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Chapter 1 Economics and Economic Reasoning

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What Economics Is

Economics is the study of how humans coordinate their wants and desires, given
the decision-making mechanisms, social customs, and political realities of the society

What (and how much) to produce

How to produce it

For whom to produce it

In our economy there is a problem of scarcity



The goods available are too few to satisfy individuals desires

Economies deal with scarcity with coercion limiting wants and increasing the
amount of work people do to fulfill them

This leads to the alternative definition of economics: the study of how to get
people to do things theyre not wild about doing and not to do things they are
wild about doing, so that the things some people want to do are consistent
with the things other people want to do

A Guide to Economic Reasoning

Cost/Benefit Analysis

Abstraction from the unimportant elements of a question and focus on the

important elements

Marginal Costs and Marginal Benefits

The relevant costs and benefits to economic reasoning are the expected incremental
costs and the expected incremental benefits that result from a decision.

Marginal costs vs. marginal benefits

Marginal cost is the additional costs to you over and above the cost you have
already incurred

This means not counting sunk costs costs that have already been incurred
and cannot be recovered

Marginal benefit is the additional benefit above what youve already derived

These two concepts yield the economic decision rule: If the marginal benefits of
doing something exceed the marginal costs, do it. If the marginal costs of doing
something exceed the marginal benefits, dont do it.

Opportunity Cost

Opportunity cost is the benefit that you might have gained from choosing the nextbest alternative.

To obtain the benefit of something, you must forgo something else. The value
of this alternative is the opportunity cost.

Economic and Market Forces

All scarce goods must be rationed in some fashion. These rationing mechanisms are
economic forces, the necessary reactions to scarcity.

A market force is an economic force that is given relatively free rein by society to
work through the market. These forces ration by affecting prices.

When theres a shortage, price rises; when theres a surplus, price falls.

The invisible hand is the price mechanism, the rise and fall of prices that
guide our actions in a market.

What happens in a society can be seen as the reaction to, and interaction of, these
three forces: economic, political/legal, and social/historical forces.

Economic Insights

An economic model is a framework that places the generalized insights of the

theory in a more specific contextual setting

An economic principle is a commonly held economic insight stated as a law or

general assumption

Economics is an observational science, not a laboratory science. Thus, models are

tested not in controlled experiments, but rather in the actual economy. Economists
observe and try to figure out what is affecting what in natural experiments, where
something has changed in one instance but not another and then compare results.

Theories, models, and principles must be combined with a knowledge of realworld economic institutions to arrive at specific policy recommendations

The Invisible Hand Theory

Much of economic theory deals with the pricing mechanism and how the market
operates to coordinate individuals decisions.

When the quantity supplied is greater than the quantity demanded, the price
has a tendency to fall.

When the quantity demanded is greater than the quantity supplied, price has
a tendency to rise.

Efficiency means achieving a goal as cheaply as possible. Economists call this

insight the invisible hand theory a market economy, through the price
mechanism, will tend to allocate resources efficiently.

Economic Theory and Stories

Economic institutions sometimes act differently than expected, this is because a)

economics abstracts from many issues that may account for the differences and b)
economic principles often affect decisions from behind the scenes

Economic Policy Options

Economic policies are (in)actions taken by government to influence economic


Objective Policy Analysis

Good economic policy analysis is objective it keeps the analysts value judgments
separate from the analysis.

This is the way the economy works, and if society wants to achieve a
particular goal, this is how it might go about doing so.

NOT like, This is the way things should be

Positive economics is the study of what is, and how the economy works.

E.g. How does the market for hog bellies work? How do price restrictions
affect market forces?

Normative economics is the study of what the goals of the economy should be.

E.g. What should the distribution of income be? What should tax policy be
designed to achieve?

The art of economics (a.k.a. political economy) is the application of the knowledge
learned in positive economics to the achievement of the goals one has determined in
normative economics.

E.g. To achieve a certain distribution of income, how would you go about it,
given the way the economy works?

Maintaining objectivity is easiest in positive economics and harder in normative

economics. Its hardest to maintain objectivity in the art of economics, the judgments
of made in political economy are likely to reflect our own value judgments.

Policy and Social and Political Forces

Economics focuses analysis on the invisible hand and how the economy would act if
only the invisible hand were present.

Chapter 2 The Production Possibility Model, Trade, and

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The Production Possibilities Model

A production possibility table is a table that lists a choices opportunity costs by

summarizing what alternative outputs you can achieve with your inputs.

An output is a result of an activity

An input is what you put into a production process to achieve an output

A Production Possibility Curve for an Individual

A production possibility curve (PPC) is a curve measuring the maximum

combination of outputs that can be obtained from a given number of inputs.

A graphical representation of the opportunity cost concept

It also measures opportunity cost

A PPC demonstrates that:


there is a limit to what you can achieve, given the existing institutions,
resources, and technology.

Every choice you make has an opportunity cost. You can get more of
something only by giving up something else.

Increasing Marginal Opportunity Cost

PPCs are rarely ever straight lines


Opportunity costs tend to rise as we choose more and more of an item

The principle of increasing marginal opportunity cost says that in order to get
more of something, one must give up ever-increasing quantities of something else

Essentially, marginal costs are increasing

PPC of increasing marginal costs bellow outwards

Comparative Advantage

A comparative advantage is the ability to be better suited to the production of one

good than to the production of another good


Productive efficiency is achieving as much output as possible from a given amount

of inputs or resources.

Inefficiency is getting less output from inputs that, if devoted to some other activity,
would produce more output.

Efficiency is achieving a goal using as few inputs as possible.

Graphically, the concept of efficiency is demonstrated by only moving ones

production on to a point on the PPC.

Distribution and Productive Efficiency

Assume that the distributional effects that accompany policy are acceptable, and that
we, as a society, prefer more input

Trade and Comparative Advantage

A society wants to be on the frontier of its PPC


Individuals must produce those goods for which they have a comparative

How to direct individuals toward those activities in which they have a comparative

Adam Smith argued that it is humankinds proclivity to trade that leads to

individuals using their comparative advantage. As people act in their best
interest, the invisible hand guides the economy as a whole.

Markets, Specialization, and Growth

Markets allow specialization and encourage trade


Individuals compete and specialize, they learn by doing, becoming even

better at what they do.

The Benefits of Trade

When people freely enter into a trade, both parties can be expected to benefit from
the trade; otherwise, they wouldnt have entered the transaction.

When there is competition in trade, so individuals can pick the best

transaction available to them, each individual can achieve the best bargain he

Laissez-faire is an economic policy of leaving coordination of individuals actions to

the market.

Trade allows countries to consume past the limitations of their individual PPCs

Comparative Advantage and the Combined PPC

The slope of the combined PPC is determined by the country with the lowest
opportunity cost

Outsourcing Trade and Comparative Advantage


Outsourcing is the relocation of production once done in the US to foreign


Insourcing is the relocation of production done abroad to the US

Outsourcing is only a problem when it significantly exceeds insourcing

These two concepts are basically comparative advantage demonstrated in

the real world


Globalization is the increasing integration of economies, cultures, and

institutions across the world

A globalized world is one where the economics of the world are highly

2 effects

The rewards for winning globally are much larger than the
rewards for winning domestically


It is much harder to win or even stay in business when

competing globally


Globalization increases competition due to greater specialization/division of


Adam Smith: Increases growth and improves standard of living for


Allows for implementation of comparative advantage

Increased productivity

Law of One Price


The law of one price states that the wages of workers in one country will not
differ significantly from the wages of equal workers in another institutionally
similar country

Chapter 3 Economic Institutions

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The U.S. Economy in Historical Perspective

The U.S. economy is a market economy, an economic system based on private

property and the market in which, in principle, individuals decide how, what, and for
whom to produce.

Individuals follow their self-interest; supply and demand coordinate those

individual pursuits

The government must allocate and defend private property rights in order for a
market to exist

Private property rights are the control a private individual or firm has over
an asset

Private ownership must be accepted as a concept by society

How Markets Work

System of rewards and payments


How much you get is determined by how much you give; fairness

Them that works, gets; them that dont, starve.

Capitalism and Socialism

Markets are not universally accepted as the most reasonable way to organize society

Arguments against markets say they bring out the worst in people

Socialism is an economic system based on individuals goodwill toward others, not

on their own self-interest, and in which, in principle, society decides what, how, and
for whom to produce

People contribute what they can and get what they need

Capitalism is an economic system based on the market in which ownership of the

means of production resides with a small group of individual called capitalists

Most economies today are distinguished by the degree to which their economies rely
on markets, not whether they are a market, capitalist, or socialist economy

The U.S. Economy

The American economy can be divided into three sectors: businesses, households,
and government.

Households supply labor and other factors of production to businesses and

are paid by businesses for doing so. This is called the factor market.

Businesses produce goods and services and sell them to households and
government. This is called the goods market.


Business is the name given to private producing units in our society

Businesses in the U.S. decide what to produce, how much to produce, and
for whom to produce it

Some businesses are easy to start, some require licenses, permits, etc.

Entrepreneurship is the ability to organize and get something done

What Do U.S. Firms Produce?


Firms produce both physical goods and intangible services

Distribution, or getting goods where you want them when you want them, is
as important as production and is a central component of a service economy

Services compose about 85% of the American economy, compared to 20% in


Consumer Sovereignty and Business


Consumer sovereignty is the power of the consumers wishes to determine

whats produced

Businesses decide what to produce based on what they believe will


Profit is whats left over from total revenues after all the appropriate costs
have been subtracted

Businesses that guess correctly about what consumers want

generally make profit; businesses that dont often operate at a loss

Forms of Business

The three main forms of business are sole proprietorships, partnerships, and

71% of American businesses are sole proprietorships, 10% are

partnerships, and 19% are corporations

Sole proprietorships are businesses that have only one owner

Easiest to start, few bureaucratic hassles

Partnerships are businesses with two or more owners

These create possibilities for sharing the burden, but they also create
unlimited liability for each of the partners

Corporations are businesses that are treated as a person, and are legally
owned by their stockholders, who are not liable for the actions of the
corporate person

Largest form of business when measured in terms of receipts

When a corporation is formed, it issues stock (certificates of

ownership in a company), which is sold/given to individuals

Proceeds from the sale of that stock compose the equity

capital of a company

A corporation provides the owners with limited liability the

stockholders liability is limited to the amount the stockholder has
invested in the company.

Owners of the other two forms of business can lose everything

they possess even if they have only invested a small amount
in the business


Households are groups of individuals living together and making joint decisions,
they are the most powerful economic institution

Households ultimately control government and business through voting in the

political arena and supplying labor/capital to businesses through spending
decisions or expenditures

Suppliers of Labor

The largest source of household income is wages/salaries from labor

The fastest-growing jobs are in the service industries and the fastestdeclining are in manufacturing and agriculture

Other Roles of Households


Households make a significant number of decisions in the economy besides

being suppliers of labor.

They control how much schooling to get, what to buy, housing

investment, and the housing stock which is half the capital stock of
the country.

They are the driving force for much of the economy


Two general roles in the economy:


A referee setting the rules that determine relations between business and

An actor collecting money in taxes and spending that money on projects such
as defense and education

Government as an Actor

The entire United States government (federal/state/local) consume about

15% of the countrys total output and employ over 22 million people

They also redistribute income through taxes and social welfare and
assistance programs

State and Local Governments

Employ over 19 million people and spend over $2.5 trillion a year

Receive most of their income from taxes and spend their revenues on
public welfare, administration, education, and roads

Federal Government

Income and Social Security taxes compose 80% of their revenue.

