Dr E’s Study Guide for ECO 012
i. Introduction to Microeconomics
The Economic Way of Thinking
“It [economics] is a method rather than a doctrine, an apparatus of the mind, a technique
of thinking which helps its possessor to draw correct conclusions.”
– John Maynard Keynes
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Guideposts to Economic Thinking
The use of scarce resources to produce a good is always costly.
– There are no free lunches.
» Goods produced by the public sector have an opportunity cost.
Decision-makers choose purposefully; therefore, they will economize.
– Economizing behavior accomplishes an objective at the least possible cost
– Utility is the subjective satisfaction derived from the choice of a specific
alternative.
Incentives matter
– Human choice is influenced in a predictable way by changes in economic
incentives.
Economic thinking is marginal thinking.
– Marginal choices involve the effects of net additions or subtractions from the
current conditions.
Although information can help us make better choices, its acquisition is costly.
– Purposeful decision-makers do not have perfect knowledge when making choices.
» Expected benefits versus cost of gathering information
Economic actions often generate secondary effects.
– Secondary effects are the consequences that are indirectly related to the initial
policy and felt only with the passage of time
The value of a good or a service is subjective.
– Preferences differ among individuals.
» How individuals value items is seldom known perfectly.
» The value of a good or service depends on many factors.
The test of a theory is its ability to predict.
– Economic theory is developed from the analysis of how incentives will affect
decision-makers.
» Economists seek to predict the general behavior of a large number of
individuals.
Opportunity Cost
– The opportunity cost of a choice is the highest valued alternative that must be
sacrificed because one chooses an option.
– Opportunity cost is subjective.
» It exists in the mind of the decision-maker.
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» The opportunity cost of the same event may differ among individuals.
– Cost may have both a subjective and objective (monetary) component.
– Opportunity Cost and the Real World
» Changes in opportunity cost will influence decisions.
 Transaction Costs
– Transaction costs are the costs of time, effort, and other resources necessary to
search out, negotiate, and conclude an exchange.
– Transaction costs reduce our ability to gain from mutually advantageous potential
trades.
Property Rights
 Property Rights
– The right to use, control, and obtain the benefits from a good or service
» Exchange takes place when property rights change hands.
– Exist when property rights are exclusively controlled by one owner and are
transferable to others.
– Private property rights link responsibility to authority, thereby making owners
accountable for their actions.
– Owners gain by employing resources in beneficial ways, lose by bearing the
opportunity cost of ignoring the wishes of others.
– Private owners have strong incentives to properly care for their items.
– They have incentive to conserve for the future.
– Those who are negligent can be held accountable for changes due to misuse of their
property.
Specialization and Division of Labor
 Division of Labor
– A method that breaks down the production of a commodity into a series of specific
tasks, each performed by a different worker.
– Often leads to enormous gains in overall output per worker.
» Allows individuals to take advantage of their existing skills and abilities.
» Allows the development of more skills through specialized experience.
» Allows complex, large scale production techniques.
 Gains From Specialization and Comparative Advantage
– The law of comparative advantage states that output of a group is always greatest
when the output of each good is produced by the one with the lowest opportunity
cost.
– When opportunity cost differs, potential gains from trade are present.
» Applies to individuals, firms, and regions
– Gains from trade are a key to economic progress.
 Personal Motivation and Specialization and Exchange
– People are motivated by the pursuit of personal gain.
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– In a market economy, individuals have an incentive to specialize voluntarily in
areas of production where they are a low opportunity producer.
Marginal Benefit vs. Marginal Costs
All of this implies that individuals make their decisions by weighing the costs and
benefits of the action. Specifically they weigh the marginal benefits and the
marginal costs of the action. Marginal benefit is the additional amount of benefit
the individual receives from one more unit of the thing that is generating the
benefit. Marginal costs the additional cost that one more unit will produce. As
long as the marginal benefit of an additional unit of the object of their desire is
greater than or equal to the marginal cost, it is worth consuming one more unit.
For example, if a family has two children and the extra benefit of a third child is
greater than the cost, they will have one more child. At that point the marginal
costs of a fourth child may outweigh the benefit, so they will stop. Marginal
benefit and marginal cost analysis thus determined for this family that they will
end up with three kids.
ii. Supply and Demand: Revisited
Consumer Choice and the Law of Demand
 Law of Demand
– As the price of a product decreases, other things constant, buyers will increase the
quantity of the product demanded.
» The price of a good is negatively related to the quantity demanded.
 The Market Demand Schedule
– Height of demand curve indicates the maximum price that consumers are willing to
pay for an additional unit of a product.
Producer Choice and the Law of Supply
 What Producers Do
– They convert resources into commodities and services.
– They pay the opportunity cost for resources used.
– They desire profits motivating them to supply goods.
– Profit is residual "income reward" granted to decision-makers who increase the
value of the resources.
– Loss results when consumers value a product less highly than the opportunity cost
of the resources used to produce the product.
 Supply and the Entrepreneur
– To prosper, entrepreneurs must use resources in a way that increases their value.
 Market Supply Schedule
– Law of supply
» As the price of a product increases, other things constant, producers will
increase the amount of the product supplied to the market.
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» The amount of a good supplied is positively related to the price of that good.
