Principles of Micro Economics

Ten Pr i nci pl es of Economi cs

Scar ci t y the limited nature of societys resources. We an not produce all the goods and services people
wish to have.
Economi cs The study of how society manages its scarce resources. Resources are allocated through
the combined actions of millions of households and firms. Study of how people make decisions.
Pr i nci pl e 1: Peopl e Face Tr adeof f s The more a society spends on national defense (guns) the less
it can spend on consumer goods (butter) to raise the standard of living at home.
Ef f i ci ency The property of society getting the most it can from its scarce resources
Equal i t y Property of distributing economic prosperity uniformly among members of society.
Pr i nci pl e 2: The Cost of Somet hi ng I s What You Gi ve Up To Get I t
The Oppor t uni t y cost of an item is what you give up to get that item.
Pr i nci pl e 3: Rat i onal Peopl e Thi nk At The Mar gi n
Rat i onal Peopl e People systematically/purposefully do best they can to achieve objectives
Mar gi nal Changes Small Incremental adjustments to a plan of action.
Pr i nci pl e 4: People Respond to incentives
I ncent i ve Something that induces a person to act.
Pr i nci pl e 5: Tr ade ca make ever yone bet t er of f . Trade allows countries to specialize in what they
do best and enjoy a greater variety of goods and services.
Pr i nci pl e 6: Mar ket s ar e usual l y a good way t o or gani ze economi c act i vi t y.
Mar ket Economy An economy that allocates resources through the decentralized decisions of
many firms and households as they interact in markets for goods and services.
Pr i nci pe 7: Governments can Sometimes improve Market outcomes
Pr oper t y Ri ght s The ability of individual to own and exercise control over scarce resources.
Mar ket Fai l ur e situation in which a market left on its own fails to allocate resources efficiently
Ext er nal i t y The impact of one persons actions. (Pollution)
Mar ket Power The ability of a single economic actor or small group of actors to have a substantial
influence on market prices.
Pr i nci pl e 8: Count r y s st andar d of l i vi ng depends on abi l i t y t o make goods & ser vi ces.
Pr oduct i vi t y The quantity of goods and services produced from each unit of labor input.
Pr i nci pl e 9: Pr i ces Ri se When The Gover nment Pr i nt s Too Much money
I nf l at i on- An increase in the overall level of prices in the economy.
Pr i nci pl e 10: Soci et y Faces a shor t r un t r ade of f bet ween i nf l at i on and unempl oyment .
Increasing the amount of money in the economy stimulates the overall level of spending and thus the
demand for goods and services.
Higher demand may over time cause firms to raise their prices, but in the meantime, it also
encourages them to hire more workers and produce a larger quantity of goods and services.
More hiring means lower unemployment.



PPF and Economi c Gr owt h
One of the keys to economic growth is investment. Investment in physical and human capital is the key to
economic growth.
Oppor t uni t y Cost What you give up to get something
Opportunity cost of investing is the amount of goods you wont be consuming.
Total Spending = Total Income.
Firms are spending money to improve their firm in the future.
PPF and I ncr easi ng Oppor t uni t y Cost
Linear PPF
Assume we are producing two different types of pasta (spaghetti and manicotti) The PPF is linear because
the opportunity cost is the same at any point no matter which direction you are going.
Calculate opportunity cost mathematically by calculating the slope. Slope is the measure of opportunity cost
of producing more x. (x on the graph)
1/slope will tell you the measure of opportunity cost of producing more y (y on the graph)
What country has a lower opportunity cost of producing cloth? (Graphs of France and England) Englands
slope is a lot flatter and cloth is on the x axis. France has a lower opportunity cost of producing wine
because 1/slope is lower for France than England.
Non Linear PPF
Now Assume Resources are Specialized. Thus we will see a bowed out ppf with increasing opportunity
costs. At first opportunity cost is very small The opportunity cost of making one more car will take away
more and more computers.
If you want to look at the opportunity cost of
computers (what was originally on the y axis) the
ppf will virtually look the same (it will still be
bowed out with increasing opportunity cost)
Is it good to have specialized resources? It depends
where you are on the curve?
IF YOU ARE AT A POINT INSIDE THE CURVE, THE
OPPORTUNITY COST TO MOVING OUTSIDE THE CURVE
IS ZERO.
PPF and Gai ns f r om Tr ade
Absolute Advantage The ability of an individual form or country to pr oduce mor e of a good or service
than competitors who are using the same amount of resources. (resource could be time). The ability to
produce the same amount of a good using fewer inputs than another producer.
Comparative Advantage The ability of an individual, firm, or a country to produce a good or service at a lower
opportunity cost than its competitors.
You Your Nei ghbor
Apples Cherries Apples Cherries
Devot e Al l Ti e To Pi cki ng Appl es 20 l bs 0l bs 30 l bs 0l bs
Devot e Al l Ti me To pi cki ng Cher r i es 0 l bs 20 l bs 0 l bs 60 l bs
Neighbor has absolute advantage of picking both types of fruit.
Opportunity cost is constant (so find slope)
Look at cherries first. Neighbor has better opportunity cost of producing cherries. You have better
opportunity cost of producing apples.
Even if someone has the absolute advantage in both things, it might still be advantageous to trade. Decide
trade by looking at comparative advantage
Assume current production bundle you are at is 12 cherries and 8 apples. Neighbor says he can offer you
15 pounds of cherries if he gets 10 pounds of apples.
New Bundle Given 15 Cherries, you use all your energy for apples and make 20 apples, give
neighbor 10 apples. New Bundle is 15 cherries and 10 apples. 3 more cherries and 2 more apples.
(This is outside the ppf) Trade has made a bundle outside your ppf possible for you because you have
increased both goods.
Look from neighbors side: Current bundle is 42 cherries and 9 apples. With trade he produces 60
cherries, gives 15 away and ends up with 45 cherries and 10 apples He has 3 more cherries and one
more apple.
Can international trade transform a poor country to a rich country?
Law of Demand, Demand Cur ve (Buyer s Si de)
The thing holding all exchanges together is price. Price is key to market economy.

