Unit I: Basic

Economic Concepts
 What is Economics in General?
• Economics is the science of scarcity.
• Scarcity is the condition in which our wants
are greater than our limited resources.
• Since we are unable to have everything we
desire, we must make choices on how we will
use our resources.
• In economics we will study the choices of
individuals, firms, and governments.
choices
Economics is the study of _________.
Examples:
You must choose between buying jeans or buying shoes.
Businesses must choose how many people to hire
Governments must choose how much to spend on welfare.

Economics Defined
Economics-Social science concerned with the
efficient use of limited resources to achieve
maximum satisfaction of economic wants.
(Study of how individuals and societies deal
with ________)
scarcity
 Micro vs. Macro
MICROeconomics-
Study of small economic units such as
individuals, firms, and industries (competitive
markets, labor markets, personal decision
making, etc.)

MACROeconomics-
Study of the large economy as a whole or in
its basic subdivisions (National Economic
Growth, Government Spending, Inflation,
Unemployment, etc.)
 How is Economics used?
• Economists use the scientific method to make
generalizations and abstractions to develop
theories. This is called theoretical economics.
• These theories are then applied to fix problems
or meet economic goals. This is called policy
economics.
Positive vs. Normative
Positive Statements- Based on facts. Avoids value
judgments (what is).
Normative Statements- Includes value judgments
(what ought to be).
 Thinking at the Margin
# Times Benefit Cost
Watching Movie

1st $30 $10

2nd $15 $10
3rd $5 $10
Total $50 $30
Would you see the movie three times?
Notice that the total benefit is more than the
total cost but you would NOT watch the movie
the 3rd time.
 Marginal Analysis
In economics the term marginal = additional
“Thinking on the margin”, or MARGINAL ANALYSIS
involves making decisions based on the additional
benefit vs. the additional cost.
For Example:
You have been shopping at the mall for a half hour, the
additional benefit of shopping for an additional half-hour
might outweigh the additional cost (the opportunity cost).
After three hours, the additional benefit from staying an
additional half-hour would likely be less than the additional
cost.
The Factors of Production

8
 PRODUCTION POSSIBILITIES
How does the PPG graphically demonstrates scarcity,
trade-offs, opportunity costs, and efficiency?
Impossible/Unattainable
A (given current resources)
14
B
12
G
10 C
Bike
s

8
Efficient
6 D

4 Inefficient/
Unemployment
2
E
0
0 2 4 6 8
10 Computer 9
 PRODUCTION POSSIBILITIES
4 Key Assumptions Revisited
• Only two goods can be produced
• Full employment of resources
• Fixed Resources (4 Factors)
• Fixed Technology
What if there is a change?
3 Shifters of the PPC
1. Change in resource quantity or quality
2. Change in Technology
3. Change in Trade 10
PRODUCTION
POSSIBILITIESWhat happens if
Q1
4
1 there is an increase
3
1 in population?
2
11
Robot

1
s

0
9
8
7
6
5
4
3 1 2 3 4 5 6 7 Q
2 8 Pizza 11
1
 Two Types of Efficiency
Productive Efficiency-
• Products are being produced in the
least costly way.
• This is any point ON the Production
Possibilities Curve
Allocative Efficiency-
• The products being produced are the
ones most desired by society.
• This optimal point on the PPC depends
on the desires of society. 12
 Capital Goods and Future Growth
Panama - FAVORS Mexico - FAVORS
CONSUMER CAPITAL GOODS
GOODS
CURREN
FUTURE
T
CURVE
CURVE
FUTURE
CURVE
Capital
Goods

CURREN

Capital
T

Goods
CURVE

Consumer Consumer
goods goods
Panama Mexico
13
Absolute and Comparative Advantage
Absolute Advantage
• The producer that can produce the most output OR
requires the least amount of inputs (resources)
• Ex: Papa John has an absolute advantage in pizzas
because he can produce 100 and Ronald can only
make 20.
Comparative Advantage
• The producer with the lowest opportunity cost.
• Ex: Ronald has a comparative advantage in burgers
because he has a lowest PER UNIT opportunity cost.
Countries should trade if they have a
relatively lower opportunity cost.
They should specialize in the good that is “cheaper” for
them to produce. 14
 International Trade
Trade: 1 Wheat for 1.5 Sugar
S W S W
0 30 4
5
USA Brazil 20 0
1.5 29 18.5 1
3 28 4 17 2
0 The US Specializes and Brazil Makes
4.5 27 15.5 3
3
makes ONLY Wheat 3
ONLY Sugar
6 26 14 4
5 0
7.5 25 12.5 5
9 24 3 2 11 6

Sugar
(tons)
Sugar

0
(tons)

5
10.5 23 9.5 7
12 22 2 2 8 8
5 0
13.5 21 6.5 9
15 20 2 1 5 10
0 5
16.5 19 3.5 11
18 18 1 1
5 5 10 15 20 25 30 0 5 10 15 20
15
19.5 17 Wheat Wheat
 International Trade
TRADE SHIFTS THE PPC!
4
5
USA Brazil
4
0 AFTER TRADE
3 3
5 0

3 2

Sugar
(tons)
Sugar

0
(tons)

5 AFTER TRADE
2 2
5 0

2 1
0 5

1 1
5 5 10 15 20 25 30 0 5 10 15 20
16
Wheat Wheat
 Wheat Sugar
USA 30 (1W costs 1S) 30 (1S costs 1W)
Brazil 10 (1W costs 2S) 20 (1S costs 1/2W)
Which country has a comparative advantage in wheat?
4
5

1. Which
4 country should EXPORT Sugar?
0
2. Which country should EXPORT Wheat?

Sugar (tons)
3
Sugar (tons)

3 0
3. Which
5 country should IMPORT Wheat?
2
3 5
0
2
2 0
5
1
2 5 10 15 20 25 30 5 5 10 15 20
Wheat Wheat 17
0
Every society must answer three questions:

The Three Economic Questions

1. What goods and services should be
produced?
2. How should these goods and services be
produced?
3. For whom these goods and services?
The way these questions are answered
determines the economic system
An economic system is the method used by a
society to produce and distribute goods and
services. 18
Economic Systems
1. Centrally-Planned
(Command) Economy
2. Free Market Economy
3. Mixed Economy

19
 DEMAND DEFINED
What is Demand?
Demand is the different quantities of goods
that consumers are willing and able to buy at
different prices.
(Ex: Bill Gates is able to purchase a Ferrari, but if
he isn’t willing he has NO demand for one)

What is the Law of Demand?

