econ101 - fall 2013

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ECON101Microeconomics

Section: 008

Instructor:

Name: Shadab Qaiser

Office: HH104

Office Hours: Tuesdays, Thurdays at 6:00PM-7:00PM or by appointment

Email: [email protected] (put "Econ 101" and full name in subject)

T.A.: Greg

12/9/13

Economics

Economy - one who manages a household

Economics is the study of how society manages scarce resources. Society has limited resources and can't produce all the goods and

services everyone wishes to have. Economics is a social science.

Scarcityis the inability to satisfy all of our wants. Economics studies the choices that we make in the face of scarcity. These choices areinfluenced by incentives.

An incentiveis a reward that encourages an action, or a penalty that discourages an action. An incentive pushes people to act in a

certain way. A disincentiveis another word for a negative incentive.

There are two main parts to economics:

Microeconomics: the study of the individual part of the economy - how individuals and entities make decisions and how they act

individually. It studies the choices and the interactions and influence of these choices.

Macroeconomics: the study of the performance of economies on the large scale. It studies phenomena such as inflation,

unemployment, and growth.

Resourcesare anything that can be used to produce something else. Resources are scarce. This may include life, land, labour,

buildings, machines, etc.

The big questions of economics are what to produce, how to produce it, and for whom to produceindividuals deal with economicactions.

Microeconomics

Who will work?

What and how much goods should be produced?

What resources are needed in production?

What price should goods be sold at?

These questions are dealt with in the field of microeconomics.

Goods and servicesare the things that people value and produce to satisfy needs and wants.
http://c/Users/Anthony/Dropbox/School/University-Notes/

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Canadian production:

Agriculture:

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Leisure vs. education: If we take less leisure time, we can educate and train ourselves to be able to become more productive and earn

higher income in the future.

Production vs. research: if a business produces less today and devote resources to research and development, they can produce more

in the future.

A choice or tradeoff is essentially an opportunity given up for another. The missed opportunity with the highest value (the best

alternative to the chosen option) is the opportunity costof the choice. It is the cost of not taking the second best option.

The cost of something is what is given up to get it.

Incentives

Rational people make choices at the margin; they look at the consequences of making incremental changesin usage of resources.

For example, the decision whether to buy something might depend on the cost of buying it, compared to the benefit of buying it.

People look at doing the next unit of something, rather than looking at and considering everything in the past.

The benefit from incremental increase is the marginal benefit.

The marginal benefit curvemeasures the marginal benefit as units of a good or service available changes. It measures the most

people are willing to pay for one more unit of a good or service, and is not derivable from the PPF.

The opportunity cost from an incremental increase (benefit of not pursuing the increase) is the marginal cost.

Example: speeding tickets give a negative incentive against speeding, which goes against the social interest.

If an economy is operating on the PPF, one good cannot be produced without giving up another. So as the marginal benefit of a good

or service decreases, its marginal cost increases. If they are equal, we say that the economy is working at allocative efficiency. This is

where the graphs of marginal cost and benefit intersect. This is efficient because the most possible people get access to the good, while

each one enjoys a benefit.

For example, at allocative efficiency, the pizzas would be worth a number of colas such that if more pizzas were produced, they would

not be worth the cola foregone, and if more colas were produced, they would not be worth the pizza foregone.

Choices respond to incentives. If the marginal benefit exceeds the marginal cost for a certain activity, people have an incentive to

perform it. Otherwise, people have an incentive not to perform it. Incentives are hugely useful in aligning self-interest and the

social interest.

Economic way of thinking: human nature is a given, and people always act in their self interest, which are not necessarily selfish

actions. The role of institutions is to create incentives for people to behave in the social interest.

Institutionsare rules and laws that define incentive structures in society and govern the behaviour of people and groups. Institutions

have many different qualities:

Political institutions: democracy, accountability, human rights, freedoms.

Economic institutions: property rights and contract enforcement, financial policy.

Other: corruption control, rule of law, civil order.

Social Science

Positive statementsare statements about the way things are. They can be tested by checking them against facts.

Normative statementsare statements about how things ought to be. They cannot be tested.

Economists might disagree about the validity of various positive statements, about the way things are. They may also disagree about

how things should be, and have different views on different normative statements.

Economics is about thinking in terms of alternatives, evaluating choices, and discovering how certain events and issues are related.

Economics tries to find the cause and effects for economic phenomena.

Economic science tries to discover positive statements that are consistent with what we observe in the world. It creates and tests

economic models.

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Economic Models

Economic models are used to simplify reality in order to improve understading, and to make predictions about potential economic

outcomes.

Scientific thinking requires deciding which assumptions to make. Economic models almost always require at least a few assumptions.

A model is tested by comparing its predictions with facts. However, this is difficult, so economists also use natural experiments

(observing natural phenomena), statistical investigations (statistical analysis of data), economic experiments (applying various

incentives and seeing the result).

Economics applies to personal, business, and government economic policies. It affects the decisions made about what, how, and for

whom things are done.

Production Possibility Frontier

PPF (Production Possibility Frontier), also known as PPB (Production Possibilities Boundary) is a simple economic model.

It is a 2D graph with each axis representing the units of a given good or service produced. There is a clearly defined boundary at the

edge of being unattainable that represents the maximum efficiency of the economy.

The graph is investigated in a model economy focusing on two goods, pretending that the value of all other goods are held constant.

Cola vs. Pizza Production

v 15 million

|

| Unattainable

|####

C |#########

o |############

l |################

a |#####################

|##### Attainable ########

|############################

|##############################

|___________________________________

0 Pizza ^ 5 million

All points in the shaded regions are attainable, while all others are not. Producing more of one good results in fewer resources

available for the other. To produce more pizza, we need to produce less cola, and vice versa.

The efficiencyof the economy is determined by how close the economy works to the frontier. The goal is to have an economy that

works on the frontier, the boundary of maximum efficiency.

A point inside the shaded region is inefficient. At this point, resources are either unemployed or misallocated.

Production efficiency is achieved when efficiency is at 100% - the economy is on the frontier.

Changes to various actors of production affect the graph.

For example, if a new technology is created to produce cola more efficiently, the PPF graph will be stretched along the Y axis. Likewise,

if the labour force increased, the graph stretches in both axes.

Opportunity Cost

The opportunity costof making more pizzas is the colas not produced.

If by producing 1 million more pizzas (moving 1 unit right), we produce 5 million fewer colas (moving 5 units down), the cost of those

pizzas is 5 colas each. Likewise, by moving 5 units down, we produce 1 million fewer pizzas, the cost of one cola is 1/5 pizzas.