Objective Satisfaction/Utility
Alternative Various Goods and Services
Demands Determinate (its own price and other related goods prices, tastes of buyers, buyers income,
expectations and number of buyers.
Law of Demand There is a negative relationship between price and quantity demanded. Other things equal. As
the price of a good increases, the quantity demanded decreases.
Inferior Good Good for which the demand increases as income decreases (pasta, fast food)
Normal Good Good for which the demand increases as income increases (airline tickets)
Related Goods
Substitutes Goods and services that can be used for the same purpose. Coke and Pepsi. If the price of
coke rises than the demand for pepsi will increase
Complements Goods and services that are used together. (computers and software) if the price of
computers rise and the demand decreases, then the demand for software will also decrease.
EX: Price of Cds decreases. demanded increases. Demand for Cassette tapes decreases because they are
complementary goods.
Law of Suppl y, Suppl y Cur ve (Sel l er s Si de)
Demands Det er mi nant s own product price, price of substitutes in production, price of competitors,
expected pries in the future, number of firms, technology,
Const r ai nt s Price that a firm can charge is
constrained by the demand of the public. Production
Technology.
Law of Suppl y The quantity supplied of a good rises
when the price of a good rises.
Positive slope because cost is going to rise as you
produce more of an item. Tbe marginal cost of producing
another unit/good when you are producing a lot is going
to be more. Supply curve is going to reflect the cost.
When you move upward on the supply curve you see an
increase in marginal cost.
Market Supply Horizontally sum of the individual supply
curves.
Example: Suppose price of input price increases? What happens to S? S shifts inward because at each price
you are supplying less.
Example: What happens to supply if the predicted future price of the product increases? Supply curve would
shift left because suppliers would want to save up their products for the next period when prices increase.
Example: What happens if professional tax return prepares raise their price of their services they provide? It
wont effect the supply. It will increase the demand, which will in sense increase the quantity supplied.
Mar ket Equi l i br i um
Mar ket Equi l i br i um Equilibrium Price and Equilibrium Quantity.
Market driven economy. Orderly efficient exchange. But it doesnt make everyone happy.
Equi l i br i um simply a matter of equilibrium price matching desires on both sides of the market. The
quantity demanded = quantity supplied.
At Pe => Qd=Qs = EQUILIBRIUM!
At prices above equilibrium, desires dont match each other. Quantity supplied is larger than quantity demanded
and there is a surplus of goods.
At prices below equilibrium desires dont match each other. Quantity supplied is less than quantity demanded
and there is a shortage of goods.
Example
John Wilkes Booth Letter $31,050
Abraham Lincoln Letter - $21,850
Why is JWBs higher? There are less supply of JWBs letters so the price is going to be higher. ON the
demand side, Abraham Lincoln was a great president. A lot more people want a letter written by the
president so the demand is really high and there is a greater supply. For JWB even though demand is
lower, the supply is also lower so the price is higher.
Why does the supply curve have a positive slope even though the number of letters are finite? People
are more willing to supply the letter of the price gets higher.
Shi f t s i n Suppl y, Demand and A New Equi l i br i um
Three Step Method
Decide whether the event shifts the
supply, the demand or both.
Decide which direction the curve shifts
Use Supply/Demand diagram to see
how the shift changes equilibrium.
Example: What happens to Pe, Qe of Music
downloads if
Fall in Pe? Demand is going to
decrease because people can just buy
CDs (substitute) Equilibrium price and
quantity are going to decrease
Sellers of music downloads negotiate
with artists a reduction in the royalties
they must pay to each song they sell.
(Supply would shift to the right because
price of the input will decrease. So the
equilibrium price and quantity would
decrease)
Both events occur price will go down
but the quantity will be undetermined
because it goes down in one situation
and up in the other situation.



























Demand Decrease + Supply Increase = Price Down + Quantity ?
Demand Decrease + Supply Decrease = Price ? + Quantity Decrease
Demand Increase + Supply Increase = Price ? + Quantity Increase
Demand Increase + Supply Decrease = Price UP + Quantity ?
When Supply and Demand both shift, the direction of the change in equilibrium can confidently be predicted for
quantity or price but not both.

