lectuer notes

7/29/2019 Lectuer Notes

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Chapter 1 notes

Definition of Economics

The first thing that we should discuss is the definition of "economics." Economists generally define economicsas the study of how individuals and societies use limited resources to satisfy unlimited wants. To see how this

concept works, think about your own situation. Do you have enough time available for everything that you wishto do? Can you afford every item that you would like to own? Economists argue that virtually everyone wantsmore of something. Even the wealthiest individuals in society do not seem to be exempt from this phenomenon.

This problem of limited resources and unlimited wants also applies to society as a whole. Can you think of anysocieties in which all wants are satisfied? Most societies would prefer to have better health care, higher qualityeducation, less poverty, a cleaner environment, etc. Unfortunately, there are not enough resources available tosatisfy all of these goals.

Thus, economists argue that the fundamental economic problem is scarcity. Since there are not enoughresources available to satisfy everyones wants, individuals and societies have to choose among available

alternatives. An alternative, and equivalent, definition of economics is that economics is the study of how suchchoices are made.

Economic Goods, Free Goods, and Economic Bads

A good is said to be an economic good (also known as a scarce good) if the quantity of the good demandedexceeds the quantity supplied at a zero price. In other words, a good is an economic good if people want moreof it than would be available if the good were available for free.

A good is said to be a free good if the quantity of the good supplied exceeds the quantity demanded at a zeroprice. In other words, a good is a free good if there is more than enough available for everyone even when the

good is free. Economists argue that there are relatively few, if any, free goods.

An item is said to be an economic bad if people are willing to pay to avoid the item. Examples of economicbads include things like garbage, pollution, and illness.

Goods that are used to produce other goods or services are called economic resources (and are also known asinputs or factors of production). These resources are often categorized into the following groups:

1. Land,2. Labor,3. Capital, and4. Entrepreneurial ability.

The category of "land" includes all natural resources. These natural resources include the land itself, as well asany minerals, oil deposits, timber, or water that exists on or below the ground. This category is sometimesdescribed as including only the "free gifts of nature," those resources that exist independent of human action.

The labor input consists of the physical and intellectual services provided by human beings. The resource called"capital" consists of the machinery and equipment used to produce output. Note that the use of the term"capital" differs from the everyday use of this term. Stocks, bonds, and other financial assets are not capitalunder this definition of the term.


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2Entrepreneurial ability refers to the ability to organize production and bear risks. Your text does not list thisas a separate resource, but instead considers it as a type of labor input. Most other introductory texts, though,list this as a separate resource. (No, your text is not wrong, it just uses a different way of classifying resources. Ithink it's better, though, to stick with the somewhat more standard classification in this course.)

The resource payment associated with each resource is listed in the table below:

Economic Resource Resource Payment

land rent

labor wages

capital interest

entrepreneurial ability profit

Rational Self-interest

As noted above, scarcity results in the need to choose among competing alternatives. Economists argue thatindividuals pursue their rational self-interest when making choices. This means that individuals are assumed toselect the alternative(s) that they believe will make them happiest, given the information that they possess at thetime of the decision.

Note that the term "self-interest" means something quite different than "selfish." Self-interested people maydonate their time to charitable organizations, give gifts to loved ones, contribute to charities and engage in othersimilarly altruistic activities. Economists assume, though, that altruistic people select these actions because theyfind these activities more enjoyable than available alternative activities.

Economic Methodology

Economic discussions may involve both positive and normative analysis. Positive analysis involves attempts todescribe how the economy functions. Normative economics relies on value judgments to evaluate orrecommend alternative policies.

As a social science, economics attempts to rely on the scientific method. The scientific method consists of thefollowing steps:

1. Observe a phenomenon,2. Make simplifying assumptions and develop a model (a set of one or more hypotheses),3. Make predictions, and4. Test the model.

If the model is rejected in step 4, formulate a new model. If the test fails to reject the model, conduct additionaltests.

Note that tests of a model can never prove that a model is true. A single test, however, may be used to establishthat a model is incorrect.


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3Economists rely on the ceteris paribus assumption in constructing models. This assumption, translatedroughly as "other things constant," allows economists to simplify reality so that it may be more readilyunderstood.

Logical fallacies

The fallacy of composition occurs when one incorrectly attempts to generalize from a relationship that is true

for each individual, but is not true for the whole group. As an example of this, note that any person can get abetter view at a concert by standing (regardless of the actions of those in from of him or her). It is incorrect,though, to state that everyone can get a better view if everyone stands.

Similarly, one would commit the fallacy of composition if one were to claim that, since anyone could increasehis or her wealth by stealing from his or her neighbors (assuming no detection), that everyone can becomewealthier if everyone steals from their neighbors.

The association as causation fallacy, also known less technically as thepost hoc, ergo propter hoc fallacy,occurs if one incorrectly assumes that one event is the cause of another simply because it precedes the otherevent. The Super Bowl example discussed in your text is a good example of this logical fallacy.

Microeconomics vs. Macroeconomics

Microeconomics involves the study of individual economic agents and individual markets. Macroeconomicsinvolves the study of economic aggregates.

Alegbra and Graphical Analysis in Economics

(This is a summary of some of the most important material in the appendix to Chapter 1.) Graphs areextensively used in economic analysis to represent the relationships that exist among economic variables. Twosimple types of relationships that may exist are direct and inverse relationships.

A direct relationship is said to exist between two variables X and Y if an increase in X is always associatedwith an increase in Y and a decrease in X is associated with a decrease in Y. A graph of such a relationship willbe upward sloping, as in the diagram below.

A direct relationship may be linear (as in the diagram above), or it may be nonlinear (as in the diagrams below).


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An inverse relationship is said to exist between the variables X and Y if an increase in X is always associatedwith a decrease in Y and a decrease in X is associated with an increase in Y. A graph of an inverse relationshipwill be downward sloping.

An inverse relationship may also be either linear or nonlinear (as illustrated below).

A linear relationship possesses a constant slope, defined as:

If an equation can be written in the form: Y = mX + b, then:

m = slope, and


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5b = y-intercept.

Chapter 2 notes

As noted in Chapter 1, economics is the study of how individuals and economies deal with the fundamentalproblem of scarcity. Since there are not enough available resources to satisfy the wants of individuals andsocieties, individuals and societies must make choices among competing alternatives.

Opportunity Cost

The opportunity cost of any alternative is defined as the cost of not selecting the "next-best" alternative. Let'sconsider a few examples of opportunity cost:

Suppose that you own a building that you use for a retail store. If the next-best use of the building is torent it to someone else, the opportunity cost of using the business for your business is the rent you couldhave received. If the next-best use of the building is to sell it to someone else, the annual opportunitycost of using it for your own business is the foregone interest that you could have received (e.g., if the

interest rate is 10% and the building is worth $100,000, you give up $10,000 in interest each year bykeeping the building, assuming that the value of the building remains constant over the year --depreciation or appreciation would have to be taken into account if the value of the building changesover time).

The opportunity class of attending college includes:o the cost of tuition, books, and supplies (the costs of room and board only appear if these costs

differ from the levels that would have been paid in your next-best alternative),o foregone income (this is usually the largest cost associated with college attendance), ando psychic costs (the stress, anxiety, etc. associated with studying, worrying about grades, etc.).

If you attend a movie, the opportunity cost includes not only the cost of the tickets and transportation,but also the opportunity cost of the time required to view the movie.

When economists discuss the costs and benefits associated with alternative activities, the discussion generallyfocuses on marginal benefits and marginal costs. The marginal benefit from an activity is the additional benefitassociated with a one-unit increase in the level of an activity. Marginal cost is defined as the additional costassociated with a one-unit increase in the level of the activity. Economists assume that individuals attempt tomaximize the net benefit associated with each activity.

If marginal benefit exceeds marginal cost, net benefit will increase if the level of the activity rises. Therefore,rational individuals will increase the level of any activity when marginal benefit exceeds marginal costs. On theother hand, if marginal cost exceeds marginal benefit, net benefit rises when the level of the activity is


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6decreased. There is no reason to change the level of an activity (and net benefit is maximized) at the level ofan activity at which marginal benefit equals marginal cost.