– Height of supply curve indicates the minimum price necessary to induce producers
to supply an additional unit of a product.
Supply and Demand Interact
 The Market
– An abstract concept that encompasses the forces generated by the buying and
selling decisions of economic participants.
 Equilibrium
– State of balance between conflicting forces such as supply and demand.
 Short-Run Market Equilibrium
– In the short run, firms do not have time to adjust fully to changes in market
conditions.
– Short-run equilibrium is attained when supply and demand are in balance.
 Long-Run Market Equilibrium
– The long run is a period of time sufficient to fully adjust to a market change.
– In long run equilibrium, supply and demand must be in balance.
– In long run equilibrium, supply and demand must be in balance.
– The selling price must equal the producer's opportunity cost of production.
– In long run equilibrium, supply and demand must be in balance.
– The selling price must equal the producer's opportunity cost of production.
– Firms are neither earning economic profit nor suffering economic loss.
Shifts in Demand
 Shifts in Demand Versus Changes in Quantity Demanded
– A change in demand shifts the demand curve.
– A change in quantity demanded is a movement along the same curve.
 Factors that Cause Shifts in Demand
– Changes in income
– Changes in the price of a related good
» Substitutes perform similar functions or fulfill similar needs.
» Complements are consumed jointly.
– Changes in consumer preferences
– Changes in the expected future price of a good
Shifts in Supply
 Shifts in Supply Versus Changes in Quantity Supplied
– A change in supply shifts the supply curve.
– A change in quantity supplied is a movement along the same curve.
 Factors That Cause Shifts in Supply
– Changes in resource prices
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– Changes in technology
– Changes in taxes or regulations on sellers
– Changes in expected future prices
Time and the Adjustment Process
 Time and the Adjustment Process
– Market adjustments of producers and consumers will be more complete with the
passage of time.
– Both demand and supply are more elastic in the long run than in the short run.
Repealing the Laws of Supply and Demand
 Price Ceilings
– A price ceiling is a legally established maximum price that sellers may charge.
– Price ceilings cause shortages.
» Shortages can be eliminated by allowing price to rise, which will encourage
production and discourage consumption.
– Secondary effects of price ceilings:
» Reduction in the quality of the good.
» Inefficient use.
» Lower future supply.
» Nonprice rationing will be of more importance.
 Price Floors
– Result in surpluses
» The surplus can be eliminated by allowing price to fall, which will encourage
consumption and discourage production.
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The Invisible Hand Principle
How the Invisible Hand Works
– Market prices tend to direct individuals pursuing their own interests into productive
activities that also promote the economic well-being of society.
Communicating Information to Decision-Makers
– Prices communicate up-to-date information about consumer valuation of additional
units of numerous commodities.
Coordinating Actions of Market Participants
– Prices coordinate the decisions of buyers and sellers.
– Price changes signal shortages or surpluses, and create profit (and loss)
opportunities for entrepreneurs.
Motivating the Economic Players
– Individuals have a strong incentive to provide productive resources in exchange for
income.
Prices and Market Order
– Market order is the result of market prices, not central planning.
Qualifications
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– The efficiency of market organization is dependent upon the presence of
competitive markets and well-defined and enforced private property rights.
iii. The Market and Government Intervention
PROBLEM AREAS FOR THE MARKET
Market Failure and Property Rights
 Market Failure
Market failure is often caused by a lack of securely defined private property rights.
 External Costs and Property Rights
Property rights give owners the exclusive right to control and benefit from their
resources as long as their actions do not harm others.
Property rights provide legal protection against the actions of parties who might
damage, abuse, or steal property.
- External costs are the harmful effects of an individual’s ora group’s action on the
welfare of a nonconsenting secondary party, not accounted for in market prices.
 Enforceable Property Rights and Information
Owners must be able to show the rights have been violated to legally enforce
property rights.
- High cost of information can make property rights unenforceable.
 Common Property Resources
Resource for which rights are held in common by a group of individuals, none of
whom has a transferable ownership interest.
If access is unrestricted, a common property resource is called an open-access
resource.
- The use of an open-access resource generates external costs and the resource will
be over-utilized.
 External Costs and Benefits
Group or individual action that spills over and has a detrimental or beneficial effect
on the well-being of third parties.
- Result in a divergence between price and social cost.
- Social cost is the sum of private and external costs.
- Private and social costs will be equal if there are no external costs.
- When external costs are present, market prices understate the social cost of
resource use.
When external costs are present, there is a net loss to the community.
- When external benefits are present, the market demand curve understates the social
gains of conducting the activity.
- Potential social gains go unrealized because no single decision-maker can capture
the gains fully.
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Public Sector Responses to Externalities
Pollution Tax Approach
User’s charge is applied to the polluting activity.
A pollution tax promotes efficient resource allocation by reducing the supply of the
pollution-intensive good by increasing its cost of production.
- Higher production costs encourage firms to use less polluting production methods.
Problems with the approach:
- Problems with the approach:
Some pollution continues
Difficult to estimate true damage costs
Emission controls must be monitored
Very high taxes may put firms out of business and increase unemployment
Maximum Emission Standard Approach
Regulators choose a tolerable level of total pollution and require all producers to
reduce pollution to that level.
Fines are imposed on those that do not comply.
- Although more costly, it is more often imposed than the more efficient pollution
tax.
