Post on 01-Apr-2018
Limits,
Alternatives,
and Choices
Chapter 1
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Economics defined
• Role of economic theory
• Microeconomics vs. macroeconomics
• Resource scarcity and the economizing problem
• Production possibilities model
1-2
Economics Defined
• Economic wants exceed
productive capacity
• Social science concerned with
making optimal choices under
conditions of scarcity
1-3
The Economic Perspective
• Thinking like an economist
• Key features:
–Scarcity and choice
–Purposeful behavior
–Marginal analysis
1-4
Scarcity and Choice
• Resources are scarce
• Choices must be made
• There is no free lunch
• Opportunity cost
1-5
Purposeful Behavior
• Rational self-interest
• Individuals and utility
• Firms and profit
• Desired outcomes
1-6
Marginal Analysis
• Marginal benefit
• Marginal cost
• Marginal means extra
• Comparison of marginal benefit
and marginal cost
1-7
Economic Models
• The scientific method
• Cause and effect
• Economic principles
• Simplification of reality
• Other-things-equal assumption
• Graphical expression
1-8
Macro vs. Micro
• Macroeconomics
–Aggregate
• Microeconomics
–Individual Units
• Positive Economics
• Normative Economics
1-9
Individual’s Economizing Problem
• Limited income
• Unlimited wants
• A budget line
• Tradeoffs & opportunity costs
• Make best choice possible
• Change in income
1-10
A Budget Line
6
5
4
3
2
1
0
0
2
4
6
8
10
12
DVDs$20
Books$10
12
10
8
6
4
2
02 4 6 8 10 12 14
$120 Budget
Income = $120
Pdvd = $20= 6
Income = $120
Pb = $10= 12
Attainable
Unattainable
Quantity of Paperback Books
Qu
an
tity
of
DV
Ds
1-11
Society’s Economizing Problem
• Scarce resources
–Land
–Labor
–Capital
–Entrepreneurial Ability
• Factors of production
1-12
Production Possibilities Model
• Illustrate production choices
• Assumptions:
–Full employment
–Fixed resources
–Fixed technology
–Two goods
1-13
Type of Product
Pizzas(in hundred thousands)
Industrial Robots(in thousands)
Production Alternatives
A B C D E
10 9 7 4 0
0 1 2 3 4
Plot Points to Create Graph…
Production Possibilities Table
1-14
Production Possibilities Curve
Pizzas
Ind
ustr
ial R
ob
ots
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
Economic
Growth
Now Attainable
A’
B’
C’
D’
E’
1-15
Production Possibilities Curve
Pizzas
Ind
ustr
ial R
ob
ots
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
Law of Increasing
Opportunity Cost
A’
B’
C’
D’
E’
Shape of
the Curve
1-16
Production Possibilities Curve
Pizzas
Ind
ustr
ial R
ob
ots
Under or
Unemployment
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
1-17
The Future Economy
• Consequences of unemployment
• Economic growth
–More resources
–Better quality resources
–Technological advances
1-18
Future Possibilities
Goods for the Present
Goods fo
r th
e F
utu
re
Goods fo
r th
e F
utu
reGoods for the Present
P
F
Current
Curve
Current
Curve
Future
CurveFuture
Curve
Presentville Futureville
1-19
International Trade
• Production point
• Consumption point
• Specialization
• Preview
1-20
Optimal Allocation of Resources
15
10
5
01 2 3
a
b
c
d
e
MB = MC
MC
MB
Quantity of Pizza
Marg
inal B
en
efi
t &
Marg
inal
Co
st
1-21
LAST Word:
Pitfalls to Sound Economic Reasoning
• Biases
• Loaded terminology
• Fallacy of composition
• Post hoc fallacy
• Correlation but not causation
1-22
Key Terms
• economics
• economic perspective
• opportunity cost
• utility
• marginal analysis
• scientific method
• economic principle
• other-things-equal assumption
• macroeconomics
• aggregate
• microeconomics
• positive economics
• normative economics
• economizing problem
• budget line
• economic resources
• land
• labor
• capital
• investment
• entrepreneurial ability
• factors of production
• consumer goods
• capital goods
• production possibilities curve
• law of increasing opportunity costs
• economic growth 1-23
The Market
System and the
Circular Flow
1-24
The Market System
and the
Circular Flow
Chapter 2
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Economic systems
• Market system characteristics
• Market system questions
–what, how, and who
• Change and progress in the market system
• The circular flow model
2-26
Economic Systems
• Set of institutional arrangements
• Coordinating mechanism
• Differ based on:
–Who owns the factors of production
–What method directs economic
activity
2-27
Economic Systems
• The market system
–Private ownership
–Markets
• The command system
–Government ownership
–Central planning board
2-28
Index of Economic Freedom
Free MostlyFree
MostlyUnfree
Repressed
1- Hong Kong
3- Ireland
5- United States
20- Belgium
31- Spain
48- France
101- Brazil
126- China
134- Russia
148- Venezuela
156- Cuba
157- North Korea
Ranking of 157 countries for 2008
2-29
Market System Characteristics
• Private property
• Freedom of enterprise and choice
• Self-interest
• Competition
• Markets and prices
2-30
Market System Characteristics
• Technology and capital goods
• Specialization
–Division of labor
–Geographic specialization
• Use of money
• Active, limited government
2-31
Market System Questions
• What will be produced?
–consumer sovereignty
–dollar votes
• How will goods be produced?
–technology
–resource cost
2-32
Market System Questions
• Who gets the output?
–willingness to pay
• How is change accommodated?
–self-interest
• How is progress promoted?
