Chapter 2 Production
As noted in Chapter 1, economics is the study of how individuals and economies deal
with the fundamental problem of scarcity. Since there are not enough available resources
to satisfy the wants of individuals and societies, individuals and societies must make
choices among competing alternatives.
The opportunity cost of any alternative is defined as the cost of not selecting the "next-
best" alternative. Let's consider a few examples of opportunity cost:
Suppose that you own a building that you use for a retail store. If the next-best use
of the building is to rent it to someone else, the opportunity cost of using the
business for your business is the rent you could have received. If the next-best use
of the building is to sell it to someone else, the annual opportunity cost of using it
for your own business is the foregone interest that you could have received (e.g.,
if the interest rate is 10% and the building is worth $100,000, you give up $10,000
in interest each year by keeping the building, assuming that the value of the
building remains constant over the year -- depreciation or appreciation would
have to be taken into account if the value of the building changes over time).
The opportunity class of attending college includes:
o the cost of tuition, books, and supplies (the costs of room and board only
appear if these costs differ from the levels that would have been paid in
your next-best alternative),
o foregone income (this is usually the largest cost associated with college
o psychic costs (the stress, anxiety, etc. associated with studying, worrying
about grades, etc.).
If you attend a movie, the opportunity cost includes not only the cost of the tickets
and transportation, but also the opportunity cost of the time required to view the
When economists discuss the costs and benefits associated with alternative activities, the
discussion generally focuses on marginal benefits and marginal costs. The marginal
benefit from an activity is the additional benefit associated with a one-unit increase in the
level of an activity. Marginal cost is defined as the additional cost associated with a one-
unit increase in the level of the activity. Economists assume that individuals attempt to
maximize the net benefit associated with each activity.
If marginal benefit exceeds marginal cost, net benefit will increase if the level of the
activity rises. Therefore, rational individuals will increase the level of any activity when
marginal benefit exceeds marginal costs. On the other hand, if marginal cost exceeds
marginal benefit, net benefit rises when the level of the activity is decreased. There is no
reason to change the level of an activity (and net benefit is maximized) at the level of an
activity at which marginal benefit equals marginal cost.
Production Possibilities Curve
Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely
by a production possibilities frontier.
For simplicity, it is assumed that a firm (or an economy) produces only two goods (this
assumption is needed only to make the representation feasible on a two-dimensional
surface -- such as a graph on paper or on a computer screen). When a production
possibilities curve is drawn, the following assumptions are also made:
1. there is a fixed quantity and quality of available resources,
2. technology is fixed, and
3. there are no unemployed nor underemployed resources
Very shortly, we'll also see what happens when these assumptions are relaxed.
For now, though, let's consider a simple example. Suppose that a student has four hours
left to study for exams in two classes: introductory microeconomics and introductory
calculus. The output in this case is the exam score in each class. The assumption of a
fixed quantity and quality of available resources means that the individual has a fixed
supply of study materials such as textbooks, study guides, notes, etc. to use in the
available time. A fixed technology suggests that the individual has a given level of study
skills that allow him or her to translate the review materials into exam scores. A resource
is unemployed if it is not used. Idle land, factories, and workers are unemployed
resources for a society. Underemployed resources are not used in the best possible way.
Society would have underemployed resources if the best brain surgeons were driving
taxis while the best taxi drivers were performing brain surgery.... The use of an adjustable
wrench as a hammer or the use of a hammer to pound a screw into wood provide
additional examples of underemployed resources. If there are no unemployed or
underemployed resources, efficient production is said to occur.
The table below represents possible outcomes from each various combinations of time
studying each subject:
# of # of
0 4 0 60
1 3 30 55
2 2 55 45
3 1 75 30
4 0 85 0
Notice that each additional hour spent studying either calculus or economics results in
smaller marginal improvements in the grade. The reason for this is that the first hour will
be spent studying the most essential concepts. Each additional hour is spent on the "next-
most" important topics that have not already been mastered. (It is important to note that a
good grade on an economics examination requires substantially more than four hours of
study time.) This is an example of a general principle known as the law of diminishing
returns. The law of diminishing returns states that output will ultimately increase by
progressively smaller amounts as additional units of a variable input (time in this case)
are added to a production process in which other inputs are fixed (the fixed inputs here
include the stock of existing subject matter knowledge, study materials, etc.).
To see how the law of diminishing returns works in a more typical production setting,
consider the case of a restaurant that has a fixed quantity of capital (grills, broilers, fryers,
refrigerators, tables, etc.). As the level of labor use increases, output may initially rise
fairly rapidly (since additional workers allow more possibilities for specialization and
reduces the time spent switching from task to task). Eventually, however, the addition of
more workers will result in progressively smaller increases in output (since there is a
fixed amount of capital for these workers to use). It is even possible that beyond some
point workers may start getting in each others way and output may decline ("too many
cooks may spoil the broth...." sorry.... I couldn't resist).
In any case, the law of diminishing returns explains why your grade will increase by
fewer points with each additional hour that you spend studying.
The points in the table above can be represented by a production possibilities curve (PPC)
such as the one appearing in the diagram below. Each point on the production
possibilities curve represents the best grades that can be achieved with the existing
resources and technology for each alternative allocation of study time.
Let's consider why the production possibilities curve has this concave shape. As the
diagram below indicates, a relatively large improvement in economics grade can be
achieved by giving up relatively few points on the calculus exam. A movement from
point A to point B results in a 30-point increase in economics grade and only a 10-point
reduction in calculus grade. The marginal opportunity cost of a good is defined to be
the amount of another good that must be given up to produce an additional unit of the
first good. Since the opportunity cost of 30 points on the economics test is a 10-point
reduction in the score on the calculus test, we can say that the marginal opportunity cost
of one additional point on the economics test is approximately 1/3 of a point on the
calculus test. (If in doubt, note that if 30 points on the economics exam have an
opportunity cost of 10 points, each point on the economics test must cost approximately
1/30th of 10 points on the calculus test -- approximately 1/3 of a point on the calculus
Now, let's see what happens a second hour is transferred to the study of economics. The
diagram below illustrates this outcome (a movement from point B to C). As this diagram
indicates, transferring a second hour from the study of mathematics to the study of
economics results in a smaller increase in economics grade (from 30 to 45 points) and a
larger reduction in calculus grade (from 75 to 55). In this case, the marginal opportunity
cost of a point on the economics exam has increased to approximately 4/3 of a point on
the calculus exam.
The increase in the marginal opportunity cost of points on the economics exam as more
time is devoted to studying economics is an example of the law of increasing cost. This
law states that the marginal opportunity cost of any activity rises as the level of the
activity increases. This law can also be illustrated using the table below. Notice that the
opportunity cost of additional points on the calculus exam rises as more time is devoted
to studying calculus. Reading from the bottom of the table up to the top, you can also see
that the opportunity cost of additional points on the economics exam rises as more time is
devoted to the study of economics.
One of the reasons for the law of increasing cost is the law of diminishing returns (as in
the example above). Each extra hour devoted to the study of economics results in a
smaller increase in the economics grade and a larger reduction in the calculus grade
because of diminishing returns to time spent on either activity.
A second reason for the law of increasing cost is the fact that resources are specialized.
Some resources are better suited for some some types of productive activities than for
other types of production. Suppose, for example, that a farmer is producing both wheat
and corn. Some land is very well suited for growing wheat, while other land is relatively
better suit for growing corn. Some workers may be more adept at growing wheat than
corn. Some farm equipment is better suited for planting and harvesting corn.
The diagram below illustrates the PPC curve for this farmer.
At the top of this PPC, the farmer is producing only corn. To produce more wheat, the
farmer must transfer resources from corn production to wheat production. Initially,
however, he or she will transfer those resources that are relatively better suited for wheat
production. This allows wheat production to increase with only a relatively small
reduction in the quantity of corn produced. Each additional increase in wheat production,
however, requires the use of resources that are relatively less well suited for wheat
production, resulting in a rising marginal opportunity cost of wheat.
Now, let's suppose that this farmer either does not use all of the available resources, or
uses them in a less than optimal manner (i.e., either unemployment or underemployment
occurs). In this case, the farmer will produce at a point that lies below the production
possibilities curve (as illustrated by point A in the diagram below).
In practice, all firms and all economies operate below their production possibilities
frontier. Firms and economies, however, generally attempt to get as close to the frontier
Points above the production possibilities cannot be produced using current resources and
technology. In the diagram below, point B is not obtainable unless more or higher quality
resources become available or technological change occurs.
An increase in the quantity or quantity of resources will cause the production possibilities
curve to shift outward (as in the diagram below). This type of outward shift could also be
caused by technological change that increases the production of both goods.
In some cases, however, technological change will only increase the production of a
specific good. The diagram below illustrates the effect of a technological change in wheat
production that does not affect corn production.
Specialization and trade
In The Wealth of Nations, Adam Smith argued that economic growth occurred as a result
of specialization and division of labor. If each household produced every commodity it
consumed, the total level of consumption and production in a society will be small. If
each individual specializes in the productive activity at which they are "best," total output
will be higher. Specialization provides such gains because it:
allows individuals to specialize in those activities in which they are more talented,
individuals become more proficient at a task that they perform repeatedly, and
less time is lost switching from task to task.
Increased specialization by workers requires a growth in trade. Adam Smith argued that
growing specialization and trade was the ultimate cause of economic growth.
Adam Smith and David Ricardo argued that similar benefits accrue from international
specialization and trade. If each country specializes in the types of production at which
they are best suited, the total amount of goods and services produced in the world
economy will increase. Let's examine these arguments a bit more carefully.
There are two measures that are commonly used to determine whether an individual or a
country is "best" at a particular activity: absolute advantage and comparative advantage.
These two concepts are often confused. An individual (or country) possesses an absolute
advantage in the production of a good if the individual (or country) can produce more
than can other individuals (or countries). An individual (or country) possesses a
comparative advantage in the production of a good if the individual (or country) can
produce the good at the lowest opportunity cost.
Let's examine an example illustrating the difference between these two concepts.
Suppose that the U.S. and Japan only produced two goods: CD players and wheat. The
diagram below represents production possibilities curves for these two countries. (These
numbers are obviously hypothetical....)
Notice that the U.S. has an absolute advantage in the production of each commodity. To
determine who has a comparative advantage, though, it is necessary to compute the
opportunity cost for each good. (It is assumed that the PPC is linear to simplify this
The opportunity cost of one unit of CD players in the U.S. is 2 units of wheat. In Japan,
the opportunity cost of one unit of CD players is 4/3 of a unit of wheat. Thus, Japan
possesses a comparative advantage in CD player production.
