Working with Supply and Demand
•
•
•
•
•
•
•
Price Ceilings, Price Floors
Price Elasticity of Demand
Elasticity and Total Revenue
Determinants of price elasticity of demand
Income Elasticity of Demand
Cross-Price Elasticity of Demand
Determinants of price elasticity of supply
1
Price Ceilings
• Government-imposed maximum price that prevents the
price of a good from rising above a certain level in a
market
• Short side of the Market
– Smaller of quantity supplied and quantity demanded at a
particular price
– When quantity supplied and quantity demanded differ, short side
of market will prevail
• Price ceiling creates a shortage and increases the time
and trouble required to buy the good
– While the price decreases, the opportunity cost may rise
• Black Market
– A market created by unintended consequences of government
intervention
• Goods are sold illegally at a price above the legal ceiling
2
Figure 1: A Price Ceiling in the
Market for Maple Syrup
5. With a black market, the
lower quantity sells for a
higher price than initially.
Price per
Bottle
3. and decreases
quantity supplied.
4. The result is a shortage
– the distance between
S
R and V.
T
$4.00
3.00
R
2.00
E
V
2. increases quantity
demanded
D
40,000 50,000 60,000
1. A price ceiling lower than
the equilibrium price . . .
Number of Bottles of
Maple Syrup per Period
3
Price Floors
• Government imposed minimum amount below which
price is not permitted to fall
– Price floors for agricultural goods are commonly called price
support programs
• When sellers produce more of the good than buyers
want at the price floor
– Remaining goods become a surplus that no one wants at the
imposed price
• Government responds by maintaining price floors
– Uses taxpayer dollars to buy up entire excess supply of the good
in question
– Prevents excess supply from doing what it would ordinarily do
• Drive price down to its equilibrium value
4
Figure 2: A Price Floor in the
Market for Nonfat Dry Milk
Price
per
Pound
2. decreases quantity
demanded . . .
1. A price floor higher
than the equilibrium
price . . .
3. and increases
quantity supplied.
S
J
K
$0.81
A
0.65
4. The result is a surplus
the – distance between
K and J – which
government must buy.
D
180
200
220
Millions of Pounds
5
Limiting Surplus
• A price floor creates a surplus of goods
– In order to maintain price floor, government must
prevent surplus from driving down market price
• Government often accomplishes this goal by purchasing
surplus with taxpayers dollars. USDA spent $500 million to
buy 636 million pounds of surplus nonfat dry milk.
• Price floors often get government deeply
involved in production decisions
– Rather than leaving them to the market
– Example: U.S. government developed a complicated
management system to control the production and
sale of milk to manufacturers and processors.
6
Benefits and costs of price floor for
diary product
• Benefits: help farmer when they are in need.
Many farmers who benefit from price floors are
wealthy or powerful who don’t need assistance.
• Costs:
(1) taxpayers’ money
(2) consumers pay higher price
($10.4 billion from 1986 to 2001)
(3) cost of health effect (calcium and protein
deficiencies)
More cost effective if given directly to those truly
in need.
7
The Problem with Rate Change
• For a particular good, when price rises by $1,
quantity demanded falls by 500 units per period.
(1)chocolate bars purchases in U.S.
(2)private jets purchased in U.S.
• Rate of change of quantity demanded compared
to the change in price is not a good measure of
price sensitivity
– Doesn’t tell whether a change in price or a change in
quantity demanded is a relatively large or relatively
small change
• Relative means compared to value of price or quantity before
change
8
The Elasticity Approach
• Elasticity approach improves on the problems with rate of change
– By comparing percentage change in quantity demanded with percentage
change in price
• Price elasticity of demand (ED) for a good is percentage change in
quantity demanded divided by percentage change in price
%Q

ED
D
%P
•
– Will virtually always be a negative number
– Tells us percentage change in quantity demanded for each 1%
increase in price
Price elasticity of demand tells us percentage change in quantity
demanded caused by a 1% rise in price as we move along a demand
curve from one point to another
9
Calculating Price Elasticity of
Demand
• When calculating elasticity base value for percentage
changes in price or quantity is always midway between
initial value and new value
– When price changes from any value P0 to any other value P1, we
define the percentage change in price as
% Change in Price 
( P1  P 0 )
( P1  P 0 )
2
– When quantity demanded changes from Q0 to Q1, percentage
