Microeconomics All Chapters PDF

MICROECONOMICS
UNIT 1
1. INTRODUCTION TO ECONOMICS
Why studying economics?
It is useful to understand the world we live in
It will teach you how to make better decisions
It provides a better understanding of economic policies
Definition of Economics
Scarcity: The limited nature of societys resources.
Economics: The study of how society manages its scarce resources, e.g.
o How people decide what to boy, how much to work, save and spend.
o How firms decide how much to produce, how many workers to hire.
o How society decided how to divide its resources between national defense, consumer goods, protecting
the environment, and other needs.
1.1. Ten basic economic principles
#1 People face tradeoffs
All decisions involve tradeoffs. Examples:
o Going to a party the night before your midterm exam leaves less time for studying.
o Having more money to buy stuff requires working longer hours, which leaves less time for leisure.
o Protecting the environment requires resources that could otherwise be used to produce consumer
goods.
Society faces an important tradeoff: efficiency vs. equity
o Efficiency: When society gets the most from its scarce resources
o Equity: When prosperity is distributed fairly among societys members
o Tradeoff: To achieve greater equity, could redistribute income from wealthy to poor. But this reduces
incentive to work and produce, shrinks the size of the economic pie.
#2 The cost of something is what you give up to get it
Making decisions requires comparing the costs and benefits of alternative choices.
The opportunity cost of any item is what you give up to obtain it.
It is the relevant cost for decision making.
#3 Rational people think at the margin
Rational people
o Systematically and purposefully do the best they can to achieve their objectives.
o Make decisions by evaluating costs and benefits of marginal changes, incremental adjustments to an
existing plan.
Examples:
o When a student considers whether to go to university for an additional year, he compares the fees &
foregone wages to the extra income he could earn with the extra year of education.
o When a manager considers whether to increase output, she compares the cost of the needed labor
and materials to the extra revenue.
#4 People respond to incentives

Incentive: Something that induces a person to act, i.e. the prospect of a reward or punishment.
Rational people respond to incentives. Examples:
o When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.
o When cigarette taxes increase, teen smoking falls.
#5 Trade can make everyone better off

Rather than being self-sufficient, people can specialize in producing one good or service and exchange it
for other goods.
Countries also benefit from trade and specialization:
o Get a better price abroad for goods they produce.
o Buy other goods more cheaply from abroad than could be produced at home.
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#6 Markets are usually a good way to organize economic activity
Market: A group of buyers and sellers (need not be in a single location).
Organize economic activity means determining:
o What goods to produce
o How to produce them
o How much of each to produce
o Who gets them
A market economy allocates resources through the decentralized decisions of many households and
firms as they interact in markets.
Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms
acts as if led by an invisible hand to promote general economic well-being.
The invisible hand works through the price system:
o The interaction of buyers and sellers determines prices.
o Each price reflects the goods value to buyers and the cost of producing the good.
o Prices guide self-interested households and firms to make decisions that, in many cases, maximize
societys economic well- being.
#7 Governments can sometimes improve market outcomes

Important role for government: enforce property rights (with police, courts).
People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen.
Market failure: when the market fails to allocate societys resources efficiently
Causes of market failure:
o Externalities: When the production or consumption of a good affects bystanders (e.g. pollution).
o Market power: A single buyer or seller has substantial influence on market price (e.g. monopoly).
Public policy may promote efficiency.
Government may alter market outcome to promote equity.
If the markets distribution of economic well-being is not desirable, tax or welfare policies can change
how the economic pie is divided.
2. THINKING LIKE AN ECONOMIST

Models and assumptions
Model: A highly simplified representation of a more complicated reality. Economists use models to
study economic issues.
Assumptions simplify the complex world, make it easier to understand.
Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to
learn and gives useful insights about the real world.
First model: The circular-flow diagram
o The Circular-Flow Diagram: A visual model of the economy shows how dollars flow through markets
among households and firms.
o Two types of actors:
Households
Own the factors of production, sell/rent them to firms for income.
Buy and consume goods and services.
o Firms
Buy/hire factors of production, use them to produce goods and services
Sell goods and services.
o Two markets:
The market for goods and services.
The market for factors of production.
Factors of production: The resources the economy uses to produce goods & services, including:
o Labor
o Land
o Capital (buildings and machines used in production)

Microeconomics and macroeconomics
Microeconomics: It is the study of how households and firms make decisions and how they interact in
markets.
Macroeconomics: It is the study of economy-wide phenomena, including inflation, unemployment, and
economic growth.
These two branches of economics are closely intertwined, yet distinct they address different questions.
The Economist as Policy Advisor
As scientists, economists make positive statements, which attempt to describe the world as it is.
As policy advisors, economists make normative statements, which attempt to prescribe how the world
should be.
Positive statements can be confirmed or refuted, normative statements cannot.
Why Economists Disagree
Economists often give conflicting policy advice.
They sometimes disagree about the validity of alternative positive theories about the world.
They may have different values and, therefore, different normative views about what policy should try to
accomplish.
Yet, there are many propositions about which most economists agree.
Second model: The production possibilities frontier (PPF)

It is a graph that shows the combinations of two goods the economy can produce given the available
resources and the available technology.
A curve depicting all maximum output possibilities for two or more goods given a set of inputs
(resources, labor). The PPF assumes that all inputs are used efficiently.
As indicated on the graph, points A, B and C represent the
points at which production of good A and good B is more
efficient. Point X demonstrates the point at which resources are
not being used efficiently in the production of both goods. Point
Y demonstrates an output that is not attainable with the given
inputs. Among other, factors such as labor, capital and
technology will affect where the production possibility frontier
lies.

