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Introduction and Course Overview

The Methods of Economics


The Product and Factor Markets

Determinants of Demand for an Individual


The Demand Curve for an Individual
From Individual Demand to Market Demand
Change in demand vs. Change in quantity demanded
Determinants of Supply for an Individual Supplier
The Supply Curve for an Individual Supplier
From Individual Supply to Market Supply
Change in supply vs. Change in quantity supplied
Equilibrium
The Necessity of Equilibrium
Calculating Equilibrium with Equations

EquilibriumPutting Supply and Demand


Together
The Necessity of Equilibrium
Price Floors
Price Ceilings

Calculating Equilibrium with Equations

Comparative Statics
The Three Questions
Examples

Elasticity
Price Elasticity of Demand
Elastic and Inelastic Curves
Calculating Elasticity: The Midpoint Formula
Elasticity and Slope

Other Elasticities
Cross-Price Elasticity of Demand
Income Elasticity of Demand
Price Elasticity of Supply

Determinants of Individual Demand


Price
Income
Normal goods: Goods whose demand increases when
income increases
Inferior goods: Goods whose demand decreases when
income increases

Price of Related Goods


Substitutes: Demand goes up when the price of a substitute
goes up
Complements: Demand goes down when the price of a
complement goes up

Tastes and Preferences


Expectations

Determinants of Market Demand


Price
Income
Normal goods: Goods whose demand increases when income
increases
Inferior goods: Goods whose demand decreases when income
increases
Price of Related Goods
Substitutes: Demand goes up when the price of a substitute
goes up
Complements: Demand goes down when the price of a
complement goes up
Tastes and Preferences
Expectations
Number of Buyers

Individual Demand
Lower Case q"

D
0

Market Demand
Capital Q"

D
0

The Market Demand Curve for Lattes


The Demand Function
P

QD = 24 3P

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


The Demand Function
P

QD = 24 3P
P = 8 QD

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00

P = 8 QD

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00

P = 8 QD
P = 8 (9)

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00

P = 8 QD
P = 8 (9)
=5

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


P

P
$6.00

P = 8 QD
P = 8 (18)
= 2

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

Demand and Inverse Demand


Functions
P Numerical Demand Function: QD = 24 3P

D
0

Demand and Inverse Demand


Functions
P Numerical Demand Function: QD = 24 3P
Inverse Demand Function:
P = 8 QD

D
0

Demand and Inverse Demand


Functions
P Numerical Demand Function: QD = 24 3P
Inverse Demand Function:
P = 8 QD
8
Slope =

D
0

24

Demand and Inverse Demand


Functions
P Parametric Demand Function: Q D a bP

a
Inverse Demand Function:
b

a 1 D
P= Q
b b

Slope = 1/b

D
0

Demand and Inverse Demand


Functions
P General Form of Demand Function: Q D f (P)
Inverse Demand Function:

P = f 1 (Q D )

dP
Slope =
dQ D

D
0

The Market Demand Curve for Lattes


Increase in quantity demanded
P

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10

15

20

25

$0.00
1.00
2.00
3.00
4.00
5.00
6.00

Qd
(Market)
24
21
18
15
12
9
6

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

$0.00

24

$4.00

1.00

21

$3.00

2.00

18

3.00

15

4.00

12

5.00

6.00

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes


Incomes, Price of related goods, Expectationsall
held constant
Tastes change more in favor of the good

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant


Tastes change more in favor of the good
Demand curve shifts right

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00
$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant


Tastes change more in favor of the good
Demand curve shifts right

P
$6.00

QDold

QDnew

$0.00

24

28

$4.00

1.00

21

25

$3.00

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

$5.00

$2.00

P = 8 QD

$1.00
$0.00

Q
0

10

15

20

25

The Market Demand Curve for Lattes

Incomes, Price of related goods, Expectationsall held constant


Tastes change more in favor of the good
Demand curve shifts right

P
$6.00
$5.00

P = 9 QD

$4.00
$3.00
$2.00

P = 8 QD

$1.00
$0.00

Q
0

10

15

20

25

QDold

QDnew

$0.00

24

28

1.00

21

25

2.00

18

22

3.00

15

19

4.00

12

16

5.00

13

6.00

11

Increase in Quantity Demanded


P
$2.00

P QD
A

An increase in quantity
demanded is a
movement down along
the demand curve
B

$1.00

D
0

12

14

Increase in Demand

One of the non-price determinants of D changes, causing the curve to shift right

Income (Normal goods)


Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers

D2
D1
0

Decrease in Quantity Demanded


P
$2.00

P QD
B

An decrease in
quantity demanded is a
movement up along
the demand curve
A

$1.00

D
0

12

14

Decrease in Demand

One of the non-price determinants of D changes, causing the curve to shift left

Income (Normal goods)


Income (Inferior goods)
Price of substitute
Price of complement
Changes in tastes or expectations
Number of buyers

D1
D2
0

Determinants of a Firms Supply

Price
Input Prices
Technology
Expectations

Determinants of Market Supply

Price
Input Prices
Technology
Expectations
Number of Sellers

The Market Supply Curve


P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
25
Q 5.00
30
10 15 20 25 30 35 6.00

The Market Supply Curve

Input prices, technology, expectations and number


of sellers all held constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35

The Market Supply Curve


QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30

P
$6.00

QS = 5P

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10 15

20 25 30

35

The Market Supply Curve


QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30

P
$6.00

QS = 5P
P = (1/5)QS

$5.00
$4.00
$3.00
$2.00
$1.00
$0.00

Q
0

10 15

20 25 30

35

The Market Supply Curve

Input prices, technology, expectations and number


of sellers all held constant
P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held


constant

Increase in quantity supplied

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
S
P = (1/5)Q
4.00
20
= (1/5)10
=2
5.00
25
Q
6.00
30
10 15 20 25 30 35

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held


constant

Increase in quantity supplied

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

S
Q
P
P = (1/5)QS
(Market)
= (1/5)25
$0.00
0
=5
1.00
5
2.00
10
3.00
15
S
P = (1/5)Q
4.00
20
= (1/5)10
=2
5.00
25
Q
6.00
30
10 15 20 25 30 35

The Market Supply Curve

Input prices, technology, expectations and number of sellers all held


constant

Increase in quantity supplied

P
$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

QS
P
(Market)
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
Q
6.00
30
10 15 20 25 30 35

The Market Supply Curve


Technology, expectations and number of sellers still held
constant
Input costs increase

P
QSold QSnew
$0.00
0
1.00
5
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
3.00
15
4.00
20
5.00
25
6.00
30
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
4.00
20
5.00
25
6.00
30
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
5.00
25
6.00
30
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
Supply curve shifts to the left
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q

$6.00
$5.00
$4.00
$3.00
$2.00
$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
Supply curve shifts to the left
P

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q

$6.00
$5.00
$4.00
$3.00
$2.00

P = (1/5)QS

$1.00
$0.00
0

10 15

20 25 30

35

The Market Supply Curve


Input costs increase
Supply curve shifts to the lefta decrease in supply

P
$6.00

P
QSold QSnew
$0.00
0
1.00
5
0
2.00
10
5
3.00
15
10
4.00
20
15
5.00
25
20
6.00
30
25
Q

P = 1 + (1/5)QS

$5.00
$4.00
$3.00
$2.00

P = (1/5)QS

$1.00
$0.00
0

10 15

20 25 30

35

Increase in Quantity Supplied


P

S
B

$3.00

$1.00

P QS
An increase in
quantity supplied
is a movement
up along the
supply curve

Increase in Supply

One of the non-price determinants of S changes, causing the curve to shift right

Technology improves

S1

Input prices
Change in expectations

S2

Number of producers

Decrease in Quantity Supplied


P

S
A

$3.00

$1.00

P QS
A decrease in
quantity
supplied is a
movement
down along the
supply curve
Q

Decrease in Supply

One of the non-price determinants of S changes, causing the curve to shift left

Technology deteriorates

S2

Input prices
Change in expectations

S1

Number of producers

Equilibrium

Point at which QS = QD

At equilibrium E = (Q*,P*),

Quantity Demanded = Quantity Supplied

P*

D
0

Q*

Disequilibrium: Getting the Price Wrong


What happens when the price is too high?

P
S

At PH, QS > QD, which results in


excess supply, or a surplus

Surplus

PH

P*

D
0

QD

Q*

QS

Disequilibrium: Getting the Price Wrong


What happens when the price is too high?

P
S
Surplus

PH

At PH, QS > QD, which results in


excess supply
There is downward pressure on
price, and price declines toward
P*
As P falls, QD increases toward
Q*, and QS decreases toward Q*
Process stops when equilibrium
is reached, and the surplus is
eliminated

P*

D
0

QD

Q*

QS

Disequilibrium: Getting the Price Wrong


What happens when the price is too low?

P
S

At PL, QD > QS, which results in


excess demand, or a shortage

P*
PL

Shortage

D
0

QS

Q*

QD

Disequilibrium: Getting the Price Wrong


What happens when the price is too low?

P
S

There is upward pressure on


price, and price increases
toward P*
As P increases, QD decreases
toward Q*, and QS increases
toward Q*

P*

At PL, QD > QS, which results in


excess demand, or a shortage

Process stops when equilibrium


is reached, and the shortage is
eliminated

PL
Shortage

D
0

QS

Q*

QD

Equilibrium

Point at which QS = QD

At equilibrium E = (Q*,P*),

Quantity Demanded = Quantity Supplied

P*

D
0

Q*

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve

Equilibrium

Point at which QS = QD

D
0

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve

Equilibrium

Point at which QS = QD

D
0

Equilibrium

Point at which QS = QD

P*

D
0

Q*

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*
5Q* = 75

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*
5Q* = 75
Q* = 15

Equilibrium

Point at which QS = QD

P*

D
0

Q*= 15

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
At equilibrium,
Demand = Supply
100 3QD = 25 + 2QS
At equilibrium, QD = QS = Q*
100 3Q* = 25 + 2Q*
5Q* = 75
Q* = 15

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:
P* = 100 3Q* = 100 3(15) = 55

Calculating Equilibrium from


Equations
P = 100 3QD Demand Curve
P = 25 + 2QS Supply Curve
Q* = 15
To find P*, substitute Q* into either
demand or supply equation:
P* = 100 3Q* = 100 3(15) = 55
P* = 25 + 2Q* = 25 + 2(15) = 55

Equilibrium

Point at which QS = QD

P*= 55

D
0

Q*= 15

Comparative Statics
Start at equilibrium

Comparative Statics
Start at equilibrium
Change the value of one of the non-price
determinants of supply or demand

Comparative Statics
Start at equilibrium
Change the value of one of the non-price
determinants of supply or demand
Compare the new equilibrium to the old one

Market for Compact Disks


P

Initial equilibrium is E1 = (Q1*,P1*)

Assume that the price of compact disk


players declines
What happens to equilibrium P and Q in
the market for compact disks?

P1*

E1

D
0

Q1*

Three Questions in Any Comparative Statics


Problem
Which curve shifts?

Three Questions in Any Comparative Statics


Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Three Questions in Any Comparative Statics


Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Which way does it shift?

Three Questions in Any Comparative Statics


Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Which way does it shift?


To the right, since a fall in the price of a complement
causes demand to increase

Market for Compact Disks


P
S

P1*

E1
D2
D1

Q1*

Three Questions in Any Comparative Statics


Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Which way does it shift?


To the right, since a fall in the price of a complement
causes demand to increase

What happens to equilibrium P and Q after the


shift?

Market for Compact Disks


P

The demand curve shifts right

E2

P2*

P1*

The increase in demand leads to an


increase in equilibrium price and an
increase in equilibrium quantity
Note: The increase in demand leads to
an increase in quantity supplied

E1
D2
D1

Q1*

Q2*

Three Questions in Any Comparative Statics


Problem
Which curve shifts?
Demandsince the price of a complement has changed
and that is a determinant of demand

Which way does it shift?


To the right, since a fall in the price of a complement
causes demand to increase

What happens to equilibrium P and Q after the


shift?
P* Q*

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price
% Q D
Algebraically, eD =
% P

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price
Q D
%Q D
QD

Algebraically, eD =
P
%P
P

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price
Q D
D
D
%Q D

Q
P
Q

Algebraically, eD =
P
%P
Q D P
P

Definition of Price Elasticity of


Demand
Price elasticity of demand = eD = percentage change
in quantity demanded divided by the percentage
change in price
Price elasticity of demand is a measure of how
sensitive quantity demanded is to changes in price

Q D
%Q D
Q D P
Q D P
QD

Algebraically, eD =
D
P
%P
Q P
P Q D
P

Inelastic Demand Curve


P

DI
0

Elastic Demand Curve


P

DE
0

Elasticity and the Change in QD


P

P2
P1

DE
0

DI
QEl

QIn Q1

Perfectly Inelastic Demand Curve


P

DPI
0

Perfectly Elastic Demand Curve


P

DPE

Calculating Price Elasticity of


Demand
eD =

% Q D
% P

Calculating Price Elasticity of


Demand
% Q D
eD =
% P
D
Q DNew QOld
D
QOld
= P P
New
Old
POld

Calculating eD
P

D
0

10

Calculating eD
P

6 10
10
D
6 10
QOld
FromQADNewtoB,
eD 10
=
46 2
D
10
QOld
6 2
4
PNew POld
2
24
24
POld

= .4

D
0

10

Calculating eD
P
D
Q DNew QOld
D
QOld
From PANewtoB,
POldeD
POld

6 10
10
6 10
10
6 10
42
=
244 2
24 2

= .4

D
0

10

Calculating eD
P
D
Q DNew QOld
QD
From PA toOldB,
POldeD
New
POld

6 10
66 10
10
10
62 10
=
42
44 2
24 2

= .4

10 6
6
From B to A, eD= 2 4
4

D
0

10

= 1.33

Calculating Elasticity Using the


Midpoint Formula
Q
Q
2
eD
PNew POld
PNew POld
2
Q
Q

D
New
D
New

D
Old
D
Old

Calculating eD
P

D
0

10

Calculating eD
P
6 10
10
6
6 106
Q Q
10
D
QOld
From
A to B,10
eD = 4 22
6
42
PNew POld
24
42
24
POld
2
D
New

D
Old

= .75

D
0

10

Calculating eD
P
D
Q DNew QOld
D to B,
FromQAOld
PNew POld
POld

6 10
10
6
6
4
2
2
4
2
4

eD10=

= .75

From B to A, eD=

D
0

6 10
6 10
2
42
42
2

10

Calculating eD
P
D
Q DNew QOld
D to B,
FromQAOld
PNew POld
POld

= .75

From B to A, eD=

D
0

6 10
10
6
6
4
2
2
4
2
4

eD10=

6 10
6 10
2
42
42
2

10

10 6
10 6
2
24
24
2

= .75

Price Elasticity of Demand


eD > 1

Elastic

Price Elasticity of Demand


eD > 1
eD = 1

Elastic
Unit elastic

Price Elasticity of Demand


eD > 1
eD = 1
eD < 1

Elastic
Unit elastic
Inelastic

Elasticity is Not Constant Along a Linear


Demand Curve
P

P = 100 QD

D
0

Elasticity is Not Constant Along a Linear


Demand Curve
P

P = 100 QD

Slope = -1 Over the


Entire Demand Curve

D
0

Elasticity is Not Constant Along a Linear


Demand Curve
P

P = 100 QD

80

D
0

20

Elasticity is Not Constant Along a Linear


Demand Curve
P

P = 100 QD

80
70

D
0

20 30

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. A and B
P
80
70

P = 100 QD
A
B

D
0

20 30

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. A and B
P
80
70

P = 100 QD
A
B

From A to B, eD =

30 20
30 20
2
70 80
70 80
2

= 3.00

D
0

20 30

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. A and B
P
80
70

P = 100 QD
A

eD=3
B

From A to B, eD =

30 20
30 20
2
70 80
70 80
2

= 3.00

D
0

20 30

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. C and D
P

P = 100 QD
A

eD=3
B

40
30
0

C
D

60 70

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. C and D
P

P = 100 QD
A

eD=3

70 60
70 60
2
From C to D, eD = 30 40
30 40
2

= .538

40
30
0

eD=.538
D

60 70

Using the Midpoint Formula, Calculate


the price elasticity of demand between
pts. C and D
P

P = 100 QD
A
eD=3
B
eD=1

C
eD=.538

Elasticity is Not Constant Along a Linear


Demand Curve
P

Unit Elastic

D
0

Inelastic Curve
P
Unit Elastic

Elastic Curve
P

Unit Elastic

Rules of Thumb for Price Elasticity


of Demand
Demand for luxuries is more elastic than
demand for necessities

Rules of Thumb for Price Elasticity


of Demand
Demand for luxuries is more elastic than
demand for necessities
Demand for a good with close substitutes is
more elastic

Rules of Thumb for Price Elasticity


of Demand
Demand for luxuries is more elastic than
demand for necessities
Demand for a good with close substitutes is
more elastic
The broader the definition of a good, the less
elastic the demand

CEREAL

PRICE ELASTICITY
OF DEMAND

Post Raisin Bran

-2.5

All family breakfast cereals

-1.8

All types of breakfast cereals

-0.9

Rules of Thumb for Price Elasticity


of Demand
Demand for luxuries is more elastic than
demand for necessities
Demand for a good with close substitutes is
more elastic
The broader the definition of a good, the less
elastic the demand
The longer the period of time, the more elastic
is demand

Other Elasticities
Cross-price elasticity of demand
Income elasticity of demand
Price Elasticity of supply

Cross-price elasticity of demand


Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
d for good 1
%
change
in
Q
Cross-price elast.
=
of demand
% change in price of good 2

For substitutes, cross-price elasticity > 0


(e.g., an increase in price of beef causes an
increase in demand for chicken)

For complements, cross-price elasticity < 0


(e.g., an increase in price of computers causes
decrease in demand for software)

Other Elasticities
Income elasticity of demand: measures the response
of Qd to a change in consumer income
Percent change in Qd

Income elasticity
=
of demand
Percent change in income

Remember: An increase in income causes an


increase in demand for a normal good.