This cost is not necessarily fixed, and depends on the current state of the economy. The slopeof the frontier determines the cost. For

example, if the graph is quadratic, the cost of pizzas increases linearly as more are produced.

Graph Shape

This graph is concave - this means that as the quantity of the good produced increases, so does its cost.

If the graph is convex, the cost of producing a good goes down as the quantity produced increases.

In other words, if the resources invested are more productive in one product than another, the graph is curved. This is because as we

produce more of one good, we must use resources that are less suited to producing this good and more suited for the other good, so

the opportunity cost is greater.

If the cost stays the same regardless of quantity, the graph is a straight downwards line - it is linear.

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Demand

Supply and demand are very common terms in economics - they are the forces that make the markets work. Microeconomics is the

study of supply, demand, and market equilibrium.

A marketis a group of buyers and sellers of a particular good or service, and an arrangement where they can get information and do

business with each other. Supply and demand describes the behaviour of people as they interact in markets.

A competitive marketis a market with many buyers and sellers, so no single entity can influence prices.

The money priceof a good is the amount of money needed to buy it.

The relative priceof a good is the ratio of its money price to the money price of the next best alternative. This is the opportunity cost

of buying something.

If you demandsomething, you want it, can afford it, and plan to buy it. This contrasts with wants, which are unlimited wishes or

desires. The quantity demandedis the amount buyers are willing and able to purchase, in a given time period and price.

Law of Demand

All other things being equal, price is inversely correlated to quantity demanded.

This is a result of the substitution effect and the income effect.

The substitution effectis a phenomena that occurs when the relative price of a good or service increases, and as a result, people seek

substitutes for it, reducing the quantity demanded.

The income effectis a phenomenon that occurs when the relative price of a good or service increases compared to income, so peoplecannot afford it as much, reducing the quantity demanded.

The demand curveshows the relationship between the relationship between the quantity demanded of a good and the largest price

people are willing to pay for it, all other influences on consumers' planned purchases remain the same. The demand scheduleis the

table of values for this curve.

It slopes downward because more people demand a product when the price is lower, and fewer people demand a product when the

price is higher.

Demand is a measure of marginal benefit - the willingness and ability to pay given a marginal cost - the price.

For example, the demand curve for energy bars might appear as follows:

Price vs. Demand

v 3.00

||....

P | .....

r | ....

i | ....

c | ....

e | .....

| ...

|________________________________________

0 Demand ^ 25 million

Demandrefers to the relationship between quantity demanded and the price - the demand curve. The quantity demandedis the

quantity demanded at a particular price - the X axis on the demand curve.

The demand curve measures the marginal benefit, the benefit from consuming one more unit of a good or service. For example, the

marginal benefit of money is the best good or service that can be bought with it.

When an influence other than the price of a good changes, there is a change in demand.

Change is demand is different from a change in quantity demanded. Change in demand is a change in the demand curve, while a

change in quantity demanded is simply movement along the non-changing demand curve.

When demand increases, the graph shifts rightwards.

When demand decreases, the graph shifts leftwards.

A substituteis a good that replaces another good. A complementis a good that is used together with another good.

The price of a good is inversely correlated to the price of its substitutes, and correlated to the price of its complements.

If the price of a good is expected to rise, then current demand increases - consumers want to buy at the lower price before it rises.

When incomeincreases, consumers buy more of certain goods. These are called normal goods. Some goods, however, are bought

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less often as income increases. These are called inferior goods. Likewise with expected increases in income, or credit.

Populationis directly correlated to demand. The more people, the more demand.

All other factors being equal, people have different demands due to personal preferences.

Supply

A firm supplies a good or service if it has the resources/technologyto produce it, can profitfrom it, and plansto do so.

The quantity supplied is the amount that the producers plan to sell during a given time period and price.

Law of Supply

All other things being equal, price is correlated to quantity supplied.

This is a result of the general tendency for the marginal cost of producing a good or service to increase with increases in quantity

produced.

Producers will only supply a good if they can at least cover the marginal cost of production - if they can profit from it.

The supply curveshows the relationship between the quantity supplied of a good and the price it is sold at, all other influences

remaining the same. The supply scheduleis the table of values for this curve.

For example, the supply curve for energy bars might appear as follows:

Price vs. Quantity Supplied

v 3.00 |

| ....

P | .....

r | ....

i | ....

c | ....

e | .....

|...

|________________________________________

0 Supply ^ 25 million

Supplyrefers to the relationship between the quantity supplied and the price, all other influences held constant. The quantity

suppliedis the quantity supplied at a particular price - the X axis on the supply curve.

The lowest price anyone is will ing to sell a unit is the marginal cost of production.

Like with demand, there are many influences that affect supply. A change in supply caused by one of these factors, other than price, iscalled a change in supply.

Change is supply is different from a change in quantity supplied. Change in supply is a change in the supply curve, while a change in

quantity supplied is simply movement along the non-changing supply curve.

When supply increases, the graph shifts rightward.

When supply decreases, the graph shifts leftward.

The price is correlated to the price of production.

A substituteis an alternative good that can be produced using the same resources as the good. A complementis a good that must

be produced together with the good.

The price is inversely correlated to the price of its substitutes, and correlated to the price of its complements.

If the price of the good is expected to rise, the current supply decreases - suppliers want to wait to supply the good or service at a

higher price.

Supply is correlated to the number of suppliers.

Advances in technologycan lower costs of production, and increase supply.

Supply is influenced by the state of nature- weather, natural disasters, etc. A hurricane might reduce supply by destroying factories.

Equilibrium

Market equilibriumoccurs when the quantity demanded is equal to the quantity supplied.

The equilibrium priceis the price at which equilibrium occurs.

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The equilibrium quantityis the quantity bought and sold at equilibrium.

If the quantity supplied exceeds the quantity demanded, there is a surplusof the good or service. This forces the price down.

If the quantity demanded exceeds the quantity supplied, there is a shortage of the good or service. This forces the price up.

At equilibrium, the plans of the buyers and sellers agree and the price remains constant.

Price vs. Supply & Demand

v 3.00

|

| *** ....

P | ***** .....

r | **** ....i | ...X**

c | .... ^ ****

e | ..... | *****

|... Equilibrium ***

|________________________________________

0 Quantity ^ 25 million

A price flooris the lower limit imposed on the price of a good or service. For example, the minimum wage is the price floor of labour.

Increases in demand shift the demand graph rightward, raising the price and quantity.

Increases in supply shifts the supply graph rightward, reducing the price and raising the quantity.

Demand is correlated to price and quantity.

Supply is inversely correlated to priceand correlated to quantity.

