INSTRUCTORS' MANUAL Microeconomics 14th Edition by Michael Parkin.

Instructor’s Resource Manual Mark Rush, University of Florida

Microeconomics 14e

Michael Parkin

Table of Contents

Preface Perspective Flexibility  Part 1 Chapter 1 Chapter 2  Part 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7  Part 3 Chapter 8 Chapter 9  Part 4 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15  Part 5 Chapter 16 Chapter 17  Part 6 Chapter 18 Chapter 19 Chapter 20

MyLab Economics How to Assemble Your Course

v vii ix

Introduction What is Economics?

The Economic Problem

1 9

How Markets Work Demand and Supply Elasticity Efficiency and Equity Government Actions in Markets Global Markets in Action

21 35 45 57 69

Households’ Choice Utility and Demand Possibilities, Preferences, and Choices

81 93

Firms and Markets Organizing Production Output and Costs Perfect Competition Monopoly Monopolistic Competition Oligopoly

103 113 125 137 151 159

Market Failure and Government Public Choices, Public Goods, and Healthcare Externalities

169 179

Factor Markets, Inequality, and Uncertainty Markets for Factors of Production Economic Inequality Uncertainty and Information

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189 203 213

P e r s p e c t i v e

MYLAB ECONOMICS

It’s About Time What if you could spend less time grading, and more time teaching? And what if, at the same time, you could strengthen the incentives for your students to do their homework and come to class better prepared?

With MyLab Economics, what sounds like a free lunch is now an achievable goal!

MyLab Economics is a turn-key, online solution for your economics course. Using a new and powerful graphing tool and question bank, students can self-test and generate a study plan, and instructors can assign homework and capture grades. With a tight, everything-in-one-place organization around the new testing tool, questions include true-false, multiple choice, fill-ins, numerical, and complete the graph. Many of the questions are generated algorithmically, a feature that rewards understanding and penalizes rote learning.

Practice tests for each section of the textbook enable students to test their ability and identify the areas in which they need further work. Based on a student’s performance on a practice test, a personalized study plan shows where further study is needed. Once students have received their study plan, additional practice exercises, keyed to the textbook, provide extensive practice and link directly to the eText with animated graphs, an electronic tutorial, and other resources.

Users of MyLab Economics will revel in the powerful graphing tool integrated into both the practice tests and practice exercises. This tool enables students to manipulate graphs and see how the concepts, numbers, and graphs are connected. Questions that use the graphing tool (like all other questions) can be submitted and graded online.

MyLab Economics saves your students time because it identifies what they have not yet mastered and creates a Personalized Study Plan. This study plan consists of a series of additional practice exercises. Using tutorial instruction launched directly from practice exercises, students can follow step-by-step solutions and tutorials that promote self-discovery. With an abundant collection of interactive resources, students will come to class better prepared.

MyLab Economics saves instructors time in answering questions, tracking performance, and giving practice tests. Instructors can customize the practice tests or leave students to use the supplied pre-built tests.

Additional MyLab Economics tools include:  eText 

Animated figures

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Electronic tutorials

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Glossary

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Glossary Flashcards

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Office Hours

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Daily Economics in the News updates and archives

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Links to the most useful economic data and information sources on the Internet

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Research Navigator—extensive help on the research process and four exclusive databases of credible and reliable source material including the New York Times, the Financial Times, and peer-reviewed journals © 2023 Pearson Education, Inc.

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MYLAB ECONOMICS

Registration for MyLab Economics To learn more, and to register for MyLab Economics, please go to www.myconlab.com and click on the link to request an access code. Your Pearson sales representative will then be in touch to help you get started.

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Flexibility

HOW TO ASSEMBLE YOUR COURSE

Introduction Instructors who have already used Michael Parkin’s Microeconomics are aware of its flexibility: There are many ways to teach from this book, depending on your preferences. Because there is no necessarily right or wrong way to teach a principles of microeconomics class, the microeconomic part of the book can be used in a variety of ways. The most obvious one is the order in which the chapters are printed. Other paths are illustrated in Table 1.

Microeconomics Table 1 presents the flexibility in the microeconomic chapters. This is organized according to the three basic foundation chapters followed by a large selection of chapters you can next tackle. After finishing some or all of these chapters, more choices are presented. You can move quickly or slowly to the examining production and firms; quickly or slowly to efficiency and government policy in markets; quickly or slowly to consumer choice.

The choice is up to you because you can shape the course you want to teach.

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HOW TO ASSEMBLE YOUR COURSE

Table 1

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C h a p t e r

1

WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative—an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits.

Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

New in the Fourteenth Edition When discussing the social interest and four major issues, the issue of financial instability has been replaced with a discussion of social interest issues surrounding the COVID pandemic. The emphasis in this discussion is that often self-interested decisions are not in the social interest (for example, whether to socially distance) so that rules governing behavior may need to be established. The last topic, dealing with Economists in the Economy, now includes a section covering the diversity challenge in economics. It points out that fewer women and minorities receive bachelor’s PhD degrees in economics than in STEM majors in general. It also discusses efforts being made to overcome this lack of diversity. The Economics in the News presenting Mark Zuckerberg’s vision to have the Internet available to the whole world has been eliminated to make room for the coverage of diversity in the profession.

This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. Students relate well to the section on self and social interest which calls out issues of both efficiency and fairness and is great for class discussion.

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CHAPTER 1

2

Lecture Notes

What Is Economics?

I.

Definition of Economics  

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants.

Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity?

According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time.

Economics  Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices.  Economists work to understand when the pursuit of self-interest advances the social interest  Economics is divided into microeconomics and macroeconomics:  Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments.  Macroeconomics is the study of the performance of the national economy and the global economy.

On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?” Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money.

Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!).

The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.”

Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.”

Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.”

A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight.

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WHAT IS ECONOMICS?

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II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced?

What, How and For Whom?  Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more streaming music than 5 years ago.  Goods and services are produced using the productive resources called factors of production. These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital).  The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training.  Owners of the factors of production earn income by selling the services of their factors. Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit.

Do Choices Made in the Pursuit of Self-Interest also promote the social interest?  You make a choice in your self-interest if you think that choice is the best one available for you.  An outcome is in the social interest if it is best for society as a whole.  A major question economists explore is “Could it be possible that when each of us makes choices in our selfinterest, these choices are in the social interest?’

Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer streaming music and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average major-league baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics.

Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit). 

We can examine whether the self-interested choices serve the social interest for a variety topics:  Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family  Information-Age Monopolies: A firm producing popular software leads to format standards  Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change  The Covid pandemic: Covid-19 spreads through social contact, so a person who socially isolates avoids infection and avoids infecting others, but people may not choose the optimal degree of isolation

III. Economic Way of Thinking Scarcity requires choices and choices create tradeoffs.

What is the difference between scarcity and poverty?

Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty. © 2023 Pearson Education, Inc.

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CHAPTER 1

A Choice is a Tradeoff  A tradeoff is an exchange—giving up one thing to get another.  Whatever choice you make, you could have chosen something else.

Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point:  Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption.  Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production.  Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production.

Making a Rational Choice  A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.  But how do people choose rationally? Why do more people choose to stream movies rather than buy blurays? Why has the U.S. government chosen to build an interstate highway system and not an interstate highspeed railroad system? The answers turn on comparing benefits and costs.

Benefit: What you Gain  The benefit of something is the gain or pleasure that it brings and is determined by preferences—by what a person likes and dislikes and the intensity of those feelings.  Some benefits are large and easy to identify, such as the benefit that you get from being in school. Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate.  Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza.

Cost: What You Must Give Up Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy.

What is the Opportunity Cost of Getting a College Degree?

When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more.

Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over.

To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States.

However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

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WHAT IS ECONOMICS?

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How Much? Choosing at the Margin  Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost).  Changes in marginal benefits and marginal costs alter the incentives that we face when making choices.

When incentives change, people’s decisions change.  For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework.

Choices Respond to Incentives  Economists take human nature as given and view people acting in their self-interest.  Self-interest actions are not necessarily selfish actions.

IV. Economics as Social Science and Policy Tool Economist as Social Scientist  Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.”  Economists tend to agree on positive statements, though they might disagree on normative statements.  An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world.  Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem:  Natural experiment: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal or similar.  Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer).  Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond.

Economist as Policy Adviser  Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions.  For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources.

The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable.

Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict

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CHAPTER 1

exactly where the cue ball would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.)

V. Economists in the Economy Jobs for an Economics Major  Economists work for private firms, governments, and international organizations. Some have a bachelor’s degree, while others have a master’s degree or a PhD.  On their jobs, economists often collect and analyze data on production and use of resources, goods, and services in order to predict future trends or devise ways to use resources more efficiently.  Economists have jobs as market research analysts, financial analysts, and, less often, budget analysts. There were about 1,300,000 of these jobs in the United States in 2020.

Will Jobs for Economics Majors Grow?  The Bureau of Labor Statistics (BLS) forecasts that from 20194 to 2029, jobs for PhD economists will grow 14 percent; jobs for budget analysts will grow by only 3 percent; but jobs for financial analysts will grow by 5 percent; and jobs for market research analysts will grow by 18 percent.

Earnings of Economics Majors  The Web resource payscale.com reports the earnings of economics majors range between $48,000 to $133,000 with a median of $108,000.  Pay in analyst jobs is lower, with an average of $65,800 for market research analysts and $83,700 for financial research analysts.

Skills Needed for Economics Jobs  Five skills are needed for an economics related job:  Critical-Thinking Skills: The ability to clarify and solve problems using logic and relevant evidence.  Analytical Skills: The use of economic ideas and tools to examine data, notice patterns, and reach a logical conclusion.  Math Skills: The ability to use mathematical and statistical tools to analyze data and reach valid conclusions.  Writing Skills: The ability to present ideas, conclusions, and reasons in succinct written reports appropriate for the target audience.  Oral Communication Skills: The ability to explain ideas, conclusions, and reasons to people with a limited background in economics.

A Diversity Challenge in the Economics Profession  Minorities and women are under-represented in the economics profession.  The American Economic Association has introduced prizes and grants to give minorities and women more incentive to pursue economics as a career.

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WHAT IS ECONOMICS?

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Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel accomodations on the trip will be $3,000, gasoline will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

2.

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space.

Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

2.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highestvalued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel accommodations ($3,000), gasoline ($200), and food ($1,400).

The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1.

Why are economists so concerned about the material aspects of life? Explain that this is a myth!

Economists are often criticized for focusing on material well-being because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index (www.freetheworld.com) and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for life-enhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters.

(Be careful not to seem to be either condoning or condemning these activities.) Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

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CHAPTER 1

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Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways.

1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means.

2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept. Indicate that this may be a Demand or Supply curve for instance.

3. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.”

I.

Graphing Data   

Graphs are valuable tools that clarify what otherwise might be obscure relationships.

Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines. The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin.

Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables.

II. Graphs Used in Economic Models 

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables:  A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship.  A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases.  A maximum or a minimum—when the variable has a highest or lowest value.

III. The Slope of a Relationship 

  

The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point.  In terms of symbols, the slope equals y/x, with  standing for “change in.”

The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related.

The slope of a curved line at a point equals the slope of the straight line that is tangent to the curved line at the point.

The slope of a curved line across an arc equals the slope of a straight line between the two points on the curved line.

IV. Graphing Relationships Among More Than Two Variables 

When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

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C h a p t e r

2

THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them— we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. The second half of the chapter begins with a model of exchange between two people that shows the “win-win” situation created through specialization and free trade. The next sections show how those individual gains scale up to economy wide gains. Lastly the traditional circular flow model highlights transformation of resources into final goods and services along with the money used in those markets Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

New in the Fourteenth Edition In Chapter 2 the introduction includes some teaser comments about Covid-19 and how it led to empty airports and how vaccines brought recovery. Related, the “Economics in the News” has a new article on “Production Possibilities in and after Covid-19” and uses the PPF to analyze issues surrounding government infrastructure expenditure.

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CHAPTER 2

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Lecture Notes

The Economic Problem   

I.

Scarcity creates the need to make choices.

Economic choices can be evaluated in terms of their efficiency.

We can expand possible choices through capital accumulation and specialization and trade.

Production Possibilities and Opportunity Cost  The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology.  Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right.

A B C D   

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other.

The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change.

Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods!

Production Efficiency Production is efficient only on the frontier.  We achieve production efficiency if we cannot produce more of one good without producing less of some other good.  Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF  Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else.

The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than © 2023 Pearson Education, Inc.

THE ECONOMIC PROBLEM

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later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production.

Opportunity Cost  The opportunity cost of an action is the highest valued alternative forgone.  Opportunity cost is a ratio; it is the cost of an additional unit of a good measured in terms of what was given up to obtain that additional unit. The formula to calculate opportunity cost is decrease in the quantity produced of one good divided by the increase in the quantity produced of a another good.  Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier.

Increasing Opportunity Cost  The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost.  Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger.  Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure. At this point all resources are used to produce movies. Basically, to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies.  As more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good.

You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve as the slope of a tangent line to the curve, that is, the slope of the line that is “just kissing” the curve at a single point.

The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. Simply stated, some resources are better suited for the production of one good or the other.

To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the N-good model.

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CHAPTER 2

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II. Using Resources Efficiently Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points.

The PPF and Marginal Cost  

Marginal cost is the opportunity cost of producing one more unit of a good.

As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

A

Books 0

B

200

C

400

D

600

Marginal cost of a book (movies per book) 0.5 1.0 1.5

Preferences and Marginal Benefit  Preferences are a description of a person’s likes and dislikes.  The marginal benefit of a good or services is the benefit received from consuming one more unit of it.  The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward.

You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve.

Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively). While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin.

Allocative Efficiency Allocative efficiency occurs only when marginal benefit equals marginal cost.  In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up.  When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month.  When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

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THE ECONOMIC PROBLEM

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III. Gains from Trade Specialization and trade expand consumption possibilities Comparative Advantage and Absolute Advantage  A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.  The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers.  A person has an absolute advantage if that person is more productive than others in that activity or activities.

A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities.

An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages.

Achieving the Gains from Trade  When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat. 

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat.

Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C along the trade line. Note that each country’s consumption point lies beyond its own PPF.



The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

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CHAPTER 2

To show the gains from trade you can use candy or any kind of small trinkets. Make sure that each person initially gets Then: 1. Create several countries with approximately even student populations. Give each country at least 3 or 4 items such as different types of candy. You can have some fun and add in a few entertaining items. For example: a can of spam, sticks of beef jerky, bubbles, etc.

2. Students record individual happiness value from 1-10 on initial allocation (I use an Excel spreadsheet to easily aggregate data at the end but keeping track on paper is fine).

3. Allow the countries to trade with each other 4. Have the students record their new happiness level after trade.

5. Compare the “happiness” level after trade with that before trade.

Here are the key points that come from the experiment:  Both parties become better off when they engage in voluntary trade.  Even without production, trade creates value.

IV. Economic Growth Economic growth expands production possibilities and shifts the PPF outward.  Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth.

You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2017, income per person in the United States was about $133 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes.

The Cost of Economic Growth  Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth.

A Nation’s Economic Growth  Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.  Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth.

Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs.

Changes in What We Produce  In a low-income country, just producing enough food is a high priority, and the marginal benefit from food is high. So, in Ethiopia, agriculture accounts for a large 35 percent of total production.  In China, where production per person is 7 times that of Ethiopia, agriculture shrinks to 8 percent of total production and industry expands to 41 percent.  Further investment in capital and in advanced robot technologies expand production possibilities to the level in the United States, which today is 4 times (per person) its level in China.

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THE ECONOMIC PROBLEM

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V. Economic Coordination Firms and Markets  A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.  A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

Property Rights and Money  The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology).  Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade.

Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves. Our focus on money creates a “veil” that hides the real economic engine of capitalism.

Circular Flows Through Markets  Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it.

Coordinating Decisions  Prices within markets coordinate firms’ and households’ decisions.

Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth. 

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

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CHAPTER 2

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Additional Problems 1.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

2.

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

3.

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

4.

In problems 1 and 2, Jane’s Island produces and consumes 2 pounds of corn and 2 yards of cloth. Joe’s Island produces and consumes 2 pounds of corn and 2 yard of cloth. Now the islands begin to trade. a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Corn (pounds per month) 3.0 2.0 1.0 0

Corn (pounds per month) 6 4 2 0

Cloth (yards per month) and and and and

0 2 4 6

and and and and

Cloth (yards per month) 0 1.0 2.0 3.0

Solutions to Additional Problems 1.

a.

b.

Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the yaxis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards.

The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth.

The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn.

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THE ECONOMIC PROBLEM

2.

a.

b.

3.

4.

17

The marginal benefit curve slopes downward. To draw the marginal benefit curve from cloth, plot the quantity of cloth on the x-axis and the willingness to pay for cloth (that is, the number of pounds of corn that Jane is willing to give up to get a yard of cloth) on the y-axis, as illustrated in Figure 2.2.

The efficient quantity is 4 yards a month. The efficient quantity to produce is such that the marginal benefit from the last yard equals the opportunity cost of producing it. The opportunity cost of a yard of cloth is 0.5 pound of corn. The marginal benefit of the fourth yard of cloth is 0.5 pound of corn. And the marginal cost of the fourth yard of cloth is 0.5 pound of corn.

Joe’s Island’s opportunity cost of a pound of corn is 1/2 yard of cloth, and its opportunity cost of a yard of cloth is 2 pounds of corn. When Joe’s Island increases the corn it produces by 2 pounds a month, it produces 1 yard of cloth less. The opportunity cost of 1 pound of corn is 1/2 yard of cloth. Similarly, when Joe’s Island increases the cloth it produces by 1 yard a month, it produces 2 pounds of corn less. The opportunity cost of 1 yard of cloth is 2 pound of corn. a. Jane’s Island sells cloth and buys corn. Jane’s Island sells the good in which it has a comparative advantage and buys the other good from Joe’s Island. Jane’s Island’s opportunity cost of 1 yard of cloth is 1/2 pound of corn, while Joe’s Island’s opportunity cost of 1 yard of cloth is 2 pounds of corn. Jane’s Island’s opportunity cost of cloth is less than Joe’s Island’s, so Jane’s Island has a comparative advantage in producing cloth.

Jane’s Island’s opportunity cost of 1 pound of corn is 2 yards of cloth, while Joe’s Island’s opportunity cost of 1 pound of corn is 1/2 yard of cloth. Joe’s Island’s opportunity cost of corn is less than Jane’s Island’s, so Joe’s Island has a comparative advantage in producing corn. b. With specialization and trade, together they can produce 6 pounds of corn and 6 yards of cloth and each will get 3 pounds of corn and 3 yards of cloth—an additional 1 pound of corn each and an additional 1 yard of cloth each. Hence the total gains from trade are 2 yards of cloth and 2 pounds of corn.

Additional Discussion Questions 1.

Use the PPF model to analyze an “Arms Race” between nations. You might like to get the students to realize how useful even a simple economic model (such as the PPF model) is for helping us understand and interpret important political events in history. Draw a PPF for military goods and civilian goods production (or, simply, the traditional example of “guns versus butter”). Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly “arms race.” Each country picks a point on the PPF that produces an equal level of military output (in absolute terms).

What would happen if the larger country decided to increase military production? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The © 2023 Pearson Education, Inc.

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CHAPTER 2

PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country.

What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post–Viet Nam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. What are the implications for the next 50 years? China is currently the world’s second largest economy. It could become the biggest by mid-century. How does this development influence the strategic balance and the position of the United States?

12. Using the PPF model to analyze global environmental agreements between nations. This application of the PPF is a more “green” perspective that uses the same logic as the “Arms Race” on a timely international policy issue. Compare a rich economy PPF to a poor economy PPF, each with the same degree of concavity. (Production levels are now measured as output per person.) The goods are now “cleaner air” and “other goods and services.”

What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curves. Show how the opportunity cost of requiring additional pollution reduction (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and African nations).

3.

Why do some of the brightest students not get a 4.0 Recreation Marginal cost GPA? The answer—because it doesn’t achieve (hours per day) (GPA points per hour) allocative efficiency—can now be approached. The 0.5 0.1 first conceptual step is to derive the marginal cost 1.5 0.2 curve from the PPF. The table provides eight points 2.5 0.3 on the MC curve. Tell the students that this table is 3.5 0.4 from a PPF between hours spent at recreation and 4.5 0.5 GPA. Use this opportunity to explain why we plot 5.5 0.6 marginal values at the midpoints of changes because 6.5 0.7 the marginal cost at the midpoint approximately equals 7.5 0.8 the average of the opportunity costs across the interval.

The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser.

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THE ECONOMIC PROBLEM

Each additional hour of recreation likely yields a smaller marginal benefit to the student. Translate this to the proposition that the student’s willingness to give up GPA points for additional hours of recreation decreases and provide a table similar to that in Figure 2.3 that captures this observation. The table has a preference schedule. Stress once again that this table did not come from the PPF.

19

Recreation

Willingness to pay

(hours per day)

(GPA points per hour)

0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

To determine the efficient amount of recreation and hence study time, the student must ask “Do I study a little bit longer?” That is the question. Walk the student through the thought experiment: 1. If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if a take a bit of time off studying and have some fun. So I will be better off if study less and take more recreation time.

2. If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time.

3. The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs—where marginal cost equals marginal benefit.

In this example, the student studies for 4.5 hours and takes 3.5 hours a week of recreation time.

Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He or she is just willing to pay what it costs him or her.

4.

Gains from Trade The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do. Here are some questions to drive home the idea of comparative advantage: Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he.

Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So, Billy plays to his comparative advantage.

Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread.

Why doesn’t Vinnie Jones play soccer? Vinnie Jones was one of the world’s best soccer players. But he stopped playing soccer and started making movies some years ago. Why? Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.

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C h a p t e r

3

DEMAND AND SUPPLY

The Big Picture Where we have been: In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market. Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources. If you have time, it is worth forging links between Chapters 2 and 3. Chapter 2 explains why we trade in markets. Chapter 3 shows how trade in markets through the interaction of supply and demand determines where on the PPF the economy operates.

Where we are going: Demand and supply lie at the heart of the principles course. Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make. And in the macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model.

New in the Fourteenth Edition The content of this chapter is largely the same except for the opener, which poses teaser questions about how Covid-19 changed the use of scarce resources, and the Economics in the News sections. The first now looks at why the price of chocolate has risen (an increase in demand), which is a nice contrast to the second, which looks at why the price of vanilla has risen (a decrease in supply). The last Economics in the News section looks at the market for hand sanitizers during the pandemic. The Review Quizzes also feature questions asking about the effects of the Covid-19 pandemic on various markets.

Previous editions used the phrase the “price of productive resources” as a factor that shifts the supply curve. This edition changes to the phrase the “price of factors of production.”

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CHAPTER 3

22

Lecture Notes

Demand and Supply I.

Markets and Prices  In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and consumed.  Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed.  Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price.  The money price of a good or service is the number of dollars that must be given up for it. The ratio of one (money) price to another is called a relative price. A relative price is an opportunity cost. The theory of demand and supply determines relative prices and so when we use the word “price” we mean “relative price.”

To show the importance of relative prices, ask your students if turkey at 40¢ a pound is a good buy. Tell them that is all they know—turkey is 40¢ a pound. Generally most students respond that turkey at this price is cheap and a good buy. Then tell them that steak is 8¢ a pound. Now is turkey such a good buy? Students realize that the relative price of turkey is 5 pounds of steak per pound of turkey and so turkey is actually expensive. These money prices are actual prices from circa 1800. At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Mention the unimportance of the money price and the importance of the relative price.

II. Demand  

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons:  Substitution Effect: When the relative price of good changes, the opportunity cost of the good changes.

An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes.  Income Effect: A change the price of a good changes the amount that a person can afford to buy. When the price rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease. Normally the good whose price rises is one of the goods for which less is purchased.

Demand Curve and Demand Schedule 





The demand for a good Price Quantity refers to the entire (dollars demanded relationship between the (units) per unit) price of the good and the 1 50 quantity demanded of the 2 40 good. The table gives a 3 30 demand schedule.

4 20 A demand curve shows 5 10 the relationship between the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same. The figure illustrates the demand curve resulting from the demand schedule.

The demand curve is a willingness-to-pay curve—for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve. © 2023 Pearson Education, Inc.

DEMAND AND SUPPLY

23

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct.

The classic demand-revealing experiment is one of the most productive and worthwhile ones. Bring to class two bottles of ice-cold, ready-to-drink Mt. Dew, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up. Tell the class that you are going to sell them to the high bidder. Tell them that this auction is real. The winner will get the drink and will pay. Ask for a show of hands of those who have some cash and can afford to buy a drink.

Explain that these indicate an ability to buy but not a definite plan to buy. Now begin the auction. Appoint a student to count hands (more than one for a big class). Begin at a low price: say 10¢ a bottle and count the number willing to buy. Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price. When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt. Dew (or other drink) in your classroom today. You can easily emphasize the law of demand. And, now that you have a demand curve, you can do some thought experiments that will shift it. Ask: How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom?

A Change in Demand (Demand Shifters) 

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Six factors change demand:  Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in conjunction with another good (sugar and coffee).

A rise in the price of a substitute or a fall in the price of a complement increases the demand for the good.  Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases.  Income: A normal good is one for which demand increases as income increases; an inferior good is one for which demand decreases as income increases.  Expected Future Income and Credit: When expected future income increases, demand today increases.

When credit becomes easier to obtain, demand increases.  Population: The larger the (relevant) population, the greater the demand.  Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

A Change in the Quantity Demanded Versus a Change in Demand 



A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand.

In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded. The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

III. Supply 



The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price.

The law of supply states that other things remaining © 2023 Pearson Education, Inc.

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the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So, the price must rise in order to induce firms to increase the quantity they produce.

Supply Curve and Supply Schedule 





Price Quantity The supply of a good (dollars supplied refers to the entire per unit) (units) relationship between the price of the good and the 1 10 quantity supplied of the 2 20 good. The table gives a 3 30 supply schedule.

4 40 A supply curve shows 5 50 the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The figure illustrates the supply curve resulting from the supply schedule.

The supply curve is a minimum-supply-price curve—for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of output which means that a supply curve is a marginal cost curve.

A Change in Supply (Supply Shifters) 

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Six factors change supply:  Prices of Factors of Production: If the price of a factor of production used to produce the good rises, the supply of the good decreases.  Prices of Related Goods Produced: A substitute in production is a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good.  Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases.  Number of Suppliers: If the number of suppliers increases, the supply increases.  Technology: Technology refers to the ways in which factors of production are used to produce a good.

A technological advance increases the supply of a good.  The State of Nature: The state of nature includes all natural forces that influence supply. Bad weather or an earthquake decreases the supply of a good.

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A Change in the Quantity Supplied Versus a Change in Supply 



A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply.

In the top figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

IV. Market Equilibrium  

An equilibrium is a situation in which opposing forces balance.

The equilibrium price is the price at which the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

Price as a Regulator and Price Adjustments  





The price of a good regulates the quantities demanded and supplied.

Shortage: If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price.

Surplus: If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price.

The price continues to adjust until the quantity supplied equals quantity demanded.

To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the intersection of the two curves. “Home Base” provides them a starting place for every story problem they face. Then as you work through examples, be sure to ask them what “shifter” is changing. This procedure will keep them using the economic tool rather than just going with a gut feeling.

The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class activity. Using the experiment is straightforward. Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class.

The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve.

Point out that the trades you made in your little economy made both buyers and sellers better off.

Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow © 2023 Pearson Education, Inc.

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from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

V. Predicting Changes in Price and Quantity The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity.

A Change In Demand    

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases.

If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases.

Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve.

The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40. The supply curve does not shift; there is, however, a movement along the supply curve.

An Economic in the News feature discusses the factors that have led to higher price of chocolate. Because the quantity of chocolate has also increased, the analysis concludes that increases in demand are the factor that has created the higher price of chocolate.

A Change In Supply    

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases.

If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases.

Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the demand curve.

The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is, however, a movement along the demand curve.

An Economic in the News explores the factors that led to a rise in the price of gasoline in Atlanta in September 2016.

The analysis concludes that a decrease in supply from a broken pipeline lies behind the rise in price.

The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five © 2023 Pearson Education, Inc.

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steps. Once you have already worked an example or two, walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question.

2. Think about the event(s) that you are told occur and decide whether they change demand, supply, or both demand and supply.

3. Determine if the events that change demand or supply bring an increase or a decrease.

4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve(s) in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—this view works ok for demand but is exactly wrong for supply. So emphasize the left-right shift.)

5. Find the new equilibrium and compare it with the original one.

It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources.

Demand and Supply Change in the Same Direction 





If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous.  If the increase in demand is greater than the increase in supply, the price rises.  If the increase in demand is the same size as the increase in supply, the price does not change.  If the increase in demand is less than the increase in supply, the price falls.

If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous.  If the decrease in demand is greater than the decrease in supply, the price falls.  If the decrease in demand is the same size as the decrease in supply, the price does not change.  If the decrease in demand is less than the decrease in supply, the price rises.

The figure illustrates an increase in both demand and supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50.

Demand and Supply Change in the Opposite Directions 

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous.  If the increase in demand is greater than the decrease in supply, the quantity increases.  If the increase in demand is the same size as the decrease in supply, the quantity does not change.  If the increase in demand is less than the decrease in supply, the quantity decreases.

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



If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous.  If the decrease in demand is greater than the increase in supply, the quantity decreases.  If the decrease in demand is the same size as the increase in supply, the quantity does not change.  If the decrease in demand is less than the increase in supply, the quantity increases.

The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5.

The Economic in the News explores the market for hand sanitizer during the pandemic. A massive increase in the demand lead to a massive increase in the price and the quantity.

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Additional Problems 1.

2.

3.

What is the effect on the price of hotdogs and the quantity of hotdogs sold if a. The price of a hamburger rises? b. The price of a hotdog bun rises? c. The supply of hotdog sausages increases? d. Consumers’ incomes increase if hot dogs are a normal good? e. The wage rate of a hotdog seller increases? f. If the wage rate of the hotdog seller rises and at the same time prices of ketchup, mustard, and relish fall?

Suppose that one of the following events occurs: (i) The price of wool rises. (ii) The price of sweaters falls. (iii) A close substitute for wool is invented. (iv) A new high-speed loom is invented.

Which of the above events increases or decreases (state which) a. The demand for wool? b. The supply of wool? c. The quantity of wool demanded? d. The quantity of wool supplied?

Figure 3.1 illustrates the market for bread. a. Label the curves in the figure. b. What are the equilibrium price of bread and the equilibrium quantity of bread?

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4.

5.

6.

The demand and supply schedules for potato Quantity Quantity chips are in the table.

Price demanded supplied a. What are the equilibrium price and (cents per bag) (millions of bags a week) equilibrium quantity of potato chips?

40 170 90 b. If chips were 60 cents a bag, describe the 50 160 100 situation in the market for potato chips and 60 150 110 explain what would happen to the price of 70 140 120 a bag of chips.

80 130 130 In problem 4, suppose a new snack food 90 120 140 comes onto the market and as a result the 100 110 150 demand for potato chips decreases by 40 110 100 160 million bags per week. a. Has there been a shift in or a movement along the supply curve of chips? b. Has there been a shift in or a movement along the demand curve for chips? c. What is the new equilibrium price and quantity of chips?

In problem 5, suppose that a flood destroys several potato farms and as a result supply decreases by 20 million bags a week at the same time as the new snack food comes onto the market. What is the new equilibrium price and quantity of chips?

Solutions to Additional Problems 1.

a.

b.

c.

d. e.

f.

2.

a.

The price of a hot dog rises, and the quantity of hot dogs sold increases. Hot dogs and hamburgers are substitutes. If the price of a hamburger rises, people buy more hot dogs and fewer hamburgers. The demand for hot dogs increases. The price of a hot dog rises, and more hot dogs are sold.

The price of a hot dog falls, and fewer hot dogs are sold. Hot dog buns and hot dogs are complements. If the price of a hot dog bun rises, fewer hot dog buns are bought. The demand for hot dogs decreases. The price of a hot dog falls, and people buy fewer hot dogs.

The price of a hot dog falls and more hot dogs are sold. The increase in the supply of hot dog sausages lowers the price of hot dog sausages. Hot dog sausages are a factor used in the production of hot dogs. With the lower priced factor, the supply of hot dogs increases. The price of a hot dog falls and people buy more hot dogs.

The price of a hot dog rises, and the quantity sold increases. An increase in consumers' income increases the demand for hot dogs. As a result, the price of a hot dog rises and the quantity bought increases.

The price of a hot dog rises, and the quantity sold decreases. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs.

The price of a hot dog rises, but the quantity might increase, decrease, or remain the same. Ketchup, mustard, and relish are complements of hot dogs. If the price of ketchup, mustard, and relish fall, more ketchup, mustard, and relish are bought and the demand for hot dogs increases. The price of a hot dog rises, and people buy more hot dogs. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. Taking the two events together, the price of a hot dog rises, but the quantity might increase, decrease, or remain the same. (ii) and (iii) Wool is used in the production of sweaters. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. If a close substitute for wool is invented, some sweater producers will switch from wool to the substitute. When they do, the demand for wool decreases. © 2023 Pearson Education, Inc.

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b. c.

d.

3.

a. b.

4.

a.

b.

5.

a. b. c.

6.

31

(iv) If a new high-speed loom is invented, the cost of making wool will fall and the supply of wool will increase. (i) and (iv) If the price of wool rises there is a movement up along the demand curve. The quantity demanded of wool decreases. If a new high-speed loom is invented, the cost of producing wool will fall. So the supply of wool increases. With no change in the demand for wool, the price of wool will fall and there is a movement down along the demand curve for wool. The quantity demanded of wool increases. (i), (ii), and (iii) If the price of wool rises there is a movement up along the supply curve. The quantity supplied of wool increases. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. With no change in the supply of wool, the price of wool rises and the quantity of wool supplied increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. If some sweater producers switch to using the new close substitute for wool, the demand for wool will decrease. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases.

The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right.

The equilibrium price is $3 a loaf, and the equilibrium quantity is 100 loaves a day. Market equilibrium is determined at the intersection of the demand curve and supply curve.

The equilibrium price is 80 cents a bag, and the equilibrium quantity is 130 million bags a week. The price of a bag adjusts until the quantity demanded equals the quantity supplied. At 80 cents a bag, the quantity demanded is 130 million bags a week and the quantity supplied is 130 million bags a week.

At 60 cents a bag, there will be a shortage of potato chips and the price will rise. At 60 cents a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 110 million bags a week. There is a shortage of 40 million bags a week. The price will rise until market equilibrium is restored—80 cents a bag.

There has been a movement along the supply curve. The demand for potato chips decreases, and the demand curve shifts leftward. Supply does not change, so the price falls along the supply curve.

The demand curve has shifted leftward. As the new snack food comes onto the market, the demand for potato chips decreases. There is a new demand schedule, and the demand curve shifts leftward.

The equilibrium price is 60 cents, and the equilibrium quantity is 110 million bags a week. Demand decreases by 40 million bags a week. That is, the quantity demanded at each price decreases by 40 million bags. The quantity demanded at 80 cents is now 90 million bags, and there is a surplus of potato chips. The price falls to 60 cents a bag, at which the quantity supplied equals the quantity demanded (110 million bags a week).

The new price is 70 cents a bag, and the quantity is 100 million bags a week. The supply of potato chips decreases, and the supply curve shifts leftward. The quantity supplied at each price decreases by 20 million bags. The result of the new snack food entering the market is a price of 60 cents a bag. At this price, there is now a shortage of potato chips. The price of potato chips will rise until the shortage is eliminated.

Additional Discussion Questions 1.

John Q: Could a legal market for human organ donations have saved his dying son? An opinion piece written by Richard Epstein in The Wall Street Journal (2/21/02) discusses the donation of human organs for transplant operations. He raises the issue that if a market for human donor organs were legal, the dilemma of a lack of organs, as raised by Denzel Washington’s character in the movie “John Q,” might be closer to fiction rather than fact. You can use this movie and the motive of the main © 2023 Pearson Education, Inc.

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character as an intriguing basis for getting students to construct and interpret the demand and supply model.

Can we illustrate a market for something as vital as organ donations? Begin by asking the students to graph a demand and supply model for the market for human organ donations, making sure that their model reflects the real-life characteristics of this unique market: i) the federal government does not allow individuals or businesses to engage in the buying and selling of human organs, unless the organs are donated and received for free, ii) a small number of organs are donated by living volunteers (like kidney donations) or by the families of the recently deceased (especially after an otherwise healthy individual suffers an accidental death), meaning that the positively sloped supply curve for human organ donations intercepts the quantity axis at some positive value, iii) the demand curve for organs must intercept the supply curve at a positive price.

Are there unintended consequences when market forces are ignored? The government wants to assure that poor people have the same access to available organ transplants as rich people, so it imposes a zero-price restriction on the market. However, this creates a shortage of organs available for transplant, where the quantity of organs demanded at a zero price far exceeds the quantity supplied.

If the market for organ donations were unregulated, then the equilibrium price for an organ would surely increase, but so would the total number of people receiving an organ transplant, and presumably, the total number of people who would survive to live another day.

Should society institute a policy that maximizes the numbers of lives saved or manipulates the characteristics of those fewer lives that do get saved? Conclude this discussion with a great set-up for the efficiency versus equity issues developed later in chapter five. Our command of the demand and supply model for human organ donations allows us to discover an important insight into one aspect of health care policy: the government places a lower priority for maximizing the total number of people saved regardless of income, and a higher priority on achieving a “proper” income mix among the smaller number of people that are saved by being one of the few receiving organ transplants.

2.

What are some goods that college students might buy today but will give up when they enter the workforce after graduation? College students usually recognize that they will change their consumption patterns when they are employed after college graduation. Use this to get the students to appreciate inferior goods. When you were an undergraduate, you probably complained about having to eat mostly canned soup or beans as a cheap staple to fill your hungry stomach on a small budget. You swore that when you finally entered the workforce you wouldn’t eat soup or beans again, unless under extreme duress. Today the single food item most frequently cited by students as an inferior good is the Raman style noodles—those dry, thin, near flavorless oriental style noodles that are reconstituted with boiling water. Get the students to create a list other such inferior goods they will avoid when their incomes increase. This gets them to carefully consider how income changes can cause demand curves to shift in an unintuitive manner for an inferior good.

3.

Because tablets are cheaper and more abundantly available now than a decade ago, doesn’t this mean the supply curve for tablets is downward sloping? This is a real world example for illustrating the confusion between changes in supply and changes in the quantity supplied. (It is easier to analyze this example if the students assume that consumer demand for software applications has not changed over the last decade.)

Has anything in the world of tablet manufacturing changed over the last decade? Point out that the observation about falling tablet prices with rising quantities sold assumes that nothing significant has changed in the tablet industry. Emphasize how such statements reflect how the ceteris paribus condition of careful economic analysis has been violated. Over the years, advances in technology have allowed tablet makers to: i) offer greater computer power and versatility for contemporary software applications at the same opportunity cost of resources (market price) as before, or ii) to provide the same level of computer power and versatility for contemporary software applications at lower opportunity costs (market prices) as before. Either way, this represents a rightward shift in the supply © 2023 Pearson Education, Inc.

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curve for tablets. The students should recognize that the two prices and two quantities that give the appearance of more tablets offered for less are actually from two separate supply curves.

4.

Because the average price of a car has increased substantially over the last 30 years, and the number of cars owned has risen faster than the population, doesn’t this mean that the demand curve for cars is upward sloping? This is a real world example for illustrating the confusion between changes in demand and changes in the quantity demanded. (It is easier to analyze this example if the students assume that automobile production technology has not changed over these last three decades.)

Has anything in the world of consumers changed over the last decade? Point out that this real world observation of car prices and rising quantities sold over time assumes that nothing significant has changed in the consumers’ environment. Emphasize how statements such as these reflect how the ceteris paribus condition of careful economic analysis has been violated. Consumer incomes have increased significantly over the last three decades, allowing them to: i) consume greater personal transportation opportunities for more family members while giving up the same amount of other goods as before, or ii) consume the same level of personal transportation opportunities while giving up less of all other goods as before. Either way, this represents a rightward shift in the demand curve for automobiles. The students should recognize that the two prices and quantities that give the appearance of more automobiles demanded at higher prices are actually from two separate demand curves.

If the status of the family automobile has increased in recent decades, what affect would this have on consumer demand? There is evidence that the proportion of income that typical families spend on automobiles (versus all other goods) has increased substantially over the last 30 years. This means that the percent increase in automobile purchases has been higher than the percent increase in family incomes. This makes for a great lead into the measures of the income elasticity of demand discussed in Chapter 4.

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ELASTICITY

The Big Picture Where we have been: The student can now use the demand and supply model to generate predictions and can supplement this knowledge with the ability to provide richer predictions based on the elasticities of demand and supply.

Where we are going: Demand, supply, and demand elasticity get an extensive workout in Chapter 6, where we use them to explain the division of a tax burden between buyer and seller and the impact of price controls and quotas. However, before doing that analysis, we study the efficiency and fairness of markets in Chapter 5. Students will also apply elasticity in Chapter 12 to describe demand in perfect competition. In Chapter 13, we study the relationship between total revenue and the price elasticity of demand to show that a monopoly never operates on the inelastic part of the demand curve.

New in the Fourteenth Edition There are only a few minor changes to this chapter. The chapter opening example and the Economics in the News case study focus on using elasticity to determine quantitative effects—how much the price or quantity change—due to changes caused by the Covid-19 pandemic.

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Lecture Notes

Elasticity  

The price elasticity of demand measures how strongly buyers respond to a change in the price of a good.

The price elasticity of demand can be used to make quantitative predictions of how changes affect the price and quantity demanded of a good.  The income elasticity of demand measures how strongly demanders respond to a change in income, and the cross elasticity of demand measures how strongly demanders respond to the change in the price of another good.  The price elasticity of supply measures how strongly producers respond to a change in the price of a good.

I. Price Elasticity of Demand  In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments because it can predict the impact of a price change on total revenue or total expenditure.

Calculating Price Elasticity of Demand  The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:

The formulas for calculating all of the elasticities in the text are based on the arc elasticity or mid-point formula, meaning the percentage changes are always calculated based on the average price (or income in the case of income elasticity) and average quantity over the range of change. If you ask students to calculate elasticities, it is important to practice calculating the percentage change using the average as the basis as it is not likely to be familiar Don’t be afraid to start with this pre-elasticity warm up to assess the sharpness of your class. Ask: “Suppose that the campus bookstore increases the price of an economics text from $75 to $100. What is the percentage increase in price?” Many will say 25 percent. But using the midpoint formula the percentage change is ($25/$87.50) × 100, which is 28.6 percent.

Devise a mnemonic for elasticity calculations. Many students have a hard time remembering whether quantity or price goes in the numerator of the elasticity formulas. Have the students create their own mnemonic. Suggest McDonald’s Quarter Pounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentage changes. 



The demand elasticity formula yields a negative value because price and quantity move in opposite directions. However, it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. So, we use the magnitude or the absolute value of the price elasticity of demand.

The table to the right has two points on the demand Price Quantity demanded curve for pizza from a particular pizza parlor. (dollars per pizza) (pizzas per week)  The absolute value of the percent change in 14 500 quantity demanded is [(500  400)  450]  100 = 16 400 22.2 percent.  The absolute value of the percentage change in price is [($14  $16)  $15]  100 = 13.3 percent.  Between these two points on the demand curve, the price elasticity of demand is 22.2%  13.3% = 1.67.

Elasticity is not the same as slope. Students sometimes wonder why we don’t just measure the slope of the demand curve to measure responsiveness. Point out to the students that the slope will change when the units change. For instance, you can compute the slope of a demand curve when the price is measured in dollars and then the slope of the exact same demand curve when the price is measured in cents. The slope with the price measured in cents is 100 © 2023 Pearson Education.

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times as large as the initial slope. Tell the students that it is not acceptable for the measure of responsiveness to change whenever the units of the price (or of the quantity) change.

Inelastic and Elastic Demand  If the price elasticity of demand is less than 1.0, the good is said to have an inelastic demand. In this case, the percentage change in the quantity demanded is less than the percentage change in price.  If the quantity demanded remains constant when the price changes, then the good is said to have perfectly inelastic demand. The price elasticity of demand is 0 and the good’s demand curve is a vertical line.  If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic demand. In this case, the percentage change in the quantity demanded equals the percentage change in price.  If the price elasticity of demand is greater than 1.0, the good is said to have an elastic demand. In this case, the percentage change in the quantity demanded exceeds the percentage change in price.  If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the good is said to have perfectly elastic demand.

Furniture 1.26 The price elasticity of demand is infinite.

Motor Vehicles 1.14  The table has some “real-life” elasticities from the book.

Clothing 0.64 Oil 0.05 Economics in Action” Elastic and Inelastic Demand This application shows real-world price elasticities of demand for a variety of goods and services as well as a table with various food elasticities. This data can be a base for discussion of the factors that might lead one item to be more elastic than the other and allow students in real-time to try to explain and apply price elasticity of demand.

Economics in the News: The Elasticity of Demand for Peanut Butter The price elasticity of demand for peanut butter is the basis for this application. Further discussion of other demand elasticities for peanut butter will be explored after those elasticities are introduced.

Elasticity Along a Linear Demand Curve  With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price elasticity of demand changes when moving along a linear demand curve.  As the figure illustrates, at points on the demand curve above the midpoint, the price elasticity of demand is elastic while at points below the midpoint, the price elasticity of demand is inelastic. At the midpoint, the price elasticity of demand is unit elastic.

Total Revenue and Elasticity  The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold.

If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases.

If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change.

If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.  The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price when all other influences on the quantity sold remain the same.  If a price cut increases total revenue, demand is elastic. And if a price hike decreases total revenue, demand is elastic. © 2023 Pearson Education, Inc.

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

If a price cut does not change total revenue, demand is unit elastic. And if a price hike does not change total revenue, demand is unit elastic.  If a price cut decreases total revenue, demand is inelastic. And if a price hike increases total revenue, demand is inelastic.  Similarly, when a price changes, a consumer’s change in expenditure depends on the consumer’s elasticity of demand.  If demand is elastic, then a price cut means that expenditure on the item increases.  If demand is inelastic, then a price cut means that expenditure on the item decreases.

If demand is unit elastic, then a price cut means that expenditure on the item does not change.

How do changes in revenue relate to elasticity mathematically? When demand is elastic, the absolute value of the ratio of the percentage change in quantity demanded to percentage change in price must be greater than one. This point implies that the numerator of the formula for the price elasticity of demand must be greater than the denominator. In that case, the percentage change in quantity demanded is stronger than the percentage change in price, so revenues will change in the same direction as the quantity demanded. On the other hand, if demand is inelastic, the denominator of the formula for the price elasticity of demand must be greater than the numerator. In that case, changes in revenue will change in the same direction as the price because the percentage change in price is stronger than the percentage change in quantity. Reviewing these results also helps students understand the logic for why 1 is the significant value for the coefficient and that the elasticity being farther away from 1 means the reaction is stronger, whether elastic or inelastic.

The Factors that Influence the Elasticity of Demand The magnitude of the price elasticity of demand depends on:  The closeness of substitutes: The closer and more numerous the substitutes for a good or service, the more elastic the demand. This is critical for understanding demand in the market structure section later in the book.  The proportion of income spent on the good: The greater the proportion of income spent on a good or service, the more elastic the demand.  The amount of time elapsed since the price change: The longer the time elapsed since the price change, the more elastic the demand.

Price elasticity of needs versus wants: Necessities, such as food or housing, generally have inelastic demand because there are few substitutes for food and shelter. Luxuries, such as exotic vacations, generally have elastic demand.

Example: Most people’s demand for salt is inelastic, largely because most people spend a miniscule amount of their income on salt. However large Northern cities’ demand for salt is significantly more elastic. These cities use salt to treat their roads after a snow storm. Salt is a significant fraction of their budgets. Because the proportion of their income they spend on salt is large, the price elasticity of demand for these cities is much larger than that of “ordinary” consumers.

How do gasoline purchases respond to changes in price over time? When gas prices rise from $2 to $4, consumers initially have few options available. At first, with a given car with a given gas mileage, higher gas prices do not reduce the quantity of gas consumers purchase by very much. As time passes and gasoline prices continue to remain high, some consumers eventually find ways to adjust their gas purchases by purchasing more fuel efficient cars, taking new jobs that are closer to their homes, or by taking fewer road trips or car pooling.

II. More Elasticities of Demand Income Elasticity of Demand  The income elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the income, other things remaining the same.  The income elasticity of demand is equal to:

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The changes in the quantity demanded and income are percentages of the average income and quantity demanded over the range of change.

The income elasticity of demand is positive for normal goods and negative for inferior goods.  If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good. As income increases, the percentage of income spent on income elastic goods increases.  If the income elasticity of demand is positive but less than 1, demand is income inelastic and the good is a normal good. As income increases, the percentage of income spent on income inelastic goods decreases.  If the income elasticity of demand is negative the good is an Airline Travel 5.82 inferior good.

Restaurant Meals 1.61 The table has some “real-life” income elasticities from the book.

Clothing 0.51 Food 0.14

One of the more common applications for income elasticity of demand that students tend to find interesting is in the stock market. Terms like cyclical, staples, and discretionary sectors are easily explained using income elasticity concepts. Students could consider questions about where in the business cycle a company’s profit might be strongest or weakest and thus more or less worthy of financial investment.

Economies in Action: The Economics in Action shows actual estimates of income and cross price elasticities. Grocery stores and retail stores are a great example of how store scanned data could be used to understand the relationships between products. If a store can put a low margin product on sale and sell more of a high margin product, that is a great use of cross price elasticity data.

Cross Elasticity of Demand  The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same.  The cross elasticity of demand is equal to:



The changes in the quantity demanded and the price are percentages of the average price and quantity demanded over the range of change.

The cross elasticity of demand is positive for substitutes and negative for complements.

