UMGC
MBA 620: Financial
Decision Making
Project 2: Review and
Practice Guide
Project 2: Review and
Practice Guide
Managerial Economics
Contents
Topic 1: Economics Principles ………………………………………………………………………………………………………..
3
How People Make Decisions ……………………………………………………………………………………………………… 3
Topic 2: Market Equilibrium…………………………………………………………………………………………………………..
4
Demand Curve ………………………………………………………………………………………………………………………… 4
Supply Curve …………………………………………………………………………………………………………………………… 4
Market Equilibrium …………………………………………………………………………………………………………………..
5
What moves the Supply/Demand Curves ……………………………………………………………………………………. 5
Topic 3: Elasticity …………………………………………………………………………………………………………………………
6
What is Price Elasticity ……………………………………………………………………………………………………………… 6
Elasticity of Demand: Inelastic …………………………………………………………………………………………………… 6
Elasticity of Demand: Unit Elastic ……………………………………………………………………………………………….
7
Elasticity of Demand: Elastic ………………………………………………………………………………………………………
8
Topic 4: Market/Industry Structure ………………………………………………………………………………………………..
9
Industry Structure Examples ……………………………………………………………………………………………………… 9
Market Structure Comparison …………………………………………………………………………………………………… 9
Perfect Competition ………………………………………………………………………………………………………………..
10
Topic 5: How Companies Make Decisions ……………………………………………………………………………………..
11
Principle 3 …………………………………………………………………………………………………………………………….. 11
Maximizing Profit …………………………………………………………………………………………………………………… 11
Problems/Exercises …………………………………………………………………………………………………………………….
12
What to do ……………………………………………………………………………………………………………………………. 12
Exercises ……………………………………………………………………………………………………………………………….. 12
…………………………………………………………………………………………………………………………… 12
…………………………………………………………………………………………………………………………… 12
…………………………………………………………………………………………………………………………… 12
References ……………………………………………………………………………………………………………………………. 12
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Topic 1: Economics Principles
How People Make Decisions
• Principle 1: People face trade-offs
• Principle 2: The cost of something is what you give up to get it (opportunity cost)
• Principle 3: Rational people thing at the margin (MR=MC)
• Principle 4: People respond to incentives
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Topic 2:
Market Equilibrium
Demand Curve
The market demand curve: a downward-sloping curve.
It depicts a movement along a stationary demand curve.
Based on Webster (2015, p. 22)
Supply Curve
The market supply curve: an upward-sloping curve.
It depicts a movement along a stationary supply curve.
Based on Webster (2015, p. 32)
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Market Equilibrium
A market equilibrium: determination of market price and
output.
It depicts a market equilibrium where the quantity
demanded equals the quantity supplied.
Based on Webster (2015, p. 37)
What Moves the Supply/Demand Curves
Demand:
• Price
• Income
• Price of related goods
• Tastes
• Expectations
• Number of buyers
Supply:
• Price
• Input prices
• Technology
• Expectations
• Number of sellers
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Topic 3: Elasticity
What is Price Elasticity?
• Price elasticity—how sensitive demand or supply is to price changes
• Formula:
Absolute value of (% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑖𝑒𝑠
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
)
% change = (new value – old value) / average of new and old values
• Three Types of Elasticity
1. Inelastic: elasticity < 1
2. Elastic: elasticity > 1
3. Unit Elastic: elasticity = 1
Based on information in Mankiw (1997)
Elasticity of Demand: Inelastic
Source: Mankiw (1997)
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Elasticity of Demand: Unit Elastic
Source: Mankiw (1997)
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Elasticity of Demand: Elastic
Source: Mankiw (1997)
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Topic 4: Market/Industry Structure
Industry Structure Examples
Source: Mankiw (1997)
Market Structure Comparison
Market Structure
Characteristic
Perfect Competition Monopolistic Competition Oligopoly Monopoly
Type of
competition
Perfect Imperfect Imperfect Imperfect
Number of firms Very many Many Few One
Type of product Homogeneous Differentiated. Many close
substitutes
Homogeneous
or
differentiated
Unique. No close
Substitutes
Market power None;
firms are “price
takers”
Some; limited by availability
of close substitutes
Limited; pricing
decisions
characterized
by strategic
behavior
Considerable;
firms are “price
makers.”
Barriers to entry
and exit
Few to none; easy
entry and exit
Few; easy entry and exit Considerable Entry impossible
Non-price
competition
None Considerable,
advertising, brand-name
recognition, and trademarks
to promote customer loyalty
Considerable;
especially with
respect to
differentiated
products
None since there
is only one firm;
monopolies
frequently
advertise for
other reasons
Source: Webster (2015)
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Perfect Competition
• Theoretical benchmark of market structure, six assumptions (Mankiw, 1997):
1. All companies have an identical (homogeneous) product
2. All competitors are price takers (they cannot influence the market price of their
product)
3. Market share does not influence price
4. Buyers have complete (“perfect”) information at all times (past, present, future) about
the product and prices
5. Resources like labor are perfectly mobile
6. Companies can enter or exit the market without cost
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Topic 5: How Companies Make Decisions
Principle 3
Rational people thing at the margin—so do companies! (Mankiw, 2015)
Maximizing Profit
Profit
𝜋 = TR – TC*
Marginal Revenue
MR = TR/Q; MC = TC/Q
Maximize (𝜋) when the following is true:
Marginal Revenue = Marginal Cost or MR – MC = 0
(Example: An empty seat on a flight at takeoff is a lost profit opportunity, because
there is almost no variable cost.)
* MR – marginal revenue, MC – marginal cost, TR – total revenue, TC – total cost, Q – quantity, —
change
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Problems/Exercises
What to do
You are encouraged to complete all the practice exercises listed below. They will help you gain the
knowledge and skills needed to fully participate in the group assignment in Step 3 and complete the
final Project 2 deliverable. The answers are provided, so you can check your own work.
Exercises
(in Webster, 2015)
• Solve exercises on pages 28, 31, 42, 45, 49
• Solve exercise on pages 57, 60, 68, 70, 71
• Solve exercises on pages 178, 181, 183, 184
References
Mankiw, N. G. (1997). Principles of Economics (1st ed.). Harcourt.
Webster, T. J. (2015). Managerial economics: tools for analyzing business. Lexington Books.
http://ezproxy.umgc.edu/login?url=https://search.ebscohost.com/login.aspx?direct=true&db=n
lebk&AN=935122&site=eds-live&scope=site&ebv=EB&ppid=pp_cover
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Now that you have read this Review and Practice Guide and completed
the exercises, you are ready to participate in the group assignment in
Step 3.
Project 2 Report
Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces several different product lines two of which are a simple Standard box and a more elaborate Deluxe box. These boxes are also produced by many other companies.
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab 1 after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will approximate the prices that maximize the profit for both boxes.
Follow these steps to complete Project 2:
1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations.
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations. Your report should be no more than 15 pages, a maximum of one page per question. Start each question with your answer on a new page.
Project 2 is the team assignment in MBA 620. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, each team member will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primary will coordinate any changes to the team’s answers to the topic questions.
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Title Page
Name
Course and section number
Faculty name
Submission date
Supply and Demand
1. Explain why an understanding of the law of demand and the law of supply is important to being an effective manager.
2. Identify the supply factors that are most important in determining the market equilibrium for the Deluxe box.
3. Identify the demand factors that are most important in determining the market equilibrium for the Standard box.
Market Structure
1. Explain why an understanding the market structure in a which company operates is important to being an effective manager.
2. Explain the market structure that is most likely operating in the market for the Deluxe boxes.
3. Explain the market structure that is most likely operating in the market for the Standard boxes.
Price Elasticity
1. Discuss what actions the company should take in setting the price of the Standard box given its price elasticity of demand.
2. Discuss what actions the company should take in setting the price of the Deluxe box given its price elasticity of demand.
3. Assuming the price elasticity of supply for the Standard box is inelastic, explain the key factors that the company must consider in expanding production.
Profit Maximization
1. Explain under what conditions profit maximization would be appropriate for the Standard box.
2. Explain why the concepts of marginal revenue, marginal cost and economies of scale are important to the financial objective of maximizing profit.
3. Assuming the company only manufactures these two product lines and they have customers who purchase both products from them, discuss what the overall company financial objective should be.
Economics and Decision Making
1. Explain how an understanding of economics is important to being an effective manager.
2. Explain why understanding the economic concept of opportunity cost is essential to managers making better decisions.
3. Explain why understanding the economic concepts of marginal revenue and marginal cost are essential to managers making better decisions.
>Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces two types of boxes, a Standard box and a Deluxe box. These boxes are also produced by many other companies. after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will determine at what price the company can maximize the profitability of both boxes. 1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations. 20. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, team members will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primaries will coordinate any changes to the team’s answers to the topic questions. per box
.00
2 1 0.6 0.8 0.4 0.2 1 0.1 Future Supply and Demand for cardboard boxes 2 0.3 0
0.4 1.6 0.5 0
1.4 0.6 1.2 0.7 0
1 0.8 0.8 0.9 0
0.6 1 0.4 1.1 0
0.2 1.2 0.1 Equilibrium: Equilibrium: 1. Based on the information provided in Table 1, create a chart in the space below showing the supply and demand curves for the number of Standard boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists. 2. Based on the information provided in Table 2, create a chart in the space below showing the supply and demand curves for the number of Deluxe boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab
1
Follow these steps to complete Project 2:
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations.
Project 2 is the team assignment in MBA 6
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Tab 1 – Supply and Demand Graph
Table 1
Future Supply and Demand for cardboard boxes
Price
Daily US demand of Standard boxes (in billions of boxes per day)
Daily US supply of Standard boxes (in billions of boxes per day)
$1
7
0.1
$17.20
1.
8
0.2
$17.40
1.6
0.3
$17.60
1.4
0.4
$17.80
1.2
0.
5
$
18.00
0.6
$18.20
0.8
0.7
$18.40
$18.60
0.
9
$18.80
$19.00
1.1
Question 1:
Create a Supply and Demand Chart for the Standard box below
Equilibrium:
Table 2
Price per box
Daily US demand of Deluxe boxes (in billions of boxes per day)
Daily US supply of Deluxe boxes (in billions of boxes per day)
$30.00
$2
9.5
1.8
$29.00
$2
8.5
$28.00
$2
7.5
$27.00
$2
6.5
$26.00
$2
5.5
$25.00
1.3
Question 2:
Create a Supply and Demand Chart for the deluxe box below
.
Tab 2 –
ity
| Quantity | ||||||||||||||||||||
| 10 | Original | |||||||||||||||||||
| New | ||||||||||||||||||||
| % change | Elasticity of Demand | |||||||||||||||||||
| Elasticity: | ||||||||||||||||||||
| By how much did revenues increase or decrease as a result of the change in price? | ||||||||||||||||||||
| By how much did profits increase or decline? | ||||||||||||||||||||
| Standard Boxes sold per day (millions) | Revenue (millions) | Variable Cost per cardboard box | Variable Cost (millions) | Fixed cost per day | Total Cost (millions) | Daily Profit (millions) | ||||||||||||||
| $ 18.00 | $ 180 | $ 10 | $ 100 | $ | 11 | $ 70 | ||||||||||||||
| Total Cost (Millions) | ||||||||||||||||||||
| Deluxe boxes sold per day (millions) | Variable Cost per metal box | |||||||||||||||||||
| 1.35 | ||||||||||||||||||||
| Select One | ||||||||||||||||||||
| Price Inelastic | ||||||||||||||||||||
| Unit Price Elastic |
1. Last month the company sold 10 million of their Standard boxes at an average price of $18.00 per box. This week the company raised the average price to $18.40 per box. The company sold 9.5 million boxes for the month. The variable cost per unit is $10 and the fixed costs are $10 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
2. After reviewing last month’s results, the company decided to lower the price of a Standard box to $17.60. After this change, the volume sold increased to
million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
3. Last month the company sold
5 million Deluxe boxes at an average price of $28 per box. This month the company raised the price to $29 and sold 1.35 million boxes. The variable cost per unit is $10 and the fixed costs are $3 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
4. After reviewing the last results, the company decided to lower the price to $27 and sold
million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
Tab 3 –
Profit Maximization
| Standard boxes sold per month (millions) | Revenue (price x volume) | Variable Cost per standard box | Variable Cost (cost per unit x volume) | Fixed cost per month (millions) | Total Cost (Fixed + Variable) | Daily Profit (revenue – all costs) | MR | MC | ||||||||
| $ 22.00 | $ 110.00 | $ 10.00 | $ 50.00 | $ 10.00000 | $ 60.0000 | |||||||||||
| $ 21.60 | ||||||||||||||||
| $ 21.20 | ||||||||||||||||
| $ 20.80 | ||||||||||||||||
| $ 20.40 | ||||||||||||||||
| $ 20.00 | ||||||||||||||||
| $ 19.60 | ||||||||||||||||
| $ 19.20 | ||||||||||||||||
| $ 18.80 | ||||||||||||||||
| $ 18.40 | ||||||||||||||||
| $ 17.60 | ||||||||||||||||
| $ 17.20 | ||||||||||||||||
| 11.5 | $ 16.80 | |||||||||||||||
| 12 | $ 16.40 | |||||||||||||||
| 12.5 | $ 16.00 | |||||||||||||||
| 13 | $ 15.60 | |||||||||||||||
| 13.5 | $ 15.20 | |||||||||||||||
| 14 | $ 14.80 | |||||||||||||||
| Deluxe boxes sold per month (millions) | ||||||||||||||||
| $ 30.00 | ||||||||||||||||
| $ 29.50 | ||||||||||||||||
| $ 29.00 | ||||||||||||||||
| $ 28.50 | ||||||||||||||||
| 1.55 | $ 28.00 | |||||||||||||||
| $ 27.50 | ||||||||||||||||
| $ 27.00 | ||||||||||||||||
| 1.7 | $ 26.50 | |||||||||||||||
| 1.75 | $ 26.00 | |||||||||||||||
| $ 25.50 | ||||||||||||||||
| 1.85 | $ 25.00 | |||||||||||||||
| 1.9 | $ 24.50 | |||||||||||||||
| 1.95 | $ 24.00 | |||||||||||||||
| $ 23.50 | ||||||||||||||||
| 2.05 | $ 23.00 | |||||||||||||||
| 2.1 | $ 22.50 | |||||||||||||||
| 2.15 | ||||||||||||||||
| 2.2 | $ 21.50 | |||||||||||||||
| 2.25 | $ 21.00 |
1. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Standard boxes.
What is the closest price that will help the company maximize the profit on Standard boxes?
2. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Deluxe boxes.
What is the closest price that will help the company maximize the profit on Deluxe boxes?
Learning Objectives
By the end of this section, you will be able to:
· Discuss the importance of studying economics
· Explain the relationship between production and division of labor
· Evaluate the significance of scarcity
Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available.
Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.
Introduction to FRED
Data is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank’s FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The
FRED website
includes data on nearly 400,000 domestic and international variables over time, in the following broad categories:
· Money, Banking & Finance
· Population, Employment, & Labor Markets (including Income Distribution)
· National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts
· Production & Business Activity (including Business Cycles)
· Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index)
· International Data from other nations
· U.S. Regional Data
· Academic Data (including Penn World Tables & NBER Macrohistory database)
For more information about how to use FRED, see the variety of
videos
on YouTube starting with this introduction.
Figure 1.2 Scarcity of Resources Homeless people are a stark reminder that scarcity of resources is real. (Credit: “daveynin”/Flickr Creative Commons)
If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as
Figure 1.2
shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.
The Problem of Scarcity
Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it?
LINK IT UP
Visit this
website
to read about how the United States is dealing with scarcity in resources.
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (
Figure 1.3
) in his book, The Wealth of Nations.
Figure 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons)
The Division of and Specialization of Labor
The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person.
To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not!
Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (
Figure 1.4
), or a hospital can have hundreds of job classifications.
Figure 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)
Why the Division of Labor Increases Production
When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better.
A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of his or her own goods and services. The division and specialization of labor has been a force against the problem of scarcity.
Trade and Markets
Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.
You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.
Why Study Economics?
Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles. If the economics “bug” has not bitten you yet, there are other reasons why you should study economics.
· Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial.
· It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know?
· A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics.
The study of economics does not dictate the answers, but it can illuminate the different choices.
Learning Objectives
By the end of this section, you will be able to:
· Describe microeconomics
· Describe macroeconomics
· Contrast monetary policy and fiscal policy
Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption.
It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy.
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake’s ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint.
Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live.
In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy’s performance ultimately depends on the microeconomic decisions that individual households and businesses make.
Microeconomics
What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?
What determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly.
Macroeconomics
What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term?
We can determine an economy’s macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation’s central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation’s legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government’s main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book.
Learning Objectives
By the end of this section, you will be able to:
· Interpret a circular flow diagram
· Explain the importance of economic theories and models
· Describe goods and services markets and labor markets
Figure 1.5 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)
John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (
Figure 1.5
) famously wrote in the introduction to a fellow economist’s book: “[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.” In other words, economics teaches you how to think, not what to think.
LINK IT UP
Watch this
video
about John Maynard Keynes and his influence on economics.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram (
Figure 1.6
). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.
Figure 1.6 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.
Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market.
Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.
Learning Objectives
By the end of this section, you will be able to:
· Interpret a circular flow diagram
· Explain the importance of economic theories and models
· Describe goods and services markets and labor markets
Figure 1.5 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)
John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (
Figure 1.5
) famously wrote in the introduction to a fellow economist’s book: “[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.” In other words, economics teaches you how to think, not what to think.
LINK IT UP
Watch this
video
about John Maynard Keynes and his influence on economics.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram (
Figure 1.6
). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.
Figure 1.6 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.
Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market.
Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.
Learning Objectives
By the end of this section, you will be able to:
· Contrast traditional economies, command economies, and market economies
· Explain gross domestic product (GDP)
· Assess the importance and effects of globalization
Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done?
There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development.
Figure 1.7 A Command Economy Ancient Egypt was an example of a command economy. (Credit: Jay Bergesen/Flickr Creative Commons)
Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in
Figure 1.7
, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.
In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies.
Figure 1.8 A Market Economy Nothing says “market” more than The New York Stock Exchange. (Credit: Erik Drost/Flickr Creative Commons)
Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (
Figure 1.8
) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A person’s income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, market forces, not governments, determine economic decisions.
Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides perspective on countries’ economic freedom, as the following Clear It Up feature discusses.
CLEAR IT UP
What countries are considered economically free?
Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. Note that while the Heritage Foundation/WSJ index is widely cited by an array of scholars and publications, it should be regarded as only one viewpoint. Some experts indicate that the index’s category choices and scores are politically biased. However, the index and others like it provide a useful resource for critical discussion of economic freedom.
The 2016 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world:
Table 1.1
lists some examples of the most free and the least free countries. Although technically not a separate country, Hong Kong has been granted a degree of autonomy such that, for purposes of measuring economic statistics, it is often treated as a separate country. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen.
The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world.
Most Economic Freedom
Least Economic Freedom
1. Hong Kong
167. Timor-Leste
2. Singapore
168. Democratic Republic of Congo
3. New Zealand
169. Argentina
4. Switzerland
170. Equatorial Guinea
5. Australia
171. Iran
6. Canada
172. Republic of Congo
7. Chile
173. Eritrea
8. Ireland
174. Turkmenistan
9. Estonia
175. Zimbabwe
10. United Kingdom
176. Venezuela
11. United States
177. Cuba
12. Denmark
178. North Korea
Table1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking)
Regulations: The Rules of the Game
Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval.
The question of how to organize economic institutions is typically not a black-or-white choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules.
Figure 1.9 Globalization Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons)
The Rise of Globalization
Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows.
Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in
Figure 1.9
, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade.
Table 1.2
presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries.
Country
2010
2011
2012
2013
2014
2015
Higher Income Countries
United States
12.4
13.6
13.6
13.5
13.5
12.6
Belgium
76.2
81.4
82.2
82.8
84.0
84.4
Canada
29.1
30.7
30.0
30.1
31.7
31.5
France
26.0
27.8
28.1
28.3
29.0
30.0
Middle Income Countries
Brazil
10.9
11.9
12.6
12.6
11.2
13.0
Mexico
29.9
31.2
32.6
31.7
32.3
35.3
South Korea
49.4
55.7
56.3
53.9
50.3
45.9
Lower Income Countries
Chad
36.8
38.9
36.9
32.2
34.2
29.8
China
29.4
28.5
27.3
26.4
23.9
22.4
India
22.0
23.9
24.0
24.8
22.9
–
Nigeria
25.3
31.3
31.4
18.0
18.4
–
Table1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/)
In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries.
Table 1.2
indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections.
Despite the rise in globalization over the last few decades, in recent years we’ve seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States.
Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called
The Use of Mathematics in Principles of Economics
. It is essential that you learn more about how to read and use models in economics.
BRING IT HOME
Decisions … Decisions in the Social Media Age
The world we live in today provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of crop harvested.
Some relatively new information forums, such as Facebook, are rapidly changing how information is distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of online adults use Facebook. This social media forum posts topics ranging from the National Basketball Association, to celebrity singers and performers, to farmers.
Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an accident, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics!
circular flow diagram
a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market
command economy
an economy where economic decisions are passed down from government authority and where the government owns the resources
division of labor
the way in which different workers divide required tasks to produce a good or service
economics
the study of how humans make choices under conditions of scarcity
economies of scale
when the average cost of producing each individual unit declines as total output increases
exports
products (goods and services) made domestically and sold abroad
fiscal policy
economic policies that involve government spending and taxes
globalization
the trend in which buying and selling in markets have increasingly crossed national borders
goods and services market
a market in which firms are sellers of what they produce and households are buyers
gross domestic product (GDP)
measure of the size of total production in an economy
imports
products (goods and services) made abroad and then sold domestically
labor market
the market in which households sell their labor as workers to business firms or other employers
macroeconomics
the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance
market
interaction between potential buyers and sellers; a combination of demand and supply
market economy
an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand
microeconomics
the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms
model
see theory
monetary policy
policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing
private enterprise
system where private individuals or groups of private individuals own and operate the means of production (resources and businesses)
scarcity
when human wants for goods and services exceed the available supply
specialization
when workers or firms focus on particular tasks for which they are well-suited within the overall production process
theory
a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation
traditional economy
typically an agricultural economy where things are done the same as they have always been done
underground economy
a market where the buyers and sellers make transactions in violation of one or more government regulations
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U.S.
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law.
)
1.1 What Is Economics, and Why Is It Important?
Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker.
1.2 Microeconomics and Macroeconomics
Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy.
1.3 How Economists Use Theories and Models to Understand Economic Issues
Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.
1.4 How To Organize Economies: An Overview of Economic Systems
We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent.
.
What is scarcity? Can you think of two causes of scarcity?
2
.
Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum amount of ham the residents can consume in a month?
3
.
A consultant works for $200 per hour. She likes to eat vegetables, but is not very good at growing them. Why does it make more economic sense for her to spend her time at the consulting job and shop for her vegetables?
4
.
A computer systems engineer could paint his house, but it makes more sense for him to hire a painter to do it. Explain why.
5
.
What would be another example of a “system” in the real world that could serve as a metaphor for micro and macroeconomics?
6
.
Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram.
7
.
What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?
8
.
The chapter defines private enterprise as a characteristic of market-oriented economies. What would public enterprise be? Hint: It is a characteristic of command economies.
9
.
Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than the United States?
10.
Give the three reasons that explain why the division of labor increases an economy’s level of production.
11.
What are three reasons to study economics?
12.
What is the difference between microeconomics and macroeconomics?
13.
What are examples of individual economic agents?
14.
What are the three main goals of macroeconomics?
15.
How did John Maynard Keynes define economics?
16.
Are households primarily buyers or sellers in the goods and services market? In the labor market?
17.
Are firms primarily buyers or sellers in the goods and services market? In the labor market?
18.
What are the three ways that societies can organize themselves economically?
19.
What is globalization? How do you think it might have affected the economy over the past decade?
20.
Suppose you have a team of two workers: one is a baker and one is a chef. Explain why the kitchen can produce more meals in a given period of time if each worker specializes in what they do best than if each worker tries to do everything from appetizer to dessert.
21.
Why would division of labor without trade not work?
22.
Can you think of any examples of free goods, that is, goods or services that are not scarce?
23.
A balanced federal budget and a balance of trade are secondary goals of macroeconomics, while growth in the standard of living (for example) is a primary goal. Why do you think that is so?
24.
Macroeconomics is an aggregate of what happens at the microeconomic level. Would it be possible for what happens at the macro level to differ from how economic agents would react to some stimulus at the micro level? Hint: Think about the behavior of crowds.
25.
Why is it unfair or meaningless to criticize a theory as “unrealistic?”
26.
Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?
27.
Why do you think that most modern countries’ economies are a mix of command and market types?
28.
Can you think of ways that globalization has helped you economically? Can you think of ways that it has not?
Figure 2.1 Choices and Tradeoffs In general, the higher the degree, the higher the salary, so why aren’t more people pursuing higher degrees? The short answer: choices and tradeoffs. (Credit: modification of work by “Jim, the Photographer”/Flickr Creative Commons)
CHAPTER OBJECTIVES
In this chapter, you will learn about:
· How Individuals Make Choices Based on Their Budget Constraint
· The Production Possibilities Frontier and Social Choices
· Confronting Objections to the Economic Approach
BRING IT HOME
Choices … to What Degree?
In 2015, the median income for workers who hold master’s degrees varies from males to females. The average of the two is $2,951 weekly. Multiply this average by 52 weeks, and you get an average salary of $153,452. Compare that to the median weekly earnings for a full-time worker over 25 with no higher than a bachelor’s degree: $1,224 weekly and $63,648 a year. What about those with no higher than a high school diploma in 2015? They earn just $664 weekly and $34,528 over 12 months. In other words, says the Bureau of Labor Statistics (BLS), earning a bachelor’s degree boosted salaries 54% over what you would have earned if you had stopped your education after high school. A master’s degree yields a salary almost double that of a high school diploma.
Given these statistics, we might expect many people to choose to go to college and at least earn a bachelor’s degree. Assuming that people want to improve their material well-being, it seems like they would make those choices that provide them with the greatest opportunity to consume goods and services. As it turns out, the analysis is not nearly as simple as this. In fact, in 2014, the BLS reported that while almost 88% of the population in the United States had a high school diploma, only 33.6% of 25–65 year olds had bachelor’s degrees, and only 7.4% of 25–65 year olds in 2014 had earned a master’s.
This brings us to the subject of this chapter: why people make the choices they make and how economists explain those choices.
You will learn quickly when you examine the relationship between economics and scarcity that choices involve tradeoffs. Every choice has a cost.
In 1968, the Rolling Stones recorded “You Can’t Always Get What You Want.” Economists chuckled, because they had been singing a similar tune for decades. English economist Lionel Robbins (1898–1984), in his Essay on the Nature and Significance of Economic Science in 1932, described not always getting what you want in this way:
The time at our disposal is limited. There are only twenty-four hours in the day. We have to choose between the different uses to which they may be put. … Everywhere we turn, if we choose one thing we must relinquish others which, in different circumstances, we would wish not to have relinquished. Scarcity of means to satisfy given ends is an almost ubiquitous condition of human nature.
Because people live in a world of scarcity, they cannot have all the time, money, possessions, and experiences they wish. Neither can society.
This chapter will continue our discussion of scarcity and the economic way of thinking by first introducing three critical concepts: opportunity cost, marginal decision making, and diminishing returns. Later, it will consider whether the economic way of thinking accurately describes either how we make choices and how we should make them.
Learning Objectives
By the end of this section, you will be able to:
· Calculate and graph budget constraints
· Explain opportunity sets and opportunity costs
· Evaluate the law of diminishing marginal utility
· Explain how marginal analysis and utility influence choices
Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. We can see Alphonso’s budget problem in
Figure 2.2
.
Figure 2.2 The Budget Constraint: Alphonso’s Consumption Choice Opportunity Frontier Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10. The relative price of burgers and bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets.
The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers).
If we connect all the points between A and F, we get Alphonso’s budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount.
If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.
The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso.
The Concept of Opportunity Cost
Economists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more.
LINK IT UP
View this
website
for an example of opportunity cost—paying someone else to wait in line for you.
A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.
The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that we further explain in the appendix
The Use of Mathematics in Principles of Economics
.
WORK IT OUT
Understanding Budget Constraints
Budget constraints are easy to understand if you apply a little math. The appendix
The Use of Mathematics in Principles of Economics
explains all the math you are likely to need in this book. Therefore, if math is not your strength, you might want to take a look at the appendix.
Step 1: The equation for any budget constraint is:
Budget=P1 × Q1 + P2× Q2Budget=P1 × Q1 + P2× Q2
where P and Q are the price and quantity of items purchased (which we assume here to be two items) and Budget is the amount of income one has to spend.
Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be:
Budget$10 budget$10===P1× Q1+ P2× Q2$2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of bus tickets$2 × Qburgers + $0.50 × Qbus ticketsBudget=P1 × Q1 + P2× Q2$10 budget=$2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of bus tickets$10=$2 × Qburgers + $0.50 × Qbus tickets
Step 3. Using a little algebra, we can turn this into the familiar equation of a line:
y = b + mxy = b + mx
For Alphonso, this is:
$10 = $2 × Qburgers + $0.50 × Qbus tickets$10 = $2 × Qburgers + $0.50 × Qbus tickets
Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:
2 × 1020 = = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 4 × Qburgers + 1 × Qbus tickets2 × 10 = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 20 = 4 × Qburgers + 1 × Qbus tickets
Step 5. Subtract one bus ticket from both sides:
20 – Qbus tickets=4 × Qburgers20 – Qbus tickets = 4 × Qburgers
Divide each side by 4 to yield the answer:
5 – 0.25 × Qbus ticketsQburgers=or=Qburgers5 – 0.25 × Qbus tickets5 – 0.25 × Qbus tickets = QburgersorQburgers = 5 – 0.25 × Qbus tickets
Step 6. Notice that this equation fits the budget constraint in
Figure 2.2
. The vertical intercept is 5 and the slope is –0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results (see
Table 2.1
), which are the points on Alphonso’s budget constraint.
Point
Quantity of Burgers (at $2)
Quantity of Bus Tickets (at 50 cents)
A
5
0
B
4
4
C
3
8
D
2
12
E
1
16
F
0
20
Table2.1
Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is −0.25, indicating that for every bus ticket he buys, he must give up 1/4 burger. To phrase it differently, for every four tickets he buys, Alphonso must give up 1 burger.
There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, we define the slope as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case $0.50/$2 = 0.25. If you want to determine the opportunity cost quickly, just divide the two prices.
Identifying Opportunity Cost
In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.
For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.
CLEAR IT UP
What is the opportunity cost associated with increased airport security measures?
After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another $2 billion.
However, the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), there were 895.5 million systemwide (domestic and international) scheduled service passengers in 2015. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million × 0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending.
In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “$5 a day,” you might make different choices.
Marginal Decision-Making and Diminishing Marginal Utility
The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics.
We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on
Consumer Choices
, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. However, later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has a burger every single day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.
A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost. Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further. As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase. Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he won’t purchase more bus tickets once the marginal utility just equals the opportunity cost. While we can’t (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20.
Sunk Costs
In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.
Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.
For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.
From a Model with Two Goods to One of Many Goods
The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.
Learning Objectives
By the end of this section, you will be able to:
· Interpret production possibilities frontier graphs
· Contrast a budget constraint and a production possibilities frontier
· Explain the relationship between a production possibilities frontier and the law of diminishing returns
· Contrast productive efficiency and allocative efficiency
· Define comparative advantage
Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.
Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in
Figure 2.3
illustrates this situation.
Figure 2.3 A Healthcare vs. Education Production Possibilities Frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.
Figure 2.3
shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF.
Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonso’s budget constraint, the slope of the production possibilities frontier shows the opportunity cost. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature.
CLEAR IT UP
What’s the difference between a budget constraint and a PPF?
There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer, are fixed, so the slope doesn’t change. In contrast, the PPF has a curved shape because of the law of the diminishing returns. Thus, the slope is different at various points on the PPF. The second major difference is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available.
Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. We measure the additional education by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education.
The PPF and the Law of Increasing Opportunity Cost
The budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape?
To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.
The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.
This pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost.
The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.
Productive Efficiency and Allocative Efficiency
The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency.
Figure 2.4
illustrates these ideas using a production possibilities frontier between healthcare and education.
Figure 2.4 Productive and Allocative Efficiency Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires.
Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in
Figure 2.4
, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).
We can show the particular mix of goods and services produced—that is, the specific combination of selected healthcare and education along the production possibilities frontier—as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.
Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.
Why Society Must Choose
In
Welcome to Economics!
we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma.
Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.
The PPF and Comparative Advantage
While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in
Figure 2.5
.
Figure 2.5 Production Possibility Frontier for the U.S. and Brazil The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount than the U.S., at point B.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In the chapter on
International Trade
you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties.
Chapter 2
demand and Supply
All businesses perform essentially the same function—producing goods or services for sale in the market. Unfortunately, many businesses fail because managers sweat the day-to-day details while losing sight of the firm’s primary objective—maximizing shareholder value. A manager who becomes mired in the firm’s operational minutia and ignores market trends courts financial disaster.
In this chapter, we will examine how the interaction of buyers and sellers in competitive markets determine prices and availability of goods or services. The market mechanism discussed in this chapter makes several simplify- ing assumptions. We begin by assuming that the market consists of a large number of relatively small buyers and sellers with complete and symmetrical information. Since their respective contributions are very small, the decisions made by individual buyers or sellers have no effect on the market-determined price. In other words, individual buyers and sellers are said to be price takers.
dEMANd
A market is any arrangement that brings together buyers and sellers. The market demand curve is the horizontal summation of individual consum- ers’ demand curves.1 According to the law of demand, which pertains to market (not individual) demand, the quantity demanded of a good or service is inversely related to its price,
ceteris paribus
. This relationship is depicted as the downward-sloping demand curve in Figure 2.1. A decline in the market price of good x from P1 to P2, for example, results in an increase in quan-
tity demanded from Q1 to Q2. This relationship is described as a movement
along a stationary demand curve from point A to point B. At a basic level,
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Figure 2.1
the law of demand can be justified on the basis of common sense and simple observation.
Income and Substitution Effects
At a more subtle level, the law of demand reflects the income and substitu- tion effects of a buyer’s purchasing decisions. The income effect says that as a product’s price declines, a buyer’s real purchasing power increases. By contrast, an increase in prices reduces a buyer’s real income and purchasing power. We will have more to say about the relationship between changes in income and demand in the next section.
The substitution effect says that when there is no change in real purchas- ing power, an increase in the price of a good will cause buyers to unambigu- ously shift their purchases into a relatively less expensive substitutes. The substitution effect reflects changes in a consumer’s opportunity costs from the price change.
The income and substitution effects usually complement and reinforce each other. A price decline, for example, will have both positive income and substitution effects, in which case there is no question that the ordinary demand curve will be downward sloping. In some cases, however, a price decline will result in a negative income effect. Fortunately, the positive sub- stitution effect almost always dominates, which gives the demand curve its expected downward slope.
demand determinants
Demand and Supply 23
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)In addition to the price of the product, the market demand for a good or ser- vice depends on a variety of other factors, including money income, tastes and preferences, the prices of related goods, the number of consumer, price and income expectations, and so on. Factors other than the price of the good in question are collectively referred to as demand determinants.
Money Income
The most important limitation on a consumer’s ability to purchase a good or service is money income. An increase in consumers’ money income will increase the demand for most goods and services. This is shown in Figure 2.2 as a right-shift in the market demand curve from D1 to D2. Likewise, in most
cases a decrease in money income, such as would occur during an economic
downturn, results in fewer purchases and a left-shift of the demand curve (not shown). Such products are referred to as normal goods.
By contrast, the demand for an inferior good varies inversely with con- sumers’ money income. During an economic expansion, rising incomes, sales and profits, the market demand for the services of bankruptcy lawyers and accountants declines. This decline is depicted as a shift to the left of the market demand curve. Conversely, the market demand curve for bankruptcy services will shift to the right during economic downturns. Other types of
Figure 2.2
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inferior goods include the demand for automobile repair services and used cars as consumers postpone purchases of new cars during recessions.
Tastes and Preferences
Changes in consumer tastes will also shift the market demand curve. Although changes in fads and fashions can be difficult to predict, there is an entire industry devoted to manipulating consumer tastes and preferences— marketing, but especially advertising. Advertising is generally of two types—informative and persuasive. Informative advertising provides pro- spective consumers with information about new or existing products, such as the seemingly ubiquitous advertisements for the iPad “tablet” during 2010. Persuasive advertising attempts to boost sales by creating an image that may have little or nothing to do with the product’s physical characteristics. Persuasive advertising appeals to consumers’ emotions.
An increase in advertising-inspired purchases is depicted as a right-shift in the market demand curve. If consumers have a negative opinion, the demand curve will shift to the left. In recent years, for example, consum- ers’ concern about the health hazards of smoking has resulted in a dramatic decline in the demand for tobacco products in the United States. Many political candidates are notorious for running negative campaign ads against their opponents.
Prices of Related Goods
Changes in the prices of related goods also affect market demand. Related goods may be substitutes or complements. If two goods are substitutes in consumption, an increase in the price of good y will cause some consum- ers to shift their purchases into relatively less expensive good x. An increase in the price of Coca-Cola, for example, results in a decrease in the quantity demanded for Coca-Cola, but an increase in the demand by many consum- ers for relatively less expensive Pepsi Cola, Dr. Pepper, or fruit juices. Other examples of substitute goods include margarine and butter, coffee and tea, beer and ale, and laptop and tablet computers.
Figure 2.3 illustrates the effect of an increase in the price of good y on the demand for substitute good x. An increase in the price of good y results in a decrease in the quantity demand of good y, which is illustrated as a movement along the D curve from point A to point B. As the quantity demanded of good y falls, the demand for substitute good x increases. This is shown as a right-shift of the demand curve for good x from D1 to D2.
Analogously, a decrease in the price of good y leads to an increase in the
quantity demanded for good y and a left-shift of the demand curve for good x (not shown).
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Figure 2.3
Goods are complements in consumption if they are consumed together, such as tennis rackets and tennis balls, skis and ski boots, kites and kite string, and computers and software. If goods x and y are complements, a decrease in the price of good y results in an increase in the quantity demanded of good y, and an increase in the demand for good x. The increase in the price of good y results in a decrease in the demand for complementary good x, which shifts the demand curve for good x to the left. Conversely, a decrease in the price of good y results in an increase in the quantity demanded of good y and an increase in the demand for good x, which shifts the demand function for good x to the right.
Sales Taxes
Sales taxes also affect the demand for a good or service. A per-unit tax, for example, is a fixed tax (t) per unit purchased. Suppose that the price is $10 and local authorities impose a $1 per-unit sales tax. This effectively raises the price to $11. A consumer who buys 100 units pays $1,100, of which $100 is collected by the government. If the price is $20 and the consumer buys 100 units, the amount going to the vendor doubles, but there is no change in government sales tax revenues.
In general, imposing a per-unit tax increases the price to the buyer to P + t. Suppose that the inverse demand equation with the per-unit tax is P + t = a – bQ. After subtracting t from both sides this becomes P = (a – t) – bQ. Increasing a per-unit sales tax lowers the P-intercept, but leaves the slope of the demand equation unchanged. In other words, there is a parallel left-shift of the demand curve. Conversely, removing or reducing the tax results in a parallel right-shift of the demand curve.
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Alternatively, an ad valorem tax (from the Latin “according to value”) is expressed as a percentage (τ) of the purchase price. Suppose that the price is $10 and there is a 10 percent ad valorem tax. A consumer who purchases 100 units at a price of $10 pays (1.1 × $10) × 100 = $1,100, of which $100 is collected by the government. A consumer who purchases 100 units at a price of $20 pays (1.1 × $20) × 100 = $2,200. In this case, the revenues going to the vendor and the government both double.
Imposing an ad valorem tax increases the price to the buyer to (1 + τ)P. In this case, the inverse demand equation becomes (1 + τ)P = a – bQ. After dividing both sides by (1 + τ) this becomes P = a/(1 + τ) – [b/(1 + τ)]Q. Increasing an ad valorem tax not only lowers the P-intercept, but the quantity demanded becomes more sensitive to a price change. In other words, the demand curve shifts to the left and becomes flatter. Reducing an ad valorem tax causes the demand curve to shift to the right and become steeper.
Number of Consumers
The market demand curve for a good or a service is the sum of the demand curves of the individual consumers. Thus, an increase in the number of buy- ers will increase the consumer purchases and shift the market demand curve to the right. The flood of Mexican immigrants since the 1980s, for example, increased the demand for Mexican cuisine in the Southwest. Conversely, economic recession in the Rust Belt lowered demand for real estate, home and auto repair services, and so on. Shifts in the market demand curve also reflect demographic changes, such as the significant increase in demand for health care and other senior citizen services as World War II “baby boomers” enter their retirement years.
Consumer Expectations
A change in consumer expectations regarding market conditions tomorrow can affect the demand for goods and services today. Suppose, for example, that pharmaceutical investors come to believe that a drug company’s stock price is about to fall because of multimillion dollar law suit. To avoid getting caught “holding the bag,” investors will act on those expectations, thereby turning their beliefs into a reality. If prospective new car buyers believe that prices for this year’s models will be lowered in October as dealerships make room for next year’s model, the demand curve for new cars in September will shift to the left.
Summarizing, a change in the quantity demanded for a good or service in response to a change in its price is illustrated as a movement along a station- ary demand curve. A change in demand following a change in something other than price is depicted as a shift in the demand curve. Table 2.1 sum- marizes several of the demand shifts discussed in this section.
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)Demand and Supply 27
Table 2.1 Changes in Demand Determinants
Determinant Change
Demand Curve Shift
Income
Normal goods ↑
→
↓
←
Inferior goods ↑
←
↓
→
Tastes and preferences ↑
→
↓
←
Prices of related goods
Substitutes ↑
→
↓
←
Complements ↑
←
↓
→
Sales taxes ↑
←
↓
→
Population ↑
→
↓
←
Estimating the Market demand Equation
(
x
)The relationships discussed in the preceding sections are of little practical value to managers unless the demand for a firm’s good or service can be quantified. Suppose, for example, that the demand for good x (Q d) depends on its price (Px), per capita money income (M), and the price of a related good y (Py). Although the precise manner in which these variables are related may never be known with complete certainty, a useful first step is to assume a linear relationship of the form
Qd P M P . (2.1)
x 0 x x M y y
The hypothesized signs of the parameter values in Eq. (2.1) are βx < 0 by the law of demand, βM > 0 if x is normal, βM < 0 if good x is an inferior, βy > 0 if good y is a substitute, and βy < 0 if good y is a complement. Several statistical techniques are used to derive estimates of the coeffi- cients on the basis of empirical data.2 A statistical estimate of Eq. (2.1) will provide the manager with more precise information about how the company’s unit sales will be affected by changes in each of these hypothesized explana- tory variables. Expanding on ideas presented earlier, rewrite Eq. (2.1) as Qd B P , (2.2) x x x where B = β0 + βMM + βyPy. Solving for Px we obtain the inverse demand equation 28 Chapter 2 P B 1 Q . (2.3) ( ) ( ) ( x ) ( )x x x Suppose an economic recession results in a decline in money income. If x is a normal good (βM > 0), the result is a decline in the value of B and a shift to the left of the demand curve.
SOLvEd ExERCISE
The estimated demand equation for a popular brand of fruit juice is given by the equation
Qx 10 5Px 0.001M 10Py , (2.4)
where Qx is the per family monthly purchases in gallons, Px is the price per gallon of the fruit drink ($2.00), M is the median annual family income ($20,000), and Py is the price per gallon of a competing brand of fruit juice ($2.50).
a. Interpret the parameter estimates of Eq. (2.4).
b. What are estimated monthly, per family purchases (sales) of this brand of fruit juice?
c. Rewrite the Eq. (2.4) to resemble Eq. (2.3).
d. Suppose that median annual family income increases to $30,000. How does this change your answers to parts b and c?
Solution
a. A $1 increase in the price of this brand of fruit juice will result in a 5-gallon, per-family decline monthly purchases. A $1,000 increase in median annual family income will result in a 1 gallon increase in per- family, monthly purchases. Since a $1 increase in the price of the compet- ing brand results in a 10-gallon, per-family increase in monthly purchases of this brand, the two brands of fruit juices are substitute goods.
b. Substituting the indicated values into the demand equation yields
Qx 10 52 0.00120, 000 10 2.5 45gallons.
(2.5)
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c. Eq. (2.4) may be rewritten
Demand and Supply 29
Qx 55 5Px . (2.6)
d. The new monthly consumption of fruit drink is
Qx 10 52 0.00130, 000 10 2.5 55 gallons.
At the higher family income, Eq. (2.6) becomes
(2.7)
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Qx 65 5Px . (2.8)
Since the value of the horizontal intercept has increased from 55 to 65, the demand curve for this brand of fruit juice shifts to the right.
Consumer Surplus
A detailed understanding of the market demand for a good or service has several important business applications. In the next chapter, for example, the estimated demand equation will be used to identify the effect of a price change on the firm’s unit sales and total revenues. It can also be used to approximate the value that consumers receive from their purchases of goods and services. In Chapter 11 we will learn how managers can use this to for- mulate pricing strategies that enhance the firm’s bottom line.
Consumer surplus is the value that buyers received from the purchase of a good or service in excess of the amount paid. In order to explain what we mean by this, consider the demand curve depicted in Figure 2.4, which illus- trates the number of bottles of Gatorade that Joe will purchase after a game of softball on a hot summer day. Suppose in this thought experiment that Joe lives in a world populated only by truth tellers. After the game, Joe goes to his health club and orders a bottle of Gatorade. The health club does not have a menu of prices. Instead, each patron is asked to pay an amount equal to the value received from each bottle purchased. In keeping with this policy, Joe is asked how much a bottle is worth to him. Being very thirsty, Joe says that a bottle of Gatorade is worth $8, which is the amount that he pays.
After finishing his first bottle, Joe orders another. As before, Joe is asked how much the second bottle is worth to him. Not being as thirsty, Joe responds that he is willing to pay $6, $4 for the third bottle, and so on. If Joe stops after the third bottle, his total expenditures will be $18, which is precisely the value that Joe received from his purchases.
In a “perfect” world, a strategy of charging a price equal to the value of each unit consumed may be practical, but in the real world buyers have an incentive to understate the true value received so as to a lower price. For this
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Figure 2.4
reason, firms typically publish a menu of fixed prices. The buyer knows precisely how much each unit will cost before deciding how many units to purchase. Suppose that a bottle of Gatorade is $4. How many bottles will Joe buy, and how much will he spend?
According to the information provided in Figure 2.4, Joe will certainly purchase the first bottle because the $4 paid is greater than the $8 of value received. Joe will also buy a second bottle since he will receive $2 of value in excess of the price paid. Joe will even buy a third bottle because the amount paid is equal to the value received. Joe will not purchase a fourth bottle, however, since he would lose $2 in value. Joe has spent 3 × $4 = $12 for total value received value of $8 + $6 + $4 = $18. Joe’s consumer surplus of
$18 – $12 = $6 is illustrated by the shaded area in Figure 2.4.
In the above example, we assumed that Joe’s beer purchases were in discrete increments. Now, consider Figure 2.5, which represents the market demand for a good or service. If prices are infinitely divisible, consumer sur- plus is given by the shaded triangle P*AE. At a price of P*, the total value received from purchasing Q* units consumed is given by the area 0P*AEQ*. Total consumer expenditures is given by the area of the rectangle 0P*EQ*. Thus, consumer surplus is 0P*AEQ* – 0P*EQ* = P*AE. For a linear demand equation, consumer surplus can be calculated using the equation
(
2
)CS 1 A P* Q*. (2.9)
Figure 2.5
Demand and Supply 31
SOLvEd ExERCISE
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Suppose that a consumer’s inverse demand equation is
P 20 2Q. (2.10)
a. How many units will be purchased at a price is $6? What are the consum- ers’ total expenditures?
b. Calculate the consumer surplus.
c. How much total value is received by this consumer?
Solution
a. From Eq. (2.10), at a price of $6, this consumer will purchase 7 units and spend $6(7) = $42.
b. From Eq. (2.9), consumer surplus is CS = 0.5(20 – 6)7 = $49.
c. The total value received is equal to the amount paid plus the value of con- sumer surplus, which is $42 + $49 = $91.
SUPPLY
According to the law of supply, the quantity supplied of a good or service is directly related to a change in its market price, ceteris paribus. The market
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Figure 2.6
supply curve is the horizontal summation of the supply curves of the indi- vidual firms in an industry. This relationship is depicted in Figure 2.6. An increase in the market price of good x from P1 to P2 results in an increase in the quantity supplied from Q1 to Q2. This cause and effect relationship is depicted as a movement along the stationary supply curve from point A to point B. This is because an increase in the price of good x increases firms’ expected revenues and profits from its sale. To exploit these profit opportuni- ties, firms will increase the number of units offered for sale.
Supply determinants
A change in any factor that affects a firm’s bottom line will change the num- ber of units offered for sale. An increase in the market price will result in an increase in the quantity supplied of a good or service. This is illustrated as a movement along a stationary market supply curve. A change in any other factor that affects the firm’s profit will result in a shift in the market supply curve. These supply determinants include, among other things, input prices, production technology, taxes and government regulation, prices of related goods, and number of firms in the industry.
Input Prices
Other things being equal, a lower input price, such as might occur from a decline in energy prices, will reduce production costs and increase expected
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)Demand and Supply 33
profit. Firms will respond by increasing output at each price, which will shift the market supply curve to the right. Conversely, an increase in employee wages and benefits from a new collective bargaining agreement will increase production costs, lower expected profit, and cause the market supply curve to shift to the left (not shown).
Production Technology
We typically think of a firm’s production technology in terms of the eco- nomic capital (machinery, plant, equipment, and so on) used to inputs into outputs for sale in the market. In fact, production technology can also refer to the process by which managers organize production processes, such as improved inventory control and personnel management. Improved produc- tion technology implies that more output can be produced from given com- bination of inputs, or an unchanged amount of output can be produced using fewer inputs. In the first instance, this suggests an increase in revenues. In the second instance, this means a decrease in production costs. Either way, an improvement in production technology at fixed input and output prices suggests an increase in profits, which provided managers with an incentive to increase supply. This would be depicted as a right-shift of the supply curve.
Taxes and Government Regulation
The objective of the firm is to maximize shareholder value, which is related to after-tax profits. From a manager’s perspective, higher corporate taxes and mandated government regulations increase the firm’s cost of doing business and lower expected after-tax profit. Managers will respond by reducing out- put, causing the market supply curve to shift to the left. Conversely, lowering corporate taxes, receiving government subsidies, and removing costly regula- tions increase expected after-tax profits, encourage production and shift the market supply curve to the right.
Another type that affects industry supply is an excise tax, which is a tax on each unit sold. The difference between an excise tax and a sales tax is that an excise tax is levied on specific goods, whereas a sales tax is a general levy. Another difference is that excise taxes are collected from the supplier—not the consumer.
The manner in which excise taxes affect the supply curve depends on whether it is a per-unit tax or an ad valorem tax. Suppose, for example, that the government levies a $1 per-unit tax on a gallon of gasoline. This has the effect of shifting the supply curve up by the amount of the tax. This upward parallel shift results in a decline in supply. In a similar fashion, a reduction in a per-unit excise tax results in a downward parallel shift of the supply, which results in an increase in supply.
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Alternatively, the government could levy an ad valorem excise tax. Since the amount of the tax is greater at higher prices than at lower prices, the supply curve not shifts up and becomes steeper. As in the case of a per- unit tax, the imposition of the ad valorem excise tax results in a decrease in supply. In an analogous fashion, the supply curve shifts down and becomes flatter following a reduction in an ad valorem excise tax resulting in an increase in supply.
Prices of Related Goods
Changes in the prices of goods sharing the same resources can also affect supply. These related goods are may be substitutes or complements in production. Substitutes in production involve trade-offs in the produc- tion of two or more goods or services using the same production facilities, such as the choice of producing halogen light bulbs or compact fluorescent light (CFL) bulbs on the same assembly line. Other things being equal, an increase in the price of halogen light bulbs will cause managers to devote a greater share of the firm’s production capacity to its production, which reduce the assembly line time available to produce CFL bulbs. Thus, the higher price of halogen bulbs resulted in a decline in the supply of CFL bulbs.
Complements in production involve the joint production of two or more goods with the same production facilities. Cowhide, for example, is a by- product of beef production. An increase in the price of beef will result in an increase in the quantity supplied of beef and an increase in the supply of cowhide, even when there is no change in the price of cowhide leather.
Number of Firms
The market supply curve of a good or service is the sum of the supply curves of each individual firm in an industry. Thus, an increase in the number of firms will cause the market supply curve to shift to the right. In fact, any flow of new investment into the industry, perhaps because of the lure of above- normal profits, will increase market supply. Conversely, when investment flows out of an industry, the market supply curve will shift to the left.
Summary
A change in the quantity supplied of a product following a change in its market price is depicted as a movement along a stationary supply curve. A change in supply following a change in something other than the market price of the product is depicted as a shift in the entire supply curve. Table 2.2 sum- marizes the supply shifts discussed in this section.
Demand and Supply 35
Table 2.2 Changes in Supply Determinants
Determinant Change Supply Curve Shift
(
↓
) (
→
)Input prices ↑ ←
Technology ↑ →
(
↓
) (
→
)Taxes ↑ ←
Prices of related goods
(
↓
) (
→
)Substitutes ↑ ←
(
↓
) (
↓
) (
←
) (
←
)Complements ↑ →
Number of firms ↑ →
Producer Surplus
The analytical supply counterpart to consumer surplus is producer surplus, which is the difference between total revenues received from the sale of a good or service and the minimum needed to produce it. A firm’s supply curve reflects its marginal cost of production. A profit-maximizing firm will produce up to a level of output where marginal cost equals marginal revenue. A firm’s total variable cost is equal to the sum of the marginal cost of produc- ing each unit. Thus, producer surplus is equal to the firm’s operating profit, which is the difference between the firm’s total revenue and expenses relat- ing to a firm’s ongoing operations (total variable cost). This is not the same thing as the firm’s total (economic) profit, which is the difference between total revenue and total (economic) cost. A firm’s total cost is the sum of total variable and total fixed cost. On the other hand, if total fixed cost is “small,” producer surplus is a good approximation of the firm’s total profit.
Producer surplus for continuous prices is illustrated by the area of the shaded triangle in Figure 2.7. If the supply curve is linear, producer surplus equals
(
2
)PS 1 P* BQ*.
(2.11)
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A firm’s producer surplus can be particularly valuable information for a manager. A profit maximizing firm will produce up to the level of output where marginal cost equals marginal revenue, which is the extra revenue received from the next unit sold. This occurs in Figure 2.7 at the output level Q*. For every unit of output up to the last unit produced, P* = MR > MC. Thus, the shaded area represents the extra revenue received in excess of what the firm would have been willing to produce each unit up to Q*.
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Figure 2.7
Producer surplus tells managers the maximum amount the firm can save by bargaining with resources suppliers over price. For example, suppose that the manager of a construction company is negotiating with a supplier over the price of steel rods. If the manager of the construction company knows the supplier’s producer surplus, he or she also knows the minimum amount that the supplier would be willing to accept for the steel rods.
MARKET EQUILIBRIUM
We will now bring together the forces of demand and supply to explain how market price and output is determined. Figure 2.8 illustrates the con- cept of market equilibrium, which is the price (P*) where the quantity demanded (Qd) equals the quantity supplied (Qs). At prices below the equi- librium price, a shortage exists since the quantity demanded exceeds the quantity supplied. At this low price, consumers compete amongst them- selves to acquire the good or service that is in short supply. As consumers bid up the price, buyers who are unwilling or unable to pay the higher price will exit the market. At the same time, the higher price provides firms to an incentive to increase production. The increase in the quantity supplied coupled with the decrease in the quantity demanded as the price rises continues shortage is eliminated and a higher market-clearing price established.
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Figure 2.8
At prices above P*, the quantity supplied exceeds the quantity demanded. Managers will respond to the unsold output and a build-up of inventories by lowering price and reducing production to more sustainable levels. This pro- cess will continue until the quantity supplied equals the quantity demand at a lower market-clearing price.
NET SOCIAL WELFARE
Consumer surplus is the value received by consumers from purchases of a product in excess of their expenditures. Producer surplus is the amount received by firms from sales of a product in excess of the minimum amount that they would have accepted to make the product available. The sum of consumer surplus and producer surpluses is referred to as net social welfare, which is depicted in Figure 2.9 for a purely competitive market.
The demand curve is a measure of the marginal social benefit (MSB) of consuming an additional unit. The supply curve measures the marginal social cost (MSC) of increasing output by another unit. As long as MSB > MSC it pays for society to increase output. But, when MSC > MSB it is in society’s best interest to reduce output. Net national welfare is maximized at the level of output where MSB = MSC.
Net social welfare can be used as a measure of market efficiency. The greater the sum of consumer and producer surplus, the more socially beneficial
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Figure 2.9
is the market structure. In this chapter, we have restricted out discussion to purely competitive market structures, which is considered the ideal way to organize commercial activity because it maximizes net social welfare.
SOLvEd ExERCISE
Suppose that the inverse market demand and supply equations are
P 9 2Qd ; (2.12)
P 6 Qs . (2.13)
Calculate the value of net social welfare in this market.
Solution
Solving Eqs. (2.12) and (2.13), the market equilibrium price is P* = $7 and the equilibrium quantity is Q* = 1. The value of consumer surplus is CS = 0.5($9 − $7)1 = $1. The value of producer surplus is PS = 0.5($7 − $6) =
$0.5. Thus, the value of net social welfare is NSW = CS + PS = $1.50. This solution is depicted in Figure 2.10.
Figure 2.10
Demand and Supply 39
CHANGES IN dEMANd ANd SUPPLY: PRICE ANd OUTPUT dETERMINATION
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We will now analyze the effects of a change in demand and supply conditions on the market-clearing price and equilibrium output. We will begin by first considering the effects of a change in market demand.
demand Shifts
Suppose that medical research determines that eating cheeseburgers is healthy, which results in an increase in the demand for cheeseburgers. Other things being equal, this will cause the cheeseburger demand curve to shift to the right, as depicted in Figure 2.11. In a similar manner, if medical research demon- strates that cheeseburgers are unhealthy, the demand curve will shift to the left. In general, a right-shift of the demand curve with no change in supply will result in an increase in both the equilibrium price and quantity. Conversely, a left-shift of the demand curve will cause the equilibrium price and quantity
to fall.
Supply Shifts
Suppose that a decline in the price of cheese leads fast-food restaurants to expect higher profits from the sale of cheeseburgers. Other things being equal, profit-maximizing cheeseburger producers will increase output, which
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Figure 2.11
causes the supply curve to shift to the right, resulting in a decline in the equi- librium price and quantity. This is depicted in Figure 2.12.
Conversely, an increase in the price of cheese reduces expected profits resulting in a left-shift of the supply curve. This results in an increase in the equilibrium price and a decline in the equilibrium quantity. In general, a right-shift of the supply curve will result in a fall in the equilibrium price and an increase in the equilibrium quantity. Conversely, a left-shift of the supply curve will result in an increase in the equilibrium price and a decrease in the equilibrium quantity.
demand and Supply Shifts
A shift in either the demand curve or the supply curve will result in an unambiguous change in both the equilibrium price and quantity. These pre- dictable changes are summarized in the second column of Table 2.3. When both demand and supply change simultaneously, however, the effect on the market-clearing price and equilibrium quantity is more difficult to predict. The final outcome depends on how demand and supply change relative to each other. In the absence of such information, all we can say is that there will be an unambiguous change in either the equilibrium price or quantity, but an ambiguous change in the other.
To appreciate the difficulty associated with predicting equilibrium price and quantity changes when demand and supply changes, consider Case 1
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Figure 2.12
Table 2.3 Changes in Demand and Supply Determinants
Case
Separately
Together
1
D↑ → P↑ and Q↑
S↑ → P↓ and Q↑
P? (ambiguous)
Q↑ (unambiguous)
2
D↑ → P↑ and Q↑
S↓ → P↑ and Q↓
P↑(unambiguous)
Q? (ambiguous)
3
D↓ → P↓ and Q↓
S↑ → P↓ and Q↑
P↓ (unambiguous)
Q? (ambiguous)
4
D↓ → P↓ and Q↓
S↓ → P↑ and Q↓
P? (ambiguous)
Q↓ (unambiguous)
in Table 2.3, which summarizes the effects of an increase in both demand (D↑) and supply (S↑). The second column of the table tells us what will happen when demand and supply change separately. An increase in demand alone results in an increase in both the equilibrium price and quantity, which is illustrated in Figure 2.11. An increase in supply alone results in a decrease in the equilibrium price and an increase in the equilibrium quantity, which is depicted in Figure 2.12. When demand and supply increase together, how- ever, the analysis becomes a bit more complicated.
As we have seen, an increase in demand and supply both result in an unambiguous increase in the equilibrium quantity. On the other hand, an increase in demand causes the equilibrium price to rise while an increase in
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supply causes the equilibrium price to fall. In the first instance there is upward pressure on price, while in the second instance there is downward pressure on price. In the absence of additional information, it is not possible to know whether the demand-side or supply-side effect dominates, in which case the effect on the equilibrium price is ambiguous.
SOLvEd ExERCISE
The marketing department of The Great Bombay Tea Company has estimated the weekly demand for its brand of gourmet pizza as
Q 500 100P 50I 20Py 30 A, (2.14)
where Q is the number of pizzas (000’s), P is the market-determined price of Bombay’s pizza, I is weekly per capita income, Py is the price of the brand of pizza sold by Universal Foods, Inc., and A is Bombay’s weekly advertising expenditures ($000’s). The supply equation for Bombay’s gourmet pizza is
Q 1,800 450P. (2.15)
a. What is the relationship between Bombay’s pizza and Universal’s pizza?
b. Suppose that I = $200, Py = $20 and A = $100. What is the equilibrium price and quantity of Bombay pizza?
c. Suppose that Bombay’s chief economist predicts that the current economic expansion will increase weekly per capita income to $255. What effect will this have on the equilibrium price and quantity?
d. Based on your answer to part c, how would you characterize Bombay’s pizza?
Solution
a. Since a $1 increase in the price of Universal pizza results in a 20 thousand unit weekly increase in Bombay pizza sales, the two brands of pizza are substitutes.
b. Substituting these values into the demand equation yields
Q 13, 900 100P. (2.16)
The equilibrium price and quantity are P* = $22 and Q* = 11,700.
c. At the higher per capita income, the demand equation becomes
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Q 16,650 100P. (2.17)
Equating this new demand with supply, the equilibrium price and quantity are P* = $27 and Q* = 13,950. The increase in per capita income has resulted in a higher market-clearing price and equilibrium quantity.
d. An increase in per capita income resulted in an increase in the demand for Bombay’s pizza. This was depicted as a right-shift of the demand curve. Bombay pizza can be characterized as a normal good.
RATIONING FUNCTION OF PRICES
How realistic is the assumption of market equilibrium? Markets are con- tinually buffeted by changes in demand and supply conditions. Temporary shortages and surpluses resulting from unexpected market disturbances are inevitable. The remarkable thing about unfettered markets is the speed at which market equilibrium is reestablished following a demand-side or supply-side shock. This fact should reinforce our faith in the underlying logic and stability of the free-market process.
When prices are “too low” and shortages result, competition among con- sumers will push up prices. Consumers who are unable or unwilling to pay the higher price drop out of the market. At the same time, higher prices are an incentive for firms to increase supply. Eventually, the shortage is eliminated and market equilibrium is reestablished. On the other hand, when prices are too high, there is a surplus of unsold goods. Firms will respond by lowering prices to dispose of excess inventory and reduce output to more sustainable levels. Consumers who were previously unwilling or unable to pay a higher price will be drawn into the market until the surplus is eliminated. This pro- cess by which changes in market-determined prices eliminate shortages and surpluses is referred to as the rationing function of prices. The essence of a decentralized free market is that impersonal changes in prices ultimately determines who gets what and how much.
The rationing function of prices underscores the notion of scarcity. Eco- nomically well-to-do consumers have a greater command over available goods and services than consumers of more modest means. This inevitably leads to complaints by some consumers who cannot afford to pay that the market-determined price is “unfair.” The fact that an individual may not be able to afford a Bentley or a private island is not a problem of fairness, but a problem of limited resources. Still, this does not dissuade some individuals who believe that market outcomes are pernicious from seeking redress through other means, such as the political process.
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Price Ceilings
While price rationing is fundamental to the market mechanism, it is not the only way to allocate scarce goods and services. At various times, and for vari- ous reasons, governments have short-circuited the price rationing function of markets by imposing a price ceiling, which is the maximum legal price that a firm can charge for its product.
To be effective, a price ceiling must be set below the market equilibrium price to prevent prices from rising. An example of a price ceiling is rent control. The political objective of rent control is to provide low-cost housing to low-income voters. The problem with price ceilings is that they create artificial shortages that are likely to persist and become worse over time. Moreover, price ceilings are socially inefficient because they result in a misallocation of resources. To understand what is involved, consider the situation depicted in Figure 2.13.
Suppose, initially, that the equilibrium price and quantity in Figure 2.13 is P* and Q*, respectively. Net social welfare, which is a measure of market effi- ciency, is the sum of consumer surplus and producer surplus. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e + f. Thus, net social welfare is given by the area a + b + c + d + e + f. Now, suppose that government imposes a price ceiling of Pc, which creates a shortage in the market of Qs − Qd. The imposition of the price ceiling reduces producer surplus to area f. Area d is the amount transferred from producers to consumers who are paying less than the full value of the last unit consumed (PF).
Figure 2.13
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The total value received by consumers from Qs units of output is given by the area a + b + d + f + g. Consumer expenditures are given by the area f + g. Thus, consumer surplus under the price ceiling is the area a + b + d. Net social welfare is now a + b + d + f. The change in net social welfare from the imposi- tion of the price ceiling is (a + b + d + f) − (a + b + c + d + e + f) = − c − e. While consumers who have been able to acquire the product at a lower price have benefitted, the loss to consumers as a whole is −c, which is referred to as consumer deadweight loss. The loss to society as a whole from the misalloca- tion of resources and a less than optimal amount of the product being supplied is given by the area −e, which is referred to as producer deadweight loss. The sum of consumer and producer deadweight loss, which is called total dead- weight loss, is given by the shaded area in Figure 2.13. Total deadweight loss is a measure of the lost net social welfare that results from the price ceiling.
Alternatively, MSB > MSC at the output level QS. In this market “too little” rental housing is supplied at the price ceiling. Society is made better off by allowing the market-clearing price to rise to P*. Moreover, freed from the economic shackles of rent control, new construction will shift the supply curve to the right, which puts downward pressure on rents.
When the price rationing mechanism of the free market is not permitted to operate, some non-price rationing mechanism must be used to allocate products that are in short supply. The most common of these non-price ration- ing mechanisms is queuing. Standing line for sometimes hours on end was how gasoline was rationed after the U.S. Congress enacted a 57¢ per gallon price ceiling following the embargo of crude oil shipments to the U.S. in 1973–1974 by Organization of Petroleum Exporting Countries (OPEC).
(
x
)Without the price ceiling, lines at gasoline stations would have disappeared overnight as higher prices would have equated the quantities demanded and supplied. Higher gasoline prices, however, would have jeopardized the reelection prospects of many members of Congress, and so the price at the pump was kept low. The full economic price of gasoline, which included the opportunity cost of waiting in line for hours on end, however, was much higher. In Figure 2.13, the full economic price is PF , which is equal to the
price ceiling plus the opportunity cost of waiting in line PF PC . The differ-
x x
ence between the full economic price and the price ceiling is the amount that consumers would be willing to pay to avoid waiting in line.
SOLvEd ExERCISE
The market demand and supply equations for a product are
Qd 300 3P; (2.18)
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Qs 100 5P. (2.19)
a. Calculate the equilibrium price and quantity for this product?
b. Suppose that an increase in consumer income increases demand to
Qd 420 3P. (2.20)
What are the new equilibrium price and quantity for this product? What is the value of net social welfare as a result of the increase in demand?
c. What is the value of net social welfare as a result of the increase in demand?
d. Suppose that the government imposes a price ceiling that is equal to the original equilibrium price. What is the result of this legislation?
e. Calculate the change in the value of net social welfare after the imposition of the price ceiling.
Solution
a. Solving Eqs. (2.18) and (2.19), the equilibrium price is P* = $50. Sub- stituting this price into the demand or supply equation and solving, the equilibrium quantity is Q* = 150 units of output.
b. Solving Eqs. (2.18) and (2.20), the new equilibrium price is P* = $65 and the equilibrium quantity is Q* = 225 units of output. This new situation is depicted in the following Figure 2.14.
Figure 2.14
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c. As a result of the increase in demand, consumer surplus is CS = 0.5(140
– 65)225 = $8,437.50. The value of producer surplus is PS = 0.5(65 − 20)225 = $5,062.50. Thus, the value of net social welfare before the price ceiling is NSW = CS +PS = $13,500.
d. At the ceiling price of Pc = $50, the quantity demanded is Qd = 270 units and the quantity supplied is Qs = 150 units. The price ceiling creates a shortage of Qd − Qs = 120 units of output.
e. After the imposition of the price ceiling, the value of consumer surplus is CS = 0.5(140 − 90)150 + (90 − 50)150 = $9,750. The value of producer surplus after the price ceiling is PS = 0.5(50 − 20)150 = $2,250. The value of net social welfare is NSW = CS +PS = $12,000. This is given by the shaded area in Figure 2.14. The imposition of the price ceiling has reduced net national welfare by $1,500.
Price Floors
The counterpart of a price ceiling is a price floor, which is the minimum legal price that a supplier can expect for its product. To be effective a price floor must be set above the market determined price of the product. Notable examples of prices floors are agricultural price supports and minimum wages. An example of the social welfare effect of a price floor is depicted in Figure 2.15. Suppose that the market for cheese is initially in equilibrium at
Figure 2.15
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P* and Q*. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e. Thus, net social welfare is given by the area a + b + c + d + e.
Now, suppose the government announces that it will guarantee cheese manufacturers a minimum price of Pf. The effect of the price floor is to create a market surplus of Qs − Qd. In the case, consumer surplus is given by area a. Producer surplus is given by the area b + c + d + e + g. Together, the sum of consumer and producer surplus is a + b + c + d + e + g. While it might appear that society has been made better off as a result of cheese price supports, this is not the end of the story.
There are several ways that federal government can administer an agricultural price support. One way is for the government to purchase the surplus at a cost to taxpayers of c + e + f + g + h + i. So far, net social welfare is (a + b + c + d + e + g) − (c + e + f + g + h + i) = a + b + d − f − h − i. The final outcome depends on what the government does with the surplus cheese. If the government distributes the cheese to low-income families free of charge, consumers receive value in the amount of the area c + e + f + i. Thus, the final outcome is net social welfare of (a + b + d − e − f − h − i) + (c + e + f + h + i) = a + b + c + d + e − h. National welfare is reduced by the area − h, which represents the amount of deadweight loss to society. Since the change in net social welfare is unambiguously negative, society has been made worse from the price floor.
Alternatively, MSC > MSB at the output level QS. In this market, “too much” cheese is being supplied at the price floor. Society will be made better off by allowing prices to fall to its market-clearing P*. Allowing the market mechanism to ration excess supply will eliminate the deadweight loss given by area h.
Another example of a price floor occurs in the labor market when the government enacts minimum-wage legislation, ostensibly to provide unskilled and uneducated workers with a “living wage.” Although government can mandate a higher minimum wage, in a free market it cannot force employ- ers to hire workers whose productivity is valued below the minimum wage. A profit-maximizing firm will not hire a worker if the addition to the firm’s revenues is less than the minimum wage paid. The result is a surplus of unskilled and uneducated workers and a loss of social welfare. To make mat- ters worse, a legal minimum wage makes it difficult for low-skilled workers to obtain work experience and on-the-job training that will enable them to command higher wages in the future. Society in general suffers because higher unemployment is associated with an increase in the crime rate. Tax- payers are made worse off because payroll taxes fund unemployment insur- ance and welfare payments.
