CHAPTER 1:

Economic is the social science that studies CHOICES that individuals, business, government
and entire societies make was they cope with SCARCITY and the INCENTIVES that influence
and reconcile those choices.

Economic choice: Why we need to make choices - Unlimited wants but limited resources.
Scarcity (limited availability such as money/time/resources): force us to make choices.

3 main agents (decision makers) in an economy:

Consumers: want to buy goods and service but limited by income and time.
Producers: want to make money by producing and selling goods and service, but are limited by
their resources.
Government: want to provide more services (defense, edu,…) but only have so much money to
do so. Government could not keep printing money because of the inflation.

Incentives: what motivates us to do something (rewards or penalties that is associate with a

particular decision).
Example:
• Getting money from parents for doing chores (positive).
• Government puts high taxes on cigarette to prevent people from smoking.
• Going to jail for doing bad things (negative)

Two main areas of Economics:

• Micro: choices that individuals and business make and how the choices interact in the
market.
Micro question: how did the GI impact enrollment in higher education.
• Macro: the performance of the national and global economy.
Macro question: why did the unemployment rate in the US so high?

Two Big Questions:

I.How do the choices we make end up determining what, how and for whom goods and
services get produce?
What goods and service getting produced?
What products will 3M produce?

How do the goods and service get produced?

How will resources and technology get combined to produced the goods and services?
• Factors of production: Land, Labor, Capital, Entrepreneurship
• Example of entrepreneur (person/company that combines land, labor and capital): Sam
Walton created the multinational retail corporation brand Walmart in 1962.
• Land is the gifts of nature or natural resources that we use to produce goods and services.

 • The work time, and work effort that people devote to produce goods and services is labor.
• Human capital is the knowledge and skill that people obtain from education, on-the-job
training, and work experience.
• Tools, instruments, machines, buildings, and other items that have been produced in the
past and that businesses now use to produce goods and services is capital.

Example: during the pandemic, restaurant pivoted “the how” = cut off the servers, boost togo/
delivery.
For Whom do the goods and service get produced?
Who consumes the goods and services depends on the income people earn.

II. Do choices made in the pursuit of self interest also promote the social interest?
• Self interest: choose that are best for you personally.
• Social interest: choose that are best for the society as a whole.
• Efficient: Cannot make someone better off without making someone else worse off.

Resource use is efficient when it is not possible to make someone better off without making
someone else worse off.

Positive vs. Negative:

• Positive Statement: A statement about what IS. Based on FACT. Describe cause and effect.
Provide description and/or quantification of economic policy or phenomenon. DONT have the
word SHOULD.
• Normative Statement: A statement about what SHOULD be. Based on VALUE
JUDGEMENT. Attempt to address the desirability of an economic outcome. Often have the
word SHOULD.

Macroeconomic statement: about the performance of the national economy and the global
economy.
Ex: The U.S. government should increase unemployment benefits.

Economic Way of Thinking:

Every choice is a trade off.
A rational choice is one that compares the costs and benefits and achieves the greatest benefit
over cost for the person making the choice

Benefit: the pleasure the decision brings.

Cost: What the decision maker gives up once make final choice (or called opportunity cost)
Opportunity cost: the true cost, the BEST next alternative.

 Preference: The decision-maker’s likes and dislikes are what determine the benefits of an
option.
*NET BENEFIT = BENEFITS - COSTS (also called economic surplus)
*Marginal cost is the opportunity cost that arises from one unit increase in an activity.
Marginal benefit is the benefit that arises from one unit increase in an activity.

Example: What is the opportunity cost of going to a concert? (Pursue ONE of the these things
below as an opportunity cost)
1. Things you can’t afford to buy if buying a concert ticket now.
2. The things you can do with your time if not spending at the concert.

Example: What is the opportunity cost of being in school (tuition of $50,000) ? Assume you have
a job offer that pays $45,000?
If choosing school: The $50,000 for tuition that you would not have to pay.

Example: You can stay in school or you can quit school and get a full-time job.
You have an incentive to stay in school if the marginal benefit from staying in school is
greater than the marginal cost of staying in school.
***ALWAYS COMPARE BETWEEN MARGINAL COST VS. MARGINAL BENEFIT OF
THE SAME SUBJECT.

Marginal decision: decision about whether to do a little bit more or less of an activity
(marginal means ONE MORE).
Example: taking both econ and history. You are in an econ major, so your econ grade matters
more to you. You will take more time to study econ.
Choosing the margin: make a decision at the margin you compare the benefits of doing a little
bit more of an activity (spend more money/time) with the COSTS. Evaluate the consequences
are making incremental changes in the use of time/money.
Rational choice: If Marginal Benefits > Marginal Cost, then do more of that activity. You will
continue until MB = MC, at which point you stop doing that activity.

*A choice on the margin is a choice that is made by comparing all the

relevant alternatives systematically and incrementally.

Sunk Cost Fallacy: a cost that has already been incurred and cannot be reverse. Good decision
makers ignore sunk cost!
Example: Last month you bought a concert ticket for $60. Today you are feeling sick and you
know you won’t enjoy the ticket. Do you still go to the concert?
=> No. Don’t let last month’s sunk cost of $60 (sunk cost) push you into going to the concert that
you won’t enjoy. Benefit nearly 0.

You paid $12 to see Transformer 3. You set thru the first 2 hrs and hated it thus far. Do you stay
for the last 37min of the movie? => No, you can’t get $12 (sunk cost) back, but you don’t have to
continue unhappy, just leave.

 CHAPTER 2:

Production Possibility:
1. Producers Deal with Scarcity.
2. Producers Make Choices: to increase the production of one good, producers have to decrease
the production of the other.
3. Production Possibilities Frontier (PPF): use to understand the trade-offs that any and all
producers face.
4. PPF Simplification: examines only 2 goods at a time, while quantities of all other goods ate
held constant.

The PPF (graph): is the boundary between the combination of goods (bundle) that CAN be
produced and those that CANNOT be produced.
Example: Harry produces 8 balloon rides and 6 boat rides an hour. Harry could not produce more
balloon rides without producing fewer boat rides. Harry is producing on his production
possibilities frontier.

Efficient Bundle: Any bundle ON the PPF (frontier).

As we move down along the PPF, the OC increase and MC also increase.

• Marginal cost can be produced from the slope of the PPF => The STEEPER the sloper,
the GREATER the OC.
• Marginal Benefit (the willing to pay for something) is UNRELATED to the PPF (bc it
depends on the personal preference).
• We measure of MB of a good by someone’s willingness to pay for an additional unit => The
smaller the MB, the less we are willing to pay for an additional unit => It is the quantity of
other good that you are willing to forgo.

Production Efficiency: production at the lowest resources (opportunity) cost.

=> The economy is efficient if there are NO missed opportunities.

Opportunity cost is a ratio of what you sacrifice over what you gain.

sa cr i f ice
• Opportunity Cost (of something you want to gain) Formula =
gain
ΔQu a nt it ySa cr i f ice
• Marginal Cost Formula (denominator is always 1) = ΔQu a nt it yG ain ed

OC is increasing in the Post-it Note/Printing Paper because resources are not always equally
productive in all uses.

 => If resource are 100% transferable = we will have a linear PPF, but instead we have to
trade off some resources to produce the other things, that is why PPF is bowed outward and not a
straight line (linear). At the CONSTANT PPF, every OC is CONSTANT because it has a
CONSTANT SLOPE.

***The PPF bow outward because as we move from point A to point B to point C , the

opportunity cost of producing one thing INCREASES <=> Resources are NOT equally
productive in all activities.

Solve:
OC 1 gallon of food = extreme sun/
extreme food
(Extreme Sacrifice/Extreme Gain)
= 150/300 = 1/2

***ONLY USE THE EXTREMES

METHOD FOR THE LINEAR PPF!!!!

Scenario: The restaurant Big Lobster sells lobster and fish, and so too does the restaurant H Salt.
If H Salt and Big Lobster decide to specialize and trade, then the source of the gains from the
trade between H Salt and Big Lobster is divergent opportunity cost (means to going in
opposite direction - trade happens in between the 2 OC)

 Productive Efficiency vs. Allocative Efficiency:

• Production efficiency occurs when we produce goods and services at the lowest possible
cost.
• Allocative efficiency occurs when goods and services are produced at the lowest possible
cost and in the quantities that provide the GREATEST possible benefit. It is produce when
MB=MC (the point of intersection between MC and MB in the graph).

• All points on the PPF are points of PRODUCTION efficiency.

• When we produce at the point on the PPF that we prefer above all other points we
achieve ALLOCATIVE efficiency. Its how we try to address the question of which bundle is
BEST.

• The stepper the tangent line => the higher the opportunity cost.
• The stepper the slope of PPF => the greater the MC.

Absolute Advantage vs. Comparative Advantage:

• Absolute Advantage: A person can do task using FEWER INPUTS (They are more
productive)
• Comparative Advantage: A person can do a task at a LOWER OC (Give up LESS).
• Absolute advantage involves comparing productivities—production per hour—whereas
comparative advantage involves comparing opportunity costs.
➡ A person who has an absolute advantage does NOT have a comparative advantage in every
activity (have a comparative advantage in one activity but not both).

=> Ex: LeBron James is a four time National Basketball Associate MVP. LeBron is also
super tall, standing 6 ft 8 in (203cm) such that he could easily repaint the walls of his house
without needing a ladder. LeBron has an absolute advantage in both basketball and painting, but
does this mean he should paint his own wall. Ms. Taylor also has the same options.
=> LeBron has absolute advantage with his height but Ms. Taylor has comparative advantage
since she does not play basketball while LeBron does and everyone wants to see him play.

Absolute Advantage example: Tom does his math homework in 2 hours while Harry takes only
30 minutes to do the same task.

• Example: The restaurant Big Lobster sells lobster and fish, and so too does the restaurant H
Salt. If H Salt and Big Lobster decide to specialize and trade, then the source of the gains
from the trade between H Salt and Big Lobster is divergent opportunity cost.

 • Trade based on Comparative Advantage - trade that lies between their Opportunity Costs
(between 2 competitors).
• Specialization and trade can allow consumption of bundles beyond the original (individual)
PPF => With specialization and trade, people can CONSUME at a point outside their PPF.
• Economic growth is represented as an outward rotation or, sometimes, a rightward shift of
the PPF => establish a new maximum frontier and we have expanded out production
possibilities.

Economic Growth is defined as the sustained expansion of production possibilities. It comes

from:
1. Technological change is the
development of new goods and of better
ways of producing goods and services. It
affect ONE industry directly => lead to
outward rotation of PPF.
2. Capital accumulation is the expansion
of resources that allow producers to
increase their production of ALL goods
and services in an economy. It is the
growth of capital resources including “Human Capital.”

Opportunity Cost of Economic Growth = Fewer consumption goods today!

• The size of an increase in out production
possibilities depends on how much of our
scare resources we devote to
technological change and capital
accumulation. => Face a trade off =>
must decrease out production of
consumption goods and services
TODAY in order to have increase
FUTURE consumption.

➡ The opportunity cost of economic

growth is forgone current consumption.
The benefit of economic growth is
increased future consumption.

➡ Marginal cost - must be Forgone/ Marginal Benefit - willing to Forgo.






 • Increased investment in human capital: education, training and professional training have
made the existing labor force more productive (bc they are highly skilled)= > Pushes out the
PPF.
• Technology improvement: Sometimes tech improvement in one industry allow other
industries to increase their production with existing resource.

Centrally Planned Economy (command economy): An economic planner (usually the

government) makes all manufacturing and distribution decision.
Decentralized Economy (free markets): Private individuals own most of the resources. The
what, how and who decision are determined by the market interaction of consumer and firms as
they pursue their own self-interest.
*Firm: hires and organizes the factors of production to produce and sell goods and services.
*Market: enable buyers and sellers to get information and do business with one another.
*Property rights: the government protects property rights (real, financial and intellectual) and
enforces contracts.
*Money: an acceptable means of payment which makes trading in markets much easier and
efficient.
=> Social institutions such as firms, markets, property rights, and money are required for
society to enjoy the benefits of specialization and trade

.



 CHAPTER 3:

I. DEMAND:

The Demand Curve:

• The demand curve plots the quantity that a person plans
to buy at each price (holding all other relevant factors
constant - ceteris paribus)
• A demand curve shows the relation between the quantity
demanded of a good and its price when all other
influences on buying plans remain the same.
• Intuition of demand curve: Summarize an individual’s
buying plans, and how these plans vary with the price of
the good.
• “Plan to buy” means you want it AND can afford it. The
willingness and ability to pay is a measure of marginal
benefit - WILLINGNESS AND ABILITY TO PAY.
• Quantity demanded is the amount a consumer plans to
buy during a given period of TIME at a given price
(THE POINT on the curve) - the quantity demanded at a particular price => The quantity
demanded of a good or service is measured as an amount per unit of time.
• Demand refers to the ENTIRE relationship between the price of the good and the quantity
demanded.
• Demand schedule is the TABLE that lists the quantities demanded at each price, when all
other influences remain CONSTANT.

***"Demand" refers to the ENTIRE relationship between price and quantities (i.e. the entire
curve), whereas "quantity demanded" refers to a specific point on the demand curve.

The Law of Demand:

• As the price INCREASES => The quantity demand FALLS
• As the price DECREASES => The quantity demand RISES.
• This is why the demand curve SLOPES DOWNWARD.
➡ The law of demand states that other things remaining the same, the higher the price of a
good, the smaller is the quantity demanded.

Example: In January 2010, the price of gasoline was $2.70 a gallon. By spring 2010, the price
had increased to $3.00 a gallon. Assume that there were no changes in average income,
population, or any other influence on buying plans. Given the law of demand, you would expect
the rise in the price of gasoline to decrease the Quantity of gasoline Demanded and NOT
change the Demand for gasoline.

 Income Effect: With high price and unchanged income, we can no longer afford the things =>
Some quantity of goods must be decreased, usually the good whose price rose.
Substitution Effect: When the price of a good rises relative to other good, people seek
substitutes for the good, so the quantity demanded of the more expensive good decrease.
*Substitute - another good that can be used in place of the good we were originally buying.

• If the price of a good DECREASES, then the quantity demanded of the good INCREASES.
This is a movement DOWN along the existing demand curve (to the RIGHT).
• If the price of a good INCREASES, then the quantity demanded of the good DECREASES.
This is a movement UP along the existing demand curve (to the LEFT).
=> Price change => Point Movement

Other Relevant Factors: these factors make the demand curve SHIFT AS A WHOLE (whole
DEMAND changes).
1. The price of the related good: Substitutes and
Complements:
I. Complement in Consumption: goods that are
consumed together.
Ex: Car and Gasoline, Milk and Cereal, Bike
frame and bike tires
How it works: your demand for a good will
INCREASE if the price of a COMPLEMENTARY good
drops.

II. Substitute in Consumption: goods that replace each other.

Ex: Cola vs. Pepsi, Rising bike vs Bus, One brand vs. Another brand.
How it works: Your demand for a good will increase if the price of a substitute good rises.

2. Income: Normal and Inferior Goods

I. Normal Good: a good for which higher
income causes an INCREASE in demand (get richer,
buy more thing)
Ex: Smartphone, organic food, nicer car,
travel by plane.

II. Inferior Good (NOT a bad thing, but

something you stop buying/shopping when you have
higher income): a good for which higher income
causes a DECREASE in demand.
Ex: regular phone, junker car, travel by bus.

3. Tastes and Preference: What you like, what your friends like and Trends
Ex: All your friends have iPhone so you decide to buy iPhone => demand increase

 In summer, your demand for sunscreen increases at

every price bc you need sunscreen => demand for
sunscreen increase.

4. Future Expectation: Expectations about future

prices, income, and product availability
I. Expected Future Income: When you
expected future income rises, demand will increase.
II. Expected Future Prices: if you expect future
prices to fall, your current demand will drop because
you will just wait and buy in the future when the sale
starts (Demand shift LEFT).
III. Expected Future Availability: If you expect the product to sell out in the future, your
demand right now will increase => If I expect it to be a shortage, my demand will increase. (ie.
Toilet paper amid Covid) -Demand shift RIGHT.

5. Population: The numbers of buyers in the market.

If the number of potential buyers in the market increases, then the demand increase (shift
to the RIGHT).
Ex: As the population ages, the demand for medical services and retirement communities
increase => the quantity of medical services that people plan to buy at each and every prices
increases.

Conclusion on Demand Movement vs. Shift:

• Change in the good’s own price = Movement up/down along the demand curve => Change in
QUANTITY DEMANDED.
• Change in “other relevant factors” = Your buying plans depend on other factors other than
just the price of the good = The entire demand curve SHIFT (left/right) => Change in the
WHOLE DEMAND.

II. SUPPLY:

The Supply Curve:

• Plots the quantity that a producer plans to sell at each price.
• Intuition of supply curve: summarizes a business selling plans
and how those plans vary with the price of the good bring
produced given their tech and resources at this point of in time.
• The quality supplied is the amount a producer plans to sell at a
given price (POINT).
• Supply refers to the entire relationship between the price of

 the good and the quantity supplied.

• The supply schedule is a table that lists the quantities supplied at each price, when all other
influences remain constant.
• The supply curves shows the MINIMUM price a producer is WILLING to sell. This
LOWES PRICE is the MARGINAL COST.
• A supply curve tells us the LOWEST PRICE at which someone is WILLING to sell.

The Law of Supply:

• As the prices INCREASES, the quantity supplied RISES.
• As the prices DECREASES, the quantity supplied DECREASES.

Movements along the Supply Curve:

• If the price of a good DECREASES, then the quantity supplied DECREASES. This is a
movement DOWN along the existing supply curve (to the LEFT).
• If the price of a good INCREASES, then the quantity supplied INCREASES. This is a
movement UP along the existing supply curve (to the RIGHT).
=> Price change => Point Movement

Other Relevant Factors: these factors make the supply curve SHIFT AS A WHOLE (whole
SUPPLY changes).
1. Price of Factors of Production:
Resources costs affect production costs and
supply. If resources such as raw materials or labor
become more expensive, production costs will
RISE and supply will be REDUCED (shift left).
Scenario: You produce pens, and one of the
inputs used in the production of pens is petroleum. If
the price of petroleum goes up, then the supply will
shift LEFT.
If the cost of producing pens increases (due to the
increase in the price of petroleum), then your pen
supply curve will shift to the left (i.e. supply
decreases). This means that at each and
every price, the producer is willing to supply fewer pen.

2. Prices of Related in Goods in Production:

I. Substitute in Production: A good that can be produced in place of another good (using
the SAME resources) => either one go up/down.
Ex: A farmer has an acre of land, and can either plant wheat or corn.

 => If the price of corn goes up, the supply demanded would go up and the farmer has to
use more land that initially intend to use for wheat to grow corn => supply for wheat shift left/
goes down.

II. Complement in Production: goods are

made together => both go up/down.
Ex: Asphalt is a byproduct of producing oil at
a petroleum refinery. A byproduct of beef is leather.
If the prices of oil increases, then the
suppliers will increase the quantity of oil they supply.
Because asphalt is a byproduct of the oil-making
process, the supply of asphalt will also increase even
though the price of asphalt has not changed. => The
supply of asphalt will increase at each and every
price.

3. Expected Future Prices:

If you are an oil producer, the price of oil is expected to rise next year, then oil producers
will be rise next year, then oil producers will be less likely to sell their oil today. They restrict
the supply of oil in the CURRENT period => The entire supply curve SHIFT LEFT (supply
decreases) ) since sellers want increase their profit by simply `storing’ oil and sell next year when
the price is higher.

4. The Number of Supplies:

If new businesses enter the market, then the supply from these new businesses gets added
into the market supply => new businesses enter the market increase the totally quantity
supplied at each price, which shift the supply curve to the RIGHT.
Ex: 10 tailors can produce more shirts than 5 tailors.

5. Technology:
Technology refers to the way factors of production is used to produce a good/ New
production techniques, new management technique => all of which REDUCE the COST of
producing the good.
Ex: You automate part of the car making production process, which allows you to
produce the same number of cars with fewer workers (or more cars at the same cost) => The cost
of producing cars decreases (due to the new technology), then your car supply curve will shift to
the RIGHT (i.e. supply increases).
=> Better technology, better supply. Worse technology, lower supply.

6. The State of Nature:

Ex: Earthquakes, tornadoes, hurricanes, floods, blizzards, heatwaves.

 Scenario: You are winemaker, and right before you harvest this year’s grades, a week of
rain hits. Now most of your grapes will have a weak and watery taste. Thus, you do not produce
any wine this year => Your wine supply curve shifts to the left (i.e. supply decreases).

Conclusion on the Supply Movement vs. Shift:

• Change in good’s own price => Move along the supply curve => Change in QUANTITY
SUPPLIED.
• Change in other factors => The WHOLE SUPPLY shift left/right.

Market Equilibrium:
• Equilibrium is the market occurs when the price balances the buying plans and selling plans.
• Equilibrium price is the price at which the quantity demanded = quantity supplied.
• Equilibrium quantity is the quantity bought and sold at the equilibrium price.
• The equilibrium price is the best deal available for both buyers and sellers because
buyers pay the highest price they are willing to pay and sellers receive the lowest price at
which they are willing to sell.
• The price at which the quantity demanded equals the quantity supplied is the equilibrium price
because the plans of producers and consumers are coordinated and there is no influence
on the price to change.

