High School
Advanced Placement Microeconomics
Course Outline
Text:
Economics, McConnell and Brue
Workbooks:
Microeconomics: Student Activities, Morton and Goodman
Numerous supplementary resources and materials
Student Evaluation:
Tests:
Homework & In-class assignments:
Term Paper:
Chapter 20: Demand and Supply: Elastics and Applications
60%(6 unit tests & 1 cumulative final)
20%(Primarily from workbooks and text)
20%(See Appendix I)
(Weeks 1-2)
1. The price elasticity of demand measures the responsiveness, or sensitivity, of consumers to a change in the price
of a product.
a.
b.
Elastic demand: consumers are highly responsive to price changes so that small changes in prices lead to
much larger changes in the quantity purchased.
Inelastic demand: consumers are price-insensitive or unresponsive to price changes so that substantial
price changes result only in small changes in the amount purchased.
2. Mathematically, the price elasticity of demand is the ratio of the percentage change in quantity demanded to the
percentage change in price that brings about the change in quantity demanded.
Price elasticity of demand =
% change in quantity demanded
% change in price
Note: Ed always expressed in positive terms even though price/quantity is an inverse relationship.
a. If Ed > 1
b. If Ed < 1
c. If Ed = 1
d. If Ed = 
e. If Ed = 0
demand is elastic: e.g. if prices increase 5% and quantity demanded falls 10% Ed = 2
demand is inelastic: e.g. if prices fall 5% and quantity demanded rises 2.5%, Ed = ½
demand is unit elastic: e.g. if prices rise 5% and quantity demanded falls 5%, Ed = 1
demand is perfectly elastic
demand is perfectly inelastic
3. Price Elasticity and Total Revenue
Total Revenue = the total amount the seller receives form product sales = P(rice) x Q(uantity)
a. If demand is elastic, a fall in price will increase total expenditure (PxQ) and an increase in price will
decrease total expenditure (PxQ) e.g. if price (P) declines 10% and quantity demanded (Q) increases 20%,
PxQ will increase.
b. If demand is unit elastic, a change in price will leave total expenditure (PxQ) unaffected. E.g. if P
declines by 10% and Q increases by 10%, PxQ will not change.
c. If demand is inelastic, a fall in price will reduce total expenditure (PxQ) and an increase in price will
increase total expenditure (PxQ). E.g. if P declines by 10% and Q increases 5%, PxQ will decrease.
4. Determinants of Elasticity of Demand
Category
1 Type of Good
2 Availability of Close Subs
3 Percentage of Budget
More Elastic Demand
Luxury Goods
Many close Substitutes
Large Percentage
More Inelastic Demand
Necessities
Few Close Substitutes
Small Percentage
5. Income elasticity of demand measures the degree to which consumers respond to a change in their income by
buying more or less of a particular good.
Ed =
% change in demand
% change in income
a. normal goods: Ed will be positive
b. inferior goods: Ed will be negative
6. Price Elasticity of Supply
Es =
percentage change in quantity supplied of product
Percentage change in price of product
If producers are relatively responsive to price changes, supply is elastic. If they are relatively insensitive to price
changes, supply is inelastic. The most important determinant of price elasticity of supply is the amount of time
available to producers to shift resources into the production of a particular good/service.
Chapter 21: consumer Behavior and Utility Maximization
(Weeks 3-4)
1. Three reasons for the downward sloping demand curve
a. income effect If the price of a commodity falls, a consumer’s real income (purchasing power) will
increase and quantity demanded of that commodity will increase. If the price of a commodity rises, a
consumer’s real income (purchasing power) will decrease and quantity demanded of that commodity will
decrease. (Note: the income effect assumes one’s income is constant and that price changes. This differs
from when we assume constant prices and a rise/fall in income increases/decreases the demand for a
normal good.)
b. substitution effect If the price of a commodity falls, such as donuts, relative to the price of some other
commodity, such as muffins, a consumer whose real income has remained unchanged can be expected to
buy more of the first – in this case donuts – and fewer of the one relatively more expensive – in this case
muffins. Thus, if we consider the substitution effect alone, a decline in price of a good always increases its
quantity demanded and a rise in price always reduces its quantity demanded.
c. The law of diminishing marginal utility asserts that additional units of a commodity are worth less and
less to a consumer in money terms. That is, as the individual’s consumption increases, although total
utility is greater, the marginal utility of each additional unit declines. Intuitively, it should make sense that
because additional units of a good yield smaller and smaller amounts of marginal utility, then the
consumer will buy additional units of a product only if its price falls.
-- utility is what a good or service is worth to a consumer in terms of pleasure/satisfaction provided.
-- total utility of a quantity of goods to a consumer (measured in dollars) is the total amount of money she
is willing to give in exchange for it.
-- marginal utility of a commodity to a consumer (measured in dollars) is the amount of money she is
willing to pay for one additional unit of it.