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)Demand and Supply 49
SOLvEd ExERCISE
Consider the following demand and supply equations for the product of a perfectly competitive industry:
Qd 25 3P; (2.21)
Qs 10 2P. (2.22)
a. What is the equilibrium price and quantity in this market?
b. Suppose that government enacts a “price floor” on this product of P = $4. What is the result of this legislation?
Solution
a. Solving Eqs. (2.28) and (2.29), the equilibrium price and quantity are P*
= $3 and Q* = 16 units of output.
b. At P = $4, the quantity demanded is Qd = 13 units of output and the quan- tity supplied is Qs = 18 units of output. As a result of the price floor there is a surplus of 5 units of output.
ALLOCATING FUNCTION OF PRICES
An examination of the price-rationing mechanism of individual markets is called partial equilibrium analysis. By contrast, general equilibrium analy- sis is concerned with the simultaneous determination of equilibrium in all markets. General equilibrium analysis examines the process whereby a dis- turbance in one sector of a market economy is transmitted to other sectors of the economy and the resulting reallocation of productive resources.
The prices of final goods and services reflect changes in a variety of demand determinants, including consumer tastes and preferences. Since the demand for productive resources is derived from the demand for final goods and services, producers use price information to reallocate inputs from lower to higher valued uses. This process is referred to as the allocating function of prices. To see how this works, consider an increase in the demand for restaurant meals, which leads to an increase in prices and industry profits.3 As a result, new capital investment flows into the restaurant and hospitality industry, which increases the demand for servers, chefs, and so on, thereby pushing up wages and benefits. This acts as a magnet for displaced workers, workers experiencing cuts in wages and benefits, and investment capital from contracting industries.
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)50 Chapter 2
Benjamin Franklin warned the signers of the American Declaration of Independence from Great Britain that “We must all hang together, or assur- edly we will all hang separately.” In a way, this admonition underscores the important role of managers in identifying emerging market trends. It is often said that in economics everything hangs together. Changes in consumer demand for seemingly unrelated goods and services may produce ripple effects that could threaten a company’s survival, or they may create new and promising profit opportunities.
CHAPTER ExERCISES
2.1 In recent years there has been a sharp increase in commercial and rec- reational fishing in the waters around Long Island. Illustrate the effect of “over fishing” on inflation-adjusted seafood prices at Long Island area restaurants.
2.2 New York City is a global financial center. In the late-1990s the financial and residential real estate markets reached record-high price levels. Are these markets related? Explain.
2.3 Large labor unions always support higher minimum-wage legislation even though no union maker earns just the minimum wage. Explain.
2.4 Discuss the effect of a frost in Florida, which damaged a significant portion of the orange crop, on each of the following.
a. Price of Florida oranges
b. Price of California oranges
c. Price of tangerines
d. Price of orange juice
e. Price of apple juice
2.5 What is consumer surplus and producer surplus? How can these con- cepts be used to evaluate changes in market efficiency?
2.6 Discuss the effect of an imposition of a wine import tariff on the price of California wine.
2.7 The market demand for Brand x has been estimated as:
Qd 1, 500 3P 0.05M 2.5P 7.5P ,
x x y z
where Px is the price of Brand x, M per capita income, Py the price of Brand y, and Pz the price of Brand z. Assume that Px = $2, M = $20,000, Py = $4, and Pz = $4.
a. With respect to changes in per capita income, what kind of good
is Brand x?
b. How are Brands x and y related?
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)Demand and Supply 51
c. How are Brands x and z related?
d. How are Brands z and y related?
e. What is the market demand for Brand x?
2.8 Yell-O Yew-Boats, Ltd. produces Blue Meanies. Consider the demand and supply equations for Blue Meanies:
Qd 150 2P 0.001M 1.5P ;
x x y
Qs 60 4P 2.5W ,
x x
where Qx is monthly per family consumption of Blue Meanies, Px the price per unit of Blue Meanies, M median annual per family income ($25,000), Py the price per unit of Apple Bonkers ($5.00) and W the hourly per worker wage rate ($8.60).
a. What type of good is Apple Bonkers?
b. What are the equilibrium price and quantity of Blue Meanies?
c. Suppose that median per family income increases by $6,000. What are the new equilibrium price and quantity of Blue Meanies?
d. Suppose that in addition to the increase in median per family income, collective bargaining by Blue Meanie Local # 1 results in a $2.40 hourly increase in the wage rate. What are the new equilib- rium price and quantity?
e. In a same diagram, illustrate your answers to parts b, c, and d.
2.9 Consider the following demand and supply equations for sugar:
Qd 1, 000 1, 000P;
Qs 800 1, 000P.
P is the price of sugar per pound and Q is the quantity of sugar in thousands of pounds.
a. What are the equilibrium price and quantity for sugar?
b. What is the value of net social welfare in this market?
c. Suppose that the government subsidizes sugar production by placing a price floor of $0.20 per pound. What is the relationship between the quantity supplied and quantity demand for sugar?
d. What is the effect on social welfare as a result of the price floor?
2.10 Occidental Pacific University is a large private university in California that is known for its strong athletics program, especially in football. At the request of the Dean of the College of Arts & Sciences, a professor
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)52 Chapter 2
from the economics department estimated that student demand for student enrollment at the university is
Qd 5, 000 0.5P 0.1M 0.25P ,
x x y
where Qx is the number of full-time students, Px tuition charged full- time students per semester, M national income ($ billions), and Py tuition charged full-time students per semester by Oriental Atlantic University in Maryland, Occidental’s closest competitor on the grid iron.
a. Suppose that full-time enrollment at Occidental is 4,000 students. If M = $7,500 and Py = $6,000, how much tuition is Occidental charging its full-time students?
b. The administration is considering a promotional campaign designed to bolster admissions and tuition revenues. The cost of the cam- paign will be $750,000. The economics professor believes that the promotional campaign will increase demand to
Qd 5,100 0.45P 0.1M 0.25P .
x x y
If the economic professor is correct, forecast Occidental’s full-time enrollment?
c. Assuming no change in real GDP or full-time tuition charged by Oriental, will the promotional campaign be effective? (Hint: Com- pare Occidental’s tuition revenues before and after the promotional campaign.)
d. The director of Occidental’s athletic department claims that the increase in enrollment resulted from the football team’s NCAA Division I national championship. Is this claim reasonable? How would it show up in the new demand equation?
2.11 The market demand and supply equations for a good are:
Qd 50 10P;
Qs 20 2.5P.
a. What is the equilibrium price and equilibrium quantity?
b. What is the value of net social welfare?
c. What is the effect on net social welfare if the government imposes a price ceiling of $3.00?
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)Demand and Supply 53
NOTES
1. The word “horizontal” indicates that the market quantity demanded is the sum of the quantities demanded by individual consumers along the horizontal axis.
2. A brief discussion of ordinary least squares regression analysis, which is used to generate parameter estimates of equations in linear form on the basis of historical data, is presented in the Appendix.
3. In 1970, Americans spent about $6 billion on fast food. By 2000, this had increased to more than $110 billion. The reason was principally economic. After peaking in1973, the hourly wage in the U.S. declined steadily for the next twenty-five years. Housewives responded by entering the workforce in record numbers, which resulted in a dramatic increase in the demand for such services as cooking, cleaning, and child care. A generation earlier, three-quarters of the family budget allocated for food was used to prepare meals at home. By 2000, about half the family budget was spent dining out, mainly at fast-food restaurants. Americans now spend more money on fast food than on higher education, personal computers, computer software, or new cars, and more on movies, books, magazines, newspapers, videos, and recorded music combined.
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)
Learning Objectives
By the end of this section, you will be able to:
· Explain demand, quantity demanded, and the law of demand
· Identify a demand curve and a supply curve
· Explain supply, quantity supplied, and the law of supply
· Explain equilibrium, equilibrium price, and equilibrium quantity
First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won’t buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter.
What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.
We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as
Table 3.1
, a demand schedule. In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like
Figure 3.2
, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)
Table 3.1
shows the demand schedule and the graph in
Figure 3.2
shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.
Price (per gallon)
Quantity Demanded (millions of gallons)
$1.00
800
$1.20
700
$1.40
600
$1.60
550
$1.80
500
$2.00
460
$2.20
420
Table3.1 Price and Quantity Demanded of Gasoline
Figure 3.2 A Demand Curve for Gasoline The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.
Confused about these different types of demand? Read the next Clear It Up feature.
CLEAR IT UP
Is demand the same as quantity demanded?
In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.
Still unsure about the different types of supply? See the following Clear It Up feature.
CLEAR IT UP
Is supply the same as quantity supplied?
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.
Figure 3.3
illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like
Table 3.2
, that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
Figure 3.3 A Supply Curve for Gasoline The supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa.
Price (per gallon)
Quantity Supplied (millions of gallons)
$1.00
500
$1.20
550
$1.40
600
$1.60
640
$1.80
680
$2.00
700
$2.20
720
Table3.2 Price and Supply of Gasoline
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
Equilibrium—Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.
Figure 3.4
illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to
Figure 3.2
. The supply curve (S) is identical to
Figure 3.3
.
Table 3.3
contains the same information in tabular form.
Figure 3.4 Demand and Supply for Gasoline The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Price (per gallon)
Quantity demanded (millions of gallons)
Quantity supplied (millions of gallons)
$1.00
800
500
$1.20
700
550
$1.40
600
600
$1.60
550
640
$1.80
500
680
$2.00
460
700
$2.20
420
720
Table3.3 Price, Quantity Demanded, and Quantity Supplied
Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in
Figure 3.4
, is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.
In
Figure 3.4
, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.
The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in
Figure 3.4
illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.
Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in
Figure 3.4
shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.
When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read
Demand, Supply, and Efficiency
for more discussion on the importance of the demand and supply model.
Learning Objectives
By the end of this section, you will be able to:
· Identify factors that affect demand
· Graph demand curves and demand shifts
· Identify factors that affect supply
· Graph supply curves and supply shifts
The previous module explored how price affects the quantity demanded and the quantity supplied. The result was the demand curve and the supply curve. Price, however, is not the only factor that influences buyers’ and sellers’ decisions. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? How is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence demand or supply?
LINK IT UP
Visit this
website
to read a brief note on how marketing strategies can influence supply and demand of products.
What Factors Affect Demand?
We defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors that affect demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.
These factors matter for both individual and market demand as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.
The Ceteris Paribus Assumption
A demand curve or a supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as the following Clear It Up feature shows.
CLEAR IT UP
When does ceteris paribus apply?
We typically apply ceteris paribus when we observe how changes in price affect demand or supply, but we can apply ceteris paribus more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumer’s demand depends on income and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.
How Does Income Affect Demand?
Let’s use income as an example of how factors other than price affect demand.
Figure 3.5
shows the initial demand for automobiles as D0. At point Q, for example, if the price is $20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?
Return to
Figure 3.5
. The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand.
Table 3.4
shows clearly that this increased demand would occur at every price, not just the original one.
Figure 3.5 Shifts in Demand: A Car Example Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.
Price
Decrease to D2
Original Quantity Demanded D0
Increase to D1
$16,000
17.6 million
22.0 million
24.0 million
$18,000
16.0 million
20.0 million
22.0 million
$20,000
14.4 million
18.0 million
20.0 million
$22,000
13.6 million
17.0 million
19.0 million
$24,000
13.2 million
16.5 million
18.5 million
$26,000
12.8 million
16.0 million
18.0 million
Table3.4 Price and Demand Shifts: A Car Example
Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of $20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.
In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.
Other Factors That Shift Demand Curves
Income is not the only factor that causes a shift in demand. Other factors that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.
Changing Tastes or Preferences
From 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.
Changes in the Composition of the Population
The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Changes in the Prices of Related Goods
Changes in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning we often use the goods together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.
Changes in Expectations about Future Prices or Other Factors that Affect Demand
While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. The following Work It Out feature shows how this happens.
WORK IT OUT
Shift in Demand
A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is an example of a shift in demand due to an income increase.
Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. See an example in
Figure 3.6
.
Figure 3.6 Demand Curve We can use the demand curve to identify how much consumers would buy at any given price.
Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1.
Figure 3.7
provides an example.
Figure 3.7 Demand Curve with Income Increase With an increase in income, consumers will purchase larger quantities, pushing demand to the right.
Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as
Figure 3.8
illustrates.
Figure 3.8 Demand Curve Shifted Right With an increase in income, consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right.
Summing Up Factors That Change Demand
Figure 3.9
summarizes six factors that can shift demand curves. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.
Figure 3.9 Factors That Shift Demand Curves (a) A list of factors that can cause an increase in demand from D0 to D1. (b) The same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1.
When a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. We are, however, getting ahead of our story. Before discussing how changes in demand can affect equilibrium price and quantity, we first need to discuss shifts in supply curves.
How Production Costs Affect Supply
A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as we described a shift in demand as a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. We can show this by the supply curve shifting to the right.
Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.
Consider the supply for cars, shown by curve S0 in
Figure 3.10
. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. We can show the same information in table form, as in
Table 3.5
.
Figure 3.10 Shifts in Supply: A Car Example Decreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.
Price
Decrease to S1
Original Quantity Supplied S0
Increase to S2
$16,000
10.5 million
12.0 million
13.2 million
$18,000
13.5 million
15.0 million
16.5 million
$20,000
16.5 million
18.0 million
19.8 million
$22,000
18.5 million
20.0 million
22.0 million
$24,000
19.5 million
21.0 million
23.1 million
$26,000
20.5 million
22.0 million
24.2 million
Table3.5 Price and Shifts in Supply: A Car Example
Now, imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.
Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.
Changes in weather and climate will affect the cost of production for many agricultural products. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country’s wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied. Conversely, especially good weather would shift the supply curve to the right.
When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. The following Work It Out feature shows how this shift happens.
WORK IT OUT
Shift in Supply
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase. (We’ll introduce some other concepts regarding firm decision-making in Chapters 7 and 8.)
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses.
Figure 3.11
provides an example.
Figure 3.11 Supply Curve You can use a supply curve to show the minimum price a firm will accept to produce a given quantity of output.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the cost of producing pizzas at the margin; in this case, the cost of producing the pizza, including cost of ingredients (e.g., dough, sauce, cheese, and pepperoni), the cost of the pizza oven, the shop rent, and the workers’ wages. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. (Desired profit is not necessarily the same as economic profit, which will be explained in Chapter 7.) If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as
Figure 3.12
illustrates.
Figure 3.12 Setting Prices The cost of production and the desired profit equal the price a firm will set for a product.
Step 3. Now, suppose that the cost of production increases. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as
Figure 3.13
shows.
Figure 3.13 Increasing Costs Leads to Increasing Price Because the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.
Step 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as
Figure 3.14
illustrates.
Figure 3.14 Supply Curve Shifts When the cost of production increases, the supply curve shifts upwardly to a new price level.
Summing Up Factors That Change Supply
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
Figure 3.15
summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Figure 3.15 Factors That Shift Supply Curves (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. We include factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.
Learning Objectives
By the end of this section, you will be able to:
· Identify equilibrium price and quantity through the four-step process
· Graph equilibrium price and quantity
· Contrast shifts of demand or supply and movements along a demand or supply curve
· Graph demand and supply curves, including equilibrium price and quantity, based on real-world examples
Let’s begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.
Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.
Step 2. Decide whether the economic change you are analyzing affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?
Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?
Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.
Let’s consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.
Good Weather for Salmon Fishing
Supposed that during the summer of 2015, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon?
Figure 3.16
illustrates the four-step approach, which we explain below, to work through this problem.
Table 3.6
also provides the information to work the problem.
Figure 3.16 Good Weather for Salmon Fishing: The Four-Step Process Unusually good weather leads to changes in the price and quantity of salmon.
Price per Pound
Quantity Supplied in 2014
Quantity Supplied in 2015
Quantity Demanded
$2.00
80
400
840
$2.25
120
480
680
$2.50
160
550
550
$2.75
200
600
450
$3.00
230
640
350
$3.25
250
670
250
$3.50
270
700
200
Table3.6 Salmon Fishing
Step 1. Draw a demand and supply model to illustrate the market for salmon in the year before the good weather conditions began. The demand curve D0 and the supply curve S0 show that the original equilibrium price is $3.25 per pound and the original equilibrium quantity is 250,000 fish. (This price per pound is what commercial buyers pay at the fishing docks. What consumers pay at the grocery is higher.)
Step 2. Did the economic event affect supply or demand? Good weather is an example of a natural condition that affects supply.
Step 3. Was the effect on supply an increase or a decrease? Good weather is a change in natural conditions that increases the quantity supplied at any given price. The supply curve shifts to the right, moving from the original supply curve S0 to the new supply curve S1, which
Figure 3.16
and
Table 3.6
show.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium. At the new equilibrium E1, the equilibrium price falls from $3.25 to $2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.
In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.
Newspapers and the Internet
According to the Pew Research Center for People and the Press, increasingly more people, especially younger people, are obtaining their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to access the news. From 2004 to 2012, the share of Americans who reported obtaining their news from digital sources increased from 24% to 39%. How has this affected consumption of print news media, and radio and television news?
Figure 3.17
and the text below illustrates using the four-step analysis to answer this question.
Figure 3.17 The Print News Market: A Four-Step Analysis A change in tastes from print news sources to digital sources results in a leftward shift in demand for the former. The result is a decrease in both equilibrium price and quantity.
Step 1. Develop a demand and supply model to think about what the market looked like before the event. The demand curve D0 and the supply curve S0 show the original relationships. In this case, we perform the analysis without specific numbers on the price and quantity axis.
Step 2. Did the described change affect supply or demand? A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former.
Step 3. Was the effect on demand positive or negative? A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they received their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans obtaining their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own over the last 15 years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not obtain their news from television at all?
The Interconnections and Speed of Adjustment in Real Markets
In the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.
Moreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.
A Combined Example
The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service?
Figure 3.18
and the text below illustrate this using the four-step analysis to answer this question.
Figure 3.18 Higher Compensation for Postal Workers: A Four-Step Analysis (a) Higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.
Since this problem involves two disturbances, we need two four-step analyses, the first to analyze the effects of higher compensation for postal workers, the second to analyze the effects of many people switching from “snail mail” to email and other digital messages.
Figure 3.18
(a) shows the shift in supply discussed in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships.
Step 2. Did the described change affect supply or demand? Labor compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.
Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S0 to S1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a higher price than the original equilibrium (E0).
Figure 3.18
(b) shows the shift in demand in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships. Note that this diagram is independent from the diagram in panel (a).
Step 2. Did the change described affect supply or demand? A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.
Step 3. Was the effect on demand positive or negative? A change in tastes away from snailmail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E2) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. Graphically, we superimpose the previous two diagrams one on top of the other, as in
Figure 3.19
.
Figure 3.19 Combined Effect of Decreased Demand and Decreased Supply Supply and demand shifts cause changes in equilibrium price and quantity.
Following are the results:
Effect on Quantity: The effect of higher labor compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snail mail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q3). This is easy to see graphically, since Q3 is to the left of Q0.
Effect on Price: The overall effect on price is more complicated. The effect of higher labor compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price. In other cases, it might be the opposite.
The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.
CLEAR IT UP
What is the difference between shifts of demand or supply versus movements along a demand or supply curve?
One common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:
“Well, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S0 to S1 on the diagram (Shift 1). The equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shows the shift from S1 to S2, shows on the diagram (Shift 2), so that the equilibrium now moves from E1 to E2. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves from E2 to E3.”
Figure 3.20 Shifts of Demand or Supply versus Movements along a Demand or Supply Curve A shift in one curve never causes a shift in the other curve. Rather, a shift in one curve causes a movement along the second curve.
At about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lee’s logic, and then read the answer that follows.
Answer: Lee’s first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D0), from E0 to E1. The rest of Lee’s argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S1 to S2. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D0 to D1. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.
Think carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.
In the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Even as they are moving toward one new equilibrium, a subsequent change in demand or supply often pushes prices toward another equilibrium.
Learning Objectives
By the end of this section, you will be able to:
· Calculate the price elasticity of demand
· Calculate the price elasticity of supply
Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary in
Table 5.1
is assuming absolute values for price elasticity of demand. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as
Table 5.1
summarizes.
If . . .
Then . . .
And It Is Called . . .
% change in quantity>% change in price% change in quantity>% change in price
% change in quantity% change in price>1% change in quantity% change in price>1
Elastic
% change in quantity=% change in price% change in quantity=% change in price
% change in quantity% change in price=1% change in quantity% change in price=1
Unitary
% change in quantity<% change in price% change in quantity<% change in price % change in quantity% change in price<1% change in quantity% change in price<1 Inelastic Table5.1 Elastic, Inelastic, and Unitary: Three Cases of Elasticity LINK IT UP Before we delve into the details of elasticity, enjoy this article on elasticity and ticket prices at the Super Bowl. To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations: % change in quantity% change in price==Q2–Q1(Q2+Q1)/2 × 100P2–P1(P2+P1)/2 × 100% change in quantity=Q2–Q1Q2+ Q1/2 × 100% change in price=P2– P1P2+ P1/2 × 100 The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases. Calculating Price Elasticity of Demand Let’s calculate the elasticity between points A and B and between points G and H as Figure 5.2 shows. Figure 5.2 Calculating the Price Elasticity of Demand We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price. First, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A: % change in quantity% change in pricePrice Elasticity of Demand========3,000–2,800(3,000+2,800)/2 × 1002002,900 × 1006.960–70(60+70)/2 × 100–1065 × 100–15.4 6.9%–15.4%0.45% change in quantity=3,000–2,800(3,000+2,800)/2 × 100=2002,900 × 100=6.9% change in price=60–70(60+70)/2 × 100=–1065 × 100=–15.4Price Elasticity of Demand= 6.9%–15.4%=0.45 Therefore, the elasticity of demand between these two points is 6.9%–15.4% 6.9%–15.4% which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. Mathematically, we take the absolute value of the result. We will ignore this detail from now on, while remembering to interpret elasticities as positive numbers. This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values. The following Work It Out feature will walk you through calculating the price elasticity of demand. WORK IT OUT Finding the Price Elasticity of Demand Calculate the price elasticity of demand using the data in Figure 5.2 for an increase in price from G to H. Has the elasticity increased or decreased? Step 1. We know that: Price Elasticity of Demand=% change in quantity% change in pricePrice Elasticity of Demand=% change in quantity% change in price Step 2. From the Midpoint Formula we know that: % change in quantity% change in price==Q2–Q1(Q2+Q1)/2 × 100P2–P1(P2+P1)/2 × 100% change in quantity=Q2–Q1(Q2+Q1)/2 × 100% change in price=P2–P1(P2+P1)/2 × 100 Step 3. So we can use the values provided in the figure in each equation: % change in quantity% change in price======1,600–1,800(1,600+1,800)/2 × 100–2001,700 × 100–11.76130–120(130+120)/2 × 10010125 × 1008.0% change in quantity=1,600–1,800(1,600+1,800)/2 × 100=–2001,700 × 100=–11.76% change in price=130–120(130+120)/2 × 100=10125 × 100=8.0 Step 4. Then, we can use those values to determine the price elasticity of demand: Price Elasticity of Demand===% change in quantity% change in price–11.7681.47Price Elasticity of Demand=% change in quantity% change in price=–11.768=1.47 Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve. Calculating the Price Elasticity of Supply Assume that an apartment rents for $650 per month and at that price the landlord rents 10,000 units are rented as Figure 5.3 shows. When the price increases to $700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity? Figure 5.3 Price Elasticity of Supply We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price. Using the Midpoint Method, % change in quantity% change in pricePrice Elasticity of Supply========13,000–10,000(13,000+10,000)/2 × 1003,00011,500 × 10026.1$700–$650($700+$650)/2 × 10050675 × 1007.426.1% 7.4%3.53% change in quantity=13,000–10,000(13,000+10,000)/2 × 100=3,00011,500 × 100=26.1% change in price=$700–$650($700+$650)/2 × 100=50675 × 100=7.4Price Elasticity of Supply=26.1% 7.4%=3.53 Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and we read it as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change. If you're starting to wonder if the concept of slope fits into this calculation, read the following Clear It Up box. CLEAR IT UP Is the elasticity the slope? It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 5.2 , at each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200 compared to the point to its left. The slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning. When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage. Thus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we'd have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic. As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a $1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change. Learning Objectives By the end of this section, you will be able to: · Differentiate between infinite and zero elasticity · Analyze graphs in order to classify elasticity as constant unitary, infinite, or zero There are two extreme cases of elasticity: when elasticity equals zero and when it is infinite. A third case is that of constant unitary elasticity. We will describe each case. Infinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as Figure 5.4 shows. While perfectly elastic supply curves are for the most part unrealistic, goods with readily available inputs and whose production can easily expand will feature highly elastic supply curves. Examples include pizza, bread, books, and pencils. Similarly, perfectly elastic demand is an extreme example. However, luxury goods, items that take a large share of individuals’ income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles. Figure 5.4 Infinite Elasticity The horizontal lines show that an infinite quantity will be demanded or supplied at a specific price. This illustrates the cases of a perfectly (or infinitely) elastic demand curve and supply curve. The quantity supplied or demanded is extremely responsive to price changes, moving from zero for prices close to P to infinite when prices reach P. Zero elasticity or perfect inelasticity, as Figure 5.5 depicts, refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves. Examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves. This is the case of life-saving drugs and gasoline. Figure 5.5 Zero Elasticity The vertical supply curve and vertical demand curve show that there will be zero percentage change in quantity (a) demanded or (b) supplied, regardless of the price. Constant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 5.6 shows a demand curve with constant unit elasticity. Using the midpoint method, you can calculate that between points A and B on the demand curve, the price changes by 66.7% and quantity demanded also changes by 66.7%. Hence, the elasticity equals 1. Between points B and C, price again changes by 66.7% as does quantity, while between points C and D the corresponding percentage changes are again 66.7% for both price and quantity. In each case, then, the percentage change in price equals the percentage change in quantity, and consequently elasticity equals 1. Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by $8.00 from A to B, by a smaller amount of $4.00 from B to C, and by a still smaller amount of $2.00 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the right—and a curved shape overall. Figure 5.6 A Constant Unitary Elasticity Demand Curve A demand curve with constant unitary elasticity will be a curved line. Notice how price and quantity demanded change by an identical percentage amount between each pair of points on the demand curve. Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line, and that line goes through the origin. In each pair of points on the supply curve there is an equal difference in quantity of 30. However, in percentage value, using the midpoint method, the steps are decreasing as one moves from left to right, from 28.6% to 22.2% to 18.2%, because the quantity points in each percentage calculation are getting increasingly larger, which expands the denominator in the elasticity calculation of the percentage change in quantity. Consider the price changes moving up the supply curve in Figure 5.7 . From points D to E to F and to G on the supply curve, each step of $1.50 is the same in absolute value. However, if we measure the price changes in percentage change terms, using the midpoint method, they are also decreasing, from 28.6% to 22.2% to 18.2%, because the original price points in each percentage calculation are getting increasingly larger in value, increasing the denominator in the calculation of the percentage change in price. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axis—so this supply curve has a constant unitary elasticity at all points. Figure 5.7 A Constant Unitary Elasticity Supply Curve A constant unitary elasticity supply curve is a straight line reaching up from the origin. Between each pair of points, the percentage increase in quantity supplied is the same as the percentage increase in price. ( Copyright © 2015. Lexington Books. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law. ) Learning Objectives By the end of this section, you will be able to: · Analyze how price elasticities impact revenue · Evaluate how elasticity can cause shifts in demand and supply · Predict how the long-run and short-run impacts of elasticity affect equilibrium · Explain how the elasticity of demand and supply determine the incidence of a tax on buyers and sellers Studying elasticities is useful for a number of reasons, pricing being most important. Let’s explore how elasticity relates to revenue and pricing, both in the long and short run. First, let’s look at the elasticities of some common goods and services. Table 5.2 shows a selection of demand elasticities for different goods and services drawn from a variety of different studies by economists, listed in order of increasing elasticity. Goods and Services Elasticity of Price Housing 0.12 Transatlantic air travel (economy class) 0.12 Rail transit (rush hour) 0.15 Electricity 0.20 Taxi cabs 0.22 Gasoline 0.35 Transatlantic air travel (first class) 0.40 Wine 0.55 Beef 0.59 Transatlantic air travel (business class) 0.62 Kitchen and household appliances 0.63 Cable TV (basic rural) 0.69 Chicken 0.64 Soft drinks 0.70 Beer 0.80 New vehicle 0.87 Rail transit (off-peak) 1.00 Computer 1.44 Cable TV (basic urban) 1.51 Cable TV (premium) 1.77 Restaurant meals 2.27 Table5.2 Some Selected Elasticities of Demand Note that demand for necessities such as housing and electricity is inelastic, while items that are not necessities such as restaurant meals are more price-sensitive. If the price of a restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause only a slight decrease of 1.2% in the quantity of housing demanded. LINK IT UP Read this article for an example of price elasticity that may have affected you. Does Raising Price Bring in More Revenue? Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this example simple, assume that the band keeps all the money from ticket sales. Assume further that the band pays the costs for its appearance, but that these costs, like travel, and setting up the stage, are the same regardless of how many people are in the audience. Finally, assume that all the tickets have the same price. (The same insights apply if ticket prices are more expensive for some seats than for others, but the calculations become more complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the band raises the ticket price and, it will sell fewer seats. How should the band set the ticket price to generate the most total revenue, which in this example, because costs are fixed, will also mean the highest profits for the band? Should the band sell more tickets at a lower price or fewer tickets at a higher price? The key concept in thinking about collecting the most revenue is the price elasticity of demand. Total revenue is price times the quantity of tickets sold. Imagine that the band starts off thinking about a certain price, which will result in the sale of a certain quantity of tickets. The three possibilities are in Table 5.3 . If demand is elastic at that price level, then the band should cut the price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at that original quantity level, then the band should raise the ticket price, because a certain percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise. If demand has a unitary elasticity at that quantity, then an equal percentage change in quantity will offset a moderate percentage change in the price—so the band will earn the same revenue whether it (moderately) increases or decreases the ticket price. If Demand Is . . . Then . . . Therefore . . . Elastic % change in Qd>% change in P% change in Qd>% change in P
A given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P × Q) falls.
Unitary
% change in Qd=% change in P% change in Qd=% change in P
A given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P × Q) is unchanged.
Inelastic
% change in Qd<% change in P% change in Qd<% change in P
A given % rise in P will cause a smaller % fall in Q so that total revenue (P × Q) rises.
Table5.3 Will the Band Earn More Revenue by Changing Ticket Prices?
What if the band keeps cutting price, because demand is elastic, until it reaches a level where it sells all 15,000 seats in the available arena? If demand remains elastic at that quantity, the band might try to move to a bigger arena, so that it could slash ticket prices further and see a larger percentage increase in the quantity of tickets sold. However, if the 15,000-seat arena is all that is available or if a larger arena would add substantially to costs, then this option may not work.
Conversely, a few bands are so famous, or have such fanatical followings, that demand for tickets may be inelastic right up to the point where the arena is full. These bands can, if they wish, keep raising the ticket price. Ironically, some of the most popular bands could make more revenue by setting prices so high that the arena is not full—but those who buy the tickets would have to pay very high prices. However, bands sometimes choose to sell tickets for less than the absolute maximum they might be able to charge, often in the hope that fans will feel happier and spend more on recordings, T-shirts, and other paraphernalia.
Can Businesses Pass Costs on to Consumers?
Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.
Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now produce aspirin more cheaply. What does this discovery mean to you?
Figure 5.8
illustrates two possibilities. In
Figure 5.8
(a), the demand curve is highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In
Figure 5.8
(b), the demand curve is highly elastic. In this case, the technological breakthrough leads to a much greater quantity sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.
Figure 5.8 Passing along Cost Savings to Consumers Cost-saving gains cause supply to shift out to the right from S0 to S1; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result of this cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a).
Aspirin producers may find themselves in a nasty bind here. The situation in
Figure 5.8
, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from aspirin sales. However, if strong competition exists between aspirin producer, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, other firms that do can drive them out of business.
Since demand for food is generally inelastic, farmers may often face the situation in
Figure 5.8
(a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue that farmers receive. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue that the farmer receives increases. The Clear It Up box discusses how these issues relate to coffee.
CLEAR IT UP
How do coffee prices fluctuate?
Coffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound. In 1995 it was four times as high, at $2 per pound. By 1997 it had fallen by half to $1.00 per pound. In 1998 it leaped back up to $2 per pound. By 2001 it had fallen back to 46 cents a pound. By early 2011 it rose to about $2.31 per pound. By the end of 2012, the price had fallen back to about $1.31 per pound.
The reason for these price fluctuations lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically.
Figure 5.8
(a) illustrates this situation.
Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances, for which demand is inelastic, are products for which producers can pass higher costs on to consumers. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted. Economic research suggests that increasing cigarette prices by 10% leads to about a 3% reduction in the quantity of cigarettes that adults smoke, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that produce cigarettes, the result will be, as in
Figure 5.9
(a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, governments mainly pass along these taxes to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.
If the goal is to reduce the quantity of cigarettes demanded, we must achieve it by shifting this inelastic demand back to the left, perhaps with public programs to discourage cigarette use or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if cigarette demand were more elastic, as in
Figure 5.9
(b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smoking—that is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.
Figure 5.9 Passing along Higher Costs to Consumers Higher costs, like a higher tax on cigarette companies for the example we gave in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, companies largely can pass the cost increase along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers suffer in either case, but in (a), they suffer from paying a higher price for the same quantity, while in (b), they suffer from buying a lower quantity (and presumably needing to shift their consumption elsewhere).
Elasticity and Tax Incidence
The example of cigarette taxes demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they mainly pass along to consumers in the form of higher prices. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.
If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.
The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only modestly when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity.
Similarly, when a government introduces a tax in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden now passes on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received.
Figure 5.10
illustrates this relationship between the tax incidence and elasticity of demand and supply.
Figure 5.10 Elasticity and Tax Incidence An excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). The vertical distance between Pc and Pp is the amount of the tax per unit. Pe is the equilibrium price prior to introduction of the tax. (a) When the demand is more elastic than supply, the tax incidence on consumers Pc – Pe is lower than the tax incidence on producers Pe – Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp. The more elastic the demand and supply curves, the lower the tax revenue.
In
Figure 5.10
(a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers can’t easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since we can view a tax as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity,
Figure 5.10
omits the shift in the supply curve.
The tax revenue is given by the shaded area, which we obtain by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In
Figure 5.10
(a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers.
Figure 5.10
(b) describes the example of the tobacco excise tax where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers’ price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the more likely that consumers will reduce quantity instead of paying higher prices. The more elastic the supply curve, the more likely that sellers will reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue.
Some believe that excise taxes hurt mainly the specific industries they target. For example, the medical device excise tax, in effect since 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. However, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply.
Long-Run vs. Short-Run Impact
Elasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.
Figure 5.11
is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was $12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975—a policy that we can interpret as a shift of the supply curve to the left in the U.S. petroleum market.
Figure 5.11
(a) and
Figure 5.11
(b) show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.
Figure 5.11 How a Shift in Supply Can Affect Price or Quantity The intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b), being more elastic in (b) than in (a). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), with more inelastic demand, or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b), with more elastic demand.
Figure 5.11
(a) shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In
Figure 5.11
(a), the new equilibrium (E1) occurs at a price of $25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day.
Figure 5.11
(b) shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to $14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.
On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. However, over a few years, all of these are possible.
In most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. However, since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run.
Learning Objectives
By the end of this section, you will be able to:
· Explain the difference between explicit costs and implicit costs
· Understand the relationship between cost and revenue
Each business, regardless of size or complexity, tries to earn a profit:
Profit=Total Revenue – Total CostProfit=Total Revenue – Total Cost
Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:
Total Revenue=Price × QuantityTotal Revenue=Price × Quantity
We will see in the following chapters that revenue is a function of the demand for the firm’s products.
Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs.
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work It Out feature for an extended example.)
These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
WORK IT OUT
Calculating Implicit Costs
Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he establishes himself. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. He could hire a law clerk for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?
Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:
Office rental:Law clerk's salary:Total explicit costs: $50,000+$35,000____________ $85,000Office rental: $50,000Law clerk's salary:+$35,000____________Total explicit costs: $85,000
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
Revenues:Explicit costs:Accounting profit:$200,000–$85,000____________$115,000Revenues:$200,000Explicit costs:–$85,000____________Accounting profit:$115,000
However, these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:
Economic profit===total revenues – explicit costs – implicit costs$200,000 – $85,000 – $125,000–$10,000 per yearEconomic profit=total revenues – explicit costs – implicit costs=$200,000 – $85,000 – $125,000=–$10,000 per year
Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.
Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.
Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections.
Learning Objectives
By the end of this section, you will be able to:
· Understand the concept of a production function
· Differentiate between the different types of inputs or factors in a production function
· Differentiate between fixed and variable inputs
· Differentiate between production in the short run and in the long run
· Differentiate between total and marginal product
· Understand the concept of diminishing marginal productivity
In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of producing that output. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost. We can answer the former question by looking at the firm’s production function.
Figure 7.3 The production process for pizza includes inputs such as ingredients, the efforts of the pizza maker, and tools and materials for cooking and serving. (Credit: Haldean Brown/Flickr Creative Commons)
Production is the process (or processes) a firm uses to transform inputs (e.g. labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool-- to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza?
Economists divide factors of production into several categories:
· Natural Resources (Land and Raw Materials) - The ingredients for the pizza are raw materials. These include the flour, yeast, and water for the dough, the tomatoes, herbs, and water for the sauce, the cheese, and the toppings. If the pizza place uses a wood-burning oven, we would include the wood as a raw material. If the establishment heats the oven with natural gas, we would count this as a raw material. Don’t forget electricity for lights. If, instead of pizza, we were looking at an agricultural product, like wheat, we would include the land the farmer used for crops here.
· Labor – When we talk about production, labor means human effort, both physical and mental. The pizzaiolo was the primary example of labor here. He or she needs to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven, but he or she also needs to know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making. The business may also have one or more people to work the counter, take orders, and receive payment.
· Capital – When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, the machines, equipment, and buildings that one uses to produce the product. In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs).
· Technology – Technology refers to the process or processes for producing the product. How does the pizzaiolo combine ingredients to make pizza? How hot should the oven be? How long should the pizza cook? What is the best oven to use? Gas or wood burning? Should the restaurant make its own dough, sauce, cheese, toppings, or should it buy them?
· Entrepreneurship – Production involves many decisions and much knowledge, even for something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur, the person who creates the business, whose idea it is to combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. Let’s explore these ideas in more detail.
We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs:
Q=f[NR,L,K,t,E]Q=f[NR,L,K,t,E]
The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs? Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently. One pizza restaurant may make its own dough and sauce, while another may buy those pre-made. A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant.
We can describe inputs as either fixed or variable.
Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the pizza example, the building is a fixed input. Once the entrepreneur signs the lease, he or she is stuck in the building until the lease expires. Fixed inputs define the firm’s maximum output capacity. This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e. the maximum quantities of outputs a society can produce at a given time with its available resources.
Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well.
Economists often use a short-hand form for the production function:
Q=f[L,K],Q=f[L,K],
where L represents all the variable inputs, and K represents all the fixed inputs.
Economists differentiate between short and long run production.
The short run is the period of time during which at least some factors of production are fixed. During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building—the owner can’t choose a larger or smaller building.
The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
Let’s explore production in the short run using a specific example: tree cutting (for lumber) with a two-person crosscut saw.
Figure 7.4 Production in the short run may be explored through the example of lumberjacks using a two-person saw. (Credit: Wknight94/Wikimedia Commons)
Since by definition capital is fixed in the short run, our production function becomes
Q=f[L,K−]orQ=f[L]Q=f[L,K−]orQ=f[L]
This equation simply indicates that since capital is fixed, the amount of output (e.g. trees cut down per day) depends only on the amount of labor employed (e.g. number of lumberjacks working). We can express this production function numerically as
Table 7.2
below shows.
# Lumberjacks
1
2
3
4
5
# Trees (TP)
4
10
12
13
13
MP
4
6
2
1
0
Table7.2 Short Run Production Function for Trees
Note that we have introduced some new language. We also call Output (Q) Total Product (TP), which means the amount of output produced with a given amount of labor and a fixed amount of capital. In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour.
We should also introduce a critical concept: marginal product. Marginal product is the additional output of one more worker. Mathematically, Marginal Product is the change in total product divided by the change in labor: MP=ΔTP/ΔLMP=ΔTP/ΔL. In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day. Why might that be the case? It’s because of the nature of the capital the workers are using. A two-person saw works much better with two persons than with one. Suppose we add a third lumberjack to the story. What will that person’s marginal product be? What will that person contribute to the team? Perhaps he or she can oil the saw's teeth to keep it sawing smoothly or he or she could bring water to the two people sawing. What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output. This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run. Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice. Both concepts are examples of the more general concept of diminishing marginal returns. Why does diminishing marginal productivity occur? It’s because of fixed capital. We will see this more clearly when we discuss production in the long run.
We can show these concepts graphically as
Figure 7.5
and
Figure 7.6
illustrate.
Figure 7.5
graphically shows the data from
Table 7.2
.
Figure 7.6
shows the more general cases of total product and marginal product curves.
Figure 7.5
Figure 7.6
Learning Objectives
By the end of this section, you will be able to:
· Understand the relationship between production and costs
· Understand that every factor of production has a corresponding factor price
· Analyze short-run costs in terms of total cost, fixed cost, variable cost, marginal cost, and average cost
· Calculate average profit
· Evaluate patterns of costs to determine potential profit
We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm. The firm’s production function tells us how much output the firm will produce with given amounts of inputs. However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost. Let’s move to the second factor we need to determine.
For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production. From the firm’s perspective, factor payments are costs. From the owner of each factor’s perspective, factor payments are income. Factor payments include:
· Raw materials prices for raw materials
· Rent for land or buildings
· Wages and salaries for labor
· Interest and dividends for the use of financial capital (loans and equity investments)
· Profit for entrepreneurship. Profit is the residual, what’s left over from revenues after the firm pays all the other costs. While it may seem odd to treat profit as a “cost”, it is what entrepreneurs earn for taking the risk of starting a business. You can see this correspondence between factors of production and factor payments in the inside loop of the circular flow diagram in
Figure 1.6
.
We now have all the information necessary to determine a firm’s costs.
A cost function is a mathematical expression or equation that shows the cost of producing different levels of output.
Q
1
2
3
4
Cost
$32.50
$44
$52
$90
Table7.3 Cost Function for Producing Widgets
What we observe is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire.
What is the origin of these cost figures? They come from the production function and the factor payments. The discussion of costs in the short run above,
Costs in the Short Run
, was based on the following production function, which is similar to
Table 7.3
except for "widgets" instead of trees.
Workers (L)
1
2
3
3.25
4.4
5.2
6
7
8
9
Widgets (Q)
0.2
0.4
0.8
1
2
3
3.5
3.8
3.95
4
Table7.4
We can use the information from the production function to determine production costs. What we need to know is how many workers are required to produce any quantity of output. If we flip the order of the rows, we “invert” the production function so it shows L=f(Q)L=f(Q).
Widgets (Q)
0.2
0.4
0.8
1
2
3
3.5
3.8
3.95
4
Workers (L)
1
2
3
3.25
4.4
5.2
6
7
8
9
Table7.5
Now focus on the whole number quantities of output. We’ll eliminate the fractions from the table:
Widgets (Q)
1
2
3
4
Workers (L)
3.25
4.4
5.2
9
Table7.6
Suppose widget workers receive $10 per hour. Multiplying the Workers row by $10 (and eliminating the blanks) gives us the cost of producing different levels of output.
Widgets (Q)
1.00
2.00
3.00
4.00
Workers (L)
3.25
4.4
5.2
9
× Wage Rate per hour
$10
$10
$10
$10
= Cost
$32.50
$44.00
$52.00
$90.00
Table7.7
This is same cost function with which we began! (shown in
Table 7.3
)
Now that we have the basic idea of the cost origins and how they are related to production, let’s drill down into the details.
Average and Marginal Costs
The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.
We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost. Average cost is the cost on average of producing a given quantity. We define average cost as total cost divided by the quantity of output produced. AC=TC/QAC=TC/Q If producing two widgets costs a total of $44, the average cost per widget is $44/2=$22$44/2=$22 per widget. The other way of measuring cost per unit is marginal cost. If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced. More formally, marginal cost is the cost of producing one more unit of output. Mathematically, marginal cost is the change in total cost divided by the change in output: MC=ΔTC/ΔQMC=ΔTC/ΔQ. If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is $44−$32.50=$11.50.$44−$32.50=$11.50. We can see the Widget Cost table redrawn below with average and marginal cost added.
Q
1
2
3
4
Total Cost
$32.50
$44.00
$52.00
$90.00
Average Cost
$32.50
$22.00
$17.33
$22.50
Marginal Cost
$32.50
$11.50
$8.00
$38.00
Table7.8 Extended Cost Function for Producing Widgets
Note that the marginal cost of the first unit of output is always the same as total cost.
Fixed and Variable Costs
We can decompose costs into fixed and variable costs. Fixed costs are the costs of the fixed inputs (e.g. capital). Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs are the costs of the variable inputs (e.g. labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.
Total costs are the sum of fixed plus variable costs. Let's look at another example. Consider the barber shop called “The Clip Joint” in
Figure 7.7
. The data for output and costs are in
Table 7.9
. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost: 2 × $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost is: $160 + $160 = $320.
Labor
Quantity
Fixed Cost
Variable Cost
Total Cost
1
16
$160
$80
$240
2
40
$160
$160
$320
3
60
$160
$240
$400
4
72
$160
$320
$480
5
80
$160
$400
$560
6
84
$160
$480
$640
7
82
$160
$560
$720
Table7.9 Output and Total Costs
Figure 7.7 How Output Affects Total Costs At zero production, the fixed costs of $160 are still present. As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two.
At zero production, the fixed costs of $160 are still present. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two.
Figure 7.7
graphically shows the relationship between the quantity of output produced and the cost of producing that output. We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs.
You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity which we discussed earlier in the
Production in the Short Run
section of this chapter, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of
Table 7.9
shows.
This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g. water) contributes less to overall production.
Average Total Cost, Average Variable Cost, Marginal Cost
The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of
Table 7.10
duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in
Figure 7.8
.
Figure 7.8 Cost Curves at the Clip Joint We can also present the information on total costs, fixed cost, and variable cost on a per-unit basis. We calculate average total cost (ATC) by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. We calculate average variable cost (AVC) by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is also typically U-shaped. We calculate marginal cost (MC) by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping.
Labor
Quantity
Fixed Cost
Variable Cost
Total Cost
Marginal Cost
Average Total Cost
Average Variable Cost
1
16
$160
$80
$240
$15.00
$15.00
$5.00
2
40
$160
$160
$320
$3.33
$8.00
$4.00
3
60
$160
$240
$400
$4.00
$6.67
$4.00
4
72
$160
$320
$480
$6.67
$6.67
$4.44
5
80
$160
$400
$560
$10.00
$7.00
$5.00
6
84
$160
$480
$640
$20.00
$7.62
$5.71
Table7.10 Different Types of Costs
Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40, or $8 per haircut. Average cost curves are typically U-shaped, as
Figure 7.8
shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect.
We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80, or $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as
Figure 7.8
shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. We can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet, as the following Clear it Up feature discusses.
CLEAR IT UP
Where do marginal and average costs meet?
The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of $6.60 in
Figure 7.8
. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve.
This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up.
The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.
Lessons from Alternative Measures of Costs
Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter
Choice in a World of Scarcity
, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
CLEAR IT UP
Why are total cost and average cost not on the same graph?
Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced. We measure these costs in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, we measured them as dollars per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since we measure them in different units ($ versus $ per unit of output).
It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. However, the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives:
average profit====profitquantity producedtotal revenue – total costquantity producedtotal revenuequantity produced–total costquantity producedaverage revenue – average costaverage profit=profitquantity produced=total revenue – total costquantity produced=total revenuequantity produced–total costquantity produced=average revenue – average cost
However, note that:
average revenue==price × quantity producedquantity producedpriceaverage revenue=price × quantity producedquantity produced=price
Thus:
average profit=price – average costaverage profit=price – average cost
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive. If price is below average cost, then profits will be negative.
We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits.
A Variety of Cost Patterns
The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.
Learning Objectives
By the end of this section, you will be able to:
· Understand how long run production differs from short run production.
In the long run, all factors (including capital) are variable, so our production function is Q=f[L,K]Q=f[L,K].
Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital. To start, the firm has just enough business for one typist and one PC to keep busy for a day. Say that’s five documents. Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow. Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents. However, in the short turn, the firm has fixed capital, i.e. only one PC. The table below shows the situation:
# Typists (L)
1
2
3
4
5
6
Letters/hr (TP)
5
7
8
8
8
8
For K = 1PC
MP
5
2
1
0
0
0
Table7.11 Short Run Production Function for Typing
In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers. What could the second worker do? What can they contribute to the firm? Perhaps they can answer the phone, which is a major impediment to completing the typing assignment. What about a third worker? Perhaps he or she could bring coffee to the first two workers. You can see both total product and marginal product for the firm above. Now here’s something to think about: At what point (e.g. after how many workers) does diminishing marginal productivity kick in, and more importantly, why?
In this example, marginal productivity starts to decline after the second worker. This is because capital is fixed. The production process for typing works best with one worker and one PC. If you add more than one typist, you get seriously diminishing marginal productivity.
Consider the long run. Suppose the firm’s demand increases to 15 documents per day. What might the firm do to operate more efficiently? If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as
Table 7.12
below shows.
# Typists (L)
1
2
3
4
5
5
Letters/hr (TP)
5
6
8
8
8
8
For K = 1PC
MP
5
2
1
0
0
0
Letters/hr (TP)
5
10
15
17
18
18
For K = 3PC
MP
5
5
5
2
1
0
Table7.12 Long Run Production Function for Typing
With more capital, the firm can hire three workers before diminishing productivity comes into effect. More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output.
Learning Objectives
By the end of this section, you will be able to:
· Calculate long run total cost
· Identify economies of scale, diseconomies of scale, and constant returns to scale
· Interpret graphs of long-run average cost curves and short-run average cost curves
· Analyze cost and production in the long run and short run
The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes).
In this context, technology refers to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.
Choice of Production Technology
A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other.
Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in
Table 7.13
. The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines.
Production technology 1
10 workers
2 machines
Production technology 2
7 workers
4 machines
Production technology 3
3 workers
7 machines
Table7.13 Three Ways to Clean a Park
Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery.
Table 7.14
outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery.
Example A: Workers cost $40, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $40 = $400
2 × $80 = $160
$560
Cost of technology 2
7 × $40 = $280
4 × $80 = $320
$600
Cost of technology 3
3 × $40 = $120
7 × $80 = $560
$680
Example B: Workers cost $55, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $55 = $550
2 × $80 = $160
$710
Cost of technology 2
7 × $55 = $385
4 × $80 = $320
$705
Cost of technology 3
3 × $55 = $165
7 × $80 = $560
$725
Example C: Workers cost $90, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $90 = $900
2 × $80 = $160
$1,060
Cost of technology 2
7 × $90 = $630
4 × $80 = $320
$950
Cost of technology 3
3 × $90 = $270
7 × $80 = $560
$830
Table7.14 Total Cost with Rising Labor Costs
Example A shows the firm’s cost calculation when wages are $40 and machines costs are $80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to $55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to $90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as example C shows.
This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.
Economies of Scale
Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.
Figure 7.9
illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is $12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to $4 per alarm clock.
Figure 7.9 Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. Economies of scale exist when the larger scale of production leads to lower average costs.
The average cost curve in
Figure 7.9
may appear similar to the average cost curves we presented earlier in this chapter, although it is downward-sloping rather than U-shaped. However, there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. The short-run average cost curves we presented earlier in this chapter assumed the existence of fixed costs, and only variable costs were allowed to change.
One prominent example of economies of scale occurs in the chemical industry. Chemical plants have many pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the cross-section area of the pipe determines the volume of chemicals that can flow through it. The calculations in
Table 7.15
show that a pipe which uses twice as much material to make (as shown by the circumference) can actually carry four times the volume of chemicals because the pipe's cross-section area rises by a factor of four (as the Area column below shows).
Circumference (2πr2πr)
Area (πr2πr2)
4-inch pipe
12.5 inches
12.5 square inches
8-inch pipe
25.1 inches
50.2 square inches
16-inch pipe
50.2 inches
201.1 square inches
Table7.15 Comparing Pipes: Economies of Scale in the Chemical Industry
A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. However, the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.
Shapes of Long-Run Average Cost Curves
While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output.
Figure 7.10
shows how we build the long-run average cost curve from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
Figure 7.10 From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other SRAC curves, not in the diagram, lie between the ones that are here. The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. If a firm wished to produce quantity Q3, it would choose the fixed costs associated with SRAC3.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result.
The shape of the long-run cost curve, in
Figure 7.10
, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in
Figure 7.9
.
In the middle portion of the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis.
CLEAR IT UP
How do economies of scale compare to diminishing marginal returns?
The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. We call this situation diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.
LINK IT UP
Visit this
website
to read an article about the complexity of the belief that banks can be “too-big-to-fail.”
The Size and Number of Firms in an Industry
The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size. For example, say that the appliance industry sells one million dishwashers every year at a price of $500 each and the long-run average cost curve for dishwashers is in
Figure 7.11
(a). In
Figure 7.11
(a), the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above $500, and the firms would not be able to compete.
Figure 7.11 The LRAC Curve and the Size and Number of Firms (a) Low-cost firms will produce at output level R. When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. In this case, a firm producing at a quantity of 10,000 will produce at a lower average cost than a firm producing, say, 5,000 or 20,000 units. (b) Low-cost firms will produce between output levels R and S. When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. In this case, any firm producing a quantity between 5,000 and 20,000 can compete effectively, although firms producing less than 5,000 or more than 20,000 would face higher average costs and be unable to compete.
CLEAR IT UP
How can we view cities as examples of economies of scale?
Why are people and economic activity concentrated in cities, rather than distributed evenly across a country? The fundamental reason must be related to the idea of economies of scale—that grouping economic activity is more productive in many cases than spreading it out. For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what appeals to many shoppers.
These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area. Cities are sometimes called “agglomeration economies.”
These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. In the United States, about 80% of the population now lives in metropolitan areas (which include the suburbs around cities), compared to just 40% in 1900. However, in poorer nations of the world, including much of Africa, the proportion of the population in urban areas is only about 30%. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise.
If cities offer economic advantages that are a form of economies of scale, then why don’t all or most people live in one giant city? At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel. High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded. There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones. The future of cities, both in the United States and in other countries around the world, will be determined by their ability to benefit from the economies of agglomeration and to minimize or counterbalance the corresponding diseconomies.
We illustrate a more common case in
Figure 7.11
(b), where the LRAC curve has a flat-bottomed area of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at about the same level of average cost. Given that the market will demand one million dishwashers per year at a price of $500, this market might have as many as 200 producers (that is, one million dishwashers divided by firms making 5,000 each) or as few as 50 producers (one million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. However, firms that produce below 5,000 units or more than 20,000 will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in
Figure 7.11
(a). However, if the long-run average cost curve has a wide flat bottom like
Figure 7.11
(b), then firms of a variety of different sizes will be able to compete with each other.
We can interpret the flat section of the long-run average cost curve in
Figure 7.11
(b) in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5,000 has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20,000. The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,000, while another firm owns four separate manufacturing plants, which each produce a quantity of 5,000. This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm. At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result.
In the examples to this point, the quantity demanded in the market is quite large (one million) compared with the quantity produced at the bottom of the long-run average cost curve (5,000, 10,000 or 20,000). In such a situation, the market is set for competition between many firms. However, what if the bottom of the long-run average cost curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower?
Return to
Figure 7.11
(a), where the bottom of the long-run average cost curve is at 10,000, but now imagine that the total quantity of dishwashers demanded in the market at that price of $500 is only 30,000. In this situation, the total number of firms in the market would be three. We call a handful of firms in a market an “oligopoly,” and the chapter on
Monopolistic Competition and Oligopoly
will discuss the range of competitive strategies that can occur when oligopolies compete.
Alternatively, consider a situation, again in the setting of
Figure 7.11
(a), where the bottom of the long-run average cost curve is 10,000, but total demand for the product is only 5,000. (For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.) In this situation, the market may well end up with a single firm—a monopoly—producing all 5,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 5,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The chapter on
Monopoly
discusses the situation of a monopoly firm.
Thus, the shape of the long-run average cost curve reveals whether competitors in the market will be different sizes. If the LRAC curve has a single point at the bottom, then the firms in the market will be about the same size, but if the LRAC curve has a flat-bottomed segment of constant returns to scale, then firms in the market may be a variety of different sizes.
The relationship between the quantity at the minimum of the long-run average cost curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC, a few firms will compete. If the quantity demanded in the market is less than the quantity at the minimum of the LRAC, a single-producer monopoly is a likely outcome.
Shifting Patterns of Long-Run Average Cost
New developments in production technology can shift the long-run average cost curve in ways that can alter the size distribution of firms in an industry.
For much of the twentieth century, the most common change had been to see alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the long-run average cost curve, the downward-sloping economies of scale portion of the curve stretched over a larger quantity of output.
However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-size tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but did so at a lower average cost than a traditional mid-sized tire plant.
Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state, or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create “winner-take-all” markets where one large company will tend to command a large share of total sales, as Microsoft has done producing of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world, and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers.
BRING IT HOME
Amazon
Traditionally, bookstores have operated in retail locations with inventories held either on the shelves or in the back of the store. These retail locations were very pricey in terms of rent. Until recently, Amazon had no retail locations. It only sold online and delivered by mail. Amazon now has retail stores in California, Oregon and Washington State and retail stores are coming to Illinois, Massachusetts, New Jersey, and New York. Amazon offers almost any book in print, convenient purchasing, and prompt delivery by mail. Amazon holds its inventories in huge warehouses in low-rent locations around the world. The warehouses are highly computerized using robots and relatively low-skilled workers, making for low average costs per sale. Amazon demonstrates the significant advantages economies of scale can offer to a firm that exploits those economies.
accounting profit
total revenues minus explicit costs, including depreciation
average profit
profit divided by the quantity of output produced; also known as profit margin
average total cost
total cost divided by the quantity of output
average variable cost
variable cost divided by the quantity of output
constant returns to scale
expanding all inputs proportionately does not change the average cost of production
diminishing marginal productivity
general rule that as a firm employs more labor, eventually the amount of additional output produced declines
diseconomies of scale
the long-run average cost of producing output increases as total output increases
economic profit
total revenues minus total costs (explicit plus implicit costs)
economies of scale
the long-run average cost of producing output decreases as total output increases
economies of scale
the long-run average cost of producing output decreases as total output increases
explicit costs
out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials
factors of production (or inputs)
resources that firms use to produce their products, for example, labor and capital
firm
an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
fixed cost
cost of the fixed inputs; expenditure that a firm must make before production starts and that does not change regardless of the production level
fixed inputs
factors of production that can’t be easily increased or decreased in a short period of time
implicit costs
opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned
long run
period of time during which all of a firm’s inputs are variable
long-run average cost (LRAC) curve
shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology
marginal cost
the additional cost of producing one more unit; mathematically, MC=ΔTC/ΔLMC=ΔTC/ΔL
marginal product
change in a firm’s output when it employees more labor; mathematically, MP=ΔTP/ΔLMP=ΔTP/ΔL
private enterprise
the ownership of businesses by private individuals
production
the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs
production function
mathematical equation that tells how much output a firm can produce with given amounts of the inputs
production technologies
alternative methods of combining inputs to produce output
revenue
income from selling a firm’s product; defined as price times quantity sold
short run
period of time during which at least one or more of the firm’s inputs is fixed
short-run average cost (SRAC) curve
the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs
total cost
the sum of fixed and variable costs of production
total product
synonym for a firm’s output
variable cost
cost of production that increases with the quantity produced; the cost of the variable inputs
variable inputs
factors of production that a firm can easily increase or decrease in a short period of time
7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.
7.2 Production in the Short Run
Production is the process a firm uses to transform inputs (e.g. labor, capital, raw materials, etc.) into outputs. It is not possible to vary fixed inputs (e.g. capital) in a short period of time. Thus, in the short run the only way to change output is to change the variable inputs (e.g. labor). Marginal product is the additional output a firm obtains by employing more labor in production. At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor. Mathematically, marginal product is the slope of the total product curve.
7.3 Costs in the Short Run
For every input (e.g. labor), there is an associated factor payment (e.g. wages and salaries). The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment.
In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.
We calculate marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.
We calculate average total cost by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.
We calculate average variable cost by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.
7.4 Production in the Long Run
In the long run, all inputs are variable. Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run. Firms can choose the optimal capital stock to produce their desired level of output.
7.5 Costs in the Long Run
A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production.
In the long run, firms can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost.
Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases. Diseconomies of scale refers to a situation where as output increases, average costs also increase.
The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom, so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand in conjunction with the long-run average cost curve determines how many firms will exist in a given industry.
If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the long-run average cost curve, where the cost of production is lowest, the market will have many firms competing. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm.
Learning Objectives
By the end of this section, you will be able to:
· Explain the characteristics of a perfectly competitive market
· Discuss how perfectly competitive firms react in the short run and in the long run
Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, he or she has to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
LINK IT UP
Visit this
website
that reveals the current value of various commodities.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as we discussed in the chapter on
Production, Costs and Industry Structure
. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest.
In the long run, positive economic profits will attract competition as other firms enter the market. Economic losses will cause firms to exit the market. Ultimately, perfectly competitive markets will attain long-run equilibrium when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.
Learning Objectives
By the end of this section, you will be able to:
· Distinguish between a natural monopoly and a legal monopoly.
· Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies
· Analyze the importance of trademarks and patents in promoting innovation
· Identify examples of predatory pricing
Because of the lack of competition, monopolies tend to earn significant economic profits. These profits should attract vigorous competition as we described in
Perfect Competition
, and yet, because of one particular characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors from entering a market. Barriers to entry can range from the simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies available for broadcasting. Once an entrepreneur or firm has purchased the rights to all of them, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in markets with significant barriers to entry, it is not necessarily true that abnormally high profits will attract new firms, and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run.
There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural monopoly, where the barriers to entry are something other than legal prohibition. The other is legal monopoly, where laws prohibit (or severely limit) competition.
Natural Monopoly
Economies of scale can combine with the size of the market to limit competition. (We introduced this theme in
Production, Cost and Industry Structure
).
Figure 9.2
presents a long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000 planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.
Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC) curve at an output level of 5,000 planes per year and at a price P1, which is higher than P0. In this situation, the market has room for only one producer. If a second firm attempts to enter the market at a smaller size, say by producing a quantity of 4,000 planes, then its average costs will be higher than those of the existing firm, and it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000 planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it produced because of insufficient demand in the market.
Figure 9.2 Economies of Scale and Natural Monopoly In this market, the demand curve intersects the long-run average cost (LRAC) curve at its downward-sloping part. A natural monopoly occurs when the quantity demanded is less than the minimum quantity it takes to be at the bottom of the long-run average cost curve.
Economists call this situation, when economies of scale are large relative to the quantity demanded in the market, a natural monopoly. Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low, once the fixed costs of the overall system are in place. This results in situations where there are substantial economies of scale. For example, once a water company lays the main water pipes through a neighborhood, the marginal cost of providing water service to another home is fairly low. Once the electric company installs lines in a new subdivision, the marginal cost of providing additional electrical service to one more home is minimal. It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes, or for a second electricity company to enter the market and invest in a whole new set of electrical wires. These industries offer an example where, because of economies of scale, one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments.
A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For example, cement production exhibits economies of scale, and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce. Moreover, the costs of transporting cement over land are high, and so a cement plant in an area without access to water transportation may be a natural monopoly.
Control of a Physical Resource
Another type of monopoly occurs when a company has control of a scarce physical resource. In the U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the 1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough aluminum to compete.
As another example, the majority of global diamond production is controlled by DeBeers, a multi-national company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It also has exploration activities on four continents, while directing a worldwide distribution network of rough cut diamonds. Although in recent years they have experienced growing competition, their impact on the rough diamond market is still considerable.
Legal Monopoly
For some products, the government erects barriers to entry by prohibiting or limiting competition. Under U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states or cities have laws or regulations that allow households a choice of only one electric company, one water company, and one company to pick up the garbage. Most legal monopolies are utilities—products necessary for everyday life—that are socially beneficial. As a consequence, the government allows producers to become regulated monopolies, to insure that customers have access to an appropriate amount of these products or services. Additionally, legal monopolies are often subject to economies of scale, so it makes sense to allow only one provider.
Promoting Innovation
Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of near ubiquitous information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation. To prevent this from happening, the Constitution of the United States specifies in Article I, Section 8: “The Congress shall have Power . . . to Promote the Progress of Science and Useful Arts, by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Discoveries.” Congress used this power to create the U.S. Patent and Trademark Office, as well as the U.S. Copyright Office. A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time. In the United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more cheaply once the patent expires.
A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. Roughly 1.9 million trademarks are registered with the U.S. government. A firm can renew a trademark repeatedly, as long as it remains in active use.
A copyright, according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United States for ‘original works of authorship’ including literary, dramatic, musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce, display, or perform a copyrighted work without the author's permission. Copyright protection ordinarily lasts for the life of the author plus 70 years.
Roughly speaking, patent law covers inventions and copyright protects books, songs, and art. However, in certain areas, like the invention of new software, it has been unclear whether patent or copyright protection should apply. There is also a body of law known as trade secrets. Even if a company does not have a patent on an invention, competing firms are not allowed to steal their secrets. One famous trade secret is the formula for Coca-Cola, which is not protected under copyright or patent law, but is simply kept secret by the company.
Taken together, we call this combination of patents, trademarks, copyrights, and trade secret law intellectual property, because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property, although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which those in other countries will respect patents and copyrights of those in other countries.
Government limitations on competition used to be more common in the United States. For most of the twentieth century, only one phone company—AT&T—was legally allowed to provide local and long distance service. From the 1930s to the 1970s, one set of federal regulations limited which destinations airlines could choose to fly to and what fares they could charge. Another set of regulations limited the interest rates that banks could pay to depositors; yet another specified how much trucking firms could charge customers.
What products we consider utilities depends, in part, on the available technology. Fifty years ago, telephone companies provided local and long distance service over wires. It did not make much sense to have many companies building multiple wiring systems across towns and the entire country. AT&T lost its monopoly on long distance service when the technology for providing phone service changed from wires to microwave and satellite transmission, so that multiple firms could use the same transmission mechanism. The same thing happened to local service, especially in recent years, with the growth in cellular phone systems.
The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation, starting in the late 1970s and continuing into the 1990s. This wave eliminated or reduced government restrictions on the firms that could enter, the prices that they could charge, and the quantities that many industries could produce, including telecommunications, airlines, trucking, banking, and electricity.
Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies.
LINK IT UP
Vist this
website
for examples of some pretty bizarre patents.
Intimidating Potential Competition
Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market. One method is known as predatory pricing, in which a firm uses the threat of sharp price cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove.
Consider a large airline that provides most of the flights between two particular cities. A new, small start-up airline decides to offer service between these two cities. The large airline immediately slashes prices on this route to the bone, so that the new entrant cannot make any money. After the new entrant has gone out of business, the incumbent firm can raise prices again.
After the company repeats this pattern once or twice, potential new entrants may decide that it is not wise to try to compete. Small airlines often accuse larger airlines of predatory pricing: in the early 2000s, for example, ValuJet accused Delta of predatory pricing, Frontier accused United, and Reno Air accused Northwest. In 2015, the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers that encouraged customers to use lower swipe fees on credit transactions.
In some cases, large advertising budgets can also act as a way of discouraging the competition. If the only way to launch a successful new national cola drink is to spend more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many companies will try. A firmly established brand name can be difficult to dislodge.
Summing Up Barriers to Entry
Table 9.1
lists the barriers to entry that we have discussed. This list is not exhaustive, since firms have proved to be highly creative in inventing business practices that discourage competition. When barriers to entry exist, perfect competition is no longer a reasonable description of how an industry works. When barriers to entry are high enough, monopoly can result.
Barrier to Entry
Government Role?
Example
Natural monopoly
Government often responds with regulation (or ownership)
Water and electric companies
Control of a physical resource
No
DeBeers for diamonds
Legal monopoly
Yes
Post office, past regulation of airlines and trucking
Patent, trademark, and copyright
Yes, through protection of intellectual property
New drugs or software
Intimidating potential competitors
Somewhat
Predatory pricing; well-known brand names
Learning Objectives
By the end of this section, you will be able to:
· Explain the significance of differentiated products
· Describe how a monopolistic competitor chooses price and quantity
· Discuss entry, exit, and efficiency as they pertain to monopolistic competition
· Analyze how advertising can impact monopolistic competition
Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell a variety of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation.
CLEAR IT UP
Who invented the theory of imperfect competition?
Two economists independently but simultaneously developed the theory of imperfect competition in 1933. The first was Edward Chamberlin of Harvard University who published The Economics of Monopolistic Competition. The second was Joan Robinson of Cambridge University who published The Economics of Imperfect Competition. Robinson subsequently became interested in macroeconomics and she became a prominent Keynesian, and later a post-Keynesian economist. (See the
Welcome to Economics!
and
The Keynesian Perspective
chapters for more on Keynes.)
Differentiated Products
A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. We call products that are distinctive in one of these ways differentiated products.
Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. A firm's location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.
The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.
Perceived Demand for a Monopolistic Competitor
A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition.
Figure 10.2
offers a reminder that the demand curve that a perfectly competitive firm faces is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.
Figure 10.2 Perceived Demand for Firms in Different Competitive Settings The demand curve that a perfectly competitive firm faces is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price. The demand curve that a monopoly faces is the market demand. It can sell more output only by decreasing the price it charges. The demand curve that a monopolistically competitive firm faces falls in between.
The demand curve as a monopolistic competitor faces is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.
At a glance, the demand curves that a monopoly and a monopolistic competitor face look similar—that is, they both slope down. However, the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s demand curve is but one of many firms that make up the “before” market demand curve. Are you following? If so, how would you categorize the market for golf balls? Take a swing, then see the following Clear It Up feature.
CLEAR IT UP
Are golf balls really differentiated products?
Monopolistic competition refers to an industry that has more than a few firms, each offering a product which, from the consumer’s perspective, is different from its competitors. The U.S. Golf Association runs a laboratory that tests 20,000 golf balls a year. There are strict rules for what makes a golf ball legal. A ball's weight cannot exceed 1.620 ounces and its diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams and a diameter of 42.67 millimeters, in case you were wondering). The Association also tests the balls by hitting them at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of 120 miles per hour. As the testing center explains: “The USGA system then uses an array of sensors that accurately measure the flight of a golf ball during a short, indoor trajectory from a ball launcher. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball. ... The distance limit is 317 yards.”
Over 1800 golf balls made by more than 100 companies meet the USGA standards. The balls do differ in various ways, such as the pattern of dimples on the ball, the types of plastic on the cover and in the cores, and other factors. Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.
However, retail sales of golf balls are about $500 million per year, which means that many large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose. Sure, Tiger Woods can tell the difference. For the average amateur golfer who plays a few times a summer—and who loses many golf balls to the woods and lake and needs to buy new ones—most golf balls are pretty much indistinguishable.
How a Monopolistic Competitor Chooses Price and Quantity
The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve.
As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. The firm’s perceived demand curve is downward sloping, as
Figure 10.3
shows and the first two columns of
Table 10.1
.
