Economics of the Firm
The Basics: Supply & Demand
Introducing homo economicus….also known as
“Economic Man”
Economic man is a RATIONAL being
The Fundamental Rule of Economics: Individuals are
rational beings and therefore respond to incentives – i.e.
they respond to opportunities with Economic Profit
Economic Profit = (Expected) Benefit – Opportunity Cost
Opportunity cost = Direct (Money) Costs + Implicit Costs
In other words, think about opportunity cost as the value
of ALL the resources that have been consumed
Example: What would be the opportunity cost of attending Notre Dame as
an undergraduate? Do students have an incentive to go to Notre Dame?
Item
Average 2011/2012 Expense
Tuition and Fees
$41,420
Room & Board
$11,390
Books & Supplies
$950
Personal Expenses
$1,000
Transportation
$500
Total
$55,260
$55,260 x 4 = $221,040
So if you wanted a 10% return on
your college education, you
would need to earn $22,000 a
year more per year after college
Is this right?
Example: What is IBM’s opportunity cost? Is IBM earning economic profit?
Item
2010*
Net Sales
99,870
Cost of Goods Sold
(49,358)
Depreciation
(4,831)
Gross Income
45,681
Selling, General, and Adm. Expense
(27,025)
Operating Income
18,656
Interest Income/Expense
1,067
Pretax Income
19,723
Income Taxes
(4,890)
Net Income
14,833
* In Millions
Current Stock Price: $166
Shares Outstanding: 1,287M
“Economics deals with the Allocation
of scarce resources to satisfy
unlimited wants”
“You can’t always get what
you want…”
- Mick Jagger
Consumers have
limited incomes to
spend on a wide variety
of goods and services
(both now and in the
future)
Workers have a
finite number of
hours in the day to
work, relax, go to
school, etc
Firms have finite
capacity and limited
financial resources,
to produce goods
and services
The economy as a whole has a finite number of resources trying to satisfy a
population with unlimited wants!
If we can’t have everything we want, so we need to decide what to do with the
limited resources we do have.
Efficiency vs. Equity
An allocation of resources
that maximum total
welfare
Under certain
circumstances, the
free market process
guarantees this
An allocation of resources
provides a “fair”
distribution of welfare
Can we trust markets to
produce a desirable
outcome?
What does this mean from a business perspective? That is, why
should we care?
Efficiency vs. Equity
An allocation of resources
that maximum total
welfare
If we have an efficient
outcome, there are no
opportunities to create wealth.
An allocation of resources
provides a “fair”
distribution of welfare
With inefficient outcomes,
there are wealth creating
opportunities.
From a business standpoint, an inefficiency offers an opportunity to create wealth by
moving resources to higher value uses! This is done through voluntary transactions.
My Value - $80,000
Consumer
Surplus = $5,000
Suppose that you own a
Porsche that you value at
$65,000, but I value at
$80,000
Sale Price = $75,000
Producer Surplus
= $10,000
Your Value - $65,000
The sale of
your car
creates
$15,000 of new
wealth. The
sale price
determines how
that wealth is
allocated
between us
Again, think about efficiency as allocating resources to their highest value
VS.
Suppose that Exxon acquires
drilling rights within a remote area
where there will be negligible
environmental damage in the
traditional sense
The Sierra club files a lawsuit to block the drilling
(Their personal serenity has been threatened by
the knowledge that the oil is being removed from
it’s natural habitat)
If you are the judge, who should prevail?
VS.
If Exxon Wins:
•Exxon stockholders
gain
•Workers gain from
added jobs
•Motorists see falling
gasoline prices
If Exxon Wins:
•Sierra club
members lay awake
at night screaming
$5M
$10M
A ruling against Exxon in this example would be inefficient – a missed
opportunity to make everyone better off.
“A subtle but damaging factor in this is the dominance of economists at
business schools. Although there is no evidence that economists are less
ethical than members of other discipline, approaching the world through the
dollar sign does make people more cynical”*
Amitai Etzioni, “When it comes to Ethics, B-Schools Get an F”, Washington Post, August 4, 2002
“In 2006, when Notre Dame played Michigan, the south bend Marriott charged $649 per night - $500
above its usual rate of $149”*
Ethicist Joe Holt responds…
“It is an act of moral abdication for businesses to pretend that they have no choice but to charge as
much as they can based on supply and demand”
* Ilan Brat, “Notre Dame Football introduces its Fans to Inflationary Spiral”, Wall Street Journal, September 6, 2006
ALL voluntary
transactions create
wealth!!
Value = $700/Night
Consumer
Surplus =
$550
Consumer
Surplus =
$50
Price = $650
Either way,
$600 of
wealth is
created!
Price = $150
Producer
Surplus =
$50
Cost = $100/Night
Producer
Surplus =
$550
Cost = $100/Night
Cost = $100/Night
Value = $1000/Night
You have three
rooms to rent.
How do you
set the price to
create the
most wealth?