The U.S. however, has a comparative advantage in wheat production since the
opportunity cost of a unit of wheat is 1/2 of a unit of CD players in the U.S., but is 3/4 of
a unit of CD players in Japan.
If each country specializes in producing the good in which it possesses a comparative
advantage, it can acquire the other good through trade at a cost that is less than the
opportunity cost of production in the domestic economy. For example, suppose that the
U.S. and Japan agree to trade one unit of CD players for 1.6 units of wheat. The U.S.
gains from this trade because it can acquire a unit of CD players for 1.6 units of wheat,
which is less than the opportunity cost of producing CD players domestically. Japan gains
from this trade since it's able to trade one CD player for 1.6 units of wheat while it only
cost Japan 4/3 of a unit of wheat to produce a unit of CD players.
If each country produces only those goods in which it possesses a comparative advantage,
each good is produced in the global economy at the lowest opportunity cost. This results
in an increase in the level of total output.
In this chapter, we'll examine the operation of markets a bit more carefully. Initially, it
will be assumed that there are no barriers to the efficient functioning of markets. We'll
examine what happens when markets work less efficiently when we discuss Chapter 5.
Production in modern economies is an extremely complex activity. Consider the
computer that you are currently using. It consists of components and raw materials that
were probably made in thousands of firms located in dozens of countries. Somehow, the
glass, plastic, metal, silica, and other raw materials were all combined into the monitor,
computer chips, mother board, and other components that form this computer. It is
interesting to note that the computer you are using contains dramatically more computing
power than the mainframe computers of 20 years or so ago. How did all of these raw
materials get converted into this computer? Well, it all happened through market
processes. All but the most primitive economies rely on markets to coordinate many
productive decisions (yes, this was even true in the former Soviet Union -- it has been
estimated that 50% or more of all output was sold in the unofficial underground market
Markets and the "three fundamental questions"
All economies, no matter what their form of economic organization, must address what
are known as the "three fundamental questions:"
Let's examine each of these questions.
The first question can be rephrased as: "What mix of goods and services will be
produced?" In a market economy, the interaction of self-interested buyers and sellers
determines the mix of goods and services that are produced. Adam Smith, writing in the
Wealth of Nations argued that competition among self-interested producers results in an
outcome that benefits all of society. Two quotes from Smith help to illustrate this
It is not from the benevolence of the butcher, the brewer, or the baker that we expect our
dinner, but from their regard to their self-interest. (Book I, Chapter I)
[A producer,]...by directing that industry in such a manner as its produce may be of the
greatest value, he intends only his own gain, and he is in this, as in many other cases, led
by an invisible hand to promote an end which was no part of his intention. Nor is it
always the worse for the society that it was no part of it. By pursuing his own interest he
frequently promotes that of the society more effectually than when he really intends to
promote it. I have never known much good done by those who affected to trade for the
public good. It is an affectation, not very common among merchants, and very few words
need be employed in dissuading them from it. (Book IV, Chapter II)
This argument suggests that competition among self-interested producers forces them to
produce goods that satisfy consumer wants. In seeking his or her own profit, each
producer attempts to produce higher quality products that better serve consumer needs.
This leads to a condition of consumer sovereignty in which it is ultimately the consumer
who determines what mix of goods and services will be produced. Some economists,
such as John Kenneth Galbraith, have questioned this argument and suggest that
marketing activities by large corporations can substantially influence the pattern of
consumer demand. Most economists argue, though, that while marketing methods may
influence consumer demand in the short run, consumers ultimately determine what goods
and services that they will buy. Effective advertising campaigns may lead to phenomena
such as pet rocks and Chia Pets, but these fads are generally fairly short-lived.
If, for whatever reason, consumers want more of a good, this results in an increase in
demand. In the short run, this increase in demand results in higher prices, increased
output, and a higher level of profit for firms in this industry. In response to these profits,
however, new firms will enter the market in the long run, resulting in an increase in
market supply. This increase in supply will drive the price back down while further
increasing the quantity sold. The short-run profits generated by the increase in demand
gradually disappear as the price declines. Thus, the long-run response to an increase in
demand is an increase in the amount produced. (Notice how this is consistent with the
concept of consumer sovereignty.)
The second fundamental question may be more completely stated as: "How is output
produced?" This question involves the determination of the mix of resources that are to
be used to produce output. In a market economy, profit-maximizing producers will be
expected to select a mix of resources that result in the lowest possible level of cost
(holding the quantity and quality of output constant). New production techniques will be
adopted only if they reduce production costs. Sellers of resources will supply them to
those activities in which they are most highly valued. Once again, Smith's "invisible hand
of the market" guides resources into their most valued uses.
This third fundamental question deals with the issue of "who gets what?" In a market
economy, this is determined by the interaction of buyers and sellers in both output and
resource markets. The distribution of income is ultimately determined by the wages,
interest payments, rents, and profits that are determined in resource markets. Those with
more highly valued land, labor, capital, and entrepreneurial ability receive higher
incomes. Given this distribution of income, individuals make their own decisions
concerning how much of each good to buy in output markets.
The three fundamental questions and government
Of course, in any real-world economy, markets do not make all of these decisions. In all
societies, governments influence what will be produced, how output will be produced,
and who receives this output. Government spending, health and safety regulations,
minimum wage laws, child labor laws, environmental regulations, tax systems, and
welfare programs all have a significant effect on any society's answers to these questions.
We'll examine many of these topics in the next chapter. For now, we'll focus on a simple
market economy. In this simple economy, there are three participants in the private
sector: households, firms, and foreign countries.
A household, as defined by the Census Bureau, consists of one or more individuals that
share living quarters.
Types of firms
There are three possible types of firms:
A sole proprietorship is a firm that has a single owner. The main advantage of this form
of ownership is that it provides the owner with autonomy (the ability to be his or her own
boss). There are, though, a few disadvantages. Because of the high failure rate for newly
founded sole proprietorships, it is difficult to acquire funds to acquire physical capital.
The owners also face unlimited liability. This means that their personal wealth is at risk if
the business fails or is sued. While sole proprietorships are the most common form of
firm, most are very small. Sole proprietorships account for a very small proportion of
total sales in the U.S. economy.
Partnerships are firms in which two or more individuals share ownership. This form of
business organization provides an advantage over sole proprietorships by allowing
owners to pool their wealth, skills, and resources. The cost of this pooling of resources is
some loss in autonomy for the owners. As in the case of sole proprietorships, partnerships
are subject to unlimited liability.
A corporation is a business that exists as a legal entity separate from the owners. The
corporation can enter contracts, own property, and borrow money as if it were a person.
The stockholders of the corporation own the corporation. If the corporation declares
bankruptcy, however, only the assets of the corporation are at risk. The owners' personal
assets are not at risk (their only loss would be the wealth used to acquire the stock). This
results in a situation in which the owners only have "limited liability." Offsetting this
advantage is that corporate income is subject to double taxation. Any profits received by
the corporation are subject to a corporate income tax before they are distributed as
dividends to the stockholders. The dividends that are received by stockholders are taxed
once again as personal income for the owners.
As your text notes, most output in the U.S. is produced in relatively large firms.
Corporations account for the largest component of this output.
Multinational business has become increasingly important during the past several
decades. Multinational businesses are firms that own and operate production facilities in
more than one country.
During the past decade, there has been a substantial increase in the volume of
international trade. The international sector's contribution to the economy includes both
imports and exports. When U.S. exports exceed imports, a trade surplus is said to occur;
a trade deficit occurs when imports exceed exports.
The circular flow diagram below illustrates the flows of goods, services, and resources
between households and firms. As this diagram illustrates, firms provide households with
goods and services while households provide firms with the economic resources (land,
labor, capital, and entrepreneurial ability) that is needed to produce this output.
The monetary flows accompanying the flows of goods, services, and resources have been
added to the diagram below. As this diagram illustrates, households pay for goods and
services using the income they receive by supplying resources. The interrelationship
between output and resource markets is obvious from this diagram. Households are able
to afford goods and services only as a result of the income they receive from firms.
Similarly, firms are only able to pay wages, interest, rent, and profits as a result of the
revenue they receive from selling goods and services to households.
The diagram above, though is a bit of an oversimplification. Not all income received by
households is spent on goods and services; some income is saved. This saving represents
a leakage of spending from the circular flow. Fortunately, investment provides an
"injection" of additional spending that offsets this leakage. As the diagram below
indicates, financial intermediaries bring borrowers and lenders. This allows the saving of
households to become a source of finance for investment spending by firms.
The diagram above does not take international trade into account. Imports represent an
additional flow of goods and services into the domestic economy while exports represent
an outward flow of goods and services. The level of net exports is equal to exports minus
imports. If net exports is positive, there is a net outflow of goods and services. A negative
level of net exports results in a net inflow of goods and services. Payments for net exports
will represent a net addition to the circular flow when net exports are positive but will
involve a net leakage when net exports are negative.
Demand and supply
In this chapter, we will examine how markets determine the price of goods and the
quantity sold and consumed. A market is a set of arrangements for the exchange of a
good or a service.
Barter vs. markets
A barter system is a market system in which goods or services are traded directly for
other goods or services. If you agree to repair your neighbor's computer in return for his
or her assistance in painting your house, you have engaged in a barter transaction. While
a barter system may be able to function effectively in a simple economy in which a
limited variety of goods are produced, it cannot function well in a complex economy that
produces an extensive collection of goods and services. The primary problem associated
with a barter system is that any trade requires a double coincidence of wants. This
means that trade can only take place if each person wants what the other person is willing
to trade and is willing to give up what the other person wants. In a developed economy in
which a diverse collection of goods and services are produced, locating someone willing
to make the trade that you desire may be quite difficult and costly. If you repair TVs and
are hungry, you must find someone with a broken TV who is willing to trade food for TV
repairs. Because it is costly to arrange such a transaction, economists note that barter
transactions have relatively high transactions costs.
For this reason, throughout recorded history virtually all societies have used some form
of money to facilitate trade. In a monetary economy, individuals trade goods or services
for money and then use this money to buy the goods or services that they wish to acquire.
Since money can be traded for any good or service, the use of money eliminates the need
for a double coincidence of wants and lowers the transaction costs associated with trade.
Relative and nominal prices
The opportunity cost of acquiring a good or a service under either a barter or a monetary
economy may be measured by the relative price of the commodity. The relative price of
a commodity is a measure of how expensive a good is in terms of units of some other
good or service. Under a barter system, the relative price is nothing more than the trading
ratio between any two goods or services. For example, if one laser printer is traded for 2
ink-jet printers, the relative price of the laser printer is two ink-jet printers. Alternatively,
the relative price of an inkjet printer is one-half of a laser printer in this case. In a
monetary economy, relative prices can also be easily computer using the ratio of the
prices of the commodities. If, for example, soccer ball costs $20 and a portable CD player
costs $60, the relative price of a portable CD player is 3 soccer balls (and the relative
price of a soccer ball is 1/3 of a CD player). Economists ague that individuals respond to
changes in relative prices since these prices reflect the opportunity cost of acquiring a
good or service.
