1

Chapter 1 notes
Definition of Economics
The first thing that we should discuss is the definition of "economics." Economists generally define economics as the study of how individuals and societies use limited resources to satisfy unlimited wants. To see how this concept works, think about your own situation. Do you have enough time available for everything that you wish to do? Can you afford every item that you would like to own? Economists argue that virtually everyone wants more of something. Even the wealthiest individuals in society do not seem to be exempt from this phenomenon. This problem of limited resources and unlimited wants also applies to society as a whole. Can you think of any societies in which all wants are satisfied? Most societies would prefer to have better health care, higher quality education, less poverty, a cleaner environment, etc. Unfortunately, there are not enough resources available to satisfy all of these goals. Thus, economists argue that the fundamental economic problem is scarcity. Since there are not enough resources available to satisfy everyones wants, individuals and societies have to choose among available alternatives. An alternative, and equivalent, definition of economics is that economics is the study of how such choices are made.

Economic Goods, Free Goods, and Economic Bads

A good is said to be an economic good (also known as a scarce good) if the quantity of the good demanded exceeds the quantity supplied at a zero price. In other words, a good is an economic good if people want more of it than would be available if the good were available for free. A good is said to be a free good if the quantity of the good supplied exceeds the quantity demanded at a zero price. In other words, a good is a free good if there is more than enough available for everyone even when the good is free. Economists argue that there are relatively few, if any, free goods. An item is said to be an economic bad if people are willing to pay to avoid the item. Examples of economic bads include things like garbage, pollution, and illness. Goods that are used to produce other goods or services are called economic resources (and are also known as inputs or factors of production). These resources are often categorized into the following groups: 1. 2. 3. 4. Land, Labor, Capital, and Entrepreneurial ability.

The category of "land" includes all natural resources. These natural resources include the land itself, as well as any minerals, oil deposits, timber, or water that exists on or below the ground. This category is sometimes described as including only the "free gifts of nature," those resources that exist independent of human action. The labor input consists of the physical and intellectual services provided by human beings. The resource called "capital" consists of the machinery and equipment used to produce output. Note that the use of the term "capital" differs from the everyday use of this term. Stocks, bonds, and other financial assets are not capital under this definition of the term.

2 Entrepreneurial ability refers to the ability to organize production and bear risks. Your text does not list this as a separate resource, but instead considers it as a type of labor input. Most other introductory texts, though, list this as a separate resource. (No, your text is not wrong, it just uses a different way of classifying resources. I think it's better, though, to stick with the somewhat more standard classification in this course.) The resource payment associated with each resource is listed in the table below: Economic Resource land labor capital entrepreneurial ability Resource Payment rent wages interest profit

Rational Self-interest
As noted above, scarcity results in the need to choose among competing alternatives. Economists argue that individuals pursue their rational self-interest when making choices. This means that individuals are assumed to select the alternative(s) that they believe will make them happiest, given the information that they possess at the time of the decision. Note that the term "self-interest" means something quite different than "selfish." Self-interested people may donate their time to charitable organizations, give gifts to loved ones, contribute to charities and engage in other similarly altruistic activities. Economists assume, though, that altruistic people select these actions because they find these activities more enjoyable than available alternative activities.

Economic Methodology
Economic discussions may involve both positive and normative analysis. Positive analysis involves attempts to describe how the economy functions. Normative economics relies on value judgments to evaluate or recommend alternative policies. As a social science, economics attempts to rely on the scientific method. The scientific method consists of the following steps: 1. 2. 3. 4. Observe a phenomenon, Make simplifying assumptions and develop a model (a set of one or more hypotheses), Make predictions, and Test the model.

If the model is rejected in step 4, formulate a new model. If the test fails to reject the model, conduct additional tests. Note that tests of a model can never prove that a model is true. A single test, however, may be used to establish that a model is incorrect.

3 Economists rely on the ceteris paribus assumption in constructing models. This assumption, translated roughly as "other things constant," allows economists to simplify reality so that it may be more readily understood.

Logical fallacies
The fallacy of composition occurs when one incorrectly attempts to generalize from a relationship that is true for each individual, but is not true for the whole group. As an example of this, note that any person can get a better view at a concert by standing (regardless of the actions of those in from of him or her). It is incorrect, though, to state that everyone can get a better view if everyone stands. Similarly, one would commit the fallacy of composition if one were to claim that, since anyone could increase his or her wealth by stealing from his or her neighbors (assuming no detection), that everyone can become wealthier if everyone steals from their neighbors. The association as causation fallacy, also known less technically as the post hoc, ergo propter hoc fallacy, occurs if one incorrectly assumes that one event is the cause of another simply because it precedes the other event. The Super Bowl example discussed in your text is a good example of this logical fallacy.

Microeconomics vs. Macroeconomics

Microeconomics involves the study of individual economic agents and individual markets. Macroeconomics involves the study of economic aggregates.

Alegbra and Graphical Analysis in Economics

(This is a summary of some of the most important material in the appendix to Chapter 1.) Graphs are extensively used in economic analysis to represent the relationships that exist among economic variables. Two simple types of relationships that may exist are direct and inverse relationships. A direct relationship is said to exist between two variables X and Y if an increase in X is always associated with an increase in Y and a decrease in X is associated with a decrease in Y. A graph of such a relationship will be upward sloping, as in the diagram below.

A direct relationship may be linear (as in the diagram above), or it may be nonlinear (as in the diagrams below).

An inverse relationship is said to exist between the variables X and Y if an increase in X is always associated with a decrease in Y and a decrease in X is associated with an increase in Y. A graph of an inverse relationship will be downward sloping.

An inverse relationship may also be either linear or nonlinear (as illustrated below).

A linear relationship possesses a constant slope, defined as:

If an equation can be written in the form: Y = mX + b, then: m = slope, and

5 b = y-intercept.

Chapter 2 notes
As noted in Chapter 1, economics is the study of how individuals and economies deal with the fundamental problem of scarcity. Since there are not enough available resources to satisfy the wants of individuals and societies, individuals and societies must make choices among competing alternatives.

Opportunity Cost
The opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative. Let's consider a few examples of opportunity cost:

Suppose that you own a building that you use for a retail store. If the next-best use of the building is to rent it to someone else, the opportunity cost of using the business for your business is the rent you could have received. If the next-best use of the building is to sell it to someone else, the annual opportunity cost of using it for your own business is the foregone interest that you could have received (e.g., if the interest rate is 10% and the building is worth $100,000, you give up $10,000 in interest each year by keeping the building, assuming that the value of the building remains constant over the year -depreciation or appreciation would have to be taken into account if the value of the building changes over time). The opportunity class of attending college includes: o the cost of tuition, books, and supplies (the costs of room and board only appear if these costs differ from the levels that would have been paid in your next-best alternative), o foregone income (this is usually the largest cost associated with college attendance), and o psychic costs (the stress, anxiety, etc. associated with studying, worrying about grades, etc.). If you attend a movie, the opportunity cost includes not only the cost of the tickets and transportation, but also the opportunity cost of the time required to view the movie.

When economists discuss the costs and benefits associated with alternative activities, the discussion generally focuses on marginal benefits and marginal costs. The marginal benefit from an activity is the additional benefit associated with a one-unit increase in the level of an activity. Marginal cost is defined as the additional cost associated with a one-unit increase in the level of the activity. Economists assume that individuals attempt to maximize the net benefit associated with each activity. If marginal benefit exceeds marginal cost, net benefit will increase if the level of the activity rises. Therefore, rational individuals will increase the level of any activity when marginal benefit exceeds marginal costs. On the other hand, if marginal cost exceeds marginal benefit, net benefit rises when the level of the activity is

6 decreased. There is no reason to change the level of an activity (and net benefit is maximized) at the level of an activity at which marginal benefit equals marginal cost.

Production Possibilities Curve

Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by a production possibilities frontier. For simplicity, it is assumed that a firm (or an economy) produces only two goods (this assumption is needed only to make the representation feasible on a two-dimensional surface -- such as a graph on paper or on a computer screen). When a production possibilities curve is drawn, the following assumptions are also made: 1. there is a fixed quantity and quality of available resources, 2. technology is fixed, and 3. there are no unemployed nor underemployed resources Very shortly, we'll also see what happens when these assumptions are relaxed. For now, though, let's consider a simple example. Suppose that a student has four hours left to study for exams in two classes: introductory microeconomics and introductory calculus. The output in this case is the exam score in each class. The assumption of a fixed quantity and quality of available resources means that the individual has a fixed supply of study materials such as textbooks, study guides, notes, etc. to use in the available time. A fixed technology suggests that the individual has a given level of study skills that allow him or her to translate the review materials into exam scores. A resource is unemployed if it is not used. Idle land, factories, and workers are unemployed resources for a society. Underemployed resources are not used in the best possible way. Society would have underemployed resources if the best brain surgeons were driving taxis while the best taxi drivers were performing brain surgery.... The use of an adjustable wrench as a hammer or the use of a hammer to pound a screw into wood provide additional examples of underemployed resources. If there are no unemployed or underemployed resources, efficient production is said to occur. The table below represents possible outcomes from each various combinations of time studying each subject:

# of # of hours hours calculus economics spent spent grade grade studying studying calculus economics 0 1 2 3 4 4 3 2 1 0 0 30 55 75 85 60 55 45 30 0

Notice that each additional hour spent studying either calculus or economics results in smaller marginal improvements in the grade. The reason for this is that the first hour will be spent studying the most essential concepts. Each additional hour is spent on the "next-most" important topics that have not already been mastered. (It is important to note that a good grade on an economics examination requires substantially more

7 than four hours of study time.) This is an example of a general principle known as the law of diminishing returns. The law of diminishing returns states that output will ultimately increase by progressively smaller amounts as additional units of a variable input (time in this case) are added to a production process in which other inputs are fixed (the fixed inputs here include the stock of existing subject matter knowledge, study materials, etc.). To see how the law of diminishing returns works in a more typical production setting, consider the case of a restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators, tables, etc.). As the level of labor use increases, output may initially rise fairly rapidly (since additional workers allow more possibilities for specialization and reduces the time spent switching from task to task). Eventually, however, the addition of more workers will result in progressively smaller increases in output (since there is a fixed amount of capital for these workers to use). It is even possible that beyond some point workers may start getting in each others way and output may decline ("too many cooks may spoil the broth...." sorry.... I couldn't resist). In any case, the law of diminishing returns explains why your grade will increase by fewer points with each additional hour that you spend studying. The points in the table above can be represented by a production possibilities curve (PPC) such as the one appearing in the diagram below. Each point on the production possibilities curve represents the best grades that can be achieved with the existing resources and technology for each alternative allocation of study time.

Let's consider why the production possibilities curve has this concave shape. As the diagram below indicates, a relatively large improvement in economics grade can be achieved by giving up relatively few points on the calculus exam. A movement from point A to point B results in a 30-point increase in economics grade and only a 10-point reduction in calculus grade. The marginal opportunity cost of a good is defined to be the amount of another good that must be given up to produce an additional unit of the first good. Since the opportunity cost of 30 points on the economics test is a 10-point reduction in the score on the calculus test, we can say that the marginal opportunity cost of one additional point on the economics test is approximately 1/3 of a point on the calculus test. (If in doubt, note that if 30 points on the economics exam have an opportunity cost of 10 points, each point on the economics test must cost approximately 1/30th of 10 points on the calculus test -approximately 1/3 of a point on the calculus test).

Now, let's see what happens a second hour is transferred to the study of economics. The diagram below illustrates this outcome (a movement from point B to C). As this diagram indicates, transferring a second hour from the study of mathematics to the study of economics results in a smaller increase in economics grade (from 30 to 45 points) and a larger reduction in calculus grade (from 75 to 55). In this case, the marginal opportunity cost of a point on the economics exam has increased to approximately 4/3 of a point on the calculus exam.

The increase in the marginal opportunity cost of points on the economics exam as more time is devoted to studying economics is an example of the law of increasing cost. This law states that the marginal opportunity cost of any activity rises as the level of the activity increases. This law can also be illustrated using the table below. Notice that the opportunity cost of additional points on the calculus exam rises as more time is devoted to studying calculus. Reading from the bottom of the table up to the top, you can also see that the opportunity cost of additional points on the economics exam rises as more time is devoted to the study of economics.

9 One of the reasons for the law of increasing cost is the law of diminishing returns (as in the example above). Each extra hour devoted to the study of economics results in a smaller increase in the economics grade and a larger reduction in the calculus grade because of diminishing returns to time spent on either activity. A second reason for the law of increasing cost is the fact that resources are specialized. Some resources are better suited for some some types of productive activities than for other types of production. Suppose, for example, that a farmer is producing both wheat and corn. Some land is very well suited for growing wheat, while other land is relatively better suit for growing corn. Some workers may be more adept at growing wheat than corn. Some farm equipment is better suited for planting and harvesting corn. The diagram below illustrates the PPC curve for this farmer.

At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmer must transfer resources from corn production to wheat production. Initially, however, he or she will transfer those resources that are relatively better suited for wheat production. This allows wheat production to increase with only a relatively small reduction in the quantity of corn produced. Each additional increase in wheat production, however, requires the use of resources that are relatively less well suited for wheat production, resulting in a rising marginal opportunity cost of wheat. Now, let's suppose that this farmer either does not use all of the available resources, or uses them in a less than optimal manner (i.e., either unemployment or underemployment occurs). In this case, the farmer will produce at a point that lies below the production possibilities curve (as illustrated by point A in the diagram below).

In practice, all firms and all economies operate below their production possibilities frontier. Firms and economies, however, generally attempt to get as close to the frontier as possible. Points above the production possibilities cannot be produced using current resources and technology. In the diagram below, point B is not obtainable unless more or higher quality resources become available or technological change occurs.

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An increase in the quantity or quantity of resources will cause the production possibilities curve to shift outward (as in the diagram below). This type of outward shift could also be caused by technological change that increases the production of both goods.

In some cases, however, technological change will only increase the production of a specific good. The diagram below illustrates the effect of a technological change in wheat production that does not affect corn production.

Chapter 3
In this chapter, we will examine how markets determine the price of goods and the quantity sold and consumed. A market is a set of arrangements for the exchange of a good or a service.

Barter vs. markets

A barter system is a market system in which goods or services are traded directly for other goods or services. If you agree to repair your neighbor's computer in return for his or her assistance in painting your house, you have engaged in a barter transaction. While a barter system may be able to function effectively in a simple economy in which a limited variety of goods are produced, it cannot function well in a complex economy that produces an extensive collection of goods and services. The primary problem associated with a barter system is

11 that any trade requires a double coincidence of wants. This means that trade can only take place if each person wants what the other person is willing to trade and is willing to give up what the other person wants. In a developed economy in which a diverse collection of goods and services are produced, locating someone willing to make the trade that you desire may be quite difficult and costly. If you repair TVs and are hungry, you must find someone with a broken TV who is willing to trade food for TV repairs. Because it is costly to arrange such a transaction, economists note that barter transactions have relatively high transactions costs. For this reason, throughout recorded history virtually all societies have used some form of money to facilitate trade. In a monetary economy, individuals trade goods or services for money and then use this money to buy the goods or services that they wish to acquire. Since money can be traded for any good or service, the use of money eliminates the need for a double coincidence of wants and lowers the transaction costs associated with trade.

Relative and nominal prices

The opportunity cost of acquiring a good or a service under either a barter or a monetary economy may be measured by the relative price of the commodity. The relative price of a commodity is a measure of how expensive a good is in terms of units of some other good or service. Under a barter system, the relative price is nothing more than the trading ratio between any two goods or services. For example, if one laser printer is traded for 2 ink-jet printers, the relative price of the laser printer is two ink-jet printers. Alternatively, the relative price of an inkjet printer is one-half of a laser printer in this case. In a monetary economy, relative prices can also be easily computer using the ratio of the prices of the commodities. If, for example, a soccer ball costs $20 and a portable CD player costs $60, the relative price of a portable CD player is 3 soccer balls (and the relative price of a soccer ball is 1/3 of a CD player). Economists ague that individuals respond to changes in relative prices since these prices reflect the opportunity cost of acquiring a good or service. In a market economy, the price of a good or service is determined through the interaction of demand and supply. To understand how market price is determined, it is important to know the determinants of both demand and supply. Let's first examine the demand for a good.

Demand
The demand for a good or service is defined to be the relationship that exists between the price of the good and the quantity demanded in a given time period, ceteris paribus. One way of representing demand is through a demand schedule such as the one appearing below:

Note that the demand for the good is the entire relationship that is summarized by this table. This demand relationship may also be represented by a demand curve (as illustrated below).

12

Both the demand schedule and the demand curve indicate that, for this good, an inverse relationship exists between the price and the quantity demanded when other factors are held constant. This inverse relationship between price and quantity demanded is so common that economists have called it the law of demand: An inverse relationship exists between the price of a good and the quantity demanded in a given time period, ceteris paribus. As noted above, demand is the entire relationship between price and quantity, as represented by a demand schedule or a demand curve. A change in the price of the good results in a change in the quantity demanded, but does not change the demand for the good. As the diagram below indicates, an increase in the price from $2 to $3 reduces the quantity of this good demanded from 80 to 60, but does not reduce demand.

Change in demand vs. change in quantity demanded

A change in demand occurs only when the relationship between price and quantity demanded changes. The position of the demand curve changes when demand changes. If the demand curve becomes steeper or flatter or shifts to the right or the left, we can say that demand has changed. The diagram below illustrates a shift in the demand for a good (from D to D'). Notice that a rightward shift in the position of the demand curve is said to be an increase in demand since a larger quantity is demanded at each price.

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Market demand
The market demand consists of the total quantity demanded by each individual in the market. Conceptually, the market demand curve is formed by computing the horizontal summation of the individual demand curves for all consumers. The diagram below illustrates this process. This diagram illustrates a simple case in which there are only two consumers, Person A and Person B. Notice that the total quanity demanded in the market is just the sum of the quantities demanded by each individual. In this diagram, Person A wished to buy 10 of this commodity and person B wishes to buy 15 units when the price is $3. Thus, at a price of $3, the total quantity demanded in the market is 25 (=10+15) units of this commodity.

Of course, this example is highly simplified since there are many buyers in most real-world markets. The same principle, though would hold: the market demand curve is derived by adding together the quantities demanded by all consumers at each and every possible price.

Determinants of demand
Let's examine some factors that might be expected to change demand for most goods and services. These factors include:

tastes and preferences, the prices of related goods, income, the number of consumers, and expectations of future prices and income.

Obviously, any change in tastes that raises the evaluation of a good will result in an increase in the demand for a good (as illustrated below). Those who remember the short-term increases in demand that occurred with slap bracelets, pogs, hypercolor t-shirts, beanie babies, Tickle-Me-Elmos, etc., can attest to the effect of changing tastes on demand. Fads will often increase the demand for a good for at least a short period of time.

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Demand will also decline if tastes change so the consumption of a good becomes less desirable. As fads fade away, the demand for the products falls (as illustrated below).

Goods may be related in consumption as either:

substitute goods, or complementary goods.

Two goods are said to be substitute goods if an increase in the price of one results in an increase in the demand for the other. Substitute goods are goods that are often used in place of each other. Chicken and beef, for example, may be substitute goods. Coffee and tea are also likely to be substitute goods. The diagram below illustrates the effect of an increase in the price of coffee. A higher price of coffee reduces the quantity of coffee demanded, but increases the demand for tea. Note that this involves a movement along the demand curve for coffee since this involves a change in the price of coffee. (Remember: a change in the price of a good, ceteris paribus, results in a movement along a demand curve; a change in demand occurs when something other than the price of the good changes.)

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Economists say that two goods are complementary goods if an increase in the price of one results in a reduction in the demand for the other. In most cases, complementary goods are goods that are consumed together. Examples of likely pairs of complementary goods include:

peanut butter and jelly, bicycles and bicycle safety helmets, cameras and film, CDs and CD players, and DVDs and DVD players.

The diagram below illustrates the effect of an increase in the price of DVDs. Note that an increase in the price of DVDs would reduce both the quantity of DVDs demanded and the demand for DVD players.

