U2 from X*, Y* to point B. Because the higher price causes purchasing power to decrease, the movement from B to X**, Y** is the income effect.

FIGURE 3.4: Income and Substitution Effects of an Increase in Price
Quantity of Y per week U2 New budget constraint Y* Old budget constraint X* Quantity of X per week

Quantity of Y per week U2 U1 B New budget constraint Y* Old budget constraint XB X* Quantity of X per week Substitution effect

Quantity of Y per week U2 U1 B Y** New budget constraint Y* Old budget constraint Quantity of X per week X** XB X* Income effect Substitution effect Total reduction in X

Substitution and Income Effects from an Increase in Price
In Figure 3.4, both the substitution and income effects cause the individual to purchase less soft drinks do to the higher price of soft drinks.

Substitution and Income Effects for a Normal Good: Summary
As shown in Figures 3.3 and 3.4, the substitution and income effects work in the same direction with a normal good. When the price falls, both the substitution and income effects result in more purchased. When the price increases, both the substitution and income effects result in less purchased.

This provides the rational for drawing downward sloping demand curves. This also helps to determine the steepness of the demand curve. If either the substitution or income effects are large, the change in quantity demanded will be large with a given price change.

If the substitution and income effects are small, the effect of a given price change in the quantity demanded will also be small. This kind of analysis also offers a number of insights about some commonly used economic statistics.

APPLICATION 3.2: The Consumer Price Index and Its Biases
The Bureau of Labor Statistics monthly calculates the Consumer Price Index (CPI) which is a principal measure of inflation in the U.S.. To construct the CPI, a typical market basket of commodities purchased by consumers in the base year (currently 1982) is calculated.

APPLICATION 3.2: The Consumer Price Index and Its Biases
The ratio of the current cost of the basket to the base year price is the measure of the value of the CPI. The rate of change in the CPI between two periods is the reported rate of inflation.

An Algebraic Example Suppose the 1982 typical market basket contained X82 of good X and Y82 of good Y. The prices of these goods are and The cost of this bundle in the 1982 base year would be written as

An Algebraic Example To compute the cost of the same bundle of goods in, say 2002, requires that we compute the cost of the bundle using current prices

An Algebraic Example The CPI is defined as the ratio of the costs of these two market baskets If the basket cost $100 in 1982 prices and $180 in 2002, the value of the CPI would be 1.80 and with a measured 80 percent increase in prices over the 20 year period.

Substitution Bias in the CPI
The CPI does not take into account the real possibility that consumers would substitute among commodities because of changes in relative prices. In Figure 1, the typical individual is initially consuming X82, Y82 maximizing utility on U1 with 1982 constraint I.

FIGURE 1: Substitution Bias of the Consumer Price Index
Quantity of Y per year Y82 U1 I I’ I” X82 Quantity of X per year

Suppose the 2002 relative prices change so that PX/PY falls. The cost of the 1982 bundle in terms of 2002 prices is reflected in the constraint I’ which is flatter and goes though the 1982 bundle. The consumer would substitute X for Y and stay on U1 on budget line I’’.

Since I’’ is inside I’ (which is used to compute the CPI), the CPI tends to overstate the inflation rate. Unfortunately, adjusting the CPI to take such substitution into account is difficult because it would require that we know the utility function of the typical consumer.

New Product Bias in the CPI
New products typically experience sharp declines in prices and rapidly grow in rates of acceptance. If the CPI does not include these new products, this source of welfare increase is omitted. The CPI basket is revised but not rapidly enough to eliminate this bias.

Outlet Bias in the CPI The typical basket is bought at the same retail outlets every month. This method can omit the benefits of sales or other bargains. The CPI does not currently take such price-reducing strategies and thus tends to overstate inflation.

Consequences of the CPI Biases
Measuring and correcting for these biases is not an easy task. The CPI is such a widely used measure of inflation that any change becomes a hot political issue. However, there is a general agreement that the CPI overstates inflation by as much as 0.75 to 1.0 percent per year.

Consequences of the CPI Biases
Politicians have proposed caps on Cost of Living Adjustments (COLAs) tied to the CPI on government programs, but none have yet been enacted. However, the private sector has adjusted so that few private COLAs provide full offsets to inflation measured by the CPI.

Substitution and Income Effects for Inferior Goods
With an inferior good, the substitution effect and the income effects work in opposite directions. The substitution effect results in decreased consumption for a price increase and increased consumption for a price decrease.

The income effect results in increased consumption for a price increase and decreased consumption for a price decrease. Figure 3.5 shows the two effects for an increase in PX. The substitution effect, holding real income constant, is shown by the move from X*, Y* to point B both on U2.

FIGURE 3.5: Income and Substitution Effects for an Inferior Good
Quantity of Y per week Y* U2 Old budget constraint Quantity of X per week X*

Quantity of Y per week B New budget constraint Y* U2 Y** Old budget constraint U1 Quantity of X per week X*

Quantity of Y per week B New budget constraint Y* U2 Y** Old budget constraint U1 Quantity of X per week X** X*

The income effect reflects the reduced purchasing power due to the price increase. Since X is an inferior good, the decrease in income results in an increase in the consumption of X shown by the move from point B on U1 to the new utility maximizing point X**, Y** on U1.

Since X** is less than X* the price increase in X results in a decrease in the consumption of X. This occurs because the substitution effect, in this example, is bigger than the income effect. Thus, if the substitution effect dominates, the demand curve is negatively sloped.

Giffen’s Paradox If the income effect of a price change is strong enough with an inferior good, it is possible for the quantity demanded to change in the same direction as the price change. Legend has it that this phenomenon was observed by English economist Robert Giffen.

Giffen’s Paradox When the price of potatoes rose in Ireland the consumption of potatoes also increased. Potatoes were not only an inferior good but constituted the source of a large portion of Irish people’s income. The situation I which an increase in a good’s price leads people to consume more of the good is called Giffen’s paradox.

The Lump Sum Principle The “lump-sum principle” hold that taxes that are imposed on general purchasing power will have a smaller welfare costs than will taxes imposed on a narrow selection of commodities. Consider Figure 3.6 where the individual initially has I dollars to spend and chooses to consume X* and Y* yielding U3 utility.

FIGURE 3.6: The Lump-Sum Principle
Quantity of Y I Y* U3 Quantity of X per week X*

The Lump Sum Principle A tax on only good X raises its price resulting in budget constraint I’ and consumption reduced to X1, Y1 and utility level U1. A general income tax that generates the same total tax revenue is represented by budget constraint I’’ that goes though X1, Y1.

Quantity of Y I Y1 Y* I’ Y2 U3 U1 Quantity of X per week X1 X*

Quantity of Y I Y1 Y* I’ I” Y2 U3 U2 U1 Quantity of X per week X1 X2 X*

The Lump Sum Principle The utility maximizing choice on I’’ is X2, Y2 yielding utility level U2. The lump-sum general income tax generates the same amount of tax revenue but leaves the consumer on a higher utility level (U2) than the utility level associated with the tax only on good X (U1).

The Lump Sum Principle The intuitive explanation of the lump-sum principle is that a single-commodity tax affects people in two ways: it reduces their purchasing power, it directs consumption away from the good being taxed. The lump-sum tax only has the first of these two effects.

Generalizations of the Lump-Sum Principle
The utility lass associated with the need to collect a certain amount of tax revenue will be minimized by taxing goods for which the substitution effect is small. Even though the tax will reduce purchasing power, it will minimize the impact of directing consumption away from the good being taxed.

APPLICATION 3.3: Wouldn’t Cash Be a Better Way to Help Poor People?
The lump-sum principle suggests that the trends in expanding in-kind programs may be unfortunate These programs do not generate as much welfare for people as would the spending of the same funds in a cash program

APPLICATION 3.3: Wouldn’t Cash Be a Better Way to Help Poor People?
In Figure 1 a subsidy on good X (constraint I’) raises utility to U2 For the same funds, an income grant (I’’) raises utility to U3

FIGURE 1: The Superiority of an Income Grant
Y per period I’’ U3 B I’ U2 I U1 X per period

Changes in the Price of Another Good
When the price of one good changes, it usually has an affect on the demand for the other good. In Figure 3.3, the increase in the price of X (a normal good) caused both an income and substitution effect that caused a reduction in the quantity demanded of X.

In addition, the substitution effect caused a decrease in the demand for good Y as the consumer substituted good X for good Y. However, the increase in purchasing power brought about by the price decrease causes an increase in the demand for good Y (also a normal good).

Since, in this case, the income effect had a dominant effect on good Y, the consumption of Y increased due to a decrease in the price of good X. With flatter indifference curves as shown in Figure 3.7, the situation is reversed. A decrease in the price of good X causes a decrease in good Y, as before.

FIGURE 3.7: Effect on the Demand for Good Y of a Decrease in the Price of Good X
Quantity of Y per week Old budget constraint Y* U1 Quantity of X per week X*

Quantity of Y per week Old budget constraint A Y* B New budget constraint U2 U1 Quantity of X per week X*

Quantity of Y per week Old budget constraint A Y* C Y** B New budget constraint U2 U1 Quantity of X per week X* X**

However, in this case, the income effect is much smaller than the substitution effect so that the consumer ends up consuming less of good Y at Y** after the decrease in the price of X. Thus, the effect of a change in the price of one good has an ambiguous effect on the demand for the other good.

Complements Complements are goods that go together in the sense that people will increase their use of both goods simultaneously. Two goods are complements if an increase in the price of one causes a decrease in the demanded of the other or a decrease in the price of one good causes an increase in the demand for the other.

Substitutes Substitutes are goods that are goods that are used for essentially the same purpose. Two goods such that if the price of one increases, the demand for the other rises are substitutes. If the price of one good decreases and the demand for the other good decreases, they are also substitutes.

APPLICATION 3.4: Why Are So Many “Trucks” on the Road?
There has been a huge gain in truck registrations over the past 10 years The Department of Transportation regards a wide variety of automobile-like vehicles as “trucks” (like vans, minivans, and SUVs) One of the most important reasons in the trend toward SUVs has been a sharp decline in real gasoline prices There has been a substitution away from more traditional automobiles.

Construction of Individual Demand Curves
An individual demand curve is a graphic representation between the price of a good and the quantity of it demanded by a person holding all other factors (preferences, the prices of other goods, and income) constant. Demand curves limit the study to the relationship between the quantity demanded and changes in the own price of the good.

In Panel a of Figure 3.8 an individual’s indifference curve map is drawn using three different budget constraints in which the price of X decreases. The decreasing prices are P’X, P”X, and P’’’X respectively. The individual’s utility maximizing choices of X are X’, X’, and X’’’ respectively.

FIGURE 3.8: Construction of an Individual’s Demand Curve
Quantity of Y per week Budget constraint for P 9 X U 1 X’ Quantity of X per week (a) Individual ’ s indifference curve map Price P’X X’ Quantity of X per week (b) Demand curve

Quantity of Y Budget constraint for P’X per week Budget constraint for P’’X U 2 U 1 X’ X” X’” Quantity of X per week (a) Individual ’ s indifference curve map Price P’X P’’X X’ X” Quantity of X per week (b) Demand curve

Quantity of Y Budget constraint for P’X per week Budget constraint for P’’X Budget constraint for P’’’X U 3 U 2 U 1 X’ X” X’” Quantity of X per week (a) Individual ’ s indifference curve map Price P 9 X P X P - X X’ X” X’” Quantity of X per week (b) Demand curve

Quantity of Y Budget constraint for P’X per week Budget constraint for P’’X Budget constraint for P’’’X U 3 U 2 U 1 X’ X” X’” Quantity of X per week (a) Individual ’ s indifference curve map Price P 9 X P X P - X d X X’ X” X’” Quantity of X per week (b) Demand curve

These three choices show that the quantity demanded of X increases as the price of X falls. Panel b shows how the three price and quantity choices can be used to construct the demand curve.

The price of X is shown on the vertical axis and the quantity of X is shown on the horizontal axis. The demand curve (dX) is downward sloping showing that when the price of X falls, the quantity demanded of X increases. As previously shown, this result follows from the substitution and income effects.

Shape of the Demand Curve
If a good, say X, has close substitutes, a increase in its price will cause a large decrease in the quantity demanded as the substitution effect will be large. The demand curve for a type of breakfast cereal will likely be relatively flat due to the strong substitution effect.

If the good has few substitutes, the substitution effect of a price increase or decrease will be small and the demand curve will be relatively steep. Water is an example of a good with few substitutes.

Food has no substitutes so it might be thought that no change in consumption would occur with a price increase. But food constitutes a large part of an individual’s budget so that price changes will cause relatively larger effects on the quantity demanded that might be thought due to the income effect.

Shifts in an Individual’s Demand Curve
When one of the variables that are held constant (price of another good, income or preferences) on a demand curve changes, the entire curve shifts. Figure 3.9 shows the kinds of shifts that might take place. If X is a normal good and income increases, demand increases as shown in Panel a.

FIGURE 3.9: Shifts in Individual’s Demand Curve
PX PX PX P1 P1 P1 X1 X2 X X1 X2 X X2 X1 X (a) (b) (c)

If X and Y are substitutes and the price of Y increases, the demand for X increases as shown in Panel b. Alternatively, if X and Y are complements, the increase in the price of Y will cause a decrease in the demand for X as shown in Panel c.

Changes in preferences can also shift demand curves. Panel b could represent an increased preference for cold drinks when a sudden hot spell occurs. Increased environmental consciousness during the 1980’s and 1990s increased the demand for recycling and organic food.

APPLICATION 3.5: Fads, Seasons, and Health Scares
Fads (sometimes termed bandwagon effects) are when preferences cause extremely large increases in demand followed later by large decreases in demand. While fads are hard to predict, seasonal items are easy to predict. Increased demand for turkeys in November and Christmas trees are examples.

APPLICATION 3.5: Fads, Seasons, and Health Scares
Health scares can cause large decreases in the demand for products. Examples include the long term decline in smoking and the decreased demand for Chinese food because of the concern for its fat content. Recent “scientific” studies have also affected demand such as the increase in the demand for tomatoes in 1998.

Be Careful in Using Terminology
A movement downward along a stationary demand curve in response to a fall in price is called an increase in quantity demanded while a rise in the price of the good results in a decrease in quantity demanded. A rightward shift in a demand curve is called an increase in demand while a leftward shift is a decrease in demand.

Consumer Surplus The extra value individuals receive from consuming a good over what they pay for it is called consumer surplus. Consumer surplus is also what people would be willing to pay for the right to consume a good at its current price. This concept is used to study the welfare effects of price changes.

Consumer Surplus The demand curve for T-shirts is shown in Figure 3.10. At the price of $11 the individual chooses to consume ten T-shirts. In other words, the individual is willing to pay $11 for the tenth T-shirt that they buy. With a price of $9, the individual chooses fifteen T-shirts, so implicitly they value the fifteenth shirt at only $9.

Consumer Surplus Because a good is usually sold at a single market price, people choose to buy additional units of the good up to the point at which their marginal valuation is equal to the price. In Figure 3.10, if T-shirts sell for $7, the individual will buy twenty shirts because the twentieth T-shirt is worth precisely $7. They will not buy the twenty-first T-shirt because it is worth less than $7.

Consumer Surplus Because the individual would be willing to pay more than $7 for the tenth or fifteenth T-shirt, it is clear that they get a “surplus” on those shirts because the individual is actually paying less than the maximal amount that they would be willing to pay. Consumer surplus is the difference between the maximal amounts a person would pay for a good and what he or she actually pays.

Consumer Surplus In graphical terms, consumer surplus is given by the area below the demand curve and above the market price. In Figure 3.10, total consumer surplus is given by area AEB ($80).

FIGURE 3.10: Consumer Surplus from T-Shirt Demand Price ($/shirt)
15 11 9 E B d Quantity (shirts) 10 15 20

Consumer Surplus and Utility
Figure 3.11 illustrates the connection between consumer surplus and utility Initially, the person is at E with utility U1. He or she would need to be compensated by amount AB in other goods to get U1 if T-shirts were not available.

Consumer Surplus and Utility
In Figure 3.11, the individual would be willing to pay BC for the right to consume T-shirts rather than spending I only on other goods. Both distance AB and BC approximate the consumer surplus area in Figure 3.10.

FIGURE 3.11: Consumer Surplus and Utility
Price ($/shirt) A B C E U1 I U0 I’ Quantity (shirts) 20

APPLICATION 3.6: Valuing Clean Air
By looking at the ceteris paribus relationship between air pollution levels in various locations and the prices of houses in these locations, it is possible to infer the amount that people will pay to avoid dirty air. This information allows the computation of a compensated demand curve for clean air.

In Figure 1, the vertical axis shows the price home buyers are willing to pay to avoid air pollution and the horizontal axis shows the quantity of clean air purchased. The national average is reflected at point E as home buyers pay $50 and consume an average of 55 micrograms of suspended particulates per cubic meter.

FIGURE 1: Compensated Demand Curve for Clean Air
Price ($) 85 80 60 E 50 40 20 D Air quality (mg/m3) 100 75 50 25 55

Consumers are paying $2,250 ($50 times 45 micrograms) extra to avoid dirty air. At E0 consumers also receive a consumer surplus equal to the shaded area in Figure 1. This consumer surplus of 788 per household can be multiplied by the total number of households to estimate total consumer surplus from clean air.

Market Demand and Elasticity
Chapter 4 Market Demand and Elasticity © 2004 Thomson Learning/South-Western

Market Demand Curves The market demand is the total quantity of a good or service demanded by all potential buyers. The market demand curve is the relationship between the total quantity demanded of a good or service and its price, holding all other factors constant.

Construction of the Market Demand Curve
The market demand curve is constructed by horizontally summing the demands of the individual consumers Assume the market consists of only two buyers as shown in Figure 4.1 At any given price, such as P*X, individual 1 demands X*1 and individual 2 demands X*2.

FIGURE 4.1: Constructing a Market Demand Curve from Individual Demand Curves
PX P* X X* 1 (a) Individual 1

PX PX P* X X* X* 1 2 (a) Individual 1 (b) Individual 2

Construction of the Market Demand Curve
The total quantity demanded at the market at P*X is the sum of the two amounts: X* = X*1 + X*2 . The point X*, P*X is one point on the market demand curve. The other points on the curve are similarly plotted.

PX PX PX P* X D X* X* X* X 1 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

Shifts in the Market Demand Curve
To discover how some event might shift a market demand curve, we must first find out how this event causes individual demand curves to shift and then compare the horizontal sum of these new demand curves with the old demand curve.