In a market economy, the price of a good or service is determined through the interaction
of demand and supply. To understand how market price is determined, it is important to
know the determinants of both demand and supply. Let's first examine the demand for a
The demand for a good or service is defined to be the relationship that exists between the
price of the good and the quantity demanded in a given time period, ceteris paribus. One
way of representing demand is through a demand schedule such as the one appearing
Note that the demand for the good is the entire relationship that is summarized by this
table. This demand relationship may also be represented by a demand curve (as illustrated
Both the demand schedule and the demand curve indicate that, for this good, an inverse
relationship exists between the price and the quantity demanded when other factors are
held constant. This inverse relationship between price and quantity demanded is so
common that economists have called it the law of demand:
An inverse relationship exists between the price of a good and the
quantity demanded in a given time period, ceteris paribus.
As noted above, demand is the entire relationship between price and quantity, as
represented by a demand schedule or a demand curve. A change in the price of the good
results in a change in the quantity demanded, but does not change the demand for the
good. As the diagram below indicates, an increase in the price from $2 to $3 reduces the
quantity of this good demanded from 80 to 60, but does not reduce demand.
Change in demand vs. change in quantity demanded
A change in demand occurs only when the relationship between price and quantity
demanded changes. The position of the demand curve changes when demand changes. If
the demand curve becomes steeper or flatter or shifts to the right or the left, we can say
that demand has changed. The diagram below illustrates a shift in the demand for a good
(from D to D'). Notice that a rightward shift in the position of the demand curve is said to
be an increase in demand since a larger quantity is demanded at each price.
The market demand consists of the total quantity demanded by each individual in the
market. Conceptually, the market demand curve is formed by computing the horizontal
summation of the individual demand curves for all consumers. The diagram below
illustrates this process. This diagram illustrates a simple case in which there are only two
consumers, Person A and Person B. Notice that the total quanity demanded in the market
is just the sum of the quantities demanded by each individual. In this diagram, Person A
wished to buy 10 of this commodity and person B wishes to buy 15 units when the price
is $3. Thus, at a price of $3, the total quantity demanded in the market is 25 (=10+15)
units of this commodity.
Of course, this example is highly simplified since there are many buyers in most real-
world markets. The same principle, though would hold: the market demand curve is
derived by adding together the quantities demanded by all consumers at each and every
Determinants of demand
Let's examine some factors that might be expected to change demand for most goods and
services. These factors include:
tastes and preferences,
the prices of related goods,
the number of consumers, and
expectations of future prices and income.
Obviously, any change in tastes that raises the evaluation of a good will result in an
increase in the demand for a good (as illustrated below). Those who remember the short-
term increases in demand that occurred with slap bracelets, pegs, hyper color t-shirts,
beanie babies, Tickle-Me-Elmos, etc., can attest to the effect of changing tastes on
demand. Fads will often increase the demand for a good for at least a short period of
Demand will also decline if tastes change so the consumption of a good becomes less
desirable. As fads fade away, the demand for the products falls (as illustrated below).
Goods may be related in consumption as either:
substitute goods, or
Two goods are said to be substitute goods if an increase in the price of one results in an
increase in the demand for the other. Substitute goods are goods that are often used in
place of each other. Chicken and beef, for example, may be substitute goods. Coffee and
tea are also likely to be substitute goods. The diagram below illustrates the effect of an
increase in the price of coffee. A higher price of coffee reduces the quantity of coffee
demanded, but increases the demand for tea. Note that this involves a movement along
the demand curve for coffee since this involves a change in the price of coffee.
(Remember: a change in the price of a good, ceteris paribus, results in a movement along
a demand curve; a change in demand occurs when something other than the price of the
Economists say that two goods are complementary goods if an increase in the price of
one results in a reduction in the demand for the other. In most cases, complementary
goods are goods that are consumed together. Examples of likely pairs of complementary
peanut butter and jelly,
bicycles and bicycle safety helmets,
cameras and film,
CDs and CD players, and
DVDs and DVD players.
The diagram below illustrates the effect of an increase in the price of DVDs. Note that an
increase in the price of DVDs would reduce both the quantity of DVDs demanded and
the demand for DVD players.
It is expected that the demand for most goods will increase when consumer income rises
(as illustrated below). Think about your demand for CDs, meals in restaurants, movies,
etc. Is it likely that you would increase your consumption of most commodities if your
income increases. (Of course, it is possible that the demand for some goods -- such as
generic foods, Ramen noodles, and other similar commodities -- may decline as your
income rises. We'll examine this possibility in more detail in Chapter 6.)
Since the market demand curve consists of the horizontal summation of the demand
curves of all buyers in the market, an increase in the number of buyers would cause
demand to increase (as illustrated below). As the population rises, the demand for cars,
TVs, food, and virtually all other commodities, is expected to increase. A decline in
population will result in a reduction in demand.
Expectations of future prices and income are also important determinants of the current
demand for a good. First, let's talk about the effect of a higher expected future price.
Suppose that you have been considering buying a new car or a new computer. If you
acquire new information that leads you to believe that the future price of this commodity
will increase, you are probably going to be more likely to buy it today. Thus, a higher
expected future price will increase current demand. In a similar manner, a reduction in
the expected future price will result in a reduction in current demand (since you'd prefer
to postpone the purchase in anticipation of a lower price in the future).
If expected future income rises, demand for many goods today is likely to rise. On the
other hand, if expected future income falls (perhaps because of rumors of future layoffs
or the beginning of a recession), individuals may reduce their current demand for goods
so that they can save more today in anticipation of the lower future income.
When international markets are taken into account, the demand for a product includes
both domestic and foreign demand. An important determinant of foreign demand for a
good is the exchange rate. The exchange rate is the rate at which the currency of one
country is converted into the currency of another country. Suppose, for example, that one
dollar exchanges for 5 French francs. In this case, the dollar value of one French franc is
$.20. Notice that the exchange rate between dollars and francs is the reciprocal of the
exchange rate between francs and dollars. If the value of the dollar rises in terms of a
foreign currency, the value of the foreign currency will fall relative to the dollar. This is a
quite intuitive result. An increase in the value of the dollar means that the dollar is worth
more relative to the foreign currencies. In this case, the foreign currencies have to be
worth less in terms of dollars.
When the value of the domestic currency rises relative to foreign currencies, domestically
produced goods and services become more expensive in foreign countries. Thus, an
increase in the exchange value of the dollar results in a reduction in the demand for U.S.
goods and services. The demand for U.S. goods and services will rise, however, if the
exchange value of the dollar declines.
Supply is the relationship that exists between the price of a good and the quantity
supplied in a given time period, ceteris paribus. The supply relationship may be
represented by a supply curve:
or a supply schedule:
Just as there is a "law of demand" there is also a "law of supply." The law of supply
A direct relationship exists between the price of a good and the
quantity supplied in a given time period, ceteris paribus.
To understand the law of supply, it's helpful to remember the law of increasing cost.
Since the marginal opportunity cost of supplying a good rises as more is produced, a
higher price is required to induce the seller to sell more of the good or service.
The law of supply indicates that supply curves will be upward sloping (as in the diagram
Change in quantity supplied vs. change in supply
As in the case of demand, it is important to distinguish between a change in supply and a
change in quantity supplied. A change in the price of a good results in a change in the
quantity supplied. A change in the price changes the quantity supplied, as noted in the
A change in supply occurs when the supply curve shifts, as in the diagram below. Note
that a rightward shift in the supply curve indicates an increase in supply since the
quantity supplied at each price increases when the supply curve shifts to the right. When
supply decreases, the supply curve shifts to the left.
The market supply curve is the horizontal summation of all individual supply curves. The
derivation of this is equivalent to that illustrated above for demand curves.
Determinants of supply
The factors that can cause the supply curve to shift include:
the prices of resources,
technology and productivity,
the expectations of producers,
the number of producers, and
the prices of related goods and services.
An increase in the price of resources reduces the profitability of producing the good or
service. This reduces the quantity that suppliers are willing to offer for sale at each price.
Thus, an increase in the price of labor, raw material, capital, or other resource, will be
expected to result in a leftward shift in supply (as illustrated below).
Technological improvements and changes that increase the productivity of labor result in
lower production costs and higher profitability. Supply increases in response to this
increase in the profitability of production (as illustrated below).
As in the case of demand, expectations can play an important role in supply decisions. If,
for example, the expected future price of a gasoline rises, refiners may decide to supply
less today so that they can stockpile gas for sale at a later date. Conversely, if the
expected future price of a good falls, current supply will increase as sellers try to sell
more today before the price declines.
An increase in the number of producers results in an increase (a rightward shift) in the
market supply curve (as illustrated below).
Since firms generally produce (or, at least, are able to produce) more than one
commodity, they have to determine the optimal balance among all of the goods and
services that they produce. The supply decision for a particular good is affected not only
by the price of the good, but also by the price of other goods and services the firm may
produce. For example, an increase in the price of corn may induce a farmer to reduce the
supply of wheat. In this case, an increase in the price of one product (corn) reduces the
supply of another product (wheat). It is also possible, but less common, that an increase
in the price of one commodity may increase the supply of another commodity. To see
this, consider the production of both beef and leather. An increase in the price of beef will
cause ranchers to raise more cattle. Since beef and leather are jointly produced from
cows, the increase in the price of beef will also be expected to result in an increase in the
supply of leather.
In our increasingly global economy, firms often import raw materials (and sometimes the
entire product) from foreign countries. The cost of these imported items will vary with
the exchange rate. When the exchange value of a dollar rises, the domestic price of
imported inputs will fall and the domestic supply of the final commodity will increase. A
decline in the exchange value of the dollar will raise the price of imported inputs and
reduce the supply of domestic products that rely on these inputs.
Let's combine the market demand and supply curves on one diagram:
It can be seen that the market demand and supply curves intersect at a price of $3 and a
quantity of 60. This combination of price and quantity represents an equilibrium since the
quantity demanded equals the quantity supplied. At this price, each buyer is able to buy
all that he or she desires and each firm is able to sell all that it desires to sell. Once this
price is achieved, there is no reason for the price to either rise or fall (as long as neither
the demand nor the supply curve shifts).
If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds
quantity demanded). This situation is illustrated in the diagram below. The presence of a
surplus would be expected to cause firms to lower prices until the surplus disappears (this
occurs at the equilibrium price of $3).