Transferable Emission Rights
Program under which each firm in an industry is assigned a maximum level of
acceptable pollution and is allowed to sell any “right to pollute” it does not use to
other firms.
Specific Prescription Approach
Regulators specify the methods polluting firms must use to reduce or eliminate
pollution
This approach is the least efficient response to externalities.
Should Government Always Try to Control Externalities?
Little net gain is likely if the economic inefficiency resulting from externalities is
small compared to the cost of government action.
- Markets often find reasonably efficient means of dealing with externalities.
Government action may impose an external cost on secondary parties.
Market Failure: Public Goods
 Public Goods
- Public goods are non-excludable and non-rival in consumption.
A good is non-excludable if producers cannot exclude those who do not pay.
A good is non-rival in consumption if consumption by one person does not
reduce the good’s availability to others.
 The Free Rider Problem
- A free rider is one who receives the benefits of a good without paying toward its
costs.
Sufficient amounts of public goods may not be provided by the market because
non-paying consumers cannot be excluded.
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Market Failure: Poor Information
Getting Your Moneys Worth
- There is a harmony of interest between producers and consumers on repeat
purchase items.
- Producers will be better off if consumers receive accurate information and are
satisfied with the products purchased.
- The probability of customer dissatisfaction is increased by the presence of
inadequate information.
- Goods are difficult to evaluate on inspection and are seldom purchased from the
same producer.
Goods are capable of serious and lasting harmful side effects.
Entrepreneurs and Information
- Entrepreneurial sellers have an incentive to bridge the information gap with
consumers.
- To bridge the information gap, firms establish franchises or build national
reputations through advertising.
One-Sided Information
The asymmetric information problem occurs when one party knows more than the
other.
I
PUBLIC CHOICE: UNDERSTANDING GOVERNMENT
AND GOVERNMENT FAILURE
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What is Government?
The distinguishing feature of government is its monopoly on the use of coercive
force.
Legitimate Economic Functions of Government
— Protective function
~ Protect people against invasions by others (externalities, misinformation).
— Productive function
~ Provide goods that cannot be easily provided by the market (public goods,
promote competition).
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The Economics of Representative Democracy
The Demand for Government
— The correction of market failure and rent seeking are the two general forces
underlying political action.
— Government failure is present when the political process leads to economic
inefficiency and the waste of scarce resources.
— Self-interest postulate
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~ Personal wealth, power, and prestige influence decision-makers in the
political arena in the same way as in the market sector.
— Survival and expansion concept
) Government decision-makers must act in the narrow self-interest of their
constituents if they hope to survive and obtain more power.
 The Voter-Consumer
— The greater the net personal economic gain from a candidate’s platform, the more
likely that the individual voter will support the candidate.
— The rational ignorance effect
> Voters have little incentive to inform themselves on issues because an
individual vote is unlikely to be decisive.
The Politician-Supplier
— Seeks to offer voters an image and a bundle of political goods that increase the
chances of election.
— Money, political advertising, and the successful politician
> Since voters have little incentive to acquire information about candidates,
political entrepreneurs must be able to supply free information.
— Being successful means being political.
> All political entrepreneurs are under strong pressure to stake out positions that
will increase their vote total in the next election.
When Voting Works Well
 When government action is productive, there is the potential for unanimity among
voters and their representatives.
 When voters pay in proportion to benefits received, all voters would gain if the
government action were productive (and all would lose if it were counterproductive).
 Possible Patterns of Voter Benefits and Costs
— Widespread benefits and widespread costs.
> Representative government will tend to undertake projects that are productive
and reject those that are not.
— Concentrated benefits and widespread costs.
> Representative government is biased toward adoption of counterproductive
activity.
» The political process may reject projects that are productive.
When Voting Conflicts with Economic Efficiency
 Special Interest Effect
— Special interest groups are far more powerful in a representative democracy than
their numbers would indicate.
— Most voters remain largely uninformed on political issues that have little effect on
their economic status.
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— Special-interest voters tend to be better informed than most others on specialinterest issues
— Political entrepreneurs have strong incentive to cater to the views of specialinterest groups.
— Rationally uninformed voters largely ignore special-interest issues.
— Counterproductive logrolling and pork barrel programs often gain majority
approval.
— Logrolling is the practice of trading votes by a representative in order to pass
intensely desired legislation.
—Pork barrel legislation bundles together a set of projects that benefit regional
interest at the expense of the general taxpayer.
The Shortsightedness Effect
— There is public sector bias against proposals with current costs and difficult-toidentify future benefits.
— Vote-maximizing politicians have incentives to follow policies of minimum
current expenditures until a crisis point is reached.
— Proposals with immediate benefits and future rather than present costs are
attractive to political entrepreneurs.
—Voters have a strong incentive to support the policy when the costs of policy are
incurred primarily in the future, and the benefits can be allocated to current
voters.
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 Rent-Seeking
— Actions taken by individuals or groups seeking to use the political process to
plunder the wealth of others.
—The incentive to engage in rent-seeking activities is directly proportional to the
ease with which the political process can be used for personal gain at the expense
of others.
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Inefficiency of Government Operations
— Cost of government operations are generally higher relative to the private sector.
— The incentive structure is inconsistent with internal efficiency.
