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BASIC ECONOMICS

WITH TAXATION AND


LAND REFORM
SS103
DEFINITIONS OF ECONOMICS
It is the study of how society allocates
scarce resources among their alternative
uses in order to satisfy human wants and
needs.
It is a social science that deals with scarce
resources and unlimited human wants.
It is a social science that seeks to describe
the factors which determine the
production, distribution and consumption of
goods and services.
The word economics comes from the Greek
word oekonomia, which means management of
the household ( any social grouping).
In a broad sense, economics can be defined
as a social science that studies and seeks to
allocate scarce human and non-human
resources among their alternative uses in order
to satisfy unlimited human wants and desires.
It is study of the efficient allocation of scarce
resources.
LET US STICK WITH ONE
DEFINITION!
ECONOMICS IS A BRANCH OF SOCIAL
SCIENCE WHICH DEALS WITH THE
STUDY OF EFFICIENT ALLOCATION OF
LIMITED RESOURCES TO SATISFY
MANS UNLIMITED NEEDS AND
WANTS.
WHY DO YOU NEED TO
KNOW?
FOR FURTHER READING
http://www.elearnportal.com/courses/b
usiness/principles-of-finance/princip
les-of-finance-role-of-economics-and-
accounting-in-finance
- FOR ACCOUNTANTS
http://www.jstor.org/stable/182313
9?seq=1#page_scan_tab_contents
FOR ENGINEERS
http://www.philosophersbeard.org/201
1/10/art-of-business-and-science-of.
html
ROAD MAP
ORIGIN OF ECONOMICS
INTIINDIHIN MOKO
KUNG SAAN AKO
NANGGALING
PARA MALAMAN
MO KUNG SAAN
AKO PATUNGO.
POST KEYNESIANS

JOHN HICKS
IS/LM

INVESTMENT
SAVINGS /
LIQUIDITY
MONEY SUPPLY

CONSUMER
DEMAND THEORY
MODERN ECONOMY
RESOURCE
https://www.youtube.com/watch?v=
3_lmd4XH-a4
BREAK
BRANCHES OF ECONOMICS:
MICROECONOMICS AND
MACROECONOMICS
V.S.
ECONOMIC WAY OF
THINKING???
FIND A SOLUTION, THINK LIKE AN
ECONOMIST. FIGHT SCARCITY.
ROLE OF MARKET IN ALLOCATION
OF RESOURCES
PLACE OF
TRANSACTION
WHERE BUYERS
AND SELLERS
MEET
SCARCITY
Scarcityis the fundamental
economic problem of having
seemingly unlimited human wants in
a world of limited resources. It states
that society has insufficient
productive resources to fulfill all
human wants and needs.
SCARCITY is the term economists use to
describe the phenomenon that people want
more of a commodity than is freely available.
Commodities include the physical goods
(automobiles, houses, and handbags) and
services (haircuts, airplane rides, and lawn
mowing) that households buy. Commodities
also include resources such as peoples work
effort, raw materials, and the land that is
used to produce the households products.
PRODUCTION POSSIBILITIES FRONTIER identifies
the combinations of commodities that may be produced from
scarce resources.
Movement along the production
possibilities illustrates a trade-of
between commodities.
Remember opportunity cost.
SOURCE
http://agr.mt.gov/agr/Programs/AgCl
assroom/LessonPlans/4-6/pdf/Economi
cs_x_Ag/Scarcity.pdf
FACTORS OF PRODUCTION ARE THOSE RESOURCES
WHICH ENABLE MAN TO PRODUCE GOODS AND
SERVICES.
LAND - Good quality and availability of land and
water resources is essential to food security.
LABOR refers to productive human effort.
CAPITAL resources include wide variety of
production equipment from simplest tool to the
most powerful computer network and from the
smallest storage shed to the largest factory or office
or building.
ENTREPRENEUR The inputs of manpower,
materials, machineries and money do not by
themselves ensure growth; they become productive
through the catalyst of management.
SCARCE RESOURCES. WHY?

DEMOGRAPHIC
PRESSURES
CLIMATE CHANGE
INCREASED
COMPETITION IN
LAND AND WATER
FINANCIAL CRISIS
HIGH CRIME RATES
POOR
MANAGEMENT
LACK OF
QUALIFICATIONS
OFWS
LACK OF
ENTERPRENEURAL
SKILLS
SOURCES
http://www.ijhssnet.com/journals/Vol
_4_No_6_April_2014/16.pdf
http://www.cfee.org/en/pdf/labourstu
dent1.pdf
http://www.fao.org/docrep/017/i1688
e/i1688e.pdf
http://www.henrygeorge.org/pdfs/dec
ons.pdf
REMINDER
DO NOT JUST RELY ON THE POWER
POINT.
READ LIBRARY BOOKS AND VISIT THE
NET.
BY THIS TIME, EVERYONE SHOULD
HAVE ALREADY CHOSEN an
ECONOMIST. (LOCAL or FOREIGN)
FORMAT
Title Page
Introduction ( this should explain why you have
chosen your economist )
I. Biography with picture
II. Background in Economics ( how and why he
became an economist )
III. Works and Publications ( it should have a
summary and discuss how it contributed to the
study of economics and how it helped the society
)
IV. Summary
ROAD MAP
The allocation of scarce resources takes place
largely in the market which is not so much a place
as an arrangement between people wanting to sell
goods or services and those who want to buy from
them and who have agreed means of exchange,
such as money. The market is governed by the
laws of supply and demand. Supply is the amount
of a commodity that producers will supply at a
certain price and demand is the amount people are
willing to buy at a given price. Producers can be
put an accurate price on the goods they sell by
analysing supply and demand.
HOW DO WE ALLOCATE OUR
LIMITED RESOURCES?

INVISIBLE HAND THEORY -


A MARKET ECONOMY
THROUGH PRICE MECHANISM
WILL ALLOCATE RESOURCES
EFFICIENTLY. ALWAYS
OPERATING

THE REST CAN BE


CONTROLLED
Economics, Scarcity, and
Choice
Economics
Study of choice under conditions of
scarcity
Scarcity
Situation in which the amount of
something available is insufficient to
satisfy the desire for it

44
Scarcity and Individual
Choice
Unlimited variety of scarcities, based
on two basic limitations:
1. Scarce time
Limited number of hours in each day to
satisfy our desires
2. Scarce spending power
Cannot afford to buy more of the things
we want

45
Scarcity and Individual
Choice
Limitations force each of us to make
choices
Economists study
Choices
Consequences of those choices
Indirect effects of individual choice on
our society

46
Scarcity and Social Choice
Society faces a scarcity of resources
Categories of resources:
Labor
Capital
Human capital
Capital stock
Land/natural resources
Entrepreneurship

47
Scarcity and Economics
Problems studied in economics: the
scarcity of resourcesand the
choices it forces us to make
Households have limited income to
allocate among goods and services
Firms production is limited by costs of
production
Government agencies the budget is
limited, so goals must be carefully
chosen

48
Scarcity and Economics
Economists study the decisions made
by households, firms, and
governments to
Explain how our economic system
operates
Forecast the future of our economy,
Suggest ways to make that future even
better

49
Microeconomics
Micro comes from the Greek word
mikros, meaning small
Studies the behavior of individual
households, firms, and governments
Choices they make
Interaction in specific markets
Focuses on individual parts of an
economy

50
Macroeconomics
Macro comes from the Greek word
makros, meaning large
Studies the behavior of the overall
economy
Focuses on big picture and ignores
fine details

51
Positive and Normative
Economics
Positive economics: how the
economy works
Can be true or false
Can be tested by looking at the facts
Normative economics: what should
be
Value judgments, identify problems, and
prescribe solutions
Cannot be proved or disproved by the
52
facts alone
Why Economists Disagree
The difference of opinion may be
positive in nature
Facts are being disputed
The disagreement can be normative
Facts are not being disputed
When economists have different
values, they may arrive to different
conclusions
Disagreement - over goals and
53
values
Why Study Economics
To understand the world better
Global events and personal phenomena
To achieve social change
Understand the origins of social
problems
Design more effective solutions

54
Why Study Economics
To help prepare for other careers
A wide range of careers deal with
economic issues on many levels
To become an economist
Develop a body of knowledge that could
lead you to become an economist in the
future

55
The Methods of Economics
Use economic models to develop
economic theories
Economic models are built with
words, diagrams, and mathematical
statements
Economic models
Abstract representation of reality
Should be as simple as possible to
accomplish its purpose
56
ECONOMIC SECTORS
1. HOUSEHOLDS
2. BUSINESS FIRMS
3. GOVERNMENT/PUBLIC SECTOR
4. EXTERNAL SECTOR
ECONOMIC PROCESSES AND
ECONOMIC QUESTIONS
1. What is to be produced?
2. How much is to be produced?
3. How is it to be produced?
4. Who is to receive the goods/service
produced?
5. How should the system be adaptive
to change?
ECONOMIC GOOD vs FREE
GOOD
Free Goods and Services are those
that can be demanded without the
need for a monetary exchange
Exchange Goods are scarce, those
that demand monetary exchange
CIRCULAR FLOW OF GOOD AND
SERVICES
Circular flow in final goods and services model
illustrates how the transfer of goods and
services can be facilitated through the
linkages with the different sectors comprising
the economy.
- All sectors configure to maintain and sustain
exchange activity
- Observe how the economy can attain the
maxim that Total leakages must equal total
injections.
THE CIRCULAR FLOW in a TWO-
SECTOR MODEL
Economic Models: Assumptions and
Conclusions

Two types of assumptions:


Simplifying assumptions
Essential features can stand out more
clearly
Critical assumptions
Affect the conclusions of a model in
important ways
If critical assumptions are wrong, the model
will be wrong

62
The Three Step Process
Economists follow the same three-
step process to analyze almost any
economic problem:
The first two steps explain how
economists build an economic model
The last step explains how they use the
model.