change is calculated as
% Change in Quantity Demanded 
(Q1 _ Q0 )
Q  Q 
0
 1

2


10
Figure 3: Calculating Price
Elasticity of Demand
Price per
Laptop
$3,500
3,000
D
C
2,500
2,000
1,500
1,000
B
A
D
100,000 200,000 300,000 400,000 500,000 600,000
Quantity of
Laptops
11
An Example: Calculating Price
Elasticity of Demand
• Now let’s calculate an elasticity of demand for
laptop computers using data in Figure 3 from point
A to point B
% Change in Quantity Demanded 
% Change in Price 
(500,000  600,000)
 100,000

 0.182, or  18.2 percent
550,000
 (500,000  600,000) 


2
($1,500  $1,000)
$500

 0.400, or 40.0 percent
 ($1,500  $1,000)  $1,250


2
• Use percentage changes for price and quantity
to calculate price elasticity of demand (ED)
ED 
 0.182
 0.46
0.400
12
Elasticity and Straight-Line
Demand Curves
• As we move upward and leftward along a straight-line
demand curve
– Same absolute increment in price will correspond to smaller and
smaller percentage increments in price
• Because base price used to calculate percentage changes keeps rising
• As we move upward and leftward along a straight-line
demand curve
– Same absolute decrease in quantity corresponds to larger and
larger percentage decreases in quantity
• As we move upward and leftward by equal distances,
percentage change in quantity rises
– Percentage change in price falls
• Elasticity of demand varies along a straight-line demand
curve
– Demand becomes more elastic as we move upward and leftward
13
Calculating Price Elasticity of
Demand from Point C to Point D
(100,000  200,000)
 0.667, or  66.7 %
 (100,000  200,000) 


2
($3,500 - $3,000)
% Change in Price Demanded 
 0.154, or15.4%
$3,250
- 66.7%
Elasticity of Demand 
 4.33
15.4%
% Change in Quantity Demanded 
14
Figure 4: Elasticity and StraightLine Demand Curves
Price
Since equal dollar increases (vertical
arrows) are smaller and smaller
percentage increases . . .
3
2
and since equal quantity decreases
(horizontal arrows) are larger and
larger percentage decreases . . .
1
demand becomes more and more
elastic as we move leftward and
upward along a straight-line
demand curve.
D
Quantity
15
Categorizing Goods by Elasticity
• Inelastic Demand
– Price elasticity of demand between 0 and -1
% Change in Quantity Demanded
Inelastic Demand 
 1.0
% Change in Price
|% Change in Quantity Demanded| < |% Change in Price|
• Perfectly Inelastic Demand: Price elasticity of
demand equal to 0
Examples:
– Drug ‘insulin’ for diabetics to control their
blood sugar. No substitutes. ‘Antibiotics’.
– Addicts. Necessities.
16
Categorizing Goods by Elasticity
• Elastic Demand
– Price elasticity of demand with absolute value > 1
Elastic Demand 
% Change in Quantity Demanded
1
% Change in Price
|% Change in Quantity Demanded| > |% Change in Price|
• Examples: Luxury goods
• Perfectly (infinitely) Elastic Demand
– Price elasticity of demand approaching minus
infinity
• Unitary Elastic Demand
– Price elasticity of demand equal to -1
17
Figure 5: Extreme Cases of
Demand
(a)
Price
per
Unit
(b)
Price
per
Unit
D
$4
3
2
$4
Perfectly Inelastic
Demand
1
3
Perfectly Elastic
Demand
2
D
1
20 40 60 80 100
Quantity
20 40 60 80 100
Quantity
18
Elasticity and Total Revenue
• Total revenue (TR) of all firms in the market is
defined as
• TR = P x Q
• When two numbers are both changing, percentage
change in their product is (approximately) the sum
of their individual percentage changes
– Applying this to total revenue
• % Change in TR = % Change in Price + % Change in Quantity
Demanded
• Assume demand is unitary elastic and Q rises by
10%
– % Change in TR = 10% + (-10%) = 0
19
Elasticity and Total Revenue
• If demand is inelastic, a 10% rise in price
will cause quantity demanded to fall by
less than 10%
– % change in TR = 10% + (something less
negative than –10%) > 0
• If demand is elastic, so that Q falls by
more than 10%
– TR will fall
• % Change in TR = 10% + (something more
negative than -10%) < 0
20
Elasticity and Total Revenue
• Where demand is inelastic, total revenue moves
in same direction as price
• Where demand is elastic, total revenue moves in
opposite direction from price
• Where demand is unitary elastic, total revenue
remains the same as price changes
• At any point on a demand curve sellers’ total
revenue (buyers’ total expenditure) is the area of
a rectangle
– Width equal to quantity demanded
– Height equal to price
21
Figure 6: Elasticity and Total
Expenditure
Price
per
Laptop
$3,500
3,000
2,500
2,000
1,500
1,000
2. At point B, revenue
is $750 million.
1. At point A , where
price is $1,000 and
600,000 laptops are
demanded, revenue
is $600 million.
3. Moving from A to B,
expenditure increases,
so demand must be
inelastic over that range.
