Chapter 6
Market Efficiency and Government Intervention
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Efficiency
A situation in which people do the best they can, given their limited resources
Principle of voluntary exchange
A voluntary exchange between two people makes both people better off
A market equilibrium will generate the largest possible surplus when four conditions are met:
1. No external benefits: the benefits of a product (a good or service) are confined to the person who pays for it
2. No external costs: the cost of producing a product is confined to the person who sells it
3. Perfect information: buyers and sellers know
The Demand Curve and Consumer Surplus
Willingness to pay
The maximum amount a consumer is willing to pay for a product
The Demand Curve and Consumer Surplus
Consumer surplus
The mount a consumer is willing to pay for a product minus the price the consumer actually pays
The Demand Curve and Consumer Surplus
Consumer surplus equals the maximum amount a consumer is willing to pay (shown by the demand curve) minus the price paid
Ex. Juan is willing to pay $22, so if the price is $10, his consumer surplus is $12
The market consumer surplus equals the same of the
The Supply Curve and Producer Surplus
Willingness to accept
The minimum amount a producer is willing to accept as payment for a product; equal to the marginal cost of production
The Supply Curve and Producer Surplus
Producer Surplus
The price a producer receives for a product minus the marginal cost of production
The Supply Curve and Producer Surplus
Producer surplus equals the market price minus the producer's willingness to accept, or marginal cost (shown by the supply curve)
Ex. Abe's marginal cost is $2, so if the price is $10, his producer surplus is $8
The market producer surplus equals the same
Total surplus
The sum of consumer surplus and producer surplus
The total surplus of the market equals consumer surplus (the lightly shaded areas) plus producer surplus (the darkly shaded areas)
Total Surplus is Lower with a Price Below the Equilibrium Price
Price ceiling
A maximum price set by the government
Total Surplus is Lower with a Price Above the Equilibrium Price
Price Floor
A minimum price set by the government
Efficiency and the Invisible Hand
The market equilibrium maximizes the total surplus of the market because it guarantees that all mutually beneficial transactions will happen
Instead of using a bureaucrat to coordinate the actions of everyone in the market, we can rely on the actions of i
Government Intervention in Efficient Markets
In most modern economics, governments take an active role
For a market that meets the four efficiency conditions, the market equilibrium generates the largest possible total surplus, so government intervention can only decrease the surplus and cause ineff
Setting maximum prices
Here are some examples of goods that have been subject to maximum prices or may be subject to maximum prices in the near future:
Rental housing, gasoline, medical goods and services
In all three cases, a maximum price will cause excess demand and reduce t
Market equilibrium
In the market equilibrium, the total surplus is the area between the demand curve and the supply curve
Deadweight loss
The decrease in the total surplus of the market that results from a policy such as rent control
Setting minimum prices
Recall that when government sets a minimum price above the equilibrium price, the result is permanent excess supply
Governments around the world establish minimum prices for agricultural goods
Under a price-support program, a government sets a minimum pri
Licensing and market efficiency
A policy that limits entry into a market
Increases price, decreases quantity, and causes inefficiency in the market
In evaluating such a policy, we must compare the possible benefits from controlling nuisances to the losses of consumer and producer surplu
Winners and losers from licensing
Who benefits and who loses from licensing programs such as a taxi medallion policy
The losers are consumers, who pay more for taxi rides
The winners are the people who receive a free medallion and the right to change an artificially high price for taxi se
Tax shifting and the price elasticity of demand
If demand is inelastic, a tax will increase the market price by a large amount, so consumers will bear a large share of the tax
If demand is elastic, the price will increase by a small amount and consumers will bear a small share of the tax
Tax burden and deadweight loss
When the supply curve is horizontal, a tax increases the equilibrium price by the tax
Tax Burden and Deadweight Loss
Deadweight loss from taxation
The difference between the total burden of a tax and the amount of revenue collected by the government
Tax Burden and Deadweight Loss
Excess burden of a tax
Another name for deadweight loss
Chapter 8
Production Technology and Cost
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Economic profit
Total revenue minus economic cost
Economic profit = total revenue - economic cost
Economic cost
The opportunity cost of the inputs used in the production process; equal to explicitly cost plus implicit cost
Principle of opportunity cost
The opportunity cost of something is what you sacrifice to get it
Explicit cost
A monetary payment
Ex. Monetary payments for labour, capital, materials
Implicitly cost
