The Market Forces of Supply and Demand. Premium PowerPoint Slides by Ron Cronovich

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1 C H A P T E R 4 The Market Forces of Supply and Demand Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

2 In this chapter, look for the answers to these questions: What factors affect buyers demand for goods? What factors affect sellers supply of goods? How do supply and demand determine the price of a good and the quantity sold? How do changes in the factors that affect demand or supply affect the market price and quantity of a good? How do markets allocate resources? 1

3 Markets and Competition A market is a group of buyers and sellers of a particular product. A competitive market is one with many buyers and sellers, each has a negligible effect on price. In a perfectly competitive market: All goods exactly the same Buyers & sellers so numerous that no one can affect market price each is a price taker In this chapter, we assume markets are perfectly competitive. THE MARKET FORCES OF SUPPLY AND DEMAND 2

4 Demand The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal THE MARKET FORCES OF SUPPLY AND DEMAND 3

5 The Demand Schedule Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded Example: Helen s demand for lattes. Notice that Helen s preferences obey the Law of Demand. Price of lattes Quantity of lattes demanded $ THE MARKET FORCES OF SUPPLY AND DEMAND 4

6 Helen s Demand Schedule & Curve Price of Lattes $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 Price of lattes Quantity of lattes demanded $ $ Quantity of Lattes THE MARKET FORCES OF SUPPLY AND DEMAND 5

7 Market Demand versus Individual Demand The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price. Suppose Helen and Ken are the only two buyers in the Latte market. (Q d = quantity demanded) Price Helen s Q d Ken s Q d Market Q d $ = = = = = = = 6 6

8 The Market Demand Curve for Lattes $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 P Q P Q d (Market) $ THE MARKET FORCES OF SUPPLY AND DEMAND 7

9 Demand Curve Shifters The demand curve shows how price affects quantity demanded, other things being equal. These other things are non-price determinants of demand (i.e., things that determine buyers demand for a good, other than the good s price). Changes in them shift the D curve THE MARKET FORCES OF SUPPLY AND DEMAND 8

10 Demand Curve Shifters: # of Buyers Increase in # of buyers increases quantity demanded at each price, shifts D curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 9

11 Demand Curve Shifters: # of Buyers $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 P Suppose the number of buyers increases. Then, at each P, Q d will increase (by 5 in this example). $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 10

12 Demand Curve Shifters: Income Demand for a normal good is positively related to income. Increase in income causes increase in quantity demanded at each price, shifts D curve to the right. (Demand for an inferior good is negatively related to income. An increase in income shifts D curves for inferior goods to the left.) THE MARKET FORCES OF SUPPLY AND DEMAND 11

13 Demand Curve Shifters: Prices of Related Goods Two goods are substitutes if an increase in the price of one causes an increase in demand for the other. Example: pizza and hamburgers. An increase in the price of pizza increases demand for hamburgers, shifting hamburger demand curve to the right. Other examples: Coke and Pepsi, laptops and desktop computers, CDs and music downloads THE MARKET FORCES OF SUPPLY AND DEMAND 12

14 Demand Curve Shifters: Prices of Related Goods Two goods are complements if an increase in the price of one causes a fall in demand for the other. Example: computers and software. If price of computers rises, people buy fewer computers, and therefore less software. Software demand curve shifts left. Other examples: college tuition and textbooks, bagels and cream cheese, eggs and bacon THE MARKET FORCES OF SUPPLY AND DEMAND 13

15 Demand Curve Shifters: Tastes Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right. Example: The Atkins diet became popular in the 90s, caused an increase in demand for eggs, shifted the egg demand curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 14

16 Demand Curve Shifters: Expectations Expectations affect consumers buying decisions. Examples: If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now. If the economy sours and people worry about their future job security, demand for new autos may fall now. THE MARKET FORCES OF SUPPLY AND DEMAND 15

17 Summary: Variables That Influence Buyers Variable A change in this variable Price causes a movement along the D curve # of buyers shifts the D curve Income Price of related goods Tastes Expectations shifts the D curve shifts the D curve shifts the D curve shifts the D curve THE MARKET FORCES OF SUPPLY AND DEMAND 16

18 A C T I V E L E A R N I N G 1 Demand Curve Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why? A. The price of ipods falls B. The price of music downloads falls C. The price of CDs falls 17

19 A C T I V E L E A R N I N G 1 A. Price of ipods falls Price of music downloads P 1 Music downloads and ipods are complements. A fall in price of ipods shifts the demand curve for music downloads to the right. D 1 D 2 Q 1 Q 2 Quantity of music downloads 18

20 A C T I V E L E A R N I N G 1 B. Price of music downloads falls Price of music downloads P 1 The D curve does not shift. Move down along curve to a point with lower P, higher Q. P 2 D 1 Q 1 Q 2 Quantity of music downloads 19

21 A C T I V E L E A R N I N G 1 C. Price of CDs falls Price of music downloads P 1 CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. D 2 D 1 Q 2 Q 1 Quantity of music downloads 20

22 Supply The quantity supplied of any good is the amount that sellers are willing and able to sell. Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal THE MARKET FORCES OF SUPPLY AND DEMAND 21

23 The Supply Schedule Supply schedule: A table that shows the relationship between the price of a good and the quantity supplied. Example: Starbucks supply of lattes. Notice that Starbucks supply schedule obeys the Law of Supply. Price of lattes Quantity of lattes supplied $ THE MARKET FORCES OF SUPPLY AND DEMAND 22

24 Starbucks Supply Schedule & Curve $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 P Price of lattes Quantity of lattes supplied $ $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 23

25 Market Supply versus Individual Supply The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price. Suppose Starbucks and Jitters are the only two sellers in this market. (Q s = quantity supplied) Price Starbucks Jitters Market Q s $ = = = = = = = 30 24

26 The Market Supply Curve $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 P P Q S (Market) $ $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 25

27 Supply Curve Shifters The supply curve shows how price affects quantity supplied, other things being equal. These other things are non-price determinants of supply. Changes in them shift the S curve THE MARKET FORCES OF SUPPLY AND DEMAND 26

28 Supply Curve Shifters: Input Prices Examples of input prices: wages, prices of raw materials. A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 27

29 Supply Curve Shifters: Input Prices $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 P Suppose the price of milk falls. At each price, the quantity of Lattes supplied will increase (by 5 in this example). Q THE MARKET FORCES OF SUPPLY AND DEMAND 28

30 Supply Curve Shifters: Technology Technology determines how much inputs are required to produce a unit of output. A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 29

31 Supply Curve Shifters: # of Sellers An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right. THE MARKET FORCES OF SUPPLY AND DEMAND 30

32 Supply Curve Shifters: Expectations Example: Events in the Middle East lead to expectations of higher oil prices. In response, owners of Texas oilfields reduce supply now, save some inventory to sell later at the higher price. S curve shifts left. In general, sellers may adjust supply * when their expectations of future prices change. ( * If good not perishable) THE MARKET FORCES OF SUPPLY AND DEMAND 31

33 Summary: Variables that Influence Sellers Variable A change in this variable Price Input Prices Technology causes a movement along the S curve shifts the S curve shifts the S curve # of Sellers shifts the S curve Expectations shifts the S curve THE MARKET FORCES OF SUPPLY AND DEMAND 32

34 A C T I V E L E A R N I N G 2 Supply Curve Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost. C. Professional tax return preparers raise the price of the services they provide. 33

35 A C T I V E L E A R N I N G 2 A. Fall in price of tax return software Price of tax return software P 1 P 2 S 1 S curve does not shift. Move down along the curve to a lower P and lower Q. Q 2 Q 1 Quantity of tax return software 34

36 A C T I V E L E A R N I N G 2 B. Fall in cost of producing the software Price of tax return software S 1 S 2 S curve shifts to the right: P 1 at each price, Q increases. Q 1 Q 2 Quantity of tax return software 35

37 A C T I V E L E A R N I N G 3 C. Professional preparers raise their price Price of tax return software S 1 This shifts the demand curve for tax preparation software, not the supply curve. Quantity of tax return software 36

38 Supply and Demand Together $6.00 $5.00 $4.00 $3.00 $2.00 P D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded $1.00 $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 37

39 Equilibrium price: $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 P the price that equates quantity supplied with quantity demanded D S THE MARKET FORCES OF SUPPLY AND DEMAND 38 Q P Q D Q S $

40 Equilibrium quantity: $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 P the quantity supplied and quantity demanded at the equilibrium price D S THE MARKET FORCES OF SUPPLY AND DEMAND 39 Q P Q D Q S $

41 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded $6.00 $5.00 $4.00 P D Surplus S Example: If P = $5, then Q D = 9 lattes $3.00 $2.00 $1.00 $ and Q S Q = 25 lattes resulting in a surplus of 16 lattes THE MARKET FORCES OF SUPPLY AND DEMAND 40

42 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 P D Surplus S Facing a surplus, sellers try to increase sales by cutting price. This causes Q D to rise and Q S to fall which reduces the surplus. $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 41

43 Surplus (a.k.a. excess supply): when quantity supplied is greater than quantity demanded $6.00 $5.00 P D Surplus S Facing a surplus, sellers try to increase sales by cutting price. $4.00 $3.00 $2.00 $1.00 This causes Q D to rise and Q S to fall. Prices continue to fall until market reaches equilibrium. $ Q THE MARKET FORCES OF SUPPLY AND DEMAND 42