B
A
D
500
100,000 200,000 300,000 400,000 500,000 600,000
Quantity of
Laptops
22
Table: Some Short-Run Price
Elasticities of Demand
Specific
Brands
Narrow
Categories
Tide Detergent -2.79 Transatlantic Travel -1.3
Pepsi -2.08
Tourism in Thailand -1.2
Coke -1.71
Ground Beef -1.02
Pork -0.78
Milk -0.54
Cigarettes -0.45
Electricity -0.40 to -0.50
Beer -0.26
Eggs -0.26
Gasoline -0.20
Oil -0.15
Broad
Categories
Recreation -1.09
Clothing -0.89
Food -0.67
Imports -0.58
Transportation -0.56
23
Availability of Substitutes
• Demand is more elastic
– If close substitutes are easy to find and
buyers can cut back on purchases of the good
in question
• Demand is less elastic
– If close substitutes are difficult to find and
buyers can not cut back on purchases of the
good in question
24
Narrowness of Market
• More narrowly we define a good, easier it
is to find substitutes
– More elastic is demand for the good
• More broadly we define a good
– Harder it is to find substitutes and the less
elastic is demand for the good
• Different things are assumed constant
when we use a narrow definition
compared with a broader definition
25
Necessities vs. Luxuries
• The more “necessary” we regard an item,
the harder it is to find a substitute
– Expect it to be less price elastic
• The less “necessary” (luxurious) we regard
an item, the easier it is to find a substitute
– Expect it to be more price elastic
26
Table: Adjustments after a rise in
the price of gasoline
Short Run (a few months Long Run (a year or
or few)
more)
Use public transit more often
Arrange a car pool
Drive more slowly on the
highway
Eliminate unnecessary trips
If there are two cars, use the
more fuel-efficient one
Buy a more fuel-efficient car
Move closer to your job
Switch to a job closer to
home
Mover to a city where less
driving is required
27
Time Horizon
• Short-run elasticity
– Measured a short time after a price change
• Long-run elasticity
– Measured a year or more after a price change
• Usually easier to find substitutes for an item in
the long run than in the short run
– Therefore, demand tends to be more elastic in the
long run than in the short run
28
Importance in the Buyer’s Budget
• The more of their total budgets that
households spend on an item
– The more elastic is demand for that item
– Example: housing, transatlantic air travel
• The less of their total budgets that
households spend on an item
– The less elastic is demand for that item
– Example: salt
29
Using Price Elasticity of Demand:
The War on Drugs
• Every year U.S. Government spends about $20
billion on efforts to restrict the supply of drugs
• Figure 9(a)
– Market for heroin without government intervention
• Figure 9(b)
– Result of government efforts to restrict supply (current
policy)
• Figure 9(c)
– Results of an effective policy of reducing demand
30
Figure 7a: The War on Drugs
(a)
Price per
Unit
S1
A
P1
D1
Q1
Quantity
31
Figure 7b: The War on Drugs
(b)
Price per
Unit
S2
B
S1
P2
A
P1
D1
Q2 Q1
Quantity
A rise in price will increase the total expenditure of drug users. Many drug users
Support themselves through crime.
Total revenue for illegal drug industry increases too.
32
Figure 7c: The War on Drugs
(c)
Price per
Unit
S1
A
P1
P3
C
D2
D1
Q3
Q1
Quantity
Heavier advertisement against drug use, and greater availability of treatment
Centers for addicts.
