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LO3
Positive and Normative Economics
• Positive economics
• Deals with economic facts
• Normative economics
• A subjective perspective of the economy
1-1
LO4
Society’s Economizing Problem
• Scarce resources
• Land
• Labor
• Capital
• Entrepreneurial Ability
1-2
LO5
Production Possibilities Curve
Pizzas
Ind
ust
rial
Ro
bo
ts
Attainable
0 1 2 3 4 5 6 7 8 9
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Unattainable
A
B
C
D
E
U
The law of increasing opportunity costs makes the PPC concave.
1-3
LO6
Present Choices, Future Possibilities
Goods for the Present
Go
od
s fo
r th
e Fu
ture
Go
od
s fo
r th
e Fu
ture
Goods for the Present
P
F
Current Curve
Current Curve
Future Curve
Future Curve
Presentville Futureville
1-4
The Five Fundamental Questions
• What goods and services will be produced?
• How will the goods and services be produced?
• Who will get the goods and services?
• How will the system accommodate change?
• How will the system promote progress?
LO3 2-5
The Circular Flow System
RESOURCE MARKET
•Households sell •Businesses buy
PRODUCT MARKET
•Businesses sell •Households buy
BUSINESSES
• buy resources • sell products
HOUSEHOLDS
• sell resources • buy products
LO5 2-6
Changes in Demand
LO1
6
5
4
3
2
1
0
Quantity Demanded (bushels per week)
Pri
ce (
pe
r b
ush
el)
P
Q
D1
2 4 6 8 10 12 14 16 18
D2
D3
3-7
Determinants of Demand
LO1
Table 3.1 Determinants of Demand: Factors That Shift the Demand Curve
Determinant Examples
Change in buyers’ tastes Physical fitness rises in popularity, increasing the
demand for jogging shoes and bicycles; cell phone
popularity rises, reducing the demand for land-line
phones.
Change in the number of buyers A decline in the birthrate reduces the demand for
children’s toys.
Change in income A rise in incomes increases the demand for normal
goods such as restaurant meals, sports tickets, and
necklaces while reducing the demand for inferior
goods such as cabbage, turnips, and inexpensive
wine.
Change in the prices of related
goods
A reduction in airfares reduces the demand for bus
transportation (substitute goods); a decline in the price
of DVD players increases the demand for DVD movies
(complementary goods).
Change in consumer expectations Inclement weather in South America creates an
expectation of higher future coffee bean prices,
thereby increasing today’s demand for coffee beans. 3-8
Changes in Supply
LO2
$6
5
4
3
2
1
0
Pri
ce (
pe
r b
ush
el)
S1
Quantity supplied (thousands of bushels per week)
2 4 6 8 10 12 14 16
P
Q
S2
S3
Change in Quantity Supplied
Change in Supply
3-9
Determinants of Supply
LO2
Table 3.2 Determinants of Supply: Factors That Shift the Supply Curve
Determinant Examples
Change in resource prices A decrease in the price of microchips increases the
supply of computers; an increase in the price of crude
oil reduces the supply of gasoline.
Change in technology The development of more effective wireless
technology increases the supply of cell phones.
Change in taxes and subsidies An increase in the excise tax on cigarettes reduces the
supply of cigarettes; a decline in subsidies to state
universities reduces the supply of higher education.
Change in prices of other goods An increase in the price of cucumbers decreases the
supply of watermelons.
Change in producer expectations An expectation of a substantial rise in future log prices
decreases the supply of logs today.
Change in the number of suppliers An increase in the number of tattoo parlors increases
the supply of tattoos; the formation of women’s
professional basketball leagues increases the supply
of women’s professional basketball games.