44 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $0.00 P D Shortage S Example: If P = $1, THE MARKET FORCES OF SUPPLY AND DEMAND 43 Q then Q D and Q S = 21 lattes = 5 lattes resulting in a shortage of 16 lattes

45 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied $6.00 $5.00 $4.00 $3.00 $2.00 P D S Facing a shortage, sellers raise the price, causing Q D to fall and Q S to rise, which reduces the shortage. $1.00 $0.00 Shortage Q THE MARKET FORCES OF SUPPLY AND DEMAND 44

46 Shortage (a.k.a. excess demand): when quantity demanded is greater than quantity supplied $6.00 $5.00 $4.00 P D S Facing a shortage, sellers raise the price, causing Q D to fall and Q S to rise. $3.00 $2.00 $1.00 $0.00 Shortage Prices continue to rise until market reaches equilibrium. Q THE MARKET FORCES OF SUPPLY AND DEMAND 45

47 Three Steps to Analyzing Changes in Eq m To determine the effects of any event, 1. Decide whether event shifts S curve, D curve, or both. 2. Decide in which direction curve shifts. 3. Use supply-demand diagram to see how the shift changes eq m P and Q. THE MARKET FORCES OF SUPPLY AND DEMAND 46

48 EXAMPLE: The Market for Hybrid Cars price of hybrid cars P S 1 P 1 Q 1 D 1 Q quantity of hybrid cars THE MARKET FORCES OF SUPPLY AND DEMAND 47

49 EXAMPLE 1: A Shift in Demand EVENT TO BE ANALYZED: Increase in price of gas. P S 1 STEP 1: D curve shifts because STEP 2: price of gas affects demand for D shifts right hybrids. because SSTEP curve 3: high gas price makes does hybrids not shift, The shift because causes price an more attractive of increase relative gas does in price to other not cars. affect and quantity cost of of producing hybrid cars. hybrids. P 2 P 1 D D 2 1 Q 1 Q 2 THE MARKET FORCES OF SUPPLY AND DEMAND 48 Q

50 EXAMPLE 1: A Shift in Demand Notice: When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. P 2 P 1 P S 1 Always be careful to distinguish b/w a shift in a curve and a movement along the curve. Q 1 Q 2 D 1 D 2 Q THE MARKET FORCES OF SUPPLY AND DEMAND 49

51 Terms for Shift vs. Movement Along Curve Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs) Change in the quantity supplied: a movement along a fixed S curve occurs when P changes Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers) Change in the quantity demanded: a movement along a fixed D curve occurs when P changes 50

52 EXAMPLE 2: A Shift in Supply EVENT: New technology reduces cost of producing hybrid cars. P S 1 S 2 STEP 1: S curve shifts because STEP 2: event affects cost of production. S shifts right D because curve does not shift, STEP because 3: event reduces cost, production The shift causes makes production technology is price not to more profitable one fall of the at factors and quantity any given that price. affect to rise. demand. P 1 P 2 D 1 Q 1 Q 2 THE MARKET FORCES OF SUPPLY AND DEMAND 51 Q

53 EXAMPLE 3: EVENTS: price of gas rises AND new technology reduces production costs STEP 1: Both curves shift. STEP 2: Both shift to the right. A Shift in Both Supply and Demand P 2 P 1 STEP 3: Q rises, but effect on P is ambiguous: If demand increases more than supply, P rises. P THE MARKET FORCES OF SUPPLY AND DEMAND 52 Q 1 S 1 Q 2 D 1 S 2 D 2 Q

54 EXAMPLE 3: EVENTS: price of gas rises AND new technology reduces production costs A Shift in Both Supply and Demand P S 1 S 2 STEP 3, cont. But if supply increases more than demand, P falls. P 1 P 2 Q 1 D 1 Q 2 D 2 Q THE MARKET FORCES OF SUPPLY AND DEMAND 53

55 A C T I V E L E A R N I N G 3 Shifts in supply and demand Use the three-step method to analyze the effects of each event on the equilibrium price and quantity of music downloads. Event A: A fall in the price of CDs Event B: Sellers of music downloads negotiate a reduction in the royalties they must pay for each song they sell. Event C: Events A and B both occur. 54

56 A C T I V E L E A R N I N G 3 A. Fall in price of CDs STEPS 1. D curve shifts 2. D shifts left 3. P and Q both fall. P 1 P 2 P The market for music downloads S 1 Q 2 Q 1 D 2 D 1 Q 55

57 A C T I V E L E A R N I N G 3 B. Fall in cost of royalties STEPS 1. S curve shifts (Royalties are part 2. S shifts right of sellers costs) 3. P falls, Q rises. P 1 P 2 P The market for music downloads S 1 S 2 Q 1 Q 2 D 1 Q 56

58 A C T I V E L E A R N I N G 3 C. Fall in price of CDs and fall in cost of royalties STEPS 1. Both curves shift (see parts A & B). 2. D shifts left, S shifts right. 3. P unambiguously falls. Effect on Q is ambiguous: The fall in demand reduces Q, the increase in supply increases Q. 57

59 CONCLUSION: How Prices Allocate Resources One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide economic decisions and thereby allocate scarce resources. THE MARKET FORCES OF SUPPLY AND DEMAND 58

60 CHAPTER SUMMARY A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. Economists use the supply and demand model to analyze competitive markets. The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good s price. 59

61 CHAPTER SUMMARY Besides price, demand depends on buyers incomes, tastes, expectations, the prices of substitutes and complements, and number of buyers. If one of these factors changes, the D curve shifts. The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good s price. Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. 60

62 CHAPTER SUMMARY The intersection of S and D curves determines the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise. 61

63 CHAPTER SUMMARY We can use the supply-demand diagram to analyze the effects of any event on a market: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one. In market economies, prices are the signals that guide economic decisions and allocate scarce resources. 62

64 THE MARKET FORCES OF SUPPLY AND DEMAND 63

65 C H A P T E R 5 Elasticity and its Application Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

66 In this chapter, look for the answers to these questions: What is elasticity? What kinds of issues can elasticity help us understand? What is the price elasticity of demand? How is it related to the demand curve? How is it related to revenue & expenditure? What is the price elasticity of supply? How is it related to the supply curve? What are the income and cross-price elasticities of demand? 65

67 A scenario You design websites for local businesses. You charge $200 per website, and currently sell 12 websites per month. Your costs are rising (including the opportunity cost of your time), so you consider raising the price to $250. The law of demand says that you won t sell as many websites if you raise your price. How many fewer websites? How much will your revenue fall, or might it increase? 66

68 Elasticity Basic idea: Elasticity measures how much one variable responds to changes in another variable. One type of elasticity measures how much demand for your websites will fall if you raise your price. Definition: Elasticity is a numerical measure of the responsiveness of Q d or Q s to one of its determinants. ELASTICITY AND ITS APPLICATION 67

69 Price Elasticity of Demand Price elasticity of demand = Percentage change in Q d Percentage change in P Price elasticity of demand measures how much Q d responds to a change in P. Loosely speaking, it measures the pricesensitivity of buyers demand. ELASTICITY AND ITS APPLICATION 68

70 Price Elasticity of Demand Price elasticity of demand = Percentage change in Q d Percentage change in P Example: P Price elasticity of demand equals P rises by 10% P 2 P 1 D -15% 10% = -1.5 Q falls by 15% Q 2 Q 1 Q ELASTICITY AND ITS APPLICATION 69

71 Price Elasticity of Demand Price elasticity of demand = Percentage change in Q d Percentage change in P Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. P 2 P 1 P D Q 2 Q 1 Q ELASTICITY AND ITS APPLICATION 70

72 Calculating Percentage Changes $250 $200 P Demand for your websites B A D Standard method of computing the percentage (%) change: end value start value start value x 100% Going from A to B, the % change in P equals (($250 $200)/$200) x 100%= 25% 8 12 Q ELASTICITY AND ITS APPLICATION 71

73 $250 $200 P Calculating Percentage Changes Demand for your websites 8 B 12 A D Q Problem: The standard method gives different answers depending on where you start. From A to B, P rises 25%, Q falls 33%, elasticity = -33/25 = From B to A, P falls 20%, Q rises 50%, elasticity = 50/-20 = ELASTICITY AND ITS APPLICATION 72

74 Calculating Percentage Changes So, we instead use the midpoint method: end value start value midpoint x 100% The midpoint is the number halfway between the start & end values, the average of those values. It doesn t matter which value you use as the start and which as the end you get the same answer either way! ELASTICITY AND ITS APPLICATION 73

75 Calculating Percentage Changes Using the midpoint method, the % change in P equals $250 $200 $225 x 100% = 22.2% The % change in Q equals x 100% = -40.0% The price elasticity of demand equals -40/22.2 = -1.8 ELASTICITY AND ITS APPLICATION 74

76 A C T I V E L E A R N I N G 1 Calculate an elasticity Use the following information to calculate the price elasticity of demand for hotel rooms: if P = $70, Q d = 5000 if P = $90, Q d =