It is expected that the demand for most goods will increase when consumer income rises (as illustrated below). Think about your demand for CDs, meals in restaurants, movies, etc. Is it likely that you would increase your consumption of most commodities if your income increases. (Of course, it is possible that the demand for some goods -- such as generic foods, Ramen noodles, and other similar commodities -- may decline as your income rises. We'll examine this possibility in more detail in Chapter 6.)

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Since the market demand curve consists of the horizontal summation of the demand curves of all buyers in the market, an increase in the number of buyers would cause demand to increase (as illustrated below). As the population rises, the demand for cars, TVs, food, and virtually all other commodities, is expected to increase. A decline in population will result in a reduction in demand.

Expectations of future prices and income are also important determinants of the current demand for a good. First, let's talk about the effect of a higher expected future price. Suppose that you have been considering buying a new car or a new computer. If you acquire new information that leads you to believe that the future price of this commodity will increase, you are probably going to be more likely to buy it today. Thus, a higher expected future price will increase current demand. In a similar manner, a reduction in the expected future price will result in a reduction in current demand (since you'd prefer to postpone the purchase in anticipation of a lower price in the future). If expected future income rises, demand for many goods today is likely to rise. On the other hand, if expected future income falls (perhaps because of rumors of future layoffs or the beginning of a recession), individuals may reduce their current demand for goods so that they can save more today in anticipation of the lower future income.

International effects
When international markets are taken into account, the demand for a product includes both domestic and foreign demand. An important determinant of foreign demand for a good is the exchange rate. The exchange rate is the rate at which the currency of one country is converted into the currency of another country. Suppose, for example, that one dollar exchanges for 5 French francs. In this case, the dollar value of one French franc is $.20. Notice that the exchange rate between dollars and francs is the reciprocal of the exchange rate between francs and dollars. If the value of the dollar rises in terms of a foreign currency, the value of the foreign

17 currency will fall relative to the dollar. This is a quite intuitive result. An increase in the value of the dollar means that the dollar is worth more relative to the foreign currencies. In this case, the foreign currencies have to be worth less in terms of dollars. When the value of the domestic currency rises relative to foreign currencies, domestically produced goods and services become more expensive in foreign countries. Thus, an increase in the exchange value of the dollar results in a reduction in the demand for U.S. goods and services. The demand for U.S. goods and services will rise, however, if the exchange value of the dollar declines.

Supply
Supply is the relationship that exists between the price of a good and the quantity supplied in a given time period, ceteris paribus. The supply relationship may be represented by a supply curve:

or a supply schedule:

Just as there is a "law of demand" there is also a "law of supply." The law of supply states that: A direct relationship exists between the price of a good and the quantity supplied in a given time period, ceteris paribus. To understand the law of supply, it's helpful to remember the law of increasing cost. Since the marginal opportunity cost of supplying a good rises as more is produced, a higher price is required to induce the seller to sell more of the good or service. The law of supply indicates that supply curves will be upward sloping (as in the diagram below).

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Change in quantity supplied vs. change in supply

As in the case of demand, it is important to distinguish between a change in supply and a change in quantity supplied. A change in the price of a good results in a change in the quantity supplied. A change in the price changes the quantity supplied, as noted in the diagram below.

A change in supply occurs when the supply curve shifts, as in the diagram below. Note that a rightward shift in the supply curve indicates an increase in supply since the quantity supplied at each price increases when the supply curve shifts to the right. When supply decreases, the supply curve shifts to the left.

Market supply
The market supply curve is the horizontal summation of all individual supply curves. The derivation of this is equivalent to that illustrated above for demand curves.

Determinants of supply
The factors that can cause the supply curve to shift include:

the prices of resources, technology and productivity, the expectations of producers, the number of producers, and the prices of related goods and services.

19 An increase in the price of resources reduces the profitability of producing the good or service. This reduces the quantity that suppliers are willing to offer for sale at each price. Thus, an increase in the price of labor, raw material, capital, or other resource, will be expected to result in a leftward shift in supply (as illustrated below).

Technological improvements and changes that increase the productivity of labor result in lower production costs and higher profitability. Supply increases in response to this increase in the profitability of production (as illustrated below).

As in the case of demand, expectations can play an important role in supply decisions. If, for example, the expected future price of a gasoline rises, refiners may decide to supply less today so that they can stockpile gas for sale at a later date. Conversely, if the expected future price of a good falls, current supply will increase as sellers try to sell more today before the price declines. An increase in the number of producers results in an increase (a rightward shift) in the market supply curve (as illustrated below).

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Since firms generally produce (or, at least, are able to produce) more than one commodity, they have to determine the optimal balance among all of the goods and services that they produce. The supply decision for a particular good is affected not only by the price of the good, but also by the price of other goods and services the firm may produce. For example, an increase in the price of corn may induce a farmer to reduce the supply of wheat. In this case, an increase in the price of one product (corn) reduces the supply of another product (wheat). It is also possible, but less common, that an increase in the price of one commodity may increase the supply of another commodity. To see this, consider the production of both beef and leather. An increase in the price of beef will cause ranchers to raise more cattle. Since beef and leather are jointly produced from cows, the increase in the price of beef will also be expected to result in an increase in the supply of leather.

International effects
In our increasingly global economy, firms often import raw materials (and sometimes the entire product) from foreign countries. The cost of these imported items will vary with the exchange rate. When the exchange value of a dollar rises, the domestic price of imported inputs will fall and the domestic supply of the final commodity will increase. A decline in the exchange value of the dollar will raise the price of imported inputs and reduce the supply of domestic products that rely on these inputs.

Equilibrium
Let's combine the market demand and supply curves on one diagram:

It can be seen that the market demand and supply curves intersect at a price of $3 and a quantity of 60. This combination of price and quantity represents an equilibrium since the quantity demanded equals the quantity supplied. At this price, each buyer is able to buy all that he or she desires and each firm is able to sell all that it

21 desires to sell. Once this price is achieved, there is no neither the demand nor the supply curve shifts). reason for the price to either rise or fall (as long as

If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds quantity demanded). This situation is illustrated in the diagram below. The presence of a surplus would be expected to cause firms to lower prices until the surplus disappears (this occurs at the equilibrium price of $3).

If the price is below the equilibrium, a shortage occurs (since quantity demanded exceeds quantity supplied). This possibility is illustrated in the diagram below. When a shortage occurs, producers will be expected to increase the price. The price will continue to rise until the shortage is eliminated when the price reaches the equilibrium price of $3.

Shifts in demand and supply

22 Let's examine what happens if demand or supply changes. First, let's consider the effect of an increase in demand. As the diagram below indicates, an increase in demand results in an increase in the equilibrium levels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity (as illustrated below).

An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated below.)

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Price ceilings and price floors

A price ceiling is a legally mandated maximum price. The purpose of a price ceiling is to keep the price of a good below the market equilibrium price. Rent controls and regulated gasoline prices during wartime and the energy crisis of the 1970s are examples of price ceilings. As the diagram below illustrates, an effective price ceiling results in a shortage of a commodity since quantity demanded exceeds quantity supplied when the price of a good is kept below the equilibrium price. This explains why rent controls and regulated gasoline prices have resulted in shortages.

A price floor is a legally mandated minimum price. The purpose of a price floor is to keep the price of a good above the market equilibrium price. Agricultural price supports and minimum wage laws are example of price ceilings. As the diagram below illustrates, an effective price floor results in a surplus of a commodity since quantity supplied exceeds quantity demanded when the price of a good is kept below the equilibrium price.

Chapter 4

24 In this chapter, we'll examine the operation of markets a bit more carefully. Initially, it will be assumed that there are no barriers to the efficient functioning of markets. We'll examine what happens when markets work less efficiently when we discuss Chapter 5.

Market coordination
Production in modern economies is an extremely complex activity. Consider the computer that you are currently using. It consists of components and raw materials that were probably made in thousands of firms located in dozens of countries. Somehow, the glass, plastic, metal, silica, and other raw materials were all combined into the monitor, computer chips, mother board, and other components that form this computer. It is interesting to note that the computer you are using contains dramatically more computing power than the mainframe computers of 20 years or so ago. How did all of these raw materials get converted into this computer? Well, it all happened through market processes. All but the most primitive economies rely on markets to coordinate many productive decisions (yes, this was even true in the former Soviet Union -- it has been estimated that 50% or more of all output was sold in the unofficial underground market economy).

Markets and the "three fundamental questions"

All economies, no matter what their form of economic organization, must address what are known as the "three fundamental questions:"

What? How? For Whom?

Let's examine each of these questions.

What?
The first question can be rephrased as: "What mix of goods and services will be produced?" In a market economy, the interaction of self-interested buyers and sellers determines the mix of goods and services that are produced. Adam Smith, writing in the Wealth of Nations argued that competition among self-interested producers results in an outcome that benefits all of society. Two quotes from Smith help to illustrate this argument: It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their self-interest. (Book I, Chapter I) [A producer,]...by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, not very common among merchants, and very few words need be employed in dissuading them from it. (Book IV, Chapter II) This argument suggests that competition among self-interested producers forces them to produce goods that satisfy consumer wants. In seeking his or her own profit, each producer attempts to produce higher quality products that better serve consumer needs. This leads to a condition of consumer sovereignty in which it is ultimately the consumer who determines what mix of goods and services will be produced. Some economists, such as John Kenneth Galbraith, have questioned this argument and suggest that marketing activities by large corporations can substantially influence the pattern of consumer demand. Most economists argue, though, that while marketing methods may influence consumer demand in the short run, consumers ultimately determine

25 what goods and services that they will buy. Effective advertising campaigns may lead to phenomena such as pet rocks and Chia Pets, but these fads are generally fairly short-lived. If, for whatever reason, consumers want more of a good, this results in an increase in demand. In the short run, this increase in demand results in higher prices, increased output, and a higher level of profit for firms in this industry. In response to these profits, however, new firms will enter the market in the long run, resulting in an increase in market supply. This increase in supply will drive the price back down while further increasing the quantity sold. The short-run profits generated by the increase in demand gradually disappear as the price declines. Thus, the long-run response to an increase in demand is an increase in the amount produced. (Notice how this is consistent with the concept of consumer sovereignty.)

How?
The second fundamental question may be more completely stated as: "How is output produced?" This question involves the determination of the mix of resources that are to be used to produce output. In a market economy, profit-maximizing producers will be expected to select a mix of resources that result in the lowest possible level of cost (holding the quantity and quality of output constant). New production techniques will be adopted only if they reduce production costs. Sellers of resources will supply them to those activities in which they are most highly valued. Once again, Smith's "invisible hand of the market" guides resources into their most valued uses.

For whom?
This third fundamental question deals with the issue of "who gets what?" In a market economy, this is determined by the interaction of buyers and sellers in both output and resource markets. The distribution of income is ultimately determined by the wages, interest payments, rents, and profits that are determined in resource markets. Those with more highly valued land, labor, capital, and entrepreneurial ability receive higher incomes. Given this distribution of income, individuals make their own decisions concerning how much of each good to buy in output markets.

The three fundamental questions and government

Of course, in any real-world economy, markets do not make all of these decisions. In all societies, governments influence what will be produced, how output will be produced, and who receives this output. Government spending, health and safety regulations, minimum wage laws, child labor laws, environmental regulations, tax systems, and welfare programs all have a significant effect on any society's answers to these questions. We'll examine many of these topics in the next chapter. For now, we'll focus on a simple market economy. In this simple economy, there are three participants in the private sector: households, firms, and foreign countries.

Household
A household, as defined by the Census Bureau, consists of one or more individuals that share living quarters.

Types of firms
There are three possible types of firms:

sole proprietorship, partnership, and corporation.

A sole proprietorship is a firm that has a single owner. The main advantage of this form of ownership is that it provides the owner with autonomy (the ability to be his or her own boss). There are, though, a few

26 disadvantages. Because of the high failure rate for newly founded sole proprietorships, it is difficult to acquire funds to acquire physical capital. The owners also face unlimited liability. This means that their personal wealth is at risk if the business fails or is sued. While sole proprietorships are the most common form of firm, most are very small. Sole proprietorships account for a very small proportion of total sales in the U.S. economy. Partnerships are firms in which two or more individuals share ownership. This form of business organization provides an advantage over sole proprietorships by allowing owners to pool their wealth, skills, and resources. The cost of this pooling of resources is some loss in autonomy for the owners. As in the case of sole proprietorships, partnerships are subject to unlimited liability. A corporation is a business that exists as a legal entity separate from the owners. The corporation can enter contracts, own property, and borrow money as if it were a person. The stockholders of the corporation own the corporation. If the corporation declares bankruptcy, however, only the assets of the corporation are at risk. The owners' personal assets are not at risk (their only loss would be the wealth used to acquire the stock). This results in a situation in which the owners only have "limited liability." Offsetting this advantage is that corporate income is subject to double taxation. Any profits received by the corporation are subject to a corporate income tax before they are distributed as dividends to the stockholders. The dividends that are received by stockholders are taxed once again as personal income for the owners. As your text notes, most output in the U.S. is produced in relatively large firms. Corporations account for the largest component of this output. Multinational business has become increasingly important during the past several decades. Multinational businesses are firms that own and operate production facilities in more than one country.

Chapter 5
The focus of this chapter is on the role of government in the economy. Markets do not always behave as efficiently as suggested in Chapter 4. When markets result in economic inefficiency, it may be possible for government to correct for this market failure.

Government in the circular flow

Your text has an elaborate circular flow diagram (on p. 111) that adds government to the private sector flows that were discussed earlier. This diagram is a bit too complex to recreate here, so it may be helpful to refer to the diagram in the text. As this diagram indicates, the government collects taxes from both households and firms and provides government services in return. To produce government services, the government buys resources from households and purchases goods and services from firms. In return, the government provides resource payments to households and payments for the goods and services it acquires from firms. In terms of the injections and leakages that were discussed earlier, taxes represent a leakage from the circular flow of income while government spending represents an injection of purchasing power.

Economic and technical efficiency

27 Technical efficiency is said to occur when the economy operates on the production possibilities curve. In this case, there are no unemployed and no underemployed resources. Economic efficiency is a more general concept that occurs when any change that benefits someone would result in harm for someone else. Note that technical efficiency is a necessary condition for economic efficiency since a movement toward the production possibilities curve would benefit one or more individuals. When there are no market imperfections (several types of market imperfections will be discussed below), markets result in a state of economic efficiency. This occurs because voluntary trade in a market economy always benefits both parties to the transaction (as long as both parties have perfect information about the quality of the commodity being exchanged). A seller is only willing to sell something if he or she receives more benefit from the monetary payment than from the continued possession of the item being sold. A buyer is only willing to buy something if he or she prefers the commodity to the alternative items that could be purchased with the monetary payment. Trade will take place in a market economy until all potential gains from trade are exhausted and economic efficiency occurs. Of course, however, this only occurs when there are no imperfections that interfere with the workings of this "ideal" market. There are several cases in which markets will not achieve economic efficiency. Market failure may occur as the result of:

imperfect information, externalities, public goods, the absence of property rights, monopoly, or macroeconomic instability.

Imperfect information
The effect of imperfect information on economic efficiency should be fairly obvious. Buyers or sellers may not gain from voluntary trade if they do not know the quality of the product being bought or sold. I suspect that everyone has made at least one purchase that they regretted later. Government may correct for this type of market failure by:

requiring that product labels list ingredients, mandating warning labels on products that may be dangerous, requiring guarantees for some products (such as the "lemon law" for used cars), banning fraudulent claims and requiring "truth in advertising," licensing workers in certain professions, and by providing public information about products.

Externalities
Externalities are side effects of production or consumption activities that affect parties not directly involved in the transaction. Positive externalities occur when parties not involved in the transaction benefit from the transaction. Negative externalities occur when third parties are harmed. If someone paints their house, shovels snow from the sidewalk in front of their dwelling, receives a vaccine for a contagious diseases, or removes junk cars from their lawn, positive externalities occur. Negative externalities occur as a result of pollution, loud music played by neighbors (assuming that you do not enjoy their choice or timing of music), fills the air with cigarette or cigar smoke, or engages in other activities that harm others.

28 When positive externalities are present, those engaged in the transaction do not take into account the external social benefits that result from their actions. As a result, the commodity or activity that generates the positive externality is under produced in a market economy. Government may correct for this by subsidizing the activity or issuing regulations or mandates that require a higher level of the activity. For example, the government both subsidizes education and mandates that individuals attend school through at least age 16. The government also subsidizes vaccines and mandates that all school-age children receive vaccines before being allowed to attend school. Negative externalities, on the other hand, result in social costs that are not taken into account by those engaged in the activity. In this case, markets will result in overproduction of the commodity or activity that generates the externality. Government may attempt to correct for this by taxing the activity or by issuing regulations designed to reduce the level of the activity. Government sets limits, for example, on the level of emissions of many chemicals and compounds that may be released into the air and water. It also taxes cigarettes and imposes restrictions on areas in which smoking is allowed. The use of taxes or subsidies to correct for externalities is referred to as "internalizing the externality" since it involves altering the price of the commodity to reflect the external costs or benefits of the activity.

Public goods
A public good is a good that is nonrival in consumption. This means that one person's consumption does not reduce the quantity or quality of the good available to other consumers. Examples of public goods include national defense and TV and radio signals broadcast through the air. Some public goods have some congestion costs in which the benefits do decline a bit as the number of people consuming them rises. Town parks, highways, police and fire protection, and other similar commodities and services fit this definition. The problem with public goods is that no individual has an incentive to pay for the good. Since it is inefficient, and not always feasible, to exclude people from consuming a public good, people can consume it even if they do not pay for it at all. In such a situation, each person has an incentive to be a "free rider" and to let others pay for the good. The problem, of course, is that the good will be either underproduced or not produced at all if the provision of such goods were left to the market. The government attempts to correct for this type of market failure by either providing or subsidizing the production of public goods.

The absence of property rights

A related problem occurs when no one has private property rights to a good. This problem occurs in the case of common property resources in which no individual has private property rights. When everyone shares ownership of some resource, each individual receives all of the benefits from using the resource, but the costs are shared by everyone. Consider, for example, the case of whales, buffalo, fisheries, and similar resources. In each case, the whaler, hunter, or fisherman receives property rights only after catching and killing the animal. Each person gets the full benefit from their activity, but the cost of a reduced breeding stock is shared by everyone. If you are an individual fisherman fishing in an endangered fishery, you have no incentive to reduce your individual harvest of fish because you know that if you do not catch an additional fish, someone else might. In such a situation, the resource is overutilized. Governments deal with this problem by setting restrictions on consumption or by introducing property rights when feasible. When alligators were a common property resource in the U.S., they were hunted until they were threatened with extinction. The introduction of "alligator farms" in which alligators were owned by individuals

29 eliminated the risk of extinction since individual breeding stock for subsequent year's harvests. alligator farmers face an incentive to maintain a

This "problem of the commons" (as it is also known) explains why public parks and highways often have more litter than most individual's back yards, why bathrooms and commons rooms in dormitories are messier than those in private houses and apartments, and why many species of animals have been hunted to extinction or threatened with extinction.

Monopoly
Adam Smith's "invisible hand of the market" works as a result of competition among self-interested sellers. When monopolies are present, prices will tend to be higher and output lower than would occur under competitive market conditions. Government may respond to this problem through antitrust enforcement, by regulating the monopoly, or by public production of the good or service.

Macroeconomic instability
The business cycle results in periodic stages of recession in which unemployment rates rise. This results in a state of economic inefficiency that the government may attempt to remedy by implementing policies designed to ameliorate the business cycle. (This is a topic discussed in much more detail in an introductory macroeconomics course.)

Public choice theory of government

The public choice theory of government suggests that government policy is made by self-interested individuals who are likely to work for their own interests rather than the "public interest." Advocates of the public choice theory argue that special interest groups will engage in "rent-seeking behavior" that is designed to increase their wealth at the expense of society as a whole. Many expenditures on lobbyists, political contributions, etc. do not result in increases in output and may result in economic inefficiency if the lobbyists are successful in redistributing income to the groups that they represent.

