Microeconomics - Slide For Students

14/09/2022
MICROECONOMICS
Tran Thi Thanh Huyen (Dr.) CHAPTER

Faculty of Economics
Banking Academy of Vietnam 1 Introduction
Mobile: 098 383 0104
Email: [email protected]
Interactive PowerPoint Slides by: Interactive PowerPoint Slides by:
V. Andreea Chiritescu V. Andreea Chiritescu
Eastern Illinois University Eastern Illinois University
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Reading materials Purpose

Lay out ten economic principles that will serve as building
Chapter 1, 2. Mankiw, N.G (2021), Principles of blocks for the rest of the text. The ten principles can be
Economics, 9th Edition, Cengage Learning. grouped into three categories: how people make decisions,
how people interact, and how the economy works as a
whole.
Familiarize students with how economists approach
economic problems.
Students will see how economists employ the scientific
method, the role of assumptions in model building, and the
application of two specific economic models.
 Students will also learn the important distinction between
two roles economists can play: as scientists when we try to
explain the economic world and as policymakers when we try
to improve it.
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Learning objectives Contents

By the end of this chapter, students should
understand:
• Ten principles of economics, about how each individual 1. Ten principles of economics
makes decision, how individuals interact with each other
and how an economy works.
• The role of an economist, as a scientist and as a policy
adviser.
• Some basic concepts: Circular-Flow Diagram,
Production Possibilities Frontier and Opportunity Cost. 2. Thinking like an economist
• The difference between microeconomics and
macroeconomics? Between positive and normative?
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Resources are scarce

• Scarcity: the limited nature of society’s
resources
– Society has limited resources and cannot
produce all the goods and services people wish
to have.
• Economics
Ten Principles of
1.1 Economics
– The study of how society manages its
scarce resources
Interactive PowerPoint Slides by:

V. Andreea Chiritescu
Eastern Illinois University
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Economists study: a. How People Make Decisions

– How people decide how much they work, Principle 1: People face trade-offs
what they buy, how much they save, and Principle 2: The cost of something is what
how they invest their savings you give up to get it
– How firms decide how much to produce
Principle 3: Rational people think at the
and how many workers to hire
margin
– How society decides how to divide its
resources between national defense, Principle 4: People respond to incentives
consumer goods, protecting the
environment, and other needs
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Principle 1: People Face Trade-Offs EXAMPLE 1A: Society faces trade-offs
To get something that we like, we have to give • The more a society spends on weapons to
up something else that we also like. protect from foreign aggressors
– The less it can spend on consumer goods
– Going to a party the night before an exam
• Less time for studying
• Pollution regulations: cleaner environment and
improved health
– In order to have more money to buy stuff
– But at the cost of reducing the well-being of
• Working longer hours, less time for leisure
the firms’ owners, workers, and customers
• More resources on the fight against the Covid-
19 Pandemic
– Less resources for economic growth
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EXAMPLE 1B: Society faces trade-offs EXAMPLE 1B: Society faces trade-offs
• Efficiency: Society gets the maximum
benefits from its scarce resources.
• Equality: Prosperity is distributed uniformly
among society’s members.
• Trade-off:
– To achieve greater equality, we could
redistribute income from wealthy to poor.
– But this reduces incentive to work and
produce, which shrinks the size of
economic “pie”.
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Equality vs. Equity Principle 2: The Cost of Something

Is What You Give Up to Get It
• Making decisions:
– Compare costs with benefits of alternatives
– Need to include opportunity costs
• Opportunity cost
– Whatever you have to give up to obtain
Equality means each Equity allocates the
individual or group of exact resources and
some item
people is given the opportunities needed for
same resources or each person with
opportunities. different circumstances
to help him/her reach an
equal outcome. 15 16
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EXAMPLE 2: Opportunity cost EXAMPLE 2: Opportunity cost
• What is the opportunity cost of going to • What is the opportunity cost of being invited
college for a year? to go to the movies?
• Tuition, books, and fees
• NOT: room and boarding/campus, food
• PLUS foregone earnings
• What is the opportunity cost of going to the
movies?
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Principle 3: Rational People Think at the Margin Principle 4: People Respond to Incentives
• Rational people • Incentive
– Do the best they can to achieve their objectives – Something that induces a person to act
given the available opportunities • People respond to incentives
– Make decisions by evaluating costs and benefits – Because the incentives change the costs and/or
of marginal changes benefits of their actions
– And rational people make decisions by
comparing the marginal costs and the marginal
benefits
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EXAMPLE 3: Incentives EXAMPLE 3: Incentives

• An increase in the price of pizzas: The government increases the gasoline tax by $1
– Consumers buy fewer pizzas. per gallon.
– Sellers produce more pizzas. • How do consumers respond?
- Carpool
- Use public transportation
- Drive smaller or more fuel-efficient cars
- Move closer to work
• How do businesses respond?
- Car manufacturers will produce more fuel-efficient
cars.
- Due to higher cost per mile, trucking companies will
hike prices
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b. How People Interact Principle 5: Trade Can Make Everyone Better Off
Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to
organize economic activity.
Principle 7: Governments can sometimes improve
market outcomes.
What would our lives be like if we had to make our own

clothing or our own food?
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Principle 5: Trade Can Make Everyone Better Off Principle 6: Markets Are Usually a Good Way to
Organize Economic Activity – 1
• People benefit from trade: • Market
– People can buy a greater variety of goods and – A group of buyers and sellers
services at lower cost. • “Organize economic activity” means
• Countries benefit from trade: determining
– Allows countries to specialize in what they do – What goods and services to produce
best – How to produce these goods and services
– Enjoy a greater variety of goods and services – How to allocate them to their final user
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Principle 6: Markets Are Usually a Good Way to Principle 7: Governments Can Sometimes
Organize Economic Activity – 3 Improve Market Outcomes – 1
• Prices: • Government: enforce property rights
– Determined by the interaction of buyers and – Enforce rules and maintain institutions that
sellers are key to a market economy
– Reflect the good’s value to buyers • People are less inclined to work, produce,
– Reflect the cost of producing the good invest, or purchase if there is a large risk of
• Adam Smith’s “invisible hand”: their property being stolen.
• We rely on government-provided police and
– In the process prices guide households and
firms to make decisions to maximize their courts to enforce our rights over the things we
produce.
benefit, it also helps to maximize society’s
economic well-being.
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Principle 7: Governments Can Sometimes Principle 7: Governments Can Sometimes

Improve Market Outcomes – 2 Improve Market Outcomes – 3
• Government: enhance economic efficiency • Government: promote equality
–In the presence of externalities – Many public policies, such as the income tax
E.g.: When the production of a good pollutes the and the welfare system, aim to achieve a more
air and creates health problems for those who live equal distribution of economic well-being.
near the factories, the market on its own may fail to
take this cost into account.
– In the presence of market power
E.g.: The owner of the only gas station in a village
(far away from other villages) will have an incentive
to restrict the output to keep the price high.
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Principle 7: Governments Can Sometimes

c. How the economy as a whole works
Improve Market Outcomes – 3
• Important here: Principle 8: A country’s standard of living depends
– To say that the government can improve market on its ability to produce goods and services.
outcomes does not mean that it always will Principle 9: Prices rise when the government prints
too much money.
Principle 10: Society faces a short-run trade-off
between inflation and unemployment.
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1.2. Thinking like an economist

• Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve the
world
Thinking like an
1.2 economist
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a. The Economist as a Scientist a. The Economist as a Scientist

• As scientists, economists employ the • Economists make assumptions.
scientific method. – Simplify the complex world and make it easier
– Observation, Theory, and More to understand.
• For example, to study the relationship between price
Observation. and quantity of rice that consumers buy, we assume
– However, for economists, conducting that other factors, including income, unchanged.
experiments is often impractical. They • Economists use models to study economic
often have to make do with whatever data issues.
the world gives them – Simplified representation of a more complicated
reality
– Two main models: The circular-flow diagram;
production possibilities frontier.
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The Circular-Flow Diagram The circular flow – 1

• Circular-flow diagram Households:
– Visual model of the economy  Own the factors of production,
– Shows how money flow through markets sell/rent them to firms for income
among households and firms  Buy and consume goods and
• Two decision makers services
Households
– Firms and households Firms
• Interacting in two markets Firms:
– Market for goods and services  Buy/hire factors of production,
use them to produce goods
– Market for factors of production (inputs)
and services
 Sell goods and services
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The circular flow – 2 The circular flow – 3

Revenue Spending
Markets for Markets for
Goods and G&S Goods &
G&S
Services sold Services bought
 Goods and services
are bought and sold.
 Sellers: firms
Firms Households
 Inputs are bought  Buyers: households
and sold.
 Sellers: households Factors of Labor, land,
 Buyers: firms Markets for production Markets for capital
Factors of Factors of
Production Wages, rent, Production Income
profit
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The PPF EXAMPLE 4: The PPF

• Production possibilities frontier (PPF) • Assume the following:
– A graph that shows various combinations of – A country produces only two goods: Cars and
outputs that the economy can possibly rice.
produce, given the available factors of – It has a fixed amount of resources (labor).
production and the available production
technology. – And it has a fixed amount and quality of
technology.
• Maximum outputs that an economy can produce
• Given: the available inputs and the available – The available resources and technology can be
production technology used to produce:
• Only rice (5,000 tons)
• Only Cars (100 Cars)
• Or a combination of rice and Cars
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EXAMPLE 4: The PPF and output combinations EXAMPLE 4: Drawing the PPF
Cars
Cars Tons of rice 100 F
Cars Tons of E
A 0 5,000 rice 80
D
B 20 4,000 A 0 5,000 60
B 20 4,000 C
C 40 3,000 40
C 40 3,000 B
D 60 2,000 20
D 60 2,000 A
E 80 1,000
E 80 1,000 0 1,000 2,000 3,000 4,000 5,000
F 100 0 Rice (tons)
F 100 0
• Efficient: the economy is getting all it can from the scarce
resources available – points on the PPF (A, B, C, D, E, F)
• Inefficient levels of production: points inside the PPF
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• Not feasible: points outside the PPF 44
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The PPF: What We Know So Far Economic growth and the PPF
• Points on the PPF (like A – F): efficient Cars • With additional resources
– Efficient: all resources are fully utilized or an improvement in
120 Economic growth technology, the economy
• Points under the PPF (like G): possible shifts the PPF
100 can produce:
– Not efficient: some resources are outward.
• more rice,
underutilized (e.g., workers unemployed, 80
• More cars,
factories idle) 50
• or any combination in
• Points above the PPF (like H) 40
between.
– Not possible 20
0 1,000 2,000 3,000 4,000 5,000 6,000

rice (tons)
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Moving Along the PPF EXAMPLE 5: The PPF and opportunity cost
Cars
• Moving along a PPF To produce the first
100 F
– Involves shifting resources from the E
1,000 tons of rice: give
production of one good to the other 80 up 20 Cars
D
• Society faces a tradeoff 60 • Opportunity cost of 1
C
40 ton of rice = _______
– Getting more of one good requires sacrificing B
some of the other. 20
A To produce the first 20
• The slope of the PPF cars: give up 1,000
0 1,000 2,000 3,000 4,000 5,000
– The opportunity cost of one good in terms of Rice (tons) tons of rice
the other is the slope of the PPF • Opportunity cost of 1
car = _______
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The Shape of the PPF Why the PPF might be bowed outward – 1
• Shape of the PPF • As the economy shifts
Beer
– Straight line: constant opportunity cost resources from beer to
• Previous example: the opportunity cost of 1 car is computers:
50 tons of rice
• The opportunity cost of
– Bowed outward: increasing opportunity cost computers increases.
• As more units of a good are produced, we need to • PPF becomes steeper
give up increasing amounts of the other good
produced.
Computers
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Why the PPF might be bowed outward – 2 Micro - and Macroeconomics

At A, opportunity cost of • At point A, most workers
• Microeconomics
Beer
computers is low. are producing beer, even – The study of how households
those who are better and firms make decisions and
A how they interact in markets
suited to producing
computers. – The study of government
interventions in each market
• At B, most workers are • Macroeconomics
At B, opportunity producing computers. – The study of economy-wide
cost of computers
B The few left in beer phenomena, including inflation,
is high. production are the best unemployment, and economic
brewers. growth
Computers – Studying the economic role of
government at macro level.
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b. The Economist as Policy Adviser SUMMARY

• Positive statements: descriptive • Individual decision making:
– Attempt to describe the world as it is • People face trade-offs among alternative goals.
– Confirm or refute by examining evidence
• The cost of any action is measured in terms of
forgone opportunities.
• “Minimum-wage laws cause unemployment.”
• Rational people make decisions by comparing
• Normative statements: prescriptive marginal costs and marginal benefits.
• People change their behavior in response to the
– Attempt to prescribe how the world should be
incentives they face.
• “The government should raise the minimum wage.”
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SUMMARY SUMMARY
• Interactions among people: • The economy as a whole:
• Trade and interdependence can be mutually • Productivity is the ultimate source of living
beneficial. standards.
• Markets are usually a good way of coordinating • Growth in the quantity of money is the ultimate
economic activity among people. source of inflation.
• Governments can potentially improve market • Society faces a short-run trade-off between
outcomes by remedying a market failure or by inflation and unemployment.
promoting greater economic equality.
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SUMMARY SUMMARY
• Economists are scientists. • A positive statement is an assertion about how the
– Make appropriate assumptions and build world is.
simplified models • A normative statement is an assertion about how
– Use the circular-flow diagram and the the world ought to be.
production possibilities frontier • As policy advisers, economists make normative
• Microeconomists study decision making by statements.
households and firms and their interactions in the • Economists sometimes offer conflicting advice.
marketplace. – Differences in scientific judgments
• Macroeconomists study the forces and trends that – Differences in values
affect the economy as a whole.
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Reading materials
Chapter 4, 5, 6. Mankiw, N.G (2020), Principles

of Economics, 9th Edition, Cengage Learning.
CHAPTER
Supply and demand

2
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Purpose Contents
Establish the model of supply and demand.
Introduce the concept of elasticity, which allows us to 1. The market forces of supply and demand
make quantitative observations about the impact of
changes in supply and demand on equilibrium prices
and quantities.
Consider two types of government policies (price 2. Elasticity
controls & taxes). Government policies sometimes
produce unintended consequences.
3. Supply, demand, and government policies
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Learning objectives
By the end of this part, students should be
able to understand:
2.1 • What factors affect buyers’ demand for goods?