Value = $800/Night
Value = $200/Night
Value = $600/Night
Cost = $100/Night
Value = $400/Night
Value = $1000/Night
CS = $400
PS = $500
At a $600 per night
price we create $2100
of wealth
Cost = $100/Night
CS = $200
Value = $800/Night
PS = $500
Cost = $100/Night
Value = $600/Night
Cost = $100/Night
CS = $500
CS = $600
PS = $1500
Value = $1000/Night
CS = $850
PS = $50
At a $150 per night
price we could create
$2100 of wealth
Cost = $100/Night
CS = $650
Value = $800/Night
PS = $50
Cost = $100/Night
CS = $450
Value = $600/Night
PS = $50
Cost = $100/Night
CS = $1950
PS = $150
Value = $200/Night
CS = $50
PS = $50
At a $150 per night
price we could create
$900 of wealth
Cost = $100/Night
CS = $250
Value = $400/Night
PS = $50
Cost = $100/Night
CS = $450
Value = $600/Night
PS = $50
Cost = $100/Night
CS = $750
PS = $150
Charles Darwin vs. Adam Smith: Efficiency and the Competitive Marketplace
"Greed captures the essence of the
evolutionary spirit."
-Gordon Gekko
What do we mean by a competitive market?
#1: Many buyers and sellers
– no individual buyer/firm has
any real market power
#2: Homogeneous products
– no variation in product
across firms
#3: No barriers to entry – it’s
costless for new firms to
enter the marketplace
#4: Perfect information –
prices and quality of products
are assumed to be known to
all producers/consumers
#5: No Externalities –ALL
costs/benefits of the product
are absorbed by the
consumer
#6: Transactions are costless
– buyers and sellers incur no
costs in an exchange
Can you think of situations where all these assumptions hold?
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
50 Fish/hr
300 Max/Day
Zone B
30 Fish/hr
300 Max/Day
You bought a boat for $1,000
Maintenance on the boat is $50/Day
You pay $16/hour in labor costs
You pay $20/hour for fuel and other expenses
What costs are fixed, sunk, and variable?
Zone C
20 Fish/hr
160 Max/Day
Lets try an example…suppose that you are a fisherman. To
catch larger quantities of fish, you have to go farther from
shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone A
$36 / hr
 $.72 / Fish
50 Fish / Hr
Quantity
Total Cost
Fixed Cost
Variable
Cost
Average Cost
Marginal
Cost
0
$50
$50
$0
---
---
1
$50.72
$50
$.72
$50.72
$.72
2
$51.44
$50
$1.44
$25.72
$.72
3
$52.16
$50
$2.16
$17.39
$.72
Let’s try and picture this…
Dollars
Dollars
AC
TC
VC = $.72*F
$50
FC
$.72
MC
# of Fish
0
# of Fish
0
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone B
$36 / hr
 $1.20 / Fish
30 Fish / Hr
Quantity
TC
FC
VC
AC
MC
300
$266
$50
$216
$0.88
$.72
301
$267.20
$50
$217.20
$0.88
$1.20
302
$268.40
$50
$218.40
$0.88
$1.20
303
$269.60
$50
$219.60
$0.88
$1.20
Let’s try and picture this…
TC
Dollars
Dollars
VC =$266 + $1.20*F
$266
$50
FC
$1.20
MC
AC
$.88
# of Fish
300
# of Fish
300
Lets try an example…suppose that you are a fisherman.
Top catch larger quantities of fish, you have to go farther
from shore and your catch per hour drops
Zone A
Zone B
50 Fish/hr
300 Max/Day
Boat = $50
Labor = $16/hr
Gas = $20/hr
Zone C
30 Fish/hr
300 Max/Day
20 Fish/hr
160 Max/Day
Lets take this section by section…
Zone C
$36 / hr
 $1.80 / Fish
20 Fish / Hr
Quantity
TC
FC
VC
AC
MC
600
$626
$50
$576
$1.04
$1.20
601
$627.80
$50
$577.80
$1.04
$1.80
602
$629.60
$50
$579.60
$1.04
$1.80
603
$631.40
$50
$581.40
$1.04
$1.80
Let’s try and picture this…
TC
Dollars
Dollars
VC =$576 + $1.80*F
$576
$50
FC
$1.80
MC
AC
$1.04
# of Fish
600
# of Fish
600
All together…
Dollars
Dollars
TC
Slope = 1.80
Slope = 1.20
MC
$1.80
Slope = .72
ATC
$50
FC
$1.20
$.72
0
300
600
# of
Fish
# of Fish
0
300
600
Perfectly competitive firms are “price takers”. They see a market price and can’t
change it. Suppose that the market price is $1.20.