For example consider the two buyer case where both consumers regard X as a normal good. An increase in income for each consumer would shift their individual demand curves out so that the market demand curve, would also shift out This situation is shown in Figure 4.2

FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward
PX PX PX D P* X X* X* X* X 1 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

FIGURE 4.2: Increases in Each individual’s Income Cause the Market Demand Curve to Shift Outward
PX D’ PX PX D P* X X* X** X* X** X* X** X 1 1 2 2 (a) Individual 1 (b) Individual 2 (c) Market Demand

However, some events result in ambiguous outcomes. If one consumer’s demand curve shifts out while another’s shifts in, the net effect depends on the size of the relative shifts. An increase in income for pizza lovers would increase the market demand for pizza so long as it is a normal good.

On the other hand, if the increase in income was for people who don’t like pizza, there would be no significant effect on the market demand curve for pizza. Changes in the prices of related goods, substitutes or complements, will also shift the individual and market demand curves.

If goods X and Y are substitutes, an increase in the price of Y will increase the demand for X. Similarly, a decrease in the price of Y will decrease the demand for X. If goods X and Y are complements, an increase in the price of Y will decrease the demand for X. A decrease in the price of Y will increase the demand for X.

APPLICATION 4.1: Consumption and Income Taxes
People’s ability to purchased goods and services is dependent upon their after tax income. In the 1950’s Milton Friedman argued that people’s consumption decisions are based mostly on their long-term (permanent) income.

APPLICATION 4.1: Consumption and Income Taxes
One implication of the permanent-income hypothesis is that temporary tax changes will have little effect on the demand for consumption goods This prediction is supported by the small impact on consumption by both the temporary tax surcharge during the Nixon administration and the Ford administration’s temporary income tax rebate

APPLICATION 4.1: Why the 2001 Tax Cut Was a Dud
In May 2001, Congress passed one of the largest cuts in personal income taxes in history. Our discussion of demand theory showed that changes in personal incomes shift demand curves outward. However, Milton Friedman viewed that spending decisions are based on a person’s “permanent” income.

APPLICATION 4.1: Why the 2001 Tax Cut Was a Dud
This insight suggests that the 2001 tax cut had little impact for two reasons. First, The $300 checks were too small to stimulate spending on any major goods, so they were largely saved. Second, Most of the tax cuts do not begin until 2006, and the largest cuts are reserved until

A Word on Notation and Terms
When looking at only one market, Q is used for the quantity of the good demanded, and P is used for its price. When drawing the demand curve, all non-price factors are assumed to not change. Movements along the curve are changes in quantity demanded, while shifts are changes in demand.

Elasticity Goods are often measured in different units (steak is measured in pounds while oranges are measured in dozens). It can be difficult to make simple comparisons between goods when trying to determine which is more responsive to changes in price.

Elasticity Elasticity is a measure of the percentage change in one variable brought about by a 1 percent change in some other variable. Since it is measured in percentages, the units cancel out so that it is a unit-less measure of responsiveness.

Price Elasticity of Demand
The price elasticity of demand is the percentage change in the quantity demanded of a good in response to a 1 percent change in its price

Price Elasticity of Demand
The price elasticity records how Q changes in percentage terms in response to a percentage change in P. Since, on a typical demand curve, P and Q move oppositely, eQ,P will be negative. For example, if eQ,P = -2, a 1 percent increase in price leads to a 2 percent decline in quantity.

Values of the Price Elasticity of Demand
When eQ,P < -1, a price increase causes more than a proportional quantity decrease and the curve is called elastic. When eQ,P = -1, a price increase causes a proportional quantity decrease, and the curve is called unit elastic. When eQ,P > -1, a price increase causes less than a proportional quantity decrease, and the curve is called inelastic.

TABLE 4.1: Terminology for the Ranges of eQ,P

Price Elasticity and the Shape of the Demand Curve
We often classify market demand curves by their elasticities For example, the market demand curve for medical services is inelastic (nearly vertical) since there is little quantity response to changes in price. Alternatively, the market demand curve for a single type of candy bar is very responsive to price change (nearly flat) and is very elastic.

Price Elasticity and the Substitution Effect
Goods which have many close substitutes are subject to large substitution effects from a price change so their market demand curve is likely to be relatively elastic. Goods with few close substitutes, on the other hand, will likely be relatively inelastic.

Price Elasticity and the Substitution Effect
There is also an income effect that will determine how responsive quantity demanded is to changes in price. However, since changes in the prices of most goods have a small effect on individuals’ real incomes, the income effect will likely not have as large an impact on elasticity as the substitution effect.

Price Elasticity and Time
Some items can be quickly substituted for, such as a brand of breakfast cereal, others, such as heating fuel, may take several years. Thus, in some situations, it is important to make the distinction between the short-term and long-term elasticities of demand.

APPLICATION 4.2: Brand Loyalty
Substitution due to price changes will likely take a longer time if individual’s develop spending habits. Such brand loyalties are rational since they reduce decision making costs. Over the long term, however, price differences may cause buyers to try other brands.

APPLICATION 4.2: Brand Loyalty
It took several years, but by the 1970s the price differences between U.S. and Japanese cars eventually convinced Americans to buy the Japanese cars. Brand name Licensing, such as Coca-Cola sweatshirts and Mickey Mouse watches, makes products that were previously nearly perfect substitutes, now much less so.

Price Elasticity and Total Expenditures
Total expenditures on a good are found by multiplying the good’s price (P) times the quantity purchased (Q). When demand is elastic, price increases will cause total expenditures to fall. The given percentage increase in price is more than counterbalanced by the decrease in quantity demanded.

For example suppose price elasticity = -2. Suppose people buy 1 million automobiles at $1000 each for a total expenditure of $10 billion. A price increase to $11,000 (10 percent) would cause a 20 percent decline in quantity to 800,000 vehicles. Total expenditures after the price increase would now be only $8.8 billion

Of course, when demand is elastic and prices fall, total expenditures increase. With unit elasticity, total expenditures remain the same with a price change. The movement in one direction by the price is fully offset by the movement in the other direction with the quantity demanded.

When demand is inelastic, a price increase will cause total expenditures to increase too. Suppose the price elasticity of wheat = -0.5. Suppose people bought 100 million bushels at $3 per bushel so total expenditures equal $300 million.

A 20 percent price increase to $3.60 means quantity falls by 10 percent to 90 million with total expenditures now equal to $324 billion. Alternatively, if the demand is inelastic and prices fall, total revenue will also fall. Table 4.2 summarizes the relationship between price elasticity and total expenditures.

TABLE 4.2: Relationship between Price Changes and Changes in Total Expenditure

APPLICATION 4.3: Volatile Farm Prices
The demand for many basic agricultural products (wheat, corn, etc.) is relatively inelastic. Even modest changes in supply, brought about by weather patterns, can have large effects on crop prices.

The Paradox of Agriculture
Good weather tends to produce bountiful crops, but very low crop prices. Bad weather can result in very high crop prices. Relatively small supply disruptions in the U.S. grain best during the early 1970s resulted in farm incomes rising more than 40 percent over a two year period.

Boom and Bust in the Late 1990s
Since the New Deal in the 1930s, the volatility of farm prices has been moderated through federal price-support programs. Acreage restrictions constrained increased planting The federal government purchased crops outright

Boom and Bust in the Late 1990s
These programs moderated severe farm price swings. With the passage of the Federal Agricultural Improvement and Reform Act in 1996, federal governmental intervention into agricultural markets was reduced. In 1997, farm prices were unusually high, but this was followed by very low prices in 1998.

Demand Curves and Price Elasticity
The relationship between a particular demand curve and the price elasticity it exhibits can be complicated. For some curves, the elasticity remains constant everywhere, but for others it is different at every point. A more accurate way to describe it would be to say the elasticity is for current prices.

Linear Demand Curves and Price Elasticity
The price elasticity of demand is always changing along a straight line demand curve. Demand is elastic at prices above the midpoint price. Demand is unit elastic at the midpoint price. Demand is inelastic at prices below the midpoint price.

Numerical Example of Elasticity on a Straight Line Demand Curve
Assume a straight-line demand curve for Walkman cassette tape players is Q = P where Q is the quantity of players demanded per week and P is their price. This demand curve is illustrated in Figure 4.3 and Table 4.3 shows several price-quantity combinations.

FIGURE 4.3: Elasticity Varies along a Linear Demand Curve
Price (dollars) 50 40 30 25 Demand 20 10 20 40 50 60 80 100 Quantity of tape players per week

TABLE 4.3: Price, Quantity, and Total Expenditures on Walkmans for the Demand Function Q = 100 - 2P

Numerical Example of Elasticity on a Straight Line Demand Curve
For prices of $50 or more, nothing is bought so total expenditures are $0. As prices fall between $50 and $25, the midpoint, total expenditures increase. At the midpoint, total expenditures reach a maximum. As prices fall below $25, total expenditures also fall.

Elasticity of a Straight Line Demand Curve
More generally, for a linear demand curve of the form Q = a - bP,

A Unitary Elastic Curve
Suppose the demand for tape players took the form The graph of this equation, shown in Figure 4.4, is a hyperbola. P·Q = $1,200 regardless of price so demand is unit elastic (-1) everywhere on the curve.

General Formula for the Elasticity of a Hyperbola
If the demand curve takes the following form, the price elasticity of demand is equal to b everywhere on the curve.

FIGURE 4.4: A Unitary Elastic Demand Curve
Price (dollars) 60 50 40 30 20 20 24 30 40 60 Quantity of tape players per week

Income Elasticity of Demand
The income elasticity of demand equals the percentage change in the quantity demanded of a good in response to a 1 percent change in income. The formula is given by (where I represents income):

Income Elasticity of Demand
For normal goods, eQ,I is positive because increases in income lead to increases in purchases of the good. For inferior goods eQ,I is negative. If eQ,I > 1, the purchase of the good increases more rapidly than income so the good might be called a luxury good.

APPLICATION 4.4: An Experiment in Health Insurance
Most developed countries have some form of national health insurance. In the U.S. Medicare covers the elderly and Medicaid is available for many of the poor. Recently a number of comprehensive government health plans have been proposed.

The Moral Hazard Problem
A “moral hazard” problem occurs because insurance misleadingly lowers the out-of-pocket expenses to patients, greatly increasing their demand for medical services. An important question, in considering implementing national health insurance is how large an increase is likely to develop?

The Rand Experiment The Rand Corporation conducted a government-funded large-scale experiment in four cities. People were assigned to different insurance plans that varied in the generosity of coverage they offered. Table 1 shows the results from the experiment.

The Rand Experiment A rough estimate of the elasticity of demand can be obtained by averaging the percentage changes across the various plans in Table 1

Table 1: Results of the Rand Health Insurance Experiment

Low Elasticities for Hospital and Doctors’ Visits
Using the estimate of found in Table 4.4, and based on other studies suggests only a small increase in hospital and doctor visits would result from the lower prices provided by insurance. Alternatively, researchers have found greater elasticities (around -0.5) for dental care and outpatient mental health care.

Cross-Price Elasticity of Demand
The cross-price elasticity of demand measures the percentage change in the quantity demanded of a good in response to a 1 percent change in the price of another good. Letting P’ be the price of another good,

Cross-Price Elasticity of Demand
If the goods are substitutes, an increase in the price of one will cause buyers to purchase more of the substitute, so the elasticity will be positive. If the goods are complements, an increase in the price of one will cause buyers to buy less of that good and also less of the good they use with it, so the elasticity will be negative

Empirical Studies of Demand: Estimating Demand Curves
Estimating a demand curve for a product is one of the more difficult but important problems in econometrics. Empirical studies are useful because they a provide a more precise estimate of the amount of change in quantity demanded that results due to a price change.

Problems Estimating Demand Curves
The first problem is how to derive an estimate holding all other factors (the ceteris paribus assumption) constant. This problem is often solved, as discussed in the Appendix to Chapter 1, by the use of multiple regression analysis.

Problems Estimating Demand Curves
The second problem deals with what is observed in the data. The data points represent quantity and price outcomes that are simultaneously determined by both the demand and the supply curves. The econometric problem is to “identify” from these equilibrium points the demand curve that generated them.

Some Elasticity Estimates
Table 4.4 gathers a number of estimated income and price elasticities of demand. Some things to note All of the estimated price elasticities are less than zero as predicted by a negatively sloped demand curve. Most of the price elasticity estimates are inelastic.

TABLE 4.4: Representative Price and Income Elasticities of Demand

Some Elasticity Estimates
The income elasticities of automobiles and transatlantic travel exceed 1 (luxuries). The high income elasticities are balanced by goods such as food and medical care which are less than 1 (necessities). There is no evidence of Giffen’s paradox in the table.

Some Cross-price Elasticity Estimates
Table 4.5 shows a few cross-price elasticity estimates All of the goods appear to be substitutes and have positive cross-price elasticities.

TABLE 4.5: Representative Cross-Price Elasticities of Demand

Application 4.5: Alcohol Taxes as Drunk Driving Policy
Each year more than 40,000 Americans die in automobile accidents. It is generally believed that alcohol consumption is a major contributing factor in at least half of those accidents. Most empirical studies of alcohol consumption show that it is sensitive to price.

Application 4.5: Alcohol Taxes as Drunk Driving Policy
The figures in Table 4.4 suggest that these elasticities range from approximately –0.3 for beer to perhaps as large as –0.9 for wine. Most teenage alcohol consumption is beer. The lower price elasticity of demand for beer poses a problem for those who would use alcohol taxes as a deterrent to drunk driving.

Production Functions The purpose of a firm is to turn inputs into outputs. An abstract model of production is the production function, a mathematical relationship between inputs and outputs.

Production Functions Letting q represent the output of a particular good during a period, K represent capital use, L represent labor input, and M represent raw materials, the following equation represents a production function.

Two-Input Production Function
An important question is how firms choose their levels of output and inputs. While the choices of inputs will obviously vary with the type of firm, a simplifying assumption is often made that the firm uses two inputs, labor and capital.

Application 5.1: Everyone is a Firm
Looking at people as “firms can yield some interesting insights Economists have tried to estimate the amount of production that people do for themselves. Time-use studies suggest that the time people spend in home production is only slightly less than the time spent working.

Application 5.1: Everyone is a Firm
Some of the more straightforward things produced at home are what might be called “housing services”. The production function concept is widely used in thinking about health issues. A somewhat more far-fetched application of the home-production concept is to view families as “producers of children.”

Marginal Product Marginal physical productivity, or more simply, the marginal product of an input is the additional output that can be produced by adding one more unit of a particular input while holding all other inputs constant. The marginal product of labor (MPL) is the extra output obtained by employing one more unit of labor while holding the level of capital equipment constant.

Marginal Product The marginal product of capital (MPK) is the extra output obtained by using one more machine while holding the number of workers constant.

Diminishing Marginal Product
It is expected that the marginal product of an input will depend upon the level of the input used. Since, holding capital constant, production of more output is likely to eventually decline with adding more labor, it is expected that marginal product will eventually diminish as shown in Figure 5.1.

FIGURE 5.1: Relationship between Output and Labor Input Holding Other Inputs Constant
Total per week Output L* Labor input per week (a) Total output MP L L* Labor input per week (b) Marginal product

Diminishing Marginal Product
The top panel of Figure 5.1 shows the relationship between output per week and labor input during the week as capital is held fixed. Initially, output increases rapidly as new workers are added, but eventually it diminishes as the fixed capital becomes overutilized.

Marginal Product Curve
The marginal product curve is simply the slope of the total product curve. The declining slope, as shown in panel b, shows diminishing marginal productivity.

Average Product Average product is simply “output per worker” calculated by dividing total output by the number of workers used to produce the output. This corresponds to what many people mean when they discuss productivity, but economists emphasize the change in output reflected in the marginal product.

Appraising the Marginal Product Concept
Marginal product requires the ceteris paribus assumption that other things, such as the level of other inputs and the firm’s technical knowledge, are held constant. An alternative way, that is more realistic, is to study the entire production function for a good.

Japan appears to have a productivity advantage.
APPLICATION 5.2: Why Do the Japanese Have a Cost Advantage in Making Cars? In 1979 Japan overtook the United States as the world’s largest producer of automobiles. Japan appears to have a productivity advantage. For example, workers at Honda or Toyota take about 30 hours to produce a car while workers in General Motors or Chrysler take about 45 hours.

APPLICATION 5.2: Why Do the Japanese Have a Cost Advantage in Making Cars?
Reasons for this are not known although it does not appear to be explained by simple substitution of capital for labor. U.S. producers tend to use more assembly lines which allows greater variability in vehicle size than in Japan. This makes it easier to use automating production, such as robots, in Japan.

APPLICATION 5.2: Why Do the Japanese Have a Cost Advantage in Making Cars?
Also, although both U.S. and Japanese producers tend to buy many components of cars from independent suppliers, these suppliers are better integrated with the assembly firms in Japan. In addition, there appears to be more of an adversarial relationship between labor and management in the U.S. than in Japan.

Isoquant Maps An isoquant is a curve that shows the various combinations of inputs that will produce the same (a particular) amount of output. An isoquant map is a contour map of a firm’s production function. All of the isoquants from a production function are part of this isoquant map.

Isoquant Map In Figure 5.2, the firm is assumed to use the production function, q = f(K,L) to produce a single good. The curve labeled q = 10 is an isoquant that shows various combinations of labor and capital, such as points A and B, that produce exactly 10 units of output per period.

FIGURE 5.2: Isoquant Map Capital per week KA A KB B q = 10 Labor
Labor per week LA LB

Isoquant Map The isoquants labeled q = 20 and q = 30 represent two more of the infinite curves that represent different levels of output. Isoquants record successively higher levels of output the farther away from the origin they are in a northeasterly direction.

FIGURE 5.2: Isoquant Map Capital per week KA A q = 30 q = 20 KB B
Labor per week LA LB

Isoquant Map Unlike indifference curves, the labeling of the isoquants represents something measurable, the quantity of output per period. In addition to the location of the isoquants, economists are also interested in their shape.

Rate of Technical Substitution
The negative of the slope of an isoquant is called the marginal rate of technical substitution (RTS), the amount by which one input can be reduced when one more unit of another input is added while holding output constant. It is the rate that capital can be reduced, holding output constant, while using one more unit of labor.

The particular value of this trade-off depends upon the level of output and the quantities of capital and labor being used. At A in Figure 5.2, relatively large amounts of capital can be given up if one more unit of labor is added (large RTS), but at B only a little capital can be sacrificed when adding one more unit of labor (small RTS).

The RTS and Marginal Products
It is likely that the RTS is positive (the isoquant has a negative slope) because the firm can decrease its use of capital if one more unit of labor is employed. If increasing labor meant the having to hire more capital the marginal product of labor or capital would be negative and the firm would be unwilling to hire more of either.