–technological advance
–capital accumulation
2-33
The Invisible Hand
• 1776 Wealth of Nations byAdam Smith
–Unity of private and social interest
• Virtues of the market system
–Efficiency
–Incentives
–Freedom
2-34
The Command System
• Soviet Union, Eastern Europe, China
• System was a failure
• The coordination problem
–Set output targets for all goods
• The incentive problem
–No adjustments for shortage or surplus
2-35
Circular Flow
Resource
Market
Product
Market
Businesses Households
2-36
Circular Flow
Resource
Market
Product
Market
Businesses Households
2-37
Circular Flow
Resource
Market
Product
Market
Businesses Households
Figure 2.2; page 40
2-38
Key Terms
• economic system
• command system
• market system
• private property
• freedom of enterprise
• freedom of choice
• self-interest
• competition
• market
• specialization
• division of labor
• medium of exchange
• barter
• money
• consumer sovereignty
• dollar votes
• creative destruction
• “invisible hand”
• circular flow diagram
• resource market
• product market2-39
Next Chapter Preview…
Demand, Supply,
and the Market
Equilibrium
2-40
Demand, Supply, and Market Equilibrium
Chapter 3
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
Chapter Objectives
• Demand and its determinants
• Supply and its determinants
• Supply, demand, & market equilibrium
• Changes in supply and demand
• Government-set prices
3-42
A Market
• Interaction between buyers
and sellers
• Buyers demand goods
• Sellers supply goods
• Assumptions
–Standardized good
–Competitive market
3-43
Demand
• Schedule or curve
• Amount consumers willing
and able to purchase at a
given price
• Other things equal
• Individual demand
• Market demand
3-44
Law of Demand
• Other things equal, as price
falls quantity demanded
rises
• Explanations:
–Diminishing marginal utility
–Income effect
–Substitution effect
3-45
Individual Demand
6
5
4
3
2
1
010 20 30 40 50 60 70 80
Quantity Demanded (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qd
$5
4
3
2
1
10
20
35
55
80
P
Q
D
3-46
Determinants of Demand
• Factors that shift the demand curve
• Cause more or less to be bought at any possible price
• Increase or decrease in demand
• Tastes
• Number of buyers
3-47
Determinants of Demand
• Income
–Normal goods
–Inferior goods
• Price of related goods
–Substitute good
–Complementary good
–Unrelated goods
• Consumer expectations3-48
Individual Demand
6
5
4
3
2
1
0
Quantity Demanded (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qd
$5
4
3
2
1
10
20
35
55
80
P
Q
D1
2 4 6 8 10 12 14 16 18
D2
D3
3-49
Individual Demand
6
5
4
3
2
1
0
Quantity Demanded (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qd
$5
4
3
2
1
10
20
35
55
80
P
Q
D1
2 4 6 8 10 12 14 16 18
D2
D3
Change in Demand
Change in Quantity
Demanded
3-50
Supply
• Schedule or curve
• Amount producers willing
and able to sell at a given
price
• Individual supply
• Market supply
3-51
Law of Supply
• Other things equal, as price
rises the quantity supplied
rises
• Explanations:
–Revenue implications
–Marginal cost
3-52
Individual Supply
6
5
4
3
2
1
0
Quantity Supplied (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qs
$5
4
3
2
1
60
50
35
20
5
P
Q
S1
10 20 30 40 50 60 70
3-53
Determinants of Supply
• Resource prices
• Technology
• Taxes and subsidies
• Prices of other goods
• Producer expectations
• Number of sellers
3-54
Individual Supply
6
5
4
3
2
1
0
Quantity Supplied (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qs
$5
4
3
2
1
60
50
35
20
5
P
Q
S1
S2
S3
10 20 30 40 50 60 70
3-55
Individual Supply
6
5
4
3
2
1
0
Quantity Supplied (bushels per week)
Pri
ce (
per
bu
sh
el)
P Qs
$5
4
3
2
1
60
50
35
20
5
P
Q
S1
S2
S3
10 20 30 40 50 60 70
Change in Quantity
Supplied
Change in Supply
3-56
Market Equilibrium
• Equilibrium price and quantity
• Surplus and shortage
• Rationing function of price
• Efficient allocation
–Productive efficiency
–Allocative efficiency
3-57
Market Equilibrium
6
5
4
3
2
1
02 4 6 8 10 12 14 16 18
Bushels of Corn (thousands per week)
Pri
ce (
per
bu
sh
el)P Qd
$5
4
3
2
1
2,000
4,000
7,000
11,000
16,000
P Qs
$5
4
3
2
1
12,000
10,000
7,000
4,000
1,000
7
3
D
S
$4 Price Floor
6,000 Bushel
Surplus
$2 Price Ceiling
7,000 Bushel
Shortage
3-58
Market Equilibrium
• Change in demand
–Shift of the demand curve
• Change in supply
–Shift of the supply curve
• Change in equilibrium price and
quantity
3-59
Market Equilibrium
• Supply increase; Demand decrease
• Supply decrease; Demand increase
• Supply increase; Demand increase
• Supply decrease; Demand decrease
Price Quantity
?
?
?
?3-60
Government-Set Prices
• Price ceilings on gasoline
–Rationing problem
–Black markets
• Rent controls
• Price floors on wheat
–Optimal allocation of
resources
3-61
Key Terms
• demand
• demand schedule
• law of demand
• diminishing marginal utility
• income effect
• substitution effect
• demand curve
• determinants of demand
• normal goods
• inferior goods
• substitute good
• complementary good
• change in demand
• change in quantity demanded
• supply
• supply schedule
• law of supply
• supply curve
• determinants of supply
• change in supply
• change in quantity supplied
• equilibrium price
• equilibrium quantity
• surplus
• shortage
• price ceiling
• price floor
3-62
Elasticity, Consumer
Surplus, and
Producer Surplus
Chapter 6
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Price elasticity of demand
• The total revenue test
• Price elasticity of supply
• Cross elasticity of demand
• Income elasticity of demand
• Consumer & producer surplus
• Efficiency losses
6-64
Price Elasticity of Demand
• Measuring responsiveness to price changes
• Elastic demand–Large change in quantity
purchased for given price change
• Inelastic demand–Small change in quantity
purchased for given price change
6-65
Price Elasticity of Demand
• Price-elasticity coefficient and formula
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product X
Ed =
6-66
Price Elasticity of Demand
• Calculate percentage change
• Restate formula
Change in Quantity Demanded of X
Original Price of X
Ed =
Change in Price of X
Original Quantity Demanded of X
÷
6-67
Price Elasticity of Demand
• Calculation problem
• Starting point matters
• Midpoint formula
Change in QuantityEd = Sum of Quantities/2
÷Change in Price
Sum of Prices/2
6-68
Interpretations of Elasticity
Elastic Demand
Inelastic Demand
Unit Elasticity
Ed = .04
.02= 2
Ed = .01
.02= .5
Ed = .02
.02= 1
6-69
Price Elasticity of Demand
• Why use percentages?