KEY GRAPH 21-2 PAGES 426-427
2. Theory of Consumer Behavior
a. The optimal purchase rule states that it always pays the rational consumer to buy more of any
commodity whose marginal utility (in dollars) exceeds its price (MU>P), and less of any commodity whose
marginal utility is less than its price (MU<P). Thus, the consumer should buy the quantity of each good at
which rice equals marginal utility (P=MU) because only these quantity swill maximize the total utility she
gains from her purchases given the fact that the money she has available must be divided among all the
good she buys.
b. Where P = MU, a rational consumer will maximize the money value of the total utility she derives from
her purchase minus the amount she must spend to make that purchase. This is known as consumer surplus
where total utility – total expenditure is the greatest.
c. From the marginal utility curve, we can derive the demand curve. According to the optimal purchase
rule, P = MU; therefore, for each list of marginal utilities above, we can determine how many goods an
individual will purchase. Due to the law of diminishing marginal utility, if the price falls, a consumer who
wishes to maximize total utility will see to it that MU falls and the only way to do this is to increase the
quantity demanded.
3. Utility Maximizing Rule: A rational consumer will allocate his/her money so that the last dollar spent on each
product yields the same amount of marginal utility. In this way, a consumer will maximize satisfaction or utility.
As a formula:
MU Good A
Price A
=
MU good B
Price B
Chapter 22: The Costs of Production
(Weeks 5-7)
1. Economic costs are those payments a firm must make, or incomes I must provide, to resource suppliers to attract
the resources away from alternative production opportunities. These payments or incomes may either be explicitly
or implicit
a. Explicit costs are money payments to non owners of the firm for the resources they supply.
b. Implicit costs are the money payments for resources that a firm itself owns determined by examining
what those resources could have earned elsewhere (I.e. the opportunity cost). An important implicit cost
includes one’s entrepreneurial talent, or normal profit.
2. Accounting profit is the firm’s total revenue (price x quantity) less its explicit costs
3. Economic or pure profit is total revenue less all costs (including explicit and implicit, the latter including a
normal profit to the entrepreneur). If economic profit is zero, a normal profit is still being earned.
4. Short Run and Long Run
a. The short run is a period of time too brief for a firm to alter its plant capacity, yet long enough to permit
a change in the degree to which the fixed plant is used.
b. The long run is a period of time long enough for that firm to adjust the quantities of all the resources it
employs, including plant capacity.
5. Short-Run Production Relationships (KEY GRAPH FIGURE 22-2 PAGE 449)
a. The total physical product (TPP) curve shows what happens to total output when a firm changes the
quantity of one input while holding other inputs constant.
b. The average physical product (APP) curve is the total physical product divided by the quantity of the
input used.
APP =
TPP
Q
where Q = quantity of input
c. The marginal physical product (MPP) of an input is the increase in total output that results form a oneunit increase in the input, holding the amounts of all other inputs constant. The law of diminishing
marginal returns states that when we increase the amount of any one input, holding the amounts of all
others constant, the marginal returns to the expanding input ultimately begin to diminish. Thus, there are
three regions of the MPP: increasing, decreasing, and negative returns.
6. Short-Run Production Costs (KEY GRAPH 22-5 PAGES 452-454)
a. The total cost (TC) of some quantity of output is simply the sum of the amounts of money that the firm
must spend on labor, fuel , raw materials, capital, etc. to produce that given output. Total costs can be
divided into two components: fixed costs (FC) and variable costs (VC). As a formula:
TC = TFC + TVC (Figure 22-3 page 452)
i. A fixed cost is the cost of the inputs whose quantity does NOT rise when output goes up, and
which are required to produce any output at all. Therefore, the total cost does NOT change when
output changes. Note: some fixed costs are also “sunk costs” or costs that are unrecoverable. In
the short run, a firm has no control over her fixed costs due to rental agreements, space limitations,
labor contracts, etc.
ii. A variable cost increase with more output. In the short run, a firm has control over her variable
costs by changing the amount of output sold.
b. Marginal cost (MC) is the increase in the firm’s total cost required if it increases its output by an
additional unit. Note that because fixed costs do not change a t higher levels of output, marginal cost is
also the change in variable cost
MC =
change in TC
=
change in TVC
Change in Q
change in Q
--Marginal costs will decrease when we have increasing marginal returns because if all units of a variable
resource (e.g. workers) are the same price, the marginal cost of each extra unit of output will fall as long as
the marginal product of each additional unit(e.g. worker) is rising. Marginal costs will increase when we
have diminishing marginal returns because if all units of a variable resource (e.g. workers) are the same
price, the marginal cost of each extra unit of output will rise as long as the marginal product of each
additional input (e.g. worker) is falling. Figure 22-6 pg. 455
c. Although total fixed costs (TFC) for any output of lemonade produced will remain the same, average
fixed costs (AFC) will become smaller with each unit of output as the fixed cost is spread among more
units.
d. Average variable costs (AVC) for any output is calculated as:
AVC = TVC
Q
e. Average total costs (ATC) =
TC =
AFC + AVC
Q
Note that while the AFC curve gradually approaches zero, both the ATC and AVC curves are “Ushaped.” There are two reasons that AC declines when output increases in the leftward portion of
the AC curve. Figure 22-4 Page 452
i. As a firm increases one input, holding others constant, a arise in output initially results in
increasing returns to output(increasing the marginal physical product) up to a certain point. This
would reduce the average cost of output as the quantity increased.
ii. Secondly, while average fixed cost constantly falls when output increases, AFC fall more
quickly at first. Since ATC = AFC + AVC, ATC will fall as well. If fixed costs are higher in an
industry, the AC curve will fall for a longer period of time.
iii. However, AC will increase after a certain point as output increases due to the law of
diminishing returns which will increase marginal (and average costs).
f. Relationship of MC to AVC and ATC When the marginal cost added to total cost is less (even if it is
rising) than the current average total cost, ATC will fall. When MC exceeds ATC, ATC will rise. The
marginal cost curve intersects the average total cost curve at the ATC curve’s minimum point. Note the
same logic applies to the AVC curve because MC is the addition to variable cost as well.