El ast i ci t y of Demand
Law of Demand Tells the direction of the quantity demanded as the price changes. (Negative Relationship)
Pr i ce El ast i ci t y of Demand measures the responsiveness of quantity demanded to changes in the price
of the product along a demand curve.
EX: Suppose cost of providing education has increased. The school would like to raise price, can we be
certain that a price increase will increase total revenue?
If we observe TR1 <TR0 D is inelastic between P0 and p1. Price effect wins. Therefore
E0 = | % !q / %! P| < 1
If we observe TR1 < TR0: D is elastic between Po and P1. The quantity effect wins therefore
E0 = | % !q / %! P| > 1
I f we observe TR1 = TR0 then demand is unit elastic between Po and P1. Price and quantity effects
cancel each other out.
E0 = | % !q / %! P| = 1
Calculating the percentage change for p,q
Standard Method: (End value start value) / Start Value x 100%
EX: Go From (200,12) to (250,8)
| 250-200 / 200| = 25% (Change in Price from A to B)
| 200-250/200|= 20% (Change in Price from B to A)
Not the same although same segment of line. Standard method is a problem for calculating elasticity
of whether price increase or price decreases, the responsiveness is the same change in quantity
demanded. To make increase and decreases symmetric, economists define the base as the midpoint.
Midpoint Method: (End value start value) / ((End value +Start Value) / 2) x 100%
El ast i ci t y = | % !q / %! P| = | (q1 q0) / ((q1+ q0)/2 | | (p1 p0) / ((p1+ p0)/2 |
Elasticity is closely related to the slope of the demand curve.
Polar Cases
Demand is vertical. Elasticity = zero. Perfectly Inelastic. Dream of firms. They can raise price and quantity
will not change. Example: Insulin. If you raise price, the dose you need is not going to change.
Demand is horizontal, Elasticity = Infinity. Slightest increase in price, demand is zero. Slightest decrease in
price demand is huge. Perfectly Elastic. Good with many other substitutes. This happens for an individual
firm in perfect competition.
Determinants of ED
Suppose that you have 2 goods and the price increases by 20% for both goods. Which of the following 2
goods would quantity demand fall by a greater amount and why. Two goods: Breakfast Cereal vs
Sunscreen.
Quantity of Breakfast cereal would fall more because there are more substitutes of breakfast cereal.
Determinant: ED is higher when close substitutes are available.
Blue jeans vs. Clothing
Quantity of Blue jeans would fall more because clothing is more general and it is a necessity.
Determinant: ED is higher for narrowly defined goods.
Insulin s. Caribbean Cruises
Quantity of cruises would decrease more because insulin is a necessity. There are other cheaper
vacations available. Determinant: ED is higher for luxuries.
Gasoline in Short Run vs. Gasoline in Long Run
Gasoline in the Long run is more elastic because in the short run people are stuck in their old habits
and in order to move away if price goes up enough, in the long run you will be able to substitute for
gasoline. Determinant: ED is higher on Long Run
Shor t Run A period of time short enough that at least one factor of production remains fixed and long
enough that at least one factor of production is variable.
Long Run A period of time long enough that the firm is able to vary all factors of production and firms can
enter and leave the industry.
Moment ar y Run The Period of time for which no factors are variable.
Fl uct uat i ons I n Oi l Pr i ces: Why are oil prices so unstable?
Steep demand curve (relatively inelastic) and you have relatively inelastic supply because oil is a natural
resource. It is finite. There are only a few suppliers.
OPEC: Cartel of oil producing countries that try to manipulate the price by supplying a certain quantity.
OPEC decides they are going to reduce quantity and supply is going to go up.
In the long run the supply and demand become more elastic because people are going to want to find
more oil or get oil from other people.
Pr i ce El ast i ci t y of Suppl y measures the responsiveness of quantity supplied to changes in price along a
supply curve.
Elasticity Supply = % !q / %! P
Case 1: If ES >1, supply is elastic between price because % !q > %! P. Quantity effect is greater.
Case 2: If ES =1, supply is unit elastic between prices.
Case 3: If ES<1, supply is inelastic between prices. (Gasoline from US refineries) % !q < %! P.
Case 4: Polar Case: ES=0. Vertical supply curve. Parking Lot, Auctioning one Painting,
Case 5: Polar Case ES=Infinitely Large: Horizontal Supply Curve. Constant Marginal Cost. Very rare.
Lemonade, Long Run Perfect Competition Market Supply.
Det er mi nant s of Es.
The amount of excess capacity. If you are at/near full capacity, Es is more inelastic. It is going to be harder
for you to churn out another unit.
Lemonade Vs. Brain Surgery: Determinant: Flexibility of Inputs. (PPF) The more specialized your resources
are the more inelastic your supply is going to be. It is very flexible to make lemonade because anyone can
make lemonade its not very hard to acquire materials. Brain surgery on the other hand is very inelastic
because not many people can just be brain surgeons.
Circus vs Broadway Determinant: mobility of Inputs. More mobility = more elastic. Circus acts go all around
the country. IF you are a Broadway show its only in New
York so elasticity of supply is more inelastic.
Gemstone makers Determinant: Availability to Produce
Substitute Inputs. As companies get better and better at
producing face diamonds, the more elastic diamonds will
become. Gemstone makers eventually will be able to
produce synthetic diamonds indistinguishable from real
ones.
Determinant: Time. Firms are better able to respond to
changing market conditions as time passes.
S1= Momentary Run S2= Short Run Supply S3= Long Run Supply
Non cl ear i ng Mar ket s: Quant i t y Compl ai nt
Market is not perfect. Not everyone is as well off as everyone else.
Ex: Meter on the street parking. There is always
a shortage. People complain there arent
enough spaces. (Quantity Complaint). The
markets arent clearing. You should not find
more spaces because that is not going to fix
the problem. Quantity demanded is greater
than quantity supplied so you should raise the
prices quantity demanded lowers. Local officials
want to keep the prices low because they want
to provide equal access to people for the
downtown area. Price might also be kept that
low because if the price is too large then you
might have incentive not to pay it at all. Supply
is inelastic because the opportunity cost of
urban land is really high. You end up with excess demand. Although having a low price sounds like a good
idea there are consequences where a lot of people are left empty handed.
Ex: baseball playoff tickets first come first serve. The price is below the equilibrium because the demand is
so high. (Doing a lottery)
Unf ai r Pr i ces (Ef f i ci ency vs. Equi t y) and
Pr i ce Cont r ol s
Markets are clear (Efficiency) but people
complain about the price (equity)
Everybody left of Qe exchange. So the right
side is shut out. The people that complain
are the people that cant afford it. Necessity
items (housing and food and medical care).
MC
MV
Metered Parking Spots
Floor
The government can force the price to be different but things will change pertaining to who is shut out.
In a price floor there is a surplus. (Minimum wage) there is going to be more workers wiling to work at the
minimum wage than at the actual equilibrium price so the supply of workers is going to be a lot more than
the demand.
In a price ceiling, there is a shortage. (Rent control) if you make a maximum price of rent on apartments in
NYC then there is going to be a huge demand for apartments in the city and not enough apartments.
WHEN GOVERNMENT IS INVOLVED YOU HAVE NO IDEA WHO YOU ARE HELPING AND WHO YOU ARE
HURTING BECAUSE ITS FIRST COME FIRST SERVE AND TOTES LUCK OF THE DRAW.
Price constraints arent perfect solutions. Organs, voting.
Taxes: Revenues t o Pr ovi de Subsi di es t o i ncr ease equi t y)
Taxes: Per Unit Tax. Parallel shift of
the supply and demand curve.
The government decides who they
are going to put the tax on but that
really doesnt matter. The market
decides who will receive the burden.
If demand is very inelastic then levy
tax on sellers. They receive a lot
worse of a burden.
If you levy the tax on the consumers
then the consumers are going to
have to pay a more for each unit they
buy. But it is the same result.
If both have the same elasticity then
the burden is equally shared.
Whether the tax is levied on the buyer or the seller, it is the MARKET who decides who truly bears the burden of
the tax. Doesnt matter who gets levied the tax, it just matters the size of the tax. If the tax is levied on the seller
their supply curve shifts left which causes the demand goes down. (Equi val ence of Tax)If you tax something
you are going to fall short of the original equilibrium. If you want less of something, tax it.
WELFARE ECONOMI CS
How do we allocate resources? According to supply and demand. Price is the one thing that brings them
together. At a supply and demand equilibrium, the equilibrium price (Pe) is simultaneously
Marginal cost, the cost to some firm of supplying the last unit of the equilibrium quantity Qe
Marginal value, the value to some person of consuming the last unit of the equilibrium quantity Qe
Thus: MC=Pe=MV
Markets try to bring in as much value as possible.
To Calculate total cost, we multiply Marginal cost by quantity. Total
Cost = Area q1 + Area Q2 + area Q3
Total Value of consuming All of Q = Area #1 + Area #2 + Area
#3
Goal: Maximize Net Value = Total Value (consumers) Total Cost
(producers)
To be Efficient maximize total surplus means that no reallocation is
possible that will benefit some people without harming others.
Par et o Ef f i ci ent - P does not equal Pe, Q does not equal Qe,
Then a transaction that will make at least some better off without
hurting anyone else. A situation is said to be Pareto efficient if there
is no way to rearrange things to make at least one person better off without making anyone worse off.
There is no connection between Pareto efficiency and equity! In particular, a Pareto efficient outcome may
be very inequitable. For example, the outcome in which I have all the goods in the world is Pareto efficient
(since there is no way to make someone better off without making me worse off).
Ceiling
CS
PS
S
D
Example: If you raise your price, quantity demanded is going to go down and you will have excess supply so
you eliminate people from the market.
To be efficient means that no r eal l ocat i on is possible that will benefit some people without harming others
(Par et o Ef f i ci ent ) In ither words, if p doesnt equal Pe and Q doesnt equal Qe then there is a transaction
that will make at least some better off without hurting anyone else.
Example. Suppose you are at Pe and Qe and then you raise the price. Producers may be better off because
they are going to gain some surplus. But then consumer surplus decreases.
The more that supply and demand are elastic, the greater the likelihood of producers and consumers being
worse off if the prices rises.
Why should efficiency still be the first goal. With efficiency you can pursue other goals.
Govt Revenue from Tax: Suppose $1 per unit excise tax is levied on producers. So producers will be affected
first (impact). Shift in supply shifts up by one dollar. Reach new equilibrium (Qt). Quantity decreases. New
equilibrium is Pb, Qt. Pb = Ps + 1. Consumers pay Pb. Producers pay to supply at this amount.
Tax Revenue = $1 x Qt (Area of rectangle)
Markets respond by consumers having incentive to buy less. Sellers have incentive to produce less.
Ef f i ci ency how tax acts on net value.
Equi t y Who bears the burden of a tax. I nci dence Division of the burden.
One price splits into two and producers and consumers lose.
Price raises from Pe to Pb (Consumers payment)
Price that producers can keep is Ps, Ps<Pe
The more inelastic D, relative to S, the more consumers will bear the burden of the tax. Suppliers can push all of
the burden onto the consumers of there are very little substitutes and they have to buy the product.
If demand is completely inelastic, then suppliers will pay the same price (Ps=Pe) and Qe=Qt.
Equity Issue Passing total tax burden onto consumers.
Efficiency Issue No change in net value. No Dead weight loss.
Is this fair? Depends on the product. Food? No. Cigarettes? Yes.