Microeconomic and macroeconomic policy

The government engages in both microeconomic and macroeconomic policy. Microeconomic policy involves policies designed to correct for imperfect information, externalities, public goods, the absence of property rights, and monopolies. Macroeconomic policy is policy designed to enhance macroeconomic stability and encourage economic growth. Macroeconomic policy involves the use of fiscal and monetary policy. Fiscal policy involves changing government spending, taxes, and transfer payments. (Transfer payments are payments made to individuals for which no good or service is provided in return. This category of spending includes unemployment compensation, social security payments, and welfare spending.) Monetary policy involves the use of changes in the money supply to affect the level of economic activity. A budget surplus exists if tax revenue exceeds the sum of government spending and transfer payments. If the sum of transfer payments and government spending exceeds tax revenue, a budget deficit exists.

Central planning
An alternative form of economic organization is provided in a centrally planned economy. In a centrally planned economy, the fundamental questions of what to produce, how output should be produced and for whom

30 should it be produced are answered (in theory) by a central planning board. With the collapse of the Soviet Union and market reforms in China, there are few economies that claim to engage in central planning today.

Chapter 6
The focus of Chapter 6 is on the concept of elasticity, a measure of the responsiveness of either quantity demanded or supplied to a change in some other variable.

Price elasticity of demand

The most commonly used elasticity measure is the price elasticity of demand, defined as: price elasticity of demand (Ed) = The price elasticity of demand is a measure of the sensitivity of quantity demanded to a change in the price of a good. Notice that the price elasticity of demand will always be expressed as a positive number (since the absolute value of a negative number is always positive). Demand is said to be:

elastic when Ed > 1, unit elastic when Ed = 1, and inelastic when Ed < 1.

When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in quantity demanded. If demand is unit elastic, quantity demanded will fall by 1% when the price rises by 1%. A 1% price increase will result in less than a 1% reduction in quantity demanded when demand is inelastic. Suppose, for example, that we know that the price elasticity of demand for a particular good equals 2. In this case, we'd say that demand is elastic and would know that a 1% increase in price will cause quantity demanded to fall by 2%. One extreme case is given by a perfectly elastic demand curve, as appears in the diagram below. Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity measure in this case is infinite (notice that the denominator of the elasticity measure equals zero). The closest we get to observing a perfectly elastic demand curve is the demand curve facing a firm that produces a very small share of the total quantity produced in a market. In this case, the firms is such a small share of the market that it must take the market price as given. An individual farmer, for example, has no control over the price that it receives when it brings its product to market. Whether it supplies 100 or 20,000 bushels of wheat, the price that it received per bushel is that day's market price.

31

At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand curve appears in the diagram below. Note that the price elasticity of demand equals zero for a perfectly inelastic demand curve since the % change in quantity demanded equals zero. In practice, we do not expect to see demand curves that are perfectly inelastic. For some range of prices, the demand for insulin, dialysis, and other such medical treatments, is likely to be close to being perfectly inelastic. As the price for these commodities rises, however, we would eventually expect to see the quantity demanded fall because individuals have limited budgets.

Students considering elasticity for the first time often believe that demand is more elastic when the demand curve is flat and less elastic when it is steep. Unfortunately, it is not quite as simple as that... In particular, if we consider the case of any downward sloping linear demand curve, we will see that elasticity varies continuously along this curve. It is true that a one-unit change in price always results in a constant change in quantity demanded along a linear demand curve (since the slope is constant). The ratio of the percentage change in quantity demanded to the percentage change in price, however, changes continuously along such a curve. To see why this occurs, it is necessary to consider the distinction between a change in the level of a variable and the percentage change in the same variable. Suppose we consider the distinction by discussing the percentage change that results from a $1 increase in the price of a good.

a price increase from $1 to $2 represents a 100% increase in price, a price increase from $2 to $3 represents a 50% increase in price, a price increase from $3 to $4 represents a 33% increase in price, and a price increase from $10 to $11 represents a 10% increase in price.

Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smaller when the starting value is larger. Let's use this concept to explain why the price elasticity of demand varies along a linear demand curve.

32 Consider the change in price and quantity demanded that are illustrated below. At the top of the curve, the percentage change in quantity is large (since the level of quantity is relatively low) while the percentage change in price is small (since the level of price is relatively high). Thus, demand will be relatively elastic at the top of the demand curve. At the bottom of the curve, the same change in quantity demanded is a small percentage change (since the level of quantity is large) while the change in price is now a relatively large percentage change (since the level of price is low). Thus, demand is relatively inelastic at the bottom of the demand curve.

More generally, we can note that elasticity declines continuously along a linear demand curve. The top portion of the demand curve will be highly elastic and the bottom is highly inelastic. In between, elasticity gradually becomes smaller as price declines and quantity rises. At some point, demand changes from being elastic to inelastic. The point at which that occurs, of course, is the point at which demand is unit elastic. This relationship is illustrated in the diagram below.

Arc elasticity measure

Suppose that we wish to measure the elasticity of demand in the interval between a price of $4 and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If we start at $5 and move to $4, however, price has fallen by 20%. Which percentage change should be used to represent a change between $4 and $5? To avoid ambiguity, the most common measure is to use a concept known as arc elasticity in which

33 the midpoint of the interval is used as the base value in computing elasticity. Under this approach, the price elasticity formula becomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to $5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since Ed < 1).

Elasticity and total revenue

The concept of price elasticity of demand is extensively used by firms that are investigating the effects of a change in the prices of their commodities. Total revenue is defined as: total revenue = price x quantity Suppose that a firm is facing a downward sloping demand curve for its product. How will it's revenue change if it lowers its price? The answer, it turns out, is somewhat ambiguous. When the price declines, quantity demanded by consumers rises. The lower price received for each unit of output lowers total revenue while the increase in the number of units sold raises total revenue. Total revenue will rise when the price falls if quantity rises by a large enough percentage to offset the reduction in price per unit. In particular, we can note that total revenue will increase if quantity demanded rises by more than one percent when the price falls by one percent. Alternatively, total revenue will decline if quantity demanded rises by less than one percent when the price declines by one percent. If the price falls by one percent and quantity demanded falls by one percent, total revenue will remain unchanged (since the changes will offset each other). A careful observer will note that this comes down to a question of the magnitude of the price elasticity of demand. As defined above, this equals:

34 price elasticity of demand (Ed) = Using the logic discussed above, we can note that a reduction in price will lead to:

an increase in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and a decrease in total revenue when demand is inelastic.

In a similar manner, an increase in price will lead to:

a reduction in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and an increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demand elasticity along a linear demand curve.

As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in the region in which demand is unit elastic. Total revenue falls as quantity increases (and price decreases) in the inelastic portion of the demand curve. Total revenue is maximized at the point at which demand is unit elastic. Does this mean that firms will choose to produce at the point at which demand is unit elastic? This would only be the case if they had no production costs. Firms are assumed to be concerned with maximizing their profits, not their revenue. The optimal level production can be determined only when we consider both revenue and costs. This topic will be extensively addressed in future chapters.

35

Price discrimination
Firms that have some control over their market price can sometimes use that control to enhance their profits by charging different prices to different customers. In particular, a firm engaging in price discrimination increases its profits by charging higher prices to those customers who have the most inelastic demand for the product and lower prices to those customers who have a more elastic demand. In essence, this strategy involves charging the highest prices to those customers who are willing to buy the commodity at a high price and charging lower prices to those customers who are more sensitive to price differentials. A classic example of price discrimination occurs with airline fares. There are two general categories of customers: those traveling on vacations and those traveling for business purposes. It is likely that the demand for air travel by business travelers is less sensitive to price changes than is true for those on vacation. Airlines are able to charge different prices to these two groups by offering a high base fare and a "super saver" fare that requires a weekend stay, the purchase of the tickets several weeks in advance, and similar restrictions. Since those traveling for vacation purposes are more likely to satisfy these requirements than business travelers, airlines accomplish the goal of charging higher prices to the business travelers with less elastic demand and lower prices to those customers with more elastic demand who are flying for vacation purposes. The use of cents-off coupons in the Sunday newspapers is another example of price discrimination that offers a lower price to those customers who have more elastic demands (since low-wage workers are more likely to be sensitive to price changes and are more likely to use coupons). Child and senior citizen discounts at restaurants and movie theaters are also examples of price discrimination that result in lower prices being charged to those customers with the most elastic demand for the products.

Determinants of price elasticity of demand

The price elasticity of demand is likely to be relatively high when:

close substitutes are available, the good or service is a large share of the consumer's budget, and a longer time period is considered.

Let's consider each of these factors. When there a large number of substitutes are available, consumers respond to a higher price of a good by buying more of the substitute goods and less of the relatively more expensive commodity. Thus, we would expect a relatively high price elasticity of demand for goods or services with many close substitutes, but would expect a relatively inelastic demand for commodities such as insulin or AZT with few close substitutes. If the good is a small share of a consumer's budget, a change in the price of the good will have little impact on the individual's purchasing power. In this case, a price change will have relatively little impact on the quantity consumed. A doubling of the price of salt, for example, would not have much of an impact on a typical consumer's budget. But, when a good is a relatively large share of a person's spending, a price increase has a larger effect on their purchasing power. To take an extreme example, suppose that a person spends 50% of his or her income on a commodity and the price doubled. It's likely that the individual will substantially reduce their spending in response to the higher price when spending on the good comprises a larger share of a consumer's budget. Thus, demand will tend to be more elastic for goods that are a small share of a typical consumer's budget.

36 Consumers often have more possibilities for substitutes for a good when a longer time period is considered. Consider, for example, the effect of a higher price for fuel oil or natural gas. In the short run, individuals may lower the temperature and wear warmer clothes, but are unlikely to reduce their energy consumption by very much. Over a longer time period, however, consumers may install more energy efficient furnaces, better insulation, and more energy efficient windows and doors. Thus, we would expect that the demand for either fuel oil or natural gas would be more elastic in the long run than in the short run.

Cross-price elasticity of demand

The cross-price elasticity of demand is a measure of the responsiveness of a change in the price of a good to a change in the price of some other good. The cross-price elasticity of demand between the goods j and k can be expressed as:

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, the sign of the cross-price elasticity of demand tells us about the nature of the relationship between the goods j and k. A positive cross-price elasticity occurs if an increase in the price of good k is associated with an increase in the demand for good j. As noted earlier (in Chapter 3), this occurs if and only if these two goods are substitutes. A negative cross-price elasticity of demand occurs when an increase in the price of good k is associated with a decline in the demand for good j. This occurs if and only if goods j and k are complements. Thus, the cross-price elasticity of demand between two goods tells us whether the two goods are substitutes or complements. Estimates of the magnitude of the cross-price elasticity can be used by firms in making pricing and output decisions. McDonald's Corporation, for example, might want to know the cross-price elasticity of demand between it's chicken sandwiches and its Big Macs if it is considering the effect of a 20% decrease in the price of its Big Macs. If the cross-price elasticity of demand is 0.5, then a 20% decrease in the price of its Big Mac sandwiches would result in a 10% decrease in the number of chicken sandwiches sold. A -.9 cross-price elasticity of demand between Big Macs and french fries, though, would indicate that a 20% decrease in the price of Big Mac sandwiches would result in an 18% increase in the sale of french fries. This sort of information would be useful in determining what prices to charge and in planning for the impact of such a price change.

Income elasticity of demand

The income elasticity of demand is a measure of how sensitive demand for a good is to a change in income. Income elasticity of demand is measured as:

As in the case of cross-price elasticity, the sign of income elasticity of demand may be either positive or negative. A positive value for the income elasticity occurs when an increase in income results in an increase in the demand for a good. In this case, the good is said to be a normal good. In practice, most goods seem to be normal goods (and therefore have a positive income elasticity). A good is said to be an inferior good if an increase in income results in a reduction in the quantity of the good demanded. An inspection of the definition of the income elasticity of demand should make it clear that an

37 inferior good will have a negative income elasticity. likely to be inferior goods for many consumers. Generic foods, used cars, and similar commodities are

Another distinction that is commonly made (although not mentioned in your text at this point) is between luxuries and necessities. An increasing share of income is spent on luxury goods as income increases. This means a 10% increase in income must be associated with a greater than 10% increase in spending on luxury goods. Using the definition of income elasticity of demand, we can see that a luxury good must have an income elasticity that is greater than one. A smaller share of income is spent on necessities as income rises. This means that necessities have an income elasticity that is less than one. Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is not immediately obvious, note that an income elasticity that is greater than one must necessarily be greater than zero while an income elasticity that is less than zero must be less than one.) Normal goods may be either necessities or luxuries.

Price elasticity of supply

We can also apply the concept of elasticity to supply. The price elasticity of supply is defined as:

Note that the absolute value sign is not used when measuring the price elasticity of supply since we do not expect to observe a downward sloping supply curve. A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of supply is zero when supply is perfectly inelastic. While your text suggests that the supply of Monet paintings is perfectly inelastic, this in not entirely correct. If someone offers $.50 for a Monet painting, how many paintings are likely to be offered for sale? What is meant in the text is that, for prices above a particular threshold, the supply curve becomes perfectly inelastic for some goods for which only a finite quantity is available. This is also true for highly perishable commodities that must be sold on the day they are brought to market. A fisherman with no storage facilities, for example, must sell all of the fish caught at the end of a given day at whatever price can be received.

A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply curve facing a single buyer in a market in which there are a very large number of buyers and sellers is likely to appear to be

perfectly elastic (or close to this, anyway). This will effect on the market price.

38 occur when each buyer is a "price-taker" who has no

Economists classify time in terms of the "short run" and the "long run." The short run is defined as the period of time in which capital is fixed. All inputs are variable in the long run. Notice that the length of the short run and long run will vary from industry to industry. In the lawnmowing industry, the long run may be as short as the few hours that may be required to buy an additional lawn mower. In the automotive manufacturing industry, the short run may last for several years (since it takes a long time to design and build new capital in this industry). It is expected that supply will be more elastic in the long run than in the short run since firms can expand or contract their capital in the long run. In the short run, an increase in the price of personal computers may result in increased employment, more overtime, and additional shifts in computer factories. In the long run, though, higher prices will lead to a larger expansion in output as new factories are built.

Tax incidence
As your text notes, the distribution of the burden of a tax depends on the elasticities of demand and supply. When supply is more elastic than demand, consumers bear a larger share of the tax burden. Producers bear a larger share of the burden of a tax when demand is more elastic than supply.

Chapter 7
This chapter provides a more detailed examination of the theory of consumer choice. The theory of demand is derived from this theory of choice.

Utility
The economic theory of choice is based on the concept of utility. Utility is defined as the level of happiness or satisfaction associated with alternative choices. Economists assume that when individuals are faced with a choice of feasible alternatives, they will always select the alternative that provides the highest level of utility.

Total and marginal utility

The total utility associated with a good is the level of happiness derived from consuming the good. Marginal utility is a measure of the additional utility that is received when an additional unit of the good is consumed.

39 The table below illustrates the relationship that exists between total and marginal utility associated with an individual's consumption of pizza (in a given time period). # of slices Total utility Marginal utility 0 1 2 3 4 5 6 0 70 110 130 140 145 140 70 40 20 10 5 -5

As the table above indicates, the marginal utility associated with an additional slice of pizza is just the change in the level of total utility that occurs when one more slice of pizza is consumed. Note, for example, that the marginal utility of the third slice of pizza is 20 since total utility increases by 20 units (from 110 to 130) when the third slice of pizza is consumed. More generally, marginal utility can be defined as:

The table above also illustrates a phenomena known as the law of diminishing marginal utility. This law states that marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus. In the example above, the marginal utility of additional slices of pizza declines as more pizza is consumed (in this time period). In this example, the marginal utility of pizza consumption becomes negative when the 6th slice of pizza is consumed. Note, though, that even though the marginal utility from pizza consumption declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative. This law of diminishing marginal utility is believed to occur for virtually all commodities. A bit of introspection should confirm the general applicability of this principle.

Diamond-water paradox
In The Wealth of Nations (1776), Adam Smith attempted to formulate a theory of value that explained why different commodities had different market values. In this attempt, however, he encountered a problem that has come to be called the "diamond-water" paradox. The paradox occurs because water is essential for life and has a low market price (often a price of zero) while diamonds are not as essential yet have a very high market price. To resolve this issue, Smith proposed two concepts of value: value in use and value in exchange. Diamonds have a low value in use but a high value in exchange while water has a high value is use but a low value in exchange. Smith argued that economists could explain the exchange value of a commodity by the amount of labor required to produce the commodity. (This "labor theory of value" later served as the basis for much of Marx's critique of capitalism.) Smith did not propose a theory to explain the use value of a commodity. Marginal analysis, however, allows us to explain both value in use and value in exchange. The diagram below contains marginal utility curves for both diamonds and water. Because individuals consume a large volume of water, the marginal utility of an additional unit of water is relatively low. Since few diamonds are consumed, the marginal utility of an additional diamond is relatively high.

40

Total utility can be derived by adding up the marginal utilities associated with each unit of the good. A bit of reflection should convince you that total utility can be measured by the area under the marginal utility curve. The shaded areas in the diagram below provide a measure of the total utility associated with the consumption of water and diamonds. Note that the total utility from water is very high (since a large volume of water is consumed) while the total utility received from diamonds is relatively low (because few diamonds are consumed).

These concepts of total and marginal utility can be used to resolve Adam Smith's diamond-water paradox. When Adam Smith was referring to "value in use," he was actually referring to the concept of total utility. Exchange value, on the other hand, is tied to how much someone is willing to pay for an additional unit of the commodity. Because diamonds are expensive, individuals consume few diamonds and the marginal utility of an additional diamond is relatively high. Since water is not very costly to acquire, people consume more water. At this high level of consumption, the marginal utility of an additional unit of water is relatively low. The price that someone is willing to pay for an additional unit of a good is related to its marginal utility. Because the marginal utility of an additional diamond is higher than the marginal utility associated with an additional glass of water, diamonds have a higher value in exchange.

Consumer equilibrium
How can the concept of marginal utility be used to explain consumer choice? As noted above, economists assume that when an individual is faced with a choice among feasible alternatives, he or she will select the alternative that provides the highest level of utility. Suppose that an individual has a given income that can be

41 spent on alternative combinations of goods and services. A utility maximizing consumer will select the bundle of goods at which the following two conditions are satisfied: 1. MUA/PA = MUB/PB = ... = MUZ/PZ, for all commodities (A-Z), and 2. all income is spent. The first of these conditions requires that the marginal utility per dollar of spending be equated for all commodities. To see why this condition must be satisfied, suppose that the condition is violated. In particular, let's assume that the marginal utility resulting from the last dollar spent on good X equals 10 while the marginal utility received from the last dollar spent on good Y equals 5. Since an additional dollar spent on good X provides more additional utility than the last dollar spent on good Y, a utility-maximizing individual would spend more on good X and less on good Y. Spending $1 less on good Y lowers utility by 5 units, but an additional dollar spent on good X raises utility by 10 units in this example. Thus, the transfer of $1 in spending from good Y to good X provides this person with a net gain of 10 units of utility. As more is spent on good Y and less on good X, though, the marginal utility of good Y will fall relative to the marginal utility of good X. This person will keep spending more on good Y and less on good X, though, until the marginal utility of the last dollar spent on good Y is the same as the marginal utility of the last dollar spent on good X. The first condition listed above is sometimes referred to as the "equimarginal principle." The reason for the assumption that all income is spent is because this relatively simple model is a single-period model in which there is no possibility of saving or borrowing (since there are no future periods in this simple model). Of course, a more detailed model can be constructed which includes such possibilities, but that is a topic left for more advanced microeconomics classes. When the two conditions above are satisfied, a state of consumer equilibrium is said to occur. This is an equilibrium because the individual consumer has no reason to change the mix of goods and services consumed once this outcome is achieved. (Unless, of course, there is a change in tastes, income, or relative prices.) The example on pages 163-165 of your textbook provides a very good discussion of how this concept of consumer equilibrium can be used to explain the mix of goods and services consumed. Be sure that you understand the decision process described in the text and summarized in Table 2 on p. 164.