If the price is below the equilibrium, a shortage occurs (since quantity demanded exceeds
quantity supplied). This possibility is illustrated in the diagram below. When a shortage
occurs, producers will be expected to increase the price. The price will continue to rise
until the shortage is eliminated when the price reaches the equilibrium price of $3.
Shifts in demand and supply
Let's examine what happens if demand or supply changes. First, let's consider the effect
of an increase in demand. As the diagram below indicates, an increase in demand results
in an increase in the equilibrium levels of both price and quantity.
A decrease in demand results in a decrease in the equilibrium levels of price and quantity
(as illustrated below).
An increase in supply results in a higher equilibrium quantity and a lower equilibrium
Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated
Price ceilings and price floors
A price ceiling is a legally mandated maximum price. The purpose of a price ceiling is to
keep the price of a good below the market equilibrium price. Rent controls and regulated
gasoline prices during wartime and the energy crisis of the 1970s are examples of price
ceilings. As the diagram below illustrates, an effective price ceiling results in a shortage
of a commodity since quantity demanded exceeds quantity supplied when the price of a
good is kept below the equilibrium price. This explains why rent controls and regulated
gasoline prices have resulted in shortages.
A price floor is a legally mandated minimum price. The purpose of a price floor is to
keep the price of a good above the market equilibrium price. Agricultural price supports
and minimum wage laws are example of price ceilings. As the diagram below illustrates,
an effective price floor results in a surplus of a commodity since quantity supplied
exceeds quantity demanded when the price of a good is kept below the equilibrium price.
The focus of Chapter 6 is on the concept of elasticity, a measure of the responsiveness of either
quantity demanded or supplied to a change in some other variable.
Price elasticity of demand
The most commonly used elasticity measure is the price elasticity of demand, defined as:
price elasticity of demand (Ed) =
The price elasticity of demand is a measure of the sensitivity of quantity demanded to a change
in the price of a good. Notice that the price elasticity of demand will always be expressed as a
positive number (since the absolute value of a negative number is always positive).
Demand is said to be:
elastic when Ed > 1,
unit elastic when Ed = 1, and
inelastic when Ed < 1.
When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in
quantity demanded. If demand is unit elastic, quantity demanded will fall by 1% when the price
rises by 1%. A 1% price increase will result in less than a 1% reduction in quantity demanded
when demand is inelastic.
Suppose, for example, that we know that the price elasticity of demand for a particular good
equals 2. In this case, we'd say that demand is elastic and would know that a 1% increase in
price will cause quantity demanded to fall by 2%.
One extreme case is given by a perfectly elastic demand curve, as appears in the diagram below.
Demand is perfectly elastic only in the special case of a horizontal demand curve. The elasticity
measure in this case is infinite (notice that the denominator of the elasticity measure equals
zero). The closest we get to observing a perfectly elastic demand curve is the demand curve
facing a firm that produces a very small share of the total quantity produced in a market. In this
case, the firms is such a small share of the market that it must take the market price as given. An
individual farmer, for example, has no control over the price that it receives when it brings its
product to market. Whether it supplies 100 or 20,000 bushels of wheat, the price that it
received per bushel is that day's market price.
At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand
curve appears in the diagram below. Note that the price elasticity of demand equals zero for a
perfectly inelastic demand curve since the % change in quantity demanded equals zero. In
practice, we do not expect to see demand curves that are perfectly inelastic. For some range of
prices, the demand for insulin, dialysis, and other such medical treatments, is likely to be close
to being perfectly inelastic. As the price for these commodities rises, however, we would
eventually expect to see the quantity demanded fall because individuals have limited budgets.
Students considering elasticity for the first time often believe that demand is more elastic when
the demand curve is flat and less elastic when it is steep. Unfortunately, it is not quite as simple
as that... In particular, if we consider the case of any downward sloping linear demand curve, we
will see that elasticity varies continuously along this curve. It is true that a one-unit change in
price always results in a constant change in quantity demanded along a linear demand curve
(since the slope is constant). The ratio of the percentage change in quantity demanded to the
percentage change in price, however, changes continuously along such a curve.
To see why this occurs, it is necessary to consider the distinction between a change in the level
of a variable and the percentage change in the same variable. Suppose we consider the
distinction by discussing the percentage change that results from a $1 increase in the price of a
a price increase from $1 to $2 represents a 100% increase in price,
a price increase from $2 to $3 represents a 50% increase in price,
a price increase from $3 to $4 represents a 33% increase in price, and
a price increase from $10 to $11 represents a 10% increase in price.
Notice that, even though the price increases by $1 in each case, the percentage change in price
becomes smaller when the starting value is larger. Let's use this concept to explain why the
price elasticity of demand varies along a linear demand curve.
Consider the change in price and quantity demanded that are illustrated below. At the top of
the curve, the percentage change in quantity is large (since the level of quantity is relatively low)
while the percentage change in price is small (since the level of price is relatively high). Thus,
demand will be relatively elastic at the top of the demand curve. At the bottom of the curve, the
same change in quantity demanded is a small percentage change (since the level of quantity is
large) while the change in price is now a relatively large percentage change (since the level of
price is low). Thus, demand is relatively inelastic at the bottom of the demand curve.
More generally, we can note that elasticity declines continuously along a linear demand curve.
The top portion of the demand curve will be highly elastic and the bottom is highly inelastic. In
between, elasticity gradually becomes smaller as price declines and quantity rises. At some
point, demand changes from being elastic to inelastic. The point at which that occurs, of course,
is the point at which demand is unit elastic. This relationship is illustrated in the diagram below.
Arc elasticity measure
Suppose that we wish to measure the elasticity of demand in the interval between a price of $4
and a price of $5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If
we start at $5 and move to $4, however, price has fallen by 20%. Which percentage change
should be used to represent a change between $4 and $5? To avoid ambiguity, the most
common measure is to use a concept known as arc elasticity in which the midpoint of the
interval is used as the base value in computing elasticity. Under this approach, the price
elasticity formula becomes:
Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price
rises from $3 to $5. The arc elasticity measure is given by:
In this interval, demand is inelastic (since Ed < 1).
Elasticity and total revenue
The concept of price elasticity of demand is extensively used by firms that are investigating the
effects of a change in the prices of their commodities. Total revenue is defined as:
total revenue = price x quantity
Suppose that a firm is facing a downward sloping demand curve for its product. How will it's
revenue change if it lowers its price?
The answer, it turns out, is somewhat ambiguous. When the price declines, quantity demanded
by consumers rises. The lower price received for each unit of output lowers total revenue while
the increase in the number of units sold raises total revenue. Total revenue will rise when the
price falls if quantity rises by a large enough percentage to offset the reduction in price per unit.
In particular, we can note that total revenue will increase if quantity demanded rises by more
than one percent when the price falls by one percent. Alternatively, total revenue will decline if
quantity demanded rises by less than one percent when the price declines by one percent. If the
price falls by one percent and quantity demanded falls by one percent, total revenue will remain
unchanged (since the changes will offset each other). A careful observer will note that this
comes down to a question of the magnitude of the price elasticity of demand. As defined above,
price elasticity of demand (Ed) =
Using the logic discussed above, we can note that a reduction in price will lead to:
an increase in total revenue when demand is elastic,
no change in total revenue when demand is unit elastic, and
a decrease in total revenue when demand is inelastic.
In a similar manner, an increase in price will lead to:
a reduction in total revenue when demand is elastic,
no change in total revenue when demand is unit elastic, and
an increase in total revenue when demand is inelastic.
The diagram below illustrates the relationship that exists between total revenue and demand
elasticity along a linear demand curve.
As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in
the region in which demand is unit elastic. Total revenue falls as quantity increases (and price
decreases) in the inelastic portion of the demand curve. Total revenue is maximized at the point
at which demand is unit elastic.
Does this mean that firms will choose to produce at the point at which demand is unit elastic?
This would only be the case if they had no production costs. Firms are assumed to be concerned
with maximizing their profits, not their revenue. The optimal level production can be
determined only when we consider both revenue and costs. This topic will be extensively
addressed in future chapters.
Firms that have some control over their market price can sometimes use that control to
enhance their profits by charging different prices to different customers. In particular, a firm
engaging in price discrimination increases its profits by charging higher prices to those
customers who have the most inelastic demand for the product and lower prices to those
customers who have a more elastic demand. In essence, this strategy involves charging the
highest prices to those customers who are willing to buy the commodity at a high price and
charging lower prices to those customers who are more sensitive to price differentials.
A classic example of price discrimination occurs with airline fares. There are two general
categories of customers: those traveling on vacations and those traveling for business purposes.
It is likely that the demand for air travel by business travelers is less sensitive to price changes
than is true for those on vacation. Airlines are able to charge different prices to these two
groups by offering a high base fare and a "super saver" fare that requires a weekend stay, the
purchase of the tickets several weeks in advance, and similar restrictions. Since those traveling
for vacation purposes are more likely to satisfy these requirements than business travelers,
airlines accomplish the goal of charging higher prices to the business travelers with less elastic
demand and lower prices to those customers with more elastic demand who are flying for
The use of cents-off coupons in the Sunday newspapers is another example of price
discrimination that offers a lower price to those customers who have more elastic demands
(since low-wage workers are more likely to be sensitive to price changes and are more likely to
Child and senior citizen discounts at restaurants and movie theaters are also examples of price
discrimination that result in lower prices being charged to those customers with the most elastic
demand for the products.
Determinants of price elasticity of demand
The price elasticity of demand is likely to be relatively high when:
close substitutes are available,
the good or service is a large share of the consumer's budget, and
a longer time period is considered.
Let's consider each of these factors.
When there a large number of substitutes are available, consumers respond to a higher price of
a good by buying more of the substitute goods and less of the relatively more expensive
commodity. Thus, we would expect a relatively high price elasticity of demand for goods or
services with many close substitutes, but would expect a relatively inelastic demand for
commodities such as insulin or AZT with few close substitutes.
If the good is a small share of a consumer's budget, a change in the price of the good will have
little impact on the individual's purchasing power. In this case, a price change will have relatively
little impact on the quantity consumed. A doubling of the price of salt, for example, would not
have much of an impact on a typical consumer's budget. But, when a good is a relatively large
share of a person's spending, a price increase has a larger effect on their purchasing power. To
take an extreme example, suppose that a person spends 50% of his or her income on a
commodity and the price doubled. It's likely that the individual will substantially reduce their
spending in response to the higher price when spending on the good comprises a larger share of
a consumer's budget. Thus, demand will tend to be more elastic for goods that are a small share
of a typical consumer's budget.
