Principles of Microeconomics

Ph.D. Shawkat Hammoudeh

Bradley R. Schiller, “The Economy Today”

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 Chapter 1: The Core Issues

Economics is the study of how people use scarce resources in an attempt to satisfy their
unlimited wants.
Resources are inputs used to produce goods and services. They are also called factors of
production.

Factors of Production:
There are four basic factors of production

 Land: Includes the ground and natural resources such as crude oil, water and
minerals.
 Labor: Includes skilled and unskilled labor. Both the quantity and the quality of
human resources are included in the labor factor (e.g., skilled, unskilled …etc).
 Capital: Final goods produced to be used as inputs in further production. It
includes machines, equipment, buildings. Example: residents of a fishing village
in southern Thailand braided huge fishing nets to catch more fish. The fishing nets
are regarded as capital.
 Entrepreneurship: This factor of production is related to how well a given
quantity of resources can be used in production. Entrepreneur is the person who
sees the opportunity of new or better products and brings together the resources
needed for producing them. The entrepreneur is an organizer and a risk taker.

Payments to Resources (returns to factors of production):

 Land is paid rent
 Labor is paid wages
 Capital is paid interest or the rental price of capital.
 Entrepreneur is rewarded profit.

Land
Production Scarce
Unlimited Resources Labor
of goods
Wants Capital
and services
Entrepreneur

Choices
Limits to Output

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Since resources are insufficient to satisfy all desired uses, then there is scarcity, which is
the core problem.
Scarcity: The imbalance between our desires and available resources. Then economic
scarcity forces us to make economic choices. The most cited example is the choice
between more defense spending (guns) or more spending on civilian goods and services
(butter). In 1986 the defense budget / total output was 6%, and this share dropped to 3%
in 2001. This decline in defense spending share is refereed to as the peace dividend. An
increase in national defense would imply more sacrifices of civilian goods and services.
This is the “Guns Vs Butter” dilemma that all nations face.

Opportunity cost:
Every time scarce resources are used in one way we must give up the opportunity to use
them in other ways. To produce more weapons, you must sacrifice the opportunity of
producing more civilian goods. The sacrificed or foregone civilian goods represent the
opportunity cost of producing more weapons.

The opportunity cost of producing more of good X is the most desired goods or services
foregone in order to transfer resources to this good.

Production Possibilities:
The limit on resources implies limits to total output that can be produced. This means that
if production of good X is increased then production of good Y must be decreased
because resources would be transferred from Y to X.

Suppose we have two goods: Shoes (S) and TVs (T). Suppose the limit on labor = 10
workers each day, given the available technology. Suppose it takes 2 workers to produce
one shoe a day. The maximum amount of shoes that can be produced with the 10 workers
= 5 shoes and zero TVs.
Suppose the production of TV is assumed as in the third column of Table: 1: 1

Table 1.1 Production Possibilities Schedule (Columns 2 &3)

Combinations Shoes TVs ΔTV

increase
A 5 0 --
B 4 2.0 +2.0 TVs
C 3 3.0 +1.0
D 2 3.8 +0.8
E 1 4.5 +0.7
F 0 5.0 + 0.5

(This column or production of TV is assumed this way)

The two columns of shoes and TVs (2&3) represent the possible output combinations of
shoes and TVs that can be produced a day from 10 workers and the given technology. If
these combinations (A, B, ----, F) are connected then they yield the production
possibilities curve (PPC) or frontier (PPF). PPC and PPF are the same.

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 Fig 1.1: Production Possibilities curve

At the beginning (point B), the opportunity cost of increasing TVs by two is the foregone
opportunity of producing one shoe (one pair), which is the sacrificed one shoe. At this
point the opportunity cost of increasing TV by one is 1/ 2 of a shoe. Next (point C), the
opportunity of increasing TVs by one extra unit is the sacrificed one shoe and so on as
shown in the table below

In this case the PPC or PPC illustrates two essential principles.

 Scarce resources or output tradeoff (limits to output)

 Opportunity cost (sacrifice in production of the other good)

Increasing Opportunity Cost:

The shape of the PPC (PPF) is related to the direction of change in opportunity cost.

Δ Shoes Δ TVs Foregone Increase in TV Opportunity cost of

Shoes (ΔS) Output (ΔT) producing one extra TV:
(ΔS / ΔT) = shoes
5–4 02 1 +2 ½ shoe
decrease increase
43 23 1 +1 1 shoe
32 3  3.8 1 +0.8 1/0.8 = 1.25 shoes
21 3.8  4.5 1 +0.7 1/0.7 = 1.43 shoes
1-0 4.5  5 1 +0.5 1/0.5 = 2 shoes

(sacrifice is numerator and increase is denominator)

 The opportunity cost of producing one more TV is increasing. Graphically, this is
represented by the concave (bowed out) curve of the PPC or PPF.

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 The reason for the increase in opportunity cost is that the transferred resources
from one good to another may not have the suitable skills or are the right match
for the new production. What would the shape of the PPC or PPF be if the
opportunity cost is constant? Increasing opportunity cost?
 All output combinations on the PPC or PPF such as point P are attainable and
efficient; although they are not equally desirable. Efficiency means getting the
maximum output from the available resources.

Inefficiency: This is represented by points inside the PPC or PPF such as point Y.

TV

Point X which lies outside the PPC or PPF is unattainable, given our resources and
technology. Point Y is inefficient because we are not getting the maximum output
from the given resources and technology.

Economic Growth(%):
This growth is a result of increases in resources and / or improvement in technology. An
increase in economic growth would shift the PPC or PPF outward, making a point like X,
unattainable in the previous graph, attainable.

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 S

PPC2

PPC1

TV

Fig. 1.5: Growth: Increasing Production Possibilities

Basic Decisions
There are millions of efficient points along a PPC or PPF, and each one represents a
specific mix of output. The country can choose only one point (the most desirable) at any
time period. In the famous example on “Guns vs. Butter”, this point determines how
many “guns”, and how much “butter” are produced. But the PPC or PPF does not tell us
which output mix is the best or most desirable. It is just a menu of available choices. It’s
up to the country to pick up the output mix.

Guns

N. Korea (16.3%) in 2002

Saudi Arabia (12%)

China (4%)

USA (3.4%)

Butter

There are three decisions the country must make:

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  What to Produce? That is, the country should pick only one point on the PPC.
This determines the output mix, more guns or butter?
 How to produce? Should we generate electricity from oil, coal, nuclear power,
solar power? Here someone should make a decision about which production
methods to use. This is a question of not just efficiency but of social values as
well.
 For whom to produce? Who is going to get the output produced? How should the
goods and services an economy produces be distributed? (income distribution)

For whom America produces? (2002)

Income Quintile 2002 income Average Income Share of Total income

Highest Fifth Above $87,000 $147,000 49.8%
fourth Fifth $ 54,000 - $87,000 $69,400 23.4%
Third fifth $34,000 - $54,00 $44,000 14.8%
Fourth fifth $18,000 - $34000 $26,000 8.7%
Lowest Fifth $0 - 18,000 $10,000 3.4%

Index of Economic Freedom

Ranks countries’ answers to the above three questions: What to Produce? How to
Produce? and For Whom to Produce?

The 2004 Index ranks 155 countries in terms of ten freedom measures such as their
market reliance on taxes, regulations, free trade, property rights …etc. It favors
economies that depend more on market signals than on government directives. Hong
Kong is ranked # 1 in economic freedom in terms of low tax rates, free trade policies,
minimal gov’t regulations and property rights, and United States is # 10 in 2004).

The 2009 Index of Economic Freedom ranks 179 countries. Hong Kong is still # 1 (score
90) and The U.S. is # 6 (score 87.3). North Korea is # 179 (score 2). See this link:

http://www.heritage.org/Index/Ranking.aspx

However, we should keep in mind that this index represents some ideological view and is
not the Bible or the Koran.

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 CHAPTER 3: Supply and Demand

Market Participants:

There are four participants in a market: consumers, business firms, government and
the international sector. There are two types of markets: the factors of production
markets and the product markets.

International
participants
Product
Goods and services markets
demanded
Goods and services
supplied

Business
Consumers Governments Firms

Factors of
production supplied
Factor Factors of
markets production demanded
International
participants

 A market includes buyers and sellers and it exists whenever any exchange
takes place. The buyers are on the demand side of the market, and the sellers
are on the supply side of the market.

DEMAND:
Let us focus first on a single consumer or a buyer.

Individual Demand:
Tom is willing and able to pay for a tutor in web-design.

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 Tom is willing to buy 1 hour of tutoring per semester if he must pay $50 an hour. If
the price drops to $45/hr, Tom would be able and willing to buy 2 hours per semester.
Thus, Tom would purchase more tutoring services if the price per hour drops.

Demand is an expression of consumer buying intention, of willingness to buy not a

statement of actual purchases. The demand curve is a summary of buying intentions.

Common feature of demand is that it has a downward slope(QD/P < 0)

↓ PCurrent  ↑QD
↑ PCurrent  ↓QD

This inverse relationship between the current price and quantity is called the law of
demand. Graphically, this is a movement along the demand curve. In the graph above,
if the price drops from say $50 to $30 the quantity demanded increases from 1 to 7
tutoring hours. Compaq used this law to increase computer sales in 2001. In the
holiday season people snapped a Compaq Presario computer priced at $1099 for
$699.

Other Determinants of Market Demand:

The simple demand schedule or curve has only one determinant which is the current
price. Other determinants of the standard demand include:

 Tastes (desire)
 Income (purchasing power)
 Price of related goods
 Expectations of future income, price and taste
 Number of buyers in the market.

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  Related goods: Include substitute goods (consumed instead of, say, tutoring in
web design), complementary goods (consumed with tutoring in web design).
 If the price of a substitute (e.g.,: Math tutoring and Scuba diving) for web-
design tutoring falls, the entire demand for web-design falls (or shifts down).
This is because other goods or services have become cheaper and they can be
substituted for web design tutoring. Then the entire demand for web design
tutoring shifts down.
 If the price of a complement (books, software …etc) to web design increases,
then the entire demand for web design declines.
 If the expected future price (Pe) for web-design, expected future income or
expected taste increases the entire demand increases.
 If the number of buyers increases, the market demand which is an aggregate
of individual demands in the market will increase.

Ceteris Paribus Assumption:

The simple demand schedule or curve, which depends only on the current price
and quantity, has a big assumption. This assumption is called ceteris paribus. It
means “nothing else other than the current price changed”. It is used to isolate
the effects of the “other determinants” on demand when the current price
changes.

Shifts in Market Demand:

If any of the so-called “other determinants” of demand changes then the entire
demand curve will shift up or down.

Suppose Tom’s income increases by $1,000 after he won the lottery. This means
his entire demand schedule will shift up if income increases (for a normal good).

QD (hours / semester)
Price Initial Demand New Demand
($/hour) (in hours) (in hours)
A $50 1 8
B 45 2 9
C 40 3 10
D 35 5 12
E 30 7 14
F 25 9 16
G 20 12 19

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The increase in income shifted market demand to the right; which is an increase in
demand.
This increase or the right shift in demand can also happen if:
 Taste increases.
 The prices of the substitutes for the web design increase
 If the prices of complements decrease.

Movements vs Shifts:

A movement along the demand curve is a change in the quantity demanded in response to
changes in the current price (slope). A shift in the demand curve is a shift in the entire
demand curve in response to changes in “other determinants” of demand.

Market Demand:

Market demand is the sum of individual demands. It is the total quantity of a good or
service consumers are willing to purchase at different prices in a given period.

Suppose there are three consumers in the market. The market demand is the sum of the
three quantities purchased by these consumers at each possible price.

Quantity Demanded by:

Price Tom George Lisa Market
($) (hours) (hours) (hours) Demand
50 1 4 0 5
45 2 6 0 8
40 3 8 0 11
30 5 11 0 16
30 7 14 1 22
25 9 18 3 30
20 12 22 5 39
15 15 26 6 47

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SUPPLY:
This is the other side of the market and it deals with producers or sellers of, say, the web-
design services.

 Market Supply: the total quantities (QS) of a good that sellers are willing and able
to sell at alternative prices (P) in a given time period, ceteris paribus. The
relationship is positive. Or QS/P > 0. Slope is positive.

↓ PCurrent  ↓QS, ceteris paribus. (That is, if current price goes down producers supply
less)

↑ PCurrent  ↑QS

 This means that slope of the market supply is positive. In other words, there is a
law of supply that parallels the law of demand. This law says that larger quantities
will be offered for sale at higher prices and vise versa.

