Principles of Economics PDF Lecture Notes

PowerPoint® Lecture Presentation Principles of Economics, Fourth Edition N. Gregory Mankiw Prepared by Kathryn Nantz and Laurence Miners, Fairfield University. © 2007 Thomson South-West...

PowerPoint® Lecture Presentation Principles of Economics, Fourth Edition N. Gregory Mankiw Prepared by Kathryn Nantz and Laurence Miners, Fairfield University. © 2007 Thomson South-Western © 2007 Thomson South-Western Economy...... The word economy comes from a Greek word for “one who manages a household.” © 2007 Thomson South-Western TEN PRINCIPLES OF ECONOMICS A household and an economy face many decisions: ▪ Who will work? ▪ What goods and how many of them should be produced? ▪ What resources should be used in production? ▪ At what price should the goods be sold? © 2007 Thomson South-Western TEN PRINCIPLES OF ECONOMICS Society and Scarce Resources: The management of society’s resources is important because resources are scarce. Scarcity... means that society has limited resources and therefore cannot produce all the goods and services people wish to have. © 2007 Thomson South-Western TEN PRINCIPLES OF ECONOMICS Economics is the study of how society manages its scarce resources. © 2007 Thomson South-Western HOW PEOPLE MAKE DECISIONS People face trade-offs. The cost of something is what you give up to get it. Rational people think at the margin. People respond to incentives. © 2007 Thomson South-Western Principle #1: People Face Trade-offs. “There is no such thing as a free lunch!” © 2007 Thomson South-Western Principle #1: People Face Trade-offs. To get one thing, we usually have to give up another thing. Guns v. butter Food v. clothing Leisure time v. work Efficiency v. equity Making decisions requires trading off one goal against another. © 2007 Thomson South-Western Principle #1: People Face Trade-offs Efficiency v. Equity Efficiency means society gets the most that it can from its scarce resources. Equity means the benefits of those resources are distributed fairly among the members of society. © 2007 Thomson South-Western Principle #2: The Cost of Something Is What You Give Up to Get It. Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to study or go out on a date? Whether to go to class or sleep in? The opportunity cost of an item is what you give up to obtain that item. © 2007 Thomson South-Western Principle #2: The Cost of Something Is What You Give Up to Get It. Basketball star LeBron James understands opportunity costs and incentives. He chose to skip college and go straight from high school to the pros where he earns millions of dollars. © 2007 Thomson South-Western Principle #3: Rational People Think at the Margin. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin. © 2007 Thomson South-Western Principle #4: People Respond to Incentives. Marginal changes in costs or benefits motivate people to respond. The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs! © 2007 Thomson South-Western HOW PEOPLE INTERACT Trade can make everyone better off. Markets are usually a good way to organize economic activity. Governments can sometimes improve economic outcomes. © 2007 Thomson South-Western Principle #5: Trade Can Make Everyone Better Off. People gain from their ability to trade with one another. Competition results in gains from trading. Trade allows people to specialize in what they do best. © 2007 Thomson South-Western Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. A market economy is an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services. Households decide what to buy and who to work for. Firms decide who to hire and what to produce. © 2007 Thomson South-Western Principle #6: Markets Are Usually a Good Way to Organize Economic Activity. Adam Smith made the observation that households and firms interacting in markets act as if guided by an “invisible hand.” Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole. © 2007 Thomson South-Western Principle #7: Governments Can Sometimes Improve Market Outcomes. Markets work only if property rights are enforced. Property rights are the ability of an individual to own and exercise control over a scarce resource Market failure occurs when the market fails to allocate resources efficiently. When the market fails (breaks down) government can intervene to promote efficiency and equity. © 2007 Thomson South-Western Principle #7: Governments Can Sometimes Improve Market Outcomes. Market failure may be caused by: an externality, which is the impact of one person or firm’s actions on the well-being of a bystander. market power, which is the ability of a single person or firm to unduly influence market prices. © 2007 Thomson South-Western © 2007 Thomson South-Western Thinking Like an Economist Every field of study has its own terminology ▪ Mathematics integrals ❖ axioms ❖ vector spaces ▪ Psychology ego ❖ id ❖ cognitive dissonance ▪ Law promissory ❖ estoppel ❖ torts ❖ venues ▪ Economics supply ❖ opportunity cost ❖ elasticity ❖ consumer surplus ❖ demand ❖ comparative advantage ❖ deadweight loss © 2007 Thomson South-Western Thinking Like an Economist Economics trains you to.... ▪ Think in terms of alternatives. ▪ Evaluate the cost of individual and social choices. ▪ Examine and understand how certain events and issues are related. © 2007 Thomson South-Western THE ECONOMIST AS A SCIENTIST The economic way of thinking... ▪ Involves thinking analytically and objectively. ▪ Makes use of the scientific method. ▪ Uses abstract models to help explain how a complex, real world operates. ▪ Develops theories, collects and analyzes data to evaluate the theories. © 2007 Thomson South-Western The Scientific Method: Observation, Theory, and More Observation Uses abstract models to help explain how a complex, real world operates. Develops theories, collects and analyzes data to evaluate the theories. © 2007 Thomson South-Western The Role of Assumptions Economists make assumptions in order to make the world easier to understand. The art in scientific thinking is deciding which assumptions to make. Economists use different assumptions to answer different questions. © 2007 Thomson South-Western Economic Models Economists use models to simplify reality in order to improve our understanding of the world. Two of the most basic economic models are: The Circular Flow Diagram The Production Possibilities Frontier © 2007 Thomson South-Western Our First Model: The Circular-Flow Diagram The circular-flow diagram is a visual model of the economy that shows how dollars flow through markets among households and firms. © 2007 Thomson South-Western Figure 1 The Circular Flow MARKETS