Consumers often have more possibilities for substitutes for a good when a longer time period is
considered. Consider, for example, the effect of a higher price for fuel oil or natural gas. In the
short run, individuals may lower the temperature and wear warmer clothes, but are unlikely to
reduce their energy consumption by very much. Over a longer time period, however, consumers
may install more energy efficient furnaces, better insulation, and more energy efficient windows
and doors. Thus, we would expect that the demand for either fuel oil or natural gas would be
more elastic in the long run than in the short run.
Cross-price elasticity of demand
The cross-price elasticity of demand is a measure of the responsiveness of a change in the price
of a good to a change in the price of some other good. The cross-price elasticity of demand
between the goods j and k can be expressed as:
Notice that this cross-price elasticity measure does not have an absolute value sign around it. In
fact, the sign of the cross-price elasticity of demand tells us about the nature of the relationship
between the goods j and k. A positive cross-price elasticity occurs if an increase in the price of
good k is associated with an increase in the demand for good j. As noted earlier (in Chapter 3),
this occurs if and only if these two goods are substitutes.
A negative cross-price elasticity of demand occurs when an increase in the price of good k is
associated with a decline in the demand for good j. This occurs if and only if goods j and k are
Thus, the cross-price elasticity of demand between two goods tells us whether the two goods
are substitutes or complements. Estimates of the magnitude of the cross-price elasticity can be
used by firms in making pricing and output decisions. McDonald's Corporation, for example,
might want to know the cross-price elasticity of demand between it's chicken sandwiches and its
Big Macs if it is considering the effect of a 20% decrease in the price of its Big Macs. If the cross-
price elasticity of demand is 0.5, then a 20% decrease in the price of its Big Mac sandwiches
would result in a 10% decrease in the number of chicken sandwiches sold. A -.9 cross-price
elasticity of demand between Big Macs and french fries, though, would indicate that a 20%
decrease in the price of Big Mac sandwiches would result in an 18% increase in the sale of
french fries. This sort of information would be useful in determining what prices to charge and
in planning for the impact of such a price change.
Income elasticity of demand
The income elasticity of demand is a measure of how sensitive demand for a good is to a
change in income. Income elasticity of demand is measured as:
As in the case of cross-price elasticity, the sign of income elasticity of demand may be either
positive or negative. A positive value for the income elasticity occurs when an increase in
income results in an increase in the demand for a good. In this case, the good is said to be a
normal good. In practice, most goods seem to be normal goods (and therefore have a positive
A good is said to be an inferior good if an increase in income results in a reduction in the
quantity of the good demanded. An inspection of the definition of the income elasticity of
demand should make it clear that an inferior good will have a negative income elasticity.
Generic foods, used cars, and similar commodities are likely to be inferior goods for many
Another distinction that is commonly made (although not mentioned in your text at this point) is
between luxuries and necessities. An increasing share of income is spent on luxury goods as
income increases. This means a 10% increase in income must be associated with a greater than
10% increase in spending on luxury goods. Using the definition of income elasticity of demand,
we can see that a luxury good must have an income elasticity that is greater than one.
A smaller share of income is spent on necessities as income rises. This means that necessities
have an income elasticity that is less than one.
Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is not
immediately obvious, note that an income elasticity that is greater than one must necessarily be
greater than zero while an income elasticity that is less than zero must be less than one.)
Normal goods may be either necessities or luxuries.
Price elasticity of supply
We can also apply the concept of elasticity to supply. The price elasticity of supply is defined as:
Note that the absolute value sign is not used when measuring the price elasticity of supply since
we do not expect to observe a downward sloping supply curve.
A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of
supply is zero when supply is perfectly inelastic. While your text suggests that the supply of
Monet paintings is perfectly inelastic, this in not entirely correct. If someone offers $.50 for a
Monet painting, how many paintings are likely to be offered for sale? What is meant in the text
is that, for prices above a particular threshold, the supply curve becomes perfectly inelastic for
some goods for which only a finite quantity is available. This is also true for highly perishable
commodities that must be sold on the day they are brought to market. A fisherman with no
storage facilities, for example, must sell all of the fish caught at the end of a given day at
whatever price can be received.
A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply
curve facing a single buyer in a market in which there are a very large number of buyers and
sellers is likely to appear to be perfectly elastic (or close to this, anyway). This will occur when
each buyer is a "price-taker" who has no effect on the market price.
Economists classify time in terms of the "short run" and the "long run." The short run is defined
as the period of time in which capital is fixed. All inputs are variable in the long run. Notice that
the length of the short run and long run will vary from industry to industry. In the lawnmowing
industry, the long run may be as short as the few hours that may be required to buy an
additional lawn mower. In the automotive manufacturing industry, the short run may last for
several years (since it takes a long time to design and build new capital in this industry).
It is expected that supply will be more elastic in the long run than in the short run since firms
can expand or contract their capital in the long run. In the short run, an increase in the price of
personal computers may result in increased employment, more overtime, and additional shifts
in computer factories. In the long run, though, higher prices will lead to a larger expansion in
output as new factories are built.
As your text notes, the distribution of the burden of a tax depends on the elasticities of demand
and supply. When supply is more elastic than demand, consumers bear a larger share of the tax
burden. Producers bear a larger share of the burden of a tax when demand is more elastic than
Chapter Consumer Choice
This chapter provides a more detailed examination of the theory of consumer choice. The
theory of demand is derived from this theory of choice.
The economic theory of choice is based on the concept of utility. Utility is defined as the
level of happiness or satisfaction associated with alternative choices. Economists assume
that when individuals are faced with a choice of feasible alternatives, they will always
select the alternative that provides the highest level of utility.
Total and marginal utility
The total utility associated with a good is the level of happiness derived from consuming
the good. Marginal utility is a measure of the additional utility that is received when an
additional unit of the good is consumed. The table below illustrates the relationship that
exists between total and marginal utility associated with an individual's consumption of
pizza (in a given time period).
# of slices Total utility Marginal utility
0 0 -
1 70 70
2 110 40
3 130 20
4 140 10
5 145 5
6 140 -5
As the table above indicates, the marginal utility associated with an additional slice of
pizza is just the change in the level of total utility that occurs when one more slice of
pizza is consumed. Note, for example, that the marginal utility of the third slice of pizza
is 20 since total utility increases by 20 units (from 110 to 130) when the third slice of
pizza is consumed. More generally, marginal utility can be defined as:
The table above also illustrates a phenomena known as the law of diminishing marginal
utility. This law states that marginal utility declines as more of a particular good is
consumed in a given time period, ceteris paribus. In the example above, the marginal
utility of additional slices of pizza declines as more pizza is consumed (in this time
period). In this example, the marginal utility of pizza consumption becomes negative
when the 6th slice of pizza is consumed. Note, though, that even though the marginal
utility from pizza consumption declines, total utility still increases as long as marginal
utility is positive. Total utility will decline only if marginal utility is negative. This law of
diminishing marginal utility is believed to occur for virtually all commodities. A bit of
introspection should confirm the general applicability of this principle.
In The Wealth of Nations (1776), Adam Smith attempted to formulate a theory of value
that explained why different commodities had different market values. In this attempt,
however, he encountered a problem that has come to be called the "diamond-water"
paradox. The paradox occurs because water is essential for life and has a low market
price (often a price of zero) while diamonds are not as essential yet have a very high
market price. To resolve this issue, Smith proposed two concepts of value: value in use
and value in exchange. Diamonds have a low value in use but a high value in exchange
while water has a high value is use but a low value in exchange. Smith argued that
economists could explain the exchange value of a commodity by the amount of labor
required to produce the commodity. (This "labor theory of value" later served as the basis
for much of Marx's critique of capitalism.) Smith did not propose a theory to explain the
use value of a commodity.
Marginal analysis, however, allows us to explain both value in use and value in
exchange. The diagram below contains marginal utility curves for both diamonds and
water. Because individuals consume a large volume of water, the marginal utility of an
additional unit of water is relatively low. Since few diamonds are consumed, the marginal
utility of an additional diamond is relatively high.
Total utility can be derived by adding up the marginal utilities associated with each unit
of the good. A bit of reflection should convince you that total utility can be measured by
the area under the marginal utility curve. The shaded areas in the diagram below provide
a measure of the total utility associated with the consumption of water and diamonds.
Note that the total utility from water is very high (since a large volume of water is
consumed) while the total utility received from diamonds is relatively low (because few
diamonds are consumed).
These concepts of total and marginal utility can be used to resolve Adam Smith's
diamond-water paradox. When Adam Smith was referring to "value in use," he was
actually referring to the concept of total utility. Exchange value, on the other hand, is tied
to how much someone is willing to pay for an additional unit of the commodity. Because
diamonds are expensive, individuals consume few diamonds and the marginal utility of
an additional diamond is relatively high. Since water is not very costly to acquire, people
consume more water. At this high level of consumption, the marginal utility of an
additional unit of water is relatively low. The price that someone is willing to pay for an
additional unit of a good is related to its marginal utility. Because the marginal utility of
an additional diamond is higher than the marginal utility associated with an additional
glass of water, diamonds have a higher value in exchange.
How can the concept of marginal utility be used to explain consumer choice? As noted
above, economists assume that when an individual is faced with a choice among feasible
alternatives, he or she will select the alternative that provides the highest level of utility.
Suppose that an individual has a given income that can be spent on alternative
combinations of goods and services. A utility maximizing consumer will select the
bundle of goods at which the following two conditions are satisfied:
1. MUA/PA = MUB/PB = ... = MUZ/PZ, for all commodities (A-Z), and
2. all income is spent.
The first of these conditions requires that the marginal utility per dollar of spending be
equated for all commodities. To see why this condition must be satisfied, suppose that the
condition is violated. In particular, let's assume that the marginal utility resulting from the
last dollar spent on good X equals 10 while the marginal utility received from the last
dollar spent on good Y equals 5. Since an additional dollar spent on good X provides
more additional utility than the last dollar spent on good Y, a utility-maximizing
individual would spend more on good X and less on good Y. Spending $1 less on good Y
lowers utility by 5 units, but an additional dollar spent on good X raises utility by 10 units
in this example. Thus, the transfer of $1 in spending from good Y to good X provides this
person with a net gain of 10 units of utility. As more is spent on good Y and less on good
X, though, the marginal utility of good Y will fall relative to the marginal utility of good
X. This person will keep spending more on good Y and less on good X, though, until the
marginal utility of the last dollar spent on good Y is the same as the marginal utility of
the last dollar spent on good X.
The first condition listed above is sometimes referred to as the "equimarginal principle."
The reason for the assumption that all income is spent is because this relatively simple
model is a single-period model in which there is no possibility of saving or borrowing
(since there are no future periods in this simple model). Of course, a more detailed model
can be constructed which includes such possibilities, but that is a topic left for more
advanced microeconomics classes.
