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Survey of Economics: Principles,

Applications and Tools Eighth Edition

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Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 1

Introduction: What Is

Economics?

Chapter Outline

1.1 What Is Economics?

1.2 The three economic questions: What, How and Who?

1.3 The Economic Way of Thinking

1.4 Microeconomics Verus Macroeconomics

1.1 What Is Economics?

Economics: The study of choices when there is scarcity.

Scarcity: The resources we use to produce goods and

services are limited.

Some Examples of Scarcity and Trade-

offs

• You have a limited amount of time. Each hour on the job

means one less hour for study or play.

• A city has a limited amount of land. If the city uses an acre

of land for a park, it has one less acre for housing, retailers,

or industry.

• You have limited income this year. If you spend $17 on a

music CD, that’s $17 less you have to spend on other

products or to save.

The Five Factors of Production (1 of 2)

Factors of Production: The resources used to produce

goods and services; also known as production inputs or

resources.

Natural Resources: Resources provided by nature and

used to produce goods and services.

Labor: Human effort, including both physical and mental,

used to produce goods and services.

The Five Factors of Production (2 of 2)

Physical Capital: The stock of equipment, machines,

structures, and infrastructure that is used to produce goods

and services.

Human Capital: The knowledge and skills acquired by a

worker through education and experience and used to

produce goods and services.

Entrepreneurship: The effort used to coordinate the factors

of production—natural resources, labor, physical capital, and

human capital—to produce and sell products.

1.2 The Three Key Economic

Questions: What, How, and Who?

The choices made by individuals, firms, and governments

answer three questions:

1. What products do we produce?

2. How do we produce the products?

3. Who consumes the products?

Economic Models

Economists use economic models to explore the choices

people make and the consequences of those choices.

Economic model: A simplified representation of an

economic environment, often employing a graph.

Positive versus Normative Analysis

Most modern economics is based on positive analysis:

Positive Analysis: Answers the question “What is?” or

“What will be?”

A second type of economic reasoning is normative in

nature:

Normative Analysis: Answers the question “What ought

to be?”

Table 1.1 Comparing Positive and

Normative Questions

Positive Questions Normative Questions

• If the government increases the

minimum wage, how many workers

will lose their jobs?

• Should the government

increase the minimum wage?

• If two office-supply firms merge, will

the price of office supplies increase?

• Should the government block

the merger of two office-supply

firms?

• How does a college education affect

a person’s productivity and earnings?

• Should the government

subsidize a college education?

• How do consumers respond to a cut

in income taxes?

• Should the government cut

taxes to stimulate the

economy?

• If a nation restricts shoe imports, who

benefits and who bears the cost?

• Should the government restrict

imports?

1.3 The Economic Way of Thinking

List the four elements of the economic way of thinking.

“The theory of economics does not furnish a body of settled

conclusions immediately applicable to policy. It is a method

rather than a doctrine, an apparatus of the mind, a technique

of thinking which helps its possessor draw correct

conclusions.”

John Maynard Keynes, The Collected Writings of John

Maynard Keynes, Volume 7

Use Assumptions to Simplify

Economists use assumptions to make things simpler and

focus attention on what really matters.

We have to be careful to make the right assumptions and

simplifications.

Isolate Variables—Ceteris Paribus

Economists often consider how one variable changes in

isolation, in order to see how its changes affect other

variables.

Variable: A measure of something that can take on

different values.

Ceteris Paribus: The Latin expression meaning that other

variables are held fixed.

Think at the Margin

How will a small change in one variable affect another

variable, and what impact will that have on people’s

decision-making?

Marginal Change: A small, one-unit change in value

Rational People Respond to Incentives

A key assumption of most economic analysis is that people

act rationally, that is, in their own self-interest.

This does not mean that people are only motivated by self-

interest, but instead that this is their primary motivation.

Rationality implies that when the payoff (benefit) to doing

something changes, people will change their behavior to

make their payoff as large as possible.

1.4 Microeconomics Vs Macroeconomics

The field of economics is divided into two categories:

macroeconomics and microeconomics.

Macroeconomics: The study of the nation’s economy as a

whole; focuses on the issues of inflation, unemployment, and

economic growth.

Microeconomics: The study of the choices made by

households, firms, and governments, and how these choices

affect the markets for goods and services.

Using Macroeconomics to Understand

Why Economies Grow

The world economy has been growing in recent decades,

averaging about 1.5 percent higher per capita income per

year.

Why do some countries grow much faster than others?

Macroeconomics will help us understand why.

Using Macroeconomics to Understand

Economic Fluctuations

All countries, even those where per capita income is

generally rising, experience economic fluctuations,

including periods where the economy temporarily shrinks.

What options do governments have to moderate these

fluctuations?

And should they do so?

Using Macroeconomics to Make

Informed Business Decisions

A manager who studies macroeconomics will be better

equipped to understand the complexities of interest rates

and inflation, and how they affect the firm.

Should a firm borrow money now at a fixed interest rate?

Or wait a while, hoping interest rates will fall?

Using Microeconomics to Understand

Markets and Predict Changes

One reason for studying microeconomics is to better

understand how markets work and to predict how various

events affect the prices and quantities of products in

markets.

For example, how would a tax on beer affect:

1. The price of beer?

2. How many people buy beer?

3. How many people are likely to drink and drive?

Using Microeconomics to Make

Personal and Managerial Decisions

On the personal level, we use economic analysis to decide

how to spend our time, what career to pursue, and how to

spend and save the money we earn.

Managers use economic analysis to decide how to produce

goods and services, how much to produce, and how much to

charge for them.

Using Microeconomics to Evaluate

Public Policies

We can use economic analysis to determine how well the

government performs its roles in the market economy.

For example, prescription drugs are protected from being

copied because of government patents.

If we shortened patent lengths, we may get cheaper generic

drugs sooner; but fewer drugs may get developed because

of the decreased profitability of drug development.

Microeconomics can help evaluate the best policy here.

Key Terms

Ceteris paribus

Economic model

Economics

Entrepreneurship

Factors of production

Human capital

Labor

Macroeconomics

Marginal change

Microeconomics

Natural resources

Normative analysis

Physical capital

Positive analysis

Scarcity

Variable

1A.1 Using Graphs

Economists use several types of graphs to present data,

represent relationships between variables, and explain

concepts.

Although it is possible to do economics without graphs, it’s

a lot easier with them in your toolbox.

Figure 1A.1 Graphs of Single Variables

Left: Pie Graph for Types of Recorded Music Sold in the United States

Right: Bar Graph for U.S. Export Sales of Copyrighted Products

Figure 1A.2 Time Series Graph

A time series graph shows how the value of a variable changes

over time. In the right panel, the vertical axis is truncated,

indicated by the double hash marks on the y-axis. This

exaggerates the fluctuations in the data.

Figure 1A.3 Basic Elements of a Two-

Variable Graph

One variable is measured along

the horizontal, or x, axis, while

the other variable is measured

along the vertical, or y, axis.

The origin is defined as the

intersection of the two axes,

where the values of both

variables are zero.

The dashed lines show the

values of the two variables at a

particular point.

Graphing Two Variables

The slope of a line relating two variables on a graph indicates

whether they have a positive or negative relationship.

Positive relationship: A relationship in which two variables

move in the same direction.

Negative relationship: A relationship in which two variables

move in opposite directions.

Figure 1A.4 Relationship between

Hours Worked and Income

There is a positive

relationship between work

hours and income, so the

income curve is positively

sloped.

The slope of the curve is

$8: Each additional hour of

work increases income by

$8.

Computing the Slope

Income Slope

Work hours

  

Vertical difference between two points rise Slope

Horizontal difference between two points run  

Slope of a curve: The vertical difference between two points (the rise)

divided by the horizontal difference (the run).

In general, if the variable on the vertical axis is y and the variable on the

horizontal axis is x, we can express the slope as:

Slope y

  

Figure 1A.5 Movement Along a Curve

versus Shifting the Curve

To draw a curve showing the

relationship between hours worked

and income, we fix the weekly

allowance ($40) and the wage ($8

per hour).

A change in the hours worked

causes movement along the curve,

for example, from point b to point c.

A change in any other variable shifts

the entire curve. For example, a $50

increase in the allowance (to $90)

shifts the entire curve upward by

$50.

Figure 1A.6 Negative Relationship between

CD Purchases and Downloaded Songs

There is a negative relationship between

the number of CDs and downloaded

songs that a consumer can afford with a

budget of $360.

The slope of the curve is −$12: Each

additional CD (at a price of $12 each)

decreases the number of downloadable

songs (at $1 each) by 12 songs.

Vertical difference Slope

Horizontal difference 

120 240 120 12

20 10 10

    



Figure 1A.7 Nonlinear Relationships (1 of 2)

There is a positive and nonlinear

relationship between study time

and the grade on an exam. As

study time increases, the exam

grade increases at a decreasing

rate.

For example, the second hour of

study increased the grade by 4

points (from 6 points to 10 points),

but the ninth hour of study

increases the grade by only 1 point

(from 24 points to 25 points).

Figure 1A.7 Nonlinear Relationships (2 of 2)

There is a positive and nonlinear

relationship between the quantity of

grain produced and total production

cost. As the quantity increases, the

total cost increases at an increasing

rate.

For example, to increase production

from 1 ton to 2 tons, production cost

increases by $5 (from $10 to $15) but

to increase the production from 10 to

11 tons, total cost increases by $25

(from $100 to $125).

1A.2 Computing Percentage Changes

and Using Equations

To compute a percentage change, we divide the change in

the variable by the initial value of the variable, and then

multiply by 100:

New value initial value Percentage change 100

Initial value

  

Application 3: The Perils of

Percentages (1 of 2)

In the 1970s, the government of Mexico City repainted the

highway lane lines on the Viaducto to transform a four-lane

highway into a six-lane highway.

• The government announced that the highway capacity had

increased by 50% (equal to 2 divided by 4).

• Unfortunately, the number of collisions and traffic fatalities

increased, and one year later the government restored the

four-lane highway and announced that the capacity had

decreased by 33% (equal to 2 divided by 6).

Application 3: The Perils of

Percentages (2 of 2)

This anecdote reveals a potential problem with using the

simple approach to compute percentage changes. Because

the initial value (the denominator) changes, the computation

of percentage increases and decreases are not symmetric.

There is a solution to this problem: using the midpoint

method for percentage changes:

New value initial value Percentage change 100

Average value

  

Using Equations to Compute Missing

Values (1 of 2)

It will often be useful to compute the value of the numerator

or the denominator of an equation. For example, if we know

the change in work hours, and the slope of the line relating

change in income and change in work hours:

Income Slope

Work hours

  

Work hours Slope Income   

Income Work hours Slope   

Using Equations to Compute Missing

Values (2 of 2)

Income Work hours Slope   

Then, if you work seven extra hours, and the slope of this

line is $8 per hour, then your change in income is:

Income 7 hours $8per hour

Income $56

  

 

Key Terms (Appendix)

Negative relationship

Positive relationship

Slope of a curve

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

any part of this work (including on the World Wide Web) will

destroy the integrity of the work and is not permitted. The work

and materials from it should never be made available to students

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restrictions and to honor the intended pedagogical purposes and

the needs of other instructors who rely on these materials.

Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 2

The Key Principles of

Economics

Chapter Outline

2.1 The Principle of Opportunity Cost

2.2 The Marginal Principle

2.3 The Principle of Voluntary Exchange

2.4 The Principle of Diminishing Returns

2.5 The Real-Nominal Principle

2.1 The Principle of Opportunity Cost

Apply the principle of opportunity cost.

Economics is all about making choices; to make good

choices, we must compare the benefit of something to its

cost.

Opportunity Cost: What you sacrifice to get something.

“There is no such thing as a free lunch”

Application 1: The cost of doing business

Jack left a job paying $60,000 per year to start his own florist shop in a building he owns. The market value of the building is $80,000. He pays $30,000 per year for flowers and other supplies, and has a bank account that pays 5 percent interest. What is the economic cost of Jack's business?

The Cost of Military Spending

The war in Iraq cost the United States an estimated $1

trillion. Each $100 billion could:

• Enroll 13 million preschool children in the Head Start

program for one year.

• Hire 1.8 million additional teachers for one year.

• Immunize all the children in less-developed countries for

the next 33 years.

The true cost of the war was its opportunity cost: what the

United States sacrificed for it.

Figure 2.1 Scarcity and the Production

Possibilities Curve (1 of 3)

Production possibilities

curve: A curve that shows

the possible combinations

of products that an

economy can produce,

given that its productive

resources are fully

employed and efficiently

used.

Figure 2.1 Scarcity and the Production

Possibilities Curve (2 of 3)

The production

possibilities curve

illustrates the principle of

opportunity cost for an

entire economy.

An economy has a fixed

amount of resources. If

these resources are fully

employed, an increase in

the production of wheat

comes at the expense of

steel.

Figure 2.1 Scarcity and the Production

Possibilities Curve (3 of 3)

Each additional 10 tons of

wheat requires sacrificing

progressively more steel—

50 tons from a to b, 180

tons from c to d.

Some resources are better

suited for steel production,

and some are better suited

to wheat production.

Figure 2.2 Shifting the Production

Possibilities Curve

An increase in the quantity

of resources or

technological innovation in

an economy shifts the

production possibilities

curve outward.

Starting from point f, a

nation could produce more

steel (point g), more wheat

(point h), or more of both

goods (points between g

and h).

2.2 The Marginal Principle

Apply the marginal principle.

We rarely make all-or-nothing choices. Economists tend to think

in marginal terms: the effect of a small or incremental change.

Marginal benefit: The additional benefit resulting from a small

increase in some activity.

Marginal cost: The additional cost resulting from a small

increase in some activity.

The marginal principle: Increase the level of an activity as long

as its marginal benefit exceeds its marginal cost. Choose the

level at which the marginal benefit equals the marginal cost.

Application 2: Hiring people

1) The table below shows the marginal benefit that Khaled earns from keeping his store open one more hour. Khaled has a marginal cost of $40 per hour. Khaled stays open 20 hours.

a) Do you think Khaled’s decision to stay open 20 hours is optimal? Why? (1 mark)

b) How many hours do you advise Khaled to stay open? Why? (2 marks)

2.3 The Principle of Voluntary Exchange

Apply the principle of voluntary exchange.

Why would two people trade with one another?

Because each believes that what they receive is worth

more to them than what they give.

The principle of voluntary exchange: A voluntary

exchange between two people makes both better off.

Example: When you work, you trade your time for money.

The money is more valuable than the time to you, and your

time is more valuable than the money to your employer.

2.4 The Principle of Diminishing

Returns

Apply the principle of diminishing returns.

You run a small copy shop with one copying machine and

one worker, who can copy 500 pages per hour.

You add another worker, but output increases to only 800

pages per hour, not doubling to 1,000.

Why? They now share the copier, so each is less productive.

The principle of diminishing returns: Suppose output is

produced with two or more inputs, and we increase one input

while holding the other input or inputs fixed. Beyond some

point—called the point of diminishing returns—output will

increase at a decreasing rate.

Why Do Diminishing Returns Occur?

Diminishing returns occurs because one of the inputs to the

production process is fixed.

When a firm can vary all its inputs, including the size of the

production facility, the principle of diminishing returns is not

relevant.

If you doubled both the number of workers and equipment,

output ought to double also—or maybe more than double, if

specialization is beneficial.

Application 4: Fertilizer and Crop Yields

Adding fertilizer to a field

increases its production; but

this is subject to diminishing

returns.

Why? The other inputs to the

production process are fixed,

such as the field itself, the rain,

the sunlight, etc. Each

additional bag of fertilizer is

progressively less productive.

Some representative numbers

are on the next slide.

Table 2.1 Fertilizer and Corn Yield

Bags of Nitrogen Fertilizer Bushels of Corn per Acre

0 85

1 120

2 135

3 144

4 147

The first bag of fertilizer increases production by 35

bushels, but subsequent bags of fertilizer increase

production by less and less.

2.5 The Real-Nominal Principle

Apply the real-nominal principle.

Most modern money is not inherently valuable, but is

valuable because of what it will buy.

The real-nominal principle: What matters to people is the

real value of money or income—its purchasing power—not

its face value.

Nominal value: The face value of an amount of money.

Real value: The value of an amount of money in terms of

what it can buy.

Table 2.2 The Real Value of the

Minimum Wage, 1974–2015

Blank 1974 2015

Minimum wage per hour $2.00 $7.25

Weekly income from minimum wage 80 290

Cost of a standard basket of goods 47 236

Number of baskets per week 1.70 1.23

Between 1974 and 2015, the federal minimum wage increased

from $2.00 to $7.25.

Was the typical minimum-wage worker better or worse off in

2015?

We can apply the real-nominal principle to see that the value of

the minimum wage has actually decreased over this time period.

Application 5: Repaying Student Loans

Suppose you finish college with $40,000 in student loans and

start a job that pays a salary of $50,000 in the first year. In 10

years, you must repay your college loans. Which would you

prefer, stable prices, rising prices, or falling prices?

Hint: The nominal value of the loans will not change, even as

prices change.

Key Terms

Marginal benefit

Marginal cost

Opportunity cost

Production possibilities curve

Nominal value

Real value

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

any part of this work (including on the World Wide Web) will

destroy the integrity of the work and is not permitted. The work

and materials from it should never be made available to students

except by instructors using the accompanying text in their

classes. All recipients of this work are expected to abide by these

restrictions and to honor the intended pedagogical purposes and

the needs of other instructors who rely on these materials.

Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 3

Demand, Supply, and

Market Equilibrium

Chapter Outline

3.1 The Demand Curve

3.2 The Supply Curve

3.3 Market Equilibrium: Bringing Demand and Supply

Together

3.4 Market Effects of Changes in Demand

3.5 Market Effects of Changes in Supply

3.6 Predicting and Explaining Market Changes

4.1 The Demand Curve

Describe and explain the law of demand.

In this chapter, we will develop the model of demand and

supply—the most important tool of economic analysis.

We will assume markets are perfectly competitive,

implying that individual sellers are so small they cannot

affect the market price.

Perfectly competitive market: A market with many buyers

and sellers of a homogeneous product and no barriers to

entry.

Consumers and Demand

How much of a particular product are consumers willing to

buy during a particular period? We call this the quantity

demanded.

Quantity demanded: The amount of a product that

consumers are willing and able to buy.

What alters the amount consumers are willing to buy? We

divide this into two categories:

• The price of the product

• Everything else!

Figure 3.1 The Individual Demand

Curve (1 of 4)

The table shows how

many pizzas a consumer

will buy at a selection of

prices. This is a demand

schedule.

Demand schedule: A

table that shows the

relationship between the

price of a product and the

quantity demanded,

ceteris paribus.

Figure 3.1 The Individual Demand

Curve (2 of 4)

We plot each of the price-

quantity pairs on the graph;

joining those points gives

the individual demand

curve for pizza.

Individual demand curve:

A curve that shows the

relationship between the

price of a good and quantity

demanded by an individual

consumer, ceteris paribus.

Figure 3.1 The Individual Demand

Curve (3 of 4)

The demand curve slopes

downward; this is so typical,

we call it the law of demand.

Law of demand: There is a

negative relationship between

price and quantity demanded,

ceteris paribus.

Figure 3.1 The Individual Demand

Curve (4 of 4)

As price rises from $8 to $10,

the consumer buys 3 fewer

pizzas. This is a change in

quantity demanded.

Change in quantity

demanded: A change in the

quantity consumers are willing

and able to buy when the price

changes; represented

graphically by movement along

the demand curve.

Figure 3.2 From Individual to Market

Demand

Adding quantity demanded by each consumer at each price

gives us the market demand curve.

Market demand curve: A curve showing the relationship

between price and quantity demanded by all consumers,

ceteris paribus.

Application 1: Young Smokers and the

Law of Demand

As price decreases, the quantity of

cigarettes demanded increases for

two reasons:

• People who already smoke,

choose to smoke more; and

• Some (mostly young) people start

smoking.

Keeping cigarette prices high, or

increasing them with taxes, is one way

that governments try to discourage

young people from starting smoking.

3.2 The Supply Curve

Describe and explain the law of supply.

How much of a particular product are firms willing to produce

and sell during a particular period? We call this the quantity

supplied.

Quantity supplied: The amount of a product that firms are

willing and able to sell.

What alters the amount firms are willing to sell? We divide this

into two categories:

• The price of the product

• Everything else!

Figure 3.3 The Individual Supply

Curve (1 of 4)

The table shows how many

pizzas a firm will sell at a

selection of prices. This is a

supply schedule.

Supply schedule: A table

that shows the relationship

between the price of a

product and the quantity

supplied, ceteris paribus.

Figure 3.3 The Individual Supply

Curve (2 of 4)

We plot each of the price-

quantity pairs on the graph;

joining those points gives the

individual supply curve for

pizza.