• What factors affect sellers’ supply of goods?
• How do supply and demand determine the
price of a good and the quantity sold?
The market forces of • How do changes in the factors that affect
demand or supply affect the market price and
supply and demand quantity of a good?
• How do markets allocate resources?
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 63 64
license distributed with a certain product or service or otherwise on a password-proteted website or school-approved learning management system for classroom use.
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2.1. The market forces of

a. Markets and Competition
supply and demand
• Market
a. Markets and competition – A group of buyers and sellers of a
particular good or service
b. Demand – Buyers as a group
• Determine the demand for the product
c. Supply – Sellers as a group
• Determine the supply of the product
d. Supply and demand together
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a. Markets and Competition b. Demand

• Competitive market • Quantity demanded
– Many buyers and many sellers, each has a – Amount of a good that buyers are willing
negligible impact on market price and able to purchase
• Perfectly competitive market • Law of demand
– All goods are exactly the same
– Other things equal
– Price takers: so many buyers and sellers that no
one can affect the market price – When the price of a good rises, the
– At the market price, buyers can buy all they quantity demanded of the good falls
want, and sellers can sell all they want – When the price falls, the quantity
demanded rises
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Demand Schedule and Demand Curve EXAMPLE 1A: Sofia’s demand for pizzas
• Demand schedule: Sofia’s demand Price Quantity

of of pizzas
− A table that shows the relationship schedule for pizzas pizzas demanded
between the price of a good and the $0.00 16
quantity demanded
− Notice that Sofia’s 1.00 14
• Demand curve preferences obey the 2.00 12
− A graph of the relationship between the law of demand. 3.00 10
price of a good and the quantity 4.00 8
demanded 5.00 6
6.00 4
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EXAMPLE 1B: Sofia’s demand schedule & demand curve Market Demand
Price of
a pizza Price Quantity
of of pizzas • Market demand
$6.00
pizzas demanded
– Sum of all individual demands for a good
$5.00 $0.00 16
or service
$4.00 1.00 14
2.00 12 – Market demand curve: sum the individual
$3.00 A decrease
in price… 3.00 10 demand curves horizontally
$2.00 4.00 8 • To find the total quantity demanded at any
$1.00 5.00 6 price, we add the individual quantities
6.00 4
$0.00
Quantity of
0 5 10 15 pizzas
… increases the quantity of pizzas demanded.
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EXAMPLE 1C: Market vs. individual demand EXAMPLE 1D: Market demand curve for pizzas
Suppose Sofia and Diego are the only two buyers in P
Qd
the market for pizzas. (Qd = quantity demanded) $6.00 P
(Market)
$5.00 $0.00 24
Price Sofia’s Qd Diego’s Qd Market Qd A movement
$4.00 1.00 21
$0.00 16 + 8 = 24 along the
An demand curve 2.00 18
1.00 14 + 7 = 21 $3.00 increase in
price… 3.00 15
2.00 12 + 6 = 18 $2.00 4.00 12
3.00 10 + 5 = 15 $1.00 5.00 9
4.00 8 + 4 = 12
$0.00 6.00 6
5.00 6 + 3 = 9 Q
0 5 10 15 20 25
6.00 4 + 2 = 6 … decreases the quantity of pizzas demanded.
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Demand Curve Shifters – 1 Demand Curve Shifters – 2

• The demand curve shifts • Shifts in the demand curve are caused by
– When something happens to alter the quantity changes in:
demanded at any given price. – Number of buyers
– Something here includes non-price determinants
– Income
of demand
• Factors shift the D curve – Prices of related goods
– Any change that increases the quantity demanded – Tastes
at any prices shifts the demand curve to the right – Expectations
and is called an increase in demand.
– Any change that decreases the quantity
demanded at any prices shifts the demand curve
to the left and is called an decrease in demand.
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Changes in Number of Buyers EXAMPLE 1E: Demand curve shifts

P Suppose the number of
• Increase in number of buyers
$6.00 buyers increases.
– Increases the quantity demanded at each price
$5.00 • Then, at each P, Qd
– Shifts the demand curve to the right
will increase (by 5 in
• Decrease in number of buyers $4.00
this example).
– Decreases the quantity demanded at each price $3.00 • The demand curve
– Shifts the demand curve to the left $2.00 shifts to the right
$1.00
$0.00
Q
0 5 10 15 20 25 30
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Changes in Income Changes in Prices of Related Goods – 1
• Normal good, other things constant • Two goods are substitutes if

– An increase in income leads to an increase in – An increase in the price of one leads to an
demand increase in the demand for the other
– Shifts the demand curve to the right • Example: pizza and hamburgers
• Inferior good, other things constant – An increase in the price of pizza increases
– An increase in income leads to a decrease in demand for hamburgers, shifting hamburger
demand demand curve to the right
– Shifts the demand curve to the left
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Changes in Prices of Related Goods – 2 Changes in Tastes
• Two goods are complements if • Tastes

– An increase in the price of one leads to a – Anything that causes a shift in tastes toward a
decrease in the demand for the other good will increase demand for that good and
• Example: smartphones and apps shift its demand curve to the right
– If price of smartphones rises, people buy fewer – Example:
smartphones, and therefore fewer apps; App • Advertising convinces consumers that drinking 3
demand curve shifts to the left glasses of orange juice a day will help lower
cholesterol: demand for orange juice increases
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Expectations about the Future Shift vs. Movement Along the Demand Curve
• People expect an increase in income • Change in demand:
– The current demand increases – A shift in the demand curve
• People expect higher prices – Occurs when a non-price determinant of
– The current demand increases demand changes (like income or number of
buyers…)
• Example:
• Change in the quantity demanded:
– If people expect their incomes to rise (because they
got a promotion at work), their demand for meals at – A movement along a fixed demand curve
expensive restaurants may increase now – Occurs when the price changes
– If the economy sours and people worry about their
future job security, demand for new cars may fall
now
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A Movement along the Demand Curve A Shift in the Demand Curve

P P Suppose the number of
$6.00 $6.00 buyers increases.
$5.00 $5.00 • Then, at each P, Qd
A movement will increase
$4.00 along the $4.00
An demand curve • The demand curve
$3.00 increase in $3.00 shifts to the right
price…
$2.00 $2.00
$1.00 $1.00
$0.00 $0.00
Q Q
0 5 10 15 20 25 0 5 10 15 20 25 30
… decreases the quantity of pizzas demanded.
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Shift vs. Movement Along the Demand Curve c. Supply

• Quantity supplied
– Amount of a good
– Sellers are willing and able to sell
• Law of supply
– Other things equal
– When the price of a good rises, the quantity
supplied of the good rises
– When the price falls, the quantity supplied falls
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Supply Schedule and Supply Curve EXAMPLE 2A: Pizza Hut's supply of pizzas
Price Quantity
• Supply schedule: Pizza Hut's supply of of pizzas
− A table that shows the relationship between the schedule of pizzas pizzas supplied
price of a good and the quantity supplied $0.00 0
• Supply curve − Notice that Pizza Hut's 1.00 3
− A graph of the relationship between the price of 2.00 6
supply schedule obeys
a good and the quantity supplied 3.00 9
the law of supply
4.00 12
5.00 15
6.00 18
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EXAMPLE 2B: Pizza Hut's supply schedule & supply curve Market Supply vs. Individual Supply
P Price Quantity • Market supply
of of pizzas – Sum of the supplies of all sellers of a good or
$6.00
pizzas supplied
service
$5.00 $0.00 0
– Market supply curve: sum of individual supply
$4.00 1.00 3
curves horizontally
2.00 6 • To find the total quantity supplied at any price, we
$3.00
3.00 9 add the individual quantities
$2.00
4.00 12
$1.00 5.00 15
$0.00 6.00 18
Q
0 5 10 15
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EXAMPLE 2C: Market vs. individual supply EXAMPLE 2D: Market supply curve of pizzas
Suppose Pizza Hut and Pepperonis are the only P QS
P
two sellers in the pizza market. (Qs = quantity $6.00 (Market)
supplied) Q Q $5.00 $0.00 0
s s
Price Pizza Hut Pepperonis Market Qs An
1.00 5
$4.00 increase in A movement
$0.00 0 + 0 = 0 price… along the 2.00 10
$3.00
1.00 3 + 2 = 5 supply curve
3.00 15
2.00 6 + 4 = 10 $2.00 4.00 20
3.00 9 + 6 = 15 $1.00 5.00 25
4.00 12 + 8 = 20 6.00 30
$0.00
5.00 15 + 10 = 25 0 5 10 15 20 25 30 35 Q
6.00 18 + 12 = 30 … increases the quantity of pizzas supplied.
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Supply Curve Shifters – 1 Supply Curve Shifters – 2

• The supply curve shifts • Shifts in the supply curve are caused by
– When something happens to alter the quantity changes in:
supplied at any given price. – Input prices
– Something here includes non-price determinants
– Technology
of supply
• Factors shift the S curve – Number of sellers
– Any change that increases the quantity supplied – Expectations about the future
at any prices shifts the supply curve to the right – Government’s policy (taxes, subsidies)
and is called an increase in supply.
– Any change that decreases the quantity supplied
at any prices shifts the supply curve to the left and
is called an decrease in supply.
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Changes in Input Prices EXAMPLE 2E: Changes in input prices

P Suppose the price
• Examples of input prices $6.00 of oranges falls.
– Wages, prices of raw materials, rent • At each price,
$5.00
• A fall in input prices the quantity of
$4.00 orange juice
– Makes production more profitable at each output supplied will
price $3.00
increase (by 5 in
– Firms supply a larger quantity at each price $2.00 this example).
The supply curve shifts to the right $1.00 • The supply curve
– Supply is negatively related to prices of inputs shifts to the right
$0.00
0 5 10 15 20 25 30 35
Q
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Changes in Technology Changes in Number of Sellers

• Technology • An increase in the number of sellers
– Determines how much inputs are required to – Increases the quantity supplied at each price
produce a unit of output  Shifts the supply curve to the right
• A cost-saving technological improvement • A decrease in the number of sellers
– Has the same effect as a fall in input prices – Decreases the quantity supplied at each price
Shifts the supply curve to the right Shifts the supply curve to the left
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Expectations about Future Shift vs. Movement Along the Supply Curve
• Example: Events in the Middle East lead to • Change in supply:
expectations of higher oil prices – A shift in the supply curve
– Owners of Texas oil fields reduce supply now, – Occurs when a non-price determinant of supply
save some inventory to sell later at the higher changes (like technology or costs)
price • Change in the quantity supplied:
The supply curve shifts left
– A movement along a fixed supply curve
• Sellers may adjust supply* when their – Occurs when the price changes
expectations of future prices change
(*If good not perishable)
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Summary: variables that influence sellers d. Supply and demand together – 1

Equilibrium:
P
Price has reached D
$6.00
S
the level where
quantity supplied $5.00
equals quantity $4.00
demanded; where
supply and $3.00
demand curves $2.00
intersect $1.00
$0.00
Q
0 5 10 15 20 25 30 35
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d. Supply and demand together – 2 Markets not in equilibrium: surplus – 1

Equilibrium price: price where QS = QD = equilibrium Surplus (excess supply):
Q P
D
quantity supplied is
P D S
S $6.00 Surplus greater than quantity
$6.00 P QD QS demanded
$5.00 $0 24 0 $5.00
If P = $5,
$4.00 1 21 5 $4.00
– then QD = 9 pizzas
2 18 10 $3.00
$3.00 – and QS = 25 pizzas,
3 15 15
$2.00 $2.00 – Resulting in a
4 12 20 surplus of 16 pizzas
$1.00 $1.00
5 9 25
$0.00 6 6 30 $0.00
Q Q
0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35
105 106
Markets not in equilibrium: surplus – 2 Markets not in equilibrium: shortage – 1

Facing a surplus, sellers Shortage
P try to increase sales by P (excess demand)
D S cutting the price: D S
$6.00 Surplus $6.00 Quantity demanded is
– This causes QD to rise greater than quantity
$5.00 $5.00
– and QS to fall… supplied
$4.00 – …which reduces the $4.00 If P = $1,
$3.00 surplus. $3.00 - then QD = 21 pizzas
$2.00 – And so on… until $2.00 - and QS = 5 pizzas
market reaches - Resulting in a
$1.00 $1.00
equilibrium. shortage of 16 pizzas
$0.00 $0.00 Shortage
Q Q
0 5 10 15 20 25 30 35 0 5 10 15 20 25 30 35
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Markets not in equilibrium: shortage – 2 Supply and Demand Together

Facing a shortage, Three steps to analyzing changes in equilibrium:
P sellers raise the price,
D S 1. Decide whether the event affects the supply,
$6.00 - Causing QD to fall
the demand, or, in some cases, both
$5.00 - and QS to rise,
2. Decide whether the demand/supply
- …which reduces the
$4.00 increase/decrease  the demand or supply
shortage.
$3.00 curve(s) shifts to the right or to the left
– And so on… until
$2.00 market reaches 3. Use the supply-and-demand diagram
$1.00 equilibrium • Compare the initial and the new
Shortage equilibrium
$0.00
Q • Effects on equilibrium price and quantity
0 5 10 15 20 25 30 35
109 110
EXAMPLE 3: The market for pizzas EXAMPLE 3A: A shift in demand

P EVENT A: Increase in the price of hamburgers.
price of
S1 Initial equilibrium: E1
pizzas
STEP 1: P
• Pizzas and hamburgers S1
Market are substitutes
P1 equilibrium • Increase in the price of P2 E2
E1
hamburgers  Consumers will buy
fewer expensive hamburgers
P1 E1
and switch to pizzas
D1 STEP 2:
Q The demand of pizzas increases
Q1  D curve shifts right D2
D1
New equilibrium: E2
quantity of Q
STEP 3: Increase in price Q1 Q2
pizzas and quantity of pizzas. The market for pizzas
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EXAMPLE 3B: A shift in supply EXAMPLE 3C: A shift in both S and D – 1

