READING

ASSIGNMENTS

INTRODUCTION TO MICROECONOMICS

E201

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 CHAPTER 1

Introduction to Economics

This is an introductory course in economics. As with most introductory courses

there are certain foundations that must be laid before the structure of the discipline may
be meaningfully examined. This chapter and the following two chapters will lay those
foundations -- the rudimentary definitions, and basic concepts upon which the following
ideas will be built are discussed. Further, there is a general discussion of the methods
used by economists in their analyses.

Specifically, this chapter will focus on specific definitions, policy, and objective
thinking. A discussion of the role of assumptions in model building will also be offered
as a basis for understanding the economic models that will be built in the following
chapters.

Definitions

Economics is a social science. In other words, it is a systematic examination of

human behavior, based on the scientific method, and reliant upon rigorous analysis of
that behavior. Economics is the mother discipline from which most of the business
disciplines arose. Most people have a vague idea of what the word economics means,
but precise definitions generally require some academic exposure to the subject.

Economics is the study of the ALLOCATION of SCARCE resources to meet

UNLIMITED human wants. In other words, economics is the study of human behavior
as it pertains to material well-being. The key words in this definition are in all capital
letters. Because there are a finite number of resources available, the fact that human
want exceed that (are unlimited) then the resources are scare relative to the want for
them. Because there are fewer resources than wants there must be allocation
mechanism of some sort – markets, government, law of the jungle, etc.

Robert Heilbroner describes economics as the "Worldly Philosophy." A "Worldly

Philosophy" is concerned with matters of how our material or worldly well-being is best
served. In fact, economics is the organized examination of how, why and for what
purposes people conduct their day-to-day activities, particularly as it relates to the
accumulation of wealth, earning an income, spending their resources, and other matters
concerning material well-being. This worldly philosophy has been used to explain most
rational human behavior. (Irrational behavior being the domain of specialties in
sociology, psychology, history, and anthropology.) Underlying all of economics is the

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base assumption that people act in their own perceived best interest (at least most of
the time and in the aggregate). Without the assumption of rational behavior,
economics would be incapable of explaining the preponderance of observed economic
activity. As limiting as this assumption may seem, it appears to be an accurate
description of reality.

In 1776 Adam Smith penned An Inquiry into the Nature and Causes of the
Wealth of Nations. With its publication, capitalism was born, from the ashes of the
mercantilist system that preceded it. Smith described an economic system of cottage
industries and relatively unfettered pursuit of self-interest, and how that unfettered
pursuit of self-interest could result in a system that distributed its limited resources in an
efficient fashion.

Adam Smith’s view of self-interest and exchange

An Inquiry in the Nature and Cause of the Wealth of Nations, Adam Smith, New York:
Knopf Publishing, 1910, p. 14.

. . . In almost every other race of animals each individual, when it is grown to

maturity, is entirely independent, and in its natural state has occasion for the
assistance of no other living creature. But man has almost constant occasion for the
help of his brethren, and it is in vain for him to expect it from their benevolence only.
He will be more likely to prevail if he can interest their self-love in his favour, and
show then that it is for their own advantage to do for him what he requires of them.
Whoever offer to another a bargain of any kind, proposes to do this. Give which I
want, and you shall have this, which you want, is the meaning of every such offer;
and it is in this manner that we obtain from one another the far greater part of those
good office which we stand in need of. It is not from the benevolence of the butcher,
the brewer, or the baker that we expect our dinner, but from their regard to their own
interest. We address ourselves, not to their humanity but to their self-love, and never
talk to them of our necessities but of their advantages. . . .

Adam Smith, Wealth of Nations. New York: Alfred A. Knopf, 1991, p. 13.