Individual demand curve: A

curve that shows the

relationship between the price

of a good and quantity supplied

by an individual firm, ceteris

paribus.

Figure 3.3 The Individual Supply

Curve (3 of 4)

The supply curve slopes upward; this

is so typical, we call it the law of

supply.

Law of supply: There is a positive

relationship between price and

quantity supplied, ceteris paribus.

There are some prices below which

the firm would not provide any pizzas;

for this firm, the minimum supply

price appears to be $2.

Minimum supply price: The lowest

price at which a product will be

supplied.

Figure 3.3 The Individual Supply

Curve (4 of 4)

As price rises from $8 to $10,

the firm is willing to provide 100

more pizzas. This is a change

in quantity supplied.

Change in quantity supplied:

A change in the quantity firms

are willing and able to sell when

the price changes; represented

graphically by movement along

the supply curve.

Why Is the Individual Supply Curve

Positively Sloped?

A higher price encourages the firm to increase its output by

purchasing more materials and hiring more workers.

Even if the new materials are more expensive, or the new

workers are more costly or less productive, the firm is willing to

incur those higher marginal costs to sell at higher prices.

• This is consistent with the marginal principle: increase the

level of an activity as long as its marginal benefit exceeds its

marginal cost. Choose the level at which the marginal benefit

equals the marginal cost.

The price is the marginal benefit; the supply curve shows the

firm’s marginal cost of production.

Figure 3.4 From Individual to Market

Supply

Adding quantity supplied by each firm at each price gives

us the market supply curve.

Market supply curve: A curve showing the relationship

between price and quantity supplied by all firms, ceteris

paribus.

Figure 3.5 The Market Supply Curve

with Many Firms

A perfectly competitive

market has hundreds of

firms rather than just two.

In the case of many firms,

the market supply curve

will be smooth rather than

kinked.

In this graph, we assume

there are 100 firms

identical to Lola’s.

Why Is the Market Supply Curve

Positively Sloped?

There are two reasons why the market supply curve is

positively sloped. As the market price increases,

1. Individual firms increase output by purchasing more

materials and hiring more workers; and

2. New firms enter the market, encouraged by the higher

price.

As with the individual supply curve, the market supply curve

shows the marginal cost of production, this time for the

market as a whole.

Application 2: Sheep, Wool, and the

Law of Supply

In the 1990s, the world

price of wool decreased

by about 30%. The law

of supply suggests wool

output would decrease.

It did; wool-exporting

countries like New

Zealand converted land

to more profitable uses,

like dairy farming,

forestry, and wine

production.

3.3 Market Equilibrium: Bringing

Demand and Supply Together

Explain the role of price in reaching a market

equilibrium.

A market is an arrangement that brings buyers and sellers

together. These buyers and sellers jointly determine prices

and quantities traded.

Market equilibrium: A situation in which the quantity

demanded equals the quantity supplied at the prevailing

market price.

When a market is in equilibrium, there is no pressure on the

price to change.

Figure 3.6 Market Equilibrium (1 of 3)

At the market equilibrium

(point a, with price = $8 and

quantity = 30,000), the

quantity supplied equals the

quantity demanded.

Everyone willing to pay $8

receives a pizza for that

price; and every pizza firms

are willing to produce at $8

gets sold.

Figure 3.6 Market Equilibrium (2 of 3)

At a price below the equilibrium

price ($6), there is excess

demand—the quantity demanded

at point c exceeds the quantity

supplied at point b.

Excess demand: A situation in

which, at the prevailing price, the

quantity demanded exceeds the

quantity supplied.

This mismatch causes the price of

pizza to rise; firms will realize they

can raise the price and still sell all

the pizzas they planned to sell.

Figure 3.6 Market Equilibrium (3 of 3)

At a price above the equilibrium price

($12), there is excess supply—the

quantity supplied at point e exceeds

the quantity demanded at point d.

Excess supply: A situation in which

the quantity supplied exceeds the

quantity demanded at the prevailing

price.

This mismatch causes the price of

pizza to fall; firms will realize they

cannot sell all of their pizzas at the

prevailing price, and will start

undercutting one another.

Application 3: Shrinking Wine Lakes

The European Union guarantees

minimum prices for agricultural

products like grapes. These

above-equilibrium prices

encourage overproduction, which

the EU guarantees to buy.

Recent reforms have reduced

(and in some cases eliminated)

these price guarantees, resulting

in shrinking excess “wine lakes”

and “butter mountains.”

3.4 Market Effects of Changes in

Demand

Describe the effect of a change in demand on the

equilibrium price.

Market equilibrium occurs when the quantity supplied equals

the quantity demanded.

Changes in the demand side of the market can affect the

equilibrium price and the equilibrium quantity.

Figure 3.7 Change in Quantity Demanded

Versus Change in Demand (1 of 2)

Panel (A) shows a change in price causing a change in quantity

demanded, a movement along a single demand curve.

A decrease in price causes a move from point a to point b, increasing

the quantity demanded.

Figure 3.7 Change in Quantity Demanded

Versus Change in Demand (2 of 2)

Panel (B) shows a change in demand caused by changes in a variable

other than the price. This shifts the entire demand curve.

An increase in demand shifts the demand curve from D1 to D2.

Change in demand: A shift of the demand curve caused by a change in

a variable other than the price of the product.

Increases in Demand Shift the Demand

Curve (1 of 3)

What could cause the demand curve to increase (shift to the

right)? Anything other than a price decrease that makes

consumers want to buy more of the good. Some examples:

• An income change: Consumers buy more vacations and

new cars when their income increases. We call these

normal goods. But consumers buy less of some goods (like

second-hand clothing, or ramen noodle packets) when their

income increases: these are inferior goods.

Normal good: A good for which an increase in income

increases demand.

Inferior good: A good for which an increase in income

decreases demand.

Increases in Demand Shift the Demand

Curve (2 of 3)

More examples:

• Increase in the price of a substitute good: Tacos and pizza are

substitutes: when the price of tacos rise, some consumers switch

to buying pizzas instead.

• Decrease in the price of a complementary good: Pay-per-view

sports events and pizza are complements: when the price of a

pay-per-view event falls, more consumers watch it, and buy more

pizza to consume with it.

Substitutes: Two goods for which an increase in the price of one

good increases the demand for the other good.

Complements: Two goods for which a decrease in the price of

one good increases the demand for the other good.

Increases in Demand Shift the Demand

Curve (3 of 3)

Even more examples:

• Increase in population: More people means more

potential pizza consumers.

• Shift in consumer preferences: Consumers might

decide the like for pizza more than they used to. A

successful pizza advertising campaign might increase

the demand for pizza.

• Expectations of higher future prices: If consumers

learn pizza prices will rise next week, they might buy

more pizzas this week, and fewer next week.

Table 3.1 Increases in Demand Shift

the Demand Curve to the Right

Figure 3.8 An Increase in Demand

Increases the Equilibrium Price (1 of 2)

An increase in demand shifts

the demand curve to the right:

At each price, the quantity

demanded increases.

At the initial price ($8), there is

excess demand, with the

quantity demanded (point b)

exceeding the quantity

supplied (point a).

The excess demand causes

the price to rise, and

equilibrium is restored at point

Figure 3.8 An Increase in Demand

Increases the Equilibrium Price (2 of 2)

The result of the increase

in demand: the equilibrium

price rises to $10, and the

equilibrium quantity of

pizzas rises to 40,000

pizzas per month.

Generally, we predict an

increase in demand will

increase the equilibrium

price and increase the

equilibrium quantity.

Table 3.2 Decreases in Demand Shift

the Demand Curve to the Left

Figure 3.9 A Decrease in Demand

Decreases the Equilibrium Price (1 of 2)

A decrease in demand shifts the

demand curve to the left: At each

price, the quantity demanded

decreases.

At the initial price ($8), there is

excess supply, with the quantity

supplied (point a) exceeding the

quantity demanded (point b).

The excess supply causes the

price to drop, and equilibrium is

restored at point c.

Figure 3.9 A Decrease in Demand

Decreases the Equilibrium Price (2 of 2)

The result of the decrease in

demand: the equilibrium price

falls to $6, and the equilibrium

quantity of pizzas falls to

20,000 pizzas per month.

Generally, we predict an

decrease in demand will

decrease the equilibrium price

and decrease the equilibrium

quantity.

Application 4: Craft Beer and the Price

of Hops

Between 2012 and 2017,

U.S. craft beer production

increased more than 30%.

Craft beer brewers

increased their demand for

ingredients, including hops.

As a result of the demand

increase, the equilibrium

price of hops rose

substantially: from $3.17 to

$5.92 per pound.

3.5 Market Effects of Changes in Supply

Describe the effect of a change in supply on the

equilibrium price.

Market equilibrium occurs when the quantity supplied equals

the quantity demanded.

Changes in the supply side of the market can affect the

equilibrium price and the equilibrium quantity.

Figure 3.10 Change in Quantity

Supplied versus Change in Supply (1 of 2)

Panel (A) shows a change in price causing a change in quantity

supplied, a movement along a single supply curve.

An increase in price causes a move from point a to point b,

increasing the quantity supplied.

Figure 3.10 Change in Quantity

Supplied versus Change in Supply (2 of 2)

Panel (B) shows a change in supply caused by changes in a variable

other than price. This shifts the entire supply curve.

An increase in supply shifts the entire supply curve from S1 to S2.

Change in supply: A shift of the supply curve caused by a change in a

variable other than the price of the product.

Increases in Supply Shift the Supply

Curve

What could cause the supply curve to increase (shift to the right)?

Anything other than a price increase that makes firms want to provide

more of the good. Some examples:

• A decrease in input costs: If wages or the cost of materials go down,

production becomes more profitable, so firms expand.

• Technological advance: New technologies can make production more

profitable and hence encourage expansion.

• Government subsidy: A payment from the government will also make

production more profitable also.

• Expected future prices falling: A firm that learns prices will fall next

month will try to sell more at current higher prices.

• Number of producers: More firms mean more production.

Table 3.3 Changes in Supply Shift the

Supply Curve Downward and to the Right

Figure 3.11 An Increase in Supply

Decreases the Equilibrium Price (1 of 2)

An increase in supply shifts

the supply curve to the right:

At each price, the quantity

supplied increases.

At the initial price ($8), there

is excess supply, with the

quantity supplied (point b)

exceeding the quantity

demanded (point a). The

excess supply causes the

price to drop, and equilibrium

is restored at point c.

Figure 3.11 An Increase in Supply

Decreases the Equilibrium Price (2 of 2)

The result of the increase in

supply: the equilibrium price

falls to $6, and the equilibrium

quantity of pizzas rises to

36,000 pizzas per month.

Generally, we predict an

increase in supply will

decrease the equilibrium price

and increase the equilibrium

quantity.

Table 3.4 Changes in Supply Shift the

Supply Curve Upward and to the Left

Figure 3.12 A Decrease in Supply

Increases the Equilibrium Price (1 of 2)

A decrease in supply shifts

the supply curve to the left.

At each price, the quantity

supplied decreases.

At the initial price ($8), there

is excess demand, with the

quantity demanded (point a)

exceeding the quantity

supplied (point b). The

excess demand causes the

price to rise, and equilibrium

is restored at point c.

Figure 3.12 A Decrease in Supply

Increases the Equilibrium Price (2 of 2)

The result of the decrease in

supply: the equilibrium price

rises to $10, and the

equilibrium quantity of pizzas

rises to 24,000 pizzas per

month.

Generally, we predict a

decrease in supply will

increase the equilibrium price

and decrease the equilibrium

quantity.

Simultaneous Changes in Demand and

Supply

What happens to the equilibrium price and quantity when

both demand and supply increase?

It depends on which change is larger.

• If the effect on demand is larger, then the overall change

will “look like” the change in demand.

• If the effect on supply is larger, then the overall change

will “look like” the change in supply.

Figure 3.13 Market Effects of Simultaneous

Changes in Demand and Supply

Application 5: The Harmattan and the

Price of Chocolate

The harmattan is a dry, dusty

wind from the Sahara desert.

Each year it sweeps through

cocoa plantations in Ghana and

Ivory Coast, drying coca pods

and decreasing yields.

In 2015, the harmattan was

longer than usual (14 days rather

than the usual 5 days) so crop

yields were lower than usual; the

decrease in supply caused world

cocoa prices to rise in 2015.

3.6 Predicting and Explaining Market

Changes

Use information on price and quantity to determine what

caused a change in price.

Using our demand and supply model, we have shown how

equilibrium prices are determined, and how changes in demand

and supply affect equilibrium prices and quantities.

When demand changes, both equilibrium price and quantity

change in the same direction as demand changes: increasing or

decreasing.

When supply changes, the equilibrium quantity changes in the

same direction as the supply change, but equilibrium price

changes in the opposite direction.

The table on the next slide summarizes this.

Table 3.5 Market Effects of Changes in

Demand or Supply

Change in Demand

or Supply

How does the equilibrium

price change?

How does the equilibrium

quantity change?

Increase in demand Increase Increase

Decrease in demand Decrease Decrease

Increase in supply Decrease Increase

Decrease in supply Increase Decrease

We can use this knowledge to predict how prices and quantities will

change in response to a demand or supply change.

We can also use this knowledge “in reverse”: if we know the price and

quantity of a product both rose or fell, we should expect a change in

demand caused the changes.

Conversely, if the price and quantity of a product moved in opposite

directions, we should infer a change in supply occurred.

Application 6: Why Did Drug Prices

Fall? (1 of 2)

“Do you know what’s happened to the price of drugs in the

United States? The price of cocaine, way down, the price of

marijuana, way down. You don’t have to be an expert in

economics to know that when the price goes down, it means

more stuff is coming in. That’s supply and demand.”

Ted Koppel, host of the ABC news program Nightline

Was Koppel right? That is, do falling drug prices prove the

U.S. government’s “war on drugs” was failing, and the

supply of illegal drugs was increasing

Application 6: Why Did Drug Prices

Fall? (2 of 2)

There are two possible explanations:

• Koppel’s hypothesis: supply rose, resulting in lower prices

and higher quantities.

• The alternative: demand fell, resulting in lower prices and

lower quantities.

According to the U.S. Department of Justice, during this time

of falling prices, drug consumption actually decreased.

• This suggests the alternative explanation is more likely to

be correct.

Key Terms

Change in demand

Change in quantity demanded

Change in quantity supplied

Change in supply

Complements

Demand schedule

Excess demand

Excess supply

Individual demand curve

Individual supply curve

Inferior good

Law of demand

Law of supply

Market demand curve

Market equilibrium

Market supply curve

Minimum supply price

Normal good

Perfectly competitive market

Quantity demanded

Quantity supplied

Substitutes

Supply schedule

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Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 4

Elasticity: A Measure of

Responsiveness

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Chapter Outline

4.1 The Price Elasticity of Demand

4.2 Using Price Elasticity

4.3 Elasticity and Total Revenue for a Linear Demand Curve

4.4 Other Elasticities of Demand

4.5 The Price Elasticity of Supply

4.6 Using Elasticities to Predict Changes in Prices

4.1 The Price Elasticity of Demand

List the determinants of the price elasticity of demand.

Price elasticity of demand (Ed): A measure of the

responsiveness of the quantity demanded to changes in price;

equal to the absolute value of the percentage change in quantity

demanded divided by the percentage change in price.

percentage change in quantity demanded

percentage change in price d

E 

Suppose that when the price of milk increases by 10%, the

quantity demanded of decreases by 15%:

percentage change in quantity demanded

percentage change in price

15% 1.5

10% d

E 

  

Computing Percentage Changes and

Elasticities

Computing elasticities requires computing percentage

changes.

We can compute percentage changes via the initial-value

method or the midpoint method.

• The initial-value method is easier.

• The midpoint method is more accurate.

In this text, we use the initial-value approach in order to

concentrate on the economic intuition rather than the math.

A comparison of calculations using the two methods is on

the next slide.

Table 4.1 Computing Price Elasticity

with Initial Values and Midpoints

Blank Blank Price Quantity

Data Initial $20 100

Blank New 22 80

Blank Blank Price Quantity

Computation with

Initial-value method

Percentage change $2 divided by $20, times 100 = 10% negative 20 divided by 100, times 100 = negative 20%

Blank Price elasticity of

demand

the absolute value of, negative 20% divided by 10%, = 2.0 Blank

Blank Blank Price Quantity

Computation with

midpoint method

Percentage change $2 divided by $21, times 100 = 9.52% negative 20 divided by 90, times 100 = negative 22.22%

Blank Price elasticity of

demand

the absolute value of negative 222.22% divided by 9.52% = 2.33

Blank

$2 10% 100

$20  

20 20% 100

100    

20% 2.0

10%

 

$2 9.52% 100

$21  

20 22.22% 100

90   

22.22% 2.33

9.52%

 

Price Elasticity and the Demand Curve

Price elasticity of demand and the slope of the demand

curve are related.

percentage change in quantity demanded

percentage change in price d

E 

rise change in price Slope

run change in quantity  

Roughly, a greater price elasticity of demand means a

shallower slope, and a smaller price elasticity of demand

means a steeper-sloped demand curve.

Figure 4.1 Elasticity and Demand

Curves (Panel A)

Elastic demand: The

price elasticity of

demand is greater than

one, so the percentage

change in quantity

exceeds the percentage

change in price.

Example goods:

restaurant meals, air

travel, movies.

Figure 4.1 Elasticity and Demand

Curves (Panel B)

Inelastic demand:

The price elasticity of

demand is less than

one, so the

percentage change in

quantity is less than

the percentage

change in price.

Example goods: milk,

salt, eggs, coffee,

cigarettes.

Figure 4.1 Elasticity and Demand

Curves (Panel C)

Unit elastic demand: The

price elasticity of demand is

one, so the percentage

change in quantity equals

the percentage change in

price.

Example goods: housing,

juice.

Figure 4.1 Elasticity and Demand

Curves (Panel D)

Perfectly inelastic

demand: The price

elasticity of demand is

zero.

In this extreme case, the

quantity demanded does

not change when the price

changes. This could only

happen if there were no

possible substitutes for the

good, say insulin for

diabetics.

Figure 4.1 Elasticity and Demand

Curves (Panel E)

Perfectly elastic

demand: The price

elasticity of demand is

infinite.

In this extreme case,

buyers will buy as much

as sellers can offer at

the given price. When a

seller provides a tiny

fraction of output for the

market, this may be a

good assumption.

Elasticity and the Availability of

Substitutes

The key factor in determining the price elasticity of demand for a

particular product is the availability of substitute products.

• For diabetics, there is no substitute for insulin, so the demand

for insulin is inelastic.

• For cereal-eaters, there are many substitutes for cornflakes, so

the demand for cornflakes is elastic.

Adjustment to price changes is easier over time. So the price

elasticity of demand tends to be greater in the long run than in the

short run.

• If gasoline prices rise, you can do little about it in the short run.

• In the long run, you can move, change cars, etc.

Table 4.2 Price Elasticities of Demand

for Selected Products (1 of 2)

Blank Product

Price Elasticity of

Demand

Inelastic Salt

Food (wealthy countries)

Weekend canoe trips

Water

Coffee

Physician visits

Sport fishing

Gasoline (short run)

Eggs

Cigarettes

Food (poor countries)

Shoes and footwear

Gasoline (long run)

0.1

0.15

0.19

0.2

0.3

0.25

0.28

0.25

0.3

0.34

0.7

0.6

Table 4.2 Price Elasticities of Demand

for Selected Products (2 of 2)

Blank Product

Price Elasticity of

Demand

Unit

elastic

Elastic

Housing

Fruit Juice

Automobiles

Foreign travel

Motorboats

Restaurant meals

Air travel

Movies

Specific brands of coffee

1.0

1.2

1.8

2.2

2.3

2.4

3.7

5.6

Other Determinants of the Price

Elasticity of Demand

1. Elasticity is higher for goods that take a relatively large part of a

consumer’s budget.

– A 10% increase in the price of gum is unlikely to change the

quantity of gum demanded by much.

– But a 10% increase in the price of cars would have a large

effect.

2. Goods that are necessities have lower elasticities of demand;

goods that are luxuries have higher elasticities of demand.

– Food demand is inelastic in both rich and poor countries.

– Demand for air travel is elastic (though for some it may be

inelastic, say for travel to a funeral).

Table 4.3 Determinants of Elasticity

Factor

Demand is relatively

elastic if …

Demand is relatively

inelastic if …

Availability of

substitutes

There are many

substitutes.

There are few

substitutes.

Passage of time a long time passes. a short time passes.

Fraction of consumer

budget

is large. is small.

Necessity the product is a

luxury.

the product is a

necessity.

Application 1: The Elasticity of Demand

for Public Transit

When the price of a city bus

or subway ride increases,

what is the price elasticity of

demand for public transit?