3-10
Efficient Allocation
• Productive efficiency • Producing goods in the least costly way
• Using the best technology
• Using the right mix of resources
• Allocative Efficiency • Producing the right mix of goods
• The combination of goods most highly valued by society
LO3 3-11
Government Set Prices
LO5
S P
Q
D
P0
PC
Q0
Shortage
Qd Qs
ceiling $3.50
3.00
3-12
Government Set Prices
LO5
S
P
Q
D
P0
Pf
Q0
Surplus
Qs Qd
floor
2.00
$3.00
3-13
Interpretation of Elasticity of Demand
• Ed > 1 demand is elastic
• Ed = 1 demand is unit elastic
• Ed < 1 demand is inelastic
• Extreme cases
• Perfectly inelastic
• Perfectly elastic
LO1 4-14
Elasticity and Total Revenue
LO2
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Pri
ce
Tota
l Rev
enu
e (T
ho
usa
nd
s o
f D
olla
rs) $20 18 16 14 12 10
8 6 4 2
$8
7
6 5
4
3
2 1
a
b
c
d e
f g
h
Elastic Ed > 1
Unit Elastic Ed = 1
Inelastic Ed < 1
D
TR
4-15
Summary of Price Elasticity of Demand
LO2
Price Elasticity of Demand: A Summary
Absolute Value
of Elasticity
Coefficient Demand Is: Description
Impact on Total Revenue of a:
Price Increase Price Decrease
Greater than 1
(Ed > 1)
Elastic or
relatively
elastic
Qd changes by a
larger
percentage than
does price
Total Revenue
decreases
Total Revenue
increases
Equal to 1
(Ed = 1)
Unit or unitary
elastic
Qd changes by
the same
percentage as
does price
Total revenue
is unchanged
Total revenue
is unchanged
Less than 1
(Ed < 1)
Inelastic or
relatively
inelastic
Qd changes by a
smaller
percentage than
does price
Total revenue
increases
Total revenue
decreases
4-16
Determinants of Elasticity of Demand
• Substitutability • More substitutes, demand is more elastic
• Proportion of Income • Higher proportion of income, demand is more
elastic
• Luxuries vs. Necessities • Luxury goods, demand is more elastic
• Time • More time available, demand is more elastic
LO1 4-17
Efficiency Revisited
LO2
Pri
ce (
pe
r b
ag)
Quantity (bags)
S
Q1
P1
D
Consumer surplus
Producer surplus
5-18
Quantity (bags)
Pri
ce (
pe
r b
ag)
Efficiency Losses
LO2
c
S
Q1 Q2
D
b d
a
e
Efficiency loss from underproduction
5-19
Efficiency Losses
LO2
c
S
Q1 Q3
D
b
f
a
g
Quantity (bags)
Pri
ce (
pe
r b
ag)
Efficiency loss from overproduction
5-20
Government Intervention
LO4
Methods for Dealing with Externalities
Problem
Resource Allocation
Outcome Ways to Correct
Negative externalities
(spillover costs)
Overproduction of output
and therefore
overallocation of
resources
1. Private bargaining
2. Liability rules and lawsuits
3. Tax on producers
4. Direct controls
5. Market for externality rights
Positive externalities
(spillover benefits)
Underproduction of output
and therefore
underallocation of
resources
1. Private bargaining
2. Subsidy to consumers
3. Subsidy to producers
4. Government provision
5-21
Utility Maximizing Rule
• Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility
• Algebraically
MU of product A MU of product B
Price of A Price of B
LO2
=
6-22
Economic Profit
LO1
Explicit costs
Accounting costs (explicit costs
only)
Implicit costs (including a
normal profit)
Economic profit Accounting profit
Eco
no
mic
(O
pp
ort
un
ity)
C
ost
s Tota
l Re
ven
ue
7-23
Per-Unit, or Average, Costs
LO3
Co
sts
1 2 3 4 5 6 7 8 9 10 0 Q
50
100
150
$200
AFC
ATC AVC
AVC
AFC
7-24
Marginal Cost
LO3
Co
sts
1 2 3 4 5 6 7 8 9 10 0 Q
50
100
150
$200
AFC
MC
ATC AVC
AVC
AFC
7-25
MC and Marginal Product
LO3
Ave
rage
Pro
du
ct a
nd
M
argi
nal
Pro
du
ct
Co
st (
Do
llars
)
MP
AP
MC AVC
Quantity of Output
Quantity of Labor
Production Curves
Cost Curves
7-26
Firm Size and Costs
LO4
Ave
rage
To
tal C
ost
s
ATC-1
ATC-2
ATC-3 ATC-4
ATC-5
Output
7-27
The Long-Run Cost Curve
LO4
Long-run ATC
Ave
rage
To
tal C
ost
s
ATC-1
ATC-2
ATC-3 ATC-4
ATC-5
Output
7-28
MES and Industry Structure
LO4
Output
Ave
rage
To
tal C
ost
s
Long-run ATC
Economies Of Scale
Constant Returns To Scale
Diseconomies Of Scale
q1 q2
7-29
MES and Industry Structure
LO4
Output
Ave
rage
To
tal C
ost
s
Economies Of Scale
Diseconomies Of Scale
Long-run ATC
7-30
MES and Industry Structure
LO4
Output
Ave
rage
To
tal C
ost
s Long-run ATC
Economies Of Scale
Diseconomies Of Scale
7-31
Four Market Models
LO1
Characteristics of the Four Basic Market Models
Characteristic
Pure
Competition
Monopolistic
Competition Oligopoly Monopoly
Number of firms A very large
number
Many Few One
Type of product Standardized Differentiated Standardized or
differentiated
Unique; no
close subs.