They spend it on income security, health and education, and national


Government as a Referee

Government sets the rules of interaction between households and

businesses, and acts as a referee, changing the rules when it sees fit.

What referee role should the government play in an economy?

Government plays a variety of specific roles in the economy

1. Providing a stable set of institutions and rules

2. Promoting effective and workable competition

3. Correcting for externalities

4. Ensuring economic stability and growth

5. Providing public goods

6. Adjusting for undesirable market results

Provide a Stable Set of Institutions and Rules

A basic role of government is to provide a stable institutional

framework that includes the set of laws specifying what can and
cannot be done as well as a mechanism to enforce those laws

The modern market economy necessitates complicated

contractual agreements between different parties

Promote Effective and Workable Competition

Monopolization and competition are always at conflict in market

economies; the government must decide to what extent it protects

The U.S. is often adverse to monopoly power the ability of

individuals or firms currently in business to prevent other individuals or
firms from entering the same kind of business

The governments job is to promote competition and prevent

excessive monopoly powers

Correct for Externalities

An externality is the effect of a decision on a third party not taken into

account by the decision maker

Externalities can be positive (society benefits from the trade

between two parties) or negative (society is harmed by the

When externalities are presented, there is potential for the

government to adjust the market result

Actions with positive externalities are promoted and those with

negative externalities should be discouraged

The role of government is a potential role because

1. Government often has difficulty dealing with externalities in

such a way that society gains.

2. Government is an institution that reflects, and is often

guided by, politics and vested interests

Ensure Economic Stability and Growth

Government has the potential role of providing economic stability

The government should prevent 1.) large fluctuations in the

level of economic activity, 2.) maintain a relatively constant
price level, and 3.) provide an economic environment
conducive to growth

These aims became the U.S. governments goals in the 1946

Employment Act

They are justified as appropriate government aims because

they involve macroeconomic externalities externalities
that affect the levels of unemployment, inflation, or growth in
the economy as a whole

Provide Public Goods

A public good is a good that if supplied to one person must be

supplied to all and whose consumption by one individual does not
prevent its consumption by another individual

A private good is a good that, when consumed by one individual,

cannot be consumed by another individual

A free rider is a person who gets a benefit but does not contribute to
paying for the cost of that benefit

Adjust for Undesirable Market Results

A controversial role for government is to adjust the results of the

market when those market results are seen as socially undesirable

E.g. redistribution of income

Demerit goods or activities are goods or activities that government

believes are bad for people even though they choose to use the
goods or engage in the activities.

E.g. How addictive drugs are illegal or highly taxed.

Merit goods or activities are goods and activities that government

believes are good for you even though you may not choose to engage
in the activities or to consume the goods

E.g. Government support for contributing to charities, etc.

through subsidies or tax benefits.

Market Failures and Government Failures


Market Failures are situations in which the market does not lead to a desired

Government failures are situations in which the government intervenes and

makes things works

Global Institutions

It is impossible to talk about the U.S. economic institutions without considering how
they integrate with the world economy

Global Corporations

Global corporations are corporations with substantial operations on both the

production and sales sides in more than one country

Global corporations provide significant benefits for countries by creating jobs,

bringing ideas/technology to a country, providing competition for domestic

They also pose a problem by evading policy through shifting its operations
between different countries

Coordinating Global Issues

Governments have developed international institutions to promote negotiations and

coordinate economic relations on the global stage

These include the UN, World Bank, World Court, and IMF

Countries have developed global/regional organizations to coordinate trade and

reduce trade barriers

These include the WTO, EU, and NAFTA

These international organizations is voluntary, thus they have limited power

Chapter 4 Supply and Demand

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Demand is the ability and willingness to pay

The Law of Demand

The law of demand states that Quantity demanded rises as price falls, other things
constant. Or alternatively, Quantity demanded falls as price rises, other things

If the price of something goes up, people will tend to buy less and buy a substitute

The Demand Curve

The demand curve is the graphical representation of the relationship between price
and quantity demanded.

It slopes downward

other things constant.


This qualifier places a limitation on the application of the law of demand. If the
fall in demand is a result of decreased income or some other factor, then
adjustments must be made to hold income constant.

These other things include individuals tastes, prices of other goods

(substitutes), and even the weather. These other factors must remain
constant if a valid study is to be made of the effect of an increase in the price
of a good on the quantity demanded.

Shifts in Demands versus Movements along a Demand Curve

Demand v. Quantity Demanded


Demand refers to a schedule of quantities of a good that will be bought per

unit of time at various prices, other things constant. I.e. how much will be
bought at various prices

Graphically, demand refers to the entire demand curve

Quantity demanded refers to a specific amount that will be demanded per

unit of time at a specific price, other things constant. I.e. how much will be
bought at a specific price.

Graphically, quantity demanded refers to a point on the demand curve

A change in price changes the quantity demanded. It refers to a movement along a

demand curve the graphical representation of the effect of a change in price on
the quantity demanded.

A shift in demand is the graphical representation of the effect of anything other than
price on demand.

Shift Factors of Demand

Important shift factors of demand are


1. Societys income

2. The prices of other goods

3. Tastes

4. Expectations

5. Taxes on and subsidies to consumers


A rise in income increases the demand for normal goods. For other goods,
called inferior goods, an increase in income reduces demand.

E.g. Normal good: steak; Inferior good: hot dog.

Price of Other Goods


When the price of a substitute rises, demand for the good whose price has
remained the same will rise.


When the price of a good declines, the demand for its complement rises.
Changes in taste can affect the demand for a good without a change in price.


If one expects his income to rise in the future, he will start spending some of it

Taxes and Subsidies


Taxes levied on consumers or subsidies given to consumers either raise or

reduce the cost of the goods to consumers, thus reducing or increasing
demand for those goods

Individual and Market Demand Curves

A market demand curve is the horizontal sum of all individual demand curves

Firms dont care who buys their goods; they only care that someone buys

Even if individuals dont respond to small changes in price, the market demand curve
can still be smooth and downward sloping

1. At lower prices, existing demanders buy more

2. At lower prices, new demanders enter the market

Six Things to Remember about a Demand Curve

1. A demand curve follows the law of demand: When price rises, quantity falls, and
vice versa

2. The horizontal axis quantity has a time dimension

3. The quality of each unit is the same

4. The vertical axis price assumes all other prices remain the same

5. The curve assumes everything else is held constant

6. Effects of price changes are shown by movements along the demand curve.
Effects of anything else on demand (shift factors) are shown by shifts of the entire
demand curve


In a sense, supply is the mirror image of demand


The supply process of produced goods is generally complicated

Many layers of firms involved

Thus, the analysis of the supply of produced goods has two parts

Analysis of the supply of factors of production to households

and firms

Analysis of the process by which firms transform those factors

of production into usable goods/services

The supply of nonproduced goods is more direct

The Law of Supply

The law of supply states that Quantity supplied rises as price rises, other things
constant. Or alternatively, Quantity supplied falls as price falls, other things

The Supply Curve

A supply curve is the graphical representation of the relationship between price and
quantity supplied.

It slopes upward

other things constant.


This qualifier also applies to the law of supply.

Shifts in Supply versus Movements along a Supply Curve

Supply v. Quantity Supplied


Supply refers to a schedule of quantities a seller is willing to sell per unit of

time at various prices, other things constant.

Graphically, supply refers to the entire curve

Quantity supplied refers to a specific amount that will be supplied at a

specific price.

Graphically, quantity supplied refers to a point on a supply curve

Changes in price cause changes in quantity supplied, these are represented by a

movement along a supply curve the graphical representation of the effect of a
change in price on the quantity supplied.

If the amount supplied is affected by anything other than price, that is, by a shift
factor of supply, there will be a shift in supply the graphical representation of the
effects of a change in a factor other than price on supply.

Shift Factors of Supply

Price of Inputs

If a firms costs rise, profits will decline, and a firm has less incentive to
supply. Thus, supply falls when the price of inputs rises.


Advances in technology allow for improvements in the production process,

reducing production costs to a firm. Thus, suppliers can increase production.


Supplier expectations are an important factor in the production decision. If a

supplier expects the price of their good to rise, they may withhold some of
todays output in order to sell it later for higher profits; decreasing supply now
and increasing it later.

Taxes and Subsidies


Taxes on suppliers increase the cost of production by requiring a firm to pay

the government a portion of the income from products or services sold. Thus,
suppliers reduce supply because of the increased cost of production and
reduced profit.

The opposite occurs for subsidies.

Individual and Market Supply Curves

The market supply curve is the horizontal sum of all the individual supply curves

The Interaction of Supply and Demand


When a market exists where neither suppliers nor consumers collude and where
prices are free to move up and down, the forces of supply and demand arrive at an

Equilibrium is a concept in which opposing dynamic forces cancel each

other out

Equilibrium quantity is the amount bought and sold at the equilibrium price

Equilibrium price is the price toward which the invisible hand drives the

Excess Supply

Excess supply, or a surplus, is when quantity supplied is greater than the

quantity demanded

Price in the market falls to allow quantity demanded to meet quantity supplied

Excess Demand

Excess demand, or a shortage, is when quantity demanded is greater than

the quantity supplied

Market price will rise to allow quantity supplied to meet quantity demanded

Price Adjusts

When quantity demanded is greater than quantity supplied, prices tend to rise

When quantity supplied is greater than quantity demanded, prices tend to fall

The greater the difference between quantity demanded and quantity

supplied, the more pressure there is for prices to rise or fall

When quantity demanded equals quantity supplied, the markets in


What Equilibrium Isnt

It is not a state of the world, its a characteristic of the model the framework you
use to look at the world.

Equilibrium is not inherently good or bad


Its simply a state in which dynamic pressures offset each other

Some equilibria are good a market in competitive equilibrium is one in

which people can buy the goods they really want at the best possible price

Some equilibria arent good at all nuclear war and resulting mutually
assured destruction

Political and Social Forces and Equilibrium

In the real world, political and social forces are acting and pushing the price away
from the supply/demand equilibrium

The Limitations of Supply/Demand Analysis

Supply and demand are tools that help only when used appropriately

When used incorrectly, they can be misleading

In supply/demand analysis, other things are assumed constant. If other things

change, then once cannot directly apply supply/demand analysis.

Micro v. Macro

The fallacy of composition is the false assumption that what is true for a
part will also be true for the whole

An understanding of the fallacy of composition is of central relevance to


In the aggregate, whenever firms produce (whenever they supply),

they create income (demand for their goods). So in macro, when
supply changes, demand changes.

In macroeconomics, the other-things-constant assumption central to

microeconomics cannot hold

To account for all these interdependencies is why macro analysis is

separated from micro analysis.

In macro, curves are used whose underlying foundations are much

more complicated than the supply and demand curves that are used
in micro.

Chapter 5 Using Supply and Demand

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Real-World Supply and Demand Applications

The Price of Foreign Currency

The forex (foreign exchange) market determines exchange rates, or the price of one
countrys currency in terms of anothers currency

Whenever a foreign good is bought, someone must trade currencies

Currency acts as a good in forex markets

Government Intervention in the Market

Price Ceilings

A price ceiling is a government-imposed limit on how high a price can be charged


This limit is generally below the equilibrium price

E.g. rent control a price ceiling on rents, set by government

With price ceilings, existing goods are no longer rationed entirely by price. Other
methods of rationing existing goods arise called non-price rationing

Price Floors

A price floor is a government-imposed limits on how low a price can be charged


This limit is generally above the equilibrium price

E.g. minimum wage laws laws specifying the lowest wage a firm can
legally pay an employee

Excise Taxes

An excise tax is a tax that is levied on a specific good.