Experimental economics, using rats in mazes, suggests that rats will act in their
own best interest (incidentally, Kahneman won a Noble Prize for this sort of research –
it is serious business, not just fun and games like it sounds). Rats, it was discovered,
prefer root beer to water. The result is that rats will pay a greater price (longer mazes
and electric shocks) to obtain root beer than they will to obtain water. Therefore it
appears to be a reasonable assumption that humans are no less rational – as Adam
Smith postulates in his view of how we might best obtain our dinner.

Most academic disciplines have evolved over the years to become collections of

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closely associated scholarly endeavors of a specialized nature. Economics is no
exception. An examination of one of the scholarly journals published by the American
Economics Association, The Journal of Economic Literature, reveals a classification
scheme for the professional literature in economics. Several dozen specialties are
identified in that classification scheme, everything from national income accounting, to
labor economics, to international economics. In other words, the realm of economics
has expanded over the centuries that it is nearly impossible for anyone to be an expert
in all aspects of the discipline, so each economist generally specializes in some narrow
portion of the discipline. The decline of the generalist is a function of the explosion of
knowledge in most disciplines.

In general, economics is bifurcated by the focus of the analysis – that is, there
are two bundles of issues that are examined by economists. These bundles of issues
are considered together, by the level of the activity upon which the analysis is focused.
Economics is generally classified into two general categories of inquiry, these two
categories are: (1) microeconomics and (2) macroeconomics.

Microeconomics is concerned with decision-making by individual

economic agents such as firms and consumers. In other words, microeconomics is
concerned with the behavior of individuals or groups organized into firms, industries,
unions, and other identifiable agents. The focus of microeconomics is on decision-
making, and hence markets. Microeconomics is the subject matter of this course
(E201).

Macroeconomics is concerned with the aggregate performance of the

entire economic system. That is, the performance of the U.S. economy or, in a more
modern sense, the global economy. The issues of unemployment, inflation, economic
development and growth, the balance of trade, and business cycles are the topics that
occupy most of the attention of students of macroeconomics. These matters are the
topics to be examined the course that follows this one (E202).

Methods in Economics

Economists seek to understand the behavior of people and economic systems

using scientific methods. These scientific endeavors can be classified into two
categories of activities, these are: (1) economic theory and (2) empirical economics.
Theoretical and empirical economics are very much related activities, even though
distinguished here for simplicity of presentation.

Economic theory relies upon principles to analyze behavior of economic

agents. These theories are typically rigorous, mathematical representations of human
behavior with respect to the production or distribution of goods and services in

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microeconomics – and the aggregate economy in macroeconomics. A good theory is
one that accurately predicts future human behavior and can be supported with
evidence.

Nobel Prize Winners in Economic Science

1969 J. Tinbergen (Netherlands); R. Frisch (Norway)

1970 P.A. Samuelson (USA - Indiana)
1971 S. Kuznets (USA, Soviet Union)
1972 J. R. Hicks (United Kingdom); K. J. Arrow (USA)
1973 W. Leontief (USA)
1974 F. A. Hayek (Austria, USA); K. G. Myrdal (Sweden)
1975 T. Koopmans (USA); L. Kantorovich (Soviet Union)
1976 M. Friedman (USA)
1977 B. Ohlin (Sweden); J. Meade (United Kingdom)
1978 H. A. Simon (USA)
1979 T. W. Schultz (USA); A. Lewis (United Kingdom)
1980 L. R. Klein (USA)
1981 J. Tobin (USA)
1982 G. J. Stigler (USA)
1983 G. Debreu (USA)
1984 R. Stone (United Kingdom)
1985 F. Modigliani (Italy, USA)
1986 J. Buchanan (USA)
1987 R. M. Solow (USA)
1988 M. Allais (France)
1989 T. Haavelmo (Norway)
1990 H. Markowitz (USA); M. Miller (USA); W. Sharpe (USA
1991 R. H. Coase (United Kingdom, USA)
1992 G. S. Becker (USA)
1993 R. W. Fogel (USA); D. C. North (USA)
1994 R. Selten (Germany); J. C. Harsanyi (USA); J. F. Nash (USA)
1995 R. E. Lucas (USA)
1996 J. A. Mirrlees (United Kingdom); William Vickery (Canada, USA)
1997 R. C. Merton (USA); M. S. Scholes (USA)
1998 A. Sen (India, United Kingdom)
1999 R. A. Mundell (USA)
2000 J. J. Heckman (USA); D. L. McFadden (USA)
2001 G. A. Akerlof (USA); A. M. Spence (USA); J. E. Stiglitz (USA - Indiana)
2002 D. Kahneman (USA, Isreal); V. L. Smith (USA)