Revenue FOR Spending GOODS AND SERVICES Goods Firms sell Goods and and services Households buy services sold bought FIRMS HOUSEHOLDS Produce and sell Buy and consume goods and services goods and services Hire and use factors Own and sell factors of production of production Factors of MARKETS Labor, land, production FOR and capital FACTORS OF PRODUCTION Wages, rent, Households sell Income and profit Firms buy = Flow of inputs and outputs = Flow of dollars © 2007 Thomson South-Western Our First Model: The Circular-Flow Diagram Firms Produce and sell goods and services Hire and use factors of production Households Buy and consume goods and services Own and sell factors of production © 2007 Thomson South-Western Our First Model: The Circular-Flow Diagram Markets for Goods and Services Firms sell Households buy Markets for Factors of Production Households sell Firms buy © 2007 Thomson South-Western Our First Model: The Circular-Flow Diagram Factors of Production Inputs used to produce goods and services Land, labor, and capital © 2007 Thomson South-Western Our Second Model: The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. © 2007 Thomson South-Western  Figure 2 The Production Possibilities Frontier Quantity of Computers Produced 3,000 C A 2,200 2,000 B Production possibilities frontier 1,000 D 0 300 600 700 1,000 Quantity of Cars Produced © 2007 Thomson South-Western Our Second Model: The Production Possibilities Frontier Concepts illustrated by the production possibilities frontier Efficiency Trade-offs Opportunity cost Economic growth © 2007 Thomson South-Western © 2007 Thomson South-Western Our Second Model: The Production Possibilities Frontier The production possibilities frontier is a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology. © 2007 Thomson South-Western  Figure 2 The Production Possibilities Frontier Quantity of Computers Produced 3,000 C A 2,200 2,000 B Production possibilities frontier 1,000 D 0 300 600 700 1,000 Quantity of Cars Produced © 2007 Thomson South-Western Our Second Model: The Production Possibilities Frontier Concepts illustrated by the production possibilities frontier Efficiency Trade-offs Opportunity cost Economic growth © 2007 Thomson South-Western Figure 3 A Shift in the Production Possibilities Frontier Quantity of Computers Produced 4,000 3,000 2,300 G 2,200 A 0 600 650 1,000 CarsQuantity Produced of © 2007 Thomson South-Western Microeconomics and Macroeconomics Microeconomics focuses on the individual parts of the economy. How households and firms make decisions and how they interact in specific markets Macroeconomics looks at the economy as a whole. Economy-wide phenomena, including inflation, unemployment, and economic growth © 2007 Thomson South-Western THE ECONOMIST AS POLICY ADVISOR When economists are trying to explain the world, they are scientists. When economists are trying to change the world, they are policy advisors. © 2007 Thomson South-Western Positive versus Normative Analysis Positive statements are statements that attempt to describe the world as it is. Called descriptive analysis Normative statements are statements about how the world should be. Called prescriptive analysis © 2007 Thomson South-Western Positive Versus Normative Analysis Are the following positive or normative ? statements? An increase in the minimum wage will cause a ? decrease in employment among the least-skilled. POSITIVE Higher federal budget deficits will cause interest rates to increase. POSITIVE ? ? © 2007 Thomson South-Western Positive Versus Normative Analysis Are the following positive or normative statements? ? The income gains from a higher minimum wage are worth more than any slight reductions in employment. ? NORMATIVE State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. NORMATIVE ? © 2007 Thomson South-Western WHY ECONOMISTS DISAGREE They may disagree about the validity of alternative positive theories about how the world works. They may have different values and, therefore, different normative views about what policy should try to accomplish. © 2007 Thomson South-Western  Summary Economists try to address their subjects with a scientist’s objectivity. – They make appropriate assumptions and build simplified models in order to understand the world around them. – Two simple economic models are the circular-flow diagram and the production possibilities frontier. © 2007 Thomson South-Western  Summary Economics is divided into two subfields: – Microeconomics is the study of decision-making by households and firms in the marketplace. – Macroeconomics is the study of the forces and trends that affect the economy as a whole. © 2007 Thomson South-Western  Summary A positive statement is an assertion about how the world is. A normative statement is an assertion about how the world ought to be. When economists make normative statements, they are acting more as policy advisors than scientists. © 2007 Thomson South-Western  Summary Economists who advise policymakers offer conflicting advice either because of differences in scientific judgments or because of differences in values. At other times, economists are united in the advice they offer, but policymakers may choose to ignore it. © 2007 Thomson South-Western © 2007 Thomson South-Western MARKETS AND COMPETITION Supply and demand are the two words that economists use most often. Supply and demand are the forces that make market economies work. Modern microeconomics is about supply, demand, and market equilibrium. © 2007 Thomson South-Western What Is a Market? A market is a group of buyers and sellers of a particular good or service. The terms supply and demand refer to the behavior of people... as they interact with one another in markets. © 2007 Thomson South-Western What Is a Market? Buyers determine demand. Sellers determine supply. © 2007 Thomson South-Western What Is Competition? A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. © 2007 Thomson South-Western What Is Competition? Competition: Perfect and Otherwise Perfect Competition Products are the same Numerous buyers and sellers so that each has no influence over price Buyers and Sellers are price takers Monopoly One seller, and seller controls price © 2007 Thomson South-Western What Is Competition? Competition: Perfect and Otherwise Oligopoly Few sellers Not always aggressive competition Monopolistic Competition Many sellers Slightly differentiated products Each seller may set price for its own product © 2007 Thomson South-Western DEMAND Quantity demanded is the amount of a good that buyers are willing and able to purchase. Law of Demand – The law of demand states that, other things equal, the quantity demanded of a good falls when the price of the good rises. © 2007 Thomson South-Western The Demand Curve: The Relationship between Price and Quantity Demanded Demand Schedule The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. © 2007 Thomson South-Western Catherine’s Demand Schedule © 2007 Thomson South-Western The Demand Curve: The Relationship between Price and Quantity Demanded Demand Curve The demand curve is a graph of the relationship between the price of a good and the quantity demanded. © 2007 Thomson South-Western © 2007 Thomson South-Western The Demand Curve: The Relationship between Price and Quantity Demanded Demand Curve The demand curve is a graph of the relationship between the price of a good and the quantity demanded. © 2007 Thomson South-Western Figure 1 Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease 2.00 in price... 