Production Possibilities Curve

Scarcity implies the existence of tradeoffs. These tradeoffs can be illustrated quite nicely by a production

possibilities frontier.For simplicity, it is assumed that a firm (or an economy) produces only two goods (this assumption is neededonly to make the representation feasible on a two-dimensional surface -- such as a graph on paper or on acomputer screen). When a production possibilities curve is drawn, the following assumptions are also made:

1. there is a fixed quantity and quality of available resources,2. technology is fixed, and3. there are no unemployed nor underemployed resources

Very shortly, we'll also see what happens when these assumptions are relaxed.

For now, though, let's consider a simple example. Suppose that a student has four hours left to study for examsin two classes: introductory microeconomics and introductory calculus. The output in this case is the examscore in each class. The assumption of a fixed quantity and quality of available resources means that theindividual has a fixed supply of study materials such as textbooks, study guides, notes, etc. to use in theavailable time. A fixed technology suggests that the individual has a given level of study skills that allow him orher to translate the review materials into exam scores. A resource is unemployed if it is not used. Idle land,factories, and workers are unemployed resources for a society. Underemployed resources are not used in thebest possible way. Society would have underemployed resources if the best brain surgeons were driving taxiswhile the best taxi drivers were performing brain surgery.... The use of an adjustable wrench as a hammer or theuse of a hammer to pound a screw into wood provide additional examples of underemployed resources. If thereare no unemployed or underemployed resources, efficient production is said to occur.

The table below represents possible outcomes from each various combinations of time studying each subject:

# ofhoursspent

studying

calculus

# ofhoursspent

studyingeconomics

calculusgrade

economicsgrade

0 4 0 60

1 3 30 552 2 55 45

3 1 75 30

4 0 85 0

Notice that each additional hour spent studying either calculus or economics results in smaller marginalimprovements in the grade. The reason for this is that the first hour will be spent studying the most essentialconcepts. Each additional hour is spent on the "next-most" important topics that have not already beenmastered. (It is important to note that a good grade on an economics examination requires substantially more


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7than four hours of study time.) This is an example of a general principle known as the law of diminishingreturns. The law of diminishing returns states that output will ultimately increase by progressively smalleramounts as additional units of a variable input (time in this case) are added to a production process in whichother inputs are fixed (the fixed inputs here include the stock of existing subject matter knowledge, studymaterials, etc.).

To see how the law of diminishing returns works in a more typical production setting, consider the case of a

restaurant that has a fixed quantity of capital (grills, broilers, fryers, refrigerators, tables, etc.). As the level oflabor use increases, output may initially rise fairly rapidly (since additional workers allow more possibilities forspecialization and reduces the time spent switching from task to task). Eventually, however, the addition ofmore workers will result in progressively smaller increases in output (since there is a fixed amount of capital forthese workers to use). It is even possible that beyond some point workers may start getting in each others wayand output may decline ("too many cooks may spoil the broth...." sorry.... I couldn't resist).

In any case, the law of diminishing returns explains why your grade will increase by fewer points with eachadditional hour that you spend studying.

The points in the table above can be represented by a production possibilities curve (PPC) such as the one

appearing in the diagram below. Each point on the production possibilities curve represents the best grades thatcan be achieved with the existing resources and technology for each alternative allocation of study time.

Let's consider why the production possibilities curve has this concave shape. As the diagram below indicates, arelatively large improvement in economics grade can be achieved by giving up relatively few points on thecalculus exam. A movement from point A to point B results in a 30-point increase in economics grade and onlya 10-point reduction in calculus grade. The marginal opportunity cost of a good is defined to be the amount ofanother good that must be given up to produce an additional unit of the first good. Since the opportunity cost of30 points on the economics test is a 10-point reduction in the score on the calculus test, we can say that themarginal opportunity costof one additional point on the economics test is approximately 1/3 of a point on the

calculus test. (If in doubt, note that if 30 points on the economics exam have an opportunity cost of 10 points,each point on the economics test must cost approximately 1/30th of 10 points on the calculus test --approximately 1/3 of a point on the calculus test).


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Now, let's see what happens a second hour is transferred to the study of economics. The diagram belowillustrates this outcome (a movement from point B to C). As this diagram indicates, transferring a second hourfrom the study of mathematics to the study of economics results in a smaller increase in economics grade (from30 to 45 points) and a larger reduction in calculus grade (from 75 to 55). In this case, the marginal opportunity

cost of a point on the economics exam has increased to approximately 4/3 of a point on the calculus exam.

The increase in the marginal opportunity cost of points on the economics exam as more time is devoted tostudying economics is an example of the law of increasing cost. This law states that the marginal opportunitycost of any activity rises as the level of the activity increases. This law can also be illustrated using the tablebelow. Notice that the opportunity cost of additional points on the calculus exam rises as more time is devotedto studying calculus. Reading from the bottom of the table up to the top, you can also see that the opportunitycost of additional points on the economics exam rises as more time is devoted to the study of economics.


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9One of the reasons for the law of increasing cost is the law of diminishing returns (as in the example above).Each extra hour devoted to the study of economics results in a smaller increase in the economics grade and alarger reduction in the calculus grade because of diminishing returns to time spent on either activity.

A second reason for the law of increasing cost is the fact that resources are specialized. Some resources arebetter suited for some some types of productive activities than for other types of production. Suppose, forexample, that a farmer is producing both wheat and corn. Some land is very well suited for growing wheat,

while other land is relatively better suit for growing corn. Some workers may be more adept at growing wheatthan corn. Some farm equipment is better suited for planting and harvesting corn.

The diagram below illustrates the PPC curve for this farmer.

At the top of this PPC, the farmer is producing only corn. To produce more wheat, the farmer must transferresources from corn production to wheat production. Initially, however, he or she will transfer those resourcesthat are relatively better suited for wheat production. This allows wheat production to increase with only arelatively small reduction in the quantity of corn produced. Each additional increase in wheat production,however, requires the use of resources that are relatively less well suited for wheat production, resulting in arising marginal opportunity cost of wheat.

Now, let's suppose that this farmer either does not use all of the available resources, or uses them in a less than

optimal manner (i.e., either unemployment or underemployment occurs). In this case, the farmer will produce ata point that lies below the production possibilities curve (as illustrated by point A in the diagram below).

In practice, all firms and all economies operate below their production possibilities frontier. Firms andeconomies, however, generally attempt to get as close to the frontier as possible.

Points above the production possibilities cannot be produced using current resources and technology. In thediagram below, point B is not obtainable unless more or higher quality resources become available ortechnological change occurs.


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An increase in the quantity or quantity of resources will cause the production possibilities curve to shift outward(as in the diagram below). This type of outward shift could also be caused by technological change thatincreases the production of both goods.

In some cases, however, technological change will only increase the production of a specific good. The diagrambelow illustrates the effect of a technological change in wheat production that does not affect corn production.

Chapter 3

In this chapter, we will examine how markets determine the price of goods and the quantity sold and consumed.A market is a set of arrangements for the exchange of a good or a service.

Barter vs. markets

A barter system is a market system in which goods or services are traded directly for other goods or services.If you agree to repair your neighbor's computer in return for his or her assistance in painting your house, youhave engaged in a barter transaction. While a barter system may be able to function effectively in a simpleeconomy in which a limited variety of goods are produced, it cannot function well in a complex economy thatproduces an extensive collection of goods and services. The primary problem associated with a barter system is


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11that any trade requires a double coincidence of wants. This means that trade can only take place ifeach person wants what the other person is willing to trade and is willing to give up what the other personwants. In a developed economy in which a diverse collection of goods and services are produced, locatingsomeone willing to make the trade that you desire may be quite difficult and costly. If you repair TVs and arehungry, you must find someone with a broken TV who is willing to trade food for TV repairs. Because it iscostly to arrange such a transaction, economists note that barter transactions have relatively high transactionscosts.