Economic theory tends to be a very abstract area of the discipline. Mathematical

modeling was introduced into the discipline early in the eighteenth century by such
scholars as Mill and Ricardo. In the middle of the twentieth century, an economist, Paul

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Samuelson, from M.I.T., published his book, Mathematical Foundations of Economic
Analysis, and from the that point forward, economic theory was to become heavily
mathematical – gone were the days of the institutionalists from the mainstream of
economic theory. (Incidentally Paul Samuelson won the Nobel Prize for Foundations,
and he is a Hoosier, Stiglitz is also from Indiana, and both are from Gary, Indiana).

The above table presents a list of those who have won Nobel Prizes in Economic
Science. Notice that the overwhelming majority of these persons are Americans – two
of whom are from Indiana, and several are from the University of Chicago. It is also
interesting to note that one must be living to receive the Nobel Prize; so many famous
economists who met their end before receiving the prize will not be listed. Further, it is
also interesting to note that the Nobel Prize in Economic Sciences is the newest of the
prizes, beginning with Tinbergen’s award in 1969.

Empirical economics relies upon facts to present a description of

economic activity. Empirical economics is used to test and refine theoretical
economics, based on tests of economic theory.

The area referred to as econometrics is the arena in economics in which

empirical tests of economic theory occurs. The area is founded in mathematical
statistics and is critical to our ability to test the veracity of economic theories.

Theory concerning human behavior is generally constructed using one of two

forms of logic – inductive logic or deductive logic. Most of the social studies, i.e.,
sociology, psychology and anthropology typically rely on inductive logic to create theory.

Inductive logic creates principles from observation. In other words, the

scientist will observe evidence and attempt to create a principle or a theory based on
any consistencies that may be observed in the evidence.

Economics relies primarily on deductive logic to create theory. Deductive logic

involves formulating and testing hypotheses. In other words, the theory is created,
and then data is applied in a statistical test to see if the theory can be rejected.

Often the theory that will be tested comes form inductive logic or sometimes
informed guess-work. The development of rigorous models expressed as equations
typically lend themselves to rigorous statistical methods to determine whether the
models are consistent with evidence from reality. The tests of hypotheses can only
serve to reject or fail to reject a hypothesis. Therefore, empirical methods are focused
on rejecting hypotheses and those that fail to be rejected over large numbers of tests
generally attain the status of principle.

However, examples of both types of logic can be found in each of the social
sciences and in most of the business disciplines. In each of the social sciences it is
common to find that the basic theory is developed using inductive logic. With increasing

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regularity standard statistical methods are being employed across all of the social
sciences and business disciplines to test the validity and the predictability of theories
developed using these logical constructs.

The usefulness of economics depends on how accurate economic theory

predicts human behavior. In other words, a good theory is one that is an accurate
description of reality. Economics provides an objective mode of analysis, with rigorous
models that permit the discounting of the substantial bias that is usually present with
discussions of economic issues. The internal consistency brought to economic theory
by mathematical models of economic behavior provides for this consistency. However,
no model is any better than the assumptions that underpin that model. If the
assumptions are unrealistic, so too will be the models' predictions.

The objective mode of analysis is an attempt to make a social study more

scientific. That is, a systematic analysis of rational human behavior. “Rational” is a
necessary component of this attempt. It is the rationality that makes behavior
predictable, and what most economists don’t like to admit is without this underlying
premise, economics quickly falls into a quagmire of irreproducible results and disjointed
theories.