–Unit free measure
–Compare responsiveness across
products
• Elimination of the (-) sign
• Extreme cases
–Perfectly inelastic demand
–Perfectly elastic demand6-70
The Total Revenue Test
• Total Revenue = TR = PxQ
• Inelastic demand
–P and TR change in same direction
• Elastic demand
–P and TR change in opposite
direction
6-71
$3
2
1
0 10 20 30 40 Q
P
• Lower price and elastic demand–Blue gain exceeds gold loss
a
b
D1
The Total Revenue Test
6-72
$4
3
2
1
0 10 20 Q
P
• Lower price and inelastic demand–Gold loss exceeds blue gain
c
d
D2
The Total Revenue Test
6-73
$3
2
1
0 10 20 30 Q
P
• Lower price and unit-elastic demand–Blue gain equals yellow loss
e
f
D3
The Total Revenue Test
6-74
]]]]]]]
Elasticity on a Linear Demand Curve
1
2
3
4
5
6
7
8
$8
7
6
5
4
3
2
1
5.00
2.60
1.57
1.00
0.64
0.38
0.20
$8,000
14,000
18,000
20,000
20,000
18,000
14,000
8,000
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
(1)Total Quantity of
Tickets DemandedPer Week, Thousands
(2)Price Per Ticket
(3)Elasticity
Coefficient (Ed)
(4)Total Revenue
(1) X (2)
(5)Total-Revenue
Test
]]]]]]]
6-75
Elasticity and the TR Curve
0 1 2 3 4 5 6 7 8
0 1 2 3 4 5 6 7 8
Quantity Demanded
Quantity Demanded
Pri
ce
To
tal
Reven
ue
(Th
ou
san
ds o
f D
ollars
)
$20
18
16
14
12
10
8
6
4
2
$8
7
6
5
4
3
2
1
a
b
c
d
e
fg
h
ElasticEd > 1
Unit ElasticEd = 1
InelasticEd < 1
D
TR
6-76
Determinants of Elasticity
• Substitutability
–More substitutes, more elastic demand
• Proportion of income
–Price relative to income
• Luxuries versus necessities
–Luxuries are more elastic
• Time
–More elastic in the long run 6-77
Applications of Elasticity
• Large crop yields–Inelastic demand
• Excise taxes–Inelastic demand
• Decriminalization of illegal drugs–Elastic or inelastic demand?
6-78
Price Elasticity of Supply
Percentage Change in Quantity
Supplied of Product X
Percentage Change in Price
of Product X
Es =
Responsiveness to price
changes by producers
6-79
Price Elasticity of Supply
• Market period
–Perfectly inelastic supply
• Short run
–Fixed plant size
• Long run
–Adjustable plant size
–Supply more elastic
6-80
P
Q
Price Elasticity of Supply
The Market Period
• Perfectly inelastic supply
D1 D2
Sm
Q0
Pm
P0
GreatestPrice
Impact
6-81
Price Elasticity of Supply
The Short Run
• Inelastic supply
P
Q
D1 D2
Ss
Q0
Ps
P0
Qs
LowerPrice
Impact
6-82
Price Elasticity of Supply
The Long Run
• Elastic supply
P
Q
D1 D2
Sl
Q0
Pl
P0
Ql
LeastPrice
Impact
6-83
Price Elasticity of Supply
• Applications
• Antiques and reproductions
–Limited, inelastic supply
–Strong demand
–Resulting high price
• Volatile gold prices
–Inelastic supply
–Shifting demand6-84
Cross Elasticity of Demand
• Responsiveness of sales to
change in price of another good
Percentage Change in Quantity
Demanded of Product X
Percentage Change in Price
of Product Y
Exy =
6-85
Cross Elasticity of Demand
• Substitute goods–Positive sign
• Complementary goods–Negative sign
• Independent goods–Zero
6-86
Income Elasticity of Demand
• Responsiveness of sales to
change in income
• Normal goods – positive sign
• Inferior goods– negative sign
Percentage Change in QuantityDemanded
Percentage Change in IncomeEi =
6-87
Consumer Surplus
• Benefit surplus
• Maximum willingness to pay (WTP)
less than actual price paid
Person Max WTP Actual Price CS
Bob $13 $8 $5
Barb $12 $8 $4
Bill $11 $8 $3
Bart $10 $8 $2
Brent $9 $8 $1
Betty $8 $8 $0
6-88
Consumer Surplus
D
Pri
ce
(P
er
Ba
g)
P1
Q1
Quantity (Bags)
ConsumerSurplus
Equilibrium
Price = $8
6-89
Producer Surplus
• Benefit surplus
• Actual price received more than
minimum acceptable price (AP)
Person Min AP Actual Price PS
Carlos $3 $8 $5
Courtney $4 $8 $4
Chuck $5 $8 $3
Cindy $6 $8 $2
Craig $7 $8 $1
Chad $8 $8 $0
6-90
Producer Surplus
SP
ric
e (P
er
Ba
g)
P1
Q1
Quantity (Bags)
ProducerSurplus Equilibrium
Price = $8
6-91
Efficiency Revisited
• Productive and allocative efficiency
D
SP
ric
e (P
er
Ba
g)
P1
Q1
Quantity (Bags)
ConsumerSurplus
ProducerSurplus
Equilibrium
Price = $8
6-92
Efficiency Loss
• Deadweight loss
D
SP
ric
e (P
er
Ba
g)
P1
Q1
Quantity (Bags)
EfficiencyLosses
Q2 Q3
6-93
Elasticity and Pricing Power
• Competitive markets–No pricing power
• Firms with market power–Charge different prices
• Differences in group elasticities–Business vs. leisure travelers
–Discounting for children
–College tuition
6-94
Key Terms
• price elasticity of demand
• midpoint formula• elastic demand• inelastic demand• unit elasticity• perfectly inelastic
demand• perfectly elastic
demand• total revenue (TR)• total-revenue test
• price elasticity of supply
• market period• short run• long run• cross elasticity of
demand• income elasticity of
demand• consumer surplus• producer surplus• efficiency losses
(deadweight losses)6-95
Next Chapter Preview…
Consumer Behavior
6-96
Consumer Behavior
Chapter 7
Chapter Objectives
• Total utility and marginal utility
• Law of diminishing marginal utility
• Marginal utility-to-price ratios
• Deriving the demand curve
• Income and substitution effects
• Appendix: the indifference curve model
7-98
Utility
• Diminishing marginal utility (again)
• Satisfaction obtained from consumption
• Three characteristics
–Differs from usefulness
–Subjective
–Difficult to quantify
7-99
Utility
• Total utility–Total satisfaction from a specific
quantity
• Marginal utility–Extra satisfaction from an
additional unit
• Law of diminishing marginal utility –Explains downward sloping
demand7-100
Utility Graphically
0
10
20
30
10
8642
0-2
1 2 3 4 5 6 7
1 2 3 4 5 6 7
To
tal
Uti
lity
(U
tils
)M
arg
inal
Uti
lity
(U
tils
)
(1)Tacos
ConsumedPer Meal
(2)Total
Utility,Utils
(3)Marginal
Utility,Utils
0
1
2
3
4
5
6
7
0
10
18
24
28
30
30
28
]]]]]]]
10
8
6
4
2
0
-2
TU
MU
Total Utility
Marginal Utility
Units Consumed Per Meal
Units Consumed Per Meal
7-101
Theory of Consumer Behavior
• Key dimensions of the consumer problem
–Rational behavior
–Preferences
