Notes: Principles of Microeconomics

Chapter 6 Supply, Demand, and Government Policies

Price controls – usually enacted when policymakers believe that the market price of a good
or service is unfair to buyers or sellers  can generate inequalities
Taxes – used to raise revenue for public purposes and influence market outcomes
- Tax incidence: the manner in which the burden of a tax shared among participants in a
market
- Government use taxes to raise revenue for public projects (roads, schools, and national
defense)
How taxes on sellers affect market outcomes
- Immediate impact on sellers: shit in supply; supply curve shifts left; higher
equilibrium price; lower equilibrium quantity; the tax reduces the size of the market
- Taxes discourage market activity: buyers and sellers share the burden of tax; buyers
pay more, are worse off; sellers receive less, are worse off (get the higher price but
pay the tax; overall; effective price fall
How taxes on buyers affect market outcomes
- Initial impact on the demand: demand curve shifts left; lower equilibrium price; lower
equilibrium quantity; the tax reduces the size of the market
- Buyers and sellers share the burden of tax; sellers get a lower price, are worse off;
buyers pay a lower market price, are worse off (effective price (with tax) rises)
Taxes levied on sellers and taxes levied on buyers are equivalent
- Wedge between the price that buyers pay and the price that sellers receive: the same,
regardless of whether the tax is levies on buyers or sellers)
- Shifts the relative position of the supply and demand curves: buyers and sellers share
the tax burden)
Elasticity and tax incidence
- Very elastic supply and relatively inelastic demand: sellers bear a small burden of tax;
buyers bare most of the burden
- Relatively inelastic supply and very elastic demand: sellers bear most of the burden;
buyers bear a small burden
Tax burden
- Falls more heavily on the side of the market that is less elastic
- Small elasticity of demand: buyers do not have good alternatives to consuming this
good
- Small elasticity of supply: sellers do not have good alternatives to produce this good.
- Half of the tax is paid by firms (out of firms’ revenue) – rest is paid by workers
(deducted from workers’ paychecks’

Price ceiling – a legal maximum on the price at which a good can be sold. Rent control.
Price floor – a legal minimum on the price at which a good can be sold. Minimum wage
How price ceilings affect market outcomes
- Not binding – set above the equilibrium price; no effect on the price or quantity sold
- Binging constraint – set below the equilibrium price; shortage; sellers must ration the
scarce goods (long lines, and discrimination according to sellers’ bias)
How price floors affect market outcomes
- Not binding – set below the equilibrium price; no effect on the market
- Binding constraint – set above the equilibrium price; surplus; some sellers are unable
to sell what they want (the rationing mechanisms: not desirable)
Notes: Principles of Microeconomics

Markets are usually a good way to organize economic activity

- Economists usually oppose price ceiling and price floors
- Prices are not the outcome of some haphazard process
- Prices have the crucial job of balancing supply and demand: coordinating economic
activity
Governments can sometimes improve market outcomes
- Want to use price controls because of unfair market outcome, and aimed at helping the
poor
- Often hurt those they are trying to help
- Other ways of helping those in need; rent subsidies; wage subsidies

Chapter 7 Consumers, Producers, and the Efficiency of Markets

Welfare economics – the study of how the allocation of resources affects economic well-
being
- Benefits that buyers and sellers receive from engaging in market transactions
- How society can make these benefits as large as possible
- In any market, the equilibrium of supply and demand maximize the total benefits
received by all buyers and sellers combined
Willingness to pay – the maximum amount that a buyer will pay for a good
Consumer surplus – the amount a buyer is willing to pay for a good minus the amount the
buyer actually pays for it  willingness to pay minus price paid
- Measures the benefit buyers receive from participating in a market; closely related to
the demand curve
 Benefit that buyers receive from a good as the buyers themselves perceive it
 Good measure of economic well-being  total surplus
 Exception: illegal drugs
At any quantity, the price given by the demand curve shows the willingness to pay of the
marginal buyer: the buyer who would leave the market first if the price were any higher
Consumer surplus in a market – area below the demand curve and above the price
A lower price raises consumer surplus
1. Existing buyer: increase in consumer surplus
- Buyers who were already buying the good at the higher price are better off
because they now pay less
2. New buyers enter the market: increase in consumer surplus
- Willing to buy the good at the lower price
 Are below the price and above the supply curve
A higher price raises producer surplus
1. Existing seller: increase in producer surplus
- Sellers who were already selling the good at the lower price are better off
because they now get more for what they sell
2. New sellers enter the market: increase in producer surplus
- Willing to produce the good at the higher price
Cost – value of everything a seller must give up to produce a good; measure of willingness to
sell
Producer surplus – amount a seller is paid for a good minus the seller’s cost of producing it;
price received minus willingness to sell  related to supply curve
Notes: Principles of Microeconomics