Hence, for normal goods, income elasticity > 0.


For inferior goods, income elasticity < 0.

Calculating Other Elasticities


Price elasticity of supply

% Q
eS =
% P

My Econ Lab Tricks and Tips


Behind the Demand Curve: Consumer Theory
The Two Factors Involved in a Consumers Decision
Indifference Curves
Principles of Indifference Curves
Marginal Rate of Substitution
Definition
Marginal Utility

Unusually Shaped Indifference Curves

The Other Part of the Consumers Decision Process: Budget


Constraints
Definition
Slope
Opportunity Cost

Consumer Optimum: Putting Indifference


Curves and Budget Constraints Together
Practice Problems

MyEconLab Tips and Tricks

Key Point: Do not click Submit


until you are ready to have your quiz
graded. After you click submit, you
cannot change your answer.

MyEconLab Tips and Tricks


Key Point: Do not click Submit until you are
ready to have your quiz graded. After you click
submit, you cannot change your answer.
However, you can save your questions before
you have submitted them simply by exiting
your browserthere is no Save button or
anything.
Once you log back into MyEconLab, you will
be able to continue the quiz where you left off,
go back and change answers, etc.

MyEconLab Tips and Tricks


Key Point: Do not click Submit until you are
ready to have your quiz graded. After you click
submit, you cannot change your answer.
Once you click Submit, however, you will
not be able to change anything, and your test
will be automatically graded.
After the due date, you can click the Review
button, and you will be able to see your answers
as well as the correct answer.

Behind the Demand Curve


P

D
0

The Two Factors in a Consumption


Decision

The Two Factors in a Consumption


Decision
Tastes and preferences

The Two Factors in a Consumption


Decision
Tastes and preferences
Budget

The Two Factors in a Consumption


Decision
Tastes and preferences

Utility
Utility = happiness, satisfaction or well-being

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices

Total
Utility

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0

Total
Utility
0 utils

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

250 utils

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

250 utils

325 utils

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

250 utils

3
4

325 utils
375 utils

Utility
Utility = happiness, satisfaction or well-being
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

250 utils

3
4
5

325 utils
375 utils
400 utils

Utility
Utility = happiness, satisfaction or well-being
Marginal Utility (MU) = the additional utility you get
from one additional unit of a good or service

U
Marginal Utility of X = MU X
X

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

Marginal
Utility

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

Marginal
Utility
U=150

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

Marginal
Utility
U=150
X=1

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

Marginal
Utility
U 150

150
1
X

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

Marginal
Utility
150 utils

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices
0
1
2
3
4
5

Total
Utility
0 utils
150 utils
250 utils
325 utils
375 utils
400 utils

Marginal
Utility
150 utils
U 100

100
X
1

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices

Marginal
Utility

0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

100 utils

150 utils

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices

Marginal
Utility

0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

100 utils
75 utils

150 utils

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices

Marginal
Utility

0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

100 utils
75 utils
50 utils

150 utils

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices

Marginal
Utility

0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

100 utils
75 utils
50 utils
25 utils

150 utils

Utility
Utility = happiness, satisfaction or well-being
Marginal Utility (MU) = the additional utility you get
from one additional unit of a good or service

U
Marginal Utility of X = MU X
X
Diminishing Marginal Utility
When I dont have much of good X, MUX is high
When I am already consuming a lot of good X, MUX is low

Marginal Utility
U
Marginal Utility of X = MU X
X
# of Pizza
Slices

Marginal
Utility

0
1

Total
Utility
0 utils
150 utils

2
3
4
5

250 utils
325 utils
375 utils
400 utils

100 utils
75 utils
50 utils
25 utils

150 utils

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Indifference Curves: The


Consumers Preferences
Minutes
Home

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Indifference Curves: The


Consumers Preferences
Minutes
Home

90

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Indifference Curves: The


Consumers Preferences
Minutes
Home

10

90

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Indifference Curves: The


Consumers Preferences
Minutes
Home

45

B
A

45

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

Indifference Curves: The


Consumers Preferences
Minutes
Home

90

C
B
A

10

Minutes to France

Indifference Curves: The


Consumers Preferences
Minutes
Home

C
B
A

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

100 Utils

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

100 Utils 100 Utils

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

100 Utils 100 Utils 100 Utils

Indifference Curves: The


Consumers Preferences
Minutes
Home

C
B
A

Minutes to France

Indifference Curves: The


Consumers Preferences
Minutes
Home

C
B
A
Indifference
curve
0

Minutes to France

Indifference Curves: The


Consumers Preferences
Minutes
Home

C
B
A
100 Utils
0

Minutes to France

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

100 Utils 100 Utils 100 Utils

Consumption Possibilities
A

90 min. to
France

45 min. to
France

10 min. to
France

120 min. to
France

10 min.
home

45 min.
home

90 min.
home

90 min.
home

100 Utils 100 Utils 100 Utils 200 Utils

Indifference Curves: The


Consumers Preferences
Minutes
Home

D
C
200 Utils
B
A
100 Utils
0

Minutes to France

Indifference Curves: The


Consumers Preferences
Minutes
Home

I4=400 utils
I3= 300 utils
I2= 200 utils
I1= 100 utils

Minutes to France

Principles of Indifference Curves


Higher indifference curves represent higher
utility

Indifference Curves: The


Consumers Preferences
Minutes
Home

I4=400 utils
I3= 300 utils
I2= 200 utils
I1= 100 utils

Minutes to France

Principles of Indifference Curves


Higher indifference curves represent higher
utility
Indifference curves never cross

Indifference Curves Cannot Cross


Minutes
Home
A
B
C
I2= 200 utils
I1= 100 utils

Minutes to France

Principles of Indifference Curves


Higher indifference curves represent higher
utility
Indifference curves never cross
Indifference curves usually slope downward

Upward Sloping Indifference Curve


Minutes
Home
(Good)

100 Utils

45

15
0

30

45

Minutes to France
(Bad)

Principles of Indifference Curves


Higher indifference curves represent higher
utility
Indifference curves never cross
Indifference curves usually slope downward
Indifference curves are usually convexbowed
inward toward the origin (sometimes called
concave up)

Convexity of Indifference Curves


Minutes
Home
A

C
D
0

Indifference
curve, I1
Minutes to France

Marginal Rate of Substitution


Marginal Rate of Substitution (MRS) measures
the amount of good Y you are willing to give
up to get one more unit of X

Marginal Rate of Substitution


Marginal Rate of Substitution (MRS) measures
the amount of good Y you are willing to give
up to get one more unit of X
MRS measures the marginal value of one more
unit of X......that value being measured in units
of Y

Diminishing Marginal Rate of


Substitution
Minutes
Home
90

From A to B, MRS = 10
From C to D, MRS = .5

80

10
9.5

C
20

21

90

100 Utils
D
91 Minutes to France

Marginal Rate of Substitution


Marginal Rate of Substitution (MRS) measures
the amount of good Y you are willing to give
up to get one more unit of X
MRS measures the marginal value of one more
unit of X......that value being measured in units
of Y
Diminishing Marginal Rate of Substitution
means that as you move down along an
indifference curve, MRS decreases

Marginal Rate of Substitution


Marginal Rate of Substitution (MRS) measures the
amount of good Y you are willing to give up to get one
more unit of X
MRS measures the marginal value of one more unit of
X......that value being measured in units of Y
MU X
MRS =
MU Y

Marginal Rate of Substitution


Marginal Rate of Substitution (MRS) measures the
amount of good Y you are willing to give up to get one
more unit of X
MRS measures the marginal value of one more unit of
X......that value being measured in units of Y
MU X
MRS =
MU Y

Remember the role of diminishing marginal utility

Diminishing Marginal Rate of


Substitution
Minutes
Home
90

At A: MUF is highsay 20 utils; but MUH is lowsay 2 utils


So, MRS = MUF / MUH = 20 utils / 2 utils = 10
and slope of IC at A = MRS = 10

80

B
At C: MUF is lowsay 5 utils; and
MUH is highsay 10 utils
MRS = MUF / MUH = 5 utils / 10 utils =
Slope of IC at C = MRS =

10
9.5

20

21

90

100 Utils
D
91 Minutes to France

Indifference Curves for Perfect


Substitutes
Nickels
6

I1
0

I2
2

I3
3

Dimes

Indifference Curves for Perfect


Complements
Left
Shoes

I2

I1

Right Shoes

Budget Constraint
Minutes
Home

PMin. France = 30
B
PF

PMin. HomePB = 10
H

Budget=B= $30

B
PF

Minutes to France

Budget Constraint: Vertical


Intercept
Minutes
Home
B/PH=300

PMin. France = 30
B
PF

PMin. HomePB = 10
H

Budget=B= $30

B
PF

Minutes to France

Budget Constraint : Horizontal


Intercept
Minutes
Home
B/PH=300

PMin. France = 30
PMin. HomePB = 10

B
PF

Budget=B= $30

B
PF

B/PF= 100

Minutes to France

Budget Constraint: Slope


Minutes
Home
B/PH=300

PMin. France = 30
PMin. HomePB = 10

B
PF

Budget=B= $30
Slope = PF/PH
= 30/10
=3
B
PF

B/PF= 100

Minutes to France

Budget Constraint: General Form


Y
B/PY=300

PX = Price of X
B
PY = Price
of Y
P

B
PF

B = Budget
Slope = PX/PY

B
PF

B/PX= 100

Slope of Budget Constraint


PXX + PYY = B

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run

Budget Constraint: General Form


Y
B/PY

PX = Price of X
B
PY = Price
of Y
P

B
PF

B = Budget

B
PF

B/PX

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)

Slope of Budget Constraint


PXX + PYY = B
PYY = B PXX
Y = B/PY (PX/PY)X
Slope = PX/PY
Alternatively:
Slope = Rise/Run
= (B/PY) / (B/PX)
= PX/PY

Consumer Optimum
Y

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRS = PX/PY

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:

Y*

MUX/PX = MUY/PY

IC
BC

X*

Consumer Optimum
Minutes
Home
B/PH=300

PF = 30, PH = 10, B = $30


At O: Slope of IC = Slope of BC
MRS = PF/PH
MUF/MUH = 30/10
Rearranging:

120

MUF/PF = MUH/PH

MUF/30 = MUH/10
For examplesatisfied if MUF = 60, MUH = 20.

IC
BC

60

B/PF=100

Minutes to France

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint
Slope of IC = Slope of BC, which is equivalent
to: MUX/PX = MUY/PY

Why Cant A Be Optimal?


Minutes
Home
A

BC

I1

I2

I3

Minutes to France

Why Cant A Be Optimal?


Minutes
Home

At A, Slope of IC > Slope of BC, which


implies that MUF/MUH > PF/PH, or
MUF/PF > MUH/PH.

For example, MUF = 90, MUH = 10, so


MUF/PF = 90/30 = 3, MUH/PH = 10/10 = 1

BC

I1

I2

I3

Minutes to France

Why Cant B Be Optimal?


Minutes
Home
A

B
0

BC

I1

I2

I3

Minutes to France

Why Cant B Be Optimal?


Minutes
Home

At B, Slope of IC < Slope of BC, which


implies that MUF/MUH < PF/PH, or
MUF/PF < MUH/PH.

For example, MUF = 30, MUH = 30, so


MUF/PF = 30/30 = 1, MUH/PH = 30/10 = 3.

B
0

BC

I1

I2

I3

Minutes to France

Why Cant C Be Optimal?


Minutes
Home
A

O
C
B
0

BC

I1

I2

I3

Minutes to France

Why Cant C Be Optimal?


Minutes
Home

At C, Slope of IC = Slope of BC,


BUT C is not on the BC

O
C
B
0

BC

I1

I2

I3

Minutes to France

Why Cant D be Optimal?


Minutes
Home
A

D
O
C
B
0

BC

I1

I2

I3

Minutes to France

Why Cant D Be Optimal?


Minutes
Home

D is not affordableit is
outside the BC

D
O
C
B
0

BC

I1

I2

I3

Minutes to France

Why Cant A, B, C or D be Optimal?


Minutes
Home

Along the BC, it is only at O


that MUF/PF = MUH/PH

D
O
C
B
0

BC

I1

I2

I3

Minutes to France

Practice Questions
JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and
books cost $20 each. Each good can only be purchased in whole numbers (not
fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:

Movies
No. per Total
Marginal
Month Utility Utility MU/$
1
50
2
80
3
100
4
110
5
116
6
121
7
123

Books
No. per Total
Marginal
Month Utility Utility MU/$
1
22
2
42
3
52
4
57
5
60
6
62
7
63

a. Fill in the figures for marginal utility and for marginal utility per dollar
spent for both movies and books.

JoAnnes Books vs. Movies


Question
Movies

Books

No. per Total Marginal


No. per Total Marginal
Month Utility Utility MU/$
Month Utility Utility MU/$
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05

Practice Questions
JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and
books cost $20 each. Each good can only be purchased in whole numbers (not
fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:

Movies
No. per Total
Marginal
Month Utility Utility MU/$
1
50
2
80
3
100
4
110
5
116
6
121
7
123

Books
No. per Total
Marginal
Month Utility Utility MU/$
1
22
2
42
3
52
4
57
5
60
6
62
7
63

b. Do JoAnnes preferences exhibit diminishing marginal utility for both


goods? Why or why not?

JoAnnes Books vs. Movies


Question
Movies

Books

No. per Total Marginal


No. per Total Marginal
Month Utility Utility MU/$
Month Utility Utility MU/$
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05

Practice Questions
JoAnne is trying to decide how many books and how many movies to consume
each month. She has $136 to spend on the two goods. Movies cost $8 each, and
books cost $20 each. Each good can only be purchased in whole numbers (not
fractions of a good).
JoAnnes preferences for movies and books are summarized by the following
table:

Movies
No. per Total
Marginal
Month Utility Utility MU/$
1
50
2
80
3
100
4
110
5
116
6
121
7
123

Books
No. per Total
Marginal
Month Utility Utility MU/$
1
22
2
42
3
52
4
57
5
60
6
62
7
63

c. Given her budget of $136, what quantity of books and what quantity of
movies will maximize JoAnnes utility? Explain how you arrived at your
answer.