Examples: Use examples to show the students why the cross elasticity of demand is positive for substitutes and negative for complements. For instance, suppose the price of Coke rises. What effect does this price hike have on the demand for Pepsi? Students will immediately realize that the demand for Pepsi increases. So in this case the cross elasticity of demand for Pepsi with respect to the price of Coke is calculated by dividing one positive number by another, so the result will be positive. (You may need to show the result of a decrease in the price of Cock as well: If the price of Coke falls, the demand for Pepsi will fall, and the cross elasticity of demand for Pepsi with respect to Coke is calculated by dividing a negative percentage change by a negative percentage change, again resulting in a positive number.) Use specific percentage changes to calculate cross price elasticities to emphasize that the sign of the coefficient matters as well as its size. A cross elasticity of 1.5 or .3 are both substitutes but not to the same degree. A cross elasticity of 0.6 or 2.5 are both complements, but again not equally impactful. Explore how knowing cross elasticities might help store managers plan “loss leaders” or how to merchandise products each week.

Some instructors will be more focused on the calculation of the elasticities while others may be more focused on interpreting the elasticity coefficients. For those focused on interpretation, tables with elasticity coefficients could be provided and questions could be framed in terms of the business cycle and how it would change sales of various products at various stores. One store that caters to higher income customers and one store that has bargain basement prices will have different amounts of shelf space devoted to different products. More data would be needed for © 2023 Pearson Education, Inc.

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calculating the elasticities, but students could then create the table and answer the interpretive questions as an class or take home application.

III. Elasticity of Supply  The elasticity of supply measures how responsive producers are to a change in the price of the good.  The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain unchanged. 

The elasticity of supply is equal to:

Three Cases of Elasticity of Supply  Supply is perfectly inelastic if the elasticity of supply equals 0. In this case, the supply curve is vertical.  Supply is unit elastic if the elasticity of supply equals 1. In this case, the supply curve is linear and passes through the origin. If any supply curve is linear and passes through the origin, the supply is unit elastic; the slope of the supply curve is irrelevant.  Supply is perfectly elastic if the elasticity of supply is infinite. In this case, the supply curve is horizontal.

Again, elasticity is not the same as slope. The unit-elastic supply curve is a good one to use to emphasize that elasticity and slope are not equal. Have the students calculate the elasticity of supply on two linear demand curves that pass through the origin, one with a slope of 0.5 and the other with a slope of 2. Regardless of the difference in slope, supply elasticity will be equal to 1.

The table to the right has two points on the supply curve for pizza Price Quantity supplied from a particular pizza parlor. (dollars per pizza) (pizzas per week)  The percentage change in the quantity supplied is 14 300 16 400 [(400  300)  350]  100 = 28.6 percent.  The percentage change in price is [($16  $14)  $15]  100 = 13.3 percent.  Between these two points, the elasticity of supply is 28.6%  13.3% = 2.15.  Supply is elastic if the elasticity of supply exceeds 1.0, unit elastic if the elasticity of supply equals 1.0, and inelastic if the elasticity of supply is less than 1.0.

The Factors that Influence the Elasticity of Supply  Resource substitution possibilities: The more unique or rare the resources used to produce the good, the smaller the elasticity of supply. The more common the resources used to produce the good, the larger the elasticity of supply.  The time frame for substitution possibilities: The longer the amount of time producers have to adjust to a change in price, the more elastic the supply will be.  Momentary supply refers to the period of time immediately following a price change. For some goods, the momentary supply can be perfectly inelastic—fresh fish the day of a price hike. For other goods, the momentary supply can be quite elastic—when the number of telephone calls increases on a holiday, the supply increases with no change in price.  Short-run supply shows how the quantity supplied responds to a price change when only some of the technological adjustments have been made.  Long-run supply shows how the quantity supplied responds to a price change when all of the technological adjustments have been made.

Economics in the News: The Elasticity of Supply of Face Masks Face Mask Production and Prices in the COVID-19 Pandemic This feature connects to the chapter opening questions about the price elasticity of supply of face masks. It discusses the short-run increase in the price of face masks due to the pandemic. It also mentions the long-run elasticity of supply and points how and why it will be significantly larger than the short-run elasticity.

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Additional Problems 1.

2.

Better-than-average weather brings a bumper tomato crop. The price of tomatoes falls from $6 to $4 a basket, and the quantity demanded increases from 200 to 400 baskets a day. Over this price range, a. What is the price elasticity of demand? b. Describe the demand for tomatoes.

The figure shows the demand for pens. a. Calculate the elasticity of demand for a rise in price from $2 to $4. b. At what prices is the elasticity of demand equal to 1, greater than 1, and less than 1?

3.

4.

If the quantity of fish demanded decreases by 5 percent when the price of fish rises by 10 percent, is the demand for fish elastic, inelastic, or unit elastic?

The table gives the demand schedule for coffee.

Price Quantity demanded What happens to total revenue if the price of coffee (dollars per (millions of pounds per rises from $10 to $20 per pound? pound) year) b. What happens to total revenue if the price rises to $15 to $25 per pound?

10 30 c. What is the price when total revenue at a maximum?

15 25 20 20 d. What quantity of coffee will be sold at the price that 25 15 answers part c? e. At an average price of $15 a pound, is the demand for coffee elastic or inelastic? Use the total revenue test to answer this question. a.

5.

If a 10 percent fall in the price of beef increases the quantity of beef demanded by 20 percent and decreases the quantity of chicken demanded by 15 percent, calculate the cross elasticity of demand between beef and chicken.

6.

Judy’s income has increased from $10,000 to $12,000. Judy increased her demand for concert tickets by 10 percent and decreased her demand for bus rides by 5 percent. Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

The table gives the income elasticities of demand for Product Income elasticity various products. Use it to answer the following questions Haircuts 1.36 a. Which product’s demand reacts the most when income Ramen noodles −0.76 changes?

Tobacco 0.86 b. Which product’s demand increases during a recession Airline travel 5.82 when incomes fall?

7.

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8.

The table gives the supply schedule for shoes.

Calculate the elasticity of supply when a. The price rises from $125 to $135 a pair. b. The price is $125 a pair.

Price (dollars per pair)

Quantity supplied (millions of pairs per year)

120 125 130 135

1,200 1,400 1,600 1,800

Solutions to Additional Problems 1.

a.

b.

2.

3.

4.

The price elasticity of demand is 1.67. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price falls from $6 to $4 a basket, a fall of $2 a basket. The average price is $5 a basket. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity increases from 200 to 400 baskets, an increase of 200 baskets. The average quantity is 300 baskets. So the percentage change in quantity equals 200 divided by 300 and then multiplied by 100, which equals 66.7 percent. The price elasticity of demand for tomatoes equals 66.7 percent divided by 40 percent, which is 1.67.

The price elasticity of demand exceeds 1, so the demand for tomatoes is elastic.

a.

The price elasticity of demand is 0.33. When the price of a pen rises from $2 to $4, the quantity demanded of pens decreases from 100 to 80 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $2 to $4, an increase of $2 a pen. The average price is $3 a pen. So the percentage change in the price equals $2 divided by $3 and then multiplied by 100, which equals 66.7 percent. The quantity decreases from 100 to 80 pens, a decrease of 20 pens. The average quantity is 90 pens. So the percentage change in quantity equals 20 divided by 90 and then multiplied by 100, which equals 22 percent. The price elasticity of demand for pens equals 22 percent divided by 66.7 percent, which is 0.33. b. The price elasticity of demand equals 1 at $6 a pen. The price elasticity of demand is greater than 1 at prices greater than $6 a pen. The price elasticity of demand is less than 1 at prices less than $6 a pen. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve hits the y-axis. That price is $6 a pen. The demand curve is linear. Along a linear demand curve, the price elasticity of demand is greater than 1 at points above the midpoint and less than 1 at points below the midpoint. The price elasticity of demand is greater than 1 at prices above $6 a pen and less than 1 at prices below $6 a pen.

The demand for fish is inelastic. The price elasticity of demand for fish equals the percentage change in the quantity of fish demanded divided by the percentage change in the price of fish. The price elasticity of demand equals 5 percent divided by 10 percent, which is 0.5. The demand is inelastic. a.

b.

c.

Total revenue increases. When the price of a pound of coffee is $10, 30 million pounds are sold and total revenue equals $300 million. When the price of a pound of coffee rises to $20, 20 million pounds are sold and total revenue is $400 million. Total revenue increases.

Total revenue does not change. When the price of a pound of coffee is $15, 25 million pounds are sold and total revenue is $375 million. When the price of a pound of coffee is $25, 15 million pounds are sold and total revenue is $375 million. Total revenue does not change.

Total revenue is maximized at $20 a pound. When the price of a pound of coffee is $20, 20 million pounds are sold and total revenue equals $400 million. When the price is $15 a pound, 25 million pounds are sold and total revenue equals $375 million. Total revenue increases as the price rises from $15 to $20 a pound.

When the price is $25 a pound, 15 million pounds are sold and total revenue equals $375 million. Total © 2023 Pearson Education.

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revenue decreases as the price rises from $20 to $25 a pound. Total revenue is maximized when the price is $20 a pound. d. The quantity will be 20 million pounds a year. The demand schedule tells us that when the price is $20 a pound, the quantity of coffee demanded is 20 million pounds a year. e. The demand for coffee inelastic. The total revenue test says that if the price rises and total revenue increases, the demand is inelastic at the average price. For an average price of $15 a pound, raise the price from $10 to $20 a pound. When the price of a pound rises from $10 to $20, total revenue increases from $300 million to $400 million. So at the average price of $15 a pound, demand is inelastic.

The cross elasticity of demand between beef and chicken is 2. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good.

The fall in the price of beef resulted in a decrease in the quantity demanded of chicken. So the cross elasticity of demand is the percentage change in the quantity demanded of chicken divided by the percentage change in the price of beef. The cross elasticity equals 20 percent divided by 10 percent, which is 2.

Income elasticity of demand for (a) concert tickets is 0.55 and (b) bus rides is 0.275. Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income.

The change in income is $2,000 and the average income is $11,000, so the percentage change in income equals 18.2 percent. a. The change in the quantity demanded of concert tickets is 10 percent. The income elasticity of demand for concert tickets equals 10/18.2, which is 0.55. b. The change in the quantity demanded of bus rides is 5 percent. The income elasticity of demand for bus rides equals 5/18.2, which is 0.275. a. The income elasticity of demand for airline travel is the largest in magnitude, so the demand for airline travel changes the most when income changes. b. The income elasticity of demand for Ramen noodles is negative, so its demand will increase when income falls in a recession. a. The elasticity of supply is 3.25. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. When the price rises from $125 to $135, the change in the price is $10 and the average price is $130. The percentage change in the price is 7.7 percent. When the price rises from $125 to $135, the quantity supplied increases from 1,400 million to 1,800 million pairs. The change in the quantity supplied is 400 million pairs, and the average quantity is 1,600 million pairs, so the percentage change in the quantity supplied is 25 percent. The elasticity of supply equals (25 percent)/(7.7 percent), which equals 3.25. b. The elasticity of supply is 3.57. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity of supply at $125, change the price such that $125 is the average price—for example, a fall in the price from $130 to $120. When the price falls from $130 to $120, the change in the price is $10 and the average price is $125. The percentage change in the price is 8 percent. When the price falls from $130 to $120, the quantity supplied decreases from 1,600 million to 1,200 million pairs. The change in the quantity supplied is 400 million pairs and the average quantity is 1,400 million pairs. The percentage change in the quantity supplied is 28.57 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 3.57.

Additional Discussion Questions 1.

How does inelastic student demand for parking hinder police efforts at preventing illegal student parking? Illegal student parking is a hassle that every university police force must deal with. Ask the students whether the campus police will have more success with doubling the current parking fine, or liberally using the “boot,” which is a heavy iron clamp locked to the wheel of a car, rendering it immobile. Students will understand that raising the parking ticket fees is simply raising the price for © 2023 Pearson Education, Inc.

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3.

4.

5.

6.

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illegal parking, and if quantity demanded does not decrease very much, demand for those choice parking spots is inelastic. To significantly decrease the incidence of illegal parking, the price must be raised substantially. Having their personal transportation severely restricted with a boot for a period of time is a much higher “price” with a more effective result.

How inelastic is the demand for gasoline and how inelastic is the supply? How might this explain sharp price fluctuations in the market for gasoline? Students recognize that there are few good substitutes for gasoline. Ask them if they think the demand for gas is relatively elastic or inelastic.

They’ll likely say that demand for gasoline is relatively inelastic. Point out that although there are some substitutes for gasoline (riding the bus, riding a bicycle, or walking), those options are not necessarily easy to substitute for driving a gas-powered vehicle. Discuss whether firms have the ability to bring more gas to the market in a short run time frame. If quantity does not adjust much when demand or supply change, price is likely to fluctuate greatly.

If the demand for gasoline is relatively inelastic, why does Joe’s Quick-Mart lose a lot of business when he raises his gas prices? Ask your students if Joe’s Quick-Mart (substitute your actual local one) convenience store would lose much business if Joe raised the price of gasoline more than a penny or two compared to the other three gas stations at the same street intersection. When the students conclude he’d lose much of his gasoline sales, point out that this would imply that the demand for gas at Joe’s is relatively elastic, not inelastic. (If an increase in price results in a decrease in revenues, demand is elastic.) Ask them to reconcile the two results. How can demand for gasoline be inelastic when demand for gasoline at Joe’s is elastic? Their response should be that because other stations offer gasoline that is a good substitute for gasoline at Joe’s, demand for gasoline at Joe’s will be more elastic than the demand for gasoline overall. If all gas stations at the intersection raised their prices by a penny or two, the reduction in quantity demanded would be much smaller.

How can knowing price elasticities of demand help student government and university officials set prices for campus events? Paying for programs in an increasingly tighter budget era makes pricing decisions even more critical. Lower prices bring in more revenue if demand is elastic. Higher prices bring in more revenue if demand is inelastic.

How can the owner of The Burger Barn determine if a one-day promotional sale on milkshakes will affect the total revenues generated by hamburger sales? This question will exercise student knowledge of cross elasticities. First, the students need to assume that the price of burgers remains unchanged.

Next, the students need to determine whether the cross elasticity is positive (substitutes) or negative (complements). If burgers and milkshakes are substitutes, then burger revenues will decrease during the sale. However, if burgers and milkshakes are complements, then burger revenues will increase.

Is the demand for higher education income elastic, income inelastic or inferior? Enrollments in many institutes of higher education rose during the economic downturn, although demand for community college education may have increased the most dramatically and some institutions did see declines in enrollment. Ask students to discuss how income changes have and could affect enrollment choices and demands for financial aid programs and products.

How does price elasticity of supply explain shortages of vaccinations for Covid-19 in 2021? What does it suggest about the availability in subsequent years? The difficulty involved and changes in resources needed to launch a new vaccine meant the elasticity of supply was small so there were priority lists and lack of availability in many places when Covid-19 vaccines were first deployed. In subsequent years the elasticity of supply will increase, and Covid-19 vaccines worldwide will be more widely available.

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EFFICIENCY AND EQUITY

The Big Picture Where we have been: This chapter develops a more thorough understanding of efficiency, which was first introduced in Chapter 2. It also develops a deeper grasp of how the demand and supply model introduced in Chapter 3 influences resource allocations in an economy. Finally, it explains the situations in which a competitive market does and does not allocate resources efficiently.

Where we are going: Chapter 6 applies the concepts of efficiency and deadweight loss to market regulation policies such as rent ceilings and minimum wage laws. Students should understand these concepts well to appreciate applying demand and supply to important markets in our economic world. Chapter 7 then applies the same concepts to issues surrounding international trade and government protectionist policies.

The concepts of efficiency and deadweight loss recur in Chapters 12, 13, and 14, which examine perfect competition, monopoly, monopolistic competition, and regulation. The same efficiency concepts are also used in Chapters 16 and 17, which cover social issues such as public goods and externalities.

New in the Fourteenth Edition The chapter opener still examines traffic and driving choices, but the articles used for the Economics in the News application at the end of the chapter have been updated and have more data about the costs of congestion. The analysis still focuses on using congestion charges to improve efficiency.

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Lecture Notes

Efficiency and Equity 

  I.

Using prices in markets to allocate scarce resources is one of many alternative methods of allocating scarce resources.

Tools such as consumer surplus and producer surplus help evaluate efficiency.

The outcomes from the various methods used to allocate scarce resources, especially markets, can be examined in terms of both their efficiency and fairness.

Resource Allocation Methods

Resources are scarce, so they somehow must be allocated. Different methods of allocating resources include:  Market price: The people who are willing and able to buy a resource get the resource.  Command: a command system allocates resources by the order (command) of someone in authority. A command system works well in organizations with clear lines of authority but does not work well at allocating resources in the entire economy.  Majority rule: resources are allocated in accordance with majority vote. Majority rule works well when the allocation decisions being made affect a large number of people and self-interest leads to bad decisions.  Contest: resources are allocated to the winner. Contests work well when the efforts of the players are hard to measure, such as top managers being in a contest to be named CEO of a company.  First-come, first-serve: resources are allocated to those who are first in line. This allocation method works well when the resource can serve just one user at a time in a sequence, as is the case with, say, a bank teller or an ATM.  Lottery: resources are allocated to the people who pick the winning number, choose the lucky card, etc.

Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.  Personal characteristics: resources are allocated to people with the “right” characteristics.  Force: resources are allocated to those who can forcibly take the resources.

Is allocating goods to those willing and able to pay higher prices fundamentally unfair? Students often believe that allocating resources using market prices is somehow unfair. The first section of this chapter, which discusses different ways of allocating resources, and the discussion in the last section of the chapter about the fairness of these different methods in a situation with a shortage, will help open students’ eyes to the fact that somehow resources must be allocated and using the market price has many desirable characteristics that are perhaps often overlooked. In particular, using market prices to allocate goods and services means that goods and services are sold to people who can afford them and want to buy them. Students often focus on the first part—“afford”—and ignore the second part— “want to buy.” Clearly wealthy people can better afford to buy goods and services. But this does not mean that the wealthy buy everything. For instance, it is likely the case that your cell phone is less advanced in features and service plans than cell phones owned by your students. You perhaps can better afford these phones than your students, but you simply may not want the newest, most wired smart device as much as they do. So using market prices means that people who most strongly want the newest and greatest smart phone will acquire it … at least as long as they can afford it. Other resource allocation methods generally do not take account of how strongly someone wants a good or service. As a result, other methods of allocation can allocate goods and services to people who may not value them the most.

II. Benefit, Cost, and Surplus Demand, Willingness to Pay, and Value  The value of one more unit of a good or service is its marginal benefit. Marginal benefit is the maximum price that people are willing to pay for another unit of a good or service. And the willingness to pay for a good or service determines the demand for it. Consequently, the demand curve for a good or service is also its marginal benefit curve.

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The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

How do you add “horizontally”? Students sometimes have trouble with the concept of adding individual demand curves “horizontally.” Emphasize that the quantity demanded is measured on the “horizontal” axis, so we’re simply adding together all the individual quantities demanded to get the market quantity demanded at a particular price. 





The demand curve in the figure shows that the maximum price a person is willing to pay for the 6 millionth gallon of milk per month is $3, so $3 is the marginal benefit of this gallon.

MSB curve: In the absence of externalities, which will be discussed later, the market demand curve is also the economy’s marginal social benefit (MSB) curve. It reflects the number of dollars’ worth of other goods and services willingly given up to obtain one more unit of a good.  The figure shows that the maximum price a consumer is willing and able to pay for the 6 millionth gallon of milk is $3, so the marginal social benefit of the 6 millionth gallon of milk is $3.

Consumer surplus is the value (or marginal benefit) of the good minus the price paid for it, summed over the quantity bought. The figure illustrates the consumer surplus as the shaded triangle when the price is $3 per gallon.

The negative slope of demand and declining marginal benefit. Marginal benefit is the maximum price people are willing to pay for one more unit of a good or service. Because willingness to pay determines demand, a demand curve is a marginal benefit curve. Demand curves have a negative slope because, as the price rises, the quantity demanded falls. The negative slope of the demand curve can also be explained by the concept of declining marginal benefit. The more you already have of a good, the less valuable an additional unit of that good is to you. In other words, the maximum price you are willing to pay for another unit of that good (its marginal benefit) declines as the quantity you have increases.

Consumer surplus graphically is the area under the demand curve and above the price. One thing that students sometimes get hung up on is the exact shape of the consumer surplus area, in particular the steps of consumer surplus for discrete units versus the complete triangle. The point isn’t worth laboring, but if students raise the matter and are curious, you might explain that we’re assuming that the good is finely divisible so that the whole triangle is (approximately) the consumer surplus.

Low prices are great for consumers. Students know that low prices are better for consumers than high prices. But consumer surplus gives them a way to demonstrate this basic idea. Take a minute to evaluate the change in consumer surplus from a given change in price. The big impact is not the marginal increase in the number of units purchased, but the increase or decrease in consumer surplus of the units that are still being purchased regardless of the change in price. The area of consumer surplus will become smaller when prices rise and larger when prices fall. This quantifies graphically something students intrinsically know: from the point of view of consumers, low prices are good and high prices are bad. The best example for most people is their strong irritation when gas prices rise and their perception of well being when gas prices fall. Even if they do not change the amount of gas they buy at all, they perceive the change in their consumer surplus.

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Supply, Cost, and Minimum Supply-Price  The cost of producing one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service. And the minimum acceptable price determines the quantity supplied. Consequently, the supply curve for a good or service is also its marginal cost curve.

The positive slope of supply and increasing marginal cost. The fact that supply curves have a positive slope implies that the marginal cost of production increases as the level of production expands. You can refer back to increasing opportunity costs to reinforce this idea for your students. As producers increase production, they will need to increase the amount of resources they use. Initially, firms use the cheapest resources possible (labor that has comparative advantage in producing the good, for example). As output expands, however, additional resources will become increasingly costly (as labor that does not have a comparative advantage in production is used in the production process). If resource costs are rising as the quantity of output supplied increases, the minimum price producers must receive to induce them to produce more will also increase.  



The market supply curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price.

MSC curve: In the absence of externalities, the market supply curve is the economy’s marginal social cost (MSC) curve.  The supply curve in the figure shows that the minimum price a producer must receive to be willing to produce the 6 millionth gallon of milk per month is $3, so $3 is the marginal social cost of this gallon.

Producer surplus is the price of a good minus its minimum supply-price (or marginal cost), summed over the quantity sold. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.

Producer surplus graphically is the area above the supply curve and below the price line. Every unit that adds more to revenue than it does to cost adds to producer surplus. Point out how increases in price expand producer surplus and how decreases in price reduce it. From producers’ point of view, high prices are better, something that often confuses students who are used to thinking of price as cost not as revenue. This is a good moment to reinforce that difference.

Is producer surplus the same as profit? At this point in the course, students don’t have all the tools necessary to understand the difference so it is perhaps best to simply say they aren’t exactly the same, and that firms will sometimes find it in their best interests to produce for a time even if they are losing money. Promise to explore profit and profit-maximization more in future chapters. If students are persistent you can explain that producer surplus equals total revenue minus total variable cost, while economic profit equals total revenue minus total cost. That means producer surplus isn’t exactly economic profit. Rather, producer surplus equals economic profit plus total fixed cost. Don’t spend much time discussing this point now, but be ready for it if you get such a question when you’re in Chapters 12, 13, or 14.

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III. Is the Competitive Market Efficient?

Efficiency of Competitive Equilibrium  The marginal benefit to the entire society is the marginal social benefit curve, MSB. If all the benefits from consuming a good go to its consumers, the market demand curve is the same as the MSB curve.  The marginal cost to the entire society is the marginal social cost curve, MSC. If all the costs of producing a good are paid by the producers, the market supply curve is the same as the MSC curve.  When the marginal social benefit of the last unit produced equals its marginal social cost, society attains efficiency. However, because the demand curve is the same as the MSB curve and the supply curve is the same as the MSC curve, the efficient quantity that sets the MSB equal to the MSC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The figure illustrates how the efficient quantity of milk, 6 million gallons per month, also is the equilibrium quantity of milk.  When the efficient quantity of milk is produced, the sum of the consumer surplus and producer surplus (total surplus) is maximized.

It helps to summarize all the results of efficiency at this point, as follows:  By definition, efficiency requires that resources are being used where they are most highly valued.  When resources are used where they are most highly valued, MSB = MSC.  When the demand and supply curves intersect, QD = QS, and the market achieves equilibrium.  At equilibrium the total surplus in the market is maximized. (This is usually the most difficult concept to prove without use of calculus in principles courses. Be sure to emphasize to your students that the following sections and chapters will show exactly what happens to consumer and producer surplus when the market moves away from equilibrium.)  Buyers and sellers acting in their own self-interest maximize social well-being.  Adam Smith, in his 1776 book The Wealth of Nations, articulated how competition led self-interested consumers and producers to make choices that unintentionally promote the social interest as if they were led by an “invisible hand.

Economics in Action: Selling the Invisible Hand This case discusses how the Invisible hand of the market allocates resources to their highest valued use first with a cartoon and then in a real-life case of pizza delivery.

The Invisible Hand at work: When demand or supply shifts in a market, equilibrium changes to a new point where the MSB = MSC, as reflected in the new demand or supply curve. Show students how an increase in demand, for example, increases the MSB of every unit of output and results in a new, higher level of output that achieves efficiency. A decrease in supply raises the MSC of every unit, and with fewer units available, the MSB of those units is greater. The resulting decrease in output from the change in supply achieves efficiency.

For students who want more information: Although done simply with words and a graph, this section explains the socalled “first fundamental theorem of welfare economics” that, under appropriate conditions, the competitive equilibrium is Pareto efficient (what this textbook calls an “efficient allocation”). You can extend Adam Smith’s © 2023 Pearson Education, Inc.

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“invisible hand” conjecture with mention of Vilfredo Pareto (1848–1923), an Italian economist who defined an efficient allocation as one in which it is not possible to rearrange the use of resources and make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s.

John Hicks, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences. (http://www.nobel.se/economics/laureates/1972/index.html, http://www.nobel.se/economics/laureates/1983/index.html). Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-DebreuMcKenzie theorem. The A-D-M proof is deeper and more restricted than the words and diagrams of a principles text.

But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.)

Market Failure  Inefficiency can occur because either too little of an item is produced (underproduction) or too much is produced (overproduction).  In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus (decrease in total surplus) that results from producing at an inefficient level of production. The figure illustrates the deadweight loss from overproduction of milk and from underproduction.

What is deadweight loss intuitively? In the figure above, production of the 4 millionth gallon of milk results in a MSB of $4 and a MSC of $2. By stopping production at 4 million gallons, society is losing that extra $2 of benefit relative to cost. In fact, the MSB will be greater than MSC for all production less than 6 million gallons. That lost value to society is deadweight loss. Similarly, production of the 8 millionth gallon of milk results in a MSB of $2 and a MSC of $4. In this case, the resources used to produce any milk beyond the 6 millionth gallon impose an additional cost that is greater than its additional benefit. In other words, resources would have a higher value elsewhere (in their best alternative use) than their use in the production of milk. That lost value to society again is deadweight loss.

Sources of Market Failure Sometimes a market overproduces or underproduces a good or service. The key obstacles to achieving an efficient allocation of resources in a market are:  Price and Quantity Regulations: A price ceiling sets the highest legal price and a price floor sets the lowest legal price. If a price ceiling or price floor makes the equilibrium price illegal, it can lead to inefficiency.

Quantity regulations that limit the amount produced also lead to inefficiency. (Studied in Chapter 6)  Taxes and Subsidies: Taxes and subsidies place a wedge between the prices consumers pay and the prices producers receive. Both can lead to inefficiency. (Studied in Chapter 6)  Externalities: An externality is a cost or a benefit that affects someone other than the seller or the buyer. In that case, the demand curve is not the same as the marginal social benefit curve and/or the supply curve is not the same as the marginal social cost curve. In these cases, inefficiency results. (Studied in Chapter 16)  Public Goods and Common Resources: A public good is a good or service that is consumed simultaneously by everyone even if they don’t pay for it. Public goods lead to a free-rider problem, in which people do not pay for their share of the good. A common resource is owned by no one but available to be used by everyone.

Common resources are generally over-used because no one owns the resource. In both cases, inefficiency can occur. (Studied in Chapter 17) © 2023 Pearson Education.

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

Monopoly: A monopoly is a firm that has sole control of a market. To maximize its profit, a monopoly produces less than the efficient quantity and so creates inefficiency. (Studied in Chapter 13)  High transactions costs: The opportunity costs of making a trade are transactions costs. When these costs are high, a market might underproduce because too few transactions take place.

Alternatives to the Market If markets do not allocate resources efficiently, then one of the alternatives might do a better job. For instance, using first-come, first-serve to allocate spaces in a line at a movie theater probably works better than a market.

IV. Is the Competitive Market Fair?  Efficiency is a positive term, while equity is a normative term. Not everyone can agree upon what is fair.  There are two general ways of defining fairness: “It’s not fair if the results aren’t fair” and “It’s not fair if the rules aren’t fair.”

It’s Not Fair If the Result Isn’t Fair  Utilitarianism adopts this view. Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the greatest number.” This principle argues that fairness requires equality of incomes, which requires that incomes be redistributed.

Numerical example: If Lawrence makes $50,000 per year and Sylvia makes $60,000, then the marginal benefit of an additional dollar is greater for Lawrence than for Sylvia. Let’s say the marginal benefit of an additional dollar to Lawrence is equal to 8 units of “happiness,” while the marginal benefit of an additional dollar to Sylvia is only 3 units of happiness. (You may want to introduce the concept of “utility” as the economist’s proxy for “happiness.” The concept of utility will be more fully developed in Chapter 8.) If $1 of income is transferred from Sylvia to Lawrence, Sylvia will lose 3 units of happiness, but Lawrence will gain 8 units of happiness. Although Sylvia is worse off individually, the overall level of “happiness” in the economy has increased by 5 units. This process of transferring income from Sylvia to Lawrence can be repeated as long as Sylvia’s marginal benefit of an additional dollar is still less than Lawrence’s marginal benefit of an additional dollar. 

Redistribution leads to the big tradeoff, the tradeoff between efficiency and fairness. The tradeoff occurs because taxes decrease people’s incentives to work, thereby decreasing the size of the “economic pie.” In addition, taxes lead to administration costs that also decrease the economic pie.  John Rawls argued that redistribution should strive to make the poorest as well off as possible which may mean a smaller piece of a bigger pie, rather than an equal piece, to keep incentives in place.

It’s Not Fair If the Rules Aren’t Fair  This perspective relies on the symmetry principle—the requirement that people in similar situations should be treated similarly. In economics, this means equality of economic opportunity rather than equality of economic outcomes.  Robert Nozick suggests government should promote fairness by establishing property rights for individuals and allowing only voluntary exchange of these resources.  If private property rights are enforced, if voluntary exchange takes place in a competitive market, and if none of the obstacles to efficiency listed before exist, then according to Nozick, the competitive market is fair.

What’s a “fair” grade in this class? Students generally expect to be graded based on their performance in a class. This scheme is a “fair rules” view of fairness. Discuss this observation with the class, and then ask if it would be fairer to grant everyone an A—a “fair results” view. Many students (especially ones who wouldn’t usually expect an A in a course) will find the guarantee of an A for everyone completely “fair.” Other students who know they work hard for their grades are likely to say this is “unfair.” Ask the question again, but this time consider automatically giving every student a D—or even an F. Would this be fair? Most students would agree that automatically failing everyone would not be “fair.” If automatically giving students an A is fair, why isn’t it equally fair to automatically give each student an F? Or, suppose on the final day of class, the rules of the course are changed so that regardless of a student’s

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previous scores, the student will be given an A—is this change fair? What if the student was automatically given an F—is this change fair? Focus again on what’s a fair “result” as opposed to a fair “rule.”

At Issue: Price Gouging This section considers the case of Price Gouging. The legal argument and the economist’s counter argument are considered in light of a case against selling generators at twice the normal price in the aftermath of Hurricane Katrina.

Economics in the News: Making Traffic Flow Efficiently Solving Traffic Congestion Recent research on how to make traffic flow more efficiently has shown the benefit of adding capacity is only temporary. Traffic expands to the natural rate of high congestion. Mass transit projects somewhat astoundingly do not reduce traffic. What does reduce traffic is congestion pricing, charging a (higher) price for driving in congested areas or at congested times.

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Additional Problems 1.

2.

The table gives the demand and supply schedules for spring water.

Price a. What is the maximum price that (dollars per bottle) consumers are willing to pay for the 30th bottle?

0 b. What is the minimum price that 0.50 producers are willing to accept for 1.00 the 30th bottle?

1.50 c. Are 30 bottles a day less than or 2.00 greater than the efficient quantity?

2.50 3.00 d. What is the consumer surplus if 3.50 the efficient quantity of spring 4.00 water is produced? e. What is the producer surplus if the efficient quantity is of spring water is produced? f. What is the deadweight loss if 30 bottles are produced?

Quantity Quantity demanded supplied (bottles per day) 80 70 60 50 40 30 20 10 0

The table gives the demand schedules for train travel for Joe, Jean, and Joy. If the price of train travel is 50 Price Quantity demanded cents a passenger mile, what is the (cents (passenger miles) consumer surplus of each per mile) Joe Jean consumer?

10 50 600 b. Which consumer has the largest 20 45 500 consumer surplus? Explain why.

30 40 400 40 35 300 c. If the price of train travel falls to 50 30 200 30 cents a passenger mile, what is 60 25 100 the change in consumer surplus 70 20 0 of each consumer?

80 15 0 90 10 0 100 5 0 110 0 0

0 10 20 30 40 50 60 70 80

a.

Joy 300 250 200 150 100 50 0 0 0 0 0

Solutions to Additional Problems 1.

a.

b.

c.

d. e.

The maximum price that consumers will pay is $2.50. The demand schedule shows the maximum price that consumers will pay for each bottle of spring water. The maximum price that consumers will pay for the 30th bottle is $2.50.

The minimum price that producers will accept is $1.50. The supply schedule shows the minimum price that producers will accept for each bottle of spring water. The minimum price that produces will accept for the 30th bottle is $1.50.

30 bottles is less than the efficient quantity. The efficient quantity is such that marginal benefit from the last bottle equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—40 bottles a day.

Consumer surplus is $40. The equilibrium price is $2. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the triangle is ½  ($4  $2)  40, which is $40.

Producer surplus is $40. The producer surplus is the area of the triangle above the supply curve below the price. The price is $2. The area of the triangle is ½  ($2  $0)  40, which is $40. © 2023 Pearson Education, Inc.

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f.

2.

a.

b. c.

The deadweight loss is $5. Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals ½  (40  30)  ($2.50  $0.50), which is $5.

Joe’s consumer surplus is $9. Jean’s consumer surplus is $20, and Joy’s consumer surplus is $10. Consumer surplus is the area under the demand curve above the price. At 50 cents, Joe will travel 30 miles, Jean will travel 200 miles, and Joy will travel 100 miles. Joe’s consumer surplus equals ½  (110¢  50¢)  30, which equals $9. Similarly, Jean’s consumer surplus equals ½  (70¢  50¢)  200, which equals $20. And Joy’s consumer surplus equals ½  (70¢  50¢)  100, which equals $10.

Jean’s consumer surplus is the largest because she places a higher value on each unit of the good than the other two do.

Joe’s consumer surplus rises by $7. Jean’s consumer surplus rises by $60, and Joy’s consumer surplus rises by $30. At 30 cents a mile, Joe travels 40 miles and his consumer surplus is $16. Joe’s consumer surplus equals ½  (110¢  30¢)  40, which equals $16. Joe’s consumer surplus increases from $9 to $16, an increase of $7. Jean travels 400 miles and her consumer surplus is $80, an increase of $60. Joy travels 200 miles and her consumer surplus is $40, an increase of $30.

Additional Discussion Questions

1. Do price controls help following a natural disaster or emergency? The text introduces the compelling dilemma of allocating necessary goods following a natural disaster. (Though this issue is serious, if you want a few laughs—and perhaps more student engagement—use the idea of a Zombie disaster as your example.) Engage the students in a careful discussion on this theme, as it opens their eyes to the complexities involved with trying to improve upon the competitive market allocation of scarce resources, even under times of economic duress.  Should “price gouging” and “profiteering” be considered criminal acts? Price controls are often imposed for weeks after the devastating event occurs. Goods such as bottled drinking water, bags of ice, batteries, electrical generators, plywood sheets (to seal broken windows), and chain saws (to remove downed trees from roadways) are typical objects for which sellers are not allowed to raise their sale price above pre-disaster levels. Ask students to critically examine the claim that such price restrictions protect the interests of disaster victims who are trying to get their lives back to normal as quickly as possible.  What happens to the demand curve for these goods? Ask the students to use the supply and demand model to reflect changes in the market for these goods immediately after the disaster has struck. Clearly the radical change in the local environment causes a rightward shift in the demand curve, sharply raising equilibrium market price. A price ceiling results in a heartwrenching shortage.  What happens to the supply curve for these goods? Emphasize that the devastation that creates trauma for the consumers also significantly increases the cost of replacing the goods sold in a timely fashion. Replacement of these items needs to be rather quick if the victims want to minimize any future damage to the community (continued water damage from damaged homes, illnesses from contaminated drinking water supplies, etc.). The increase in the opportunity cost of supplying these goods pushes the supply curve to the left, aggravating the shortage. Motivate the students to consider how the goods will ultimately be distributed.  Distribution under price regulation: There is much pain, but is there any gain (in efficiency or in fairness)? Often the government sets and enforces price controls for these goods after a disaster. Point out to students that in an unregulated market, only those victims who value the goods at least as much as the unregulated equilibrium price would receive the scarce goods.

Under price controls, it is uncertain how the goods will be allocated. Consumers with relatively © 2023 Pearson Education.

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

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low valuation of the goods are just as likely end up with the goods as those who have a relatively high valuation, decreasing total consumer surplus. Also, point out that if private resale prices are not closely monitored, then those victims with a relatively low value for their goods would engage in arbitrage by selling the goods at a high price to victims with a relatively high valuation for the goods. This simply transfers producer surplus from sellers to low valuation consumers, the fairness of which would be difficult to justify.

Can price regulation contribute to undesirable seller behavior? Since the price control erases the opportunity cost that suppliers would normally face if they fail to sell their scarce goods to the highest bidder, these sellers may consider any number of non-monetary benefits when they determine who will ultimately receive their goods: Friends and well-networked acquaintances of the suppliers will likely receive consideration over strangers who would otherwise be willing to pay a higher price. In other words, sellers can use a personal characteristics method of allocation, so they might practice racial, gender, or religious discrimination when selling their goods.

Can price regulation actually prolong victims’ suffering? Point out that for suppliers to quickly replace their depleted inventory they must be willing to bid away the goods from other areas not devastated by the disaster. Also, special deliveries of these goods to the disaster area must be arranged, meaning transportation resources must also be bid away from their usual employment.

Both realities increase the cost of inventory replacement. Under a price ceiling there is insufficient incentive for goods to be quickly redistributed to where they are needed the most.

2.

The big tradeoff: How can economic analysis make us more informed citizen voters? How to properly address the big tradeoff in society is the heart of continuing debates over proposed changes to the federal income tax code.  Should tax rates be decreased in order to spur greater economic activity and increase total production of goods and services in the economy? Get the students to identify and describe the opportunity cost of this proposal. Would income inequality increase? Would the “social fabric” change?  Should tax rates be increased to reduce the federal budget deficit and outstanding, national debt, or to fund greater government services and income redistribution programs? This chapter has shown that the economic pie would decrease if income were redistributed. How much decrease in economic activity is worth the greater equality? Greater knowledge of economic analysis lets people weigh these opportunity costs more carefully and thoughtfully.

3.

Does the concept of decreasing marginal benefits actually imply that rich people will lose fewer benefits from an income transfer than the poor will gain? Emphasize to the students that many social policies (both private and public) that favor the poor at the expense of the rich are justified on utilitarian grounds. Marginal income tax rates that rise with income provide one obvious example. A business discount for college students (who are presumed to be poorer than the general population) is another example. Yet the students should understand that the ability to make a direct comparison of benefits lost for one person against the benefits gained by another is not implied by the concept of diminishing marginal benefits. Explain to them that the assumption of decreasing marginal benefits allows us to compare the marginal benefits across different levels of consumption for the same person, but it says nothing about comparing the marginal benefits across different people at different consumption levels.

To clarify, ask them the following question: Can we truly measure and compare the happiness from a rich person’s consumption level to a poor person’s consumption level for the same good?

Have the students assume that the quantity of income taken away from a rich mother means that she is now able to send only one, rather than both, of her children to college. Assume also that the same quantity of income given to a poor mother enables her to send one of her two children to college when she otherwise couldn’t have afforded to send either child to college. Ask the students, “Does © 2023 Pearson Education, Inc.

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this imply that the happiness, or perceived value, lost by the rich mother is somehow smaller than the happiness, or perceived value gained by the poor mother?” Ask the students if anyone can honestly claim to know that one mother’s concern about providing for her second child is smaller in magnitude than another mothers’ concern about providing for her first child. Obviously not! Explain that if this claim is false for this example, then it is false for all examples comparing benefit gains and losses across people at different levels of in income.

4.

Do “liberals” care more about fairness than “conservatives”? Some years ago, Jim Tobin told Michael Parkin about a nice test of whether a person is a liberal or a conservative. It also generates a good classroom discussion. Here’s how it goes. Give the students the following scenario and question: You are at an oasis in a large desert and you have some ice cream in an immovable refrigerator. (Assume, for the sake of the story, that ice cream is the only food available.) The people in the next oasis some miles away have no ice cream (and no other food) and are too old and infirm to travel. You have plenty of ice cream and you can transport it to the next oasis, but on the journey, some of it will melt. Now the question: How much of the ice cream would have to survive the journey for it to be worth transporting to the next oasis?

Your students will not agree (and you may not agree with your students’ conclusions). According to Tobin, the most liberal would transport if only the smallest percentage survived the journey. The most conservative would want a large proportion to survive before undertaking the redistribution.

You can point out that different people choose different points on the “big tradeoff.” Be careful not to support one view over the other as the only correct viewpoint. The focus here is on understanding the tradeoff between fairness and efficiency, not the value of one over the other.

You could spend the rest of the course talking about and discussing equity, fairness, or distributive justice as it is sometimes called. This material is not standard, and you’ll be hard-pressed to find it in any other principles text. It is included here because governments and the news media often make judgments about what is fair and what is not fair, and students need to know what criteria are included in those judgments.

5.

When is it price gouging and when are prices “just high”? It is common at events to have extremely high prices for items such as bottled water, beer, food, prices much higher than would be paid outside the venue. Consider soda at professional baseball games or bottled water at a theme park.

Prices might be double or triple what they would be outside, but it isn’t considered to be illegal.

Have students discuss fairness in this context and in the context of the aftermath of a disaster. If a bottle of water is selling for $4 in both cases, why is only one case considered gouging? What do they think the outcome should have been for the man described in the case that purchased generators and transported them to the hurricane region to profit? Was he serving himself, others, or both, as Adam Smith would argue?

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GOVERNMENT ACTIONS IN MARKETS

The Big Picture Where we have been: Chapter 6 uses the demand and supply concepts of Chapter 3, the elasticity concepts of Chapter 4, and the efficiency concepts of Chapter 5 to study price ceilings and floors, taxes and subsidies, production quotas, and the markets for illegal goods. The chapter helps round out the student’s exploration of the demand and supply model and its application, and should be a fulfilling exercise for putting together the “big picture.”

Where we are going: Chapter 7 continues the theme of this chapter by exploring international trade and the effects on consumer surplus, producer surplus, and national welfare. It also examines the deadweight loss of government policies that limit trade, such as tariffs and import quotas. Efficiency and deadweight loss are again explored as we consider how perfectly competitive markets allocate resources in Chapter 12, and then contrast that with results for monopoly (Chapter 13), monopolistic competition (Chapter 14), and oligopoly (Chapter 15). We will return to taxes and efficiency issues when we study externalities in Chapter 16 and public goods and common resources in Chapter 17.

New in the Fourteenth Edition The opener to the chapter has updated data about minimum wages and rents in New York City, which then leads to a new end of chapter article that focuses on President Biden’s proposal to raise the minimum wage to $15. Throughout the chapter, the term “black market” is changed to “illicit market.”

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Lecture Notes

Government Actions in Markets 

I.

Government intervention in markets—using price controls, taxes, production quotas, and making products illegal—can affect the price and quantity in those markets.  Government intervention affects the efficiency of markets and can lead to the creation of deadweight losses.

A Housing Market with a Rent Ceiling 

A price ceiling is a government regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to a housing market it is called a rent ceiling.  A rent ceiling set above the equilibrium rent has no effect on the market.  A rent ceiling set below the equilibrium rent creates a housing shortage, increased search activity, and an illicit market.

A Housing Shortage  If the government imposes a rent ceiling below the equilibrium rent, then a shortage results. In the figure the equilibrium rent is $400 per month and the equilibrium quantity of units rented is 3,000.

If the government imposes a rent ceiling of $200 per month, a shortage results. The quantity demanded at that price is 5,000 and the quantity supplied is 1,000. There is a shortage of 4,000 apartments per month.  Rent ceilings lead to inefficiency. In a competitive market, the equilibrium quantity is the same as the efficient quantity. In a housing market with a rent ceiling, the quantity of units available is less than the equilibrium quantity and so is less than the efficient quantity. The market underproduces, and there is a deadweight loss, as shown in the figure as the darkened triangular area.

How is the “shortage” calculated? In looking at the effects of a price ceiling, students sometimes focus only on the change in the quantity supplied relative to equilibrium instead of looking at the entire difference between the quantity demanded and quantity supplied. The shortage is measured by the difference between the quantity demanded and the quantity supplied, NOT simply by the difference between the original equilibrium quantity and the new quantity supplied.

Housing Markets and Rent Ceilings: Time and the elasticity of supply. Even given the caveat above, it is worth noting the reduction in quantity supplied of rent controlled housing, especially since policy makers’ intent is usually to make housing more available to lower income tenants and less housing is available after the policy. Where might those units and firms go instead? Recall supply elasticity from Chapter 4 and ask students how the passage of time might allow property owners to fully respond to the policy. In the long run, apartment owners are more likely to change the number of apartments they offer in response to a price ceiling than in the short run. Will they switch to condominiums? Will they be able to maintain public parts of the building given lower rents? What will happen to the average age of buildings over time in a rent controlled city? Eventually, however, apartment owners may find that alternative uses for their property (as a strip mall or a storage facility, for example) become more profitable.

Increased Search Activity  Search activity is the time spent looking for someone with whom to do business. Search activity is costly and increases the opportunity cost of a given product or service. A rent ceiling (or a price ceiling) that creates a shortage increases search activity. © 2023 Pearson Education, Inc.

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An Illicit Market  An illicit market is an illegal market in which the price exceeds the legally-imposed price ceiling. In an illicit market, illegal arrangements are made between renters and landlords—often at effective rental rates that are higher than would be the case in an unregulated market.  The level of the illicit market rent depends on how tightly the rent ceiling is enforced. When the rent ceiling is strictly enforced, the illicit market rent will be closer to the maximum that consumers are willing to pay, which in the figure is $600 per month.

Are Rent Ceilings Fair?  Using the “fair rules” criteria, blocking voluntary exchange is unfair.  Using the “fair outcomes” criteria, rent ceilings are fair if they help the poor and disadvantaged. Some other allocative mechanism, such as a lottery, queuing, some form of discrimination is often used to allocate housing. These alternative allocation methods of distribution do not favor the poor and disadvantaged.

What is the goal of a rent ceiling? Replacing the market price as an allocative mechanism for the rental market conflicts with the stated goals of those who promote rent ceilings as a means to create affordable housing. Rent ceilings lead to a shortage, which means landlords have more ability to discriminate against renters who have a different color of skin, or practice a different religion, or who have “too many” tattoos or “too many” children. It can increase incentives for corruption as outright bribes or excessive deposits and charges for building services make up for below market rent. In addition, there is less incentive for landlords to make needed electrical or plumbing repairs, or perform maintenance on appliances. Builders have less incentive to build new housing units so that in the long run, the stock of available housing will not grow with the population, making the shortage worse.

Rent Ceilings in Practice Cities with rent ceilings tend to have significant housing shortages. Some tenants, especially those who have lived longest in the city, have lower rents but others must pay higher rents.

Economics in Action: Rent Control Winners: The Rich and Famous This Economics in Action application examines the impact of rent controls in the New York City housing market.

II. A Labor Market With a Minimum Wage 



A price floor is a government-imposed regulation that makes it illegal to charge a price lower than a specified level. When a price floor is applied to labor markets, it is called a minimum wage. A minimum wage that is set above the equilibrium wage rate creates unemployment.

Minimum Wage Brings Unemployment  If a minimum wage is set above the equilibrium wage rate, the quantity of labor demanded is less than the quantity of labor supplied. This surplus of labor is unemployed workers. The minimum wage creates unemployment because some workers who are willing to work at the minimum wage will not find a job.  In the figure, the equilibrium wage is $8 an hour and the equilibrium quantity of employment is 30,000 hours per month. If a minimum wage rate of $12 is imposed, the initial equilibrium wage rate is made illegal. At the minimum age the quantity of labor supplied is 50,000 hours per month and the quantity demanded is 10,000 so there is a surplus of 40,000 hours. The 40,000 hour surplus means that 40,000 hours of labor is unemployed.

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Labor is work that households supply and firms demand. You might be surprised to find that quite a few students think that the demand for labor is the demand by a household for a job and the supply of labor is the supply of jobs by firms. Of course, they get into a big mess with this mirror image view of the labor market. Try to avoid this alltoo-common mistake by being very explicit that households supply labor and firms demand it. Sure, firms provide jobs and people want jobs to earn an income. But it is labor, not jobs, that is supplied and demanded in the labor market.

Inefficiency of a Minimum Wage  Fewer workers are employed with a minimum wage, so less than the efficient quantity of workers is employed. At the quantity of labor employed, the marginal social benefit of labor exceeds its marginal social cost.  Because the quantity of labor employed is less than the efficiency quantity, there is deadweight loss. In addition to the deadweight loss, there is also increased job search. Higher job search costs borne by workers add to the loss from the minimum wage.

The Minimum Wage in Practice  While some estimates say that a 10 percent rise in the minimum wage results in a decrease in employment 1 to 3 percent (particularly among teenagers), other economists argue that higher minimum wages have little impact—and potentially even a positive impact—on employment. Such studies emphasize the idea that higher wages reduce a given employee’s incentive to quit, thereby reducing recruitment and training costs for employers and increasing labor productivity and labor demand.