The law of demand states There is an
INVERSE relationship between price and
quantity demanded
20
 Why does the Law of Demand occur?
3. Law of Diminishing Marginal Utility

U-TIL- IT- Y
• Utility = Satisfaction
• We buy goods because we get utility from them
• The law of diminishing marginal utility states that as
you consume more units of any good, the additional
satisfaction from each additional unit will eventually
start to decrease
• In other words, the more you buy of ANY GOOD the
less satisfaction you get from each new unit.
Discussion Questions:
1. What does this have to do with the Law of Demand?
2. How does this effect the pricing of businesses? 21
 c
Shifts ineDemand
CHANGES IN DEMAND
• Ceteris paribus-“all other things held constant.”
D
• When the ceteris paribus assumption is
dropped, movement no longer occurs along the
demand curve. Rather,Othe entire demand curve
shifts.
N
• A shift means that at the same prices, more
people are willing and’able to purchase that
good.
T
This is a change in demand, not a change in
quantity demanded
s 22
 What Causes a Shift in Demand?
5 Determinates (SHIFTERS) of Demand:
1. Tastes and Preferences
2. Number of Consumers
3. Price of Related Goods
4. Income
5. Future Expectations
Changes in PRICE don’t shift the curve. It
only causes movement along the curve. 23
 Supply Defined
What is supply?
Supply is the different quantities of a good that sellers
are willing and able to sell (produce) at different prices.
What is the Law of Supply?
There is a DIRECT (or positive) relationship between
price and quantity supplied.
• As price increases, the quantity producers make
increases
• As price falls, the quantity producers make falls.
Why? Because, at higher prices profit seeking
firms have an incentive to produce more.
EXAMPLE: Mowing 24
6 Determinants (SHIFTERS) of Supply
1. Prices/Availability of inputs (resources)
2. Number of Sellers
3. Technology
4. Government Action: Taxes & Subsidies

5. Opportunity Cost of Alternative

Production
6. Expectations of Future Profit
Changes in PRICE don’t shift the curve. It only
causes movement along the curve. 25
 Supply and Demand Analysis
Easy as 1, 2, 3
1. Before the change:
• Draw supply and demand
• Label original equilibrium price and quantity
2. The change:
• Did it affect supply or demand first?
• Which determinant caused the shift?
• Draw increase or decrease
3. After change:
• Label new equilibrium?
• What happens to Price? (increase or decrease)
1. What happens to Quantity? (increase or decrease)
Let’s Practice! 26
 Double Shifts
• Suppose the demand for sports cars fell at the
same time as production technology improved.
• Use S&D Analysis to show what will happen to
PRICE and QUANTITY.

If TWO curves shift at the same

time, EITHER price or quantity
will be indeterminate.
27
 Voluntary Exchange Terms
Consumer Surplus is the difference
between what you are willing to pay
and what you actually pay.
CS = Buyer’s Maximum – Price
Producer’s Surplus is the difference
between the price the seller received
and how much they were willing to sell
it for.
PS = Price – Seller’s Minimum
28
Consumer and Producer’s Surplus
P Calculate the area of:
1. Consumer Surplus
2. Producer Surplus
$10
3. Total Surplus S
8

6 CS 1. CS= $25
$5 2. PS= $20
4 3. Total= $45
PS

1 D
2 4 6 8 10 Q 29
 e
Price Ceiling
Maximum legal price a seller can charge for a product.
c
Goal: Make affordable by keeping price from reaching Eq.
P Gasoline
$5 e S
Does this
policy help 4
i
consumers? l
Result: 3

BLACK i Price
MARKETS 2
n
Shortage
Ceiling

1
g
(Qd>Qs) D

o 10 20 30 40 50 60 70 80 Q 30
 c
Price Floor e can sell a product.
Minimum legal price a seller
Goal: Keep price high by keeping price from falling to Eq.
P Corn
$
Surplus
f S

4
(Qd<Qs) l Price Floor

3
o
Does this o
2
policy help
corn
r
1
producers? D

o 10 20 m
30 40 50 60 70 80 Q 31
International Trade and Quotas
Identify the following:
1. CS with no trade
2. PS with no trade
3. CS if we trade at
world price (PW)
4. PS if we trade at
world price (PW)
5. Amount we import at
world price (PW)
This graphs show the domestic 6. If the government sets
supply and demand for grain. a quota on imports of
The letters represent area. Q4 - Q2, what happens
to CS and PS?
Result of Subsidies to Corn Producers
Price of Corn S
SSubsidy

Price Down
Pe Quantity Up
Everyone
P1 Wins, Right?

D
o Qe Q1 Q
Quantity of 33
 Identify the
Excise Taxes S
following:
1. Price before tax
2. Price P
consumers pay $5 S
after tax
3. Price producers 4
get after tax
4. Total tax 3
revenue for the
government 2
before tax
5. Total tax
revenue for the 1 D
government
after tax o 40 60 80 100 120 140 Q 34
Tax Practice

1. CS Before Tax
2. PS Before Tax
3. CS After Tax
4. PS After Tax
5. Tax Revenue
for Government
6. Dead Weight
Loss due to tax
7. Amount of tax
revenue
producers pay
35
 1. Elasticity of Demand
Elasticity of Demand-
• Measurement of consumers
responsiveness to a change in price.
• What will happen if price increase? How
much will it effect Quantity Demanded
Who cares?
• Used by firms to help determine prices
and sales
• Used by the government to decide how to
tax
 Total Revenue Test
Uses elasticity to show how changes in price will
affect total revenue (TR).
(TR = Price x Quantity)
Elastic Demand-
• Price increase causes TR to decrease
• Price decrease causes TR to increase
Inelastic Demand-
• Price increase causes TR to increase
• Price decrease causes TR to decrease
Unit Elastic-
• Price changes and TR remains unchanged
Ex: If demand for milk is INelastic, what will happen to
expenditures on milk if price increases?
 2. Price Elasticity of Supply
Elasticity of Supply-
• Elasticity of supply shows how sensitive producers
are to a change in price.
Elasticity of supply is based on time limitations.
Producers need time to produce more.