A tariff is an excise tax on an imported good

Quantity Restrictions

Governments often regulate markets with licenses that limit entry into a market

Quantity restrictions tend to raise price because with quantity restrictions, increases
in demand lead only to price increases

Third-Party-Payer Markets

A third-party-payer market is one where the person who receives the good differs
from the person paying for the good

E.g. The healthcare industry with insurance/HMOs

In third-party-payer markets, equilibrium quantity and total spending are much higher

Because the co-payment faced by the consumer is much lower, quantity

demanded is much greater

Chapter 6 Thinking Like a Modern Economist

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The Nature of Economists Models

A model is a simplified representation of the problem or question that captures the

essential issues

Economic models differ from others. What does differentiate economists are:

1. The building blocks that economists use in their models and

2. The structure of formal models that economists find acceptable

Models dont have to be mathematical


Heuristic models are models that are expressed informally in words

The building blocks and structures of models that economists use have
evolved. Early economists used only a highly restricted set of building blocks
and a narrow set of simple formal models.

Modern economists are economists who are willing to use a wider

range of models than did earlier economists. Modern economists use
a more inductive approach to modeling. Earlier economists used a
much more deductive approach.

An inductive approach is an approach to understanding a

problem in which understanding is developed empirically from
statistically analyzing what is observed in the data

A deductive approach is one that begins with certain selfevident principles from which implications are logically

Behavioral and Traditional Building Blocks

Traditional building blocks of microeconomics are the assumptions that people are
rational and self-interested

Traditional economists are economists who study the logical implications of

rationality and self-interest in relatively simple algebraic or graphical models such as
the supply and demand model

Behavioral Economic Models

Behavioral economics is microeconomic analysis that uses a broader set of

building blocks than rationality and self-interest used in traditional economics.

Inductive study of peoples behavior that argues that rationality and selfinterest should be broadened

Rationality should be broadened to purposeful behavior behavior

reflecting reasoned but not necessarily rational judgment

Self-interest should be broadened to enlightened self-interest in

which people care about other people as well as themselves

These differing assumptions affect the patterns economists see in the results of their
models analysis

Predictable Irrationality

Behavioral economists argue that what might be deemed irrational behavior

by a traditional economist might not be so irrational if the context is evaluated

For behavioral economists, universality is less important than the fact that the
model captures how people actually behave

An example of this is precommitment strategy, a strategy in which

people consciously place limitations on their future actions, thereby
limiting their choices

The Advantages and Disadvantages of Modern Traditional and Behavioral Models

The Difficulty with Behavioral Building Blocks: Testing


Traditional economists argue against moving away from traditional building

blocks is difficult because it leads to much less clear-cut models and results

Behavioral economists respond by using experimental economics, i.e. lab

and field experiments to test alternative building blocks and find those that
best describe how people actually act

Endowment effects is the concept that people value something more just
because they have it

Traditional Models Provide Simplicity and Insight


Traditional models provide simple and clear results, which can highlight
issues that behavioral models cannot

Behavioral Economic Models Reflect Observed Behavior

Types of Models
Behavioral and Traditional Informal (Heuristic Models)

The Armchair Economist: Heuristic Models Using Traditional Building Blocks


Armchair Economist

More Sex Is Safer Sex

Martin wants to hook up with Joan. Joan wants to hook up with Martin.
Martin is prudent and he is scared of STDs so he does not attend a
party where Joan and him expected to hook up. In his stead, Joan
hooks up with not-so-prudent Maxwell. Maxwell gives Joan AIDS all
because Martin was virtuous and did not have safe sex with Joan.

Decisions about sex may have externalities and therefore what is best
for the individuals involved may not be best for society.

Why Car Insurance Costs More Some Places Than Others

Insurance rates in Ithaca, NY cost a third of what they cost in

Philadelphia, PA even though theft/accident rates are similar. There is
a feedback effect of the initial choices people make of whether to buy
insurance that affects the cost of insurance. If a few people decide not
to get insurance, the costs of insurance to who buy it will be higher
because their accidents will be more likely to be with an uninsured
driver and, thus, their insurance would have to pay. Which is what
happened in Philadelphia. The opposite occurred in Ithaca.

A path-dependent tripping point model is used in this case. It is a

type of a path-dependent model a model in which the path to
equilibrium affects the equilibrium.

The Economic Naturalist: Heuristic Models Using Behavioral Building Blocks


Why Are People More Likely to Return Cash Than a Lampshade?

That people return a $20 lampshade that was mistakenly not scanned
less often than they will return an overpayment of $20 in change
supports the assumption of purposeful behavior.

Why Dont More People Wear Velcro Shoes?

Behavioral models take social considerations into account; traditional

models do not.

The Limits of Heuristic Models


Heuristic models are very easy to modify and come to different conclusions.

Empirical Models

The Importance of Empirical Work in Modern Economics


Econometrics the statistical analysis of economic data developed in the

late 20th century because computers allowed for the lack of data and
computing power to be overcome. Thus, economics started making its way
from deductive reasoning to inductive reasoning.

Modern economics relies on experiments and statistical analysis of real-world


Empirical models are models that statistically discover a pattern in the data

Regression Models

A regression model is an empirical model in which one statistically relates

one set of variables to another

Running a regression finds the line of best fit between the points plotted on a
graph of the two sets of variables

The goodness of fit between the two variables is described by the

coefficient of determination, which is a measure of the proportion of
the variability in the data that is accounted for by the statistical model

Regression models can reveal all sorts of relationships. They have been
called data-mining models but a better term for them is pattern-finding

The Role of Formal Models

Data alone has no meaning

Framing is an important concept in empirical modeling


Two economists can draw different conclusions from the same empirical

Economists rely on theoretical models to help them interpret data

In economics, controlled experiments are generally impossible. Thus, natural

experiments an event created by nature that can serve as an experiment are
used instead

Different Types of Formal Models That Economists Use


Models with many equilibria, so its difficult to know what an equilibrium is

Models in which not only are the variable related, but also are the changes in
variables and the changes in changes in variables

Models in which systemic equilibrium involves enormous continual change in

the parts so that even though the system is in equilibrium, the individual parts
are not

Models in which relationships are non linear on various levels, and in which
an infinitely small change can lead to drastically different results

The Trade-off between Simplicity and Completeness


Complexity in models provides the broadest approach, however it also yields

results that make it difficult to arrive at a conclusion

A self-confirming equilibrium is an equilibrium in a model in which peoples

beliefs become self-fulfilling

A strange attractor model or a butterfly effect model is a model in which a

small change causes a large effect

Other Formal Models


Game theory models are models in which one analyzes the strategic
interaction of individuals when they take into account the likely response of
other people to their actions

More complicated models often yield no analytic solution

The agent-based computational (ACE) model is a culture dish

approach to the study of economic phenomena in which agents
(encapsulated collections of data and methods representing an entity
residing in that environment on the computer) are allowed to interact
in a computationally constructed environment and the researcher
observes the results of that interaction

Empirically Testing Formal Models


Bringing the model to the data

Formal model where all the relationships are specified

What Difference Does All This Make to Policy?

Modern economists, with their various frames, are less sure of the conclusion that
the market will solve every problem

For a modern economist, policy does not follow directly from a model

Models provide theorems results that follow logically from a model not
precepts general rules for public policy.

Chapter 7 Describing Supply and Demand: Elasticities12/2/15 7:48 PM

Price Elasticity
The price elasticity of demand is the percent change in quantity demanded

divided by the percentage change in price


ED =

Percentage change in quantity demanded

Percentage change in price

The price elasticity of supply is the percentage change in quantity supplied divided

by the percentage change in price

ES =

Percentage change in quantity supplied

Percentage change in price

What Information Price Elasticity Provides

How quantity responds to a change in price

Demand and Supply as Elastic or Inelastic


Demand or supply is classified as elastic if the percentage change in quantity is

greater than the percentage change in price. Oppositely, demand or supply is
inelastic if the percentage change in quantity is less than the percentage change in

Elastic: E > 1

Inelastic: E < 1

An inelastic supply means that the quantity supplied doesnt change much with a
change in price.

An elastic supply means that quantity supplied changes by a larger percentage than
the percentage change in price

Elasticity Is Independent of Units

Percentages allow us to have a measure of responsiveness that is independent of

units, making comparisons of responsiveness among different goods easier.

Calculating Elasticities

In 2005, the city of London raised the daily toll motorists pay to drive in central
London by 46%. The increase reduced the number of motorists driving in central
London by 3%.

E = 3/46 = .07

The endpoint problem arises because the percentage change differs depending on
whether you view the change as a rise or a decline.

Economists use the average of the two end values to get around the endpoint

Elasticity and Supply and Demand Curves

Elasticity Is Not The Same as Slope

The relationship between elasticity and slope is the following: The steeper the curve
becomes at a given point, the less elastic is supply or demand.

A vertical demand curve is described by economists as perfectly inelastic

quantity does not respond at all to changes in price (E = 0)

A horizontal demand curve is described by economists as perfectly elastic

quantity responds enormously to changes in price (E = )

Elasticity Changes along Straight-Line Curves

On straight-line supply and demand curves, slope remains constant, but elasticity
does not.

At one point along the demand curve, between an elasticity of infinity and zero,
demand is unit elastic the percentage change in quantity equals the percentage
change in price (E = 1)


Perfectly elastic





Unit elastic



Perfectly inelastic


Substitution and Elasticity

The most important determinant of price elasticity of demand is the number of

substitutes for the good. The more substitutes a good has, the more elastic is its
supply or demand.

Substitution and Demand

The number of substitutes a good has affected by various factors. Several important
ones are listed.

1. The time period being considered

2. The degree to which a good is a luxury

3. The market definition

4. The importance of the good in ones budget

The more substitutes, the more elastic the demand and the more elastic the supply

1. The time period being considered

The larger the time interval considered, the more elastic is the goods
demand. There are more substitutes in the long run than the short run.

2. The degree to which a good is a luxury


The less a good is a necessity, the more elastic is its demand

3. The market definition


As the definition of a good becomes more specific, demand becomes more


Substitutes for transportation are more difficult to find, than substitutes for
unicycle transportation.

4. The importance of the good in ones budget


Demand for goods that represent a large proportion of ones budget is more
elastic than demand for goods that represent a small proportion of ones

Goods that cost very little relative to ones total expenditures arent worth
spending a lot of time figuring out whether theres a good substitute.

Substitution and Supply

The same general issues involving substitution are relevant when considering
determinants of the elasticity of supply. But when it comes to supply, economists
focus on time rather than on other factors because time plays such a central role in
determining supply elasticity.

The longer the time period considered, the more elastic is supply.

Economists distinguish 3 time periods relevant to supply


1. In the instantaneous period, quantity supplied is fixed, so supply is

perfectly inelastic. This supply is sometimes called the momentary supply.

2. In the short run, some substitution is possible, so short-run supply is

somewhat elastic.

3. In the long run, significant substitution is possible; supply becomes very


Elasticity, Total Revenue, and Demand

Knowing elasticity of demand is useful to firms when they want to know whether total
revenue will rise or fall when they change their pries.

If demand is elastic (ED > 1), a rise in price lowers total revenue

If demand is unit elastic (ED = 1), a rise in price leaves total revenue

If demand is inelastic (ED < 1), a rise in price increases total revenue

Total Revenue along a Demand Curve

With elastic demands, a rise in price decreases total revenue. With inelastic

demands, a rise in price increases total revenue.