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2.... increases quantity of cones demanded. © 2007 Thomson South-Western Market Demand versus Individual Demand Market demand refers to the sum of all individual demands for a particular good or service. Graphically, individual demand curves are summed horizontally to obtain the market demand curve. © 2007 Thomson South-Western  The Market Demand Curve When the price is $2.00, When the price is $2.00, The market demand at Catherine will demand 4 Nicholas will demand 3 $2.00 will be 7 ice-cream ice-cream cones. ice-cream cones. cones. Catherine’s Demand + Nicholas’s Demand = Market Demand Price of Ice- Price of Ice- Price of Ice- Cream Cone Cream Cone Cream Cone 2.00 2.00 2.00 1.00 1.00 1.00 7 13 4 8 3 5 Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones Quantity of Ice-Cream Cones When the price is $1.00, When the price is $1.00, The market demand at Catherine will demand 8 Nicholas will demand 5 $1.00, will be 13 ice- ice-cream cones. ice-cream cones. cream cones. © 2007 Thomson South-Western Shifts in the Demand Curve Change in Quantity Demanded Movement along the demand curve. Caused by a change in the price of the product. © 2007 Thomson South-Western Changes in Quantity Demanded A tax on sellers of ice- Price of Ice- Cream cream cones raises the Cones price of ice-cream B cones and results in a $2.00 movement along the demand curve. 1.00 A D 0 4 8 Quantity of Ice-Cream Cones © 2007 Thomson South-Western Shifts in the Demand Curve Consumer income Prices of related goods Tastes Expectations Number of buyers © 2007 Thomson South-Western Shifts in the Demand Curve Change in Demand A shift in the demand curve, either to the left or right. Caused by any change that alters the quantity demanded at every price. © 2007 Thomson South-Western  Figure 3 Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D2 Demand curve, D1 Demand curve, D3 0 Quantity of Ice-Cream Cones © 2007 Thomson South-Western Shifts in the Demand Curve Consumer Income As income increases the demand for a normal good will increase. As income increases the demand for an inferior good will decrease. © 2007 Thomson South-Western Consumer Income Normal Good Price of Ice- Cream Cone $3.00 An increase 2.50 in income... Increase 2.00 in demand 1.50 1.00 0.50 D2 D1 Quantity of Ice-Cream 0 1 2 3 4 5 6 7 8 9 10 11 12 Cones © 2007 Thomson South-Western Consumer Income Inferior Good Price of Ice- Cream Cone $3.00 2.50 An increase 2.00 in income... Decrease 1.50 in demand 1.00 0.50 D2 D1 Quantity of Ice-Cream 0 1 2 3 4 5 6 7 8 9 10 11 12 Cones © 2007 Thomson South-Western Shifts in the Demand Curve Prices of Related Goods When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. When a fall in the price of one good increases the demand for another good, the two goods are called complements. © 2007 Thomson South-Western Table 1 Variables That Influence Buyers © 2007 Thomson South-Western SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell. Law of Supply – The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises. © 2007 Thomson South-Western The Supply Curve: The Relationship between Price and Quantity Supplied Supply Schedule The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. © 2007 Thomson South-Western Ben’s Supply Schedule © 2007 Thomson South-Western The Supply Curve: The Relationship between Price and Quantity Supplied Supply Curve The supply curve is the graph of the relationship between the price of a good and the quantity supplied. © 2007 Thomson South-Western Figure 5 Ben’s Supply Schedule and Supply Curve Price of Ice-Cream Cone $3.00 2.50 1. An increase in price... 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2.... increases quantity of cones supplied. © 2007 Thomson South-Western SUPPLY Quantity supplied is the amount of a good that sellers are willing and able to sell. Law of Supply – The law of supply states that, other things equal, the quantity supplied of a good rises when the price of the good rises. © 2007 Thomson South-Western The Supply Curve: The Relationship between Price and Quantity Supplied Supply Schedule The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. © 2007 Thomson South-Western Ben’s Supply Schedule © 2007 Thomson South-Western The Supply Curve: The Relationship between Price and Quantity Supplied Supply Curve The supply curve is the graph of the relationship between the price of a good and the quantity supplied. © 2007 Thomson South-Western Figure 5 Ben’s Supply Schedule and Supply Curve Price of Ice-Cream Cone $3.00 2.50 1. An increase in price... 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2.... increases quantity of cones supplied. © 2007 Thomson South-Western Market Supply versus Individual Supply Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. Graphically, individual supply curves are summed horizontally to obtain the market supply curve. © 2007 Thomson South-Western Shifts in the Supply Curve Input prices Technology Expectations Number of sellers © 2007 Thomson South-Western Shifts in the Supply Curve Change in Quantity Supplied Movement along the supply curve. Caused by a change in anything that alters the quantity supplied at each price. © 2007 Thomson South-Western Change in Quantity Supplied Price of Ice- Cream S Cone C $3.00 A rise in the price of ice cream cones results in a movement along A the supply curve. 