If supply is inelastic











Equity Cant pass burden to consumres because supply is perfectly inelastic. Supply wont respond to price.
Therefore producers bear full burden.
Efficiency Situation To change in net value (no dead weight loss) are
we ok with this? Depends on product.
AS SUPPLY AND DEMAND ELASTICITY APPROACHES ZERO (INELASTIC)
DEAD WEIGHT LOSS APPROACHES ZERO.
Taxes arent all bad. If you tax cigarettes then you can create efficiency
Right away. (use the money for something good.




In the case of goods with
inelastic demand, the picture is
very different. Because
consumers are much less
sensitive to price changes of
these goods, the bulk of the tax
can be passed on by the firm,
as the diagram below shows:
Here the quantity has only
fallen very slightly and the
price has risen almost by the
full amount of the tax. In fact,
if the demand for the good had
been perfectly inelastic, then all
the tax could have been passed
on as a price increase. So when
the demand for a product is
inelastic, the burden of the tax
will fall on the consumer.
3UNIT 2 Econ
Total (Economic) costs at any given output is the total opportunity cost of supplying that output. OR Total economic cost
measures the total opportunity cost of the factors of production.
Total cost in tax law refers to the annual operating expenses of the firm.
What about the opportunity cost of the owner supplied capital?
What about the opportunity cost of owner supplied labor.
Example; 2 Friends start a business. Use $1 Million of own money to purchase plant and equipment. Available interest
rate on the $1 million is 10% (100,000 is next best alternative after using 1 mil for business)
Revenue (price x Quantity)
Operating expenses (Accounting Costs)
Out of packet expenses (labor, marginal inputs, sales tax)
Depreciation of capital
Economists will go a step further because they are interested in knowing of the current decision (running the business)
results in the best use of scarce resources.
Non Monetary Opportunity Costs (Owner Supplied Labor. Owner Supplied Capital)
If you have zero economic profit there is no alternative for you that will give you more than what you have now.
Negative economic profit shows there is something else for you where you would be doing better off.
Positive economic profit: you are doing whats best for you.
Just as PPF is important in showing what bundles are efficient, inefficient, not sustainable, cost curves (Fronteinr) is
important to identify efficient cost given a certain quantity on Long Run Total Cost Curves.
Long Run Total Cost: If on the LRTC firm can increase output only by hiring more factors of production thereby increasing
Total Cost
Short Run Production Function is the relationship between inputs employed by a firm and the maximum output it can
produce with those inputs. Represents the firms technology.
LABOR TOTAL
PRODUCT
(OUTPUT)
Marginal Product of Labor Change
TP/Change L
Average Product of Labor (Total
Product/Number of Hours) = Output
per hour
1 43 43 43
2 160 117 80
3 351 191 117
4 600 249 150
5 875 275 175
6 1152 277 192
7 1372 220 196
8 1536 164 184
9 1656 120 175
10 1750 74 166
Graph (Labor on the X axis, Output on the Y axis)
When you graph total product you see diminishing marginal product because although total product is growing after a
certain point the marginal product decreases.
Average Product How much on average each worker is giving you.
Short Run because you are only varying one factor. When you are increasing your labor, land, stays constant.
As long as Marginal Product of Labor is greater than Average product of labor at any output, the average product of labor
must be rising.
APL= (MP1 + MP2 + MP3) / 3
In Short run we can write Total Cost (TCSR)= Variable Cost + Fixed Cost.
Fixed Cost fixed from past decisions (Sunk Costs)
In long run all costs are variable so you dont have any fixed costs.
Minimum Level of Profit to Supply
In Short Run: Total Revenue > Variable Costs
In Long Run: Total Revenue > Variable Costs.
If you dont produce (shut down) Then q=o TR=o VC=0 FC=FC. It is more expensive to shut down than it is to be
incurring a loss.
Produce as long as Loss < FC
If Total Revenue = Variable Cost this is the shut down point (Point of indifference) because Loss = FC.
Diminishin
g Marginal
Product
If Total revenue > Variable cost then the Loss < FC
In Long run, Total revenue has to cover total cost (unlike short run). IN the long run,
TR>VC=TC TR>TC Break even point. Zero economic profit.
PER UNIT COST CURVES
Total Cost/Quantity = Variable Cost/Quantity + Fixed Cost/Quantity
Average Total Cost = Average Variable Cost + Average Fixed Cost
Average Fixed Cost decreases with every increase in output.
Why economists say sellers shold ifnore fixed costs when making decision of whether to
produce or not?
At q=0, TR=0 VC=0, FC=FC
Also, as you produce more, the average fixed cost approaches zero.
1= MC 2=ATC, 3=AVC 4=AFC
Recall TC= VC + FC. If total revenue is greater than TC then you are making a profit.
Variable Cost is concave and then convex. You experience diminishing marginal
product when you keep hiring more workers in the greebe factory and there are too
many workers in the factory.
Low levels of marginal product of labor lead to high cost Margianl Cost.
In the long run all factors are variable. The long run average cost shows you how
much you should produce.
Everything above the Long run average cost curve is attainable and everything
below the long run average cost curve is unattainable.
ECONOMIES of SCALE Long Run average cost is decreasing. If you expand then
your average cost is going to go down. It is cheaper to produce more.
At the slope of the LRTCs lowest point, the LRAC is at its minimum which splits
economies from scale (LRAC slopes downward) from diseconomies of scale (LRAC
is rising)
In the long run you can make a decision about what size firm you want based on
what is cost efficient.