63
Math, Jargon, and Other Concerns

Economic jargon
Special words that allow economists to
more precisely express themselves
Math
High school level algebra and geometry
We will covers some of the basic
math concepts that you will need
tomorrow

64
DEMAND

VS
DEMAND
THE LAW OF DEMAND

PRICE FALLS

Ceteris Paribus

PRICE RISES
METHODS OF DEMAND
ANALYSIS
DEMAND SCHEDULE - Information provided by a
demand schedule can be used to construct a demand
curve showing the price-quantity demanded
relationship in graphical form.

Example: Hypothetical Demand Schedule for Rice Per Month.

SITUATION PRICE P/kg QUANTITY (kg)


A 35 8
B 24 13
C 13 20
D 11 45
DEMAND CURVE
Demand Curve is a graphical
representation showing the
relationship between price and
quantities demanded per time
period.
DEMAND FUNCTION
Qd = quantity demanded at a particular pric
a = intercept of the demand curve
b = slope of the demand curve
P = price of the good at a given particular pe

= -
Road Map
The Basic Decision-Making
Units
A firm is an organization that transforms
resources (inputs) into products
(outputs). Firms are the primary
producing units in a market economy.
An entrepreneur is a person who
organizes, manages, and assumes the
risks of a firm, taking a new idea or a
new product and turning it into a
successful business.
Households are the consuming units in
an economy.
The Circular Flow of Economic
Activity

The circular flow of


economic activity
shows the
connections between
firms and
households in input
and output markets.
Input Markets and Output
Markets
Output, or product,
markets are the
markets in which goods
and services are
exchanged.
Input markets are the
markets in which
resourceslabor,
Payments flow in the opposite
direction as the physical flow of
capital, and landused
resources, goods, and services to produce products,
(counterclockwise). are exchanged.
Input Markets
Input markets include:
The labor market, in which households
supply work for wages to firms that demand
labor.
The capital market, in which households
supply their savings, for interest or for
claims to future profits, to firms that
demand funds to buy capital goods.
The land market, in which households
supply land or other real property in
exchange for rent.
Determinants of Household Demand
A households decision about the quantity of a particular output to demand
depends on:

The price of the product in question.


The income available to the household.
The households amount of accumulated
wealth.
The prices of related products available
to the household.
The households tastes and preferences.
The households expectations about future
income, wealth, and prices.
Quantity Demanded

Quantity demanded is the


amount (number of units) of
a product that a household
would buy in a given time
period if it could buy all it
wanted at the current
market price.
Demand in Output Markets
ANNA'S DEMAND
A demand
SCHEDULE FOR schedule is a table
TELEPHONE CALLS showing how much
QUANTITY of a given product
PRICE DEMANDED
(PER (CALLS PER a household would
CALL) MONTH) be willing to buy at
$ 0 30
0.50 25 different prices.
3.50 7
7.00 3
Demand curves are
10.00 1 usually derived
15.00 0
from demand
schedules.
The Demand Curve
ANNA'S DEMAND
SCHEDULE FOR
The demand curve
TELEPHONE CALLS is a graph illustrating
QUANTITY how much of a given
PRICE DEMANDED
(PER (CALLS PER product a household
$
CALL)
0
MONTH)
30
would be willing to
0.50 25 buy at different
3.50 7
7.00 3 prices.
10.00 1
15.00 0
The Law of Demand
The law of demand
states that there is a
negative, or inverse,
relationship between
price and the quantity
of a good demanded
and its price.

This means that


demand curves slope
downward.
Other Properties of Demand Curves

Demand curves intersect


the quantity (X)-axis, as a
result of time limitations and
diminishing marginal utility.
Demand curves intersect
the (Y)-axis, as a result of
limited incomes and wealth.
Income and Wealth

Income is the sum of all


households wages, salaries, profits,
interest payments, rents, and other
forms of earnings in a given period
of time. It is a flow measure.
Wealth, or net worth, is the total
value of what a household owns
minus what it owes. It is a stock
measure.
Related Goods and Services

Normal Goods are goods for which


demand goes up when income is
higher and for which demand goes
down when income is lower.
Inferior Goods are goods for which
demand falls when income rises.
Related Goods and Services

Substitutes are goods that can


serve as replacements for one
another; when the price of one
increases, demand for the other goes
up. Perfect substitutes are
identical products.
Complements are goods that go
together; a decrease in the price of
one results in an increase in demand
for the other, and vice versa.
Shift of Demand Versus Movement Along a
Demand Curve

A change in demand is
not the same as a change
in quantity demanded.
In this example, a higher
price causes lower
quantity demanded.
Changes in determinants
of demand, other than
price, cause a change in
demand, or a shift of the
entire demand curve, from
DA to DB.
A Change in Demand Versus a Change in
Quantity Demanded

When demand shifts to


the right, demand
increases. This causes
quantity demanded to be
greater than it was prior to
the shift, for each and
every price level.
A Change in Demand Versus a Change in
Quantity Demanded
To summarize:

Change in price of a good or service


leads to

Change in quantity demanded


(Movement along the curve).

Change in income, preferences, or


prices of other goods or services
leads to

Change in demand
(Shift of curve).
The Impact of a Change in
Income
Higher income Higher income
decreases the demand increases the demand
for an inferior good for a normal good
The Impact of a Change in the
Price of Related Goods
Demand for complement good
(ketchup) shifts left

Demand for substitute good (chicken)


shifts right

Price of hamburger rises


Quantity of hamburger
demanded falls
From Household to Market Demand

Demand for a good or service can


be defined for an individual
household, or for a group of
households that make up a market.
Market demand is the sum of all
the quantities of a good or service
demanded per period by all the
households buying in the market for
that good or service.
From Household Demand to Market
Demand
Assuming there are only two households in the
market, market demand is derived as follows:
Supply in Output Markets
CLARENCE BROWN'S A supply schedule is a table
SUPPLY SCHEDULE showing how much of a product
FOR SOYBEANS
firms will supply at different
QUANTITY
SUPPLIED prices.
PRICE (THOUSANDS
(PER OF BUSHELS Quantity supplied represents the
BUSHEL) PER YEAR)
$ 2 0 number of units of a product that
1.75
2.25
10
20
a firm would be willing and able to
3.00 30 offer for sale at a particular price
4.00
5.00
45
45
during a given time period.
The Supply Curve and
the Supply Schedule
A supply curve is a graph illustrating how much
of a product a firm will supply at different prices.
CLARENCE BROWN'S 6

Price of soybeans per bushel ($)


SUPPLY SCHEDULE
FOR SOYBEANS 5
QUANTITY
SUPPLIED
4
PRICE (THOUSANDS
(PER OF BUSHELS
3
BUSHEL) PER YEAR) 2
$ 2 0
1.75 10 1
2.25 20
3.00 30 0
4.00 45
5.00 45 0 10 20 30 40 50
Thousands of bushels of soybeans
produced per year
The Law of Supply
6 The law of
Price of soybeans per bushel ($)

5 supply states that


4 there is a positive
3
relationship
2
between price and
1
0
quantity of a good
0 10 20 30 40 50 supplied.
Thousands of bushels of soybeans
produced per year This means that
supply curves
typically have a
positive slope.
Determinants of Supply
The price of the good or service.
The cost of producing the good,
which in turn depends on:
The price of required inputs
(labor, capital, and land),
The technologies that can be used
to produce the product,
The prices of related products.
A Change in Supply Versus
a Change in Quantity Supplied

A change in supply is
not the same as a
change in quantity
supplied.
In this example, a higher
price causes higher
quantity supplied, and
a move along the
demand curve.
In this example, changes in determinants of supply, other
than price, cause an increase in supply, or a shift of the
entire supply curve, from SA to SB.
A Change in Supply Versus
a Change in Quantity Supplied

When supply shifts


to the right, supply
increases. This
causes quantity
supplied to be
greater than it was
prior to the shift, for
each and every price
level.
A Change in Supply Versus
a Change in Quantity Supplied
To summarize:

Change in price of a good or service


leads to

Change in quantity supplied


(Movement along the curve).

Change in costs, input prices, technology, or prices of


related goods and services
leads to

Change in supply
(Shift of curve).
From Individual Supply
to Market Supply
The supply of a good or service can be
defined for an individual firm, or for a
group of firms that make up a market or
an industry.
Market supply is the sum of all the
quantities of a good or service supplied
per period by all the firms selling in the
market for that good or service.
Market Supply
As with market demand, market
supply is the horizontal summation
of individual firms supply curves.
Market Equilibrium
The operation of the market
depends on the interaction
between buyers and sellers.
An equilibrium is the
condition that exists when
quantity supplied and quantity
demanded are equal.
At equilibrium, there is no
tendency for the market price
to change.
Market Equilibrium
Only in
equilibrium is
quantity
supplied equal
At any price level
to quantity
other than P0, the
demanded.
wishes of buyers
and sellers do not
coincide.
Market Disequilibria
Excess demand, or
shortage, is the
condition that exists
when quantity
demanded exceeds
quantity supplied at
the current
When quantityprice.
demanded
exceeds quantity
supplied, price tends to
rise until equilibrium is
restored.
Market Disequilibria
Excess supply, or
surplus, is the
condition that exists
when quantity
supplied exceeds
quantity demanded at
the current price.
When quantity supplied
exceeds quantity
demanded, price tends to
fall until equilibrium is
restored.
Increases in Demand and
Supply

Higher demand leads Higher supply leads to


to higher equilibrium lower equilibrium price
price and higher and higher equilibrium
equilibrium quantity. quantity.
Decreases in Demand and
Supply

Lower supply leads


Lower demand leads
to higher price and
to lower price and
lower quantity
lower quantity
exchanged.
exchanged.
Relative Magnitudes of
Change

The relative magnitudes of change in supply and


demand determine the outcome of market equilibrium.
Relative Magnitudes of
Change