1.00 Quantity of Ice-Cream 0 1 5 Cones © 2007 Thomson South-Western Shifts in the Supply Curve Change in Supply A shift in the supply curve, either to the left or right. Caused by a change in a determinant other than price. © 2007 Thomson South-Western  Figure 7 Shifts in the Supply Curve Price of Ice-Cream Supply curve, S3 Supply Cone curve, S1 Supply Decrease curve, S2 in supply Increase in supply 0 Quantity of Ice-Cream Cones © 2007 Thomson South-Western Table 2: Variables That Influence Sellers © 2007 Thomson South-Western SUPPLY AND DEMAND TOGETHER Equilibrium refers to a situation in which the price has reached the level where quantity supplied equals quantity demanded. © 2007 Thomson South-Western SUPPLY AND DEMAND TOGETHER Equilibrium Price – The price that balances quantity supplied and quantity demanded. – On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity – The quantity supplied and the quantity demanded at the equilibrium price. – On a graph it is the quantity at which the supply and demand curves intersect. © 2007 Thomson South-Western SUPPLY AND DEMAND TOGETHER Demand Schedule Supply Schedule At $2.00, the quantity demanded is equal to the quantity supplied! © 2007 Thomson South-Western  Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply Equilibrium price Equilibrium $2.00 Equilibrium Demand quantity 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of Ice-Cream Cones © 2007 Thomson South-Western Equilibrium Surplus When price > equilibrium price, then quantity supplied > quantity demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales, thereby moving toward equilibrium. © 2007 Thomson South-Western Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Supply Cone Surplus $2.50 2.00 Demand 0 4 7 10 Quantity of Quantity Quantity Ice-Cream demanded supplied Cones © 2007 Thomson South-Western Equilibrium Shortage When price < equilibrium price, then quantity demanded > the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium. © 2007 Thomson South-Western Figure 9 Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Supply Cone $2.00 1.50 Shortage Demand 0 4 7 10 Quantity of Quantity Quantity Ice-Cream supplied demanded Cones © 2007 Thomson South-Western Equilibrium Law of supply and demand The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance. © 2007 Thomson South-Western Table 3: Three Steps for Analyzing Changes in Equilibrium © 2007 Thomson South-Western Figure 10 How an Increase in Demand Affects the Equilibrium Price of Ice-Cream 1. Hot weather increases Cone the demand for ice cream... Supply $2.50 New equilibrium 2.00 2.... resulting Initial in a higher equilibrium price... D D 0 7 10 Quantity of 3.... and a higher Ice-Cream Cones quantity sold. © 2007 Thomson South-Western Three Steps to Analyzing Changes in Equilibrium Shifts in Curves versus Movements along Curves A shift in the supply curve is called a change in supply. A movement along a fixed supply curve is called a change in quantity supplied. A shift in the demand curve is called a change in demand. A movement along a fixed demand curve is called a change in quantity demanded. © 2007 Thomson South-Western Figure 11 How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream 1. An increase in the Cone price of sugar reduces the supply of ice cream... S2 S1 New $2.50 equilibrium 2.00 Initial equilibrium 2.... resulting in a higher price of ice cream... Demand 0 4 7 Quantity of 3.... and a lower Ice-Cream Cones quantity sold. © 2007 Thomson South-Western Table 4: What Happens to Price and Quantity When Supply or Demand Shifts? © 2007 Thomson South-Western  Summary Economists use the model of supply and demand to analyze competitive markets. In a competitive market, there are many buyers and sellers, each of whom has little or no influence on the market price. © 2007 Thomson South-Western  Summary The demand curve shows how the quantity of a good depends upon the price. – According to the law of demand, as the price of a good falls, the quantity demanded rises. Therefore, the demand curve slopes downward. – In addition to price, other determinants of how much consumers want to buy include income, the prices of complements and substitutes, tastes, expectations, and the number of buyers. – If one of these factors changes, the demand curve shifts. © 2007 Thomson South-Western  Summary The supply curve shows how the quantity of a good supplied depends upon the price. – According to the law of supply, as the price of a good rises, the quantity supplied rises. Therefore, the supply curve slopes upward. – In addition to price, other determinants of how much producers want to sell include input prices, technology, expectations, and the number of sellers. – If one of these factors changes, the supply curve shifts. © 2007 Thomson South-Western  Summary Market equilibrium is determined by the intersection of the supply and demand curves. At the equilibrium price, the quantity demanded equals the quantity supplied. The behavior of buyers and sellers naturally drives markets toward their equilibrium. © 2007 Thomson South-Western  Summary To analyze how any event influences a market, we use the supply-and-demand diagram to examine how the event affects the equilibrium price and quantity. In market economics, prices are the signals that guide economic decisions and thereby allocate resources. © 2007 Thomson South-Western © 2007 Thomson South-Western THE ELASTICITY OF SUPPLY Price elasticity of supply is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Price elasticity of supply is the percentage change in quantity supplied resulting from a percentage change in price. © 2007 Thomson South-Western Figure 5 The Price Elasticity of Supply (a) Perfectly Inelastic Supply: Elasticity Equals 0 Price Supply $5 4 1. An increase in price... 0 100 Quantity 2.... leaves the quantity supplied unchanged. © 2007 Thomson South-Western Figure 5 The Price Elasticity of Supply (b) Inelastic Supply: Elasticity Is Less Than 1 Price Supply $5 4 1. A 22% increase in price... 0 100 110 Quantity 2.... leads to a 10% increase in quantity supplied. © 2007 Thomson South-Western Figure 5 The Price Elasticity of Supply (c) Unit Elastic Supply: Elasticity Equals 1 Price Supply $5 4 (If SUPPLY is unit elastic and linear, it will 1. A 22% increase begin at the origin.) in price... 0 100 125 Quantity 2.... leads to a 22% increase in quantity supplied. © 2007 Thomson South-Western Figure 5 The Price Elasticity of Supply (d) Elastic Supply: Elasticity Is Greater Than 1 Price Supply $5 4 1. A 22% increase in price... 0 100 200 Quantity 2.... leads to a 67% increase in quantity supplied. © 2007 Thomson South-Western Figure 5 The Price Elasticity of Supply (e) Perfectly Elastic Supply: Elasticity Equals Infinity Price 1. At any price above $4, quantity supplied is infinite. $4 Supply 2. At exactly $4, producers will supply any quantity. 