ap microeconomics: master notes unit 1: fundamentals of ... · ap microeconomics: master notes unit...
TRANSCRIPT
AP Microeconomics: Master Notes UNIT 1: FUNDAMENTALS OF ECONOMIS
Key Terms
Economics: The study of how limited resources are
allocated.
Microeconomics: Study of how individuals (firms or
households) make choices and are influenced by economic
forces.
Macroeconomics: Looks at the economy as a whole,
focusing on issues such as growth, unemployment,
inflation, and business cycles.
Scarcity: material wants are unlimited and economic
resources are limited or scarce.
Factors of Production o Land: Any productive resource existing in nature, Ex.
water, wind, mineral deposits.
o Labor: Physical and mental effort of people. Ex. Teacher
o Capital: Manufactured goods that can be used in the
production process Ex. tools, buildings, machinery
Human Capital: Knowledge and skills acquired
through training and experience Ex. College or
Technical School. o Entrepreneurship: Ability to identify opportunities and
organize production, risk taker. Ex. Elon Musk
Economic Reasoning
Given limited resources (SCARCITY), there are
opportunity costs for every choice
Trade-offs- All the possible options given up when you
make a choice
The opportunity cost of an action is the benefit missed by
not choosing the next-best alternative. An action should be
chosen only if the expected benefit is greater than the
opportunity cost.
Implicit Cost: Forgone benefits of any single transactions.
Ex. time and effort an owner puts into maintaining a
company, rather than expanding it.
Explicit Cost: Expenses that are paid with cash or
equivalent. Ex. Wages to workers, electricity bill
Individuals attempt to maximize utility by allocating and
spending their resources according to their preferences.
Individual consumption and production options are
expanded through the market, where goods and services
are exchanged for mutual benefit.
Economic Systems
All economic systems must answer three basic economic
questions
o What goods and services to produce?
o How to produce those goods and services?
o Who consumes those goods and services?
Types of Economic Systems
o Command
Minimize imbalance in wealth via the collective
ownership of property
Lacks incentives for extra effort, risk taking, and
innovation
Wages determined by the gov. Particularly vulnerable to corruption as the gov. plays
the central role in allocating resources; only one
political party
Economic goal emphasized: Price stability, equity, full
employment, security
Economic goal deemphasized: Efficiency, freedom,
growth of consumer goods/services
o Market
Pursuit of individual profit
Private individuals control the factors of production
Wages determined by negotiations between trade unions
and managers
Market forces of supply and demand determine the allocation of resources
Gov. can regulate business and provide tax-supported
social benefits
Economic goal emphasized: Efficiency, freedom, price
stability, growth
Economic goal deemphasized: Equity, security, full-
employment
o Mixed- Both market and command together, reality
Production Possibilities Model (Curve)
Identify the Points on the PPC
o The A, B, and C represents: Attainable and efficient with
these resources Allocative vs. Productive Efficiency
Productive Efficiency: Products are being produced
in the least costly way (any point on the curve)
Allocative Efficiency: The products being produces
are the ones most desired by society. (optimal point
depends on the desire of society)
o The X represents: Inefficiency
o The Y represents: Not Attainable/Unattainable with these
resources
o Movement from A to B is an increase or decrease in
consumer demand.
Production Possibilities Model (Curve)
Reasons for Economic Growth/Contraction
o Technology (Quality of Resources)
o Land (Quantity of Resources)
o Population (Quantity of Resources)
o Education (Quality of Resources)
Production Possibilities Model: Economic Growth
Other Shifts: Contraction to just Butter
Increasing Opportunity Cost
Why does the graph curve? Resources are not easily
adaptable between products- GUNS VS BUTTER)
Explain opportunity cost of curve: The opportunity cost of
the 4th Butter is small (1 Gun), as we go to the 6th, 7th or 8th butter, the opportunity of Guns will go up (2 Guns).
Increasing Opportunity Cost Graph
Constant Opportunity Cost
o Why does the graphs curve remain straight? Resources are easily adapted between products (PIZZA VS
CALZONE)
o Explain opportunity cost of the curve: As more calzones
are made, resources that are easily adapted to produce
either good are moved away from pizza and toward
calzones. Opportunity cost for each calzone is constant at
2 bicycles.
Constant Opportunity Cost Graph
Trade (Absolute and Comparative Advantage)
Absolute advantage describes a situation in which an
individual, business, or country can produce more of a
good or service than any other producer with the same
quantity of resources.
o Just because a country has an absolute advantage, it
doesn’t mean that the country necessarily benefits the
most from producing that good.
Comparative advantage describes a situation in which an individual, business, or country can produce a good or
service at a lower opportunity cost than another producer.
o Countries will benefit from specialization if one country
has a comparative advantage in one good, and the other
country has a comparative advantage in the other good.
Example
o Which nation has the absolute advantage in producing
corn? Dallas
o Which nation has the absolute advantage in kiwi? Dallas o Which nation has the comparative advantage in corn?
Dallas
o Which nation has the comparative advantage in kiwi?
Montezuma
o Should Dallas specialize in corn or kiwi? Corn
o Should Montezuma specialize in corn or kiwi? Kiwi
UNIT 2: SUPPLY, DEMAND AND CONSUMER CHOICE
Demand (CONSUMERS, BUYERS, INDIVIDUALS)
Law of Demand: if Price goes ↑, the Quantity goes↓, or if
Price goes ↓, the Quantity goes ↑
Reasons for Law of Demand (DOWNWARD SLOPING
CURVE) o Substitution Effect: At a higher price, consumers are
willing to and able to look for substitute (COKE or
PEPSI). The substitution effect suggest that at a lower
price, consumers have the incentive to substitute the
cheaper good for the more expensive service.
o Income Effect: A decline in the price of a good will give
more purchasing power to the consumer and he/she can
buy more now with the same amount of income.
o Law of Diminishing Marginal Utility: This law states
that as we consume additional units of something, the
satisfaction (utility) we derive from each additional unit (marginal unit) grows smaller (diminishes)
Changes in Quantity (MOVING ALONG THE
CURVE)
o What changes quantity demanded: A change in the price
of the good/service
Changes in Demand (SHIFTING THE CURVE)
o What shifts the demand curve?
o Change in income:
Normal goods: an increase in income leads to a
rightward shift in the demand curve
Income goes ↑, Demand goes ↑
Income goes ↓, Demand goes ↓
Inferior goods: an increase in income leads to a
leftward shift since these are usually low-quality items
people will avoid when the have more to spend
Income goes ↑, Demand goes ↓
Income goes ↓, Demand goes ↑
o Change in taste/preferences
o Change in price of complementary goods: the linkage of
products’ demand because the work with each other can
affect demand for each (Milk and cookies)
Price of A ↑ Demand for B goes ↑
Price of A ↓ Demand for B goes ↓ o Change in price of substitutes: When the prices of or
preference for a substitute changes, demand for both
products will change.