When the two conditions above are satisfied, a state of consumer equilibrium is said to
occur. This is an equilibrium because the individual consumer has no reason to change
the mix of goods and services consumed once this outcome is achieved. (Unless, of
course, there is a change in tastes, income, or relative prices.)
The example on pages 163-165 of your textbook provides a very good discussion of how
this concept of consumer equilibrium can be used to explain the mix of goods and
services consumed. Be sure that you understand the decision process described in the text
and summarized in Table 2 on p. 164.
Consumer equilibrium and demand
The concept of consumer equilibrium can be used to explain the negative slope of a
consumer's demand curve. Suppose that an individual is initially buying only two goods,
X and Y. At a point of consumer equilibrium:
and all income is spent. Let's consider what happens if the price of good X rises. An
examination of the equation above indicates that the marginal utility per dollar spent on
good X will fall when the price of good X rises. To restore a consumer equilibrium, the
individual will increase his or her consumption of good Y and reduce his or her spending
on good X. This change in the mix of goods consumed is called the substitution effect.
When good X becomes relatively more expensive, the quantity of good X demanded falls
as a result of the substitution effect.
In addition to this substitution effect, there is also an income effect that occurs when the
price of a good changes. Since good X has become more expensive in this example, the
individual can no longer afford the original combination of goods X and Y. This income
effect results in a reduction in the quantity demanded for all normal goods. If good X is a
normal good, the substitution and income effects both work together to reduce the
quantity of good X demanded.
A careful reader will note that there is a possibility that an inferior good may have an
upward sloping demand curve if the income effect is larger in magnitude than the
substitution effect. A good that exhibits such a demand curve is called a Giffen good.
(This type of good is named after an economist who believed that he had found evidence
that indicated that the quantity of potatoes demanded increased in Ireland when the price
rose during the Irish Potato Famine - more careful later analysis indicated that Giffen's
evidence was flawed.) In practice, though, no one has found reliable evidence of a Giffen
good. Thus, it is probably fairly safe to assume that demand curves are downward
sloping. This will, of course, unambiguously be expected to occur for normal goods.
An individual buys a good only if the purchase is expected to makes the person better off
(or at least no worse off). In general, the total benefit received from the purchase of a
commodity is expected to exceed the opportunity cost. This provides consumers with a
net gain from trade, referred to as consumer surplus. Let's examine this concept in more
Suppose that an individual buys 10 units of a good at a price of $5. The diagram below
illustrates this possibility.
As the diagram below indicates, the first unit of this good costs $5, but this individual
would have been willing to pay a price of up to $9 for this first unit of this good. In this
case, the consumer receives a good that he or she values at $9 by giving up only $5.
Thus, the first unit of the good generates $4 in consumer surplus. In the diagram below,
the benefit received from the first unit of the good is the sum of the two shaded areas
(notice the height of this rectangle equals the price the person is willing to pay - $9 -
while the base equals 1, thus the area of the rectangle equals $9) The cost of this first unit
of the good ($5) is given by the green shaded area. The blue shaded area at the top of the
graph represents the consumer surplus ($4) received from the first unit of this good.
More generally, the total benefit from consuming 10 units of this good is the entire area
under the demand curve (as illustrated by the blue shaded area in the diagram below).
The total cost of consuming 10 units of this good at a price of $5 is $50. This is
represented by the green shaded rectangle in the diagram below.
The consumer surplus received by this consumer is the difference between the total
benefit and total cost. This is represented by the red shaded area in the diagram below. As
noted above, the consumer surplus represents the consumer's net benefit from engaging in
Consumer choice can also be explained through the use of indifference curves. An
indifference curve is a graph of all combinations of goods that provide a given level of
utility. The diagram below contains an indifference curve for two goods, X and Y.
Any two points on an indifference curve generate the same level of utility. Thus, the
diagram below indicates that this person would be indifferent if faced with a choice
between the combinations of goods represented by points A and B. Points that lie above
and to the right of an indifference curve provide a higher level of consumption of each
good than points on an indifference curve. Because of this, such points provide a higher
level of utility than points on the indifference curve. Thus, point C would be preferred to
either point A or B (or any other point on the indifference curve Uo). Points that lie
below and to the left of the indifference curve (such as point D) provide a lower level of
utility. Therefore, this individual would prefer the bundle of goods represented by point
A if faced with a choice between the bundles of goods represented by points D and A.
An indifference curve crosses through each and every point in this diagram. Thus, an
infinite number of indifference curves exist for these two goods. Two additional
indifference curves, corresponding to the levels of utility received at points C and D have
been added to the diagram below.
It is assumed that individuals attempt to place themselves on the highest level of utility
that they can achieve, given the constraints that they face. Let's examine the budget
constraint facing individuals.
Let's consider the budget constraint facing an individual who has a fixed level of income
(I) that can be used to buy two goods (X and Y) at fixed prices (PX and Py). The budget
constraint facing this individual can be expressed as:
A graph of this budget constraint appears below. The intercepts of this budget constraint
on each axis equals income divided by the price of the good represented on the axis (this
can be demonstrated quite easily using basic algebra).
As your text illustrates on p. 182, changes in income will result in a parallel shift in the
budget constraint while changes in the prices of goods X and Y will affect the slope of
the budget constraint.
Consumer equilibrium and indifference curves
Individuals maximizing utility subject to their budget constraint attain the highest
possible level of utility at a point of tangency between their budget constraint and an
indifference curve. In the diagram below, this occurs when the individual consumes X*
units of good X and Y* units of good Y. While other points on the budget constraint,
such as point A, are feasible, they provide a lower level of utility. Points such as point B
provide a higher level of utility, but are not feasible. It is not possible to attain a higher
level of utility than Uo without violating the budget constraint (and there are laws that
prevent people from acquiring more goods than they can pay for...).
Chapter P production and cost
During the first weeks of the course, we examined how a market economy functioned.
The past two weeks have focused on the behavior of consumers in more detail. We'll be
focusing on the supply side of the economy for the next two weeks. This week, we begin
by discussing the determinants of production costs.
The total amount of output produced by a firm is a function of the levels of input usage
by the firm. In the short run, a simplified version of this relationship is provided by a
firm's total physical product (TPP) (also known more simply as total product)
function. This function captures the relationship that exists between the maximum level
of output that can be produced by a firm and its level of labor use, holding other inputs
and technology constant. (Remember, the short run is defined to be the period of time in
which capital cannot be changed.) The table below contains an example of a possible
total product function.
A careful inspection of the table above indicates that output initially increases more
rapidly as the level of labor use increases, but ultimately increases by smaller and smaller
increments. In the example illustrated above, output even declines at higher levels of
labor use (note that output declines from 275 to 270 when the level of labor use increases
from 40 to 45). Economists argue that equal increases in the level of labor use will
ultimately result in progressively smaller increases in output in virtually all production
processes. This is a consequence of the law of diminishing returns that was first
introduced in Chapter 2 of your text.
The relationship between the level of input use can also be represented through the
average physical product (APP) of labor. The average physical product is defined as the
ratio of total physical product to the quantity of labor. The average physical product for
the firm described above has been added to the table below. Notice how the value of APP
is equal to the ratio of TPP to the quantity of labor in each row of this table. As in this
example, economics expect that the APP may initially rises but will ultimately decline as
a result of the law of diminishing returns. The average physical product of labor is what
is meant when economists talk about labor productivity. So, when you hear references to
rising or declining labor productivity, you'll now know that they're talking about changes
The marginal physical product (MPP) (also know more simply as just marginal
product), is another useful and important concept. MPP is defined as the additional output
that results from the use of an additional unit of a variable input, holding other inputs
constant. It is measured as the ratio of the change in output (TPP) to the change in the
quantity of labor used. In mathematical terms, this can be expressed as:
The table below continues the estimated MPP for each of the reported intervals. Be sure
that you understand how the MPP is computed from the information contained in the first
two columns of this table. For example, consider the interval between 10 and 15 units of
labor. Note that since TPP increases by 60 (from 120 to 180) when the quantity of labor
increases by 5, the MPP of labor in this interval equals 60/5 = 12.
As the table above indicates, the MPP is positive when an increase in labor use results in
an increase in output; the MPP is negative when an increase in labor use results in a
decrease in output.
The TPP, APP, and APP curves can also be illustrated using a graph. The diagram below
contains a graph of a possible TPP curve. As was true in the table above, this diagram
suggests that output initially rises more rapidly as labor use increases. Beyond some
point, however, TPP starts to rise by less and less with each additional unit of labor. It is
possible (as in the example here) that TPP may eventually fall when too many workers
are present (yes, the old "too many cooks spoil the broth" cliché applies here again....).
The diagrams below illustrate the APP and MPP curves associated with this TPP curve.
As in the table above, APP initially rise and then falls. MPP rises in the range in which
TPP is increasing at a more rapid rate and declines in the range in which TPP increases at
a declining rate. MPP equals zero at the point at which TPP reaches a maximum and is
negative when TPP declines.
As the diagram above indicates, the MPP and APP curves intersect at the maximum level
of APP. The reason for this is relatively intuitive. For levels of labor use below Lo, MPP
is greater than APP. This means that an additional workers adds more to output than the
average worker is producing. In this case, the average has to increase. An analogy is quite
useful here. Suppose that your grade in a class at any point in time is formed by taking
the average of all of the grades that you have achieved up to that point in time. If your
score on an additional test (this may be thought of, quite appropriately in many cases, as a
"marginal grade") exceeds your average average, your average grade will rise. Using
similar reasoning, if your marginal grade is less than your average grade, your average
will decline. In the same manner, the average physical product of labor will decline when
the marginal physical product of labor is less than the average physical product of labor.
An inspection of the diagram above indicates that APP increases whenever the level of
labor use is less than Lo. APP declines, however, when the level of labor use is greater
than Lo. Since APP increases up to this point and declines after this point, APP must
reach a maximum when Lo workers are employed (at the point at which MPP = APP).
In the short run, total costs (TC) consist of two categories of cost: total fixed costs and
total variable costs. Total fixed costs (TFC) are costs that do not vary with the level of
output. The level of total fixed costs is the same at all levels of output (even when output
equals zero). Examples of such fixed costs include rent, annual license fees, mortgage
payments, interest payments on loans, and monthly connection fees for utilities (note that
this last category includes only fixed monthly charges, not the portion of utility fees that
varies with the level of use). Total variable costs (TVC) are costs that vary with the
level of output. Labor costs, raw material costs. and energy costs are examples of variable
costs. Variable costs are equal to zero when no output is produced and increase with the
level of output.