Mar ket St r uct ur es
Monopoly (One firm in entire market).
Highest market power possible.
Then oligopoly Few firms that run the markt.
Then monopolistic Competition A lot more firms. Each firm has less power.
Then Perfect Competition has the lowest market power possible.
Perfect Competition:
Why are perfectly competitive firms price takers?
Thre is no product differentiation
It is so small compared to the market, its individual actions will not make a response.
Produce Max TR-TC
Or Max Profit Per Unit-Average Cost
If P(equilibrium) > AC PROFIT
If P(equilibrium) = AC -> Break Even
If P(equilibrium) < AC -> Loss
For Perfect competition, produce
at the intercetion of Supply and
Demand. P=MR=AR = MC
Firms demand curve is a horizontal
line because it is equal to the price
and is a price taker.
What output does the firm produce
and why? Goal to make a profit.
Produce at Q where Pe=MC
Does the firm take a profit or loss
and how do we measure? Depends
on Short Run and Long Run. In the
long run a firm would have zero
economic profit.
Profit = TR-TC = (Pe AC) x Q
When moving from short run to long run, Any firm can change factors as they see fit in the long run. Also, new firms can
enter and exit the market.
In a perfectly competitive market its not good enough to have good ideas, you have to be the first one and be able to go to
the market and get those profits. In the long run, there will be zero economic profit.

PERFECT COMPETITION Example
Farmers costs: Operating costs -> 200,000
Non-Monetary Opportunity cost -> 50,000 Forgone Salary
10,000 cost of 10% interest rate of investment.
Total Cost = 260,000
Oranges sell for $20 a box.
Farmers sell 15,000 boxes
Thus TR = $30,000
Total Economic Profit = $40,000
However getting economic profit signals others to enter the market which shifts supply to the right which lowers the
price of oranges which then results in a zero economic profit. Because the price is lowered demand shifts out.
Farmer Making economic Loss: Price is below Average total cost -> firms will leave the market which will shift in supply so
price will increase which will decrease demand and zero economic profit will happen again.
IN short run, as long as price is greater than average variable cost (shut down point) each firm will produce its profit
maximizing, loss minimizing quantity, where MR = MC. Otherwise, you shit down when P is less than average variable cost.
In Long Run, P = Min ATC because P=MC=ATC. Firms have competed all profits.
Market Supply Assumptions
All existing firms and potential entrants have identical costs.
Each firms costs do not change as other firms enter or exit the market.
The number of forms in the market are fixed in the short run and variable in the long run.
Short Run Market Supply Curve Horizontally add all of the quantity supplied of the firms out there.
In the lung run, the number of firms can change, entry and exit leads to zero economic profit (Price = Minimum ATC). The
long run supply curve is horizontal. The price is not able to go up or down in the long run because you get zero economic
profit.
In the long run, assume Pe, Qe is at point of zero economic profit.
Then shock to the market. Demand increases and price therefore
increases. Higher price results In positive profit, positive profit signals
entry. Entry of firms shifts out until profit is leveled.
This is why we see a horizontal long run supply curve because the
price will always level out regardless of a change in quantity.
Criteria to Judge Market Structure
Results: Price = MC in short run and long run. Only in the long
run will Price = MC =ATC min.
Allocational Efficiency is perfect competition efficient socially.
Maximum net value. P=MC
Price works as an invisible hand to bring both sides of the market together. Public interest is filled.
Goal: Supply Q(Outout) with least use of scarce resources (Produce as cheaply as possible). Market Test: IN Long Run, Q
@ AC Min.

MONOPOLY
A monopolist can not charge whatever they want.
High prices Quantity demand is small, Low prices Quanity demand is bigger.
P=10-Q Qd=10-p
PROFIT = TR-TC
Marginal revenue curve has to lie below the demand curve.
Will the monopoly ever produce where the demand curve is inelastic? No. The marginal
revenue will be negative.
Maximum quantity: MR=MC
MR = Change in Price/Change in Quantity x Quantity +
P(Q)
As you increase your quantity the price falls.












Wel f ar e:
Prices are higher in a monopoly.
Consumer surplus is smaller because prices have been restricted. The decrease in consumer surplus goes partially to
the profit of monopolies are partially to the dead weight loss.
Dead weight triangle is an allocative efficiency loss. We have artificial dwl.
Price Discrimination
Fi r st Degr ee -price varies by customer's willingness or ability to pay
Second Degr ee -price varies according to quantity sold. Larger quantities are available at a lower unit price. This is
particularly widespread in sales to industrial customers, where bulk buyers enjoy higher discounts.
Thi r d Degr ee Senior citizen gets a lower price at the movies. Student discount. Group people and charge them
different prices.
MR1=MC MR2=MC Elasticity of good 2 has to be greater than elasticity of good one. You charge regular
people higher prices than senior citizens.
Nat ur al Monopol y High fixed cost and low marginal cost. Its easier to have a single firm produce and spread out
its fixed cost. Public Utilities have really large sunk costs in setting up pipes and wires but almost zero cost in sending
electricity across powerlines.
Pat ent s Legal right to exclude for 20 years. Why have patents? Protection so other forms cant steal the idea.
Without patents, what happens when innovation is made? Set a time limit: 20 years on patent. Without patents, perfect
competition would happen. They create monopolies but they allow for innovation. If I invest a lot of time and money
into a product and have no patent, then someone can just steal my idea with no time or money and then make it for
less. Imitation = low prices. Why does imitation retard firms from investing in R&D? They dont have an incentive to
innovate if they know that people are going to just steal their ideas why should they be the ones to put in the time and
effort? With patents, there is a monopoly, little consumer surplus, a very low marginal cost (doesnt take that much to
produce another pill). IF there is no patent, everyone will produce the drug. The market will turn into perfect
competition and consumer surplus will increase. So if everyone produces, then consumers gain but not everyone will
QP P TR MR
0 10 0