When supply and demand both increase, quantity


will increase, but price may go up or down.
Law of Demand and the Law of
Supply
Market Equilibrium
Changes in Demand And
Supply
KEY CONCEPTS
Demand curve is the graphic representation of the relationship
between price and quantity demanded.
Demand refers to a schedule of quantities of a good that will be
bought per unit of time at diverse prices, other things constant. In
graphical terms, demand pertains to the entire demand curve.
Quantity demanded relates to a specific amount that will be
demanded per unit of time at a particular price, other things
constant. Quantity demanded pertains to a point on a demand
curve.
Movement along a demand curve applies to the graphical
representation of the effect of a change in price on the quantity
demanded.
Shift in demand pertains to the effect of anything other than price
on demand. The terminology allows us to distinguish between
changes in quantity demanded, and shifts in demand.
Factors of demand are factors that give rise to shifts in the
demand curve. A change in anything other than price causes a
shift of the entire demand curve.
The important shift factors of demand are as follows:
1. Individuals income
2. The price of other goods
3. Tastes
4. Expectations
Income. As individuals income rises, they can provide more of the
goods they want.
Prices of other goods. People make their purchasing decision on
the prices of other goods.
Tastes. Changes in taste can affect the demand for a good without
a change in price. You may find that your taste for action movies
has changed to a taste for science fiction movie.
Expectations. Expectation will also affect demand. If you count on
your income to go up in the future, you are bound to begin
spending some of it today. If you expect the price of computers to
fall soon, you may postpone buying one until later.
Supply curve refers to the graphical
representation of the relationship between price
and quantity supplied.
Supply refers to a schedule of quantities a seller
is eager to sell per unit of time at varying prices,
others things constant. Quantity supplied relates
to a definite amount that will be supplied at a
specific price. A supply curve tells us how much
will be offered for sale at various prices.
Movement along a supply curve is represented
graphically between effects of a change in price
and the effects of shift factors on how much of a
good is supplied. Change in price cause changes
in quantity supplied. Shift in supply pertains to
the graphic representation of the amount
supplied affected by anything other than price,
that is, by a shift factors of supply.
Factors of Supply

Prices of inputs. Any business company is tied to costs in order to earn a


profit. Cost will determine how much a firm is willing to supply. If cost rises,
profits will suddenly go down, and a firm has less action or effort to supply.
Supply slopes downward when the prices of inputs extend upwards. If cost
rise considerably, a business establishment might even shut down.
Technology. Recent times technology change the production process,
decreasing the number of inputs needed to produce a given supply of
goods. To this extent, technological development that reduces the number
of workers will cut costs of production. A reduction in expenses of
production rise profits and leads suppliers to expand production. Recent
technology increases supply.
Taxes and subsidies. Government requires a business company to pay a
portion of the income from products or services sold. Thus, taxes increase
the costs of production, profit cut down and suppliers will reduce supply.
Subsidies are payments by the government to suppliers to produce goods;
in this way, they reduce the cost of production. Taxes on supplier decrease
supply. The opposite is true for subsidies. A shift factor of supply is
anything that affects supply, other than its price.
Expectations. Supplier expectations are significant aspect in the production
decision. If a supplier anticipates the price of his goods to rise at some time
in the future, he may reserve for future use some of todays supply in order
to sell it later and gain higher profits, restricting supply now and expanding
it later.
Market Equilibrium
In supply and demand analysis, equilibrium
means that the moving up pressure on price is
exactly counterbalance by the moving down
pressure on price. Generally, it pertains to a
balance that exists when quantity demanded
equals quantity supplied. Market equilibrium is
the general agreement of the buyer and the
seller in the exchange of goods and services at a
particular price and at a particularly quantity. At
equilibrium point, there are always two sides of
the story, the side of buyer and that of the seller.
3 Ways to illustrate Market
Equilibrium
Schedule Approach
Graphical Approach
Algebraic Equations
Surplus and Shortage
Surplus is experienced when the price of a good is
above the equilibrium point. Surplus, above the
equilibrium point means that a price more than
equilibrium price, the quantity supplied of a good in
the market exceeds its quantity demanded.
Shortage occurs when the quantity demanded
exceeds the quantity being supplied. In other
words, there are demands for the commodity that
are not being met. This happens when the price is
below its equilibrium level. When shortage exists in
the market, the consumers cannot buys as much of
the good as they would like.
Elasticity
The relationship between the price and
quantity, as introduced in the previous
chapter, can be either directly proportional to
supply or inversely proportional to demand.
Under the ceteris paribus assumption, when
price increases, it is expected that quantity
demanded will decrease and quantity
supplied will increase; and when the price
decreases, it follows that quantity demanded
will increase and quantity supplied will
decrease.
HOWEVER
Demand and supply are not static in
a competitive market. Both supply
and demand respond to changes in
price and other factors. As a result,
we can observe some shifts in the
demand and supply curves as a
reaction to the change in these
various determinants. THE DEGREE
TO WHICH EITHER THE DEMAND OR
SUPPLY CURVE REACTS TO THESE
Elasticity of Demand
Price Elasticity of Demand
Income Elasticity of Demand
Cross Price Elasticity of Demand
Price Elasticity
Price Elasticity of Demand and
Pricing Decisions
PRICE ELASTICITY OF DEMAND IS THE
DEGREE OF RESPONSIVENESS OF
QUANTITY DEMANDED TO A CHANGE
IN PRICE.
Summary of Price
Price Elasticity of Elasticity of
Interpretation
Demand
Demand
=1 Unitary Elastic
>1 Elastic
<1 Inelastic
Interpretation
Deborah sells bangus for P100 and
the Quantity Demanded is 500
pieces. She decided to sell at P125
for 450 pieces.
QUESTION: As a seller, is her decision
correct? Is the quantity elastic or
inelastic? Would the buyers buy at a
certain price or would they buy at
any given price? What will be the
total revenue of each? Which is more
Price Elasticity of Demand = % change
in Qd
----------------------
% change in P
TOTAL REVENUE = P x Q
% change in Qd Qd2-Qd1
----------------
Qd1+Qd2
------------
2
% Change in P = P2 P1
-----------------
P1 +P2
---------
2
Also compute for the following:
1. If Theresa sells tilapia for Php 80 per
kilo, the demand for it is 200. When
she raises it by Php20, the quantity
demanded diminishes by 100. At
what price will Theresa maximize her
profit? Is the demand elastic or
inelastic?
Review for Price Elasticity of
Demand
Mina sells tuyo for Php 20 per pack,
and gets 200 packs quantity
demanded. However, if she lowers
her price to Php 15, quantity demand
doubles. Is the demand for tuyo
elastic or inelastic? At what price will
Mina get a bigger revenue?
Income Elasticity of Demand
It is the degree of responsiveness of
a percentage change in quantity
demanded with a percentage change
in come.

Qd2 y2 y1
Qd1 =
= --------------
-------------- y1 + y2
Qd1 +
Qd2 -------------
2
It will help the seller see how
consumers perceive goods he is
selling. Are they luxurious? Necessary?
Or Just Common?
Exercise
Georgina earns a monthly Every month, Tembong
salary of Php 5000 and earns Php5000 as a fish
she consumes Php1000 ball vendor. During this
worth of chicken per period, he also consumes
month. When her income Php100 worth of tuyo.
increased by When his income
Php2500/month, she increases by Php2500, he
started to consume began lessening his
Php2000 worth of chicken consumption of tuyo to
meat a month. Is Chriss Php50. From the given, is
demand for chicken tuyo normal, inferior, or
meat, normal, inferior, common good for
necessity or luxury? Tembong?
Consumer Behaviour

The behaviour that


consumers display in
searching for, purchasing,
using, evaluating, and
disposing of products and
services that they expect
will satisfy their needs.
Copyright 2006
Pearson Education 1-138
Canada Inc.
Personal Consumer

The individual who buys


goods and services for his
or her own use, for
household use, for the use
of a family member, or for
a friend.
Copyright 2006
Pearson Education 1-139
Canada Inc.
Development of the Marketing
Concept
Production
Concept

Product Concept

Selling Concept

Marketing
Concept
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Pearson Education 1-140
Canada Inc.
The Production Concept

Assumes that consumers are


interested primarily in product
availability at low prices
Marketing objectives:
Cheap, efficient production
Intensive distribution
Market expansion

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Canada Inc.
The Product Concept

Assumes that consumers will buy


the product that offers them the
highest quality, the best
performance, and the most
features
Marketing objectives:
Quality improvement
Addition of features
Tendency toward Marketing
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1-142
The Selling Concept

Assumes that consumers are


unlikely to buy a product unless
they are aggressively persuaded
to do so
Marketing objectives:
Sell, sell, sell
Lack of concern for customer
needs and satisfaction
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Canada Inc.
The Marketing Concept

Assumes that to be successful, a


company must determine the
needs and wants of specific
target markets and deliver the
desired satisfactions better than
the competition
Marketing objectives:
Profits through customer satisfaction

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Canada Inc.
Business Leaders Who
Understood Consumer Behaviour
Alfred Sloan, General Motors
Colonel Sanders, KFC
Ray Kroc, McDonalds

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Implementing the
Marketing Concept
Consumer Research
Segmentation
Targeting
Positioning

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Segmentation, Targeting, and
Positioning
Segmentation: process of
dividing the market into subsets
of consumers with common
needs or characteristics
Targeting: selecting one ore more
of the segments to pursue
Positioning: developing a distinct
image for the product in the
mind of the consumer
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Successful Positioning
Communicating the benefits of
the product, rather than its
features
Communicating a Unique Selling
Proposition for the product

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The Marketing Mix
Product
Price
Place
Promotion

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The Societal Marketing
Concept
All companies prosper when
society prospers.
Companies, as well as
individuals, would be better off
if social responsibility was an
integral component of every
marketing decision.
Requires all marketers adhere
to principles of social
responsibility.
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1-150
Digital Revolution in the Marketplace

Allows customization of products,


services, and promotional messages
like never before
Enhances relationships with
customers more effectively and
efficiently
Has increased the power of
customers and given them access to
more information

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Digital Revolution in the
Marketplace - Continued
The exchange between consumers
and marketers has become more
interactive
May affect the way marketing is done

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Changes brought on by the digital
revolution

Changes in segmentation strategies


Re-evaluation of promotional budgets
reduced impact of television?
More internet-based promotion?
Integrated marketing becomes critical
Using off-line promotions to drive
consumers to companys website (and
vice-a-versa)
Continued

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Changes brought on by the digital revolution -
continued