Increases in both supply and demand: the quantity increases, but the price change is uncertain because supply decreases price, and

demand increases it.

In Summary

Increases in demand and decreases in supply increase equilibrium price and quantity.

Decreases in demand and increases in supply decrease equilibrium price and quantity.

Increases in both demand and supply increase quantity.

Decreases in both demand and supply decrease quantity.

Increases in demand and decreases in supply increase price.

Decreases in demand and increases in supply decrease price.

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Elasticity

What are the effects of high gas prices on buying plans?

Elasticity is the measure of how responsive buyers and sellers are to changes in market conditions.

We measure how the quantity demanded and supplied is affected by changes in price, income, or price of related goods.

Own price elasticity of demand

Price elasticity of demandis the ratio of the percentage change in quantity demanded per percentage change in price. The

percentage change is a percentage of the average of the initial and new values. This is also known as own price elasticity.

Dimensionless value, a ratio.

Negative due to law of demand.

Values larger in magnitude mean higher sensitivity to price changes.

Values smaller in magnitude mean lower sensitivity to price changes.

Values larger in magnitude than 1 are called elastic demand.

Values smaller in magnitude than 1 are called inelastic demand.

Values equal in magnitude to 1 are called unit elastic demand.

Values of 0 are called perfectly inelastic demand.

Values of are called perfectly elastic demand.

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For perfectly inelastic demand, the demand curve is vertical. The quantity demanded is the same regardless of the price. For example,

life-saving surguries need to be bought regardless of the price.

For perfectly elastic demand, the demand curve is horizontal. The quantity demanded is highly dependent on the price. For example, in

agriculture markets a slight decrease in price means much more demand.

According to the law of demand, the own price elasticity is always negative. This is because demand is inversely correlated to price.

Elasticity is not the same thing as the slope of the demand curve. It measures percentage changes. Consider a linear demand curve:

Price vs. Quantity

v 3.00

|

| ***

P | ***** Inelastic

r | **** v-----------v

i | *****

c | ----------- ^ ****

e | Elastic | *****

| Unit Elastic ***

|________________________________________


At low prices, a given change in price is a larger percentage of the average price. Likewise, a given change in demand is a larger

percentage of the average demand at lower demand.

At quantity demanded being 0, there is perfect elasticity. At price being 0, there is perfect inelasticity.

The price of milk increases 2% and the quantity demanded decreases by 0.5%.

So the elasticity is , or .

In general, goods and services that are necessities or in uncompetitive markets have inelastic demand, since people need them

even if they're expensive.

In general, goods and services that are luxuries or in highly competitive markets have elastic demand, since people have a lot of

choice with whether to buy these things.

In general, goods and services with close substituteshave elastic demand. For example, Coca Cola and Pepsi.

Over longer amounts of time between price changes, goods and services tend to be more elastic - people can find more

substitutes with more time. In other words, the longer consumers have had time to adjust to a price change, or the longer the good can

be stored without losing its value, the more elastic is the demand.

Narrowly defined marketsare more elastic than broader ones. For example, demand for food is inelastic, but demand for broccoli is

elastic.

Goods on which a larger proportion of budgets are spenttend to be more elastic. For example, demand for cars is more elastic than

groceries.

Revenue

Revenue is the product of price with quantity. The goal is to maximize revenue.

When demand is elastic, there is an incentive to reduce prices. This is because any given reduction in price has a larger increase in

demand, so revenue would increase.

When demand is inelastic, there is an incentive to raise prices. This is because any given rise in price has a smaller decrease in demand,

so revenue would increase.

Revenue is maximized at unit e lasticity- when revenue would decrease from any changes in the price.

o w n e l a s t i c i t y =

% c h a n g e i n d e m a n d

% c h a n g e i n p r i c e

% c h a n g e i n d e m a n d =

n e w d e m a n d o l d d e m a n d

n e w d e m a n d + o l d d e m a n d

2

% c h a n g e i n p r i c e =

n e w p r i c e o l d p r i c e

n e w p r i c e + o l d p r i c e

2

0 . 5

2

1

4

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Price vs. Quantity

v 3.00

|

R | ....X....

e | ... ^ ...

v | .. | ..

e | . Unit Elasticity .

n | . | .

u | . Elastic | Inelastic .

e |. | .

|________________________________________


Real elasticities: furniture is 1.26, motor vehicles is 1.14, clothing is 0.64, and oil is 0.05.

Cross price elasticity of demand

This measures the effect changes in the price of substitutes and complements on demand.

Instead of using the percentage change in the price of a good itself, we use the percentage change in the price of a substitute or a

complement.

Using this, we can determine whether a good is a substitute or a complement:

Positive cross elasticity means the good is a substitute.

Negative cross elasticity means the good is a complement.

A zero cross elasticity means the good is unrelated.

Income elasticity of demand

This measures the effect of changes in income on demand.

Instead of using the percentage change in the price of a good itself, we use the percentage change in income.

Using this, we can determine whether a good is a normal good or an inferior good:

Positive income elasticity means the good is a normal good - greater demand as income increases.

Negative income elasticity means the good is an inferior good - lesser demand as income increases.

Income elasticity less in magnitude than 1 is income inelastic.

Income elasticity greater in magnitude than 1 is income elastic.

Income elasticity equal in magnitude to 1 is income unit elastic.

Own price elasticity of supply

The elasticity of supplymeasures the responsiveness of the quantity supplied to a change in the price of a good, all other influences

being constant.

c r o s s e l a s t i c i t y =


% c h a n g e i n p r i c e o f s u b s t i t u t e o r c o m p l e m e n t




2

% c h a n g e i n p r i c e o f s u b s t i t u t e o r c o m p l e m e n t =

n e w p r i c e o f s u b s t i t u t e o r c o m p l e m e n t o l d p r i c e o f s u b s t i t u t e o r c o m p l e m

n e w p r i c e o f s u b s t i t u t e o r c o m p l e m e n t + o l d p r i c e o f s u b s t i t u t e o r c o m p l e m e n t

2

i n c o m e e l a s t i c i t y =






2

% c h a n g e i n i n c o m e =

n e w i n c o m e o l d i n c o m e

n e w i n c o m e + o l d i n c o m e

2

o w n e l a s t i c i t y =

% c h a n g e i n s u p p l y


% c h a n g e i n s u p p l y =

n e w s u p p l y o l d s u p p l y

n e w s u p p l y + o l d s u p p l y

2

% c h a n g e i n p r i c e =

n e w p r i c e o l d p r i c e

n e w p r i c e + o l d p r i c e

2

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Resources are allocated based on characteristics of individuals.