Diminishing RTS Along any isoquant the (negative) slope become flatter and the RTS diminishes. When a relatively large amount of capital is used (as at A in Figure 5.2) a large amount can be replaced by a unit of labor, but when only a small amount of capital is used (as at point B), one more unit of labor replaces very little capital.

APPLICATION 5.3: Engineering and Economics
Engineering studies can be used to provide information about a production function. Engineers have developed three different methods (A, B, and C) to produce output. These methods are shown in Figure 1, when method A uses a greater capital labor ratio than B, and the capital labor ratio at B exceeds that at C.

FIGURE 1: Construction of an Isoquant from Engineering Data
K per period A B a C c b q0 L per period

The points a, b, and c represent three different methods to produce q0 units of output, so these points are one the same isoquant. This method was used by economists to examine the production of domestic hot water by rooftop solar collectors.

This method has been used to examine the extent to which energy and capital can be substituted in industrial equipment design. Economists have also found that energy and capital are sometimes complements in production, which may have caused the poor productivity of the 1970s due to high energy costs.

Returns to Scale Returns to scale is the rate at which output increases in response to proportional increases in all inputs. In the eighteenth century Adam Smith became aware of this concept when he studied the production of pins.

Returns to Scale Adam Smith identified two forces that come into play when all inputs are increased. A doubling of inputs permits a greater “division of labor” allowing persons to specialize in the production of specific pin parts. This specialization may increase efficiency enough to more than double output. However these benefits might be reversed if firms become too large to manage.

Constant Returns to Scale
A production function is said to exhibit constant returns to scale if a doubling of all inputs results in a precise doubling of output. This situation is shown in Panel (a) of Figure 5.3.

FIGURE 5.3: Isoquant Maps showing Constant, Decreasing, and Increasing Returns to Scale
Capital per week 4 q = 40 3 q = 30 2 q = 20 1 q = 10 Labor 1 2 3 4 per week (a) Constant Returns to Scale

Decreasing Returns to Scale
If doubling all inputs yields less than a doubling of output, the production function is said to exhibit decreasing returns to scale. This is shown in Panel (b) of Figure 5.3.

Capital Capital per week per week 4 4 q = 40 3 q = 30 3 q = 30 2 2 q = 20 q = 20 1 1 q = 10 q = 10 Labor Labor 1 2 3 4 1 2 3 4 per week per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale

Increasing Returns to Scale
If doubling all inputs results in more than a doubling of output, the production function exhibits increasing returns to scale. This is demonstrated in Panel (c) of Figure 5.3. In the real world, more complicated possibilities may exist such as a production function that changes from increasing to constant to decreasing returns to scale.

Capital Capital per week per week 4 4 q = 40 3 q = 30 3 q = 30 2 2 q = 20 q = 20 1 1 q = 10 q = 10 Labor Labor 1 2 3 4 1 2 3 4 per week per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale Capital A per week 4 3 q = 40 2 q = 30 q = 20 1 q = 10 1 2 3 4 Labor per week (c) Increasing Returns to Scale

APPLICATION 5.4: Returns to Scale in Beer Brewing
Because beer is produced in volume (barrels per year) but capital has costs that are proportional to surface area, larger breweries were able to achieve increasing returns to scale. Economies to scale were also achieved through automated control systems in filling beer cans.

National markets may also foster economies of scale in distribution, advertising (especially television), and marketing. These factors became especially important after World War II and the number of U.S. brewing firms fell by over 90 percent between 1945 and the mid-1980s.

The output of the industry became consolidated in a few large firms which operated very large breweries in multiple locations to reduce shipping costs. Beginning the the mid-1980s, however, smaller firms offering premium brands, provided and opening for local microbreweries.

The 1990s have seen a virtual explosion of new brands with odd names or local appeal. A similar event occurred in great Britain during the 1980s with the “real ale” movements, but it was followed by small firms being absorbed by national brands. A similar absorption may be starting to take place in the United States.

Input Substitution Another important characteristic of a production function is how easily inputs can be substituted for each other. This characteristic depends upon the slope of a given isoquant, rather than the whole isoquant map.

Fixed-Proportions Production Function
It may be the case that absolutely no substitution between inputs is possible. This case is shown in Figure 5.4. If K1 units of capital are used, exactly L1 units of labor are required to produce q1 units of output. If K1 units of capital are used and less than L1 units of labor are used, q1 can not be produced.

Fixed-Proportions Production Function
If K1 units of capital are used and more than L1 units of labor are used, no more than q1 units of output are produced. With K = K1, the marginal physical product of labor is zero beyond L1 units of labor. The q1 isoquant is horizontal beyond L1. Similarly, with L1 units of labor, the marginal physical product of capital is zero beyond K1 resulting in the vertical portion of the isoquant.

FIGURE 5.4: Isoquant Map with Fixed Proportions
Capital per week A K2 q2 K1 q1 q0 K0 Labor per week L0 L1 L2

Fixed-proportions Production Function
This type of production function is called a fixed-proportion production function because the inputs must be used in a fixed ratio to one another. Many machines require a fixed complement of workers so this type of production function may be relevant in the real world.

The Relevance of Input Substitutability
Over the past century the U.S. economy has shifted away from agricultural production and towards manufacturing and service industries. Economists are interested in the degree to which certain factors of production (notable labor) can be moved from agriculture into the growing industries.

Changes in Technology Technical progress is a shift in the production function that allows a given output level to be produced using fewer inputs. Isoquant q0 in Figure 5.5, summarized the initial state of technical knowledge. K0 and L0 units of capital and labor respectively can produce this level of output.

Changes in Technology After a technology improvement, the same level of output can be produced with the same level of capital and reduced labor, L1. The improvement in technology is represented in Figure 5.5 by the shift of the q0 isoquant to q’0. Technical progress represents a real savings in inputs.

FIGURE 5.5: Technical Change
Capital per week K1 K0 A q0 q’0 L1 L0 Labor per week

Technical Progress versus Input Substitution
In studying productivity data, especially data on output per worker, it is important to make the distinction between technical improvements and capital substitution. In Figure 5.5, the first is shown by the movement from L0, K0 to L1, K0, while the latter is L0, K0 to L1, K1.

Technical Progress versus Input Substitution
In both cases, output per worker would rise (q0/L0 to q0/L1) With technical progress there is a real improvement in the way things are produced. With substitution, no real improvement in the production of the good takes place.

APPLICATION 5.5: Multifactor Productivity
Table 1 shows the rates of change in productivity for three countries measured as output per hour. While the data show declines during the 1974 to 1991 period, they still averaged over 2 percent per year. However, this measure may simply reflect simple capital-labor substitution.

A measure that attempts to control for such substitution is called mutifactor productivity. As table 2 shows, the period looks much worse using the multifactor productivity measure.

Reasons for the decline in post 1973 productivity include rising energy prices, high rates of inflation, increasing environmental regulations, deteriorating education systems, or a general decline in the work ethic. Clearly after 1991, productivity has improved greatly.

TABLE 1: Annual Average Change in Output per Hour in Manufacturing

TABLE 2: Annual Average Change in Multifactor Productivity Manufacturing

A Numerical Example Assume a production function for the fast-food chain Hamburger Heaven (HH): where K represents the number of grills used and L represents the number of workers employed during an hour of production.

A Numerical Example This function exhibits constant returns to scale as demonstrated in Table 5.1. As both workers and grills are increased together, hourly hamburger output rises proportionally.

TABLE 5.1: Hamburger Production Exhibits Constant Returns to Scale

Average and Marginal Productivities
Holding capital constant (K = 4), to show labor productivity, we have Table 5.2 shows this relationship and demonstrates that output per worker declines as more labor is employed.

TABLE 5.2: Total Output, Average Productivity, and Marginal Productivity with Four Grills

Average and Marginal Productivities
Also, Table 5.2 shows that the productivity of each additional worker hired declines. Holding one input constant yields the expected declining average and marginal productivities.

The Isoquant Map Suppose HH wants to produce 40 hamburgers per hour. Then its production function becomes

The Isoquant Map Table 5.3 show several K, L combinations that satisfy this equation. All possible combinations in the “q = 40” isoquant are shown in Figure 5.6. All other isoquants would have the same shape showing that HH has many substitution possibilities.

TABLE 5.3: Construction of the q = 40 Isoquant

FIGURE 5.6: Technical Progress in Hamburger Production
Grills (K) 10 4 q = 40 1 4 10 Workers (L)

Technical Progress Technical advancement can be reflected in the equation Comparing this to the old technology by recalculating the q = 40 isoquant

Technical Progress In Figure 5.6 the new technology is the isoquant labeled “q = 40 after invention.” With 4 grills, average productivity is now 40 hamburgers per hour per worker whereas it was 10 hamburgers per hour before the invention. This level of output per worker would have required 16 grills with the old technology.

FIGURE 5.6: Technical Progress in Hamburger Production
Grills (K) 10 4 q = 40 after invention q = 40 1 4 10 Workers (L)

Basic Concepts of Costs
Opportunity cost is the cost of a good or service as measured by the alternative uses that are foregone by producing the good or service. If 15 bicycles could be produced with the materials used to produce an automobile, the opportunity cost of the automobile is 15 bicycles. The price of a good or service often may reflect its opportunity cost.

Basic Concepts of Costs
Accounting cost is the concept that goods or services cost what was paid for them. Economic cost is the amount required to keep a resource in its present use; the amount that it would be worth in its next best alternative use.

Labor Costs Like accountants, economists regard the payments to labor as an explicit cost. Labor services (worker-hours) are purchased at an hourly wage rate (w): The cost of hiring one worker for one hour. The wage rate is assumed to be the amount workers would receive in their next best alternative employment.

Capital Costs While accountants usually calculate capital costs by applying some depreciation rule to the historical price of the machine, economists view this amount as a sunk cost. A sunk cost is an expenditure that once made cannot be recovered. These costs do not focus on foregone opportunities.

Capital Costs Economists consider the cost of a machine to be the amount someone else would be willing to pay for its use. The cost of capital services (machine-hours) is the rental rate (v) which is the cost of hiring one machine for one hour. This is an implicit cost if the machine is owned by the firm.

APPLICATION 6.1: Stranded Costs and Electricity Deregulation
Until the mid 1990s, the electric power industry in the United States was heavily regulated. The expected decline in the wholesale price of electricity resulting from deregulation has sparked a debate over “stranded costs”.

The Nature of Stranded Costs
When the average costs of generating electricity exceed the price of electricity in the open market, the generating facilities become “uneconomic.” The historical costs of these facilities have been “stranded” by deregulation.

The Nature of Stranded Costs
To economists, these are sunk costs. Generating facilities that have become “uneconomic” have zero market value, a situation that occurs frequently in many other business (for example, machines that produce 78 RPM recordings). Economist Joseph Schumpeter coined such situations, “creative destruction.”

The Legal Framework--Socking It to the Consumer
Utilities companies argue that they were promised a “fair” return on their investment, so they should be compensated for the impact of deregulation. Southern California Edison Company was awarded stranded cost compensation that exceeded the company’s value on the New York Stock Exchange.

A result of mandated stranded-cost compensation is the slowing of the pace of deregulation. Since consumers see little of the price decline, they have little incentive to push for deregulation. Would-be entrants are also not encouraged by consumers because of the stranded-cost compensation.

Entrepreneurial Costs
Owners of the firm are entitled to the difference between revenue and costs which is generally called (accounting) profit. However, if they incur opportunity costs for their time or other resources supplied to the firm, these should be considered a cost of the firm.

A computer programmer that started a software firm would supply time, the value of which is an opportunity cost. The wages the programmer would have earned if he or she worked elsewhere could be used as a measure of this cost. Economic profit is revenue minus all costs including these entrepreneurial costs.

Two Simplifying Assumptions
The firm uses only two inputs: labor (L, measured in labor hours) and capital (K, measured in machine hours). Entrepreneurial services are assumed to be included in the capital costs. Firms buy inputs in perfectly competitive markets so the firm faces horizontal supply curves at prevailing factor prices.

Economic Profits and Cost Minimization
Total costs = TC = wL + vK. Assuming the firm produces only one output, total revenue equals the price of the product (P) times its total output [q = f(K,L) where f(K,L) is the firm’s production function].

Economic Profits and Cost Minimization
Economic profits () is the difference between a firm’s total revenues and its total economic costs.

Cost-Minimizing Input Choice
Assume, for purposes of this chapter, that the firm has decided to produce a particular output level (say, q1). The firm’s total revenues are P·q1. How the firm might choose to produce this level of output at minimal costs is the subject of this chapter.

Cost-Minimizing Input Choice
Cost minimization requires that the marginal rate of technical substitution (RTS) of L for K equals the ratio of the inputs’ costs, w/v:

Graphic Presentation The isoquant q1 shows all combinations of K and L that are required to produce q1. The slope of total costs, TC = wL + vK, is -w/v. Lines of equal cost will have the same slope so they will be parallel. Three equal total costs lines, labeled TC1, TC2, and TC3 are shown in Figure 6.1.

FIGURE 6.1: Minimizing the Costs of Producing q1
Capital per week TC1 TC2 TC3 K* q1 Labor per week L*

Graphic Presentation The minimum total cost of producing q1 is TC1 (since it is closest to the origin). The cost-minimizing input combination is L*, K* which occurs where the total cost curve is tangent to the isoquant. At the point of tangency, the rate at which the firm can technically substitute L for K (the RTS) equals the market rate (w/v).

An Alternative Interpretation
From Chapter 5 Cost minimization requires or, rearranging

The Firm’s Expansion Path
A similar analysis could be performed for any output level (q). If input costs (w and v) remain constant, various cost-minimizing choices can be traces out as shown in Figure 6.2. For example, output level q1 is produced using K1, L1, and other cost-minimizing points are shown by the tangency between the total cost lines and the isoquants.

The Firm’s Expansion Path
The firm’s expansion path is the set of cost-minimizing input combinations a firm will choose to produce various levels of output (when the prices of inputs are held constant). Although in Figure 6.2, the expansion path is a straight line, that is not necessarily the case.

FIGURE 6.2: Firm’s Expansion Path
Capital per week TC1 TC3 TC2 Expansion path q3 K1 q2 q1 Labor per week L1

Cost Curves A firm’s expansion path shows how minimum-cost input use increases when the level of output expands. With this it is possible to develop the relationship between output levels and total input costs. These cost curves are fundamental to the theory of supply.

Cost Curves Figure 6.3 shows four possible shapes for cost curves.
In Panel a, output and required input use is proportional which means doubling of output requires doubling of inputs. This is the case when the production function exhibits constant returns to scale.

FIGURE 6.3: Possible Shapes of the Total Cost Curve
Quantity per week (a) Constant Returns to Scale

Cost Curves Panels b and c reflect the cases of decreasing and increasing returns to scale, respectively. With decreasing returns to scale the cost curve is convex, while the it is concave with increasing returns to scale. Decreasing returns to scale indicate considerable cost advantages from large scale operations.

Quantity per week Quantity per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale Total cost TC Quantity per week (c) Increasing Returns to Scale

Cost Curves Panel d reflects the case where there are increasing returns to scale followed by decreasing returns to scale. This might arise because internal co-ordination and control by managers is initially underutilized, but becomes more difficult at high levels of output. This suggests an optimal scale of output.

Quantity per week Quantity per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale TC Total cost Total cost TC Quantity per week Quantity per week (c) Increasing Returns to Scale (d) Optimal Scale

Average Costs Average cost is total cost divided by output; a common measure of cost per unit. If the total cost of producing 25 units is $100, the average cost would be

Marginal Cost The additional cost of producing one more unit of output is marginal cost. If the cost of producing 24 units is $98 and the cost of producing 25 units is $100, the marginal cost of the 25th unit is $2.

Marginal Cost Curves Marginal costs are reflected by the slope of the total cost curve. The constant returns to scale total cost curve shown in Panel a of Figure 6.3 has a constant slope, so the marginal cost is constant as shown by the horizontal marginal cost curve in Panel a of Figure 6.4.

FIGURE 6.4: Average and Marginal Cost Curves
AC, MC AC, MC Quantity per week (a) Constant Returns to Scale

Marginal Cost Curves With decreasing returns to scale, the total cost curve is convex (Panel b of Figure 6.3). This means that marginal costs are increasing which is shown by the positively sloped marginal cost curve in Panel b of Figure 6.4.

AC, MC AC, MC MC AC AC, MC Quantity per week Quantity per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale

Marginal Cost Curves Increasing returns to scale results in a concave total cost curve (Panel c of Figure 6.3). This causes the marginal costs to decrease as output increases as shown in the negatively sloped marginal cost curve in Panel c of Figure 6.4.

AC, MC AC, MC MC AC AC, MC Quantity per week Quantity per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale AC, MC AC MC Quantity per week (c) Increasing Returns to Scale

Marginal Cost Curves When the total cost curve is first concave followed by convex as shown in Panel d of Figure 6.3, marginal costs initially decrease but eventually increase. Thus, the marginal cost curve is first negatively sloped followed by a positively sloped curve as shown in Panel d of Figure 6.4.

AC, MC AC, MC MC AC AC, MC Quantity per week Quantity per week (a) Constant Returns to Scale (b) Decreasing Returns to Scale AC, MC AC AC, MC MC AC MC Quantity per week Quantity per week q* (c) Increasing Returns to Scale (d) Optimal Scale

Average Cost Curves If a firm produces only one unit of output, marginal cost would be the same as average cost Thus, the graph of the average cost curve begins at the point where the marginal cost curve intersects the vertical axis.

Average Cost Curves For the constant returns to scale case, marginal cost never varies from its initial level, so average cost must stay the same as well. Thus, the average cost curve are the same horizontal line as shown in Panel a of Figure 6.4.

Average Cost Curves With convex total costs and increasing marginal costs, average costs also rise as shown in Panel b of Figure 6.4. Because the first few units are produced at low marginal costs, average costs will always b less than marginal cost, so the average cost curve lies below the marginal cost curve.

Average Cost Curves With concave total cost and decreasing marginal costs, average costs will also decrease as shown in Panel c in Figure 6.4. Because the first few units are produced at relatively high marginal costs, average is less than marginal cost, so the average cost curve lies below the marginal cost curve.

Average Cost Curves The U-shaped marginal cost curve shown in Panel d of Figure 6.4 reflects decreasing marginal costs at low levels of output and increasing marginal costs at high levels of output. As long as marginal cost is below average cost, the marginal will pull down the average.

Average Cost Curves When marginal costs are above average cost, the marginal pulls up the average. Thus, the average cost curve must intersect the marginal cost curve at the minimum average cost; q* in Panel d of Figure 6.4. Since q* represents the lowest average cost, it represents an “optimal scale” of production for the firm.