• The equilibrium price is the best deal available for both buyers and sellers because
buyers at the highest price they are willing to pay and sellers receive the lowest price at
which they are willing to sell.

*At the market equilibrium, consumer can buy as much as they want at the given price, and
suppliers can sell as such as they want at the given price.

Example:

 At the market equilibrium, the market forces are in balance such that there is no shortage and
no surplus.
A surplus occurs when the quantity demanded is less than the quantity supplied.
A shortage occurs when the quantity demanded exceeds the quantity supplied.

 Shift in EITHER Demand AND Supply:

Shift in BOTH Demand AND Supply:

I. DECREASE:
*Equilibrium QUANTITY will always FALL when both demand and supply DECREASE.
But New Equilibrium Price will depend on the changing MAGNITUDE of each.

(A) If the supply shift MORE than the demand

(shortage) => Price INCREASES.

(B) If the demand shift MORE than the supply

(surplus) => Price DECREASES.

 II. INCREASE:
*Equilibrium QUANTITY will always be ABOVE the original when both demand and
supply INCREASE. But New Equilibrium Price will depend on the changing
MAGNITUDE of each.

(A) If the supply shift MORE than the demand

(surplus) => Price DECREASES.

(B) If the demand shift MORE than the supply

(shortage) => Price INCREASES.



 Demand and Supply Shift in OPPOSITE DIRECTION:

(A) If we have an increase in supply

and decrease in demand => Price
DECREASES.
=> New equilibrium will be BELOW
the original.

(B) If we have an increase in demand

and decrease in supply => Price
INCREASES.
=> New equilibrium will be ABOVE
the original.

The price at which the quantity demanded equals the quantity supplied is the equilibrium
price because the plans of producers and consumers are coordinated and there is no
influence on the price to change.

 CHAPTER 4: ELASTICITY

• Elasticity: the responsiveness of one variable to changes in another.

• The price elasticity of demand helps us measure how responsive consumers are to changes in
price.
• The price elasticity of supply helps us measure how responsive producers are to changes in
price.

I. Price Elasticity of Demand:

• The responsiveness of the quantity demanded of a good to change in its price.
• Intuition: A measure of how responsive buyers are to changes in price.

ΔQu a nt it yDem a n ded

E Demand = %
ΔPr ice
***(Use Midpoint formula when there is only one percentage given!!!)

Example: If cutting the price of strawberries by 20% leads to an increase in the quantity
demanded by 10% then the price elasticity of demand for strawberries is:
➡ E Demand = 0.10/-0.20 = ⎮-0.5⎮=0.5
*Technically, elastic demand most of the time is negative, but we always take the absolute value
of it.

I. Relatively Inelastic: quantity demanded is NOT VERY responsive to changes in price

➡ Result: (0 < ⎮ED⎮1) (relatively inelastic situation where QUANTITY DEMANDED does
NOT change much in response for the change in PRICE)
➡ A 1% increase in price results in a less than 1% decrease in quantity demanded.

II. Perfectly Inelastic: The quantity demanded is TOTALLY UNRESPONSIVE to changes in

price => Result:⎮ED⎮= 0

III. Relatively Elastic: When quantity demanded is VERY responsive to changes in price.
➡ Result: (1 < ⎮ED⎮∞) (relatively elastic situation where quantity demanded CHANGE in
response for the change in PRICE)
➡ A 1% increase in price results in a more than 1% decrease in quantity demanded.

IV. Perfectly Elastic: The quantity demanded is INFINTELY RESPONSIVE to changes in

price => Result:⎮ED⎮= ∞

V. Unit Elastic: The percentage change in quantity demanded is EQUAL to the percentage
change in price => Result:⎮ED⎮= 1

 Determinant of Elasticity:

I. The price of elasticity of demand is relatively elastic when:

1. Many close substitute are available => More subs, more elastic (easy to switch between
the producers).
2. Proportion of income spend is LARGE => Larger proportion of income spend on the
good, the larger elastic.
=> Example: If the price of gum doubles, you probably won’t even notice, but if the price of a
car doubles you definitely notice and you will probably adjust your buying plans.
3. Luxury: expensive things tend to also have MORE available substitutes.
=> Example: A trip to Hawaii or eating out, tend to have MORE elastic.
4. Time to Adjust: when consumers have more time to adjust their buying plans, their demand
tends to be MORE elastic.

II. The price of elasticity of demand is relatively inelastic when:

1. Not many close substitute are available => Harder for consumers to switch even if the price
of the original good rises => Less sub, more inelastic (not easy to switch between
products, stuck in one supplier).
2. Proportion of income spend is SMALL => Small proportion share of income, more
inelastic.
Example: If the price of gum doubles, you probably won’t even notice and dont really care to
bother changing your buying plans
3. Necessities: Prescription drugs, electricity, utilities tends to have demands that are MORE
inelastic.
4. No Time to Adjust: when consumer have little to no time to adjust their buying plans, their
demand tends to be MORE inelastic.

 Elastic vs. Inelastic:

• The same change in price can cause a different change in quantity depending on the
elasticity.
• When demand is elastic, the increase in quantity demanded is LARGE compared to when the
demand is inelastic.
*When demand is INelastic, then consumers are INsensitive to the change in price.

Calculating the Price Elasticity of Demand:

Midpoint method:

=> This result is Relatively Inelastic value because E is between 0 & 1.

*Midpoint Method is preferred since for the base method, direction of the price matters.
***Example: U.S. drivers are ranked as the least sensitive to changes in the price of gasoline.
For example, if the price rose from $3 to $4 per gallon and stayed there for a year, then U.S.
purchases of gasoline would fall only about 5 percent. => ) The price elasticity of demand for
gasoline is E Demand = 0.05 / [(4-3)/(4+3)/2] = 0.175.
***Use this formula when there is only one given percentage (while the other side is
numbers from other units).

Elasticity is a Unit-Free Measure:

 Elasticity CHANGES along the demand curve => Each point contain different elasticity
(because quantity and price is changing)

***When asked to calculate the elasticity => NEED specific point to be able to do that
calculation!!!

Total Revenue and Elasticity:

Total Revenue: How many units do you sell, and at what price do you sell each unit? (Not the
same thing as profit) => TOTAL REVENUE = Price x Quantity.
The total revenue test is a method of estimating the price elasticity of demand by observing
the change in total revenue that results from a change in the price, when all other influences
on the quantity sold remain the same (ceteris paribus).

 The Total Revenue Rule:

How can you (as a producer) increase your total revenue?
=> It depends on how ELASTIC the demand for your product is!
• If the demand curve is relatively inelastic, then you should RAISE the price of your good to
increase your total revenue.
• If the demand curve is relatively elastic, then you should LOWER the price of your good to
increase your total revenue.
=> If the change in total revenue depends on the price elasticity of the demand curve, then
the effect of a price increase on total revenue will vary as the price elasticity varies.
Example: When the price of tomatoes rises from $3 per pound to $4 per pound, the quantity of
tomatoes sold decreases from 15 pounds to 10 pounds. Total revenue decreases from $45 to
$40, and using the total revenue test, we can determine that the demand for tomatoes is Elastic.

II. Income Elasticity of Demand:

Intuition: A measure of how responsive the demand for a good is to change in income (ceteris
paribus)

ΔQu a nt it yDem a n ded

E Income = %
ΔIn com e

***(Use Midpoint formula when there is only one percentage given!!!)

For example: If a 10% increase in your income leads to a 40% increase in the quantity of
strawberries demanded, then the income elasticity of demand for strawberries is:
=> E Income = 0.40/0.10 = 4
*DO NOT take absolute value for the Income Elasticity of Demand because the SIGN
MATTERS.

Inferior Good: Negative income elasticity of demand

=> The change in demand goes in the OPPOSITE direction
as the change in income: If income rises, then QD falls.

Normal Good: Positive income elasticity of demand

=> The change in demand goes in the SAME direction as
the change in income: If income rises, then QD rises.
• Income inelastic (necessities) - Positive and LESS
than 1 - when consumers’ income
grows, QD rises but by LESS than
the rise in income.
• Income elastic (luxury) - Positive
and MORE than 1 - when Necessities Luxury
consumers; income grows, QD rises
but by MORE than the rise in income.

 III. Cross Elasticity of Demand:

Is a measure of how responsive the quantity demanded of good X is to changes in the price
good Y.

ΔQ DG ood X
E XY = %
ΔPr iceG oodY

**The sign of the result DOES matter!!

Complements: Negative cross elasticity of demand

=> The change in demand for good X goes in the OPPOSITE direction as the change in the
price of good Y: If the price of Y rises, then QD of X falls (negative cross of elasticity of
demand).

Substitutes: Positive cross elasticity of demand

=> The change in demand for good X goes in the SAME direction as the change in
the price of good Y: If the price of Y rises, then QD of X rises (positive cross of elasticity of
demand).

Note: E XY = 0 => Unrelated Good.

 Elasticity of Supply:
• Allows us to measure by how much the sellers will respond, and help us understand what
drives whether their response is likely to be small or large.
• Intuition: A measure of how responsive sellers are to changes in price.

ΔQ DSupply
E Supply= %
ΔPr ice

Example: If a 10% increase in the price leads to a 5% increase in the quantity of strawberries
supplied, then the elasticity of supply for strawberries is:
=> E Supply = 0.05/0.10 = 0.5

***Elasticity of Supply is a POSITIVE Number (ALWAYS!!)

Elastic and Inelastic Supply:

• E Supply < 1 => Inelastic
• E Supply > 1 => Elastic
• E Supply =1 => Unit Elastic Supply



 Determinant of Supply Elasticity:

1. Resource Substitution Possibilities:

• If a good requires very unique or rare productive resources, then supply for this type of
product tends to be more inelastic.
• If a good can be produced using any commonly available resource that could also be used to
produce any number of other goods, then the supply for these types of products tend to be
more elastic.
=> The easier the access to the production resources, the MORE elastic.

2. Easily Stored Products:

• If your firm’s product is easily stored, then you can simply stockpile your product and quickly/
easily adjust the quantity supplied to the market as price changes. This yields a more elastic
(responsive) supply.
• For example, gasoline is easily stored. If the price of gas falls, the firms simply store the gas
and wait until the price rises again.
=> The easier the product can be stored, the MORE elastic.

3. Time Frame:
The shorter the time frame, the more inelastic the supply (however, there are exceptions). This is
because firms do not have the flexibility to immediately increase/decrease output when the price
rises.
In the long run, firms can hire/fire workers, expand/contract their capital stock (i.e. build or sell
off buildings or equipment). These adjustments allow them fully respond to the price change.
=> The more the time frame, the MORE elastic.

a. Momentary Supply:
Momentary supply tends to be almost PERFECTLY INELASTIC for most goods and
services
Example: The raspberry crop for a given year is fixed. The planting decision have been made and
firms cannot grow more raspberries in a single day. Exception: streaming platforms (spotify,
netflix), phone calls, uber.
b. Short-Run Supply:
Short-run (SR) supply tends to be RELATIVELY INELASTIC for most goods and services.
Example: In the short run a firm can hire a few more workers to expand (or lay off workers to
contract)
c. Long-Run Supply:
Long-run (LR) supply is very ELASTIC (if not PERFECTLY ELASTIC). In the long run,
firms can make large adjustments to their production process that would allow them to fully react
to the change in price.
There is also firm exit and entry in the long run (new businesses enter the market or old
businesses shutdown), making the market supply more elastic.

 CHAPTER 5:

Allocation Methods: One of the BIGGEST questions facing society is how to allocate its scare
resources. In particular, how to allocate resources efficiency and fairly.

1. Marker Price: Whoever is willing AND able to pay gets the good old service.
2. Command: Some authority decides (commands) where resources go => Starbuck manager
decides who doing which.
3. Majority Rule: Resources go where the majority decides they go
4. Contest: Good at motivating many people to work harder.
5. First-Come-First-Serve: Example is restaurant that do not take reservation.
6. Lottery: Good when there is no effective way to distinguish among potentials users.
7. Personal Characteristics: The basis of individual attribute. Sometimes used in
unacceptable ways (discrimination) - ex: line up alphabetically, only hire certain race for a
job.
8. Force: Example is war, theft…. But also the legal system.

Demand and Willingness to Pay: Recall that the demand curve is the same as the marginal
benefit curve, where the marginal benefit is the maximum price that a consumer willingly
pays for another unit of the good or services.

Individual Demand: The consumer’s personal willingness to pay for that unit of the good or
service (how they value the good).
*Individual demand curve is the same thing as individuals marginal benefit curve. In the
market setting, it is called the marginal social benefit.

The Market Price: The price is what the market determines a person would have to pay in order
to get the good or service.

Value vs. Price: How an individual values the good does not always equal the market price of the
good.

“Price is what you pay and value is what you get.”

=> Example: In the market for blankets, the value of the 20th blanket is the MAXIMUM price
that someone is willing to pay for the 20th blanket.

Individual Demand and Market Demand: The market demand is the horizontal sum
of the individual demand curves: For each price, add up the total quantity demanded by the
consumers in your market.
=> Pick a dollar price, point out the quantity demanded of each and add them up to get the
MARKET DEMAND.

**Note that in this example the top most part of the market demand (in blue) is only composed
of Geeta’s demand. This is because at prices above $5, Hameed’s demand is 0.

Consumer Surplus:
• Is when my willingness to pay is GREATER than the market price of the good.
• The gain from buying something at a price below the highest price you were willing to pay
(which is your Marginal Benefit).
• Is the Marginal Benefits (the willingness to pay) of a good in excess of the Price paid for it,
summed over the quantity bought.
• Consumer Surplus = Marginal Benefit - Price = 1/2 * Base * Height
• **NOTE: The consumer surplus on the LAST ITEM is 0 (no consumer surplus).
• Consumer surplus decreases as the marginal benefit decreases.

 Supply and Marginal Cost:

The supply curve is the same as the marginal cost curve, where the marginal cost is the
MINIMUM price that a firm must receive to induce them to offer one more unit of the good.
In the market setting, it is called the marginal social cost.

Firm’s Cost: The cost of production represents what the firm gave up to make the good or
service.

The Market Price: The price is what the market determines a firm will receive when they sell a
unit of their good (what they get for the effort).
*Recall: On the supply curve, every point is the LOWEST price they are willing to sell =
marginal cost => LOWEST PRICE = MARGINAL COST (from the PRODUCERS).

Cost vs. Price: Firms make a profit when they receive more from the sale of a good than the cost
of producing (Price Sale > Production Cost).

Individual Firm Supply and Market Supply: The market supply is the horizontal
sum of the individual firm supply curves: For each price, add up the total quantity supplied by
the firms in your mar

=> Pick a dollar price, point out the quantity demanded of each and add them up to get the
MARKET SUPPLY. (At $4, we have 7 quantity supply in market supply).

 Producer Surplus:
• The gain from selling something at a price ABOVE the marginal cost incurred from the
production process.
• The excess of the amount received from the sale of a good over the cost of producing it.
• Producer surplus is the Price of a good or service, in excess of the Marginal Cost of
producing it, summed over the quantity produced.
• Producer Surplus = Price - (Marginal) Cost = 1/2 * Base * Height
• The area between the equilibrium price and supply curve.
• NOTE: Producers earn producer surplus on ALL except on the LAST UNIT produced
because at that price producer surplus = 0.

 Efficiency of Competitive
Equilibrium:
• Equilibrium in the competitive market
occurs where the demand and supply curves
intersect.
• Resources are used efficiently when
marginal social benefit = marginal social
cost (individual demand curve intercept
with supply curve).
• At this intersection point the MSB
(marginal social benefit) = the MSC
(marginal social cost) => the condition
for allocative efficiency => Resources are
used Efficiently!!

=> TOTAL SURPLUS (the SUM of

consumer surplus and producer surplus) is MAXIMIZED!

• Producer Surplus + Consumer Surplus = Total Surplus

• With the DWL: Producer Surplus + Consumer Surplus - Deadweight Loss =
Total Surplus

• Voluntary exchange creates both Consumer Surplus and Producer Surplus –both the buyer
and the seller gain from the market exchange (at every point from the surplus except on the
equilibrium point where consumer/producer surplus is 0).

When PRODUCTION is:

• Less than the equilibrium quantity => Marginal Social Benefit > Marginal
Social Cost
• Greater than the equilibrium quantity => MSB < MSC
• Greater than the equilibrium quantity => MSB = MSC

 Market Failure:
• Markets are NOT always efficient.
• Market failures occur if there is either too little (underproduction) or too much
(overproduction) of an item produced.
• If any quantity other than the efficient quantity is produced, the market is inefficient
• Deadweight loss (DWL) measures the scale of the market inefficiency => Reduce the TOTAL
SURPLUS.
• With the DWL: PRODUCER SURPLUS + CONSUMER SURPPLUS - DEADWEIGHT
LOSS = TOTAL SURPLUS
**Social loss = Deadweight Loss = Loss produced by BOTH consumers and providers.

Market Failure UNDERPRODUCTION:

Example:

 Market Failure OVERPRODUCTION:

Example:

Sources of Market Failures:

1. Price and Quantity Regulations: Price Floors or Price ceilings which set maximum or
minimum prices. Quotas limit the quantity produced. => Cause either overproduction or
underproduction.
2. Tax and Subsides: Taxes lead to underproduction. While subsides lead to overproduction.
3. Externalities: External costs or benefits that are not taken into account and result in over or
underproduction.
4. Monopoly: Because there is no competitors, a firm with a monopoly chargers too much and
produces too little. => Underproduction.
5. Public Goods and Common Resources:
• Public good - everyone benefits and no one can be excluded (Ex:when being attacked,
National Defense protects everyone not just the tax-payers).
• Common Resources: owned by no one and available to all (ex: ocean, fresh air,
environment)
6. High Transaction Costs: When transaction costs are high, the market often underproduces
=> Costs that bring buyers and sellers together (ex: anything in real estate - when the
realtor’s price is high, it discourage the buyer)

 Is the Competitive Market Fair?

Fair Result: Equality Of Outcome requires things like income transfer from the rich to the poor.
Fair Rules: Equality Of Opportunity requires Property Right and Voluntary Exchange.

=>*The imbalance between willingness to pay and ability to pay can have negative
consequences.
*Involuntary exchange can have negative consequences.

 CHAPTER 6: GOVERNMENT ACTIONS IN MARKETS

Price Ceiling (or Price Cap):

• It is the Maximum Price that sellers can charge.
• Specifically, it is a government regulation that
makes it illegal to charge a price higher than a
specified level.
• Binding Price Ceiling (or Effective Price
Ceiling): A price ceiling that prevents the market
from reaching the natural market equilibrium
price.

• A binding (effective) price ceiling will lower

prices in the market and cause a SHORTAGE.
• It helps consumers who actually get to buy the
good, and hurts those who were unable to obtain
the good.
• Price Ceiling is affordable (pro) but hurts
those who cant get it (con).

Price Ceiling and the Housing Market:

• When a price ceiling is applied to the housing
market it is called a Rent Ceiling.
• The rent ceiling leads to a housing SHORTAGE.
• This helps people who already have an apartment
but hurts consumers entering the market looking
for an apartment.

 • The rent ceiling creates DEADWEIGHT

LOSS (DWL) (gray area).
• This rent ceiling also increases the
SEARCH ACTIVITY (yellow area),
which is another sources of POTENTIAL
SURPLUS LOSS.
• Search Activity is the time spent looking
for someone with whom to do business.
This time could have been used in other
productive ways.
• Unintended Consequences of a rent
ceiling:
• Black Market
• Key money/Bribes
• Discrimination
• Little to no incentives for landlord to do repair.

Outcomes of the Rent Ceiling:

• Create a housing SHORTAGE.
• Lower rents for the lucky few and raise them for everyone else.
• According to the fair rules view, a rent ceiling is unfair because it blocks voluntary
exchange.
• According to the fair results view, a rent ceiling is generally unfair because while it does help
some lower income renters, it is clearly not a well targeted policy.

Conclusion:
• A rent ceiling that is set above the equilibrium rent has no effect = ineffective (different than
inefficient! The price ceiling may be efficient, in terms of laws for the government, but is
ineffective)
• A rent ceiling that is set below the equilibrium rent creates a housing shortage, increased
search activity, and a black market => INEFFICIENT AND UNFAIR.



 Price Floor:

• It is the minimum price that sellers can charge.

• Specifically, it is a government regulation that
makes it illegal to charge a price lower than a
specified level.
• Binding Price Floor (Effective Price Floor): A
price floor that prevents the market from
reaching the natural market equilibrium price.

• A binding (effective) price floor will raise prices

in the market, and will cause a SURPLUS.
• It helps suppliers who are able to successfully
sell their good, but hurts those who were unable
to sell their good.

• When a price floor is applied to the Labor Market it is called Minimum Wage.
• In a Labor Market, firms are the demanders of labor and people are the suppliers of labor.

 Conclusion:
• A minimum wage set below the equilibrium wage rate has no effect.
• A minimum wage set above the equilibrium wage rate creates unemployment and increases
the amount of time people spend searching for a job => INEFFICIENT, UNFAIR, AND
HITS LOW-SKILLED YOUNG PEOPLE HARDEST => Marginal social benefit exceeds
marginal social cost.