1 9 9 9
2 8 16 7
3 7 21 5
4 6 24 3
5 5 25 1
6 4 24 -1
7 3 21 -3
8 2 16 -5
Q TC MC Profit
0 0

0
1 3 3 6
2 6 3 10
3 9 3 12
4 12 3 12
5 15 3 10
6 18 3 3
7 21 3 0
8 24 3 .6
want to innovate and do research. They have ot invest a lot in R&D so they want to be sure that that money comes
back and recoup investments. Allows market to decide which drugs we get and which drugs we dont get.
Why mi ght t he pat ent syst em be har d t o get r i d of ?

Monopol i st i c Compet i t i on
Shares three structural characteristics with Perfect Competition
Large number of firms.
Barriers to entry and exit are minimal
Firms do not behave strategically especially with respect to price.
The one non competitive element of monopolistic competition is the assumption that products are differentiated by firm.
Firms search for a niche to distance themselves from rivals.
In perfect competition, firms face a horizontal demand curve.
In monopolistic competition: Monopolistic competition (imperfectly competitive) firm faces a downward sloping curve.
Four ways to differentiate your firm
Geography More distance apart softens competition
Quality
Varying Product Characteristics Car manufactures
Advertising and Sale Promotin Gaining Loyalty gives firms market power.
Firm Makes Profit, more firms want to join, demand shifts inward
which drives down the price and gets rid of profit
Firms Make loses firms exit the market, demand of each firm
increases price goes up and gets rid of losses.
Long run: zero economic profit. Demand =ATC at downward
sloping portion of ATC.
In the short run, firms maximize profit at quantity where MR=MC
and by charging a price along the demand curve.
If the price in the short run is greater than the average at the
equilibrium quantity in the short run, firms profit.
In the long run as firms enter each firm earns less and less profit
as new firms enter and market is aplit up among the larger number of firms.
Maximize profits where quantity is where MR long run = MC and changing along demand curve. Since Price in Long run =
Average Cost in long run at Quantity in the long run, there is zero economic profit.
Allocative Efficiency Goal max net value price = marginal cost
Monopolistic Competition: Price does not equal marginal cost. Price is greater than marginal cost. Quantity is where
MR=MC so it is not allocative efficient.
Production Efficiency: Conserve Scarce Resources: quantity produced: AC=AC min
In monopolistic competition AC is above the minimum atc. If you forced them to produce at the minimum atc they
would be making a loss.




Oligopoly
Oligopoly A market structure in which only a few sellers offer similar or identical products.
Barriers to entry that help oligopoly firms make profit
Economies of Scale The larger you get the more output you are providing gives you a cost advantage. Buying In
volume brings your average cost down. The greater the economies of scale, the fewer the number of firms will be in
the industry (if less competitive)
Ownership of a Key input If production of a good requires a particular input, then control of that input can be a
barrier of entry. (DeBeers Company of South Africa diamond market)
Government Imposed Barriers Firms sometimes try to have government impose barriers to entry (patents,
occupational licenses, tariffs, quotas)
We use Game theory to decide how much to produce.
When not to use same graphs as three other structures?
Because of strong interdependence among firms, we need to incorporate strategic behavior. PC and MC Too
many firms to be strategic.
Each firms strategy can affect the demand that competition faces. Hard to derive a firms demand while taking
into account all other palyers strategies.
Games have three characteristics.
Players
Strategies: player can employ to attain objectives
Payoffs.
Example: Target, Wallmart
TARGET
WALMART
600 400
600 10000,10000 5000,15000
400 15000 5000 75000, 75000
Given Target Charges $600 Wal-Mart Charges 400
Given Target charges $400 Wal-Mart charges 400
Given Wal-Mart charges $600 Target Charges 400
Given Wal-Mart charges $400, Target charges 400.
Dominant strategy Best strategy for a firm no matte what strategy other firms use.
Nash s Equi l i br i um - Am equilibrium where each firm chooses the best strategy given the strategies chosen by other
firms. No firm has incentive to deviate from their current strategy.
Firms collude so that they dont have to compete on price. So in some instances we see Nashs equilibrium and some cases
you can cheat and collude and set the price high.
Some firms honor their agreement because they know that in the short run they can cheat but they will be punished in the
end.
Example: Prisoner Dilema.


Bonni e
Clyde
Conf ess Not COnf ess
Conf ess 8 Years, 8 Years 0 Years,20 Years
Not Conf ess 20 Years 0 Years 1 Year, 1 Year
If collude you both dont want to confess.
If no collusion then both should confess. (Dominant Strategy)
If you collude you both dont want to confess.

GAME THEORY
Prisoners Dilema Game
Go through steps assuming the other player has chosen a strategy.
Dominant Strategy Your best response is independent of what the other person does.
Nashs Equilibrium Given what the other player have chosen. This is your best response.
Cooperative Outcome. Might not be the best answer is if they collude but is the best answer if they work
independently.
Conclusion Players are worse off at nashs equilibrium doe to lack of cooperation/self interest.
Value of cheating ends up being a tit for tat. If you cheat, then the next person is going to cheat. And you are going
to revert to the nashs equilibrium.
Examples, Advertising.
Coordination Game
Nashs Equilibrium (2) if they coordinate and produce the same thing.
Rousseaus Stag Hunt
Hume
Rousseau
Hunt St ag Hunt Rabbi t
Hunt St ag 5, 5 0, 3
Hunt Rabbi t 3, 0 3, 3
If you think the player is goig to be nice you be nice. If you think they are goig to cheat you cheat too.
Bottom Right is risk dominant strategy. Peope down there when they are more concerned with risk involved then they
are the payoff. The top equilibrium the players are more interested in the payoff than the risk.