Price of A ↑ Demand for B goes ↓
Price of A ↓ Demand for B goes ↑
o Change in number of buyers
o Change in price expectation of buyers
Supply (SELLERS, FIRMS, PRODUCERS)
The Law of Supply: If price goes ↑, the quantity produced
goes ↑ or if the price goes ↓, the quantity produced goes ↓
Reasons for Law of Supply (UPWARD SLOPING
CURVE)
o Opportunity cost: At a higher prices, profit seeking
firms have an incentive to produce more.
o Law of Diminishing Marginal Returns: Since the
additional cost of each unit will eventually increase, the
firm must increase the price to increase quantity supplied
Changes in Supply (SHIFTING THE CURVE)
o What shifts the supply curve?
o Price/Availability of inputs (resources)
o Number of sellers
o Technology
o Government Action: taxes and subsidies o Change price expectation
o Expectations of future profit
Equilibrium
Market Equilibrium: A market is in equilibrium when the
price and quantity are at a level at which supply equals
demand. The quantity that consumers demand is exactly
equal to the quantity that producers supply.
o Equation for Equilibrium: Qd = Qs
Market Disequilibrium: Quantity demanded doesn’t equal
quantity supplied. Creates shortages and surpluses
o Shortage: The price is below equilibrium, the amount demanded will be greater than the amount supplied
Equation for Shortage: Qd > Qs o Surplus: The price is above equilibrium, the amount
demanded will be less than the amount supplied
Equation for Surplus: Qd < Qs
Double Shift in Supply and Demand
Double shift rule: If two curves shift at the same time, either
price or quantity will be indeterminate.
Example below: Demand and supply are increasing, so Price
is INDETERMINATE and Quantity has INCREASED
Double Shifts in Supply and Demand Curve
Elasticity
Elasticity: Is the responsiveness of consumer to a change in the price of a product.
Equations for elasticity:
Be sure to use absolute values and ignore the --------sign;
useful for comparing different products.
Interpreting elasticity
o Inelastic Demand
Elasticity coefficient less than 1
Few substitutes and necessities
Example: Cancer medication
o Elastic Demand
Elastic coefficient greater than 1
Luxury goods and many substitutes
Example: Coke
Inelastic Demand Elastic Demand
Elasticity of Demand Coefficients
o Perfect Inelastic= 0
o Relatively Inelastic= Less than 1
o Unit Elastic = 1
o Relatively Elastic= Greater than 1
o Perfectly Elastic = Undefined
Elasticity Varies with Price Range: o More elastic toward to left, less elastic at lower right.
o Slope does not measure elasticity—Slope measures
absolute changes; elasticity measures relative changes
Elasticity Varies with Price Range
Types of Elasticity
o Cross-Price Elasticity: Measures responsiveness of sales
to changes in price of another good
Substitute= Positive sign
Complement= Negative sign
Independent Goods=zero
Equation below
o Income Elasticity: Measures responsiveness of buyer to
changes in income
Normal Good= positive sign
Inferior Goods= negative sign
Equation below
o Elasticity of Supply: Measures seller’s responsiveness to
changes
Es > 1 Supply is elastic- Producers are responsive to
price change
Es < 1 Supply is inelastic- Producers are not responsive
to price change
Equation below
Total Revenue and the Price Elasticity of Demand
o Total Revenue: Is the amount paid by buyers and
received by sellers of a good.
o Equation: TR=P x Q
o Total Revenue Test
Elastic Demand (EXAMPLE- Coke/Pepsi)
Price increase causes TR to decrease
Price decrease causes TR to increase
Inelastic Demand (EXAMPLE- CANCER DRUGS)
Price increase causes TR to increase
Price decrease causes TR to decrease
Unit Elastic
Price changes and TR remains unchanged
Elastic Demand and Total Revenue Graphs
Inelastic Demand and Total Revenue Graphs
Consumer and Producer Surplus at Market Equilibrium
Consumer Surplus: Difference between the price a buyer
would have been ready to pay for a good or service
(willingness) and the price that he/she actually pays
(market price)
o Equation for Consumer Surplus: ½ Quantity x Price
Producer Surplus: Difference between the price that a
seller actually receives (market price) and the price at
which he/she would have been ready to supply the good or
service (willingness)
o Equation for Producer Surplus: ½ Quantity x Price
Total Surplus (SOCIAL WELFARE): The sum of the
total consumer surplus and the total producer surplus.
o Equation for Total Surplus: ½ Quantity x Price
CS and PS allows us to access the soundness of economic
policies
Consumer and Producer Surplus Graph (EFFICENT)
Calculate using Consumer and Producer Surplus Graph
o Consumer Surplus =$1,250
o Producer surplus=$1,250
o Total Surplus (Social Welfare)=$2,500
Government Effects on Market (DISEQUILIBRIUM AND
INEFFICENTCY)
Government Price Floors:
o Effective Price Floors, the price is above the equilibrium
price
o Example: Minimum wage
o Leads to a surplus, because Qs > Qd
o Non-effective price floors, the price is below the
equilibrium price
Government Price Ceilings:
o Effective price ceilings, the price is below equilibrium price
o Example: Rent Control Housing
o Provide lower costs for consumers
o Leads to a shortage in the market because, Qd > Qs
o Can also result in illegal black market activity- selling
goods for a higher price
Price Floor/Surplus Graph
Price Ceiling/Shortage Graph
Government Taxes
o Indirect Tax: Is one place by the government on the
producers of a particular good
o Excise Tax: Tax on producers, but the goal is for them to
make less of the good (Cigarette, alcohol tax)
o For every unit made, the producer must pay
o Consumers will pay the tax indirectly through producers
o An indirect tax will be shared by both consumers and
producers.
o Creates disequilibrium and inefficiency in the market, the
result is dead weight loss o Dead weight loss: Represents the loss of former consumer
and producer surplus in excess of the total revenue of the
tax. Transactions that would have taken place in the
market if there was not tax.
o Tax Incidence: The distribution of the tax burden (WHO
ACTUALLY PAYS THE TAX)
o Tax Incident (WHO PAYS)
If demand is perfectly inelastic: Tax burden paid entirely
by consumers
If demand is relatively inelastic: Tax burden mostly on
consumers If demand is unit elastic: Tax burden shared between
consumer and producer
If demand is relatively elastic: Tax burden mostly on
producers
If demand is perfectly elastic: Tax burden paid entirely
by producer.