Figure 10.3 How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price To maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a price of $16.
Quantity
Price
Total Revenue
Marginal Revenue
Total Cost
Marginal Cost
Average Cost
10
$23
$230
$23
$340
$34
$34
20
$20
$400
$17
$400
$6
$20
30
$18
$540
$14
$480
$8
$16
40
$16
$640
$10
$580
$10
$14.50
50
$14
$700
$6
$700
$12
$14
60
$12
$720
$2
$840
$14
$14
70
$10
$700
–$2
$1,020
$18
$14.57
80
$8
$640
–$6
$1,280
$26
$16
Table10.1 Revenue and Cost Schedule
We can multiply the combinations of price and quantity at each point on the demand curve to calculate the total revenue that the firm would receive, which is in the third column of
Table 10.1
. We calculate marginal revenue, in the fourth column, as the change in total revenue divided by the change in quantity. The final columns of
Table 10.1
show total cost, marginal cost, and average cost. As always, we calculate marginal cost by dividing the change in total cost by the change in quantity, while we calculate average cost by dividing total cost by quantity. The following Work It Out feature shows how these firms calculate how much of their products to supply at what price.
WORK IT OUT
How a Monopolistic Competitor Determines How Much to Produce and at What Price
The process by which a monopolistic competitor chooses its profit-maximizing quantity and price resembles closely how a monopoly makes these decisions process. First, the firm selects the profit-maximizing quantity to produce. Then the firm decides what price to charge for that quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level of output. In this case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to produce by considering its marginal revenues and marginal costs. Two scenarios are possible:
· If the firm is producing at a quantity of output where marginal revenue exceeds marginal cost, then the firm should keep expanding production, because each marginal unit is adding to profit by bringing in more revenue than its cost. In this way, the firm will produce up to the quantity where MR = MC.
· If the firm is producing at a quantity where marginal costs exceed marginal revenue, then each marginal unit is costing more than the revenue it brings in, and the firm will increase its profits by reducing the quantity of output until MR = MC.
In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When the firm has determined its profit-maximizing quantity of output, it can then look to its perceived demand curve to find out what it can charge for that quantity of output. On the graph, we show this process as a vertical line reaching up through the profit-maximizing quantity until it hits the firm’s perceived demand curve. For Authentic Chinese Pizza, it should charge a price of $16 per pizza for a quantity of 40.
Once the firm has chosen price and quantity, it’s in a position to calculate total revenue, total cost, and profit. At a quantity of 40, the price of $16 lies above the average cost curve, so the firm is making economic profits. From
Table 10.1
we can see that, at an output of 40, the firm’s total revenue is $640 and its total cost is $580, so profits are $60. In
Figure 10.3
, the firm’s total revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of $16 on the vertical axis. The firm’s total costs are the light shaded rectangle with the same quantity of 40 on the horizontal axis but the average cost of $14.50 on the vertical axis. Profits are total revenues minus total costs, which is the shaded area above the average cost curve.
Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions, two differences are worth remembering. First, although both a monopolist and a monopolistic competitor face downward-sloping demand curves, the monopolist’s perceived demand curve is the market demand curve, while the perceived demand curve for a monopolistic competitor is based on the extent of its product differentiation and how many competitors it faces. Second, a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic competitor who earns profits must expect the entry of firms with similar, but differentiated, products.
Monopolistic Competitors and Entry
If one monopolistic competitor earns positive economic profits, other firms will be tempted to enter the market. A gas station with a great location must worry that other gas stations might open across the street or down the road—and perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers. A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes. A laundry detergent with a great reputation for quality must take note that other competitors may seek to build their own reputations.
The entry of other firms into the same general market (like gas, restaurants, or detergent) shifts the demand curve that a monopolistically competitive firm faces. As more firms enter the market, the quantity demanded at a given price for any particular firm will decline, and the firm’s perceived demand curve will shift to the left. As a firm’s perceived demand curve shifts to the left, its marginal revenue curve will shift to the left, too. The shift in marginal revenue will change the profit-maximizing quantity that the firm chooses to produce, since marginal revenue will then equal marginal cost at a lower quantity.
Figure 10.4
(a) shows a situation in which a monopolistic competitor was earning a profit with its original perceived demand curve (D0). The intersection of the marginal revenue curve (MR0) and marginal cost curve (MC) occurs at point S, corresponding to quantity Q0, which is associated on the demand curve at point T with price P0. The combination of price P0 and quantity Q0 lies above the average cost curve, which shows that the firm is earning positive economic profits.
Figure 10.4 Monopolistic Competition, Entry, and Exit (a) At P0 and Q0, the monopolistically competitive firm in this figure is making a positive economic profit. This is clear because if you follow the dotted line above Q0, you can see that price is above average cost. Positive economic profits attract competing firms to the industry, driving the original firm’s demand down to D1. At the new equilibrium quantity (P1, Q1), the original firm is earning zero economic profits, and entry into the industry ceases. In (b) the opposite occurs. At P0 and Q0, the firm is losing money. If you follow the dotted line above Q0, you can see that average cost is above price. Losses induce firms to leave the industry. When they do, demand for the original firm rises to D1, where once again the firm is earning zero economic profit.
Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm with positive economic profits will attract competition. When another competitor enters the market, the original firm’s perceived demand curve shifts to the left, from D0 to D1, and the associated marginal revenue curve shifts from MR0 to MR1. The new profit-maximizing output is Q1, because the intersection of the MR1 and MC now occurs at point U. Moving vertically up from that quantity on the new demand curve, the optimal price is at P1.
As long as the firm is earning positive economic profits, new competitors will continue to enter the market, reducing the original firm’s demand and marginal revenue curves. The long-run equilibrium is in the figure at point Y, where the firm’s perceived demand curve touches the average cost curve. When price is equal to average cost, economic profits are zero. Thus, although a monopolistically competitive firm may earn positive economic profits in the short term, the process of new entry will drive down economic profits to zero in the long run. Remember that zero economic profit is not equivalent to zero accounting profit. A zero economic profit means the firm’s accounting profit is equal to what its resources could earn in their next best use.
Figure 10.4
(b) shows the reverse situation, where a monopolistically competitive firm is originally losing money. The adjustment to long-run equilibrium is analogous to the previous example. The economic losses lead to firms exiting, which will result in increased demand for this particular firm, and consequently lower losses. Firms exit up to the point where there are no more losses in this market, for example when the demand curve touches the average cost curve, as in point Z.
Monopolistic competitors can make an economic profit or loss in the short run, but in the long run, entry and exit will drive these firms toward a zero economic profit outcome. However, the zero economic profit outcome in monopolistic competition looks different from the zero economic profit outcome in perfect competition in several ways relating both to efficiency and to variety in the market.
Monopolistic Competition and Efficiency
The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency: goods are produced at the lowest possible average cost. However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient.
In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short and long run. This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. In a monopolistically competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than marginal revenue, not equal to it because the demand curve is downward sloping. When P > MC, which is the outcome in a monopolistically competitive market, the benefits to society of providing additional quantity, as measured by the price that people are willing to pay, exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. This is the same argument we made about monopoly, but in this case the allocative inefficiency will be smaller. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry. See the following Clear It Up feature for more detail on the impact of demand shifts.
CLEAR IT UP
Why does a shift in perceived demand cause a shift in marginal revenue?
We use the combinations of price and quantity at each point on a firm’s perceived demand curve to calculate total revenue for each combination of price and quantity. We then use this information on total revenue to calculate marginal revenue, which is the change in total revenue divided by the change in quantity. A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output. Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price. Another way of interpreting this shift in demand is to notice that, for each quantity sold, the firm will charge a lower price. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well. Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.
A monopolistically competitive industry does not display productive or allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits.
The Benefits of Variety and Product Differentiation
Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own. Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles; not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. They argue that much of the cost of creating such a high degree of product differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price. Defenders of a market-oriented economy respond that if people do not want to buy differentiated products or highly advertised brand names, no one is forcing them to do so. Moreover, they argue that consumers benefit substantially when firms seek short-term profits by providing differentiated products. This controversy may never be fully resolved, in part because deciding on the optimal amount of variety is very difficult, and in part because the two sides often place different values on what variety means for consumers. Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition.
CLEAR IT UP
How does advertising impact monopolistic competition?
The U.S. economy spent about $180.12 billion on advertising in 2014, according to eMarketer.com. Roughly one third of this was television advertising, and another third was divided roughly equally between internet, newspapers, and radio. The remaining third was divided between direct mail, magazines, telephone directory yellow pages, and billboards. Mobile devices are increasing the opportunities for advertisers.
Advertising is all about explaining to people, or making people believe, that the products of one firm are differentiated from another firm’s products. In the framework of monopolistic competition, there are two ways to conceive of how advertising works: either advertising causes a firm’s perceived demand curve to become more inelastic (that is, it causes the perceived demand curve to become steeper); or advertising causes demand for the firm’s product to increase (that is, it causes the firm’s perceived demand curve to shift to the right). In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits.
However, economists and business owners have also long suspected that much of the advertising may only offset other advertising. Economist A. C. Pigou wrote the following back in 1920 in his book, The Economics of Welfare:
It may happen that expenditures on advertisement made by competing monopolists [that is, what we now call monopolistic competitors] will simply neutralise one another, and leave the industrial position exactly as it would have been if neither had expended anything. For, clearly, if each of two rivals makes equal efforts to attract the favour of the public away from the other, the total result is the same as it would have been if neither had made any effort at all.
Learning Objectives
By the end of this section, you will be able to:
· Explain why and how oligopolies exist
· Contrast collusion and competition
· Interpret and analyze the prisoner’s dilemma diagram
· Evaluate the tradeoffs of imperfect competition
Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)’ decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.
Why Do Oligopolies Exist?
A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.
Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.
Collusion or Competition?
When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion. A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel. See the following Clear It Up feature for a more in-depth analysis of the difference between the two.
CLEAR IT UP
Collusion versus cartels: How to differentiate
In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.
The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.
Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors.
The Prisoner’s Dilemma
Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory, a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.
The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner’s dilemma goes like this:
Two co-conspiratorial criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.
The game theory situation facing the two prisoners is in
Table 10.2
. To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A should confess, too, so as to not get stuck with the eight years in prison. However, if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. To confess is called the dominant strategy. It is the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them.
Prisoner B
Remain Silent (cooperate with other prisoner)
Confess (do not cooperate with other prisoner)
Prisoner A
Remain Silent (cooperate with other prisoner)
A gets 2 years, B gets 2 years
A gets 8 years, B gets 1 year
Confess (do not cooperate with other prisoner)
A gets 1 year, B gets 8 years
A gets 5 years B gets 5 years
Table10.2 The Prisoner’s Dilemma Problem
The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.
The Oligopoly Version of the Prisoner’s Dilemma
The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits.
Table 10.3
shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly. If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.
Firm B
Hold Down Output (cooperate with other firm)
Increase Output (do not cooperate with other firm)
Firm A
Hold Down Output (cooperate with other firm)
A gets $1,000, B gets $1,000
A gets $200, B gets $1,500
Increase Output (do not cooperate with other firm)
A gets $1,500, B gets $200
A gets $400, B gets $400
Table10.3 A Prisoner’s Dilemma for Oligopolists
Can the two firms trust each other? Consider the situation of Firm A:
· If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in
Table 10.3
) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
· If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).
Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions that will lead B also to expand output.
The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits. The following Clear It Up feature discusses one cartel scandal in particular.
CLEAR IT UP
What is the Lysine cartel?
Lysine, a $600 million-a-year industry, is an amino acid that farmers use as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.
From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:
I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.
The price of lysine doubled while the cartel was in effect. Confronted by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and paid a fine of $100 million. A number of top executives, both at ADM and other firms, later paid fines of up to $350,000 and were sentenced to 24–30 months in prison.
In another one of the FBI recordings, the president of Archer Daniels Midland told an executive from another competing firm that ADM had a slogan that, in his words, had “penetrated the whole company.” The company president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” That slogan could stand as the motto of cartels everywhere.
How to Enforce Cooperation
How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.
Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC), have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.
LINK IT UP
Visit the Organization of the Petroleum Exporting Countries
website
and learn more about its history and how it defines itself.
Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.
One example of the pressure these firms can exert on one another is the kinked demand curve, in which competing oligopoly firms commit to match price cuts, but not price increases.
Figure 10.5
shows this situation. Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.
If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price, and share a monopoly level of profits even without any legally enforceable agreement.
Figure 10.5 A Kinked Demand Curve Consider a member firm in an oligopoly cartel that is supposed to produce a quantity of 10,000 and sell at a price of $500. The other members of the cartel can encourage this firm to honor its commitments by acting so that the firm faces a kinked demand curve. If the oligopolist attempts to expand output and reduce price slightly, other firms also cut prices immediately—so if the firm expands output to 11,000, the price per unit falls dramatically, to $300. On the other side, if the oligopoly attempts to raise its price, other firms will not do so, so if the firm raises its price to $550, its sales decline sharply to 5,000. Thus, the members of a cartel can discipline each other to stick to the pre-agreed levels of quantity and price through a strategy of matching all price cuts but not matching any price increases.
Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.
Tradeoffs of Imperfect Competition
Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.
Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffered by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.
The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers.
Monopoly and Antitrust Policy
discusses the delicate judgments that go into this task.
BRING IT HOME
The Temptation to Defy the Law
Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, sometimes lasting more than four hours, the companies established complex pricing structures. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.
How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region. There were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.
Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.
cartel
a group of firms that collude to produce the monopoly output and sell at the monopoly price
collusion
when firms act together to reduce output and keep prices high
differentiated product
a product that consumers perceive as distinctive in some way
duopoly
an oligopoly with only two firms
game theory
a branch of mathematics that economists use to analyze situations in which players must make decisions and then receive payoffs based on what decisions the other players make
imperfectly competitive
firms and organizations that fall between the extremes of monopoly and perfect competition
kinked demand curve
a perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases
monopolistic competition
many firms competing to sell similar but differentiated products
oligopoly
when a few large firms have all or most of the sales in an industry
prisoner’s dilemma
a game in which the gains from cooperation are larger than the rewards from pursuing self-interest
product differentiation
any action that firms do to make consumers think their products are different from their competitors’
10.1 Monopolistic Competition
Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product.
The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price that the firm’s demand curve indicates.
If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run.
A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm.
Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.
10.2 Oligopoly
An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.
The prisoner’s dilemma is an example of the application of game theory to analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.
.
Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product. How will that affect the price it charges and the quantity it supplies?
2
.
Continuing with the scenario in question 1, in the long run, the positive economic profits that the monopolistic competitor earns will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm’s profit, what will happen to the original firm’s profit-maximizing price and output levels?
3
.
Consider the curve in the figure below, which shows the market demand, marginal cost, and marginal revenue curve for firms in an oligopolistic industry. In this example, we assume firms have zero fixed costs.
Figure 10.6
a. Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn?
b. Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will be the industry quantity and price? What will be the collective profits of all firms in the industry?
c. Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes.
4
.
Sometimes oligopolies in the same industry are very different in size. Suppose we have a duopoly where one firm (Firm A) is large and the other firm (Firm B) is small, as the prisoner’s dilemma box in
Table 10.4
shows.
Firm B colludes with Firm A
Firm B cheats by selling more output
Firm A colludes with Firm B
A gets $1,000, B gets $100
A gets $800, B gets $200
Firm A cheats by selling more output
A gets $1,050, B gets $50
A gets $500, B gets $20
Table10.4
Assuming that both firms know the payoffs, what is the likely outcome in this case?
5.
What is the relationship between product differentiation and monopolistic competition?
6.
How is the perceived demand curve for a monopolistically competitive firm different from the perceived demand curve for a monopoly or a perfectly competitive firm?
7.
How does a monopolistic competitor choose its profit-maximizing quantity of output and price?
8.
How can a monopolistic competitor tell whether the price it is charging will cause the firm to earn profits or experience losses?
9.
If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?
10.
Is a monopolistically competitive firm productively efficient? Is it allocatively efficient? Why or why not?
11.
Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain.
12.
Does each individual in a prisoner’s dilemma benefit more from cooperation or from pursuing self-interest? Explain briefly.
13.
What stops oligopolists from acting together as a monopolist and earning the highest possible level of profits?
14.
Aside from advertising, how can monopolistically competitive firms increase demand for their products?
15.
Make a case for why monopolistically competitive industries never reach long-run equilibrium.
16.
Would you rather have efficiency or variety? That is, one opportunity cost of the variety of products we have is that each product costs more per unit than if there were only one kind of product of a given type, like shoes. Perhaps a better question is, “What is the right amount of variety? Can there be too many varieties of shoes, for example?”
17.
Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product? Explain your reasoning.
18.
When OPEC raised the price of oil dramatically in the mid-1970s, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude? Hint: You may wish to consider non-economic reasons.
19.
Andrea’s Day Spa began to offer a relaxing aromatherapy treatment. The firm asks you how much to charge to maximize profits. The first two columns in
Table 10.5
provide the price and quantity for the demand curve for treatments. The third column shows its total costs. For each level of output, calculate total revenue, marginal revenue, average cost, and marginal cost. What is the profit-maximizing level of output for the treatments and how much will the firm earn in profits?
Price
Quantity
TC
$25.00
0
$130
$24.00
10
$275
$23.00
20
$435
$22.50
30
$610
$22.00
40
$800
$21.60
50
$1,005
$21.20
60
$1,225
Table10.5
20.
Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn. If they work independently, they will each earn $100. If they decide to work together and both lower their output, they can each earn $150. If one person lowers output and the other does not, the person who lowers output will earn $0 and the other person will capture the entire market and will earn $200.
Table 10.6
represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate? If Mary thinks Raj will cheat, what should Mary do and why? What is the prisoner’s dilemma result? What is the preferred choice if they could ensure cooperation? A = Work independently; B = Cooperate and Lower Output. (Each results entry lists Raj’s earnings first, and Mary’s earnings second.)
Mary
A
B
Raj
A
($100, $100)
($200, $0)
B
($0, $200)
($150, $150)
Table10.6
21.
Jane and Bill are apprehended for a bank robbery. They are taken into separate rooms and questioned by the police about their involvement in the crime. The police tell them each that if they confess and turn the other person in, they will receive a lighter sentence. If they both confess, they will be each be sentenced to 30 years. If neither confesses, they will each receive a 20-year sentence. If only one confesses, the confessor will receive 15 years and the one who stayed silent will receive 35 years.
Table 10.7
below represents the choices available to Jane and Bill. If Jane trusts Bill to stay silent, what should she do? If Jane thinks that Bill will confess, what should she do? Does Jane have a dominant strategy? Does Bill have a dominant strategy? A = Confess; B = Stay Silent. (Each results entry lists Jane’s sentence first (in years), and Bill’s sentence second.)
Jane
A
B
Bill
A
(30, 30)
(15, 35)
B
(35, 15)
(20, 20)
Table10.7
Figure 11.1 Oligopoly versus Competitors in the Marketplace Large corporations, such as the natural gas producer Kinder Morgan, can bring economies of scale to the marketplace. Will that benefit consumers, or is more competition better? (Credit: modification of work by Derrick Coetzee/Flickr Creative Commons)
CHAPTER OBJECTIVES
In this chapter, you will learn about:
· Corporate Mergers
· Regulating Anticompetitive Behavior
· Regulating Natural Monopolies
· The Great Deregulation Experiment
BRING IT HOME
More than Cooking, Heating, and Cooling
If you live in the United States, there is a slightly better than 50–50 chance your home is heated and cooled using natural gas. You may even use natural gas for cooking. However, those uses are not the primary uses of natural gas in the U.S. In 2016, according to the U.S. Energy Information Administration, home heating, cooling, and cooking accounted for just 16% of natural gas usage. What accounts for the rest? The greatest uses for natural gas are the generation of electric power (36%) and in industry (28%). Together these three uses for natural gas touch many areas of our lives, so why would there be any opposition to a merger of two natural gas firms? After all, a merger could mean increased efficiencies and reduced costs to people like you and me.
In October 2011, Kinder Morgan and El Paso Corporation, two natural gas firms, announced they were merging. The announcement stated the combined firm would link “nearly every major production region with markets,” cut costs by “eliminating duplication in pipelines and other assets,” and that “the savings could be passed on to consumers.”
The objection? The $21.1 billion deal would give Kinder Morgan control of more than 80,000 miles of pipeline, making the new firm the third largest energy producer in North America. Policymakers and the public wondered whether the new conglomerate really would pass on cost savings to consumers, or would the merger give Kinder Morgan a strong oligopoly position in the natural gas marketplace?
That brings us to the central questions this chapter poses: What should the balance be between corporate size and a larger number of competitors in a marketplace, and what role should the government play in this balancing act?
The previous chapters on the theory of the firm identified three important lessons: First, that competition, by providing consumers with lower prices and a variety of innovative products, is a good thing; second, that large-scale production can dramatically lower average costs; and third, that markets in the real world are rarely perfectly competitive. As a consequence, government policymakers must determine how much to intervene to balance the potential benefits of large-scale production against the potential loss of competition that can occur when businesses grow in size, especially through mergers.
For example, in 2006, AT&T and BellSouth proposed a merger. At the time, there were very few mobile phone service providers. Both the Justice Department and the FCC blocked the proposal.
The two companies argued that the merger would benefit consumers, who would be able to purchase better telecommunications services at a cheaper price because the newly created firm would take advantage of economies of scale and eliminate duplicate investments. However, a number of activist groups like the Consumer Federation of America and Public Knowledge expressed fears that the merger would reduce competition and lead to higher prices for consumers for decades to come. In December 2006, the federal government allowed the merger to proceed. By 2009, the new post-merger AT&T was the eighth largest company by revenues in the United States, and by that measure the largest telecommunications company in the world. Economists have spent – and will still spend – years trying to determine whether the merger of AT&T and BellSouth, as well as other smaller mergers of telecommunications companies at about this same time, helped consumers, hurt them, or did not make much difference.
This chapter discusses public policy issues about competition. How can economists and governments determine when mergers of large companies like AT&T and BellSouth should be allowed and when they should be blocked? The government also plays a role in policing anticompetitive behavior other than mergers, like prohibiting certain kinds of contracts that might restrict competition. In the case of natural monopoly, however, trying to preserve competition probably will not work very well, and so government will often resort to regulation of price and/or quantity of output. In recent decades, there has been a global trend toward less government intervention in the price and output decisions of businesses.
Chapter 3
Elasticity
A firm’s market performance depends on several factors, some of which are directly under a manager’s control, while others are not. The individual firm cannot affect market interest rates, the pricing and advertising strategies of rivals, foreign-exchange rates that affect overseas sales or the cost of imports, business cycles, unemployment, or the rate of inflation. On the other hand, managers do control the firm’s organizational structure, pricing, product design and packaging, marketing strategy, research and development expen- ditures, and so on. Changes in any of these factors can have a profound effect on the firm’s bottom line.
In the previous chapter we examined how changes in price and other determi- nants affect the demand for goods and services. In this chapter we will explore these relationships in greater detail by introducing the important concept of elasticity, and how this measure can be used by managers to assess the effects of changes in the firm’s pricing and advertising strategies, business cycle fluctua- tions, changes in the pricing and advertising strategies of rival firms, and other factors that affect the firm’s bottom line. We will begin our discussion with the most important of these elasticity measures—the price elasticity of demand.
PRICE ELASTICITY OF dEMANd
(
x
)In general, elasticity measures the percent change in the value of a dependent variable given a percent change in the value of an explanatory variable. Sup- pose, for example, the demand for a firm’s product (Q d) depends on its price (Px), the consumer’s money income (M), the price charge by rival firms (Py),
and the firm’s advertising expenditures (A). This relationship may be written
Qd f P , M, P , A. (3.1)
x x y
55
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)56 Chapter 3
On the basis of historical data, it should be possible for a firm to estimate the demand equation for its product, which may be used by a manager to improve the company’s overall performance. Suppose, for example, that the demand for a firm’s product x is given by the equation
Qx 127 50Px . (3.2)
This linear demand equation is depicted in Figure 3.1. The slope coefficient βx = −50 tells us that the quantity demanded of good x increases (decreases) by 50 thousand units for every $1 decrease (increase) in its price.
The value of the slope may be calculated directly from the information provided in Figure 3.1. As we move along the demand curve from point A to point B, the value of the slope may be calculated as
(
x
) Qx Q2 Q1 22 12 50. (3.3)
Px P2 P1 2.10 2.30
The value of the slope (βx) measures the change in unit sales resulting from a change in the price of a good or service. How a consumer reacts to a $10 rebate on the purchase of an item selling for $100, however, can be quite different than the same rebate on an item that costs $1,000. A 10 percent rebate may be viewed as a real bargain; 1 percent rebate may be interpreted as a marketing ploy. On the other hand, if a firm offers a 10 percent rebate regardless of price, the consumer’s reaction may be quite different. For the
Figure 3.1
Elasticity 57
manager, the question is how will a 10 percent rebate affect the company’s unit sales, revenues, and profits?
Another problem with the slope is that its numerical value depends on how we measure unit sales. Suppose, for example, that unit sales in Eq. (3.3) are measured in units instead of thousands of units. In this case, the value of the slope is β1 = −50,000. Although we are dealing with the same rela- tionship, changing the units of measurement changes the slope’s numerical value. A related problem is comparing consumer sensitivity to similar price changes for different products, such as the demand for automobiles, yards of cloth, gallons of beer, and pounds of beef. To overcome these measurement problems, economists substitute the slope with the price elasticity of demand, which is a dimensionless measure of consumer sensitivity.
The price elasticity of demand measures the percent change in the quan- tity demanded of a good or service given a percent change in its price, that is
Ex, x
%Qx .
%Px
(3.4)
The first subscript of Ex,x refers the quantity demanded of good x and the second subscript refers to the price of good x. In subsequent sections we will discuss several other elasticity measures that follow this convention.
SOLvEd ExERCISE
Suppose that the price elasticity of demand for a product is −2. How will the quantity demanded of this product change is price is reduced by 5 percent?
Solution
Substituting these values into Eq. (3.4) we get
2 %Qx .
5
(3.5)
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)
Solving, the percent change in the quantity demanded is %Qx = 10. That is, a 5 percent reduction in price results in a 10 percent increase in quantity demanded.
Calculating the Price Elasticity of demand
The price elasticity of demand is the percent change in the quantity demanded given a percent change in price. How we calculate the price elasticity of demand depends on the available information.
58 Chapter 3
Midpoint Formula
Suppose you are given two price quantity combinations (P1, Q1) and (P2, Q2), such as points A and B in Figure 3.1. Calculating the price elasticity of demand using Eq. (3.4) is not as straightforward as it appears. This is because we normally calculate a percent change by subtracting the starting value from the ending value, and then divide by the starting value. For example, if price
increases from P1 to P2, the percent change in price is would be calculated as
%P P2 P1 100 0.
(3.6)
x
P1
On the other hand, if the price declines from P2 to P1, the percent change in price is
%P P2 P1 100 0.
(3.7)
x
P2
Ignoring the sign change, Eqs. (3.6) and (3.7) are not equal because are the denominators are different. The same applies to calculating the percent change in quantity demanded. The effect on the calculated price elasticity of demand can be significant. For example, the price elasticity of demand when moving from point A to point B in Figure 3.1 is
E %Qx 22 12 / 12 9.58.
(3.8)
x,x %P 2.10 2.30 / 2.30
x
By contrast, the value of the price elasticity of demand when moving from point B to point A is
E %Qx 12 22 / 22 4.77.
(3.9)
x,x %P 2.30 2.10 / 2.10
x
What is needed is an elasticity measure that does not depend on whether we are moving from point A to point B, or from point B to point A. A con- venient approximation of the price elasticity of demand is the midpoint formula, which is given by the equation
E Q2 Q1 P1 P2
P1 P2 ,
(3.10)
x, x
P P
Q Q
x Q Q
2 1
1 2
1 2
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)where βx = (Q2 − Q1)/(P2 − P1) = Qx/Px is the slope of the demand curve.
The midpoint formula allows us to calculate a price elasticity of demand
that is invariant with respect to a price increase or decrease. Moving from point A to point B, the price elasticity of demand using Eq. (3.10) is
Elasticity 59
E 22 12 2.30 2.10 6.47 .
(3.11)
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)x, x 2.10 2.30 12 22 1
It is left as an exercise for the reader to show that this is the same value for the price elasticity of demand when moving from point B to point A. The interpretation of this result is that a one percent increase in price will result in a 6.47 percent decrease in the quantity demanded. Conversely, a one percent decrease in price will result in a 6.47 percent increase in the quantity demanded.
Point Price Elasticity of Demand
As we have seen, the price elasticity of demand has several advantages over the slope as a measure of consumer sensitivity. It is also easy to calculate and interpret. Unfortunately, the midpoint formula suffers from two weaknesses that reduce its usefulness. To begin with, the midpoint formula implicitly assumes that the underlying demand curve is linear. Since demand curves are
more appropriately convex, the value Ex,x is sometimes referred to as the arc price elasticity of demand.
Another weakness of the midpoint formula is that it produces a value that depends on the price-quantity combinations selected for its calculation. Care must be exercised when choosing (P1, Q1) and (P2, Q2). To see why, consider
Figure 3.2. As we will soon discover, the percent change in the quantity
Figure 3.2
60 Chapter 3
demanded is greater than the percent change in price for all price-quantity combinations above the midpoint, such as points A and B, and vice versa for price-quantity combinations below the midpoint, such as points C and D. At the midpoint, the percent change in the quantity demand equals the percent change in price.
It is important for a manager to know whether the quantity demanded for the firm’s product is above or below the midpoint since a change in price will have predictable effects on a firm’s revenues and profits. Unfortunately, a manager may know whether the price charged is above or below the mid- point. For this reason, it is important when using the midpoint formula for managers to choose price-quantity combinations that are “close” together. This will minimize the possibility of spanning the midpoint, which would make it difficult to identify consumer sensitivity to price changes.
An alternative to the midpoint formula is the point price elasticity of demand (εx,x), which is unique at each and every point along a demand curve. The point price elasticity of demand is given by the equation
Qx Px
Px ,
(3.12)
x, x
P
Q
x Q
x x x
where βx is the slope of the demand curve.
Consider, for example, the demand curve given by Eq. (3.2). Using the
midpoint formula, the price elasticity of demand over the line segment AB is Ex,x = −6.47. Since the slope of the demand curve is βx = −50, the point price elasticity of demand at point A is
A Qx Px 50 2.30 9.58.
(3.13)
x, x
P
Q
12
x x
The point price elasticity of demand at point B is
Qd P
2.10
B x
x
50
4.77.
(3.14)
(
Q
d
)x, x
Px x
22
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)The reader should note that the value of the price elasticity of demand using the midpoint formula is between the point price elasticity at points A and B. The reader is also cautioned that the price elasticity of demand using the midpoint formula is not a simple average of the point price elasticities.
SOLvEd ExERCISE
Suppose that the demand for a good is given by the equation Qx = 50 − 2.25Px. Calculate the point price elasticity of demand when Px = $2.
Solution
Elasticity 61
Qx Px 2.25
2
0.099.
x, x
P
Q
50 2.252
(3.15)
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) x x
Midpoint Formula versus the Point Price Elasticity
The main advantage of the midpoint formula is its minimal data require- ments. Only two price-quantity combinations are needed to calculate its value. This is particularly important for small and medium sized firms that lack the financial and technical resources to conduct sophisticated market and statistical research. All a manager needs to do is change the price of the firm’s product by a small amount and use the resulting sales data to approximate the price elasticity of demand using the midpoint formula.
Unfortunately, the midpoint formula may not be a particularly good mea- sure of consumer sensitivity to price changes. The midpoint formula intro- duces distortions that become more acute when price changes are large, or when the underlying demand curve is nonlinear. The point price elasticity is a superior measure of consumer sensitivity to price changes, although manag- ers should limit its application to small changes in price.
definitions
According to the law of demand, there is an inverse relationship between a percent change in price and the percent change in the quantity demanded. For this reason, the price elasticity of demand is between zero and −∞. It is sometimes convenient, however, to express the price elasticity of demand in absolute terms, which is always positive.
Price Elastic Demand
Demand is said to be price elastic when |εx,x| >1 (εx,x < −1). In this case, the absolute value of the percent change in quantity demanded is greater than the absolute value of the percent change in price (|%Qx| > |%Px|). Suppose, for example, that a 2 percent increase in price results in a 4 percent decline in quantity demanded. The demand for this product is price elastic because
|εx,x| = |−4/2| = 2 >1. Demand is described as perfectly elastic when |εx,x| = ∞ (εx,x = −∞). This occurs when Qx/Px = −∞ or Px/Qx = ∞. These conditions are depicted for the linear demand curve in Figure 3.3.
Price Inelastic Demand
Demand is said to be price inelastic when |εx,x| <1 (−1 < εx,x < 0). This occurs when |%Q d| < |%P |. Suppose, for example, that a 2 percent increase in
x x
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)62 Chapter 3
price leads to a 1 percent decline in quantity demanded. The demand for this product is price inelastic because |εx,x| = |−1/2| < 1. Demand is perfectly inelastic when εx,x = 0, which occurs when Qx/Px = 0 or Px/Qx = 0. These conditions are depicted in Figure 3.4.
Figure 3.3
Figure 3.4
Unit Elastic Demand
Elasticity 63
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)Finally, demand is said to be unit elastic when |εx,x| =1 (εx,x = −1), which occurs when |%Q d| = |%P |. Suppose that a 2 percent increase in price
x x
leads to a 2 percent decline in quantity demanded. The demand for this prod- uct is unit elastic since |εx,x| = |−2/2| = 1.
determinants of the Price Elasticity of demand
Several factors that affect a consumer’s sensitivity to a price change. In this section we will discuss three factors that affect the price elasticity of demand, including the number of close substitutes, the proportion of the consumer’s income spent on the product, and the amount of time that a consumer has to adjust to the price change.
Substitutability
The price elasticity of demand is partly explained by the availability of close substitutes. Intuitively, the greater the number of close substitutes, the more price elastic is the demand for a product. This is because it is easier for buyers to find less expensive, albeit not perfect, alternatives. Conversely, the fewer the number of close substitutes, the less price elastic since substitutes are dif- ficult to locate.
The price elasticity of demand also depends on how narrowly we define classes of products. The demand for Coca-Cola, for example, is more price elastic than the demand for soft drinks in general. When the price of Coca- Cola increases, consumers can switch to Pepsi Cola, 7-Up, Dr. Pepper, Gatorade, and so on. On the other hand, there are fewer alternatives if there is an increase in the price of all soft drinks.
The demand curve for the product of a firm that has a large number of sub- stitutes is “flatter” than the demand curve for a firm with few substitutes. The extreme case is when a firm has a large number of rivals that sell identically the same product. In this case, the demand for the firm’s product is perfectly elastic (|εx,x| = ∞) and the demand curve horizontal. In this case, a manager
that increases the price even slightly will discover that consumers will pur-
chase nothing at all as they switch to the cheaper, identical products of rival firms. By contrast, when the demand for a firm’s good is perfectly inelastic
(|εx,x| = 0), consumers do not alter their purchases at all in response to a price change. In this case, demand curve is vertical.
Of course, the demand for a good or service is rarely perfectly elastic or perfectly inelastic. The demand curve for most goods and services is down- ward sloping. In the next section, we will learn about the important relation- ship between the price elasticity of demand and the firm’s total revenue from
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)64 Chapter 3
sales of its product. In Chapter 11, we will discuss how this information can be used to formulate an optimal pricing strategy.
Proportion of Income
When the purchase of a good constitutes a relatively large proportion of a person’s total expenditures increases, an increase in the price of a big-ticket item, such as a washer dryer or automobile, than an equivalent increase in the price of a good that constitutes a relatively small percentage of a family’s income, such as an ounce of table salt. In 2013, the median per family income in the
U.S was around $51,000. Members of this group will sit up and take notice of a 10 percent increase in the price of a $20,000 Honda Civic, will hardly bat an eye- lash at an equivalent increase in the $1.40 price of a 2 liter bottle of Coke Classic.
Adjustment Period
In general, consumers tend to be less price sensitive in the short run than in the long run. For many goods and services it takes time for individuals and families to adjust their budgets expenditures to a price change. Consider, for example, an increase in the price of gasoline from, say, $3.50 to $5.00 per gallon. In the short run, many drivers have no choice but to pay the higher price since automobiles are essential to many aspects of a family’s daily lives, such as getting the kids to school, driving to work, grocery shopping, and so on. In the short run, many drivers may be able to make modest adjustments in their driving patterns to reduce the number of miles driven, perhaps by combining trips to the super market with the daily commute to work. Over a longer period of time, however, some people will trade in their gas guzzlers for more fuel efficient substitutes. The fact that consumer purchases are sensitive to the adjustment period also helps to explain why airlines charge higher fares for tickets purchased the day before a scheduled flight than when a ticket is purchased two months in advance.
Total and Marginal Revenue
The price elasticity of demand is a valuable business tool because it enables a manager to predict how a price will affect unit sales and revenues. Suppose, for example, that a manager is contemplating a 10 percent price increase and the demand for the firm’s product is price inelastic. If the price elasticity of
demand is εx,x = %Qx/%Px = −1/2, the result will be a 5 percent decline in unit sales. The effect on total revenues can be can be decomposed into two effects. On the one hand, the price increase will push up revenues by about 10 percent. On the other hand, the decline in unit sales will push down rev- enues by about 5 percent. The net effect is an increase in total revenues of around 5 percent.
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)Elasticity 65
Suppose, on the other hand, that demand is price elastic and εx,x = −2. In this case, a 10 percent increase in price will increase revenues by about 10 percent, but the fall in sales will reduce revenues by about 20 percent. In this case, the net effect is a decline in total revenues of around 10 percent. Finally, if demand is unit elastic, a 10 percent increase in price will increase total reve- nues by about 10 percent, which will be exactly offset by a 10 percent decline in revenues from lost unit sales. The net effect is no change in total revenues.
To make the discussion more concrete, suppose that the demand for good
x is given by the equation
Qx 80 10Px . (3.16)
Table 3.1 summarizes the price elasticity of demand and total revenue (TRx = Px Qx) for alternative price quantity combinations. At a price of $6, for example, the quantity demanded is 20 units. At this price-quantity combina- tion the point price elasticity of demand is −3 and the firm’s total revenue is
$6(20) = $120. The price elasticity of demand tells us that in the neighbor- hood of this price-quantity combination, a 1 percent decline in price will result in 3 percent increase in the quantity demanded and an increase in total revenue. Suppose that the firm lowers price to $5, which increases sales to 30 units and total revenue to $5(30) = $150. At this price-quantity combina- tion the point price elasticity of demand is εx,x = −1.67. The price reduction
from $6 to $5 results in a decline of total revenues of −$1 × 20 = −$20. The
increase in sales at the lower price, however, results in increase in revenues of $5(10) = $50.
A $1 price reduction when demand is price elastic results in an increase in total revenue. What happens when price is reduced by $1 when demand is price inelastic? Suppose, for example, that the firm initially charges a price of $3 and sells 50 units. At this price-quantity combination the point price elasticity of demand is εx,x = −0.6 and total revenue is $3(50) = $150. If
the firm cuts price to $2, sales will increases to 60 units. At this price-quantity
Table 3.1
Px
Qx
Qx/Px
Px/Qx
d
εx,x
Demand is
MR
TR
0
80
−10
0
0
Perfectly inelastic
–8
0
1
70
−10
0.014
−0.14
Inelastic
–6
70
2
60
−10
0.033
−0.33
Inelastic
–4
120
3
50
−10
0.060
−0.60
Inelastic
–2
150
4
40
−10
0.100
−1.00
Unit elastic
0
160
5
30
−10
0.167
−1.67
Elastic
2
150
6
20
−10
0.300
−3.00
Elastic
4
120
7
10
−10
0.700
−7.00
Elastic
6
70
8
0
−10
∞
−∞
Perfectly elastic
8
0
66 Chapter 3
combination the point price elasticity of demand is εx,x = −0.33 and total revenue is $2(60) = $120. Reducing price by $1 causes total revenue to decline from $150 to $120. The price reduction lowers total revenue by
−$1(50) = −$5. The increase in revenues from greater units sales is only
$2(10) = $20. Lowering price by $1 when demand is price elastic causes revenues to decline by $30.
The above example highlights several important features that are common to all linear demand curves. Although the slope of this linear demand curve is the same at every price-quantity combination, the price elasticity of demand can take on any value between 0 and −∞. Demand is perfectly inelastic (εx,x = 0) where the demand curve intersects the quantity (horizontal) axis. The
demand curve is perfectly elastic (εx,x = −∞) where the demand curve inter-
sects the price (vertical) axis. At the midpoint of the demand curve, demand
is unit elastic (εx,x = −1). Demand is price elastic for any price-quantity com- bination above the midpoint. Finally, demand is price inelastic for any price quantity combination below the midpoint.
The relationship between total revenues and price elasticity for a linear demand curve depicted is summarized in Figure 3.5 and Table 3.2. Total rev- enue is maximized when demand is unit elastic, which occurs at the midpoint of the demand curve. As price is lowered (raised) in the elastic region, the quantity demanded increases (falls) and total revenue increases (decreases). When the price is lowered (raised) in the inelastic region, the quantity demanded increases (decreases) and total revenue falls (rises).
Figure 3.5 summarizes the relationships among the price elasticity of demand, total revenue and marginal revenue (MR), which is the change in total revenue (TR) from a change in the number of units sold. MR is positive for all price-quantity combinations along the elastic portion of the demand curve. Thus, lowering price will result in an increase in sales and revenues. MR is negative for all price-quantity combinations along the inelastic region of the demand curve. Reducing price in this region will result in an increase in sales, but a decrease in revenues.2
Formal Relationship between the Price Elasticity of demand and Total Revenue
The tight relationship between price, the price elasticity of demand, total revenue and marginal revenue is summarized by the equation
MR P 1 1 P 1 x, x .
(
)x
x, x
x
x, x
(3.17)
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)We know that total revenue is maximized where MR = 0. Since Px > 0, the term in the parenthesis of Eq. (3.17) must be equal to zero, which occurs
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)Elasticity 67
Figure 3.5
Table 3.2
|εx,x|
Px
Qx
TRx /Q = MRx
>1
−
+
+
>1
+
−
−
<1
−
+
−
<1
+
−
+
=1
−
+
−
=1
+
−
−
68 Chapter 3
when εx,x = –1. When demand is elastic, (εx,x < −1) the term in the parenthe- sis and marginal revenue must be positive. Thus, lowering price increases total revenue increases. When demand is inelastic (−1 < εx,x < 0), the term in parenthesis and marginal revenue must be negative. Lowering price reduces total revenue. These relationships are also summarized in Figure 3.5 and Table 3.2.
SOLvEd ExERCISE
Suppose that the demand for a firm’s product is given by the equation
Qx 50 2.5Px . (3.18)
Calculate the point price elasticity of demand and total revenue for Px = $0, Px = $5, Px = $10, Px = $15, and Px = $20. What can you conclude about the relationship between the price elasticity of demand and total revenue?
Solution
Total revenue is TR = Px Qx. From Eq. (3.18) we get
. Px .
(3.19)
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)x, x 2 5 50 2.5P
x
Eq. (3.19) can be used to calculate the price elasticity of demand for each price. These calculations are summarized in Table 3.3.
According to Table 3.3, total revenue is zero when demand is perfectly elastic or perfectly inelastic. When demand is inelastic, total revenue increases (decreases) when price is raised (lowered). When demand is elas- tic, total revenue increases (decreases) when price is lowered (raised). When demand is unit elastic, total revenue is maximized at $250.
Table 3.3
Px
Qx
TR
εx,x
Demand is
0
50
0
0
Perfectly inelastic
5
37.5
187.5
−0.33
Inelastic
10
25
250
−1.00
Unit elastic
15
12.5
187.5
−3.00
Elastic
20
0
0
−∞
Perfectly elastic
Elasticity 69
INCOME ELASTICITY OF dEMANd
There are other important elasticity measures that are of concern to managers. The income elasticity of demand is a measure of consumer sensitivity to changes in money income, which reflects the ups and downs of the business cycle. The income elasticity of demand is the percent change in demand with respect to a percent change in money income, that is
Ex, M
%Qx .
%M
(3.20)
As with the price elasticity of demand, how we estimate the income elastic- ity of demand depends on the information available. With pairs of values for income and quantity, the income elasticity of demand may be calculated as
E Q2 Q1 M1 M2 Qx M1 M2 . (3.21)
x, M
M M
Q Q
M Q Q
2 1
1 2
1 2
The corresponding point income elasticity of demand is
(
) (
x
) Qd M
M
x,M
M
Qd M
Qd .
(3.22)
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) x x
We learned that the demand for a normal good varies directly with con- sumers’ money income, in which case the value of βM is positive. Since money income and quantity must are also positive, for a normal good εx,M > 0, which says that a percent increase (decrease) in money income is accompanied by a percent increase (decrease) in demand. Normal goods may be further classi- fied as necessities or luxuries. The demand for a necessity is relatively insen- sitive to income changes. The percent change in the demand for a good is
less than the percent change in money income, that is, 0 < εx,M < 1. Examples of necessities include electricity, rent, food, and health care. By contrast, the demand for luxuries tends to exaggerate swings consumers’ money income. A good is a luxury good when the percent change in demand is greater than
the percent change in money income, that is εx,M > 1. Examples of luxuries include foreign travel, restaurant meals, and foreign imports.
Since the demand for an inferior good is inversely related to a consumer’s money income, the value of βM in Eq. (2.1) is negative, thus εx,M < 0. Inferior goods are fairly common for individual consumers, but difficult to identify
at the market level. An oft cited example of an inferior good at the market level is the demand for bankruptcy services, which tends to increase during recessions.
In Chapter 2 we discussed how a change in the price of a good affects a consumer’s real income. The income effect for normal goods is closely
70 Chapter 3
related to the price elasticity of demand. Purchases of goods that are sensitive to price changes tend to be luxuries. Purchases of goods that are not sensitive to price changes tend to be necessities.
CROSS-PRICE ELASTICITY OF dEMANd
Another frequently used elasticity measure is the cross-price elasticity of demand, which measures the sensitivity of consumer purchases of a prod- uct with respect to a change in the price of a related good. Related goods in consumption may be complements or substitutes. The cross-price elasticity of demand measures the percent change in the demand for good x given a percent change in the price of related good y, that is
%Qx Qx Py
Py .
(3.23)
x, y
%P
P
Q
y Q
y y x x
The cross-price elasticity of demand takes its sign from the value of βy. When εx,y > 0, goods x and y are substitutes. When εx,y < 0, the two goods are complements.
Up to this point, we have assumed that a firm produces a single product. Now, suppose that the firm produces multiple related products. What effect will a change in the price of one good have on a firm’s total revenues? Sup- pose, for example, that a company sells two goods, x and y. The company’s total revenue from the sale of these two products is
TR TRx TRy , (3.24)
where TRx = PxQx and TRy = PyQy. For very small changes in the price of good
x, the change in the firm’s total revenue given is given by the equation
TR TR
1 TR %Px . (3.25)
x x, x y y, x
100%
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)
SOLvEd ExERCISE
Suppose that a firm earns $5,000 a month from the sale of good x and
$3,000 from the sale of good y. The price-elasticity of demand for good x is εx,x = –2 and the cross-price elasticity of demand for good y is εy,x = –4. How will a one percent cut in the price of good x affect the firm’s total
revenue?
Solution
From Eq. (3.26) we obtain
Elasticity 71
TR $5, 0001 2 $3, 000 4 0.01 $170.
(3.26)
This result says that a one percent cut in the price of good x will result in a $170 increase in total revenues.
AdvERTISING ELASTICITY OF dEMANd
A very useful management tool is the advertising elasticity of demand, which measures the percent change in unit sales arising from a percent change in advertising expenditures. Ceteris paribus, we would expect that an increase in advertising expenditures will increase in unit sales and revenues. Symbolically, the advertising elasticity of demand is
%Qx Qx A .
(3.27)
x, A
%A A Q
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) x
SOLvEd ExERCISE
A business consultant has estimated the following demand function for Rubi- con & Styx’s world-famous hot sauce “Sergeant Garcia’s Revenge.”
Qx 62 2Px 0.2M 25A, (3.28)
where Qx is the quantity demanded per month in thousands of units, Px is the price per 6-oz. bottle, M is an index of consumer income, and A is the com- pany’s monthly advertising expenditures per month in thousands of dollars. Assume that Px = $4, M = $150, and A = $4 (thousand).
a. Calculate the number of bottles of “Sergeant Garcia’s Revenge” demanded.
b. Calculate the price elasticity of demand. According to your calculations, is the demand for this product elastic, inelastic, or unit elastic? What, if anything, can you say about the demand for this product?
c. Calculate the income elasticity of demand. Is “Sergeant Garcia’s Revenge” a normal good or an inferior good? Is it a luxury or a necessity?
d. Calculate the advertising elasticity of demand. Explain your result.
72 Chapter 3
Solution
a. Substituting the given information into the demand function we get
Qx 62 2 4 0.2 150 252 184 thousand. (3.29)
b. The price elasticity of demand is
Qx Px 2
4 0.04.
(3.30)
x, x
P
Q
184
x x
This result tells us that a 1 percent increase in the price of “Sergeant Garcia’s Revenge” results in a 0.04 percent decrease in quantity demanded. Since |εx,x| < 1, the demand for this product is price inelastic. This might
suggest that “Sergeant Garcia’s Revenge” has no close substitutes.
c. The income elasticity of demand is
Qx M 0.2 150 0.16,
(3.31)
x,M
M Q 184
x
which says that a 1 percent increase in consumer income results in a 0.16 percent increase in the demand. Since 0 < εx,M < 1, this normal good is a necessity.
d. The advertising elasticity of demand is given as
Qx
A 25
4 0.54.
(3.32)
x, A
A Q
184
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) x
This result tells us that a 1 percent increase in Rubicon & Styx’s advertis- ing expenditures results in a 0.54 percent increase in unit sales.
CHAPTER ExERCISES
3.1 Suppose that you are a portfolio manager for a large, diversified mutual fund. The fund’s chief economist is forecasting an economic slowdown. How will your knowledge of estimated income elasticities of demand to alter the composition of the portfolio?
3.2 Suppose that crime is positively related to profits from illegal drug sales and that the demand for drugs is price inelastic. The government’s primary weapon in the war on drugs is the interdiction of illegal drugs flowing into the country from outside its borders. What is the likely effect of this policy on domestic crime rates? Can you suggest an alter- native approach to the war on drugs?
Project 2: Managerial Economics
Scenario
In Project 1, you confirmed that Largo GIobal Inc. (LGI) is on a downward trajectory. In Project 2 you must identify some of the root causes of the company’s financial stress so that you understand what can be done to turn things around. Reversing the trend is not going to be an easy task, but you are confident because your team has years of experience working with troubled companies.
You have seen many marketing-driven CEOs bankrupt their businesses by losing sight of their company’s bottom line. It is going to be a balancing act to find the right mix of decisions that will improve the efficiency of LGI as well as make it sustainable in the long run.
In Project 2 you are going to put on your “economist” hat. You will study how supply and demand affect LGI. You know that calculating elasticity will help you figure out how to reverse LGI’s downward trend.
You also need to explore the structure of the industry from various angles and understand how consolidation or transformation impact LGI.
To turn things around, LGI can take one of three approaches: (1) increase revenue, (2) maintain revenue at the current level, or (3) choose a different strategy based on a limited production quantity that may be below the current level.
Competencies
Your work will be evaluated using the competencies listed below.
· 3.1: Identify numerical or mathematical information that is relevant in a problem or situation.
· 3.2: Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution.
· 3.3: Analyze mathematical or statistical information, or the results of quantitative inquiry and manipulation of data.
· 4.1: Lead and/or participate in a diverse group to accomplish projects and assignments.
· 4.3: Contribute to team projects, assignments, or organizational goals as an engaged member of a team.
· 4.4: Demonstrate diversity and inclusiveness in a team setting.
· 5.1: Develop constructive resolutions for ethical dilemmas based on application of ethical theories, principles and models.
· 10.1: Apply relevant microeconomics principles to support strategic decisions for the organization.
Project 2: Managerial Economics
Step 1: Prepare for the Project
In two weeks, you will provide your business report to your team at Maryland Creative Solutions so they can advise Largo Global Inc. (LGI) on the best way to optimize production and reverse the trend. Before preparing the report, you must review information on supply and demand, elasticity, and industry structures. Complete the required reading to explore these topics.
Required Reading
Greenlaw, S. A. & Shapiro, D. (Senior Contributor), Principles of Microeconomics 2e
Chapter 1 – sections 1.1-1.4
1.1:
What Is Economics, and Why Is It Important?
1.2:
Microeconomics and Macroeconomics
1.3:
How Economists Use Theories and Models to Understand Economic Issues
1.4:
How To Organize Economies: An Overview of Economic Systems
Chapter 2 – sections 21.-2.2
2.1:
How Individuals Make Choices Based on Their Budget Constraint
2.2: The Production Possibilities Frontier and Social Choices
Chapter 3 – sections 31.-3.3
3.1:
Demand, Supply, and Equilibrium in Markets for Goods and Services
3.2:
Shifts in Demand and Supply for Goods and Services
3.3:
Changes in Equilibrium Price and Quantity: The Four-Step Process
Chapter 5 – sections 5.1-5.3
5.1:
Price Elasticity of Demand and Price Elasticity of Supply
5.2:
Polar Cases of Elasticity and Constant Elasticity
5.3:
Elasticity and Pricing
Chapter 7 – sections 7.1.-7.5
7.1:
Explicit and Implicit Costs, and Accounting and Economic Profit
7.2:
Production in the Short Run
7.3:
Costs in the Short Run
7.4:
Production in the Long Run
7.5: C
osts in the Long Run
Chapter 8 – section 8.1
8.1:
Perfect Competition and Why It Matters
Chapter 9 – section 9.1
9.1:
How Monopolies Form: Barriers to Entry
Chapter 10 – sections 10.1-10.2
10.1:
Monopolistic Competition
10.2:
Oligopoly
Project 2: Managerial Economics
Step 2: Review and Practice
Equipped with the analyses performed in the business report you submitted for Project 1, you should feel well prepared to dive into the company data provided about the industry structure. Using the
Project 2 Review and Practice Guide
provided, review supply and demand, elasticity, and industry structures to determine how these affect the company’s profitability. Then apply what you have learned so far by completing the exercises referenced in the Project 2 Review and Practice Guide.
You must review the material provided and do the practice exercises so that you can
· complete a supply and demand graph,
· calculate elasticity and assess market structure,
· understand the impact of an industry structure on an organization, and
· use the above information to make recommendations for improvements.
Review and Practice
You must complete the review and practice to fully collaborate with your group in Step 3.
Project 2 Review and Practice Guide
Project 2: Managerial Economics
Step 3: Collaborate With Your Group
Peopleimages / E+ / Getty Images
This project is a group assignment. You have been assigned to a group. Your group assignment was communicated through the weekly announcement. If you have not completed the
Team Agreement and Work Plan
, do so now and submit it to the dropbox.
To fully participate with your group and prepare for the next steps, complete the Review and Practice content on your own. Then take time to interact collaboratively with your teammates in the discussion area established for each group.
It is imperative that you are well prepared and have developed synergy within your group, so that you can learn from each other and together produce a coherent business report. Your report should reflect the work of your team—not be individual responses patched together.
Regardless of your role within your group, make sure that you contribute to this team project as an engaged participant.
Take Action
Submit your assignment to your instructor for review and feedback.
Follow these steps to access the assignment:
· Click My Tools in the top navigation bar.
· Click Assignments.
· Select the relevant assignment.
Project 2: Managerial Economics
Step 4: Complete the Analysis Calculation for Project 2
To help you analyze LGI so that you can make recommendations to reverse the trends, you receive an Excel workbook containing the following:
· Prices and quantities of LGI’s product
After plotting a supply/demand graph and calculating elasticity, submit your team’s initial findings.
Complete the analysis calculation for the project:
· Download the
Project 2 Excel workbook
, click the Instructions tab, and read the instructions.
· Draw a supply and demand graph and calculate elasticity.
· If you would like instructor feedback on this step, follow the instructions in the Take Action box below to submit your Excel file to the Assignments folder as a milestone by the end of Week 3. This is optional. If you choose to submit the milestone, you will receive instructor feedback on the milestone submission. To distinguish the milestone submission from the file you will submit at the end of Project 2, label your file as follows: P2_milestone_lastname_Calculation_date.
Take Action
Submit your assignment to your instructor for review and feedback.
Follow these steps to access the assignment:
· Click My Tools in the top navigation bar.
· Click Assignments.
· Select the relevant assignment.
· You should use the comments your instructor made about your optional milestone submission to revise your work as needed. Next, proceed to Step 5, where you will answer questions about your analysis, make recommendations for LGI, and compile and submit your final report.
Project 2: Managerial Economics
Step 5: Prepare the Analysis Report for Project 2
fizkes/iStock/Getty Images
You are ready to make a recommendation about how to mitigate the decline in revenue that LGI has experienced. You looked at the industry structure, created a supply/demand graph, and calculated elasticity. Answer the questions in the
Project 2 Questions – Report Template
. Prepare the business report.
Complete the business report for the project:
· Download the Project 2 Questions – Report Template
· Read the instructions.
· Answer all the questions.
· Include your recommendations.
· Submit the business report (Word document) and calculation (Excel file) to the Assignments folder as your final deliverable. Here is the file name convention for both files:
· P2_Final_lastname_Report_date x
· P2_Final_lastname_Calculation_date.xlsx
Check Your Evaluation Criteria
Before you submit your assignment, review the competencies below, which your instructor will use to evaluate your work. A good practice would be to use each competency as a self-check to confirm you have incorporated all of them. To view the complete grading rubric, click My Tools, select Assignments from the drop-down menu, and then click the project title.
· 3.1: Identify numerical or mathematical information that is relevant in a problem or situation.
· 3.2: Employ mathematical or statistical operations and data analysis techniques to arrive at a correct or optimal solution.
· 3.3: Analyze mathematical or statistical information, or the results of quantitative inquiry and manipulation of data.
· 4.1: Lead and/or participate in a diverse group to accomplish projects and assignments.
· 4.3: Contribute to team projects, assignments, or organizational goals as an engaged member of a team.
· 4.4: Demonstrate diversity and inclusiveness in a team setting.
· 5.1: Develop constructive resolutions for ethical dilemmas based on application of ethical theories, principles and models.
· 10.1: Apply relevant microeconomics principles to support strategic decisions for the organization.
Take Action
Submit your assignment to your instructor for review and feedback.
Follow these steps to access the assignment:
· Click My Tools in the top navigation bar.
· Click Assignments.
· Select the relevant assignment.
Project 2 Report
Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces several different product lines two of which are a simple Standard box and a more elaborate Deluxe box. These boxes are also produced by many other companies.
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab 1 after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will approximate the prices that maximize the profit for both boxes.
Follow these steps to complete Project 2:
1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations.
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations. Your report should be no more than 6 pages, a maximum of one page per question. Start each question with your answer on a new page.
Project 2 is the team assignment in MBA 620. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, each team member will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primary will coordinate any changes to the team’s answers to the topic questions.
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Market Structure
1. Explain why an understanding the market structure in a which company operates is important to being an effective manager.
2. Explain the market structure that is most likely operating in the market for the Deluxe boxes.
3. Explain the market structure that is most likely operating in the market for the Standard boxes.
Price Elasticity
1. Discuss what actions the company should take in setting the price of the Standard box given its price elasticity of demand.
2. Discuss what actions the company should take in setting the price of the Deluxe box given its price elasticity of demand.
3. Assuming the price elasticity of supply for the Standard box is inelastic, explain the key factors that the company must consider in expanding production.
Required Reading
Greenlaw, S. A. & Shapiro, D. (Senior Contributor), Principles of Microeconomics 2e
Chapter 1 – sections 1.1-1.4
1.1:
What Is Economics, and Why Is It Important?
1.2:
Microeconomics and Macroeconomics
1.3:
How Economists Use Theories and Models to Understand Economic Issues
1.4:
How To Organize Economies: An Overview of Economic Systems
Chapter 2 – sections 21.-2.2
2.1:
How Individuals Make Choices Based on Their Budget Constraint
2.2: The Production Possibilities Frontier and Social Choices
Chapter 3 – sections 31.-3.3
3.1:
Demand, Supply, and Equilibrium in Markets for Goods and Services
3.2:
Shifts in Demand and Supply for Goods and Services
3.3:
Changes in Equilibrium Price and Quantity: The Four-Step Process
Chapter 5 – sections 5.1-5.3
5.1:
Price Elasticity of Demand and Price Elasticity of Supply
5.2:
Polar Cases of Elasticity and Constant Elasticity
5.3:
Elasticity and Pricing
Chapter 7 – sections 7.1.-7.5
7.1:
Explicit and Implicit Costs, and Accounting and Economic Profit
7.2:
Production in the Short Run
7.3:
Costs in the Short Run
7.4:
Production in the Long Run
7.5: C
osts in the Long Run
Chapter 8 – section 8.1
8.1:
Perfect Competition and Why It Matters
Chapter 9 – section 9.1
9.1:
How Monopolies Form: Barriers to Entry
Chapter 10 – sections 10.1-10.2
10.1:
Monopolistic Competition
10.2:
Oligopoly
Learning Objectives
By the end of this section, you will be able to:
· Discuss the importance of studying economics
· Explain the relationship between production and division of labor
· Evaluate the significance of scarcity
Economics is the study of how humans make decisions in the face of scarcity. These can be individual decisions, family decisions, business decisions or societal decisions. If you look around carefully, you will see that scarcity is a fact of life. Scarcity means that human wants for goods, services and resources exceed what is available. Resources, such as labor, tools, land, and raw materials are necessary to produce the goods and services we want but they exist in limited supply. Of course, the ultimate scarce resource is time- everyone, rich or poor, has just 24 expendable hours in the day to earn income to acquire goods and services, for leisure time, or for sleep. At any point in time, there is only a finite amount of resources available.
Think about it this way: In 2015 the labor force in the United States contained over 158 million workers, according to the U.S. Bureau of Labor Statistics. The total land area was 3,794,101 square miles. While these are certainly large numbers, they are not infinite. Because these resources are limited, so are the numbers of goods and services we produce with them. Combine this with the fact that human wants seem to be virtually infinite, and you can see why scarcity is a problem.
Introduction to FRED
Data is very important in economics because it describes and measures the issues and problems that economics seek to understand. A variety of government agencies publish economic and social data. For this course, we will generally use data from the St. Louis Federal Reserve Bank’s FRED database. FRED is very user friendly. It allows you to display data in tables or charts, and you can easily download it into spreadsheet form if you want to use the data for other purposes. The
FRED website
includes data on nearly 400,000 domestic and international variables over time, in the following broad categories:
· Money, Banking & Finance
· Population, Employment, & Labor Markets (including Income Distribution)
· National Accounts (Gross Domestic Product & its components), Flow of Funds, and International Accounts
· Production & Business Activity (including Business Cycles)
· Prices & Inflation (including the Consumer Price Index, the Producer Price Index, and the Employment Cost Index)
· International Data from other nations
· U.S. Regional Data
· Academic Data (including Penn World Tables & NBER Macrohistory database)
For more information about how to use FRED, see the variety of
videos
on YouTube starting with this introduction.
Figure 1.2 Scarcity of Resources Homeless people are a stark reminder that scarcity of resources is real. (Credit: “daveynin”/Flickr Creative Commons)
If you still do not believe that scarcity is a problem, consider the following: Does everyone require food to eat? Does everyone need a decent place to live? Does everyone have access to healthcare? In every country in the world, there are people who are hungry, homeless (for example, those who call park benches their beds, as
Figure 1.2
shows), and in need of healthcare, just to focus on a few critical goods and services. Why is this the case? It is because of scarcity. Let’s delve into the concept of scarcity a little deeper, because it is crucial to understanding economics.
The Problem of Scarcity
Think about all the things you consume: food, shelter, clothing, transportation, healthcare, and entertainment. How do you acquire those items? You do not produce them yourself. You buy them. How do you afford the things you buy? You work for pay. If you do not, someone else does on your behalf. Yet most of us never have enough income to buy all the things we want. This is because of scarcity. So how do we solve it?
LINK IT UP
Visit this
website
to read about how the United States is dealing with scarcity in resources.
Every society, at every level, must make choices about how to use its resources. Families must decide whether to spend their money on a new car or a fancy vacation. Towns must choose whether to put more of the budget into police and fire protection or into the school system. Nations must decide whether to devote more funds to national defense or to protecting the environment. In most cases, there just isn’t enough money in the budget to do everything. How do we use our limited resources the best way possible, that is, to obtain the most goods and services we can? There are a couple of options. First, we could each produce everything we each consume. Alternatively, we could each produce some of what we want to consume, and “trade” for the rest of what we want. Let’s explore these options. Why do we not each just produce all of the things we consume? Think back to pioneer days, when individuals knew how to do so much more than we do today, from building their homes, to growing their crops, to hunting for food, to repairing their equipment. Most of us do not know how to do all—or any—of those things, but it is not because we could not learn. Rather, we do not have to. The reason why is something called the division and specialization of labor, a production innovation first put forth by Adam Smith (
Figure 1.3
) in his book, The Wealth of Nations.
Figure 1.3 Adam Smith Adam Smith introduced the idea of dividing labor into discrete tasks. (Credit: Wikimedia Commons)
The Division of and Specialization of Labor
The formal study of economics began when Adam Smith (1723–1790) published his famous book The Wealth of Nations in 1776. Many authors had written on economics in the centuries before Smith, but he was the first to address the subject in a comprehensive way. In the first chapter, Smith introduces the concept of division of labor, which means that the way one produces a good or service is divided into a number of tasks that different workers perform, instead of all the tasks being done by the same person.
To illustrate division of labor, Smith counted how many tasks went into making a pin: drawing out a piece of wire, cutting it to the right length, straightening it, putting a head on one end and a point on the other, and packaging pins for sale, to name just a few. Smith counted 18 distinct tasks that different people performed—all for a pin, believe it or not!
Modern businesses divide tasks as well. Even a relatively simple business like a restaurant divides the task of serving meals into a range of jobs like top chef, sous chefs, less-skilled kitchen help, servers to wait on the tables, a greeter at the door, janitors to clean up, and a business manager to handle paychecks and bills—not to mention the economic connections a restaurant has with suppliers of food, furniture, kitchen equipment, and the building where it is located. A complex business like a large manufacturing factory, such as the shoe factory (
Figure 1.4
), or a hospital can have hundreds of job classifications.
Figure 1.4 Division of Labor Workers on an assembly line are an example of the divisions of labor. (Credit: Nina Hale/Flickr Creative Commons)
Why the Division of Labor Increases Production
When we divide and subdivide the tasks involved with producing a good or service, workers and businesses can produce a greater quantity of output. In his observations of pin factories, Smith noticed that one worker alone might make 20 pins in a day, but that a small business of 10 workers (some of whom would need to complete two or three of the 18 tasks involved with pin-making), could make 48,000 pins in a day. How can a group of workers, each specializing in certain tasks, produce so much more than the same number of workers who try to produce the entire good or service by themselves? Smith offered three reasons.
First, specialization in a particular small job allows workers to focus on the parts of the production process where they have an advantage. (In later chapters, we will develop this idea by discussing comparative advantage.) People have different skills, talents, and interests, so they will be better at some jobs than at others. The particular advantages may be based on educational choices, which are in turn shaped by interests and talents. Only those with medical degrees qualify to become doctors, for instance. For some goods, geography affects specialization. For example, it is easier to be a wheat farmer in North Dakota than in Florida, but easier to run a tourist hotel in Florida than in North Dakota. If you live in or near a big city, it is easier to attract enough customers to operate a successful dry cleaning business or movie theater than if you live in a sparsely populated rural area. Whatever the reason, if people specialize in the production of what they do best, they will be more effective than if they produce a combination of things, some of which they are good at and some of which they are not.
Second, workers who specialize in certain tasks often learn to produce more quickly and with higher quality. This pattern holds true for many workers, including assembly line laborers who build cars, stylists who cut hair, and doctors who perform heart surgery. In fact, specialized workers often know their jobs well enough to suggest innovative ways to do their work faster and better.
A similar pattern often operates within businesses. In many cases, a business that focuses on one or a few products (sometimes called its “core competency”) is more successful than firms that try to make a wide range of products.
Third, specialization allows businesses to take advantage of economies of scale, which means that for many goods, as the level of production increases, the average cost of producing each individual unit declines. For example, if a factory produces only 100 cars per year, each car will be quite expensive to make on average. However, if a factory produces 50,000 cars each year, then it can set up an assembly line with huge machines and workers performing specialized tasks, and the average cost of production per car will be lower. The ultimate result of workers who can focus on their preferences and talents, learn to do their specialized jobs better, and work in larger organizations is that society as a whole can produce and consume far more than if each person tried to produce all of his or her own goods and services. The division and specialization of labor has been a force against the problem of scarcity.
Trade and Markets
Specialization only makes sense, though, if workers can use the pay they receive for doing their jobs to purchase the other goods and services that they need. In short, specialization requires trade.
You do not have to know anything about electronics or sound systems to play music—you just buy an iPod or MP3 player, download the music, and listen. You do not have to know anything about artificial fibers or the construction of sewing machines if you need a jacket—you just buy the jacket and wear it. You do not need to know anything about internal combustion engines to operate a car—you just get in and drive. Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and services that you wish to consume, the market allows you to learn a specialized set of skills and then use the pay you receive to buy the goods and services you need or want. This is how our modern society has evolved into a strong economy.
Why Study Economics?
Now that you have an overview on what economics studies, let’s quickly discuss why you are right to study it. Economics is not primarily a collection of facts to memorize, although there are plenty of important concepts to learn. Instead, think of economics as a collection of questions to answer or puzzles to work. Most importantly, economics provides the tools to solve those puzzles. If the economics “bug” has not bitten you yet, there are other reasons why you should study economics.
· Virtually every major problem facing the world today, from global warming, to world poverty, to the conflicts in Syria, Afghanistan, and Somalia, has an economic dimension. If you are going to be part of solving those problems, you need to be able to understand them. Economics is crucial.
· It is hard to overstate the importance of economics to good citizenship. You need to be able to vote intelligently on budgets, regulations, and laws in general. When the U.S. government came close to a standstill at the end of 2012 due to the “fiscal cliff,” what were the issues? Did you know?
· A basic understanding of economics makes you a well-rounded thinker. When you read articles about economic issues, you will understand and be able to evaluate the writer’s argument. When you hear classmates, co-workers, or political candidates talking about economics, you will be able to distinguish between common sense and nonsense. You will find new ways of thinking about current events and about personal and business decisions, as well as current events and politics.
The study of economics does not dictate the answers, but it can illuminate the different choices.
Learning Objectives
By the end of this section, you will be able to:
· Describe microeconomics
· Describe macroeconomics
· Contrast monetary policy and fiscal policy
Economics is concerned with the well-being of all people, including those with jobs and those without jobs, as well as those with high incomes and those with low incomes. Economics acknowledges that production of useful goods and services can create problems of environmental pollution. It explores the question of how investing in education helps to develop workers’ skills. It probes questions like how to tell when big businesses or big labor unions are operating in a way that benefits society as a whole and when they are operating in a way that benefits their owners or members at the expense of others. It looks at how government spending, taxes, and regulations affect decisions about production and consumption.
It should be clear by now that economics covers considerable ground. We can divide that ground into two parts: Microeconomics focuses on the actions of individual agents within the economy, like households, workers, and businesses. Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of production, the number of unemployed people, the inflationary increase in prices, government deficits, and levels of exports and imports. Microeconomics and macroeconomics are not separate subjects, but rather complementary perspectives on the overall subject of the economy.