An opportunity cost that does not involve a monetary payment
Ex. Opportunity cost of entrepreneur's time
Ex. Opportunity cost of funds
Economic cost
Economic cost = explicit cost + implicit cost
Accounting cost
The explicit cost of production
Accounting cost = explicit cost
Accounting profit
Total revenue minus accounting cost
Accounting profit = total revenue - accounting cost
Production and Marginal Product
Marginal product of labor
The change in output from one additional unit of labor
Production and Marginal Product
Diminishing returns
As one input increases while the other inputs are held fixed, output increases at a decreasing rate
Production and Marginal Product
Total-product curve
A curve showing the relationship between the quantity of labor and the quantity of output produced, ceteris paribus
Production and Marginal Product
The total-product curve shows the relationship between the quantity of labor and the quantity of output given a fixed production facility
Short-Run Total Cost
Fixed Cost (FC)
Cost that does not vary with the quantity produced
Short-Run Total Cost
Variable cost (VC)
Cost that varies with the quantity produced
Short-Run Total Cost
Short-run total cost (TC)
The total cost of production when at least one input is fixed; equal to fixed cost plus variable cost
Short-Run Total Cost
The short-run total-cost curve shows the relationship between the quantity of output and production costs, given a fixed production facility
Short-Run Average Costs
Average fixed cost (AFC)
Fixed cost divided by the quantity produced
AFC = FC/Q
Short-Run Average Costs
Average variable cost (AVC)
Variable cost divided by the quantity produced
AVC = VC/Q
Short-Run Average Costs
The short-run average-total-cost curve (ATC) is U-shaped
As the quantity produced increases, fixed costs are spread over more and more units, pushing down the average total cost
In contrast, as the quantity increases, diminishing returns eventually pulls
Short-Run Average Costs
Short-run average total cost (ATC)
Short-run total cost divided by the quantity produced; equal to AFC plus AVC
ATC = TC/Q = FC/Q + VC/Q = AFC + AVC
Short-Run Marginal Cost
Short-run marginal cost (MC)
The change in short-run total cost resulting from a one-unit increase in output
MC = change in TC / change in output
The relationship between marginal cost and average cost
The marginal-cost curve (MC) is negatively sloped for small quantities of output, because of the benefits of labor specialization, and positively sloped for large quantities, because of diminishing returns
Expansion and Replication
Long-run total cost (LTC)
The total cost of production where a firm is perfectly flexible in choosing its inputs
Expansion and Replication
Long-run average cost (LAC)
The long-run cost divided by the quantity produced
Expansion and Replication
Constant returns to scale
A situation in which the long-run total cost increases proportionately with output, so average cost is constant
Expansion and Replication
Long-run marginal cost (LMC)
The change in long-run cost resulting from a one-unit increase in output
Reducing Output with Indivisible Inputs
Indivisible input
An input that cannot be scaled down to produce a smaller quantity of output
Scaling down and labor specialization
Labor specialization makes works more productive because of continuity and repetition
When we reduce the workforce each worker will become less specialized, performing a wider variety of production tasks
The loss of specialization will decrease labor prod
Economies of Scale
A situation in which the long-run average cost of production decreases as output increases
Economies of Scale
Minimum efficient scale
The output at which scale economies are exhausted
Diseconomies of Scale
A situation in which the long-run average cost of production increases as output increases
Short-run versus Long-run average cost
The difference between the short run and long run is a firm's flexibility in choosing inputs
Chapter 9
Perfect Competition
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Perfectly competitive market
A market with many sellers and buyers of a homogenous product and no barriers to entry
Price taker
A buyer or seller that takes the market price as given
Perfect competition
Here are the five features of a perfectly competitive market:
1. There are many sellers
2. There are many buyers
3. The product is homogenous
4. There are no barriers to market entry
5. Both buyers and sellers are price takers
Firm-specific demand curve
A curve showing the relationship between the price charged by a specific firm and the quantity the firm can sell
The total approach: computing total revenue and total cost
Economic profit is shown by the vertical distance between the total revenue curve and the total-cost curve
To maximize profit, the firm chooses the quantity of output that generates the largest vertical difference between the two curves
Marginal revenue
The change in total revenue from selling one more unit of output
Marginal revenue = price
To maximize profit, produce the quantity where price = marginal cost
The marginal approach
A perfectly competitive firm takes the market price as given, so the marginal benefit, or marginal revenue, equals the price
Economic profit
economic profit = (price - average cost) x quantity produced
Break-Even Price