Inelastic = Insensitive to a change in price (Steep curve)

• Most goods have INelastic supply in the short-run
Elastic = Sensitive to a change in price (Flat curve)
• Most goods have elastic supply in the long-run
Perfectly Inelastic = Q doesn’t change (Vertical line)
• Set quantity supplied
3. Cross-Price Elasticity of Demand
• Cross-Price elasticity shows how sensitive a product
is to a change in price of another good
• It shows if two goods are substitutes or compliments
% change in quantity of product “b”
% change in price of product “a”

P increases 20% Q decreases 15%

• If coefficient is negative (shows inverse relationship)

than the goods are complements
• If coefficient is positive (shows direct relationship)
than the goods are substitutes
 4. Income-Elasticity of Demand
• Income elasticity shows how sensitive a product is to
a change in INCOME
• It shows if goods are normal or inferior
% change in quantity
% change in income
Income increases 20%, and quantity decreases 15%
then the good is a… INFERIOR GOOD
• If coefficient is negative (shows inverse relationship)
then the good is inferior
• If coefficient is positive (shows direct relationship)
then the good is normal
Ex: If income falls 10% and quantity falls 20%…
 Calculate Marginal Utility
# of Slices of Pizza Total Utility Marginal Marginal Cost
(in dollars) Utility/Benefit

0 0 0 2

1 8 8 2

2 14 6 2

3 19 5 2
4 23 4 2

5 25 2 2

6 26 1 2

7 26 0 2

8 24 -2 2

How many pizzas would you buy if the price

per slice was $2? 41
 Utility Maximizing Rule
The consumer’s money should be spent so that the
marginal utility per dollar of each goods equal each
other.
MUx = MUy
Px Py

Assume apples cost $1 each and oranges cost $2 each. If the

consumer has $7, identify the combination that maximizes utility. 42
61%
34%

14%
53%
 Three Stages of Returns
Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each others way
Total
Product
Total
Product

Quantity of
Labor
Marginal
and
Average Average Product
Product

Quantity of 46
Marginal Product
 Definition of the “Short-Run”
• We will look at both short-run and long-run
production costs.
• Short-run is NOT a set specific amount of
time.
• The short-run is a period in which at least one
resource is fixed.
– Plant capacity/size is NOT changeable
• In the long-run ALL resources are variable
– NO fixed resources
– Plant capacity/size is changeable
Today we will examine Short-run costs.
47
 Different Economic Costs
Total Costs
FC = Total Fixed Costs
VC = Total Variable Costs
TC = Total Costs
Per Unit Costs
AFC = Average Fixed Costs
AVC = Average Variable Costs
ATC = Average Total Costs
MC = Marginal Cost 48
 Definition
Fixed Costs:
s
Costs for fixed resources that DON’T change
with the amount produced
Ex: Rent, Insurance, Managers Salaries, etc.
Average Fixed Costs = Fixed Costs
Quantity
Variable Costs:
Costs for variable resources that DO change as
more or less is produced
Ex: Raw Materials, Labor, Electricity, etc.
Variable Costs
Average Variable Costs =
Quantity 49
 Definition
Total Cost: s
Sum of Fixed and Variable Costs

Average Total Cost = Total Costs

Quantity
Marginal Cost:
Additional costs of an additional output.
Ex: If the production of two more output
increases total cost from $100 to $120, the MC
$1
is _____.
0 Change in Total Costs
Marginal Cost
Change in Quantity
= 50
 Per-Unit Costs (Average and Marginal)
M
12 C
11
10 ATC
9
8 AVC
7
6 How much does
(dollars)

5
Costs

4
the 11th unit costs?
3
2
1 AF
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 C
15
Quantit 51
 Per-Unit Costs (Average and Marginal)
M ATC and AVC get
closer and closer but
12 C
NEVER touch
11
10 ATC
9
8 AVC
7
6
(dollars)

5 Average Fixed
Costs

4 Cost
3
2
1 AF
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 C
15
Quantit 52
Per-Unit Costs (Average and Marginal)

At output Q, what
area represents:
TC 0CDQ
VC 0BEQ
FC 0AFQ or BCDE

53
 Why is the MC curve U-shaped?

12
11 M
10 C
9
8
7
6
(dollars)

5
Costs

4
3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantit
54
 Relationship between Production and Cost
Average product and
marginal product

Why is the MC curve U-

shaped?
•When marginal product is
MP
increasing, marginal cost falls.
Quantity of
•When marginal product falls,
labor
M marginal costs increase.
C MP and MC are mirror images
of each other.
(dollars)
Costs

Quantity of 55
output
Aver
m RelationshipMP
between Production and Cost
Quantity of Why is the ATC curve U-
labor
M shaped?
C •When the marginal cost is
below the average, it pulls
(dollars)

ATC the average down.

Costs

•When the marginal cost is

above the average, it pulls
Quantity of
output
the average up.
The MC curve intersects the ATC curve at its lowest point.
Example:
• The average income in the room is $50,000.
• An additional (marginal) person enters the room: Bill Gates.
• If the marginal is greater than the average it pulls it up.
• Notice that MC can increase but still pull down the average.
56
Shift from an increase in a Fixed Cost
M
C ATC1

ATC
AVC
(dollars)
Costs

AFC1
AF
CQuantit 57
Shift from an increase in a Fixed Cost
M
C ATC1

AVC
(dollars)
Costs

AFC1

Quantit 58
Shift from an increase in a Variable Costs
MC1
M
C ATC1
AVC1
ATC
AVC
(dollars)
Costs

AF
CQuantit 59
Shift from an increase in a Variable Costs
MC1

ATC1
AVC1
(dollars)
Costs

AF
CQuantit 60
 ECONOMIES OF SCALE
Why does economies of scale occur?
• Firms that produce more can better use Mass
Production Techniques and Specialization.
Example:
• A car company that makes 50 cars will have a very
high average cost per car.
• A car company that can produce 100,000 cars will
have a low average cost per car.
• Using mass production techniques, like robots, will
cause total cost to be higher but the average cost for
each car would be significantly lower.

63
 Long Run AVERAGE Total Cost
These are all short run
Costs MC1 average costs curves.
ATC1 Where is the Long Run
MC2
Average Cost Curve?
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

64
Quantity
 Long Run AVERAGE Total Cost

Costs
Economies of Constant Diseconomies
Scale Returns to of Scale
Scale

Long Run
Average Cost
Curve

0 1 100 1,000 100,000 1,000,0000

65
Quantity
 LRATC Simplified
The law of diminishing marginal returns doesn’t apply in
the long run because there are no FIXED RESOURCES.
Costs
Economies of Constant Diseconomies
Scale Returns to Scale of Scale

Long Run
Average Cost
Curve

66
Quantit
Perfect Competition

67
 The Competitive Firm is a Price Taker
Price is set by the Industry

P S P

$1 $1 Demand
5 5

D
5000 Q Q
Industry Firm
68
(price taker)
 The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit earns $15
2nd unit earns $15
Marginal revenue is $1 Demand
constant at $15 5 MR=D=AR=P
Notice:
• Total revenue increases
at a constant rate
• MR equal Average Q
Revenue Firm
69
(price taker)
 Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11 70
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?
P
$9 MC
8
7 MR=D=AR=P
6 Profit = $18 ATC
5 AVC
4
3 Don’t forget
2 that averages
Total Cost=$45 show PER UNIT
1 Total Revenue =$63 COSTS
1 2 3 4 5 6 7 8 9 10 Q
71
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?