Control over
price
None Some, but within rather
narrow limits
Limited by mutual
inter-dependence;
considerable with
collusion
Considerable
Conditions of
entry
Very easy, no
obstacles
Relatively easy Significant
obstacles
Blocked
Nonprice
Competition
None Considerable emphasis
on advertising, brand
names, trademarks
Typically a great
deal, particularly
with product
differentiation
Mostly public
relation
advertising
Examples Agriculture Retail trade, dresses,
shoes
Steel, auto, farm
implements
Local utilities
8-32
Average, Total, and Marginal Revenue
• Average Revenue
• Revenue per unit
• AR = TR/Q = P
• Total Revenue
• TR = P X Q
• Marginal Revenue
• Extra revenue from 1 more unit
• MR = ΔTR/ΔQ
LO3 8-33
Profit Maximization: MR-MC Approach
LO3
Co
st a
nd
Re
ven
ue
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10
Output
Economic Profit MR = P
MC MR = MC
AVC
ATC
P=$131
A=$97.78
8-34
Shutdown Case
LO3
Co
st a
nd
Re
ven
ue
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10
Output
MR = P
MC
AVC
ATC
P=$71
V = $74
Short-Run Shut Down Point P < Minimum AVC
$71 < $74
8-35
Marginal Cost and Short-Run Supply
LO4
P1
0
Co
st a
nd
Re
ven
ue
s (D
olla
rs)
Quantity Supplied
MR1
P2 MR2
P3 MR3
P4 MR4
P5 MR5
MC
AVC
ATC
Q2 Q3 Q4 Q5
a
b
c
d
e
S
Shut-Down Point (If P is Below)
8-36
3 Production Questions
LO3
Output Determination in Pure Competition in the Short Run
Question Answer
Should this firm produce? Yes, if price is equal to, or greater than,
minimum average variable cost. This
means that the firm is profitable or that
its losses are less than its fixed cost.
What quantity should this firm produce? Produce where MR (=P) = MC; there,
profit is maximized (TR exceeds TC by
a maximum amount) or loss is
minimized.
Will production result in economic
profit?
Yes, if price exceeds average total cost
(TR will exceed TC). No, if average
total cost exceeds price (TC will exceed
TR).