The price at which economic profit is zero; price equals average total cost
Total revenue, variable cost, and the shut down decision
Operate if total revenue > variable cost
Shut down if total revenue < variable cost
Shut-down price
The price at which the firm is indifferent between operating and shutting down; equal to the minimum average variable cost
Sunk cost
A cost that a firm has already paid or committed to pay, so it cannot be recovered
Short-run supply curve
A curve showing the relationship between the market price of a product and the quantity of output supplied by a firm in the short run
Short-run market supply curve
A curve showing the relationship between market price and the quantity supplied in the short run
Long-run market supply curve
A curve showing the relationship between the market price and quantity supplied in the long run
Increasing-cost industry
An industry in which the average cost of production increases as the total output of the industry increases; the long-run supply curve is positively sloped
The average cost of production increases as the total output increases, for two reasons:
Increasing input price -- As an industry grows, it competes with other industries for limited amounts of various inputs, and this competition drives up the prices of these inputs
Less productive inputs -- A small industry will use only the most productive
Drawing the long-run market supply curve
The long-run market supply curve shows the relationship between the price and quantity supplied in the long run, when firms can enter or leave the industry
At each point on the supply curve, the market price equals the long-run average cost of production
The long-run response to an increase in demand
The short-run supply curve is steeper than the long-run supply curve because of diminishing returns in the short run
The large upward jump in price after the increase in demand is followed by a downward slide to the new long-run equilibrium price
Constant-cost industry
An industry in which the average cost of production is constant; the long-run supply curve is horizontal
In a constant-cost industry, input prices do not change as the industry grows
Therefore, the average production cost is constant and the long-run supp
Chapter 10
Perfect Competition
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Monopoly
A market in which a single firm sells a product that does not have any close substitutes
Market power
The ability of a firm to affect the price of its product
Barrier to entry
Something that prevents firms from entering a profitable market
Patent
The exclusive right to sell a new good for some period of time
Network externalities
The value of a product to a consumer increases with the number of other consumers who use it
Natural monopoly
A market in which the economies of scale in production are so large that only a single large firms can earn a profit
A formula for marginal revenue
Marginal revenue = new price + (slope of demand curve x old quantity)
The first part of the formula is the good news, the money received for the extra unit sold
The second part is the bad news from selling one more unit, the revenue lost by cutting the pr
Using the marginal principle
A monopolist can use the marginal principle to decide how much output to produce
Marginal principle - increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level are which the marginal benefit equals the m
The three-step process explaining how a monopolist picks a quantity and how to compute the monopoly profit is as follows:
1. Find the quantity that satisfies the marginal principle, that is, the quantity at which marginal revenue equals marginal cost
2. Using the demand curve, find the price associated with the monopolist's chosen quantity
3. Compute the monopolist's profit.
Deadweight loss from monopoly
A measure of the inefficiency from monopoly; equal to the decrease in the market surplus
Rent seeking
The process of using public policy to gain economic profit
Monopoly and public policy
Give the social costs of monopoly, the government uses a number of policies to intervene in markets dominated by a single firm or likely to become a monopoly
Price discrimination
The practice of selling a good at different prices to different consumers
Although price discrimination is widespread, it is not always possible. A firm has an opportunity for price discrimination if three conditions are met:
1. Market power
2. Different consumer groups
3. Resale is not possible
Chapter 11
Marke Entry and Monopolistic Competition
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Monopolistic competition
A market served by many firms that sell slightly different products
The term monopolistic competition actually conveys the two key features of the market:
Each firm is the market produces a good that is slightly different from the goods of other firms, so each firm has a narrowly defined monopoly
The products sold by different firms in the market are close substitutes for one another, so there is intense co
Under a market structure called monopolistic competition, firms will continue to enter the market until economic profit is zero. Here are the features of monopolistic competition:
Many firms
A differentiated product
Product differentiation
The process used by firms to distinguish their products from the products of competing firms
No artificial barriers to entry