MC
Cost and Revenue

$9
8
7 ATC
6 AVC
Loss =$7
5
4
MR=D=AR=P
3
Total Cost = $42
2
Total Revenue=$35
1
1 2 3 4 5 6 7 8 9 10 Q
72
 P<AVC. They should shut down
Producing nothing is cheaper than staying open.

MC
Cost and Revenue

$9
8
7 ATC
Fixed Costs=$10
6 AVC
5
TC=$35
4 MR=D=AR=P
3
2 TR=$20
1
1 2 3 4 5 6 7 8 9 10 Q
73
 Profit Maximizing Rule
MR = MC
Three Characteristics of MR=MC Rule:
1. Rule applies to ALL markets
structures (PC, Monopolies, etc.)
2. The rule applies only if price is
above AVC
3. Rule can be restated P = MC for
perfectly competitive firms (because
MR = P) 74
 Side-by-side graph for perfectly
competitive industry and firm.
Is the firm making a profit or a loss? Why?
P S P
MC

ATC
$1 $1 MR=D
5 5 AVC

D
5000 Q 8 Q
Industry Firm
75
(price taker)
Where is the profit maximization point? How do you know?
What output should be produced? What is TR? What is TC?
How much is the profit or loss? Where is the Shutdown Point?

$2
5 MC
Cost and Revenue

20 MR=P
Profit
ATC
AVC
15

10 Total Revenue Total Cost

76
0 1 2 3 4 5 6 7 8 9 10
 Marginal Cost and Supply
As price increases, the quantity
increases
$5
MC
0
ATC
Cost and Revenue

45
40 MR5
35 AVC MR4
30
MR3
25
MR2
20
15 MR1
10
5 Q
0 1 2 3 4 5 6 7 9
77
 Marginal Cost and Supply
When price increases, quantity increases
When price decrease, quantity decreases
$5
MC = Supply
0
MC above AVC ATC
Cost and Revenue

45
40
35 is the AVC
30
25 supply curve
20
15
10
5 Q
0 1 2 3 4 5 6 7 9
78
 Marginal Cost and Supply
What if variable costs increase (ex: tax)?
MC2=Supply2
$5
0
MC1=Supply1
Cost and Revenue

45
40
AVC
35
30
AVC
25
20
15
When MC increases, SUPPLY decrease
10
5 Q
0 1 2 3 4 5 6 7 9
79
 Marginal Cost and Supply
What if variable costs decrease (ex: subsidy)?
$5 MC1=Supply1
0
Cost and Revenue

45 MC2=Supply2
40
AVC
35
30
AVC
25
20
15
When MC decreases, SUPPLY increases
10
5 Q
0 1 2 3 4 5 6 7 9
80
Perfect Competition
in the Long-Run

81
In the Long-
•Firms will enter if there is profit
run…
•Firms will leave if there is loss
•So, ALL firms break even, they make
NO economic profit
(No Economic Profit=Normal Profit)
•In long run equilibrium a perfectly
competitive firm is EXTREMELY
efficient.

82
Side-by-side graph for perfectly completive
industry and firm in the LONG RUN
Is the firm making a profit or a loss? Why?
P S P
MC
ATC

$1 $1 MR=D
5 5

D
5000 Q 8 Q
Industry Firm
83
(price taker)
Firm in Long-Run Equilibrium
Price = MC = Minimum ATC
Firm making a normal profit
P
MC
ATC

$1 MR=D
5 There is no incentive
to enter or leave the
TC = TR industry
8 Q 84
Going from Long-Run
to Short-Run

85
 1. Is this the short or the long run? Why?
2. What will firms do in the long run?
3. What happens to P and Q in the industry?
4. What happens to P and Q in the firm?
P S P
MC

ATC
$1 $1 MR=D
5 5
D
5000 6000 Q 8 Q
Industry Firm 86
Firms enter to earn profit so supply
increases in the industry
Price decreases and quantity increases
P S P
MC
S1

ATC
$1 $1 MR=D
5$1 5
0 D
5000 6000 Q 8 Q
Industry Firm 87
Price falls for the firm because they are
price takers.
Price decreases and quantity decreases
P S P
MC
S1

ATC
$1 $1 MR=D
5$1 5 MR1=D1
$1
0 D 0
5000 6000 Q 5 8 Q
Industry Firm 88
New Long Run Equilibrium at $10 Price
Zero Economic Profit

P P
MC
S1

ATC

$1 $1 MR1=D1
0 D 0
5000 6000 Q 5 Q
Industry Firm 89
 1. Is this the short or the long run? Why?
2. What will firms do in the long run?
3. What happens to P and Q in the industry?
4. What happens to P and Q in the firm?
P S P
MC
ATC

$1 $1 MR=D
5 5
D
4000 5000 Q 8 Q
Industry Firm 90
Firms leave to avoid losses so supply
decreases in the industry
Price increases and quantity decreases
S1
P S P
MC
ATC

$2
0$1 $1 MR=D
5 5
D
4000 5000 Q 8 Q
Industry Firm 91
Price increase for the firm because they
are price takers.
Price increases and quantity increases
S1
P S P
MC
ATC

$2 $2 MR1=D1
0$1 0$1 MR=D
5 5
D
4000 5000 Q 89 Q
Industry Firm 92
New Long Run Equilibrium at $20 Price
Zero Economic Profit

S1
P P
MC
ATC

$2 $2 MR1=D1
0 0

D
4000 Q 9 Q
Industry Firm 93
Going from Long-Run
to Long-Run

94
 Currently in Long-Run Equilibrium
If demand increases, what happens in the short-run
and how does it return to the long run?

P S P
MC
ATC
MR1=D1
$1 $1 MR=D
5 5
D
5000 Q 8 Q
Industry Firm 95
 Demand Increases
The price increases and quantity increases
Profit is made in the short-run
P S P
MC
ATC
$2 $2 MR1=D1
0$1 0$1 MR=D
5 D5
1

D
5000 Q 8 9 Q
Industry Firm 96
 Firms enter to earn profit so supply
increases in the industry
Price Returns to $15
P S S1 P
MC
ATC
$2 $2 MR1=D1
0$1 0$1 MR=D
5 D5
1

D
5000 7000 Q 8 9 Q
Industry Firm 97
 Back to Long-Run Equilibrium
The only thing that changed from long-run to
long-run is quantity in the industry
P S1 P
MC
ATC

$1 $1 MR=D
5 D5 1

D
7000 Q 8 Q
Industry Firm 98
Efficiency
99
 Productive Efficiency
The production of a good in a least
costly way. (Minimum amount of
resources are being used)
Graphically it is where…

Price = Minimum ATC

100
 Short-Run
MC
ATC
D=MR
Profit
Price

Notice that the product is NOT being made

at the lowest possible cost
(ATC not at lowest point).
Q
Quantity
101
 Short-Run
MC
ATC
Price

P Loss
D=MR

Notice that the product is NOT being made at the

lowest possible cost (ATC not at lowest point).