Other Determinants of Market Supply:

These determinants change the entire supply curve:

 Technology: Improvement in technology enables sellers or producers to supply

the good or service easier and quicker. Then the market supply curve increases.
 Costs of factors of production: If labor, capital or materials cost of production
decreases the supply curve increases and shifts to the right because of increased
profitability.
 Prices of related goods: If other jobs or business offer better prices than web-
design, sellers of web-design will offer less web design services. The entire
supply curve for web-design services decreases.
 Taxes: An increase in taxes decreases the supply curve which shifts to the left.
 Expectation of a price change: The supply curve may increase or decrease if the
price is expected to increase in the future. It depends on storability of the good.
 Storable: (e.g., Oil) an expected increase in price of oil decreases the
supply curve because oil is storable and extraction can be reduced.
 Non-Storable: (e.g., Milk) an expected increase in price, increases the
supply curve. Here the producers can increase output easily and they want
to maintain market share. This is the standard case.
 Number of individual suppliers: The market supply is also an aggregate supply in
the sense that it is the sum of individual quantities supplied at each price during a
given time period, Ceteris Paribus. If this number increases then the aggregate
will increase, which means an increase in the aggregate supply.

Suppose there are three individual suppliers: Ann, Bob and Cory.

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 (Prices in the first column should be multiplied by 10 to be consistent with the
previous table. So $5.00 should be $50 and son on)

Shifts in the Market Supply (again): Graphs

Changes in the “other determinants” (other than the current price) of the market
supply shifts the entire supply curve.

 A decrease in any of the costs of production (labor, capital and materials

factor costs) or taxes, or an improvement in technology, or an increase in the
number of individual suppliers will shift the market supply curve to the right
(an increase in supply).
 If the good is non storable (milk), an increase in the expected future price will
also shift the supply curve to the right (an increase in supply

S1

S2
(Non
Storable)

QS

 If the good is storable (oil), an increase in the expected future price will shift
the supply curve to the left (a decrease in supply. See below)

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 P

S2

S1
Storable

QS
Thus, the impact of change in Pex on supply depends on good’s storability.

Market Equilibrium
Market equilibrium occurs at the intersection of market supply and demand (QS = QD)

Fig. 3.6: Equilibrium price and quantity

shortage = 47
(Prices should be multiplied by 10 to be consistent with previous tables)

If QS > QD , there is a market surplus= QS- QD

If QS < QD , there is a market shortage =QD - QS
If QS = QD , there is a market equilibrium = QD- DS = 0

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 (Equilibrium price Pe = $20 and equilibrium Qe = 39 units)

Changes in Equilibrium (within Supply/Demand framework):

If there is a change in one of the “other determinants” of supply or demand, there will
be a change in market equilibrium.

Suppose there is an increase in taste, or income, or prices of substitutes or expected

price. Then the market demand will shift up, leading to a new intersection or
equilibrium with the given supply.

Fig 3.7: Changes in Equilibrium

Both equilibrium quantity and price increase.

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MARKET (DIS)EQUILIBRIUM
There are two types of market dis-equilibrium (shortage or surplus): Price controls
(shortages) and Price floors (surpluses).

Price Control or Ceiling: Government’s intervention prevents the market price from
moving up to clear the market and achieve equilibrium. Thus PC < Pe ; where PC is the
ceiling price. Pc < Pe. Sometimes business impose price ceilings

D
P S

Pe
Shortage
PC

QSC Qe QDC Q

(Figure : Price ceiling)

Price controls such as rent controls lead to shortages because the controlled price is too
low.
Total shortages = QCD – QCS.
If these are apartments, then the total shortage can be divided into two parts:
Qe- QCS = # of existing apartments that are taken out of the market.
QCD – Qe = # of new apartments that are sought by new renters.
Shortages will need a rationing mechanism. (1) First come , first served; (2) California’s
government and gasoline rationing in 1979; (3) sports team and preferred customers with
season tickets at times of playoffs. For more information on ceilings see:
http://daphne.palomar.edu/llee/101Chapter08.pdf

How Do Businesses Deal with Losses Created by Price Ceilings?

Price ceilings provide a gain for buyers and a loss for sellers. Sellers would like to

avoid the loss if they can.

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 1. One way to do so is called a black market. In this case, the sellers illegally raise

the price and hope to get away with it. So, for example, tickets to popular events

are sold by scalpers at high prices. (In California, ticket scalping is not illegal if it

is not conducted at the place the event takes place.) While there are many other

examples, black markets are not smart; it is just too easy to be caught. It is also

not smart because of the existence of gray markets.

2. A gray market is a way of getting around the price ceiling without actually doing

anything illegal. There are two forms of gray market. (a) One form of gray

market involves charging for goods or services that were formerly provided free.

If the rent cannot be raised on the apartment, there is nothing preventing the

landlord from charging for the parking space, charging for use of the elevator,

charging for gardening and cleaning services, forcing the tenants to pay for

electricity and water, and so forth. In New York, a rent-controlled apartment near

Central Park might rent for $300 to $400 per month; in a free market, the rent

would probably be $2,000 per month. To get in, one needs the key. This has been

known to cost $1,000. This is not a refundable deposit; this is a charge to have the

key. It is obviously worth it to be able to rent the apartment for $300 to $400 per

month. A Berkeley apartment owner converted his apartment into a church. To be

able to live there, one had to pay church dues of $1,200 per year in addition to the

rent. Gasoline stations would commonly charge for washing the windows,

checking the tires, and so forth. The price of oil used in oil changes would be

raised. (Those having oil changes at the station were favored in access to gasoline

during the years of the price ceiling. In these years, Americans had the cleanest

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 engines in history.) Some gas station owners ran the line to the gasoline pump

through the car wash. One San Diego station forced people to have a $7 car wash

to get to the gasoline pump. ($7 in these years is the equivalent of about $20

today.). This practice was later declared illegal. (b) The second form of gray

market is to provide less service for the same price.

Numerical Example on Price Ceilings : (Rent control and shortages)

QD = 100 – 5P (where P is expressed in $100 but we ignore the zeros)
QS = 50 + 5P (where number of apartments is in 10,000 an zeros will be ignored).

a. Calculate market equilibrium

QD = QS
100 – 5Pe = 50 + 5 Pe
100 - 50 = 5Pe + 5Pe
Pe = 50/10
→ Pe = $5 (one hundred which is ignored) is the equilibrium price.

Plug = $5 into any of the two equations. Then Qe = 50 + 5*($5) = 75 apartments is

equilibrium quantity.

b. Assume ceiling PC = $1 (one hundred) as set by the gov’t. Calculate the total shortage.
QCD = 100 - 5PC = 100 – 5*($1) = 95 apartments

QCS = 50 + 5PC = 50 + 5*($1) = 55 apartments

D S
Total shortage = QC – QC = 95 – 55 = 40 apartments.

Price Floor or Support: The government sets the price floor (Pf ) above the equilibrium
price to support farmers’ income. Price support leads to surplus, which is usually
purchased by the government. Thus,
Pf > Pe
Because the intervention price (Pf) is set too high, there is a surplus of this agricultural
commodity.

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Sometimes manufactures imposes floors on the prices of goods sold at retailers such as
bookstores, music stores and so on. For more information, see :
http://daphne.palomar.edu/llee/101Chapter08.pdf

http://en.wikipedia.org/wiki/Price_floor

P
D
S
Surplus
f
P

Pe

QDf Qe QSf Q

S
Total Surplus = Qf - QfD For the price to stay at Pf the government must purchase the
surplus.

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Cost of purchasing the surplus is illustrated in the Figure above (A Price Floor).

The cost of purchasing the surplus = (amount of surplus)*(price floor).

Example:
Suppose price floor for corn is $4/bushel). Equilibrium price is #3/bushel
Quantity supplied at the price floor is 100 bushels, while the quantity demanded is 75
bushels. Calculate the cost of purchasing the surplus.

Cost of purchasing the surplus = Price floor*(QS-QD)

= $4*(100 -75) =$100 million.

How Do Businesses Solve the Surplus Problem?

There were many ways to solve the problem of surpluses.

1. Occasionally, a store simply broke the manufacturer's policy. The store

lowered the price to get rid of the surplus. The manufacturer had threatened that

the store would be prohibited from selling the manufacturer's product; the store

either believed that the manufacturer would not carry-out the threat or did not

care. For example, Crown Books began lowering the prices of its books and a

company called Discount Records began lowering the prices of phonograph

records.

2. More likely, stores would try to get around the price floor without actually

violating. (a) One common solution was to provide more service for the same

money. Stereo stores could add free CDs or other free accessories. Washing

machine stores used to virtually give away the dryer. Gas stations gave away

glasses, knives, and Blue Chip Stamps. (b) A second solution was to simply

absorb the surplus. Your textbook producers would have a surplus of textbooks.

At the end of each edition, the books would be returned to the publisher and the

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 paper was recycled. (c) A third solution was to change the name of the product

in order to reduce the price. Surplus gasoline was sold to independent dealers who

would sell it as Thrifty, 7-11, or Discount Gas at a lower price. Surplus liquor was

bottled with a different label and sold as Slim Price, or Yellow Wrap at a lower

price. Surplus washing machines and refrigerators were sold, for example, to

Sears and marketed as Kenmore at a lower price. When automobiles were fair-

traded, the dealers could not lower the price; however, they would give a trade-in

value that was much greater than the trade-in car was actually worth.

The main point here is that, even if someone interferes with the market process, there

are powerful forces to return to equilibrium

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 Chapter 5: Consumer Choice

DEMAND CURVE

One of the determinants of demand is taste or desire. We measure desires by the

pleasure, satisfaction or utility obtained from a good or a service.
The more we desire a good or the more utility we obtain from it, the more we are willing
to pay for it.

Total Utility Vs Marginal Utility

 Total Utility (TU): measures the satisfaction derived from the entire consumption
of a product. This could be the total utility from drinking three cups of
cappuccino. Total utility usually increases with additional amounts of a good
consumed. Then TU(3 cups) > TU(2 Cups). That is, total utility of consuming 3
cups is greater than total utility of consuming two cups … and so on.
 Marginal Utility (MU): The utility derived from the last or an additional unit is
called marginal utility.

Marginal Utility = Δtotal Utility / Δquantity

MU = ΔTU / ΔQ

Example:

Cups TU MU= ΔTU / ΔQ

0 0 -

1 50 (50-0)/(1-0) = 50

2 80 (80-50)/(2-1) =30

3 100 20

In this example, the utility derived from each additional cup/unit of cappuccino
consumed decreases as more units of a good are consumed. This is a universal
phenomenon and applies to many goods. Economists have fashioned a law around it, and
called the law of diminishing marginal utility. It states that each successive unit of a good
consumed yields less additional or marginal utility.

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Example: Eating Popcorn (boxes) at the Movies:

Boxes TU MU= ΔTU / ΔQ

0 0 -
1 30 30
2 50 20
3 60 10
4 65 5
5 65 0
6 62 -3

20 units of satisfaction under MU is the number of units of satisfaction derived from

consuming the 2nd boxt, 10 from the 3rd box and so on. From Box 1 to 4, MU is positive
and TU is increasing, at Box 5, MU = 0 and TU is flat. Finally at Box 6, MU is negative
and TU is decreasing.

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Price and Quantity:

MU is a measure of how much we desire particular goods (our taste). The more we desire
a good, the greater MU of each additional unit consumed of that good. In this case we are
willing to pay more for it. But since MU is diminishing as additional units of the good is
consumed, the consumers are willing to pay progressively less for additional quantities
of the product, given that income, tastes, prices of other goods are held constant (Ceteris
Paribus). This is the law of demand.

 Law of Demand: the quantity of a good demanded increases as its price falls
during a given time period, Ceteris Paribus.
 Demand Curve: A curve that describes the quantities the consumer is willing and
able to buy at alternative prices in a given time period, Ceteris Paribus.

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 Figure 5.3

Choosing Among Products

Consumer choice and Optimal consumption

Our analysis of demand has focused on the decision to buy a single product at different
prices. But consumer behavior is multi dimensional and involves buying more than one
product.
The basic objective is still the same: to maximize satisfaction or utility from our income.
The consumer choice that maximizes utility out of income builds on the theory of
marginal utility and the law of demand. Rational consumer behavior requires that we
compare the anticipated utility of buying each product with its price.
Suppose we have two goods: Coke, whose price is PCoke and marginal utility is
MUCoke; and video game with price PV and marginal utility MUV. Then we must
compare MU and the price for each purchase.

MUCoke / PCoke with MUV / PV

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In this case we are comparing units of utility per dollar for coke with units of utility per
dollar for video games.

If (MUCoke / PCoke) > (MUV / PV)

(anticipated MU per dollar for coke > anticipated MU per dollar for video game)

then the coke should be bought before the video game. This continues until

MUCoke / PCoke = MUV / PV

You should also check that Pcoke*Qcoke + Pv*Qv = I (expenditures = income).