The purpose of economic theory is to describe behavior, but behavior is

described using models. Models are abstractions from reality - the best model is the
one that best describes reality and is the simplest (the simplest requirement is called
Occam's Razor). Economic models of human behavior are built upon assumptions; or
simplifications that allow rigorous analysis of real world events, without irrelevant
complications. Often (as will be pointed-out in this course) the assumptions underlying
a model are not accurate descriptions of reality. When the model's assumptions are
inaccurate then the model will provide results that are consistently wrong (known as
bias).

One assumption frequently used in economics is ceteris paribus which means

all other things equal (notice that economists, like lawyers and doctors will use Latin for
simple ideas). This assumption is used to eliminate all sources of variation in the model
except those sources under examination (not very realistic!).

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Economic Goals, Policy, and Reality

Most people and organizations do, at least, rudimentary planning, the purpose of
planning is the establishment of an organized effort to accomplish some economic
goals. Planning to finish your education is an economic goal. Goals are, in a sense, an
idea of what should be (what we would like to accomplish). However, goals must be
realistic and within our means to accomplish, if they are to be effective guides to action.
This brings another classification scheme to bear on economic thought. Economics
can be again classified into positive and normative economics. Positive economics is
concerned with what is; and normative economics is concerned with what should
be. Economic goals are examples of normative economics. Evidence concerning
economic performance or achievement of goals falls within the domain of positive
economics.

The normative versus positive economics arguments begs the question of

whether economics is truly a value free science. In fact, economics contains numerous
value judgments. Rational behavior assumes that people will always behave in their
own self-interest. Self-interest is therefore presented as a positive element of behavior.
In fact, it is a value judgment. Self-interest is probably descriptive of the majority of
Americans’ behaviors over the majority of time, however, each of us can think of
instances where self-less behavior is observed, and is frequently encouraged.

Efficiency is a measurable concept, and is taken as a desirable outcome.

However, efficiency is not always desirable. Equity or fairness is also something prized
by most people. The efficiency criterion in economics is not always consistent with
equity; in fact, these two ideas are often in conflict.

Economics also generally assumes that more is preferred to less by all

consumers and firms. However, there are disposal problems, distributional effects, and
other problems where more may not be such a good thing. Obesity is a result of more,
but a bad result. Pollution, poverty, and crime may also be examined as more begetting
problems.

Most nations have established broad social goals that involve economic issues.
The types of goals a society adopts depends very much on the stage of economic
development, system of government, and societal norms. Most societies will adopt one
or more of the following goals:

(1) economic efficiency,

(2) economic growth,

(3) economic freedom,

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 (4) economic security,

(5) an equitable distribution of income,

(6) full employment,

(7) price level stability, and

(8) a reasonable balance of trade.

Each goal (listed above) has obvious merit. However, goals are little more than
value statements in this broad context. For example, it is easy for the very wealthy to
cite as their primary goal, economic freedom, but it is doubtful that anybody living in
poverty is going to get very excited about economic freedom; but equitable distributions
of income, full employment and economic security will probably find rather wide support
among the poor. Notice, if you will, goals will also differ within a society, based on
socio-political views of the individuals that comprise that society.

Economics can hardly be separated from politics because the establishment of

national goals occurs through the political arena. Government policies, regulations, law,
and public opinion will all effect goals and how goals are interpreted and whether they
have been achieved. A word of warning, eCONomics can be, and has often been used,
to further particular political agendas.