• In the short run (one to two

years) it is 0.40: relatively

inelastic.

• In the long run it is 0.80:

close to unit elastic.

4.2 Using Price Elasticity

Use price elasticity of demand to predict changes in quantity and

total revenue.

If we have values for two of the three variables in the elasticity formula,

we can compute the value of the third. The three variables are:

• the price elasticity of demand itself,

• percentage change in quantity, and

• the percentage change in price.

Specifically, we can rearrange the elasticity formula:

percentage change in quantity demanded

percentage change in price d

E 

percentage change in quantity demanded

percentage change in price d

E 

Predicting Changes in Quantity

Suppose you are running a campus film series, and you

know the price elasticity of demand for tickets is 2.0.

If you raise prices by 15%, how many fewer tickets will you

sell?

percentage change in quantity demanded

percentage change in price

15% 2.0

30%

d E 

 



Price Elasticity and Total Revenue

Firms use the concept of price elasticity to predict the effects

of changing their prices.

Total revenue: The money a firm generates from selling its

product.

Suppose a firm increases the price of its product. Two things

happen:

• Good news: it gets more money for each product sold.

• Bad news: it sells fewer products.

The extent of the “bad news” depends on the price elasticity

of demand for the firm’s product.

Table 4.4 Price and Total Revenue with

Different Elasticities of Demand

Blank Elastic Demand: Ed = 2.0 Blank

Price Quantity Sold Total Revenue

$10 100 $1,000

11 80 880

Blank Inelastic Demand: Ed = 0.50 Blank

Price Quantity Sold Total Revenue

100 10 $1,000

120 9 1,080

When elasticity is high, the “bad news” is large, and total

revenue falls.

When elasticity is low, the “bad news” is small, and total

revenue rises.

Table 4.5 Price Elasticity and Total

Revenue

Blank Blank Elastic Demand: Ed > 1.0

If price … Total

revenue …

Because the percentage change in

quantity is …

  Larger than the percentage change in price.

  Larger than the percentage change in price.

Blank Blank Inelastic Demand: Ed < 1.0

If price … Total

revenue …

Because the percentage change in

quantity is …

  Smaller than the percentage change in

price.

  Smaller than the percentage change in

price.

Using Elasticity to Predict the Revenue

Effects of Price Changes (1 of 2)

1. Market versus Brand Elasticity:

The demand for a specific brand of a product is more elastic

than the demand for the product.

Raising the price of all coffees would increase coffee revenue;

but raising the price of one brand would decrease revenue for

that brand.

2. Bus Fares and Deficits:

Public bus systems almost always run a deficit.

But demand is typically inelastic.

If fares were raised, the “good news” (more revenue per rider)

would dominate the “bad news” (fewer riders), so total fare

revenue would increase, potentially eliminating the deficit.

Using Elasticity to Predict the Revenue

Effects of Price Changes (2 of 2)

3. A Bumper Crop is Bad News for Farmers:

An unusually large crop of soy beans increases the number of

bushels of soy beans for sale (good news).

But the price decreases, because of the increased supply (bad

news).

But demand is inelastic, so the bad news dominates the good

news: a bumper crop results in lower overall revenues.

4. Antidrug Policies and Property Crime:

Antidrug policies raise the price of drugs. But demand for drugs

is inelastic, so total spending on drugs increases.

This increases property crime, as drug addicts commit crime to

obtain money for drugs.

Application 2: Vanity Plates and the

Elasticity of Demand

Virginia has the highest ratio of

vanity license plates: over 10% of

vehicles have them.

Why? Because the price is so low,

$10 per year.

If Virginia wanted to raise more

revenue from vanity license plates,

it should raise its price: the price

elasticity of demand is only 0.26.

• A 100% increase in price would

decrease quantity demanded

only 26%.

4.3 Elasticity and Total Revenue for a

Linear Demand Curve

Explain how the price elasticity of demand varies along a linear

demand curve.

It is often useful to represent the demand for a product with a linear

demand curve.

• A linear demand curve—a straight line—has a constant slope, but

that does not mean that it has a constant elasticity of demand.

In fact, the price elasticity of demand decreases as we move downward

along a linear demand curve.

• On the upper half of a linear demand curve, demand is elastic.

• On the lower half of the curve, demand is inelastic.

• At the midpoint of a linear demand curve, demand is unit elastic.

Figure 4.2 Elasticity and Total Revenue

along a Linear Demand Curve (Panel A)

The slope of this demand curve is −$2 per unit quantity. We

will use this in the table on the next slide to compute the

elasticity at three points: e, u, and i (elastic, unit elastic,

and inelastic).

Table 4.6 Elasticity of Demand along a

Linear Demand Curve

A B C D E F

Starting

Point

Change

in Price

Percentage

Change in

Price

Change

Quantity

Percentage

Change in

Quantity

Elasticity of

Demand

e: Elastic ‒$2 negative $2 over $80 = negative 2.5%

+1 1 over 10 = 10% absolute value of 10% over negative 2.5% = 4.

u: Unit

elastic

‒$2 negative $2 over $50 = negative 4%.

+1 1 over 25 = 4%. absolute value of 4% over negative 4% = 1.

i: inelastic ‒$2 negative $2 over $20 = negative 10%

+1 1 over 40 = 2.5% absolute value of 2.5% over negative 10% = 0.25

$2 2.5%

$80

  

1 10%

10 

10% 4

2.5% 



$2 4%

$50

  

1 4%

25 

4% 1

4% 



$2 10%

$20

  

1 2.5%

40 

2.5% 0.25

10% 



The slope of −$2 per unit quantity means each increase in quantity of 1

(column D) is associated with the price decreasing by $2 (column B).

The elasticity is lower at greater quantities (lower prices): a large

percentage change in price induces a smaller quantity change.

Figure 4.2 Elasticity and Total Revenue along

a Linear Demand Curve (Both Panels)

Since elasticity varies along the

linear demand curve, so does

the total revenue:

• When demand is elastic,

lowering price raises total

revenue.

• When demand is inelastic,

raising price raises total

revenue.

• When demand is unit elastic,

total revenue is maximized.

Application 3: Drones and the Lower

Half of a Linear Demand Curve

Suppose a firm that produces hobby

drones (for civilian use) has a linear

demand curve for its product, with a

vertical intercept of $800. The firm

currently charges a price of $300.

Should the firm raise its price? Yes!

1. The price is below the midpoint of

the linear demand curve, so

raising price would increase

revenue.

2. It would need to make fewer

drones, so its costs would fall.

4.4 Other Elasticities of Demand

Define the income elasticity and cross-price elasticity

of demand.

Price elasticity of demand measures the responsiveness of

consumers to changes in the price of a particular good.

But demand depends on other variables too; we can obtain

an elasticity for those variables, by seeing how quantity

demanded responds to changes in those other variables.

We will examine the effects of income and the prices of

related goods.

Income Elasticity of Demand

Income elasticity of demand: A measure of the responsiveness

of demand to changes in consumer income; equal to the

percentage change in the quantity demanded divided by the

percentage change in income.

percentage change in quantity demanded

percentage change in income i

E 

If a 10% increase in income increases the quantity of books

demanded by 15%:

percentage change in quantity demanded

percentage change in income

15% 1.5

10% i

E   

Cross-Price Elasticity of Demand

Cross-price elasticity of demand: A measure of the

responsiveness of demand to changes in the price of another

good; equal to the percentage change in the quantity demanded

of one good (X) divided by the percentage change in the price of

another good (Y).

percentage change in quantity of demanded

percentage change in price of xy

Y E 

If a 20% increase in the price of bananas (B) increases the

quantity of apples (A) demanded by 5%:

percentage change in quantity of demanded

percentage change in price of

5% 0.25

20% AB

E A

B   

Table 4.7 Income and Cross-Price

Elasticities for Different Types of Goods

This elasticity Is Positive for … Is Negative for …

Income elasticity Normal goods Inferior goods

Cross-price elasticity Substitute goods Complementary goods

Recall inferior goods are ones we buy less of as our income

rises, resulting in a negative income elasticity of demand.

• Normal goods—ones we buy more of as our income rises—

have a positive income elasticity of demand.

Substitutes are bought in place of one another: when the price of

one rises, the demand for the other increases (a positive cross-

price elasticity).

• Complements work the other way: when the price of one rises,

we buy less of the other—a negative cross-price elasticity.

How Are These Elasticities Useful?

During a recession, incomes fall (or rise slowly).

• If you operate a retail store and know the income elasticity of

demand for your product and how incomes are changing, you

can predict how sales of your product will change.

A supermarket sells many products. When ordering for the

produce department of a supermarket, suppose you know

bananas will be on sale.

• If you know the price change for the bananas, and the cross-

price elasticities for other products, you can predict how much

more or less you will sell of the other products, and order

accordingly.

Application 4: I Can Find That

Elasticity in Four Clicks!

The USDA has a web site

that provides estimates of

demand elasticities (own-

price, income, or cross-

price) for hundreds of food

products, and for dozens of

countries.

Check it out:

https://data.ers.usda.gov/

reports.aspx?ID=17825

https://data.ers.usda.gov/reports.aspx?ID=17825

4.5 The Price Elasticity of Supply

List the determinants of the price elasticity of supply.

We can also use elasticity do measure the responsiveness

of firms to changes in prices.

Price elasticity of supply: A measure of the

responsiveness of the quantity supplied to changes in price;

equal to the percentage change in quantity supplied divided

by the percentage change in price.

percentage change in quantity supplied

percentage change in price s

E 

Figure 4.3 The Slope of the Supply

Curve and Supply Elasticity

As with demand curves, a steeper slope means a smaller price

elasticity of supply, and a shallower slope means a greater price

elasticity of supply. For panel A,

percentage change in quantity supplied

percentage change in price

2% 0.10

20% s

E   

What Determines the Price Elasticity of

Supply?

The price elasticity of supply is determined by how rapidly

production costs increase as the total output of the industry

increases.

• If the marginal cost increases rapidly, the supply curve is

relatively steep and the price elasticity is relatively low.

• Consider the pencil industry: increasing output is unlikely

to increase input costs much, so the supply curve will be

quite flat, with a high price elasticity of supply.

The Role of Time: Short-Run versus

Long-Run Supply Elasticity

The supply curve is positively sloped because of two

increases to an increase in price:

• Short run: A higher price encourages existing firms to

increase their output by purchasing more materials and

hiring more workers.

• Long run: New firms enter the market and existing firms

expand their production facilities to produce more output.

Greater quantity changes will result from a given price

change in the long run: a greater price elasticity of supply.

Extreme Cases: Perfectly Inelastic

Supply and Perfectly Elastic Supply

For some goods and services, there is only a fixed amount of the

good or service available: a perfectly inelastic supply.

Perfectly inelastic supply: The price elasticity of supply equals

zero.

Land is a good example: as Will Rogers said, “The trouble with land

is that they’re not making it anymore.”

For other goods and services, the marginal cost of production may

not change as we provide one more unit. These have a perfectly

elastic supply.

Perfectly elastic supply: The price elasticity of supply is equal to

infinity.

Figure 4.4 Perfectly Inelastic Supply

and Perfectly Elastic Supply

In Panel A, the quantity supplied is the same at every price, so the

price elasticity of supply is zero.

In Panel B, the quantity supplied is infinitely responsive to changes

in price, so the price elasticity of supply is infinite.

Predicting Changes in Quantity

Supplied

We can rearrange the formula for price elasticity of supply as we

did for price elasticity of demand:

percentage change in quantity supplied

percentage change in price s

E 

percentage change in quantity supplied

percentage change in price s

E 

If the elasticity of supply is 0.80 and price rises by 5%:

percentage change in quantity supplied

percentage change in price 5% 0.80 4% s

E    

Application 5: The Short-Run and Long-

Run Elasticity of Supply of Coffee

Suppose the price of coffee beans

rises.

In the short run, farmers will use

more fertilizer and water, and more

labor, to obtain greater output per

bush.

In the long run, they will also plant

more bushes, resulting in a greater

output increase for the same size

price increase—greater price

elasticity of supply in the long run.

4.6 Using Elasticities to Predict

Changes in Prices

Use demand and supply elasticities to predict changes

in equilibrium prices.

When demand or supply changes, we can use a simple

demand-and-supply graph to predict whether the equilibrium

price will increase or decrease.

But we might want to do better: predicting how much the

equilibrium price will change.

• Demand and supply elasticities can help us to make this

prediction.

The Price Effects of a Change in

Demand

Suppose the demand for milk increases. Immediately, there

is an excess demand for milk. We know the price will rise to

eliminate the excess demand.

What would make the resulting increase in price relatively

small?

1. A small increase in demand (so the amount of excess

demand is small).

2. Highly elastic demand (so the quantity demanded

changes a lot in response to a price change).

3. Highly elastic supply (so the quantity supplied changes a

lot in response to a price change).

Figure 4.5 An Increase in Demand

Increases the Equilibrium Price

Demand increases by 35 million

gallons; perhaps a new trade

deal sends 35 million gallons

overseas.

The supply elasticity is 2.5 and

the demand elasticity is 1.0.

A 10% increase in price will

increase quantity supplied by

25% (25 million) and decrease

quantity demanded by 10% (10

million), eliminating the excess

demand.

Predicting the Change In Equilibrium

Price

More generally, we can use the following formula:

percentage change in demand percentage change in equilibrium price

s d E E

 

In our example:

35% percentage change in equilibrium price

2.5 1.0

35%

3.5

10%

 



The Price Effects of a Change in Supply

Let’s work through a similar exercise for a change in supply.

Suppose the supply of shoes decreases. Immediately, there is an

excess demand for shoes. We know the price will rise to eliminate

the excess demand.

What would make the resulting increase in price relatively small?

1. A small decrease in supply (so the amount of excess demand is

small).

2. Highly elastic demand (so the quantity demanded changes a lot

in response to a price change).

3. Highly elastic supply (so the quantity supplied changes a lot in

response to a price change).

Figure 4.6 An Increase in Demand

Increases the Equilibrium Price

The supply of shoes falls by 30

million pairs; perhaps a

protectionist government

introduces import restrictions.

The supply elasticity is 2.3 and

the demand elasticity is 0.7.

A 10% increase in price will

increase quantity supplied by

23% (23 million) and decrease

quantity demanded by 7% (7

million), eliminating the excess

demand.

Finding the Change In Equilibrium Price

More generally, we can use the following formula:

percentage change in supply percentage change in equilibrium price

s d E E

 

In our example:

30% percentage change in equilibrium price

2.3 0.7

30%

3.0

10%

    

 

    

 



Application 6: A Broken Pipeline and

the Price of Gasoline (1 of 2)

In 2003, a pipeline break

decreased the supply of

gasoline to the city of Phoenix

by 30%.

The equilibrium price

increased only 40%; with a

short-run demand elasticity of

demand for gasoline of 0.2, a

price increase of 150% would

have been necessary to

eliminate the excess demand

if there were not supply

adjustment.

Application 6: A Broken Pipeline and

the Price of Gasoline (2 of 2)

What actually happened? Gasoline was diverted to Phoenix via a

different pipeline: quantity supplied increased in response to the high

prices.

Suppose the price elasticity of supply was 0.55:

percentage change in supply percentage change in equilibrium price

30%

0.55 0.20

30%

0.75

40%

s d E E

  

    

 



Key Terms

Cross-price elasticity of demand

Elastic demand

Income elasticity of demand

Inelastic demand

Perfectly elastic demand

Perfectly elastic supply

Perfectly inelastic demand

Perfectly inelastic supply

Price elasticity of demand (Ed)

Price elasticity of supply

Total revenue

Unit elastic demand

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

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destroy the integrity of the work and is not permitted. The work

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classes. All recipients of this work are expected to abide by these

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Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 5

Production Technology

and Cost

Chapter Outline

5.1 Economic Cost and Economic Profit

5.2 A Firm with a Fixed Production Facility: Short-Run Costs

5.3 Production and Cost in the Long Run

5.4 Examples of Production Cost

5.1 Economic Cost and Economic Profit

Define economic cost and economic profit.

A firm’s objective is to maximize its economic profit:

economic profit total revenue economic cost 

Economic profit: Total revenue minus economic cost.

Economic cost: The opportunity cost of the inputs used in the

production process; equal to explicit cost plus implicit cost.

The economic cost is the entire opportunity cost of production:

whatever must be sacrificed in the course of production.

Explicit cost: A monetary payment.

Implicit cost: An opportunity cost that does not involve a

monetary payment.

Table 5.1 Economic Cost versus

Accounting Cost

blank Economic Cost Accounting

Cost

Explicit: monetary payments for labour,

capital, materials

$10,000 $10,000

Implicit: opportunity cost of

entrepreneur’s time

5,000 -

Implicit: opportunity cost of funds 2,000 -

Total 17,000 10,000

Accountants calculate profit and cost differently from economists. Their

purpose is to account for flows of money. Economists are interested in

questions like “should this firm continue to operate?” which require

considering implicit costs as well as flows of money.

Accounting cost: The explicit costs of production.

Accounting profit: Total revenue minus accounting cost.

Application 1: Opportunity Cost and

Entrepreneurship

A homeowner is considering

renting out his or her home

through Airbnb, earning $90 for a

typical two-night stay.

While that may sound like a nice

payoff, it fails to account for the

opportunity cost of the

homeowner’s time:

• Emails to arrange the stay

• Cleaning up after guests leave

The economic profit will be much less than $90.

5.2 A Firm with a Fixed Production

Facility: Short-Run Costs

Draw the short-run marginal-cost and average-cost

curves.

Consider first the case of a firm with a fixed production

facility.

Suppose you have decided to start a small firm to produce

plastic paddles for rafts.

Before we can discuss the cost of production, we need

information about the nature of the production process.

Figure 5.1 Total-Product Curve (1 of 2)

Total-product curve: A

curve showing the

relationship between the

quantity of labor and the

quantity of output produced,

ceteris paribus.

For the first two workers,

output increases at an

increasing rate because of

labor specialization.

Marginal product of labor:

The change in output from

one additional unit of labor.

Labor

Quantity of

Output Produced

Marginal

Product of

Labor

1 1 1

2 5 4

3 8 3

4 10 2

5 11 1

6 11.5 0.5

Figure 5.1 Total-Product Curve (2 of 2)

Diminishing returns

occurs for three or more

workers, so output

increases at a decreasing

rate.

Diminishing returns: As

one input increases while

the other inputs are held

fixed, output increases at

a decreasing rate.

Labor

Quantity of

Output Produced

Marginal

Product of

Labor

1 1 1

2 5 4

3 8 3

4 10 2

5 11 1

6 11.5 0.5

Short-Run Total Cost

In the short-run analysis of costs, we divide production costs

into two types, fixed cost and variable cost.

Fixed cost (FC): Cost that does not vary with the quantity

produced.

Variable cost (VC): Cost that varies with the quantity

produced.

Short-run total cost (TC): The total cost of production when

at least one input is fixed; equal to fixed cost plus variable

cost.

Figure 5.2 Short-Run Costs: Fixed Cost,

Variable Cost, and Total Cost

The short-run total-cost curve shows the relationship between the

quantity of output and production costs, given a fixed production

facility.

Short-run total cost equals fixed cost (the cost that does not vary

with the quantity produced) plus variable cost (the cost that varies

with the quantity produced).

Table 5.2 Short-Run Costs (1 of 2) 1

Labor

Output

Fixed

Cost

(FC)

Variable

Cost (V

Total

Cost (TC)

Average

Fixed

Cost (AF

Average

Variable

Cost (AV

Average

Total

Cost (AT

Marginal

Cost (M

0 0 $100 $0 $100 - - - -

1 1 100 50 150 $100.00 $50.00 $150.00 $50.00

2 5 100 100 200 20.00 20.00 40.00 12.50

3 8 100 150 250 12.50 18.75 31.25 16.67

4 10 100 200 300 10.00 20.00 30.00 25.00

5 11 100 250 350 9.09 22.73 31.82 50.00

6 11.5 100 300 400 8.70 26.09 34.78 100.00

The table shows a variety of measures of cost for the firm.

Average fixed cost (AFC): Fixed cost divided by the quantity produced.

Average variable cost (AVC): Variable cost divided by the quantity

produced.

Table 5.2 Short-Run Costs (2 of 2) 1

Labor

Output

Fixed

Cost

(FC)

Variable

Cost (V

Total

Cost (TC)

Average

Fixed

Cost (AF

Average

Variable

Cost (AV

Average

Total

Cost (AT

Marginal

Cost (M

0 0 $100 $0 $100 - - - -

1 1 100 50 150 $100.00 $50.00 $150.00 $50.00

2 5 100 100 200 20.00 20.00 40.00 12.50

3 8 100 150 250 12.50 18.75 31.25 16.67

4 10 100 200 300 10.00 20.00 30.00 25.00

5 11 100 250 350 9.09 22.73 31.82 50.00

6 11.5 100 300 400 8.70 26.09 34.78 100.00

Short-run average total cost (ATC): Short-run total cost divided by

the quantity produced; equal to AFC plus AVC.