For example, people might choose their friends and partners based on their characteristics. On the other hand, it might be used in

unacceptable ways, like racism and sexism.

Force

Resources are allocated based on the strongest.

For example, war, revolution, theft, and robbery allocate resources to the takers.

This is an effective but inefficient way to allocate resources, and makes the creation of markets possible.

There is no single resource allocation mechanism resulting in full efficiency.

Demand and Marginal Benefit

Valueis what we get. Priceis what we pay.

The value of obtaining one more unit of a good or service is the marginal benefit.

We measure value as the maximum pricethat a person is will ing to pay.

Demand is determined by the willingness to pay. So a demand curve is a marginal benefit curve.

Individual demandis demand in terms of one consumer. Market demandis demand in terms of all the buyers in the market. The

quantity demanded for market demand is the sum of all the quantities demanded for each buyer.

Supply and Marginal Benefit

Costis what the producer gives up. Priceis what the producer receives.

The cost of obtaining one more unit of a good or service is the marginal cost.

We measure cost as the minimum costthe producer is willing to accept.

Supply is determined by the minimum supply price. So a supply curve is a marginal cost curve .

Individual supplyis supply in terms of one producer. Market supplyis supply in terms of all the sellers in the market. The quantity

supplied for market supply is the sum of all the quantities supplied for each producer.

10/10/13Profit is total revenue minus total cost.

Total revenue is price times quantity.

Surplus/shortage

Consumers

The consumer surplusfor a given person is the area between the amount willing to be paid for a good/service and the actual pricethat must be paid for it. It is the amount someone is willing to pay above the actual price.

Price vs. Quantity Demanded

v 3.00

|

|....

P | .....

r | ####....

i | ########....

c |-----------------....---------

e | ^ .....

| Consumer surplus ...

|________________________________________

0 Quantity Demanded ^ 10

This means the consumer saved 2 units on the first 4 units he or she wanted to buy, and 1 unit on the next 4 units, before the price is

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the maximum he or she is willing to pay.

When there is a consumer surplus, suppliers raise prices to reduce the surplus and therefore make more profit.

Producers

Producer surplusis the area between the price received for selling a good and the minimum supply-price, summed over the quantity

sold. It is the price above what it actually costs to produce.


v 3.00

| Producer surplus

| v ....P |--------------------.....--------

r | ###########....

i | #######....

c | ###....

e | .....

|...

|________________________________________

0 Supply ^ 25 million

This means the producer made 3 extra units of profit for the first units, 2 extra units on the next 4, and 1 on the next 4.

When there is a producer surplus, competitors are willing to sell for less and therefore make more profit by selling more. This causes

prices to be reduced.

Equilibrium

Markets are efficient when marginal cost equals the marginal benefit - when quantity supplied equals quantity demanded. This is

efficient because consumer surplus plus producer surplus - the total surplus - is at its highest.

When there is underproduction or overproduction, the total surplus is reduced and efficiency lowers. The reduction in surplus is a

social loss known as deadweight loss.

Underproduction and overproduction can occur for a few reasons:

Price/quantity regulationsmay limit price or production quantities to a certain value and lead to underproduction.

Taxesincrease the price paid by buyers and reduce the prices received by sellers, leading to underproduction. Subsidiesdecrease the

prices pair by buyers and increase the prices received by sellers, leading to overproduction.

Externalitiesare costs/benefits affecting someone other than the producer or consumer, such as acid rain caused by pollution. The

producer, acting out of self interest, does not consider this cost and overproduces or underproduces.

Public goodsbenefit and are available to everyone. The free-rider problemstates that everyone wants to use the good, but nobody

wants to pay for it, leading to underproduction.

Common goodsare owned by nobody and can be used by everyone. The tragedy of the commonsstates that each user ignores the

costs that fall on everyone, leading to overproduction.

Monopoliesare the only provider of a particular good or service. As a result, there are no competitors to force them to lower prices,

leading to underproduction.

Transaction costscause underproduction due to the additional overhead of making each trade.

Fairness

Fairness can be categorized into two main groups.

The first states that fairness only occurs when the result is fair. The view that equality is fairness is known as utilitarianism- that

we should attempt to achieve the greatest happiness for the most people.

According to this view, since marginal benefit of income decreases as income increases, and everyone gets the same marginal benefit

from the same income, then taking wealth from the rich and giving it to the poor increases total benefit. Equal income means

maximum benefit.

The second states that fairness only occurs when the rules are fair. This is based on the symmetry principle- similar situations

should be treated similarly.

According to this view, there should be equality of opportunity. So private property should be protected, and exchange should be

purely voluntary.

Government Intervention

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Price controls

Price controls are put in place when policy makers think prices are unfair to buyers or sellers. They limit prices to a certain range to try

to increase total benefit.

For example, a rent ceilingmight be used to ensure poorer people can afford housing if normal market prices are too high.

If the ceiling is above or equal to the equilibrium price, the market is unaffected since it will continue to operate at the equilibrium

price.

If the ceiling is below the equilibrium price, supply is decreased and demand is increased. This causes a shortage, but it cannot be

resolved because the price cannot be raised.

In shortages, there is also the cost of search activity- the effort of finding someone to do business with.

A rent ceiling is unfair because it blocks voluntary exchange and does not benefit everyone. Since the resources cannot be allocated by

the market properly, they are then allocated by other means like lottery, which are less efficient and fair.

Another example would be the minimum wage, which sets a price floor on labour.

If the floor is below or equal to the equilibrium price, the market is unaffected since it will continue to operate at the equilibrium price.

If the floor is above the equilibrium price, supply is increased and demand is increased. This causes a surplus, but it cannot be resolved

because the price cannot be lowered.

As a result, people have trouble finding jobs, since not enough employers are willing to pay the minimum wage.

Price floors lead to overproduction. These surpluses are wasted since they can't be put on the open market, since there isn't enough

demand.

Taxes

Taxes can reduce supply and demand, when applied to the supplier and consumer, respectively.

Taxes include income tax, HST, and social insurance tax (paid by employers).

Tax incidenceis the way the burden of taxes is divided between buyers and sellers. If the price rises by the full amount of the tax,

buyers pay the tax. If the price doesn't rise, the sellers pay the price.

This depends on elasticity - the more inelastic the demand, the more the burden of the tax is put on the buyer. Perfectly inelastic

demand means buyers pay the tax. Perfectly elastic demand means sellers pay the tax.

Taxes on suppliers shift the supply curve upward.

Taxes on consumers shift the demand curve down.

Taxes are usually put on goods and services with inelastic supply or demand. Gasoline has inelastic demand, so the buyer pays more of

the tax, while labour has inelastic supply, so the employer pays more of the tax.