EVENT B: New technology EVENTS: Price of hamburgers rises AND new
of producing pizzas. technology reduces production costs.
Initial equilibrium: E1 P
STEP 1: S1 S2 STEP 1: Both demand and P
• New technology supply are affected. S1 S2
reduces production costs STEP 2: Both shift
 supply of pizzas rises.
STEP 2: to the right.
P1 E1 P2 E2
• Because lower
production cost makes P2 E2 STEP 3: P1 E1
production more profitable Q rises but the effect
at any given price D1 on P is ambiguous:
 S shifts right
Q D1 D2
New equilibrium: E2 Q1 Q2 If demand increases more
STEP 3: Decrease in price than supply, P rises. Q
and increase in quantity Q1 Q2
The market for pizzas The market for pizzas
113 114
EXAMPLE 3C: A Shift in Both S and D – 2 EXAMPLE 3C: A Shift in Both S and D – 2
P S1 S2 P S1 S2
P1 E1 P1 E1 E2
E2 If increase of supply
P2
equals increase of D2
D1 D2 demand, P remains D1
If supply increases more unchanged.
Q Q
than demand, P falls. Q1 Q2 Q1 Q2
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SUMMARY SUMMARY
• Economists use the model of supply and demand • The supply curve shows how the quantity of a
to analyze competitive markets. good supplied depends on the price.
– Many buyers and sellers, all are price takers – Law of supply: as the price of a good rises, the
• The demand curve shows how the quantity of a quantity supplied rises; the S curve slopes upward.
good demanded depends on the price. • Other determinants of supply: input prices,
– Law of demand: as the price of a good falls, the technology, expectations, and number of sellers.
quantity demanded rises; the D curve slopes – If one of these factors changes, supply curve shifts.
downward • The intersection of the supply and demand curves
• Other determinants of demand: income, prices of determines the market equilibrium.
substitutes and complements, tastes, expectations, – At the equilibrium price, quantity demanded =
and number of buyers. quantity supplied
– If one of these factors changes, the D curve shifts
117 118
SUMMARY SUMMARY
• The behavior of buyers and sellers naturally drives • To analyze how any event influences a market, we
markets toward their equilibrium. use the supply-and-demand diagram to examine
– When the market price is above the equilibrium how the event affects the equilibrium price and
price, there is a surplus of the good, which quantity.
causes the market price to fall. 1. Decide whether the event affects the supply, the
– When the market price is below the equilibrium demand (or both).
price, there is a shortage, which causes the 2. Decide in which direction the curve shifts.
market price to rise. 3. Compare the new equilibrium with the initial one.
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Learning objectives
By the end of this part, students should be able to
understand:
• What is elasticity?
• What kinds of issues can elasticity help us
understand?
• What is the price elasticity of demand? How is it
2.2 Elasticity related to the demand curve? How is it related to
revenue and expenditure?
• What is the price elasticity of supply? How is it
related to the supply curve?
• What are the income and cross-price elasticity of
demand?
121 122
2.2.1. The Elasticity of Demand A. The Price Elasticity of Demand

Price elasticity of demand is
• Elasticity percentage change in Q d
P 
– Measure of the responsiveness of Qd or Qs to a percentage change in P
change in one of its determinants
P rises P2 15%
  1.5
• Price elasticity of demand by 10% P1 10%
– How much the quantity demanded of a good D
responds to a change in the price of that good
Q Along a D curve, P and Q
• Loosely speaking, it measures the price-sensitivity of Q2 Q1 move in opposite
buyers’ demand Q falls directions, which would
by 15% make price elasticity
%
EDP = negative.
%
We will drop the minus sign and report all price elasticities as
positive numbers (absolute values).
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The Variety of Demand Curves Perfectly inelastic demand

• Demand is perfectly inelastic: Price elasticity % change in Q 0%
= = =0
– Price elasticity of demand = 0 of demand % change in P 10%
• Demand is inelastic: • D curve:
P
– Price elasticity of demand < 1 D
Vertical
• Demand has unit elasticity: P1
– Price elasticity of demand = 1 P falls • Consumers’
by 10% P price sensitivity:
• Demand is elastic: 2
– Price elasticity of demand > 1 None

• Demand is perfectly elastic:
Q1 Q
• Elasticity:
– Price elasticity of demand = infinity 0
Q changes
by 0%
125 126
Inelastic demand Unit elastic demand

Price elasticity % change in Q <10% Price elasticity % change in Q 10%
= = <1 = = =1
of demand % change in P 10% of demand % change in P 10%
P
• D curve P • D curve
relatively steep intermediate
P
P falls 1 P falls
P1 slope
by 10% P • Consumers’ price by 10%
2
sensitivity: P2 • Consumers’ price
D D
sensitivity:
relatively low
Q1 Q2 Q intermediate
• Elasticity: Q1 Q2 Q
Q rises less Q rises • Elasticity:
than 10%
<1 by 10% =1
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Elastic demand Perfectly elastic demand

Price elasticity % change in Q >10% Price elasticity % change in Q any %
= = >1 = = = infinity
of demand % change in P 10% of demand % change in P 0%
P • D curve P • D curve
relatively flat D horizontal
P P2 = P1
P falls 1
by 10% P
• Consumers’ price P changes
• Consumers’
2 D sensitivity: price sensitivity:
by 0%
relatively high extreme
Q1 Q2 Q • Elasticity: Q1 Q2 Q • Elasticity:
Q rises more >1 Q changes infinity
than 10% by any %
129 130
The Variety of Demand Curves Calculating the Price Elasticity of Demand

• The greater the price elasticity of demand • Standard method Standard method of
– The flatter the demand curve computing the percentage (%)
P
change:
B
$2500 end value  start value
$2000
A  100%
start value
D
Going from A to B:
Q • the % change in P = 25%
8 12
• the % change in Q = - 33%
Going from B to A: Price elasticity = 33/25 = 1.33
• % change in P = - 20%
• % change in Q = 50% We get different values!
Price elasticity =50/20 = 2.5
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Calculating the Price Elasticity of Demand Our scenario

• Midpoint method
Using the midpoint method
– The midpoint is the average of the start and end P of computing % changes:
values B
$2500
A 40%
end value  start value $2000
Price elasticity =  1.8
percentage change   100% D 22.2%
midpoint
(Q  Q1 ) / [(Q2  Q1 ) / 2 ] Q
8 12
Price elasticity of demand  2
(P2  P1 ) / [(P2  P1 ) / 2 ] % change in P =
$2500  $2000
 100%  22.2%
$2250
12  8
% change in Q =  100%  40%
10
133 134
Elasticity along a linear demand curve Determinants of price elasticity of demand - 1

 The slope of a  Prices of both of these goods rise by 20%.
P linear demand For which good does Qd drop the most? Why?
200% curve is constant, • Apple
$30 EDP = = 5.0
40% but its elasticity – has many close substitutes, so buyers can
67% is not. easily switch if the price rises
20 EDP = = 1.0
67%  Elasticity falls as • Traveling by airplanes
40% you move – has no close substitutes, so a price increase
10 EDP = = 0.2 downward and would not affect demand very much
200%
rightward along a  Price elasticity is higher when close substitutes
$0 Q linear demand are available.
0 20 40 60 curve.
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Determinants of price elasticity of demand - 2 Determinants of price elasticity of demand - 3

Prices of both of these goods rise by 20%. Prices of both of these goods rise by 20%.
For which good does Qd drop the most? Why? For which good does Qd drop the most? Why?
• Viettien shirts • Insulin
– For a narrowly defined good, Viettien shirts, – is a necessity to diabetics. A rise in price would
there are many substitutes cause little or no decrease in quantity demanded
• Clothing • A Rolex watch
– There are fewer substitutes available for – is a luxury. If the price rises, some people will
broadly defined goods (clothing)
forego it.
 Price elasticity is higher for narrowly defined
goods than for broadly defined ones.  Price elasticity is higher for luxuries than for
necessities.
137 138
Determinants of price elasticity of demand - 4 Price Elasticity and Total Revenue

The price of gasoline rises 20%. Does Qd drop If a firm raises its price, would the revenue rise
more in the short run or the long run? Why? or fall?
• In the short run Total Revenue (TR) = P x Q
– There’s not much people can do in the
• A price increase has two effects on revenue:
short run, other than ride the bus or carpool.
• In the long run
– Higher revenue: because of the higher P
– In the long run, people can buy smaller cars or – Lower revenue: because of the lower Q
live closer to work. • Which of these two effects is bigger?
 Price elasticity is higher in the long run. – It depends on the price elasticity of demand
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Our scenario: Elastic demand Our scenario: Inelastic demand
increased P and Q  TR increased P and Q  TR

P
P revenue due to revenue due to
higher P When D is elastic, higher P
a price increase P2 When D is inelastic,
lost revenue lost revenue a price increase
P2 due to lower Q causes revenue to due to lower Q
causes revenue to
fall. P1
P1 rise.
D D
Q
Q Q2 Q1
Q2 Q1
141 142
Our scenario: Unit - elastic demand Price Elasticity and Total Revenue - Summary
For a price increase, if demand is elastic
P and Q  TR constant  E > 1: % change in Q > % change in P
increased When D is unit-elastic,
P  The fall in revenue from lower Q > the increase in
revenue due to
higher P
an increase in price leaves revenue from higher P  TR decreases
P2 revenue unchanged: the For a price increase, if demand is inelastic
lost revenue increase in revenue from
due to lower Q higher P exactly offsets
 E < 1: % change in Q < % change in P
P1 the lost revenue due to  The fall in revenue from lower Q < the increase in
lower Q. revenue from higher P  TR increases
When D is unit-elastic, an increase in price leaves
revenue unchanged:
Q  the increase in revenue from higher P exactly
Q2 Q1 offsets the lost revenue due to lower Q.
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B. Income Elasticity of Demand C. Cross-Price Elasticity of Demand

• Income elasticity of demand • Cross-price elasticity of demand
– How much the quantity demanded of a good – How much the Qd of one good responds to a
change in the price of another good
responds to a change in consumers’ income
– Percentage change in Qd of the first good divided
– Percentage change in quantity demanded by the percentage change in price of the second
divided by the percentage change in income good
• Classification • Classification
– Normal goods: income elasticity > 0 – Substitutes: cross-price elasticity > 0
• E.g.: an increase in price of beef causes an increase in
– Inferior goods: income elasticity < 0 demand for chicken.
– Luxuries: income elasticity > 1 – Complements: cross-price elasticity < 0
• E.g.: an increase in price of computers causes decrease
– Necessities: income elasticity positive but < 1 in demand for software
145 146
2.2.2. The Elasticity of Supply Calculating Price Elasticity of Supply

• Price elasticity of supply Price elasticity percentage change in Q s 16%
– How much the quantity supplied of a good of supply   2
percentage change in P 8%
responds to a change in the price of that good
– Percentage change in quantity supplied divided P
S
by the percentage change in price Again, we use the
midpoint method to P rises P2
– Loosely speaking, it measures sellers’ by 8% P
price-sensitivity compute the 1
percentage
changes.
Q
Q1 Q2
Q rises
by 16%
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How the price elasticity of supply can vary The Variety of Supply Curves
• Supply is perfectly inelastic
Price Supply
Elasticity is small – Price elasticity of supply = 0
$15 (less than 1).
• Supply is inelastic
12
– Price elasticity of supply < 1
Elasticity is large
(greater than 1). • Supply is unit elastic
4
3 – Price elasticity of supply = 1
0 100 200 500 525 Quantity

• Supply is elastic
– Price elasticity of supply > 1
• Supply often becomes less elastic as Q rises, due • Supply is perfectly elastic
to capacity limits.
– Price elasticity of supply = infinity
149 150
Perfectly inelastic supply Inelastic supply

Price elasticity % change in Q 0% Price elasticity % change in Q < 10%
= = =0 = = <1
of supply % change in P 10% of supply % change in P 10%
• S curve: P • S curve: P
S S
vertical relatively steep
P • Sellers’ price P rises P2
• Sellers’ price P rises 2
sensitivity: by 10% P sensitivity: by 10% P1
1
none relatively low

• Elasticity: Q • Elasticity: Q
Q1 Q1 Q2
0 Q changes <1 Q rises less
by 0% than 10%
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Unit elastic supply Elastic supply

Price elasticity % change in Q 10% Price elasticity % change in Q > 10%
= = =1 = = >1
of supply % change in P 10% of supply % change in P 10%
• S curve: P
• S curve: P
intermediate slope S relatively flat S
• Sellers’ price P2 • Sellers’ price P rises P2
sensitivity: sensitivity: by 10%
P1 P1
intermediate P rises relatively high
• Elasticity: by 10% Q • Elasticity: Q
Q1 Q2 Q1 Q2
=1 Q rises
>1 Q rises more
by 10% than 10%
153 154
Perfectly elastic supply The Variety of Supply Curves

Price elasticity % change in Q any % • The greater the price elasticity of supply
= = = infinity
of supply % change in P 0% – The flatter the supply curve
• S curve:
P
horizontal
• Sellers’ price P2 = P1 S
sensitivity: P changes
extreme by 0%
• Elasticity: Q
Q1 Q2
infinity Q changes
by any %
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The Determinants of Supply Elasticity 2.2.3. Some applications of elasticity

• The more easily sellers can change the 1. Can Good News for Farming Be Bad News
quantity they produce, the greater price for Farmers?
elasticity of supply – Applying new technological production of rice
– E.g.: the supply of real estate is harder to vary  20% increased production per hectare
and thus less elastic than supply of new cars. • Supply curve shifts to the right
• Notice: Demand is inelastic
• Price elasticity of supply is greater in the
long run than in the short run
– In the long run: firms can build new factories, or
new firms may be able to enter the market
157 158
An increase in supply in the market for rice 2.2.3. Some applications of elasticity
1. When demand is inelastic,
Price of an increase in supply . . . 2. Why Did OPEC Fail to Keep the Price of Oil
rice High?
S1
• Decrease in oil supply  large increase in price
in short-run (1973-1974)
S2
• Decrease in supply  small increase in price in
2. … leads
to a large P1 E1 long-run (1971-1981)
fall in 3. … and a proportionately
price. . . P2 smaller increase in quantity
E2 sold. As a result, total
revenue falls.
Demand
0 Q1 Q2 Quantity of rice 159 160

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Why Did OPEC Fail to Keep the Price of Oil High? A reduction in supply in the world market for oil
 In the short-run: (a) The Oil Market in the Short Run (b) The Oil Market in the Long Run
• Supply and demand are inelastic 1. In the short run, when supply and 1. In the long run, when
demand are inelastic, a shift in supply and demand are
 S and D curves are very steep. supply. . . elastic, a shift in supply. . .
 In the long run: Price
Price
• Producers respond to high prices by S2 2. … leads to a
S1
increasing oil exploration and by building new P2
small increase S2 S1
in price
extraction capacity.
• Consumers respond with greater P1
P2
P1
conservation, such as by replacing old
inefficient cars with newer efficient ones.
Demand
 Supply and demand are elastic Demand
 S and D curves are very flat 0
2. … leads to a
Quantity 0 Quantity
large increase in
161 price 162
2.2.3. Some applications of elasticity Policy 1: Interdiction