Example: Two goods: coke and video game

Suppose PCoke = $0.50 and PV = $0.25 and Income = $3.00

Q TUCoke MUCoke MUCoke / PCoke TUV MUV MUV / PV

0 0 0 0 0 0 0
1 15 15 15/$0.5 = 30 (#3) 10 10 10/$.25= 40 (#1)
2 23 8 16 (#6) 19 9 = 36 (#2)
3 25 2 4 (#8) 26 7 = 28 (#4)
4 25 0 0 31 5 = 20 (#5)
5 22 -3 -6 34 3 = 12 (#7)
6 12 -10 -20 35 1 = 4 (#9)

(Note: The yellow table is reproduced in the table below it but with more details)

The consumer choice or optimal consumption that maximizes utility requires that:

MUCoke / PCoke = MUV / PV

N. 26
 4=4

(coke, video) = (3, 6) = consumer equilibrium

Check if this consumer choice (Coke =3, V=6) is affordable.

(PCoke* Coke) + (PV * V) = I
($0.5*3) + ($0.25*6) = $3.00

N. 27
 Chapter 6: Price Elasticity (% / %):
This elasticity measures by how much the quantity demanded would fall if the price
were raised or vice versa. Suppose the price increases by 10%, would the quantity
change by more or less than 10%? The elasticity answers this question.

Price elasticity of demand:

Elasticity = %ΔQ / %ΔP

= {(Q2 – Q1 )/Average Q)} / {(P2 – P1)/Average P)}

where Average Q = (Q1+Q2 )/ 2 , Average P = (P2+P1) / 2

Example: (calculate the midpoint price elasticity of demand)

P QD
$9 (P1 ) 15 Units Q1
7 (P2 ) 25 Q2

EPD = (Q2 - Q1) / ½(Q1 + Q2) = (Q2 - Q1) / average Q =

(P2 - P1) / ½ (P1 + P2) (P2 - P1) / average P

EPD = (25 - 15)/ ½ (15 + 25)

(7 - 9) / ½ (7 + 9)

= -2 (if the price increases by 10% percent, then the quantity decreases by 20%).

The price elasticity of demand is expressed as a positive number for convenience (not
compare negative numbers) but it is always negative.

Types of Elasticities: We use the absolute value of the elasticity (coefficient of

Elasticity)

 If EDP > 1 in absolute value (e.g., -1.5, -2.3, -3.4…etc) then the demand is
price elastic (the consumer is responsive to the price change).
 If EDP < 1 in absolute value (e.g., -0.33, -0.50, -0.76 …etc) then the demand is
price inelastic (the consumer is not very sensitive to the price change).
 If EDP = 1 in absolute value then the demand is price unitary elastic (%ΔQ =
%ΔP in absolute value).

N. 28
Table 6.1: Elasticity Estimates (remember: the demand elasticity is always negative)
There are positive elasticties which mean coefficient of price elasticity of demand.

Example:
Price elasticity of demand for the airline industry is -2.4 (p-elastic). How much
will the quantity drop %ΔQ if the price increases on average by 10% (i.e., %ΔP = 10%)?
Elasticity = EDP = %ΔQ / %ΔP = %ΔQ / +10% = -2.4.
Then %ΔQ =elasticity* %ΔP= -2.4* %ΔP = -2.4* 10%= -24%.

Demand for Popcorn:

Price Quantity Demanded
(Per Ounce) (Ounces Per Show)
A $0.50 1
B 0.45 2
C 0.40 4
D 0.35 6
E 0.30 9
F 0.25 12
G 0.20 16

Example: Let the price drop from $0.50 to $0.45 and quantity increases from 1 to 2
ounces.
P1 = $0.50 Q1 = 1 ounces
P2 = $0.45 Q2 = 2 ounces

Average P = (0.5 + 0.45)/2 = $ 0.475

N. 29
Average Q = 1.5 units

Calculate: EDP = (Q2 – Q1)/[( Q1 + Q2)/2] / (P2 – P1)/[( P1 + P2)/2]

In this definition, the two 2s cancel out. Then
EDP = [(2 -1) / ½*(1+2)] / [(0.45 – 0.50) / ½*(0.50 + 0.45)] or
EDP = (1/1.5) / (-0.05/0.475)
EDP = -0.6667 / 0.1053 = -6.331 (Price-elastic)

Next, suppose %ΔP = +10%. Then solve for %ΔQ by using the calculated elasticity:
%ΔQ = EDP * %ΔP
Then %ΔQ = -6.331*10% = -63.31% (quantity drops by more than 63 percent).
The consumer is highly responsive or sensitive to the change in the price.

Extremes of Elasticities
 If EDP = ∞, then the demand is perfectly price elastic. The demand curve would be
a horizontal line.
If P1 increases to P2 then quantity can decrease to zero. Or if price decreases,
quantity can increase to infinity.

 If EDP = 0 (that is, %ΔQ / %ΔP = 0/%ΔP), then the demand is perfectly price
inelastic. The demand curve would be a vertical line and the consumer is not at all
responsive to the change in price. An example of this case is the demand for heart
transplants. Demand for illegal drugs is almost perfectly inelastic.

Example: Domestic Rise in Youth Smoking (highly inelastic)

N. 30
 Youth
Smoking

Years
1971 1991 1992 1997 1998

Major explanation for the rise in youth smoking in 1990s was a sharp drop in cigarette
prices in the 1990, caused by a price war between the tobacco companies.

The two researchers Gruber and Zinman found that young people are relatively more
sensitive to the price of cigarettes (EDP = 0.7 for youth vs. 0.4 for adults). This means
that for every 10% drop in price, youth smoking rose by almost 7%, a much stronger
price sensitivity for youth smokers then for adult smokers.

N. 31
Determinants of Price Elasticity of Demand

Why consumers are more sensitive, in terms of changing quantity demanded, to the same
percentage change in price of airlines travel than to changes in price of gasoline. We must
look at the determinants of the price elasticity demand. Four determinants are particularly
important.

 Necessities Vs. Luxuries:

Necessities are goods to which we have a strong taste to have (e.g.; tooth paste,
shaving cream, salt … etc). Demand for necessities is relatively price inelastic.
Luxuries: are the goods we like to have, but can get by without them. Ex: vacation
travel, new cars. The demand for luxuries is relatively price elastic.
 Availability of substitutes: The greater the availability of substitutes for a certain
good, the more price elastic is the demand (compare Pepsi and gasoline).
 Relative price of a good to consumer income: The greater the ratio
(price/income), the more elastic the demand is. The ratio is high for vacation
travel and for new cars but low for salt.

Price Elasticity & Total Revenue

N. 32
 Total revenue of a seller = Price*quantity sold.
TR = ↑P * Q↓ (an ambiguous effect on total revenue because D has a negative slope).
If price increases, total quantity sold decreases because the demand has a negative
slope. What will happen to the demand curve? Will revenues increase or decrease?
The change in total revenue depends on the EDP.

P QD TR=P*Q EDP P and TR

($/Pack) (Packs) ($)
1 100 100 - -
2 90 180 Low (inelastic = -0.16) ↑P and TR↑
3 70 210 Low (inelastic = -0.63) ↑P and TR↑
4 50 200 High (elastic = -1.17) ↑P and TR↓
5 25 125 High (elastic) ↑P and TR↓
6 10 60 High (elastic) ↑P and TR↓
7 6 42 High (elastic) ↑P and TR↓

Changing Values of Elasticity along demand Curve:

Recall, EDP = (ΔQ/ΔP) * P/Q . The first part of the elasticity is the slope of demand with
respect to the quantity. The second part is the location of a point along demand curve. In
this case, elasticity can change along the curve if location changes.

Price Elasticity of Demand along a Linear Demand Curve.

The demand is unitary elastic around the middle of the demand line. It is elastic for
prices higher than the middle price, and inelastic for prices below the middle.

N. 33
Effect on TR if
Demand is Price increase Price reduction
Elastic(E>1) TR Decreases TR Increases
Inelastic(E<1) TR Increase Decrease
Unitary Elastic(E=1) TR Unchanged Unchanged

Other Elasticities:
The price elasticity of demand changes not only when the price changes along the
demand curve but also when there is a shift in demand.

Income Elasticities of Demand:

Suppose there is an increase in income. Given the same price, the demand curve shifts
out to the right as a result of the income increase.

EID = %ΔQD / %ΔI = (ΔQ/Average quantity) / (ΔI/Average income)

= (Q2 – Q1) / [( Q1 + Q2)/2] / (I2 – I1) / [( I1 + I2)/2]

Example: Suppose income increases and the price stays constant at $0.25 a unit.
Calculate the income elasticity of demand.

I QD
$110 12 ounces
$120 16

EID ={(16-12) / [½* (12+16)]} / {(120-110) / [½*(110+120)]}

EID = (4/14) / (10/115) = 0.286/0.087
EID = 3.2 (income elastic)

N. 34
An increase in income does not always shift the demand curve out or to the right. If the
good is normal, an increase in income shifts demand out. In this case, EID>0 or demand is
income elastic (example: designer clothes). This means if income increases quantity
demanded also increases.
If the good is inferior (EID < 0), demand shifts to the left. Inferior goods include discount
clothes, used books, used cars, cheap beer, and generic brands.

Cross Price Elasticity of demand

Demand and quantity demanded for good X can also change when prices of related goods
Y or Z change. There are two related goods: substitutes and complements.

The Case of Substitutes: Coke and Pepsi

The cross Elasticity of demand for coke when the price of Pepsi changes is:

Ep(Pepsi)Q(Coke) = (ΔQCoke /Average quantity of coke) / (ΔPPepsi /Average price of

Pepsi) >0

This means if the price of Pepsi increases, the quantity demanded of coke also
increases because the entire demand for Coke below shifts from R to F. The cross
price elasticity of demand for substitutes is positive.

Or in general, EpyQx = (ΔQx/average Qx)/(ΔPy/average Py) > 0 (substitutes). This is

infinity under perfect under perfect competition because the products are identical.

If the cross price elasticity of demand is negative the two goods are complements.

EQ(tea)P(sugar) = (%ΔQtea / %ΔPsugar) < 0

N. 35
Demand for teas below shifts to the right from F to R if price of sugar increases with no
change in price of tea.

N. 36
 Chapter 7: Costs of Production

The Production Function

Resources are used in producing goods and services. These resources are called factors of
production. The basic factors include land, labor and capital.
The costs of production are measured as the costs of those resources. To asses these
costs, we should know that given an amount of the resources, what is the best way of
producing a product? Or that’s the maximum amount attainable from a given quantity of
resources?
The answer to these questions is reflected in the production function. Thus this function
defines a relation between maximum amount of output for given amount of inputs,
holding technology constant. In this case, the production function represents maximum
technical efficiency.

Varying Input Levels:

Table 7.1 reports a production function for the Tight Jeans Corporation. The output is
pairs of jeans per day, and the inputs include workers (labor) per day and sewing
machines (capital) per day. If both labor and capital change freely without any amount is
fixed, we are in a planning period and the production function is in the long term.

Table 7.1: Production Function Schedule for Producing Pairs of Jeans

Both capital and labor are essential inputs for production. If sewing machines are zero,
then output is zero regardless of how many workers are used. Additionally, the output
(pairs of jeans) is zero regardless of how many sewing machines we rent.
If we use one worker per day and one machine per day the maximum attainable output
from this particular input combination is 15 pairs of jeans. If we employ two workers and
rent two machines per day, the total output is 46 pairs of jeans per day.

N. 37
Short-Run Production Function:
In the short-run, there are constraints on increasing certain inputs, particularly, capital. In
other words, there are constraints on capacity of facilities. In Table 7.2 the capacity
constraint is fixing the number of machines and moving row-wise. If sewing machines =
1, then increasing labor will give us a short-run production function associated with one
machine, and so on.

Fig. 7.1: Short-run Production Function

Along this short run production function, total output increases as input (workers)
increases until the 7th worker where output is flat. For workers = 8, total output declines.

Fig. 7.2: Marginal Physical Product:

Marginal Productivity

N. 38
Marginal productivity of labor is a movement along short-run production function.
Suppose the number of machines is fixed at one. Then the first worker adds 15 jeans to
total output per day. If we add a second worker, this worker increases total output by 19
jeans per day. This increase in productivity of the second worker is because of
specialization among the two workers. There is no difference in quality between the
workers. Thus, it does not mean that the first worker is lazy and the second worker is
more hard-working. If you reverse the order, you get the same productivity. This
productivity is called marginal physical product (MPP).
MPPL = Δ Total output / Δ Workers. For the 1st worker, MPPL= (15-0)/(1-0)=15 pairs.