For this reason, throughout recorded history virtually all societies have used some form of money to facilitatetrade. In a monetary economy, individuals trade goods or services for money and then use this money to buy thegoods or services that they wish to acquire. Since money can be traded for any good or service, the use ofmoney eliminates the need for a double coincidence of wants and lowers the transaction costs associated withtrade.

Relative and nominal prices

The opportunity cost of acquiring a good or a service under either a barter or a monetary economy may bemeasured by the relative price of the commodity. The relative price of a commodity is a measure of how

expensive a good is in terms of units of some other good or service. Under a barter system, the relative price isnothing more than the trading ratio between any two goods or services. For example, if one laser printer istraded for 2 ink-jet printers, the relative price of the laser printer is two ink-jet printers. Alternatively, therelative price of an inkjet printer is one-half of a laser printer in this case. In a monetary economy, relativeprices can also be easily computer using the ratio of the prices of the commodities. If, for example, a soccer ballcosts $20 and a portable CD player costs $60, the relative price of a portable CD player is 3 soccer balls (andthe relative price of a soccer ball is 1/3 of a CD player). Economists ague that individuals respond to changes inrelative prices since these prices reflect the opportunity cost of acquiring a good or service.

In a market economy, the price of a good or service is determined through the interaction of demand andsupply. To understand how market price is determined, it is important to know the determinants of both demand

and supply. Let's first examine the demand for a good.

Demand

The demand for a good or service is defined to be the relationship that exists between the price of the good andthe quantity demanded in a given time period, ceteris paribus. One way of representing demand is through ademand schedule such as the one appearing below:

Note that the demand for the good is the entire relationship that is summarized by this table. This demandrelationship may also be represented by a demand curve (as illustrated below).


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Both the demand schedule and the demand curve indicate that, for this good, an inverse relationship existsbetween the price and the quantity demanded when other factors are held constant. This inverse relationshipbetween price and quantity demanded is so common that economists have called it the law of demand:

An inverse relationship exists between the price of a good and the quantity demanded ina given time period, ceteris paribus.

As noted above, demand is the entire relationship between price and quantity, as represented by a demandschedule or a demand curve. A change in the price of the good results in a change in the quantity demanded, but

does not change the demand for the good. As the diagram below indicates, an increase in the price from $2 to$3 reduces the quantity of this good demanded from 80 to 60, but does not reduce demand.

Change in demand vs. change in quantity demanded

A change in demand occurs only when the relationship between price and quantity demanded changes. Theposition of the demand curve changes when demand changes. If the demand curve becomes steeper or flatter orshifts to the right or the left, we can say that demand has changed. The diagram below illustrates a shift in thedemand for a good (from D to D'). Notice that a rightward shift in the position of the demand curve is said to bean increase in demand since a larger quantity is demanded at each price.


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Market demand

The market demand consists of the total quantity demanded by each individual in the market. Conceptually, themarket demand curve is formed by computing the horizontal summation of the individual demand curves for allconsumers. The diagram below illustrates this process. This diagram illustrates a simple case in which there areonly two consumers, Person A and Person B. Notice that the total quanity demanded in the market is just the

sum of the quantities demanded by each individual. In this diagram, Person A wished to buy 10 of thiscommodity and person B wishes to buy 15 units when the price is $3. Thus, at a price of $3, the total quantitydemanded in the market is 25 (=10+15) units of this commodity.

Of course, this example is highly simplified since there are many buyers in most real-world markets. The sameprinciple, though would hold: the market demand curve is derived by adding together the quantities demandedby all consumers at each and every possible price.

Determinants of demand

Let's examine some factors that might be expected to change demand for most goods and services. These factorsinclude:

tastes and preferences, the prices of related goods, income, the number of consumers, and expectations of future prices and income.

Obviously, any change in tastes that raises the evaluation of a good will result in an increase in the demand for agood (as illustrated below). Those who remember the short-term increases in demand that occurred with slapbracelets, pogs, hypercolor t-shirts, beanie babies, Tickle-Me-Elmos, etc., can attest to the effect of changingtastes on demand. Fads will often increase the demand for a good for at least a short period of time.


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Demand will also decline if tastes change so the consumption of a good becomes less desirable. As fads fadeaway, the demand for the products falls (as illustrated below).

Goods may be related in consumption as either:

substitute goods, or complementary goods.

Two goods are said to be substitute goods if an increase in the price of one results in an increase in the demandfor the other. Substitute goods are goods that are often used in place of each other. Chicken and beef, forexample, may be substitute goods. Coffee and tea are also likely to be substitute goods. The diagram belowillustrates the effect of an increase in the price of coffee. A higher price of coffee reduces the quantity of coffeedemanded, but increases the demand for tea. Note that this involves a movement along the demand curve forcoffee since this involves a change in the price of coffee. (Remember: a change in the price of a good, ceterisparibus, results in a movement along a demand curve; a change in demand occurs when something other than

the price of the good changes.)


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Economists say that two goods are complementary goods if an increase in the price of one results in areduction in the demand for the other. In most cases, complementary goods are goods that are consumedtogether. Examples of likely pairs of complementary goods include:

peanut butter and jelly,

bicycles and bicycle safety helmets, cameras and film, CDs and CD players, and DVDs and DVD players.

The diagram below illustrates the effect of an increase in the price of DVDs. Note that an increase in the priceof DVDs would reduce both the quantity of DVDs demanded and the demand for DVD players.

It is expected that the demand for most goods will increase when consumer income rises (as illustrated below).Think about your demand for CDs, meals in restaurants, movies, etc. Is it likely that you would increase yourconsumption of most commodities if your income increases. (Of course, it is possible that the demand for somegoods -- such as generic foods, Ramen noodles, and other similar commodities -- may decline as your incomerises. We'll examine this possibility in more detail in Chapter 6.)


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Since the market demand curve consists of the horizontal summation of the demand curves of all buyers in themarket, an increase in the number of buyers would cause demand to increase (as illustrated below). As thepopulation rises, the demand for cars, TVs, food, and virtually all other commodities, is expected to increase. Adecline in population will result in a reduction in demand.

Expectations of future prices and income are also important determinants of the current demand for a good.First, let's talk about the effect of a higher expected future price. Suppose that you have been considering buyinga new car or a new computer. If you acquire new information that leads you to believe that the future price ofthis commodity will increase, you are probably going to be more likely to buy it today. Thus, a higher expectedfuture price will increase current demand. In a similar manner, a reduction in the expected future price willresult in a reduction in current demand (since you'd prefer to postpone the purchase in anticipation of a lowerprice in the future).

If expected future income rises, demand for many goods today is likely to rise. On the other hand, if expectedfuture income falls (perhaps because of rumors of future layoffs or the beginning of a recession), individualsmay reduce their current demand for goods so that they can save more today in anticipation of the lower future

income.

International effects

When international markets are taken into account, the demand for a product includes both domestic andforeign demand. An important determinant of foreign demand for a good is the exchange rate. The exchangerate is the rate at which the currency of one country is converted into the currency of another country. Suppose,for example, that one dollar exchanges for 5 French francs. In this case, the dollar value of one French franc is$.20. Notice that the exchange rate between dollars and francs is the reciprocal of the exchange rate betweenfrancs and dollars. If the value of the dollar rises in terms of a foreign currency, the value of the foreign


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17currency will fall relative to the dollar. This is a quite intuitive result. An increase in the value of the dollarmeans that the dollar is worth more relative to the foreign currencies. In this case, the foreign currencies have tobe worth less in terms of dollars.

When the value of the domestic currency rises relative to foreign currencies, domestically produced goods andservices become more expensive in foreign countries. Thus, an increase in the exchange value of the dollarresults in a reduction in the demand for U.S. goods and services. The demand for U.S. goods and services will

rise, however, if the exchange value of the dollar declines.