Consumer equilibrium and demand

The concept of consumer equilibrium can be used to explain the negative slope of a consumer's demand curve. Suppose that an individual is initially buying only two goods, X and Y. At a point of consumer equilibrium:

and all income is spent. Let's consider what happens if the price of good X rises. An examination of the equation above indicates that the marginal utility per dollar spent on good X will fall when the price of good X rises. To restore a consumer equilibrium, the individual will increase his or her consumption of good Y and reduce his or her spending on good X. This change in the mix of goods consumed is called the substitution effect. When good X becomes relatively more expensive, the quantity of good X demanded falls as a result of the substitution effect. In addition to this substitution effect, there is also an income effect that occurs when the price of a good changes. Since good X has become more expensive in this example, the individual can no longer afford the original combination of goods X and Y. This income effect results in a reduction in the quantity demanded for

42 all normal goods. If good X is a normal good, the reduce the quantity of good X demanded. substitution and income effects both work together to

A careful reader will note that there is a possibility that an inferior good may have an upward sloping demand curve if the income effect is larger in magnitude than the substitution effect. A good that exhibits such a demand curve is called a Giffen good. (This type of good is named after an economist who believed that he had found evidence that indicated that the quantity of potatoes demanded increased in Ireland when the price rose during the Irish Potato Famine - more careful later analysis indicated that Giffen's evidence was flawed.) In practice, though, no one has found reliable evidence of a Giffen good. Thus, it is probably fairly safe to assume that demand curves are downward sloping. This will, of course, unambiguously be expected to occur for normal goods.

Consumer surplus
An individual buys a good only if the purchase is expected to makes the person better off (or at least no worse off). In general, the total benefit received from the purchase of a commodity is expected to exceed the opportunity cost. This provides consumers with a net gain from trade, referred to as consumer surplus. Let's examine this concept in more detail. Suppose that an individual buys 10 units of a good at a price of $5. The diagram below illustrates this possibility.

As the diagram below indicates, the first unit of this good costs $5, but this individual would have been willing to pay a price of up to $9 for this first unit of this good. In this case, the consumer receives a good that he or she values at $9 by giving up only $5. Thus, the first unit of the good generates $4 in consumer surplus. In the diagram below, the benefit received from the first unit of the good is the sum of the two shaded areas (notice the height of this rectangle equals the price the person is willing to pay - $9 - while the base equals 1, thus the area of the rectangle equals $9) The cost of this first unit of the good ($5) is given by the green shaded area. The blue shaded area at the top of the graph represents the consumer surplus ($4) received from the first unit of this good.

43

More generally, the total benefit from consuming 10 units of this good is the entire area under the demand curve (as illustrated by the blue shaded area in the diagram below).

The total cost of consuming 10 units of this good at a price of $5 is $50. This is represented by the green shaded rectangle in the diagram below.

The consumer surplus received by this consumer is the difference between the total benefit and total cost. This is represented by the red shaded area in the diagram below. As noted above, the consumer surplus represents the consumer's net benefit from engaging in voluntary trade.

44

Indifference curves
Consumer choice can also be explained through the use of indifference curves. An indifference curve is a graph of all combinations of goods that provide a given level of utility. The diagram below contains an indifference curve for two goods, X and Y.

Any two points on an indifference curve generate the same level of utility. Thus, the diagram below indicates that this person would be indifferent if faced with a choice between the combinations of goods represented by points A and B. Points that lie above and to the right of an indifference curve provide a higher level of consumption of each good than points on an indifference curve. Because of this, such points provide a higher level of utility than points on the indifference curve. Thus, point C would be preferred to either point A or B (or any other point on the indifference curve Uo). Points that lie below and to the left of the indifference curve (such as point D) provide a lower level of utility. Therefore, this individual would prefer the bundle of goods represented by point A if faced with a choice between the bundles of goods represented by points D and A.

45 An indifference curve crosses through each and every point in this diagram. Thus, an infinite number of indifference curves exist for these two goods. Two additional indifference curves, corresponding to the levels of utility received at points C and D have been added to the diagram below.

It is assumed that individuals attempt to place themselves on the highest level of utility that they can achieve, given the constraints that they face. Let's examine the budget constraint facing individuals.

Budget constraint
Let's consider the budget constraint facing an individual who has a fixed level of income (I) that can be used to buy two goods (X and Y) at fixed prices (PX and Py). The budget constraint facing this individual can be expressed as:

A graph of this budget constraint appears below. The intercepts of this budget constraint on each axis equals income divided by the price of the good represented on the axis (this can be demonstrated quite easily using basic algebra).

As your text illustrates on p. 182, changes in income will result in a parallel shift in the budget constraint while changes in the prices of goods X and Y will affect the slope of the budget constraint.

Consumer equilibrium and indifference curves

46 Individuals maximizing utility subject to their budget constraint attain the highest possible level of utility at a point of tangency between their budget constraint and an indifference curve. In the diagram below, this occurs when the individual consumes X* units of good X and Y* units of good Y. While other points on the budget constraint, such as point A, are feasible, they provide a lower level of utility. Points such as point B provide a higher level of utility, but are not feasible. It is not possible to attain a higher level of utility than Uo without violating the budget constraint (and there are laws that prevent people from acquiring more goods than they can pay for...).

Chapter 8
During the first weeks of the course, we examined how a market economy functioned. The past two weeks have focused on the behavior of consumers in more detail. We'll be focusing on the supply side of the economy for the next two weeks. This week, we begin by discussing the determinants of production costs.

Production
The total amount of output produced by a firm is a function of the levels of input usage by the firm. In the short run, a simplified version of this relationship is provided by a firm's total physical product (TPP) (also known more simply as total product) function. This function captures the relationship that exists between the maximum level of output that can be produced by a firm and its level of labor use, holding other inputs and technology constant. (Remember, the short run is defined to be the period of time in which capital cannot be changed.) The table below contains an example of a possible total product function.

A careful inspection of the table above indicates that output initially increases more rapidly as the level of labor use increases, but ultimately increases by smaller and smaller increments. In the example illustrated above,

47 output even declines at higher levels of labor use (note that output declines from 275 to 270 when the level of labor use increases from 40 to 45). Economists argue that equal increases in the level of labor use will ultimately result in progressively smaller increases in output in virtually all production processes. This is a consequence of the law of diminishing returns that was first introduced in Chapter 2 of your text. The relationship between the level of input use can also be represented through the average physical product (APP) of labor. The average physical product is defined as the ratio of total physical product to the quantity of labor. The average physical product for the firm described above has been added to the table below. Notice how the value of APP is equal to the ratio of TPP to the quantity of labor in each row of this table. As in this example, economics expect that the APP may initially rises but will ultimately decline as a result of the law of diminishing returns. The average physical product of labor is what is meant when economists talk about labor productivity. So, when you hear references to rising or declining labor productivity, you'll now know that they're talking about changes in APP.

The marginal physical product (MPP) (also know more simply as just marginal product), is another useful and important concept. MPP is defined as the additional output that results from the use of an additional unit of a variable input, holding other inputs constant. It is measured as the ratio of the change in output (TPP) to the change in the quantity of labor used. In mathematical terms, this can be expressed as:

The table below continues the estimated MPP for each of the reported intervals. Be sure that you understand how the MPP is computed from the information contained in the first two columns of this table. For example, consider the interval between 10 and 15 units of labor. Note that since TPP increases by 60 (from 120 to 180) when the quantity of labor increases by 5, the MPP of labor in this interval equals 60/5 = 12.

48

As the table above indicates, the MPP is positive when an increase in labor use results in an increase in output; the MPP is negative when an increase in labor use results in a decrease in output. The TPP, APP, and APP curves can also be illustrated using a graph. The diagram below contains a graph of a possible TPP curve. As was true in the table above, this diagram suggests that output initially rises more rapidly as labor use increases. Beyond some point, however, TPP starts to rise by less and less with each additional unit of labor. It is possible (as in the example here) that TPP may eventually fall when too many workers are present (yes, the old "too many cooks spoil the broth" clich applies here again....).

The diagrams below illustrate the APP and MPP curves associated with this TPP curve. As in the table above, APP initially rise and then falls. MPP rises in the range in which TPP is increasing at a more rapid rate and declines in the range in which TPP increases at a declining rate. MPP equals zero at the point at which TPP reaches a maximum and is negative when TPP declines.

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As the diagram above indicates, the MPP and APP curves intersect at the maximum level of APP. The reason for this is relatively intuitive. For levels of labor use below Lo, MPP is greater than APP. This means that an additional workers adds more to output than the average worker is producing. In this case, the average has to increase. An analogy is quite useful here. Suppose that your grade in a class at any point in time is formed by taking the average of all of the grades that you have achieved up to that point in time. If your score on an additional test (this may be thought of, quite appropriately in many cases, as a "marginal grade") exceeds your average average, your average grade will rise. Using similar reasoning, if your marginal grade is less than your average grade, your average will decline. In the same manner, the average physical product of labor will decline when the marginal physical product of labor is less than the average physical product of labor. An inspection of the diagram above indicates that APP increases whenever the level of labor use is less than Lo. APP declines, however, when the level of labor use is greater than Lo. Since APP increases up to this point and declines after this point, APP must reach a maximum when Lo workers are employed (at the point at which MPP = APP).

Total Costs
In the short run, total costs (TC) consist of two categories of cost: total fixed costs and total variable costs. Total fixed costs (TFC) are costs that do not vary with the level of output. The level of total fixed costs is the same at all levels of output (even when output equals zero). Examples of such fixed costs include rent, annual license fees, mortgage payments, interest payments on loans, and monthly connection fees for utilities (note that this last category includes only fixed monthly charges, not the portion of utility fees that varies with the level of use). Total variable costs (TVC) are costs that vary with the level of output. Labor costs, raw material costs. and energy costs are examples of variable costs. Variable costs are equal to zero when no output is produced and increase with the level of output. The table below contains a listing of a hypothetical set of total fixed cost and total variable cost schedules. As this table indicates, total fixed costs are the same at each possible level of output. Total variable costs are expected to rise as the level of output rises.

50 As the table below indicates, we can use the TFC and TVC schedules to determine the total cost schedule for this firm. Note that, at each level of output, TC = TFC + TVC.

The diagram below contains a graph of a total fixed cost curve. Since total fixed costs are the same at all levels of output, a graph of the total fixed cost curve is a horizontal line.

The total variable cost curve increases as output increases. Initially, it is expected to increase at a decreasing rate (since marginal productivity increases initially, the cost of additional units of output decline). As the level of output rises, however, variable costs are expected to increase at an increasing rate (as a result of the law of diminishing marginal returns). The diagram below contains a possible total variable cost curve.

Since total cost equals the sum of total variable and total fixed costs, the total cost curve is just the vertical summation of the TFC and TVC curves. The diagram below illustrates this relationship.

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Average and marginal costs

Average fixed cost (AFC) is defined as: AFC = TFC / Q. An average fixed cost schedule has been added to the diagram below. Note that average fixed costs always decline as the level of output increases.

Average variable cost (AVC) is defined as: AVC = TVC / Q. An average variable cost schedule has been added to the table below. It is expected that average variable costs will initially decrease as output increases but will eventually increase as output continues to rise. The reason for the eventual increase in AVC is the law of diminishing returns discussed above. If each additional worker adds progressively less additional output, the average cost of the additional output must eventually increase.

Average total cost (ATC) is defined as: ATC = TC / Q. The table below includes an ATC schedule. Note that ATC can also be measured as: ATC = AVC + AFC (since TC=TFC+TVC, TC/Q = TFC/Q + TVC/Q).

52

In addition to these average cost measures, it is also useful to measure the cost of an additional unit of output. The cost of an additional unit of output is called marginal cost (MC). Marginal cost can be measured as:

A marginal cost schedule has been added to the table below. Be sure that you understand how marginal cost is computed in this table. Consider, for example, the interval between 10 and 20 units of output. In this case, total costs increase by 20 (from 40 to 60) when 10 additional units of output are produced, so in this interval, marginal cost is 20/10 = 2.

We can also represent these average and marginal cost relationships using diagrams. The diagram below contains a graph of a typical AFC curve. Note that AVC declines as output increases.

The diagram below contains a graph of the ATC, AVC, and MC curves for a typical firm. Note that the vertical distance between the ATC and the AVC curve is equal to AFC (since AFC+AVC=ATC). It is also useful to observe that the MC curve intersects the AVC and the ATC curves at their respective minimum points. To see this, note that whenever marginal costs are less than average costs, the average cost must decline. Similarly, when marginal costs exceed average costs, the average must rise. Thus, the MC curve must cross each of these average cost curves at their respective minimum points.

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Long-run costs
In the long run, all inputs are variable. As the firm changes the amount of capital it uses, it will shift from one short-run averate total cost curve (SRATC) to another. The diagram below illustrates this relationship. As a firm acquires more capital, the minimum point on it's average total cost curve is associated with a higher level of output. Thus, in this diagram, SRATC4 represents a firm with a relatively high level of capital while SRATC1 represents a firm with a low level of capital.

The long-run average total cost curve (LRATC) represents the lowest level of average cost that can occur in the long run at each possible level of output. It is assumed that firms producing any given level of output in the long run would always select the size of firm that has the lowest short-run average total costs at that level of output. In the diagram above, a firm would select a level of capital that places it on the short-run average total cost curve SRATC2 if it were to produce Qo units of output. (Notice that the costs of producing this level of output would be higher with either a smaller or a larger firm.) It is often argued that the long-run average cost curves has a shape similar to the diagram below. At low levels of output, it is suggested that economies of scale result in a decrease in long-run average costs as output increases. Economies of scale are factors that result in a reduction in LRATC as output rises. These factors include gains from specialization and division of labor, indivisibilities in capital, and similar factors. Diseconomies of scale, factors that result in higher levels of LRATC as output increase, are believed to be important at high levels of output. These factors include the increased cost of managing and coordinating a firm as the size of the firm rises. Constant returns to scale occur when LRATC does not change when the firm becomes larger or smaller. It is believed that this happens over a relatively large range of output (as illustrated in the diagram below).

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The diagram above also illustrates the concept of minimum efficient scale (MES). The minimum efficient scale of a firm is the lowest output level at which LRATC are minimized. As we'll see in later chapters, the MES is important in determining the market structure for a particular output market. Competition among firms forces firms to produce at a level of output at which LRATC is minimized. If the MES is large, relative to the quantity of output demanded in a market, only a small number of firms can profitably coexist. If, for example, the MES is 10,000 and a quantity of only 20,000 units of output is demanded, at most two firms can survive in the market. We'll return to this topic in later chapters.

Chapter 9
During this week, we'll examine how firms determine the profit-maximizing level of output. As part of this discussion, we'll also examine differences among perfectly competitive, monopolistically competitive, oligopoly, and monopoly markets.

Profit maximization
Economists assume that firms select prices and output levels that maximize their profits. When economists discuss profits, however, they are referring to the concept of economic profit defined as: Economic profit = total revenue - all economic costs As you should recall from our discussion of the material in Chapter 2, economic costs include all opportunity costs, regardless of whether these costs are explicit or implicit. An explicit cost is a cost in which a payment is actually made. An implicit cost, on the other hand, is a cost in which no money changes hands. An example may help to illustrate this distinction. Suppose that you borrow money from a bank to acquire capital to open a business. In this case, the interest payments on the loan would be an explicit cost. If, on the other hand, you use your own savings to finance this capital, you do not have to pay interest to someone else for the use of these funds. In this case, however, the opportunity cost would be the implicit cost of the interest that you could have received had you placed this money in an interest-bearing asset instead of buying this capital. Note that economic costs are different than accounting costs. Accounting costs, for the most part, include only explicit costs. (The only exception is that accounting cost includes a measure of depreciation, which is an implicit cost. But, even in this case, the accounting measure of depreciation is based on the historical price of capital, and not based on its opportunity cost.) The reason for this distinction, of course, is that accounting systems are designed to provide a record of a firm's receipts and expenditures. For such a record to be meaningful to tax authorities and the owners of a firm, each receipt and expenditure must be accompanied by

55 some verifiable record of transactions. Implicit costs that can be used to verify accounts.) are not directly observed (and provide no "receipts"

Since economic costs include both implicit and explicit costs while accounting costs consist (almost exclusively) of explicit costs, economic costs are virtually always greater than accounting costs. The difference between these two measures of cost is the opportunity cost of resources supplied by the firm's owner. The opportunity cost of these owner-supplied resources is called normal profit. As your text notes, the owners of corporations (the shareholders) must receive a rate of return on their stock that is equivalent to what they could receive if their next-best alternative. So, normal profit (or "normal accounting profit" as your text defines it) is an economic cost that is not counted as an accounting cost. Accounting profit is defined as: Accounting profit = total revenue - all accounting costs A comparison of the definitions for economic and accounting profits indicates that accounting profits will virtually always exceed economic profits. Let's take a simple example. Suppose that the owner of a firm could receive $90,000 a year using the labor, capital, and other resources that she uses to operate her own business. If she receives $70,000 in accounting profits, she would actually have suffered $20,000 in economic losses, since she is earning $20,000 less than she could receive with an alternative employment of these resources. If the owners of a firm economic profits, this means that they are receiving a rate of return on the use of their resources that exceeds that which can be received in their next-best use. In this situation, we'd expect to see other firms entering the industry (unless barriers to entry exist). If a firm is receiving economic losses (negative economic profits), the owners are receiving less income than could be received if their resources were employed in an alternative use. In the long run, we'd expect to see firms leaving the industry when this occurs. If the owners of a typical firm receive zero economic profits, this means that they are receiving an income that is just equal to what they could receive in their next-best alternative. In this case, there would be no incentive for firms to either enter or leave this industry. Be sure to understand that zero economic profits occur only if the owners are receiving accounting profits equal to normal profit.

Marginal Revenue and Marginal Cost

Let's consider what happens to a firm's profits when it produces an additional unit of output. Recall that its economic profits are defined as: Economic profit = total revenue - economic costs When a firm produces an additional unit of output its revenue rises (in all practical situations) and its costs rise as well. Profits rise if revenue rises by more than costs and fall if costs rise by more than revenue. The additional revenue resulting from the sale of an additional unit of output is called marginal revenue (MR). As noted in Chapter 8, the additional cost associated with the production of an additional unit of output is marginal cost (MC). Let's consider a firm's decision about whether to produce more or less output. If marginal revenue exceeds marginal cost, the production of an additional unit of output adds more to revenue than to costs. In this case, a firm is expected to increase its level of production to increase its profits. If, instead, marginal cost exceeds marginal revenue, the production of the last unit of output costs more than the additional revenue generated by the sale of this unit. In this case, firms can increase their profits by producing less. So, a profit-maximizing firm

56 will produce more output when MR > MC and less output when MR < MC. If MR = MC, however, the firm has no incentive to produce either more or less output. In fact, the firm's profits are maximized at the level of output at which MR = MC. Since marginal revenue is such an important part of a firm's decision concerning how much output to produce, it should be examined in greater detail. (We already examined marginal cost last week.) Marginal revenue is defined as:

If a firm faces a perfectly elastic demand curve, the price of the good is the same at all levels of output. In this case, marginal revenue is simply equal to the market price. Suppose, for example, that corn sells for $1 per dozen. The marginal revenue received by a farmer from the sale of an additional dozen ears of corn is simply the price of $1. This possibility is illustrated in the diagram below.

Suppose, however, that a firm faces a downward sloping demand curve. In this case, it must lower the price if it wishes to sell additional units of this good. In this case, marginal revenue is less than the price. Let's use an example to see why this is true. Consider the situation described in the diagram below. When the price is $6, the firm can sell 4 units of output while receiving a total revenue equal to $6 x 4 = $24. If it wishes to sell the 5th unit of output, it must lower the price to $5. Its total revenue in this case will equal $25. Marginal revenue in this case equals: change in total revenue / change in quantity = $1 / 1 = $1. As this example illustrates, marginal revenue will always be less than the price of the good when the firm faces a downward sloping demand curve. This is because the firm has to lower the price not just on the last unit sold but instead on all units that it sells. In this case, the firm received an additional $5 in revenue from the same of the 5th unit, but it lost $4 in revenue when it lowered the price on the first 4 units by $1. Thus, total revenue increased by only $1 when the 5th unit is sold.