33
Income Elasticity of Demand
• Percentage change in quantity demanded
divided by the percentage change in income
– With all other influences on demand—including the
price of the good—remaining constant
EY 
% change in Quantity Demanded
% Change in Income
• Interpret this number as percentage increase in
quantity demanded for each 1% rise in income
34
Income Elasticity of Demand
• Income elasticities vs. price elasticities of
demand
– Price elasticity of demand
• Measures effect of change in price of good
– Assumes that other influences on demand, including income,
remain unchanged
– Income elasticity
• Measures effect on demand we would observe if income
changed and all other influences on demand—including price
of the good—remained the same
• Instead of letting price vary and holding income
constant, now we are letting income vary and
holding price constant
35
Income Elasticity of Demand
• Another difference between price and
income elasticity of demand
– Price elasticity measures sensitivity of
demand to price as we move along a demand
curve from one point to another
– Income elasticity tells us relative shift in
demand curve—increase in quantity
demanded at a given price
• While a price elasticity is virtually always
negative
– Income elasticity can be positive or negative
– Normal goods and Inferior goods
36
Some Income Elasticities
Narrow Categories
Income
Elasticities
Broad
Categories
Income
Elasticities
Fresh fruit
Computers
Transatlantic Air Travel
College Education
Cigarettes
Chicken
Pork
Fresh Vegetables
Tooth Extraction
Ground Beef
Bread
Potatoes
1.99
1.71
1.4
0.55
0.50
0.42
0.34
0.26
-0.13 ~ 0.47
-0.20
-0.42
-0.81
Imports
Transportation
Recreation
Clothing
Food
2.73
1.79
1.07
1.02
0.60-0.85
37
Income and Spending on Economic
Necessities and Economic Luxuries
Income
Spending
on Food
Percent of
Spending on
% of income
Income Spent on Transportation spend on
Food
Transportation
$10,000 $6,000
60%
$1,000
10%
$20,000 $96,000
48%
$2,800
14%
$40,000 $15,360
38%
$7,840
20%
$80,000 $24,576
30%
$21,952
27%
38
Income Elasticity of Demand
• Economic necessity
– Good with an income elasticity of demand between 0 and 1
• Economic luxury
– Good with an income elasticity of demand greater than 1
• An implication follows from these definitions
– As income rises, proportion of income spent on economic
necessities will fall
• While proportion of income spent on economic luxuries will rise
• But, it is important to remember that economic
necessities and luxuries are categorized by actual
consumer behavior
– Not by our judgment of a good’s importance to human survival
– Example: Cigarettes
39
Cross-Price Elasticity of Demand
• Cross-price elasticity of demand
– Percentage change in quantity demanded of one good caused by
a 1% change in price of another good
• While all other influences on demand remain unchanged
EXZ 
% Change in Quantity of X Demanded
% Change in Price of Z
• While the sign of the cross-price elasticity helps us
distinguish substitutes (positive) and complements
(negative) among related goods
• Its size tells us how closely the two goods are related
– A large absolute value for EXZ suggests that the two goods are close
substitutes or complements
– While a small value suggests a weaker relationship
40
Some Cross-Price Elasticities
Products
Cross-Price Elasticity
Margarine with price of butter
Pepsi with price of Coke
Coke with price of Pepsi
Ground beef with price of poultry
Electricity with price of natural gas
Theater with price of all other lively
arts
Entertainment with price of food
1.53
0.80
0.61
0.24
0.20
0.12
-0.72
41
Price Elasticity of Supply
• Percentage change in quantity of a good supplied
that is caused by a 1% change in the price of the
good
– With all other influences on supply held constant
% Change in Quantity Supplied
ES 
% Change in Price
42
Price Elasticity of Supply
• When do we expect supply to be price elastic,
and when do we expect it to be price inelastic?
– Ease with which suppliers can find profitable activities
that are alternatives to producing the good in question
• Supply will tend to be more elastic when suppliers can switch
to producing alternate goods more easily (produce orange to
orange juice)
– When can we expect suppliers to have easy alternatives?
Depends on
» Nature of the good itself (Envelope v.s. microprocessor
chips)
» Narrowness of the market definition—especially
geographic narrowness (the market of orange in Iowa v.s.
the market of orange in U.S.A.)
» Time horizon—longer we wait after a price change, greater
the supply response to a price change
43
Price Elasticity of Supply
• Extreme cases of supply elasticity
– Perfectly inelastic supply curve is a vertical
line
• Many markets display almost completely inelastic
supply curves over very short periods of time
• Example: the supply of fresh-caught tuna
– Perfectly elastic supply curve is a horizontal
line
The supply of IBM Stock when the price of IBM stock
at Pacific Stock Exchange rises even the tiniest bit
above the price in other markets
44
Figure 8: Extreme Cases of Supply
(a)
(b)
Price
per
Unit
Price
per
Unit
S
P2
Perfectly Inelastic
Supply
Perfectly Elastic
Supply
S
P1
Quantity per Period
Quantity per Period
45
The Tax on Airline Travel: Taxes
and Market Equilibrium
• A tax on a particular good or service is called an
excise tax
– Shifts market supply curve upward by amount of tax
• For each quantity supplied, the new, higher curve tells us
firms’ gross price, and the original, lower curve tells us the
net price
• Who really pays excise taxes?
– Buyers and sellers share in the payment of an excise
tax
• Called tax shifting
– Process that causes some of tax collected from one side of
market (sellers) to be paid by other side of market (buyers)
46
Figure 9a: The Tax on Airline
Travel
Price per
Ticket
(a)
4. and then find the minimum price needed
for the market to supply that quantity.
SBefore Tax
$300
$260
1. One way to use the supply
curve is to start with the
price . . .
3. But another way
is to start with a
quantity . . .
A
7
10
Millions of
Tickets per Year
2. and then find the quantity
supplied at that price.
47
Figure 9b: The Tax on Airline
Travel
Price per
Ticket
(b)
SAfter Tax
$360
A'
SBefore Tax
$300
A
3. But another way is to start
with a quantity . . .