JoAnnes Books vs. Movies


Question
Movies

Books

No. per Total


Marginal
No. per Total
Marginal
Month Utility Utility MU/$
Month Utility Utility MU/$
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05

JoAnnes Books vs. Movies


Question
Movies

Books

No. per Total


Marginal
No. per Total
Marginal
Month Utility Utility MU/$
Month Utility Utility MU/$
1
50
50
6.25
1
22
22
1.10
2
80
30
3.75
2
42
20
1.00
3
100
20
2.50
3
52
10
0.50
4
110
10
1.25
4
57
5
0.25
5
116
6
0.75
5
60
3
0.15
6
121
5
0.63
6
62
2
0.10
7
123
2
0.25
7
63
1
0.05

Graphical Question on
Optimal Consumption
At her present levels of consumption of goods X and Y,
Dana is spending her entire budget, and her
MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint

Graphical Question on
Optimal Consumption
At her present levels of consumption of goods X and Y,
Dana is spending her entire budget, and her
MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint
Slope of IC = Slope of BC

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:

Y*

MUX/PX = MUY/PY

IC
BC

X*

Graphical Question on
Optimal Consumption
At her present levels of consumption of goods X and Y,
Dana is spending her entire budget, and her
MRSX,Y = 5. PX = $9 and PY = $2.
Is Dana consuming the optimal amount of goods X and Y?
At O: Slope of IC = Slope of BC
MRS = PX/PY
MUX/MUY = PX/PY
Rearranging:

MUX/PX = MUY/PY

MRS = PX / PY
MRS = PX / PY
5 = PX / PY
5

9/2

Dana is not at her consumer optimum

Danas Current Consumption


Slope of IC = MRS = 5

Slope of BC = PX/PY = 9/2 = 4.5


So, Dana is at a point like A. She is
spending too much of her budget on
good Y

Dana should reallocate her budget to buy


more of good X and less of good Y

BC

I1

I2

I3

Consumer Theory (cont.)


Consumer Optimum (Review)
Changes in the Budget
Effect on the Budget Constraint
Effect on Consumer Optimum
Normal Good
Inferior Good

Changes in Prices
Effect on the Budget Constraint
Income and Substitution Effects

Deriving the Demand Curve


Why does the Demand Curve Slope Down?

Consumer Optimum
Y

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY
MUX/MUY = PX/PY

Y*

IC
BC

X*

Consumer Optimum
Y
At O: Slope of IC = Slope of BC
MRSX,Y = PX/PY
MUX/MUY = PX/PY
Rearranging:

Y*

MUX/PX = MUY/PY

IC
BC

X*

Conditions for a Consumer


Optimum
Optimal consumption bundle (X*,Y*) is on the
budget constraint
Slope of IC = Slope of BC, which is equivalent
to: MUX/PX = MUY/PY

Budget Constraint: General Form


Y
B/PY

PX = Price of X
B
PY = Price
of Y
P

B
PF

B = Budget
Slope = PX/PY

B
PF

B/PX

Budget Constraint: Example


Minutes
Home
B/PH=300

PMin. France = 30
PMin. HomePB = 10

B
PF

Budget=B= $30
Slope = PF/PH
= 30/10
=3
B
PF

B/PF= 100

Minutes to France

A Change in Budget
What if the prices of calls stay the same, but
consumers budget for phone calls doubles?

Effect of a change in budget


on slope of BC
Minutes
Home

PMin. France = 30
PMin. HomePB = 10

B
PF

New Budget=B=
$60
Will the slope of the
Budget Constraint
Change?
B
PF

Minutes to France

Slope doesnt change with a change


in budget
Minutes
Home

PMin. France = 30
PMin. HomePB = 10

B
PF

New Budget=B=
$60
Slope = PF/PH
B
PF

= 30/10
=3

Minutes to France

Slope doesnt change with a change


in budget
Minutes
Home

PMin. France = 30
PMin. HomePB = 10

B
PF

New Budget=B=
$60
Slope = PF/PH
B
PF

= 30/10

What does change


when the budget
changes?

=3

Minutes to France

When budget increases, budget


constraint shifts right: Vertical and
horizontal intercepts increase
Minutes
Home
B/PH=600

PMin. France = 30
PMin. HomePB = 10

B
PF

New Budget=B
B/PH=300

= $60

B
PF

B/PF=100

B/PF= 200

Minutes to France

When budget decreases, budget


constraint shifts left: Vertical and
horizontal intercepts decrease
Minutes
Home
B/PH=300

PMin. France = 30
PMin. HomePB = 10

B
PF

New Budget=B
B/PH=180

= $18

B
PF

B/PF=60

B/PF= 100

Minutes to France

A Change in Budget
What happens to consumers calls to France and
calls home when the budget for phone calls
increases?

Consumer Optimum When Budget Doubles if Calls


to France and Calls Home are Normal Goods
Minutes
Home
B/PH=600

PF = 30, PH = 10, B = $30, B = $60


Calls to France and Calls Home are Normal
Goods
Old Optimum = O = 50 min. to France
150 min. Home
New Optimum = O = 120 min. to France

240
150

240 min. Home

O
O

IC
BC
BC

50

120

IC
IC

B/PF=200

Minutes to France

What Do We Know About the


Phone Calls Now?
Minutes
Home
B/PH=600

240

150

PF = 30, PH = 10, B = $30, B = $60

IC

BC

50 75

IC
BC
B/PF=200

Minutes to France

What Do We Know About the


Phone Calls Now?
Minutes
Home
B/PH=600

PF = 30, PH = 10, B = $30, B = $60


Calls Home are Normal Goods (QD when B)
Calls to France are Inferior Goods

240

150

(QD when B)

IC

BC

50 75

IC
BC
B/PF=200

Minutes to France

What Do We Know About the Two


Goods Now?
Minutes
Home
B/PH=600

240
150

PF = 30, PH = 10, B = $30, B = $60

O
IC
BC

BC

50

120

IC

B/PF=200

Minutes to France

What Do We Know About the Two


Goods Now?
Minutes
Home
B/PH=600

PF = 30, PH = 10, B = $30, B = $60


Calls to France are Normal Goods
Calls Home are Inferior Goods

240
150

O
IC
BC

BC

50

120

IC

B/PF=200

Minutes to France

Effects of a Price Change:


PH to 15
Minutes
Home
B/PH=300

PF = 30, PH = 15, B = $30


What happens to the Budget Constraint?

BC

B/PF=100

Minutes to France

Effects of a Price Change:


PH to 15
Minutes
Home
B/PH=300

PF = 30, PH = 15, B = $30

BC

What happens to the Budget Constraint?


It pivots around the horizontal interceptthe
vertical intercept moves down
Slope changes from PF/PH = -.3/.1= -3
to PF/PH = -.3/.15 = -2

B/PH=200

BC

B/PF=100

Minutes to France

A Change in Prices
What happens to consumers optimum
consumption bundle when the price of calls
home goes up to 15?

Effects of a Price Change:


PH to 15
Minutes
Home
B/PH=300

PF = 30, PH = 15, B = $30


Optimum bundle moves from O to O, with
fewer minutes home, and fewer minutes to
France.

BC

B/PH=200
BC

IC
IC

B/PF=100

Minutes to France

What Happens to the BC


if PF to 10?
Minutes
Home
B/PH=300

PF=30, PF = 10, PH =10, B = $30


Budget constraint pivots around the vertical
intercepthorizontal intercept increases

BC
BC

B/PF=100

B/PF=300

Minutes to France

What Happens to the Consumer


Optimum if PF to 10?
Minutes
Home
B/PH

PF = 10, PH = 10, B = $30

IC
BC
IC

BC

B/PF

Minutes to France

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments
These are
always
opposite

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect

Income
Effect

Combined
Effect

Calls to
France

Comments
These are
always
opposite

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

These are
always
opposite

These are
always the same
if both goods are
normal

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

These are
always
opposite

These are
always the same
if both goods are
normal

What Happens to the Consumer


Optimum if PF to 10?
Minutes
Home
B/PH

PF = 10, PH = 10, B = $30

IC
BC
IC

BC

B/PF

Minutes to France

Substitution and Income Effects when PF Goes


Down
Calls to France and Calls Home are Normal Goods
Calls Home
Substitution
Effect
Income
Effect

Combined if IE > SE
Effect if SE > IE

Calls to
France

Comments

These are
always
opposite

These are
always the same
if both goods are
normal

What Happens to the Consumer


Optimum if PF to 10?
Minutes
Home
B/PH

PF = 10, PH = 10, B = $30

IC
BC
IC

BC

B/PF

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
300

180

120

PF by 30
IC

IC
BC
BC

20

50

60

100

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home

Calls to France
SE: O O

200

by 5

Calls Home
by 80

O
SE

120

PF by 30
IC

IC
BC
BC

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France
SE O O

200
180

IE

by 5

Calls Home
by 80

IE O O

O
SE

120

PF by 30
IC

IC
BC
BC

20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home

200
180

Calls to France

IE

SE O O

by 5

IE O O

by 35

Calls Home
by 80

SE

120

PF by 30
IC

IC
BC
BC

20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France

200
180

IE

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

SE

120

PF by 30
IC

IC
BC
BC

20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France

200
180

IE

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

SE

Net
120

PF by 30
IC

IC
BC
BC

20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home

200
180

Calls to France

IE

SE

Net
120

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

Net Effect
O O

PF by 30
IC

IC
BC
BC

20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France

200
180

IE

SE

Net
120

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

Net Effect

by 40

O O

PF by 30
IC

IC
BC
BC

0 20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France

200
180

IE

SE

Net
120

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

Net Effect

by 40

by 60

O O

PF by 30
IC

IC
BC
BC

0 20

55

60

Minutes to France

What Happens to the Consumer


Optimum if PF to 60?
Minutes
Home
Calls to France

200
180

IE

SE

Net
120

Calls Home

SE O O

by 5

by 80

IE O O

by 35

by 20

Net Effect

by 40

by 60

O O

(SE > IE)

PF by 30
IC

IC
BC
BC

0 20

55

60

Minutes to France

Deriving the Demand Curve


Y
As PX goes down, optimum moves
from O to O to O

PX=P1

IC1

X1

Demand Curve
P

P1

X1

Deriving the Demand Curve


Y
As PX goes down, optimum moves
from O to O to O

PX=P1

O
O
PX=P2

X1 X2

IC2
IC1

Demand Curve
P

P1
P2

X1

X2

Deriving the Demand Curve


Y
As PX goes down, optimum moves
from O to O to O

PX=P1

O
IC3
PX=P2

IC2
PX=P3

X1 X2 X3

IC1

Demand Curve
P

P1
P2
P3
0

X1

X2

X3

Demand Curve
P

P1
P2
P3
0

D
X1

X2

X3

Demand Curve
P

P1
P2
P3
0

D
X1

X2

X3

Why Does the Demand Curve Slope


Down?

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

What if the good is inferior?

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

if IE > SE
if SE > IE

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

if IE > SE
if SE > IE

Comments
When P,
SE always
makes Q

If IE>SE, PF
and QD goes
downthis is a
Giffen Good

Giffen Goods vs. Inferior Goods


All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods

Giffen Goods vs. Inferior Goods


For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE

Demand Curve for a Giffen Good


IE > SE, so as P, QD
P
D

Demand Curve for an Inferior Good


for which SE > IE
P

D
0

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction
(2) The good is inferior, but the
SE outweighs the IE

Why Does the Demand Curve Slope Down?


(Review)
Choice Under Uncertainty

Probability and Expected Value


Expected Utility
Attitudes Toward Risk
Insurance

Why Does the Demand Curve Slope


Down?

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments

Substitution and Income Effects when


PF Goes Down
Calls to France are Normal Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction

What if the good is inferior?

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home
Substitution
Effect
Income
Effect
Combined
Effect

Calls to
France

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

if IE > SE
if SE > IE

Comments
When P,
SE always
makes Q

Substitution and Income Effects when PF


Goes Down
Calls to France are Inferior Goods
Calls Home

Calls to
France

Substitution
Effect

Income
Effect

Combined
Effect

if IE > SE
if SE > IE

Comments
When P,
SE always
makes Q

If IE>SE, PF
and QD goes
downthis is a
Giffen Good

Giffen Goods vs. Inferior Goods


All Giffen Goods are Inferior Goods
BUT
Not All Inferior Goods are Giffen Goods

Giffen Goods vs. Inferior Goods


For a good to be Giffen:
(1) It must be an inferior good: and
(2) IE must outweigh SE

Demand Curve for a Giffen Good


IE > SE, so as P, QD
P
D

Demand Curve for an Inferior Good


for which SE > IE
P

D
0

Why Does the Demand Curve Slope


Down?
(1) The good is normal, so the SE
and IE work in the same direction
(2) The good is inferior, but the
SE outweighs the IE

Expected Value
Expected Value (EV)
= Probability of Outcome 1 Value of Outcome 1
+ Probability of Outcome 2 Value of Outcome 2
+ Probability of Outcome 3 Value of Outcome 3
+ .......
+ Probability of Outcome N Value of Outcome N

Expected Value
Example
Lottery with
Outcome 1: Win $10,000
Outcome 2: Win
$0

P(1) = .1
P(2) = .9

EV = Probability of Outcome 1 Value of Outcome 1


+ Probability of Outcome 2 Value of Outcome 2
= (.1) ($10,000) + (.9) (0)
= $1,000

Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure

Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000

Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000

Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000
EV(Option II) =

Another Example of EV
Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500

Expected Utility
Expected Utility (EU)
= Probability of Outcome 1 Utility from Outcome 1
+ Probability of Outcome 2 Utility from Outcome 2
+ Probability of Outcome 3 Utility from Outcome 3
+ .......
+ Probability of Outcome N Utility from Outcome N

Expected Value vs. Expected Utility


Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000

Expected Value vs. Expected Utility


Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

Expected Value vs. Expected Utility


Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500

Expected Value vs. Expected Utility


Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EV(Option I) = 1 $2,000 = $2,000
EU(Option 1) = 1 U($2,000) = U($2,000)

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000
EV(Option II) = .5 ($1,000) + .5 ($4,000)
= $2, 500
EU(Option II) = .5 U($1,000) + .5 U($4,000)

EU and the Summer Jobs Example


Two Possible Summer Jobs
Option I: Work on the Local Newspaper:
Pays $2,000 for sure
EU(Option I) = 1 U($2,000) = $2,000

Option II: Internet start-up


50% chance of making $1,000
50% chance of making $4,000
EU(Option II) = .5 U($1,000) + .5 U($4,000)
= $2,500

Take Option II only if:


EU(Option II) > EU (Option I)

Three Attitudes Toward Risk

Three Attitudes Toward Risk

Risk Aversion

Three Attitudes Toward Risk

Risk Aversion Diminishing


Marginal Utility of Money

Risk Aversion: Diminishing


Marginal Utility of Money
Utility

Money

Risk Aversion: Diminishing


Marginal Utility of Money
Utility

U(4,000)
U(2,500)
EU
U(1,000)

1,000

EV = 2,500

4,000

Money

Risk Aversion: Diminishing


Marginal Utility of Money
Utility

U(4,000)
U(2,500)
EU
U(1,000)

1,000

CE

2,500 = EV

4,000

Money

Three Attitudes to Risk and the Relation of


EV to CE

Risk Aversion: CE < EV

Three Attitudes Toward Risk

Risk Aversion
Risk Neutrality

Three Attitudes Toward Risk

Risk Aversion Diminishing


Marginal Utility of Money
Risk Neutrality Constant Marginal
Utility of Money

Risk Neutrality: Constant


Marginal Utility of Money
Utility
U(4,000)

U(2,500)

U(1,000)

1,000

EV = 2,500

4,000

Money

Risk Neutrality: Constant


Marginal Utility of Money
Utility
U(4,000)

U(2,500)

= EU

U(1,000)

1,000

EV = 2,500

4,000

Money

Risk Neutrality: Constant


Marginal Utility of Money
Utility
U(4,000)

U(2,500)

= EU

U(1,000)

1,000

EV = 2,500

= CE

4,000

Money

Three Attitudes to Risk and the Relation of


EV to CE

Risk Aversion: CE < EV


Risk Neutrality: CE = EV

Three Attitudes Toward Risk

Risk Aversion
Risk Neutrality
Risk Loving

Three Attitudes Toward Risk

Risk Aversion Diminishing


Marginal Utility of Money
Risk Neutrality Constant Marginal
Utility of Money
Risk Loving Increasing Marginal
Utility of Money

Risk Loving: Increasing


Marginal Utility of Money
Utility

U(4,000)

EU
U(2,500)

U(1,000)
1,000

2,500=EV

4,000

Money

Risk Loving: Increasing


Marginal Utility of Money
Utility

U(4,000)

EU
U(2,500)

U(1,000)
1,000

2,500=EV

CE 4,000

Money

Three Attitudes to Risk and the Relation of


EV to CE

Risk Aversion: CE < EV


Risk Neutrality: CE = EV
Risk Loving: CE > EV

Three Attitudes to Risk and the Relation of


EV to CE
Risk Averse: CE < EV
Risk Neutral: CE = EV
Risk Loving: CE > EV

Insurance Example
Income = $30,000
10% chance of becoming ill, and having
$20,000 in medical bills
EV of her income = .9 ($30,000)
+.1 ($10,000)

= $28,000

Insurance Example for a RiskAverse Person


Utility

U(30,000)
EU = U(27,000)
U(10,000)

Max willing to pay for


insurance = H CE
10K

CE=27K 28K = EV

30,000

Money

Behind the Supply Curve: Producer Theory


Production Function
Economies of Scale
Marginal Product vs. Economies of Scale

Economies of Scope
Firms Costs
Total, Average and Marginal Costs
Fixed and Variable Costs

Practice Problem on Calculating Costs


Short-run vs. Long-run Costs

Production Function
The Production Function
The production function shows the relationship
between quantity of inputs used to make a
good and the quantity of output of that good.
q=f(K, L, X)
Example: q = 2K + 3L + 4X
When K = 4, L = 2 and X = 1, q = 18

Production Function
The Production Function
The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output of that good.

q=f (K, L, X)
Example: q = 2K + 3L + 4X
When K = 4, L = 2 and X = 1, q = 18

Cobb-Douglas Form of the


Production Function

q AK L

Returns to Scale
q = f (K, L, X)
What happens when K, L and X double?
Constant Returns to Scale
(CRTS)
If output more than doubles Increasing Returns to Scale
(IRTS)
If output less than doubles Decreasing Returns to Scale
(DRTS)
Example: q = f (K, L, X) = 2K + 3L + 4X
K = 4, L = 2, X = 1 q = 18
Double K, L and X to K = 8, L = 4, X = 2;
Now q = 36 = 2q
Output doubled when inputs doubled CRTS

If output doubles

Returns to Scale and the Cobb-Douglas


Form of the Production Function

q f ( K , L) AK L

q f (2 K , 2 L)

A(2 K ) (2 L)

A2 K 2 L


2 AK L

2 q

Returns to Scale and the Cobb-Douglas


Form of the Production Function

q f (2 K , 2 L) 2

1 f (2 K , 2 L) 2q
CRTS
1 IRTS
1 DRTS

Returns to Scale
vs. Marginal Product
Returns to Scale: What happens to output when
all inputs are changed. . . . .
By the same proportion
Simultaneously
Marginal product: What happens to output when
one input is changed. . . . .
By itself
Holding all other inputs constant

Product Transformation Curve


Product Transformation Curve

The product transformation


curve describes the different
combinations of two outputs
that can be produced with a
fixed amount of production
inputs.
The product transformation
curves O1 and O2 are bowed
out (or concave) because
there are economies of scope
in production.

product transformation curve

Curve showing the


various combinations of two different outputs
(products) that can be produced with a given set of
inputs.