Supply

Supply is the relationship that exists between the price of a good and the quantity supplied in a given timeperiod, ceteris paribus. The supply relationship may be represented by a supply curve:

or a supply schedule:

Just as there is a "law of demand" there is also a "law of supply." The law of supply states that:

A direct relationship exists between the price of a good and the quantity supplied in a

given time period, ceteris paribus.To understand the law of supply, it's helpful to remember the law of increasing cost. Since the marginalopportunity cost of supplying a good rises as more is produced, a higher price is required to induce the seller tosell more of the good or service.

The law of supply indicates that supply curves will be upward sloping (as in the diagram below).


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Change in quantity supplied vs. change in supply

As in the case of demand, it is important to distinguish between a change in supply and a change in quantitysupplied. A change in the price of a good results in a change in the quantity supplied. A change in the pricechanges the quantity supplied, as noted in the diagram below.

A change in supply occurs when the supply curve shifts, as in the diagram below. Note that a rightward shift inthe supply curve indicates an increase in supply since the quantity supplied at each price increases when thesupply curve shifts to the right. When supply decreases, the supply curve shifts to the left.

Market supply

The market supply curve is the horizontal summation of all individual supply curves. The derivation of this isequivalent to that illustrated above for demand curves.

Determinants of supply

The factors that can cause the supply curve to shift include:

the prices of resources, technology and productivity, the expectations of producers, the number of producers, and the prices of related goods and services.


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19An increase in the price of resources reduces the profitability of producing the good or service. Thisreduces the quantity that suppliers are willing to offer for sale at each price. Thus, an increase in the price oflabor, raw material, capital, or other resource, will be expected to result in a leftward shift in supply (asillustrated below).

Technological improvements and changes that increase the productivity of labor result in lower production costsand higher profitability. Supply increases in response to this increase in the profitability of production (as

illustrated below).

As in the case of demand, expectations can play an important role in supply decisions. If, for example, theexpected future price of a gasoline rises, refiners may decide to supply less today so that they can stockpile gasfor sale at a later date. Conversely, if the expected future price of a good falls, current supply will increase assellers try to sell more today before the price declines.

An increase in the number of producers results in an increase (a rightward shift) in the market supply curve (asillustrated below).


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Since firms generally produce (or, at least, are able to produce) more than one commodity, they have todetermine the optimal balance among all of the goods and services that they produce. The supply decision for aparticular good is affected not only by the price of the good, but also by the price of other goods and servicesthe firm may produce. For example, an increase in the price of corn may induce a farmer to reduce the supply ofwheat. In this case, an increase in the price of one product (corn) reduces the supply of another product (wheat).

It is also possible, but less common, that an increase in the price of one commodity may increase the supply ofanother commodity. To see this, consider the production of both beef and leather. An increase in the price ofbeef will cause ranchers to raise more cattle. Since beef and leather are jointly produced from cows, the increasein the price of beef will also be expected to result in an increase in the supply of leather.

International effects

In our increasingly global economy, firms often import raw materials (and sometimes the entire product) fromforeign countries. The cost of these imported items will vary with the exchange rate. When the exchange valueof a dollar rises, the domestic price of imported inputs will fall and the domestic supply of the final commoditywill increase. A decline in the exchange value of the dollar will raise the price of imported inputs and reduce the

supply of domestic products that rely on these inputs.

Equilibrium

Let's combine the market demand and supply curves on one diagram:

It can be seen that the market demand and supply curves intersect at a price of $3 and a quantity of 60. Thiscombination of price and quantity represents an equilibrium since the quantity demanded equals the quantitysupplied. At this price, each buyer is able to buy all that he or she desires and each firm is able to sell all that it


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21desires to sell. Once this price is achieved, there is no reason for the price to either rise or fall (as long asneither the demand nor the supply curve shifts).

If the price is above the equilibrium, a surplus occurs (since quantity supplied exceeds quantity demanded). Thissituation is illustrated in the diagram below. The presence of a surplus would be expected to cause firms tolower prices until the surplus disappears (this occurs at the equilibrium price of $3).

If the price is below the equilibrium, a shortage occurs (since quantity demanded exceeds quantity supplied).This possibility is illustrated in the diagram below. When a shortage occurs, producers will be expected toincrease the price. The price will continue to rise until the shortage is eliminated when the price reaches theequilibrium price of $3.

Shifts in demand and supply


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22Let's examine what happens if demand or supply changes. First, let's consider the effect of an increasein demand. As the diagram below indicates, an increase in demand results in an increase in the equilibriumlevels of both price and quantity.

A decrease in demand results in a decrease in the equilibrium levels of price and quantity (as illustrated below).

An increase in supply results in a higher equilibrium quantity and a lower equilibrium price.

Equilibrium quantity will fall and equilibrium price will rise if supply falls (as illustrated below.)


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Price ceilings and price floors

A price ceiling is a legally mandated maximum price. The purpose of a price ceiling is to keep the price of agood below the market equilibrium price. Rent controls and regulated gasoline prices during wartime and theenergy crisis of the 1970s are examples of price ceilings. As the diagram below illustrates, an effective price

ceiling results in a shortage of a commodity since quantity demanded exceeds quantity supplied when the priceof a good is kept below the equilibrium price. This explains why rent controls and regulated gasoline priceshave resulted in shortages.

A price floor is a legally mandated minimum price. The purpose of a price floor is to keep the price of a goodabove the market equilibrium price. Agricultural price supports and minimum wage laws are example of priceceilings. As the diagram below illustrates, an effective price floor results in a surplus of a commodity sincequantity supplied exceeds quantity demanded when the price of a good is kept below the equilibrium price.

Chapter 4


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24In this chapter, we'll examine the operation of markets a bit more carefully. Initially, it will be assumed thatthere are no barriers to the efficient functioning of markets. We'll examine what happens when markets workless efficiently when we discuss Chapter 5.

Market coordination

Production in modern economies is an extremely complex activity. Consider the computer that you are currently

using. It consists of components and raw materials that were probably made in thousands of firms located indozens of countries. Somehow, the glass, plastic, metal, silica, and other raw materials were all combined intothe monitor, computer chips, mother board, and other components that form this computer. It is interesting tonote that the computer you are using contains dramatically more computing power than the mainframecomputers of 20 years or so ago. How did all of these raw materials get converted into this computer? Well, itall happened through market processes. All but the most primitive economies rely on markets to coordinatemany productive decisions (yes, this was even true in the former Soviet Union -- it has been estimated that 50%or more of all output was sold in the unofficial underground market economy).

Markets and the "three fundamental questions"

All economies, no matter what their form of economic organization, must address what are known as the "threefundamental questions:"

What? How? For Whom?

Let's examine each of these questions.

What?

The first question can be rephrased as: "What mix of goods and services will be produced?" In a marketeconomy, the interaction of self-interested buyers and sellers determines the mix of goods and services that areproduced. Adam Smith, writing in the Wealth of Nations argued that competition among self-interestedproducers results in an outcome that benefits all of society. Two quotes from Smith help to illustrate thisargument:It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from theirregard to their self-interest. (Book I, Chapter I)[A producer,]...by directing that industry in such a manner as its produce may be of the greatest value, heintends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an endwhich was no part of his intention. Nor is it always the worse for the society that it was no part of it. Bypursuing his own interest he frequently promotes that of the society more effectually than when he reallyintends to promote it. I have never known much good done by those who affected to trade for the public good. Itis an affectation, not very common among merchants, and very few words need be employed in dissuadingthem from it. (Book IV, Chapter II)This argument suggests that competition among self-interested producers forces them to produce goods thatsatisfy consumer wants. In seeking his or her own profit, each producer attempts to produce higher qualityproducts that better serve consumer needs. This leads to a condition ofconsumer sovereignty in which it isultimately the consumer who determines what mix of goods and services will be produced. Some economists,such as John Kenneth Galbraith, have questioned this argument and suggest that marketing activities by largecorporations can substantially influence the pattern of consumer demand. Most economists argue, though, thatwhile marketing methods may influence consumer demand in the short run, consumers ultimately determine
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25what goods and services that they will buy. Effective advertising campaigns may lead to phenomena such aspet rocks and Chia Pets, but these fads are generally fairly short-lived.