APPLICATION 6.2: Findings on Firms’ Costs
Entries in Table 1 represent long-run average cost estimates for different size firms as a percentage of the minimal average-cost firm in the industry. These estimates, except for trucking, suggest lower average cost for medium and large firms. Figure 1 shows the average cost firm suggested by the data.

FIGURE 1: Long-Run Average Cost Curve Found in Many Empirical Studies
AC Quantity per period q*

TABLE 1: Long-Run Average-Cost Estimates

APPLICATION 6.3: Airlines’ Costs
Costs for airlines have been of interest to economists because of recent changes such as deregulation, bankruptcy, and mergers. Two general findings: Costs seem to differ substantially among U.S. firms. Costs for U.S. airlines appear to be significantly lower than for airlines in other countries.

Reasons for Differences among U.S. Firms
Airlines that fly longer average distances or operate a greater number of flights over a given network tend to have lower costs. Firms can spread the fixed costs associated with terminals, maintenance facilities, and reservation systems over a larger output volume.

Reasons for Differences among U.S. Firms
Firms that operate older fleets or that operate fleets with many different types of planes tend to have higher maintenance and fuel costs. Wage costs, especially for pilots, also differ significantly among the airlines.

International Airline Regulation and Costs
Many foreign carriers’ have not adopted the “hub and spoke” system which appears to be more efficient. Foreign firms are subject to more regulation. This situation appears to be changing. For example, Australia ended rigid controls and costs fell by 15 to 20 percent.

Distinction between the Short Run and the Long Run
The short run is the period of time in which a firm must consider some inputs to be absolutely fixed in making its decisions. The long run is the period of time in which a firm may consider all of its inputs to be variable in making its decisions.

Holding Capital Input Constant
For the following, the capital input is assumed to be held constant at a level of K1, so that, with only two inputs, labor is the only input the firm can vary. As examined in Chapter 5, this implies diminishing marginal productivity to labor.

Types of Short-Run Costs
Fixed costs; costs associated with inputs that are fixed in the short run. Variable costs; costs associated with inputs that can be varied in the short run.

Input Inflexibility and Cost Minimization
Since capital is fixed, short-run costs are not the minimal costs of producing variable output levels. Assume the firm has fixed capital of K1 as shown in Figure 6.5. To produce q0 of output, the firm must use L1 units of labor, with similar situations for q1, L1, and q2, L2.

FIGURE 6.5: “Nonoptimal” Input Choices Must Be Made in the Short Run
Capital per week STC0 STC2 STC1 K1 q2 q1 q0 L0 L1 L2 Labor per week

Input Inflexibility and Cost Minimization
The cost of output produced is minimized where the RTS equals the ratio of prices, which only occurs at q1, L1. Q0 could be produce at less cost if less capital than K1 and more labor than L0 were used. Q2 could be produced at less cost if more capital than K1 and less labor than L2 were used.

Per-Unit Short-Run Cost Curves

Per-Unit Short-Run Cost Curves
Having capital fixed in the short run yields a total cost curve that has both concave and convex sections, the resulting short-run average and marginal cost relationships will also be U-shaped. When SMC < SAC, average cost is falling, but when SMC > SAC average cost increase.

Relationship between Short-Run and Long-Run per-Unit Cost Curves
Figure 6.6 shows all cost relationships for a firm that has U-shaped long-run average and marginal cost curves. At output level q* long-run average costs are minimized and MC = AC. Associated with q* is a certain level of capital, K*.

FIGURE 6.6: Short-Run and Long-Run Average and Marginal Cost Curves at Optimal Output Level
AC, MC MC AC SMC SAC q* Quantity per week

Relationship between Short-Run and Long-Run per-Unit Cost Curves
In the short-run, when the firm using K* units of capital produces q*, short-run and long-run total costs are equal. In addition, as shown in Figure AC = MC = SAC(K*) = SMC(K*). For output above q* short-run costs are higher than long-run costs. The higher per-unit costs reflect the facts that K is fixed.

APPLICATION 6.4: Can We Do Anything About Traffic Snarls?
For any traffic facility (road, bridge, tunnel, and so forth), output is measured in number of vehicles per hour. Capital costs are largely fixed, as depreciation occurs regardless of the level of traffic. Variable costs consist primarily of motorists’ time.

Studies, based on people’s willingness to spend time commuting, indicate travel time “costs” about $8 per hour. The marginal cost of producing “one more trip” is the overall increase in travel time experienced by all motorists when one more vehicle uses a traffic facility.

The high costs associated with adding an extra automobile to an already crowded facility are not directly experienced by the motorist driving the car, because these costs are imposed on other motorists. This divergence between the private costs and the total social costs leads to motorists opting for overutilizeing traffic facilities.

Congestion Tolls The standard economists answer to this problem is to adopt taxes that bring social and private marginal costs into agreement. This implies the adoption of highway, bridge, or tunnel tolls, that accurately reflect social costs. Since these costs vary by time of day, tolls should also vary over the day.

Toll-Collecting Technology
This approach was previously not feasible since collection booths for tolls would add more to the congestion that in aiding to the solving of the problem. However, the development of low-cost electronic toll collection techniques, now make it possible using cards with pre-coded computer chips.

Shifts in Cost Curves Any change in economic conditions that affects the expansion path will also affect the shape and position of the firm’s cost curves. Three sources of such change are: change in input prices technological innovations, and economies of scope.

Changes in Input Prices
A change in the price of an input will tilt the firm’s total cost lines and alter its expansion path. For example, a rise in wage rates will cause firms to use more capital (to the extent allowed by the technology) and the entire expansion path will rotate toward the capital axis.

Changes in Input Prices
Generally, all cost curves will shift upward with the extent of the shift depending upon how important labor is in production and how successful the firm is in substituting other inputs for labor. With important labor and poor substitution possibilities, a significant increase in costs will result.

Technological Innovation
Because technological advances alter a firm’s production function, isoquant maps as well as the firm’s expansion path will shift when technology changes. Unbiased improvements would shift isoquants toward the origin enabeling firms to produce the same level of output with less of all inputs.

Technological Innovation
Technological change that is biased toward the use of one input will alter isoquant maps, shift expansion paths, and affect the shape and location of cost curves. For example, if workers became more skilled, this would save only on labor input.

Economies of Scope Economies of scope is the reduction in the costs of one product of a multiproduct firm when the output of another product is increased. For example, when hospitals do many surgeries of one type, it may have cost advantages in doing other types because of the similarities in equipment and operating personnel used.

APPLICATION 6.5: Economies of Scope in Banks and Hospitals
Banks and hospitals are both complex types of firms that produce many different products. Recently, a large number of mergers has occurred in both of these industries. One of the primary reasons for expected the lower costs associated with these mergers is that the mergers make it possible for firms to have a broader array of products.

If economies of scope are important, the additional production after mergers, may cause the costs of these firms’ traditional business lines to be lower. Banks represent an industry where for-profit firms dominate whereas hospitals are more commonly regarded as nonprofit firms.

Banks are financial intermediaries. Economies of scope can reduce banks’ costs if the costs associated with any one particular financial product fall when the bank offers other products. The possibility of economies of scope has played an important role in the evolution of banking regulations (e.g. Glass-Steagall Acts in the U.S. and the more flexible merger guidelines adopted by the European Community.)

Although most hospitals are not intended to earn economic profits, they still face revenue constraints that push them toward cost-minimization. Economies of scope arise in a variety of hospital activities Facilities for surgical operations tend to have lower costs the wider the variety of operations that are done The provision of of outpatient services, running intensive care units, and establishing hospital owned pharmacies also lead to economies of scope.

A Numerical Example Assume Hamburger Heaven (HH) can hire workers at $5 per hour and it rents all of its grills for $5 per hour. Total costs for HH during one hour are TC = 5K + 5L where K and L are the number of grills and the number of workers hired during that hour, respectively.

A Numerical Example Suppose HH wishes to produce 40 hamburgers per hour. Table 6.1 repeats the various ways HH can produce 40 hamburgers per hour. This shows that total costs are minimized when K = L = 4. Figure 6.10 shows the cost-minimizing tangency.

TABLE 6.1: Total Costs of Producing 40 Hamburgers per Hour

Figure 6.7: Cost-Minimizing Input Choice for 40 Hamburgers per Hour
Grills per hour 8 E 4 2 40 hamburgers per hour Total cost = $40 2 4 8 Workers per hour

Long-Run cost Curves HH’s production function is constant returns to scale so As long as w = v = $5, all of the cost minimizing tangencies will resemble the one shown in Figure 6.10 and long-run cost minimization will require K = L.

Long-Run cost Curves This situation, resulting from constant returns to scale, is shown in Figure 6.8. HH’s long-run total cost function is a straight line through the origin as shown in Panel a. Its long-run average and marginal costs are constant at $1 per burger as shown in Panel b.

FIGURE 6.8: Total, Average, and Marginal Cost Curves
costs Average and marginal costs Total costs $80 60 40 Average and marginal costs 20 $1.00 20 40 60 80 20 40 60 80 Hamburgers per hour Hamburgers per hour (a) Total Costs (b) Average and Marginal Costs

Short-Run Costs Table 6.2 repeats the labor input required to produce various output levels holding grills fixed at 4. Diminishing marginal productivity of labor causes costs to rise rapidly as output expands. Figure 6.9 shows the short-run average and marginal costs curves.

TABLE 6.2: Short-Run Costs of Hamburger Production

FIGURE 6.12: Short-Run and Long-Run Average and Marginal Cost Curves for Hamburger Heaven
marginal costs $2.50 SMC (4 grills) 2.00 SAC (4 grills) 1.50 1.00 AC, MC .50 20 40 60 80 100 Hamburgers per hour

Profit Maximization and Supply
Chapter 7 Profit Maximization and Supply © 2004 Thomson Learning/South-Western

The Nature of Firms While firms are complex institutions, the typical approach taken by economists is to assume that the firm’s decisions are made by a single dictatorial manager who rationally pursues some goal. The goal most often used is that the firm maximizes economic profit.

APPLICATION 7.1: Corporate Profits, Taxes, and Leveraged Buyout Craze
The U.S. corporate profit tax was levied in was levied in 1909, four years before the personal income tax. Some economists believe that this tax seriously distorts the allocation of resources because It fails to use the economic profit definition. It taxes corporate income twice.

Definition of Profits Much of what is defined as corporate profits under the tax laws is a normal return to shareholders for the equity they have invested in the corporation. Shareholders expect return on their investment whether interest from bonds or returns on equity.

Definition of Profits Some portion of corporate profits reflects the owners forgone earnings by making equity investments. If this cost were added to corporate costs, profits would be substantially reduced.

Effects of the Double Tax
The corporate profits tax is a tax on the equity returns of corporate shareholders. Two effects of this tax. Corporations find it more attractive to finance new capital investments through loans and bond offerings whose interest is tax deductible.

Effects of the Double Tax
Since corporate income is taxed twice--when it is earned by the corporation and when it is paid to shareholders as dividends--the total rate of tax applied to corporate equity capital is much higher than applied to other capital. Investors will be less willing to invest in corporate business than in other assets that are not taxed at as high a tax rate.

The Leveraged Buyout Craze
Some suggest that these peculiarities are partly responsible for the wave of leveraged buyouts (LBOs) that swept financial markets in the 1980s. The basic principle is to use borrowed funds to acquire most of the outstanding stock of a corporation which substitutes a less highly taxed source of capital (debt) for the highly taxed form (equity).

The Leveraged Buyout Craze
The benefits of LBOs are larger when corporations can be purchased cheaply. The huge increases in stock prices in starting in 1991 made such deals less profitable. Most late 1990 buyouts came through the use of vastly appreciated share prices as high prices made equity finance cheaper.

Marginalism Firms as profit maximizers will make decisions in a marginal way. The manager looks, for example, at the marginal profit from producing one more unit of output or the additional profit from hiring one more unit of labor. When the incremental profit of an activity becomes zero, profits are maximized.

The Output Decision Economic profits () are defined as  = R(q) - TC(q) where R(q) is the amount of revenues received and TC(q) are the economic costs incurred, , both depending upon the level of output (q) produced. The firm will choose the level of output that generates the largest level of profit.

The Output Decision In Figure 7.1, (TC) is the total cost curve that is drawn consistent with the discussion in Chapter 6. The total revenues curve is labeled (R). As drawn in the figure, profits reach their maximum at the output level q*.

FIGURE 7.1: Marginal Revenue Must Equal Marginal Cost for Profit Maximization
Costs (TC) Revenues (R) Costs, Revenue (a) Output per week Profits (b) Output per week q1 q* q2 Profits

The Marginal Revenue/Marginal Cost Rule
At output levels below q* increasing output causes profits to increase, so profit maximizing firms would not stop short of q*. Increasing output beyond q* reduces profits, so profit maximizing firms would not produce more than q*.

At q* marginal cost equals marginal revenue, the extra revenue a firm receives when it sells one more unit of output. In order to maximize profits, a firm should produce that output level for which the marginal revenue from selling one more unit of output is exactly equal to the marginal cost of producing that unit of output.

At the profit maximizing level of output Marginal Revenue = Marginal Cost or MR = MC. Firms, starting at zero output, can expand output so long as marginal revenue exceeds marginal cost, but don’t go beyond the point where these two are equal.

Marginalism in Input Choices
Both labor and capital should be hired up to the point where the additional revenue brought in by selling the output produced by the extra labor or capital equals the increase in costs brought on by hiring the additional inputs.

Marginal Revenue A price taker is a firm or individual whose decisions regarding buying or selling have no effect on the prevailing market price of a good or service. For a price taking firm MR = P.

Marginal Revenue for a Downward-Sloping Demand Curve
A firm that is not a price taker faces a downward sloping demand curve for its product. These firms must reduce their selling price in order to sell more goods or services. In this case marginal revenue is less than market price MR < P.

A Numerical Example Assume the quantity demanded of tape cassettes from a particular store per week (q) is related to the price (P) by q = 10 - P. Total revenue is (P·q) and marginal revenue (MR) is the change in total revenue due to a change in quantity demanded.

A Numerical Example This example demonstrates that MR < P as shown in Table 7.1. Total revenue reaches a maximum at q = 5, P = 5. For q > 5, total revenues decline causing marginal revenue to be negative.

TABLE 7.1: Total and Marginal Revenue for Cassette Tapes (q = 10 - P)

A Numerical Example This hypothetical demand curve is shown in Figure 7.2. When q = 3, P = $7 and total revenue equals $21 which is shown by the area of the rectangle P*Aq*0. If the firm wants to sell four tapes it must reduce the price to $6.

FIGURE 7.2: Illustration of Marginal Revenue for the Demand Curve for Cassette Tapes (q = 10 - P)
Price (dollars) 10 P* = $7 A Demand 1 2 3 4 10 Cassette tapes per week q*

A Numerical Example Total revenue is not $24 as illustrated by the area of the rectangle P**Bq**0. The sale of one more tape increases revenue by the price at which it sells ($6). But, to sell the fourth tape, it must reduce its selling price on the first three tapes from $7 to $6 which reduces revenue by $3, which is shown in the lightly shaded rectangle.

FIGURE 7.2: Illustration of Marginal Revenue for the Demand Curve for Cassette Tapes (q = 10 - P)
Price (dollars) 10 P* = $7 A P* = $6 B Demand 1 2 3 4 10 Cassette tapes per week q* q**

A Numerical Example The net result of this price decrease is total revenue increases by only $3 ($6 - $3). Thus, the marginal revenue of the fourth tape is $3. The sale of the sixth tape, instead of five, results in an increase in revenue of the price ($4), but a decrease for the five other tapes (-$5) with a net effect (MR) = -$1.

Marginal Revenue and Price Elasticity
As previously defined in Chapter 4, the price elasticity of demand for the market is This same concept can be defined for a single firm as

If demand facing the firm is inelastic (0  eq,P > -1), a rise in the price will cause total revenues to rise. If demand is elastic (eq,P < -1), a rise in price will result in smaller total revenues. This relationship between the price elasticity and marginal revenue is summarized in Table 7.2.

TABLE 7.2: Relationship between Marginal Revenue and Elasticity

It can be shown that all of the relationships in Table 7.2 can be derived from the basic equation For example, if eq,P < -1 (elastic), this equation shows that MR is positive.

If demand is infinitely elastic (eq,P = -), MR will equal price, as was shown when the firm is a price taker. Suppose a non price taker firm knows elasticity = -2 and its current price is $10. Selling one more product will result in a marginal revenue of $5 [$10(1+1/-2)], which would be produced only if MC < $5.

Marginal Revenue Curve
It is sometimes useful to think of the demand curve as the average revenue curve since it shows the revenue per unit (price). The marginal revenue curve is a curve showing the relation between the quantity a firm sells and the revenue yielded by the last unit sold. It is derived from the demand curve.

Marginal Revenue Curve
With a downward-sloping demand curve, the marginal revenue curve will lie below the demand curve since, at any level of output, marginal revenue is less than price. A demand and marginal revenue curve are shown in Figure 7.3. For output levels greater than q1, marginal revenue is negative.

FIGURE 7.3: Marginal Revenue Curve Associated with a Demand Curve
Price P1 Demand (Average Revenue) q1 Quantity per week Marginal Revenue

Shifts in Demand and Marginal Revenue Curves
As previously discussed, changes in such factors as income, other prices, or preferences cause demand curves to shift. Since marginal revenue curves are derived from demand curves, whenever the demand curve shifts, the marginal revenue curve also shifts.

APPLICATION 7.2: How Did Airlines Respond to Deregulation?
Due to the Airline Deregulation Act of 1978 Regulation of airline fares was reduced or eliminated entirely. Rules governing the assignment of airline routes were relaxed The response of airlines was generally consistent with the profit-maximization hypothesis.

Marginal Revenue Businesspeople have relatively inelastic demands, so the prices for the type of seats they normally buy did not change much. Tourists and similar persons have relatively elastic demands, and large price reductions were targeted for these groups. Overall, these discount fares generated far more revenue than across-the-board cuts.

Marginal Cost While fleets of aircraft could not be changed in the short-run, airlines altered their route structure. Service to many small communities, previously required by the Civil Aeronautics Board, were curtailed. Hub-and-spoke procedures were adopted to allow firms to use different types of aircraft on different routes.

Marginal Cost Because the marginal cost associated with filling empty seats on a plane is essentially zero, profits from the last few passengers on a flight are very high. Airlines have tried very hard to reduce the losses they suffer from “no shows” by selling more space than is available--overbooking.

Short-Run Profit Maximization
Since the firm has no effect on the price it receives for its product, the goal of maximizing profits dictates that it should produce the quantity for which marginal cost equals price. At a given price, such as P* in Figure 7.4, the firm’s demand curve is a horizontal line through P*.