Econ Unit 3
Factors of Production
Assume perfect competition for both product and labor market.
Recall the main elements of finding quantity
o Firm is a price taker, the demand firce facing firm is perfectly eleastic, horizontal at PC
o Goal: maximize profits.
! Firm supply where mr=mc
! Firm supply curve is actually mc.
! Most supply slope up because demand marginal product labor.
Firm faces the established market wage. Wage is determined by entire market.
Each individual firm faces perfectly elastic supply curve for the labor market.
Wage for baseball players is higher than wage for trash haulers because supply for baseball players is so small and
the demand for taking trash away is big.
Since Marginal cost is constant at equilibrium wage, the key to find labor where MR=MC is to look at MR from hiring
labor, just as the key to the supply of output is the mc of output because mr was constant.
Firms demand labor because they want to make money.
Derived Demand is the demand for a factor of production (labor) that is based on the demand for the good the
factor produces.
Apples demand for labor depends on
o The additional ipods apple will be able to produce if it hires one more worker.
o The additional revenue Apple receives from selling the additional ipods.


April 13
th
2010
Wage is less than or equal to Value Marginal Product of Labor Hiring decision by firm.
The demand for labor is a derived demand because it depends on the price of the output.
Supply of Labor
o Assume that all people are identical and all jobs are identical. Wage rate is the same
o Assume people are identical and jobs differ. Occupation 2 is not as desirable as occupation 1 so the wage
of occupation 2 is less. Occupation is a higher wage because less people are willing to supply (the night
shift in a factory).
! Wage differentials all workers are equally well off despite earning different wages. The wages
are equalizing or complementary. Wage of first firm is greater than the wage of the second firm
in the long run.
o Both workers and jobs differ. People differ tastes, abilities, intelligence, competitiveness,. Jobs differ,
desirability. The wage differences are not necessarily equalizing wage differences. They recite economic
rent wage . minimum required wage.
Individual Preferences and attributes of various jobs.
Discrimination When might the market solve this problem? When might it not?
o Median earnings of full time US workers in 2007 White males earn 21% more than white females and white
males earn 24% more than black males.
o While males are 75% more likely to have college degree than black males
o White males are 11% more likely to have graduate degrees than white females
o Women have less on the job experience than meb.
o We like to hire pretty people. When people have contact with the public, you want to hire a pretty person
because they will make more money.
o Discrimination study company sent 5,000 resumes with white names and black names people with white
names got 50% more calls than ethnic names.
Ex: Assume perfectly competitive labor market. Occupation one is higher skilled labor and occupation two is lower
skilled labor. Occupation one requires more formal training. suppose employers in occupation one refuse to hire
women since they are prejudice against women. The supply of men is revealed which reveals the wage of occupation
one and wage of occupation one is greater than occupation 2. For occupation 2, supply shifts right. As a result, men
on occupation one receive higher wage (gain from discrimination). All other worksers lose including men and women
in occupation 2.
What does this do to society as a whole. If you do not discriminate, firms can make profit. Supply will increase and
wage will decreases. Decreases costs if you hire women and men. Of one firm hires women and makes this profit then
other firms will be run out of the market or forced to discriminate because the firms not discriminating will have a
lower price of their product.

Inequality and Poverty and income Redistribution.
How inequality and poverty arise
o Human Capital
o Discrimination
o Financial and Physical Capital
o Entrepreneural ability
o Personal and family characteristics.
Quantity demanded of low skilled workers is lower than quantity
demanded of high skilled workers.
o At any wage, the firm is willing to pay more high skilled
workers than low skilled workers.
o They have a higher value of marginal product.
o Equilibrium wage of low skilled workers and high skilled
workers higher skilled workers get a higher wage. With
increase demand and decrease in supply which will give you a
higher wage but quantity is ambiguous.
o Wage increases with an increase of high skilled labor because.
High skilled labor has a higher value marginal product.
(demand shift out) Skills are costly to acquire at a given wage
rate. The quantity of high skilled labor supplied is less. (supply
shifts in)
Earnings based on education (average income)
o The more education you have the more you are going to
make. The higher the VMP shifts up, the higher salary we see.
What are the two economic theories on education?

o Skills in education gives you more productivity and boost your value of marginal product of labor. If
everyone increased their education everyone would be more productive.
o Signaling Theory -You are born with a particular type. In the future, increases in the education level of the
workforce will actually cause the education premium to rise, simply because different workers are being
labeled as highly educated.
From 1945-1970 incomes grew 3% a year for all distributions. Since then income growth has been concentrated
among the top earners.
Methods of Income Distribution
o Welfare
o Minimum wage laws
o Negative income tax
o Earned income tax credit
o In kind transfers
o Anti poverty programs and work incentives.
If minimum wage laws are enacted, workers both gain and lose. Workers who are willing to work for less than the
minimum wage win because they are getting paid more but less workers can now work because quantity decreases so
there are workers who worked before that now can not work. Minimum wage laws makes an inefficient quantity.
Earned Income Tax Credit Shows up on income tax return.
o Employment will be 5000 units of labor enacted.
o Compensate workers with an extra $4000. Then worker surplus will be came surplus resulting from a $7
minimum wage. (Problem above)
o Government offer tax credit worth $0;80 per hour for each of the 5000 person hours. Low income families.
Lower income families are better off but. EITC were financed by a $4000 tax on employers. $12,500-
$4000 = $8500. Total surplus = $16500 + 8500 = $25000
Utilitarism Government should choose policies to maximize total utility. (satisfaction). Dont care about cost of
resources.
Liberalism Government should choose policies to be just by the partial server.

April 22
nd

Four types of goods
o Private Good: Rival in consumption and Excludable. Ice cream cone. Clothing. Congested toll roads.
o Natural monopolies No rival in consumption. Excludable. Fire protection. Cable TV. Uncongested toll
roads.
o Common Resources Rivalry in consumption. Not excludable. Fish in the ocean, the environment,
congested nontoll roads.
o Publ i c Goods Non excludable, non rival. Tornado alert system, national defense, uncongested nontoll
roads.
A good is excludable if people can be prevented from using it.
A good is rival in consumption if one persons use of the good diminishes other peoples use of it.
Natural Defense Very expensive Public good
Basic Research General Knowledge
Fighting poverty welfare system, food stamps.
Light House mark specific locations that passing ships can avoid treacherous waters. Not excludable, not rival in
consumption. Incentive free ride without paying. Most are operated by the government. IN some cases lighthouses
can be closer to private goods if they are privately owned and operated.
Public Goods The difficult job of cost benefit analysis. The government decides what public goods provide.
Free Rider Problem The incentive to free ride destroys the normal incentive to engage in market transaction.
o Two roommates Each has a wealth of $500
o Each person values the tv at $100. Cost of the TV is $150.
o Is there a private solution to this problem? Yes. With side payments.
Pl ayer B
Pl ayer A Buy Don t Buy
Buy -50,-50 -50,100 (maximize utility)





Transaction Cost, Coordination Cost, Hold Up Cost
o Hold Up Cost The Potential for one of the people to hold out and say im not going to pay you. If player A
buys the tv and then player two refuses to pay him back.
Tragedy of the Commons The tendency for a common resource to be overused.
o Deforestation You end up overproducing the firewood.
o Fish Permits so that you dont oversfish.