Price vs. Supply & Demand

v 3.00

| Quantity with tax

| ***| ....

P |####***** .....

r |$$$$|$$$$**** ....

i |$$$$|$$$$$$$...X** # represents surplus with tax

c |$$$$|$$$.... ^ **** $ represents difference in surplus from without tax

e |###..... | *****

|... | Equilibrium ***

|________________________________________


There are conflicting principles of fairness when considering a tax system:

people should pay taxes according to the benefits they receive from them - taxes based on use

people should pay taxes according to their ability to bear the burden of the tax - taxes based on income

Subsidies

Subsidies act like taxes, but have the opposite effect.

They shift the supply curve down and the demand curve up.

Quotas

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Quotas restrict the quantity that can be sold, generally an upper limit.

For example, fishing licenses limit how much fish can be sold in order to prevent overfishing. This increases the price paid by the

consumer because quantity supplied is restricted.

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Utility and Demand

Choices made by consumers can be categorized into consumption possiblitiesand preferences.

Utility

Utilityis the satisfaction or benefit obtained by consuming a good or service. We can give it an imaginary unit to quantify and

measure it. This is like temperature, which is also an abstract concept we measure with arbitrary units.

For example, the first sip of a drink might give 50 utility units, the second 80 utility units, and the twentieth 30 utility units.

Total utilityis the total benefit obtained by consuming a good or service. In general, total utility is correlated with quantity

consumed.

Marginalmeans "change in".

Marginal utilityis the change in total utility caused by consuming one more unit of a good or service. In other words, it is the benefit

received from consuming one more unit of a good or service.

The principle of diminishing marginal utilitystates that as quantity consumed increases, the marginal utility decreases.

Marginal utility per dollar of a good or service is the marginal utility from spending one more dollaron the good or service. It is

equivalent to the marginal utility of a good ( ) divided by its price ( ).

Consumption possibilities

This measures everything that is possible for a consumer to consume, given constraints such as time and money. We can represent it

using something similar to the PPF - we call this the budget line.

The budget line shows various combinations that income can be spent on two particular goods or services, everything else remaining

the same.

Monthly Cola vs. Pizza Consumption

v 30

|

| Unaffordable

|####

C |#########

o |############

l |################

a |#####################

|##### Affordable ########

|############################

|##############################

|___________________________________

0 Pizza ^ 15

When the spending takes place on the frontier - the budget line - the consumer has reached the limits of their consumption

possibilities. So the budget line represents the limits of consumption possibilities.

On the budget line, income ( ) equals expenditure (price of cola * quantity of cola + price of pizza times quantity of pizza -

). So .

Every consumer seeks to make choices that maximise utility. To find the total utility in the budget line shown above, we add the

utility obtained by the amount of cola and the utility obtained by the amount of pizza.

When a consumer is spending in a way that maximises utility, the situation is known as consumer equilibrium.

We can find consumer equilibrium by calculating the total utility of every combination and picking the one that results in the highest

value.

However, a more natural way to find consumer equilibrium is to compare the marginal utility per dollar of a good or service:

M UP

M

+ +

c

c

M= +

c

c

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When the marginal utility per dollar of cola is less than that of pizza, total utility would be increased by spending more on pizza.

When the marginal utility per dollar of pizza is less than that of cola, total utility would be increased by spending more on cola.

When the marginal utility per dollar of both are equal, there is consumer equilibrium .

This is because the more we spend on something, the less its marginal benefit, from the principle of diminishing marginal utility.

So to maximise utility, we spend all available incomeand equalize the marginal utility per dollarof all goods.

For example, if the price of pizza decreased, its marginal benefit per dollar increases and we would buy more of it to make it equal to

the marginal benefits per dollar of other goods.

Essentially, we want to ensure .

Marginal utility theory helps explain things like the paradox of value:

Why are diamonds more expensive than water, even though water is so essential, and diamonds not essential at all?

We distinguish between total utility and marginal utility to resolve the paradox.

The explanation is that we consume a lot of water, so marginal utility is small while total utility is large , while we consume

few diamonds, so marginal utility is large while total utility is small . However, note that the marginal utility per dollar is the

same for both water and diamonds.

The consumer surplus of water is very high while the consumer surplus of diamonds is very low.

24/10/13Review for first half. MIDTERM TOMORROW AT 4:30 PM COVERING CHAPTERS 4, 5, 6, 8

A determinantof something is a factor affecting it, like whether it happens or not.

Economics seek to optimize.

Organizing Production

A firmis an institution that hires and organizes factors of production to produce and sell goods and services.

The goal of a firm is to maximise profit. If it does not, it is eliminated or bought out by other firms .

Most firms don't make anything themselves. For example, Apple's iPod has its parts manufactured by Toshiba and is assembled by

Inventec.

Accountants are responsible for measuring profit - revenue minus explicit costs - to pay taxes and show investors how their funds are

being used.

Explicit costsare those costs paid directly to run the firm. Accountants do not take implicit costs into account and so may

overestimate profit.

Economists are concerned with implicit costs- the opportunity cost resulting from using something instead of renting or selling it.

The total costsare the sum of the implicit and explicit costs, and is always greater than or equal to the explicit costs.

The total costsare the explicit costs plus implicit costs.

Accounting profitis revenue minus explicit costs. Economic profitis revenue minus the total costs.

31/10/13A positive economic profit means that going ahead with the plan earns more than any other possible option.

AccountingCost = Wage*Labour + CapitalCost*CapitalAmount

=

M U

p i z z a

P

p i z z a

M U

c o l a

P

c o l a

C =W L

+ K

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A firm's opportunity cost of production is the value of the best alternative use of the resources used.

The three main types of opportunity costs for firms are:

bought in the market- the firm could have bought different resources to produce something different

owned by the firm- the firm could have sold or rented those resources, and using them means implicitly renting them from

themselves; the cost is called the implicit rental rateof the resource

supplied by the firm owner- the firm owner could supply entrepreneurship and labour, where the forgone profit for

entrepreneurship, or the forgone wages for labour, is an opportunity cost

The use of resources owned by the first incurs a cost from renting it from themselves - the cost of having had the potential of renting it

to other people. The cost is also made up of economic depreciationand forgone interest.

Economic depreciationis the change in the market value of some particular capital over time.

Interest forgoneis the interest that could have been earned using the funds used to the acquire the capital - the return on the funds

used to acquire the capital.

The return on entrepreneurship is profit. In other words, entrepreneurship earns profit.

The profit that an entrepreneur can expect to receive on average is known as normal profit. It is the opportunity cost of applying

entrepreneurship.