–Budget constraint
–Prices
7-102
Theory of Consumer Behavior
• Find utility maximizing combination of goods
• Utility maximizing rule
–Allocate income
–Last dollar spent on each good yields same marginal utility
–Marginal utility per dollar
7-103
Numerical ExampleCombinations of apples and oranges obtainable with an income of $10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Apple (product A)
Price = $1
(3)Orange (product B)
Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Compare marginal utilities
Then compare per dollar - MU/Price
Choose the highest
Check budget - proceed to next item 7-104
Numerical ExampleCombinations of apples and oranges obtainable with an income of $10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Apple (product A)
Price = $1
(3)Orange (product B)
Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per dollar - MU/Price
Choose the highest
Buy one of each – budget has $5 left
Proceed to next item 7-105
Numerical ExampleCombinations of apples and oranges obtainable with an income of $10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Apple (product A)
Price = $1
(3)Orange (product B)
Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per dollar - MU/Price
Buy one more orange – budget has $3 left
Proceed to next item 7-106
Numerical ExampleCombinations of apples and oranges obtainable with an income of $10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Apple (product A)
Price = $1
(3)Orange (product B)
Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, compare per dollar - MU/Price
Buy one of each – budget exhausted7-107
Numerical ExampleCombinations of apples and oranges obtainable with an income of $10
(1)Unit of
Product
(a)Marginal
Utility,Utils
(a)Marginal
Utility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Apple (product A)
Price = $1
(3)Orange (product B)
Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Final result – at these prices,
purchase 2 apples and 4 oranges 7-108
Algebraic Generalization
MU of product A
price of A
MU of product B
price of B=
8 Utils
$1
16 Utils
$2=
Optimum Achieved – Money income
is allocated so that the last dollar spent on
each product yields the same extra or
marginal utility7-109
Pri
ce
of
Pro
du
ct
B
0
1
2
4 6
Quantity Demanded of B
Deriving the Demand Curve
$2
1
4
6
Price Per
Unit of B
Quantity
Demanded
DBIncome Effects
Substitution Effects7-110
Applications and Extensions
• New products increase utility
– iPods
• The diamond-water paradox
• The value of time
• Medical care purchases
• Cash and noncash gifts
7-111
Behavioral Economics
• Human instinct for variety
• Consume more when there is more variety–M&Ms
• Time inconsistency
–Final exams
–Retirement savings
7-112
Key Terms
• Law of diminishing marginal utility
• Utility
• Total utility
• Marginal utility
• Rational behavior
• Budget constraint
• Utility maximizing rule
• Income effect
• Substitution effect
7-113
Next Chapter Preview…
The Costs ofProduction
7-114
The Budget Line
–Income changes
–Price changes
2 4 6 8 10 12
Qu
an
tity
of
A
6
8
10
12
4
2
0
Quantity of B
Units of A(Price = $1.50)
Units of B(Price = $1)
TotalExpenditure
8
6
4
2
0
0
3
6
9
12
$12
12
12
12
12(Attainable)
(Unattainable)
Income = $12
PA = $1.50
Income = $12
PB = $1
7-115
Indifference Curves
What is preferred– Downsloping and convex– Marginal rate of substitution
2 4 6 8 10 12
Qu
an
tity
of
A
6
8
10
12
4
2
0
Quantity of B
Combination Units of A Units of B
j
k
l
m
12
6
4
3
2
4
6
8
j
k
lm
I
7-116
Indifference Curve Analysis
• The indifference map
• Equilibrium position at tangency
2 4 6 8 10 12
Qu
an
tity
of
A
6
8
10
12
4
2
0
Quantity of B
I1I2
I3
I4
X
W
Preferred –But RequiresMore Income
MRS = PB
PA
7-117
Demand Curve Derived
Pri
ce o
f B
$1.50
1.00
.50
2 4 6 8 10 12Quantity of B
X
2 4 6 8 10 12
Qu
an
tity
of
A
6
8
10
12
4
2
0
Quantity of B
I2I3
DB
At $1 price for B, 6 units of B are purchased
Record the results
As price of B increases to $1.50, only 3 units of B are bought
Record the results
Connect the points tocreate the demand curve for B 7-118
Appendix Key Terms
• Budget Line
• Indifference curve
• Marginal rate of substitution (MRS)
• Indifference map
• Equilibrium position
7-119
Next Chapter Preview…
The Costs ofProduction
7-120
The Costs of
Production
Chapter 8
Chapter Objectives
• Explicit and implicit costs
• Law of diminishing returns
• Fixed and variable costs
• Total, average, and marginal costs
• The firm’s size in the long run
8-122
Economic Costs
• Equal to opportunity costs
• Explicit + implicit costs
• Explicit costs
–Monetary payments
• Implicit costs
–Value of next best use
–Self-owned resources
–Self-employed resources8-123
Profit
• Accounting profit
–Total revenue less explicit cost
• Normal profit
–Equal to implicit cost
• Economic or pure profit
–Total revenue less economic cost
8-124
Profits Compared
Economic
Profit
Accounting
Costs (Explicit
Costs Only)
Accounting
Profit
Explicit
Costs
Implicit Costs(Including a
Normal Profit)
Eco
no
mic
(Op
po
rtu
nit
y)
Co
sts
To
tal R
even
ue
Economic Accounting
8-125
Short and Long Run
• The short run
–Fixed plant capacity
–Variable intensity of plant use
–Variable output
• The long run
–Variable plant capacity
–Firms enter and exit
8-126
Production Relationships
• Total product (TP)
• Marginal product (MP)
• Average product (AP)
Average ProductTotal Product
Units of Labor=
Marginal ProductChange in Total Product
Change in Labor Input=
8-127
Law of Diminishing Returns
• Fixed technology
• Add variable resource to fixed
resource
• Marginal product will decline
–Beyond some point
• Rationale
8-128
IncreasingMarginalReturns
Law of Diminishing Returns
(1)Units of the
Variable Resource(Labor)
(2)Total Product
(TP)
(3)Marginal Product
(MP),Change in (2)/Change in (1)
(3)AverageProduct
(AP),(2)/(1)
0
1
2
3
4
5
6
7
8
0
10
25
45
60
70
75
75
70
10
15
20
15
10
5
0
-5
-
10.00
12.50