7. Shifting the Cost Curves
a. If fixed costs increased (e.g. a $50 rent increase at each level of output) the AFC curve would shift
upward by that amount, as would the ATC curve. But the MC and AVC curve would remain unchanged.
If fixed costs decreased, the AFC and ATC curve would shift downward.
b. If a variable input rose in price (e.g. if workers received higher wages) the AVC, ATC, and MC curves
would all shift upward, but not the AFC curve. If variable costs decrease, due to a more efficient capital
equipment, for example, then AVC, ATC, and MC would all fall.
8. Long-Run Production Costs
a.
The Long-Run Cost Curve—Figures 22-7 and KEY GRAPH FIGURE 22-8 In the long run, all fixed
costs become variable and a firm can alter its capital equipment and size of operation. Due to the law
of diminishing marginal returns, after a certain level of output, a firm can achieve lower average costs
by moving to larger plant capacity. Thus, the long-run average total cost (LRATC) curve for a firm is
composed of the SRATC curves for the various plant sizes which can be constructed. The LRATC
curve shows the least average total cost at which any output can be produced after the firm has had
time to make all appropriate adjustments in its plant size.
b. The scale of operation of a business enterprise is defined by the quantities of the various inputs it uses.
Unlike the short-run, where we assume one resource is fixed, in the long-run all resources are variable.
Thus, the law of diminishing marginal returns does NOT apply. Why is the LRATC U-shaped as well?
Figure 22-9 Page 459
i. In general, production involves economies of scale or increasing returns to scale if, when all
input quantities are doubled, the quantity of output is more than doubled. If all input quantities are
doubled, total cost doubles, but if output more than doubles, the cost per unit (average cost) must
decline. Thus, production functions with economies of scale lead to long-run average total cost
(LRATC) curves that decline as output expands.
ii. Diseconomies of scale or decreasing returns to scale occur when all input quantities are
doubled, the quantity of output is less than doubled. If all input quantities are doubled, total cost
doubles, but if output less than doubles, the cost per unit (average cost) must increase. Thus,
production functions with diseconomies of scale lead to long-run average total cost (LRATC)
curves that increase as output expands.
iii. Constant returns to scale occur when all input quantities are doubled, the quantity of output is
doubled. If all input quantities are doubled, total cost doubles, and if output doubles, the cost per
unit (average cost) must remain constant. Thus, production functions with constant economies of
scale lead to long-run average total cost (LRATC) curves that are horizontal as output expands.
Chapter 23: Pure Competition
(Weeks 8-9)
1. Perfectly competitive market conditions
a. many buyers and sellers with no single buyer or seller able to influence price
b. homogeneous or identical product
c. freedom of entry and exit I.e. no barriers to entry/exit
d. perfect information by both buyers and sellers concerning price and availability
2. The Competitive Firm’s Demand Curve
a. A firm in a perfectly competitive markets a pure price taker; that is, it has no choice but to accept the
price that has been determined by the market interaction of supply and demand. Thus, a perfectly
competitive firm has a horizontal demand curve (i.e. perfectly elastic) so that a firm may produce as
much as it wants at the prevailing market price. This is true due to the large number of competitors selling
an identical product so that the actions of one seller are insignificant.
It is important here to differentiate between the market demand curve which is downward sloping and the
individuals firm’s demand curve which is horizontal. For example, if the entire industry restricted supply, prices
would rise due to the law of demand; however, if only one firm decided to reduce output, the effect on total market
supply and price would be negligible.
b. Total revenue is the price x quantity sold. Or TR = P x Q.
c. A firm’s demand curve the average revenue (AR) curve. The price of a product is the revenue per unit
that the firm receives. That is,
AR = TR = PxQ = P
Q
Q
d. Marginal revenue (MR) is the addition to total revenue resulting from the addition of one unit to total
output. Under perfect competition, product price is constant to the individual fir. Thus, marginal revenue
equals price in pure competition because additional units can be sold at the constant price.
3. Profit-Maximization in the Short Run
a. As a price taker, a firm can only maximize economic profit ( or minimizing losses) by adjusting output.
In the short run, some commitments are fixed, so a firm can only adjust output by changing variable
resources.
b. Total profit for a firm is the net earnings during a period of time or total revenue subtracted from total
costs.
