Chapter 1 · –Purposeful behavior –Marginal analysis 1-4. ... Chapter 2 McGraw-Hill/Irwin...

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


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


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


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


2-37

Circular Flow

Resource

Market

Product

Market


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


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


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


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


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


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 coefficient and formula

Percentage Change in Quantity

Demanded of Product X

Percentage Change in Price

of Product X

Ed =

6-66


• 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


• 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


• 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


6-72

$4

3

2

1

0 10 20 Q

P

• Lower price and inelastic demand–Gold loss exceeds blue gain

c

d

D2


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


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


Supplied of Product X


of Product X

Es =

Responsiveness to price

changes by producers

6-79


• Market period

–Perfectly inelastic supply

• Short run

–Fixed plant size

• Long run

–Adjustable plant size

–Supply more elastic

6-80

P

Q


The Market Period

• Perfectly inelastic supply

D1 D2

Sm

Q0

Pm

P0

GreatestPrice

Impact

6-81


The Short Run

• Inelastic supply

P

Q

D1 D2

Ss

Q0

Ps

P0

Qs

LowerPrice

Impact

6-82


The Long Run

• Elastic supply

P

Q

D1 D2

Sl

Q0

Pl

P0

Ql

LeastPrice

Impact

6-83


• 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


Demanded of Product X


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


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


(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


(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal



Price = $1


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


(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal



Price = $1


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


Buy one more orange – budget has $3 left

Proceed to next item 7-106


(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal



Price = $1


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


Buy one of each – budget exhausted7-107


(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal



Price = $1


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


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


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


(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


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


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


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


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



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


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


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


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


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


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


Monopolistic Competitionand Oligopoly

10-201

Monopolistic Competition and Oligopoly

Chapter 11


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


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


11-207

Short-Run Losses

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D2

ATC

Loss

Q2

A2

P2

0


11-208

Long-Run Equilibrium

Quantity

Pri

ce

an

d C

os

ts

MR = MC

MC

MR

D3

ATC

Q3

P3= A3

0


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


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


Technology, R&D,And Efficiency

11-230

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