To understand why both microeconomic and macroeconomic perspectives are useful, consider the problem of studying a biological ecosystem like a lake. One person who sets out to study the lake might focus on specific topics: certain kinds of algae or plant life; the characteristics of particular fish or snails; or the trees surrounding the lake. Another person might take an overall view and instead consider the lake’s ecosystem from top to bottom; what eats what, how the system stays in a rough balance, and what environmental stresses affect this balance. Both approaches are useful, and both examine the same lake, but the viewpoints are different. In a similar way, both microeconomics and macroeconomics study the same economy, but each has a different viewpoint.
Whether you are scrutinizing lakes or economics, the micro and the macro insights should blend with each other. In studying a lake, the micro insights about particular plants and animals help to understand the overall food chain, while the macro insights about the overall food chain help to explain the environment in which individual plants and animals live.
In economics, the micro decisions of individual businesses are influenced by whether the macroeconomy is healthy. For example, firms will be more likely to hire workers if the overall economy is growing. In turn, macroeconomy’s performance ultimately depends on the microeconomic decisions that individual households and businesses make.
Microeconomics
What determines how households and individuals spend their budgets? What combination of goods and services will best fit their needs and wants, given the budget they have to spend? How do people decide whether to work, and if so, whether to work full time or part time? How do people decide how much to save for the future, or whether they should borrow to spend beyond their current means?
What determines the products, and how many of each, a firm will produce and sell? What determines the prices a firm will charge? What determines how a firm will produce its products? What determines how many workers it will hire? How will a firm finance its business? When will a firm decide to expand, downsize, or even close? In the microeconomics part of this book, we will learn about the theory of consumer behavior, the theory of the firm, how markets for labor and other resources work, and how markets sometimes fail to work properly.
Macroeconomics
What determines the level of economic activity in a society? In other words, what determines how many goods and services a nation actually produces? What determines how many jobs are available in an economy? What determines a nation’s standard of living? What causes the economy to speed up or slow down? What causes firms to hire more workers or to lay them off? Finally, what causes the economy to grow over the long term?
We can determine an economy’s macroeconomic health by examining a number of goals: growth in the standard of living, low unemployment, and low inflation, to name the most important. How can we use government macroeconomic policy to pursue these goals? A nation’s central bank conducts monetary policy, which involves policies that affect bank lending, interest rates, and financial capital markets. For the United States, this is the Federal Reserve. A nation’s legislative body determines fiscal policy, which involves government spending and taxes. For the United States, this is the Congress and the executive branch, which originates the federal budget. These are the government’s main tools. Americans tend to expect that government can fix whatever economic problems we encounter, but to what extent is that expectation realistic? These are just some of the issues that we will explore in the macroeconomic chapters of this book.
Learning Objectives
By the end of this section, you will be able to:
· Interpret a circular flow diagram
· Explain the importance of economic theories and models
· Describe goods and services markets and labor markets
Figure 1.5 John Maynard Keynes One of the most influential economists in modern times was John Maynard Keynes. (Credit: Wikimedia Commons)
John Maynard Keynes (1883–1946), one of the greatest economists of the twentieth century, pointed out that economics is not just a subject area but also a way of thinking. Keynes (
Figure 1.5
) famously wrote in the introduction to a fellow economist’s book: “[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.” In other words, economics teaches you how to think, not what to think.
LINK IT UP
Watch this
video
about John Maynard Keynes and his influence on economics.
Economists see the world through a different lens than anthropologists, biologists, classicists, or practitioners of any other discipline. They analyze issues and problems using economic theories that are based on particular assumptions about human behavior. These assumptions tend to be different than the assumptions an anthropologist or psychologist might use. A theory is a simplified representation of how two or more variables interact with each other. The purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If done well, this enables the analyst to understand the issue and any problems around it. A good theory is simple enough to understand, while complex enough to capture the key features of the object or situation you are studying.
Sometimes economists use the term model instead of theory. Strictly speaking, a theory is a more abstract representation, while a model is a more applied or empirical representation. We use models to test theories, but for this course we will use the terms interchangeably.
For example, an architect who is planning a major office building will often build a physical model that sits on a tabletop to show how the entire city block will look after the new building is constructed. Companies often build models of their new products, which are more rough and unfinished than the final product, but can still demonstrate how the new product will work.
A good model to start with in economics is the circular flow diagram (
Figure 1.6
). It pictures the economy as consisting of two groups—households and firms—that interact in two markets: the goods and services market in which firms sell and households buy and the labor market in which households sell labor to business firms or other employees.
Figure 1.6 The Circular Flow Diagram The circular flow diagram shows how households and firms interact in the goods and services market, and in the labor market. The direction of the arrows shows that in the goods and services market, households receive goods and services and pay firms for them. In the labor market, households provide labor and receive payment from firms through wages, salaries, and benefits.
Firms produce and sell goods and services to households in the market for goods and services (or product market). Arrow “A” indicates this. Households pay for goods and services, which becomes the revenues to firms. Arrow “B” indicates this. Arrows A and B represent the two sides of the product market. Where do households obtain the income to buy goods and services? They provide the labor and other resources (e.g. land, capital, raw materials) firms need to produce goods and services in the market for inputs (or factors of production). Arrow “C” indicates this. In return, firms pay for the inputs (or resources) they use in the form of wages and other factor payments. Arrow “D” indicates this. Arrows “C” and “D” represent the two sides of the factor market.
Of course, in the real world, there are many different markets for goods and services and markets for many different types of labor. The circular flow diagram simplifies this to make the picture easier to grasp. In the diagram, firms produce goods and services, which they sell to households in return for revenues. The outer circle shows this, and represents the two sides of the product market (for example, the market for goods and services) in which households demand and firms supply. Households sell their labor as workers to firms in return for wages, salaries, and benefits. The inner circle shows this and represents the two sides of the labor market in which households supply and firms demand.
This version of the circular flow model is stripped down to the essentials, but it has enough features to explain how the product and labor markets work in the economy. We could easily add details to this basic model if we wanted to introduce more real-world elements, like financial markets, governments, and interactions with the rest of the globe (imports and exports).
Economists carry a set of theories in their heads like a carpenter carries around a toolkit. When they see an economic issue or problem, they go through the theories they know to see if they can find one that fits. Then they use the theory to derive insights about the issue or problem. Economists express theories as diagrams, graphs, or even as mathematical equations. (Do not worry. In this course, we will mostly use graphs.) Economists do not figure out the answer to the problem first and then draw the graph to illustrate. Rather, they use the graph of the theory to help them figure out the answer. Although at the introductory level, you can sometimes figure out the right answer without applying a model, if you keep studying economics, before too long you will run into issues and problems that you will need to graph to solve. We explain both micro and macroeconomics in terms of theories and models. The most well-known theories are probably those of supply and demand, but you will learn a number of others.
Learning Objectives
By the end of this section, you will be able to:
· Contrast traditional economies, command economies, and market economies
· Explain gross domestic product (GDP)
· Assess the importance and effects of globalization
Think about what a complex system a modern economy is. It includes all production of goods and services, all buying and selling, all employment. The economic life of every individual is interrelated, at least to a small extent, with the economic lives of thousands or even millions of other individuals. Who organizes and coordinates this system? Who ensures that, for example, the number of televisions a society provides is the same as the amount it needs and wants? Who ensures that the right number of employees work in the electronics industry? Who ensures that televisions are produced in the best way possible? How does it all get done?
There are at least three ways that societies organize an economy. The first is the traditional economy, which is the oldest economic system and is used in parts of Asia, Africa, and South America. Traditional economies organize their economic affairs the way they have always done (i.e., tradition). Occupations stay in the family. Most families are farmers who grow the crops using traditional methods. What you produce is what you consume. Because tradition drives the way of life, there is little economic progress or development.
Figure 1.7 A Command Economy Ancient Egypt was an example of a command economy. (Credit: Jay Bergesen/Flickr Creative Commons)
Command economies are very different. In a command economy, economic effort is devoted to goals passed down from a ruler or ruling class. Ancient Egypt was a good example: a large part of economic life was devoted to building pyramids, like those in
Figure 1.7
, for the pharaohs. Medieval manor life is another example: the lord provided the land for growing crops and protection in the event of war. In return, vassals provided labor and soldiers to do the lord’s bidding. In the last century, communism emphasized command economies.
In a command economy, the government decides what goods and services will be produced and what prices it will charge for them. The government decides what methods of production to use and sets wages for workers. The government provides many necessities like healthcare and education for free. Currently, Cuba and North Korea have command economies.
Figure 1.8 A Market Economy Nothing says “market” more than The New York Stock Exchange. (Credit: Erik Drost/Flickr Creative Commons)
Although command economies have a very centralized structure for economic decisions, market economies have a very decentralized structure. A market is an institution that brings together buyers and sellers of goods or services, who may be either individuals or businesses. The New York Stock Exchange (
Figure 1.8
) is a prime example of a market which brings buyers and sellers together. In a market economy, decision-making is decentralized. Market economies are based on private enterprise: the private individuals or groups of private individuals own and operate the means of production (resources and businesses). Businesses supply goods and services based on demand. (In a command economy, by contrast, the government owns resources and businesses.) Supply of goods and services depends on what the demands are. A person’s income is based on his or her ability to convert resources (especially labor) into something that society values. The more society values the person’s output, the higher the income (think Lady Gaga or LeBron James). In this scenario, market forces, not governments, determine economic decisions.
Most economies in the real world are mixed. They combine elements of command and market (and even traditional) systems. The U.S. economy is positioned toward the market-oriented end of the spectrum. Many countries in Europe and Latin America, while primarily market-oriented, have a greater degree of government involvement in economic decisions than the U.S. economy. China and Russia, while over the past several decades have moved more in the direction of having a market-oriented system, remain closer to the command economy end of the spectrum. The Heritage Foundation provides perspective on countries’ economic freedom, as the following Clear It Up feature discusses.
CLEAR IT UP
What countries are considered economically free?
Who is in control of economic decisions? Are people free to do what they want and to work where they want? Are businesses free to produce when they want and what they choose, and to hire and fire as they wish? Are banks free to choose who will receive loans, or does the government control these kinds of choices? Each year, researchers at the Heritage Foundation and the Wall Street Journal look at 50 different categories of economic freedom for countries around the world. They give each nation a score based on the extent of economic freedom in each category. Note that while the Heritage Foundation/WSJ index is widely cited by an array of scholars and publications, it should be regarded as only one viewpoint. Some experts indicate that the index’s category choices and scores are politically biased. However, the index and others like it provide a useful resource for critical discussion of economic freedom.
The 2016 Heritage Foundation’s Index of Economic Freedom report ranked 178 countries around the world:
Table 1.1
lists some examples of the most free and the least free countries. Although technically not a separate country, Hong Kong has been granted a degree of autonomy such that, for purposes of measuring economic statistics, it is often treated as a separate country. Several additional countries were not ranked because of extreme instability that made judgments about economic freedom impossible. These countries include Afghanistan, Iraq, Libya, Syria, Somalia, and Yemen.
The assigned rankings are inevitably based on estimates, yet even these rough measures can be useful for discerning trends. In 2015, 101 of the 178 included countries shifted toward greater economic freedom, although 77 of the countries shifted toward less economic freedom. In recent decades, the overall trend has been a higher level of economic freedom around the world.
Most Economic Freedom
Least Economic Freedom
1. Hong Kong
167. Timor-Leste
2. Singapore
168. Democratic Republic of Congo
3. New Zealand
169. Argentina
4. Switzerland
170. Equatorial Guinea
5. Australia
171. Iran
6. Canada
172. Republic of Congo
7. Chile
173. Eritrea
8. Ireland
174. Turkmenistan
9. Estonia
175. Zimbabwe
10. United Kingdom
176. Venezuela
11. United States
177. Cuba
12. Denmark
178. North Korea
Table1.1 Economic Freedoms, 2016 (Source: The Heritage Foundation, 2016 Index of Economic Freedom, Country Rankings, http://www.heritage.org/index/ranking)
Regulations: The Rules of the Game
Markets and government regulations are always entangled. There is no such thing as an absolutely free market. Regulations always define the “rules of the game” in the economy. Economies that are primarily market-oriented have fewer regulations—ideally just enough to maintain an even playing field for participants. At a minimum, these laws govern matters like safeguarding private property against theft, protecting people from violence, enforcing legal contracts, preventing fraud, and collecting taxes. Conversely, even the most command-oriented economies operate using markets. How else would buying and selling occur? The government heavily regulates decisions of what to produce and prices to charge. Heavily regulated economies often have underground economies (or black markets), which are markets where the buyers and sellers make transactions without the government’s approval.
The question of how to organize economic institutions is typically not a black-or-white choice between all market or all government, but instead involves a balancing act over the appropriate combination of market freedom and government rules.
Figure 1.9 Globalization Cargo ships are one mode of transportation for shipping goods in the global economy. (Credit: Raul Valdez/Flickr Creative Commons)
The Rise of Globalization
Recent decades have seen a trend toward globalization, which is the expanding cultural, political, and economic connections between people around the world. One measure of this is the increased buying and selling of goods, services, and assets across national borders—in other words, international trade and financial capital flows.
Globalization has occurred for a number of reasons. Improvements in shipping, as illustrated by the container ship in
Figure 1.9
, and air cargo have driven down transportation costs. Innovations in computing and telecommunications have made it easier and cheaper to manage long-distance economic connections of production and sales. Many valuable products and services in the modern economy can take the form of information—for example: computer software; financial advice; travel planning; music, books and movies; and blueprints for designing a building. These products and many others can be transported over telephones and computer networks at ever-lower costs. Finally, international agreements and treaties between countries have encouraged greater trade.
Table 1.2
presents one measure of globalization. It shows the percentage of domestic economic production that was exported for a selection of countries from 2010 to 2015, according to an entity known as The World Bank. Exports are the goods and services that one produces domestically and sells abroad. Imports are the goods and services that one produces abroad and then sells domestically. Gross domestic product (GDP) measures the size of total production in an economy. Thus, the ratio of exports divided by GDP measures what share of a country’s total economic production is sold in other countries.
Country
2010
2011
2012
2013
2014
2015
Higher Income Countries
United States
12.4
13.6
13.6
13.5
13.5
12.6
Belgium
76.2
81.4
82.2
82.8
84.0
84.4
Canada
29.1
30.7
30.0
30.1
31.7
31.5
France
26.0
27.8
28.1
28.3
29.0
30.0
Middle Income Countries
Brazil
10.9
11.9
12.6
12.6
11.2
13.0
Mexico
29.9
31.2
32.6
31.7
32.3
35.3
South Korea
49.4
55.7
56.3
53.9
50.3
45.9
Lower Income Countries
Chad
36.8
38.9
36.9
32.2
34.2
29.8
China
29.4
28.5
27.3
26.4
23.9
22.4
India
22.0
23.9
24.0
24.8
22.9
–
Nigeria
25.3
31.3
31.4
18.0
18.4
–
Table1.2 The Extent of Globalization (exports/GDP) (Source: http://databank.worldbank.org/data/)
In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S. economy. Interestingly, the share of U.S. exports in proportion to the U.S. economy is well below the global average, in part because large economies like the United States can contain more of the division of labor inside their national borders. However, smaller economies like Belgium, Korea, and Canada need to trade across their borders with other countries to take full advantage of division of labor, specialization, and economies of scale. In this sense, the enormous U.S. economy is less affected by globalization than most other countries.
Table 1.2
indicates that many medium and low income countries around the world, like Mexico and China, have also experienced a surge of globalization in recent decades. If an astronaut in orbit could put on special glasses that make all economic transactions visible as brightly colored lines and look down at Earth, the astronaut would see the planet covered with connections.
Despite the rise in globalization over the last few decades, in recent years we’ve seen significant pushback against globalization from people across the world concerned about loss of jobs, loss of political sovereignty, and increased economic inequality. Prominent examples of this pushback include the 2016 vote in Great Britain to exit the European Union (i.e. Brexit), and the election of Donald J. Trump for President of the United States.
Hopefully, you now have an idea about economics. Before you move to any other chapter of study, be sure to read the very important appendix to this chapter called
The Use of Mathematics in Principles of Economics
. It is essential that you learn more about how to read and use models in economics.
BRING IT HOME
Decisions … Decisions in the Social Media Age
The world we live in today provides nearly instant access to a wealth of information. Consider that as recently as the late 1970s, the Farmer’s Almanac, along with the Weather Bureau of the U.S. Department of Agriculture, were the primary sources American farmers used to determine when to plant and harvest their crops. Today, farmers are more likely to access, online, weather forecasts from the National Oceanic and Atmospheric Administration or watch the Weather Channel. After all, knowing the upcoming forecast could drive when to harvest crops. Consequently, knowing the upcoming weather could change the amount of crop harvested.
Some relatively new information forums, such as Facebook, are rapidly changing how information is distributed; hence, influencing decision making. In 2014, the Pew Research Center reported that 71% of online adults use Facebook. This social media forum posts topics ranging from the National Basketball Association, to celebrity singers and performers, to farmers.
Information helps us make decisions as simple as what to wear today to how many reporters the media should send to cover a crash. Each of these decisions is an economic decision. After all, resources are scarce. If the media send ten reporters to cover an accident, they are not available to cover other stories or complete other tasks. Information provides the necessary knowledge to make the best possible decisions on how to utilize scarce resources. Welcome to the world of economics!
circular flow diagram
a diagram that views the economy as consisting of households and firms interacting in a goods and services market and a labor market
command economy
an economy where economic decisions are passed down from government authority and where the government owns the resources
division of labor
the way in which different workers divide required tasks to produce a good or service
economics
the study of how humans make choices under conditions of scarcity
economies of scale
when the average cost of producing each individual unit declines as total output increases
exports
products (goods and services) made domestically and sold abroad
fiscal policy
economic policies that involve government spending and taxes
globalization
the trend in which buying and selling in markets have increasingly crossed national borders
goods and services market
a market in which firms are sellers of what they produce and households are buyers
gross domestic product (GDP)
measure of the size of total production in an economy
imports
products (goods and services) made abroad and then sold domestically
labor market
the market in which households sell their labor as workers to business firms or other employers
macroeconomics
the branch of economics that focuses on broad issues such as growth, unemployment, inflation, and trade balance
market
interaction between potential buyers and sellers; a combination of demand and supply
market economy
an economy where economic decisions are decentralized, private individuals own resources, and businesses supply goods and services based on demand
microeconomics
the branch of economics that focuses on actions of particular agents within the economy, like households, workers, and business firms
model
see theory
monetary policy
policy that involves altering the level of interest rates, the availability of credit in the economy, and the extent of borrowing
private enterprise
system where private individuals or groups of private individuals own and operate the means of production (resources and businesses)
scarcity
when human wants for goods and services exceed the available supply
specialization
when workers or firms focus on particular tasks for which they are well-suited within the overall production process
theory
a representation of an object or situation that is simplified while including enough of the key features to help us understand the object or situation
traditional economy
typically an agricultural economy where things are done the same as they have always been done
underground economy
a market where the buyers and sellers make transactions in violation of one or more government regulations
1.1 What Is Economics, and Why Is It Important?
Economics seeks to solve the problem of scarcity, which is when human wants for goods and services exceed the available supply. A modern economy displays a division of labor, in which people earn income by specializing in what they produce and then use that income to purchase the products they need or want. The division of labor allows individuals and firms to specialize and to produce more for several reasons: a) It allows the agents to focus on areas of advantage due to natural factors and skill levels; b) It encourages the agents to learn and invent; c) It allows agents to take advantage of economies of scale. Division and specialization of labor only work when individuals can purchase what they do not produce in markets. Learning about economics helps you understand the major problems facing the world today, prepares you to be a good citizen, and helps you become a well-rounded thinker.
1.2 Microeconomics and Macroeconomics
Microeconomics and macroeconomics are two different perspectives on the economy. The microeconomic perspective focuses on parts of the economy: individuals, firms, and industries. The macroeconomic perspective looks at the economy as a whole, focusing on goals like growth in the standard of living, unemployment, and inflation. Macroeconomics has two types of policies for pursuing these goals: monetary policy and fiscal policy.
1.3 How Economists Use Theories and Models to Understand Economic Issues
Economists analyze problems differently than do other disciplinary experts. The main tools economists use are economic theories or models. A theory is not an illustration of the answer to a problem. Rather, a theory is a tool for determining the answer.
1.4 How To Organize Economies: An Overview of Economic Systems
We can organize societies as traditional, command, or market-oriented economies. Most societies are a mix. The last few decades have seen globalization evolve as a result of growth in commercial and financial networks that cross national borders, making businesses and workers from different economies increasingly interdependent.
1
.
What is scarcity? Can you think of two causes of scarcity?
2
.
Residents of the town of Smithfield like to consume hams, but each ham requires 10 people to produce it and takes a month. If the town has a total of 100 people, what is the maximum amount of ham the residents can consume in a month?
3
.
A consultant works for $200 per hour. She likes to eat vegetables, but is not very good at growing them. Why does it make more economic sense for her to spend her time at the consulting job and shop for her vegetables?
4
.
A computer systems engineer could paint his house, but it makes more sense for him to hire a painter to do it. Explain why.
5
.
What would be another example of a “system” in the real world that could serve as a metaphor for micro and macroeconomics?
6
.
Suppose we extend the circular flow model to add imports and exports. Copy the circular flow diagram onto a sheet of paper and then add a foreign country as a third agent. Draw a rough sketch of the flows of imports, exports, and the payments for each on your diagram.
7
.
What is an example of a problem in the world today, not mentioned in the chapter, that has an economic dimension?
8
.
The chapter defines private enterprise as a characteristic of market-oriented economies. What would public enterprise be? Hint: It is a characteristic of command economies.
9
.
Why might Belgium, France, Italy, and Sweden have a higher export to GDP ratio than the United States?
10.
Give the three reasons that explain why the division of labor increases an economy’s level of production.
11.
What are three reasons to study economics?
12.
What is the difference between microeconomics and macroeconomics?
13.
What are examples of individual economic agents?
14.
What are the three main goals of macroeconomics?
15.
How did John Maynard Keynes define economics?
16.
Are households primarily buyers or sellers in the goods and services market? In the labor market?
17.
Are firms primarily buyers or sellers in the goods and services market? In the labor market?
18.
What are the three ways that societies can organize themselves economically?
19.
What is globalization? How do you think it might have affected the economy over the past decade?
20.
Suppose you have a team of two workers: one is a baker and one is a chef. Explain why the kitchen can produce more meals in a given period of time if each worker specializes in what they do best than if each worker tries to do everything from appetizer to dessert.
21.
Why would division of labor without trade not work?
22.
Can you think of any examples of free goods, that is, goods or services that are not scarce?
23.
A balanced federal budget and a balance of trade are secondary goals of macroeconomics, while growth in the standard of living (for example) is a primary goal. Why do you think that is so?
24.
Macroeconomics is an aggregate of what happens at the microeconomic level. Would it be possible for what happens at the macro level to differ from how economic agents would react to some stimulus at the micro level? Hint: Think about the behavior of crowds.
25.
Why is it unfair or meaningless to criticize a theory as “unrealistic?”
26.
Suppose, as an economist, you are asked to analyze an issue unlike anything you have ever done before. Also, suppose you do not have a specific model for analyzing that issue. What should you do? Hint: What would a carpenter do in a similar situation?
27.
Why do you think that most modern countries’ economies are a mix of command and market types?
28.
Can you think of ways that globalization has helped you economically? Can you think of ways that it has not?
Learning Objectives
By the end of this section, you will be able to:
· Calculate and graph budget constraints
· Explain opportunity sets and opportunity costs
· Evaluate the law of diminishing marginal utility
· Explain how marginal analysis and utility influence choices
Consider the typical consumer’s budget problem. Consumers have a limited amount of income to spend on the things they need and want. Suppose Alphonso has $10 in spending money each week that he can allocate between bus tickets for getting to work and the burgers that he eats for lunch. Burgers cost $2 each, and bus tickets are 50 cents each. We can see Alphonso’s budget problem in
Figure 2.2
.
Figure 2.2 The Budget Constraint: Alphonso’s Consumption Choice Opportunity Frontier Each point on the budget constraint represents a combination of burgers and bus tickets whose total cost adds up to Alphonso’s budget of $10. The relative price of burgers and bus tickets determines the slope of the budget constraint. All along the budget set, giving up one burger means gaining four bus tickets.
The vertical axis in the figure shows burger purchases and the horizontal axis shows bus ticket purchases. If Alphonso spends all his money on burgers, he can afford five per week. ($10 per week/$2 per burger = 5 burgers per week.) However, if he does this, he will not be able to afford any bus tickets. Point A in the figure shows the choice (zero bus tickets and five burgers). Alternatively, if Alphonso spends all his money on bus tickets, he can afford 20 per week. ($10 per week/$0.50 per bus ticket = 20 bus tickets per week.) Then, however, he will not be able to afford any burgers. Point F shows this alternative choice (20 bus tickets and zero burgers).
If we connect all the points between A and F, we get Alphonso’s budget constraint. This indicates all the combination of burgers and bus tickets Alphonso can afford, given the price of the two goods and his budget amount.
If Alphonso is like most people, he will choose some combination that includes both bus tickets and burgers. That is, he will choose some combination on the budget constraint that is between points A and F. Every point on (or inside) the constraint shows a combination of burgers and bus tickets that Alphonso can afford. Any point outside the constraint is not affordable, because it would cost more money than Alphonso has in his budget.
The budget constraint clearly shows the tradeoff Alphonso faces in choosing between burgers and bus tickets. Suppose he is currently at point D, where he can afford 12 bus tickets and two burgers. What would it cost Alphonso for one more burger? It would be natural to answer $2, but that’s not the way economists think. Instead they ask, how many bus tickets would Alphonso have to give up to get one more burger, while staying within his budget? Since bus tickets cost 50 cents, Alphonso would have to give up four to afford one more burger. That is the true cost to Alphonso.
The Concept of Opportunity Cost
Economists use the term opportunity cost to indicate what one must give up to obtain what he or she desires. The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else. In short, opportunity cost is the value of the next best alternative. For Alphonso, the opportunity cost of a burger is the four bus tickets he would have to give up. He would decide whether or not to choose the burger depending on whether the value of the burger exceeds the value of the forgone alternative—in this case, bus tickets. Since people must choose, they inevitably face tradeoffs in which they have to give up things they desire to obtain other things they desire more.
LINK IT UP
View this
website
for an example of opportunity cost—paying someone else to wait in line for you.
A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class, the opportunity cost is the learning you miss from not attending class. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. In short, opportunity cost is all around us and part of human existence.
The following Work It Out feature shows a step-by-step analysis of a budget constraint calculation. Read through it to understand another important concept—slope—that we further explain in the appendix
The Use of Mathematics in Principles of Economics
.
WORK IT OUT
Understanding Budget Constraints
Budget constraints are easy to understand if you apply a little math. The appendix
The Use of Mathematics in Principles of Economics
explains all the math you are likely to need in this book. Therefore, if math is not your strength, you might want to take a look at the appendix.
Step 1: The equation for any budget constraint is:
Budget=P1 × Q1 + P2× Q2Budget=P1 × Q1 + P2× Q2
where P and Q are the price and quantity of items purchased (which we assume here to be two items) and Budget is the amount of income one has to spend.
Step 2. Apply the budget constraint equation to the scenario. In Alphonso’s case, this works out to be:
Budget$10 budget$10===P1× Q1+ P2× Q2$2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of bus tickets$2 × Qburgers + $0.50 × Qbus ticketsBudget=P1 × Q1 + P2× Q2$10 budget=$2 per burger × quantity of burgers + $0.50 per bus ticket × quantity of bus tickets$10=$2 × Qburgers + $0.50 × Qbus tickets
Step 3. Using a little algebra, we can turn this into the familiar equation of a line:
y = b + mxy = b + mx
For Alphonso, this is:
$10 = $2 × Qburgers + $0.50 × Qbus tickets$10 = $2 × Qburgers + $0.50 × Qbus tickets
Step 4. Simplify the equation. Begin by multiplying both sides of the equation by 2:
2 × 1020 = = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 4 × Qburgers + 1 × Qbus tickets2 × 10 = 2 × 2 × Qburgers + 2 × 0.5 × Qbus tickets 20 = 4 × Qburgers + 1 × Qbus tickets
Step 5. Subtract one bus ticket from both sides:
20 – Qbus tickets=4 × Qburgers20 – Qbus tickets = 4 × Qburgers
Divide each side by 4 to yield the answer:
5 – 0.25 × Qbus ticketsQburgers=or=Qburgers5 – 0.25 × Qbus tickets5 – 0.25 × Qbus tickets = QburgersorQburgers = 5 – 0.25 × Qbus tickets
Step 6. Notice that this equation fits the budget constraint in
Figure 2.2
. The vertical intercept is 5 and the slope is –0.25, just as the equation says. If you plug 20 bus tickets into the equation, you get 0 burgers. If you plug other numbers of bus tickets into the equation, you get the results (see
Table 2.1
), which are the points on Alphonso’s budget constraint.
Point
Quantity of Burgers (at $2)
Quantity of Bus Tickets (at 50 cents)
A
5
0
B
4
4
C
3
8
D
2
12
E
1
16
F
0
20
Table2.1
Step 7. Notice that the slope of a budget constraint always shows the opportunity cost of the good which is on the horizontal axis. For Alphonso, the slope is −0.25, indicating that for every bus ticket he buys, he must give up 1/4 burger. To phrase it differently, for every four tickets he buys, Alphonso must give up 1 burger.
There are two important observations here. First, the algebraic sign of the slope is negative, which means that the only way to get more of one good is to give up some of the other. Second, we define the slope as the price of bus tickets (whatever is on the horizontal axis in the graph) divided by the price of burgers (whatever is on the vertical axis), in this case $0.50/$2 = 0.25. If you want to determine the opportunity cost quickly, just divide the two prices.
Identifying Opportunity Cost
In many cases, it is reasonable to refer to the opportunity cost as the price. If your cousin buys a new bicycle for $300, then $300 measures the amount of “other consumption” that he has forsaken. For practical purposes, there may be no special need to identify the specific alternative product or products that he could have bought with that $300, but sometimes the price as measured in dollars may not accurately capture the true opportunity cost. This problem can loom especially large when costs of time are involved.
For example, consider a boss who decides that all employees will attend a two-day retreat to “build team spirit.” The out-of-pocket monetary cost of the event may involve hiring an outside consulting firm to run the retreat, as well as room and board for all participants. However, an opportunity cost exists as well: during the two days of the retreat, none of the employees are doing any other work.
Attending college is another case where the opportunity cost exceeds the monetary cost. The out-of-pocket costs of attending college include tuition, books, room and board, and other expenses. However, in addition, during the hours that you are attending class and studying, it is impossible to work at a paying job. Thus, college imposes both an out-of-pocket cost and an opportunity cost of lost earnings.
CLEAR IT UP
What is the opportunity cost associated with increased airport security measures?
After the terrorist plane hijackings on September 11, 2001, many steps were proposed to improve air travel safety. For example, the federal government could provide armed “sky marshals” who would travel inconspicuously with the rest of the passengers. The cost of having a sky marshal on every flight would be roughly $3 billion per year. Retrofitting all U.S. planes with reinforced cockpit doors to make it harder for terrorists to take over the plane would have a price tag of $450 million. Buying more sophisticated security equipment for airports, like three-dimensional baggage scanners and cameras linked to face recognition software, could cost another $2 billion.
However, the single biggest cost of greater airline security does not involve spending money. It is the opportunity cost of additional waiting time at the airport. According to the United States Department of Transportation (DOT), there were 895.5 million systemwide (domestic and international) scheduled service passengers in 2015. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively high-paid business people, conservative estimates set the average price of time for air travelers at $20 per hour. By these back-of-the-envelope calculations, the opportunity cost of delays in airports could be as much as 800 million × 0.5 hours × $20/hour, or $8 billion per year. Clearly, the opportunity costs of waiting time can be just as important as costs that involve direct spending.
In some cases, realizing the opportunity cost can alter behavior. Imagine, for example, that you spend $8 on lunch every day at work. You may know perfectly well that bringing a lunch from home would cost only $3 a day, so the opportunity cost of buying lunch at the restaurant is $5 each day (that is, the $8 buying lunch costs minus the $3 your lunch from home would cost). Five dollars each day does not seem to be that much. However, if you project what that adds up to in a year—250 days a year × $5 per day equals $1,250, the cost, perhaps, of a decent vacation. If you describe the opportunity cost as “a nice vacation” instead of “$5 a day,” you might make different choices.
Marginal Decision-Making and Diminishing Marginal Utility
The budget constraint framework helps to emphasize that most choices in the real world are not about getting all of one thing or all of another; that is, they are not about choosing either the point at one end of the budget constraint or else the point all the way at the other end. Instead, most choices involve marginal analysis, which means examining the benefits and costs of choosing a little more or a little less of a good. People naturally compare costs and benefits, but often we look at total costs and total benefits, when the optimal choice necessitates comparing how costs and benefits change from one option to another. You might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics.
We now turn to the notion of utility. People desire goods and services for the satisfaction or utility those goods and services provide. Utility, as we will see in the chapter on
Consumer Choices
, is subjective but that does not make it less real. Economists typically assume that the more of some good one consumes (for example, slices of pizza), the more utility one obtains. At the same time, the utility a person receives from consuming the first unit of a good is typically more than the utility received from consuming the fifth or the tenth unit of that same good. When Alphonso chooses between burgers and bus tickets, for example, the first few bus rides that he chooses might provide him with a great deal of utility—perhaps they help him get to a job interview or a doctor’s appointment. However, later bus rides might provide much less utility—they may only serve to kill time on a rainy day. Similarly, the first burger that Alphonso chooses to buy may be on a day when he missed breakfast and is ravenously hungry. However, if Alphonso has a burger every single day, the last few burgers may taste pretty boring. The general pattern that consumption of the first few units of any good tends to bring a higher level of utility to a person than consumption of later units is a common pattern. Economists refer to this pattern as the law of diminishing marginal utility, which means that as a person receives more of a good, the additional (or marginal) utility from each additional unit of the good declines. In other words, the first slice of pizza brings more satisfaction than the sixth.
The law of diminishing marginal utility explains why people and societies rarely make all-or-nothing choices. You would not say, “My favorite food is ice cream, so I will eat nothing but ice cream from now on.” Instead, even if you get a very high level of utility from your favorite food, if you ate it exclusively, the additional or marginal utility from those last few servings would not be very high. Similarly, most workers do not say: “I enjoy leisure, so I’ll never work.” Instead, workers recognize that even though some leisure is very nice, a combination of all leisure and no income is not so attractive. The budget constraint framework suggests that when people make choices in a world of scarcity, they will use marginal analysis and think about whether they would prefer a little more or a little less.
A rational consumer would only purchase additional units of some product as long as the marginal utility exceeds the opportunity cost. Suppose Alphonso moves down his budget constraint from Point A to Point B to Point C and further. As he consumes more bus tickets, the marginal utility of bus tickets will diminish, while the opportunity cost, that is, the marginal utility of foregone burgers, will increase. Eventually, the opportunity cost will exceed the marginal utility of an additional bus ticket. If Alphonso is rational, he won’t purchase more bus tickets once the marginal utility just equals the opportunity cost. While we can’t (yet) say exactly how many bus tickets Alphonso will buy, that number is unlikely to be the most he can afford, 20.
Sunk Costs
In the budget constraint framework, all decisions involve what will happen next: that is, what quantities of goods will you consume, how many hours will you work, or how much will you save. These decisions do not look back to past choices. Thus, the budget constraint framework assumes that sunk costs, which are costs that were incurred in the past and cannot be recovered, should not affect the current decision.
Consider the case of Selena, who pays $8 to see a movie, but after watching the film for 30 minutes, she knows that it is truly terrible. Should she stay and watch the rest of the movie because she paid for the ticket, or should she leave? The money she spent is a sunk cost, and unless the theater manager is sympathetic, Selena will not get a refund. However, staying in the movie still means paying an opportunity cost in time. Her choice is whether to spend the next 90 minutes suffering through a cinematic disaster or to do something—anything—else. The lesson of sunk costs is to forget about the money and time that is irretrievably gone and instead to focus on the marginal costs and benefits of current and future options.
For people and firms alike, dealing with sunk costs can be frustrating. It often means admitting an earlier error in judgment. Many firms, for example, find it hard to give up on a new product that is doing poorly because they spent so much money in creating and launching the product. However, the lesson of sunk costs is to ignore them and make decisions based on what will happen in the future.
From a Model with Two Goods to One of Many Goods
The budget constraint diagram containing just two goods, like most models used in this book, is not realistic. After all, in a modern economy people choose from thousands of goods. However, thinking about a model with many goods is a straightforward extension of what we discussed here. Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can draw multiple budget constraints, showing the possible tradeoffs between many different pairs of goods. In more advanced classes in economics, you would use mathematical equations that include many possible goods and services that can be purchased, together with their quantities and prices, and show how the total spending on all goods and services is limited to the overall budget available. The graph with two goods that we presented here clearly illustrates that every choice has an opportunity cost, which is the point that does carry over to the real world.
Learning Objectives
By the end of this section, you will be able to:
· Interpret production possibilities frontier graphs
· Contrast a budget constraint and a production possibilities frontier
· Explain the relationship between a production possibilities frontier and the law of diminishing returns
· Contrast productive efficiency and allocative efficiency
· Define comparative advantage
Just as individuals cannot have everything they want and must instead make choices, society as a whole cannot have everything it might want, either. This section of the chapter will explain the constraints society faces, using a model called the production possibilities frontier (PPF). There are more similarities than differences between individual choice and social choice. As you read this section, focus on the similarities.
Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. The production possibilities frontier in
Figure 2.3
illustrates this situation.
Figure 2.3 A Healthcare vs. Education Production Possibilities Frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.
Figure 2.3
shows healthcare on the vertical axis and education on the horizontal axis. If the society were to allocate all of its resources to healthcare, it could produce at point A. However, it would not have any resources to produce education. If it were to allocate all of its resources to education, it could produce at point F. Alternatively, the society could choose to produce any combination of healthcare and education on the production possibilities frontier. In effect, the production possibilities frontier plays the same role for society as the budget constraint plays for Alphonso. Society can choose any combination of the two goods on or inside the PPF. However, it does not have enough resources to produce outside the PPF.
Most importantly, the production possibilities frontier clearly shows the tradeoff between healthcare and education. Suppose society has chosen to operate at point B, and it is considering producing more education. Because the PPF is downward sloping from left to right, the only way society can obtain more education is by giving up some healthcare. That is the tradeoff society faces. Suppose it considers moving from point B to point C. What would the opportunity cost be for the additional education? The opportunity cost would be the healthcare society has to forgo. Just as with Alphonso’s budget constraint, the slope of the production possibilities frontier shows the opportunity cost. By now you might be saying, “Hey, this PPF is sounding like the budget constraint.” If so, read the following Clear It Up feature.
CLEAR IT UP
What’s the difference between a budget constraint and a PPF?
There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods, which from the point of view of an individual consumer, are fixed, so the slope doesn’t change. In contrast, the PPF has a curved shape because of the law of the diminishing returns. Thus, the slope is different at various points on the PPF. The second major difference is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education. If this were a real world example, that data would be available.
Whether or not we have specific numbers, conceptually we can measure the opportunity cost of additional education as society moves from point B to point C on the PPF. We measure the additional education by the horizontal distance between B and C. The foregone healthcare is given by the vertical distance between B and C. The slope of the PPF between B and C is (approximately) the vertical distance (the “rise”) over the horizontal distance (the “run”). This is the opportunity cost of the additional education.
The PPF and the Law of Increasing Opportunity Cost
The budget constraints that we presented earlier in this chapter, showing individual choices about what quantities of goods to consume, were all straight lines. The reason for these straight lines was that the relative prices of the two goods in the consumption budget constraint determined the slope of the budget constraint. However, we drew the production possibilities frontier for healthcare and education as a curved line. Why does the PPF have a different shape?
To understand why the PPF is curved, start by considering point A at the top left-hand side of the PPF. At point A, all available resources are devoted to healthcare and none are left for education. This situation would be extreme and even ridiculous. For example, children are seeing a doctor every day, whether they are sick or not, but not attending school. People are having cosmetic surgery on every part of their bodies, but no high school or college education exists. Now imagine that some of these resources are diverted from healthcare to education, so that the economy is at point B instead of point A. Diverting some resources away from A to B causes relatively little reduction in health because the last few marginal dollars going into healthcare services are not producing much additional gain in health. However, putting those marginal dollars into education, which is completely without resources at point A, can produce relatively large gains. For this reason, the shape of the PPF from A to B is relatively flat, representing a relatively small drop-off in health and a relatively large gain in education.
Now consider the other end, at the lower right, of the production possibilities frontier. Imagine that society starts at choice D, which is devoting nearly all resources to education and very few to healthcare, and moves to point F, which is devoting all spending to education and none to healthcare. For the sake of concreteness, you can imagine that in the movement from D to F, the last few doctors must become high school science teachers, the last few nurses must become school librarians rather than dispensers of vaccinations, and the last few emergency rooms are turned into kindergartens. The gains to education from adding these last few resources to education are very small. However, the opportunity cost lost to health will be fairly large, and thus the slope of the PPF between D and F is steep, showing a large drop in health for only a small gain in education.
The lesson is not that society is likely to make an extreme choice like devoting no resources to education at point A or no resources to health at point F. Instead, the lesson is that the gains from committing additional marginal resources to education depend on how much is already being spent. If on the one hand, very few resources are currently committed to education, then an increase in resources used can bring relatively large gains. On the other hand, if a large number of resources are already committed to education, then committing additional resources will bring relatively smaller gains.
This pattern is common enough that economists have given it a name: the law of increasing opportunity cost, which holds that as production of a good or service increases, the marginal opportunity cost of producing it increases as well. This happens because some resources are better suited for producing certain goods and services instead of others. When government spends a certain amount more on reducing crime, for example, the original increase in opportunity cost of reducing crime could be relatively small. However, additional increases typically cause relatively larger increases in the opportunity cost of reducing crime, and paying for enough police and security to reduce crime to nothing at all would be a tremendously high opportunity cost.
The curvature of the production possibilities frontier shows that as we add more resources to education, moving from left to right along the horizontal axis, the original increase in opportunity cost is fairly small, but gradually increases. Thus, the slope of the PPF is relatively flat near the vertical-axis intercept. Conversely, as we add more resources to healthcare, moving from bottom to top on the vertical axis, the original declines in opportunity cost are fairly large, but again gradually diminish. Thus, the slope of the PPF is relatively steep near the horizontal-axis intercept. In this way, the law of increasing opportunity cost produces the outward-bending shape of the production possibilities frontier.
Productive Efficiency and Allocative Efficiency
The study of economics does not presume to tell a society what choice it should make along its production possibilities frontier. In a market-oriented economy with a democratic government, the choice will involve a mixture of decisions by individuals, firms, and government. However, economics can point out that some choices are unambiguously better than others. This observation is based on the concept of efficiency. In everyday usage, efficiency refers to lack of waste. An inefficient machine operates at high cost, while an efficient machine operates at lower cost, because it is not wasting energy or materials. An inefficient organization operates with long delays and high costs, while an efficient organization meets schedules, is focused, and performs within budget.
The production possibilities frontier can illustrate two kinds of efficiency: productive efficiency and allocative efficiency.
Figure 2.4
illustrates these ideas using a production possibilities frontier between healthcare and education.
Figure 2.4 Productive and Allocative Efficiency Productive efficiency means it is impossible to produce more of one good without decreasing the quantity that is produced of another good. Thus, all choices along a given PPF like B, C, and D display productive efficiency, but R does not. Allocative efficiency means that the particular mix of goods being produced—that is, the specific choice along the production possibilities frontier—represents the allocation that society most desires.
Productive efficiency means that, given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good. All choices on the PPF in
Figure 2.4
, including A, B, C, D, and F, display productive efficiency. As a firm moves from any one of these choices to any other, either healthcare increases and education decreases or vice versa. However, any choice inside the production possibilities frontier is productively inefficient and wasteful because it is possible to produce more of one good, the other good, or some combination of both goods.
For example, point R is productively inefficient because it is possible at choice C to have more of both goods: education on the horizontal axis is higher at point C than point R (E2 is greater than E1), and healthcare on the vertical axis is also higher at point C than point R (H2 is great than H1).
We can show the particular mix of goods and services produced—that is, the specific combination of selected healthcare and education along the production possibilities frontier—as a ray (line) from the origin to a specific point on the PPF. Output mixes that had more healthcare (and less education) would have a steeper ray, while those with more education (and less healthcare) would have a flatter ray.
Allocative efficiency means that the particular combination of goods and services on the production possibility curve that a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually a discussion in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.
Why Society Must Choose
In
Welcome to Economics!
we learned that every society faces the problem of scarcity, where limited resources conflict with unlimited needs and wants. The production possibilities curve illustrates the choices involved in this dilemma.
Every economy faces two situations in which it may be able to expand consumption of all goods. In the first case, a society may discover that it has been using its resources inefficiently, in which case by improving efficiency and producing on the production possibilities frontier, it can have more of all goods (or at least more of some and less of none). In the second case, as resources grow over a period of years (e.g., more labor and more capital), the economy grows. As it does, the production possibilities frontier for a society will tend to shift outward and society will be able to afford more of all goods.
However, improvements in productive efficiency take time to discover and implement, and economic growth happens only gradually. Thus, a society must choose between tradeoffs in the present. For government, this process often involves trying to identify where additional spending could do the most good and where reductions in spending would do the least harm. At the individual and firm level, the market economy coordinates a process in which firms seek to produce goods and services in the quantity, quality, and price that people want. However, for both the government and the market economy in the short term, increases in production of one good typically mean offsetting decreases somewhere else in the economy.
The PPF and Comparative Advantage
While every society must choose how much of each good or service it should produce, it does not need to produce every single good it consumes. Often how much of a good a country decides to produce depends on how expensive it is to produce it versus buying it from a different country. As we saw earlier, the curvature of a country’s PPF gives us information about the tradeoff between devoting resources to producing one good versus another. In particular, its slope gives the opportunity cost of producing one more unit of the good in the x-axis in terms of the other good (in the y-axis). Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology, or skills.
Suppose two countries, the US and Brazil, need to decide how much they will produce of two crops: sugar cane and wheat. Due to its climatic conditions, Brazil can produce quite a bit of sugar cane per acre but not much wheat. Conversely, the U.S. can produce large amounts of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true: the U.S. has a lower opportunity cost of producing wheat than Brazil. We illustrate this by the PPFs of the two countries in
Figure 2.5
.
Figure 2.5 Production Possibility Frontier for the U.S. and Brazil The U.S. PPF is flatter than the Brazil PPF implying that the opportunity cost of wheat in terms of sugar cane is lower in the U.S. than in Brazil. Conversely, the opportunity cost of sugar cane is lower in Brazil. The U.S. has comparative advantage in wheat and Brazil has comparative advantage in sugar cane.
When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good. Comparative advantage is not the same as absolute advantage, which is when a country can produce more of a good. In our example, Brazil has an absolute advantage in sugar cane and the U.S. has an absolute advantage in wheat. One can easily see this with a simple observation of the extreme production points in the PPFs of the two countries. If Brazil devoted all of its resources to producing wheat, it would be producing at point A. If however it had devoted all of its resources to producing sugar cane instead, it would be producing a much larger amount than the U.S., at point B.
The slope of the PPF gives the opportunity cost of producing an additional unit of wheat. While the slope is not constant throughout the PPFs, it is quite apparent that the PPF in Brazil is much steeper than in the U.S., and therefore the opportunity cost of wheat generally higher in Brazil. In the chapter on
International Trade
you will learn that countries’ differences in comparative advantage determine which goods they will choose to produce and trade. When countries engage in trade, they specialize in the production of the goods in which they have comparative advantage, and trade part of that production for goods in which they do not have comparative advantage. With trade, manufacturers produce goods where the opportunity cost is lowest, so total production increases, benefiting both trading parties.
Learning Objectives
By the end of this section, you will be able to:
· Explain demand, quantity demanded, and the law of demand
· Identify a demand curve and a supply curve
· Explain supply, quantity supplied, and the law of supply
· Explain equilibrium, equilibrium price, and equilibrium quantity
First let’s first focus on what economists mean by demand, what they mean by supply, and then how demand and supply interact in a market.
Demand for Goods and Services
Economists use the term demand to refer to the amount of some good or service consumers are willing and able to purchase at each price. Demand is fundamentally based on needs and wants—if you have no need or want for something, you won’t buy it. While a consumer may be able to differentiate between a need and a want, from an economist’s perspective they are the same thing. Demand is also based on ability to pay. If you cannot pay for it, you have no effective demand. By this definition, a homeless person probably has no effective demand for shelter.
What a buyer pays for a unit of the specific good or service is called price. The total number of units that consumers would purchase at that price is called the quantity demanded. A rise in price of a good or service almost always decreases the quantity demanded of that good or service. Conversely, a fall in price will increase the quantity demanded. When the price of a gallon of gasoline increases, for example, people look for ways to reduce their consumption by combining several errands, commuting by carpool or mass transit, or taking weekend or vacation trips closer to home. Economists call this inverse relationship between price and quantity demanded the law of demand. The law of demand assumes that all other variables that affect demand (which we explain in the next module) are held constant.
We can show an example from the market for gasoline in a table or a graph. Economist call a table that shows the quantity demanded at each price, such as
Table 3.1
, a demand schedule. In this case we measure price in dollars per gallon of gasoline. We measure the quantity demanded in millions of gallons over some time period (for example, per day or per year) and over some geographic area (like a state or a country). A demand curve shows the relationship between price and quantity demanded on a graph like
Figure 3.2
, with quantity on the horizontal axis and the price per gallon on the vertical axis. (Note that this is an exception to the normal rule in mathematics that the independent variable (x) goes on the horizontal axis and the dependent variable (y) goes on the vertical. Economics is not math.)
Table 3.1
shows the demand schedule and the graph in
Figure 3.2
shows the demand curve. These are two ways to describe the same relationship between price and quantity demanded.
Price (per gallon)
Quantity Demanded (millions of gallons)
$1.00
800
$1.20
700
$1.40
600
$1.60
550
$1.80
500
$2.00
460
$2.20
420
Table3.1 Price and Quantity Demanded of Gasoline
Figure 3.2 A Demand Curve for Gasoline The demand schedule shows that as price rises, quantity demanded decreases, and vice versa. We graph these points, and the line connecting them is the demand curve (D). The downward slope of the demand curve again illustrates the law of demand—the inverse relationship between prices and quantity demanded.
Demand curves will appear somewhat different for each product. They may appear relatively steep or flat, or they may be straight or curved. Nearly all demand curves share the fundamental similarity that they slope down from left to right. Demand curves embody the law of demand: As the price increases, the quantity demanded decreases, and conversely, as the price decreases, the quantity demanded increases.
Confused about these different types of demand? Read the next Clear It Up feature.
CLEAR IT UP
Is demand the same as quantity demanded?
In economic terminology, demand is not the same as quantity demanded. When economists talk about demand, they mean the relationship between a range of prices and the quantities demanded at those prices, as illustrated by a demand curve or a demand schedule. When economists talk about quantity demanded, they mean only a certain point on the demand curve, or one quantity on the demand schedule. In short, demand refers to the curve and quantity demanded refers to the (specific) point on the curve.
Supply of Goods and Services
When economists talk about supply, they mean the amount of some good or service a producer is willing to supply at each price. Price is what the producer receives for selling one unit of a good or service. A rise in price almost always leads to an increase in the quantity supplied of that good or service, while a fall in price will decrease the quantity supplied. When the price of gasoline rises, for example, it encourages profit-seeking firms to take several actions: expand exploration for oil reserves; drill for more oil; invest in more pipelines and oil tankers to bring the oil to plants for refining into gasoline; build new oil refineries; purchase additional pipelines and trucks to ship the gasoline to gas stations; and open more gas stations or keep existing gas stations open longer hours. Economists call this positive relationship between price and quantity supplied—that a higher price leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law of supply. The law of supply assumes that all other variables that affect supply (to be explained in the next module) are held constant.
Still unsure about the different types of supply? See the following Clear It Up feature.
CLEAR IT UP
Is supply the same as quantity supplied?
In economic terminology, supply is not the same as quantity supplied. When economists refer to supply, they mean the relationship between a range of prices and the quantities supplied at those prices, a relationship that we can illustrate with a supply curve or a supply schedule. When economists refer to quantity supplied, they mean only a certain point on the supply curve, or one quantity on the supply schedule. In short, supply refers to the curve and quantity supplied refers to the (specific) point on the curve.
Figure 3.3
illustrates the law of supply, again using the market for gasoline as an example. Like demand, we can illustrate supply using a table or a graph. A supply schedule is a table, like
Table 3.2
, that shows the quantity supplied at a range of different prices. Again, we measure price in dollars per gallon of gasoline and we measure quantity supplied in millions of gallons. A supply curve is a graphic illustration of the relationship between price, shown on the vertical axis, and quantity, shown on the horizontal axis. The supply schedule and the supply curve are just two different ways of showing the same information. Notice that the horizontal and vertical axes on the graph for the supply curve are the same as for the demand curve.
Figure 3.3 A Supply Curve for Gasoline The supply schedule is the table that shows quantity supplied of gasoline at each price. As price rises, quantity supplied also increases, and vice versa. The supply curve (S) is created by graphing the points from the supply schedule and then connecting them. The upward slope of the supply curve illustrates the law of supply—that a higher price leads to a higher quantity supplied, and vice versa.
Price (per gallon)
Quantity Supplied (millions of gallons)
$1.00
500
$1.20
550
$1.40
600
$1.60
640
$1.80
680
$2.00
700
$2.20
720
Table3.2 Price and Supply of Gasoline
The shape of supply curves will vary somewhat according to the product: steeper, flatter, straighter, or curved. Nearly all supply curves, however, share a basic similarity: they slope up from left to right and illustrate the law of supply: as the price rises, say, from $1.00 per gallon to $2.20 per gallon, the quantity supplied increases from 500 gallons to 720 gallons. Conversely, as the price falls, the quantity supplied decreases.
Equilibrium—Where Demand and Supply Intersect
Because the graphs for demand and supply curves both have price on the vertical axis and quantity on the horizontal axis, the demand curve and supply curve for a particular good or service can appear on the same graph. Together, demand and supply determine the price and the quantity that will be bought and sold in a market.
Figure 3.4
illustrates the interaction of demand and supply in the market for gasoline. The demand curve (D) is identical to
Figure 3.2
. The supply curve (S) is identical to
Figure 3.3
.
Table 3.3
contains the same information in tabular form.
Figure 3.4 Demand and Supply for Gasoline The demand curve (D) and the supply curve (S) intersect at the equilibrium point E, with a price of $1.40 and a quantity of 600. The equilibrium is the only price where quantity demanded is equal to quantity supplied. At a price above equilibrium like $1.80, quantity supplied exceeds the quantity demanded, so there is excess supply. At a price below equilibrium such as $1.20, quantity demanded exceeds quantity supplied, so there is excess demand.
Price (per gallon)
Quantity demanded (millions of gallons)
Quantity supplied (millions of gallons)
$1.00
800
500
$1.20
700
550
$1.40
600
600
$1.60
550
640
$1.80
500
680
$2.00
460
700
$2.20
420
720
Table3.3 Price, Quantity Demanded, and Quantity Supplied
Remember this: When two lines on a diagram cross, this intersection usually means something. The point where the supply curve (S) and the demand curve (D) cross, designated by point E in
Figure 3.4
, is called the equilibrium. The equilibrium price is the only price where the plans of consumers and the plans of producers agree—that is, where the amount of the product consumers want to buy (quantity demanded) is equal to the amount producers want to sell (quantity supplied). Economists call this common quantity the equilibrium quantity. At any other price, the quantity demanded does not equal the quantity supplied, so the market is not in equilibrium at that price.
In
Figure 3.4
, the equilibrium price is $1.40 per gallon of gasoline and the equilibrium quantity is 600 million gallons. If you had only the demand and supply schedules, and not the graph, you could find the equilibrium by looking for the price level on the tables where the quantity demanded and the quantity supplied are equal.
The word “equilibrium” means “balance.” If a market is at its equilibrium price and quantity, then it has no reason to move away from that point. However, if a market is not at equilibrium, then economic pressures arise to move the market toward the equilibrium price and the equilibrium quantity.
Imagine, for example, that the price of a gallon of gasoline was above the equilibrium price—that is, instead of $1.40 per gallon, the price is $1.80 per gallon. The dashed horizontal line at the price of $1.80 in
Figure 3.4
illustrates this above equilibrium price. At this higher price, the quantity demanded drops from 600 to 500. This decline in quantity reflects how consumers react to the higher price by finding ways to use less gasoline.
Moreover, at this higher price of $1.80, the quantity of gasoline supplied rises from the 600 to 680, as the higher price makes it more profitable for gasoline producers to expand their output. Now, consider how quantity demanded and quantity supplied are related at this above-equilibrium price. Quantity demanded has fallen to 500 gallons, while quantity supplied has risen to 680 gallons. In fact, at any above-equilibrium price, the quantity supplied exceeds the quantity demanded. We call this an excess supply or a surplus.
With a surplus, gasoline accumulates at gas stations, in tanker trucks, in pipelines, and at oil refineries. This accumulation puts pressure on gasoline sellers. If a surplus remains unsold, those firms involved in making and selling gasoline are not receiving enough cash to pay their workers and to cover their expenses. In this situation, some producers and sellers will want to cut prices, because it is better to sell at a lower price than not to sell at all. Once some sellers start cutting prices, others will follow to avoid losing sales. These price reductions in turn will stimulate a higher quantity demanded. Therefore, if the price is above the equilibrium level, incentives built into the structure of demand and supply will create pressures for the price to fall toward the equilibrium.
Now suppose that the price is below its equilibrium level at $1.20 per gallon, as the dashed horizontal line at this price in
Figure 3.4
shows. At this lower price, the quantity demanded increases from 600 to 700 as drivers take longer trips, spend more minutes warming up the car in the driveway in wintertime, stop sharing rides to work, and buy larger cars that get fewer miles to the gallon. However, the below-equilibrium price reduces gasoline producers’ incentives to produce and sell gasoline, and the quantity supplied falls from 600 to 550.
When the price is below equilibrium, there is excess demand, or a shortage—that is, at the given price the quantity demanded, which has been stimulated by the lower price, now exceeds the quantity supplied, which had been depressed by the lower price. In this situation, eager gasoline buyers mob the gas stations, only to find many stations running short of fuel. Oil companies and gas stations recognize that they have an opportunity to make higher profits by selling what gasoline they have at a higher price. As a result, the price rises toward the equilibrium level. Read
Demand, Supply, and Efficiency
for more discussion on the importance of the demand and supply model.
Learning Objectives
By the end of this section, you will be able to:
· Identify factors that affect demand
· Graph demand curves and demand shifts
· Identify factors that affect supply
· Graph supply curves and supply shifts
The previous module explored how price affects the quantity demanded and the quantity supplied. The result was the demand curve and the supply curve. Price, however, is not the only factor that influences buyers’ and sellers’ decisions. For example, how is demand for vegetarian food affected if, say, health concerns cause more consumers to avoid eating meat? How is the supply of diamonds affected if diamond producers discover several new diamond mines? What are the major factors, in addition to the price, that influence demand or supply?
LINK IT UP
Visit this
website
to read a brief note on how marketing strategies can influence supply and demand of products.
What Factors Affect Demand?
We defined demand as the amount of some product a consumer is willing and able to purchase at each price. That suggests at least two factors that affect demand. Willingness to purchase suggests a desire, based on what economists call tastes and preferences. If you neither need nor want something, you will not buy it. Ability to purchase suggests that income is important. Professors are usually able to afford better housing and transportation than students, because they have more income. Prices of related goods can affect demand also. If you need a new car, the price of a Honda may affect your demand for a Ford. Finally, the size or composition of the population can affect demand. The more children a family has, the greater their demand for clothing. The more driving-age children a family has, the greater their demand for car insurance, and the less for diapers and baby formula.
These factors matter for both individual and market demand as a whole. Exactly how do these various factors affect demand, and how do we show the effects graphically? To answer those questions, we need the ceteris paribus assumption.
The Ceteris Paribus Assumption
A demand curve or a supply curve is a relationship between two, and only two, variables: quantity on the horizontal axis and price on the vertical axis. The assumption behind a demand curve or a supply curve is that no relevant economic factors, other than the product’s price, are changing. Economists call this assumption ceteris paribus, a Latin phrase meaning “other things being equal.” Any given demand or supply curve is based on the ceteris paribus assumption that all else is held equal. A demand curve or a supply curve is a relationship between two, and only two, variables when all other variables are kept constant. If all else is not held equal, then the laws of supply and demand will not necessarily hold, as the following Clear It Up feature shows.
CLEAR IT UP
When does ceteris paribus apply?
We typically apply ceteris paribus when we observe how changes in price affect demand or supply, but we can apply ceteris paribus more generally. In the real world, demand and supply depend on more factors than just price. For example, a consumer’s demand depends on income and a producer’s supply depends on the cost of producing the product. How can we analyze the effect on demand or supply if multiple factors are changing at the same time—say price rises and income falls? The answer is that we examine the changes one at a time, assuming the other factors are held constant.
For example, we can say that an increase in the price reduces the amount consumers will buy (assuming income, and anything else that affects demand, is unchanged). Additionally, a decrease in income reduces the amount consumers can afford to buy (assuming price, and anything else that affects demand, is unchanged). This is what the ceteris paribus assumption really means. In this particular case, after we analyze each factor separately, we can combine the results. The amount consumers buy falls for two reasons: first because of the higher price and second because of the lower income.
How Does Income Affect Demand?
Let’s use income as an example of how factors other than price affect demand.
Figure 3.5
shows the initial demand for automobiles as D0. At point Q, for example, if the price is $20,000 per car, the quantity of cars demanded is 18 million. D0 also shows how the quantity of cars demanded would change as a result of a higher or lower price. For example, if the price of a car rose to $22,000, the quantity demanded would decrease to 17 million, at point R.
The original demand curve D0, like every demand curve, is based on the ceteris paribus assumption that no other economically relevant factors change. Now imagine that the economy expands in a way that raises the incomes of many people, making cars more affordable. How will this affect demand? How can we show this graphically?
Return to
Figure 3.5
. The price of cars is still $20,000, but with higher incomes, the quantity demanded has now increased to 20 million cars, shown at point S. As a result of the higher income levels, the demand curve shifts to the right to the new demand curve D1, indicating an increase in demand.
Table 3.4
shows clearly that this increased demand would occur at every price, not just the original one.
Figure 3.5 Shifts in Demand: A Car Example Increased demand means that at every given price, the quantity demanded is higher, so that the demand curve shifts to the right from D0 to D1. Decreased demand means that at every given price, the quantity demanded is lower, so that the demand curve shifts to the left from D0 to D2.
Price
Decrease to D2
Original Quantity Demanded D0
Increase to D1
$16,000
17.6 million
22.0 million
24.0 million
$18,000
16.0 million
20.0 million
22.0 million
$20,000
14.4 million
18.0 million
20.0 million
$22,000
13.6 million
17.0 million
19.0 million
$24,000
13.2 million
16.5 million
18.5 million
$26,000
12.8 million
16.0 million
18.0 million
Table3.4 Price and Demand Shifts: A Car Example
Now, imagine that the economy slows down so that many people lose their jobs or work fewer hours, reducing their incomes. In this case, the decrease in income would lead to a lower quantity of cars demanded at every given price, and the original demand curve D0 would shift left to D2. The shift from D0 to D2 represents such a decrease in demand: At any given price level, the quantity demanded is now lower. In this example, a price of $20,000 means 18 million cars sold along the original demand curve, but only 14.4 million sold after demand fell.
When a demand curve shifts, it does not mean that the quantity demanded by every individual buyer changes by the same amount. In this example, not everyone would have higher or lower income and not everyone would buy or not buy an additional car. Instead, a shift in a demand curve captures a pattern for the market as a whole.
In the previous section, we argued that higher income causes greater demand at every price. This is true for most goods and services. For some—luxury cars, vacations in Europe, and fine jewelry—the effect of a rise in income can be especially pronounced. A product whose demand rises when income rises, and vice versa, is called a normal good. A few exceptions to this pattern do exist. As incomes rise, many people will buy fewer generic brand groceries and more name brand groceries. They are less likely to buy used cars and more likely to buy new cars. They will be less likely to rent an apartment and more likely to own a home. A product whose demand falls when income rises, and vice versa, is called an inferior good. In other words, when income increases, the demand curve shifts to the left.
Other Factors That Shift Demand Curves
Income is not the only factor that causes a shift in demand. Other factors that change demand include tastes and preferences, the composition or size of the population, the prices of related goods, and even expectations. A change in any one of the underlying factors that determine what quantity people are willing to buy at a given price will cause a shift in demand. Graphically, the new demand curve lies either to the right (an increase) or to the left (a decrease) of the original demand curve. Let’s look at these factors.
Changing Tastes or Preferences
From 1980 to 2014, the per-person consumption of chicken by Americans rose from 48 pounds per year to 85 pounds per year, and consumption of beef fell from 77 pounds per year to 54 pounds per year, according to the U.S. Department of Agriculture (USDA). Changes like these are largely due to movements in taste, which change the quantity of a good demanded at every price: that is, they shift the demand curve for that good, rightward for chicken and leftward for beef.
Changes in the Composition of the Population
The proportion of elderly citizens in the United States population is rising. It rose from 9.8% in 1970 to 12.6% in 2000, and will be a projected (by the U.S. Census Bureau) 20% of the population by 2030. A society with relatively more children, like the United States in the 1960s, will have greater demand for goods and services like tricycles and day care facilities. A society with relatively more elderly persons, as the United States is projected to have by 2030, has a higher demand for nursing homes and hearing aids. Similarly, changes in the size of the population can affect the demand for housing and many other goods. Each of these changes in demand will be shown as a shift in the demand curve.
Changes in the Prices of Related Goods
Changes in the prices of related goods such as substitutes or complements also can affect the demand for a product. A substitute is a good or service that we can use in place of another good or service. As electronic books, like this one, become more available, you would expect to see a decrease in demand for traditional printed books. A lower price for a substitute decreases demand for the other product. For example, in recent years as the price of tablet computers has fallen, the quantity demanded has increased (because of the law of demand). Since people are purchasing tablets, there has been a decrease in demand for laptops, which we can show graphically as a leftward shift in the demand curve for laptops. A higher price for a substitute good has the reverse effect.
Other goods are complements for each other, meaning we often use the goods together, because consumption of one good tends to enhance consumption of the other. Examples include breakfast cereal and milk; notebooks and pens or pencils, golf balls and golf clubs; gasoline and sport utility vehicles; and the five-way combination of bacon, lettuce, tomato, mayonnaise, and bread. If the price of golf clubs rises, since the quantity demanded of golf clubs falls (because of the law of demand), demand for a complement good like golf balls decreases, too. Similarly, a higher price for skis would shift the demand curve for a complement good like ski resort trips to the left, while a lower price for a complement has the reverse effect.
Changes in Expectations about Future Prices or Other Factors that Affect Demand
While it is clear that the price of a good affects the quantity demanded, it is also true that expectations about the future price (or expectations about tastes and preferences, income, and so on) can affect demand. For example, if people hear that a hurricane is coming, they may rush to the store to buy flashlight batteries and bottled water. If people learn that the price of a good like coffee is likely to rise in the future, they may head for the store to stock up on coffee now. We show these changes in demand as shifts in the curve. Therefore, a shift in demand happens when a change in some economic factor (other than price) causes a different quantity to be demanded at every price. The following Work It Out feature shows how this happens.
WORK IT OUT
Shift in Demand
A shift in demand means that at any price (and at every price), the quantity demanded will be different than it was before. Following is an example of a shift in demand due to an income increase.
Step 1. Draw the graph of a demand curve for a normal good like pizza. Pick a price (like P0). Identify the corresponding Q0. See an example in
Figure 3.6
.
Figure 3.6 Demand Curve We can use the demand curve to identify how much consumers would buy at any given price.
Step 2. Suppose income increases. As a result of the change, are consumers going to buy more or less pizza? The answer is more. Draw a dotted horizontal line from the chosen price, through the original quantity demanded, to the new point with the new Q1. Draw a dotted vertical line down to the horizontal axis and label the new Q1.
Figure 3.7
provides an example.
Figure 3.7 Demand Curve with Income Increase With an increase in income, consumers will purchase larger quantities, pushing demand to the right.
Step 3. Now, shift the curve through the new point. You will see that an increase in income causes an upward (or rightward) shift in the demand curve, so that at any price the quantities demanded will be higher, as
Figure 3.8
illustrates.
Figure 3.8 Demand Curve Shifted Right With an increase in income, consumers will purchase larger quantities, pushing demand to the right, and causing the demand curve to shift right.
Summing Up Factors That Change Demand
Figure 3.9
summarizes six factors that can shift demand curves. The direction of the arrows indicates whether the demand curve shifts represent an increase in demand or a decrease in demand. Notice that a change in the price of the good or service itself is not listed among the factors that can shift a demand curve. A change in the price of a good or service causes a movement along a specific demand curve, and it typically leads to some change in the quantity demanded, but it does not shift the demand curve.
Figure 3.9 Factors That Shift Demand Curves (a) A list of factors that can cause an increase in demand from D0 to D1. (b) The same factors, if their direction is reversed, can cause a decrease in demand from D0 to D1.
When a demand curve shifts, it will then intersect with a given supply curve at a different equilibrium price and quantity. We are, however, getting ahead of our story. Before discussing how changes in demand can affect equilibrium price and quantity, we first need to discuss shifts in supply curves.
How Production Costs Affect Supply
A supply curve shows how quantity supplied will change as the price rises and falls, assuming ceteris paribus so that no other economically relevant factors are changing. If other factors relevant to supply do change, then the entire supply curve will shift. Just as we described a shift in demand as a change in the quantity demanded at every price, a shift in supply means a change in the quantity supplied at every price.
In thinking about the factors that affect supply, remember what motivates firms: profits, which are the difference between revenues and costs. A firm produces goods and services using combinations of labor, materials, and machinery, or what we call inputs or factors of production. If a firm faces lower costs of production, while the prices for the good or service the firm produces remain unchanged, a firm’s profits go up. When a firm’s profits increase, it is more motivated to produce output, since the more it produces the more profit it will earn. When costs of production fall, a firm will tend to supply a larger quantity at any given price for its output. We can show this by the supply curve shifting to the right.
Take, for example, a messenger company that delivers packages around a city. The company may find that buying gasoline is one of its main costs. If the price of gasoline falls, then the company will find it can deliver messages more cheaply than before. Since lower costs correspond to higher profits, the messenger company may now supply more of its services at any given price. For example, given the lower gasoline prices, the company can now serve a greater area, and increase its supply.
Conversely, if a firm faces higher costs of production, then it will earn lower profits at any given selling price for its products. As a result, a higher cost of production typically causes a firm to supply a smaller quantity at any given price. In this case, the supply curve shifts to the left.
Consider the supply for cars, shown by curve S0 in
Figure 3.10
. Point J indicates that if the price is $20,000, the quantity supplied will be 18 million cars. If the price rises to $22,000 per car, ceteris paribus, the quantity supplied will rise to 20 million cars, as point K on the S0 curve shows. We can show the same information in table form, as in
Table 3.5
.
Figure 3.10 Shifts in Supply: A Car Example Decreased supply means that at every given price, the quantity supplied is lower, so that the supply curve shifts to the left, from S0 to S1. Increased supply means that at every given price, the quantity supplied is higher, so that the supply curve shifts to the right, from S0 to S2.
Price
Decrease to S1
Original Quantity Supplied S0
Increase to S2
$16,000
10.5 million
12.0 million
13.2 million
$18,000
13.5 million
15.0 million
16.5 million
$20,000
16.5 million
18.0 million
19.8 million
$22,000
18.5 million
20.0 million
22.0 million
$24,000
19.5 million
21.0 million
23.1 million
$26,000
20.5 million
22.0 million
24.2 million
Table3.5 Price and Shifts in Supply: A Car Example
Now, imagine that the price of steel, an important ingredient in manufacturing cars, rises, so that producing a car has become more expensive. At any given price for selling cars, car manufacturers will react by supplying a lower quantity. We can show this graphically as a leftward shift of supply, from S0 to S1, which indicates that at any given price, the quantity supplied decreases. In this example, at a price of $20,000, the quantity supplied decreases from 18 million on the original supply curve (S0) to 16.5 million on the supply curve S1, which is labeled as point L.