Total profit = TR – TC. Figure 23-2 Page 473
c. Where total revenue and total cost (including a normal profit) are equal, economic profit is zero. This
output level is known as the break-even point.
d. Marginal profit is the addition to total profit resulting from one more unit of output. If the marginal
profit from increasing output by one unit is positive, then output should be increased. If the marginal profit
from increasing output by one unit is negative, then output should e decreased. Thus, an output level can
maximize total profit only if marginal profit equals zero at that output.
e. Marginal revenue is the increase in total revenue resulting from the sale of an additional unit and
marginal cost is the increase in total cost. If MR > MC, a firm can increase profit by producing more; if
MR < MC, a firm can increase profit by producing less. Let us complete the table below and graph
Narcissus’s marginal revenue and marginal cost curves. Thus where MR intersects MC total profit is
maximized.
f. In a perfectly competitive market, marginal revenue equals price or MR = P. Thus the equilibrium of a
profit-maximizing firm in a perfectly competitive market must occur at an output level at which marginal
cost is equal to price (because price is equal o marginal revenue). Or P = MR = MC.
g. Economic profit can be calculated form the average-total-cost (ATC) data. KEY GRAPH 23-3 PAGE
475
Profit per-unit = Price or AR – ATC at the profit-maximizing output where MR = MC
Total economic profit = profit per-unit x total output at the profit-maximizing output where MR = MC.
4. Marginal Cost and Short Run Supply KEY GRAPH FIGURE 23-6 PAGE 479
a. A firm should continue to operate in the short run if TR exceeds total short-run variable cost (TVC).
Since TR/Q = P and TVC/Q = AVC, P> AVC for a firm to operate. If a firm stops producing, both its
revenues and short-run variable become zero, leaving only sunk costs. Thus, its loss if it shuts down =
sunk costs = TC – TVC. If a firm continues to operate, it can receive enough total revenue to cover its
TVC and still pay off some of its fixed costs.
b. A firm should nevertheless plan to shut down if TR is less than TVC or if P < AVC.
c. The short-run supply curve of the perfectly competitive firm is the portion of its marginal cost curve
that is above the point where it intersects the average short-run variable cost curve; that is, above the
minimum level of AVC. If price falls below that level, the firm’s quantity supplied drops to zero. But as
the price/marginal revenue increases, a firm’s output of increases as it operates where MC = MR. Note that
the MC is upward sloping due to the law of diminishing marginal returns.
d. A firm breaks even and achieves normal profits where (P = AR) = ATC. At any point where (P = AR)
> ATC, a firm experiences economic profits in the short run.
e. An increase in variable costs will shift the MC up (left) along with the AVC and ATC curves resulting in
lower output per firm, whereas a decrease in variable costs will shift the MC down (right) along with the
AVC and ATC curves resulting in higher output per firm.
f. In the short run, the number of firms in a competitive industry is fixed because the period of time does
not allow entry and exit. To derive the supply curve of the competitive industry, at any price we simply
add up the quantities supplied by each firm to arrive at the industry-wide quantity supplied. Figure 23-7
Page 481
5. Profit Maximization in the Long Run
In the short run, there are a fixed number of firms who have a fixed size of operation. Firms may shut down by
producing zero output, but they cannot liquidate and go out of business. In the long run, individual firms may
expand or contact their plant capacities and the number of firms may change as new firms enter and old firms exit.
After all long-run adjustments are completed, product price will be exactly equal to, and production will occur at,
each firm’s minimum average total cost.
a. Long run equilibrium = S1 and D1 in industry where each firm operates at P = MR = MC = minimum
ATC (normal profit).
b. Demand increases to D2 increasing price and quantity supplied in the industry
c. Each firm in short run accepts higher price ($60) and increases output where P = MR = MC
d. Each firm in the short run experiences economic profit.
e. In the long run firms enter the market to achieve economic profits shifting the industry’s short urn supply
curve right to S2.
f. Due to the increase in supply (and the downward sloping market demand curve) the new market in
higher output and lower prices (equal to original equilibrium price of o$50).
g. A new long run equilibrium occurs at S2 and D2 with more firms in the industry where each firm
operates again where P = MR = MC = minimum ATC (normal profit).
See Figure 23-8 below reproduced from the text on page 482. Also see Figure 23-9 for decreased demand scenario
6. The long-run industry supply curve for a constant cost industry is horizontal or perfectly elastic. Figure 23-10
page 484 When demand for a product increases, price increases, economic profit increases, new firms enter,
industry output increases, and price returns to the original equilibrium tangent to the minimum ATC. When demand
falls, prices fall, economic profit falls, old firms exit, industry output decreases, and price returns to the original
equilibrium tangent to the minimum ATC. Thus, the supply curve in the long run will reflect the price level where P
= minimum ATC.
7. Pure Competition and Efficiency
The long run equilibrium of a purely competitive market will ensure that P = MR = MC = minimum ATC
A competitive market will ensure both productive efficiency (goods produced in the least costly way) and allocative
efficiency (resources apportioned among firms and industries so as to yield the mix of products and services which
is most wanted by society).
a. Productive Efficiency: P = Minimum ATC: In the long run, pure competition forces firms to produce at
the minimum average total cost of production and to charge a price which if equal with that cost
(guaranteeing a normal profit, but zero economic profit). Thus, purely competitive firms are forced to use
the least-cost production methods and combination of inputs or they will not survive. The minimum
amount of resources will be used and consumers will benefit by paying the lowest product price possible
given existing conditions.
b. Allocative Efficiency: P = MC: Efficiency in the choice of output quantities requires that, for each of the
economy’s outputs, the marginal cost (MC) of the last unit produced be equal to the marginal utility (MU)
of the last unit consumed. At MC = MU, total benefit total utility) to society minus the total cost to society
of producing the output quantities that are chosen will be maximized. (TU > TC by largest amount where
MU = MC).