• Minimum wage creates Deadweight Loss

(DWL).
• This minimum wage also increases the search
activity, which is another source of potential
surplus loss.
• Search activity is the time spent looking for
someone with whom to do business. In this case,
time spent looking for a job.

• ***NOTE: Be Careful! Supply now lives on the

demand curve and vice versa, because we are
the suppliers in the labor market.

• If the demand for labor is relatively inelastic

then fewer people get fired when a minimum
wage is implemented.
• Also, there are certain non-perfect competition
market settings (such as a non-discriminating
monopolist) in which implementing a minimum
wage not only raises worker wages but also
increases the level of employment.

=> Worker’s surplus = 1/2*1*1 = 0.5

DWL = 2*(1/2*2*2) = 4

 Taxes:
• Buyers only care about the price that includes the tax (i.e the total amount they have to pay to
purchase the good or service).
• Sellers only care about to the price that excludes the tax (i.e the amount they get to keep as
revenue from the sale).

Tax Incident:
• It is the division of the burden of the tax between buyers and sellers.
• It does NOT depend on the tax law.

• Law makers do NOT actually determine who pays the tax

• A tax on consumers may/may not ultimately be paid by the consumers.
• A tax on suppliers may/may not ultimately be paid by the suppliers.

*Tax Incident is actually determine by the relative elasticities of the market’s supply and
demand curve.
*The more inelastic your curve, the more of the tax you will bear:
• If the consumers have the relatively more inelastic curve, then consumers will ultimately
pay more of the tax.
• If the suppliers have the relatively more inelastic curve, then suppliers will ultimately pay
more of the tax.
=> ELASTICITY IS WHAT MATTERS!!!

Equivalents Of Tax On Buyers And Sellers:

I. Example: $4 Tax On SELLERS:

This $4 tax is seen as a rise in the cost of production,
so supply shifts to the left (i.e. supply decreases):
=> Supply decreases by a VERTICAL DISTANCE
equal to the tax of $4.
=> To be able to keep the same revenue, the supply
pushes the price up so that after they give up the tax
amount, their revenue is still $8 as the original.
For each (price, quantity) pair on the original supply
curve we now have the following pairs: (price + $4,
quantity)

 The result:
• The new equilibrium quantity is where S0 + tax
and D0 intersect.
• The price that consumers pay is now $17
(buyers paid $1 of the $4 tax)
• But the price the sellers get to keep is only
$13 (17 - tax = 13) - sellers paid $3 of the $4
tax.
➡ Shift Supply => Use new equilibrium to get
the New Price that the consumers pay and
calculate the actual profit that the producers
get by New Price - Tax.
**NOTE: If there isn’t a tax amount given, we can find the actual profit that the producers get
by follow the line draw from the new supply curve (pink) and link it the the original supply curve
(blue) to get $13.
➡ The amount of tax each side pay is calculated by comparing the new price/profit to the
old price at the old equilibrium.

II. $4 Tax on BUYERS:

• This $4 tax lowers the amount consumer are willing to
pay sellers, so demand shifts to the left.
• Demand decreases by a VERTICAL DISTANCE
equal to the tax of $4
• For each (price, quantity) pair on the original demand
curve we now have the following pairs: (price - $4,
quantity)

The Result:
• The new equilibrium quantity is where the
D0+tax and S0 intersect
• But the price the sellers get to keep is only $13
(sellers paid $3 of the $4 tax)
• The price that consumers pay is now $17 ($13
+ tax = $17) (buyers paid $1 of the $4 tax).
➡ Use new equilibrium to get New Profit that
the producers get and calculate the New Price
that the buyers pay by New Profit + Tax.
**NOTE: Without the tax amount given, we can
find the price that the buyers pay by following the line draw from the new demand curve (pink)
and link it to the original demand curve (blue) to get $17.



 Conclusion:
• Tax Incident does NOT depend on the tax law.
• In both scenario, the $4 tax was born by both sellers and buyers:
• The sellers always paid $3 out of the $4 tax.
• The consumers always paid $1 out of the $4 tax.
• ***Shift Supply => Get New Price (consumers pay) / Shift Demand => Get New Profit
(producers get).
• => Tax disincentivize the exchange in the market such that we want to pull back our
incentive to buy/produce.

***Whoever is more INELASTIC will pay MORE of the tax (**Inelastic graph is more
CLOSE to the y-vertical) => Bad thing.

Tax as a Wedge:
• The tax can be thought of as a wedge driven
between the price the buyers pay, and the
price the seller gets to keep.
• We can use this wedge method to easily
determine the new equilibrium quantity, as
well as the new price for consumers and
sellers:
• Simply find where the vertical gap between
the curves equals the size of the tax.

Taxes and Efficiency:

• When the tax is implemented in the market
the Consumer Surplus and Producer
Surplus is going to shrink as Deadweight
Loss is created => This happens because the
new equilibrium quantity is not the same as
the original equilibrium quantity (which is an
efficient point)
• CS and PS are further reduced by the tax
revenue that the government now collects.
• The size of the tax revenue is equal to the
tax times each unit that is sold: $4 x 22 =
$88.

Extreme Cases: Perfectly Inelastic and Elastic:

Recall Tax Incidence and Elasticity: The tax incidence is determined by the relatively elasticities
of the market’s supply and demand curves. Who ever has the more inelastic curve bears more of
the tax incidence.

• Perfectly Inelastic Demand: Buyers pay the full tax, but no DWL is created.
• Perfectly Elastic Demand: Sellers pay the full tax, and very large DWL is created.
• Perfectly Inelastic Supply: Sellers pay the full tax, but no DWL is created
• Perfectly Elastic Supply: Buyers pay the full tax, and very large DWL is created.

I. Perfectly Inelastic Cases:

**No DWL for Perfectly Inelastic Demand and Perfectly Inelastic Supply because we are
STILL at the EFFICIENT production point (no wasted quantity supplied or demanded).
We only get DWL because of the market failure (market is underproduce or overproduce).
=> New equilibrium ABOVE the natural market equilibrium quantity.

 II. Perfectly Elastic Cases:

*The consumers/producers for this case are really responsive to the price change and only
willing to pay/sell at 1 certain price => No consumer surplus for Perfectly Elastic Demand or
producer surplus for Perfect Elastic Supply (not profiting anything) => The other party has
to pay an entire tax amount and therefore, has to lower the quality supply/demand => Move out
of the original efficient equilibrium point => Create Deadweight Loss.
=> New equilibrium BELOW the natural market equilibrium quantity.

Tax Rates and Tax Revenue:

*When the tax is slit EVENLY

between the buyer and seller =>
We can conclude that the
elasticity of demand and supply
is the SAME.

*More tax raise DOES NOT

mean more tax revenue.

 Subsidies:
• A payment made by the government to producers (sometimes consumers).
• The government uses subsidies to try to encourage the production and consumption (in
opposite to the discouragement that taxes impose).
• Example:
• Government subsidies farmers to produce agriculture products (subsidy for supplies).
• Fossil fuels production, renewable energy, green energy is also subsidized.
• Pell Grants is a subsidy for lower income students who choose to go to college (subsidy
for consumers).
• Subsidy can be thought as a negative tax since it operates just like a tax, but with the opposite
sign (while for tax, consumers have to pay more and sellers get to keep less => Both of their
surpluses are decreased).
=> Meanwhile, subsidy increases the quantity demanded and supplied.
=> Lower the price that consumer pay and increase the price that sellers receive.

*NOTE: The fact that the government puts a subsidy on the seller does NOT mean that sellers
will get all the subsidy but the distribution of the subsidy is ultimately determined by the
MARKET FORCES - The elasticity of Supply and Demand.

=> Whoever is more INELASTIC will get MORE of the subsidy => Good thing (**Inelastic
graph is more CLOSE to the y-vertical)

A $4 Subsidy for Seller:

• This $4 subsidy is seen as a drop in the cost of

production, so supply shifts to the right (i.e.
increases)
• Supply shifts right by a vertical distance equal to
the subsidy of $4
• For each (price, quantity) pair on the original
supply curve we now have the following pairs:
• (price -$4, quantity).

 The Result:
• The new equilibrium quantity is where
the S0 - subsidy and D0 intersect
• Interpreting the new equilibrium price
requires attention to detail:
• The price that consumers pay is now
$15 (buyers get $1 of the $4 subsidy)
• The price the sellers get to keep is $19
($15 + subsidy = $19) (sellers get $3 of
the $4 subsidy)
• As the new equilibrium quantity has
risen from 30 to 38 units => the MSC
exceeds the MSB => This
overproduction results in the creation
of DWL.
=> In this market for subsidy, the marginal social cost EXCEEDS the marginal social
benefit.

Total Subsidy:
The WHOLE rectangle area that contains
both consumer’s subsidy and seller’s
subsidy, include the Deadweight Loss space.
=> In the example, the total subsidy = 20(from
50-30) * 60 (the quantity number) = 1200.

 ***NOTE: Difference between Subsidy and Tax:

1. Demand/Supply Shifting:
Tax: Curves LEFT
Sub: Curves RIGHT

2. Price Placement:
Tax: BUYERS on top
Sub: SELLERS on top

 Quotas - A Quantity Regulation:

• It is an upper limit/maximum QUANTITY on the quality of some good that can be bought
or sold in the market.
• The government uses quotas to try to reduce the production and consumption of certain
goods or services.
• Example:
• Many states that have legalized marijuana limit the amount that people can buy per say
(quota on consumers)
• Legal limits on the amount of pollutants firms can release into the air (quota on
producers).
• Immigration laws limit the labor supply.
• Trade quotas limit the numbers of certain goods that can enter the country.
• Limits on the production of a good which cap the quantity producers can put on the market
during a given time frame.

Binding Quota (or effective

quota):
• Is a quota that prevents the market
from reaching the natural market
equilibrium quantity.
• An effective quotas always need to
be to the LEFT of the natural
equilibrium quantity (ie. BELOW
the natural equilibrium quantity).

=> On the graph, an effective binding

quota stop the market from reaching
the equilibrium point.

***NOTE: Binding Quota different from Price Ceiling/Floor that it limits the QUANTITY
that is bought and sold whereas the Price Ceiling/Floor limits the PRICE.

***CAUTION: Binding Quota (EFFECTIVE quota) is different from EFFICIENT point

which is at the natural equilibrium!! => Quota may be effective but NOT efficient!

 Zoning Laws:
• It specify the type and quantity of housing that can be built in an area.

Example:
• Let’s say the current zoning laws
allow for only 200 houses to be built
in the given area. From the graph,
the quota starts a bidding war
between the buyers for which they
are willing to pay up to $600 for
limited 200 houses => The price got
driven up => Create a massive
producer surplus but
RELATIVELY SMALL
CONSUMER SURPLUS.
• Because of the 100 house (from
200-300) that will never get bought
and sold in the market => Create an
underproduction situation for
which we are not at the efficient
point => Deadweight Loss exists.

**NOTE: When an effective production quota is applied in the market, the marginal social
benefit EXCEEDS marginal social cost (compare two point on the vertical line of quota,
marginal benefit in the demand curve is ABOVE the marginal cost in the supply curve).

 CHAPTER 16-17: EXTRERNALITIES AND PUBLIC GOOD

• Externality is a cost or benefit from an action that falls on someone NOT involved in the
activity.
• Externality is about the side effects on people whose interest are not taken into account.
• Positive externalities generate benefits for others, while negative externalities impose costs
on others.
• Example:
• You are smoking and the only one who consumes the cigarette but that action has a
spillover effect/ externality on the people around you (negative externality).
• Your neighbor is a good piano player and it is a pleasure for you to listen to them playing
the piano (positive externality).
• In the market setting, if there are bystanders who are affected by your choices, and whose
interests are ignored or underweighted then the market will produce inefficient outcomes that
are not in society’s best interest => In short, externalities lead to market failures as there
will be either overproduction (negative externality) or underproduction (positive
externality).

More example:
I. Positive:
• Plant a garden: Beauty that can be enjoyed by anyone who walks by.
• Brilliant ideas: breadth that benefits multiple business (invention of computer, internet,…)
• Exercise: Your health insurer will benefit because they will likely spend less on your medical
care.

II. Negative:
• Air and water pollution: Firms rarely bear the full costs of the pollution they emit.
• Idiots at concert: If you stand up at a concert, then I cant see the stage.
• iPhone in class: If I have a harder time focusing in class if my neighbor is on their phone.

***NOTE:
• Negative Production Externality is an impact from the PRODUCER side.
• Positive Consumption Externality is an impact from the CONSUMER side.

 I. Negative Externality:
• When a market transactions HARM people NOT involved in the transition, negative
externalities exist.
• Negative externalities are linked to either the production of the good (negative production
externality) or the consumption of the good (negative consumption externality).

A. Negative Production Externality:

• Example:
• Pollution emitted from the production process
• Clearing forest or logging adds carbon dioxide into the atmosphere and destroy the habitat of
wildlife.
• => These are production-related externalities => If you scale back production, you would
scale back on the negative externality.

Let’s focus on the negative externality causes by the production of gasoline. There are 3 types of
COST:
1. Marginal Private Cost: Firms base their quantity supplied decision on analysis of their
private marginal costs - how much do they have to pay to produce an additional unit of this
good? (Cost just for the Firms themselves to bear - Supply Curve). (Marginal private cost
is the cost of producing an additional unit of a good or service that is borne by
the producer of that good or service.)
2. Marginal External Cost: The additional external cost imposed on bystanders from the
production of that additional unit (Cost that impacts the society and NOT the Firm).
3. Marginal Social Cost: The marginal costs incurred by everyone in society. In other words,
the MSC is all marginal costs added together - the SUM of the two => Marginal Social
Cost = Marginal Private Cost + Marginal External Cost.

 ***Note: The negative externality increases along with the production and outside impact
(i.e marginal external cost).

• With the adding of the demand curve, it first creates a natural market equilibrium (Point A)
where Demand (Marginal Social Benefit) intersect with the Marginal Private Cost (S0) =>
Inefficient because the Marginal Social Benefit needs to align with Marginal Social Cost not
Private Cost.
=> Move to point B where Demand (Marginal Social Benefit) equals the Marginal Social Cost
=> Compare point A vs. point B which is the best for the society, we are going to have an
overproduction (MSC > MSB) => Deadweight Loss exist => Need to scale back the
production in order to satisfy what is best for the society at the social optimal point (new
equilibrium).

B. Native Consumption Externality:

• Example:
• The second-hand smoke others experience when an individual smokes a cigarette.
• The person in the next apartment listening to loud music.
=> The consumption of these goods that generate the negative externalities.

 II. Positive Externality:

When a market transition BENEFIT people NOT involved in the transaction, positive
externality exists.
Positive externalities are linked to either the production of the good (positive production
externality) or the consumption of the good (positive consumption externality).

A. Positive Production Externality

• Example:
• Maintaining beehives next to an apple orchard.
• Building a new factory in town can lead to new shops and restaurant in town as well.

B. Positive Consumption Externality

• Example:
• Getting a flu shot or exercising (activities to remain healthy) => Be immune and protect
those who dont get flu shot.
• Getting an education => Make society run smoother and better.
• Maintaining a nice exterior to your home and yard, plant a garden.

Let’s focus on the positive externalities caused by the consumption of flu shots. There are 3 types
of BENEFIT:
1. Marginal Private Benefit: Consumers based their quantity demanded decision on analysis
of their private marginal benefit - how much they they personally benefit from consuming
an additional unit of this good? (Demand Curve).
2. Marginal External Benefit: The benefit from the consumption of an additional unit of the
good that people (other than the consumer) enjoy.
3. Marginal Social Benefit: the marginal benefit accruing to everyone in the society. In other
words, the Marginal Social Benefit is all marginal benefits added together: Marginal Social
Benefit = Marginal Private Benefit + Marginal External Benefit.

 => The size of positive externality shrinks slowly with the consumption of the flu shots as the
large proportion in the society has been vaccinated and it reaches a certain number for the herd
immunity, the external benefit stops being so big compared to the beginning.

=> With the present of Supply (Marginal Social Cost), the market naturally be at the market
equilibrium point (Point A) where Marginal Social Cost and Marginal Private Benefit meet =>
This point is inefficient because the Marginal Social Benefit is way bigger and exceeds the cost
=> Have to move to Point B where Marginal Social Benefit intersect with Marginal Social Cost.
=> Compare point A vs. point B which is the best for the society, we are going to have an
underproduction (MSC > MSB) => Deadweight Loss exist => Need to push up the production
in order to satisfy what is best for the society at the social optimal point (new equilibrium).

 => Find the way to get the person who is generating the externality to internalize that external
cost or benefit. If they internalize what is originally external, then the Private Marginal
Benefit/Private Marginal Cost becomes the SAME as the Social Line => No “divergence”
between the private and social.

1. The Coase Theorem:

• When people can bargain costlessly (or at least low cost bargaining) and legal rights are clear
and enforced, then externality issues can be solved via private bargaining.
• Example: A paint factory is dumping their polluted product into a river (negative production
externality) and the nearby residences are suffering the pollution. In order to solve this, we can
either assign the property right to the factory (give them the rights to do whatever they want to
the land of the factory and the houses) or give the property right to the residence people. And
regardless of how and who we assign the property rights to, we will get the SAME outcome.

2. Pigovian Taxes and Subsidies:

• Taxes (or subsidies) can be used to
decrease (or increase) market activity by
setting the tax equal to the size of the
negative externality.
• The government can set a tax (or sub)
equal to the marginal EXTERNAL
cost. The effect of such a tax is to make
marginal private cost plus the tax equal
to the marginal social cost (MC + tax
= MSC) - This is called Pigovian Tax.

*** Explanation: Set the Tax equal to

the size of the Marginal External Cost
(Negative cost that impacts the society),
then the Marginal Private Cost (Cost
that impacts solely the Firm) + that Tax
= The Marginal Social Cost.

*Reverse for the Subsidy case. Set the subsidy (voucher) equals to the size of Positive
Externality that you want to be internalized.

 ***NOTE: Market equilibrium (unregulated

market) is different than the socially optimal
equilibrium!! It is the equilibrium at the MC -
Demand not MSC - Demand!

=> Market equilibrium for this graph is at

8 tons and $250. While socially optimal equilibrium
is 4 tons and $450.

3. Cap and Trade (Quotas):

The government can eliminate the market
effects of negative externality by setting the
quota at the socially optimal quantity.

*** Explanation: At the naturally equilibrium,

the market is at the inefficient point where the
Marginal Social Benefit (Demand curve) is
intersect with the Marginal Private Cost (Firm
Cost only) => we need to scale back the
production in order to get the Marginal Social
Benefit equals to the Marginal Social Cost by
placing a Quota right at the MSC!

4. Laws, Rules and Regulation: Speed limits, workplace safety laws and noise restriction
all help discourage activities that would otherwise cause negative externalities.

 Public Goods, Free Riders, and Tragedy of the Commons:

Characteristics of Goods:
1. Excludable: It is possible to prevent someone from enjoying/CONSUMING the benefits of
that good (Example: as an owner of a limited car, I can exclude you from buying it by
buying it and now it is mine. Or as the owner of a clothing store, I can exclude people from
the goods by setting a price and if the consumers choose not to pay that price, they are
excluded from the benefits of that good).
2. Non-Excludable: It is NOT possible to exclude others from enjoying/CONSUMING the
good (Example: Fireworks - no one could exclude you from enjoying the benefits of
fireworks).
3. Rival: My use of the good decreases the QUANTITY available to others (Example: If there
are 12 cupcakes and I eat 2, it means there are 2 less for everyone else).
4. Non-Rival: One person’s use of the good does NOT subtract from another person’s use
(Example: Internet, Youtube, Instagram, music in the park - just because I am watching a
movie on Netflix does NOT prevent everyone else from watching it).

1. Public Goods and Free Riders:

• It is special because NO individual or firm is able to claim ownership of the product. As such,
it is difficult (if not impossible) to exclude others from consuming, and therefore benefiting
from the product (Public Goods and Common Resources).
• Typically, the owner of a good controls the consumption of that good:
• If I own a car, then I can stop others from using my car by locking the doors.

 • If I own a cupcake shop, then people who do not pay for product cannot consume my
product.

• Public Goods: Something its consumers cannot be excluded from (Non-Rival and Non-
Excludable) => This results in the Free Riders (always present with the Non-Excludability
factor) issue in which they are the people who enjoy the benefits of a good without bearing
any of the costs. In case of Non-Rival Goods, free riders enjoy positive externalities of the
good without hurting others.
• Example: Free riders in the group project that get the same grade as everyone else.

Why the market will underproduce (or entirely fail to provide) a NON-
EXCLUDABLE good?
1. If consumers CANNOT be excluded from a good once it is provided, then they have NO
incentive to pay for the good.
2. Since public goods are Non-Excludable, consumers have NO incentive to contribute toward its
production.
3. And no one pays for the goods, then the private market (the firms) will NOT provide it since
they will NOT earn any money and no one will cover their costs.
=> The problem is that even though we all benefit from public goods, the market fails to
provide it. The solution is that the government will step in and provide these goods instead.

2. The Common Resources and the Tragedy of the Common:

• Commonly held resources are subject to Non-Exclusion but are Rival in consumption
(Example: Fish in the ocean and illegal fishing issue).
• Market failures associated with these types of goods are referred to as “the tragedy of the
commons.”
• The tragedy is that these resources tend to be overused and exploited. Individuals race to “get
theirs” before it is used up.



