经济学原理：曼昆经济学原理

Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Lecture Presentation in PowerPoint to Accompany Principles of Economics Second Edition by N. Gregory Mankiw Prepared by Mark P. Karscig, Department of Economics & Finance, Central Missouri State University. Ten Principles of Economics Chapter 1 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economy. . . . . . The word economy comes from a Greek word for “one who manages a household.” Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A household and an economy face many decisions: ?Who will work? ?What goods and how many of them should be produced? ?What resources should be used in production? ?At what price should the goods be sold? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Society and Scarce Resources: The management of society’s resources is important because resources are scarce. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Scarcity . . . . . . means that society has limited resources and therefore cannot produce all the goods and services people wish to have. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economics Economics is the study of how society manages its scarce resources. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economists study. . . ?How people make decisions. ?How people interact with each other. ?The forces and trends that affect the economy as a whole. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ten Principles of Economics How People Make Decisions 1. People face tradeoffs. 2. The cost of something is what you give up to get it. 3. Rational people think at the margin. 4. People respond to incentives. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ten Principles of Economics How People Interact 5. Trade can make everyone better off. 6. Markets are usually a good way to organize economic activity. 7. Governments can sometimes improve economic outcomes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ten Principles of Economics How the Economy as a Whole Works 8. The standard of living depends on a country’s production. 9. Prices rise when the government prints too much money. 10. Society faces a short-run tradeoff between inflation and unemployment. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 1. People face tradeoffs. “There is no such thing as a free lunch!” Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 1. People face tradeoffs. To get one thing, we usually have to give up another thing. ? Guns v. butter ? Food v. clothing ? Leisure time v. work ? Efficiency v. equity Making decisions requires trading off one goal against another. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 1. People face tradeoffs. Efficiency v. Equity ?Efficiency means society gets the most that it can from its scarce resources. ?Equity means the benefits of those resources are distributed fairly among the members of society. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 2. The cost of something is what you give up to get it. Decisions require comparing costs and benefits of alternatives. ? Whether to go to college or to work? ? Whether to study or go out on a date? ? Whether to go to class or sleep in? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 2. The cost of something is what you give up to get it. The opportunity cost of an item is what you give up to obtain that item. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 3. Rational people think at the margin. Marginal changes are small, incremental adjustments to an existing plan of action. People make decisions by comparing costs and benefits at the margin. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 4. People respond to incentives. ?Marginal changes in costs or benefits motivate people to respond. ?The decision to choose one alternative over another occurs when that alternative’s marginal benefits exceed its marginal costs! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 4. People respond to incentives. LA Laker basketball star Kobe Bryant chose to skip college and go straight to the NBA from high school when offered a $10 million contract. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 5. Trade can make everyone better off. ?People gain from their ability to trade with one another. ?Competition results in gains from trading. ?Trade allows people to specialize in what they do best. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 6. Markets are usually a good way to organize economic activity. ?In a market economy, households decide what to buy and who to work for. ?Firms decide who to hire and what to produce. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 6. Markets are usually a good way to organize economic activity. Adam Smith made the observation that households and firms interacting in markets act as if guided by an “invisible hand.” Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 6. Markets are usually a good way to organize economic activity. ?Because households and firms look at prices when deciding what to buy and sell, they unknowingly take into account the social costs of their actions. ?As a result, prices guide decision makers to reach outcomes that tend to maximize the welfare of society as a whole. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 7. Governments can sometimes improve market outcomes. When the market fails (breaks down) government can intervene to promote efficiency and equity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 7. Governments can sometimes improve market outcomes. Market failure occurs when the market fails to allocate resources efficiently. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 7. Governments can sometimes improve market outcomes. Market failure may be caused by an externality, which is the impact of one person or firm’s actions on the well-being of a bystander. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 7. Governments can sometimes improve market outcomes. Market failure may also be caused by market power, which is the ability of a single person or firm to unduly influence market prices. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 8. The standard of living depends on a country’s production. Standard of living may be measured in different ways: ?By comparing personal incomes. ?By comparing the total market value of a nation’s production. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 8. The standard of living depends on a country’s production. Almost all variations in living standards are explained by differences in countries’ productivities. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 8. The standard of living depends on a country’s production. Productivity is the amount of goods and services produced from each hour of a worker’s time. Higher productivity ? Higher standard of living Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 9. Prices rise when the government prints too much money. Inflation is an increase in the overall level of prices in the economy. ? One cause of inflation is the growth in the quantity of money. ? When the government creates large quantities of money, the value of the money falls. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 10. Society faces a short-run tradeoff between inflation and unemployment. The Phillips Curve illustrates the tradeoff between inflation and unemployment: ?Inflation ?×Unemployment It’s a short-run tradeoff! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?When individuals make decisions, they face tradeoffs. ?Rational people make decisions by comparing marginal costs and marginal benefits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?People can benefit by trading with each other. ?Markets are usually a good way of coordinating trades. ?Government can potentially improve market outcomes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A country’s productivity determines its living standards. ?Society faces a short-run tradeoff between inflation and unemployment. Thinking Like an Economist Chapter 2 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Every field of study has its own terminology Mathematics axioms integrals vector spaces Psychology ego id cognitive dissonance Law torts venues Promissory estoppel Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Every field of study has its own terminology Economics Opportunity cost Elasticity Supply Consumer Surplus Comparative advantage Deadweight loss Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economics trains you to. . . . ?Think in terms of alternatives. ?Evaluate the cost of individual and social choices. ?Examine and understand how certain events and issues are related. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Economist as a Scientist The economic way of thinking . . . ?Involves thinking analytically and objectively. ?Makes use of the scientific method. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Scientific Method ?Uses abstract models to help explain how a complex, real world operates. ?Develops theories, collects, and analyzes data to prove the theories. Observation, Theory and More Observation! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Role of Assumptions ? Economists make assumptions in order to make the world easier to understand. ? The art in scientific thinking is deciding which assumptions to make. ? Economists use different assumptions to answer different questions. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Economic Way of Thinking ?Includes developing abstract models from theories and the analysis of the models. ?Uses two approaches: ?Descriptive (reporting facts, etc.) ?Analytical (abstract reasoning) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Models ? Economists use models to simplify reality in order to improve our understanding of the world ? Two of the most basic economic models include: ?The Circular Flow Model ?The Production Possibilities Frontier Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Model The circular-flow model is a simple way to visually show the economic transactions that occur between households and firms in the economy. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Diagram Firms Households Market for Factors of Production Market for Goods and Services SpendingRevenue Wages, rent, and profit Income Goods & Services sold Goods & Services bought Labor, land, and capital Inputs for production Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Diagram Firms ? Produce and sell goods and services ? Hire and use factors of production Households ? Buy and consume goods and services ? Own and sell factors of production Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Diagram Markets for Goods & Services ? Firms sell ? Households buy Markets for Factors of Production ? Households sell ? Firms buy Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Diagram Factors of Production ? Inputs used to produce goods and services ? Land, labor, and capital Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier The production possibilities frontier is a graph showing the various combinations of output that the economy can possibly produce given the available factors of production and technology. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3,000 0 1,000 2,000 700 1,000 300 A B 2,200 600 C D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3,000 1,000 2,000 2,200 A 7006003000 1,000 B C D Production possibilities frontier Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Concepts Illustrated by the Production Possibilities Frontier ?Efficiency ?Tradeoffs ?Opportunity Cost ?Economic Growth Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 4,000 The Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3,000 2,000 A 700 0 1,000 E 2,100 750 An outward shift in the production possibilities frontier Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Microeconomics and Macroeconomics ?Microeconomics focuses on the individual parts of the economy. ? How households and firms make decisions and how they interact in specific markets ?Macroeconomics looks at the economy as a whole. ? How the markets, as a whole, interact at the national level. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Two Roles of Economists ?When they are trying to explain the world, they are scientists. ?When they are trying to change the world, they are policymakers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive versus Normative Analysis ?Positive statements are statements that describe the world as it is. ?Called descriptive analysis ?Normative statements are statements about how the world should be. ?Called prescriptive analysis Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive or Normative Statements? ? An increase in the minimum wage will cause a decrease in employment among the least-skilled. ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive or Normative Statements? ? Higher federal budget deficits will cause interest rates to increase. ? ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. ?? Positive or Normative Statements? The income gains from a higher minimum wage are worth more than any slight reductions in employment. ? ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. ? ? Positive or Normative Statements? State governments should be allowed to collect from tobacco companies the costs of treating smoking-related illnesses among the poor. ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economists in Washington . . . . . . serve as advisers in the policymaking process of the three branches of government: ? Legislative ? Executive ? Judicial Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why Economists Disagree ?They may disagree on theories about how the world works. ?They may hold different values and, thus, different normative views. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Examples of What Most Economists Agree On ?A ceiling on rents reduces the quantity and quality of housing available. ?Tariffs and import quotas usually reduce general economic welfare. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?In order to address subjects with objectivity, economics makes use of the scientific method. ?The field of economics is divided into two subfields: microeconomics and macroeconomics. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Economics relies on both positive and normative analysis. Positive statements assert how the world “is” while normative statements assert how the world “should be.” ?Economists may offer conflicting advice due to differences in scientific judgments or to differences in values. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Circular-Flow Diagram Firms Households Market for Factors of Production Market for Goods and Services SpendingRevenue Wages, rent, and profit Income Labor, land, and capital Inputs for production Goods & Services sold Goods & Services bought Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3,000 0 1,000 2,000 700 1,000 300 A B 2,200 600 C D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier Quantity of Computers Produced Quantity of Cars Produced 3,000 1,000 2,000 2,200 A 7006003000 1,000 B C D Production possibilities frontier Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Possibilities Frontier 4,000 Quantity of Computers Produced Quantity of Cars Produced 3,000 2,000 A 700 0 1,000 E 2,100 750 An outward shift in the production possibilities frontier Interdependence and the Gains from Trade Chapter 3 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Interdependence and Trade Consider your typical day: ?You wake up to an alarm clock made in Korea. ?You pour yourself some orange juice made from oranges grown in Florida. ?You put on some clothes made of cotton grown in Georgia and sewn in factories in Thailand. ?You watch the morning news broadcast from New York on your TV made in Japan. ?You drive to class in a car made of parts manufactured in a half-dozen different countries. …and you haven’t been up for more than two hours yet! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Interdependence and Trade Remember, economics is the study of how societies produce and distribute goods in an attempt to satisfy the wants and needs of its members. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How do we satisfy our wants and needs in a global economy? ?We can be economically self- sufficient. ?We can specialize and trade with others, leading to economic interdependence. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Interdependence and Trade A general observation . . . Individuals and nations rely on specialized production and exchange as a way to address problems caused by scarcity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Interdependence and Trade But, this gives rise to two questions: ?Why is interdependence the norm? ?What determines production and trade? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why is interdependence the norm? Interdependence occurs because people are better off when they specialize and trade with others. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What determines the pattern of production and trade? Patterns of production and trade are based upon differences in opportunity costs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Parable for the Modern Economy ? Imagine . . . … only two goods: potatoes and meat … only two people: a potato farmer and a cattle rancher ? What should each produce? ? Why should they trade? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Opportunities of the Farmer and the Rancher Hours Needed to Make 1 lb. of: Amount Produced in 40 Hours Meat Potatoes Meat Potatoes Farmer 20 hours/lb 10 hours/lb 2 lbs. 4 lbs. Rancher 1 hours/lb 8 hours/lb. 40 lbs. 5 lbs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Self-Sufficiency By ignoring each other: ? Each consumes what they each produce. ? The production possibilities frontier is also the consumption possibilities frontier. Without trade, economic gains are diminished. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Production Possibilities Frontiers Meat (pounds) (a) The Farmer’s Production Possibilities Frontier 2 1 2 A 0 4 Potatoes (pounds) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) 5 40 20 2.5 (b) The Rancher’s Production Possibilities Frontier 0 B Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Farmer and the Rancher Specialize and Trade Each would be better off if they specialized in producing the product they are more suited to produce, and then trade with each other. ? The farmer should produce potatoes. ? The rancher should produce meat. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Gains from Trade: A Summary The Outcome Without Trade: What They Produce and Consume Farmer 1 lb meat (A) 2 lbs potatoes Rancher 20 lbs meat (B) 2.5 lbs potatoes Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Gains from Trade: A Summary The Outcome With Trade: What They Produce What They Trade What They Consume Farmer 0 lbs meat 4 lbs potatoes Gets 3 lbs meat for 1 lb potatoes 3 lbs meat (A*) 3 lbs potatoes Rancher 24 lbs meat 2 lbs potatoes Gives 3 lbs meat for 1 lb potatoes 21 lbs meat (B*) 3 lbs potatoes Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities (a) How Trade Increases the Farmer’s Consumption Meat (pounds) Potatoes (pounds) 42 2 1 0 A 3 3 A* Farmer’s consumption without trade Farmer’s consumption with trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) 52.5 40 20 (b) How Trade Increases The Rancher’s Consumption 0 B 21 3 B* Rancher’s consumption without trade Rancher’s consumption with trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Gains from Trade: A Summary The Gains From Trade: The Increase in Consumption Farmer 2 lbs meat (A*- A) 1 lb potatoes Rancher 1 lb meat (B*- B) 1/2 lb potatoes Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Principle of Comparative Advantage Differences in the costs of production determine the following: ? Who should produce what? ? How much should be traded for each product? Who can produce potatoes at a lower cost--the farmer or the rancher? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Differences in Costs of Production Two ways to measure differences in costs of production: ? The number of hours required to produce a unit of output. (for example, one pound of potatoes) ? The opportunity cost of sacrificing one good for another. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Absolute Advantage ?Describes the productivity of one person, firm, or nation compared to that of another. ?The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Comparative Advantage ?Compares producers of a good according to their opportunity cost. ?The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Specialization and Trade ?Who has the absolute advantage? The farmer or the rancher? ?Who has the comparative advantage? The farmer or the rancher? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Absolute Advantage ?The Rancher needs only 8 hours to produce a pound of potatoes, whereas the Farmer needs 10 hours. ?The Rancher needs only 1 hour to produce a pound of meat, whereas the Farmer needs 20 hours. The Rancher has an absolute advantage in the production of both meat and potatoes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Opportunity Cost of Meat and Potatoes Opportunity Cost of: 1 lb of Meat 1 lb of Potatoes Farmer 2 lb potatoes ? lb meat Rancher 1/8 lb potatoes 8 lb meat Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Comparative Advantage ?The Rancher’s opportunity cost of a pound of potatoes is 8 pounds of meat, whereas the Farmer’s opportunity cost of a pound of potatoes is 1/2 pound of meat. ?The Rancher’s opportunity cost of a pound of meat is only 1/8 pound of potatoes, while the Farmer’s opportunity cost of a pound of meat is 2 pounds of potatoes... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Comparative Advantage …so, the Rancher has a comparative advantage in the production of meat but the Farmer has a comparative advantage in the production of potatoes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Principle of Comparative Advantage ?Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. ?Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Benefits of Trade Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Adam Smith and Trade In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. David Ricardo and Trade In his 1816 book Principles of Political Economy and Taxation, David Ricardo developed the principle of comparative advantage as we know it today. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Should Tiger Woods Mow His Own Lawn? ? ?? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Interdependence and trade allow people to enjoy a greater quantity and variety of goods and services. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The person who can produce a good with a smaller quantity of inputs has an absolute advantage. ?The person with a smaller opportunity cost has a comparative advantage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The gains from trade are based on comparative advantage, not absolute advantage. ?Comparative advantage applies to countries as well as to people. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) 4 2 1 2 (a) The Farmer’s Production Possibilities Frontier 0 A Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Production Possibilities Frontiers Potatoes (pounds) Meat (pounds) 5 40 20 2.5 (b) The Rancher’s Production Possibilities Frontier 0 B Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) 42 2 1 (a) How Trade Increases the Farmer’s Consumption 0 A 3 3 A* Farmer’s consumption without trade Farmer’s consumption with trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Trade Expands the Set of Consumption Possibilities Potatoes (pounds) Meat (pounds) 52.5 40 20 (b) How Trade Increases The Rancher’s Consumption 0 B 21 3 B* Rancher’s consumption without trade Rancher’s consumption with trade The Market Forces of Supply and Demand Chapter 4 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market Forces of Supply and Demand ?Supply and demand are the two words that economists use most often. ?Supply and demand are the forces that make market economies work. ?Modern microeconomics is about supply, demand, and market equilibrium. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markets ?A market is a group of buyers and sellers of a particular good or service. ?The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markets ? Buyers determine demand. ? Sellers determine supply. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Type: A Competitive Market A competitive market is a market. . . … with many buyers and sellers. … that is not controlled by any one person. … in which a narrow range of prices are established that buyers and sellers act upon. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition: Perfect and Otherwise Perfect Competition ?Products are the same ?Numerous buyers and sellers so that each has no influence over price ?Buyers and Sellers are price takers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition: Perfect and Otherwise ?Monopoly ?One seller, and seller controls price ?Oligopoly ?Few sellers ?Not always aggressive competition Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition: Perfect and Otherwise ?Monopolistic Competition ?Many sellers ?Slightly differentiated products ?Each seller may set price for its own product Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Quantity demanded is the amount of a good that buyers are willing and able to purchase. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Law of Demand The law of demand states that there is an inverse relationship between price and quantity demanded. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Schedule The demand schedule is a table that shows the relationship between the price of the good and the quantity demanded. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Schedule Price Quantity $0.00 12 0.50 10 1.00 8 1.50 6 2.00 4 2.50 2 3.00 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Demand ?Market price ?Consumer income ?Prices of related goods ?Tastes ?Expectations Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Curve The demand curve is the downward- sloping line relating price to quantity demanded. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Curve $3.00 2.50 2.00 1.50 1.00 0.50 21 345678910 1211 Price of Ice-Cream Cone 0 Price Quantity $0.00 12 0.50 10 1.00 8 1.50 6 2.00 4 2.50 2 3.00 0 Quantity of Ice-Cream Cones Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ceteris Paribus Ceteris paribus is a Latin phrase that means all variables other than the ones being studied are assumed to be constant. Literally, ceteris paribus means “other things being equal.” The demand curve slopes downward because, ceteris paribus, lower prices imply a greater quantity demanded! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Demand ?Market demand refers to the sum of all individual demands for a particular good or service. ?Graphically, individual demand curves are summed horizontally to obtain the market demand curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Demand ?Market price ?Consumer income ?Prices of related goods ?Tastes ?Expectations Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Demanded versus Change in Demand Change in Quantity Demanded ?Movement along the demand curve. ?Caused by a change in the price of the product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Quantity Demanded Price of Cigarettes per Pack D 1 0 Number of Cigarettes Smoked per Day A tax that raises the price of cigarettes results in a movement along the demand curve. A C 20 2.00 $4.00 12 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Demanded versus Change in Demand Change in Demand ?A shift in the demand curve, either to the left or right. ?Caused by a change in a determinant other than the price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Demand Price of Ice-Cream Cone 0 D 1 Quantity of Ice-Cream Cones D 3 Increase in demand Decrease in demand D 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Income ?As income increases the demand for a normal good will increase. ?As income increases the demand for an inferior good will decrease. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Income Normal Good $3.00 2.50 2.00 1.50 1.00 0.50 21 345678910 1211 Price of Ice-Cream Cone Quantity of Ice-Cream Cones Increase in demand An increase in income... D 1 D 2 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Income Inferior Good $3.00 2.50 2.00 1.50 1.00 0.50 21 345678910 1211 Price of Ice-Cream Cone Quantity of Ice-Cream Cones 0 Decrease in demand An increase in income... D 1 D 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Prices of Related Goods Substitutes & Complements ?When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. ?When a fall in the price of one good increases the demand for another good, the two goods are called complements. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Demanded versus Change in Demand Variables that Affect Quantity Demanded A Change in This Variable . . . Price Represents a movement along the demand curve Income Shifts the demand curve Prices of related goods Shifts the demand curve Tastes Shifts the demand curve Expectations Shifts the demand curve Number of buyers Shifts the demand curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Quantity supplied is the amount of a good that sellers are willing and able to sell. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Law of Supply The law of supply states that there is a direct (positive) relationship between price and quantity supplied. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Supply ?Market price ?Input prices ?Technology ?Expectations ?Number of producers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Schedule The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Schedule Price Quantity $0.00 0 0.50 0 1.00 1 1.50 2 2.00 3 2.50 4 3.00 5 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Curve The supply curve is the upward- sloping line relating price to quantity supplied. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Curve $3.00 2.50 2.00 1.50 1.00 0.50 21 34567891011 Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Price Quantity $0.00 0 0.50 0 1.00 1 1.50 2 2.00 3 2.50 4 3.00 5 12 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Supply ?Market supply refers to the sum of all individual supplies for all sellers of a particular good or service. ?Graphically, individual supply curves are summed horizontally to obtain the market supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Supply ?Market price ?Input prices ?Technology ?Expectations ?Number of producers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Supplied versus Change in Supply Change in Quantity Supplied ?Movement along the supply curve. ?Caused by a change in the market price of the product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Supplied 150 Price of Ice-Cream Cone S 1.00 Quantity of Ice-Cream Cones A C $3.00 A rise in the price of ice cream cones results in a movement along the supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Supplied versus Change in Supply Change in Supply ?A shift in the supply curve, either to the left or right. ?Caused by a change in a determinant other than price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Supply Price of Ice-Cream Cone Quantity of Ice-Cream Cones 0 S 1 S 2 S 3 Increase in Supply Decrease in Supply Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Change in Quantity Supplied versus Change in Supply Variables that Affect Quantity Supplied A Change in This Variable . . . Price Represents a movement along the supply curve Input prices Shifts the supply curve Technology Shifts the supply curve Expectations Shifts the supply curve Number of sellers Shifts the supply curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply and Demand Together Equilibrium Price ?The price that balances supply and demand. On a graph, it is the price at which the supply and demand curves intersect. Equilibrium Quantity ?The quantity that balances supply and demand. On a graph it is the quantity at which the supply and demand curves intersect. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply and Demand Together Demand Schedule Supply Schedule Price Quantity $0.00 0 0.50 0 1.00 1 1.50 4 2.00 7 2.50 10 3.00 13 Price Quantity $0.00 19 0.50 16 1.00 13 1.50 10 2.00 7 2.50 4 3.00 1 At $2.00, the quantity demanded is equal to the quantity supplied! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium of Supply and Demand Supply Demand Price of Ice-Cream Cone $3.00 Quanti Ice-Cream Cones 21 345678910 12110 2.50 2.00 1.50 1.00 0.50 ty of Equilibrium Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Supply Price of Ice-Cream Cone 21 345678910 12110 Quantity of Ice-Cream Cones Supply Demand Surplus $3.00 2.50 2.00 1.50 1.00 0.50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Surplus When the price is above the equilibrium price, the quantity supplied exceeds the quantity demanded. There is excess supply or a surplus. Suppliers will lower the price to increase sales, thereby moving toward equilibrium. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Demand Quantity of Ice-Cream Cones Price of Ice-Cream Cone $2.00 0123 4 5 6 7 8 9 10111213 Supply Demand $1.50 Shortage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Shortage When the price is below the equilibrium price, the quantity demanded exceeds the quantity supplied. There is excess demand or a shortage. Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward equilibrium. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Three Steps To Analyzing Changes in Equilibrium ?Decide whether the event shifts the supply or demand curve (or both). ?Decide whether the curve(s) shift(s) to the left or to the right. ?Examine how the shift affects equilibrium price and quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 7 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... D 2 2. ...resulting in a higher price... $2.50 10 3. ...and a higher quantity sold. New equilibrium Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Shifts in Curves versus Movements along Curves ?A shift in the supply curve is called a change in supply. ?A movement along a fixed supply curve is called a change in quantity supplied. ?A shift in the demand curve is called a change in demand. ?A movement along a fixed demand curve is called a change in quantity demanded. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium S 2 Price of Ice-Cream Cone 2.00 0 1 2 3 4 7 8 9 11 12 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... New equilibrium 2. ...resulting in a higher price... $2.50 3. ...and a lower quantity sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What Happens to Price and Quantity When Supply or Demand Shifts? No Change In Supply An Increase In Supply A Decrease In Supply No Change In Demand P same Q same P down Q up P up Q down An Increase In Demand P up Q up P ambiguous Q up P up Q ambiguous A Decrease In Demand P down Q down P down Q ambiguous P ambiguous Q down Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Economists use the model of supply and demand to analyze competitive markets. ?The demand curve shows how the quantity of a good depends upon the price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?According to the law of demand, as the price of a good rises, the quantity demanded falls. ?In addition to price, other determinants of quantity demanded include income, tastes, expectations, and the prices of complements and substitutes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The supply curve shows how the quantity of a good supplied depends upon the price. ?According to the law of supply, as the price of a good rises, the quantity supplied rises. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?In addition to price, other determinants of quantity supplied include input prices, technology, and expectations. ?Market equilibrium is determined by the intersection of the supply and demand curves. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Supply and demand together determine the prices of the economy’s goods and services. ?In market economies, prices are the signals that guide the allocation of resources. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... D 2 New equilibrium $2.50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... D 2 New equilibrium 2. ...resulting in a higher price... $2.50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... D 2 New equilibrium 2. ...resulting in a higher price... $2.50 3. ...and a higher quantity sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 710 Quantity of Ice-Cream Cones Supply Initial equilibrium D 1 1. Hot weather increases the demand for ice cream... D 2 New equilibrium 2. ...resulting in a higher price... $2.50 3. ...and a higher quantity sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 123456789 1112 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 123456789 1112 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 123456789 1112 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 123456789 1112 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... New equilibrium $2.50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 123456789 1112 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... New equilibrium $2.50 2. ...resulting in a higher price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone 2.00 0 1 2 3 4 7 8 9 11 12 Quantity of Ice-Cream Cones 13 Demand Initial equilibrium S 1 10 1. An earthquake reduces the supply of ice cream... New equilibrium $2.50 2. ...resulting in a higher price... 3. ...and a lower quantity sold. Elasticity and Its Application Chapter 5 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity . . . ? … is a measure of how much buyers and sellers respond to changes in market conditions ? … allows us to analyze supply and demand with greater precision. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Elasticity of Demand ?Price elasticity of demand is the percentage change in quantity demanded given a percent change in the price. ?It is a measure of how much the quantity demanded of a good responds to a change in the price of that good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Price Elasticity of Demand ?Necessities versus Luxuries ?Availability of Close Substitutes ?Definition of the Market ?Time Horizon Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Price Elasticity of Demand Demand tends to be more elastic : ?if the good is a luxury. ?the longer the time period. ?the larger the number of close substitutes. ?the more narrowly defined the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand The price elasticity of demand is computed as the percentage change in the quantity demanded divided by the percentage change in price. Price Elasticity of Demand = Percentage Change in Quantity Demanded Percentage Change in Price ce El mand Percen ge Change tity Dema Percen ge Change Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand price inchange Percentage demandedquatity inchange Percentage demand of elasticityPrice = Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones then your elasticity of demand would be calculated as: 2 percent10 percent20 100 002 002202 100 10 810 == × ? × ? . )..( )( Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand Using the Midpoint Formula The midpoint formula is preferable when calculating the price elasticity of demand because it gives the same answer regardless of the direction of the change. )/2]P)/[(PP(P )/2]Q)/[(QQ(Q =Demand of Elasticity Price 1212 1212 +? +? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand )/2]P)/[(PP(P )/2]Q)/[(QQ(Q =Demand of Elasticity Price 1212 1212 +? +? Example: If the price of an ice cream cone increases from $2.00 to $2.20 and the amount you buy falls from 10 to 8 cones the your elasticity of demand, using the midpoint formula, would be calculated as: 32.2 5.9 22 2/)20.200.2( )00.220.2( 2/)810( )810( == + ? + ? percent percent Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ranges of Elasticity Inelastic Demand ?Quantity demanded does not respond strongly to price changes. ?Price elasticity of demand is less than one. Elastic Demand ?Quantity demanded responds strongly to changes in price. ?Price elasticity of demand is greater than one. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand Demand is price elastic $5 4 Demand Quantity1000 Price 50 -3 percent 22- percent 67 5.00)/2(4.00 5.00)-(4.00 50)/2(100 50)-(100 E D == + + = Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ranges of Elasticity ?Perfectly Inelastic Quantity demanded does not respond to price changes. ?Perfectly Elastic Quantity demanded changes infinitely with any change in price. ?Unit Elastic Quantity demanded changes by the same percentage as the price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Variety of Demand Curves Because the price elasticity of demand measures how much quantity demanded responds to the price, it is closely related to the slope of the demand curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Inelastic Demand - Elasticity equals 0 Quantity Price 4 $5 Demand 100 2. ...leaves the quantity demanded unchanged. 1. An increase in price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Demand - Elasticity is less than 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10090 2. ...leads to a 11% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Unit Elastic Demand - Elasticity equals 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10080 2. ...leads to a 22% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Demand - Elasticity is greater than 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10050 2. ...leads to a 67% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Elastic Demand - Elasticity equals infinity Quantity Price Demand $4 1. At any price above $4, quantity demanded is zero. 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue ?Total revenue is the amount paid by buyers and received by sellers of a good. ?Computed as the price of the good times the quantity sold. TR = P x Q Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue $4 Demand Quantity P 0 Price P x Q = $400 (total revenue) 100 Q Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue With an inelastic demand curve, an increase in price leads to a decrease in quantity that is proportionately smaller. Thus, total revenue increases. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue: Inelastic Demand $3 Quantity 0 Price 80 Revenue = $240 Demand $1 Demand Quantity 0 Revenue = $100 100 Price An increase in price from $1 to $3... …leads to an increase in total revenue from$100 to $240 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue With an elastic demand curve, an increase in the price leads to a decrease in quantity demanded that is proportionately larger. Thus, total revenue decreases. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue: Elastic Demand Demand Quantity0 Price $4 50 Demand Quantity0 Price Revenue = $100 $5 20 …leads to a decrease in total revenue from$200 to $100 Revenue = $200 An increase in price from $4 to $5... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Elasticity of a Linear Demand Curve Price Quantity Total Revenue (Price x Quantity) Percent Change in Price Percent Change in Quantity Elasticity Description $0 14 $0 200% 15% 0.1 Inelastic 1 12 12 67 18 0.3 Inelastic 2 10 20 40 22 0.6 Inelastic 38 4 29 29 1 Unit elastic 46 2 22 40 1.8 elastic 5 4 20 18 67 3.7 elastic 6 2 12 15 200 13 elastic 70 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Income Elasticity of Demand ?Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers’ income. ?It is computed as the percentage change in the quantity demanded divided by the percentage change in income. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing Income Elasticity Income Elasticity of Demand Percentage Change in Quantity Demanded Percentage Change in Income = Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Income Elasticity - Types of Goods - ?Normal Goods ?Inferior Goods ?Higher income raises the quantity demanded for normal goods but lowers the quantity demanded for inferior goods. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Income Elasticity - Types of Goods - ?Goods consumers regard as necessities tend to be income inelastic Examples include food, fuel, clothing, utilities, and medical services. ?Goods consumers regard as luxuries tend to be income elastic. Examples include sports cars, furs, and expensive foods. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Elasticity of Supply ?Price elasticity of supply is the percentage change in quantity supplied resulting from a percent change in price. ?It is a measure of how much the quantity supplied of a good responds to a change in the price of that good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ranges of Elasticity ?Perfectly Elastic E S = ∞ ?Relatively Elastic E S > 1 ?Unit Elastic E S = 1 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Ranges of Elasticity ?Relatively Inelastic E S < 1 ?Perfectly Inelastic E S = 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Inelastic Supply - Elasticity equals 0 Quantity Price 4 $5 Supply 100 2. ...leaves the quantity supplied unchanged. 1. An increase in price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Supply - Elasticity is less than 1 Quantity Price 4 $5 1. A 22% increase in price... 110100 Supply 2. ...leads to a 10% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Unit Elastic Supply - Elasticity equals 1 Quantity Price 4 $5 1. A 22% increase in price... 125100 Supply 2. ...leads to a 22% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Supply - Elasticity is greater than 1 Quantity Price 4 $5 1. A 22% increase in price... 200100 Supply 2. ...leads to a 67% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Elastic Supply - Elasticity equals infinity Quantity Price Supply $4 1. At any price above $4, quantity supplied is infinite. 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, quantity supplied is zero. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Elasticity of Supply ?Ability of sellers to change the amount of the good they produce. ?Beach-front land is inelastic. ?Books, cars, or manufactured goods are elastic. ?Time period. ?Supply is more elastic in the long run. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Supply The price elasticity of supply is computed as the percentage change in the quantity supplied divided by the percentage change in price. Elasticity of Supply = Percentage Change in Quantity Supplied Percentage Change in Price Per Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Application of Elasticity ?Can good news for farming be bad news for farmers? ?What happens to wheat farmers and the market for wheat when university agronomists discover a new wheat hybridthat is more productive than existing varieties? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Application of Elasticity ?Examine whether the supply or demand curve shifts. ?Determine the direction of the shift of the curve. ?Use the supply-and-demand diagram to see how the market equilibrium changes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Increase in Supply in the Market for Wheat $3 Quantity of Wheat1000 Price of Wheat Demand S 1 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. 3. ...and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. An Increase in Supply in the Market for Wheat $3 Quantity of Wheat1000 Price of Wheat 1. When demand is inelastic, an increase in supply... Demand S 1 S 2 2 110 2. ...leads to a large fall in price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Compute Elasticity -0.24 0.4 0.095- 2.00)/2(3.00 2.00-3.00 110)/2(100 110-100 =E D ≈= + + Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Compute Elasticity -0.24 0.4 0.095- 2.00)/2(3.00 2.00-3.00 110)/2(100 110-100 =E D ≈= + + Demand is inelastic Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Price elasticity of demand measures how much the quantity demanded responds to changes in the price. ?If a demand curve is elastic, total revenue falls when the price rises. ?If it is inelastic, total revenue rises as the price rises. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The price elasticity of supply measures how much the quantity supplied responds to changes in the price. ?In most markets, supply is more elastic in the long run than in the short run. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Computing the Price Elasticity of Demand Demand is price elastic $5 4 Demand Quantity1000 Price 50 -3 percent 22- percent 67 5.00)/2(4.00 5.00)-(4.00 50)/2(100 50)-(100 E D == + + = Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Inelastic Demand - Elasticity equals 0 Quantity Price 4 $5 Demand 100 2. ...leaves the quantity demanded unchanged. 1. An increase in price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Demand - Elasticity is less than 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10090 2. ...leads to a 11% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Unit Elastic Demand - Elasticity equals 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10080 2. ...leads to a 22% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Demand - Elasticity is greater than 1 Quantity Price 4 $5 1. A 22% increase in price... Demand 10050 2. ...leads to a 67% decrease in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Elastic Demand - Elasticity equals infinity Quantity Price Demand $4 1. At any price above $4, quantity demanded is zero. 2. At exactly $4, consumers will buy any quantity. 3. At a price below $4, quantity demanded is infinite. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue $4 Demand Quantity P 0 Price P x Q = $400 (total revenue) 100 Q Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue: Inelastic Demand $3 Quantity 0 Price 80 Revenue = $240 Demand $1 Demand Quantity 0 Revenue = $100 100 Price An increase in price from $1 to $3... …leads to an increase in total revenue from$100 to $240 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elasticity and Total Revenue: Elastic Demand Demand Quantity0 Price $4 50 Demand Quantity0 Price Revenue = $100 $5 20 Revenue = $200 An increase in price from $4 to $5... …leads to a decrease in total revenue from$200 to $100 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Inelastic Supply - Elasticity equals 0 Quantity Price 4 $5 Supply 100 2. ...leaves the quantity supplied unchanged. 1. An increase in price... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Supply - Elasticity is less than 1 Quantity Price 4 $5 1. A 22% increase in price... 110100 Supply 2. ...leads to a 10% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Unit Elastic Supply - Elasticity equals 1 Quantity Price 4 $5 1. A 22% increase in price... 125100 Supply 2. ...leads to a 22% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Supply - Elasticity is greater than 1 Quantity Price 4 $5 1. A 22% increase in price... 200100 Supply 2. ...leads to a 67% increase in quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfectly Elastic Supply - Elasticity equals infinity Quantity Price Supply $4 1. At any price above $4, quantity supplied is infinite. 2. At exactly $4, producers will supply any quantity. 3. At a price below $4, quantity supplied is zero. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Increase in Supply in the Market for Wheat $3 Quantity of Wheat1000 Price of Wheat Demand S 1 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Increase in Supply in the Market for Wheat 3. ...and a proportionately smaller increase in quantity sold. As a result, revenue falls from $300 to $220. $3 Quantity of Wheat1000 Price of Wheat 1. When demand is inelastic, an increase in supply... Demand S 1 S 2 2 110 2. ...leads to a large fall in price... Supply, Demand and Government Policies Chapter 6 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply, Demand, and Government Policies ?In a free, unregulated market system, market forces establish equilibrium prices and exchange quantities. ?While equilibrium conditions may be efficient, it may be true that not everyone is satisfied. ?One of the roles of economists is to use their theories to assist in the development of policies. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Controls... ?Are usually enacted when policymakers believe the market price is unfair to buyers or sellers. ?Result in government-created price ceilings and floors. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Ceilings & Price Floors Price Ceiling ? A legally established maximum price at which a good can be sold. Price Floor ? A legally established minimum price at which a good can be sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Ceilings Two outcomes are possible when the government imposes a price ceiling: ? The price ceiling is not binding if set above the equilibrium price. ? The price ceiling is binding if set below the equilibrium price, leading to a shortage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Ceiling That Is Not Binding... $4 3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply Price ceiling Equilibrium price 100 Equilibrium quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 Quantity supplied Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Effects of Price Ceilings A binding price ceiling creates ... … shortages because Q D > Q S . ?Example: Gasoline shortage of the 1970s … nonprice rationing ?Examples: Long lines, Discrimination by sellers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Lines at the Gas Pump In 1973 OPEC raised the price of crude oil in world markets. Because crude oil is the major input used to make gasoline, the higher oil prices reduced the supply of gasoline. What was responsible for the long gas lines? Economists blame government regulations that limited the price oil companies could charge for gasoline. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Not Binding... $4 P 1 Quantity of Gasoline 0 Price of Gasoline Q 1 Demand Supply Price ceiling 1. Initially, the price ceiling is not binding... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Binding... P 1 Quantity of Gasoline 0 Price of Gasoline Q 1 Demand S 1 Price ceiling S 2 2. …but when supply falls... P 2 3. …the price ceiling becomes binding... 4. …resulting in a shortage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Rent Control ?Rent controls are ceilings placed on the rents that landlords may charge their tenants. ?The goal of rent control policy is to help the poor by making housing more affordable. ?One economist called rent control “the best way to destroy a city, other than bombing.” Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Floors When the government imposes a price floor, two outcomes are possible. ?The price floor is not binding if set below the equilibrium price. ?The price floor is binding if set above the equilibrium price, leading to a surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Floor That Is Not Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 Equilibrium quantity Equilibrium price Demand Supply Price floor 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Floor That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium price Demand Supply Price floor$4 120 Quantity supplied 80 Quantity demanded Surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Effects of a Price Floor ?A price floor prevents supply and demand from moving toward the equilibrium price and quantity. ?When the market price hits the floor, it can fall no further, and the market price equals the floor price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Effects of a Price Floor A binding price floor causes . . . … a surplus because Q S >Q D . … nonprice rationing is an alternative mechanism for rationing the good, using discrimination criteria. ?Examples: The minimum wage, Agricultural price supports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Minimum Wage An important example of a price floor is the minimum wage. Minimum wage laws dictate the lowest price possible for labor that any employer may pay. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Minimum Wage Quantity of Labor 0 Wage Equilibrium wage Labor demand Labor supply A Free Labor Market Equilibrium employment Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Minimum Wage Minimum wage Quantity of Labor 0 Wage Labor demand Labor supply Quantity supplied Quantity demanded Labor surplus (unemployment) A Labor Market with a Minimum Wage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Taxes Governments levy taxes to raise revenue for public projects. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What are some potential impacts of taxes? ?Taxes discourage market activity. ?When a good is taxed, the quantity sold is smaller. ?Buyers and sellers share the tax burden. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Taxes ?Tax incidence is the study of who bears the burden of a tax. ?Taxes result in a change in market equilibrium. ?Buyers pay more and sellers receive less, regardless of whom the tax is levied on. Copyright ? 2001 by Harcourt, Inc. All rights reserved Impact of a 50￠ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 D 1 Supply, S 1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D 2 Copyright ? 2001 by Harcourt, Inc. All rights reserved Impact of a 50￠ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 10090 $3.30 Price buyers pay D 1 D 2 Equilibrium with tax Supply, S 1 Equilibrium without tax 2.80 Price sellers receive Price without tax Tax ($0.50) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What was the impact of tax? ?Taxes discourage market activity. ?When a good is taxed, the quantity sold is smaller. ?Buyers and sellers share the tax burden. Copyright ? 2001 by Harcourt, Inc. All rights reserved Impact of a 50￠ Tax on Sellers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 10090 S 1 S 2 Demand, D 1 Price without tax 2.80 Price sellers receive $3.30 Price buyers pay Equilibrium without tax A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Tax ($0.50) Equilibrium with tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Payroll Tax Quantity of Labor 0 Wage Wage without tax Labor demand Labor supply Tax wedge Wage firms pay Wage workers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Incidence of Tax ?In what proportions is the burden of the tax divided? ?How do the effects of taxes on sellers compare to those levied on buyers? The answers to these questions depend on the elasticity of demand and the elasticity of supply. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Supply, Inelastic Demand... Quantity0 Price Demand Supply Tax 1. When supply is more elastic than demand... 2. ...the incidence of the tax falls more heavily on consumers... 3. ...than on producers. Price without tax Price buyers pay Price sellers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Supply, Elastic Demand... Quantity0 Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply... 2. ...the incidence of the tax falls more heavily on producers... 3. ...than on consumers. Price buyers pay Price sellers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. So, how is the burden of the tax divided? The burden of a tax falls more heavily on the side of the market that is less elastic. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Price controls include price ceilings and price floors. ? A price ceiling is a legal maximum on the price of a good or service. An example is rent control. ?A price floor is a legal minimum on the price of a good or a service. An example is the minimum wage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Taxes are used to raise revenue for public purposes. ?When the government levies a tax on a good, the equilibrium quantity of the good falls. ?A tax on a good places a wedge between the price paid by buyers and the price received by sellers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The incidence of a tax refers to who bears the burden of a tax. ?The incidence of a tax does not depend on whether the tax is levied on buyers or sellers. ?The incidence of the tax depends on the price elasticities of supply and demand. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Ceiling That Is Not Binding... $4 3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Demand Supply Price ceiling Equilibrium price 100 Equilibrium quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Ceiling That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 2 Demand Supply Equilibrium price Price ceiling Shortage 125 Quantity demanded 75 Quantity supplied Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Not Binding... $4 P 1 Quantity of Gasoline 0 Price of Gasoline Q 1 Demand Supply Price ceiling 1. Initially, the price ceiling is not binding... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Price Ceiling on Gasoline Is Binding... P 1 Quantity of Gasoline 0 Price of Gasoline Q 1 Demand S 1 Price ceiling S 2 2. …but when supply falls... P 2 3. …the price ceiling becomes binding... 4. …resulting in a shortage. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Rent Control in the Short Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Supply and demand for apartments are relatively inelastic Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Rent Control in the Long Run... Quantity of Apartments 0 Rental Price of Apartment Demand Supply Controlled rent Shortage Because the supply and demand for apartments are more elastic... …rent control causes a large shortage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Floor That Is Not Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 Equilibrium quantity Equilibrium price Demand Supply Price floor 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Price Floor That Is Binding... $3 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone Equilibrium price Demand Supply Price floor$4 120 Quantity supplied 80 Quantity demanded Surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Minimum Wage Quantity of Labor 0 Wage Equilibrium wage Labor demand Labor supply A Free Labor Market Equilibrium employment Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Minimum Wage Minimum wage Quantity of Labor 0 Wage Labor demand Labor supply Quantity supplied Quantity demanded Labor surplus (unemployment) A Labor Market with a Minimum Wage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Impact of a 50￠ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 100 D 1 Supply, S 1 A tax on buyers shifts the demand curve downward by the size of the tax ($0.50). D 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Impact of a 50￠ Tax Levied on Buyers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 10090 $3.30 Price buyers pay D 1 D 2 Equilibrium with tax Supply, S 1 Equilibrium without tax 2.80 Price sellers receive Price without tax Tax ($0.50) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Impact of a 50￠ Tax on Sellers... 3.00 Quantity of Ice-Cream Cones 0 Price of Ice-Cream Cone 10090 S 1 S 2 Demand, D 1 Price without tax 2.80 Price sellers receive $3.30 Price buyers pay Equilibrium without tax A tax on sellers shifts the supply curve upward by the amount of the tax ($0.50). Tax ($0.50) Equilibrium with tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Payroll Tax Quantity of Labor 0 Wage Wage without tax Labor demand Labor supply Tax wedge Wage firms pay Wage workers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Elastic Supply, Inelastic Demand... Quantity0 Price Demand Supply Tax 1. When supply is more elastic than demand... 2. ...the incidence of the tax falls more heavily on consumers... 3. ...than on producers. Price without tax Price buyers pay Price sellers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Inelastic Supply, Elastic Demand... Quantity0 Price Demand Supply Price without tax Tax 1. When demand is more elastic than supply... 2. ...the incidence of the tax falls more heavily on producers... 3. ...than on consumers. Price buyers pay Price sellers receive Consumers, Producers, and the Efficiency of Markets Chapter 7 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revisiting the Market Equilibrium Do the equilibrium price and quantity maximize the total welfare of buyers and sellers? ? Market equilibrium reflects the way markets allocate scarce resources. ? Whether the market allocation is desirable is determined by welfare economics. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare Economics Welfare economics is the study of how the allocation of resources affects economic well-being. ? Buyers and sellers receive benefits from taking part in the market. ? The equilibrium in a market maximizes the total welfare of buyers and sellers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare Economics Equilibrium in the market results in maximum benefits, and therefore maximum total welfare for both the consumers and the producers of the product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare Economics ?Consumer surplus measures economic welfare from the buyer’s side. ?Producer surplus measures economic welfare from the seller’s side. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Surplus ?Willingness to pay is the maximum price that a buyer is willing and able to pay for a good. ?It measures how much the buyer values the good or service. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Surplus Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Four Possible Buyers’ Willingness to Pay... Buyer Willingness to Pay John $100 Paul 80 George 70 Ringo 50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Surplus The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Four Possible Buyers’ Willingness to Pay... Price Buyer Quantity Demanded More than $100 None 0 $80 to $100 John 1 $70 to $80 John, Paul 2 $50 to $70 John, Paul, George 3 $50 or less Ringo 4 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums John’s willingness to pay Paul’s willingness to pay George’s willingness to pay Ringo’s willingness to pay Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums Demand John’s consumer surplus ($20) Price = $80 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums Demand John’s consumer surplus ($30) Total consumer surplus ($40) Price = $70 Paul’s consumer surplus ($10) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve The area below the demand curve and above the price measures the consumer surplus in the market. Copyright ? 2001 by Harcourt, Inc. All rights reserved How the Price Affects Consumer Surplus... Q 2 P 2 Quantity Price 0 Demand Initial consumer surplus Additional consumer surplus to initial consumers Consumer surplus to new consumers Q 1 P 1 DE F B C A Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer Surplus and Economic Well-Being Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Producer Surplus ?Producer surplus is the amount a seller is paid minus the cost of production. ?It measures the benefit to sellers participating in a market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Costs of Four Possible Sellers... Seller Cost Mary $900 Frida 800 Georgia 600 Grandma 500 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve ?Just as consumer surplus is related to the demand curve, producer surplus is closely related to the supply curve. ?At any quantity, the price given by the supply curve shows the cost of the marginal seller, the seller who would leave the market first if the price were any lower. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply Schedule for the Four Possible Sellers... Price Sellers Quantity Supplied $900 or more Mary, Frida, Georgia, Grandma 4 $800 to $900 Frida, Georgia, Grandma 3 $600 to $800 Georgia, Grandma 2 $500 to $600 Grandma 1 Less than $500 None 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Grandma’s cost Georgia’s cost Frida’s cost Mary’s cost Supply Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve The area below the price and above the supply curve measures the producer surplus in a market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Supply Grandma’s producer surplus ($100) Price = $600 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Supply Grandma’s producer surplus ($300) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Price Affects Producer Surplus... P 2 Q 2 Quantity Price 0 Supply Q 1 P 1 A B C Initial Producer surplus Additional producer surplus to initial producers D E F Producer surplus to new producers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Efficiency Consumer surplus and producer surplus may be used to address the following question: Is the allocation of resources determined by free markets in any way desirable? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Well-Being and Total Surplus Consumer Surplus = Value to buyers _ Amount paid by buyers and Producer Surplus = Amount received by sellers _ Cost to sellers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Well-Being and Total Surplus Total Surplus = Consumer Surplus Producer Surplus + or Total Surplus = Value to buyers _ Cost to sellers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Efficiency Market efficiency is achieved when the allocation of resources maximizes total surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Efficiency In addition to market efficiency, a social planner might also care about equity – the fairness of the distribution of well-being among the various buyers and sellers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Evaluating the Market Equilibrium... Price Equilibrium price 0 QuantityEquilibrium quantity A Supply C B Demand D E Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer and Producer Surplus in the Market Equilibrium... Price Equilibrium price 0 QuantityEquilibrium quantity A Supply C B Demand D E Producer surplus Consumer surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Three Insights Concerning Market Outcomes ?Free markets allocate the supply of goods to the buyers who value them most highly. ?Free markets allocate the demand for goods to the sellers who can produce them at least cost. ?Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price 0 Quantity Equilibrium quantity Supply Demand Cost to sellers Value to buyers Value to buyers Cost to sellers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. The Efficiency of the Equilibrium Quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Efficiency of the Equilibrium Quantity ?Because the equilibrium outcome is an efficient allocation of resources, the social planner can leave the market outcome as he/she finds it. ?This policy of leaving well enough alone goes by the French expression laissez faire. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Power ?If a market system is not perfectly competitive, market power may result. ?Market power is the ability to influence prices. ?Market power can cause markets to be inefficient because it keeps price and quantity from the equilibrium of supply and demand. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Externalities Externalities are created when a market outcome affects individuals other than buyers and sellers in that market. ?Externalities cause welfare in a market to depend on more than just the value to the buyers and cost to the sellers. ?When buyers and sellers do not take externalities into account when deciding how much to consume and produce, the equilibrium in the market can be inefficient. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Consumer surplus measures the benefit buyers get from participating in a market. ?Consumer surplus can be computed by finding the area below the demand curve and above the price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Producer surplus measures the benefit sellers get from participating in a market. ?Producer surplus can be computed by finding the area below the price and above the supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The equilibrium of demand and supply maximizes the sum of consumer and producer surplus. ?This is as if the invisible hand of the marketplace leads buyers and sellers to allocate resources efficiently. ?Markets do not allocate resources efficiently in the presence of market failures. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?An allocation of resources that maximizes the sum of consumer and producer surplus is said to be efficient. ?Policymakers are often concerned with the efficiency, as well as the equity, of economic outcomes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums John’s willingness to pay Paul’s willingness to pay George’s willingness to pay Ringo’s willingness to pay Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums Demand John’s consumer surplus ($20) Price = $80 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Consumer Surplus with the Demand Curve... Price of Album 50 70 80 0 $100 1234 Quantity of Albums Demand John’s consumer surplus ($30) Total consumer surplus ($40) Price = $70 Paul’s consumer surplus ($10) How the Price Affects Consumer Surplus... Q 2 P 2 Quantity Price 0 Demand Copyright ? 2001 by Harcourt, Inc. All rights reserved Initial consumer surplus Additional consumer surplus to initial consumers Consumer surplus to new consumers Q 1 P 1 B C A DE F Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Producer Surplus and the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Grandma’s cost Georgia’s cost Frida’s cost Mary’s cost Supply Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Supply Grandma’s producer surplus ($100) Price = $600 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Producer Surplus with the Supply Curve... Quantity of Houses Painted Price of House Painting 500 800 $900 0 600 1234 Supply Grandma’s producer surplus ($300) Price = $800 Georgia’s producer surplus ($200) Total producer surplus ($500) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Price Affects Producer Surplus... P 2 Q 2 Quantity Price 0 Supply Q 1 P 1 A B C Initial Producer surplus Additional producer surplus to initial producers D E F Producer surplus to new producers Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Evaluating the Market Equilibrium... Price Equilibrium price 0 QuantityEquilibrium quantity A Supply C B Demand D E Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumer and Producer Surplus in the Market Equilibrium... Price Equilibrium price 0 QuantityEquilibrium quantity A Supply C B Demand D E Producer surplus Consumer surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price 0 Quantity Equilibrium quantity Supply Demand Cost to sellers Value to buyers Value to buyers Cost to sellers Value to buyers is greater than cost to sellers. Value to buyers is less than cost to sellers. The Efficiency of the Equilibrium Quantity Application: The Costs of Taxation Chapter 8 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Costs of Taxation How do taxes affect the economic well- being of market participants? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Costs of Taxation It does not matter whether a tax on a good is levied on buyers or sellers of the good…the price paid by buyers rises, and the price received by sellers falls. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tax... Price 0 Quantity Quantity without tax Supply Demand Price without tax Price buyers pay Quantity with tax Size of tax Price sellers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tax ?A tax places a wedge between the price buyers pay and the price sellers receive. ?Because of this tax wedge, the quantity sold falls below the level that would be sold without a tax. ?The size of the market for that good shrinks. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Revenue T = the size of the tax Q = the quantity of the good sold T×Q = the government’s tax revenue Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Revenue... Price 0 Quantity Quantity without tax Supply Demand Price buyers pay Price sellers receive Quantity with tax Size of tax (T) Quantity sold (Q) Tax Revenue (T x Q) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Tax Affects Welfare... Quantity0 Price Demand Supply Q 1 A B C F D E Q 2 Tax reduces consumer surplus by (B+C) and producer surplus by (D+E) Tax revenue = (B+D) Deadweight Loss = (C+E) Price buyers pay = P B P 1 Price without tax = P S Price sellers receive = Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Welfare from a Tax Without Tax With Tax Change Consumer Surplus A + B + C A -(B + C) Producer Surplus D + E + F F -(D + E) Tax Revenue none B + D + (B + D) Total Surplus A + B + C + D + E + F A + B + D + F -(C + E ) The area C+E shows the fall in total surplus and is the deadweight loss of the tax. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Tax Affects Welfare The change in total welfare includes: ?The change in consumer surplus, ?The change in producer surplus, ?The change in tax revenue. ?The losses to buyers and sellers exceed the revenue raised by the government. ?This fall in total surplus is called the deadweight loss. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Losses and the Gains from Trade Taxes cause deadweight losses because they prevent buyers and sellers from realizing some of the gains from trade. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss... Quantity0 Price Demand Supply Q 1 P B Price = P 1 without tax P S Q 2 Size of tax Lost gains from trade Cost to sellers Value to buyers Reduction in quantity due to the tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Deadweight Loss What determines whether the deadweight loss from a tax is large or small? ?The magnitude of the deadweight loss depends on how much the quantity supplied and quantity demanded respond to changes in the price. ?That, in turn, depends on the price elasticities of supply and demand. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... (a) Inelastic Supply Quantity Price Demand Supply 0 When supply is relatively inelastic, the deadweight loss of a tax is small. Size of tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... (b) Elastic Supply Quantity Price Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large. 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... Quantity Price Demand Supply 0 When demand is relatively inelastic, the deadweight loss of a tax is small. (c) Inelastic Demand Size of tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... Quantity Price Demand Supply 0 Size of tax When demand is relatively elastic, the deadweight loss of a tax is large. (d) Elastic Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Determinants of Deadweight Loss The greater the elasticities of demand and supply: ? the larger will be the decline in equilibrium quantity and, ? the greater the deadweight loss of a tax. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss Debate Some economists argue that labor taxes are highly distorting and believe that labor supply is more elastic. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss Debate Some examples of workers who may respond more to incentives: ?Workers who can adjust the number of hours they work ?Families with second earners ?Elderly who can choose when to retire ?Workers in the underground economy (i.e. those engaging in illegal activity) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue as Taxes Vary With each increase in the tax rate, the deadweight loss of the tax rises even more rapidly than the size of the tax. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (a) Small Tax P B Quantity Q 2 0 Price Q 1 Demand Supply Tax revenue P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (b) Medium Tax Demand Supply Tax revenue P B Quantity Q 2 0 Price Q 1 P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (c) Large Tax T a x r e v e n u e P B Quantity Q 2 0 Price Q 1 Demand Supply P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue ?For the small tax, tax revenue is small. ?As the size of the tax rises, tax revenue grows. ?But as the size of the tax continues to rise, tax revenue falls because the higher tax reduces the size of the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (a) Deadweight Loss Deadweight Loss 0 Tax Size Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (b) Revenue (the Laffer curve)Tax Revenue 0Tax Size Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue Vary with the Size of the Tax ?As the size of a tax increases, its deadweight loss quickly gets larger. ?By contrast, tax revenue first rises with the size of a tax; but then, as the tax gets larger, the market shrinks so much that tax revenue starts to fall. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Laffer Curve and Supply-Side Economics ?The Laffer curve depicts the relationship between tax rates and tax revenue. ?Supply-side economics refers to the views of Reagan and Laffer who proposed that a tax cut would induce more people to work and thereby have the potential to increase tax revenues. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A tax on a good reduces the welfare of buyers and sellers of the good. And the reduction in consumer and producer surplus usually exceeds the revenues raised by the government. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The fall in total surplus – the sum of consumer surplus, producer surplus, and tax revenue – is called the deadweight loss of the tax. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Taxes have a deadweight loss because they cause buyers to consume less and sellers to produce less. ?This change in behavior shrinks the size of the market below the level that maximizes total surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?As a tax grows larger, it distorts incentives more, and its deadweight loss grows larger. ?Tax revenue first rises with the size of a tax. ?Eventually, however, a larger tax reduces tax revenue because it reduces the size of the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tax... Price 0 Quantity Quantity without tax Supply Demand Price without tax Price buyers pay Quantity with tax Size of tax Price sellers receive Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Revenue... Price 0 Quantity Quantity without tax Supply Demand Price buyers pay Price sellers receive Quantity with tax Size of tax (T) Quantity sold (Q) Tax Revenue (T x Q) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How a Tax Affects Welfare... Quantity0 Price Demand Supply Q 1 A B C F D E Q 2 Tax reduces consumer surplus by (B+C) and producer surplus by (D+E) Tax revenue = (B+D) Deadweight Loss = (C+E) Price buyers pay = P B P 1 Price without tax = P S Price sellers receive = Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss... Quantity0 Price Demand Supply Q 1 P B Price = P 1 without tax P S Q 2 Size of tax Lost gains from trade Cost to sellers Value to buyers Reduction in quantity due to the tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... (a) Inelastic Supply Quantity Price Demand Supply 0 When supply is relatively inelastic, the deadweight loss of a tax is small. Size of tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... (b) Elastic Supply Quantity Price Demand Supply Size of tax When supply is relatively elastic, the deadweight loss of a tax is large. 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... Quantity Price Demand Supply 0 When demand is relatively inelastic, the deadweight loss of a tax is small. (c) Inelastic Demand Size of tax Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tax Distortions and Elasticities... Quantity Price Demand Supply 0 Size of tax When demand is relatively elastic, the deadweight loss of a tax is large. (d) Elastic Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (a) Small Tax P B Quantity Q 2 0 Price Q 1 Demand Supply Tax revenue P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (b) Medium Tax Demand Supply Tax revenue P B Quantity Q 2 0 Price Q 1 P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue... (c) Large Tax T a x r e v e n u e P B Quantity Q 2 0 Price Q 1 Demand Supply P S Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (a) Deadweight Loss Deadweight Loss 0 Tax Size Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Deadweight Loss and Tax Revenue Vary with the Size of the Tax... (b) Revenue (the Laffer curve)Tax Revenue 0Tax Size Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Application: International Trade Chapter 9 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade What determines whether a country imports or exports a good? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade Who gains and who loses from free trade among countries? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade What are the arguments that people use to advocate trade restrictions? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium Without Trade Assume: ?A country is isolated from rest of the world and produces steel. ?The market for steel consists of the buyers and sellers in the country. ?No one in the country is allowed to import or export steel. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium Without Trade... Price of Steel Equilibrium Price 0 Quantity of Steel Equilibrium quantity Domestic supply Domestic demand Producer surplus Consumer surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium Without Trade Results: ?Domestic price adjusts to balance demand and supply. ?The sum of consumer and producer surplus measures the total benefits that buyers and sellers receive. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. World Price and Comparative Advantage If the country decides to engage in international trade, will it be an importer or exporter of steel? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. World Price and Comparative Advantage The effects of free trade can be shown by comparing the domestic price of a good without trade and the world price of the good. The world price refers to the prevailing price in the world markets. ?A country will either be an exporter or an importer of the good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. World Price and Comparative Advantage If a country has a comparative advantage, then the domestic price will be below the world price, and the country will be an exporter of the good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. World Price and Comparative Advantage If the country does not have a comparative advantage, then the domestic price will be higher than the world price, and the country will be an importer of the good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade in an Exporting Country... Price of Steel 0 Quantity of Steel Domestic demand Domestic supply World price Price after trade Exports Domestic quantity demanded Domestic quantity supplied Price before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply A B C D Exports Price after trade Price before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply A Consumer surplus before trade B C Producer surplus before trade Price after trade Price before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply A Consumer surplus after trade C B Producer surplus after trade D Exports Price after trade Price before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Welfare from Free Trade: The Case of an Exporting Country Before Trade After Trade Change Consumer Surplus A + B A -B Producer Surplus C B + C + D + (B + D) Total Surplus A + B + C A + B + C + D + D The area D shows the increase in total surplus and represents the gains from trade. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country The analysis of an exporting country yields two conclusions: ? Domestic producers of the good are better off, and domestic consumers of the good are worse off. ? Trade raises the economic well-being of the nation as a whole. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade and the Importing Country If the world price of steel is lower than the domestic price, the country will be an importer of steel when trade is permitted. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade and the Importing Country Domestic consumers will want to buy steel at the lower world price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade and the Importing Country Domestic producers of steel will have to lower their output because the domestic price moves to the world price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade and the Importing Country... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World Price Price after trade Domestic quantity demanded Domestic quantity supplied Price before trade Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price before trade Price after trade A B C D Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price before trade Price after trade A Consumer surplus before trade C B Producer surplus before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price before trade Price after trade A Consumer surplus after trade B D C Producer surplus after trade Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Welfare from Free Trade: The Case of an Importing Country Before Trade After Trade Change Consumer Surplus A A + B + D + (B + D) Producer Surplus B + C C -B Total Surplus A + B + C A + B + C + D + D The area D shows the increase in total surplus and represents the gains from trade. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country The analysis of an importing country yields two conclusions: ? Domestic producers of the good are worse off, and domestic consumers of the good are better off. ? Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Gains and Losses from Free International Trade ?The gains of the winners exceed the losses of the losers. ?The net change in total surplus is positive. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tariffs ?Tariffs are taxes on imported goods. ?Tariffs raise the price of imported goods above the world price by the amount of the tariff. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price with tariff World price Price without tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff Q 1 S Q 1 D Imports without tariff Imports with tariff Q 2 D Q 2 S Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World price Q 1 S Q 1 D Price without tariff Imports without tariff Consumer surplus before tariff Producer surplus before tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Price without tariff Price with tariff Imports without tariff Imports with tariff A Consumer surplus with tariff B Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Imports without tariff Imports with tariff C G Producer surplus before tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Imports without tariff Imports with tariff E Tariff revenue Price with tariff Price without tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Price without tariff Price with tariff Imports without tariff Imports with tariff A B CE G DF Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Welfare from a Tariff Before Tariff After Tariff Change Consumer Surplus A+B+C+D+E+F A + B -(C+D+E+F) Producer Surplus G C + G + C Government Revenue None E + E Total Surplus A+B+C+D+E+F+G A+B+ C+ E+ G -(D + F) The area D+F shows the fall in total surplus and represents the deadweight loss of the tariff. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff ?A tariff reduces the quantity of imports and moves the domestic market closer to its equilibrium without trade. ?With a tariff, total surplus in the market decreases by an amount referred to as a deadweight loss. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota An import quota is a limit on the quantity of imports. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ... Price with quota World price Price without quota Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Q 1 S Q 2 S Q 2 D Imports without quota Imports with quota Domestic supply + Import Supply Quota Equilibrium with quota Equilibrium without trade Q 1 D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ?Because the quota raises the domestic price above the world price, domestic buyers of the good are worse off, and domestic sellers of the good are better off. ?License holders are better off because they make a profit from buying at the world price and selling at the higher domestic price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World price Q 1 S Q 2 S Q 2 D Q 1 D Price without quota Price with quota Imports without quota Imports with quota Domestic supply + Import Supply Quota A B CE ' E '' F G D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Changes in Welfare from an Import Quota A+B+C+D+E’+E”+F+G A+B+C+E’+E”+G Before Quota After Tariff Change Consumer Surplus Producer Surplus Government Revenue Total Surplus A+B+C+D+E’+E”+F A+B -(C+D+E’+E”+F) G C+G +C None E’+E” +(E’+E”) -(D+F) The area D+F shows the fall in total surplus and represents the deadweight loss of the quota. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ?With a quota, total surplus in the market decreases by an amount referred to as a deadweight loss. ?The quota can potentially cause an even larger deadweight loss, if a mechanism such as lobbying is employed to allocate the import licenses. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of Tariffs and Quotas If government sells import licenses for full value, revenue equals that of equivalent tariff and the results of tariffs and quotas are identical. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Both tariffs and import quotas . . . … raise domestic prices. … reduce the welfare of domestic consumers. … increase the welfare of domestic producers. … cause deadweight losses. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Other Benefits of International Trade ?Increased variety of goods ?Lower costs through economies of scale ?Increased competition ?Enhanced flow of ideas Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Arguments for Restricting Trade ?Jobs ?National Security ?Infant Industry ?Unfair Competition ?Protection as a Bargaining Chip Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Trade Agreements ?Unilateral: when a country removes its trade restrictions on its own. ?Multilateral: a country reduces its trade restrictions while other countries do the same. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. NAFTA ?The North American Free Trade Agreement (NAFTA) is an example of a multilateral trade agreement. ?In 1993, NAFTA lowered the trade barriers among the U.S., Mexico, and Canada. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. GATT ?The General Agreement on Tariffs and Trade (GATT) refers to a continuing series of negotiations among many of the world’s countries with a goal of promoting free trade. ?GATT has successfully reduced the average tariff among member countries from about 40% after WWII to about 5% today. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The effects of free trade can be determined by comparing the domestic price without trade to the world price. ?A low domestic price indicates that the country has a comparative advantage in producing the good and that the country will become an exporter. ?A high domestic price indicates that the rest of the world has a comparative advantage in producing the good and that the country will become an importer. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?When a country allows trade and becomes an exporter of a good, producers of the good are better off, and consumers of the good are worse off. ?When a country allows trade and becomes an importer of a good, consumers of the good are better off, and producers are worse off. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A tariff – a tax on imports – moves a market closer to the equilibrium than would exist without trade, and therefore reduces the gains from trade. ?Import quotas will have effects similar to those of tariffs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?There are various arguments for restricting trade: protecting jobs, defending national security, helping infant industries, preventing unfair competition, and responding to foreign trade restrictions. ?Economists, however, believe that free trade is usually the better policy. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium Without Trade... Price of Steel Equilibrium Price 0 Quantity of Steel Equilibrium quantity Domestic supply Domestic demand Producer surplus Consumer surplus Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade in an Exporting Country... Price of Steel 0 Quantity of Steel Domestic demand Domestic supply World price Price after trade Exports Domestic quantity demanded Domestic quantity supplied Price before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply Price after trade Price before trade A B C D Exports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply Price after trade Price before trade A Consumer surplus before trade B C Producer surplus before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Exporting Country... Price of Steel 0 Quantity of Steel World price Domestic demand Domestic supply Price after trade Price before trade A Consumer surplus after trade C B Producer surplus after trade D Exports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. International Trade and the Importing Country... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World Price Price after trade Domestic quantity demanded Domestic quantity supplied Price before trade Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A B C D Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A Consumer surplus before trade C B Producer surplus before trade Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How Free Trade Affects Welfare in an Importing Country... Price of Steel 0 Quantity of Steel Domestic supply World Price Domestic demand Price after trade Price before trade A Consumer surplus after trade B D C Producer surplus after trade Imports Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price with tariff World price Price without tariff Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff Q 1 S Q 1 D Imports without tariff Imports with tariff Q 2 D Q 2 S Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World price Q 1 S Q 1 D Price without tariff Imports without tariff Consumer surplus before tariff Producer surplus before tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Price without tariff Price with tariff Imports without tariff Imports with tariff A Consumer surplus with tariff B Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Imports without tariff Imports with tariff C G Producer surplus before tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Imports without tariff Imports with tariff E Tariff revenue Price with tariff Price without tariff Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of a Tariff... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Tariff World price Q 1 S Q 2 S Q 2 D Q 1 D Price without tariff Price with tariff Imports without tariff Imports with tariff A B CE G DF Deadweight loss Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ... Price with quota World price Price without quota Price of Steel 0 Quantity of Steel Domestic supply Domestic demand Q 1 S Q 2 S Q 2 D Imports without quota Imports with quota Domestic supply + Import Supply Quota Equilibrium with quota Equilibrium without trade Q 1 D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Effects of an Import Quota ... Price of Steel 0 Quantity of Steel Domestic supply Domestic demand World price Q 1 S Q 2 S Q 2 D Q 1 D Price without quota Price with quota Imports without quota Imports with quota Domestic supply + Import Supply Quota A B CE ' E '' F G D Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Externalities Chapter 10 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Efficiency - Market Failures Recall that: Adam Smith’s “invisible hand” of the marketplace leads self- interested buyers and sellers in a market to maximize the total benefit that society can derive from a market. But market failures can still happen. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Failures: Externalities ?When a market outcome affects parties other than the buyers and sellers in the market, side-effects are created called externalities. ?Externalities cause markets to be inefficient, and thus fail to maximize total surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An externality arises... . . . when a person engages in an activity that influences the well- being of a bystander and yet neither pays nor receives any compensation for that effect. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market Failures: Externalities ?When the impact on the bystander is adverse, the externality is called a negative externality. ?When the impact on the bystander is beneficial, the externality is called a positive externality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. ?Automobile exhaust ?Cigarette smoking ?Barking dogs (loud pets) ?Loud stereos in an apartment building Examples of Negative Externalities Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. ?Immunizations ?Restored historic buildings ?Research into new technologies Examples of Positive Externalities Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Aluminum... Quantity of Aluminum 0 Price of Aluminum Q MARKET Demand (private value) Supply (private cost) Equilibrium Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Aluminum and Welfare Economics The quantity produced and consumed in the market equilibrium is efficient in the sense that it maximizes the sum of producer and consumer surplus. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Aluminum and Welfare Economics If the aluminum factories emit pollution (a negative externality), then the cost to society of producing aluminum is larger than the cost to aluminum producers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Aluminum and Welfare Economics For each unit of aluminum produced, the social cost includes the private costs of the producers plus the cost to those bystanders adversely affected by the pollution. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Pollution and the Social Optimum... Q MARKET Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q optimum Cost of pollution Equilibrium Optimum Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Negative Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. ?The socially optimal output level is less than the market equilibrium quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Achieving the Socially Optimal Output Internalizing an externality involves altering incentives so that people take into account the external effects of their actions. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Achieving the Socially Optimal Output The government can internalize an externality by imposing a tax on the producer to reduce the equilibrium quantity to the socially desirable quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive Externalities in Production When an externality benefits the bystanders, a positive externality exists. ?The social costs of production are less than the private cost to producers and consumers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive Externalities in Production A technology spillover is a type of positive externality that exists when a firm’s innovation or design not only benefits the firm, but enters society’s pool of technological knowledge and benefits society as a whole. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive Externalities in Production... Quantity of Robots 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Social cost Q MARKET Value of technology spillover Equilibrium Optimum Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive Externalities in Production The intersection of the demand curve and the social-cost curve determines the optimal output level. ?The optimal output level is more than the equilibrium quantity. ?The market produces a smaller quantity than is socially desirable. ?The social costs of production are less than the private cost to producers and consumers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Internalizing Externalities: Subsidies Government many times uses subsidies as the primary method for attempting to internalize positive externalities. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Technology Policy Government intervention in the economy that aims to promote technology-enhancing industries is called technology policy. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Technology Policy ?Patent laws are a form of technology policy that give the individual (or firm) with patent protection a property right over its invention. ?The patent is then said to internalize the externality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Internalizing Production Externalities ?Taxes are the primary tools used to internalize negative externalities. ?Subsidies are the primary tools used to internalize positive externalities. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumption Externalities... (a) Negative Consumption Externality (b) Positive Consumption Externality Quantity of Education 0 Price of Education Q MARKET Demand (private value) Social value Q OPTIMUM Supply (private cost) Quantity of Alcohol 0 Price of Alcohol Q MARKET Demand (private value) Supply (private cost) Social value Q OPTIMUM Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Externalities and Market Inefficiency ? Negative externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. ? Positive externalities in production or consumption lead markets to produce a larger quantity than is socially desirable. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Private Solutions to Externalities Government action is not always needed to solve the problem of externalities. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Private Solutions to Externalities ?Moral codes and social sanctions ?Charitable organizations ?Integrating different types of businesses ?Contracting between parties Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Coase Theorem The Coase Theorem states that if private parties can bargain without cost over the allocation of resources, then the private market will always solve the problem of externalities on its own and allocate resources efficiently. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Transactions Costs Transaction costs are the costs that parties incur in the process of agreeing to and following through on a bargain. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why Private Solutions Do Not Always Work Sometimes the private solution approach fails because transaction costs can be so high that private agreement is not possible. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Public Policy Toward Externalities When externalities are significant and private solutions are not found, government may attempt to solve the problem through . . . … command-and-control policies. … market-based policies. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Command-and-Control Policies ?Usually take the form of regulations: ?Forbid certain behaviors. ?Require certain behaviors. ?Examples: ?Requirements that all students be immunized. ?Stipulations on pollution emission levels set by the Environmental Protection Agency (EPA). Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market-Based Policies ?Government uses taxes and subsidies to align private incentives with social efficiency. ?Pigovian taxes are taxes enacted to correct the effects of a negative externality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Examples of Regulation versus Pigovian tax If the EPA decides it wants to reduce the amount of pollution coming from a specific plant. The EPA could… … tell the firm to reduce its pollution by a specific amount (i.e. regulation). … levy a tax of a given amount for each unit of pollution the firm emits (i.e. Pigovian tax). Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Market-Based Policies ?Tradable pollution permits allow the voluntary transfer of the right to pollute from one firm to another. ?A market for these permits will eventually develop. ?A firm that can reduce pollution at a low cost may prefer to sell its permit to a firm that can reduce pollution only at a high cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Equivalence of Pigovian Taxes and Pollution Permits... (a) Pigovian Tax (b) Pollution Permits Quantity of Pollution 0 Price of Pollution P Q Demand for pollution rights Pigovian tax 2. ...which, together with the demand curve, determines the quantity of pollution. 1. A Pigovian tax sets the price of pollution... Quantity of Pollution 0 Q Demand for pollution rights Supply of pollution permits Price of Pollution P 2. ...which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution... Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?When a transaction between a buyer and a seller directly affects a third party, the effect is called an externality. ?Negative externalities cause the socially optimal quantity in a market to be less than the equilibrium quantity. ?Positive externalities cause the socially optimal quantity in a market to be greater than the equilibrium quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Those affected by externalities can sometimes solve the problem privately. ?The Coase theorem states that if people can bargain without a cost, then they can always reach an agreement in which resources are allocated efficiently. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?When private parties cannot adequately deal with externalities, then the government steps in. ?The government can either regulate behavior or internalize the externality by using Pigovian taxes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Aluminum... Quantity of Aluminum 0 Price of Aluminum Q MARKET Demand (private value) Supply (private cost) Equilibrium Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Pollution and the Social Optimum... Q MARKET Quantity of Aluminum 0 Price of Aluminum Demand (private value) Supply (private cost) Social cost Q optimum Cost of pollution Equilibrium Optimum Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Positive Externalities in Production... Quantity of Robots 0 Price of Robot Q OPTIMUM Demand (private value) Supply (private cost) Social cost Q MARKET Value of technology spillover Equilibrium Optimum Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Consumption Externalities... Quantity of Education 0 Price of Education Q MARKET Demand (private value) Social value Q OPTIMUM (b) Positive Consumption Externality Supply (private cost) Quantity of Alcohol 0 Price of Alcohol Q MARKET Demand (private value) Supply (private cost) Social value Q OPTIMUM (a) Negative Consumption Externality Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Equivalence of Pigovian Taxes and Pollution Permits... Quantity of Pollution 0 Price of Pollution P Q Demand for pollution rights Pigovian tax (a) Pigovian Tax 2. ...which, together with the demand curve, determines the quantity of pollution. 1. A Pigovian tax sets the price of pollution... Quantity of Pollution 0 Q Demand for pollution rights Supply of pollution permits (b) Pollution Permits Price of Pollution P 2. ...which, together with the demand curve, determines the price of pollution. 1. Pollution permits set the quantity of pollution... Public Goods and Common Resources Chapter 11 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. “The best things in life are free. . .” Free goods provide a special challenge for economic analysis Most goods in our economy are allocated in markets… …for these goods, prices are the signals that guide the decisions of buyers and sellers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. “The best things in life are free. . .” When goods are available free of charge, the market forces that normally allocate resources in our economy are absent. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. “The best things in life are free. . .” When a good does not have a price attached to it, private markets cannot ensure that the good is produced and consumed in the proper amounts. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. “The best things in life are free. . .” In such cases, government policy can potentially remedy the market failure that results, and raise economic well-being. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Different Kinds of Goods When thinking about the various goods in the economy, it is useful to group them according to two characteristics: ? Is the good excludable? ? Is the good rival? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Different Kinds of Goods ?Excludability ? People can be prevented from enjoying the good. ? Laws recognize and enforce private property rights. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Different Kinds of Goods ? Rivalness ?One person’s use of the good diminishes another person’s enjoyment of it. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Four Types of Goods ?Private Goods ?Public Goods ?Common Resources ?Natural Monopolies Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Goods ?Private Goods ?Are both excludable and rival. ?Public Goods ?Are neither excludable nor rival. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Goods ?Common Resources ?Are rival but not excludable. ?Natural Monopolies ?Are excludable but not rival. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Goods Rival? Yes No Yes Private Goods ? Ice-cream cones ? Clothing ? Congested toll roads Natural Monopolies ? Fire protection ? Cable TV ? Uncongested toll roads No Common Resources ? Fish in the ocean ? The environment ? Congested nontoll roads Public Goods ? National defense ? Knowledge ? Uncongested nontoll roads Excludable? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Free-Rider Problem A free-rider is a person who receives the benefit of a good but avoids paying for it. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Free-Rider Problem ?Since people cannot be excluded from enjoying the benefits of a public good, individuals may withhold paying for the good hoping that others will pay for it. ?The free-rider problem prevents private markets from supplying public goods. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Solving the Free-Rider Problem ?The government can decide to provide the public good if the total benefits exceed the costs. ?The government can make everyone better off by providing the public good and paying for it with tax revenue. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Some Important Public Goods ?National Defense ?Basic Research ?Programs to Fight Poverty Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Are Lighthouses Public Goods? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost-Benefit Analysis ?In order to decide whether to provide a public good or not, the total benefits of all those who use the good must be compared to the costs of providing and maintaining the public good. ?Cost benefit analysis estimates the total costs and benefits of a good to society as a whole. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost-Benefit Analysis ?A cost-benefit analysis would be used to estimate the total costs and benefits of the project to society as a whole. ?It is difficult to do because of the absence of prices needed to estimate social benefits and resource costs. ?The value of life, the consumer’s time, and aesthetics are difficult to assess. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Common Resources Common resources, like public goods, are not excludable. They are available free of charge to anyone who wishes to use them. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Common Resources Common resources are rival goods because one person’s use of the common resource reduces other people’s use. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tragedy of the Commons The Tragedy of the Commons is a story with a general lesson: When one person uses a common resource, he or she diminishes another person’s enjoyment of it. ?Common resources tend to be used excessively when individuals are not charged for their usage. ?This creates a negative externality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Examples of Common Resources ?Clean air and water ?Oil pools ?Congested roads ?Fish, whales, and other wildlife Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why Isn’t the Cow Extinct? Private Ownership and the Profit Motive! Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Importance of Property Rights The market fails to allocate resources efficiently when property rights are not well-established (i.e. some item of value does not have an owner with the legal authority to control it). Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Importance of Property Rights When the absence of property rights causes a market failure, the government can potentially solve the problem. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Goods differ in whether they are excludable and whether they are rival. ?A good is excludable if it is possible to prevent someone from using it. ?A good is rival if one person’s enjoyment of the good prevents other people from enjoying the same unit of the good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Public goods are neither rival nor excludable. ?Because people are not charged for their use of public goods, they have an incentive to free ride when the good is provided privately. ?Governments provide public goods, making quantity decisions based upon cost-benefit analysis. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Common resources are rival but not excludable. ?Because people are not charged for their use of common resources, they tend to use them excessively. ?Governments tend to try to limit the use of common resources. The Costs of Production Chapter 13 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Costs of Production The Law of Supply: ?Firms are willing to produce and sell a greater quantity of a good when the price of the good is high. ?This results in a supply curve that slopes upward. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Objective The economic goal of the firm is to maximize profits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Firm’s Total Revenue and Total Cost ?Total Revenue ?The amount that the firm receives for the sale of its output. ?Total Cost ?The amount that the firm pays to buy inputs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Firm’s Profit Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Costs as Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. ?Explicit costs involve a direct money outlay for factors of production. ?Implicit costs do not involve a direct money outlay. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Profit versus Accounting Profit ?Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit). ?Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Profit versus Accounting Profit ?When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. ?Economic profit is smaller than accounting profit. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Profit versus Accounting Profit Explicit costs Accounting profit How an Accountant Views a Firm Revenue Revenue Total opportunity costs How an Economist Views a Firm Explicit costs Economic profit Implicit costs Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Production Function and Total Cost Number of Workers Output Marginal Product of Labor Cost of Factory Cost of Workers Total Cost of Inputs 0 0 $30 $0 $30 1 50 50 30 10 40 2 90 40 30 20 50 3 120 30 30 30 60 4 140 20 30 40 70 5 150 10 30 50 80 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Product The marginal product of any input in the production process is the increase in the quantity of output obtained from an additional unit of that input. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Product Additional input Additional output = Marginal product Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Diminishing Marginal Product ?Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. ?Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Production Function... Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired0 12345 Production function Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Diminishing Marginal Product ?The slope of the production function measures the marginal product of an input, such as a worker. ?When the marginal product declines, the production function becomes flatter. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. From the Production Function to the Total-Cost Curve ?The relationship between the quantity a firm can produce and its costs determines pricing decisions. ?The total-cost curve shows this relationship graphically. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Production Function and Total Cost Number of Workers Output Marginal Product of Labor Cost of Factory Cost of Workers Total Cost of Inputs 0 0 $30 $0 $30 1 50 50 30 10 40 2 90 40 30 20 50 3 120 30 30 30 60 4 140 20 30 40 70 5 150 10 30 50 80 Hungry Helen’s Cookie Factory Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Total-Cost Curve... Total Cost $80 70 60 50 40 30 20 10 Quantity of Output (cookies per hour) 0 20 40 1401201008060 Total-cost curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Various Measures of Cost Costs of production may be divided into fixed costs and variable costs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Fixed and Variable Costs ?Fixed costs are those costs that do not vary with the quantity of output produced. ?Variable costs are those costs that do change as the firm alters the quantity of output produced. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Family of Total Costs ?Total Fixed Costs (TFC) ?Total Variable Costs (TVC) ?Total Costs (TC) TC = TFC + TVC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Family of Total Costs Quantity 0 1 2 3 4 5 6 7 8 9 10 Total Cost $ 3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00 Fixed Cost $3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 Variable Cost $ 0.00 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Average Costs ?Average costs can be determined by dividing the firm’s costs by the quantity of output produced. ?The average cost is the cost of each typical unit of product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Family of Average Costs ?Average Fixed Costs (AFC) ?Average Variable Costs (AVC) ?Average Total Costs (ATC) ATC = AFC + AVC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Family of Average Costs AFC = Fixed cost Quantity = FC Q AVC = Variable cost Quantity = VC Q ATC = Total cost Quantity = TC Q Fixed cost tity AVC able cost To Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Family of Average Costs $3.00 Quantity AFC AVC ATC 0——— 1 $0.30 $3.30 2 1.50 0.40 1.90 3 1.00 0.50 1.50 4 0.75 0.60 1.35 5 0.60 0.70 1.30 6 0.50 0.80 1.30 7 0.43 0.90 1.33 8 0.38 1.00 1.38 9 0.33 1.10 1.43 10 0.30 1.20 1.50 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Cost ?Marginal cost (MC) measures the amount total cost rises when the firm increases production by one unit. ?Marginal cost helps answer the following question: ?How much does it cost to produce an additional unit of output? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Cost Q TC = quantity) in (Change cost)total in(Change =MC ? ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Cost Quantity Total Cost Marginal Cost Quantity Total Cost Marginal Cost 0$3.0 — 1 3.30 $0.30 6 $7.80 $1.30 2 3.80 0.50 7 9.30 1.50 3 4.50 0.70 8 11.00 1.70 4 5.40 0.90 9 12.90 1.90 5 6.50 1.10 10 15.00 2.10 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Total-Cost Curve... $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 0 24681012 Total Cost Total-cost curve Quantity of Output (glasses of lemonade per hour) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. ATC AVC MC Average-Cost and Marginal-Cost Curves... $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 0 2 4 6 8 10 12 Costs AFC Quantity of Output (glasses of lemonade per hour) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes Marginal cost rises with the amount of output produced. ?This reflects the property of diminishing marginal product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 024681012 Quantity of Output (glasses of lemonade per hour) Costs MC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes The average total-cost curve is U-shaped. ? At very low levels of output average total cost is high because fixed cost is spread over only a few units. ? Average total cost declines as output increases. ? Average total cost starts rising because average variable cost rises substantially. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes The bottom of the U-shape occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 024681012 Total Costs ATC Quantity of Output (glasses of lemonade per hour) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Relationship Between Marginal Cost and Average Total Cost ?Whenever marginal cost is less than average total cost, average total cost is falling. ?Whenever marginal cost is greater than average total cost, average total cost is rising. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Relationship Between Marginal Cost and Average Total Cost The marginal-cost curve crosses the average-total-cost curve at the efficient scale. ?Efficient scale is the quantity that minimizes average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. MC ATC Relationship Between Marginal Cost and Average Total Cost $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 024681012 Costs Quantity of Output (glasses of lemonade per hour) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Various Measures of Cost It is now time to examine the relationships that exist between the different measures of cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Various Measures of Cost Big Bob’s Bagel Bin Quantity of Bagels Total Cost Fixed Cost Variable Cost Average Fixed Cost Average Variable Cost Average Total Cost Marginal Cost 0 $2.00 $2.00 $0.00 1 $3.00 $2.00 $1.00 $2.00 $1.00 $3.00 $1.00 2 $3.80 $2.00 $1.80 $1.00 $0.90 $1.90 $0.80 3 $4.40 $2.00 $2.40 $0.67 $0.80 $1.47 $0.60 4 $4.80 $2.00 $2.80 $0.50 $0.70 $1.20 $0.40 5 $5.20 $2.00 $3.20 $0.40 $0.64 $1.04 $0.40 6 $5.80 $2.00 $3.80 $0.33 $0.63 $0.97 $0.60 7 $6.60 $2.00 $4.60 $0.29 $0.66 $0.94 $0.80 8 $7.60 $2.00 $5.60 $0.25 $0.70 $0.95 $1.00 9 $8.80 $2.00 $6.80 $0.22 $0.76 $0.98 $1.20 10 $10.20 $2.00 $8.20 $0.20 $0.82 $1.02 $1.40 11 $11.80 $2.00 $9.80 $0.18 $0.89 $1.07 $1.60 12 $13.60 $2.00 $11.60 $0.17 $0.97 $1.13 $1.80 13 $15.60 $2.00 $13.60 $0.15 $1.05 $1.20 $2.00 14 $17.80 $2.00 $15.80 $0.14 $1.13 $1.27 $2.20 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Big Bob’s Cost Curves... $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 $18.00 $20.00 0246810121416 Quantity of Output (bagels per hour) Total Cost Total Cost Curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Big Bob’s Cost Curves... AFC AVC MC 0 0.5 1 1.5 2 2.5 3 3.5 0246810121416 Quantity of Output Costs ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Three Important Properties of Cost Curves ?Marginal cost eventually rises with the quantity of output. ?The average-total-cost curve is U- shaped. ?The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Costs in the Long Run ?For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. ?In the short run some costs are fixed. ?In the long run fixed costs become variable costs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Costs in the Long Run Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Average Total Cost in the Short and Long Runs... Quantity of Cars per Day 0 Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economies and Diseconomies of Scale ?Economies of scale occur when long-run average total cost declines as output increases. ?Diseconomies of scale occur when long- run average total cost rises as output increases. ?Constant returns to scale occur when long-run average total cost does not vary as output increases. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economies and Diseconomies of Scale Diseconomies of scale Quantity of Cars per Day 0 Average Total Cost ATC in long run Economies of scale Constant Returns to scale Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The goal of firms is to maximize profit, which equals total revenue minus total cost. ?When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. ?Some opportunity costs are explicit while other opportunity costs are implicit. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A firm’s costs reflect its production process. ?A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. ?A firm’s total costs are divided between fixed and variable costs. Fixed costs don’t vary with quantities produced; variable costs do. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Average total cost is total cost divided by the quantity of output. ?Marginal cost is the amount by which total cost would rise if output were increased by one unit. ?The marginal cost always rises with the quantity of output. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The average-total-cost curve is U- shaped. ?The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. ?A firm’s costs often depend on the time horizon being considered. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economic Profit versus Accounting Profit Revenue Total opportunity costs How an Economist Views a Firm Explicit costs Economic profit Implicit costs Explicit costs Accounting profit How an Accountant Views a Firm Revenue Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Production Function... Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired0 12345 Production function Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Total-Cost Curve... Total Cost $80 70 60 50 40 30 20 10 Quantity of Output (cookies per hour) 0 20 40 1401201008060 Total-cost curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Total-Cost Curve... $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 0 24681012 Quantity of Output (glasses of lemonade per hour) Total Cost Total-cost curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Average-Cost and Marginal-Cost Curves... ATC AVC MC $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 0 2 4 6 8 10 12 Quantity of Output (glasses of lemonade per hour) Costs AFC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 024681012 Quantity of Output (glasses of lemonade per hour) Costs MC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Cost Curves and Their Shapes $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 024681012 Quantity of Output (glasses of lemonade per hour) Total Costs ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Relationship Between Marginal Cost and Average Total Cost MC ATC $0.00 $0.50 $1.00 $1.50 $2.00 $2.50 $3.00 $3.50 024681012 Quantity of Output (glasses of lemonade per hour) Costs Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Big Bob’s Cost Curves... $0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 $18.00 $20.00 0246810121416 Quantity of Output (bagels per hour) Total Cost Total Cost Curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Big Bob’s Cost Curves... AFC AVC MC 0 0.5 1 1.5 2 2.5 3 3.5 0246810121416 Quantity of Output Costs ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Average Total Cost in the Short and Long Runs... Quantity of Cars per Day 0 Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economies and Diseconomies of Scale Diseconomies of scale Quantity of Cars per Day 0 Average Total Cost ATC in long run Economies of scale Constant Returns to scale Firms in Competitive Markets Chapter 14 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Meaning of Competition ?A perfectly competitive market has the following characteristics: ?There are many buyers and sellers in the market. ?The goods offered by the various sellers are largely the same. ?Firms can freely enter or exit the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Meaning of Competition ?As a result of its characteristics, the perfectly competitive market has the following outcomes: ?The actions of any single buyer or seller in the market have a negligible impact on the market price. ?Each buyer and seller takes the market price as given. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Meaning of Competition Buyers and sellers in competitive markets are said to be price takers. Buyers and sellers must accept the price determined by the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = (P X Q) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm Total revenue is proportional to the amount of output. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm Average revenue tells us how much revenue a firm receives for the typical unit sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm In perfect competition, average revenue equals the price of the good. Average revenue = Total revenue Quantity = (Price Quantity) Quantity =Price × Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm Marginal revenue is the change in total revenue from an additional unit sold. MR =?TR/ ?Q Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Revenue of a Competitive Firm For competitive firms, marginal revenue equals the price of the good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Total, Average, and Marginal Revenue for a Competitive Firm Quantity (Q) Price (P) Total Revenue (TR=PxQ) Average Revenue (AR=TR/Q) Marginal Revenue (MR= ) 1 $6.00 $6.00 $6.00 2 $6.00 $12.00 $6.00 $6.00 3 $6.00 $18.00 $6.00 $6.00 4 $6.00 $24.00 $6.00 $6.00 5 $6.00 $30.00 $6.00 $6.00 6 $6.00 $36.00 $6.00 $6.00 7 $6.00 $42.00 $6.00 $6.00 8 $6.00 $48.00 $6.00 $6.00 QTR ?? / Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm ?The goal of a competitive firm is to maximize profit. ?This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization: A Numerical Example Price (P) Quantity (Q) Total Revenue (TR=PxQ) Total Cost (TC) Profit (TR-TC) Marginal Revenue (MR= ) Marginal Cost MC= 0 $0.00 $3.00 -$3.00 $6.00 1 $6.00 $5.00 $1.00 $6.00 $2.00 $6.00 2 $12.00 $8.00 $4.00 $6.00 $3.00 $6.00 3 $18.00 $12.00 $6.00 $6.00 $4.00 $6.00 4 $24.00 $17.00 $7.00 $6.00 $5.00 $6.00 5 $30.00 $23.00 $7.00 $6.00 $6.00 $6.00 6 $36.00 $30.00 $6.00 $6.00 $7.00 $6.00 7 $42.00 $38.00 $4.00 $6.00 $8.00 $6.00 8 $48.00 $47.00 $1.00 $6.00 $9.00 QTR ?? / QTC ?? / Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm... P = AR = MR P=MR 1 MC Quantity 0 Costs and Revenue ATC AVC Q MAX The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC 1 Q 1 MC 2 Q 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm Profit maximization occurs at the quantity where marginal revenue equals marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm When MR > MC D increase Q When MR < MC D decrease Q When MR = MC D Profit is maximized. Copyright ? 2001 by Harcourt, Inc. All rights reserved The Marginal-Cost Curve and the Firm’s Supply Decision... Quantity 0 Costs and Revenue MC ATC AVC Q 1 P 1 P 2 Q 2 This section of the firm’s MC curve is also the firm’s supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down ?A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. ?Exit refers to a long-run decision to leave the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down. ?Sunk costs are costs that have already been committed and cannot be recovered. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down ?The firm shuts down if the revenue it gets from producing is less than the variable cost of production. Shut down if TR < VC Shut down if TR/Q < VC/Q Shut down if P < AVC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down... Quantity ATC AVC 0 Costs MC If P < AVC, shut down. If P > AVC, keep producing in the short run. If P > ATC, keep producing at a profit. Firm’s short-run supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Long-Run Decision to Exit or Enter a Market ?In the long-run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Long-Run Decision to Exit or Enter a Market ?A firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC = Long-run S ATC AVC 0 Costs Firm enters if P > ATC Firm exits if P < ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC ATC AVC 0 Costs Firm’s long-run supply curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run and Long-Run Supply Curves ?Short-Run Supply Curve ?The portion of its marginal cost curve that lies above average variable cost. ?Long-Run Supply Curve ?The marginal cost curve above the minimum point of its average total cost curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Profit Q Quantity 0 Price P = AR = MR ATCMC P ATC a. A Firm with Profits Profit-maximizing quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Loss Quantity 0 Price P = AR = MR ATCMC P Q ATC b. A Firm with Losses Loss-minimizing quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Supply in a Competitive Market Market supply equals the sum of the quantities supplied by the individual firms in the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms ?For any given price, each firm supplies a quantity of output so that its marginal cost equals price. ?The market supply curve reflects the individual firms’ marginal cost curves. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms... (a) Individual Firm Supply (b) Market Supply Quantity (firm) 0 Price Quantity (market) Price 0 Supply MC 1.00 $2.00 100 200 1.00 $2.00 100,000 200,000 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit ?Firms will enter or exit the market until profit is driven to zero. ?In the long run, price equals the minimum of average total cost. ?The long-run market supply curve is horizontal at this price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit... (a) Firm’s Zero-Profit Condition (b) Market Supply Quantity (firm) 0 Price P = minimum ATC Quantity (market) Price 0 Supply MC ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit ?At the end of the process of entry and exit, firms that remain must be making zero economic profit. ?The process of entry & exit ends only when price and average total cost are driven to equality. ?Long-run equilibrium must have firms operating at their efficient scale. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Firms Stay in Business with Zero Profit ?Profit equals total revenue minus total cost. ?Total cost includes all the opportunity costs of the firm. ?In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run ?An increase in demand raises price and quantity in the short run. ?Firms earn profits because price now exceeds average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... (a) Initial Condition Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... (b) Short-Run Response D 2 Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply Q 2 B P 2 P 2 Profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... (c) Long-Run Response Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply D 2 B Q 2 P 2 S 2 C Q 3 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why the Long-Run Supply Curve Might Slope Upward ?Some resources used in production may be available only in limited quantities. ?Firms may have different costs. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal Firm The marginal firm is the firm that would exit the market if the price were any lower. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. ?The price of the good equals both the firm’s average revenue and its marginal revenue. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?To maximize profit a firm chooses the quantity of output such that marginal revenue equals marginal cost. ?This is also the quantity at which price equals marginal cost. ?Therefore, the firm’s marginal cost curve is its supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. ?In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale. ?Changes in demand have different effects over different time horizons. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization for the Competitive Firm... P = AR = MR P=MR 1 MC Quantity 0 Costs and Revenue ATC AVC Q MAX The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC 1 Q 1 MC 2 Q 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Marginal-Cost Curve and the Firm’s Supply Decision... Quantity 0 Costs and Revenue MC ATC AVC Q 1 P 1 P 2 Q 2 This section of the firm’s MC curve is also the firm’s supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down... Quantity ATC AVC 0 Costs MC If P < AVC, shut down. If P > AVC, keep producing in the short run. If P > ATC, keep producing at a profit. Firm’s short-run supply curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC = Long-run S ATC AVC 0 Costs Firm enters if P > ATC Firm exits if P < ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC ATC AVC 0 Costs Firm’s long-run supply curve Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Profit Q Quantity 0 Price P = AR = MR ATCMC P ATC Profit-maximizing quantity a. A Firm with Profits Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Loss Quantity 0 Price P = AR = MR ATCMC P Q Loss-minimizing quantity ATC b. A Firm with Losses Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms... (a) Individual Firm Supply Quantity (firm) 0 Price (b) Market Supply Quantity (market) Price 0 Supply MC 1.00 $2.00 100 200 1.00 $2.00 100,000 200,000 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit... (a) Firm’s Zero-Profit Condition Quantity (firm) 0 Price P = minimum ATC (b) Market Supply Quantity (market) Price 0 Supply MC ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply (a) Initial Condition P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... D 2 Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply (b) Short-Run Response Q 2 B P 2 P 2 Profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MC ATC P 1 Quantity (market) Price 0 D 1 P 1 Q 1 A S 1 Long-run supply (c) Long-Run Response D 2 B Q 2 P 2 S 2 C Q 3 Monopoly Chapter 15 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopoly While a competitive firm is a price taker, a monopoly firm is a price maker. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopoly ?A firm is considered a monopoly if . . . … it is the sole seller of its product. … its product does not have close substitutes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why Monopolies Arise The fundamental cause of monopoly is barriers to entry. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why Monopolies Arise Barriers to entry have three sources: ? Ownership of a key resource. ? The government gives a single firm the exclusive right to produce some good. ? Costs of production make a single producer more efficient than a large number of producers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopoly Resources Although exclusive ownership of a key resource is a potential source of monopoly, in practice monopolies rarely arise for this reason. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Government-Created Monopolies Governments may restrict entry by giving a single firm the exclusive right to sell a particular good in certain markets. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Government-Created Monopolies Patent and copyright laws are two important examples of how government creates a monopoly to serve the public interest. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Natural Monopolies An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a smaller cost than could two or more firms. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Natural Monopolies A natural monopoly arises when there are economies of scale over the relevant range of output. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economies of Scale as a Cause of Monopoly... Cost Average total cost Quantity of Output 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopoly versus Competition Monopoly ?Is the sole producer ?Has a downward-sloping demand curve ?Is a price maker ?Reduces price to increase sales Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition versus Monopoly Competitive Firm ?Is one of many producers ?Has a horizontal demand curve ?Is a price taker ?Sells as much or as little at same price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Curves for Competitive and Monopoly Firms... Quantity of Output Demand (a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve 0 Price 0 Quantity of Output Price Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopoly’s Revenue ?Total Revenue P x Q = TR ?Average Revenue TR/Q = AR = P ?Marginal Revenue ?TR/?Q = MR Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopoly’s Total, Average, and Marginal Revenue Quantity (Q) Price (P) Total Revenue (TR=PxQ) Average Revenue (AR=TR/Q) Marginal Revenue (MR= ) 0 $11.00 $0.00 1 $10.00 $10.00 $10.00 $10.00 2 $9.00 $18.00 $9.00 $8.00 3 $8.00 $24.00 $8.00 $6.00 4 $7.00 $28.00 $7.00 $4.00 5 $6.00 $30.00 $6.00 $2.00 6 $5.00 $30.00 $5.00 $0.00 7 $4.00 $28.00 $4.00 -$2.00 8 $3.00 $24.00 $3.00 -$4.00 QTR ?? / Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopoly’s Marginal Revenue A monopolist’s marginal revenue is always less than the price of its good. ?The demand curve is downward sloping. ?When a monopoly drops the price to sell one more unit, the revenue received from previously sold units also decreases. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopoly’s Marginal Revenue When a monopoly increases the amount it sells, it has two effects on total revenue (P x Q). ?The output effect—more output is sold, so Q is higher. ?The price effect—price falls, so P is lower. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand and Marginal Revenue Curves for a Monopoly... Quantity of Water Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 12345 678 Marginal revenue Demand (average revenue) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit Maximization of a Monopoly ?A monopoly maximizes profit by producing the quantity at which marginal revenue equals marginal cost. ?It then uses the demand curve to find the price that will induce consumers to buy that quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit-Maximization for a Monopoly... Monopoly price QuantityQ MAX 0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost A 1. The intersection of the marginal-revenue curve and the marginal- cost curve determines the profit-maximizing quantity... B 2. ...and then the demand curve shows the price consistent with this quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Comparing Monopoly and Competition ?For a competitive firm, price equals marginal cost. P = MR = MC ?For a monopoly firm, price exceeds marginal cost. P > MR = MC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopoly’s Profit Profit equals total revenue minus total costs. Profit = TR - TC Profit = (TR/Q - TC/Q) x Q Profit = (P - ATC) x Q Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Monopolist’s Profit... Mo n o p o l y p r o f i t Quantity0 Costs and Revenue Demand Marginal cost Marginal revenue Q MAX B Monopoly price E Average total cost D Average total cost C Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Monopolist’s Profit The monopolist will receive economic profits as long as price is greater than average total cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Drugs... Costs and Revenue Price during patent life Price after patent expires Monopoly quantity Competitive quantity Quantity Marginal revenue 0 Marginal cost Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Welfare Cost of Monopoly ?In contrast to a competitive firm, the monopoly charges a price above the marginal cost. ?From the standpoint of consumers, this high price makes monopoly undesirable. ?However, from the standpoint of the owners of the firm, the high price makes monopoly very desirable. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Efficient Level of Output... Price 0 Quantity Marginal cost Demand (value to buyers) Efficient quantity Cost to monopolist Value to buyers Value to buyers Cost to monopolist Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss Because a monopoly sets its price above marginal cost, it places a wedge between the consumer’s willingness to pay and the producer’s cost. ?This wedge causes the quantity sold to fall short of the social optimum. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Inefficiency of Monopoly... Quantity0 Demand Marginal revenue Marginal cost Monopoly price Deadweight loss Efficient quantity Monopoly quantity Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Inefficiency of Monopoly The monopolist produces less than the socially efficient quantity of output. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Deadweight Loss ?The deadweight loss caused by a monopoly is similar to the deadweight loss caused by a tax. ?The difference between the two cases is that the government gets the revenue from a tax, whereas a private firm gets the monopoly profit. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Public Policy Toward Monopolies Government responds to the problem of monopoly in one of four ways. ? Making monopolized industries more competitive. ? Regulating the behavior of monopolies. ? Turning some private monopolies into public enterprises. ? Doing nothing at all. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Increasing Competition with Antitrust Laws ? Antitrust laws are a collection of statutes aimed at curbing monopoly power. ? Antitrust laws give government various ways to promote competition. ?They allow government to prevent mergers. ?They allow government to break up companies. ?They prevent companies from performing activities which make markets less competitive. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Two Important Antitrust Laws ?Sherman Antitrust Act (1890) ?Reduced the market power of the large and powerful “trusts” of that time period. ?Clayton Act (1914) ?Strengthened the government’s powers and authorized private lawsuits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Regulation Government may regulate the prices that the monopoly charges. ?The allocation of resources will be efficient if price is set to equal marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal-Cost Pricing for a Natural Monopoly... Regulated price Quantity 0 Loss Price Demand Marginal cost Average total cost Average total cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Regulation In practice, regulators will allow monopolists to keep some of the benefits from lower costs in the form of higher profit, a practice that requires some departure from marginal-cost pricing. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Public Ownership Rather than regulating a natural monopoly that is run by a private firm, the government can run the monopoly itself. (e.g. in the U.S., the government runs the Postal Service). Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Doing Nothing Government can do nothing at all if the market failure is deemed small compared to the imperfections of public policies. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Discrimination Price discrimination is the practice of selling the same good at different prices to different customers, even though the costs for producing for the two customers are the same. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Discrimination Price discrimination is not possible when a good is sold in a competitive market since there are many firms all selling at the market price. In order to price discriminate, the firm must have some market power. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Perfect Price Discrimination Perfect price discrimination refers to the situation when the monopolist knows exactly the willingness to pay of each customer and can charge each customer a different price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Price Discrimination ?Two important effects of price discrimination: ?It can increase the monopolist’s profits. ?It can reduce deadweight loss. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare Without Price Discrimination... Deadweight loss Consumer surplus Price 0 Quantity Profit Demand Marginal cost Marginal revenue Quantity sold Monopoly price (a) Monopolist with Single Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare With Price Discrimination... Price 0 Quantity Demand Marginal cost Quantity sold (b) Monopolist with Perfect Price Discrimination Profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Examples of Price Discrimination ?Movie tickets ?Airline prices ?Discount coupons ?Financial aid ?Quantity discounts Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prevalence of Monopoly ?How prevalent are the problems of monopolies? ?Monopolies are common. ?Most firms have some control over their prices because of differentiated products. ?Firms with substantial monopoly power are rare. ?Few goods are truly unique. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A monopoly is a firm that is the sole seller in its market. ?It faces a downward-sloping demand curve for its product. ?A monopoly’s marginal revenue is always below the price of its good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Like a competitive firm, a monopoly maximizes profit by producing the quantity at which marginal cost and marginal revenue are equal. ?Unlike a competitive firm, its price exceeds its marginal revenue, so its price exceeds marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A monopolist’s profit-maximizing level of output is below the level that maximizes the sum of consumer and producer surplus. ?A monopoly causes deadweight losses similar to the deadweight losses caused by taxes. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Policymakers can respond to the inefficiencies of monopoly behavior with antitrust laws, regulation of prices, or by turning the monopoly into a government-run enterprise. ?If the market failure is deemed small, policymakers may decide to do nothing at all. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Monopolists can raise their profits by charging different prices to different buyers based on their willingness to pay. ?Price discrimination can raise economic welfare and lessen deadweight losses. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Economies of Scale as a Cause of Monopoly... Average total cost Quantity of Output Cost 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand Curves for Competitive and Monopoly Firms... Quantity of Output Demand (a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve 0 Price 0 Quantity of Output Price Demand Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Demand and Marginal Revenue Curves for a Monopoly... Quantity of Water Price $11 10 9 8 7 6 5 4 3 2 1 0 -1 -2 -3 -4 12345 678 Marginal revenue Demand (average revenue) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Profit-Maximization for a Monopoly... Monopoly price QuantityQ MAX 0 Costs and Revenue Demand Average total cost Marginal revenue Marginal cost A 1. The intersection of the marginal-revenue curve and the marginal- cost curve determines the profit-maximizing quantity... B 2. ...and then the demand curve shows the price consistent with this quantity. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Monopolist’s Profit... Mo n o p o l y p r o f i t Quantity0 Costs and Revenue Demand Marginal cost Marginal revenue Q MAX B Monopoly price E Average total cost D Average total cost C Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for Drugs... Costs and Revenue Price during patent life Price after patent expires Monopoly quantity Competitive quantity 0 Quantity Demand Marginal cost Marginal revenue Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Efficient Level of Output... Price 0 Quantity Marginal cost Demand (value to buyers) Efficient quantity Cost to monopolist Value to buyers Value to buyers Cost to monopolist Value to buyers is greater than cost to seller. Value to buyers is less than cost to seller. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Inefficiency of Monopoly... Quantity0 Demand Marginal revenue Marginal cost Monopoly price Deadweight loss Efficient quantity Monopoly quantity Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Marginal-Cost Pricing for a Natural Monopoly... Regulated price Quantity 0 Loss Price Demand Marginal cost Average total cost Average total cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare Without Price Discrimination... Deadweight loss Consumer surplus Price 0 Quantity Profit Demand Marginal cost Marginal revenue Quantity sold Monopoly price (a) Monopolist with Single Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Welfare With Price Discrimination... Price 0 Quantity Demand Marginal cost Quantity sold (b) Monopolist with Perfect Price Discrimination Profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Oligopoly Chapter 16 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Imperfect Competition Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Imperfect Competition Imperfect competition includes industries in which firms have competitors but do not face so much competition that they are price takers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Imperfectly Competitive Markets ?Oligopoly ?Only a few sellers, each offering a similar or identical product to the others. ?Monopolistic Competition ?Many firms selling products that are similar but not identical. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Four Types of Market Structure Monopoly Oligopoly Monopolistic Competition Perfect Competition ? Tap water ? Cable TV ? Tennis balls ? Crude oil ? Novels ? Movies ? Wheat ? Milk Number of Firms? Type of Products? Many firms One firm Few firms Differentiated products Identical products Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markets With Only a Few Sellers Because of the few sellers, the key feature of oligopoly is the tension between cooperation and self-interest. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Characteristics of an Oligopoly Market ?Few sellers offering similar or identical products ?Interdependent firms ?Best off cooperating and acting like a monopolist by producing a small quantity of output and charging a price above marginal cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Duopoly Example A duopoly is an oligopoly with only two members. It is the simplest type of oligopoly. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Duopoly Example: Demand Schedule for Water Quantity Price Total Revenue 0 $120 $ 0 10 110 1,100 20 100 2,000 30 90 2,700 40 80 3,200 50 70 3,500 60 60 3,600 70 50 3,500 80 40 3,200 90 30 2,700 100 20 2,000 110 10 1,100 120 0 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Duopoly Example: Price and Quantity Supplied ?The price of water in a perfectly competitive market would be driven to where the marginal cost is zero: P = MC = $0 Q = 120 gallons ?The price and quantity in a monopoly market would be where total profit is maximized: P = $60 Q = 60 gallons Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Duopoly Example: Price and Quantity Supplied ?The socially efficient quantity of water is 120 gallons, but a monopolist would produce only 60 gallons of water. ?So what outcome then could be expected from duopolists? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition, Monopolies, and Cartels ?The duopolists may agree on a monopoly outcome. ?Collusion ?The two firms may agree on the quantity to produce and the price to charge. ?Cartel ?The two firms may join together and act in unison. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Competition, Monopolies, and Cartels Although oligopolists would like to form cartels and earn monopoly profits, often that is not possible. Antitrust laws prohibit explicit agreements among oligopolists as a matter of public policy. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Equilibrium for an Oligopoly A Nash equilibrium is a situation in which economic actors interacting with one another each choose their best strategy given the strategies that all the others have chosen. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Equilibrium for an Oligopoly When firms in an oligopoly individually choose production to maximize profit, they produce quantity of output greater than the level produced by monopoly and less than the level produced by competition. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Equilibrium for an Oligopoly The oligopoly price is less than the monopoly price but greater than the competitive price (which equals marginal cost). Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary of Equilibrium for an Oligopoly ?Possible outcome if oligopoly firms pursue their own self-interests: ?Joint output is greater than the monopoly quantity but less than the competitive industry quantity. ?Market prices are lower than monopoly price but greater than competitive price. ?Total profits are less than the monopoly profit. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Duopoly Example: Demand Schedule for Water Quantity Price Total Revenue 0 $120 $ 0 10 110 1,100 20 100 2,000 30 90 2,700 40 80 3,200 50 70 3,500 60 60 3,600 70 50 3,500 80 40 3,200 90 30 2,700 100 20 2,000 110 10 1,100 120 0 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How the Size of an Oligopoly Affects the Market Outcome ?How increasing the number of sellers affects the price and quantity: ?The output effect: Because price is above marginal cost, selling more at the going price raises profits. ?The price effect: Raising production lowers the price and the profit per unit on all units sold. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How the Size of an Oligopoly Affects the Market Outcome ?As the number of sellers in an oligopoly grows larger, an oligopolistic market looks more and more like a competitive market. ?The price approaches marginal cost, and the quantity produced approaches the socially efficient level. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Game Theory and the Economics of Cooperation ?Game theory is the study of how people behave in strategic situations. ?Strategic decisions are those in which each person, in deciding what actions to take, must consider how others might respond to that action. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Game Theory and the Economics of Cooperation ?Because the number of firms in an oligopolistic market is small, each firm must act strategically. ?Each firm knows that its profit depends not only on how much it produced but also on how much the other firms produce. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prisoners’ Dilemma The prisoners’ dilemma provides insight into the difficulty in maintaining cooperation. Often people (firms) fail to cooperate with one another even when cooperation would make them better off. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prisoners’ Dilemma Bonnie’s Decision Confess Remain Silent Confess Remain Silent Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Clyde’s Decision Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prisoners’ Dilemma The dominant strategy is the best strategy for a player to follow regardless of the strategies pursued by other players. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prisoners’ Dilemma Cooperation is difficult to maintain, because cooperation is not in the best interest of the individual player. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Oligopolies as a Prisoners’ Dilemma Iraq’s Decision High Production Low Production High Production Low Production Iran gets $40 billion Iraq gets $40 billion Iraq gets $30 billion Iraq gets $50 billion Iraq gets $60 billion Iran gets $30 billion Iran gets $50 billion Iran gets $60 billion Iran’s Decision Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Oligopolies as a Prisoners’ Dilemma Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with low production, high prices, and monopoly profits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Arms-Race Game Decision of the United States (U.S.) Arm Disarm Arm Disarm USSR at risk U.S. at risk U.S. at risk and weak U.S. safe U.S. safe and powerful USSR at risk and weak USSR safe USSR safe and powerful Decision of the Soviet Union (USSR) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Advertising Game Marlboro’s Decision Advertise Don’t Advertise Advertise Don’t Advertise Camel gets $3 billion profit Marlboro gets $3 billion profit Marlboro gets $2 billion profit Marlboro gets $4 billion profit Marlboro gets $5 billion profit Camel gets $2 billion profit Camel gets $4 billion profit Camel gets $5 billion profit Camel’s Decision Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Common-Resources Game Exxon’s Decision Drill Two Wells Drill One Well Drill Two Wells Drill One Well Arco gets $4 million profit Exxon gets $4 million profit Exxon gets $3 million profit Exxon gets $5 million profit Exxon gets $6 million profit Arco gets $3 million profit Arco gets $5 million profit Arco gets $6 million profit Arco’s Decision Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Why People Sometimes Cooperate Firms that care about future profits will cooperate in repeated games rather than cheating in a single game to achieve a one-time gain. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Jack and Jill’s Oligopoly Game Jack’s Decision Sell 40 gallons Sell 30 gallons Sell 40 gallons Sell 30 gallons Jill gets $1,600 profit Jack gets $1,600 profit Jack gets $1,500 profit Jack gets $1,800 profit Jack gets $2,000 profit Jill gets $1,500 profit Jill gets $1,800 profit Jill gets $2,000 profit Jill’s Decision Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Public Policy Toward Oligopolies Cooperation among oligopolists is undesirable from the standpoint of society as a whole because it leads to production that is too low and prices that are too high. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Restraint of Trade and the Antitrust Laws ?Antitrust laws make it illegal to restrain trade or attempt to monopolize a market. ? Sherman Antitrust Act of 1890 ? Clayton Act of 1914 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Controversies over Antitrust Policy ?Antitrust policies sometimes may not allow business practices that have potentially positive effects: ?Resale price maintenance ?Predatory pricing ?Tying Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Resale Price Maintenance Resale price maintenance (or fair trade) occurs when suppliers (like wholesalers) require the retailers that they sell to, to charge customers a specific amount. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Predatory Pricing Predatory pricing occurs when a large firm begins to cut the price of its product(s) with the intent of driving its competitor(s) out of the market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Tying Tying refers to when a firm offers two (or more) of its products together at a single price, rather than separately. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Oligopolists maximize their total profits by forming a cartel and acting like a monopolist. ?If oligopolists make decisions about production levels individually, the result is a greater quantity and a lower price than under the monopoly outcome. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The prisoners’ dilemma shows that self- interest can prevent people from maintaining cooperation, even when cooperation is in their mutual self- interest. ?The logic of the prisoners’ dilemma applies in many situations, including oligopolies. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Policymakers use the antitrust laws to prevent oligopolies from engaging in behavior that reduces competition. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Four Types of Market Structure Monopoly Oligopoly Monopolistic Competition Perfect Competition ? Tap water ? Cable TV ? Tennis balls ? Crude oil ? Novels ? Movies ? Wheat ? Milk Number of Firms? Type of Products? Many firms One firm Few firms Differentiated products Identical products Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Prisoners’ Dilemma Bonnie’s Decision Confess Remain Silent Confess Remain Silent Clyde’s Decision Clyde gets 8 years Bonnie gets 8 years Bonnie gets 20 years Bonnie gets 1 year Bonnie goes free Clyde gets 20 years Clyde gets 1 year Clyde goes free Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Oligopolies as a Prisoners’ Dilemma Iraq’s Decision High Production Low Production High Production Low Production Iran’s Decision Iran gets $40 billion Iraq gets $40 billion Iraq gets $30 billion Iraq gets $50 billion Iraq gets $60 billion Iran gets $30 billion Iran gets $50 billion Iran gets $60 billion Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Arms-Race Game Decision of the United States (U.S.) Arm Disarm Arm Disarm Decision of the Soviet Union (USSR) USSR at risk U.S. at risk U.S. at risk and weak U.S. safe U.S. safe and powerful USSR at risk and weak USSR safe USSR safe and powerful Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. An Advertising Game Marlboro’s Decision Advertise Don’t Advertise Advertise Don’t Advertise Camel’s Decision Camel gets $3 billion profit Marlboro gets $3 billion profit Marlboro gets $2 billion profit Marlboro gets $4 billion profit Marlboro gets $5 billion profit Camel gets $2 billion profit Camel gets $4 billion profit Camel gets $5 billion profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Common-Resources Game Exxon’s Decision Drill Two Wells Drill One Well Drill Two Wells Drill One Well Arco’s Decision Arco gets $4 million profit Exxon gets $4 million profit Exxon gets $3 million profit Exxon gets $5 million profit Exxon gets $6 million profit Arco gets $3 million profit Arco gets $5 million profit Arco gets $6 million profit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Jack and Jill’s Oligopoly Game Jack’s Decision Sell 40 gallons Sell 30 gallons Sell 40 gallons Sell 30 gallons Jill’s Decision Jill gets $1,600 profit Jack gets $1,600 profit Jack gets $1,500 profit Jack gets $1,800 profit Jack gets $2,000 profit Jill gets $1,500 profit Jill gets $1,800 profit Jill gets $2,000 profit Monopolistic Competition Chapter 17 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Four Types of Market Structure Monopoly Oligopoly Monopolistic Competition Perfect Competition ? Tap water ? Cable TV ? Tennis balls ? Crude oil ? Novels ? Movies ? Wheat ? Milk Number of Firms? Type of Products? Many firms One firm Few firms Differentiated products Identical products Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Types of Imperfectly Competitive Markets ?Monopolistic Competition ?Many firms selling products that are similar but not identical. ?Oligopoly ?Only a few sellers, each offering a similar or identical product to the others. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition Markets that have some features of competition and some features of monopoly. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Attributes of Monopolistic Competition ?Many sellers ?Product differentiation ?Free entry and exit Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Many Sellers There are many firms competing for the same group of customers. ?Product examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Product Differentiation ?Each firm produces a product that is at least slightly different from those of other firms. ?Rather than being a price taker, each firm faces a downward-sloping demand curve. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Free Entry or Exit ?Firms can enter or exit the market without restriction. ?The number of firms in the market adjusts until economic profits are zero. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competitors in the Short Run... (a) Firm Makes a Profit Quantity 0 Price Demand MR ATC Profit MC Profit- maximizing quantity Price Average total cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competitors in the Short Run... Quantity 0 Price Demand MR Losses (b) Firm Makes Losses MC ATC Average total cost Loss- minimizing quantity Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition in the Short Run Short-run economic profits encourage new firms to enter the market. This: ? Increases the number of products offered. ? Reduces demand faced by firms already in the market. ? Incumbent firms’ demand curves shift to the left. ? Demand for the incumbent firms’ products fall, and their profits decline. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition in the Short Run Short-run economic losses encourage firms to exit the market. This: ? Decreases the number of products offered. ? Increases demand faced by the remaining firms. ? Shifts the remaining firms’ demand curves to the right. ? Increases the remaining firms’ profits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Long-Run Equilibrium Firms will enter and exit until the firms are making exactly zero economic profits. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopolistic Competitor in the Long Run... Quantity Price 0 Demand MR ATC MC Profit-maximizing quantity P=ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Two Characteristics of Long- Run Equilibrium ?As in a monopoly, price exceeds marginal cost. ?Profit maximization requires marginal revenue to equal marginal cost. ?The downward-sloping demand curve makes marginal revenue less than price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Two Characteristics of Long- Run Equilibrium ?As in a competitive market, price equals average total cost. ?Free entry and exit drive economic profit to zero. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic versus Perfect Competition There are two noteworthy differences between monopolistic and perfect competition—excess capacity and markup. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Capacity ?There is no excess capacity in perfect competition in the long run. ?Free entry results in competitive firms producing at the point where average total cost is minimized, which is the efficient scale of the firm. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Capacity ?There is excess capacity in monopolistic competition in the long run. ?In monopolistic competition, output is less than the efficient scale of perfect competition. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Capacity... (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Quantity Price P = MR (demand curve) MC ATC Price Demand MC ATC Excess capacity Quantity produced Efficient scale P = MC Quantity produced = Efficient scale P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markup Over Marginal Cost ?For a competitive firm, price equals marginal cost. ?For a monopolistically competitive firm, price exceeds marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markup Over Marginal Cost Because price exceeds marginal cost, an extra unit sold at the posted price means more profit for the monopolistically competitive firm. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markup Over Marginal Cost... (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Quantity Price P = MC P = MR (demand curve) MC ATC Quantity produced Price P Demand Marginal cost MC ATC MR Markup Quantity produced Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic versus Perfect Competition... (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Quantity Price P = MR (demand curve) MC ATC Quantity produced Efficient scale Price P Demand MC ATC P = MC Excess capacity Marginal cost Markup MR Quantity produced = Efficient scale Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society Monopolistic competition does not have all the desirable properties of perfect competition. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society ?There is the normal deadweight loss of monopoly pricing in monopolistic competition caused by the markup of price over marginal cost. ?However, the administrative burden of regulating the pricing of all firms that produce differentiated products would be overwhelming. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the “ideal” one. There may be too much or too little entry. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society Externalities of entry include: ? product-variety externalities. ? business-stealing externalities. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competition and the Welfare of Society The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Advertising When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Advertising ?Firms that sell highly differentiated consumer goods typically spend between 10 and 20 percent of revenue on advertising. ?Overall, about 2 percent of total revenue, or over $100 billion a year, is spent on advertising. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Advertising ?Critics of advertising argue that firms advertise in order to manipulate people’s tastes. ?They also argue that it impedes competition by implying that products are more different than they truly are. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Advertising ?Defenders argue that advertising provides information to consumers ?They also argue that advertising increases competition by offering a greater variety of products and prices. ?The willingness of a firm to spend advertising dollars can be a signal to consumers about the quality of the product being offered. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Brand Names ?Critics argue that brand names cause consumers to perceive differences that do not really exist. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Brand Names ?Economists have argued that brand names may be a useful way for consumers to ensure that the goods they are buying are of high quality. ?providing information about quality. ?giving firms incentive to maintain high quality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?A monopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. ?The equilibrium in a monopolistically competitive market differs from perfect competition in that each firm has excess capacity and each firm charges a price above marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Monopolistic competition does not have all of the desirable properties of perfect competition. ?There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. ?The number of firms can be too large or too small. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The product differentiation inherent in monopolistic competition leads to the use of advertising and brand names. ?Critics of advertising and brand names argue that firms use them to take advantage of consumer irrationality and to reduce competition. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Defenders argue that firms use advertising and brand names to inform consumers and to compete more vigorously on price and product quality. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Four Types of Market Structure Monopoly Oligopoly Monopolistic Competition Perfect Competition ? Tap water ? Cable TV ? Tennis balls ? Crude oil ? Novels ? Movies ? Wheat ? Milk Number of Firms? Type of Products? Many firms One firm Few firms Differentiated products Identical products Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competitors in the Short Run... (a) Firm Makes a Profit Quantity 0 Price Demand MR ATC Profit MC Profit- maximizing quantity Price Average total cost Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic Competitors in the Short Run... Quantity 0 Price Demand MR Losses (b) Firm Makes Losses MC ATC Average total cost Loss- minimizing quantity Price Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Monopolistic Competitor in the Long Run... Quantity Price 0 Demand MR ATC MC Profit-maximizing quantity P=ATC Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Excess Capacity... Quantity (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Price P = MR (demand curve) MC ATC Price Demand MC ATC Excess capacity Quantity produced Efficient scale P = MC Quantity produced = Efficient scale P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Markup Over Marginal Cost... Quantity (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Price P = MC P = MR (demand curve) MC ATC Quantity produced Price P Demand Marginal cost MC ATC MR Markup Quantity produced Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Monopolistic versus Perfect Competition... Quantity (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Quantity Price P = MR (demand curve) MC ATC Quantity produced Efficient scale Price P Demand MC ATC P = MC Excess capacity Marginal cost Markup MR Quantity produced = Efficient scale The Economics of Labor Markets Chapter 18 Copyright ? 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida 32887-6777. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Factors of Production Factors of production are the inputs used to produce goods and services. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Market for the Factors of Production The demand for a factor of production is a derived demand. ?A firm’s demand for a factor of production is derived from its decision to supply a good in another market. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Demand for Labor Labor markets, like other markets in the economy, are governed by the forces of supply and demand. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Versatility of Supply and Demand... (a) The Market for Apples (b) The Market for Apple Pickers Quantity of Apples Quantity of Apple Pickers QL W 00 Wage of Apple Pickers Demand Demand Supply Supply Price of Apples P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Demand For Labor Most labor services, rather than being final goods ready to be enjoyed by consumers, are inputs into the production of other goods. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function and The Marginal Product of Labor The production function illustrates the relationship between the quantity of inputs used and the quantity of output of a good. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. How the Competitive Firm Decides How Much Labor to Hire Labor L Output Q Marginal Product of Labor MPL Value of the Marginal Product of Labor VMPL=PxMPL Wage W Marginal Profit 00 1 100 100 $1,000 $500 $500 2 180 80 $800 $500 $300 3 240 60 $600 $500 $100 4 280 40 $400 $500 -$100 5 300 20 $200 $500 -$300 ? Pr ofit VMPL W=? MPL Q/ L=? ? Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function... 0 0 50 100 150 200 250 300 350 0123456 Quantity of Apple Pickers 1 2 3 4 5 Quantity of Apples Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function and The Marginal Product of Labor The marginal product of labor is the increase in the amount of output from an additional unit of labor. MPL = ?Q/?L MPL = (Q2 – Q1)/(L2 – L1) Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Diminishing Marginal Product of Labor ?As the number of workers increases, the marginal product of labor declines. ?As more and more workers are hired, each additional worker contributes less to production than the prior one. ?The production function becomes flatter as the number of workers rises. This property is called diminishing marginal product. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function... 0 0 50 100 150 200 250 300 350 0123456 Quantity of Apple Pickers 1 2 3 4 5 Quantity of Apples Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product of Labor ?The value of the marginal product is the marginal product of the input multiplied by the market price of the output. VMPL = MPL X P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product of Labor ?The value of the marginal product is measured in dollars. ?It diminishes as the number of workers rises because the market price of the good is constant. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product and the Demand for Labor ?To maximize profit, the competitive, profit-maximizing firm hires workers up to the point where the value of marginal product of labor equals the wage. VMPL = Wage Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product and the Demand for Labor The value-of-marginal-product curve is the labor demand curve for a competitive, profit-maximizing firm. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product of Labor... 0 Quantity of Apple Pickers Value of the Marginal Product Value of marginal product (demand curve for labor) Market wage Profit-maximizing quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Input Demand and Output Supply When a competitive firm hires labor up to the point at which the value of the marginal product equals the wage, it also produces up to the point at which the price equals the marginal cost. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What Causes the Labor Demand Curve to Shift? ?Output Price ?Technological Change ?Supply of Other factors Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Labor Supply Curve ?The labor supply curve reflects how workers’ decisions about the labor- leisure tradeoff respond to changes in opportunity cost. ?An upward-sloping labor supply curve means that an increase in the wages induces workers to increase the quantity of labor they supply. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Labor Supply Curve Wage (price of labor) Supply 0 Quantity of Labor Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. What Causes the Labor Supply Curve to Shift? ?Changes in Tastes ?Changes in Alternative Opportunities ?Immigration Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in the Labor Market ?The wage adjusts to balance the supply and demand for labor. ?The wage equals the value of the marginal product of labor. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in the Labor Market... Equilibrium employment, L Supply 0 Wage (price of labor) Demand Equilibrium wage, W Quantity of Labor Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in the Labor Market ?Labor supply and labor demand determine the equilibrium wage. ?Shifts in the supply or demand curve for labor cause the equilibrium wage to change. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Shift in Labor Supply... Wage (price of labor) W 1 0 Quantity of Labor L 1 Supply, S 1 Demand 2. ...reduces the wage... 3. ...and raises employment. 1. An increase in labor supply... S 2 W 2 L 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Shift in Labor Supply ?An increase in the supply of labor : ?Results in a surplus of labor. ?Puts downward pressure on wages. ?Makes it profitable for firms to hire more workers. ?Results in diminishing marginal product. ?Lowers the value of the marginal product. ?Gives a new equilibrium. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Shift in Labor Demand... Wage (price of labor) W 1 0 Quantity of Labor L 1 Supply Demand, D 1 2. ...increases the wage... 3. ...and increases employment. 1. An increase in labor demand... D 2 W 2 L 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Shifts in Labor Demand ?An increase in the demand for labor : ?Makes it profitable for firms to hire more workers. ?Puts upward pressure on wages. ?Raises the value of the marginal product. ?Gives a new equilibrium. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Three Determinants of Productivity ?Physical Capital ? When workers work with a larger quantity of equipment and structures, they produce more. ?Human Capital ? When workers are more educated, they produce more. ?Technological Knowledge ? When workers have access to more sophisticated technologies, they produce more. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Productivity and Wage Growth in the United States Time Period Growth Rate of Productivity Growth Rate of Wages 1959 - 1997 1.8 1.7 1959 - 1973 2.9 2.9 1973 - 1997 1.1 1.0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Productivity and Wage Growth around the World Country Growth Rate of Productivity Growth Rate of Real Wages South Korea 8.5 7.9 Hong Kong 5.5 4.9 Singapore 5.3 5.0 Indonesia 4.0 4.4 Japan 3.6 2.0 India 3.1 3.4 United Kingdom 2.4 2.4 United States 1.7 0.5 Brazil 0.4 -2.4 Mexico -0.2 -3.0 Argentina -0.9 -1.3 Iran -1.4 -7.9 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Other Factors of Production: Land and Capital ?Capital refers to the stock of equipment and structures used for production. ?The economy’s capital represents the accumulation of goods produced in the past that are being used in the present to produce new goods and services. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Prices of Land and Capital ?The purchase price is what a person pays to own a factor of production indefinitely. ?The rental price is what a person pays to use a factor of production for a limited period of time. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in Markets for Land and Capital ?The rental price of land and the rental price of capital are determined by supply and demand. ?The firm increases the quantity hired until the value of the factor’s marginal product equals the factor’s price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Markets for Land and Capital... (a) The Market for Land (b) The Market for Capital Quantity of Land Quantity of Capital QQ00 Rental Price of Capital Demand Demand Supply Supply Rental Price of Land P P Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in Markets for Land and Capital ?Each factor’s rental price must equal the value of their marginal product. ?They each earn the value of their marginal contribution to the production process. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Linkages Among the Factors of Production Factors of production are used together. ?The marginal product of any one factor depends on the quantities of all factors that are available. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Linkages Among the Factors of Production A change in the supply of one factor alters the earnings of all the factors. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Linkages Among the Factors of Production A change in earnings of any factor can be found by analyzing the impact of the event on the value of the marginal product of that factor. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The three most important factors of production are labor, land, and capital. ?The demand for factors, such as labor, is a derived demand that comes from firms that use the factors to produce goods and services. ?Competitive, profit-maximizing firms hire each factor up to the point at which the value of the marginal product of the factor equals its price. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The supply of labor arises from individuals’ tradeoff between work and leisure. ?An upward-sloping labor supply curve means that people respond to an increase in the wage by enjoying less leisure and working more hours. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?The price paid to each factor adjusts to balance the supply and demand for that factor. ?Because factor demand reflects the value of the marginal product of that factor, in equilibrium each factor is compensated according to its marginal contribution to the production of goods and services. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Summary ?Because factors of production are used together, the marginal product of any one factor depends on the quantities of all factors that are available. ?As a result, a change in the supply of one factor alters the equilibrium earnings of all the factors. Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Graphical Review Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Versatility of Supply and Demand... (a) The Market for Apples (b) The Market for Apple Pickers Quantity of Apples Quantity of Apple Pickers QL P W 00 Price of Apples Wage of Apple Pickers Demand Demand Supply Supply Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Production Function... 0 0 50 100 150 200 250 300 350 0123456 Quantity of Apple Pickers Quantity of Apples 1 2 3 4 5 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Value of the Marginal Product of Labor... 0 Quantity of Apple Pickers Value of the Marginal Product Value of marginal product (demand curve for labor) Market wage Profit-maximizing quantity Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Labor Supply Curve Supply Wage (price of labor) Quantity of Labor 0 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. Equilibrium in the Labor Market... Equilibrium employment, L Supply Wage (price of labor) Quantity of Labor 0 Demand Equilibrium wage, W Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Shift in Labor Supply... Wage (price of labor) W 1 0 Quantity of Labor L 1 Supply, S 1 Demand 2. ...reduces the wage... 3. ...and raises employment. 1. An increase in labor supply... S 2 W 2 L 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. A Shift in Labor Demand... Wage (price of labor) W 1 0 Quantity of Labor L 1 Supply Demand, D 1 2. ...increases the wage... 3. ...and increases employment. 1. An increase in labor demand... D 2 W 2 L 2 Harcourt, Inc. items and derived items copyright ? 2001 by Harcourt, Inc. The Markets for Land and Capital... Quantity of Land Quantity of Capital QQ P P 00 Rental Price of Land Rental Price of Capital Demand Demand Supply Supply (a) The Market for Land (b) The Market for Capital