0 Quantity 3. At a price below $4, quantity supplied is zero. © 2007 Thomson South-Western The Price Elasticity of Supply and Its Determinants Ability of sellers to change the amount of the good they produce. Beach-front land is inelastic. Books, cars, or manufactured goods are elastic. Time period Supply is more elastic in the long run. © 2007 Thomson South-Western Computing the Price Elasticity of Supply The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Percentage change in quantity supplied Price elasticity of supply = Percentage change in price © 2007 Thomson South-Western TWO APPLICATIONS OF SUPPLY, DEMAND, AND ELASTICITY Can good news for farming be bad news for farmers? What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybrid that is more productive than existing varieties? © 2007 Thomson South-Western Can Good News for Farming Be Bad News for Farmers? Examine whether the supply or demand curve shifts. Determine the direction of the shift of the curve. Use the supply-and-demand diagram to see how the market equilibrium changes. © 2007 Thomson South-Western Figure 7 An Increase in Supply in the Market for Wheat Price of Wheat 1. When demand is inelastic, 2.... leads an increase in supply... to a large fall S1 in price... S2 $3 2 Demand 0 100 110 Quantity of Wheat 3.... and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. © 2007 Thomson South-Western Compute the Price Elasticity of Demand When There Is a Change in Supply 100 − 110 (100 + 110) / 2 ED = 3.00 − 2.00 (3.00 + 2.00) / 2 −0.095 =  −0.24 0.4 Demand is inelastic. © 2007 Thomson South-Western Why Did OPEC Fail to Keep the Price of Oil High? Supply and Demand can behave differently in the short run and the long run In the short run, both supply and demand for oil are relatively inelastic But in the long run, both are elastic © 2007 Thomson South-Western © 2007 Thomson South-Western Elasticity... … allows us to analyze supply and demand with greater precision. … is a measure of how much buyers and sellers respond to changes in market conditions © 2007 Thomson South-Western THE ELASTICITY OF DEMAND The price elasticity of demand is a measure of how much the quantity demanded of a good responds to a change in the price of that good. When we talk about elasticity, that responsiveness is always measured in percentage terms. Specifically, the price elasticity of demand is the percentage change in quantity demanded due to a percentage change in the price. © 2007 Thomson South-Western Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Percentage change in quantity demanded Price elasticity of demand = Percentage change in price © 2007 Thomson South-Western The Price Elasticity of Demand and Its Determinants Availability of Close Substitutes Necessities versus Luxuries Definition of the Market Time Horizon © 2007 Thomson South-Western The Price Elasticity of Demand and Its Determinants Demand tends to be more elastic: the larger the number of close substitutes. if the good is a luxury. the longer the time period. © 2007 Thomson South-Western The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the price change. (Q2 − Q1 ) /[(Q2 + Q1 ) / 2] Price elasticity of demand = ( P2 − P1 ) /[( P2 + P1 ) / 2] © 2007 Thomson South-Western The Midpoint Method: A Better Way to Calculate Percentage Changes and Elasticities Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones, then your elasticity of demand, using the midpoint formula, would be calculated as: x/y, where x=(8-10)/((10+8)/2), and y=(2.20- 2.00)/((2.00+2.20)/2)= -2.32 © 2007 Thomson South-Western The Variety of Demand Curves Inelastic Demand Quantity demanded does not respond strongly to price changes. Absolute Value of Price elasticity of demand is between zero and one. Elastic Demand Quantity demanded responds strongly to changes in price. Absolute Value of Price elasticity of demand is greater than one. © 2007 Thomson South-Western Computing the Price Elasticity of Demand (100 − 50) (100 + 50)/2 ED = (4.00 − 5.00) Price (4.00 + 5.00)/2 $5 67 percent 4 = = −3 Demand − 22 percent 0 50 100 Quantity Demand is price elastic. © 2007 Thomson South-Western The Variety of Demand Curves Perfectly Inelastic Quantity demanded does not respond to price changes. Perfectly Elastic Quantity demanded changes infinitely with any change in price. Unit Elastic Quantity demanded changes by the same percentage as the price. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (a) Perfectly Inelastic Demand: Elasticity Equals 0 Price Demand $5 4 1. An increase in price... 0 100 Quantity 2.... leaves the quantity demanded unchanged. © 2007 Thomson South-Western The Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. But it is not the same thing as the slope! © 2007 Thomson South-Western Own-Price Elasticity of Demand p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand 10-packs Single Units p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? © 2007 Thomson South-Western Own-Price Elasticity of Demand 10-packs Single Units p1 p1 slope slope 10 =-2 10 = - 0.2 5 X1* 50 X * 1 In which case is the quantity demanded X1* more sensitive to changes to p1? It is the same in both cases. © 2007 Thomson South-Western Own-Price Elasticity of Demand Q: Why not just use the slope of a demand curve to measure the sensitivity of quantity demanded to a change in a commodity’s own price? A: Because the value of sensitivity then depends upon the (arbitrary) units of measurement used for quantity demanded. © 2007 Thomson South-Western Own-Price Elasticity of Demand * %  x1  x* ,p = 1 1 % p1 is a ratio of percentages and so has no units of measurement. Hence own-price elasticity of demand is a sensitivity measure that is independent of units of measurement. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (b) Inelastic Demand: Absolute value of Elasticity Is Between 0 and 1 Price $5 4 1. A 22% Demand increase in price... 0 90 100 Quantity 2.... leads to an 11% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (c) Unit Elastic Demand: Absolute value of Elasticity Equals 1 Price $5 4 1. A 22% Demand increase in price... 0 80 100 Quantity 2.... leads to a 22% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (d) Elastic Demand: Absolute value of Elasticity Is Greater Than 1 Price $5 4 Demand 1. A 22% increase in price... 0 50 100 Quantity 2.... leads to a 67% decrease in quantity demanded. © 2007 Thomson South-Western Figure 1 The Price Elasticity of Demand (e) Perfectly Elastic Demand: Absolute value of Elasticity Equals Infinity Price 1. At any price above $4, quantity demanded is zero. $4 Demand 2. At exactly $4, consumers will buy any quantity. 