Q
Quantity
102
 Long-Run Equilibrium
MC
ATC
Price

D=MR
P

Notice that the product is being made at

the lowest possible cost (Minimum ATC)
Q
Quantity 103
Allocative Efficiency
Producers are allocating resources
to make the products most wanted
by society.
Graphically it is where…
Price = MC
Why? Price represents the benefit
people get from a product.
104
 Long-Run Equilibrium
MC

MR
Price

P
Optimal amount
being produced
The marginal benefit to society
(as measured by the price) equals
the marginal cost.
Q
Quantity 105
What if the firm makes 15 units?
MC

MR
Price

$5
The marginal benefit to
$3 society is greater the
marginal cost.
Not enough produced.
Society wants more
1 2 Underallocation
Quantity
5 0 of resources 106
What if the firm makes 22 units?

MC
$7
MR
Price

$5
The marginal benefit to
society is less than the
marginal cost.
Too much Produced.
Society wants less

2 2 Overallocation of
Quantity
0 2 resources 107
 Long-Run Equilibrium

MC
ATC
Price

D=MR
P

P = Minimum ATC = MC
EXTREMELY EFFICIENT!!!!
Q
Quantity 108
19%

41%
20%

85%
 Drawing
Monopolies
112
Monopoly Practice FRQ
 The Main Difference
• Monopolies (and all Imperfectly
competitive firms) have downward
sloping demand curve.
• Which means, to sell more a firm must
lower its price.
• This changes MR…
THE MARGINAL REVENUE
DOESN’T EQUAL THE PRICE!
114
Why is MR less than P Qd TR MR
Demand? $11 0 - -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6

$8 $8 MR
$8 IS LESS THAN
$7 4 28 4
$6 5 30 2
$7 $7 $7 $7 PRICE $5 6 30 0
$4 7 28 -2
$6 $6 $6 $6 $6
$5 $5 $5 $5 $5 $5
$4 $4 $4 $4 $4 $4 $4
115
 Calculating
Marginal Revenue

116
Plot the Demand, Marginal Revenue, and
Total Revenue Curves
P
$1
5

10

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR
$6
4

40

20

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q 117
Demand and Marginal Revenue Curves
What happens to TR when MR hits zero?
P
$1
5

10

5 D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR
$6 MR
4
Total Revenue is
40 at it’s peak when
MR hits zero
20
TR
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q 118
 Elastic vs. Inelastic
Range of Demand Curve

119
 Elastic and Inelastic Range
P Elasti Inelasti
Total Revenue Test c c
$1
If price falls and TR 5

increases then
10
demand is elastic.
5 D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR A monopoly
$6 MR will only
Total Revenue Test 4

If price falls and produce in

TR falls then
40 the elastic
demand is inelastic. 20
range
TR
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q 120
Maximizing
Profit

121
What output should this monopoly produce?
MR = MC
How much is the TR, TC and Profit or Loss?
P
$9 MC
ATC
8
7
Profit
6 =$6
5 D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 122
 Conclusion: A monopolist produces where
MR=MC, buts charges the price consumers are
willing to pay identified by the demand curve.
P
$9 MC
ATC
8
7
6
5 D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 123
 What if costs are higher?
How much is the TR, TC, and Profit or Loss?
MC
P ATC
$10
9 AVC
8
7
6
D
5 TR= $90
4 TC= $100
MR
3 Loss=$10
6 7 8 9 10 Q 124
 TR= $70
Identify and Calculate: TC= $56
Profit/Loss= $14
Profit/Loss per Unit= $2
P MC

$10 ATC
9
8
7
D
6
5 MR
4
1 2 3 4 5 6 7 8 9 10 Q 125
Are Monopolies
Efficient?
127
Monopolies vs. Perfect Competition
P S = MC

CS
In perfect competition,
Ppc CS and PS are
PS maximized.

Q
Qpc 128
Monopolies vs. Perfect Competition
P S = MC

At MR=MC,
Pm A monopolist will
produce less and
Ppc
charge a higher price

D
MR
Q
Qm Qpc 129
Monopolies vs. Perfect Competition
Where is CS S = MC
P and PS for a
monopoly?
CS
Pm Total surplus falls.
Now there is
PS DEADWEIGHT
LOSS

Monopolies underproduce and overD

charge, decreasing CS and
MR
increasing PS.
Q
Qm 130
Are Monopolies Productively Efficient?
Does Price = Min ATC? No. They are not
producing at the lowest
cost (min ATC)
P
$9 MC
ATC
8
7
6
5 D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 131
Are Monopolies Allocatively Efficiency?
Does Price = MC? No. Price is greater.
The monopoly is under
producing.
P
$9 MC
ATC
8
7
6
5
Monopolies are NOT efficient!
4
D

3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 132
Monopolies are inefficient because
they…
1. Charge a higher price
2. Don’t produce enough
• Not allocatively efficiency
3. Produce at higher costs
• Not productively efficiency
4. Have little incentive to innovate
Why?
Because there is little external pressure to
be efficient 133
 Natural Monopoly
One firm can produce the socially optimal quantity
at the lowest cost due to economies scale.
P
It is better to have only
one firm because ATC is
falling at socially
optimal quantity
MC
ATC

MR D
Qsocially optimal Q 134
Regulating
Monopolies
135
 Why Regulate?
Why would the government regulate a
monopoly?
1. To keep prices low
2. To make monopolies efficient

How do they regulate?