Is the Minimum Wage Fair?  The minimum wage is unfair based on an evaluation of both the “result” and the “rules” of a minimum wage. The result if unfair because workers who become unemployed are worse off than they would be with no minimum wage. The minimum wage imposes an unfair rule because it blocks voluntary exchange. Even if firms are willing to hire more labor at a wage that people are willing to take, they are not permitted to do so by the minimum wage law.

At Issue: Does the Minimum Wage Cause Unemployment?

This At Issue examines the issue of whether the minimum wage creates unemployment. In addition to considering the Yes and No cases presented for the minimum wage, consider pulling up data on unemployment rates by educational level and race. Minority teens in urban areas have significantly higher rates than other populations. Ask your students why they think this situation exists? Perhaps the minimum wage has become a price floor about equilibrium for this population as they have to compete with more experienced, older workers. You can also ask them if they think this outcome is “fair”? Given that many students are often paid the minimum wage, asking them if they think the differential outcome is fair can create an interesting and perhaps even heated discussion.

III. Taxes Tax Incidence  Tax Incidence is the division of the burden of a tax between the buyer and the seller. The buyers’ burden arises when the price paid by the buyers rises after the tax is imposed. The sellers’ burden arises when the price they receive falls after the tax is imposed. Tax incidence does not depend on whether the tax law imposes the tax on buyers or on sellers.

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A Tax on Sellers  Imposing a tax on sellers decreases supply because the tax is like a cost that sellers must pay. The supply curve shifts leftward. The vertical distance between the initial supply curve and the new supply curve is equal to the amount of the tax.

The price paid by buyers rises, the price received by sellers falls, and the quantity decreases.  The figure shows the effect of a tax imposed on sellers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week.

When the tax is imposed, the supply curve shifts from S to S + tax. The length of the double headed arrow showing the vertical distance between the two supply curves equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per week.

A Tax on Buyers  Imposing a tax on buyers decreases demand because the tax lowers the amount they are willing to pay to the sellers. The demand curve shifts leftward. The vertical distance between the initial demand curve and the new demand curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases.  The figure shows the effect of a tax imposed on buyers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week.

When the tax is imposed, the demand curve shifts from D to D  tax. The length of the double headed equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per year.

Equivalence of Tax on Buyers and Sellers  The figures above confirm the general conclusion: Regardless of whether the tax is imposed on buyers or sellers, the tax leads to the same outcome in which the new equilibrium price and quantity are identical. The tax burden is split the same way regardless of who is responsible for paying the tax to the government.

Tax Incidence and Elasticity of Demand  With perfectly inelastic demand (a vertical demand curve), the buyer pays the entire tax. In general, the less elastic the demand, the larger the tax burden paid by the buyers (and the smaller the tax burden paid by the sellers).  With perfectly elastic demand (a horizontal demand curve) the seller pays the entire tax. In general, the more elastic the demand, the smaller the tax burden paid by the buyers (and the larger the tax burden paid by the sellers).

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Tax Incidence and Elasticity of Supply  With perfectly inelastic supply (a vertical supply curve) the seller pays the entire tax. In general, the less elastic the supply, the larger the tax burden paid by the sellers (and the smaller the tax burden paid by the buyers).  With perfectly elastic supply (a horizontal supply curve) the buyer pays the entire tax. In general, the more elastic the supply, the smaller the tax burden paid by the sellers (and the larger the tax burden paid by the buyers).

Do consumer prices always rise when taxes rise? As long as the demand curve is not horizontal and the supply curve is not vertical, when a tax is hiked buyers will bear some of the burden of a tax and the prices they pay for good will increase. The elasticity of demand relative to the elasticity of supply is the key to determining how much burden each side of the market will bear. Consider the situation faced by smokers when the tax on cigarettes is increased. First, the demand for cigarettes is relatively inelastic. (Ask your students why they would expect cigarettes to have a relatively low elasticity of demand, relying on the determinants of elasticity presented in Chapter 4.) With relatively inelastic demand, when the government raises taxes on cigarettes, the price paid by buyers rises substantially. The incidence of the tax falls heavily on buyers. In addition, state governments have sued tobacco companies for past and future health care costs arising from the smoking-related illnesses. Tobacco companies settled these suits, paying billions of dollars in penalties, which raised their costs and decreased their supply. But smokers’ very inelastic demand for cigarettes means that the tobacco producers were able to pass on most of these costs to smokers without seeing a significant decrease in the quantity sold. On the other hand, when taxes were imposed on luxury yachts in the 1990s, because the demand for yachts was relatively elastic, yacht buyers drastically reduced their yacht purchases, and shipbuilders bore most of the burden of that tax.

Taxes and Efficiency  Taxes drive a wedge between the price buyers pay and sellers receive. Therefore, they put a wedge between marginal benefit and marginal cost and create inefficiency. The quantity produced is less than the efficient quantity.

Economics in Action: Workers and Consumers Pay the Most Tax This Economics in Action case considers the incidence of employment and excise taxes and concludes workers and consumers are most responsible for paying them.

Taxes and Fairness The Benefits Principle  The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government.

The Ability-to-Pay Principle  The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden on the tax.

Examples: The federal excise tax on gasoline is an example of the “benefits principle” of taxation. Revenue collected from excise taxes on gasoline are used to finance interstate maintenance and improvements. To the extent that the purchasers of gasoline are the same people who use the interstates, then gas taxes are paid by those who receive the benefits of public interstates. On the other hand, income taxes are an example of the “ability-to-pay” principle. The progressive marginal tax rates of the U.S. tax code require those with higher incomes to pay a greater share of government expenditures.

IV. Production Quotas and Subsidies Production Quotas  A production quota is an upper limit to the quantity of a good that may be produced in a specific period of time. Production quotas will only have an impact if they are set below the equilibrium level of output in a market. © 2023 Pearson Education, Inc.

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A production quota results in a decrease in supply, a rise in price, a decrease in marginal cost, inefficiency from underproduction, and an incentive to cheat and overproduce.

Subsidies  A subsidy is a payment made by the government to a producer. A subsidy increases the supply.  A subsidy results in an increase in supply, a fall in price and increase in quantity produced, an increase in marginal cost, payment to producers by the government, and inefficiency from overproduction.

Economics in Action: Rich High-Cost Farmers the Winners This Economics in Action examines farm subsidies and the tension they are creating between developed and developing countries.

V. Markets for Illegal Goods The government prohibits the trade of some goods, such as illegal drugs. Yet markets still exist, with both buyers and sellers engaging in trade.

A Free Market for a Drug  With no penalties for selling or buying drugs, drug prices would be lower and more would be sold.

A Market for an Illegal Drug  Imposing penalties on sellers decreases the supply and shifts the supply curve leftward compared to the free market case. These penalties raise the price and decrease the quantity.  Imposing penalties on buyers decreases the demand and shifts the demand curve leftward compared to the free market case. These penalties lower the price and decrease the quantity.  When both buyers and sellers face penalties, both the demand and supply curves shift leftward. The quantity decreases but the effect on the price is ambiguous.  If the decrease in demand exceeds the decrease in supply, the price falls.  If the decrease in demand equals the decrease in supply, the price does not change.  If the decrease in demand is less than the decrease in supply, the price rises.

Legalizing and Taxing Drugs  Compared to a legal and untaxed market, if drugs are legal and taxed, the price of drugs will be higher and the quantity consumed will be lower. But a high tax rate might be necessary to decrease the consumption of drugs to the level that occurs when they are illegal and so illicit markets might arise.  An advantage of legalization and taxation is that the government can raise tax revenues for educating the population against using drugs. A disadvantage is that legalization might signal that drugs are socially acceptable, which could increase demand.

Economics in the News: Push to Raise the Minimum Wage State Minimum Wages Rising to Exceed the Federal Minimum This Economics in the News examines the push to raise the federal minimum wage to $15 an hour. This is a very timely issue for students to apply their recently learned economic analysis skills to understand. It shows how a minimum wage set above the equilibrium wage rate creates unemployment while a minimum wage set below the equilibrium wage rate has no effect.

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Additional Problems 1.

Figure 6.1 shows the demand for and supply of rental housing in Township. a. What are the equilibrium rent and equilibrium quantity of rental housing?

If a rent ceiling is set at $150 a month, what is b. The quantity of housing rented? c. The shortage of housing? d. The maximum price that someone is willing to pay for the last unit available?

2.

The table gives the demand schedule and the Wage rate Quantity of Quantity of supply schedule for high school graduates. (dollars per hours hours a. What is the equilibrium wage and the hour demanded supplied equilibrium quantity of employment.

16 9,000 4,000 b. What is the number of hours of labor 17 8,000 5,000 unemployed?

18 7,000 6,000 19 6,000 7,000 c. If a minimum wage is set at $17 an hour, 20 5,000 8,000 how many hours do high school graduates work? d. If a minimum wage is set at $17 an hour, how many hours of labor are unemployed? e. If a minimum wage is set at $19 an hour, what are the number of hours of labor employed and the number of hours of labor unemployed? f. If the minimum wage is $19 an hour and demand increases by 500 hours a month, what is the wage rate paid to high school graduates and how many hours of their labor are unemployed?

3.

The demand and supply schedules for coffee are given in the table. a. If there is no tax on coffee, what is the price of a cup of coffee and how much coffee is bought? b. If a tax of 75¢ a cup is introduced, what is the price of a cup of coffee and how much coffee is bought? Who pays the tax?

Price (dollars per cup) 1.50 1.75 2.00 2.25 2.50

Quantity Quantity demanded supplied (cups per hour) 90 30 70 40 50 50 30 60 10 70

Solutions to Additional Problems 1.

a. b.

Equilibrium rent is $300 a month and the equilibrium quantity is 30,000 housing units.

The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling. © 2023 Pearson Education, Inc.

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c. d.

2.

a. b. c.

d. e.

f.

3.

a. b.

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The shortage of housing is 40,000 housing units. At the rent ceiling, the quantity of housing demanded is 50,000, but the quantity supplied is 10,000, so there is a shortage of 40,000 housing units.

The maximum price that someone is willing to pay for the 10,000th unit available is $450 a month. The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

The equilibrium wage rate is $18.50 an hour, and employment is 6,500 hours a month.

Unemployment is zero. Everyone who wants to work for $18.50 an hour is employed.

They work 6,500 hours a month. A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage exceeds the minimum wage, the minimum wage is ineffective. The wage rate will be $18.50 an hour and employment is 6,500 hours.

There is no unemployment. The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment.

At $19 an hour, 6,000 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $19 an hour. Unemployment is equal to the quantity of labor supplied at $19 an hour minus the quantity of labor demanded at $19 an hour. The quantity supplied is 7,000 hours a month, and the quantity demanded is 6,000 hours a month. So 1,000 hours a month are unemployed.

The wage rate is $19 an hour, and unemployment is 500 hours a month. At the minimum wage of $19 an hour, the quantity demanded is 6,500 hours a month and the quantity supplied is 7,000 hours a month. So 500 hours a month are unemployed.

With no tax on coffee, the price is $2.00 a cup and 50 cups an hour are bought.

The price is $2.25 a cup, and 30 cups an hour are bought. Consumers pay 25 cents of the tax on a cup of coffee and sellers pay 50 cents of the tax on a cup of coffee. The tax decreases the supply of coffee and raises the price of coffee. With no tax, sellers are willing to sell 30 cups an hour at $1.50 a cup. But with a 75 cent tax, they are willing to sell 30 cups an hour only if the price is 75 cents higher at $2.25 a cup.

Additional Discussion Questions 1.

Do rent controls improve the quality of life for university students? The following provides a useful example to make the issue of market price regulation personally relevant for the students. Inform them that the University of California is located in the city of Berkeley, California, where the city government imposes strict rent controls. The University of Florida is located in Gainesville, Florida, where there are no rent controls.

In which city would you expect incoming freshman students to have the least trouble renting an apartment? The students should understand that while apartments with low monthly rents would be very nice, they would also be very scarce due to a market shortage. Emphasize that under a rent control policy, not only are there fewer apartments for lease than if the market were unregulated, there are also many more students looking for an apartment who wouldn’t have even thought about renting at the higher rental rates of the unregulated market.

Who ultimately gets the apartments? Students should see that the available units must be allocated somehow. Too many students trying to locate too few apartments means a new student will face the following difficulties: 

Significant increase in search costs, such as time spent, gasoline consumed, and promising leads followed for nothing, etc.

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Greater risk of being rejected by landlords simply for being the “wrong” race or ethnic background; having the “wrong” religious beliefs or personal attributes. © 2023 Pearson Education, Inc.

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Unscrupulous landlords requiring huge deposits; charging premiums for electricity or natural gas consumed; gouging the renters for minor maintenance actions; delaying important repairs to air conditioning or heating units or leaking plumbing fixtures.

If rent control laws fail to promote fairness, what about efficiency? Students should see that having a rent control policy means the economy suffers from three sources of inefficiency (meaning net benefits to society are not maximized): 

Those who get an apartment are not always the ones who value it the most.



Difference in the marginal benefit and marginal cost at the level of housing produced means that too few resources are used for producing the rental housing market, creating a deadweight loss.



Underused resources in the rental housing market imply that too many resources are used in other markets, resulting in the overproduction of goods and services in those markets.

2. After the OPEC oil embargo in the 1970s, price controls were placed on gas markets that did not allow price to rise to the market clearing level. Gas shortages resulted as did illicit markets. Use the analysis provided in Chapter 6 on the use of price controls to discuss whether price controls likely hurt or helped consumers and the economy. Consider the following: 

Who is helped and harmed by price ceilings?



Had gas prices been allowed to increase sharply, would we have made changes in our economy faster? At what cost?



3.

How does the elasticity of demand and supply impact the degree to which price and quantity would change in the gasoline market?

Price controls on gas meant people had to deal with gas shortages, informal rationing, and illicit markets, which reduced their ability to purchase gasoline even if the price of gasoline did not rise enough to reflect the change in market conditions. Firms paying higher costs and unable to charge higher prices would leave the market, willingly or through economic losses. Higher prices create incentives for people to reduce their purchases and find substitutes. Higher prices increase incentives for firms to develop alternate sources.

Will raising the minimum wage help or hurt those who need help the most? This question makes students apply simple demand and supply analysis to discover the counter-intuitive implications from market regulation policies. Point out that minimum wage laws have at least two devastating impacts on the very people that supporters of a minimum wage say need these jobs the very most: 

The higher wage attracts people with higher qualifications—like college students—to seek unskilled labor jobs that they wouldn’t otherwise seek out at a lower, unregulated wage. This means unskilled laborers who are heads of households are competing to get jobs against greater numbers of relatively more educated college students with relatively greater human capital.



Additionally, when employers determine which workers they are going to lay off after a raise in minimum wage takes effect, they are first going to release those employees with the least skills and the least experience. Those are precisely the characteristics of many uneducated, minority workers who are in the greatest need of retaining any paying job to ensure a better future.

Students should understand that both of these results are the unintended consequences of trying to manipulate the market forces of supply and demand.

4.

What specifically are the “inefficiencies” of agriculture policies that prop up farm prices? Get the students to integrate concepts from many different chapters with the following example of agricultural market regulation. Inform students that the federal government regulates agriculture markets in many ways: i) it pays farmers to NOT produce output to prop up farm prices; ii) it uses output quotas to limit total farm production; and iii) it imposes price floors and pays farmers for any © 2023 Pearson Education, Inc.

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unsold, surplus quantities. Have the students examine the impact of such market regulation and recognize that: 

Too many resources are used in the agriculture markets, causing a deadweight loss from overproduction. Too few resources are used in other competitive, unregulated markets, causing deadweight loss from underproduction. Remind the students that even if the deadweight losses were not realized, society would still be moving to a lower valued point on the production possibilities frontier.



The federal government uses additional resources managing the huge surplus agricultural inventories, some of which (milk, e.g.) is very perishable and requires expensive storage facilities.

Much of these perishable farm goods are spoiled before it is decided what could be done with them without depressing the market price. This implies that society is moving towards the interior of the production possibilities frontier. (If an agricultural product cannot be stored, it can sometimes be converted to other goods, like cheese. Alternatively, surplus product can be “dumped” on the world market, thereby depressing the equilibrium price of the product on the world market—to the detriment of small agrarian countries.)



The higher prices for food are used to justify increases in food stamp allotments to the poor and disadvantaged, increasing the tax revenues necessary to pay for this program. Higher tax burdens increase the deadweight loss to all markets that are taxed. This implies that society is moving even further to the interior of the production possibilities frontier.

5.

What are “sin taxes”? Ask your students to think about some of the markets mentioned in the chapter that are heavily taxed (cigarettes, for example). Alcohol purchases are also subject to federal excise taxes. Some of these taxes are often referred to as “sin” taxes. Ask students why they think that is the case. Consumption of cigarettes and alcohol is traditionally considered somewhat “taboo” (or at least unhealthy), so purchases of these products are subject to a sin tax. By taxing this consumption, the quantity consumed of these goods will decrease (although not by much if the demand for these goods is relatively inelastic).

Ask your students whether they think a tax on gasoline is a sin tax. While it may not be “sinful” or unhealthy personally to buy gasoline, some politicians actually favor increasing taxes on gasoline to further discourage use of this scarce fossil fuel. They argue that use of gasoline is unhealthy for the environment. As with other sin taxes, part of the motivation for the tax on gasoline is the resulting reduction in consumption.

6.

How are taxes related to tax revenues? In markets with relatively inelastic demand, consumers bear most of the burden of taxes, and the quantity purchased of those goods decreases only slightly in response to higher prices. As a result, markets with relatively inelastic demand would also be expected to generate high tax revenues. On the other hand, imposing taxes in markets where demand is relatively elastic would result in large reductions in consumer purchases and, ultimately, smaller collections of tax revenue.

Show this result to your students graphically, reminding them that “less elastic” demand would be steeper and “more elastic” demand would be flatter. The area of tax revenue has a smaller base when the quantity consumers purchase falls dramatically when prices rise (i.e., when a tax is imposed in a market where demand is relatively elastic). The area of tax revenue has a larger base when the quantity consumers purchase falls only a little when prices rise after the tax (i.e., when a tax is imposed in a market where demand is relatively inelastic).

Example: Use Figure 6.5 in the text. With a tax of $1.50 imposed in the market, the price of cigarettes rises to $4, and the quantity purchased falls from 350 million to 325 million. The government therefore collects ($1.50 x 325 million = $487.5 million) in revenue. What if the quantity of cigarettes purchased had fallen only to 335 million instead of 325 million? In other © 2023 Pearson Education, Inc.

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7.

8.

9.

words, what if the demand for cigarettes was less elastic? Now the government would collect (1.50 x 335 million = $502.5 million) in revenue. (Note that the “sin” taxes placed in markets with relatively inelastic demand are likely to be the very markets that generate the greatest government tax revenue as well.)

How are elasticity and deadweight loss related? Show your students how the size of the deadweight loss triangle is related to elasticities as well. With linear supply and demand curves, the area of deadweight loss is a triangle with a height equal to the amount of the tax (the vertical distance between the two supply or demand curves) and a base equal to the decrease in the quantity purchased as a result of the tax. For any given tax, the only difference in deadweight loss across two markets will be the size of the decrease in the quantity purchased as a result of the tax. You can show this graphically by showing deadweight loss when demand is relatively steep as opposed to deadweight loss when demand is relatively flat. Just make sure you use the same tax (same vertical distance between the two supply curves) in the comparison.

A Swedish economist famously noted that rent controls are possibly the best way to destroy a city, except perhaps for bombing it. Explain why this might be true. If rents are below market, it is hard for firms to cover their production costs. As time passes, building maintenance suffers, roofs aren’t replaced, new construction is eliminated, and the housing stock deteriorates.

USA Today recently reported that significant increases in federal cigarette taxes (more than $1 per pack) led to a significant increase in the number of people who quit smoking, especially among teens, seniors, and low income individuals. Discuss what this means about elasticity, potential government revenue from the cigarette tax, and the goals government is trying to accomplish through “sin” tax policy. Do governments really want people to quit? If enough people quit so that the tax revenue falls, demand has hit the elastic portion of the curve. If government truly wants people to quit, taxes must be high enough to reach that portion of the curve. If government, however, wants tax revenue to help meet budget goals, they do not want to set the tax so that it moves demand into the elastic part of the demand. What do the students think is the “true” goal of the government? You can return to this discussion after discussing externalities when it will be even more meaningful.

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GLOBAL MARKETS IN ACTION

The Big Picture Where we have been: Chapter 2 introduced the gains from trade in a simple model with a linear production possibilities frontier. This chapter continues the explanation of the gains from trade by looking at individual markets using demand and supply. The chapter uses the concepts of consumer surplus, producer surplus, and deadweight loss, first introduced in Chapter 5. Because of this mode of analysis, the chapter now integrates tightly with the preceding chapter, which examined changes in consumer surplus, producer surplus, and deadweight loss resulting from government policies. The chapter examines trade restrictions and protection with a focus on the deadweight loss resulting from trade restrictions.

Where we are going: Chapter 7 marks the end of the basic applications of supply and demand analysis. Chapters 8 and 9 cover utility theory and indifference curves in explaining consumer demand, and Chapters 10 to 15 develop the theory of the firm and supply decisions.

New in the Fourteenth Edition The chapter has been updated to incorporate new data about U.S. trade and trade patterns with the rest of the world. The closing Economics in the News article has been changed. This chapter closer shows why the trade war with China hurts U.S. and Chinese producers and consumers.

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Lecture Notes

Global Markets in Action   

Comparative advantage means that all countries can gain from trade.

Total surplus increases with international trade.

There are many arguments in favor of restricting international trade, but restricting free trade results in deadweight loss and inefficiency.

The first Economics in Action application shows the major U.S. exports and imports. A great source of information about global business for undergraduates is Global Edge, which is hosted by Michigan State University (http://globaledge.msu.edu). This site compiles information from many sources and is great entry point for student research, in addition to hosting modules and other resources for global business. Students can search by state or country to compare what is traded and to get an overview of the economies of other regions.

I.

How Global Markets Work

   

The goods and services that we buy from people in other countries are called imports. The goods and services that we sell to people in other countries are called exports.

The United States is the world’s largest international trader and accounts for 10 percent of world exports and 13 percent of world imports.

In 2020, U.S. exports were $2.1 trillion (about 10 percent of the value of U.S. production) and U.S. imports were $2.8 trillion (about 13 percent of total U.S. expenditure).

The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. By specializing in producing the good in which each country has comparative advantage, both countries gain from international trade.

For more data on international trade: The data on U.S. international trade can be accessed at the Bureau of Economic Analysis web site: www.bea.gov/international/index.htm. Key facts worth emphasizing are the enormous growth in volume of trade over time and huge two-way trade in manufactures. Explain that the balance of trade along with the international borrowing and lending that finances it results from spending and saving decisions in the United States and the rest of the world, and is independent of the forces that generate the volume of trade, which this chapter covers.

U.S. Exports 



The United States will export goods for which it has comparative advantage. In the figure the world price of coal is $60 per ton and the price in the United States before trade is $40 per ton. The United States has a comparative advantage in producing coal because the price before trade is lower than the world price. In this case the United States will export coal.

In the figure, before international trade the price of coal in the United States was $40 per ton and at that price the United States produced 3 million tons of coal per year and consumed 3 million tons per year.

With international trade, the price in the United States rises to the world price, $60 per ton. At that price the United States produces 5 million tons of coal per year, consumes 1 million tons per year, and exports the difference, 4 million tons per year.

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U.S. Imports 



The United States will import goods in which it does NOT have a comparative advantage. In the figure, the world price of automobiles is $20,000 per car and the price in the United States before trade is $40,000 per car, so the United States does not have a comparative advantage in producing automobiles. In this case the United States will import cars.

In the figure, before international trade the price of a car in the United States was $40,000 per car and at that price the United States produced 3 million cars per year and consumed 3 million cars per year. With international trade the price in the United States falls to the world price, $20,000 per car. At that price the United States produces 1 million cars per year, consumes 5 million cars per year, and imports the difference, 4 million cars per year.

II. Winners, Losers, and the Net Gain from Trade U.S. Exports 

Exports raise the U.S. price of the good or service.

With the higher price consumers lose and producers gain. The figure shows this breakdown of winners and losers. Consumer surplus decreases from area A + area B to only area A. Producer surplus increases from area D to area B + area C + area D. The increase in producer surplus more than offsets the decrease in consumer surplus, so total surplus increases. The total surplus increases by area C. Also note that the loss to consumers, area B, is picked up as a gain to producers.

U.S. Imports 

Imports lower the U.S. price of the good or service.

With the lower price consumers win and producers lose. The figure shows this breakdown of winners and losers. Consumer surplus increases from area A to area A plus area B + area C. Producer surplus decreases from area B + area D to only area D. The increase in consumer surplus more than offsets the decrease in producer surplus, so total surplus increases. The total surplus increases by area C. Also note that the loss to producers, area B, is picked up as a gain to consumers.

The Fable of Adam Blackbox: There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram (from International Economic Problems, John Wiley, 1970) is a powerful way to begin. Make up your own version with local flavor and embellishment. © 2023 Pearson Education, Inc.

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Adam Blackbox announces that he has discovered an amazing way to produce low-price, high-quality automobiles.

He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, high-quality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love him. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and Congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering low-price, high-quality automobiles is clearly part of the process of achieving greater prosperity for all.

The press becomes increasingly curious about what is going on in the giant New England auto plant. Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer. He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles.

Ask your students why the president and Congress accepted Adam Blackbox initially but then changed their tune.

Was Adam Blackbox hurting America or helping America?

III. International Trade Restrictions 

Governments restrict international trade to protect domestic industries from foreign competition using tariffs, import quotas, other import barriers, and subsidies

Tariffs 





A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary.

A tariff increases the price in the nation for the good. If the supply to the nation from the rest of the world is perfectly elastic, the price rises by the full amount of the tariff. The following occur:  Consumers buy less of the good and producers increase the quantity supplied  Government collects tariff revenue equal to the tariff times the quantity imported of the good  Less of the good is imported  A deadweight loss results.

As a result of a tariff, U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss. All these results are shown in the figure. The government imposes a $10,000 per car tariff on imported automobiles so the U.S. price rises to $30,000. U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million.

Imports decrease from 4 million per year to 2 million.

Consumer surplus decreases from area A + area B + area C + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The government gains tariff revenue equal to area D. But both areas C are now deadweight losses, so on net society is harmed by the tariff.

Two notes on the impact of tariffs to point out to students: First, when a tariff is imposed imports decrease more than domestic production increases. Flipping this observation around means that when tariffs are lowered, imports increase by more than domestic production decreases. Basically, every unit we import is not a lost sale to a domestic © 2023 Pearson Education, Inc.

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firm. Indeed, if domestic supply is inelastic and demand elastic, domestic production may expand very little even with a huge drop in imports. Second tariffs basically force foreign firms to be more efficient than domestic firms, something that harms incentives and may limit domestic firms’ opportunities in the long run. They also can give foreign firms the incentive to move operations into the domestic economy. For instance Japanese automakers opened many manufacturing plants in the United States when their imports to the U.S. economy were limited. The upshot?

U.S. automakers now face competition from Toyota, Honda, and many other automakers that have set up shop in the United States.

The Economics in Action application in this section considers the decrease in U.S. tariffs followed by the recent rise.

This feature gives you a good chance to discuss the current state of global trade negotiations.

Import Quotas 





An import quota is a restriction that limits the maximum quantity of a good that may be imported in a given period.

An import quota increases the price in the nation for the good. As a result, the following occur:  Consumers buy less of the good and producers increase the quantity supplied  The importers gain additional profit  Less of the good is imported  A deadweight loss results.

As was the case with a tariff, with an import quota U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss. All these results are shown in the figure. The government imposes a 2 million per year import quota on automobiles as shown. With this quota, the supply curve becomes the U.S. supply curve below the world price of $20,000 per car and then the U.S. supply curve plus the 2 million import quota at prices above the $20,000 world price. The U.S. price rises to $30,000 per car. As a result U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million so that imports decrease from 4 million per year to 2 million. Consumer surplus decreases from area A + area B + area C + area D + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The importers’ profit is equal to the total area D. Both areas C are deadweight losses, so on net society is harmed by the import quota.

An Economics in the News case considers why the United States has switched from exporting to importing coat hangers. It examines the potential impact of a 21 percent tariff on imports of coat hangers.

Other Import Barriers  

Although they might not have been designed to limit international trade, health, safety, and regulation barriers have that effect.

Voluntary export restraints, while not common, act like a quota and exist if a country negotiates with foreign trade partners to voluntarily limit their exports.

An Economics in Action case discusses the Doha Development Agenda, the World Trade Organization and the problems with reaching agreement. Again, this is a good opportunity to have students research the current status of this negotiation and the industries that are most affected.

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Export Subsidies 

An export subsidy is a payment by the government to the producer of an exported good. These are illegal under most international trade agreements. One of the reasons that progress on international trade agreements such as the Doha Round has been difficult is that the United States and European Union pay subsidies to their farmers, which would be illegal under the past trade agreements reached for most other goods and services.

IV. The Case Against Protection Arguments for protection include the following:  The infant-industry argument: The so-called infant-industry argument for protection is that protection is necessary for a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to dynamic comparative advantage—comparative advantages change over time due to learning-by-doing. However, the infant industries argument only applies if the benefits of learning-bydoing spill over to other industries and if firms have incentives to become more competitive over time, something that protection tends to limit.  The counteracts dumping argument: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly.

However, it is difficult to measure the cost of production, so whether dumping is taking place is difficult to determine. Charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets.  Saves domestic jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors.  Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in wage rates generally reflect differences in productivity, and competitiveness is determined by both differences in wages and differences in productivity.  Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-thebottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries.  Prevents rich countries from exploiting developing countries: The argument for protection to prevent people of the rich industrial world from exploiting the poorer people of the developing countries is wrong.

While wage rates in many developing countries are very low, they would be even lower without foreign demand for the goods that these countries produce. Through trade, countries gain access to capital and new technology that will speed development and the growth of living standards.  Reduces offshore outsourcing that sends good U.S. jobs to other countries: When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished goods from other U.S. or foreign firms, they are outsourcing. Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt. The actual number of jobs lost to offshoring is small but these people are hurt even though the overall economy gains.

Does offshoring help or hurt the U.S. economy? A nifty “At Issue” application discusses this issue. It presents the conventional non-economist view that offshoring is bad and contrasts that with the conventional economist view that offshoring is similar to other (beneficial!) international trade.

Does free trade exploit workers in developing countries? Students might be somewhat familiar with the terminology of “exploitation.” Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the © 2023 Pearson Education, Inc.

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condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor.

Why is International Trade Restricted?

Despite arguments against protection, trade is still restricted because key economic interests benefit from protection.  Tariff revenues provide a relatively inexpensive way for the government to collect revenues.  Rent seeking is lobbying and other political activity that seeks to capture the gains from trade. While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers.

Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection.  If the gains from free trade exceed the losses, it is possible to compensate the losers so that everyone can be in favor of free trade. To some extent, unemployment compensation and job-retraining programs are designed to serve this purpose. However, providing compensation is difficult because it is hard to identify exactly who has lost a job as a result of free international trade and not because of other reasons.

Another fable: There is also a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” or “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities.

For further reading: If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, 3rd Edition, 2007, Prentice Hall (ISBN: 0131433547).

The book tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialogue between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism.

Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: --The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains.

--Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade.

--Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage. © 2023 Pearson Education, Inc.

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--International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity can be achieved only through free trade among nations, and that the surplus generated is more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale.

--There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. The section of the chapter entitled “Cases Against Protection” contains concise and complete counter-arguments to the often heard justifications for restraining international trade.

Emphasize that economists overwhelmingly agree that there is no good argument against free trade.

The chapter ends with a new Economics in the News on the impacts of the U.S./China trade war. It focuses on the economic impact of the tariffs each side has imposed on the other and how both sides will win if the tariffs are removed.

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Additional Problems 1.

Suppose that the world price of bananas is 18 U.S. cents a pound and that when Australia does not trade bananas internationally, their equilibrium price in Australia is 12 U.S. cents a pound.

If Australia opens up to international trade, does it export or import bananas? Explain how the price of bananas in Australia changes. How does the quantity of bananas consumed in Australia change? How does the quantity of bananas grown in Australia change?

2.

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. a. Explain how the tariff on textiles will change the price of textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. b. Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

3.

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument?

4.

Use the information below to answer the following question U.S. Expands China Paper Anti-Dumping Tariff Responding to a case brought by the NewPage Corporation of Dayton, Ohio, the U.S. Commerce Department announced it was imposing a tariff of 99.65 percent on imported glossy paper from China. Glossy paper is the type of paper used to manufacture art books, high-end magazines, textbooks, and annual reports. In 2006 imports of glossy paper from China was estimated to be $224 million.

Reuters, May 30, 2007 a. What is dumping? Who in the United States loses from China’s dumping of glossy paper? b. What argument might NewPage Corp. have used to persuade the U.S. Commerce Department to impose a 99.65 percent tariff? c. Explain who, in the United States, will gain and who will lose from the tariff on glossy paper.

How do you expect the prices of magazines and textbooks that you buy to change?

Solutions to Additional Problems 1.

2.

With no international trade, the price in Australia is less than that in the world, so Australia has a comparative advantage in producing bananas. As a result, if Australia opens up to international trade, it will export bananas.

With international trade, the price of bananas in Australia rises. The higher price leads to a decrease in the quantity of bananas consumed in Australia. The higher price also leads to an increase in the quantity of bananas grown in Australia. a.

b.

3.

Higher tariffs increase the price U.S. consumers pay for textiles imported from China. Because the price of Chinese imported textiles rises, the quantity imported decreases. The quantity of textiles produced in the United States increases.

This trade restriction means that the U.S. and Chinese gains from trade definitely decrease. Textile workers and owners of textile firms will gain from the higher price. Textile consumers will lose from the higher price.

Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can © 2023 Pearson Education, Inc.

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compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

4.

a. b.

c.

Dumping is when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper.

Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production.

The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises.

Additional Discussion Questions 1.

How can we know that the benefits to the economy from free trade are greater than the benefits accruing to the domestic industry that is protected from foreign competition? Stress to the students that if unrestrained international trade creates the efficient outcome for both countries involved, it also must mean that prosperity for each country is maximized.  Emphasize that free trade between nations encourages each country to pursue specialization in production in those industries for which the country has a comparative advantage relative to other countries.  If the total quantity of goods and services consumed in each country after international trade is greater than without international trade, then total incomes accruing to individuals must be greater, which means the prosperity of each nation’s economy as a whole is greater under free trade.

2.

How will countries know which domestic industries have a comparative advantage in order to allocate resources towards specialization in producing those goods and services? Specialization and gains from international trade will arise naturally through relative price changes on the world market.  When domestic firms within an industry have a lower opportunity cost of production than firms in other countries, these firms discover that the price they can receive from foreign buyers (importers from other countries) is higher than the price they can receive from domestic consumers. In other words, the domestic price before international trade is lower than the world price. These domestic firms increase output, demand more labor, capital, and raw materials, and resources flow toward these industries.  When domestic firms within an industry have a higher opportunity cost of production than firms in other countries, domestic consumers discover that the price they must pay to foreign sellers for a good is lower than the price they must pay domestic producers. Domestic consumers switch their purchases to foreign imports. The domestic firms producing this good decrease their production, decrease their use of labor, capital, and raw materials, and resources flow away from these firms.  Each country’s economy naturally becomes specialized in producing output in those industries for which the country enjoys a comparative advantage. However, for each country to gain, each country must allow consumers and producers to have free access to foreign markets. © 2023 Pearson Education, Inc.

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3.

Shouldn’t we protect the workers of those industries that are hurt by foreign competition? Point out that protecting the workers in industries for which our country does not have a comparative advantage is akin to making everyone in the economy suffer a lower level of prosperity than under unrestricted trade—all to ensure that a small minority of people does not suffer the economic losses associated with relocating to another community and finding employment in another industry. Use some specific examples in recent history:  In 2002 and 2017, Presidents Bush and Trump raised tariffs on foreign steel by significant amounts. They effectively cost the hundreds of millions of American consumers tens of billions of dollars in higher prices for the myriad of goods containing steel, as well as those goods and services requiring transportation in trucks, trains, airplanes, and ships that are made from steel.

They did this seeking political support from those states with a large presence of steel workers who work for firms that could not make a profit at the unregulated world market price of steel.

The presidents both claimed that other nations’ steel industries were receiving subsidies and had an “unfair” advantage in production costs, effectively “dumping” steel in the U.S. markets at prices below production costs. Ask the students: What is “unfair” about having foreign governments effectively subsidizing the purchase of automobiles, trucks, and rail and air transportation by hundreds of millions of American citizens? Point out it is only “unfair” to the tens of thousands of steel workers who stand to face job relocation costs of finding work in another industry.  Emphasize that in each of these cases of trade restrictions, the economy as a whole would have gained from free international trade, even if autoworkers and steel workers lost some jobs. When we protect steel, or timber, or sugar, there are many more jobs in the downstream industries that use these inputs than there are jobs being protected. Higher costs limit expansion for those downstream industries. So why do they get protection? Autoworkers and steel workers are groups of people that are much more easily organized and stand to benefit much more individually from trade restrictions than the wide-spread American consumers. The result is successful lobbying efforts to restrict trade to the detriment to all consumers in the American economy.

4.

Discuss the following: Adam Smith told British politicians in the 18th century that they shouldn’t focus so much on producers. Free trade is not about importing so that others will take our exports. The argument “seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce.” But “consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer,” according to Smith.

This idea will have applications as the class studies perfect competition. In the end, competition means that firms make only a normal return and society’s resources are allocated efficiently.

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UTILITY AND DEMAND

The Big Picture Where we have been: Chapter 8 uses marginal utility theory to derive the downward-sloping demand curve introduced in Chapter 3 (and used throughout Chapters 4 to 7). Utility theory will also further explain the factors that change demand. Consumer surplus has been used in multiple chapters and will be reinforced in this chapter to help explain the diamond-water paradox and the difference between total utility and marginal utility.

Where we are going: Chapter 9 presents a parallel analysis of the consumer problem using indifference curves. Each chapter is self-contained, so either can be omitted. Marginal analysis is used in this chapter to describe marginal utility and the utility maximizing choice for consumers. The importance of marginal analysis will be reinforced in future chapters as we move through profit maximization and choice making in factor markets. Chapter 19, which deals with risk, uses some of the concepts from this chapter, although Chapter 19 also is self-contained.

New in the Fourteenth Edition The data in the Economics in Action case study on maximizing utility from streaming music have been updated. The example calculates consumer surplus both from downloads and from streaming. The data in the Economics in Action case study on maximizing utility from downloading music have been updated and now cover the growth in streaming video subscriptions during the Covid-19 pandemic. Using hypothetical marginal utility data, the example calculates the marginal utility per dollar from various streaming sources to explain what the consumer will do during the pandemic and afterwards.

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Lecture Notes

Utility and Demand  



I.

Economists assume that people behave to make themselves as well off as possible.

Consumption possibilities tell us what the consumer can afford to buy given a limited income and the prices of the goods and services they are considering.

Preferences are reflected in the discussion of utility maximization

Consumption Choices 

Consumption possibilities are all the things a consumer can afford to buy.

The Budget Line   



The limits of consumption possibilities are illustrated with a budget line.

The budget line marks the boundary between those combinations of goods and services that the consumer can afford to buy and those that it cannot afford.

The budget line shown illustrates the possible combinations of pizza and books that a consumer with $50 income could purchase if the price of pizzas were $10 and the price of books were $10.

The budget line constrains choices: Points on the budget line and inside the budget line are affordable and within the consumer’s consumption possibilities. Points beyond the budget line are not affordable.

Changes in Consumption Possibilities    

Consumption possibilities change when income or prices change.

An increase in income shifts the budget line rightward without changing its slope.

A change in the price of one of the goods changes the intercept on its axis and changes the slope of the budget line.

These changes are used again in the alternate consumer choice model in chapter 9.

Preferences 

The choice a consumer makes depends on preferences.

Total utility 



Total utility is the total benefit that a person gets from the consumption of goods and services.

As more of a good or service is consumed, total utility increases.

The table provides an example of utility from consuming movies and paperback books in a given week.

Quantity of movies 0 1 2 3 4 5 6

Total utility 0 24 44 72 80 84 86

Quantity of books 0 1 2 3 4 5 6

Total utility 0 20 30 38 44 48 50

Where do the utility numbers come from? Year after year, you will get this question from the curious student. While the numbers for utility are ordinal rather than cardinal, using those terms to explain utility to undergraduates will generally result only in many blank stares. To help with one answer to this question, try the following story: Lisa likes movies and books. We tell Lisa that we’re going to call the utility she gets from 1 movie a month 24 units of utility. © 2023 Pearson Education, Inc.

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Then we ask her to tell us, using the same scale, how much she would like 2, 3, or more movies, and 1, 2, 3, or more books.

Marginal Utility 



Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. The table shows the marginal utility from movies.

When a good generates value, it has a positive marginal utility. Total utility increases as the quantity consumed increases.

Total utility 0

1

24

2

44

3

72

4

80

Marginal utility 24 20 18

Diminishing Marginal Utility 

Quantity of movies 0

Diminishing marginal utility is the principle that as more of a good or service is consumed, its marginal utility decreases. In the table the marginal utility diminishes as more movies are consumed.

8

II. Utility-Maximizing Choice 



A consumer’s choices influence the total level of his or her utility because different combinations of goods generate different amounts of utility. The key assumption of marginal utility theory is that the household consumes the combination that maximizes its utility.

We have to combine the constraint imposed by the budget line with the consumer’s preferences to find the combination of products that gives the consumer the maximum available utility.

Consumer Equilibrium 

Consumer equilibrium occurs when a situation in which a consumer has allocated all available income in a way that maximizes utility given the prices of the products.

A Spreadsheet Solution 



The most direct way to find the quantity of goods Quantity of Total Quantity Total and services is to make a table with the choices movies utility of books utility available. Suppose the price of a movie is $8, the 0 0 0 0 price of a book is $4, and the consumer has 1 24 1 20 income of $24.

2 44 2 30  Calculate the combinations of products that 3 72 3 38 exhaust the available income given the prices 4 80 4 44 of the goods. In the table, the consumer can 5 84 5 48 afford (3 movies/0 books), (2 movies/2 6 86 6 50 books), (1 movie/4 books), and (0 movies/6 books). While the consumer can also afford the combinations of products inside the budget line, the smaller quantities associated with those points would have less utility than the points on the budget line.  From the utility figures given for each product, calculate the total utility from the combination of the two products. In the same order as the affordable combinations above, these total utilities are 72, 74, 68, and 50. Emphasize that it is total utility from the combination of the two products that the consumer is trying to maximize.  Select the combination that gives the maximum total utility, (2 movies/2books for total utility of 74) in this case.

While in a model we might calculate the total utility from all the possible combinations of products and then select the combination with the highest utility, this is not a likely approach for consumers in practice. © 2023 Pearson Education, Inc.

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

A more natural way to find the consumer equilibrium is to use marginal analysis to make the decision.

Choosing at the Margin   

A consumer’s utility is maximized when the consumer spends all available income and equalizes marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

If the consumer is left with money to spend, opportunities for increasing utility are left unused, so the consumer can only be maximizing utility when all available income is spent.

The table to the Marginal Marginal right has the Quantity Marginal utility per Quantity Marginal utility per marginal utility of movies utility dollar of books utility dollar schedules that are 1 22 2.75 1 15 4.75 computed from 2 18 2.25 2 9 2.25 the total utility 3 13 1.63 3 7 1.75 schedules in the 4 6 0.75 4 5 1.25 table above. (The 5 3 0.38 5 3 0.75 marginal utilities are the averages of the two adjacent marginal utilities for each quantity.) Given the price of a movie of $8, the price of a paperback book of $4, the table also has the marginal utility per dollar schedules. Assume the consumer has $24 to allocate between movies and books. To maximize utility, the individual buys 2 movies and 2 books because that combination of movies and books spends all the available income and sets the marginal utility per dollar from a movie equal to that from a book. (Both equal 2.25.)

Do people really calculate and compare marginal utilities and prices? One of the challenges in teaching the marginal utility theory is getting the students to appreciate the fundamental role of a model of choice. The goal is to predict choices, not to describe the thought processes that make them. Gary Becker has made the following point, updating the reference to the pitcher (from Parkin, Economics, first edition, 1990, p. 154): Roger Clemens won more Cy Young awards (seven!) for pitching than any other pitcher. He effectively knew all the laws of motion, of hand-eye coordination, about the speed of the bat and ball, and so on. He was in fact solving a complicated physics problem when he stepped up to pitch, but obviously he did not have to know physics to do that. Likewise, when people solve economic problems rationally they’re really not thinking, “Well, I have this budget and I read this textbook and I look at my marginal utilities and the prices and determine what maximizes my utility.” People don’t do that, but it doesn’t mean they’re not being rational. Just because a Cy Young Award winner isn’t Albert Einstein doesn’t mean he can’t make rational decisions about pitching. 

The rule to spend all income and equalize marginal utility per dollar from each good maximizes utility because anytime the marginal utility per dollar from one good exceeds that of another good, the consumer can increase his or her total utility by spending a dollar less on the good with the lower marginal utility per dollar and spending the dollar on the good with the higher marginal utility per dollar.

Counterexamples can help. To help the students see that maximizing total utility requires equalizing the marginal utility per dollar on each good, work with the case when they are not equal. Suppose the marginal utility per dollar from a movie is 20 and the marginal utility per dollar from a soda is 10. Ask “If you gained an additional dollar, what would you spend it on and by how much would your total utility increase?” The students will spend it on movies and their total utility will rise by 20. Now ask the students “If you lost a dollar, what you cut back on and how much would your total utility decrease?” The students will cut back on sodas and their total utility will fall by 10. Now tell the students that they can gain a dollar by cutting back a dollar on sodas. Ask them the net change in their total utility, which is +10. The point to make is that anytime the marginal utility per dollar from one good differs from that for another good, consumption can be rearranged by cutting back on the good with the low marginal utility per dollar and spending the dollar on the good with the high marginal utility per dollar and increasing total utility.

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Why don’t consumers simply choose the goods with the highest marginal utility? Students will find it relatively easy to simply memorize the rule that maximizing utility requires that the marginal utility per dollar is equal across all goods, but, intuitively, students still often expect marginal utility to be the only determinant of utility maximization. To provide some additional intuition, ask them to think about two goods they’re trying to choose between, like a new shirt and a new download of a song. Say a new shirt would have a marginal utility of 20, while the download would have a marginal utility of 1. The price of a new shirt is $30, while the price of the download is $1. Should you purchase the new shirt because it has a higher marginal utility? No! You may prefer the shirt, but it costs thirty times as much as the download. Even though the download has the lower marginal utility, it has a higher marginal utility per dollar (1 as opposed to 2/3).

The Power of Marginal Analysis 



The goal of maximizing utility does not require a computer and spreadsheet, but simply comparing the marginal utility per dollar of each of the products.

In the example the person’s choice between movies and books, the person maximizes his or her utility where the marginal utility per dollar from movies is equal to the marginal utility per dollar from books.

Mathematically, this is represented by the equation:

Other applications of marginal reasoning. Help your students to appreciate that marginal reasoning is one of the most important tools for understanding the economic perspective. Remind them that we have been using marginal reasoning for many chapters now: In Chapter 2 we derived the marginal cost of production from the PPF. In Chapter 5 we discovered that competitive equilibrium is efficient because marginal social benefit (from the demand curve) equals the marginal social cost (from the supply curve). In this chapter, we discover that equating the marginal utility per dollar across all goods and services maximizes a consumer’s utility. More generally, marginal analysis shows that if the marginal gain from an action exceeds the marginal loss, take the action.

Revealing Preference  

We don’t have to ask a consumer to state preferences because we can figure them out by observing what is purchased at various prices.

The units we use to measure preference don’t matter. Any arbitrary unit will work; for instance, if utility is multiplied by 2, the marginal utility per dollar equation shows that the equilibrium consumption bundle does not change.

III. Predictions of Marginal Utility Theory Marginal utility theory predicts the law of demand. It also predicts that a decrease in the price of a substitute good increases the demand for the good; and, for a normal good, an increase in income increases demand.

A Fall in the Price of a Movie A Change in the Quantity Demanded 

If the price of a good falls and other things remain the same, the marginal utility per dollar from that good rises. As a result, the consumer increases his or her purchases of that good in order to maximize utility. (As more of the good is purchased, its marginal utility decreases; as less of other goods are purchased, their marginal utilities increase. Eventually the consumer reaches a new equilibrium at which the marginal utility per dollar for all the goods is equal.)

A Change in Demand 

When the price of a good falls, it will have an impact on the demand for related goods (substitutes and complements in consumption). In the example above, when movie prices fall, the demand for paperback books decreases, implying that movies and books are substitute goods. © 2023 Pearson Education, Inc.

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A Rise in Income 

If a consumer’s income increases, the consumer will reach a new consumer equilibrium in which all the income is spent and the marginal utility per dollar from all goods is equal. Marginal utility theory predicts that as the consumer’s income increases, the demand for normal goods increases and the demand for inferior goods decreases.

Paradox of Value 





The paradox of value is that water, which is essential to life, costs little, but diamonds, which are useless in comparison to water, are expensive.

The resolution to this paradox comes from distinguishing total utility from marginal utility. The total utility from water is much more than from diamonds. But we have so much water that its marginal utility is small.

And we have so few diamonds that their marginal utility is high. When a household maximizes its utility, it makes the marginal utility per dollar equal for all goods. Because diamonds have a high marginal utility, they have a high price. Because water has a low marginal utility, it has a low price.

Consumer surplus also can be used to resolve the paradox as well. The consumer surplus from consuming water is vast but the consumer surplus from consuming diamonds is small.

Temperature as an Analogy   

Temperature and utility are both abstract concepts.

The concept of utility allows economists to make predictions about human choices just as temperature allows predictions of physical phenomena.

Utility may not be as precise a thermometer in making some types of predictions but is still useful.

An Economics in Action case considers the utility from recorded music and looks at the growth of streaming and downfall in downloading music. It compares the consumer surplus obtained from downloads with that obtained from streaming.

IV. New Ways of Explaining Consumer Choices Behavioral Economics 



Behavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influences economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.

There are three impediments to rational choice: bounded rationality, bounded will-power, and bounded selfinterest.