— Public sector managers are generally unable to capture personal gain from
improving the operational efficiency of their units.
— Public officials and managers axe likely to spend public money less carefully than
they would their own.
— There is no clear test that makes it easy to determine the efficiency of a
government operation.
—There is no bankruptcy constraint in the public sector so that even extremely
inefficient government operations may survive.
Public Sector Versus the Market: A Summary
Factors that weaken the case for the market:
— External costs
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— External benefits
— Public goods
— Monopoly
— Uninformed consumers
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Factors weakening the case for government:
— Rational ignorance
— Special-interest effect
— Shortsightedness effect
— Lack of incentive for internal efficiency
Constitutional Organization and Getting More from Government
 Keeping government from engaging in counterproductive activities, while
encouraging it to undertake things that it does well, is difficult.
 Properly designed constitutional rules and restraints may help keep government from
engaging in counterproductive activities and help it undertake things that it does well.
 Constitutional Provisions Enhancing Government Efficiency
— Provisions that constrain government from taking rights and wealth from some in
order to bestow them on others.
— Restricting transfers only to the poor, for example.
— Requirements that the primary beneficiaries of government activities are required
to foot the bill for their cost.
— Federalism and decentralization to encourage competition among government.
iv. A Closer Look at Demand [Utility and elasticity]
Choice and Individual Demand
 Principles of Consumer Theory
– Limited income necessitates choice.
– Consumers make decisions purposefully.
– One good can be substituted for another.
– Consumers must make decisions without perfect information, but knowledge and
past experiences will help.
– The law of diminishing marginal utility applies.
» As the rate of consumption increases, the utility derived from consuming
additional units of a good will decline.
» Marginal utility is the additional utility received by a person from the
consumption of an additional unit of a good within a given time period.
 Substitution and Income Effects
– The substitution effect is buyer tendency to substitute a now relatively cheaper
product for goods that are more expensive.
– The income effect is buyer tendency to buy more of a good because a price
increase allows them to afford to do so.
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 Market Demand Reflects the Demand of Individual Consumers
– Market demand is the amount demanded by all individuals in the market area.
– The market demand curve is the horizontal sum of the individual demand curves.
» Because individual consumers purchase less at higher prices, the amount
demanded is also inversely related to price.
Consumer Surplus
 Consumer Surplus and Total Value
– Consumer surplus is the difference between the amount buyers are willing to pay
and the amount they actually pay for a good.
» It measures the gain that accrues to the buyer.
» Its size is determined by the market price.
» It reflects the laws of diminishing marginal utility.
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The Elasticity of Demand
Measuring the Elasticity of Demand
– Elasticity of demand refers to the flexibility of consumers' desire for a product.
– It is the degree of their responsiveness to a change in a product's price.
– The price elasticity of demand is the percentage change in the quantity of a product
demanded divided by the percentage change in its price.
Determinants of Demand Elasticity
– Availability of substitutes
– Share of total budget expended on the product
Total Expenditures and Demand Elasticity
– Price varies directly with total revenue when demand is inelastic.
» A decline in price will lead to an decrease in total revenue when demand is
inelastic.
– Price varies inversely with total revenue when demand is elastic.
» A decline in price will lead to an increase in total revenue when demand is
elastic.
Using the Concept of Elasticity
Burden of a Tax
– Tax burdens can be split between buyers and sellers.
» The relative burdens depend upon demand and supply elasticities.
» Elasticity of supply is the percent change in the quantity supplied, divided by
the percent change in the price that caused the quantity change.
» When demand is more elastic, buyers bear less of the tax burden.
» When supply is more elastic, sellers bear less of the tax burden.
Elasticity and Deadweight Loss of Taxation
– When either demand or supply is highly elastic, more trades are squeezed out and
the deadweight burden of a tax is greater.
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v. A Closer Look at Supply: What's behind the costs of production?
COSTS AND THE SUPPLY OF GOODS
Organization of the Business Firm
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Incentives, Cooperation, and Nature of the Firm
– Residual claimants are individuals who personally receive the excess, if any, of
revenues over assets.
» Residual claimants gain if the firm’s costs are reduced or revenues increased.
– Business firms organize production by contracting or by team production.
– When team production is used, the owner must direct workers' efforts, provide
incentives, and prevent shirking.
» Shirking occurs when output is reduced due to less than a normal rate of
productivity.
– The principal-agent problem arises when the interests of the agent conflict with
those of the principal.
» May reduce the efficiency of the corporate business structure.
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Types of Business Firms
– The three types of business firms are proprietorship, partnership, and corporation.
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The Economic Role of Costs
Costs balance consumer desire for goods.
– Costs of production represent the voice of consumers saying that other items that
could be produced with the resources are also desired.
Calculating Economic Costs and Profits
– Total costs are the sum of both explicit and implicit costs of production.
» Implicit costs are the opportunity costs associated with a firm’s use of resources
that it owns.
» The opportunity cost of equity capital is the basis for determining the normal
rate of return.
Accounting Profit and Economic Profit
– Economic profit is total revenues minus total costs (including all opportunity
costs).
» It requires an above normal rate of return—a rate of return greater than the
opportunity cost of capital.
» Firms earning zero economic profit are earning exactly the market (normal) rate
of return.
– Accounting profit is sales revenue minus the expenses of a firm over a designated
time period.