CHAPTER 8 & 9 : UTILITY AND CONSUMER CHOICE

Consumer choice can be broken down into 2 steps:

I. Determine what is affordable (What can I buy) - Budget Line
II. Out of the affordable options, which option is the BEST (What brings the MOST happiness?)

I. Budget line:
• It tells consumers’ their consumption possibilities given their income and prices.
• It graphically illustrates the possible combinations of 2 goods that can be purchased given the
consumer’s income and the price of both goods.
• Consumer Budget Line Equation: Income = (price1 * quantity1) + (price2 * quantity2)
=> Linear Equation

a. Budget Line - Price Change:

Original Scenario - Income = $40, Movie = $8, Soda = $4:

***TIP: Only focus on the END points (the Maximum amount) of each good => Easier to
locate and find out the correspond quantity/price.
=> For example: in the above case, we can find the 2 end points (2 extremes on the graph) by
diving the total income ($40) to the price of each good ($4 and $8) to find out the maximum
amount we can buy for that good only => help locate the 2 extreme quantities on the graph and
mark other points easier.

Scenario A - Price of Movie rises from $8 to $20:

=> Price of Soda has NOT change, therefore the end point of soda is still at 10. Whereas the
price of the movie went up => we can afford less movie than we did before => the end point of
movie shrink in => Budget Line Rotates In.

Scenario B - Price of Soda rises from $4 to $8:

=> Price of movie has NOT change, therefore the end point of soda is still at 5. Whereas the
price of the soda went up => we can afford less soda than we did before => the end point of soda
shrink in => Budget Line Rotates In.

Scenario C - Price of Movie falls from $8 to $4:

=> Price of Soda has NOT change, therefore the end point of soda is still at 10. Whereas the
price of the movie went down => we can afford more movie than we did before => the end point
of movie expands => Budget Line Rotates Out.

b. Budget Line - Income Change:

Scenario D - Income falls from $40 to $20:

=> Find the 2 end points again (because new incomes shift BOTH ends - BOTH shrinks in) =>
Parallel Shift => Have the SAME slope as the old line.

 II. Preference and Utility:

A. Preference (Choosing the Best Bundle):

• Being on the Line: For the consumer to achieve maximum happiness given their constraints,
choosing a bundle on their budget line is a necessary but NOT sufficient condition.

**NOTE: The BEST BUNDLE is 100% of the time is the bundle that is ON THE BUDGET
LINE => Have to be ON the line in order for the consumers to MAXIMIZE HAPPINESS.

• Necessary: To maximize happiness the consumer needs to maximize consumption (i.e spend
their ENTIRE budget). More is better => Want to do as much consumption as possible
because More Consumption brings More Happiness!!

• Not Sufficient: NOT all bundles on the budget line provide the same level of happiness to
the consumer. There is a BEST bundle, and this BEST bundle depends on the consumer’s
preference.

B. Utility (The measure of happiness/satisfaction):

• Definition: It is the hypothetical measure of the happiness or satisfaction a person receives
from consuming a good or service.
• Utility unit: Utils
• Total Utility: The total satisfaction (benefit) a person receives from consuming a given
amount of goods and services. It depends on the Level of Consumption. Total utility
increases as the consumption increases.
=> Lower Level of Consumption, Lower Utility (or More Consumption brings More
Happiness!)

• Marginal Utility: The CHANGE in total utility that results from a ONE-unit increase in the
quantity of a good consumed
• Example: Originally, my total utility for consuming 1 pizza is 20 utils. If I consumed ONE
more of the pizza, my total utility is now 30 utils => The change in total utility is 30-20 = 10
Utils = Marginal Utility.

*The best bundle is the one that gives the consumer the MOST satisfaction!

Difference between Total and Marginal Utility:

• Total Utility: Increase as the consumption increases (Direct Relationship)
• Marginal Utility and MU/$: Decrease as the consumption increases (Inverse
Relationship)

 ***NOTE: Be careful with picking the quantities because the End Point does NOT
always maximize the happiness (or Highest Utility as possible). Example below.

*The reason Morgan chooses 2 movies and 6 sodas for the example because she is sticking to the
Budget Line listed above (The price of 2 movies + 6 sodas add up to $40 = Lisa’s income).

Relationship between Total Utility and Marginal Utility:

• The total utility rises by an amount exactly equal to the marginal utility (Marginal Utility is
nothing but the change in the Total Utility obtained from consuming one more movie or one
more soda)
• => Example: My first soda brings me a utility of 50 utils, and the 2nd soda brings me up to the
total utility of 75 utils => I have 25 unit of marginal utilities (The second unit brings 25 utils).
• => Marginal and Total Utility strongly link and define one another.

• The marginal utility is POSITIVE but DISMINISHING.

• Positive: because we are consuming “goods” which is a good thing => more goods makes us
more happier.
• Diminishing: means that the increase in total utility get smaller and smaller with each
additional unit of consumption => The satisfaction of consuming the first slice of pizza is way
higher than the satisfaction of consuming the 4th slice of pizza (because you are already full
=> having more pizza would not bring you as much happiness as when you eat the first slice).

 ΔTotalUt ilit y
• Equation for Marginal Utility = ΔQu a nt it y
(equation to calculate 1 unit)

• The Law of Diminishing Marginal Utility: As we consume more of a given product, the
dded satisfaction we get from consuming an additional unit DECLINES => MORE goods,
LESS marginal utility => This is about the happiness you are getting decline!

=> Example shows how Marginal Utility is declining as the Total Utility increases. From 7-8
movie, the marginal utility = (242-222)/1 = 20 utils.
***NOTE: Pay attention to the Marginal Utility place, the marginal unit lists next to the
first good is actually the marginal utility that the second brings. For example: the 8th
movie brings me the marginal utility (happiness) of 20 utils. The 5th soda brings me the
marginal utility of 22 utils. The 10th soda brings me the positive of 5 boost (5 marginal
utility).

=> The graph shows the total utility is increasing but at a decreasing rate (the change in total
utility is Marginal Utility) => Marginal Utility curve is sloping down because of the
diminishing marginal utility.

 Utility Maximization Methods:

1. Method 1: Optimal Consumer Choice - Utility Maximization (may require a lot of

work):
• Goal: Find the consumption bundle that maximizes the person’s total utility (happiness) given
their budget constraint (limit).

RECIPE for Method 1:

• Step 1: Find all the “just-affordable” (good(s) that require me to maximize the ENTIRE
income => any bundles that are ON the Budget Line.
• Step 2: Calculate the total utility for each bundle and pick the bundle that has the MOST
utility (sum of MAXIMUM total utility).

=> For the example, to calculate the Utility Maximization, compare the sums of each bundle and
pick out the Maximum. Example, at the bundle of 2 movies and 6 soda, add up 90 + 225 = 315 to
get the total utility. Do the same thing to get the total utility for other bundles and pick out the
Maximum => This is the CONSUMER EQUILIBRIUM!

• Consumer Equilibrium is when the consumer has allocated all their available income in a
way that maximizes their TOTAL UTILITY!

 2. Method 2: Choosing at the Margin:

• Intuition: when you go shopping you decide how to allocate your budget in a way that is best
for you. When you have achieved the “best” allocation, then it means you can’t make yourself
better off by spending more on one item or less on another item (you have spend everything
optimally - cant rearrange your spending anymore) => You think about how much to spend on
each good, given everything you want to buy, and how much of each good would make me
happy? => This is thinking about how to spend the marginal (or additional) dollar -
Thinking about where and what item should I put my next dollar towards that would
bring me the MOST happiness - “Am I better off spending this dollar on Good X or Good
Y?”

• Marginal Utility per Dollar: is the additional utility that results from spending ONE MORE
DOLLAR on that good.
Margin alUt ilit y(x)
• Equation of Marginal Utility per Dollar : Pr ice(x)

• Example: The MU from the 10th movies is 16 utils, and the price of a movie is $8. Thus, the
MU per Dollar is 2 (16/8 = 2) => The consumer gets 2 units of utility per dollar.
=> By comparing the MU per Dollar of various goods, we can determine whether the
budget has been allocated in a way that maximizes total utility => The happy you are
spending that ONE EXTRA DOLLAR, the efficient you allocate your budget and maximize
the MU!

***NOTE: The more marginal utility earned, the more happy you are getting one more of
the good. In this context of MU per dollar, the more happy (utilities) you are getting the
good by spending that 1 dollar, the maximize you spend it! Recall the NOTE about the
location of the “Marginal Utility” in the chart, the MU of one good is actually located next to the
first item, not the second!!

Calculating the
Marginal Utility Per
Dollar, we have:
MU(Pizza) = 40/4 =
10 (utils).
MU (Cookie) 30/12
= 15 (utils).
=> This is the MU
(happiness) that the
One Dollar Extra
can earn => Cookie
is more beneficial
in this case!!

 RECIPE for Method 2:

• Step 1: Find all the “just-affordable” bundles (same as Method 1) - Bundles ON the Budget
Line - Maximize the ENTIRE income.
• Step 2: Equalize the MU per Dollar for all goods (2 goods).

Equalizing the Marginal Utility per Dollar:

• Intuition: If one good yields more happiness per dollar than some other good, then you should
keep spending your dollar on that good until some other activities start yielding MORE
happiness per dollar.
• If your MU per dollar for movies is higher than your MU per dollar for soda, then a
simple way to make yourself better off is to spend that dollar on movies! Keep doing this
until diminishing MU ultimately equates the MU per dollar for the 2 goods => This is the
Stopping Point and the Equilibrium!
• => For example: The MU per Dollar for cookie is 5 utils while the MU per Dollar for pizza is 1
utils => You will keep spending your money on cookie (as it earns you more MU per Dollar
compared to pizza) until your MU for cookie is 1 unit of utility for Dollar just like pizza =>
Now they are equated and at this point, you CANNOT rearrange that dollar to make yourself
better off because they BOTH yielding the same of MU per Dollar => This is the
EQUILIBRIUM (MARGINAL UTILITY OF GOOD X = MARGINAL UTILITY FOR
GOOD Y)!
=> When the last dollar spent on each good gives the same MARGINAL utility, TOTAL
utility cannot be increased by changing the consumption combination.

*NOTE: Recall about the Law of Diminishing Marginal Utility => Continue picking the good
with HIGHER MU per Dollar until the MU of that good equal the other one (we are ultimately
bored of that good, therefore the MU starts diminishing!)

Analysis Tips:
If the Marginal Utility per Dollar of movie > soda [ (MU/$ movie) > (MU/$ soda) ] => Then see
more movies and buy less soda.
If the Marginal Utility per Dollar of soda > movie [ (MU/$ soda) > (MU/$ movie) ] => Then see
less movies and buy more soda.
=> STOP when [(MU/$ soda) = (MU/$ movie)]. Any movement away from this allocation
would make you WORSE off!

=> For this example, the reason why Point C is the best allocation for both goods because the
calculation of MU/$ of Movie (40/8=5) is EQUAL to the MU/$ of Soda (20/4=5) -
COMPARING THE MARGINAL UTILITY PER DOLLAR OF 2 GOODS!!

***When to use which Method?

Whichever methods has to find the corresponding quantity of 2 goods in

response for total income first!

MAKE 2 SEPARATE TABLES. ONE IS FOR THE CORRESPONDING

QUANTITY OF 2 GOODS. THE OTHER ONE IS FOR EITHER SUM
OF TOTAL QUANTITY OR MU/$.

• Method 1: Use when the chart gives us the TOTAL UTILITY of 2 goods.
(Sum up Total Utility of 2 goods)
• Method 2: Use when the chart gives us the MARGINAL UTILITY of 2
goods. (***Remember to find the MU/$ in order to use the method!!!)

 CHANGES IN PRICE AND INCOME (*Have to use METHOD 2 to solve!*):

Scenario 1 - The Price of Movie Falls - Soda Remains:

Affordable region GROWS - Law of Demand

Question: How does Lisa adjust her consumption if the price of movies falls from $8 to $4?
What is Lisa’s new utility maximizing bundle?
***Note: Lisa’s preference does NOT change and the Marginal Utility does NOT
change, her MU Per Dollar will CHANGE.

=> Think about the worth of happiness that One Dollar Extra will bring her. Even though her
preference for movies does NOT change, but the changing in prices will affect the MU/$ =>
Margin alUt ilit y(x)
Back to the MU/$ Formula = - INVERSE relationship between MU/$
Pr ice(x)
and Price => Price rises, MU/$ falls.

METHOD 2 RECIPE:
Step 1: Determine the NEW just-affordable bundles.
Step 2: Calculate the NEW MU/$ (for movies). Keep in mind that the Soda data will NOT
change at all because her preference and her total utility and the price for soda has NOT
changed!!!
Step 3: Determine which bundles equates the MU/$ for movies and soda! Means: Find the
NEW Equilibrium between Soda and Movie!!

Intuition:
The Budget Line will rotate OUTWARD because the movie prices FELL => The new optimal
bundle should be FURTHER out from the origin and associated with a higher level of
consumption for at least 1 good (and a higher level of total utility for Lisa overall) => At least
one good must have higher consumption (more quantities) as the price of one has changed to be
cheaper (Could happen to be BOTH but has to be AT LEAST 1).

=> These are the

possibilities for which
the NEW OPTIMAL
POINT might be.
Note that, at least one
good must have
higher consumption
(because one price is
cheaper!).

 => Since everything about Soda has not change, we only need to update the MU/$ column
of movie and compare with the MU/$ of soda
=> With the new Optimal point, we can conclude that we are doing LESS of soda (move from
6-4) and MORE of movies (from 2-6).
As the price of movie fell, Lisa increased the quantity of movies she purchases and decreases
sodas. We can equate this into 2 effect:

1. Substitution Effect:
• Substitute away from soda, towards movies since movies got relatively CHEAPER.
• Think of it as the movies went on sale for which the price reduces by haft, therefore, people
substitute the money that is spend on soda towards movies.
• => You move away from one item towards the thing that went on sale (more movie, less
soda).

2. Income Effect:
• Lisa can afford more movies because her purchasing power INCREASE when Pmovie fell.
• NOT that her income increase but actually because the price for movies got cheaper, Lisa now
has more POWER to buy more movies with that same amount of money.
• => Definitely more movies and more soda.

 => DIFFERENCE between Sub and Income Effect: Income Effect meant to scale up BOTH
goods since the purchasing power rose while the Sub Effect meant to scale up the ONE with
price goes down.
➡ Substitution effect and Income effect work together to force incentivizing Lisa to do more
movies.

• Law of Demand: Fall in the price of movies led to an increase in the quantity demanded for
movies (movement along the curve) => It reflects all the price-quantity relationship. As the
price changes, we move along the curve, and increase the quantity of movies bought.
• Substitute in Consumption: When the price of a substitute falls, the consumers increase the
quantity demanded for that good (movies) and decrease the demanded for the other (soda).

Scenario 2 - The Price of Soda Rises - Movie Remains:

Affordable region SHRINKS - Law of Demand

Question: How does Lisa adjust her consumption if the price of soda rises from $4 to $8, movies
price remain at $4 (from the previous scenario)? What is Lisa’s new utility maximizing bundle?
***Note: Lisa’s preference does NOT change and the Marginal Utility does NOT change,
but her MU Per Dollar will CHANGE.

Intuition:
The budget line will rotate INWARD since the price of soda rose => The new optimal bundle
should be CLOSER to the origin and should be associate with a LOWER level of
consumption for AT LEAST one good (and a lower level of total utility for Lisa overall).

 =>These are the possibilities for which the NEW OPTIMAL POINT might be. Note that, at least
one good must have LOWER consumption (because one price is higher!).

=> All of the movie columns dont change (because nothing about movie is changing). The soda
Quantity and Marginal Utility also dont change because her preference is not changing, ONLY
the MU/$ changes. => Need update!

• Law of Demand: Rise in the price of sola led to an decrease in the quantity demanded for
soda (movement along the curve)
• Substitutes in Consumption: When the price of a sub rises, the consumer decreases the
quantity demanded for that good (soda), and increase the demanded for this good (movies) =>
Rightward shift of the movie demand curve.

Result:
• Income Effect: Purchasing power fell due to increase in Price of Soda (Less income => Buy
less) => Scale back BOTH soda and movie.
• Sub Effect: Sub away from soda since it got relatively more expensive: Rise in the price of
soda => Consumer more movies => Scale back => buy less sodas, more movies.
=> DIFFERENCE: Income Effect meant to scale back BOTH goods since the purchasing
power fell while the Sub Effect meant to scale down the one with price goes up. Income says
less movie, Sub says more movies and both say less Soda => Even each other out so movie
quantities stay the same while both say less soda, quantity of soda fell.

 Scenario 3 - Income Rises - The Goods remain constant:

Affordable region GROWS - Normal or Inferior Good?

Question: How does Lisa adjust her consumption if her income rises from $40 to $56 (the price
of each good is $4). What is Lisa’s new utility maximizing bundle.
***Note: For this case of increasing income, the only change is the the paired quantities of
each good, everything else (quantity, MU and MU/$ stay the SAME) => Just have to
relocate them, update the paired quantities and compared the given MU/$ again to get the
new OPTIMAL point!

Intuition: The budget line will SHIFT OUTWARD (Parallel Shift - slope DONT change but
the position of the budget line DOES) since her income rose. This means the new optimal
bundle should be FARTHER from the origin, and should be associated with a HIGHER level of
consumption for AT LEAST one good (and a higher level of total utility for Lisa overall).

***NOTE: Find the 2 new extremes for both goods (New Income/Price) to get the new shift
position => Then find out the new correspondent quantities or pairs for 2 goods because the old
ones not efficient (For example, 6 movies was paired with 4 sodas now 6 movies was paired with
8 sodas).

Because both Soda and Movies are NORMAL GOODS!

=> When income increases, demand for both goods increased (ie. Both demand curves SHIFT
OUT TO THE RIGHT!)



 CHAPTER 5: INDIFERRENCE CURVES

Visualizing A Consumer’s Preference:

• Preference Map: We can create a graphical map to summarize a consumer’s
PREFERENCE on higher indifference curves to combinations on lower indifference curves
• Indifference Curve: The set of all bundles that the consumer views as being EQUALLY
DESIRABLE. It is a line that shows COMBINATIONS of goods among which a consumer is
INDIFFERENT (DOWNWARD SLOPE).

*Note: Think that any two bundles on the indifference curve means we are “indifference”
between them and dont prefer one over another => View them as equally desirable!!

=> In this case, the consumer gets just as

much utility from bundle C as they do from
bundle G, since bundle C and G are on the
same indifference curve.

=> We are INDIFFERENCE in every

single bundle on this line => EQUALLY
DESIRABLE = Bring us the SAME level of
Happiness.

=> The graph is DOWNWARD slope because:

For example, at point C I have 2 movies and 6 sodas, then I am given an extra 4 movies. In order
to balance out the happiness. I am also being taken away 4 sodas. We have point G => That is
why at point C and point G, the happiness is equal => remaining INDIFFERENCE.

 •Bundle FARTHER from the origin are

preferred than those CLOSER to the origin
(more is better than less). Ex: 10 sodas 10
movies is more preferred than 8 sodas 8
movies.
•Every bundle can be placed on an indifferent
curve (associate with that bundle).
•We can create a family of indifference curves
called A Preference Map to summarize the
consumers’ preference.
•Every points ABOVE the indifference curve
is PREFERRED!
•(Think about if I am giving you 2 extra
movies without taking away any soda =>
Happier/ But if I am giving you 2 extra
movies and take 2 sodas in return => back to the origin indifference curve.)

Interpretation of the graph:

•C and G are 2 indifference points
(but what points Lisa would choose
depends on her preference of whether
she likes soda more or movie more).
•We prefer J point rather than BOTH
point C and G (more is better) =>
Higher indifference curve =
higher level of utility! => We
prefers every bundle on indifference
curve I2 to any bundle of I1. (I2 > I1 >
IOriginal)

 **NOTE:
• Indifference curves DO NOT cross or intersect with one another => People are rational.

But if they do, here is what going to happen:

•See that there is the

indifference between Y&X.
•There is also the indifference
between Y&Z.
•But Z is preferred than X
(Because it is above, therefore
have higher utility)
•=> NONSENSE! We dont
have the situation like this!

 Marginal Rate of Substitution:

• The rate at which a person will give up Good Y (on y-axis) to get an additional unit of Good
X (on x-axis) while remaining indifferent (ie. on the same indifferent curve).
• =>Example: How many soda am I willing to substitute in order to get an additional of
movie (while still remain on the same indifferent curve).
• The MRS is the SLOPE of the indifference curve.
• The MRS is NOT CONSTANT! My willingness to substitute CHANGES depends on
where I am.
• The MRS DECREASE as we move DOWN the curve.

•=> On the graph, at Point C - 6 sodas

and 2 movies, my willingness to give
up soda for an additional movie
(MRS) is 2 soda .
•At Point G - 1.5 soda and 6 movie,
my MRS to give up soda for an
additional movie decreases to only
1/2 soda.
•=> Method: In order to get MRS = 2
or 1/2, we need to find the slope of
the curve at that points => Extend the
tangent line until it touches the axis x
and y => We then can find the slope
of the straight line = RISE/RUN
(Slope at C = 10/5 = 2; Slope at G =
4.5/9 = 0.5).