0 Quantity 3. At a price below $4, quantity demanded is infinite. © 2007 Thomson South-Western Total Revenue and the Price Elasticity of Demand Total revenue is the amount paid by buyers and received by sellers of a good. Computed as the price of the good times the quantity sold. TR = P  Q © 2007 Thomson South-Western  Figure 2 Total Revenue Price When the price is $4, consumers will demand 100 units, and spend $400 on this good. $4 P × Q = $400 P (revenue) Demand 0 100 Quantity Q © 2007 Thomson South-Western Elasticity and Total Revenue along a Linear Demand Curve With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. © 2007 Thomson South-Western  Figure 3 How Total Revenue Changes When Price Changes: Inelastic Demand Price Price An Increase in price from $1 … leads to an Increase in to $3 … total revenue from $100 to $240 $3 Revenue = $240 $1 Revenue = $100 Demand Demand 0 100 Quantity 0 80 Quantity © 2007 Thomson South-Western Elasticity and Total Revenue along a Linear Demand Curve With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. © 2007 Thomson South-Western  Figure 3 How Total Revenue Changes When Price Changes: Elastic Demand Price Price An Increase in price from $4 … leads to an decrease in to $5 … total revenue from $200 to $100 $5 $4 Demand Demand Revenue = $200 Revenue = $100 0 50 Quantity 0 20 Quantity Note that with each price increase, the Law of Demand still holds – an increase in price leads to a decrease in the quantity demanded. It is the change in TR that varies! © 2007 Thomson South-Western Elasticity of a Linear Demand Curve © 2007 Thomson South-Western Figure 4 Elasticity of a Linear Demand Curve Demand is elastic; When price increases from Price demand is responsive to $4 to $5, TR declines from $7 changes in price. $24 to $20. 6 Absolute value of Elasticity is > 1 in this range. 5 4 Absolute value of Elasticity is < 1 in this range. Demand is inelastic; demand is 3 not very responsive to changes 2 in price. When price increases from 1 $2 to $3, TR increases from $20 to $24. 0 2 4 6 8 10 12 14 Quantity © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity of Demand Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. It is computed as the percentage change in the quantity demanded divided by the percentage change in income. © 2007 Thomson South-Western  Other Demand Elasticities Computing Income Elasticity Percentage change in quantity demanded Income elasticity of demand = Percentage change in income Remember, all elasticities are measured by dividing one percentage change by another © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity Types of Goods Normal Goods: Income elasticity is positive Inferior Goods: Income elasticity is negative Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. © 2007 Thomson South-Western Other Demand Elasticities Income Elasticity Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. © 2007 Thomson South-Western Other Demand Elasticities Cross-price elasticity of demand A measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good For complements, cross price elasticity is negative For substitutes, cross price elasticity is positive %change in quantity demanded of good 1 Cross - price elasticity of demand = %change in price of good 2 © 2007 Thomson South-Western  Summary Price elasticity of demand measures how much the quantity demanded responds to changes in the price. Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price. – If a demand curve is elastic, total revenue falls when the price rises. – If it is inelastic, total revenue rises as the price rises. © 2007 Thomson South-Western  Summary The income elasticity of demand measures how much the quantity demanded responds to changes in consumers’ income. The cross-price elasticity of demand measures how much the quantity demanded of one good responds to the price of another good. The price elasticity of supply measures how much the quantity supplied responds to changes in the price. © 2007 Thomson South-Western  Summary In most markets, supply is more elastic in the long run than in the short run. The price elasticity of supply is calculated as the percentage change in quantity supplied divided by the percentage change in price. The tools of supply and demand can be applied in many different types of markets. © 2007 Thomson South-Western © 2007 Thomson South-Western Supply, Demand, and Government Policies In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. One of the roles of economists is to use their theories to assist in the development of policies. © 2007 Thomson South-Western CONTROLS ON PRICES Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. Result in government-created price ceilings and floors. © 2007 Thomson South-Western CONTROLS ON PRICES Price Ceiling – A legal maximum on the price at which a good can be sold. Price Floor – A legal minimum on the price at which a good can be sold. © 2007 Thomson South-Western How Price Ceilings Affect Market Outcomes Two outcomes are possible when the government imposes a price ceiling: The price ceiling is not binding if set above the equilibrium price. The price ceiling is binding if set below the equilibrium price, leading to a shortage. © 2007 Thomson South-Western Figure 1 A Market with a Price Ceiling (a) A Price Ceiling That Is Not Binding Price of Ice-Cream Cone Supply $4 Price ceiling 3 The market clears at Equilibrium $3 and the price price ceiling is ineffective. Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones © 2007 Thomson South-Western Figure 1 A Market with a Price Ceiling (b) A Price Ceiling That Is Binding Price of Ice-Cream Cone Supply Equilibrium price $3 2 Price Shortage ceiling Demand 0 75 125 Quantity of Quantity Quantity Ice-Cream supplied demanded Cones © 2007 Thomson South-Western How Price Ceilings Affect Market Outcomes Effects of Price Ceilings A binding price ceiling creates Shortages because QD > QS. Example: Gasoline shortage of the 1970s Nonprice rationing Examples: Long lines, discrimination by sellers © 2007 Thomson South-Western CASE STUDY: Rent Control in the Short Run and Long Run Rent controls are ceilings placed on the rents that landlords may charge their tenants. The goal of rent control policy is to help the poor by making housing more affordable. © 2007 Thomson South-Western Figure 3 Rent Control in the Short Run and in the Long Run (a) Rent Control in the Short Run (supply and demand are inelastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments © 2007 Thomson South-Western Figure 3 Rent Control in the Short Run and in the Long Run (b) Rent Control in the Long Run (supply and demand are elastic) Rental Price of Apartment Supply Controlled rent Shortage Demand 0 Quantity of Apartments © 2007 Thomson South-Western How Price