Consumer Choice
Maximizing utility constrained by an income.
Yo can raise your total utility by buying one less pizza and two more cakes.
Budget Constraint: What the consumer can afford
o Budget Constraint Limit on the consumpton bundes that a consumer can afford. Trade off between goods
o Slope of the budget constraint Rate at which the consumer can trade one good for the other. Changes in
the vertical distance. Divided by the change in the horizontal distance. Relative price of the two goods.
Preferences: What the Customer Wants
o Indifference Curve Shows consumption bundles that give the consumer the same level of satisfaction.
Combination of goods on the same cuve. Same satisfaction
o Slope of indifferent curve
o Higher indifference curve = higher level of satisfaction
Four Properties
o Higher indifference curves are preferred tolower ones
! Higher indifference curves = more goods
o Indifference curves are downward clopping
o Indifference curves do not cross
o Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of
substitutionthe rate at which the consumer is willing to trade off one good for the other. The marginal rate
of substitution (MRS) usually depends on the amount of each good the consumer is currently consuming. In
particular, because people are more willing to trade away goods that they have in abundance and less
willing to trade away goods of which they have little, the indifference curves are bowed inward. As an
example, consider Figure 4. At point A, because the consumer has a lot of Pepsi and only a little pizza, he
is very hungry but not very thirsty. To induce the consumer to give up 1 pizza, he has to be given 6 pints of
Pepsi: The marginal rate of substitution is 6 pints per pizza. By contrast, at point B, the consumer has little
Pepsi and a lot of pizza, so he is very thirsty but not very hungry. At this point, he would be willing to give
up 1 pizza to get 1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza. Thus, the bowed
shape of the indifference curve reflects the consumer's greater willingness to give up a good that he
already has in large quantity.
Two extreme examples of indifference cureves
o Perfect Substitues Two goods with straight line indifference curves. Marginal rate of substitution is
constant (nickels and dimes)
o Perfect complements Two goods with right angle indifference curves right show and left show bundle.




Dont Buy 100, -50 (maximize utility) 0,0 (Nash equilibrium)





Number
of
Slices
Of
Pizza
Total
Utility
From
Eating
Pizza
Marginal Utility
From the
Last Slice
Number
of
Cups
Of Coke
Total
Utility
From
Drinking
Coke
Marginal Utility
From the
Last Cup

0

0

-

0

0

-

1

20

20

1

20

20

2

36

16

2

35

15

3

46

10

3

45

10

4

52

6

4

50

5

5

54

2

5

53

3

6

51

-3

6

52

-1
Number
of
Slices
Of
Pizza
Marginal
Utility

(MUpizza)
Marginal Utility
Per Dollar
(MUpizza/Ppizza)
Number
of
Cups
Of Coke
Marginal
Utility

(MUcoke)
Marginal Utility
Per Dollar
(MUcoke/Pcoke)

1

20

20/2=10

1

20

20/1=20

2

16

8

2

15

15

3

10

5

3

10

10

4

6

3

4

5

5

5

2

1

5

3

3

6

-3

-1.5

6

-1

-1

Number
of
Slices
Of
Pizza
Marginal
Utility

(MUpizza)
Marginal Utility
Per Dollar
(MUpizza/Ppizza)
Number
of
Cups
Of Coke
Marginal
Utility

(MUcoke)
Marginal Utility
Per Dollar
(MUcoke/Pcoke)

1

20

20/1.50=13.33

1

20

20/1=20

2

16

10.67

2

15

15

3

10

6.67

3

10

10

4

6

4

4

5

5

5

2

1.33

5

3

3

6

-3

-2

6

-1

-1
I NCOME EFFECT I NCOME EFFECT SUBSTI TUTI ON EFFECT



Price
Decrease
Increases the
consumers
purchasing power,
which.
if a normal
good, causes the
quantity
demanded to
increase.
if an
inferior
good,
causes the
quantity
demanded
to decrease.
Lowers the
opportunity cost of
consuming the good,
which causes the
quantity of the good
demanded to increase





Price
Increase
Decreases the
consumers
purchasing power,
which
if a normal
good, causes the
quantity
demanded to
decrease.
if an
inferior
good,
causes the
quantity
demanded
to increase.
Raises the
opportunity cost of
consuming the good,
which causes the
quantity of the good
demanded to
decrease




SHORTANSWER FROM NEW MATERIAL. 18-21 NO CHAPTER 22 Though that was on the prev exam.
50 multiple choice. 2 hour exam. May 11
th
labsci 300 6-8

LAST LECTURE
Consumer Bundle A: 2 Slices of Pizza, 1 can of coke
Consumer Bundle B: One Slice of Pizza, 2 cans of coke
Consumer prefers A to B or consumer prefers B to A or consumer is indifferent between A and B.
Consumer prefers higher bundles over lower bundles. But is probably indifferent along a bundle.
Budget Line: Slope is Change in Y over Change in X = marginal rate of
substitution.





































































Giffen Good: Upward Sloping demand curve.
Extreme inferior good.
Recall when price declines, income rises,
consumers buy more of a normal good and
less of an inferior good.

Income and Substitution Effects

The effect of a change in price can be broken down into an income effect and
a substitution effect. The substitution effectthe movement along an
indifference curve to a point with a different marginal rate of substitutionis
shown here as the change from point A to point B along indifference curve I1.
The income effectthe shift to ahigher indifference curveis shown here as
the change from point B on indifference curve I1 to point C on indifference
curve I2.

An Increase in the Wage

The two panels of this figure show how a person might respond to an increase in the wage. The graphs on the left show the
consumer's initial budget constraint, BC1, and new budget constraint, BC2, as well as the consumer's optimal choices over
consumption and leisure. The graphs on the right show the resulting labor-supply curve. Because hours worked equal total
hours available minus hours of leisure, any change in leisure implies an opposite change in the quantity of labor supplied. In
panel (a), when the wage rises, consumption rises and leisure falls, resulting in a labor-supply curve that slopes upward. In panel
(b), when the wage rises, both consumption and leisure rise, resulting in a laborsupply curve that slopes backward.