The diagram below illustrates the relationship that exists between the marginal revenue curve and the demand curve. The demand curve provides the price that can be charged at each level of output. Since we know that MR is less than the price, the marginal revenue curve must lie below the demand curve. Using the results from the

57 chapter on elasticity, we can also note that marginal revenue is positive in the elastic section of the demand curve (since a price decrease results in an increase in total revenue in this case), is zero when demand is unit elastic (since total revenue remains unchanged when the price falls when demand is unit elastic) and is negative when demand is inelastic (since total revenue declines when the price falls in this portion of the demand curve.)

Table 1 on p. 223 in your text provides a good numerical example of the computation of marginal revenue. Be sure that you understand how the marginal revenue column is computed in this table.

Profit maximization
The diagram below illustrates the profit-maximizing levels of price and output for a firm facing a downward sloping demand curve. As noted above, the profit-maximizing level of output occurs at the point at which MR = MC. This occurs at an output level of Qo, the level of output at which the MR and MC curves intersect. The price that firms can charge to sell this much output is given by the demand curve. In this example, the price equals Po.

The shaded area in the diagram above represents the level of economic profits recveived by this firm. Note that the height of this rectangle equals the difference between the price of the good and average total cost. This vertical distance is equal to the profit received per unit of output. The base of the rectangle is equal to the quantity of output sold by the firm. The area of this rectangle (the shaded area) equals the profit per unit of output x the number of units of output. This product is equal to total economic profit.

Alternative market structures

The basis market structures that we'll be examining over the next several weeks include: perfect competition, monopoly, monopolistic competition, and oligopoly. Let's examine the defining characteristics of each market structure. Perfect competition is characterized by:

a very large number of buyers and sellers, easy entry,

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a standardized product, and each buyer and seller has no control over the market price (this means that each firm is a price taker that faces a horizontal demand curve for its product).

A monopoly market is characterized by:

a single seller producing a product with no close substitutes, effective barriers to entry into the market, and the firm is a price maker, also called a price searcher because it faces a downward sloping demand curve for its product (in fact, note that this demand curve is the market demand curve).

One special type of monopoly is a natural monopoly, a monopoly that arises because of the existence of economies of scale over the entire relevant range of output. In this case, a larger firm will always be able to produce output at a lower cost than could a smaller firm. The pressure of competition in such an industry would result in a long-run equilibrium in which only a single firm can survive (since the largest firm can produce at a lower cost and can charge a price that is less than the ATC of smaller firms). Under a monopolistically competitive market:

there is a large number of firms, the product is differentiated (i.e., each firm produces a similar, but not identical, product), entry is relatively easy, and the firm is a price maker that faces a downward sloping demand curve.

In an oligopoly market:

a small number of firms produce most output, the product may be either standardized or differentiated, there are significant barriers to entry, and recognized interdependence exists (i.e., each firm realizes that its profitability depends on the actions and reactions of rival firms).

Most output is produced and sold in oligopoly and monopolistically competitive industries.

Chapter 10
This week, we'll examine how price and output is determined in a perfectly competitive market. A perfectly competitive market is characterized by:

many buyers and sellers, identical (also known as homogeneous) products, no barriers to either entry or exit, and buyers and sellers have perfect information.

In particular, there are so many buyers and sellers for the product in a perfectly competitive market that each buyer and seller is a price taker.

Demand curve facing a single firm

59 The diagram below illustrates the relationship between the market and an individual firm. The equilibrium price is determined by the interaction of market demand and market supply. Since the output of each firm is such an infinitesimally small share of this total output, no individual firm can affect the market price. Thus, each firm faces a demand curve for its product that is perfectly elastic at the market price.

Profit maximization
As discussed last week, a firm maximizes its profits by producing the level of output at which marginal revenue equals marginal cost. (If you're not comfortable with the concepts of marginal revenue and marginal cost, it would be useful to review last week's material.) As noted in the module accompanying Chapter 9, marginal revenue is defined as:

In a similar manner, marginal cost is defined as:

As noted last week, marginal revenue equals the market price for a firm facing a perfectly elastic demand curve. The diagram below illustrates this relationship.

Marginal and average total cost curves have been added to the diagram below. As this diagram indicates, a profit-maximizing firm will produce at the level of output (Qo) at which MR = MC. The price, Po, is determined by the firm's demand curve.

60

At an output level of Qo, the firm faces average total costs equal to ATCo. Thus, it's profit per unit of output equals Po - ATCo (= revenue per unit or output - total cost per unit of output). Economic profits are equal to: profit per unit x # of units of output. An inspection of the diagram below should confirm that economic profits equals the area of the shaded rectangle (notice that the height of this rectangle equals profit per unit of output and the base equals the number of units of output).

If a firm is receiving economic profits, the owners are receiving a return on their investment that exceeds that which they could receive if their resources had been used in an alternative occupation. In this case, existing firms will stay in the market and new firms will enter the market. We'll discuss the effects of this entry on price and output in more detail below.

Loss minimization and shutdown rule

Suppose that P < ATC at the level of output at which MR = MC. Will the firm continue operations? To determine this, we have to compare the firm's loss if it stays in business with its loss if it shuts down. If the firm decides to shut down, it's revenue will equal zero and its costs will equal its fixed costs. (Remember, fixed costs must be paid even if the firm shuts down.) Thus, the firm receives an economic loss equal to its fixed costs if it shuts down. It will stay in business in the short run even if it receives an economic loss as long as it's loss is less than its fixed costs. This will occur if the revenue received by the firm is large enough to cover its variable costs and some of its fixed costs. In mathematical terms, this means that the firm will stay in business as long as: TR = P x Q > VC Dividing both sides of the above expression by Q, we can write this condition in an alternative form as: P > AVC

61 What this means in practice, is that the firm will stay in business if the price is greater than average variable cost; the firm will shut down if the price is less than average variable cost. Consider the situation illustrated by the diagram below. In this case, losses are minimized at the level of output at which MR = MC. This occurs at an output level of Q'. Since the level of average total cost (ATC') exceeds the market price (P'), this firm receives economic losses. Since the price is greater than AVC, however, this firm will choose to stay in business in the short run.

If the firm illustrated above were to shut down, it would lose its fixed costs. The shaded area in the diagram below equals the firm's fixed costs (to see this, note that the height of this rectangle equals the firm's AFC and the base equals Q -- therefore, the shaded area equals AFC x Q = TFC). A comparison of the firm's losses if it shuts down (the shaded area in the diagram below) with its losses if it continues to operate in the short run (the shaded area in the diagram above) indicates that this firm will receive lower losses if it decides to remain in business in the short run.

So, this discussions should suggest that the shut down rule for a firm is: shut down if P < AVC. In the long run, of course, firms will leave the industry if economic losses are received (remember, there are no fixed costs in the long run.)

Break-even price
If the market price is just equal to the minimum point on the ATC curve, the firm will receive a level of economic profits equal to zero. In this case, the owners of the firm are receiving a rate of return on all of their resources that is just equal to that which they could receive in any alternative employment. When this occurs, there is neither an incentive to enter or leave this market. This possibility is illustrated in the diagram below.

62

If the price drops below AVC, the firm will shut down. This possibility is illustrated in the diagram below. The green shaded area equals the firm's fixed costs (its losses if it shuts down). The loss if it continues operations, however, equals the combined blue and green shaded areas. As this diagram suggests, a firm's economic losses are lower when it shuts down if P < AVC.

Short-run supply curve

So far, we have observed that a perfectly competitive firm will produce at the point at which P = MC, as long as P > AVC. The diagram below indicates that at prices of Po, P1, P2, and P3, this firm would produce output levels of Qo, Q1, Q2, and Q3, respectively. A bit of reflection should convince you that the MC curve can be used to determine the quantity of output that this firm will supply whenever P > AVC. Since the portion of the MC curve that lies above the AVC curve indicates the quantity of output supplied at each price, it is the firm's short-run supply curve. In general, a perfectly competitive firm's short-run supply curve is the portion of its marginal cost curve that lies above the AVC curve. This is illustrated by the darker and thicker portion of the MC curve in the diagram below.

63

Long Run
In the long run, firms will enter the market if positive economic profits are received and will leave the market if economic losses are realized. Let's think about the consequences of such entry and exit. Suppose that the current equilibrium price in a market results in economic profits for a typical firm. In this case, firms enter the market and the market supply curve shifts to the right. As market supply increases, the equilibrium price falls. This process will continue until firms no longer have an incentive to enter the market. As the diagram below indicates, a typical firm will receive zero economic profits in this long-run equilibrium situation.

Suppose instead that a typical firm is receiving an economic loss. In this situation, firms will leave the industry in the long run. As they exit, the market supply curve shifts to the left and the equilibrium price rises. Firms will continue to leave until the market supply curve has shifted enough so that a typical firm receives zero economic profits (as illustrated in the diagram above). Thus, as the above diagram illustrates, a long-run equilibrium is characterized by the receipt of zero economic profits by a typical firm. This means, of course, that the owners of a typical firm receive accounting profits just equal to normal profit.

Long-run equilibrium and economic efficiency

This long-run equilibrium condition has two desirable efficiency properties:

P = MC, and P = minimum ATC.

64 The equality between P and MC is important for society because the price reflects society's marginal benefit from the consumption of the good while the marginal cost reflects the social marginal cost of producing the good (in the absence of externalities). At the competitive equilibrium, society's marginal benefit just equals society's marginal costs. Society's net benefit from the production of each good is maximized when social marginal benefit equals social marginal cost. Production at minimum average cost means that society is producing each good at the lowest possible cost per unit. This, obviously, is also a desirable property. Economic efficiency occurs when both of the above conditions are satisfied.

Consumer and Producer Surplus

We had discussed the concept of consumer surplus earlier. As noted in the section on demand and utility, consumer surplus is equal to the net benefit that consumers receive from the consumption of a good. It occurs because the marginal benefit from each unit of the good exceeds the marginal cost up to the point until the last unit is consumed. Producer surplus is defined in a similar manner as the net benefit received by producers from the sale of a good. It occurs because P = MC only for the last unit produced. Up to that point, the marginal cost of producing the good is below the price received by the firm. In the diagram below, the yellow shaded region equals the amount of consumer surplus, while the blue shaded region represents producer surplus. The net benefit to society, also known as the "gains from trade," equals the sum of these two areas.

Chapter 11
This week, we'll examine how price and output is determined in a monopoly market. A monopoly market is characterized by:

a single seller, no close substitutes, and effective barriers to entry.

Monopoly markets
Barriers to entry may exist for three reasons:

65 1. economies of scale, 2. actions by firms, and/or 3. actions by the government. If economies of scale exist throughout the relevant range of output, large firms can produce output at a lower cost than can smaller firms. The diagram below illustrates this possibility. When an industry of this sort begins to develop, there may be many small firms. Suppose, for example that all of the firms have the average total cost curve labeled "ATCo." If one of them becomes larger than the others, though, it can produce output at a lower cost per unit (as illustrated by the curve ATC'). This allows the larger firm to sell its output at a lower price (such as P') at which smaller firms will experience economic losses. (Note that the smaller firms would receive zero economic profit if the price were Po. At a price of P' the smaller firms would receive economic losses and the larger firm would receive zero economic profits.)

In this situation, the smaller firms will eventually be forced to either leave the industry or merge with other firms to become at least as large as the current largest firm. As firms keep growing (either through internal expansion or by buying up smaller firms), their average costs continue to decline. Smaller firms continue to disappear until eventually only one large firm remains. Such an industry is referred to as a natural monopoly since the long-run outcome of the competitive process is the creation of a monopoly industry. The concept of "natural monopoly" in the U.S. was first used to explain the early development of the telephone industry in the U.S. In the early years, most cities had several telephone companies competing to offer telephone service. To call all of the other people who had phones in a given city, people might have to subscribe to 3 or 4 telephone services (since they were not initially interconnected). By virtue of its patents and head start, though, the Bell Company was larger than most of its competitors. To see why this provided an advantage, note that once a company pays for the right-of-way and places telephone poles and wires on a given street, the cost of adding an additional customer (on that street) is fairly small. The company that acquires the most customers faces lower average costs. This is why AT&T was able to offer lower prices then its competitors. AT&T bought up these companies when they were no longer profitable. Since the government recognized that it would be more costly to have many small telephone companies, it chose to allow AT&T to operate as a regulated monopoly in which the government regulated the prices that could be charged for telephone services. (The government chose to break up AT&T in the latter part of the 20th century because the introduction of microwave and satellite transmissions of telephone signals and digital switching networks were believe to have eliminated some of the economies of scale that were present under the earlier technology.) One way in which firms may acquire monopoly power is by acquiring exclusive ownership of a raw material. As your text notes, a single family in New Mexico controls most of the known supply of desiccant clay. Firms can also raise the sunk costs associated with entry into an industry to help discourage entry by new firms. Sunk costs are costs that cannot be recovered upon exit from an industry. These sunk costs include things like the advertising expenditures needed to ensure brand-name recognition. If a firm spends a large amount of money on

66 advertising, new firms in the industry will have to spend a similar amount to counteract this advertising spending. While investments in buildings can be (at least partly) recovered if a firm leaves the industry, it cannot recover it's sunk costs. These costs represent a cost of exit that must be taken into account by firms considering entry into an industry. If all costs were recoverable on exit, firms would be quite willing to enter to receive even just temporary short-run profits. If they know that they'd lose a large amount in the form of sunk costs, though, they'd be much more cautious about entering an industry. Large sunk costs are also difficult to finance. (A problem experienced by John DeLorean when he attempted to enter the automotive manufacturing industry.... His method of financing the high sunk costs of this industry were not well received by the legal authorities...) Patents and licenses provide two types of barriers to entry that are created by the government. While patent protection is necessary to ensure that there are sufficient incentives for firms to engage in research and development expenditures, it also provides the patent holder with some degree of monopoly power. This is how Polaroid has been able to maintain it's long-term monopoly of the instant film business. A local monopoly is a monopoly that exists in a specific geographical area. In many regions, there is only a single company providing local newspapers (at least on a daily basis). In Syracuse, for example, the Syracuse Newspapers company is the only local newspaper (note that this company publishes both the Post-Standard, a morning newspaper, and the Herald American, an afternoon paper).

Demand, AR, MR, TR, and elasticity

The demand curve facing a monopoly firm is the market demand curve (since the firm is the only firm in the market). Since the market demand curve is a downward sloping curve, marginal revenue will be less than the price of the good (this relationship was discussed in some detail in Chapter 9). As noted earlier, marginal revenue is:

positive when demand is elastic, equal to zero when demand is unit elastic, and negative when demand is inelastic.

These relationships are illustrated in the diagram below. As this diagram illustrates, total revenue is maximized at the level of output at which demand is unit elastic (and MR = 0). It might be tempting to assume that this is the best output level for the firm to produce. This would be the case, though, only if the firm's goal is to maximize it's revenue. A profit- maximizing firm must take its costs as well as its revenue into account in determining how much output to produce.

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As in all other market structures, average revenue (AR) is equal to the price of the good. (To see this note that AR = TR/Q = (PxQ)/Q = P.) Thus, the price given by the demand curve is the average revenue that the firm receives at each level of output. As discussed in Chapter 9, any firm maximizes its profits by producing at the level of output at which marginal revenue equals marginal cost (as long as P > AVC). For the monopoly firm described by the diagram below, MR = MC at an output level of Qo. The price that this firm will charge is Po (the price that the firm can charge for this level of output given by the demand curve). Since the price (Po) exceeds average total cost (ATCo) at this level of output, the firm receives economic profit. These monopoly profits, though, differ from those received by a perfectly competitive firm in that these profits will persist in the long run (due to the barriers to entry that characterize a monopoly industry).

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Of course, it is possible that a monopoly firm may experience losses. The diagram below illustrates this possibility. In this diagram, the firm receives economic losses equal to the shaded area. Since price is above AVC, though, it will continue operations in the short run, but will leave the industry in the long run. Note that the ownership of a monopoly does not guarantee the existence of economic profits. It is quite possible to have a monopoly in the production of a good that few people want....

A monopoly firm will shut down in the short run if the price falls below AVC. This possibility is illustrated in the diagram below.

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Those who have not studied economics often believe that a monopolist is able to choose any price that it wishes and that it can always receive higher profits by raising its price. As in all other market structures, though, the monopolist is constrained by the demand for its product. If a monopoly firm wishes to maximizes its profit, it must select the level of output at which MR = MC. This determines a unique price that will be charged in this industry. An increase in the price above this level would reduce the profits received by the firm.

Price discrimination and dumping

Firms operating in markets other than those of perfect competition are able to increase their profits by engaging in price discrimination, a practice in which higher prices are charged to those customers who have the most inelastic demand for the product. Necessary conditions for price discrimination include:

the firm cannot be a price taker, the firm must be able to sort customers according the their elasticity of demand, and resale of the product must not be feasible.

The diagram below illustrates how price discrimination may be used in the market for airline travel. Those flying for vacation purposes are likely to have a more elastic demand than those who fly for business purposes. As the diagram below indicates, the optimal price is higher in for business travelers than for vacation travelers. Airlines engage in price discrimination by offering low price "super saver" fares that require a weekend stay and that tickets be purchased 2-4 weeks in advance. These conditions are much more likely to be satisfied by individuals traveling for vacation purposes. This helps to ensure that the customers with the most elastic demand pay the lowest price for this commodity.

70 Other examples of price discrimination includes daytime and evening telephone rates, child and senior citizen discounts at restaurants and movie theaters, and cents-off coupon in Sunday newspapers. (Be sure to understand why each of these is an example of price discrimination.) When countries practice price discrimination by charging different prices in different countries, they are often accused of dumping in the low-price countries. Predatory dumping occurs if a country charges a low price initially in an attempt to drive out domestic competitors and then raises the price once the domestic industry is destroyed. While it is often claimed that predatory dumping occurs, the evidence on this is rather weak.

Comparison of perfect competition and monopoly

The left-hand side portion of the diagram below illustrates the consumer and producer surplus that is received in a perfectly competitive market. The right-hand side portion of the diagram illustrates the loss in consumer and producer surplus that results when a perfectly competitive industry is replaced by a monopoly. As this diagram indicates, the introduction of a monopoly firm causes the price to rise from P(pc) to P(m) while the quantity of output falls from Q(pc) to Q(m). The higher price and reduced quantity in the monopoly industry causes consumer surplus to fall by the trapezoidal area ACBP(pc). This does not all represent a cost to society, though, since the rectangle P(m)CEP(pc) is transferred to the monopolist as additional producer surplus. The net cost to society is equal to the blue shaded triangle CBF. This net cost of a monopoly is called deadweight loss. It is a measure of the loss of consumer and producer surplus that results from the lower level of production that occurs in a monopoly industry.

Some economists argue that the threat of potential competition may encourage monopoly firms to produce more output at a lower price than the model presented above suggests. This argument suggests that the deadweight loss from a monopoly is smaller when barriers to entry are less effective. Fear of government intervention (in the form of price regulation or antitrust action) may also keep prices lower in a monopoly industry than would otherwise be expected. A related point is that it is unreasonable to compare outcomes in a perfectly competitive market with outcomes in monopoly market that results from economies of scale. While competitive firms may produce more output than a monopoly firm with the same cost curves, a large monopoly firm produces output at a lower cost than could smaller firms when economies of scale are present. This reduces the amount of deadweight loss that might be expected to occur as a result of the existence of a monopoly.

71 On the other hand, deadweight loss may understate the cost of monopoly as a result of either X-inefficiency or rent-seeking behavior on the part of monopolies. X-inefficiency occurs if monopolies have less incentive to produce output in a least-cost manner since they are not threatened with competitive pressures. Rent-seeking behavior occurs when firms expend resources to acquire monopoly power by hiring lawyers, lobbyists, etc. in an attempt to receive governmentally granted monopoly power. These rent-seeking activities do not benefit society as a whole and divert resources away from productive activity.