TC FC VC ATC AFC AVC

Q Q Q     

Figure 5.3 Short-Run Average Costs

The short-run average-total-cost

curve (ATC) is U-shaped.

• As the quantity increases, fixed

costs are spread over more

units, pushing down the ATC.

• As the quantity increases,

diminishing returns eventually

pull up the ATC.

The gap between ATC and AVC is

the average fixed cost (AFC).

Short-Run Marginal Cost

Short-run marginal cost (MC): The change in short-run

total cost resulting from a one-unit increase in output.

change in

change in output

TC TC MC

  



One worker produces 1 paddle, with total cost $150.

Two workers produce 5 paddles, with total cost $200.

$200 $150 $50 $12.50

5 1 4

TC MC

     

 

Figure 5.4 Short-Run Marginal and

Average Cost

The marginal-cost curve (MC) is

negatively sloped for small

quantities of output, because of

the benefits of labor

specialization, and positively

sloped for large quantities,

because of diminishing returns.

The MC curve intersects the

average-cost curve (ATC) at the

minimum point of the average

curve.

At this point ATC is neither

falling nor rising.

Table 5.3 Marginal Grade and Average

Grade Labor Marginal

Grade

Number of

Courses

Grade

Points

Grade Point Average

Starting point - 9 27 3.0 = 27 over 9

Marginal grade < GPA D 10 28 = 27+1 2.8 = 28 over 10

Marginal grade = GPA B 10 30 = 27+3 3.0 = 30 over 10

Marginal grade > GPA A 10 31 = 27+4 3.1 = 31 over 10

3.0 27 / 9

2.8 28 / 10

3.0 30 / 10

3.1 31/ 10

To illustrate the relationship between marginal and average, suppose

you have a B (3.0) average after 9 classes, and are waiting for the

grade for the 10th to come in.

The 10th is your marginal grade; your GPA is your average grade.

• If the 10th grade is less than your GPA, your GPA will fall.

• If it is equal to your GPA, your GPA will stay the same.

• If it is greater than your GPA, your GPA will rise.

Application 2: The Rising Marginal

Cost of Crude Oil

The first 40 million barrels of oil

produced worldwide per day

have a marginal cost less than

$10 per barrel; oil costs little to

extract in the Middle East and

Russia.

The next 25 million barrels cost

about $20 per barrel, from more

expensive offshore rigs and oil

sands projects.

Higher quantities see the

marginal cost rise quickly, for

Arctic drilling, biodiesel, etc.

5.3 Production and Cost in the Long

Run

Draw the long-run marginal-cost and average cost curves.

The long run is defined as the period of time over which a firm is

perfectly flexible in its choice of all inputs.

• In the long run, a firm can build or modify a production facility

such as a factory, store, office, or restaurant.

The key difference between the short run and the long run is that

there are no diminishing returns in the long run.

• Diminishing returns occur because workers share a fixed

production facility.

• In the long run, a firm can expand its production facility as its

workforce grows.

Expansion and Replication

Suppose our paddle-production firm was producing 10 paddles

per day, with a total cost of $300 per day—an average cost of

$30 per paddle.

If we wanted to double production, we could do so in our old

facility; but the workers would be cramped, and average costs

would rise.

Another option: build another identical workshop, to replicated

our already successful production methods.

The cost to produce, when we can flexibly change our facilities,

is the long-run total cost.

Long-run total cost (LTC): The total cost of production when a

firm is perfectly flexible in choosing its inputs.

Figure 5.5 Expansion and

Replication (1 of 2)

Initially (up to point b) the short-run

and long-run total cost curves are the

same; while average costs are falling,

replication is not useful.

Long-run average cost (LAC): The

long-run cost divided by the quantity

produced.

Labor 1 Capital 2 Output 3 Labor

Cost

4 Long-Run Total

Cost (LTC)

5 Long-Run Average

Cost (LAC)

1 $100 1 $ 50 $150 $150

2 100 5 100 200 40

4 100 10 200 300 30

8 200 20 400 600 30

12 300 30 600 900 30

Figure 5.5 Expansion and

Replication (2 of 2)

Once we exhaust our gains from

specialization, we can replicate and

achieve constant returns to scale.

Constant returns to scale: A

situation in which the long-run total

cost increases proportionately with

output, so average cost is constant.

Labor 1 Capital 2 Output 3 Labor

Cost

4 Long-Run Total

Cost (LTC)

5 Long-Run Average

Cost (LAC)

1 $100 1 $ 50 $150 $150

2 100 5 100 200 40

4 100 10 200 300 30

8 200 20 400 600 30

12 300 30 600 900 30

Long-Run Marginal Cost

If we achieve constant returns to scale by replication, each

additional batch of output costs the same as the ones

before, so the long-run marginal cost is constant also.

Long-run marginal cost (LMC): The change in long-run

cost resulting from a one-unit increase in output.

We may be able to do even better—say, by combining two

workshops into a single larger workshop. Then the long-run

marginal cost would be falling.

Reducing Output with Indivisible Inputs

While replication will often allow us to increase production and keep

average costs the same, we often cannot decrease production with the

same result.

Many inputs cannot be divided—they must be all-or-nothing.

Indivisible input: An input that cannot be scaled down to produce a

smaller quantity of output.

• For example, to produce up to 10 paddles per day, perhaps we need

one plastic mold; we cannot have half a mold.

• Similarly, a hospital cannot buy half an MRI machine, and a railroad

company can’t build half a set of tracks.

• This helps to explain why long-run average costs are often high for

small quantities.

Scaling Down and Labor Specialization

Another problem with getting smaller is that we cannot

benefit as much from labor specialization.

• In our paddle-production example, if we cut down to just

a couple of workers, each would have to perform many

tasks. With more workers, they could specialize.

• Similarly a large hospital benefits from size by having

specialist surgeons, radiologists, etc. A small hospital

could have one person perform multiple roles, but they

would likely not be as productive; or it could contract

some roles out, at higher cost.

Economies of Scale

The foregoing examples help to explain why larger firms can

enjoy economies of scale.

Economies of scale: A situation in which the long-run

average cost of production decreases as output increases.

Eventually we will likely exhaust all possible economies of

scale.

Minimum efficient scale: The output at which scale

economies are exhausted.

Diseconomies of Scale

Could a firm get so big, its average cost actually starts to rise?

Diseconomies of scale: A situation in which the long-run average

cost of production increases as output increases.

Diseconomies of scale could occur because of:

• Coordination problems: Organizing a large operation with many

layers of management may be difficult to do effectively.

• Increasing input costs: A firm could get so big that it may be

forced to pay higher prices for its inputs. For example, a large

coal-fired power plant may have to source coal from far away,

with higher delivery costs than a small power plant would face.

Figure 5.6 Actual Long-Run Cost Curves for

Aluminum, Truck Freight, and Hospital Services

Different industries can

have dramatically different

long-run average cost

curves.

Short-Run Versus Long-Run Average

Cost

Why is the firm’s short-run average-cost curve U-shaped,

while the long-run average-cost curve is L-shaped?

• The difference between the short run and long run is a

firm’s flexibility in choosing inputs.

In the long run, a firm can increase all of its inputs, scaling up

its operation by building a larger production facility.

• As a result, the firm will not suffer from diminishing returns.

Application 3: Indivisible Inputs and

the Cost of Fake Killer Whales

Sea lions off the Washington coast

threaten some fish species with

extinction and threaten commercial

fisheries.

One innovative idea: build big

plastic killer whales, on roller-

coaster-like rails, to scare off the

sea lions.

The cost for the first fake whale

would be $16,000: $11,000 for the

plastic mold, and $5,000 for labor

and materials; each extra whale

would cost only $5,000.

5.4 Examples of Production Cost

Provide examples of production costs.

In this section we will look at actual production costs for

several products:

• Electricity from wind turbines

• Music videos

• Solar and nuclear power

Table 5.4 Wind Turbines and the

Average Cost of Electricity

blank Small Turbine

(150 kilowatt)

Large Turbine

(600 kilowatt)

Purchase price of turbine $150,000 $420,000

Installation cost $100,000 $100,000

Operating and maintenance cost $75,000 $126,000

Total Cost $325,000 $646,000

Electricity generated (kilowatt-hours) 5 million 20 million

Average cost (per kilowatt-hour) $0.065 $0.032

A large wind turbine is more expensive, but also more cost-effective:

installation and maintenance costs are relatively low for the large turbine,

considering the much higher output of electricity.

A wind turbine company would experience economies of scale as it moved

from small to large turbines.

Figure 5.7 Average-Cost Curve for an

Information Good

A music video is an

information good; almost

all of its cost is in the initial

production, and the

marginal cost of

reproduction is essentially

zero.

The average cost will fall

for all reasonable

quantities.

A similar cost structure

exists for other products

distributed online.

Solar Versus Nuclear: The Crossover

In 1998, the cost of electricity produced with solar technology

was $0.32 per kilowatt-hour (Kwh), vs $0.07 per Kwh for

nuclear.

Over the last 20 years, the cost for electricity from nuclear

power plants has increased to about $0.16 per Kwh, because

the cost of building reactors has increased

Meanwhile the cost from solar has decreased: $0.21 per Kwh

in 2005, and $0.16 per Kwh in 2010.

As further innovations happen in the solar industry, it is likely

that solar energy costs will continue to fall: solar has crossed

over to being more cost-effective than nuclear.

Table 5.5 The Language and

Mathematics of Costs (1 of 3)

Type of Cost Definition Symbols and

Equations

Economic cost The opportunity cost of the inputs used

in the production process; equal to

explicit cost plus implicit cost

Explicit cost The actual monetary payment for inputs -

Implicit cost The opportunity cost of inputs that do not

involve a monetary payment

Accounting cost Explicit cost -

Table 5.5 The Language and

Mathematics of Costs (2 of 3)

Type of Cost Definition Symbols and

Equations

Short-Run Costs blank blank

Fixed cost Cost that does not vary with the quantity

produced

Variable cost Cost that varies with the quantity produced VC

Short-run total cost The total cost of production when at least one

input is fixed

TC = FC + VC

Short-run marginal

cost

The change in cost from a one-unit increase

in output

MC = Delta TC over Delta Q

Average fixed cost Fixed cost divided by the quantity produced AFC = FC over Q

Average variable

cost

Variable cost divided by the quantity produced AVC = VC over Q

Short-run average

total cost

Short-run total cost divided by the quantity

produced

ATC = AFC + AV

/MC TC Q  

/AFC FC Q

/AVC VC Q

Table 5.5 The Language and

Mathematics of Costs (3 of 3)

Type of Cost Definition Symbols and

Equations

Long-Run Costs blank blank

Long-run total cost The total cost of production when a firm is

perfectly flexible in choosing its inputs

LTC

Long-run average

cost

Long-run total cost divided by the quantity

produced

LAC = LTC over Q

Long-run marginal

cost

The change in long-run cost resulting from a

one-unit increase in

output

LMC = Delta LTC over Delta

/LAC LTC Q

/LMC LTC Q  

Key Terms

Accounting cost

Accounting profit

Average fixed cost (AFC)

Average variable cost (AVC)

Constant returns to scale

Diminishing returns

Diseconomies of scale

Economic cost

Economic profit

Economies of scale

Explicit cost

Fixed cost (FC)

Implicit cost

Indivisible input

Long-run average cost (LAC)

Long-run marginal cost (LMC)

Long-run total cost (LTC)

Marginal product of labor

Minimum efficient scale

Short-run average total cost (ATC)

Short-run marginal cost (MC)

Short-run total cost (TC)

Total-product curve

Variable cost (VC)

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

any part of this work (including on the World Wide Web) will

destroy the integrity of the work and is not permitted. The work

and materials from it should never be made available to students

except by instructors using the accompanying text in their

classes. All recipients of this work are expected to abide by these

restrictions and to honor the intended pedagogical purposes and

the needs of other instructors who rely on these materials.

Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 6

Perfect Competition

Chapter Outline

6.1 Preview of the Four Market Structures

6.2 The Firm’s Short-Run Output Decision

6.3 The Firm’s Shut-Down Decision

6.4 Short-Run Supply Curves

6.5 The Long-Run Supply Curve for an Increasing-Cost

Industry

6.6 Short-Run and Long-Run Effects of Changes in Demand

6.7 Long-Run Supply for a Constant-Cost Industry

6.1 Preview of the Four Market

Structures

Distinguish between four market structures.

Our next four chapters will explore how firms make decisions in

different types of markets.

First, we will look at perfectly competitive markets.

Perfectly competitive market: A market with many sellers and

buyers of a homogeneous product and no barriers to entry.

In such a market, there are hundreds or even thousands of firms

selling homogeneous products. Each firm is a price taker.

Price taker: A buyer or seller that takes the market price as given.

Features of a Perfectly Competitive

Market

Here are the five features of a perfectly competitive market:

1. There are many sellers.

2. There are many buyers.

3. The product is homogeneous.

4. There are no barriers to market entry.

5. Both buyers and sellers are price takers.

Figure 6.1 Monopoly Versus Perfect

Competition (1 of 2)

When studying firm behavior, we distinguish between the

market demand curve and the firm-specific demand curve.

Firm-specific demand curve: A curve showing the

relationship between the price charged by a specific firm and

the quantity the firm can sell.

Figure 6.1 Monopoly Versus Perfect

Competition (2 of 2)

A monopolist is the only firm in its market; so it faces the

entire market demand curve.

A perfectly competitive firm takes the market price as given;

it can sell as much as it would like at the market price, and

would sell nothing if it charged a higher price.

The Other Three Market Structures

Over the coming chapters, we will discuss:

• Monopoly: A single firm serves the entire market, with

barriers to entry preventing new firms entering and

breaking the monopoly.

• Monopolistic Competition: Many firms serve the market

with nonidentical products. Firms can enter and exit the

market.

• Oligopoly: Only a few firms are in the market, because of

economies of scale or because government policies limit

the number of firms.

Table 6.1 Characteristics of the Four

Market Structures

Characteristics

Perfect

Competition

Monopolistic

Competition Oligopoly Monopoly

Number of firms Many Many Few One

Type of product Homogeneous Differentiated Homogeneous or

differentiated

Unique

Firm-specific

Demand curve

Demand is

perfectly

Elastic

Demand is

elastic but not

perfectly elastic

Demand is less

elastic than demand

facing

monopolistically

competitive firm

Firm faces market

demand curve

Entry conditions No barriers No barriers Large barriers from

economies of scale

or government

policies

Large barriers from

economies of scale

or govern-ment

policies

Examples Corn, plain T-

shirts

Toothbrushes,

music stores,

groceries

Air travel,

automobiles,

beverages,

cigarettes, mobile

phone service

Local phone

service, patented

drugs

Application 1: Wireless Women in

Pakistan

In Pakistan, phone service is now

provided by thousands of “wireless

women,” entrepreneurs who invest

$310 in wireless phone equipment, a

sign, and a stopwatch.

They sell phone service to their

neighbors, earning about $2 per day.

Why so little? The market is close to

perfectly competitive: easy entry, a

standardized good, and a large

number of suppliers.

6.2 The Firm’s Short-Run Output

Decision

Explain the short-run output rule and the break-even

price.

How much output should an individual firm produce?

We assume a firm’s objective is to maximize economic

profit: total revenue minus economic cost.

Our example for the remainder of this chapter will be a firm

that produces plain t-shirts, a relatively generic product with

many firms producing essentially identical competitive

products.

The Total Approach: Computing Total

Revenue and Total Cost

One way to decide how much to produce is to compute the

economic profit for different quantities, and choose the

quantity that generates the highest profit.

A firm in a perfectly competitive market sells all output for the

same price—the market price.

• Total revenue equals the price of the product times the

quantity sold.

Table 6.2 Deciding How Much to

Produce When the Price Is $12

Output: Shirts

per Minute (Q)

Fixed

Cost (F

Variable

Cost (VC)

Total

Cost

(TC)

Total

Revenue (TR)

Profit = T

R −TC

Marginal

Revenue =

Price

8 Marginal

Cost (MC)

0 $17 $0 $ 17 $ 0 −$17 Blank Blank

1 17 5 22 12 −10 $12 $5

2 17 6 23 24 1 12 1

3 17 9 26 36 10 12 3

4 17 13 30 48 18 12 4

5 17 18 35 60 25 12 5

6 17 25 42 72 30 12 7

7 17 34 51 84 33 12 9

8 17 46 63 96 33 12 12

9 17 62 79 108 29 12 16

10 17 83 100 120 20 12 21

Profit is maximized at a quantity of 7 or 8 shirts: $33. When this

happens, we assume the firm produces the larger quantity.

Figure 6.2 Using the Total Approach to

Choose an Output Level

Economic profit is shown by

the vertical distance between

the total-revenue curve and

the total-cost curve.

To maximize profit, the firm

chooses the quantity of

output that generates the

largest vertical difference

between the two curves.

The Marginal Approach

The other way for a firm to decide how much output to

produce relies on the marginal principle: Increase the level

of an activity as long as its marginal benefit exceeds its

marginal cost. Choose the level at which the marginal

benefit equals the marginal cost.

The marginal benefit of production is the marginal revenue.

Marginal revenue: The change in total revenue from selling

one more unit of output.

For a perfectly competitive firm, the price doesn’t change as

it sells more; so

marginal revenue price

Figure 6.3 The Marginal Approach to

Picking an Output Level (1 of 4)

The marginal principle tells us that the firm will maximize its

profit by choosing the quantity at which price equals marginal

cost. This occurs at point a.

 

economic profit price average cost quantity produced

economic profit $12 $7.875 8 $4.125 8 $33

  

     

The shaded area shows this economic profit.

Figure 6.3 The Marginal Approach to

Picking an Output Level (2 of 4)

If the firm produced less—say, 6 shirts—it would make less profit.

• The extra revenue from the 6th and 7th shirts would be $12.

• The extra cost from the 6th and 7th shirts would be less than

$12.

• So producing the 6th and 7th shirts increases profit.

Figure 6.3 The Marginal Approach to

Picking an Output Level (3 of 4)

If the firm produced more—say, 9 shirts—it would make less

profit.

• The extra revenue from the 9th shirt would be $12.

• The extra cost from the 9th shirts would be greater than $12.

• So producing the 9th shirt decreases profit.

Economic Profit and the Break-Even

Price

The marginal cost curve is positively sloped.

If the price rose, the marginal revenue (price) line would

move upward, and intersect the marginal cost curve at a

higher quantity.

• This is the law of supply in action: higher price results in

higher quantity supplied.

Figure 6.3 The Marginal Approach to

Picking an Output Level (4 of 4)

If price fell to $7, the marginal revenue line would intersect the marginal

cost curve at point c: a quantity of 6 shirts.

At this quantity, the average total cost is also $7, so the firm would make

zero economic profit: it would break even.

Break-even price: The price at which economic profit is zero; price

equals average total cost.

Application 2: The Break-Even Price for

Switchgrass, A Feedstock for Biofuel

Switchgrass is a perennial grass

native to U.S. plains states.

Farmers can grow it for biofuel.

Suppose the alternative crop for

farmers to grow is alfalfa, which

earns $120 per acre. Switchgrass

yields 3 tons per acre, so the

opportunity cost of growing

switchgrass is $40 per ton.

Explicit costs (capital, labor, etc.)

total $36 per ton; so the break-

even price for switchgrass is $76

per ton.

6.3 The Firm’s Shut-Down Decision

Explain the shut-down rule.

When prices are high and the firm is making a profit, everything is

easy: just choose the quantity that yields the highest profit.

What about when prices are so low the firm cannot make a profit?

Should the firm continue to operate at a loss, or shut down?

• It may seem obvious that the firm should shut down if it’s making

a loss, but this is a short-run decision: the firm has some fixed

costs.

• So even if it shuts down, it will still make a loss.

• The right choice will make the loss as small as possible.