Diminishing Marginal Rate of Substitution:

Intuition: The tendency for a person to be LESS WILLING to give up Good Y to get an
additional unit of Good X as their quantity of Good X INCREASE (while remaining
indifferent) => Less willing to give up soda to get an additional unit of movie as the quantity of
movies is increasing (and even more than soda).
Let Good Y be apple and Good X be oranges. If original you DO NOT have many oranges but
have many apples, then you are likely willing to give up apples for that first orange. However, as
you get more and more oranges (and less and less apple), you are less likely willing to give up
apples for additional oranges.
=> The MRS DECREASE as we move DOWN the curve.

=> On the graph, the additional unit of X (blue line) is used to compare the MRS magnitude
(ΔY) between A-B and C-D. Under that same amount of X = 1, my willingness to give up apples
from Point C-D is less than from Point A-B (because I already gave up too much apples for
oranges => less willing to trade more) => Diminishing Marginal Rate of Substitution.

=> Flatter curve = Lower MRS or the Steeper curve = Higher MRS.

 Practice Problem: Who loves Ice Cream more??

***NOTE: Who is willing to give up donut to get the SAME one unit of increasing is the one
that loves ice cream more!!

There are 2 ways to find out who loves more:

1. Compare the Slope (Steeper/Flatter?)
=> Geeta has the STEEPER slope for Ice Cream (The steeper the slope, the higher the MRS).
=> Means she is willing to sacrifice more of donuts for an additional unit of ice cream => Geeta
loves ice cream more.

2. Compare the dotted line method:

=> Choose 1 position that represents 1 unit of Ice Cream => From that point of X, draw a dotted
line up to find out the 2 Before/After quantities of Donuts => Compare that magnitude (purple
square space in the graph) to see who has a larger magnitude of sacrificing good => In this case
is Getta. For this method, we dont need to calculate the actual MRS and not being confused of
which one is steeper.

Conclusion:
We use MRS to say things about people’s preferences about the good (how much will they
sacrifice depends on how much they like the good!)

 Utility Maximization using Inference Curves:

Goal: Maximize utility (i.e get on the HIGHEST indifference curve POSSIBLE)

Blue: Unaffordable region,

too high.
Green: Affordable but too
low, we can do better.
Yellow: Affordable but too
low, we can do better. Even
though yellow line
intercepts at 2 points on the
budget line but those are
NOT the good points.
=> Purple: Highest level of
utility given her budget
constraint. Even though it
only intercepts at 1 point on
the budget line, it is the best
optimal point!

=> Being on the budget line is necessary but not sufficient to decide which yields the
HIGHEST level of utility (The yellow line vs Purple line).
=> The purple indifferent curve is just TANGENT to the budget line. We cant go higher or
lower than this line in order to be sufficient!!!

 CHAPTER 10: THE FIRM

• The Firm: Is an institution that hires and organizes factors of production (land, labor,
capital) to produce and sell goods and services (***NOTE: it can also be a single person).
• The Firm’s Goal: MAXIMIZE ECONOMIC PROFIT!! => The firm requires Maximal
Profit to be an ultimate goal if you want to keep going.

PROFIT = DIFFERENCE between TOTAL REVENUE and TOTAL COST!

• Total Revenue: The amount of money the firm receives from the sale of it products (Raw
amount with no deduction of cost)
• Total Costs:
✦ Explicit Costs (explicit financial cost): Out of pocket costs/ Money firms have to pay
out = wages for workers, lease payments, taxes, utilities and cost of production in general
(cost to buy plastic, ink,…) - The only thing that includes in the accountant’s measure
of cost!
✦ Implicit cost (opportunity cost): The opportunity cost of using resources that belong to
the firm (i.e forgone wages, forgone interest of the previous job/business/saving money in
the bank for example). It is what you GIVE UP to pursue the current business/job
(forgone salary - salary from the previous job that you give up to pursue the current
one).

• Accounting Profit = Total Revenue - Explicit Costs => This is to keep track of all
of the money that goes into and out of a business (the number at the bottom of your profit-loss
statement, what the firm pays taxes on).
• Accounting Profit answers the question, “Where did my money go last year?” - This is
about the current financial situation of the current job.

• Economic Profit = Total Revenue - Explicit Cost - Implicit Cost => Simple
analysis where the only relevant implicit cost considered is “forgone salary”.
• ***NOTE: Explicit Cost - Implicit Cost together is called the Opportunity Cost of
Production!
• Economic Profit answers questions such as “Is starting a business worth it?” or “Did I
make the best decision?”. - This is to compare between the current job and the previous one.
• If forgone salary is $80,000 => EP = $200,000 - $150,000 -$80,000 = -$30,000 => Bad
business (Because the accounting profit $200,000 - $150,000= $50,000 = the money earn
from current business is $30,000 LESS than the previous one of $80,000).
• If forgone salary is $40,000 => EP = $200,000 - $150,000 -$40,000 = $10,000 => Good
current position (Because the accounting profit $200,000 - $150,000= $50,000 = the money
earn from current business is $10,000 MORE than the previous one of $40,000).

 => An accountant (accounting profit) calculates a firm's cost and profit to ensure that the firm
pays the correct amount of income tax and to show its investors how their funds are being used
(keep track of all the money the firms pay tax on/ in and out money). An economist (economic
profit) calculates a firm's cost and profit to enable them to predict the firm's decisions (answer
the question “Is starting a business worth it?”).

***NOTE: Earning zero economic profit IS NOT A BAD THING, but it is actually fine. What
this zero means is that firm is earning the SAME profit it would have earned if it had chosen
its next best alternative use of its resources. It looks at the forgone salary and benefits.
=>Think about Economic Profit means looking at the opportunity cost and 0 mean you even out
that benefit/ profit that you would have earned with the current one => If Mark Zuckerberg left
FB and opened a new business, his new business would have to earn billion of dollars a year just
to achieve zero economic profit. Any profit less than what he would have earned at FB would be
considered as ECONOMIC LOSS.

***NOTE: Asset is the money that will eventually come in (Money that someone owes you but
have NOT paid you yet). Liabilities are the money that will eventually come out (money you
owe someone but have NOT paid them yet). Capital is the money investment that you put into
the company.

Scenario:
• You are considering launching your own business. You expect to earn total revenue of
$200,000. You expect explicit cost to sum to $150,000. => Accounting profit = $200,000 -
$150,000 = $50,000. Should you launch your business? => It depends because we dont have
enough information. I need to know the Implicit Cost to conclude if its a good/bad idea.
• For example, if you currently have a job that pays you $80,000 then launching your own
business mean forgoing your annual income of $80,000 (implicit cost) => This mean you
could have gotten $80,000 with the old job > $50,000 with the business.
• But, if on the other hand, your current job pays only $40,000 then starting your own business is
a good idea!

 Implicit Costs - Firm’s Opportunity Cost (cont):

The opportunity cost of an ACTION is the HIGHEST valued alternative forgone.
The opportunity cost of PRODUCTION is the value of the BEST alternative use of the
resources that a firm uses in production.

Resources:
1. Bought in the market:
• A firm incurs an opportunity cost when it buys resources in the market.
• Why? Because the money spent on the resources could have been used to buy different
resources to produce some other goods.
• Example: If I use the money to buy resources to produce a yellow highlighter, it means that
money could have been used to buy resources to produce a pencil => Opportunity cost.

2. Own by the firm:

A firm incurs an opportunity cost when it uses its own capital.
• The firm could sell the capital it owns, or rent it out to another firm. When a firm uses its own
capital, it is essentially renting the capital from itself.
• The firm’s opportunity cost of using the capital it owns is called the Implicit Rental Rate of
capital.
• Example: If you are a farmer and you own a tractor and using it instead of selling or renting it
out to someone else => The money you are forgoing which could have earned by selling or
renting out to someone else (instead you using it = renting it out to YOURSELF) = Implicit
Rental Rate = Opportunity Cost!
• A. Economic Depreciation: The market value of a firm’s capital over a given period is
going to FALL (mất giá trị) => Opportunity cost from the Subject of Depreciation.
Example: Suppose you could sell your tractor for $2000 on June 1st, 2020, and for only
$1700 on Dec 1st, 2020. This forgone $300 is an opportunity cost of production. Subject
of Depreciation = Market value decreasing by time.
• B. Forgone Interest: The funds used to buy capital could have been invested and earned
interest => Opportunity cost from future earning interest.
Example: I have $2000 in my saving account but I took it out to buy a tractor. Because
that money could have still staying in the bank to earn interest = I forgone the future
interest of that saving money.

3. Supplied by the firm’s owner:

A firm’s owner supplies labor and entrepreneurial abilities are considered an opportunity cost
because this person could have earn $X in salary of they provided these skills to another firm
(forgone wages/salary) - Had mentioned in the first part - (forgone salary - salary from the
previous job that you give up to pursue the current one).

Practice: you are considering quitting your job to open a photography studio. You currently earn
$85,000 plus an additional $15,000 in benefits (forgone salary). You project that your studio will
bring in $140,000 per year, and you will have $40,000 in explicit costs. To get started, you will

need to withdraw $20,000 from the bank where it is currently earning 5% interest per year
(forgone interest).

=> Accounting profit = TR - Explicit Cost = $140,000 - $40,000 = $100,000

Economic Profit = AP - Implicit Cost =$100,000 - [($85,000+$15,000)+($20,000*0.05)]=-$1000
=> Negative $1000 means if I choose to open the studio, I will earn $1000 LESS than my current
job => Bad move.

 Firm Constraints and Efficiency:

• The firm’s goal is to maximize economic profit. However, there are environmental features
that limit the firms ability to do so.

Constraint Features:
1. Technological Constraint:
• The firm’s technology is their method of production (all of the production process in general
includes machines, layout of the workplace, organization of the firm,…).
• While technology is ever evolving, at any given point in time the firm is constrained by their
current technology/ production method, such that they can only produce some maximum
amount of output per day.
=> The firm tries to get away from this constraint by hiring a lean engineer for example, to
maximize the efficiency of the production process, or to minimize the degree to which their
technology constraint them.

2. Informational Constraint:
• The firm has INCOMPLETE information about BOTH the present and future.
• The firm is constrained by the limited information it has about:
1. The quality and effort of its workforce (they dont know who is using their work time to
play around and who is actually working hard).
2. The current and future buying plans of its consumers
3. The plans of its competitors.
=> The way that they try to get away from this constraint may be to set up incentive system to
induce workers such as sale target (workers get money when they hit the target).

3. Market Constraint:
• The quantity each firm can sell, and the price it can obtain are constrained by the consumer’s
willingness to pay and by the prices that other firms charge (and their marketing efforts).
• Another constraint comes from the resources a firm can buy and the costs of those
resources are limited in a similar manner.

Efficiency:
• There are 2 concepts of production efficiency:
1. Technological Efficiency
• Occurs when the firm produces a given output by using the LEAST amount of input (labor,
capital like rent, utility,…).
• A firm that uses the latest technology is not necessarily technologically efficient
because the firm might not use the least amount of inputs to produce a given output.
=> Just need to have less of an input utilized in ONE of our categories.

 • Example: If you can produce 100 iPhones using 100 workers and pieces of capital > Produce
100 iPhone using 1000 workers and pieces of capital.
=> When finding the technological efficiency in the table, choose one prime “method” and
compare others based on it. In order to be technological efficiency, that method has to win the
“prime” in at least one factor (ex: capital or labor).

2. Economic Efficiency
• Occurs when the firm produces a given output at the LOWEST COST possible.

Example 1:
• The only method that is NOT efficient is D
since there are 100 workers work on 10 capital
and produce only 10 TV. It also has a common
point with B (10 capitals) => Not technological
efficient.
•Compared to D, B uses less labor =>
Technological efficient.
•Compared to B, A uses more capital but less
labor => Still technological efficient.
•Compared to A, C uses more workers but less
capital (We need to do less in AT LEAST one
category) => Still technological efficient.
• => This table is not giving us enough info to
determine the best technological efficient.

Example 2:
What is the cheapest way to produce 10TV? In
other words, what method achieve economic
efficiency?

• What we would do if take the number of labor and

capital multiply by the respective given cost and
sum it up => We have the total cost!

• We figure out the BEST economic efficiency

which is B with the LOWEST COST! => So from
the unclear answer from Example 1, we have
enough info to figure out the BEST Economic
Efficiency Method!

***NOTE: Changing the wage/capital cost DOES impact the economical efficiency outcome
but DOES NOT impact the technological efficiency!

Final Notes on Efficiency:

• An economically efficient production process is also technologically efficient. In other word,

technological efficiency is a necessary condition for economic efficiency.
• Economic efficiency is a sufficient condition for technological efficiency.
• A technologically INEFFICIENT method is never economically efficient.
• Changes in the input prices impact the economic efficiency, but NOT the technological process
for using them in production (no impact on the technological efficiency).
• Changing the wage/capital cost DOES impact the economical efficiency outcome but
DOES NOT impact the technological efficiency!
=> Technological Efficiency is the PRERESIQUISITE for Economic Efficiency!!! If it is NOT
technological efficiency, it is NOT economic efficiency. But if it is economic efficient = it is
technological efficient!

The key distinction between technological efficiency and economic efficiency is that
technological efficiency concerns the quantity of inputs used in production for a given level
of output and economic efficiency concerns the value of the inputs used.

 Organization System:

System of Organization (how business organize workers within the firm):

1. Command System
• Uses a managerial hierarchy. Command pass down through the hierarchy and information
flows upward.
• Example: CEO at the top has a plan for the company => Pass down the instruction to senior
executives, managers, workers => Then these stages will report back up to the CEO through
the same way that it has passed down.

2. Incentive System
• Create compensation schemes to incentive workers to perform in ways that maximize the
firm’s profit.
• The Principle-Agent Problem: Is the problem of devising compensation rules that
induce an agent to act in the BEST interest of a principal = Encourage them to act upon
the company’s benefits like theirs.
• Methods:
1. Ownership. Example: some people got their shares/stakes in the company that’s is
why they should care about the company’s overall benefits like their own (Not that
common to the regular workers but to the senior executive/ manager).
2. Incentive Pay. Example: If you hit your sale target, you get the monetary reward/
promotions.
3. Longterm Contracts: They want the workers to sign for a longterm contract since it
benefits the company betters => The company sometimes have an incentive to devise
plan that brings about longterm period of sustained profitability.

Types of Business Organization:

1. (Sole) Proprietorship: Type of business structure composed of a single owner who

supervises and manages the business and is subject to UNLIMITED LIABILITY.
(Example: auto repair shop, local restaurant, dry cleaner,…)
*Unlimited Liability: is the legal responsibility for all the debts of the firm up to an
amount equal to entire personal wealth of the owner. This is also the BIGGEST CON of the
Sole Proprietorship. (Also the single owner has to raise all the capital themselves and it can be
expensive - another Cons).
Example: You open a cleaning shop, someone comes pick up their clothes and slips on
the floor. They could sue you and if you don’t have sufficient insurance to pay for the injuries,
your entire personal wealth, including home, savings,… will be wiped out. This is the unlimited
liability that the single store owner has to bear.

 2. Partnership: Similar to proprietorship but involves more than one owner who share the
management of the business. Partnerships are also subject to JOINT UNLIMITED
LIABILITY - still subject to unlimited legal responsibility but now it is shared among other
owners. (Example: partnership law firm).

3. Corporation: Firm owned by one or more LIMITED LIABILITY STOCKHOLDERS. A

stockholders’ liability is limited to the value of their stock (depends on the value of my
stocks, that how much I am liable for). This mean owners do not use their personal wealth to
pay the corporation’s debt = Huge PRO. But the decision process for this type of firm is very
slow because it has to go through several levels/chains in order to get approved => as a
result, it can be expensive = Big CONS. (Example: Delta Airlines, Wells Fargo, General
Electric,…).

Market Structure:

1. Perfect competition. :
• Example: sellers in the market sell corn, rice, fish,…(chợ)
• Many buyers/sellers
• Sell homogenous (identical) products
• No barriers to market entry and exit (if someone wants to come in and become a part of
this type of market (chợ), it is easier to join and easy to leave.)
• Both buyers and sellers have complete information about prices and products.
=> Firms have LITTLE TO NO market power => So many sellers and the Firms have to be
the PRICE TAKERS (the market supply and demand determine what the price would be and
the firms have to accept that and don’t get to set it higher/lower.)

2. Monopolistic Competition:
• Example: Pizza restaurant, clothing, shoes, bar/pubs.
• Many buyers/sellers
• Product differentiation (the DIFFERENCE between Monopolistic and Perfect
Competition).
• No barriers to market entry and exit
=> Firms have SOME market power (the firms now have “slightly” different products and can
get away with charging a little more/less).

3. Oligopoly:
• Example: Cell phone services, airplane manufacturers, Coke and Pepsi (duopoly), Visa
and MasterCard (duopoly).
• Still many buyers but FEW sellers
• EITHER homogeneous or differentiated products
• Moderate barriers to entry exists (Firms can block people from entering the market)

 => Firms HAVE market power (because the numbers of sellers now FEWER, they have more
market power in hand)

4. Monopoly:
• Example: Local monopolies includes electric, gas and water companies, Microsoft is the
sole producers of Windows.
• ONE seller for many buyers
• No close substitutes
• Higher barriers to market entry exist.
=> Firms have LARGE market power = they can set their price! (Only one seller to sell the
product therefore, it has big market power!)

Measures of Concentration:
To determine the market structure of a particular industry we measure the extend to which a
small number of firms dominate the market.

1. The Four-Firm Concentration Ratio

What percentage of the value of sales is accounted for by the largest 4 firms in the industry?
(Example: the largest four firms have $80 billion, the industry itself is $100 billion total sales =>
So the largest four firm have 80 out of 100.)

If the ratio is:

• Close to 0% = Perfect Competition (Firms don’t have the power in the industry = thousands
suppliers)
• Less than 60% = Monopolistic Competition (Market is competitive)
• Exceeds 60% = Oligopoly (Market is highly concentrated)
• Equal to 100% = Monopoly (Just think of One Firm = Monopoly)

Scenario: The total sales of the largest four firms sum to $700 million. The other firms sales
total to $300 million (anyone else that is NOT in the largest four firms).
=> Total industry sales = 700 + 300 = 1000
=> Four-Firm Ratio = 700/1000 = 0.7 *100 = 70% => Oligopoly.

Solving step summary:

1. Add up the Big 4 and everybody else in the market to get the total industry sale
2. Take the ratio = the Big 4 / The Total.
3. Determine which market it belongs to.

 ***NOTE: If it is already in the percentage form, we DONT need to divide by the total industry
sale!

Example: A Personal Care Study conducted by TABS Analytics shows that Walmart has a 19.4
percent share of the $40 billion personal care market, while grocery stores Kroger and Public
each have a 16.6 percent share, and Target, 12.8 percent.
=> The four-firm concentration ratio is 19.4 + 16.6*2 + 12.8 = 65.4

2. The Herfindahl - Hirschman Index (HHI):

Square of the percentage market share of each firm summed over the largest 50 firms (or over
all firms if fewer than 50).

If the HHI:
• Close to 0 = Perfect Competition
• < 1500 = Competitive Market
• 1500 < HHI < 2500 = Moderately competitive
• 2500 < HHI = Uncompetitive (Oligopoly)
• HHI = 10,000 = Monopoly (it is 10000 because Monopoly market has the entire 100% in the
industry => (100)2 = 10000).

Example:
If a market has 4 firms with the following market shares = 50, 25, 15, 10
HHI = (50)2 + (25)2 + (15)2 + (10)2 = 3450 = Uncompetitive (Oligopoly)

***Limitation of Concentration Measures:

• Geographical scope of market (sometimes the geographical scope of the market is not
national market but regional in a single town, and you may have a monopoly situation in that
specific town only => it can look competitive market nationally but in your town, it can be a
monopoly).
• Low barriers to exit and entry (this aspect is NOT acknowledged and included in the
concentration measure => If we skip over this aspect, this may be a big turn over!)
• Market and Industry correspondence (These don’t always match up. There are firms that
produce items that are sold in multiples industry => One single firm can be in different
markets.)

 CHAPTER 11: OUTPUT AND COSTS

• Every firm, across all market structures, must decide how to produce a given quantity of their
product. When making this decision, the firm must carefully consider the relationship
between output and costs.

• Time Frame: The degree to which the firm can influence the relationship between costs and
output strongly depends on the time frame the firm is subject to.

• Suppose a firm wants to double its output. Perhaps the most cost-effective way to accomplish
this is to buy more machinery and expand the factory. However, the firm cannot accomplish
this type of adjustment in a few days or even a few weeks. It might be that the best this firm
can do in the immediate future is to hire a few more workers or have current employees work
overtime.

Short Run:
• A period of time over which at least one factor of production (land, labor, capital,
entrepreneur) is fixed, or CANNOT be changed - due to short period of time.
• For most firms the fixed factors are capital (machine), land and entrepreneurship. We refer to
these fixed factors as the firm’s plant.
• Labor is the variable factor of production. This factor can be adjusted (i.e adjusted in a short
period of time = hire a few more workers or have current employees work overtime/ maybe
shrinks down some employees). This short-run decisions are easily reversed => means that
if I expand my labor pool today to hire more workers, I can also resend that decision the next
week easily.

Long Run:
• A period of time sufficient for firms to adjust ALL factors of production. In other words, the
firm can adjust the quantity of labor, land, capital and entrepreneurship being used.
Everything is the variable costs (NO FIXED COST)! => Long-run decisions are NOT
easily reversed.