The wages given up by not taking wages for labour is the opportunity cost working at a firm.

Decisions made by Firms

A firm can make several different choices to maximise profit:

What and how much to produce.

How to produce.

How to organize and compensate managers and workers.

How to market and price products.

What to produce or buy from other firms.

Profit is l imited by constraints in technology , information, and markets:

Technologyis any method of producing a good or service. It tends to improve over time. With available technology, a firm can

only produce more if it hires more resources. This would increase costs and limits profits.

A firm never has complete informationabout the past, present, and future. The cost of coping with limited information limits

profit, such as not knowing the plans of its competitors or future consumer choices.

The price and quantity a firm can sell a product at depends on the customers' willingness to pay, and the prices and marketing of

the competition. The resources a firm can obtain is limited by the willingness of people to work or invest in it. The cost of

overcoming this l imits profits.

Technological efficiencyis the state in which it is impossible to decrease any inputs when holding other inputs constant.

Economic efficiencyis the state in which a firm produces a given amount of output with the least cost. This depends on the relative

costs of capital and labour.

Technological efficiency is concerned with the quantity of inputs, while economic efficiency is concerned with the costs of the inputs.

Economic efficiency implies technological efficiency, but it may not be the other way around.

Organization

A firm organizes production by combining and coordinating resources using command systemsand incentive systems.

Command systemsare systems where a firm issues commands to be completed by the resources. A firm would directly control theprocess of production.

Incentive systemsare systems where a firm provides incentives to induce the resources to behave in the desired way. A firm would

guide the process of production.

Most firms mix the systems, using command when it is easy to monitor performance, or when it is important to have the ideal

performance, and incentive systems when monitoring performance is impractical.

The principal-agent problemis the problem of finding incentives that induce agentsto act in the interests of principals. For

example, the managers of a firm are agents, and the goal is to induce them to act in the interest of the stockholders, the principals.

There are three main ways to do this:

Ownership- if managers (agents) are made also to be stockholders (principals), then they are induced to act in the interest of

the principals, themselves.

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Incentive pay- if the pay of workers/managers (agents) are linked to performance, then they are induced to perform better, in

the interest of the principals.

long-term contracts- if the long-term rewards of workers/managers (agents) is linked to the long-term success of the firm,

then they are induced to make the firm more successful, which is in the principals' interests.

There are three main types of business organization:

Sole proprietorship- a single owner with unlimited liability- they are responsible for all the debts of the firm - who receives

all of the profits and makes all the decisions. Profits are taxed the same as the owner's other income.

Partnership- two or more owners share unlimited liability, split profits somehow, and must agree on management decisions.

Profits are taxed as personal income.

Corporation- owned by one or more stockholders with limited liability- they are responsible only for what they invested

initially - who make decisions using some system and receive profits as dividendson their stocks. Profits are taxed twiceas

corporate tax on the firm, then income tax on the stockholders.

Sole proprietership generally dies with the owner; partnerships and corporations can still survive.

Market Types

Perfect competition

Identical product, many firms, many buyers, no barrier of entry for new firms, everyone informed of prices and products available.

Monopolistic competition

Similar product (known as product differentiation), many firms, no barrier of entry for new firms, each firm has some market power.

Oligopoly

Identical or similar product, few firms, barriers of entry limit new firms.

Monopoly

Product without close substitutes, one firm, barriers of entry prevent new firms.

Market concentrationis a measure of the amount of competition. High concentration means low competition; low concentration

means high competition.

We measure market concentration using:

Four-firm concentration ratio - percentage of total sales in the industry by the four largest firms.

Herfindahl-Hirschman Index - sum of squares of percentage market shares for largest 50 firms.

However, these do not reflect differences specific to geographic regions, barriers to entry, and relations with the industry. As a

result, they are not fully accurate in determining the structure of a market.

Markets and firms both coordinate production. An example of market coordination is outsourcing - buying parts or products from

other firms.

However, firms do more production because they are more efficient than markets. This is caused by:

Lower transaction costs- lower costs of finding someone to do business with and ensuring the transaction is successful.

Economies of scale- the cost of producing a good or service falls as a firm gets bigger. This does not violate the law of supply

because we are shifting the supply curve rightwards, rather than moving along it.

Economies of scope- specializing in a particular area allows lower costs of production.

Firms can engage in *team production**, where they each specialize in mutually supportive tasks.

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Output

The main objective of a firm is to maximize profit - the difference between total revenue and total cost.

Total revenue is the quantity times the price. Total cost is the explicit cost plus the implicit cost.

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Firms also face resource constraints.

Firms need to decide:

How much to produce.

How many people to employ.

How much capital and what kind of capital to use.

Decisions are made in two possible time frames:

A short-run periodis a time frame less than a year such that at least one resource is fixed.

For most firms, the plant (capital) is fixed in the short run and labour, raw materials, and energy are not.

Decisions made in the short run are easily reversed, since firms can take a temporary loss.A long-run periodis a time frame longer than a year such that all resources are variable.

The plant size can change in the long run.

Over time, substitutes and alternatives appear.

Decisions made in the long run are difficult to reverse, since losses cannot be sustained in the long run.

A sunk costis a cost incurred by a firm that cannot be recovered or changed. For example, if a firm's plant has no resale value, it is a

sunk cost. These costs are irrelevant to a firm's current decisions or the profit calculations.

Output

To increase output, a firm must increase capital or labour. The relationship between the amount of labour and output is described by

total product, marginal product, and average product.

Total productis the total output produced in the given time period.

Marginal product of labouris the change in total product resulting from an increase in the amount of labour by 1 unit, all other

factors remaining the same.

Average product of labouris the average product per unit of labour - the total product divided by the amount of labour.

For example, a labour unit may be 5 workers per day, a total product may be 80 sweaters per day, a marginal product may be 4

sweaters per additional worker, and average product may be 7 sweaters per worker.

As the quantity of labour increases most production processes undergo the following:

Total product increases.

Marginal product increases and then decreases - diminishing marginal returns.

Average product increases and then decreases.

Product curves

Product curves are graphs of total, marginal, or average product over labour.

Total Product vs. Labour

v 300 units

|

| ....

P | .....

r | Impossible ....

i | ....

c | ....

e | ..... Possible

|...

|________________________________________

0 Total Product ^ 25 workers/day

This is similar to the PPF - everything below or on the total product line is attainable, while everything above is not.

Marginal Product vs. Labour

v 300 units

|

| ...

P | .. ..

r | . ..

i | . ..

c | . ..

e | . ...

|. ...

|________________________________________

0 Marginal Product ^ 25 workers/day

Law of diminishing returns

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As a firm uses more of a variable input with all other inputs remaining constant, the marginal product with respect to the

variable input eventually diminishes/decreases.