The table below contains a listing of a hypothetical set of total fixed cost and total
variable cost schedules. As this table indicates, total fixed costs are the same at each
possible level of output. Total variable costs are expected to rise as the level of output
As the table below indicates, we can use the TFC and TVC schedules to determine the
total cost schedule for this firm. Note that, at each level of output, TC = TFC + TVC.
The diagram below contains a graph of a total fixed cost curve. Since total fixed costs are
the same at all levels of output, a graph of the total fixed cost curve is a horizontal line.
The total variable cost curve increases as output increases. Initially, it is expected to
increase at a decreasing rate (since marginal productivity increases initially, the cost of
additional units of output decline). As the level of output rises, however, variable costs
are expected to increase at an increasing rate (as a result of the law of diminishing
marginal returns). The diagram below contains a possible total variable cost curve.
Since total cost equals the sum of total variable and total fixed costs, the total cost curve
is just the vertical summation of the TFC and TVC curves. The diagram below illustrates
Average and marginal costs
Average fixed cost (AFC) is defined as: AFC = TFC / Q. An average fixed cost schedule
has been added to the diagram below. Note that average fixed costs always decline as the
level of output increases.
Average variable cost (AVC) is defined as: AVC = TVC / Q. An average variable cost
schedule has been added to the table below. It is expected that average variable costs will
initially decrease as output increases but will eventually increase as output continues to
rise. The reason for the eventual increase in AVC is the law of diminishing returns
discussed above. If each additional worker adds progressively less additional output, the
average cost of the additional output must eventually increase.
Average total cost (ATC) is defined as: ATC = TC / Q. The table below includes an
ATC schedule. Note that ATC can also be measured as: ATC = AVC + AFC (since
TC=TFC+TVC, TC/Q = TFC/Q + TVC/Q).
In addition to these average cost measures, it is also useful to measure the cost of an
additional unit of output. The cost of an additional unit of output is called marginal cost
(MC). Marginal cost can be measured as:
A marginal cost schedule has been added to the table below. Be sure that you understand
how marginal cost is computed in this table. Consider, for example, the interval between
10 and 20 units of output. In this case, total costs increase by 20 (from 40 to 60) when 10
additional units of output are produced, so in this interval, marginal cost is 20/10 = 2.
We can also represent these average and marginal cost relationships using diagrams. The
diagram below contains a graph of a typical AFC curve. Note that AVC declines as
The diagram below contains a graph of the ATC, AVC, and MC curves for a typical firm.
Note that the vertical distance between the ATC and the AVC curve is equal to AFC
(since AFC+AVC=ATC). It is also useful to observe that the MC curve intersects the
AVC and the ATC curves at their respective minimum points. To see this, note that
whenever marginal costs are less than average costs, the average cost must decline.
Similarly, when marginal costs exceed average costs, the average must rise. Thus, the
MC curve must cross each of these average cost curves at their respective minimum
In the long run, all inputs are variable. As the firm changes the amount of capital it uses,
it will shift from one short-run averate total cost curve (SRATC) to another. The diagram
below illustrates this relationship. As a firm acquires more capital, the minimum point on
it's average total cost curve is associated with a higher level of output. Thus, in this
diagram, SRATC4 represents a firm with a relatively high level of capital while SRATC1
represents a firm with a low level of capital.
The long-run average total cost curve (LRATC) represents the lowest level of average
cost that can occur in the long run at each possible level of output. It is assumed that
firms producing any given level of output in the long run would always select the size of
firm that has the lowest short-run average total costs at that level of output. In the
diagram above, a firm would select a level of capital that places it on the short-run
average total cost curve SRATC2 if it were to produce Qo units of output. (Notice that
the costs of producing this level of output would be higher with either a smaller or a
It is often argued that the long-run average cost curves has a shape similar to the diagram
below. At low levels of output, it is suggested that economies of scale result in a decrease
in long-run average costs as output increases. Economies of scale are factors that result
in a reduction in LRATC as output rises. These factors include gains from specialization
and division of labor, indivisibilities in capital, and similar factors. Diseconomies of
scale, factors that result in higher levels of LRATC as output increase, are believed to be
important at high levels of output. These factors include the increased cost of managing
and coordinating a firm as the size of the firm rises. Constant returns to scale occur
when LRATC does not change when the firm becomes larger or smaller. It is believed
that this happens over a relatively large range of output (as illustrated in the diagram
The diagram above also illustrates the concept of minimum efficient scale (MES). The
minimum efficient scale of a firm is the lowest output level at which LRATC are
minimized. As we'll see in later chapters, the MES is important in determining the market
structure for a particular output market. Competition among firms forces firms to produce
at a level of output at which LRATC is minimized. If the MES is large, relative to the
quantity of output demanded in a market, only a small number of firms can profitably
coexist. If, for example, the MES is 10,000 and a quantity of only 20,000 units of output
is demanded, at most two firms can survive in the market. We'll return to this topic in
Chapter Profit maximization
During this week, we'll examine how firms determine the profit-maximizing level of
output. As part of this discussion, we'll also examine differences among perfectly
competitive, monopolistically competitive, oligopoly, and monopoly markets.
Economists assume that firms select prices and output levels that maximize their profits.
When economists discuss profits, however, they are referring to the concept of economic
profit defined as:
Economic profit = total revenue - all economic costs
As you should recall from our discussion of the material in Chapter 2, economic costs
include all opportunity costs, regardless of whether these costs are explicit or implicit. An
explicit cost is a cost in which a payment is actually made. An implicit cost, on the other
hand, is a cost in which no money changes hands. An example may help to illustrate this
distinction. Suppose that you borrow money from a bank to acquire capital to open a
business. In this case, the interest payments on the loan would be an explicit cost. If, on
the other hand, you use your own savings to finance this capital, you do not have to pay
interest to someone else for the use of these funds. In this case, however, the opportunity
cost would be the implicit cost of the interest that you could have received had you
placed this money in an interest-bearing asset instead of buying this capital.
Note that economic costs are different than accounting costs. Accounting costs, for the
most part, include only explicit costs. (The only exception is that accounting cost
includes a measure of depreciation, which is an implicit cost. But, even in this case, the
accounting measure of depreciation is based on the historical price of capital, and not
based on its opportunity cost.) The reason for this distinction, of course, is that
accounting systems are designed to provide a record of a firm's receipts and expenditures.
For such a record to be meaningful to tax authorities and the owners of a firm, each
receipt and expenditure must be accompanied by some verifiable record of transactions.
Implicit costs are not directly observed (and provide no "receipts" that can be used to
Since economic costs include both implicit and explicit costs while accounting costs
consist (almost exclusively) of explicit costs, economic costs are virtually always greater
than accounting costs. The difference between between these two measures of cost is the
opportunity cost of resources supplied by the firm's owner. The opportunity cost of these
owner-supplied resources is called normal profit. As your text notes, the owners of
corporations (the shareholders) must receive a rate of return on their stock that is
equivalent to what they could receive if their next-best alternative. So, normal profit (or
"normal accounting profit" as your text defines it) is an economic cost that is not counted
as an accounting cost.
Accounting profit is defined as:
Accounting profit = total revenue - all accounting costs
A comparison of the definitions for economic and accounting profits indicates that
accounting profits will virtually always exceed economic profits. Let's take a simple
example. Suppose that the owner of a firm could receive $90,000 a year using the labor,
capital, and other resources that she uses to operate her own business. If she receives
$70,000 in accounting profits, she would actually have suffered $20,000 in economic
losses, since she is earning $20,000 less than she could receive with an alternative
employment of these resources.
If the owners of a firm economic profits, this means that they are receiving a rate of
return on the use of their resources that exceeds that which can be received in their next-
best use. In this situation, we'd expect to see other firms entering the industry (unless
barriers to entry exist).
If a firm is receiving economic losses (negative economic profits), the owners are
receiving less income than could be received if their resources were employed in an
alternative use. In the long run, we'd expect to see firms leaving the industry when this
If the owners of a typical firm receive zero economic profits, this means that they are
receiving an income that is just equal to what they could receive in their next-best
alternative. In this case, there would be no incentive for firms to either enter or leave this
industry. Be sure to understand that zero economic profits occur only if the owners are
receiving accounting profits equal to normal profit.
Marginal Revenue and Marginal Cost
Let's consider what happens to a firm's profits when it produces an additional unit of
output. Recall that its economic profits are defined as:
Economic profit = total revenue - economic costs
When a firm produces an additional unit of output its revenue rises (in all practical
situations) and its costs rise as well. Profits rise if revenue rises by more than costs and
fall if costs rise by more than revenue. The additional revenue resulting from the sale of
an additional unit of output is called marginal revenue (MR). As noted in Chapter 8, the
additional cost associated with the production of an additional unit of output is marginal
Let's consider a firm's decision about whether to produce more or less output. If marginal
revenue exceeds marginal cost, the production of an additional unit of output adds more
to revenue than to costs. In this case, a firm is expected to increase its level of production
to increase its profits. If, instead, marginal cost exceeds marginal revenue, the production
of the last unit of output costs more than the additional revenue generated by the sale of
this unit. In this case, firms can increase their profits by producing less. So, a profit-
maximizing firm will produce more output when MR > MC and less output when MR <
MC. If MR = MC, however, the firm has no incentive to produce either more or less
output. In fact, the firm's profits are maximized at the level of output at which MR = MC.
Since marginal revenue is such an important part of a firm's decision concerning how
much output to produce, it should be examined in greater detail. (We already examined
marginal cost last week.) Marginal revenue is defined as:
If a firm faces a perfectly elastic demand curve, the price of the good is the same at all
levels of output. In this case, marginal revenue is simply equal to the market price.
Suppose, for example, that corn sells for $1 per dozen. The marginal revenue received by
a farmer from the sale of an additional dozen ears of corn is simply the price of $1. This
possibility is illustrated in the diagram below.
Suppose, however, that a firm faces a downward sloping demand curve. In this case, it
must lower the price if it wishes to sell additional units of this good. In this case,
marginal revenue is less than the price. Let's use an example to see why this is true.
Consider the situation described in the diagram below. When the price is $6, the firm can
sell 4 units of output while receiving a total revenue equal to $6 x 4 = $24. If it wishes to
sell the 5th unit of output, it must lower the price to $5. Its total revenue in this case will
equal $25. Marginal revenue in this case equals: change in total revenue / change in
quantity = $1 / 1 = $1. As this example illustrates, marginal revenue will always be less
than the price of the good when the firm faces a downward sloping demand curve. This is
because the firm has to lower the price not just on the last unit sold but instead on all
units that it sells. In this case, the firm received an additional $5 in revenue from the same
of the 5th unit, but it lost $4 in revenue when it lowered the price on the first 4 units by
$1. Thus, total revenue increased by only $1 when the 5th unit is sold.