If, for whatever reason, consumers want more of a good, this results in an increase in demand. In the short run,this increase in demand results in higher prices, increased output, and a higher level of profit for firms in thisindustry. In response to these profits, however, new firms will enter the market in the long run, resulting in anincrease in market supply. This increase in supply will drive the price back down while further increasing the

quantity sold. The short-run profits generated by the increase in demand gradually disappear as the pricedeclines. Thus, the long-run response to an increase in demand is an increase in the amount produced. (Noticehow this is consistent with the concept of consumer sovereignty.)

How?

The second fundamental question may be more completely stated as: "How is output produced?" This questioninvolves the determination of the mix of resources that are to be used to produce output. In a market economy,profit-maximizing producers will be expected to select a mix of resources that result in the lowest possible levelof cost (holding the quantity and quality of output constant). New production techniques will be adopted only ifthey reduce production costs. Sellers of resources will supply them to those activities in which they are mosthighly valued. Once again, Smith's "invisible hand of the market" guides resources into their most valued uses.

For whom?

This third fundamental question deals with the issue of "who gets what?" In a market economy, this isdetermined by the interaction of buyers and sellers in both output and resource markets. The distribution ofincome is ultimately determined by the wages, interest payments, rents, and profits that are determined inresource markets. Those with more highly valued land, labor, capital, and entrepreneurial ability receive higherincomes. Given this distribution of income, individuals make their own decisions concerning how much of eachgood to buy in output markets.

The three fundamental questions and government

Of course, in any real-world economy, markets do not make all of these decisions. In all societies, governmentsinfluence what will be produced, how output will be produced, and who receives this output. Governmentspending, health and safety regulations, minimum wage laws, child labor laws, environmental regulations, taxsystems, and welfare programs all have a significant effect on any society's answers to these questions. We'llexamine many of these topics in the next chapter. For now, we'll focus on a simple market economy. In thissimple economy, there are three participants in the private sector: households, firms, and foreign countries.

Household

A household, as defined by the Census Bureau, consists of one or more individuals that share living quarters.

Types of firms

There are three possible types of firms:

sole proprietorship, partnership, and corporation.

A sole proprietorship is a firm that has a single owner. The main advantage of this form of ownership is that itprovides the owner with autonomy (the ability to be his or her own boss). There are, though, a few


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26disadvantages. Because of the high failure rate for newly founded sole proprietorships, it is difficult toacquire funds to acquire physical capital. The owners also face unlimited liability. This means that theirpersonal wealth is at risk if the business fails or is sued. While sole proprietorships are the most common formof firm, most are very small. Sole proprietorships account for a very small proportion of total sales in the U.S.economy.

Partnerships are firms in which two or more individuals share ownership. This form of business organization

provides an advantage over sole proprietorships by allowing owners to pool their wealth, skills, and resources.The cost of this pooling of resources is some loss in autonomy for the owners. As in the case of soleproprietorships, partnerships are subject to unlimited liability.

A corporation is a business that exists as a legal entity separate from the owners. The corporation can entercontracts, own property, and borrow money as if it were a person. The stockholders of the corporation own thecorporation. If the corporation declares bankruptcy, however, only the assets of the corporation are at risk. Theowners' personal assets are not at risk (their only loss would be the wealth used to acquire the stock). Thisresults in a situation in which the owners only have "limited liability." Offsetting this advantage is thatcorporate income is subject to double taxation. Any profits received by the corporation are subject to acorporate income tax before they are distributed as dividends to the stockholders. The dividends that are

received by stockholders are taxed once again as personal income for the owners.

As your text notes, most output in the U.S. is produced in relatively large firms. Corporations account for thelargest component of this output.

Multinational business has become increasingly important during the past several decades. Multinationalbusinesses are firms that own and operate production facilities in more than one country.

Chapter 5

The focus of this chapter is on the role of government in the economy. Markets do not always behave asefficiently as suggested in Chapter 4. When markets result in economic inefficiency, it may be possible forgovernment to correct for this market failure.

Government in the circular flow

Your text has an elaborate circular flow diagram (on p. 111) that adds government to the private sector flowsthat were discussed earlier. This diagram is a bit too complex to recreate here, so it may be helpful to refer tothe diagram in the text. As this diagram indicates, the government collects taxes from both households andfirms and provides government services in return.

To produce government services, the government buys resources from households and purchases goods andservices from firms. In return, the government provides resource payments to households and payments for thegoods and services it acquires from firms.

In terms of the injections and leakages that were discussed earlier, taxes represent a leakage from the circularflow of income while government spending represents an injection of purchasing power.

Economic and technical efficiency


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27Technical efficiency is said to occur when the economy operates on the production possibilitiescurve. In this case, there are no unemployed and no underemployed resources. Economic efficiency is a moregeneral concept that occurs when any change that benefits someone would result in harm for someone else.Note that technical efficiency is a necessary condition for economic efficiency since a movement toward theproduction possibilities curve would benefit one or more individuals.

When there are no market imperfections (several types of market imperfections will be discussed below),

markets result in a state of economic efficiency. This occurs because voluntary trade in a market economyalways benefits both parties to the transaction (as long as both parties have perfect information about the qualityof the commodity being exchanged). A seller is only willing to sell something if he or she receives more benefitfrom the monetary payment than from the continued possession of the item being sold. A buyer is only willingto buy something if he or she prefers the commodity to the alternative items that could be purchased with themonetary payment. Trade will take place in a market economy until all potential gains from trade are exhaustedand economic efficiency occurs.

Of course, however, this only occurs when there are no imperfections that interfere with the workings of this"ideal" market. There are several cases in which markets will not achieve economic efficiency. Market failuremay occur as the result of:

imperfect information, externalities, public goods, the absence of property rights, monopoly, or macroeconomic instability.

Imperfect information

The effect of imperfect information on economic efficiency should be fairly obvious. Buyers or sellers may not

gain from voluntary trade if they do not know the quality of the product being bought or sold. I suspect thateveryone has made at least one purchase that they regretted later. Government may correct for this type ofmarket failure by:

requiring that product labels list ingredients, mandating warning labels on products that may be dangerous, requiring guarantees for some products (such as the "lemon law" for used cars), banning fraudulent claims and requiring "truth in advertising," licensing workers in certain professions, and by providing public information about products.

Externalities

Externalities are side effects of production or consumption activities that affect parties not directly involved inthe transaction. Positive externalities occur when parties not involved in the transaction benefit from thetransaction. Negative externalities occur when third parties are harmed. If someone paints their house, shovelssnow from the sidewalk in front of their dwelling, receives a vaccine for a contagious diseases, or removes junkcars from their lawn, positive externalities occur. Negative externalities occur as a result of pollution, loudmusic played by neighbors (assuming that you do not enjoy their choice or timing of music), fills the air withcigarette or cigar smoke, or engages in other activities that harm others.


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28When positive externalities are present, those engaged in the transaction do not take into account the externalsocial benefits that result from their actions. As a result, the commodity or activity that generates the positiveexternality is under produced in a market economy. Government may correct for this by subsidizing the activityor issuing regulations or mandates that require a higher level of the activity. For example, the government bothsubsidizes education and mandates that individuals attend school through at least age 16. The government alsosubsidizes vaccines and mandates that all school-age children receive vaccines before being allowed to attendschool.

Negative externalities, on the other hand, result in social costs that are not taken into account by those engagedin the activity. In this case, markets will result in overproduction of the commodity or activity that generates theexternality. Government may attempt to correct for this by taxing the activity or by issuing regulations designedto reduce the level of the activity. Government sets limits, for example, on the level of emissions of manychemicals and compounds that may be released into the air and water. It also taxes cigarettes and imposesrestrictions on areas in which smoking is allowed.