8-37
Firm and Industry: Equilibrium
LO4
Economic Profit
d
ATC
AVC
s = MC
$111 $111
D
S = ∑ MC’s
8 8000
8-38
Entry Eliminates Economic Profits
LO3
(a) Single Firm
(b) Industry
P P
q Q 0 0 100 90,000 80,000 100,000
ATC
MR
MC
$60
50
40
D1
S1
D2
$60
50
40
S2
9-39
Exit Eliminates Losses
LO3
(a) Single Firm
(b) Industry
P P
q Q 0 0 100 90,000 80,000 100,000
ATC
MR
MC
$60
50
40
D3
S3
D1
$60
50
40
S1
9-40
LR Supply: Constant-Cost Industry
LO4
P
0 Q 90,000 100,000 110,000
Q3 Q1 Q2
$50
P1
P2
P3
S Z1 Z2 Z3
D3 D1 D2
9-41
LR Supply: Increasing-Cost Industry
LO4
P
0 Q 90,000 100,000 110,000
Q3 Q1 Q2
$50 P1
S
Y1
Y2
Y3
D3 D1
D2
$40
$55 P2
P3
9-42
LR Supply: Decreasing-Cost Industry
LO4
P
0 Q 90,000 100,000 110,000
Q3 Q1 Q2
$50 P1
S
X1
X2
X3
D3
D1
D2
$40
$55 P3
P2
9-43
Pure Competition and Efficiency
LO5
Single Firm Market
Pri
ce
Pri
ce
Quantity Quantity
0 0
P MR
D
S
Qe Qf
ATC
MC P=MC=Minimum ATC (Normal Profit)
P
Consumer Surplus
Producer Surplus
9-44
Monopoly Demand
• Marginal Revenue < Price
• Monopolist is a price maker
• Monopolist sets prices in elastic region of demand curve
LO2 10-45
Output and Price Determination
LO2
$200
150
100
50
0
$750
500
250
0
2 4 6 8 10 12 14 16 18
2 4 6 8 10 12 14 16 18
Pri
ce
Tota
l Rev
enu
e
Elastic Inelastic
Demand and Marginal-Revenue Curves
Total-Revenue Curve
D MR
TR
10-46
$200
175
150
125
25
100
75
50 Pri
ce, C
ost
s, a
nd
Rev
enu
e
1 2 3 4 5 6 7 8 9 10 Quantity
Output and Price Determination
LO2
0
D
MR
ATC
MC
MR=MC A=$94
Economic Profit
Pm=$122
10-47
Misconceptions of Monopoly Pricing
LO2
0
Pri
ce, C
ost
s, a
nd
Rev
enu
e
Quantity
D
MR
ATC
MC
MR=MC
Loss
AVC Pm
Qm
V
A
10-48
Economic Effects of Monopoly
LO3
(a) Purely Competitive Market
(b) Pure Monopoly
D D
S=MC MC
P=MC= Minimum
ATC
MR
Pc
Qc
Pc
Pm
Qc Qm
Pure competition is efficient Monopoly is inefficient
a
b
c d
10-49
Consumer surplus
Deadweight loss
Monopoly profit
Perfect Price Discrimination vs. Single Price Monopoly
Here, the monopolist charges the same price (PM) to all buyers.
A deadweight loss results.
MC
Quantity
Price
D
MR
PM
QM
Regulated Monopoly
LO5
0
Pri
ce a
nd
Co
sts
(Do
llars
)
Quantity
Monopoly Price
Fair-Return Price
Socially Optimal
Price
Pr
D
r
f
b
a Pf
Pm
Qm Qf Qr
MR
MC
ATC
10-51
Comparing Perfect & Monop. Competition
yes none, price-taker firm has market power?
downward-
sloping horizontal D curve facing firm
differentiated identical the products firms sell
zero zero long-run econ. profits
yes yes free entry/exit
many many number of sellers
Monopolistic
competition
Perfect
competition
Comparing Monopoly & Monop. Competition
yes yes firm has market power?