Bounded Rationality 

Bounded rationality is rationality that is bounded by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.

Bounded Willpower 

Bounded willpower is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

Bounded Self-Interest 

Bounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others.

The Endowment Effect 

The endowment effect is the tendency for people to value something more highly simply because they own it.

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Endowment effect in the housing market: The housing market entered a severe slump in the late 2000s and took years to even begin to emerge. One factor might have been the endowment effect: The price that home buyers were willing to pay for a house is lower than what homeowners, with the endowment effect, believe their home is worth.

Consequently, homes might sit on the market for long periods of time.

Neuroeconomics 

Neuroeconomics is the study of the activity of the human brain when a person makes an economic decision. Different decisions appear to activate different areas of the brain. Some decisions are made in the pre-frontal cortex, which is where memories are stored and data are analyzed. These decisions might be deemed rational. Other decisions are made in the hippocampus, which is where memories of anxiety and fear are stored. These decisions might be deemed irrational.

Controversy 

Whether economics should focus on explaining the decisions we observe or on what goes on inside people’s heads is the source of controversy.

How did consumers’ moving viewing respond to the Covid-19 pandemic? The chapter closes with an Economics in the News analysis that considers this question using data on U.S. prices for various streaming services and some hypothetical data on marginal utility. The consumer’s choices during and after the pandemic are examined.

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Additional Problems 1.

Mary enjoys classical CDs and Quantity Total utility from Total utility from travel books and spends $50 a per month classical CDs travel books month on them. The table shows 1 30 30 the utility she gets from each good.

2 40 38 a. Compare the two utility schedules.

3 48 44 Can you say anything about 4 54 46 Mary’s preferences?

5 58 47 b. What do the two utility schedules tell you about Mary’s preferences? c. If a classical CD and a travel book cost $10 each, how does Mary spend the $50 a month?

2.

Rob enjoys rock concerts and the Concerts Marginal utility Marginal utility opera. The table shows the marginal per month from rock concerts from operas utility he gets from each activity.

1 90 120 Rob has $100 a month to spend on 2 80 90 concerts. A rock concert ticket is 3 60 60 $20, and an opera ticket is $10.

4 40 30 How many rock concerts and how 5 20 20 many operas does he attend?

3.

In problem 2, Rob’s uncle gives him $30 to spend on concert tickets, so he now has $130.

How many rock concerts and how many operas does he attend now that he has $130 to spend?

4.

In problem 2, if the price of a rock concert decreases to $10, how many rock concerts and operas will Rob attend?

Solutions to Additional Problems 1.

a. b.

c.

2.

Mary gets the same utility from 1 classical CD as from 1 travel book, but at quantities greater than 1 she gets more utility from any number of classical CDs than she does from the same number of travel books.

Mary receives the same marginal utility from her first classical CD as from her first travel book. At quantities greater than 1, Mary gets more marginal utility from an additional classical CD than she gets from an additional travel book when she has the same number of each.

Mary buys 3 classical CDs and 2 travel books.

When Mary buys 3 classical CDs and 2 travel books she spends $50. Mary maximizes her utility when she spends all of her money and the marginal utility per dollar from classical CDs and travel books is the same.

When Mary buys 3 classical CDs her marginal utility per dollar spent is 0.8 units per dollar and when Mary buys 2 travel books her marginal utility per dollar spent is 0.8 units per dollar.

To maximize his utility, Rob attends 3 rock concerts and 4 opera concerts.

Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 3 rock concerts and 4 operas, he spends $60 on rock concerts and $40 on operas—a total of $100.

The marginal utility from the third rock concert is 60 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 3. The marginal utility from the fourth opera is 30 and an opera ticket is $10, so the marginal utility per dollar from operas is 3. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

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3.

To maximize his utility, Rob attends 4 rock concerts and 5 operas.

Rob will spend his $130 such that all of the $130 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 4 rock concerts and 5 operas, he spends $80 on rock concert tickets and $50 on operas—a total of $130.

The marginal utility from the fourth rock concert is 40 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from opera is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

4.

To maximize his utility, Rob attends 5 rock concerts and 5 operas.

Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 5 rock concerts and 5 operas, he spends $50 on rock concert tickets and $50 on opera tickets—a total of $100.

The marginal utility from the fifth rock concert is 20 and a rock concert ticket is $10, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from operas is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

Additional Discussion Questions 1.



Have you ever eaten or drank “too much”? Use the students’ personal experience with food or drink to show them that the marginal utility for a good can be increasing, diminishing, or even negative.

The example works well for many types of food and drink consumption, but college students often especially enjoy sharing their experiences (or their friends’ experiences) with alcohol.

Can alcohol consumption exhibit increasing marginal utility? The first drink may not induce the euphoric feeling that many students seek, but two drinks might, with the third drink increasing the euphoria even more than the second drink. In this range of consumption, the student experiences increasing marginal utility. Point out that this increasing marginal utility isn’t likely to last forever.

Can alcohol exhibit diminishing marginal utility? By the fourth or fifth drink of the evening, the additional euphoria from each drink is not as much as the prior drink, meaning the student is in the zone of diminishing marginal utility.

Can alcohol exhibit negative marginal utility? After the fifth or sixth drink for the evening, most students quickly feel the discomfort of intoxication and suffer a significant decline in euphoria mixed with a significant increase in discomfort and disorientation. Continued consumption of alcohol can eventually bring the onset of alcohol poisoning, when the body starts to reject further intake of alcohol by ejecting the excess alcohol. Most students would agree that, at that point, an additional drink would generate negative marginal utility.

2.

If the Surgeon General (and the American Medical Association) concludes that moderate wine and beer consumption can have a positive influence on cardiovascular health, how will utility and demand be affected? Ask the students to use utility theory to explain how changes in the marginal utility of beer and wine consumption will cause the demand for beer and wine to increase, despite unchanged short-run prices or consumer incomes.

3.

Would people voluntarily pay for something seemingly undesirable? Get students to see that the utility they get from one good is oftentimes dependent on the level of other goods and services consumed.

Ask the students to use utility theory to explain: 1) Why do people regularly put themselves through undesirable, rigorous exercise programs? (better health increases our marginal utility of engaging in other activities) © 2023 Pearson Education, Inc.

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2) Why do students forgo lots of leisure time to take college classes? (better education increases our appreciation of the world and allows us make better choices in our lives) Help the students see that consumers invest in apparently undesirable goods the same way society invests in capital to increase future consumption—except it is human capital that consumers are investing in.

4.

How could utility theory help us understand the difference between a federal income tax and a federal sales tax on consumer consumption patterns? This is a real-world application of utility theory designed to boost student confidence.  Mention that federal sales tax proponents point out that sales taxes do not penalize savings whereas income taxes penalize both savings and consumption, motivating consumers to save less and consume more.  Recall how Chapter 2 used the production possibilities frontier model to show that higher present consumption and lower present investment (which is largely based on savings) decreases future consumption for society through slower economic growth.  Explain how consumers allocate their income across affordable consumption and savings combinations by equating the ratio of marginal utility per dollar for both. If the same tax revenue was collected by a federal sales tax rather than the income tax, the tax price for savings would decrease and the tax price for consumption would increase. (Make sure you explain that “savings” is an example of a “good.” In the examples used in the text, there is no savings. All income is spent on goods. When savings exists, not all of a consumer’s income is spent, but all of the income is allocated to either consumption goods or savings.)  Show how consumers adjust these ratios by increasing the marginal utility of consumption through less consumption and decreasing the marginal utility of savings by saving more. Utility is maximized at a higher level of savings when consumption is penalized through a consumption tax instead of an income tax.

5.

How does utility theory differentiate a “need” from a “want”? If you are really in the mood for a very heated discussion on utility analysis, just ask the students what the marginal utility function for a “necessity” looks like. The students should recognize that it is perfectly vertical, where no increase in price is sufficiently large to cause the person to decrease consumption of a necessity in order to equate the marginal utility per dollar ratios across all goods and services. All income is spent on necessity until the consumer is sated, and remaining income is allocated across goods and services until the marginal utility per dollar ratios equalize. (This type of a utility function reflects lexicographic preference orderings.)

Is a vertical utility function a reasonable outcome to expect for any good, even medicine or food? Point out that even the poorest of people allocate their meager incomes across more than just one good or service (the necessities). Somehow the income is allocated despite the supposed vertical marginal utility curve.

How is income allocated across multiple “necessities” if all have vertical marginal utility functions?

Point out that if there is more than one “necessity,” then there is more than one marginal utility function involved in allocating income. Help students to recognize that because in the real world the poor allocate their income across multiple goods, then the marginal utility per dollar ratios involved cannot be vertical, but they may be very steep. Emphasize that for these consumers to maximize their utilities, each of the marginal utility per dollar ratios will need to be equalized, making the income allocation process indistinguishable from mere “wants.”

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Is it even meaningful to differentiate needs from wants among multiple goods or services? There is no positive answer to this question—only a normative one. Utility analysis has just proven that there is no positive definition of a necessity. Now step back and let the sparks fly!

It is often difficult to create incentives for behavior that is very good for us in the long run but not necessarily pleasurable in the short run (studying, eating right, and exercising) and disincentives for activities that lead to future pain but present pleasure (smoking, eating whatever is convenient and tasty, sleeping through class). Have students suggest possible incentives/disincentives that they think might address this problem. Attendance and being prepared for class, eating right and moving more, and all kinds of other things promote our long run best interests but we live in world where diabetes is a growth industry and where many students think that access to notes in classroom technology packages means they don’t need to attend or read the book. What do they think would work, both personally and at the level of social policy? How does this relate to marginal utility theory?

Type 2 Diabetes is often related to poor diets and lack of exercise. If it is avoidable, how does the material in this chapter help us understand why it is on the rise around the world? The answer to this question might well be related to bounded rationality.

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POSSIBILITES, PREFERENCES, AND CHOICES

The Big Picture Where we have been: This chapter, along with Chapter 8, examines the consumer choices that underlie the law of demand.

Budget lines were introduced in Chapter 8 and are more fully explored in this chapter. This chapter shows how the substitution effect combined with the income effect for a normal good always leads to the downward-sloping demand curve, which was assumed in Chapter 3. The concept of slope, as explained in Chapter 1 (appendix), is used to show that in equilibrium the MRS equals the relative price of the goods.

Where we are going: Chapters 10 and 11 study the theory of the firm and the firm’s costs, and Chapters 12 through 15 look at firm behavior in different market structures.

New in the Fourteenth Edition The material in this chapter is similar to the last edition, but the case studies have been updated. The chapter opener considers how we can be encouraged to limit consumption of sugary drinks and why video streaming hasn’t completely replaced movie theaters, both of which are addressed in later examples. The Economics in Action about how we watch movies has been updated. The concluding Economics in News analysis considers how and why a tax imposed on sugary drinks will lead to decreased consumption of these drinks.

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Lecture Notes

Possibilities, Preferences, and Choices 



I.

A person’s budget in combination with his or her preferences determines what goods and services the person consumes.

Using the budget line and indifference curves, economists can predict how changes in the price of a good or service affect the quantity a person demands.

Consumption Possibilities

 

 

A household’s consumption choices are constrained by its income and the prices of the goods and services available. A household’s budget line describes the limits to its consumption choices.

The figure to the right shows a budget line for a household that buys only pizzas and books. The household can buy any combination of pizza and books that lies on or within the budget line. Combinations that lie beyond the budget line are unaffordable.

Divisible goods can be bought in any quantity and we can best understand household choices if we assume all goods are divisible.

The budget line illustrates a constraint on choices. Any point on or inside the line can be purchased. Any point outside the line is unaffordable and cannot be purchased.

Budget Equation  





 

We can describe the budget line by using a budget equation, which states that income equals expenditure.

Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the quantity of pizza QP, and income Y, we can write a budget equation as PB  QB + PP  QP = Y, which can be rearranged into slope-intercept form as QB = Y/PB  (PP /PB )  QP. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. In the figure above, in terms of books, the household’s real income is Y/PB (5 books), which is the vertical intercept of the budget line.

A relative price is the price of one good divided by the price of another good. The magnitude of the slope of the budget line, (PP /PB ), is the relative price of a pizza in terms of a book. A relative price is an opportunity cost, so the relative price of a pizza in terms of books gives the opportunity cost of a pizza in terms of books forgone.

When the price of the good measured along the horizontal axis (pizzas) changes, the budget line rotates around the vertical intercept. If the price of the good falls, the budget line rotates outward and becomes flatter; if the price of the good rises, the budget line rotates inward and becomes steeper.

When income changes, the budget line shifts and its slope does not change. If income increases, the budget line shifts outward; if income decreases, the budget line shifts inward.

Example: The budget line as a menu. Emphasize that the consumer’s budget line is like that part of a menu that delineates all affordable combinations of food and drinks that are available to the consumer given a budget.

If you want to push this analogy, have the students assign a price to each of the two goods and then choose a level of income to be spent on the dinner. Draw the budget line and then have the students show how a rise in the price of drinks or the price of food would rotate the budget line and change relative prices. Then have the students help you illustrate how an increase in income shifts the budget line allowing more food (perhaps dessert) and the second glass of wine. © 2023 Pearson Education, Inc.

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II. Preferences and Indifference Curves  

A preference map shows how a person ranks various combinations of goods and services.

Indifference curves are used to illustrate a person’s preference map. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. The figure to the right shows three of a person’s indifference curves between pizza and books.  By construction the consumer is indifferent among all the points on any particular indifference curve.  The consumer prefers points above any particular indifference curve to points on the curve. And the consumer prefers points on the indifference curve to points below the curve. In the figure, the consumer prefers any point on indifference curve I2 to any point on I1 and any point on I3 to any point on I2.

Marginal Rate of Substitution 

The marginal rate of substitution (MRS) is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remaining indifferent (remaining on the same indifference curve).  The magnitude of the slope of the indifference curve at any point measures the marginal rate of substitution between the goods. If the indifference curve is steep, the MRS is high; if the indifference curve is flat, the MRS is small.  The diminishing marginal rate of substitution is the general tendency for a person to be willing to give up less of good y to get one unit of good x, and at the same time remain indifferent, as the quantity of x increases. This principle implies that indifference curves generally become flatter moving along them to the right.

Degree of Substitutability   

The indifference curves between most goods are bowed in, with a diminishing MRS. The indifference curves for perfect substitutes are linear, with a constant MRS. The indifference curves for perfect complements are L-shaped. Utility increases (the consumer moves to a higher indifference curve) only if the quantity of both goods x and y increases.

Perfect substitutes or just substitutes? Students will remember discussions of substitutes and complements in consumption from Chapter 3, and often don’t see how “perfect” substitutes or complements are any different. Be sure to use examples to show how, even for most goods that are considered substitutes (or complements), the MRS will still be diminishing. Only when a consumer’s willingness to trade one good for the other is constant (i.e., MRS is linear) are two goods considered “perfect” substitutes. Similarly, you may drink cream in your coffee, implying coffee and cream are complements, but they’re not likely to be “perfect” complements. A cup of coffee without cream may still be better (increase your utility) than no coffee at all.

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III. Predicting Consumer Choices Best Affordable Choice 



The consumer will select his or her best affordable point. This point:  is on the budget line,  is on the highest attainable indifference curve,  has a marginal rate of substitution between the two goods equal to the relative price of the two goods.

The figure shows the best affordable point, 2 pizzas and 3 books. This combination is on the budget, and hence is “affordable.” It also is on the highest indifference curve so that the marginal rate of substitution equals the relative price of the two goods, and hence the point is “best.”

The meaning of tangency. Emphasize to your students the meaning behind the tangency point between the indifference curve and the budget line. In particular, the marginal rate of substitution (MRS) shows the consumer’s willingness to give up one good to get more of the other good. The relative price of the two goods shows what the consumer must give up one good to get more of the other good. When a consumer equates the marginal rate of substitution (MRS) to the relative price ratio, the consumer is just willing to give up what he or she must give up, and there are no unrealized gains from substituting one good for another.

A Change In Price  



The price effect shows how a change in the price of a good affects the quantity consumed of that good.

When the price of the good on the x-axis falls, the budget line rotates around the y-axis intercept and becomes flatter. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: It is on the new budget line, it is on the highest attainable indifference curve, and the MRS equals the slope of the new budget line.

When the price of a good changes, tracking the change in the quantity of the good consumed reveals the demand curve for that good.

The Economics in Action case study considers how the best affordable combination of movies, DVD rentals, and video streaming have changed over time, largely due to changes in prices, first in the DVD rental market and now with Netflix and video streaming. Have students illustrate this result for themselves, shifting the budget line between movies and streaming and seeing what the new equilibrium might look like.

A Change In Income  

 

The income effect shows how a change in income affects the buying plans of consumers.

When the price of the goods remains constant, a change in income shifts the budget line. This shift changes which indifference curve is highest attainable indifference curve. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: it is on the new budget line; it is on the highest attainable indifference curve; and the MRS equals the slope of the new budget line.

A change in income shifts the demand curve, because a different quantity is consumed at the same prices.

If income rises and more is consumed at each price (or if income falls and less is consumed at each price) the good is a normal good.

Substitution Effect and Income Effect 

For a normal good, a rise in price always decreases the quantity consumed. This result is shown by breaking the price effect into two parts, as illustrated in the figure in which the price of movies rise: © 2023 Pearson Education, Inc.

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The substitution effect is the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one.

The substitution effect is showing by moving the new budget line (with its new slope) so that it is tangent to the initial indifference curve. This procedure creates a (hypothetical) new best affordable point using the initial indifference curve and the hypothetical budget line.

Comparing the initial best affordable point to this new one captures the substitution effect. In the figure this compares point a to point b. The substitution effect of a rise in price always leads to a decrease in the quantity consumed.

The income effect is the effect on the quantity bought of a change in income sufficient to shift the hypothetical budget line used to measure the substitution effect, so that it is the same as the actual new budget line. This process is the movement from point b to point d in the figure. For a rise in price, this change requires a decrease in income. For a normal good, the decrease in income decreases the quantity consumed. So for a normal good, the substitution effect and the income effect reinforce each other: both demonstrate that the quantity consumed decreases. For an inferior good, the decrease in income increases the quantity consumed. So for an inferior good, the substitution effect and the income effect have opposite effects on the quantity consumed. It is theoretically possible for the income effect to be large enough that the rise in the price of the good results in an increase in the quantity demanded. But such a case has not been observed in reality.

Income and substitution effects: two separate influences over demand. Income and substitution effects are typically difficult concepts for students to grasp. Be sure that the students understand how a change in a good’s price causes two separate influences on a consumer’s purchase decision: i) a higher (lower) price raises (lowers) the opportunity cost of that good, making that good less (more) attractive than all other goods; and ii) a higher (lower) price means less (more) of all goods and services is affordable, causing the quantity demanded for all normal goods to decrease (increase). A consumer may not think of each effect individually when making consumption decisions, but both effects will have an impact.

Can the income effect for an inferior good ever dominate the substitution effect? Many economists have studied the infamous potato famine in Ireland in the mid-19th century in search of the elusive “upward-sloping demand curve” associated with strongly inferior goods. Indeed, when food became even scarcer than usual in that poverty-stricken country, historical records indicate that Irish families consumed a greater quantity of potatoes as the market price of potatoes increased. Many economists were misled into thinking they had found historical evidence of the world’s first recorded positively-sloped demand curve! However, they failed to remember their basic economics: it is the relative price of potatoes that is tracked on the demand curve for potatoes, not the money price. The money price of potatoes rose more slowly than the prices of other foods. This change lowered the relative price of potatoes to Irish families and so the quantity they consumed increased, in accord with the law of demand. Although some experimental evidence exists to show that demand curves with a positive slope might exist, there are no good real-world examples.

An Addendum: Relationship between MRS and MU ratios: If you’ve covered both the marginal utility theory (from Chapter 8) and indifference curve theory of consumer choice in this chapter--and you’re teaching an honors section of economics majors--you might want to spend a bit of time demonstrating the equivalence of the two sets of results.

The basic analysis that you might cover is the following: In marginal utility theory, total utility is maximized when MUM /PM = MUS/PS. (the subscript M stands for movies and the subscript S stands for sodas to be consistent with the textbook example) © 2023 Pearson Education, Inc.

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In indifference curve theory, the consumer is at the best affordable point when the marginal rate of substitution of movies for soda equals the relative price of movies in terms of soda. That is: MRS = PM /PS These two propositions are equivalent. To see why, there are a couple of ways to explain this. If your students are particularly good at math, begin with the fact that the change in total utility can be written as: Change in Total Utility = MUM  QM + MUS  QS where  means “change in” and QM and QS are the quantities of movies and soda.

Because a consumer is indifferent between any pair of points along an indifference curve, you can think of an indifference curve as a constant utility curve. So along an indifference curve, the change in total utility is zero. When the change in total utility is zero, 0 = MUM QM + MUS  QS, And so MUM  QM = –MUS  QS. Now divide both sides of this equation by QM and also divide both sides by MUS to obtain: QS /QM = -MUM /MUS Notice that the left-hand side of the last equation is the change in soda divided by the change in movies along an indifference curve, which is the slope of the indifference curve. But the magnitude of the slope of an indifference curve is the marginal rate of substitution. So, MRS = MUM /MUS That is, the marginal rate of substitution of movies for soda is the ratio of the marginal utilities of movies and soda.

Alternatively (or even in addition), many students appreciate an intuitive explanation of the relationship between the MRS and MUM /MUS. Simply start with the marginal utility of a movie equal to some number (20, for example). If the consumer would like a soda half as much as a movie, then the marginal utility of a soda would be 10 in that example. In that case, MUM /MUS = 20/10 = 2.

Then ask students if they could answer the following question: “How many sodas would the consumer be willing to give up for a movie?” Most students will see that the movie is worth 2 sodas. This is simply the definition of the marginal rate of substitution, and it will always be the case that the ratio of marginal utilities will be equal to the marginal rate of substitution.

Regardless of the method you use to show that MRS = MUM /MUS, the main point is that the consumer chooses the best affordable point by making the MRS equal the relative price. But that is the same as MUM /MUS = PM /PS. Multiply both sides of this equation by MUS and divide both sides by PM to obtain the marginal utility theory proposition: MUM /PM = MUS /PS. Economics in the News at the end of the chapter considers how and why a tax can lead consumers to reduce their consumption of unhealthy sugary drinks.

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Additional Problems 1.

Marc has an income of $20 per week. Root beer costs $5 a can and CDs cost $10 each. Figure 9.1 illustrates his preferences. a. What are the quantities of root beer and CDs that Marc buys? b. What is Marc’s marginal rate of substitution of CDs for root beer at the point at which he consumes?

2.

Now suppose that in the situation described in problem 1, the price of a CD falls to $5 and the price of root beer and Marc’s income remain constant. a. Find the new quantities of root beer and CDs that Marc buys. b. Find two points on Marc’s demand curve for CDs. c. Find the substitution effect of the price change. d. Find the income effect of the price change. e. Are CDs a normal good or an inferior good for Marc?

3.

Pete buys tuna and golf balls. The price of tuna is $2 a can, and the price of a golf ball is $1.

Each month, Pete spends all of his income and buys 20 cans of tuna and 40 golf balls. Next month, the price of tuna will rise to $3 a can and the price of a golf ball will fall to 50¢.

Assume that Pete’s preference map shows indifference curves have a bowed in shape so that they show a diminishing marginal rate of substitution. a. Will Pete be able to buy 20 cans of tuna and 40 golf balls next month? b. Will Pete want to buy 20 cans of tuna and 40 golf balls? c. Which situation does Pete prefer: tuna at $2 a can and golf balls at $1 each or tuna at $3 a can and golf balls at 50¢ each? d. If Pete changes the quantities that he buys, which good will he buy more of and which less of? e. When the prices change next month, will there be an income effect and a substitution effect at work or just one of them?

4.

The sales tax is a tax on goods. Some people say that a consumption tax, a tax on both goods and services, would be better. Explain and illustrate with a graph what would happen if we replaced the sales tax with a consumption tax to a. The relative price of books and haircuts. b. The budget line showing the quantities of books and haircuts you can afford to buy. c. Your purchases of books and haircuts.

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Solutions to Additional Problems 1.

a.

b.

2.

a.

b. c.

d.

e.

3.

a.

b.

c. d.

e.

Marc buys 2 cans of root beer and 1 CD. Marc buys the quantities of root beer and CDs that moves him onto the highest indifference curve, given his income and the prices of root beer and CDs. The graph shows Marc’s indifference curves. So draw Marc’s budget line on the graph. The budget line is tangential to indifference curve I0 at 2 cans of root beer and 1 CD. The indifference curve I0 is the highest indifference curve that Marc can get attain.

Marc’s marginal rate of substitution is 2. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Marc’s consumption point, which equals the magnitude of the slope of the budget line. The slope of Marc’s budget line is 2, so the marginal rate of substitution is 2.

Marc buys 1 can of root beer and 3 CDs. Draw the new budget line on the graph with Marc’s indifference curves. The budget line now runs from 4 CDs on the x-axis to 4 cans of root beer on the y-axis. The new budget line is tangential to indifference curve I1 at 1 can of root beer and 3 CDs. The indifference curve I1 is the highest indifference curve that Marc can now get attain.

Two points on Marc’s demand curve for CDs are the following: At $10 a CD, Marc buys 1 CD. At $5 a CD, Marc buys 3 CDs. The substitution effect is 1 CD. To divide the price effect into a substitution effect and an income effect, take enough income away from Marc and gradually move his new budget line back toward the origin until it just touches Marc’s indifference curve I0. The point at which this budget line just touches indifference curve I0 is 2 CDs and 0.5 can of root beer. The substitution effect is the increase in the quantity of CDs from 1 CD to 2 CDs along the indifference curve I0. The substitution effect is 1 CD. The income effect is 1 CD. The income effect is the change in the quantity of CDs from the price effect minus the change from the substitution effect. The price effect is 2 CDs (3 CDs minus the initial 1 CD).

The substitution effect is an increase in the quantity of CDs from 1 CD to 2 CDs. So the income effect is 1 CD. CDs are a normal good for Marc because the income effect is positive.

Pete can still buy 20 cans of tuna and 40 golf balls. When Pete buys 20 cans of tuna at $2 a can and 40 golf balls at $1 each, he spends $80 a month. Now that the price of a can of tuna is $3 and the price of a golf ball is $0.50, 20 cans of tuna and 40 golf balls will cost $80. So Pete can still buy 20 cans of tuna and 40 golf balls.

Pete will not want to buy 20 cans of tuna and 40 golf balls because the marginal rate of substitution does not equal the relative price of the goods. Pete will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price.

Pete prefers tuna at $3 a can and golf balls at $0.50 each because he can get onto a higher indifference curve than when tuna is $2 a can and golf balls are $1 each.

Pete will buy more golf balls and fewer cans of tuna. The new budget line and the old budget line pass through the point at 20 cans of tuna and 40 golf balls. If cans of tuna are plotted on the x-axis, the marginal rate of substitution at this point on Pete’s indifference curve is equal to the relative price of a can of tuna at the original prices, which is 2. The new relative price of a can of tuna is $3/50 cents, which is 6. That is, the budget line is steeper than the indifference curve at 20 cans of tuna and 40 golf balls. Pete will buy more golf balls and fewer cans of tuna.

There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant. © 2023 Pearson Education, Inc.

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a.

b.

c.

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Books are goods and so are taxed under both a sales tax and a consumption tax. Haircuts are services and so are taxed only under a consumption tax. If the sales tax is replaced with a consumption tax, the relative price of a haircut rises and the relative price of a book falls.

Assuming the sales tax and consumption tax are the same rate, in the figure the budget line rotates inward around a fixed book intercept. In Figure 9.2, the new budget line is BL1. The price of a book does not change but the price of a haircut rises.

In general, if the relative price of a haircut rises and the relative price of a book falls, the substitution effect leads consumers to buy more books and fewer haircuts.

There is, however, also an income effect. The consumer’s real income falls, which decreases the demand for normal goods. Assuming that both books and haircuts are normal goods, then the income effect offsets the substitution effect of buying more books but reinforces the substitution effect of buying fewer haircuts. In the figure, with the sales tax and budget line BL0 the consumer is initially at point A and buys 20 books per year and 4 haircuts per year. With the consumption tax and budget line BL1 the consumer moves to point B and buys 15 books per year and 3 haircuts per year.

Additional Discussion Questions 1.

2.

3.

How does an increase in the price of basic food staples affect real income in poor countries? Illustrate this with a budget line and hypothetical consumption bundle. Where money incomes are low, increases in food prices can devastate real incomes and the achievable consumption bundle. The budget line, already close to the origin, shifts inward even closer.

How would the preference map shift if a consumer had a strong preference for one of the products versus the other? How might that affect the tangency point? The map tilts to be “long” on the axis of the non-preferred product. Basically to get the person give up a unit of the preferred product, compensation in terms of units of the other product to maintain indifference would be immense.

The tangency is thus likely to be near the axis of the preferred product, which means a large quantity of this good is consumed.

Will a low-income person’s optimal consumption bundle change if he or she receives food stamps?

Have the students apply a normal preference mapping between food and all other goods for a lowincome person. With food on the vertical axis, show that a person receiving food stamps experiences a new, steeper budget line with a higher y-intercept. Show that the person can now afford a greater total amount of food for any given level of other goods, but the maximum amount of all other goods available remains unchanged. Have the students locate the consumption combination that matches the slope of the new budget line with the marginal rate of substitution of the highest indifference curve.

Could the low-income person be better off with an income subsidy of equal value to the food stamp subsidy? Show that if the same level of income were given in place of food stamps, this opens up even more combinations of goods and services than with food stamps. It is impossible not find a higher indifference curve without a very unconventional indifference curve map.

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4.

5.

Could a low-income person be made equally as well off with a lower total income subsidy than the initial food stamp subsidy? Ask them to consider why the government continues to use food stamps instead of income assistance when the same quantity of extra income would bring them even more utility. Ask them why the government doesn’t minimize total welfare assistance expenditures by giving them just enough income to maintain a consumption bundle on the same indifference curve as with the current food stamp expenditures. Students should recognize that part of the government’s intention is to control the type of items purchased with food stamps. If low-income households were simply given cash subsidies, the costs of the welfare system would be lower, but not all low-income households would spend that cash subsidy on food only.

Would the indifference curves of a preference map ever change shape when the prices of goods change?

Marketing managers for Ferrari claim that they would not consider a significant price decrease in the face of falling demand. They worry that the decrease in the perceived “exclusivity” of the brand would diminish the consumer perception of their product and eventually decrease market demand.

Ask the students to model this theory and show how a sharp decline in the price of a Ferrari might causes a change in the consumer’s indifference curves. (The answer is that if Ferraris were placed on the vertical axis, the indifference curves are steeper.)

Would indifference curves ever move whenever the consumer’s income changes? Consumers change their buying habits as they increase their income. They buy cars with leather seats instead of cloth, designer dresses and purses, choose restaurants merely to “be seen” dining there. Does this really represent a change in the preference mapping over consumption possibilities when incomes increase?

Does it change the slope of the indifference curve?

Do perfect substitutes imply perfectly elastic demand? When indifference curves are straight lines, the MRS is almost never equal to the relative price ratio, meaning the consumer selects a “corner solution” (all of one good, or all of another, but not a mix of both). In the case of a relative price change, the consumer immediately switches to consuming only the other good. Ask the students if they have ever observed such peculiar consumer behavior in the real world.

Do perfect complements imply perfectly inelastic demand? When the indifference curves are 90-degree angles, the consumer always purchases the product only in exact proportions. Ask the students if there is any usefulness to separating out the two goods as separate items, or whether it is more meaningful to consider them two necessary components of a single good. For example, we rarely see single shoes being offered for sale, but surely the occasional consumer loses a single shoe, or there are a small number of amputees that need only one shoe. Why is there no market for single shoes? (As a counterexample, Lands’ End actually sells single gloves or mittens to consumers who have lost one of a pair.)

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ORGANIZING PRODUCTION

The Big Picture Where we have been: Chapter 10 introduces students to the firm as a decision maker with an organizational structure and a specific goal. Key ideas in this chapter are recognizing the importance of having access to accurate cost and profitability information for making sound business decisions (learning the difference between economic versus accounting profit) and using the correct notion of efficiency as a criteria for making these decisions (understanding the difference between technological versus economic efficiency).

Where we are going: The chapter provides a clear overview to the key features of the market structures to be studied in the following chapters and will help students to be able to compare and contrast the features as each is introduced. Understanding the nature of the firm allows students to gain a better appreciation of those chapters, which cover business decisions made by the firm under different market structures.

Chapter 11 introduces the firm’s production function and cost functions. Chapter 12 examines firm performance in a competitive environment, and Chapter 13 explores the firm as a monopoly.

Chapters 13 and 14 look at firm behavior under monopolistic competition and oligopoly. Chapter 18 covers the firm’s decisions in the resource and labor markets.

New in the Fourteenth Edition The HHI measures of concentration are slightly changed. Now an HHI of less than 1,500 is regarded as highly competitive, an HHI between 1,500 and 2,500 is regarded as moderately concentrated, and an HHI greater than 2,500 is considered highly concentrated. Economics in the News application in the chapter has been updated to consider principles and agents at Apple in 2020 when Apple’s revenue and profit exceeded their targets. The end of chapter Economics in News analysis now discusses the expanding market for digital advertising and focuses on Amazon, Facebook, and Google.

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Lecture Notes

Organizing Production   

I.

Firms must organize their production so that it is as efficient as possible.

Firms operate in markets that differ according to the competition within the market.

Firms organize some economic activities while markets are used for other economic activity.

The Firm and Its Economic Problem



The number and scope of business firms in the economy is vast and diverse. A firm is an institution that hires factors of production and organizes those factors to produce and sell goods and services.

The Firm’s Goal 

The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through competition or bought out by other firms seeking to maximize profit.

Do firms really maximize profit? Sometimes firms state they are willing to bear lower profits to expand market share.

Other firms claim to utilize only the “greenest” technology in their production process. Ask the students if these are long term goals or short term objectives for these firms. They should see that maximizing market share or using the latest green technology is an effort to gain greater market power and consumer loyalty in the long run, so that the firm can raise market prices and increase its profits. Remember that the capital necessary to pursue green production methods can only be retained if the firms are able to match the alternative profitable uses for that capital, because the owners of that capital seek out the highest rate of return.

Accounting Profit and Economic Profit  

A firm’s accounting profit is the firm’s revenues minus expenses and depreciation.

A firm’s economic profit is equal to total revenue minus total opportunity cost.

A Firm’s Opportunity Cost of Production 



A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.

Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.  For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital. The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital.  The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.

Is economic profit a “better” measure of profit than accounting profit? Economic profit and accounting profit really have different purposes, so one is not universally better or worse than the other. Economic profit is a better measure of whether a firm is using its resources efficiently and is a better measure for predicting a firm’s actions, but accounting profit may be a better measure of whether the firm is earning enough revenue to pay its expenses.

Emphasize the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Only economic profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated © 2023 Pearson Education, Inc.

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according to strict, generally accepted accounting procedures (GAAP). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and overreport revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners.

Decisions 

In order to maximize economics profit, a firm must decide:  What to produce and in what quantities.  How to produce.  How to organize and compensate its managers and workers.  How to market and price its products.  What to produce itself and what to buy from others.

The Firm’s Constraints 

A firm faces three basic constraints that limit its maximum profit:  Technology Constraints: A technology is any method of producing a good or service. At the existing level of technology, a firm can produce more output only if it hires more resources, which increases its costs and limits its profits.  Information Constraints: A firm has only limited information about the quality and effort of its work force, about the current and future buying plans of its customers, and about the plans of its competitors.  Market Constraints: What a firm can sell and the prices it sets are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms.

II. Technological and Economic Efficiency 



There typically are many different combinations of inputs that can produce a specific level of output.

Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient.

The table has 4 different methods of producing a unit of output.

Method Labor Capital The columns show the number of units of labor and capital 1 5 10 needed to produce 1 unit of output.  Method 2 is technologically inefficient because it uses the 2 10 10 same amount of capital but more labor than does Method 1.

3 15 9  Which method is economically efficient depends on the 4 20 1 prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).

Does technological efficiency imply economic efficiency (or vice versa)? Point out that technological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency.

III. Information and Organization A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems. 

A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward. © 2023 Pearson Education, Inc.

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 

An incentive system uses a market-like mechanism inside the firm.

The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways:  Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners.  Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners.  Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the long-term performance of the firm.

The Economics in the News considers principals and agents at Apple, and how top executives took received large bonuses in 2020 as Apple exceeded revenue and profit targets. Because the case identifies both the questions and the solution, it would be useful to reinforce this example with another drawn from recent headlines.

Types of Business Organization 

 



A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income.

A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners.

A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment, so the personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on the firm’s profits, and then again as income taxes paid by stockholders receiving their aftertax profits distributed as dividends.

Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization.

Student businesses: Students generally have no idea how to legally form and operate a business. Discussing a sole proprietorship example for a simple business is helpful and engages interest of some students. How they would legally start a business and report income so easily often reinforces the efficiency ideas we discuss elsewhere. The Economics in Action case summarizes the numbers for the various types of firms in the U.S. economy and table 10.4 nicely identifies the pros and cons of each form of organization.

IV. Markets and the Competitive Environment 

  

Perfect competition is a market structure when there are many firms, each selling an identical product, many buyers, and with no restrictions on entry of new firms to the industry. Both firms and buyers are well informed of the prices of the products of all firms in the industry.

Monopolistic competition is a market structure in which a large number of firms compete by making similar but slightly different products. Making a product slightly different from the product of a competitor is called product differentiation and it gives the firm an element of market power.

Oligopoly is a market structure in which a small number of firms compete. Oligopolies might produce almost identical or differentiated goods.

Monopoly arises when there is one firm, which produces a good or service that has no close substitutes and in which the firm is protected by a barrier preventing the entry of new firms. © 2023 Pearson Education, Inc.

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Measures of Concentration There are two measures of market concentration:  

The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely competitive) to 100 (not very competitive).

The Herfindahl–Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly).

An Economics in Action case identifies the HHI for various industries in the United States, with cigarettes and batteries being the most concentrated and quick printers and bakeries the least of those included. It also describes why other information may also be necessary to conclude how competitive a specific market is. 



The U.S. Justice Department uses the HHI to classify markets:  Markets with an HHI of less than 1,500 are regarded as highly competitive.  Markets with an HHI of between 1,500 and 2,500 are regarded as moderately competitive.  Markets with an HHI above 2,500 are regarded as concentrated.

Concentration measures fail to take account of:  Geographic Scope of the Market: Concentration ratios define the market as the entire United States, but the relevant market might be smaller than the entire nation (newspapers, for which the market is a city) or larger than the entire nation (automobiles, for which the market is the entire world).  Barriers to Entry and Firm Turnover: For some industries, only a few firms might be in the market but competition in these industries might be fierce, with firms regularly entering and exiting the industry.

An Economics in Action application considers data from 1939 to 1980 that were used to study the degree of competition in U.S. markets. These data concluded there were more firms operating in competitive markets in 1980 than in 1939. Because the data do not capture the degree of global competition that has resulted after 1980, the study may understate the degree to which markets are competitive today. 

Market and Industry Correspondence: Some firms produce a product with very specific applications for which few competitors exist, but are classified in too broad of a market (specific pharmaceutical drugs) while other firms have diversified into several distinct product lines and are subject to more effective competition than what their market share for just one product might suggest.

How do economists identify the market for a product? Examples: Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market.

Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share.

Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well?

How about motorcycles and scooters?

The World Wide Web of business. Conclude the discussion of market definition by mentioning how today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. Stress how difficult it is to discern even the relevance of the term “market” in today’s business climate. © 2023 Pearson Education, Inc.

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What is the relevant market for Ford Motor Company? Ford Motor Company advertises that it is the largest seller of pickup trucks in the United States. Should we be concerned that Ford might have too much market power in that area of the market? Ask the students to consider identifying what would be an appropriate definition for the “market” such that a proper market concentration measure might be calculated. Should only pickup trucks be included? Or should all cars and trucks be considered as possible substitutes? How about minivans and/or SUVs?

V. Produce or Outsource? Firms and Markets   



Factors of production can be coordinated by firms or by markets.

Firms coordinate production when they can do so more efficiently than a market.

Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors of production consistent.

Outsourcing, buying parts or products from other firms, is an example of market coordination.

Why might firms be more efficient at coordinating production than markets?     

Firms can reduce transactions costs, which are the costs that arise from finding someone with whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled.

Firms can capture economies of scale, which occurs when the cost of producing a unit of a good falls as its output rate increases.

Firms can capture economies of scope, which occurs when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.

Firms can engage in team production, in which the individuals can coordinate to specialize in mutually supporting tasks.

Because of these advantages, firms rather than markets coordinate most of our economic activity.

Economics in Action: Apple doesn’t produce the iPhone by itself. Global supply chains, high degrees of specialization and competition, and other innovations have made it possible for a company to design and market a product, collect most of the profit from it, and yet not produce it.

Why do firms exist? Ronald Coase is the classic on this topic. You might like to tell your students about this remarkable person. Born in England in 1910, he graduated with a bachelor of commerce degree in 1932, at the depth of the Great Depression. While still an undergraduate, he was puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially important at that time because Socialists (and the young Coase was one of them) thought that central planning by government was superior to the market.

Quoting from Coase’s autobiography, http://www.nobel.se/economics/laureates/1991/coase-autobio.html, “I spent the academic year 1931-32 on my Cassel Travelling Scholarship in the United States studying the structure of American industries, with the aim of discovering why industries were organized in different ways. I carried out this project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory answering the questions with which I started but the introduction of a new concept into economic analysis, transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article “The Nature of the Firm,” published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the 1991 Alfred Nobel Memorial Prize in Economic Sciences.”

So, this amazing scholar had done his Nobel-prize-winning work at the age of 22!

An Economics in the News article discusses the growth of mobile advertising and how Facebook and Google are both dominant in advertising with smartphones.

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Additional Problems 1.

Sue can do her accounting assignment by using: a personal computer; a pocket calculator; a pocket calculator and a pencil and paper; or a pencil and paper. With a PC, Sue completes the job in half an hour; with a pocket calculator, it takes 4 hours; with a pocket calculator and with a pencil and paper, it takes 5 hours; and with a pencil and paper, it takes 14 hours. The PC and its software cost $2,000, the pocket calculator costs $15, and the pencil and paper cost $3. a. Which, if any, of the methods is technologically efficient? b. Which methods is economically efficient if Sue’s wage rate is (i) $10 an hour? (ii) $20 an hour? (iii) $50 an hour?

2.

Alternative ways of making 100 shirts a day are in the Method Labor Capital table to the right. (hours) (machines) a. Which methods are technologically efficient?

A 10 50 b. Which method is economically efficient if: B 20 40 (i) The wage rate is $1 an hour and the rental cost of a C 50 20 machine is $100 an hour?

D 100 10 (ii) The wage rate is $5 an hour and the rental cost of a machine is $50 an hour? (iii) The wage rate is $50 an hour and the rental cost of a machine is $5 an hour?

3.

Sales of the firms in the pet food industry are in the Sales table to the right. (thousands of a. Calculate the four-firm concentration ratio.

Firm dollars) b. What is the structure of the industry?

Big Collar, Inc 50

4.

Market shares of mat makers are in the table to the right. a. Calculate the Herfindahl-Hirschman Index. b. What is the structure of the industry?

Shiny Coat, Inc Friendly Pet, Inc Naturals Way, Inc Other 8 firms

75 60 65 400

Firm Made-to-last, Inc Big Wheel, Inc Magic Carpet, Inc Supreme, Inc Copra, Inc

Market share (percent) 20 17 22 17 24

Solutions to Additional Problems 1.

a.

All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the accounting assignment is not a technologically efficient method because it takes more hours than it would with a pocket calculator and it uses more capital. © 2023 Pearson Education, Inc.

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2.

b.

The economically efficient method is the technologically efficient method that allows the task to be done at least cost. (i) When the wage rate is $10 an hour: Total cost with a PC is $2,005, total cost with a pocket calculator is $55, and total cost with paper and pencil is $143. Total cost is least with a pocket calculator. (ii) When the wage rate is $20 an hour: Total cost with a PC is $2,010, total cost with a pocket calculator is $95, and the total cost with paper and pencil is $283. Total cost is least with a pocket calculator. (iii) When the wage rate is $50 an hour: Total cost with a PC is $2,025, total cost with a pocket calculator is $215, and total cost with pencil and paper is $703. Total cost is least with a pocket calculator.

a.

Methods A, B, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B to C to D, the amount of labor increases and the amount of capital decreases in each case.

The economically efficient method in (i) is method D, in (ii) is method D, and in (iii) is method A. The economically efficient method is the technologically efficient method that allows the 100 shirts to be made at least cost. (i) Total cost with method A is $5,010, total cost with method B is $4,020, total cost with method C is $2,050, and total cost with method D is $1,100. Method D has the lowest total cost. (ii) Total cost with method A is $2,550, total cost with method B is $2,100, total cost with method C is $1,250, and total cost with method D is $1,000. Method D has the lowest total cost. (iii) Total cost with method A is $750, total cost with method B is $1,200, total cost with method C is $2,600, and total cost with method D is $5,050. Method A has the lowest total cost.

b.

3.

a.

b.

4.

a.

b.

The four-firm concentration ratio is 38.46. The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $50,000 + $75,000 + $60,000 + $65,000, which equals $250,000. Total industry sales equal $250,000 + $400,000, which equals $650,000. The four-firm concentration ratio equals ($250,000/$650,000) • 100, which is 38.46 percent.

This industry is competitive because the four-firm concentration ratio is less than 60 percent.

The Herfindahl-Hirschman Index is 2,038. The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms. The HerfindahlHirschman Index equals 202 + 172 + 222 + 172 + 242, which equals 2,038.

This industry is not competitive because the Herfindahl-Hirschman Index exceeds 1,800.

Additional Discussion Questions 1.

What decisions go into setting up and operating your own business? Have the students imagine starting up their own firm after graduation. Let them dream about pursuing their passion and trying to make a living at it, and get them to appreciate the complexities of organizing production and making a profit. Challenge them with the following business decision issues and open their eyes to how much risk must be endured and how much market perceptiveness is necessary to be a successful entrepreneur.

Organizing your firm. Ask students if the initial capital requirements for their dream business would be extensive, such as starting up a high-performance car manufacturing firm (John DeLorean tried this, but his attempt to raise financial capital caused him to take a bit of a career detour—he was tried, and acquitted, for trafficking drugs!), or merely a modest capital outlay. Will the size and scope of their operation require a large management structure with a diversity of specialized managers, or a small, streamlined structure with only a few managers in multi-purpose roles? Will they want to © 2023 Pearson Education, Inc.

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spread out the risk of financial liability among stockholders in exchange for sharing a portion of their profit?

Determining your firm’s financial reporting standards. What financial reporting standards will their firm practice? Ask the students how they will treat the wages paid to themselves, the owners of the firm? Mention that if their best alternative job has just experienced a significant increase in salary, the implicit cost of running their own business has just increased and their economic profitability has decreased. Point out that if they were to give themselves a raise to reflect the higher opportunity cost and transform that implicit cost into an explicit cost, their accounting profit then declines as well.

Not only will a lower profit report for the period hurt their firm’s perceived stature in the industry, it will also make it more costly for their firm to raise financial capital in the future.

Determining appropriate sources of information. Where will they receive the information needed to locate good workers and managers? Where can they find the market wages, salaries, and benefits that they must offer to their employees in order to attract quality people to work with them instead of other firms? How will they uncover all the business regulations, licensing, periodic tax filing procedures, and labor laws that must be strictly followed to remain in operation?

2.

How do corporate taxes affect efficiency? Ask the students to recall the deadweight loss of taxation analyzed in Chapter 6 and apply it to the double taxation of corporate profits. Help them to see that they can model the effects of the compounding deadweight losses by using the production possibilities frontier. Show them how the corporate tax causes movement of the economy to production combinations that are inefficient and in the interior of the production possibilities frontier.

3.

Should you hire a contractor or a development company to build your house? Mention to the students that if a market is more efficient at allocating resources among buyers and sellers than a firm, the market will be characterized by the presence of many different contractors or consultants, rather than with traditional companies. Ask the students to identify some of these kinds of markets and get them to consider what characteristics of the products or services do not lend themselves to the organizational structure of the firm. For example, ask the students what characteristics that describe the building of new residential homes that encourages a predominance of contractors rather than firms to supply new residential housing? In this market, independent, general construction contractors who deal with many sub-contractors are the entities that tend to build individual “spec” homes. Yet, in the same market there are also a few large residential developments of “cookie cutter” homes built in a small geographic area by one firm. Perhaps the high cost of monitoring the progress in many off-site work areas, combined with a high degree of variation in the customer preferences for the product, prevents any economies of scale to be enjoyed by a firm trying to build “spec” homes. Perhaps the economies of scale can only be enjoyed in a small geographic area with a high concentration of construction sites managed by one firm.

4.

Compare and contrast the possible result of Apple outsourcing the iPad’s production with doing it all within the firm. Competition among component makers likely leads to lower costs and a greater speed of innovation in terms of product features. Technology transfer will be more widespread as firms try to mimic what others are producing and as firms that develop new technologies are likely to be able to sell some or all of those features to other firms or markets (such as programmable chips migrating from devices to autos to green energy grids). Under the outsourcing system, Apple is more vulnerable to problems with a supplier delaying products or damaging the firm’s reputation.

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OUTPUT AND COSTS

The Big Picture Where we have been: This chapter has explained how the firm’s output decision affects its costs when the firm allocates its factors of production efficiently in the short run and in the long run. The student sees how establishing short-run productivity and cost measures and understanding how they are related reveals how a firm can predict how its costs will change with the level of output. This relationship helps firm managers make profitable output decisions in the short run and make commitments to efficient plant size in the long run.

Where we are going: Chapters 12, 13, 14, and 15 use the productivity and cost relationships developed in this chapter to explain how firms make decisions in competition, monopoly, and other market structures. Chapter 18 uses these same ideas to explain how firms decide how much labor and capital to use.

New in the Fourteenth Edition Some of the examples and applications have been updated. The introduction connects to the new concluding Economics in the News case that discusses Amazon’s fulfillment centers and how each center’s average total cost curve contributes to Amazon’s long-run average cost curve. An in-the-test Economics in the News examines Target’s decision to spend millions to remodel stores with self-service checkout lanes and how the average total cost curve of these new checkout lanes compares with that of the older, conventional checkout lanes with a clerk.