77 A C T I V E L E A R N I N G 1 Answers Use midpoint method to calculate % change in Q d (( )/4000 ) x 100 = 50% % change in P (($70 $90)/$80) x 100 = -25% The price elasticity of demand equals 50% -25% =

78 Using absolute values to compare which good has more (less) price-elasticity of demand than the others.. ELASTICITY AND ITS APPLICATION 77

79 What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example: Suppose the prices of both goods rise by 20%. The good for which Q d falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why? What lesson does the example teach us about the determinants of the price elasticity of demand? ELASTICITY AND ITS APPLICATION 78

80 EXAMPLE 1: Breakfast cereal vs. Sunscreen The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why? Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises. Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises. Lesson: Price elasticity is higher when close substitutes are available. ELASTICITY AND ITS APPLICATION 79

81 EXAMPLE 2: Blue Jeans vs. Clothing The prices of both goods rise by 20%. For which good does Q d drop the most? Why? For a narrowly defined good such as blue jeans, there are many substitutes (khakis, shorts, Speedos). There are fewer substitutes available for broadly defined goods. (There aren t too many substitutes for clothing, other than living in a nudist colony.) Lesson: Price elasticity is higher for narrowly defined goods than broadly defined ones. ELASTICITY AND ITS APPLICATION 80

82 EXAMPLE 3: Insulin vs. Caribbean Cruises The prices of both of these goods rise by 20%. For which good does Q d drop the most? Why? To millions of diabetics, insulin is a necessity. A rise in its price would cause little or no decrease in demand. A cruise is a luxury. If the price rises, some people will forego it. Lesson: Price elasticity is higher for luxuries than for necessities. ELASTICITY AND ITS APPLICATION 81

83 EXAMPLE 4: Gasoline in the Short Run vs. Gasoline in the Long Run The price of gasoline rises 20%. Does Q d drop more in the short run or the long run? Why? There s not much people can do in the short run, other than ride the bus or carpool. In the long run, people can buy smaller cars or live closer to where they work. Lesson: Price elasticity is higher in the long run than the short run. ELASTICITY AND ITS APPLICATION 82

84 The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on: the extent to which close substitutes are available whether the good is a necessity or a luxury how broadly or narrowly the good is defined the time horizon elasticity is higher in the long run than the short run ELASTICITY AND ITS APPLICATION 83

85 The Variety of Demand Curves The price elasticity of demand is closely related to the slope of the demand curve. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications of D curves. ELASTICITY AND ITS APPLICATION 84

86 Perfectly inelastic demand (one extreme case) Price elasticity of demand = % change in Q % change in P D curve: vertical P D Consumers price sensitivity: none P 1 P 2 Elasticity: 0 P falls by 10% Q 1 Q changes by 0% Q ELASTICITY AND ITS APPLICATION 85

87 Inelastic demand Price elasticity of demand = % change in Q % change in P D curve: relatively steep P Consumers price sensitivity: relatively low Absolute value of the Elasticity < 1 P falls by 10% ELASTICITY AND ITS APPLICATION 86 P 1 P 2 Q 1 Q 2 D Q rises less than 10% Q

88 Unit elastic demand Price elasticity of demand = % change in Q % change in P D curve: intermediate slope P Consumers price sensitivity: intermediate P 1 P 2 D Absolute value of the Elasticity = 1 P falls by 10% Q 1 Q 2 Q Q rises by 10% ELASTICITY AND ITS APPLICATION 87

89 Elastic demand Price elasticity of demand = % change in Q % change in P D curve: relatively flat P Consumers price sensitivity: relatively high Absolute value of the Elasticity > 1 P falls by 10% ELASTICITY AND ITS APPLICATION 88 P 1 P 2 Q 1 Q 2 Q rises more than 10% D Q

90 Perfectly elastic demand (the other extreme) Price elasticity of demand D curve: horizontal Consumers price sensitivity: extreme Absolute value of the Elasticity is infinity. = % change in Q % change in P P 2 = P changes by 0% ELASTICITY AND ITS APPLICATION 89 P 1 P Q 1 Q 2 Q changes by any % D Q

91 Elasticity of a Linear Demand Curve P $ E = -200% 40% = -5.0 E = -67% 67% = -1.0 E = -40% 200% = -0.2 The slope of a linear demand curve is constant, but its elasticity is not. $ Q ELASTICITY AND ITS APPLICATION 90

92 Price Elasticity and Total Revenue Continuing our scenario, if you raise your price from $200 to $250, would your revenue rise or fall? Revenue = P x Q A price increase has two effects on revenue: Higher P means more revenue on each unit you sell. But you sell fewer units (lower Q), due to Law of Demand. Which of these two effects is bigger? It depends on the price elasticity of demand. ELASTICITY AND ITS APPLICATION 91

93 Price Elasticity and Total Revenue Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is elastic, then Absolute value of price elast. of demand > 1 % change in Q > % change in P The fall in revenue from lower Q is greater than the increase in revenue from higher P, so revenue falls. ELASTICITY AND ITS APPLICATION 92

94 Price Elasticity and Total Revenue Elastic Demand (elasticity = -1.8) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 8 and revenue = $2000. When D is elastic, a price increase causes revenue to fall. $250 $200 P increased revenue due to higher P ELASTICITY AND ITS APPLICATION 93 8 Demand for your websites 12 lost revenue due to lower Q D Q

95 Price Elasticity and Total Revenue Price elasticity of demand = Percentage change in Q Percentage change in P Revenue = P x Q If demand is inelastic, then Absolute value of price elast. of demand < 1 % change in Q < % change in P The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. In our example, suppose that Q only falls to 10 (instead of 8) when you raise your price to $250. ELASTICITY AND ITS APPLICATION 94

96 Price Elasticity and Total Revenue Inelastic Demand (elasticity = -0.82) If P = $200, Q = 12 and revenue = $2400. If P = $250, Q = 10 and revenue = $2500. When D is inelastic, a price increase causes revenue to rise. $250 $200 P increased revenue due to higher P ELASTICITY AND ITS APPLICATION Demand for your websites 12 lost revenue due to lower Q D Q

97 A C T I V E L E A R N I N G 2 Elasticity and expenditure/revenue A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall? 96

98 A C T I V E L E A R N I N G 2 Answers A. Pharmacies raise the price of insulin by 10%. Does total expenditure on insulin rise or fall? Expenditure = P x Q Since demand is inelastic, Q will fall less than 10%, so expenditure rises. 97

99 A C T I V E L E A R N I N G 2 Answers B. As a result of a fare war, the price of a luxury cruise falls 20%. Does luxury cruise companies total revenue rise or fall? Revenue = P x Q The fall in P reduces revenue, but Q increases, which increases revenue. Which effect is bigger? Since demand is elastic, Q will increase more than 20%, so revenue rises. 98

100 APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime? One side effect of illegal drug use is crime: Users often turn to crime to finance their habit. We examine two policies designed to reduce illegal drug use and see what effects they have on drug-related crime. For simplicity, we assume the total dollar value of drug-related crime equals total expenditure on drugs. Demand for illegal drugs is inelastic, due to addiction issues. ELASTICITY AND ITS APPLICATION 99

101 Interdiction reduces the supply of drugs. Since demand for drugs is inelastic, P rises proportionally more than Q falls. Policy 1: Interdiction Price of Drugs P 2 P 1 Result: an increase in total spending on drugs, and in drug-related crime new value of drugrelated crime D 1 Q 2 Q 1 S 2 S 1 initial value of drugrelated crime Quantity of Drugs ELASTICITY AND ITS APPLICATION 100

102 Education reduces the demand for drugs. Policy 2: Education Price of Drugs new value of drugrelated crime D 2 D 1 S P and Q fall. Result: A decrease in total spending on drugs, and in drug-related crime. P 1 P 2 Q 2 Q 1 initial value of drugrelated crime Quantity of Drugs ELASTICITY AND ITS APPLICATION 101

103 Price Elasticity of Supply Price elasticity of supply = Percentage change in Q s Percentage change in P Price elasticity of supply measures how much Q s responds to a change in P. Loosely speaking, it measures sellers price-sensitivity. Again, use the midpoint method to compute the percentage changes. ELASTICITY AND ITS APPLICATION 102

104 Price Elasticity of Supply Price elasticity of supply = Percentage change in Q s Percentage change in P Example: Price elasticity of supply equals 16% 8% = 2.0 P rises by 8% P 2 P 1 P Q rises by 16% Q 1 Q 2 S Q ELASTICITY AND ITS APPLICATION 103

105 The Variety of Supply Curves The slope of the supply curve is closely related to price elasticity of supply. Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity. Five different classifications. ELASTICITY AND ITS APPLICATION 104

106 Perfectly inelastic (one extreme) Price elasticity of supply = % change in Q % change in P = 0% 10% = 0 S curve: vertical P S Sellers price sensitivity: none Elasticity: 0 P rises by 10% ELASTICITY AND ITS APPLICATION 105 P 2 P 1 Q 1 Q changes by 0% Q

107 Inelastic Price elasticity of supply = % change in Q % change in P = < 10% 10% < 1 S curve: relatively steep P S Sellers price sensitivity: relatively low Elasticity: < 1 P rises by 10% ELASTICITY AND ITS APPLICATION 106 P 2 P 1 Q 1 Q 2 Q rises less than 10% Q