Revamping distribution
systems
Direct distribution becomes more of
an option
Pricing methods may need to
be re-evaluated
Comparison shopping made easier
Consumer research methods
may change
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web-based
Why study consumer
behaviour?
Understanding consumer
behaviour will help you become
better marketers as it is the
foundation for
Segmenting markets
Positioning products
Developing an appropriate marketing
continued

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Why study consumer
behaviour?
Knowledge of consumer
behaviour is essential for non-
profit organizations
Non profits have different
customers to please
Donors, users, volunteers, general
public, government
continued

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Why study consumer
behaviour?
Public service initiatives have to
be based on an understanding of
consumer behaviour
Canadas largest advertiser is the
federal government
Most government initiatives (e.g.,
antismoking campaigns) need a
knowledge of consumer behaviour
to succeed
continued

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Why study consumer
behaviour?
Better understanding of our own
consumption behaviour

Copyright 2006
Pearson Education 1-158
Canada Inc.
Copyright 2006
Pearson Education 1-159
Canada Inc.
Consumer Behavior and
Utility Maximization
4 Key Concepts
1. Understanding Utility: Total and
Marginal
2. Utility Maximization: Equalizing
Marginal Utility per Dollar (MU/PA =
MU/PB)
3. Individual and Market Demand Curves
4. Income and Substitution Effects
(review from unit two)
Introduction
The CONSUMER is essential to the
market. Understanding how the
consumer makes his/her purchasing
decisions is key.
1. Understanding Utility

Utility =
Satisfaction/Happiness/Pleasure one
gets from consuming a good.
Utility and usefulness are NOT
synonymous in economics.
Utility is difficult to quantify, as it
differs between people and situations
ie. A blanket to a person living in Arizona
vs. a person living in Minnesota.
Measured in utils (a personal
1. Understanding Utility
Total Utility (TU)
Total amount of satisfaction or pleasure
a person derives from consuming a
given quantity of that product
Marginal Utility (MU)
The extra satisfaction a consumer
derives from one additional unit of that
product.
In other words, the change in Total
Utility that results from the consumption
of one more unit
Law of Diminishing Marginal Utility

Explains that the more of a good a


person gets, the less utility he gets
from each additional unit.
Consumer wants in general are
insatiable, but wants for particular
items can be satisfied for a time.
Example: Durable goods such as an
automobile
First is the Best
It is important to note that your
marginal utility begins to fall after
the very first unit you consume.
In other words, your very first taco
holds great utility. While you may
enjoy your second taco, it doesnt
bring as much utility as the first
At some point, your MU becomes
negative. (takes away from your total
satisfaction).
Law of Diminishing Marginal
Utility
Total Utility

30

Total Utility (Utils)


(1) (2) (3)
Tacos Total Marginal TU
Consumed Utility, Utility,
Per Meal Utils Utils
20

0 0
1 10
] 10 10

2 18
] 8

3 24 ] 6 0 1 2 3 4 5
Units Consumed Per Meal
6 7
] 4

Marginal Utility (Utils)


4 28 Marginal Utility
5 30 ] 2 10

6 30 ] 0 8
6
7 28 ] -2 4
2
0
-2 MU
1 2 3 4 5 6 7
Units Consumed Per Meal
2. Utility Maximization
Explains how consumers allocate their
money incomes among the many
goods and services available for
purchase
You will be faced with problems that
provide you with a consumers MU or
TU derived from purchasing 2 goods.
You will be expected to show how
many of each a rational consumer
would purchase.
Theory of Consumer Behavior
Numerical Example:
Find the Utility-Maximizing Combination of
A and B, if you have an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
Theory of Consumer
NumericalBehavior
Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Compare Marginal
Fourth 6 Utilities
6 16 8
Then Compare
Fifth 5 Per Dollar
5 - MU/Price
12 6
Choose the4Highest4
Sixth 6 3
Check Budget
Seventh 3 - Proceed
3 to Next
4 Item2
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Again,
Fourth Compare
6 Per6 Dollar - 16
MU/Price8
Choose
Fifth the5Highest5 12 6
Buy
Sixth One of 4Each Budget
4 Has6 $5 Left
3
Proceed
Seventh to 3Next Item
3 4 2
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Again,
Fifth Compare
5 Per5 Dollar - 12
MU/Price6
Buy
Sixth One More
4 B Budget
4 Has6 $3 Left
3
Proceed
Seventh to 3Next Item
3 4 2
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Again,
Sixth Compare
4 Per4 Dollar - MU/Price
6 3
Buy One of 3Each 3Budget Exhausted
Seventh 4 2
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(2) (3)
Product A: Product B:
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Final Result At These Prices,
Sixth 4 4 6 3
Purchase 2 of Item A and 4 of B
Seventh 3 3 4 2
Theory of Consumer Behavior
Algebraic Restatement:

MU of Product A MU of Product B
Price of A
= Price of B

8 Utils 16 Utils
$1
= $2

Optimum Achieved - Money Income


is Allocated so that the Last Dollar
Spent on Each Good Yields the Same
Extra or Marginal Utility
Two-Good Practice Problem
Given MU, and an income/budget
constraint of $20 find the Utility-
Maximizing Combination of A and B
(2) (3)
Product A: Product B:
Price = $2 Price = $5

Unit MU Unit MU

1 20 1 30

2 10 2 20

3 6 3 15

4 3 4 5

5 1 5 -5
Two-Good Practice Problem
Given TU, and an income/budget
constraint of $9 find the Utility-
Maximizing Combination of A and B
(2) (3)
Product A: Product B:
Price = $2 Price = $1

Unit TU Unit TU

1 22 1 10

2 32 2 16

3 40 3 20

4 46 4 22

5 48 5 20
The Problem with Utils
Answer the following problem:
If Henry derives 5 utils from the 1st
candy bar, 3 utils from the 2nd candy
bar, 0 utils from the 3rd candy bar,
and -5 utils from the 4th candy bar
How many candy bars should Henry
consume if each candy bar
Is absolutely free (MC = 0)
Costs $2
Costs $4
From Utils to Benefit
Because Utils cannot be compared
between people, and cannot be
compared to dollars economists
must measure satisfaction in Benefit.
Benefit is the same concept as utility, but
it is measured in dollars (according to the
consumers WILLINGNESS TO PAY.
Total Benefit ($), Marginal Benefit ($)
Golden Rule of Consumption
A rational consumer will continue to
purchase until

MB = MC
To consume one more would mean your
marginal cost is greater than your
marginal benefit
3. Individual and Market Demand
Curves
Start with an individual consumer
maybe you, maybe me, but could be
anyone
Derive demand curve for that
individual
focus on marginal utility or marginal
benefit
Add up demand curves for many such
individuals to get market demand
curve
Assumption about consumer behavior

General economic
principle
People When applied to
make purposeful the behavior of
choices consumers
with limited People
resources maximize utility
subject to a
budget constraint
3. Individual and Market Demand
Curves
Consider all consumers in the market
Add up quantity demanded by all
individuals at each price to get market
demand
Add horizontally to create market
demand curve
05_06 PRICE PRICE
(DOLLARS) (DOLLARS)

5 5

4 4

3
Pete's
3
Ann's

2 demand 2 demand
curve curve
1 1

0 1 2 3 4 5 0 1 2 3 4 5
QUANTITY DEMANDED QUANTITY DEMANDED
BY PETE (POUNDS) BY ANN (POUNDS)

PRICE
(DOLLARS)

2 Market
demand
1 curve

0 1 2 3 4 5 6 7 8 9 10
QUANTITY DEMANDED
IN MARKET (POUNDS)
4. Substitution and Income
Effects
This topic on the AP Course Outline
was already covered in unit 2.
To review, just remember that both of
these effects help to explain why the
demand curve slopes downward.
Review Questions Utility
Which of the following factors contributes to a
downward-sloping demand curve?
I. The income effect
II. The substitution effect
III. Diminishing marginal utility

A. I only
B. III only
C. I and II only
D. II and III only
E. I, II, and III
Review Questions Utility

What is the marginal utility of the third cup of


peanuts Brian consumes?
A. 3 units of utility
B. 9 units of utility
C. 12 units of utility
D. 2 units of utility
E. 14 units of utility
Review Questions Utility

If the price of peanuts is $1 per cup and the price of jelly


beans is $2 per cup, and Brian wants to maximize his
utility, what should he purchase first?
A. 1 cup of peanuts because peanuts produce a lower
total utility
B. 1 cup of peanuts because the price of peanuts is lower
C. 1 cup of peanuts, because the marginal utility per
dollar for peanuts is lower than the marginal utility per
dollar of jelly beans
D. 1 cup of jelly beans, because the marginal utility per
dollar for jelly beans is higher than the marginal utility per
dollar of peanuts
E. 1 cup of jelly beans, because jelly beans produce a
higher total utility
Review Questions Utility
If TU = total utility, MU = marginal utility, and P =
price, in order to maximize utility, a consumer
should purchase the mix of hamburgers and hot
dogs where
A. the MU of hamburgers equals the MU of hot
dogs
B. the MU equals the TU of hamburgers, and the
MU equals the TU of hot dogs
C. the TU of hamburgers equals the TU of hot
dogs
D. the MU / P of hamburgers equals the MU / P of
hot dogs
E. the TU / P of hamburgers equals the TU / P of
Review Questions Utility
If Matts total utility from consuming slices of
cheese increased at a constant rate, no matter
how many bratwurst Matt consumed, what would
Matts demand curve for slices of cheese look
like?
A. Vertical
B. Horizontal
C. Downward sloping
D. Upward sloping
E. First upward, but eventually downward sloping
Review Questions Utility
Every day Molly spends her lunch money consuming apples, at
$1 each, and oranges, at $2 each. At her current level of
consumption, mollys marginal utility of apples is 12 and her
marginal utility of oranges is 18. If she has already spent all of
her lunch money, how should Molly change her consumption
decision to maximize utility?
A. She should make no changes; she is consuming the utility
maximizing combination of apples and oranges.
B. She should increase her apple consumption and decrease
her orange consumption until the marginal utility per dollar is
equal for both.
C. She should decrease her apple consumption and increase
her orange consumption until the marginal utility per dollar is
equal for both.
D. She should increase her apple consumption and decrease
her orange consumption until the marginal utility is equal for
both.
E. She should decrease her apple consumption and increase
her orange consumption until the marginal utility is equal for
both.
Review Questions Utility
If generic peanut butter is an inferior good, a decline
in consumer income causes
A. the price of generic peanut butter to go down.
B. the demand for name-brand peanut butter to go
up.
C. the supply of generic peanut butter to go up.
D. the demand for generic peanut butter to go up.
E. the price of bread to go down.
Key Terms

law of diminishing marginal


utility
utility
total utility
marginal utility
rational behavior
budget constraint
utility-maximizing rule
income effect
substitution effect
Deriving the Demand Curve
Same Numeric Example:

Price of Product B
Price Per Quantity
Unit of B Demanded

$2 4
1 6 1

Income Effects DB

Substitution Effects0 4 6
Quantity Demanded of B
Four Market Structures
The focus of this lecture is the four market structures. Students will learn the
characteristics of pure competition, pure monopoly, monopolistic competition, and
oligopoly.
OBJECTIVES
1. Identify various market structures and their characteristics.
2. Be able to categorize firms into four market structures.
3. Describe the effects of imperfect competition upon the market and the firm.
4. Understand the pricing structure of the four structures.