Price of
3. Does Drug Interdiction Increase or Decrease Interdiction reduces Drugs new value of drug-
Drug-related Crime? the supply of drugs. related crime
D1 S2
• Demand for drugs S1
is inelastic: P rises P2
proportionally
more than Q falls. initial value
P1
Result: an increase of drug-
in total spending on related
crime
drugs, and in drug-
related crime.
Q2 Q1 Quantity
of Drugs
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Policy 1: Interdiction Policy 2: Education

Increase the number of federal agents new value of drug-
Price of related crime
devoted to the war on drugs Drugs
D2 D1
– Illegal drugs: supply curve shifts left Education reduces
S
• Higher price and lower quantity the demand for
– Amount of drug-related crimes drugs.
initial value
• Inelastic demand for drugs • P and Q fall. P1
of drug-
• Higher drugs price: higher total revenue Result: P2 related
• Increase drug-related crime A decrease in total crime
spending on drugs,
and in drug-related Q2 Q1 Quantity
crime. of Drugs
165 166
Policy 2: Education SUMMARY

Policy of drug education • The price elasticity of demand
– Reduce demand for illegal drugs – Measures how much the quantity demanded
– Left shift of demand curve responds to changes in the price.
– Lower quantity – Is the percentage change in quantity demanded
divided by the percentage change in price.
– Lower price
• The variety of the price elasticity of demand
– Reduce drug-related crime
– If < 1, inelastic demand: quantity demanded
moves proportionately less than the price
– If > 1, elastic demand: quantity demanded
moves proportionately more than the price
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SUMMARY SUMMARY
• Demand tends to be more elastic if • The cross-price elasticity of demand
– Close substitutes are available – Measures how much the quantity demanded of
– The good is a luxury rather than a necessity one good responds to changes in the price of
– The market is narrowly defined another good
– Buyers have substantial time to react to a price • The income elasticity of demand
change. – Measures how much the quantity demanded
• Total revenue (PxQ), total amount paid for a good responds to changes in consumers’ income
– Moves in the same direction as P (inelastic D)
– Moves in the opposite direction as P (elastic D)
169 170
SUMMARY
• The price elasticity of supply
– Measures how much the quantity supplied responds
to changes in the price.
– Is the percentage change in quantity supplied
divided by the percentage change in price
• The variety of the price elasticity of supply Supply, Demand, and
– If < 1, inelastic supply: quantity supplied moves
proportionately less than the price
2.3 Government Policies
– If > 1, elastic supply: quantity supplied moves
proportionately more than the price
• Depends on the time horizon under consideration. In
most markets, supply is more elastic in the long run
than in the short run. V. Andreea Chiritescu
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Learning objectives Government Policies
By the end of this part, students should be able to • Economists as policy advisers
understand: – Use theories to help change the world for the
• What are price ceilings and price floors? better.
What are some examples of each? How do • Policies
price ceilings and price floors affect market – Use price controls and taxes to alter the private
outcomes? market outcome
• How do taxes affect market outcomes?
– Often have effects that their architects did not
How do the effects depend on whether
intend or anticipate
the tax is imposed on buyers or sellers? What
is the incidence of a tax? What determines the
incidence?
173 174
A. Controls on Prices PRICE CEILING

• Price ceiling: Rental P S
– Legal maximum on the price at which a good price of
can be sold apartments
Equilibrium without
– In order to protect buyers $800 price controls
– Example: Rent-control laws
• Price floor:
– Legal minimum on the price at which a good
D
can be sold Q
300
– In order to protect sellers Quantity
– Example: Minimum wage laws of apartments
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PRICE CEILING: Not binding price ceiling PRICE CEILING: Binding price ceiling
A price ceiling above The price ceiling below

The Market for Apartments The Market for Apartments
the equilibrium price the equilibrium price
P S P S
is not binding— Price is binding, and causes
$1000 a shortage.
has no effect on the ceiling
market outcome. P = $500
$800 $800
Qd = 400
Qs = 250 Price
$500
ceiling
shortage
D D
Q Q
300 250 400
177 178
PRICE CEILING: Binding price ceiling in long run BIDING PRICE CEILING: Evaluation
In the long run, supply The Market for Apartments • Impacts of biding price ceiling
and demand of rental - Long lines
apartments are more P S - Discrimination according to sellers’ biases
price-elastic. - Are often unfair and inefficient
• Conclusion
$800 - Even though the price ceiling was motivated by
So, the shortage a desire to help buyers, not all buyers benefit
is larger. Price from the policy.
$500
ceiling - Some buyers pay a lower price, although they
shortage may have to wait in line to do so.
D
Q - Other buyers even cannot buy the goods
150 450 anymore (because the quantity supplied,
available on the market, is too small).
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PRICE FLOOR PRICE FLOOR: Not binding price floor

Wage W A price floor below the
paid to S The Market for Unskilled Labor
unskilled
equilibrium price is not
binding – has no W S
workers
Equilibrium without effect on the market
$9.00
price controls outcome.
W = $9.00 $9.00
Q = 500 Price
$7.00
D floor
L
500
D
Quantity of L
unskilled workers 500
181 182
PRICE FLOOR: Binding price floor Minimum Wage Laws: Evaluation

The equilibrium wage The Market for Unskilled Labor • Pros: One way to raise the income of
($9) is below the floor working poor
and therefore illegal. labor
W surplus S • Cons:
Price o Causes unemployment
$10.25
The price floor is floor
o Encourages teenagers to drop out of high
binding, causes a
$9.00 school
surplus (i.e.,
unemployment). o Prevents some unskilled workers from getting
on-the-job training
W = $10.25
Qd = 400 D
L
Qs = 550 400 550
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Evaluating Price Controls Evaluating Price Controls

• Economists usually oppose price ceilings • Governments can sometimes improve market
and price floors, because: outcomes by using price controls
– Policymakers are motivated to control prices
– Markets are usually a good way to organize
because they view the market’s outcome as
economic activity unfair. Besides, price controls are often aimed
– Prices have the crucial job of balancing supply at helping the poor.
and demand – Yet price controls often hurt those they are
trying to help
• Other ways of helping those in need is
subsidies, which does not lead to shortage or
surplus. However, this policy costs money and
therefore, requires higher taxes.
185 186
B. Taxes Case 1: Tax imposed on sellers

• Government uses taxes Effects of a $3 per unit A tax on sellers is like
– To raise revenue for public projects tax on sellers a cost increase,
• Roads, schools, and national defense
causes their supply to
• Should the government impose tax on buyers or P S2
$13.00 fall
sellers? Tax S1
– The government can make the seller or the Hence, a tax on
buyer to pay the tax $10.00 sellers shifts the S
• The tax can be a percentage of the good’s price, curve up (left) by the
or a specific amount for each unit sold. For amount of the tax.
D1
simplicity, we analyze per-unit taxes only.
Q
500
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Case 1: Tax imposed on sellers Case 1: Tax imposed on sellers

New equilibrium: • Tax incidence: how the burden of a tax is
Effects of a $3 per unit
tax on sellers Q = 450 shared among market participants
P
S2
P Buyers pay
S2 In our S1
PB = $12 PB = $12.00
Tax
S1 example,
PB = $12.00 Sellers receive
Tax $10.00
PS = $9 • buyers pay
$10.00 PS = $9.00
$2.00 more,
PS = $9.00
• sellers get D1
Difference between $1.00 less.
D1 them = $3 = tax
450 500 Q
Buyers and sellers share the burden of tax
450 500 Q • Sellers get a lower price, are worse off
189 • Buyers pay a higher price, are worse off 190
Case 2: Tax imposed on buyers Case 2: Tax imposed on buyers

Effects of a $3 per unit tax Buyers will have to pay Effects of a $3 per unit tax New equilibrium:
on buyers on buyers Q = 450
more, which causes their
P demand to fall P Sellers receive
S1 S1
PB = $12
PS = $9
Hence, a tax on buyers Tax
$10.00 Buyers pay
Tax shifts the D curve down $10.00
PB = $12
by the amount of the tax. PS = $9
$7
D1 D1 Difference between
D2 D2 them = PB - PS =
500 Q
$3 = tax
450 500 Q
191 192
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Case 2: Tax imposed on buyers The outcome is the same in both cases!
The effects on P and Q, and the tax incidence
are the same, whether the tax is imposed on
P
S1 buyers or sellers!
PB = $12
In our Tax - the price buyers pay rises P
$10 (in this case to $12) S1
example, PB = $12
- the price sellers receive Tax
PS = $9
• buyers pay falls (to $9) $10
$2.00 more, D1 - the equilibrium quantity S $9P =
• sellers get D2
falls (to 450)
$1.00 less. - the incidence of the tax is D1
Q
450 500 the same (in this case,
Buyers and sellers share the burden of tax buyers pay $2.00 more,
• Sellers get a lower price, are worse off sellers get $1.00 less). 450 500 Q
• Buyers pay a higher price, are worse off 193 194
Elasticity and Tax Incidence Tax Incidence: Elastic supply, inelastic demand
• When a good is taxed Buyers’ share P • It’s easier for
– Buyers and sellers of the good share the of tax burden sellers than
burden of the tax PB S buyers to leave
– But how exactly is the tax burden divided? the market.
Tax
• Depends on the elasticity of demand and elasticity of Price if no tax • So buyers bear
supply most of the
PS
burden of the
Sellers’ share tax.
D
of tax burden
Q
195 196
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Tax Incidence: Inelastic supply, elastic demand Elasticity and Tax Incidence – Conclusion
• It’s easier for Tax burden falls more heavily on the side of
buyers than the market that is less elastic:
P
Buyers’ share S sellers to leave • Small elasticity of demand: Buyers do not have
of tax burden the market. good alternatives to consuming this good.
PB • Sellers bear Buyers bear most of the burden of the tax.
Price if no tax most of the • Small elasticity of supply: Sellers do not have
Tax burden of the good alternatives to producing this good.
tax. Sellers bear most of the burden of the tax.
Sellers’ share PS
D
of tax burden
Q
197 198
SUMMARY SUMMARY
• A price ceiling is a legal maximum on the price • When the government levies a tax on a good,
of a good or service. Example: rent control. the equilibrium quantity of the good falls.
– Binding if below the equilibrium price: causing – The tax places a wedge between the price
shortage. paid by buyers and the price received by
– Sellers must in some way ration the good or sellers.
service among buyers. – Buyers pay more for the good and sellers
• A price floor is a legal minimum on the price of a receive less for it.
good or service. Example: minimum wage. • Buyers and sellers share the tax burden.
– Binding if above the equilibrium price: causing – The incidence of tax depends on the price
surplus. elasticities of supply and demand.
– Buyers’ demands for the good or service must – Most of the burden falls on the side of the
in some way be rationed among sellers. market that is less elastic.
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Reading materials
Chapter 7. Mankiw, N.G (2020), Principles of

Economics, 9th Edition, Cengage Learning.
CHAPTER
Consumers, Producers, and
3 the Efficiency of Markets
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 202
201 license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
Purpose Learning objectives

Develop welfare economics - the study of how the By the end of this chapter, students should be
allocation of resources affects economic well-being. able to:
Discover that under most circumstances the Understand what consumer surplus is, how it is
equilibrium price and quantity is also the one that related to the demand curve?
maximizes welfare. Understand what producer surplus is, how it is related
to the supply curve?
Explain why the equilibrium quantity in a market
maximizes total surplus in that market.
Explain the difference between efficiency and
equality.
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 203 © 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 204
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use. license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
14/09/2022
Contents Welfare Economics

• Welfare economics
1. Consumer surplus – Studies how the allocation of resources affects
economic well-being
• Allocation of resources refers to how much of each
good is produced, which producers produce it, and
2. Producer surplus which consumers consume it
• Economic well-being: the benefits that buyers and
sellers receive from engaging in market transactions.
3. Market efficiency – Looks at how society can make these benefits

as large as possible
3.1. Consumer Surplus EXAMPLE 1A: Willingness to pay

• Consumer surplus (CS) You work at the local store that sells iPads. The
– CS reflects benefits buyers receive from store is running a sale on the iPad mini 3. Each of
participating in a market. your roommates wants to buy an iPad mini 3.
However, their willingness to pay is not the same.
– CS = WTP – P
Buyers’ willingness to pay for a good minus Q: If the sale price is $200, who
Name WTP
the actual price. will buy an iPad, and what is the
– WTP (willingness to pay): A $250 quantity demanded?
• Is maximum amount the buyer will pay for B 175 - A & C buy an iPad mini. But B &
that good. C 300 D will not.
• Reflects how much the buyer values the good • Hence, Qd = 2 when P = $200
D 125
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208
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EXAMPLE 1B: WTP and the demand schedule EXAMPLE 1C: WTP and the demand curve -1
Derive the P
demand P (price $350
who buys Qd P Qd
schedule: of iPad) $300
$301 & up nobody 0 $250 $301 & up 0
Name WTP
251 – 300 C 1 $200 251 – 300 1
A $250
176 – 250 A & C 2
$150 176 – 250 2
B 175
$100
126 – 175 3
C 300 126 – 175 A, B & C 3
$50
D 125 0 – 125 4
0 – 125 A, B, C & D 4 $0
0 1 2 3 4 Q
© 2021 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
® © 2021 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
®
license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.
210
About the staircase shape… EXAMPLE 1C: WTP and the demand curve - 2
P This D curve looks like P C’s WTP At any Q, the height of
$350 a staircase with 4 $350 the D curve is the
$300 steps – one per buyer. $300 A’s WTP WTP of the marginal
$250 If there were a huge # $250 buyer, the buyer who
of buyers, there would
$200 $200 would leave the
be a huge # of very
$150 tiny steps, and it $150 B’s WTP market if P were any
$100 would look like a $100 higher.
straight curve. D’s
$50 $50 WTP
$0 $0
Q
0 1 2 3 4 Q 0 1 2 3 4
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212
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EXAMPLE 2A: Calculating consumer surplus EXAMPLE 2B: CS and the demand curve
P
CS = WTP - P C’s WTP Suppose P = $220
$350
Suppose P = $220. $300 C’s CS = $300 – 220
Name WTP
= $80
• C’s CS = $300 – 220 = $80. $250
A $250
• A’s CS = $250 – 220 = $30. A’s CS = $250 – 220
B 175 $200 = $30
• The others get no CS because A’s WTP
C 300 $150 Total CS = $110
they do not buy an iPad mini
D 125 at this price. $100
CS is the area
• Total CS = $110. $50 below the demand
$0 curve and above
0 1 2 3 4 Q the price.
214
EXAMPLE 2C: Consumer surplus for one buyer EXAMPLE 2D: Total consumer surplus
Price
per unit
P The demand for T-shirts CS is the area P The demand for T-shirts
$ 60 between P and $ 60 P = $30, Qd = 15
At Q = 5, the the D curve,
marginal buyer is 50 from 0 to Q. 50
h
willing to pay $50 for 40 Recall: area of 40
a T-shirt. a triangle equals
30 30
½ x base x height
20 T-shirts 20
Suppose P = $30. Height =
10 $60 – 30 = $30. 10
D D
Then his consumer 0 Q So, 0 Q
surplus = $20. 0 5 10 15 20 25 30 CS = ½ x 15 x $30 0 5 10 15 20 25 30
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
= $225.
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EXAMPLE 2E: A higher price reduces CS 3.2. Producer Surplus