108 Unit elastic Price elasticity of supply = S curve: intermediate slope % change in Q % change in P = P 10% 10% = 1 S Sellers price sensitivity: intermediate Elasticity: = 1 P rises by 10% ELASTICITY AND ITS APPLICATION 107 P 2 P 1 Q 1 Q 2 Q rises by 10% Q

109 Elastic Price elasticity of supply = % change in Q % change in P = > 10% 10% > 1 S curve: relatively flat P S Sellers price sensitivity: relatively high Elasticity: > 1 P rises by 10% ELASTICITY AND ITS APPLICATION 108 P 2 P 1 Q 1 Q 2 Q rises more than 10% Q

110 Perfectly elastic (the other extreme) Price elasticity of supply S curve: horizontal Sellers price sensitivity: extreme Elasticity: infinity = % change in Q % change in P = P 2 = P changes by 0% ELASTICITY AND ITS APPLICATION 109 P 1 P Q 1 any % 0% = infinity Q 2 Q changes by any % S Q

111 The Determinants of Supply Elasticity The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars. For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. ELASTICITY AND ITS APPLICATION 110

112 A C T I V E L E A R N I N G 3 Elasticity and changes in equilibrium The supply of beachfront property is inelastic. The supply of new cars is elastic. Suppose population growth causes demand for both goods to double (at each price, Q d doubles). For which product will P change the most? For which product will Q change the most? 111

113 A C T I V E L E A R N I N G 3 Answers When supply is inelastic, an increase in demand has a bigger impact on price than on quantity. P 2 P D 1 Beachfront property (inelastic supply): D 2 S B P 1 A Q 1 Q 2 Q 112

114 A C T I V E L E A R N I N G 3 Answers When supply is elastic, an increase in demand has a bigger impact on quantity than on price. P 2 P 1 P D 1 D 2 New cars (elastic supply): A B S Q 1 Q 2 Q 113

115 How the Price Elasticity of Supply Can Vary P $ elasticity > 1 elasticity < 1 S Supply often becomes less elastic as Q rises, due to capacity limits. $ Q ELASTICITY AND ITS APPLICATION 114

116 Other Elasticities Income elasticity of demand: measures the response of Q d to a change in consumer income Income elasticity of demand = Percent change in Q d Percent change in income Recall from Chapter 4: An increase in income causes an increase in demand for a normal good. Hence, for normal goods, income elasticity > 0. For inferior goods, income elasticity < 0. ELASTICITY AND ITS APPLICATION 115

117 Other Elasticities Cross-price elasticity of demand: measures the response of demand for one good to changes in the price of another good Cross-price elast. of demand = % change in Q d for good 1 % change in price of good 2 For substitutes, cross-price elasticity > 0 (e.g., an increase in price of beef causes an increase in demand for chicken) For complements, cross-price elasticity < 0 (e.g., an increase in price of computers causes decrease in demand for software) ELASTICITY AND ITS APPLICATION 116

118 Cross-Price Elasticities in the News As Gas Costs Soar, Buyers Flock to Small Cars -New York Times, 5/2/2008 Gas Prices Drive Students to Online Courses -Chronicle of Higher Education, 7/8/2008 Gas prices knock bicycle sales, repairs into higher gear -Associated Press, 5/11/2008 Camel demand soars in India (as a substitute for gas-guzzling tractors ) -Financial Times, 5/2/2008 High gas prices drive farmer to switch to mules -Associated Press, 5/21/2008 ELASTICITY AND ITS APPLICATION 117

119 CHAPTER SUMMARY Elasticity measures the responsiveness of Q d or Q s to one of its determinants. Price elasticity of demand equals percentage change in Q d divided by percentage change in P. When it s less than one, demand is inelastic. When greater than one, demand is elastic. When demand is inelastic, total revenue rises when price rises. When demand is elastic, total revenue falls when price rises. 118

120 CHAPTER SUMMARY Demand is less elastic in the short run, for necessities, for broadly defined goods, or for goods with few close substitutes. Price elasticity of supply equals percentage change in Q s divided by percentage change in P. When it s less than one, supply is inelastic. When greater than one, supply is elastic. Price elasticity of supply is greater in the long run than in the short run. 119

121 CHAPTER SUMMARY The income elasticity of demand measures how much quantity demanded responds to changes in buyers incomes. The cross-price elasticity of demand measures how much demand for one good responds to changes in the price of another good. 120

122 THE MARKET FORCES OF SUPPLY AND DEMAND 121

123 C H A P T E R 6 Supply, Demand, and Government Policies Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

124 In this chapter, look for the answers to these questions: What are price ceilings and price floors? What are some examples of each? How do price ceilings and price floors affect market outcomes? How do taxes affect market outcomes? How do the effects depend on whether the tax is imposed on buyers or sellers? What is the incidence of a tax? What determines the incidence? 123

125 Government Policies That Alter the Private Market Outcome Price controls Price ceiling: a legal maximum on the price of a good or service Example: rent control Price floor: a legal minimum on the price of a good or service Example: minimum wage Taxes The govt can make buyers or sellers pay a specific amount on each unit bought/sold. We will use the supply/demand model to see how each policy affects the market outcome (the price buyers pay, the price sellers receive, and eq m quantity). SUPPLY, DEMAND, AND GOVERNMENT POLICIES 124

126 EXAMPLE 1: The Market for Apartments Rental price of apts P S Eq m w/o price controls $ D Q Quantity of apartments SUPPLY, DEMAND, AND GOVERNMENT POLICIES 125

127 How Price Ceilings Affect Market Outcomes A price ceiling above the eq m price is not binding has no effect on the market outcome. $1000 $800 P S Price ceiling 300 D Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 126

128 How Price Ceilings Affect Market Outcomes The eq m price ($800) is above the ceiling and therefore illegal. The ceiling is a binding constraint on the price, causes a shortage. $800 $500 P S shortage D Price ceiling Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 127

129 How Price Ceilings Affect Market Outcomes In the long run, supply and demand are more price-elastic. So, the shortage is larger. $800 $500 P S shortage Price ceiling D Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 128

130 Shortages and Rationing With a shortage, sellers must ration the goods among buyers. Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers biases These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly. In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). SUPPLY, DEMAND, AND GOVERNMENT POLICIES 129

131 EXAMPLE 2: The Market for Unskilled Labor Eq m w/o price controls Wage paid to unskilled workers $4 W 500 S D Quantity of unskilled workers L SUPPLY, DEMAND, AND GOVERNMENT POLICIES 130

132 How Price Floors Affect Market Outcomes A price floor below the eq m price is not binding has no effect on the market outcome. $4 $3 W S Price floor 500 D L SUPPLY, DEMAND, AND GOVERNMENT POLICIES 131

133 How Price Floors Affect Market Outcomes The eq m wage ($4) is below the floor and therefore illegal. The floor is a binding constraint on the wage, causes a surplus (i.e., unemployment). $5 $4 W labor surplus S D Price floor L SUPPLY, DEMAND, AND GOVERNMENT POLICIES 132

134 Min wage laws do not affect highly skilled workers. They do affect teen workers. Studies: A 10% increase in the min wage raises teen unemployment by 1-3%. The Minimum Wage $5 $4 W unemployment S D Min. wage L SUPPLY, DEMAND, AND GOVERNMENT POLICIES 133

135 A C T I V E L E A R N I N G 1 Price controls Determine effects of: A. $90 price ceiling B. $90 price floor C. $120 price floor P The market for hotel rooms Q S D 134

136 A C T I V E L E A R N I N G 1 A. $90 price ceiling The price falls to $90. Buyers demand 120 rooms, sellers supply 90, leaving a shortage. P Price ceiling The market for hotel rooms shortage = Q S D 135

137 A C T I V E L E A R N I N G 1 B. $90 price floor Eq m price is above the floor, so floor is not binding. P = $100, Q = 100 rooms. P Price floor The market for hotel rooms Q S D 136

138 A C T I V E L E A R N I N G 1 C. $120 price floor The price rises to $120. Buyers demand 60 rooms, sellers supply 120, causing a surplus. P The market for hotel rooms surplus = 60 Price floor Q S D 137

139 Evaluating Price Controls Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Prices are the signals that guide the allocation of society s resources. This allocation is altered when policymakers restrict prices. Price controls often intended to help the poor, but often hurt more than help. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 138

140 Taxes The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc. The govt can make buyers or sellers pay the tax. The tax can be a % of the good s price, or a specific amount for each unit sold. For simplicity, we analyze per-unit taxes only. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 139

141 EXAMPLE 3: The Market for Pizza Eq m w/o tax P S 1 $10.00 D Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 140

142 A Tax on Buyers The Hence, price a tax buyers on buyers pay is shifts now the $1.50 D curve higher down than the by the market amount price of P. the tax. P would have to fall by $1.50 to make buyers willing to buy same Q as before. E.g., if P falls from $10.00 to $8.50, buyers still willing to purchase 500 pizzas. $10.00 $8.50 P Effects of a $1.50 per unit tax on buyers 500 Tax D 2 S 1 D 1 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 141

143 A Tax on Buyers New eq m: Q = 450 Sellers receive P S = $9.50 Buyers pay P B = $11.00 P B = $11.00 $10.00 P S = $9.50 Difference between them = $1.50 = tax 450 P Effects of a $1.50 per unit tax on buyers Tax 500 D 2 S 1 D 1 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 142