Tax (EXCISE or INDIRECT) Graph
Calculate using Tax Graph
o Before Tax
PS before tax: EFG
CS before tax: ABCD
o After Tax
Tax per unit: $4 per unit tax (vertical distance between
two supply curves)
PS after tax: G
CS after tax: A
Dead weight loss: DF Total tax revenue to gov’t: BCE
Total spending by buyers: BCEGH
Total revenue to sellers: GH
Amount of tax buyers pay: BC
Amount of tax sellers pay: E
International Trade
o World Trade Price:
If the world price of good is lower than the domestic
price, the country will import the good.
If the world price of a good is higher than the domestic
price the country will import the good. o Subsidy: tax on imports
o Quota: a limit on import
International Trade Graph
Identify using International Trade Graph
o Consumer Surplus with no trade: P
o Producers Surplus with no trade: IDA
o Amount we import and world price(Pw): KLMN or Q5-
Q1
o Producers Surplus if we trade at world price (Pw): I o Consumer Surplus if we trade at world price (Pw):
PABCDEFGH
o If government tariff leads to a world price of Pt, how
much is imported and what is the Consumer Surplus and
Producers Surplus: LM or Q4-Q2, PS is I, PC is PABC
o If government tariff leads to world price of Pt, what is the
deadweight loss and tariff revenue? DW is EH, TR is FG
Utility Maximization and Consumer Behavior
Total Utility (TU): This is the total happiness a consumer
at a particular level of consumption. Total utility will
generally increase as total consumption of a particular good increases, until the consumer has “had too much” of a good,
when total utility will begin to decline.
Marginal Utility (MU): This is the increase in total utility
resulting from the consumption of each additional unit of a
good.
Equation for Marginal Utility (MU): MU=ΔTU/ΔQ
Reasoning: Since MU measures the change in TU, as long
as MU is positive at a particular level of output, TU will be
increasing. But if MU becomes negative, TU will decrease.
Law of Diminishing Marginal Utility: The greater the
levels of consumption of a particular good, the les utility consumers derive from each additional unit of the good.
Point of Satiety: The point where marginal utility of a good
is zero.
Total Utility and Marginal Utility Graph
Graph Explained:
o Point A: A total utility increases, marginal utility
increases.
o Point B: Point of satiety, total utility is maximized and
marginal utility is zero.
o Point C: Consumer Dissatisfaction, total utility starts to diminish and marginal utility becomes negative.
Maximizing Utility Rule: To maximize your total utility,
you should instead consume the combination of good that
maximizes your marginal utility per dollar spent, so that:
Equation: MUgood A/PgoodA=MugoodB/PgoodB
Calculate Maximizing Utility
o Assume the following You have a budget of $20 that you wish to spend
entirely on Good A and Good B.
The price of Good A is $5 and the price of Good B is
$2.
o Calculate the following
If you have $20, what combination maximizes your
utility? 2 of Good A and 3 of Good B
o Reasoning (USING THE GRAPH)
You should first buy 1st of Good B because MU/P is
2.5, you have $18 remaining.
You should then buy 2nd of Good B because MU/P is 2, you have $16 remaining.
You should then buy 1st of Good A because MU/P is 2,
you have $11 remaining
You should then buy 2nd of Good A because MU/P is
1.6, you have $6 remaining.
You should then buy 3rd of Good B because MU/P is
1.5.
NOW based on utility maximizing rule, you should buy
2 widgets and 3 robots or where MUgood
A/PgoodA=MugoodB/PgoodB
Quantity TU
(Good A)
MU
(Good A)
MU/P
(Good A)
1 10 10 2
2 18 8 1.6
3 24 6 1.2
4 28 4 .8
5 30 2 .4
Quantity TU
(Good B)
MU
(Good B)
MU/P
(Good B)
1 5 5 2.5
2 9 4 2
3 12 3 1.5
4 14 2 1
5 15 1 0.5
UNIT 3: COST CURVES AND PERFECT
COMPETITION
Cost of Production
Profit Maximization: The goal of most firms is to maximize their profits. To do so, they must produce at a
level of output at which the difference between their
revenue and their costs is maximized
Total Revenue: The amount a firm receives for the sale of
its output or Price x Quantity
Total Cost: The market value of the inputs a firm uses in
production
Economic Profit = Total Revenue (TR) – Total Cost (TC)
Economic Cost or Cost of Production: Payments a firm
must make, or income it must pay to resources suppliers to
attract those resources from alternative uses. This would
mean all the opportunity costs.
Economic Profit vs Accounting Profit
Explicit Costs: Payment to outsiders for labor, materials, service, fuel
Implicit Costs: Cost of self-owned, self-employed
resources. The opportunity cost that firms “pay” for using
their own resources.
Accounting Profit Equation: Total Revenue – Accounting
Cost (EXPLICIT ONLY)
Economic Profit Equation: Total Revenue- Economic
Costs (Explicit + Implicit)
Accounting profit must be larger than economic profit
because there is always an opportunity cost.
FOR MICROECONOMICS ALL COST WILL BE
ECONOMIC COSTS
Normal Profit: Is zero economic profit. Minimum level of
profit needed just to keep an entrepreneur operating in his
current market. If firms are not covering their costs they
may shut down.
It’s important to understand that if a firm ears zero
economic profit they are still making money.