Table 6.3 Deciding How Much to

Produce When the Price Is $4 (1 of 2)

Output:

Shirts per

Minute (Q)

Fixed

Cost

(FC)

Variable

Cost (V

Total

Cost (T

Total

Revenue (T

Profit =

TR − TC

Marginal

Revenue =

Price

Marginal

Cost (MC)

0 $17 $0 $17 $0 −$17 Blank Blank

1 17 5 22 4 −18 $4 $5

2 17 6 23 8 −15 4 1

3 17 9 26 12 −14 4 3

4 17 13 30 16 −14 4 4

5 17 18 35 20 −15 4 5

Because the firm cannot do anything about its fixed costs, the

decision of whether to shut down comes down to variable costs:

• Operate if total revenue > variable cost

• Shut down if total revenue < variable cost

Table 6.3 Deciding How Much to

Produce When the Price Is $4 (2 of 2)

Output:

Shirts per

Minute (Q)

Fixed

Cost

(FC)

Variable

Cost (V

Total

Cost (T

Total

Revenue (T

Profit =

TR − TC

Marginal

Revenue =

Price

Marginal

Cost (MC)

0 $17 $0 $17 $0 −$17 Blank Blank

1 17 5 22 4 −18 $4 $5

2 17 6 23 8 −15 4 1

3 17 9 26 12 −14 4 3

4 17 13 30 16 −14 4 4

5 17 18 35 20 −15 4 5

Producing 3 or 4 shirts, the firm’s total revenue is greater than its

variable cost, so it should produce rather than shut down.

• Notice that for these quantities, the loss is smaller than the loss

from producing 0 shirts.

Figure 6.4 The Shut-Down Decision and

the Shut-Down Price (1 of 2)

When the price is $4, marginal

revenue equals marginal cost at

four shirts (point a).

At this quantity, average cost is

$7.50, so the firm loses $3.50 on

each shirt, for a total loss of $14.

Total revenue is $16 and the

variable cost is only $13, so the

firm is better off operating at a

loss rather than shutting down

and losing its fixed cost of $17.

Figure 6.4 The Shut-Down Decision

and the Shut-Down Price (2 of 2)

To determine whether to operate

or shut down, compare the price

to the average variable cost.

• Operate if price > AVC

• Shut down if price < AVC

The shutdown price, shown by

the minimum point of the AVC

curve, is $3.00.

Shut-down price: The price at

which the firm is indifferent

between operating and shutting

down; equal to the minimum

average variable cost.

Fixed Costs and Sunk Costs

We ignore the fixed cost in the short run—the cost of the

facility—because we assume it is a sunk cost.

Sunk cost: A cost that a firm has already paid or

committed to pay, so it cannot be recovered.

It is often psychologically difficult to put sunk costs out of

your mind when making decisions, but it is an essential

element of good decision making.

Application 3: Shutting Down a Coal

Mine

In early 2018, the 4 West

coal mine in West Virginia

shut down.

The price of coal had

decreased from $140 per

ton to roughly $61 per ton.

Some firms could continue

to operate at that price,

because their costs were

lower; but $61 per ton was

below the shut-down price

for 4 West.

6.4 Short-Run Supply Curves

Explain why the short-run supply curve is positively

sloped.

Now we’re ready to explore short-run supply curves for the

individual firm and for the whole market.

Short-run supply curve: A curve showing the relationship

between the market price of a product and the quantity of

output supplied by a firm in the short run.

Short-run market supply curve: A curve showing the

relationship between the market price and quantity supplied

in the short run.

Figure 6.5 Short-Run Supply Curves

(Panel A)

When the price is below

the shut-down price ($3

for this firm), the firm

produces no output.

For any price above the

shut-down price, the firm

will choose the quantity at

which price equals

marginal cost, so we can

read the firm’s quantity

supplied directly from its

marginal-cost curve.

Figure 6.5 Short-Run Supply Curves

(Panel B)

In Panel B, there are 100

identical firms in the market,

so the market supply at a

given price is 100 times the

quantity supplied by the

typical firm.

At a price of $7, each firm

supplies 6 shirts per minute

so the market supply is 600

shirts per minute (point f).

Figure 6.6 Market Equilibrium

In Panel A, the market demand curve intersects the short-run market

supply curve at a price of $7.

In Panel B, given the market price of $7, the typical firm satisfies the

marginal principle at point b, producing six shirts per minute. The $7

price equals the average cost at the equilibrium quantity, so economic

profit is zero, and no other firms will enter the market.

Application 4: Short-Run Supply

Curve for Cargo

Consider the supply of shipping

service.

• At low freight rates, only the most

efficient ships operate, and they

economize on fuel by traveling at a

relatively low speed.

• As freight rates increase, less

efficient ships join the fleet, and

ships can afford to travel faster

(and burn more fuel), so the

amount of shipping service offered

increases.

6.5 The Long-Run Supply Curve for an

Increasing-Cost Industry

Explain why the long-run industry supply curve may be

positively sloped.

We have dealt with the short run; now we move on to the

long run, a period long enough that firms can enter or leave

the market.

What will the long-run market supply curve look like?

Long-run market supply curve: A curve showing the

relationship between the market price and quantity supplied

in the long run.

An Increasing-Cost Industry

We start with the case of an increasing-cost industry:

Increasing-cost industry: An industry in which the average cost

of production increases as the total output of the industry

increases; the long-run supply curve is positively sloped.

Why positively sloped?

• Increasing input price: As the industry grows, it competes with

other industries for scarce inputs, raising their price, and hence

the break-even price in the industry.

• Less productive inputs: A small industry uses only the most

productive inputs, but as it grows it will be forced to use less

productive inputs.

Table 6.4 Industry Output and Average

Production Cost

Number of

Firms

Industry

Output

Shirts per

Firm

Total Cost for

Typical Firm

Average Cost

per Shirt

100 600 6 $42 $7

200 1,200 6 60 10

300 1,800 6 78 13

As the number of firms increases, the total cost for the

typical firm increases (because of higher input prices and

less productive inputs).

Figure 6.7 Long-Run Market Supply

Curve

This allows us to form the long-run market supply curve for

this industry.

As price rises, production for the existing firms is more

profitable; new firms enter the market, raising the cost until

profits fall back down to the zero economic profit level.

Examples of Increasing-Cost

Industries: Sugar and Apartments

If the price of sugar is only 11 cents per pound, sugar production

is profitable only in areas with low production costs—the

Caribbean, Latin America, Australia, and South Africa.

• As price rises, more countries would begin to produce sugar:

some countries in the European Union, and eventually the

United States.

The market for apartments is another increasing-cost industry.

• Many communities restrict the land available for apartments with

zoning laws.

• As the industry expands, housing firms bid up the price of land.

Input prices rise, which is justifiable only if the price the

apartments can rent for is higher.

Application 5: Chinese Coffee

Growers Obey the Law of Supply

Pu’er is a southern

Chinese city famous for its

tea, but gaining a

reputation for coffee also.

As world coffee prices

doubled from 2009 to

20012, farmers cleared

hillside to double the

acreage of coffee.

6.6 Short-Run and Long-Run Effects of

Changes in Demand

Describe the short-run and long-run effects of changes

in demand for an increasing-cost industry.

We now consider what happens in perfectly competitive

markets when demand increases.

The general idea is this:

• The increase in demand makes output prices higher.

• In the short run, existing firms produce more in response to

the higher prices.

• In the long run, new firms enter the market; the increase in

competition helps to lower the price.

Figure 6.8 Short-Run Effects of an

Increase in Demand

In panel A, an increase in demand for shirts occurs. In the short

run, this is served only by existing firms, with the market

equilibrium changing to point b.

In panel B, we see that at the higher price, the typical firm now

makes positive economic profit: price > ATC.

Figure 6.9 Short-Run and Long-Run

Effects of an Increase in Demand

In the long run, firms can

enter the industry and build

more production facilities, so

the price eventually drops to

$10 (point c).

The large upward jump in

price after the increase in

demand is followed by a

downward slide to the new

long-run equilibrium price.

Application 6: The Upward Jump and

Downward Slide of Blueberry Prices

In the late 2000s, blueberry demand

increased ~72%.

Price increased from $1.44 per pound in

2005 to $1.85 per pound in 2007.

• In the short run, supply is limited, and

the increased demand bid up the price.

By 2010, production had increased by

almost 50%, bringing the price back

down under $1.50 per pound.

• This suggests the blueberry industry

is approximately a constant-cost

industry.

6.7 Long-Run Supply for a Constant-

Cost Industry

Describe the short-run and long-run effects of changes

in demand for a constant-cost industry.

In a constant-cost industry, the prices of inputs such as

labor, land, and materials do not change as the output of the

industry increases.

This happens when the industry uses a relatively small

amount of the available labor, land, and materials, so events

in the industry do not change the prices of these inputs.

Constant-cost industry: An industry in which the average

cost of production is constant; the long-run supply curve is

horizontal.

Figure 6.10 Long-Run Supply Curve for

a Constant-Cost Industry

For the candle industry, the cost per candle is constant at

$0.05, so the supply curve is horizontal at $0.05 per candle.

At any higher price, firms would enter the candle industry in

droves, pushing the price back down to $0.05 per candle.

Figure 6.11 Hurricane Andrew and the

Price of Ice

In 1992, Hurricane Andrew struck the southeastern United States.

Millions of people were without electricity, so they turned to ice to

cool and preserve food.

The jump in price prompted entrepreneurs to bring ice to the area;

this increase in the number of firms pushed the price back down.

Application 7: The Upward Jump and

Downward Slide of Blueberry Prices

In the 2000s, the demand for margarine

decreased.

Total U.S. consumption of margarine

halved, but the price barely changed. How

could this be?

• Firms saw the decrease in demand, and

switched production away from

margarine.

• As the total output of the margarine

industry decreased, the prices of inputs

didn’t change.

• So the cost of producing margarine, and

hence the price, stayed constant.

Key Terms

Break-even price

Constant-cost industry

Firm-specific demand curve

Increasing-cost industry

Long-run market supply

curve

Marginal revenue

Perfectly competitive market

Price taker

Short-run market supply curve

Short-run supply curve

Shut-down price

Sunk cost

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Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 7

Monopoly and Price

Discrimination

Chapter Outline

7.1 The Monopolist’s Output Decision

7.2 The Social Cost of Monopoly

7.3 Patents and Monopoly Power

7.4 Price Discrimination

7.1 The Monopolist’s Output

Decision

Describe and explain a monopolist’s output decision.

In this chapter we will examine the production and pricing decisions

of a monopoly.

Monopoly: A market in which a single firm sells a product that does

not have any close substitutes.

Some sort of barrier to entry exists to maintain the monopoly; and

the lack of competition gives the monopolist a large degree of

market power.

Barrier to entry: Something that prevents firms from entering a

profitable market.

Market power: The ability of a firm to affect the price of its product.

Barriers to Entry

What sort of barriers to entry can exist?

• Patent: The exclusive right to sell a new good for some period of time.

• Network externalities: The value of a product to a consumer increases

with the number of other consumers who use it.

• Licensing policies, where the government chooses a single firm to sell a

particular product.

• Control of a key resource, like DeBeers with diamonds or Alcoa with

aluminum.

• Natural monopoly: A market in which the economies of scale in

production are so large that only a single large firm can earn a profit.

Figure 7.1 The Demand Curve and the

Marginal-Revenue Curve (1 of 2)

(1) Price (P)

(2) Quantity

Sold (Q)

(3) Total Revenue

(TR = P × Q)

(4) Marginal Revenue MR = Delta TR over Delta Q

$16 0 0 -

14 1 $14 $14

12 2 24 10

10 3 30 6

8 4 32 2

6 5 30 −2

4 6 24 −6

MR = ΔTR / ΔQ

Marginal revenue equals the price for the first unit sold, but is less

than the price for additional units sold.

To sell an additional unit, the firm cuts the price and receives less

revenue on the units that could have been sold at the higher price.

Figure 7.1 The Demand Curve and the

Marginal-Revenue Curve (2 of 2)

A key feature of monopoly

is that the marginal

revenue is less than the

price; this results from the

downward-sloping firm-

specific demand curve.

Contrast this with perfect

competition, where the

horizontal firm-specific

demand curve led the

marginal revenue to be

equal to the price.

A Formula for Marginal Revenue

With a straight-line demand curve:

marginal revenue new price slope of demand curve old quant( )ity  

We can think of selling an additional unit as having both

good news and bad news:

• Good news: we receive revenue equal to the price of the

unit we sell (the new price).

• Bad news: to sell more, we had to reduce the price—not

just for the next unit, but for all units. This decreases

revenue by however much we had to drop the price by

(the slope of the demand curve) multiplied by how

many units we were already selling (the old quantity).

Using the Marginal Principle

The three-step process explaining how a monopolist

picks a quantity and how to compute the monopoly profit

is as follows:

1. Find the quantity that satisfies the marginal principle,

that is, the quantity at which marginal revenue equals

marginal cost.

2. Using the demand curve, find the price associated

with thea monopolist’s chosen quantity.

3. Compute the monopolist’s profit. The profit per unit

sold equals the price minus the average cost, and the

total profit equals the profit per unit times the number

of units sold.

Figure 7.2 The Monopolist Picks a

Quantity and a Price (1 of 2)

(1)

Price (P)

(2 )

Quantity

Sold (Q)

(3)

Marginal

Revenue

(4)

Marginal

Cost

(5)

Total Revenue

(TR = P × Q)

(6)

Total Cost

(TC)

(7)

Profit

(TR − TC)

$18 600 $12 $4.00 $10,800 $5,710 $5,090

17 700 10 4.60 11,900 6,140 5,760

16 800 8 5.30 12,800 6,635 6,165

15 900 6 6.00 13,500 7,200 6,300

14 1,000 4 6.70 14,000 7,835 6,165

13 1,100 2 7.80 14,300 8,560 5,740

12 1,200 0 9.00 14,400 9,400 5,000

A firm patents a new drug that cures the common cold.

• At a quantity of 600, the marginal revenue ($12) is greater than the

marginal cost ($4) so the firm increases profit by increasing production.

• At a quantity of 900, marginal revenue equals marginal cost, so profit is

maximized.

Figure 7.2 The Monopolist Picks a

Quantity and a Price (2 of 2)

We can see the profit on the graph at the quantity of 900:

 

Profit profit per unit quantity

Profit price quantity

Profit $15 $8 900

Profit $6,300

ATC

 

  



Application 1: Marginal Revenue from

a Baseball Fan

We expect Major League Baseball teams

to choose the quantity—number of fans—

to set MR = MC.

The cost of an additional fan is essentially

zero.

But for the typical team, the marginal

revenue from tickets is negative: teams

could make more ticket revenue by raising

price.

Why? Teams gain additional profit from

concessions and merchandise, making up

for the lost revenue.

7.2 Patents and Monopoly Power

Identify the trade-offs associated with a patent.

One source of monopoly power is a government patent that

gives a firm the exclusive right to produce a product for 20

years.

The patent encourages innovation through the promise of the

reward of monopoly power.

The increased innovation may be worth the deadweight loss

of the resulting monopoly.

Incentives for Innovation

Suppose a firm is considering developing a new arthritis drug.

• The cost of research and development will be $14 million.

• The estimated annual economic profit from a monopoly will

be $2 million.

• Other firms will be able to copy the drug in three years.

Without the promise of patent protection, the firm will not

develop the drug—it could not recoup its cost.

• The possible consumer surplus from the drug would

disappear.

Trade-Offs from Patents

All else equal, more competition is almost always desirable.

• Under monopoly, total surplus will be lower.

• But if the product would not be developed, the outcome for

society would be worse.

Is the patent for the drug good for society?

• No one knows in advance whether a particular product

would be developed without a patent, so the government

can’t be selective in granting patents.

• In some cases, patents lead to new products, although in

other cases, they merely prolong monopoly power.

Application 2: Bribing the Makers of

Generic Drugs

When a patent expires, new firms

enter the market; the resulting

competition for consumers

decreases prices and increases

quantities.

The former patent holders dislike

this, and sometimes use illegal

means to prevent competition.

• In 2003, the Federal Trade

Commission found two drug

makers had paid $60 million in

bribes to keep lower-priced

generic drugs off the market.

7.3 Price Discrimination

Identify the trade-offs associated with a patent.

So far we have always assumed a firm charges the same

price to all its customers.

However a firm may be able to engage in price

discrimination:

Price discrimination: The practice of selling a good at

different prices to different consumers.

Conditions for Price Discrimination

In order to engage in price discrimination, firms need:

1. Market power: The firm must have some control over its

price.

2. Different consumer groups: Groups of consumers that

differ in their willingness to pay for the product, along with

the ability to distinguish these groups.

3. Resale is not possible: Otherwise a low-price consumer

could resell to a high-price consumer, circumventing the

price discrimination.

How to Price Discriminate

Firms commonly engage in price discrimination by finding

consumers who are not willing to pay the regular price, and

offering them a discount. Examples include:

• Discounts on airline tickets

• Discount coupons for groceries and restaurant meals

• Manufacturers’ rebates for appliances

• Senior citizen or student discounts

Figure 7.3 The Marginal Principle and

Price Discrimination

To engage in price discrimination, the firm divides potential

customers into two groups and applies the marginal principle

twice—once for each group.

Using the marginal principle, the profit-maximizing prices are

$3 for seniors (point b) and $6 for nonseniors (point d).

Price Discrimination and the Elasticity

of Demand

Elasticity of demand helps to explain why price

discrimination can increase profits.

For a high price elasticity group (Ed > 1), decreasing price

will increase revenues: the firm gains a lot of customers

when it decreases price a little.

For a low price elasticity group (Ed < 1), increasing price will

increase revenues: the firm loses few customers when it

increases price.

Example: Movie Admission versus

Popcorn

Why do senior citizens pay less than everyone else for

admission to a movie, but the same as everyone else for

popcorn?

• Seniors have a lower willingness to pay for both movies

and popcorn.

• But admission cannot be traded from one consumer to

another, while popcorn can.

Example: Hardback versus Paperback

Books

Why are hardback books so much more expensive than

paperback books?

• The cost difference between the two is small, about 20%

higher for hardbacks, so that doesn’t explain the price

difference.

• Publishers use different editions to price discriminate: the

hardback edition comes out first, and is bought by the most

eager readers. The paperback edition comes out later,

priced to gain profit from the casual (and more price-

sensitive) audience.

Application 3: Refillable Soda Bottles

and Price Discrimination

In some countries, customers can

purchase cola in either a refillable or

a disposable bottle.

The refillable bottle receives a 20%

discount—much more than the

actual cost difference.

People who use the refillable format

are more price sensitive, so

customers sort themselves into

groups for price discrimination.

The price discrimination increases

both firm profits and consumer well-

being.

Key Terms

Barrier to entry

Market power

Monopoly

Natural monopoly

Network externalities

Patent

Price discrimination

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

any part of this work (including on the World Wide Web) will

destroy the integrity of the work and is not permitted. The work

and materials from it should never be made available to students

except by instructors using the accompanying text in their

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restrictions and to honor the intended pedagogical purposes and

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C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

Market Entry, Monopolistic

Competition, and Oligopoly

Brock Williams

P R E P A R E D B Y

During the recession that started in 2008, some industries

actually experienced increases in demand that caused market

entry – new firms entered the markets.

CHAPTER

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

How does brand competition within stores affect prices?

Name Brands versus Store Brands

What does it take to enter a market with a franchise?

Opening a Dunkin’ Donuts Shop

What are the effects of market entry?

C3PO and Entry in the Market for Space Flight

What signal does an expensive advertising campaign send

to consumers?

Advertising and Movie Buzz

How do firms conspire to fix prices?

Marine Hose Conspirators Go to Prison

A P P L Y I N G T H E C O N C E P T S

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

How do patent holders respond to the introduction of

generic drugs?

Merck and Pfizer Go Generic

What is the rationale for regulating a natural monopolist?

Public versus Private Waterworks

When does a natural monopoly occur?

Satellite Radio as a Natural Monopoly

Does competition between the second- and third-largest

firms matter?

Heinz and Beech-Nut Battle for Second Place

How does a merger affect prices?

Xidex Recovers Its Acquisition Cost in Two Years

A P P L Y I N G T H E C O N C E P T S

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

Market Entry, Monopolistic Competition,

and Oligopoly

●monopolistic competition A market served by many firms that

sell slightly different products.

The term, monopolistic competition, actually conveys the two key

features of the market:

• Each firm in the market produces a good that is slightly different from

the goods of other firms, so each firm has a narrowly defined

monopoly.

• The products sold by different firms in the market are close

substitutes for one another, so there is intense competition between

firms for consumers.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE EFFECTS OF MARKET ENTRY8.1

M A R G I N A L P R I N C I P L E

Increase the level of an activity as long as its marginal benefit exceeds its

marginal cost. Choose the level at which the marginal benefit equals the

marginal cost.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE EFFECTS OF MARKET ENTRY (cont’d)8.1

FIGURE 8.1 Market Entry Decreases Price and Squeezes Profit

(A) A monopolist maximizes profit at point a, where marginal revenue equals marginal cost. 300 toothbrushes

at a price of $2.00 (point b) and an average cost of $0.90 (point c). Profit of $330 is shown by the shaded

rectangle.

(B) Entry of a second firm shifts the firm-specific demand curve for the original firm to the left. The firm

produces only 200 toothbrushes (point d) at a lower price ($1.80, shown by point e) and a higher average cost

($1.00, shown by point f). Profit, shown by the shaded rectangle, shrinks to $160.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE EFFECTS OF MARKET ENTRY (cont’d)8.1

Entry Squeezes Profits from Three Sides

Entry shrinks the firm’s profit rectangle because it is squeezed from three

directions.