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Lecture Notes

Output and Costs  



I.

In the short run, a firm needs to increase the quantity of labor employed in order to increase its production.

In the long run, a firm can increase the quantity of any or all of the factors of production it employs to increase its production.

Firms must pay for the factors they use, so when a firm changes its production, its costs change.

Decision Time Frames 

A firm owner’s decisions can be categorized as short run decisions and long run decisions.  The short run is a time frame in which the quantities of some factors of production are fixed. The fixed factors include the firm’s management organization structure, level of technology, buildings and large equipment. These factors are called the firm’s plant.  The long run is a time frame in which the quantities of all factors of production can be varied. Longrun decisions are not easily reversed so usually a firm must live with the plant size that it has created for some time. The past cost of buying a plant that has no resale value is called a sunk cost.

Help the students to understand that the difference between the long run and short run is not related to calendar time. Compare the street vendor, who is a firm owner operating out of a food truck, to the giant automaker firm, Honda. Ask them how long it would take for the food vendor to double the size of his or her plant (truck, oven, etc.) versus Honda to double its plant size (factory buildings covering multiple blocks, computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long run differs among firms.

II. Short-Run Technology Constraint To increase its output in the short run, a firm must increase the quantity of labor employed. There are three relationships between the quantity of labor and the firm’s output.

Product Schedules 

Total product is the maximum output that a given quantity of labor can produce. The marginal product of labor is the increase in total product that results from a one-unit increase in the quantity of labor employed with all other inputs remaining the same. The average product of labor is equal to the total product of labor divided by the quantity of labor. The table to the right has examples of these product schedules.

Labor 0

Total product 0

1

10

Marginal product

Average product

10 10 20 2

30

15 6

3

36

12

Product Curves  

The total product curve illustrates the total product schedule. The slope of the total product curve equals the marginal product of labor at that quantity of labor.

The marginal product curve shows the additional output generated by each additional unit of labor. The marginal product of labor curve (MP) has an upside-down U shape. Increasing marginal returns occurs when the marginal product of an additional worker is greater than the marginal product of the previous worker. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and diminishing marginal returns set in. Diminishing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. The law of diminishing returns states that as a firm uses more of a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes.

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

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The average product curve shows the average product that is generated by labor at each level of labor. As the figure shows, the average product of labor curve (AP) has an upside-down U shape.

As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the average product of labor increases; when the marginal product of labor is less than the average product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.

The marginal pulls (but cannot not push) the average. Don’t let the students fall into the trap of thinking that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise (fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-and-true grade point average (GPA) example used in the text. Explain that if a student’s GPA is a 3.5 and the next marginal class grade is a C (2.0), followed by a B (3.0), this increasing marginal grade will not be pushing their GPA up at all. Conceptually, the students should understand that the marginal value can’t “push” the average measure higher when it is, itself, lower than the average measure. The marginal measure must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity, thereby “pulling” the average up (down).

Understanding marginal returns: Ask students to picture a typical fast food restaurant. This is a “plant” and equipment with which they are familiar as customers if not also as workers. Fixed inputs include the building and the equipment. Ask them to imagine one worker trying to cook the food, take the orders and run the drive through. Add a second worker and specialization can begin to occur, so the MP initially rises. But keep adding workers and marginal product will inevitably fall. Diminishing returns is not the same as negative returns; students might need help understanding that total product is still rising, but at a decreasing rate.

III. Short-Run Cost

Labor 0

Output 0

Fixed cost (dollars) 50

Variable cost (dollars) 0

Total cost (dollars) 50

Average fixed cost (dollars)

Average variable cost (dollars)

Average total cost (dollars)

1

10

50

100

150

5.00

10.00

15.00

2

30

50

200

250

1.66

6.67

8.33

3

36

50

300

350

1.39

8.33

9.72

Marginal cost (dollars) 10.00 5.00 16.67

The table above continues the previous product schedule table and shows different costs.

Total Cost 

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm’s fixed factors. Total variable cost (TVC) is the cost of the firm’s variable factors. Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

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Relation between TP and TVC. Make a graph of a TP curve on a transparency. Label the x-axis labor and the y-axis output. Put some actual numbers on the labor axis (use 1, 2, 3, 4, and 5 labor units) and tell the students that the price of a unit of labor $10. Next, change the label on the x-axis to TVC and ask the students to tell you the numbers to put on the x-axis now that it measures TVC (the numbers will now be $10, $20, $30, $40 and $50). Once the students are really clear about what you have done, pick up the transparency, turn it over, and replace it on the display base with what was previously the x-axis (TVC) running vertically. Point out that the students are now looking at a TVC curve. Emphasize that all the product curves can be derived from the TP curve and all the cost curves can be derived from the TVC curve.

Marginal Cost 

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output. The MC curve is U-shaped. Initially greater specialization makes additional units cost less than those that have come before, but eventually diminishing returns sets in and marginal costs rise.

Average Cost  



Average fixed cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output increases.

Average variable cost (AVC) is total variable costs per unit of output. At low levels of output, AVC falls as output increases but at higher levels of output, AVC rises as output increases.

Average total cost (ATC) is the total cost per unit of output. ATC = AFC + AVC. At low levels of output, ATC falls as output increases but at higher levels of output, ATC rises as output increases.

Marginal Cost and Average Cost 

The figure illustrates typical MC, AFC, AVC, and ATC curves. As the figure shows, the MC curve, the AVC curve, and the ATC curve are all U-shaped. There are other additional important points about this figure:  The vertical distance between the AVC curve and the ATC curve is the AFC. Because the AFC decreases as output increases, these curves become vertically closer to each other as output increases.  The MC curve intersects the AVC curve and ATC curve at their minimums

Why the Average Total Cost Curve is U-shaped 

The ATC curve combines the shapes of the AFC and AVC curves. The AFC curve constantly falls as output expands, pulling down ATC curve. The AVC curve first falls but then rises because of diminishing returns. Eventually AVC curve starts to rise more rapidly than the AFC falls, so at that point the ATC rises.

An Economics in the News case describes a new cost curve application inspired by Target’s decision to spend millions to remodel its checkout lanes. The case derives and analyzes the cost curves for both traditional clerks and for selfservice checkout lanes.

Cost Curves and Product Curves 



The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP curve is falling, the AVC curve is rising.

The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for which the MP curve is rising, the MC curve is falling and over the range of output for which the MP curve is falling, the MC curve is rising.

Making Decisions Using the Relationships Between Productivity and Cost. Explain to the students the usefulness of understanding the intuition behind the relationship between productivity measures and cost measures. For example: © 2023 Pearson Education, Inc.

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If a firm manager knows that average productivity of labor has been falling with the last additional quantity of labor hired, then the manager knows that the average variable cost (AVC) of production has necessarily been rising as the output from that additional labor has increased.

If the manager knows that AVC is rising as output increases, then the manager also knows that the marginal cost (MC) of the additional output has been higher than the AVC (which has been pulling AVC up).

If the manager has sold the previous units of output at a small profit, the manager might be faced with a timesensitive contractual opportunity that arises within the same short run time period. The manager might be asked to sell a little more output at the same market price as the previous sales. The manager can quickly infer that the profitability of this potential new contract will not be as high because the marginal cost of producing the extra output will be higher than the last units of output produced. The manager can infer this result through productivity-cost relationships rather than knowing marginal costs directly.

Firm managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs might behave when the firm’s output must change to accommodate market changes.

Shifts in the Cost Curves 



The cost curves shift with changes in technology or changes in prices of factors of production.  An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a fixed input, then the average total cost curve shifts upward at low levels of output and downward at higher levels of output.

A fall in the price of the fixed factor shifts the AFC and ATC curves downward but leaves the AVC and MC curves unchanged. A fall in the price of a variable factor shifts the AVC, ATC, and MC curves downward but leaves the AFC curve unchanged.

IV. Long-Run Cost In the long run, a firm can vary the level of all resources so both labor and capital are variable factors. As a result, in the long run all costs are variable costs.

The Production Function The production function determines the behavior of long run costs.  A firm’s production function typically exhibits diminishing returns to capital as well as diminishing returns to labor. The marginal product of capital is the change in total product divided by the change in capital when the quantity of labor is held constant. Holding constant the quantity of employment, after some level of output the firm will have diminishing returns to capital—the marginal product of capital decreases as more capital is used.

Short-Run Cost and Long-Run Cost 



In the long run, a firm can use different plant sizes.

Each plant size has a different short-run ATC curve.

Each short-run ATC curve is U-shaped and the larger the plant size, the greater is the output at which the average total cost is a minimum.

The figure illustrates three average total cost curves for three plant sizes. ATC1 pertains to the smallest plant size and ATC3 to the largest.

The Long-Run Average Cost Curve 

The long-run average cost curve, LRAC, is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. This curve is derived from the short-run

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

average total cost curves. It shows the lowest average total cost to produce a given level of output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

The LRAC curve is a planning curve. Once the firm chooses a plant size, then it operates on the short-run costs curves associated with that plant size.

An Economics in Action case describes why a firm in the auto industry might have capital equipment that is not fully used. The firm is producing at a point on its short-run average total cost curve that is not the minimum of the shortrun average cost curve, so the firm has under-utilized capital. But the production point is on the long-run average cost, so the quantity being manufactured is produced at the minimum average total cost.

Economies and Diseconomies of Scale 







Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output exceeds the percentage increase in all factors of production. The long-run average cost curve slopes downward in this range of output. The main source of economies of scale is greater specialization of both labor and capital.

Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output equals the percentage increase in all factors of production. The long run average cost curve is horizontal in this range of output.

Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output is less than the percentage increase in all factors of production. The long run average cost curve slopes upward in this range of output.

The minimum efficient scale is the smallest quantity of output at which the long-run average cost curve reaches its lowest level.

Concepts are important, not just the formulas. Make good use of the glossary of productivity and cost terms provided in Table 11.2 in the text, but don’t get mired down in reciting productivity and cost measure definitions! Students must learn the definitions, but they are secondary to the concepts they define and the insights they bring. Stand back from the details of this chapter and be sure that your students learn two big ideas.  A firm’s lowest production costs depend on the manager’s flexibility to choose the level of all factors. This flexibility enables firm managers to produce at a lower cost in the long run than in the short run when some factors are fixed.  In the short run, with one or more fixed factors, production costs vary with output in a predictable way because they are directly linked to measures of factor productivity.

When does the firm actually reach the “long run”? Think of the long run as a window of opportunity in which firms get to re-make decisions. If things are going well, firms may be re-making decisions regularly and extending fixed inputs on a regular basis. But if things are going poorly, the window in which a lease can be broken or a contract not renewed will be pressing. Point out to the students that the long-run average cost curve yields the lowest average cost of production possible when plant size is free to change. Once a firm commits to a specific plant size, it is locked into a specific short run cost curve configuration. Any significant departure from the range of output per period that best suits that configuration means the firm will incur higher short-run average total costs than it would have had it chosen a more appropriate plant size. If faulty market analysis or unexpected changes in market conditions cause a firm to commit to a plant that is too small (or too large) when the required range of production is actually relatively high (or relatively low), then the firm will suddenly be locked into a much less competitive production cost situation with potentially dire economic consequences. If the firm’s competitors chose their plant size more wisely, the firm might have a tough time surviving! Who is successful in the long run may depend on decisions to get bigger or smaller that wound up being correct as market conditions changed.

Experiment: Learn about production by producing. This chapter is one more place where an in-class experiment has a huge payoff in student comprehension. This 30 minute experiment teaches students about product curves and © 2023 Pearson Education, Inc.

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production cost measures. It motivates the students to go beyond memorizing the cost and productivity definitions by getting them directly involved with generating their own data as well as productivity and cost measures. This fun exercise will illustrate the concept of diminishing returns to labor as well as how short-run productivity measures and production cost measures are related.  Factors: Capital: A medium-sized table (the class must have an unobstructed view of it), tear-off scratch pads with about 500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fully loaded). Labor: Provided by your students.  The Task: To produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very carefully so that the corners of the paper align, and stapled. (The first fold bisects the paper along its long side and the second fold is at right angles to the first.) Once folded, it is stapled to hold the folds in place. A widget is fragile and breaks if it falls off the table.  The Pre-Experiment Stage: Hire a manager from your class and appoint an auditor. Get the manager to hire a quality controller, an accountant, and some workers. Tell the manager that he must produce widgets as efficiently as possible and that he can discuss the process with his workers and with the class.  The Experiment: A “work day” lasts for 1 minute. Get the class to keep time. On day 1, have one worker produce widgets. On day 2, have two workers produce widgets, and so on. You’ll probably run for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets don’t get used in a subsequent day. Each day must start clean.  The Assignment (Stage 1): Have the students to calculate marginal product and average product from the total product numbers that you’re recorded. Get them to make graphs of the total product, marginal product, and average product curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweater production in the textbook.  The Assignment (Stage 2). Use the data from your widget production experiment and give the students figures for the cost of the capital and the wage rate of a worker. (Make up the numbers—any will do.) Tell the students to calculate total cost, marginal cost, and average cost. Get them to make graphs of the total cost, marginal cost, and average cost curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweaters in the textbook. (This assignment and the previous one make an outstanding assignment for credit.)  The Experiment Extended. If you have the time, duplicate the capital of the first experiment and repeat all its steps. You should generate a horizontal LRAC. Get the class to think about what would have to happen in the context of this experiment to get economies of scale and diseconomies of scale.

Economics in the News discusses Amazon’s fulfilment centers and how their average total costs give Amazon’s a longrun average cost curve that is flat.

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Additional Problems 1.

Charlie’s Chocolates total product schedule is in the table. a. Draw the total product curve. b. Calculate the average product of labor and draw the average product curve. c. Calculate the marginal product of labor and draw the marginal product curve. d. What is the relationship between the average product and marginal product when Charlie’s Chocolates produces (i) less than 276 boxes a day and (ii) more than 276 boxes a day?

2.

In problem 1, the price of labor is $50 per day, and total fixed costs are $50 per day. a. Calculate total cost, total variable cost, and total fixed costs for each level of output and draw the short-run total cost curves. b. Calculate average total cost, average fixed cost, average variable cost, and marginal cost at each level of output and draw the short-run average and marginal cost curves.

Labor (workers per day) 1 2 3 4 5 6 7 8 9 10

Output (boxes per day) 12 24 48 84 121 192 240 276 300 312

3.

In problem 2, suppose that the price of labor increases to $70 per day. Explain what changes occur to the short-run average and marginal cost curves?

4.

In problem 2, Charlie’s Chocolates buys a second plant and now the total product of each quantity of labor doubles. The total fixed cost of operating each plant is $50 a day. The wage rate is $50 a day. a. Set out the average total cost curve when Charlie’s operates two plants. b. Draw the long-run average cost curve. c. Over what output range is it efficient to operate one plant and two plants?

5.

The table shows the Labor Output production function of (workers (pizzas per day) Mario’s Pizza-to-Go. per day) Plant 1 Plant 2 Plant 3 Plant 4 Mario must pay $100 1 4 8 11 13 a day for each oven he 2 8 12 15 17 rents and $75 a day 3 11 15 18 20 for each kitchen hand 4 13 17 20 22 he hires Ovens 1 2 3 4 a. Find and graph the average total cost curve for each plant size. b. Draw Mario’s long-run average cost curve. c. Over what output range does Mario experience economies of scale? d. Explain how Mario uses his long-run average cost curve to decide how many ovens to rent.

Solutions to Additional Problems 1.

a.

To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping. © 2023 Pearson Education, Inc.

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The average product of labor is equal to total product divided by the quantity of labor employed. For example, when 3 workers are employed, they produce 48 boxes a day, so average product is 16 boxes per worker. The average product curve is upward sloping when the number of workers is between 1 and 8, but it becomes downward sloping when 9 and 10 workers are employed.

The marginal product of labor is equal to the increase in total product when an additional worker is employed. For example, when 3 workers are employed, total product is 48 boxes a day. When a fourth worker is employed, total product increases to 84 boxes a day. The marginal product of going from 3 to 4 workers is 36 boxes. The marginal product curve is upward sloping when the number of workers is between 1 and 6, but it becomes downward sloping when 7 or more workers are employed. (i) When Charlie’s Chocolates produces fewer than 276 boxes a day, it employs fewer than 8 workers a day.

With fewer than 8 workers a day, marginal product exceeds average product and average product is increasing. Up to an output of 276 boxes a day, each additional worker adds more to output than the average. Average product increases. (ii) When Charlie’s Chocolates produces more than 276 boxes a day, it employs more than 8 workers a day.

With more than 8 workers a day, average product exceeds marginal product and average product is decreasing. For outputs greater than 276 boxes a day, each additional worker adds less to output than average. Average product decreases.

Total cost is the sum of the costs of all the inputs that Charlie’s Chocolates uses in production. Total variable cost is the total cost of the variable inputs. Total fixed cost is the total cost of the fixed inputs.

For example, the total variable cost of producing 48 boxes a day is the total cost of the workers employed, which is 3 workers at $50 a day, which equals $150. Total fixed cost is $50, so the total cost of producing 48 boxes a day is $200.

To draw the short-run total cost curves, plot output on the x-axis and the total cost on the y-axis. The total fixed cost curve is a horizontal line at $50. The total variable cost curve and the total cost curve have shapes similar to those in Fig. 11.4, but the vertical distance between the total variable cost curve and the total cost curve is $50.

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output.

For example, when the firm makes 48 boxes a day: Total fixed cost is $50, so average fixed cost is $1.04 per box; total variable cost is $150, so average variable cost is $3.13 per box; and total cost is $200, so average total cost is $4.17 per box.

Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 24 to 48 boxes a day, total cost increases from $150 to $200, an increase of $50. That is, the increase in output of 24 boxes increases total cost by $50. Marginal cost is equal to $50 divided by 24 boxes, which is $2.08 a box.

The short-run average and marginal cost curves are similar to those in Fig. 11.5.

The increase in the price of labor increases total variable cost and total cost but does not change total fixed cost.

Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward.

Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward. Average fixed cost does not change.

a.

b.

Total cost is the cost of all the factors of production. For example, when 3 workers are employed they now produce 96 boxes a day. With 3 workers, the total variable cost is $150 a day and the total fixed cost is $100 a day. The total cost is $250 a day. The average total cost of producing 96 boxes is $2.60.

The long-run average cost curve is made up of the lowest parts of the firm’s short-run average total cost curves when the firm operates one plant and two plants. The long-run average cost curve is similar to Fig. 11.8. © 2023 Pearson Education, Inc.

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5.

c.

It is efficient to operate the number of plants that has the lower average total cost of a box of chocolates. It is efficient to operate one plant when output is less than 48 boxes a day, and it is efficient to operate two plants when the output is more than 48 boxes a day. Over the output range 1 to 48 boxes a week, average total cost is less with one plant than with two, but if output exceeds 48 boxes a day, average total cost is less with two plants than with one.

a.

For example, the average total cost of producing a pizza when Mario rents 2 ovens and employs 4 workers equals the total cost ($200 rent for the ovens plus $300 for the workers) divided by the 17 pizzas produced.

The average total cost equals $500÷17, which is $29.41 a pizza. The average total cost curve is U-shaped, as in Fig. 11.5.

The long-run average cost curve is similar to that in Fig. 11.8.

Mario experiences economies of scale at output levels of 4 to 15 pizzas a day. When economies of scale are present, the LRAC curve slopes downward. Mario’s LRAC curve slopes downward between the output levels of 4 to 15 pizzas a day.

Mario will choose the plant (number of ovens to rent) that gives him minimum average total cost for the normal or average number of pizzas that people buy.

b. c.

d.

Additional Discussion Questions 11. Is the law of diminishing returns a result of firms hiring the best workers first? Students should understand that diminishing returns to labor occur under the assumption of a homogenous work force. Emphasize that diminishing marginal returns occur due to labor’s decreasing productivity given a fixed level of capital. The law of diminishing returns is defined in the short run only. As the amount of capital increases, as technology changes, or as the size of the plant increases, labor productivity can increase. If the variable input was a herbicide or a fertilizer on a farm field, diminishing returns would still be observed.

2.

Do increasing marginal costs result from the rising wages of workers? Students should understand that rising marginal cost in the short run results from diminishing marginal productivity of labor holding the wages for labor constant. Show the students the following thought process:  Employing another labor unit increases output, but the extra output is less than the added output from the previous labor unit (diminishing marginal productivity).  Each labor unit costs the same to employ, so the firm is getting less additional output for the same additional cost (constant cost of labor).  As a result, each additional unit of output is more expensive for the firm to make than the previous units of output (rising marginal cost).

This chain of reasoning is very important because it clearly shows the linkage from the firm’s production decisions and production constraints to its costs and the behavior of its cost curves.

3.

Fixating on fixed costs. Students should be aware of how fixed costs affect pricing decisions made by firms:  Why are some consumer products cheaper to buy in bulk? The students should be aware that if packaging costs comprise a significant proportion of the total cost of an item, then an increase in the ratio of product to packaging lowers the cost per unit. The firm can be more competitive and still retain profitability if it passes some of the savings on to the customer through a lower unit price.

Do firms produce where the ATC (or MC) curve is at its minimum? Students frequently ask a variation of this question. Students who ask this question should be praised because they are clearly thinking ahead and trying to use what they are learning to better understand the real world around

4.

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them. However, you need to be clear to these students that costs are essentially half of the picture.

Firms are in business for one reason, to maximize their profit. Profit equals revenue minus cost, so in order to maximize their profit, firms need also to be concerned with their revenue. You can intuitively tell the students that the next chapters “cover the revenue side of the picture” by looking at how the market structure in which a firm competes affects the firm’s revenue and hence affects its decisions. Firms want to minimize the cost of producing a given level of output, but the level of output that maximizes profit may not be at the minimum of any cost function.

5.

Discuss the following in terms of fixed costs, the short run and the long run: In agricultural markets, firms hesitate to be early adopters of new technologies embodied in new capital equipment, which can be quite expensive. But once they are proven to increase productivity, firms rush to adopt them and firms that don’t (or can’t) will have difficulty surviving. Equipment is a huge fixed cost for farmers.

Committing to a particular piece of equipment is a decision they will be stuck with for a while, and making the wrong choice may make them a higher cost producer. A smart farmer could buy what turns out to be the wrong piece of equipment because the new technology perhaps proved less durable than expected. This farmer might be unable to reverse that choice in time to save the farm if market conditions are overall poor.

6.

Suppose you open a restaurant. Which inputs are fixed and variable in the short run? When might you hit the long run and have to make new decisions? Labor, food, and other raw materials, some portion of the utility bills, advertising all might be examples of variable inputs. The building and the equipment, whether owned or leased, are typically fixed inputs. When the lease is up, the firm gets to decide whether to renew, shut down, or go to a smaller space or a bigger space. Ask students to describe what market conditions might lead to each of the above. Why do they think so many restaurants fail?

7.

Are firms that survive over long periods of time simply lucky or smarter than other firms? Sometimes the capital choice a firm makes determines its survival and it can’t change the choice easily once made. Unexpected changes in the economy or technology create winners and losers based on past capital decisions.

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PERFECT COMPETITION

The Big Picture Where we have been: Chapter 12 relies heavily on the productivity and cost analysis material of Chapter 11, the marginal analysis and efficiency issues introduced in Chapter 2 and Chapter 5, and the concept of economic profit introduced in Chapter 10.

Where we are going: Chapter 12 is the first of four chapters that explore the price and output decisions of firms under various market characteristics. Chapter 12 studies perfect competition, Chapter 13 studies monopoly, Chapter 14 studies monopolistic competition, and Chapter 15 studies oligopoly. All four chapters use cost curves, marginal analysis, and the concept of efficiency.

New in the Fourteenth Edition The teaser introduction now asks about the effect of the Covid-19 pandemic on small gym operators. The concluding Economics in the News focuses on answering these questions about exit and the new long-run market equilibrium.

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Lecture Notes

Perfect Competition 

 

I.

Firms in perfect competition face the maximum amount of competition because there are many competing firms, each of which produces an identical product.

Firms in perfect competition maximize their profit by producing where MR = MC. Perfect competition leads to an efficient allocation of resources.

What is Perfect Competition?    

Perfect competition is an industry in which Many firms sell identical products to many buyers There are no restrictions on entry into the industry Established firms have no advantage over existing ones Sellers and buyers are well informed about prices

How Perfect Competition Arises 

These characteristics of perfect competition arise when the minimum efficient scale for a firm is small relative to the size of the entire market. The minimum efficient scale is the smallest output at which long-run average costs are minimized.

What markets satisfy the characteristics of perfect competition? Have the students consider the markets for goods with which they are familiar to see if any meet the strict criteria for perfect competition. The markets that come closest are agricultural markets, though others such as lawn service, plumbing, gas stations, and so on, also come close. Students sometimes “worry” that these markets are not exact examples of perfect competition. Reassure them that the model of perfect competition gives us a great deal of understanding into the workings of extremely competitive real world markets and the real world firms in the markets.

If there aren’t really any perfectly competitive markets, what use is studying perfect competition? The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a much fancier model! Economists use the model of perfect competition in a similar way to understand our economic world. Emphasize to students that, although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

Price Takers 

Firms in perfect competition are price takers, meaning that a firm that cannot influence the market price and so it sets its own price equal to the market price.

What is a price taker? Spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are “price takers.” On the one hand, they could offer to sell for a lower price, but they’d be giving profits away because they can sell all they want at the going market price. On the other hand, they can ask for a higher price but not even one consumer will pay because consumers know where to buy an exact substitute at a lower price.

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Economic Profit and Revenue 

 

Firms operating in perfect competition seek to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total opportunity cost of production Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases.

The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.

II. The Firm’s Output Decision Marginal Analysis and the Supply Decision 



The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit.

Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output.  When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit.  When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits  When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output.  In the figure the firm produces 4 units of output because that is the quantity that sets the firm’s marginal cost equal to its marginal revenue, that is, MR = MC. The firm then charges the going market price of $30 for its good.

What’s the point? Students find the topic of competitive market dynamics challenging. Part of their problem is that understanding the dynamics requires a strong understanding of the cost curves of the previous chapter, yet many of them still have only a shaky grasp of that important material. So emphasize the cumulative nature of economics and remind the students of the huge payoff from mastering material a bite at a time.

You also can help your students by emphasizing two primary goals of this chapter: (1) To derive the market supply curve in a competitive industry and (2) to deepen your students’ understanding of how competition among selfinterested consumers and producers will move society’s resources from less valued uses to more highly valued uses, achieving an efficient allocation in the eyes of society.

Temporary Shutdown Decision 



The firm will temporarily shut down in the short run when price falls below the shutdown point, which is the output and price that just allows the firm to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its fixed cost.)

The firm will continue operating in the short run even if it incurs an economic loss as long as the price exceeds the minimum AVC. © 2023 Pearson Education, Inc.

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Why would a restaurant open on days it knows business will be bad? Monday is typically the slowest day in the restaurant industry. So why do so many restaurants stay open on Monday? The answer is that even if a restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be good business!

Students often have a hard time understanding why operating at an economic loss can be the best action for a firm owner. The key is emphasizing:  The firm’s short-run decisions are made after some irreversible commitments have generated sunk costs.  The firm considers only avoidable future costs when making decisions. Unavoidable costs have no impact on the decision (other than to learn from them).  For the firm to continue to produce output, the firm needs only to receive revenues that exceed any avoidable costs, not necessarily all total costs.

Basically, the goal of profit maximization does not guarantee that the firm will earn a positive economic profit in the short run. Sometimes the best the firm can do is to minimize its economic loss.

The Firm’s Supply Curve 



As long as the firm remains open, it produces where MR = MC. So, the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.

The figure shows the firm’s supply curve as the heavy dark line.  At prices less than the minimum average variable cost, which equals P in the figure, the firm shuts down and supplies zero.  At prices greater than the minimum average variable cost, the firm supplies along its marginal cost curve.

Hence the firm’s marginal cost curve is its supply, indicated in the figure by the S = MC curve.

III. Output, Price, and Profit in the Short Run The short run is a situation in which the number of firms is fixed. In the short run, market demand and market supply interact to determine the price and quantity produced in a perfectly competitive market.

Market Supply in the Short Run 

The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and number of firms remain the same. The quantity supplied in the industry at any price is the summation of all quantities supplied by each firm at that price, so the short-run industry supply curve is the horizontal summation of all the firms’ supply curves.

Short-Run Equilibrium 

Market demand and short-run market supply determine the market price and market output. Each firm takes the market price as given, and produces its profit maximizing output.

A Change in Demand  

Changes in market demand influence the output and the entry or exit decisions made by firms.

An increase in market demand shifts the market demand curve rightward and raises the market price. Each firm responds by increasing its quantity supplied. © 2023 Pearson Education, Inc.

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A decrease in market demand shifts the market demand curve leftward and decreases the market price. Each firm responds by decreasing its quantity supplied.

Profits and Losses in the Short Run 

In the short run, even though firms attempt to maximize profit, they may end up breaking even or incurring an economic loss. The total economic profit (or loss) is equal to (P − ATC) × q.  If the price exceeds the ATC, the firm makes an economic profit (as illustrated in the figure).  If the price equals the ATC, the firm “breaks even” by making zero economic profit. In this case, the entrepreneur makes a normal profit.  If the price is less than the ATC, the firm incurs an economic loss.

An Economics in Action application considers the situation of Harley Davidson after a decrease in the market demand. Harley Davidson cut production and laid off workers. One plant was temporarily idled and other jobs were lost permanently.

IV. Output, Price, and Profit in the Long Run In the short run, a firm might break even, earn an economic profit or incur a loss. Because of entry and exit, in the long run a firm can only break even.

Entry

 



Economic profit motivates firms to enter the industry, thereby increasing the market supply.

When the market supply curve shifts rightward, the market price falls. Eventually the price falls to equal the minimum ATC for each firm in the industry and firms have adjusted their plant size so they are producing at the minimum long-run average cost. At this price, firms in the industry no longer make an economic profit and so firms no longer enter the industry. The figure illustrates this long-run equilibrium. In the figure, LRAC is the long-run average cost curve and SRAC is the short-run average cost curve.

One difference between the old and new market equilibriums is that the number of firms in the industry has risen and total quantity produced in the industry has increased.

Exit  

The effects of a decrease in market demand are the opposite of those outlined above.

In the long run, competitive firms make zero economic profit (price = average total cost) so that their owners make a normal profit.

Long Run Equilibrium 

Long run equilibrium in a competitive market occurs when there is zero economic profit and entry and exit have stopped.

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

Because markets are constantly experiencing new changes and shocks, it is rare to see one in a state of longrun equilibrium, but each competitive markets reacts to any new changes by pushing toward it.

Profit as a “signal”: When demand for a good increases so that the existing firms in an industry make an economic profit, the economic profit indicates that consumers are willing to pay a higher price for the good than they were willing to pay before the demand increased. The economic profit for the firms is a signal from the consumers to the owners of firms in other industries that society now values the availability of the good more highly than the availability of goods from those other industries. These self-interested firm owners choose to enter the industry in order to make an economic profit. Their self-interested decisions promote the social interest by using more resources to produce those goods that are more highly valued by society. The dynamic behavior of a perfectly competitive market characterizes the “invisible hand” coined by Adam Smith.

Why would a firm stay in business if profit is zero? It is likely that you will hear this question from at least one of your students. Remind them that the profit we’re measuring is economic profit. Zero economic profit doesn’t necessarily mean that the firm isn’t making any money. Rather, zero economic profit means that the profits the accountant is reporting is exactly the same as the value of the firm’s best alternative. If the firm were to move to its best alternative, it would make the same amount of profit. If a firm is making zero economic profit, there isn’t any incentive to go anywhere else as there isn’t any place that would generate a higher return for the firm. You may need to continue reminding your students of this throughout this chapter. Stress the role played by entry in driving competitive firms’ economic profit to zero. This will foreshadow the important role barriers to entry play in the next chapter to allow monopolies to make an economic profit indefinitely.

An Economics in Action feature examines entry and exit using the personal computer market and the farm equipment market.

V. Changes in Demand and Supply as Technology Advances Change in Demand 

Technological change can increase demand if it creates new applications for a product or new products.

Technological change can also decrease demand if new ways of doing things or new products displace previous ones.  If demand increases, the price and economic profit rise. The economic profit leads to entry, which increases market supply and causes the price to fall so that eventually firms again make zero economic profit. The number of firms is greater than before the increase in demand.  If demand decreases, the price falls and economic losses are created. Firms exit the market, which raises the price and decreases the remaining firms’ economic losses. Eventually the price rises so that the surviving firms make zero economic profit. The number of firms is less than before the decrease in demand.

An Economics in the News case explores the effects of an increase in demand for vinyl records on the decisions of record stores.

Change in Supply 

 

New, cost-saving technologies typically require new plant and equipment. Consequently it takes time for new technology to spread throughout an industry. Firms that adopt the new technology lower their costs and their supply curves shift rightward. The price of the good falls but the firms with the new technology make an economic profit.

Firms using the old technology incur economic losses. These firms either adopt the new technology or else exit the industry. In the long run, all the firms use the new technology and make zero economic profit.

Changes in technology brings only temporary economic profit to producers, but the lower prices and better products that technological advances bring are permanent gains for consumers.

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An Economics in the News case explores the implications of technological changes that have created falling costs to sequence DNA. Do firms in perfectly competitive markets advertise? Firms in perfectly competitive markets have no incentive to advertise because their product is indistinguishable from the output of rival firms. Industry associations will sometimes advertise to increase demand for the product as a whole. Brainstorming all the ads for agricultural products such as “Pork: the other white meat,” and all the varieties of milk ads can be fun, but the point is that it isn’t a pork producer or a dairy farmer creating the ad, but all of the pork producers or dairy farmers paying dues to an industrial organization that then creates the ads. Successful advertisements might lead to an economic profit in the short run, but in the long run entry will force the firms back to zero economic profit.

VI. Competition and Efficiency Efficient Use of Resources 

Resource allocation in a market is efficient when society values no other use of the resources more highly.

Resource use is efficient when production is such that the marginal social benefit of the good equals the marginal social cost of the good.

Choices, Equilibrium, and Efficiency 





Consumers allocate their budgets to get the most value out of them. Because consumers get the most value out of their budget, a consumer’s individual demand curve for a good is the consumer’s marginal benefit curve for the good. If no one else benefits from the good other than the consumers, then, as shown on the figure, the market demand curve for a good, which is the sum of the individual consumers’ demand curves (and hence their individual marginal benefit curves), is the marginal social benefit curve.

Firms maximize their profits in order to get the most value out of their resources. Firms make choices across all possible allocations of their resources. A firm’s supply curve for a good is its marginal cost curve. If all the costs of production of the good are paid by the producers, then, as shown in the figure, the market supply curve for a good is the marginal social cost curve.

In a competitive equilibrium, the quantity demanded equals the quantity supplied. If there are no externalities, the demand curve is the same as the marginal social benefit curve and the supply curve is the same as the marginal social cost curve, so at the competitive equilibrium, the marginal social benefit equals the marginal social cost. Resource use is efficient. Because resources are used efficiently, at the competitive equilibrium there is no other allocation of resources that will generate greater net benefits to society. The figure shows this outcome, where resource use is efficient at the equilibrium quantity of 3,000 units.

Watching the work of the invisible hand: The power of the market to make firms respond to consumers’ changing demands becomes visible to the student in this chapter. When you teach the dynamics of firm entry and exit, do the analysis with a specific (and current) example with which the students can identify. Have them pick an industry that has grown and largely died in their lifetime (for me, VCRs, for them, perhaps downloading music). What has replaced it and how is society served by failure as well as success? You can also ask them for forecasts of industries they expect will disappear in the future, perhaps gas stations. Your students may well enjoy envisioning what will replace the industries they expect will ultimately disappear.

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The concluding Economics in the News analyzes a prototypical gym’s decision to stay open of close during the Covid19 pandemic. The analysis continues to explore the long-run market equilibrium which will have fewer gyms and people making more use of online fitness offerings.

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Additional Problems 1.

Bob’s is one of many burger stands along the beach. Figure 12.1 shows Bob’s cost curves. a. If the market price of a burger is $4, what is Bob’s profit-maximizing output? b. Calculate the economic profit that Bob’s makes. c. With no change in demand or technology, how will the price change in the long run?

2.

Lucy’s Lasagna is a price taker that has the costs shown in the table. a. If lasagna sells for $7.50 a plate, what is Lucy’s profit-maximizing output? b. What is Lucy’s shutdown point? c. Over what price range will Lucy leave the lasagna industry? d. Over what price range will other firms with costs identical to Lucy’s enter the industry? e. What is the price of lasagna in the long run?

Output (plates per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 5 20 26 35 46 59

Solutions to Additional Problems 1.

a.

b.

c.

2.

a.

Bob’s profit-maximizing quantity is 300 burgers a day. Bob’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $4 a burger. Marginal cost is $4 when 300 burgers a day are produced.

Bob’s economic profit is $300 a day. Profit equals total revenue minus total cost. Total revenue equals $1,200 a day ($4 a burger multiplied by 300 burgers). The average total cost of producing 300 burgers is $3.00 a burger, so total cost equals $900 a day ($3.00 multiplied by 300 burgers). Profit equals $1,200 minus $900, which is $300 a day.

The price will fall in the long run to $2.80 a burger. At a price of $4 a burger, firms make economic profit.

In the long run, the economic profit will encourage new firms to enter the burger industry. As they do, the price will fall and economic profit will decrease. Firms will enter until economic profit is zero, which occurs when the price is $2.80 a burger (price equals minimum average total cost).

Lucy’s profit-maximizing output is 2 plates an hour. Lucy’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $7.50 a plate. Marginal cost is the change in total cost when output is increased by 1 plate an hour. The marginal cost of increasing output from 1 to 2 plates an hour is $6 ($26 minus $20). The marginal cost of © 2023 Pearson Education, Inc.

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b.

c.

d.

e.

increasing output from 2 to 3 plates an hour is $9 ($35 minus $26). So the marginal cost of the second plate is half-way between $6 and $9, which is $7.50. Marginal cost equals marginal revenue when Lucy produces 2 plates an hour.

Lucy’s shutdown point is at a price of $10 a plate. The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($5, which is total cost at zero output) from total cost. Average variable cost equals total variable cost divided by the quantity produced. For example, the average variable cost of producing 3 plates is $10 a plate. Average variable cost is a minimum when marginal cost equals average variable cost. The marginal cost of producing 3 plates is $10. So the shutdown point is a price of $10 a plate.

Lucy will leave the industry if in the long run the price is less than $11 a plate. Lucy’s Lasagna will leave the industry if it incurs an economic loss in the long run. To incur an economic loss, the price will have to be below minimum average total cost. Average total cost equals total cost divided by the quantity produced. For example, the average total cost of producing 2 plates is $13 a plate. Average total cost is a minimum when it equals marginal cost. The average total cost of producing 3 plates is $11.67, and the average total cost of producing 4 plates is $11.50. Marginal cost when Lucy's produces 3 plates is $10 and marginal cost when Lucy's produces 4 plates is $12. At 3 plates, marginal cost is less than average total cost; at 4 plates, marginal cost exceeds average total cost. So minimum average total cost occurs between 3 and 4 plates—$11 at 3.5 plates an hour.

Firms with costs identical to Lucy’s will enter at any price above $11 a plate. Firms will enter an industry when firms currently in the industry are making economic profit. Firms with costs identical to Lucy's will make economic profit when the price exceeds minimum average total cost, which is $11 a plate.

The price in the long run is $11 a plate. At $11 a plate, firms in the industry make zero economic profit.

Additional Discussion Questions 1.

Why do firms do what they do? Students should see how a clear understanding of a perfectly competitive market justifies firm behavior that otherwise might appear somewhat peculiar: Late night TV is full of zany TV commercials with firm owners who claim “I must be crazy, because I’m losing money on every sale!” Why do they advertise to increase sales if they’ll cause the owner to lose even more money? At first, it appears that these owners must be lying about “losing money on every sale.” Yet their unlikely claim is potentially true, as the various firms in their industry may currently face a market price above AVC, but below ATC in the short run. In this case they would remain in business and continue advertising, despite “losing money on every sale” because they are earning revenues above their variable costs to at least help contribute toward paying their fixed cost obligations to their creditors.

Why do the same farmers always complain of losing money but never seem to exit the industry? Point out that agriculture is a collection of highly competitive markets where farming operations typically have an extremely high capital-to-labor ratio. This fact makes the typical farm’s ratio of fixed costs to variable costs very high relative to most industries. Also, much of a farmer’s capital is in the form farmland, which is difficult to sell during falling agriculture prices, lengthening the farmer’s short run time frame. In this case, the dollar difference between market price and minimum AVC will be rather large. As long as market price exceeds AVC, the farmer will minimize losses by continuing to produce output over an extended short run time frame.

2.

What is implied about efficiency if the average cost of producing a good exceeds the price people are willing to pay for it? Remind the students that a firm’s cost curves reflect the opportunity cost to society of the firm using the resources to make the goods in its market (the resources could be making goods in some other market that could bring benefits to society). The demand curve reflects the value society places on each quantity of goods produced. If the price people are willing to pay is © 2023 Pearson Education, Inc.

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determined by the market supply and demand and the going market price is less than the opportunity cost of producing the last unit of the good, using more resources to increase output creates fewer net benefits for society than could be generated if the resources were used elsewhere in other markets.

What happens to the resources that were used by a firm for production when that firm exits the industry? Point out that when price falls below ATC, this generates an economic loss for the firm.

This is a signal from a society of consumers to the owner of the resources that he or she will benefit from reallocating the resources to making different goods and services from the same resources.

Society also stands to benefit from this switch.

How can an increase in net benefits to society be generated from the systematic destruction of firms leaving the market? A famous economist named Joseph Schumpeter coined the phrase “creative destruction” to describe the dynamics of a competitive market. While the productive capacity of a perfectly competitive industry facing declining consumer demand is ultimately destroyed, the resources themselves are not destroyed. They are simply released to firms in other markets to create goods and services that are relatively more valuable to society. This “destruction” of an industry creates goods of greater social value in another industry. That is Schumpeter’s “creative destruction.”

3.

What makes all the self-interested firms adopt the latest available technology for producing at the lowest opportunity cost possible over time? Emphasize that competitive firms cannot increase their economic profits by raising their price, so they must search for ways to increase economic profit through lowering production costs. This means that firms are constantly seeking out the latest production technologies to find a cost advantage over their competitors. If the other firms failed to adopt this low-cost production technology, they would suffer an economic loss when those that do adopt the technology lower their prices to increase market share. Firms that refuse to adopt the technology must then match a lower market price to retain their market shares, causing them to bear an economic loss and face an eventual exit from the market.

4.

Discuss whether there are economies of scale or diseconomies of scale in class size at colleges and universities. Does it matter if the “output” is measured in tuition dollars and costs or in student success as measured by grades? Does technology impact the answer? This situation can be fun to explore. Can a great teacher supported by excellent technology be best used in a huge lecture class?

Are there some types of instruction, like experimental labs, where increasing class size might lead to disaster? Why do colleges advertise their average class size and do parents and students care? How might the educational “plant” and equipment differ to support various choices in class size?

5.

Using the global corn market, consider the impact of increasing demand for ethanol made from corn in the short and long run. The increase in demand for ethanol raises the price of corn and thereby increases corn farmers’ economic profit…at least in the short run. But in the long run, the economic profit leads existing farmers to plant more corn and more corn farmers to enter the. These long-run changes increase the supply of corn, thereby lowering the price of corn and decreasing corn farmers’ economic profit. Entry (and expansion) continues until, in the long run, corn farmers’ economic profit equals zero. At that point entry ceases and the corn market is back in long-run equilibrium.

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The Big Picture Where we have been: Chapter 12 on perfect competition has shown the student how firms make output and pricing decisions under competitive market assumptions. Chapter 13 explains how a firm with monopoly power makes those same decisions. Chapter 13 evaluates the efficiency of monopoly relative to perfect competition. It also covers regulation of a natural monopoly.

Where we are going: Chapter 14 describes firms and industries in monopolistic competition. Chapter 15 fills in the middle of the spectrum with a study of oligopoly. The material discussing a monopoly’s downwardsloping demand curve and resulting downward sloping marginal revenue curve is used in the next chapter in the context of a firm in monopolistic competition. The result that a monopoly can earn an economic profit is used in Chapter 15 as the explanation why oligopolistic firms want to collude to raise their prices and decrease the quantity they produce.

New in the Fourteenth Edition Many of the applications have been updated. The Economics in Action on information age monopolies, focusing on Microsoft’s dominance in operating systems and Google’s in search, has been updated. Also updated is the Economics in Action on price discrimination, which now reflects more current Disney World ticket pricing. The Economics in the News on Microsoft has been updated to reflect the Windows 10 May 2021 update release. The final Economics in the News focuses on how Google’s search emerged as dominant and, accordingly, its alleged misuse of its monopoly power in search.

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Lecture Notes

Monopoly     

I.

A monopoly is a market with a single firm that is protected by barriers to entry.

A monopoly maximizes its profit by producing where MR = MC and then using its demand curve to set its price.

Price-discriminating monopolies charge a higher price to customers with a higher willingness to pay.

Compared to a competitive market, a monopoly sets a higher price, produces a smaller quantity, and converts consumer surplus into economic profit.

Natural monopolies can be regulated by the government.

Monopoly and How It Arises

A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service.

How a Monopoly Arises A monopoly has two key features:  No Close Substitutes: There are no close substitutes for the good or service.  Barriers to Entry: A constraint that protects a firm from potential competition is called a barrier to entry. There are three types of entry barriers:  Natural barriers to entry create a natural monopoly, which is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost.  An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.  Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work). In the U.S., patents last twenty years, encouraging innovation and stimulating invention.

Who has to have a license to produce? There are many examples of government licensing. Licensing can protect consumers from fraud and abuse, but it can also hurt consumers by preventing competition from producing an efficient allocation of resources. Have the students debate the merits of the following licensing arrangements: 1) Doctors can receive a medical license to practice medicine only by graduating from an AMA-approved medical program; 2) Lawyers can practice law only after passing an extensive Bar Exam; 3) Cab drivers in New York City can operate a taxi only if they have purchased a medallion from the city, of which there are a finite number; 4) Beauticians in many states cannot operate a beauty parlor without a state certification that requires training in sanitary practices as well as other courses completely unrelated to their profession (such as civics and history courses).

What’s the advantage of patents? Granting an innovator a monopoly to the innovation increases the incentives to innovate. Consider the struggle for developing countries with populations dealing with Covid-19. In the developed countries in which they operate, pharmaceutical companies are granted legal barriers (patents) on their drugs, granting them a legal monopoly and enabling them to earn a high economic profit once they bring a new and successful medicine to market. The anticipation of this profit provides the incentive for these firms to undertake the expensive (currently estimated at over $1 billion per approved drug) and risky development of innovative cures and vaccines, such as for Covid-19. Pfizer, for example, invested several billion dollars to develop its vaccine. However, once the new medicines and vaccines are made available, the absence of competition means the price is high, which decreases the use of these new medicines, especially among the population of the poorer, developing nations that have been hit the hard by this disease. So, once the drug is discovered, the monopoly creates a deadweight loss but without © 2023 Pearson Education, Inc.

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the economic profit the monopoly brings, the drugs and vaccines might not have been discovered. More generally, there is a tradeoff between current sufferers, who want a low price, and sufferers in the future, who want new and better medicines developed.

The Economics in Action case considers how the information age has led to the creation of new natural monopolies and now focuses on Microsoft’s dominance in the operating systems market and Google’s dominance in search.

These firms have high fixed costs but almost zero marginal costs.

Monopoly Price-Setting Strategies  

A single-price monopoly is a firm that sells each unit of its output for the same price to all its customers.

Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

II. A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue 

 

The demand curve facing a monopoly firm Quantity Total Marginal is the market demand curve. Total revenue Price demanded revenue revenue (TR) is the price (P) multiplied by the $4 0 $0 quantity sold (Q). Marginal revenue (MR) $3 is the change in total revenue resulting from $3 20 $60 a one-unit increase in the quantity sold. $1 The table shows the calculation of TR and $2 40 $80 MR. $1 A key feature of a single-price monopoly is $1 60 $60 that MR < P at each quantity so the MR curve lies below the demand curve. MR < P because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

Why is MR below the price? While the formula isn’t difficult, students often have trouble understanding this concept intuitively. If a firm sells output for $2, why aren’t they getting $2 of revenue for each unit of output they sell so that marginal revenue is $2? Remind students that we are assuming that the monopoly charges the same price to all consumers. As in the table above, if on any given day, every consumer is paying $2 for output, 40 units are demanded and total revenue is $80. If the monopoly decides it wants to sell more than 40 units the next day, it must lower the price to do so. The monopoly is NOT simply lowering the price to $1 for units 41 through 60. Rather, the monopoly lowers the price on ALL units it will sell the next day. As a result, units 1 through 40 that customers used to pay $2 for will now be sold for only $1. That’s a loss of $1 on each of those 40 units for a revenue loss of $40. Part of that revenue loss is offset by the sales of units 41 through 60. Since the firm gains $1 in revenue from the sale of each of those units, there is a revenue gain of $20. A revenue loss of $40 (from lowering prices) compared with a revenue gain of $20 (from selling more output) generates a net revenue loss of $20, and (when divided by the change in output from 40 to 60) a marginal revenue of negative $1. For visual learners, showing these areas of revenue gain and revenue loss should also help (similar to Figure 13.2 in the text).

Marginal Revenue and Elasticity 

 

If demand is elastic, the MR is positive. A decrease in the price will result in a proportionately greater increase in quantity, generating an increase in revenue.

If demand is unit elastic (as it is at the midpoint of a linear demand curve), the MR equals zero. A change in the price will result in a proportionate change in quantity, generating no change in revenue. If further increase in revenue is not possible from changing price, this is also the point where revenue is maximized.

If demand is inelastic, MR is negative. A decrease in price will result in a proportionately smaller increase in quantity, generating a decrease in revenue.

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

A single-price monopoly never produces in the inelastic part of its demand because if it did, the firm could increase its total profit by decreasing its output, which would raise its total revenue and decrease its total cost.