Short Run v. Long Run Costs of Production
Short Run—Fixed Plant
o Period of time to brief for firms to alter its plant capacity
o Output can be varied by adding larger or smaller amounts of labor, material, and other resources.
o Exiting plant capacity can be used more or less intensively
Long Run----Variable Plant
o Period of time extensive enough to change the quantity of
all resources employed, including plant capacity
o Enough time for existing firms to dissolve and exit the
industry or for new firms to form and enter the industry
Production Function:
The production function shows the relationship between
inputs and outputs in both the short-run and the long-run
Inputs: Resources used to make outputs also called factors
Outputs: Finished product
Marginal Production (MP): The increase in output that
arises from an additional unit of that input (each additional
worker)
o Equation: MP= Change in Total Product/Change in
Inputs
Average Production (AP): Total production/quantity
produced
Diminishing Marginal Returns or (Production): If at least
one input is held fixed, while the other inputs are variable,
output increases at a decreasing rate. Example: PAPER CHAIN EXPERIMENT- Labor is variable, scissors and
staplers are fixed.
Fixed Costs: Costs that do not change with the rate of
productions. Examples: Rents, salaries, insurance
Variable Costs: Costs that change with the rate of
production. Examples: Wages, utilities
Reasoning/Key Concepts for Diminishing Marginal
Returns. o No harvest or production at zero workers
o Production from hiring second worker more than
doubles, because of specialization.
o From worker 0 to 2, is increasing marginal returns, marginal product is rising, total product increasing at an
increasing rate.
o At the third worker or point A on graph below,
diminishing returns starts, look a marginal production.
o At the fourth worker, decreasing marginal returns
because marginal production is falling. Total Production
increasing at a decreasing rate. Fixed resources and
variable resources (worker) add less production
o At the fifth worker or point B on graph below, total
product is maximized when marginal product is zero.
# of Workers Corn Harvested
(Pounds per
Hour)
Marginal Production
Average Production
0 0
1 5 5 5
2 15 10 7.5
3 20 5 6.6
4 22 2 5.5
5 22 0 4.4
6 18 -4 3
Total Product vs Marginal Product Graphs
Cost of Production
Marginal Cost (MC): The additional cost from hiring each additional unit of labor. (DOUBLE ADDITIONAL)
o Equation: MC= Change in Total Cost/ Change in
Quantity
Total Cost (TC): Fixed + Variable Cost
Averaged Fixed Cost (AFC): Fixed Cost/Quantity
Average Variable Cost (AVC): Variable Cost/Quantity
Average Total Cost (AVC): AFC+AVC
Shapes of Cost Curves in Short-Run o Marginal Cost: MC typically falls at first but begins
rising due to Diminishing Marginal Returns. MC rises
when MP falls (MIRROR IMAGES)
o Average Fixed Cost: The fixed costs get spread over a
large quantity so they decline throughout o Average Variable Cost: If MC is below AVC, AVC is
falling. As MC goes above AVC, AVC is falling. As MC
goes above AVC, AVC begins rising.
o Average Total Cost: If MC is below ATC, ATC is
falling. As MC goes above ATC, ATC begins rising.
Drawing the Cost Curves in Short-Run
o MC goes through the bottom of both the AVC and ATC.
This is because if the last unit produced cost less than the
average, then the average must be falling, and vice versa
o ATC= AFC =AVC—Vertical distance between ATC and
AVC equals the AFC at each level of production. o Notice that AVC gets closer at ATC as Quantity increases.
This is due to AFC falling as Q increases.
o As quantity produced increases, fixed costs become a
smaller percentage of total cost. This means that the
distance between the ATC and AVC curves will get
smaller as more is produced.
o MC is at the minimum when MP is at its maximum,
because beyond that point diminishing returns sets in and
the firm start getting less money. (LOOK AT
MARGINAL PRODUCTION GRAPH)
o MC>AVC is the firm’s short-run supply curve
o MC> ATC is the firm’s long-run supply curve
Cost Curves Graph
Calculating Cost Curves using the Cost Curve Graph
Below
o Situation: If the firm decides to produce at a quantity of
3, calculate the following cost curves
Total Cost= 3 (Q) x $10 (P) = 30
Variable Cost= 3 (Q) x $8 (P)= 24 Fixed Cost= 3(Q) x $2 (P) = 6, or subtract Total Cost
from Variable Cost.
Calculating Cost Curves Graph
Cost of Production in the Long Run
Firms in the long-run can make all the resource
adjustments they desire. As these changes are made, ATC
changes and set of possible plant sizes produces varying
sets of short-run cost curves. If the number of possible
plant sizes is large, the long-run ATC creates a smooth
curve.
Why does economies of scale occur? Firms that produce more can better use Mass Production Techniques and
Specialization.
Three Ranges of a Firm’s Long-Run Average Total Cost
Curve
o Increasing Returns to Scale (ECONOMIES OF
SCALE): when a firm receives increasing amounts of
output per additional unit of input (land, labor and
capital). Average cost decrease as output increases.
Explanation: Better specialization, division of labor, bulk
buying larger and more efficient machines.
o Constant Returns to Scale: When a firm receives the same amount of output per additional unit of input.
Average costs do not change as output increases.
o Decreasing Returns to Scale (DISECONOMIES OF
SCALE): When a firm becomes “too big for its own
good”. The output per unit of input decreases as more
inputs are added. Average costs increase as output
increases. Explanation: Control and communication
problems, trying to coordinate production across a wide
geographic may make firms less efficient.
Long Run Average Total Cost Curve
Characteristics of Markets
Perfect Competition (Pure)
o Number of firms: Very large number of firms
o Ability to set price: None, Market determines price and
the seller is the price taker
o Product Differentiation: None, Product are identical
o Barriers to Enter Market: Relatively easy to start a new
business.
Monopolistic Competition
o Number of firms: Large number of firms
o Ability to set price: Some. The degree of differentiation
will always affect the ability of the seller to set price
o Product Differentiation: Varies, depending on the industry. Differences may be subtle.
o Barriers to Enter Market: Relatively easy to start a new
business.
Oligopoly
o Number of firms: A few large businesses
o Ability to set price: More. Sellers can act as monopoly
setting price or sellers can act independently and ability to
set price is determined by differentiation.
o Product Differentiation: Varies. Some industries may be
identical; others may be differentiated
o Barriers to Enter Market: Difficult. High start-up costs.
