Pizzas (hundred thousands) PRODUCTION POSSIBILITIES Q 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Unemployment & Underemployment Shown by Point U Robots (thousands) More of either or both is possible U Q 1 2 3 4 5 6 7 8 Pizzas (hundred thousands) 55

Pizzas (hundred thousands) PRODUCTION POSSIBILITIES Q A’ 14 13 12 11 10 9 8 7 6 5 4 3 2 1 Economic Growth B’ C’ Robots (thousands) D’ E’ Q 1 2 3 4 5 6 7 8 Pizzas (hundred thousands) 58

Circular Flow Model $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION 77

THE COMPETITIVE MARKET SYSTEM The Five Fundamental Questions.... Can the system adapt to change? Who is to receive the output? What is to be produced? How much to produce? How is the output to be produced?

HOUSEHOLDS AS INCOME RECEIVERS FUNCTIONAL DISTRIBUTION WAGES $4,703 Billion 71% PROPRIETOR’S 545 Billion 8% INCOME CORPORATE 804 Billion 12% PROFITS INTEREST 450 Billion 7% RENTS 148 Billion 2% 1997 DATA

THE CIRCULAR FLOW REVISITED $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES GOVERNMENT HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION

The Circular Flow Revisited $ COSTS $ INCOMES RESOURCE MARKET RESOURCES INPUTS BUSINESSES GOVERNMENT HOUSEHOLDS GOODS & SERVICES GOODS & SERVICES PRODUCT MARKET $ REVENUE $ CONSUMPTION Foreign Expenditures U.S. Imports U.S. Exports U.S. Expenditures REST OF THE WORLD

Protective Tariffs Import Quotas Nontariff Barriers Export Subsidies GOVERNMENT & TRADE Trade Impediments & Subsidies Protective Tariffs Import Quotas Nontariff Barriers Export Subsidies

D % P Q Price Elasticity is... Commonly expressed as... d P D Q P2 P1

Price Elasticity is... P D Q Total revenue rises with price to a point... TR Inelastic Demand D Inelastic Demand Q Quantity Demanded

Price Elasticity is... P D Q then declines Total revenue rises with price to a point... TR then declines Elastic Demand Unit Elastic Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded

Price Elasticity is... P D Q then declines Total revenue rises with price to a point... TR then declines Elastic Demand Inelastic Demand D Elastic Demand Inelastic Demand Q Quantity Demanded

Price Elasticity is... ¥ Inelastic from 0 to 1 Elastic from 1 to Typical of necessities one must have Elastic from 1 to ¥ Typical of luxuries one wants Unit elastic when exactly = 1 Price change does not reduce total revenue

Luxuries versus Necessities Time Determinants of Price Elasticity of Demand Substitutability Proportion of Income Luxuries versus Necessities Time

Price Elasticity of Supply Immediate market period P Sm An increase in demand without enough time to change supply causes… Po D1 Q Copyright McGraw-Hill, Inc., 1999

Price Elasticity of Supply Short run P Ss An increase in demand with less intensity supply use causes... Po D1 Q Qo Copyright McGraw-Hill, Inc., 1999

Price Elasticity of Supply Long run An increase in demand in the long run allows greater change causing... P SL Po D1 Q Qo Copyright McGraw-Hill, Inc., 1999

Percentage change in quantity Cross Elasticity of Demand Percentage change in quantity demanded of good X Exy = Percentage change in the price of good y Substitute Goods - Positive Sign Complementary Goods - Negative Sign Independent Goods - Zero or near-zero value

Ei = Income Elasticity of Demand Normal Goods - Positive Sign Percentage change in quantity demanded Ei = Percentage change in income Normal Goods - Positive Sign Inferior Goods - Negative Sign

Applications... Price Ceiling P D S P Legal Price Ceiling Pc SHORTAGE Q Schill 2002

Applications... SURPLUS P The result of imposing a legal price floor is a... D S SURPLUS Pf Legal Price Floor P S D Q Qd Q Qs Schill 2002

Utility Analysis Total Utility Rises as Marginal Utility Falls Diminishing Marginal Utility explains a downward sloping demand curve! Typical Utility Table: Q TU MU 0 0 0 1 10 10 2 18 8 3 24 6

Consumer Surplus If an ice cream cone costs $1.50, but Ivan would pay $2.00 for the ice cream cone than Matt’s consumer surplus is $0.50. If a new calculator costs 84.50, and Lori and Jessica would pay $90.00 for that calculator than their consumer surplus is $5.50. All three feel good about their lucky purchases! All have received some UTILITY!

Consumer Surplus in Total D Q Q

Optimum Purchase Rule Consumers will purchase as long as their MU (Value of the next one purchased) is greater than the price. If MU > P a rational consumer will make the purchase! When MU = P, Consumer Surplus is Zero! When MU = P we are at optimum purchase!