– Accounting profit is not the same as economic profit.
» Because accounting profit omits implicit costs, it is generally greater than
economic profit.
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Short Run and Long Run
 The Short Run (in production)
– The short run is a period of time so short that at least one factor of production is
fixed.
» The firm cannot alter its present plant size in the short run.
– In the short run output can only be altered by changing the usage of variable
resources, such as labor and raw materials.
 The Long Run
– The long run is a period of time sufficient for the firm to alter all factors of
production.
» The firm can alter its plant size and capacity in the long run.
» In the long run firms can enter and exit the industry.
 The actual short run and long run differs by industry.
Output and Costs in the Short Run
 Total Fixed Cost
– Total fixed cost is the sum of the costs that do not vary with output.
» It will be incurred as long as a firm continues in business and the assets have
alternative uses.
 Average Fixed Cost
– Average fixed cost is fixed cost divided by number of units produced.
» It always declines as output increases.
 Average Variable Cost
– Average variable cost is total variable costs divided by the number of units
produced.
 Total Cost
– Total cost is the sum of fixed and variable costs.
TC = TFC + TVC
 Average Total Cost
– Average total cost is total cost divided by the number of units produced.
– It is also the sum of average fixed and average variable costs.
ATC = AFC + AVC
 Marginal Cost
– Marginal cost is the change in total cost required to produce an additional unit of
output.
 Diminishing Returns and Production in the Short Run
– The law of diminishing returns states that as more of a variable input is combined
with fixed inputs, output will eventually increase by smaller and smaller amounts.
– Once diminishing returns are confronted, more variable factors will be needed to
expand output.
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» As a result, short run marginal cost will rise.
– Marginal product is the increase in total product resulting from an incremental
increase in the use of a variable input.
Law of Diminishing Returns
 Diminishing Returns and Cost Curves
– Once diminishing returns are confronted, more of the variable factors will be
needed to expand output.
» Thus, the law of diminishing returns explains why short-run marginal cost will
rise.
Output and Costs in the Long Run
 Long Run Unit Costs
– Firms may alter the size of their plant and vary all other factors of production in the
long run.
– The long-run ATC curve shows the minimum average cost of producing each
output level when the firm is free to choose among all possible plant sizes.
 Firm's Planning Curve
– The long-run ATC cost curve outlines the possibilities available at the planning
stage.
» It indicates the expected average total costs of production for each of a large
number of plants, which differ in size.
 Size of Firm and Long Run Unit Costs
– Per unit costs tend to fall as the firm produces a larger volume of output.
» Adoption of mass production techniques
» Specialization of labor and machines
» Learning by doing
What Factors Cause the Firm's Cost Curves to Shift?
 Prices of resources
 Taxes
 Technology
vi. The Starting Point: Our Model of Perfect Competition
Markets When Firms Are Price Takers
Output In The Short Run
 Profit Maximization
In the short run, the price taker will expand output until marginal revenue (price) is
just equal to marginal cost.
This will maximize the firm’s profits (or minimize its losses).
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Marginal revenue is the incremental change in total revenue derived from the sale
of one additional unit of a product.
 Losses and Going Out of Business
When prices fall too low, losses resulting from the firm’s inability to cover variable
costs may cause it to go out of business.
A firm will shutdown in the short run whenever price falls below average variable
cost.
A firm will shutdown in the long run whenever price falls below average total cost.
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 Firm’s Short-Run Supply Curve
The price taker that intends to stay in business will maximize profits (or minimize
losses) when it produces the output level at which P=MC and variable costs are
covered
Thus, a firm’s short-run supply curve is its MC above AVC
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 Short-Run Market Supply Curve
The short-run market supply curve is the horizontal summation of the marginal
cost curves for all the firms in the industry
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Output Adjustments in the Long Run
Long-Run Equilibrium
Economic profits induce entry, economic losses induce exit.
In long-run equilibrium, firms earn zero economic profit.
The firm’s minimum ATC will just equal the market price.
Supply Elasticity and the Role of Time
Faster expansion in output means greater cost penalties are necessary to adjust to
an increase in demand.
The supply curve is more elastic in long run than in short run.
Profits and losses signal consumer value relative to production costs.
Profits reward producers for producing a good valued more highly than the
resources used to produce the good.
Losses penalize producers who operate inefficiently and/or produce goods that
consumers do not prefer.
In a competitive environment, self-interested individuals and profit-seeking business
firms have a strong incentive to recognize and serve the interests of others.
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vii. PRICE-SEARCHER MARKETS WITH LOW ENTRY BARRIERS
Competitive Price-Searcher Markets
 A market where the firms have a downward-sloping demand curve and entry into and
exit from the market are relatively easy.
 Characteristics
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Differentiated products are ones distinguished from similar products by such
characteristic as quality, design, location, and promotion.
A term often used by economists to describe markets with a large number of sellers
supplying differentiated products to a market with low entry barriers.
 Monopolistic Competition
Sellers in competitive price-searcher markets face competition both from firms
already in the market and from potential new entrants.
If profits are present, firms can expect new rivals will be attracted.
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Price and Output
 Price and Output Decision
For any firm with a downward sloping demand curve (a price searcher) marginal
revenue will be less than price.