Conversely, if the price of steel decreases, producing a car becomes less expensive. At any given price for selling cars, car manufacturers can now expect to earn higher profits, so they will supply a higher quantity. The shift of supply to the right, from S0 to S2, means that at all prices, the quantity supplied has increased. In this example, at a price of $20,000, the quantity supplied increases from 18 million on the original supply curve (S0) to 19.8 million on the supply curve S2, which is labeled M.
Other Factors That Affect Supply
In the example above, we saw that changes in the prices of inputs in the production process will affect the cost of production and thus the supply. Several other things affect the cost of production, too, such as changes in weather or other natural conditions, new technologies for production, and some government policies.
Changes in weather and climate will affect the cost of production for many agricultural products. For example, in 2014 the Manchurian Plain in Northeastern China, which produces most of the country’s wheat, corn, and soybeans, experienced its most severe drought in 50 years. A drought decreases the supply of agricultural products, which means that at any given price, a lower quantity will be supplied. Conversely, especially good weather would shift the supply curve to the right.
When a firm discovers a new technology that allows the firm to produce at a lower cost, the supply curve will shift to the right, as well. For instance, in the 1960s a major scientific effort nicknamed the Green Revolution focused on breeding improved seeds for basic crops like wheat and rice. By the early 1990s, more than two-thirds of the wheat and rice in low-income countries around the world used these Green Revolution seeds—and the harvest was twice as high per acre. A technological improvement that reduces costs of production will shift supply to the right, so that a greater quantity will be produced at any given price.
Government policies can affect the cost of production and the supply curve through taxes, regulations, and subsidies. For example, the U.S. government imposes a tax on alcoholic beverages that collects about $8 billion per year from producers. Businesses treat taxes as costs. Higher costs decrease supply for the reasons we discussed above. Other examples of policy that can affect cost are the wide array of government regulations that require firms to spend money to provide a cleaner environment or a safer workplace. Complying with regulations increases costs.
A government subsidy, on the other hand, is the opposite of a tax. A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if the firm carries out certain actions. From the firm’s perspective, taxes or regulations are an additional cost of production that shifts supply to the left, leading the firm to produce a lower quantity at every given price. Government subsidies reduce the cost of production and increase supply at every given price, shifting supply to the right. The following Work It Out feature shows how this shift happens.
WORK IT OUT
Shift in Supply
We know that a supply curve shows the minimum price a firm will accept to produce a given quantity of output. What happens to the supply curve when the cost of production goes up? Following is an example of a shift in supply due to a production cost increase. (We’ll introduce some other concepts regarding firm decision-making in Chapters 7 and 8.)
Step 1. Draw a graph of a supply curve for pizza. Pick a quantity (like Q0). If you draw a vertical line up from Q0 to the supply curve, you will see the price the firm chooses.
Figure 3.11
provides an example.
Figure 3.11 Supply Curve You can use a supply curve to show the minimum price a firm will accept to produce a given quantity of output.
Step 2. Why did the firm choose that price and not some other? One way to think about this is that the price is composed of two parts. The first part is the cost of producing pizzas at the margin; in this case, the cost of producing the pizza, including cost of ingredients (e.g., dough, sauce, cheese, and pepperoni), the cost of the pizza oven, the shop rent, and the workers’ wages. The second part is the firm’s desired profit, which is determined, among other factors, by the profit margins in that particular business. (Desired profit is not necessarily the same as economic profit, which will be explained in Chapter 7.) If you add these two parts together, you get the price the firm wishes to charge. The quantity Q0 and associated price P0 give you one point on the firm’s supply curve, as
Figure 3.12
illustrates.
Figure 3.12 Setting Prices The cost of production and the desired profit equal the price a firm will set for a product.
Step 3. Now, suppose that the cost of production increases. Perhaps cheese has become more expensive by $0.75 per pizza. If that is true, the firm will want to raise its price by the amount of the increase in cost ($0.75). Draw this point on the supply curve directly above the initial point on the curve, but $0.75 higher, as
Figure 3.13
shows.
Figure 3.13 Increasing Costs Leads to Increasing Price Because the cost of production and the desired profit equal the price a firm will set for a product, if the cost of production increases, the price for the product will also need to increase.
Step 4. Shift the supply curve through this point. You will see that an increase in cost causes an upward (or a leftward) shift of the supply curve so that at any price, the quantities supplied will be smaller, as
Figure 3.14
illustrates.
Figure 3.14 Supply Curve Shifts When the cost of production increases, the supply curve shifts upwardly to a new price level.
Summing Up Factors That Change Supply
Changes in the cost of inputs, natural disasters, new technologies, and the impact of government decisions all affect the cost of production. In turn, these factors affect how much firms are willing to supply at any given price.
Figure 3.15
summarizes factors that change the supply of goods and services. Notice that a change in the price of the product itself is not among the factors that shift the supply curve. Although a change in price of a good or service typically causes a change in quantity supplied or a movement along the supply curve for that specific good or service, it does not cause the supply curve itself to shift.
Figure 3.15 Factors That Shift Supply Curves (a) A list of factors that can cause an increase in supply from S0 to S1. (b) The same factors, if their direction is reversed, can cause a decrease in supply from S0 to S1.
Because demand and supply curves appear on a two-dimensional diagram with only price and quantity on the axes, an unwary visitor to the land of economics might be fooled into believing that economics is about only four topics: demand, supply, price, and quantity. However, demand and supply are really “umbrella” concepts: demand covers all the factors that affect demand, and supply covers all the factors that affect supply. We include factors other than price that affect demand and supply are included by using shifts in the demand or the supply curve. In this way, the two-dimensional demand and supply model becomes a powerful tool for analyzing a wide range of economic circumstances.
Learning Objectives
By the end of this section, you will be able to:
· Identify equilibrium price and quantity through the four-step process
· Graph equilibrium price and quantity
· Contrast shifts of demand or supply and movements along a demand or supply curve
· Graph demand and supply curves, including equilibrium price and quantity, based on real-world examples
Let’s begin this discussion with a single economic event. It might be an event that affects demand, like a change in income, population, tastes, prices of substitutes or complements, or expectations about future prices. It might be an event that affects supply, like a change in natural conditions, input prices, or technology, or government policies that affect production. How does this economic event affect equilibrium price and quantity? We will analyze this question using a four-step process.
Step 1. Draw a demand and supply model before the economic change took place. To establish the model requires four standard pieces of information: The law of demand, which tells us the slope of the demand curve; the law of supply, which gives us the slope of the supply curve; the shift variables for demand; and the shift variables for supply. From this model, find the initial equilibrium values for price and quantity.
Step 2. Decide whether the economic change you are analyzing affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?
Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to the left, and sketch the new demand or supply curve on the diagram. In other words, does the event increase or decrease the amount consumers want to buy or producers want to sell?
Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity to the new equilibrium price and quantity.
Let’s consider one example that involves a shift in supply and one that involves a shift in demand. Then we will consider an example where both supply and demand shift.
Good Weather for Salmon Fishing
Supposed that during the summer of 2015, weather conditions were excellent for commercial salmon fishing off the California coast. Heavy rains meant higher than normal levels of water in the rivers, which helps the salmon to breed. Slightly cooler ocean temperatures stimulated the growth of plankton, the microscopic organisms at the bottom of the ocean food chain, providing everything in the ocean with a hearty food supply. The ocean stayed calm during fishing season, so commercial fishing operations did not lose many days to bad weather. How did these climate conditions affect the quantity and price of salmon?
Figure 3.16
illustrates the four-step approach, which we explain below, to work through this problem.
Table 3.6
also provides the information to work the problem.
Figure 3.16 Good Weather for Salmon Fishing: The Four-Step Process Unusually good weather leads to changes in the price and quantity of salmon.
Price per Pound
Quantity Supplied in 2014
Quantity Supplied in 2015
Quantity Demanded
$2.00
80
400
840
$2.25
120
480
680
$2.50
160
550
550
$2.75
200
600
450
$3.00
230
640
350
$3.25
250
670
250
$3.50
270
700
200
Table3.6 Salmon Fishing
Step 1. Draw a demand and supply model to illustrate the market for salmon in the year before the good weather conditions began. The demand curve D0 and the supply curve S0 show that the original equilibrium price is $3.25 per pound and the original equilibrium quantity is 250,000 fish. (This price per pound is what commercial buyers pay at the fishing docks. What consumers pay at the grocery is higher.)
Step 2. Did the economic event affect supply or demand? Good weather is an example of a natural condition that affects supply.
Step 3. Was the effect on supply an increase or a decrease? Good weather is a change in natural conditions that increases the quantity supplied at any given price. The supply curve shifts to the right, moving from the original supply curve S0 to the new supply curve S1, which
Figure 3.16
and
Table 3.6
show.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium. At the new equilibrium E1, the equilibrium price falls from $3.25 to $2.50, but the equilibrium quantity increases from 250,000 to 550,000 salmon. Notice that the equilibrium quantity demanded increased, even though the demand curve did not move.
In short, good weather conditions increased supply of the California commercial salmon. The result was a higher equilibrium quantity of salmon bought and sold in the market at a lower price.
Newspapers and the Internet
According to the Pew Research Center for People and the Press, increasingly more people, especially younger people, are obtaining their news from online and digital sources. The majority of U.S. adults now own smartphones or tablets, and most of those Americans say they use them in part to access the news. From 2004 to 2012, the share of Americans who reported obtaining their news from digital sources increased from 24% to 39%. How has this affected consumption of print news media, and radio and television news?
Figure 3.17
and the text below illustrates using the four-step analysis to answer this question.
Figure 3.17 The Print News Market: A Four-Step Analysis A change in tastes from print news sources to digital sources results in a leftward shift in demand for the former. The result is a decrease in both equilibrium price and quantity.
Step 1. Develop a demand and supply model to think about what the market looked like before the event. The demand curve D0 and the supply curve S0 show the original relationships. In this case, we perform the analysis without specific numbers on the price and quantity axis.
Step 2. Did the described change affect supply or demand? A change in tastes, from traditional news sources (print, radio, and television) to digital sources, caused a change in demand for the former.
Step 3. Was the effect on demand positive or negative? A shift to digital news sources will tend to mean a lower quantity demanded of traditional news sources at every given price, causing the demand curve for print and other traditional news sources to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The decline in print news reading predates 2004. Print newspaper circulation peaked in 1973 and has declined since then due to competition from television and radio news. In 1991, 55% of Americans indicated they received their news from print sources, while only 29% did so in 2012. Radio news has followed a similar path in recent decades, with the share of Americans obtaining their news from radio declining from 54% in 1991 to 33% in 2012. Television news has held its own over the last 15 years, with a market share staying in the mid to upper fifties. What does this suggest for the future, given that two-thirds of Americans under 30 years old say they do not obtain their news from television at all?
The Interconnections and Speed of Adjustment in Real Markets
In the real world, many factors that affect demand and supply can change all at once. For example, the demand for cars might increase because of rising incomes and population, and it might decrease because of rising gasoline prices (a complementary good). Likewise, the supply of cars might increase because of innovative new technologies that reduce the cost of car production, and it might decrease as a result of new government regulations requiring the installation of costly pollution-control technology.
Moreover, rising incomes and population or changes in gasoline prices will affect many markets, not just cars. How can an economist sort out all these interconnected events? The answer lies in the ceteris paribus assumption. Look at how each economic event affects each market, one event at a time, holding all else constant. Then combine the analyses to see the net effect.
A Combined Example
The U.S. Postal Service is facing difficult challenges. Compensation for postal workers tends to increase most years due to cost-of-living increases. At the same time, increasingly more people are using email, text, and other digital message forms such as Facebook and Twitter to communicate with friends and others. What does this suggest about the continued viability of the Postal Service?
Figure 3.18
and the text below illustrate this using the four-step analysis to answer this question.
Figure 3.18 Higher Compensation for Postal Workers: A Four-Step Analysis (a) Higher labor compensation causes a leftward shift in the supply curve, a decrease in the equilibrium quantity, and an increase in the equilibrium price. (b) A change in tastes away from Postal Services causes a leftward shift in the demand curve, a decrease in the equilibrium quantity, and a decrease in the equilibrium price.
Since this problem involves two disturbances, we need two four-step analyses, the first to analyze the effects of higher compensation for postal workers, the second to analyze the effects of many people switching from “snail mail” to email and other digital messages.
Figure 3.18
(a) shows the shift in supply discussed in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for the U.S. Postal Service looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships.
Step 2. Did the described change affect supply or demand? Labor compensation is a cost of production. A change in production costs caused a change in supply for the Postal Service.
Step 3. Was the effect on supply positive or negative? Higher labor compensation leads to a lower quantity supplied of postal services at every given price, causing the supply curve for postal services to shift to the left, from S0 to S1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E1) occurs at a lower quantity and a higher price than the original equilibrium (E0).
Figure 3.18
(b) shows the shift in demand in the following steps.
Step 1. Draw a demand and supply model to illustrate what the market for U.S. Postal Services looked like before this scenario starts. The demand curve D0 and the supply curve S0 show the original relationships. Note that this diagram is independent from the diagram in panel (a).
Step 2. Did the change described affect supply or demand? A change in tastes away from snail mail toward digital messages will cause a change in demand for the Postal Service.
Step 3. Was the effect on demand positive or negative? A change in tastes away from snailmail toward digital messages causes lower quantity demanded of postal services at every given price, causing the demand curve for postal services to shift to the left, from D0 to D1.
Step 4. Compare the new equilibrium price and quantity to the original equilibrium price. The new equilibrium (E2) occurs at a lower quantity and a lower price than the original equilibrium (E0).
The final step in a scenario where both supply and demand shift is to combine the two individual analyses to determine what happens to the equilibrium quantity and price. Graphically, we superimpose the previous two diagrams one on top of the other, as in
Figure 3.19
.
Figure 3.19 Combined Effect of Decreased Demand and Decreased Supply Supply and demand shifts cause changes in equilibrium price and quantity.
Following are the results:
Effect on Quantity: The effect of higher labor compensation on Postal Services because it raises the cost of production is to decrease the equilibrium quantity. The effect of a change in tastes away from snail mail is to decrease the equilibrium quantity. Since both shifts are to the left, the overall impact is a decrease in the equilibrium quantity of Postal Services (Q3). This is easy to see graphically, since Q3 is to the left of Q0.
Effect on Price: The overall effect on price is more complicated. The effect of higher labor compensation on Postal Services, because it raises the cost of production, is to increase the equilibrium price. The effect of a change in tastes away from snail mail is to decrease the equilibrium price. Since the two effects are in opposite directions, unless we know the magnitudes of the two effects, the overall effect is unclear. This is not unusual. When both curves shift, typically we can determine the overall effect on price or on quantity, but not on both. In this case, we determined the overall effect on the equilibrium quantity, but not on the equilibrium price. In other cases, it might be the opposite.
The next Clear It Up feature focuses on the difference between shifts of supply or demand and movements along a curve.
CLEAR IT UP
What is the difference between shifts of demand or supply versus movements along a demand or supply curve?
One common mistake in applying the demand and supply framework is to confuse the shift of a demand or a supply curve with movement along a demand or supply curve. As an example, consider a problem that asks whether a drought will increase or decrease the equilibrium quantity and equilibrium price of wheat. Lee, a student in an introductory economics class, might reason:
“Well, it is clear that a drought reduces supply, so I will shift back the supply curve, as in the shift from the original supply curve S0 to S1 on the diagram (Shift 1). The equilibrium moves from E0 to E1, the equilibrium quantity is lower and the equilibrium price is higher. Then, a higher price makes farmers more likely to supply the good, so the supply curve shifts right, as shows the shift from S1 to S2, shows on the diagram (Shift 2), so that the equilibrium now moves from E1 to E2. The higher price, however, also reduces demand and so causes demand to shift back, like the shift from the original demand curve, D0 to D1 on the diagram (labeled Shift 3), and the equilibrium moves from E2 to E3.”
Figure 3.20 Shifts of Demand or Supply versus Movements along a Demand or Supply Curve A shift in one curve never causes a shift in the other curve. Rather, a shift in one curve causes a movement along the second curve.
At about this point, Lee suspects that this answer is headed down the wrong path. Think about what might be wrong with Lee’s logic, and then read the answer that follows.
Answer: Lee’s first step is correct: that is, a drought shifts back the supply curve of wheat and leads to a prediction of a lower equilibrium quantity and a higher equilibrium price. This corresponds to a movement along the original demand curve (D0), from E0 to E1. The rest of Lee’s argument is wrong, because it mixes up shifts in supply with quantity supplied, and shifts in demand with quantity demanded. A higher or lower price never shifts the supply curve, as suggested by the shift in supply from S1 to S2. Instead, a price change leads to a movement along a given supply curve. Similarly, a higher or lower price never shifts a demand curve, as suggested in the shift from D0 to D1. Instead, a price change leads to a movement along a given demand curve. Remember, a change in the price of a good never causes the demand or supply curve for that good to shift.
Think carefully about the timeline of events: What happens first, what happens next? What is cause, what is effect? If you keep the order right, you are more likely to get the analysis correct.
In the four-step analysis of how economic events affect equilibrium price and quantity, the movement from the old to the new equilibrium seems immediate. As a practical matter, however, prices and quantities often do not zoom straight to equilibrium. More realistically, when an economic event causes demand or supply to shift, prices and quantities set off in the general direction of equilibrium. Even as they are moving toward one new equilibrium, a subsequent change in demand or supply often pushes prices toward another equilibrium.
Learning Objectives
By the end of this section, you will be able to:
· Calculate the price elasticity of demand
· Calculate the price elasticity of supply
Both the demand and supply curve show the relationship between price and the number of units demanded or supplied. Price elasticity is the ratio between the percentage change in the quantity demanded (Qd) or supplied (Qs) and the corresponding percent change in price. The price elasticity of demand is the percentage change in the quantity demanded of a good or service divided by the percentage change in the price. The price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price.
We can usefully divide elasticities into three broad categories: elastic, inelastic, and unitary. Because price and quantity demanded move in opposite directions, price elasticity of demand is always a negative number. Therefore, price elasticity of demand is usually reported as its absolute value, without a negative sign. The summary in
Table 5.1
is assuming absolute values for price elasticity of demand. An elastic demand or elastic supply is one in which the elasticity is greater than one, indicating a high responsiveness to changes in price. Elasticities that are less than one indicate low responsiveness to price changes and correspond to inelastic demand or inelastic supply. Unitary elasticities indicate proportional responsiveness of either demand or supply, as
Table 5.1
summarizes.
If . . .
Then . . .
And It Is Called . . .
% change in quantity>% change in price% change in quantity>% change in price
% change in quantity% change in price>1% change in quantity% change in price>1
Elastic
% change in quantity=% change in price% change in quantity=% change in price
% change in quantity% change in price=1% change in quantity% change in price=1
Unitary
% change in quantity<% change in price% change in quantity<% change in price % change in quantity% change in price<1% change in quantity% change in price<1 Inelastic Table5.1 Elastic, Inelastic, and Unitary: Three Cases of Elasticity LINK IT UP Before we delve into the details of elasticity, enjoy this article on elasticity and ticket prices at the Super Bowl. To calculate elasticity along a demand or supply curve economists use the average percent change in both quantity and price. This is called the Midpoint Method for Elasticity, and is represented in the following equations: % change in quantity% change in price==Q2–Q1(Q2+Q1)/2 × 100P2–P1(P2+P1)/2 × 100% change in quantity=Q2–Q1Q2+ Q1/2 × 100% change in price=P2– P1P2+ P1/2 × 100 The advantage of the Midpoint Method is that one obtains the same elasticity between two price points whether there is a price increase or decrease. This is because the formula uses the same base (average quantity and average price) for both cases. Calculating Price Elasticity of Demand Let’s calculate the elasticity between points A and B and between points G and H as Figure 5.2 shows. Figure 5.2 Calculating the Price Elasticity of Demand We calculate the price elasticity of demand as the percentage change in quantity divided by the percentage change in price. First, apply the formula to calculate the elasticity as price decreases from $70 at point B to $60 at point A: % change in quantity% change in pricePrice Elasticity of Demand========3,000–2,800(3,000+2,800)/2 × 1002002,900 × 1006.960–70(60+70)/2 × 100–1065 × 100–15.4 6.9%–15.4%0.45% change in quantity=3,000–2,800(3,000+2,800)/2 × 100=2002,900 × 100=6.9% change in price=60–70(60+70)/2 × 100=–1065 × 100=–15.4Price Elasticity of Demand= 6.9%–15.4%=0.45 Therefore, the elasticity of demand between these two points is 6.9%–15.4% 6.9%–15.4% which is 0.45, an amount smaller than one, showing that the demand is inelastic in this interval. Price elasticities of demand are always negative since price and quantity demanded always move in opposite directions (on the demand curve). By convention, we always talk about elasticities as positive numbers. Mathematically, we take the absolute value of the result. We will ignore this detail from now on, while remembering to interpret elasticities as positive numbers. This means that, along the demand curve between point B and A, if the price changes by 1%, the quantity demanded will change by 0.45%. A change in the price will result in a smaller percentage change in the quantity demanded. For example, a 10% increase in the price will result in only a 4.5% decrease in quantity demanded. A 10% decrease in the price will result in only a 4.5% increase in the quantity demanded. Price elasticities of demand are negative numbers indicating that the demand curve is downward sloping, but we read them as absolute values. The following Work It Out feature will walk you through calculating the price elasticity of demand. WORK IT OUT Finding the Price Elasticity of Demand Calculate the price elasticity of demand using the data in Figure 5.2 for an increase in price from G to H. Has the elasticity increased or decreased? Step 1. We know that: Price Elasticity of Demand=% change in quantity% change in pricePrice Elasticity of Demand=% change in quantity% change in price Step 2. From the Midpoint Formula we know that: % change in quantity% change in price==Q2–Q1(Q2+Q1)/2 × 100P2–P1(P2+P1)/2 × 100% change in quantity=Q2–Q1(Q2+Q1)/2 × 100% change in price=P2–P1(P2+P1)/2 × 100 Step 3. So we can use the values provided in the figure in each equation: % change in quantity% change in price======1,600–1,800(1,600+1,800)/2 × 100–2001,700 × 100–11.76130–120(130+120)/2 × 10010125 × 1008.0% change in quantity=1,600–1,800(1,600+1,800)/2 × 100=–2001,700 × 100=–11.76% change in price=130–120(130+120)/2 × 100=10125 × 100=8.0 Step 4. Then, we can use those values to determine the price elasticity of demand: Price Elasticity of Demand===% change in quantity% change in price–11.7681.47Price Elasticity of Demand=% change in quantity% change in price=–11.768=1.47 Therefore, the elasticity of demand from G to is H 1.47. The magnitude of the elasticity has increased (in absolute value) as we moved up along the demand curve from points A to B. Recall that the elasticity between these two points was 0.45. Demand was inelastic between points A and B and elastic between points G and H. This shows us that price elasticity of demand changes at different points along a straight-line demand curve. Calculating the Price Elasticity of Supply Assume that an apartment rents for $650 per month and at that price the landlord rents 10,000 units are rented as Figure 5.3 shows. When the price increases to $700 per month, the landlord supplies 13,000 units into the market. By what percentage does apartment supply increase? What is the price sensitivity? Figure 5.3 Price Elasticity of Supply We calculate the price elasticity of supply as the percentage change in quantity divided by the percentage change in price. Using the Midpoint Method, % change in quantity% change in pricePrice Elasticity of Supply========13,000–10,000(13,000+10,000)/2 × 1003,00011,500 × 10026.1$700–$650($700+$650)/2 × 10050675 × 1007.426.1% 7.4%3.53% change in quantity=13,000–10,000(13,000+10,000)/2 × 100=3,00011,500 × 100=26.1% change in price=$700–$650($700+$650)/2 × 100=50675 × 100=7.4Price Elasticity of Supply=26.1% 7.4%=3.53 Again, as with the elasticity of demand, the elasticity of supply is not followed by any units. Elasticity is a ratio of one percentage change to another percentage change—nothing more—and we read it as an absolute value. In this case, a 1% rise in price causes an increase in quantity supplied of 3.5%. The greater than one elasticity of supply means that the percentage change in quantity supplied will be greater than a one percent price change. If you're starting to wonder if the concept of slope fits into this calculation, read the following Clear It Up box. CLEAR IT UP Is the elasticity the slope? It is a common mistake to confuse the slope of either the supply or demand curve with its elasticity. The slope is the rate of change in units along the curve, or the rise/run (change in y over the change in x). For example, in Figure 5.2 , at each point shown on the demand curve, price drops by $10 and the number of units demanded increases by 200 compared to the point to its left. The slope is –10/200 along the entire demand curve and does not change. The price elasticity, however, changes along the curve. Elasticity between points A and B was 0.45 and increased to 1.47 between points G and H. Elasticity is the percentage change, which is a different calculation from the slope and has a different meaning. When we are at the upper end of a demand curve, where price is high and the quantity demanded is low, a small change in the quantity demanded, even in, say, one unit, is pretty big in percentage terms. A change in price of, say, a dollar, is going to be much less important in percentage terms than it would have been at the bottom of the demand curve. Likewise, at the bottom of the demand curve, that one unit change when the quantity demanded is high will be small as a percentage. Thus, at one end of the demand curve, where we have a large percentage change in quantity demanded over a small percentage change in price, the elasticity value would be high, or demand would be relatively elastic. Even with the same change in the price and the same change in the quantity demanded, at the other end of the demand curve the quantity is much higher, and the price is much lower, so the percentage change in quantity demanded is smaller and the percentage change in price is much higher. That means at the bottom of the curve we'd have a small numerator over a large denominator, so the elasticity measure would be much lower, or inelastic. As we move along the demand curve, the values for quantity and price go up or down, depending on which way we are moving, so the percentages for, say, a $1 difference in price or a one unit difference in quantity, will change as well, which means the ratios of those percentages and hence the elasticity will change. Learning Objectives By the end of this section, you will be able to: · Differentiate between infinite and zero elasticity · Analyze graphs in order to classify elasticity as constant unitary, infinite, or zero There are two extreme cases of elasticity: when elasticity equals zero and when it is infinite. A third case is that of constant unitary elasticity. We will describe each case. Infinite elasticity or perfect elasticity refers to the extreme case where either the quantity demanded (Qd) or supplied (Qs) changes by an infinite amount in response to any change in price at all. In both cases, the supply and the demand curve are horizontal as Figure 5.4 shows. While perfectly elastic supply curves are for the most part unrealistic, goods with readily available inputs and whose production can easily expand will feature highly elastic supply curves. Examples include pizza, bread, books, and pencils. Similarly, perfectly elastic demand is an extreme example. However, luxury goods, items that take a large share of individuals’ income, and goods with many substitutes are likely to have highly elastic demand curves. Examples of such goods are Caribbean cruises and sports vehicles. Figure 5.4 Infinite Elasticity The horizontal lines show that an infinite quantity will be demanded or supplied at a specific price. This illustrates the cases of a perfectly (or infinitely) elastic demand curve and supply curve. The quantity supplied or demanded is extremely responsive to price changes, moving from zero for prices close to P to infinite when prices reach P. Zero elasticity or perfect inelasticity, as Figure 5.5 depicts, refers to the extreme case in which a percentage change in price, no matter how large, results in zero change in quantity. While a perfectly inelastic supply is an extreme example, goods with limited supply of inputs are likely to feature highly inelastic supply curves. Examples include diamond rings or housing in prime locations such as apartments facing Central Park in New York City. Similarly, while perfectly inelastic demand is an extreme case, necessities with no close substitutes are likely to have highly inelastic demand curves. This is the case of life-saving drugs and gasoline. Figure 5.5 Zero Elasticity The vertical supply curve and vertical demand curve show that there will be zero percentage change in quantity (a) demanded or (b) supplied, regardless of the price. Constant unitary elasticity, in either a supply or demand curve, occurs when a price change of one percent results in a quantity change of one percent. Figure 5.6 shows a demand curve with constant unit elasticity. Using the midpoint method, you can calculate that between points A and B on the demand curve, the price changes by 66.7% and quantity demanded also changes by 66.7%. Hence, the elasticity equals 1. Between points B and C, price again changes by 66.7% as does quantity, while between points C and D the corresponding percentage changes are again 66.7% for both price and quantity. In each case, then, the percentage change in price equals the percentage change in quantity, and consequently elasticity equals 1. Notice that in absolute value, the declines in price, as you step down the demand curve, are not identical. Instead, the price falls by $8.00 from A to B, by a smaller amount of $4.00 from B to C, and by a still smaller amount of $2.00 from C to D. As a result, a demand curve with constant unitary elasticity moves from a steeper slope on the left and a flatter slope on the right—and a curved shape overall. Figure 5.6 A Constant Unitary Elasticity Demand Curve A demand curve with constant unitary elasticity will be a curved line. Notice how price and quantity demanded change by an identical percentage amount between each pair of points on the demand curve. Unlike the demand curve with unitary elasticity, the supply curve with unitary elasticity is represented by a straight line, and that line goes through the origin. In each pair of points on the supply curve there is an equal difference in quantity of 30. However, in percentage value, using the midpoint method, the steps are decreasing as one moves from left to right, from 28.6% to 22.2% to 18.2%, because the quantity points in each percentage calculation are getting increasingly larger, which expands the denominator in the elasticity calculation of the percentage change in quantity. Consider the price changes moving up the supply curve in Figure 5.7 . From points D to E to F and to G on the supply curve, each step of $1.50 is the same in absolute value. However, if we measure the price changes in percentage change terms, using the midpoint method, they are also decreasing, from 28.6% to 22.2% to 18.2%, because the original price points in each percentage calculation are getting increasingly larger in value, increasing the denominator in the calculation of the percentage change in price. Along the constant unitary elasticity supply curve, the percentage quantity increases on the horizontal axis exactly match the percentage price increases on the vertical axis—so this supply curve has a constant unitary elasticity at all points. Figure 5.7 A Constant Unitary Elasticity Supply Curve A constant unitary elasticity supply curve is a straight line reaching up from the origin. Between each pair of points, the percentage increase in quantity supplied is the same as the percentage increase in price. Learning Objectives By the end of this section, you will be able to: · Analyze how price elasticities impact revenue · Evaluate how elasticity can cause shifts in demand and supply · Predict how the long-run and short-run impacts of elasticity affect equilibrium · Explain how the elasticity of demand and supply determine the incidence of a tax on buyers and sellers Studying elasticities is useful for a number of reasons, pricing being most important. Let’s explore how elasticity relates to revenue and pricing, both in the long and short run. First, let’s look at the elasticities of some common goods and services. Table 5.2 shows a selection of demand elasticities for different goods and services drawn from a variety of different studies by economists, listed in order of increasing elasticity. Goods and Services Elasticity of Price Housing 0.12 Transatlantic air travel (economy class) 0.12 Rail transit (rush hour) 0.15 Electricity 0.20 Taxi cabs 0.22 Gasoline 0.35 Transatlantic air travel (first class) 0.40 Wine 0.55 Beef 0.59 Transatlantic air travel (business class) 0.62 Kitchen and household appliances 0.63 Cable TV (basic rural) 0.69 Chicken 0.64 Soft drinks 0.70 Beer 0.80 New vehicle 0.87 Rail transit (off-peak) 1.00 Computer 1.44 Cable TV (basic urban) 1.51 Cable TV (premium) 1.77 Restaurant meals 2.27 Table5.2 Some Selected Elasticities of Demand Note that demand for necessities such as housing and electricity is inelastic, while items that are not necessities such as restaurant meals are more price-sensitive. If the price of a restaurant meal increases by 10%, the quantity demanded will decrease by 22.7%. A 10% increase in the price of housing will cause only a slight decrease of 1.2% in the quantity of housing demanded. LINK IT UP Read this article for an example of price elasticity that may have affected you. Does Raising Price Bring in More Revenue? Imagine that a band on tour is playing in an indoor arena with 15,000 seats. To keep this example simple, assume that the band keeps all the money from ticket sales. Assume further that the band pays the costs for its appearance, but that these costs, like travel, and setting up the stage, are the same regardless of how many people are in the audience. Finally, assume that all the tickets have the same price. (The same insights apply if ticket prices are more expensive for some seats than for others, but the calculations become more complicated.) The band knows that it faces a downward-sloping demand curve; that is, if the band raises the ticket price and, it will sell fewer seats. How should the band set the ticket price to generate the most total revenue, which in this example, because costs are fixed, will also mean the highest profits for the band? Should the band sell more tickets at a lower price or fewer tickets at a higher price? The key concept in thinking about collecting the most revenue is the price elasticity of demand. Total revenue is price times the quantity of tickets sold. Imagine that the band starts off thinking about a certain price, which will result in the sale of a certain quantity of tickets. The three possibilities are in Table 5.3 . If demand is elastic at that price level, then the band should cut the price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at that original quantity level, then the band should raise the ticket price, because a certain percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise. If demand has a unitary elasticity at that quantity, then an equal percentage change in quantity will offset a moderate percentage change in the price—so the band will earn the same revenue whether it (moderately) increases or decreases the ticket price. If Demand Is . . . Then . . . Therefore . . . Elastic % change in Qd>% change in P% change in Qd>% change in P
A given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P × Q) falls.
Unitary
% change in Qd=% change in P% change in Qd=% change in P
A given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P × Q) is unchanged.
Inelastic
% change in Qd<% change in P% change in Qd<% change in P
A given % rise in P will cause a smaller % fall in Q so that total revenue (P × Q) rises.
Table5.3 Will the Band Earn More Revenue by Changing Ticket Prices?
What if the band keeps cutting price, because demand is elastic, until it reaches a level where it sells all 15,000 seats in the available arena? If demand remains elastic at that quantity, the band might try to move to a bigger arena, so that it could slash ticket prices further and see a larger percentage increase in the quantity of tickets sold. However, if the 15,000-seat arena is all that is available or if a larger arena would add substantially to costs, then this option may not work.
Conversely, a few bands are so famous, or have such fanatical followings, that demand for tickets may be inelastic right up to the point where the arena is full. These bands can, if they wish, keep raising the ticket price. Ironically, some of the most popular bands could make more revenue by setting prices so high that the arena is not full—but those who buy the tickets would have to pay very high prices. However, bands sometimes choose to sell tickets for less than the absolute maximum they might be able to charge, often in the hope that fans will feel happier and spend more on recordings, T-shirts, and other paraphernalia.
Can Businesses Pass Costs on to Consumers?
Most businesses face a day-to-day struggle to figure out ways to produce at a lower cost, as one pathway to their goal of earning higher profits. However, in some cases, the price of a key input over which the firm has no control may rise. For example, many chemical companies use petroleum as a key input, but they have no control over the world market price for crude oil. Coffee shops use coffee as a key input, but they have no control over the world market price of coffee. If the cost of a key input rises, can the firm pass those higher costs along to consumers in the form of higher prices? Conversely, if new and less expensive ways of producing are invented, can the firm keep the benefits in the form of higher profits, or will the market pressure them to pass the gains along to consumers in the form of lower prices? The price elasticity of demand plays a key role in answering these questions.
Imagine that as a consumer of legal pharmaceutical products, you read a newspaper story that a technological breakthrough in the production of aspirin has occurred, so that every aspirin factory can now produce aspirin more cheaply. What does this discovery mean to you?
Figure 5.8
illustrates two possibilities. In
Figure 5.8
(a), the demand curve is highly inelastic. In this case, a technological breakthrough that shifts supply to the right, from S0 to S1, so that the equilibrium shifts from E0 to E1, creates a substantially lower price for the product with relatively little impact on the quantity sold. In
Figure 5.8
(b), the demand curve is highly elastic. In this case, the technological breakthrough leads to a much greater quantity sold in the market at very close to the original price. Consumers benefit more, in general, when the demand curve is more inelastic because the shift in the supply results in a much lower price for consumers.
Figure 5.8 Passing along Cost Savings to Consumers Cost-saving gains cause supply to shift out to the right from S0 to S1; that is, at any given price, firms will be willing to supply a greater quantity. If demand is inelastic, as in (a), the result of this cost-saving technological improvement will be substantially lower prices. If demand is elastic, as in (b), the result will be only slightly lower prices. Consumers benefit in either case, from a greater quantity at a lower price, but the benefit is greater when demand is inelastic, as in (a).
Aspirin producers may find themselves in a nasty bind here. The situation in
Figure 5.8
, with extremely inelastic demand, means that a new invention may cause the price to drop dramatically while quantity changes little. As a result, the new production technology can lead to a drop in the revenue that firms earn from aspirin sales. However, if strong competition exists between aspirin producer, each producer may have little choice but to search for and implement any breakthrough that allows it to reduce production costs. After all, if one firm decides not to implement such a cost-saving technology, other firms that do can drive them out of business.
Since demand for food is generally inelastic, farmers may often face the situation in
Figure 5.8
(a). That is, a surge in production leads to a severe drop in price that can actually decrease the total revenue that farmers receive. Conversely, poor weather or other conditions that cause a terrible year for farm production can sharply raise prices so that the total revenue that the farmer receives increases. The Clear It Up box discusses how these issues relate to coffee.
CLEAR IT UP
How do coffee prices fluctuate?
Coffee is an international crop. The top five coffee-exporting nations are Brazil, Vietnam, Colombia, Indonesia, and Ethiopia. In these nations and others, 20 million families depend on selling coffee beans as their main source of income. These families are exposed to enormous risk, because the world price of coffee bounces up and down. For example, in 1993, the world price of coffee was about 50 cents per pound. In 1995 it was four times as high, at $2 per pound. By 1997 it had fallen by half to $1.00 per pound. In 1998 it leaped back up to $2 per pound. By 2001 it had fallen back to 46 cents a pound. By early 2011 it rose to about $2.31 per pound. By the end of 2012, the price had fallen back to about $1.31 per pound.
The reason for these price fluctuations lies in a combination of inelastic demand and shifts in supply. The elasticity of coffee demand is only about 0.3; that is, a 10% rise in the price of coffee leads to a decline of about 3% in the quantity of coffee consumed. When a major frost hit the Brazilian coffee crop in 1994, coffee supply shifted to the left with an inelastic demand curve, leading to much higher prices. Conversely, when Vietnam entered the world coffee market as a major producer in the late 1990s, the supply curve shifted out to the right. With a highly inelastic demand curve, coffee prices fell dramatically.
Figure 5.8
(a) illustrates this situation.
Elasticity also reveals whether firms can pass higher costs that they incur on to consumers. Addictive substances, for which demand is inelastic, are products for which producers can pass higher costs on to consumers. For example, the demand for cigarettes is relatively inelastic among regular smokers who are somewhat addicted. Economic research suggests that increasing cigarette prices by 10% leads to about a 3% reduction in the quantity of cigarettes that adults smoke, so the elasticity of demand for cigarettes is 0.3. If society increases taxes on companies that produce cigarettes, the result will be, as in
Figure 5.9
(a), that the supply curve shifts from S0 to S1. However, as the equilibrium moves from E0 to E1, governments mainly pass along these taxes to consumers in the form of higher prices. These higher taxes on cigarettes will raise tax revenue for the government, but they will not much affect the quantity of smoking.
If the goal is to reduce the quantity of cigarettes demanded, we must achieve it by shifting this inelastic demand back to the left, perhaps with public programs to discourage cigarette use or to help people to quit. For example, anti-smoking advertising campaigns have shown some ability to reduce smoking. However, if cigarette demand were more elastic, as in
Figure 5.9
(b), then an increase in taxes that shifts supply from S0 to S1 and equilibrium from E0 to E1 would reduce the quantity of cigarettes smoked substantially. Youth smoking seems to be more elastic than adult smoking—that is, the quantity of youth smoking will fall by a greater percentage than the quantity of adult smoking in response to a given percentage increase in price.
Figure 5.9 Passing along Higher Costs to Consumers Higher costs, like a higher tax on cigarette companies for the example we gave in the text, lead supply to shift to the left. This shift is identical in (a) and (b). However, in (a), where demand is inelastic, companies largely can pass the cost increase along to consumers in the form of higher prices, without much of a decline in equilibrium quantity. In (b), demand is elastic, so the shift in supply results primarily in a lower equilibrium quantity. Consumers suffer in either case, but in (a), they suffer from paying a higher price for the same quantity, while in (b), they suffer from buying a lower quantity (and presumably needing to shift their consumption elsewhere).
Elasticity and Tax Incidence
The example of cigarette taxes demonstrated that because demand is inelastic, taxes are not effective at reducing the equilibrium quantity of smoking, and they mainly pass along to consumers in the form of higher prices. The analysis, or manner, of how a tax burden is divided between consumers and producers is called tax incidence. Typically, the tax incidence, or burden, falls both on the consumers and producers of the taxed good. However, if one wants to predict which group will bear most of the burden, all one needs to do is examine the elasticity of demand and supply. In the tobacco example, the tax burden falls on the most inelastic side of the market.
If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.
The intuition for this is simple. When the demand is inelastic, consumers are not very responsive to price changes, and the quantity demanded reduces only modestly when the tax is introduced. In the case of smoking, the demand is inelastic because consumers are addicted to the product. The government can then pass the tax burden along to consumers in the form of higher prices, without much of a decline in the equilibrium quantity.
Similarly, when a government introduces a tax in a market with an inelastic supply, such as, for example, beachfront hotels, and sellers have no alternative than to accept lower prices for their business, taxes do not greatly affect the equilibrium quantity. The tax burden now passes on to the sellers. If the supply was elastic and sellers had the possibility of reorganizing their businesses to avoid supplying the taxed good, the tax burden on the sellers would be much smaller. The tax would result in a much lower quantity sold instead of lower prices received.
Figure 5.10
illustrates this relationship between the tax incidence and elasticity of demand and supply.
Figure 5.10 Elasticity and Tax Incidence An excise tax introduces a wedge between the price paid by consumers (Pc) and the price received by producers (Pp). The vertical distance between Pc and Pp is the amount of the tax per unit. Pe is the equilibrium price prior to introduction of the tax. (a) When the demand is more elastic than supply, the tax incidence on consumers Pc – Pe is lower than the tax incidence on producers Pe – Pp. (b) When the supply is more elastic than demand, the tax incidence on consumers Pc – Pe is larger than the tax incidence on producers Pe – Pp. The more elastic the demand and supply curves, the lower the tax revenue.
In
Figure 5.10
(a), the supply is inelastic and the demand is elastic, such as in the example of beachfront hotels. While consumers may have other vacation choices, sellers can’t easily move their businesses. By introducing a tax, the government essentially creates a wedge between the price paid by consumers Pc and the price received by producers Pp. In other words, of the total price paid by consumers, part is retained by the sellers and part is paid to the government in the form of a tax. The distance between Pc and Pp is the tax rate. The new market price is Pc, but sellers receive only Pp per unit sold, as they pay Pc-Pp to the government. Since we can view a tax as raising the costs of production, this could also be represented by a leftward shift of the supply curve, where the new supply curve would intercept the demand at the new quantity Qt. For simplicity,
Figure 5.10
omits the shift in the supply curve.
The tax revenue is given by the shaded area, which we obtain by multiplying the tax per unit by the total quantity sold Qt. The tax incidence on the consumers is given by the difference between the price paid Pc and the initial equilibrium price Pe. The tax incidence on the sellers is given by the difference between the initial equilibrium price Pe and the price they receive after the tax is introduced Pp. In
Figure 5.10
(a), the tax burden falls disproportionately on the sellers, and a larger proportion of the tax revenue (the shaded area) is due to the resulting lower price received by the sellers than by the resulting higher prices paid by the buyers.
Figure 5.10
(b) describes the example of the tobacco excise tax where the supply is more elastic than demand. The tax incidence now falls disproportionately on consumers, as shown by the large difference between the price they pay, Pc, and the initial equilibrium price, Pe. Sellers receive a lower price than before the tax, but this difference is much smaller than the change in consumers’ price. From this analysis one can also predict whether a tax is likely to create a large revenue or not. The more elastic the demand curve, the more likely that consumers will reduce quantity instead of paying higher prices. The more elastic the supply curve, the more likely that sellers will reduce the quantity sold, instead of taking lower prices. In a market where both the demand and supply are very elastic, the imposition of an excise tax generates low revenue.
Some believe that excise taxes hurt mainly the specific industries they target. For example, the medical device excise tax, in effect since 2013, has been controversial for it can delay industry profitability and therefore hamper start-ups and medical innovation. However, whether the tax burden falls mostly on the medical device industry or on the patients depends simply on the elasticity of demand and supply.
Long-Run vs. Short-Run Impact
Elasticities are often lower in the short run than in the long run. On the demand side of the market, it can sometimes be difficult to change Qd in the short run, but easier in the long run. Consumption of energy is a clear example. In the short run, it is not easy for a person to make substantial changes in energy consumption. Maybe you can carpool to work sometimes or adjust your home thermostat by a few degrees if the cost of energy rises, but that is about all. However, in the long run you can purchase a car that gets more miles to the gallon, choose a job that is closer to where you live, buy more energy-efficient home appliances, or install more insulation in your home. As a result, the elasticity of demand for energy is somewhat inelastic in the short run, but much more elastic in the long run.
Figure 5.11
is an example, based roughly on historical experience, for the responsiveness of Qd to price changes. In 1973, the price of crude oil was $12 per barrel and total consumption in the U.S. economy was 17 million barrels per day. That year, the nations who were members of the Organization of Petroleum Exporting Countries (OPEC) cut off oil exports to the United States for six months because the Arab members of OPEC disagreed with the U.S. support for Israel. OPEC did not bring exports back to their earlier levels until 1975—a policy that we can interpret as a shift of the supply curve to the left in the U.S. petroleum market.
Figure 5.11
(a) and
Figure 5.11
(b) show the same original equilibrium point and the same identical shift of a supply curve to the left from S0 to S1.
Figure 5.11 How a Shift in Supply Can Affect Price or Quantity The intersection (E0) between demand curve D and supply curve S0 is the same in both (a) and (b). The shift of supply to the left from S0 to S1 is identical in both (a) and (b). The new equilibrium (E1) has a higher price and a lower quantity than the original equilibrium (E0) in both (a) and (b). However, the shape of the demand curve D is different in (a) and (b), being more elastic in (b) than in (a). As a result, the shift in supply can result either in a new equilibrium with a much higher price and an only slightly smaller quantity, as in (a), with more inelastic demand, or in a new equilibrium with only a small increase in price and a relatively larger reduction in quantity, as in (b), with more elastic demand.
Figure 5.11
(a) shows inelastic demand for oil in the short run similar to that which existed for the United States in 1973. In
Figure 5.11
(a), the new equilibrium (E1) occurs at a price of $25 per barrel, roughly double the price before the OPEC shock, and an equilibrium quantity of 16 million barrels per day.
Figure 5.11
(b) shows what the outcome would have been if the U.S. demand for oil had been more elastic, a result more likely over the long term. This alternative equilibrium (E1) would have resulted in a smaller price increase to $14 per barrel and larger reduction in equilibrium quantity to 13 million barrels per day. In 1983, for example, U.S. petroleum consumption was 15.3 million barrels a day, which was lower than in 1973 or 1975. U.S. petroleum consumption was down even though the U.S. economy was about one-fourth larger in 1983 than it had been in 1973. The primary reason for the lower quantity was that higher energy prices spurred conservation efforts, and after a decade of home insulation, more fuel-efficient cars, more efficient appliances and machinery, and other fuel-conserving choices, the demand curve for energy had become more elastic.
On the supply side of markets, producers of goods and services typically find it easier to expand production in the long term of several years rather than in the short run of a few months. After all, in the short run it can be costly or difficult to build a new factory, hire many new workers, or open new stores. However, over a few years, all of these are possible.
In most markets for goods and services, prices bounce up and down more than quantities in the short run, but quantities often move more than prices in the long run. The underlying reason for this pattern is that supply and demand are often inelastic in the short run, so that shifts in either demand or supply can cause a relatively greater change in prices. However, since supply and demand are more elastic in the long run, the long-run movements in prices are more muted, while quantity adjusts more easily in the long run.
Learning Objectives
By the end of this section, you will be able to:
· Explain the difference between explicit costs and implicit costs
· Understand the relationship between cost and revenue
Each business, regardless of size or complexity, tries to earn a profit:
Profit=Total Revenue – Total CostProfit=Total Revenue – Total Cost
Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold:
Total Revenue=Price × QuantityTotal Revenue=Price × Quantity
We will see in the following chapters that revenue is a function of the demand for the firm’s products.
Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs.
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. Implicit costs also include the depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work It Out feature for an extended example.)
These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.
WORK IT OUT
Calculating Implicit Costs
Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he establishes himself. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. He could hire a law clerk for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?
Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:
Office rental:Law clerk's salary:Total explicit costs: $50,000+$35,000____________ $85,000Office rental: $50,000Law clerk's salary:+$35,000____________Total explicit costs: $85,000
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
Revenues:Explicit costs:Accounting profit:$200,000–$85,000____________$115,000Revenues:$200,000Explicit costs:–$85,000____________Accounting profit:$115,000
However, these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:
Economic profit===total revenues – explicit costs – implicit costs$200,000 – $85,000 – $125,000–$10,000 per yearEconomic profit=total revenues – explicit costs – implicit costs=$200,000 – $85,000 – $125,000=–$10,000 per year
Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.
Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.
Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections.
Learning Objectives
By the end of this section, you will be able to:
· Understand the concept of a production function
· Differentiate between the different types of inputs or factors in a production function
· Differentiate between fixed and variable inputs
· Differentiate between production in the short run and in the long run
· Differentiate between total and marginal product
· Understand the concept of diminishing marginal productivity
In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of producing that output. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost. We can answer the former question by looking at the firm’s production function.
Figure 7.3 The production process for pizza includes inputs such as ingredients, the efforts of the pizza maker, and tools and materials for cooking and serving. (Credit: Haldean Brown/Flickr Creative Commons)
Production is the process (or processes) a firm uses to transform inputs (e.g. labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool-- to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza?
Economists divide factors of production into several categories:
· Natural Resources (Land and Raw Materials) - The ingredients for the pizza are raw materials. These include the flour, yeast, and water for the dough, the tomatoes, herbs, and water for the sauce, the cheese, and the toppings. If the pizza place uses a wood-burning oven, we would include the wood as a raw material. If the establishment heats the oven with natural gas, we would count this as a raw material. Don’t forget electricity for lights. If, instead of pizza, we were looking at an agricultural product, like wheat, we would include the land the farmer used for crops here.
· Labor – When we talk about production, labor means human effort, both physical and mental. The pizzaiolo was the primary example of labor here. He or she needs to be strong enough to roll out the dough and to insert and retrieve the pizza from the oven, but he or she also needs to know how to make the pizza, how long it cooks in the oven and a myriad of other aspects of pizza-making. The business may also have one or more people to work the counter, take orders, and receive payment.
· Capital – When economists uses the term capital, they do not mean financial capital (money); rather, they mean physical capital, the machines, equipment, and buildings that one uses to produce the product. In the case of pizza, the capital includes the peel, the oven, the building, and any other necessary equipment (for example, tables and chairs).
· Technology – Technology refers to the process or processes for producing the product. How does the pizzaiolo combine ingredients to make pizza? How hot should the oven be? How long should the pizza cook? What is the best oven to use? Gas or wood burning? Should the restaurant make its own dough, sauce, cheese, toppings, or should it buy them?
· Entrepreneurship – Production involves many decisions and much knowledge, even for something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur, the person who creates the business, whose idea it is to combine the inputs to produce the outputs.
The cost of producing pizza (or any output) depends on the amount of labor capital, raw materials, and other inputs required and the price of each input to the entrepreneur. Let’s explore these ideas in more detail.
We can summarize the ideas so far in terms of a production function, a mathematical expression or equation that explains the engineering relationship between inputs and outputs:
Q=f[NR,L,K,t,E]Q=f[NR,L,K,t,E]
The production function gives the answer to the question, how much output can the firm produce given different amounts of inputs? Production functions are specific to the product. Different products have different production functions. The amount of labor a farmer uses to produce a bushel of wheat is likely different than that required to produce an automobile. Firms in the same industry may have somewhat different production functions, since each firm may produce a little differently. One pizza restaurant may make its own dough and sauce, while another may buy those pre-made. A sit-down pizza restaurant probably uses more labor (to handle table service) than a purely take-out restaurant.
We can describe inputs as either fixed or variable.
Fixed inputs are those that can’t easily be increased or decreased in a short period of time. In the pizza example, the building is a fixed input. Once the entrepreneur signs the lease, he or she is stuck in the building until the lease expires. Fixed inputs define the firm’s maximum output capacity. This is analogous to the potential real GDP shown by society’s production possibilities curve, i.e. the maximum quantities of outputs a society can produce at a given time with its available resources.
Variable inputs are those that can easily be increased or decreased in a short period of time. The pizzaiolo can order more ingredients with a phone call, so ingredients would be variable inputs. The owner could hire a new person to work the counter pretty quickly as well.
Economists often use a short-hand form for the production function:
Q=f[L,K],Q=f[L,K],
where L represents all the variable inputs, and K represents all the fixed inputs.
Economists differentiate between short and long run production.
The short run is the period of time during which at least some factors of production are fixed. During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because it is limited to using the current building—the owner can’t choose a larger or smaller building.
The long run is the period of time during which all factors are variable. Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place.
Let’s explore production in the short run using a specific example: tree cutting (for lumber) with a two-person crosscut saw.
Figure 7.4 Production in the short run may be explored through the example of lumberjacks using a two-person saw. (Credit: Wknight94/Wikimedia Commons)
Since by definition capital is fixed in the short run, our production function becomes
Q=f[L,K−]orQ=f[L]Q=f[L,K−]orQ=f[L]
This equation simply indicates that since capital is fixed, the amount of output (e.g. trees cut down per day) depends only on the amount of labor employed (e.g. number of lumberjacks working). We can express this production function numerically as
Table 7.2
below shows.
# Lumberjacks
1
2
3
4
5
# Trees (TP)
4
10
12
13
13
MP
4
6
2
1
0
Table7.2 Short Run Production Function for Trees
Note that we have introduced some new language. We also call Output (Q) Total Product (TP), which means the amount of output produced with a given amount of labor and a fixed amount of capital. In this example, one lumberjack using a two-person saw can cut down four trees in an hour. Two lumberjacks using a two-person saw can cut down ten trees in an hour.
We should also introduce a critical concept: marginal product. Marginal product is the additional output of one more worker. Mathematically, Marginal Product is the change in total product divided by the change in labor: MP=ΔTP/ΔLMP=ΔTP/ΔL. In the table above, since 0 workers produce 0 trees, the marginal product of the first worker is four trees per day, but the marginal product of the second worker is six trees per day. Why might that be the case? It’s because of the nature of the capital the workers are using. A two-person saw works much better with two persons than with one. Suppose we add a third lumberjack to the story. What will that person’s marginal product be? What will that person contribute to the team? Perhaps he or she can oil the saw's teeth to keep it sawing smoothly or he or she could bring water to the two people sawing. What you see in the table is a critically important conclusion about production in the short run: It may be that as we add workers, the marginal product increases at first, but sooner or later additional workers will have decreasing marginal product. In fact, there may eventually be no effect or a negative effect on output. This is called the Law of Diminishing Marginal Product and it’s a characteristic of production in the short run. Diminishing marginal productivity is very similar to the concept of diminishing marginal utility that we learned about in the chapter on consumer choice. Both concepts are examples of the more general concept of diminishing marginal returns. Why does diminishing marginal productivity occur? It’s because of fixed capital. We will see this more clearly when we discuss production in the long run.
We can show these concepts graphically as
Figure 7.5
and
Figure 7.6
illustrate.
Figure 7.5
graphically shows the data from
Table 7.2
.
Figure 7.6
shows the more general cases of total product and marginal product curves.
Figure 7.5
Figure 7.6
Learning Objectives
By the end of this section, you will be able to:
· Understand the relationship between production and costs
· Understand that every factor of production has a corresponding factor price
· Analyze short-run costs in terms of total cost, fixed cost, variable cost, marginal cost, and average cost
· Calculate average profit
· Evaluate patterns of costs to determine potential profit
We’ve explained that a firm’s total costs depend on the quantities of inputs the firm uses to produce its output and the cost of those inputs to the firm. The firm’s production function tells us how much output the firm will produce with given amounts of inputs. However, if we think about that backwards, it tells us how many inputs the firm needs to produce a given quantity of output, which is the first thing we need to determine total cost. Let’s move to the second factor we need to determine.
For every factor of production (or input), there is an associated factor payment. Factor payments are what the firm pays for the use of the factors of production. From the firm’s perspective, factor payments are costs. From the owner of each factor’s perspective, factor payments are income. Factor payments include:
· Raw materials prices for raw materials
· Rent for land or buildings
· Wages and salaries for labor
· Interest and dividends for the use of financial capital (loans and equity investments)
· Profit for entrepreneurship. Profit is the residual, what’s left over from revenues after the firm pays all the other costs. While it may seem odd to treat profit as a “cost”, it is what entrepreneurs earn for taking the risk of starting a business. You can see this correspondence between factors of production and factor payments in the inside loop of the circular flow diagram in
Figure 1.6
.
We now have all the information necessary to determine a firm’s costs.
A cost function is a mathematical expression or equation that shows the cost of producing different levels of output.
Q
1
2
3
4
Cost
$32.50
$44
$52
$90
Table7.3 Cost Function for Producing Widgets
What we observe is that the cost increases as the firm produces higher quantities of output. This is pretty intuitive, since producing more output requires greater quantities of inputs, which cost more dollars to acquire.
What is the origin of these cost figures? They come from the production function and the factor payments. The discussion of costs in the short run above,
Costs in the Short Run
, was based on the following production function, which is similar to
Table 7.3
except for "widgets" instead of trees.
Workers (L)
1
2
3
3.25
4.4
5.2
6
7
8
9
Widgets (Q)
0.2
0.4
0.8
1
2
3
3.5
3.8
3.95
4
Table7.4
We can use the information from the production function to determine production costs. What we need to know is how many workers are required to produce any quantity of output. If we flip the order of the rows, we “invert” the production function so it shows L=f(Q)L=f(Q).
Widgets (Q)
0.2
0.4
0.8
1
2
3
3.5
3.8
3.95
4
Workers (L)
1
2
3
3.25
4.4
5.2
6
7
8
9
Table7.5
Now focus on the whole number quantities of output. We’ll eliminate the fractions from the table:
Widgets (Q)
1
2
3
4
Workers (L)
3.25
4.4
5.2
9
Table7.6
Suppose widget workers receive $10 per hour. Multiplying the Workers row by $10 (and eliminating the blanks) gives us the cost of producing different levels of output.
Widgets (Q)
1.00
2.00
3.00
4.00
Workers (L)
3.25
4.4
5.2
9
× Wage Rate per hour
$10
$10
$10
$10
= Cost
$32.50
$44.00
$52.00
$90.00
Table7.7
This is same cost function with which we began! (shown in
Table 7.3
)
Now that we have the basic idea of the cost origins and how they are related to production, let’s drill down into the details.
Average and Marginal Costs
The cost of producing a firm’s output depends on how much labor and physical capital the firm uses. A list of the costs involved in producing cars will look very different from the costs involved in producing computer software or haircuts or fast-food meals.
We can measure costs in a variety of ways. Each way provides its own insight into costs. Sometimes firms need to look at their cost per unit of output, not just their total cost. There are two ways to measure per unit costs. The most intuitive way is average cost. Average cost is the cost on average of producing a given quantity. We define average cost as total cost divided by the quantity of output produced. AC=TC/QAC=TC/Q If producing two widgets costs a total of $44, the average cost per widget is $44/2=$22$44/2=$22 per widget. The other way of measuring cost per unit is marginal cost. If average cost is the cost of the average unit of output produced, marginal cost is the cost of each individual unit produced. More formally, marginal cost is the cost of producing one more unit of output. Mathematically, marginal cost is the change in total cost divided by the change in output: MC=ΔTC/ΔQMC=ΔTC/ΔQ. If the cost of the first widget is $32.50 and the cost of two widgets is $44, the marginal cost of the second widget is $44−$32.50=$11.50.$44−$32.50=$11.50. We can see the Widget Cost table redrawn below with average and marginal cost added.
Q
1
2
3
4
Total Cost
$32.50
$44.00
$52.00
$90.00
Average Cost
$32.50
$22.00
$17.33
$22.50
Marginal Cost
$32.50
$11.50
$8.00
$38.00
Table7.8 Extended Cost Function for Producing Widgets
Note that the marginal cost of the first unit of output is always the same as total cost.
Fixed and Variable Costs
We can decompose costs into fixed and variable costs. Fixed costs are the costs of the fixed inputs (e.g. capital). Because fixed inputs do not change in the short run, fixed costs are expenditures that do not change regardless of the level of production. Whether you produce a great deal or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease expires. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The amount of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.
Variable costs are the costs of the variable inputs (e.g. labor). The only way to increase or decrease output is by increasing or decreasing the variable inputs. Therefore, variable costs increase or decrease with output. We treat labor as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.
Total costs are the sum of fixed plus variable costs. Let's look at another example. Consider the barber shop called “The Clip Joint” in
Figure 7.7
. The data for output and costs are in
Table 7.9
. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. We calculate these by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost: 2 × $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. For example, with two barbers the total cost is: $160 + $160 = $320.
Labor
Quantity
Fixed Cost
Variable Cost
Total Cost
1
16
$160
$80
$240
2
40
$160
$160
$320
3
60
$160
$240
$400
4
72
$160
$320
$480
5
80
$160
$400
$560
6
84
$160
$480
$640
7
82
$160
$560
$720
Table7.9 Output and Total Costs
Figure 7.7 How Output Affects Total Costs At zero production, the fixed costs of $160 are still present. As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two.
At zero production, the fixed costs of $160 are still present. As production increases, we add variable costs to fixed costs, and the total cost is the sum of the two.
Figure 7.7
graphically shows the relationship between the quantity of output produced and the cost of producing that output. We always show the fixed costs as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero so there are no variable costs.
You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal productivity which we discussed earlier in the
Production in the Short Run
section of this chapter, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain (or marginal product) of 16. As the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal product diminishes as we add each additional barber. For example, as the number of barbers rises from two to three, the marginal product is only 20; and as the number rises from three to four, the marginal product is only 12.
To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be increasing marginal productivity. However, as the shop adds other barbers, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal productivity. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as the last row of
Table 7.9
shows.
This pattern of diminishing marginal productivity is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that the farmer can add to the land is the key variable cost. As the farmer adds water to the land, output increases. However, adding increasingly more water brings smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal productivity occurs because, with fixed inputs (land in this example), each additional unit of input (e.g. water) contributes less to overall production.
Average Total Cost, Average Variable Cost, Marginal Cost
The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of
Table 7.10
duplicate the previous table, but the last three columns show average total costs, average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves in
Figure 7.8
.
Figure 7.8 Cost Curves at the Clip Joint We can also present the information on total costs, fixed cost, and variable cost on a per-unit basis. We calculate average total cost (ATC) by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. We calculate average variable cost (AVC) by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is also typically U-shaped. We calculate marginal cost (MC) by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping.
Labor
Quantity
Fixed Cost
Variable Cost
Total Cost
Marginal Cost
Average Total Cost
Average Variable Cost
1
16
$160
$80
$240
$15.00
$15.00
$5.00
2
40
$160
$160
$320
$3.33
$8.00
$4.00
3
60
$160
$240
$400
$4.00
$6.67
$4.00
4
72
$160
$320
$480
$6.67
$6.67
$4.44
5
80
$160
$400
$560
$10.00
$7.00
$5.00
6
84
$160
$480
$640
$20.00
$7.62
$5.71
Table7.10 Different Types of Costs
Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40, or $8 per haircut. Average cost curves are typically U-shaped, as
Figure 7.8
shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost. Mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. However, as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns come into effect.
We obtain average variable cost when we divide variable cost by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80, or $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as
Figure 7.8
shows. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.
Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. It is not the cost per unit of all units produced, but only the next one (or next few). We calculate marginal cost by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. We can see small range of increasing marginal returns in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet, as the following Clear it Up feature discusses.
CLEAR IT UP
Where do marginal and average costs meet?
The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of $6.60 in
Figure 7.8
. The reason why the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve.
This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up.
The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.
Lessons from Alternative Measures of Costs
Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.
Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. As explored in the chapter
Choice in a World of Scarcity
, fixed costs are often sunk costs that a firm cannot recoup. In thinking about what to do next, typically you should ignore sunk costs, since you have already spent this money and cannot make any changes. However, you can change variable costs, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.
CLEAR IT UP
Why are total cost and average cost not on the same graph?
Total cost, fixed cost, and variable cost each reflect different aspects of the cost of production over the entire quantity of output produced. We measure these costs in dollars. In contrast, marginal cost, average cost, and average variable cost are costs per unit. In the previous example, we measured them as dollars per haircut. Thus, it would not make sense to put all of these numbers on the same graph, since we measure them in different units ($ versus $ per unit of output).
It would be as if the vertical axis measured two different things. In addition, as a practical matter, if they were on the same graph, the lines for marginal cost, average cost, and average variable cost would appear almost flat against the horizontal axis, compared to the values for total cost, fixed cost, and variable cost. Using the figures from the previous example, the total cost of producing 40 haircuts is $320. However, the average cost is $320/40, or $8. If you graphed both total and average cost on the same axes, the average cost would hardly show.
Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit gives:
average profit====profitquantity producedtotal revenue – total costquantity producedtotal revenuequantity produced–total costquantity producedaverage revenue – average costaverage profit=profitquantity produced=total revenue – total costquantity produced=total revenuequantity produced–total costquantity produced=average revenue – average cost
However, note that:
average revenue==price × quantity producedquantity producedpriceaverage revenue=price × quantity producedquantity produced=price
Thus:
average profit=price – average costaverage profit=price – average cost
This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive. If price is below average cost, then profits will be negative.
We can compare this marginal cost of producing an additional unit with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit—or not. Thus, marginal cost helps producers understand how increasing or decreasing production affects profits.
A Variety of Cost Patterns
The pattern of costs varies among industries and even among firms in the same industry. Some businesses have high fixed costs, but low marginal costs. Consider, for example, an internet company that provides medical advice to customers. Consumers might pay such a company directly, or perhaps hospitals or healthcare practices might subscribe on behalf of their patients. Setting up the website, collecting the information, writing the content, and buying or leasing the computer space to handle the web traffic are all fixed costs that the company must undertake before the site can work. However, when the website is up and running, it can provide a high quantity of service with relatively low variable costs, like the cost of monitoring the system and updating the information. In this case, the total cost curve might start at a high level, because of the high fixed costs, but then might appear close to flat, up to a large quantity of output, reflecting the low variable costs of operation. If the website is popular, however, a large rise in the number of visitors will overwhelm the website, and increasing output further could require a purchase of additional computer space.
For other firms, fixed costs may be relatively low. For example, consider firms that rake leaves in the fall or shovel snow off sidewalks and driveways in the winter. For fixed costs, such firms may need little more than a car to transport workers to homes of customers and some rakes and shovels. Still other firms may find that diminishing marginal returns set in quite sharply. If a manufacturing plant tried to run 24 hours a day, seven days a week, little time remains for routine equipment maintenance, and marginal costs can increase dramatically as the firm struggles to repair and replace overworked equipment.
Every firm can gain insight into its task of earning profits by dividing its total costs into fixed and variable costs, and then using these calculations as a basis for average total cost, average variable cost, and marginal cost. However, making a final decision about the profit-maximizing quantity to produce and the price to charge will require combining these perspectives on cost with an analysis of sales and revenue, which in turn requires looking at the market structure in which the firm finds itself. Before we turn to the analysis of market structure in other chapters, we will analyze the firm’s cost structure from a long-run perspective.
Learning Objectives
By the end of this section, you will be able to:
· Understand how long run production differs from short run production.
In the long run, all factors (including capital) are variable, so our production function is Q=f[L,K]Q=f[L,K].
Consider a secretarial firm that does typing for hire using typists for labor and personal computers for capital. To start, the firm has just enough business for one typist and one PC to keep busy for a day. Say that’s five documents. Now suppose the firm receives a rush order from a good customer for 10 documents tomorrow. Ideally, the firm would like to use two typists and two PCs to produce twice their normal output of five documents. However, in the short turn, the firm has fixed capital, i.e. only one PC. The table below shows the situation:
# Typists (L)
1
2
3
4
5
6
Letters/hr (TP)
5
7
8
8
8
8
For K = 1PC
MP
5
2
1
0
0
0
Table7.11 Short Run Production Function for Typing
In the short run, the only variable factor is labor so the only way the firm can produce more output is by hiring additional workers. What could the second worker do? What can they contribute to the firm? Perhaps they can answer the phone, which is a major impediment to completing the typing assignment. What about a third worker? Perhaps he or she could bring coffee to the first two workers. You can see both total product and marginal product for the firm above. Now here’s something to think about: At what point (e.g. after how many workers) does diminishing marginal productivity kick in, and more importantly, why?
In this example, marginal productivity starts to decline after the second worker. This is because capital is fixed. The production process for typing works best with one worker and one PC. If you add more than one typist, you get seriously diminishing marginal productivity.
Consider the long run. Suppose the firm’s demand increases to 15 documents per day. What might the firm do to operate more efficiently? If demand has tripled, the firm could acquire two more PCs, which would give us a new short run production function as
Table 7.12
below shows.
# Typists (L)
1
2
3
4
5
5
Letters/hr (TP)
5
6
8
8
8
8
For K = 1PC
MP
5
2
1
0
0
0
Letters/hr (TP)
5
10
15
17
18
18
For K = 3PC
MP
5
5
5
2
1
0
Table7.12 Long Run Production Function for Typing
With more capital, the firm can hire three workers before diminishing productivity comes into effect. More generally, because all factors are variable, the long run production function shows the most efficient way of producing any level of output.
Learning Objectives
By the end of this section, you will be able to:
· Calculate long run total cost
· Identify economies of scale, diseconomies of scale, and constant returns to scale
· Interpret graphs of long-run average cost curves and short-run average cost curves
· Analyze cost and production in the long run and short run
The long run is the period of time when all costs are variable. The long run depends on the specifics of the firm in question—it is not a precise period of time. If you have a one-year lease on your factory, then the long run is any period longer than a year, since after a year you are no longer bound by the lease. No costs are fixed in the long run. A firm can build new factories and purchase new machinery, or it can close existing facilities. In planning for the long run, the firm will compare alternative production technologies (or processes).
In this context, technology refers to all alternative methods of combining inputs to produce outputs. It does not refer to a specific new invention like the tablet computer. The firm will search for the production technology that allows it to produce the desired level of output at the lowest cost. After all, lower costs lead to higher profits—at least if total revenues remain unchanged. Moreover, each firm must fear that if it does not seek out the lowest-cost methods of production, then it may lose sales to competitor firms that find a way to produce and sell for less.
Choice of Production Technology
A firm can perform many tasks with a range of combinations of labor and physical capital. For example, a firm can have human beings answering phones and taking messages, or it can invest in an automated voicemail system. A firm can hire file clerks and secretaries to manage a system of paper folders and file cabinets, or it can invest in a computerized recordkeeping system that will require fewer employees. A firm can hire workers to push supplies around a factory on rolling carts, it can invest in motorized vehicles, or it can invest in robots that carry materials without a driver. Firms often face a choice between buying a many small machines, which need a worker to run each one, or buying one larger and more expensive machine, which requires only one or two workers to operate it. In short, physical capital and labor can often substitute for each other.
Consider the example of local governments hiring a private firm to clean up public parks. Three different combinations of labor and physical capital for cleaning up a single average-sized park appear in
Table 7.13
. The first production technology is heavy on workers and light on machines, while the next two technologies substitute machines for workers. Since all three of these production methods produce the same thing—one cleaned-up park—a profit-seeking firm will choose the production technology that is least expensive, given the prices of labor and machines.