There is a diminishing MPPL starting with the 3rd worker. This happened because of
facility constraint. There is a downtime when there are three workers or more with one
machine. This phenomenon of diminishing marginal product for labor (MPPL) happens to
many production processes in the short run when there is a facility or a short run
constraint. Then economists fashioned the law of diminishing returns to the single
variable input (labor) around it. This law is a short-run concept because capital is fixed.

Resource costs

The production function reports the maximum output attainable from a given amount of
resources. It does not tell us how much the firm wants to produce.
In order to determine the most desirable output (that output that maximizes profit), the
firm needs to know the economic cost or the resource cost of production.
In Table 7.1, the resource cost of producing jeans includes the physical amounts of labor,
denim, machines and land. We translate output data into related input (cost) data. For
example, if we use one worker a day to produce 15 pairs of jeans at point b then the labor
(resource) cost of producing one pair of jeans for the first worker is

Δ L/ Δ Q = (1-0)/ (15-0) = 1 /15 jeans = 0.067 labor units per one pair of jeans
Marginal Resource Cost (MRC= Δ Total resource cost / Δ output)

N. 39
How do input or resource costs change when output increases per one additional unit? In
Fig 7.3a, at point c, total output increases by 19 pairs when we hire an additional worker.
Then what’s the implied labor (resource) cost of producing one additional pair of jeans
when those additional 19 pairs produced by the second worker?

= Δ L/ Δ Q = (2-1)/ (34-15) = 1 / 19 labor units per one additional per of jeans

= 0.053
is the labor cost of that extra output (point 1/c in Fig 21.3b). Marginal resource cost (MC)
is the additional costs of resources ( in input units) from a change in output by an extra
unit. In general, for marginal resource cost
MC of resources = Δ Total resource cost / Δ output.
Suppose labor is the only variable input. Then the marginal resource cost of the
additional jeans is = (1 additional worker / 19 additional pairs) = 0.053 worker’s day per
pair (point c). Marginal labor costs of jeans production declines when the 2nd worker is
employed.

Fig. 7.3 (a and b): Fall MPP and Rising Marginal Cost

Diminishing marginal physical product implies increasing the labor cost of consecutive
workers. That is, the diminishing marginal productivity implies rising cost of each
additional worker which is called marginal cost (MC)

Summary of marginal resource cost

MC = Δ Total cost / Δ Output
MC of the added one paper of jeans associated with the 1st worker = Cost of 1st worker /
Δ output = 1 / 15 = 0.06 worker day per one pair.
MC of the added jeans associated with the 2nd worker = Cost of 1 additional worker / Δ
output = 1 / 19 = 0.053 worker day per one pair.
MC of the added jeans associated with the 3rd worker = 1 / 10 = 0.1 worker day
This is point 1/d in Fig 7.3
MC of the added jeans associated with the 4th worker = 1 / 4 = 0.25 of a worker day.

N. 40
It should be obvious that if there is a diminishing physical marginal product then there is
an increasing marginal cost. It means that at a certain worker level, each additional pair
of jeans becomes more expensive because it uses more labor than the one before it.

Dollar Costs
In calculating the dollar costs, we add up the market ($) values of all the resources we use
in production. In producing jeans we assumed to use a factory, sewing machines,
operators (workers) and bolts of (denim) jeans. These resources can be classified into two
types:

Fixed resources: The factory and sewing machines (do not change with output)
Variable resources: Operators and bolts of jeans (change with output).

The cost of fixed resources is called fixed costs (do not vary with output)
The cost of variable resources is called variable costs (vary with output)
Total cost is the sum of fixed costs and variable costs.

Example: (Table 7.2) suppose to produce 15 jeans per day the total cost includes:
Cost of factory rent $100 per day (Fixed cost)
Cost of one sewing machine rent $20 per day (Fixed cost)
Cost of one operator $80 per day (Variable cost)
Cost of 1.5 bolts of denim (1.5 * $30 a bolt) $45 (Variable cost)
Total cost of producing 15 jeans per day = $245.

(Footnote: One bolt of denim can make 10 jeans and costs $30).

The fixed cost (FC) to produce the 15 jeans is $120 per day and the variable cost (VC) is
$125 per day. Then the total cost (TC) is $245. What will happen to FC and VC if we
produce more than 15 pairs of jeans? FC does not change but VC will increase.

In the short run, total cost (TC) increases because variable cost (VC) increases as a result
of increases in output. Fixed cost (FC) does not change with output. Other examples of
FC are costs of a copy machine (not including ink and electricity), a school bus (not
including gasoline)

In short run, there is an upper limit on production of jeans, which is the capacity of the
factors. Once output reaches 51 jeans a day, adding more workers will make total cost
rise rapidly without any noticeable increases in output. Thus, there is no upper limit on
total cost of production. However there is a lower limit on total cost which is the fixed
cost.

N. 41
Fixed, Variable and Total Costs in the short run

Output Q (pairs) Fixed Cost FC ($) Variable Cost VC($) Total Cost TC ($)
0 pairs $120 $0 $120=FC
10 pairs $120 $85 $205
15 120 125 245 (example above)
20 120 150 270
30 120 240 360
40 120 ?= 470 -120 =350 470
50 120 ? = 670 -120 = 550 670
51 (max capacity) 120 753- 120 =633 753
47 120 (no limit)

Notice that TC + FC when output is zero. Then VC can be derived by subtracting FC

from TC. Note that TC = FC + FC or VC = TC -FC

Average Costs in the short run

These are costs per unit.

Average fixed cost (AFC)

AFC = Fixed cost / Total output

Fixed cost (FC) does not change with the level of total output. But the average fixed cost
(AFC) means dividing the fixed cost over more output units, which reduces the fixed cost
per unit. Examples, maintenance cost, property tax…etc AFC declines all the way as
output increases.

Average variable cost (AVC)

AVC = Variable cost / Total output

N. 42
AVC declines initially then it increases as output increases. The rise in AVC is due to
diminishing returns in production which happens because of facility constraints. This
happens at point k where output is 20 units in the figure below.

Average total cost (ATC)

ATC = Total cost / Total output
or ATC = AFC + AVC.

ATC is U–shaped because of the battle between the declining AFC and the declining and
rising AVC. Initially, both AFC and AVC decline, so does the ATC. Still the decline in
AFC dominates the rise in AVC, so ATC declines. Then later the rise in AVC dominates
the small decline in AFC, and ATC rises.

AVERAGE COSTS IN THE SHORT_RUN

Output Fixed AFC = Variable AVC = VC/Q Total cost ATC = TC/Q
(Q) Cost FC/Q Cost (VC) (TC)
(FC)
0 $120 $120/0 $0 $0/0 $120=FC 120/0
Pairs
10 120 120/10=12 $85 $85/10= 8.5 205 205/10=20.50
15 120 120/15=8 125 125/15=8.33 245 245/15=16.33
20 120 120/20= 6 150 150/20= 270 270/20=13.50
7.5=min AVC
30 120 120/30=4 240 240/30= 8.0 360 360/30=12.00
40 120 120/4 = 3 350 8.75 470 11.75 =min
ATC
50 120 120/50 = 2.4 ? = TC- FC 550/50=11.00 670 13.40
51 120 120/51=2.35 753-120=633 ? = VC/Q 753 ?

FC does not change with output but its AFC declines all the way.

VC increases with output, but AVC goes down for a while reaching a minimum at $7.5
per pair then it goes up and thus is U-shaped because the initial decline has to do with
increase in productivity due to specialization and then the later increase in AVC has to do
with downtime.

ATC is also U-shaped. It reaches it minimum at $11.75 per pair

N. 43
AVC reaches its minimum at an output level less than that corresponding to the min
ATC.

Marginal Cost
This is the cost of additional increases in the amounts of resources as output increases by
one extra unit.
There are a marginal resource cost and a marginal dollar cost. We can move from the
marginal resource cost to the marginal dollar cost by multiplying the amounts of the
resources by their corresponding prices.

Marginal resource cost:

N. 44
Recall an increase in output of jeans from 15 pairs to 16 pairs (an additional pair)
requires an increase in labor cost by 1 / 19 = 0.053 workers day and an increase in denim
cost by 1 / 10 = 0.1 bolt of one denim ( recall one bolt produces 10 pairs of jeans). There
is no change in fixed cost.

Resources used Market value of MC

per an additional pair resources
0.053 (worker/ day) $80 / worker a day 0.053*80 = $4.24
0.1 bolt of denim $30 / bolt 0.1*30 = $3.00

Marginal dollar cost in the short-run:

MC = change in total cost / change in total output. Or MC = ΔVC/ΔQ you get the
same marginal cost in the short run because FC will cancel out.

Output TC ΔTC/ΔQ = MC Output VC MC = ΔVC/ΔQ

0 $120 - 0 $0 -
P 10 205 $85 /10 =$8.5 10 $85 $8.5 = $85 /10
Q 15 245 40 / 5 = $8.0 15 125 $8.0 = 40 / 5
R 20 270 25 / 5 = $5.0 20 150 $5.0 = 25 / 5
S 30 360 90 / 10 = $9.0 30 240 $9.0 = 90 /10

Marginal cost decreases then starts rising. It crosses AVC and ATC at their respective
minimums.

N. 45
Economic Vs Accounting Costs
The distinction between economic costs and accounting costs is one between resource
cost and dollar cost. Dollar cost refers to actual dollar payments and thus are accounting
costs, while resource costs reflect the economic costs to the society whether it has cash
payments or not. Part of economic cost is imputed and the other part is actual payments.
In this case economic costs include accounting costs.

Examples of costs without cash payments include: self-employed labor, self owned
capital.

Accounting cost = explicit dollar costs

Economic cost = explicit dollar costs + implicit costs.
Economic cost = Accounting cost + implicit costs
Implicit costs are the costs of the self-employed labor, self-owned capital …etc.

N. 46
Economic Cost versus Accounting Cost
Accountants:
 Take a retrospective view of a firm’s finances
 Their purpose is to evaluate past performance
 Equate cost with actual expenses and depreciation expenses
 Depreciation expenses are calculated according to tax rules

Economists:
 Take a forward-looking view of the firm’s finances.
 Purpose to evaluate future profitability
 Equate costs with opportunity costs because the firm rearranges resources to
minimize cost and increase expected profitability. The cost = actual expenses +
opportunity costs of own time, money, materials and buildings.
 Depreciation expenses = actual wear or tear.

Example :

Owner/manager of a pizza restaurant in his/her own building

Accounting costs Economic costs

Owners/managers salary = 0 Owners / managers salary = opportunity cost > 0
Own building rent = 0 Own building rent = opportunity cost > 0
Workers wages > 0 Workers wages > 0
Cheese > 0 Cheese > 0
Flour > 0 Flour > 0
Other expenses > 0 other expenses > 0

Total accounting cost < Total economic cost

Total economic Cost = Explicit $ cost + Implicit cost

Explicit $ cost = accounting cost (out of pocket expenses).
Implicit cost = forgone own salary + forgone interest on own money + forgone own rent
In this case, the implicit cost is the sum of opportunity costs.

N. 47
Long Run Cost
The long run is a planning period during which the firm attempts to figure out the future
demand for its product. Capacity or size is not fixed in the long-run.
Once a firm chooses a fixed size, then there is a fixed capital, and hence there is a fixed
cost and the firm is operating in the short-run. Suppose the firm is considering three sizes:
Small Size with short–run ATC = ATC1
Mid Size with short– run ATC = ATC2
Large Size with short – run ATC = ATC3

If the anticipated demand is between 0 and point a, the firm should consider building a
small plant (size 1) because this is the size that gives the lowest possible cost per unit. If
the demand is between a and b it should consider the medium size with ATC2. If the
demand is expected to exceed b, then the firm should build the large size. In the long-run
the firm should consider building sizes with lowest possible cost per unit. The long run
ATC is the three solid portions of the three short run ATC’s.

Since the firm can build any size, then it is faced by infinitely many sizes with infinitely
many short run ATCs. These ATC’s can smooth out the long run ATC, which includes
only one point on each short run ATC. This point corresponds to the minimum ATC.

A Cost Summary

MC equals AVC when the latter is at its minimum. MC also equals ATC when the latter is
at its minimum.

N. 48
 ATC
MC AVC

Min
ATC

Min
AVC Output
MC goes through min AVC and min ATC.

Scale Economies
Scale economies include three types: economies of scale; no economies of scale (constant
returns to scale) and diseconomies of scale. This concept summarizes the relationship
between changes in output and changes in costs, and it is characterized by the shape of
the long-run ATC (LATC).

Suppose the desired output is a relatively large one such as level “QM” in the graph
below. This output level can be produced using several small plants or one large one.
Let ATCS represent the ATC for a typical small plant and ATCL be the ATC for the large
plant. How would the choice of plant size or scale affect costs? This has to do with scale
economies.