The use of taxes or subsidies to correct for externalities is referred to as "internalizing the externality" since itinvolves altering the price of the commodity to reflect the external costs or benefits of the activity.

Public goods

A public good is a good that is nonrival in consumption. This means that one person's consumption does notreduce the quantity or quality of the good available to other consumers. Examples of public goods includenational defense and TV and radio signals broadcast through the air. Some public goods have some congestioncosts in which the benefits do decline a bit as the number of people consuming them rises. Town parks,highways, police and fire protection, and other similar commodities and services fit this definition.

The problem with public goods is that no individual has an incentive to pay for the good. Since it is inefficient,and not always feasible, to exclude people from consuming a public good, people can consume it even if theydo not pay for it at all. In such a situation, each person has an incentive to be a "free rider" and to let others pay

for the good. The problem, of course, is that the good will be either underproduced or not produced at all if theprovision of such goods were left to the market.

The government attempts to correct for this type of market failure by either providing or subsidizing theproduction of public goods.

The absence of property rights

A related problem occurs when no one has private property rights to a good. This problem occurs in the case ofcommon property resources in which no individual has private property rights. When everyone sharesownership of some resource, each individual receives all of the benefits from using the resource, but the costs

are shared by everyone. Consider, for example, the case of whales, buffalo, fisheries, and similar resources. Ineach case, the whaler, hunter, or fisherman receives property rights only after catching and killing the animal.Each person gets the full benefit from their activity, but the cost of a reduced breeding stock is shared byeveryone. If you are an individual fisherman fishing in an endangered fishery, you have no incentive to reduceyour individual harvest of fish because you know that if you do not catch an additional fish, someone elsemight. In such a situation, the resource is overutilized.

Governments deal with this problem by setting restrictions on consumption or by introducing property rightswhen feasible. When alligators were a common property resource in the U.S., they were hunted until they werethreatened with extinction. The introduction of "alligator farms" in which alligators were owned by individuals


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29eliminated the risk of extinction since individual alligator farmers face an incentive to maintain abreeding stock for subsequent year's harvests.

This "problem of the commons" (as it is also known) explains why public parks and highways often have morelitter than most individual's back yards, why bathrooms and commons rooms in dormitories are messier thanthose in private houses and apartments, and why many species of animals have been hunted to extinction orthreatened with extinction.

Monopoly

Adam Smith's "invisible hand of the market" works as a result of competition among self-interested sellers.When monopolies are present, prices will tend to be higher and output lower than would occur undercompetitive market conditions. Government may respond to this problem through antitrust enforcement, byregulating the monopoly, or by public production of the good or service.

Macroeconomic instability

The business cycle results in periodic stages of recession in which unemployment rates rise. This results in a

state of economic inefficiency that the government may attempt to remedy by implementing policies designedto ameliorate the business cycle. (This is a topic discussed in much more detail in an introductorymacroeconomics course.)

Public choice theory of government

The public choice theory of government suggests that government policy is made by self-interested individualswho are likely to work for their own interests rather than the "public interest." Advocates of the public choicetheory argue that special interest groups will engage in "rent-seeking behavior" that is designed to increase theirwealth at the expense of society as a whole. Many expenditures on lobbyists, political contributions, etc. do notresult in increases in output and may result in economic inefficiency if the lobbyists are successful inredistributing income to the groups that they represent.

Microeconomic and macroeconomic policy

The government engages in both microeconomic and macroeconomic policy. Microeconomic policy involvespolicies designed to correct for imperfect information, externalities, public goods, the absence of propertyrights, and monopolies. Macroeconomic policy is policy designed to enhance macroeconomic stability andencourage economic growth. Macroeconomic policy involves the use of fiscal and monetary policy. Fiscalpolicy involves changing government spending, taxes, and transfer payments. (Transfer payments are paymentsmade to individuals for which no good or service is provided in return. This category of spending includesunemployment compensation, social security payments, and welfare spending.) Monetary policy involves theuse of changes in the money supply to affect the level of economic activity.

A budget surplus exists if tax revenue exceeds the sum of government spending and transfer payments. If thesum of transfer payments and government spending exceeds tax revenue, a budget deficit exists.

Central planning

An alternative form of economic organization is provided in a centrally planned economy. In a centrallyplanned economy, the fundamental questions of what to produce, how output should be produced and for whom


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30should it be produced are answered (in theory) by a central planning board. With the collapse of the SovietUnion and market reforms in China, there are few economies that claim to engage in central planning today.

Chapter 6

The focus of Chapter 6 is on the concept ofelasticity, a measure of the responsiveness of either quantity

demanded or supplied to a change in some other variable.

Price elasticity of demand

The most commonly used elasticity measure is the price elasticity of demand, defined as:

price elasticity of demand (Ed) =

The price elasticity of demand is a measure of the sensitivity of quantity demanded to a change in the price of agood. Notice that the price elasticity of demand will always be expressed as a positive number (since the

absolute value of a negative number is always positive).

Demand is said to be:

elastic when Ed > 1, unit elastic when Ed = 1, and inelastic when Ed < 1.

When demand is elastic, a 1% increase in price will result in a greater than 1% reduction in quantity demanded.If demand is unit elastic, quantity demanded will fall by 1% when the price rises by 1%. A 1% price increasewill result in less than a 1% reduction in quantity demanded when demand is inelastic.

Suppose, for example, that we know that the price elasticity of demand for a particular good equals 2. In thiscase, we'd say that demand is elastic and would know that a 1% increase in price will cause quantity demandedto fall by 2%.

One extreme case is given by a perfectly elastic demand curve, as appears in the diagram below. Demand isperfectly elastic only in the special case of a horizontal demand curve. The elasticity measure in this case isinfinite (notice that the denominator of the elasticity measure equals zero). The closest we get to observing aperfectly elastic demand curve is the demand curve facing a firm that produces a very small share of the totalquantity produced in a market. In this case, the firms is such a small share of the market that it must take themarket price as given. An individual farmer, for example, has no control over the price that it receives when it

brings its product to market. Whether it supplies 100 or 20,000 bushels of wheat, the price that it received perbushel is that day's market price.


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31

At the other extreme, a vertical demand curve is said to be perfectly inelastic. Such a demand curve appears inthe diagram below. Note that the price elasticity of demand equals zero for a perfectly inelastic demand curvesince the % change in quantity demanded equals zero. In practice, we do not expect to see demand curves thatare perfectly inelastic. For some range of prices, the demand for insulin, dialysis, and other such medicaltreatments, is likely to be close to being perfectly inelastic. As the price for these commodities rises, however,we would eventually expect to see the quantity demanded fall because individuals have limited budgets.

Students considering elasticity for the first time often believe that demand is more elastic when the demandcurve is flat and less elastic when it is steep. Unfortunately, it is not quite as simple as that... In particular, if weconsider the case of any downward sloping linear demand curve, we will see that elasticity varies continuouslyalong this curve. It is true that a one-unit change in price always results in a constant change in quantitydemanded along a linear demand curve (since the slope is constant). The ratio of the percentage change inquantity demanded to the percentage change in price, however, changes continuously along such a curve.

To see why this occurs, it is necessary to consider the distinction between a change in the level of a variable andthe percentage change in the same variable. Suppose we consider the distinction by discussing the percentagechange that results from a $1 increase in the price of a good.

a price increase from $1 to $2 represents a 100% increase in price, a price increase from $2 to $3 represents a 50% increase in price, a price increase from $3 to $4 represents a 33% increase in price, and a price increase from $10 to $11 represents a 10% increase in price.

Notice that, even though the price increases by $1 in each case, the percentage change in price becomes smallerwhen the starting value is larger. Let's use this concept to explain why the price elasticity of demand variesalong a linear demand curve.


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32

Consider the change in price and quantity demanded that are illustrated below. At the top of the curve, thepercentage change in quantity is large (since the level of quantity is relatively low) while the percentage changein price is small (since the level of price is relatively high). Thus, demand will be relatively elastic at the top ofthe demand curve. At the bottom of the curve, the same change in quantity demanded is a small percentagechange (since the level of quantity is large) while the change in price is now a relatively large percentagechange (since the level of price is low). Thus, demand is relatively inelastic at the bottom of the demand curve.