But if a monopoly is the only producer so there are no substitutes, isn’t demand always inelastic? This question is common. As the only producer of a good, a monopoly does have some control over the price it charges for output, and students understand that conceptually. For example, when you go to the movie theater, you know you’re likely to pay $5 or more for a tub of popcorn, even though you could buy the same amount of popcorn at the grocery store for $1 or less. Because you’re stuck at the movie theater with whatever options they offer, consumers end up paying a higher price. In other words, because there are fewer substitutes at the theater, demand for popcorn is less elastic.

However, that fact does NOT mean that the demand for popcorn at a movie theater universally has an elasticity of demand that’s less than one. Even if demand for a monopoly’s product is fairly inelastic, the demand still has some ranges where elasticity is greater than one (anywhere above the midpoint on a linear demand curve, for example).

Price and Output Decision 



To maximize its profit, a monopoly produces the level of output where MR = MC. The monopoly then uses its demand curve to set the price at the highest price for which it will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 20 units of output and sets a price of $3 per unit.

The firm makes an economic profit if P > ATC, which is the case for the firm in the figure. The monopoly can make an economic profit even in the long run because the barriers to entry protect the firm from competition.

However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might make zero economic profit, (P = ATC) or in the short run, it might incur an economic loss (P < ATC).

Joan Robinson and Paul Samuelson: The classic monopoly diagram provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old.

Women are still not attracted to economics on the scale that they’re attracted to most other disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk. Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

III. Single-Price Monopoly and Competition Compared Comparing Price and Output 

Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied. In the figure above, the competitive equilibrium quantity is 30 units and the competitive equilibrium price is $2.50 per unit. © 2023 Pearson Education, Inc.

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Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 20 units of output and sets a price of $3.00 per unit.

Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Is the monopolist’s marginal cost curve its supply curve? Although most students will be satisfied with the comparison of the monopolist’s marginal cost curve to a competitive market’s supply curve, some students will mistakenly assume that the monopolist’s marginal cost curve is also the monopolist’s supply curve. A monopolist actually has no “supply curve” because there is no single curve that provides information both on the quantity supplied and the price. If the firm produces 20 units of output when it is maximizing profit, that output level is determined by the point where MC = MR. However, the price charged for that output doesn’t come from the MC curve. The price comes from the market demand curve. As a result, there is no relationship between the quantity supplied and price that is defined by the marginal cost curve.

Efficiency Comparison and Redistribution of Surpluses 





A perfectly competitive industry produces the efficient quantity of output, where MSB = MSC. Because a single-price monopoly produces less output (where MSB > MR = MC = MSC), it underproduces and creates a deadweight loss.

Consumer surplus is smaller with a monopoly than with perfect competition. In the figure above, the consumer surplus under perfect competition is the area under the demand curve and above the competitive equilibrium price of $2.50 per unit. Under monopoly the consumer surplus is the area under the demand curve and above the monopoly price of $3.00.

Though the monopoly creates a deadweight loss, the monopoly’s owners benefit because it earns an economic profit. A monopoly’s owners benefits because the monopoly redistributes some of the consumer surplus away from the consumer and to the monopoly.

Does inefficiency imply less profit? It is important for students to recognize that the source of the inefficiency of a monopoly firm’s output and pricing decision arises from the absence of competition in the market, rather than any change in the behavioral assumptions about the firm owners. All firms maximize profit, but that goal does not imply efficiency when there is less than perfect competition in a market.

Rent Seeking 



Any surplus—consumer surplus, producer surplus, and economic profit—is called economic rent. Rent seeking is the pursuit of wealth by capturing economic rent.  Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit.  Rent seeking also can occur when someone uses resources lobbying the government to create a monopoly. Because of rent seeking, the social cost of monopoly exceeds the deadweight loss it creates.

The resources used in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit, reducing monopoly profit.

IV. Price Discrimination

Price discrimination is the practice of selling different units of a good or service for different prices. Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must:  Identify and separate different buyer types.  Sell a product that cannot be resold

Two Ways of Price Discriminating 

Price discrimination occurs because of people’s different willingness to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers. © 2023 Pearson Education, Inc.

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



Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher willingness to pay are charged a higher price and groups with a lower willingness to pay are charged a lower price. For example, business airline travelers who have a high willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low willingness to pay and often make advance reservations.

Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.

Increasing Profit and Producer Surplus  If buyers pay close to the maximum they are willing to pay, a monopoly converts consumer surplus into producer surplus. More producer surplus means more economic profit.  Economic profit is TR − TC and Producer Surplus is TR − TVC. Therefore Economic Profit = Producer Surplus − Total Fixed Costs. Consequently, for a given level of fixed costs, anything that increases producer surplus increases economic profit.  Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay for it. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the demand (= marginal revenue) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the greatest possible. But consumer surplus equals zero because the firm captures the entire consumer surplus.

An Economic in Action feature considers Disney World’s ticket pricing. High prices for the first four days seem to extract most of the consumer surplus.

Efficiency and Rent Seeking With Price Discrimination 



The more perfectly a monopoly can price discriminate, the greater the amount of its output and the more efficient the outcome.

Because the producer grabs the entire surplus in perfect price discrimination, rent seeking becomes profitable, and the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

Can only monopolies price discriminate? The text uses the example of price discrimination by an airline. Another easy example of price discrimination is movie theaters: The price of watching a movie at 8:00 is higher than the price of watching the same movie at 5:00. But these examples often lead to a very pertinent question from students: “Neither airlines nor theaters are monopolies. So why can they price discriminate?” You need to explicitly tell your students that any firm which has some control over the price it sets has the potential to price discriminate. Monopolies have control over the price it sets, so we discuss price discrimination in the chapter dealing with monopoly. But in the “real world,” many firms other than monopolies, such as airlines and movie theaters, practice price discrimination.

An Economics in the News application describes Microsoft’s pricing of Windows 10 and includes data from various sources to explore price discrimination.

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V. Monopoly Regulation 







A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve.

The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied.

A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency.

The social interest theory says that political and regulatory processes seek out inefficiency, reduce deadweight loss, and allocate resources efficiently. Capture theory says regulation serves the interest of producers who capture the regulators to maximize economic profits.

Efficient Regulation of a Natural Monopoly 





An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Qm and sets a price of Pm. There is a deadweight loss.

A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Qmc and sets a price of Pmc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss.

If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

Second-best Regulation of a Monopoly 



 

An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Qac and sets a price of Pac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated. Government subsidies could offset those losses but would create deadweight losses from the taxes that would have to be increased to pay the subsidies.

Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.  Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

Because rate of return regulation does not give the firm the incentive to operate efficiently, price-cap regulation is now used more frequently.

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and © 2023 Pearson Education, Inc.

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earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

Economics in the News: The Economics in the News analyzes whether Google leveraged its dominant position in search to highlight its own products and services in search results and to prevent advertisers from moving content to other platforms. It concludes that Google is attempting to perfectly price discriminate and does not appear to be acting against the social interest.

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Additional Problems 1.

The table has the demand schedule for industrial diamonds faced by Dolly’s Diamond Mines, a single-price monopoly. a. Calculate Dolly’s total revenue schedule. b. Calculate its marginal revenue schedule.

Price (dollars per pound) 2,200 2,000 1,800 1,600 1,400 1,200

2.

Quantity demanded (pounds per day) 5 6 7 8 9 10

Dolly’s Diamond Mines in problem 1 has the Quantity produced Total cost total cost schedule in the table. Calculate the (pounds per day) (dollars) profit-maximizing levels of 5 8,000 a. Output 6 9,000 b. Price 7 10,000 c. Economic profit 8 11,600 9 13,200 d. Does Dolly’s Mines use resources efficiently?

10 15,000 Explain your answer.

3.

Figure 13.1 illustrates the situation facing the publisher of the only newspaper containing local news in an isolated community. The publisher’s marginal cost for the new plant is constant at 20 cents per copy printed. a. What quantity of newspapers will maximize the publisher’s profit? b. What price will the publisher charge for a daily newspaper? c. What is the publisher’s daily total revenue? d. At the price charged for a newspaper, is the demand for newspapers elastic or inelastic?

Why? 4.

In the monopoly newspaper market described in problem 3, a. What is the efficient quantity of newspapers to print each day? Explain your answer. b. When the market is a monopoly, what is the consumer surplus of the readers of the newspaper? c. What is the deadweight loss created by the monopoly newspaper publisher?

5.

What is the maximum value of resources that will be used in rent seeking to acquire Dolly’s monopoly in problem 1? Considering this loss, what is the total social cost of Dolly’s monopoly?

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Solutions to Additional Problems Price (dollars per pound) 2,200

Quantity demanded (pounds per day) 5

Total revenue (dollars per day) 11,000

2,000

6

12,000

1,800

7

12,600

1,600

8

12,800

1,400

9

12,600

1,200

10

12,000

Marginal revenue (dollars per pound) 1,000 600 200 −200 −600

1.

a.

b.

2.

a.

b.

c.

d.

3.

a.

b.

The table above shows the total revenue schedule. Dolly’s total revenue schedule lists the total revenue at each quantity sold. For example, Dolly’s can sell 10 pounds for $1,200 a pound, which gives it total revenue of $12,000 at the quantity 10 pounds.

The table above shows the marginal revenue schedule. Dolly’s marginal revenue schedule lists the marginal revenue that results from increasing the quantity sold by 1 pound. For example, Dolly’s can sell 5 pounds for $2,200 each, which is total revenue of $11,000 at the quantity of 5 pounds. Dolly’s can sell 6 pounds for $2,000 each, which is $12,000 of total revenue at the quantity of 6 pounds. By increasing the quantity sold from 5 pounds to 6 pounds, marginal revenue is $1,000 a pound ($12,000 minus $11,000).

Dolly’s profit-maximizing output is 5.5 pounds. The marginal cost of increasing the quantity from 5 pounds to 6 pounds is $1,000 a pound ($9,000 minus $8,000). That is, the marginal cost of 5.5 pounds is $1,000 a pound. The marginal revenue of increasing the quantity sold from 5 pounds to 6 pounds is $1,000 ($12,000 minus $11,000). So the marginal revenue from 5.5 pounds is $1,000 a pound. Profit is maximized when the quantity produced is such that marginal cost equals marginal revenue. The profit-maximizing output is 5.5 pounds.

Dolly’s profit-maximizing price is $2,100 a pound. The profit-maximizing price is the highest price that Dolly’s can sell the profit-maximizing output of 5.5 pounds. Dolly’s can sell 5 pounds for $2,200 and 6 pounds for $2,000, so it can sell 5.5 pounds for $2,100 a pound.

Economic profit equals total revenue minus total cost. Total revenue equals price ($2,100 a pound) multiplied by quantity (5.5 pounds), which is $11,550. Total cost of producing 5 pounds is $8,000 and the total cost of producing 6 pounds is $9,000, so the total cost of producing 5.5 pounds is $8,500. So Dolly’s economic profit equals $11,550 minus $8,500, which is $3,050.

Dolly’s is inefficient. Dolly’s charges a price of $2,100 a pound, so consumers receive a marginal benefit of $2,100 a pound. Dolly’s marginal cost is $1,000 a pound. That is, the marginal benefit of $2,100 a pound exceeds Dolly’s marginal cost.

The profit-maximizing output is 200 newspapers a day. Profit is maximized when the firm produces the output at which marginal cost equals marginal revenue. Draw in the marginal revenue curve. It runs from 100 on the y-axis to 250 on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 200 newspapers a day.

The highest price that the publisher can sell 200 newspapers a day is determined from the demand curve.

The price charged is 60 cents a paper. © 2023 Pearson Education, Inc.

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c. d.

The daily total revenue is $120 (200 papers at 60 cents each).

Demand is elastic. Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the demand curve. The price at the midpoint is 50 cents. So at 60 cents a paper, demand is elastic.

a.

The efficient quantity is 300 newspapers—the quantity that makes marginal benefit (price) equal to marginal cost. With 300 newspapers available, people are willing to pay 40 cents for a paper. To produce 300 newspapers, the publisher incurs a marginal cost of 40 cents a paper.

Consumer surplus is the area under the demand curve above the price. When the market is a monopoly, the price is 60 cents, so consumer surplus equals (100 cents minus 60 cents) multiplied by 200/2 papers a day, so the consumer surplus is $40 a day.

Deadweight loss arises because the publisher does not produce the efficient quantity. Output is restricted to 200, and the price is increased to 60 cents. The deadweight loss equals (60 cents minus 40 cents) multiplied by 100/2 so the deadweight loss is $10 a day.

b.

c.

5.

147

The maximum that will be spent on rent seeking is $3,050 a day—an amount equal to Dolly’s economic profit. The total social cost equals the deadweight loss plus the amount spent on rent seeking. To calculate the deadweight loss, first calculate the efficient output—the intersection point of the demand curve (marginal benefit curve) and the marginal cost curve. Do this by finding the equations to the two curves and solving them. The efficient output is 8.25 pounds. The deadweight loss equals $1,512.50. The loss to society is $4,562.50 ($3,050 plus $1,512.50).

Additional Discussion Questions 1.

The double-edged sword of a natural monopoly. Emphasize how economic analysis reveals the social benefits and costs of an industry characterized by a downward sloping, long-run LRAC curve. Ask the student the following questions: What is the characteristic of the monopoly market that allows a natural monopoly to potentially produce output at the lowest possible LRAC? The student should see that a lack of competition allows the firm to potentially serve the entire market at a lower unit cost than if it had to share the market with any other number of firms. A multi-firm market would be forced to produce at a higher LRAC. What is the characteristic of a monopoly market that allows a natural monopoly to potentially charge consumers a price premium above long-run LRAC? If the natural monopoly has the freedom to set its own price, the student should identify the lack of competition that prevents the consumer from benefiting from production actually occurring at the lowest LRAC. On the one hand, the lack of competition is the only way to allow society to enjoy a (potentially) more efficient allocation of resources, yet it also allows the firm to extract consumer surplus while generating an inefficient resource allocation—a “double-edged sword.”

2.

Troubles with price discrimination: The ethics of scalping. Get the students to address the realities of arbitrage in secondary markets that arise when the primary seller of a good refuses to price discriminate.

Is it in society’s best interest (economically efficient) to allow the scalping of tickets? The students should see that ticket scalping is just a form of price discrimination, which is a business practice shown in the text to increase the level of efficiency in resource allocation within a monopoly market context.

Why do the original ticket sellers refuse to price discriminate like the scalpers? There are many possible reasons:

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3.

The original seller of the tickets (usually the music group giving the concert or the ticket sellers that are under direct contract for them) may want to avoid the reputation of charging different prices to different people, or different prices at different time intervals before the concert.  The original seller may not have the ability to distinguish between high and low demand customers, unlike the “scalpers” who sell the tickets standing outside the doors on the day of the concert.  The original sellers may be very risk averse and prefer to sell every ticket well in advance of the concert date, based on the expectations of sales potential made with the best available information at the time. They may reason that if a concert sells out quickly, the demand for future concerts will increase because more people come to believe that the group is “hot” and a must-see act. However, information about the actual demand for a concert becomes clearer as the concert date draws nearer and the equilibrium price for a ticket may change significantly.

Scalpers must gamble that ticket prices will increase when it eventually becomes clear that demand for the event is relatively high. They bear the risk that the original ticket seller would not bear: that the ticket prices may also decrease if it is revealed that demand for the event is relatively low.

Is it “fair” to allow scalping of concert tickets? Remind the students that the practice of price discrimination can increase monopoly profits for the resellers while simultaneously increasing efficiency for society. Remind them also of the principle of opportunity cost and ask them to consider how much efficiency they are willing to give up in the name of “fairness.” Point out that fairness is a normative concept—different people might have different ideas of fairness. For instance, the scalper who sells his or her tickets surely believes that the actions are fair. The purchaser of the scalped ticket might believe that paying above the asked price is unfair but the person is still willing to buy the ticket as long as the scalped price is less than the maximum price he or she is willing to pay.

If it is unfair to scalp tickets because of the way price discrimination transfers consumer surplus to producer surplus, then what about other forms of price discrimination? Ask the students to consider the following scenarios. They should understand that, in each case, there is an identifiable group of consumers who have a different willingness to pay for the product or service mentioned.  If the costs of projecting a movie are the same at all times of day, why are matinee movie prices lower than evening movie prices for the exact same movie in the exact same theater? Why do movie theaters often give students discounts?  If the cost of publication is the same for all potential subscribers, then why do magazines and newspapers offer students discounts on subscription prices?  If the cost of serving beverages and supplying entertainment (live bands) is the same for both men and women, then why do bars and clubs offer “Ladies’ Night” where women get free drinks or pay no cover charge?  If the cost of serving food and beverages is the same for all diners, then why do seniors get a price break from restaurants for the exact same meals?

How would you measure the inefficiency of a monopoly? The students should see that the lost potential for consumer and producer surplus could be calculated as deadweight loss, but that is only part of the total loss of benefits. Ask the students: Is there more to the inefficiency of a monopoly than meets the eye? If you are rather brave, you may want to ask the students to play the following game: Show the class a fresh, real five-dollar bill.

Announce that it is a monopoly profit that anyone in class can receive simply by submitting the highest, non-zero price bid for it. Mention that even if the highest bid is only one penny, then that person will receive the five-dollar bill. However, everyone else that submits a bid must also pay you the value of that bid, regardless of whether they are successful. (This bid price reflects the cost involved with rent-seeking behavior.) In the case of a tie for highest bid, a run-off bidding contest © 2023 Pearson Education, Inc.

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among the tied high bidders will occur, but their first bid still stands as a debt to you, the holder of the monopoly profit.

How much would YOU bid for this monopoly profit? Ask the students to write down on a small piece of paper their name and the price he or she is willing to bid for the five-dollar bill. They may write a bid of zero cents, but they will not get a chance to win. Announce that you will collect the money from them later (you will have their name and their bid). After collecting the bids, roughly tally them up and announce the winning bid, as well as the total sum of the bids to be collected. There are two possible scenarios to the outcome of this auction:  There is one high bidder, and this bid is usually very close to the monopoly profit offered for sale—there are usually one or two students who want to signal their “devil-may-care” attitude or signal their status as a relatively wealthy student who can afford to play extravagant games.  There is a tie between two or more students. The resulting run-off bidding is usually very high, because each of the remaining students hasn’t yet fully appreciated the economic notion of sunk costs. In this latter case, do not be surprised if the winning bid is more than five dollars, as the “winner” wants desperately not to lose the full amount of his or her initial bid.

What is the total opportunity cost of the resources used to pursue monopoly profits? Point out that the bids represent the resources people use (usually through lobbying efforts) to pursue a monopoly market position by convincing government to restrict competition. Ultimately, only one person wins, but all contenders expend resources in the pursuit. That is why all losing bidders had to pay their bid price.

Can we compare the value of lost output in other markets that could have been produced against the value of those goods and services produced specifically for pursuing a monopoly? Emphasize that the goods and services that were used to pursue a monopoly would not have been chosen for production if the monopoly profit hadn’t been offered up for sale in the first place. That is how we can know that rent seeking is inefficient—there was a decline in net benefits for society from forgone production of higher-valued goods. After the discussion is over, give the highest bidder the five-dollar bill in exchange for the bid he or she pledged. (You were warned about having to be brave!) If the highest bid is over five dollars, just state that you will forgive the student his or her debt and call it a wash. Then announce that the other bidders are also off the hook, as you were just trying to make the scenario as realistic as possible. Many sighs of relief will be heard.

4.

5.

When the old AT&T had a virtual monopoly on long distance service, it created a rate structure that had high prices M-F 8 am to 5 pm, medium prices M-F 5:01 pm – 11 pm, and low prices M-F 11:01 pm -7:59 am and all day weekends and holidays. How might the differences in elasticities for business phone users and household phone users explain this rate structure? Long distance pricing under the unregulated AT&T monopoly is a great example of price discrimination. Add on to the example the “Reach Out and Touch Someone” campaign to increase residential demand, and price sensitive households across America called Grandma on Sunday evening. Businesses had little ability in that era to shift their demand to other periods and phone service, while expensive, was a small part of their total costs. Both these factors made business demand for long distance phone services relatively inelastic and lead to the high price of long-distance calling during business hours.

Gilead has changed the pricing structure on its essential AIDS medications so that prices are high in industrialized countries, medium in emerging countries, and low in the poorest countries. Discuss whether this is an example of price discrimination and whether resources are efficiently allocated given patents and high drug development costs. This issue could easily be the basis for a good debate or opinion essay. Clearly Gilead is price discriminating. Likely Gilead is increasing its economic profit. Society has a strong interest in creating more innovation and technological change. Perhaps Gilead’s pricing structure can further these goals by increasing the profit from its innovation. This three-tier pricing model could be regarded as “fair” or “unfair” depending on which nation and © 2023 Pearson Education, Inc.

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which part of the health care matrix an agent represents.

How does technological change lead to new competition for old monopolies and sometimes to their failure? Changes at the U.S. Postal Service are widely reported. Kodak filed bankruptcy. Streaming on computers becomes potentially a viable substitute for cable television. These examples certainly help frame an answer to the important question “Does having a monopoly guarantee success?”

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MONOPOLISTIC COMPETITION

The Big Picture Where we have been: Chapter 14 continues the general analysis of the firm’s output and price decision by examining the case of monopolistic competition. This chapter also examines efficiency using the ideas introduced and explained in Chapters 2 and 5 and uses the market concentration measures explained in Chapter 10.

Where we are going: Chapter 15 presents the final market structure, oligopoly. Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. The material presented in this chapter is not used explicitly in the following chapters.

New in the Fourteenth Edition A new chapter introduction and concluding Economics in the News application focus on product differentiation in the market for streaming. The data in the Economics in Action on 10 industries that operate as monopolistic competition has been updated.

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Lecture Notes

Monopolistic Competition 



I.

Firms in monopolistic competition face competition from many other firms that produce a similar but differentiated product from its own.

Firms in monopolistic competition maximize their profit by producing where MR = MC.

What Is Monopolistic Competition?

Monopolistic competition is a market structure in which:  A large number of firms compete  Each firm produces a differentiated product  Firms compete on product quality, price, and marketing  Firms are free to enter and exit

Large Number of Firms 

The large number of firms in a monopolistically competitive industry implies that each firm has a small market share, no firm can dictate market conditions, and collusion (conspiring to fix a higher price) is impossible.

Product Differentiation 

Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Because close but not perfect substitutes exist, some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping.

Competing on Quality, Price, and Marketing  

 

Product differentiation allows a firm to compete with other firms in product quality, price, and marketing.

Quality: Physical attributes that differentiate a product, including differences in design, reliability, and service provided.

Price: There is a tradeoff between quality and price.

Marketing: The two main forms are advertising and packaging.

An Economics in Action application considers 10 monopolistically competitive industries. The application shows the 4-firm concentration ratios and Herfindahl-Hirschman Index.

Entry and Exit 

With no barriers to entry, firms in monopolistically competitive industries make zero economic profit in the long run.

Examples of Monopolistic Competition 

Examples of a monopolistic industry include audio and video equipment, sporting goods, and jewelry.

Ask students to bring in an empty beverage bottle of their choice. From the pile in the front of the room, have students help separate them into products in competing markets. A surprising large numbers of water bottles will appear, and differences as simple as packaging enter the conversation.

II. Price and Output in Monopolistic Competition The Firm’s Short-Run Output and Price Decision 

The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly). The downward sloping demand curve means that the firm’s marginal revenue curve also is downward sloping and lies below the demand curve.

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Why do these firms face a downward-sloping demand curve if there are so many substitutes available? Remind the students about the “everything-else-constant” condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant.

Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough. Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded—a downward sloping demand. 





In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve, which, as noted, lies below the demand curve.

The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $15 per pizza.

The firm earns an economic profit if P > ATC (as is the case for the firm in the figure). If P = ATC, the firm earns zero economic profit, and if P < ATC, the firm incurs an economic loss.

Profit Maximizing Might be Loss Minimizing 

In the short run, profit maximizing quantity of output might be the loss minimizing quantity of output. The text explores the case of Excite@Home.

Long Run: Zero Economic Profit 



Unlike a monopoly, firms in monopolistic competition cannot earn economic profit in the long run. If the firms are earning an economic profit, other firms enter the market. Entry continues as long as firms in the industry earn an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward.

Eventually the demand decreases enough so that the firms earn only a normal profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 10 pizzas per hour (where MR = MC) and sets a price of $7.50 per pizza.

Why do entry and exit shift the demand curve facing the firm? Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. You can now haul out your cell phone and return to it as your in-class example. Likely your phone will have a camera. Though the early history is fuzzy—it’s replete with small attempts that led to either small failures or small successes—the first largely successful cell phone/camera was the Jphone marketed in Japan in 1997. In the United States, Sprint had the first success: It sold over 1 million camera phones in 2002. Clearly these phones were wildly popular and inspired imitators. You can draw the figure showing a monopolistic competitive firm earning a large economic profit and tell the students that this was the case with these first phones. But then competitors entered the market. When the second phone entered the market, show how the © 2023 Pearson Education, Inc.

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demand for the first firm was affected by shifting it and its marginal revenue curve leftward. You can easily point out how entry decreased the first firm’s profit. Continue by discussing how further entry shifted the demand curve further leftward until, in the long run, the company was left with only a normal profit.

Monopolistic Competition and Perfect Competition Unlike firms in perfect competition, firms in monopolistic competition have excess capacity and a markup:  Excess Capacity: A firm has excess capacity if it produces less than its efficient scale, the quantity that minimizes its average total cost. In the long run, a firm in perfect competition produces at the minimum ATC but, a firm in monopolistic competition produces less than the quantity that minimizes the ATC.  Markup: A firm’s markup is the amount by which its price exceeds its marginal cost. A firm in perfect competition has no markup but a firm in monopolistic competition charges a price that is greater than its marginal cost of production.

Is Monopolistic Competition Efficient? 

Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity, monopolistic competition might be efficient.

III. Product Development and Marketing Product Development 



Product development is costly but can bring in additional revenue. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation. At a low level of product development, the marginal revenue of better products exceeds the marginal cost so firms develop more new products. At high levels, the marginal cost exceeds the marginal revenue and so firms develop fewer new products.

Because MR is less than P in monopolistic competition, product development is probably not at its socially efficient level.

Food lore says that buffalo wings started out at a restaurant in Buffalo, New York, and now are on the menu of virtually every bar and casual dining restaurant in the nation. Many other similar examples can be identified. Success breeds imitation in the world of competition and sometimes the original creator is not in business in the end as rivals creep in and engage in a never-ending series of one-upmanship.

Advertising 

Advertising and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.

An Economics in Action case explores the cost of selling a pair of shoes. The vast majority of the costs are selling costs. 

Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. Advertising efforts are successful if they increase demand, which can lead to increased profit.

But if all firms advertise, more firms might survive, and so the demand for any one firm is less than otherwise.

Using Advertising to Signal Quality 

Heavy marketing and advertising expenditures are a signal to consumers of a high-quality product. A signal is an action taken by an informed person (or firm) to send a message to uninformed people.

Efficiency of Advertising and Brand Names 

Advertising and brand names might be efficient if they provide consumers with information about the precise nature of product differences and about product quality. So, the final verdict about the efficiency of monopolistic competition is ambiguous.

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An Economics in the News feature considers product differentiation in the market for streaming. It studies how Amazon successfully differentiates its streaming service (for example, by purchasing MGM studios) and maintains a higher market share.

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Additional Problems 1.

The figure shows the situation facing Well Done, Inc., a producer of steak sauce. a. What quantity does Well Done produce? b. What does it charge? c. How much profit does Well Done make? d. If all steak sauce firms have identical cost curves and face identical demand curves, what happens to the number of firms in the market in the long run? e. In the long run, will the price of steak sauce rise, fall, or not change?

Solutions to Additional Problems 1.

a. b. c.

d. e.

To maximize profit, Well Done produces the quantity at which marginal revenue equals marginal cost. Well Done produces 200 bottles a week.

To maximize profit, Well Done charges the highest price that allows it to sell the 200 bottles of steak sauce it produces. This price is read from the demand curve and is $4 a bottle.

Economic profit equals total revenue minus total cost. The price is $4 and the quantity sold is 200 bottles, so total revenue is $800. Average total cost is $3, so total cost equals $600. Economic profit equals $800 minus $600, so Well Done makes an economic profit of $200 a week The firms are making an economic profit so new firms will enter the market. In the long run the number of firms is greater than in the short run.

In the long run the number of firms increases so that each firm’s demand is less than in the short run. With the lowered demand the price of steak sauce is lower in the long run.

Additional Discussion Questions 1.

In what sense is a firm in monopolistic competition similar to a monopoly firm? Emphasize that each firm has some ability to raise market price through marketing effort and product differentiation. This means MR < P at all levels of output. In the long run, both markets are inefficient in the strict allocative efficient sense because: i) production does not occur at the lowest possible unit cost, and ii) P (=MSB) > MC (=MSC) at equilibrium, so each firm produces less output than is socially efficient.

2.

In what sense is a firm in monopolistic competition similar to a perfectly competitive firm? Emphasize that entry and exit affect the market price that each firm can charge in both markets. Also, low barriers to entry and exit make it impossible for any firm to enjoy economic profits in the long run.

3.

Is advertising real information or is it just hype? Have the class discuss whether an increase in the consumer’s willingness to pay for a product is sufficient to justify advertising as socially beneficial.

There are only normative answers to this question, but it is still a useful exercise in carefully thinking about how we define efficiency in economic modeling.

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4.

Imagine a four lane road in any suburban area in the country. Often there will be gas stations directly across the road from one another, rarely facing peak demand. Would it be more efficient to have just one gas station? If so, why do two survive over long periods of time? The situation of competing gas stations on opposite corners is a good example of excess capacity in monopolistic competition. Empty pumps and a less busy attendant mean gas costs a little more than otherwise; that is, the mark-up is positive. But consumers much prefer the convenience of pulling up to an open pump on the side of the road on which they are traveling rather than trying to cross multiple lanes of traffic to get in line for a gas pump with slightly cheaper gas which would more likely be the case if gasoline stations competed in a perfect competitive industry. Drivers find it worth paying a few cents more rather than having to maneuver across traffic and then wait available pump at a big busy station.

5.

What does it mean for a product to be differentiated? In papers and other assignments, I have had students argue that beer and soda were products that were “identical” or homogeneous rather than differentiated. It is worth having a discussion about what it means to be differentiated and the various methods firms can use to differentiate their products. Location, staffing and service, flavors, sizes, formulas, and even just packaging might differentiate products. As long as there is some difference between the goods or services, they might well be differentiated.

6.

Ford Motor Company today is taking market share from rivals and innovating new products with features consumers find desirable. But in the past, Ford famously lost market share to rivals when founder Henry Ford refused to engage in product differentiation, preferring instead the efficiency of mass production of a single product, saying that customers could get a Model T in any color, as long as it was black. What are the advantages and disadvantages of product differentiation? Can the market itself work out the right amount of product differentiation over time? If there are economies of scale, having fewer, larger amounts of production reduces cost. Differentiation adds costs, not just in formulas, but in packaging and other resources. If the differentiation is meaningful to consumers, then having various types of products and levels of quality and service adds meaningful value. To some degree, if a differentiation persists in the market, people must find it worth paying for.

Consumers though must have good access to information and firms must be free to enter and exit as what the market wants changes over time.

7.

Are brands the same as companies? Does a crowded aisle at the store mean lots of competition? Most nationally distributed consumer products are created by firms in markets that are oligopolistic. The breakfast cereal aisle is crowded with all kinds of brands, but only 3-4 companies make most of the breakfast cereal sold nationwide. The toothpaste aisle is again crowded with varieties but the toothpaste market is dominated by just a couple of firms. Going back to the material in Chapter 10 about the differences between market structures and market concentration measures, now is a good time for an assignment or a discussion about the differences between brands and firms. Brand proliferation can be a sign of a lack of competition when students may interpret it as robust competition. This assignment or discussion can serve as a good bridge to discussing oligopoly.

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OLIGOPOLY

The Big Picture Where we have been: Chapter 10 began the study of the theory of the firm by describing various market structures and defining economic profit. Chapter 11 introduced various cost and production measures. Chapters 12, 13, and 14 presented perfect competition, monopoly, and monopolistic competition, respectively.

Chapter 15 now wraps up the analysis of the firm’s output and price decision by examining oligopoly. The chapter examines various approaches to studying firm behavior in oligopoly and is the last of the chapters that focus on the theory of the firm.

Where we are going: Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. None of the material in this chapter is used explicitly in the following chapters.

New in the Fourteenth Edition The chapter is little changed since the last edition. The final Economics in the News analysis has been changed to focus on the decisions the big tree cell phone providers have made about upgrading to 5G.

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Lecture Notes

Oligopoly 

Firms in oligopoly have only a few competitors. Their behavior can be analyzed using game theory, which shows the prisoners’ dilemma they can face.

The Economics in Action shows the Herfindahl-Hirschman Indices for 10 markets that are oligopolies. The text points out that the dividing line between oligopolistic and monopolistic competition is usually a HHI of 2,500.

I.

What is Oligopoly?

The distinguishing features of an oligopoly are the presence of natural or legal barriers that prevent the entry of new firms and so only a small number of firms compete.

Barriers to Entry 



A natural oligopoly market occurs when the efficient scale of production allows only a few firms to meet the market demand.

A legal oligopoly arises when a legal barrier to entry protects the small number of firms in the market.

Small Number of Firms  



Because of entry barriers, the number of firms is small and each has a large share of the market.

Because there are a small number of firms, the firms in an oligopoly market are interdependent—each firm’s profit depends on its actions and the actions of its competitors.

The firms have a temptation to form a cartel, which is a group of firms acting together—colluding—to limit output, raise price, and increase economic profit. Such collusion is illegal in the United States but it still occurs.

II. Oligopoly Games 

Economists think of oligopoly as a game between just a few players and use game theory to study oligopolistic behavior.

Game theory is a tool for studying strategic behavior—behavior that takes into account the expected behavior of others and the recognition of mutual interdependence.

What is a Game? 

 Games have rules, strategies, payoffs, and outcomes.

The Prisoner’s Dilemma captures many of the essential features of games and gives a good illustration of how game theory works and generates predictions.

Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decision-making process.

Game theory is a big step for the student and need a significant amount of time to develop. This chapter is designed to be flexible and provide you with many options on just how far to go.

1. You might want to introduce only the prisoner’s dilemma game.

2. You might want to spend serious time applying the prisoner’s dilemma to a cartel game.

3. You might want to extend the range of examples and apply the prisoner’s dilemma to a real-world research and development game.

4. Finally, you might want to introduce repeated and sequential games and some of their applications and implications.

Each of the steps laid out above is optional, but cumulative. You can stop at any point, but shouldn’t try to skip a step except that you can teach the R&D game based on the general introduction to the prisoner’s dilemma without teaching the longer and more complex cartel game.

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The Prisoners’ Dilemma 

   



In the prisoner’s dilemma, the rules specify that each prisoner is placed in a separate room and must choose whether to confess without conferring with his accomplice.

Strategies are all the possible actions of each player.

The game’s payoff matrix, a table that shows the payoffs for every possible action by each player for every possible action by each other player, is to the right. In it are the payoffs from each prisoner’s strategies, which are to confess or deny involvement in the serious crime.

The choices of both players determine the outcome of the game. We use the concept of a Nash equilibrium to predict the outcome of a game.

Art (A) and Bob (B) have been caught stealing A’s strategies cars. Both men are sentenced to two years in Deny Confess jail for this crime. Both are suspected of committing a more serious crime for which the 10 years 3 years prosecutor has insufficient evidence for a Confess conviction. The two men are each interrogated 3 years for the more serious crime in separate cells.

1 year B’s Each prisoner is told that if he confesses and strategies his partner denies, he will serve 1 year in jail 2 years 1 year and his partner will serve 10 years, while if Deny both confess, both serve 3 years. If neither confesses, each man will spend 2 years in jail, 10 years 2 years after being convicted of a lesser crime. These “payoffs” are in the payoff matrix.

In the Nash equilibrium of the prisoner’s dilemma game, player A takes the best possible action given the action of player B and player B takes the best possible action given the action of player A. The Nash equilibrium for the prisoners’ dilemma is for both players to confess. This outcome is bad for them because both would be better off if each denied.  A dominant strategy is a strategy is better than another for one player, regardless of how the other players play. In the prisoners’ dilemma, each player has a dominant strategy of “Confess.”

An Oligopoly Price-Fixing Game 

 

Firms in an oligopoly can face a prisoners’ dilemma game. Suppose there are two firms, A and B. The firms could enter into a collusive agreement to jointly boost their price and decrease their output. Once the agreement is made, each firm must select its strategy: cheat on the agreement or comply with the agreement.

The payoff matrix is to the right. Each A’s strategies firm’s profit depends on its strategy and that Comply of its competitor.

Cheat The Nash equilibrium for the game is for $0 $1 million both firms to cheat on the agreement. The Cheat outcome is bad for them because both would be better off if each complied with B’s $0 $5 million the agreement. This Nash equilibrium is strategies called a dominant strategy equilibrium, $3 million $5 million which is an equilibrium in which the best Comply strategy of each player is to cheat regardless of the strategy of the other player. $3 million $1 million

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The Economics in Action considers R&D spending in the facial tissue market, with Proctor & Gamble producing Puffs and Kimberly Clark, Kleenex. In this game both firms spend for R&D, which is less profitable for both than if they could collude and do no research. Rivalry forces them to be innovative. This case reminds students that firms do R&D to sell products rather than for higher moral purposes.

A Game of Chicken 

 

In an R&D game of chicken, two firms, A and B, can conduct R&D. The firm that conducts the R&D must pay for the R&D, but the R&D will lead to a new product that both firms can produce.

Each firm’s strategies are to conduct the R&D or not conduct the R&D. The payoff matrix for this game is to the right This game does not have a Nash equilibrium that is a dominant strategy equilibrium.

Here the equilibrium is for one firm to conduct the R&D but we cannot predict which firm will conduct it.

A’s strategies R&D

No R&D

$2 million

$3 million

R&D B’s strategies

$2 million $1 million

$1 million $0 million

No R&D $3 million

$0 million

Examples of oligopoly to discuss: Gillette and Schick compete aggressively to capture the market for men’s razors; AMD and Intel do likewise for the CPU market. These products are made by dominant consumer products corporations that spend significant resources on research and development and advertising to develop brand loyalty.

Discuss the entry barriers a firm considering going into these markets might face and why they are likely to remain dominated by just a couple of key firms. Ask your students to apply this analysis to another oligopolistic market and to identify the entry barriers and ways firms engage in both price and non-price competition.

III. Repeated Games and Sequential Games Many more potential outcomes are possible if players repeatedly play games. Players also can often wait until a rival has made a move before choosing a response.

A Repeated Duopoly Game 

If a game is played repeatedly, it is possible for players of the game to reach the cooperative equilibrium in which the players make and share the monopoly profit. Because the game is played repeatedly, a player can use a tit-for-tat strategy, in which the player cooperates in the current period if the other player cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period.

Economics in the News, Airbus versus Boeing, considers the plane makers’ rivalry in producing passenger jets and their decisions whether to discount or charge list price.  A tit-for-tat strategy used with the payoff matrix at the top of the page leads to the cooperative equilibrium.

Are there any real-world cooperative equilibria? The OPEC oil cartel is an excellent example of how useful game theory can be to explain real world events. Use the prisoner’s dilemma game to illustrate the incentive each nation faces: whether to cheat on their agreement or comply with it. A tit-for-tat strategy makes all the nations (as a group) better off but the demand for oil fluctuates and it is difficult for each nation to determine whether the other nations are cheating on the agreement. This combination makes a cartel agreement difficult to monitor, which is why we see the price of oil fluctuate so much, even during peaceful times. Saudi Arabia is widely believed to be the market leader for the cartel. Its oil output decisions have waxed and waned significantly over time, so oil prices fall when its government needs the extra oil revenues (cheating) or rises when the political environment requires greater economic unity among the Arab nations (cooperating).

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A Sequential Entry Game in a Contestable Market 



A contestable market is a market in which firms can enter and leave so easily that those firms in the market face competition from potential entrants.

Firms in a contestable market play a sequential entry game. In this game, the firms in the market might set a competitive price and earn only a normal profit to keep the potential entrant out. A less costly strategy is limit pricing, which sets the price at the highest level that inflicts a loss on the entrant. The potential entrant is kept out and the existing firms earn an economic profit. However, limit pricing works only if the firm that sets the price is somehow locked into the price it will set at the second stage of the game.

How does a game tree work? The textbook uses the simplest possible example to illustrate the sequential entry game in a contestable market. It doesn’t explicitly explain the “backward induction” method of solving such a game, but it implicitly uses that method. If you choose to spend more time on sequential entry examples, you might want to be more explicit.

IV. Antitrust Law 



Antitrust law is the law that regulates oligopolies and prevents them from becoming monopolies or behaving like monopolies.

The two federal agencies that enforce antitrust laws are the Federal Trade Commission and the Antitrust Division of the U.S. Justice Department.

The Antitrust Laws  

The Sherman Act (1890) made it a felony to create or attempt to monopolize an industry. Section I declares it illegal to conspire with others to restrict competition. Section II deems any attempt to monopolize illegal.

The Clayton Act (1914) makes illegal certain business practices if they “substantially lessen competition or tends to create a monopoly.” These practices include price discrimination, typing arrangements, requirements contracts, exclusive dealing, territorial confinement, acquiring a competitor’s shares or assets, or becoming a director of a competing firm. If these actions do not substantially lessen competition and do not tend to create a monopoly, the actions are legal.

Price Fixing by Competitors Always Illegal  

Price fixing by competitors is per se illegal, which means it is always illegal. There is no defense that can justify the practice.

By restricting production, a price-fixing cartel raises the price to the monopoly level. Consumers suffer and deadweight losses are created.

Three Antitrust Policy Debates 

 

Resale Price Maintenance: Resale price maintenance (also called vertical price fixing) occurs when a distributor agrees with a manufacturer to resell a product at or above a specified minimum price. Resale price maintenance is illegal only when it is judged to be anticompetitive. Whether resale price maintenance creates an inefficient or efficient use of resources is debated. It is efficient when it induces retailers to provide the efficient level of service to customers (e.g., be financially able to explain to potential consumers the benefits of a particular good).

Tying Arrangements: A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another, different product. These bundling arrangements may enable a firm to price discriminate, resulting in an increase in efficiency.

Predatory Pricing: Predatory pricing is setting a low price to drive competitors out of business with the intention of setting a monopoly price when the competition has gone. Economists are skeptical that predatory pricing occurs.

An Economics in Action case considers the U.S. versus Microsoft antitrust case, including the charges, Microsoft’s response and the outcome. Students may want to consider how Microsoft’s market power has changed in the last decade. Is it a result of government intervention? Or is it a result of competition as Apple has gained increasing © 2023 Pearson Education, Inc.

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market share in operating systems as its sales have grown?

Mergers and Acquisitions 



A merger occurs when two or more firms agree to combine to create one larger firm. Acquisitions occur when one firm buys another firm.

FTC guidelines stipulate that a HHI above 1,800 indicates a concentrated market, and a merger in this market that would increase the index by 50 points is likely to be challenged.

The Economics in Action feature describes how the FTC used its HHI guidelines to block the proposed AT&T acquisition of T Mobile.

The Economics in the News feature again examines how the three major cell phone service providers decided whether to invest in expensive 5G infrastructure. The feature models these decisions as prisoners’ dilemmas, so all three major providers have invested in 5G infrastructure.

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Additional Problems 1.

Two firms, Faster and Quicker, are the only two producers of sports cars on an island that has no contact with the outside world. The firms collude and agree to share the market equally. If neither firm cheats on the agreement, each firm makes $3 million economic profit. If either firm cheats, the cheater can increase its economic profit to $4.5 million, while the firm that abides by the agreement incurs an economic loss of $1 million. Neither firm has any way of policing the actions of the other. a. What is the payoff matrix of a game that is played just once? b. Describe the best strategy for each firm in a game that is played once. c. What is the equilibrium if the game is played once?

Solutions to Additional Problems 1.

a.

b.

c.

The payoff matrix has the following cells: Both abide by the agreement: Faster makes $3 million profit, and Quicker makes $3 million profit; both cheat: Faster makes $0 profit, and Quicker makes $0 profit; Faster cheats and Quicker abides by the agreement: Faster makes $4.5 million profit, and Quicker incurs a $1 million loss; Quicker cheats and Faster abides by the agreement: Quicker makes $4.5 million profit, and Faster incurs $1 million loss.

The best strategy for each firm is to cheat. If Quicker abides by the agreement, the best strategy for Faster is to cheat because it would make a profit of $4.5 million rather than $3 million. If Quicker cheats, the best strategy for Faster is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $1 million. So Faster’s best strategy is to cheat, no matter what Quicker does. Repeat the exercise for Quicker. Quicker’s best strategy is to cheat, no matter what Faster does.

The equilibrium is that both firms cheat and each makes normal profit.

Additional Discussion Questions 1.

Could you manage a successful cartel? Emphasize the fragility of cartel arrangements by using the following numerical example. Point out that if a cartel is to operate successfully, all the firms must behave collectively as a monopoly, producing market output where MR = MC and charging the resulting profit-maximizing price. Because there are multiple firms in a cartel, and each firm is likely to have different production cost functions, then this raises two critical issues:  How should production quotas be allocated across firms to minimize total production costs and maximize potential profits?  How should the profit quotas be allocated across firms to maintain compliance?

Start by assuming there are 3 firms in the MC for MC for MC for cartel with the marginal cost schedules in the Quantity Firm A Firm B Firm C table. Also assume that the profit-maximizing 1 2 1 2 level of output for a monopoly would occur at 9 units per period, where MR = $3. Finally 2 1 2 3 assume that there are no fixed costs. Now, if 3 2 3 4 you were the leader for the cartel, how would 4 3 4 5 you propose the production quotas be 5 4 5 6 allocated to minimize production costs and maximize profits to share?

Based on minimizing variable costs, and knowing that MR = $3 at 9 units of output, Firm A should produce 4 units, Firm B should produce 3 units and Firm C should produce at 2 units per period. © 2023 Pearson Education, Inc.

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2.

3.

4.

5.

Total output is 9 units, MC = $3 for all three firms, and the total cost of industry production is: $8 for Firm A, $6 for firm B, and $5 for firm C for a total cost of $19 per period.

How should the profit quotas be distributed across the firms? Ask the students to consider allocating profits according to each firm’s share of total production costs. Firm A would receive 8/19 of the profits, firm B would receive 6/19 and firm C would receive 5/19 of the profits. Most students will accept this as a “fair” allocation of profits for the firms. But this agreement will not work for long.

Will the cartel survive using this profit quota arrangement? Point out that what keeps each firm in compliance with the agreement is not an independent assessment of “fairness” for the ultimate profit distribution. The profit quota agreement must be worthwhile to each and every firm in the cartel.

Emphasize that the profit from complying must exceed the profit from cheating for each firm if the cartel agreement is to be successful in the long run.

What is the opportunity cost for complying for each firm? Point out that based on Firm C’s cost function, the prospect of its competing with the other firms is rather grim. But Firm A’s cost function implies that it would not fear the threat of competition from the other firms because A’s marginal cost is lower than each of its two (potential) competitors. Because A does not fear cheating, it will have the upper hand in determining profit quotas for the cartel. Clearly Firm A will want as much profit as it can have from each of the other firms without making their profit from cheating exceed their profit from complying. That is the only profit sharing arrangement that will allow the cartel to survive over time. What, then, is the long-run profit-sharing agreement? The answer depends on the demand for the good or service as well as the strategies played by each firm. For instance if the demand is inelastic but low, so that if Firm A increased its output by 1 unit the price would fall so precipitously that Firm C suffered an economic loss, then even though the 4th unit would not be directly profitable for Firm A to produce, the threat of so doing might allow Firm A to grab some of Firm C’s “fair share” of profit.

What industries are dominated by cartels? OPEC isn’t the only example of a cartel. Ask students what they think of when they hear the word “cartel,” and a common response is “drug cartel.” Like the cartels studied in this chapter, members of a drug cartel agree upon the price at which their merchandise can be sold. Cooperation can be maintained through a repeated game where a system of punishments is incorporated. Consider the punishments members of a drug cartel can impose for violating an agreed-upon price rule. It probably isn’t much of a surprise that cooperation among drug cartel members can be maintained when the consequences of cheating on any agreement include death or the slow and painful removal of one’s fingernails.

Has Microsoft attempted to create a monopoly? Whether Microsoft is a monopoly depends on the market being defined. Many of your students will have their own opinions, but use the “Antitrust Showcase” in the text is a starting point for discussion. The issue of having a standard to create programs and products around continues to be debated as programming for Apple’s applications for the iPhone differ from standards used by other firms, and as Apple rejected flash technology offered

by Adobe and widely used in other applications.

Can firms create entry barriers? Students often have a difficult time identifying entry barriers. Some come from economies of scale, some from government activity, and some the firms create. Consider the barriers in the airline industry or cell phone services. Gates and landing slots may come from government activity. Economies of scale certainly exist. But firms also work hard to differentiate their products and try to capture market share through strategic barriers such as AT&T’s initially exclusive ability to offer the iPhone. Students have little knowledge of distribution generally so using specific examples from different types of industries can broaden their knowledge.

If predatory pricing is generally not regarded as a problem by economists and antitrust enforcers, why is dumping such a big deal? Again as suggested in the lecture notes, this is a good place to reinforce the trade theory discussed in chapter 7. Prior to the Uruguay Round, voluntary export restraints were widely used (and abused) as a way around agreements to reduce trade barriers. Their use was © 2023 Pearson Education, Inc.

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restricted by that agreement. Since then, dumping cases have exploded at the same time predatory pricing cases are largely no longer pursued. Searching the World Trade Organization web site will yield many examples of dumping cases. Alleging dumping can be as simple as saying the product is being sold at a lower price than a domestic firm can match, which is often the definition of a product likely to be imported. Do low prices hurt consumers? Consumer surplus and producer surplus can be used to reinforce the prior examples.

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PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

The Big Picture Where we have been: A parallel is drawn between the equilibrium in markets, introduced in Chapter 3, and the concept of equilibrium in a political marketplace. The concept of efficiency, introduced in Chapter 2 and elaborated upon in Chapter 5, is used in this chapter to assess market failure. The definitions of marginal social benefit, marginal social cost, and deadweight loss are used explore the provision of public goods and mixed goods that have external benefits.