- Supply curve: derived from the cost of the supply  reflects sellers’ costs; used to
measure producer surplus
- Price given by the supply curve shows the cost of the marginal seller: seller who
would leave the market first if the price were any lower
Total surplus = consumer surplus + producer surplus  Total surplus = value to buyers
– cost to sellers
- Consumer surplus = value to buyers – amount paid by buyers
- Producer surplus = mount received by seller – cost to sellers
- Amount paid by buyers = amount received by sellers
Efficiency – property of a recourse allocation; maximizing the total surplus received by all
members of society
Equality – property of distributing economic property uniformly among the members of
society
Market outcomes
1. Free markets allocate the supply of goods to the buyers who value them most highly:
measured by their willingness to pay
2. Free markets allocate the demand for goods to the sellers who can produce them at
the least cost
3. Free markets produce the quantity of goods that maximizes the sum of consumer
and producer surplus
At market equilibrium, social planner
- Cannot increase economic well-being by: changing the allocation of consumption
among buyers; changing the allocation of production among sellers
- Cannot rise total economic well-being by increasing or decreasing the quantity of the
good

B*H/2

The efficiency of the equilibrium quantity

Notes: Principles of Microeconomics

Chapter 13 The Cost of Production

Industrial organization – the study of how firms’ decisions about prices and quantities
depend on the market conditions they face

A firm’s objective: profit (Caroline’s objective is to make her firm’s profit as large as
possible)
Total revenue: the amount a firm receives for the sale of its outputs (quantity * selling price)
Total cost: the market value of the inputs a firm uses in production (sum of implicit and
explicit)
= fixed cost + variable cost
 Explicit costs: input costs that require an outlay of money by the firm; require the firm
to pay out some money; ex. wages
 Implicit costs: input cost that do not require an outlay of money by the firm;
opportunity cost; what you give up to get something
 When no money flows out of the business to pay for a cost, it never shows up on the
accountant’s financial statements. An economist, however, will count the forgone income
as a cost because it will affect the decisions (shows hidden opportunity costs)
 Total cost curve
o Gets steeper as the amount produced rises: diminishing marginal production;
producing one additional unit of output requires a lot of additional units of
inputs – very costly
Profit = total revenue – total cost
Assumption – the goal of a firms to maximize profit  economists normally assume that the
goal of a firm is to maximize profit

Because economists and accountants measure costs differently, they also measure profit
differently.
Economic profit: total revenue – total cost; including all the opportunity costs (both explicit
and implicit costs)
 For a business to be profitable from an economist’s standpoint, total revenue must
exceed all the opportunity costs, both explicit and implicit
 Economic profit is an important concept because it motivates the firms that supply
goods and services
Accounting profit: total revenue – total explicit cost
 Because accountant ignores the implicit costs, accounting profit is usually larger than
economic profit

Production function: the relationship between the quantity of inputs used to make a good
(workers) and the quantity of output of that good (product)
Marginal product: the increase in output that arises from an additional unit of input (When
the number of workers goes from 1 to 2, cookie production increases from 50 to 90, so the
marginal product of the second worker is 40 cookies. Workers goes from 2 to 3, cookie
production increases from 90 to 120, so the marginal product of the third worker is 30
cookies)  Notice that as the number of workers increases, the marginal product declines 
diminishing marginal production: the property whereby the marginal product of an input
declines as the quantity of the input increases
Notes: Principles of Microeconomics

Fixed costs: costs that do not vary with the quantity of output produced (rent, bookkeeper to
pay bills etc.)  in the short run
Variable costs: costs that very with the quantity of output produced (items needs to by)  in
the long run

Average total cost = total cost / quantity of output

Average fixed cost = fixed cost / quantity of output
Average variable cost = variable cost / quantity of output
Marginal cost: the increase in total cost that arises from an extra unit of production