FIGURE 7.4: Short-Run Supply Curve for a Price-Taking Firm
SMC SAC P* = MR E q* Quantity per week

At P* = MR, the firm maximizes profits by producing q*, since this is where price equals short-run marginal costs. At P* profits are positive since P > SAC, but at a price such as P***, short-run profits would be negative. If price just equaled average cost (and marginal cost), short-run profits equal zero.

SMC P** SAC P* = MR E A F P*** P1 q1 q*** q* q** Quantity per week

If, at P* the firm produced less than q*, profits could be increased by producing more since MR > SMC below q*. Alternatively, if the firm produced more than q* profits could be increased by producing less since MR < SMC beyond q*. Thus, profits can only be maximized by producing q* when price is P*.

Total profits are given by the area P*EFA which can be calculated by multiplying profits per unit (P* - A) times the firm’s chosen output level q*. For this situation to truly be a maximum profit, the marginal cost curve must also be be increasing (it would be a profit minimum if the marginal cost curve was decreasing).

The Firm’s Short-Run Supply Curve
The firm’s short-run supply curve is the relationship between price and quantity supplied by a firm in the short-run. For a price-taking firm, this is the positively sloped portion of the short-run marginal cost curve. For all possible prices, the marginal cost curve shows how much output the firm should supply.

The Shutdown Decision For very low prices, the firm could also produce zero output. Since fixed costs are incurred whether or not the firm produces any goods, the decision to produce is based on short-run variable costs.

The Shutdown Decision The firm will opt for q > 0 providing
The price must exceed average variable cost.

The Shutdown Decision The shutdown price is the price below which the firm will choose to produce no output in the short-run. It is equal to minimum average variable costs. In Figure 7.4, the shutdown price is P1. For all P  P1 the firm will follow the P = MC rule, so the supply curve will be the short-run marginal cost curve.

The Shutdown Decision Notice, the firm will still produce if P < SAC, so long as it can cover its fixed costs. However, if price is less than the shutdown price (P < P1 in Figure 7.4), the firm will have smaller losses if it shuts down. This decision is illustrated by the colored segment 0P1 in Figure 7.4.

SMC P1 Quantity per week

Table 1 shows U.S. oil well drilling activity over the past 27 years.
APPLICATION 7.3: Why Is Drilling for Crude Oil Such a Boom or Bust Business? Since prices for crude oil are set in international markets, oil drilling firms are price takers responding to price incentives. Rising marginal costs reflect increased costs encountered as firms have to drill to greater depths or in less accessible areas. Table 1 shows U.S. oil well drilling activity over the past 27 years.

TABLE 1: Wold Oil Prices and Oil-Well Drilling Activity in the United States

APPLICATION 7.3: Why Is Drilling for Crude Oil Such a Boom or Bust Business?
The table also shows average prices of crude oil in various years, adjusted for changing prices or drilling equipment. Between 1970 and 1980 real oil prices tripled resulting in a tripling of drilling. Many of these additional wells were drilled in the high cost areas like the Gulf of Mexico or the Arctic Slope of Alaska.

By 1990 real crude oil prices had declined by 40 in response to recessions and increased supplies of crude oil from the such places as the North Sea and Mexico. As the table shows, drilling declined in response to lower prices. This continued throughout the 1990s with the number of wells falling below 20,000 by 1997.

The decline in oil prices caused several shutdowns of marginal operations; especially those that used pressurized steam or produced fewer than 10 barrels per day. Despite continued new drilling, by 1997 the number of operating wells had dropped by nearly 10 percent compared to the mid-1980s.

This lead to problems with suppliers of oil exploration industry.
APPLICATION 7.3: Why Is Drilling for Crude Oil Such a Boom or Bust Business? This lead to problems with suppliers of oil exploration industry. Producers of high-strength oil pipe suffered huge financial losses as they were unable to sell enough to keep their factories fully utilized. Suppliers of other materials for the oil exploration industry had similar problems and many cities in Texas and Louisiana experienced sharp economic downturns.

Profit Maximization and Managers’ Incentives
The principal-agent relationship is an economic actor (the principal) delegating decision-making authority to another party (the agent). As early as Adam Smith, it was understood that managers of a company may have different goals than are the goals of the owners of the company.

A Model of the Principal-Agent Relationship
Figure 7.5 shows the indifference curve map of a manager’s preferences between the firm’s profits (the primary interest of the owners) and various benefits that accrue mainly to the manager. Assuming the manager is also the owner, if the manager chooses no special benefits, profits will be max.

A Model of the Principal-Agent Relationship
Each dollar of benefits received by the manger reduces profits by one dollar. The slope of the budget constraint is -1, and profits will be zero when benefits equal max. The owner-manager maximizes utility at *, B* which, which is somewhat less than max.

FIGURE 7.5: Incentives for a Manager Acting as an Agent for a Firm’s Owners
Profits per week max * B U1 Owner’ constraint max B* Benefits per week

Conflicts in the Agent Relationship
Now suppose that the manager owns only one-third of the capital with the other two-thirds owned by outside investors. In this case, one dollar in benefits only costs the manager $0.33 in profits which is reflected in the Agent’s constraint in Figure 7.6. Now the manager will maximize profits by choosing **, B**, a lower level of profits and a higher level of benefits.

FIGURE 7.5: Incentives for a Manager Acting as an Agent for a Firm’s Owners
Profits per week max Agent’s constraint * B ** U2 U1 Owner’ constraint *** max B* B** Benefits per week

Conflicts in the Agent Relationship
However, **, B** is not attainable by the firm, so profits will actually be ***. The other owners have been harmed by relying on an agency relationship. It appears that the smaller the ownership by the manager, the greater the reduction in profits. Other agent conflicts studied by economists include investment managers and automobile mechanics.

APPLICATION 7.4: Principals and Agents in Franchising and Medicine
Many large business, such as McDonald’s Corporation, operate their local retail outlets through franchise contracts. For example, local McDonalds restaurants are usually owned by local groups of investors. The problem for the parent company is to ensure that their franchise agents operate in a proper manner.

Various provisions of franchise contracts help to assure proper behavior. With McDonald’s franchises, for example, must meet food-quality and service standards and must purchase supplies from firms that meet standards set by the parent company. The franchisee, in return, gets some management assistance and national advertising and gets to keep a large share of the profits.

Physicians act as agents for patients who often lack knowledge of their illness or what treatments are warranted. There are several reasons why physicians might not chose exactly what a fully informed patient might choose. Unlike the physician, the patient must pay the medical bills.

Since the physician is usually the care provider, he or she may financially benefit from the services provided. Studies find evidence of this physician induced demand, especially for patients with insurance. Doctors are “double agents” with insured patients since they represent both the patients and the insurance company.

Current controversies, such as the growth of managed care organizations arise from this dual relationship. The rapid escalation of health costs have resulted in managed care organizations. Alternatively, restrictions place by managed care organizations have resulted in a major backlash among patients.

Incentive Contracts Owners, however, could refuse to invest in firms where managers behave this way. Managers would then have two options. They could go it alone and finance the company solely with their funds. This would return to the original case and result in *, B*. A manger could work out some agreement with potential investors.

Incentive Contracts It would likely be too costly for other owners to have managers completely pay for their benefits. But owners could construct contracts that give managers incentives to economize on benefits and pursue more profit maximizing goals. Incentives include stock options and profit sharing bonuses.

APPLICATION 7.5: The Good and Bad Effects of Stock Options
Stock options grant the holder the ability to buy shares at a fixed price. If the market price of the shares increases, the holder will benefit by buying at the option price and selling at the higher price. Firms grand options to their executives as incentives to manage the firm in a way that leads to increases in stock value.

While stock options were uncommon in the 1980s, by the 1990s top executives of the largest companies received more than half their total compensation in the form of stock options. Reasons for this increase in the use of options include Rising stock prices made this option attractive.

Since options are often assigned a zero cost to the firm, they made a low-cost way to pay their executives. A special provision of the tax laws enacted in 1993 limited deductions of executive pay to no more than $1 million per year, unless pay was tied to company performance--which increased the incentive to use stock options.

One estimate found that stock options provide more than 50 times the pay-to-performance ratio provided by conventional pay packages. Dollar for dollar, options also provide more pay-to-performance incentives than a simple grant of shares to the executives.

The exact incentive effects of stock options are complex depending on how the options are granted and the ways in which the stock price for the firm performs. Say a company grants an executive a fixed dollar value of options for each of the next five years. If stock prices increase, the executive will be better off but the value of the options will not change.

Alternatively, if the firm grants the executive a fixed number of shares for five years, then increases in the share price will affect his or her future compensation. In general, options are less valuable when the firm pays large dividends to its shareholders, so executives with options have an incentive to not pay dividends.

Options are more valuable when the company’s stock price is more volatile, so executives with options have incentives to take greater risks. Given the complexity, there is little strong evidence about the actual effects of incentives on management behavior.

Comparison between Europe (where options are rare) and the United States suggest that U.S. executives are more careful about how their decisions affect shareholders. The rise of “superstar” managers during the 1990s may mean that executives are now given a freer hand in running businesses.

Timing of a Supply Response
A supply response is the change in quantity of output in response to a change in demand conditions. The pattern of equilibrium prices will be different depending upon the time period In the very short run, quantity is fixed so there is no supply response

Timing of a Supply Response
In the short run existing firms may change the quantity they are supplying, but no firms enter or exit the market. In the long run firms can further change the quantity supplied and new firms may enter the market.

Pricing in the Very Short Run
The market period (very short run) is a short period of time during which quantity supplied is fixed. In this period, price acts to ration demand as it adjusts to clear the market. This situation is illustrated in Figure 8.1 where supply is fixed at Q*.

FIGURE 8.1: Pricing in the Very Short Run
Price S P1 D Quantity per week Q*

Pricing in the Very Short Run
When demand is represented by the curve D, P1 is the equilibrium price. The equilibrium price is the price at which the quantity demanded by buyers of a good is equal to the quantity supplied by sellers of the good.

Shifts in Demand: Price as a Rationing Device
If demand were to increase, as illustrated by the new demand curve D’ in Figure 8.1, P1 is no longer the equilibrium price since the quantity demanded exceeds the quantity supplied. The new equilibrium price is now P2 where price has rationed the good to those who value it the most.

FIGURE 8.1: Pricing in the Very Short Run
Price S P2 P1 D’ D Quantity per week Q*

APPLICATION 8.1: Internet Auctions
Auctions on the internet have rapidly become one of the most popular ways of selling all manner of goods. There is a sense that internet auctions resemble the theoretical situation illustrated in Figure 8.1…the goods are in fixed supply and will be sold for whatever bidders are willing to pay. However, this view of things may be too simple because it ignores dynamic elements which may be present in suppliers’ decisions.

A quick examination of internet auction sites suggests that operators employ a variety of features in their auctions. “Reserve” prices, bidding history, and “buy it now” prices are all features offered at various sites. Attempts to answer the many questions that surround the returns to operators usually focus on the uncertainties inherent in the auction process and how bidders respond to them.

Because buyers and sellers are total strangers in internet auctions, a number of special provisions have been developed to mitigate the risks of fraud that the parties might encounter in such situations. The primary risk facing bidders is in knowing that the goods being offered meet expected quality standards. Previous bidders provide rankings to many of the auction sites.

For sellers, the primary risk is that they will not be paid. Various intermediaries (such as Pay Pal) have been developed to address this problem.

Applicability of the Very Short-Run Model
This model may only apply where the goods are very perishable. It is usually assumed that a rise in price will prompt producers to bring additional quantity to the market. This can result from greater production, or, if the goods are durable, from existing stock held by producers.

Short-Run Supply In the short-run the number of firms is fixed as no firms are able to enter or leave the market. However, existing firms can adjust their quantity in response to price changes. Because of the large number of firms, each firm is treated as a price taker.

Construction of a Short-Run Supply Curve
The quantity that is supplied is the sum of the quantities supplied by each firm. The short-run market supply curve is the relationship between market price and quantity supplied of a good in the short run. In Figure 8.2 it is assumed that there are only two firms, A and B.

FIGURE 8.2: Short-Run Market Supply Curve
Price Price Price SA P qA1 Output Output Quantity per week (a) Firm A (b) Firm B (c) The Market

Price Price Price SB SA P qA1 qB1 Output Output Quantity per week (a) Firm A (b) Firm B (c) The Market

Price Price Price SB S SA P qA1 qB1 Output Output Q1 Quantity per week (a) Firm A (b) Firm B (c) The Market

Construction of a Short-Run Supply Curve
Both firm A’s and firm B’s short-run supply curves (their marginal cost curves) are shown in Figure 8.2(a) and Figure 8.2(b) respectively. The market supply curve is the horizontal sum of the two firms are every price. In Figure 8.2(c), Q1 equals the sum of q1A and q1B.

Short-Run Price Determination
Figure 8.3 (b) shows the market equilibrium where the market demand curve D and the short-run supply curve S intersect at a price of P1 and quantity Q1. This equilibrium would persist since what firms supply at P1 is exactly what people want to buy at that price.

FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run
SMC Price Price S Price SAC P1 D d q1 q2 Q1 Q2 Quantity per week q1 q2 q1 ‘ Output Quantity (a) Typical Firm (b) The Market (c) Typical Person

FIGURE 8.3: Interaction of Many Individuals and Firms Determine market price in the Short Run
SMC Price Price S Price SAC P2 D’ P1 d’ D d q1 q2 Q1 Q2 Quantity per week q1 q2 q1 ‘ Output Quantity (a) Typical Firm (b) The Market (c) Typical Person

Functions of the Equilibrium Price
The price serves as a signal to producers about how much should be produced. To maximize profit, firms will produce the output level for which marginal costs equal P1. This yields an aggregate production of Q1.

Functions of the Equilibrium Price
Given the price, utility maximizing individuals will decide how much of their limited incomes to spend At price P1 the total quantity demanded is Q1. No other price brings about the balance of quantity demanded and quantity supplied. These situations are depicted in Figure 8.3 (a) and (b) for the typical firm and individual, respectively.

Effect of an Increase in Market Demand
If the typical person’s demand for the good increases from d to d’, the entire market demand curve will shift to D’ as shown in figure 8.3. The new equilibrium is P2, Q2 where a new balance between demand and supply is established.

Effect of an Increase in Market Demand
The increase in demand resulted in a higher equilibrium price, P2 and a greater equilibrium quantity, Q2. P2 has rationed the typical person’s demand so that only q2 is demanded rather than the q’1 that would have been demanded at P1. P2 also signals the typical firm to increase production from q1 to q2.

Shifts in Demand Curves
Demand will increase, shift outward, because Income increases The price of a substitute rises The price of a complement falls Preferences for the good increase

Shifts in Demand Curves
Demand will decrease, shift inward, because Income falls The price of a substitute falls The price of a complement rises Preferences for the good diminish

Shifts in Supply Curves
Supply will increase, shift outward, because Input prices fall Technology improves Supply will decrease, shift inward, because Input prices rise

Table 8.1: Reasons for a Shift in a Demand or Supply Curve

Short-Run Supply Elasticity
The short-run elasticity of supply is the percentage change in quantity supplied in the short run in response to a 1 percent change in price.

Short-Run Supply Elasticity
If a 1percent increase in price causes firms to increase quantity supplied by more than 1 percent, supply is elastic. If a 1 percent increase in price causes firms to increase quantity supplied by less than 1 percent, supply is inelastic.

Shits in Supply Curves and the Importance of the Shape of the Demand Curve
The effect of a shift in supply upon equilibrium levels of P and Q depends upon the shape of the demand curve. If demand is elastic, as in Figure 8.4 (a), a decrease in supply has a small effect on price but a relatively large effect on quantity. If demand is inelastic, as in Figure 8.4 (b), the decrease in supply has a greater effect on price than on quantity.

FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve
Price Price S S D P P D Quantity per week Q Q Quantity per week (a) Elastic Demand (b) Inelastic Demand

FIGURE 8.4: Effect of a Shift in the Short-Run Supply Curve on the Shape of the Demand Curve
Price Price S’ S S P’ P’ D P P D Q’ Quantity per week Q’ Q Q Quantity per week (a) Elastic Demand (b) Inelastic Demand

Shifts in Demand Curves and the Importance of the Shape of the Supply Curve
The effect of a shift in demand upon equilibrium levels of P and Q depends upon the shape of the supply curve. If supply is inelastic, as in Figure 8.5 (a), the effect on price is much greater than on quantity. If the supply curve is elastic, as in Figure 8.5 (b), the effect on price is relatively smaller than the effect on quantity.

Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve
Price Price S P’ P P D D Quantity per week Q Quantity per week Q (a) Inelastic Supply (b) Elastic Supply

Figure 8.5: Effect of A shift in the Demand Curve Depends on the Shape of the Short-Run Supply Curve
Price Price S P’ P’ P P D’ D’ D D Quantity per week Q Q’ Quantity per week Q Q’ (a) Inelastic Supply (b) Elastic Supply

APPLICATION 8.2: Ethanol Subsidies in the United States and Brazil
Ethanol has potentially desirable properties as a fuel for automobiles or additive to gasoline that may reduce air pollution. Several governments have adopted subsides to producers of ethanol. One way to show the effect of a subsidy is to treat it as a shift in the short-run supply curve as shown in Figure 1.

APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price
($/gallon) S1 P1 D Q1 Quantity (million gallons)

APPLICATION 8.2: Figure 1: Ethanol Subsidies Shift the Supply Curve Price
($/gallon) S1 S2 P1 P2 Subsidy D Q1 Q2 Quantity (million gallons)

The subsidy shifts out the supply curve (by about 54 cents-a-gallon in the U.S.) which results in a quantity demanded increase from Q1 to Q2. The total cost of the subsidy depends upon the per-gallon amount and on the amount of the increase in quantity demanded.

In the U.S. it is made from corn, and the subsidy is primarily found in Iowa where many major corn producers are located. In Brazil it is made from sugar cane and was heavily subsidized until Economic liberalization in the 1990s. Due to political pressure from producers, the subsidy is again being proposed.

A Numerical Illustration
Suppose the quantity of cassette tapes demanded per week (Q) depends on the price of the tapes (P) per equation 8.2, Suppose short-run supply is given by equation 8.3.

Figure 8.6 shows the graph for these equations. Since the supply curve intersects the vertical axis at P = 2, this is the shutdown price. The equilibrium price is $6 with people demanding 4 tapes which equals the amount supplied by the firms.

FIGURE 8.6: Demand and Supply Curves for Cassette Tapes
Price S 10 6 2 D 4 10 Tapes per week

If the demand increased as reflected in equation 8.4, the former equilibrium price and quantity would no longer hold. As shown in Figure 8.6, the new equilibrium price is $7 where the quantity demanded and supplied of tapes is 5.