•Use Price controls: Price Ceilings
•Why don’t taxes work?
• Taxes reduce supply and that’s the problem 136
 Where should the government
place the price ceiling?
1.Socially Optimal Price
P = MC (Allocative Efficiency)

OR
2. Fair-Return Price (Break–Even)
P = ATC (Normal Profit)
137
 Regulating Monopolies
Where does the firm produce if it is
P
unregulated?
MC

Pm ATC

D
MR

Qm Q 138
 Regulating Monopolies
PriceOptimal
Socially Ceiling at Socially Optimal
= Allocative Efficiency
P
MC

Pm ATC
Pso

D
MR

Qm Qso Q 139
 Regulating Monopolies
Price Ceiling
Fair Return meansatnoFair Returnprofit
economic
P
MC

Pm ATC
Pso
Pfr
D
MR

Qm Qso Qfr Q 140

 Regulating Monopolies
Unregulated
Socially
P
Optimal MC
Fair
Return
Pm ATC
Pso
Pfr
D
MR

Qm Qso Qfr Q 141

 Regulating a Natural Monopoly
What happens if the government sets a price ceiling
to get the socially optimal quantity?
P
The firm would make a
loss and would require
a subsidy
MC

Pso
ATC

MR D
Qsocially optimal Q 142
2007 FRQ #1
 Price
Discrimination
144
 Price
Discrimination
Definition:
Practice of selling the same products
to different buyers at different prices

145
 P Qd TR MR
$11 0 0 -
$10 1 10 10
$10
$9 2 19 $9
$10 $9 $8 3 27 $8
WHEN PRICE$7 4 34 $7
$10 $9 $8
DISCIMINATING,
$6 5 40 $6
$10 $9 $8 $7 MR = D $5 6 45 $5
$4 7 49 $4
$10 $9 $8 $7 $6
$10 $9 $8 $7 $6 $5
$10 $9 $8 $7 $6 $5 $4
146
 Regular Monopoly vs.
Price Discriminating Monopoly
P
MC

Pm
ATC

MR
Qm Q 147
A perfectly discriminating monopoly can charge
each person differently so the
Marginal Revenue = Demand
P
MC

ATC

MR
Q 148
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand
Identify the Price, Profit, CS, and DWL
P
MC

ATC

D =MR

Qnm Q 149
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand
Identify the Price, Profit, CS, and DWL
P
MC

ATC

D =MR
Price Discrimination results in several
prices, more profit, no CS, and a higher
socially optimal
Q
quantity Q 150
nm
Monopolistic
Competition

151
22%
 Monopolistic Competition is made up of
prices makers so MR is less than Demand
In the short-run, it is the same graph as a
monopoly making profit
P
MC
ATC
P1

In the long-run, new firms will Denter,

driving down the DEMAND for firms
already in the market.
MR
Q1 Q 153
Firms enter so demand falls until there is no
economic profit

P
MC
ATC
P1

MR
Q1 Q 154
Firms enter so demand falls until there is no
economic profit
Price and quantity falls and TR=TC
P
MC
ATC

PLR

MR
QLR Q 155
 LONG-RUN EQUILIBRIUM
Quantity where MR =MC up to Price = ATC
P
MC
ATC

PLR

MR
QLR Q 156
 Why does DEMAND shift?
When short-run profits are made…
– New firms enter.
– New firms mean more close substitutes and
less market share for each existing firm.
– Demand for each firm falls.
When short-run losses are made…
– Firms exit.
– Result is less substitutes and more market
shares for remaining firms.
– Demand for each firm rises.

157
 What happens when there is a loss?
In the short-run, the graph is the same as a
monopoly making a loss
ATC
P
MC

P1

In the long-run, firms will leave, D

driving
up the DEMAND for firms already in the
market. MR
Q1 Q 158
Firms leave so demand increases until there
is no economic profit

ATC
P
MC

P1

MR
Q1 Q 159
Firms leave so demand increases until there
is no economic profit
Price and quantity increase and TR=TC
ATC
P
MC
PLR

MR
QLR Q 160
 LONG-RUN EQUILIBRIUM
The firm can produce at a lower cost but it
holds back production to maximize profit
P
MC ATC
PLR

Excess D
Capacity
MR
QLR QProd Efficient Q 161
Oligopoly
69%
 Game Theory Matrix
You and your partner are competing firms. You
have one of two choices: Price High or Price Low.
Without talking, write down your choice
Firm 2
High Low

High Both High = Low = $30

$20 Each High = 0
Firm 1
High = 0 Both Low=
Low
Low = $30 $10 each
 Game Theory Matrix
Notice that you have an incentive to collude but
also an incentive to cheat on your agreement
Firm 2
High Low

High Both High = Low = $30

$20 Each High = 0
Firm 1
High = 0 Both Low=
Low
Low = $30 $10 each
 Dominant Strategy
The Dominant Strategy is the best move to
make regardless of what your opponent does
What is each firm’s dominant strategy?
Firm 2 No Dominant
High Low Strategy

High $100, $50 $50, $90

Firm 1
Low $80, $40 $20, $10
 2007 FRQ #3
Payoff matrix for two competing bus companies
 2009 FRQB #3
Payoff matrix for two competing bus companies
Oligopoly
Graphs
Firms in a colluding oligopoly act as a
monopoly and share the profit
P
MC
ATC

MR
Q
 Kinked Demand Curve
Model
The kinked demand curve model shows how
noncollusive firms are interdependent
If firms are NOT colluding they are likely to
react to competitors’ pricing in two ways:
1. Match price-If one firm cuts its prices, then
the other firms follow suit causing inelastic
demand
2. Ignore change-If one firm raises prices,
others maintain the same price causing
elastic demand
If this firm increases its price, other firms will
ignore it and keep prices the same
As the only firm with high prices, Qd for this firm
P will decrease a lot
Elas
P1 ti c
Pe

D
Q1 Qe Q
 If this firm decreases its price, other firms
will match it and lower their prices
Since all firms have lower prices, Qd for this firm
P will increase only a little
Elas
P1 ti c
Pe
P2

In
ela
st i
c D
Q1 Qe Q2 Q
 Where is Marginal Revenue?
MR has a vertical gap at the kink. The result is that
MC can move and Qe won’t change. Price is sticky.
P

MC
Pe

MR D
Q Q
 Unit 5: The
Resource Market
(aka: The Factor Market or Input Market)

175
81%

58%
64%

46%
 Resource Markets
Perfect
Monopson
Competition
y

Perfectly Competitive Labor Market

Characteristics:
•Many small firms are hiring workers
• No one firm is large enough to manipulate the
market.
•Many workers with identical skills
•Wage is constant
•Workers are wage takers
• Firms can hire as many workers as they want
at a wage set by the industry
178
 Perfectly Competitive
Labor Market and Firm
Wage SL
Wage

$1
0 ?
DL
5000 Q Q
Industry Firm
How do you know how many resources
(workers) to employ?
Continue to hire until…
MRP = MRC