--Output where MU > MC is not optimal because society would be made better off by an increases in that
output level. In pure competition, if MR = P > MC, there will be an under allocation of resources to this
product, and a firm would maximize profits by producing more.
--Output where MC > MU is not optimal because society would be better off by a decrease in that output
level. In pure competition, if MC > MR = P, there is an over allocation of resources to this product, and a
firm would maximize profits by producing less.
--Under perfect competition, it is most profitable for each firm to produce where its marginal cost (MC) =
price (P). Similarly, it is in the interest of each consumer to purchase goods at which the marginal utility
(MU) is equal to the price (P) of that good. MC = P = MU or MC = MU. In other words, the
uncoordinated decisions of producers and consumers can be expected automatically to tend to produce
exactly the quantity of each good that satisfies the MC = MU rule for efficiency in deciding what to
produce.
Unit Activity: Research and present an example of a business operating in a competitive market
Chapter 24: Pure Monopoly
(Weeks 10-11)
1. A pure monopoly has the following characteristics:
a. Only one firm in the industry
b. No close substitute for the monopolist’s product
c. Firm is a “price maker”
d. Nonprice competition not necessary due to unique product, although it does exist
e. Impenetrable barriers to entry (e.g. economies of scale, legal restrictions, control of scare resource, etc.)
2. A specific type of monopoly is a natural monopoly – an industry in which advantages of large-scale production
make it possible for a single firm to produce the entire output of the market a t lower average cost than a number of
firms each producing a smaller quantity. However, this would only occur if the market demand curve intersected
the LRATC in this region where economies of scale occurred.
3. Monopoly Demand
a. A monopolist faces the industry’s downward sloping demand curve and can select a higher price without
losing all its customers like the perfect competitor. In fact, by controlling output, the monopolist can
effectively determine the market price based upon existing elasticity of demand. (Thus, the monopolist is a
price maker.)
b. Whereas the perfect competitor’s price (i.e. average revenue) will equal marginal revenue due to the
perfect elasticity of demand, for the monopolist, his marginal revenue (MR) curve is always below the
demand curve (=AR). Because the monopolist must set a lower price to obtain greater sales marginal
revenue is less than price (AR) for every level of output except the first. Figure 24-2 Page 499
c. The monopolist prices in the elastic region of demand. When demand is elastic, a decline in price will
increase total revenue (and thus marginal revenue is positive). If demand where inelastic, a price decline
would cause total revenue to decrease (and marginal revenue would be negative).
4. Determining the Profit-Maximizing Output for a Monopolist KEY GRAPH Figure 24-4 Page 502
Step 1. Determine the profit-maximizing output b finding where MR = MC
Step 2. Determine the profit-maximizing price by extending a vertical line upward from the output determined in
step1 to the pure monopolist’s demand curve.
Step 3. Determine the pure monopolist’s economic profit using one of two methods
Method 1.
Find profit per unit by subtracting the average total cost of the profit-maximizing output
from the profit-maximizing price. Then multiply the difference by the profit-maximize
output to determine economic profit (if any).
Method 2.
Find total cost by multiplying the average total cost of the profit-maximizing output by
that output. Find total revenue by multiplying the profit-maximizing output by the profitmaximizing price. Then subtract total cost from total revenue to determine economic
profit (if any).
5. Monopoly Supply Curve: Unlike the purely competitive firm where MC = supply curve above AVC, the
monopolist has no supply curve. For a purely competitive firm which maximizes profit where MR = P = MC there
is one and only one price at every level of output yet for a monopolist who does not maximize profit where P = MC,
but maximizes profit where MR= MC, it is possible for there to be many prices at that level of output. Because we
can have two (or more) prices for the same level of output, we cannot determine a supply curve for a monopolist.
6. Monopoly Pricing: A monopolist will not necessarily charge the highest price. A firm is more concerned with
maximizing profit than price. Where MR = MC may not be the highest price, but it will be at the h highest profit.
7. Monopoly Economic Losses: In the short run, if demand falls or costs increase, a monopolist may experience
economic losses. In the long run, however, a monopolist would not operate with losses. It is more typical for a
monopolist to have positive economic profit. Figure 24-5 Page 504
8. A comparison of Monopoly and Perfect Competition Figure 24-6 Page 504
a. Excess monopoly profits In a perfectly competitive market, in the long run, free entry of other
enterprising firms would increase supply, lower prices and economic profits until each firm earned zero
economic profit (i.e. normal profit). But higher profits can continue for the monopolist due to barriers to
entry.
b. Restricted output and higher prices As compared with the perfectly competitive ideal, the monopolist
restricts output and charges a higher price.