Fish
Price
Total Revenue
Total Cost
Profit
0
$1.20
$0
$50
-$50
1
$1.20
$1.20
$50.72
-$49.52
2
$1.20
$2.40
$51.44
-$49.04
3
$1.20
$3.60
$52.16
-$48.56
300
$1.20
$360
$266
$94
301
$1.20
$361.20
$267.20
$94
302
$1.20
$362.40
$268.40
$94
303
$1.20
$363.60
$269.60
$94
600
$1.20
$720
$626
$94
601
$1.20
$721.20
$627.80
$93.40
602
$1.20
$721.40
$629.60
$91.80
603
$1.20
$721.60
$631.40
$90.20
We are looking to maximize profits where profits are the
difference between total revenues and total costs
Dollars
Dollars
TC
$94
TR
$0
# of Fish
Slope = 1.80
$50
Profit
-$50
Slope = 1.20
Slope = .72
0
Marginal
revenue is
greater than
marginal cost
# of Fish
300
600
Marginal
revenue is
equal to
marginal cost
0
Marginal
revenue is
less than
marginal cost
Profits are
increasing
300
Profits are
maximized
600
Profits are
decreasing
We could also go at this by looking at costs and benefits at the margin. For a
perfectly competitive firm the market price equals marginal revenue.
Fish
Total Cost
Total Revenue
Marginal Revenue
Marginal
Cost
0
$50
$0
$1.20
$.72
1
$50.72
$1.20
$1.20
$.72
2
$51.44
$2.40
$1.20
$.72
3
$52.16
$3.60
$1.20
$.72
300
$266
$360
$1.20
$.72
301
$267.20
$361.20
$1.20
$1.20
302
$268.40
$362.40
$1.20
$1.20
303
$269.60
$363.60
$1.20
$1.20
600
$626
$720
$1.20
$1.20
601
$627.80
$721.20
$1.20
$1.80
602
$629.60
$721.40
$1.20
$1.80
603
$631.40
$721.60
$1.20
$1.80
Lets plot out marginal revenues and costs rather than total
costs and revenues…
Dollars
Dollars
$94
MC
$1.80
$0
# of Fish
MR
$1.20
Profit
-$50
$.72
0
Marginal
revenue is
greater than
marginal cost
300
0
600
Marginal
revenue is
equal to
marginal cost
Marginal
revenue is
less than
marginal cost
Profits are
increasing
300
Profits are
maximized
600
Profits are
decreasing
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
$1.80
MR
$1.20
$1.20
$.72
# of Fish
0
300
600
At a market price of
$1.20, MR = MC for
any quantity of fish
between 300 and
600
0
300
600
At a market price of
$1.20, this firm will
be willing to supply
any quantity of fish
between 300 and
600
Perfectly competitive firms are “price takers”. They see a market price and can’t
change it. Suppose that the market price is $0.72.
Fish
Price
Total Revenue
Total Cost
Profit
0
$0.72
$0
$50
-$50
1
$0.72
$0.72
$50.72
-$50
2
$0.72
$1.44
$51.44
-$50
3
$0.72
$2.16
$52.16
-$50
300
$0.72
$216
$266
-$50
301
$0.72
$216.72
$267.20
-$50.48
302
$0.72
$217.44
$268.40
-$50.96
303
$0.72
$218.16
$269.60
-$51.44
600
$0.72
$432
$626
-$194
601
$0.72
$432.72
$627.80
-$195.08
602
$0.72
$433.44
$629.60
-$196.16
603
$0.72
$434.16
$631.40
-$197.24
All together…
Dollars
Dollars
$0
# of Fish
TC
Slope = 1.80
-$50
Slope = 1.20
Slope = .72
TR
$50
Profit
# of Fish
0
300
Marginal
revenue is
equal to
marginal cost
600
Marginal
revenue is
less than
marginal cost
0
300
Profits are
maximized
600
Profits are
decreasing
Perfectly competitive firms are “price takers”. They see a market price and can’t
change it. Suppose that the market price is $.72.
Fish
Total Cost
Total Revenue
Marginal Revenue
Marginal
Cost
0
$50
$0
$.72
$.72
1
$50.72
$0.72
$.72
$.72
2
$51.44
$1.44
$.72
$.72
3
$52.16
$2.16
$.72
$.72
300
$266
$216
$.72
$.72
301
$267.20
$216.72
$.72
$1.20
302
$268.40
$217.44
$.72
$1.20
303
$269.60
$218.16
$.72
$1.20
600
$626
$432
$.72
$1.20
601
$627.80
$432.72
$.72
$1.80
602
$629.60
$433.44
$.72
$1.80
603
$631.40
$434.16
$.72
$1.80
All together…
Dollars
Dollars
$0
MC
$1.80
-$50
$1.20
$.72
MR
Profit
0
300
Marginal
revenue is
equal to
marginal cost
0
600
Marginal
revenue is
less than
marginal cost
300
Profits are
maximized
600
Profits are
decreasing
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
$1.80
$1.20
$1.20
$.72
MR
$.72
# of Fish
0
300
600
At a market price of
$.72, MR = MC for
any quantity of fish
between 0 and 300
0
300
600
At a market price of
$.72, this firm will be
willing to supply any
quantity of fish
between 0 and 300
When we talk about a supply curve we are talking about the profit maximizing
decisions of individual firms at prevailing market prices
Dollars
Dollars
MC
MR
$1.80
$1.80
$1.20
$1.20
$.72
$.72
# of Fish
0
300
600
At a market price of
$1.80, MR = MC for
any quantity of fish
between 600 and
760
0
300
600
At a market price of
$1.80, this firm will be
willing to supply any
quantity of fish between
600 and 760
What if the prevailing market was $1.35?