P If P rises to $40, • Producer surplus (PS)
CS = ½ x 10 x $20 – Measures the benefits sellers receive from
60
1. Fall in CS due participating in a market
= $100.
to buyers leaving 50 – PS = P – cost/WTS
the market Two reasons for
40 • Amount a seller is paid for a good minus the seller’s
the fall in CS. cost of providing it.
30 • Price received minus willingness to sell
2. Fall in CS due 20 – Cost vs. WTS (Willingness to sell)
to remaining • WTS: The lowest price accepted by a seller for one
10
buyers paying the D unit of a good or service
higher P 0 Q • The cost is a measure of willingness to sell: produce
0 5 10 15 20 25 30 and sell the good/service only if the price > cost
217 © 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 218
EXAMPLE 3A: Cost and willingness to sell EXAMPLE 3B: WTS and the supply curve – 1
You want to get your house painted. There are 3
P
sellers of painting services that you can hire. The
$40 P Qs
table below shows their willingness to sell the
services. $0 – 9 0
$30
Q: Derive the supply schedule 10 – 19 1
P Qs
from the cost data.
$20
$0 – 9 0 20 – 34 2
Name cost
10 – 19 1 $10 35 & up 3
DULUX $10
NIPPON 20 20 – 34 2 $0
Q
MY KOLOR 35 35 & up 3 0 1 2 3
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EXAMPLE 3B: WTS and the supply curve – 2 EXAMPLE 4A: Calculating producer surplus
P At each Q, the PS = P - cost
height of the S Suppose P = $25.
$40
MY
curve is the cost of Name cost • DULUX’s PS = 25 – 10 = $15
KOLOR’s
$30 cost the marginal DULUX $10
seller, the seller • NIPPON’s PS = 25 – 20 = $5
NIPPON’s NIPPON 20
$20 cost
who would leave • MY KOLOR gets no PS
the market if the MY KOLOR 35 because this firm doesn’t sell
DULUX’s
price were any the service at this price.
$10
cost lower.
• Total PS = $20.
$0 Q
0 1 2 3
222
EXAMPLE 4B: Producer surplus & the S curve EXAMPLE 4C: Producer surplus for one seller
P PS = P – cost Price P The supply of T-shirts
$40 Suppose P = $25. per unit
MY 60
KOLOR’s DULUX’s PS = 25 – 10 = $15
Suppose P = $40. 50 S
$30 cost
NIPPON’s PS = 25 – 20 = $5 40
NIPPON’
$20 s cost MY KOLOR’ PS = $0 At Q = 15, the 30
Total PS = $20 marginal seller’s cost
$10 DULUX’s cost (WTS) is $30, and 20 T-shirts
her producer surplus 10
$0 PS is the area below is $10.
0 Q
0 1 2 3 Q the price and above
0 5 10 15 20 25 30
the supply curve
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EXAMPLE 4D: Total producer surplus EXAMPLE 4E: A lower price reduces PS
The supply of T-shirts If P falls to $30,

PS is the area P P 1. Fall in PS
PS = ½ x 15 x (30-15)
between P and 60 60 due to sellers
= $112.50 leaving market
the S curve, from
50 S Two reasons for the fall 50 S
0 to Q.
in PS.
The height of this 40 40
triangle is $40 – 15 30 30
= $25. h
20 2. Fall in PS due to 20
So, 10 remaining sellers 10
PS = ½ x b x h getting lower P
= ½ x 25 x $25 0 Q 0 Q
= $312.50 0 5 10 15 20 25 30 0 5 10 15 20 25 30
226
3.3. Market Efficiency – 1 Does eq’m Q maximize Total surplus?
• Total surplus = CS + PS Market equilibrium: P

• CS: Buyers’ gains from buying in the market
P = $30 60
• PS: Sellers’ gains from selling in the market
Q = 15
50 S
– CS = Value to buyers – Amount paid by buyers Total surplus
40
– PS = Amount received by sellers – Cost to sellers = CS + PS TS
30
Total surplus = Value to buyers – Cost to sellers
20
10
D
0 Q
0 5 10 15 20 25 30
© 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 227 © 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
228
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Does eq’m Q maximize Total surplus? Does eq’m Q maximize Total surplus?
At Q = 20, cost of At Q = 10, cost of
producing the marginal P P
producing the marginal
unit is $35; the value to 60 60
unit is $25; the value to
consumers of the 50 S consumers of the 50 S
marginal unit is only $20 marginal unit is $40
40 40
Total surplus = Total surplus =
30 30
20 20
10 10
D D
0 Q 0 Q
0 5 10 15 20 25 30 0 5 10 15 20 25 30
© 2021 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
® © 2021 Cengage Learning . May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a
®
230
Does eq’m Q maximize Total surplus? Market Inefficiency & Market Failure – 1
• Yes. The market equilibrium quantity • Market Efficiency exists when resources are
maximizes total surplus. allocated efficiently
• At any other quantity, total surplus will
• Two important assumptions:
increase by moving toward the market
equilibrium quantity. 1. Markets are perfectly competitive
2. Outcome in a market matters only to the
buyers and sellers in that market
• When these assumptions do not hold
– Q will be over or below eq’m Q
– “Market equilibrium is efficient” may no longer
be true
231 © 2021 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a 232
14/09/2022
Market Inefficiency & Market Failure – 2 Market Inefficiency & Market Failure – 3
• Market failures • Market failures
– Market power: a single buyer or seller (small – Externalities: decisions of buyers and sellers
group) control market prices affect people who are not participants in the
• The owner of the only gas station in a village (far market at all
away from other villages) will have an incentive to • When the production of a good pollutes the air and
restrict the output to keep the price high. Q is below creates health problems for those who live near the
eq’m Q  markets are inefficient. factories, the market on its own may fail to take this
cost into account.
• Q is over eq’m Q  market is inefficient.
SUMMARY SUMMARY
• Consumer surplus: • An allocation of resources that maximizes total
– Measures the benefit buyers get from surplus is said to be efficient
participating in a market – Policymakers are concerned with the efficiency,
– Buyers’ willingness to pay for a good minus the as well as the equality of economic outcomes.
amount they actually pay • Equilibrium of S and D maximizes total surplus
– Area below the D curve and above P
• Producer surplus: – The invisible hand of the marketplace leads
– Measures the benefit sellers get from buyers and sellers to allocate resources
participating in a market efficiently.
– Amount sellers receive for their goods minus • Markets do not allocate resources efficiently in the
their costs of production presence of market failures (market power or
– Area below P and above the S curve externalities)
236
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Reading materials
Chapter 21. Mankiw, N.G (2020), Principles of

Economics, 9th Edition, Cengage Learning.
CHAPTER
The Theory of
4 Consumer Choice

23
237
8
Purpose Learning objectives
By the end of this chapter, students should be able to

• Develop the theory that describes how consumers
understand:
make decisions about what to buy. • How the budget constraint represents the choices a
• After that, the theory is applied to derive demand consumer can afford?
• How indifference curves represent the consumer’s
curve. preferences?
• What determines how a consumer divides her resources
between two goods?
23 24
9 0
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Contents
4.1. The Budget Constraint
• Budget constraint:
– Shows all combinations (bundles) of the two goods that
1. The budget constraint the consumer can afford to buy
– The limit on the consumption bundles that a consumer
can afford  It is a “consumption possibility frontier” for
the consumers.
2. Preferences • Trade-offs: Buying more of one good leaves less
income to buy other goods
3. Optimization
24 24
1 2
EXAMPLE 1A: Russell’s budget constraint EXAMPLE 1A: Solutions
Russell divides his income of $3,000 between two goods: Cups of coffee
pizzas and coffee. Prices are: Pz = $10 per pizza and Pc = A. $3,000/$10 B
1200
$2.50 per cup of coffee = 300 pizzas
1000
A. If Russell spends all his income on pizzas, how many
B. $3,000/$2.50
pizzas does he buy? 800
= 1,200 cups of coffee
B. If Russell spends all his income on coffee, how many
600
cups of coffee does he buy? C. 200 pizzas cost $2,000, C
C. If Russell buys 200 pizzas, how many cups of coffee can the $1,000 left buys 400
he buy? 400 cups of coffee 200

D. Plot each of the bundles from above on a graph (pizzas A
on the horizontal axis and cups of coffee on the vertical D. Russell’s budget 0
0 50 100 150 200 250 300 350
axis). constraint shows the
Pizzas
bundles he can afford
24 24
3 4
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The slope of the budget constraint - 1 The slope of the budget constraint - 2
The slope of the budget constraint More generally, budget constraint

= how many coffee (y-axis good) I Cups of coffee Y
have to give up to get 1 more1200 formula:
I/Py
pizza (x-axis good). X.Px + Y.Py = I
1000
= the rate at which a consumer
can afford to trade one good for D Where:
800
another. X, Y: Quantities of 2 goods
600
Px, Py: Prices of X, Y
From D to C, C
400 I: Income
“increase” = +100 pizzas
“give up” = – 400 coffee 200 Other way: Y = (- Px/Py)*Y + I/Py
Slope = 4 (*) The slope of the budget constraint
0
Russell must give up 0 50 100 150 200 250 300 350 equals the relative price of the two I/Px X
4 coffee to get one pizza. Pizzas goods (-Px/Py) (*)
(*) We can ignore the minus sign (*) We can ignore the minus sign
24 24
5 6
EXAMPLE 1B: The slope of Russell’s budget constraint Changes to the budget constraint
X.Px + Y.Py = I
Cups of coffee
1200 Where: X, Y: Quantities of 2 goods
The slope of the budget Px, Py: Prices of X, Y
1000
constraint
800
D I: Income
= P pizzas / P coffee
Show what happens to budget constraint if:
= 10/2.5 = 4 600
A. Income falls
400
C
B. Py rises
200 C. Px rises
0
0 50 100 150 200 250 300 350
Pizzas
24 24
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Changes to the budget constraint - income falls Changes to the budget constraint – price rises
A fall in income shifts the Y Px increases Y

budget constraint inward. I1/Py An increase in the price of
I/Py
the good on the horizontal

I2/Py axis pivots the budget
constraint inward.
The budget constraint is
steeper.
I2/Px I1/Px X I/Px2 I/Px X
24 25
9 0
Changes to the budget constraint – price rises EXAMPLE 1C: Change to Russell’s budget constraint
Initial problem: Russell’s income = $3,000 and prices:

Py increases Y
PP = $10 per pizza, PC = $2.50 cup of coffee.
I/Py1
An increase in the price Show what happens to Russell’s budget constraint if:
of the good on the A. His income falls to $2,000.
vertical axis pivots the B. The price of coffee rises to PC = $4 per cup of coffee
I/Py2
budget constraint (Income doesn’t change)
inward.
The budget constraint is
flatter.
I/Px X
25 25
1 2
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EXAMPLE 1C: Change to Russell’s budget constraint EXAMPLE 1C: Change to Russell’s budget constraint
Cups of coffee  P coffee = $4 Cups of coffee

Income = $2,000
Russell can still buy 1200
Now, Russell can buy: 1200
$2,000/ $2.50 = 800 cups 300 pizzas. 1000

1000
of coffee But now he can only buy
800
800 $3,000/$4 = 750 cups of
OR
coffee. 600
$2,000/$10 = 200 pizzas 600
 Notice: slope is smaller,
or any combination in 400 relative price of pizza is 400
between. now only 2.5 cups of coffee 200
200
 A fall in income shifts An increase in the price of
the budget constraint 0 one good pivots the budget 0 0 50 100 150 200 250 300 350
0 50 100 150 200 250 300 350
inward. constraint inward. Pizzas
Pizzas
25 25
3 4
B. Indifference curve
4.2. Preferences
A. Assumptions of consumer’s preferences
1. Preferences can be ranked in order
7
Indifference curve (IC): a curve
2. Transitivity of preferences
that shows different consumption
6
3. “More is better than less” Cups bundles that give the consumer
of coffee 5
per week 4 the same level of satisfaction.
A
3
2 B
IC
1
0 1 2 3 4 5 6 7
Pizzas per week
25 25
5 6
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Property 1: Higher indifference curves

Four properties of indifference curve are preferred to lower ones - 2
- Points on the same IC

Increasing represent the same satisfaction.
satisfaction
- Points on different ICs reflect
7
different satisfaction.
6 - The farther away of an IC from
Cups
of coffee 5
the origin, the higher level of
per week 4 satisfaction it represents.
A E F IC3
3
IC2
2
IC1
1
0 1 2 3 4 5 6 7
Pizzas per week
257 25
8
Property 2: Indifference curves slope downward - 2 Property 3 : Indifference curves cannot cross - 1
• The only way for us to

keep satisfaction constant Suppose they did.
7 A & B cannot when consuming more of 7

belong to an IC
6 one good is by 6
Cups consuming less of the Cups
of coffee 5 of coffee 5
per week 4 A B other. per week 4 C
B
3
• The downward shape 3
B reveals the consumers’ A
2 2
IC1 willingness to trade one IC1
1 1
good to the other. IC2
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7
Pizzas per week Pizzas per week
26
0
25
9
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Property 3: Indifference curves cannot cross - 2 Property 4: Indifference curves are bowed inward - 1
10
A
Cups
Compare level of satisfaction of: of coffee 9 Tradeoff -Marginal rate of substitution
 Bundle A and bundle B per week
8
7 (MRS) measures the rate at
 Bundle A and bundle C MRS = 4
7 4
6 which consumers are willing
Cups • A is preferred as B
6
of coffee 5 • A is preferred as C
1
to forgo a number of this
B
per week 4 C => B is preferred as C 5 good in order to get one more
B
3 But C is preferred to B 4 other good, while keeping
2 A
IC1 Indifference curves cannot cross 3 your satisfaction constant.
1
IC2 2
IC1
0 1 2 3 4 5 6 7 1
Pizzas per week
26
0 1 2 3 4 5 6 7 8 9 10 Pizzas per week
1
Property 4: Indifference curves are bowed inward - 2 Property 4: Indifference curves are bowed inward - 3
10 10
A No of Cups of Cups of
MRS A MRS = slope of IC
Cups Bundle Increase in Cups
of coffee 9 pizzas coffee per
number of
coffee
(6) = of coffee 9
per week week forgone
per week (1) pizzas
per week MRS falls when moving
8 (2) (3)
(4)
(5)
(5)/(4) 8 down along the IC
MRS = 4 MRS = 4
7 4 A 1 9 - - 7 4 People are more willing to
B 2 5 1 4 4 trade away goods that they
6 C 3 3 1 2 2
6 have in abundance
1 B 1 B
5 D 4 2 1 1 1 5
4 2 MRS = 2 4 2 MRS = 2
1 C 1 C
3 3 Slope of IC tends to decrease
1 MRS = 1 1 MRS = 1
2 1D 2 1D
IC1 IC1 ICs are bowed inward
1 1
0 1 2 3 4 5 6 7 8 9 10 Pizzas per week 0 1 2 3 4 5 6 7 8 9 10 Pizzas per week