The PPF represents the point at which an economy is most efficiently producing its goods and services
and, therefore, allocating its resources in the best way possible. If the economy is not producing the
quantities indicated by the PPF, resources are being managed inefficiently and the production, so an
economy, to achieve efficiency, must decide what combination of goods and services can be produced.
Example. Imagine an economy that can produce only wine and
cotton. According to the PPF, points A, B and C - all appearing
on the curve - represent the most efficient use of resources by
the economy. Point X represents an inefficient use of resources,
while point Y represents the goals that the economy cannot
attain with its present levels of resources. As we can see, in
order for this economy to produce more wine, it must give up
some of the resources it uses to produce cotton (point A). If the
economy starts producing more cotton (represented by points B
and C), it would have to divert resources from making wine and,
consequently, it will produce less wine than it is producing at
point A. As the chart shows, by moving production from point A
to B, the economy must decrease wine production by a small amount in comparison to the increase in
cotton output. However, if the economy moves from point B to C, wine output will be significantly
reduced while the increase in cotton will be quite small. Keep in mind that A, B, and C all represent the
most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF
and which combination to use. If more wine is in demand, the cost of increasing its output is proportional
to the cost of decreasing cotton production. Point X means that the country's resources are not being
used efficiently or, more specifically, that the country is not producing enough cotton or wine given the
potential of its resources. Point Y, as we mentioned above, represents an output level that is currently
unreachable by this economy. However, if there was a change in technology whiles the level of land,
labor and capital remained the same, the time required to pick cotton and grapes would be reduced.
Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear,
would represent the new efficient allocation of resources.
When the PPF shifts outwards, we know there is growth in an
economy. Alternatively, when the PPF shifts inwards it
indicates that the economy is shrinking as a result of a decline
in its most efficient allocation of resources and optimal
production capability. A shrinking economy could be a result of
a decrease in supplies or a deficiency in technology.
An economy can be producing on the PPF curve only in
theory. In reality, economies constantly struggle to reach an
optimal production capacity. And because scarcity forces an
economy to forgo one choice for another, the slope of the PPF
will always be negative; if production of product A increases
then production of product B will have to decrease
accordingly.
Opportunity cost. It is the value of what is foregone in order to have something else. This value is
unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of
mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always
change your mind in the future because there may be some instances when the mashed potatoes are
just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is
determined by his or her needs, wants, time and resources (income). This is important to the PPF
because a country will decide how to best allocate its resources according to its opportunity cost.
Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine
than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.
Let's look at another example to demonstrate how opportunity cost ensures that an individual will buy
the least expensive of two similar goods when given the choice. For example, assume that an individual
has a choice between two telephone services. If he or she were to buy the most expensive service, that
individual may have to reduce the number of times he or she goes to the movies each month. Giving up
these opportunities to go to the movies may be a cost that is too high for this person, leading him or her
to choose the less expensive service. Remember that opportunity cost is different for each individual and
nation. Thus, what is valued more than something else will vary among people and countries when
decisions are made about how to allocate resources.

3. INTERDEPENDENCE AND THE GAINS FROM TRADE
Example
Hours in labor United States Japan
2 countries (United States and Japan)
Available 50,000 30,000
2 goods (Computers and wheat)
To produce 1 computer 100 125
1 resource (labor in hours) To produce 1 ton of wheat 10 25
United States PPF Japans PPF
o Production without trade

o Production with trade
o 3400(10)= 34000
50000 34000= 16000
16000/100= 160
Where
Trade makes both

countries better off
Exports and imports

Exports: Goods produced domestically and sold abroad. To export means to sell domestically produced
abroad.
Imports: Goods produced abroad and bought domestically. To import means to purchase goods
produced in other countries.

Where do these gains come from?
Absolute advantage: The ability to produce goods using fewer inputs than another producer.
The United States has an absolute advantage in wheat: producing a tone of wheat uses 10 labor hours
in the US versus 25 in Japan. If each country has an absolute advantage in one good and specializes in
that good, then both countries can gain from trade.
Therefore, what country has an absolute advantage in computers? Producing one computer requires
125 labor hours in Japan, but only 100 hours in the US.
The United States has an advantage in both goods.
Two measures of the cost of a good
Two countries can gain from trade when each specializes in the good it produces at lowest cost.
Absolute advantage measures the cost of a good in terms of the inputs required to produce it.
Recall: Another measure of cost is opportunity cost.
In our example, the opportunity cost of a computer is the amount of wheat that could be produced using
labor needed to produce one computer.
Opportunity cost and comparative advantage
Comparative advantage: The ability to produce a good at a lower opportunity cost than another
produce.
If we want to know which country has the comparative advantage in computers, we must determine the
opportunity cost of a computer in each country.
The opportunity cost of a computer is
o 10 tons of wheat in the United States, because producing one computer requires 100 labor hours,
which instead could produce 10 tons of wheat.
o 5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead
could produce 5 tons of wheat.
o So, Japan has a comparative advantage in computers. Absolute advantage is not necessary for
comparative
Comparative advantage and trade
o Gains from trade arise from comparative advantage (differences in opportunity cost).
o When each country specializes in the good(s) in which it has a comparative advantage, total production
in all countries is higher, the worlds economic pie is bigger, and all countries can gain from trade.
o The same applies to individual producers (like the farmer and the gardener) specializing in different
goods and trading with each other.

UNIT 2
4. THE MARKET FORCES OF SUPPLY AND DEMAND
4.1. Markets and competition
A market is a group of buyers and sellers of a particulars product.
A competitive market is one with many buyers and sellers; each has a negligible effect on price.
In a perfectly competitive market:
All good are exactly the same.
Buyers and sellers are so numerous that no one can affect price (each is a price taker).
4.2. Demand
The quantity demanded of any good is the amount of the good that buyers are willing and able to
purchase.
Demand schedule: A table that shows the relationship between the price of a good and the quantity
demanded
Law of demand: The claim that the quantity demanded of a good falls when the price of the good rises,
other things equal
Factors (variables that influence buyers):
Price causes a movement along the demand curve
Income
# of buyers
Price of related goods
Preferences shits the demand curve
Expectations
Dimension of the market
Individual demand
Market demand versus Individual demand

The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.
Suppose Helen and Ken are the only two buyers in the Latte Market. (Qd = quantity demanded)