Dollars
Dollars
MC
MR
$1.35
$1.35
# of Fish
0
300
600
At a market price of
$1.35, 600 fish are
profitable to supply,
but the 601st is not!
0
300
600
At a market price of
$1.35, this firm will be
willing to supply exactly
600 fish.
So we can get an individual firm’s supply curve by following marginal costs!
Suppose that there are 1000 fishermen in the village – all with the same costs.
Dollars
Dollars
$1.80
$1.80
$1.20
$1.20
$.72
$.72
0
300
600
Individual Supply
# of
Fish
0
300,000
600,000
# of
Fish
Market Supply
Market supply adds up the decisions of each individual firm at each prevailing
market price
So where do prices come from? We need to know how many fish people are
actually willing to buy at any prevailing market price.
Dollars
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
$1.80
$1.20
$.72
0
150,000
500,000
900,000
# of
Fish
A demand curve is just a record of how much the market collectively is willing to
buy at any given market price
In equilibrium, total supply should equal total demand. If not, the price
will adjust.
Dollars
Supply
At a $1.80 price, fishermen will bring at
least 600,000 fish to the market, but
only 150,000 will get sold – the price
needs to drop
$1.80
$1.20
$.72
Demand
0
300,000
600,000
# of
Fish
At a $.72 price, fishermen will bring at
most 300,000 fish to the market, but
600,000 are demanded– the price
needs to rise
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
$1.80
$1.80
$1.20
$1.20
MC
MR
$.72
$.72
Demand
0
300,000
600,000
500,000
The market determines the
equilibrium price of $1.20 and 500,000
fish sold by the 1,000 fishermen
0
300
600
At the prevailing market price of
$1.20, each fisherman supplies
between 300 and 600 fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
Fish
Total Revenue
Total Cost
Profit
300
$360
$266
$94
301
$361.20
$267.20
$94
$36 / hr
 $1.20 / Fish
30 Fish / Hr
302
$362.40
$268.40
$94
303
$363.60
$269.60
$94
A Few Diagnostics…
Dollars
Price= $1.20
- Gas Cost = $0.67
Labor’s Value Added= $0.53
* Labor Productivity = 30 Fish/Hr
$16/hr = hourly wage
MC
$1.80
$1.20
MR
Producer Surplus = $144
- Fixed Cost = $50
$144
Accounting Profit= $94
$.72
0
300
600
$94 *100 = 9.4% Return
$1,000
Is this fisherman earning economic profits?
Suppose that the excess returns causes 800 more fishermen (all with
identical costs) to enter the market.
Dollars
Supply
$1.80
$1.20
$.72
Demand
0
300,000
# of
Fish
600,000
540,000
1,080,000
1,368,000
Price
Fish
$2.00
50,000
$1.80
150,000
$1.50
200,000
$1.20
500,000
$1.00
540,000
$.72
600,000
$.50
700,000
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
$1.80
MC
$1.80
$1.20
$1.00
MR
$1.00
$.72
$.72
Demand
0
300,000
600,000
540,000
The market determines the
equilibrium price of $1.00 and 540,000
fish sold by the 1,800 fishermen
0
300
600
At the prevailing market price of
$1.00, each fisherman supplies 300
fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
$36 / hr
 $.72 / Fish
50 Fish / Hr
Fish
Price
Total Revenue
Total Cost
Profit
0
$1.00
$0
$50
-$50
1
$1.00
$1.00
$50.72
-$49.72
2
$1.00
$2.00
$51.44
-$49.44
3
$1.00
$3.00
$52.16
-$49.16
300
$1.00
$300
$266
$34
A Few Diagnostics…
Dollars
Price= $1.00
- Gas Cost = $0.40
Labor’s Value Added= $0.60
* Labor Productivity = 50 Fish/Hr
MC
$1.80
MR
$1.00
$84
$30/hr > hourly wage
Producer Surplus = $84
- Fixed Cost = $50
$.72
Accounting Profit= $34
0
300
600
$34 *100 = 3.4% Return
$1,000
Let’s see if we can’t generalize this a bit. We want marginal costs to be
increasing – this reflects decreasing labor productivity at the margin
TC
Dollars
Dollars
MC
$1.80
$50
$1.20
FC
$.72
0
300
600
0
300
600
# of
Fish
All together…
Dollars
Dollars
TC
$94
TR
Slope = 1.20
$0
# of Fish
F*
Profit
-$50
# of Fish
0
300
F*
600
0
300
600
We are still looking for where marginal revenue equals marginal costs
(i.e. the slopes are the same)
All together…
Dollars
Dollars
MC
$0
F*
P*
MR
Profit
-$50
0
F*
0
300
600
We are still looking for where marginal revenue equals marginal costs
Dollars
Dollars
Supply
MC
P*
P*
MR
# of Fish
0
F*
For any market price (which is marginal
revenue for a perfectly competitive firm, there
is a profit maximizing quantity where MR = MC
0
F*
That optimizing quantity becomes a point on
that firms supply curve
We still aggregate decisions across individual suppliers to get market supply
(again, assume 1,000 fishermen)
Dollars
Dollars
Supply
P*
0
Supply
P*
F
# of
Fish
0
1000*F
Individual Supply
Market Supply
# of
Fish
In equilibrium, total supply should equal total demand
Individual
Market
Dollars
Dollars
Supply
MC
$1.44*
MR
1.44*
Demand
0
0
400
400,000*
The market determines the
equilibrium price of $1.44 and 400,000
fish sold by the 1,000 fishermen
At the prevailing market price of
$1.44, each fisherman supplies 400
fish
Boat = $50
Labor = $16/hr
Gas = $20/hr
We can still perform whatever diagnostics
we want…
At 400 fish, your productivity is 25
Fish/hour
Price= $1.44
- Gas Cost = $.80
Labor’s Value Added= $0.64
* Labor Productivity = 25 Fish/Hr
Dollars
$16/hr = hourly wage
MC
PS = (1/2)(400)(1.44)=288
Producer Surplus = $288
- Fixed Cost = $50
Accounting Profit= $238
MR
$1.44
$288
$238 *100 =23.8% Return
$1,000
0
400
Is this fisherman earning economic profits?