The assumptions underlying a model used to analyze a particular set of

circumstances will often reflect the political agenda of the economist doing the analysis.
An example liberals are fond of is, Ronald Reagan argued that government deficits
were inexcusable, and that the way to reduce the deficit was to lower peoples' taxes --
thereby spurring economic growth, therefore more income that could be taxed at a
lower rate and yet produce more revenue. Mr. Reagan is often accused, by his
detractors, of having a specific political agenda that was well-hidden in this analysis.
His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to
make his tax cuts for rich acceptable to most of the voters. (Who really knows?)
Conservatives are fonder of criticizing the Clinton administration’s assertions that the
way to reduce the deficit was to spend money where it was likely to be respent, and
hence grow the economy and the result was more tax revenues, hence eliminate the
deficit. Most political commentators, both left and right, have mastered the use of
assumptions and high sounding goals to advance a specific agenda. This adds to the
lack of objectivity that seems to increasingly dominate discourse on economic problems.

On the other hand, goals can be public spirited and accomplish a substantial
amount of good. President Lincoln was convinced that the working classes should have
access to higher education. The Morrell Act was passed 1861 and created Land Grant
institutions for educating the working masses (Purdue, Michigan State, Iowa State, and

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Kansas State (the first land grant school) are all examples of these types of schools).
By educating the working class, it was believed that several economic goals could be
achieved, including growth, a more equitable distribution of income, economic security
and freedom. In other words, economic goals that are complementary are consistent
and can often be accomplished together. Therefore, conflict need not be the
centerpiece of establishing economic goals.

Because any society's resources are limited there must be decisions about which
goals should be most actively pursued. The process by which such decisions are made
is called prioritizing. Prioritizing is the rank ordering of goals, from the most important to
the least important. Prioritizing of goals also involve value judgments, concerning which
goals are the most important. In the public policy arena prioritizing of economic goals is
the subject of politics.

Policy

Policy can be generally classified into two categories, public and private policy.
The formulation of public and private policy is the creation of guidelines, regulations, or
law designed to effect the accomplishment of specific economic (or other) goals.
Public policy is how economic goals are pursued. Therefore, to understand goals one
needs to understand something of the process of formulating policy.

Business students will have an in depth treatment of policy making in

Administrative Policy (J401) and the School of Public and Environmental Affairs requires
a similar course in some of its degree programs. For students in other programs the
brief treatment here will suffice for present purposes.

The steps in formulating policy are:

1. stating goals - must be measurable with specific stated objective to be

accomplished.

2. options - identify the various actions that will accomplish the stated
goals & select one, and

3. evaluation - gather and analyze evidence to determine whether policy

was effective in accomplishing goal, if not reexamine options and
select option most likely to be effective.

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 Both the public and private policy formulation process is a dynamic one.
Economic goals change with public opinion and with achievement. Step 1 involves the
value statement of setting goals. Step 2 involves selecting the appropriate model and
the options associated with that model to accomplish the specified goal. The final step
involves gathering evidence and the appropriate analysis to determine whether the
policy needs revision. The process of formulating policy is therefore a loop, and
requires continuous monitoring and revising.

The major difference between public policy and private policy is that private
policy is not subject to democratic processes. The Board of Directors or management
of a company will decide what goals are to be accomplished and what policy options are
best used to do so. Often private policy is made behind closed-doors without public
accountability, even though there are often public costs imposed. The strength of public
policy is created in the open, with public debate, and often has the force of law (and not
just company rules and regulations).

Objective Thinking

Most people bring many misconceptions and biases to economics. After all,
economics deals with people's material well-being – a very serious matter to most.
Because of political beliefs and other value system components rational, objective
thinking concerning various economic issues fail. Rational and objective thought
requires approaching a subject with an open-mind and a willingness to accept what ever
answer the evidence suggests is correct. In turn, such objectivity requires the shedding
of the most basic preconceptions and biases -- not an easy assignment.

What conclusions an individual draws from an objective analysis using economic

principles, are not necessarily cast in stone. The appropriate decision based on
economic principles may be inconsistent with other values. The respective evaluation
of the economic and "other values" (i.e., ethics) may result in a conflict. If an
inconsistency between economics and ethics is discovered in a particular application, a
rational person will normally select the option that is the least costly (i.e., the majority
view their integrity as priceless). An individual with a low value for ethics or morals may
find that a criminal act, such as theft, as involving minimal costs. In other words,
economics does not provide all of the answers; it provides only those answers capable
of being analyzed within the framework of the discipline.