Demand curve shifters: income
Demand for a normal good is positively related to income: Increase in income causes increase in
quantity demanded at each price, shifts D curve to the right.
Demand for an inferior good is negatively related to income: An increase in income shifts D curves for
inferior goods to the left.
Demand curve shifters: prices of related good
Two goods are substitutes if an increase in the price of one causes an increase in demand for the other.
o Example: Pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers,
shifting hamburger demand curve to the right.
o Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads.
Two goods are complements if an increase in the price of one causes a fall in demand for the other.
o Example: Computers and software. If price of computers rises, people buy fewer computers, and
therefore less software. Software demand curve shifts left.
o Other examples: College tuition and textbooks, bagels and cream cheese, eggs and bacon.
Changes in preferences: Anything that causes a shift in tastes toward a good will increase demand for that
good and shift its D curve to the right.
Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right.
Expectations affect consumers buying decision
4.3. Supply
The quantity supplied of any good is the amount that sellers are willing and able to sell.
Supply schedule: A table that shows the relationship between the price of a good and the quantity
supplied.
Law of supply: The claim that the quantity supplied of a good rises when the price of the good rises, other
things equal.
Individual supply
Market supply versus individual supply

The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price.
Suppose Starbucks and Jitters are the only two sellers in this market. (Qs = quantity supplied)

Factors (variables that influence sellers):
Price causes a movement along the supply curve
Input prices (wages, prices of raw materials)
# of sellers
Technology shits the demand curve
Preferences
Expectations
4.4. Supply and demand together

Equilibrum: Price has reached the level where
quantity supplied equals quantity demanded.
Equilibrum price: The price that equates quantity
supplied with quantity demanded.
Equilibrum quantity: The quantity supplied and
quantity demanded at the equilibrium price.
Surplus (excess supply): When quantity supplied is greater than

quantity demanded.
Example: If P= $5, then QD= 9 lattes, and QS= 25 lattes. Resulting in
a surplus of a 16 lattes
Facing a surplus, sellers try to increase sales by cutting price.
This causes QD to rise and QS to fall, which reduces the surplus.
Prices continue to fall until market reaches equilibrium.
Shortage (excess demand): When quantity demanded is greater

than quantity supplied.
Example: If P= $1, then QD= 21 lattes, and QS= 5 lattes. Resulting
in a shortage of a 16 lattes
Facing a shortage, sellers try to increase price, causing QD to
fall and QS to rise, which reduces the shortage. Prices continue
to rise until market reaches equilibrium.

Three steps to analyzing changes in Equilibrium
Decide whether event shifts supply curve, demand curve, or both.
Decide in which direction curve shifts.
Use supply, demand diagram to see how the shift changes equilibrium prince and quantity.
o Example: The market for hybrid cars (A shift in demand)
o Example: The market for hybrid cars (A shift in

supply)
o Example: The market for hybrid cars (A shift in both supply and demand)
Terms for Shift versus Movement along the curve

Change in supply: A shift in the supply curve occurs
when a non-price determinant of supply changes (like
technology or costs).
Change in the quantity supplied: A movement along
a fixed supply curve occurs when price changes.
Change in demand: A shift in the demand curve
occurs when a non-price determinant of demand
changes (like income or # of buyers).
Change in the quantity demanded: A movement
along a fixed demand curve occurs when price
changes.

Summary
In market economies, prices adjust to balance supply and demand. These equilibrium prices are the
signals that guide economic decisions and thereby allocate scarce resources.
A competitive market has many buyers and sellers, each of whom has little or no influence on the market
price.
Economists use the supply and demand model to analyze competitive markets.
The downward-sloping demand curve reflects the law of demand, which states that the quantity buyers
demand of a good depends negatively on the goods price.
Besides price, demand depends on buyers incomes, tastes, expectations, the prices of substitutes and
complements, and number of buyers. If one of these factors changes, the D curve shifts.
The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply
depends positively on the goods price.
Other determinants of supply include input prices, technology, expectations, and the # of sellers.
Changes in these factors shift the S curve.
The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity
supplied equals quantity demanded.
If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market
price is below equilibrium, a shortage results, causing the price to rise.
Interdependence and trade allow everyone to enjoy a greater quantity and variety of goods & services.
Comparative advantage means being able to produce a good at a lower opportunity cost. Absolute
advantage means being able to produce a good with fewer inputs.
When peopleor countriesspecialize in the goods in which they have a comparative advantage, the
economic pie grows and trade can make everyone better off.
7. CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS

7.1. Welfare economics
Recall, the allocation of resources refers to:
How much of each good is produced
Which producers produce it
Which consumers consume it
Welfare economics studies how the allocation of resources affects economic well-being.
Willingness to pay (WTP). A buyers willingness to pay for a good is the maximum amount the buyer will
pay for that good. WTF measures how much the buyer values the good.
Name WTP Example: 4 buyers WTP for an iPod.
Paul 250
Q: If price of iPod is 200, who will buy and iPod, and what is the quantity
George 175
John 300 demanded?
Ringo 125
Consumer surplus. The amount a buyer is willing to pay minus the amount the buyer actually pays:
CS= WTP P
Suppose P= 260. Johns CS it will be 300-260=40, the others get no CS because they do not buy an
iPod at this price. Thus, total surplus it will be 40.

Consumer surplus and the Demand Curve
Cost and the supply curve

Cost is the value of everything a seller must give up to produce a good (i.e. Opportunity cost).
Includes cost of all resources used to produce good, including value of the sellers time.
Example: Costs of 3 sellers in the lawn-cutting business.
Name Cost
A seller will produce and sell the good/service only if the prices exceed his or her Jack 10
cost. Hence, cost is a measure of willingness to sell. Janet 20
Chrissy 35

Producer surplus. The amount a seller is paid for a good minus the sellers cost.
PS= P - cost
Suppose P= 25. Jacks PS= 15, Janets PS= 5. Chrissys PS= 0. Total PS= 20. Total PS equals the
area above the supply curve under the price, from 0 to Q.
The Markets Allocation of Resources

In a market economy, the allocation of resources is decentralized, determined by the interactions of
many self-interested buyers and sellers.
Is the markets allocation of resources desirable? Or would a different allocation of resources make
society better off?
To answer this, we use total surplus as a measure of societys well-being, and we consider whether the
markets allocation is efficient. (Policymakers also care about equality, though our focus here is on
efficiency.)
Efficiency
Total surplus = (Value to buyers) (Costs to sellers)
An allocation of resources is efficient if it maximizes total surplus. Efficiency means:
o The goods are consumed by the buyers who value them most highly.
o The goods are produced by the producers with the lowest costs.
o Raising or lowering the quantity of a good would not increase total surplus.