Competitive price searcher firms will maximize profits by expanding output to the
point where marginal cost rises to equal marginal revenue.
With free entry and exit, long-run equilibrium occurs with zero economic profit.
Economic profits will attract new competitors to the market.
With free entry and exit, long-run equilibrium occurs with zero economic profit. The
increased availability of the product will drive the price down until the profits
are eliminated.
With free entry and exit, long-run equilibrium occurs with zero economic profit.
Economic losses cause competitors to exit the market.
With free entry and exit, long-run equilibrium occurs with zero economic profit.
>The decline in the availability of the product will allow price to rise until firms
are once again able to cover their average total costs.
 The Positive Side of Business Failure
Losses and bankruptcy provide both the information and the incentives to move
resources to more highly valued, more productive uses.
Resources are wasted in low-valued uses when failing businesses are subsidized by
taking income from successful ones or protected by tariffs or other laws.
 A contestable market is one in which entry and exit costs are low.
When entry barriers are low, firms risk little by entering.
Efficient production and zero economic profits should prevail in a contestable
market.
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The Left-Out Variable: Entrepreneurship
Is alert to business opportunities.
Makes correct decisions most of the time.
Backs away quickly when a business mistake is made.
We are unable to fully incorporate the function of the entrepreneur into economic
models.
>Entrepreneurs often make judgments when there is no decision rule that can be
applied using only information that is freely available.
>There is simply no way to model these complex decisions that involve
uncertainty, discovery, and business judgment.
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An Evaluation of Competitive Price-Searcher Markets
 Comparing Price-Taker and Price-Searcher Markets
Similarities:
>Zero long-run economic profit
> Responsiveness to consumer desires
>Low barriers to entry
in price searcher markets:
> Equilibrium not at minimum LRATC
>Price above short-run marginal cost
> Competitive advertising involved
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 Allocative Efficiency in Price-Searcher Markets With Low Entry Barriers
Efficiency is violated because price exceeds marginal cost and firms fail to
minimize average total cost.
>Firms in the market engage in self-defeating and wasteful advertising.
Under the modern view, price searcher markets are not considered to be as
inefficient as in the traditional view.
>Product variety is stimulated.
>Excess capacity may or may not be wasteful.
>Advertising that influences choice cannot be judged in terms of efficiency.
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Price Discrimination
 Price discrimination occurs when a seller charges different consumers different prices
for the same product or service.
 Gains from Price Discrimination
A price searcher can gain from price discrimination if it can do two things:
>Identify and separate at least two groups of consumers whose price elasticity of
demand for the firm’s product differ.
>Prevent those who buy at the low price from reselling to the customers charged
a higher price.
A higher price will be charged to groups with a more inelastic demand, while a
lower price will be charged to groups with a more elastic demand.
- Price discrimination can increase the total gains from trade and thereby reduce
allocative inefficiency.
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Competition Among Firms: How It Increases Prosperity
 A competitive environment promotes economic prosperity.
Competition places pressure on producers to operate efficiently and cater to the
preferences of consumers.
Competition provides firms with a strong incentive to develop improved products
and discover lower-cost methods of production.
Competition causes firms to discover the types of business structure and size that
can best keep the per unit costs of production low.
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In essence, competition harnesses personal self-interest and puts it to work
elevating out
standard of living.
viii. PRICE-SEARCHER MARKETS WITH HIGH ENTRY BARRIERS
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Why Are Entry Barriers Sometimes High?
Economies of scale
Government licensing
Patents
Control over essential resource
The Case of Monopoly
 A monopoly is a market structure characterized by a single seller of a well-defined
product for which there are no good substitutes producing in a market with high
barriers to entry.
 Price and Output Under Monopoly
Like other price searchers, the monopolist expands output until marginal cost
equals marginal revenue.
- High barriers to entry insulate the monopolist from competitors.
Economic profits may persist into the long run.
 The Monopoly Model and Decision-Making in the Real World
Like other price searchers, a monopolist cannot be sure of the demand conditions
for its product.
Given imperfect information, the profit-maximizing price may only be
approximated.
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Oligopoly
Oligopoly is a market situation in which a small number of sellers compose the entire
industry.
Characteristics
Interdependence among firms is recognized
The policies of one firm clearly affect others
There are substantial economies of scale.
There are significant barriers to entry.
Firms produce either identical or differentiated products.
>When products are identical, there is less opportunity for nonprice competition.
Price and Output
Because of interdependence among firms, it is impossible for a single firm to
determine the precise price and output required to maximize profit.
Prices charged by individual firms will be less than the profit-maximizing price of
a monopolist but higher than the competitive market price.
Price and output will depend on whether the firms collude or compete.
Price and Output
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Cartels and collusion result from interdependence among firms.
> Firms have a strong incentive to cooperate in an effort to raise price.
A cartel is an organization of sellers designed to coordinate supply decisions so
that the joint profits of the members are maximized.
> A cartel will seek to create a monopoly in the market.
Collusion involves the cooperative action of sellers to avoid competition.
>It may involve either formal agreements or merely tacit recognition that
competition is self-defeating in the long run.
> Tacit collusion is difficult to detect.
> Antitrust laws prohibit collusion and conspiracies to restrain trade.