Economies of Scope
economies of scope Situation in
which joint output of a single firm is
greater than output that could be
achieved by two different firms when
each produces a single product.

diseconomies of scope Situation in


which joint output of a single firm is
less than could be achieved by
separate firms when each produces a
single product.

Economies of Scope
To measure the degree to which there are economies of
scope, we should ask what percentage of the cost of
production is saved when two (or more) products are
produced jointly rather than individually.

degree of economies of scope (SC)


Percentage of cost savings resulting when
two or more products are produced jointly
rather than Individually.

Economies of Scope: Example


Banks have introduced other financial products like
mutual funds, brokerage services, etc., because they
can integrate these services with their more traditional
banking operations.
Let service 1 be checking accounts, and
service 2 be brokerage
So, q1 is the number of checking accounts,
and q2 is the number of brokerage accounts

Economies of Scope: Example


Let service 1 be checking accounts, and
service 2 be brokerage
So, q1 is the number of checking accounts,
and q2 is the number of brokerage accounts
If checking accounts are offered exclusively
and alone by banks, say C(q1) = $5 per
account
If brokerage accounts are offered exclusively and
alone by brokerage firms, say C(q2) = $10 per
account

Economies of Scope: Example


C(q1) = $5 per account
C(q2) = $10 per account
C(q1,q2)=$8 per account.
So, SC, the degree of economies of scope,
would equal:
C (q1 ) C (q2 ) C (q1 , q2 )
SC
C (q1 , q2 )

$5 $10 $8

$8
7
.875
8

Economies of Scope: Example

SC > 0

economies of scope are present

SC < 0

diseconomies of scope are present

Short Run vs. Long Run


short run Period of time in which
quantities of one or more production
factors cannot be changed.
long run Amount of time needed
to make all production inputs
variable.
fixed input Production factor that
cannot be varied.

Average and Marginal Products


average product Output per unit
of a particular input.
marginal product Additional output
produced one additional unit of an
input.

Average and Marginal Products


average product Output per unit
of a particular input.

q
Example: average product of labor
L
q
average product of capital
K

Average and Marginal Products


marginal product Additional output
produced from one additional unit of
an input.

q
Example: marginal product of labor
L
q
marginal product of capital
K

Production with One Variable Input


(Labor)
Production with One Variable Input
Amount
of Labor (L)

Average
Product (q/L)

Marginal
Product (q/L)

Amount
of Capital (K)

Total
Output (q)

10

10

10

10

10

10

30

15

20

10

60

20

30

10

80

20

20

10

95

19

15

10

108

18

13

10

112

16

10

112

14

10

108

12

10

10

100

10

Production with One Variable Input


Production with One Variable Input

The total product curve in (a) shows


the output produced for different
amounts of labor input.
The average and marginal products
in (b) can be obtained (using the
data in the table on the previous
slide) from the total product curve.
At point A in (a), the marginal
product is 20 because the tangent
to the total product curve has a
slope of 20.
At point B in (a) the average product
of labor is 20, which is the slope of
the line from the origin to B.
The average product of labor at
point C in (a) is given by the slope
of the line 0C.

Production with One Variable Input


Production with One Variable Input
(continued)

To the left of point E in (b), the


marginal product is above the
average product and the average is
increasing; to the right of E, the
marginal product is below the
average product and the average is
decreasing.
As a result, E represents the point
at which the average and marginal
products are equal, when the
average product reaches its
maximum.
At D, when total output is
maximized, the slope of the tangent
to the total product curve is 0, as is
the marginal product.

Production with One Variable Input


(Labor)
law of diminishing marginal returns

Principle that as the


use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

The Effect of Technological


Improvement

Labor productivity (output


per unit of labor) can
increase if there are
improvements in technology,
even though any given
production process exhibits
diminishing returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.

Total Cost
Total Cost = TC = the total cost of producing q
units of output
Example: TC = 10q
q
TC
0
0
1
10
2
20
3
30
4
40

Graph of Total Cost Curve


q
0
1
2
3
4

TC
0
10
20
30
40

TC

TC=10q

Total Cost
Example: TC = q3 + 2q2 + 3q + 5
TC
TC

Average Cost
Average Cost = AC = TC/q

Example: Average Cost


Example: TC = 10q AC = 10q/q = 10
$/unit

10

AC=10

Example: Average Cost


Example: TC = q3 + 2q2 + 3q + 5
AC = q2 + 2q + 3 + 5/q
$/unit
AC

Marginal Cost
Marginal Cost = MC = TC / q
= cost of producing an
additional unit of ouput

Example: Marginal Cost


Example: TC = 10q MC = 10
$/unit

10

MC=AC=10

Example: Marginal Cost


Example: TC = q3 + 2q2 + 3q + 5
MC = 3q2 + 4q + 3
$/unit

MC

Relationship Between Marginal Cost


and Average Cost
$/unit

MC>AC AC is rising

MC

AC

MC<AC AC is falling
MC=AC AC is flat

Summary of Costs
Total
Total
Average
Marginal

Fixed

Variable

Summary of Costs
Total
Total
TC

Average
Marginal

Fixed

Variable

Summary of Costs
Total

Fixed

TC

TFC=costs
that do not
vary with q

Total
Average
Marginal

Variable

Total Fixed Cost


Example: TC = q3 + 2q2 + 3q + 5
TC
TFC = 5
TC

5
q

Summary of Costs
Total

Fixed

Variable

TC

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

Total
Average
Marginal

Total Variable Cost


Example: TC = q3 + 2q2 + 3q + 5
TVC
TVC = q3 + 2q2 + 3q
TVC

Cost Equations
TC = TFC + TVC

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed
TFC=costs
that do not
vary with q

Variable
TVC=costs
that do vary
with q

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed
TFC=costs
that do not
vary with q
AFC=TFC/q

Variable
TVC=costs
that do vary
with q

Average Fixed Cost


$/unit

AFC
q

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed

Variable

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

AFC=TFC/q

AVC=TVC/q

Cost Equations
AC = AFC + AVC

Relationship Between Average Cost


and Average Variable Cost
$/unit

AC
AVC

AFC
q

Summary of Costs
Total
Total
TC

Average

AC = TC / q

Marginal
MC = TC/q

Fixed

Variable

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

AFC=TFC/q

AVC=TVC/q

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed

Variable

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

AFC=TFC/q

AVC=TVC/q

MC = TC/q MFC=TFC/q

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed

Variable

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

AFC=TFC/q

AVC=TVC/q

MC = TC/q MFC=TFC/q
=0

Summary of Costs
Total
Total
TC

Average
Marginal

AC = TC / q

Fixed

Variable

TFC=costs
that do not
vary with q

TVC=costs
that do vary
with q

AFC=TFC/q

AVC=TVC/q

MC = TC/q MFC=TFC/q MVC=TVC/q


=0

=MC

Cost Equations
MC = MFC + MVC
= 0 + MVC
= MVC

The Family of Cost Curves


$/unit
MC

AC
AVC

AFC
q

Cost Equations
TC = TFC + TVC
AC = AFC + AVC
MC = MFC + MVC
= 0 + MVC
= MVC

Long-run vs. Short-run Costs


Long-Run Average and
Marginal Cost

When a firm is producing at


an output at which the longrun average cost LAC is
falling, the long-run marginal
cost LMC is less than LAC.
Conversely, when LAC is
increasing, LMC is greater
than LAC.
The two curves intersect at A,
where the LAC curve
achieves its minimum.

Long-run vs. Short-run Costs


long-run average cost curve
(LAC) Curve relating average cost
of production to output when all
inputs, including capital, are
variable.

short-run average cost curve


(SAC) Curve relating average cost
of production to output when level of
capital is fixed.

long-run marginal cost curve


(LMC) Curve showing the change in
long-run total cost as output is
increased incrementally by 1 unit.

Long-run vs. Short-run Cost Curves


Long-Run Cost with
Economies and Diseconomies
of Scale

The long-run average cost


curve LAC is the envelope of
the short-run average cost
curves SAC1, SAC2, and
SAC3.
With economies and
diseconomies of scale, the
minimum points of the shortrun average cost curves do
not lie on the long-run
average cost curve.

Revenue Concepts
Short-run Equilibrium for a Perfectly
Competitive Firm
The Shut-Down Rule

Long-run Equilibrium for a Perfectly


Competitive Firm

Accounting Profit vs. Economic Profit


Entry
Exit
Long-run Supply Curve

Revenue Concepts
Total Revenue (TR) = p q, where p is the price
per unit and q is the number of units sold

Revenue Concepts
Total Revenue (TR) = p q, where p is the price
per unit and q is the number of units sold
Example: A gas station sells 1000 gals. of gas
at $3.00 per gallon.
TR = $3,000

Revenue Concepts
Total Revenue (TR) = p q, where p is the price
per unit and q is the number of units sold
Example: A gas station sells 1000 gals. of gas
at $3.00 per gallon
TR = $3,000
Average Revenue (AR) = TR/q = (p q) / q =
p; so AR is just a fancy name for price
\

Revenue Concepts
Total Revenue (TR) = p q, where p is the price per unit and q
is the number of units sold
Example: A gas station sells 1000 gals. of gas at $3.00 per
gallon.
TR = $3,000
Average Revenue (AR) = TR/q = (p q) / q = p; so AR is just a
fancy name for price
Marginal Revenue (MR) =TR/ q = the additional revenue
received from selling the last unit
Example: The 110th widget is sold for $40; so TR = 40, q=
1, so the MR of the 110th unit = 40.

Perfect Competition:
Three Conditions
Many buyers and sellers
Complete information
Well-specified property rights

Characteristics of
Perfectly Competitive Firm
Homogeneous products
Ease of entry and exit
Price-taking behavior

How Price is Determined for a


Perfectly Competitive Firm
P

Market

P*

P*

Firm

P*

How Price is Determined for a


Perfectly Competitive Firm
P

Market

P*

P*

Firm

P*= D

How Price is Determined for a


Perfectly Competitive Firm
P

Market

P*

P*

Firm

P*= D = AR

How Price is Determined for a


Perfectly Competitive Firm
P

Market

P*

P*

Firm

P*= D = AR = MR

Profit
Profit = = TR TC

Profit Maximization Condition


For continuous quantities, produce that q for
which MR = MC

Determining the Profit-Maximizing


Quantity
P

P*

MC

MR (=P*= D = AR)

At q*, MR = MC
q*

Why Cant qA Be the ProfitMaximizing Quantity?


P

MC

P*

MR (=P*= D = AR)

At q*, MR = MC
q* qA

Why Cant qA Be the ProfitMaximizing Quantity?


P
MCA
P*

MC

At qA, MC > MR

A
MR (=P*= D = AR)

At q*, MR = MC
q*

qA

Why Cant qB Be the ProfitMaximizing Quantity?


P
MCA

MC

At qA, MC > MR

P*

A
MR (=P*= D = AR)

At q*, MR = MC
B
qB

q*

qA

Why Cant qB Be the ProfitMaximizing Quantity?


P
MCA

MC

At qA, MC > MR

P*

MR (=P*= D = AR)

At q*, MR = MC

At qB, MR > MC
B
MCB
qB

q*

qA

Profit Maximization Condition


For continuous quantities, produce that q for
which MR = MC (derived from calculus)
For discrete quantities, produce the highest q
for which MR MC

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.

q TC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

Finding the profit-maximizing


quantity
DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
The market-determined
price of digital toilet
paper is $65

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

Profit
Profit = = TR TC

Profit
Profit = = TR TC
= q (TR/q TC/q)

Profit
Profit = = TR TC
= q (TR/q TC/q)
= q (AR AC)

Profit
Profit = = TR TC
= q (TR/q TC/q)
= q (AR AC)
= q (p AC)

Showing the Firms Profits


Graphically
P

MC
AC

P*

P = MR = AR

q*

Showing the Firms Profits


Graphically
P

MC
AC

P*

P = MR = AR

O
P AC at q*

q*

Showing the Firms Profits


Graphically
P

MC
AC

P*

P = MR = AR

O
P AC at q*

Profits

q*

What if at q*, AC > P


P

P*

MC

AC

P = MR = AR

q*

What if at q*, AC > P


P

MC

AC

At q*, AC > P, so

P*

q*

P AC < 0

Showing the Firms Losses


Graphically
P

MC

AC

O
P*

Losses

At q*, P AC < 0
so the firm is
making losses

q*

Deriving the Firms Supply Curve


P

MC

P4*

O4

P3*
P2*
P1*

O3
O2
O1

q1* q2* q3* q4*

Deriving the Firms Supply Curve


P

MC

P4*

O4

P3*
P2*
P1*

O3
O2
O1

q1* q2* q3* q4*

What if the Firm is Losing Money?


P

MC

AC

O
P*

Losses

At q*, P AC < 0
so the firm is
making losses

q*

Should the Firm Shut Down?


Profits from continuing to operate at q*

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC
Profits from shutting down

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC
Profits from shutting down
= TR TC

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC
Profits from shutting down
= TR TC
= 0 TFC TVC

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC
Profits from shutting down
= TR TC
= 0 TFC TVC
= 0 TFC 0

Should the Firm Shut Down?


Profits from continuing to operate at q*
= TR TC
= TR TFC TVC
Profits from shutting down
= TR TC
= 0 TFC TVC
= 0 TFC 0
= TFC

Shut Down Condition: Shut Down


If.......
Profits if shut down > Profits if produce at q*

Shut Down Condition: Shut Down


If.......
Profits if shut down > Profits if produce at q*
-TFC
> TR - TFC - TVC

Shut Down Condition: Shut Down


If.......
Profits if shut down > Profits if produce at q*
-TFC
> TR - TFC - TVC
0
> TR - TVC

Shut Down Condition: Shut Down


If.......
Profits if shut down
-TFC
0
TVC

> Profits if produce at q*


> TR - TFC - TVC
> TR - TVC
>
TR

Shut Down Condition: Shut Down


If.......
Profits if shut down
-TFC
0
TVC
TVC/q

> Profits if produce at q*


> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q

Shut Down Condition: Shut Down


If.......
Profits if shut down
-TFC
0
TVC
TVC/q
AVC

> Profits if produce at q*


> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q
>
AR

Shut Down Condition: Shut Down


If.......
Profits if shut down
-TFC
0
TVC
TVC/q
AVC
AVC

> Profits if produce at q*


> TR - TFC - TVC
> TR - TVC
>
TR
>
TR/q
>
AR
>
P

Should the firm shut down?


DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
Assume the marketdetermined price of
digital toilet paper falls to
$25: Should the firm
shut down?

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

Should the firm shut down?


DigitalToiletPaper.com is
a perfectly competitive
firm (price-taker). Its
total cost of producing
various quantities is
given in the table.
Assume the marketdetermined price of
digital toilet paper falls to
$25: Should the firm
shut down?

q TC MC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

Should the firm shut down?


q TC MC TFC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

100
100
100
100
100
100
100

Should the firm shut down?


q TC MC TFC TVC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

100
100
100
100
100
100
100

0
50
70
90
140
200
280

Should the firm shut down?


q TC MC TFC TVC AVC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

100
100
100
100
100
100
100

0
50
70
90
140
200
280

50
35
30
35
40
46.67

Should the firm shut down?


q TC MC TFC TVC AVC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

100
100
100
100
100
100
100

0
50
70
90
140
200
280

50
35
30>25
35
40
46.67

Should the firm shut down?


Yesat q*, P*<AVC
q TC MC TFC TVC AVC
0
1
2
3
4
5
6

100
150
170
190
240
300
380

50
20
20
50
60
80

100
100
100
100
100
100
100

0
50
70
90
140
200
280

50
35
30>25
35
40
46.67

The Firms Supply Curve


$/unit

MC

AC
AVC

From the Firms Supply Curve to the


Market Supply Curve
Assume there are 1000 identical firms
Price

(a) Individual Firm


Supply

(b) Market Supply


Price

MC

Supply

$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

Long-Run Firm Equilibrium


P

Market
S

$/unit

Firm

P*

P*

MC

P*= MR = D

q*

Long-Run Firm Equilibrium: At q*,


economic profits = 0
P

Market
S

$/unit

Firm

MC
AC

P*

P*

P*= MR = D

q*
At q*, P*= MC = AC,
so P* AC = profits = 0

LibbyCo T-Shirts

LibbyCo T-Shirts

Harvard
Extension....
Where Harvard
Comes to Life!

Accounting Costs
Accounting Costs
Labor

Accounting Costs
Accounting Costs
Labor
Raw materials

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment

$ 500

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment

$ 500
$1000

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment

$ 500
$1000
$ 200

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
Total Accounting Costs

$ 500
$1000
$ 200
$1700

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
Total Accounting Costs

$ 500
$1000
$ 200
$1700

Accounting Costs are Explicit Costs

Accounting Costs
Accounting Costs
Labor
Raw materials
Equipment
Total Accounting Costs

$ 500
$1000
$ 200
$1700

Accounting Costs are Explicit Costs

Accounting profit = TR Accounting


Costs

Accounting Profit
Accounting Costs
Labor
Raw materials
Equipment
Total Accounting Costs

$ 500
$ 1000
$ 200
$ 1700

Accounting profit = TR Accounting


Costs
Say TR = $5,000; then-accounting profit = $5,000 $1,700 = $3,300

Economic Costs
Implicit Costs
Foregone salary
Foregone interest
Total implicit costs
costs

$ 4,000
$
15
$ 4,015

Economic Costs
Implicit Costs
Foregone salary
Foregone interest
Total implicit costs
costs

$ 4,000
$
15
$ 4,015

Total Economic Costs


= Total explicit (accounting) costs + Total implicit
costs

Economic Costs
Implicit Costs
Foregone salary
Foregone interest
Total implicit costs
costs

$ 4,000
$
15
$ 4,015

Total Economic Costs


= Total explicit (accounting) costs + Total implicit
costs
= $1,700 + $4,015

Economic Costs
Implicit Costs
Foregone salary
Foregone interest
Total implicit costs
costs

$ 4,000
$
15
$ 4,015

Total Economic Costs


= Total explicit (accounting) costs + Total implicit
costs
= $1,700 + $4,015
= $5,715

Economic Profits
Total Economic Costs = $5,715

Economic Profits
Total Economic Costs = $5,715
Economic Profit = TR Total Economic Costs

Economic Profits
Total Economic Costs = $5,715
Economic Profit = TR Total Economic Costs
= $5,000 $5,715

Economic Profits
Total Economic Costs = $5,715
Economic Profit = TR Total Economic Costs
= $5,000 $5,715
= $715

Economic Profits < Accounting Profits

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs
= TR (Explicit Costs + Implicit Costs)

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs
= TR (Explicit Costs + Implicit Costs)
= TR Explicit Costs Implicit Costs

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs
= TR (Explicit Costs + Implicit Costs)
= (TR Explicit Costs) Implicit Costs

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs
= TR (Explicit Costs + Implicit Costs)
= (TR Explicit Costs) Implicit Costs
= Accounting Profits Implicit Costs

Economic Profits < Accounting Profits


Economic Profit = TR Total Economic Costs
= TR (Explicit Costs + Implicit Costs)
= (TR Explicit Costs) Implicit Costs
= Accounting Profits Implicit Costs
Economic Profits < Accounting Profits

The Family of Cost Curves Capture


Economic Costs, not just Accounting
Costs
$/unit
MC

AC
AVC

AFC
q

At q*, economic profits are 0 if the


market is in LR equilibrium
P

Market
S

$/unit

Firm

MC
AC

P*

P*

P*= MR = D

q*

At P1, a typical firm is making


economic profits
P

Market
S

Firm

$/unit

P1

P1

MC
AC
P*= MR

Profits

Q1

q1

Firms enter, shifting S curve to the right


and lowering the equilibrium price
P

Market
S

Firm

$/unit
S
P1
P2

P1
P2

MC
AC

P2= MR

Profits

D
Q1 Q2

q2 q1

Eventually, entry lowers the market


price to P***=min AC, lowering economic
profits to 0; then entry ceases
P

Market
S

$/unit

Firm

S
S
P1
P2
P3

P1
P2
P3

P***= MR

D
Q1 Q2 Q3

MC
AC

q3 q2 q1

When a typical firm in a perfectly


competitive market is making economic
profits:
>0

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Supply

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Supply Supply curve shifts R

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Supply Supply curve shifts R
P*

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Supply Supply curve shifts R
P*, Q*

When a typical firm in a perfectly


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Supply Supply curve shifts R
P*, Q*, to 0

At P*, a typical firm is making


economic losses
P

Market

$/unit

Firm

MC
AC

P*

P*
D
Q*

Losses

q*

Firms exit, shifting S curve to the left


and raising P*
P

Market

$/unit
S

MC
AC

P2

P2
P1

P1

D
Q2 Q1

Firm

Losses

q1 q2

LR equilibrium is restored when P increases


to P3, no more firms exit, and a typical firm is
making 0 economic profit
P

Market
S
S

$/unit

Firm

MC
AC

P3
P2
P1

P3
P2
P1

D
Q3Q2Q1

q1q2q3

When a typical firm in a perfectly


competitive market is making economic
losses:
<0

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Supply

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Supply Supply curve shifts L

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Supply Supply curve shifts L
P*

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Supply Supply curve shifts L
P*, Q*

When a typical firm in a perfectly


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Supply Supply curve shifts L
P*, Q*, to 0

LR Equilibrium
P

Market
S

$/unit

Firm

AC

P*

P*

MC

P*= MR = D

D
q*
Q
P*LR = min AC for a typical firm

All firms make 0 economic profit

Perfectly Elastic Supply Curve


P
SSR

P*

LR

SLR
In the LR, S is perfectly elastic at the
min of AC for a typical firm; there is
only one possible price:
P*LR = min AC

Comparative Static Exercise: Toner


Market Starts in LR Equilibrium
P

Toner Market
S

$/unit

Toner Firm

MC
AC

P*

P*

P*= MR = D

D
Q*

q*

Price of Laser Printers Goes Down


P

Toner Market
S

$/unit

Toner Firm

MC
AC

P*

P*

P*= MR = D

D
Q*

q*

Demand for Toner Goes Up


P*, Typical Firm Makes Profit
P

Toner Market
S

$/unit
P2
P1

P2
P1

Toner Firm

MC
AC

Profits

D
D
Q1 Q2

q1 q2

Entry causes S to shift R, P* to


min AC, and economic profits return to 0
P

Toner Market
S

$/unit

Toner Firm

AC

P2
P1

P2
P1

MC

D
D
Q1 Q2 Q3

q1 q2

Monopoly

Conditions for Monopoly


Sources of Monopoly
Demand and Marginal Revenue for a Monopoly
Profit Maximization for a Monopoly
Monopoly Power and Elasticity
Measures of Monopoly Power
Sources of Monopoly Power

Monopoly
Price Discrimination
First Degree
Second Degree
Third Degree

Monopolistic Competition
Product Differentiation
Attributes of a monopolistically competitive
market
Profit Maximizing Quantity
Long-run Equilibrium

Summary of Market Structure:


Perfect Competition
Perfect
Competition
Number of Firms

Very many

Output of Different Identical


Firms
View of Pricing

Price taker

Barriers to Entry/
Exit

No

Output and Pricing MR = MC = P


q* at min AC

SR Profit

Positive, zero,
or negative

LR Profit

Zero

Advertising

Never

Types of Market Structure


Number of Firms
Many
Firms

One
Firm

Monopoly
Tap water
Cable TV

Identical
Products

Perfect
Competition
Wheat
Milk

Conditions for Monopoly

(1)One Seller

Conditions for Monopoly

(1)One Seller
(2)Barriers to Entry

Sources of Monopoly

Sources of Monopoly

Govt grant of a monopoly


Sole ownership of a scarce resource
Natural monopoly
Patents and copyrights

Average Cost for a Natural


Monopoly
$/unit

AC
Q

Demand Curve for a Perfectly


Competitive Firm vs. Demand Curve for
a Monopoly
P
P*

Perfectly
Competitive Firm

$/unit

Monopoly

D=AR=P*

Demand Curve for a Perfectly


Competitive Firm vs. Demand Curve for
a Monopoly
P
P*

Perfectly
Competitive Firm

$/unit

Monopoly

D=AR=P*

Marginal Revenue for a Perfectly


Competitive Firm vs. Marginal Revenue
for a Monopoly
P
P*

Perfectly
Competitive Firm

$/unit

Monopoly

D=MR=AR=P*

Marginal Revenue for a Perfectly


Competitive Firm vs. Marginal Revenue
for a Monopoly
P
P*

Perfectly
Competitive Firm

$/unit

Monopoly

D=MR=AR=P*

MR
q

D
Q

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20

D
10

TR

$20

10

$200

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20

D
10

11

TR

$20

10

$200

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19

D
10

11

TR

$20

10

$200

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19

TR

$20

10

$200

$19

11

$209

D
10

11

MR

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19

TR

$20

10

$200

$19

11

$209

D
10

11

MR
$9

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19

TR

$20

10

$200

$19

11

$209

$9

D
10

11

MR
$9

Firm gains $19 from 11th unit.


but gets $1 less on each of
the previous 10 units, so:
MR = $19 $10 = $9

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19
$9

TR

$20

10

$200

$19

11

$209

$9

$18

12

$216

$7

D
10

11

12

MR

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19
$9

TR

$20

10

$200

$19

11

$209

$9

$18

12

$216

$7

$7
10

11

12

MR

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19
$9

TR

$20

10

$200

$19

11

$209

$9

$18

12

$216

$7

$7
10

11

12

MR

MR

Marginal Revenue for a Monopoly


$/unit

Monopoly

MR

D
Q

Marginal Revenue and Average


Revenue
Consider a firm facing the following demand curve:
P=6Q
TOTAL, MARGINAL, AND AVERAGE REVENUE
PRICE (P)

QUANTITY (Q)

TOTAL
REVENUE (R)

MARGINAL
REVENUE (MR)

AVERAGE
REVENUE (AR)

$6

$0

$5

$5

Determining the Profit-Maximizing


Quantity for a Monopoly
P
MC

MR

At Q*, MR = MC
MR
QMon

What is the monopoly price?


P
MC

MR

At Q*, MR = MC
MR
QMon

What is the monopoly price?


P
MC

MR

At Q*, MR = MC
MR
QMon

What is the monopoly price?


P
MC

PMon
MR

At Q*, MR = MC
MR

For a monopoly,
MR<P at Q*

QMon

Profit Maximization for a Monopoly


PROFIT IS MAXIMIZED WHEN
MARGINAL REVENUE
EQUALS MARGINAL COST
Q* is the output level at
which MR = MC.
If the firm produces a smaller
outputsay, Q1it sacrifices
some profit because the
extra revenue that could be
earned from producing and
selling the units between Q1
and Q* exceeds the cost of
producing them.
Similarly, expanding output
from Q* to Q2 would reduce
profit because the additional
cost would exceed the
additional revenue.

A Monopoly Has No Supply Curve


SHIFTS IN DEMAND
Shifting the demand curve shows
that a monopolistic market has no
supply curvei.e., there is no
one-to-one relationship between
price and quantity produced.
In (a), the demand curve D1 shifts
to new demand curve D2.
But the new marginal revenue
curve MR2 intersects marginal
cost at the same point as the old
marginal revenue curve MR1.
The profit-maximizing output
therefore remains the same,
although price falls from P1 to P2.
In (b), the new marginal revenue
curve MR2 intersects marginal
cost at a higher output level Q2.
But because demand is now more
elastic, price remains the same.

Monopoly with Profits


P
MC

MR

MR
QMon

Monopoly with Profits


P
MC

PMon
MR
MR
QMon

Monopoly with Profits


P
MC
AC

PMon
MR
MR
QMon

Monopoly with Profits


P
MC
AC

PMon

P AC at QMon

AC

MR
MR
QMon

Monopoly with Profits


P
MC
AC

PMon
AC

Profits

P AC at QMon

MR
MR
QMon

Monopoly with Losses


P
MC
AC

PMon
MR
MR
QMon

Monopoly with Losses


P
MC
AC
AC

PMon
MR
MR
QMon

Monopoly with Losses


P
MC
AC
AC

PMon

P AC < 0

MR
MR
QMon

Monopoly with Losses


P
MC
AC
AC

PMon

Losses

P AC < 0

MR
MR
QMon

Profit and Profit Maximization:


A Numerical Example
Cost Function: C (Q ) 50 Q 2
Demand: P(Q ) 40 Q
Part (a) shows total revenue TR, total cost C, and
profit, the difference between the two.
Part (b) shows average and marginal revenue
and average and marginal cost.
Marginal revenue is the slope of the total revenue
curve, and marginal cost is the slope of the total
cost curve.
The profit-maximizing output is Q* = 10, the point
where marginal revenue equals marginal cost.
At this output level, the slope of the profit curve is
zero, and the slopes of the total revenue and
total cost curves are equal.
The profit per unit is $15, the difference between
average revenue and average cost. Because 10
units are produced, total profit is $150.

Marginal Revenue for a Monopoly:


An Example
$/unit

Nickelback
CDs per Day

$20
$19

TR

$20

10

$200

$19

11

$209

$9

D
10

11

MR
$9

Firm gains $19 from 11th unit.


but gets $1 less on each of
the previous 10 units, so:
MR = $19 $10 = $9

ASTRA-MERCK PRICES PRILOSEC


In 1995, Prilosec, represented a new generation of
antiulcer medication. Prilosec was based on a very
different biochemical mechanism and was much
more effective than earlier drugs.
By 1996, it had become the best-selling drug in
the world and faced no major competitor.
Astra-Merck was pricing Prilosec at about $3.50 per daily dose.
The marginal cost of producing and packaging Prilosec is only about
30 to 40 cents per daily dose.
The price elasticity of demand, ED, should be in the range of roughly
1.0 to 1.2.
Setting the price at a markup exceeding 400 percent over marginal
cost is consistent with our rule of thumb for pricing.

MARKUP PRICING: SUPERMARKETS TO


DESIGNER JEANS
Although the elasticity of market demand for food is
small (about 1), no single supermarket can raise its
prices very much without losing customers to other
stores.
The elasticity of demand for any one supermarket is
often as large as 10. We find P = MC/(1 0.1) =
MC/(0.9) = (1.11)MC.
The manager of a typical supermarket should set prices about 11 percent
above marginal cost.
Small convenience stores typically charge higher prices because its customers
are generally less price sensitive.
Because the elasticity of demand for a convenience store is about 5, the
markup equation implies that its prices should be about 25 percent above
marginal cost.
With designer jeans, demand elasticities in the range of 2 to 3 are typical.
This means that price should be 50 to 100 percent higher than marginal cost.