Why are more Big Mac Purchased than Pizzas? Consumer may like pizza more than Big Macs, but rational consumers also understand the value of money. MU = 20 P = $2 MU/P = 10 MU = 30 P = $10 MU/P = 3 Rational consumers purchase where MU/P is greatest!

The Law of Equal Marginal Utility or the Final Purchase Rule Consumers will maximize Total Utility when final purchases give the same MU/P’s. MU/P Big Mac = 4 MU/P Fries = 4 MU/P Shake = 4

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I3 Combination Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B Schill 2002

A Customer’s Budget Line Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 (Unattainable) Quantity of A (Attainable) Quantity of B Schill 2002

A Customer’s Equilibrium Position j Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 Equilibrium occurs when the consumer selects the combination which reaches the highest attainable indifference curve (Unattainable) 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I4 (Attainable) I3 Combination Units of A Units of B I2 I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B Schill 2002

Profits to an Economist Profits to an Accountant Economic Profits Accounting Profits Implicit costs (including a normal profit) Total Revenue Economic (opportunity) Costs Accounting costs (explicit costs only) Explicit Costs Schill 2002

Summary of Definitions... Total Fixed Costs = TFC Total Variable Costs = TVC Total Costs = TC Average Fixed Costs = AFC Average Variable Costs = AVC Average Total Costs = ATC Marginal Cost = MC

Costs Graphically Presented... MC ATC AVC Short-run average costs (dollars) AFC Quantity Copyright McGraw-Hill, Inc. 1999

Productivity & Cost Curve Relationship Average product and marginal product AP MP Quantity of labor MC AVC Costs (dollars) Quantity of output Copyright McGraw-Hill, Inc. 1999

Long-run Production Costs For every plant capacity size... there is a short-run ATC curve and every ATC has a minimum cost Unit Costs Output

Long-run Production Costs For every plant capacity size... there is a short-run ATC curve and every ATC has a minimum cost LRATC Unit Costs Increasing Return to Scale Decreasing Return to Scale Constant Return to Scale Output

Costs Graphically Presented... TC TVC Fixed Cost Costs (dollars) Total Cost Variable Cost TFC Quantity Copyright McGraw-Hill, Inc. 1999

Long-run ATC Curves Long-run ATC Unit Costs Output Economies of scale Constant returns to scale Diseconomies of scale Unit Costs Long-run ATC Output Copyright McGraw-Hill, Inc. 1999

Four Market Models Pure Competition: Very Large Numbers Standardized Product “Price Taker” Free Entry and Exit Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum Copyright McGraw-Hill, Inc. 1999

{ Total-Revenue-Total Cost Approach P Total Revenue Maximum Economic 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 P Total Revenue Maximum Economic Profits $299 Break-Even Point (Normal Profit) TR(P=$131) { Total revenue and total costs (dollars) Total Cost Break-Even Point (Normal Profit) Q 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Copyright McGraw-Hill, Inc. 1999

Short Run Profit Maximization Two Approaches... Total-Revenue-Total Cost Approach Marginal Revenue - Marginal Cost Approach MR = MC Rule Three features: Firms would rather produce than shut down MR = MC profit maximization in all markets Competitive markets maximize at P = MC Copyright McGraw-Hill, Inc. 1999

Marginal-Revenue-Marginal Cost Approach 200 150 100 50 P Economic Profit MC 131 MR ATC Total revenue and total costs (dollars) 97.78 AVC Q 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc. 1999

Long-run ATC Curves Where extensive economies of scale exist Unit Costs Long-run ATC Output Copyright McGraw-Hill, Inc. 1999

MR = MC Optimum Solution Marginal-Revenue-Marginal Cost Approach 200 150 100 50 P Economic Profit MC 131 MR MR = MC Optimum Solution ATC Total revenue and total costs (dollars) 97.78 AVC Q 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc. 1999

When price is inadequate to meet minimum AVC, Marginal-Revenue-Marginal Cost Approach P 200 150 100 50 MC Economic Loss ATC Total revenue and total costs (dollars) AVC 71 MR When price is inadequate to meet minimum AVC, the firm should shut down Q 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc. 1999

Marginal-Revenue-Marginal Cost Approach Break-even (normal profit) point ATC MC P5 MR5 Costs and revenues (dollars) P4 MR4 AVC P3 MR3 P2 MR2 P1 MR1 Firm should not produce unless revenue is at least able to meet AVC Q Q2 Q3 Q4 Q5 Copyright McGraw-Hill, Inc. 1999

Long-run Profit Maximization What happens if demand decreases... P P S1 MC ATC $60 $50 $40 $60 $50 $40 MR D1 Q Q $100 $90,000 $100,000 Firm (price taker) Industry Copyright McGraw-Hill, Inc. 1999