 Obstacles to Collusive Behavior
Firms have a strong incentive to cheat on price agreements because the firm’s
demand curve will be more elastic than the demand curve of the industry.
As the number of firms in an oligopolistic market increases, the likelihood of
effective collusion declines.
When it is difficult to detect and eliminate price cuts, collusion is less attractive.
Low entry barriers are an obstacle to collusion.
Unstable demand conditions are an obstacle to collusion.
Vigorous antitrust action increases the cost of collusion.
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 Uncertainty and Oligopoly
Game theory analyzes the strategic choices made by competitors in a conflict
situation.
Interdependent decisions of firms in an oligopolistic industry can be understood
with the aid of game theory and the classic prisoner’s dilemma model.
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Defects of Markets With High Entry Barriers
 Competition is generally preferred by economists.
A reduction in the competitiveness of a market limits the options available to
consumers.
Reduced competition results in allocative inefficiency.
When barriers to entry are high, consumers are less able to direct producers to
serve their interests.
Government grants of monopoly power will encourage rent seeking.
Government grants of monopoly power will encourage rent seeking.
>Resources will be wasted by firms attempting to secure and maintain grants of
market protection.
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Policy Alternatives When Entry Barriers are High
 Restructure Existing Firms
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Increasing the number of firms is not appropriate in the case of a natural
monopoly. Policy Alternatives When Entry Barriers are High
 Restructure Existing Firms
A natural monopoly is a market where average costs of production continually
decline as output increases.
>Average costs of production will be lowest when a single large firm produces
the entire output demanded.
 Reduce Artificial Barriers to Trade
Foreign competition may help ensure that domestic firms seek to improve product
quality and keep their costs low.
 Regulate the Protected Producer
By regulating using average cost pricing, the firm earns zero economic profit
(normal accounting profit).
By using marginal cost pricing, the regulators could attempt to achieve economic
efficiency.
The problems with regulation include lack of information, cost shifting, and
special-interest influence.
 Supply Market With Government Production
Government operated firms present an alternative to private moaopoly and
regulation.
Fewer incentives to minimize costs and satisfy consumers in government operated
firms.
 Pulling It Together
intervening into these markets with government policy may not create an attractive
outcome.
- Competitive forces are widespread, even influencing markets with high entry
barriers. For example, sellers of CDs compete with bookstores and other
entertainment firms am not just other CD firms.
- Quality competition is an important element in the competitive process.
- Patents and monopoly profit encourage innovation.
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ix. Markets for the Factors of Production
SUPPLY, DEMAND, AND RESOURCE PRICES
The Demand for Resources
Derived Demand
— The demand for each resource is based on the demand for the products it
produces.
— The demand curve for a resource shows the amount of the resource that will be
used at different prices.
— The demand For a resource is downward sloping.
— Substitution in production
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> As prices increase, producers will turn to substitute resources.
 Consumers will buy less of goods that become more expensive as the result of
higher resource cost.
 Other things constant, the more elastic the demand for the product, the more
elastic the demand for the resource.
 Time and the Demand for Resources
— The price elasticity of demand for a resource usually increases with time.
 Shifts in the Demand for Resources
— A change in the demand for a product will cause a similar change in the demand
for the resources used to make the product.
— Changes in the productivity of a resource will alter the demand for the resource.
— A change in the price of a related resource will affect the demand for the original
resource
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Marginal Productivity and the Firm’s Hiring Decision
Essential Concepts
— The marginal product of a resource is the change in total output that results from
the employment of an additional unit of a factor of production.
— The marginal revenue product of a resource is the change in the firm’s total
revenue that results from the employment of an additional unit of a factor of
production.
MRP = MARGINAL PRODUCT X MARGINAL REVENUE

Employment of a Variable Resource With a Fixed Resource
— A firm maximizes profits by hiring units of a resource so long as the
employment of each additional unit adds more to the firm’s revenues than it adds
to its costs.
— The firm hires additional units of a variable resource up to the level at which the
price of the resource—-the firm’s marginal cost—is just equal to the MRP of the
resource.
MRP = PRICE OF THE RESOURCE
— This profit-maximization rule applies to all firms, pure competitors and price
searchers alike.
— A resource’s value marginal product is its marginal product multiplied by the
selling price of the product it helps to produce.
— The firm’s demand for a resource equals the MRP curve.
— Factors affecting curve’s location
~ Product price
~ Resource productivity
~ Amount and price of other resources with which the resource is working
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
Profit Maximization When Multiple Resources Are Employed
— When profits are maximized, the MRP of each resource will equal the price of
that resource.
MRPM = PM MRPSL = PSL
MRP = Pfor all resource inputs
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To minimize costs, the marginal dollar expenditure for each resource will have
the same impact on output as every other marginal resource expenditure.
— Factors of production will be employed such that the marginal product per last
dollar spent on each factor is the same for all factors.
 Productivity and Wage Differences
— Wage differences across skill categories will tend to reflect productivity
differences.
— If skilled workers are twice as productive as unskilled workers, their wage rates
will tend toward twice the wage rates of unskilled workers.
— Low wages do not necessarily mean low cost.
— It is not always cheaper to hire the lowest wage workers.
 The Central Proposition of the Marginal Productivity Theory of Employment
— The market price of a resource will equal its marginal revenue product.