9. Monopoly Leads to Inefficient Resource Allocation Figure 24-6 Page 504
a. Productive efficiency occurs where P = minimum ATC. Under pure competition, due to free entry
and exit, in the long run, P = minimum ATC and economic profits will be zero (normal profits only). Since
a monopolist produces at an output below the pure competition (Qc) where ATC is lowest and price is
higher than the competitive price (Pc), then the price for a monopolist must e greater than minimum ATC.
That is, Pm > minimum ATC for a monopolist and productive inefficiency is the result.
b. Allocative efficiency occurs where P = MC = MU That is, under pure competition, the price (a
measurement of a product’s value or marginal benefit/utility to society) equals marginal cost (a
measurement of the alternative products forgone by society in producing any given commodity). However,
at the restricted monopolist’s output (Qm), price will be higher than marginal cost. In other words, because
Pm = MU > MC, too small a share of society’s resources is being used to produce the monopolized
commodity. Even though consumers are willing to pay for additional products (its MU) that exceed what it
costs to produce that unit (its MC), the monopolist, is unwilling to increase production because if it raises
output by one unit, the revenue it collects (the MR) would be less than its marginal cost (MC). Thus, the
monopolist does not increase production and resources are allocated inefficiently.
10. Government Regulation of Natural Monopolies Figure 24-9 Page 510
a. Allocative Efficiency: P = MC. The price of a commodity should never be less than its marginal cost.
The government could impose a price ceiling at Pr on the graph below in order to ensure that the natural
monopolist increase output and lower price. If rational consumers equate P = MU then MU = MC and we
have a socially optimal output/price. However, under this policy the monopolist will most likely face
short-term economic losses and potential long run bankruptcy. Because of economies of scale the ATC is
downward sloping and when ATC is declining, then marginal cost must be below average total cost. If P =
MC under allocative efficiency, P must be below ATC and the firm will lose money. Thus the government
would have to nationalize (own and operate) the industry, subsidize it, or permit some form of price
discrimination to allow the monopolist to charge higher prices to some customers.
b. Fair Return Price: P = min. ATC. The price of a commodity should not be less than its average total
cost. In this scenario, the government would not have to worry about economic losses for the monopolist
because a fair-return price would be established at Pf = min ATC. Profits for the monopolist would be
normal (P=AR=ATC) with output higher than without regulation. However, this does not ensure
productive efficiency because P > minimum ATC or allocative efficiency because price is higher and
output lower than where Pr = MC.
11. Price Discrimination is the practice of selling a specific product at more than one price when the price
differences are not justified by cost differences. Three conditions are necessary for effective price discrimination:
 monopoly power in order to control price/output
 market segregation of buyers who have different elasticities of demand
 no resale of product/service by original purchaser in low-price segment
As a result of price discrimination, the monopolist will
a. Earn more total economic profit
b. Increase production (thereby reducing some, but not all, allocative inefficiency)
c. Increase prices for some consumers
d. And lower prices for other consumers
For a perfectly discriminating monopolist its marginal revenue equals its demand curve. If this monopolist can
identify what each customer is willing to pay, it does not have to lower its price on all preceding units to sell more
output. Thus, MR would equal demand curve at all levels of output. Figure 24-8 Page 509
Unit Activity: Research and present an example of a business operating in a monopolistic market
Chapter 25: Monopolistic competition and Oligopoly
(Weeks 12-13)
1. Monopolistic Competition
Features Similar to pure Competition
a. Many sellers each with a relatively small percentage of market share
b. Freedom of entry and exit due to relatively small size of firms
c. Zero economic profit in the long run (P = ATC)
Features Similar to Monopoly
a. Product differentiation (e.g. quality, packaging, brand name, location, service, etc.)
b. Some control over price due to product differentiation and brand loyalty –therefore, downward sloping
demand curve
c. Allocative and productive inefficiency
2. Price and Output Determination Under Monopolistic Competition KEY GRAPH figure 25-1 Page 519
a. Due to product differentiation and a smaller number of rivals compared to pure competition, a
monopolistic competitor does not have a perfectly elastic demand curve like a perfectly competitive
producer. On the other hand its demand curve is more elastic than a pure monopolist because of the large
number of competitors.
b. Like all other firms, a monopolistic competitor will maximize its profit or minimize his loss where MR =
MC. If there are short-run economic profits, new firms will enter the industry which will cause an
individual firm’s demand curve (and thus, the marginal revenue curve) to shift to the left because each
firms will have a smaller share of total demand due to the arrival of more close substitutes. If firms exit,
each firm’s demand curve shifts right.
c. Long-run equilibrium under monopolistic competition requires that the firm’s demand curve be tangent
to its average curve where economic profit will be zero (normal profits only). If output were any greater or
less than this long equilibrium, average cost would be greater than price and the firm would have economic
losses. Only where P = ATC there no longer be an incentive to enter the industry. However, note that this
is NOT productive efficiency since P > minimum ATC at this point where demand is downward sloping.
3. An oligopoly is a market dominated by a few sellers (of a homogenous or differentiated product) at least several
of which are large enough relative to the total market to be able to influence price. Mutual interdependence is
important in oligopolies as each firm’s profit depends upon the price and sales strategies, but also those of its rivals.