***NOTE:
• Short run and long run are NOT about time, but rather defined by the firms ABILITY to
adjust the quantities of various resources being utilized in the production process (about how
quickly the firms are able to change ALL the factors of production!) => “Long run”
adjustment in one industry may not be considered “long run” in a different industry.
• For example: Can I adjust capital in a week? If I can adjust capital on a week then a week
is a “long-run” for me. Or if I cannot adjust the capital in a week, it is a “short-run” =>
Once I am able to change ALL factor of productions, that will put me in the long-
run timeframe.

 • A family own restaurant wants to expand their business, they will look for a bigger space
to rent. They will need a couple months to adjust to the new place and this is considered a
“long-run” for them. While for the Chemical Plant industry, which is a huge corporation,
a couple months is not considered as a long-run for them but rather short-run because it is
hard for them make big adjustments or decisions in a short time with so many regulations
to meet.
• The decision that they make in the long-run could be different than short-run because in the
long-run, they can adjust the capital, land and entrepreneurship. And if it is in their best
interest to do it, then they are going to do it in the long-run (for which some factors are
fixed, and not able to be changed in the short-run) => They need to know what is a better
option for them!
• In the long-run, since ALL factors can be altered, existing firms can close and exit the
industry, and new firms can build new plants and enter the market (Because only for long-
run, all the factors can be changed, therefore, they have the choice to enter or exit and get rid of
all that. While for short-run, they are stuck with at least one of the factors and can’t get in/out).
• In the short-run, since the plant is fixed, the number of firms in a given industry is fixed
(short-run firms can’t get in or get out - stated in the above explanation)
• Additionally, any changes in a firm’s output in the short-run can be entirely attributed to
changes in the employment of labor (since all other factors are fixed) => Hire more workers
will result in more outputs and vice versa, fire workers will result in less output => If we see
the output is adjusted up or down in the Short Run, we know FOR SURE that it is
because the LABOR is being adjusted up or down. But for Long Run, if the output is
adjusted, it may be because of other factors, maybe more capitals => Change in labor =
short-run decision.
• In the short-run, a firm’s plant (fixed factor) is fixed while in the long-run, a firm can
change its plant!

Sunk Costs:
• Costs that have already been incurred and CANNOT be recovered. Sunk cost are irrelevant
to the firms current decision about what to do at this new point in time.
• For example, the firm CANNOT get back the monthly rent it has already paid for its current
machinery and building space => Its gone and can’t recover!
• Good decision makers will ignore sunk cost!

 Short-Run Production (cont):

To increase output in the short run, a firm MUST increase the quantity of LABOR employed.
There are 3 main concepts we will use to discuss the relationship between output and the
quantity of labor employed:

1. Total Product (= OUTPUT):

• It is the MAXIMUM output that a given quantity of labor can produce.
• It summarizes the firm’s total output for a given quantity of labor (if they have 50 workers,
how much stuff can those 50 workers produce?) (C.P - means other factors, except labor,
remain the SAME! = Short-run)

=> As I hire more and more unit of labor, I have more output means more Total Product!
Point ON the curve is Technologically Efficient! Anything on and below the curve is
ATTAINABLE - below the curve is attainable but not efficient (for example: as 2 workers
can produce maximum is 10 products but they certainly can produce 5 or 7 or less than
that - which is not efficient)

***NOTE: This Total Product curve is NOT a linear line but rather a varying rate depends on
the quantity of labor => This curve increases at an increasing rate (rise quickly) and then
start to slow down! Because looking at the table above, the increase in total product per
additional worker is not constant!

2. Marginal Product of Labor:

• It is the CHANGE in total product that results from a one-unit increase in the quantity of
labor employed (if I hire ONE MORE labor, how much does that one additional worker add to
my TOTAL OUTPUT?)

 ΔTotal Produ ct
• => Marginal Product =ΔL a bor = 1
(The change in LABOR will ALWAYS = 1 =>
We ONLY pay attention to the change in TOTAL PRODUCT).

•Marginal Product from 1-2 workers = (10-4)/

1 = 6 or from 3-4 workers = (15-13)/1 = 2.
•Note that if there is a negative number in
the marginal product chart, it means that
the total product is decreasing (maybe the
cut off workers).
•Another point to focus is that moving from
workers (0-1) and (1-2), we see MP is
positive and increasing. This means each
additional workers adds more to the total
product than the previous workers
•But from (2-3) and (3-4) and (4-5), we see
MP is positive but decreasing. This means
each additional workers adds to the total output but adds LESS than the previous workers.
(The 3rd worker only add 3 units, the 4th only adds 2 units and the 5th only adds 1 unit).

The Relationship between Total Product and Marginal Product:

•The blue is the Total Product and the

box is the Marginal Product, for
which the size of the box represents
the contribution of the workers!
•From 0-1 worker, the size of the box
is 4 (only look at the y-axis), from
1-2, the size of the box is 10-4= 6.
•Look at the bottom graph, the first 2
box for which MP is positive and
increasing is called the increasing
marginal returns => Curve is
increasing at an increasing rate (very
steep slope, upward sloping).
•The last 3 box for which MP is
positive and decreasing is called the
diminishing marginal returns =>
Curve is increasing at a decreasing rate (LESS steep slope, downward sloping).

 => Total Product and Marginal Product has a Direct Relationship => If the Marginal Product
is INCREASING, then the Total Product will be increasing at an INCREASING rate (or
High Return). If the Marginal Product is DECREASING, then the Total Product will be
increasing at a DECREASING rate.

***NOTE: Total Product is usually increasing (at a decreasing/increasing rate is depends on the
Marginal Product), but if Total Product is decreasing, it means hiring anymore workers will
actually destroy the business output (For example, too many cooks in the kitchen but don’t have
enough job to do).

The Law of Diminishing Marginal Returns:

As a firm uses more of a variable factor of production (in this case is labor) with a given
quantity of the fixed factor of production => The marginal product of the variable factor
eventually diminishes.

For example: I am the owner of a tailor shop and I have only 2 sewing machines (“given a
quantity of the fixed factor of production”, in this case the machines are capital stocks) in the
shop with me where I am currently the only worker. If I hire a 2nd worker to work with me, I am
able to double my output because I could not use the 2 machines myself at the same time. Even if
I hire a 3rd worker and have that person sits at the desk to manage phone calls and customers,
my Marginal Product is still increasing and the Total output is still increasing at an
increasing rate. But if I hire a 4th workers, they could be helpful by cleaning and doing some
errands but they are not adding as much to the production as my other 2 workers. Now I am
approaching the diminishing marginal returns phrase where the addition person is contributing
but their contribution is smaller than the previous contributions. If I keep hiring more and more
workers where I only have a fixed capital (same numbers of sewing machines, in the same
building,…), these additional workers will actually affect the productivity of the current workers
(ex: little room/space to move around => hard to be productive). This is destroying the business
output!

3. Average Product of Labor:

• This is the output per worker, found by dividing total product by the number of workers
employed (the average of the product being produced per worker)

Total Produ ct
• Average Product = L a bor
(be mindful that this formula does NOT have the Δ
CHANGE in front of the total product and labor !!!)
• The average product of labor gives a sense of the OVERALL PRODUCTIVITY of the firm.
• Just as with MP, the average product increases at first and then decreases.

 => At C, I need 2 workers to produce the

output of 10, each produce 10/2 = 5
products. Or at F, I need 5 workers to
produce 16, each produce 16/5 = 3.20
product.
=> Look at the Average Product, just as
with AP, the average product increases
at first and then decreases.

The Relationship between Average Product and Marginal Product:

• When Marginal Product exceeds average product, then the average produce rises.
• When Marginal Product falls below average product, then the average produce falls.

• The pink curve is the Marginal Product

curve, the purple curve is the Average
Product.
• Notice that as soon as the Marginal
Product FALLS below the Average, the
Average gets pulled down (look at the
previous graph, at point D from 3 workers,
as soon as MP falls, AP falls).
•Below point C is the intersection
between MP and AP, when MP falls
below C, AP curve immediately falls =>
Point C is the MAXIMUM AVERAGE
PRODUCT!
• => Think as when an additional worker
stops adding as much contribution to the
total product as the previous workers =>
The marginal product starts decreasing,
total output still increases but at a
decreasing rate and that is why the average
product per worker is NOT as effective
anymore (average product a worker can produce is now less than before).

=> The MP very much influences the AP = Direct Relationship!

 Example: Think about your grade in the class. Suppose, you have a B in this class, then getting
an A on your next exam (marginal exam) will pull up your average grade to be higher! Vice
versa, if you get a badder grade, for example, a C in the next exam (marginal), then your average
grade will drop lower!

***Think about the position of the

Pink and Purple line on the 2nd
graph:

•When marginal product exceeds

average product, average product
is increasing. (Think about the
grade in class, you currently have an
average of B+, having a A in a test
(marginal test) will pull your
average grade up!)

•When average product exceeds

marginal
product, average product is
decreasing. (Exceed here does NOT
mean up, but instead means lay
ABOVE on the graph (look at the
2nd graph, when the purple line lays
above the pink line, it is when
average got pulled down by
marginal).

***NOTE:
• When marginal product exceeds average product, average product is increasing.
• When average product exceeds marginal product, average product is decreasing.

 Short Run Cost Curves (cont)

I. Costs of Production:
While production, specifically the relationship between OUTPUT and QUANTITY OF
LABOR employed, certainly plays a key role of the firm’s decision-making processes, it is
also essential for the firm to know how much it cost to produce this output. Only then can the
firm determine whether it is profitable to produce said quantity, and importantly, if the
firm can maximize profits.

3 fundamental concepts which characterize the relationship between the firm COST and
OUTPUT:

1. Fixed Cost: Costs that DO NOT change as a firm’s output expands or contract (Cost that
firm can’t get rid of). This cost category includes the costs of the firm’s fixed factors (ie. the
cost of renting the building/machines). The firm has to pay these costs even if it produces 0
or 100 units of output.
2. Variable Cost: Costs that DO change with the firm’s output. This cost category includes the
costs of the firm’s variable factors (ie. cost of labor). Note that if the firm does NOT produce
any output then the firm’s variable cost will equal to zero (unlike fixed cost).
=> If I want to INCREASE my output in the short-run, I will have to INCREASE my
variable cost. In the short run, the only thing I can do is hire more workers, and the variable
cost is the wages that the firm pays them. Hire workers over time means that the firm will need
to pay that overtime extra wages and vice versa, no output means the firm does not need any
workers and does not need to pay them wages or no variable cost.
3. Total Cost: the sum of fixed and variable costs (i.e all the costs associated with production).
=> Total Cost = Total Fixed Cost + Total Variable Cost.

• Notice that the fixed cost

is always fixed at 25 and
represents with a straight
line (green).
• The variable cost (purple
line) is the number that is
increasing as the output
increases.

***NOTE: The
DISTANCE between the
Total Cost and the
Variable Cost is always
EQUAL to the Fixed Cost!

 • => Explain the shape of these two curves and why it is steeper at the later phase: Think about
the Marginal Product of Labor. At the beginning phase, these very first workers are very
productive (they have increasing marginal return = output), the cost/wage that the firm pays for
them is reasonable and increase at a decreasing rate (for the firm’s viewpoint). But as the firm
hires more workers and from the point where their additional workers are not contributing as
much as the previous ones (the diminishing marginal return sets in), the cost that the firm pays
are actually hurting the company itself (the cost is increasing at an increasing rate). Note that
all workers are paid the same wage!

Difference between the Total/Marginal Product Curve and Total/Variable Cost

Curve:

Beginning Phrase:
• Total/Marginal Product Curve: Steep - as their first few workers are productive and bring
out the most effective output for the company = Increase at an increasing rate.
• Total/Variable Cost Curve: Slight - Because the first few workers are so productive, the cost
(wage) that the firms pay out is reasonable and not hurting the company = Increase at a
decreasing rate.

End Phrase:
• Total/Marginal Product Curve: Slight - from the Maximum Average Point, any additional
workers are not contributing as much to the total output of the company as the previous ones
=> The production is no longer productive as before = Increase at a decreasing rate.
• Total/Variable Cost Curve: Steep - because these later workers are not contributing as much
to the total output as the previous workers, the cost (wage) that the company is paying out
(wages are equal for all workers) are now “hurting” them in some ways, too much compared to
the production output = Increase at a increasing rate.

 II. Marginal Cost:

• Total Costs are certainly key in helping the firm determine their overall profitability. However,
the decision about what quantity of output to produce (Q) ultimately depends on how total
costs change if the firm produces ONE MORE or ONE LESS unit of output.
• Is the additional revenue earned from producing this unit of output greater than addition costs
associated with producing this unit? If the additional revenue > the additional cost => This
unit is worth it!
• Marginal Cost = the change in the total cost resulting from one-unit increase in output (Output
is denoted as Q).
ΔTotalCost (TC ) ΔTotalVar ia bleCost (T VC )
• Marginal Cost = ΔOut put (Q) (also
ΔQ
) (Be careful

because for this formula, we have to take the CHANGE from both the numerator and
denominator, NOTHING is equal to 1 for this part!).

=> Marginal Cost from A-B = (50-25)/(4-0) = 6.25

(Pay attention because for this formula, we have to take the CHANGE from both the numerator
and denominator.)

***NOTE: Be careful with the fixed cost at 0 output!

 III. Average Costs:

TFC
• Average Fixed Cost - Total fixed cost per unit of output ( )
Q
T VC
• Average Variable Cost - Total variable cost per unit output ( Q )
TC
• Average Total Cost - Total cost per unit of output ( )
Q

TC TFC T VC
• TC = TFC + TVC => Q = Q + Q => ATC = AFC + AVC

=> For Point C, the AFC = TFC/Q = 25/10 = 2.5

For Point D, the AVC = TVC/Q = 75/13 = 5.77
For Point F, the ATC = TC/Q = 150/16 = 9.38
But ATC = AFC + AVC so for Point C, ATC = 2.5+5 = 7.5



1. The pink line Marginal Cost (MC) will always intersect with the Average Total Cost (ATC)
and Average Variable Cost (AVC) at their respective MINIMUM point.
• Whenever the marginal is BELOW the average, the average will always FALL. Vice
versa, whenever the marginal is ABOVE the average, the average will RISE (We have
explained about this back in the Marginal Product and Average Product section - MP have a
big influence on AP - Think about the grade in class => This is also why the Marginal
Curve is below the Average).
• Look at the graph, from the point of intersection between MC - ATC and MC - AVC
(the arrows in the graph pointing), the curve of both ATC and AVC starts going up,
mark an end to the “going down” phrase (MINIMUM POINT).
• ***Tip for graphing: Always draw the MC curve first! The AVC will always lay BELOW
the ATC because ATC = AVC + AFC, therefore ATC will always be greater!
ΔTotalCost (TC )
Also with the formula Marginal Cost = , the MC has a direct
• ΔOut put (Q)
relationship with the TC, and TC has a direct relationship with TVC => As MC goes up,
they all go up (start from the point of intersection).

TFC
2. The green Average Fixed Cost (AFC) will continuously falling (AFC = but TFC is
Q
always fixed at the same rate so the only thing that is changing is Q = output. Looking at the

 position of Q and AFC => They have an inverse relationship => As Q is increasing, AFC
will decrease - The fixed cost from capital (machine) is now disregarded thank to the big
output (profit).
***NOTE: Be careful, AFC is continuously decreasing because it relates to the increasing
of output in the formula, AFC is different from Fixed Cost!!

3. The Average Total Cost (ATC = blue line) and Average Variable Cost (AVC = purple line)
converge as output increases (means get closer together).
• They are far part at the beginning but get closer together when going further => Because
the only thing that separates between them is the Average Fixed Cost, which is
continuously falling as output increases (like we just explained) => The distance between
them is getting smaller and smaller.
• They also have the SAME shape - recall to the explanation of the TC and TVC curves
when the distance between them is just the fixed cost.

4. The Average Total Cost falls then rises such that it has a U-Shaped Curve:
• At the initial levels of output, average cost declines since fixed costs are being spread out
TFC
over larger output quantities , and because Marginal Product of Labor is rising
Q
initially (the firm is using the cost effective - with enough workers that contribute to
company’s output effectively). However, as production levels continue to rise,
diminishing marginal returns set in (too many workers that not contributing as much
to the total output as the previous ones) and average costs climb back up (bad thing to
the firm).
=> Keep in mind this is the curve about the COST that the firms have to pay out. Downward
curve is actually a good thing to the firm and vice versa.

Shifts In Cost Curves

The position of a firm’s cost curves depend on:

1. Technology (high fixed cost - low variable cost)

• A technological change often increases the productivity of the firm’s factors of production. In
other words, with better technology, the same factors of production can now produce more
output => Lowers the costs of production => Shift the TOTAL COST curves DOWN!
• While technological change often decreases the total cost, fixed costs often increase. This is
because most technological changes result in increased utilization of machinery (i.e capital - a
fixed factor). => Fixed Cost (the cost of capital = machines in this case) is now HIGHER

 because firms have to pay to invest, install, maintain,…machines while Variable Cost is
LOWER because the firms don’t need as much labors as they used to.
➡ Since Fixed Cost are HIGH and Variable Cost are LOW, for SMALL level of output Q,
High Fi xedCost
ATC (Average Total Cost) is going to be high (because +
L o wQ
L o wVar ia bleCost
will produce a High Average Total Cost). But by times, as we
L o wQ
continue to increase production and have a HIGH level of output, we will have a
decreased Fixed Cost (revisit the above explanation for why Average Fixed Cost is
continuously falling) - increase in output disregard the fixed cost and make it “low” by
L o wFi xedCost L o wVar ia bleCost
being spread over ( + will produce a Low Average
HighQ HighQ
Total Cost).

=> Summary: This change in the mix of fixed costs and variable costs means that for small
levels of output, ATC will likely increase, while at large outputs, ATC will decrease.

2. Change in the prices of the factors of production:

• How the cost curves shift depends on which factors experience a change in price (fixed factor
or variable factor?), and in what direction that price changes (up or down?).
• If the price of a variable factor increases (ie. Wages or the price of gasoline increases), then
the AVC, ATC and MC all SHIFT UPWARD, but the AFC curve remains unchanged!
=> AVC and ATC always shift together because the only thing that separates them is the
ΔTotalCost (TC )
fixed cost (not changing in this case), and the MC = =
ΔOut put (Q)
ΔTotalVar ia bleCost (T VC )
(MC relates to both TC and TVC) so if the ATC shifts, MC will
ΔQ
shift as well.
• If the price of a fixed factor increases (i.e the rent increases), then the AFC and ATC curves
will both SHIFT UPWARD and AVC and MC remains unchanged (because ATC = AFC +
AVC so if AFC increase and AVC remains unchanged, it will shift the ATC up as well).

 Long Run Costs

• In the long run, firms can adjust ALL factor inputs (everything is the variable cost and NO
FIXED COST) => We only have ONE relevant cost curve for which VC = ATC.
➡ This gives firms the ability to build plants of the size best fitting the levels of output it
wishes to produce. In other words, the firm can tailor it plant to complement their desired level
of output => Give them the ability to produce at their LOWEST UNIT COST (minimize the
per unit cost much better than short run).
• Let’s now explore how the firm’s long-run ability to switch from one plant size to another
allows them to minimize their costs at each production level.

Deriving Long Run Cost:

• Plant 1 has the fewest machines (the lowest level of capital) - smallest firm
• Plant 2 has the 2nd fewest machines (the 2nd lowest level of capital)
• Plant 3 has the 2nd most machines (the 2nd highest level of capital)
• Plant 4 has the most machines (the highest level of capital) - largest firm

• In the short run, everybody (either big or small firm) is trying to produce a low level of output
for which they only require a low level of variable cost (low level of labor) => Everyone has
the same level of output, same low variable cost (workers) for the short run, then the only
difference between these plants comes from the Fixed Cost (depends on the size of the firms,
how many machines that firms have) => As everyone is trying to reach a small level of
output (for short run), those with less machines and small business space (small firm) will
benefit!!
• Imagine the big firm will have to pay a BIG fixed cost even though they are only
producing a small level of output (short run). These big firms can only benefit when they
producing in a long run because as production increase, their fixed cost will decrease.
➡ Based on the above explanation, Plant 1 has the lowest fixed costs in the short run, and is
thus able to produce smaller quantities of output at LOWER COST than the other plants in
the short run (everybody has the same low variable cost but plant 1 has the advantage because
besides having a low variable cost like other plants, they also have LOW Fixed Cost or Cost
Advantage - less machines, smaller building). Vice versa, plant 4 has the highest fixed cost (so
many machines and big renting space for a small production = worst off).
• However, as they increase production in the long run, and Plant 1 tries to increase its output, its
limited machinery will cause average costs to rise very quickly. In this case, Plant 4 has the
advantage of bigger space and more machines to run for large level of output = cost effective.