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Extreme Cases of Indifference Curves Extreme Cases of Indifference Curves
• Shape of an indifference curve

50,000 Left shoes
VND 6 – Reveals the consumer’s willingness to trade one good
bills for the other
4 10 • Perfect substitutes:
– Two goods with straight-line indifference curves
2 5 (constant MRS)
• Perfect complements:
– Two goods with right-angle indifference curves
1 2 3 5 10 Right shoes
100,000 VND bills
Perfect substitutes: 100,000 VND Perfect complements: left shoe and
and 50,000 VND bills: always right shoe. The {10 left shoes, 5 right
trade two 50,000 VND bills for one shoes} combination is just as good as
100,000 VND bill. the {5 left shoes, 5 right shoes} one.
26 26
5 6
Close substitutes & close complements:

Which one has a more bowed shape? 4.3. Optimization
Hamburgers Shoes
• Consumer optimization
– Buying the bundle that makes the consumer happiest,
given his income.
• The consumer’s optimal choices/Optimum:
– Represents the best bundle of the two goods that the
consumer can afford
– The point on the budget constraint that touches the
highest possible indifference curve
Hot dogs Socks
Indifference curves for Indifference curves

close substitutes are for close complements
not very bowed. are very bowed.
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7 8
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B. Changes in Income
A. Optimal bundle
• A change in income
Y
– Shifts the budget constraint outward/inward
• Russell prefers B to A but – Move on a different indifference curve
cannot afford B
• Russell can afford D and B
C, but A is on a higher
indifference curve  A is A
Optimal bundel
• Slope of indifference C
curve = Slope of budget D
constraint
MRS = PX/PY X
26 27
9 0
Increase in income: Normal goods Increase in income: Inferior vs. normal goods
initial optimum: A. Y Y
• An increase in income • Initial optimum: A

shifts the budget I2 • New optimum: B I1 I2
constraint outward.
I1 – More X
• If both goods are normal
B – Less Y
goods, Russell buys
A X is a normal good A B
more of each.
New optimum: B Y is an inferior good.
X and Y are normal goods.
X
X
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C. Change in price - overall C. Change in price – in details

The income and substitution effects – 1
Initial optimum: A. Y
PX decreases A decrease in the price of a good has two effects:
I1 I
• Budget constrains pivots 2
I/PY 1. Consumers tend to buy more cheaper goods and
outward
less of more expensive goods - Substitution effect
• New optimum: C
• Russell buys more X and A C 2. Since one of the goods is cheaper, the consumer
fewer Y enjoys an increase in real purchasing power –
Income effect
I/Px1 I/Px2
X
27
3
C. Change in price – in details C. Change in price – in details

The income and substitution effects – 1 The income and substitution effects – 2
A fall in the price of X has two effects on Russell’s optimal
consumption
● Substitution Effect: A change in consumption of a
good that is associated with a change in the price of
• Substitution effect
that good. The degree of benefit is constant. – A fall in PX makes X cheaper relative to Y: Russell buys
more X and fewer Y
● Income effect: The change in consumption of a
good that is brought about by an increase in • Income effect
purchasing power, with the relative prices of the – A fall in PX boosts the purchasing power of Russell’s
goods remaining the same. income: buy more X and more Y (if X is a normal good,
Y is a normal good)
Total Effect (TE) = Substitution Effect (SE) + Income Effect (IE)  Russell buys more X
The net effect on Y is ambiguous. However, for simplicity,
we skip studying about consumption of Y.
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C. Change in price – in details The income and substitution effects – X is a normal good
The income and substitution effects – 3
A fall in the price of X has two effects on Russell’s optimal • Initial optimum: A. Y
consumption PX falls.
• Substitution effect I1 I2
• Substitution effect: from A
– A fall in PX makes X cheaper relative to Y: Russell buys to B, buy more X I/PY
more X
• Income effect: from B to C,
• Income effect
buy more X A C
– A fall in PX boosts the purchasing power of Russell’s
income: buy less X (if X is inferior good)
Overall:
B
– SE and IE have reverse direction When X is a normal good, SE
• In case income effect < substitution effect: Russell buys more and IE have the same SE IE
X, his D curve is downward. direction. Consumers buy XA XB XC I/PX1 I/PX2
• In case income effect > substitution effect: Russell buys fewer more X X
Total effect
X; X is a Giffen good (his D curve is upward).
27 27
7 8
The income and substitution effects – X is an inferior good The income and substitution effects – X is a Giffen good
• Initial optimum: A. • Initial optimum: A.

Y Y
PX falls.
PX falls.
• Substitution effect: from A to I1 I2 • Substitution effect: from A to
B, buy more X and fewer Y I1
B, buy more X I/PY I/PY I2
• Income effect: buy less X C
• Income effect: buy less X
C • income effect > substitution
• income effect < substitution A effect  Overall: buy less X A
effect  Overall: buy more X B B
In conclusion:
In conclusion:
IE When X is an inferior good, SE IE
When X is an inferior good, SE SE and IE have reverse direction. SE
and IE have reverse direction. If XA XC XB I/PX1 I/PX2 If IE > SE, consumers buy less XC XA XB I/PX1 I/PX2
IE < SE, consumers buy more X X X
Total effect X  X is a Giffen good Total effect
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D. Deriving the Demand Curve D. Deriving the Demand Curve – normal goods
and inferior goods (not including Giffen goods)
• The demand curve Y
– Shows the quantity demanded of a good for any given I1 I2
1,200
price
A
• When Px = $10, QDX = 100
– Reflects the consumption decisions C
• When PX = $6, QDX = 250
– Is a summary of the optimal decisions that arise from
the budget constraint and indifference curves
100 250 300 500 X
PX
B1
$10
B2
$6
DX
100 250 QDX
28 28
1 2
Deriving the Demand Curve – Giffen goods SUMMARY
Y • Consumer’s budget constraint: possible combinations of different

1,200 C goods she can buy given her income and the prices of the goods.
I2
• When Px = $10, QDX = 100 • The slope of the budget constraint equals the relative price of the
A goods.
I1 • When PX = $6, QDX = 90
• Consumer’s indifference curves represent her preferences. An
indifference curve: various bundles of goods that make the
90 100 300 500 X consumer equally happy. (Higher indifference curves are
PX
DX preferred.)
• The slope of an indifference curve at any point = marginal rate of
$10 B1 substitution (rate at which the consumer is willing to trade one
$6 B2 good for the other).
90 100 QDX
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SUMMARY
• The consumer optimizes by choosing the point on her budget

constraint that lies on the highest indifference curve.
– At this point, slope of the indifference curve (MRS) = slope of the
budget constraint (relative price of the goods).
• The substitution effect of a drop in price is the change in
consumption that arises because a price change encourages
greater consumption of the good that has become relatively
cheaper. Is reflected by a movement along an indifference curve CHAPTER
to a point with a different slope.
• The income effect of a drop in price is the change in consumption
Firm behavior and the
that arises because a lower price makes the consumer better off.
It is reflected in the movement from a lower to a higher
indifference curve.
5 organization of industry
• The theory of consumer choice can be applied in many situations. V. Andreea Chiritescu
28
286
5
Reading materials Purpose
Chapter 13, 14, 15, 16, 17. Mankiw, N.G (2020),

Address the costs of production and develop
the firm’s cost curves, which underlie the firm’s
Principles of Economics, 9th Edition, Cengage
supply curve.
Learning.
Examine the behavior of firms in different
kinds of markets:
• Competitive markets where firms do not have
market power large number
• Monopoly with sole firm only one firm
• Monopolistic competition - a market structure in
which many firms sell products that are similar
but not identical
• Oligopoly - a market structure in which only a
287
few sellers offer similar or identical products 288
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Contents
1. The costs of production
2. Firms in competitive markets
3. Monopoly
4. Monopolistic competition
5. Oligopoly
5.1 The Costs of Production

289
290
Learning objectives 5.1.1. What are costs?

By the end of this part, students should be • Assumption:
able to grasp: – The goal of a firm is to maximize profit
• What is a production function? What is • Profit = TR – TC
marginal product? How are they
• Total revenue, TR = P × Q
related?
• What are the various costs? How are – The amount a firm receives for the sale of
they related to each other and to output? its output
• How are costs different in the short run • Total cost, TC
vs. the long run? – The market value of the inputs a firm uses
• What are “economies of scale”? in production
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EXAMPLE 1A: Mary’s milk tea shop Explicit and Implicit costs
Mary owns a small milk tea shop. She can • “The cost of something is what you give up to
make 15,000 cups of milk tea a year, and sell
get it.”
them at $5 each. If Mary’s total costs are
$65,000 a year, how much profit the shop – Explicit costs chi phí hiện
OPPORTUNITY COST
brings in one year? • Input costs that require an outlay of money by the
firm (E.g.: paying wages to workers). Accounts keep
• Total revenue: TR = P × Q = $5 × 15,000 track of how much money flows into and out of the
firm.
= $75,000
– Implicit costs chi phí ẩn
• Profit = TR – TC = $75,000 – $65,000
• Input costs that do not require an outlay of money by
= $10,000 the firm (E.g.: opportunity cost of the owner’s time)
• Total cost = Explicit + Implicit costs
293 294
EXAMPLE 1B: Costs for Mary’s milk tea shop EXAMPLE 1C: The cost of capital for Mary’s
Mary owns a small milk tea shop on campus. Mary Mary invested $80,000 in the factory and equipment
pays $20,000 a year for raw materials, and $12,000 to start the business last year: $30,000 from savings
in rent. Mary can work at the local coffee shop for and borrowed $50,000 (interest 10% for saving and
$25,000 a year. Identify and calculate the explicit borrowing). Identify and calculate the explicit and
and implicit costs. implicit costs.
• Explicit cost: the interest Mary has to pay every
year: the 10% interest on the borrowed money =
• Explicit costs: raw materials and rent
0.10 × 50,000 = $5,000
= $20,000 + $12,000 = $32,000
• Implicit cost: the interest Mary could have earned
• Implicit cost: opportunity cost of the owner’s time if savings were saved not spent: the 10% on
= $25,000 $30,000 = 0.10 × 30,000 = $3,000
• Total costs = $32,000 + $25,000 = $57,000 The opportunity cost of capital = $8,000 per year
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Economic Profit vs. Accounting Profit EXAMPLE 1D: Profit for Mary’s milk tea shop
• Accounting profit Mary owns a small milk tea shop on campus.

She can make 15,000 cups of milk tea a year,
– Total revenue minus total explicit costs
and sell them at $5 each.
• Economic profit Mary pays $20,000 a year for raw materials,
– Total revenue minus total costs (explicit and $12,000 in rent. Mary can work at the local
and implicit costs) coffee shop for $25,000 a year.
• Accounting profit ignores implicit costs, Mary invested $80,000 in the factory and
so it’s higher than economic profit. equipment to start the business last year:
Accounting profit = TR-EC $30,000 from savings and borrowed $50,000
(interest 10% for saving and borrowing).
Economic profit=TR-EC-IC Q: Calculate accounting and economic profit.
==> Economic profit = Accounting profit - IC 297 298
EXAMPLE 1D: Solutions 5.1.2. Production and Costs

• Total revenue TR = $5 × 15,000 = $75,000
• Assumption:
• Explicit costs = raw materials + rent + interest
paid = $20,000 + $12,000 + $5,000 = $37,000 – Production in the short run
• Implicit costs = alternative job + forgone interest – Factory size is fixed
= $25,000 + $3,000 = $28,000 – To increase production: hire more workers
• Accounting profit = TR – explicit costs
= $75,000 – $37,000 = $38,000
• Economic profit = TR – (explicit + implicit costs)
= $75,000 – ($37,000 + $28,000) = $10,000
= Accounting profit – implicit cost
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Production function Production function

• Jonhny has a popcorn truck (fixed resource) • Reflects the Q
that he takes to fairs and sporting events. relationship between 100
the quantity of inputs 90

• He can hire as many workers as he wants
Quantity of Output
(workers) and quantity 75
– The quantity of output produced varies of output
with the number of workers L Q 55
workers buckets
– If Jonhny hires only 1 worker, his truck will 0 0 30
produce 30 buckets of popcorn per day 1 30
– If Jonhny hires 5 workers, his truck will 2 55
produce 100 buckets of popcorn per day 3 75
0 1 2 3 4 5 L
Number of workers
4 90
301 302
5 100
Marginal Product EXAMPLE 2A: Jonhny’s total and marginal product
• Marginal product L Q MPL

workers buckets buckets
– Increase in output that arises from an
0 0
additional unit of input (Other inputs ∆L = 1
constant) 1 30 ∆Q = 30 30
∆L = 1
2 55 ∆Q = 25 25
– Slope of the production function ∆L = 1
3 75 ∆Q = 20 20
• Marginal product of labor, MPL = ∆Q / ∆L ∆L = 1
4 90 ∆Q = 15 15
– If Jonhny hires one more worker, his ∆L = 1
5 100 ∆Q = 10 10
output rises by the marginal product of
labor.
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Diminishing MPL Active Learning 3: Diminishing MPL
• Diminishing marginal product A. What is the marginal