More generally, we can note that elasticity declines continuously along a linear demand curve. The top portionof the demand curve will be highly elastic and the bottom is highly inelastic. In between, elasticity graduallybecomes smaller as price declines and quantity rises. At some point, demand changes from being elastic toinelastic. The point at which that occurs, of course, is the point at which demand is unit elastic. This relationshipis illustrated in the diagram below.

Arc elasticity measure

Suppose that we wish to measure the elasticity of demand in the interval between a price of $4 and a price of$5. In this case, if we start at $4 and increase to $5, price has increased by 25%. If we start at $5 and move to$4, however, price has fallen by 20%. Which percentage change should be used to represent a change between$4 and $5? To avoid ambiguity, the most common measure is to use a concept known as arc elasticity in which


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33the midpoint of the interval is used as the base value in computing elasticity. Under this approach, the priceelasticity formula becomes:

where:

Let's consider an example. Suppose that quantity demanded falls from 60 to 40 when the price rises from $3 to

$5. The arc elasticity measure is given by:

In this interval, demand is inelastic (since Ed < 1).

Elasticity and total revenue

The concept of price elasticity of demand is extensively used by firms that are investigating the effects of achange in the prices of their commodities. Total revenue is defined as:

total revenue = price x quantity

Suppose that a firm is facing a downward sloping demand curve for its product. How will it's revenue change ifit lowers its price?

The answer, it turns out, is somewhat ambiguous. When the price declines, quantity demanded by consumersrises. The lower price received for each unit of output lowers total revenue while the increase in the number ofunits sold raises total revenue. Total revenue will rise when the price falls if quantity rises by a large enoughpercentage to offset the reduction in price per unit. In particular, we can note that total revenue will increase ifquantity demanded rises by more than one percent when the price falls by one percent. Alternatively, totalrevenue will decline if quantity demanded rises by less than one percent when the price declines by one percent.If the price falls by one percent and quantity demanded falls by one percent, total revenue will remainunchanged (since the changes will offset each other). A careful observer will note that this comes down to aquestion of the magnitude of the price elasticity of demand. As defined above, this equals:


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34

price elasticity of demand (Ed) =

Using the logic discussed above, we can note that a reduction in price will lead to:

an increase in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and a decrease in total revenue when demand is inelastic.

In a similar manner, an increase in price will lead to:

a reduction in total revenue when demand is elastic, no change in total revenue when demand is unit elastic, and an increase in total revenue when demand is inelastic.

The diagram below illustrates the relationship that exists between total revenue and demand elasticity along alinear demand curve.

As this diagram illustrates, total revenue increases as quantity increases (and price decreases) in the region inwhich demand is unit elastic. Total revenue falls as quantity increases (and price decreases) in the inelasticportion of the demand curve. Total revenue is maximized at the point at which demand is unit elastic.

Does this mean that firms will choose to produce at the point at which demand is unit elastic? This would onlybe the case if they had no production costs. Firms are assumed to be concerned with maximizing their profits,not their revenue. The optimal level production can be determined only when we consider both revenue andcosts. This topic will be extensively addressed in future chapters.


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Price discrimination

Firms that have some control over their market price can sometimes use that control to enhance their profits bycharging different prices to different customers. In particular, a firm engaging in price discrimination increasesits profits by charging higher prices to those customers who have the most inelastic demand for the product andlower prices to those customers who have a more elastic demand. In essence, this strategy involves charging thehighest prices to those customers who are willing to buy the commodity at a high price and charging lower

prices to those customers who are more sensitive to price differentials.

A classic example of price discrimination occurs with airline fares. There are two general categories ofcustomers: those traveling on vacations and those traveling for business purposes. It is likely that the demandfor air travel by business travelers is less sensitive to price changes than is true for those on vacation. Airlinesare able to charge different prices to these two groups by offering a high base fare and a "super saver" fare thatrequires a weekend stay, the purchase of the tickets several weeks in advance, and similar restrictions. Sincethose traveling for vacation purposes are more likely to satisfy these requirements than business travelers,airlines accomplish the goal of charging higher prices to the business travelers with less elastic demand andlower prices to those customers with more elastic demand who are flying for vacation purposes.

The use of cents-off coupons in the Sunday newspapers is another example of price discrimination that offers alower price to those customers who have more elastic demands (since low-wage workers are more likely to besensitive to price changes and are more likely to use coupons).

Child and senior citizen discounts at restaurants and movie theaters are also examples of price discriminationthat result in lower prices being charged to those customers with the most elastic demand for the products.

Determinants of price elasticity of demand

The price elasticity of demand is likely to be relatively high when:

close substitutes are available, the good or service is a large share of the consumer's budget, and a longer time period is considered.

Let's consider each of these factors.

When there a large number of substitutes are available, consumers respond to a higher price of a good bybuying more of the substitute goods and less of the relatively more expensive commodity. Thus, we wouldexpect a relatively high price elasticity of demand for goods or services with many close substitutes, but wouldexpect a relatively inelastic demand for commodities such as insulin or AZT with few close substitutes.

If the good is a small share of a consumer's budget, a change in the price of the good will have little impact onthe individual's purchasing power. In this case, a price change will have relatively little impact on the quantityconsumed. A doubling of the price of salt, for example, would not have much of an impact on a typicalconsumer's budget. But, when a good is a relatively large share of a person's spending, a price increase has alarger effect on their purchasing power. To take an extreme example, suppose that a person spends 50% of hisor her income on a commodity and the price doubled. It's likely that the individual will substantially reducetheir spending in response to the higher price when spending on the good comprises a larger share of aconsumer's budget. Thus, demand will tend to be more elastic for goods that are a small share of a typicalconsumer's budget.


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36Consumers often have more possibilities for substitutes for a good when a longer time period isconsidered. Consider, for example, the effect of a higher price for fuel oil or natural gas. In the short run,individuals may lower the temperature and wear warmer clothes, but are unlikely to reduce their energyconsumption by very much. Over a longer time period, however, consumers may install more energy efficientfurnaces, better insulation, and more energy efficient windows and doors. Thus, we would expect that thedemand for either fuel oil or natural gas would be more elastic in the long run than in the short run.

Cross-price elasticity of demand

The cross-price elasticity of demand is a measure of the responsiveness of a change in the price of a good to achange in the price of some other good. The cross-price elasticity of demand between the goodsj and kcan beexpressed as:

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, the sign of

the cross-price elasticity of demand tells us about the nature of the relationship between the goods j and k. Apositive cross-price elasticity occurs if an increase in the price of good kis associated with an increase in thedemand for goodj. As noted earlier (in Chapter 3), this occurs if and only if these two goods are substitutes.

A negative cross-price elasticity of demand occurs when an increase in the price of good kis associated with adecline in the demand for goodj. This occurs if and only if goodsj and kare complements.

Thus, the cross-price elasticity of demand between two goods tells us whether the two goods are substitutes orcomplements. Estimates of the magnitude of the cross-price elasticity can be used by firms in making pricingand output decisions. McDonald's Corporation, for example, might want to know the cross-price elasticity ofdemand between it's chicken sandwiches and its Big Macs if it is considering the effect of a 20% decrease in the

price of its Big Macs. If the cross-price elasticity of demand is 0.5, then a 20% decrease in the price of its BigMac sandwiches would result in a 10% decrease in the number of chicken sandwiches sold. A -.9 cross-priceelasticity of demand between Big Macs and french fries, though, would indicate that a 20% decrease in the priceof Big Mac sandwiches would result in an 18% increase in the sale of french fries. This sort of informationwould be useful in determining what prices to charge and in planning for the impact of such a price change.