15.00
15.00
14.00
12.50
10.71
8.75
]]]]]]]]
DiminishingMarginalReturns
NegativeMarginalReturns
8-129
0
10
20
30
To
tal
Pro
du
ct,
TP
1 2 3 4 5 6 7 8 9
20
10
Marg
inal
Pro
du
ct,
MP
1 2 3 4 5 6 7 8 9
TP
MP
AP
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns
Law of Diminishing Returns
8-130
Short-Run Production Costs
• Fixed Costs
–Do not vary with output
• Variable Costs
–Materials, most labor
• Total Cost
–TC = TFC + TVC
8-131
Per-Unit Production Costs
• Average fixed cost AFC = TFC/Q
• Average variable costAVC = TVC/Q
• Average total cost ATC = TC/Q = TFC/Q + TVC/Q
ATC = AFC+AVC
• Marginal costMC = change in TC/change in Q
8-132
Short-Run Production Costs
Co
sts
1 2 3 4 5 6 7 8 9 100 Q
100
200
300
400
500
600
700
800
900
1000
$1100
TFC
TC
TVC
TotalCost
VariableCost
FixedCost
8-133
Short-Run Production Costs
Co
sts
1 2 3 4 5 6 7 8 9 100 Q
50
100
150
$200
AFC
MC
ATC
AVC
AVC
AFC
8-134
Production Relationships
• Marginal cost and diminishing returns
• Marginal cost and marginal product
• Marginal cost and average variable
cost
• Marginal cost and average total cost
• Production curves and cost curves
• Shifts in cost curves
8-135
Avera
ge P
rod
uct
an
d
Marg
inal
Pro
du
ct
Co
st
(Do
llars
)
Graphical Relationships
MP
AP
MCAVC
Quantity of Output
Quantity of Labor
Production Curves
Cost Curves
8-136
Long-Run Production Costs
• Choose your plant size
• Minimize ATC
• Different ATC curves
–Short run
• Long run ATC
–Envelope of short run ATC
8-137
Long-Run ATC Curve
Ave
rag
e T
ota
l C
osts ATC-1
ATC-2
ATC-3 ATC-4
ATC-5
Output
Any number of short-run optimum
size cost curves can be constructed
8-138
Long-Run ATC Curve
Long-RunATC
Ave
rag
e T
ota
l C
osts ATC-1
ATC-2
ATC-3 ATC-4
ATC-5
Output
The long-run ATC curve just
“envelopes” the short run ATCs
8-139
Long-Run ATC Shapes
Output
Long-run ATC curve where economies
of scale exist
Ave
rag
e T
ota
l C
osts
Long-RunATC
Economies
Of Scale
Constant Returns
To Scale
Diseconomies
Of Scale
q1 q2
8-140
Output
Long-run ATC curve where costs arelowest only when large numbers areparticipating
Ave
rag
e T
ota
l C
osts
Economies
Of Scale
Diseconomies
Of Scale
Long-RunATC
Long-Run ATC Shapes
8-141
Output
Long-run ATC curve where economiesof scale exist, are exhausted quickly,and turn back up substantially
Ave
rag
e T
ota
l C
osts
Long-RunATC
Economies
Of Scale
Diseconomies
Of Scale
Long-Run ATC Shapes
8-142
Key Terms
• economic (opportunity) cost
• explicit costs
• implicit costs
• normal profit
• economic profit
• short run
• long run
• total product (TP)
• marginal product (MP)
• average product (AP)
• law of diminishing returns
• fixed costs
• variable costs
• total cost
• average fixed cost (AFC)
• average variable cost (AVC)
• average total cost (ATC)
• marginal cost (MC)
• economies of scale
• diseconomies of scale
• constant returns to scale
• minimum efficient scale (MES)
• natural monopoly
8-143
Next Chapter Preview…
PureCompetition
8-144
Pure
Competition
Chapter 9
Chapter Objectives
• The four basic market models• Conditions for pure competition• Profit maximization for
competitive firms• The competitive firm supply
curve• Industry entry and exit• Industry cost structure• Economic efficiency
9-146
Four Market Models
• Pure competition
• Pure monopoly
• Monopolistic competition
• Oligopoly
Market Structure Continuum
PureCompetition
MonopolisticCompetition Oligopoly
PureMonopoly
Imperfect Competition
9-147
Pure Competition
• Very large numbers
• Standardized product
• “Price takers”
• Free entry and exit
• Perfectly elastic demand
–Average revenue
–Marginal revenue
–Price 9-148
Firm’sDemandSchedule(AverageRevenue)
Firm’sRevenue
Data
Pure Competition
Pri
ce a
nd
Reven
ue
2 4 6 8 10 12
131
262
393
524
655
786
917
1048
$1179
Quantity Demanded (Sold)
D = MR = AR
TR
P QD TR MR
$131
131
131
131
131
131
131
131
131
131
131
0
1
2
3
4
5
6
7
8
9
10
$0
131
262
393
524
655
786
917
1048
1179
1310
$131
131
131
131
131
131
131
131
131
131
]
]]]]
]
]
]
]
]
9-149
Short Run Profit Maximization
• Market price is given
• Three questions:
–Should the product be produced?
–If so, in what amount?
–What economic profit (loss) will
be realized?
9-150
Profit Maximization
• Two approaches
• Total revenue and total cost
approach
–Produce where TR-TC is greatest
• Marginal revenue and marginal
cost approach
–Produce where MR=MC
9-151
Total Revenue Total Cost Approach
(1)Total Product(Output) (Q)
(2)Total FixedCost (TFC)
(3)Total Variable
Cost (TVC)
(4)Total Cost
(TC)
(5)Total Revenue
(TR)
(6)Profit (+)
or Loss (-)
Price = $131
0
1
2
3
4
5
6
7
8
9
10
$100
100
100
100
100
100
100
100
100
100
100
$0
90
170
240
300
370
450
540
650
780
930
$100
190
270
340
400
470
550
640
750
880
1030
$0
131
262
393
524
655
786
917
1048
1179
1310
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Now Let’s Graph The Results…Do You See Profit Maximization?9-152
10 2 3 4 5 6 7 8 9 10 11 1213 14
10 2 3 4 5 6 7 8 9 10 11 1213 14
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
$500
400
300
200
100
To
tal R
eve
nu
e a
nd
To
tal C
os
tTo
tal E
co
no
mic
Pro
fit
Quantity Demanded (Sold)
Quantity Demanded (Sold)
Total Revenue, (TR)
Break-Even Point(Normal Profit)
Break-Even Point(Normal Profit)
MaximumEconomic
Profit$299
Total Economic
Profit$299
P=$131
Total Cost,
(TC)
Total Revenue Total Cost Approach
9-153
Marginal Revenue Marginal Cost Approach
(1)Total
Product(Output)
(2)Average
FixedCost(AFC)
(3)AverageVariable
Cost(AVC)
(4)Average
TotalCost(ATC)
(6)MarginalRevenue
(MR)
(7)Profit (+)
or Loss (-)
0
1
2
3
4
5
6
7
8
9
10
$100.00
50.00
33.33
25.00
20.00
16.67
14.29
12.50
11.11
10.00
$90.00
85.00
80.00
75.00
74.00
75.00
77.14
81.25
86.67
93.00
$190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
103.00
$131
131
131
131
131
131
131
131
131
131
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
No Surprise - Now Let’s Graph It…Do You See Profit Maximization Now?