Regulation of natural monopoly

As noted above, a monopoly firm can produce at a lower cost per unit of output than could any smaller firms in a natural monopoly industry. In this case, the government generally regulates the price that a monopoly firm can charge. The diagram below illustrates alternative regulatory strategies in such an industry. If the government leaves the monopolist alone, it will maximize its profits by producing Q(m) units of output and charging a price of P(m). Suppose, instead, though, that the government attempts to emulate a perfectly competitive market by setting the price equal to marginal cost. This would occur at a price of P(mc) and a quantity of output of Q(mc). Since this is a natural monopoly, though, the average cost curve declines over the relevant range of output. If average costs are declining, marginal costs must be less than average costs (this relationship between marginal and average costs was discussed in detail in Chapter 9). Thus, if the price equals marginal costs, the price will be less than average total costs and the monopoly firm will experience economic losses. This pricing strategy could only exist in the long run if the government subsidized the production of this good.

An alternative pricing strategy is to ensure that the owners of the monopoly receive only a "fair rate of return" on their investment rather than monopoly profits. This would occur if the price were set at P(f). At this price, it would be optimal for the firm to produce Q(f) units of output. As long as the owners receive a fair rate of return, there would be no incentive for this firm to leave the industry. Roughly speaking, this is the pricing strategy that regulators use in establishing prices for utilities, cable services, and the prices of other services produced in regulated monopoly markets.

Chapter 12
In this chapter, we'll examine how price and output is determined in oligopoly and monopolistically competitive markets. Let's begin with a discussion of monopolistic competition. A monopolistically competitive market is characterized by:

72

many buyers and sellers, differentiated products, and easy entry and exit.

The monopolistically competitive market is similar to perfect competition in that there are many buyers and sellers who can enter or leave the market easily in response to economic profits or losses. A monopolistically competitive firm, though, is similar to a monopoly in that it produces a product that is different from that produced by all other firms in the market. The restaurant market in New York City provides a good example of a monopolistically competitive market. Each restaurant has its own recipes, decor, ambiance, etc. but also must compete with many other similar restaurants. Because each firm produces a differentiated product, it won't lose all of its customers if it raises its prices. Thus, a monopolistically competitive firm faces a downward sloping demand curve for its product. As noted in Chapters 8 and 10, whenever a firm faces a downward sloping demand curve, its marginal revenue curve lies below its demand curve. The diagram below illustrates the relationship that exists between a monopolistically competitive firm's demand and marginal revenue curves.

While the diagram above seems similar to the demand and marginal revenue curves facing a monopolist, there is a critical difference. In a monopolistically competitive market, the number of firms changes as firms enter or leave the industry. When new firms enter the market, the customers are spread over a larger number of firms and the demand for each firm's product declines. An increase in the number of firms also tends to result in an increase in the elasticity of demand for each firm's products (since demand is more elastic when more substitutes are available). The diagram below illustrates the shift in a typical firm's demand curve that occurs when additional firms enter a monopolistically competitive market.

Short-run and long-run equilibrium in monopolistically competitive markets

Let's examine the determination of short-run equilibrium in a monopolistically competitive output market.

73 The diagram below illustrates a possible short-run equilibrium for a typical firm in a monopolistically competitive market. As with any profit-maximizing firm, a monopolistically competitive firm maximizes its profits by producing at a level of output at which MR = MC. In the diagram below, this occurs at an output level of Qo. The price is determined by the amount that customers are willing to pay to buy Qo units of output. In the example below, the demand curve indicates that a price of Po will be charged when Qo units of output are sold.

In a monopoly industry, economics profits could persist indefinitely due to the existence of barriers to entry. In a monopolistically competitive industry, however, the existence of economic profits results in the entry of additional firms into the industry. As additional firms enter, the demand for each firm's product will fall and become more elastic. This reduction in demand, though, results in a reduction in the level of economic profit received by a typical firm. Entry into the market continues until a typical firm receives zero economic profits. This possibility is illustrated in the diagram below.

The diagram above depicts a monopolistically competitive firm in a state of long-run equilibrium. This firm maximizes its profit by producing an output level of Q'. The equilibrium price is P'. Since the price equals average total cost at this level of output, a typical firm receives a level of economic profit equal to zero. This long-run equilibrium situation is often referred to as a "tangency equilibrium" since the demand curve is tangent to the ATC curve at the profit-maximizing level of output.

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In the short run, a monopolistically competitive firm may receive economic losses in the short run. This possibility is illustrated in the diagram below. While each firm will continue operations in the short run, firms will leave the industry in the long run. As firms leave, the demand curves facing the remaining firms will shift to the right and become less elastic. (To see this, note that when firms leave the industry, the remaining firms will receive some of the customers that used to purchase the commodity at the firms that have left the industry.) Exit from the industry will continue until economic profits again equal zero (as illustrated in the diagram below).

Monopolistic competition vs. perfect competition

As noted in Chapter 10, perfectly competitive markets result in economic efficiency since P = MC and firms produce at the minimum level of ATC. The diagram below compares price and output levels for perfectly competitive and monopolistically competitive firms. As this diagram suggests, a perfectly competitive firm produces output at a price (Ppc) that is less than the price that would be charged by a monopolistically competitive firm (Pmc). A perfectly competitive firm will also produce a larger quantity of output (Qpc) than would be produced by a monopolistically competitive firm (Qmc).

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Because monopolistically competitive firms produce at a level of cost that exceeds the minimum level of ATC, they are less efficient than perfectly competitive firms. This efficiency loss, however, is a cost that society must bear if it wishes to have differentiated products. One of the costs of having variety in restaurants, clothing, most types of prepared foods, etc., is that average production costs will be higher than they would be if a homogenous product were produced. It should be noted, though, that the larger the number of firms in the market, the more elastic will be the demand for each firm's product. As the number of firms grows very large, the demand curve facing a monopolistically competitive firm will approach the perfectly elastic demand curve that is faced by a perfectly competitive firm. In such a situation, the efficiency cost of product differentiation will be relatively small. In the short run, monopolistically competitive firms may receive economic profits by successfully differentiating their product. Successful product differentiation, however, will soon be copied by other firms. It is expected that such profits will disappear in the long run. Advertising campaigns may raise the profits of a firm in this industry in the short run, but will successful advertising campaigns will lead to similar efforts by other firms in the industry. As your text notes, monopolistically competitive firms in the same industry often locate near each other in communities as a result of their attempts to appeal to the median customer in a geographic region. This is why we often see car dealerships and fast-food restaurants locating near each other on a particular street.

Oligopoly
An oligopoly market is characterized by:

a small number of firms, either a standardized or a differentiated product, recognized mutual interdependence, and difficult entry.

Because there are few firms in an oligopoly industry, each firm's output is a large share of the market. Because of this, each firm's pricing and output decisions have a substantial effect on the profitability of other firms. Furthermore, when making decisions concerning price or output, each firm has to take into account the expected reaction of rival firms. If McDonald's lowers the price of their Big Macs, for example, the effect on their profits would be very different if Burger King responded by lowering the price on their Whopper sandwiches by a larger amount. Because of this mutual interdependence, oligopoly firms engage in strategic behavior. Strategic behavior occurs when the best outcome for one party is determined by the actions of other parties.

76 The kinked demand curve model describes a situation in which a firm assumes that other firms will match its price reductions but will not follow price increases. As your text notes, the optimal strategy in such a situation is frequently to leave the price at the current level and to rely on nonprice competition rather than price competition. There is little evidence, though, that the kinked-demand curve model accurately describes the behavior of oligopoly firms. Instead, economists generally rely on game-theory models to describe outcomes in oligopoly markets. Game theory attempts to explain strategic behavior by examining the payoffs associated with alternative choices by each participant in the "game." A possible situation that can be analyzed by game theory is whether each firm in a 2-firm oligopoly should maintain a high or a low price. In such a situation, the highest level of combined profits may be received if each firm charges a high price. Either firm, however, could increase its profits by offering a low price if the other firm continues to charge a high price. If both firms charge a low price, combined profits are lower than if they both charged a high price. Participants in a game face a relatively simple choice when a dominant strategy exists. A dominant strategy is one that provides the highest payoff to an individual for each and every possible action of their rivals. In the oligopoly pricing decision described above, the dominant strategy is to offer a lower price. To see this, suppose that you are making this decision and do not know what the other firm will do. If the other firm charges a high price, you can receive the highest profits by undercutting this firm's price. On the other hand, if the other firm charges a low price, the best strategy for you is again to charge a low price (if you charge a high price when the other firm offers a low price, you will receive larger losses). In this case, if this game is played only once, each firm would be expected to charge a low price even though their combined profits would be higher if they both charged a high price. If collusion is possible (and enforceable), though, both firms may charge a high price. The oligopoly pricing decision described above is an example of a general type of game known as a prisoners' dilemma. Under the traditional prisoners' dilemma game, two prisoners are arrested and held separately. When they are interrogated, each is offered a reduced sentence if he or she provides evidence against the other party. The dominant strategy in this situation is to confess since for each possible action chosen by the other party, the prisoner receives a lighter sentence by confessing. The prisoners' dilemma model is used in a wide variety of academic disciplines to explain individual behavior in strategic situations. Not all strategic situations result in a dominant strategy. It becomes much more difficult to predict the outcome of a game when no dominant strategy exists. The analysis of strategic decision making, though, becomes much more complex when they are played repeatedly by the same players. In the case of the prisoners' dilemma, even though each individual may gain in a single case by confessing, both prisoners will have a wealthier life of crime if neither of them confesses and provides evidence against the other. If they know that they will engage in further crimes in the future, they will be less likely to confess. By not confessing, they are able to attain a higher level of lifetime income. In the case of oligopolies, each firm has an incentive to undercut the prices charged by other firms in any given time period. Each firm, though, realizes that if it charges a lower price now, the other firm may respond by charging lower prices in the future. The threat of future retaliation may encourage firms to maintain high prices in each time period. The situations described above involve noncooperative games in which participants could not work together to mutually decide on outcomes. If oligopoly firms are free to collude and jointly determine their prices and output levels, they would be able to attain a higher combined level of profits. In the U.S. collusion of this sort is illegal. While it is illegal for firms to officially meet and determine prices and output levels, it is perfectly legal for them to charge the same high prices as long as they didn't meet to determine the prices. Firms may be able to achieve outcomes equivalent to the collusive outcome by engaging in a price-leadership situation in which one

77 firm sets the price for the industry and the other firms follow that firms' price changes. Other facilitating practices such as cost-plus/markup pricing may also result in an equivalent outcome. (Cost-plus or markup pricing occurs when firms determine the retail price of a commodity as a given multiple of the wholesale price if there is a 50% markup, a good that costs the firm $10 to acquire will be sold for $15.) If all firms use the same markup percentage, they will all tend to charge the same price. Manufacturers of goods often facilitate this practice by posting "recommended retail prices" on the products. Cartels are legal in some countries. Under a cartel arrangement, firms engage in explicit collusive behavior. One problem with cartels, though, is that any individual firm can increase its profits by cheating on the agreement. For this reason, most cartels have not been lasted very long.

Imperfect information
One complicating factor in markets is that buyers and sellers do not always possess perfect information about the characteristics of the products that they are buying and selling. Brand name identification is important in many oligopoly and monopolistically competitive markets because a seller that wishes to remain in business has an incentive to produce a high quality product. Customers are often willing to pay a higher price for a product produced by an established firm rather than buying a product from a firm that they do not recognize. Product guarantees are also used by firms as a signal of product quality. One problem caused by imperfect information is the adverse selection problem. The adverse selection problem occurs when those who willing to agree to a transaction are selling a lower-quality product than is typical in the population as a whole. A classic example of the adverse selection problem occurs in the market for used cars. Once a car is driven off the lot, its value declines rather dramatically. The reason for this is that individuals who are stuck with "lemons" are more likely to sell their cars in the used-car market than those who purchased reliable vehicles. Because buyers cannot always determine whether a car is a good used car or a "lemon" the price of all used cars is lower because of the lower average quality of the used cars that are offered for sale. Another example of the adverse selection problem occurs in the market for insurance. If there are no restrictions on who is eligible to purchase a health insurance or life insurance policy, those who purchase them are disproportionately those individuals who are more seriously ill. Because of this, the cost of insurance policies offered to the general public is much higher than the cost of insurance that is provided to all employees in a firm or all students at a college. Moral hazard is another problem that results from imperfect information. Moral hazard occurs when the existence of a contract causes one party to alter his or her behavior from the behavior that was anticipated by the other party at the time the contract was agreed to. Medical insurance provides an example of the moral hazard problem since the existence of insurance encourages individuals to consumer more medical services than would otherwise be consumed.

Chapter 13
In this chapter, we'll discuss government policy toward business, with particular attention on antitrust laws. Two explanations for government intervention in markets are: 1. public interest theory, and 2. capture theory.

78 Public interest theory suggests that the government takes actions that are designed to correct for market failure. This view suggests that the government undertakes actions that are designed to improve the welfare of society as a whole. Those who believe in the capture theory, though, argue that government actions transfer wealth across individuals and groups in society. The capture theory suggests that special interests receive the benefits from government intervention in the economy. Advocates of this position suggest that even regulatory agencies charged with serving the public interest will eventually be "captured" by the firms that they regulate.

Antitrust
The measure of market concentration that is used by the U.S. Justice Department is the Herfindahl index defined as the sum of squared market shares (expressed as a percentage) of all of the firms in an industry. In a pure monopoly, this would equal 10,000. If there are 100 equal sized firms in an industry, the Herfindahl index would equal 100. The Justice Department argues that an industry in which the Herfindahl index is less than 1,000 is highly competitive. A Herfindahl index between 1,000 and 1,800 indicates that an industry is moderately competitive. An industry is said to be highly concentrated if the Herfindahl index exceeds 1,800. The basis of antitrust law in the United States is the Sherman Antitrust Act of 1890. This act prohibited firms from engaging in activities that were "in restraint of trade." Initially, this act was not used to break up many monopolies, though, because it did not define what activities were illegal. The Clayton Act of 1914 (and subsequent amendments), however, provided a list of activities that were held to be violations of antitrust law. In particular, the Clayton Act prohibited firms from engaging in price discrimination designed to reduce competition and from engaging in exclusive dealing and tieing contracts that limited competition. Initially, courts followed the "rule of reason" that suggested that size alone is not evidence of a violation of antitrust law. This changed with the Alcoa case of 1945 that held that size, per se, is sufficient evidence of antitrust violation. By the 1980s, though, the Justice Department and subsequent court decisions had effectively returned to the earlier "rule of reason."

Regulation
During the earlier years of these industries, the U.S. regulated the trucking, airline, and railroad industries. The rationale behind the regulation was that it was needed to prevent "destructive competition" that would result in the failure of these new industries that had relatively high fixed costs. In the 1970s, however, the airline and trucking industries were deregulated. Transportation costs in these industries fell rather substantially. As your text notes, the government also engages in a variety of social regulatory activities.

Chapter 14
Government and Market Failure
This chapter addresses the major types of market failure that provides an economic rationale for corrective governmental action:

externalities, common property resources, public goods, and asymmetric information.

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Externalities
Externalities are side effects of production or consumption that impose costs on or provide benefits to thirdparties who are not directly involved in the activity. Positive externalities are side-effects that provide benefits to one or more third-parties, while negative externalities harm others. If someone paints their house, shovels snow from the sidewalk in front of their dwelling, receives a vaccine for a contagious diseases, or removes junk cars from their lawn, positive externalities occur. Negative externalities occur as a result of pollution, loud music played by neighbors (assuming that you do not enjoy their choice or timing of music), cigarette or cigar smoke, or any other activities that people engage in that harm others. In earlier chapters, you learned that the optimal level of consumption for a good occurs at the point at which the price of the good equals the consumer's private marginal benefit from the good. You also should recall that, in a perfectly competitive market, a firm will produce output at the point at which P = MC (where MC includes only the firm's private marginal costs). Thus, we know that, at a competitive equilibrium, private marginal benefit (as reflected in the demand curve) must equal private marginal cost (as represented by the supply curve). If there are no externalities, social marginal cost will equal private marginal cost (since no costs are imposed on others) and social marginal benefit will equal private marginal cost. When negative externalities are present, the social marginal cost exceeds the private marginal cost to those who are engaged in the activity that generates the externality. In this case, competitive markets, left to themselves, will result in a level of production at which the social marginal cost exceeds the social marginal benefit associated with the activity. In this case, society would be better off if the level of the activity was reduced. The presence of negative externalities results in overproduction. One of the most commonly used examples of a negative externality is pollution. If firms are able to pollute the air, water, or soil without any costs, they will not take these external costs into account when formulating their production plans. Social marginal benefits exceed private marginal benefits when positive externalities are present. Since people do not take external benefits into account when weighing their own private benefits and costs, social marginal benefits exceed social marginal cost at their optimal level of the activity. Thus, competitive markets will underproduce those activities that generate positive external benefits. Consider, for example, the case of a vaccine. When you receive a vaccine, you not only protect yourself from the virus, you also protect those with whom you come into contact from contracting the virus from you. Suppose that you would receive $10 in benefits by receivng the vaccine and those around you would (in total) receive $4 in benefits from your consumption of the vaccine. If the vaccine cost $12 (including the cost of time), it would not be optimal for you to consume this (since your private benefit is less than your private cost) even though it the gains to society outweigh the social cost of providing you with the vaccine.

Solutions to externality problems

One method of dealing with externalities is to impose a tax (in the case of a negative externality) or provide a subsidy (in the case of a positive externality). If the tax (or subsidy) is set at the level of the marginal external cost (or marginal external benefit), individuals will select the optimal level of the activity since thgeir own costs and benefits now reflect social costs and benefits. This method of correcting for the presence of an externality was first suggested by A. Pigou, and is known as a Pigovian tax (or subsidy). This type of approach is said to "internalize the externality" by converting an external cost or benefit into an internal cost or benefit.

80 An alternative method of dealing with externalities is the use of government regulations. Restrictions on pollution emissions, mandatory schooling requirements, laws banning driving whil intoxicated, and similar laws all attempt to correct for the presence of externalities. In recent decades, marketable pollution permits have been introduced as an alternative to emission restrictions for several pollutants. Firms must buy permits to emit spoecific quantities of these pollutants into the air or water. The advantage of this system over the use of taxes or regulations is that it provides a more efficient reduction in pollution. Those firms that face lower costs of reducing pollution have an incentive to reduce pollution by more than those firms that find pollution reduction more costly. In this case, society attains a given reduction in total emissions at a lower opportunity cost than would occur if all firms were forced to reduce emissions to the same level. The Coase theorem suggests that, as long as property rights are well established and there are no transaction costs, private bargaining may correct for the presence of externalities. In practice, however, the existence of transaction costs makes it unlikely that an efficient outcome will occur in the absence of government intervention.

Common property resources

A common property resource is one for which no individual has private property rights. When everyone shares ownership of a resource, each individual receives all of the benefits from using the resource, but the costs are shared by everyone. Consider, for example, the case of whales, buffalo, fisheries, and similar resources. In each case, the whaler, hunter, or fisherman receives property rights only after catching and killing the animal. Each person gets the full benefit from their activity, but the cost of a reduced breeding stock is shared by everyone. If you are an individual fisherman fishing in an endangered fishery, you have no incentive to reduce your individual harvest of fish because you know that if you do not catch an additional fish, someone else might. In such a situation, the resource is overutilized. Governments deal with this problem by setting restrictions on consumption or by introducing property rights when feasible. When alligators were a common property resource in the U.S., they were hunted until they were threatened with extinction. The introduction of "alligator farms" in which alligators were owned by individuals eliminated the risk of extinction since individual alligator farmers face an incentive to maintain a breeding stock for subsequent year's harvests. This "problem of the commons" (as it is also known) explains why public parks and highways often have more litter than most individual's back yards, why bathrooms and commons rooms in dormitories are messier than those in private houses and apartments, and why many species of animals have been hunted to extinction or threatened with extinction.