180
 Side-by-side graph showing
Market and Firm
Wage SL
Wage

WE SL=MRC

DL DL=MRP
QE Q Qe Q
Industry Firm
Industry Graph

182
 Equilibrium
Wage (the price of labor) is set by the market.
EX: Supply and Demand for Carpenters
Wage Labor
Supply

$30hr

Labor Demand
=
MRP
Quantity of Workers 183
Individual Firms
Wage

SL=MRC

DL=MRP
Qe Q

184
Use the following Price = Wage =
$10 $20
Units data:
Total
Product
Margina
Produc
Marginal
Revenue
Marginal
Resource
l
of (Output t
Product Product Cost
Labor ) Price
(MP)
0 0 - 0 0 0
1 7 7 20
2 17 10 10 70 20
3 24 7 10 10 20
4 27 3 10 0 20
5 29 2 10 70 20
6 30 1 10 30 20
7 27 -3 10 20 20
10
How many workers should10
you hire?
185
 Demand=MRP
Wage Rate This model applies to
$100 land, labor, and capital
Notice the inverse
80 relationship between wage
and quantity of resources
60
demanded
40

20
D=MRP
1 2 3 4 5 6 7 8 Q
Quantity of Workers
186
What happens if demand for the product
Wage Rate
increases?
$100

80 MRP increases causing

demand to shift right
60

40

D1=MRP1
20
D=MRP
1 2 3 4 5 6 7 8 Q
Quantity of Workers
187
 3 Shifters of Resource Demand
1.) Changes in the Demand for the Product
• Price increase of the product increases MRP
and demand for the resource.
2.) Changes in Productivity
• Technological Advances increase Marginal
Product and therefore MRP/Demand.
3.) Changes in Price of Other Resources
• Substitute Resources
• Ex: What happens to the demand for assembly line
workers if the price of robots falls?
• Complementary Resources
• Ex: What happens to the demand for nails if the price
of lumber increases significantly?
188
 Resource Supply Shifters
Supply Shifters for Labor
1. Number of qualified workers
• Education, training, & abilities required
2. Government regulation/licensing
Ex: What if waiters had to obtain a license to serve
food?
3. Personal values regarding leisure time and
societal roles.
Ex: Why did the U.S. Labor supply increase
during WWII?
Why do some occupations get paid more
than others?
Use side-by-side graphs to draw a
perfectly competitive labor market
and firm hiring workers

190
 Wage is set by the market

Wage SL
Wage

WE SL=MRC

DL DL=MRP
QE Q Qe Q
Industry Firm
 What happens to the wage and quantity in the
market and firm if new workers enter the
industry?

Wage SL
Wage

WE SL=MRC

DL DL=MRP
QE Q Qe Q
Industry Firm
 What happens to the wage and quantity in the
market and firm if new workers enter the
industry?

Wage SL
Wage
SL1

WE SL=MRC
W1 SL1=MRC1

DL DL=MRP
QE Q1 Q Qe Q1 Q
Industry Firm
Wage Fast Food
Cooks
S

$12
The government wants to
$8 “help” workers because the
equilibrium wage is too low
$6

D
5 6 7 8 9 10 11 12 Q Labor 194
Wage Fast Food Cooks

$12
Government sets up a
$8 “WAGE FLOOR.”
Where?
$6

D
5 6 7 8 9 10 11 12 Q Labor 195
 Minimum Wage
Wage

$12
Above
$8 Equilibrium!
$6

D
5 6 7 8 9 10 11 12 Q Labor 196
 Minimum Wage
Wage
Surplus of workers
(Unemployment) S

$12
What’s the result?
$8 Q demanded falls.
Q supplied increases.
$6

D
5 6 7 8 9 10 11 12 Q Labor 197
 Maximizing Output
MPx = MPy
$10 Px Py $5
# Times MPR MP/PR MPW MP/PW
Going (Robots) (PriceR =$10) (Workers) (PriceW =$5)

1st 30 3 20 4
2nd 20 2 15 3
3rd 10 1 10 2
4th 5 .50 5 1

If you only have $35, what combination of robots

and workers will maximize output?
 Maximizing Output
MPx = MPy
$10 Px Py $5
# Times MPR MP/PR MPW MP/PW
Going (Robots) (PriceR =$10) (Workers) (PriceW =$5)

1st 30 3 20 4
2nd 20 2 15 3
3rd 10 1 10 2
4th 5 .50 5 1

If you only have $35, the best combination is

2 robots and 3 workers.
 Resource Markets
Perfect
Monopson
Competition
y

Imperfect Competition: Monopsony

Characteristics:
• One firm hiring workers
• The firm is large enough to manipulate the market
• Workers are relatively immobile
• Firm is a wage maker
• To hire additional workers the firm must increase
wages
Examples:
Central American Sweat Shops
Midwest small town with a large Car Plant
NCAA
200
Assume that this firm CAN’T wage discriminate and
must pay each worker the same wage.
Acme Coal Mining Co.
Wage rate Number of Marginal
(per hour) Workers Resource Cost
$4.00 0 -
MRC doesn’t
4.50 1 $4.50
5.00 2 5.50
equal wage
5.50 3 6.50
6.00 4 7.50
7.00 5 11
8.00 6 13
9.00 7 15
10.00 8 17
 Monopsony
If the firm can’t wage discriminate, where is MRC?

Wage MRC

SL

WE

DL=MRP
QE
 The Four Market Failures
We will focus on four different market
failures:
1. Public Goods
2. Externalities (third-person side effects)
3. Monopolies
4. Unfair distribution of income
In each of the above situations,
the government steps in to
allocate resources more efficiently.

203
Market Failure #1:
PUBLIC GOODS
79%

76%
70%

61%
53%
 Public Goods
Why must the government provide public
goods and services?
•It is impractical for the free-market to
provide these goods because there is little
opportunity to earn profit.
•This is because of the Free-Rider Problem
Free Riders are individuals who
benefit without paying.

209
 The Free Rider
Problem
Examples:
1. People who download music illegally
2. People who watch a street performer and don’t pay
3. Teenagers who live at home and don’t have a job
210
 Definition of Public Goods
To be considered a true public good, it
must meet two criteria:
1. Nonexclusion
• Everyone can use the good.
• Cannot exclude benefits of the good for
those who will not pay.
• Ex: National Defense
2. Shared Consumption (Nonrivalry)
• One person’s consumption of a good does
not reduce the usefulness to others.
• Ex: Ron Feist Park
211
 How does the government determine what
quantity of public goods to produce?
It uses (surprise!) Supply and Demand
Demand for Public Goods-
The Marginal Social Benefit of the good as
determined by citizens’ willingness to pay.
Supply of Public Goods-
The Marginal Social Cost of providing
additional quantities/amounts of the good.
Video: Dam Tragedy
 Demand for a New Park
Marginal willingness to pay higher taxes
# of Adam is Jill is Society’s Marginal
Parks “Optimal”
willing to willingamount
to Demand Social
pay pay
of a public good (MSB) Cost

1 $4 $5
is where $9 $5
2 $3 MSB
$4 = $7 $5
3 $2 $3
MSC! $5 $5
4 $1 $2 $3 $5
5 $0 $1 $1 $5
 Supply and Demand for Public Parks
Price
$9 The Demand is
equal to the
marginal benefit
7 to society

D=MSB
3
0 1 2 3 4
5 Quantity of Parks
 Supply and Demand for Public Parks
Price 1. What if the government
$9 made 1 park?
2. What if the government
made 4 parks?