Production technology 1
10 workers
2 machines
Production technology 2
7 workers
4 machines
Production technology 3
3 workers
7 machines
Table7.13 Three Ways to Clean a Park
Production technology 1 uses the most labor and least machinery, while production technology 3 uses the least labor and the most machinery.
Table 7.14
outlines three examples of how the total cost will change with each production technology as the cost of labor changes. As the cost of labor rises from example A to B to C, the firm will choose to substitute away from labor and use more machinery.
Example A: Workers cost $40, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $40 = $400
2 × $80 = $160
$560
Cost of technology 2
7 × $40 = $280
4 × $80 = $320
$600
Cost of technology 3
3 × $40 = $120
7 × $80 = $560
$680
Example B: Workers cost $55, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $55 = $550
2 × $80 = $160
$710
Cost of technology 2
7 × $55 = $385
4 × $80 = $320
$705
Cost of technology 3
3 × $55 = $165
7 × $80 = $560
$725
Example C: Workers cost $90, machines cost $80
Labor Cost
Machine Cost
Total Cost
Cost of technology 1
10 × $90 = $900
2 × $80 = $160
$1,060
Cost of technology 2
7 × $90 = $630
4 × $80 = $320
$950
Cost of technology 3
3 × $90 = $270
7 × $80 = $560
$830
Table7.14 Total Cost with Rising Labor Costs
Example A shows the firm’s cost calculation when wages are $40 and machines costs are $80. In this case, technology 1 is the low-cost production technology. In example B, wages rise to $55, while the cost of machines does not change, in which case technology 2 is the low-cost production technology. If wages keep rising up to $90, while the cost of machines remains unchanged, then technology 3 clearly becomes the low-cost form of production, as example C shows.
This example shows that as an input becomes more expensive (in this case, the labor input), firms will attempt to conserve on using that input and will instead shift to other inputs that are relatively less expensive. This pattern helps to explain why the demand curve for labor (or any input) slopes down; that is, as labor becomes relatively more expensive, profit-seeking firms will seek to substitute the use of other inputs. When a multinational employer like Coca-Cola or McDonald’s sets up a bottling plant or a restaurant in a high-wage economy like the United States, Canada, Japan, or Western Europe, it is likely to use production technologies that conserve on the number of workers and focuses more on machines. However, that same employer is likely to use production technologies with more workers and less machinery when producing in a lower-wage country like Mexico, China, or South Africa.
Economies of Scale
Once a firm has determined the least costly production technology, it can consider the optimal scale of production, or quantity of output to produce. Many industries experience economies of scale. Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit goes down. This is the idea behind “warehouse stores” like Costco or Walmart. In everyday language: a larger factory can produce at a lower average cost than a smaller factory.
Figure 7.9
illustrates the idea of economies of scale, showing the average cost of producing an alarm clock falling as the quantity of output rises. For a small-sized factory like S, with an output level of 1,000, the average cost of production is $12 per alarm clock. For a medium-sized factory like M, with an output level of 2,000, the average cost of production falls to $8 per alarm clock. For a large factory like L, with an output of 5,000, the average cost of production declines still further to $4 per alarm clock.
Figure 7.9 Economies of Scale A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock. A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock. A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock. Economies of scale exist when the larger scale of production leads to lower average costs.
The average cost curve in
Figure 7.9
may appear similar to the average cost curves we presented earlier in this chapter, although it is downward-sloping rather than U-shaped. However, there is one major difference. The economies of scale curve is a long-run average cost curve, because it allows all factors of production to change. The short-run average cost curves we presented earlier in this chapter assumed the existence of fixed costs, and only variable costs were allowed to change.
One prominent example of economies of scale occurs in the chemical industry. Chemical plants have many pipes. The cost of the materials for producing a pipe is related to the circumference of the pipe and its length. However, the cross-section area of the pipe determines the volume of chemicals that can flow through it. The calculations in
Table 7.15
show that a pipe which uses twice as much material to make (as shown by the circumference) can actually carry four times the volume of chemicals because the pipe's cross-section area rises by a factor of four (as the Area column below shows).
Circumference (2πr2πr)
Area (πr2πr2)
4-inch pipe
12.5 inches
12.5 square inches
8-inch pipe
25.1 inches
50.2 square inches
16-inch pipe
50.2 inches
201.1 square inches
Table7.15 Comparing Pipes: Economies of Scale in the Chemical Industry
A doubling of the cost of producing the pipe allows the chemical firm to process four times as much material. This pattern is a major reason for economies of scale in chemical production, which uses a large quantity of pipes. Of course, economies of scale in a chemical plant are more complex than this simple calculation suggests. However, the chemical engineers who design these plants have long used what they call the “six-tenths rule,” a rule of thumb which holds that increasing the quantity produced in a chemical plant by a certain percentage will increase total cost by only six-tenths as much.
Shapes of Long-Run Average Cost Curves
While in the short run firms are limited to operating on a single average cost curve (corresponding to the level of fixed costs they have chosen), in the long run when all costs are variable, they can choose to operate on any average cost curve. Thus, the long-run average cost (LRAC) curve is actually based on a group of short-run average cost (SRAC) curves, each of which represents one specific level of fixed costs. More precisely, the long-run average cost curve will be the least expensive average cost curve for any level of output.
Figure 7.10
shows how we build the long-run average cost curve from a group of short-run average cost curves. Five short-run-average cost curves appear on the diagram. Each SRAC curve represents a different level of fixed costs. For example, you can imagine SRAC1 as a small factory, SRAC2 as a medium factory, SRAC3 as a large factory, and SRAC4 and SRAC5 as very large and ultra-large. Although this diagram shows only five SRAC curves, presumably there are an infinite number of other SRAC curves between the ones that we show. Think of this family of short-run average cost curves as representing different choices for a firm that is planning its level of investment in fixed cost physical capital—knowing that different choices about capital investment in the present will cause it to end up with different short-run average cost curves in the future.
Figure 7.10 From Short-Run Average Cost Curves to Long-Run Average Cost Curves The five different short-run average cost (SRAC) curves each represents a different level of fixed costs, from the low level of fixed costs at SRAC1 to the high level of fixed costs at SRAC5. Other SRAC curves, not in the diagram, lie between the ones that are here. The long-run average cost (LRAC) curve shows the lowest cost for producing each quantity of output when fixed costs can vary, and so it is formed by the bottom edge of the family of SRAC curves. If a firm wished to produce quantity Q3, it would choose the fixed costs associated with SRAC3.
The long-run average cost curve shows the cost of producing each quantity in the long run, when the firm can choose its level of fixed costs and thus choose which short-run average costs it desires. If the firm plans to produce in the long run at an output of Q3, it should make the set of investments that will lead it to locate on SRAC3, which allows producing q3 at the lowest cost. A firm that intends to produce Q3 would be foolish to choose the level of fixed costs at SRAC2 or SRAC4. At SRAC2 the level of fixed costs is too low for producing Q3 at lowest possible cost, and producing q3 would require adding a very high level of variable costs and make the average cost very high. At SRAC4, the level of fixed costs is too high for producing q3 at lowest possible cost, and again average costs would be very high as a result.
The shape of the long-run cost curve, in
Figure 7.10
, is fairly common for many industries. The left-hand portion of the long-run average cost curve, where it is downward- sloping from output levels Q1 to Q2 to Q3, illustrates the case of economies of scale. In this portion of the long-run average cost curve, larger scale leads to lower average costs. We illustrated this pattern earlier in
Figure 7.9
.
In the middle portion of the long-run average cost curve, the flat portion of the curve around Q3, economies of scale have been exhausted. In this situation, allowing all inputs to expand does not much change the average cost of production. We call this constant returns to scale. In this LRAC curve range, the average cost of production does not change much as scale rises or falls. The following Clear It Up feature explains where diminishing marginal returns fit into this analysis.
CLEAR IT UP
How do economies of scale compare to diminishing marginal returns?
The concept of economies of scale, where average costs decline as production expands, might seem to conflict with the idea of diminishing marginal returns, where marginal costs rise as production expands. However, diminishing marginal returns refers only to the short-run average cost curve, where one variable input (like labor) is increasing, but other inputs (like capital) are fixed. Economies of scale refers to the long-run average cost curve where all inputs are allowed to increase together. Thus, it is quite possible and common to have an industry that has both diminishing marginal returns when only one input is allowed to change, and at the same time has economies of scale when all inputs change together to produce a larger-scale operation.
Finally, the right-hand portion of the long-run average cost curve, running from output level Q4 to Q5, shows a situation where, as the level of output and the scale rises, average costs rise as well. We call this situation diseconomies of scale. A firm or a factory can grow so large that it becomes very difficult to manage, resulting in unnecessarily high costs as many layers of management try to communicate with workers and with each other, and as failures to communicate lead to disruptions in the flow of work and materials. Not many overly large factories exist in the real world, because with their very high production costs, they are unable to compete for long against plants with lower average costs of production. However, in some planned economies, like the economy of the old Soviet Union, plants that were so large as to be grossly inefficient were able to continue operating for a long time because government economic planners protected them from competition and ensured that they would not make losses.
Diseconomies of scale can also be present across an entire firm, not just a large factory. The leviathan effect can hit firms that become too large to run efficiently, across the entirety of the enterprise. Firms that shrink their operations are often responding to finding itself in the diseconomies region, thus moving back to a lower average cost at a lower output level.
LINK IT UP
Visit this
website
to read an article about the complexity of the belief that banks can be “too-big-to-fail.”
The Size and Number of Firms in an Industry
The shape of the long-run average cost curve has implications for how many firms will compete in an industry, and whether the firms in an industry have many different sizes, or tend to be the same size. For example, say that the appliance industry sells one million dishwashers every year at a price of $500 each and the long-run average cost curve for dishwashers is in
Figure 7.11
(a). In
Figure 7.11
(a), the lowest point of the LRAC curve occurs at a quantity of 10,000 produced. Thus, the market for dishwashers will consist of 100 different manufacturing plants of this same size. If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers per year, the average costs of production at such plants would be well above $500, and the firms would not be able to compete.
Figure 7.11 The LRAC Curve and the Size and Number of Firms (a) Low-cost firms will produce at output level R. When the LRAC curve has a clear minimum point, then any firm producing a different quantity will have higher costs. In this case, a firm producing at a quantity of 10,000 will produce at a lower average cost than a firm producing, say, 5,000 or 20,000 units. (b) Low-cost firms will produce between output levels R and S. When the LRAC curve has a flat bottom, then firms producing at any quantity along this flat bottom can compete. In this case, any firm producing a quantity between 5,000 and 20,000 can compete effectively, although firms producing less than 5,000 or more than 20,000 would face higher average costs and be unable to compete.
CLEAR IT UP
How can we view cities as examples of economies of scale?
Why are people and economic activity concentrated in cities, rather than distributed evenly across a country? The fundamental reason must be related to the idea of economies of scale—that grouping economic activity is more productive in many cases than spreading it out. For example, cities provide a large group of nearby customers, so that businesses can produce at an efficient economy of scale. They also provide a large group of workers and suppliers, so that business can hire easily and purchase whatever specialized inputs they need. Many of the attractions of cities, like sports stadiums and museums, can operate only if they can draw on a large nearby population base. Cities are big enough to offer a wide variety of products, which is what appeals to many shoppers.
These factors are not exactly economies of scale in the narrow sense of the production function of a single firm, but they are related to growth in the overall size of population and market in an area. Cities are sometimes called “agglomeration economies.”
These agglomeration factors help to explain why every economy, as it develops, has an increasing proportion of its population living in urban areas. In the United States, about 80% of the population now lives in metropolitan areas (which include the suburbs around cities), compared to just 40% in 1900. However, in poorer nations of the world, including much of Africa, the proportion of the population in urban areas is only about 30%. One of the great challenges for these countries as their economies grow will be to manage the growth of the great cities that will arise.
If cities offer economic advantages that are a form of economies of scale, then why don’t all or most people live in one giant city? At some point, agglomeration economies must turn into diseconomies. For example, traffic congestion may reach a point where the gains from being geographically nearby are counterbalanced by how long it takes to travel. High densities of people, cars, and factories can mean more garbage and air and water pollution. Facilities like parks or museums may become overcrowded. There may be economies of scale for negative activities like crime, because high densities of people and businesses, combined with the greater impersonality of cities, make it easier for illegal activities as well as legal ones. The future of cities, both in the United States and in other countries around the world, will be determined by their ability to benefit from the economies of agglomeration and to minimize or counterbalance the corresponding diseconomies.
We illustrate a more common case in
Figure 7.11
(b), where the LRAC curve has a flat-bottomed area of constant returns to scale. In this situation, any firm with a level of output between 5,000 and 20,000 will be able to produce at about the same level of average cost. Given that the market will demand one million dishwashers per year at a price of $500, this market might have as many as 200 producers (that is, one million dishwashers divided by firms making 5,000 each) or as few as 50 producers (one million dishwashers divided by firms making 20,000 each). The producers in this market will range in size from firms that make 5,000 units to firms that make 20,000 units. However, firms that produce below 5,000 units or more than 20,000 will be unable to compete, because their average costs will be too high. Thus, if we see an industry where almost all plants are the same size, it is likely that the long-run average cost curve has a unique bottom point as in
Figure 7.11
(a). However, if the long-run average cost curve has a wide flat bottom like
Figure 7.11
(b), then firms of a variety of different sizes will be able to compete with each other.
We can interpret the flat section of the long-run average cost curve in
Figure 7.11
(b) in two different ways. One interpretation is that a single manufacturing plant producing a quantity of 5,000 has the same average costs as a single manufacturing plant with four times as much capacity that produces a quantity of 20,000. The other interpretation is that one firm owns a single manufacturing plant that produces a quantity of 5,000, while another firm owns four separate manufacturing plants, which each produce a quantity of 5,000. This second explanation, based on the insight that a single firm may own a number of different manufacturing plants, is especially useful in explaining why the long-run average cost curve often has a large flat segment—and thus why a seemingly smaller firm may be able to compete quite well with a larger firm. At some point, however, the task of coordinating and managing many different plants raises the cost of production sharply, and the long-run average cost curve slopes up as a result.
In the examples to this point, the quantity demanded in the market is quite large (one million) compared with the quantity produced at the bottom of the long-run average cost curve (5,000, 10,000 or 20,000). In such a situation, the market is set for competition between many firms. However, what if the bottom of the long-run average cost curve is at a quantity of 10,000 and the total market demand at that price is only slightly higher than that quantity—or even somewhat lower?
Return to
Figure 7.11
(a), where the bottom of the long-run average cost curve is at 10,000, but now imagine that the total quantity of dishwashers demanded in the market at that price of $500 is only 30,000. In this situation, the total number of firms in the market would be three. We call a handful of firms in a market an “oligopoly,” and the chapter on
Monopolistic Competition and Oligopoly
will discuss the range of competitive strategies that can occur when oligopolies compete.
Alternatively, consider a situation, again in the setting of
Figure 7.11
(a), where the bottom of the long-run average cost curve is 10,000, but total demand for the product is only 5,000. (For simplicity, imagine that this demand is highly inelastic, so that it does not vary according to price.) In this situation, the market may well end up with a single firm—a monopoly—producing all 5,000 units. If any firm tried to challenge this monopoly while producing a quantity lower than 5,000 units, the prospective competitor firm would have a higher average cost, and so it would not be able to compete in the longer term without losing money. The chapter on
Monopoly
discusses the situation of a monopoly firm.
Thus, the shape of the long-run average cost curve reveals whether competitors in the market will be different sizes. If the LRAC curve has a single point at the bottom, then the firms in the market will be about the same size, but if the LRAC curve has a flat-bottomed segment of constant returns to scale, then firms in the market may be a variety of different sizes.
The relationship between the quantity at the minimum of the long-run average cost curve and the quantity demanded in the market at that price will predict how much competition is likely to exist in the market. If the quantity demanded in the market far exceeds the quantity at the minimum of the LRAC, then many firms will compete. If the quantity demanded in the market is only slightly higher than the quantity at the minimum of the LRAC, a few firms will compete. If the quantity demanded in the market is less than the quantity at the minimum of the LRAC, a single-producer monopoly is a likely outcome.
Shifting Patterns of Long-Run Average Cost
New developments in production technology can shift the long-run average cost curve in ways that can alter the size distribution of firms in an industry.
For much of the twentieth century, the most common change had been to see alterations in technology, like the assembly line or the large department store, where large-scale producers seemed to gain an advantage over smaller ones. In the long-run average cost curve, the downward-sloping economies of scale portion of the curve stretched over a larger quantity of output.
However, new production technologies do not inevitably lead to a greater average size for firms. For example, in recent years some new technologies for generating electricity on a smaller scale have appeared. The traditional coal-burning electricity plants needed to produce 300 to 600 megawatts of power to exploit economies of scale fully. However, high-efficiency turbines to produce electricity from burning natural gas can produce electricity at a competitive price while producing a smaller quantity of 100 megawatts or less. These new technologies create the possibility for smaller companies or plants to generate electricity as efficiently as large ones. Another example of a technology-driven shift to smaller plants may be taking place in the tire industry. A traditional mid-size tire plant produces about six million tires per year. However, in 2000, the Italian company Pirelli introduced a new tire factory that uses many robots. The Pirelli tire plant produced only about one million tires per year, but did so at a lower average cost than a traditional mid-sized tire plant.
Controversy has simmered in recent years over whether the new information and communications technologies will lead to a larger or smaller size for firms. On one side, the new technology may make it easier for small firms to reach out beyond their local geographic area and find customers across a state, or the nation, or even across international boundaries. This factor might seem to predict a future with a larger number of small competitors. On the other side, perhaps the new information and communications technology will create “winner-take-all” markets where one large company will tend to command a large share of total sales, as Microsoft has done producing of software for personal computers or Amazon has done in online bookselling. Moreover, improved information and communication technologies might make it easier to manage many different plants and operations across the country or around the world, and thus encourage larger firms. This ongoing battle between the forces of smallness and largeness will be of great interest to economists, businesspeople, and policymakers.
BRING IT HOME
Amazon
Traditionally, bookstores have operated in retail locations with inventories held either on the shelves or in the back of the store. These retail locations were very pricey in terms of rent. Until recently, Amazon had no retail locations. It only sold online and delivered by mail. Amazon now has retail stores in California, Oregon and Washington State and retail stores are coming to Illinois, Massachusetts, New Jersey, and New York. Amazon offers almost any book in print, convenient purchasing, and prompt delivery by mail. Amazon holds its inventories in huge warehouses in low-rent locations around the world. The warehouses are highly computerized using robots and relatively low-skilled workers, making for low average costs per sale. Amazon demonstrates the significant advantages economies of scale can offer to a firm that exploits those economies.
accounting profit
total revenues minus explicit costs, including depreciation
average profit
profit divided by the quantity of output produced; also known as profit margin
average total cost
total cost divided by the quantity of output
average variable cost
variable cost divided by the quantity of output
constant returns to scale
expanding all inputs proportionately does not change the average cost of production
diminishing marginal productivity
general rule that as a firm employs more labor, eventually the amount of additional output produced declines
diseconomies of scale
the long-run average cost of producing output increases as total output increases
economic profit
total revenues minus total costs (explicit plus implicit costs)
economies of scale
the long-run average cost of producing output decreases as total output increases
economies of scale
the long-run average cost of producing output decreases as total output increases
explicit costs
out-of-pocket costs for a firm, for example, payments for wages and salaries, rent, or materials
factors of production (or inputs)
resources that firms use to produce their products, for example, labor and capital
firm
an organization that combines inputs of labor, capital, land, and raw or finished component materials to produce outputs.
fixed cost
cost of the fixed inputs; expenditure that a firm must make before production starts and that does not change regardless of the production level
fixed inputs
factors of production that can’t be easily increased or decreased in a short period of time
implicit costs
opportunity cost of resources already owned by the firm and used in business, for example, expanding a factory onto land already owned
long run
period of time during which all of a firm’s inputs are variable
long-run average cost (LRAC) curve
shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology
marginal cost
the additional cost of producing one more unit; mathematically, MC=ΔTC/ΔLMC=ΔTC/ΔL
marginal product
change in a firm’s output when it employees more labor; mathematically, MP=ΔTP/ΔLMP=ΔTP/ΔL
private enterprise
the ownership of businesses by private individuals
production
the process of combining inputs to produce outputs, ideally of a value greater than the value of the inputs
production function
mathematical equation that tells how much output a firm can produce with given amounts of the inputs
production technologies
alternative methods of combining inputs to produce output
revenue
income from selling a firm’s product; defined as price times quantity sold
short run
period of time during which at least one or more of the firm’s inputs is fixed
short-run average cost (SRAC) curve
the average total cost curve in the short term; shows the total of the average fixed costs and the average variable costs
total cost
the sum of fixed and variable costs of production
total product
synonym for a firm’s output
variable cost
cost of production that increases with the quantity produced; the cost of the variable inputs
variable inputs
factors of production that a firm can easily increase or decrease in a short period of time
7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.
7.2 Production in the Short Run
Production is the process a firm uses to transform inputs (e.g. labor, capital, raw materials, etc.) into outputs. It is not possible to vary fixed inputs (e.g. capital) in a short period of time. Thus, in the short run the only way to change output is to change the variable inputs (e.g. labor). Marginal product is the additional output a firm obtains by employing more labor in production. At some point, employing additional labor leads to diminishing marginal productivity, meaning the additional output obtained is less than for the previous increment to labor. Mathematically, marginal product is the slope of the total product curve.
7.3 Costs in the Short Run
For every input (e.g. labor), there is an associated factor payment (e.g. wages and salaries). The cost of production for a given quantity of output is the sum of the amount of each input required to produce that quantity of output times the associated factor payment.
In a short-run perspective, we can divide a firm’s total costs into fixed costs, which a firm must incur before producing any output, and variable costs, which the firm incurs in the act of producing. Fixed costs are sunk costs; that is, because they are in the past and the firm cannot alter them, they should play no role in economic decisions about future production or pricing. Variable costs typically show diminishing marginal returns, so that the marginal cost of producing higher levels of output rises.
We calculate marginal cost by taking the change in total cost (or the change in variable cost, which will be the same thing) and dividing it by the change in output, for each possible change in output. Marginal costs are typically rising. A firm can compare marginal cost to the additional revenue it gains from selling another unit to find out whether its marginal unit is adding to profit.
We calculate average total cost by taking total cost and dividing by total output at each different level of output. Average costs are typically U-shaped on a graph. If a firm’s average cost of production is lower than the market price, a firm will be earning profits.
We calculate average variable cost by taking variable cost and dividing by the total output at each level of output. Average variable costs are typically U-shaped. If a firm’s average variable cost of production is lower than the market price, then the firm would be earning profits if fixed costs are left out of the picture.
7.4 Production in the Long Run
In the long run, all inputs are variable. Since diminishing marginal productivity is caused by fixed capital, there are no diminishing returns in the long run. Firms can choose the optimal capital stock to produce their desired level of output.
7.5 Costs in the Long Run
A production technology refers to a specific combination of labor, physical capital, and technology that makes up a particular method of production.
In the long run, firms can choose their production technology, and so all costs become variable costs. In making this choice, firms will try to substitute relatively inexpensive inputs for relatively expensive inputs where possible, so as to produce at the lowest possible long-run average cost.
Economies of scale refers to a situation where as the level of output increases, the average cost decreases. Constant returns to scale refers to a situation where average cost does not change as output increases. Diseconomies of scale refers to a situation where as output increases, average costs also increase.
The long-run average cost curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology. A downward-sloping LRAC shows economies of scale; a flat LRAC shows constant returns to scale; an upward-sloping LRAC shows diseconomies of scale. If the long-run average cost curve has only one quantity produced that results in the lowest possible average cost, then all of the firms competing in an industry should be the same size. However, if the LRAC has a flat segment at the bottom, so that a firm can produce a range of different quantities at the lowest average cost, the firms competing in the industry will display a range of sizes. The market demand in conjunction with the long-run average cost curve determines how many firms will exist in a given industry.
If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the long-run average cost curve, where the cost of production is lowest, the market will have many firms competing. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm.
1
.
A firm had sales revenue of $1 million last year. It spent $600,000 on labor, $150,000 on capital and $200,000 on materials. What was the firm’s accounting profit?
2
.
Continuing from
Exercise 7.1
, the firm’s factory sits on land owned by the firm that it could rent for $30,000 per year. What was the firm’s economic profit last year?
3
.
The WipeOut Ski Company manufactures skis for beginners. Fixed costs are $30. Fill in
Table 7.16
for total cost, average variable cost, average total cost, and marginal cost.
Quantity
Variable Cost
Fixed Cost
Total Cost
Average Variable Cost
Average Total Cost
Marginal Cost
0
0
$30
1
$10
$30
2
$25
$30
3
$45
$30
4
$70
$30
5
$100
$30
6
$135
$30
Table7.16
4
.
Based on your answers to the WipeOut Ski Company in
Exercise 7.3
, now imagine a situation where the firm produces a quantity of 5 units that it sells for a price of $25 each.
a. What will be the company’s profits or losses?
b. How can you tell at a glance whether the company is making or losing money at this price by looking at average cost?
c. At the given quantity and price, is the marginal unit produced adding to profits?
5
.
If two painters can paint 200 square feet of wall in an hour, and three painters can paint 275 square feet, what is the marginal product of the third painter?
6
.
Return to the problem explained in
Table 7.13
and
Table 7.14
. If the cost of labor remains at $40, but the cost of a machine decreases to $50, what would be the total cost of each method of production? Which method should the firm use, and why?
7
.
Suppose the cost of machines increases to $55, while the cost of labor stays at $40. How would that affect the total cost of the three methods? Which method should the firm choose now?
8
.
Automobile manufacturing is an industry subject to significant economies of scale. Suppose there are four domestic auto manufacturers, but the demand for domestic autos is no more than 2.5 times the quantity produced at the bottom of the long-run average cost curve. What do you expect will happen to the domestic auto industry in the long run?
9.
What are explicit and implicit costs?
10.
Would you consider an interest payment on a loan to a firm an explicit or implicit cost?
11.
What is the difference between accounting and economic profit?
12.
What is a production function?
13.
What is the difference between a fixed input and a variable input?
14.
How do we calculate marginal product?
15.
What shapes would you generally expect a total product curve and a marginal product curve to have?
16.
What are the factor payments for land, labor, and capital?
17.
What is the difference between fixed costs and variable costs?
18.
How do we calculate each of the following: marginal cost, average total cost, and average variable cost?
19.
What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs?
20.
Are there fixed costs in the long-run? Explain briefly.
21.
Are fixed costs also sunk costs? Explain.
22.
What are diminishing marginal returns as they relate to costs?
23.
Which costs are measured on per-unit basis: fixed costs, average cost, average variable cost, variable costs, and marginal cost?
24.
What is a production technology?
25.
In choosing a production technology, how will firms react if one input becomes relatively more expensive?
26.
What is a long-run average cost curve?
27.
What is the difference between economies of scale, constant returns to scale, and diseconomies of scale?
28.
What shape of a long-run average cost curve illustrates economies of scale, constant returns to scale, and diseconomies of scale?
29.
Why will firms in most markets be located at or close to the bottom of the long-run average cost curve?
30.
Small “Mom and Pop firms,” like inner city grocery stores, sometimes exist even though they do not earn economic profits. How can you explain this?
31.
A common name for fixed cost is “overhead.” If you divide fixed cost by the quantity of output produced, you get average fixed cost. Supposed fixed cost is $1,000. What does the average fixed cost curve look like? Use your response to explain what “spreading the overhead” means.
32.
How does fixed cost affect marginal cost? Why is this relationship important?
33.
Average cost curves (except for average fixed cost) tend to be U-shaped, decreasing and then increasing. Marginal cost curves have the same shape, though this may be harder to see since most of the marginal cost curve is increasing. Why do you think that average and marginal cost curves have the same general shape?
34.
What is the relationship between marginal product and marginal cost? (Hint: Look at the curves.) Why do you suppose that is? Is this relationship the same in the long run as in the short run?
35.
It is clear that businesses operate in the short run, but do they ever operate in the long run? Discuss.
36.
Return to
Table 7.12
. In the top half of the table, at what point does diminishing marginal productivity kick in? What about in the bottom half of the table? How do you explain this?
37.
How would an improvement in technology, like the high-efficiency gas turbines or Pirelli tire plant, affect the long-run average cost curve of a firm? Can you draw the old curve and the new one on the same axes? How might such an improvement affect other firms in the industry?
38.
Do you think that the taxicab industry in large cities would be subject to significant economies of scale? Why or why not?
39.
A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment? Show your work.
40.
Return to
Figure 7.7
. What is the marginal gain in output from increasing the number of barbers from 4 to 5 and from 5 to 6? Does it continue the pattern of diminishing marginal returns?
41.
Compute the average total cost, average variable cost, and marginal cost of producing 60 and 72 haircuts. Draw the graph of the three curves between 60 and 72 haircuts.
42.
A small company that shovels sidewalks and driveways has 100 homes signed up for its services this winter. It can use various combinations of capital and labor: intensive labor with hand shovels, less labor with snow blowers, and still less labor with a pickup truck that has a snowplow on front. To summarize, the method choices are:
Method 1: 50 units of labor, 10 units of capital
Method 2: 20 units of labor, 40 units of capital
Method 3: 10 units of labor, 70 units of capital
If hiring labor for the winter costs $100/unit and a unit of capital costs $400, what is the best production method? What method should the company use if the cost of labor rises to $200/unit?
Figure 8.1 Depending upon the competition and prices offered, a wheat farmer may choose to grow a different crop. (Credit: modification of work by Daniel X. O'Neil/Flickr Creative Commons)
CHAPTER OBJECTIVES
In this chapter, you will learn about:
· Perfect Competition and Why It Matters
· How Perfectly Competitive Firms Make Output Decisions
· Entry and Exit Decisions in the Long Run
· Efficiency in Perfectly Competitive Markets
BRING IT HOME
A Dime a Dozen
When you were younger did you babysit, deliver papers, or mow the lawn for money? If so, you faced stiff competition from many other competitors who offered identical services. There was nothing to stop others from also offering their services.
All of you charged the “going rate.” If you tried to charge more, your customers would simply buy from someone else. These conditions are very similar to the conditions agricultural growers face.
Growing a crop may be more difficult to start than a babysitting or lawn mowing service, but growers face the same fierce competition. In the grand scale of world agriculture, farmers face competition from thousands of others because they sell an identical product. After all, winter wheat is winter wheat, but if they find it hard to make money with that crop, it is relatively easy for farmers to leave the marketplace for another crop. In this case, they do not sell the family farm, they switch crops.
Take the case of the upper Midwest region of the United States—for many generations the area was called “King Wheat.” According to the United States Department of Agriculture National Agricultural Statistics Service, statistics by state, in 1997, 11.6 million acres of wheat and 780,000 acres of corn were planted in North Dakota. In the intervening 20 or so years has the mix of crops changed? Since it is relatively easy to switch crops, did farmers change what they planted in response to changes in relative crop prices? We will find out at chapter’s end.
In the meantime, let's consider the topic of this chapter—the perfectly competitive market. This is a market in which entry and exit are relatively easy and competitors are “a dime a dozen.”
Most businesses face two realities: no one is required to buy their products, and even customers who might want those products may buy from other businesses instead. Firms that operate in perfectly competitive markets face this reality. In this chapter, you will learn how such firms make decisions about how much to produce, how much profit they make, whether to stay in business or not, and many others. Industries differ from one another in terms of how many sellers there are in a specific market, how easy or difficult it is for a new firm to enter, and the type of products that they sell. Economists refer to this as an industry's market structure. In this chapter, we focus on perfect competition. However, in other chapters we will examine other industry types:
Monopoly
and
Monopolistic Competition and Oligopoly
.
Learning Objectives
By the end of this section, you will be able to:
· Explain the characteristics of a perfectly competitive market
· Discuss how perfectly competitive firms react in the short run and in the long run
Firms are in perfect competition when the following conditions occur: (1) many firms produce identical products; (2) many buyers are available to buy the product, and many sellers are available to sell the product; (3) sellers and buyers have all relevant information to make rational decisions about the product that they are buying and selling; and (4) firms can enter and leave the market without any restrictions—in other words, there is free entry and exit into and out of the market.
A perfectly competitive firm is known as a price taker, because the pressure of competing firms forces it to accept the prevailing equilibrium price in the market. If a firm in a perfectly competitive market raises the price of its product by so much as a penny, it will lose all of its sales to competitors. When a wheat grower, as we discussed in the Bring It Home feature, wants to know the going price of wheat, he or she has to check on the computer or listen to the radio. Supply and demand in the entire market solely determine the market price, not the individual farmer. A perfectly competitive firm must be a very small player in the overall market, so that it can increase or decrease output without noticeably affecting the overall quantity supplied and price in the market.
A perfectly competitive market is a hypothetical extreme; however, producers in a number of industries do face many competitor firms selling highly similar goods, in which case they must often act as price takers. Economists often use agricultural markets as an example. The same crops that different farmers grow are largely interchangeable. According to the United States Department of Agriculture monthly reports, in 2015, U.S. corn farmers received an average price of $6.00 per bushel. A corn farmer who attempted to sell at $7.00 per bushel, would not have found any buyers. A perfectly competitive firm will not sell below the equilibrium price either. Why should they when they can sell all they want at the higher price? Other examples of agricultural markets that operate in close to perfectly competitive markets are small roadside produce markets and small organic farmers.
LINK IT UP
Visit this
website
that reveals the current value of various commodities.
This chapter examines how profit-seeking firms decide how much to produce in perfectly competitive markets. Such firms will analyze their costs as we discussed in the chapter on
Production, Costs and Industry Structure
. In the short run, the perfectly competitive firm will seek the quantity of output where profits are highest or, if profits are not possible, where losses are lowest.
In the long run, positive economic profits will attract competition as other firms enter the market. Economic losses will cause firms to exit the market. Ultimately, perfectly competitive markets will attain long-run equilibrium when no new firms want to enter the market and existing firms do not want to leave the market, as economic profits have been driven down to zero.
Learning Objectives
By the end of this section, you will be able to:
· Distinguish between a natural monopoly and a legal monopoly.
· Explain how economies of scale and the control of natural resources led to the necessary formation of legal monopolies
· Analyze the importance of trademarks and patents in promoting innovation
· Identify examples of predatory pricing
Because of the lack of competition, monopolies tend to earn significant economic profits. These profits should attract vigorous competition as we described in
Perfect Competition
, and yet, because of one particular characteristic of monopoly, they do not. Barriers to entry are the legal, technological, or market forces that discourage or prevent potential competitors from entering a market. Barriers to entry can range from the simple and easily surmountable, such as the cost of renting retail space, to the extremely restrictive. For example, there are a finite number of radio frequencies available for broadcasting. Once an entrepreneur or firm has purchased the rights to all of them, no new competitors can enter the market.
In some cases, barriers to entry may lead to monopoly. In other cases, they may limit competition to a few firms. Barriers may block entry even if the firm or firms currently in the market are earning profits. Thus, in markets with significant barriers to entry, it is not necessarily true that abnormally high profits will attract new firms, and that this entry of new firms will eventually cause the price to decline so that surviving firms earn only a normal level of profit in the long run.
There are two types of monopoly, based on the types of barriers to entry they exploit. One is natural monopoly, where the barriers to entry are something other than legal prohibition. The other is legal monopoly, where laws prohibit (or severely limit) competition.
Natural Monopoly
Economies of scale can combine with the size of the market to limit competition. (We introduced this theme in
Production, Cost and Industry Structure
).
Figure 9.2
presents a long-run average cost curve for the airplane manufacturing industry. It shows economies of scale up to an output of 8,000 planes per year and a price of P0, then constant returns to scale from 8,000 to 20,000 planes per year, and diseconomies of scale at a quantity of production greater than 20,000 planes per year.
Now consider the market demand curve in the diagram, which intersects the long-run average cost (LRAC) curve at an output level of 5,000 planes per year and at a price P1, which is higher than P0. In this situation, the market has room for only one producer. If a second firm attempts to enter the market at a smaller size, say by producing a quantity of 4,000 planes, then its average costs will be higher than those of the existing firm, and it will be unable to compete. If the second firm attempts to enter the market at a larger size, like 8,000 planes per year, then it could produce at a lower average cost—but it could not sell all 8,000 planes that it produced because of insufficient demand in the market.
Figure 9.2 Economies of Scale and Natural Monopoly In this market, the demand curve intersects the long-run average cost (LRAC) curve at its downward-sloping part. A natural monopoly occurs when the quantity demanded is less than the minimum quantity it takes to be at the bottom of the long-run average cost curve.
Economists call this situation, when economies of scale are large relative to the quantity demanded in the market, a natural monopoly. Natural monopolies often arise in industries where the marginal cost of adding an additional customer is very low, once the fixed costs of the overall system are in place. This results in situations where there are substantial economies of scale. For example, once a water company lays the main water pipes through a neighborhood, the marginal cost of providing water service to another home is fairly low. Once the electric company installs lines in a new subdivision, the marginal cost of providing additional electrical service to one more home is minimal. It would be costly and duplicative for a second water company to enter the market and invest in a whole second set of main water pipes, or for a second electricity company to enter the market and invest in a whole new set of electrical wires. These industries offer an example where, because of economies of scale, one producer can serve the entire market more efficiently than a number of smaller producers that would need to make duplicate physical capital investments.
A natural monopoly can also arise in smaller local markets for products that are difficult to transport. For example, cement production exhibits economies of scale, and the quantity of cement demanded in a local area may not be much larger than what a single plant can produce. Moreover, the costs of transporting cement over land are high, and so a cement plant in an area without access to water transportation may be a natural monopoly.
Control of a Physical Resource
Another type of monopoly occurs when a company has control of a scarce physical resource. In the U.S. economy, one historical example of this pattern occurred when ALCOA—the Aluminum Company of America—controlled most of the supply of bauxite, a key mineral used in making aluminum. Back in the 1930s, when ALCOA controlled most of the bauxite, other firms were simply unable to produce enough aluminum to compete.
As another example, the majority of global diamond production is controlled by DeBeers, a multi-national company that has mining and production operations in South Africa, Botswana, Namibia, and Canada. It also has exploration activities on four continents, while directing a worldwide distribution network of rough cut diamonds. Although in recent years they have experienced growing competition, their impact on the rough diamond market is still considerable.
Legal Monopoly
For some products, the government erects barriers to entry by prohibiting or limiting competition. Under U.S. law, no organization but the U.S. Postal Service is legally allowed to deliver first-class mail. Many states or cities have laws or regulations that allow households a choice of only one electric company, one water company, and one company to pick up the garbage. Most legal monopolies are utilities—products necessary for everyday life—that are socially beneficial. As a consequence, the government allows producers to become regulated monopolies, to insure that customers have access to an appropriate amount of these products or services. Additionally, legal monopolies are often subject to economies of scale, so it makes sense to allow only one provider.
Promoting Innovation
Innovation takes time and resources to achieve. Suppose a company invests in research and development and finds the cure for the common cold. In this world of near ubiquitous information, other companies could take the formula, produce the drug, and because they did not incur the costs of research and development (R&D), undercut the price of the company that discovered the drug. Given this possibility, many firms would choose not to invest in research and development, and as a result, the world would have less innovation. To prevent this from happening, the Constitution of the United States specifies in Article I, Section 8: “The Congress shall have Power . . . to Promote the Progress of Science and Useful Arts, by securing for limited Times to Authors and Inventors the Exclusive Right to their Writings and Discoveries.” Congress used this power to create the U.S. Patent and Trademark Office, as well as the U.S. Copyright Office. A patent gives the inventor the exclusive legal right to make, use, or sell the invention for a limited time. In the United States, exclusive patent rights last for 20 years. The idea is to provide limited monopoly power so that innovative firms can recoup their investment in R&D, but then to allow other firms to produce the product more cheaply once the patent expires.
A trademark is an identifying symbol or name for a particular good, like Chiquita bananas, Chevrolet cars, or the Nike “swoosh” that appears on shoes and athletic gear. Roughly 1.9 million trademarks are registered with the U.S. government. A firm can renew a trademark repeatedly, as long as it remains in active use.
A copyright, according to the U.S. Copyright Office, “is a form of protection provided by the laws of the United States for ‘original works of authorship’ including literary, dramatic, musical, architectural, cartographic, choreographic, pantomimic, pictorial, graphic, sculptural, and audiovisual creations.” No one can reproduce, display, or perform a copyrighted work without the author's permission. Copyright protection ordinarily lasts for the life of the author plus 70 years.
Roughly speaking, patent law covers inventions and copyright protects books, songs, and art. However, in certain areas, like the invention of new software, it has been unclear whether patent or copyright protection should apply. There is also a body of law known as trade secrets. Even if a company does not have a patent on an invention, competing firms are not allowed to steal their secrets. One famous trade secret is the formula for Coca-Cola, which is not protected under copyright or patent law, but is simply kept secret by the company.
Taken together, we call this combination of patents, trademarks, copyrights, and trade secret law intellectual property, because it implies ownership over an idea, concept, or image, not a physical piece of property like a house or a car. Countries around the world have enacted laws to protect intellectual property, although the time periods and exact provisions of such laws vary across countries. There are ongoing negotiations, both through the World Intellectual Property Organization (WIPO) and through international treaties, to bring greater harmony to the intellectual property laws of different countries to determine the extent to which those in other countries will respect patents and copyrights of those in other countries.
Government limitations on competition used to be more common in the United States. For most of the twentieth century, only one phone company—AT&T—was legally allowed to provide local and long distance service. From the 1930s to the 1970s, one set of federal regulations limited which destinations airlines could choose to fly to and what fares they could charge. Another set of regulations limited the interest rates that banks could pay to depositors; yet another specified how much trucking firms could charge customers.
What products we consider utilities depends, in part, on the available technology. Fifty years ago, telephone companies provided local and long distance service over wires. It did not make much sense to have many companies building multiple wiring systems across towns and the entire country. AT&T lost its monopoly on long distance service when the technology for providing phone service changed from wires to microwave and satellite transmission, so that multiple firms could use the same transmission mechanism. The same thing happened to local service, especially in recent years, with the growth in cellular phone systems.
The combination of improvements in production technologies and a general sense that the markets could provide services adequately led to a wave of deregulation, starting in the late 1970s and continuing into the 1990s. This wave eliminated or reduced government restrictions on the firms that could enter, the prices that they could charge, and the quantities that many industries could produce, including telecommunications, airlines, trucking, banking, and electricity.
Around the world, from Europe to Latin America to Africa and Asia, many governments continue to control and limit competition in what those governments perceive to be key industries, including airlines, banks, steel companies, oil companies, and telephone companies.
LINK IT UP
Vist this
website
for examples of some pretty bizarre patents.
Intimidating Potential Competition
Businesses have developed a number of schemes for creating barriers to entry by deterring potential competitors from entering the market. One method is known as predatory pricing, in which a firm uses the threat of sharp price cuts to discourage competition. Predatory pricing is a violation of U.S. antitrust law, but it is difficult to prove.
Consider a large airline that provides most of the flights between two particular cities. A new, small start-up airline decides to offer service between these two cities. The large airline immediately slashes prices on this route to the bone, so that the new entrant cannot make any money. After the new entrant has gone out of business, the incumbent firm can raise prices again.
After the company repeats this pattern once or twice, potential new entrants may decide that it is not wise to try to compete. Small airlines often accuse larger airlines of predatory pricing: in the early 2000s, for example, ValuJet accused Delta of predatory pricing, Frontier accused United, and Reno Air accused Northwest. In 2015, the Justice Department ruled against American Express and Mastercard for imposing restrictions on retailers that encouraged customers to use lower swipe fees on credit transactions.
In some cases, large advertising budgets can also act as a way of discouraging the competition. If the only way to launch a successful new national cola drink is to spend more than the promotional budgets of Coca-Cola and Pepsi Cola, not too many companies will try. A firmly established brand name can be difficult to dislodge.
Summing Up Barriers to Entry
Table 9.1
lists the barriers to entry that we have discussed. This list is not exhaustive, since firms have proved to be highly creative in inventing business practices that discourage competition. When barriers to entry exist, perfect competition is no longer a reasonable description of how an industry works. When barriers to entry are high enough, monopoly can result.
Barrier to Entry
Government Role?
Example
Natural monopoly
Government often responds with regulation (or ownership)
Water and electric companies
Control of a physical resource
No
DeBeers for diamonds
Legal monopoly
Yes
Post office, past regulation of airlines and trucking
Patent, trademark, and copyright
Yes, through protection of intellectual property
New drugs or software
Intimidating potential competitors
Somewhat
Predatory pricing; well-known brand names
Table9.1 Barriers to Entry
Learning Objectives
By the end of this section, you will be able to:
· Explain the significance of differentiated products
· Describe how a monopolistic competitor chooses price and quantity
· Discuss entry, exit, and efficiency as they pertain to monopolistic competition
· Analyze how advertising can impact monopolistic competition
Monopolistic competition involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing; restaurants or grocery stores that sell a variety of food; and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. There are over 600,000 restaurants in the United States. When products are distinctive, each firm has a mini-monopoly on its particular style or flavor or brand name. However, firms producing such products must also compete with other styles and flavors and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition, and the following Clear It Up feature introduces its derivation.
CLEAR IT UP
Who invented the theory of imperfect competition?
Two economists independently but simultaneously developed the theory of imperfect competition in 1933. The first was Edward Chamberlin of Harvard University who published The Economics of Monopolistic Competition. The second was Joan Robinson of Cambridge University who published The Economics of Imperfect Competition. Robinson subsequently became interested in macroeconomics and she became a prominent Keynesian, and later a post-Keynesian economist. (See the
Welcome to Economics!
and
The Keynesian Perspective
chapters for more on Keynes.)
Differentiated Products
A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, location from which it sells the product, intangible aspects of the product, and perceptions of the product. We call products that are distinctive in one of these ways differentiated products.
Physical aspects of a product include all the phrases you hear in advertisements: unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. A firm's location can also create a difference between producers. For example, a gas station located at a heavily traveled intersection can probably sell more gas, because more cars drive by that corner. A supplier to an automobile manufacturer may find that it is an advantage to locate close to the car factory.
Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high quality, services like free delivery, or offering a loan to purchase the product. Finally, product differentiation may occur in the minds of buyers. For example, many people could not tell the difference in taste between common varieties of ketchup or mayonnaise if they were blindfolded but, because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.
The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.
Perceived Demand for a Monopolistic Competitor
A monopolistically competitive firm perceives a demand for its goods that is an intermediate case between monopoly and competition.
Figure 10.2
offers a reminder that the demand curve that a perfectly competitive firm faces is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.
Figure 10.2 Perceived Demand for Firms in Different Competitive Settings The demand curve that a perfectly competitive firm faces is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price. The demand curve that a monopoly faces is the market demand. It can sell more output only by decreasing the price it charges. The demand curve that a monopolistically competitive firm faces falls in between.
The demand curve as a monopolistic competitor faces is not flat, but rather downward-sloping, which means that the monopolistic competitor can raise its price without losing all of its customers or lower the price and gain more customers. Since there are substitutes, the demand curve facing a monopolistically competitive firm is more elastic than that of a monopoly where there are no close substitutes. If a monopolist raises its price, some consumers will choose not to purchase its product—but they will then need to buy a completely different product. However, when a monopolistic competitor raises its price, some consumers will choose not to purchase the product at all, but others will choose to buy a similar product from another firm. If a monopolistic competitor raises its price, it will not lose as many customers as would a perfectly competitive firm, but it will lose more customers than would a monopoly that raised its prices.
At a glance, the demand curves that a monopoly and a monopolistic competitor face look similar—that is, they both slope down. However, the underlying economic meaning of these perceived demand curves is different, because a monopolist faces the market demand curve and a monopolistic competitor does not. Rather, a monopolistically competitive firm’s demand curve is but one of many firms that make up the “before” market demand curve. Are you following? If so, how would you categorize the market for golf balls? Take a swing, then see the following Clear It Up feature.
CLEAR IT UP
Are golf balls really differentiated products?
Monopolistic competition refers to an industry that has more than a few firms, each offering a product which, from the consumer’s perspective, is different from its competitors. The U.S. Golf Association runs a laboratory that tests 20,000 golf balls a year. There are strict rules for what makes a golf ball legal. A ball's weight cannot exceed 1.620 ounces and its diameter cannot be less than 1.680 inches (which is a weight of 45.93 grams and a diameter of 42.67 millimeters, in case you were wondering). The Association also tests the balls by hitting them at different speeds. For example, the distance test involves having a mechanical golfer hit the ball with a titanium driver and a swing speed of 120 miles per hour. As the testing center explains: “The USGA system then uses an array of sensors that accurately measure the flight of a golf ball during a short, indoor trajectory from a ball launcher. From this flight data, a computer calculates the lift and drag forces that are generated by the speed, spin, and dimple pattern of the ball. ... The distance limit is 317 yards.”
Over 1800 golf balls made by more than 100 companies meet the USGA standards. The balls do differ in various ways, such as the pattern of dimples on the ball, the types of plastic on the cover and in the cores, and other factors. Since all balls need to conform to the USGA tests, they are much more alike than different. In other words, golf ball manufacturers are monopolistically competitive.
However, retail sales of golf balls are about $500 million per year, which means that many large companies have a powerful incentive to persuade players that golf balls are highly differentiated and that it makes a huge difference which one you choose. Sure, Tiger Woods can tell the difference. For the average amateur golfer who plays a few times a summer—and who loses many golf balls to the woods and lake and needs to buy new ones—most golf balls are pretty much indistinguishable.
How a Monopolistic Competitor Chooses Price and Quantity
The monopolistically competitive firm decides on its profit-maximizing quantity and price in much the same way as a monopolist. A monopolistic competitor, like a monopolist, faces a downward-sloping demand curve, and so it will choose some combination of price and quantity along its perceived demand curve.
As an example of a profit-maximizing monopolistic competitor, consider the Authentic Chinese Pizza store, which serves pizza with cheese, sweet and sour sauce, and your choice of vegetables and meats. Although Authentic Chinese Pizza must compete against other pizza businesses and restaurants, it has a differentiated product. The firm’s perceived demand curve is downward sloping, as
Figure 10.3
shows and the first two columns of
Table 10.1
.
Figure 10.3 How a Monopolistic Competitor Chooses its Profit Maximizing Output and Price To maximize profits, the Authentic Chinese Pizza shop would choose a quantity where marginal revenue equals marginal cost, or Q where MR = MC. Here it would choose a quantity of 40 and a price of $16.
Quantity
Price
Total Revenue
Marginal Revenue
Total Cost
Marginal Cost
Average Cost
10
$23
$230
$23
$340
$34
$34
20
$20
$400
$17
$400
$6
$20
30
$18
$540
$14
$480
$8
$16
40
$16
$640
$10
$580
$10
$14.50
50
$14
$700
$6
$700
$12
$14
60
$12
$720
$2
$840
$14
$14
70
$10
$700
–$2
$1,020
$18
$14.57
80
$8
$640
–$6
$1,280
$26
$16
Table10.1 Revenue and Cost Schedule
We can multiply the combinations of price and quantity at each point on the demand curve to calculate the total revenue that the firm would receive, which is in the third column of
Table 10.1
. We calculate marginal revenue, in the fourth column, as the change in total revenue divided by the change in quantity. The final columns of
Table 10.1
show total cost, marginal cost, and average cost. As always, we calculate marginal cost by dividing the change in total cost by the change in quantity, while we calculate average cost by dividing total cost by quantity. The following Work It Out feature shows how these firms calculate how much of their products to supply at what price.
WORK IT OUT
How a Monopolistic Competitor Determines How Much to Produce and at What Price
The process by which a monopolistic competitor chooses its profit-maximizing quantity and price resembles closely how a monopoly makes these decisions process. First, the firm selects the profit-maximizing quantity to produce. Then the firm decides what price to charge for that quantity.
Step 1. The monopolistic competitor determines its profit-maximizing level of output. In this case, the Authentic Chinese Pizza company will determine the profit-maximizing quantity to produce by considering its marginal revenues and marginal costs. Two scenarios are possible:
· If the firm is producing at a quantity of output where marginal revenue exceeds marginal cost, then the firm should keep expanding production, because each marginal unit is adding to profit by bringing in more revenue than its cost. In this way, the firm will produce up to the quantity where MR = MC.
· If the firm is producing at a quantity where marginal costs exceed marginal revenue, then each marginal unit is costing more than the revenue it brings in, and the firm will increase its profits by reducing the quantity of output until MR = MC.
In this example, MR and MC intersect at a quantity of 40, which is the profit-maximizing level of output for the firm.
Step 2. The monopolistic competitor decides what price to charge. When the firm has determined its profit-maximizing quantity of output, it can then look to its perceived demand curve to find out what it can charge for that quantity of output. On the graph, we show this process as a vertical line reaching up through the profit-maximizing quantity until it hits the firm’s perceived demand curve. For Authentic Chinese Pizza, it should charge a price of $16 per pizza for a quantity of 40.
Once the firm has chosen price and quantity, it’s in a position to calculate total revenue, total cost, and profit. At a quantity of 40, the price of $16 lies above the average cost curve, so the firm is making economic profits. From
Table 10.1
we can see that, at an output of 40, the firm’s total revenue is $640 and its total cost is $580, so profits are $60. In
Figure 10.3
, the firm’s total revenues are the rectangle with the quantity of 40 on the horizontal axis and the price of $16 on the vertical axis. The firm’s total costs are the light shaded rectangle with the same quantity of 40 on the horizontal axis but the average cost of $14.50 on the vertical axis. Profits are total revenues minus total costs, which is the shaded area above the average cost curve.
Although the process by which a monopolistic competitor makes decisions about quantity and price is similar to the way in which a monopolist makes such decisions, two differences are worth remembering. First, although both a monopolist and a monopolistic competitor face downward-sloping demand curves, the monopolist’s perceived demand curve is the market demand curve, while the perceived demand curve for a monopolistic competitor is based on the extent of its product differentiation and how many competitors it faces. Second, a monopolist is surrounded by barriers to entry and need not fear entry, but a monopolistic competitor who earns profits must expect the entry of firms with similar, but differentiated, products.
Monopolistic Competitors and Entry
If one monopolistic competitor earns positive economic profits, other firms will be tempted to enter the market. A gas station with a great location must worry that other gas stations might open across the street or down the road—and perhaps the new gas stations will sell coffee or have a carwash or some other attraction to lure customers. A successful restaurant with a unique barbecue sauce must be concerned that other restaurants will try to copy the sauce or offer their own unique recipes. A laundry detergent with a great reputation for quality must take note that other competitors may seek to build their own reputations.
The entry of other firms into the same general market (like gas, restaurants, or detergent) shifts the demand curve that a monopolistically competitive firm faces. As more firms enter the market, the quantity demanded at a given price for any particular firm will decline, and the firm’s perceived demand curve will shift to the left. As a firm’s perceived demand curve shifts to the left, its marginal revenue curve will shift to the left, too. The shift in marginal revenue will change the profit-maximizing quantity that the firm chooses to produce, since marginal revenue will then equal marginal cost at a lower quantity.
Figure 10.4
(a) shows a situation in which a monopolistic competitor was earning a profit with its original perceived demand curve (D0). The intersection of the marginal revenue curve (MR0) and marginal cost curve (MC) occurs at point S, corresponding to quantity Q0, which is associated on the demand curve at point T with price P0. The combination of price P0 and quantity Q0 lies above the average cost curve, which shows that the firm is earning positive economic profits.
Figure 10.4 Monopolistic Competition, Entry, and Exit (a) At P0 and Q0, the monopolistically competitive firm in this figure is making a positive economic profit. This is clear because if you follow the dotted line above Q0, you can see that price is above average cost. Positive economic profits attract competing firms to the industry, driving the original firm’s demand down to D1. At the new equilibrium quantity (P1, Q1), the original firm is earning zero economic profits, and entry into the industry ceases. In (b) the opposite occurs. At P0 and Q0, the firm is losing money. If you follow the dotted line above Q0, you can see that average cost is above price. Losses induce firms to leave the industry. When they do, demand for the original firm rises to D1, where once again the firm is earning zero economic profit.
Unlike a monopoly, with its high barriers to entry, a monopolistically competitive firm with positive economic profits will attract competition. When another competitor enters the market, the original firm’s perceived demand curve shifts to the left, from D0 to D1, and the associated marginal revenue curve shifts from MR0 to MR1. The new profit-maximizing output is Q1, because the intersection of the MR1 and MC now occurs at point U. Moving vertically up from that quantity on the new demand curve, the optimal price is at P1.
As long as the firm is earning positive economic profits, new competitors will continue to enter the market, reducing the original firm’s demand and marginal revenue curves. The long-run equilibrium is in the figure at point Y, where the firm’s perceived demand curve touches the average cost curve. When price is equal to average cost, economic profits are zero. Thus, although a monopolistically competitive firm may earn positive economic profits in the short term, the process of new entry will drive down economic profits to zero in the long run. Remember that zero economic profit is not equivalent to zero accounting profit. A zero economic profit means the firm’s accounting profit is equal to what its resources could earn in their next best use.
Figure 10.4
(b) shows the reverse situation, where a monopolistically competitive firm is originally losing money. The adjustment to long-run equilibrium is analogous to the previous example. The economic losses lead to firms exiting, which will result in increased demand for this particular firm, and consequently lower losses. Firms exit up to the point where there are no more losses in this market, for example when the demand curve touches the average cost curve, as in point Z.
Monopolistic competitors can make an economic profit or loss in the short run, but in the long run, entry and exit will drive these firms toward a zero economic profit outcome. However, the zero economic profit outcome in monopolistic competition looks different from the zero economic profit outcome in perfect competition in several ways relating both to efficiency and to variety in the market.
Monopolistic Competition and Efficiency
The long-term result of entry and exit in a perfectly competitive market is that all firms end up selling at the price level determined by the lowest point on the average cost curve. This outcome is why perfect competition displays productive efficiency: goods are produced at the lowest possible average cost. However, in monopolistic competition, the end result of entry and exit is that firms end up with a price that lies on the downward-sloping portion of the average cost curve, not at the very bottom of the AC curve. Thus, monopolistic competition will not be productively efficient.
In a perfectly competitive market, each firm produces at a quantity where price is set equal to marginal cost, both in the short and long run. This outcome is why perfect competition displays allocative efficiency: the social benefits of additional production, as measured by the marginal benefit, which is the same as the price, equal the marginal costs to society of that production. In a monopolistically competitive market, the rule for maximizing profit is to set MR = MC—and price is higher than marginal revenue, not equal to it because the demand curve is downward sloping. When P > MC, which is the outcome in a monopolistically competitive market, the benefits to society of providing additional quantity, as measured by the price that people are willing to pay, exceed the marginal costs to society of producing those units. A monopolistically competitive firm does not produce more, which means that society loses the net benefit of those extra units. This is the same argument we made about monopoly, but in this case the allocative inefficiency will be smaller. Thus, a monopolistically competitive industry will produce a lower quantity of a good and charge a higher price for it than would a perfectly competitive industry. See the following Clear It Up feature for more detail on the impact of demand shifts.
CLEAR IT UP
Why does a shift in perceived demand cause a shift in marginal revenue?
We use the combinations of price and quantity at each point on a firm’s perceived demand curve to calculate total revenue for each combination of price and quantity. We then use this information on total revenue to calculate marginal revenue, which is the change in total revenue divided by the change in quantity. A change in perceived demand will change total revenue at every quantity of output and in turn, the change in total revenue will shift marginal revenue at each quantity of output. Thus, when entry occurs in a monopolistically competitive industry, the perceived demand curve for each firm will shift to the left, because a smaller quantity will be demanded at any given price. Another way of interpreting this shift in demand is to notice that, for each quantity sold, the firm will charge a lower price. Consequently, the marginal revenue will be lower for each quantity sold—and the marginal revenue curve will shift to the left as well. Conversely, exit causes the perceived demand curve for a monopolistically competitive firm to shift to the right and the corresponding marginal revenue curve to shift right, too.
A monopolistically competitive industry does not display productive or allocative efficiency in either the short run, when firms are making economic profits and losses, nor in the long run, when firms are earning zero profits.
The Benefits of Variety and Product Differentiation
Even though monopolistic competition does not provide productive efficiency or allocative efficiency, it does have benefits of its own. Product differentiation is based on variety and innovation. Most people would prefer to live in an economy with many kinds of clothes, foods, and car styles; not in a world of perfect competition where everyone will always wear blue jeans and white shirts, eat only spaghetti with plain red sauce, and drive an identical model of car. Most people would prefer to live in an economy where firms are struggling to figure out ways of attracting customers by methods like friendlier service, free delivery, guarantees of quality, variations on existing products, and a better shopping experience.
Economists have struggled, with only partial success, to address the question of whether a market-oriented economy produces the optimal amount of variety. Critics of market-oriented economies argue that society does not really need dozens of different athletic shoes or breakfast cereals or automobiles. They argue that much of the cost of creating such a high degree of product differentiation, and then of advertising and marketing this differentiation, is socially wasteful—that is, most people would be just as happy with a smaller range of differentiated products produced and sold at a lower price. Defenders of a market-oriented economy respond that if people do not want to buy differentiated products or highly advertised brand names, no one is forcing them to do so. Moreover, they argue that consumers benefit substantially when firms seek short-term profits by providing differentiated products. This controversy may never be fully resolved, in part because deciding on the optimal amount of variety is very difficult, and in part because the two sides often place different values on what variety means for consumers. Read the following Clear It Up feature for a discussion on the role that advertising plays in monopolistic competition.
CLEAR IT UP
How does advertising impact monopolistic competition?
The U.S. economy spent about $180.12 billion on advertising in 2014, according to eMarketer.com. Roughly one third of this was television advertising, and another third was divided roughly equally between internet, newspapers, and radio. The remaining third was divided between direct mail, magazines, telephone directory yellow pages, and billboards. Mobile devices are increasing the opportunities for advertisers.
Advertising is all about explaining to people, or making people believe, that the products of one firm are differentiated from another firm’s products. In the framework of monopolistic competition, there are two ways to conceive of how advertising works: either advertising causes a firm’s perceived demand curve to become more inelastic (that is, it causes the perceived demand curve to become steeper); or advertising causes demand for the firm’s product to increase (that is, it causes the firm’s perceived demand curve to shift to the right). In either case, a successful advertising campaign may allow a firm to sell either a greater quantity or to charge a higher price, or both, and thus increase its profits.
However, economists and business owners have also long suspected that much of the advertising may only offset other advertising. Economist A. C. Pigou wrote the following back in 1920 in his book, The Economics of Welfare:
It may happen that expenditures on advertisement made by competing monopolists [that is, what we now call monopolistic competitors] will simply neutralise one another, and leave the industrial position exactly as it would have been if neither had expended anything. For, clearly, if each of two rivals makes equal efforts to attract the favour of the public away from the other, the total result is the same as it would have been if neither had made any effort at all.
Learning Objectives
By the end of this section, you will be able to:
· Explain why and how oligopolies exist
· Contrast collusion and competition
· Interpret and analyze the prisoner’s dilemma diagram
· Evaluate the tradeoffs of imperfect competition
Many purchases that individuals make at the retail level are produced in markets that are neither perfectly competitive, monopolies, nor monopolistically competitive. Rather, they are oligopolies. Oligopoly arises when a small number of large firms have all or most of the sales in an industry. Examples of oligopoly abound and include the auto industry, cable television, and commercial air travel. Oligopolistic firms are like cats in a bag. They can either scratch each other to pieces or cuddle up and get comfortable with one another. If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit. We typically characterize oligopolies by mutual interdependence where various decisions such as output, price, and advertising depend on other firm(s)’ decisions. Analyzing the choices of oligopolistic firms about pricing and quantity produced involves considering the pros and cons of competition versus collusion at a given point in time.
Why Do Oligopolies Exist?
A combination of the barriers to entry that create monopolies and the product differentiation that characterizes monopolistic competition can create the setting for an oligopoly. For example, when a government grants a patent for an invention to one firm, it may create a monopoly. When the government grants patents to, for example, three different pharmaceutical companies that each has its own drug for reducing high blood pressure, those three firms may become an oligopoly.
Similarly, a natural monopoly will arise when the quantity demanded in a market is only large enough for a single firm to operate at the minimum of the long-run average cost curve. In such a setting, the market has room for only one firm, because no smaller firm can operate at a low enough average cost to compete, and no larger firm could sell what it produced given the quantity demanded in the market.
Quantity demanded in the market may also be two or three times the quantity needed to produce at the minimum of the average cost curve—which means that the market would have room for only two or three oligopoly firms (and they need not produce differentiated products). Again, smaller firms would have higher average costs and be unable to compete, while additional large firms would produce such a high quantity that they would not be able to sell it at a profitable price. This combination of economies of scale and market demand creates the barrier to entry, which led to the Boeing-Airbus oligopoly (also called a duopoly) for large passenger aircraft.
The product differentiation at the heart of monopolistic competition can also play a role in creating oligopoly. For example, firms may need to reach a certain minimum size before they are able to spend enough on advertising and marketing to create a recognizable brand name. The problem in competing with, say, Coca-Cola or Pepsi is not that producing fizzy drinks is technologically difficult, but rather that creating a brand name and marketing effort to equal Coke or Pepsi is an enormous task.
Collusion or Competition?
When oligopoly firms in a certain market decide what quantity to produce and what price to charge, they face a temptation to act as if they were a monopoly. By acting together, oligopolistic firms can hold down industry output, charge a higher price, and divide the profit among themselves. When firms act together in this way to reduce output and keep prices high, it is called collusion. A group of firms that have a formal agreement to collude to produce the monopoly output and sell at the monopoly price is called a cartel. See the following Clear It Up feature for a more in-depth analysis of the difference between the two.
CLEAR IT UP
Collusion versus cartels: How to differentiate
In the United States, as well as many other countries, it is illegal for firms to collude since collusion is anti-competitive behavior, which is a violation of antitrust law. Both the Antitrust Division of the Justice Department and the Federal Trade Commission have responsibilities for preventing collusion in the United States.
The problem of enforcement is finding hard evidence of collusion. Cartels are formal agreements to collude. Because cartel agreements provide evidence of collusion, they are rare in the United States. Instead, most collusion is tacit, where firms implicitly reach an understanding that competition is bad for profits.
Economists have understood for a long time the desire of businesses to avoid competing so that they can instead raise the prices that they charge and earn higher profits. Adam Smith wrote in Wealth of Nations in 1776: “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”
Even when oligopolists recognize that they would benefit as a group by acting like a monopoly, each individual oligopoly faces a private temptation to produce just a slightly higher quantity and earn slightly higher profit—while still counting on the other oligopolists to hold down their production and keep prices high. If at least some oligopolists give in to this temptation and start producing more, then the market price will fall. A small handful of oligopoly firms may end up competing so fiercely that they all find themselves earning zero economic profits—as if they were perfect competitors.
The Prisoner’s Dilemma
Because of the complexity of oligopoly, which is the result of mutual interdependence among firms, there is no single, generally-accepted theory of how oligopolies behave, in the same way that we have theories for all the other market structures. Instead, economists use game theory, a branch of mathematics that analyzes situations in which players must make decisions and then receive payoffs based on what other players decide to do. Game theory has found widespread applications in the social sciences, as well as in business, law, and military strategy.
The prisoner’s dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner’s dilemma goes like this:
Two co-conspiratorial criminals are arrested. When they are taken to the police station, they refuse to say anything and are put in separate interrogation rooms. Eventually, a police officer enters the room where Prisoner A is being held and says: “You know what? Your partner in the other room is confessing. Your partner is going to get a light prison sentence of just one year, and because you’re remaining silent, the judge is going to stick you with eight years in prison. Why don’t you get smart? If you confess, too, we’ll cut your jail time down to five years, and your partner will get five years, also.” Over in the next room, another police officer is giving exactly the same speech to Prisoner B. What the police officers do not say is that if both prisoners remain silent, the evidence against them is not especially strong, and the prisoners will end up with only two years in jail each.
The game theory situation facing the two prisoners is in
Table 10.2
. To understand the dilemma, first consider the choices from Prisoner A’s point of view. If A believes that B will confess, then A should confess, too, so as to not get stuck with the eight years in prison. However, if A believes that B will not confess, then A will be tempted to act selfishly and confess, so as to serve only one year. The key point is that A has an incentive to confess regardless of what choice B makes! B faces the same set of choices, and thus will have an incentive to confess regardless of what choice A makes. To confess is called the dominant strategy. It is the strategy an individual (or firm) will pursue regardless of the other individual’s (or firm’s) decision. The result is that if prisoners pursue their own self-interest, both are likely to confess, and end up doing a total of 10 years of jail time between them.
Prisoner B
Remain Silent (cooperate with other prisoner)
Confess (do not cooperate with other prisoner)
Prisoner A
Remain Silent (cooperate with other prisoner)
A gets 2 years, B gets 2 years
A gets 8 years, B gets 1 year
Confess (do not cooperate with other prisoner)
A gets 1 year, B gets 8 years
A gets 5 years B gets 5 years
Table10.2 The Prisoner’s Dilemma Problem
The game is called a dilemma because if the two prisoners had cooperated by both remaining silent, they would only have had to serve a total of four years of jail time between them. If the two prisoners can work out some way of cooperating so that neither one will confess, they will both be better off than if they each follow their own individual self-interest, which in this case leads straight into longer jail terms.
The Oligopoly Version of the Prisoner’s Dilemma
The members of an oligopoly can face a prisoner’s dilemma, also. If each of the oligopolists cooperates in holding down output, then high monopoly profits are possible. Each oligopolist, however, must worry that while it is holding down output, other firms are taking advantage of the high price by raising output and earning higher profits.
Table 10.3
shows the prisoner’s dilemma for a two-firm oligopoly—known as a duopoly. If Firms A and B both agree to hold down output, they are acting together as a monopoly and will each earn $1,000 in profits. However, both firms’ dominant strategy is to increase output, in which case each will earn $400 in profits.
Firm B
Hold Down Output (cooperate with other firm)
Increase Output (do not cooperate with other firm)
Firm A
Hold Down Output (cooperate with other firm)
A gets $1,000, B gets $1,000
A gets $200, B gets $1,500
Increase Output (do not cooperate with other firm)
A gets $1,500, B gets $200
A gets $400, B gets $400
Table10.3 A Prisoner’s Dilemma for Oligopolists
Can the two firms trust each other? Consider the situation of Firm A:
· If A thinks that B will cheat on their agreement and increase output, then A will increase output, too, because for A the profit of $400 when both firms increase output (the bottom right-hand choice in
Table 10.3
) is better than a profit of only $200 if A keeps output low and B raises output (the upper right-hand choice in the table).
· If A thinks that B will cooperate by holding down output, then A may seize the opportunity to earn higher profits by raising output. After all, if B is going to hold down output, then A can earn $1,500 in profits by expanding output (the bottom left-hand choice in the table) compared with only $1,000 by holding down output as well (the upper left-hand choice in the table).
Thus, firm A will reason that it makes sense to expand output if B holds down output and that it also makes sense to expand output if B raises output. Again, B faces a parallel set of decisions that will lead B also to expand output.
The result of this prisoner’s dilemma is often that even though A and B could make the highest combined profits by cooperating in producing a lower level of output and acting like a monopolist, the two firms may well end up in a situation where they each increase output and earn only $400 each in profits. The following Clear It Up feature discusses one cartel scandal in particular.
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What is the Lysine cartel?
Lysine, a $600 million-a-year industry, is an amino acid that farmers use as a feed additive to ensure the proper growth of swine and poultry. The primary U.S. producer of lysine is Archer Daniels Midland (ADM), but several other large European and Japanese firms are also in this market. For a time in the first half of the 1990s, the world’s major lysine producers met together in hotel conference rooms and decided exactly how much each firm would sell and what it would charge. The U.S. Federal Bureau of Investigation (FBI), however, had learned of the cartel and placed wire taps on a number of their phone calls and meetings.