144 The Incidence of a Tax: how the burden of a tax is shared among market participants In our example, buyers pay $1.00 more, sellers get $0.50 less. P B = $11.00 $10.00 P S = $9.50 P Tax S 1 D D 2 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 143

145 A Tax on Sellers The tax effectively raises sellers costs by $1.50 per pizza. Sellers will supply 500 pizzas only if P rises to $11.50, to compensate for this cost increase. P $11.50 $10.00 Effects of a $1.50 per unit tax on sellers S 2 Tax S 1 D 1 Hence, a tax on sellers shifts the S curve up by the amount of the tax. 500 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 144

146 A Tax on Sellers New eq m: Q = 450 Buyers pay P B = $11.00 Sellers receive P S = $9.50 P P B = $11.00 $10.00 P S = $9.50 Effects of a $1.50 per unit tax on sellers Tax S 2 S 1 Difference between them = $1.50 = tax D 1 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 145

147 The Outcome Is the Same in Both Cases! The effects on P and Q, and the tax incidence are the same whether the tax is imposed on buyers or sellers! What matters is this: A tax drives a wedge between the price buyers pay and the price sellers receive. P B = $11.00 $10.00 P S = $9.50 P 450 Tax 500 S 1 D 1 Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 146

148 A C T I V E L E A R N I N G 2 Effects of a tax Suppose govt imposes a tax on buyers of $30 per room. Find new Q, P B, P S, and incidence of tax. P The market for hotel rooms Q S D

149 A C T I V E L E A R N I N G 2 Answers Q = 80 P B = $110 P S = $80 Incidence buyers: $10 sellers: $ P B = 110 P S = P Tax The market for hotel rooms Q S D

150 Elasticity and Tax Incidence CASE 1: Supply is more elastic than demand Buyers share of tax burden Price if no tax Sellers share of tax burden P B P S P Tax D S Q It s easier for sellers than buyers to leave the market. So buyers bear most of the burden of the tax. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 149

151 Elasticity and Tax Incidence CASE 2: Demand is more elastic than supply Buyers share of tax burden Price if no tax Sellers share of tax burden P B P S P Tax S D It s easier for buyers than sellers to leave the market. Sellers bear most of the burden of the tax. Q SUPPLY, DEMAND, AND GOVERNMENT POLICIES 150

152 CASE STUDY: Who Pays the Luxury Tax? 1990: Congress adopted a luxury tax on yachts, private airplanes, furs, expensive cars, etc. Goal of the tax: raise revenue from those who could most easily afford to pay wealthy consumers. But who really pays this tax? SUPPLY, DEMAND, AND GOVERNMENT POLICIES 151

153 CASE STUDY: Who Pays the Luxury Tax? The market for yachts Buyers share of tax burden P B P S Demand is price-elastic. In the short run, supply is inelastic. Sellers share of tax burden P S Tax D Q Hence, companies that build yachts pay most of the tax. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 152

154 CONCLUSION: Government Policies and the Allocation of Resources Each of the policies in this chapter affects the allocation of society s resources. Example 1: A tax on pizza reduces eq m Q. With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. Example 2: A binding minimum wage causes a surplus of workers, a waste of resources. So, it s important for policymakers to apply such policies very carefully. SUPPLY, DEMAND, AND GOVERNMENT POLICIES 153

155 CHAPTER SUMMARY A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq m price, it is binding and causes a shortage. A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. 154

156 CHAPTER SUMMARY A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq m quantity to fall, whether the tax is imposed on buyers or sellers. The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. 155

157 THE MARKET FORCES OF SUPPLY AND DEMAND 156

158 C H A P T E R 13 The Costs of Production Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

159 A C T I V E L E A R N I N G 1 Brainstorming costs You run General Motors. List 3 different costs you have. List 3 different business decisions that are affected by your costs. 158

160 In this chapter, look for the answers to these questions: What is a production function? What is marginal product? How are they related? What are the various costs, and how are they related to each other and to output? How are costs different in the short run vs. the long run? What are economies of scale? 159

161 Total Revenue, Total Cost, Profit We assume that the firm s goal is to maximize profit. Profit = Total revenue Total cost the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production THE COSTS OF PRODUCTION 160

162 Costs: Explicit vs. Implicit Explicit costs require an outlay of money, e.g., paying wages to workers. Implicit costs do not require a cash outlay, e.g., the opportunity cost of the owner s time. Remember one of the Ten Principles: The cost of something is what you give up to get it. This is true whether the costs are implicit or explicit. Both matter for firms decisions. THE COSTS OF PRODUCTION 161

163 Explicit vs. Implicit Costs: An Example You need $100,000 to start your business. The interest rate is 5%. Case 1: borrow $100,000 explicit cost = $5000 interest on loan Case 2: use $40,000 of your savings, borrow the other $60,000 explicit cost = $3000 (5%) interest on the loan implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp + imp) costs are $5000. THE COSTS OF PRODUCTION 162

164 Economic Profit vs. Accounting Profit Accounting profit = total revenue minus total explicit costs Economic profit = total revenue minus total costs (including explicit and implicit costs) Accounting profit ignores implicit costs, so it s higher than economic profit. THE COSTS OF PRODUCTION 163

165 A C T I V E L E A R N I N G 2 Economic profit vs. accounting profit The equilibrium rent on office space has just increased by $500/month. Compare the effects on accounting profit and economic profit if a. you rent your office space b. you own your office space 164

166 A C T I V E L E A R N I N G 2 Answers The rent on office space increases $500/month. a. You rent your office space. Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month. b.you own your office space. Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month. 165

167 The Production Function A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good. It can be represented by a table, equation, or graph. Example 1: Farmer Jack grows wheat. He has 5 acres of land. He can hire as many workers as he wants. THE COSTS OF PRODUCTION 166

168 Quantity of output Example 1: Farmer Jack s Production Function L (no. of workers) Q (bushels of wheat) 3,000 2, , , , No. of workers THE COSTS OF PRODUCTION 167

169 Marginal Product If Jack hires one more worker, his output rises by the marginal product of labor. The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Notation: (delta) = change in Examples: Q = change in output, L = change in labor Marginal product of labor (MPL) = Q L THE COSTS OF PRODUCTION 168

170 EXAMPLE 1: Total & Marginal Product L (no. of workers) Q (bushels of wheat) MPL L = 1 L = 1 L = 1 L = 1 L = Q = 1000 Q = 800 Q = 600 Q = 400 Q = THE COSTS OF PRODUCTION 169

171 Quantity of output EXAMPLE 1: MPL = Slope of Prod Function L (no. of workers) Q (bushels of wheat) MPL MPL equals the slope of the production function. 3,000 2,500 2,000 Notice that MPL diminishes as L increases. 1,500 1,000 This explains why the 500 production function gets flatter 0 as L increases No. of workers THE COSTS OF PRODUCTION 170

172 Why MPL Is Important Recall one of the Ten Principles: Rational people think at the margin. When Farmer Jack hires an extra worker, his costs rise by the wage he pays the worker his output rises by MPL Comparing them helps Jack decide whether he would benefit from hiring the worker. THE COSTS OF PRODUCTION 171

173 Why MPL Diminishes Farmer Jack s output rises by a smaller and smaller amount for each additional worker. Why? As Jack adds workers, the average worker has less land to work with and will be less productive. In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.). Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal) THE COSTS OF PRODUCTION 172

174 EXAMPLE 1: Farmer Jack s Costs Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows. The market wage for a farm worker is $2000 per month. So Farmer Jack s costs are related to how much wheat he produces. THE COSTS OF PRODUCTION 173

175 EXAMPLE 1: Farmer Jack s Costs L (no. of workers) Q (bushels of wheat) Cost of land Cost of labor Total Cost 0 0 $1,000 $0 $1, $1,000 $2,000 $3, $1,000 $4,000 $5, $1,000 $6,000 $7, $1,000 $8,000 $9, $1,000 $10,000 $11,000 THE COSTS OF PRODUCTION 174

176 EXAMPLE 1: Farmer Jack s Total Cost Curve Q (bushels of wheat) Total Cost 0 $1, $3, $5, $7, $9, $11,000 Total cost $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $ Quantity of wheat THE COSTS OF PRODUCTION 175

177 Marginal Cost Marginal Cost (MC) is the increase in Total Cost from producing one more unit: MC = TC Q THE COSTS OF PRODUCTION 176

178 EXAMPLE 1: Total and Marginal Cost Q (bushels of wheat) Total Cost Marginal Cost (MC) 0 $1,000 Q = 1000 TC = $ $3,000 Q = 800 TC = $ $5,000 Q = 600 TC = $ $7,000 Q = 400 TC = $ $9,000 Q = $11,000 TC = $2000 $2.00 $2.50 $3.33 $5.00 $10.00 THE COSTS OF PRODUCTION 177

179 EXAMPLE 1: The Marginal Cost Curve Q (bushels of wheat) TC $1,000 $3,000 $5,000 $7,000 $9,000 $11,000 MC $2.00 $2.50 $3.33 $5.00 $10.00 Marginal Cost ($) $12 $10 $8 $6 $4 $2 $0 MC usually rises as Q rises, as in this example. 0 1,000 2,000 3,000 Q THE COSTS OF PRODUCTION 178