Elasticity of Individual and Market Demand
Firms have a strong incentive to separate out people with less elastic demand and

charge them a higher price


Price discrimination

Other Elasticity Concepts

The income elasticity of demand is the percentage change in demand divided by

the percentage change in income. It shows responsiveness of demand to changes in


Income elasticity of demand =

Percentage change in demand

Percentage change in income

the cross-price elasticity of demand is the percentage change in demand divided

by the percentage change in the price of a related good. It shows responsiveness of

demand to changes in prices of related goods.


Cross price elasticity of demand =

Percentage change in demand

Percentage change in price of a related good

Income Elasticity of Demand

Normal goods are goods whose consumption increases with an increase in income.

Luxuries are goods that have an income elasticity of greater than 1

A necessity is a good that has an income elasticity between 0 and 1.

An inferior good is a good whose consumption decreases when income increases

Cross-Price Elasticity of Demand

Substitutes are goods that can be used in place of another. When the price of a

good goes up, the demand for the substitute goes up.

Most goods have substitutes, so most cross-price elasticities are positive.

Complements are goods that are used in consumption with other goods. A fall in the

price of a good will increase the demand for its complement.


The cross-price elasticity of complements is negative

The Power of Supply/Demand Analysis

Elasticity and Shifting Supply and Demand
When demand shifts

Percentage change in price =

When supply shifts

Percentage change in demand


Percentage change in price =

Percentage change in supply

E D + ES

Chapter 10 The Logic of Individual Choice: The Foundation

of Supply and Demand
12/2/15 7:48 PM
Utility Theory and Individual Choice

Economists agree that there is an underlying psychological foundation of why people

make certain choices and execute certain actions: self-interest.

Much of what people do reflects their rational self-interest.

Using the theory of self-interest, two things determine what people do:

Utility the pleasure or satisfaction people get from doing or consuming


Price the tool the market uses to bring the quantity supplied equal to the
quantity demanded

Economists theory of rational choice is simple, it shows how pleasure and price are

Total Utility and Marginal Utility

Total utility refers to the total satisfaction one gets from consuming a product

Total utility is the sum of marginal utilities

Marginal utility refers to the satisfaction one gets from consuming one additional
unit of a product above and beyond what one has consumed up to that point.

Marginal utility tends to decrease as a consumption of a good increases

Diminishing Marginal Utility

When graphed, the marginal utility curve slopes downward, this is due to the
principle of diminishing marginal utility as you consume more of a good, after
some point, the marginal utility received from each additional unit of a good
decreases with each additional unit consumed, other things equal.

At some point, marginal utility can become negative

Rational Choice and Marginal Utility

The analysis of rational choice is the analysis of how individuals choose goods within
their budget to maximize total utility

Premise that rational individuals want as much satisfaction as possible from

their available resources

The term rational in economics means that people prefer more to less and will
make choices that give them as much satisfaction as possible

The Principle of Rational Choice

The principle of rational choice is as follows: Spend your money on those goods
that give you the most marginal utility (MU) per dollar

Thus, if

MU x MU y
, choice y would be the more rational choice in terms of

marginal utility
Simultaneous Decisions

are not always so neatly separated in real life


Maximizing Utility and Equilibrium

The principle of rational choice says you should keep adjusting your spending within

your budget if the marginal utility per dollar (

) of two goods differs

The utility-maximizing rule says that when the ratios of the marginal utility to price

of the two goods are equal, youre maximizing utility


MU x MU y

When you are maximizing utility, youre in equilibrium

As we consume more of an item, the marginal utility we get from the last unit
consumed decreases. Conversely, as we consume less of an item, the
marginal utility we get form the last unit consumed increases.

The principle of diminishing marginal utility operates in reverse

Extending the Principle of Rational Choice

The general principle of rational choice is to consume more of the good that provides
a higher marginal utility per dollar.

MU x MU z
, consume more of good x
MU y MU z
o When
, consume more of good y

MU x MU y MU z
o When
, you are maximizing utility


this rule is met, the consumer is in equilibrium; the cost per additional unit of
utility is equal for all goods and he consumer is as well off as it is possible to be

Thisrule does not say that the rational consumer should consume a good until its
marginal utility reaches zero because consumers dont have enough money to buy
all they want

Consumers have budgets and they do the best they can under that constraint

Rational Choice and the Laws of Demand and Supply

The Law of Demand

The law of demand in relation to the principle of rational choice: when the price of a
good goes up, the marginal utility per dollar goes down. Thus, if we are initially in
equilibrium as a consumer and the price of a good goes up, we no longer are and we
choose to consume less of that good.


MU x MU y
MU x MU y
and the price of good x goes up, then

To satisfy our utility-maximizing rule so that our choice will be rational, we must
somehow raise the MU we get from the good whose price has risen. According the

principle of diminishing marginal utility we can increase

MU only by decreasing
consumption of the good whose price has risen.

If the price of a good rises, youll increase your total utility by consuming less
of it.

Income and Substitution Effects

There is a certain ambiguity with the changes in nominal prices and their precise
effects on how much quantity demand will change.

The income effect is the reduction/increase in quantity demanded because

were poorer/richer

Second, a substitution effect is the reduction/increase in quantity

demanded because relative price has risen/fallen

When the relative price of a good goes up, the quantity purchased of
that good decreases (even when youre given money to compensate
for the price increase)

The Law of Supply

According to the principle of rational choice, if there is diminishing marginal utility and
the price of supplying a good goes up, you supply more of that good.

Opportunity Cost

Opportunity cost is essentially the marginal utility per dollar you forgo from the
consumption of the next-best alternative.

To say

MU x MU y
, is to say that the opportunity cost of not consuming

good x is greater than the opportunity cost of not consuming good y

Applying Economists Theory of Choice to the Real World

Given Tastes

Some behavioral economists are questioning whether tastes are given or shaped by

Conspicuous Consumption

Conspicuous consumption the consumption of goods not for ones direct

pleasure, but simply to show off to others

Tastes and Individual Choice


Somehow, whenever a need is met, its replaced by a want, which soon

becomes another need

Utility Maximization

The ultimatum game is a game where the first person only gets the money if the
other person accepts the offer. If the second person does not accept, they both get

Reveals that people have a sense of fairness in their decisions

A status quo bias is where an individuals actions are very much influenced by the
current situation, even when that reasonably does not seem to be very important to
the decision

Chapter 11 Game Theory, Strategic Decision Making, and

Behavioral Economics
12/2/15 7:48 PM
Game Theory and the Economic Way of Thinking

John Nash was a large figure in the development of game theory


Nashs realization was that each person, acting in his or her own best
interest, will not necessarily arrive at the best of all possible outcomes; Adam
Smith is wrong.

The central element of the modern economic way of thinking is strategic thinking

Whenever the decisions being analyzed involve interdependent decisions,

the decision makers strategy needs to be considered

Game theory is formal economic reasoning applied to situations in which decisions

are interdependent

Game Theory and Economic Modeling

Where does game theory fit into the modern economists modeling method?

Bob Solow: You look at a problem; you create a simple model that captures
its essence you empirically test how well that model fits the data, and if it fits,
you use that model as a guide to understanding the problem and devising a

Game theory offers a new set of models with which to approach economic issues.

They can be better tailored to fit the actual problem and are more flexible than
the standard models of economics

A different game theory model must be developed for each different situation
and each different set of assumptions

Rather than one model with one equilibrium solution, game theory had many
models with multiple equilibrium solutions

The Game Theory Framework

A screening question is a question structured in a way to reveal strategic

information about the person who answers

The Prisoners Dilemma

The prisoners dilemma is a well-known two-person game that demonstrates the

difficulty of cooperative behavior in certain circumstances

A payoff matrix is a table that shows the outcome of every choice by every player,
given the possible choices of all the other players.

The prisoners dilemma is an example of a noncooperative game a game in

which each player is out for himself and agreements are either not possible or not

Cheap talk is communication tat occurs before the game is played that carries no
cost and is backed up only by trust, and not any enforceable agreement

Economists find, through empirical findings, that people do have

interdependent utility functions and cheap talk does influence the outcome of
a game

Informal Game Theory and Modern Behavioral Economics

Informal Game Theory

Informal game theory (often called behavioral game theory) relies on empirical
observation, not deductive logic alone, to determine the likely choices of individuals.
It looks at how people actually think and behave and is thus empirically based.

Informal game theory proves a framework for approaching questions rather than
providing definite answers

Real-World Applications of Informal Game Theory

Survivor example pg. 267

Warren Buffet example pg. 267

An Application of Game Theory: Auction Markets

William Vickrey was a Nobel Prize-winning economist that developed an example of

game theory: the Vickrey auction a sealed-bid auction where the highest bidder
wins but pays the price bid by the next-highest bidder

This second-price auction changes the strategy of the bidders

Behavioral Economics and Game Theory

Informal game theory is used to explore what rationality is and the nature of
individuals utility functions.

Behavioral economists use experiments in which people actually play the

formal games to explore the validity of the assumptions in formal game theory

Games and Perceptions of Fairness

If people feel someone is being unfair, people will reduce their own income to make
that person pay

Loss Aversion and Incorrect Inference

Ownership increases the value of a good

Framing Effects

Framing effects are the tendency of people to base their choices on how the choice
is presented

Behavioral Economics and the Traditional Model

Behavioral economics provides a more nuanced view of human behavior than does
standard economics

People are purposeful, rather than fully rational; they demonstrate

enlightened self-interest rather than greed; and they are boundedly rational
rather than fully Nash-style rational

The Importance of the Traditional Model: Money Is Not Left on the Table

Just because people dont act as the traditional economic model predicts doesnt
mean that the traditional assumption and model are irrelevant

People acting differently than they would if the standard rationality

assumptions hold true creates potential profit opportunities for individuals to
take advantage of peoples actual behavior

Chapter 12 Production and Cost Analysis I

12/2/15 7:48 PM

The Role of the Firm

Production is the transformation of factors into goods and services

A firm is an economic institution that transforms factors of production into goods and
services. Firms:

1) organize factors of production and/or

2) produce goods and/or

3) sell produced goods to individuals, businesses, or government

Some firms are virtual firms, which dont produce anything but they simply
subcontract out all production

Firms Maximize Profit

The firm plays the same role in the theory of supply that the individual does in the
theory of demand

The difference is that whereas individuals maximize utility, firms maximize


Profit = Total revenue Total cost

In accounting, Total revenue = Total sales x Price

When determining that to include in total revenue and total costs, accountants
focus on explicit revenues and explicit costs because they must have
quantifiable measures to go into a firms income statement.

Thus, Accounting profit = Explicit revenue Explicit costs

Economists include both explicit and implicit costs and revenues into their analysis

Implicit costs include opportunity costs of the factors of production

For economists, total cost is explicit payments to the factors of

production plus the opportunity cost of the factors provided by the
owners of the firm

Implicit revenues include the increase in the value of assets

Total revenue is the amount a firm receives for selling its product or
service plus any increase in the value of the assets owned by the firm

Economic profit = (Explicit/implicit revenue) (Explicit/implicit cost)

The Production Process

The Long Run and the Short Run

The production process is conventionally divided into the a long-run planning

decision and a short-run adjustment decision

Long-run planning decisions choose the least expensive method of

producing from among all possible methods. A firm chooses among all
possible production techniques.