The free market versus Government intervention
The market equilibrium is efficient. No other outcome achieves higher total surplus.
Government cannot raise total surplus by changing the markets allocation of resources.
Laissez faire (French for allow them to do): the notion that government should not interfere with the
market.
The free market versus Central Planning
Suppose resources were allocated not by the market, but by a central planner who cares about
societys well-being.
To allocate resources efficiently and maximize total surplus, the planner would need to know every
sellers cost and every buyers WTP for every good in the entire economy.
This is impossible, and why centrally-planned economies are never very efficient.
Conclusion
Such market failures occur when:
o A buyer or seller has market powerthe ability to affect the market price.
o Transactions have side effects, called externalities, that affect bystanders. (example: pollution)
Well use welfare economics to see how public policy may improve on the market outcome in such
cases. Despite the possibility of market failure, the analysis in this chapter applies in many markets,
and the invisible hand remains extremely important

7. ELASTICITY AND ITS APPLICATIONS
7.1. Elasticity
Basic idea: Elasticity measures how much one variable responds to changes in another variable.
Example: One type of elasticity measures how much demand for your websites will fall if you raise your
price.
Definition: Elasticity is a numerical measure of the responsiveness of Qd or Qs to one of its determinants.
7.2. Price elasticity of demand

% in Qd
Price elasticity
=
of demand
% in P
Price elasticity of demand measures how much Qd responds to a change in P.

Loosely speaking, it measures the price-sensitivity of buyers demand.
7.3. Calculating percentage changes

Use the midpoint method:
The midpoint is the number halfway

between the start and end values, the
average of those values.
It doesnt matter which value you use
as the start and which as the end; you
get the same answer either way.
Using the midpoint method, the %
change in P equal:
$250 - $200 / $225 100%= 22.2%
The % change in Q equals:
12 8 / 10 100% = 40.0%
The price elasticity of demand equals:

40/22.2= 1.8
What determines price elasticity? To learn the determinants of price elasticity, we look at a series of
examples. Each compares two common goods. In each example:
Suppose the prices of both goods rise by 20%.
The good for which Qd falls the most (in percent) has the highest price elasticity of demand. Which
good is it? Why?
What lesson does the example teach us about the determinants of the price elasticity of demand?
Look several examples to understand in the next page.

o Example 1: Breakfast cereal vs. Sun cream
The prices of both of these goods rise by 20%. For which good does Qd drop the most? Why?
Lesson: Price elasticity is higher when close substitutes are available.
o Example 2: Blue jeans vs. clothing
Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones.
o Example 3: Insulin vs. Caribbean cruises
Lesson: Price elasticity is higher for luxuries than for necessities.
o Example 4: Gasoline in the Short Run vs. Gasoline in the Long Run
Lesson: Price elasticity is higher in the long run than the short run.
Determinants of price elasticity: summary

o The price elasticity of demand depends on:
The extent to which close substitutes are available.
Whether the good is a necessity or a luxury.
How broadly or narrowly the good is defined.
The time horizon; elasticity is higher in the long run than the short run.
7.4. The variety of demand curves

The price elasticity of demand is closely related to the slope of the demand curve.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
Types of elasticity demand curves

1. Elasticity equals to 0 2. Elasticity is less than 1 3. Elasticity equals to 1
Perfectly inelastic demand Inelastic demand Unit elastic demand
|% Qd| < |% p| |% Qd| = |% p|
4. Elasticity is greater than 1 5. Elasticity equals to infinity

Elastic demand Perfectly elastic demand
|% Qd| > |% p|

7.5. Elasticity of a linear demand curve
The slope of a linear demand curve is constant, but its elasticity is not.
7.6. Price elasticity and total revenue

Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall?
Revenue = P Q
A price increase has two effects on revenue:
Higher P means more revenue on each unit you sell.
But you sell fewer units (lower Q), due to law of demand.
Which of these two effects is bigger? It depends on
7.7. Application: Does drug interdiction increase or decrease drug-related crime?
One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.
We examine two policies designed to reduce illegal drug use and see what effects they have on drug-
related crime.
For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs.
Demand for illegal drugs is , due to addiction issues.
Policy 1: Interdiction Policiy 2: Education
7.8. Price elasticity of supply

% in Qd
Price elasticity
of supply =
% in P
Price elasticity of supply measures how much Qs responds to a change in P.
Loosely speaking, it measures sellers price-sensitivity.
Again, use the midpoint method to compute the percentage changes.
7.9. The variety of supply curves
The slope of the supply is closely related to price elasticity of supply.
Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.

Types of elasticity supply curves
1. Elasticity equals to 0 2. Elasticity is less than 1 3. Elasticity equals to 1
Perfectly price Inelastic supply Unit elastic supply
inelastic supply
4. Elasticity is greater than 1 5. Elasticity equals to infinity

Elastic supply Perfectly elastic supply
7.10. Determinants of supply elasticity

The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.
Example: Supply and beachfront property is harder to vary and this less elastic than supply of new cars.
For many goods, price elasticity of supply is greater in the long run than in the short run, because firms
can build new factories or new firms may be able to enter the market.
7.11. How the price elasticity of supply can vary
Supply often becomes less elastic as Q rises, due to capacity limits.
7.12. Other elasticities

Income elasticity of demand measures the response of Qd to a change in consumer income.
Income elasticity % in Qd
of demand =
% in income
Recall from Chapter 4: An increase in income causes an increase in demand for a normal good.
Hence, for normal goods, income elasticity
For inferior goods, income elasticity