Floors Affect Market Outcomes When the government imposes a price floor, two outcomes are possible. The price floor is not binding if set below the equilibrium price. The price floor is binding if set above the equilibrium price, leading to a surplus. © 2007 Thomson South-Western Figure 4 A Market with a Price Floor (a) A Price Floor That Is Not Binding The government says that ice- Price of cream cones must Ice-Cream sell for at least $2; Cone Supply this legislation is ineffective at the Equilibrium current market price price. $3 Price floor 2 Demand 0 100 Quantity of Equilibrium Ice-Cream quantity Cones © 2007 Thomson South-Western Figure 4 A Market with a Price Floor (b) A Price Floor That Is Binding Price of Ice-Cream Cone Supply Surplus $4 Price floor 3 Equilibrium price Demand 0 80 Quantity of 120 Quantity Quantity Ice-Cream demanded supplied Cones © 2007 Thomson South-Western How Price Floors Affect Market Outcomes A price floor prevents supply and demand from moving toward the equilibrium price and quantity. When the market price hits the floor, it can fall no further, and the market price equals the floor price. © 2007 Thomson South-Western CASE STUDY: The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay. © 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Wage Labor Supply Equilibrium wage Labor demand 0 Equilibrium Quantity of employment Labor © 2007 Thomson South-Western Figure 5 How the Minimum Wage Affects the Labor Market Wage Labor Labor surplus Supply (unemployment) Minimum wage Labor demand 0 Quantity Quantity Quantity of demanded supplied Labor © 2007 Thomson South-Western TAXES Governments levy taxes to raise revenue for public projects. © 2007 Thomson South-Western How Taxes on Buyers (and Sellers) Affect Market Outcomes Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. © 2007 Thomson South-Western How Taxes on Buyers Affect Market Outcomes Elasticity and tax incidence Tax incidence is the manner in which the burden of a tax is shared among participants in a market. © 2007 Thomson South-Western How Taxes on Buyers Affect Market Outcomes Elasticity and Tax Incidence Tax incidence is the study of who bears the burden of a tax. Taxes result in a change in market equilibrium. Buyers pay more and sellers receive less, regardless of whom the tax is levied on. © 2007 Thomson South-Western  Figure 6 A Tax on Buyers Price of Ice-Cream Price Cone Supply, S1 buyers pay $3.30 Equilibrium without tax Tax ($0.50) Price 3.00 A tax on buyers without 2.80 shifts the demand tax curve downward by the size of Price Equilibrium the tax ($0.50). sellers with tax receive D1 D2 0 90 100 Quantity of Ice-Cream Cones © 2007 Thomson South-Western  Figure 7 A Tax on Sellers Price of Ice-Cream A tax on sellers Price Cone Equilibrium S2 shifts the supply buyers with tax curve upward pay by the amount of $3.30 S1 Tax ($0.50) the tax ($0.50). Price 3.00 without 2.80 Equilibrium without tax tax Price sellers receive Demand, D1 0 90 100 Quantity of Ice-Cream Cones © 2007 Thomson South-Western Elasticity and Tax Incidence What was the impact of tax? Taxes discourage market activity. When a good is taxed, the quantity sold is smaller. Buyers and sellers share the tax burden. © 2007 Thomson South-Western  Figure 8 A Payroll Tax Wage Labor supply Wage firms pay Tax wedge Wage without tax Wage workers receive Labor demand 0 Quantity of Labor © 2007 Thomson South-Western Elasticity and Tax Incidence In what proportions is the burden of the tax divided? How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply. © 2007 Thomson South-Western Figure 9 How the Burden of a Tax Is Divided (a) Elastic Supply, Inelastic Demand Price 1. When supply is more elastic than demand... Price buyers pay Supply Tax 2.... the incidence of the Price without tax tax falls more heavily on Price sellers consumers... receive 3.... than Demand on producers. 0 Quantity © 2007 Thomson South-Western Figure 9 How the Burden of a Tax Is Divided (b) Inelastic Supply, Elastic Demand Price 1. When demand is more elastic than supply... Price buyers pay Supply Price without tax 3.... than on consumers. Tax 2.... the Demand Price sellers incidence of receive the tax falls more heavily on producers... 0 Quantity © 2007 Thomson South-Western Elasticity and Tax Incidence So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic. © 2007 Thomson South-Western  Summary Price controls include price ceilings and price floors. A price ceiling is a legal maximum on the price of a good or service. – An example is rent control. A price floor is a legal minimum on the price of a good or a service. – An example is the minimum wage. © 2007 Thomson South-Western  Summary Taxes are used to raise revenue for public purposes. When the government levies a tax on a good, the equilibrium quantity of the good falls. A tax on a good places a wedge between the price paid by buyers and the price received by sellers. © 2007 Thomson South-Western  Summary The incidence of a tax refers to who bears the burden of a tax. The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. The burden tends to fall on the side of the market that is less elastic. © 2007 Thomson South-Western © 2007 Thomson South-Western The Costs of Production The Market Forces of Supply and Demand – Supply and demand are the two words that economists use most often. – Supply and demand are the forces that make market economies work. – Modern microeconomics is about supply, demand, and market equilibrium. © 2007 Thomson South-Western WHAT ARE COSTS? According to the Law of Supply: – Firms are willing to produce and sell a greater quantity of a good when the price of the good is high. – This results in a supply curve that slopes upward. © 2007 Thomson South-Western WHAT ARE COSTS? The Firm’s Objective – The economic goal of the firm is to maximize profits. © 2007 Thomson South-Western Total Revenue, Total Cost, and Profit Total Revenue The amount a firm receives for the sale of its output. Total Cost The market value of the inputs a firm uses in production. © 2007 Thomson South-Western Total Revenue, Total Cost, and Profit Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost © 2007 Thomson South-Western Costs as Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm. © 2007 Thomson South-Western Economic Profit versus Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. © 2007 Thomson South-Western Economic Profit versus Accounting Profit When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit. © 2007 Thomson South-Western  Figure 1 Economists versus Accountants How an Economist How an Accountant Views a Firm Views a Firm Economic profit Accounting