Public goods
A public good is a good that is nonrival in consumption. This means that one person's consumption does not reduce the quantity or quality of the good available to other consumers. Examples of public goods include national defense and TV and radio signals broadcast through the air. Some public goods have some congestion costs in which the benefits do decline a bit as the number of people consuming them rises. Town parks, highways, police and fire protection, and other similar commodities and services fit this definition. The problem with public goods is that no individual has an incentive to pay for the good. Since it is inefficient, and not always feasible, to exclude people from consuming a public good, people can consume it even if they

81 do not pay for it at all. In such a situation, each person has an incentive to be a "free rider" and to let others pay for the good. The problem, of course, is that the good will be either underproduced or not produced at all if the provision of such goods were left to the market. The government attempts to correct for this type of market failure by either providing (or subsidizing the production of) public goods.

Asymmetric information
Asymmetric information is said to exist when one party to a contract has more information than the other party. Among the problems associated with asymmetric information are:

adverse selection, and moral hazard.

Adverse selection
An adverse selection problem occurs when the average "quality" of one of the participants in a transaction is of lower quality than in the population. A classic example occurs in the market for used cars. As noted by George Akerlof, the value of a car declines substantially once the car has been purchased by its original owner. The reason for this is that a 1-year old used car that is offered for sale is of lower quality than a typical 1-year old used car. If 1% of new cars are "lemons," it is quite possible that 50% of one-year old used cars might be "lemons." The reason is that those who bought high-quality cars are more likely to keep them while those who ended up with lower-quality cars are more likely to try to sell them. Asymmetric information occurs in this case because the buyer of a used car has less information about the true quality of the car than does the seller. The equilibrium price of a 1-year old used car reflects the average value of these cars. Those who try to sell high-quality used cars end up with the same price that sellers of "lemons" receive since buyers cannot tell them apart. As noted in your text, markets for insurance and loans also experience adverse selection problems. The government may attempt to correct for adverse selection by requiring product warranties. Insurance companies require physical exams as a condition for receiving health or life insurance as a way of dealing with adverse selection. Banks and other financial intermediaries use credit reports to reduce the adverse selection problem. Brand-name loyalty is one method by which consumers may avoid adverse selection problems.

Moral hazard
A moral hazard problem occurs when one of the party to a transaction has an incentive to alter their behavior in a manner detrimental to the other party once a contract is formed. Insurance, for example, generates a moral hazard problem since the individual with the insurance has less incentive to avoid the events for which they are insured against. Copayments and deductibles are by insurance companies to reduce the moral hazard problem.

Government failure

The government consists of many individuals who may attempt to maximize their own utility rather than serving the general "social interest." "Logrolling" in legislatures may lead to higher spending than is optimal. Rent-seeking behavior may result in policies being

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pursued that provide large benefits to a majority of the population.

small group but small damage to the vast

Chapter 15
In this chapter, we'll examine how employment and resource prices are determined in resource markets. As noted earlier, there are four basic categories of resources: land, labor, capital, and entrepreneurial ability. The associated resource payments for these resources are: Resource land labor capital entrepreneurial ability Resource Payment rent wages interest profit

Rent, wages, and interest are determined in the markets for land, labor, and capital. The entrepreneurs, though, are residual claimants who receive profits, the revenue that is left over after all other factors of production have been paid. The relationship between output and resource markets is described by the circular flow diagram that we had examined in the early part of this course. This diagram illustrates the very important interdependence between output and resource markets. Firms purchase resources in resource markets so that they can produce the output that is sold in the output markets. Because of this, we say that the demand for resources is a derived demand that is derived from the demand for final output. The demand for autoworkers, for example, increases when the demand for automobiles rises.

The circular flow diagram above also illustrates another point that should be remembered: households are the source of supply in the resource market and firms are the source of demand. Note that these roles are the opposite of the roles played by both households and firms in the output market.

Market demand and supply of resources

The diagram below illustrates the market demand and supply curves for a resource market. The demand curve is downward sloping since a reduction in the price of a resource increases a firm's willingness and ability to pay for the resource. The quantity of a resource supplied rises as the price of the resource rises since the owners of

83 the resource will transfer the resource to the most highly-valued alternative. As the diagram below suggests, a market equilibrium occurs at the level of resource price at which quantity demanded equals quantity supplied.

Let's examine the resource demand and supply relationships in more detail.

Market demand
The elasticity of resource demand is defined as:

The price elasticity of demand for a resource is expected to be higher when:

the price elasticity of demand for the final product is relatively high, this resource accounts for a relatively large share of the firm's total costs, there are many substitutes for the resource, and a longer time period is considered.

Let's consider why the price elasticity of demand for the final product affects the price elasticity of resource demand. Resource demand is more elastic when the quantity of the resource demanded declines by a larger amount when the price of the resource declines. Let's examine how a change in the resource price affects the quantity of the resource demanded. As the price of the resource rises, marginal and average total costs will increase. This increase in costs results in a higher equilibrium price of the product being sold. As the price of the product rises, the quantity of the product demanded declines. Since the demand for resources is a derived demand, this decline in the quantity of the product demanded results in a reduction in the quantity of resources demanded. When the price elasticity of demand for the final product is relatively large, there will be a larger reduction in the quantity of the final product demanded (and therefore a larger reduction in the quantity of resources demanded) when the price of a product rises in response to an increase in resource price. Be sure to think through the chain of causality rather carefully to understand the relationship between the price elasticity of demand for the product and the price elasticity of resource demand. The resource's share in total costs affects the elasticity of resource demand in a similar manner. When the price of the resource rises, the effect on marginal and average total costs will depend upon the resource's share in total costs. If a resource comprises 10% of total costs, a doubling of the price of the resource would result in a 10% increase in total costs. If the resource accounts for only 1% of the firm's cost, a doubling of it's price will raise the firm's costs by only 1%. Thus, a change in the price of the resource will have a larger effect on the cost of and the price of the final product when the resource is a larger share of total costs. In this situation, the quantity

84 of output sold will decline by more, as will the quantity of the resource demanded. Thus, resource demand is more elastic when the resource accounts for a larger share of total costs. Firms will reduce the employment of a resource by a larger amount when many substitute resources are available. Thus, resource demand is more elastic when there are more substitutes. Since it takes time for firms to alter their production methods, an increase in the price of a resource will have a larger effect in the long run when there are more possibilities for substitution. Thus, resource demand will be more elastic when a longer time period is considered. Let's examine those factors that will cause the demand for a resource to shift. The demand for a resource will increase when:

the price of the product increases, the productivity of the resource rises, the number of buyers rises, the price of a substitute resource rises, the price of a complementary resource falls, and/or the firm possesses high levels of other resources.

In determining how many workers (or units of another resource) to employ, a firm weights the benefits from employing the resource against the cost. An additional worker will be hired only if the additional benefit exceeds the additional cost. The benefit the firm receives from adding additional workers is the revenue generated from the sale of the output produced by the workers. An increase in the price of the product or the productivity of the workers raises the marginal benefits associated with hiring workers. Thus, labor demand will increase when the price of the output sold rises or the productivity of the workers rises. An equivalent argument applies to other resources. Since the market demand curve for a resource is constructed by adding together the demand curves for all of the firms in a resource market, an increase in the number of firms will increase the market demand for the resource. Substitute resources are used in place of each other (such as assembly line welders and robotic welders). If one of these resources becomes more expensive, firms will replace the more expensive resource with the relatively less expensive resource. Complementary inputs are inputs that tend to be used together. Computer-controlled production equipment and computer technicians are likely to be complementary inputs. If one of these inputs becomes more expensive the demand for the complementary input will decline. If a firm has a high level of some input, the productivity of other inputs will increase. A firm possessing a large amount of capital, for example, may find that its workers are more productive than workers in firms where the workers have fewer tools to assist their work. In this case, an increase in capital may result in an increase in the demand for labor.

Market Supply
As your text notes, the price elasticity of resource supplied is given by:

85 The price elasticity of supply is greater when there are many alternative uses for the resource and a longer time period is considered. Workers who can work in many occupations will be reduce the quantity of labor supplied by more if their wage falls than would workers who do not have many alternative employments. Since it takes time for workers to retrain and acquire information about other labor markets, a larger change in the quantity of labor supplied will occur in response to a wage change when a larger time period is considered. The earnings of a resource that has a perfectly inelastic supply curve is called economic rent. Economic rent represents a payment in excess of the opportunity cost of supplying a resource. If a firm has a perfectly inelastic supply curve, the same amount of the resource is available even if the price is zero. Thus, any payment receives by this resource constitutes economic rent. The earnings of a resource possessing a perfectly elastic supply curve are called transfer earnings. Transfer earnings are payments that equal the opportunity cost of supplying a resource. When a resource has a perfectly elastic supply curve, the price of the resource is the same in all alternative employments in this market. Thus, all earnings are transfer earnings. In the more typical case of a resource with an upward sloping market supply curve, the resource receives a mix of economic rent and transfer earnings. Resource supply shifts in response to changes in tastes, changes in the number suppliers and changes in the price of the resource in alternative uses.

Price ceilings and price floors

As noted above, an equilibrium in a resource market occurs when the quantity supplied equals the quantity demanded. If an effective price floor is introduced (such as a minimum wage law) that keeps the price above the equilibrium, a surplus will occur (since quantity supplied exceeds quantity demanded). In the labor market, this surplus takes the form of unemployed workers. This possibility is illustrated in the diagram below. Note that quantity supplied exceeds quantity demanded when a price floor is introduced at a price equal to Pf.

The diagram below illustrates the effect of an effective price ceiling. When the price is kept below the equilibrium (as at Pc in this diagram), quantity demanded exceeds quantity supplied and a shortage occurs.

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Individual firm demand

A firm will hire an additional unit of a resource if this increases its profits. Recall that economic profit equals: economic profit = total revenue - total cost When the level of resource use rises, both total revenue and total cost rise. Economic profit will increase if total revenue rises by more than total cost. The additional revenue that results when the level of resource use rises by one unit is called the marginal revenue product (MRP) of the resource. Marginal factor cost (MFC) is defined as the additional cost associated with a one-unit increase in resource use. A little bit of reflection should convince you that it is optimal for the firm to:

increase the level of resource use when MRP > MFC, and reduce the level of resource use when MRP < MFC.

An optimal level of employment occurs at the level of resource use at which MRP = MFC. Marginal revenue product can be expressed as: MRP = MR x MPP where MR (marginal revenue) equals the additional revenue resulting from the sale of an additional unit of output and MPP (marginal physical product) is the additional output that results from the use of an additional unit of the resource. Suppose, for example, that you wished to compute the marginal revenue product of labor that occurs when MR = $3 and MPP = 4. In this case, the use of an additional unit of labor results in the production of an additional 4 units of output. Since revenue increases by $3 when an additional unit of output is sold, total revenue will increase by $12 (= $3 x 4 units of output) when an additional worker is employed. In the special case of a perfectly competitive output market, MRP = P x MPP since MR = P (where P is the market price of the product). (In the case of perfectly competitive output markets, the MRP curve is sometimes referred to as the VMP - the "value of the marginal product.") The diagram below illustrates a possible MRP curve. This curve is downward sloping as a result of the law of diminishing returns. As you recall, the law of diminishing returns states that as the level of resource use rises, holding other resources constant, the MPP of the resource ultimately declines. While it is possible that the MPP of the resource may initially increase (as illustrated in the diagrams in the text), a profit-maximizing firm will only employ resources in the range in which MPP is decreasing. Thus, only the downward sloping portion of

87 the MRP curve is illustrated below. (In the case of imperfectly competitive markets, MR will also decline as the level of resource use rises - since MR declines when output increases in imperfectly competitive markets.)

If the resource market is perfectly competitive, each firm faces a perfectly elastic resource supply curve. The diagram below illustrates this relationship. The market price of the resource is determined by the interaction of market demand and supply. Since each firm is a price taker in a perfectly competitive resource market, each firm faces a resource supply curve that is perfectly elastic at the equilibrium resource price.

Since each firm is a price taker in a perfectly competitive resource market, the additional cost that results from the use of an additional unit of the resource is just equal to the resource price. Thus, the marginal factor cost curve is horizontal at the market price of the resource in such a market. Two possible MFC curves are illustrated in the diagram below.

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As the diagram above suggests, the optimal level of employment occurs at the level of resource use at which MRP = MFC. When the level of marginal factor costs is given by the MFC curve, the optimal level of resource use is Qo. If MFC increases to MFC', the optimal level of resource use will fall to Q'. A bit of reflection should convince you that at any given level of resource price (= MFC), the MRP curve determines the quantity of the resource that is demanded by a firm. Since the MRP curve determines the quantity of resource demanded at each level of the resource price, it serves as the firm's resource demand curve.

Monopsony resource markets

The situation is a bit more complex in the case of a monopsony resource market, a market in which there is only a single buyer for a resource. An example of a monopsony labor market is a small "company town" in which there is only a single employer in a particular labor market. In some communities, a hospital may be the only employer of nurses, medical technologists, and radiologists. While there are few pure monopsonies, many firms have some degree of monopsony power. Let's examine what this entails. A monopsony firm faces the entire upward sloping resource supply curve. The labor supply curve in the diagram below illustrates such a possibility. In this example, the firm must pay a wage of $6.00 an hour when 8 workers are hired and must raise the wage to $6.20 to induce the ninth worker to work for the firm. Of course, when the ninth worker is hired at this higher wage, the firm will have to raise the wages of the first eight workers to $6.20. Because of this, the cost of adding a 9th worker each hour is the $6.20 that is paid to this worker plus a $.20 increase in the wage rate of the first 8 workers (costing the firm $1.60 each hour in wage increases to these workers). Thus, the marginal factor cost of adding the 9th worker equals $7.80.

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Multiple resources
The discussion above applies to the optimal level of employment of any resource, considered by itself. A costminimizing firm selects a mix of resources at which the ratio of the MRP to the MFC is the same for all resources. This condition guarantees that the marginal revenue generated by the last dollar spent on each resource is the same for all resources.

Chapter 16
In this chapter, we'll examine the labor market in more detail. Since we discussed resource demand in a fair amount of detail in Chapter 15, let's start by examining labor supply.

Overview
Individuals have a fixed amount of time that is available for work or leisure activities. If an additional hour is spent at work, then one less hour is available for alternative uses. The opportunity cost of an hour of leisure time is the wage that is given up by consuming this leisure. Thus, an increase in the wage rate raises the opportunity cost of leisure time and results in a substitution effect that reduces leisure time and increases hours worked. A wage increase, however, also raises the worker's real income and results in an increase in the amount of leisure the individual wishes to consume (assuming that leisure is a normal good). This second effect, called an income effect, tends to increase the quantity of leisure time and reduces time spent at work when the wage increases. Individuals will work more when the wage rate increases if the substitution effect outweighs the income effect. As the diagram below indicates, an individual's labor supply curve will be upward sloping for the range of wage rates in which the substitution effect is larger in magnitude than the income effect. When the wage is high enough, though, it is generally argued that the income effect will eventually outweigh the substitution effect and the labor supply curve will become backward bending (as in the top portion of the diagram below).

The market labor supply curve is the horizontal summation of the labor supply curves for all individuals in a labor market. Even though individuals may have backward-bending labor supply curves, it is expected that the market labor supply curve will be upward sloping. One reason for this result is that individuals will not enter the labor force unless the wage is above a particular threshold value (the individual's "reservation wage"). As the wage rate rises, more individuals enter the market, offsetting any reduction in the quantity of labor supply that

90 may occur as a result of backward-bending labor diagram on p. 366 in your text illustrates this concept. supply curves on the part of some individuals. The

An equilibrium in the labor market occurs at the wage at which quantity demanded equals quantity supplied. In the diagram below, this occurs at a wage level of w* and an employment level of Q*.

Wage differentials
Let's examine some of the reasons for wage differentials across individuals and across occupations. Jobs differ in terms of the level of risk, stress, educational requirements, physical effort, etc. When workers choose jobs, they do so on the basis of all characteristics of the job, not just the wage. Suppose that two occupations are initially perceived as equivalent in all characteristics, including the wage. If new evidence is dscovered that indicates that one job has a higher risk of an work-related injury, then the supply of labor will decrease in the risky occupation and increase at the safer occupation as workers move from the risky job to the safer job. As this migration of labor occurs, wages will fall in the safer occupation and rise at the riskier occupation. This migration will continue until the wage differential between the two jobs is just large enough to compensate for the difference in risk. The equilibrium wage differential between the risky and the safer occupations is called a compensating wage differential since it compensates individuals for differences in job risk. This compensating wage differential is equal to the additional wage payment that must be made to the last worker hired at the risky job to induce him or her to accept the additional risk. The diagram below illustrates the compensating wage differential that is associated with job risk. In this example, the compensating wage differential equals Wr - Ws (the wage difference between the risky and the safer occupation).

91 Compensating wage differentials may be expected to exist for any job characteristic that is valued either negatively or positively by workers. Ceteris paribus, wages will be higher in those occupations that are less pleasant and will be lower in those occupations that are more pleasant. As noted earlier, an individual's human capital is a measure of his or her productive capacity. Individuals that are more productive receive higher wages. Investments in education, training, or health care will be expected to increase an individual's stock of human capital. Thus, as your text indicates, earnings increase with both education and years of work experience. There are two types of human capital: general human capital and firm-specific human capital. General human capital raises an individual's productivity in more than one firm. Firm-specific human capital raises an individual's productivity only in his or her current job. The education that individual's receive in elementary, secondary, and post-secondary educational institutions increases an individual's stock of general human capital. Training about specific production processes, policies, or procedures used at a specific firm increases an individual's stock of firm-specific human capital. Since firm-specific human capital increases a worker's productivity only in the current firm, it provides a return only if the worker remains with the firm. To help encourage long-term attachment to the firm, earnings tend to rise substantially with the worker's tenure in the firm.

Team production
One of the problems that firms experience is that in many production processes it is difficult to assess the contributions of individual workers. A team production process is said to occur when managers can observe the joint output produced by a group of workers but not the individual contributions of each worker. In such situations, job categories are defined in which each job category has a specified wage rate.

Choice of major
One of the major determinants of the income of college graduates is the choice of a college major. Economists argue that students make this choice by weighing the all of the expected costs and benefits associated with each major. One of the major factors in this decisions in the level of net benefits anticipated for alternative career paths.

Discrimination
Gender and racial discrimination are common phenomena in most economies. Economists say that discrimination occurs when a worker's wage is based positively or negatively on some factor other than marginal revenue productivity. Economists note that discrimination may be the result of one of the following forms of personal prejudice:

employer prejudice, worker prejudice, or consumer prejudice.

Employer prejudice occurs when employers are willing to pay a higher price for the groups they favor. In this situation, a profit-maximizing firm that does not discriminate will be able to hire the victims of this discrimination at a lower wage than the favored groups. This means that firms that discriminate on the basis of employer prejudice will have higher costs and lower profits. Gary Becker has argued that this type of prejudice

92 will be eventually eliminated by the pressures of competition in reasonably competitive markets (since firms that do not discrimimate against workers can charge a lower price and remain profitable). Worker prejudice occurs when workers who are prejudiced are willing to accept lower wages to avoid association with some other group of workers. The cost of this type of prejudice is expected to be borne by these workers (in the long run, at least). Consumer prejudice occurs when consumers are willing to pay a higher price for products that are produced or sold by workers from the groups that they favor. This type of discrimination may persist indefinitely, even though it imposes a cost on those who discriminate.