Cross-price elasticity of demand measures the response of demand for one good to changes in the price
of another good.
Cross-price elasticity % in Qd for good 1

of demand =
% in P of good 2
For substitutes, cross-price elasticity (e.g. an increase in price of beef causes an
increase in demand for chicken).
For complements, cross-price elasticity (e.g. an increase in price of computers causes
decrease in demand for software).
UNIT 3
6.1. Government policies that alter the private market outcome
Price controls:
Price ceiling: A legal maximum on the price of a good or service. E.g. rent control.
Price floor: A legal minimum on the price of a good or service. E.g. minimum wage.
Taxes
The government can make buyers or sellers pay a specific amount on each unit.
We will use the supply/demand model to see how each policy affects the market outcome (the price buyers
pay, the price sellers receive and equilibrium quantity).
Example 1: The market for apartments
How price ceilings affect market outcomes
o A price ceiling above the equilibrium price, it will not
affect the market.
o The equilibrium price ($800) is above the ceiling
and therefore this it would be illegal.
o The ceiling is a binding constraint on the price, it
causes a shortage.
o The government wants to help poor people, but this
policy doesnt help them.
o In the long-run supply and demand are more price-
elastic. Shortage will be larger, the situation will be
worse.
Shortages and rationing
o With a shortage, sellers must ration the good among buyers.
o Some ration mechanisms:
Long lines
Discrimination according to sellers biases (children smoking).
o These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who
value them most highly.
o In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the
buyers that value them most highly) and impersonal (and thus fair).
Example 2: The market for unskilled labor

How price floors affect market outcomes
o Supply curve comes from workers (households).
o Demand curve comes from employers (firms).
o A price floor below the equilibrium price is not binding
has not effect on the market outcome.
o The equilibrium wage ($6) is below the floor, thus it will
be illegal.
o The floor is a binding constant on the wage, causes a
surplus (i.e. employment).

The minimum wage
o Minimum wage laws do not affect highly skilled workers.
o They do affect teen workers.
o Studies: A 10% increase in the minimum wage raises teen unemployment by 1-3%.
6.2. Evaluating price controls
Recall one of the Ten principles from Chapter 1: Markets are usually a good way to organize economic
acivity.
Prices are the signals that guide the allocation of societys resources. This allocation is altered when policy
workers restrict prices.
Price controls often intended to help the poor, but often hurt more than help.
6.3. Taxes
The government levies taxes on many good and services to raise revenue to pay for national defense,
public schools
The government can make buyers or sellers pay the tax.
The tax can be a percentage of the goods price, or a specific amount for each unit sold.
Example 3: The market for pizza
The price buyers pay is now $1.50 higher than the
market price P.
P would have to fall by $1.50 to make buyers willing
to buy same quantity as before.
E.g. if P falls from $10.00 to $8.50, buyers still willing
to purchase 500 pizzas.
o Effects of a $1.50 per unit tax on buyers.
o New equilibrium: 450
o Sellers receive PS= $9.50
o Buyers pay PB= $11,00
o Difference between them equals to $1.50=tax
Hence, a tax on buyers shifts the D curve down by
the amount of the tax,
6.4. The incidence of a tax
It is how the burden of a tax is shared among market participants.
In our example, buyers pay $1,00 more, sellers get $0.50 less.
A tax on sellers:
The tax effectively raises sellers cost by $1.50 per pizza.
Sellers will supply 1500 pizzas only if P rises to $11.50 to
compensate for this cost increase.
Hence, a tax in sellers shifts the supply curve the amount of the
tax.
Effects of a $1.50 per unit tax on sellers.
New equilibrium:
o Q= 450
o Buyers pay PB= $11,00
o Sellers receive PS= $1.50
o Difference between is $1.50
6.5. The outcome is the same in both cases

The effects on P and Q, and the tax incidende are the same if the tax is imposed on buyers or sellers.
What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive.

10. EXTERNALITIES
Recall: Adam Smiths invisible hand of the marketplace leads self-interested buyers and sellers in a market
to maximize the total benefit that society can derive from a market. But market failures can still happen.
10.1. Externalities and market inefficiency

An externality is an uncompensated impact of one persons actions on the well-being of a bystander.
Externalities cause markets to be inefficient, and so fail to maximize total surplus.
An externality arises when a person engages in an activity that affects the well-being of a bystander and
yet neither pays nor receives any compensation for that effect.
When the impact on the bystander is adverse, the externality is called a negative externality. Negative
externalities lead markets to produce a larger quantity than is socially desirable.
Car exhaust fumes
Cigarette smoking
Barking dogs (loud pets)
Loud stereos in an apartment building
When the impact on the bystander is beneficial, the externality is called a positive externality. Positive
externalities lead markets to produce a larger quantity than is socially desirable.
Immunizations
Restored historic buildings
Research into new technologies
10.2. Welfare economics: A recap

The Market for aluminum
The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes
the sum of producer and consumer surplus.
If the aluminum factories emit pollution (a negative externality), then the cost to society of producing
aluminum is larger than the cost to aluminum producers.
For each unit of aluminum produced, the social cost includes the private costs of the producers plus the
cost to those bystanders adversely affected by the pollution.
Pollution and the social optimum
10.3. Negative externalities

The intersection of the demand curve and the social-cost curve determines the optimal output level.
The socially optimal output level is less than the market equilibrium quantity.
Internalizing an externality involves altering incentives so that people take account of the external effects
of their actions.
Achieving the Socially Optimal Output.
The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium
quantity to the socially desirable quantity.

10.4. Positive externalities
When an externality benefits the bystanders, a positive externality exists.
The social value of the good exceeds the private value.
A technology spillover is a type of positive externality that exists when a firms innovation or design not only
benefits the firm, but enters societys pool of technological knowledge and benefits society as a whole.
The intersection of the supply curve and the social value curve determines the optimal output level.
The optimal output level is more than the equilibrium quantity.
The market produces a smaller quantity than is socially desirable.
The social value of the good exceeds the private value of the good.
Internalizing Externalities: Subsidies.
Used as the primary method for attempting to internalize positive externalities.
Industrial policy
Government intervention in the economy that aims to promote technology-enhancing industries.
Patent laws are a form of technology policy that give the individual (or firm) with patent protection a
property right over its invention.
The patent is then said to internalize the externality
10.5. Private solutions to externalities

Government action is not always needed to solve the problem of externalities.
Moral codes and social sanctions.
Charitable organizations
Integrating different types of businesses
Contracting between parties
10.6. The Coase theorem
The Coase Theorem is a proposition that if private parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities on their own.
Transactions costs are the costs that parties incur in the process of agreeing to and following through on
a bargain.
10.7. Why private solutions do not always work? Sometimes the private solution approach fails because
transaction costs can be so high that private agreement is not possible.
10.8. Public policy toward externalities

When externalities are significant and private solutions are not found, government may attempt to solve the
problem through:
Command and control policies
Usually take the form of regulations:
o Forbid certain behaviors
o Require certain behaviors
Examples:
o Requirements that all students be immunized.
o Stipulations on pollution emission levels set by the government.