There are several common pitfalls to objective thinking in economics. Among the
most common of these pitfalls, which affect economic thought, are: (1) the fallacy of
composition, and (2) post hoc, ergo prompter hoc. Each of these will be reviewed, in
turn in the following paragraphs.

The fallacy of composition is the mistaken belief that what is true for the

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individual must be true for the group. An individual or small group of individuals may
exhibit behavior that is not common to an entire population. For example, if one
individual in this class is a I.U. fan then everyone in this class must be an I.U. fan is an
obvious fallacy of composition. Statistical inference can be drawn from a sample of
individuals, but only within confidence intervals that provide information concerning the
likelihood of making an erroneous conclusion (E270, Introduction to Statistics provides a
more in depth discussion of confidence intervals and inference).

Post hoc, ergo prompter hoc means after this, hence because of this, and
is a fallacy in reasoning. Simply because one event follows another does not
necessarily imply there is a causal relation. One event can follow another and be
completely unrelated, this is simple coincidence. One event can follow another, but
there may be something other than direct causal relation that accounts for the timing of
the two events. For example, during the thirteenth century people noticed that the black
plague occurred in a location when the population of cats increased. Unfortunately,
some concluded that the plague was caused by cats so they killed the cats. In fact, the
plague was carried by fleas on rats. When the rat population increased, cats were
attracted to the area because of the food supply. The rat populations increased, and so
did the population of fleas that carried the disease. This increase in the rat population
also happened to attract cats, but cats did not cause the plague, if left alone they may
have gotten rid of the real carriers (the rats, therefore the fleas).

Perhaps it is interesting to note that in any scientific endeavor there is a basic

truth. Simple answers to complex problems are appealing, abundant, and often
wrong. This twist on Occam’s razor is true. Too often the desire to have a simple
solution will blind individuals, and public opinion to the more complex and often more
harsh realities. One must take great care to assure that this simple trap does not befall
one in their search for truth, because not all truth is simple.

Policy is fraught with danger. Failure to anticipated the consequences of certain

aspects of policy may cause results that were neither intended nor anticipated by the
policy-makers; this is referred to as the law of unintended consequences.

The following box presents an excellent historical example of the law of

unintended consequences.

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Law of Unitended Consequences “The Legend of Pig Iron”
(David A. Dilts, Indiana Policy Review, Vol. 1, No. 5, pp. 28-29.)
Many a cliché seems to center on pork. The head of the household is
supposed to " put bacon on the table," "pork barrels," and politicians are frequently
accused of being in too close a proximity. It only seems fitting that one more story
concerning pork should be brought to your attention.
During World War II, farmers in the corn belt argued that regulation of the
price of pork had no effect on the war effort, and that they should be permitted to sell
their commodities without government interference. The farmers brought political
pressure to bear on the Congress and our representatives to deregulate the price of
pork. The end result was to shut down the steel mills in Gary.
Shut down our steel mills? How could this be?
Since it is not intuitively obvious how this happened, I'll explain. In 1942, there
had been a change in management in the Philippines. And, as luck would have it, we
didn't have good trade relations with the new management -- the Japanese.
Therefore we did not have access to Manila fibre, necessary in making everything
from rope to battleships. We had not yet developed synthetic fibre and therefore has
to rely on the fibre previously available. That fibre was hemp.
Now hemp grows in the same places, under the same climatic conditions as
does corn. Corn is what hogs eat. And because corn was not being grown in the
Midwest, the farmers sought alternative feed for the increased number of hogs they
were raising. (Remember, increased price results in a larger quantity supplied.)
Oats, wheat and barley were available from the Great Plains region. The problem
was shipping it to where the hogs were raised in the Corn Belt of the Lower Midwest.
In their search for transportation, the farmers found that railroads were
regulated and reserved for military and heavy industry; trucks needed gasoline and
rubber, both in short-supply; and airplanes were being built almost exclusively for
military purposes.
This left the farmers without a ready source of domestic transportation for the
needed grain. But they eventually found a source of shipping that was neither
regulated nor controlled, because it was international in nature -- the iron-ore barges
on the Great Lakes.
They bid up the price and the barges started hauling oats to the pigs and
stopped hauling ore to the Gary steel mills. And there you have it:
Without the requisite iron ore the steel mills could not produce; they were
actually shut down for a period as a direct result of deregulating the price of pork.