Short-run adjustment decisions adjust a firms long-run planning decision

to reflect new information. The firm is constrained in regard to what
production decisions it can make.

In the long run, all inputs are variable; in the short run, some inputs are fixed.

Production Tables and Production Functions

A production table is a table showing the output resulting from various

combinations of factors of production or inputs.

Marginal product is the additional output that will be forthcoming from an additional

worker, other inputs constant. Marginal product is how much additional output will be
forthcoming if the number of workers changes.
Average product is output per worker. Workers average product is the total output

divided by the number of workers.

A production function is the relationship between the inputs and outputs

The Law of Diminishing Marginal Productivity

Both marginal and average productivities initially increase with the number of

workers, but eventually they both decrease

The law of diminishing marginal productivity states that as more and more of a

variable input is added to an existing fixed input, eventually the additional output one
gets from that additional input is going to fall.

Sometimes called the flowerpot law

The Costs of Production

Fixed Costs, Variable Costs, and Total Costs
Fixed costs are costs that are spent and cannot be changed in the period of time

under consideration

Variable costs are costs that change as output changes

These two sum to total cost (TC = FC + VC)

Average Total Cost, Average Fixed Cost, and Average Variable Cost
Average total cost (average cost) equals total cost divided by the quantity






Average fixed cost equals fixed cost divided by quantity produced



Average variable cost equals variable cost divided by quantity produced



Marginal Cost

Marginal cost is the most important cost a firm considers when deciding how much to


Marginal cost is the increase (decrease) in total cost from increasing (decreasing)
the level of output by one unit

Graphing Cost Curves

Total Cost Curves

Average and Marginal Cost Curves


The MC curve goes through the minimum point of the ATC curve and AVC
curve. Each of these curves is U-shaped. The AFC curve slopes down

Downward-Sloping Shape of the Average Fixed Cost Curve

As output increases, the same fixed cost can be spread over a wider
range of output, so average fixed cost falls

The U Shape of the Average Cost Curves

In the short run, output can be raised only by increasing the variable
input. But as increasing variable inputs are added to a fixed input, the
law of diminishing marginal productivity enters in. Marginal and
average productivities fall and marginal and average costs rise.

Thus, if eventually the law of diminishing marginal productivity holds

true, then eventually both the marginal cost curve and the average
cost curve must be upward sloping.

Average total cost initially falls faster and then rises more slowly than
average variable cost.

The Relationship between the Marginal Productivity and Marginal Cost


When MC exceeds AC, AC must be rising. When MC is less than AC,

AC must be falling. This relationship explains why MC curves always
intersect the AC curve at the minimum of the AC curve.

When the productivity curves are falling, the corresponding cost

curves are rising

The Relationship between the Marginal Cost and Average Cost Curves

The positioning of the MC curve is indicative of the ATC curve

If MC > ATC, then ATC is rising

If MC = ATC, then ATC is at its minimum

If MC < ATC, then ATC if falling

Marginal and average reflect a general relationship that also holds for
MC and AVC

If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum

If MC < AVC, then AVC is falling

This part is best understood by reading pages 285-289 in the text book

Marginal cost

The additional cost resulting from a one-unit increase in output


Total cost

The sum of all costs of inputs used by a firm in production

TC = FC + VC

Average total cost

Total cost per unit of production



Fixed cost

Cost that is already spent and cannot be recovered. It exists only in the short


Averaged fixed cost

Fixed costs per unit of production



Variable cost

Costs that vary with production


Average variable cost

Variable costs per unit of production



Chapter 13 Production and Cost Analysis II

12/2/15 7:48 PM

Making Long-Run Production Decisions

Firms have many more options in the long run than in the short run

They can change any input they want

Plant size is not given

To make their long-run decisions, firms look at the costs of the various inputs and the
technologies available for combining those inputs and seeing which has the lowest

Technical Efficiency and Economic Efficiency

Technical efficiency in production means that as few inputs as possible are used to
produce a given output

Many production processes can have equal technical efficiencies, but their
economic efficiencies distinguish some from others

An economically efficient method of production is the method that produces a

given level of output at the lowest possible cost

In long-run production decisions, firms look at all production technologies and

choose the most economically efficient method of producing

Determinants of the Shape of the Long-Run Cost Curve

The shape of the long-run cost curve is due to the existence of economies and
diseconomies of scale

In the long run, all inputs are variable

Economies of Scale

Economies of scale is when long-run average total costs decrease as output


In real-world production, low levels of production are greatly affected by economies

of scale because many production techniques require a certain minimum level of
output to be useful

An indivisible setup cost is the cost of an indivisible input for which a

certain minimum amount of production must be undertaken before the input
becomes economically feasible to use

E.g. Books: buying a printing press is a cost that must be incurred if

any production is to take place, but not a cost that increases with the
number of books produced

The minimum efficient level of production is the amount of production that

spreads setup costs out sufficiently for a firm to undertake production profitably

Diseconomies of Scale

Diseconomies of scale is when long-run average total costs increase as output


Diseconomies of scale sometimes, but not always, start occurring as firms

get large.

Diseconomies of scale could not occur if production relationships were only technical

The same technical process could be used over and over again at the same
per-unit cost.

In reality, production relationships have social dimensions that effect the production

1) As the size of the firm increases, monitoring costs generally rise

Monitoring costs are the costs incurred by the organizer of

production in seeing to it that the employees do what theyre
supposed to do

Larger firms have to have more and more people devoted to simply
monitoring employees

2) As the size of the firm increases, team spirit/morale generally declines

Team spirit is the feelings of friendship and being part of a team that
bring out peoples best efforts

Most types of production are highly dependent on team spirit

Constant Returns to Scale

Constant returns to scale are where long-run average total costs do not change
with an increase in output

Together, economies of, constant returns to, and diseconomies of scale contribute to
the U-shaped curve of long-run average total costs

The Importance of Economies and Diseconomies of Scale

If firms can make and sell more at lower per-unit costs they can make more profits

Envelope Relationship

Since long-run costs are variable and short-run costs arent, long-run costs will
always be less than or equal to short-run cost at the same level of output

In the short run, all expansion must be done by increasing only the variable
input. This constraint must increase average cost (or at least not decrease it)
compared to what the average cost would have been if the firm had planned
to initially produce that level.

This envelope relationship comes from the fact that the long-run average total cost
curve is an envelope of short-run average total cost curves

The more options you have to choose from, the lower the costs of production.

I.e. constraints always raise costs

When there are economies of scale and you have chosen an efficient plant size for a
given output, your short-run average costs will fall as you increase production.

Pg 302

Entrepreneurial Activity and the Supply Decision

The expected price of a good must exceed the opportunity cost of supplying the good
for a good to be supplied

An entrepreneur is a person who sees an opportunity to sell an item at a price

higher than the average cost of producing it

Using Cost Analysis in the Real World

Economies of Scope

Economies of scope are when the costs of producing products are interdependent
so that its less costly for a firm to produce one good when its already producing

Learning by Doing and Technological Change

Learning by doing means that as we do something, we learn what works and what
doesnt, and over time we become more proficient at it

Many firms estimate that worker productivity grows 1-2% p.a. due to learning
by doing

Technological change is an increase in the range of production techniques that

leads to more efficient ways of producing goods as well as the production of new and
better goods

Tech changes can fundamentally alter the nature of production costs

Technological change and learning by doing are intricately related.

Many Dimensions

Real-world economic decisions have many dimensions besides the single dimension
of output in the standard model

Unmeasured Costs

Economists Include Opportunity Cost


Accountants calculations dont take into account the time and effort that the
owner inputs

Economic Depreciation versus Accounting Depreciation


Depreciation is a measure of the decline in value of an asset that occurs

over time

Chapter 14 Perfect Competition

12/2/15 7:48 PM

Perfect Competition

Competition as a process is a rivalry among firms

Competition is also a perfectly competitive market structure

A Perfectly Competitive Market

A perfectly competitive market is a market in which economic forces operate


A market in perfect competition must meet certain stringent requirements


1. Both buyers and sellers are price takers

2. The number of firms is large

3. There are no barriers to entry

4. Firms products are identical

5. There is complete information

6. Selling firms are profit-maximizing entrepreneurial firms

These requirements are needed to ensure that economic forces operate

instantaneously and arent hindered by social and political forces

The Necessary Conditions for Perfect Competition

Both Buyers and Sellers are Price Takers


A price taker is a firm or individual who takes the price determined by market
supply and demand as given

The Number of Firms is Large


The term large means sufficiently large so that any one firms output
compared to the market output is imperceptible and what one firm does has
no influence on what other firms do

There are No Barriers to Entry


Barriers to entry are social, political, or economic impediments that prevent

firms from entering a market

Firms Products are Identical


Legal barriers, technological barriers

Each firms output is indistinguishable from any others

Complete Information

Firms and consumers know all there is to know about the market prices,
products, and available technology

No firm/consumer has a competitive edge

Selling Firms are Profit-maximizing Entrepreneurial Firms

Firms can have many goals, but for perfect competition, firms must seek
maximum profit and only profit. The people who make the decisions must
receive only profits and no other form of income from the firms.

The Definition of Supply and Perfect Competition

The stated conditions are enormously strong and rarely meet simultaneously,
however theyre necessary for a perfectly competitive market to exist. When they do
meet, they create an environment in which each firm, following its own self-interest,
will offer goods to the market in a predictable way.

Recall the definition of supply: a schedule of quantities of goods that will be offered
to the market at various prices.

This definition requires the supplier to be a price taker

In almost all other market structures, firms arent price takers; they are price

Market structure frameworks within which firms interact


The second condition the number of firms is large is necessary so that firms have
no ability to collude (operate in concert to reap more benefits)

Conditions 3-5 are closely related to the first two; they make it impossible for any firm
to forget about the hundreds of other firms

Condition 6 tells a firms goals; without these, we wouldnt knowhow firms would
react when faced with the given price

Marginal Cost

If the conditions for perfect competition hold, then a firms supply curve will be
that portion of the firms short-run marginal cost curve above the AVC curve

Demand Curves for the Firm and the Industry

The demand curve for an industry is downward-sloping, but the demand curve for the
firm is horizontal (perfectly elastic)

The difference is explained by perception. Each firm in a competitive industry is so

small that it perceives that its actions will not affect the price it can get for its product.
Price is the same no matter how much the firm produces.

The price a firm can get is determined by the market supply and demand

Firms will increase their output in response to an increase in market demand, even
though that increase in output will cause price to fall and can make all firms
collectively worse off. But in perfect competition firms dont act collectively.

The Profit-Maximizing Level of Output

The goal of a firm is to maximize profits

Since profit is the difference between total revenue and total cost, the effect of
change in output on profit is determined by marginal revenue and marginal cost.

Marginal revenue (MR) the change in total revenue associated with a

change in quantity

Marginal cost (MC) the change in total cost associated with a change in

A firm maximizes profit when MC=MR

Marginal Revenue

Since a perfect competitor accepts the market price as a given, marginal revenue is
simply the market price.

For a competitive firm, MR=P


The Marginal revenue curve and demand curve are the same for a perfect

Profit Maximization: MC = MR

To maximize profit, a firm should produce where MC=MR

Since MR is market price, the profit-maximizing condition of a competitive firm is


If marginal revenue does not equal marginal cost, a firm can increase profit by
changing output

The Marginal Cost Curve is the Supply Curve

Consider the definition of the supply curve as a schedule of quantities of goods that
will be offered on the market at various prices.