Case1: Economies of Scale

Suppose in this case the minimum ATC decreases as the plant size or scale increases as
shown in( Fig 7. 10 (b) middle graph).

N. 49
If the producer builds several small sized plants, the typical minimum ATC is min ATCS
at point c, and if it builds the large size plant the min ATC is min ATCL at point m2. In
this case as the plant size increases, min ATC decreases.

Min ATCS > Min ATCL

This implies that a producer who wants to minimize costs should build a large plant
rather than several small ones. In this case, economies of scale exist.

This type of scale economies is characterized by declining long run average cost.
Centralization of operations has a cost advantage in this case. Specialization also has a
cost advantage.

Case 2: No Economies of Scale or Constant Returns to Scale. In this case plant size
does not affect min ATC (Fig. 7.10 a). That is, the min ATCS at point c for any of the
small-sized plants equals the min ATCL at m2 for the large plant. For this case there is no
economic advantage to centralization of manufacturing operations by building a large
plant. This is the case of no economies of scale or constant returns to scale.

Thus: Min ATCS = Min ATCL

N. 50
 ATCL
ATCS

Min ATCS
= Min ATCL

Output
QM
FIG 7.10 a: Constant returns to scale (or no economies of scale)

This is the case of no economies of scale or Constant returns to scale. This type of scale
economies is characterized by constant long run ATC

LATC

LATC

Output
(constant returns to scale)

Case 3:Diseconomies of scale

Suppose that Min ATCL > Min ATCS
That is, as the scale or size increases the minimum ATC increases. That is, as the size
becomes large, the firm becomes large too.

N. 51
This is diseconomies of scale (Fig. 7.10.c)

ATCL

ATCS
Min ATCL

Min ATCS

Output
QM
Diseconomies of scale (Fig. 21.10 C)

In terms of long run ATC (LATC), the cost per unit increases as output decreases.

Description of Diseconomies of Scale in terms of the long-run ATC curve:

LATC

LATC

Output
(diseconomies of scale)

N. 52
Example: Determine the type of scale economies?
Output Total Cost LATC
10 Units $20 2
12 24 ?
15 30 ?

where LATC is the long-run average total cost.

Solution of the above example:

To determine the type of scale economies, calculate first the long-run average cost
(LATC = Total Cost/Output)

Output Total Cost LATC

10 Units $20 20/10=2
12 24 24/12=2
15 30 30/15=2

[LATC= (total cost /output) is constant, suggesting no economies of scale or constant

returns to scale]

Global Competitiveness
The US productivity is high relative to that of other countries because it depends
on the quantity and quality of the other resources used in the production process.
US workers work with vast quantities of capital and the state of art technology.
They also have more education than other workers. Their high wages reflect their
greater productivity.

Those two factors (productivity and wages) should be taken into account in
measuring international competitiveness of a country.

A measure of international competitiveness that uses both of these factors is called

the unit labor cost.

Unit labor cost = wage rate/MPPL

where MPPL is the marginal physical product of labor OR MARGINAL

PRODUCTIVITY.

Suppose MPPL of a US worker is 6 units of output per hour and the wage rate is
$12 an hour, then the unit labor cost would be

Unit labor cost = $12/6 = $ 2 per unit of output. Relatively lower unit labor
cost means greater global competitiveness.

N. 53
 http://krugman.blogs.nytimes.com/2010/02/06/spains-problem-
illustrated/

N. 54
 CHAPTER 8: The Competitive Firm

The Profit Motive:

The basic incentive for producing goods and services is profit.

Profit = total revenue – total costs.

Other motives may include worrying about social status or recognition.

Profit may encourage producers to produce the goods desired by the consumers and
provide it at reasonable prices. Profit may encourage producers to damage the
environment and produce inferior goods.

The typical consumer in the US believes that 35 cents of every sales dollar goes to the
product. In reality, average profit is 5 cents per sales dollar.

What’s the profit margin for Service Corp International (SCI)? What type of company is
SCI? 12 cents per one dollar of sales!

N. 55
Economic Vs Accounting Cost:
We use economic (resource) and accounting ($) costs to distinguish between accounting
profit and economic profit. To economists, total costs are economic costs which include
the explicit costs and the implicit non dollar costs. The implicit costs are the opportunity
costs of using self-owned labor, land and money.

Accounting costs = explicit dollar costs or $ costs

Economic costs = explicit dollar costs + implicit costs = resource costs

Economic Profits
As mentioned above, people have different views of total costs. To accountants, total cost
is explicit dollar payments. This is known as accounting cost.

Thus,
Accounting profit = total revenue – explicit costs
= total revenue – accounting costs

Economic profit = total revenue - explicit dollar cost - implicit costs

N. 56
 = accounting profit - implicit costs.
Suppose TR =$100, explicit cost is $60 million, implicit cost is $40 million. How much are accounting and
economic profits?

Thus if, implicit cost is included and is high, a positive accounting profit may turn into a
negative economic profit.

Table 8.1: Economic cost and computation of economic profit

Suppose an owner/ manager has a drug store. In this drug store, the owner works
10hrs/day, seven days a week for a total of 300 hrs/ month at $10 an hour. Then the
opportunity cost of working for him-self (monthly labor implicit cost or labor
opportunity cost) is $3,000 a month.

He has on his shelf an inventory of drugs that he bought with his own money. The drugs
on the shelf are worth $120,000. If he invests this money at 10% a year then the annual
opportunity cost of sacrificing return on own capital (yearly capital implicit cost) is
10% * 120,000 = $12,000 (yearly return on capital). The sacrificed monthly return on
self-owned capital is $12,000/12= $1,000 a month.

Total implicit cost = labor implicit cost + capital implicit cost

= $3,000 + $1,000
= $4,000 per month.

Suppose the following monthly explicit costs:

the cost of merchandise sold = $17,000. This is an explicit cost.
the wages and salaries = $2,500. This is an explicit cost.
the rent and utilities =$800. This is an explicit cost.
the taxes = $700. This is an explicit cost.

Than total accounting or explicit cost equals =17,000+2,500+800+700=$21,000.

N. 57
 Market Structure
The size of a company’s profit depends on the market structure in which it operates

A market structure is the number and relative size of individual firms in an industry.

Market Power and Market Structure

Monopoly Duopoly Oligopoly Monopolistic Perfect

Competition Competition

One Producer Two Producers Few producers

Homogeneous Product Many producers with Many Producers.
Or Differentiated Product Differentiated products homogeneous
Free entry/exit
Equilibrium Conditions:
MR = MC MR = MC MR = MC MR = MC P = MC
P=equation P=equation P=eq P=eq P=constant

N. 58
If the market structure is monopoly, then the firm is producing the entire supply of the
product and its product dose not have a close substitute. This is an extreme case.

At the other extreme is the case of perfect competition which is a market in which no
buyer or seller has market power because each is very small. Prices are constant.

In the US, there are 20 million businesses which fall between monopoly and perfect
competition.

The Nature of Perfect Competition

A perfectly competitive industry has several characteristics:
 Many small firms
 Identical or homogenous products (e.g. agricultural products).
 Very low barriers of entry (whether financial, legal or technological) to new firms
in a certain industry.

Small Firms:
The individual firm is very small relative to the market and it cannot influence the market
price. Thus in this case, the individual firm takes the prices as set by the market. Thus,
the implication of “smallness” is that the perfectly competitive firm is a price taker and
the price facing each firm is a constant.

The Production Decisions under Perfect Competition

Output and Resources:
Since the price facing the perfectly competitive firm is constant, the implication is that
the firm has the option of only determining the output level that maximizes profit.

Profit = Total revenue –Total cost = TR – TC

where
_
_
TR = P*quantity sold = P*q.
_
and the price P in this case is constant and q is variable.
Thus, the firm should select the quantity sold (q*) in order to maximize profit.

The total revenue curve (TR = P*q) is a straight line because the price is a constant and q
is variable (this is like Y = aX then graph for Y is a straight line starting from the origin).

N. 59
TR = Price*Quantity is a straight line because Price is a constant.

Slope of total revenue under perfect competition is the price (slope =MR=ΔTR/Δq = P).

Low Entry Barriers:

Basically there are no technological, legal and capital barriers to entry under perfect
competition. Thus entry which takes place when profit is positive is free. Entry shrinks
profit because supply curve shifts to the right and P decreases, decreasing TR.

Market demand curve Vs. Firm demand curve:

Under perfect competition, the firm is a price-taker. It cannot influence price regardless
of the level of its output. Thus the individual firm’s demand is a straight (horizontal) line.

On the other hand, collective action of all the firms in a specific market can influence the
price. Thus, the market demand is negatively sloped.

N. 60
Output and Costs:
The perfectly competitive firm in the short run has fixed costs and variable costs. The
typical total cost curve under perfect competition is an inverted S – curve (cubic eq.).

Eventually, total cost escalates due to the law of diminishing returns. The concave part in
TC curve signifies that at first total cost rises slowly or MC is declining and the convex
part implies that the cost increases rapidly later or MC is rising. Concave part in total cost
curve corresponds to convex production part in short run production function and vice
versa.
“Concave” means the variable increases at a decreasing rate, while “convex” means the
variable increases at an increasing rate.

Marginal Cost:

Recall, MC = ΔTC / ΔQ = Δ Total Cost / Δ Output

Profit Maximization

There are two approaches for profit maximization: The total approach and the marginal
approach.

 Total Approach: This approach pictures a profit or a loss as the difference

between TR and TC curves. To determine the maximum profit in the case of
profit, look for the maximum difference (Vertical distance) between TR and TC.
In the case of loss, look for the minimum loss or minimum difference between TC
and TR.

N. 61
At the beginning the firm experiences losses then it moves to economic profit, and then
back to losses.

The output that maximizes the profit difference between TR and TC, it is around point h.

Price Output (q) Total Revenue Total Cost (TC) Profit or loss
(1) (2) (TR) (3) =1*2 (4) (5) = (3) –(4)
$13 0 $0 $10 = FC $-10 loss
$13 1 13 15 -2 loss
$13 2 26 22 +4 profit
$13 3 =q* or 39 31 8 Max
$13 4 52 44 8 Max
$13 5 65 61 4

The output q* that maximizes the profit difference between TR and TC, is 3 or 4 units.

The marginal approach.

This approach compares the addition to TR with the addition to TC as output increases by
an extra unit each time. If the addition to TR exceeds the addition to TC, then the firm
should produce the extra unit (i.e., increase output). If the case is reversed, then the firm
should reduce output by an extra unit (i.e., reduce output). But if

Addition to TR = Addition to TC
Then the firm reached the maximum profit or the minimum loss and it should stop. This
is the equilibrium profit-maximizing output level. Note that

N. 62
Addition to TR = ΔTR / ΔQ and addition to TC = ΔTC / ΔQ when output changes
by one extra unit. Then equilibrium or profit-maximizing output is realized when:

ΔTR / ΔQ = ΔTC / ΔQ (this is the 1st profit maximization rule).

Marginal Revenue = ΔTR / ΔQ = ΔTC / ΔQ = Marginal Cost

Before we apply this rule, let us look at the relation between Price and Marginal
Revenue, and also calculate marginal cost.
Example 1:

Then under perfect competition P =MR. So the rule becomes P = MC

According to the marginal approach, profit is maximized when Q* = 4 baskets because

MR = MC (1st profit maximization rule)

$13 = $13

N. 63
since MR = Price under perfect competition, then the 1st profit maximization rule
can be rewritten as
P = MC
$ 13 = $13 which implies that Q* = 4

Sometimes we do not have equality between P and MC. Then in this case q* is
determined according to this rule
P > MC
P < MC
and q* is in between those two inequalities.

Example 2: Find profit-maximizing output q* (Check both rules). HERE P ≠ MC.

Price Output (q) MC TR= TC Profit or loss=

(1) (2) P*q TR- TC
$13 0 - 0 $10 =FC 0-$15 = - $10 (loss)

$13 1 $7 $13 17 -4
(P>MC)
$13 2 $10 $26 27 -1 loss
(P>MC)
$13 3 =q* or $12 $39 39 0 =normal profit
(P>MC)
$13 4 $17 $52 56 -4 loss
(P< MC)
$13 5 $30 $65 85 -$20 loss

Recall P =MR. P =13 > MC =12 when q =3units and P = 13 < MC=17. Then q*
=3 units
Let us examine the three cases related to positive and loss in the short-run.