The top of the rectangle drops because the price decreases.

The bottom of the rectangle rises because the average cost increases.

The right side of the rectangle moves to the left because the quantity

decreases.

Examples of Entry: Stereo Stores, Trucking, and Tires

Empirical studies of other markets provide ample evidence that entry

decreases market prices and firms’ profits. In other words, consumers

pay less for goods and services, and firms earn lower profits.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In many stores, nationally advertised brands share the shelves with store brands.

The introduction of a store brand is a form of market entry—a new competitor for a

national brand—and usually decreases the price of the national brand.

The classic example of the price effects of store brands occurred in the market for

light bulbs:

• In the early 1980s, the price of a four-pack of General Electric bulbs was about

$3.50.

• The introduction of store brands at a price of $1.50 caused General Electric to

cut its price to $2.00.

• In markets without store brands, the General Electric price remained at $3.50.

For a wide variety of products—laundry detergent, ready-to-eat breakfast cereals,

motor oil, and aluminum foil—the entry of store brands decreased the price of

national brands.

NAME BRANDS VERSUS STORE BRANDS

APPLYING THE CONCEPTS #1: How does brand

competition within stores affect prices?

A P P L I C A T I O N 1

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

MONOPOLISTIC COMPETITION8.2

Under a market structure called monopolistic competition, firms will

continue to enter the market until economic profit is zero. Here are the

features of monopolistic competition:

• Many firms.

• A differentiated product.

• No artificial barriers to entry.

●product differentiation The process used by firms to

distinguish their products from the

products of competing firms.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

MONOPOLISTIC COMPETITION (cont’d)8.2

When Entry Stops: Long-Run Equilibrium

FIGURE 8.2

Long-Run Equilibrium with

Monopolistic Competition

Under monopolistic competition,

firms continue to enter the market

until economic profit is zero.

Entry shifts the firm specific

demand curve to the left.

The typical firm maximizes profit at

point a, where marginal revenue

equals marginal cost.

At a quantity of 80 toothbrushes,

price equals average cost (shown

by point b), so economic profit is

zero.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

MONOPOLISTIC COMPETITION (cont’d)8.2

Differentiation by Location

FIGURE 8.3

Long-Run Equilibrium with

Spatial Competition

Book stores and other retailers

differentiate their products by

selling at different locations.

The typical book store chooses

the quantity of books at which

its marginal revenue equals its

marginal cost (point a).

Economic profit is zero

because the price equals

average cost (point b).

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OPENING A DUNKIN’ DONUTS SHOP

APPLYING THE CONCEPTS #2: What does it take to

enter a market with a franchise?

One way to get into a monopolistically competitive market is to get a

franchise for a nationally advertised product.

Table 8.1 shows the franchise fees and royalty rates for several franchising

opportunities. The fees indicate how much entrepreneurs are willing to pay

for the right to sell a brand-name product.

A P P L I C A T I O N 2

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

TRADE-OFFS WITH ENTRY AND

MONOPOLISTIC COMPETITION8.3

Average Cost and Variety

There are some trade-offs associated with monopolistic competition.

Although the average cost of production is higher than the minimum,

there is also more product variety.

When firms sell the same product at different locations, the larger the

number of firms, the higher the average cost of production.

But when firms are numerous, consumers travel shorter distances to get

the product.

Therefore, higher production costs are at least partly offset by lower

travel costs.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

TRADE-OFFS WITH ENTRY AND

MONOPOLISTIC COMPETITION (cont’d)8.3

Monopolistic Competition versus Perfect Competition

 FIGURE 8.4

Monopolistic Competition

versus Perfect Competition

(A) In a perfectly competitive

market, the firm-specific

demand curve is horizontal at

the market price, and marginal

revenue equals price.

In equilibrium, price = marginal

cost = average cost.

Equilibrium occurs at the

minimum of the average-cost

curve.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

TRADE-OFFS WITH ENTRY AND

MONOPOLISTIC COMPETITION (cont’d)8.3

Monopolistic Competition versus Perfect Competition

 FIGURE 8.4 (cont’d.)

Monopolistic Competition

versus Perfect Competition

(B) In a monopolistically

competitive market, the firm-

specific demand curve is

negatively sloped and marginal

revenue is less than price.

In equilibrium, marginal

revenue equals marginal cost

(point b) and price equals

average cost (point c).

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

C3PO AND ENTRY IN THE MARKET FOR SPACE FLIGHT

APPLYING THE CONCEPTS #3: What are the effects of market entry?

Entry into a market increases the competition for consumers, leading to lower prices

and profit. Once the shuttle program ends, the Russian Space Agency will charge the

monopoly price of $47 million per flight.

The C3PO (Commercial Crew & Cargo Program) should stimulate competition and

result in lower prices

• NASA expects cheaper more flexible rockets

• Price should drop to about $20 million per flight

A P P L I C A T I O N 3

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ADVERTISING FOR PRODUCT

DIFFERENTIATION8.4

Celebrity Endorsements and Signaling

An advertisement that doesn’t provide any product information may actually

help consumers make decisions.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ADVERTISING AND MOVIE BUZZ

APPLYING THE CONCEPTS #4: What signal does an

expensive advertising campaign send to consumers?

For another example of signaling from advertising, consider movies:

• A movie distributor may produce several movies each year but advertise

just a few of them.

• Although there are few repeat consumers for a particular movie, there is

word-of-mouth advertising, also known as “buzz”: People who enjoy a

movie talk about it and persuade their friends and family members to see

it.

• An advertisement that gets the buzz started could pay for itself.

• In contrast, a distributor won’t expect much buzz from a less-appealing

movie, so advertising won’t be sensible.

In general, an expensive advertisement sends a signal that the movie

will generate enough word-of-mouth advertising to cover the cost of

the advertisement.

A P P L I C A T I O N 4

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

WHAT IS AN OLIGOPOLY?8.5

●concentration ratio The percentage of the market output

produced by the largest firms.

An alternative measure of market concentration is the Herfindahl-Hirschman

Index (HHI). It is calculated by squaring the market share of each firm in the

market and then summing the resulting numbers.

An oligopoly—a market with just a few firms—occurs for three reasons:

1 Government barriers to entry.

2 Economies of scale in production.

3 Advertising campaigns.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

WHAT IS AN OLIGOPOLY?8.5

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA8.6

●duopoly A market with two firms.

●cartel A group of firms that act in unison,

coordinating their price and quantity

decisions.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6

●price-fixing An arrangement in which firms conspire to fix prices.

FIGURE 8.5

A Cartel Picks the Monopoly Quantity

and Price

The monopoly outcome is shown by

point a, where marginal revenue equals

marginal cost.

The monopoly quantity is 60

passengers and the price is $400.

If the firms form a cartel, the price is

$400 and each firm has 30 passengers

(half the monopoly quantity).

The profit per passenger is $300 (equal

to the $400 price minus the $100

average cost), so the profit per firm is

$9,000.

profit = (price − average cost) × quantity per firm

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6  FIGURE 8.6

Competing Duopolists

Pick a Lower Price

(A) The typical firm

maximizes profit at point a,

where marginal revenue

equals marginal cost. The

firm has 40 passengers.

(B) At the market level, the

duopoly outcome is shown

by point d, with a price of

$300 and 80 passengers.

The cartel outcome, shown

by point c, has a higher

price and a smaller total

quantity.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6

 FIGURE 8.7

Game Tree for the Price-

Fixing Game

The equilibrium path of the

game is square A to square C

to rectangle 4: Each firm picks

the low price and earns a

profit of $8,000.

The duopolists’ dilemma is

that each firm would make

more profit if both picked the

high price, but both firms pick

the low price.

●game tree A graphical representation of the consequences

of different actions in a strategic setting.

Price-Fixing and the Game Tree

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6

Price-Fixing and the Game Tree (pickup)

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6

Equilibrium of the Price-Fixing Game

●dominant strategy An action that is the best choice for a

player, no matter what the other

player does.

●duopolists’ dilemma A situation in which both firms in a

market would be better off if both

chose the high price, but each

chooses the low price.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

CARTEL PRICING AND THE

DUOPOLISTS’ DILEMMA (cont’d)8.6

Nash Equilibrium

●Nash equilibrium An outcome of a game in which each

player is doing the best he or she can,

given the action of the other players.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OVERCOMING THE

DUOPOLISTS’ DILEMMA8.7

Low-Price Guarantees

●low-price guarantee A promise to match a lower price of a competitor.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OVERCOMING THE

DUOPOLISTS’ DILEMMA (cont’d)8.7

Low-Price Guarantees

 FIGURE 8.8

Low-Price Guarantees Increase Prices

When both firms have a low-price guarantee, it is impossible for one firm to underprice the other. The only

possible outcomes are a pair of high prices (rectangle 1) or a pair of low prices (rectangles 2 or 4).

The equilibrium path of the game is square A to square B to rectangle 1. Each firm picks the high price

and earns a profit of $9,000.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OVERCOMING THE

DUOPOLISTS’ DILEMMA (cont’d)8.7

Repeated Pricing Games with Retaliation for Underpricing

●grim-trigger strategy A strategy where a firm responds to underpricing by choosing a

price so low that each firm makes zero economic profit.

●tit-for-tat A strategy where one firm chooses whatever price the

other firm chose in the preceding period.

Repetition makes price-fixing more likely because firms can punish a firm that

cheats on a price-fixing agreement, whether it’s formal or informal:

1 A duopoly pricing strategy.

Choosing the lower price for life.

2 A grim-trigger strategy.

3 A tit-for-tat strategy.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OVERCOMING THE

DUOPOLISTS’ DILEMMA (cont’d)8.7

Repeated Pricing Games with Retaliation for Underpricing

 FIGURE 8.9

A Tit-for-Tat Pricing Strategy (cont’d)

Under tit-for-tat retaliation, the first firm (Jill, the square) chooses whatever price the second firm

(Jack, the circle) chose the preceding month.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

OVERCOMING THE

DUOPOLISTS’ DILEMMA (cont’d)8.7

Price-Fixing and the Law

Under the Sherman Antitrust Act of 1890 and subsequent

legislation, explicit price-fixing is illegal.

It is illegal for firms to discuss pricing strategies or

methods of punishing a firm that underprices other firms.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In 2007, the U.S. government discovered a seven-year conspiracy to fix the price

of marine hose, which is used to transfer oil from tankers to onshore storage

facilities.

• The case ultimately led to fines and prison sentences for the employees of

several marine-hose firms and for a person paid by the firms to coordinate the

price-fixing scheme.

• The executives were arrested after a meeting in Houston in which they

allocated customers to different members of the cartel and fixed prices.

• Each firm in the cartel agreed to submit artificially high bids for customers

allocated to other firms, a practice known as bid rigging.

There is some evidence that prison sentences are more effective than fines in

deterring business crimes such as price fixing.

In the United States, people convicted of price fixing regularly offer to pay bigger

fines to avoid prison.

MARINE HOSE CONSPIRATORS GO TO PRISON

APPLYING THE CONCEPTS #5: How do firms

conspire to fix prices?

A P P L I C A T I O N 5

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE INSECURE MONOPOLIST

AND ENTRY DETERRENCE8.8

 FIGURE 8.10

Deterring Entry with Limit

Pricing

Point c shows a secure

monopoly, point d shows a

duopoly, and point z shows the

zero-profit outcome.

The minimum entry quantity is 20

passengers, so the entry-

deterring quantity is 100 (equal to

120 – 20), as shown by point e.

The limit price is $200.

The Passive Approach

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE INSECURE MONOPOLIST AND

ENTRY DETERRENCE (cont’d)8.8

Entry Deterrence and Limit Pricing

The quantity required to prevent the entry of the second firm is computed

as follows:

deterring quantity = zero profit quantity − minimum entry quantity

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE INSECURE MONOPOLIST AND

ENTRY DETERRENCE (cont’d)8.8

Entry Deterrence and Limit Pricing

 FIGURE 8.11

Game Tree for the Entry-Deterrence Game

The path of the game is square A to square C to

rectangle 4. Mona commits to the entry-deterring

quantity of 100, so Doug stays out of the market.

Mona’s profit of $10,000 is less than the monopoly

profit but more than the duopoly profit of $8,000.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE INSECURE MONOPOLIST AND

ENTRY DETERRENCE (cont’d)8.8

Entry Deterrence and Limit Pricing

●limit pricing The strategy of reducing the price

to deter entry.

●limit price The price that is just low enough to

deter entry.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

Between 2006 and 2011 many top-selling branded drugs will lose their patent

protection. Producers of generic versions will enter markets with hundreds of

billions of dollars in annual sales.

There are two way companies are responding to this increased competition.

• Companies are producing their own versions of generic drugs

• They are cutting the prices of branded drugs to compete with the generic

versions.

MERCK AND PFIZER GO GENERIC?

APPLYING THE CONCEPTS #6: How do patent holders

respond to the introduction of generic drugs?

A P P L I C A T I O N 6

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

THE INSECURE MONOPOLIST AND

ENTRY DETERRENCE (cont’d)8.8

Examples: Microsoft Windows and Campus Bookstores

●contestable market A market with low entry and exit

costs.

Entry Deterrence and Contestable Markets

When Is the Passive Approach Better?

Entry deterrence is not the best strategy for all insecure monopolists.

Sharing a duopoly can be more profitable than increasing output and cutting

the price to keep the other firm out.

Microsoft picks a lower price to discourage entry and preserve its monopoly.

If your campus bookstore suddenly feels insecure about its monopoly

position, it could cut its prices to prevent online booksellers from capturing

too many of its customers.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

NATURAL MONOPOLY8.9

Picking an Output Level

M A R G I N A L P R I N C I P L E

Increase the level of an activity as long as its marginal benefit exceeds its

marginal cost. Choose the level at which the marginal benefit equals the

marginal cost.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

NATURAL MONOPOLY (cont’d)8.9

 FIGURE 8.12

A Natural Monopoly Uses the

Marginal Principle to Pick

Quantity and Price

Because of the indivisible input of

cable service (the cable system),

the long-run average-cost curve is

negatively sloped.

The monopolist chooses point a,

where marginal revenue equals

marginal cost.

The firm serves 70,000

subscribers at a price of $27 each

(point b) and an average cost of

$21 (point c). The profit per

subscriber is $6 ($27 – $21).

Picking an Output Level

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

NATURAL MONOPOLY (cont’d)8.9

Will a Second Firm Enter?

 FIGURE 8.13

Will a Second Firm Enter the

Market?

The entry of a second cable

firm would shift the demand

curve of the typical firm to the

left.

After entry, the firm’s demand

curve lies entirely below the

long-run average-cost curve.

No matter what price the firm

charges, it will lose money.

Therefore, a second firm will

not enter the market.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

NATURAL MONOPOLY (cont’d)8.9

Price Controls for a Natural Monopoly

 FIGURE 8.14

Regulators Use Average-Cost

Pricing to Pick a Monopoly’s

Quantity and Price

Under an average-cost pricing

policy, the government chooses

the price at which the demand

curve intersects the long-run

average-cost curve—$12 per

subscriber.

Regulation decreases the price

and increases the quantity.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In the early part of the nineteenth century, public water works

could not keep up with rapidly growing demand, so cities allowed

private companies to provide water.

However, problems with competing private wager providers

caused cities to switch back to public systems

The British determined that water distribution is a natural monopoly and

allowing competition hurts rather than helps public access to water.

PUBLIC VERSUS PRIVATE WATERWORKS

APPLYING THE CONCEPTS #7: What is the rationale

for regulating a natural monopoly?

A P P L I C A T I O N 7

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In 2008, the nation’s only two satellite radio providers, Sirius Satellite Radio and XM

Satellite Radio, merged into a single firm. Together the two firms had 14 million

subscribers, each paying $13 per month for dozens of channels, most of which are

free of advertisements. Both firms were losing money as they struggled to get

enough subscribers to cover their substantial fixed costs.

The proposed merger needed to be approved by the U.S. Department of Justice and

the Federal Communication Commission.

Two years later, the new firm, Sirius XM, earned its first quarterly profit of $14.2

million, compared to a loss one year earlier of $245.8 million.

The merger transformed two unprofitable firms into a single profitable firm.

SATELLITE RADIO AS A NATURAL MONOPOLY

APPLYING THE CONCEPTS #8: When does a natural

monopoly occur?

A P P L I C A T I O N 8

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY8.10

●trust An arrangement under which the

owners of several companies transfer

their decision-making powers to a

small group of trustees.

Breaking Up Monopolies

One form of antitrust policy is to break up a monopoly into several smaller

firms. The label “antitrust” comes from the names of the early conglomerates

that the government broke up.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10

Blocking Mergers

●merger A process in which two or more firms

combine their operations.

A horizontal merger involves two firms producing a similar product, for

example, two producers of pet food.

A vertical merger involves two firms at different stages of the production

process, for example, a sugar refiner and a candy producer..

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10 Blocking Mergers

 FIGURE 8.15

Pricing by Staples in Cities with and without Competition

Using the marginal principle, Staples picks the quantity at which marginal revenue equals marginal cost.

In a city without a competing firm, Staples picks the monopoly price of $14.

In a city where Staples competes with Office Depot, the demand facing Staples is lower, so the profit-

maximizing price is only $12.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10

Merger Remedy for Wonder Bread

In some cases, the government allows a merger to happen

but imposes restrictions on the new company.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10

Regulating Business Practices: Price-Fixing, Tying, and

Cooperative Agreements

●tie-in sales A business practice under which a

business requires a consumer of one

product to purchase another product.

●predatory pricing A firm sells a product at a price below

its production cost to drive a rival out

of business and then increases the

price.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10

The Microsoft Cases

In recent years, the most widely reported antitrust actions have

involved Microsoft Corporation, the software giant.

In the case of United States v. Microsoft Corporation, the judge

concluded that Microsoft stifled competition in the software industry.

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

ANTITRUST POLICY (cont’d)8.10

A Brief History of U.S. Antitrust Policy

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In 2001, H.J. Heinz Company announced plans to buy Milnot Holding Company’s

Beech-Nut for $185 million. The merger would combine the nation’s second- and

third-largest sellers of baby food, with a combined market share of 28 percent. The

combined company would still be less than half the size of the market leader,

Gerber, with its 70 percent market share.

The FTC successfully blocked the merger, based on two observations:

• Most retailers stock only two brands of baby food, Gerber and either

Heinz or Beech-Nut. After the merger, the Heinz brand would

disappear, leaving Beech-Nut as a secure second brand on the shelves

next to Gerber. The elimination of competition for second place would

lead to higher prices.

• The smaller the number of firms in an oligopoly, the easier it is to

coordinate pricing. In a market with two firms instead of three, it would

be easier for the baby-food manufacturers to fix prices.

HEINZ AND BEECH-NUT BATTLE FOR SECOND PLACE

APPLYING THE CONCEPTS #9: Does competition

between the second- and third-largest firms matter?

A P P L I C A T I O N 9

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly

In 1981 the FTC brought an antitrust suit against Xidex Corporation for its

earlier acquisition of two rivals in the microfilm market.

XIDEX RECOVERS ITS ACQUISITION COST IN TWO YEARS

APPLYING THE CONCEPTS #10:

How does a merger affect prices?

Xidex increased its market share from 46 percent to 71 percent.

• Price on one type of microfilm increased by 11 percent.

• Price on the other type increased by 23 percent.

• Xidex recovered it acquisition cost in two years.

Xidex agreed to license its microfilm at bargain prices to other firms

A P P L I C A T I O N 10

C H A P T E R 8

Market Entry, Monopolistic

Competition, and Oligopoly K E Y T E R M S

cartel

concentration ratio

contestable market

dominant strategy

duopolists’ dilemma

duopoly

game theory

game tree

grim-trigger strategy

low-price guarantee

limit price

limit pricing

merger

monopolistic competition

Nash equilibrium

oligopoly

predatory pricing

price-fixing

product differentiation

tie-in sales

tit-for-tat

trust

Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 9

Imperfect Information,

External Benefits, and

External Costs

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Chapter Outline

9.1 Adverse Selection for Buyers: The Lemons Problem

9.2 Responding to the Lemons Problem

9.3 Adverse Selection for Sellers: Insurance

9.4 Insurance and Moral Hazard

9.5 External Benefits and Public Goods

9.6 The Efficient Level of Pollution

9.7 Taxing Pollution

9.8 Traditional Regulation

9.9 Marketable Pollution Permits

9.1 Adverse Selection for Buyers: The

Lemons Problem

Explain the notion of adverse selection for buyers.

In this chapter, we explore the circumstances under which

the decisions of individuals do not promote the social

interest:

• Imperfect information: Either buyers or sellers do not

know enough about the product to make informed

decisions.