As labour is increased, marginal product increases initially since the workers can divide the work and specialize better.

As labour is increased even more, the marginal product starts to diminish since each worker has access to less capital and space with

which to work.

When the marginal product equals the average cost, the average product is at its maximum .

Costs

Short-run cost

To increase total product, a firm must employ more labour. As a result, costs increase.

Total costis the cost of all resources used - the total fixed cost plus the total variable cost.

Total fixed costis the cost of a firm's fixed inputs. These do not depend on the output. This is usually capital like ovens for a bakery.

Total variable costis the cost of a firm's variable inputs. These depend on the output. This is usually labour like employees.

Total cost usually does not start from 0. There is usually a fixed cost even if there isn't any output.

As output increases, the total variable cost increases. The marginal variable cost is inversely correlated with the marginal product - if

the total product curve is increasing, then the total variable cost curve is decreasing.

The marginal costis the increase in total cost resulting from an increase in total product by 1 unit.

When the marginal product is increasing, the marginal cost is decreasing. When the marginal product is decreasing, the marginal cost

is increasing.

Average total costis the total cost per unit of output - the average fixed cost plus the average variable cost.

Average fixed costis the total fixed cost per unit of output - the total fixed cost divided by the output. This is decreasing since the

fixed costs are constant.

Average variable costis the total variable cost per unit of output - the total variable cost divided by the output.

Where is the output quantity.

The average variable cost curve is U-shaped, and as a result, so is the average total cost curve. This is because the average product is

initially increasing, but later decreases - so the average cost is initially decreasing, but later increases.

Average variable cost and average total cost are decreasing when the MC curve is below them, and increasing when the MC curve is

above. When they intersect, the average variable cost and average total cost are at their minimum.

The exact shape of the cost curves are determined by the technology.

Marginal cost is at its minimum when marginal product is at its maximum, and vice versa, with respect to output.

Average variable cost is at its minimum when average product is at its maximum, and vice versa, with respect to output.

Changes

Technologyinfluences the product and cost curves. Improvements in technology shift the product curves upwards and the cost

curves downwards.

If a technological improvement uses more capital and less labour, then fixed costs increase and variable costs decrease.

An increase in prices of factors of productionincreases costs. An increase shifts the product curves downwards and the cost curves

upwards, and vice versa.

Long-run cost

In the long run, we are not guaranteed that some resources are fixed. So the inputs can change and all costs are variable.

The behavior of long-run cost depends on the production functionof the firm - the relationship between the maximum attainable

output and the quantities of inputs like capital and labour.

T C = T F C + T V C

A T C = A F C + A V C = = +

T C

Q

T F C

Q

T V C

Q

Q

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As the firm's labour increases, the marginal product of labour increases.

As the amount of labour employed per plant increases, the marginal product of capital decreases.

The marginal product of capitalis the increase in output resulting from an increase in the amount of capital used by 1 unit, all other

factors like labour being constant.

For each possible plant size, there are a set of corresponding curves for marginal cost, average variable cost, and average total cost.

The larger the plant, the greater the output at which the average total cost is at a minimum.

So for a given output quantity desired, we would consider each possible plant and see which possibility has the lowest average total

cost.

The long-run average cost curveis the minimum of all the possible curves. It has parts of many different curves that correspond to

different plant sizes.

We can use this to find the plant size with the minimum average total cost for a given output quantity. This is the plant size with the

lowest cost per output.

Economies

Economies of scaleare aspects of the firm's technology that lead to decreasing long-run average cost with respect to output.

Diseconomies of scaleare the opposite, with increasing long-run average cost.

Constant returns to scaleare similar, with constant long-run average cost.

A firm experiences economies of scale up to a certain output quantity, before going into diseconomies of scale or constant returns toscale.

The minimum efficient scaleis the smallest output quantity resulting in the minimum long-run average cost.

If the long-run average cost curve is U-shaped, the minimum point identifies the output level achieving the minimum efficient scale.

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Perfectly Competitive Markets

Perfect competitionis an industry where there are:

Many firms selling.

Everyone is selling the same product.

There are many buyers.

There are no restrictions to entering the industry (e.g., patents, exclusive rights to needed inputs).

Established firms have no advantage over new ones.

Sellers and buyers are perfectly informed about all prices.

The actions of each individual buyer or seller have a negligible effect because there are so many of them.

As a result, no single firm has the power to control prices . The price comes from the market supply and demand, and firms must

take the price.

When a firm cannot control prices, it is called a price taker- it has to take the price.

Each firm's product is a perfect substitute for the others. This means the demand for each product is perfectly elastic .

Initiation

Perfect competition begins when buyers don't care about which firm they buy from. This is generally caused by the products sold by

each firm being perceived as the same.

Actions

The marginal revenueis the change in total revenue resulting from an increase in the quantity sold by 1 unit.

A firm in a perfectly competitive market must decide how to produce at minimum cost, how much to produce, and whether to

enter/exit the market.

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How much should a firm produce? The firm has the highest economic profit when the quantity produced results in a point on the

economic profit graph at the maximum.

The maximum economic profit occurs when the marginal revenue equals the marginal cost. This is because at this point, the derivative

of the economic profit is 0, and the marginal cost eventually must increase. At this point, the economic profit decreases if the quantity

produced changes in any direction.

A firm needs to decide whether to stay or exit the market if it takes an economic loss. If the firm decides to stay, it must decide whether

to continue prodcing, or shut down temporarily. The decision is based on the one that minimizes the firm's loss.

If a firm decides to shut down, it has no variable costs or revenue, but still has to pay the fixed costs(e.g., rent, insurance, security).

Whether a firm should continue producing is determined by whether a firm has enough revenue to cover the variable costs. If itdoes, then it is better to keep producing. Otherwise, it should stop producing and take a loss of only the fixed costs. In other words, a

firm shuts down if and only if price*quantity < total variable costs , or price < average variable costs

Short-run Supply

In the short run, it is difficult for firms to enter or exit the market.

A firm in a perfectly competitive market has a supply curve similar to the following:


v $30

|

| ....

P | .....

r | ....

i | ....c |............--------- SHUTDOWN POINT

e |.

|.

|________________________________________

0 Quantity Supplied ^ 25

When the price falls below the shutdown point, the firm stops producing in order to minimize losses. The shutdown price is

determined by the point where the price becomes less than the average variable cost, or where the marginal cost equals the marginal

revenue.

The maximum economic profit is not necessarily positive. If the economic profit is 0, the firm is breaking even.