Suppose that the excess returns causes 800 more fishermen (all with
identical costs) to enter the market.
Dollars
Dollars
Supply
$1.44
$1.44
$1.03
Demand
0
400,000
576,000 720,000
# of
Fish
0
320
400
Boat = $50
Labor = $16/hr
Gas = $20/hr
We can still perform whatever diagnostics
we want…
At 320 fish, your productivity is 35
Fish/hour
Price= $1.03
- Gas Cost = $.57
Labor’s Value Added= $0.46
* Labor Productivity = 35 Fish/Hr
Dollars
$16/hr = hourly wage
MC
PS = (1/2)(320)(1.03)=165
Producer Surplus = $165
- Fixed Cost = $50
Accounting Profit= $115
MR
$1.03
$165
$115 *100 =11.5% Return
$1,000
0
320
Suppose that we have three fishermen with different productivities. Each
bought a boat for $1,000 and have the same costs as before.
Boat = $50
Labor = $16/hr
Gas = $20/hr
30 Fish/hr
300 Max/Day
$1.20 per
fish
20 Fish/hr
200 Max/Day
$1.80 per
fish
10 Fish/hr
100 Max/Day
$3.60 per
fish
Each of the above fishermen will provide fish to
the marketplace as long as the market price is
equal to or greater to their marginal cost
All a supply curve really does is
order production from lowest cost
to highest cost
Dollars
$3.60
$1.80
$1.20
Fish
0
300
500
600
For a market price that is at least $3.60, fisherman #1 sells 300
fish, fisherman #2 sells 200 fish and fisherman #3 sells 100 fish
For a market price that is at least $1.80, but below $3.60, fisherman #1 sells
300 fish and fisherman #2 sells up to 200 fish.
For a market price that is at least $1.20, but below $1.80, only fisherman #1 sells
fish. He can supply up to 300
Adding a demand curve will give us the equilibrium price and identify the
fisherman who participate in the market as well as the fisherman’s economic
profits
Boat = $50
Labor = $16/hr
Gas = $20/hr
Fisherman #1
Producer Surplus = $540
- Fixed Cost = $50
Dollars
Accounting Profit= $490
Supply
$490 *100 = 49% Return
$1,000
$3.60
Fisherman #2
$3.00
PS= $240
$1.80
PS= $540
Demand
$1.20
Accounting Profit= $190
Fish
0
Producer Surplus = $240
- Fixed Cost = $50
300
500
600
$190 *100 = 19% Return
$1,000
A Supply Function represents the rational
decisions made by a profit maximizing
firm(s).
“Is a function of”
QS  S P 
Quantity
Supplied
Market
Price (+)
Price
S
Higher cost producers are in this portion – they will
make the lowest profits (if they participate in the
marketplace)
Lower cost producers are in this portion – they will
make the largest profits
Quantity
A supply curve naturally ranks potential
suppliers from lowest marginal costs to
higher marginal costs
Example: Cell Phones
Company
Price
EPS
EPS/P (%)
ROE
ROA
Sprint
$3.11
(1.05)
33%
21%
.06%
Verizon
$34.62
$2.23
6.4%
16%
5%
AT&T
$28.44
$3.44
12%
18%
4.5%
Price
S
Quantity
A supply curve naturally ranks potential
suppliers from lowest marginal costs to
higher marginal costs
By the same token, a demand curve naturally ranks potential
consumers from highest valuation to lowest valuation. Suppose that
we have three potential consumers of rats.
Would pay up
to $25/rat. Can
consume 100
rats per week.
Would pay up
to $10/rat. Can
consume 50
rats per week.
Would pay up
to $1/rat. Can
consume 20
rats per week.
What would this demand curve look like?
Dollars
If rats cost more than $25/rat,
nobody buys them!
$25
If rats cost more between
$25/rat and $15/rat, only
Shrek buys them!