Like a monopoly, there are many barriers to entry.
4. The Kinked Demand Curve Model KEY GRAPH Figure 25-4 Page 528
If one firm in an oligopoly decides to lower its price, t is likely the other two firms will also lower their prices in
order to prevent their customers from switching companies (thus, the relevant demand curve for price cuts would be
inelastic). If, on the other hand, one firm decides to raise its price, it is likely the other two firms will not increase
their prices in order to gain some of that firm’s customers (thus, the relevant demand curve for price increases would
be elastic). Due to the kinked demand curve, each oligopolist has an incentive not to change prices. If one firm
raises its prices, the others won’t and its total revenue will fall (elastic demand). If one firm lowers its prices, the
others will too and its total revenue will fall (inelastic demand).
5. One specific type of oligopoly is a cartel or a group of sellers of a product who have joined together to control its
production, sale, and price in the hope of obtaining the advantages of a monopoly. (e.g. OPEC – the Organization
of Petroleum Exporting Countries). If a cartel is successful, it may end dup charging monopoly prices and
obtaining monopoly profits, but without any offsetting benefits of economies of large-scale production since each
firm operates separately.
Unit Activity: Research and present an example of a business operating in an oligopolistic market
Chapter 27: The Demand For Resources and
Chapter 28: Wage Determination
(Weeks 14-15)
1. The expenditures firms make in acquiring economic resources flow as wage, interest, rent, and profit (WIRP) to
those households which supply these resources (labor, capital, land, and entrepreneurship).
2. Marginal Productivity Theory of Resource Demand
a. The marginal revenue product (MRP) of an input (e.g. labor) is the additional revenue that the
producer earns from the increased sales when she uses an additional unit of the input.
MRP = MP (marginal product) x Price of Product or the change in total revenue/change in resource
quantity
b. The marginal resource cost (MRC) is the amount by which each additional unit of a resource adds to
the firm’s total (resource) cost. In equation form:
MRC = change in total (resource) cost/change in resource quantity
c. When the marginal revenue product (MRP) of an input exceeds its price, the firm can increase profits if it
uses more of that input. Similarly, when the marginal revenue product of the input is less than its price, the
firm can increase profits by using less of that input. Only when the MRP of an input has been reduced (by
diminishing returns) to the level of the MRC (i.e. the price of the input) has the proper amount of the input
been employed, because then the firm will be wasting no opportunity to add to its profit.
According to the optimal purchase rule, the optimal quantity of an input is where MRP = MRC.
(Note: this is the same profit-maximizing principle of MR = MC for firms in the product market).
d. MRP as a Resource Demand Schedule Figure 27-1 Page 567
The demand curve for any input is the downward-sloping portion of its marginal revenue produce (MRP)
curve and indicates the number of workers the firm would hire at each possible wage rate.
e. The wage rate (MRC) in a perfectly competitive resource market is established by the market forces of
supply and demand. In a perfectly competitive resource market, each firm hires such small fraction of
workers, it cannot influence the market wage rate (i.e. it is a “wage taker” not a “wage maker.”) Thus,
resource “price” (the market wage rate) and resource “cost” (marginal resource cost) are equal for a firm
hiring a resource in a purely competitive labor market. KEY GRAPH 28-3 Page 586 (reproduced below).
3. Determinants of Resource Demand
a. price of the product: Because the demand for labor (like other inputs) is a derived demand, anything
that raises or lowers the demand for a particular product will tend to raise or lower the wages of the
workers that produce that product. Here are the linkages:
--An increase or shift right in the demand curve for a product results in
--an in increase n the price of the product and
--an increase in marginal revenue which increases MRP and
--shifts right the demand curve(MRP) for factors used in producing that commodity.
b. Marginal physical product: A worker’ MPP or productivity depends on several factors, including a
worker’s ability, degree of effort, and other factors of production she has to work with (e.g. technology,
natural resources, etc.). An increase in productivity will increase MRP and thus increase the demand for
the resource.
4. change in quantity demanded for a resource A common error occurs when students think that resource
demand changes due to change in the wage rate. However, this is NOT a change in demand (a shift in the MRP),
but a movement along the MRP curve. If wages increase in the labor market, the quantity demanded for cupcake
workers would decrease.
5. Optimal Input combinations
a. A firm is producing a specific output with the least-cost combination of resources when the last dollar
spent on each resource yields the same marginal product. In equation form, for any two inputs, such as
capital (c) and labor (l) a competitive firm will minimize its total cost of a specific output when
MP c/P c = MP l / P l
b. In a purely competitive resource market, the profit-maximizing condition is MRP = MRC where the
MRC was equal to the resource price (P). In competitive markets, a firm will therefore achieve its profitmaximizing combination of resources when each resource is employed so that MRP = P = 1. If the firm is
in a profit-maximizing position, it MUST be using the least-cost combination of inputs. However, the
converse is NOT true. If a firm is operating at least cost, it may not be operating at the output that
maximizes profit.