Rising marginal cost curve: because of diminishing marginal product

U-shaped average total cost curve
 Average total cost = average variable cost + average fixed cost
 Average fixed cost: always declines as output rises
 Average variable cost: typically rises as output increases; because of diminishing
marginal product
 The bottom of the u-shape: at quantity that minimizes average total cost
Efficient scale: quantity of output that minimizes at average total cost
Relationship between marginal cost and average total cost
 When marginal cost < average total cost: average total cost is falling
 When marginal cost > average total cost: average cost is rising
 The marginal cost curve crosses the average total cost curve at its minimum
Typical cost curves
 Marginal cost eventually rises with the quantity of output
 Average total cost curves are U-shaped
 Marginal cost curve crosses the average total cost curve at the minimum of average
total cost

 Long run cost curves: differ from short run cost curves; much flatter than short run
cost curves
 Short run cost curves: lie on or above the long run cost curves

Economies of scale: long run average total cost falls as the quantity of output increases;
increasing specialization among workers
Constant returns to scale: long run average total cost stays the same as the quantity of
output changes
Diseconomies of scale: long run average total cost rises as the quantity of output increases;
increasing coordination problems
Notes: Principles of Microeconomics

Chapter 14 Firms in Competitive Markets

Add: def. of market
Competitive market – a market with many buyers and sellers trading identical products so
that each buyer and seller is a price taker
 firms can freely enter or exit the market
 firms try to maximize profit = revenue - cost  profit = Q*P – average total cost* Q
Perfectly competitive market:
 There are many buyers and many sellers in the market
 The goods offered by the various sellers are largely the same
 negligible impact on the market price
Average revenue = total revenue /quantity sold
Marginal revenue: the change in total revenue from an additional unit sold
Maximize profit
 Produce quantity where total revenue – total cost is greatest
 Compare marginal revenue with marginal cost:
- If marginal revenue > marginal cost: should increase production/output
- If marginal revenue < marginal cost: should decrease production/output
- Maximize profit is where marginal revenue = marginal cost
The marginal cost curve and the firm’s supply decision:
- Marginal cost curve determines the quantity of the good the firm is willing to
supply at any price (supply curve)
- Marginal cost is upward sloping
- Average total cost curve is u-shaped
- Marginal cost curve crosses the average total cost curve at the minimum of
average total cost curve
- The price line is horizontal: profit = average revenue = marginal revenue
Shutdown
- Short-run decision not to produce anything
- During a specific period of time
- Because of current market conditions
- Firm still has to pay fixed costs
 Total revenue < variable cost (profit < average variable cost) (total revenue/Q <
variable cost/Q)
 Lies above average variable cost curve
Exit
 Total revenue < total cost  total revenue/Q < total cost/Q  profit < average total
cost  profit > average total cost
- Long-run decisions to leave the market if total revenue < total cost; same as profit
< average total cost
o ENTER the market if total revenue > total cost; same as profit > average
total cost
o Long run supply curve: the portion of its marginal cost curve that lies
above average total cost
- Firm doesn’t have to pay any costs
Sunk cost
- A cost that has already been committed and cannot be recovered
- Should be ignored when making decisions
Notes: Principles of Microeconomics

- In the short-run, fixed costs are sunk costs

Chapter 15 Monopoly
Add: figure 4 + picture from Wilma
Market power: alters the relationship between a firm’s costs and the selling price
Monopoly: a firm that is the sole seller of a product without any close substitutes – because
other firms cannot enter the market and compete with it  price maker
- Monopoly resources: a key resource required for production is owned by a single
firm
- Government regulation: the government gives a single firm the exclusive right to
produce some good or service
- The production process: a single firm can produce output at a lower cost than a
larger number of firms
- Downward sloping demand: the market demand curve
- Competitive firm: price taker; one producer of many; demand is a horizontal line
(price)
 Produce quantity where MC = MR; produces less than socially efficient quantity of
output; charge P > MC; deadweight loss (social loss) is the triangle between the
demand curve and MC curve
Natural monopoly: a type of monopoly the arises because a single firm can supply a good or
service to an entire market at a lower cost than could two or more firms
A monopoly’s total revenue = price * quantity
A monopoly’s average revenue = total revenue / quantity: revenue per unit sold; always
equals the price
A monopoly’s Profit:
 Profit = TR – TC  (TR / Q – TC / Q) * Q  (P – ATC) *Q
Total surplus = consumer surplus + producer surplus
Consumer surplus = consumers’ willingness to pay – the amount they actually pay
Producer surplus = amount producer receives for a good – cost of production
A monopoly’s marginal revenue: revenue per each additional unit of output; change in total
revenue when output increases by 1 unit: marginal revenue < profit; downward-sloping
demand; to increase the amount sold, a monopoly firm must lower the price it changes to all
customers  can be negative  always below the demand w
Increase in quantity sold: when Q is higher: increase in total revenue; when P is lower:
decrease in total revenue  because marginal revenue < profit; marginal revenue curve is
below the demand curve
For a competitive firm: P = MR = MC
For a monopoly firm: P > MR = MC
 The monopolist’s profit-maximizing quantity of output is determined by the
intersection of the marginal-revenue curve and the marginal-cost curve.
 In competitive markets, price equals marginal cost. In monopolized markets, price
exceeds marginal cost.
 The socially efficient quantity is found where the demand curve and the marginal-cost
curve intersect The monopolist produces less than the socially efficient quantity of
output.
Price discrimination: the business practice of selling the same good at different prices to
different customers
Perfect price discrimination describes a situation in which the monopolist knows exactly each
customer’s willingness to pay and can charge each customer a different price. In this case, the
Notes: Principles of Microeconomics