Long-run Profit Maximization Short-run losses at lower prices... P P S1 MC ATC $60 $50 $40 $60 $50 $40 MR D1 D2 Q Q $100 $90,000 $100,000 Firm (price taker) Industry Copyright McGraw-Hill, Inc. 1999

Long-Run Competitive Equilibrium MC ATC Price P MR Price = MC = Minimum ATC (normal profit) Q Q Quantity Copyright McGraw-Hill, Inc. 1999

Productive Efficiency Pure Competition and Efficiency Productive Efficiency Price = Minimum ATC Allocative Efficiency Price = MC Copyright McGraw-Hill, Inc. 1999

Single Seller No Close Substitutes “Price Maker” Blocked Entry Characteristics of Monopoly Single Seller No Close Substitutes “Price Maker” Blocked Entry Advertising importance...

Output and Price Determination Cost Data MR = MC Rule No Monopoly Supply Curve Monopoly Pricing Misconceptions Not Highest Price Total, Not Unit, Profits Losses

Marginal-Revenue-Marginal Cost Approach 200 150 100 50 MC Economic Loss ATC Total revenue and total costs (dollars) AVC 81 MR Q 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc. 1999

The Natural Monopoly Case Economies of Scale: The Natural Monopoly Case $20 15 ATC Average Total Cost 10 If ATC declines over extended output, least-cost production is realized only if there is one producer - a natural monopoly 50 100 200 Quantity Copyright McGraw-Hill, Inc., 1999

Monopoly Demand 3 Basic Assumptions... Price Exceeds Marginal Revenue Monopoly Status is Secured Firm is not Governmentally Regulated Firm charges the same price for all units Price Exceeds Marginal Revenue example...

Demand, Marginal Revenue, Total Revenue Imperfectly Competitive Firm 200 150 50 Elastic Dollars Inelastic MR D Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 750 500 250 Dollars TR Copyright 1999 McGraw-Hill, Inc. Q 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

Profit Maximization Under Monopoly 200 175 150 125 100 75 50 25 MC $122 Profit ATC $94 D MR Q 0 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc., 1999

Loss Minimization Under Monopoly 200 175 150 125 100 75 50 25 Loss Per Unit MC ATC Loss AVC D MR = MC MR Q 0 1 2 3 4 5 6 7 8 9 10 Copyright McGraw-Hill, Inc., 1999

Regulated Monopoly P Price and Costs ATC MC D MR Q Copyright McGraw-Hill, Inc., 1999

Barriers to Entry Economies of Scale Legal Barriers: Patents & Licenses Ownership of Essential Resources Monopolies are relatively rare There are times when monopoly is desired

Regulated Monopoly Fair Return Price Price = ATC P Price and Costs ATC MC D MR Q Copyright McGraw-Hill, Inc., 1999

Regulated Monopoly Monopoly Price MR = MC P Price and Costs ATC MC D Q Copyright McGraw-Hill, Inc., 1999

Monopolistic Competition Characteristics... Relatively Large Numbers Small Market Share No Collusion Independent Actions Product Differentiation Product Attributes Services Location Brand Names and Packaging Some Control Over Price

Short-Run Price and Output Determination MC P How would the long-run differ? ATC Economic Losses Price and Costs Expect Less Competitors D MR Q Q

Short-Run Price and Output Determination Long-run equilibrium MC P ATC Price and Costs D MR Q Q

Nonprice Competition Monopolistic Competition and Economic Efficiency Not Productively Efficient Not Allocatively Efficient Excess Capacity Nonprice Competition Product Differentiation Product Development

Oligopoly: Characteristics Oligopoly Defined Homogeneous or Differentiated Products Control over Price Mutual Interdependence Entry Barriers Mergers

Oligopoly: Characteristics Concentration Ratios 1 - Localized Markets 2 - Interindustry Competition 3 - World Trade Import Competition 4 - Herfindahl Index 5 - Performance

Three Oligopoly Models No Standard Model due to... Diversity Interdependence 1 - Kinked Demand Curve 2 - Collusive Pricing 3 - Price Leadership

Kinked Demand: Noncollusive Oligopoly Rivals tend to follow a price cut D2 MR2 D1 Q Quantity MR1

Kinked Demand: Noncollusive Oligopoly Rivals tend to follow a price cut or ignore a price increase D2 MR2 D1 Q Quantity MR1

Kinked Demand: Noncollusive Oligopoly Effectively creating a kinked demand curve D2 MC2 MC1 MR2 D1 Q Quantity MR1

Price Wars Kinked Demand: Noncollusive Oligopoly Effectively creating a kinked demand curve D2 MC1 Price Wars MR2 MC2 D1 Q Quantity MR1

Socially Optimum Price Regulated Monopoly P Socially Optimum Price Price = MC Price and Costs ATC MC D MR Q Copyright McGraw-Hill, Inc., 1999