The upward-sloping portion of the marginal cost curve fits this definition

Because the marginal cost curve tells us how much of a produced good a firm will
supply at a given price, the marginal cost curve is the firms supply curve; MC=S

Firms Maximize Total Profit

Maximizing profit means maximizing total profit, not profit per unit

As long as increase in output will increase total profits, a profit-maximizing should

increase output

Profit Maximization Using Total Revenue and Total Cost

Total revenue and total cost curves can also be used to determine the profitmaximizing level of output

Total profit is maximized where the vertical distance between total revenue
and total cost is greatest. At that output, marginal revenue (the slope of the

total revenue curve) and marginal cost (the slope of the total cost curve) are

Total Profit at the Profit-Maximizing Level of Output

Marginal cost is all that is needed to determine a competitive firms supply curve

Determining Profit from a Table of Costs and Revenue

The P=MR=MC demonstrates how much output a competitive firm should produce to
maximize profit, however it does not tell us how much profit the firm makes

Profit is determined by total revenue minus total cost at the point where MR=MC

Determining Profit from a Graph

The profit-maximizing output can be determined in a table or in a graph

Find Output Where MC=MR


Find point where MC=MR, this point marks the quantity that the firm will

Find Profit per Unit Where MC=MR


After finding the profit-maximizing quantity, drop a vertical line down to the
horizontal axis. Find the ATC at that output level and extend a line from the
ATC to the Y-axis (price).

This rectangle is the amount of profit the firm earns

To determine maximum profit, you must first determine what output the firm
will choose to produce by seeing where MC equals MR and then determine
the ATC at that quantity by dropping a line down to the ATC curve

Zero Profit or Loss Where MC=MR


ATC at the profit-maximizing position is below the price, thus making profit

When the ATC is below the marginal revenue curve, the firm makes a

When the ATC is above the marginal revenue curve, the firm incurs a

To determine maximum profit, first determine what output the firm will choose
to produce by seeing where MC=MR, and then extending a line to the ATC

MC=MR=P is both a profit-maximizing and a loss-minimizing condition

The Shutdown Point

The supply curve of a competitive firm is the MC curve where it is above the AVC
curve. If a firm is operating above AVC, there is no point of shutting down. The fixed
costs are sunk costs and the firm must pay them regardless of whether it produces

or not. The firm only considers the variable costs, as long as it covers its variable
costs, it pays to keep on producing.

The shutdown point is the point below which the firm will be better off if it
temporarily shuts down than it will if it stays in business

Short-Run Market Supply and Demand

In the short run when the number of firms in the market is fixed, the market supply
curve is the horizontal sum of all the firms marginal cost curves, taking account of
any changes input prices that might occur

All firms in a competitive market have identical MCs

As the short run evolves into the long run, the number of firms in the market is
variable and the market supply curve shifts to the right because more firms are
supplying the quantity indicated by the representative marginal cost curve

Long-Run Competitive Equilibrium

In the long run, firms can enter and exit the market

Thus, in the long run only the zero profit equilibrium (shown on pg 329) can

Firms cant make economic profit or economic loss in the long run because of
the entry and exit of firms

If there are economic profits, firms will enter the market, shifting the
market supply curve to the right. As market supply increases, the
market price will decline and reduce profits for each firm. Firms will
continue to enter the market until economic profit is eliminated

Only at zero profit will entry and exit stop

Normal profit is the amount the owners of business would have received in the
next-best alternative

The zero-profit condition is enormously powerful; it makes the analysis of

competitive markets far more applicable to the real world than would
otherwise be the case

Adjustment from the Short Run to the Long Run

An Increase in Demand

A market in equilibrium that experiences an increase demand. Firms are making zero
profit because theyre in long-run equilibrium. If demand increases, firms will see the
market price increasing and will increase their output until theyre once again at a
position where MC=P.

As new firms enter

Chapter 15 - Monopoly

12/2/15 7:48 PM

Monopoly is a market structure in which one firm makes up the entire market

Opposite of perfect competition

Exist due to barriers to entry into a market that prevent competition


Legal barriers (i.e. patents)

Sociological barriers - custom or tradition

Natural barriers - unique ability to produce what other firms cant duplicate

Technological barriers the size market can support only one firm

The Key difference between a monopolist and a Perfect Competitor

A competitive firm is too small to affect price so it does not take into account the
effect of its output decision on the price it receives (price taker)

MR=Market price

A monopolistic firm takes into account that its output decision can affect price; its
marginal revenue is not its price

In competitive markets the firms do not act in the interest of the firms collectively

Each firm is pitted against another; consumers benefit

Monopolists see to it that they, not the consumer, benefit

A Model of Monopoly


Profit-Maximizing output at MC=MR

MR is not equal to market price

MR changes as output changes

Demand curve downward sloping (more inelastic demand)

MR curve lies below demand curve

If MR>MC the monopolist gains profit by increasing output

If MR<MC the monopolist gains profit by decreasing output

If MR=MC the monopolist is maximizing profit

Equilibrium output for the monopolist, like equilibrium output for the
competitor is determined by the MC=MR condition, but because the
monopolists marginal revenue is below its price, its equilibrium output is
different from the competitive market

Profits and Monopoly

Profit is determined by subtracting ATC from average revenue (P) at that level of
output and multiplying by the chosen output

If Price>ATC the monopolist will make a profit

If Price=ATC the monopolist will make no profit (only a normal return)

If Price<ATC the monopolist will incur a loss

Price is given by the demand curve (at the Quantity where MR=MC)

Monopolist are not guaranteed a profit

The Welfare Loss from Monopoly

Because monopolies charge a price that is higher than marginal cost, peoples
decisions dont reflect the true cost to society. Price exceeds marginal cost. Because
price exceeds marginal cost, peoples choices are distorted, they choose to consume
less of the monopolists output and more of some other output than they would if
markets were competitive.

The marginal cost of increasing output is lower than the marginal benefit of
increasing output, so theres a welfare loss

The Price-Discriminating Monopolist

Price-discriminate to charge different prices to different individuals or groups of


If monopolies can identify groups of customers who have different elasticities

of demand, separate them in some way, and limit their ability to resell its
product between groups, it can charge each group a different price

It could charge consumers with less elastic demands a higher price

and vice versa


Movie theaters give discounts to senior citizens and children

Automobiles are seldom sold at list price

Barriers to entry and Monopoly

Natural Ability

A firm might have unique abilities that make it more efficient than all other

Economies of Scale

If sufficiently large economies of scale exist, it would be inefficient to have two


Referred to as Natural Monopolies

An industry in which a single firm can produce at a lower cost than

can two or more firms

Occurs when the technology is such that indivisible set up costs are
so large that average total costs fall within the range of possible

Results in a welfare gain

Government Created Monopolies

Normative Views of Monopoly

Monopolies are unfair and inconsistent with liberty (entrance barriers)

The public does not like the income distributional effects of monopoly

Government-created monopoly encourages people to spend a lot of their time in

political pursuits trying to get the government to favor them with a monopoly rather
than doing productive things

Chapter 16 Monopolistic Competition and Oligopoly12/2/15 7:48 PM

Market structure is the physical characteristics of the market within which firms interact

Monopolistic competition is a market structure in which there are many firms selling
differentiated products and few barriers to entry

Oligopoly is a market structure in which there are only a few firms and firms explicitly
take other firms likely response into account

Characteristics of Monopolistic Competition

Many sellers

There is no need to take competitors responses to price changes into


Differentiated products

The goods sold arent homogenous, each firm has a monopoly on the good it

This monopoly is based on advertising to convince people that one firms

good is different from the goods of competitors

Advertising to increase monopoly power makes sense as long as the

marginal benefit exceeds marginal cost

Multiple dimensions of competition


Such as advertising or service and distribution outlets. They follow two

general decision rules

Compare marginal costs and marginal benefits

Change that dimension of competition until marginal costs equal

marginal benefits

Easy entry of new firms in the long run

Output, Price and Profit of a Monopolistic Competitor

Downward sloping demand curve

Profit maximization occurs at MC=MR

Competition implies zero economic profit in the long run


Due to new suppliers entering the market in search of profit

Comparing Monopolistic Competition with Perfect Competition


In perfect competition demand is perfectly elastic so firms produce where

MC=P=ATC (minimum)

In Monopolistic Competition the demand curve is downward sloping. Price

exceeds marginal cost. Produces at MC=MR

This means that for monopolistic competitors market share is a valid concern

Since increasing output lowers average cost, increasing market share

would allow the firm to do better

For perfect competitors increasing output offers no benefit

Monopolies can make long-term economic profit though monopolistic competitors


Advertising and Monopolistic Competition


Goals of Advertising

Shifting the demand curve to the right and making it more inelastic

Does advertising help or hurt society?

Joan Robinson believed that the difference between the cost of a

perfect competitor and the cost of a monopolistic competitor was the
cost of what he called differentness. If consumers are willing to pay
this cost its not a waste but, rather, a benefit.

Characteristics of Oligopoly

There are a small number of firms in the industry, so that, in any decision a firm
makes, it must take into account the expected reaction of other firms

Can be collusive or noncollusive

Mutual interdependence

Fosters strategic decision making- taking explicit account of a rivals

expected response to a decision you are making

Models of Oligopoly Behavior

There is no single model because an oligopolist can decide on pricing and output
strategy in many possible ways

The Cartel Model


A cartel is a combination of firms that acts as if it were a single firm, a shared


The Cartel model of oligopoly is a model that assumes that oligopolies act as
if they were monopolists that have assigned output quotas to individual
member firms of the oligopoly so that total output is consistent with joint profit

Explicit formal collusion is illegal in the United States

Dominant firm cartel model- a single large firm makes pricing and
output decisions and smaller, fringe firms follow

Implicit price collusion

Implicit collusion multiple firms make the same pricing decisions

even though they have not explicitly consulted with one another

Social pressures play an important role in stabilizing prices

Since other firms can enter the market, cartels encourage technological
advances to retain their monopoly

Why are prices sticky?

They dont change frequently, due to informal collusion as well as the

kinked demand curve

If a firm increases its price and the firm believes that other
firms wont go along, its perceived demand curve is very
elastic. It will lose a lot of business

If a firm decreases its price, the firm assumes that its

competitors would immediately match that price so it would
gain very few, if any, additional sales. Thus its demand curve
is here very inelastic

Thus the demand curve has a kink and MR curve has a gap

The Contestable Market Model


A model of oligopoly in which barriers to entry and barriers to exit, not the
structure of the market, determine a firms price and output decisions.

Comparison of the Contestable Market Model and the Cartel Model


New Entry limits the Cartelization Strategy

Price Wars

Firms utilize the strategy of pushing down price to drive the other firm
out of business

Classifying Industries and Markets in Practice

See the table on page 372 of Collander

Problems with classification


Choosing the relevant market (whole U.S or town?)

Deciding what is to be included in an industry (Transportation industry vs

urban transit industry)

The narrower the definition, the fewer firms

Economists classify using cross-price elasticities

The North American Industry Classification System (NAICS)


An industry classification that categorizes industries by type of economic

activity and groups firms with like production processes

Consists of six digits with each successive digit specifying a subgroup of the
initial two digit sector

Empirical Measures of Industry Structure

Concentration Ratio the value of sales by the top firms of an industry stated
as a percentage of total industry sales

The higher the ratio, the closer the industry is to an oligopolistic or

monopolistic type of market structure

Herfindahl index an index of market concentration calculated by adding the

squared value of the individual market shares of all the firms in the industry

Conglomerate firms and bigness


Bigness is not measured by either the Concentration Ratio or Herfindahl


This is due to Conglomerates- companies that span a variety of unrelated


Oligopoly models and Empirical Estimates of Market Structure


The Cartel model fits best with these empirical measurements because it
assumes that the structure of the market (the number of firms) is directly
related to the price a firm charges

The Contestable market model gives less weight to the empirical estimates
because a market structure that looks highly oligopolistic could actually be
highly competitive

Barriers to entry and exit are what matter

Chapter 17 Real-World Competition and Technology12/2/15 7:48 PM

The Goals of Real-World Firms and the monitoring Problem

Short-run versus Long-run profit


If firms are profit maximizers they arent just concerned with short-run profit;
most are concerned with long-run profit.