7 MSB = MSC
S=MSC

The supply is the

5 public good’s
marginal cost to
society D=MSB
3
0 1 2 3 4
5 Quantity of Parks
 Market Failure #2:
EXTERNALITIES

216
 What are Externalities?
•An externality is a third-person side effect.
•When there are EXTERNAL benefits or costs to
someone OTHER than the original decision maker.
Why are Externalities Market Failures?
•The free market fails to include external costs or
external benefits.
•With no government involvement, there would be
too much of some goods and too little of others.
Example: Smoking Cigarettes.
• The free market assumes that the cost of smoking is
fully paid by people who smoke.
• The government recognizes external costs and makes
policies to limit smoking.
217
 Market for Cigarettes
The marginal private cost doesn’t include the
costs to society.
P

Supply =
Marginal
Private Cost

D=MSB
QFree Market Q 218
 Market for Cigarettes
What will the MC/Supply look like when EXTERNAL
costs are factored in? Supply =
P
Marginal
Social Cost
Supply =
Marginal
Private Cost

D=MSB
QOptimal QFree Market Q 219
 Market for Cigarettes
If the market produces QFM why is it a market
P failure? S =MSC

S=MPC

At QFM the MSC is

greater than the MSB.
Too much is being
produced
Overallocatio
n D=MSB
QOptimal QFree Market Q 220
 Market for Cigarettes
What should the government do to fix a negative
P externality?
S =MSC

S=MPC

Solution: Tax the

amount of the
externality
(Per Unit Tax)

D=MSB
QOptimal QFree Market Q 221
 Positive Externalities
(aka: Spillover Benefits)
Situations that result in a BENEFIT for someone
other than the original decision maker.
The benefits “spill over” to other people or society.
(EX: Flu Vaccines, Education, Home Renovation)
Example: A mom decides to get a flu vaccine for
her child
•Mom only looks at the INTERNAL benefits.
•She ignores the social benefits of a healthier society.
•So, her private marginal benefit is her demand
•When you factor in EXTERNAL benefits, the
marginal benefit and demand would be greater.
•The government recognizes this and subsidizes flu
shots. 222
 Market for Flu Shots
The marginal private benefit doesn’t include
the additional benefits to society.
P

S = MSC

D=Marginal
Private Benefit
QFree Market Q 223
 Market for Flu Shots
What will the MSB/D look like when
P EXTERNAL benefits are factored in?

S = MSC

D=Marginal
Social Benefit

D=Marginal
Private Benefit
QFM QOptimal Q 224
 Market for Flu Shots
If the market produces QFM why is it a market
P failure?

S = MSC

D=Marginal
Social Benefit

D=MSB
QFM QOptimal Q 225
 Market for Flu Shots
At QFM the MSC is less than the MSB.
P Too little is being produced

S = MSC

D=Marginal
Social Benefit
Underallocatio
n

QFM QOptimal Q 226

 Market for Flu Shots
What should the government do to address a
positive externality?
P
Subsidize the amount of the
externality (Per Unit Subsidy)
S = MSC
Subsidy shifts MSB/D right (yellow);
amount of subsidy is vertical distance
between MB curves (black)

D=MSB =MPB

D=MPB
QFM QOptimal Q 227
Market Failure #3

Monopolies

228
 Monopoly
Socially
Unregulated Optimal
P $9
MC
8 ATC
7
Fair
6 Profit
5
=$5 Return
4 D
3
2
MR
1 2 3 4 5 6 7 8 9 10 Q 229
 WHAT DOES THE GOVERNMENT DO?
Legislative Branch
•Passed laws designed to stop monopolies
•Sherman Act of 1890-
“Every person who shall monopolize …or conspire to
monopolize…shall be deemed guilty of a felony.”
Executive Branch
•The Federal Trade Commission must approve all
corporate mergers. (Like AT&T and …)
•When firms use anti-competitive tactics the
Department of Justice files suit against them.
Judicial Branch
•The courts find the firm guilty or not guilty and assign
a punishment.
230
 Market Failure #4
Unfair Distribution
of Wealth
Net
Worth
over $2.3
billion

231
 The Lorenz Curve
10
Percent of Income 0

80
Perfect Equality

60

40

20

0
20 40 60 80 100
Percent of 232
 The Lorenz Curve
10
0 Lorenz Curve
(actual distribution)
Percent of Income

80
Perfect Equality

60

55

40

30

20
15

50
20 40 60 80 100
Percent of 233
 The Lorenz Curve
10
0 Lorenz Curve
(actual distribution)
Percent of Income

80
Perfect Equality

60

55

40
The size of the
30 banana shows
20 the degree of
15 income inequality.
50
20 40 60 80 100
Percent of 234
 The Lorenz Curve
10
0
After Distribution
Percent of Income

80
Perfect Equality

60

55

40
The banana gets
30 smaller when the
20 government re-
15 distributes income
50
20 40 60 80 100
Percent of 235
 What are Taxes?
Taxes – mandatory payments made to the
government to cover costs of governing.
Why does the government tax?
Two purposes:
1. Finance government operations.
• Public goods – highways, defense, employee
wages
• Fund Programs – welfare, social security
2. Influence economic behavior of firms and
individuals.
Ex: Excise tax on tobacco raises tax revenue and
discourages the use of cigarettes. 236
 The LAST micro graph to
learn!!!!

The Laffer Curve

Shows relationship between tax rate
and tax revenue.
What would happen if the highest tax
bracket was 75%?
237
 THINK ROBIN HOOD!!!!!!
What was his group’s name?
Merry Men
What did they do?
Laugh a lot … they were “Laffers.”
What was his weapon of choice?
Bow and Arrow
What did Robin Hood do?
Steal from the rich and give to the poor.
What would happen to the amount of travelers
through Sherwood Forest if he took 95%
instead of 39% of their money?
What would happen to the total amount of
money he collects? 238
 The Laffer Curve
If the government
increase taxes rates
% Tax tax revenue will
Rate increase

If the tax rate

becomes too high, tax
revenue will fall since
workers have no
incentive to work
harder

Tax Revenue 239