Where we are going: Chapter 17 continues the analysis by studying the inefficiencies that result when private markets produce mixed goods with external costs and allocate common resources. It also considers methods that can be used to fix the misallocation. Chapters 18 and 19 cover the labor and other resource markets and the resulting distribution of income. Redistribution of income is addressed as a possible role for government in this chapter. Chapter 20 discusses risk and uncertainty.

New in the Fourteenth Edition In this edition, the introduction at the start of the chapter focuses on bridges, and asks why government rather than private companies provides bridges. Them=n the concluding Economics In The News returns to the topic of bridges to analyze and study the infrastructure spending necessary to keep bridges safe.

For your notes, in the fourfold classification of goods, a good that is nonrival and excludable is now called a club good. Netflix, the Internet, a bridge or tunnel are all club goods.

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Lecture Notes

Public Choices, Public Goods, and Healthcare I.

Public choices

  

A private choice is a decision that has consequences only for the person making it.

A public choice is a decision that has consequences for many people and perhaps the entire society.

Decisions by political leaders and senior public servants might improve efficiency, but, as was observed in prior chapters, these choices might also make things worse and lead to deadweight losses.

Why Governments Exist 

   

Governments establish and maintain property rights, provide nonmarket mechanisms for allocating scarce resources, and implement arrangements that redistribute income and wealth.

Markets rely on property rights to function.

Choices made pursuing self interest may not always be in the social interest and governments may reallocate resources.

The market economy delivers a distribution of income and wealth that many people regard as unfair, so equity requires some redistribution.

Government failure occurs when government action leads to inefficiency, which could be underprovision or overprovision of resources to a given activity.

Public Choice and the Political Marketplace     

The political marketplace is made up of many individuals each with their own economic objectives. Four groups of decision makers—voters, firms, politicians and bureaucrats—interact in the political marketplace.

In the economic model of public choice, voters support the politicians whose policy proposals make the voter better off. Voters express their demand for policies by voting, helping in campaigns, lobbying, and making political contributions.

In the economic model of public choice, firms also support the politicians who policy proposals make them better off and express their demand for public goods and services, but firms can’t vote. They do make political contributions and engage in lobbying activities.

Politicians are elected persons at all levels of government. They make the policies that bureaucrats carry out.

Politicians’ goals are to gain election and reelection, so voters to a politician are like profits to a firm.

Bureaucrats are public servants who work in government departments. Their self interest is best served by larger budgets, which bring more authority and prestige.

Political Equilibrium  



All four groups make choices that are in their own self interest and are constrained by what is feasible.

In a political equilibrium, the choices of all four groups are compatible and no group can see a way of improving its position by making a different choice.

Allocative efficiency in the use of resources is possible but is not guaranteed.

The political marketplace does not work as smoothly as the private marketplace. Throughout this text students have learned that competitive markets can deliver an efficient resource allocation:  Individuals and firms act in their own self-interest, but in the private market (in the absence of externalities) individuals receive the full benefits of making good decisions with their resources, and bear the full costs of making poor decisions with their resources. Market prices and profits send signals to consumers and producers that coordinate their decisions. In the absence of price floors, price ceilings, quotas, monopoly, and taxes, the competitive pressures of the market determine an equilibrium price where the marginal social benefit is equal to marginal social cost, and the outcome is efficient.

However, the political marketplace does not possess the same power as the competitive market to convert self-interest into an efficient outcome: © 2023 Pearson Education, Inc.

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Individuals still act in their self-interest. As James Buchanan, the Nobel Prize winning economist, once noted, when we pull the curtain closed in the voting booth to indicate which representative we wish to elect, we do not suddenly sprout the wings of angels and vote in the public interest. We vote our own best interests, possibly to the detriment of the public interest. But one person, one vote does not ensure equal political influence over the resource allocation process. Some avenues to seek favor from politicians and bureaucrats require resources, which are unequally distributed. Individuals no longer receive the full benefits nor bear the full costs of their decisions over publicly provided resources, and so individuals are less motivated to act on the basis of complete information. The absence of price and profit signals and incentives to make wise decisions with publicly provided resources makes it difficult to coordinate the decisions of self-interested individuals to generate socially beneficial outcomes. Many political marketplace decisions over public goods provisions are inseparable, bundled together as a package, which decreases the competitive pressures that force individuals to respond to opportunity cost and marginal benefit.

What is a Public Good?

Goods, services, and resources can be classified along several dimensions:  Excludability: A good or service is excludable if only the people who pay for it are able to enjoy its benefits.

An automobile or watching an NFL game in person would be excludable. A good or service is nonexcludable if everyone benefits from it regardless of whether they pay for it. National defense or a town’s Fourth of July fireworks display are nonexcludable.  Rivalry: A good, service, or resource is rival if its use by one person decreases the quantity available for someone else. A blouse or a slice of pizza is rival. A good, service, or resource is nonrival if its use by one person does not decrease the quantity available for someone else. Watching television or national defense is nonrival.

Examples: The more examples you give of each classification, the easier this topic will be for your students. Be sure to identify each characteristic for a given good. For example, a candy bar is a private good. It is excludable because, if you purchased it, you can decide who gets it. It is also rival because, once you eat it, there is less available for anyone else. Sunshine, on the other hand, is a public good. It is nonexcludable because you can’t determine who gets to use the sun and who can’t. It is nonrival because your use of the sun does not diminish the amount of sun available for anyone else. Ask your students to think of other goods and resources and evaluate each on the basis of these characteristics. More examples are included in the “Additional Discussion Questions” section.

Is a highway a public good or a private good? Interstate highways are generally public goods. They are nonexcludable because anyone is permitted to drive on the interstate. When they are not congested, they are also nonrival because adding one more car to the interstate has little to no impact on the ability of other drivers to continue using the highway. However, interstate highways that charge a toll become excludable. And many interstates become rival goods during rush hour. If a highway charges a toll and is often jammed with traffic, it is actually a private good.

A Fourfold Classification Based on these differences, goods, services, or resources can be classified into one of four categories:  A private good is both rival and excludable. A cow owned by a dairy farmer is a private good.  A public good is both nonrival and nonexcludable. National defense is a public good.  A common resource is rival and nonexcludable. Fish in the ocean are a common resource.  A club good is nonrival and excludable. Cable television is a club good.

Is every publicly provided good a “public good”? Students often think that, by definition, everything provided by the government is a public good. This belief is false. Point out to them that many government services are neither nonrival nor nonexcludable: Electricity provided by the TVA and many local governments, satellite launching services, and food stamps are three quick examples. Food stamps are provided as a means of redistribution. But for the goods and services that are rival and excludable (electricity and satellites) the private market ought to be able to provide the efficient allocation without government provision. © 2023 Pearson Education, Inc.

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Healthcare 

Healthcare is actually two goods: 1) Care supplied by doctors and other professionals; 2) insurance.

II. Providing Public Goods The Free-Rider Problem  

A public good creates a free-rider problem—the absence of an incentive for people to pay for what they consume.

The free rider problem leads private markets to produce an inefficiently small quantity of a public good; that is, the private market underproduces a public good. The marginal social benefit from the public good exceeds the marginal social cost and a deadweight loss arises.

Are you a free rider? Ask your students what they think would happen if Starbucks set up a serve-yourself coffee bar in the student union. No one would work the counter, and charges would be collected on the honor system. How many of your students would actually pay for coffee in that case?

What free-rider problems do your students deal with on a daily basis?  In some classes the students are assigned to a group for completing a graded project, where the grade earned on the project is shared by each group member. Sharing the grade means that there are insufficient incentives for each group member to provide the level of effort that would achieve the highest potential grade for the group.  Waiting tables is a common part-time job for many students. Many restaurants make the wait staff share their tips with the other wait staff and busboys that clear the tables. Under this system, there are insufficient incentives for the busboys and less-motivated wait staff to provide the level of service that maximizes tipping from diners.  Public restrooms are generally recognized as being far less clean than the vast majority of users would like, especially compared to their own private bathrooms. There are insufficient incentives for each user of a public bathroom to keep it clean enough to appease most users.

Marginal Social Benefit of a Public Good 

Public goods have a marginal social benefit that differs from the marginal social benefit of a private good.

Because everyone can consume services from the same unit of a public good, the marginal social benefit of a public good is the maximum amount that all the people are willing to pay for one more unit. The economy’s marginal social benefit curve of a public good is obtained by vertically summing each individual’s marginal benefit curve.

What is “vertical” vs. “horizontal” summation? Whether we add marginal benefit curves together vertically or horizontally is sometimes a source of confusion for students. Tell them to focus on the unit of measurement on each axis. When we are looking at private goods, we want to know how many units should be produced to satisfy market demand at a given price. Because private goods are both rival and excludable, each buyer must have his or her own units, so we must add together the number of units demanded by each individual. In other words, we’re adding the horizontal coordinates (quantities) of individual demand curves to get the market demand curve, and we say we are adding the individual demand curves or marginal benefit curves “horizontally.” For public goods that are nonrival and nonexcludable, anyone who purchases a good is providing that good to everyone. If every consumer in the market demands one unit of a good, we can’t simply add together all of those units. Once one unit is provided to anyone, it is provided to everyone. The benefit of that unit will be determined by the sum of individual marginal benefits for that unit. An individual’s marginal benefit is measured as the y coordinate of an individual demand curve, so to find the marginal social benefit, we add all of the individual marginal benefits together. We say we are adding the individual demand curves or marginal benefit curves “vertically.”

Marginal Social Cost of a Public Good 

The marginal social cost of a public good is determined the same way as that of a private good.

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Efficient Quantity of a Public Good 

The efficient quantity of a public good is the quantity that sets the marginal social benefit equal to the marginal social cost. At this quantity, society’s net benefit from the public good is maximized.

Inefficient Private Provision 

A private market will produce an inefficient quantity of a public good because of the free rider problem.

Consumers free ride by choosing not to pay for the public good, and instead use the funds to purchase private goods.

Efficient Public Provision  

Competition in the political marketplace can result in the efficient provision of public goods.

The Principle of Minimum Differentiation is the tendency for competitors (including political parties) to make themselves similar in order to appeal to the maximum number of customers. Consequently political parties tend to have similar policies in order to appeal to the maximum number of voters.  For the political process to deliver efficient outcomes in providing public goods, voters must be well informed, evaluate the alternatives, and vote in the election. Political parties must be well informed about voter preferences.

The Economics in Action feature considers the case of providing fire protection to extinguish the 2020 California wild fires. While fire protection is provided by the government, it is often produced by private companies.

Inefficient Public Overprovision 

Bureaucrats translate the choices of politicians into programs, and control the day-to-day activities that deliver public goods. Bureaucrats may have other ideas and frustrate rather than facilitate the efficient outcome. By expanding the size and scope of their programs, bureaucrats gain more power, potentially greater management authority, and more lucrative compensation. Bureaucratic actions may lead to government failure.



Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Each voter is likely to be rationally ignorant about the efficient quantity of a public good.

Rational ignorance, combined with special interest groups and bureaucrats seeking larger quantities of public goods, might lead voters to support political policies that generate inefficiently high levels of public goods.

Do politicians and bureaucrats make choices the same way voters do? Economists are comfortable with the assumption that, in their private lives, individuals make choices based on their own self-interest. As a result, many economists believe that the same assumption should be made about voters, politicians, and bureaucrats. If these groups make choices in their own self-interest, the assumptions of the public choice theory are upheld: voters will be rationally ignorant, bureaucrats will seek to increase the scale of their programs, and politicians will propose more than the efficient quantity of public goods.

III. The Economics of Health Care Health Care Market Failure  

The market for health care consists of health care services and health insurance.

Consumers underestimate the benefits of health care, underestimate their own future needs, and can’t afford the care they need, so the marginal social benefit exceeds the private willingness to pay for it. Consequently a private health care markets underproduces health care.

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The figure shows the market demand curve or perceived marginal benefit curve (MB) and the marginal social benefit curve (MSB) for health care.

The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1.

An unregulated market, however, produces where S = D. In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure.

This loss is unevenly spread across consumers leading to unfairness. Healthy, higher income earners can afford care. The long-term sick, the aged, and the poor can’t afford care and thus bear most of the deadweight loss.

Alternative Public Choice Solutions  



Across nations, there is a wide range of public funding for health care. The text examines three approaches to supplementing or replacing the private market for health care: universal coverage, single payer; private and government insurance; and, subsidized private insurance.

Universal Coverage, Single Payer  The model in the United Kingdom and Canada: is universal coverage with a single payer. The government is the sole buyer and everyone is covered. People access services a zero (or a low) price and the quantity available is set by the government, leading to excess demand. Services are allocated on a first-come, first-served basis, resulting in long delays for treatment. The quantity made available by the government is less than the efficient quantity, so a deadweight loss results.

Private and Government Insurance  In the United States, most health care is provided privately and paid for by private health insurance, government, and patients. It is difficult to determine if healthcare is overprovided given the different payment types, but the scale of healthcare spending in the United States compared to other rich countries suggests it may be. Over provision leads to deadweight losses. Government spending on health care is dependent on the quantity of care demanded, not on a set budget. Without changes, an aging population will significantly increase this spending in the future.

The Economics in Action case breaks down the sources of payment for health care in the United States. 

Mandate and Subsidize Private Insurance  Obamacare, or the Patient Protection and Affordable Care Act, uses a subsidized insurance market. To determine whether the outcome of the subsidy is efficient, we need to know the extent to which the marginal benefit of health insurance actually exceeds a household’s ability to pay.

The At Issue feature considers whether Obamacare is the answer to U.S. health care provision problems.

Vouchers a Better Solution? 

When marginal social benefits exceed the ability and willingness to pay, economists suggest vouchers can be used to attain efficiency. A voucher is a token that can be used to buy only the specified item.

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A voucher program could replace most government health programs. The total value of vouchers would be set by government, but households would decide how to allocate healthcare spending.

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The markets for health care services and health insurance would be free to work similarly to other competitive markets, which allocate resources efficiently. © 2023 Pearson Education, Inc.

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The concluding Economics in Action case returns to the teaser introduction to consider the challenges of maintaining the U.S. transportation infrastructure given the decrease in gasoline taxes, which is the primary revenue source used to maintain the infrastructure. The analysis shows how the outcome might be an inefficient quantity of infrastructure being provided.

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Additional Discussion Questions 1. How “public” are government goods and services? Challenge your students to name public services provided by the government. In case the students miss them, mention the following services:  Postal Services: This is somewhat nonrival, in that the postman is walking by everyone’s house anyway, but definitely excludable—no stamp, no delivery. It is a club good rather than a public good.  Education: This is also somewhat nonrival, in that increased human capital benefits more than just the student. However, the private sector education industry is growing rather than shrinking over time, indicating that the private benefits are large compared to the public benefits. Also, it is excludable, meaning that it is not a public good.  Passenger Rail Service like Amtrak: Rail service is nonrival when the trains are not crowded because, in that case, one individual’s use of rail service doesn’t preclude others from also using the service. When the train is at its maximum carrying capacity, however, rail service is then rival because adding an additional consumer requires that another consumer be bumped. Train service is definitely excludable. As such, when the trains are crowded it would fall into the category of private good, and when they are not crowded they would be a club good.  National Parks and Forests: Given the vast size of our national parks and forests, use by one individual has little impact on the level of benefit others receive from using the same services.

However, parks and forests that are overused and trashed become rival. Most national parks are excludable. Fees are charged for camping in them, for example. However, the large area covered by national parks and forests makes it more difficult to exclude others from using the parks and forests, even if fees aren’t paid, making them somewhat nonexcludable. National parks and forests may be public, private, common resources, or club goods, depending on the extent of rivalry and excludability.

2.

Will resource allocation be efficient when the price mechanism is absent in the provision of public goods and services? Emphasize that when political equilibrium conditions separate the people who consume the services from the people who pay for the services, the valuable price signal is lost. Those that consume the good do not take into account the opportunity cost of consuming that good or service when making their own resource allocation decisions. Examples: Why are private schools and home schooling so prevalent when all children in the United States (even the children of illegal immigrants) are provided with free education? The student and his or her family receive the benefits of increased human capital but pay only a portion of the cost of providing it. The median voter is reluctant to support higher taxes for educational programs and rational ignorance implies that he or she is also unlikely to be motivated to see whether the existing funds are being utilized efficiently. This results in government delivering relatively poor public educational services. Also point out that the parents of children attending private school, or the parents who use their own labor to teach their children at home, all still pay local taxes to support public education.

This implies that the high opportunity cost of consuming private education is still less than the perceived opportunity cost of sending their children to public schools.

Why are private security companies so prevalent when each city has a legitimate, professional police force? The greatest benefactors of police protective services are usually those citizens living in the poorest neighborhoods with the lowest incomes. The median voter’s income level isn’t so far away from the average income voter that the level of protective service that he or she receives is above average. This means the median voter does not support a level of protective services that could effectively deal with the high crime areas as well as the less frequent incidence of crime that occurs in average or above average income neighborhoods.

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3.

Is government regulation better than an inefficient market result? The simple answer is “not necessarily.” Stress that when market failure brings pleas for political processes to replace the market process for resource allocation, it should be shown that the inefficiencies created by the market failure are greater than the inefficiencies inherent in the proposed political allocation process. Point out that when politicians and bureaucrats propose public sector policies to replace market allocation processes, they rarely discuss whether their policy prescriptions would pass such an analysis. Emphasize that when it comes to moving resource allocation decisions out of the private market and into the realm of political markets, there is still an opportunity cost to be weighed against the perceived benefits: there is no such thing as a free lunch!

4.

Are you a free-rider in your school’s computer lab? Many colleges and universities have run into problems with the amount of printing that occurs on their campuses. The more students print, the more paper expenses rise, and the more frequent repairs and maintenance will be for printers at the school. If a school does not charge students for printing in the computer labs, what incentive is there to minimize printing? While this may be an expense that is “included” in tuition and fees, because that cost is spread across all students, no single student bears the entire cost of his or her printing. As more books become available online as e-books, this problem has become more difficult to handle.

Because e-books are typically cheaper than traditional paper books, many students simply buy the ebook and then print the entire book in the school computer lab, effectively pushing the cost of the book onto the school. To alleviate some of this free-rider problem, many schools have begun to charge their students for printing, or they have predetermined limits set on the number of pages students are allowed to print.

5.

Does a democratic process ensure an efficient outcome? Many political science classes tout that democratic politics is the “art of compromise,” implying that the compromise solutions to conflicting objectives that are inherent in democratic decision processes necessarily generate efficient outcomes.

The example in the table below illustrates why a democratic vote can fail to ensure the economic definition of efficiency.  If tax policy proposal A (a levy supporting education) were presented by itself, it would fail to receive support from the majority of voters. 

Likewise, if tax policy proposal B (a levy supporting the police force) were presented by itself, it would also fail to gain support from the majority of voters.

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Yet, the politicians sponsoring each bill can act cooperatively and present an omnibus bill combining both policy proposals. This is known as logrolling—trading political favors to pass separate bills that would otherwise fail to achieve majority support on their own.

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The majority of voters will support the omnibus bill, despite the fact that net benefits for all society would be higher if the omnibus bill had not passed.

Policy Valuation

by Voter A

Policy Valuation

by Voter B

Policy Valuation

by Voter C

A: Education

+$150

-$100

-$100

B: Police

-$100

+$150

-$100

Policy A + B

+$50

+$50

-$200

Policy Proposal

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Does Vote Pass? Net Social Benefits No: (1-2) -$50 No: (1-2) -$50 Yes: (2-1) -$100

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6.

Snow and road plowing—when is it a public good versus a private good? If you teach in a part of the country that gets snow, state and local governments may spend significant resources plowing roads.

Who plows which roads and parking lots? Why? If state and local governments ceased offering snow plowing services, what would happen in the local economies affected by snow?

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EXTERNALITES

The Big Picture Where we have been: Achieving efficiency by equating marginal social benefit and marginal social cost introduced in Chapter 2 and elaborated upon in Chapter 5 is the key concept used in this chapter. Mixed goods with external costs and the problem of common resources were introduced in Chapter 16 as was the idea that public choices might improve resource allocation or might make things worse.

Where we are going: The efficiency analysis introduced in Chapter 16 is extended in this chapter to the case where private and social costs diverge and where resources are common rather than private. Public choices about how to address the resulting misallocations of resources are also analyzed.

New in the Fourteenth Edition This chapter has not had many changes from the prior edition. The introduction has been changed to reflect the new Economics in the News case at the end of the chapter, which now focuses on a carbon tax, The Economics in Action case about the reduction in air pollution has been updated to include data through 2020 and there is a new Economics in Action case discussing the prices and effects of carbon taxes in British Columbia, Ireland, and the U.K..

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Lecture Notes

Externalities I.

Externalities in Our Lives

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External costs result when actions cause negative effects on bystanders. This chapter considers why private markets might not act in the social interest and whether government action can offer incentives so that pollution and overuse of common resources is less likely to occur.

An Economics in Action detail points out that many types of air pollution are less serious today in the United States than they were in the past. But rising CO2 in the atmosphere has accompanied an increase in the global temperature.

Private, External, and Social Cost

A private cost of production is a cost that is borne by the producer. Marginal private cost (MC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.  An external cost is a cost of producing a good or service that is not borne by the producer but is borne by other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls on people other than the producer.  Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost: MSC = MC + Marginal external cost.

Have the students consider what is included in the idea of marginal external costs. Be sure that they understand that external costs are the costs of either cleaning up the damage caused by the polluting activity or the extra costs of having to take actions to avoid the damage in the first place. Emphasize that both actions require payment by people other than the producer or consumer, which is why the costs are considered “external.” 

The figure shows the marginal private cost curve (MC) and the marginal social cost curve (MSC) for a good with an external cost. The vertical distance between the two curves is the marginal external cost.  Because the marginal social cost includes the marginal private cost and the marginal external cost, the marginal social cost exceeds the marginal private cost (MSC > MC) for all quantities.  The efficient quantity of output occurs where the marginal social cost equals marginal benefit, that is, where MSC = MSB. In the figure, the efficient quantity is Q1. If the external cost reflects pollution, there is still some pollution created but it is the efficient quantity of pollution.  An unregulated market produces where S = D. In the figure, the unregulated market is at Q0. At this level of output, MSC exceeds MSB so there is inefficient overprovision and a deadweight loss, as illustrated in the figure.

An At Issue case considers whether more should be done to eliminate carbon emissions. While most agree that incentives need to change, there is fundamental disagreement about how to change incentives. One side, represented by the Stern Review, argues for taxes on prices on carbon emissions. The other side is taken by the Copenhagen

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Consensus, which argues that raising the price of carbon emissions today has high present costs and low future benefits.

Three Approaches to Address Negative Externalities Three approaches can be taken to address the misallocation of resources created by the negative externality  Establish property rights  Mandate clean technology  Tax or price pollution.

Establish Property Rights and the Coase Theorem 

Property rights are legally established titles to the ownership, use, and disposal of factors of production, goods, and services that are enforceable in the courts. Assigning property rights can reduce the inefficiency arising from an externality. Once property rights are given, polluters can respond by using an abatement technology or by producing less and thereby polluting less.  The Coase theorem is the proposition that if property rights exist, if only a small number of parties are involved, and if the transactions costs are low, then private transactions are efficient. Transactions costs are the opportunity costs of conducting a transaction.  A remarkable feature of the Coase theorem is that it does not matter if the property right is given to the creators of the externality (the polluters) or to the victims. In either case, the result will be efficient.

If the polluters value the benefits from the activity generating the pollution more highly than the victims value being free from the pollution (that is, the cost of reducing the pollution exceeds the benefit of the reduction), then the efficient outcome is for the pollution to continue. If polluters are assigned the right to pollute, the victims are not able to pay enough to convince the polluters to stop. If the victims are assigned the property right to be free from pollution, then the polluters are able to pay the victims sufficient compensation to continue polluting. Either way, the pollution continues.

If the victims value the benefits from being free from pollution more highly than the polluters value the benefits of the pollution, (that is, the benefit of reducing pollution exceeds the cost of the reduction) then the efficient outcome is for the pollution to stop. If the polluters are assigned the right to pollute, then the victims are willing to pay the polluters sufficient compensation to stop the pollution. If the victims are assigned the right to be free from pollution, then the polluters are not able to pay the victims enough to allow them to continue polluting. Either way, the pollution stops.

The role of property rights in the market. Explain that when the property rights are well defined, the owner of that right receives the full social benefit and bears the full social cost of using that resource. Assigning property rights “internalizes” the externality. The best government policies emulate, rather than replace, the market process.

Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it.

In the case of negative externalities like pollution, the government can choose from three policies (emissions charges, pollution taxes, or cap-and-trade), all of which require the government to assess the marginal social costs and benefits to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in: i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

Mandate Clean Technology 

An abatement technology is a production technology that reduces or prevents pollution. Cutting production will also reduce pollution and avoid the expense of purchasing abatement technologies. Direct regulation that requires specific abatement technologies can and has reduced emissions, but economists are skeptical of this approach because it is not always the least cost alternative.

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Tax or Cap and Price Pollution 

Taxes: The government can set a tax equal to the marginal external cost, so that marginal private cost plus the tax equals marginal social cost: MSC = MC + Tax. In the figure, the appropriate tax equals the length of the double headed arrow. These sorts of taxes are called Pigovian taxes, in honor of the British economist Arthur Cecil Pigou, the British economist who first proposed this approach to externalities.

An Economics in Action case reviews the use of taxes in British Columbia, Ireland, and the United Kingdom. It concludes that whether it is overtly a carbon tax or simply a tax on gasoline, the taxes reduce carbon emissions. 

Cap-and-trade: The government sets a limit on the total amount of pollution allowed, ideally the efficient amount. Initially the government allocates the cap across the firms by issuing marketable permits, wherein each firm is assigned permits that allow it to emit a certain amount of pollution. The firms are allowed to trade the permits. The market in permits determines the price of a permit and firms will buy or sell permits until their marginal cost of pollution reduction equals the price of a permit.

Coping with Global Externalities 



The United States has made its own air much cleaner. But global warming and climate change cannot be solved by a single, albeit large, industrial economy.

A lower CO2 concentration is a global public good and like all public goods leads to free rider problems. No mechanisms currently compel participation in global carbon reduction programs.

An Economics in Action case reviews the global prisoners’ dilemma in reducing carbon emissions. If a nation reduces carbon emissions, its costs are higher than its trading partners, making its exports less competitive. But if all nations reduced carbon emissions, all nations would be better off.

II. Negative Externality: The Tragedy of the Commons 



The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. When nobody owns a resource, each individual consumer fails to consider the full opportunity cost of consuming it, so the resource is consumed at a higher than inefficient rate.

The example of the commons problem comes from medieval England. Grasslands near a town were called the commons because they were publicly accessible by all villagers to support their livestock. These grasslands were over-grazed and usually couldn’t support much livestock.

Are there examples of the “tragedy of the commons” on campus? Have the students consider the many problems arising from the many commons areas on campus:  Why does so much trash like candy wrappers, gum stuck to the pavement and cigarette butts litter the sidewalks and entry ways of all the buildings on campus?  Why does the library implement such a strict rule over the level of noise that students can make (no loud conversations, laughing, etc.) in the open areas in and around the library book shelves?

Unsustainable Use of a Common Resource 

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A renewable natural resource is one that replenishes itself by the birth and growth of new members of the population. For fish, the sustainable catch is the quantity of fish that can be caught year after year without depleting the stock.

A common resource is being used unsustainably of its use decreases the stock of the resource.

Sustainable use of a resource is the rate of production that can be maintained indefinitely. As more of a renewable resource is harvested, there is less left to reproduce and replace what has been harvested. If heavy harvesting depletes the resource stock to levels that are too low to replace the amount harvested, then the size of the stock available for harvest declines over time and that harvest rate is not sustainable.

If the quantity of fish harvested if less than the sustainable catch, the fish stock grows; if the quantity caught exceeds the sustainable catch, the fish stock shrinks; and if the quantity caught equals the sustainable harvest, then the fish stock remains constant and is available for future generations. © 2023 Pearson Education, Inc.

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Inefficient Use of a Common Resource 

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Marginal Private Cost: In the market for fish, the marginal private cost is the additional cost incurred by keeping a boat and crew at sea one more day. As the figure shows, marginal private costs, MC, increase as more fish are harvested due to diminishing returns. The marginal private cost curve is the same as the supply curve.

Marginal External Cost: This is the cost per additional ton that one fisher’s production imposes on all other fishers. This cost also increases as the number of fish harvested increases.

Marginal Social Cost: The marginal private cost plus the marginal external cost, MSC. Because both of its components increase as more fish are caught, marginal social cost increases with the quantity of fish harvested.

The figure shows the MSC curve.

Marginal Social Benefit and Demand: The marginal private benefit, MB, is the price consumers are willing to pay for an additional quantity of fish. If there is no external benefit, the marginal private benefit equals the marginal social benefit. As shown in the figure, the marginal private benefit (and hence the marginal social benefit) decreases as more fish are harvested and consumed. This curve is the same as the demand curve.

Overfishing equilibrium: The market demand curve is the marginal social benefit curve because there are no external benefits. The market supply curve is the marginal private cost curve. In the figure the market equilibrium is 30 tons of fish. The efficient quantity sets the MSC equal to the MSB and is 20 tons of fish in the figure. The equilibrium quantity exceeds the efficient quantity. A deadweight loss occurs and the fish stock is depleted.

Deadweight Loss from Overfishing: Every fish harvested for which the marginal social cost exceeds the marginal social benefit increases the size of the deadweight loss.

Achieving an Efficient Outcome Society can use three different methods to achieve the efficient outcome for common resources:  Property rights: Property rights can be assigned to the common resource. The owner then will receive the marginal benefit of using the resource. The resource will be used efficiently and not overused. However, assigning property rights to some resources, such as the fish in the ocean, is not always feasible.  Production quotas: Quotas can be set for the efficient total catch, with the total divided among all users.

However, it is in every user’s self-interest to cheat on the quota, so the quota might be ineffective. In addition, the marginal cost of using the resource varies across users, so an equal allocation of quotas generates an inefficient outcome.  Individual transferable quotas: An individual transferable quota scheme might be used. An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer the quota to someone else.  Less efficient users with higher marginal costs are willing to sell their quotas to more efficient harvesters who are willing to buy them.  The price of the quota will equal the difference between the marginal social benefit of the quota minus the marginal private cost of using the quota. In the figure, at the efficient quantity the price of an ITQ is $3 per pound. Note that marginal private cost + price of a quota = marginal social cost.  Users with the quotas will use the resource until the marginal social benefit equals the marginal private cost plus the price of the quota (the marginal private cost plus the price of the quota equals the marginal social cost). If the quota was set at the efficient quantity, the equilibrium is efficient.

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An Economics in Action application considers ITQs. Evidence from Iceland, New Zealand, and Australia suggests they work well to sustain fish stocks. But they also reduce the size of the fishing industry, making the industry oppose ITQs in every country in which they are proposed. The opposition was not large enough to block them in New Zealand and Australia but it did in the United States for a time. Since 2004 they have been used in 28 U.S. fisheries.

Economists have found them to be an effective tool.

III. Positive Externality: Knowledge Private Benefits and Social Benefits 

 

A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the benefit of an additional unit of a good or service that the consumer of that good or service receives.

An external benefit of a good or service is a benefit that someone other than the consumer receives. A marginal external benefit is the benefit of an additional unit of a good or service that people other than the consumer enjoy.

Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else who enjoys a benefit—and is the sum of marginal private benefit and marginal external benefit: MSB = MB + Marginal external benefit.



The figure shows the marginal private benefit curve (MB) and the marginal social benefit curve (MSB) for a good with an external benefit. The vertical distance between the two curves is the marginal external benefit.  Because marginal social benefit includes marginal external benefit, the marginal social benefit exceeds the marginal private benefit (MSB > MB) for all quantities.  The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1.  An unregulated market, however, produces where S = D. In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure.

Government Actions in the Market for with External Benefits The efficient outcome is production of the quantity at which MSB = MSC. There are three main methods that the government can use to cope with external benefits:  Public production: One possibility is public production, when a public authority that receives its revenue from the government produces the good or service. (Public colleges are an example.) In this case, the government can fund the authority to produce the efficient quantity.  Private subsidies: A subsidy, a payment that the government makes to private producers, can be used. If the government pays the producer a subsidy equal to the marginal external benefit, then the quantity produced by the private firm increases to that at which the marginal cost equals the marginal social benefit and an efficient allocation of resources occurs. In the figure, the correct subsidy is equal to the length of the double headed arrow.  Vouchers: A voucher, a token that the government provides to households to buy specified goods or services, can be used. Households receiving a voucher pay a lower price to acquire the specific good or service, which increases their demand and increases the quantity consumed.

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Bureaucratic Inefficiency and Government Failure 

 

Government intervention might not make the marginal social benefit equal the marginal social cost. This situation is government failure.  Overproduction can result if bureaucrats seek to maximize their budgets and programs.  Underproduction can result if bureaucrats pad their budgets and have wasteful spending. In this case, the costs of enterprises run by bureaucracies often exceed the minimum efficient cost.

Private subsidies might overcome some of the problems associated with bureaucracies, but the subsidy budget ultimately depends on bureaucracies. It is also in the best interests of those receiving the subsidies to try to maximize it, leading to rent seeking activities and lost resources.

Vouchers have four advantages when it comes to insuring the efficient quantity of the good or service is produced:  They can be used for public or private provision, which creates competition.  Governments set the value and total size of voucher programs which can avoid bureaucratic padding and overprovision.  The public contribution is spread thinly across many participants, leaving little incentive for individual recipients to engage in rent seeking.  The final consumer has the buying power, forcing firms to compete by offering more and better services.

An Economics in Action case considers charter schools’ role in improving educational quality and controlling costs.

Public provision, private subsidies and vouchers can all increase the quantity of education, but not necessarily the quality while controlling costs. Charter schools are funded as public schools, but set their own educational policies.

When spaces for students in charter schools are allocated by lottery (thereby eliminating self-selection bias), charter school performance can be more easily tested. So far, charter schools are doing well both in terms of achieving educational standards and controlling costs.

The final Economics in the News case considers the efforts to cut carbon emissions by imposing a price on carbon emissions through a tax.

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Additional Problems 1.

Fast-Food Trash Be Gone!

To help clean up the city, the Oakland City Council is considering a tax on fast-food restaurants, gas station markets, liquor stores and convenience stores that serve take-out food or beverages. The revenue from the tax will be used to help pay the costs of clean-up crews picking up burger wrappers and soda cans.

CNN, February 6, 2006 a. What is the external cost associated with takeout food and beverages? b. Draw a graph to illustrate and explain why the market for take-out food and beverages creates a deadweight loss. c. Use your graph to illustrate and explain how Oakland’s policy might improve efficiency.

2.

The table shows the marginal benefit and marginal cost Marginal Marginal of driving a private car into central London. How many benefit cost cars a day enter London? In 2004, the city introduced a Number (pounds (pounds per congestion charge of £5 per car per day. How many cars of cars per car) car) a day entered London after the congestion charge was 10,000 17 2 levied? What was the reduction in congestion and how 30,000 14 4 much revenue did the congestion charge raise for the 60,000 11 6 city?

90,000 8 8 120,000 5 10

Solutions to Additional Problems 1.

a. b.

c.

The external cost is the pollution from discarding the wrappers and beverage containers after use.

Figure 17.1 shows the market for take-out food and beverages. The marginal social cost, MSC, exceeds the marginal private cost, MC, because of the marginal external cost of pollution. The MC curve, which is also the supply curve, lies below the MSC curve. The equilibrium quantity of take-out meals, which is determined at the intersection of the supply curve and the demand curve, is 50 million per month. The efficient quantity of take-out meals, which is determined at the intersection of the marginal social cost curve and the marginal social benefit curve, is 30 million meals per month. The resulting deadweight loss from the overproduction is equal to the area of the grey triangle illustrated in the figure. This deadweight loss occurs because the consumers of take-out meals do not pay the full marginal social cost of their take-out meals. As a result the quantity of take-out meals consumed exceeds the efficient quantity.

Presuming the tax equals the marginal external cost, which in Figure 17.1 is $3 per meal, then in Figure 17.1 the tax shifts the S = MC curve so that it is the same as the MSC curve. In this (optimal) case, the equilibrium quantity becomes the same as the efficient quantity and there is no deadweight loss. © 2023 Pearson Education, Inc.

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Before the congestion charge, 90,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both equal £8.) After the congestion charge, the marginal cost to the driver increased by £5, the amount of the charge. So after the congestion charge, 60,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both now equal £11.) The congestion was reduced by 30,000 cars per day. The city gains £5 per car entering central London. 60,000 cars now enter central London, so the city gains revenue of £5 per car  60,000 cars, which is £300,000 per day.

Additional Discussion Questions 1.

Do good fences make good neighbors? To illustrate the role of property rights and prices in promoting efficient resource allocation within a market, tell this story of a hearty apple tree that adorned the central square on the campus of a local university. Each spring, an economics student watched as the beautiful white apple blossoms transformed into little green spheres that could eventually become juicy red delicious apples—if they were allowed to mature. But he never once in his four years at school saw a single mature apple hanging from that tree. Ask students why they think that was the case. A few students will recognize that apples were often picked before they were fully ripe. Every student wanting an apple assumed that waiting to pick one when it was truly ripe would be futile, because someone else would surely pick it one or two days earlier when it was almost as ripe and still somewhat delicious. However, those people would think picking it only two days earlier would also be futile, because someone else might pick it a day or two days earlier than that when the apples were still somewhat good for eating if they were allowed to ripen on the shelf. In this way the “best” harvest day for the apples regressed until the very first day that any one apple would even be worth trying to eat if it were left on the shelf to ripen. Every apple on the tree was harvested before it was allowed to ripen sufficiently to create the highest possible quality.

How else could the apples have been brought to their highest valued use to society? The problem was that no individual had an ownership claim, or property right, to the tree and the apples upon it.

Perhaps, because it was a state university, all the state taxpayers could lay claim to the tree. Either way, no one could realistically expect to receive the full benefits that fully mature apples could bring by protecting and maintaining the tree. This reality is at the heart of the phrase, “What everybody owns, nobody takes care of.” A lack of property rights meant that nobody would be held responsible for the full opportunity cost of failing to wait until the apples were mature. Many different individuals acted in a way that destroyed all the potential value of those apples to society, and none were held accountable for their actions.

Do property rights motivate socially beneficial behavior using a “carrot” or a “stick”? The answer is both. If someone were granted the property rights to the apple tree and its fruit, pilfering would be an illegal and punishable offence. The owner would receive the full benefits from maintaining the tree and waiting to harvest the apples until they were mature and would maximize profit by picking the apples when their marginal cost equals their marginal benefit.

2.

What is the optimal penalty for skipping class? Some professors penalize students with excessive, unexcused absences by making a portion of a student’s course grade depend on his or her attendance record. One reason behind such a policy is that students interact in class and benefit each other with their insightful remarks and questions, creating a positive externality. So a student missing classes deprives other students of these external benefits. To draw a similar perspective on the issues of recycling and pollution abatement, ask if a zero-tolerance policy giving an F to any student with even one unexcused absence is optimal for the class. Just as a rule requiring zero absences seems overly harsh, so would a rule requiring zero pollution. Zero pollution can be achieved only by stopping all

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production, all transportation, and, literally, all human activity. Clearly a balance between the marginal social costs and marginal social benefits is required.

3.

Evaluate the statement: “If this program saves even one life, it will have been worth the money.” Ask the following questions: Is the value of one life saved truly immeasurable? What is the opportunity cost of expending resources to save one life? Could more than one life have been saved if the same resources were used for a different policy? Should we try to fund all policies that could potentially save one life? Students should see the problem with this idea. Just because something has value doesn’t mean we should use resources to produce it. We must compare the value with its cost.

4.

Can you apply the Coase theorem in your own life? Ask your students if they’ve ever had the experience of studying for an important exam when a neighbor decides to throw a party or play music loudly. At the very least, students should understand that a party could interfere with their ability to study effectively, generating an external cost. According to the Coase theorem, this externality can be effectively dealt with by private transactions. The student studying can offer the partying student money to stop the party (or at least move the party elsewhere). The partying student will accept the money if the value of that money is at least as great as the cost of moving or stopping the party. Whether the transaction takes place will depend on how much the quiet time is worth to the studying student and how much the party is worth to the partying student. If efficiency would result in more quiet time and less partying, then this private transaction will result in the efficient outcome.

5.

Are laws that ban smoking economically efficient? Many cities are banning smoking in all public places including bars and restaurants. Consider alternate solutions to a complete ban, especially given an application of Coase’s theorem to smoking in shared offices. If smokers owned the air, would smoking necessarily occur? What if nonsmokers owned the air?

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The Big Picture Where we have been: Chapter 18 uses the productivity and cost definitions and concepts introduced in Chapter 10 and the conditions for maximum profit introduced in Chapter 11. It builds on these concepts to explain value of marginal product and to show how factor markets work.

Where we are going: Chapter 18 explores the workings of factor markets and the resulting distribution of income. The labor, capital, and natural resource markets are introduced here and Chapter 19 studies the implications of factor market equilibrium for the distribution of income and trends in the distribution.

New in the Fourteenth Edition This chapter is essentially the same as in the previous edition. The data have been updated in the text and in other applications.

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Lecture Notes

Markets for Factors of Production   

I.

Firms choose the quantities of factors they demand in order to maximize their profit.

Households choose the quantities of factors they supply.

The interaction of demand and supply determines factor prices.

The Anatomy of Factor Markets The four factors of production are labor, capital, land (natural resources), and entrepreneurship.

Labor services are traded in the labor market. The price of labor is the wage rate. Most labor services are traded on a job contract.  Capital goods are traded in goods markets. Capital services are traded in rental markets. The services of capital that a firm owns have an implicit price that arises from depreciation and interest costs. Firms that buy capital and use it themselves are implicitly renting the capital to themselves.  The price of the services of land is a rental rate. Nonrenewable natural resources are resources that can be used only once.  Entrepreneurs receive the profit (or loss) that results from their business decisions and their services are not traded in markets. 

Looking back Before you jump into the content of this chapter, provide your students with some context and perspective.

1. Recall the big issues of microeconomics discussed in Chapter 1. Point out that the course so far has addressed the first two questions: “What?” and “How?” and that you’re now going to address how markets determine the answer to the third question: “For whom?”

2. Spend a minute or two reviewing the course so far. Point out that Chapters 3–7, demand and supply and its extensions and applications studied the flows of goods and services from firms to households. Chapters 8 and 9 studied the choices of households. Chapters 10–15 studied the choices of firms. Now, we’re going to study the flow of goods and services from firms to consumer households in the product market and the flow of factors of production from households to firms in the factor markets.

3. Understanding choices at the margin, demand and supply, and market forces that bring equilibrium and coordinate activity to produce efficiency are all used in this chapter. Emphasize the power of the economic tools that the students already know and the payoff from keeping on top of the entire course.

II. The Demand for a Factor of Production The Value of Marginal Product 





The demand for a factor of production is called a derived demand because it is derived from the demand for the goods and services produced by the factor.

The value to the firm of hiring one more unit of a factor of production is called the factor’s value of marginal product. It is equal to the price of a unit of output multiplied by the marginal product of the factor of production: VMP = P  MP The table shows the calculation of the VMP for a firm whose output has a price of $7 per unit.

A Firm’s Demand for Labor 

Labor (hours per day)

Output (units per day)

200

1,000

300 400 500

The firm hires the quantity of labor that

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Marginal product of labor (units per day)

Value of marginal product (dollars)

20

140

10

70

5

35

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maximizes its profit by comparing the value of one more worker (the VMP) to the cost of employing one more worker, the wage rate.

As more labor is employed, the MP diminishes (as shown in the table above). So as more labor is employed, the VMP diminishes.

If VMP of labor exceeds the wage rate, the firm increases its profit by employing one more worker; if VMP is less than the wage rate, the firm increases its profit by employing one less worker; and, if VMP equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

A Firm’s Demand for Labor Curve The value of marginal product curve is the firm’s labor demand curve.  Because the VMP of labor diminishes as the quantity of labor employed increases, the demand curve for labor is downward sloping.

The profit-maximizing level of inputs implies the profit-maximizing level of output. If you wish to go beyond the analysis in the book, you can take a bit of time to show your students the basic math of the equivalence of the two conditions for maximum profit—MR = MC and W = VMP—and give them a good intuitive grasp of what is going on. There are six steps: 1. The cost of producing one more unit, MC, equals the cost of one more worker, W, divided by that worker’s marginal product, MP. That is: MC = W/MP. 2. The revenue from selling one more unit, MR, equals the revenue from hiring one more worker, VMP, divided by that worker’s marginal product, MP. That is: MR = VMP/MP. 3. Setting these two equations side by side: MC = W/MP and MR = VMP/MP is a tiny step to see that MC = MR implies W = VMP. 4. Just write MC = MR implies W/MP = VMP/MP; multiply by MP and W = VMP. 5. Now put in some numbers to make the student who freezes on symbols more comfortable.

6. Finally, just talk about what the equations mean. Explain that the marginal worker costs $x and generates a revenue of $x, so that worker is just worth hiring. Hiring one more worker costs $x but generates less than $x in revenue, so is not worth hiring. Hiring one fewer worker saves $x but forgoes more than $x in revenue, so profit falls. Go on to point out that one unit of output produced by the marginal worker sells for $p and it costs $x/MP, which equals marginal cost.

Changes in a Firm’s Demand for Labor Three factors can change the demand for labor and shift the labor demand curve:  If the price of the firm’s output changes, the VMP changes, which changes the demand for labor. An increase in the price of the output increases the demand for labor and shifts the demand curve rightward.  If the prices of other factors of production change, in the long run the demand for labor changes. An increase in the price of a substitute factor leads the firm to increase the demand for labor.  If a change in technology increases the productivity of one type of labor, the demand for this labor increases and the demand curve shifts rightward.

III. Labor Markets A Competitive Labor Market  

The market demand for labor is determined by adding together the quantities of labor demanded by all the firms in the market at each wage.

The market supply of labor is derived from the supply of labor decisions made by individual households.

Aren’t households demanders? Point out that in the labor market, the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumer of goods and services is now on the supply side of the market.

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



A person’s reservation wage is the lowest wage rate for which the person is willing to supply labor. As the wage rate rises above the reservation wage, there is a substitution effect and an income effect. The substitution effect occurs because a higher wage rate increases the opportunity cost of leisure, which increases the quantity of labor supplied. The income effect occurs because an increase in the wage rate increases the person’s income and so increases the demand for leisure, which decreases the quantity of labor supplied.

At lower wage rates, the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At higher wage rates, the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied and the supply of labor curve bends backward.

What’s your reservation wage? Ask the students if they would be willing to work 40 hours each week at a wage rate of $20 per hour (which is about $40,000 per year). Next, ask them whether they would increase their labor supplied to 48 hours per week if they could earn $40 per hour (about $80,000 per year, if working 40 hours per week). Most students would be willing to work more hours per week at this wage rate. Then ask them how many hours per week they would work if they were paid $10,000 per hour. In this case, working only one day per week would garner them about $8 million per year, leaving the remaining six days of each week to enjoy their high income. Many would not be willing to continue working 48 hours a week, thereby creating a backward-bending supply of labor curve.  

The supply of labor increases (shifts rightward) when the adult population increases and when capital and technology used in the home increase.

Labor market equilibrium determines the wage rate and employment.

Comparing competitive output markets with competitive input markets. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land.

Differences and Trends in Wage Rates 

 

Differences in demand and supply across labor markets make wage rates unequal. The highest wage rates are earned in markets where the value of marginal product is high and where few people have the ability and training for the job.

Because the value of marginal product increases over time as new capital and new technologies increase labor productivity, wage rates also increase over time.

Wage inequality has increased recently with high wage rates increasing more rapidly than low wage rates.

Some low wage rates have stagnated or fallen. The new information technologies increased the productivity and wage rates of already high-paid workers. Globalization has brought increased competition for low-skilled workers and lowered the wages of already low-paid workers.

An Economics in Action case has been updated with current Bureau of Labor Statistics data on U.S. wages. The difference between median and mean income is highlighted as more Americans earn less than the average income.

The application also notes that higher than average wage jobs typically require college and post graduate degrees.

A Labor Market with a Union

A labor union is an organized group of workers that aims to increase the wage rate and influence other job conditions. The text analyzes how unions impact the labor market equilibrium for union workers and how this impacts nonunion workers.  To reach their goals, unions attempt to restrict the quantity of labor available for the firm to employ (shifting the labor supply curve leftward).  Unions also attempt to influence the demand for labor and to increase the demand for labor (shifting the labor demand curve rightward) with the following strategies: © 2023 Pearson Education, Inc.

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 Increase the marginal product of union members to increase the demand for their labor.  Encourage import restrictions to increase the demand for union-made U.S. products.  Support minimum wage laws to raise the cost of non-union low-skilled labor.  Support immigration restrictions to decrease the supply of competitive labor.

In equilibrium, if a union decreases the supply of labor, there will be fewer jobs at higher wages. If it is able to also increase the demand for union labor, this will further increase wages and offset some of the decrease in employment. The market for nonunion labor will also be effected workers unable to get union jobs increase the supply.

Monopsony in the Labor Market  

A monopsony is a market in which there is a single buyer.

For a monopsony, the marginal cost of labor exceeds the wage rate because the monopsony faces an upwardsloping labor supply curve. To attract one more worker, the monopsony must offer a higher wage rate, and it must pay this higher wage rate to all its workers.

Example: The idea that the marginal cost of labor is somehow different from the wage rate is often confusing for students. Be sure to go through the intuition and the math calculations for the marginal cost of labor several times. As in the table below, if employment rises from 200 to 300 hours per day, the wage rate will rise from $3 to $6. The total cost of labor rises from $600 to $1,800, a difference of $1,200. The change in total cost divided by the change in employment will be $1,200/100 = $12. Intuitively, all 200 hours of labor were earning a wage of $3 per hour until the next 100 hours of labor were employed. To entice those units of labor to supply their services, the wage rate rose to $6 for all 300 units of labor. As a result, the firm pays $6 for the new 100 hours of labor, and pays an additional $3 for the 200 hours of labor it was previously employing. That’s $600 for the new 100 units of labor and an additional $600 for the wage increase paid to the original 200 units of labor, for a marginal cost of labor equal to $1,200/100 = $12 again.