(5)Marginal
Cost(MC)
$90
80
70
60
70
80
90
110
130
150
9-154
Co
st
an
d R
even
ue
$200
150
100
50
01 2 3 4 5 6 7 8 9 10
Output
Economic Profit MR = P
MCMR = MC
AVC
ATC
P=$131
A=$97.78
Marginal Revenue Marginal Cost Approach
9-155
Short Run Profit Maximization
• Produce where MR (=P) = MC
• Suffer loss, still produce?
• Yes if loss is less than fixed cost
–Cover variable cost
• Shut down if loss greater than
fixed cost
• Produce if P > min AVC9-156
Lower the Price to $81 and
Observe the Results!
Co
st
an
d R
even
ue
$200
150
100
50
01 2 3 4 5 6 7 8 9 10
Output
Loss
Short Run Loss Minimizing Case
MR = P
MC
AVC
ATC
P=$81
A=$91.67
V = $75
9-157
Lower the Price Further to
$71 and Observe the Results!
Co
st
an
d R
even
ue
$200
150
100
50
01 2 3 4 5 6 7 8 9 10
Output
Short Run Shut Down Case
MR = P
MC
AVC
ATC
P=$71
Short-Run Shut Down PointP < Minimum AVC
$71 < $74
V = $74
9-158
Short-Run Supply Curve
Continuing the Same Example…
Supply Schedule of a Competitive Firm
Price
Quantity
Supplied
Maximum Profit (+)
or Minimum Loss (-)
$151
131
111
91
81
71
61
10
9
8
7
6
0
0
$+480
+299
+138
-3
-64
-100
-100
The schedule shows the quantity a firmwill produce at a variety of prices
9-159
Short-Run Supply Curve
Firms produce where MR=MC
P1
0
Co
st
an
d R
even
ues (
Do
llars
)
Quantity Supplied
MR1
P2 MR2
P3 MR3
P4 MR4
P5 MR5
MC
AVC
ATC
Q2 Q3 Q4 Q5
This Price is Below AVCAnd Will Not Be Produced
a
b
c
d
e
9-160
Short-Run Supply Curve
P1
0
Co
st
an
d R
even
ues (
Do
llars
)
Quantity Supplied
MR1
P2 MR2
P3 MR3
P4 MR4
P5 MR5
MC
AVC
ATC
Q2 Q3 Q4 Q5
a
b
c
d
e
MC Above AVC Becomesthe Short-Run Supply Curve S
Examine the MC for the Competitive Firm
Break-even(Normal Profit) Point
Shut-Down Point (If P is Below)
Firms produce where MR=MC
9-161
Firm and Industry Supply
• Changes in firm supply
–Shifts in marginal cost
–Input price or technology
• The industry (total) supply curve
–Sum of individual supply
• Industry supply and demand
–Determine market price
9-162
Single Firm Industryp P
p P0 0
Firm and Industry Supply
Economic
Profit
d
ATC
AVC
s = MC
$111 $111
D
S = ∑ MC’s
8 8000
Competitive firm must take the price that isEstablished by industry supply and demand
9-163
Long Run Profit Maximization
• Assumptions
–Entry and exit only
–Identical costs
–Constant-cost industry
• Goal of the analysis
–In the long run, P = min ATC
–Entry eliminates profits
–Exit eliminates losses9-164
Single Firm Industryp P
p P0 0100 90,00080,000 100,000
Entry Eliminates Profits
ATC
MR
MC
$60
50
40
D1
S1
An increase in demand temporarily raises priceHigher prices draw in new competitorsIncreased supply returns price to equilibrium
D2
$60
50
40
S2
9-165
Single Firm Industryp P
p P0 0100 90,00080,000 100,000
Exit Eliminates Losses
ATC
MR
MC
$60
50
40
D3
S3
A decrease in demand temporarily lowers priceLower prices drive away some competitorsDecreased supply returns price to equilibrium
D1
$60
50
40
S1
9-166
Long Run Supply
• Constant cost industry–Entry/exit does not affect LR ATC
–Constant resource price
–Special case
• Increasing cost industry–Most industries
–LR ATC increases with expansion
–Specialized resources
• Decreasing cost industry9-167
P
0 Q
Long-Run Supply Curve
Constant-Cost Industry
90,000 100,000 110,000
Q3 Q1 Q2
$50
P1
P2
P3
SZ1 Z2Z3
D3 D1 D2
9-168
P
0 Q
Long-Run Supply Curve
Increasing-Cost Industry
90,000 100,000 110,000
Q3 Q1 Q2
$50P1
S
Y1
Y2
Y3
D3
D1
D2
$40
$55P2
P3
How would a decreasing-cost industry look?9-169
Pure Competition and Efficiency
• Productive efficiency
P = minimum ATC
• Allocative efficiency
P = MC
• Maximum consumer and producer surplus
• Dynamic adjustments
• “Invisible Hand” revisited 9-170
Single Firm MarketP
rice
Pri
ce
Quantity Quantity
0 0
Long-Run Equilibrium
P MR
D
S
QeQf
ATC
Productive Efficiency: Price = minimum ATCAllocative Efficiency: Price = MC
Pure competition has both inits long-run equilibrium
MCP=MC=MinimumATC (Normal Profit)
P
9-171
The Case of Generic Drugs
• Efficiency gains from entry–Lower price and greater output
• Purpose of drug patent–Encourage R&D
–Cost recovery
• Expiration of patent on drugs–Generics enter
–Profits decrease, output increase
–Combined CS and PS increase9-172
Pri
ce
Quantity
P1
P2
D
S
Q1 Q2
f
a
d
cb
• As price decreases to f,
• Consumer surplus abcincreases to adf
• Producer and consumersurplus is maximizedas shown bythe gray triangle
Initial Patent Price
Result: Greater Quantity at Lower Prices
as Predicted by the Competitive Model
New Producers Enter Market
The Case of Generic Drugs
9-173
Key Terms
• pure competition• pure monopoly• monopolistic
competition• oligopoly• imperfect
competition• price taker• average revenue• total revenue• marginal revenue• break-even point• MR=MC rule• short-run supply
curve
• long-run supply curve
• constant-cost industry
• increasing-cost industry
• decreasing-cost industry
• productive efficiency
• allocative efficiency• consumer surplus• producer surplus
9-174
Next Chapter Preview…
PureMonopoly
9-175
Pure Monopoly
Chapter 10
Chapter Objectives
• Characteristics of pure
monopoly
• Profit-maximizing output and
price
• Economic effects of monopoly
• Charging different prices in
different markets
10-177
Characteristics of Monopoly
• Single seller
• No close substitutes
• “Price maker”
• Blocked entry
• Nonprice competition
10-178
Examples of Monopoly