Expenditures on reputation and goodwill (to be perceived as good citizens) can increase long-run profit,
even if they reduce short-run profit

The Problem with Profit Maximization


In the real world the decision makers income is often a cost of the firm

Managers incentives

Self-interested decision makers have little incentive to hold down their pay, which is a
cost of the firm.

Increased pay results in decreased profit

Monitoring problem- the need to oversee employees to ensure that

their actions are in the best interest of the firm

Need for monitoring

Employees incentives differ from the owners incentives

Incentive-Compatible Contract- the incentives of each of the two parties to the contract are made to
correspond as closely as possible
Self-interested managers are interested in maximizing the firms profit only if the structure of the firm
requires them to do so

What do Real-World Firms Maximize


Profit is one of the goals of firms

Often other intermediate goals become the focus of the firm (ex: growth of sales)

The Lazy Monopolist and X-Inefficiency

Lazy monopolist- firms that do not push for efficiency, but merely enjoy the position
they are already in

Not profit maximizers, they perform as efficiently as is consistent with keeping

their jobs

Results in X-Inefficiency- firms operating far less efficiently than they could technically
These firms are in monopoly positions
The standard model avoids dealing with monitoring problems by assuming the owner of the firm makes all
the decisions

How Competition Limits the Lazy Monopolist


All economic institutions must have sufficient revenue coming in to cover

costs, so all economic institutions have a limit to how lazy they can get
imposed by their monopoly position

Profit can be translated into inefficiency but no more

The degree of competition determines the limit on laziness

Competitive pressure can be generated by a Corporate takeover- in which a firm or group of individuals
issues a tender offer (that is, offers to buy up the stock of a company) to gain control and install its own

Managers lose perks or even their jobs with takeovers so they will often preventively
restructure the company

Restructuring incurs debt so even more pressure is placed on the management to operate efficiently

Motivations for Efficiency other than the Profit Incentive


Some individuals derive pleasure from efficiently-run organizations. In such

cases monitoring increases costs and is inefficient


The Fight Between Competitive and Monopolistic Forces

Self-interest-seeking individuals dont like competition for themselves (though they do

like it for others) and when competitive pressures grow strong, they push back with
social or political forces

How monopolistic Forces Affect Perfect Competition

Our laws and social values and customs simply do not allow perfect competition to
work because government emphasizes other goals besides efficiency

Economic Insights and Real-World Competition


The movement away from perfectly competitive markets can be predicted by

economic theory

Firms collude and restrict entry into the market in order to increase
profits (in self interest)

How Competitive Forces Affect Monopoly


For a Monopoly to exist it must prevent other firms from entering the market,
which is nearly impossible

Breaking Down Monopoly

To get some of the profit firms will break down monopolies

through political or economic means

Reverse Engineering

The process of a firm buying other firms products,

disassembling them, figuring out whats special about them,
and then copying them within the limits of the law

Competition and Natural Monopoly

Natural monopolies often have high profits, which gives other firms an
incentive to research alternate ways (new technologies) of supplying the

Political Pressure is also used to regulate or break up the monopoly

Regulating Natural Monopolies

Given the exclusive right to operate in an industry in return to submission to pricing


They are allowed to make a normal return but no economic profit and thus have no incentive to keep
costs down, resulting in X-Inefficiency

Deregulating Natural Monopolies


In order to prevent X-inefficiency, more and more outside oversight is needed

to determine appropriate and inappropriate costs, resulting in high costs to
the board overseeing the firm

How Firms Protect their Monopolies

Cost/Benefit Analysis of Creating and Maintaining Monopolies


Monopolies are expensive to create and maintain, thus firms will buy
monopoly power until the marginal cost of such power equals the marginal

Establishing Market Position

Similar to a Winner-take-all competition. The winner (established because of brand

loyalty, patent protection, or simply consumer laziness) achieves monopoly and can
charge significantly higher prices than its costs without facing competition.


Technological development the discovery of new or improved

products or methods of production

Technological advance lowers costs and improves efficiency

Natural outcome of specialization due to the increased knowledge gained in specialization that allows a

Technology, Efficiency, and Market Structure

Some market structures are more conducive to growth than others (they provide
more incentives)

Dynamic Efficiency- a markets ability to promote cost-reducing or product-enhancing technological

Perfect Competition and Technology

Perfect Competitors have no incentive to develop new technologies

They also make no economic profit and thus may not be able to acquire the funds needed to devote to

Monopolistic Competition and Technology


The promise of gaining market power provides the incentive to fund research
in new technologies

However, in Monopolistic competition, long-term economic profit is zero so the gained market power will
eventually deteriorate

Monopoly and technology


Monopolies seldom have the incentive to innovate because their market is

protected from entry. This results in a lazy monopoly

Oligopoly and Technology


Oligopoly is the market structure most conducive to technological change

Typical oligopolistic firms have continual economic profit and can thus fund R&D

Also spurred on by the belief their competitors are doing so, and the desire to gain
an edge on said competitors

Network Externalities, Standards, and Technological Lock-In


Network externality- occurs when greater use of a product increases the

benefit of that product to everyone (ex: telephones)

Network Externalities lead to the development of Industry standards (such as AC vs. DC)
Standards and Winner-take-all industries

Network externalities increase the likelihood that the industry becomes a winnertake-all industry.

Network externalities increase the need for an industry standard, benefitting the firm whose standard is

First-Mover Advantage

Firms will be willing to incur large losses in order to set the industry standard

Technological Lock-In

The market might not gravitate toward the most efficient standard, yet
be maintained by the First mover advantage.

Technological lock-in when prior use of a technology makes the adoption of subsequent technologies
This does not, however, merit government interference because this would slow or stop the competitive
process and make society worse off

Chapter 19 Work and the Labor Market

12/2/15 7:48 PM

The Supply of Labor

The labor market is a factor market in which individuals supply labor services for
wages to other individuals and to firms that demand labor services

If the invisible hand were the only force operating in the labor market, wages
would be determined entirely by supply and demand; this is not the case

The incentive effect is how much a person will change his or her hours worked in
response to a change in the wage rate

Economists focus on the incentive effect when considering an individuals

choice of whether and how much to work

Normal relationship: The higher the wage, the higher the quantity of labor

As per the rational choice theory

Real Wages and the Opportunity Cost of Work

Over the last century, real wages in the U.S. rose significantly, but average number
of house worked per person fell.

This is counter to the logic that opportunity cost of leisure rises as wages rise

Higher incomes, however, make people richer and richer people can afford more to
choose more leisure

Income Taxation, Work, and Leisure

After-tax income is what determines how much people work


Taxes reduce peoples incentives to work

Societal and political programs reward the needy with less expenses/taxes

This ironically increases peoples incentives to be needy

The Elasticity of the Supply of Labor

Elasticity of Market Supply depends on


1. Individuals opportunity cost of working

2. The type of market being discussed

3. The elasticity of individuals supply curve

4. Individuals entering and leaving the labor market

Individuals opportunity cost of working determine individuals supply curves and the
amounts of people entering and leaving the labor force

Immigration and the International Supply of Labor

International limitations on immigration play an important role in elasticities of labor


The Derived Demand for Labor

The demand for labor follows the basic law of demand:

The higher the wage, the lower the quantity of labor demanded

When people are self-employed, the demand for the labor is the demand for the
product or service they supply

When a person isnt self-employed, determining the demand for labor isnt as direct

Theres 2 steps: Consumers demand products from firms; firms then demand

Labor is a derived demand the demand for factors of production by firms, which
depends on consumers demands

Factors Influencing the Elasticity of Demand for Labor

Factors that influence the elasticity of demand for labor are


1. The elasticity of demand for the firms good

2. The relative importance of labor in the production process

3. The possibility, and cost, of substitution in production

4. The degree to which marginal productivity falls with an increase in labor

Labor as a Factor of Production

Land, labor, and capital are the traditional factors of production along with
entrepreneurship labor that involves high degrees of organizational skills,
concern, oversight responsibility, and creativity

Labor and entrepreneurship are differentiated in the sense that an hour of

work is not an hour work if organizational skills/creativity/etc are exerted

Should a firm try to higher high-wage entrepreneurial labor or low-wage

nonentrepreneurial labor?

Shift Factors of Demand

Factors that shift the demand curve for labor will put pressure on the equilibrium
price to change

If the price of a machine that is used in production rises, then demand for
labor (a substitute) would shift right and the wage would rise

Technology and the Demand for Labor


Technology makes it possible to replace workers with machines, so it will

decrease the demand for labor

This Luddite reasoning is incorrect

Technology increases output, however its affect on demand of labor is

ambiguous; technology decreases the demand for certain types of labor but
increases demand for other types.

E.g. Computers decreased demand for calligraphers and increased

demand for computer programmers

International Competitiveness and a Countrys Demand for Labor


A central determinant of a countrys competitiveness is the relative wage rate

of labor in that country

Hence why MNCs often establish manufacturing plants in the third


The focal point phenomenon is when a company chooses to move, or

expand, production to another country because other companies have
already moved there

The Role of Other Forces in Wage Determination

Supply and demand forces greatly influence wages, but do not determine them

Real-world labor markets are filled with individuals/firms that resist market
forces of supply and demand

Imperfect Competition and the Labor Market


A monopsony is a market in which a single firm is the only buyer


It buys less and pays less

When theres only one buyer of labor, with each worker hired, the equilibrium wages
of the next one rise

The marginal factor cost the additional cost to a firm of hiring another
worker is above the supply curve

Union Monopoly Power

A union monopoly is where workers organized together that allows them to act as if
there were only a single seller

The union will have the incentive to act like a monopoly and increase its members

To do so, it must be able to restrict supply and union membership

The wage that the union sets wouldnt be below the competitive wage, it would be
above it

Bilateral Monopoly

A bilateral monopoly is a market with only a single seller and single buyer

The equilibrium wage will between that of the monopsonist wage and the union
monopoly power wage; the equilibrium quantity will be between the monopsonist
quantity and union monopoly power quantity

Political and Social Forces and the Labor Market

To understand real-world labor markets, one must broaden the analysis

Fairness and the Labor Market

Efficiency Wages

Efficiency wages are wages paid above the going market wage to keep
workers happy and productive

Comparable Worth Laws


Comparable worth laws are laws mandating comparable pay for

comparable work

Job Discrimination and the Labor Market

On average women are paid les than men and blacks are often directed into lowerpaying jobs

Three Types of Direct Demand-Side Discrimination


1. Discrimination based on individual characteristics that will affect job


2. Discrimination based on correctly perceived statistical characteristics of the


3. Discrimination based on individual characteristics that dont affect job

performance or are incorrectly perceived

Discrimination based on characteristics that affect job performance is hard to

eliminate, while discrimination based on characteristics that do affect job
performance is easy to eliminate as there are no economic motivations
causing such discrimination.