downward-
sloping
downward-sloping
(market demand) D curve facing firm
many none close substitutes
zero positive long-run econ. profits
yes no free entry/exit
many one number of sellers
Monopolistic
competition Monopoly
Monopolistically Competitive
• Industry concentration
• Measured by:
• Four-firm concentration ratios
•Percentage of 4 largest firms
• Herfindahl index
• Sum of squared market shares
LO1
4-Firm CR = Output of four largest firms Total output in the industry
HI = (%S1)2 + (%S2)2 + (%S3)2 + …. + (%Sn)2
11-54
The Short Run: Profit or Loss
LO2
Quantity
Pri
ce a
nd
Co
sts
MR = MC
MC
MR
D1
ATC
Economic Profit
Q1
A1
P1
0
11-55
The Short Run: Profit or Loss
LO2
Quantity
Pri
ce a
nd
Co
sts
MC
MR
D2
ATC
Loss
Q2
A2
P2
0
MR = MC
11-56
The Long Run: Only a Normal Profit
LO2
Quantity
Pri
ce a
nd
Co
sts
MC
MR
D3
ATC
Q3
P3= A3
0
MR = MC
11-57
Monopolistic Competition: Efficiency
LO2
Quantity
Pri
ce a
nd
Co
sts
MR = MC
MC
MR
D3
ATC
Q3 0
P3= A3
P=MC=Min ATC for pure competition (recall)
P4
Q4
Price is Lower
Excess Capacity at Minimum ATC
Monopolistic competition is not efficient 11-58
Oligopoly
• A few large producers
• Homogeneous or differentiated products
• Limited control over price
• Mutual interdependence
• Strategic behavior
• Entry barriers
• Mergers
LO3 11-59
•Rule for employing resources:
• MRP = MRC
Marginal Revenue Product
= Change in Total Revenue
Unit Change in Resource Quantity
Marginal Resource
Cost =
Change in Total (Resource) Cost
Unit Change in Resource Quantity
• Marginal Revenue Product (MRP)
• Marginal Resource Cost (MRC)
Resource Demand
LO1 12-60
The Least Cost Rule
• Minimize cost of producing a given output
• Last dollar spent on each resource yields the same marginal product
Marginal Product Of Labor (MPL)
Price of Labor (PL)
Marginal Product Of Capital (MPC)
Price of Capital (PC) =
LO3 12-61
Profit Maximizing Rule
• MRP of each resource equals its price
MRPL
PL
MRPC
PC = = 1
MRPL PL = MRPC PC = and
LO3 12-62
($10) WC
($10) WC
Wag
e R
ate
(D
olla
rs)
Labor Market
Quantity of Labor
Wag
e R
ate
(Do
llars
)
Individual Firm
Quantity of Labor
QC
(1000)
0 0
d=mrp
qC
(5)
s=MRC
Competitive Labor Market
LO2
D=MRP (∑ mrp’s)
S
e b
a
c
13-63
• Examples of monopsony power Monopsony Model
Wag
e R
ate
(D
olla
rs)
Quantity of Labor
0
S
MRP
MRC
c
b
a Wc
Wm
Qm Qc
LO3 13-64
Bilateral Monopoly Model
LO4
Wag
e R
ate
(D
olla
rs)
Quantity of Labor
D=MRP
S
Qc
Wc
Wu
Qu=Qm
MRC
Wm
a
13-65
Economic Rent
Acres of Land
Lan
d R
en
t (D
olla
rs)
L0
D1
D2
D3
D4
S
R1
R2
R3
0
a b
LO1 14-66
Loanable Funds Theory
Quantity of Loanable Funds
Inte
rest
Rat
e (
Pe
rce
nt)
0
D
S
i = 8%
F0
The equilibrium interest rate
LO2 14-67
LO1
Government and the Circular Flow
(1) Costs
RESOURCE MARKET
PRODUCT MARKET
BUSINESSES
HOUSEHOLDS
(4) Goods and services
(7) Expenditures
(8) Resources
(9) Goods and services
(4) Goods and services
(10)
Goods and services
Net taxes (12)
Net taxes (11)
(3) Consumption expenditures (3) Revenues
GOVERNMENT
(1) Money income (rents, wages, interest, profits)
(2) Land, labor, capital
Entrepreneurial Ability
(2) Resources
(5) Expenditures (6) Goods and services
16-68
Efficiency Loss of a Tax
Pri
ce (
Pe
r B
ott
le)
Quantity (Millions of Bottles Per Month)
S
D
St
Tax $2
Tax paid by consumers
5 10 15 20 25 Q
P
14 12 10 8 6 4 2 0
Tax paid by producers
Efficiency loss (or deadweight loss)
LO3 16-69
Mergers
Automobiles Blue Jeans
Autos
Glass
Blue Jeans
Denim Fabric
A C B D E F
Z Y X W V U T
Horizontal Merger
Conglomerate Merger
Vertical Merger
LO2 18-70