Pure Monopoly
o Number of firms: A single producer
o Ability to set price: Most. Seller is only source of product
and can act like price maker
o Product Differentiation: None. Product is unique.
o Barriers to Enter Market: Very difficult to entry.
Perfect Competition
Individual firms in a perfectly competitive market has no
control over the price of its own output. This is because the
price is determined based on market supply and market
demand.
Reasoning or Key Concepts to Perfect Competition Graphs o The demand seen by the firm is determined by the price
in the market.
o Demand = Marginal Revenue
o Price also determines the firm’s marginal revenue
o The firm has no “price making power” because if it raises
its price, it will sell no output, and if it lowers its price, it
will not be able to cover its costs of production.
o Demand for individual firm’s output is perfectly elastic
o To maximize its profit, a firm should produce where its
marginal revenue equals its marginal cost.
o Total Revenue increases at a constant rate (price)
Perfect Competition Graph
Short-Run Profit Maximization
The firm is facing marginal revenue equal to Pe (Price), determined by the market price at any given time.
The firm’s marginal cost increases steadily due to
diminishing returns (to make more pizza in the short-run,
more cooks need to be hired, but because capital is fixed
the marginal production of cooks decreases as more is
added.
Based on its MC and MR, the firm maximize its profits (or
minimize it losses) by producing at a quantity of 10
Perfect Competition Graph- Profit Maximization
Reasoning or Key Concepts on Profit Maximizing Graph
o If a firm decided to produce at a quantity of 5,
MC is below MR: Your costs are below your revenue,
you should continue to produce
At the price of $5 you will make quantity of 5, but you
could have charged $10 and make a quantity of 10. Total Revenue= $50
o If a firm decided to produce at a quantity of 10,
MC =MR: Profit Maximizing Point, Normal Profit
At the price of $10 you will make a quantity of 10.
Total Revenue = $100
o If a firm decide to produce at a quantity of 15,
MC is above MR: Your costs are above your revenue,
you should decrease production
At the price of $15 you will make a quantity of 15, but
will anybody buy your product (PRICE TAKER)
Short-Run and Long-Run Decisions
If Price > ATC: The firm is profitable and this will attract
other firms to enter the market.
If Price = ATC: The firm will break even and no longer
will firms try to enter the market. (PRICE TAKER)
If Price < ATC: The firm is not profitable and will stay
open in the short-run, but exit in the long-run.
If Price > AVC: The firm should shut down in the short
run.
In the long-run, firms enter a market if there are profit-
making opportunities. They will exit a market when they
anticipate economic losses
Allocative Efficiency for PC- In short run and long run the
PC curve will be allocative Efficient because firms will
produce at Profit Maximization with is MC=P,
Productive Efficiency for PC- In the short run, the PC is
not Productively Efficient because MC does not equal AVC
at its lowest Point. In the long run, MC will equal AVC at
its lowest point so it will be productively efficient.
Perfect Competition: Shut Down Rule (P<AVC)
Reasoning or Key Concepts of Shut Down Rule
o At the profit maximizing point (MC=MR) draw you gold
road connecting to MR, AVC, ATC.
o Shut-down rule says to shut down because P > AVC. o Find the Fixed Cost, Total Cost, and Total Revenue.
Green is Total Fixed Cost=$16 (2x8), Yellow is Variable
Cost = $4 (2x2), Blue is Total Revenue=$12 (2x6)
o But why should the firm shut down?
o The Revenue (Blue) is less than the cost of production
(Green and Yellow)
o So, a firm will lose its fixed cost ($16) no matter what, but
if they produced they will also lose their variable cost
($4).
o It would be better for the firm shut down and pay off its
fixed.
Profit Maximizing in Short Run PC- Profit Earning Firm
Remember: A firm will maximize profits (or minimize its
losses ) by producing at the quantity were MR=MC
To determine whether a firm is actually earning profits,
breaking even, or earning a loss at this quantity, we must
consider both the firm’s average revenue (PRICE) and it Average Total Cost.
So, If and when a firm is producing at its MC=MR, a firm
in a PC market is selling it output for a price greater than
its Average Total Cost, the firm is earning economic profit.
Economic profit means the firm is covering all of its
explicit and implicit cost, and is earning additional revenue
beyond as well
Perfect Competition Graph- PROFIT
Reasoning or Key Concepts on PC Profit Graph
o The market demand is relatively high, presenting firms
with a price that is greater than their ATC. o The firm’s economic profits is the YELLOW BOX
o The firm is maximizing it profits were MC=MR.
o Due to absence of entry barriers, the profits will not be
sustained in the long run, as new firms will enter the
market.
o Drawing Tip: Remember one you are given quantity,
follow the golden road to MR=MC, then continue down
the golden road to find ATC to find Profit
Profit Maximization in the Short-Run: The Loss-
minimizing firm
If, the firm is producing at its MC=MR point, a firm in a PC market is selling at a price that is lower than its
Average Total Cost, the firm will be minimizing it losses,
but earning economic profit at all.
The loss-minimizing firm will either exit the industry in the
long run, or hope other firms exit until the supply
decreases, causing price to rise once again.
Perfect Competition Graph- LOSS
Reasoning or Key Concepts on PC Loss Graph
o The market demand is relatively low, so the price point the
firm can sell its output for is below its average total cost. o The firm’s economic losses are the BLUE BOX
o The firm is minimizing its losses by producing at MR=MC
o Due to the absence of entry barriers, these losses will be
eliminated in the long run as firms exit the industry to
avoid further losses.
o Drawing Tip: Remember once you are given quantity
follow the golden road to MR=MC, then continue up the
golden road to ATC to find loss.
Profit Maximization in the Short-Run/Lon-Run: The
Breaking-Even Firm
If, when a firm is producing a MC=MR level of output, the price the firm can sell its output for its exactly equal to the
firm’s minimum average total cost, then the best the firm
can hope to do is break even.
Breaking even means the firm is covering all of its explicit
and implicit costs, but earning no additional profit
The firm is earning a NORMAL PROFIT
The long-run PC curve is break-even or normal profit
because the firm is a Price Taker.
In the long-run, a perfectly competitive firm will always
break even.