FIGURE 8.6: Demand and Supply Curves for Cassette Tapes
Price $12 S 10 7 6 5 2 D’ D 3 4 5 6 10 12 Tapes per week

Table 8.2 shows the two cases. After the increase in demand, there is an excess demand for tapes at the old equilibrium price of $6. The increase in price from $6 to $7 restores equilibrium in the market.

TABLE 8.2: Supply and Demand Equilibrium in the Market for Cassette Tapes
New equilibrium Initial equilibrium

The Long Run Long run supply responses are much more flexible than in the short run. Long-run cost curves reflect greater input flexibility. Firms can enter and exit the market in response to profit opportunities.

Equilibrium Conditions
In a perfectly competitive equilibrium, no firm has an incentive to change its behavior. Firms must be choosing the profit maximizing level of output. Firms must be content to stay in or out of the market.

Profit Maximization It is assumed that the goal of each firm is to maximize profits. Since each firm is a price taker, this implies that each firm product where price equals long-run marginal cost. This equilibrium condition, P = MC determines the firm’s output choice and its choice of inputs that minimize their long-run costs.

Entry and Exit The perfectly competitive model assumes that firms entail no special costs when they exit and enter the market. Firms will be enticed to enter the market when economic profits are positive. Firms will leave the market when economic profits are negative.

Entry and Exit Entry will cause the short-run market supply curve to shift outward causing the market price to fall. This will continue until positive economic profits are no longer available. Exit causes the short-run market supply curve to shift inward causing the market price to increase, eliminating the economic losses.

Long-Run Equilibrium For purposes of this chapter, it is assumed that all firms producing a particular good have identical cost curves. Thus, in the long-run equilibrium all firms earn zero economic profits. Firms will produce at minimum average total costs where P = MC and P = AC.

Long-Run Equilibrium P = MC results from the assumption that firm’s are profit maximizers. P = AC results because market forces cause long run economic profits to equal zero. In the long run, firm owners will only earn normal returns on their investments.

Long-Run Supply: The Constant Cost Case
The constant cost case is a market in which entry or exit has no effect on the cost curves of firms. Figure 8.7 demonstrates long-run equilibrium for the constant cost case. Figure 8.7 (b) shows that market where the market demand and supply curves are D and S, respectively, and equilibrium price is P1.

FIGURE 8.7: Long-Run Equilibrium for a Perfectly Competitive Constant Market: Cost Case
Price Price SMC MC S AC P1 D q1 Output Q1 Quantity per week (a) Typical Firm (b) Total Market

Price Price SMC MC S AC P2 P1 D D q1 q2 Output Q1 Quantity per week Q2 (a) Typical Firm (b) Total Market

Price Price SMC MC S AC S’ P2 P1 LS D D q1 q2 Output Q1 Q3 Quantity per week Q2 (a) Typical Firm (b) Total Market

Long-Run Supply: The Constant Cost Case
The typical firm will produce output level q1 which results in Q1 in the market. The typical firm is maximizing profits since price is equal to long-run marginal cost. The typical firm is earning zero economic profits since price equals long-run average total costs. There is no incentive for exit or entry.

A Shift in Demand If demand increases to D’, the short-run price will increase to P2. A typical firm will maximize profits by producing q2 which will result in short-run economic profits (P2 > AC). Positive economic profits cause new firms to enter the market until economic profits again equal zero.

A Shift in Demand Since costs do no increase with entry, the typical firm’s costs curves do not change. The supply curve shifts to S’ where the equilibrium price returns to P1 and the typical firm produces q1 again. The new long-run equilibrium output will be Q3 with more firms in the market.

Long-Run Supply Curve Regardless of the shift in demand, market forces will cause the equilibrium price to return to P1 in the long-run. The long-run supply curve is horizontal at the low point of the firms long-run average total cost curves. This long-run supply curve is labeled LS in Figure 8.7 (b).

APPLICATION 8.3: Movie Rentals
Movies have been available for home rental since the 1920s. The basic rental business has consistently exhibited the characteristics of a constant cost industry. By the end of the 1980s, more than 70% of U.S. households owned VHS tape players. At first the rental industry was quite profitable, but there were no significant barriers to entry.

Because inputs used by the industry (low-wage workers and simple rental space) were readily available at market prices, the industry had a perfectly elastic long-run supply curve – it could easily meet exploding demand with no increase in price. The number of tape rental outlets grew fourfold and the standard price for rental of a movies fell to about $1.50 per night.

Introduction of DVD technology in the mid-1990s followed a similar path. Once a critical threshold of households owned DVD players, the rental market for movies on DVD emerged quickly. Again, the absence of barriers to entry together with the ready availability of inputs resulted in a close approximation to the constant cost model.

This elastic supply response has also dictated a strict market test for innovations in the movie rental business – such innovations must be cost-competitive with existing methods of distribution or they will not be adopted. The fate of “Divx” technology provides an instructive example. Because consumers had to purchase special equipment, Divx gained few adherents and was largely abandoned by the start of 1999.

Shape of the Long-Run Supply Curve: The Increasing Cost Case
The increasing cost case is a market in which the entry of firms increases firms’ costs. New firms may increase demand for scarce inputs driving up their prices. New firms may impose external costs in the form of air or water pollution. New firms may place strains on public facilities increasing costs for all firms in the market.

FIGURE 8.8: Increasing Costs Result in a Positively Sloped Long-Run Supply Curve
Price Price Price SMC S MC SMC D AC MC P2 AC P3 P3 P1 P1 2 q1 q2 Output q3 Output Q1 Quantity per week Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

Price Price Price D’ SMC S MC SMC D AC P2 MC P2 AC P1 P1 2 q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

Price Price Price D’ SMC S S’ MC SMC D AC LS P2 MC P2 AC P3 P3 P1 P1 2 q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

The Increasing Cost Case
This case is shown in Figure 8.8, where the initial equilibrium price is P1 with the typical firm producing q1 with total output Q1. Economic profits are zero. The increase in demand to D’, with short-run supply curve S, causes equilibrium price to increase to P2 with the typical firm producing q2 resulting in positive profits.

The Increasing Cost Case
The positive profits entice firms to enter which drives up costs. The typical firm’s new cost curves are shown in Figure 8.8 (b). The new long-run equilibrium price is P3 with market output Q3. The long-run supply curve, LS, is positively sloped because of the increasing costs.

Long-Run Supply Elasticity
The long-run elasticity of supply is the percentage change in quantity supplied in the long run in response to a 1 percent change in price.

TABLE 8.3: Estimated Long-Run Supply Elasticities

The Decreasing Cost Case
The decreasing cost case is a market in which the entry of firms decreases firms’ costs. Entry may produce a larger pool of trained labor which reduces the costs of hiring. Entry may provide a “critical mass” of industrialization that permits the development of more efficient transportation, communications, and financial networks.

The initial equilibrium is shown as P1, Q1 in Figure 8.9 (c). The increase in demand from D to D’ results in the short-run equilibrium, P2, Q2 where the typical firm is earning positive economic profits. Entry drives down costs for the typical firm, as shown in Figure 8.9 (b).

FIGURE 8.9: Decreasing Costs Result in a Negatively Sloped Long-Run Supply Curve
Price Price Price S SMC D P2 MC AC SMC MC P1 AC P1 2 q1 Output Output Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

Price Price Price S D’ SMC D P2 MC P2 AC SMC MC P1 AC P1 2 q1 q2 Output Output Q2 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

Price Price Price D’ S SMC D P2 MC P2 S’ AC SMC MC P1 AC P1 2 P3 P3 LS q1 q2 Output q3 Output Q2 Q3 Q1 Quantity per week (a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market

Entry continues until short-run economic profits are eliminated. The new long-run equilibrium is P3, Q3 as shown in Figure 8.9 (c). The long-run supply curve is downward sloping due to the decreasing costs as labeled LS in Figure 8.9 (c).

APPLICATION 8.4: How Do Network Externalities Affect Supply Curves?
Network externalities occur when additional users cause network costs to decline. Subject to Metcalfe’s Law which states that the number of interconnections possible in a given communications network expands with the square of the number of subscribers in the network.

These cause negatively sloped long-run supply curves. This can cause lower consumer prices when demand expands. Industries subject to network externalities include telecommunications, computer software, and the Internet.

Telecommunications Most of the gains in developed countries have been realized, but remain for less developed. Computer Software As adoption grows, lower learning costs for users. These benefits may explain why software companies are not too concerned with pirating.

The Internet Since anything that can be encoded in digital format can be shared over the network, benefits for specialized groups can also be realized. This, along with the improved storage capacity of computers, makes it possible to provide specific types of services that where cost prohibitive before the Internet.

Infant Industries Initially the cost of production of a new product may be very high. As the pool of skilled workers grows, costs may decline. It is often argued that these “infant” industries must be protected from lower-cost foreign competition until they reach the lower cost portion of their supply curves.

Consumer Surplus Consumer surplus is the extra value individuals receive from consuming a good over what they pay for it. Alternatively, it is what people would be willing to pay for the right to consume a good at its current price.

Consumer Surplus In Figure 9.1, the equilibrium price and quantity are P* and Q*. The demand curve, D, shows what people are willing to pay for the good. The total value of the good to buyers is given by the area below the demand curve from Q = 0 to Q = Q* (AEQ*0).

FIGURE 9.1: Competitive Equilibrium and Consumer/Producer Surplus
Price A S P* E D B Q* Quantity per period

Consumer Surplus Consumers expenditures for Q* are given by the area P*EQ*0. Consumers receive a “surplus” (total value less what they pay) equal to the area AEP*, which is shaded gray in Figure 9.1.

Producer Surplus Producer surplus is the extra value producers get for a good in excess of the opportunity costs they incur for producing it. It can also be defined as what all producers would pay for the right to sell a good at its current market price.

Producer Surplus At the equilibrium shown in Figure 9.1, producers receive total revenue equal to the area P*EQ*0. If producers sold one unit at a time at the lowest possible price, producers would have been willing to produce Q* for the payment of BEQ*0.

Producer Surplus Thus, producer surplus the the area P*EB shaded in green in Figure 9.1.

Short-Run Producer Surplus
The positive slope of the short-run supply curve, S, in Figure 9.1 results from the diminishing returns to variable inputs that are encountered as output is increased. For production up to Q*, price exceeds marginal cost, so total short-run profits equal the area P*EB less fixed costs

Short-Run Producer Surplus
Producer surplus, the area P*EB, reflects the sum of total short-run profits and short-run fixed costs. Short-run producer surplus is the part of total profits that is in excess of the profits firms would have if they chose to produce nothing at all. As such, it is similar to consumer surplus.

Long-Run Producer Surplus
Since long-run economic profits are zero and there are no fixed costs in the long-run, producer surplus is much different in the long run. The positive slope of the long-run supply curve reflects increasing input costs as output is expanded.

Long-Run Producer Surplus
Consider the area P*EB in Figure 9.1 as long-run producer surplus. It measures all of the increased payments relative to the situation in which the industry produces no output. The inputs would have received lower prices if this industry had not produced output.

Ricardian Rent Ricardian rent is the long-run profits earned by owners of low-cost firms. It may be capitalized into the prices of these firms’ inputs. Assume there are many parcels of land on which tomatoes might be grown. These farms range from very fertile land (low cost) to poor, dry land (high cost).

Ricardian Rent At low prices, only the most fertile land is used.
As output increases, higher-cost plots of land are brought into production because higher prices make this land profitable. The long-run supply curve is positively sloped because of the increasing costs associated with using less fertile land.

Ricardian Rent The market equilibrium price and quantity, P*, Q*, are shown in Figure 9.2 (d). Low-cost farms, Figure 9.2 (a) and medium-cost farms, Figure 9.2 (b), earn long-run economic profits. Marginal farms, Figure 9.2 (c) earn zero economic profits

FIGURE 9.2 (d): The Market Price S P* E D B Q per Q* period

FIGURE 9.2 (a): Low-Cost Farm
Price MC AC P* q* q per period

FIGURE 9.2 (b): Medium-Cost Farm
Price AC P* q per period q*

FIGURE 9.2 (c): Marginal Farm
Price MC AC P* q* q per period

FIGURE 9.2: Ricardian Rent
Price Price MC AC MC AC P* P* q* q per q* q per period period (a) Low-Cost Farm (b) Medium-Cost Farm Price Price MC AC S P* P* E D B q* q per Q* Q per period period (c) Marginal Farm (d) The Market

Ricardian Rent Profits earned by the intramarginal farms can persist in the long run because they reflect the returns to a scarce resource, low-cost land. Entry can not erode these profits because of the scarcity of the low-cost land. The sum of these long run profits (P*EB) is the producer surplus ( Ricardian rent).

Economic Efficiency The competitive equilibrium is efficient in that it produces the largest surplus equal to the sum of producer and consumer surplus. In Figure 9.1, an output level of Q1 results in a loss of surplus equal to the area FEG. Consumers would be willing to pay P1 for a good that producers are willing to produce for P2, so mutually beneficial transactions exit.

Price A S F P1 P* E P2 G D B Q1 Q* Quantity per period

APPLICATION 9.1: Does Buying Things on the Internet Improve Welfare?
Transaction costs associated with conducting business on the internet have been reduced due to Technical innovations significant network externalities. Prior to this, transaction costs exceed the difference between consumers’ willingness to pay and producers costs.

Prior to the decline in internet costs, transaction costs exceeded P2 - P1 in Figure 1, so no transactions occurred. Assuming transaction costs fell to zero, trading would start and a competitive equilibrium would occur at P*, Q*.

FIGURE 1: Reduced Transaction Costs Promote Internet Commerce
Price P 2 S P* P 1 D Quantity Q*

Some early evidence Electronic retailing directly to consumers totaled about $20 billion in 2001. Business to business sales represented another $50 to $75 billion. Most sales are in travel-related goods, on-line financial services, and some narrow categories of consumer goods such as books.

Retailers as Infomediaries The role for retailing “middlemen” on the internet is to provide information to the consumer. Internet automobile sellers provide comparative information about the features of cars and point to dealers with the best price. Internet airline services search for the lowest price or most convenient departure.

A Numerical Example The market equilibrium is P* = $6 and Q* = 4.
The equilibrium is shown as point E in Figure 9.3. At point E consumers are spending $24 ($6·4).

A Numerical Example At point E in Figure 9.3, consumer surplus is $8 (= ½·$4·4). Producers also gain a producer surplus of $8 at point E. Total consumer and producer surplus is $16. If price stays at $6 but output falls to 3, total surplus falls to $15.

FIGURE 9.3: Efficiency in Tape Sales
Price 10 S 6 E D 2 1 2 3 4 5 Tapes per period

A Numerical Example For any output level, total surplus is the area between the demand and supply curves out to that level of output. Once output is specified, the price affects the distribution of the surplus between producers and consumers, but does not affect the total amount of the surplus.

A Numerical Example If output > 4 tapes per period with P = $6, total surplus is less than $16. At Q = 5, consumer surplus falls to $7.50. $8 for four tapes less $.50 because the fifth tapes sells for more than people want to pay for the fifth tape. Producer surplus also equals $7.50 reflecting the loss of $.50 on the production of the fifth tape. Total surplus is $15 for Q = 5 tapes per week.

Price Controls and Shortages
In Figure 9.4 the market initially is in equilibrium at P1, Q1 (point E). Then demand increases from D to D’. This would cause price to rise to P2 encouraging entry in the short-run. Eventually entry would bring the price down to P3 and the market would be in long-run equilibrium.

FIGURE 9.4: Price Controls and Shortages
SS LS P 1 E D Q Quantity 1 per period

SS LS P 2 P 3 E’ P 1 E D’ D Q Q Q Quantity 1 2 3 per period

Suppose the government imposed a price control at the below equilibrium price of P1 when demand increased. Firms would only supply Q1 and no entry would take place. Since customers would demand Q4 at this price, there would be a shortage of Q4 - Q1.

The welfare consequences of price control can be analyzed using consumer and producer surplus. Consumers would gain surplus of P3CEP1 (colored in gray) due to the lower price. This is a direct transfer of surplus from producers to consumers with no gain in total surplus.

SS A LS P 2 C P 3 E’ P 1 E D’ D Q Q Q Quantity 1 3 4 per period

If output had expanded, consumers would gain the area AE’C. Since output is reduced by the price control, this is a loss of surplus to consumers. Similarly, producers don’t gain the area CE’E that would have resulted from increased output. The area AE’E is the total welfare loss.

Application 9.2: Rent Control: Why This Bad Idea Never Dies
History of Rent Control Controls were adopted in man U.S. and European cities in response to rapidly rising rents during World War II which continued after the war in several European countries and New York City. Inflation of the 1970s resulted in several U.S. cities introducing more “flexible” rent controls More than 10 percent of U.S. rentals are controlled.

Rent Control and Housing Quality Studies have confirmed the prediction that rent controls will benefit current tenants and harm landlords and new tenants. However, the most important effect is that landlords effectively reduce the supply of housing by reducing the quality of their units.

Effects of the “New” Rent Control Laws By allowing landlords to pass on increases in taxes or utility costs, post World War II laws were more flexible. Many also allow rents to be increased to market levels when current tenants leave. Some economists suggest that such laws help to deal with the landlords market power, but few economists support this position.

Tax Incidence The study of the final burden of a tax after considering all market reactions to it is tax incidence theory. The incidence of a “specific tax” of a fixed amount per unit of output that is imposed on all firms in a constant cost industry is illustrated in Figure 9.5

FIGURE 9.5: Effect of the Imposition of a Specific Tax on a Perfectly Competitive Constant Cost Industry Price Price S’ S SMC MC P 4 AC P 3 P 1 LS P 2 Tax D D’ q2 q1 Output Q Q Q Quantity 3 2 1 per week (a) Typical Firm (b) The Market

Tax Incidence Since for any price, P, consumers pay the firm gets to keep P - t (where t is the per unit tax), the effect of the tax on firms can be shown as a decrease in demand. The vertical distance between the demand curves is t. It creates a wedge between the consumers’ price, P, and the price firms receive.

Short-Run Tax Incidence
The short-run effect is to decrease output from Q1 to Q2, where firms receive P2 and consumers pay P3 (P3 - P2 = t). So long as P2 is above minimum variable costs, the firm continues to produce and the tax incidence is shared by consumers, whose price increased to P3, and by firm’s who now receive only P2 rather than P1.

Long-Run Tax Incidence
Firms will not operate at a loss in the long run, so exit will take place shifting the short-run supply curve back to S’. In the new long-run equilibrium, output will return to Q3 where the firm’s will receive P1 again and consumers will pay P4. The long-run tax incidence is all on the consumer although the firms pays the tax.