• External benefits: The benefits of a product are not

confined to the person who pays for it.

• External costs: The cost of producing a product is not

confined to the person who sells it.

Asymmetric Information

Asymmetric information: A situation in which one side of

the market—either buyers or sellers—has better information

than the other.

How can asymmetric information can produce problems?

• The side with less information cannot make good buying or

selling decisions.

• Because of this, they may be reluctant to buy or sell at all,

which hurts the side with more information also.

Uninformed Buyers and Knowledgeable

Sellers

Suppose there are two types of used cars: low-quality

“lemons” and high-quality “plums.” They sell together in a

single mixed market.

Mixed market: A market in which goods of different

qualities are sold for the same price.

The price of used cars in this market will be based on:

1. How much is a consumer willing to pay for a plum?

2. How much is a consumer willing to pay for a lemon?

3. What is the chance that a used car purchased in the

mixed market will be of low quality?

Figure 9.1 All Used Cars on the Market

Are Lemons (1 of 2)

Suppose a consumer values a plum at $4,000 and a lemon

at $2,000.

If he guesses there is a 50–50 mix of plums and lemons on

the market, he is willing to pay $3,000; but if he offers

$3,000, 80% of the cars will be lemons.

Figure 9.1 All Used Cars on the Market

Are Lemons (2 of 2)

This would lead the consumer to offer less; but now an

even lower fraction of cars available are plums.

The equilibrium in this market is that all cars offered for

sale are lemons, and the price is $2,000.

Table 9.1 Equilibrium with All Low-

Quality Goods

blank Buyers Initially

Have 50–50

Expectations

Equilibrium:

Pessimistic

Expectations

Demand Side of Market blank blank

Amount buyer is willingness to pay for a lemon $2,000 $2,000

Amount buyer is willingness to pay for a plum $4,000 $4,000

Assumed chance of getting a lemon 50% 100%

Assumed chance of getting a plum 50% 0%

Amount buyer is willing to pay for a used car in

mixed market

$3,000 $2,000

Supply Side of Market blank blank

Number of lemons supplied 80 45

Number of plums supplied 20 0

Total number of used cars supplied 100 45

Actual chance of getting a lemon 80% 100%

Equilibrium with All Low-Quality Goods

The domination of the used car market by lemons is an

example of the adverse-selection problem.

Adverse-selection problem: A situation in which the

uninformed side of the market must choose from an

undesirable or adverse selection of goods.

The asymmetric information in the market generates a

downward spiral of price and quality, in this case until all

cars on the market are lemons.

A Thin Market: Equilibrium with Some

High-Quality Goods

The result that all cars on the market are lemons occurs

because no plum-seller is willing to sell at the value of a

lemon.

If the minimum supply price of plums were lower (below

$2,000 in this example), then some cars sold would be

plums. The result is a thin market:

Thin market: A market in which some high-quality goods

are sold but fewer than would be sold in a market with

perfect information.

Figure 9.2 The Market for High-Quality

Cars (Plums) Is Thin

If buyers are pessimistic and assume that only lemons will be

sold, they are willing to pay $2,000 for a used car. At this price, 5

plums are supplied (point a), along with 45 lemons (point b).

This is not an equilibrium because 10% of consumers get plums,

contrary to their expectations.

Table 9.2 A Thin Market for High-

Quality Goods

Blank Initial

Pessimistic

Expectations

Equilibrium:

75–25

Expectations

Demand Side of Market Blank Blank

Amount buyer is willing to pay for a lemon $2,000 $2,000

Amount buyer is willing to pay for a plum $4,000 $4,000

Assumed chance of getting a lemon 100% 75%

Assumed chance of getting a plum 0% 25%

Amount buyer is willing to pay for a used car in

mixed market

$2,000 $2,500

Supply Side of Market Blank Blank

Number of lemons supplied 45 60

Number of plums supplied 5 20

Total number of used cars supplied 50 80

Actual chance of getting a lemon 90% 75%

Predictions from the Lemons Problem

The lemons model makes two predictions about markets with

asymmetric information.

1. The presence of low-quality goods in a market will at least

reduce the number of high-quality goods in the market and

may even eliminate them.

2. Buyers and sellers will respond to the lemons problem by

investing in information and other means of distinguishing

between low-quality and high-quality goods.

Evidence of the Lemons Problem

In studies of the market for used trucks:

1. For trucks less than 10 years old, the ones sold on the

used market are about as reliable as ones retained by

owners.

2. For older trucks (about 1/3 of transactions), the

probability of requiring engine and transmission repairs

is much higher for those that are sold on the used

market.

The problem of information asymmetry appears to be more

severe for older trucks.

Application 1: Are Baseball Pitchers

Like Used Cars?

After playing for six years, MLB

players can become free agents.

Free-agent pitchers who change

teams get injured more: 28 days

per season, versus 5 for players who

stay with their original team.

Adverse selection helps to explain

this: original teams will be more

willing to part with an injury-prone

“lemon” baseball player than with a

healthy “plum.”

9.2 Responding to the Lemons Problem

Discuss the possible responses to adverse selection

for buyers.

There are strong incentives for buyers and sellers to solve the

lemons problem.

• In our car market example, consumers are willing to pay a

high price if they can be guaranteed a “plum.”

• Similarly, sellers benefit from a higher sale price if they can

demonstrate their car is high quality.

In this section, we will examine some ways of overcoming

the lemons problem.

Buyers Invest in Information

Buyers may be able to pay for information about the

product they want to buy.

In the market for lemons, a buyer could:

• Take the car to a mechanic to learn more about it.

• Obtain a report on the history of the car, say from

Carfax.com.

• Learn more about the likely reliability, say by reading

Consumer Reports publications on repair histories of

car models.

http://carfax.com/

Consumer Satisfaction Scores from

Angie’s List and eBay

Asymmetric information also exists when purchasing

services. How can you know if your mechanic or plumber is

high quality? Or if an unknown seller online is trustworthy?

• Angie’s list was created in 1995 to solve this problem,

collecting reviews of local businesses.

• eBay and other online marketplaces collect reviews of

sellers and make those available, to help reduce the

information asymmetry between buyers and sellers.

Guarantees and Lemons Laws

Sellers can credibly signal to buyers that their product is

high quality by offering money-back guarantees or repair

warranties.

Governments can also help to increase the ability of

buyers to trust sellers by creating “Lemons Laws,”

protecting consumers against unusually poor products.

• In the new car market, such laws sometimes require

manufacturer to buy back cars with recurring problems.

Application 2: Regulation of the

California Kiwifruit Market

The sweetness level of kiwifruit

cannot be determined by customers

before purchase; producers know it

but buyers don’t, an asymmetric

information problem.

In 1987, California producers

implemented a federal marketing

order: fruit must meet a minimum

maturity standard.

Within a few years, kiwifruit prices

went up as buyers could trust the

product they were buying.

9.3 Adverse Selection for Sellers:

Insurance

Explain the notion of adverse selection for sellers.

Sometimes, buyers can be more knowledgeable than

sellers, when they are buying a service but the seller does

not know how expensive it will be to provide the service.

The best example of this is insurance markets:

• Auto insurance sellers have limited information about

your driving ability and habits.

• Health and life insurance companies have limited

information about your overall health and lifestyle.

Health Insurance

What is the insurance company’s average cost per customer? To

determine the average cost in a mixed market, we must answer

three questions:

• What is the cost of providing medical care to a high-cost person?

• What is the cost of providing medical care to a low-cost person?

• What fraction of the customers are low-cost people?

There is asymmetric information in the insurance market because

potential buyers know from everyday experience and family

histories what type of customer they are, either low cost or high

cost.

Figure 9.3 All Insurance Customers

Are High-Cost People

A high-cost customer

requires $6,000 worth of

care, while a low-cost

customer requires $2,000.

If the insurance company

assumes a 50–50 mix, it

charges $4,000; but this is

not an equilibrium, because

too many high-cost

customers buy insurance.

Table 9.3 Equilibrium with All High-Cost

Consumers

Blank

50–50

Expectations

Equilibrium: Pessimistic

Expectations

Supply Side of Market Blank Blank

Cost of serving a high-cost customer $6,000 $6,000

Cost of serving a low-cost customer $2,000 $2,000

Assumed fraction of high-cost customers 50% 100%

Assumed chance of low-cost customers 50% 0%

Expected average cost per customer (price) $4,000 $6,000

Demand Side of Market Blank Blank

Number of high-cost customer 75 40

Number of low-cost customers 25 0

Total number of customers 100 40

Actual fraction of high-cost customers 75% 100%

Actual average cost per customer $5,000 $6,000

In the equilibrium, relatively few people buy health insurance, and

they are all high cost: an adverse-selection problem.

Responding to Adverse Selection in

Insurance: Group Insurance

Insurance companies use group insurance plans to diminish

the adverse-selection problem.

By enrolling all the employees of an organization in one or

two insurance plans, they ensure that all workers, not just

high-cost people, join the pool of consumers.

Prices are then usually set by experience rating.

Experience rating: A situation in which insurance

companies charge different prices for medical insurance to

different firms depending on the past medical bills of a firm’s

employees.

The Uninsured

One implication of asymmetric information in the insurance

market is that many low-cost consumers who are not

eligible for a group plan will not carry insurance.

The Affordable Care Act (ACA) tried to solve this problem

with the individual mandate, requiring U.S. residents to

obtain health insurance.

• Changes to the law were passed in 2017 ending the

individual mandate.

• The Congressional Budget Office (CBO) estimates that

this will increase the uninsured population by 15 million

by 2026.

Other Types of Insurance

The same logic of adverse selection applies to the markets

for other types of insurance.

• Homeowners know more than home insurers about the

state of repair of their homes.

• Individuals know more about their family history of illness

than life insurance companies.

Insurance companies can try to reduce this information

asymmetry, say by requiring home inspections or physical

exams.

Application 3: Genetic Testing and

Adverse Selection

The cost of genetic testing

continues to decrease, giving

consumers insights into their

ancestry and future health.

If you test positive for APOE4, a

mutation of a gene related to

increased risk of Alzheimer’s,

would you be more willing to buy

long-term care insurance?

• A recent study showed those

who knew they had the gene

were 2.3–5.8 times more likely

to buy that insurance.

9.4 Insurance and Moral Hazard

Explain the notion of moral hazard.

Another problem of asymmetric information is that people who are

insured against the consequences of their actions may change their

behavior in undesirable ways.

• Someone with auto insurance may drive less safely.

• A student guaranteed a good grade may not study hard to learn

class material.

• A worker who will be paid regardless of performance may not put

in high effort at work

Moral hazard: A situation in which one side of an economic

relationship takes undesirable or costly actions that the other side

of the relationship cannot observe.

Insurance Companies and Moral Hazard

Insurance companies use various measures to decrease

the moral-hazard problem.

For example, many insurance policies have a

deductible—a dollar amount that a policyholder must pay

before getting compensation from the insurance

company.

• Deductibles reduce the moral-hazard problem because

they shift to the policyholder part of the cost of a claim

on the policy.

Deposit Insurance for Savings and

Loans

When you deposit money in a Savings and Loan (S&L), the

S&L will invest the money, loaning it out and expecting to

make a profit when loans are repaid with interest.

• For S&L managers, pursuing high-risk, high-reward

investments could be beneficial: succeed and obtain large

financial rewards, fail and lose your job, and move on to the

next company.

• Because consumer deposits are protected by FDIC

insurance, consumers have little incentive to insist on safe

S&L investment practices.

Savings and Loans in the 1980s

Recognizing this moral hazard problem, the federal

government has historically limited S&Ls to relatively safe

investments.

• In the 1980s, the government loosened investment

restrictions. Managers engaged in risky behaviors, and

taxpayers bailed out failed S&Ls at a cost of about $200

billion.

Application 4: Car Insurance and Risky

Driving

Do people really drive less

safely when they have car

insurance?

When a state makes car

insurance compulsory,

collisions and the number of

traffic deaths increase.

• A 1% decrease in the share

of uninsured drivers

increases traffic fatalities by

2%.

9.5 External Benefits and Public Goods

Define a public good and the free-rider problem.

Writing and enforcing laws and regulations are important

activities that take place within governments.

In this section, we focus on another aspect of government:

provision of, and decisions about, goods with external

benefits.

External benefit: A benefit from a good experienced by

someone other than the person who buys the good.

Public Goods and the Free-Rider

Problem

Suppose a new dam will provide $50 in benefit to each of

1,000 residents, while costing $20,000 to build.

The dam is an example of a public good; it is nonrival in

consumption (one person benefiting from it does not prevent

another person from benefiting from it) and nonexcludable

(impractical to exclude people who do not pay).

• Examples include national defense, space exploration, the

preservation of endangered species, and fireworks shows.

Public good: A good that is available for everyone to

consume, regardless of who pays and who doesn’t; a good

that is nonrival in consumption and nonexcludable.

Free Riders

Suppose, we were to build the dam only if people volunteered

to pay for it. Would you pay, knowing you would benefit from

this public good regardless of whether you paid?

Free rider: A person who gets the benefit from a good but

does not pay for it.

Private goods do not have the free-rider problem because we

can stop people from benefiting from the good if they do not

pay for it.

Private good: A good that is consumed by a single person or

household; a good that is rival in consumption and excludable.

Public Goods and Public Provision

Governments often provide public goods as a solution to the

free-rider problem.

• Governments can force people to pay for the good through

taxation.

Be careful: just because a good is provided by the

government, does not necessarily make it a public good.

• For example, public housing is a private good: it is both

rival in consumption and excludable.

Behavioral Economics and Free Riding

Some economic experiments investigate the extent of free

riding.

• In one experiment, participants decide how much of their

private funds to contribute to a public good, helping out the

other participants by more than their own cost.

• Participants tend to start out contributing to the public good,

but contribute less and less over time; that is, they free ride

more as time goes on.

Overcoming the Free-Rider Problem

Some organizations are successful at getting people to

contribute rather than free ride. Successful strategies

include:

• Giving contributors private goods such as coffee mugs,

books, musical recordings, and magazine subscriptions.

• Arranging matching contributions.

• Appealing to a person’s sense of civic or moral

responsibility.

Application 5: Clearing Space Debris

NASA estimates there are

about 300,000 pieces of

“space debris” orbiting the

earth, each large enough to

destroy an orbiting satellite.

Cleaning up the space debris

is a public good subject to the

free-rider problem:

• If one nation clears space

debris, the benefits are

shared by all.

Application 6: Global Weather

Observation

Weather information gathered by

one country has external benefits

for other countries.

The United States has taken the

lead in encouraging cooperation

and sharing of data collected by

different organizations around the

world.

The National Oceanic and

Atmospheric Organization was able

to predict the El Niño weather

pattern in 1997–98, saving the

California economy over $1 billion.

9.6 The Efficient Level of Pollution

Use the marginal principle to describe the efficient level

of pollution.

In an earlier chapter, we saw that one condition for market

efficiency is that there are no external costs in production.

• External costs will lead to market failure: markets will fail to

allocate resources efficiently.

How can we deal with situations in which there are large

external costs, such as pollution costs?

• The consequences for our environment if we fail to account

for these external costs of production may be dire.

Using the Marginal Principle

Caring about pollution does not mean eliminating all

pollution.

Recall the marginal principle: increase the level of an

activity as long as its marginal benefit exceeds its

marginal cost. Choose the level at which the marginal

benefit equals the marginal cost.

Pollution and other external costs make the marginal cost

of production higher. This alters the optimal level of many

activities, though the ideal reduction depends on the

balance of benefits and costs.

Costs and Benefits of Pollution

Abatement

Instead of considering the pollution-producing activity, it

is convenient to consider a new good: pollution

abatement, or the reduction in pollution.

• Pollution abatement has costs: resources (land, labor,

and capital) will be used in the abatement process.

• Pollution abatement has benefits: better health,

increased enjoyment of the natural environment, and

lower production costs (e.g., for farmers gaining

access to clean water).

Figure 9.4 Efficient Abatement and

Coase Bargaining (1 of 4)

With no abatement, 500 tons

of waste is produced.

The marginal cost of

abatement rises as more

waste is abated; similarly, the

marginal benefit falls.

The ideal amount of

abatement is 300 tons: 200

tons of waste will still be

formed.

Coase Bargaining

Under some circumstances, an external-cost problem can be

resolved through bargaining among the affected parties.

The Coase bargaining solution, named after economist

Ronald Coase, applies to a situation when:

• There is a small number of affected parties, and

• The transactions costs of bargaining are relatively low.

Figure 9.4 Efficient Abatement and

Coase Bargaining (2 of 4)

If we started with 500 tons of

waste, the people who would

benefit from waste abatement

could pay the polluting firm to

reduce waste.

They value 1 ton of waste

reduction at $21, while

reducing pollution by that 1 ton

costs the firm only $3.

They could bargain for some

price in the middle, making

both better off.

Figure 9.4 Efficient Abatement and

Coase Bargaining (3 of 4)

Similarly, if we started with

full waste abatement

(pollution is banned), the

firm would offer $13 to be

allowed to produce 1 ton of

waste.

Because the benefit to the

rights-holders of that last 1

ton of pollution abatement

is only $1, the parties can

again agree on a mutually

beneficial trade.

Figure 9.4 Efficient Abatement and

Coase Bargaining (4 of 4)

In either case, the process

can continue until point e is

reached: the efficient

outcome.

The Coase bargaining result

does not depend on who is

assigned the property rights

as long as those property

rights are well defined.

If many parties are involved,

however, bargaining may

break down.

Application 7: Reducing Methane

Emissions

Methane is a greenhouse gas

that contributes to global

warming.

Determining the cost of methane

abatement is not too hard; the

problem is determining the

benefit.

How much will reducing methane

by particular amounts reduce

adverse climate effects?

• The uncertainty makes forming

good public policy difficult.

9.7 Taxing Pollution

Describe the role of taxation in promoting efficient environmental

policy.

The economic approach to pollution is to get producers to pay for the

waste they generate, just as they pay for labor, capital, and materials.

One way of doing this is with a tax on pollution.

Private cost of production: The production cost borne by a producer,

which typically includes the costs of labor, capital, and materials.

External cost of production: A cost incurred by someone other than

the producer.

Social cost of production: Private cost plus external cost.

Pollution tax: A tax or charge equal to the external cost per unit of

pollution.

Figure 9.5 The Firm’s Response to an

SO2 Tax

The efficient outcome is 6 tons

of abatement; at that level, the

marginal cost of abatement just

equals the marginal benefit.

To achieve this, we can set the

tax per ton to be the same as

the marginal benefit ($3,500).

The firm will abate pollution as

long as it can do that more

cheaply than paying the tax.

Figure 9.6 The Effects of SO2 and NOx Taxes on the Electricity Market

A tax on pollution raises the firm’s cost of production, shifting

the supply curve upward; the tax is an additional cost the firm

has to pay when it produces.

The tax is shifted forward to consumers, who pay a higher

price, and consequently choose to consume less.

Figure 9.7 Responses to SO2 and NOx Taxes on Electricity Generation

Firms can also adjust their production process to avoid the

pollution tax. Electricity generators switch to low-sulfur coal

and alternate energy sources.

Example: A CO2 Tax

A tax on carbon dioxide-producing fuels could help reduce or avoid

global warming caused by greenhouse gases.

A tax of $30 per ton of CO2 would add $0.27 per gallon to the price

of gasoline, $1.60 per 1,000 cubic feet of natural gas, and $63 per

short ton of coal.

How would this help the environment?

• People would drive less and buy more energy-efficient vehicles.

• Higher home energy costs would encourage better home

insulation and reduced electricity consumption.

British Columbia implemented such a tax; since 2008, fuel

consumption in the province decreased by 4.5%.

Application 7: Washing Carbon Out of

the Air

One option to address the

problem of CO2 in the

atmosphere is large machines

to wash CO2 out of the air.

With current technology, the

cost of carbon washing is $200

per ton.

As costs fall, this may become

an effective alternative to the

cost of avoiding CO2 emission.

9.8 Traditional Regulation

Explain the superiority of taxation over traditional

regulation.

Although the economic approach to pollution is to get

polluters to pay for the waste they generate, governments

often take a different approach.

• Under a traditional regulation policy, the government tells

each firm how much pollution to abate and what

abatement techniques to use.

Why might is this not ideal?

• We are likely to be able to achieve the same reduction in

pollution at a lower cost using other methods.

Table 9.4 Uniform Reduction Versus

Pollution Tax

blank blank Abatement cost Abatement cost

blank Marginal

Abatement cost

Uniform Abatement

policy

Pollution tax = $3,000 per ton

Low-cost firm $2,000 $2,000 $4,000

High-cost firm $5,000 $5,000 $ 0

Total Blank $7,000 $4,000

Suppose, we want to achieve 2 tons of pollution abatement. Two firms emit 2 tons of

pollution each.