Perfect Competition Graph- Breaking Even
Reasoning or Key Concepts on PC Break Even Graph
o The market demand and supply have set a price equal to
the firm’s minimum average total cost.
o The firm is just covering all its costs, meaning its earning
zero economic profits, but no losses.
o If the firm produced at any quantity other than Qf, it would earn economic losses. By producing at Qf, it is
breaking even.
o There is no incentive for firms to enter or exit this
market.
o Drawing Tip: Remember one you are given quantity,
follow the golden road to MR=MC, then ATC should be
connect to the golden road.
Profit Maximizing Short Run to Long Run- Perfect
Competition or CONSTANT-CONSANT INDUSTRY
Short Run to Long Run- Demand Shift Example, demand
could shift the other way
Constant Cost Industry: Number of firms in the industry
don’t affect production cost- in these examples notice there
is no change in costs.
In the short run (PC Short Run Graph Below)
o Supply has shifted to the left or decrease in supply.
o Price has increased due to the shift in supply.
o The firm is now receiving a profit.
As a result of the short run profit, what will happen in the
long run? (PC Long Run Graph Below)
o Demand will shift to the left or decrease
o Price will decrease due to the shift in demand.
o The firm will start to loss profit and firms will exit the market. (BACK TO BREAK EVEN or LONG RUN)
Perfectly Competitive Short Run Profit
Now, Perfectly Competitive Firm BACK to Long Run
Short Run to Long Run- Supply Shift Example, supply
could shift the other way.
In the short run (PC Short Run Graph Below)
o Demand has shifted to the left or decreased
o Price has decreased due to the demand shift
o The firms are losing profit
As a result of the short run loss, what will happen in the
long run?
o The supply will shift to the left or decrease
o Price will rise due to the shift in supply
o The firms will start gain profit and go firms will enter the
market (back to Break Even or Long run)
Perfectly Competitive Short Run Loss
Now, Perfectly Competitive Firm BACK to Long Run
UNIT 4: IMPERFECT COMPETITION-MONOPOLIES,
OLIGOPOLIES AND MONOPOLISTIC COMPETITION
Monopolies vs. Perfect Competition Characteristics Perfect Comp Monopolies
Number of
Firms
Very large number
of firms
Only one firm. The
firm is the industry
Price making ability of
individual
firms
Each firm is so small that changes
in its own output do
not affect market
price, Ex. firms are
price takers
Changes in the firm’s output cause
changes in the
price, ex. the firm
is price-maker
Types of
products
Firms all produce
identical products,
with no
differentiation
Unique product, no
other firm makes
anything like it.
Entry barriers Completely free
entry and exit from
the industry. Ex. No
barriers to entry
Significant barriers
to entry exit,
preventing new
firms from entering and
competing with
monopolist
Efficiency Will achieve both
allocative and
productive
efficiency in the
long-run
Will never achieve
allocative nor
productive
efficiency in the
long-run
Types of Barriers to Enter Monopolies
Legal Barriers: Monopolist may have rights granted by
government to provide certain goods and services (Postal
Service)
Economies of Scale: The advantages of being big. Some firms have achieved such a great size or efficiency that it’s
hard for other firms to compete. (Nuclear Power Plant)
o Natural Monopoly: It is Natural for only one firm to
produce because they can produce at the lowers cost.
Ownership of Resources: If a firm has exclusive access to
the resources needed to make it good, then there will be no
competition (De Beers)
Strategic Pricing: A monopolist may be able to block
entry to maker by temporarily selling its output at price
below its per-unit cost. (Standard Oil Company)
Brand Loyalty: Some firms are well known and popular among consumers. (Atlanta United or Atlanta Braves)
Per Unit or Lump Sum Tax
Lump Sum: A one-time payment to a company. The tax
will impact a firms fixed cost such as Average Fixed Cost
and Average Total Cost
o If the lump sum is a tax the ATC curve shifts up, if it’s a
subsidy it shifts down.
Per Unit- A tax on each unit a company produces. The tax
will impact a firm’s variable cost such as Marginal Cost,
Average Variable Cost and Average Total Cost. o If the per unit is a tax the ATC shifts up, BUT it will also
shift MC curve to the left o If the per unit is a subsidy it shifts down, BUT it will also
shift MC curve to the right.
Monopolies and Revenue Curves
Cost curves are still the same as previous units
The MR=MC rule still applies for Monopolies
The Shut Down rule still applies for Monopolies
MC= Supply Curve
Demand for the Firm’s output is the market demand.
Demand Curve: The firm is the industry so it can dictate
price, but the demand is not perfectly elastic, so the demand
curve is downward sloping.
o Why does a monopoly curve face a downward sloping
demand curve: To sell more of his/her goods, the
monopolist must lower the price. This puts a constraint of
his/her ability to profit from his market power. This is why
a monopolist does NOT charge the highest price he wants!
Instead he charges the highest price he/she can!
Marginal Revenue doesn’t equal Price
Marginal Revenue is less than Demand/Price
When Marginal Revenue (MR) is positive, demand is
elastic, since Total Revenue increases when Price decreases
When Marginal Revenue (MR) is negative, demand is
inelastic, since a decrease in Price will cause Total Revenue
to fall.
Monopolies and Revenue Curves
Reasoning or Key Concepts on Monopolies and Revenue
Curves
A monopolist will never produce in the inelastic range of its
demand (D=AR=P).
Because if a monopolist were to sell beyond Qrm it would always do better by decreasing its output until MR were
positive once again.
o Total cost would decease as the firms reduces its output
o Total revenue would increase, therefore…..
o Reducing output to a point below Qrm would definitely
increase the firm’s profits (remember ECONOMIC
PROFITS= TR-TC)
Profit Maximizing for Monopolies
Just like a firm in perfect competition, a monopolist wishes
to maximize its profits wants to produce at the quantity at
which: Marginal Revenue =Marginal Cost (MR=MC)
But monopolies charge the price consumers are willing to
pay identified by the demand curve.
Profit Maximizing Monopolist
Monopolies will produce at MC=MR to maximize profits
(GOLD ROAD)
The monopolist’s MC and ATC demonstrate relationships
as a firm in perfect competition.
Monopoly Profit Curve
Reasoning or key concepts on profit maximizing
monopolist.
o Economic Profit= (P1-ATC) x Q. YELLOW BOX
o Because of barriers to enter the market, the firm’s profits
are sustainable in the long-run.
Profit Loss Minimizing Monopolist
Having price control does not mean that the monopoly will
earn economic profits.