profit Implicit Revenue costs Revenue Total opportunity costs Explicit Explicit costs costs © 2007 Thomson South-Western PRODUCTION AND COSTS 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. © 2007 Thomson South-Western The Production Function Marginal Product The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. © 2007 Thomson South-Western The Production Function Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. © 2007 Thomson South-Western  Figure 2 Hungry Helen’s Production Function Quantity of output 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 Number of Workers Hired © 2007 Thomson South-Western The Production Function Diminishing Marginal Product The slope of the production function measures the marginal product of an input, such as a worker. When the marginal product declines, the production function becomes flatter. © 2007 Thomson South-Western From the Production Function to the Total-Cost Curve The relationship between the quantity a firm can produce and its costs determines pricing decisions. The total-cost curve shows this relationship graphically. © 2007 Thomson South-Western Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory © 2007 Thomson South-Western  Figure 2 Hungry Helen’s Total-Cost Curve Total Cost 100 90 80 70 60 50 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 Quantity of Output (cookies per hour) © 2007 Thomson South-Western THE VARIOUS MEASURES OF COST Costs of production may be divided into fixed costs and variable costs. – Fixed costs are those costs that do not vary with the quantity of output produced. – Variable costs are those costs that do vary with the quantity of output produced. © 2007 Thomson South-Western Fixed and Variable Costs Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC © 2007 Thomson South-Western Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand © 2007 Thomson South-Western Fixed and Variable Costs Average Costs Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. © 2007 Thomson South-Western Fixed and Variable Costs Average Costs Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC © 2007 Thomson South-Western Average and Marginal Costs Fixed cost FC AFC = = Quantity Q Variable cost VC AVC = = Quantity Q Total cost TC ATC = = Quantity Q © 2007 Thomson South-Western Average and Marginal Costs Marginal Cost Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? © 2007 Thomson South-Western Average and Marginal Cost (change in total cost) TC MC = = (change in quantity) Q © 2007 Thomson South-Western Thirsty Thelma’s Lemonade Stand Note how Marginal Cost changes with each change in Quantity. Quantity Total Marginal Quantity Total Marginal Cost Cost Cost Cost 0 $3.00 — 1 3.30 $0.30 6 $7.80 $1.30 2 3.80 0.50 7 9.30 1.50 3 4.50 0.70 8 11.00 1.70 4 5.40 0.90 9 12.90 1.90 5 6.50 1.10 10 15.00 2.10 © 2007 Thomson South-Western Figure 3 Thirsty Thelma’s Total-Cost Curves Total Cost $15.00 Total-cost curve 14.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) © 2007 Thomson South-Western Cost Curves and Their Shapes Marginal cost rises with the amount of output produced. This reflects the property of diminishing marginal product. © 2007 Thomson South-Western Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. © 2007 Thomson South-Western Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost The marginal-cost curve crosses the average-total- cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost. © 2007 Thomson South-Western Figure 5 Cost Curves for a Typical Firm Marginal Cost declines at first and then Costs increases due to diminishing marginal product. $3.00 AFC, a short-run concept, declines throughout. 2.50 Note how MC hits both ATC and AVC at their minimum points. MC 2.00 1.50 ATC AVC 1.00 0.50 AFC 0 2 4 6 8 10 12 14 Quantity of Output © 2007 Thomson South-Western Typical Cost Curves Three Important Properties of Cost Curves Marginal cost eventually rises with the quantity of output. The marginal-cost curve crosses the average-total- cost curve at the minimum of average total cost. © 2007 Thomson South-Western Cost Curves and Their Shapes The average total-cost curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. © 2007 Thomson South-Western Cost Curves and Their Shapes The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. © 2007 Thomson South-Western COSTS IN THE SHORT RUN AND IN THE LONG RUN For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. – In the short run, some costs are fixed. – In the long run, all fixed costs become variable costs. Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves. © 2007 Thomson South-Western Economies and Diseconomies of Scale Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases. © 2007 Thomson South-Western  Figure 6 Average Total Cost in the Short and Long Run Average Total ATC in short ATC in short ATC in short Cost run with run with run with small factory medium factory large factory ATC in long run $12,000 10,000 Economies Constant of returns to scale scale Diseconomies of scale 0 1,000 1,200 Quantity of Cars per Day © 2007 Thomson South-Western  Summary The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. Some opportunity costs are explicit while other opportunity costs are implicit. © 2007 Thomson South-Western  Summary A firm’s costs reflect its production process. – A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. – A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced. © 2007 Thomson South-Western  Summary Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost always rises with the quantity of output. Average cost first falls as output increases and then rises. © 2007 Thomson South-Western  Summary The average-total-cost curve is U-shaped. The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run. © 2007 Thomson South-Western © 2007 Thomson South-Western WHAT IS A COMPETITIVE MARKET? A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. – Buyers and sellers must accept the price determined by the market. © 2007 Thomson South-Western The Meaning of Competition A perfectly competitive market has the following characteristics: There are many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market. © 2007 Thomson South-Western The Meaning of Competition As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given. © 2007 Thomson South-Western The Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = (P  Q) Total revenue is proportional to the amount of output. © 2007 Thomson South-Western The Revenue of a Competitive Firm Average revenue tells us how much revenue a firm receives for the typical unit sold. Average revenue is total revenue divided by the quant