TOPICS
Please read all the following topics.
PERFECT COMPETITION
PERFECT COMPETITION CONT.
PERFECT COMPETITION EXAMPLE
PURE MONOPOLY
MONOPOLY EXAMPLE
PRICE DISCRIMINATION
MONOPOLISTIC COMPETITION
OLIGOPOLY
TECHNOLOGICAL DEVELOPMENT
ECONOMIC EFFICIENCY
Perfect Competition

Pure or perfect competition is rare in the real world, but the model is important
because it helps analyze industries with characteristics similar to pure competition.
This model provides a context in which to apply revenue and cost concepts
developed in the previous lecture. Examples of this model are stock market and
agricultural industries.

Characteristics
1. Many sellers: there are enough so that a single sellers decision has no impact
on market price.
2. Homogenous or standardized products: each sellers product is identical to its
competitors.
3. Firms are price takers: individual firms must accept the market price and can
exert no influence on price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving
the industry.

Demand
The individual firm will view its demand as perfectly elastic. A perfectly elastic
demand curve is a horizontal line at the price. The demand curve for the industry is
not perfectly elastic, it only appears that way to the individual firms, since they
must take the market price no matter what quantity they produce. Therefore, the
firms demand curve is a horizontal line at the market price.

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit
Profit-Maximizing Output
Short Run Analysis
In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting
output. Firms should produce if the difference between total revenue and total cost is profitable (EP
>0), or if the loss is less than the fixed cost (EP>- FC). The firm should not produce, but should shut
down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal
those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment
lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would
be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered,
then this unit should be produced to minimize the loss. However, if by producing one unit of output,
this loss would be higher , then this unit should not be produced. The firm should shut down, just
pay for the fixed cost.
If EP< - FC firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < -
FC, market price, P, must be lower than the minimum AVC.
If EP> - FC, firm should produce. That is when market price is greater than minimum AVC.
Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.
If MR > MC, then the firm should continue to produce.
If MR = MC, then the firm should stop producing the additional unit. As the additional units MC
would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm
would loss profit by producing additional units. Therefore, this is the profit maximizing output level.
If MR < MC, then the firm should lower its output.
In conclusion:
The shutdown point is the level of output and price at which the firm just covers its total variable
cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm
will shut down because this action minimizes the firms loss. In this case, the firms economic loss
equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the
loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand.
Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC,
then the firm should produce. Price and MC are compared to find the profit maximizing or loss
minimizing output level. The supply curve of the pure competition firms would be the portion of the
Perfect Competition Cont.
Following the rules discussed in the previous section. Here is an example.

Firms fixed cost is $100, its min AVC is $55.

If market price is 50 which is less than min AVC, the firm would loss $5 more by producing each
unit. If the firm produces one unit, its total loss would be $5 plus $100 fixed cost. If the firm decides
to shut down, its loss would be only $100 as the firm does not need to pay for the variable cost.
Shut down would be the loss minimization strategy.

If the market price is 60, the firm would lose $5 less by producing each unit. If the firm produces
one unit, its total cost would be fixed cost less $5, which is $95. The firm is better off by producing,
not shutting down. When the market price is higher than the minimum AVC, MR and MC should be
compared to find out the optimal level of output.

Long Run Analysis


Obviously, the firm cannot be in loss for long. Three assumptions are made for the long run
analysis:

1. Entry and exit are the only long run adjustments.


2. Firms in the industry have identical cost curves.
3. The industry is in constant return to scale.

In long run, if economic profits are earned, firms enter the industry, which increases the market
supply, causing the product price to go down. Until zero economic profits are earned, then the
supply will be steady. If losses are incurred in the short run, firms will leave the industry which
decreases the market supply, causing the product price to rise until losses disappear. This model is
Efficiency Analysis
1. Productive efficiency: occurs where P= min ATC. Perfect
competitive firms will achieve productive efficiency as firms must
use the least-cost technology or they won't survive.

2. Allocative efficiency: occurs where P = MC. Price represent the


benefit that society gets from additional units of a product, MC
represents the cost to society of other goods given up to produce
this product. Dynamic adjustments will occur in this market
structure when changes in demand, supply or technology occurs.
Perfect competitive firms will achieve this efficiency. Since no
explicit orders are given to the industry, "the Invisible Hand" works
in this system.

Even though both efficiencies are achieved in this system, the


consumers are facing standard products, making shopping to be no
fun at all. On the other hand, the consumers will receive the highest
consumer surplus in this structure as the long run market price will be
at the min ATC. Producers will receive the lowest producer surplus as
consumers can easily find substitutes.
An Example
The following data represents a cost function of
a perfect competitive firm:
TP or Q AFC AVC ATC MC

1 60 45 105 45
2 30 42.5 72.5 40
3 20 40 60 35
4 15 37.5 52.5 30
5 12 37 49 35
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
10 6 46.5 52.5 75

If the market price, P < 37; this firm's output Q


= 0; firm's economic profit, EP = -60

If the market price, P > 37, this firm's output Q
> 0; firms' economic profit , EP= TR - TC.

For example, when P = 65, Q = 9, EP = $65 x 9 -
50 X 9 = 135
An Example Cont.
By given the market demand at various price level, a market equilibrium price could
be found.
TP or Q AFC AVC ATC MC
One firm's output level (column 2 in the above
0 table) is obtained by comparing P and MC. Since
1 60 45 105 45 all firms are having the same cost function, the
2 30 42.5 72.5 40 market output level is the sum of individual firms'
3 20 40 60 35 output (column 4 in the above table).
4 15 37.5 52.5 30 By comparing the market supply and market
5 12 37 49 35 demand, we can find the market equilibrium at:
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45 P= 46 and Q = 10500
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
At this level, each firm is losing 8 dollars, indicating
10 6 46.5 52.5 75
a contraction in this industry. Some firms may
leave in the long run, causing the market supply to
decrease and equilibrium price will increase to the
PRICE Qs (1 firm's output) PROFIT Qs(1500 firms in the market) / market supply Qd / market demand
26 0 -60
break-even level. 0 17000
32 0 -60 0 15000
38 5 -55 7500 13500
41 6 -39 9000 12000
46 7 -8 10500 10500
56 8 63 12000 9500
66 9 144 13500 8000

(assuming identical cost function for all firms)


Pure Monopoly
Pure monopoly exists when a single firm is the sole producer of a product for which there are no
close substitutes. Examples are public utilities and professional sports leagues.

Characteristics
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firms product.
3. The firm is the price maker: the firm has considerable control over the price because it can
control the quantity supplied.
4. Entry or exit is blocked.

Barriers to Entry
Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low
unit prices for consumers depend on the existence of a small number of large firms, or in the case
of monopoly, only one firm. Because a very large firm with a large market share is most efficient,
new firms cannot afford to start up in industries with economies of scale. Public utilities are known
as natural monopolies because they have economies of scale in the extreme case. More than one
firm would be inefficient because the maze of pipes or wires that would result if there were
competition among water companies or cable companies. Legal barriers also exist in the form of
patents and licenses, such as radio and TV stations. Ownership or control of essential resources is
another barrier to entry, such as the professional sports leagues that control player contracts and
leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the
telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays,
cellular phones are very popular. It creates a substitute for your house phone, causing the
traditional telephone companies to lose their monopoly position.

Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping. Price will
exceed marginal revenue because the monopolist must lower price to boost sales and cannot price
discriminate in most cases. The added revenue will be the price of the last unit less the sum of the
Profit Maximizing Output & Efficiency
Profit Maximizing Output:
The MR = MC rule will still tell the monopolist the profit maximizing output. The monopolist
cannot charge the highest price possible, it will maximize profit where TR minus TC is the greatest.
This depends on quantity sold as well as on price.

The monopolist can charge the price that consumers will pay for that output level. Therefore, the
price is on the demand curve. Losses can occur in monopoly, although the monopolist will not
persistently operate at loss in the long run.
Monopolies will sell at a smaller output and charge a higher price than would pure competitive
producers selling in the same market.

Income distribution is more unequal than it would be under a more competitive situation, unless
the government regulates the monopoly and prevents monopoly profits. If a monopoly creates
substantial economic inefficiency and appears to be long-lasting, antitrust laws could be used to
break up the monopoly.

Efficiency:
1. Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive
efficiency as firms will produce at an output which is less than the output of min ATC. X-inefficiency
may occur since there is no competitive pressure to produce at the minimum possible costs.
2. Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what
product is worth to consumers) is above MC (opportunity cost of product).