Case 1: Positive Economic Profit (more than opportunity cost):

N. 64
 E
ATC
P D-curve
Profit
ATC* A
AVC
AVC B

Min AVC
MC

O
q*
Output
Case 1: One Firm’s Profit Maximization under Perfect Competition

Total Revenue = P*q* = O P E q*

Total Cost = ATC*q* = O ATC A q*

(total) Profit = TR – TC = ATC P E A

Variable cost = AVC B Q* 0
Fixed cost = AVC ATC A B

Profit per unit = = P – ATC = E – A

Profit per unit is also called the markup on cost per unit.
If profit per unit (P-ATC) is multiplied by the quantity produced (q*) then the result is
(total) profit.

(P-ATC)*q* = P*q* – q**ATC = TR – TC = total profit

Comparison between the total approach and the Marginal Approach

Profit under the total approach is a vertical distance between total revenue and total cost,
while in the marginal approach it is a rectangle. In the vertical approach at the vertical
distance:

slope of total revenue=slope of total cost

or MR = MC

as is in the marginal approach.

N. 65
The Shutdown Decision (in the short-run)
This is illustrated in terms of the second profit maximization rule.

The second profit maximization rule: The shutdown rule.

You check this rule only when the firm is making a loss. The first profit maximization
rule (P = MC) gives either the maximum profit or the minimum loss. If the firm is
producing at a loss, the firm profit maximization rule does not specify whether the firm
should produce or shut down (q* =0). The firm can produce (q*>0) while realizing a loss
in the short-run. However, it should compare the loss with the fixed cost.

 If loss < fixed cost, the firm should not shut down (it should produce, q*>0)
 If loss > fixed cost, the firm should shutdown (it should not produce, q*= 0)
The shutdown rule can also be cast in terms of the price (P) and the average variable
cost (AVC) by eyeballing without mentioning the fixed cost and the loss.

 If P > min AVC (then loss < fixed cost), then the perfectly competitive
firm should produce (q*> 0) in the short run.

 If P < min AVC (then loss > fixed cost), then the perfectly competitive
firm should shutdown (q* = 0) in the short run.

Case 2: Loss/no shutdown:

Example: P= $5, q* = 5 units, FC = $60, ATC = $15 and loss = $50. Since this firm is
making a loss, should it shut down? Loss=TR –TC= $5*5 - $15*5 = $50 < FC (no
shutdown because loss < FC) where TC = qxATC.

N. 66
 MC
Price
costs ATC

A AVC
ATC*
Loss
P E D-curve

AVC* B

Min AVC

O q*
Output
Case 2: Loss with no Shutdown: Price is above Min AVC (or loss < FC)

TC = O ATC* A q*
TR = O P E q*
Loss = [P ATC* A E ]
FC = AFC*q* = [AVC* ATC* A B] which is greater than the loss (no shutdown: loss <
FC). Also, compare P with min AVC*??? By eyeballing, price P is above AVC*.

N. 67
Case 3: Loss with Shutdown:

MC
Price
costs ATC

A AVC
ATC*
Loss
AVC* B
Min AVC
D-curve
P E

O
q*
Output
Loss with Shutdown: Price is below the Min AVC at Point B

TC = O ATC* A q*
TR = O P E q*
Loss = [P ATC* A E ] > FC = [AVC* ATC* A B]
Since the loss exceeds FC, the firm is better off to just accept to pay the fixed cost and
shutdown in the short run (q* = 0).

N. 68
Determinants of Supply (in the short run)
Since FC is fixed in the short run, production decisions are dominated by marginal costs.
Thus, the quantity supplied will be affected by all the forces that alter MC.

Thus, the determinants of a perfectly competitive firm’s MC or supply in the short-run

include:
 Prices of factor inputs or production costs (labor wage, capital rental price,
etc.)
 Technology (productivity)
 Expectation (perception of the future price)
 Taxes and subsidies (affects disposable profits)

These determinants shift the supply curve because they shift the MC curve.

Derivation of short-run supply curve under perfect competition:

Use the first rule only (no shutdown) if there is a positive profit. Use the two rules
if there is a loss. The first profit maximization rule says:

MC = P (or marginal profit = P - MC = zero). This rule is sufficient if the firm is making
a profit.

Thus, under perfect competition MC (=P) is the lowest or minimum price a firm will
accept to supply a given quantity of output. In this sense, the MC curve is the supply
curve for the perfectly competitive firm in the short run. Each time the price changes it
will intersect MC at a new point, and a new output q* will be chosen. In this case the
positive relation between MC and output is really a relation between P and output.
Therefore, the supply curve traces the MC curve.

To derive the supply curve we need to use the two rules if there is a loss.

From the 2nd profit maximization (shutdown) rule:

The firm shuts down or q* = 0 if P < min AVC (or loss > FC). Then the lowest point on
the MC curve is the one associated with the shutdown corresponds to min AVC. The other
points on the supply curve are associated with P being greater than min AVC. Thus, the
supply curve is the MC above the min AVC curve.

N. 69
 Supply Curve is
MC curve above
min AVC
MC

AVC

Min AVC

N. 70
 Chapter 9: Competitive Markets

The Market Supply Curve

We know that individual firm’s supply curve under perfect competition in the short run is
the MC curve above the min AVC. How about the market or industry supply curve
under perfect competition? It is the sum of the individual firms’ supply curves above their
min AVC curves. Suppose we have 3 farmers: A, B and C.

For each price, determine where the price P equals MC for each farmer. Then add up
horizontally the output levels for all farmers. This makes one point on the market supply.
Repeat this process for each price. Then connect the aggregate output points. This will
make up the market supply. If P = 3, the point on the market supply is =40+60+50=150.

Market Entry

Since entry barriers are low, if positive economic profit exists in the market then new
firms will enter the market. This will shift the market supply curve to the right and in the
Market supply/demand framework the market price will drop. The end result is that the
individual firm’s profit will shrink. This process of market entry will continue until
economic profit becomes zero (or normal economic profit pays all opportunity costs) in
the long run under perfect competition. In this case,

Normal econ profit = total revenue – explicit cost - implicit cost = 0

Or under zero or normal economic, accounting profit = implicit cost (owners/managers
just make their own opportunity costs) no more no less. But if there is positive economic
profit then those owners/managers make more than their opportunity costs. Positive econ
profit does not exist in the long-run under perfect competition. Must be zero.

N. 71
After entry, the supply-curve in the market graph shifts to the right, thus creating the new
equilibrium E2. As a result, the price drops from P1 to P2 and the positive econ profit
shrinks in the typical firm’s graph to the purple rectangle.

Entry will continue as long as economic profit is positive. It stops when it becomes zero
(normal econ profit). In this case, the price line will touch the ATC at its minimum (point
m in the individual firm’s graph). Since now we have

Min ATC = P (multiply both sides by q) then

ATC * q = P*q
or TC = TR or zero econ profit.

Or profit = TR – TC = 0 (normal economic profit in the long run under perfect

competition).

N. 72
 Industry Firm

D
P S
ATC

P P
Min
ATC

Q q
Q* q*

Long run equilibrium conditions under perfect competition:

1. MC = P.

2. P = min ATC (zero or normal economic profit)

N. 73
 Chapter 10: Monopoly

Market Power

Market power is the ability of the producer to alter the price of the product and have P >
MC. In chapter (8) for perfect competition, there are 2000 catfish producers. Under
perfect competition, the product is homogenous. No individual catfish producer has the
ability to alter price of catfish. The demand for this producer is a horizontal line. This
means the perfectly competitive producer is a price taker. The price is set by the market
which can alter the price and the firm is a price-taker.

If the perfectly competitive firm increases the price it would lose all its customers. Only
the firms collectively can change output and consequently the price.

Downward sloping demand curve:

If the firm has market power, then it can alter the price of its product without losing all its
customers because some customers will continue to buy. In this case, firms with market
power confront a downward sloping demand curve for their own output.

N. 74
 Price

d-curve

quantity

Figure: demand curve for firms with market power

Monopoly

The entire output in the market can be produced by a single firm. In this case, the firm is
a monopoly. So the monopolistic firm is the market. Therefore, the demand curve facing
the monopolist is identical to the market demand curve for the product, and thus has a
downward slope. The monopolist can be small (e.g. gas station in a remote) or large (like
PECO). It restricts output to jack up the price and make huge profit.

Price

$5

Demand curve for a monopoly

0
4 6 Q

Figure: Demand curve for monopoly

N. 75
Price, Marginal Revenue and Marginal cost

Marginal revenue is the contribution of the additional unit of output to the total revenue.
MR = Δ TR / Δ Output = (TR2 - TR1)/(Q2 - Q1).

If the demand curve is downward sloping then the contribution of each additional unit
and all the previous units decline as output increases.

Conclusion: Price is not constant and MR is lower than the price under monopoly.

MR < P and P is not a constant under monopoly.

Example: If price equation is P = 10 -2 Q and inverse slope is -2, then MR = 10 – 2*2Q

(slope of MR is twice the inverse slope of demand ).

N. 76
Graph P equation and MR equation.

Profit Maximization under Monopoly: Two Decisions

Therefore, the first profit maximization rule is expressed as

MR =MC  Q*  P*
This rule will determine producer’s equilibrium output q* and the price P*.

TR MR= TC MC= Profit=

Q Price
ΔTR/ Δ Q ΔTC/ Δ Q TR-TC
A 1 $13 $13 - $16 -
B 2 12 24 $11 > 21 $5
C 3 11 33 9 > 27 6
D Q*=4 P*=10 $40 7 = 34 7 $6=$40-$34
E 5 9 ? 5 < 44 10

MR = MC
$7 = $7
Then Q* = 4 baskets and P* = $10
Max profit = TR – TC = $40 – $34 = $6 or (another way):
= (Profit per unit)*Q* =(P* – ATC*)*Q*= P* – TC*/Q*)*Q*= (P* – 34/4) *Q*
= ($10 - $34/4)*4 = ($10 - $8.5)*4 = 1.5*4 = $6 where 8.5 = TC/Q=ATC.

Profit maximization under monopoly

TR = O P A q* = P*Q =$10*4 = $40

TC = O ATC* B q* = ATC*Q= $8.5*4 = $34

N. 77
Profit = P A B ATC* = $40- $ 34 = $6

Market Power at Work

Assume a mythical Universal Electronics has a patent on producing microprocessors and

thus constituting a monopoly. In this case, there is a legal barrier to entry (PATENT).

Assume for illustration purposes that this monopolist produces from plants which are
identical to the typical firm under perfect competition (this is not usually the case because
monopoly has larger sizes to generate economies of scale).

Suppose the demand facing the monopoly plant and the perfectly competitive firm is the
same.

Example: Figure 10.4 (Panel b: the market). The intersection of market supply and
demand determines the market equilibrium at point X for the competitive industry (D =
S). The market equilibrium price is $1,000 per computer and market equilibrium quantity
is 24,000 computers (Fig. 10.4).

Q*PC = 600 units, P*PC =$1,000 and ATC PC = $700. Market Q*PC = 24,00 units

Q*M = 475 units, P*M =$1,100 and ATC M = $630.All these numbers are assumed.

The perfectly competitive price per computer is $1000 and the competitive industry
produces 24,000 computers. In Panel (a) (the firm’s competitive equilibrium) the typical
competitive firm’s equilibrium (P=MC) is at point C and this firm produces 600
computers. All this information is assumed.

N. 78
For monopoly, in Panel (a) the monopoly equilibrium (MR = MC) is at point M. The
monopoly price is at point W ($1,100 per computer) on the demand curve. The monopoly
output for the typical plant is 475 computers.
Conclusions: The monopolist restricts output and charges a higher price than the
perfectly competitive firm.
P*M > P*PC ($1,100 > $1,000)
Q*M < Q*PC ( 475 units < 600 units)

In this case, monopoly aims at realizing a higher profit than perfect competition.

Question: 1. how many firms are in the perfectly competitive market? (Market output /
Firm’s output)
= 24,000 / 600 = 40 firms (not high enough for perfect competition)

Question 2. Does the monopolist prefer an elastic or inelastic demand? Elastic because if
demand is inelastic then MR is negative. Here is the relationship between MR and price
elasticity of demand: MR = P* [(1+EDp)/ EDp]. What would MR be if EDp = -1? -1/2? -2?

Reduced Output

Question 3. Why does monopoly restrict output in comparison to perfect competition?

The typical monopoly plant cannot produce 600 computers like the typical perfectly
competitive firm because at this output level, MR (at point B) is less than MC (at point C)
which means a loss for the typical monopoly plant. Thus this plant must reduce output to
475 computers because at this level MR = MC (at point M).

Monopoly Profit
Compare the monopoly plant’s profit with perfect competition firm’s profit.

Monopoly Plant’s total profit = TRM - TCM = [P*M *Q*M] – [Q*M * ATC*M]
= [$1,100 * 475] – [475 * $630] = $223,250

where $630 is the assumed monopoly plant’s ATC at point K and 475 is the equilibrium
output. We can calculate this monopoly plant’s total profit using the profit per unit
method.
Monopoly Profit per unit = P*M - ATC*M = $1,100 - $630 = $470.