Long-Run Incidence with Increasing Costs
When the long-run supply curve has a positive slope, both consumers and firms pay a portion of the tax. The imposition of the tax shifts the long-run demand curve inward to D’ (as shown in Figure 9.6) which causes the price to fall from P1 to P2 as some firms exit and input prices fall.

FIGURE 9.6: Tax Incidence in an Increasing Cost Industry
Price LS A P 3 P E 1 B 1 P 2 E 2 Tax D D’ Q Q Quantity 2 1 per period

Long-Run Incidence with Increasing Costs
Consumers pay a portion of the tax since the gross price of P3 exceeds the pre-tax price. Total tax collection is the gray area P3ARE2P2. The inputs to the firm pay the remainder of the tax as they are not paid based on a lower net price of P2.

Incidence and Elasticity
The economic actor who has the most elastic curve will be able to avoid more of the tax leaving the actor with the more inelastic curve to pay most of the tax. If demand is relatively inelastic and supply is elastic, demanders will pay most of the tax. If supply is relatively inelastic and demand is elastic, suppliers will pay most of the tax.

APPLICATION 9.3: The Tobacco Settlement Is Just a Tax
In November 1998 most U.S. states reached agreements with the tobacco companies that amounted to about $200 billion. The Tobacco Settlement as a Tax Increase. This can be treated as an increase in cigarette taxes. The settlement added about $0.30 per pack, a 15 percent increase on the initial $3.00 price.

The Tobacco Settlement as a Tax Increase
With an elasticity of demand of (Table 4.4), the quantity of cigarettes sold would be expected to fall by about 5.25 percent (0.350.15) from 24 billion packs per year to billion packs. Total “tax collections” would be about $6.8 billion per year.

The Tobacco Settlement as a Tax Increase
If tobacco companies continue to earn about $0.25 per pack, the 1.25 billion reduction in sales will cost them about $300 million per year. Thus, consumers pay most of the “tax” resulting from this settlement. Since tobacco consumers tend to have relatively low incomes, the tax is regressive.

Other Effects of the Settlements
Empirical evidence suggests that young smokers may have a larger price elasticity. The goal of a decline in smoking by young people may be obtained. Also, studies suggest that individuals who do not smoke as teenagers are much less likely to smoke later. In addition, advertising aimed at young people was sharply restricted.

Other Effects of the Settlements
Special interest also benefited. Many states adopted programs to aid tobacco farmers who were affected by the decline in tobacco sales. The smallest tobacco company (Liggett) provided evidence for the states, and the higher cigarette prices will increase its profits. The lawyers who represented the states each received between $1 - $2 million per year.

Taxation and Efficiency
Taxes reduce output of the taxed commodities and a reallocation of production to other areas. Reallocation means that some mutually beneficial transactions will be foregone so economic welfare will decline.

In Figure 9.6, the total loss of consumer surplus is the area P3AE1P1. The area P3ABP1 is transferred into tax revenue and the area AE1B is simply lost. The loss in producer surplus is P1E1E2P2 of which P1BE2P2 is tax revenue and BE1E2 lost.

The effect of the transfer into tax revenue on welfare is ambiguous since consumers and producers may benefit from government expenditures. However, the deadweight loss is the losses of consumer and producer surplus that are not transferred to other parties. This is also called the “excess burden” of a tax.

Using the supply-demand equilibrium in the market for cassette tapes, suppose the government implements a $2 per tape tax that retailers add to the sales price of each tape sold.

Demanders, on the other hand, must pay P + t for each tape so the demand function becomes:

Equilibrium requires supply equal demand. or P* = 5, Q* =3. Consumers pay $7 for each tape and total tax collections are $6 per week. Total consumer and producer surplus is decreased by $6 of tax revenue and the excess burden is $1.

Transactions Costs Transaction costs, such as a real estate broker fee, also cause a wedge between buyers’ and sellers’ prices. To the extent that transaction costs are on a per-unit basis, the same analysis as with a tax applies, so both parties bear some of the cost and output will be reduced.

Transactions Costs If the wedge is a lump-sum amount per transaction, such as the cost of driving to the supermarket to buy groceries, the individual will seek to reduce the number of transactions. While prices will not change significantly, persons will hold larger inventories to reduce their transaction costs.

Gains from International Trade
Figure 9.7 shows the domestic demand and supply curves for a particular good, say shoes. Without international trade, the equilibrium price and quantity would be PD, QD. If the world shoe price is PW, the opening of trade will cause prices to fall causing quantity to increase to Q1.

Gains from International Trade
The quantity supplied by domestic producers will fall to Q2 with shoe imports of Q1 - Q2. Consumer surplus increases by the area PDE0E1PW. Part, PDE0APW, comes as a transfer from domestic producers, and the rest is an unambiguous gain in welfare (E0E1A).

FIGURE 9.7: Opening of International Trade Increases Total Welfare
Price LS P E D E P 1 W A D Q Q Q Quantity 2 D 1 per period

Tariff Protection Producers will resist their losses, and since the loss is spread over fewer producers than the gain for consumers, they have a stronger incentive to organize for trade protection. A major trade protection is a tariff which is a tax on an imported good. Effects of a tariff are shown in Figure 9.8.

FIGURE 9.8: Effects of a Tariff
Price LS E P B 2 R E P 1 W C F A D Q Q Q Q Quantity 2 4 3 1 per period

Tariff Protection Compared to the free trade equilibrium E1, the imposition of a per-unit tariff in the amount of t raises the effective price to PW + t = PR. Quantity demanded falls to Q3 while domestic production expands to Q4. Tariff revenue is the area BE2FC, equal to t(Q3 - Q4).

Tariff Protection Total consumer surplus is reduced by the area PRE2E1PW. Part becomes tariff revenue and part is transferred into domestic producer’s surplus (area PRBAPW). The two colored triangles BCA and E2E1F represent losses that are not transferred; these are the deadweight losses from the tariff.

Other Types of Trade Protection
Because of the General Agreement on Tariffs and Trade (GATT), there has been a decline in tariffs. However, other restrictive measures including quotas, “voluntary” export restrains, and a series of nonquantitative restrictions have been used for protectionism.

A quota that limits imports to Q3 - Q4 (in Figure 9.8) would have a similar effect to a tariff. Market price would rise to PR. Consumer surplus would be transferred to domestic producers (area PRBAPW). A deadweight loss equal to the areas of the colored triangles would also occur.

However, with a quota, no tax revenue is generated. The area BE2FC can go to foreign producers or to windfall gains to owners of import licenses. Nonquantitative restrictions such as health or other inspections also impose costs like a a tariff on imports, and can be analyzed in a similar manner using Figure 9.8.

APPLICATION 9.4: The Endless Saga of Steel Protectionism
On March 6, 2002, President Bush announced that the U.S. would adopt a “temporary” tariff on steel imports. This tariff amounted to 30% on many major steel products. Other products were taxed at somewhat lower rates (8 to 15 percent).

It would be hard to find an industry that has had the degree of special protection from trade pressures that has characterized the U.S. steel industry. Over the past 30 years, the industry has succeeded in obtaining the following protectionist measures: Import quotas Minimum price agreements with exporters “Voluntary” export restraints by nations that import into the U.S.

Economists concluded that the costs of the 2002 tariffs to the overall economy could be quite large. Estimated tariff revenues are about $900 million annually; gains in domestic producer surplus might amount to another $700 million. Balanced against this would be estimated losses of about $2.5 billion in consumer surplus. There might then be an annual deadweight loss of perhaps $900 million from the tariffs.

Monopoly A market is described as a monopoly if there is only one producer. This single firm faces the entire market demand curve. The monopoly must make the decision of how much to produce. The monopoly’s output decision will completely determine the good’s price.

Causes of Monopoly Barriers to entry which are factors that prevent new firms from entering a market are the source of all monopoly power. There are two general types of barriers to entry Technical barriers Legal barriers

Technical Barriers to Entry
A primary technical barrier is when the firm is a natural monopoly because it exhibits diminishing average cost over a broad range of output levels. Hence, a large-scale firm is more efficient than a small scale firm. A large firm could drive out competitors by price cutting.

Technical Barriers to Entry
Other technical barriers to entry. Special knowledge of a low-cost method of production. Ownership of a unique resource. Possession of unique managerial talents.

Legal Barriers to Entry
Pure monopolies can be created by law. The basic technology for a product can be assigned to only one firm through a patent. The rational is that it makes innovation profitable and encourages technical advancement. The government can award an exclusive franchise or license to serve a market. This may make it possible to ensure quality standards

APPLICATION 10.1: Should You Need a License to Shampoo a Dog?
State governments license many occupations and impose penalties for those who run a business without a license. Specific examples include: Dry Cleaning in California Perspective dry-cleaners must take a licensing exam which may require attending a school. Profits are higher than in other states. Existing firms are staunch defenders of the law.

APPLICATION 10.1: Should You Need a License to Shampoo a Dog?
Liquor Stores Currently 16 states operate liquor-store monopolies. In 34 other states, liquor stores are licensed and subject to restrictions on pricing and advertising. States with licenses have higher prices. Existing owners are most stringent supporters. Taxicabs Many cities limit number of taxicabs. In Toronto, prices are about 225 percent higher. New York city taxi medallions cost about $250,000.

Profit Maximization To maximize profits, a monopoly will chose the output at which marginal revenue equals marginal costs. The demand curve is downward-sloping so marginal revenue is less than price. To sell more, the firm must lower its price on all units to be sold in order to generate the extra demand.

A Graphic Treatment A monopoly will produce an output level in which price exceeds marginal cost. Q* is the profit maximizing output level in Figure 10.1. If a firm produced less than Q*, the loss in revenue (MR) will exceed the reduction in costs (MC) so profits would decline.

FIGURE 10.1: Profit Maximization and Price Determination in a Monopoly Market
MC Price AC E P* A C D MR Quantity Q* per week

A Graphical Treatment The increase in costs (MC)would exceed the gain in revenue (MR) if output exceeds Q*. Hence, profits are maximized when MR = MC. Given output level Q*, the firm chooses P* on the demand curve because that is what consumers are willing to pay for Q*. The market equilibrium is P*, Q*.

Monopoly Supply Curve With a fixed market demand curve, the supply “curve” for a monopoly is the one point where MR = MC (point E in Figure 10.1.) If the demand curve shifts, the marginal revenue curve will also shift and a new profit maximizing output will be chosen. Unlike perfect competition, these output, price points do not represent a supply curve.

Monopoly Profits Monopoly profits are shown as the area of the rectangle P*EAC in Figure 10.1. Profits equal (P - AC)Q*, If price exceeds average cost at Q* > 0, profits will be positive. Since entry is prohibited, these profits can exits in the long run.

Monopoly Rents Monopoly rents are the profits a monopolist earns in the long run. These profits are a return to the factor that forms the basis of the monopoly. Patent, favorable location, license, etc.. Others might be willing to pay up to the amount of this rent to operate the monopoly to obtain its profits.

What’s Wrong with Monopoly?
Profitability Monopoly power is the ability to raise price above marginal cost. Profits are the difference between price and average cost. In Figure 10.2, one firm earns positive economic profits (a) while the other (b) earns zero economic profits.

FIGURE 10.2: Monopoly Profits Depend on the Relationship between the Demand and Average Cost Curves
Price Price MC AC MC AC P* P*=AC AC D D MR MR Q* Quantity Q* Quantity per week per week (a) Monopoly with Large Profits (b) Zero-Profit Monopoly

What’s Wrong with Monopoly?
If monopoly rents accrue to inputs, the monopoly may appear to not earn a profit. People may also be concerned that economic profits go to the wealthy. However, as with the Navajo blanket monopoly, the profits of the low-income Navajo are coming from the more wealthy tourists.

APPLICATION 10.2: Who Makes Money at Casinos?
U.S. casinos take in about $50 billion each year in gross revenues. In some markets, casinos operate quite competitively…there are so many casinos in Las Vegas that it is unlikely that any one of them has much power to set prices monopolistically. However, many other locales have adopted such restrictions on the numbers and sizes of casinos that owners of these casinos are able to capture substantial monopoly profits.

Riverboat Gambling A number of states on the Mississippi River permit casino gambling only in riverboats. One clear impact of the way that riverboat gambling is regulated is to provide monopoly rents to a number of different parties. States are the primary beneficiaries – they usually tax net profits from riverboats at more than 30 percent. The owners of riverboats also make monopoly profits.

Indian Gaming The Indian Gaming Regulatory Act of 1988 clarified the relationship between state and the Indian tribes living within their borders. The Act made it possible for these tribes to offer casino gambling under certain circumstances. Since the passage of the Act, more than 120 tribes have adopted some form of legalized gambling. The distributional consequences of Indian gaming are generally beneficial.

What’s Wrong with Monopoly
Distortion of Resource Allocation Monopolists restrict their production to maximize profits. Since price exceeds marginal cost, consumers are willing to pay more for extra output than it costs to produce it. From societies point of view, output is too low as some mutually beneficial transactions are missed.

Distortion of Resource Allocation
In Figure 10.3 the monopolist is assumed to produce under conditions of constant marginal cost. Further, it is assumed that if the good where produced by a perfectly competitive industry, the long-run cost curve would be the same as the monopolist’s.

Distortion of Resource Allocation
In this situation, a perfectly competitive industry would produce Q* where demand equals long-run supply. A monopolist produces at Q** where marginal revenue equals marginal cost. The restriction in output (Q* - Q**) is a measure of the harm done by a monopoly.

FIGURE 10.3: Allocational and Distributional Effects of Monopoly
Price D MR P** B MC ( =AC) A Q** Quantity per week

Monopolistic Distortions and Transfers of Welfare
The competitive output level (Q* in Figure 10.3) is produced at price P*. The total value to consumers is the area DEQ*0 Consumers’ pay P*EQ*0. Consumer surplus is DEP*.

MR Price P** B E P* MC ( =AC) A Q** Q* Quantity per week

Allocational Effects A monopolist would product Q** at price P**.
Total value to the consumer is reduced by the area BEQ*Q**. However, the area AEQ*Q** is money freed for consumers to spend elsewhere. The loss of consumer surplus is BEA which is often called the deadweight loss from monopoly.

Price MR P** B E P* MC ( =AC) A Value of transferred inputs Q** Q* Quantity per week

Distributional Effects
In Figure 10.3 monopoly profits equal the area P**BAP*. This would be consumer surplus under perfect competition. It does not necessarily represent a loss of social welfare. This is the redistributional effects of monopoly that may or may not be desirable.

Price D MR P** B Transfer from consumers to firm E P* MC ( =AC) A Value of transferred inputs Q** Q* Quantity per week

Price D MR P** B Transfer from consumers to firm Deadweight loss E P* MC ( =AC) A Value of transferred inputs Q** Q* Quantity per week

Monopolists’ Costs Monopolists costs may be higher due to:
Resources spent to achieve monopoly profits such as ways to erect barriers to entry. Monopolists may expend resources for lobbying or legal fees to seek special favors from the government such as restrictions on entry through licensing or favorable treatment from regulatory agencies.

Monopolists’ Costs The possibility that costs may be higher for monopolists complicates the comparison of monopoly with perfect competition. Studies that have attempted to measure welfare losses from monopoly find estimates are sensitive to assumptions. Estimates range from as little as 0.5 percent of GDP to as much as 5 percent of GDP.

APPLICATION 10.3: Pricing Problems in Dallas
“People in the same trade seldom meet together even for merriment and diversion but the conversation ends … in some contrivance to raise prices” (Adam Smith) The CEO of American Airlines was taped in a conversation where he suggested that if Braniff Airway would raise prices, American Airlines would follow.

APPLICATION 10.3: Pricing Problems in Dallas
Later, American Airlines was accused of predatory pricing. It was accused of lowering prices to drive small carriers out of the market and then raise prices after the small firms leave. Unless prices are below average variable cost (a “shutdown standard”), this pricing behavior is not necessarily illegal.

A Numerical Illustration of Deadweight Loss
Table 10.1 repeats the information about the cassette tape market used as an illustration in previous chapters. If tapes have a $3 marginal cost, this would be the price under perfect competition. As shown in the Table, this would result in consumer surplus equal to $21.

TABLE 10.1: Effects of Monopolization on the Market for Cassette Tapes
Competitive Equilibrium: (P = MC) Monopoly equilibrium: (MR = MC)

A Numerical Illustration of Deadweight Loss
If the industry were a monopoly the firm would produce where marginal revenue equals marginal cost, an output of 4 units. As shown in the Table, this would result in $12 of monopoly profits and $6 of consumer surplus which totals $18. The deadweight loss is the difference between the $21 and the $18 or $3.

Price Discrimination Price discrimination occurs if identical units of output are sold at different prices. If the monopolist could sell its product at different prices to different customers, new opportunities exits as shown in Figure 10.4. Some consumer surplus still exists (area DBP**). The possibility of mutually beneficial trades exist as represented by the area BEA.

FIGURE 10.4: Targets for Price Discrimination
MR B P** E MC ( =AC) P* A Q** Q* Quantity per week

Perfect Price Discrimination
Perfect price discrimination is selling each unit of output for the highest price obtainable. The firm would sell the first unit at slightly below 0D (Figure 10.4), the next for slightly less, and so on until the firm reaches Q*, where a lower price would result in less profit. All consumer surplus (area P*DE) would be monopoly profit.

Perfect Price Discrimination
Since the monopolist would produce and sell Q* units of output, which is the competitive equilibrium. This pricing scheme requires a way to determine what each consumer would be willing to pay, and The monopolist must be able to stop consumers from selling to each other.

APPLICATION 10.4: Financial Aid at Private Colleges
Prior to the 1990s the U.S. government proposed a formula to determine a student’s need, and schools would offer such aid. Because the formula differed among colleges, the net price (family contribution) differed. The Overlap Group (23 prestigious colleges) negotiated the differences so that each college offered the same net price.

The U.S. Justice Department challenged this pricing scheme as price fixing. Although the schools signed a consent decree, they were exempted from the antitrust laws by the Higher Education Act of 1992.

Several innovative pricing schemes were put forth by schools in the 1990s. Several schools adopted sophisticated statistical models used to offer the lowest price necessary to get a particular student to accept an offer of admission. Schools using this approach come very close to perfect price discrimination.

Quantity Discounts Quantity discounts allow some sales at the monopolist’s price (P** in Figure 10.4), and sales beyond Q** at a lower price which increases profits. Examples include a second pizza for a lower price and supermarket coupons. The monopolist must keep customers who buy at lower prices to sell to customers at a price less than P**.