• Regulated or natural monopolies–electricity
• Near monopolies–Western Union–Frisbee–De Beers
• Geographic monopolies–Professional sport teams
• Dual objectives of study
10-179
Barriers to Entry
• Economies of scale
• Legal barriers to entry
–Patents
–Licenses
• Ownership or control of
essential resources
• Pricing and other strategic
barriers to entry10-180
Monopoly Demand
• Assumptions:
–Monopoly status is secure
–No government regulation
–Single-price monopolist
• Face down-sloping demand
–Entire market demand
10-181
0 1 2 3 4 5 6
$142
132
122
112
102
92
82
Price and Marginal Revenue
Marginal revenue is less than price
D
• A monopolist isselling 3 units at$142
• To sell 4, price mustbe lowered to $132
• All customers must pay the sameprice
• TR increases $132 minus $30 (3x$10)
Gain = $132
Loss = $30
10-182
0 1 2 3 4 5 6
$142
132
122
112
102
92
82
D
• A monopolist isselling 3 units at$142
• To sell 4, price mustbe lowered to $132
• All customers must pay the sameprice
• TR increases $132 minus $30 (3x$10)
• $102 becomes a point on the MR curve
• Try other prices todetermine other MR points
Gain = $132
Loss = $30
The Constructed Marginal Revenue CurveMust Always Be Less Than the Price
MR
Price and Marginal Revenue
Marginal revenue is less than price
10-183
Down-Sloping Demand
• Marginal revenue < price
–To increase sales, must lower price
• Firm is a price maker
–Choose P,Q combination
• Operate in the elastic region
–Marginal revenue > 0
–Total-revenue test (recall)
10-184
Profit Maximization
• Output-price determination
–Marginal revenue marginal cost
rule
–Same cost definitions
• No supply curve
10-185
Monopoly Revenue and Costs
(1)Quantity
Of Output
(2)Price
(AverageRevenue)
(3)Total
Revenue(1) X (2)
(4)MarginalRevenue
(5)Average
Total Cost
(6)Total Cost
(1) X (5)
(7)Marginal
Cost
(8)Profit (+)
or Loss (-)
0
1
2
3
4
5
6
7
8
9
10
$172
162
152
142
132
122
112
102
92
82
72
$0
162
304
426
528
610
672
714
736
738
720
$162
142
122
102
82
62
42
22
2
-18
$190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
103.00
$100
190
270
340
400
470
550
640
750
880
1030
$90
80
70
60
70
80
90
110
130
150
$-100
-28
+34
+86
+128
+140
+122
+74
-14
-142
-310
Revenue Data Cost Data
]]]]]]]]]]
]]]]]]]]]]
Can you See Profit Maximization?10-186
$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
To
tal
Reven
ue
Monopoly Revenue and Costs
Elastic InelasticDemand and Marginal-Revenue Curves
Total-Revenue Curve
DMR
TR
10-187
Profit Maximization
0
$200
175
150
125
25
100
75
50
Pri
ce,
Co
sts
, an
d R
even
ue
1 2 3 4 5 6 7 8 9 10
Quantity
D
MR
ATC
MC
MR=MC
Pm=$122
A=$94
EconomicProfit
10-188
Misconceptions
• Not the highest price
• Total, not unit, profit
• Possibility of losses
10-189
Loss Minimization
0
Pri
ce,
Co
sts
, an
d R
even
ue
Quantity
D
MR
ATC
MC
MR=MC
Loss
AVC
Pm
Qm
V
A
10-190
Economic Effects
PurelyCompetitive
Market
PureMonopoly
D D
S=MC MC
P=MC=
Minimum
ATC
MR
Pc
Qc
Pc
Pm
QcQm
Pure competition is efficient
Monopoly is inefficient
a
b
c
10-191
• Pure competition is efficient–Productive efficiency
–Allocative efficiency
–CS+PS maximized
• Monopoly is inefficient–Charge P>MC
–Deadweight loss
• Income transfer
Economic Effects
10-192
Cost Complications
• Economies of scale–Simultaneous consumption
–Network effects
• X-inefficiency–Lowest ATC not achieved
• Rent seeking behavior
• Technological advance–More likely with monopoly?
10-193
Policy Options
• Use antitrust laws
–Divide the firm
• Natural monopoly
–Regulate price
• Ignore
–Unstable in long run
10-194
Price Discrimination
• Three forms– Charge each customer max
willingness to pay
– Charge one price for first unit and a lower price for subsequent units
– Charge different customers different prices
10-195
• Conditions– Monopoly power– Market segregation– No resale
• Examples– Airfares– Electric utilities– Theaters & golf courses
Price Discrimination
10-196
Regulated Monopoly
• Natural monopolies
• Rate regulation
• Socially optimum price
P = MC
• Fair return price
P = ATC
10-197
0
Pri
ce a
nd
Co
sts
(D
ollars
)
Quantity
Dilemma of Regulation
MonopolyPrice
Fair-ReturnPrice
SociallyOptimal
Price
Pr
D
r
f
b
aPf
Pm
Qm Qf Qr
MR
MC
ATC
Regulated Monopoly
10-198
De Beers Diamonds
• 66 years of monopoly pricing–Independent producers went along
• Mid-2000 abandoned monopoly
–New discoveries
–Independent producers withdrew
–Political considerations
• New strategy
–“The diamond supplier of choice”
10-199
Key Terms
• pure monopoly
• barriers to entry
• simultaneous consumption
• network effects
• X-inefficiency
• rent-seeking behavior
• price discrimination
• socially optimal price
• fair-return price10-200
Next Chapter Preview…
Monopolistic Competitionand Oligopoly
10-201
Monopolistic Competition and Oligopoly
Chapter 11
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Characteristics of monopolistic competition
• Normal profit in the long run
• Characteristics of oligopoly
• Game theory
• The oligopolist’s kinked demand curve
• Collusion among oligopolists
• The effects of advertising
11-203
Monopolistic Competition
• Large number of sellers–Small market shares
–No collusion
–Independent action
• Differentiated Products–Product attributes
–Service
–Location
–Brand names and packaging
–Some control over price 11-204
• Easy entry and exit
• Need for advertising
–Nonprice Competition
• Which industries?