The diagram below illustrates the relationship that exists between the marginal revenue
curve and the demand curve. The demand curve provides the price that can be charged at
each level of output. Since we know that MR is less than the price, the marginal revenue
curve must lie below the demand curve. Using the results from the chapter on elasticity,
we can also note that marginal revenue is positive in the elastic section of the demand
curve (since a price decrease results in an increase in total revenue in this case), is zero
when demand is unit elastic (since total revenue remains unchanged when the price falls
when demand is unit elastic) and is negative when demand is inelastic (since total
revenue declines when the price falls in this portion of the demand curve.)
Table 1 on p. 223 in your text provides a good numerical example of the computation of
marginal revenue. Be sure that you understand how the marginal revenue column is
computed in this table.
The diagram below illustrates the profit-maximizing levels of price and output for a firm
facing a downward sloping demand curve. As noted above, the profit-maximizing level
of output occurs at the point at which MR = MC. This occurs at an output level of Qo, the
level of output at which the MR and MC curves intersect. The price that firms can charge
to sell this much output is given by the demand curve. In this example, the price equals
The shaded area in the diagram above represents the level of economic profits recveived
by this firm. Note that the height of this rectangle equals the difference between the price
of the good and average total cost. This vertical distance is equal to the profit received
per unit of output. The base of the rectangle is equal to the quantity of output sold by the
firm. The area of this rectangle (the shaded area) equals the profit per unit of output x the
number of units of output. This product is equal to total economic profit.
Alternative market structures
The basis market structures that we'll be examining over the next several weeks include:
perfect competition, monopoly, monopolistic competition, and oligopoly. Let's examine
the defining characteristics of each market structure. Perfect competition is
a very large number of buyers and sellers,
a standardized product, and
each buyer and seller has no control over the market price (this means that each
firm is a price taker that faces a horizontal demand curve for its product).
A monopoly market is characterized by:
a single seller producing a product with no close substitutes,
effective barriers to entry into the market, and
the firm is a price maker, also called a price searcher because it faces a
downward sloping demand curve for its product (in fact, note that this demand
curve is the market demand curve).
One special type of monopoly is a natural monopoly, a monopoly that arises because of
the existence of economies of scale over the entire relevant range of output. In this case, a
larger firm will always be able to produce output at a lower cost than could a smaller
firm. The pressure of competition in such an industry would result in a long-run
equilibrium in which only a single firm can survive (since the largest firm can produce at
a lower cost and can charge a price that is less than the ATC of smaller firms).
Under a monopolistically competitive market:
there is a large number of firms,
the product is differentiated (i.e., each firm produces a similar, but not identical,
entry is relatively easy, and
the firm is a price maker that faces a downward sloping demand curve.
In an oligopoly market:
a small number of firms produce most output,
the product may be either standardized or differentiated,
there are significant barriers to entry, and
recognized interdependence exists (i.e., each firm realizes that its profitability
depends on the actions and reactions of rival firms).
Most output is produced and sold in oligopoly and monopolistically competitive
Chapter Perfect Competition
This week, we'll examine how price and output is determined in a perfectly competitive
market. A perfectly competitive market is characterized by:
many buyers and sellers,
identical (also known as homogeneous) products,
no barriers to either entry or exit, and
buyers and sellers have perfect information.
In particular, there are so many buyers and sellers for the product in a perfectly
competitive market that each buyer and seller is a price taker.
Demand curve facing a single firm
The diagram below illustrates the relationship between the market and an individual firm.
The equilibrium price is determined by the interaction of market demand and market
supply. Since the output of each firm is such an infinitesimally small share of this total
output, no individual firm can affect the market price. Thus, each firm faces a demand
curve for its product that is perfectly elastic at the market price.
As discussed last week, a firm maximizes its profits by producing the level of output at
which marginal revenue equals marginal cost. (If you're not comfortable with the
concepts of marginal revenue and marginal cost, it would be useful to review last week's
material.) As noted in the module accompanying Chapter 9, marginal revenue is defined
In a similar manner, marginal cost is defined as:
As noted last week, marginal revenue equals the market price for a firm facing a perfectly
elastic demand curve. The diagram below illustrates this relationship.
Marginal and average total cost curves have been added to the diagram below. As this
diagram indicates, a profit-maximizing firm will produce at the level of output (Qo) at
which MR = MC. The price, Po, is determined by the firm's demand curve.
At an output level of Qo, the firm faces average total costs equal to ATCo. Thus, it's
profit per unit of output equals Po - ATCo (= revenue per unit or output - total cost per
unit of output). Economic profits are equal to: profit per unit x # of units of output. An
inspection of the diagram below should confirm that economic profits equals the area of
the shaded rectangle (notice that the height of this rectangle equals profit per unit of
output and the base equals the number of units of output).
If a firm is receiving economic profits, the owners are receiving a return on their
investment that exceeds that which they could receive if their resources had been used in
an alternative occupation. In this case, existing firms will stay in the market and new
firms will enter the market. We'll discuss the effects of this entry on price and output in
more detail below.
Loss minimization and shutdown rule
Suppose that P < ATC at the level of output at which MR = MC. Will the firm continue
operations? To determine this, we have to compare the firm's loss if it stays in business
with its loss if it shuts down. If the firm decides to shut down, it's revenue will equal zero
and its costs will equal its fixed costs. (Remember, fixed costs must be paid even if the
firm shuts down.) Thus, the firm receives an economic loss equal to its fixed costs if it
shuts down. It will stay in business in the short run even if it receives an economic loss as
long as it's loss is less than its fixed costs. This will occur if the revenue received by the
firm is large enough to cover its variable costs and some of its fixed costs. In
mathematical terms, this means that the firm will stay in business as long as:
TR = P x Q > VC
Dividing both sides of the above expression by Q, we can write this condition in an
alternative form as:
P > AVC
What this means in practice, is that the firm will stay in business if the price is greater
than average variable cost; the firm will shut down if the price is less than average
variable cost. Consider the situation illustrated by the diagram below. In this case, losses
are minimized at the level of output at which MR = MC. This occurs at an output level of
Q'. Since the level of average total cost (ATC') exceeds the market price (P'), this firm
receives economic losses. Since the price is greater than AVC, however, this firm will
choose to stay in business in the short run.
If the firm illustrated above were to shut down, it would lose its fixed costs. The shaded
area in the diagram below equals the firm's fixed costs (to see this, note that the height of
this rectangle equals the firm's AFC and the base equals Q -- therefore, the shaded area
equals AFC x Q = TFC). A comparison of the firm's losses if it shuts down (the shaded
area in the diagram below) with its losses if it continues to operate in the short run (the
shaded area in the diagram above) indicates that this firm will receive lower losses if it
decides to remain in business in the short run.
So, this discussions should suggest that the shut down rule for a firm is: shut down if P <
AVC. In the long run, of course, firms will leave the industry if economic losses are
received (remember, there are no fixed costs in the long run.)
If the market price is just equal to the minimum point on the ATC curve, the firm will
receive a level of economic profits equal to zero. In this case, the owners of the firm are
receiving a rate of return on all of their resources that is just equal to that which they
could receive in any alternative employment. When this occurs, there is neither an
incentive to enter or leave this market. This possibility is illustrated in the diagram below.
If the price drops below AVC, the firm will shut down. This possibility is illustrated in
the diagram below. The green shaded area equals the firm's fixed costs (its losses if it
shuts down). The loss if it continues operations, however, equals the combined blue and
green shaded areas. As this diagram suggests, a firm's economic losses are lower when it
shuts down if P < AVC.
Short-run supply curve
So far, we have observed that a perfectly competitive firm will produce at the point at
which P = MC, as long as P > AVC. The diagram below indicates that at prices of Po, P1,
P2, and P3, this firm would produce output levels of Qo, Q1, Q2, and Q3, respectively. A
bit of reflection should convince you that the MC curve can be used to determine the
quantity of output that this firm will supply whenever P > AVC. Since the portion of the
MC curve that lies above the AVC curve indicates the quantity of output supplied at each
price, it is the firm's short-run supply curve. In general, a perfectly competitive firm's
short-run supply curve is the portion of its marginal cost curve that lies above the AVC
curve. This is illustrated by the darker and thicker portion of the MC curve in the diagram
In the long run, firms will enter the market if positive economic profits are received and
will leave the market if economic losses are realized. Let's think about the consequences
of such entry and exit. Suppose that the current equilibrium price in a market results in
economic profits for a typical firm. In this case, firms enter the market and the market
supply curve shifts to the right. As market supply increases, the equilibrium price falls.
This process will continue until firms no longer have an incentive to enter the market. As
the diagram below indicates, a typical firm will receive zero economic profits in this
long-run equilibrium situation.
Suppose instead that a typical firm is receiving an economic loss. In this situation, firms
will leave the industry in the long run. As they exit, the market supply curve shifts to the
left and the equilibrium price rises. Firms will continue to leave until the market supply
curve has shifted enough so that a typical firm receives zero economic profits (as
illustrated in the diagram above).
Thus, as the above diagram illustrates, a long-run equilibrium is characterized by the
receipt of zero economic profits by a typical firm. This means, of course, that the owners
of a typical firm receive accounting profits just equal to normal profit.
Long-run equilibrium and economic efficiency
This long-run equilibrium condition has two desirable efficiency properties:
P = MC, and
P = minimum ATC.
The equality between P and MC is important for society because the price reflects
society's marginal benefit from the consumption of the good while the marginal cost
reflects the social marginal cost of producing the good (in the absence of externalities).
At the competitive equilibrium, society's marginal benefit just equals society's marginal
costs. Society's net benefit from the production of each good is maximized when social
marginal benefit equals social marginal cost.
Production at minimum average cost means that society is producing each good at the
lowest possible cost per unit. This, obviously, is also a desirable property.
Economic efficiency occurs when both of the above conditions are satisfied.
Consumer and Producer Surplus
We had discussed the concept of consumer surplus earlier. As noted in the section on
demand and utility, consumer surplus is equal to the net benefit that consumers receive
from the consumption of a good. It occurs because the marginal benefit from each unit of
the good exceeds the marginal cost up to the point until the last unit is consumed.
Producer surplus is defined in a similar manner as the net benefit received by producers
from the sale of a good. It occurs because P = MC only for the last unit produced. Up to
that point, the marginal cost of producing the good is below the price received by the
In the diagram below, the yellow shaded region equals the amount of consumer surplus,
while the blue shaded region represents producer surplus. The net benefit to society, also
known as the "gains from trade," equals the sum of these two areas.