Two-Part Tariffs In this pricing scheme, customers must pay an entry fee for the right to purchase a good. A classic example is the pricing of movie popcorn. The entry fee, which should be set to obtain as much of the consumer surplus as possible, is the price of movie itself. Popcorn is then priced to maximize admission so long as the price exceeds cost.

APPLICATION 10.4: Pricing at the Magic Kingdom
During the 1960s Disneyland patrons had to purchase a “passport” containing a ticket for admission to the rides (see Table 1 for the structure of a typical passport). Because of higher labor costs, Disney switched to an entry fee with zero marginal prices for all rides.

TABLE 1: Structure of a Typical Disneyland Passport

APPLICATION 10.4: Pricing at the Magic Kingdom
Disney could also use other price discrimination practices such as reduced prices for multiday tickets. With ever-growing attractions and newer ticket technology (especially optical scanners) has allowed Disney to again price discriminate in a manner similar to their practices in the 1960s.

Market Separation If the market can be separated into two or more categories may be able to chare different prices. Figure 10.5 shows the separation into two markets. The profit-maximizing decision is to sell Q1* in the first market and Q2* in the second market where, in both cases, MR = MC.

FIGURE 10.5: Separated Markets Raise the Possibility of Price Discrimination
2 D 2 MC D 1 MR MR 1 2 Quantity in market 1 Q* Q* Quantity in market 2 1 2

Market Separation The two market prices will be P1and P2 respectively.
As shown in Figure 10.5, the price-discriminating monopolist will charge a higher price in the market with the more inelastic demand. Examples include book publishers charging higher prices in the U.S. or charging different prices for a movie in the day than at night.

Pricing for Multiproduct Monopolies
If a firm has pricing power in markets for several related products, other strategies can be used. Firms can require users of one product to also buy a related product such as coffee filters bought with coffee machines. Firms can also create pricing bundles such as option packages on cars or computers.

APPLICATION 10.6: Bundling of Satellite TV Offerings
Theory of Program Bundling Four consumer’s willingness to pay for either sports or movie programming is shown in Figure 1. Two, A and D, are willing to pay $20 per month for sports (A) or movies (D). B want sports but some movies and C wants movies with some sports.

FIGURE 1: Willingness to Pay for Cable TV Options
Movies 20 D C 15 B A 8 15 20 Sports

Charging $15 per each package would yield $60 from these customers. A bundling scheme that charges $20 per package, if purchased individually, or $23 if both are bought, would yield $86. Thus, revenue can be increased by the proper choice of pricing bundles of services.

Bundling by Direct TV, Inc. Bundling prices are shown in Table 1, where the incremental costs help to demonstrate the bundling price scheme. Notice adding sports costs $10 extra, but the full movie package adds $43 ($15 for Showtime and $28 for HBO/STARZ). Both packages together ($51) offers a minor savings over buying the separate packages.

TABLE 1: Sample Direct TV Program Options

Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma
By marginal cost pricing the deadweight loss from monopolies is minimized. However, this would require a natural monopoly to operate at a loss. A unregulated monopoly would produce QA at price PA in Figure 10.6, yielding a profit of PAABC.

FIGURE 10.6: Price Regulation for a Natural Monopoly
B C AC MC MR D Q Q Quantity A R per week

Marginal Cost Pricing Regulation and the Natural Monopoly Dilemma
Marginal cost pricing of PR which results in QR demanded would generate an a loss equal to the area GFEPR because PR < AC. Either marginal cost pricing must be abandoned or the government must subsidize the monopoly.

FIGURE 10.6: Price Regulation for a Natural Monopoly
B C F H G AC E P MC R J MR D Q Q Quantity A R per week

Two-Tier Pricing Systems
Under this system the monopoly is permitted to charge some users a high price and charge “marginal” users a low price. The regulatory commission might allow the monopoly to charge PA and sell QA to one class of buyers. Other users would pay PR and would demand QR - QA.

Two-Tier Pricing Systems
At total output of QR average costs are 0G. Under this system, monopoly profits (area PAAHG) balance the losses (area HFEJ). Here the “marginal user” pays marginal cost and is subsidized by the “intramarginal” user.

APPLICATION 10.7: Can Anyone Understand Telephone Pricing?
In January 1, 1984 AT& T formally divested itself of its seven local Bell Operating Companies as the result of a 1974 Department of Justice antitrust suit. The goal of the restructuring was to improve the performance and competitiveness of the U.S. telephone industry.

Subsidization of Local Phone Service Prior to the breakup, regulators forced AT&T to subsidize local residential phone services. They covered these losses by charging above-average costs on long distance calls. Residential services cost an average of $28 per month but the typical charge was $11.

After the breakup regulators had to choose between implementing huge increases in residential telephone rates or continuing subsidies. The politically expedient choice was to force AT&T and other to continue to subsidize local residential rates.

The Telecommunications Act of 1996 The government used this act to increase entry into the local phone market to try to reduce the monopoly power of local providers. This was attempted by specifying specific conditions under which these local companies could offer long distance service. To obtain this right, local companies had to sell services to potential entrants into their market.

Rate of Return Regulation
Regulators may permit a monopoly to charge a price above average cost that will earn a “fair” rate of return on investment. If the allowed rate exceeds that an owner might earn under competitive circumstances, the firm has an incentive to use relatively more capital input than needed to minimize costs.

Imperfect Competition
Pricing in these markets falls between perfect competition and monopoly. Three topics considered: Pricing of homogeneous goods in markets with few firms. Product differentiation in these markets. How entry and exit affect long-run outcomes in imperfectly competitive markets.

Pricing of Homogeneous Goods
In this market a relatively few firms produce a single homogeneous good. Assume demanders are price takers. Assume there are no transactions or informational costs. These assumptions result in a single equilibrium price for the good. Initially, assume a fixed, small number of identical firms.

Quasi-Competitive Model
A model of oligopoly pricing in which each firm acts as a price taker even though there may be few firms is a quasi-competitive model. As a price taker, a firm will produce where price equals long-run marginal costs. This equilibrium will resemble the perfectly competitive solution, even with few firms.

Quasi-Competitive Model
In Figure 11.1, the quasi-competitive equilibrium is PC (= MC), QC. This equilibrium represents the highest quantity and lowest price that can prevail in the long run given the demand curve D. A lower price would not be sustainable in the long run because it would not cover average costs.

FIGURE 11.1: Pricing under Imperfect Competition
Price C P MC C D MR Q Quantity C per week

Cartel Model A model of pricing in which firms coordinate their decisions to act as a multiplant monopoly is the cartel model. Assuming marginal costs are constant and equal across firms, the cartel output is point M (the monopoly output) in Figure 11.1. The plan would require a certain output by each firm and how to share the monopoly profits.

FIGURE 11.1: Pricing under Imperfect Competition
Price P M M P A A C P MC C D MR Q Q Q Quantity M A C per week

Cartel Model Maintaining this cartel solution poses three problems:
Cartel formations may be illegal, as it is in the U.S. by Section I of the Sherman Act of 1890. It requires a considerable amount of costly information be available to the cartel. The market demand function. Each firm’s marginal cost function.

Cartel Model The cartel solution may be fundamentally unstable.
Each member produces an output level for which price exceeds marginal cost. Each member could increase its own profits by producing more output than allocated by the cartel. If the cartel directors are not able to enforce their policies, the cartel my collapse.

APPLICATION 11.1: The De Beers Cartel
In the 1870s the discovery of the rich diamond fields in South Africa lead to major gem and industrial markets. After a competitive start, the ownership of the richest mines became incorporated into the De Beers Consolidated Mines which continues to dominate the world diamond trade.

Operation of the De Beers Cartel Since the 1880s diamonds found outside of South Africa are usually sold to De Beers who markets the diamonds to the final consumers through its central selling organization (CSO) in London. By controlling supply, the CSO maintains high prices which have been estimated to be as much as one thousand times marginal cost.

Dealing with Threats to the Cartel This large markup promotes threat of entry with any new diamond discovery. De Beers has used its market power to control would-be-chiselers. They drove down prices when the former Soviet Union and Zaire tried market entry in the 1980s. New finds in Australia were sold to the CSO rather than try to fight the cartel.

The Glamour of D Beers De Beers controls most print and television advertising, including “Diamonds Are Forever”. They convinced Japanese couples to adopt the western habit of buying engagement rings. De Beers has attempted to generate a brand name with customers to get consumers to judge De Beers diamonds superior to other suppliers.

The Cournot Model The Cournot model of duopoly is one in which each firm assumes the other firm;s output will not change if it changes its own output level. Assume A single owner of a costless spring. A downward sloping demand curve for water has the equation Q = P.

The Cournot Model As shown in Figure 11.2, the monpolist would maximize profit by producing Q = 60 with a price = $60 and profits (revenue) = $3600. Note, this output equals one-half of the quantity that would be demanded at a price of zero. Assume a second spring is discovered.

FIGURE 11.2: Spring Monopolist’s Output Choice
Price 120 60 MR D Output per week 60 120

Duopoly Model Cournot assumed that firm A, say, chooses its output level (qA) assuming the output of firm B (qB) is fixed and will not adjust to A’s actions. The total market output is given by

Duopoly Model If the demand curve is linear, the marginal revenue curve will bisect the horizontal axis between the price axis and the demand curve. Thus, the profit maximizing point is given by

Duopoly Model If firm B chooses to produce 60 units, firm A would choose 30 [=( )  2]. Equation 11.4 is called a reaction function which, in the Cournot model, is a function or graph that shows how much one firm will produce given what the other firm produces.

FIGURE 11.3: Cournot Reaction Functions in a Duopoly Market
120 Output of firm B(qB) Firm A’s reactions Output of firm A(qA) 60 120

Duopoly Model Firm A’s reaction function is shown in Figure 11.3.
Firm B’s reaction function is given below and also shown in Figure 11.3

120 Output of firm B(qB) Firm A’s reactions 60 Equilibrium Firm B’s reactions Output of firm A(qA) 60 120

Cournot Equilibrium The actions of the two firms are consistent with each other only at the point where the two lines intersect. The point of intersection is the Cournot equilibrium, a solution to the Cournot model in which each firm makes the correct assumption about what the other firm will produce.

120 Output of firm B(qB) Firm A’s reactions 60 Equilibrium 40 Firm B’s reactions Output of firm A(qA) 40 60 120

Cournot Equilibrium In this Cournot equilibrium each firm produces 40 units of output. Total industry profit is $3,200, $1600 for each firm). Because the firms do not fully coordinate their actions, their profits are less than the cartel profit ($3,600) but much greater than the competitive solution where P = MC = 0.

Price Leadership Model
A model in which one dominant firm takes reactions of all other firms into account in its output and pricing decisions is the price leadership model. A formal model assumes the industry is composed of a single price-setting leader and a competitive fringe which is a group of firms that act as price takers.

This model is shown in Figure 11.4. The demand curve D represents the total demand curve for the industry’s product. The supply curve SC represents the supply decisions of all the firms in the competitive fringe.

FIGURE 11.4: Formal Model of Price Leadership Model
SC D Quantity per week

The demand curve (D’) for the dominant firm is derived as follows: For a price of P1 or above the competitive fringe will supply the entire market. For a price of P2 or below, the dominant firm will supply the entire market. Between P2 and P1 the curve D’ is constructed by subtracting what the fringe will supply from the total market demand.

SC P 1 D’ P 2 D Quantity per week

Given D’, the leader’s marginal revenue curve is MR’ which equals the leader’s marginal cost (MC) at the profit maximizing level QL. Market price is PL and equilibrium output is QT (= QC + QL). The model does not explain how the leader is chosen.

SC P 1 D’ P L P 2 MC MR’ D Quantity per week Q Q Q C L T

APPLICATION 11.2: Cournot in California
Borenstein and Bushnell paper: Perhaps the most elaborate attempt at modeling the impact of electricity deregulation in California. Authors focus on competition between the three major electricity-generating firms. They argue that the smaller suppliers can be treated as competitive suppliers but that the major in-state producers behave in the way assumed in the Cournot model.

APPLICATION 11.2: Cournot in California
Borenstein and Bushnell show that under certain circumstances there is substantial market power in California wholesale electricity markets. One way to measure that power is by the Lerner Index, the ratio (P – MC/P). The authors showed with the Lerner Index that during peak periods, equilibrium in these markets is far from the competitive ideal. They also show that market power can be significantly restrained by larger price elasticities of demand for electricity.

Product Differentiation: Market Definition and Firms Choices
A product group is a set of differentiated products that are highly substitutable for one another. Assume few firms in each product group. Firms will incur additional costs to differentiate their product up to the point where the additional revenue from this activity equals the marginal cost.

Product Differentiation: Market Equilibrium
The demand curve for each firm depends on the prices and product differentiation activities of its competitors. The firm’s demand curve may shift frequently, and its position at any point in time may only be partially understood. Each firm must make assumptions about its competitors’ actions, and whatever one firm decides may affect its competitor’s actions.

APPLICATION 11.3: Price Leadership in Financial Markets
The Prime Rate at New York Commercial Banks Major New York commercial banks quote a “prime rate” which purports to be the interest rate that they charge on loans to their most creditworthy customers. Recent research indicates actual pricing is more complex, but the prime provides a visible and influential indicator or rate change.

While rates changes are sluggish, when “large” changes (0.25 or more) are required one of the major banks will act like a leader and announce a new prime rate on a trial basis. After a few days, either most banks will follow or the initiator will return to its old rate.

A number of researchers have found that rates tend to rise soon after an increase in bank costs, but decline only slowly when costs fall. Similarly, a rise in the prime tends to hurt the stock prices of banks that increase because the increase signals that profits hare being squeezed by costs. Alternatively, stock prices rise when the prime rate falls.

Price Leadership in the Foreign Exchange Market The large market for world currencies is dominated by major financial institutions and is heavily influenced by the “intervention” of various nations’ central banks. Because central bank intervention is not announced in advance, well informed traders may have an information market advantage.

In a study of the German Mark (DM), an author found that one bank tended to pay the role of leader in setting the DM/$ exchange rate. This leadership role arose because of the bank’s ability to foresee intervention by the German central bank in exchange markets. Quoted exchange rate between 25 and 60 minutes before the intervention were copied by other banks, while within 25 minutes (with information more diffused) no clear cut pattern emerged.

APPLICATION 11.4: Competition in Breakfast Space
Industrial Concentration Three major firms control approximately 80 percent of the market. Returns on invested capital are more than double those of the average industry. It is unclear why the market is not more competitive since there do not seem to be any major economies of scale and no obvious barriers to entry.

The FTC Complaint and Product Differentiation In 1972 the U.S. Federal Trade Commission (FTC) claimed the largest producers actions tended to establish monopoly-like conditions. Proliferation of new, highly advertised, brands left no room for potential new entrants. Brand identification also prevented new entrants from duplicating existing cereal.

Demise of the Legal Case Firms claimed that they were engaging in active competition by creating new cereal brands. Also, many new “natural” cereals did enter the market in the 1970s. The case was quietly dropped in 1982. Recent studies still indicate a lack of competition and continued higher profits.

One of illustrating the contention that major firms so proliferated their brands so as to keep potential competitors out was developed by S. Salop. Figure 1 depicts consumers evenly located along the circle which may represent an actual geographic space or product space. The presence of two firms (A and B) with two products each deters entry by C.

Application Figure 1: Salop’s Model of Spatial Competition.
B1 C . . B2 A2

Product Differentiation: Entry by New Firms
The degree to which firms can enter the market plays an important role. Even with few firms, to the extent that entry is possible, long-run profits are constrained. If entry is completely costless, long-run economic profits will be zero (as in the competitive case).

Monopolistic Competition
If firms are price takers, P = MR = MC for profit maximization. Since P = AC, if entry is to result in zero profits, production will take place where MC = AC (at minimum average cost). If, say through product differentiation, firms have some control over price, each firm faces a downward sloping demand curve.

Entry still may reduce profits to zero, but production at minimum cost is not assured. Monopolistic competition is a market in which each firm faces a negatively sloped demand curve and there are no barriers to entry. This type of market is illustrated in Figure 11.5.

FIGURE 11.5: Entry Reduces Profitability in Oligopoly
Price, costs d mr AC MC P* Quantity per week q*

Initially the demand curve is d, marginal revenue is mr, and q* is the profit-maximizing output level. If entry is costless, the entry shifts the firm’s demand curve inward to d’ where profits are zero. At output level q’, average costs are not minimum, and qm - q’ is excess capacity.

FIGURE 11.5: Entry Reduces Profitability in Oligopoly
Price, costs d mr AC MC d’ P* P’ mr’ Quantity per week q’ q* qm

Sustainability of Monopolistic Competition
Monopolistic competition focuses only on the behavior of actual entrants but ignores the effects of potential entrants. A broader perspective of the “ invisible hand” is the distinction between competition in the market and competition for the market.

Determination of Industry Structure
Let q* represent that output level for which average costs are minimized. Let Q* represent the total market for the commodity when price equals market (and average) cost. The number of firms, n, in the industry (which may be relatively small) is given by

Determination of Industry Structure
As shown in Figure 11.6, for example, only four firms fulfill the market demand Q*. The contestability assumption will ensure competitive behavior even though firms may recognize strategic relationships among themselves. The potential for entrants constrains the types of behavior that are possible.

FIGURE 11.6: Contestability and Industry Structure
Price AC AC AC AC 2 3 4 1 P* D Quantity per week q* 2* 3* Q* = 4* q q q

APPLICATION 11.4: Airline Deregulation Revisited
Airlines Contestability Since planes are mobile, they can be moved into a market that promises excess profits. Such potential entry should hold prices at competitive levels even with few firms. However, terminal facilities are market specific and brand loyalty appears to exist. Also, some major airports have limited potential for growth.

Effects of Deregulation Studies suggest that fares declined after deregulation with one study suggesting yearly gains to customers of about $8.6 billion. However, this study found that additional welfare gains of about $2.5 billion were not realized because of the limitations of landing slots and computer reservations systems may aid in price collusion among major airlines.

Trend in Airline Competition Many new airlines entered after the 1978 deregulation, but they were often consolidated into larger carriers. Several existing airlines went out of business. The hub-and-spoke designs of flight networks were introduced which has lead to dominance of one or two airlines in a hub city which may have resulted in higher fares.

Barriers to Entry The existence of barriers to entry change the type of analysis. In addition to those previously discussed, barriers include brand loyalty and strategic pricing. Firms may drive out potential entrants with low prices followed later by price increases or they may buy up smaller firms.

Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College © 2004 Thomson Learning/South-Western.

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Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College © 2004 Thomson Learning/South-Western.

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Presentation on theme: "Intermediate Microeconomics and Its Application 9th Edition by Walter Nicholson, Amherst College © 2004 Thomson Learning/South-Western."— Presentation transcript:

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