Marked-based policies
Government uses taxes and subsidies to align private incentives with social efficiency.
Pigovian taxes are taxes enacted to correct the effects of a negative externality
Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another.
o A market for these permits will eventually develop.
o A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce
pollution only at a high cost.
Examples of regulation versus Pigovian tax
If the government decides it wants to reduce the amount of pollution coming from a specific plant, the
government could
Tell the firm to reduce its pollution by a specific amount (i.e. regulation).
Levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax).
Public/private policies
Property rights
If I have ownership rights over the air 1 km above my house then no one can legally pollute it.
I can negotiate with a firm that wishes to pollute that air and agree a price for the right to do so.
However, it is a complex task to establish a system of such property rights and they may be expensive to
enforce.
Summary
When one partys activity affects another party, the effect is called an externality.
Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium
quantity.
Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium
quantity.
Those affected by externalities can sometimes solve the problem privately.
The Coase theorem states that if people can bargain without a cost, then they can always reach an
agreement in which resources are allocated efficiently.
When private parties cannot adequately deal with externalities, then the government steps in.
The government can either regulate behavior or internalize the externality by using Pigovian taxes or by
issuing pollution permits or it might create property rights so that the private parties may be able to
bargain and reach a satisfactory outcome.

11. PUBLIC GOODS AND COMMON RESOURCE
11.1. The best things in life are free
Free goods provide a special challenge for economic analysis.
Most goods in our economy are allocated in markets.
When goods are available free of charge, the market forces that normally allocate resources in our
economy are absent.
When a good does not have a price attached to it, private markets cannot ensure that the good is
produced and consumed in the proper amounts private markets cannot allocate the good efficiently.
In such cases, government policy can potentially remedy the market failure that results, and raise
economic well-being.
11.2. The different kinds of goods
When thinking about the various goods in the economy, it is useful to group them according to two
characteristics:
Excludability: It refers to the property of a good whereby a person can be prevented from using it.
Rivalry: It refers to the property of a good whereby one persons use diminishes other peoples use.
Four types of goods:
Private good: Are both excludable and rival.
Public goods: Are neither excludable nor rival.
Common resources: Are rival but not excludable.
Natural monopolies: Are excludable but not rival.
11.3. Public goods

A free-rider is a person who receives the benefit of
a good but avoids paying for it.
The Free Rider problem
Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold
paying for the good hoping that others will pay for it.
The free rider problem prevents private markets from supplying public goods.
Solution: The government can decide to provide the public good if the total benefits exceed the costs.
Furthermore, it can make everyone better off by providing the public good and paying for it with tax
revenue.
Some important public goods
National defense
Basic research
Fighting poverty
11.4. The difficult job of cost-benefit analysis

Cost-benefit analysis refers to a study that compares the costs and benefits to society of providing a public
good.
In order to decide whether to provide a public good or not, the total benefits of all those who use the good
must be compared to the costs of providing and maintaining the public good.
A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a
whole.
It is difficult to do because of the absence of prices needed to estimate social benefits and resource
costs.
The value of life, the consumers time, and aesthetics are difficult to charge.
11.5. CASE STUDY: How much is life worth?

We must place a monetary value on life in order to conduct a cost-benefit analysis.
But is life not priceless? There is no amount of money that you could be paid to voluntarily give up your
life.
But we dont behave as if this is the case.
People do more risky jobs in return for higher pay.
Courts may also value life by looking at the earnings a person will earn over a period.

11.6. Common resources
Common resources, like public goods, are not excludable.
They are available free of charge to anyone who wishes to use them.
Common resources are rival goods because one persons use of the common resource reduces other
peoples use.
The Tragedy of the Commons is a parable that illustrates why common resources get used more than is
desirable from the standpoint of society as a whole.
Common resources tend to be used excessively when individuals are not charged for their usage.
This is similar to a negative externality.
Some important common resources:
Clean air and water
Congested roads
Fish, whales and other wildlife
11.7. Conclusion: The importance of property rights

The market fails to allocate resources efficiently when property rights are not well- established (i.e. some
item of value does not have an owner with the legal authority to control it).
When the absence of property rights causes a market failure, the government can potentially solve the
problem.
11.8. Summary
Goods differ in whether they are excludable and whether they are rivals.
A good is excludable if it is possible to prevent someone from using it.
A good is rival if one persons enjoyment of the good prevents other people from enjoying the same unit
of the good.
Public goods are neither rival nor excludable.
Because people are not charged for their use of public goods, they have an incentive to free ride when the
good is provided privately.
Governments provide public goods, making quantity decisions based upon cost-benefit analysis.
Common resources are rival but not excludable.
Because people are not charged for their use of common resources, they tend to use them excessively.
Governments tend to try to limit the use of common resources.
UNIT 4
13. THE COSTS OF PRODUCTION
13.1. The different kinds of costs and decisions a firm has
Costs Decisions
Raw materials Price
Wages Quantity produced
Energy Location
Rent Quality
Capital # of workers
Transportation Which suppliers
Insurance Production method
Taxes Transportation method
R+D Employees status
Marketing Amount of stocks
Distribution of your budget
13.2. Total revenue, total cost, profit

We assume that the firms goal is to maximize profit.
Profit = Total Revenue Total Cost
The amount a firms receives from the sale of its output The market value of the inputs a firm uses in production

13.3. Costs: explicit vs. implicit
Explicit costs require an outlay of money. (Paying wages to workers)
Implicit costs do not require a cash outlay desembolso. (The opportunity cost of the owners time)
Remember one of the ten principles: the cost of something is what you give up to get it.
This is true whether the costs are implicit or explicit.
Example: You need $100,000 to start your business, the interest rate is 5%.
Case 1: Borrow $100,000
Explicit cost = $5,000 interest on loan
Case 2: use $40,000 of your savings, borrow the other $60,000
Explicit cost= $3,000 (5%) interest on the loan
Implicit cost= $2,000 (5%) foregone interest you could have earned on your $40,000
In both cases, total (explicit + implicit) costs are $5,000.
13.4. Economic profit vs. Accounting profit

Accounting profit= TR Total explicit costs
Economic profit= TR Total costs (including explicit
and implicit costs)
Accounting profit ignores implicit costs, so its higher
than economic profit.
13.5. The production function
A production function shows the relationship between
the quantity of inputs used to produce a good and the
quantity of output of that good.
It can be represented by a table, equation, or graph.
Example 1:
Farmer Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
13.6. Marginal product

The marginal product of any input is the increase
in output arising from an additional unit of that input, holding all other inputs constant.
If Jack hires one more worker, his output rises by the marginal product of labor.
Q
Marginal product of labor (MPL) =
L
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explain why the production function gets flatter as L
increases.