$10
If rats cost more between
$10/rat and $1/rat, Shrek AND
Anthony Zimmern buy them!
If rats cost more less than $1/rat,
EVERYBODY buys them!
$1
Fish
0
100
150
170
Price
Quantity Demanded
Above $25
0
$25
0 – 100
Between $25 and $10
100
$10
100 - 150
Between $10 and $1
150
$1
Between 150 and 170
Between $1 and $0
170
For any market price, we know how many rats are
sold and how much each consumer benefits from
the market (consumer surplus)
At a market price of $15
Dollars
Shrek buys 100 rats for $15 apiece. He
saves $10 per rat for a total of $1000 in
savings (surplus)
Neither the baby of Anthony Zimmern are
willing to buy rats for $15.
$25
CS = $1000
$15
$10
$1
Fish
0
100
150
170
For any market price, we know how many rats are
sold and how much each consumer benefits from
the market (consumer surplus)
At a market price of $5
Dollars
Shrek buys 100 rats for $5 apiece. He
saves $20 per rat for a total of $2000 in
savings (surplus)
Anthony Zimmern buys 50 rats for $5.
He saves $5 per rat for a total of $250 in
surplus
The baby still is unwilling to buy rats!
$25
CS = $2000
$10
CS = $250
$5
$1
Fish
0
100
150
170
A Demand Function represents the
rational decisions made by a
representative consumer(s)
“Is a function of”
Quantity
Demanded
QD  DP
Market
Price (-)
Price
Consumers with high valuations are located
here
Consumers with low valuations are located
here
D
Quantity
Key Point: Demand curves represent marginal utility (what we are willing to pay
for one additional unit). Consumer surplus measures total value.
Example: The Diamond/Water Paradox
Water
Diamonds
Price
Price
S
P*
S
P*
D
Quantity
D
Quantity
Market Equilibrium: There exists a price where supply equals demand – the
market will find this price automatically.
Price
S
At a price above the equilibrium price, supply
is greater than demand. A surplus drives the
price down
P*
At a price above the equilibrium price, demand
is greater than supply. A surplus drives the
price up
D
Quantity
Q*
Let’s suppose that we are talking about the market for bananas.
There was a pound of bananas
sold that cost $3 to supply and was
valued by someone at $7. This
transaction created $4 of wealth $2 went to a seller (producer
surplus) and $2 went to a buyer
(consumer surplus)
Would this transaction be wealth
creating?
Price
S
$8
$7
$5
$3
$2
D
Quantity
1,000
There was a pound of bananas sold that cost $2 to supply and was
valued by someone at $8. This transaction created $6 of wealth - $3
went to a seller (producer surplus) and $3 went to a buyer (consumer
surplus)
Recall an earlier discussion about allocations of resources.
Efficiency vs. Equity
An allocation of resources
that maximum total
welfare
Under certain
circumstances, the
market process
guarantees this
An allocation of resources
provides a “fair”
distribution of welfare
Can we trust markets to
produce a desirable
outcome?
Competitive markets provide efficient outcomes in that every wealth creating
transaction was undertaken. In other words, consumer surplus and producer
surplus are maximized.
Price
$12
S
Consumer Surplus = (1/2)*($12- $5)*1,000
$3,500
$5
$2,500
Producer Surplus = (1/2)*($5- $0)*1,000
D
$0
Quantity
1,000
Note that $6,000 of wealth was created by this market!
Example: Suppose we have the following petroleum firms. Further suppose that
there is pressure from the public to reduce pollution levels.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
How would you
go about
reducing
emissions by
50%
The cheapest way to reduce pollution by 50% would be to require the cheapest 4 firms
to reduce their emissions completely and let the other four firms continue as in the past
$ Per Unit
Pollution
Reduction
Hess
$54
Gulf
$48
First
$42
Exxon
$36
Devon
$30
Chevron
$24
BP
$18
$12
Problems:
•Unfair
•Requires information on
abatement costs
Apache
Quantity of
Emissions
Reduction
We could follow an “across the board” emission reduction program (note:
pollution taxes would have the same basic effect)
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Tons of emission
to be reduced
Total abatement
cost
Apache
50
12
25
300
BP
50
18
25
450
Chevron
50
24
25
600
Devon
50
30
25
750
Exxon
50
36
25
900
First Texas
50
42
25
1,050
Gulf
50
48
25
1,200
Hess
50
54
25
1,350
Industry Total
400
200
6,600
Let markets work for you!!!
Example: Cap and Trade as a solution to pollution reduction.
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement Cost
($/Ton)
Apache
50
12
BP
50
18
Chevron
50
24
Devon
50
30
Exxon
50
36
First Texas
50
42
Gulf
50
48
Hess
50
54
Industry Total
400
Could BP profit from
selling a pollution
permit to Gulf? What
should the selling price
be?
The Market for pollution permits
$ Per Unit
Pollution
Reduction
$54
Hess
Gulf
$48
Equilibrium price range
Hess
Gulf
First
$42
S
$36
First
Exxon
Exxon
Devon
Devon
$33
$30
Chevron
$24
BP
$18
$12
Apache
Chevron
BP
Apache
D
Quantity of
Emissions
Reduction
The cap and trade program lowered the cost of pollution reduction by $2,400
(from $6,600 to $4,200).