10
Millions of
Tickets per Year
4. and then find the minimum price needed for the
market to supply that quantity.
48
Figure 10: Effect of Excise Tax on
Airlines
2. The $60 tax shifts the
supply curve up by $60.
Price per Ticket
SAfter Tax
B
$340
3. In the new
equilibrium,
buyers pay
$340.
SBefore Tax
$300
A
1. Before the tax,
the supply curve
is SBefore Tax and
the price is $300.
$280
4. And, net of the
tax, sellers
receive $280.
D
Millions of Tickets per Year
49
Tax Incidence and Demand
Elasticity
• In most cases excise tax will be shared by
both buyer and seller
– For a given supply curve, the more elastic is
demand, the more of an excise tax is paid by
sellers
– The more inelastic is demand, the more of the
tax is paid by buyers
50
Figure 11: Tax Incidence and
Demand Elasticity
(a)
Price per
Ticket
D
(b)
Price per
SAfter Tax Ticket
SAfter Tax
SBefore Tax
SBefore Tax
B
$360
$300
A
10
$300
Millions of
Tickets per Year
B
A
2
10
D
Millions of
Tickets per Year
51
Tax Incidence and Supply Elasticity
• Although there are extreme cases of
supply elasticity, in general the following is
true
– For a given demand curve, the more elastic is
supply, the more of an excise tax is paid by
buyers
– The more inelastic is supply, the more of the
tax is paid by sellers
52
Figure 12: Tax Incidence and
Supply Elasticity
(a)
Price per
Ticket
(b)
SBefore and After Tax
Price per
Ticket
$360
$300
A
$240
B
SAfter Tax
A
$300
D
10
Millions of
Tickets per Year
SBefore Tax
D
8
10
Millions of
Tickets per Year
53
Health Insurance and the Market
for Health Care
• Health insurance has definite benefits to
our society
• Our current health care system keeps
patients from facing the full opportunity
cost of their health care decisions
– Can cause people to over consume health
care
• Health insurance reduces buyers’
incentives to monitor their health care
expenditures closely or to shop around for
high-quality low-cost care
54
Figure 14: The Market For Health
Care With Coinsurance
Price per D
After Insurance
Examination
$100
S
DBefore Insurance
B
70
50
A
100,000 150,000
Examinations per Year
55
The Nature of the Firm
• What is a business firm?
– An organization, owned and operated by private individuals, that
specializes in ___________.
• Production is _________________________________.
• The firm must deal with a variety of individuals and organizations
– Owners, Customers, Input suppliers, and government.
• Where does the revenue go?
– Much of it goes to __________________
• The total of all of these payments makes up the firm’s costs of production
– When costs are deducted from revenue, what remains is the firm’s _______
» The firm’s profit (after taxes) accrues to ________ who provided the firm’s
initial financing.
56
The Nature of the Firm
• Every firm must deal with the government
– Pays ____ to the government
– Must obey government ___________
– Receive valuable services from the government
• Public capital
• Legal systems
• Financial systems
57
Fig. 1 The Firm and Its Environment
Owners
Initial Financing
Profit After Taxes
Input Costs
Input
Suppliers
Taxes
The Firm
(Management)
Inputs
Output
Government
Government Services
Government Regulations
Revenue
Customers
58
Types of Business Firms
• There are more than 25 million business firms in United
States—each of them falls into one of three legal
categories
– A _________________
• A firm owned by a single individual
– A _________________
• A firm owned and usually operated by several individuals who share in
the profits and bear personal responsibility for any losses
– Both of the above face
• Unlimited liability
– Each owner is held personally responsible for the obligations of the firm
• The difficulty of raising money to expand the business
– Each partner bears full responsibility for the poor judgment of any one of
them
59
Types of Business Firms
• A __________
– Owned by those who buy shares of stock and whose
liability is limited to the amount of their investment in the
firm
– Ownership is divided among those who buy shares of
stock
– Each share of stock entitles its owner to a share of the
corporation’s profit
• Some of this is paid out in _________
• If the corporation needs additional funds it may
sell more stock
• Offers the stockholder _____ liability
• However, stockholders suffer double taxation
60
Figure 2: Forms of Business
Organization
Percent of Firms
Percent of Total Sales
Corporations 20%
Partnerships 7%
Corporations 90%
Sole
Proprietorships
73%
Partnerships 4%
Sole
Proprietorships
6%
61
Why Employees?
• Most firms have employees
• Each of us could operate our own oneperson firms as independent contractors
– So why don’t more of us do this?