Price Discrimination
price discrimination Practice of charging
different prices to different consumers for
similar goods.
If a firm can charge only one price
for all its customers, that price will
be P* and the quantity produced
will be Q*.
Ideally, the firm would like to
charge a higher price to
consumers willing to pay more
than P*.
The firm would also like to sell to
consumers willing to pay prices
lower than P*, but only if doing so
does not entail lowering the price
to other consumers.
In that way, the firm could earn
additional profits by selling to
consumers represented by region
B of the demand curve.

Price Discrimination
First degree price discrimination

First-Degree Price Discrimination


reservation price Maximum price
that a customer is willing to pay for a
good.
first-degree price discrimination
Practice of charging each customer
her reservation price.

First-Degree Price Discrimination


Perfect Price Discrimination
The additional profit from
producing and selling an
incremental unit is now the
difference between demand
and marginal cost.

Price Discrimination
First degree price discrimination
Second degree price discrimination

Second-Degree Price Discrimination


second-degree price discrimination Practice of
charging different prices per unit for different quantities
of the same good or service.
block pricing Practice of charging different prices for
different quantities or blocks of a good.

Second-Degree Price Discrimination


Second-Degree Price Discrimination

Different prices are charged


for different quantities, or
blocks, of the same good.
Here, there are three blocks,
with corresponding prices P1,
P2, and P3.
There are also economies of
scale, and average and
marginal costs are declining.
Second-degree price
discrimination can then make
consumers better off by
expanding output and
lowering cost.

Price Discrimination
First degree price discrimination
Second degree price discrimination
Third degree price discrimination

Third-Degree Price Discrimination


third-degree price discrimination Practice of
dividing consumers into two or more groups with
separate demand curves and charging different
prices to each group.

Third-Degree Price Discrimination:


Creating Consumer Groups
If third-degree price discrimination is feasible, how
should the firm decide what price to charge each
group of consumers?
1. We know that however much is produced, total
output should be divided between the groups of
customers so that marginal revenues for each
group are equal.
2. We know that total output must be such that the
marginal revenue for each group of consumers
is equal to the marginal cost of production.

Third-Degree Price Discrimination:


Creating Consumer Groups
Third-Degree Price Discrimination

Consumers are divided into two


groups, with separate demand
curves for each group. The
optimal prices and quantities
are such that the marginal
revenue from each group is the
same and equal to marginal
cost.
Here group 1, with demand
curve D1, is charged P1,
and group 2, with the more
elastic demand curve D2, is
charged the lower price P2.
Marginal cost depends on the
total quantity produced QT.
Note that Q1 and Q2 are chosen
so that MR1 = MR2 = MC.

Price Discrimination and Coupons


Coupons provide a means of price
discrimination.
Studies show that only about 20 to 30
percent of all consumers regularly
bother to clip, save, and use coupons.
Rebate programs work the same way.
Only those consumers with relatively
price-sensitive demands bother to send
in the materials and request rebates.
Again, the program is a means of price
discrimination.

Price Discrimination and Coupons


Price Elasticities of Demand for Users versus Nonusers of Coupons
PRICE ELASTICITY
Product

Nonusers

Users

Toilet tissue

0.60

0.66

Stuffing/dressing

0.71

0.96

Shampoo

0.84

1.04

Cooking/salad oil

1.22

1.32

Dry mix dinners

0.88

1.09

Cake mix

0.21

0.43

Cat food

0.49

1.13

Frozen entrees

0.60

0.95

Gelatin

0.97

1.25

Spaghetti sauce

1.65

1.81

Creme rinse/conditioner

0.82

1.12

Soups

1.05

1.22

Hot dogs

0.59

0.77

Price Discrimination and Air Fares


Travelers are often amazed at the variety of fares available for round-trip
flights from New York to Los Angeles.
Recently, for example, the first-class fare was above $2000; the regular
(unrestricted) economy fare was about $1700, and special discount fares (often
requiring the purchase of a ticket two weeks in advance and/or a Saturday
night stayover) could be bought for as little as $400.
These fares provide a profitable form of price discrimination. The gains from
discriminating are large because different types of customers, with very
different elasticities of demand, purchase these different types of tickets.
Elasticities of Demand for Air Travel
FARE CATEGORY
Elasticity

First Class

Unrestricted Coach

Discounted

Price

0.3

0.4

0.9

Income

1.2

1.2

1.8

Summary of Market Structures:


Perfect Competition and Monopoly
Number of Firms

Perfect
Competition

Monopoly

Very many

One

Output of Different Identical


Firms

--

View of Pricing

Price taker

Price maker

Barriers to Entry/
Exit

No

Yes

Output and Pricing MR = MC = P


q* at min AC

MR = MC
P > MC
q* below pt. of min AC

SR Profit

Positive, zero,
or negative

Positive, zero,
or negative

LR Profit

Zero

Positive

Advertising

Never

Sometimes: PR Type

Types of Market Structure


Number of Firms

One
Firm

Many
Firms
Type of Products

Differentiated
Products

Identical
Products

Monopoly
(Chapter 15)

Monopolistic
Competition
(Chapter 17)

Perfect
Competition
(Chapter 14)

Tap water
Cable TV

Household Goods
Movies

Wheat
Milk

Monopolistic Competition
A monopolistically competitive market has two key
characteristics:
1. Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect substitutes.

Cross-price Elasticity of Demand


Cross-price elasticity of demand:
measures the response of demand for one good to
changes in the price of another good
d for good 1
%
change
in
Q
Cross-price elast.
=
of demand
% change in price of good 2

For substitutes, cross-price elasticity > 0


(e.g., an increase in price of Diet Pepsi causes an increase in
demand for Diet Coke)

For perfect substitutes, cross-price elasticity


For close (but not perfect) substitutes, cross-price elasticity is
high but not infinite

Monopolistic Competition
A monopolistically competitive market has two key
characteristics:
1. Firms compete by selling differentiated products that are
highly substitutable for one another but not perfect
substitutes.
In other words, the cross-price elasticities of demand are
large but not infinite.
2. There is free entry and exit: It is relatively easy for new firms
to enter the market with their own brands and for existing
firms to leave if their products become unprofitable.

Monopolistic Competition as a
Hybrid Market Structure
Many sellers
Like perfect
competition
Free entry and exit
Downward sloping demand Like
monopoly
curve
Product differentiation (Unlike perfect competition)
Demand curve much more elastic than
monopoly

MONOPOLISTIC COMPETITION IN THE MARKETS


FOR COLAS AND COFFEE
The markets for soft drinks and coffee illustrate the
characteristics of monopolistic competition. Each
market has a variety of brands that differ slightly
but are close substitutes for one another.

TABLE 12.1

ELASTICITIES OF DEMAND FOR COLAS AND COFFEE


BRAND

Colas

RC Cola
Coke

Ground coffee

ELASTICITY OF DEMAND
2.4
5.2 to 5.7

Folgers

6.4

Maxwell House

8.2

Chock Full o Nuts

3.6

With the exception of RC Cola and Chock Full o Nuts, all the colas and
coffees are quite price elastic. With elasticities on the order of 4 to 8,
each brand has only limited monopoly power. This is typical of
monopolistic competition.

Determining the Profit-Maximizing


Quantity for a Monopolistically
Competitive Firm
P
MC

MR

At QMC,MR = MC D

MR
qMC

Determining the Price for a


Monopolistically Competitive Firm
P
MC

PMC
MR

At QMC,MR = MC D

MR
qMC

Monopolistically Competitive Firm


Making Profits in the Short Run
P
MC
AC

PMC
AC
MR=MC

P AC at QMC

Profits

MR
qMC

As firms enter, a monopolistically


competitive firms demand decreases,
and its demand curve shifts left
P
MC
AC

MR

MR

In the Long Run, a Monopolistically


Competitive Firms Profits are Zero
P
MC
AC

PMC=AC
min AC
MR=MC
MR
qMC

When a typical firm in a monopolistically


competitive market is making economic
profits:
>0

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs Number of firms

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Demand for product of incumbent
firms

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Demand for product of incumbent
firms
Demand curve of incumbent firms
shifts left

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Demand for product of incumbent
firms
Demand curve of incumbent firms
shifts left
qMC goes down to point where P = AC

When a typical firm in a monopolistically


competitive market is making economic
profits:
> 0 Entry occurs Number of firms
Demand for product of incumbent
firms
Demand curve of incumbent firms
shifts left
qMC goes down to point where P = AC
Economic profits are 0

Is this firm making profits or losses?


P
AC

MC

PMC
MR=MC

MR
qMC

Monopolistically Competitive Firm


Making Losses
P
AC

MC

AC
PMC

Losses

P AC < 0

MR=MC

MR
qMC

As firms exit, a monopolistically


competitive firms demand increases,
and its demand curve shifts right
P
AC

MC

MR

MR

In the Long Run, a Monopolistically


Competitive Firms Profits are Zero
P
MC
AC

PMC=AC
min AC
MR=MC
MR
qMC

When a typical firm in a monopolistically


competitive market is making economic
losses:
<0

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs Number of firms

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Demand for product of remaining
firms

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Demand for product of remaining
firms
Demand curve of incumbent firms
shifts right

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Demand for product of remaining
firms
Demand curve of incumbent firms
shifts right
qMC goes up to point where P = AC

When a typical firm in a monopolistically


competitive market is making economic
losses:
< 0 Exit occurs Number of firms
Demand for product of remaining
firms
Demand curve of incumbent firms
shifts right
qMC goes up to point where P = AC
Economic profits are 0

Monopolistic versus Perfect


Competition
(a) Monopolistically Competitive Firm

(b) Perfectly Competitive Firm


Price

Price
MC

MC

AC

AC

Markup

P
P = MR
(demand
curve)

MC
MR

Quantity
produced

Efficient
scale

Demand

Quantity

At equilibrium:
P > MC
q < q at min AC

Quantity produced =
Efficient scale

Quantity

At equilibrium:
P = MC
q = q at min AC

Summary of Market Structures


Perfect
Competition

Monopolistic
Competition

Monopoly

Very many

Many

One

Output of Different Identical


Firms

Differentiated

--

View of Pricing

Price taker

Price maker

Price maker

Barriers to Entry/
Exit

No

No

Yes

q* at min AC

MR = MC
P > MC
q* below pt. of min AC

MR = MC
P > MC
q* below pt. of min AC

SR Profit

Positive, zero,
or negative

Positive, zero,
or negative

Positive, zero,
or negative

LR Profit

Zero

Zero

Positive

Advertising

Never

Always

Sometimes: PR Type

Number of Firms

Output and Pricing MR = MC = P

Oligopoly
Four-four concentration ratios
The Cournot Model
The Stackelberg Model

Types of Market Structure


Number of Firms

One
Firm

Few
Firms

Many
Firms
Type of Products

Differentiated
Products

Monopoly
(Chapter 15)

Oligopoly
(Chapter 16)

Monopolistic
Competition
(Chapter 17)

Tap water
Cable TV

Tennis balls
Crude oil

Household Goods
Movies

Identical
Products

Perfect
Competition
(Chapter 14)
Wheat
Milk

Measuring Market Concentration


Four-firm concentration ratio: the
percentage of the markets total output supplied
by its four largest firms.
The higher the concentration ratio, the less
competition.
Oligopoly is a market structure with high
concentration ratios.

Concentration Ratios in Selected U.S. Industries


Industry
Video game
consoles
Tennis balls
Credit cards
Batteries
Soft drinks
Web search
engines
Breakfast cereal
Cigarettes
Greeting cards
Beer
Cell phone service
Autos

Concentration
ratio
100%
100%
99%
94%
93%
92%
92%
89%
88%
85%
82%
79%

Oligopoly
Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
Strategic behavior in oligopoly:
A firms decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making
decisionsstrategic interdependence
Game theory: the study of how people behave
in strategic situations.

Oligopoly
In monopolistic competition:
Many firms
Free entry and exit
In oligopoly:
Few firms (High concentration ratios)
Barriers to entry

Sources of Barriers to Entry


in Oligopoly
Natural barriers:
(inherent in basic market structure)
Scale economies
Patents or limited access to a technology
Need to spend money to establish name recognition
and market reputation

Strategic actions by incumbent firms:


Examples

Excess capacity
q > q which maximizes profit
(p < p consistent with profit maximization)

Equilibrium in Oligopoly
vs. Other Market Structures
In perfect competition, monopoly, and
monopolistic competition:
Firms find profit-maximizing q where MR = MC
Any other firms in the market can be ignored

In oligopoly:
Strategic interdependence
Optimal decisions about p, q, or anything else
depend on competitors decisions
Sohow do we find equilibrium?

Equilibrium in Oligopoly
Regardless of market structure, equilibrium is
where a firm is doing the best that it can, and has
no incentive to change output or price
In oligopoly, a firm also does the best that it can
in equilibrium . . . . . .

. . . . given what its competitors are doing

Cournot Model
Researches on the Mathematical
Principles of the Theory of Wealth
(1838)

Antoine Augustin Cournot


(1801 - 1877)

First introduced concepts of functions


and probability into economics
First to conceive the idea of supply and
demand as a function of price
First to draw supply and demand curves
First to analyze oligopoly

Cournot Model
Assumptions:

Two firms
Homogeneous good
Firms know the market demand curve
The two firms decide simultaneously how
much to produce
Each firm treats the output of its competitors
as fixed

Cournot Model
Market Demand: P = 75 2Q
Total Cost: TC = 10 + 3Q
Marginal Cost: MC = 3
Cournot Outcome
Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qFqL
MRL = 75 4qL 2qF = MC = 3
75 4qL 2qF = 3 4qL = 72 2qF
* = 18 q
q
F
L

Cournot Model
Market Demand: P = 75 2Q
Total Cost: TC = 10 + 3q
Marginal Cost: MC = 3
Cournot Outcome
Firm F: TRF = PqF= (75 2Q)qF
= 75qF 2(qL + qF)qF
= 75qF 2qLqF 2qF2
MRF = 75 2qL 4qF = MC = 3
75 2qL 4qF = 3 4qF = 72 2qL
* = 18 q
q
L
F

Cournot Model
Firm Ls Reaction Function: qL* = 18 qF
Firm Fs Reaction Function: qF* = 18 qL
Find qL*: qL*= 18 qF*
= 18 (18 qL*)
= 18 9 + qL*)
qL*= 9

qL*= 12

Find qF*: qF*= 18 (12)

qF*= 12

Cournot Model
qL* = qF* = 12
Q* = qL* + qF* = 24
P* = 75 2Q*
= 75 2(24)
P* = 27
TRL= TRF= P*qL*= P*qF* = (27)(12) = 324
TCL= TCF= 10 + 3qL* = 10 + 3qF* = 10 + 3(12) = 46
ProfitsL= ProfitsF = 324 46 = 278

Cournot Model: Another Example


Duopolists face the following market demand curve: P = 30 Q
MC1 = MC2 = 0
Total revenue for firm 1: R1 = Pq1 = (30 Q)q1
then MR1 = R1/q1 = 30 2q1 q2
Setting MR1 = 0 (the firms marginal cost) and solving for q1, we find:
Firm 1s reaction curve:

q1 15 1 q2
2

By the same calculation, Firm 2s reaction curve:


Cournot equilibrium:

q1 q2 10

Total quantity produced: Q q1 q2 20

q2 15 1 q1
2

Cournot Model
If the two firms collude, then the total profit-maximizing
quantity can be obtained as follows:
Total revenue for the two firms: R = PQ = (30 Q)Q =
30Q Q2, then MR = R/Q = 30 2Q
Setting MR = 0 (the firms marginal cost) we find that
total profit is maximized at Q = 15.
Then, q1 + q2 = 15 is the collusion curve.
If the firms agree to share profits equally, each will
produce half of the total output:
q1 = q2 = 7.5

Cournot Model
Duopoly Example

The demand curve is P


= 30 Q, and both
firms have zero
marginal cost. In
Cournot equilibrium,
each firm produces 10.
The collusion curve
shows combinations of
Q1 and Q2 that
maximize total profits.
If the firms collude and
share profits equally,
each will produce 7.5.
Also shown is the
competitive
equilibrium, in which
price equals marginal
cost and profit is zero.

Stackelberg Model
Cournot: The two firms make their output decisions
simultaneously

Stackelberg Model
Cournot: The two firms make their output decisions
simultaneously
Stackelberg: One of the firms can set its output first

Stackelberg Model
Two firms: A leader and a follower
Leader produces quantity qL
Follower produces quantity qF
What would be the outcome if one of the firms
(firm L, the leader) sets its output first?