Firm
Historical
Emissions
(Tons/yr)
Marginal
Abatement
Cost ($/Ton)
Initial
Permit
Holdings
Permits
Sold
Permits
Bought
Final Permit
Holdings
Required
Emission
Reduction
Emission
Abatement Cost
Apache
50
12
25
25
0
0
50
$600
BP
50
18
25
25
0
0
50
$900
Chevron
50
24
25
25
0
0
50
$1200
Devon
50
30
25
25
0
0
50
$1500
Exxon
50
36
25
0
25
50
0
$0
First
Texas
50
42
25
0
25
50
0
$0
Gulf
50
48
25
0
25
50
0
$0
Hess
50
54
25
0
25
50
0
$0
Industry
Total
400
200
100
100
400
200
$4,200
Note that cost of purchasing permits equals revenues from selling permits and so
add so additional costs. Lets set the equilibrium permit price at $33.
Firm
Initial
Pollution
Reduction
Final
Pollution
Requirement
Marginal
Abatement
Cost ($/Ton)
Abatement
Cost
Additions/
Savings
Permits
Bought
Permits
Sold
Permit
Cost/Permit
Revenue
Net Gain
Apache
25
50 (+25)
12
$300
0
25
-$825
-$525
BP
25
50 (+25)
18
$450
0
25
-$825
-$375
Chevron
25
50 (+25)
24
$600
0
25
-$825
-$225
Devon
25
50 (+25)
30
$750
0
25
-$825
-$75
Exxon
25
0 (-25)
36
-$900
25
0
$825
-$75
First Texas
25
0 (-25)
42
-$1050
25
0
$825
-$225
Gulf
25
0 (-25)
48
-$1200
25
0
$825
-$375
Hess
25
0 (-25)
54
-$1350
25
0
$825
-$525
Industry
Total
200
200
-$2,400
200
200
$0
-$2,400
The consumer/producer surplus
represents the gains by all firms
$ Per Unit
Pollution
Reduction
$54
Hess
Hess
Gulf
$48
S
Gulf
$525
First
$42
First
$375
$225
Exxon
$36
Exxon
$75
$33
$30
$225
Devon
Devon
$375
$24
Chevron
$525
Chevron
$75
BP
$18
$12
Apache
BP
Apache
D
Quantity of
Emissions
Reduction
Demand is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QD  DP,...
•Income
•Prices of other goods
(Substitutes vs.
Compliments)
•Tastes
•Future Expectations
•Number of Buyers
Price
Demand Shifters
Example: Increase in
Demand
At the initial price of
$10, but with a new
value for one of the
demand shifters,
quantity demanded
has risen to 120 (An
increase in demand)
Price
Holding all the demand
shifters constant at
some level, quantity
demanded at a price of
$10 is 100
$10
D(.’.)
D(…)
Quantity
100
120
Supply is not simply a function of price, but is, instead, a function of many
variables
“Is a function of”
QS  DP,...
Price
Supply Shifters
Example: Decrease in Supply
•Technology
Marginal costs
•Input prices
•Number of sellers
Holding all the supply
shifters constant at
some level, quantity
supplied at a price of
$10 is 100
At the initial price of $10,
but with a new value for
one of the supply shifters,
quantity demanded has
fallen to 80
Price
S(.’.)
S(…)
$10
Quantity
80
100
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
At the current $150 market price,
supply is still 50,000, but with a
lower level of income, demand has
fallen to 40,000
$150
DI  $50,000
40,000
50,000
DI  $75,000
# of
Rooms
At the new income level of $50,000, $150 can no longer be
the equilibrium price
Example: How would the loss in income
during the last recession impact the hotel
industry?
S ...
Rate
per
night
$150
$125
DI  $50,000
45,000 50,000
DI  $75,000
# of
Rooms
The decrease in income (which causes a decrease in demand) causes a drop
in sales and a drop in market price
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
D...
Pounds
10,000
At the current $5
market price, supply
has risen to 18,000,
but demand is still at
10,000
18,000
At the wage level of $6, $5 can no longer be the equilibrium
price
Example: How would a drop in the wage
rate in Columbia influence the price of
coffee?
Price
per
pound
S w  $8
S w  $6
$5
$4
D...
Pounds
10,000
16,000
The lower wage (which causes an increase in supply) , results
in a lower price and higher sales
Partial Equilibrium vs. General Equilibrium
Price
Suppose that effective
advertising increased
the demand for
lemonade. What would
happen.
S
P*
D'
D
Q
*
Quantity
A rise in demand should increase sales and increase
the price right? Is that all?
Partial equilibrium deals with a disturbance in one market. General
Equilibrium recognizes that markets interact with one another and looks at
the interrelations between markets
Price
S
A rise in demand for lemonade
should increase sales and
increase the price.