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The Supply of Resources
Resource owners will supply their services to those who offer them the best job, all
factors considered.
Other things constant, as the price of a specific resource increases, the incentive of
potential suppliers to provide the resource increases.
Short-Run Supply
— Most resources have alternative uses.
— Resource owners consider both monetary and nonpecuniary factors to use their
assets to their greatest net advantage.
— Resource mobility refers to the ease with which factors of production are able to
move among alternative uses.
— Highly mobile resources are ones that can be easily transferred to a different use
or location.
— A resource is immobile when it has few alternative uses.
Long Run Supply
— The supply of a resource will be more elastic in the long run than in the short
run.
— Given time, investment in physical and human capital can substantially expand
the availability of a resource.
— Price changes have greater effect in the long run.
— The supply of resources becomes more elastic with time.
Adjusting to Dynamic Change
— Increases in demand for a resource usually cause its price to rise more in the short
run than in the long run.
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Why Do Earnings Differ?
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Earnings Differentials from Nonhomogeneous Labor
— Worker productivity and specialized skills
>The demand for employees who are highly productive is greater than the
demand for those who are less productive.
— Worker preferences
>Persons who are more highly motivated by monetary objectives are more likely
to do the things necessary to command higher wage rates.
— Race and sex discrimination
>Employment discrimination exists when minority or women employees are
treated differently than similarly productive whites or men.
— Nonpecuniary job characteristics
>Workers are willing to trade off higher wage rates for more favorable
nonpecuniary job characteristics.
>Nonpecuniary job characteristics include working conditions, prestige, variety,
location, employee freedom and responsibilities, and other nonwage factors. »
Compensating wage differentials are differences that compensate workers for
risk, unpleasant working conditions, and other undesirable nonpecuniary
aspects of a job.
— Immobility of Labor
>Resources are highly immobile in the short run.
>Institutional barriers such as licensing, unions, and the minimum wage may
limit the mobility of labor.
>Demand increases may cause wages of specialized laborers to rise sharply.
Fringe Benefits Are Components of Employee Compensation
— Employers and employees have an incentive to structure the compensation
package so that it will transfer the maximum amount of value to employees for
any given cost to the employer.
— Compensation packages of this type will attract employees and thereby minimize
the employer’s labor cost.
— Failure to include a fringe benefit in a wage package is strong evidence that it
costs more than the ‘value to employees or that the employee could purchase the
benefit less expensively outside the employer.
— Increasing a single component of the compensation package will not necessarily
increase the size of the overall package.
— Workers will not be hired if their employment adds more to costs than to
revenues.
— When neither cost saving nor tax advantage exists, fringe benefits are an
inefficient form of compensation.
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INVESTMENT, CAPITAL FORMATION, AND THE WEALTH OF NATIONS
INVESTMENT AND Capital FORMATION
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Why People Invest
Capital
— Capital is a term used by economists to describe long-lasting resources that are
valued because they can help us produce goods and services in the future.
— There are two broad categories of capital.
— There are two broad categories of capital.
> Physical capital—nonhuman resources such as buildings, machines, tools, and
natural resources.
> Human capital—human resources, that is, the knowledge and skills of people.
Investment
— Investment is the purchase, construction, or development of a capital resource.
Saving
— Saving is income that is not spent on current consumption.
— Saving is required for investment.
— Saving is income that is not spent on current consumption.
> Someone must refrain from current consumption in order to provide the
resources for investment.
Consumption
— Consumption is the ultimate objective of all production.
— The use of capital to produce consumption goods makes sense only when the
capital enhances the total production of consumption goods.
— In general, individuals have a positive rate of time preference, meaning that they
value goods now greater than in the future.
Determination of the Interest Rate
— The interest rate is determined by the demand and supply of loanable funds.
— At equilibrium, the quantity of finds borrowers demand for investment and current
consumption just equals the quantity of funds lenders save.
— The interest rate brings the choices of borrowers and lenders into harmony.
Money Rate Versus Real Rate of Interest
— Also known as the nominal interest rate, the money rate of interest is the rate of
interest in monetary terms that borrowers pay for borrowed funds unadjusted for
inflation.
— The real interest rate is the money rate of interest minus the expected rate of
inflation.
— The money rate of interest will exceed the real rate of interest during a period of
prolonged inflation
— The difference between the money rate of interest and the real rate of interest is the
expected rate of inflation
— The inflationary premium is the component of the money interest rate that
compensates lenders for the decrease in purchasing power resulting from inflation.
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— Interest rates in the loanable funds market will differ primarily as the result of the
differences in the risk associated with the loan.
 Components of an Interest Rate
— The pure-interest component is the price of earlier availability.
— The risk-premium compensates for the possibility that the borrower may be
unable to repay the loan.
— The inflationary-premium reflects the expectation that the loan will be repaid with
dollars of less purchasing power
Profit and Prosperity
 Economic Profit
— Economic profit is the return to investment in excess of the opportunity cost of
loanable funds
— The major sources of economic profit are uncertainty and entrepreneurial alertness.
— At any given time, there is virtually an infinite number of potential investment
projects.
» Some will increase the value of resources and therefore lead to a handsome rate
of return on capital.
» Others will reduce the value of resources, generating economic losses.
— Entrepreneurship involves finding profitable ones that have gone unnoticed by
others.
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