13.7. Why MPL is important
Recall one of the Ten Principles: Rational people think at the margin.
When the farmer Jack hires an extra worker,
His costs rise by the wage he pays the worker
His output rises by MPL
Comparing those helps Jack decide whether he should hire the worker.
13.8. Why MPL diminishes
Farmer Jacks output rises by a smaller and smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has less land to work with and will be less productive.
In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines).
Diminishing marginal product: the marginal product of an input declines as the quantity of the input
increases (other things equal).
Example 1: Farmer Jacks costs
Farmer Jack must pay $1000 per month for the land,
regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jacks costs are related to how much wheat he
produces.
Cost of labor = wage workers
13.9. Marginal cost

Marginal cost (MC) is the increase in total cost from
producing one more unit.
TC
MC=
Q
MC usually rises as Q rises in this example.
13.10. Why MC is important?

Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or
less wheat?
To find the answer, Farmer Jack needs to think at the margin.
If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jacks profits
rise if the produce more.
Diminishing marginal product means the additional production from and addition worker decreases when
labor increases. He should produce more, because this will increase profits.
13.11. Fixed and variable costs

FC: Do not vary with the quantity of output produced (Capital, insurance, rent, marketing, R+D, costs of
equipment, loan payments).
VC: Vary with the quantity produced (wage, raw materials, transportation, taxes).
TC= FC + VC

Example: Costs Example: Marginal Cost
Example: Average fixed cost Example: Average variable cost

Notice that AFC falls as Q rises: the firm is Notice that as Q rises, AVC may fall initially. In
spreading its fixed costs over a larger and larger most cases, AVC will eventually rise as output
number of units. It always decreases. rises.
FC VC
AFC= AVC=
Q Q
Example: The various cost curves together

Example: Average total cost
FC VC

= Q + Q or = AFC + AVC

Calculating costs table
Q VC TC AFC AVC ATC MC
0 0 50 n/a n/a n/a
1 10 60 50 10 60
2 30 80 25 15 40
3 60 110 16.67 20 36.67
4 100 150 12.50 25 37.5
5 150 200 10 30 40
6 210 260 8.33 35 43.33
(*) Reading check question: When discussing firms supply decision long-run means enough time to
change all factors of production.
13.12. Properties of cost curves

First property
Types of slopes
AFC AVC ATC
Principle of dividends: As you increase

output (addition workers) are less
productive on average in terms of cost.
Why ATC is usually U-shaped (example)
As Q rises: Initially, falling AFC pulls ATC down and
eventually, rising AVC pulls ATC up.
Efficient scale: the quantity of output that minimizes ATC.
Second property
ATC and MC
When MC < ATC, ATC is falling.
When MC > ATC, ATC is rising.
The MC curve crosses the ATC curve at the ATC curves
minimum.
When there is an intersection point between both curves (ATC
and MC curves). ATC is placed at the minimum of its curve
long.

13.13. Costs in the short-run and long-run
Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones).
In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the
factory size with the lowest ATC).
13.14. LRATC with 3 factory sizes (example)

Firm can choose from three factory sizes: S, M or L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run,
but not in the short run.
To produce less than QA, firm will choose size S in the long
run. To produce between QA and QB, firm will choose size M in
the long run. To produce more than QB, firm will choose size L
in the long run.
13.15. A typical LRATC curve

In the real world, factories come in many sizes, each with its
own SRATC curve.
So a typical LRATC curve looks like this:
13.16. How ATC changes as the Scale of Production Changes

Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scales: ATC rises as Q increases.
Explanation about above information:
Economies of scale occur when increasing production allows
greater specialization: workers more efficient when focusing on
a narrow task. More common when Q is low.
Diseconomies of scale are due to coordination problems in
large organizations. E.g. management becomes stretched, cant
control costs. More common when Q is high.
14. Firms in competitive markets

14.1. Firms decisions
The goal of any firm is to maximize profits.
= TR TC
pQ
pQ
Average revenue (AR) =
Q
=P
TR
Marginal revenue (MR)=
Q

Review of costs
The true cost of taking some action is its opportunity cost.
Average cost is falling when MC is below it, and rising when MC is above it
A cost does not depend on the quantity produced is a FC.
P= TR TC
Review reading question
The MC of producing the fourth unit is 20. What type of cost is included in MC? VC only.
The MC curve crosses the AC Curve at its minimum.
AR is always equal to the price.
What is the profit maximizing rule for any type of firm whose goal is to maximize profits? MR = MC
Profit maximizing rule
Characteristics of perfect competition

Many buyers and many sellers.
The goods offered for sale are largely the same (identical product homogeneous).
Firms can freely enter or exit the market (no barriers).
Because of 1 and 2, each buyer and seller is a price-taker-takes the price as given.
This price comes from the market.
Implication of no barriers in the LR profits will be equal to zero.
Active learning 1
Q P TR AR MR
0 10 0 10
1 10 10 10 10
2 10 20 10 10 MR = P
3 10 30 10 10
4 10 40 10 10
MR = P for a competitive firm

A competitive firm can keep increasing its output without affecting the market price.
So, each one-unit increase in Q causes revenue to rise by, i.e, MR = P.
MR=P is only true for firms in competitive markets.
Profit maximization
Q TR TC Profit MR MC MR - MC
0 0 5 -5 10 4 6 At any Q with MR > MC,
1 10 9 1 10 6 4 increasing Q raises profit.
2 20 15 5 10 8 2
3 30 23 7 10 10 0 At any Q with MR < MC,
4 40 33 7 10 12 -2 reducing Q raises profit.
5 50 45 5
Shutdown vs. Exit

Shutdown: A SR decision not to produce anything because of market conditions.
Exit: A LR decision to leave the market.
A key difference:
If shot down in SR, must still pay FC.
If exit in LR (enough time to change all factors of production), zero costs.
A firms supply curve: Is the MC curve but, as long as P > AVC.