– The advantages of employment
 ______________
 ______________
 ______________
62
Further Gains From Specialization
• Independent contractor must
–
–
–
–
Design the good
Make the good
Deal with customers
Advertise services
• At a factory each of these tasks would be
performed by different individuals who would work
full time at their activity
63
Lower Transaction Costs
• Transaction costs are time costs and other
costs required to carry out market
exchanges
• In a firm with employees many supplies and
services can be produced inside the
organization
– Firm can enjoy significant savings on
transaction costs
64
Reduced Risk
• Large firm with employees offers opportunities for
everyone involved to reduce risk through
– ______________
• Process of reducing risk by spreading sources of income
among different alternatives
• With large firms, two kinds of diversification are
possible
– Within the firm
– Among firms
• These advantages help it attract customers,
workers, and potential owners
65
The Limits to the Firm
• You might be tempted to conclude that
bigger is always better
– The larger the firm, the greater will be the cost
savings
• However, there are limits
66
Thinking About Production
• Outputs
• Inputs include resources
–
–
–
–
–
–
Labor
Human Capital
Physical Capital
Land
Raw materials
Other goods and services provided by other firms
• Way in which these inputs may be combined to
produce output is the firm’s _________
67
Thinking About Production
• A firm’s technology is treated as a given
– Constraint on its production
– For each different combination of inputs, the production
function tells us ___________________ a firm can
produce over some period of time
68
Figure 3: The Firm’s Production
Function
Alternative
Input
Combinations
Production
Function
Different
Quantities of
Output
69
The Short Run and the Long Run
• Useful to categorize firms’ decisions into
– Long-run decisions—involves a time horizon long
enough for a firm to vary all of its inputs
– Short-run decisions—involves any time horizon over
which at least one of the firm’s inputs cannot be varied
• To guide the firm over the next several years
– Manager must use the long-run lens
• To determine what the firm should do next week
– Short run lens is best
70
Production in the Short Run
• When firms make short-run decisions, there is nothing
they can do about their _________
– Stuck with whatever quantity they have
– However, can make choices about their variable inputs
• Fixed inputs
•Outputs
– An input whose quantity must remain constant, regardless of how
much output is produced
• Variable input
– An input whose usage can change as the level of output changes
• Total product
– Maximum quantity of output that can be produced from a given
combination of inputs
71
Production in the Short Run
• Marginal product of labor (MPL) is the change in
total product (ΔQ) divided by the change in the
number of workers hired (ΔL)
ΔQ
MPL 
ΔL
– Tells us the rise in output produced when one
more worker is hired
72
Figure 4: Total and Marginal Product
Units of Output
Total Product
196
184
161
Q from hiring fourth worker
130
Q from hiring third worker
90
Q from hiring second worker
30
Q from hiring first worker
1
increasing
marginal
returns
2
3
4
5
6
Number of Workers
diminishing
marginal returns
73
Marginal Returns To Labor
• As more and more workers are hired
– MPL first increases
– Then decreases
• Pattern is believed to be typical at many
types of firms
74
Increasing Marginal Returns to Labor
• The marginal product of labor ______ as
employment rises
– Each time a worker is hired, total output rises
by more than it did when the previous worker
was hired
– The additional worker not only produces some
additional output as an individual, but also
makes all other workers more productive.
75
Diminishing Returns To Labor
• The marginal product of labor is ________
– Output rises when another worker is added so
marginal product is ________
– But the rise in output is ___________ with each
successive worker
• Law of diminishing (marginal) returns states
that as we continue to add more of any one
input (holding the other inputs constant)
– Its marginal product will eventually _______
76
Thinking About Costs
• A firm’s total cost of producing a given level
of output is ______________
– Everything they must give up in order to
produce that amount of output
– At the core of economist’s thinking about costs.
– Help us understand which costs matter and
which don’t.
77
The Irrelevance of Sunk Costs
• Sunk cost is one that already has been paid,
or must be paid, regardless of any future
action being considered
• Should not be considered when making
decisions
• Even a future payment can be sunk
– If an unavoidable commitment to pay it has
already been made
78
Explicit vs. Implicit Costs
• Types of costs
– Explicit (involving actual payments)
• Money actually paid out for the use of inputs
– Implicit (no money changes hands)
• The cost of inputs for which there is no direct money
payment
79
Costs in the Short Run
• Costs for a time horizon during which at
least one of the firm’s inputs is fixed.