180 Why MC Is Important Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat? To find the answer, Farmer Jack needs to think at the margin. If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack s profits rise if he produces more. THE COSTS OF PRODUCTION 179

181 Fixed and Variable Costs Fixed costs (FC) do not vary with the quantity of output produced. For Farmer Jack, FC = $1000 for his land Other examples: cost of equipment, loan payments, rent Variable costs (VC) vary with the quantity produced. For Farmer Jack, VC = wages he pays workers Other example: cost of materials Total cost (TC) = FC + VC THE COSTS OF PRODUCTION 180

182 EXAMPLE 2 Our second example is more general, applies to any type of firm producing any good with any types of inputs. THE COSTS OF PRODUCTION 181

183 Costs EXAMPLE 2: Costs Q FC VC TC 0 $100 $0 $ $800 FC $700 VC TC $600 $500 $400 $300 $200 $100 $ Q THE COSTS OF PRODUCTION 182

184 EXAMPLE 2: Marginal Cost Q TC $ MC $ Recall, Marginal Cost (MC) is $175 the change in total cost from producing one more unit: $125 TC MC = $100 Q Usually, MC rises as Q rises, due $75 to diminishing marginal product. Costs $200 $150 $50 Sometimes (as here), MC falls $25 before rising. $0 (In other examples, MC may be constant.) Q THE COSTS OF PRODUCTION 183

185 EXAMPLE 2: Average Fixed Cost Q FC $ AFC n/a $ Costs Average $200 fixed cost (AFC) is $175 fixed cost divided by the quantity of output: $150 AFC = FC/Q $125 $100 Notice $75 that AFC falls as Q rises: The firm is spreading its fixed $50 costs over a larger and larger $25 number of units. $ THE COSTS OF PRODUCTION 184 Q

186 EXAMPLE 2: Average Variable Cost Q VC $ AVC n/a $ Costs Average $200 variable cost (AVC) is $175 variable cost divided by the quantity of output: $150 AVC = VC/Q $125 $100 As $75 Q rises, AVC may fall initially. In most cases, AVC will $50 eventually rise as output rises. $25 $ Q THE COSTS OF PRODUCTION 185

187 EXAMPLE 2: Average Total Cost Q 0 1 TC $ ATC n/a $170 AFC n/a $100 AVC n/a $70 Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Also, ATC = AFC + AVC THE COSTS OF PRODUCTION 186

188 Costs EXAMPLE 2: Average Total Cost Q TC $ ATC n/a $ $200 Usually, as in this example, $175 the ATC curve is U-shaped. $150 $125 $100 $75 $50 $ $ Q THE COSTS OF PRODUCTION 187

189 Costs EXAMPLE 2: The Various Cost Curves Together $200 $175 ATC AVC AFC MC $150 $125 $100 $75 $50 $25 $ Q THE COSTS OF PRODUCTION 188

190 A C T I V E L E A R N I N G 3 Calculating costs Fill in the blank spaces of this table. Q VC TC AFC AVC ATC MC $50 n/a n/a $10 n/a $60.00 $

191 A C T I V E L E A R N I N G 3 Answers First, Use relationship deduce AFC AVC ATC = TC/Q FC/Q VC/Q between = $50 and MC use and FC TC + VC = TC. Q VC TC AFC AVC ATC MC $ $ n/a $ n/a $ n/a $ $

192 Costs EXAMPLE 2: Why ATC Is Usually U-Shaped As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. Efficient scale: The quantity that minimizes ATC. $200 $175 $150 $125 $100 $75 $50 $25 $ Q THE COSTS OF PRODUCTION 191

193 Costs EXAMPLE 2: ATC and MC When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curve s minimum. $200 $175 $150 $125 $100 $75 $50 $25 $0 ATC MC Q THE COSTS OF PRODUCTION 192

194 Costs in the Short Run & Long Run Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones). In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC). THE COSTS OF PRODUCTION 193

195 EXAMPLE 3: LRATC with 3 factory Sizes Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run. Avg Total Cost ATC S ATC M ATC L Q THE COSTS OF PRODUCTION 194

196 EXAMPLE 3: LRATC with 3 factory Sizes To produce less than Q A, firm will choose size S in the long run. Avg Total Cost ATC S ATC M ATC L To produce between Q A and Q B, firm will choose size M in the long run. LRATC To produce more than Q B, firm will choose size L in the long run. Q A Q B Q THE COSTS OF PRODUCTION 195

197 A Typical LRATC Curve In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: ATC LRATC Q THE COSTS OF PRODUCTION 196

198 How ATC Changes as the Scale of Production Changes Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. ATC LRATC Diseconomies of scale: ATC rises as Q increases. Q THE COSTS OF PRODUCTION 197

199 How ATC Changes as the Scale of Production Changes Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. More common when Q is low. Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can t control costs. More common when Q is high. THE COSTS OF PRODUCTION 198

200 CONCLUSION Costs are critically important to many business decisions, including production, pricing, and hiring. This chapter has introduced the various cost concepts. The following chapters will show how firms use these concepts to maximize profits in various market structures. THE COSTS OF PRODUCTION 199

201 CHAPTER SUMMARY Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms decisions. Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs. The production function shows the relationship between output and inputs. 200

202 CHAPTER SUMMARY The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly. Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper. Variable costs vary with output; fixed costs do not. 201

203 CHAPTER SUMMARY Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping. Average variable cost is variable cost divided by output. Average fixed cost is fixed cost divided by output. AFC always falls as output increases. Average total cost (sometimes called cost per unit ) is total cost divided by the quantity of output. The ATC curve is usually U-shaped. 202

204 CHAPTER SUMMARY The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises. In the long run, all costs are variable. Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises. 203

205 THE MARKET FORCES OF SUPPLY AND DEMAND 205

206 C H A P T E R 14 Firms in Competitive Markets Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

207 In this chapter, look for the answers to these questions: What is a perfectly competitive market? What is marginal revenue? How is it related to total and average revenue? How does a competitive firm determine the quantity that maximizes profits? When might a competitive firm shut down in the short run? Exit the market in the long run? What does the market supply curve look like in the short run? In the long run? 207

208 Introduction: A Scenario Three years after graduating, you run your own business. You must decide how much to produce, what price to charge, how many workers to hire, etc. What factors should affect these decisions? Your costs (studied in preceding chapter) How much competition you face We begin by studying the behavior of firms in perfectly competitive markets. FIRMS IN COMPETITIVE MARKETS 208

209 Characteristics of Perfect Competition 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. Because of 1 & 2, each buyer and seller is a price taker takes the price as given. FIRMS IN COMPETITIVE MARKETS 209

210 The Revenue of a Competitive Firm Total revenue (TR) TR = P x Q Average revenue (AR) AR = TR Q = P Marginal revenue (MR): The change in TR from selling one more unit. MR = TR Q FIRMS IN COMPETITIVE MARKETS 210

211 A C T I V E L E A R N I N G 1 Calculating TR, AR, MR Fill in the empty spaces of the table. Q P TR AR MR 0 $10 n/a 1 $10 $10 2 $10 3 $ $10 $10 $40 $50 $10 211

212 A C T I V E L E A R N I N G 1 Answers Fill in the empty spaces of the table. Q P TR = P x Q AR = TR Q MR = TR Q $10 $10 $10 $10 $10 $10 $0 n/a $10 Notice that MR = P $20 $10 $10 $30 $10 $40 $10 $50 $10 $10 $10 $10 $10 $10 212

213 MR = P for a Competitive Firm A competitive firm can keep increasing its output without affecting the market price. So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets. FIRMS IN COMPETITIVE MARKETS 213

214 Profit Maximization What Q maximizes the firm s profit? To find the answer, think at the margin. If increase Q by one unit, revenue rises by MR, cost rises by MC. If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit. FIRMS IN COMPETITIVE MARKETS 214

215 Profit Maximization (continued from earlier exercise) At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit. Q TR $ TC $ Profit $ MR $ MC $ Profit = MR MC $ FIRMS IN COMPETITIVE MARKETS 215

216 MC and the Firm s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Q a, MC < MR. So, increase Q to raise profit. Costs MC At Q b, MC > MR. So, reduce Q to raise profit. P 1 MR At Q 1, MC = MR. Changing Q would lower profit. Q a Q 1 Q b Q FIRMS IN COMPETITIVE MARKETS 216

217 MC and the Firm s Supply Decision If price rises to P 2, then the profitmaximizing quantity rises to Q 2. Costs MC The MC curve determines the firm s Q at any price. Hence, the MC curve is the firm s supply curve. P 2 MR 2 P 1 MR Q 1 Q 2 Q FIRMS IN COMPETITIVE MARKETS 217

218 Shutdown vs. Exit Shutdown: A short-run decision not to produce anything because of market conditions. Exit: A long-run decision to leave the market. A key difference: If shut down in SR, must still pay FC. If exit in LR, zero costs. FIRMS IN COMPETITIVE MARKETS 218

219 A Firm s Short-run Decision to Shut Down Cost of shutting down: revenue loss = TR Benefit of shutting down: cost savings = VC (firm must still pay FC) So, shut down if TR < VC Divide both sides by Q: TR/Q < VC/Q So, firm s decision rule is: Shut down if P < AVC FIRMS IN COMPETITIVE MARKETS 219