LONG RUN
SHORT RUN

A firms short-run decision to shut down
Cost of shutting down: Revenue loss= TR
Benefit of shutting down: VC= cost savings (firm must still pay FC)
So, shut down if TR < VC
TR VC
Divide both sides by Q: <
Q Q
So, firms decision rule is: Shut down if P < AVC
A competitive firms SR supply curve The irrelevance of sunk costs

Sunk cost: A cost that has already been committed
and cannot be recovered.
Sunk costs should be irrelevant to decisions; you must
pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed costs
whether it produced or shuts down.
So, FC should not matter in the decision to shut down.
A firms short-run decision to exit

Cost of exiting the market: Revenue loss = TR
Benefit of exiting the market: TC (zero FC in the LR)
So, firm exits if P < ATC
Divide both sides by Q to write the firms decision rule as:
A new firms decision to enter market

In the LR, a new firm will enter the market if it is profitable to do so: if TR > TC
Divide both sides by Q to express the firms entry decision as enter if P > ATC
The competitive firms supply curve

The firms LR supply curve is the portion of its MC curve above LRATC.
Active learning 2
Profit per unit = p-

ATC=$10-6= $4
Total profit= (p-ATC)

Q= $4 50= $200
Market supply: Assumptions

All existing firms and potential entrants have
Each firms costs do no change as other firms enter or exit the market.
The number of firms in the market is:
Fixed in the SR (due to the fixed costs).
Variable in the LR (due to free entry and exit).
The SR market supply curve
Example: 1000 identical firms
At each P, market Qs = 1000 (one firms Qs)

Entry and exit in the Long run
In the LR, the number of firms can change due to entry and exit.
If existing earn positive economic profit:
New firms enter, SR market supply shifts right.
P falls, reducing profits and slowing entry.
If existing firms incur losses:
Some firms exit, SR market supply shifts left.
P rises, reducing remaining firms losses.
The zero-profit condition
Long-run equilibrium: The process of entry or exit is complete-remaining firms earn zero economic profit
Zero economic profit occurs when P = ATC.
Since firms profit occurs where P= MR-MC, the zero profit condition is P=MC=ATC.
Recall that MC intersects ATC at minimum ATC.
Hence, in the LR, P = minimum ATC.
The LR market supply curve
Long run supply
SR and LR effects of an increase in demand

One firm Market
A firm begins in LR equilibrium, but

then an increase in demand raises
P. Over time, profits entry, shifting
supply curve to the right, reducing P.
Driving profits to zero and restoring
LR equilibrium.
Why the LR supply curve might slope upward

The LR market supply curve is horizontal if
All firms have identical costs
o As P rises, firms with lower costs enter the market before those with higher costs.
o Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity
supplied.
o Hence, LR market supply curve slopes upward.
o At any P:
For the marginal firm, P = minimum ATC and profit = 0
For lower-cost firms, profit > 0
Costs do not change as other firms enter or exit the market
o In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed).
o The entry of new firms increases demand for this input, causing its price to rise.
o This increases all firms costs.
o Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-
slopping.
If either of these assumptions is not true, then LR supply curve slopes upward.

15. MONOPOLY
15.1. Introduction
Definition
One firm
No close substitutes
Has market power
Cause: barriers to entry
Why monopolies arise

A single firm owns a key resource. (DeBeers owns most of the worlds diamond mines)
The government gives a single firm the exclusive right to produce the good. (Patents, copyright laws)
Natural monopoly: A single firm can produce the entire market Q at lower cost than could several firms.
15.2. Demand and Marginal Revenue

Active learning 1
Common Grounds is the only seller of cappuccinos in town. The table shows the market demand for cappuccinos.
Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR?
Q P TR AR MR Common grounds D and MR curves
0 4.5 0 n/a 4 Here, P = AR,
1 4 4 4 3 same as for a
2 3.5 7 3.5 2 competitive firm.
3 3 9 3 1
Here, MR < P,
4 2.5 10 2.5 0
whereas MR = P
5 2 10 2 -1
6 1.5 9 1.5 for a competitive
firm.
MR can be
negative
For a competitive firm Market Monopoly

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MICROECONOMICS

#4 People respond to incentives

#5 Trade can make everyone better off

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#7 Governments can sometimes improve market outcomes

2. THINKING LIKE AN ECONOMIST

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Second model: The production possibilities frontier (PPF)

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United States PPF Japans PPF

o Production without trade

Trade makes both

Exports and imports

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Market demand versus Individual demand

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Market supply versus individual supply

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4.4. Supply and demand together

Surplus (excess supply): When quantity supplied is greater than

Shortage (excess demand): When quantity demanded is greater

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o Example: The market for hybrid cars (A shift in

Terms for Shift versus Movement along the curve

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7. CONSUMERS, PRODUCERS AND THE EFFICIENCY OF MARKETS

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Cost and the supply curve

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The Markets Allocation of Resources

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7.2. Price elasticity of demand

Price elasticity of demand measures how much Qd responds to a change in P.

7.3. Calculating percentage changes

The midpoint is the number halfway

The % change in Q equals:

The price elasticity of demand equals:

Look several examples to understand in the next page.

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Determinants of price elasticity: summary

7.4. The variety of demand curves

Types of elasticity demand curves

4. Elasticity is greater than 1 5. Elasticity equals to infinity

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7.6. Price elasticity and total revenue

7.8. Price elasticity of supply

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4. Elasticity is greater than 1 5. Elasticity equals to infinity

7.10. Determinants of supply elasticity

Supply often becomes less elastic as Q rises, due to capacity limits.

7.12. Other elasticities

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Cross-price elasticity % in Qd for good 1

Example 2: The market for unskilled labor

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6.5. The outcome is the same in both cases

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10.1. Externalities and market inefficiency

10.2. Welfare economics: A recap

Pollution and the social optimum