Number product of the second
– Marginal product of an input declines as the of Output MPL worker?
quantity of the input increases workers 40
– MPL is the slope of the production function 0 0 B. What is the marginal
Production function gets flatter as more inputs 1 45 product of the fourth
45 worker?
are being used 2 85 40 20
• Why MPL is important? 3 115 30 C. Does this production
– “Rational people think at the margin” 4 135 20 function exhibits
diminishing marginal
– Decide to hire an extra worker by comparing 5 145 10 returns?
output rises by MPL and the costs rise by the Yes
wage paid
305 306
Relationship between production & cost EXAMPLE 2B: Jonhny’s production and cost
• Jonhny must pay $200 per day for the truck,
regardless of how much popcorn he L Q Cost of Cost Total
produces workers buckets the truck of labor Cost
• The market wage for popcorn makers is $50 0 0 $200 $0 $200

per day 1 30 $200 $50 $250
2 55 $200 $100 $300
• So, Jonhny’s costs are related to how much
popcorn the truck produces 3 75 $200 $150 $350
4 90 $200 $200 $400
5 100 $200 $250 $450
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Total cost curve 5.1.3. The Various Measures of Cost

Total Cost
Q Total
buckets Cost
$500
• Total cost, TC = FC + VC
450
0 $200 400 – Total cost of producing a given amount of
30 $250
350 output
300
55 $300 250 • Fixed costs, FC
200
75 $350 – Do not vary with the quantity of output
90 $400 produced
100 $450 – Incur even if production is zero
0 30 55 75 90 100 Q
Quantity of Output • Variable costs, VC
Total cost gets steeper as the amount produced rises because of
diminishing marginal product: producing one additional unit of output – Vary with the quantity of output produced
requires more and more additional units of inputs, so the cost increases
309 310
sharply.
Average and Marginal Cost EXAMPLE 3A: Anna’s knitted scarves business
Q FC VC TC Anna loves to knit
• Average fixed cost, AFC = FC / Q
0 18 0 18 scarves:
• Average variable cost, AVC = VC / Q 1 18 15 33
• Anna paid $18 for
• Average total cost, 2 18 25 43
two pairs of knitting
3 18 30 48
ATC = TC / Q = AFC + AVC needles
4 18 32 50
– The cost of the typical unit produced 54
• To produce more
5 18 36
– Total cost divided by the quantity of output 62
scarves, Anna
6 18 44
76
needs more yarn
• Marginal cost, MC = ΔTC / ΔQ 7 18 58
96
and more workers
8 18 78
– The increase in total cost that arises from an
9 18 104 122
extra unit of production
10 18 136 154
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FC, VC, and TC curves EXAMPLE 3B: Anna’s average and marginal cost
Q FC VC TC Cost Q FC VC TC AFC AVC ATC MC
$160
0 18 0 18 0 $18 $0 $18 - - -
TC
1 18 15 33 120 1 18 15 33 $18.0 $15.0 $33.0 $15.0
2 18 25 43 VC 2 18 25 43 9.0 12.5 21.5 10.0
80
3 18 30 48 3 18 30 48 6.0 10.0 16.0 5.0
4 18 32 50 40 4 18 32 50 4.5 8.0 12.5 2.0
5 18 36 54 FC 5 18 36 54 3.6 7.2 10.8 4.0
6 18 44 62 0 6 18 44 62 3.0 7.3 10.3 8.0
0 2 4 6 8 10 Q
7 18 58 76 Quantity of output 7 18 58 76 2.6 8.3 10.9 14.0
8 18 78 96 8 18 78 96 2.3 9.8 12.0 20.0
The TC and VC curves are parallel
9 18 104 122 9 18 104 122 2.0 11.6 13.6 26.0
The FC curve is a horizontal line
10 18 136 154 10 18 136 154 1.8 13.6 15.4 32.0
313 314
AFC curve AVC and ATC curves

Costs
Q FC AFC Q VC TC AVC ATC Costs
$ 35.0
0 $0 $18 - - $ 35.0
0 18 - Efficient scale:
30.0
1 18 18.0 1 15 33 15.0 33.0 30.0 quantity that
2 18 9.0 25.0 2 25 43 12.5 21.5
25.0
minimizes ATC
3 18 6.0 3 30 48 10.0 16.0
20.0 20.0 ATC
4 18 4.5 4 32 50 8.0 12.5
5 18 3.6 15.0 5 36 54 7.2 10.8 15.0
6 18 3.0 6 44 62 7.3 10.3 10.0 AVC

10.0
7 18 2.6 7 58 76 8.3 10.9
5.0 AFC 5.0
8 18 2.3 8 78 96 9.8 12.0
9 104 122 11.6 13.6 0.0
9 18 2.0 0.0
0 2 4 6 8 10 Q
0 2 4 6 8 10 Q 10 136 154 13.6 15.4 Quantity of output
10 18 1.8 Quantity of output
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Marginal cost curve Cost curves

Q TC MC Costs
$ 35.0
0 $18 Costs MC
1 33 $15.0 $ 35 30.0
2 43 10.0 30 MC
25.0
3 48 5.0 25
4 20.0
50 2.0 20 ATC
5 54 4.0 15 15.0
6 62 8.0 AVC
10 10.0
7 76 14.0
5
8 96 20.0 5.0
0 AFC
9 122 26.0 0 2 4 6 8 10 Q 0.0
10 154 32.0 Quantity of output 0 2 4 6 8 10 Q
Quantity of output
317 318
ATC and MC curves 5.1.4. Costs in the Short Run & Long Run
Costs
$ 35.0 • When MC < ATC, • Short run, SR:
MC ATC is falling.
30.0 – At least one input is fixed (e.g., factories, land)
– The costs of these inputs are FC
25.0
• When MC > ATC, • Long run, LR:
20.0
ATC ATC is rising. – All inputs are variable (e.g., firms can expand
15.0 the size of factories, build more factories or sell
existing ones)
10.0 • The MC curve – FC = 0
A
crosses the ATC
5.0 • How long does it take a firm to get to the
curve at the ATC
0.0
curve’s minimum. long run?
0 2 4 6 8 10 Q
Quantity of output
– It depends on the firm.
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Relationship between Relationship between

short run vs. long run average cost short run vs. long run average cost
• All the short-run curves lie on or above the long-run
• Long run, LR:
curve. In other words, the long-run average cost curve
– Firms have greater flexibility in choosing to use
(LAC) is found to be the “envelope” of the SATCs
the most efficient mix of inputs to produce the
• LTC ≤ STC, LAC ≤ SAC (at each Q)
same quantity as in the short run.
– ATC at any Q does not exceed that in the short AC SAC1
SAC2 SAC4 LAC
run SAC3
Q
321
322
Economies and diseconomies of scale SUMMARY

(1) Economies of • The goal of firms is to maximize profit, which
scale: LATC falls ATC equals total revenue minus total cost.
as Q increases. • When analyzing a firm’s behavior, it is important to
(2) Constant returns LRATC include all the opportunity costs of production.
to scale: LATC – Explicit: wages a firm pays its workers
(1) (3)
stays the same as (2) – Implicit: wages the firm owner gives up by
Q increases.
working at the firm rather than taking another
(3) Diseconomies of job
scale: LATC rises
Q • Economic profit takes both explicit and implicit
as Q increases.
(Q1) (Q2) costs into account, whereas accounting profit
considers only explicit costs.
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SUMMARY SUMMARY
• A firm’s costs reflect its production process. • Average total cost is total cost divided by the
– Diminishing marginal product: production quantity of output.
function gets flatter as Q of an input increases • Marginal cost is the amount by which total cost
– Total-cost curve gets steeper as the quantity rises if output increases by 1 unit.
produced rises. • Graph average total cost and marginal cost.
• Firm’s total costs = fixed costs + variable costs. – Average total cost first falls as output increases
– Fixed costs: do not change when the firm alters and then rises as output increases further.
the quantity of output produced. – The MC curve always crosses the ATC curve at
– Variable costs: change when the firm alters the the minimum of ATC
quantity of output produced.
325 326
SUMMARY
• A firm’s costs often depend on the time horizon
considered.
– Many costs are fixed in the short run but
variable in the long run.
– In long run:
• Firms have greater flexibility in choosing to use the
most efficient mix of inputs to produce the same
quantity as in the short run.
• Firms may have to face: economies of scale,
constant returns to scale and diseconomies of scales.
5.2 Firms in competitive markets

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Learning objectives 5.2.1. What is a Competitive Market?

Characteristics of perfectly
By the end of this part, students should be able to
competitive markets
understand:
1. Market with many/numerous A competitive firm:
• What is a perfectly competitive market? buyers and sellers -is a price-taker
• What is marginal revenue? How is it related – Each firm does not need to -can sell as much as it
to total and average revenue? reduce its price in order to sell wants at the market
a larger quantity (*) price.
• How does a competitive firm determine the -faces a perfectly elastic
2. Trading identical products
quantity that maximizes profits? – If a firm raises its price above demand
• When might a competitive firm shut down in the market price, demand for
the short run? its product falls to zero (**)
3. Firms can freely enter or exit
the market
329
5.2.1. What is a Competitive Market? The Revenue of a Competitive Firm
Market Firm • Total revenue, TR = P ˣ Q

• Average revenue, AR = TR / Q
P S P
– How much revenue does the firm receive for
Eo Po A B C d curve one unit produced
P0
• Marginal revenue, MR = ∆TR / ∆Q
D – Change in TR from an additional unit sold
Q 0 q
Q0 q1 q2 q3 – How much additional revenue does the firm
receive if it increases production by 1 unit
• For competitive firms: AR = P = MR
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EXAMPLE 4: Linda's apple farm: revenue 5.2.2. Profit Maximization

Linda's apple farm can Q P TR AR MR • Goal of a firm: maximize profit = TR – TC
produce up to 10 0 $20 $0 $20
• TR = P × Q and TC = FC + VC
bushels of apples per 1 20 20 20 $20
year, and the current 2 20 40 20 20
• What Q maximizes a firm’s profit?
market price is $20 – Think at the margin: if Q increases by one unit,
3 20 60 20 20
per bushel. revenue rises by MR and cost rises by MC
4 20 80 20 20
• Calculate Linda’s
apple orchard’s total 5 20 100 20 20 • Comparing MC with MR
revenue, average 6 20 120 20 20 – If MR > MC: increasing Q will raise profit
revenue, and 7 20 140 20 20 – If MR < MC: increasing Q will cause a loss of profit
marginal revenue 8 20 160 20 20 – MR = MC: Profit is maximized
9 20 180 20 20
10 20 200 20 20
333 334
EXAMPLE 5: Linda’s apple farm: profit MC and the firm’s supply decision – 1
Δ Profit If the market price
If MR > MC, Q TR TC Profit MR MC = MR - MC Rule: MR = MC at the
increasing Q -6
is P1 = MR1 profit-maximizing Q.
0 $0 $6
raises profit. 1 20 14 6 $20 8 12
At Qa, MC < MR. Costs
2 40 24 16 20 10 10 So, increase Q
MC
3 60 36 24 20 12 8
to raise profit.
MR = MC:
profit is 4 80 50 30 20 14 6 At Qb, MC > MR.
maximized 5 100 66 34 20 16 4 So, reduce Q
6 120 85 35 20 19 2 to raise profit. P1 MR1
7 140 105 35 20 20 0
If MR < MC, 8 160 126 34 20 22 -2
At Q1, MC = MR.
increasing Q 9 180 150 30 20 24 -4 Changing Q
decreases 10 200 176 26 20 -6
would lower profit. Q
26 Qa Q1 Qb
profit.
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MC and the firm’s supply decision – 2 Shutdown or Exit?
If price rises to P2, the MC curve is the • Shutdown:

then the profit- firm’s supply curve. – A short-run decision not to produce anything
Costs
maximizing quantity because of market conditions.
MC
rises to Q2. – Q = 0 in the short run
P2 MR2
The MC curve • Exit:
determines the – A long-run decision to leave the market.
firm’s Q at any price. P1 MR1
• A key difference:
Hence, the MC curve – If shut down in SR, must still pay FC.
is the firm’s supply – If exit in LR, zero costs.
curve Q
Q1 Q2
337 338
Sunk Costs Short-run Decision to Shut Down - 1

• Sunk cost • Q = 0: Loss = FC
– A cost that has already been committed and • Continue to produce if the loss decreases:
cannot be recovered Loss ≤ FC
– Should be ignored when making decisions - (TR – TC) ≤ FC
– You must pay them regardless of your choice TR ≥ TC – FC
– In the short run, FC are sunk costs TR ≥ VC
• So, FC should not matter in the decision to shut • Shut down (Produce Q = 0 in the short run) if
down
TR < VC
P x Q < AVC x Q
or P < AVC
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Short-run Decision to Shut Down – 2

Another way to explain
 Should a firm shut-down in the short run?
• Cost of shutting down
= revenue loss = TR
• Benefit of shutting down
= cost savings = VC
(because the firm must still pay FC)
 Shut down (Produce Q = 0 in the short run)
• If TR < VC, or P < AVC
341 342
A competitive firm’s short run supply curve A firm’s Long-Run Decision

Costs
• Should a firm exit in the long run?
MC
• Cost of exiting market = revenue loss = TR
If P > AVC, then the
• Benefit of exiting market = cost savings = TC
firm produces Q ATC (remember, FC = 0 in long run)
where P = MC.
AVC • Firm’s long-run decision
If P < AVC, then firm – Exit the market if: TR < TC
shuts down (produces (same as: P < ATC)
Q = 0). Q
The firm’s short run supply curve is the portion of its

MC curve above AVC.
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SUMMARY
• A competitive firm is a price - taker
– Its revenue is proportional to the amount of
output it produces.
– P = MR = AR
– The firm’s marginal-cost curve above AVC is its
supply curve in the short run
• Short run: a firm cannot recover its FC
– Shut down temporarily if P < AVC
• Long run: the firm can recover both FC and VC
5.3 Monopoly
– Exit if P < ATC Interactive PowerPoint Slides by:

345
346
Learning objectives 5.3.1. Why Monopolies Arise

By the end of this part, students should be able to • Monopoly
understand: – A firm that is the sole seller of a product without
Why do monopolies arise? close substitutes
Why is MR < P for a monopolist? – Has market power
How do monopolies choose their P and Q? • The ability to influence the market price of the product
it sells: “price maker”
– Arise due to barriers to entry
• Other firms cannot enter the market to compete with it
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Three Barriers to Entry – 1 Three Barriers to Entry – 2

1. Monopoly resources 2. Government regulation
– A single firm owns a key resource. – The government gives a single firm the
• e.g.: Single water provider in town; DeBeers - owns exclusive right to produce the good.
most of the world’s diamond mines • Patent and copyright laws
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Three Barriers to Entry – 3 EXAMPLE 6: Natural monopoly