From FBI surveillance tapes, following is a comment that Terry Wilson, president of the corn processing division at ADM, made to the other lysine producers at a 1994 meeting in Mona, Hawaii:
I wanna go back and I wanna say something very simple. If we’re going to trust each other, okay, and if I’m assured that I’m gonna get 67,000 tons by the year’s end, we’re gonna sell it at the prices we agreed to . . . The only thing we need to talk about there because we are gonna get manipulated by these [expletive] buyers—they can be smarter than us if we let them be smarter. . . . They [the customers] are not your friend. They are not my friend. And we gotta have ‘em, but they are not my friends. You are my friend. I wanna be closer to you than I am to any customer. Cause you can make us … money. … And all I wanna tell you again is let’s—let’s put the prices on the board. Let’s all agree that’s what we’re gonna do and then walk out of here and do it.
The price of lysine doubled while the cartel was in effect. Confronted by the FBI tapes, Archer Daniels Midland pled guilty in 1996 and paid a fine of $100 million. A number of top executives, both at ADM and other firms, later paid fines of up to $350,000 and were sentenced to 24–30 months in prison.
In another one of the FBI recordings, the president of Archer Daniels Midland told an executive from another competing firm that ADM had a slogan that, in his words, had “penetrated the whole company.” The company president stated the slogan this way: “Our competitors are our friends. Our customers are the enemy.” That slogan could stand as the motto of cartels everywhere.
How to Enforce Cooperation
How can parties who find themselves in a prisoner’s dilemma situation avoid the undesired outcome and cooperate with each other? The way out of a prisoner’s dilemma is to find a way to penalize those who do not cooperate.
Perhaps the easiest approach for colluding oligopolists, as you might imagine, would be to sign a contract with each other that they will hold output low and keep prices high. If a group of U.S. companies signed such a contract, however, it would be illegal. Certain international organizations, like the nations that are members of the Organization of Petroleum Exporting Countries (OPEC), have signed international agreements to act like a monopoly, hold down output, and keep prices high so that all of the countries can make high profits from oil exports. Such agreements, however, because they fall in a gray area of international law, are not legally enforceable. If Nigeria, for example, decides to start cutting prices and selling more oil, Saudi Arabia cannot sue Nigeria in court and force it to stop.
LINK IT UP
Visit the Organization of the Petroleum Exporting Countries
website
and learn more about its history and how it defines itself.
Because oligopolists cannot sign a legally enforceable contract to act like a monopoly, the firms may instead keep close tabs on what other firms are producing and charging. Alternatively, oligopolists may choose to act in a way that generates pressure on each firm to stick to its agreed quantity of output.
One example of the pressure these firms can exert on one another is the kinked demand curve, in which competing oligopoly firms commit to match price cuts, but not price increases.
Figure 10.5
shows this situation. Say that an oligopoly airline has agreed with the rest of a cartel to provide a quantity of 10,000 seats on the New York to Los Angeles route, at a price of $500. This choice defines the kink in the firm’s perceived demand curve. The reason that the firm faces a kink in its demand curve is because of how the other oligopolists react to changes in the firm’s price. If the oligopoly decides to produce more and cut its price, the other members of the cartel will immediately match any price cuts—and therefore, a lower price brings very little increase in quantity sold.
If one firm cuts its price to $300, it will be able to sell only 11,000 seats. However, if the airline seeks to raise prices, the other oligopolists will not raise their prices, and so the firm that raised prices will lose a considerable share of sales. For example, if the firm raises its price to $550, its sales drop to 5,000 seats sold. Thus, if oligopolists always match price cuts by other firms in the cartel, but do not match price increases, then none of the oligopolists will have a strong incentive to change prices, since the potential gains are minimal. This strategy can work like a silent form of cooperation, in which the cartel successfully manages to hold down output, increase price, and share a monopoly level of profits even without any legally enforceable agreement.
Figure 10.5 A Kinked Demand Curve Consider a member firm in an oligopoly cartel that is supposed to produce a quantity of 10,000 and sell at a price of $500. The other members of the cartel can encourage this firm to honor its commitments by acting so that the firm faces a kinked demand curve. If the oligopolist attempts to expand output and reduce price slightly, other firms also cut prices immediately—so if the firm expands output to 11,000, the price per unit falls dramatically, to $300. On the other side, if the oligopoly attempts to raise its price, other firms will not do so, so if the firm raises its price to $550, its sales decline sharply to 5,000. Thus, the members of a cartel can discipline each other to stick to the pre-agreed levels of quantity and price through a strategy of matching all price cuts but not matching any price increases.
Many real-world oligopolies, prodded by economic changes, legal and political pressures, and the egos of their top executives, go through episodes of cooperation and competition. If oligopolies could sustain cooperation with each other on output and pricing, they could earn profits as if they were a single monopoly. However, each firm in an oligopoly has an incentive to produce more and grab a bigger share of the overall market; when firms start behaving in this way, the market outcome in terms of prices and quantity can be similar to that of a highly competitive market.
Tradeoffs of Imperfect Competition
Monopolistic competition is probably the single most common market structure in the U.S. economy. It provides powerful incentives for innovation, as firms seek to earn profits in the short run, while entry assures that firms do not earn economic profits in the long run. However, monopolistically competitive firms do not produce at the lowest point on their average cost curves. In addition, the endless search to impress consumers through product differentiation may lead to excessive social expenses on advertising and marketing.
Oligopoly is probably the second most common market structure. When oligopolies result from patented innovations or from taking advantage of economies of scale to produce at low average cost, they may provide considerable benefit to consumers. Oligopolies are often buffered by significant barriers to entry, which enable the oligopolists to earn sustained profits over long periods of time. Oligopolists also do not typically produce at the minimum of their average cost curves. When they lack vibrant competition, they may lack incentives to provide innovative products and high-quality service.
The task of public policy with regard to competition is to sort through these multiple realities, attempting to encourage behavior that is beneficial to the broader society and to discourage behavior that only adds to the profits of a few large companies, with no corresponding benefit to consumers.
Monopoly and Antitrust Policy
discusses the delicate judgments that go into this task.
BRING IT HOME
The Temptation to Defy the Law
Oligopolistic firms have been called “cats in a bag,” as this chapter mentioned. The French detergent makers chose to “cozy up” with each other. The result? An uneasy and tenuous relationship. When the Wall Street Journal reported on the matter, it wrote: “According to a statement a Henkel manager made to the [French anti-trust] commission, the detergent makers wanted ‘to limit the intensity of the competition between them and clean up the market.’ Nevertheless, by the early 1990s, a price war had broken out among them.” During the soap executives’ meetings, sometimes lasting more than four hours, the companies established complex pricing structures. “One [soap] executive recalled ‘chaotic’ meetings as each side tried to work out how the other had bent the rules.” Like many cartels, the soap cartel disintegrated due to the very strong temptation for each member to maximize its own individual profits.
How did this soap opera end? After an investigation, French antitrust authorities fined Colgate-Palmolive, Henkel, and Proctor & Gamble a total of €361 million ($484 million). A similar fate befell the icemakers. Bagged ice is a commodity, a perfect substitute, generally sold in 7- or 22-pound bags. No one cares what label is on the bag. By agreeing to carve up the ice market, control broad geographic swaths of territory, and set prices, the icemakers moved from perfect competition to a monopoly model. After the agreements, each firm was the sole supplier of bagged ice to a region. There were profits in both the long run and the short run. According to the courts: “These companies illegally conspired to manipulate the marketplace.” Fines totaled about $600,000—a steep fine considering a bag of ice sells for under $3 in most parts of the United States.
Even though it is illegal in many parts of the world for firms to set prices and carve up a market, the temptation to earn higher profits makes it extremely tempting to defy the law.
cartel
a group of firms that collude to produce the monopoly output and sell at the monopoly price
collusion
when firms act together to reduce output and keep prices high
differentiated product
a product that consumers perceive as distinctive in some way
duopoly
an oligopoly with only two firms
game theory
a branch of mathematics that economists use to analyze situations in which players must make decisions and then receive payoffs based on what decisions the other players make
imperfectly competitive
firms and organizations that fall between the extremes of monopoly and perfect competition
kinked demand curve
a perceived demand curve that arises when competing oligopoly firms commit to match price cuts, but not price increases
monopolistic competition
many firms competing to sell similar but differentiated products
oligopoly
when a few large firms have all or most of the sales in an industry
prisoner’s dilemma
a game in which the gains from cooperation are larger than the rewards from pursuing self-interest
product differentiation
any action that firms do to make consumers think their products are different from their competitors’
10.1 Monopolistic Competition
Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the firm sells the product, intangible aspects of the product, and perceptions of the product.
The perceived demand curve for a monopolistically competitive firm is downward-sloping, which shows that it is a price maker and chooses a combination of price and quantity. However, the perceived demand curve for a monopolistic competitor is more elastic than the perceived demand curve for a monopolist, because the monopolistic competitor has direct competition, unlike the pure monopolist. A profit-maximizing monopolistic competitor will seek out the quantity where marginal revenue is equal to marginal cost. The monopolistic competitor will produce that level of output and charge the price that the firm’s demand curve indicates.
If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will experience exit of firms until economic losses are driven up to zero in the long run.
A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve. A monopolistically competitive firm is not allocatively efficient because it does not produce where P = MC, but instead produces where P > MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and to charge a higher price than a perfectly competitive firm.
Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.
10.2 Oligopoly
An oligopoly is a situation where a few firms sell most or all of the goods in a market. Oligopolists earn their highest profits if they can band together as a cartel and act like a monopolist by reducing output and raising price. Since each member of the oligopoly can benefit individually from expanding output, such collusion often breaks down—especially since explicit collusion is illegal.
The prisoner’s dilemma is an example of the application of game theory to analysis of oligopoly. It shows how, in certain situations, all sides can benefit from cooperative behavior rather than self-interested behavior. However, the challenge for the parties is to find ways to encourage cooperative behavior.
.
Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product. How will that affect the price it charges and the quantity it supplies?
2
.
Continuing with the scenario in question 1, in the long run, the positive economic profits that the monopolistic competitor earns will attract a response either from existing firms in the industry or firms outside. As those firms capture the original firm’s profit, what will happen to the original firm’s profit-maximizing price and output levels?
3
.
Consider the curve in the figure below, which shows the market demand, marginal cost, and marginal revenue curve for firms in an oligopolistic industry. In this example, we assume firms have zero fixed costs.
Figure 10.6
a. Suppose the firms collude to form a cartel. What price will the cartel charge? What quantity will the cartel supply? How much profit will the cartel earn?
b. Suppose now that the cartel breaks up and the oligopolistic firms compete as vigorously as possible by cutting the price and increasing sales. What will be the industry quantity and price? What will be the collective profits of all firms in the industry?
c. Compare the equilibrium price, quantity, and profit for the cartel and cutthroat competition outcomes.
4
.
Sometimes oligopolies in the same industry are very different in size. Suppose we have a duopoly where one firm (Firm A) is large and the other firm (Firm B) is small, as the prisoner’s dilemma box in
Table 10.4
shows.
Firm B colludes with Firm A
Firm B cheats by selling more output
Firm A colludes with Firm B
A gets $1,000, B gets $100
A gets $800, B gets $200
Firm A cheats by selling more output
A gets $1,050, B gets $50
A gets $500, B gets $20
Table10.4
Assuming that both firms know the payoffs, what is the likely outcome in this case?
.
What is the relationship between product differentiation and monopolistic competition?
6.
How is the perceived demand curve for a monopolistically competitive firm different from the perceived demand curve for a monopoly or a perfectly competitive firm?
7.
How does a monopolistic competitor choose its profit-maximizing quantity of output and price?
8.
How can a monopolistic competitor tell whether the price it is charging will cause the firm to earn profits or experience losses?
9.
If the firms in a monopolistically competitive market are earning economic profits or losses in the short run, would you expect them to continue doing so in the long run? Why?
10.
Is a monopolistically competitive firm productively efficient? Is it allocatively efficient? Why or why not?
11.
Will the firms in an oligopoly act more like a monopoly or more like competitors? Briefly explain.
12.
Does each individual in a prisoner’s dilemma benefit more from cooperation or from pursuing self-interest? Explain briefly.
13.
What stops oligopolists from acting together as a monopolist and earning the highest possible level
14.
Aside from advertising, how can monopolistically competitive firms increase demand for their products?
15.
Make a case for why monopolistically competitive industries never reach long-run equilibrium.
16.
Would you rather have efficiency or variety? That is, one opportunity cost of the variety of products we have is that each product costs more per unit than if there were only one kind of product of a given type, like shoes. Perhaps a better question is, “What is the right amount of variety? Can there be too many varieties of shoes, for example?”
17.
Would you expect the kinked demand curve to be more extreme (like a right angle) or less extreme (like a normal demand curve) if each firm in the cartel produces a near-identical product like OPEC and petroleum? What if each firm produces a somewhat different product? Explain your reasoning.
18.
When OPEC raised the price of oil dramatically in the mid-1970s, experts said it was unlikely that the cartel could stay together over the long term—that the incentives for individual members to cheat would become too strong. More than forty years later, OPEC still exists. Why do you think OPEC has been able to beat the odds and continue to collude? Hint: You may wish to consider non-economic reasons.
19.
Andrea’s Day Spa began to offer a relaxing aromatherapy treatment. The firm asks you how much to charge to maximize profits. The first two columns in
Table 10.5
provide the price and quantity for the demand curve for treatments. The third column shows its total costs. For each level of output, calculate total revenue, marginal revenue, average cost, and marginal cost. What is the profit-maximizing level of output for the treatments and how much will the firm earn in profits?
Price
Quantity
TC
$25.00
0
$130
$24.00
10
$275
$23.00
20
$435
$22.50
30
$610
$22.00
40
$800
$21.60
50
$1,005
$21.20
60
$1,225
Table10.5
20.
Mary and Raj are the only two growers who provide organically grown corn to a local grocery store. They know that if they cooperated and produced less corn, they could raise the price of the corn. If they work independently, they will each earn $100. If they decide to work together and both lower their output, they can each earn $150. If one person lowers output and the other does not, the person who lowers output will earn $0 and the other person will capture the entire market and will earn $200.
Table 10.6
represents the choices available to Mary and Raj. What is the best choice for Raj if he is sure that Mary will cooperate? If Mary thinks Raj will cheat, what should Mary do and why? What is the prisoner’s dilemma result? What is the preferred choice if they could ensure cooperation? A = Work independently; B = Cooperate and Lower Output. (Each results entry lists Raj’s earnings first, and Mary’s earnings second.)
Mary
A
B
Raj
A
($100, $100)
($200, $0)
B
($0, $200)
($150, $150)
Table10.6
21.
Jane and Bill are apprehended for a bank robbery. They are taken into separate rooms and questioned by the police about their involvement in the crime. The police tell them each that if they confess and turn the other person in, they will receive a lighter sentence. If they both confess, they will be each be sentenced to 30 years. If neither confesses, they will each receive a 20-year sentence. If only one confesses, the confessor will receive 15 years and the one who stayed silent will receive 35 years.
Table 10.7
below represents the choices available to Jane and Bill. If Jane trusts Bill to stay silent, what should she do? If Jane thinks that Bill will confess, what should she do? Does Jane have a dominant strategy? Does Bill have a dominant strategy? A = Confess; B = Stay Silent. (Each results entry lists Jane’s sentence first (in years), and Bill’s sentence second.)
Jane
A
B
Bill
A
(30, 30)
(15, 35)
B
(35, 15)
(20, 20)
Table10.7
Figure 11.1 Oligopoly versus Competitors in the Marketplace Large corporations, such as the natural gas producer Kinder Morgan, can bring economies of scale to the marketplace. Will that benefit consumers, or is more competition better? (Credit: modification of work by Derrick Coetzee/Flickr Creative Commons)
CHAPTER OBJECTIVES
In this chapter, you will learn about:
· Corporate Mergers
· Regulating Anticompetitive Behavior
· Regulating Natural Monopolies
· The Great Deregulation Experiment
BRING IT HOME
More than Cooking, Heating, and Cooling
If you live in the United States, there is a slightly better than 50–50 chance your home is heated and cooled using natural gas. You may even use natural gas for cooking. However, those uses are not the primary uses of natural gas in the U.S. In 2016, according to the U.S. Energy Information Administration, home heating, cooling, and cooking accounted for just 16% of natural gas usage. What accounts for the rest? The greatest uses for natural gas are the generation of electric power (36%) and in industry (28%). Together these three uses for natural gas touch many areas of our lives, so why would there be any opposition to a merger of two natural gas firms? After all, a merger could mean increased efficiencies and reduced costs to people like you and me.
In October 2011, Kinder Morgan and El Paso Corporation, two natural gas firms, announced they were merging. The announcement stated the combined firm would link “nearly every major production region with markets,” cut costs by “eliminating duplication in pipelines and other assets,” and that “the savings could be passed on to consumers.”
The objection? The $21.1 billion deal would give Kinder Morgan control of more than 80,000 miles of pipeline, making the new firm the third largest energy producer in North America. Policymakers and the public wondered whether the new conglomerate really would pass on cost savings to consumers, or would the merger give Kinder Morgan a strong oligopoly position in the natural gas marketplace?
That brings us to the central questions this chapter poses: What should the balance be between corporate size and a larger number of competitors in a marketplace, and what role should the government play in this balancing act?
The previous chapters on the theory of the firm identified three important lessons: First, that competition, by providing consumers with lower prices and a variety of innovative products, is a good thing; second, that large-scale production can dramatically lower average costs; and third, that markets in the real world are rarely perfectly competitive. As a consequence, government policymakers must determine how much to intervene to balance the potential benefits of large-scale production against the potential loss of competition that can occur when businesses grow in size, especially through mergers.
For example, in 2006, AT&T and BellSouth proposed a merger. At the time, there were very few mobile phone service providers. Both the Justice Department and the FCC blocked the proposal.
The two companies argued that the merger would benefit consumers, who would be able to purchase better telecommunications services at a cheaper price because the newly created firm would take advantage of economies of scale and eliminate duplicate investments. However, a number of activist groups like the Consumer Federation of America and Public Knowledge expressed fears that the merger would reduce competition and lead to higher prices for consumers for decades to come. In December 2006, the federal government allowed the merger to proceed. By 2009, the new post-merger AT&T was the eighth largest company by revenues in the United States, and by that measure the largest telecommunications company in the world. Economists have spent – and will still spend – years trying to determine whether the merger of AT&T and BellSouth, as well as other smaller mergers of telecommunications companies at about this same time, helped consumers, hurt them, or did not make much difference.
This chapter discusses public policy issues about competition. How can economists and governments determine when mergers of large companies like AT&T and BellSouth should be allowed and when they should be blocked? The government also plays a role in policing anticompetitive behavior other than mergers, like prohibiting certain kinds of contracts that might restrict competition. In the case of natural monopoly, however, trying to preserve competition probably will not work very well, and so government will often resort to regulation of price and/or quantity of output. In recent decades, there has been a global trend toward less government intervention in the price and output decisions of businesses.
Chapter
2
Demand and Supply
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All businesses perform essentially the same function—producing goods or services for sale in the market. Unfortunately, many businesses fail because managers sweat the day-to-day details while losing sight of the firm’s primary objective—maximizing shareholder value. A manager who becomes mired in the firm’s operational minutia and ignores market trends courts financial disaster.
In this chapter, we will examine how the interaction of buyers and sellers in competitive markets determine prices and availability of goods or services. The market mechanism discussed in this chapter makes several simplify-ing assumptions. We begin by assuming that the market consists of a large number of relatively small buyers and sellers with complete and symmetrical information. Since their respective contributions are very small, the decisions made by individual buyers or sellers have no effect on the market-determined price. In other words, individual buyers and sellers are said to be price takers.
DEMAND
A market is any arrangement that brings together buyers and sellers. The market demand curve is the horizontal summation of individual consum-ers’ demand curves.1 According to the law of demand, which pertains to market (not individual) demand, the quantity demanded of a good or service is inversely related to its price,
ceteris paribus
. This relationship is depicted as the downward-sloping demand curve in Figure 2.1. A decline in the market price of good x from P1 to P2, for example, results in an increase in quan-tity demanded from Q1 to Q2. This relationship is described as a movement along a stationary demand curve from point A to point B. At a basic level,
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Chapter 2
Figure 2.1
the law of demand can be justified on the basis of common sense and simple observation.
Income
and Substitution Effects
At a more subtle level, the law of demand reflects the income and substitu-tion effects of a buyer’s purchasing decisions. The income effect says that as a product’s price declines, a buyer’s real purchasing power increases. By contrast, an increase in prices reduces a buyer’s real income and purchasing power. We will have more to say about the relationship between changes in income and demand in the next section.
The substitution effect says that when there is no change in real purchas-ing power, an increase in the price of a good will cause buyers to unambigu-ously shift their purchases into a relatively less expensive substitutes. The substitution effect reflects changes in a consumer’s opportunity costs from the price change.
The income and substitution effects usually complement and reinforce each other. A price decline, for example, will have both positive income and substitution effects, in which case there is no question that the ordinary demand curve will be downward sloping. In some cases, however, a price decline will result in a negative income effect. Fortunately, the positive sub-stitution effect almost always dominates, which gives the demand curve its expected downward slope.
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Demand and Supply |
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Demand Determinants
In addition to the price of the product, the market demand for a good or ser-vice depends on a variety of other factors, including money income, tastes and preferences, the prices of related goods, the number of consumer, price and income expectations, and so on. Factors other than the price of the good in question are collectively referred to as demand determinants.
Money Income
The most important limitation on a consumer’s ability to purchase a good or service is money income. An increase in consumers’ money income will increase the demand for most goods and services. This is shown in
Figure 2.2
as a right-shift in the market demand curve from D1 to D2. Likewise, in most cases a decrease in money income, such as would occur during an economic downturn, results in fewer purchases and a left-shift of the demand curve (not shown). Such products are referred to as normal goods.
By contrast, the demand for an inferior good varies inversely with con-sumers’ money income. During an economic expansion, rising incomes, sales and profits, the market demand for the services of bankruptcy lawyers and accountants declines. This decline is depicted as a shift to the left of the market demand curve. Conversely, the market demand curve for bankruptcy services will shift to the right during economic downturns. Other types of
Figure 2.2
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24
Chapter 2
inferior goods include the demand for automobile repair services and used cars as consumers postpone purchases of new cars during recessions.
Tastes and Preferences
Changes in consumer tastes will also shift the market demand curve. Although changes in fads and fashions can be difficult to predict, there is an entire industry devoted to manipulating consumer tastes and preferences— marketing, but especially advertising. Advertising is generally of two types—informative and persuasive. Informative advertising provides pro-spective consumers with information about new or existing products, such as the seemingly ubiquitous advertisements for the iPad “tablet” during 2010. Persuasive advertising attempts to boost sales by creating an image that may have little or nothing to do with the product’s physical characteristics. Persuasive advertising appeals to consumers’ emotions.
An increase in advertising-inspired purchases is depicted as a right-shift in the market demand curve. If consumers have a negative opinion, the demand curve will shift to the left. In recent years, for example, consum-ers’ concern about the health hazards of smoking has resulted in a dramatic decline in the demand for tobacco products in the United States. Many political candidates are notorious for running negative campaign ads against their opponents.
Prices of Related Goods
Changes in the prices of related goods also affect market demand. Related goods may be substitutes or complements. If two goods are substitutes in consumption, an increase in the price of good y will cause some consum-ers to shift their purchases into relatively less expensive good x. An increase in the price of Coca-Cola, for example, results in a decrease in the quantity demanded for Coca-Cola, but an increase in the demand by many consum-ers for relatively less expensive Pepsi Cola, Dr. Pepper, or fruit juices. Other examples of substitute goods include margarine and butter, coffee and tea, beer and ale, and laptop and tablet computers.
Figure 2.3 illustrates the effect of an increase in the price of good y on the demand for substitute good x. An increase in the price of good y results in a decrease in the quantity demand of good y, which is illustrated as a movement along the D curve from point A to point B. As the quantity demanded of good y falls, the demand for substitute good x increases. This is shown as a right-shift of the demand curve for good x from D1 to D2. Analogously, a decrease in the price of good y leads to an increase in the quantity demanded for good y and a left-shift of the demand curve for good x (not shown).
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Figure 2.3
Goods are complements in consumption if they are consumed together, such as tennis rackets and tennis balls, skis and ski boots, kites and kite string, and computers and software. If goods x and y are complements, a decrease in the price of good y results in an increase in the quantity demanded of good y, and an increase in the demand for good x. The increase in the price of good y results in a decrease in the demand for complementary good x, which shifts the demand curve for good x to the left. Conversely, a decrease in the price of good y results in an increase in the quantity demanded of good y and an increase in the demand for good x, which shifts the demand function for good x to the right.
Sales
Taxes
Sales taxes
also affect the demand for a good or service. A per-unit tax, for example, is a fixed tax (t) per unit purchased. Suppose that the price is $10 and local authorities impose a $1 per-unit sales tax. This effectively raises the price to $11. A consumer who buys 100 units pays $1,100, of which $100 is collected by the government. If the price is $20 and the consumer buys 100 units, the amount going to the vendor doubles, but there is no change in government sales tax revenues.
In general, imposing a per-unit tax increases the price to the buyer to P
+
t. Suppose that the inverse demand equation with the per-unit tax is P + t = a – bQ. After subtracting t from both sides this becomes P = (a – t) – bQ. Increasing a per-unit sales tax lowers the P-intercept, but leaves the slope of the demand equation unchanged. In other words, there is a parallel left-shift of the demand curve. Conversely, removing or reducing the tax results in a parallel right-shift of the demand curve.
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26
Chapter 2
Alternatively, an ad valorem tax (from the Latin “according to value”) is expressed as a percentage (τ) of the purchase price. Suppose that the price is $10 and there is a 10 percent ad valorem tax. A consumer who purchases 100 units at a price of $10 pays (1.1 × $10) × 100 = $1,100, of which $100 is collected by the government. A consumer who purchases 100 units at a price of $20 pays (1.1 × $20) × 100 = $2,200. In this case, the revenues going to the vendor and the government both double.
Imposing an ad valorem tax increases the price to the buyer to (1 + τ)P. In this case, the inverse demand equation becomes (1 + τ)P = a – bQ. After dividing both sides by (1 + τ) this becomes P = a/(1 + τ) – [b/(1 + τ)]Q. Increasing an ad valorem tax not only lowers the P-intercept, but the quantity demanded becomes more sensitive to a price change. In other words, the demand curve shifts to the left and becomes flatter. Reducing an ad valorem tax causes the demand curve to shift to the right and become steeper.
Number of Consumers
The market demand curve for a good or a service is the sum of the demand curves of the individual consumers. Thus, an increase in the number of buy-ers will increase the consumer purchases and shift the market demand curve to the right. The flood of Mexican immigrants since the 1980s, for example, increased the demand for Mexican cuisine in the Southwest. Conversely, economic recession in the Rust Belt lowered demand for real estate, home and auto repair services, and so on. Shifts in the market demand curve also reflect demographic changes, such as the significant increase in demand for health care and other senior citizen services as World War II “baby boomers” enter their retirement years.
Consumer Expectations
A change in consumer expectations regarding market conditions tomorrow can affect the demand for goods and services today. Suppose, for example, that pharmaceutical investors come to believe that a drug company’s stock price is about to fall because of multimillion dollar law suit. To avoid getting caught “holding the bag,” investors will act on those expectations, thereby turning their beliefs into a reality. If prospective new car buyers believe that prices for this year’s models will be lowered in October as dealerships make room for next year’s model, the demand curve for new cars in September will shift to the left.
Summarizing, a change in the quantity demanded for a good or service in response to a change in its price is illustrated as a movement along a station-ary demand curve. A change in demand following a change in something other than price is depicted as a shift in the demand curve. Table 2.1 sum-marizes several of the demand shifts discussed in this section.
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27 |
||||||||||||||||||||||||||
|
Table 2.1 Changes in Demand Determinants |
||||||||||||||||||||||||||
|
Determinant |
Change |
Demand Curve Shift |
||||||||||||||||||||||||
| Income |
↑ |
→ |
||||||||||||||||||||||||
|
Normal goods |
||||||||||||||||||||||||||
|
↓ |
← |
|||||||||||||||||||||||||
|
Inferior goods |
||||||||||||||||||||||||||
|
Tastes and preferences |
||||||||||||||||||||||||||
|
Prices of related goods |
||||||||||||||||||||||||||
|
Substitutes |
||||||||||||||||||||||||||
|
Complements |
||||||||||||||||||||||||||
| Sales taxes | ||||||||||||||||||||||||||
|
Population |
Estimating the Market Demand Equation
The relationships discussed in the preceding sections are of little practical value to managers unless the demand for a firm’s good or service can be quantified. Suppose, for example, that the demand for good x (Qxd) depends on its price (Px), per capita money income (M), and the price of a related good y (Py). Although the precise manner in which these variables are related may never be known with complete certainty, a useful first step is to assume a linear relationship of the form
|
Qd = b |
0 |
+ b P + b |
M |
M + b P . |
(2.1) |
|
x |
x x |
y y |
The hypothesized signs of the parameter values in
Eq. (2.1)
are βx < 0 by the law of demand, βM > 0 if x is normal, βM < 0 if good x is an inferior, βy > 0 if good y is a substitute, and βy < 0 if good y is a complement.
Several statistical techniques are used to derive estimates of the coeffi-cients on the basis of empirical data.2 A statistical estimate of Eq. (2.1) will provide the manager with more precise information about how the company’s unit sales will be affected by changes in each of these hypothesized explana-tory variables. Expanding on ideas presented earlier, rewrite Eq. (2.1) as
|
Qd = B + b P , |
(2.2) |
where B = β0 + βMM + βyPy. Solving for Px we obtain the inverse demand equation
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28
Chapter 2
|
B |
1 | |||
|
Px |
= − |
+ |
Qx . |
(2.3) |
|
b x |
bx |
Suppose an economic recession results in a decline in money income. If x is a normal good (βM > 0), the result is a decline in the value of B and a shift to the left of the demand curve.
Solved Exercise
The estimated demand equation for a popular brand of fruit juice is given by the equation
|
Qx = 10 − 5Px + 0.001M +10Py , |
(2.4) |
where Qx is the per family monthly purchases in gallons, Px is the price per gallon of the fruit drink ($2.00), M is the median annual family income ($20,000), and Py is the price per gallon of a competing brand of fruit juice ($2.50).
a. Interpret the parameter estimates of
Eq. (2.4).
b. What are estimated monthly, per family purchases (sales) of this brand of fruit juice?
c. Rewrite the
Eq. (2.4)
to resemble
Eq. (2.3)
.
d. Suppose that median annual family income increases to $30,000. How does this change your answers to parts b and c?
Solution
a.
A $1 increase in the price of this brand of fruit juice will result in a 5-gallon, per-family decline monthly purchases. A $1,000 increase in median annual family income will result in a 1 gallon increase in per-family, monthly purchases. Since a $1 increase in the price of the compet-ing brand results in a 10-gallon, per-family increase in monthly purchases of this brand, the two brands of fruit juices are substitute goods.
b. Substituting the indicated values into the demand equation yields
|
Qx = 10 − 5( 2) + 0.001( 20,000) +10 ( 2.5) = 45 gallons. |
(2.5) |
c.
Eq. (2.4)
may be rewritten
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29 |
|
|
Q x = 55 − 5Px . |
(2.6) |
d. The new monthly consumption of fruit drink is
|
Qx = 10 − 5( 2) + 0.001( 30,000) +10 ( 2.5) = 55 gallons. |
(2.7) |
At the higher family income,
Eq. (2.6)
becomes
|
Qx = 65 − 5Px . |
(2.8) |
Since the value of the horizontal intercept has increased from 55 to 65, the demand curve for this brand of fruit juice shifts to the right.
Consumer Surplus
A detailed understanding of the market demand for a good or service has several important business applications. In the next chapter, for example, the estimated demand equation will be used to identify the effect of a price change on the firm’s unit sales and total revenues. It can also be used to approximate the value that consumers receive from their purchases of goods and services. In Chapter 11 we will learn how managers can use this to for-mulate pricing strategies that enhance the firm’s bottom line.
Consumer surplus is the value that buyers received from the purchase of a good or service in excess of the amount paid. In order to explain what we mean by this, consider the demand curve depicted in
Figure 2.4,
which illus-trates the number of bottles of Gatorade that Joe will purchase after a game of softball on a hot summer day. Suppose in this thought experiment that Joe lives in a world populated only by truth tellers. After the game, Joe goes to his health club and orders a bottle of Gatorade. The health club does not have a menu of prices. Instead, each patron is asked to pay an amount equal to the value received from each bottle purchased. In keeping with this policy, Joe is asked how much a bottle is worth to him. Being very thirsty, Joe says that a bottle of Gatorade is worth $8, which is the amount that he pays.
After finishing his first bottle, Joe orders another. As before, Joe is asked how much the second bottle is worth to him. Not being as thirsty, Joe responds that he is willing to pay $6, $4 for the third bottle, and so on. If Joe stops after the third bottle, his total expenditures will be $18, which is precisely the value that Joe received from his purchases.
In a “perfect” world, a strategy of charging a price equal to the value of each unit consumed may be practical, but in the real world buyers have an incentive to understate the true value received so as to a lower price. For this
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30
Chapter 2
Figure 2.4
reason, firms typically publish a menu of fixed prices. The buyer knows precisely how much each unit will cost before deciding how many units to purchase. Suppose that a bottle of Gatorade is $4. How many bottles will Joe buy, and how much will he spend?
According to the information provided in Figure 2.4, Joe will certainly purchase the first bottle because the $4 paid is greater than the $8 of value received. Joe will also buy a second bottle since he will receive $2 of value in excess of the price paid. Joe will even buy a third bottle because the amount paid is equal to the value received. Joe will not purchase a fourth bottle, however, since he would lose $2 in value. Joe has spent 3 × $4 = $12 for total value received value of $8 + $6 + $4 = $18. Joe’s consumer surplus of $18 – $12 = $6 is illustrated by the shaded area in
Figure 2.4.
In the above example, we assumed that Joe’s beer purchases were in discrete increments. Now, consider Figure 2.5, which represents the market demand for a good or service. If prices are infinitely divisible, consumer sur-plus is given by the shaded triangle P*AE. At a price of P*, the total value received from purchasing Q* units consumed is given by the area 0P*AEQ*. Total consumer expenditures is given by the area of the rectangle 0P*EQ*. Thus, consumer surplus is 0P*AEQ* – 0P*EQ* = P*AE. For a linear demand equation, consumer surplus can be calculated using the equation
|
CS = |
(A − P* )Q*. |
(2.9) |
| 2 |
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31 |
Figure 2.5
Solved Exercise
Suppose that a consumer’s inverse demand equation is
|
P =20−2Q. |
(2.10) |
a. How many units will be purchased at a price is $6? What are the consum-ers’ total expenditures?
b. Calculate the consumer surplus.
c. How much total value is received by this consumer?
Solution
a. From
Eq. (2.10),
at a price of $6, this consumer will purchase 7 units and spend $6(7) = $42.
b. From Eq. (2.9), consumer surplus is CS = 0.5(20 – 6)7 = $49.
c. The total value received is equal to the amount paid plus the value of con-sumer surplus, which is $42 + $49 = $91.
SUPPLY
According to the law of supply, the quantity supplied of a good or service is directly related to a change in its market price, ceteris paribus. The market
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32
Chapter 2
Figure 2.6
supply curve is the horizontal summation of the supply curves of the indi-vidual firms in an industry. This relationship is depicted in
Figure 2.6.
An increase in the market price of good x from P1 to P2 results in an increase in the quantity supplied from Q1 to Q2. This cause and effect relationship is depicted as a movement along the stationary supply curve from point A to point B. This is because an increase in the price of good x increases firms’ expected revenues and profits from its sale. To exploit these profit opportuni-ties, firms will increase the number of units offered for sale.
Supply Determinants
A change in any factor that affects a firm’s bottom line will change the num-ber of units offered for sale. An increase in the market price will result in an increase in the quantity supplied of a good or service. This is illustrated as a movement along a stationary market supply curve. A change in any other factor that affects the firm’s profit will result in a shift in the market supply curve. These supply determinants include, among other things, input prices, production technology, taxes and government regulation, prices of related goods, and number of firms in the industry.
Input Prices
Other things being equal, a lower input price, such as might occur from a decline in energy prices, will reduce production costs and increase expected
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33 |
profit. Firms will respond by increasing output at each price, which will shift the market supply curve to the right. Conversely, an increase in employee wages and benefits from a new collective bargaining agreement will increase production costs, lower expected profit, and cause the market supply curve to shift to the left (not shown).
Production
Technology
We typically think of a firm’s production technology in terms of the eco-nomic capital (machinery, plant, equipment, and so on) used to inputs into outputs for sale in the market. In fact, production technology can also refer to the process by which managers organize production processes, such as improved inventory control and personnel management. Improved produc-tion technology implies that more output can be produced from given com-bination of inputs, or an unchanged amount of output can be produced using fewer inputs. In the first instance, this suggests an increase in revenues. In the second instance, this means a decrease in production costs. Either way, an improvement in production technology at fixed input and output prices suggests an increase in profits, which provided managers with an incentive to increase supply. This would be depicted as a right-shift of the supply curve.
Taxes and Government Regulation
The objective of the firm is to maximize shareholder value, which is related to after-tax profits. From a manager’s perspective, higher corporate taxes and mandated government regulations increase the firm’s cost of doing business and lower expected after-tax profit. Managers will respond by reducing out-put, causing the market supply curve to shift to the left. Conversely, lowering corporate taxes, receiving government subsidies, and removing costly regula-tions increase expected after-tax profits, encourage production and shift the market supply curve to the right.
Another type that affects industry supply is an excise tax, which is a tax on each unit sold. The difference between an excise tax and a sales tax is that an excise tax is levied on specific goods, whereas a sales tax is a general levy. Another difference is that excise taxes are collected from the supplier—not the consumer.
The manner in which excise taxes affect the supply curve depends on whether it is a per-unit tax or an ad valorem tax. Suppose, for example, that the government levies a $1 per-unit tax on a gallon of gasoline. This has the effect of shifting the supply curve up by the amount of the tax. This upward parallel shift results in a decline in supply. In a similar fashion, a reduction in a per-unit excise tax results in a downward parallel shift of the supply, which results in an increase in supply.
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34
Chapter 2
Alternatively, the government could levy an ad valorem excise tax. Since the amount of the tax is greater at higher prices than at lower prices, the supply curve not shifts up and becomes steeper. As in the case of a per-unit tax, the imposition of the ad valorem excise tax results in a decrease in supply. In an analogous fashion, the supply curve shifts down and becomes flatter following a reduction in an ad valorem excise tax resulting in an increase in supply.
Prices of Related Goods
Changes in the prices of goods sharing the same resources can also affect supply. These related goods are may be substitutes or complements in production. Substitutes in production involve trade-offs in the produc-tion of two or more goods or services using the same production facilities, such as the choice of producing halogen light bulbs or compact fluorescent light (CFL) bulbs on the same assembly line. Other things being equal, an increase in the price of halogen light bulbs will cause managers to devote a greater share of the firm’s production capacity to its production, which reduce the assembly line time available to produce CFL bulbs. Thus, the higher price of halogen bulbs resulted in a decline in the supply of CFL bulbs.
Complements in production involve the joint production of two or more goods with the same production facilities. Cowhide, for example, is a by-product of beef production. An increase in the price of beef will result in an increase in the quantity supplied of beef and an increase in the supply of cowhide, even when there is no change in the price of cowhide leather.
Number of Firms
The market supply curve of a good or service is the sum of the supply curves of each individual firm in an industry. Thus, an increase in the number of firms will cause the market supply curve to shift to the right. In fact, any flow of new investment into the industry, perhaps because of the lure of above-normal profits, will increase market supply. Conversely, when investment flows out of an industry, the market supply curve will shift to the left.
Summary
A change in the quantity supplied of a product following a change in its market price is depicted as a movement along a stationary supply curve. A change in supply following a change in something other than the market price of the product is depicted as a shift in the entire supply curve. Table 2.2 sum-marizes the supply shifts discussed in this section.
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| 35 |
|
Table 2.2 Changes in Supply Determinants |
|
Supply Curve Shift |
|
Input prices |
| Technology |
| Taxes |
|
Number of firms |
Producer Surplus
The analytical supply counterpart to consumer surplus is producer surplus, which is the difference between total revenues received from the sale of a good or service and the minimum needed to produce it. A firm’s supply curve reflects its marginal cost of production. A profit-maximizing firm will produce up to a level of output where marginal cost equals marginal revenue. A firm’s total variable cost is equal to the sum of the marginal cost of produc-ing each unit. Thus, producer surplus is equal to the firm’s operating profit, which is the difference between the firm’s total revenue and expenses relat-ing to a firm’s ongoing operations (total variable cost). This is not the same thing as the firm’s total (economic) profit, which is the difference between total revenue and total (economic) cost. A firm’s total cost is the sum of total variable and total fixed cost. On the other hand, if total fixed cost is “small,” producer surplus is a good approximation of the firm’s total profit.
Producer surplus for continuous prices is illustrated by the area of the shaded triangle in Figure 2.7. If the supply curve is linear, producer surplus equals
|
PS = |
(P* − B)Q*. |
(2.11) |
A firm’s producer surplus can be particularly valuable information for a manager. A profit maximizing firm will produce up to the level of output where marginal cost equals marginal revenue, which is the extra revenue received from the next unit sold. This occurs in Figure 2.7 at the output level Q*. For every unit of output up to the last unit produced, P* = MR > MC. Thus, the shaded area represents the extra revenue received in excess of what the firm would have been willing to produce each unit up to Q*.
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36
Chapter 2
Figure 2.7
Producer surplus tells managers the maximum amount the firm can save by bargaining with resources suppliers over price. For example, suppose that the manager of a construction company is negotiating with a supplier over the price of steel rods. If the manager of the construction company knows the supplier’s producer surplus, he or she also knows the minimum amount that the supplier would be willing to accept for the steel rods.
MARKET EQUILIBRIUM
We will now bring together the forces of demand and supply to explain how market price and output is determined. Figure 2.8 illustrates the con-cept of market equilibrium, which is the price (P*) where the quantity demanded (Qd) equals the quantity supplied (Qs). At prices below the equi-librium price, a shortage exists since the quantity demanded exceeds the quantity supplied. At this low price, consumers compete amongst them-selves to acquire the good or service that is in short supply. As consumers bid up the price, buyers who are unwilling or unable to pay the higher price will exit the market. At the same time, the higher price provides firms to an incentive to increase production. The increase in the quantity supplied coupled with the decrease in the quantity demanded as the price rises continues shortage is eliminated and a higher market-clearing price established.
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37 |
Figure 2.8
At prices above P*, the quantity supplied exceeds the quantity demanded. Managers will respond to the unsold output and a build-up of inventories by lowering price and reducing production to more sustainable levels. This pro-cess will continue until the quantity supplied equals the quantity demand at a lower market-clearing price.
NET SOCIAL WELFARE
Consumer surplus is the value received by consumers from purchases of a product in excess of their expenditures. Producer surplus is the amount received by firms from sales of a product in excess of the minimum amount that they would have accepted to make the product available. The sum of consumer surplus and producer surpluses is referred to as net social welfare, which is depicted in Figure 2.9 for a purely competitive market.
The demand curve is a measure of the marginal social benefit (MSB) of consuming an additional unit. The supply curve measures the marginal social cost (MSC) of increasing output by another unit. As long as MSB > MSC it pays for society to increase output. But, when MSC > MSB it is in society’s best interest to reduce output. Net national welfare is maximized at the level of output where MSB = MSC.
Net social welfare can be used as a measure of market efficiency. The greater the sum of consumer and producer surplus, the more socially beneficial
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38
Chapter 2
Figure 2.9
is the market structure. In this chapter, we have restricted out discussion to purely competitive market structures, which is considered the ideal way to organize commercial activity because it maximizes net social welfare.
|
Suppose that the inverse market demand and supply equations are |
|
|
P = 9 − 2Qd ; |
(2.12) |
|
P = 6 + Qs . |
(2.13) |
|
Calculate the value of net social welfare in this market. |
Solution
Solving
Eqs. (2.12)
and
(2.13),
the market equilibrium price is P* = $7 and the equilibrium quantity is Q* = 1. The value of consumer surplus is CS = 0.5($9 − $7)1 = $1. The value of producer surplus is PS = 0.5($7 − $6) = $0.5. Thus, the value of net social welfare is NSW = CS + PS = $1.50. This solution is depicted in Figure 2.10.
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39 |
Figure 2.10
CHANGES IN DEMAND AND SUPPLY:
PRICE AND OUTPUT DETERMINATION
We will now analyze the effects of a change in demand and supply conditions on the market-clearing price and equilibrium output. We will begin by first considering the effects of a change in market demand.
Demand Shifts
Suppose that medical research determines that eating cheeseburgers is healthy, which results in an increase in the demand for cheeseburgers. Other things being equal, this will cause the cheeseburger demand curve to shift to the right, as depicted in Figure 2.11. In a similar manner, if medical research demon-strates that cheeseburgers are unhealthy, the demand curve will shift to the left.
In general, a right-shift of the demand curve with no change in supply will result in an increase in both the equilibrium price and quantity. Conversely, a left-shift of the demand curve will cause the equilibrium price and quantity to fall.
Supply Shifts
Suppose that a decline in the price of cheese leads fast-food restaurants to expect higher profits from the sale of cheeseburgers. Other things being equal, profit-maximizing cheeseburger producers will increase output, which
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40
Chapter 2
Figure 2.11
causes the supply curve to shift to the right, resulting in a decline in the equi-librium price and quantity. This is depicted in Figure 2.12.
Conversely, an increase in the price of cheese reduces expected profits resulting in a left-shift of the supply curve. This results in an increase in the equilibrium price and a decline in the equilibrium quantity. In general, a right-shift of the supply curve will result in a fall in the equilibrium price and an increase in the equilibrium quantity. Conversely, a left-shift of the supply curve will result in an increase in the equilibrium price and a decrease in the equilibrium quantity.
Demand and Supply Shifts
A shift in either the demand curve or the supply curve will result in an unambiguous change in both the equilibrium price and quantity. These pre-dictable changes are summarized in the second column of Table 2.3. When both demand and supply change simultaneously, however, the effect on the market-clearing price and equilibrium quantity is more difficult to predict. The final outcome depends on how demand and supply change relative to each other. In the absence of such information, all we can say is that there will be an unambiguous change in either the equilibrium price or quantity, but an ambiguous change in the other.
To appreciate the difficulty associated with predicting equilibrium price and quantity changes when demand and supply changes, consider Case 1
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41 |
Figure 2.12
Table 2.3 Changes in Demand and Supply Determinants
|
Case |
Separately |
Together |
|
|
∆D↑ → ∆P↑ and ∆Q↑ |
∆P? (ambiguous) |
||
|
∆S↑ → ∆P↓ and ∆Q↑ |
∆Q↑ (unambiguous) |
||
|
∆P↑(unambiguous) |
|||
|
∆S↓ → ∆P↑ and ∆Q↓ |
∆Q? (ambiguous) |
||
| 3 |
∆D↓ → ∆P↓ and ∆Q↓ |
∆P↓ (unambiguous) |
|
| 4 | |||
|
∆Q↓ (unambiguous) |
in
Table 2.3,
which summarizes the effects of an increase in both demand (∆D↑) and supply (∆S↑). The second column of the table tells us what will happen when demand and supply change separately. An increase in demand alone results in an increase in both the equilibrium price and quantity, which is illustrated in Figure 2.11. An increase in supply alone results in a decrease in the equilibrium price and an increase in the equilibrium quantity, which is depicted in
Figure 2.12.
When demand and supply increase together, how-ever, the analysis becomes a bit more complicated.
As we have seen, an increase in demand and supply both result in an unambiguous increase in the equilibrium quantity. On the other hand, an increase in demand causes the equilibrium price to rise while an increase in
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42
Chapter 2
supply causes the equilibrium price to fall. In the first instance there is upward pressure on price, while in the second instance there is downward pressure on price. In the absence of additional information, it is not possible to know whether the demand-side or supply-side effect dominates, in which case the effect on the equilibrium price is ambiguous.
Solved Exercise
The marketing department of The Great Bombay Tea Company has estimated the weekly demand for its brand of gourmet pizza as
|
Q = 500 −100P + 50I + 20Py + 30A, |
(2.14) |
where Q is the number of pizzas (000’s), P is the market-determined price of Bombay’s pizza, I is weekly per capita income, Py is the price of the brand of pizza sold by Universal Foods, Inc., and A is Bombay’s weekly advertising expenditures ($000’s). The supply equation for Bombay’s gourmet pizza is
Q = 1,800 + 450P.
(2.15)
a. What is the relationship between Bombay’s pizza and Universal’s pizza?
b. Suppose that I = $200, Py = $20 and A = $100. What is the equilibrium price and quantity of Bombay pizza?
c. Suppose that Bombay’s chief economist predicts that the current economic expansion will increase weekly per capita income to $255. What effect will this have on the equilibrium price and quantity?
d. Based on your answer to part c, how would you characterize Bombay’s pizza?
Solution
a. Since a $1 increase in the price of Universal pizza results in a 20 thousand unit weekly increase in Bombay pizza sales, the two brands of pizza are substitutes.
b. Substituting these values into the demand equation yields
|
Q = 13, 900 −100P. |
(2.16) |
The equilibrium price and quantity are P* = $22 and Q* = 11,700.
c. At the higher per capita income, the demand equation becomes
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43 |
|
|
Q = 16,650 − 100P. |
(2.17) |
Equating this new demand with supply, the equilibrium price and quantity are P* = $27 and Q* = 13,950. The increase in per capita income has resulted in a higher market-clearing price and equilibrium quantity.
d. An increase in per capita income resulted in an increase in the demand for Bombay’s pizza. This was depicted as a right-shift of the demand curve. Bombay pizza can be characterized as a normal good.
RATIONING FUNCTION OF PRICES
How realistic is the assumption of market equilibrium? Markets are con-tinually buffeted by changes in demand and supply conditions. Temporary shortages and surpluses resulting from unexpected market disturbances are inevitable. The remarkable thing about unfettered markets is the speed at which market equilibrium is reestablished following a demand-side or supply-side shock. This fact should reinforce our faith in the underlying logic and stability of the free-market process.
When prices are “too low” and shortages result, competition among con-sumers will push up prices. Consumers who are unable or unwilling to pay the higher price drop out of the market. At the same time, higher prices are an incentive for firms to increase supply. Eventually, the shortage is eliminated and market equilibrium is reestablished. On the other hand, when prices are too high, there is a surplus of unsold goods. Firms will respond by lowering prices to dispose of excess inventory and reduce output to more sustainable levels. Consumers who were previously unwilling or unable to pay a higher price will be drawn into the market until the surplus is eliminated. This pro-cess by which changes in market-determined prices eliminate shortages and surpluses is referred to as the rationing function of prices. The essence of a decentralized free market is that impersonal changes in prices ultimately determines who gets what and how much.
The rationing function of prices underscores the notion of scarcity. Eco-nomically well-to-do consumers have a greater command over available goods and services than consumers of more modest means. This inevitably leads to complaints by some consumers who cannot afford to pay that the market-determined price is “unfair.” The fact that an individual may not be able to afford a Bentley or a private island is not a problem of fairness, but a problem of limited resources. Still, this does not dissuade some individuals who believe that market outcomes are pernicious from seeking redress through other means, such as the political process.
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44
Chapter 2
Price Ceilings
While price rationing is fundamental to the market mechanism, it is not the only way to allocate scarce goods and services. At various times, and for vari-ous reasons, governments have short-circuited the price rationing function of markets by imposing a price ceiling, which is the maximum legal price that a firm can charge for its product.
To be effective, a price ceiling must be set below the market equilibrium price to prevent prices from rising. An example of a price ceiling is rent control. The political objective of rent control is to provide low-cost housing to low-income voters. The problem with price ceilings is that they create artificial shortages that are likely to persist and become worse over time. Moreover, price ceilings are socially inefficient because they result in a misallocation of resources. To understand what is involved, consider the situation depicted in
Figure 2.13.
Suppose, initially, that the equilibrium price and quantity in
Figure 2.13
is P* and Q*, respectively. Net social welfare, which is a measure of market effi-ciency, is the sum of consumer surplus and producer surplus. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e + f. Thus, net social welfare is given by the area a + b + c + d + e + f. Now, suppose that government imposes a price ceiling of Pc, which creates a shortage in the market of Qs − Qd. The imposition of the price ceiling reduces producer surplus to area f. Area d is the amount transferred from producers to consumers who are paying less than the full value of the last unit consumed (PF ).
Figure 2.13
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| 45 |
The total value received by consumers from Qs units of output is given by the area a + b + d + f + g. Consumer expenditures are given by the area f + g. Thus, consumer surplus under the price ceiling is the area a + b + d. Net social welfare is now a + b + d + f. The change in net social welfare from the imposi-tion of the price ceiling is (a + b + d + f) − (a + b + c + d + e + f) = − c − e. While consumers who have been able to acquire the product at a lower price have benefitted, the loss to consumers as a whole is −c, which is referred to as consumer deadweight loss. The loss to society as a whole from the misalloca-tion of resources and a less than optimal amount of the product being supplied is given by the area −e, which is referred to as producer deadweight loss. The sum of consumer and producer deadweight loss, which is called total dead-weight loss, is given by the shaded area in Figure 2.13. Total deadweight loss is a measure of the lost net social welfare that results from the price ceiling.
Alternatively, MSB > MSC at the output level QS. In this market “too little” rental housing is supplied at the price ceiling. Society is made better off by allowing the market-clearing price to rise to P*. Moreover, freed from the economic shackles of rent control, new construction will shift the supply curve to the right, which puts downward pressure on rents.
When the price rationing mechanism of the free market is not permitted to operate, some non-price rationing mechanism must be used to allocate products that are in short supply. The most common of these non-price ration-ing mechanisms is queuing. Standing line for sometimes hours on end was how gasoline was rationed after the U.S. Congress enacted a 57¢ per gallon price ceiling following the embargo of crude oil shipments to the U.S. in 1973–1974 by Organization of Petroleum Exporting Countries (OPEC).
Without the price ceiling, lines at gasoline stations would have disappeared overnight as higher prices would have equated the quantities demanded and supplied. Higher gasoline prices, however, would have jeopardized the reelection prospects of many members of Congress, and so the price at the pump was kept low. The full economic price of gasoline, which included the opportunity cost of waiting in line for hours on end, however, was much higher. In Figure 2.13, the full economic price is PxF , which is equal to the price ceiling plus the opportunity cost of waiting in line PxF − PxC . The differ-ence between the full economic price and the price ceiling is the amount that consumers would be willing to pay to avoid waiting in line.
Solved Exercise
The market demand and supply equations for a product are
|
Qd = 300 − 3P; |
(2.18) |
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46
Chapter 2
|
Q s = −100 + 5P. |
(2.19) |
a. Calculate the equilibrium price and quantity for this product?
b. Suppose that an increase in consumer income increases demand to
|
Qd = 420 − 3P. |
(2.20) |
What are the new equilibrium price and quantity for this product? What is the value of net social welfare as a result of the increase in demand?
c. What is the value of net social welfare as a result of the increase in demand?
d. Suppose that the government imposes a price ceiling that is equal to the original equilibrium price. What is the result of this legislation?
e. Calculate the change in the value of net social welfare after the imposition of the price ceiling.
Solution
a. Solving Eqs. (2.18) and
(2.19),
the equilibrium price is P* = $50. Sub-stituting this price into the demand or supply equation and solving, the equilibrium quantity is Q* = 150 units of output.
b. Solving Eqs. (2.18) and
(2.20),
the new equilibrium price is P* = $65 and the equilibrium quantity is Q* = 225 units of output. This new situation is depicted in the following
Figure 2.14.
Figure 2.14
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|
47 |
c. As a result of the increase in demand, consumer surplus is CS = 0.5(140 − 65)225 = $8,437.50. The value of producer surplus is PS = 0.5(65 − 20)225 = $5,062.50. Thus, the value of net social welfare before the price ceiling is NSW = CS +PS = $13,500.
d. At the ceiling price of Pc = $50, the quantity demanded is Qd = 270 units and the quantity supplied is Qs = 150 units. The price ceiling creates a shortage of Qd − Qs = 120 units of output.
e. After the imposition of the price ceiling, the value of consumer surplus is CS = 0.5(140 − 90)150 + (90 − 50)150 = $9,750. The value of producer surplus after the price ceiling is PS = 0.5(50 − 20)150 = $2,250. The value of net social welfare is NSW = CS +PS = $12,000. This is given by the shaded area in Figure 2.14. The imposition of the price ceiling has reduced net national welfare by $1,500.
Price Floors
The counterpart of a price ceiling is a price floor, which is the minimum legal price that a supplier can expect for its product. To be effective a price floor must be set above the market determined price of the product. Notable examples of prices floors are agricultural price supports and minimum wages.
An example of the social welfare effect of a price floor is depicted in
Figure 2.15.
Suppose that the market for cheese is initially in equilibrium at
Figure 2.15
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48
Chapter 2
P* and Q*. Consumer surplus is the value of the area a + b + c. Producer surplus is given by the area d + e. Thus, net social welfare is given by the area a + b + c + d + e.
Now, suppose the government announces that it will guarantee cheese manufacturers a minimum price of Pf. The effect of the price floor is to create a market surplus of Qs − Qd. In the case, consumer surplus is given by area a. Producer surplus is given by the area b + c + d + e + g. Together, the sum of consumer and producer surplus is a + b + c + d + e + g. While it might appear that society has been made better off as a result of cheese price supports, this is not the end of the story.
There are several ways that federal government can administer an agricultural price support. One way is for the government to purchase the surplus at a cost to taxpayers of c + e + f + g + h + i. So far, net social welfare is (a + b + c + d + e + g) − (c + e + f + g + h + i) = a + b + d − f − h − i. The final outcome depends on what the government does with the surplus cheese. If the government distributes the cheese to low-income families free of charge, consumers receive value in the amount of the area c + e + f + i. Thus, the final outcome is net social welfare of (a + b + d − e − f − h − i) + (c + e + f + h + i) = a + b + c + d + e − h. National welfare is reduced by the area − h, which represents the amount of deadweight loss to society. Since the change in net social welfare is unambiguously negative, society has been made worse from the price floor.
Alternatively, MSC > MSB at the output level QS. In this market, “too much” cheese is being supplied at the price floor. Society will be made better off by allowing prices to fall to its market-clearing P*. Allowing the market mechanism to ration excess supply will eliminate the deadweight loss given by area h.
Another example of a price floor occurs in the labor market when the government enacts minimum-wage legislation, ostensibly to provide unskilled and uneducated workers with a “living wage.” Although government can mandate a higher minimum wage, in a free market it cannot force employ-ers to hire workers whose productivity is valued below the minimum wage. A profit-maximizing firm will not hire a worker if the addition to the firm’s revenues is less than the minimum wage paid. The result is a surplus of unskilled and uneducated workers and a loss of social welfare. To make mat-ters worse, a legal minimum wage makes it difficult for low-skilled workers to obtain work experience and on-the-job training that will enable them to command higher wages in the future. Society in general suffers because higher unemployment is associated with an increase in the crime rate. Tax-payers are made worse off because payroll taxes fund unemployment insur-ance and welfare payments.
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Solved Exercise
Consider the following demand and supply equations for the product of a perfectly competitive industry:
|
Qd = 25 − 3P; |
(2.21) |
|
Qs = 10 + 2P. |
(2.22) |
a. What is the equilibrium price and quantity in this market?
b. Suppose that government enacts a “price floor” on this product of P = $4. What is the result of this legislation?
Solution
a. Solving Eqs. (2.28) and (2.29), the equilibrium price and quantity are P* = $3 and Q* = 16 units of output.
b. At P = $4, the quantity demanded is Qd = 13 units of output and the quan-tity supplied is Qs = 18 units of output. As a result of the price floor there is a surplus of 5 units of output.
ALLOCATING FUNCTION OF PRICES
An examination of the price-rationing mechanism of individual markets is called partial equilibrium analysis. By contrast, general equilibrium analy-sis is concerned with the simultaneous determination of equilibrium in all markets. General equilibrium analysis examines the process whereby a dis-turbance in one sector of a market economy is transmitted to other sectors of the economy and the resulting reallocation of productive resources.
The prices of final goods and services reflect changes in a variety of demand determinants, including consumer tastes and preferences. Since the demand for productive resources is derived from the demand for final goods and services, producers use price information to reallocate inputs from lower to higher valued uses. This process is referred to as the allocating function of prices. To see how this works, consider an increase in the demand for restaurant meals, which leads to an increase in prices and industry profits.3 As a result, new capital investment flows into the restaurant and hospitality industry, which increases the demand for servers, chefs, and so on, thereby pushing up wages and benefits. This acts as a magnet for displaced workers, workers experiencing cuts in wages and benefits, and investment capital from contracting industries.
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50
Chapter 2
Benjamin Franklin warned the signers of the American Declaration of Independence from Great Britain that “We must all hang together, or assur-edly we will all hang separately.” In a way, this admonition underscores the important role of managers in identifying emerging market trends. It is often said that in economics everything hangs together. Changes in consumer demand for seemingly unrelated goods and services may produce ripple effects that could threaten a company’s survival, or they may create new and promising profit opportunities.
CHAPTER EXERCISES
2.1
In recent years there has been a sharp increase in commercial and rec-reational fishing in the waters around Long Island. Illustrate the effect of “over fishing” on inflation-adjusted seafood prices at Long Island area restaurants.
2.2
New York City is a global financial center. In the late-1990s the financial and residential real estate markets reached record-high price levels. Are these markets related? Explain.
2.3
Large labor unions always support higher minimum-wage legislation even though no union maker earns just the minimum wage. Explain.
2.4
Discuss the effect of a frost in Florida, which damaged a significant portion of the orange crop, on each of the following.
a. Price of Florida oranges
b. Price of California oranges
c. Price of tangerines
d. Price of orange juice
e. Price of apple juice
2.5
What is consumer surplus and producer surplus? How can these con-cepts be used to evaluate changes in market efficiency?
2.6
Discuss the effect of an imposition of a wine import tariff on the price of California wine.
2.7
The market demand for Brand x has been estimated as:
Q xd = 1,500 − 3Px − 0.05M − 2.5Py + 7.5Pz ,
where Px is the price of Brand x, M per capita income, Py the price of Brand y, and Pz the price of Brand z. Assume that Px = $2, M = $20,000, Py = $4, and Pz = $4.
a.
With respect to changes in per capita income, what kind of good is Brand x?
b. How are Brands x and y related?
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51 |
c. How are Brands x and z related?
d. How are Brands z and y related?
e. What is the market demand for Brand x?
2.8
Yell-O Yew-Boats, Ltd. produces Blue Meanies. Consider the demand and supply equations for Blue Meanies:
Qxd = 150 − 2Px + 0.001M + 1.5Py ;
Qxs = 60 + 4Px − 2.5W,
where Qx is monthly per family consumption of Blue Meanies, Px the price per unit of Blue Meanies, M median annual per family income ($25,000), Py the price per unit of Apple Bonkers ($5.00) and W the hourly per worker wage rate ($8.60).
a. What type of good is Apple Bonkers?
b. What are the equilibrium price and quantity of Blue Meanies?
c. Suppose that median per family income increases by $6,000. What are the new equilibrium price and quantity of Blue Meanies?
d. Suppose that in addition to the increase in median per family income, collective bargaining by Blue Meanie Local # 1 results in a $2.40 hourly increase in the wage rate. What are the new equilib-rium price and quantity?
e. In a same diagram, illustrate your answers to parts b, c, and d.
2.9
Consider the following demand and supply equations for sugar:
Qd = 1, 000 −1, 000P;
Qs = 800 + 1, 000P.
P is the price of sugar per pound and Q is the quantity of sugar in thousands of pounds.
a. What are the equilibrium price and quantity for sugar?
b. What is the value of net social welfare in this market?
c. Suppose that the government subsidizes sugar production by placing a price floor of $0.20 per pound. What is the relationship between the quantity supplied and quantity demand for sugar?
d. What is the effect on social welfare as a result of the price floor?
2.10
Occidental Pacific University is a large private university in California that is known for its strong athletics program, especially in football. At the request of the Dean of the College of Arts & Sciences, a professor
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52
Chapter 2
from the economics department estimated that student demand for student enrollment at the university is
Q xd = 5, 000 − 0.5Px + 0.1M + 0.25Py ,
where Qx is the number of full-time students, Px tuition charged full-time students per semester, M national income ($ billions), and Py tuition charged full-time students per semester by Oriental Atlantic University in Maryland, Occidental’s closest competitor on the grid iron.
a. Suppose that full-time enrollment at Occidental is 4,000 students. If M = $7,500 and Py = $6,000, how much tuition is Occidental charging its full-time students?
b. The administration is considering a promotional campaign designed to bolster admissions and tuition revenues. The cost of the cam-paign will be $750,000. The economics professor believes that the promotional campaign will increase demand to
Q xd = 5,100 − 0.45Px + 0.1M + 0.25Py .
If the economic professor is correct, forecast Occidental’s full-time enrollment?
c. Assuming no change in real GDP or full-time tuition charged by Oriental, will the promotional campaign be effective? (Hint: Com-pare Occidental’s tuition revenues before and after the promotional campaign.)
d. The director of Occidental’s athletic department claims that the increase in enrollment resulted from the football team’s NCAA Division I national championship. Is this claim reasonable? How would it show up in the new demand equation?
2.11
The market demand and supply equations for a good are:
Q d = 50 −10P;
Q s = 20 + 2.5P.
a. What is the equilibrium price and equilibrium quantity?
b. What is the value of net social welfare?
c. What is the effect on net social welfare if the government imposes a price ceiling of $3.00?
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53 |
Notes
1. The word “horizontal” indicates that the market quantity demanded is the sum of the quantities demanded by individual consumers along the horizontal axis.
2. A brief discussion of ordinary least squares regression analysis, which is used to generate parameter estimates of equations in linear form on the basis of historical data, is presented in the Appendix.
3. In 1970, Americans spent about $6 billion on fast food. By 2000, this had increased to more than $110 billion. The reason was principally economic. After peaking in1973, the hourly wage in the U.S. declined steadily for the next twenty-five years. Housewives responded by entering the workforce in record numbers, which resulted in a dramatic increase in the demand for such services as cooking, cleaning, and child care. A generation earlier, three-quarters of the family budget allocated for food was used to prepare meals at home. By 2000, about half the family budget was spent dining out, mainly at fast-food restaurants. Americans now spend more money on fast food than on higher education, personal computers, computer software, or new cars, and more on movies, books, magazines, newspapers, videos, and recorded music combined.
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Chapter
3
Elastic
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A firm’s market performance depends on several factors, some of which are directly under a manager’s control, while others are not. The individual firm cannot affect market interest rates, the pricing and advertising strategies of rivals, foreign-exchange rates that affect overseas sales or the cost of imports, business cycles, unemployment, or the rate of inflation. On the other hand, managers do control the firm’s organizational structure, pricing, product design and packaging, marketing strategy, research and development expen-ditures, and so on. Changes in any of these factors can have a profound effect on the firm’s bottom line.
In the previous chapter we examined how changes in price and other determi-nants affect the demand for goods and services. In this chapter we will explore these relationships in greater detail by introducing the important concept of elasticity, and how this measure can be used by managers to assess the effects of changes in the firm’s pricing and advertising strategies, business cycle fluctua-tions, changes in the pricing and advertising strategies of rival firms, and other factors that affect the firm’s bottom line. We will begin our discussion with the most important of these elasticity measures—the price elasticity of demand.
PRICE ELASTICITY OF DEMAND
In general, elasticity measures the percent change in the value of a dependent variable given a percent change in the value of an explanatory variable. Sup-pose, for example, the demand for a firm’s product
(
Qxd
)
depends on its price (Px), the consumer’s money income (M), the price charge by rival firms (Py), and the firm’s advertising expenditures (A). This relationship may be written
|
Q xd
= f ( Px , M, Py , A). |
(3.1) |
|
55 |
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56
Chapter 3
On the basis of historical data, it should be possible for a firm to estimate the demand equation for its product, which may be used by a manager to improve the company’s overall performance. Suppose, for example, that the demand for a firm’s product x is given by the equation
|
Q x = 12 7
− 50 Px . |
(3.2) |
This linear demand equation is depicted in
Figure 3.1.
The slope coefficient βx =
−5
0 tells us that the quantity demanded of good x increases (decreases) by 50 thousand units for every $1 decrease (increase) in its price.
The value of the slope may be calculated directly from the information provided in Figure 3.1. As we move along the demand curve from point A to point B, the value of the slope may be calculated as
|
bx = |
ΔQx |
= |
Q2 |
− Q1 |
22 |
−12 |
= − 50. |
(3.3) |
|||||||||||||||||||||||||||||||
|
ΔPx |
P2 |
− P1 |
2. 10 − 2. 30 |
||||||||||||||||||||||||||||||||||||
The value of the slope (βx) measures the change in unit sales resulting from a change in the price of a good or service. How a consumer reacts to a $10 rebate on the purchase of an item selling for $
100
, however, can be quite different than the same rebate on an item that costs $1,000. A 10 percent rebate may be viewed as a real bargain; 1 percent rebate may be interpreted as a marketing ploy. On the other hand, if a firm offers a 10 percent rebate regardless of price, the consumer’s reaction may be quite different. For the
Figure 3.1
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|
Elasticity |
57 |
manager, the question is how will a 10 percent rebate affect the company’s unit sales, revenues, and profits?
Another problem with the slope is that its numerical value depends on how we measure unit sales. Suppose, for example, that unit sales in Eq. (3.3) are measured in units instead of thousands of units. In this case, the value of the slope is β1
= −50
,000. Although we are dealing with the same rela-tionship, changing the units of measurement changes the slope’s numerical value. A related problem is comparing consumer sensitivity to similar price changes for different products, such as the demand for automobiles, yards of cloth, gallons of beer, and pounds of beef. To overcome these measurement problems, economists substitute the slope with the price elasticity of demand, which is a dimensionless measure of consumer sensitivity.
The price elasticity of demand measures the percent change in the quan-tity demanded of a good or service given a percent change in its price, that is
%
ΔQ
Ex , x = %ΔPx .
(3.4)
x
The first subscript of Ex,x refers the quantity demanded of good x and the second subscript refers to the price of good x. In subsequent sections we will discuss several other elasticity measures that follow this convention.
Solved Exercise
Suppose that the price elasticity of demand for a product is −2. How will the quantity demanded of this product change is price is reduced by 5 percent?
Solution
Substituting these values into
Eq. (3.4)
we get
−2 =
%ΔQx
(3.5)
Solving, the percent change in the quantity demanded is %∆Qx = 10. That is, a 5 percent reduction in price results in a 10 percent increase in quantity demanded.
Calculating the Price Elasticity of Demand
The price elasticity of demand is the percent change in the quantity demanded given a percent change in price. How we calculate the price elasticity of demand depends on the available information.