220 A Competitive Firm s SR Supply Curve The firm s SR supply curve is the portion of its MC curve If P > AVC, then above AVC. firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0). Costs MC ATC AVC Q FIRMS IN COMPETITIVE MARKETS 220

221 The Irrelevance of Sunk Costs Sunk cost: a cost that has already been committed and cannot be recovered Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. So, FC should not matter in the decision to shut down. FIRMS IN COMPETITIVE MARKETS 221

222 A Firm s Long-Run Decision to Exit Cost of exiting the market: revenue loss = TR Benefit of exiting the market: cost savings = TC (zero FC in the long run) So, firm exits if TR < TC Divide both sides by Q to write the firm s decision rule as: Exit if P < ATC FIRMS IN COMPETITIVE MARKETS 222

223 A New Firm s Decision to Enter Market In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. Divide both sides by Q to express the firm s entry decision as: Enter if P > ATC FIRMS IN COMPETITIVE MARKETS 223

224 The Competitive Firm s Supply Curve The firm s LR supply curve is the portion of its MC curve above LRATC. Costs MC LRATC Q FIRMS IN COMPETITIVE MARKETS 224

225 A C T I V E L E A R N I N G 2 Identifying a firm s profit Determine this firm s total profit. Costs, P A competitive firm MC Identify the area on the graph that represents the firm s profit. P = $10 $6 50 MR ATC Q 225

226 A C T I V E L E A R N I N G 2 Answers Profit per unit = P ATC = $10 6 = $4 Total profit = (P ATC) x Q = $4 x 50 = $200 Costs, P P = $10 $6 A competitive firm MC profit 50 MR ATC Q 226

227 A C T I V E L E A R N I N G 3 Identifying a firm s loss Determine this firm s total loss, assuming AVC < $3. Identify the area on the graph that represents the firm s loss. Costs, P $5 P = $3 A competitive firm 30 MC ATC MR Q 227

228 A C T I V E L E A R N I N G 3 Answers Total loss = (ATC P) x Q = $2 x 30 = $60 Costs, P $5 P = $3 A competitive firm MC ATC loss loss per unit = $2 MR 30 Q 228

229 Market Supply: Assumptions 1) All existing firms and potential entrants have identical costs. 2) Each firm s costs do not change as other firms enter or exit the market. 3) The number of firms in the market is fixed in the short run (due to fixed costs) variable in the long run (due to free entry and exit) FIRMS IN COMPETITIVE MARKETS 229

230 The SR Market Supply Curve As long as P AVC, each firm will produce its profit-maximizing quantity, where MR = MC. Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantities supplied by all firms. FIRMS IN COMPETITIVE MARKETS 230

231 The SR Market Supply Curve Example: 1000 identical firms At each P, market Q s = 1000 x (one firm s Q s ) P One firm MC P Market S P 3 P 3 P 2 AVC P 2 P 1 P Q (firm) Q (market) 10,000 20,000 30,000 FIRMS IN COMPETITIVE MARKETS 231

232 Entry & Exit in the Long Run In the LR, the number of firms can change due to entry & exit. If existing firms earn positive economic profit, new firms enter, SR market supply shifts right. P falls, reducing profits and slowing entry. If existing firms incur losses, some firms exit, SR market supply shifts left. P rises, reducing remaining firms losses. FIRMS IN COMPETITIVE MARKETS 232

233 The Zero-Profit Condition Long-run equilibrium: The process of entry or exit is complete remaining firms earn zero economic profit. Zero economic profit occurs when P = ATC. Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC. Recall that MC intersects ATC at minimum ATC. Hence, in the long run, P = minimum ATC. FIRMS IN COMPETITIVE MARKETS 233

234 Why Do Firms Stay in Business if Profit = 0? Recall, economic profit is revenue minus all costs including implicit costs, like the opportunity cost of the owner s time and money. In the zero-profit equilibrium, firms earn enough revenue to cover these costs accounting profit is positive FIRMS IN COMPETITIVE MARKETS 234

235 The LR Market Supply Curve In the long run, the typical firm earns zero profit. The LR market supply curve is horizontal at P = minimum ATC. P One firm MC P Market P = min. ATC LRATC Q (firm) long-run supply Q (market) FIRMS IN COMPETITIVE MARKETS 235

236 SR & LR Effects of an Increase in Demand A firm begins in but then an increase long-run leading eq m to driving SR profits Over time, to zero in profits demand induce raises entry, P, profits for the and firm. restoring shifting long-run S to the eq m. right, reducing P P One firm MC P Market S 1 P 2 P 1 Profit ATC P 2 P 1 A B C S 2 long-run supply D 2 Q (firm) Q 1 Q 2 Q 3 D 1 Q (market) FIRMS IN COMPETITIVE MARKETS 236

237 Why the LR Supply Curve Might Slope Upward The LR market supply curve is horizontal if 1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market. If either of these assumptions is not true, then LR supply curve slopes upward. FIRMS IN COMPETITIVE MARKETS 237

238 1) Firms Have Different Costs As P rises, firms with lower costs enter the market before those with higher costs. Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied. Hence, LR market supply curve slopes upward. At any P, For the marginal firm, P = minimum ATC and profit = 0. For lower-cost firms, profit > 0. FIRMS IN COMPETITIVE MARKETS 238

239 2) Costs Rise as Firms Enter the Market In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed). The entry of new firms increases demand for this input, causing its price to rise. This increases all firms costs. Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping. FIRMS IN COMPETITIVE MARKETS 239

240 CONCLUSION: The Efficiency of a Competitive Market Profit-maximization: Perfect competition: So, in the competitive eq m: MC = MR P = MR P = MC Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. So, the competitive eq m is efficient, maximizes total surplus. In the next chapter, monopoly: pricing & production decisions, deadweight loss, regulation. FIRMS IN COMPETITIVE MARKETS 240

241 CHAPTER SUMMARY For a firm in a perfectly competitive market, price = marginal revenue = average revenue. If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. If P < ATC, a firm will exit in the long run. In the short run, entry is not possible, and an increase in demand increases firms profits. With free entry and exit, profits = 0 in the long run, and P = minimum ATC. 241

242 THE MARKET FORCES OF SUPPLY AND DEMAND 244

243 C H A P T E R 15 Monopoly Economics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 2009 South-Western, a part of Cengage Learning, all rights reserved

244 In this chapter, look for the answers to these questions: Why do monopolies arise? Why is MR < P for a monopolist? How do monopolies choose their P and Q? How do monopolies affect society s well-being? What can the government do about monopolies? What is price discrimination? 246

245 Introduction A monopoly is a firm that is the sole seller of a product without close substitutes. In this chapter, we study monopoly and contrast it with perfect competition. The key difference: A monopoly firm has market power, the ability to influence the market price of the product it sells. A competitive firm has no market power. MONOPOLY 247

246 Why Monopolies Arise The main cause of monopolies is barriers to entry other firms cannot enter the market. Three sources of barriers to entry: 1. A single firm owns a key resource. E.g., DeBeers owns most of the world s diamond mines 2. The govt gives a single firm the exclusive right to produce the good. E.g., patents, copyright laws MONOPOLY 248

247 Why Monopolies Arise 3. Natural monopoly: a single firm can produce the entire market Q at lower cost than could several firms. Example: 1000 homes need electricity Cost ATC is lower if one firm services all 1000 homes $80 than if two firms $50 each service 500 homes. 500 Electricity ATC slopes downward due to huge FC and small MC 1000 ATC MONOPOLY 249 Q

248 Monopoly vs. Competition: Demand Curves In a competitive market, the market demand curve slopes downward. But the demand curve for any individual firm s product is horizontal at the market price. The firm can increase Q without lowering P, so MR = P for the competitive firm. P A competitive firm s demand curve D Q MONOPOLY 250

249 Monopoly vs. Competition: Demand Curves A monopolist is the only seller, so it faces the market demand curve. To sell a larger Q, the firm must reduce P. Thus, MR P. P A monopolist s demand curve D Q MONOPOLY 251

250 A C T I V E L E A R N I N G 1 A monopoly s revenue Common Grounds is the only seller of cappuccinos in town. The table shows the market demand for cappuccinos. Fill in the missing spaces of the table. What is the relation between P and AR? Between P and MR? Q P TR AR MR 0 $ n.a. 252

251 A C T I V E L E A R N I N G 1 Answers Here, P = AR, same as for a competitive firm. Here, MR < P, whereas MR = P for a competitive firm. Q P $ TR $ AR n.a. $ MR $

252 Common Grounds D and MR Curves P, MR Q P $ MR $ $ Demand curve (P) MR Q MONOPOLY 254

253 Understanding the Monopolist s MR Increasing Q has two effects on revenue: Output effect: higher output raises revenue Price effect: lower price reduces revenue To sell a larger Q, the monopolist must reduce the price on all the units it sells. Hence, MR < P MR could even be negative if the price effect exceeds the output effect (e.g., when Common Grounds increases Q from 5 to 6). MONOPOLY 255

254 Profit-Maximization Like a competitive firm, a monopolist maximizes profit by producing the quantity where MR = MC. Once the monopolist identifies this quantity, it sets the highest price consumers are willing to pay for that quantity. It finds this price from the D curve. MONOPOLY 256