Income elasticity of demand

The income elasticity of demand is a measure of how sensitive demand for a good is to a change in income.Income elasticity of demand is measured as:

As in the case of cross-price elasticity, the sign of income elasticity of demand may be either positive ornegative. A positive value for the income elasticity occurs when an increase in income results in an increase inthe demand for a good. In this case, the good is said to be a normal good. In practice, most goods seem to benormal goods (and therefore have a positive income elasticity).

A good is said to be an inferior good if an increase in income results in a reduction in the quantity of the gooddemanded. An inspection of the definition of the income elasticity of demand should make it clear that an


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37inferior good will have a negative income elasticity. Generic foods, used cars, and similar commodities arelikely to be inferior goods for many consumers.

Another distinction that is commonly made (although not mentioned in your text at this point) is betweenluxuries and necessities. An increasing share of income is spent on luxury goods as income increases. Thismeans a 10% increase in income must be associated with a greater than 10% increase in spending on luxurygoods. Using the definition of income elasticity of demand, we can see that a luxury good must have an income

elasticity that is greater than one.

A smaller share of income is spent on necessities as income rises. This means that necessities have an incomeelasticity that is less than one.

Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is not immediatelyobvious, note that an income elasticity that is greater than one must necessarily be greater than zero while anincome elasticity that is less than zero must be less than one.) Normal goods may be either necessities orluxuries.

Price elasticity of supply

We can also apply the concept of elasticity to supply. The price elasticity of supply is defined as:

Note that the absolute value sign is not used when measuring the price elasticity of supply since we do notexpect to observe a downward sloping supply curve.

A perfectly inelastic supply curve is vertical (as in the diagram below). The price elasticity of supply is zero

when supply is perfectly inelastic. While your text suggests that the supply of Monet paintings is perfectlyinelastic, this in not entirely correct. If someone offers $.50 for a Monet painting, how many paintings are likelyto be offered for sale? What is meant in the text is that, for prices above a particular threshold, the supply curvebecomes perfectly inelastic for some goods for which only a finite quantity is available. This is also true forhighly perishable commodities that must be sold on the day they are brought to market. A fisherman with nostorage facilities, for example, must sell all of the fish caught at the end of a given day at whatever price can bereceived.

A perfectly elastic supply curve is horizontal (as illustrated in the diagram below). The supply curve facing asingle buyer in a market in which there are a very large number of buyers and sellers is likely to appear to be


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38perfectly elastic (or close to this, anyway). This will occur when each buyer is a "price-taker" who has noeffect on the market price.

Economists classify time in terms of the "short run" and the "long run." The short run is defined as the periodof time in which capital is fixed. All inputs are variable in the long run. Notice that the length of the short run

and long run will vary from industry to industry. In the lawnmowing industry, the long run may be as short asthe few hours that may be required to buy an additional lawn mower. In the automotive manufacturing industry,the short run may last for several years (since it takes a long time to design and build new capital in thisindustry).

It is expected that supply will be more elastic in the long run than in the short run since firms can expand orcontract their capital in the long run. In the short run, an increase in the price of personal computers may resultin increased employment, more overtime, and additional shifts in computer factories. In the long run, though,higher prices will lead to a larger expansion in output as new factories are built.

Tax incidence

As your text notes, the distribution of the burden of a tax depends on the elasticities of demand and supply.When supply is more elastic than demand, consumers bear a larger share of the tax burden. Producers bear alarger share of the burden of a tax when demand is more elastic than supply.

Chapter 7

This chapter provides a more detailed examination of the theory of consumer choice. The theory of demand isderived from this theory of choice.

Utility

The economic theory of choice is based on the concept of utility. Utility is defined as the level of happiness orsatisfaction associated with alternative choices. Economists assume that when individuals are faced with achoice of feasible alternatives, they will always select the alternative that provides the highest level of utility.

Total and marginal utility

The total utility associated with a good is the level of happiness derived from consuming the good. Marginalutility is a measure of the additional utility that is received when an additional unit of the good is consumed.


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39The table below illustrates the relationship that exists between total and marginal utility associated with anindividual's consumption of pizza (in a given time period).

# of slices Total utility Marginal utility

0 0 -

1 70 70

2 110 40

3 130 20

4 140 10

5 145 5

6 140 -5

As the table above indicates, the marginal utility associated with an additional slice of pizza is just the change inthe level of total utility that occurs when one more slice of pizza is consumed. Note, for example, that themarginal utility of the third slice of pizza is 20 since total utility increases by 20 units (from 110 to 130) whenthe third slice of pizza is consumed. More generally, marginal utility can be defined as:

The table above also illustrates a phenomena known as the law of diminishing marginal utility. This law statesthat marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus.In the example above, the marginal utility of additional slices of pizza declines as more pizza is consumed (inthis time period). In this example, the marginal utility of pizza consumption becomes negative when the 6thslice of pizza is consumed. Note, though, that even though the marginal utility from pizza consumptiondeclines, total utility still increases as long as marginal utility is positive. Total utility will decline only if

marginal utility is negative. This law of diminishing marginal utility is believed to occur for virtually allcommodities. A bit of introspection should confirm the general applicability of this principle.

Diamond-water paradox

In The Wealth of Nations (1776), Adam Smith attempted to formulate a theory of value that explained whydifferent commodities had different market values. In this attempt, however, he encountered a problem that hascome to be called the "diamond-water" paradox. The paradox occurs because water is essential for life and has alow market price (often a price of zero) while diamonds are not as essential yet have a very high market price.To resolve this issue, Smith proposed two concepts of value: value in use and value in exchange. Diamondshave a low value in use but a high value in exchange while water has a high value is use but a low value in

exchange. Smith argued that economists could explain the exchange value of a commodity by the amount oflabor required to produce the commodity. (This "labor theory of value" later served as the basis for much ofMarx's critique of capitalism.) Smith did not propose a theory to explain the use value of a commodity.

Marginal analysis, however, allows us to explain both value in use and value in exchange. The diagram belowcontains marginal utility curves for both diamonds and water. Because individuals consume a large volume ofwater, the marginal utility of an additional unit of water is relatively low. Since few diamonds are consumed,the marginal utility of an additional diamond is relatively high.


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40

Total utility can be derived by adding up the marginal utilities associated with each unit of the good. A bit ofreflection should convince you that total utility can be measured by the area under the marginal utility curve.The shaded areas in the diagram below provide a measure of the total utility associated with the consumption ofwater and diamonds. Note that the total utility from water is very high (since a large volume of water is

consumed) while the total utility received from diamonds is relatively low (because few diamonds areconsumed).

These concepts of total and marginal utility can be used to resolve Adam Smith's diamond-water paradox.When Adam Smith was referring to "value in use," he was actually referring to the concept of total utility.Exchange value, on the other hand, is tied to how much someone is willing to pay for an additional unit of thecommodity. Because diamonds are expensive, individuals consume few diamonds and the marginal utility of anadditional diamond is relatively high. Since water is not very costly to acquire, people consume more water. At

this high level of consumption, the marginal utility of an additional unit of water is relatively low. The price thatsomeone is willing to pay for an additional unit of a good is related to its marginal utility. Because the marginalutility of an additional diamond is higher than the marginal utility associated with an additional glass of water,diamonds have a higher value in exchange.

Consumer equilibrium

How can the concept of marginal utility be used to explain consumer choice? As noted above, economistsassume that when an individual is faced with a choice among feasible alternatives, he or she will select thealternative that provides the highest level of utility. Suppose that an individual has a given income that can be


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41spent on alternative combinations of goods and services. A utility maximizing consumer will selectthe bundle of goods at which the following two conditions are satisfied:

1. MUA/PA = MUB/PB = ... = MUZ/PZ, for all commodities (A-Z), and2. all income is spent.

The first of these conditions requires that the marginal utility per dollar of spending be equated for all

commodities. To see why this condition must be satisfied, suppose that the condition is violated. In particular,let's assume that the marginal utility resulting from the last dollar spent on good X equals 10 while the marginalutility received from the last dollar spent on good Y equals 5. Since an additional

lectuer notes

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