–Degree of concentration
–Four-firm concentration ratio
–Herfindahl index
Monopolistic CompetitionMonopolistic Competition
11-205
• Firm’s demand curve–Highly elastic
• Short run profit or loss–Produce where MR=MC
• Long run normal profit–Entry and exit
• Inefficient• Product variety
Monopolistic Competition
11-206
Short-Run Profits
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D1
ATC
Economic
Profit
Q1
A1
P1
0
Monopolistic Competition
11-207
Short-Run Losses
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D2
ATC
Loss
Q2
A2
P2
0
Monopolistic Competition
11-208
Long-Run Equilibrium
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D3
ATC
Q3
P3= A3
0
Monopolistic Competition
11-209
Quantity
Pri
ce
an
d C
os
ts
MR = MC
MC
MR
D3
ATC
Q30
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
Monopolistic Competition
11-210
Oligopoly
• A few large producers
• Homogeneous or differentiated products
• Control over price–Mutual interdependence
–Strategic behavior
• Entry barriers
• Mergers
11-211
Oligopoly
• Four-firm concentration ratio–Needs to be more than 40%
–Half of U.S. manufacturing
• Localized markets
• Interindustry competition
• World trade–Import Competition
• Herfindahl index11-212
Game Theory
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low•2 competitors
•2 price
strategies
•Each strategy
has a payoff
matrix
•Greatest
combined
profit
• Independent
actions
stimulate a
response
11-213
Game Theory
RareAir’s Price Strategy
Up
tow
n’s
Pri
ce
Str
ate
gy A B
C D
$12
$12
$15
$6
$8
$8
$6
$15
High
High
Low
Low• Independently
lowered prices
in expectation
of greater profit
leads to the
worst
combined
outcome
•Eventually low
outcomes make
firms return to
higher prices
11-214
Game Theory
•Mutual interdependence–Pricing policy
•Collusion–Enhances profit
• Incentive to cheat
•Prisoner’s dilemma
11-215
Three Oligopoly Models
• Kinked-demand curve
• Collusive pricing
• Price leadership
• Why three models?
–Diversity of oligopolies
–Complications of interdependence
11-216
Kinked-Demand Curve
• Noncollusive oligopoly
• Strategies
–Match price changes
–Ignore price changes
• Combined strategy
• Price inflexibility
• The kinked-demand curve
11-217
Pri
ce
Pri
ce
an
d C
os
tsQuantity Quantity
0 0
P0
MR2
D2
D1
MR1
e
f
g
Rivals IgnorePrice Increase
Rivals MatchPrice Decrease
Q0
Competitor and rivals strategize versus each otherConsumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
MR2
D2
D1
MR1Q0
MC1
MC2
P0
Resulting in a kinked-demand curve to the consumer – price and output
are optimized at the kink
e
f
g
Kinked-Demand Curve
11-218
• Criticisms of the model–How does price get to P0
–Explains inflexibility, not price
–Prices are not that rigid
–Price wars
Kinked-Demand Curve
11-219
Pri
ce a
nd
Co
sts
Quantity
Cartels and Other Collusion
• Price and output–Joint profit maximization
D
MR=MC
ATC
MC
MR
P0
A0
Q0
Economic
Profit
Effectively Sharing
The Monopoly Profit
11-220
The OPEC Cartel
Source: A. T. Kearney, Foreign Policy
Iran 3,843,000Kuwait 2,538,000Venezuela 2,368,000Iraq 2,297,000
Nigeria 2,183,000UAE 2,117,000Angola 1,804,000Libya 1,737,000Algeria 1,417,000Qatar 848,000Indonesia 843,000Ecuador 530,000
Daily oil production (barrels) , November 2008
Saudi Arabia 8,904,000
11-221
Cartels and Other Collusion
• Covert collusion–Tacit understandings
• Obstacles to collusion–Demand and cost differences
–Number of firms
–Cheating
–Recession
–Potential entry
–Legal obstacles: antitrust law11-222
Price Leadership Model
• Leadership tactics
• Infrequent price changes
• Communications
• Limit pricing
• Breakdowns in price leadership:
–Price wars
11-223
Advertising
• Prevalent in monopolistic
competition and oligopoly
• Capture market share
• Better than a price cut
• Information for consumers
• Manipulation
11-224
Oligopoly and AdvertisingThe Largest U.S. Advertisers, 2006
Company
Advertising Spending
Millions of $
Proctor and Gamble
AT&T
General Motors
Time Warner
Verizon
Ford Motor
GlaxoSmithKline
Walt Disney
Johnson & Johnson
Unilever
$4898
3345
3296
3089
2822
2577
2444
2320
2291
2098Source: Advertising Age
11-225
World’s Top 10 Brand Names, 2007
Source: Interbrand
Coca-Cola
Microsoft
IBM
General Electric
Nokia
Toyota
Intel
McDonald’s
Disney
Mercedes-Benz
Oligopoly and Advertising
11-226
Oligopoly and Efficiency
• Not productively efficient
• Not allocatively efficient
• Tendency to share the monopoly profit
• Qualifications–Increased foreign competition
–Limit pricing
–Technological advance
11-227
Oligopoly in the Beer Industry
• From hundreds to a few firms
• Demand side changes
– Taste shifts to lighter beers
– Shift from tap to cans or bottles
• Supply side changes
– Technological change increased minimum efficient scale
– National brands enjoy cost advantages
• Consolidation into oligopoly11-228
Key Terms
• monopolistic competition
• product differentiation
• nonprice competition
• four-firm concentration ratio
• Herfindahl index
• excess capacity
• oligopoly
• homogeneous oligopoly
• differentiated oligopoly
• strategic behavior
• mutual interdependence
• interindustry
competition
• import competition
• game theory
• collusion
• kinked-demand curve
• price war
• cartel
• price leadership
11-229
Next Chapter Preview…
Technology, R&D,And Efficiency
11-230