It is possible that monopoly is more efficient than many small firms. Economies of scale (natural
monopoly) may make monopoly the most efficient market model in some industries. However, X-
inefficiency and rent-seeking cost (lobbying, legal fees, etc.) can entail substantial costs, causing
inefficiency.
An Example
In this example, the cost function is the same as the TP or Q AFC AVC ATC MC
one used in the perfect competition example. You can
see from the following analysis that the output level 0
and market price are different in monopoly . The output 1 60 45 105 45
level is lower than output of the perfect competitive 2 30 42.5 72.5 40
firm; and price is higher than the price of perfect 3 20 40 60 35
competitive firm. 4 15 37.5 52.5 30
5 12 37 49 35
6 10 37.5 47.5 40
7 8.57 38.57 47.14 45
8 7.5 40.63 48.13 55
9 6.67 43.33 50 65
10 6 46.5 52.5 75

Pd Qd TR MR EP

115 0 0 0

100 1 100 100 -5


83 2 166 66 21
71 3 213 47 33
63 4 252 39 42
55 5 275 23 30
By comparing the MR and MC unit by unit, we can find 48 6 288 13 3
this firm's output at: 42 7 294 6 -35.98
Q = 4, and P= 63. This is the profit maximization 37 8 296 2 -89.04
output level, with EP = 42. 33 9 297 1 -153
29 10 290 -7 -235
It is possible for this firm to continue earning this profit
in the long run as there are no competition in the
Price Discrimination
Price discrimination is selling a good or service at a number of
different prices, and the price differences is not justified by the cost
differences. In order to price discriminate, a monopoly must be able
to
1. be able to segregate the market
2. make sure that buyers cannot resell the original product or
services.

Perfect price discrimination is a price discrimination that extracts the


entire consumer surplus by charging the highest price that consumer
are willing to pay for each unit.

As a result, the demand curve becomes the MR curve for a perfect


price discriminator. Firms capture the entire consumer surplus and
maximize economic profit.
Monopolistic Competition
Monopolistic competition refers to a market situation with a relatively
large number of sellers offering similar but not identical products.
Examples are fast food restaurants and clothing stores.

Characteristics
1. A lot of firms: each has a small percentage of the total market.
2. Differentiated products: variety of the product makes this model
different from pure competition model. Product differentiated in style,
brand name, location, advertisement, packaging, pricing strategies,
etc.
3. Easy entry or exit.

Demand Curve
The firms demand curve is highly elastic, but not perfectly elastic. It
is more elastic than the monopolys demand curve because the seller
has many rivals producing close substitutes; it is less elastic than
pure competition, because the sellers product is differentiated from
its rivals.
Profit - Maximizing Output
The MR = MC rule will give the firms the profit maximizing output. The price they
charge would be on the demand curve.

In the long run, the situation will tend to be breaking even for firms. Firms can enter
the industry easily and will if the existing firms are making an economic profit. As
firms enter the industry, the demand curve facing by an individual firm shift down, as
buyers shift some demand to new firms until the firm just breaks even. If the demand
shifts below the break-even point, some firms will leave the industry in the long run.

Therefore, most monopolistic competitive firms should experience break-even in the


long run theoretically. In reality, some firms experience profit as they able to
distinguish themselves from the others and build a loyal customer base; such as
some name brand apparel companies. Some firms experience lost in long run but
may continue the business as they are still earning normal profit. These firm owners
usually like the flexible life style and willing to earn a normal profit that is lower than
their opportunity cost.

Price exceeds marginal cost in the long run, suggesting that society values additional
units which are not being produced. Average costs may also be higher than under
pure competition, due to advertising cost involved to attract customers from
competitors. The various types, styles, brands and quality of products offers
consumers choices. However, economic inefficiency is the result. The excess capacity
(producing at the quantity that a firm produces is less than the quantity at which ATC
is a minimum) exists in this industry.
Oligopoly
Oligopoly exits where few large firms producing a homogeneous or
differentiated product dominate a market. Examples are automobile
and gasoline industries.

Characteristics
1. Few large firms: each must consider its rivals reactions in
response to its decisions about prices, output, and advertising.
2. Standardized or differentiated products.
3. Entry is hard: economies of scale, huge capital investment may
be the barriers to enter.

Demand Curve
Facing competition or in tacit collusion, oligopolies believe that
rivals will match any price cuts and not follow their price rise. Firms
view their demands as inelastic for price cuts, and elastic for price
rise. Firms face kinked demand curves. This analysis explains the
fact that prices tend to be inflexible in some oligopolistic industries.
Efficiency & Advertisement
1. Productive efficiency: occurs where P= min ATC.

Monopolistic competitive firms will not achieve productive efficiency


as firms will produce at an output which is less than the output of min
ATC. Product differentiation is the major cause of excess capacity.

2. Allocative efficiency: occurs where P = MC.

This efficiency is not achieved because price( what product is worth to


consumers) is above MC (opportunity cost of product).

Advertisement is very crucial for each firm in this market structure as


firms need exposure to get consumer's attention. However, too much
spending will result in higher cost, and lower profit. Price, product
attributes, and advertisement are three main factors that producers
have to consider. The perfect combination cannot be forecasted easily.
Game Theory & Cartel
Game theory suggests that collusion is beneficial to the participating firms. Collusion reduces
uncertainty, increases profits, and may prohibit entry of new rivals.
Consider the following payoff matrix in which the numbers indicate the profit in millions of dollars
for a duopoly (GM and Ford) based on either a high-price or a low-price strategy. This example
illustrated that GM or Ford will earn the highest individual profit when each adopts low price
strategy while other firm continues with the higher price strategy (in B or C). But firms will earn the
highest total profit when both adopt the high price strategy (A). When firms form a cartel, they are
acting as one entity (A). They will perform as they are a large monopoly, earning the highest total
profit possible. However, members do have an incentive to cheat as individuals can increase their
own profits by cheating in short run (B or C). WhenGM
Duopoly other members are aware of the cheating, they
may carry out the same practice, sometimes it High-price
may result in a price war Low-price
and all members loss (D).
Ford High-price A:GM=$50MFord=$50M B:GM=$60MFord=$20M
Low-price C:GM=$20MFord=$60M D:GM=$30MFord=$30M

Profit Analysis GM Profit FordProfit Total profit in the industry


A:Bothfirmsadopthighpricestrategy Earns$50M Earns$50M $50+$50=$100M

B:GMlowerspriceandFordcontinueswith Increasedto$60M Droppedto$20M $60+$20=$80M


highpricestrategy

C:FordlowerspriceandGMcontinueswith Droppedto$20M Increasedto$60M $20+$60=$80M


highpricestrategy

D:Bothfirmsadoptlowpricestrategy Earns$30M Earns$30M $30+$30=$60M

The Organization of Petroleum Exporting Countries (OPEC) is a cartel. The eleven countries
agreed on the output amount and working together to control the worlds crude oil supply. In US,
anti-trust law has set up guidelines for corporations to follow to avoid collusion of large firms in
Technological Development
Technological advance is a three-step process that shifts the economys production
possibilities curve outward enabling more production of goods and services.

1. Invention: is the discovery of a product or process and the proof that it will work.
2. Innovation: is the first successful commercial introduction of a new product, the
first use of a new method, or the creation of a new form of business enterprise.
3. Diffusion: is the spread of innovation through imitation or copying.

Expenditures on research and development (R&D) include direct efforts by business


toward invention, innovation, and diffusion. Government also engages in R&D,
particularly for national defense. Finding the optimal amount of R&D is an
application of basic economics: marginal benefit and marginal cost analysis.
Optimal R&D expenditures occur when the interest rate cost of funds is equal to the
expected rate of return.

Many projects may be affordable but not worthwhile because the marginal benefit is
less than marginal cost. Often the R&D spending decision is complex because the
estimation of future benefits is highly uncertain while costs are immediate and
more clear-cut.
The Role of Market
Structure
1. Pure competition: the small size of competitive firms and the fact hat
they earn zero economic profit in the long run leads to serious questions as
to whether such producers can finance substantial R&D programs. The
firms in this market structure would spend no significant amount. However,
firms of the same industry may gather their resources and develop R&D
programs.

2. Monopolistic competition: there is a strong profit incentive to engage


in product development in this market structure as the firms depend on
product differentiation to stand out from a large number of rivals. However,
most firms remain small which limits their ability to secure inexpensive
financing for R&D and any economic profits are usually temporary.
Therefore, spending on R&D is limited in this market structure.

3. Oligopoly: many of the characteristics of oligopoly are conducive to


technical advances including: their large size, ongoing economic profits, the
existence of barriers to entry and a large volume of sales. Firms in oligopoly
spent the highest amount on R&D among the four different market
structures.
Economic Efficiency
Economics is a science of efficiency in the use of scarce resources. Efficiency requires full
employment of available resources and full production. Full employment means all available
resources should be employed. Full production means that employed resources are providing
maximum satisfaction for our material wants. Full production implies two kinds of efficiency:

1. Allocative efficiency means that resources are used for producing the combination of goods
and services most wanted by society. For example, producing computers with word processors
rather than producing manual typewriters.
2. Productive efficiency means that least costly production techniques are used to produce
wanted goods and services.

Full efficiency means producing the "right" (Allocative efficiency) amount in the "right
"way (productive efficiency).
Pure competition:

Productive efficiency occurs where price is equal to minimum average total cost (min ATC); at
this point firms must use the lease-cost technology or they wont survive.

Under pure competition, this outcome will be achieved, as the long run equilibrium price of pure
competitive firms would be at the min ATC.

Allocative efficiency occurs where price is equal to marginal cost ( P=MC), because price is
societys measure of relative worth of a product at the margin or its marginal benefit. And the
marginal cost of producing product X measures the relative worth of the other goods that the
resources used in producing an extra unit of X could otherwise have produced. In short, price
measures the benefit that society gets from additional units of good X, and the marginal cost of
this unit of X measures the sacrifice or cost to society of other goods given up to produce more
of X.
Efficiency Cont.
Non-perfect competition:
Price of non-perfect competitive firms will exceed marginal cost, because price exceeds marginal
revenue and the firms produce where marginal revenue (MR) and marginal cost are equal. Then the
firms can charge the price that consumers will pay for that output level. Allocative efficiency is not
achieved because price (what product is worth to consumers) is above marginal cost (opportunity
cost of product). Ideally, output should expand to a level where P=MC, but this will occur only under
pure competitive conditions where P = MR. Productive efficiency is not achieved because the firms
output is less than the output at which average total cost is minimum.