If the demand for a firms output falls it could face losses
If the cost of production rises then the firm could face losses.
Monopoly Loss Curve
Reasoning or key concepts on profit loss minimizing
monopolist.
o The firm will produce at MR=MC (GOLD ROAD)
o At this point the ATC is greater than the price the firm
can sell its goods for.
o The firm is earning an economic loss- BLUE BOX
o The firms should not shut down, because the price still
covers the average variable cost.
o If total losses were larger than the total fixed cost the firm
should shut down.
o To reduce losses, the firm must try to increase demand by reducing its cost.
The Break-even Monopolist
It is possible that a monopolist could sell its product where
price equals ATC.
When price=ATC then the monopolist is at the Break-even
point.
Monopoly Break Even Curve
Reasoning or key concepts on break-even point. o The firm is producing a MC=MR (GOLD ROAD), and
ATC=Price.
o The monopolist’s total revenue is the same or equal to its
total cost.
o The monopolist is covering its explicit and implicit cost.
o If a firm covers its explicit and implicit cost then it’s
earning a normal profit.
o The firm is not earning an economic profit, to earn an
economic profit the firm would have to increase demand
(advertise) for its product or improve efficiency in
production (lower costs)
The Shut Down Monopolist
Monopolist should shut down if AVC is larger than the
price.
Monopoly Shut Down Curve
Reasoning or key concepts on shut down monopolists
o The monopolist is producing at MR=MC (GOLD
ROAD).
o Shut-down rule says to shut down because P > AVC.
o Find the Fixed Cost, Total Cost, and Total Revenue.
Green is Total Fixed Cost=$10 (5x2), Yellow is Variable Cost = $10 (5x2), Blue is Total Revenue=$10
(5x2)
o But why should the firm shut down?
o The Revenue (Blue) is less than the cost of production
AVC and ATC (Green and Yellow)
Efficiency and Monopolies
Monopolies are inefficient because
o They charge a higher price and lower output
o Don’t produce enough
Not Allocative Efficient because firms produce P > MC
Remember: Allocative efficiency is when firms will produce at MC=P
o Produce at higher costs
Not Productively Efficient because firms produce
Remember: Productive efficiency is when firms will
produce where P=Minimum ATC
Inefficient Monopolies (CS, PS and Deadweight)
Reasoning or key concepts on inefficient monopolies.
o While monopolies produce at the profit maximizing
point- MR=MC, they charge a price at D=AR=P.
o This price point (Pm) creates a consumer surplus (Pink),
producer’s surplus (Green) and deadweight loss (Blue).
o Remember: Deadweight loss shows inefficiency of a
firm.
o If you look at the graph you can see that monopolies
under produce. (Should produce where Pe = Min ATC)
o If you look at the graph, you can see that monopolies
over charge. (Should charge where Pe = MC) o The under producing and over charging causes
monopolist to be inefficient (producers surplus increases,
consumer surplus decreases, and deadweight loss is
created)
Natural Monopoly
In a natural monopoly, long-run economies of scale exist for
a single firm exist throughout the entire effective demand
for its product.
Natural Monopoly Rule: If Demand intersects ATC while
downward sloping, then the industry is a natural monopoly.
Ex. Utilities companies, mass transit
Natural Monopoly Graph
Reasoning behind Natural Monopolies
o At ATC, if there were 10 monopolies in the market, then they would charge to high and produce too little (Qf).
(Imagine 10 Electric companies)
o The fixed cost are so high for this market that it would be
better for 1 natural monopoly firm to operate.
o If the other companies leave the market, and only one
natural monopoly remains it will produce at MR=MC and
the price will be too high for consumers.
o So, how can government allow natural monopolies to
operate and still benefit the public (ELECTRIC
COMPANIES)
o Government must regulate the natural monopoly
Government Regulating Natural Monopolies
Reasons for government regulating natural monopolies
o To keep price low for consumers
o To make monopolies efficient
How can governments regulate monopolies?
o Price controls- such as price ceilings
o TAX WANT WORK BECAUSE IT LIMITES SUPPLY
Where should the government set price ceilings for
monopolies?
o Socially Optimal Point or Fair- Return Price
Socially Optimal Point: Where P=MC or Allocative
Efficiency (NO DEAD WEIGHT LOSS) Fair-Return Price= Where P=ATC or Normal Profit or
Break Even
Regulating Natural Monopolies Graph
Reasoning or key concepts on government regulated
monopolies.
o At the monopoly price there are no government
regulations
o If government sets a price ceiling at the Fair-Return Price
The firm will break even (TR=TC or P=ATC)
o If government sets a price ceiling at Socially-Optimal
Price
The firm will loss profit, so the government will need
to provide a subsidy for keep the natural monopoly
operating.
Graphing Monopolies
Use the graph below to answer the following questions.
o P and Q unregulated monopoly: P5, Q1
o P and Q socially optimal monopoly: P4, Q2
o P and Q fair return monopoly: P2, Q4
o Consumer Surplus: ABP5
o Dead Weight Loss: BCG
o Q where TR is Maximized:Q3
o Elastic Price Range of Demand Curve: AD
o Price unit tax causes price increase and quantity decrease
o Lump sum subsidy causes price to stay the same and quantity to stay the same.
Monopoly Graph
Monopolies and Price Discrimination
Price Discrimination: The practice of selling the same
product to different buyers at different prices.
Examples- Movie Tickets- child, adult, senior citizen or
veteran.
Price discrimination seeks to charge consumers what they are willing to pay in an effort to increase profits.
Products with inelastic demand are charged more than those
with elastic.
When monopolies price discriminate MR=D
Price discrimination requires three condition
o Must be a monopolist or have considerable monopoly
power.
o Sellers must be capable of dividing consumers into
different classes, each class being charged a different
price----called Market Segmentation
o Consumers must not be able to resell the product.