P*
D'
Sugar
Price
Lemons
S
Price
S
D
Q
*
Quantity
D
Quantity
This increase in
marginal costs
should lower
supply, right!
The rise in lemonade sales
should raise demand for
lemons and sugar which
increases their prices
D
Quantity
Where would you rather live? South Bend or Chicago?
Why?
What’s better in Chicago?
What’s better in South Bend?
Pretty much everything is
better in Chicago!
It’s cheaper in South Bend!
The indifference principle states that once everything is accounted for, every
city must be equally desirable. Otherwise, who would choose to live in an
inferior city.
Lets say that the key advantage to South Bend is its low housing costs. If
Chicago was still preferred, South Bend residents would start moving to
Chicago – this will magnify the benefits of South Bend (cheaper housing)
Median
Home
Price
Chicago Housing Market
Median
Home
Price
South Bend Housing market
S
S
$238,000
$86,000
D
D
Houses
The difference between housing costs should just offset any
advantages Chicago has!
Houses
Renting vs. Buying a House….what’s the better move?
Median
Home
Price
South Bend Rental Market
Median
Rent
South Bend Housing market
S
S
$600
$120,000
D
D
Houses
Suppose that the median rental
rate is $600 per month ($7200 per
year) and the current mortgage
rate is 6%
Rentals
P
$7200
 $120,000
.06
Can you spot the housing bubble?
Question: Are we in an ‘Education Bubble”?
Can we really justify the rapidly rising costs of college tuition or are
students getting in over their heads taking out loans that they will never
be able to afford?
High School Labor Force
College Educated Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
S
Can these markets be in
equilibrium?
$15,000
D
Enrollment
Consider the earnings across different ages and different education levels.
Age Group
Attainment
25-29
30-34
35-39
40-44
45-49
50-54
55-59
College
$43,121
$55,440
$62,244
$65,973
$66,280
$64,254
$65,240
High School
$28,097
$31,366
$33,443
$35,283
$36,316
$35,270
$37,573
Differential
$15,024
$24,074
$28,801
$30,690
$29,964
$28,984
$27,667
x5
= $75,120
x5
= $120,370
x5
x5
x5
x5
x5
=$926,020
= $144,005 = $153,450 = $149,820 = $144,920 = $138,335
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Lets assume
that you could
earn 5%
elsewhere
You receive the first payment 4 years from
now
This isn’t really
right because
you don’t get all
this money up
front
What are the costs of going to college?
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$20,000
Books, Fees, etc
$1,000
Room & Board
$5,000
$36,000 x 4 = $144,000
Note: we really should
discount these costs as well!
This is not a relevant cost…you
would have paid this anyways!!!
So, a college education costs $144,000 and yields $350,386 in
(discounted) lifetime benefits! Seems worth it!
PV 
$15,024 $15,024
$27,667


...

 $350,386
4
5
39
1.05 1.05
1.05
Alternatively, we can think about the annual salary differential for a college graduate like
the annual payout on a bond. The annual return to a college education would be like
calculating the return necessary so that the PV of the wage differential equals the cost
Cost
Annual
Expense
Tuition
$15,000
Lost Wages
$20,000
Books, Fees, etc
$1,000
$36,000 x 4 = $144,000
Note: we really should
discount these costs as well!
$15,024 $15,024
$27,667
PV 

 ... 
 $144,000
4
5
39
1  i 
1  i 
1  i 
Annual return
i  11%
Thought of as an investment, a college education pays
11% per year!!
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
If the costs of
college were truly
less than the
benefits, we would
see more people go
to school
S
Wage differentials
would fall and
college tuitions
would increase
$15,000
D
Enrollment
High School Labor Force
College Education Labor Force
Salary
S
Salary
S
$38,000
$26,000
D
D
Employees
Employees
Universities
Tuition
What we are seeing
is a steady increase
in demand for
skilled labor as
demand for
unskilled labor falls
S
Wage differentials
continue to increase
as college tuitions
increase
$15,000
D
Enrollment
The Average Shopping cart in the US today is
approximately three times as big as its 1975
counterpart
Ralph Nader has argued that this is a prime
example of consumers being manipulated by
unscrupulous capitalists – bigger carts shame
consumers into bigger purchases.
What’s wrong with this argument?
Microsoft’s new Xbox 360 gaming console was released in North America
on November 22 at a retail price of $299.99. Available supply sold out
almost immediately as Christmas shoppers stood in line for this year’s hot
item. (Microsoft has increased its sales target from 3M units to 6M units).
What’s odd about this??
On December 22, 2001, Richard Reid was arrested
trying to blow up an American Airlines flight from
Paris to Miami with a bomb hidden in his shoes.
Many human rights groups have fought
heavily against the practice of racial
profiling by airline security
Isn’t there a better way to secure the safety of our
airplanes? (Hint: could we create a marketplace?)
Paul “Freck” Morgan started a website in 2001 offering a
$20 Pay Per View event…..to watch him cut off his feet
with a homemade guillotine.
Note: The site turned out to be a
hoax…Paul never actually went
through with it!
How should we feel about this entrepreneurial effort? (i.e.
could we/should we repress this market?)