Chapter 30: Government and market Failure: Public Goods and Externalities
(Week 16-17)
1. An efficient allocation of resources requires that each product’s price be equal to its marginal cost or P = MC. In
a free market, the price of any good reflects the money value to consumers of an additional unit (its marginal utility
or MU). Similarly, the marginal cost (MC) measures the value (opportunity cost) of the resources needed to
produce an additional unit of the good. If prices are set equal to marginal costs, then consumers, by using their own
money in the most effective way to maximize their own satisfaction, will automatically be using society’s resources
in the most effective way. That is, the market in pure competition will satisfy the MC = MU rule for efficient
resource allocation.
2. Many economic activities provide incidental benefits to others for whom they are not specifically intended. A
positive or beneficial externality (spillover benefits) provides pleasure to people who do not pay (a free ride)
whereas a negative or detrimental externality (spillover costs) imposes a cost on others. Figure 30-2 Page 625
3. The presence of externalities causes the price system to misallocate resources because some of the costs and
benefits of economic activities are left out of the profit calculation. If a firm imposes a cost on others (e.g. polluting
a river) for which it does not have to pay, it will use up more resources than socially desirable. Similarly, if a firm
provides benefits to others for which it receives no payment (e.g. street music) it will allocate too few resources to
the activity, even if socially desirable.
a. Negative externalities. In figure A below, we can illuminate this concept by introducing the concept of
marginal social cost (MSC) which includes a) marginal private cost (MPC) which is the share of
marginal cost caused by an activity that is paid for by the persons who carry out the activity; and b)
incidental cost, which is the share borne by others. With negative externalities, since neither the producer
nor immediate consumers pay for these costs, there is an overallocation of resources devoted to theses
goods. With negative externalities, MSC > MPC. If in equilibrium, efficient resource allocation occurs
when MU = MPC, then when negative externalities exist, MSC > MU, and society would be better off if
output of the product were produced. That is, smaller outputs than those that maximize profits would be
socially desirable. Three basic solutions to this problem of negative externalities include
i) government tax on the producer’s good/service (e.g. cigarette tax) which will increase costs,
shift the MPC left, and increase price and reduce output until the MPC curve coincides with the
MSC curve
ii) legal restriction on the sale/reduction of item
iii) lawsuits
b. Positive externalities In figure B below, MSC < MPC due to spillover benefits. If MU = MPC, then
MU > MSC and society would be better off if output of the product were increased. That is, lager outputs
than those that maximize profits would be socially desirable; however, since the producer does not receive
financial compensation for these spillover benefits, she ahs no incentive to increase production. There are
three basic solutions to this problem of positive externalities:
i) Subsidies to the producer of the good/service which will reduce costs, shift the MPC curve to
the right, and decrease prices and increase output until the MPC curve coincides with the MSC
curve.
ii) Subsidies to the buyers of the good/service
iii) Government provision of the good/service using tax dollars.
4. Public Goods – A second area in which the market fails to perform adequately is in the provision of public goods.
Public goods contrast with private goods in two important.
a. Depletability: Unlike a private good, a public good’s benefits are not depleted by an additional user
b. Excludability: Unlike a private good, is generally difficult or even impossible to exclude people from
the benefits of a public good.
c. There are two implications of these characteristics of public goods.
--Since non paying users usually cannot be excluded from enjoying a public good, suppliers of
such goods will find it difficult or impossible to collect fees for the benefits they provide (a “free
rider” problem). In essence, people will not pay for what they can get for free and businesses will
not give away goods/services for nothing.
--Since the supply of a public good is not depleted by an additional user, the marginal
(opportunity) cost of serving an additional user is zero. With marginal cost equal to zero, the basic
principle of optimal resource allocation (P = MC) calls for provision of public goods and services
to anyone who wants them at no charge.
Thus, not only is it often impossible to charge a market price for a public good, it is often undesirable as well since
any non zero price would discourage some users form enjoying the public good. This would be inefficient, since
one more persons’ enjoyment of the good costs society nothing. As a result, the government supplies many public
goods.
Appendix I: Term Paper
Microeconomics Term Paper
Overview:
This paper is designed to be a position paper on a contemporary microeconomic issue. You are required to select an
issue that has social significance in today’s society and take a stance on that issue using economic reasoning as the
foundation of your argument. All research will be from sources no earlier than September 1, 2004 and will be
properly cited.
Research Paper:
The paper will have 3 basic components:
1) A detailed description of the problem
2) A clear position about the issue
3) A recommendation to the government about how to handle the position. (Anti-Trust Legislation
for Monopolies, Minimum Wage for labor e.g.)
Article Analyses:
You will be required to turn in 6 Article Analyses (1 per week) as the foundation for your paper. You will use the
designated summary sheet, including each of the following:
1. Name of the article
2. Source of the article-including page number, website, or location of the article.
3. Date of the article
4. Is the source of the article in any way bias-why?
5. Summary
a. What does the article say?
b. Is the source credible?
c. Do you agree or disagree with the article and why?
d. How will you use the information for your paper?
Requirements:
Typed 5-6 pages
Bibliography
Title Page
9 Sources (Including 6 Article Analyses)
Grading:
Topic:
Article and Analysis:
Title Page:
Bibliography:
Term Paper:
Total Points:
5 points
5 points each (30 points)
5 points
10 points
50 points
100 points