Price Discriminating Monopoly Graph
Reasoning or key concepts on price discriminating
monopolies.
o Price discriminating firms can charge differently, so the
marginal revenue = demand.
o Creates more profit (BLUE) for company because it can
charge different prices (Higher socially optimal point) o Price discrimination reduces consumer surplus
o Perfect price discrimination completely wipes out
consumer surplus.
o Allocative efficiency improved. The higher level of output
will be closer to (or equal to if perfect price
discrimination) the P=MC level. The monopolist will
continue to sell right up to the las price it charged is equal
to the firm’s marginal cost.
o No Deadweight loss for perfect price discrimination
Monopolistic Competition
In the short run sellers act like monopolist
Examples: Automobile, cereal, clothing companies
In the long-run
o New firms will enter, driving down demand for firms
already in the market
o Competition ensures zero economic (normal) profit.
o Price is greater than marginal cost so that the consumer is
willing to pay more than it costs to produce the good; no
allocative efficiency
o Monopolistic Competition does not operate at minimum
average cost, so that productive efficiency is not achieved
either.
Monopolistic Competition Long-run Equilibrium Graph
Reasoning or key concepts on monopolistic competition in
long- equilibrium.
o Not Efficient
Not allocatively efficient because P doesn’t equal MC
Not productively efficient because not produced at Minimum ATC
o The Firm has excess capacity because of under allocation
of resources.
Excess capacity: The difference between the social
optimal point (Qso) and the long-run output (Qlr)
Oligopolies
Oligopolies occur when only a few large firms start to
control an industry, which creates high barriers to enter the
market.
Types of Barriers
o Economies of Scale: Movie industry is difficult to enter because only large firms can make movies at the lowest
cost.
o High start up costs
o Ownership of raw materials
Examples: Gas companies, movie companies, soft drink
companies
Because there are only a few firms in an oligopolistic
market, they have greater incentives to cooperate, rather
than compete, with one another on output and pricing.
To understand whey collusion is so attractive to
oligopolistic firms, it is beneficial to think of competition between them as a game.
For this, we will use a model of oligopoly behavior called
game theory.
Game Theory for Oligopolies
Consider the following: Two firms Americom and
Chinacom, provide cell phone service to consumers in
America. These firms are trying to decide on the following.
o Should the firm offer unlimited data to their customers
(FREE) or
o Should the firm charge customers based on data use
(PAY)
Profit of each firm depends not only on whether the firm offers free data, but also on whether its competitor offers
free data. In this regard, the firm is highly interdependent
on each other.
The possible levels of profit both companies can earn
depending on their decision regarding data plans and based
on competition’s decisions can be plotted with a payoff
matrix.
Payoff Matrix Americom
PAY FREE
Chinacom PAY 10,10 5,20
FREE 20,5 7,7
Determining the likely outcome of the game:
o The firms are not colluding.
o What will each firm most likely do?
o To determine the most likely outcome in the game above,
consider the possible pay offs both firms face. o If Chinacom chooses PAY
And Americom also chooses PAY, Chinacom will earn
profits of $10 Million
But if Americom chooses FREE, Chinacom profits will
fall to $5 million
o If Chinacom chooses FREE
And Americom chooses PAY, Chinacom will earn
profits of $20 million.
But Americom chooses FREE, Chinacom profits will be
$7 million.
Determining a Dominant Strategy:
o Dominant Strategy: A strategy is dominant if it results in a higher payoff regardless of what strategy the opponent
chooses.
o In this game, both firms have a dominant strategy of
choosing FREE.
o IF Americom chooses PAY, Chinacom can do better by
choosing FREE.
o If Americom chooses FREE, Chinacom can do better by
choosing FREE
o BOTH FIRMS CAN ALWAYS DO BETTER BY
CHOOSING TO OFFER FREE DATA
This game is known as the Prisoner’s Dilemma. The firms face this dilemma because:
o Both firms want to maximize their own profits, but….
o The rational thing to do is to offer FREE data, because the
potential profits are so great!
$20 million if the competitor chooses PAY
$7 million if the competitor chooses FREE
For a total possible payoff of $27
o The possible payoffs for offering PAY are lower.
$10 million if the competitor offer PAY
$5 million if the competitor offers FREE
For a total possible payoff of $15million.
When both firms act in their own rational interest, both
firms end up earning less profits than if they had instead
acted irrationally.
The dilemma is that, the firms are likely to earn less total
profits between them by offering FREE data than they
would have earned if they had only chosen PAY data.
This occurs because collusion was not possible
Three Types of Oligopolies
Price leadership
o Collusion is illegal
o Firms cannot set prices
o Price leadership is a strategy used by firms to coordinate
prices without collusion. o In general the dominate firm sets a price change, then the
other firms follow the price leader.
o Price leadership causes temporary price wars to occur,
firms trying to undercut each other.
Colluding oligopolies
o Collusion is defined as the open or tacit cooperation
between firms in an oligopolistic to set prices or agree on
other strategies that often benefit the firms at the expense
of consumers.
o Cartels are colluding oligopolies
o Cartel: A group of producers that create an agreement to fix prices high.
o Characteristics of Cartels
Cartels set price and output at an agreed upon level
Firms require identical or highly similar demand and
costs
Cartel must have a way to punish cheaters
Together they act as a monopoly and share the profit
(BLUE BOX)
Non Colluding Oligopolies-THE KINKED DEMAND
CURVE
o The Kinked Demand Curve: This model shows how non
collusive firms are interdependent.
o If firms are NOT colluding they are likely to react to
competitor’s pricing in two ways:
o Match price: If one firm cuts it’s price, then the other firms follow suit causing inelastic demand.
As the only firm with low prices, other firms will
decided to match the low price.
Since all firms have lower prices, Output for this firm
will increase only a little.
o Ignore change: If one firm raises price, other will
maintain the same price causing elastic demand.
As the only firm with high prices, Output for this firm
will decease a lot.
Kinked Demand Curve Graph
Reasoning or key concepts on kinked demand curve
Demand is highly elastic above the current price o Firms should ignore a price increase by a single seller.
o Many consumers will switch to the lower price products
o A price increase by the single firm will result in a fall in
total revenue.
Demand is highly inelastic below the current price
o Firms will match price increases by a single firm
o Very few new consumers will buy from firms
o A price decrease by a single firm will lead do a fall in total
revenue for firms.
Marginal Revenue has a vertical gap at the kink of the
demand curve.
The result is that Marginal Cost can move and Equilibrium
Quantity won’t change.
This situation is called Sticky Price.
Firms in non-colluding oligopolies markets tend to be very
stable.
Firms are unlikely to increase or lower prices since in either
case, total revenue will fall, possibly reducing profit.