 => For 7 unit (the first vertical line), note that plant 1 (blue curve) has the lowest intersect point
(at 8.5) and plant 2 (at 9) - only looking straight up from the vertical line, whereas the intersect
point for plant 3 and 4 is at a very high level (not even present in the graph, has to extend the
vertical line up more) => Plant 1 has the most cost advantage for small level of output.
=> For 14 unit (2nd vertical line), plant 2 which has the second lowest amount of capital now has
the cost advantage. Looking straight up at the vertical line, plant 3 now has the 2nd advantage
lowest, plant 1 with the 3rd lowest and plant 4 has the highest cost.
=> For 21 unit, plant 3 now has the lowest cost advantage, follow up is plant 4 - 2 - 1.
=> For 27 units, plant 4 has the lowest cost advantage, follow up is plant 3 - 2 - 1.

 Long Run Average (Total) Cost:

• The LRAC represents THE LOWEST UNIT COST at which any specific output can be
produced in the long run. This curve tells the firm what plant and quantity of labor to use
to produce each output such that average costs are MINIMIZED.

=> Plant 1 has the cost advantage from the beginning of production up until the 10th unit. Then it
switches to plant 2 (from 10 - 18) and plant 3 (from 18 - 24) then plant 4 (from 24 - end).
=> The bold blue curve is the Long Run Average Cost Curve.

Economies of Scale: how we categories the cost trend in the Long Run.

• Economies of Scale (LRAC declines): Average total costs fall as output initially increases
(happens at the initial level of output - look at the above graph, it is the stage where the bold
blue curve has a downward slope).
• Constant Returns to Scale (LRAC constants): Average total costs remain relatively constant
as output continues to increase (look as the below graph).
• Diseconomies of Scale (LRAC rises): Average total costs increase as output increases to even
greater levels (happens once you hit high enough levels of output, the ATC starts to rise back
up again - look at the above graph, it is the stage where the bold blue curve has a upward
slope).

• Minimum Efficient Scale: The smallest level of output for which the firm has the LOWEST
LRAC. This is the START of constant returns to scale.
• When Minimum Efficient Scale is small relative to market demand, the market has room for
many firms and so the market will be fairly competitive!
• => For example, the market demands for 100 unit and you hit the minimum efficient scale at 5
units, then the market will have rooms for a lot of firms to join => Competitive.

 CHAPTER 12: PERFECT COMPETITION

Review: Perfect Competition:

A perfectly competitive market has the following characteristics:

1. Many sellers (many firms)
2. These firms sell homogenous products (identical)
3. No barriers to market entry or exit
4. Complete information about prices (everyone knows information about the prices) = No
market power for the firms

As a result of these characteristics, all firms in a perfectly competitive market are Price
Takers. This means that no individual firm can influence the market price, nor does any
individual firm have market power.

Review: Economic Profit:

• Firm’s Goal: Maximize Economic Profit

• Economic Profit = Total Revenue - Total Costs
• Total revenue (raw profit) = Price x Quantity
• Under the economic profit definition, total costs include both explicit and implicit costs of
production, where implicit costs are the opportunity cost of production.

Total Revenue Curve:

=> This graphical

representation of a firm’s total
revenue is an upward sloping
straight line (constant slope).
The slope of which is equal to
the Market Price (as the
quantity rises from 8-9, the TR
rises from 200-225 and the
distance is equal to 25 = price)
=> It is climbing by the price
- constant price - constant
slope!

 The Profit Maximizing Q*:

• One way to visualize the firm’s goal of profit MAXIMIZATION is to overlay the firm’s
total revenue and total cost curves.
• The profit-maximizing quantity (Q*) will be where the GAP between Total Revenue and
Total Cost is as LARGE as possible.

*Note:
Total Cost = Blue line
Total Revenue = Pink line
Depiction #1:

• From 0 - 4 unit, the TC exceeds (means lay

above) TR => Economic Loss = Firm lose
money (for example: the TC to make 5
sweaters is $100 when the TR earned from it
is only $50 = Firm lost $50)
• From 4 - 12, the TR exceeds (lay above) the
TC => Great region. The profit maximizing
quantity will be at 9 where the TR = 225
and TC = 183 which will produce the
highest profit at (225-183 = 42). Compare to
other quantity, for example, at 6, the TR =
170 and TC = 160, the profit is only
170-160= 10 => Way less that at quantity =
9 where the gap is the LARGEST!

***NOTE: DO NOT look for the place where Total Revenue is the highest but look for the
BIGGEST GAP!!!

Depiction #2:
•Also, one can visualize profit maximization
by graphing the profit function directly
and looking for the quantity at which the
profit curves reaches its MAXIMUM
value.
•The pink region is shown to be under 0, a
negative regions => where we lose their
money => We want to be in a positive
region (blue)!
•Just like other graph, the profit-maximizing
quantity is Q* = 9, at the peak position,
which correspond to a profit of $42.

 • Another way to find the profit-maximizing quantity is through marginal analysis. This method
compares Marginal Revenue with Marginal Cost!

ΔTotalCost (TC )
• If the Marginal Cost = the slope of Total Cost curve = ΔOut put (Q)
)

• The Marginal Revenue = change in the Total Revenue that results from selling One more unit
of output. In perfect competition settings, MR is always equal to the Price.

ΔTotal Re venu e(T R)

• Marginal Revenue = = Price
ΔOut put (Q)
(CONSTANT)
• (If I sell another unit, I get another $25 bucks for example,
that will be added to the TR)
• => From 8-9 sweater, my MR = (225-200)/1 = 25. From
9-10 sweater, my MR = (250-225)/1 = 25.
=> Always constant and always equal to the PRICE!

Marginal Analysis (overlaying 2 marginal curves: revenue and cost):

•The Marginal Cost is represented as the Nike

Swoosh where the Marginal Revenue is just a
straight line (constant).
•The profit-maximizing Q* is where MR =
MC (in this case is at 9).
•If MR>MC, then economic profit can be
increased by producing another unit of
output.
•If MR<MC, then economic profit increased
by NOT producing that unit of output.
=> If I go a little bit to the left, I would lose
money by not producing enough and
efficiently. If I go a little bit to the right, I
would also lose money because cost >
revenue => the BEST at the point of equality
is where MC = MR!
***NOTE: Every point where MC < MR (under the MR line) is attainable and still a good
point to produce because the cost < revenue. But we should continue (not stopping) doing
those “under MR line” point until we get to the point where MC = MR (point of
MAXIMIZATION).

Firms as Price Takers (take it from the Market):

=> The market determines the price (firms have no power in the perfect competition) so the
market will look for its equilibrium (where supply and demand intersect). After that, the market
will hand the equilibrium price to the firm and the firms now have to work with that price when
they are doing the analysis!

 Short-Run Profit Analysis:

***NOTE: Profit here is referred to the Economic Profit NOT Accountant Profit!

Four Profit Scenarios (in order from the most positive production to a disaster of business):

*The only changing in these scenario is the PRICE (which is determined and given by the
market to the firm), the cost will remained unchanged in these scenario!

A. Economic Profit (positive profit) - MR (q) (price) > ATC (q)

=> Market hands out to the firm $25, which will also be the MR.

1. The first thing we should do is finding the Profit Maximization Point (Q*) where MR =
MC which is at 9.
2. Next, find the elements for the profit analysis (Profit = TR - TC, we need to find TR and
TC)
TR = Price * Quantity = 25 * 9 = 225
Because ATC = TC/Q => TC = ATC * Q = (note that we can find the ATC on the graph by lining
the intersection of Q* and ATC to get the price of the ATC) = 20.33 * 9 = 182.97
3. Calculate Profit and do the analysis. Compare if the TR is < or > TC to conclude the status
of the economy.
Profit = = TR - TC = 225 - 182.97 = 42.03 (the striped orange region on the above graph) =>
Positive number => Positive Economic Profit.

 B. Break-Even Point - MR (q) = ATC (q) => Economic Profit = 0 = Normal Profit (TR
= TC)

=> Market hands out $20 to the firm.

**This situation is when (Economic) Profit = 0 and TR = TC => 0 Profit point = Break
Even!

Analysis Note:
• MC always intercept ATC at its minimum point of ATC!
• For this case, we have a triple intersection between MC - ATC - MR at the minimum
point (the VERY BOTTOM of the ATC curve) of ATC!

1. Finding the maximizing Profit Maximization Point (Q*) where MR = MC which is at 8.

2. Next, find the elements for the profit analysis (Profit = TR - TC, we need to find TR and
TC)
TR = Price (or MR) * Quantity = 20 * 8 = 160
Because ATC = TC/Q => TC = ATC * Q = (note that we can find the ATC on the graph by lining
the intersection of Q* and ATC to get the price of the ATC) = 20 * 9 = 169
3. Calculate Profit and do the analysis. Compare if the TR is < or > TC to conclude the status
of the economy.
Profit = = TR - TC = 160 - 160 = 0 => Break even profit => Revenue is just enough to cover
the total cost of production!

***NOTE: In perfect competition, a firm maximizes its economic profit if it produces the output
at which price equals marginal cost.

 C. Economic Loss (Negative Profit) - AVC (q) < MR (q) < ATC (q) - BUT SHOULD
CONTINUE DOING BUSINESS.

=> Market hands out $18 to the firm.

This is the situation where the firm is actually losing money but it is in their BEST interest
to continue doing the business.

1. Finding the maximizing Profit Maximization Point (Q*) where MR = MC which is at 7.5.
2. Next, find the elements for the profit analysis (Profit = TR - TC, we need to find TR and
TC)
TR = Price (or MR) * Quantity = 18 * 7.5 = 135
Because ATC = TC/Q => TC = ATC * Q = (note that we can find the ATC on the graph by lining
the intersection of Q* and ATC to get the price of the ATC) = 20.5 * 7.5 = 153.75
3. Calculate Profit and do the analysis. Compare if the TR is < or > TC to conclude the status
of the economy.
Profit = = TR - TC (striped area) = 135 - 153.75 = -18.75 => We are losing 18.75 a day!

 ***NOTE:
•VC (intersection between Q & AVC) =
Brown rectangle
•FC (space between VC and TC) = green
+ yellow rectangle
• TC (the whole rectangle) = VC + FC
=> The Total Revenue (price *q) = The
whole area under the Price Line (= Brown
+ Yellow area) for which the firm only
loses the little green area at the top = Loss
Minimizing Output (this is the case when
they have enough revenue to cover all of
their variable cost and a portion of their
fixed cost).

• Even though the firm experiences economic loss ( negative economic profit), it is still best to
stay open and produce 7.5 sweaters. This allows them to MINIMIZE losses (Goal change
from Profit Maximization to Minimize Loss).
• Because even if they shutdown and produce zero sweaters (produce nothing), they still
have to pay the Fixed Cost (ic, fixed rent, machine cost = Sunk Cost) while the variable
cost is 0 (shut down = no labor = no variable cost)
• => It is best to stay open and produce if the firms has enough revenue to cover all of their
variable costs, and still has some money left over to cover a portion of their fixed costs,
then it is best to stay open and produce (The firm only lose the REMAINING PORTION
of the fixed cost instead of ALL of them)
• At prices ABOVE the minimum average variable cost, but BELOW average total cost
minimum the firm will produce the loss-minimizing output (the little green rectangle).
While this means that the firm will incur a loss that will be LESS than their total fixed
cost!
• Economic Loss = TFC + (AVC-P) * Q = TFC + TVC - TR

 D. Shutdown Point MR (q) ≦ AVC (q)

a. Price is Equal the Minimum Point of AVC:

=> Market hands out $17 to the firm.

Analysis Note:
• Triple intersection between MR - AVC - MC!

1. Finding the maximizing Profit Maximization Point (Q*) where MR = MC which is at 7.

2. Next, find the elements for the profit analysis (Profit = TR - TC, we need to find TR and
TC)
TR = Price (or MR) * Quantity = 17 * 7 = 119
Because ATC = TC/Q => TC = ATC * Q = (note that we can find the ATC on the graph by lining
the intersection of Q* and ATC to get the price of the ATC) = 20.14 * 7 = 140.98
3. Calculate Profit and do the analysis. Compare if the TR is < or > TC to conclude the status
of the economy.
Profit = = TR - TC (striped area) = 119 - 140.98 = -21.98 => We are losing 21.98 a day!
=> Note that the space between ATC and AVC = AFC {Area = (20.14-17*7 = 21.98, exactly
equal to the negative profit of the firm}. At this point, if they shut down, they will lose their fixed
cost; if they stay open, their negative profit is also happened to be the fixed cost (Same Loss
Side) => The firm lost $21.98 in either way! => The firm is indifferent between shutting

 down, and producing where MR= MC => Can choose either shut down or continue
business!

b. Price is Below the Minimum Point of AVC:

=> Market hands down $15 to the firm

1. Finding the maximizing Profit Maximization Point (Q*) where MR = MC which is at 5.

2. Next, find the elements for the profit analysis (Profit = TR - TC, we need to find TR and
TC)
TR = Price (or MR) * Quantity = 15 * 5 = 75
Because ATC = TC/Q => TC = ATC * Q = (note that we can find the ATC on the graph by lining
the intersection of Q* and ATC to get the price of the ATC) = 21 * 5 = 105
3. Calculate Profit and do the analysis. Compare if the TR is < or > TC to conclude the status
of the economy.
Profit = = TR - TC (striped area) = 75 - 105 = -30 => We are losing 30 a day!
=>The negative profit is not even covering the variable cost (look at the graph and the area
it is covered). It means the firm’s profit is not even enough to pay their workers => SHUT
DOWN is the ONLY option!

CONCLUSION:

Price Above ATC:

• Making profit.

Price equals ATC:

• Break Even Point.

Price below ATC but above AVC:

• Face an economic loss but it is in their best interest to keep doing business (in order to cover
a portion of the fixed cost instead of paying the full amount).

Price equals the Minimum Point of AVC:

• If the price exactly EQUALS the minimum AVC, then the firm incurs the same loss whether
they produce or not – a loss exactly equal to the total fixed costs. Thus, the firm is indifferent
between shutting down, and producing where MR= MC.

Price Below the Minimum Point of AVC:

• If the price is BELOW the minimum AVC, then the firm will DEFINITELY SHUT DOWN
since they will not even have enough revenue to cover all of their variable costs (let alone a
portion of their fixed costs).

 The Firm’s Short-Run Supply Curve:

=>As the market hands down different prices (=MR), the firm has to redo their analysis all over
for which everything starts with MR=MC.
Note that for this particular situation where Q=7 (price is at the AVC), the firm can either
choose to continue their business or shutting it down => The reason for the gap in the
second graph!

If we were to scale this up to the marker (situation with large numbers of firms involved), there is
going to be a line that fills in the gap as shown below:

• Suppose there are 1,000 firms in this

market that are identical to the firm we
have been working with up to this point.
• The market supply curve is derived
from the 1,000 individual supply curves,
such that the quantity supplied by the
market at any given price is equal to the
sum of the quantities supplied by all
1,000 firms.
• At the shutdown price of $17, some
firms will decide to produce 0 while
others will decide to produce 7.

 Long-Run Entry and Exit:

***NOTE: Recall that we only have 1 single cost curve in the long run (no fixed cost).

Short-Run vs. Long-Run:

• In the short-run we have seen a variety of potential profit outcomes (positive profit, break-even
profit and loss). Firms can earn positive economic profit, zero economic profit or suffer a loss.
• Note that even under extreme profit loss, the best a firm can do to minimize their losses is
shutdown in the short-run.
• Exiting the industry is not an option because the plant size is fixed in the short run. In
other words, the firm cannot sell off the building and machinery and truly exit the
market (capital adjustment) => The number of firms in the given industry is fixed. This
means no new firms can enter the market, and no existing firms can exit the market.
• However, in the long-run, all factor inputs are adjustable, and so the number of firms in
the market can adjust. Firms can enter and exit a market at will.

Long-Run Equilibrium:
• Note: Though in long-run, firms can either enter or exit at its will. However, for a market to
be in equilibrium, no firms can be entering or exiting said market. Thus, long-run
equilibrium requires the elimination of any and all incentive for firm entry or exit.
• Incentive for Entry: If there is positive economic profit in a market, then new firms will want
to enter that market.
• Incentive for Exit: If there is economic loss in a market, then existing firms will want to exit
that market.
➡ In order to keep the Long-run Equilibrium, it requires firms to be earning zero
economic profit. This occurs at the BREAK EVEN POINT (price is at the minimum of
the ATC)!! (Go back to review the previous lesson)

Entry and LR Equilibrium:

=> Based on the original price MR0 that the market hands over to the firm on the second graph,
it shows that the firms are earning positive profits (MR above ATC) (This also correspond to the
original supply curve S0 on the first graph). This creates the incentive for other firms to join the
industry (which is bad for the LR equilibrium) => Supply curve shift to the right S1 and intersect
the demand at a different price (first graph). This new equilibrium at the market graph means that
there will be a new market price created and handed over to the firm => Create MR1 =>
Reevaluate everything! This new MR1 eventually results in the Break Even point where the
price equals ATC.

Analyze the graphs:

Short-run economic profit incentivizes entry into the market in the long-run.
1. Supply shift out to the RIGHT as new firms enter
2. This causes the market price to FALL (more firms to supply, more elastic)
3. The firm reacts to this new, lower price by adjusting production => the new MR line means a
new MR=MC point.

LR Firm Outcomes:
• Each individual firm supplies a SMALLER quantity to the market: (q1* < q0*)
• Firms now make zero economic profit (Break-Even point)

LR Market Outcomes:
• More firms are supplying product to the market
• Equilibrium market price is LOWER

 • Equilibrium market quantity is HIGHER (even though individually, each firm is providing less
(from Q0 - Q1), but because MORE firms are now joining the market, the total market quantity
is higher).

***NOTE: In real life, the shift to the Break-Even point is not all the sudden but rather,
gradually (incrementally).

Exit and LR Equilibrium:

=> The original price from the equilibrium point of S0 and demand that the market hands over
the firm shows that the firm is making negative profit at Q0 (price is under the ATC) =>
Incentivize the firms to leave the market => Supply shifts to the left as the result => Create a new
market equilibrium and price got pushed up => Hand over to the firms and now they have to
adjust their analysis with new intersection point of MC and MR => New MR1 with new Q1
(higher quantity) at the Break Even point.

Analyze the graphs:

Short-run economic loss incentivizes exit from the market in the long-run.
1. Supply shift in to the LEFT as existing firms exit
2. This causes the market price to RISE (less firms to supply)
3. The firm reacts to this new, higher price by adjusting production○the new MR line means a
new MR=MC point

 LR Firm Outcomes:
• Each individual firm supplies a GREATER quantity to the market: (q1* > q0*)
• Firms now make zero economic profit (Break Even point)

LR Market Outcomes:
• FEWER firms are supplying product to the market
• Equilibrium market price is HIGHER
• Equilibrium market quantity is LOWER (even though individually, each firm is providing
more (from Q0 - Q1), but because LESS firms are now joining the market, the total market
quantity is less).

The Firm’s Minimum Average Cost Point (the point where MC-MR-ATC meet and
create a Break-Even point):
1. The firm will, ultimately, end up producing at the quantity associated with this minimum
average cost point.
2. The long-run market equilibrium price will be the price associated with the minimum
Average Cost point.
3. If you already know the market equilibrium quantity, then you can solve for the equilibrium
number of firms.

Visualization for the above summary:

1. EACH firm will ultimately end up
supply 50 units in the long run equilibrium.
2. Know the market price (demand/supply)
correspond to the equilibrium price of the
Break Even point.
3. As EACH firm supply 50 units
(quantity) in the long run, and we know the
market demand is 600 => The number of
firms must be in the market will be
calculated by 600/50 = 12 (firms)

Scenario Summary:
• Market Equilibrium Quantity: 600 units demanded
• Individual Firm’s minimum ATC quantity: 50 units
• There must be 600/50 = 12 firms will supply product to this market in long-run equilibrium.

Changes in Demand and Supply:

A. Decrease in Demand: An initial drop in demand will later spur a DECREASE in supply
(Demand shift LEFT, Supply shift LEFT).

=> Assume the market is initially in LR equilibrium (first intersection). If demand then
decreases, the market price will fall. This drop in price means the firm has to find the new
MR=MC point (at Q1 - the second intersection). At this new point firms are experiencing an
economic loss. Thus, EXIT will occur in the long run (firms lose money and want to leave the
market). As firms leave the market, the supply curve shifts to the LEFT. This pushes the price
back up, less firms = higher price for the market (this is where S1 meet D1 at P0 again), the
market price will continue to rise until firm’s return to earning 0 economic profit (the market is
in long run equilibrium once again).
***Even though the market is back to the same price as they return to the LR equilibrium,
the market quantity (Total of all firm quantity = Q1* on the left graph) is now LOWER
because many firms had left earlier during an economic loss (S1 curve has FEWER firms
than S0), the market quantity Q1* < Q0*, but each firm’s quantity (q1* joins q0* later on
the right graph) is unchanged!

Original vs. New LR Equilibrium:

• The market PRICE is the SAME (S1 meets D1 and MR=MC)
• Market QUANTITY (total of all firms quantity) is LOWER (the one on the left graph above)
• FEWER firms supply produce to this market (some had left during an economic loss).
• EACH firm’s individual quantity produced is UNCHANGED (each firm produce the same
quantity as the beginning, but a few of them left during economic loss so the total quantity in
the market is less).

 B. Increase in Demand: An initial rise in demand will later spur an INCREASE in supply
(Demand shift RIGHT, Supply shift RIGHT).