3. The production process: natural monopoly You live in a small town where 1,000 homes
– A single firm can produce the entire market Q need electricity.
at lower cost than could several firms • ATC is lower if one firm services all 1,000 homes
– Arises when there are economies of scale over than if two firms each service 500 homes.
the relevant range of output Electricity
Cost
– Distribution of water, electricity, etc.
ATC slopes downward due
to huge FC and small MC
$80
$50 ATC
Q
500 1000
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Monopoly versus Competition Demand curves: competitive firm vs. monopoly

• Competitive firm P A competitive firm’s P A monopolist’s
– Price taker demand curve demand curve
– Small, one of many

P = MR
– Faces individual demand at P: perfectly elastic D
demand The market
• Monopoly firm demand curve D
– Price maker, market power Q Q
– Faces the entire market demand: downward The firm can increase To sell a larger Q, the
sloping demand Q without lowering P, firm must reduce P.
so MR = P for the Thus, MR ≠ P.
competitive firm.
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EXAMPLE 7: JJ’s MR and demand curves A Monopolist’s Revenue

Q P MR P, MR
$60
• Increasing Q has two effects on revenue:
0 $60
1 50 – Output effect: higher output raises revenue
55 55 Demand curve (P)
2 50 45 40 – Price effect: lower price reduces revenue
3 45 35 30
• Marginal revenue, MR < P
4 40 20
25 – To sell a larger Q, the monopolist must reduce
5 35 10
15 MR the price on all the units it sells
6 30 0
5 – MR is negative if price effect > output effect
-10
Q
7 25 -5 • e.g., when JJ’s increases Q from 6 to 7
8 20 -20
-15
9 15 -25 -30
0 1 2 3 4 5 6 7 8 9 10
10 10 -35
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5.3.2. Monopoly Profit Maximization Profit-maximization for a monopoly

• Produce Q where MR = MC Costs and
Revenue MC
• Sets the highest price consumers are willing to
pay for that quantity At this Q, find P on P
• Finds this price on the D curve the demand curve.
• P > MR = MC
• If P > ATC, the monopoly earns a profit The profit-maximizing D
Q is where MR = MC. MR
Q Quantity
Profit-maximizing output
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The monopolist’s profit A Monopoly Does Not Have a Supply Curve

Costs and • A competitive firm takes P as given
Revenue MC
– Has a supply curve that shows how its Q
As with a depends on P
P
competitive firm, ATC
the monopolist’s ATC • A monopoly firm is a “price-maker”
profit equals – Q does not depend on P
D
(P – ATC) x Q – Q and P are jointly determined by MC, MR, and
MR the demand curve
Q Quantity
– Hence, no supply curve for monopoly.
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CASE STUDY: Monopoly vs. Generic Drugs The Welfare Cost of Monopolies
The market for
Price • Competitive market equilibrium:
Patents on new a typical drug
– At P = MC and maximizes total surplus
drugs give a temporary
monopoly to the seller: PM • Monopoly equilibrium: at P > MR = MC
PM, QM. – The monopoly Q is lower than competitive
PC = MC market equilibrium Q Market is not efficient
D
 Monopoly results in a deadweight loss
When the patent
MR
expires, the market
becomes competitive, QM QC
generics appear: PC, QC. Quantity
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Competition versus monopoly SUMMARY

Competition Monopoly • Monopoly: the sole seller in its market.
Similarities
• Monopoly arises when:
Goal of firms Maximize profits Maximize profits
Rule for maximizing MR = MC MR = MC – A single firm owns a key resource
Can earn economic profits in SR? Yes Yes – The government gives a firm the exclusive
Differences right to produce a good
Number of firms Many One
– A single firm can supply the entire market at a
Marginal revenue MR = P MR < P
Price P = MC P > MC
lower cost than many firms could.
Produces welfare-maximizing Yes No • Monopoly faces a downward-sloping demand
level of output? curve for its product: MR < P
Entry in the LR? Yes No
Can earn economic profits in LR? No Yes
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SUMMARY
• Monopoly maximizes profit
– Produce Q where MR = MC, but Q is not
efficient
– For this Q, the price is on the demand curve.
– So P > MR = MC
– A monopoly does not have a supply curve
– Causes deadweight loss
5.4 Monopolistic competition

365
366
Learning objectives 5.4.1. Between monopoly and perfect competition
By the end of this part, students should be able to • Two extreme forms of market structures:
understand: • Perfect competition: many firms, identical
products, price takers, P = MC
• What market structures lie between perfect
competition and monopoly, and what are their • Monopoly: one firm, price maker, P > MC
characteristics? • Imperfect competition – in between the
• How do monopolistically competitive firms extremes:
choose price and quantity? Do they earn • Monopolistic competition: many firms sell
economic profit? similar but not identical products
• Oligopoly: only a few sellers offer similar or
identical products.
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The four types of market structure Monopolistic Competition

Number of firms? • Characteristics:
Many firms – Many sellers: competing over customers
One
firm
– Product differentiation
Type of products? • Not price takers; downward sloping D curve
Identical • Location is a critical product differentiation

Differentiated
Few products products – Free entry and exit
firms • Zero economic profit in the long run
Monopolistic Perfect
Monopoly Oligopoly Competition Competition • Examples:
– Books, computer games, restaurants, piano
Tap water Tennis balls Movies Wheat lessons, cookies, clothing
Cable TV Cigarettes Restaurants Milk
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Comparisons 5.3.2. Competition with differentiated products

Perfect Monopolistic Monopoly A. The Short Run Equilibrium
competition competition
Number of Many Many One • Profit maximization in the short-run for the
sellers
monopolistically competitive firm:
Free entry/exit Yes Yes No
LR economic Zero Zero Positive
– Produce the quantity where MR = MC
profit – Price: on the demand curve
Products firm Identical Differentiated No close – If P > ATC: profit
sells substitute
Market power? None Yes Yes – If P < ATC: loss
D curve facing Horizontal Downward- Downward- – Similar to monopoly
firm sloping sloping
(market D)
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EXAMPLE 8: Short-run equilibrium EXAMPLE 8: Short-run equilibrium

The firm faces a
Identify the firm’s
downward-sloping
D curve. Price profit or loss. Price
profit MC MC
At each Q, MR < P. For this firm,
ATC losses ATC
P P < ATC
Identify the firm’s profit at the output where ATC
or loss. ATC
D MR = MC. P
To maximize profit, firm
produces Q where The best this firm can D
MR do is to minimize its
MR = MC. MR
Q losses. Q Quantity
The firm uses the Quantity
D curve to set P.
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B. The Long-Run Equilibrium Long-run equilibrium

• If monopolistically competitive firms are Entry and exit
making profit in short run occurs until: Price
– New firms: incentive to enter the market MC
P = ATC and
• Increase number of products ATC
profit = zero.
– Reduces demand faced by each firm P = ATC
• Demand curve shifts left; prices fall Notice that the firm
– Each firm’s profit declines to zero charges a markup markup
• If losses in the short run: of price over D
marginal cost and MC MR
– Some firms exit the market, remaining firms
enjoy higher demand and prices does not produce at Q Quantity
minimum ATC.
– D curve shifts left, prices rise
– Each firm’s profit increases to zero
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C. Monopolistic vs. Perfect Competition Monopolistic vs. Perfect Competition

• Monopolistic competition
• Excess capacity: quantity is not at minimum
ATC (it is on the downward-sloping portion
of ATC)
• Markup over marginal cost: P > MC
• Perfect competition
• Quantity: at minimum ATC (efficient scale)
• P = MC
Market quantity < Socially efficient quantity

Inefficiency Efficiency
377 378
SUMMARY
• Monopolistically competitive market: many firms,
differentiated products, and free entry and exit.
• LR equilibrium
– Each firm has excess capacity (Q is on the
downward-sloping portion of the ATC curve)
– Each firm charges a price above marginal cost.
 Inefficiencies
• Product differentiation:
– Through actual physical differences, advertising
(or branding), and location.
5.5 Oligopoly
– Location is a critical product differentiation Interactive PowerPoint Slides by:

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Learning objectives Review: the four types of market structure
By the end of this part, students should be able to Number of firms?

grasp: Many firms
One
• What outcomes are possible under oligopoly? firm Type of products?
• Why is it difficult for oligopoly firms to
cooperate? Identical
Differentiated products
• How we can use game theory to analyze the Few products
economics of cooperation? firms
Monopolistic Perfect
Monopoly Oligopoly Competition Competition
Tap water Tennis balls Movies Wheat

Cable TV Cigarettes Restaurants Milk
381 382
5.5.1. Markets with Only a Few Sellers The Equilibrium for an Oligopoly
• Characteristics: • When firms in an oligopoly individually
– Market structure in which only a few sellers choose production to maximize profit
offer similar or identical products – Produce Q at which MR = MC: greater than
• Strategic behavior in oligopoly: monopoly Q, less than competitive Q
“Interdependence among firms” – The price: is less than the monopoly P, greater
– A firm’s decisions about P or Q can affect other than the competitive P = MC
firms and cause them to react
– The firm will consider these reactions when
making decisions
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The Size of an Oligopoly 5.5.2. The Economics of Cooperation

• As the number of sellers in an oligopoly A. The prisoners’ dilemma
increases: – Particular “game” between two captured
– The oligopoly looks more and more like a prisoners
competitive market – Illustrates why cooperation is difficult to
– The price approaches marginal cost maintain even when it is mutually beneficial
– The market quantity approaches the socially
efficient quantity
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EXAMPLE 9: The prisoners’ dilemma – 1 EXAMPLE 9: The prisoners’ dilemma – 2

The police have caught Bonnie and Clyde, two Confessing is the dominant strategy for both players.
suspected bank robbers, but only have enough Bonnie’s decision
evidence to imprison each for 1 year. Nash equilibrium:
both confess Confess Remain silent
• The police question each in separate rooms, offer
each the following deal: Bonnie gets Bonnie gets
8 years 20 years
– If you confess and implicate your partner, Confess
you go free. Clyde Clyde
Clyde’s gets 8 years goes free
– If you do not confess but your partner implicates decision Bonnie goes Bonnie gets
you, you get 20 years in prison. free 1 year
Remain
– If you both confess, each gets 8 years in prison. silent Clyde Clyde
gets 20 years gets 1 year
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EXAMPLE 9: The prisoners’ dilemma – 3 B. Oligopolies as a Prisoners’ Dilemma

• Outcome of the game: Bonnie and Clyde both • When oligopolies form a cartel
confess, each gets 8 years in prison. – Hoping to reach the monopoly outcome, they
– Both would have been better off if both become players in a prisoners’ dilemma
remained silent. – The monopoly outcome is jointly rational, but
– But even if Bonnie and Clyde had agreed each firm has an incentive to cheat: self-interest
before being caught to remain silent, the logic of makes it hard to maintain the cooperative
self-interest takes over and leads them to outcome with low production, high prices, and
confess. monopoly profits
• Why People Sometimes Cooperate
– When the game is repeated many times,
cooperation may be possible
389 390
SUMMARY SUMMARY
• Oligopolists maximize their total profits by • The prisoners’ dilemma shows that self-interest
forming a cartel and acting like a monopolist. can prevent people from maintaining
– Yet, if oligopolists make decisions about cooperation, even when cooperation is in their
production levels individually, the result is a mutual interest. However, when the game is
greater quantity and a lower price than under repeated many times, cooperation may be
the monopoly outcome. possible
– The larger the number of firms in the
oligopoly, the closer the quantity and price will
be to the levels that would prevail under
perfect competition.
391 392

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14/09/2022

Tran Thi Thanh Huyen (Dr.) CHAPTER

Reading materials Purpose

Learning objectives Contents

Resources are scarce

Interactive PowerPoint Slides by:

Economists study: a. How People Make Decisions

Principle 1: People Face Trade-Offs EXAMPLE 1A: Society faces trade-offs

Equality vs. Equity Principle 2: The Cost of Something

EXAMPLE 2: Opportunity cost EXAMPLE 2: Opportunity cost

EXAMPLE 3: Incentives EXAMPLE 3: Incentives

Principle 5: Trade can make everyone better off.

What would our lives be like if we had to make our own

Principle 7: Governments Can Sometimes Principle 7: Governments Can Sometimes

Principle 7: Governments Can Sometimes

1.2. Thinking like an economist

a. The Economist as a Scientist a. The Economist as a Scientist

The Circular-Flow Diagram The circular flow – 1

The circular flow – 2 The circular flow – 3

The PPF EXAMPLE 4: The PPF

0 1,000 2,000 3,000 4,000 5,000 6,000

Why the PPF might be bowed outward – 2 Micro - and Macroeconomics

b. The Economist as Policy Adviser SUMMARY

Chapter 4, 5, 6. Mankiw, N.G (2020), Principles

Supply and demand

3. Supply, demand, and government policies

2.1 • What factors affect buyers’ demand for goods?

2.1. The market forces of

a. Markets and Competition b. Demand

• Demand schedule: Sofia’s demand Price Quantity

Demand Curve Shifters – 1 Demand Curve Shifters – 2

Changes in Number of Buyers EXAMPLE 1E: Demand curve shifts

Changes in Income Changes in Prices of Related Goods – 1

• Normal good, other things constant • Two goods are substitutes if

Changes in Prices of Related Goods – 2 Changes in Tastes

• Two goods are complements if • Tastes

A Movement along the Demand Curve A Shift in the Demand Curve

Shift vs. Movement Along the Demand Curve c. Supply

Supply Curve Shifters – 1 Supply Curve Shifters – 2

Changes in Input Prices EXAMPLE 2E: Changes in input prices

Changes in Technology Changes in Number of Sellers

Summary: variables that influence sellers d. Supply and demand together – 1

d. Supply and demand together – 2 Markets not in equilibrium: surplus – 1

Markets not in equilibrium: surplus – 2 Markets not in equilibrium: shortage – 1

Markets not in equilibrium: shortage – 2 Supply and Demand Together

EXAMPLE 3: The market for pizzas EXAMPLE 3A: A shift in demand

EXAMPLE 3B: A shift in supply EXAMPLE 3C: A shift in both S and D – 1

2.2.1. The Elasticity of Demand A. The Price Elasticity of Demand

The Variety of Demand Curves Perfectly inelastic demand

– Price elasticity of demand > 1 None

Inelastic demand Unit elastic demand

Elastic demand Perfectly elastic demand

The Variety of Demand Curves Calculating the Price Elasticity of Demand

Calculating the Price Elasticity of Demand Our scenario

Elasticity along a linear demand curve Determinants of price elasticity of demand - 1

Determinants of price elasticity of demand - 2 Determinants of price elasticity of demand - 3

Determinants of price elasticity of demand - 4 Price Elasticity and Total Revenue

Our scenario: Elastic demand Our scenario: Inelastic demand

increased P and Q  TR increased P and Q  TR