Statistical discrimination
Another source of discrimination is a phenomenon known as statistical discrimination. Employers do not have perfect information about the productivity or reliability of workers who apply for positions with the firm. College graduates applying for positions in a given occupation often have similar resumes, similar letters of recommendation, and have even learned to dress alike and answer questions alike during their interviews (through their planning with career placement offices at their colleges). Firms having to make decisions on hiring in this situation will often judge people based on the average productivity that they have observed for workers with similar characteristics in the past. If, for example, that they have observed that graduates of College X have been more productive than graduates from College Y, they'd be more likely to hire someone from College X if two people with other equivalent characteristics applied. Since women and older workers, on average, have historically had higher quit rates than males in their mid-20s, women and older workers may be the victims of statistical discrimination in jobs in which the firm provides costly training programs (since it is more profitable to select workers who will remain with the firm for an extended period of time). Firms that rely on statistical discrimination will make some mistakes, but will be more profitable - on average - than firms that do not engage in this practice. This type of discrimination is particularly difficult to eliminate since it is a profitable practice for the employer. On the bright side, the effect of statistical discrimination on women should lessen as female labor force participation rates rise and quit rates decline.

Occupational segregation
Statistical discrimination, combined with societal norms and prejudice, often leads to crowding in some occupations in which there are a large number of women or minorities. Jobs such as nurse, health care aide, secretary, and elementary teacher are occupations that are disproportionately filled by women. Since the supply of labor is relatively large in these occupations, the equilibrium wage tends to be relatively low. Predominately male occupations such as engineering, computer programming, and physicians, tend to be less "crowded" and have higher wages. This gender difference in the mix of occupations is referred to as "occupational segregation."

CEO pay packages

CEOs in large U.S. firms receive salaries that are dramatically above those of other managers in the firm. This may be the result of market failure caused by a separation between ownership and control in large corporations. It may also be the result of a "tournament" in which the promise of a very large prize to the most successful managers provides an incentive for lower-level managers to work hard to achieve this position. The frequent relocation of managers may also be indicative of this "tournament" process since firms may wish to examine how managers perform in different market settings. (These frequent moves may also be simply due to the shortterm productivity boost that often occurs when new managers are brought into a new position.)

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Superstar effects
Another phenomenon that is often observed in real-world labor markets is that a small number of workers in an occupation receive salaries that are dramatically above those of other workers. Star actors, athletes, musicians, lawyers, etc. often receive salaries that are dramatically above those of other workers in these occupations. The main reason for this is that these "superstars" provide a return to the firm that is much larger than that generated by other actors, athletes, musicians, lawyers, etc. These "superstars" fill more theater seats, stadium seats, etc. than do other with less star quality.

Antidiscrimination laws
The Civil Rights Act of 1964 made it illegal for employers to discriminate on the basis of race, color, religion, sex, or national origin (except for cases where there is a legitimate reason for such policies - such as the employment of religious leaders by a church, mosque, synagogue, etc.) Two standards of discrimination have evolved: disparate treatment and disparate impact. Disparate treatment occurs when personnel and employment practices are adopted that treat individuals in the same way without regard to gender, race, or religion. One criticism of this standard is that it tends to perpetuate the effects of past discrimination. Even if all workers are given the same chances of promotion in a seniority system, minorities and women may not be employed for a long time at the top of th hierarchy if they had been discriminated against for a long period of time. The disparate impact standard is based on the outcomes of a policy, rather than the policy itself. This stricter standard requires that the effects of past discrimination be remedied. Court decisions have frequently gone back and forth between these two standards.

Comparable worth
Comparable worth pay schemes attempt to base wages on the characteristics of a job rather than on a market equilibrium. It involves an attempt to provide equal pay for "comparable" jobs. Economists are generally opposed to comparable worth pay systems because they raise the wage above the equilibrium in low-wage markets (creating a labor surplus) and below the equilibrium in high-wage markets (creating a labor shortage).

Unions
Unions provide another explanation for wage differentials. In at least some cases, unions operate in a labor market that may be characterized as a bilateral monopoly, a situation in which a single buyer negotiates price with a single seller. The diagram below illustrates the monopsony outcome in the absence of a union. The level of employment occurs at the point at which MRP = MFC and the wage is determined by the supply curve at this level of output (as discussed a few chapters back). In this example, the monopsony firm would hire Lm workers and pay a wage of Wm.

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Suppose, however, that a union negotiates a wage of Wu. At this wage, the supply firm facing the firm is now perfectly elastic at this wage and the firm's marginal factor cost equals the wage (Wu). Thus, the firm will still hire Lm workers, but will pay a higher wage (as illustrated in the diagram, below).

If the union and firm negotiate a wage between Wm and Wu, the level of employment will actually increase (since the MFC is lower - even though the wage is higher). Employment will decline if the negotiated wage exceeds Wu. In perfectly competitive labor markets, the introduction of a union will result in higher wages but less employment in unionized firms (as illustrated by the diagram on p. 403 of your text). This will result in unemployed workers if all firms in the labor market are unionized. If the union does not cover all firms in the industry, some of the workers who lose there jobs in the unionized sector will shift to nonunion firms. This increases the supply of labor in nonunion firms and lowers the wage received by nonunion workers. Until 1947, unions were sometimes able to negotiate a closed shop arrangement under which only union workers can be hired. This arrangement became illegal under the Taft-Hartley Act of 1947. Since then, a more common arrangement is the union shop in which the firm may hire either union or nonunion workers, but all workers must join the union after employment. Unions have also attempted to increase the demand for union workers by supporting:

child labor laws and mandatory education requirements (eliminating competition from low-wage child workers), restrictions on immigration,

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barriers to entry in certain occupations (such as licensing requirements for plumbers and electricians, and other actions that increase the demand for union workers (such as ad campaigns encouraging consumers to "look for the union label" or "buy American").

In some cases, unions have been accused of "featherbedding," a practice in which union contracts mandate the employment of more workers than are needed in a firm. Union contracts in the railroad industry long required that firemen be employed on each train. The original job of these firemen was to maintain the temperatures of the coal furnaces used for the steam engines. There was no need for such workers, though, on the diesel engines that were used later. The effect of minimum wage laws is quite similar to the effect of a union. In competitive markets, a minimum wage law reduces employment. In monopsony labor markets, it will increase the wage but may cause employment to increase, decrease, or remain the same. What matters is the real value of the minimum wage, not it's nominal value. Over time, the purchasing power of a given minimum wage declines. In response, however, Congress and the President have often passed new minimum wage laws that raise the value. Typically, the increase restores the real minimum to its earlier level. The real minimum wage had not changed very much, on average, from its inception until 1990. Since then, the real minimum wage has declined substantially.

Chapter 17
In this chapter, we'll examine the market for capital and the determinants of technological change.

Capital
Capital consists of the buildings and machinery that are used to produce output. Be sure to not confuse this definition of capital with the concept of "financial capital," the funds that are used to purchase capital. Capital differs from the other factors of production in that capital is produced using all of the other factors of production. The production of capital involves a process of roundabout production in which society uses some of its resources today to produce capital instead of commodities intended for immediate consumption. Thus, the production of capital requires that society forgoes current consumption. To acquire this capital, society must engage in saving. This saving makes it possible to engage in capital investment that enhances society's future productive capacity. The demand for capital is tied to the marginal revenue product of capital. Additional capital is acquired as long as the marginal revenue product of capital exceeds the marginal factor cost of capital. When purchasing capital, though, firm's must take into account the revenue generated by capital over its entire productive life. Since capital tends to last for a relatively long period of time, the calculation of the marginal revenue product requires taking into account revenue generated in the relatively distant future as well as revenue generated in the more immediate future. Since $1,000 in revenue received in 10 years is worth less than $1,000 in revenue received today, it is necessary to find a some way of comparing benefits received in different time periods. This calculation can be done by determining the present value of these payments. The present value of any future balance is the amount that must be given up today to receive that balance at the specified future date. For example, the present value of $1,000 received in 5 years would equal the amount of money that you would have to deposit in an interestbearing asset today so that you would have $1,000 in 5 years. As a result of interest accumulation, the present value of this payment will be substantially less than $1,000. In particular, the present value of a payment of $K received in T years in the future is given by:

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where r is the market interest rate. As the formula above suggests, the present value of any given future balance will be less when the payment is received in the more distant future or when the interest rate is higher. To see this intuitively, note that a smaller current balance will have to be given up today to reach the specified future value if interest accumulates for a longer period of time (T increases) or more interest is received each year (r increases). For a given interest rate, the demand curve for capital is the present value of the stream of marginal revenue product generated at each possible level of capital. Holding other resources constant, the marginal revenue product of capital is expected to fall (in each time period). Thus, we would expect that the demand curve for capital will be a downward sloping curve, as in the diagram below).

Since the demand curve for capital is tied to the present value of the marginal revenue product stream generated by capital, an increase in the interest rate results in a reduction in demand (since the present value of the future revenue generated by capital declines when the interest rate rises). Thus, the demand curve for capital shifts to the left (declines) when interest rates rise (as illustrated below).

The supply of capital is provided by firms that manufacture capital goods. As in other markets, an increase in the price of capital induces firms to supply a larger quantity of capital. Thus, the capital supply curve is upward sloping. As the diagram below indicates, an increase in the market interest rate results in a reduction in the equilibrium quantity of capital sold.

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Technological change
Firms also acquire more recent technology when they buy capital. New computers are substantially faster than older ones. New furnaces are more energy efficient than old furnaces.... and so on. This technological change makes it possible for a firm to produce more output from each unit of inputs. Technological change may be the result of either basic or applied research. Basic research is research that is solely designed to create new knowledge. Applied research is research conducted for a specific practical application. Successful applied research activities result in the development of new production methods or products. Basic research is generally sponsored by universities, the government, and private foundations. Applied research and development are generally undertaken by firms. As Figure 6 in your text indicates, technological change not only lowers costs, it also may either increase or decrease the extent of the economies of scale that exist in an industry. One issue associated with the adoption of new technologies is the possibility of path dependence. Path dependence occurs when an "industry standard" is established as a result of the dominance of the first company that introduces a product. It is often argued that once an initial standard receives widespread acceptance, it is difficult for better systems to be adopted. It should be noted that most economists have found little empirical evidence to support the path dependence argument. The most commonly cited story is the adoption of the QWERTY typewriter design. Many people argue that the DVORAK keyboard layout is better as a result of a single typing test several decades ago. What is generally ignored is that this typing test was sponsored by the inventor of the DVORAK keyboard and was not successfully duplicated despite numerous trials.....

Financial capital
The financial instruments that firms use to finance capital purchases are called financial capital. Stocks, bonds, and similar instruments are examples of financial capital. Owners of stock receive two types of return: dividends and capital gains. Dividends are profits that are distributed to the owners of stock. Capital gains occur when the value of stock rises over time. The annual return on stock consists of dividends plus capital gains. Coupon bonds are corporate bonds that provide a fixed coupon payment each year (twice a year, actually). This coupon payment provides the holder of the bond with an annual interest payment that is a fixed proportion of the face value of the bond. The entire value of the bond is paid back at the bond's maturity date. Since the

98 price of the bond can be above or below the bond's face value, the yield on a bond also comes about through both coupon payments and capital gains (note that for either stocks or bonds, negative capital gains also known as capital losses - are not uncommon). As the price of a bond rises, it's yield declines (since the coupon payment and payment at maturity are fixed). Thus, there is an inverse relationship between bond prices and bond yields. For the sake of completeness, we should also briefly discuss discount bonds. Discount bonds do not provide coupon payments, but are instead sold at a price below the face value. The difference between the purchase price of the bond and its value when it is sold provides a yield to the bond holder. Government bonds (such as Treasury bills, Treasury bonds, and savings bonds) are discount bonds. Risky bonds provide a higher average yield than safer bonds since financial investors will only hold riskier financial assets if they receive a risk premium that is large enough to induce them to accept the additional risk. As your text notes, economic profits are equal to accounting profits minus the cost of equity capital. Positive economic profits occur when the level of profits exceed the dividend payments that must be made to stockholders. Stock prices are expected to rise in response to higher expected profits.

Chapter 18
In this chapter, we'll examine natural resource markets and environmental policy. Natural resources can be divided into two categories: nonrenewable resources and renewable resources. Nonrenewable resources (also known as exhaustible resources) have a finite supply that is depleted as the resource is consumed. Fossil fuels provide an important example of a nonrenewable resource. Renewable resources can be replenished by producers. Examples of renewable resources include: timber, land, agricultural products, cows, etc. Let's first examine the market for nonrenewable resources. As with any other commodity, the equilibrium price and quantity for a nonrenewable resource is determined by the interaction of demand and supply. A larger quantity of the resource is supplied today when the current price is higher. More oil wells will be drilled, for example, when the price of oil is higher. Firms will shift to other fuel sources, though, and the quantity of oil demanded will decline when the price of oil rises. This is illustrated in the diagram below.

As the supply of the resource is depleted over time, the cost of extracting the resource will rise (since the lowest cost sources will be used first) and the supply curve will shift to the left. In response to this reduction in supply, the equilibrium price will rise and the quantity consumed will decline (as illustrated below).

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The owner of a nonrenewable resource faces a choice between supplying the resource today, or selling it at a higher price in the future. The owner will supply more today if the rate of increase in the price over time is less than the market interest rate (since the owner can take the proceeds from the current sale and receive a future value greater than the price that would have been received if the resource was not extracted until the following period). Since many producers would increase current supply (and reduce future supply), the current price will fall and the future price will rise until the rate of price increase equals the market interest rate. (If the difference in price is greater than the market interest rate, current supply will fall while future supply will increase until the rate of growth in the price is equal to the market interest rate.) The situation for renewable resource is even simpler. In any given time period, the price is determined by the interaction of demand and supply. An exceptionally large harvest results in higher prices, less consumption, and increased production of the commodity in the future.

Environmental problems
As noted earlier in the course, markets allocate resources efficiently when the price reflects all of the marginal costs and benefits associated with an activity. Market failure occurs when externalities are present. Environmental pollution is an example of a negative externality in which the marginal social cost of the activity exceeds the marginal private cost. Thus, in a market equilibrium, too much of the underlying activity occurs (since the marginal social costs exceeds the marginal social benefit at the market equilibrium). This relationship is represented in the diagram that appears on p. 450 in your text. The government may attempt to correct for this market failure through the use of taxes or regulations (such as those specifying emission standards). A related environmental problem is caused by the absence of private property rights for common property resources. As noted earlier in the class, the lack of private property rights in fisheries, etc. will be expected to result in overfishing.

The Coase theorem

The Coase theorem suggests that the assignment of property rights may correct for the presence of externalities if there are no transactions cost. If, for example, the right to pollute is assigned to a firm, then those who wish to have cleaner air may bargain with the firm to reduce it's emissions in return for a monetary payment. In practice, though, such bargaining is not costless and there are public goods problems associated with such negotiations (i.e., individuals would have an incentive to be free riders).

International aspects

100 Since the problem of pollution is global, attempts to correct for it must have a global dimension. The Kyoto accords represent an attempt to move in such a direction.

Chapter 19
In this chapter, we'll examine some of the economic issues associated with aging, social security, and health care.

Economics of the family

In recent decades, economists have devoted a great deal of attention to understanding the economics of the family. One area of particular interest is the decision of households to have children. In developed economies, children provide consumption benefits for their parents (well... except when they are teenagers). Children provide labor services on family farms and provide old-age security for their parents in less developed economies. The diagram below contains a simple demand and supply diagram that may be used to explain the number of children selected by a household. The demand curve is expected to be downward sloping as a result of the law of diminishing marginal utility. The supply curve may initially slope downward since the marginal cost of a 2nd child may be lower than that of a first child since cribs, clothing, toys, and other items may be used more than once. Since raising children is a time-intensive activity, though, it is expected that the marginal cost will ultimately increase (since the opportunity cost of time increases as more time is taken away from other activities). An optimal quantity of children occurs at the point at which the demand and supply curves intersect.

World War II had a very substantial impact on child bearing. After the war, men and women who had been separated by the war were able to have children that would, under other circumstances, have been born in earlier years. The rapid increase in income that accompanied the end of the Great Depression made it easier for households to afford new homes and to raise children. This lead to a dramatic increase in fertility during the years between 1946 and 1961. From the 1960s onward, though, fertility rates declined. One of the major reasons for this is the increase in female wage rates and labor market opportunities. Higher wages and improved job opportunities for married women substantially raised the opportunity cost of having children. (In the diagram above, this would be indicated by a reduction in the supply curve for children.) As wage rates for married women have continued to increase, fertility levels have remained substantially lower than in earlier periods. Rising divorce rates and increased educational attainment by women, have also helped to maintain low fertility levels.

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Aging and Social Security

The large baby-boom generation, combined with low fertility rates in recent decades, have resulted in a potential problem for the social security system. As the baby-boom generation retires, there will be substantially fewer workers supporting each Social Security recipient. This problem is exacerbated by increased longevity resulting from improvements in medical care. The problems associated with the future of the social security system are covered in a fair amount of detail on the web page on Social Security that I've constructed for SouthWestern College Publishing. Click here to jump to this site.

Health Care
Health care expenditures in the U.S. have increased quite dramatically in recent years. HMOs and similar arrangements have been created in response to these rising health care costs. The issues and problems associated with health care are covered on a health care reform web page that I've written for South-Western College Publishing. Click here to go to this site.

Chapter 20
In this chapter, we'll examine some of the economic issues associated with income distribution and poverty.

Income Distribution
In a pure market economy, income is determined by the resource payments that individuals and households receive in resource markets. The level of wages, interest, rent, and profits that are received are determined by resource prices in resource markets and the quantity and quality of the resources that are owned by individuals and households. Those households with the most valuable bundles of resources receive the highest income. The quantity of land, capital, and human capital (to some extent), is partly determined by the income that was received by past generations of the family. This system of income determination can result in a quite unequal distribution of income. The extent of income distribution in an economy is often represented using a Lorenz curve. To construct a Lorenz curve, individuals (or households) are ranked from highest to lowest according to income. The Lorenz curve illustrates the proportion of total income that is received by the poorest x% of the population (where x is allowed to vary between 0 and 100). The diagram below contains a possible Lorenz curve.

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For the country represented by the green Lorenz curve in the above diagram:

the poorest 20% of the population receives 7% of the economy's total income, the poorest 40% of the population receives 18% of the economy's total income, the poorest 60% of the population receives 32% of the economy's total income, the poorest 80% of the population receives 52% of the economy's total income, and the poorest 100% of the population (the entire population) must receive 100% of the economy's total income.

If each person had an identical income, the Lorenz curve for society would correspond to the line of income equality in the diagram above. The greater the distance between the Lorenz curve and the line of perfect equality, the greater the level of income inequality. In the diagram below, Country B's income distribution is more unequal than that of Country A.

Poverty
A household is considered to be in a state of poverty if its income is less than the amount that is required to provide a nutritious diet. The level of income required to place a household above the poverty level varies with

103 geographical location and household size (as well as with the ages of household members - teenagers eat more than 2-year olds). Federal poverty statistics are based on a measure of total household income that includes earnings and any cash transfers received by the household. Transfer payments are defined as any payment for which no good or service is provided in return. Examples of cash transfers include social security benefits, unemployment compensation, and disability payments. Households also receive transfers in the form of goods of services. These transfers are called in-kind transfers. Examples of in-kind transfers include food stamps and housing subsidies. Both cash and in-kind transfers reduce the degree of income inequality in the U.S. economy. Income inequality in the U.S. had fallen steadily in the U.S. until the 1980s as a result of poverty programs and economic growth. Income inequality increased in the 1980s and during the early 1990s. It is important to note that a substantial portion of those living in poverty remain in poverty for long periods of time. As your text notes, poverty is more common for:

the youngest and oldest members of society, those with relatively low levels of education and training, members of racial minority groups, and female-headed households.

Government antipoverty programs include the cash and in-kind transfer programs above, as well as the use of progressive tax systems that impose lower tax rates on low-income groups. The distribution of income in an economy is also affected by its tax structure. Taxes as a share of income rise under progressive taxes, remain constant under proportional taxes, and decline under a regressive tax system. Federal and most state income taxes systems are progressive. Sales taxes and the social security tax are regressive (sales taxes are regressive because high income individuals spend a smaller share of their income and save more, social security taxes are regressive at high levels of income because they are capped at a specified income level). The labor supply disincentives existing under the U.S. welfare system and the earned income tax credit (a form of negative income tax) are discussed on the web page on workfare that I've created for South-Western College Publishing. Click here to visit this page.