Oligopoly and Economic Efficiency oligopoly market structure Recall... Allocative Efficiency (Price = MC) Productive Efficiency (Price = Minimum ATC) Neither is likely in an oligopoly market structure

Marginal Productivity Theory of Resource Demand Resource Demand as a Derived Demand Marginal Product (MP) Marginal Revenue Product (MRP) Productivity Product Price Marginal Resource Cost (MRC) Rule for Employing Resources: MRP = MRC

Changes in Product Demand Changes in Productivity Determinants of Resource Demand Changes in Product Demand Changes in Productivity 1 - Quantities of Other Resources 2 - Technological Progress 3 - Quality of the Resource Prices of Other Resources

Optimum Combination of Resources Least-Cost Rule MP of Labor MP of Capital Price of Labor Price of Capital

1 Optimum Combination of Resources MRPL MRPC PL PC Least-Cost Rule MP of Labor MP of Capital Price of Labor Price of Capital Profit-Maximizing Combination MRPL MRPC 1 PL PC

Monopsonistic Labor Market MRC MRP S MRP = MRC b Wage Rate (dollars) Wm c MRP Qm units of labor hired Qm Quantity of Labor Copyright McGraw-Hill, Inc. 1999

Monopsonistic Labor Market MRC MRP S Wage rate is only Wm due to monopsony power b Wage Rate (dollars) Wm c MRP Qm units of labor hired Qm Quantity of Labor Copyright McGraw-Hill, Inc. 1999

Monopsonistic Labor Market MRC MRP S The competitive solution would result in a higher wage and greater employment Wage Rate (dollars) Wc Wm MRP Qm Qc Quantity of Labor Copyright McGraw-Hill, Inc. 1999

Note: Fixed Total Supply ECONOMIC RENT Note: Fixed Total Supply means... Perfectly Inelastic Supply therefore... Demand Determines Price!

Determination of Land Rent Changes in the demand for land... S Inelastic Supply... combines with demand... to determine RENT R1 Land Rent (dollars) D1 S Q Acres of Land Copyright McGraw-Hill, Inc., 1999

Loanable Funds Theory of Interest Quantity of Loanable Funds Interest Rate i, (percent) 8% D F0 Quantity of Loanable Funds Copyright McGraw-Hill, Inc., 1999

Private Goods

Private Goods Divisibility Public Goods Indivisible Demand Curve is Horizontal Summation Public Goods Indivisible

The Exclusion Principle Does Not Apply Public Goods & Services Note: The Exclusion Principle Does Not Apply Some Goods & Services Would Not Be Produced By The Market System Public or Social Goods Are...

Public or Social Goods Are... Indivisible Subject to the free-rider problem NO LANDING FEES PAID

Quasi-public Goods Public or Social Goods Are... Indivisible Subject to the free-rider problem May Provide Large Spillover Benefits Quasi-public Goods

ECONOMIC FUNCTIONS OF GOVERNMENT REALLOCATION OF RESOURCES.... Spillovers or Externalities Spillover Costs

ECONOMIC FUNCTIONS OF GOVERNMENT REALLOCATION OF RESOURCES.... Spillovers or Externalities Spillover Costs Correcting For Spillover Costs Legislation Specific Taxes

ECONOMIC FUNCTIONS OF GOVERNMENT REALLOCATION OF RESOURCES.... Spillovers or Externalities Spillover Benefits Correcting for Spillover Benefits.... Increase Demand Increase Supply

Optimal Amount of a Public Good $ 9 7 5 3 1 S Yields the optimum amount of the public good MB = MC DC Q 0 1 2 3 4 5 Copyright McGraw-Hill, Inc. 1999

Externalities Benefit-Cost Analysis Spillover Costs Overallocation Marginal Benefit = Marginal Cost Rule Externalities Spillover Costs Overallocation Spillover Benefits Underallocation

Correcting for Spillover Costs D Q Overallocation Copyright McGraw-Hill, Inc. 1999

Correcting for Spillover Costs Overallocation Corrected TAX D Q Overallocation Corrected Copyright McGraw-Hill, Inc. 1999

Correcting for Spillover Benefits Dt D Underallocation Q Copyright McGraw-Hill, Inc. 1999

Correcting for Spillover Benefits Subsidy to consumer Dt D Underallocation Corrected Q Copyright McGraw-Hill, Inc. 1999

Correcting for Spillover Benefits St S’t Subsidy to producers U Dt D Underallocation Corrected Q Copyright McGraw-Hill, Inc. 1999

Apportioning the Tax Burden

Progressive Tax Regressive Tax Proportional Tax Apportioning the Tax Burden Benefits-Received Principle Ability-to-Pay Principle Progressive Tax Regressive Tax Proportional Tax