Monopoly Plant’s Total profit = profit per unit * quantity

=(P*M - ATC*M) * Q*M
= ($1,100 - $630) * 475 = $223,250

N. 79
Figure 10.6: Competitive profit vs. monopoly profit for the entire company
(not just for one plant)

Competitive Profit
It is the area defined by [T, $1000, X, U] which is smaller than the profit purple area for
monopoly.

Competitive Firm’s short-run total profit = (P*PC – ATC*PC) * Q*PC

= ($1,000 - $700) * 600 = $180,000

The competitive firm’s long-run profit is zero (i.e., P = min ATC or TR = TC) because of
free entry (exit) which drives positive profit (loss) to normal economic profit

Competitive Firm’s profit per unit= (P*PC – ATC*PC) =$1000 -$700 = $300.

Barriers to Entry
The presence of positive economic profit whether under monopoly or perfect competition
would entice other firms to enter the market. Under perfect competition in the long run
high profits and low barriers to entry lure newcomers to this market, and this entry would
bring about an enormous expansion of output and a steep decline in the price. In Figure
9.6 the long–run equilibrium price for a competitive industry is at point V which
corresponds to where:

P = MC = min ATC (normal or zero economic profit in the long-run)

Profit per unit = P - ATC= 0. Output qc is much lower in the L/R than in the S/R after entry.

Under monopoly, our company Universal Electronics is assumed to have an exclusive

patent on microprocessor chips. This is a legal and a very high barrier to entry. In this
case, this monopolist can prevent a surge in output and this can keep the prices so high.

N. 80
Example of monopoly in live concert industry:
Clear Channel Entertainment and Ticket Master have controls on the live concerts. The
cost of a ticket for example to a Godsmack’s concert that was held in Verizon wireless
amphitheater (Irvine, CA) in the summer 2001 was $16.5. The monopolist added a 116%
market convenience fee, facility fee, handing fee and a parking fee to the cost of the
ticket, boosting the price to $ 35.60 a ticket. The monopolist jacks up the price to increase
profit.

N. 81
 Chapter 11: Oligopoly

Market Structure

There are two basic determinants of a market structure:

1. The number of firms in a product’s market.
2. The relative size of firms in this market (market concentration).

Monopoly and perfect competition are two types of market structure. The higher the
number of the firm and smaller the relative size of the individual firm, the closer the
market is to perfect competition and vice versa. Monopoly has one firm with one product.

Between those two market structures, there are many degrees of market power. To sort
these degrees out, we classify firms into five market structures: perfect competition,
monopolistic competition, oligopoly, duopoly and monopoly. If we exclude perfect
competition, we call the other four structures imperfectly competitive. Under imperfect
competition, the firm in a particular market has some degree of market power over prices
because of its differentiated product or its size relative to the overall market (or both).

Oligopoly is a market structure that yields a market power primarily because there are a
few firms controlling most of the output in the market. These firms could produce
homogenous product (example: the steel industry) or heterogeneous product (the airline
industry). In the long distance telephone service market, there are 800 firms supply this
service. But three of them (AT&T-MCI and Sprint merged?, Verizon) account for 74% of
all calls.

Determinants of Market Power

There are four determinants of market power:

1. Number of firms in the market.
2. Size of each firm in the market.
3. Barriers of entry.
4. Availability of substitute goods or product differentiation.
5. Production costs and technolog.

Quantitative Measure of Market Power:

Although there are four determinants of market power, one quantitative measure is
usually sufficient to gauge market power. The standard measure is the concentration
ratio.

Concentration Ratio: C4
This measure relates the size of few individual firms to the size of the overall market. It
tells the share of the largest few (usually four) firms relative to the total market.

0= <C4 = (S1 +S2 + S3 +S4)/ Total industry sales = (S1 +S2 + S3 +S4)/ ST =<1.

N. 82
where S1 is sales of the first largest firm in dollars, S2 sales of the second largest …etc
and ST is the total sales of all firms in the industry.

If C4 is close to zero it means that there are many small sellers in the market and the
market structure is close to perfect competition. If it is close 1, then …..?

Example 1: Suppose the industry has six firms and the sale of the firms from the largest
to the smallest are: $40, $30, $20,10, $5 and $5. Then

C4 = (40+30+20+10)/110=100/110 = 91%.

where ST = $110.

Example 2: suppose there are six firms and their sizes in dollars are:
$25, $25, $20, $15, $10 and $5. Here total sales ST = $100
C4 = (25+25+20+15)/100 = 85/100???

As indicated above, C4 is given by

C4 = (S1 + S2 + S3 + S4)/ST
which can be expressed in terms in terms of market shares:

C4 = (S1/ST) + (S2/ST) + (S3/ST) + (S4/ST) or

0 < C4 = w1 + w2 + w3 + w4 ≤ 1

where wi (i = 1,2,3,4) are the four firms’ market shares. If C4 is close to zero it indicates
there are many sellers, giving rise to much competition (see wood containers and pallets
in Table). If it is close to one, it implies little competition, see motor vehicles industry
and breweries.

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N. 84
(The above table came from another book)

Table 11.2 below (Market Power in US product markets) gives the concentration of
the market share accounted for by the largest four or less firms in a particular market.
In the baby food market and in the infant breakfast market, four firms or less in the each
of these markets control about 100% of the market. In the laser eye surgery two firms
control 100% of the market.

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APPENDIX

Measure of Industry concentration

There are two measures of share concentration: C4 and HHI. We discusse C4 above.

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The Herfindahl–Hirschman index (HHI)
This is the second quantitative measure of market concentration and this measure is used
in courts. Let firm i’s share of total industry output denoted by
wi = Si / ST
HHI is defined as the squared market shares of all firms in an industry.
HHI = [ {(w1)2 + (w2)2 + ….. +(wn)2 }*10,000]
The multiplication by 10,000 is to eliminate the need for decimals, squaring the shares
means giving higher weights to higher shares in the index.

0 < HHI ≤ 10,000

If HHI = 10,000 it means there is a single firm in the industry and w1 = 1. A value close
to zero means very small firms in the industry. The government cutoff point is for
concentration is 1,800. In this case, the industry is considered “highly concentrated” and
the Justice Department may challenge or block a horizontal merger if leads to an
increase in the HHI =  = [wi*wj]*10,000 by more than 100 points. However, the
Justice department permits the merger in industries that have high HHI if there is
evidence of significant foreign competition, an emerging new technology, increased
efficiency or when one of the firms has financial problems.
Industries with HHI below 1,000 are generally considered “unconcentrated” by
the Justice Department and mergers are usually allowed. If HHI is between 1,000 and
1,800 the Justice Department relies on other factors such as economies of scale.

Example:
Suppose an industry has three firms. The largest firm’s sales are $30 and the
remaining two have sales of $10 each. Calculate both the HHI and the four-firm
concentration ratio.
HHI = [ {(w1)2 + (w2)2 + (w3)2 }*10,000]
HHI = 10,000*[(30/50)2 + (10/50)2 + (10/50)2 ] = 4,400
Would the government challenge any potential merger in this industry? Yes?
Why? 4,400 > 1,800.

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The four-firm concentration ratio is:
C4 = (S1 + S2 + S3 + S4)/ST
C4 = (30+10+10)/50 = 1,
because the three firms account for all industry sales.

Oligopoly Behavior:
Assume that the initial condition in the fictitious computer market is that there are three
firms in this market: Universal Electronics, World Computers and International
Semiconductor.

Producer Output Market share

(Computers per month) (%)

Universal 8,000 40.0 =8,000/20,000

World 6,500 32.5
International 5,500 27.5

Total 20,000 100.00

Assume that the initial price is $1,000 per computer. The consumers are willing to buy
only 20,000 computers. This is the market demand at this price.

The Battle for Market Share

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Universal electronics can increase its market share by, say, 1,000 computers to increase
its sales from 8,000 to 9,000 computers. If total market sales stay at 20,000 computers per
month, then the other two firms will face a possible reduction in their market shares.

Universal can sell the 1,000 increase at either the existing price ($1,000 a computer) or
by reducing the existing price, say, to $900 per computer.

Case1: Universal Electronics is selling at existing price.

In the face of increase in production by Universal, the two other firms (World and
International) can defend their market shares by following two strategies:
 At the existing price, they may step up their marketing efforts to differentiate their
products (product differentiation strategy, i.e., nonprice competition strategy).
 They may cut prices on their computers (price competition strategy).

Product differentiation strategy may maintain the two firms’ market shares but cutting
prices may bring them more customers and could increase their market shares. Universal
will respond to cutting prices by lowering its own price to $900 per computer. This
means that the three companies become more competitive and there will be a downward
slide along the market demand. Now the initial situation has changed (see Figure 11.2).

Figure 11.2: Rivalry for the Market Shares Threatens an Oligopoly

Case 2: Universal Electronics is selling at lower price.

The other two firms will retaliate by cutting their prices if Universal Electronics lowers
its price to increase market share. In this case, the price slides downward along the
market demand as in Fig. 11.2.

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Accordingly, it is safe to conclude that an attempt by an oligopolist to increase its market
share by cutting prices will lead to a general reduction in the market price. The three
oligopolists will end up using price reductions as weapons in the battle for market shares,
the kind of behavior normally associated with competitive firms. This is why oligopolists
avoid price competition and instead pursue non-price competition (e.g., advertising,
product differentiation). See the In the News box “Pop Culture: RC Cola Goes for the
Youth market”. It spent $15 million on a new advertising campaign to cast its product as
the hip alternative to “corporate colas”. RC Cola also added new products.

The Kinked Demand Curve (Price Stability)

It is rational to assume that rivals do not match price increases. That is, if universal
decides to increase the price of its computer, it is reasonable to assume that World and
International will not match the price increase. On the other hand, it is rational to assume
that rivals will match price reduction. This rational assumption produces a kinked
demand curve for the oligopolist. This demand is a composite of two demand curves: the
no-match demand curve (d1) and the match demand curve (d2) in Figure 11.3.

Figure 11.3: The Kinked Demand Curve confronting an Oligopolist

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 Price D1
No Match

A
$1,000

Match

D2

Q
8,000

Kinked Demand Curve

Oligopoly Vs. Competition

We will consider two models of oligopoly behavior: sticky price (kinked demand) model
and the shared monopoly model.

The Sticky Price (kinked demand) Model:

In this oligopoly model prices are stable because oligopolists avoid starting price wars,
which will eventually destroy their oligopoly profits. (Coke Vs Pepsi in 1977). This
model is motivated by two assumptions. First, there is a common satisfaction with market
shares or trust among the oligopolists. Second, there is a cost cushion which will not
change the price if the cost changes within a specific gap. This gap is called the
“marginal revenue gap” which is created by the kinked demand curve.

The kinked demand curve is a composite of two demand curves: the no-match demand
curve (d1) and the match demand curve (d2). Corresponding to these demand curves,
there are two marginal revenue curves: MR1 which corresponds to d1 (segment SF) and
MR2 (segment GH) which corresponds to d2. At the kink point there is a MR gap between
MR1 and MR2, which the MR gap FG.

In this kinked demand model each firm starts down the demand curve (d1) and then
switches to demand curve (d2) at the kink point A. Correspondingly, we start from point
S on MR1 and slide down to point F, corresponding to our slide on d2 at point A, we slide

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on MR2 from G down to point H. Just below the kink, there is the MR gap FG. This gap
creates a cost cushion that leads to stable prices

Fig. 11.5: An oligopolist’s marginal revenue

.
If the MC curve passes through the MR gap, modest shifts, upward or downward, in this
curve will not change the industry price or the firms output. Fig.10.6 (the cost cushion)
shows the shifts in the MC1 curve to the MC2 and MC3 curves without a change in output
or price ( price stability). Recall, the 1st profit maximization rule requires that
MR = MC  q*  p*

Fig: 11.6: the Cost Cushion

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The Shared Monopoly Model:
The three oligopolists may want to coordinate decisions and act like a shared monopoly
because price competition would destroy their profits. For that to happen, the three
monopolists must have common view of total industry market demand, satisfaction of
market share and price coordination. In this case, they maximize joint total industry profit
and determine output and price like a monopoly.

This is they set: Industry MR = Industry MC  Q*  P*.

Here where industry demand = Industry supply determines the industry output Q* and
also the market price P*. Note that MC is the horizontal sum of all oligopolists’ MCs
which gives the industry or market supply.

Then they use the market shares to slice Q* among themselves to determine the
individual outputs.

Figure 11.4: profit Maximization under shared monopoly.

World view: “OPEC to cut output by 1 million barrels”. OPEC is an example of shared
monopoly.