Using a uniform abatement policy, we would require both the low-cost and high-cost

firms to reduce pollution by 1 ton.

• The total cost of abatement is $7,000.

If we tax pollution instead, the high-cost firm will not reduce pollution at all, choosing to

pay the tax.

• The low-cost firm will abate 2 tons of pollution, costing $4,000.

Command and Control

Command-and-control policies specify maximum amounts

of pollution and mandate particular pollution reduction

technologies.

Economists discourage command-and-control approaches:

• Requiring the same technology for all firms is unlikely to be

efficient when firms differ in their production technology.

• Even worse, there is no incentive to improve beyond the

mandated technology.

Market Effects of Pollution Regulations

Why do governments use these policies, when:

• Uniform abatement policies are inefficient, ignoring firm-

specific costs of reducing pollution.

• Command-and-control policies discourage innovation.

One reason is predictability: we are more able to predict the

amount of waste generated.

• Using a pollution tax, firms will choose how much pollution

to abate, and this may not match the government’s goals.

Lesson from Dear Abby: Options for

Pollution Abatement

A reader wrote to columnist “Dear Abby” Van Buren, asking

how to deal with pollution from their neighbor’s wood-burning

stove. The reader had offered $500 to the neighbors to

remove the stove, but they refused.

Other readers offered some sub-$500 ideas, including:

• Buy the neighbors a pollution-reducing stove add-on

• Pay the neighbors to hire a chimney sweep

• Purchase an air purifier for the reader’s own home

The lesson: by getting creative, we may be able to find a

lower-cost solution to pollution problems.

Application 9: Options for Reducing CO2 Emissions from International Shipping

International shipping is responsible

for about 3% of global CO2 emissions.

Some ways to reduce CO2 emissions:

• Switch from diesel to gas-powered

engines: $20 per ton

• Reduce speed and increase fleet

size: $90 per ton

• Install fixed sails and wings to tap

wind power: $105 per ton

9.9 Marketable Pollution Permits

Describe the virtues of marketable pollution permits

and the factors that determine their price.

One new approach to environmental policy is the use of

marketable pollution permits, sometimes called

pollution allowances.

Marketable pollution permits: A system under which the

government picks a target pollution level for a particular

area, issues just enough pollution permits to meet the

pollution target, and allows firms to buy and sell the

permits; also known as a cap-and-trade system.

Voluntary Exchange and Marketable

Permits

Making pollution permits marketable is sensible because it

allows mutually beneficial exchanges between firms with

different abatement costs.

• This is another illustration of the principle of voluntary

exchange: A voluntary exchange between two people

makes both people better off.

A firm with a low cost of pollution abatement would sell its

permits (i.e., abate more pollution); a firm with a high cost of

pollution abatement would buy those permits.

• This system uses market forces to discover which firms

have the lowest cost of pollution abatement.

The Clean Air Act (1990) and the SO2 Cap-and-Trade Program

The Clean Air Act (1990) established a system of marketable

pollution permits for SO2.

• Firms received permits equal to 50–70% of their previous

pollution levels.

• Over time, the number of permits would decrease, in order

to encourage innovation in pollution abatement.

A report from the National Acid Precipitation Assessment

Program showed the permit system lowered the cost of

abatement by 15–20%.

In 2011, courts invalidated the program, and by 2012, it was

no longer an important force in pollution reduction.

Figure 9.8 The Market for Pollution

Permits

A similar system for smog pollutant

permits was created in the Los

Angeles basin.

Again, the number of permits shrunk

over time, eventually allowing only

30% as much pollution as at the start

of the program.

• This created incentives for

innovation in pollution abatement,

since the demand for pollution

abatement technologies would rise

over time.

Application 10: The Price of CO2 Permits in the European Union

The EU designed an Emissions

Trading System (ETS) to serve

as a market for CO2 permits.

The number of permits was not

designed to shrink fast enough,

however, resulting in falling

prices for the permits—resulting

in low incentives for innovation.

2017 reforms are expected to

decrease the supply of permits.

Key Terms

Adverse-selection problem

Asymmetric information

Experience rating

External benefit

External cost of production

Free rider

Marketable pollution permits

Mixed market

Moral hazard

Pollution tax

Private cost of production

Private good

Public good

Social cost of production

Thin market

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Survey of Economics: Principles,

Applications and Tools Eighth Edition

Chapter 10

The Labor Market and

the Distribution of

Income

Chapter Outline

10.1 The Demand for Labor

10.2 The Supply of Labor

10.3 Labor Market Equilibrium

10.4 The Distribution of Income and Public Policy

10.1 The Demand for Labor

Explain why competition generates wages equal to marginal

revenue product.

Most of our work so far has been on the markets for final goods and

services.

In this chapter, we examine the market for one of the factors of

production: labor.

• We can use a labor demand and supply model to investigate why

wages are different for different types of people, and in different

occupations.

• We will also look at recent changes in the distribution of income

and the effects of government tax and transfer policies.

Labor Demand by an Individual Firm in

the Short Run

Labor demand is a derived demand, derived from the

demand for the products that workers produce.

Consider a perfectly competitive firm producing rubber

balls and selling them for $0.50 each. The firm decides

how many people to hire using the marginal principle:

• Increase the level of an activity as long as its

marginal benefit exceeds its marginal cost. Choose

the level at which the marginal benefit equals the

marginal cost.

Table 10.1 Using the Marginal Principle

to Make a Labor Decision (1)

Workers

(2)

Balls

(3)

Marginal Product of

Labour

(4)

Price

(5)

Marginal Revenue

Product of Labour (MRP)

(6)

Marginal Cost

When Wage = $8

1 26 26 $0.50 $13 $8

2 50 24 0.50 12 8

3 72 22 0.50 11 8

4 92 20 0.50 10 8

5 108 16 0.50 8 8

6 120 12 0.50 6 8

7 128 8 0.50 4 8

8 130 2 0.50 1 8

Marginal product of labor: The change in output from one additional unit

of labor.

Marginal-revenue product of labor (MRP): The extra revenue generated

from one additional unit of labor; MRP is equal to the price of output times

the marginal product of labor.

Figure 10.1 The Marginal Principle and

the Firm’s Demand for Labor (1 of 2)

The MRP curve is also the short-run demand curve for labor:

Short-run demand curve for labor: A curve showing the

relationship between the wage and the quantity of labor

demanded over the short run, when the firm cannot change its

production facility.

Figure 10.1 The Marginal Principle and

the Firm’s Demand for Labor (2 of 2)

The firm chooses how many workers to hire (demand) based on

the marginal cost (the wage) and the marginal benefit (the MRP).

To form the market labor demand for labor in the short run, we

add up the number of workers demanded by each individual firm

at each wage.

Figure 10.2 An Increase in the Price of

Output Shifts the Labor-Demand Curve (1 of 2)

Long-run demand curve for labor: A curve showing the

relationship between the wage and the quantity of labor demanded

over the long run, when the number of firms in the market can

change and firms can modify their production facilities.

Labor Demand in the Long Run

The long-run demand curve for labor slopes downward for two

reasons:

1. The output effect: when wages are higher, the price of output

will be higher; less output will be demanded, and hence fewer

workers also.

2. The input-substitution effect: when wages are higher, firms

can substitute toward other inputs.

Output effect: The change in the quantity of labor demanded

resulting from a change in the quantity of output produced.

Input-substitution effect The change in the quantity of labor

demanded resulting from an increase in the price of labor relative

to the price of other inputs.

Figure 10.2 An Increase in the Price of

Output Shifts the Labor-Demand Curve (2 of 2)

Labor demand is a derived demand, deriving from the demand for

the product.

If consumers are willing to pay a higher price for the product, the

firm will supply more, and hence labor demand will be higher.

Short-Run Versus Long-Run Demand

How does the short-run demand curve for labor compare to

the long-run demand curve? There is less flexibility in the

short run because

1. Firms cannot enter or leave the market

2. Firms cannot modify their production facilities.

As a result, the demand for labor is less elastic in the short

run.

• That means the short-run demand curve is steeper than

the long-run demand curve.

Application 1: Marginal Revenue

Product in Major League Baseball

In 2018, the average salary in Major

League Baseball (MLB) was $4.5

million. Are players really worth that

much?

A team will pay $4.5 million for a

player only if the player’s marginal

revenue product (MRP) is at least

$4.5 million.

• How could it be so high? Fans are

more willing to pay to watch

winning teams; and they purchase

more merchandise when teams

win.

10.2 The Supply of Labor

Explain why an increase in the wage could increase,

decrease, or not change hours worked

How many hours of labor will be supplied at each wage?

When we speak of a labor market, we are referring to the

market for a specific occupation in a specific geographical

area.

Consider the supply for nurses in the hypothetical city of

Florence. The supply question is, “How many hours of

nursing services will be supplied at each wage?”

The Individual Labor-Supply Decision:

How Many Hours?

The decision of how much to work is how much leisure time to sacrifice

for money. The price of leisure is the wage.

As the wage increases:

1. Leisure becomes more expensive, so workers substitute away from

it; but

2. Workers have higher incomes, so they consume more normal

goods—including leisure!

Substitution effect for leisure demand: The change in leisure time

resulting from a change in the wage (the price of leisure) relative to the

price of other goods.

Income effect for leisure demand: The change in leisure time resulting

from a change in real income caused by a change in the wage.

An Example of Income and Substitution

Effects

Suppose each nurse in Florence initially works 36 hours per week

at an hourly wage of $10 and the wage increases to $12.

1. Lester works fewer hours. If Lester works 30 hours instead of

36 hours, he gets 6 hours of extra leisure time and still earns

the same income per week ($360 = 30 hours × $12 per hour).

2. Sam works the same number of hours. If Sam continues to

work 36 hours per week, he gets an additional $72 of income

($2 per hour × 36 hours) and the same amount of leisure time.

3. Maureen works more hours. If Maureen works 43 hours

instead of 36 hours, she sacrifices 7 hours of leisure time but

earns a total of $516, compared to only $360 at a wage of $10

per hour.

The Market Supply Curve for Labor

Now consider the market supply curve for nursing labor in

Florence. As wages rise:

1. Hours worked per employee is hard to predict, but unlikely to

change much.

2. Some workers will switch to nursing from other occupations.

3. Some workers will migrate to Florence for the higher pay.

So overall the market supply curve for labor will slope

upward.

Market supply curve for labor: A curve showing the

relationship between the wage and the quantity of labor

supplied.

Application 2: Bike Messengers and

Revenue Sharing in Zurich

A bike messenger in Zurich earns 40% of

their employer’s revenue from deliveries.

A study investigated how they would

respond to a higher wage: 50% revenue

share instead. What happened?

• Messengers worked 40% more shifts.

• They pedaled a little slower each shift,

but made a little more money because

of the higher revenue share.

• Combining these two, their incomes

increased from 1,200 francs to 2,000

francs.

10.3 Labor Market Equilibrium

Explain why wages differ across occupations and

levels of human capital.

We can now consider a labor market equilibrium: a situation

where there is no pressure to change the wage because the

amount of work demanded is equal to the amount of work

supplied at the prevailing wage.

After this, we will consider a number of reasons why people

earn different amounts.

Figure 10.3 Supply, Demand, and Labor

Market Equilibrium

At the market equilibrium

shown by point a, the wage is

$15 per hour and the quantity

of labor is 16,000 hours.

The quantity supplied equals

the quantity demanded, so

there is neither excess

demand for labor nor excess

supply of labor.

Figure 10.4 The Market Effect of an

Increase in Demand for Labor

An increase in the demand for nursing services shifts the demand

curve to the right, moving the equilibrium from point a to point b.

The equilibrium wage increases from $15 to $17 per hour, and the

equilibrium quantity increases from 16,000 hours to 19,000 hours.

The Market Effects of the Minimum

Wage

In 2012, the federal minimum wage was $7.25 per hour.

What are the trade-offs associated with the minimum wage?

For restaurant workers and restaurant diners, there is good

news and bad news:

• Good news for some restaurant workers: those who keep

their jobs at the higher minimum wage.

• Bad news for some restaurant workers: those who lose

their jobs or have their hours cut.

• Bad news for diners: increased wages are passed on in

higher meal prices.

Figure 10.5 The Market Effects of a

Minimum Wage

The market equilibrium is shown

by point a: The wage is $6.05

per hour, and the quantity of

labor is 50,000 hours.

A minimum wage of $7.25

decreases the quantity of labor

demanded to 49,000 hours per

day (point b).

Although some workers receive

a higher wage, others lose their

jobs or work fewer hours.

Variation in Wages across Occupations

Why do some jobs pay more than others? Generally, because

the supply of labor in those jobs is low. Why?

• Few people with the required skills (e.g., to play

professional baseball)

• High training costs (e.g., to become a medical doctor)

• Undesirable working conditions (e.g., working third shift)

• Danger (e.g., crabbing in Alaska)

• Artificial barriers to entry (e.g., licensing requirements for

beauticians)

Figure 10.6 The Equilibrium Wage When

Labor Supply Is Low Relative to Demand

If supply is low relative to

demand—because few

people have the skills,

training costs are high, or

the job is undesirable—the

equilibrium wage will be

high.

The College Premium

College graduates earn more than those without college

degrees—on average 72% more in 2015. Why?

1. College students learn useful skills: the learning effect.

2. College students demonstrate by completing college that

they can manage time and work hard: the signaling

effect.

Learning effect: The increase in a person’s wage resulting

from the learning of skills required for certain occupations.

Signaling effect: The information about a person’s work

skills conveyed by completing college.

The Gender Pay Gap

A 2016 study showed the typical woman earned about 82% as

much as the typical man, compared with 62% in 1976. Why?

1. Human capital: In the past, women had less education than

men; though this is no longer true.

2. Work experience: In 1981, the average man had seven more

years of work experience; by 2011, the gap was only 1.4 years.

3. Industry and occupational mix: Women are overrepresented

in lower-wage industries, and jobs within those industries.

The factors above explain about 62% of the gender pay gap,

leaving about 38% unexplained.

Racial Discrimination

Blank Male Female

African American 76% 83%

Hispanic 67% 77%

The table shows the fraction of a corresponding average white

worker’s full time pay that African American and Hispanic workers

received in 2016.

A portion of the differences can be attributed to productivity

differences; but a recent study concluded that racial discrimination

probably accounts for about a 10% pay gap.

This gap is not identical across the earnings distribution: it appears

to be small or nonexistent for high-skill and very low-skill workers.

Labor Unions and Wages

Labor union: A group of workers organized to increase job

security, improve working conditions, and increase wages and

fringe benefits.

In the United States in 2017, about 1 in 9 wage and salary

workers belongs to a union, down from 1 in 3 in the 1950s.

Union workers earn about 10–20% of nonunion workers in typical

jobs. Firms respond to the higher wages by hiring fewer workers.

Unions try to combat this with practices like featherbedding.

Featherbedding: Work rules that increase the amount of labor

required to produce a given quantity of output; may actually

decrease the demand for labor.

Effects of Unions

Practices like featherbedding tend to reduce output,

raising production costs and increasing prices for

consumers.

Unions have some potential benefits also, like facilitating

communication between management and workers, and

decreasing turnover.

• The decreased turnover resulting from unions is

estimated to reduce costs for firms by 1–2%.

Immigration and Labor Markets

A substantial fraction of the U.S. labor force was born in other

countries.

A naïve labor supply-based argument would conclude that adding

immigrant workers would decrease the wage of native workers,

because they compete for the same jobs. But:

1. Immigrants are often complements to, rather than substitutes

for, native labor (because of different skill sets etc.).

2. Increased production by immigrants benefits consumers.

3. Immigrants tend to locate in large cities where labor productivity

is relatively high—because demand for labor is high.

Figure 10.7 Percentage of Workers Who Are

Foreign Born for Different Education Levels

Immigrants to the United States are more likely to be very high or

very low education, compared with the native population.

Results of Recent Immigration Studies

From dozens of studies over the period 1990–2010, we learn:

• Immigrants have relatively small effects on wages of native

workers overall, neither consistently positive nor negative.

• Because many immigrants are low-skill/education, low-skill

native workers do receive a negative effect on wage due to

immigration.

• Immigrants are substitutes for one another also: increased

immigration hurts the wages of earlier immigrants.

Application 3: The Value of a Statistical

Life

By examining how much more

people require to work in risky jobs

than safer ones, economists can

estimate how much people value

their own lives.

Suppose working on a skyscraper

pays more than working on the

ground by $6,000, and carries a

0.001 higher risk of death.

We would conclude 0.001 of a life

is worth $6,000; so 1 life is worth

$6,000,000.

10.4 The Distribution of Income and

Public Policy

Describe the effects of government policies on poverty

and the distribution of income.

In 2016, the median household income in the United States

was $59,039.

But some households earn much more or much less than

others.

There are three key reasons for inequality:

1. Differences in labor skills and effort

2. Luck and misfortune

3. Discrimination

Figure 10.8 Distribution of Market

Income and After-Tax Income, 2013

The figure shows the distribution of income before (green bars)

and after (purple bars) accounting for government transfers and

federal taxes.

Table 10.2 Changes in Income for

Different Quintiles, 1979 – 2013

Change in

Average

Income

Bottom 20

Percent

(quintile 1)

Middle 60 Percent

(quintiles 2, 3, 4)

Next 19 Percent (quintile

5 without top 1%)

Top 1

percent

Before tax

(market)

39% 32% 65% 187%

After tax 46% 41% 70% 192%

Over the last several decades, the distribution of income has

become more unequal.

• The largest income gains were experienced by households at

the top end of the income distribution.

Over this time, the college premium doubled, and the advanced-

degree premium increased also.

• The dropout penalty almost doubled.

Changes in the Distribution of Income

What explains these changes?

• Technological change: advances in technology like

computers have complemented high-skill workers, making

them more productive; but reduced the demand for low-skill

workers.

• Increased international trade: Trade has facilitated the

export of goods produced in the United States with high-skill

labor; but it has allowed import of goods that low-skill

workers in the United States would have produced

previously.

Economists have not yet reached a consensus on the relative

importance of these two factors.

Table 10.3 Poverty Rates for Different

Groups, 2016

A household in the United States

is classified as poor if it does not

receive at least three times as

much income as it would take to

feed the family.

In 2016, 40.6 million people were

below the poverty line.

Some government programs

provide assistance to the poor.

Means-tested program: A

program that restricts eligibility to

people or households with less

than a specified maximum wealth

or income.

Characteristic Poverty Rate in 2010

All Races 12.7%

White 11.0

Black 22.0

Hispanic 19.4

Asian 10.1

Type of Family Blank

Married couple 5.1

Female-headed household 26.9

Age Blank

Under 18 years 18.0

65 years and older 9.3

Education Blank

College graduates 4.5

High-school graduates 13.3

High-school dropouts 24.8

1996 Welfare Reform

In 1996, the overhaul of federal antipoverty programs ended

decades of policy based on the notion that low-income families

are entitled to cash and in-kind assistance.

Most programs became administered by states as Temporary

Assistance for Needy Families (TANF). Further,

• A recipient must participate in work activities, defined as

employment, on-the-job training, work experience, community

service, or vocational training.

• After a total of 60 months of cash assistance (consecutive or

nonconsecutive), assistance stops. States can allow

exceptions to the 60-month rule for up to 20% of recipients.

Earned Income Tax Credit

The government also provides assistance to low-income

households through the tax system.

• The earned income tax credit (EITC) is an earnings

subsidy for low-income households that is determined by

the number of children in the household.

• For the fiscal year 2018, federal spending on the EITC

was $64 billion, which was more than twice the spending

on TANF.

Economists believe the EITC results in significant increases

in workforce participation and decreases in poverty.

Application 4: Earned Income Tax

Credit and Child Health

Economists used differences in

state tax credit programs to

estimate that:

1. The EITC increased the use

of private health insurance

2. An increase in the value of a

state EITC decreases the

chance a child is in fair or

poor health, and increases

the chance a child is in

excellent health.

Key Terms

Featherbedding

Income effect for leisure

demand

Input-substitution effect

Labor union

Learning effect

Long-run demand curve for

labor

Marginal product of labor

Marginal-revenue product of

labor (MRP)

Market supply curve for labor

Means-tested programs

Output effect

Short-run demand curve for

labor

Signaling effect

Substitution effect for leisure

demand

This work is protected by United States copyright laws and is

provided solely for the use of instructors in teaching their

courses and assessing student learning. Dissemination or sale of

any part of this work (including on the World Wide Web) will

destroy the integrity of the work and is not permitted. The work

and materials from it should never be made available to students

except by instructors using the accompanying text in their

classes. All recipients of this work are expected to abide by these

restrictions and to honor the intended pedagogical purposes and

the needs of other instructors who rely on these materials.