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 CHAPTER 2

Economic Problems

The purpose of this chapter is to introduce you to several basic economic

principles that will be useful in understanding the costs, markets, and the materials to
follow in subsequent chapters. This chapter will examine scarcity, factors of production,
economic efficiency, opportunity costs, and economic systems. In this chapter the first
economic model will also be developed, the production possibilities frontier (or curve).

The Economizing Problem

Economics is concerned with decision-making. An economic decision is one that

allocates resources, time, money, or something else of use or value. The fundamental
question in economics is called the economizing problem. The economizing problem
follows directly from the definition of economics offered in Chapter 1. The economizing
problem involves the allocation of resources among competing wants. The
economizing problem exists because there is scarcity. Scarcity arises because of two
facts; (1) there are unlimited human wants, but (2) there are limited resources available
to meet those wants. In other words, scarcity exists because we do not have sufficient
resources to produce everything we want. Perhaps at some date in the future, a
utopian world may be obtained where everyone's desires can be fully satisfied -- most
economists probably hope that will not happen in their lifetimes because of their own
self-interest.

Economists do not differentiate between wants and needs in examining scarcity.

Unfortunately, the want of a millionaire for a new Porsche is not differentiated from the
need of a starving child for food in the aggregate. However, in a realistic sense, social
welfare and the implications of needs versus wants are partially addressed later in this
chapter in the discussions offered for allocative efficiency and economic systems.

The concept of scarcity is embedded in virtually every analysis found in

economics. Because there is scarcity there is always the question of how resources are
allocated and the effects of allocations on various economic agents. Each decision
allocating resources to one use or economic agent is also, by necessity, a decision not
to allocate resources to an alternative use.

To fully understand the idea of scarcity, each of its components must be

mastered. The following section of this chapter examines resources. The next sections
will examine economic efficiency, opportunity costs and allocations, before proceeding

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to the production possibilities model and economic systems.

Productivity is the key

Head to Head (Lester Thurow, New York: William Morrow and Company, Inc., 1992,
p. 273.)

If the "British disease" is adversarial labor-management relations, the

"American disease" is the belief that low wages solve all problems. When under
competitive pressure, American firms first go the low-wage nonunion parts of
America and then on to succession of countries with ever-lower wages. But the
strategy seldom works. For a brief time lower wages lead to higher profits, but
eventually other with even lower wages enter the business (low wages are easy to
copy), prices fall, and the higher profits generated by lower wages vanish.

The search for the holy grail of high profitability lies elsewhere -- in a relentless
upscale drive in technology to ever-higher levels of productivity -- and wages. Since
rapid productivity growth is a moving target and therefore hard to copy, high long-run
profits can be sustained. But to get the necessary human talent to employ new
technologies, large skill investments have to be made. High wages have to be paid,
but paradoxically high wages also leave firms with no choice but to go upscale in
technology. High wages and high profits are not antithetical -- they go together.

Resources and factor payments

The resources used to produce economic goods and services (also called
commodities) are called factors of production. These resources are the physical
assets needed to produce commodities. The way that these resources are combined to
produce is called technology. For example, a man with a shovel digging a ditch is one
technology from which ditches can be obtained. Another technology that can produce
the same commodity as a man with a shovel is a backhoe and an operator -- the
former is more labor intensive, and the latter is more capital intensive.