Economies of scale (natural monopoly) may make monopoly the most efficient market model in
some industries. X-inefficiency, the inefficiency that occurs in the absence of fear of entry and
rivalry, may occur in monopoly since there is no competitive pressure to produce at the minimum
possible costs. Rent-seeking behavior often occurs as monopolies seek to acquire or maintain
government granted monopoly privileges. Such rent-seeking may entail substantial cost (lobbying,
legal fees, public relations advertising etc.) which are inefficient.

There are several policy options available when monopoly creates substantial economic
inefficiency:
1. Antitrust laws could be used to break up the monopoly if the monopolys inefficiency appears to
be long-lasting.
2. Society may choose to regulate its prices and operations if it is a natural monopoly.
3. Society may simply ignore it if the monopoly appears to be short-lived because of changing
conditions or technology.

Efficiency Vs technological advances:


Allocative efficiency is improved when technological advance involves a new product that increases
the utility consumers can obtain from their limited income. Process innovation can lower production
cost and improve productive efficiency. Innovation can create monopoly power through patents or
the advantages of being first, reducing the benefit to society from the innovation. Innovation can
R. Larry Reynolds 1997
Production
Production is an activity where
resources are altered or changed and
there is an increase in the ability of
these resources to satisfy wants.
change in physical characteristics
change in location
change in time
change in ownership

Fall 97 Principles of Microeconomics Slide -- 216


Production and Cost
Production is a technical relationship between a set of
inputs or resources and a set of outputs or goods.
QX = f( inputs [land, labour, capital], technology, . . .
) [Legal and social/cultural institutions influence the production
function.]
Cost functions are the pecuniary relationships between
outputs and the costs of production;
Cost = f(QX {inputs, technology} , prices of inputs, . . . )
Cost functions are determined by input prices and
production relationships. It is necessary to understand
production functions if you are to interpret cost data.

Fall 97 Principles of Microeconomics Slide -- 217


Costs
Costs are incurred as a result of production. The
important concept of cost is opportunity cost
[marginal cost]. These are the costs associated
with an activity. When inputs or resources are
used to produce one good, the other goods they
could have been used to produce are sacrificed.
Costs may be in real or monetary terms;
implicit costs
explicit costs

Fall 97 Principles of Microeconomics Slide -- 218


Implicit Costs
Opportunity costs or MC should include all costs
associated with an activity. Many of the costs are
implicit and difficult to measure.
A production activity may adversely affect a
persons health. This is an implicit cost that is
difficult to measure.
Another activity may reduce the time for other
activities. It may be possible to make a
monetary estimate of the value.

Fall 97 Principles of Microeconomics Slide -- 219


Explicit Costs
Explicit costs are those costs where
there is an actual expenditure in a
market. The costs of labour or
interest payments are examples.
Some implicit costs are estimated
and used in the decision process.
Depreciation is an example.

Fall 97 Principles of Microeconomics Slide -- 220


Normal Profit
In neoclassical economics, all costs
should be included:
wages represent the cost of labour
interest represents the cost of Kapital
rent represents the cost of land
normal profit [ ] represents the cost
of entrepreneurial activity
normal profit includes risk

Fall 97 Principles of Microeconomics Slide -- 221


Production Function
A production function expresses the
relationship between a set of inputs and
the output of a good or service.
The relationship is determined by the
nature of the good and technology.
A production function is like a recipe for
cookies; it tells you the quantities of each
ingredient, how to combine and cook, and
how many cookies you will produce.

Fall 97 Principles of Microeconomics Slide -- 222


QX = f(L, K, R, technology, . . . )
QX = quantity of output
L = labour input
K = Kapital input
R = natural resources [land]
Decisions about alternative ways to produce good X require
that we have information about how each variable influences
QX .

One method used to identify the effects of each variable on


output is to vary one input at a time. The use of the ceteris
paribus convention allows this analysis.

The time period used for analysis also provides a way to


determine the effects of various changes of inputs on the
output.

Fall 97 Principles of Microeconomics Slide -- 223


Technology
The production process [and as result, costs]
is divided up into various time periods;
the very long run is a period
sufficiently long enough that technology
used in the production process changes.
In shorter time periods [long run, short
run and market periods], technology is a
constant.

Fall 97 Principles of Microeconomics Slide -- 224


Long Run
The long run is a period that:
is short enough that technology is unchanged.
all other inputs [labour, kapital, land, . . . ] are
variable, i.e. can be altered.
these inputs may be altered in fixed or variable
proportions. This may be important in some
production processes.
If inputs are altered, the output changes.
QX = f(L, K, R, . . . ) technology is constant

Fall 97 Principles of Microeconomics Slide -- 225


Short Run
The short run is a period in which at least
one of the inputs has become a constant
and at least one of the inputs is a variable.
If kapital [K] and land [R] are fixed or
constant in the short run, labour [L] is the
variable input. Output is changed by
altering the labour input. QX = f(L)
Technology, K and R are fixed or constant.

Fall 97 Principles of Microeconomics Slide -- 226


Market Period
When Alfred Marshall included time
into the analysis of production and
cost, he included a market period
in which inputs, technology and
consequently outputs could not be
varied.
The supply function would be
perfectly inelastic in this case.

Fall 97 Principles of Microeconomics Slide -- 227


Production in the Short Run
Consider a production process where K, R and technology are
fixed: As L is changed, the output
changes, QX= f(L) Production of Good X

L = labour input L TPL APL MPL


TPL = QX = output of good X 0 0 0 --
APL = average product [TP/L] L = 1 1
4TPL=4
4 4
MPL = Marginal product [TP/ L]
2 10 5 6
TPLL
AP
AP =
APLLL== 3 20 6.67 10
L
TPL 4 25 6.25 5
MPL =
L 5 29 5.8 4
TPL output 3
APL = = Efficiency 6 32 5.3
L = input
7 34 4.87 2
Maximum of APL is at the 3 input of
8 35 4.37 1
labour.
9 35 3.89 0
Fall 97 Principles of Microeconomics Slide -- 228
Production in the Short Run

TPL output
APL = Efficiency of Production of Good X
L = input =
labour L TPL APL MPL
Notice that the APL increases as the first
three units of labour are added to the
0 0 0 --
fixed inputs of K and R. The maximum 1 4 4 4
efficiency of Labour or maximum APL , given 2 10 5 6
our technology, plant and natural
resources is with the third worker. 3 20 6.67 10
4 25 6.25 5
As additional units of labour are added 5 29 5.8 4
beyond the third worker the 3
6 32 5.3
output per worker [APL ] declines.
7 34 4.87 2
8 35 4.37 1

9 35 3.89 0

Fall 97 Principles of Microeconomics Slide -- 229


Graphically TPL can be shown:
TPL initially increases at an increasing L TPL

..
rate; it is convex from below.

. .
0 0
TPL
Output, QX

.
1 4
35

.
Maximum
2 10
30 output

.
3 20
25
After some point it 4 25
20 then increases at a

.
decreasing rate and 5 29
15
reaches a maximum

.
6 32
10 level of output,

.
7 34
5 and declines
8 35

1 2 3 4 5 6 7 8 9 9 35
Labour

Fall 97 Principles of Microeconomics Slide -- 230


Given the TP , the APL can calculated: TPL L APL
TPL output Efficiency of 0 0 0
APL = = =
L input labour 4 1 4
10 2 5
20 3 6.67
APL 25 4 6.25
10

. .
29 5 5.8

. ..
8

.
32 6 5.3
6

4 . .. 34

35
7
8
4.87
4.37
2
. 1 2 3 4 5 6 7 8 9
APL 35 9 3.89

Labour

Fall 97 Principles of Microeconomics Slide -- 231


Output, QX
Z W

.
.
35 TPL

.
.
The APL is the

.
.
30 slope of a Graphically the relationship
between APL and TPL can be shown:

.
ray from
25 M
the origin 5 1 unit of L produces 4Q,APL is 4/1 = 4 or the
20 to the =
n slope of line 0H.
TPL . u H

.
15 e/r 2 units of L produces 10Q,
ris =
4
10 u n APL is 10/2 = 5 or the slope of line 0M.
r

.
e /
ris 3 units of L produces 20Q,

APL
5
4
0 .1 2 3 4 5
APL is 20/3 = 6.67 or the slope of line 0Z.

6 7 8 9 4 units of L produces 25Q,

.
10

.
Labour APL is 25/4 = 6.25 or

. .. .
8 the slope of line 0W.
6

4 . .. As additional units of L are added,


the AP falls.
The maximum AP is where
2
.
Fall 97
1 2 3 4 5 Principles
6 7 8
APL the ray with the greatest

9
slope is tangent to the TP.

of Microeconomics Slide -- 232


Labour
Output, QX

.
.
35 TPL

.
.
Given TPL , the APL was

.
30
calculated and graphed.

.
25 MPL was calculated as L MP
APLL TPL
20 the change in TPL given a
change in L.
0 --
0 0

.
4-0
15 The first unit of labour added 1 44 4
4 units of output.
10 2 65 10

.
Between the 1st and 2cd units

. .
5 of labour, Q increases by 6. 3 10
6.67 20
4
0 4 5
6.25 25
APL 1 2 3 4 5 6 87 9

.
10 5 4
5.8 29

.
Labour

.
Note: Where MPL = APL, APL

.. .
8 3 32

.
6 5.3

. .. . ..
is a maximum.

..
MPL = APL
6 7 2
4.87 34

4 8 1
4.37 35

2
. . .
APL 9 0
3.89
MPL Remember: MP is graphed
35

Fall 97
1 2 3 4 5 Principles
6 7 8 9 at between unitsSlide
of Microeconomics
of L.
-- 233
Labour
Output, QX
Z

.
.
35 TPL

.
.
.
30 Useful things to notice:
1. MPL is the slope of TPL.

.
25
2. When TPL increases at an increasing
20 rate, MPL increases. At the inflection

.
point in the TPL , MPL is a maximum.
15
When TPL increases at a decreasing rate,
10

.
MPL is decreasing.

. .
3. The APL is a maximum when:
5
4 a. MPL = APL ,
0 b. the slope of the
APL 1 2 3 4 5 6 7 8 ray9 from origin is tangent to

.
10

.
Labour

.
TPL .