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58
Chapter 3
Midpoint Formula
Suppose you are given two price quantity combinations (P1, Q1) and (P2, Q2), such as points A and B in Figure 3.1. Calculating the price elasticity of demand using Eq. (3.4) is not as straightforward as it appears. This is because we normally calculate a percent change by subtracting the starting value from the ending value, and then divide by the starting value. For example, if price increases from P1 to P2, the percent change in price is would be calculated as
|
P − P |
||||||||||||||||||||||
|
%ΔPx |
2 | 1 | 100 |
> 0. |
(3.6) |
|||||||||||||||||
|
P1 |
||||||||||||||||||||||
On the other hand, if the price declines from P2 to P1, the percent change in price is
|
< 0. |
(3.7) |
Ignoring the sign change,
Eqs. (3.6)
and
(3.7)
are not equal because are the denominators are different. The same applies to calculating the percent change in quantity demanded. The effect on the calculated price elasticity of demand can be significant. For example, the price elasticity of demand when moving from point A to point B in Figure 3.1 is
|
Ex , x |
( |
− 12 |
) |
/ 12 |
= −9.58. |
(3.8) |
||||||||||
|
(2.10 − 2.30) / 2.30 |
||||||||||||||||
By contrast, the value of the price elasticity of demand when moving from point B to point A is
| 12 |
− 22 |
/ 22 |
|||
|
= −4 .77. |
(3.9) |
||||
|
(2.30 − 2.10) / 2.10 |
What is needed is an elasticity measure that does not depend on whether we are moving from point A to point B, or from point B to point A. A con-venient approximation of the price elasticity of demand is the midpoint formula, which is given by the equation
|
Q |
− Q |
P
+ P |
|||
|
Q1 +Q2 |
|
P |
+ P | ||||||
|
= bx |
, |
(3.10) |
|||||
|
+ Q2 |
|||||||
| Q1 |
where βx = (Q2 − Q1)/(P2 − P1) = ∆Qx/∆Px is the slope of the demand curve. The midpoint formula allows us to calculate a price elasticity of demand that is invariant with respect to a price increase or decrease. Moving from
point A to point B, the price elasticity of demand using
Eq. (3.10)
is
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|
59 |
||
|
22 −12 |
2.30 + 2.10 |
6.47 |
| = − |
(3.11) |
|
|
+ 22 |
It is left as an exercise for the reader to show that this is the same value for the price elasticity of demand when moving from point B to point A. The interpretation of this result is that a one percent increase in price will result in a 6.47 percent decrease in the quantity demanded. Conversely, a one percent decrease in price will result in a 6.47 percent increase in the quantity demanded.
Point Price Elasticity of Demand
As we have seen, the price elasticity of demand has several advantages over the slope as a measure of consumer sensitivity. It is also easy to calculate and interpret. Unfortunately, the midpoint formula suffers from two weaknesses that reduce its usefulness. To begin with, the midpoint formula implicitly assumes that the underlying demand curve is linear. Since demand curves are more appropriately convex, the value Ex,x is sometimes referred to as the arc price elasticity of demand.
Another weakness of the midpoint formula is that it produces a value that depends on the price-quantity combinations selected for its calculation. Care must be exercised when choosing (P1, Q1) and (P2, Q2). To see why, consider
Figure 3.2.
As we will soon discover, the percent change in the quantity
Figure 3.2
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60
Chapter 3
demanded is greater than the percent change in price for all price-quantity combinations above the midpoint, such as points A and B, and vice versa for price-quantity combinations below the midpoint, such as points C and D. At the midpoint, the percent change in the quantity demand equals the percent change in price.
It is important for a manager to know whether the quantity demanded for the firm’s product is above or below the midpoint since a change in price will have predictable effects on a firm’s revenues and profits. Unfortunately, a manager may know whether the price charged is above or below the mid-point. For this reason, it is important when using the midpoint formula for managers to choose price-quantity combinations that are “close” together. This will minimize the possibility of spanning the midpoint, which would make it difficult to identify consumer sensitivity to price changes.
An alternative to the midpoint formula is the point price elasticity of demand (εx,x), which is unique at each and every point along a demand curve. The point price elasticity of demand is given by the equation
| ΔQ | x | ||||||||||||||||||
|
e x , x |
= bx |
(3.12) |
|||||||||||||||||
|
ΔPx Qx |
Qx |
where βx is the slope of the demand curve.
Consider, for example, the demand curve given by
Eq. (3.2)
. Using the midpoint formula, the price elasticity of demand over the line segment AB is Ex,x = −6.47. Since the slope of the demand curve is βx = −50, the point price elasticity of demand at point A is
|
A |
Px |
2.30 | ||||
|
ex , x |
= −50 |
(3.13) |
||||
The point price elasticity of demand at point B is
| B |
ΔQxd |
2.10 |
|
(3.14) |
||
|
d |
||
The reader should note that the value of the price elasticity of demand using the midpoint formula is between the point price elasticity at points A and B. The reader is also cautioned that the price elasticity of demand using the midpoint formula is not a simple average of the point price elasticities.
Solved Exercise
Suppose that the demand for a good is given by the equation Qx = 50 − 2.
25
Px.
Calculate the point price elasticity of demand when Px = $2.
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|
61 |
|||
|
Solution |
|||
|
= −0.099. |
|||
|
ex , x = |
= −2 .25 |
(3. 15 ) |
|
| 50 | |||
|
− 2.25(2) |
Midpoint Formula versus the Point Price Elasticity
The main advantage of the midpoint formula is its minimal data require-ments. Only two price-quantity combinations are needed to calculate its value. This is particularly important for small and medium sized firms that lack the financial and technical resources to conduct sophisticated market and statistical research. All a manager needs to do is change the price of the firm’s product by a small amount and use the resulting sales data to approximate the price elasticity of demand using the midpoint formula.
Unfortunately, the midpoint formula may not be a particularly good mea-sure of consumer sensitivity to price changes. The midpoint formula intro-duces distortions that become more acute when price changes are large, or when the underlying demand curve is nonlinear. The point price elasticity is a superior measure of consumer sensitivity to price changes, although manag-ers should limit its application to small changes in price.
Definitions
According to the law of demand, there is an inverse relationship between a percent change in price and the percent change in the quantity demanded. For this reason, the price elasticity of demand is between zero and −
∞
. It is sometimes convenient, however, to express the price elasticity of demand in absolute terms, which is always positive.
Price Elastic Demand
Demand is said to be price elastic when |εx,x| >1 (εx,x < −1). In this case, the absolute value of the percent change in quantity demanded is greater than the
absolute value of the percent change in price (|%∆Qx| > |%∆Px|). Suppose, for example, that a 2 percent increase in price results in a 4 percent decline in quantity demanded. The demand for this product is price elastic because |εx,x| = |−4/2| = 2 >1. Demand is described as perfectly elastic when |εx,x| = ∞ (εx,x =
−∞
). This occurs when ∆Qx/∆Px = −∞ or Px/Qx = ∞. These conditions are depicted for the linear demand curve in Figure 3.3.
Price
Inelastic
Demand
Demand is said to be price inelastic when |εx,x|
<1
(−1 < εx,x < 0). This occurs when |%∆Qxd| < |%∆Px|. Suppose, for example, that a 2 percent increase in
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62
Chapter 3
price leads to a 1 percent decline in quantity demanded. The demand for this product is price inelastic because |εx,x| = |−1/2| < 1. Demand is perfectly inelastic when εx,x = 0, which occurs when ∆Qx/∆Px = 0 or Px/Qx = 0. These conditions are depicted in
Figure 3.4.
Figure 3.3
Figure 3.4
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63 |
Unit Elastic Demand
Finally, demand is said to be unit elastic when |εx,x|
=1
(εx,x = −1), which occurs when |%∆Qxd| = |%∆Px|. Suppose that a 2 percent increase in price leads to a 2 percent decline in quantity demanded. The demand for this prod-uct is unit elastic since |εx,x| = |−2/2| = 1.
Determinants of the Price Elasticity of Demand
Several factors that affect a consumer’s sensitivity to a price change. In this section we will discuss three factors that affect the price elasticity of demand, including the number of close substitutes, the proportion of the consumer’s income spent on the product, and the amount of time that a consumer has to adjust to the price change.
Substitutability
The price elasticity of demand is partly explained by the availability of close substitutes. Intuitively, the greater the number of close substitutes, the more price elastic is the demand for a product. This is because it is easier for buyers to find less expensive, albeit not perfect, alternatives. Conversely, the fewer the number of close substitutes, the less price elastic since substitutes are dif-ficult to locate.
The price elasticity of demand also depends on how narrowly we define classes of products. The demand for Coca-Cola, for example, is more price elastic than the demand for soft drinks in general. When the price of Coca-Cola increases, consumers can switch to Pepsi Cola, 7-Up, Dr. Pepper, Gatorade, and so on. On the other hand, there are fewer alternatives if there is an increase in the price of all soft drinks.
The demand curve for the product of a firm that has a large number of sub-stitutes is “flatter” than the demand curve for a firm with few substitutes. The extreme case is when a firm has a large number of rivals that sell identically the same product. In this case, the demand for the firm’s product is perfectly elastic (|εx,x| = ∞) and the demand curve horizontal. In this case, a manager that increases the price even slightly will discover that consumers will pur-chase nothing at all as they switch to the cheaper, identical products of rival firms. By contrast, when the demand for a firm’s good is perfectly inelastic (|εx,x| = 0), consumers do not alter their purchases at all in response to a price change. In this case, demand curve is vertical.
Of course, the demand for a good or service is rarely perfectly elastic or perfectly inelastic. The demand curve for most goods and services is down-ward sloping. In the next section, we will learn about the important relation-ship between the price elasticity of demand and the firm’s total revenue from
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64
Chapter 3
sales of its product. In Chapter 11, we will discuss how this information can be used to formulate an optimal pricing strategy.
Proportion of Income
When the purchase of a good constitutes a relatively large proportion of a person’s total expenditures increases, an increase in the price of a big-ticket item, such as a washer dryer or automobile, than an equivalent increase in the price of a good that constitutes a relatively small percentage of a family’s income, such as an ounce of table salt. In 2013, the median per family income in the U.S was around $51,000. Members of this group will sit up and take notice of a 10 percent increase in the price of a $20,000 Honda Civic, will hardly bat an eye-lash at an equivalent increase in the $1.
40
price of a 2 liter bottle of Coke Classic.
Adjustment Period
In general, consumers tend to be less price sensitive in the short run than in the long run. For many goods and services it takes time for individuals and families to adjust their budgets expenditures to a price change. Consider, for example, an increase in the price of gasoline from, say, $3.50 to $5.00 per gallon. In the short run, many drivers have no choice but to pay the higher price since automobiles are essential to many aspects of a family’s daily lives, such as getting the kids to school, driving to work, grocery shopping, and so on. In the short run, many drivers may be able to make modest adjustments in their driving patterns to reduce the number of miles driven, perhaps by combining trips to the super market with the daily commute to work. Over a longer period of time, however, some people will trade in their gas guzzlers for more fuel efficient substitutes. The fact that consumer purchases are sensitive to the adjustment period also helps to explain why airlines charge higher fares for tickets purchased the day before a scheduled flight than when a ticket is purchased two months in advance.
Total and Marginal Revenue
The price elasticity of demand is a valuable business tool because it enables a manager to predict how a price will affect unit sales and revenues. Suppose, for example, that a manager is contemplating a 10 percent price increase and the demand for the firm’s product is price inelastic. If the price elasticity of
demand is εx,x = %∆Qx/%∆Px = −1/2, the result will be a 5 percent decline in unit sales. The effect on total revenues can be can be decomposed into two
effects. On the one hand, the price increase will push up revenues by about 10 percent. On the other hand, the decline in unit sales will push down rev-enues by about 5 percent. The net effect is an increase in total revenues of around 5 percent.
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65 |
Suppose, on the other hand, that demand is price elastic and εx,x = −2. In this case, a 10 percent increase in price will increase revenues by about 10 percent, but the fall in sales will reduce revenues by about 20 percent. In this case, the net effect is a decline in total revenues of around 10 percent. Finally, if demand is unit elastic, a 10 percent increase in price will increase total reve-nues by about 10 percent, which will be exactly offset by a 10 percent decline in revenues from lost unit sales. The net effect is no change in total revenues.
To make the discussion more concrete, suppose that the demand for good x is given by the equation
|
Q x = 80
−10 Px . |
(3.16) |
Table 3.1
summarizes the price elasticity of demand and total revenue (TRx = Px Qx) for alternative price quantity combinations. At a price of $6, for example, the quantity demanded is 20 units. At this price-quantity combina-tion the point price elasticity of demand is −3 and the firm’s total revenue is $6(20) = $
120
. The price elasticity of demand tells us that in the neighbor-hood of this price-quantity combination, a 1 percent decline in price will result in 3 percent increase in the quantity demanded and an increase in total revenue. Suppose that the firm lowers price to $5, which increases sales to 30 units and total revenue to $5(30) = $
150
. At this price-quantity combina-tion the point price elasticity of demand is εx,x =
−1.
67
. The price reduction from $6 to $5 results in a decline of total revenues of −$1
×
20 = −$20. The increase in sales at the lower price, however, results in increase in revenues of $5(10) = $50.
A $1 price reduction when demand is price elastic results in an increase in total revenue. What happens when price is reduced by $1 when demand is price inelastic? Suppose, for example, that the firm initially charges a price of $3 and sells 50 units. At this price-quantity combination the point price elasticity of demand is ε x,x = −0.6 and total revenue is $3(50) = $150. If the firm cuts price to $2, sales will increases to 60 units. At this price-quantity
Table 3.1
|
∆Q |
/∆P |
/Q d |
ε |
x,x |
Demand is |
MR |
TR |
|||||||||||||||||
| 0 | 80 | −10 |
Perfectly inelastic |
–8 |
||||||||||||||||||||
|
70 |
0.014 |
−0.14 |
Inelastic |
–6 |
||||||||||||||||||||
| 60 |
0.033 |
−0.33 |
–4 |
120 | ||||||||||||||||||||
| 3 |
0.060 |
−0.60 |
–2 |
150 | ||||||||||||||||||||
| 4 | 40 |
0.100 |
−1.00 |
Unit elastic |
160 |
|||||||||||||||||||
| 5 | 30 |
0.167 |
−1.67 | Elastic | ||||||||||||||||||||
| 6 | 20 |
0.300 |
−3.00 |
|||||||||||||||||||||
| 7 | 10 |
0.700 |
−7.00 |
|||||||||||||||||||||
| 8 | ∞ | −∞ |
Perfectly elastic |
|||||||||||||||||||||
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66
Chapter 3
combination the point price elasticity of demand is εx,x = −0.33 and total revenue is $2(60) = $120. Reducing price by $1 causes total revenue to decline from $150 to $120. The price reduction lowers total revenue by −$1(50) = −$5. The increase in revenues from greater units sales is only $2(10) = $20. Lowering price by $1 when demand is price elastic causes revenues to decline by $30.
The above example highlights several important features that are common to all linear demand curves. Although the slope of this linear demand curve is the same at every price-quantity combination, the price elasticity of demand can take on any value between 0 and −∞. Demand is perfectly inelastic (εx,x = 0) where the demand curve intersects the quantity (horizontal) axis. The demand curve is perfectly elastic (εx,x = −∞) where the demand curve inter-sects the price (vertical) axis. At the midpoint of the demand curve, demand is unit elastic (εx,x = −1). Demand is price elastic for any price-quantity com-bination above the midpoint. Finally, demand is price inelastic for any price quantity combination below the midpoint.
The relationship between total revenues and price elasticity for a linear demand curve depicted is summarized in Figure 3.5 and Table 3.2. Total rev-enue is maximized when demand is unit elastic, which occurs at the midpoint of the demand curve. As price is lowered (raised) in the elastic region, the quantity demanded increases (falls) and total revenue increases (decreases). When the price is lowered (raised) in the inelastic region, the quantity demanded increases (decreases) and total revenue falls (rises).
Figure 3.5 summarizes the relationships among the price elasticity of demand, total revenue and marginal revenue (MR), which is the change in total revenue (∆TR) from a change in the number of units sold. MR is positive for all price-quantity combinations along the elastic portion of the demand curve. Thus, lowering price will result in an increase in sales and revenues. MR is negative for all price-quantity combinations along the inelastic region of the demand curve. Reducing price in this region will result in an increase in sales, but a decrease in revenues.2
Formal Relationship between the Price Elasticity of Demand and Total Revenue
The tight relationship between price, the price elasticity of demand, total revenue and marginal revenue is summarized by the equation
|
1 + ex , x |
|||||||||||
|
MR = Px 1 |
+ |
= Px |
(3.17) |
||||||||
|
e |
|||||||||||
|
x , x |
|||||||||||
We know that total revenue is maximized where MR = 0. Since Px > 0, the term in the parenthesis of
Eq. (3.17)
must be equal to zero, which occurs
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| 67 |
Figure 3.5
Table 3.2
|
|εx,x| |
∆Px |
∆Qx |
∆TRx /∆Q = MRx |
||||||||
| >1 | − | ||||||||||
| <1 | |||||||||||
| =1 | |||||||||||
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68
Chapter 3
when εx,x = –1. When demand is elastic, (εx,x < −1) the term in the parenthe-sis and marginal revenue must be positive. Thus, lowering price increases
total revenue increases. When demand is inelastic (−1 < εx,x < 0), the term in parenthesis and marginal revenue must be negative. Lowering price reduces total revenue. These relationships are also summarized in Figure 3.5 and Table 3.2.
Solved Exercise
Suppose that the demand for a firm’s product is given by the equation
|
Qx = 50 − 2.5Px . |
(3.18) |
Calculate the point price elasticity of demand and total revenue for Px = $0, P x = $5, Px = $10, Px = $15, and Px = $20. What can you conclude about the relationship between the price elasticity of demand and total revenue?
Solution
Total revenue is TR = Px Qx. From
Eq. (3.18)
we get
|
= −2.5 |
(3.19) |
|
− 2.5Px |
Eq. (3.19)
can be used to calculate the price elasticity of demand for each price. These calculations are summarized in
Table 3.3.
According to
Table 3.3,
total revenue is zero when demand is perfectly elastic or perfectly inelastic. When demand is inelastic, total revenue increases (decreases) when price is raised (lowered). When demand is elas-tic, total revenue increases (decreases) when price is lowered (raised). When demand is unit elastic, total revenue is maximized at $
250
.
Table 3.3
|
εx,x |
||
|
37.5 |
187.5 |
|
| 25 | 250 | |
| 15 |
12.5 |
|
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69 |
INCOME ELASTICITY OF DEMAND
There are other important elasticity measures that are of concern to managers. The income elasticity of demand is a measure of consumer sensitivity to changes in money income, which reflects the ups and downs of the business cycle. The income elasticity of demand is the percent change in demand with respect to a percent change in money income, that is
|
Ex , M |
(3.20) |
|
|
% ΔM |
As with the price elasticity of demand, how we estimate the income elastic-ity of demand depends on the information available. With pairs of values for income and quantity, the income elasticity of demand may be calculated as
|
Q2 −Q1 |
M1+M2 |
|
|
M2−M1 |
||
| ΔM |
The corresponding point income elasticity of demand is
|
ΔQd |
M |
||
|
e x , M |
= bM |
||
|
ΔM Qx |
(3.21)
(3.22)
We learned that the demand for a normal good varies directly with con-sumers’ money income, in which case the value of βM is positive. Since money income and quantity must are also positive, for a normal good εx,M > 0, which says that a percent increase (decrease) in money income is accompanied by a percent increase (decrease) in demand. Normal goods may be further classi-fied as necessities or luxuries. The demand for a necessity is relatively insen-sitive to income changes. The percent change in the demand for a good is less than the percent change in money income, that is, 0 < εx,M < 1. Examples of necessities include electricity, rent, food, and health care. By contrast, the demand for luxuries tends to exaggerate swings consumers’ money income. A good is a luxury good when the percent change in demand is greater than the percent change in money income, that is εx,M > 1. Examples of luxuries include foreign travel, restaurant meals, and foreign imports.
Since the demand for an inferior good is inversely related to a consumer’s money income, the value of β M in Eq. (2.1) is negative, thus εx,M < 0. Inferior goods are fairly common for individual consumers, but difficult to identify at the market level. An oft cited example of an inferior good at the market level is the demand for bankruptcy services, which tends to increase during recessions.
In Chapter 2 we discussed how a change in a consumer’s real income. The income effect
the price of a good affects for normal goods is closely
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70
Chapter 3
related to the price elasticity of demand. Purchases of goods that are sensitive to price changes tend to be luxuries. Purchases of goods that are not sensitive to price changes tend to be necessities.
CROSS-PRICE ELASTICITY OF DEMAND
Another frequently used elasticity measure is the cross-price elasticity of demand, which measures the sensitivity of consumer purchases of a prod-uct with respect to a change in the price of a related good. Related goods in consumption may be complements or substitutes. The cross-price elasticity of demand measures the percent change in the demand for good x given a percent change in the price of related good y, that is
|
%ΔQ |
Py |
(3.23) |
|
|
e x , y |
= by |
||
|
% ΔP |
ΔP | ||
|
y |
The cross-price elasticity of demand takes its sign from the value of βy. When εx,y > 0, goods x and y are substitutes. When εx,y < 0, the two goods are complements.
Up to this point, we have assumed that a firm produces a single product. Now, suppose that the firm produces multiple related products. What effect will a change in the price of one good have on a firm’s total revenues? Sup-pose, for example, that a company sells two goods, x and y. The company’s total revenue from the sale of these two products is
|
TR = TRx + TRy , |
(3.24) |
where TRx = PxQx and TRy = PyQy. For very small changes in the price of good x, the change in the firm’s total revenue given is given by the equation
|
ΔTR = TRx (1 |
+ e x , x ) + TRy ( ey , x ) |
× |
(3.25) |
|
100% |
Solved Exercise
Suppose that a firm earns $5,000 a month from the sale of good x and $3,000 from the sale of good y. The price-elasticity of demand for good x
is εx,x = –2 and the cross-price elasticity of demand for good y is εy,x = –4. How will a one percent cut in the price of good x affect the firm’s total
revenue?
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|
71 |
||||||
|
From |
||||||
|
ΔTR = $5,000 1 − 2 |
] |
+ $3,000 |
−4 |
−0.01 |
= $170. |
(3.26) |
|
[ |
This result says that a one percent cut in the price of good x will result in a $170 increase in total revenues.
ADVERTISING ELASTICITY OF DEMAND
A very useful management tool is the advertising elasticity of demand, which measures the percent change in unit sales arising from a percent change in advertising expenditures. Ceteris paribus, we would expect that an increase in advertising expenditures will increase in unit sales and revenues. Symbolically, the advertising elasticity of demand is
| A | ||
|
ex , A |
(3.27) |
|
|
%ΔA |
||
|
ΔA Qx |
Solved Exercise
A business consultant has estimated the following demand function for Rubi-con & Styx’s world-famous hot sauce “Sergeant Garcia’s Revenge.”
|
Qx = 62 − 2Px + 0.2M + 25A, |
(3.28) |
where Qx is the quantity demanded per month in thousands of units, Px is the price per 6-oz. bottle, M is an index of consumer income, and A is the com-pany’s monthly advertising expenditures per month in thousands of dollars. Assume that Px = $4, M = $150, and A = $4 (thousand).
a. Calculate the number of bottles of “Sergeant Garcia’s Revenge” demanded.
b. Calculate the price elasticity of demand. According to your calculations, is the demand for this product elastic, inelastic, or unit elastic? What, if anything, can you say about the demand for this product?
c. Calculate the income elasticity of demand. Is “Sergeant Garcia’s Revenge” a normal good or an inferior good? Is it a luxury or a necessity?
d. Calculate the advertising elasticity of demand. Explain your result.
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Chapter 3
Solution
a. Substituting the given information into the demand function we get
|
Qx = 62 − 2 ( 4) + 0.2 (150) + 25( 2) = 184 thousand. |
(3.29) |
b. The price elasticity of demand is
| = −2 |
= −0.04. |
|
|
(3.30) |
||
| 184 |
This result tells us that a 1 percent increase in the price of “Sergeant Garcia’s Revenge” results in a 0.04 percent decrease in quantity demanded. Since |εx,x| < 1, the demand for this product is price inelastic. This might suggest that “Sergeant Garcia’s Revenge” has no close substitutes.
c. The income elasticity of demand is
|
ex , M |
= 0.2 |
= 0.16, |
(3.31) |
|
ΔM Qx |
which says that a 1 percent increase in consumer income results in a 0.16 percent increase in the demand. Since 0 < εx,M < 1, this normal good is a necessity.
d. The advertising elasticity of demand is given as
|
= 25 |
= 0.54. |
(3.32) |
This result tells us that a 1 percent increase in Rubicon & Styx’s advertis-ing expenditures results in a 0.54 percent increase in unit sales.
CHAPTER EXERCISES
3.1
Suppose that you are a portfolio manager for a large, diversified mutual fund. The fund’s chief economist is forecasting an economic slowdown. How will your knowledge of estimated income elasticities of demand to alter the composition of the portfolio?
3.2
Suppose that crime is positively related to profits from illegal drug sales and that the demand for drugs is price inelastic. The government’s primary weapon in the war on drugs is the interdiction of illegal drugs flowing into the country from outside its borders. What is the likely effect of this policy on domestic crime rates? Can you suggest an alter-native approach to the war on drugs?
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73 |
3.3
Explain why a monopolist would never price its product along the inelastic portion of a linear demand curve.
3.4
A consortium of the world’s leading oil producers form a cartel to control the supply of crude oil. The objective of the cartel is to raise price and increase revenues. What must be true about the demand for oil for this policy to be successful?
3.5
A consortium of the world’s leading coffee bean producers form a cartel to the supply of coffee beans. The objective of the cartel is to lower prices and increase cartel revenues. What must be true about the demand for coffee beans for this policy to be successful?
3.6
The Sylvan Corporation produces wood sorrels. The price elasticity of demand is −0.25.
a. What will happen to the quantity demanded if Sylvan raises its price by 10 percent?
b. What will happen to Sylvan’s revenues following this price increase?
3.7
Suppose that the cross-price elasticity of demand for good x is 2.5 and the price of good y increases by 25 percent.
a. How would you characterize the relationship between goods x and y?
b. How will the increase in the price of good y affect unit sales of good x?
3.8
Suppose that the cross-price elasticity of demand for good m is −1.
75
and the price of good n falls by 10 percent.
a. What is the relationship between goods m and good n?
b. How will the fall in the price of good n affect sales of good m?
3.9
Suppose that the income elasticity of demand for a good is 3.5.
a. How would you classify this good?
b. What increase in income is required for demand to increase by 21 percent?
3.10
Suppose that the estimated demand equation for a firm’s good is
Q x = 100 −10Px − 2Py + 0.1M + 0.2 A,
where Qxd is unit sales of good x, Px is the price of good x, Py is the price of good y, M is per-family money income in thousands of dollars, and A is the level of advertising expenditures in thousands of dollars. Suppose that Px = $2, Py = $3, M = $50 (thousand), and A = $20 (thousand). Calculate the price elasticity of demand.
3.11
Silkwood Enterprises specializes in gardening supplies. The demand for its new brand of fertilizer is given by the equation
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74
Chapter 3
Q = 120 − 4P.
a. Silkwood is currently charging $10 a pound. What is the price elasticity of demand?
b. At this price, what is Silkwood’s marginal revenue?
c. What price should Silkwood charge if it wants to maximize total revenue?
d. What is the price elasticity of demand at the revenue maximizing price?
3.12
Just-the-Fax, Max, Inc. has determined that the demand for its FAX machines is
Q = 3,000 −1.5P.
a. Calculate the point price elasticity of demand when P = $600.
b. At P = $600 what is Max’s marginal revenue?
c. Determine the total revenue maximizing price and quantity for the firm.
3.13
The market research department of Paradox Enterprises has deter-mined that the demand for its product is
Q x = 1, 000 − 5Px + 0.05M − 50Pz ,
where Px is the price, M median family income, and Pz is the price of bailiwicks. Suppose that Px = $5, M = $20,000, and Pz = $15. a. What is the price elasticity of demand?
b. Is the firm maximizing its total revenue at Px = $5. If not, what price should Paradox charge?
c. Calculate the income elasticity of demand at Px = $5.
d. Calculate the cross-price elasticity of demand at Px = $5.
3.14
Suppose that the demand equation for a firm’s product is
Q = 10 − 0.4P,
where Q is quantity and P is price.
a. Calculate the price elasticity of demand using the midpoint formula when P1 = $13 and P2 = $12.
b. Calculate the point price elasticity of demand at these prices. What, if anything, can you say about the relationship between the price elasticity of demand and total revenue at these prices?
c. What is the price elasticity of demand at the price that maximizes total revenue?
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| 75 |
3.15
Suppose that the demand equation for widgets is
Q = 10, 000 − 25P.
a. How many widgets will be sold for $100?
b. At what price will the demand for widgets zero?
c. What is the total revenue equation for widgets in terms of output? What is the marginal revenue equation in terms of output?
d. What is the price elasticity of demand when P = $200? What is the firm’s total and marginal revenue at this price?
e. What is the price elasticity of demand if the price of widgets falls to P = $150? At this price what is the firm’s total and marginal revenue? Explain your results.
f. What is the price elasticity of demand if the price of widgets rises to P = $250? At this price what is the firm’s total and marginal revenue? Explain your results.
g. Suppose that the supply of widgets is given by the equation
Q = −5, 000 + 50P.
What is the equilibrium price and quantity?
h. What is the relationship between quantity supplied and quantity demanded at P = $300?
3.16
The demand for a product is given by the equation
Q =50−2P.
a. What is the point price elasticity of demand at P = $20?
b. If the price falls to P = $15, what happens to total revenues? What does this imply about the price elasticity of demand?
c. Verify your answer to part b by computing the arc price elasticity over this price interval.
d. What, if anything, can you say about the relationship between the point price-elasticities of demand calculated in parts a and b, and the arc price elasticity of demand calculated in part c?
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178
Chapter 7
which are published Census Bureau of the U.S. Department of Commerce, which can be readily accessed on the Internet. Concentration ratios measure the percentage of total industry sales accounted for by the largest n firms, that is
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Cn = w1 + w2 + + wn , |
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where ωi = 100(Si/ST), Si the sales of the ith firm, and ST the sales for the entire industry. The U.S. Census Bureau calculates concentration ratios for the larg-est 4, 8, 20, and 50 companies in an industry. Industries with a large number of small firms have concentration ratios are closer to zero percent, which indicates low concentration. Industries that are dominated by a few very large firms have concentration ratios closer to 100 percent. Table 7.3 summarizes the 4-firm concentration ratios (CR) and Herfindahl-Hirschman indices (HHI) for 32 industries in the Unites States in
19
92 according to their four-digit Standard Industrial Classification (SIC) code.1 A four digit number assigned to identify a business based on the type of business or trade and manufacturing.
Another problem with concentration ratios is that they are sensitive to how narrowly an industry is defined. Concentration ratios are calculated using standard industrial classifications published by the U.S. Department of Commerce, which are based on the similarity of production processes. These classification, however, ignore substitutability across products, such as glass versus plastic containers, which have a high cross-price elasticity of demand.
Still another problem is that U.S. census data used to calculate concentra-tion ratios are based on domestically produced goods and do not include import competing products. Table 7.3 indicates, for example, that the eight largest motor vehicles and car bodies companies account for
84
percent of industry output. This statistic clearly overstates the actual market share of U.S. automobile companies when foreign automobile manufacturers are included.
Finally, concentration ratios are calculated using national statistics. As such, they ignore the regional distribution of industry sales. Suppose, for example, that an industry has a 4-firm concentration ratio of 0.5, which sug-gests that the industry is not highly concentrated. But, suppose that these firms sell their products in different parts of the country. Regionally, this industry may be highly concentrated, but this fact is masked by the 4-firm concentration ratio that is calculated using national data.
Solved Exercise
An industry consists of 10 firms. The first two firms have sales of $5 million each, the next two firms have sales of $3 million each, and the remaining six
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AN: 93
51
22 ; Thomas J. Webster.; Managerial Economics : Tools for Analyzing Business Strategy
Account: s
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.main.eds
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Industry Organization |
1 79 |
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Table 7.3 Measures of Industrial Concentration (1992) |
|||||||
|
Value of |
|||||||
|
Number |
Shipments |
4-Firm CR |
HHI |
||||
|
SIC |
Industry |
of Firms |
($million) |
(percent) |
|||
|
2021 |
Creamery butter |
31 |
1,0 34 |
49 |
874 |
||
|
20 24 |
Ice cream and frozen desserts |
411 |
5,291 |
24 |
293 |
||
|
20 37 |
Frozen fruits and vegetables |
182 |
7, 52 8 |
28 |
313 |
||
|
2041 |
Flour and grain mill products |
23 0 |
6,294 |
56 |
972 |
||
|
20 43 |
Cereal breakfast foods |
42 |
9,799 |
85 |
2, 25 3 |
||
|
20 46 |
Wet corn milling |
7,045 |
73 |
1,521 |
|||
|
2047 |
Dog and cat food |
102 |
7,024 |
58 |
1,229 |
||
|
2 27 3 |
Carpets and rugs |
383 |
9,831 |
40 |
854 |
||
|
2296 |
Tire cord and fabrics |
12 |
9 76 |
75 |
2,682 |
||
|
2411 |
Logging |
12,985 |
13,879 |
19 |
158 |
||
|
251 1 |
Wood household furniture |
2, 63 6 |
8,743 |
20 |
16 7 |
||
|
2731 |
Book publishing |
2,504 |
16,753 |
23 | 251 | ||
|
2771 |
Greeting cards |
1 57 |
4,196 |
84 |
2,922 |
||
|
2812 |
Alkalis and chlorine |
34 |
2,787 |
1,994 |
|||
|
2833 |
Medicines and botanicals |
208 |
6,439 |
76 |
2,999 |
||
|
2841 |
Soap and other detergents |
635 |
14,762 |
63 |
1,584 |
||
|
2911 |
Petroleum refining |
131 |
136,579 |
30 |
414 |
||
|
3221 |
Glass containers |
16 |
4, 86 0 |
2,162 |
|||
|
3274 |
Lime |
57 |
904 |
46 |
693 |
||
|
3312 |
Blast furnaces and steel mills |
135 |
16,565 |
37 |
551 |
||
|
3334 |
Primary aluminum |
5,849 |
59 |
1,456 |
|||
|
3411 |
Metal cans |
132 |
12,112 |
1,042 |
|||
|
3484 |
Small arms |
177 |
1,384 |
43 |
679 |
||
|
3511 |
Turbines and turbine generators |
64 |
5,843 |
79 |
2,549 |
||
|
3562 |
Ball and roller bearings |
123 |
4,290 |
51 |
852 |
||
|
3565 |
Packaging machinery |
590 |
3,127 |
154 |
|||
|
3581 |
Automatic vending machines |
105 |
816 |
52 |
844 |
||
|
3641 |
Electric lamps |
3,001 |
86 |
2,702 |
|||
|
3711 |
Motor vehicles and car bodies |
398 |
151,712 |
2,676 |
|||
|
3823 |
Process control instruments |
822 |
6,469 |
27 |
256 |
||
|
3931 |
Musical instruments |
437 |
982 |
25 |
304 |
||
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3993 |
Signs and advertising specialties |
4,468 |
5,424 |
6 |
Source: Concentration ratios in manufacturing, 1992 Census of Manufacturers Report MC92-S -2, Washington, DC: U.S. Department of Commerce, Economics and Statistics Administration, Bureau of the Census, 1997.
firms have sales of $2 million each. Calculate the 4-firm and 8-firm concen-tration ratios for this industry.
Solution
Total industry sales are ST = $28 million. From Eq. (7.1), C4 = 18 + 18 + 11 + 11 = 58 percent and C8 = 18 + 18 + 11 + 11 + 7 + 7 + 7 + 7 = 86 percent. The largest eight firms account for 58 percent of total industry sales. The largest eight firms account for 86 percent of total industry sales.
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180
Chapter 7
Herfindahl-Hirschman Index
An alternative measure of industrial concentration is the Hirschman Index (HHI), which is calculated as
HHI = w12 + w22 +
+ wn2 ,
Herfindahl-
(7.2)
where n is the total number of firms in the industry and ωi is firm i’s percent share of total industry. HHI is superior to concentration ratios because it used data for the entire industry instead of just a few large firms. Moreover, by squaring individual market shares, HHI assigns a greater weight to larger firms. The Herfindahl-Hirschman Index ranges in value from zero to 10,000. An HHI close to zero is typical of an industry consisting of a very a large number of very small firms that is not very concentrated. By contrast, an HHI of 10,000 is an industry consisting of a single firm. Unfortunately, HHI suf-fers from many of the same shortcomings as concentration ratios since it is also calculated using U.S. census data.
While HHI is a better measure of industrial concentration, it suffers from the other shortcomings of concentration ratios. Both measures are sensitive to how broadly or how narrowly industries are classified. Since both mea-sures ignore domestic penetration by foreign firms they tend to overstate the degree of industrial concentration. Lastly, both measures are calculated using data for the entire country and tell us nothing about the degree of local and regional industrial concentration.
The practical significance of the HHI stems from its role in the enforce-ment of U.S. antitrust legislation. The belief that increased industrial concen-tration was detrimental to consumers was initially addressed in the U.S. with the passage of the Clayton Act (1914). This legislation proscribed several business practices that “substantially lessen competition in an industry.” The Clayton Act also gave the U.S. Department of Justice (DOJ) the authority to monitor and, if necessary, prohibit horizontal integration (the merger of two or more firms from the same industry producing near or perfect substitutes). The Celler-Kefauver Act (1950) closed this loophole by extending this man-date to include vertical integration (the merger of upstream and downstream firms in the supply chain) and conglomerate mergers (the merger of two or more firms from different supply chains).
Although the Clayton and Celler-Kefauver Acts gave the federal government the authority to take legal action to block mergers, it was not until 1968 that the Antitrust Division of DOJ published guidelines to reduce uncertainty about proposed mergers that it found unacceptable. Until then, firms might devote substantial financial resources to structure a merger, only to have these efforts undermined by a DOJ lawsuit. Initially, these guide-lines specified that if an industry’s 4-firm concentration ratio was equal to or
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|
181 |
greater than 75 percent, the merger of a firm with a 15 percent or more market share with another firm controlling as little as 1 percent market share would be challenged in the courts. These guidelines, which were amended in 1984, replaced the 4-firm concentration ratio with the Herfindahl-Hirschman Index.
According to the revised guidelines, a proposed merger between two firms in an industry with a HHI of 1,000 or less will not be challenged since it is not a threat to social welfare. If HHI is between 1,000 and 1,800, proposed mergers within the same industry will be reviewed if the resulting index rises by more than 100 points. Finally, an industry with an HHI greater than 1,800 would be considered highly concentrated. In this case, proposed mergers that raise the index by more than 50 points will be challenged. A recent example of this was the proposed takeover of T-Mobile by the American Telephone and Telegraph Company (AT&T).
In March, 2011, AT&T announced its intention to acquire T-Mobile, the American subsidiary of T-Mobile International AG, a division of Deutsche Telekom. The following August, the DOJ filed a lawsuit in federal court to block the proposed merger. In November, the Federal Communication Commission announced that it opposed the proposed $39 billion takeover on the grounds that it was not in the public interest. Less than a month later, AT&T withdrew its tender offer and would write off $4 billion in the current quarter to cover breakup fees owed to T-Mobile’s parent company. Had the proposed merger been approved, it would have catapulted AT&T, the second-largest mobile phone provider in the U.S., into the number one spot, ahead of industry leader Verizon Wireless.
DOJ opposition to the proposed merger came as no surprise. From the beginning, the takeover faced a storm of criticism from smaller wireless net-work competitors. More importantly, the DOJ found that the merger would have raised the Herfindahl-Hirschman Index by 368 points to 3,216—well above the trigger of 50 and 1,800 required for DOJ review under the revised antitrust guidelines. According to the DOJ complaint, AT&T and T-Mobile competed in 97 of the nation’s largest 100 consumer markets. They also com-peted nationwide for business and government customers. AT&T’s acquisi-tion of T-Mobile would result in higher prices, poorer quality services, fewer choices and fewer innovative products for the millions of American consum-ers who rely on mobile wireless services.
Solved Exercise
Two industries consist of 10 firms. Both industries have total sales of $28 million. The two largest firms in industry A have sales of $5 million, the next two firms have sales of $3 million, and the remaining six firms have
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>Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces two types of boxes, a Standard box and a Deluxe box. These boxes are also produced by many other companies. after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will determine at what price the company can maximize the profitability of both boxes. 1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations. 20. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, team members will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primaries will coordinate any changes to the team’s answers to the topic questions. per box
.00
2 1 0.6 0.8 0.4 0.2 1 0.1 0.740 Future Supply and Demand for cardboard boxes 2 0.3 0
0.4 1.6 0.5 0
1.4 0.6 1.2 0.7 0
1 0.8 0.8 0.9 0
0.6 1 0.4 1.1 0
0.2 1.2 0.1 Given: 0
0.872 Future Supply & Demand for Standard Boxes Daily US demand of Standard boxes (in billions of boxes per day) 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.600000000000001 18.8 19 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 Daily US supply of Standard boxes (in billions of boxes per day) 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.600000000000001 18.8 19 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1. 00000000000001 Price Per Box Billions of Boxes Per Day Future Supply & Demand for Deluxe Boxes Daily US demand of Deluxe boxes (in billions of boxes per day) 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 Daily US supply of Deluxe boxes (in billions of boxes per day) 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1000000000000001 1.2 1.3 Price Per Box 1. Based on the information provided in Table 1, create a chart in the space below showing the supply and demand curves for the number of Standard boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2. Based on the information provided in Table 2, create a chart in the space below showing the supply and demand curves for the number of Deluxe boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab
1
Follow these steps to complete Project 2:
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations.
Project 2 is the team assignment in MBA 6
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Tab 1 – Supply and Demand Graph
Table 1
Future Supply and Demand for cardboard boxes
Price
Daily US demand of Standard boxes (in billions of boxes per day)
Daily US supply of Standard boxes (in billions of boxes per day)
$1
7
0.1
$17.20
1.
8
0.2
$17.40
1.6
0.3
$
17.60
1.4
0.4
$17.80
1.2
0.
5
$
18.00
0.6
$18.20
0.8
0.7
$
18.40
$18.60
0.
9
$18.80
$19.00
1.1
Question 1:
Create a Supply and Demand Chart for the Standard box below
Given:
Demand Slope
y=-.977x+18.6
Supply Slope
y=.5x-8.4
solve for value of x at intersect
-.977x+18.6=.5x-8.4
add 8.4
-.977x+27=.5x
add .977x
27=1.477x
divide by 1.477
18.280
solve for Y
y=.5(18.28)-8.4
0.740
y=-.977(18.28)+18.6
Equilibrium:
.74 Billion boxes per day, at a price of $18.28 per box
Table 2
Price per box
Daily US demand of Deluxe boxes (in billions of boxes per day)
Daily US supply of Deluxe boxes (in billions of boxes per day)
$30.00
$2
9.5
1.8
$29.00
$2
8.5
$28.00
$2
7.5
$27.00
$2
6.5
$26.00
$2
5.5
$25.00
1.3
Question 2:
Create a Supply and Demand Chart for the deluxe box below
Demand Slope
y=.391x-9.74
Supply Slope
y=-.2x+6.3
solve for value of x at intersect
.391x-9.74=-.2x+6.3
add 9.74
.391x=-.2x+16.04
add .2x
.591x=16.04
divide by .4
11
27.
14
solve for Y y=-.2x+6.3
0.872
y=.391(27.14)-9.74
Equilibrium:
.87 Billion Boxes per Day, at a price of $27.14 per box
10
Billions of Boxes Per DayTab 2 –
ity
| Quantity | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Original | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| New | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| % change | Elasticity of Demand | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| -5. | 12 | 2.1 | -2.33 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Elasticity: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Price Inelastic | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| By how much did revenues increase or decrease as a result of the change in price? | $ (5.20) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| By how much did profits increase or decline? | $ (0.20) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Standard Boxes sold per monthly (millions) | Revenue (millions) | Variable Cost per cardboard box | Variable Cost (millions) | Fixed cost per month (millions) | Total Cost (millions) | Monthly Profit (millions) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 18.00 | $ 180.00 | $ 10.00 | $ 100.00 | $ 110.00 | $ 70.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 18.40 | $ 174.80 | $ 95.00 | $ 105.00 | $ 69.80 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 10.5 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 10.000% | -4.444% | – | 2.2 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ (0.80) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ – 0 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Standard Boxes sold per month (millions) | Total Cost (Millions) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 17.60 | $ 184.80 | $ 115.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.5 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.35 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| – | 13 | 3.509% | -3.93 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ (4.25) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ ( | 2.25 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Deluxe boxes sold per month (millions) | Variable Cost per metal box | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.55 | $ 43.40 | $ 15.50 | $ 3.00 | $ 18.50 | $ 24.90 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 39.15 | $ | 13.5 | $ 16.50 | $ 22.65 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.65 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 20.000% | -7.143% | -2.80 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 5.40 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 2.40 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Deluxe boxes sold per month (millions) | $ 13.50 | $ 16.5000 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 44.55 | $ 19.50 | $ 25.05 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Select One | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Unit Price Elastic |
1. Last month the company sold 10 million of their Standard boxes at an average price of $18.00 per box. This week the company raised the average price to $18.40 per box. The company sold 9.5 million boxes for the month. The variable cost per unit is $10 and the fixed costs are $10 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
2. After reviewing last month’s results, the company decided to lower the price of a Standard box to $17.60. After this change, the volume sold increased to 10.5 million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
3. Last month the company sold 1.55 million Deluxe boxes at an average price of $28 per box. This month the company raised the price to $29 and sold 1.35 million boxes. The variable cost per unit is $10 and the fixed costs are $3 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
4. After reviewing the last results, the company decided to lower the price to $27 and sold 1.65 million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
Tab 3 –
Profit Maximization
| Standard boxes sold per month (millions) | Revenue (price x volume) | Variable Cost per standard box | Variable Cost (cost per unit x volume) | Total Cost (Fixed + Variable) | Monthly Profit (revenue – all costs) | MR | MC | Difference | |||||||||||||||||
| $ 22.00 | $ 50.00 | $ 10.00000 | $ 60.00 | ||||||||||||||||||||||
| $ 21.60 | $ 118.80 | $ 55.00 | $ 65.00 | $ 53.80 | $ 7.60 | ||||||||||||||||||||
| $ 21.20 | $ 127.20 | $ 70.0000 | $ 57.20 | $ 16.80 | $ 6.80 | ||||||||||||||||||||
| $ 20.80 | $ 135.20 | $ 75.00 | $ 60.20 | $ 16.00 | $ 6.00 | ||||||||||||||||||||
| $ 20.40 | $ 142.80 | $ 80.00 | $ 62.80 | $ 15.20 | $ 5.20 | ||||||||||||||||||||
| $ 20.00 | $ 150.00 | $ 85.00 | $ 14.40 | $ 4.40 | |||||||||||||||||||||
| $ 19.60 | $ 156.80 | $ 90.00 | $ 66.80 | $ 13.60 | $ 3.60 | ||||||||||||||||||||
| $ 19.20 | $ 163.20 | $ 95.0000 | $ 68.20 | $ 12.80 | $ 2.80 | ||||||||||||||||||||
| $ 18.80 | $ 169.20 | $ 100.0000 | $ 69.20 | $ 12.00 | $ 2.00 | ||||||||||||||||||||
| $ 105.0000 | $ 11.20 | $ 1.20 | |||||||||||||||||||||||
| $ 110.0000 | $ 10.40 | $ 0.40 | |||||||||||||||||||||||
| $ 115.0000 | $ 9.60 | $ (0.40) | |||||||||||||||||||||||
| $ 17.20 | $ 189.20 | $ 120.00 | $ 8.80 | $ (1.20) | |||||||||||||||||||||
| 11.5 | $ 193.20 | $ 125.00 | $ 8.00 | $ (2.00) | |||||||||||||||||||||
| $ 16.40 | $ 196.80 | $ 130.00 | $ 7.20 | $ (2.80) | |||||||||||||||||||||
| 12.5 | $ 200.00 | $ 135.00 | $ 6.40 | $ (3.60) | |||||||||||||||||||||
| $ 15.60 | $ 202.80 | $ 140.00 | $ 5.60 | $ (4.40) | |||||||||||||||||||||
| $ 205.20 | $ 145.0000 | $ 4.80 | |||||||||||||||||||||||
| $ 14.80 | $ 207.20 | $ 150.0000 | $ 4.00 | $ (6.00) | |||||||||||||||||||||
| Standard Boxes priced at $17.80 | |||||||||||||||||||||||||
| $ 30.00 | $ 3.00000 | $ 13.00 | $ 17.00 | ||||||||||||||||||||||
| $ 29.50 | $ 35.40 | $ 15.00 | $ 27.00 | ||||||||||||||||||||||
| $ 29.00 | $ 25.00 | ||||||||||||||||||||||||
| $ 28.50 | $ 42.75 | $ 18.0000 | $ 24.75 | $ 24.00 | $ 14.00 | ||||||||||||||||||||
| $ 28.00 | |||||||||||||||||||||||||
| $ 27.50 | $ 44.00 | $ 19.00 | |||||||||||||||||||||||
| $ 11.00 | $ 1.00 | ||||||||||||||||||||||||
| 1.7 | $ 26.50 | $ 45.05 | $ 20.0000 | ||||||||||||||||||||||
| 1.75 | $ 26.00 | $ 45.50 | $ 17.50 | $ 20.50 | $ 9.00 | $ (1.00) | |||||||||||||||||||
| $ 25.50 | $ 45.90 | $ 21.00 | |||||||||||||||||||||||
| 1.85 | $ 46.25 | $ 21.50 | $ 7.00 | $ (3.00) | |||||||||||||||||||||
| 1.9 | $ 24.50 | $ 46.55 | $ 22.0000 | $ 24.55 | $ (4.00) | ||||||||||||||||||||
| 1.95 | $ 46.80 | $ 22.50 | $ 24.30 | $ 5.00 | $ (5.00) | ||||||||||||||||||||
| $ 23.50 | $ 47.00 | $ 23.00 | |||||||||||||||||||||||
| 2.05 | $ 47.15 | $ 23.5000 | $ 23.65 | $ (7.00) | |||||||||||||||||||||
| $ 47.25 | $ 24.0000 | $ 23.25 | $ (8.00) | ||||||||||||||||||||||
| 2.15 | $ 47.30 | $ 24.5000 | $ 22.80 | $ (9.00) | |||||||||||||||||||||
| $ 25.0000 | $ 22.30 | $ (10.00) | |||||||||||||||||||||||
| $ 25.5000 | $ 21.75 | $ (11.00) | |||||||||||||||||||||||
| Deluxe Boxes priced at $26.50 |
1. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Standard boxes.
What is the closest price that will help the company maximize the profit on Standard boxes?
2. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Deluxe boxes.
What is the closest price that will help the company maximize the profit on Deluxe boxes?
Price Elasticity
1. Discuss what actions the company should take to set the Standard box price given its price elasticity of demand.
Price elasticity of demands shows that the proportion change in quantity demanded affects the change in the prices of the commodities. The price elasticity of demand for normal goods is expected to be negative due to the laws of demand. As the price of a commodity increase, the product’s demand reduces. A product is said to be elastic because demand’s price elasticity has a higher value than one (Rubio-Herrero, J., & Baykal-Gürsoy, 2020). In this case, the standard boxes had a price elasticity of -2.25 when the prices were increased from $18.0 to $18.4. However, when the prices dropped to $17.6 from $18.4, the elasticity of demand increased to -2.42. The information below will look into some of the actions that can be taken to set the standard box price.
The first step in ensuring that the organization has set up the correct price for the product is by assessing the nature of the standard boxes. If the product is said to have close substitutes, setting the prices will be in terms of the market forces of demand and supply as there will be many suppliers in the industry. Moreover, the management will have to look into the percentage of income spent on the product. The standard box seems to have a higher proportion of income spent on the product as the product is price elastic. In the long run, the management must ensure that it can meet the costs and increase profits (Atkin et al., 2020). In this case, the standard boxes seem to reduce profits when the prices are increased. When the prices are set to $18.4, the profits reduce. They retain the same profitability levels when they are set to $17.6. But when the prices are set to an average of $18.0, the organization is more efficient as it makes more revenues than the expenditure.
2. Discuss what actions the company should take to set the Deluxe box price given its price elasticity of demand.
Price elasticity of demands shows that the proportion change in quantity demanded affects the change in the prices of the commodities. The price elasticity of demand for normal goods is expected to be negative due to the laws of demand. As the price of a commodity increase, the product’s demand reduces. A product is said to be elastic because demand’s price elasticity has a higher value than one (Rubio-Herrero, J., & Baykal-Gürsoy, 2020). In this case, the deluxe boxes had a price elasticity of -3.93 when the prices were increased from $28.0 to $29. However, when the prices dropped to $27.0 from $29.0, the elasticity of demand dropped to -3.22. The information below will look into some of the actions that can be taken to set the standard box price.
The first step in ensuring that the organization has set up the correct price for the product is by assessing the nature of the deluxe boxes. If the product is said to have close substitutes, setting the prices will be in terms of the market forces of demand and supply as there will be many suppliers in the industry (Atkin et al., 2020). Moreover, the management will have to look into the percentage of income spent on the product. The deluxe box seems to have a higher proportion of income spent on the product as the product is price elastic. In the long run, the management must ensure that it can meet the costs and increase profits. In this case, the deluxe boxes seem to reduce profits when the prices are increased. The profits were highest when deluxe boxes sold for the lowest price, which is $27.00, and profits were lower when the organization sold the deluxe boxes at $29.00. The profit generated from selling deluxe boxes at $28.00 resulted in an average profit of $27.80 million. This analysis is essential as the management would consider selling the deluxe boxes at the lowest price to increase profitability.
3. Assuming the price elasticity of supply for the Standard box is inelastic, explain the key factors that the company must consider in expanding production.
When a product’s price elasticity is inelastic, the percentage change in quantity demanded over the percentage change in price is less than one. In this case, the change in prices will have little or no effect on the quantity demanded. Organizations must analyze several elements when considering the expanding production of the product. The standard box may have an inelastic elasticity of demand when the product has little or no substitutes (Wang, Chou & Liang, 2020). In such a case, increasing the price will increase profits. The management will also look into the income spent on the standard boxes. If the proportion of income spent on the standard boxes is low, then the product can be inelastic if the prices increase or reduce. Another element to be looked into is the classification of the standard box. If the standard box is a necessity, it will be inelastic.
Price inelastic products are good for business as the quantity demanded does not significantly affect the quantity demanded. In such a case, the organization should maximize the economies of scale and push for increased prices to increase revenues and reduce costs (Tovar-García & Carrasco, 2019). In the long run, the profits will be maximized.
Price Elasticity
1. Discuss what actions the company should take to set the Standard box price given its price elasticity of demand.
Price elasticity of demands shows that the proportion change in quantity demanded affects the change in the prices of the commodities. As the price of a commodity increase, the product’s demand reduces. A product is said to be elastic because demand’s price elasticity has a higher value than one (Rubio-Herrero, J., & Baykal-Gürsoy, 2020). In this case, the standard boxes had a price elasticity of 2.33 when the prices were increased from $18.0 to $18.4. However, when the prices dropped to $17.6 from $18.4, the elasticity of demand increased to 2.25. The information below will look into some of the actions that can be taken to set the standard box price.
The first step in ensuring that the organization has set up the correct price for the product is by assessing the nature of the standard boxes. If the product is said to have close substitutes, setting the prices will be in terms of the market forces of demand and supply as there will be many suppliers in the industry. Moreover, the management will have to look into the percentage of income spent on the product. The standard box seems to have a higher proportion of income spent on the product as the product is price elastic. In the long run, the management must ensure that it can meet the costs and increase profits (Atkin et al., 2020). In this case, the standard boxes seem to reduce profits when the prices are increased. When the prices are set to $18.4, the profits reduce. They retain the same profitability levels when they are set to $17.6. But when the prices are set to an average of $18.0, the organization is more efficient as it makes more revenues than the expenditure.
1. Discuss what actions the company should take to set the Deluxe box price given its price elasticity of demand.
Price elasticity of demands shows that the proportion change in quantity demanded affects the change in the prices of the commodities. As the price of a commodity increase, the product’s demand reduces. A product is said to be elastic because demand’s price elasticity has a higher value than one (Rubio-Herrero, J., & Baykal-Gürsoy, 2020). In this case, the deluxe boxes had a price elasticity of 3.93 when the prices were increased from $28.0 to $29. However, when the prices dropped to $27.0 from $29.0, the elasticity of demand dropped to 2.80. The information below will look into some of the actions that can be taken to set the standard box price.
The first step in ensuring that the organization has set up the correct price for the product is by assessing the nature of the deluxe boxes. If the product is said to have close substitutes, setting the prices will be in terms of the market forces of demand and supply as there will be many suppliers in the industry (Atkin et al., 2020). Moreover, the management will have to look into the percentage of income spent on the product. The deluxe box seems to have a higher proportion of income spent on the product as the product is price elastic. In the long run, the management must ensure that it can meet the costs and increase profits. In this case, the deluxe boxes seem to reduce profits when the prices are increased. The profits were highest when deluxe boxes sold for the lowest price, which is $27.00, and profits were lower when the organization sold the deluxe boxes at $29.00. The profit generated from selling deluxe boxes at $28.00 resulted in an average profit of $27.80 million. This analysis is essential as the management would consider selling the deluxe boxes at the lowest price to increase profitability.
1. Assuming the price elasticity of supply for the Standard box is inelastic, explain the key factors that the company must consider in expanding production.
When a product’s price elasticity is inelastic, the percentage change in quantity demanded over the percentage change in price is less than one. In this case, the change in prices will have little or no effect on the quantity demanded. Organizations must analyze several elements when considering the expanding production of the product. The standard box may have an inelastic elasticity of demand when the product has little or no substitutes (Wang, Chou & Liang, 2020). In such a case, increasing the price will increase profits. The management will also look into the income spent on the standard boxes. If the proportion of income spent on the standard boxes is low, then the product can be inelastic if the prices increase or reduce. Another element to be looked into is the classification of the standard box. If the standard box is a necessity, it will be inelastic.
Price inelastic products are good for business as the quantity demanded does not significantly affect the quantity demanded. In such a case, the organization should maximize the economies of scale and push for increased prices to increase revenues and reduce costs (Tovar-García & Carrasco, 2019). In the long run, the profits will be maximized.
Atkin, D., Faber, B., Fally, T., & Gonzalez-Navarro, M. (2020). A new engel on price index and welfare estimation. National Bureau of Economic Research.
Rubio-Herrero, J., & Baykal-Gürsoy, M. (2020). Mean-variance analysis of the newsvendor problem with price-dependent, isoelastic demand. European Journal of Operational Research, 283(3), 942-953.
Tovar-García, E. D., & Carrasco, C. A. (2019). Export and import composition as determinants of bilateral trade in goods: evidence from Russia. Post-Communist Economies, 31(4), 530-546.
Wang, K. C. A., Chou, P. Y., & Liang, W. J. (2020). Comparing Specific and Ad Valorem Taxes under Price-inelastic Demand with Quality Differentiation. Academia Economic Papers, 48(2), 183-216.
Tolliver, C., Keeley, A. R., & Managi, S. (2020). Drivers of green bond market growth: The importance of
Nationally Determined Contributions to the Paris Agreement and implications for
sustainability. Journal of cleaner production, 244, 118643.
Currid‐Halkett, E., Lee, H., & Painter, G. D. (2019). Veblen goods and urban distinction: The economic geography of conspicuous consumption. Journal of Regional Science, 59(1), 83-117.
Oosterman, N., & Angelini, F. (2021). One Flew Over the Cuckoo’s Clock. In Crime and Art (pp. 267-284). Springer, Cham.
Asmare, A., & Worku, A. (2018). Determinants of Micro-Insurance Demand in Jimma Zone. International Research Journal of Business Studies, 11(3), 145-157.
Du, T., Wang, J., Wang, H., Tian, X., Yue, Q., & Tanikawa, H. (2020). CO2 emissions from the Chinese cement sector: Analysis from both the supply and demand sides. Journal of Industrial Ecology, 24(4), 923-934.
>Instructions
Largo Global Inc. is a fictious firm that is will be used to allow you to understand the market forces of supply and demand as they impact a company as well as the industry in which the company operates. The company produces two types of boxes, a Standard box and a Deluxe box. These boxes are also produced by many other companies. after reading the instructions, you will chart the supply and demand curves for the two different boxes. In tab 2 you will focus on the price elasticity of demand for these two products. In tab 3 you will determine at what price the company can maximize the profitability of both boxes. 1. In step 2, you will complete this Excel file by placing your answers to the questions in the boxes provided. You may submit this file as the Milestone submission so you can receive feedback on the accuracy of your calculations. 20. Each team member will have three deliverables for the project. First, each team member will complete the Excel spreadsheet. Second, each team member will serve as the team’s primary respondent for one of the five topics and will answer all questions for that topic. Third, team members will serve as the secondary respondent to one of the five topics and submit their answers to the primary for that topic. The primary respondent will coordinate the answers for that topic and submit them to the editor for the team’s Word file. Once the faculty member’s feedback is provided, the primaries will coordinate any changes to the team’s answers to the topic questions. per box
.00
2 1 0.6 0.8 0.4 0.2 1 0.1 0.740 Future Supply and Demand for cardboard boxes 2 0.3 0
0.4 1.6 0.5 0
1.4 0.6 1.2 0.7 0
1 0.8 0.8 0.9 0
0.6 1 0.4 1.1 0
0.2 1.2 0.1 Given: 0
0.872 Future Supply & Demand for Standard Boxes Daily US supply of Standard boxes (in billions of boxes per day) 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1. 00000000000001 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.600000000000001 18.8 19 Daily US demand of Standard boxes (in billions of boxes per day) 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 17 17.2 17.399999999999999 17.600000000000001 17.8 18 18.2 18.399999999999999 18.60000000 0000001 18.8 19 Billions of Boxes per Day Price per Box Future Supply & Demand for Deluxe Boxes Daily US demand of Deluxe boxes (in billions of boxes per day) 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.1 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 Daily US supply of Deluxe boxes (in billions of boxes per day) 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1000000000000001 1.2 1.3 30 29.5 29 28.5 28 27.5 27 26.5 26 25.5 25 Billions of Boxes per Day Price per Box 1. Based on the information provided in Table 1, create a chart in the space below showing the supply and demand curves for the number of Standard boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2. Based on the information provided in Table 2, create a chart in the space below showing the supply and demand curves for the number of Deluxe boxes in the United States per day. This information is helpful in knowing how many boxes to produce. After you have examined the graph below, identify the price and quantity at which market equilibrium exists.
2
In Project 2, you will learn about how to apply the tenets of microeconomics to improve the company’s profitability. In tab
1
Follow these steps to complete Project 2:
2. In step 3, you will answer the questions provided in the Word file for this project that will guide/give direction to your analysis. These questions will constitute the core of your report where you will be asked to make key recommendations.
Project 2 is the team assignment in MBA 6
All team members must submit their three deliverables in order to receive a grade for the project. Your faculty member will let you know how you will submit your deliverables as well as the team’s consolidated Word file which will be graded.
Tab 1 – Supply and Demand Graph
Table 1
Future Supply and Demand for cardboard boxes
Price
Daily US demand of Standard boxes (in billions of boxes per day)
Daily US supply of Standard boxes (in billions of boxes per day)
$1
7
0.1
$17.20
1.
8
0.2
$17.40
1.6
0.3
$
17.60
1.4
0.4
$17.80
1.2
0.
5
$
18.00
0.6
$18.20
0.8
0.7
$
18.40
$18.60
0.
9
$18.80
$19.00
1.1
Question 1:
Create a Supply and Demand Chart for the Standard box below
Given:
Demand Slope
y=-.977x+18.6
Supply Slope
y=.5x-8.4
solve for value of x at intersect
-.977x+18.6=.5x-8.4
add 8.4
-.977x+27=.5x
add .977x
27=1.477x
divide by 1.477
18.280
solve for Y
y=.5(18.28)-8.4
0.740
y=-.977(18.28)+18.6
Equilibrium:
.74 Billion boxes per day, at a price of $18.28 per box
Table 2
Price per box
Daily US demand of Deluxe boxes (in billions of boxes per day)
Daily US supply of Deluxe boxes (in billions of boxes per day)
$30.00
$2
9.5
1.8
$29.00
$2
8.5
$28.00
$2
7.5
$27.00
$2
6.5
$26.00
$2
5.5
$25.00
1.3
Question 2:
Create a Supply and Demand Chart for the deluxe box below
Demand Slope
y=.391x-9.74
Supply Slope
y=-.2x+6.3
solve for value of x at intersect
.391x-9.74=-.2x+6.3
add 9.74
.391x=-.2x+16.04
add .2x
.591x=16.04
divide by .4
11
27.
14
solve for Y y=-.2x+6.3
0.872
y=.391(27.14)-9.74
Equilibrium:
.87 Billion Boxes per Day, at a price of $27.14 per box
10
Tab 2 –
ity
| Quantity | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Original | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| New | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| % change | Elasticity of Demand | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| -5. | 12 | 2.1 | 2.33 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Elasticity: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| By how much did revenues increase or decrease as a result of the change in price? | $ (5.20) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| By how much did profits increase or decline? | $ (0.20) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Standard Boxes sold per monthly (millions) | Revenue (millions) | Variable Cost per cardboard box | Variable Cost (millions) | Fixed cost per month (millions) | Total Cost (millions) | Monthly Profit (millions) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 18.00 | $ 180.00 | $ 10.00 | $ 100.00 | $ 110.00 | $ 70.00 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 18.40 | $ 174.80 | $ 95.00 | $ 105.00 | $ 69.80 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 10.5 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 10.000% | -4.444% | 2.2 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ (0.80) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ – 0 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Standard Boxes sold per month (millions) | Total Cost (Millions) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 17.60 | $ 184.80 | $ 115.00 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.5 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.35 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| – | 13 | 3.509% | 3.93 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ (4.25) | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ ( | 2.25 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Deluxe boxes sold per month (millions) | Variable Cost per metal box | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.55 | $ 43.40 | $ 15.50 | $ 3.00 | $ 18.50 | $ 24.90 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 39.15 | $ | 13.5 | $ 16.50 | $ 22.65 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 1.65 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| 20.000% | -7.143% | 2.80 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 5.40 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 2.40 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Deluxe boxes sold per month (millions) | $ 13.50 | $ 16.5000 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| $ 44.55 | $ 19.50 | $ 25.05 | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Select One | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Price Inelastic | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Unit Price Elastic |
1. Last month the company sold 10 million of their Standard boxes at an average price of $18.00 per box. This week the company raised the average price to $18.40 per box. The company sold 9.5 million boxes for the month. The variable cost per unit is $10 and the fixed costs are $10 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
2. After reviewing last month’s results, the company decided to lower the price of a Standard box to $17.60. After this change, the volume sold increased to 10.5 million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
3. Last month the company sold 1.55 million Deluxe boxes at an average price of $28 per box. This month the company raised the price to $29 and sold 1.35 million boxes. The variable cost per unit is $10 and the fixed costs are $3 million per month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
4. After reviewing the last results, the company decided to lower the price to $27 and sold 1.65 million boxes for the month.
What is the price elasticity of demand?
Can the demand be characterized as price elastic, price inelastic, or neither?
By how much did revenues increase or decrease as a result of the change in price?
By how much did profits increase or decline?
Tab 3 –
Profit Maximization
| Standard boxes sold per month (millions) | Revenue (price x volume) | Variable Cost per standard box | Variable Cost (cost per unit x volume) | Total Cost (Fixed + Variable) | Monthly Profit (revenue – all costs) | MR | MC | Difference | |||||||||||||||||
| $ 22.00 | $ 50.00 | $ 10.00000 | $ 60.00 | ||||||||||||||||||||||
| $ 21.60 | $ 118.80 | $ 55.00 | $ 65.00 | $ 53.80 | $ 7.60 | ||||||||||||||||||||
| $ 21.20 | $ 127.20 | $ 70.0000 | $ 57.20 | $ 16.80 | $ 6.80 | ||||||||||||||||||||
| $ 20.80 | $ 135.20 | $ 75.00 | $ 60.20 | $ 16.00 | $ 6.00 | ||||||||||||||||||||
| $ 20.40 | $ 142.80 | $ 80.00 | $ 62.80 | $ 15.20 | $ 5.20 | ||||||||||||||||||||
| $ 20.00 | $ 150.00 | $ 85.00 | $ 14.40 | $ 4.40 | |||||||||||||||||||||
| $ 19.60 | $ 156.80 | $ 90.00 | $ 66.80 | $ 13.60 | $ 3.60 | ||||||||||||||||||||
| $ 19.20 | $ 163.20 | $ 95.0000 | $ 68.20 | $ 12.80 | $ 2.80 | ||||||||||||||||||||
| $ 18.80 | $ 169.20 | $ 100.0000 | $ 69.20 | $ 12.00 | $ 2.00 | ||||||||||||||||||||
| $ 105.0000 | $ 11.20 | $ 1.20 | |||||||||||||||||||||||
| $ 110.0000 | $ 10.40 | $ 0.40 | |||||||||||||||||||||||
| $ 115.0000 | $ 9.60 | $ (0.40) | |||||||||||||||||||||||
| $ 17.20 | $ 189.20 | $ 120.00 | $ 8.80 | $ (1.20) | |||||||||||||||||||||
| 11.5 | $ 193.20 | $ 125.00 | $ 8.00 | $ (2.00) | |||||||||||||||||||||
| $ 16.40 | $ 196.80 | $ 130.00 | $ 7.20 | $ (2.80) | |||||||||||||||||||||
| 12.5 | $ 200.00 | $ 135.00 | $ 6.40 | $ (3.60) | |||||||||||||||||||||
| $ 15.60 | $ 202.80 | $ 140.00 | $ 5.60 | $ (4.40) | |||||||||||||||||||||
| $ 205.20 | $ 145.0000 | $ 4.80 | |||||||||||||||||||||||
| $ 14.80 | $ 207.20 | $ 150.0000 | $ 4.00 | $ (6.00) | |||||||||||||||||||||
| Standard Boxes priced at $18 | |||||||||||||||||||||||||
| $ 30.00 | $ 3.00000 | $ 13.00 | $ 17.00 | ||||||||||||||||||||||
| $ 29.50 | $ 35.40 | $ 15.00 | $ 27.00 | ||||||||||||||||||||||
| $ 29.00 | $ 25.00 | ||||||||||||||||||||||||
| $ 28.50 | $ 42.75 | $ 18.0000 | $ 24.75 | $ 24.00 | $ 14.00 | ||||||||||||||||||||
| $ 28.00 | |||||||||||||||||||||||||
| $ 27.50 | $ 44.00 | $ 19.00 | |||||||||||||||||||||||
| $ 11.00 | $ 1.00 | ||||||||||||||||||||||||
| 1.7 | $ 26.50 | $ 45.05 | $ 20.0000 | ||||||||||||||||||||||
| 1.75 | $ 26.00 | $ 45.50 | $ 17.50 | $ 20.50 | $ 9.00 | $ (1.00) | |||||||||||||||||||
| $ 25.50 | $ 45.90 | $ 21.00 | |||||||||||||||||||||||
| 1.85 | $ 46.25 | $ 21.50 | $ 7.00 | $ (3.00) | |||||||||||||||||||||
| 1.9 | $ 24.50 | $ 46.55 | $ 22.0000 | $ 24.55 | $ (4.00) | ||||||||||||||||||||
| 1.95 | $ 46.80 | $ 22.50 | $ 24.30 | $ 5.00 | $ (5.00) | ||||||||||||||||||||
| $ 23.50 | $ 47.00 | $ 23.00 | |||||||||||||||||||||||
| 2.05 | $ 47.15 | $ 23.5000 | $ 23.65 | $ (7.00) | |||||||||||||||||||||
| $ 47.25 | $ 24.0000 | $ 23.25 | $ (8.00) | ||||||||||||||||||||||
| 2.15 | $ 47.30 | $ 24.5000 | $ 22.80 | $ (9.00) | |||||||||||||||||||||
| $ 25.0000 | $ 22.30 | $ (10.00) | |||||||||||||||||||||||
| $ 25.5000 | $ 21.75 | $ (11.00) | |||||||||||||||||||||||
| Deluxe Boxes priced at $26.50 |
1. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Standard boxes.
What is the closest price that will help the company maximize the profit on Standard boxes?
2. The company views its goal as profit maximization. Complete the table to the right to approximate the profit-maximizing price for the Deluxe boxes.
What is the closest price that will help the company maximize the profit on Deluxe boxes?
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