Stackelberg Model
Firm L sets its output first

Stackelberg Model
Firm L sets its output first
Firm F then sets its output based on firm Ls output

Stackelberg Model
Firm L sets its output first
Firm F then sets its output based on firm Ls output
Firm L takes firm Fs reaction into consideration when
it sets its output first

Stackelberg Model
Firm L sets its output first
Firm F then sets its output based on firm Ls output
Firm L takes firm Fs reaction into consideration when
it sets its output first
Since firm F sets output after firm L, it treats firm Ls
output as fixedjust like in the Cournot model

Stackelberg Outcome
Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
Firm Fs Reaction Function: qF* = 18 qL
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3
2qL*= 36
qL*= 18

Stackelberg Outcome
Firm Fs Reaction Function: qF* = 18 qL
qF*= 18 qL*
qL*= 18
qF*= 18 (18)

qF*= 9

Stackelberg Outcome
qL* = 18

qF* = 9

Q* = qL* + qF* = 27
P* = 75 2Q*
= 75 2(27)
P* = 21
TRL= P*qL*= (21)(18) = 378
TCL= 10 + (3)(18) = 64

TRF= P*qF* = (21)(9) = 189


TCF= 10 + (3)(9) = 37

ProfitsL= 378 64 = 314

ProfitsF= 189 37 = 152

Cournot vs. Stackelberg Outcomes


Cournot Outcome

Stackelberg Outcome

qL* = 12

qL* = 18

qF* = 12

qF* = 9

Q* = qL* + qF* = 24

Q* = qL* + qF* = 27

P* = 27

P* = 21

ProfitsL= 278

ProfitsL= 314

ProfitsF= 278

ProfitsF= 152

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function

Find Followers Reaction Function


Market Demand: P = 75 2Q
Total Cost: TC = 10 + 3Q
Marginal Cost: MC = 3
Firm F: TRF = PqF= (75 2Q)qF
= 75qF 2(qL + qF)qF
= 75qF 2qLqF 2qF2
MRF = 75 2qL 4qF = MC = 3
75 2qL 4qF = 3 4qF = 72 2qL

qF* = 18 qL

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)

Find Firm Ls TR Function

Firm L: TRL = PqL= (75 2Q)qL


= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function

Substitute for qF
in leaders TR function

Firm L: TRL = PqL= (75 2Q)qL


= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
Firm Fs Reaction Function: qF* = 18 qL
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function

Find Leaders MR Function


Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
Firm Fs Reaction Function: qF* = 18 qL
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC

Set MRL = MC
Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
Firm Fs Reaction Function: qF* = 18 qL
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*

Solve for qL*


Firm L: TRL = PqL= (75 2Q)qL
= 75qL 2(qL + qF)qL
= 75qL 2qL2 2qLqF
Firm Fs Reaction Function: qF* = 18 qL
TRL = 75qL 2qL2 2qL(18 qL)
= 75qL 2qL2 36qL + qL2
= 75qL 36qL qL2
= 39qL qL2
MRL = 39 2qL = MC = 3
2qL*= 36
qL*= 18

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*
7. Substitute qL* into followers reaction function

Substitute qL*
into Expression for qF*
Firm Fs Reaction Function: qF* = 18 qL
qF*= 18 qL*
qL*= 18
qF*= 18 (18)

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*
7. Substitute qL* into followers reaction function
8. Solve for qF*

Solve for qF*


Firm F:
Firm Fs Reaction Function: qF* = 18 qL
qF*= 18 qL*
qL*= 18
qF*= 18 (18)

qF*= 9

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*
7. Substitute qL* into followers reaction function
8. Solve for qF*
9. Find Q* = qL* + qF*

Find Q*
qL* = 18

qF* = 9

Q* = qL* + qF* = 27

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*
7. Substitute qL* into followers reaction function
8. Solve for qF*
9. Find Q* = qL* + qF*
10. Substitue Q* in demand function to find P*

Find P*
qL* = 18

qF* = 9

Q* = qL* + qF* = 27
P* = 75 2Q*
= 75 2(27)
P* = 21

Steps in Solving for


Stackelberg Equilibrium
1. Find followers reaction function
2. Find leaders TR function (which will include
a qF term)
3. Substitute followers reaction function for qF in
leaders TR function
4. Find leaders MR function
5. Set leaders MR = MC
6. Solve for qL*
7. Substitute qL* into followers reaction function
8. Solve for qF*
9. Find Q* = qL* + qF*
10. Substitue Q* in demand function to find P*

Oligopoly and Game Theory


Bertrand Model
Game Theory
Prisoners Dilemma
Dominant Strategies
Repeated Games

Bertrand Model
Competition based on setting prices
not quantities (like Cournot)
Two variants:
Homogeneous goods
Differentiated goods

Bertrand Model
with Homogeneous Products
Market demand curve: P = 30 Q
Q = q 1 + q2
MC1 = MC2 = 3
Good is homogeneous Buyers only care
about price
Outcome: Both firms will charge $3
Total output will be Q = 27 q1 = q2 = 13.5
1 = 2 = 0

Bertrand Model
with Differentiated Products
Firm 1s Demand: Q1 = 12 2P1 + P2
Firm 2s Demand: Q2 = 12 2P2 + P1
TFC = $20

TVC = 0

1 = P1Q1 20 = 12P1 2P12 + P1P2 20


1 / P1 =12 4P1 + P2 = 0
Firm 1s reaction curve: P1 = 3 + P2
Firm 2s reaction curve: P2 = 3 + P1

Bertrand Model
with Differentiated Products
Firm 1s reaction curve: P1 = 3 + P2
Firm 2s reaction curve: P2 = 3 + P1
To find the Nash Equilibrium:
P1 = 3 + P2
= 3 + (3 + P1)

3 3 4 116 P1
1516 P1 15 4
P1 4

Nash Equilibrium in a Bertrand


Model with Differentiated Products
P1

Firm 2s
reaction curve
Firm 1s
reaction curve

$4

Nash
Equilibrium

$4

P2

What if Firm 1 and 2 Could Collude?


1 = 12P1 2P12 + P1P2 20
2 = 12P2 2P22 + P1P2 20
T = 24P 4P2 + 2P2 40
= 24P 2P2 40
T / P = 24 4P = 0
P* = 6
T = 24(6) 2(62) 40
T = 32 1 = 2 = 16

Components of a Game
Players
Example: Coke and Pepsi

Components of a Game
Players
Example: Coke and Pepsi

Strategies for Each Player


Example: Spend a little (small) or a lot
(large) on advertising

Prisoners Dilemma Situation


Pepsis Spending
On Advertising
Small
Cokes
Spending on
Advertising

Small

Large

Large

Components of a Game
Players
Example: Coke and Pepsi

Strategies for Each Player


Example: Spend a little (small) or a lot
(large) on advertising

Payoffs

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Large

Small
C = +8

Large

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Large

Small
C = +8
P = +8

Large

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Large

Small
C = +8
P = +8

Large
C = 2

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Large

Small
C = +8
P = +8

Large
C = 2
P = +13

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Prisoners Dilemma Situation


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Nash Equilibrium
Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Equilibrium if Players Could Collude


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Cokes Dominant Strategy


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Pepsis Dominant Strategy


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Outcome of the Game


Pepsis Spending
On Advertising

Cokes
Spending on
Advertising

Small

Small
C = +8
P = +8

Large
C = 2
P = +13

Large

C = +13
P = 2

C = +3
P = +3

Repeated Games
repeated game Game in which actions are taken and payoffs
received over and over again.
PRICING PROBLEM
Firm 2

Firm 1

Low price

High price

Low price

10, 10

100, 50

High price

50, 100

50, 50

Suppose this game is repeated over and over againfor example, you and
your competitor simultaneously announce your prices on the first day of every
month. Should you then play the game differently? 13.8
TIT-FOR-TAT STRATEGY
In the pricing problem above, the repeated game strategy that works best is the
tit-for-tat strategy.
tit-for-tat strategy Repeated-game strategy in which a player responds in
kind to an opponents previous play, cooperating with cooperative opponents
and retaliating against uncooperative ones.

Welfare Economics

Consumer, Producer, and Social Surplus


Pareto Optimality
Welfare Analysis of a Price Ceiling
Welfare Analysis of a Price Floor
Nobody Buys the Surplus
Government Buys the Surplus

Welfare Analysis of a Monopoly


Welfare Analysis of Taxes

What Does
Consumer Surplus Measure?
Consumer surplus, the amount that buyers are
willing to pay for a good minus the amount they
actually pay for it, measures the benefit that
buyers receive from a good as the buyers
themselves perceive it.

Consumer Surplus
Consumer Surplus
= Value to buyers Amount paid by buyers

Price and Consumer Surplus:


Consumer Surplus at Price P1
Price
A

Consumer
surplus
P1

Demand

Q1

Quantity

Price and Consumer Surplus:


Consumer Surplus When Price
Goes Down from P1 to P2
Price
A

Initial
consumer
surplus
P1

P2

C
B

Consumer surplus
to new consumers
F

D
E
Additional consumer
surplus to initial
consumers
Q1

Demand

Q2

Quantity

What Does Producer Surplus


Measure?
Producer surplus, the amount that sellers
receive for a good over and above the minimum
for which they are willing to sell the good. The
minimum for which they are willing to sell the
good is their marginal cost, and is given by
their supply curve.

Producer Surplus
Consumer Surplus
= Value to buyers Amount paid by buyers

Producer Surplus
= Amount received by sellers Cost to sellers

Price and Producer Surplus:


Producer Surplus at Price P1
Price
Supply

P1

B
Producer
surplus

A
0

Q1

Quantity

Price and Producer Surplus:


Producer Surplus When Price
Goes Up from P1 to P2
Price
Supply

Additional producer
surplus to initial
producers

P2

P1

E
F

B
Initial
producer
surplus

Producer surplus
to new producers

A
0

Q1

Q2

Quantity

Social Surplus
Social surplus
= Consumer surplus + Producer surplus

Consumer Surplus, Producer


Surplus and Social Surplus
Price

Supply

Consumer
surplus
Equilibrium
price

E
Producer
surplus

Demand

C
0

Equilibrium
quantity

Quantity

Consumer Surplus, Producer


Surplus and Social Surplus
Price A

Supply

Consumer
surplus

Social
Equilibrium
price

E
Producer
Surplus
surplus

Demand

C
0

Equilibrium
quantity

Quantity

Efficiency
Efficiency is the property of a resource
allocation of maximizing the total surplus
received by all members of society.

The Omniscient Planner


P

V(1)
V(2)
V(3)
C(Q*+1)
V(Q*) =C(Q*)

V(Q*+1)
C(3)
C(2)

C(1)

Q* Q*+1

Pareto Efficiency
(or Pareto Optimality)
A situation in which nobody can be made better
off without making somebody else worse off

First Fundamental Welfare Theorem


Any market equilibrium will be Pareto Efficient

Efficiency vs. Equity


In addition to market efficiency, a social
planner might also care about equity the
fairness of the distribution of well-being among
the various buyers and sellers.

Welfare Analysis of Price Ceiling


P
S

P*
PC

Shortage

D
0

QS

Q*

QD

Welfare Analysis of Price Ceiling


P
S
Before Price
Ceiling

A
P*

CS

B
D

PS

SS

PC

E
D
0

QS

Q*

QD

After Price
Ceiling

Change

Welfare Analysis of Price Ceiling


P
S
Before Price
Ceiling

A
P*

CS

B
D

A+B

PS

SS

PC

E
D
0

QS

Q*

QD

After Price
Ceiling

Change

Welfare Analysis of Price Ceiling


P
S
Before Price
Ceiling

A
P*

B
D

CS

A+B

PS

C+D+E

SS

PC

E
D
0

QS

Q*

QD

After Price
Ceiling

Change

Welfare Analysis of Price Ceiling


P
S
Before Price
Ceiling

A
P*

B
D

PC

CS

A+B

PS

C+D+E

SS

A+B+C
+D+E

E
D
0

QS

Q*

QD

After Price
Ceiling

Change

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

CS

A+B

A+C

PS

C+D+E

SS

A+B+C
+D+E

E
D
0

QS

Q*

QD

Change

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

CS

A+B

A+C

PS

C+D+E

SS

A+B+C
+D+E

E
D
0

QS

Q*

QD

Change

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

CS

A+B

A+C

PS

C+D+E

SS

A+B+C
+D+E

A+C+E

E
D
0

QS

Q*

QD

Change

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

Change

CS

A+B

A+C

+CB

PS

C+D+E

SS

A+B+C
+D+E

A+C+E

E
D
0

QS

Q*

QD

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

Change

CS

A+B

A+C

+CB

PS

C+D+E

CD

SS

A+B+C
+D+E

A+C+E

E
D
0

QS

Q*

QD

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

Change

CS

A+B

A+C

+CB

PS

C+D+E

CD

SS

A+B+C
+D+E

A+C+E

BD

E
D
0

QS

Q*

QD

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

Change

CS

A+B

A+C

+CB

PS

C+D+E

CD

SS

A+B+C
+D+E

A+C+E

BD

E
D
0

QS

Q*

QD

SS = B D

Welfare Analysis of Price Ceiling


P
S

A
P*

B
D

PC

Before Price
Ceiling

After Price
Ceiling

Change

CS

A+B

A+C

+CB

PS

C+D+E

CD

SS

A+B+C
+D+E

A+C+E

BD

E
D
0

QS

Q*

QD

SS = B D
DWL = SS = (BD)
Q =B+D

Price Ceilings: Sources of Even


Higher DWL
Who ends up with the available
output?

Price Ceilings: Sources of Even Higher


DWL
Rent Control Example
P

QD = 200
QS = 120

$1000
$950

Shortage = 80

$800=
$700
$600 PC
=
P*

Shortage

D
0

100

QS

QD

Price Ceilings: Sources of Even


Higher DWL
Who ends up with the available
output?
Lines

Price Ceilings: Sources of Even


Higher DWL
Who ends up with the available
output?
Lines
Corruption/Black Markets

Welfare Analysis of a Price Floor


P
S
Surplus

PF

P*

D
0

QD

Q*

QS

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

P*

G
H
F

F
D

QD

Q*

QS

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS
PS

P*

After Price
Floor

SS

H
F

F
D

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

After Price
Floor

SS

H
F

F
D

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

After Price
Floor

G+H

SS

G
H
F

F
D

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

+G+H

H
F

F
D

QD

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H
+G+H

H
F

F
D

QD

SS A+B+C

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

B+H

+G+H

H
F

F
D

QD

SS A+B+C

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

G
F

B+H
A+B+H

F
D

QD

+G+H

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

G
F

BC

B+H
A+B+H

F
D

QD

Change

+G+H

After Price
Floor

Q*

QS

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

G
F

BC

B+H

+BG

A+B+H

F
D

QD

Change

+G+H

After Price
Floor

Q*

QS

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

G
F

BC

B+H

+BG

A+B+H

CG

F
D

QD

Change

+G+H

After Price
Floor

Q*

QS

Welfare Analysis of a Price Floor:


Govt. Does Not Buy Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

SS A+B+C

G
F

BC

B+H

+BG

A+B+H

CG

F
D

QD

Change

+G+H

After Price
Floor

Q*

QS

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

P*

G
H
F

F
D

QD

Q*

QS

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS
PS

P*

Gov

H
F

SS

D
0

QD

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

H
F

SS

D
0

QD

After Price
Floor

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

G+H

Gov

G
H

SS

F
D

After Price
Floor

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

G
H

G+H
---

SS

F
D

After Price
Floor

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

G
H

G+H
---

SS A+B+C

+G+H

D
0

After Price
Floor

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

G
H

G+H
---

SS A+B+C

+G+H

D
0

After Price
Floor

QD

Q*

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

H
F

G+H

QD

B+C+D+G
+H

SS A+B+C

F
Q*

---

+G+H

After Price
Floor

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

H
F
QD

B+C+D+G
+H

---

C D E
F G

SS A+B+C

F
Q*

G+H

+G+H

After Price
Floor

QS

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

H
F

B+C+D+G
+H

---

C D E
F G

+G+H

QD

Q*

QS

G+H

SS A+B+C

After Price
Floor

A+B+H
E F

Change

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

CS A+B+C
PS

P*

Gov

H
F
QD

Q*

B C

---

C D E
F G

+G+H

QS

A
B+C+D+G
+H

Change

G+H

SS A+B+C

After Price
Floor

A+B+H
E F

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

PS

Gov

H
F

Change

B C

G+H

B+C+D+G
+H

+B+C+D

---

C D E
F G

CS A+B+C

P*

After Price
Floor

SS A+B+C

+G+H

QD

Q*

QS

A+B+H
E F

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

PS

Gov

H
F

Change

B C

G+H

B+C+D+G
+H

+B+C+D

---

C D E
F G

C D E
F G

CS A+B+C

P*

After Price
Floor

SS A+B+C

+G+H

QD

Q*

QS

A+B+H
E F

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

PS

Gov

H
F

Change

B C

G+H

B+C+D+G
+H

+B+C+D

---

C D E
F G

C D E
F G

A+B+H
E F

C E
F G

CS A+B+C

P*

After Price
Floor

SS A+B+C

+G+H

QD

Q*

QS

Welfare Analysis of a Price Floor:


Government Buys the Surplus
P
S
PF

Surplus

A
B

Before
Price
Floor

PS

Gov

H
F

After Price
Floor

Change

B C

G+H

B+C+D+G
+H

+B+C+D

---

C D E
F G

C D E
F G

A+B+H
E F

C E
F G

CS A+B+C

P*

DWL = C+E+F+G

SS A+B+C

+G+H

QD

Q*

QS

Monopoly vs. Perfect Competition


P
MC

PMon
PPC
MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P
MC

A
PMon
PPC

B
D

C
E

MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P
MC
Perfect
Competition

PMon
PPC

CS

PS

C
E

MR
MR
QMon QPC

Monopoly

SS

Change

Monopoly vs. Perfect Competition


P
MC
Perfect
Competition

PMon
PPC

CS

PS

C
E

MR
MR
QMon QPC

Monopoly

A+B+C

SS

Change

Monopoly vs. Perfect Competition


P
MC
Perfect
Competition

PMon
PPC

CS

A+B+C

PS

D+E

C
E

MR
MR
QMon QPC

Monopoly

SS

Change

Monopoly vs. Perfect Competition


P
MC
Perfect
Competition

PMon
PPC

CS

A+B+C

PS

D+E

SS

A+B+C
+D+E

C
E

MR
MR
QMon QPC

Monopoly

Change

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

CS

A+B+C

PS

D+E

SS

A+B+C
+D+E

C
E

MR
MR
QMon QPC

Change

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

CS

A+B+C

PS

D+E

B+D

SS

A+B+C
+D+E

C
E

MR
MR
QMon QPC

Change

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

CS

A+B+C

PS

D+E

B+D

SS

A+B+C
+D+E

A+B+D

C
E

MR
MR
QMon QPC

Change

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

Change

B C

CS

A+B+C

PS

D+E

B+D

SS

A+B+C
+D+E

A+B+D

C
E

MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

Change

CS

A+B+C

B C

PS

D+E

B+D

+B E

SS

A+B+C
+D+E

A+B+D

C
E

MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P
MC

PMon
PPC

Perfect
Competition

Monopoly

Change

CS

A+B+C

B C

PS

D+E

B+D

+B E

SS

A+B+C
+D+E

A+B+D

C E

C
E

MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P

PMon
PPC

DWL = C + E

MC
Perfect
Competition

Monopoly

Change

CS

A+B+C

B C

PS

D+E

B+D

+B E

SS

A+B+C
+D+E

A+B+D

C E

C
E

MR
MR
QMon QPC

Monopoly vs. Perfect Competition


P

PMon
PPC

DWL = C + E

MC
Perfect
Competition

Monopoly

Change

CS

A+B+C

B C

PS

D+E

B+D

+B E

SS

A+B+C
+D+E

A+B+D

C E

C
E

MR
MR
QMon QPC

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

10,000

$1.00

12,500

$1.50

15,000

$2.00

17,500

$2.50

20,000

$3.00

22,500

$3.50

25,000

$4.00

Price with Tax

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

15,000

$2.00

17,500

$2.50

20,000

$3.00

22,500

$3.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

17,500

$2.50

20,000

$3.00

22,500

$3.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

$3.00

17,500

$2.50

20,000

$3.00

22,500

$3.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

$3.00

17,500

$2.50

$3.50

20,000

$3.00

22,500

$3.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

$3.00

17,500

$2.50

$3.50

20,000

$3.00

$4.00

22,500

$3.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

$3.00

17,500

$2.50

$3.50

20,000

$3.00

$4.00

22,500

$3.50

$4.50

25,000

$4.00

Quantity Supplied with a


$1 Per Gallon Tax
QS

Price

Price with Tax

10,000

$1.00

$2.00

12,500

$1.50

$2.50

15,000

$2.00

$3.00

17,500

$2.50

$3.50

20,000

$3.00

$4.00

22,500

$3.50

$4.50

25,000

$4.00

$5.00

Tax on Producers
P
S + Tax
$4.00

S
Tax

$3.00

20,000

Tax on Producers
P
S + Tax
$3.00

S
$1=Tax

PC
$1=Tax

$2.00

PP

D
QTax 15,000

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

20,000

$1.00

17,500

$1.50

15,000

$2.00

12,500

$2.50

10,000

$3.00

7,500

$3.50

5,000

$4.00

Max willing to
pay with $1 tax

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

15,000

$2.00

12,500

$2.50

10,000

$3.00

7,500

$3.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

12,500

$2.50

10,000

$3.00

7,500

$3.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

$1.00

12,500

$2.50

10,000

$3.00

7,500

$3.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

$1.00

12,500

$2.50

$1.50

10,000

$3.00

7,500

$3.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

$1.00

12,500

$2.50

$1.50

10,000

$3.00

$2.00

7,500

$3.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

$1.00

12,500

$2.50

$1.50

10,000

$3.00

$2.00

7,500

$3.50

$2.50

5,000

$4.00

Quantity Demanded with a


$1 Per Gallon Tax
QD

Price

Max willing to
pay with $1 tax

20,000

$1.00

$0

17,500

$1.50

$.50

15,000

$2.00

$1.00

12,500

$2.50

$1.50

10,000

$3.00

$2.00

7,500

$3.50

$2.50

5,000

$4.00

$3.00

Tax on Consumers
P
$3.00
$1=Tax

$2.00

D
D with Tax

10,000

Tax on Consumers
P
S
PC
Tax

$2.00

E
Tax

PP

D
$1.00

D with Tax
0

QTax

15,000

Tax Incidence
P

S with Tax
S

PC
Tax

P*

PP

D
D with Tax
0

QTax

Q*

The Burden of a Tax


P

S with Tax
S

PC
Tax

P*

Burden on consumers = PC P*

Tax

Burden on producers = P* PP

Wedge

Tax

PP

D
D with Tax
0

QTax

Q*

Consumers Bear More of the Burden of


the Tax
P
S

Tax

Burden on consumers

P*
Burden on producers

Tax Wedge

PC
Burden on consumers = PC P*
is greater than

Burden on producers = P* PP

PP

D
QTax Q*

Consumers Bear All of the Burden of


the Tax
P

S + Tax
S

PC

Tax

Burden on consumers = PC P*
= Tax

Burden on consumers

Burden on producers = P* PP = 0

PP= P*

D
0

QTax= Q*

Consumers bear the entire burden

Consumers Bear All of the Burden of


the Tax
P
S + Tax

Tax

PC

PP=

Burden on consumers = PC P*

Burden on consumers

= Tax

P*

Burden on producers = P* PP = 0

Consumers bear the entire burden

D
0

QTax

Q*

Producers Bear More of the Burden of


the Tax
P

Burden on consumers = PC P*
Burden on consumers

Tax

P*
Burden on producers

Tax Wedge

PC

PP

is less than

Burden on producers = P* PP

QTax Q*

Producers Bear All of the Burden of the


Tax
P
S
Burden on consumers = PC P* = 0

PC= P*

Tax

Burden on producers = P* PP = Tax


Burden on producers

Producers bear the entire burden

PP

D with Tax
0

QTax= Q*

Producers Bear All of the Burden of the


Tax
S+Tax
S

PC= P*

Burden on consumers = PC P* = 0

Tax

Burden on producers = P* PP = Tax


Burden on producers

Producers bear the entire burden

PP

QTax

Q*

Welfare Analysis of Taxes


P

S with Tax
S

PC
Tax

P*

PP

D
D with Tax
0

QTax

Q*

Welfare Analysis of Taxes


P
A

PC

Before
Tax

P*

CS

After Tax

PS
Gov

SS
PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
A

PC

Before
Tax

P*

CS A+B+C

After Tax

PS
Gov

SS
PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
A

PC

Before
Tax

P*

CS A+B+C

After Tax

PS D+E+F
Gov

SS
PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
A

PC

Before
Tax

P*

CS A+B+C

After Tax

PS D+E+F
Gov

---

SS
PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

CS A+B+C

After Tax

PS D+E+F
Gov

---

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

CS A+B+C

PS D+E+F
Gov

After Tax

---

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

CS A+B+C

PS D+E+F

Gov

After Tax

---

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

CS A+B+C

PS D+E+F

Gov

After Tax

---

B+D

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

CS A+B+C

PS D+E+F

Gov

---

B+D

SS A+B+C

A+B+D+F

+D+E+F

PP

F
0

After Tax

D
QTax

Q*

Change

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

After Tax

Change

CS A+B+C

B C

PS D+E+F

Gov

---

B+D

SS A+B+C
+D+E+F

PP

F
0

A+B+D+F

D
QTax

Q*

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

After Tax

Change

CS A+B+C

B C

PS D+E+F

D E

Gov

---

B+D

SS A+B+C
+D+E+F

PP

F
0

A+B+D+F

D
QTax

Q*

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

After Tax

Change

CS A+B+C

B C

PS D+E+F

D E

B+D

+B+D

Gov

---

SS A+B+C
+D+E+F

PP

F
0

A+B+D+F

D
QTax

Q*

Welfare Analysis of Taxes


P
S

A
PC

Before
Tax

P*

After Tax

Change

CS A+B+C

B C

PS D+E+F

D E

B+D

+B+D

A+B+D+F

C E

Gov

---

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Welfare Analysis of Taxes


P

DWL = C + E

A
PC

Before
Tax

P*

After Tax

Change

CS A+B+C

B C

PS D+E+F

D E

B+D

+B+D

A+B+D+F

C E

Gov

---

SS A+B+C
+D+E+F

PP

F
0

D
QTax

Q*

Three Conditions for Perfect Competition


Asymmetric Information
Adverse Selection
Market Unraveling
Remedies
Screening
Signaling

Moral Hazard
Principal-Agent Problem

Auto Depreciation

Three Conditions for Perfect Competition


1. Many buyers and sellers

Three Conditions for Perfect Competition


1. Many buyers and sellers
2. Complete informationwell informed buyers
and sellers

Three Conditions for Perfect Competition


1. Many buyers and sellers
2. Complete informationwell informed buyers
and sellers
3. Well-specified property rights

Three Conditions for Perfect Competition


1. Many buyers and sellers
Violations: Monopoly and Imperfect
Competition
2. Complete informationwell informed buyers
and sellers
3. Well-specified property rights

Three Conditions for Perfect Competition


1. Many buyers and sellers
Violations: Monopoly and Imperfect
Competition
2. Complete informationwell informed buyers
and sellers
3. Well-specified property rights
Violations: Externalities; Public goods

Three Conditions for Perfect Competition


1. Many buyers and sellers
Violations: Monopoly and Imperfect
Competition
2. Complete informationwell informed buyers
and sellers
Violations: Asymmetric information
3. Well-specified property rights
Violations: Externalities; Public goods

Problems Arising from Asymmetric


Information
Adverse selection

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction

Moral hazard

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction

Moral hazard
Occurs after a market transaction

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction

Moral hazard
Occurs after a market transaction

Principal-agent problem
A variant of moral hazard

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of the
(better informed) possible trading partners

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of the
(better informed) possible trading partners
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)

Auto Depreciation

The lemon dilemma


The Economist, Oct. 11, 2001

Numerical Example of Adverse


Selection
Max price
offered by
buyers
Peaches
Lemons

Min price
wanted by
sellers

Numerical Example of Adverse


Selection
Max price
offered by
buyers
Peaches $20,000
Lemons

Min price
wanted by
sellers

Numerical Example of Adverse


Selection
Max price
offered by
buyers
Peaches $20,000
Lemons

Min price
wanted by
sellers
$17,000

Numerical Example of Adverse


Selection
Max price
offered by
buyers
Peaches $20,000
Lemons $10,000

Min price
wanted by
sellers
$17,000

Numerical Example of Adverse


Selection
Max price
offered by
buyers

Min price
wanted by
sellers

Peaches $20,000

$17,000

Lemons $10,000

$ 8,000

Numerical Example of Adverse


Selection
Max price
offered by
buyers

Min price
wanted by
sellers

Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000

Numerical Example of Adverse


Selection
Max price
offered by
buyers

Min price
wanted by
sellers

Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%

Numerical Example of Adverse


Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
Max buyer is willing to offer for any given car?

Numerical Example of Adverse


Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
Max buyer is willing to offer for any given car
= 1/2 ($20,000) + 1/2 ($10,000) = $15,000

Numerical Example of Adverse


Selection
Max price
Min price
offered by
wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
The maximum a buyer is willing to offer for
any given car ($15,000) is less than the
minimum ($17,000) that the seller of a peach
wants for his car

Numerical Example of Adverse


Selection
Max price Min price
offered by wanted by
buyers
sellers
Peaches $20,000
$17,000
Prob (Peach) = 50%
Lemons $10,000
$ 8,000
Prob (Lemon) = 50%
The maximum a buyer is willing to offer for any given
car ($15,000) is less than the minimum ($17,000) that
the seller of a peach wants for his car
Result: Peaches will disappear from the market, and
only lemons will be sold

Problems Arising from Asymmetric


Information
Adverse selection
Occurs prior to a market transaction
Definition: Any situation in which an uninformed
party gets exactly the wrong people wanting to
trade with her; there is an adverse selection of the
(better informed) possible trading partners
Examples
Used car market (which gives rise to another term for
adverse selectionthe lemons problem)
Market for insurance
Market for credit

Remedies for Adverse Selection


Market screeningprocess by which an
uninformed party attempts to gather
information about the product or service offered
by the informed party

Remedies for Adverse Selection


Market screeningprocess by which an
uninformed party attempts to gather
information about the product or service offered
by the informed party
Examples

Remedies for Adverse Selection


Market signaling

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples
Branding

Remedies for Adverse Selection


Market signalingprocess by which an
informed party sends signals to uninformed
parties conveying information about the quality
of the product or service theyre trying to sell
Signal must be effective in distinguishing
between different levels of quality
Signal will be more costly for a low-quality
producer than for a high-quality producer
Examples
Branding
Guarantees and Warranties

Remedies for Adverse Selection


Market signalingprocess by which an informed
party sends signals to uninformed parties conveying
information about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing between
different levels of quality
Signal will be more costly for a low-quality producer
than for a high-quality producer
Examples
Branding
Guarantees and warranties
Education

Remedies for Adverse Selection


Market signalingprocess by which an informed
party sends signals to uninformed parties conveying
information about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing between
different levels of quality
Signal will be more costly for a low-quality producer
than for a high-quality producer
Examples

Branding
Guarantees and warranties
Education
Signals on the job

Remedies for Adverse Selection


Market signalingprocess by which an informed
party sends signals to uninformed parties conveying
information about the quality of the product or service
theyre trying to sell
Signal must be effective in distinguishing between
different levels of quality
Signal will be more costly for a low-quality producer
than for a high-quality producer
Examples

Branding
Guarantees and warranties
Education
Signals on the job
Reputation

Remedies for Adverse Selection


Market signalingprocess by which an informed party sends
signals to uninformed parties conveying information about the
quality of the product or service theyre trying to sell
Signal must be effective in distinguishing between different
levels of quality
Signal will be more costly for a low-quality producer than for a
high-quality producer
Examples

Branding
Guarantees and warranties
Education
Signals on the job
Reputation
Gifts

Problems Arising from Asymmetric


Information
Moral hazard
Occurs after a market transaction

Problems Arising from Asymmetric


Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a transaction to change
peoples incentives and therefore their behavior

Problems Arising from Asymmetric


Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a transaction to change
peoples incentives and therefore their behavior
Examples
On the job

Problems Arising from Asymmetric


Information
Moral hazard
Occurs after a market transaction
Definition: the tendency of a transaction to change
peoples incentives and therefore their behavior
Examples
Insurance market
On the job

Principal-agent problem
Principal-agent problem
A variant of moral hazard

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent
(2) Divergent interestsprincipal and agent must
have different interests or goals

Principal-agent problem
Principal-agent problem
A variant of moral hazard
Two conditions necessary for a principal-agent
problem
(1) Asymmetric informationit must be difficult
or costly for the principal to monitor the
actions of the agent
(2) Divergent interestsprincipal and agent must
have different interests or goals
Examples and Remedies