Institutional Discrimination

When the structure of the job makes it difficult/impossible for some groups to
succeed, there is institutional discrimination

The Evolution of Labor Markets

Evolving Labor Laws

Unions and Collective Bargaining


A closed shop is a firm in which the union controls hiring

These are illegal

A union shop is a firm in which all workers must join the union

Federal law permits these

Chapter 20 Who Gets What? The Distribution of Income12/2/15 7:48 PM

Ways of Considering the Distribution of Income

The share distribution of income is the relative division of total income among
income groups

The socioeconomic distribution of income is the allocation of income among

relevant socioeconomic groupings

The Lorenz Curve

A Lorenz curve is a geometric representation of the share distribution of income

among families in a given country at a given time

Real-world Lorenz curves are below the diagonal line

U.S. Income Distribution over Time

Until 1970, income equality rose; it has fallen since

Redistribution measures instated by the U.S. government


Social Security

Progressive taxation

Improved macroeconomic performance of the economy

Defining Poverty

Poverty can be defined absolutely and relatively

The Official Definition of Poverty

The poverty threshold is the income below which a family is considered to live in

A family is in poverty if its income is equal to or less than three times an

average familys minimum food expenditures as calculated by the U.S.
Department of Agriculture.

Debates about the Definition of Poverty

The poverty line is seen as too high and too low by various groups based on
observations on prices of food, etc.

Like most economic statistics, poverty statistics should be used with care

The Costs of Poverty

Poverty is argued to bring significant costs to society


General morale

Increases crime (lower opportunity cost)

Social and Economic Mobility

The U.S. was seen as a meritocracy


Recently, this view is under question

International Dimensions of Income Inequality

Comparing Income Distribution across Countries

The U.S. has less income inequality than most developing countries but more
income inequality than many developed countries

Income Distribution among Countries

International wealth distribution is incredibly unequal


Income is highly unequally distributed among countries

The Total Amount of Income in Various Countries

There are enormous differences of income among countries

The Distribution of Wealth

Equality of wealth and equality of income are used measuring equality


Wealth is the value of the things individuals own less the value of what they

A static concept

Income is payments received plus or minus changes in value in a persons

assets in a specified time period

A flow concept

A Lorenz Curve of the Distribution of Wealth

Wealth is significantly more unequally distributed than is income in the U.S.

Socioeconomic Dimensions of Income Inequality

Income Distribution According to Socioeconomic Characteristics

Income differs substantially by type of job

Income Distribution According to Class

Class divisions by income source have become blurred


The U.S. has socioeconomic classes with some mobility among classes. This
is not to say such classes should exist, just that they do.

The Importance of the Middle Class


Economists used to see the class structure as a pyramid, with a large lower
class, a smaller middle class, and an even smaller upper class

However, now the class structure is more like a pentagon with the
middle class being the largest

Distributional Questions and Tensions in Society


Mainstream economists tend to focus on the share distribution of income,

nonmainstream economists emphasize class and group structures in their

Radical economists emphasize the control that the upper class has
over the decision process

Libertarian economists emphasize the role of special interests of all

types in shaping government policy

Peoples acceptance of the U.S. economic system is based not only on what
the distribution of income is but also on what people thing it should be and
what they consider fair

Income Distribution and Fairness

Value judgments necessarily underlie all policy prescriptions

Philosophical Debates about Equality and Fairness

Different philosophies hold very different normative views on how incomes should be
distributed if at all

Fairness and Equality

Fairness has many dimensions and it is often difficult to say what is fair and what

Determining whether an equal income distribution is fair involves 3 things to keep in


1. People dont start from equivalent positions

2. Peoples needs differ

3. Peoples efforts differ

Fairness and Equality of Opportunity

Equality of income given that individuals are comparably endowed

The Problems of Redistributing Income

The Important Side Effects of Redistributive Programs

Three main side effects of income redistribution are


1. A tax may result in a switch from labor to leisure

2. People may attempt to avoid or evade taxes, leading to a decrease in

measured income

3. Redistributing money may cause people to make themselves look as if

theyre more needy than they really are

People will change their behavior in response to changes in taxation and income
redistribution programs

Incentive effects of taxation

The importance of incentive effects of taxation is debated by economists to

the point where theyre considered marginal or crucial and taxation should be

Politics, Income Redistribution, and Fairness

Often, politics (instead of value judgments) plays a central role in determining what
taxes an individual will pay

Politics/voting is not a socioeconomically fair way to determine taxation practices


Poor people are discouraged from voting feeling one vote cant make a

Elections require financing

Education levels, etc.

Income Redistribution Policies

The government uses taxation and expenditures for income redistribution

Taxation to Redistribute Income

A progressive tax is one in which the average tax rate increases with income

A proportional tax is one in which the average rate of tax is constant regardless of
income level

A regressive tax is one in which the average tax rate decreases as income

Federal Income Taxes


In the 1940s, the federal personal income tax was made highly progressive.
But since then, the rates have become less progressive.

The Social Security tax is initially proportional

State and Local Taxes


State and local governments get most of their income from the following

1. Income taxes (somewhat progressive)

2. Sales tax, which tend to be proportional or slightly regressive

3. Property taxes which are roughly proportional

Expenditure Programs to Redistribute Income

Expenditure programs have been more successful in redistributing income than


Social Security

The Social Security system is a social insurance program that provides

financial benefits to the elderly and disabled and to their eligible dependents
and/or survivors

Medicare is a multibillion-dollar medical insurance system

Public Assistance

Public assistance programs are means-tested social programs targeted to

the poor and providing financial, nutritional, medical, and housing assistance

E.g. Medicaid, SNAP (food stamps)

Supplemental Security Income


Supplemental Security Income (SSI) is a federal program that pays

benefits, based on need, to the elderly, blind, and disabled

Unemployment Compensation

Unemployment compensation is short-term financial assistance,

regardless of need, to eligible individuals who are temporarily out of work

Housing Programs

How Successful Have Income Redistribution Programs Been?

The gain in equality is at the expense of total income of society

Chapter 21 Market Failure versus Government Failure12/2/15 7:48 PM

Market Failures

There is an ongoing debate between whether or not government intervention is

acceptable in certain markets

The invisible hand framework says that if markets are perectly competitive,
they will lead individuals to make voluntary choices that are in societys

When conditions arent met to ensure that the invisible hand guides private actions
towards social good, market failure occurs

Market failure is a situation in which the invisible hand pushes in such a way
that individual decisions do not lead to socially desirable outcomes

There are three sources of market failures


Public goods

Imperfect information

Any time theres a market failure, it is possible government intervention could

improve the outcome but is not certain as the politics of execution often result in
more problems

These problems of government intervention are called government failures

when the government intervention in the market to improve the market
failure actually makes the situation worse


Externalities are the effects of a decision on a third party that are not taken into
account by the decision maker

Can be positive and negative

Negative externalities occur when the effects of a decision not taken into
account by the decision maker are detrimental to others

Positive externalities occur when the effects of a decision not taken into
account by the decision maker are beneficial to others

A Negative Externality Example

When there are externalities, the marginal social cost differs from the marginal
private cost

The marginal social cost includes all them marginal costs that society bears
or the marginal private costs of production plus the cost of the negative
externalities associated with that production

The distance between the two marginal cost curves (social vs. private) is the
additional marginal cost of the externality

The vertical distance between the two (MC [or supply]) curves at a
given quantity is the MC of the externality

A Positive Externality Example

Positive externalities make the marginal private benefit below the marginal social

The marginal social benefit equals the marginal private benefit of

consuming a good plus the benefits of the positive externalities resulting from
consuming that good

The distance between the two marginal benefit curves (social vs. private) is
the additional marginal benefit of the externality

The vertical distance between the two (demand) curves at a given

quantity is the marginal benefit of a decision

Alternative Methods of Dealing with Externalities

1) Direct Regulation

2) Incentive Policies

3) Voluntary Solutions

Direct Regulation

Direct regulation is when the amount of a good people are allowed to use is directly
limited by the government

Can require an equal quantity reduction or an equal percentage reduction

Direct regulation is not efficient achieving a goal at the lowest cost in total
resources without consideration as to who pays those costs

Direct regulation does not take into account that the costs of reducing
consumption may differ among individuals

A solution is inefficient when a goal is achieved in amore costly manner than


Incentive Policies

Tax Incentive Policies


A tax incentive program is a program using a tax to create incentives for

individuals to structure their activities in a way that is consistent with the
desired ends

More efficient than a regulatory solution as the person for whom the
reduction is lest costly cuts consumption the most

An efficient tax equals the additional cost imposed on society but not taken
into account by the decision maker

Such taxes on externalities are called effluent fees charges

imposed by government on the level of pollution created

With such a tax, the cost the suppliers face is the social cost of
supplying the good. With the tax, the invisible hand guides the traders
to equate the marginal social cost to the marginal social benefit and
the equilibrium is socially optimal

Market Incentive Policies


A market incentive plan is a plan requiring market participants to certify that

they have reduced total consumption not necessarily their own individual
consumption by a specific amount

Close to the regulatory solution, but different in the fact that if

individuals choose to reduce consumption by more than the required
amount, theyll be given a marketable certificate that they can sell to
someone who has chosen to reduce consumption by less than the
required amount

Incentive policies are more efficient than direct regulatory policies

Voluntary Reductions

Leaving individuals free to choose whether to follow a socially optimal or a privately

optimal path

The free rider problem is individuals unwillingness to share in the cost of a

public good

The Optimal Policy

The optimal policy is one in which the marginal cost of undertaking the policy
equals the marginal benefit of that policy

If a policy isnt optimal, resources are being wasted because the savings from
reducing expenditures on a program will be worth more than the gains that
will be lost from reducing the program

To spend too little on a beneficial program is as inefficient as spending too much on

a non beneficial program

Public Goods

A public good is a good that is nonexclusive (no one can be excluded from its
benefits) and nonrival (consumption by one does not preclude consumption by

No such thing as a pure public good in reality

Governments generally provide goods with public aspects as private businesses will
not supply them without transforming them into a mainly private goods

Supply and demand of public goods


The market demand curve represents the marginal social benefit of a good

While the market demand curve for a private goods is the horizontal
sum of all the individual demand curves, the market demand curve of
a public good is the vertical sum. This is because the quantity of the
good supplied is not split up; the full benefit of the total output is
received by everyone

Excludability and the Costs of Pricing

Public/private good differentiation is seldom clear-cut


Goods can be non rival but highly excludable and vice versa

Informational Problems

If a buyer doesnt have perfect information, then they can be deceived


Real-world markets often involve deception, cheating, and inaccurate


Imperfect information can be the source of market failure


An adverse selection problem is a problem that occurs when buyers and

sellers have different amounts of information about the good for sale

Problems in imperfect information can be solved by signaling an action taken by

an informed party that reveals information to an uninformed party that offsets the
false signal that caused the adverse selection problem in the first place

Policies to Deal with Informational Problems

Licenses, regulatory commissions, etc.


These have a problem of their own; they can slow down the economic
process. E.g. FDA

A Market in Information

Information is valuable, markets will develop to provide the information that

people need and are willing to pay for

Government Failure and Market Failures

Government failures can occur for various reasons


Governments dont have an incentive to correct the problem

Political pressures often dominate over the general good

Governments dont have enough information to deal with the problem

Intervention in markets is always more complicated than it seems

Long-run vs. short-run incentives conflict with government intervention

The bureaucratic nature of government intervention does not allow fine tuning

Government intervention leads to more government intervention

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