• Fixed costs
– Costs of a firm’s ____ inputs
– Remains the same no matter what the level of
output
• Variable costs
– Costs of obtaining the firm’s ______ inputs
– Rise as output increases
80
Measuring Short Run Costs: Total
Costs
• Types of total costs
– Total fixed costs
• Cost of all inputs that are fixed in the short run
– Total variable costs
• Cost of all variable inputs used in producing a
particular level of output
– Total cost
• Cost of all inputs—fixed and variable
• TC = TFC + TVC
81
Figure 5: The Firm’s Total Cost
Curves
Dollars
TC
$435
375
TVC
TFC
315
255
195
135
TFC
0
30
90
130
161
184 196
Units of Output
82
Average Costs
• Average fixed cost (AFC)
– Total fixed cost divided by the quantity of output produced
AFC 
TFC
Q
• Average variable cost (TVC)
– Total variable cost divided by the quantity of output produced
TVC
AVC 
Q
• Average total cost (TC)
– Total cost divided by the quantity of output produced
TC
ATC 
Q
83
Marginal Cost
• Marginal Cost
– Increase in total cost from producing one more unit or
output
• Marginal cost is the change in total cost (ΔTC)
divided by the change in output (ΔQ)
ΔTC
MC 
ΔQ
– Tells us how much cost rises per unit increase in output
– Marginal cost for any change in output is equal to shape
of total cost curve along that interval of output
84
Figure 6: Average And Marginal
Costs
Dollars
MC
$4
3
AFC
ATC
AVC
2
1
0
30
90
130
161
196
Units of Output
85
Explaining the Shape of the Marginal
Cost Curve
• When the marginal product of labor (MPL)
rises (falls), marginal cost (MC) ____ (____)
• Since MPL ordinarily rises and then falls,
MC will do the opposite—it will fall and then
rise
– Thus, the MC curve is _______
86
The Relationship Between Average
And Marginal Costs
• At low levels of output, the MC curve lies below
the AVC and ATC curves
– These curves will slope downward
• At higher levels of output, the MC curve will rise
above the AVC and ATC curves
– These curves will slope upward
• As output increases; the average curves will first
slope downward and then slope upward
– Will have a U-shape
• MC curve will intersect the minimum points of the
AVC and ATC curves
87
Production And Cost in the Long Run
• In the long run, costs behave differently
– Firm can adjust all of its inputs in any way it wants
• In the long run, there are no ___ inputs or ___ costs
– All inputs and all costs are ______
– Firm must decide what combination of inputs to use in producing
any level of output
• The firm’s goal is to ___________
– To do this, it must follow ______________
• To produce any given level of output the firm will choose the
input mix with the lowest cost
Different ways to wash 196 cars per day
Capital cost =$75 per day
Labor cost = $60 per unit per day
Method
Quantity of Quantity of Cost
Capital
Labor
A
0
9
B
1
6
C
2
4
D
3
3
Production And Cost in the Long
Run
• Long-run total cost
– The cost of producing each quantity of output when
the least-cost input mix is chosen in the long run
• Long-run average total cost
– The cost per unit of output in the long run, when all
inputs are variable
• The long-run average total cost (LRATC)
– Cost per unit of output in the long-run
LRTC
LRATC 
Q
Long-Run and Short-Run Costs for Spotless Car Wash
Output
TC($)
LRTC($)
0
30
90
130
161
184
196
250
300
75
135
195
255
315
375
435
0
100
195
255
315
360
390
650
1,200
LRATC($)
The Relationship Between Long-Run
And Short-Run Costs
• For some output levels, LRTC is ______ than TC
• Long-run total cost of producing a given level of
output can be less than or equal to, but never
greater than, short-run total cost (LRTC ≤ TC)
• Long-run average cost of producing a given level
of output can be less than or equal to, but never
greater than, short–run average total cost (LRATC
≤ ATC)
Average Cost And Plant Size
• Plant
– Collection of fixed inputs at a firm’s disposal
• Can distinguish between the long run and the short run
– In the long run, the firm can change the size of its plant
– In the short run, it is stuck with its current plant size
• ATC curve tells us how average cost behaves in the short
run, when the firm uses a plant of a given size
• To produce any level of output, it will always choose that
ATC curve—among all of the ATC curves available—that
enables it to produce at lowest possible average total cost
– This insight tells us how we can graph the firm’s LRATC curve
Figure 7: Long-Run Average Total
Cost
Dollars
ATC1
$4.00
ATC0
ATC2
3.00
C
D
B
A
2.00
LRATC
ATC3
E
1.00
0
30
Use 0
automated
lines
90
130
161 184
175 196
Use 1
automated
lines
250
Use 2
automated
lines
300
Use 3
automated
lines
Units of Output
Graphing the LRATC Curve
• A firm’s LRATC curve combines portions of each
ATC curve available to firm in the long run
– For each output level, firm will always choose to
operate on the ATC curve with ________________
• In the short run, a firm can only move along its
current ATC curve
• However, in the long run it can move from one
ATC curve to another by varying the size of its
plant
– Will also be moving along its LRATC curve
Economics of Scale
• Economics of scale
– Long-run average total cost _____ as output increases
• When an increase in output causes LRATC to
decrease, we say that the firm is enjoying
economics of scale
– The more output produced, the lower the cost per unit
• When long-run total cost rises proportionately less