What about “wage discrimination”? Monopolies faced a downward-sloping demand curve for their output, resulting in a marginal revenue curve that was below the demand curve. To sell more output, monopolies had to lower the price. The story for monopsony is similar. Because a monopsony faces an upward-sloping supply curve for labor, to hire more labor, monopsonies have to raise the wage, resulting in a marginal cost of labor curve that is above the labor supply curve. Some of your especially attentive students will remember that marginal revenue and demand were the same when the firm could practice perfect price discrimination. In the basic model of monopsony, we’re assuming there’s no “wage discrimination.” Every worker is paid the same wage, just as every customer in a single-price monopoly is charged the same price.

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





The first two columns of the table show the labor supply schedule and the last column has the marginal cost of labor, MCL, schedule. The MCL curve is Wage rate Marginal cost upward sloping and lies above the labor supply curve.

Labor (dollars per of labor (hours per day) hour) (dollars per hour) To maximize its profit, a monopsony hires the quantity of labor where its MCL is equal to VMP 200 3 and then pays the wage rate necessary to attract 12 that quantity of labor. In the figure, the monopsony employs 300 hours of labor per day 300 6 and pays a wage rate of $6 per hour.

18 A monopsony hires less labor and pays a lower 400 9 wage rate than it would if it were operating in a competitive labor market. In the figure, in a 24 competitive labor market 400 hours of labor 500 12 would be employed and the wage rate would be $9 per hour.

A Union and a Monopsony 

If a union, a monopoly seller of labor services, faces a monopsony buyer of labor services, the situation is called bilateral monopoly. In a bilateral monopoly, the wage rate is determined by bargaining and depends on the costs that each party can inflict on the other if they fail to agree upon a wage rate.

Examples of bilateral monopoly: Have the students consider the relationship between professional team owners (NBA, NFL, etc.) and the players who work for these owners. Such markets are classic examples of bilateral monopoly. Team owners operate a legal cartel and maintain strict rules for hiring labor (drafting and trading players) that prevent most of the competition among team owners who might want to sign the same player. So the owners are close to a monopsony. The best players with uniquely talented skills cannot be duplicated in the short run, so these players have a monopoly on their skills. The resulting bilateral monopoly equilibrium is such that player’s wages in general are high compared to most all other professions. This observation might surprise the students because it suggests that bargaining position of the players is greater than that of the owners.

Monopsony and Minimum Wages 

The imposition of a minimum wage in a monopsony labor market might increase both the wage rate and employment. The minimum wage makes the supply of labor perfectly elastic over some range of employment. Over this range the supply curve is horizontal and the MCL of an additional employee equals the minimum wage rate. If this part of the supply curve of labor intersects the monopsony’s VMP curve, the minimum wage increases both the quantity of labor employed by the monopsony and the wage rate paid by the monopsony. The wage rate equals the minimum wage rate.

The At Issue case presents the argument over whether monopolies are always bad, focusing on the NCAA. Robert Barro argues that the NCAA monopoly hurts the market for college athletics. Richard McKenzie and Dwight Lee argue that the NCAA monopoly has helped college athletics. © 2023 Pearson Education, Inc.

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IV. Capital and Natural Resource Markets 



Capital rental markets and land rental markets can be understood using the same basic ideas from the competitive labor market.

Markets for nonrenewable natural resources are different.

Capital Rental Markets 



The demand for capital is equal to the value of the marginal product of capital, and equilibrium in the market for capital occurs where the value of the marginal product of capital is equal to the rental rate of capital.

Whether a firm rents or buys capital depends on a comparison of the cost of a purchase relative to the stream of rental costs incurred over some future period. The Mathematical Note develops this result and the concept of present value.

An Economics in the News case considers the impact of Airbnb on the Boston Hotel market. It concludes that the Boston hotel market has still grown even while Airbnb has expanded its service in the area and uses demand and supply curves to complete the analysis.

Land Rental Markets  

The demand for land is based on the value of marginal product of land, and equilibrium in the market for land occurs where the value of the marginal product is equal to the rental rate of land.

The supply of land is fixed, so the supply curve is vertical.

Nonrenewable Natural Resource Markets 

 



Oil, gas, and coal are examples of nonrenewable natural resources that are used to produce energy.  The demand for oil is determined by the value of the marginal product of oil—the fundamental influence on demand—and the expected future price of oil—the speculative influence on demand. The opportunity cost for a trader of buying and holding oil is the interest rate that could be earned as an alternative.  The supply of oil is determined by known oil reserves, the scale of current oil production facilities, and the expected future price of oil. The marginal cost of extracting oil increases, which results in an upward-sloping supply curve for oil.

The market fundamentals price of oil is determined by the value of marginal product of oil and the marginal cost of extraction.

Speculative forces based on expectations of the future price also can affect the current price. When expectations are revised so that the price is expected to be higher in the future, the current demand increases and the current supply decreases. Speculation can drive a wedge between the equilibrium price and the market fundamentals price.

The Hotelling Principle states that traders expect the price of a nonrenewable natural resource to rise at a rate equal to the interest rate. The actual path of a nonrenewable natural resource will not necessarily rise at this rate because the actual path depends on exploration and technological changes.

An Economics in Action case considers the U.S. and world market for oil. It analyzes why energy independence for U.S. oil production won’t mean the U.S. is not affected by changes in the global price of oil.

When will we run out of oil? Students are very interested in the doomsday issue. When will we run out of nonrenewable resources such as the hydrocarbon fuels? (Minerals are different because they can be recycled. They are nonrenewable, but somewhat durable.) Some numbers for your class: At the current usage rate and the current growth rate of usage and assuming that we will discover no new reserves, the world runs out of coal in 2082, natural gas in 2043, and oil in 2030. But, assure them this will never happen and explain the reasons: As the resource becomes more scarce, the price increases, causing a number of actions: 1) society is more willing to explore previously unexplored areas which were “too expensive” to explore before the price increase, and new deposits will be discovered, 2) the remaining level of resources in existing deposits that were “too expensive” to extract are now more affordable to © 2023 Pearson Education, Inc.

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extract and will be made available, 3) Alternate resources that were “too expensive” to use as a substitute resource before the price change to be efficient are now efficient to use, decreasing the rate of use of the initial resource. With an increase in resource prices, the “empty tank” keeps on extending.

Doomsday and the Hotelling Principle: Another really neat bit of analysis that addresses the doomsday scenario headon is the Hotelling Principle. The textbook keeps this material as simple as possible without losing the point. You can elaborate a bit and explain the end-game a bit more fully if you wish. To do so, you draw a demand curve for coal that hits the y-axis at the so-called “choke price.” Explain that today’s expectation of the choke price and today’s expectation of the year that the resource runs out determines today’s price. That price, P, is the expected choke price, PCHOKE, discounted by the expected number of years to running out, T. So P = PCHOKE/(1 + r)T. (Your students will likely have to have had some exposure to the concept of present value to understand this.) No one actually performs the calculation of this equilibrium price, but rational owners of reserves of the natural resource behave as if they performed the calculation. At each point in time, the future price is expected to rise at a rate equal to the interest rate.

But the actual price fluctuates because expectations about the choke price and the number of years left fluctuate. And historically, the prices of many resources have fallen because the T has continually become unexpectedly longer.

Economics in the News at the end of the chapter describes the impact of Uber on the taxi industry. It concludes that it has had a relatively small negative impact on the wages of traditional salaried taxi drivers, a large impact on the number of self-employed taxi drivers, and that self-employed taxi drivers have higher hourly earnings which is credited to a more efficient use of their time given the sharing technology.

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Mathematical Note Present Value and Discounting Rent-versus-Buy Decision Firms must compare the current cost of buying capital with the future cost of renting the capital

Comparing Current and Future Dollars 

The returns to capital come in the future, so the firm must convert the future marginal revenue product of capital to a present value. The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account.

Discounting is converting a future amount of money into a present value.

Compound Interest Compound interest is the interest on an initial investment plus the interest on the interest that the investment has already earned.  To illustrate present value, begin with the relationship between an amount invested today (Present value), the interest income that it earns (Interest income), and the amount it grows to in the future (Future amount): Future amount = Present value + Interest income  The interest in the first year is equal to the present value multiplied by the interest rate, r, so Amount after 1 year = Present value + (Present value  r) = Amount after 1 year = Present value  (1 + r).  The amount after 2 years is equal to the amount after 1 year multiplied (1 + r), so Amount after 2 years = Present value  (1 + r)2  Similarly, the amount of money that a person has n years in the future equals: Amount after n years = Present value  (1 + r)n.  Example: $100 saved for 5 years at 6 percent interest equals $100  (1 + 0.06)5 = $133.82.

Discounting a Future Amount To discount a future amount into its present value, the formulas above need to be rearranged.  Rearranging the formula for the amount of money after 1 year shows that: Present value = 

In turn, rearranging the formula for the amount of money after 2 years shows that: Present value =



Similarly, the present value of an amount of money n years in the future is: Present value =



Example: $300 to be paid in 4 years when the interest rate is 5 percent per year for each year has a present value of $300/(1 + 0.05)4 = $246.81. As a check, $246.81  (1 + 0.05)4 = $300.

Present Value of a Sequence of Future Amounts 



If money payments are to be paid at several times in the future, the present value of this stream of payments is equal to the sum of the present value of each money payment.

Example: $100 is paid for the next three years at the end of each year. The interest rate is 6 percent. The present value equals $100/(1 + 0.06) + $100/(1 + 0.06)2 + $100/(1 + 0.06)3 = $267.30.

The Decision 

Renting a unit of capital will require payments to be made in the future. The present value of this stream of payments is compared to the price of buying the unit of capital. If the price is greater than the present value © 2023 Pearson Education, Inc.

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of rental payments, the capital is rented while if the price is less than the present value of the rental payments, the capital is purchased.

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Additional Problems 1.

Barry makes party ice. He employs workers to bag the ice who can produce the quantities of ice in an hour that are listed in the table. The market for ice is competitive and Barry can sell ice for 50¢ a bag. The labor market is competitive and the equilibrium wage rate of baggers is $10.00 an hour. a. Calculate the marginal product of the workers. b. Calculate the value of marginal product of the workers. c. Find Barry’s demand for labor curve. d. How much ice does Barry sell?

Number of workers 1 2 3 4 5 6 7 8 2.

Back at Barry’s ice making plant described in problem 1, the price of party ice falls to 25¢ a bag but baggers’ wages remain at $10.00 an hour. a. What happens to Barry’s marginal product? b. What happens to his value of marginal product? c. What happens to his demand for labor curve? d. What happens to the number of baggers that he employs?

3.

Quantity of ice (bags) 40 100 180 240 290 330 360 380

Back at Barry’s party ice shop described in problem 1, baggers’ wages increase to $20 an hour, but the price of ice remains at 50¢ a bag. a. What happens to his value of marginal product? b. What happens to Barry’s demand for labor curve? c. How many baggers does Barry employ?

4.

What is discounting? What is present value? How do the two relate?

Solutions to Additional Problems 1.

a.

Marginal product of labor is the increase in total product that results from hiring one additional bagger.

For example, if Barry increases the number of baggers hired from 2 to 3, total product (the quantity of ice) increases from 100 to 180 bags. The marginal product of 2.5 baggers is 80 bags of ice. The table shows the remainder of these marginal products.

Number of workers 1

Quantity of ice (bags) 40

2

100

Marginal product (bags) 60 80

3

180

4

240

5

290

6

330

7

360

8

380

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b.

c. d.

2.

a. b.

c.

d.

3.

a.

b. c.

4.

The value of marginal product of labor is the increase in Value of total revenue that results from hiring one additional Marginal marginal bagger, which equals the marginal product multiplied Number of product product by the price. The second table shows that the marginal workers (bags) (dollars) product of 2.5 workers is 80 bags of ice. Barry sells the 1.5 60 30 ice for 50¢ a bag, so this worker’s value of marginal 2.5 80 40 product is 80 bags  50¢ a bag = $40. The schedule 3.5 60 30 showing the value of marginal products in the table are 4.5 50 25 calculated similarly.

5.5 40 20 Barry’s demand for labor curve is the same as his value 6.5 30 15 of marginal product curve.

7.5 20 10 Barry sells 370 bags. Barry hires the number of baggers that makes the value of marginal product equal to the wage rate of $10 an hour. When Barry hires 7.5 baggers, marginal product is 20 bags of ice in an hour, which Barry sells for 50 cents a bag. The value of marginal product is $10—the same as the wage rate. Barry hires 7.5 baggers and produces 370 bags of ice an hour.

The marginal product does not change. The marginal product that results from hiring 2.5 baggers an hour is still 80 bags of ice.

The value of marginal product decreases. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice. Now Barry sells the ice for 25 cents, so the value of marginal product is 80 bags  25¢ a bag = $20, down from $40.

Barry’s demand for labor decreases, and his demand for labor curve shifts leftward. Barry is willing to pay the baggers their value of marginal product, and the fall in the price of ice has lowered their value of marginal product.

Barry will hire fewer baggers. At the wage rate of $10.00, the number of baggers Barry hires decreases to 5.5 as the demand for labor curve shifts leftward.

The value of marginal product does not change. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice and Barry sells the ice for 50 cents a bag, so the value of marginal product remains at $40.

Barry’s demand for labor remains the same because the value of marginal product of labor has not changed.

Barry will hire fewer baggers. At the wage rate of $20 an hour, Barry hires the number of baggers that makes the value of marginal product equal to $20 an hour. Barry now hires 5.5 baggers an hour—down from 7.5 an hour. The marginal product that results when Barry hires 5.5 baggers is 40 bags of ice an hour, and Barry sells this ice for 50 cents a bag. The value of marginal product is $20 an hour, which is equal to the wage that Barry must now pay.

Discounting is converting a future amount of money into a present value. If a firm did not receive money today but instead received that money in the future, the firm would forgo the interest that this sum of money would have earned over that period. The present value of a future amount of money is the amount that, if invested today, grows to be as large as that future amount when the interest that it earns is taken into account. If a person is to receive a number of periodic payments in the future, then that person can use discounting to establish the present value of that future income stream.

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Additional Discussion Questions 1.

Do advances in technology replace jobs with capital and increase unemployment? Emphasize that the firm’s demand curve for labor depends on the value of marginal product (VMP) of labor, which is comprised of both the marginal product (MP) of labor and the value to the firm of the goods or services labor helps produce, which is price (P). Have the students mentally work through the following series of impacts that an increase in the MP of capital has on the labor market in the long run: What happens to the demand for labor when capital becomes more productive? Point out that if the firm substitutes capital for labor, then some labor is unemployed, but the remaining labor is more productive (higher effective capital to labor ratio) and earns a higher wage (VMP = W).

Who gains from increased productivity? The competitive firm passes on the cost savings to the consumers through lower prices. The rise in consumer buying power and the higher incomes of those remaining employees increase the overall demand for goods and services in the economy.

What happens to the level of employment? Because most firms are experiencing increased demand for their goods and services, the price facing firms in these markets rises. The result is that the value of marginal product for labor in those markets increases with output, increasing the overall demand for labor in the labor market.

2.

Why do college graduates earn, on average, so much more than non-graduates? Part of the benefits of earning a degree in higher education is that the graduate has acquired additional critical thinking skills that make him or her much more productive (better able to contribute towards making goods and services that the rest of society values more highly than those goods and services that nongraduates can make). The existence of a significant wage differential between these two groups of people over time is contributing evidence that a college education is a good signal to employers of a value of marginal product of labor. Looking at the unemployment rates for those with a college education versus those without a college education as we have gone through the financial crisis and the recession will bring this home even more than wages.

3.

Do union actions impose the costs of increased labor benefits onto the consumer? Ask the students to identify the opportunity cost associated with employment levels and wage rates in unionized labor markets.  Emphasize that labor unions try to raise demand for their labor by appealing to governments to raise import quotas on foreign goods and services and to restrict immigration of labor. All of these activities are aimed at increasing the wages paid to union laborers through increasing the price of the goods and services produced by union labor. This increases their value of marginal product and the wage the firm is willing to pay.  If the firm is a perfectly competitive firm, then the increase in labor costs leads some firms to exit the industry, and the equilibrium market price that consumers must pay for the goods and services rises and both producer surplus and consumer surplus decrease.  You can make the point that unions are similar to monopolies in that both violate Adam Smith’s “Invisible Hand” idea. In particular, for both unions and monopolies, people looking out for only their self-interest take actions that harm society. So for both unions and monopolies, decisions made in the private interest do not further the social interest. 

4.

You might look at General Motors or Ford pre-financial crisis and the concessions that unions made to change the costs of care production.

Why do unions support the minimum wage? Union members earn much more than the minimum wage, so why do unions support the minimum wage? The answer is that low-skill labor that earns the minimum wage and high-skill union labor are substitutes. A rise in the minimum wage induces a © 2023 Pearson Education, Inc.

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substitution effect—a decrease in the quantity of low-skilled labor demanded, and an increase in the demand for union labor. With an increase in demand for union labor, the wage rate of union labor rises.

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ECONOMIC INEQUALITY

The Big Picture Where we have been: Chapter 18 explained how factor markets allocate income based on demand and supply for land, capital, and labor. Chapter 19 examines how the factor market outcomes influence the distribution of income and wealth in society. This chapter explains how we measure the degree of inequality, the characteristics of households at different places in the distribution, trends in inequality, and redistribution policies. A theme of the chapter is the role played by human capital and the resulting increase in productivity in affecting the distribution of income.

Where we are going: The following chapter is the last of the microeconomic theory chapters. It focuses on risk and uncertainty and market efficiency in the face of uncertainty.

New in the Fourteenth Edition The introduction to the chapter has been updated to focus on the widening gap between rich and poor.

The final Economics in the News analyzes the increasing difference between the incomes of households at the top and bottom of the income distribution as a result of the Covid-19 pandemic and government regulations.

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Lecture Notes

Economic Inequality    

I.

Incomes are distributed unequally.

In large part, features of the labor market account for the unequal distribution of income.

Other factors also affect income inequality.

The government has policies that redistribute income.

Economic Inequality in the United States 

Money income equals market income plus cash payments to households by the government. Market income equals wages, interest, rent, and profit earned in factor markets before paying income taxes. In the United States in 2019, the median money income was $68,703, and the mean money income was $98,088.

Where are you in the income distribution? Ask the students to place themselves in the U.S. income distribution by estimating their household income. Be sure to remind them to add together the income of both of their parents if they live with both and both earn income. Many students will be surprised that they are from upper-middle income families, even if they suspected that they were middle income to lower middle income families.

The Distribution of Income 

The distribution of money income in the United States is positively skewed, so that the distribution of incomes has a long tail of high income households. In 2019,  the poorest 20 percent of households received 3.1 percent of total income  the middle 20 percent of households received 14.1 percent of total income  the richest 20 percent of households received 51.8 percent of total income.

The Income Lorenz Curve  

An income Lorenz curve graphs the cumulative percentage of income earned against the cumulative percentage of households.

The table below has the (approximate) income shares for the United States and the figure graphs the resulting Lorenz curve.

Households (percentage) Lowest 20 Second 20 Middle 20 Next highest 20 Highest 20 

Income (percentage) 3 9 15 23 50

Income (cumulative percentage) 3 12 27 50 100

The “Line of Equality” shows what the distribution of income would be if incomes were equally distributed.

The closer the Lorenz curve to the line of equality, the more equal is the distribution of income and the farther away the Lorenz curve from the line of equality, the less equal is the distribution of income.

Interpreting the Lorenz curve. Emphasize that the Lorenz curve measures economic equality within a given population. Ask: which is more unequal, the distribution of income in the United States or the distribution of income among the 849 major league baseball players? After a minute or two of discussion, you can provide the data in the table below. Make the point that although income is much more unequally distributed among major league © 2023 Pearson Education, Inc.

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baseball players, in 2019 the poorest earned $555,000 a year, which is more than twice the average of the fifth quintile in the United States, $240,000. Relate this reality to a comparison of countries to the United States. Get the students to consider the fact that the average income person living in the poorest quintile in the United States is still enjoying a higher level of income than the median income individual living in any of a majority of other countries around the world.

Quintile U.S. Households Major league baseball players percentage of income percentage of income Lowest 3.1 1.8 Second 8.1 2.8 Middle 14.1 8.2 Fourth 25.5 24.0 Highest 51.8 63.3

The Distribution of Wealth 

Wealth is the value of all the things that are owned by a household at a given point in time. The distribution of wealth can be examined with a Lorenz Curve. Because human capital is not included in measured wealth, the distribution of wealth is more unequal than the distribution of income and the income distribution is a more accurate measure of economic inequality.

Annual or Lifetime Distribution of Wealth? 



Household income varies over the life cycle, typically starting out low, growing to a peak at retirement, and then falling after retirement. Wealth follows a similar pattern.

Inequality in annual income and wealth data overstates life time inequality because households are at different stages in their life cycles.

Trends in Inequality 

The Gini ratio is based on the Lorenz curve and equals the ratio of the area between the line of equality and the Lorenz curve to the entire area beneath the line of equality. The larger the Gini ratio, the more unequal the distribution. The Gini ratio shows that since 1970 the distribution of income in the United States has become less equal.

Economics In Action considers the growing inequality of U.S. incomes. It notes the steady increase in income share for the richest Americans. In 2021 about 2/3 of Americans surveyed said that incomes were too unequal when in 1991 only 21 percent said this. The Economics in Action feature also presents data on the impact of education, type of household, age, race, and region on incomes.

Poverty 

Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. In 2019, the poverty level calculated by the Social Security Administration for a four-person family was $25,926.



In 2019, 34 million Americans, 10.5 percent of the population, lived below the poverty level.  Race: In 2019, 9.1 percent of white Americans lived in poverty compared to 15.7 percent of Hispanicorigin Americans and 18.8 percent of black Americans.  Age: Poverty rates are 14 percent for children and 9 percent for seniors over age 65.  Work Experience: The poverty rate for those with jobs is 2 percent or for those without 26 percent.  Physical Ability: 26 percent of people with disabilities are poor.  Household Status: 23 percent of households headed by women with no husbands present experience poverty.

The Economics in Action considers whether the American Dream is still alive. It uses data to examine mobility up and down the income distribution. The analysis concludes that between 2007 and 2009 most households did not move from one quintile to the next. But there is still mobility, to both higher and lower quintiles. © 2023 Pearson Education, Inc.

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II. Inequality in the World Economy Income Distribution in Selected Countries 

Countries such as South Africa have more unequally distributed incomes, with the average person in the highest quintile receiving 28.4 times the income of the average person in the lowest quintile. The United States lie somewhere in the middle globally, with the average person in the highest quintile receiving 17 times the income of the average person in the lowest quintile. Sweden has a more equally distributed income, with the average person in the highest quintile receiving 4.6 times the income of the average person in the lowest quintile.  South Africa is somewhat extreme and have relatively small and rich European populations and relatively large and poor indigenous populations.  Sweden is also somewhat extreme, but less unusual. It is similar in income distribution to many European countries where governments pursue aggressive income redistribution policies.

Global Inequality and Its Trends      

The global distribution of wealth is much more unequal than the distribution within any one country.

Many nations are still pre-industrial and very poor, while others are sophisticated industrial producers and accordingly quite rich.

3.5 billion people or 50 percent of the world’s population live on $5.50 per day or less.

An average person in the United States has an income of $270 per day. The average person in the highest quintile in the industrialized countries has $700 per day. The average American earns 49 times the income of half the world’s population.

The world Gini ratio in 2009 is about .61. The U.S. Gini ratio is about .47. These Gini ratios mean the world’s Lorenz curve lies much farther to the right (away from the line of equality) than the U.S. curve.

Over time, incomes have become more unequal in the United States and the same trend can be found in most economies. But while incomes are more unequal within countries, the world distribution of income as a whole is becoming less unequal. The average incomes in poor countries are rising faster than the average incomes in rich countries, narrowing the gap across countries.

Is capitalism heartless? Emphasize that there are no societies where income or wealth is equally distributed. Society has two main concerns: prosperity and equality. Private enterprise (capitalist) societies are, in general, more prosperous, and in most cases (but not all) have no less equal an income distribution than socialist societies. Ask which is better for a family, to be the poorest in a rich but unequal society or equal with everyone else in a poor society.

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III. The Sources of Economic Inequality Human Capital In labor markets, differences in human capital as well as discrimination can lead to differences in incomes.  In general, people with more human capital are high-skilled workers. Skills affect both the demand and supply side of the labor market:  High-skilled workers have a larger VMP than low-skilled workers, so the demand for high-skilled workers exceeds the demand for low-skilled workers.  High-skilled workers must incur the cost of acquiring their skills, so the supply of high-skilled workers is less than the supply of low-skilled workers.  As the figure shows, the combination of higher demand (DH compared to DL) and lower supply (SH compared to SL) for highskilled workers versus low-skilled workers leads to a higher wage rate for high-skilled workers.  The wage differential between high-skilled and low-skilled workers has widened over time because technological changes and globalization have increased the demand for high-skilled workers and decreased the demand for low-skilled workers.

(Technological change has been a complement for high-skilled workers and substitute for low-skilled workers.)

Discrimination 

 

Discrimination is another possible source of income inequality. The VMP of the group being discriminated against is less than the VMP of the other group, so discrimination can lower the wage rate of the group being discriminated against. Economists disagree to the extent that discrimination actually affects wage rates.

One line of reasoning states that those firms that practice discrimination face higher costs than those firms that do not. As a result, the profits of the discriminating firms will be lower and the market price of their goods and services will be higher so that these firms cannot survive in competitive markets.

How much workers choose to specialize primarily in a career versus spending more time and energy on home life affects wages. This factor explains part of the wage gap between married men and other types of workers.

When the wages of never married men and never married women with the same amount of human capital were compared, wages of the two groups were the same.

Contests Among Superstars   

Some of the really large differences in wages cannot be accounted for by differences in human capital.

Contests among superstars can explain this difference.

Contests with prizes do a good job of allocating scarce resources efficiently when the efforts of participants are hard to monitor and reward directly. This describes the case for CEOs and other stars.

The prizes are so different because they need to induce enough effort.  In sports, globalization has increased the total revenue generated by sports. The total prize money has increased and, to generate enough effort amongst all the players, the share going to winner has increased.  In business, more businesses are global in nature so the number of executives vying for the top positions has increased. To generate enough effort amongst all the executives, the salary paid the CEO—the “winner” of the “contest”—has increased.

What demographic characteristics are correlated with household income? List the demographic characteristics that tend to be correlated with household income: level of education, size of household, and marital status, for example. © 2023 Pearson Education, Inc.

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These result from individual choices and not from characteristics outside the individual’s control (age or race).

Emphasize that not all who are living in the lowest (or highest) income quintile will remain in that same economic situation in the long term. Emphasize that private enterprise democracies create dynamic socio-economic pathways for their citizens. Investing in human capital today (deferring current consumption) ensures a much more prosperous life for tomorrow. Advise your students that this investment is much harder to implement after reaching middle age than as a young adult.

Unequal Wealth Greater wealth inequality arises from two sources: life cycle saving patterns and transfers of wealth from one generation to the next.  Life-Cycle Saving Patterns: Wealth is built over one’s lifetime, so much of the wealth is owned by people in their sixties.  Intergenerational Transfers: Households that inherit wealth are likely to transfer that wealth to the next generation.  Marriage and Wealth Concentration: Assortive mating (“like attracts like”) implies that wealthy people seek wealthy partners, so wealth becomes concentrated in a small number of families.

IV. Income Redistribution 

Governments in the United States use three main ways to redistribute income: taxes, income maintenance programs, and subsidized services.

Income Taxes 

All levels of government collect income taxes. Income taxes may be progressive, regressive, or proportional. A progressive income tax is one that taxes income at an average rate that increases with income. A regressive income tax is one that taxes income at an average rate that decreases with income. A proportional income tax (also called a flat income tax) is one that taxes income at a constant average rate, regardless of income.

The U.S. federal income tax is progressive. Ask the students if they think they know the tax burden paid by the richest 1 percent, 5 percent, and 10 percent of taxpayers. The students usually underestimate how progressive the income tax rate system is. IRS figures based on income tax returns collected for the year 2017 reveal that:  The richest 1 percent paid 38.5 percent of all income taxes collected.  The richest 5 percent paid 59.1 percent of all income taxes collected.  The richest 10 percent paid 70.1 percent of all income taxes collected.  The lowest 50 percent paid 3.1 percent of the total income tax collected.

Clearly the progressive nature of the federal tax system redistributes income away from richer households.

Income Maintenance Programs There are three major types of programs that redistribute income by making direct payments to people in the lower part of the income distribution:  Social security programs: Old Age, Survivors, Disability, and Health Insurance (OASDHI) makes monthly cash payments to retired or disabled workers or their surviving spouses and children.  Unemployment compensation: Every state government has established an unemployment compensation program that taxes all workers in the state and gives unemployed workers in the state a periodic cash benefit for a specified period of time.  Welfare programs: Welfare programs provide incomes for people with incomes below a specified level and who do not qualify for social security or unemployment programs. These programs include the Supplementary Security Income (SSI) program, the Temporary Assistance for Needy Households (TANF) program, the Food Stamp program, and Medicaid.

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Subsidized Services 

A great deal of income redistribution takes place in the United States through the provision of subsidized services, services provided by the government at prices below the cost of production. Examples include primary and secondary public education, as well as state colleges and universities. Medicare and Medicaid are other examples of subsidized services.

An Economics in Action feature presents data that shows how government taxes and benefit programs redistribute income and make the distribution more equal.

The Big Tradeoff 

Redistributing income leads to a tradeoff between equity and efficiency, known as the big tradeoff.

Programs to redistribute income lead to inefficiency because the process of income redistribution uses up resources and, more importantly, because redistribution decreases the incentives for the taxpaying workers to provide labor and decreases the incentives for the benefit recipients to provide labor.

What are the costs of redistributing income? Emphasize that there is an opportunity cost to redistributing income in any society: when a dollar is taken from a rich person, a poor person receives less than a dollar. The size of the economic pie shrinks because:  Productive resources are consumed to implement the program rather than produce goods and services,  Redistribution requires taxation of income or exchange, which imposes a dead weight loss to society, and  The incentives facing the recipient of supplemental income are altered, delaying re-entry into the work force.

Economics in the News: “The Legacy of 2020: Riches for the Wealthy, Well-Educated, and Often White, Financial Paid for Others” reports on how the Covid-19 pandemic increased income inequality by raising demand for higherskilled workers who could work at home and reducing demand for lower-skilled workers who could not.

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Additional Problems 1.

2.

3.

How does the minimum wage affect the distribution of income?

Compared to the United States, managers in Hong Kong and Malaysia are paid much more than the low-skilled factory workers that they supervise. What accounts for this difference in relative pay?

Many pets in rich nations eat better than people in poor nations. To equalize the international distribution of income, do you think that rich nations should tax their citizens and give the income to the poor of very poor nations? Would this policy be fair?

Solutions to Additional Problems 1.

The minimum wage affects the distribution of income in several ways. First, workers who without the minimum wage would be paid less, receive a higher income than otherwise with the minimum wage. Because these workers are low-income workers, the minimum wage makes the distribution of income a bit more equal.

Second, some workers lose their jobs when a minimum wage is imposed. These workers’ incomes fall and the minimum wage makes the distribution of income less equal. Finally, the minimum wage probably decreases some firms’ profits and so decreases their owners’ incomes. Because owners are generally higher-income earners, the minimum wage makes the distribution of income more equal.

2.

The difference in pay is a result of the fact that managerial skills are in much smaller supply in Hong Kong and Malaysia. There are many low-skilled factory floor workers in Hong Kong and Malaysia. There are few highskilled managers. As a result, the equilibrium wage rate paid to the few high-skilled managers in Hong Kong and Malaysia is many times greater than the wage rate paid to the many low-skilled factory floor workers.

3.

It is indeed the case that people in rich nations are much better off than people in poor nations. Rich nations are better off because their citizens are more productive because they have immensely greater amounts of physical and human capital. The question of redistributing income from one nation to another has a big tradeoff associated with it. In particular, while the transfer of income to poorer nations equalizes income among nations, it lessens the poor nations’ incentives to develop and so slows their economic growth. In addition, the issue of fairness comes into play. The “fair results” approach to fairness argues that it is definitely fair to transfer resources to poor nations. But the “fair rules” approach to fairness suggests that these transfers aren’t fair.

Taking tax revenue from people in rich nations to transfer the funds to poor nations is not a voluntary exchange and so is unfair.

Additional Discussion Questions 1.

What is the difference between poverty and an unequal income distribution? Ask the students to consider each of these measures of economic inequality by asking the following set of questions: How would you define poverty? Get the students to realize that poverty is a relative measure, rather than a positive measure of economic inequality. The minimum quantity of food, clothing, and shelter to a U.S. student is likely to be considered as abundant riches to the average citizen of developing countries.

Does an unequal income distribution imply that poverty exists? Does poverty imply that an unequal income distribution exists? The upper-income people in some developing countries have annual incomes that are less than the monthly income of the typical unskilled laborer living in the U.S. Because poverty is a relative measure, there is little direct relationship between unequal income distribution and the incidence of poverty. © 2023 Pearson Education, Inc.

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Is it necessarily a bad thing for the Gini Ratio to increase over time? Ask the students what the implications are for a society in which: 1) workers are rewarded based on merit, 2) most workers make good decisions over their lifetime, (invest in human capital, maintain a good work ethic, etc.) some workers make bad decisions (drop out of school, waste their life on drugs, crime, etc.), and 3) those that make good decisions in life become more productive and earn higher wages than those that make bad decisions in life. Point out that even in a “perfect world” where race or gender discrimination was completely absent, and no “bad luck” situations were to ever affect anyone, the Gini Ratio would still increase over time as this merit-based economy continues to reward those who make good decisions more highly than those who make bad decisions. This implies that an increasing Gini Ratio is not necessarily a bad indicator for those concerned about equity as well as efficiency.

2. If you were a benevolent dictator, how would you deal with the Big Tradeoff? Ask the students to choose a degree of economic inequality they think should be the maximum that our society must endure (in terms of lost efficiency). Have them justify this level of economic inequality by using the economic concepts of marginal benefit and marginal costs: How would you measure the marginal cost to society of an unequal income distribution? Point out that before we embark on a program to rectify the problem of economic inequality, we first must assess the degree of the problem: How should we measure the social cost of unequal economic opportunities? Many economic studies have attempted to do this, but without much success in gaining wide acceptance of the methodology.

How would you measure the marginal cost to society of implementing an income redistribution program? Once we are comfortable with our measure of the social cost of economic inequality, we turn to the alternative: What amount of prosperity would we all be willing to give up as a society to increase economic equality in our society (how much smaller would we want the economic pie to be)? More importantly, what cost would we be willing to impose on others in society to rectify economic inequality? How should this decision be made? Help the students to see how complex the issue of economic inequality really is in the world. There are no simple solutions.

3.

If two different but equally “important” occupations in society were to earn very different levels of income, is this necessarily reflective of discrimination? Remind students that while it is true that firms’ demand for labor is partially derived from society’s demand for the product generated from the occupation’s labor force, the wages that firms pay for that labor is also determined by the households’ willingness to supply labor to that occupation. Much of the observed differences in wages across equally “important” occupations can be attributed to the relative unwillingness of households to supply as much labor for the higher paid occupation as for the lower paid occupation. This is a different reality than assuming that firms’ are largely unwilling to pay a wage equal to the value of the true VMP of labor to a certain class of laborers that tend to dominate the lower paid occupations.

4.

Are prizes on shows like American Idol unfair? Discuss whether the unevenness in the rewards for shows induces more effort or are unfair.

5. Are there fewer women CEOs and do women CEOs make lower wages because they are not giving enough to their careers as they try to maintain family responsibilities? Recently the CFO of Facebook wrote a book that garnered a lot of press and sparked conversation about what women need to be giving to the labor market to succeed. Supportive and critical opinion pieces on this topic are widely available and might spark a good classroom conversation.

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UNCERTAINTY AND INFORMATION

The Big Picture Where we have been: Chapter 20 uses the general economic reasoning featured in many of the previous chapters. For instance, Chapter 20 uses the concepts of marginal utility first covered in Chapter 8. It concludes with a general discussion of efficiency in information markets, which draws upon material first covered in Chapter 2 and expanded upon in Chapter 5.

Where we are going: Chapter 20 is the final chapter in the microeconomics section. This chapter is important because it relaxes many of the implicit assumptions concerning information that bother students about the efficiency of the market. Chapter 20 provides some interesting, real-life examples of market processes in an uncertain world.

New in the Fourteenth Edition The chapter has been lightly revised to help enhance students’ understanding. The ending Economics in the News case on grade inflation has been updated.

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Lecture Notes

Uncertainty and Information    

I.

People need to make decisions in the face of uncertainty and risk.

Markets allow people to buy and sell risk.

Some people may have private information.

Markets must cope with incomplete information, which can lead to moral hazard and adverse selection.

Decisions in the Face of Uncertainty

Expected wealth  

Expected wealth is the money value of what a person expects to own at a given point in time.

An expectation is an average calculated by using a formula that weights each possible outcome with a probability (chance) that it will occur.

Risk aversion 

Risk aversion is the dislike of risk. Most people are risk averse.

Utility of Wealth 

Wealth yields utility, but the marginal utility of wealth diminishes as wealth increases, as shown in the figure. Because the slope of the utility of wealth curve diminishes as wealth increases, the utility gained from a $1 increase in wealth is less than the utility lost from a $1 decrease in wealth.

Expected utility 

This is the utility value of what a person expects to own at a given point in time. It is calculated by using a formula that weights each possible outcome with the probability that it will occur.  In the figure, suppose a person is faced with two investments: One offers wealth of $26,000 with no uncertainty and so has utility of 40 units with no uncertainty. The other option has, with a 0.50 probability, wealth equal to $40,000 and utility of 50 units; or, with another 0.50 probability, it has wealth of $20,000 and utility of 30 units.

Expected utility from this second option is 0.50  50 units + 0.50  30 units = 40 units. If given the choice between $26,000 with certainty and a 50:50 chance of having $40,000 or $20,000, the person is indifferent between the two choices because both have the same (expected) utility, 40 units.  The expected wealth from the second option is 0.50  $40,000 + 0.50  $20,000 = $30,000, which is $4,000 more than the certain wealth of $26,000 from the first option. The $4,000 difference is called the cost of risk.

Making a Choice with Uncertainty  

Faced with uncertainty, people choose the option with the highest expected utility.

By comparing the expected utility from a risky prospect with the expected utility from a safe prospect, you can choose the one that maximizes expected utility.

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II. Buying and Selling Risk Both buyers and sellers gain from exchanging risk as they would any product. What they are trading is avoiding risk. A buyer of risk avoidance is transferring the risk to the seller. The seller is willing to assume the risk because the costs of risk are lower to the seller than what the buyer is willing to pay.

Insurance Markets   

How insurance reduces risk: People pool and share risk. When people buy insurance against the risk of an unwanted event, they pay an insurance company a premium. If the unwanted event occurs, the insurance company pays out the amount to the insured.

Why people buy insurance: People buy insurance because they are risk averse. If premiums are not too high, loss of utility from paying the premium for the insurance is less than the expected utility loss if the adverse event were to occur.

How insurance companies earn a profit:  Everyone pays into the insurance pool, but only the small fraction of people who actually suffer a loss are paid from these funds.  Although the probability of any particular individual suffering a loss is quite small, for a large number of people the total number and the total amount of losses can be estimated very accurately.  Insurance companies earn a profit because the insurance company can collect a premium that is high enough to at least break even, and customers who are risk averse are willing to pay that premium.

A Graphical Analysis of Insurance 

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

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Risk Taking Without Insurance: In the figure, suppose the person has a 50 percent chance of keeping $40,000 of wealth and a 50 percent chance of having $20,000 of wealth. As seen before, the expected wealth is $30,000 and the expected utility is 40. The figure shows that the person is willing to accept a lower wealth with certainty, $26,000, which will give the same utility, 40, as the risky case.

The Value and Cost of Insurance: The key point is that the certain wealth with utility of 40 ($26,000) is less than the expected wealth with utility of 40 ($30,000). As long as the person can buy insurance for less than $14,000, the individual is better off (has higher expected utility) from the purchase of insurance than from the uncertainty of wealth with no insurance.

Ignoring any operating costs, if there are many people in the same situation the insurance will cost the insurance company $10,000 per person, the expected loss per person. As long as the company can sell the insurance for more than $10,000, the insurance company is better off by selling the insurance.

Gains from Trade: Both the insurance company and the person will be better off if insurance can be bought and sold for between $14,000 and $10,000.

Why are men (especially young men) charged more for auto insurance? Have the students consider the difficulty of providing insurance with affordable premiums to consumers, yet be profitable enough to encourage producers to accept the risks involved. For example, car insurance companies charge higher premiums to unmarried young men than they charge unmarried young women, even if two such individuals have the same driving records. This difference is based on statistical probabilities calculated by the insurance company keeping record of large samples of loss claims. Ask the students if this difference is “fair?” Then ask how a drivers’ risk-taking behavior might change

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once he or she is insured. This last question is a good introduction to the following material on private information and moral hazard.

Risk That Can’t Be Insured  

If risks are not independent, they cannot be insured (e.g., private markets will not insure homeowners in a flood plain because the occurrence of a flood negatively affects everyone in that area).

Risks must be observable to both the buyer and the seller in order to be insurable.

Economics in Action considers insurance in the United States, both private and public such as Medicare, Social Security, and unemployment insurance.

III. Private Information Asymmetric Information: Examples and Problems 



Private information is information about the value of the item being traded that is possessed by only buyers or sellers. A market in which buyers or sellers have private information has asymmetric information.

Asymmetric information creates two problems:  Adverse selection is the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.  Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less-informed party.

The Market for Used Cars    

The owner of a used car has private information about the quality of the car. If the buyer cannot determine the quality of the car before the purchase, moral hazard occurs when the seller claims that each car is high quality but in truth offers “lemons” for sale.

Because consumers are unable to distinguish between a “lemon” and a good vehicle, they must assume that all used vehicles for sale are “lemons,” and used car dealers must price their cars at the highest price that consumers will pay for a “lemon.”

The problem that in markets in which it is not possible to distinguish reliable products from lemons, there are too many lemons and too few reliable products traded is called the lemons problem.

However, used car dealers can overcome the lemon problem by offering a warranty on the vehicle, which is a signal that the car is of high quality. Signaling occurs when an informed person takes actions that send information to uninformed persons.  An equilibrium in a market when only one message is available and an uninformed person cannot determine quality (as with the market for lemons) is called a pooling equilibrium.  An equilibrium when signaling provides full information to a previously uninformed person (as in the used car market with warranties) is called a separating equilibrium.

The Market for Loans 

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Some borrowers are low risk, and will likely repay their loans, and others are high risk, and will likely default on their loans. The risk that a borrower might not repay a loan is called credit risk or default risk. Banks want to charge low-risk borrowers a low interest rate and high-risk borrowers a high interest rate, but banks cannot immediately distinguish between the two classes of borrowers.

If banks cannot charge different interest rates to different individuals with varying default risks, the result is an inefficient pooling equilibrium.  Banks use signals, such as length of time on the job, marital status, age, and other factors correlated with low-risk borrowers to try to determine the risk of loaning funds to each individual borrower. Borrowers may have an incentive to mislead lenders, so banks often require that borrowers provide relevant © 2023 Pearson Education, Inc.

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information about the likelihood the loan will be repaid (salary, wealth, tenure on the job, for example).

Inducing an informed party to reveal private information is called screening.

An Economics in Action examines the sub-prime credit crisis. Prior to the crisis the supply of funds to the sub-prime market was much greater than during the crisis.

The Market for Insurance 

Moral hazard occurs when insured people have less incentive to be careful and avoid risky behavior. And adverse selection arises because people who create greater risks are more likely to buy insurance.  Insurance companies seek out signals (such as an auto insurer looking at an individual’s driving record) to limit the extent of the adverse selection problem.  Deductibles, where the insured person also must pay part of the expense of an incident, can reduce the moral hazard problem.

Moral hazard in game shows. The television show, “Who Wants to Be a Millionaire?” was insured by an insurance company that reimbursed the producers of the show when a contestant answered all the questions correctly and won a big dollar pay-out. This insurer had some serious disagreements with the show’s producers after the show ran on national television for the first year, claiming concerns over moral hazard. In particular, the insurer claimed that the producer eased the questions asked of the contestants in order to guarantee that some contestants won and thereby boosted the show’s excitement and ratings. The insurer wanted greater control over the difficulty of the questions being asked of the contestants.

IV. Uncertainty, Information and the Invisible Hand Information as a Good 



Obtaining more information has increasing opportunity costs and consuming more information has decreasing marginal benefits.

The efficient amount of information is the amount at which the marginal benefit from information equals the marginal cost. It is hard to determine whether a competitive market for information would produce it at the efficient level.

Monopoly in Markets that Cope with Uncertainty  

Large economies of scale probably exist is providing services to reduce uncertainty and to provide better information. Therefore insurance markets are highly concentrated.

Monopoly leads to inefficient results, even in the absence of uncertainty, so underproduction of information is thus likely.

Economics in the News considers the case of grade inflation. Grade inflation makes it more difficult for employers to determine who is outstanding and who is not.

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Additional Problem 1.

2.

3.

How might adverse selection discourage firms from underpaying their workers?

How might moral hazard discourage firms from offering workers a fixed wage?

Baseball players often seek contracts with a “no-trade” clause so that the player cannot be traded from his current team without his permission. a. Provide an example of private information that a baseball player who wants a no-trade clause possesses. b. Does a baseball player with a no-trade clause present a moral hazard to his baseball team? c. Does a baseball player with a no-trade clause present adverse selection problems to his baseball team?

4.

How does health insurance and flood insurance result in both a moral hazard and adverse selection problem?

How do insurance companies use premiums and deductibles in an attempt to resolve these problems?

5.

Solutions to Additional Problems 1.

If a firm gets the reputation for underpaying its workers, only low quality workers will apply to work at the firm, thereby presenting the firm with a severe adverse selection problem.

2.

If firms offer workers a fixed wage regardless of their effort workers have the incentive to shirk, that is, to work less hard than otherwise.

3.

a. b.

c.

A player could know that he was injured or that he had not healed as well as possible from an injury.

A player with a no-trade clause presents a moral hazard problem. The player can claim to be more badly injured than is truly the case to avoid playing some games. The player can make this claim knowing that even if he often does so, his team cannot trade him and must continue to pay his salary.

If there are two types of contracts—contracts with the no-trade clause and contracts without it—then there is a potential adverse selection problem. Players who know they are more inclined to want to skip a game or two will be eager to sign a no-trade contract because this contract lessens their cost of feigning injury to take leisure.

4.

Health and flood insurance both present moral hazard and adverse selection problems. Adverse selection is present because less healthy people will be more likely to buy health insurance and people living in flood prone areas will be more likely to buy flood insurance. Moral hazard is present because people with health insurance become more prone to take risks and people with flood insurance become less prone to build flood resistant structures.

5.

Insurance companies use premiums and deductibles in an effort to create a separating equilibrium. The companies offer policies with high deductibles and low premiums to attract low-risk customers, that is people who are not likely to be susceptible to diseases or people who have not built in a flood plain. Simultaneously the companies also offer policies with high premiums and low deductibles to appeal to high-risk customers, that is people who are prone to contracting certain ailments or who have built in a flood plain.

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Additional Discussion Questions 11. What does being risk averse mean? Get the students to consider why a risk premium must be paid to overcome the consumer’s cost of risk.

12. Why do people prefer the utility arising from a level of income known with certainty more than the utility arising from the same value of expected income arising from a risky choice? Get the students to understand that the consumer will never achieve the expected level of income arising from a risky decision when confronted with a single choice. Expected income is the value of income that is averaged over numerous outcomes under the same circumstances. For any one point in time, knowing utility from a given outcome is preferred to the expected utility of a risky outcome, despite the two having the same expected level of income.

13. Would insurance companies prefer a higher or lower degree of risk aversion among consumers? Point out to students that the more concave the utility of wealth schedule, the higher the cost of risk, and the greater the risk premium that the consumer is willing to pay to avoid risk.

14. Why will private insurance companies sell health insurance that pays for unexpected illness but not unemployment insurance that pays for unexpected unemployment? Explain that adverse selection motivates high risk workers who know they are likely to be laid off will be willing to pay a high risk premium for unemployment insurance, but low risk workers who know they are unlikely to be laid off will only pay a low risk premium. By offering insurance premiums that are desirable to the low risk workers, high risk workers will buy the insurance as well, preventing the insurance companies from knowing which workers are high risk and which are low risk. This burden on insurance carriers is not as evident in offering health insurance because the insurers can seek out signals from consumers which reveal who has low-risk lifestyle and who have a high-risk lifestyle (such as determining whether the potential health insurance customer is a smoker, or is older, or is overweight, etc.)

15. What are some examples of goods that require “information” for consumers to enjoy and goods that require “private information”? All goods require consumers to have access to price and availability information. However, private information relates to goods that consumers cannot completely understand until they commit to purchasing the good. Goods in this category include used cars, long-wearing and comfortable shoes, high-end consumer electronics, good homes in pleasant neighborhoods, etc. Markets for these goods typically create opportunities for middlemen (like realtors, retailers and car dealers) to supply advice and match consumer tastes with producer goods.

16. Is the use of signals to discern between high and low risk consumers “fair”? Ask the students whether charging 17-year-old, unmarried males higher auto insurance premiums than 35-year-old, unmarried females “fair”? Is it “fair” for individuals with pre-existing health conditions to pay higher insurance bills? Is it “fair” for employers to pay women less because women are (obviously) more likely to give birth? On the other hand, is the use of signals “efficient”? Get the students to consider the tradeoff between pooling risk (making avoiding risk affordable) and avoiding moral hazard (making careful, thoughtful consumers pay for the mistakes of careless, thoughtless consumers).

7.

Health care reform uses “pools” of individuals to help to reduce health care costs for those currently without insurance. How is this intended to help and why was it designed so people could not “opt out” of having insurance? The larger the pool, the more risk is spread out. If younger, healthier workers less likely to have claims can avoid participation, the expected outlays for the insurance company are spread across a smaller pool, risk rises for the insurance company, and customers have to pay higher premiums.

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