Coordination Problem

Successful oligopoly will achieve monopoly-level profit if it solves the coordination

problem. This may not be easy.
1. Price fixing (e.g: laser eye surgery inflated price by $500 per eye). Price fixing
does not need agreements. It can be achieved by price leadership. Just follow the
leader in price!
2. Allocation of market shares (this transforms an oligopoly into a cartel).

N. 93
n

Game Theory

Game theory is used to explain oligopoly models because this market structure is
characterized by strategic interaction and interdependence between firms in the markets.

The game includes: players which are the firms, strategies which are plans of actions or
decisions, payoffs which are profits, and solutions. There are four types of solutions:
Nash equilibrium, cheating, collusion or cooperation and no Nash equilibrium.

Games can be played once (a one-shot game) and after that there is no future between the
payers or it can be repeated (a repeated game). The repetition of the game can be finite
with or without a known end and infinite with no end.

The Nash equilibrium or solution means the players have done their best and have
achieved their best payoffs. The players cannot improve their payoffs without hurting
other players. The Collusion or Cooperation solution does not exist in one shot games
because there is no future for the players play and cooperate. It can exist in infinitely
repeated games where future exists.

One-shot game means that the game is played one time only. So cheating is almost
certain in one-shot games because the game is over after it is played once, and the cheater
cannot be punished by the other player. In infinitely repeated games, the game is played
infinitely many times and the cheater can be punished in this came. This gives the players
incentives to collude or cooperate with each other without cheating.

A player can have a dominant strategy which gives him/her the highest payoff compared
to his/her other strategies, regardless of the strategies of the other player. If both players
have dominant strategies, those strategies will be a Nash equilibrium. If players have
dominant strategies, they tend to play those strategies.

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In the previous example about computer, the three oligopolists (Universal, World and
International) are not independent in their price and output decisions. They have to take
into account rivals’ reactions. Thus, in oligopoly there is strategic interaction among
firms. In our case, there are four strategic options that could affect gross profits (the
payoffs) in the industry. Suppose Universal is contemplating a price cut. It has four
options as seen below:

Player A is Universal and Player B is the rivals. The two off-diagonal cells are called the
cheating solution where in one of these cells Universal cheats while the rival does not,
resulting in huge gains for Universal and loss for the rival, and the opposite is true in the
other cell where the rival cheats and Universal does not. In the second diagonal cell, both
firms collude not to reduce the price. So this is the collusion solution in this cell which is
illegal. The first diagonal cell is called Nash equilibrium because you cannot make any of
the firms better off with hurting the other one.

Demonstration: Advertising and Dominant Strategies

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Firms advertise in order to entice customers from other competing companies.
Suppose there are two firms: A and B, and two strategies: to advertise or not to
advertise as illustrated in Table 11-3.

Table 11-3: An Advertising Game

Firm A Firm B
Strategy Advertise Do not
Advertise
Advertise $4,$4 $20,$1
Do not $1,$20 $10,$10
Advertise

For Player A to find her dominant strategy, she should move column-wise by fixing the
strategy of her rival in each column and find in each column which of her two strategies
gives the highest payoff. She repeats this process for each column. The strategy that
gives her the highest payoff in both columns is Player A’s dominant strategy.

For Player B to find his dominant strategy, he should move row-rise and find which of
his strategies gives the highest payoff in each row. Then he should find the best strategy
over the two rows.

The profit-maximizing strategies for both firms are to “advertise” to cancel each other
advertising out. These to-advertise strategies are dominant strategies for both firms. For
each player “TO ADVERTISE” brings more money than the “DO NOT ADVERTISE”,
regardless of what the strategy of the other player, because of cheating. Thus if both
“advertise” each will make $4. Note that if both collude and agreed to “Do not advertise”
each will make more money ($10). But collusion does not work in one-shot games. If one
cheats and “advertises” it will make $20 and the one that “did not advertise” will make
$1. In one-shot game, the game is over right after it is played and there is no chance for
punishment. So collusion or cooperation payoff ($10, $10) does not work. Here

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advertising brings more money. The advice is to advertise and those are the dominant
strategies for both player.

Try to move column-wise and find Player A’s dominant strategy.

Then move row-wise and find Player B’s dominant strategy.

Those two dominant strategies make up the Nash solution or equilibrium.

What if Player A has a dominant strategy and player B does not have a dominant
strategy, how should Player B play? Player B should assume that Player A will play her
dominant strategy and should take this dominant strategy as given. Then Player B should
select the strategy that gives him the highest payoff.

N. 97
Example: Player A has a dominant strategy which is “Up” but player B does not.

Table 10-1: A Normal Form Game

Player B

Player A
Strategy Left Right
Up 10,20 15,8
Down -10,7 10,10

Player B should assume as given that player A will play her dominant strategy. Then
player B should find the strategy that maximizes his payoff by moving row-wise given
the dominant strategy of player A. Then Player B should play “Left” when Player A
plays her dominant strategy “Up”. Solution is (Up, Left). In general, this situation
may or may not be a Nash equilibrium because it depends on the strategy player b
selects to maximize his payoff, given the dominant strategy of Player A.

What if Player B does not have a dominant strategy but Player A does. Suppose that
Player B is risk averse (does not go to Atlantic City because he avoids risk). Player
A will play her dominant strategy. But Player B will play a secure strategy. This is, a
strategy that is called a max-min strategy. That is, Player B will choose the worst
scenario first (min strategy), then he makes the best out of the worst scenario (max
strategy). This is not a Nash Equilibrium.

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Chapter 12: Monopolistic Competition

Examples: fast-food (McDonalds, Burger King, Wendy’s, etc.) , toothpaste (Colgate,

Crest, Close-up, etc.), soap ( Dove, Irish Spring, Olay, etc.), shampoo (Pantene, Salon

Selective, Perk, Paul Mitchell, etc.), cold medicine (Tylenol, Advil, Zicam), among

others. There are more than 400 brands of toothpaste and Colgate has about 40 brans

ranging from Shrek Fruit bubble to Colgate Total Advanced Whitening.

Brands of toothpaste: Crest, Colgate-Sub-brand of Colgate: Shrek Bubble Fruit

http://images.search.yahoo.com/search/images?_adv_prop=image&fr=ush_onnetwork_fp

&va=shrek+bubble+fuit

Characteristics:

Monopolistic competition has three key characteristics:

1) Each firm competes by selling differentiated products. The differentiated products
are highly substitutable but are not perfect substitutes like under perfect
competition (i.e. the cross price elasticity of demand between the products of the
firms is high but not infinite). Crest is different from Colgate, Aim, and Close-
up… etc. Therefore, because of differentiation there is consumer loyalty on part of
some consumers. Consumers are willing to pay 25¢ to 50¢ more (but may be not
a 1$). Therefore, Proctor &Gamble has some but limited monopoly power.
However, some of the customers may move to the substitutes. Therefore,
advertising is important under monopolistic competition.
2) The demand curve is downward sloping but is fairly price elastic. The demand
elasticity for crest is –7. Thus, because of its limited monopoly power, P&G
charges a price that is higher than marginal cost but not much higher.

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 3) There is free entry and exit. It’s easier to introduce, new brands of toothpaste than
to start new models of cars. The latter requires large capital and technology to
realize economies of scale. The free entry and exit implies that economic profit
under monopolistic competition is zero (normal).

Equilibrium in the short run and the long run: Like in monopoly, firms under
monopolistic competition have monopoly power and, thus, they face a downward
sloping demand curve. Therefore, MR < P. The profit maximization rule is
MR = MC.
In the short run the firm can earn a positive economic profit as shown below.

MC
ATC

P*
Profit $
ATC* DSR
MR = MC

Q*SR MR

Profit Maximization under Monopolistic Competition

If there is a positive profit there will be an entry into this market and prices should

drop. This will shift both demand and MR curves of the individual firm down, and

profit will shrink until it becomes zero as shown by the tangency between the new

inverse demand P and ATC curve (see next figure).

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 Effect of Entry on Monopolistically Competitive Firm’s Demand

Like in perfect competition, because of free entry and exit firms under monopolistic

competition earn zero economic profit in the L/R. The point where MR=MC should

correspond to the point where the demand curve is tangent to the ATC curve to

realize zero profit.

The Long run

The positive profit will induce entry by other firms who introduce competing brands.

The incumbent firm will lose some market share and the demand curve will shift

down. ATC and MC may also shift when more firms enter the market. Assume no

shift in those cost curves. The DLR will shift down until it becomes tangent to the long

run AC corresponding to where MR=MC. In this case the profit is zero. We have two

rules for the long run under monopolistic competition:

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 1. MR = MC (The 1st profit-max rule)

2. P = ATC > min ATC  zero profit (because R = TC). See figure below. This

condition is different from the long run condition for perfect competition P = min

ATC.

MC
AC

ACLR = P*LR

DLR
Q*LR MRLR

Long-Run Equilibrium under Monopolistic Competition

Implication of Product Differentiation: Advertising

As mentioned above, monopolistically competitive firms differentiate their products in
order to have some control over the price. In this case, the products are not perfect
substitutes, and this makes the demand less than perfectly elastic. The implication of this
is that some consumer won’t switch when the prices go up within a limit, while others are
willing to switch. To keep the other consumers from switching to the substitutes, firms
under monopolistic competition spend a lot of money on advertising. There are two kinds
of advertising under monopolistic competition.
1) Comparative Advertising: This involves campaigns designed to differentiate a given
firm’s brand from brands sold by competing firms. Comparative advertising is common
in the fast–food industry, where firms such as McDonalds attempt to simulate demand for

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their hamburgers by differentiating them from competing brands. This may induce
consumers to pay a premium for a particular brand. This additional value for a brand is
called brand equity.

2) Niche Marketing: Firms under monopolistic competition frequently introduce new

products. The products could be totally “new” or “new improved”. Firms can also
advertise a product that fills special needs in the market. This advertising strategy targets
a special group of consumers. For example “green marketing” advertise “environmentally
friendly” products to target the segment of the society that is concerned with the
environment. The firm packages a product with materials that are recyclable.

These advertising strategies can bring positive profits in the short–run. In the long–run
other firms will mimic their strategy and reduce profits to zero.

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 Chapter 12: Natural Monopolies
Regulation of Business

REGULATIONS vs. ANTITRUST

Ideal Situation: Laissez-fair (free market, no market power, perfect information of price,
output, cost, etc.)

- Efficient market outcomes (price, output, etc.)

- Maximizes social welfare

Reality: There is market Power (P > MC for all types of imperfect competition)

P >> MC (P is much higher than MC in the case of monopoly

V (leads to)

Market Failure (inefficient outcomes)

V (leads to)

Gov't interventions

Two Types of Gov’t intervention

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 Antitrust Laws Regulations
e.g., bust companies e.g., set price limits
etc

Antitrust Laws: focus on two areas:

i. Industry Structure ii. Industry behavior
Enhances competition at the expense Pricing behavior,
of monopoly advertising behavior,
merging & acquisition behavior

Regulations: focus on industry behavior:

Ex: limits on prices and output of public Public utilities are natural monopoly
utilities. (different from pure monopoly)

NATURAL MONOPLY

Examples: Public Utilities,

PECO,
NJ transit (mass transit) <-
These are characterized by:
- very high fixed cost (which implies very high AFC)
- Very low marginal cost (very little for adding one passenger/customer to VC of
Septa, for example)
- ATC=AFC +AVC is very high and declining because AFC is very high and
declining.

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(Please see Figure13.1 (not Fig. 12-1) in the book for more accuracy)

Hallmark of Natural Monopoly: Declining ATC or Economies of Scale

Economies of scale Means declining ATC at all output levels (or cost savings)

This implies that natural monopoly is desirable because of cost savings, but it's still a
monopoly. That is, it has a monopoly Power

Unregulated Natural Monopoly

It sets MR = MC.
This implies that P > marginal cost, which means monopoly profits
See Figure 13.2.

Consumers are not likely to reap any of the economic benefits if the natural monopolist is
left unregulated.

What to do? Don’t bust Natural Monopoly: Just regulate it.

Regulated Natural Monopoly

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There are three types of regulations. Each one of them has its own drawback because it is
inherently flawed of the natural monopolist will go around it
- Price regulations
- Profit Regulations
- Output Regulations

Price regulations:
 Efficient marginal cost pricing.
This means P = MC like under perfect completion. It yields efficient prices but it
can bankrupt the natural monopolist if the government forces it to set P =MC. In
this case
P < ATC or there is a loss per unit at this marginal cost pricing. Then the
taxpayers would have to give subsidy to this producer to make up for the loss.
Taxpayers are loath to subsidy private producers.

Point B in Figure 13.2.

 Efficient production pricing (P = min ATC).

Point C in Figure 13.2

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