monopolist charges each customer exactly her willingness to pay, and the monopolist gets the
entire surplus in every transaction.
 Movie tickets – lower price for children and seniors
 Airline prices – lower price for round-trip with Saturday night stay
 Discount coupons – not all customers are willing to spend time to clip coupons
 Financial aid – high tuition and need-based financial aid; willingness to pay
 Quantity discount – customer pays a higher price for the first unit bought that for the
last unit bought
Policymakers in the government can respond to the problem of monopoly in one of four ways:
- By trying to make monopolized industries more competitive
- By regulating the behavior of the monopolies
- By turning some private monopolies into public enterprises
- By doing nothing at all
Notes: Principles of Microeconomics

Chapter 16 Monopolistic Competition

Imperfect competition: the point between perfect competition and monopoly
Oligopoly: a market structure in which only a few sellers offer similar or identical products
Monopolistic competition: a market structure in which many firms sell products that are
similar but not identical
To be more precise, monopolistic competition describes a market with the following
attributes:
 Many sellers: there are many firms competing for the same group of customers: not
price takers; downward sloping demand curve
 Product differentiation: each firm produces a product that is at least slightly different
from those of other firms. Thus, rather than being a price taker, each frim faces a
downward-sloping demand curve
 Free entry and exit: firms can enter or exit the market without restriction. Thus, the
number of firms in the market adjust until economic profits are driven to zero: zero
economic profit in the long run
Concentration ratio: percentage of total output in the market supplied by the four largest
firms
Profit maximization: produce the quantity where MR=MC
- If P < ATC: loss
- If P > ATC: profit
Monopolistic competitors in the short run

if firms are making profit in short run: new firms; incentive to enter the market
- Increase number of products
- Reduces demand faced by each firm; demand curve shifts left
- Each firm’s profit declines until: zero economic profit  Price = ATC
Monopolistic VS. perfect competition
 Monopolistic: Q not at minimum ATC; excess capacity  P > MC, markup over MC
 Perfect: Q at minimum ATC; efficient scale  P = MC
Notes: Principles of Microeconomics

Sources of inefficiency
 Markup of price over MC: deadweight loss of monopoly pricing
 Too much or too little entry
- Product-variety externality; positive externality on consumers
- Business-stealing externality; negative externality on producers
Incentive to advertise: when firms sell differentiated products and charge process above MC;
advertise to attract more buyers
Advertising spending: highly differentiated goods: 10-20% of revenue; industrial products
have little advertising; homogenous products have no advertising
Debate over advertising: Wasting resources? Valuable purpose?
The critique of advertising: firms advertise to manipulate people’s tastes; psychological
rather than informational; creates a desire that otherwise might not exist
- Impedes competition
- Increase perception of product differentiation; foster brand loyalty
- Makes buyers less concerned with price differences among similar goods
The defense of advertising: provide information to costumers; costumers make better
choices; enhances the ability of markets to allocate resources efficiently
- Foster competition; costumers take advertising of price differences
- Allows new firms to enter more easily
Advertising as a signal of quality: little apparent information; real information offered
- Willingness to spend large amount of money = signal about quality of the product
- Content of advertising = irrelevant
Brand names: spend more on advertising and charge higher prices than generic substitutes
Critics of brand names: products are not differentiated; irrationality: consumers are willing
to pay more for brand names
Defenders of brand names: consumers get information about quality; firms have incentive to
maintain high quality