255 Profit-Maximization 1. The profitmaximizing Q is where MR = MC. Costs and Revenue P MC 2. Find P from the demand curve at this Q. MR D Q Quantity Profit-maximizing output MONOPOLY 257

256 The Monopolist s Profit Costs and Revenue MC As with a competitive firm, the monopolist s profit equals P ATC ATC D (P ATC) x Q MR Q Quantity MONOPOLY 258

257 A Monopoly Does Not Have an S Curve A competitive firm takes P as given has a supply curve that shows how its Q depends on P. A monopoly firm is a price-maker, not a price-taker Q does not depend on P; rather, Q and P are jointly determined by MC, MR, and the demand curve. So there is no supply curve for monopoly. MONOPOLY 259

258 CASE STUDY: Monopoly vs. Generic Drugs Patents on new drugs give a temporary monopoly to the seller. Price The market for a typical drug When the patent expires, the market P C = becomes competitive, generics appear. P M MC MR D Q M Q C Quantity MONOPOLY 260

259 The Welfare Cost of Monopoly Recall: In a competitive market equilibrium, P = MC and total surplus is maximized. In the monopoly eq m, P > MR = MC The value to buyers of an additional unit (P) exceeds the cost of the resources needed to produce that unit (MC). The monopoly Q is too low could increase total surplus with a larger Q. Thus, monopoly results in a deadweight loss. MONOPOLY 261

260 The Welfare Cost of Monopoly Competitive eq m: quantity = Q C P = MC total surplus is maximized Monopoly eq m: quantity = Q M P > MC deadweight loss Price P P = MC MC Deadweight loss MC D MR Q M Q C Quantity MONOPOLY 262

261 Price Discrimination Discrimination: treating people differently based on some characteristic, e.g. race or gender. Price discrimination: selling the same good at different prices to different buyers. The characteristic used in price discrimination is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP. MONOPOLY 263

262 Perfect Price Discrimination vs. Single Price Monopoly Here, the monopolist charges the same price (P M ) to all buyers. A deadweight loss results. Monopoly profit Price P M MC Consumer surplus Deadweight loss MR D Q M Quantity MONOPOLY 264

263 Perfect Price Discrimination vs. Single Price Monopoly Here, the monopolist produces the competitive quantity, but charges each buyer his or her WTP. This is called perfect price discrimination. The monopolist captures all CS as profit. But there s no DWL. Price MC Monopoly profit MR Quantity MONOPOLY 265 Q D

264 Price Discrimination in the Real World In the real world, perfect price discrimination is not possible: No firm knows every buyer s WTP Buyers do not announce it to sellers So, firms divide customers into groups based on some observable trait that is likely related to WTP, such as age. MONOPOLY 266

265 Examples of Price Discrimination Movie tickets Discounts for seniors, students, and people who can attend during weekday afternoons. They are all more likely to have lower WTP than people who pay full price on Friday night. Airline prices Discounts for Saturday-night stayovers help distinguish business travelers, who usually have higher WTP, from more price-sensitive leisure travelers. MONOPOLY 267

266 Examples of Price Discrimination Discount coupons People who have time to clip and organize coupons are more likely to have lower income and lower WTP than others. Need-based financial aid Low income families have lower WTP for their children s college education. Schools price-discriminate by offering need-based aid to low income families. MONOPOLY 268

267 Examples of Price Discrimination Quantity discounts A buyer s WTP often declines with additional units, so firms charge less per unit for large quantities than small ones. Example: A movie theater charges $4 for a small popcorn and $5 for a large one that s twice as big. MONOPOLY 269

268 Public Policy Toward Monopolies Increasing competition with antitrust laws Ban some anticompetitive practices, allow govt to break up monopolies. E.g., Sherman Antitrust Act (1890), Clayton Act (1914) Regulation Govt agencies set the monopolist s price. For natural monopolies, MC < ATC at all Q, so marginal cost pricing would result in losses. If so, regulators might subsidize the monopolist or set P = ATC for zero economic profit. MONOPOLY 270

269 Public Policy Toward Monopolies Public ownership Example: U.S. Postal Service Problem: Public ownership is usually less efficient since no profit motive to minimize costs Doing nothing The foregoing policies all have drawbacks, so the best policy may be no policy. MONOPOLY 271

270 CONCLUSION: The Prevalence of Monopoly In the real world, pure monopoly is rare. Yet, many firms have market power, due to: selling a unique variety of a product having a large market share and few significant competitors In many such cases, most of the results from this chapter apply, including: markup of price over marginal cost deadweight loss MONOPOLY 272

271 CHAPTER SUMMARY A monopoly firm is the sole seller in its market. Monopolies arise due to barriers to entry, including: government-granted monopolies, the control of a key resource, or economies of scale over the entire range of output. A monopoly firm faces a downward-sloping demand curve for its product. As a result, it must reduce price to sell a larger quantity, which causes marginal revenue to fall below price. 273

272 CHAPTER SUMMARY Monopoly firms maximize profits by producing the quantity where marginal revenue equals marginal cost. But since marginal revenue is less than price, the monopoly price will be greater than marginal cost, leading to a deadweight loss. Monopoly firms (and others with market power) try to raise their profits by charging higher prices to consumers with higher willingness to pay. This practice is called price discrimination. 274

273 CHAPTER SUMMARY Policymakers may respond by regulating monopolies, using antitrust laws to promote competition, or by taking over the monopoly and running it. Due to problems with each of these options, the best option may be to take no action. 275

274 THE MARKET FORCES OF SUPPLY AND DEMAND 276

275 277 Price Discrimination Price discrimination Charging different customers different prices for the same product when the price differences are not due to differences in costs. Examples of price discrimination Student / Senior Citizen movie ticket prices. Airline ticket prices Tourist prices for local attractions

276 278 Who can price discriminate? Market power Firms must have market power. Otherwise, it cannot charge more than the competitive price. Difference in demand elasticities Consumer must differ in their demand elasticities and the firm must be able to identify how consumers differ. Prevent or limit resale Prevent higher-price-paying customers to buy from lower-price-paying customers The firm must be able to segment the market.

277 279 Example: price discrimination by an airline Suppose the market for Bangkok-Phuket airline ticket consists of: High-valuation business people: They have relatively inelastic demand and need to book at shortnotice (less than 7 days). Low-valuation tourists: They have relatively elastic demand and book well in advance.

278 280 Example: price discrimination by an airline Suppose that AirAsia is the only airline flying this route but cannot distinguish between a business person and a tourist when they book a flight online. Is it possible for AirAsia to price discriminate? o o Offering a high-priced flexible ticket that allows travellers to book a ticket at any time Offering a low-priced budget saver ticket that requires travellers to book over 7 days in advance.

279 281 Example: price discrimination by an airline P Total Revenue uniform P For business travelers, total revenue increases by A-C. Total Revenue discriminate For tourist, total revenue increases by F-D. P flexible A P uniform B C P budget D E F MC MR Deman d Business Travellers Q MR Tourists Deman d Q

280 282 Example: price discrimination by an airline The demand by high-valuation business travelers q = B p B 1 MR B = 25- q 2 B The demand by low-valuation tourists qt = 100-8p t 1 MR t = q 4 t The cost is $2 per unit regardless of the number of units supplied and fixed cost is $20. P Business Travellers MR B Q P Tourists Demand B MR t Demand 50 t MC 10 0 Q

281 283 Example: price discrimination by an airline When the monopolists can set different prices, it will set each marginal revenue equal to the marginal cost. P 2 5 Business Travellers P Tourists MR B = MC = 2 MR t = MC = 2 P flexible = MR B P budget =7.25 Demand B MR t Demand Q t MC 10 0 Q

282 284 Example: price discrimination by an airline Profit = TR -TC P Business Travellers P Tourists TR = P flexible qb + Pbudgetqt = 13. 5( 46) ( 42) = TC = FC+ ( q + q ) MC = 20 + ( ) 2 = 196 B Profit = t 2 5 P flexible = MR B P budget =7.25 Demand B MR t Demand Q t MC 10 0 Q

283 285 Example: Set a uniform price P Business Travellers P Tourists P Business Travellers + Tourists q = 100-4p q q B q p t MR 50 Deman d 10 0 Q MR 50 Deman d 10 0 Q 50 Deman d 20 0 Q

284 286 Example: Set a uniform price MR = MC = q = 88 p = q 2 Substitute into an inverse demand 88 = p Profit = 9. 33( 88) ( 2) = MR MR 1 = 25-2 q q P Q 2 Business Travellers + Tourists q = 100-4p M R q q B q p Deman d 20 0 t Q MC

285 288 Exercise 4 Disney land observes that their customers can be categorized into two different groups of customers; adults and teenagers. The demand curves for both customers are given by q adult 32-1 p 2 adult qteenageer 28- p teenager Fixed cost is $100 and Disney land has a constant marginal cost of $2 per ticket. a) Suppose that price discrimination is not allowed. What would be the price and quantity Disney land should set in order to maximize its profit? b) Now the government allows Disney land to do price discrimination. What would be the price and quantity Disney land should charge and sell for each group of customers in order to maximize its profit? How much more profit Disney land can earn through price discrimination?