Long-run Supply

In the long run, firms can enter or exit the market. Firms cannot shut down in the long run.

New firms enter a market when exising firms in the market are making an economic profit. Firms exit markets where they make

economic losses.

When a firm enters the market, the market supply (price vs. quantity supplied for the whole market) increases, so the market price

decreases.

This decreases the economic profit of all firms, which can result in some firms exiting the market or shutting down. The economic profit

decreases until it reaches 0.

When a firm exits the market, the market supply decreases, so the market price increases.

This increases the economic profit of all firms, which can result in some new firms entering the market. The economic profit increases

until it reaches 0.

As a result, the economic profit is held around 0.

When demand decreases permanently, the price falls, which causes firms to exit and decrease supply. The price then rises again

until firms stop leaving - economic profit is 0. Afterwards, there are fewer firms than before.

When demand increases permanently, the price rises, which causes new firms to enter and increase supply. The price then falls

again until firms stop entering - economic profit is 0. Afterwards, there are more firms than before.

In the long run, firms make the normal rate of return. This is because economic profit considers opportunity costs in addition to the

explicit costs.

The long-run market supply curveis the measure of the equilibrium price over quantity supplied. This curve is useful because it

takes into account things like plant changes and the number of firms in the market.

Improvements in technology reduces the average costs and creates economic profit. Firms either adopt the new technology or exit the

market. New firms then join the market and increase supply until the economic profit is 0.

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Economies

External economiesare factors beyond a single firm's control that lower a firm's costs as the market quantity supplied increases.

External diseconomiesare factors beyond a single firm's control that increase a firm's costs as the market quantity supplied

increases.

These affect the new equilibrium price in the long run after a permanent change in demand.

If there are no external economies or diseconomies, then each firm's costs remain constant as the market output changes-

changes in the total quantity produced in a market. In this case, after a change in demand, price stays constant . The long-run

market supply curve is constant.

If there are external economies, the price decreases if demand increases, because quantity supplied also increases. The long-run market

supply curve has a negative slope.

If there are external diseconomies, the price increases if demand increases, because quantity supplied also increases. The long-run

market supply curve has a positive slope.

Efficiency

Resources are used efficiency when no person can be made better off without making another person worse off. This occurs when

marginal social benefit equals marginal social cost.

A consumer's demand curve shows the best budget allocation over changes in the price of a good. Consumers are efficient at all

points on the demand curve. Without external benefits, the market demand curve is the marginal social benefit curve .

A firm's supply curve shows the best profit maximization over changes in the price of a good. Firms are efficient at all points on thesupply curve. Without external cost, the market supply curve is the marginal social cost curve.

Because of this, competitive markets are efficient- marginal social benefit equals marginal social cost. The gains from trade for

consumers and producers are consumer and producer surplus, respectively. The sum of these is the total surplus.

At long-run equilibrium, total surplus is maximized.

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Monopoly

A monopolyis a market that produces a good without good substitutesand with only one supplier protected from

competition by barriers of entry.

A monopolyis characterized by not having any competition.

If a good has any close substitutes, then the firm faces competition from the producers of the substitute. So it is only a monopoly if

there are no close substitutes.

Barriers to entry

The main causes of a monopoly are the barriers to entry. Some barriers to entry are:

A single firm has ownership of a needed resource.

This is rare because other firms can often find other instances of the resource needed.For example, De Beers has exclusive use of most African natural diamonds.

The government gives one firm exclusive rights to produce/sell the good.

For example, patents and copyright.

Another example is cable companies being given regions where they have exclusive rights to sell service.

Barriers to entry fall under three categories:

Natural barriers to entry

Natural monopolycaused by economies of scale allowing the biggest firm to supply the good at the lowest cost, making

it difficult for new, smaller firms to enter the market.

For example, Walmart can sell products at a lower price than some small supermarkets because they have much higher

outputs.

Ownership barriers to entry

Monopoly caused by one firm owning a significant part of a key resource needed in producing a good.

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For example, De Beers owns 90% of the world's diamond sources, making it difficult or impossible for other firms to

produce the good.

Legal barriers to entry

Legal monopolycaused by competition and entry restricted by government intervention.

For example, public franchises like Canada Post are to deliver first-class mail.

For example, there might be a government license needed to produce the good or service, like a license to practice law or

medicine.

For example, a patent or copyright granted to one firm would disallow other firms from producing it.

Pricing

A single-price monopolyhas each unit of the good or service sold at the same price to all customers.

A monopoly is a price setter. The market demand is the demand for the monopoly's output.

To increase quantity sold, the monopoly must reduce prices.

Total revenue(TR) is the product of price and quantity sold. Marginal revenue(MR) is the change in total revenue resulting from the

quantity sold increasing by 1 unit.

The marginal revenue is less than the price of the good( ) at al l levels of output in a single-pr ice monopoly.

If a firm cuts the price of a good, it will also sell more. The marginal revenue is the difference between the revenue gain from selling

more and the revenue loss from lower price.

The price depends on the elasticity of the good. If the demand is elastic, a fall in the price brings an increase in total revenue. If the

demand is inelastic, a rise in price brings an increase in total revenue.

So the profit is maximized when the marginal revenue is 0, when the quantity demanded is unit elastic.

In a monopoly, the demand is always elastic. So a monopoly always seeks to lower price.

Efficiency

A monopoly faces technology constraints like a firm in a competitive market, but does not need to worry about competition.

Monopolies set their price at such a value that they sell the quantity that maximizes profit.

It is possible to make an economic profit in a monopolistic market. If a firm incurs an economic loss, it may shut down temporarily in

the short run or exit the market in the long run.

Compared to a perfectly competitive market, a good in a monopoly is sold at a higher priceand lower quantity.

A monopoly is inefficient because the marginal social benefit is greater than the marginal social cost, causing deadweight losses. Some

of the consumer surplus also becomes producer surplus.

Economic rentis any type of surplus, including consumer surpus, producer surplus, and economic profit.

Rent seekingis the pursuit of wealth by capturing economic rent rather than creating more wealth. This can be done by buying a

monopoly or creating one. Often, rent seekers work by manipulating the social and politicial environment in which economic activities

happen.

Profits spent rent seeking can use up all the producer surplus, and is considered a deadweight loss. Rent seeking increases deadweight

loss.

Price discrimination

Some firms practice price discrimination- goods or services are sold at different prices to different customers.

A firm does not need to be a monopoly to price discriminate, but it happens most often in monopolies.

For example, an energy company might sell electricity at higher prices during certain hours of the day and lower prices at other times.

Copyright 2013 Anthony Zhang

This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported License.

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econ101 - fall 2013

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