.. .
8

.. . .
.. . ..
4. When MPL > APL the APL is increasing.
6 When MPL < APL the APL is decreasing
4 5. When MPL is 0, the
2
. . .
APL
MPL
slope of TPL is 0, and TP
is a maximum.

Fall 97
1 2 3 4 5 Principles
6 7 8 9
of Microeconomics Slide -- 234
Labour
Summary: TPL , MPL and APL

In many production processes Z


Q initially increases at an TPL
TPL
increasing rate. This is due to At the
division of labour and a better inflection
mix of the variable input with the point
fixed inputs. Diminishing
marginal
product
As Q [TPL ]increases at an increasing
rate, MP increases.
0
As Q [TPL ]increases at a L
MPL
decreasing rate, MPL decreases. MPL is {MP< AP,
APL
a max AP falls}
Where 0Z is tangent to TPL , APL is a
maximum; APL = MPL .
When TPL is a maximum, MPL is zero. APL
When TPL is decreasing, MPL is
MPL
negative.
{MP> AP, AP rises} L1 L2 L3 L
Fall 97 Principles of Microeconomics Slide -- 235
To calculate AP:
PRODUCTION TPL
APL =
L
LABOUR KAPITAL OUTPUT MP AP

0 5 0 0 0 = ? AP is a maximum
L= 1 TPL = 8 when L = 4.
1 5 8 8TP8.0 8 1 = 8
L= 1 L = 15
2 5 23 15TP11.5 23 2 = 11.5Note that MP is
L= 1 L = 19
3 5 42 19 14.0 42 3 = 14 15 between 3rd & 4th
L= 1 TPL = 15
4 5 57 15TP14.25 574 = 14.25 units of L, it is 10
L= 1 = 10
67 5 = 13.4 between 4th & 5th,
L
5 5 67 10TP13.4
= 7
L= 1 L so it equals
6 5 74 7 12.33 AP = 14.25 at L=4.
7 5 79 5 11.28
8 5 82 3 10.25 To calculate MP:
1 9.22
9 5 83
TPL
10 5 82 -1 8.2 MP =
L
L

MP is a maximum between 2cd and 3rd unit of L.

Fall 97 Principles of Microeconomics Slide -- 236


As L is added to production
PRODUCTION process, output per worker [AP]
increases. to a maximum
LABOUR KAPITAL OUTPUT MP AP efficiency [output/input which
occurs at L = 4.
0 5 0 0
1 5 8 8 8.0
MP increases to a max between
2 5 23 15 11.5 the 2cd & 3rd units of L.
3 5 42 19 14.0 When MP > AP the output per
4 5 57 15 14.25 worker is increasing.
5 5 67 10 13.4
Division of Labour and a more
6 5 74 7 12.33 efficient mix of L, K & R causes
7 5 79 5 11.28 AP to increase.
8 5 82 3 10.25 Output per worker decreases
9 5 83 1 9.22 after the 4th worker. Too
10 5 82 -1 8.2 many workers for K, R & tech,
Diminishing Marginal Productivity begins MP< AP.
with the 4rth unit of L.

Fall 97 Principles of Microeconomics Slide -- 237


The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
TFC = PK x K = $6K = 6 x5 = $30, This cost does not change in the short run.
TVC = PL x L = $4L, as L changes TVC and Output change.
PRODUCTION AND COST TC = TVC+TFC
LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 x $4 =
5 0 0
$30 + $ 0
--

1 x $4 =
5 8 8 8 =$30
$30 + $ 4
2 x $4 =
5 23 11.5 15 $30 =$34
+ $ 8=$38
3 x $4 =
5 42 14 19
$30 + $12=$42
4 x $4 =
5 57 14.25 15
$30 + $16=$46
5 x $4 =
5 67 13.4 10
$30 + $20=$50
6 5 74 12.33 7 $30 + $24=$54
7 5 79 11.28 5
$30 + $28=$58
8 5 82 10.25 3
$30 + $32=$62
9 5 83 9.22 1 $30 + $36=$66
10 5 82 8.2 -1 $30 + $40=$70

Fall 97 Principles of Microeconomics Slide -- 238


The price of labour [PL] is $4 per unit and the price of kapital [PK] is $6
per unit. Calculate the cost functions for this production process.
AFC = TFCQ = $30Q ATC = AVC + AFC = TCQ
AVC = TVC Q
PRODUCTION AND COST

LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 5 0 0 --
$0 $30
$30
1 5 8 8 8 $4 $34 $3.75 $ .50 $4.25
$30
2 5 23 11.5 15 $30 $8 $38 $1.30 $ .35 $1.65
3 5 42 14 19 $30 $12 $42 $ .71 $ .29 $1.00
4 5 57 14.25 15 $46 $ .53 $ .28 $.81
$30 $16
5 5 67 13.4 10 $50 $ .45 $ .30 $.75
$30 $20
6 5 74 12.33 7 $54 $ . $ .32 $.729
$30 $24
7 5 79 11.28 5 41
$30 $28 $58 $ .38 $ .35 $.734
8 5 82 10.25 3 $62 $ .37 $ .39 $.76
$30 $32
9 5 83 9.22 1 $30 $66 $ .36 $ .43 $.79
$36
10 5 82 8.2 -1 $70 $ .37 $ .49 $.86
$30 $40

Fall 97 Principles of Microeconomics Slide -- 239


Things to note . . .
As AP increases, AVC decreases. Since AFC declines, it will pull
When AP is a maximum, AVC is a minimum. the ATC down as Q increases
AFC declines so long as Q or output increases. beyond the minimum of the AVC.
{Up to the point where TP becomes negative.}
PRODUCTION AND COST

LABOUR KAPITAL OUTPUT AP MP TFC TVC TC AFC AVC ATC

0 5 0 0 -- $30
$30 $0
1 5 8 8 8 $4 $34 $3.75 $ .50 $4.25
$30
2 5 23 11.5 15 $8 $38 $1.30 $ .35 $1.65
$30
3 5 42 14 19 $12 $42 $ .71 $ .29 $1.00
$30
4 5 57 14.25 15 $46 $ .53 $ .28 $.81
$30 $16
5 5 67 13.4 10 $50 $ .45 $ .30 $.75
$30 $20
6 5 74 12.33 7 $54 $ . $ .32 $.729
$30 $24
7 5 79 11.28 5 41
$30 $28 $58 $ .38 $ .35 $.734
8 5 82 10.25 3 $62 $ .37 $ .39 $.76
$30 $32
9 5 83 9.22 1 $30 $66 $ .36 $ .43 $.79
$36
10 5 82 8.2 -1 $70 $ .37 $ .49 $.86
$30 $40

Fall 97 Principles of Microeconomics Slide -- 240


C
VLCx PL = TV
TPL is Q =T
Z PL Q TVC = L x PL
Lx TVC =
TP L
TPL When TP or Q Z
L2 x PL ]
increases TVC increases at a adecreasing ge TVC rate.
at an i]m
TPL re
increasing L2 x PL i rraog
rate, L1 x PL rmim Q* is the output
[
r ao
ir with the lowest
m AVC! [Max AP]
[a
TPL = Q
0 L1 L2 L3 L 0 Q* Q
At L1 [inflection point] the MP is a maximum; the point of Diminishing Marginal
productivity begins, each additional worker increases output, but at a smaller and
smaller amount.
At L2 the AP is a maximum; output per worker is a maximum, maximum efficiency;
additional units of labour are less productive.
At L3 the TP is a maximum; this is the maximum amout of output [Q] that can
be produced given the size of the plant [fixed input K]. Additional [marginal] L is
negative.

Fall 97 Principles of Microeconomics Slide -- 241


The average variable cost [AVC] and marginal cost [MC] are mirror images
MPL of the AP and MP functions.
APL
APL

APL APL

MPL MPL
L1 L2 L3 L The maximum of the AP is consistent with
the minimum of the AVC.
1 xP $
MC = L
MC
MPL
MP
APL
AVC
AVC = 1 xP
L
AP AVC

Q
APL x L2

Fall 97 Principles of Microeconomics Slide -- 242


MC will intersect the AVC at the
$ minimum of the AVC [always].
MC

ATC
AVC
ATC* MC will intersect the ATC
R
at the minimum of the ATC.
AVC* TC = ATC* x Q** J
The vertical distance between
TVC = AVC* x Q* ATC and AVC at any output is
the AFC. At Q** AFC is RJ.

Q* Q** Q
At Q* output, the AVC is at a minimum AVC* [also max of APL].
At Q** the ATC is at a MINIMUM.

Fall 97 Principles of Microeconomics Slide -- 243


The
The Long
Long Run
Run

The long run is a period of time where:


technology is constant
All inputs are variable
The long run period is a series of short run
periods. [For each short run period there is a set of TP,
AP, MP, MC, AFC, AVC, ATC, TC, TVC & TFC for each
possible scale of plant]

Fall 97 Principles of Microeconomics Slide -- 244


LONG RUN COSTS

MC1 Plant ATC* is the LRMC


$ ATC! optimal size!
MC2 ATC6
ATC2
ATC3 ATC5
ATC*
ATC*
LRAC
There is a long run
Cmin marginal cost function.
At Q* the cost per unit are
minimized [the least inputs
used].
Q* Q
For Plant size 1, the costs are ATC1 and MC1 :
For a bigger Plant 2, the unit costs move out and down. It is more cost
effective. As bigger plants are built the ATC moves out and down.
Eventually, the plant size is too large, the ATC moves out but also up!
An envelope curve is constructed to represent the long run AC [LRAC].

Fall 97 Principles of Microeconomics Slide -- 245


The LRAC
LRAC is U-Shaped
The LRAC initially decreases due to economies of
scale
economies of scale are due to division of
labour.
Eventually, diseconomies of scale begin
usually lack of adequate information to
manage the production process
Calculation of LRAC
With a little mathematics, the long
run cost functions can be calculated.
It is easier to use equations rather
than tables and graphs.
If consumer behavior, production and
cost is understood, you can then
think about how to achieve your
objectives.

Fall 97 Principles of Microeconomics Slide -- 247