=> Assume the market is initially in LR equilibrium. If demand then increases, the market price
will rise. This rise in price means the firm has to find the new MR = MC point. At this new point
firms are experiencing an economic profit. Thus, ENTRY will occur in a long run (profit =
more firms enter the market). As firms enter the market, the supply curve shifts to the RIGHT.
This push the price back down, more firms = cheaper price for the market (this is where S1
meet D1 at P0 again), and the market price will continue to FALL until firms return to earning
0 economic profit (this market is in the long run equilibrium once again).
***Even though the market is back to the same price as they return to the LR equilibrium,
the market quantity (Total of all firm quantity = Q1* on the left graph) is now HIGHER
because many firms had joined during an economic loss (S1 curve has MORE firms than
S0), the market quantity Q1* > Q0*, even though each firm’s quantity (q1* joins q0* later
on the right graph) is unchanged!

Original vs. new LR Equilibrium:

• The market price is the SAME (S1 meets D1 and MR=MC)
• Market quantity (total of all firms quantity) is HIGHER.
• There are MORE firms supply produce to this market (some had joined during an economic
profit).
• Each firm’s individual quantity produced is UNCHANGED (each firm produce the same
quantity as the beginning, but a few of them joined during economic profit so the total quantity
in the market is more).

 CHAPTER 13: MONOPOLY

Recall:
• Definition: A single firm that produces a good or service with no close substitutes and
operates in an industry with substantial barriers to entry. In other words, there is ONLY
ONE FIRM in the market.
• Because there are no close substitutes (1) and barriers to entry (2) that prevent other firms
from entering the market as producers, the monopoly firm has significant market power. In
fact, they sets it own price based on their output decision (Monopoly firm is a PRICE-
SETTER).

Source of Monopoly Power:

• If consumers are not able to easily substitute other products for the good that the monopoly
firm is producing => then this gives the firm market power.
• Market power: firm’s ability to set prices for the goods and services it produces for a market.
• If the market has significant barriers to entry => then potential competing firms are unable to
enter the market further contributing to the monopoly’s market power (harder for other firms to
join).
• No substitute for the products because of the significant barriers to entry => Big market
power for the existing firm!

Some barriers in the Monopoly Power:

1. Natural Barriers: create natural monopolies:

• Economies of Scale (revisit the LRAC graph,
Economy of Scale is the downward sloping part = means
LRAC is decreasing as we increase Output) - see
attached photo on the right => This will allow the firm
to undercut their competition profitably as they
increase/ produce a LARGE number of output with
the LOWEST cost (allow you to be the SOLE
PROVIDER that no one else can outprice you!)
• Large sunk cost: expenditures that already been made
and cannot be recovered. Could be understood as a huge
start-up cost/ initial investments at the beginning => not
everyone can afford to start this line of business that
recovers at a very slow rate.
• Location
Example: Electric, water, sewage, gas companies are local, natural monopolies

 2. Ownership Barriers: Exclusive ownership of essential or strategic inputs (firms exclusively

OWN some inputs that are needed for the production).
Example: DeBeers diamond, Aluminum Company of America (ALCOA), International Nickel
Company of Canada.

3. Legal Barriers: arise when market entry is restricted by (with the law):
• Granting a public franchise (The government granted USPS an exclusive legal right to
carry first-class mail)
• Government license
• Patent (most seen in pharmaceutical companies, if you invent a recipe for a certain drug,
then you could be the sole producer for that recipe for a period of time)
• Copyright (similar to patents but for creative stuff)

Additional Examples:
Monopolies in Sports:
• Major League Baseball (MLB) was declared a legal monopoly by the Supreme Court in 1922
(granted an antitrust exemption).
• Exclusive rights over the city in which the MLB team plays (no other professional team may
establish itself, or relocate within this area.)

Las Vegas and Gambling:

• From 1931 until 1976, the only legal place people could gamble in the U.S. was Nevada (Las
Vegas)
• 1976 New Jersey becomes the 2nd state to legalize casino gambling (Atlantic City)
• 1988 The Indian Gaming Regulatory Act was passed.

 Price-Setting Strategies:
• In a monopoly setting, because the single firm is the only supplier, the quantity the firm
chooses to produce determines the market quantity and price (FIRMS pick the quantity and
the market quantity/price is determined upon that decision - whatever quantity they
choose, there will be a corresponding price that gets charge based off the MARKET
DEMAND).
=> It is NOT that the firms pick both quantity and determine the price they desire!
• Clarifying Note: Monopoly firm cannot set both quantity and price at whatever levels it
desires. As we will see later, the monopoly firm is still constrained by market demand!

Two pricing strategies:

• Single Price: charge all consumers the same price
• Price Discrimination: charging different consumer groups different prices for the same
product (Example: people may experience paying different price for an airplane ticket).
• A firm practices price discrimination when it sells different units of a good or service for
different prices (Example: IMAX charges $6 per movie ticket for children younger than
8, and $8.50 per movie ticket for adults/ Pizza producers offer a second pizza for a lower
price than the first one.)

Single-Price Monopoly:
• A single price monopoly is a firm that must sell each unit of its output the same price to all its
customers.
• The monopoly firm faces a downward-sloping demand curve. As such, if the firm wants to
sell another unit of output, it can do so by lowering the price (Law of Demand is at play):

•=> Firms start by selling 2 units of output,

according to the market demand, firms are
allowed to charge $16 (Point C).
•If they want to sell the 3rd unit, they can
utilize the law of demand and accept to
charge $14 instead. Because this is a Single
Price Monopoly, this increase in output
means unit 1,2,3 are now all get sold at
$14.
•Summary: To increase the quantity sold
from 2-3 units, the firm needs to drop the
price from $16-$14.

Marginal Revenue:
• It is the additional revenue from selling an additional unit.
• MR is the change in total revenue resulting from a one-unit increase in the quantity sold
ΔT R
• => MR =
ΔQ

•From point C - D, MR = (42-32)/1 = 10

•From D-E, MR = (48-42)/1 = 6

For a single-price monopoly firm:

• MR < Price (MR will ALWAYS LESS than the price - common sense: our profit could never
be more than the price we are selling)
• MR curve will look different than a straight line than we saw in perfect competition!
• If the demand curve is LINEAR (straight line), then the MR curve will be TWICE as STEEP
as the demand curve (bisection rule).

Why is Marginal Revenue Below the Price?

• Because this is a single-price monopoly! They face the downward sloping demand curve, if
they want to sell another unit of output, they need to lower the price! => We are going to have
2 opposing forces acting on total revenue.
• Total Revenue is price x quantity (lower P to raise Q => opposing):
✦ 1.The lower price decreases total revenue
✦ 2.The higher quantity sold increases total revenue
➡ 1.At the original price of $16, the firm sold 2 units. Now, those 2 units are sold for $14
(because of the additional 3rd, firm accept to lower the price), so the firm lose 2 x ($16 -
$14) = $4 => Lost $4 for agreeing to lower the price from $16-$14.
➡ 2.But there is also a $14 boost to revenue since an additional unit is sold (i.e. a 3rd unit is
now sold for $14)

 => There is a net gain of $10 (-4+14=10) = the MR. This net gain is the MR associated with
the sale of this additional unit of output.

•=> 2 units for $16/each now changes to 3 units for $14/

each.
•The net gain in MR is visually apparent in that the
“gain” (blue) rectangle is clearly much larger than the
“loss” (red) rectangle.
•=> Positive net gain!

=> The MR from 2-3 unit is 10, which is why it is plotted in between the 2-3 unit in the graph.
• The linear equation is y = mx+b for which Price = 20 - 2Q (20 is the y-intersect, demand
curve is going down so it is a negative slope which rise/run = (20-16)/2 = 2)
• Same thing for the MR curve, MR = 20 - 4Q (20 is the y-intersect, demand curve is going
down so it is a negative slope which rise/run = (10/2.5)/2 = 4)
• ***NOTE: Notice that MR curve lays BELOW the demand curve (because MR is always
BELOW the price). The blue line is what is determined by the price and quantity demanded.
=> Marginal Revenue curve is TWICE as STEEP as Demand curve => Marginal Revenue
will bisect any horizontal line drawn between the price axis and the demand curve.

 Bisection Rule:
• Set both MR and Price equal = 0 => we will get the number of Quantity it intersects at x-axis
(MR = 20 - 4Q = 0 => Q = 5/ Price = 20 - 2Q = 0 => Q = 10)
• Bisection means the horizontal line that contains the haft point (MR = 5= Price /2) of the MR
to the Demand.

Marginal Revenue and Elasticity:

Recall: Elasticity changes along a linear

demand curve. It measures how sensitive the
consumer’s quantity demanded is to changes
in price.

• Elastic Demand (0 < ⎮ED⎮1): QD is VERY sensitive to ΔP

A 1% decrease in price results in a more than 1% increase in quantity demanded.

• Inelastic Demand (1 < ⎮ED⎮∞): QD is NOT very sensitive to ΔP

A 1% decrease in price results in a less than 1% increase in quantity demanded.

• Unit Elastic (⎮ED⎮= 1): Not a range like the other 2 but a single point (Midpoint = where
the Total Revenue is maximized)
A 1% decrease in price results in a 1% (exactly) increase in quantity demanded.

 The Total Revenue Rule:

• Elastic Demand: If you decrease your price, then
your total revenue will rise (because customers are
sensitive to the price change, decrease in price will
make them buy more = more total revenue for
you).

• Inelastic Demand: If you decrease your price,

then your total revenue will fall (because
customers are not sensitive to the price change,
therefore, cutting the price will not incentivize
them to buy more. They may buy a little but not
enough to bring the total revenue up => less total
revenue for you).

=> As the price decreases, total revenue initially rises, peaks and then falls (This is based on
different part of elasticity on the demand curve. Price drop will make the elastic part increase in
total revenue but decrease in total revenue for the inelastic part. The peak is the Unit Elastic).

ΔT R
MR also describes how TR changes as quantity changes (MR = = the slope of TR)
ΔQ

• Elastic Portion of Demand (MR > 0):

Marginal Revenue will be positive but
diminishing since total revenue is rising at
a decreasing rate (TR goes up but slowly
going to reach its peak and gets less, then
finally, 0 off).

• Unit Elastic Point (MR = 0)

MR will equal 0 since TR does NOT
change (slope if flat = 0). This peak is
also where TR is maximized (before
going down). MR = 0

• Inelastic Portion of Demand (MR < 0):

MR will be negative and growing since
TR is falling at an increasing rate (TR goes
down a little, then fall dramatically).

=> From the graph, the below depiction

shows how the total revenue changes as an

 additional unit is added. For the blue haft, the total revenue increase at first but decrease as it gets
closer to the peak (means that the decrease in price for the elastic part will help us to earn
more total revenue, and that earning will decrease in a long run). In the opposite, total
revenue has a negative slope for the inelastic part, which will fall at an increasing rate (means
the decrease in price will result in less total revenue for you and that loss in revenue will
become bigger as the quantity goes up).

***NOTE:
• Monopoly firm will ALWAYS choose to operate on the ELASTIC portion of the demand
curve (where decrease in price will help them earn more profit).
• The firm would NEVER choose to produce an output on the inelastic portion of market
demand since that portion is associated with negative marginal revenue (Bad idea because
decrease in price will make them lose more in profit).
• If the firm DID operate on the INELASTIC portion, then it could simply charge a
HIGHER PRICE, produce a SMALLER QUANTITY (scale back production to cut back
production cost and increase MR), and this would increase the firms => Move backward
on the MR curve from the pink haft back to the blue haft to decrease the quantity
produced, which increases total revenue, decreases total cost, and increases economic
profit (Revisit the Inelasticity Rule of Demand, if the customers are inelastic, the raise in price
would increase your total revenue).

Maximizing Profit:

Recall:
• The goal of any firm (in any market setting) is to maximize profit (regardless of the market
setting types). This profit-maximizing output is always, always, always where MR = MC.

• Note that maximizing profit is NOT the same as maximizing total revenue.
Why? Think about these 2 scenarios:
• Scenario A:
If TR = $200, and TC = $199. Profit = $1.
• Scenario B:
If TR = $100, and TC = $50. Profit = $50.

• The only instance in which maximizing

profit corresponds to maximizing total
revenue is if marginal costs are zero
(Profit = TR - TC, if TC = 0 means
Profit = TR => More TR, more Profit)

 The monopoly firm’s cost curves behave just like those of a firm in perfect competition.
However, because total revenue behaves differently, the monopoly optimal Q* will be
different than the Q* of perfectly competitive firms.

*** In order to MAXIMIZING THE PROFIT, we would look for the BIGGEST GAP
between the TR and TC. But when given MR and MC, we would look for the point of
EQUALITY where MR = MC.

Monopoly Profit-Maximization Recipe:

1. Find the optimal Q* where MR=MC (QM*).

2. Determine the price the monopoly will charge by
extending a vertical line from Q* up to the
demand curve, and then to the left (PM*).
3. Use this same vertical line to find the
corresponding point on the ATC curve to
determine the average total cost per unit of output.
4. Find the total profit by taking TR - TC (where TR
= P*Q and TC = ATC*Q).

=> The profit in the graph shown is the pink striped rectangle (after deducting green area cost
from the big rectangle). This amount of profit will NOT get eaten away over time, the firms
will get to keep these profit to themselves even in Long Run (at least until the demand
changes or cost curves change)!! (Think back to the perfect competition, if there are any
positive economic profit, that will incentivize entry for firms and will continue until the market is
brought back to 0 in the Long Run Equilibrium => It will not happen here in Monopoly because
there is NO entry!).

 ***NOTE:

• Being a monopoly does NOT guarantee

profits.
• If the price the firm can charge falls
BELOW AVC, then the monopolist (just
like the perfectly competitive firm) will
minimize losses by shutting down and
loosing their fixed costs (i.e. sunk cost).

=> From the TC to the Price is the loss if we

stay open. From the TC, line down to where
we cross AVC is the shutdown losses => Shut
down loss is LESS than the Loss if we stay
open (for Short run) => If these losses
persist, then the monopoly firm will exit in the
Long run.
*If we stay open, we have to pay extra for the
AVC, which will be 0 if we close.

Inefficiencies of Monopolies:

Compared to Perfectly Competitive firms, a single-price Monopoly firm:

1. Produce a SMALLER output, and charges a HIGHER price (because there are so many
sellers in PC while there is one single seller in Monopoly => Monopoly firm can charge a
higher price while produce a small amount of output, compared to many output produced by
many firms in PC).
2. Does NOT maximize total surplus (because DWL is created and subtracted out from the
Total Surplus, MB > MC = inefficient)
3. Generates deadweight loss (DWL) because QM < Qpc. There will ALWAYS be DWL that
gets generated anytime we are not at the Qpc* (because at that optimal equilibrium
quantity, social benefit = social cost = EFFICIENT!)
4. Consumer surplus SHRINKS (much SMALLER consumer surplus) because of (1) the
DWL, and (2) because part of the consumer surplus was transferred to the firm as
producer surplus = rent seeking behavior (the blue striped rectangle, which could have
been part of the CS in the PC, now merge as part of the Producer Surplus which the
Monopoly firms are able to keep for themselves = good thing for the Producer).

 There are additional social costs of monopolies beyond the creation of DWL:

Rent Seeking Behavior:

• The resources expended to protect a monopoly position in an effort to capture economic rent
(means any surplus in the market— consumer surplus, producer surplus, or economic profit).
In other words, rent seeking behavior is the firm’s attempt to capture surplus or create
economic profit = steal other firm’s producer surplus and add it to their own to protect/
create a Monopoly position (i.e. lobbying to the government, extending patents, copyrights–
efforts to strengthen or create barriers to market entry).
• The resources expended in rent seeking behavior could have instead been used to expand
production, or in some other more socially optimal manner.

Price Discriminating Monopoly:

Price Discrimination: Charging different consumers different prices for the SAME product.
Price discrimination increases a monopoly's economic profit by capturing Consumer
Surplus. (Example: Movie theater tickets, Airline tickets, College tuition (people not paying the
same price).

Conditions for Price Discrimination:

• The firm has price-setting abilities (sort of monopoly/oligopoly power to set the price).
• Consumers have different willingness to pay (different elasticities of demand from the
consumers).
• The firm can successfully identify and separate consumers by their different willingness to pay.
• The firm can prevent resale (people who pay low price can resell for a profitable amount =>
firm needs to prevent or limit that).

=> Not ALL price differences are price discrimination. Some price difference reflects a
difference in costs of production. For example, an e-book versus a hard-cover physical book
will have different prices despite being the same book.

Types of Price Discrimination:

First-degree Price Discrimination (Perfect Price Discrimination):

• Charge each consumer their individual maximum price each is willing to pay.
• Examples: auctions/bid (eBay), car saleman at most dealerships, any market setting in which
the buyer and seller haggle/bargain over the price.

Second-degree Price Discrimination:

• Charge different prices based on the quantity purchased.
• Examples: “buy one, get one half-off”, single unit is priced higher compared to bulk purchase.

 Third-degree Price Discrimination (Group Price Discrimination):

• Charge different consumer groups different prices based on their varying elasticities of
demand. Firms can easily identify the elastic demand for these groups.
• Examples: Student discount, senior discount at movie theaters (show ID to prove), airline
tickets, early bird specials at restaurants, ladies night at bars and clubs.

Perfect Price Discrimination Monopoly:

• Imagine if the firm could read the mind of each

consumer to see each individual’s maximum
willingness to pay, and then charged each
individual that price.
• The firm captures ALL the surplus in this market.
Consumer Surplus equals 0 since EACH
consumer pays exactly what they are willing to
pay. The whole blue triangle area is the Producer
Surplus (keep in mind this is in the Price
Discrimination setting, each customer pay
different amount at their maximum
willingness!)
• QM* will be the LAST unit sold (because beyond
that point MC > MR = not profit for the firm) at
that corresponding Px price for that last person.
=> This is the difference between the perfect competitive market and monopoly where ALL
the consumers pay at that Px price!
***NOTE: Keep in mind that the Px price and QM* in the Perfect Price Discrimination
setting is the same as in the Perfect Competition Market. MR in this perfect discriminating
is not the same in the Single Price Monopoly => A perfect price discriminating monopoly
produces the SAME QUANTITY of output as a perfectly competitive market.
• For this perfect discrimination monopoly, the demand curve = MR because for each quantity
that the firm sells, they get different revenue from the next customer that is willing to pay at a
different price (decreasing slowly) => The next additional revenue is P1 + P2 + P(n)…
• There is no DWL since the total quantity being bought/sold in this market is the same as in
perfect competition (No DWL = Maximizing Total Surplus (with PS is maximized and CS
=0) => More efficient than single-price monopoly because it contains DWL)

 Group Price Discrimination Monopoly:

• More often, the firm will separate consumers into groups (with different demand curve)
and then charge each group a different price (Student discount, senior discount, adult tickets,
children tickets).
• In group price discrimination the firm does NOT charge each consumers their exact
willingness to pay. Thus, there will be some positive amount of Consumer Surplus in the
market for each consumer group (with the discount, there will be consumer surplus for
some consumers in the group!)
• Compared to perfect price discrimination (which firms can sell to whoever they are
profitable to sell to), FEWER units are bought and sold in this group pricing scheme (this will
create DWL - because we are not that the point where Supply equals Demand quantity - firms
cannot identity each person and put them all into a group with same willingness to pay => lose
some customers).
• Compared to a single-price monopoly (not any discriminating groups), MORE units are
bought and sold under the group pricing scheme (scenario below will explain this).

Scenario:
• Firm Marginal Cost is $30
• Single-Price monopoly charges $60
• Customer’s willingness to pay is only $50 => in the single price monopoly, this person would
have been priced out of the market, this would also damage the firm profit too!
• In this case, if the firm can offer a discounted price to this consumer (and others in this group)
the firm can actually gain more PS (compared to losing a customer and gain nothing). =>
Charge this group $40, and gain $10 of surplus for each unit sold to this second group (40-30
=10).

***NOTE:
• Firm’s preference ranking, they would prefer to be in Perfect Price Discriminating (to capture
ALL the surplus), then Group Price Discriminating and last option is the Single-Price
Monopoly (regular market with no discrimination) => Perfect Price Dis (No DWL, PS
maximized) > Group Price Dis (DWL but not as much as Single-Price) > Single Price
Monopoly (DWL) .

Pros and Cons:

• Monopolies do create some benefits that are shared among all of society.
• The outsized profit typically associated with monopoly status (economic profit that the firms
can keep in the Long Run) encourages firms to innovate, and to invest time and money into the
development of new products that will generate substantial profits over time.
• Examples: books (copyright), music, TV and movies, pharmaceuticals.

• However, aside from innovation, there are NOT many other benefits to monopolies.

• In general, monopolies produce less (except perfectly price discriminating firms), and charge
more than competitive firms. Not only do monopolies have less total surplus (due to DWL),
but the distribution of surplus leaves consumers with less consumer surplus. There is additional
social loss from rent seeking behavior.

Single Price (III) Perfect Price Dis (I) Group Price Dis (II)
DWL Yes No Yes
Twice as Steep as the MR = Demand curve
MR
Demand
Maximize total
Cannot maximize total Have some positive
surplus but firms
surplus because of DWL consumer surplus
Surplus capture all surplus
(Producer Surplus > (because of the
(NO Consumer
Consumer Surplus) discount group,…)
Surplus)
LOWER quantity of output
SAME quantity of
with HIGHER price
Output output as a perfectly
compared to the perfectly
competitive market
competitive market