than output, production is characterized by
economies of scale
– LRATC curve slopes ________
Figure 8: The Shape Of LRATC
Dollars
$4.00
3.00
LRATC
2.00
1.00
130
0
Economies of Scale
184
Constant
Returns to
Scale
Diseconomies of Scale
Units of Output
Gains From Specialization
• One reason for economies of scale is gains
from specialization
• The greatest opportunities for increased
specialization occur when a firm is
producing at a relatively low level of output
– With a relatively small plant and small
workforce
• Thus, economies of scale are more likely to
occur at lower levels of output
More Efficient Use of Lumpy Inputs
• Another explanation for economies of scale involves the
“lumpy” nature of many types of plant and equipment
– Some types of inputs cannot be increased in tiny increments, but
rather must be increased in large jumps
• Plant and equipment must be purchased in large lumps
– Low cost per unit is achieved only at high levels of output
• Making more efficient use of lumpy inputs will have more
impact on LRATC at low levels of output
– When these inputs make up a greater proportion of the firm’s total
costs
• At high levels of output, the impact is smaller
Diseconomies of Scale
• Long-run average total cost _______ as output increases
• As output continues to increase, most firms will reach a
point where bigness begins to cause problems
– True even in the long run, when the firm is free to increase its plant
size as well as its workforce
• When long-run total cost rises more than in proportion to
output, there are diseconomies of scale
– LRATC curve slopes ________________
• While economies of scale are more likely at low levels of
output
– Diseconomies of scale are more likely at higher output levels
Constant Returns To Scale
• Long-run average total cost is ______ as output increases
• When both output and long-run total cost rise by the same
proportion, production is characterized by constant returns
to scale
– LRATC curve is ___
• In sum, when we look at the behavior of LRATC, we often
expect a pattern like the following
– Economies of scale (decreasing LRATC) at relatively low levels of
output
– Constant returns to scale (constant LRATC) at some intermediate
levels of output
– Diseconomies of scale (increasing LRATC) at relatively high levels
of output
• This is why LRATC curves are typically U-shaped
Using the Theory: Long Run Costs,
Market Structure and Mergers
• The number of firms in a market is an
important aspect of market structure—a
general term for the environment in which
trading takes place
• What accounts for these differences in the
number of sellers in the market?
– Shape of the LRATC curve plays an important
role in the answer
LRATC and the Size of Firms
• The output level at which the LRATC first hits bottom is known as the
minimum efficient scale (MES) for the firm
– Lowest level of output at which it can achieve minimum cost per unit
• Can also determine the maximum possible total quantity demanded by
using market demand curve
• Applying these two curves—the LRATC for the typical firm, and the
demand curve for the entire market—to market structure
– When the MES is small relative to the maximum potential market
• Firms that are relatively small will have a cost advantage over relatively large
firms
• Market should be populated by many small firms, each producing for only a tiny
share of the market
LRATC and the Size of Firms
• There are significant economies of scale that continue as
output increases
– Even to the point where a typical firm is supplying the maximum
possible quantity demanded
• This market will gravitate naturally toward monopoly
• In some cases the MES occurs at 25% of the maximum
potential market
– In this type of market, expect to see a few large competitors
• There are significant lumpy inputs that create economies
of scale
– Until each firm has expanded to produce for a large share of the
market
Figure 9: How LRATC Helps Explain
Market Structure
LRATCTypical Firm
Dollars
F
$160
E
80
DMarket
0
1,000
3,000
100,000
Units per Month
Figure 9: How LRATC Helps Explain
Market Structure
LRATCTypical Firm
Dollars
$160
80
DMarket
0
100,000
Units per Month
Figure 9: How LRATC Helps Explain
Market Structure
Dollars
LRATCTypical Firm
H
$200
F
E
80
DMarket
0
25,000
100,000
Units per Month
Figure 9: How LRATC Helps Explain
Market Structure
LRATCTypical Firm
Dollars
$160
E
F
80
DMarket
0
1,000
10,000
100,000
Units per Month
LRATC and the Size of Firms
• The MES of the typical firm in this market is
1,000 units
– Lowest output level at which it reaches
minimum cost per unit
– For firms in this market, diseconomies of scale
don’t set in until output exceeds 10,000 units
• Since both small and large firms can have
equally low average costs with neither
having any advantage over the other
– Firms of varying sizes can coexist
The Urge To Merge
• If by doubling their output, firms could slide down
the LRATC curve in Figure 9, and enjoy a
significant cost advantage over any other, stillsmaller firm, they would
– This is a market that is ripe for a merger wave
• A sudden merger wave is usually set off by some
change in the market
• Market structure in general—and mergers and
acquisitions in particular—raise many important
issues for public policy
– Low-cost production can benefit consumers—if it
results in lower prices