Land is a factor of production. Land includes space, natural resources, and

what is commonly thought of as land. A building lot, farm land, or a parking space is
what people normally think of when they think of land. However, iron ore, water
resources, oil, and other natural resources obtained from land are also one dimension
of this factor of production. Another, perhaps equally important dimension, is space.
The location of a building site for a business is an important consideration. For
example, a retail establishment may succeed or fail because of location, therefore
location is another important aspect of the resource called land. The factor payment
that accrues to land for producing is rent.

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 Capital includes the physical assets (i.e., plant and equipment) used in the
production of commodities. Often accountants refer to capital as money balances
that are earmarked for the purchase of plant or equipment. The accounting view of
capital is not the physical asset envisioned by economists (in reality the difference is
one of a future claim (the accountant's view) and a present stock of capital (the
economist's view) and is not trivial). Capital receives interest for its contributions to
production.

There is one important variation on capital. Economists also called the skills,
abilities, and knowledge of human beings as human capital. Human capital is a
characteristic of labor. Human capital can be acquired (i.e., education) or may be
something inherent in a specific individual (i.e., size, beauty, etc.). This subject will be
examined in more depth in Chapters 10 and 11.

Labor includes the broad range of services (and their characteristics)

exerted in the production process. Labor is a rather unique factor of production
because it cannot be separated from the human being who provides it. Human beings
also play other roles in the economic system, such as consumer that complicates the
analysis of labor as a productive factor. The amount of human capital possessed by
labor varies widely from the totally unskilled to highly trained professionals and highly
skilled journeymen. Labor also includes hired management, and the lowest paid janitor.
Labor is paid wages for its contribution to the production of commodities.

Entrepreneur (risk taker) is the economic agent who creates the enterprise.
Entrepreneurial talent not only assumes the risk of starting a business, but is generally
responsible for innovations in products and production processes. The vibrancy of the
U.S. economy is, in large measure, due to a wealth of entrepreneurial talent. This
factor of production receives profits for its contribution to output.

To obtain the maximum amount of output from the available productive resources
an economic system should have full employment. Full employment is the utilization
of all resources that is consistent with normal job search and maintenance of
productive capacity. Full employment includes the natural rate of unemployment,
which economists estimate to be between four and six percent (unemployment due to
job search and normal structural changes in the economy). Empirical evidence
suggests that about 80% capacity utilization is consistent with the natural rate of
unemployment. When the economy is operating at rates consistent with the natural rate
of unemployment it is producing the potential total output. However, full production,
100% capacity utilization involves greater than full employment and cannot be
maintained for a prolonged period without labor and capital breaking-down.
Underemployment has been a persistent problem in most developed economies.
Underemployment results from the utilization of a resource that is less than what is
consistent with full employment. There are two ways that underemployment manifests
itself. First, individuals can be employed full time, but not making use of the human

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capital they possess. For example, in many European countries it is not uncommon for
an M.D. to be employed as a practical nurse. The second way that underemployment is
typically observed is when someone is involuntarily a part-time employee rather than
employed full-time in an appropriate position.

Economic Efficiency

Economic efficiency consists of three components; these are: (1) allocative

efficiency, (2) technical or productive efficiency, and (3) full employment. For an
economy to be economically efficient all three conditions must be fulfilled.

Allocative efficiency is concerned with how resources are allocated. In a

perfectly competitive economy, without institutional impediments, monopoly power, or
cartels the markets will allocate resources in an allocatively efficient manner. Allocative
efficiency is measured using a concept known as Pareto Optimality (or Superiority in an
imperfect world).

Pareto Optimality is that allocation where no person could be made better-

off without inflicting harm on another. A Pareto Optimal allocation of resources can
exist, theoretically, only in the case of a purely competitive economy (which has never
existed in reality). What is of practical significance is a Pareto Superior allocation of
resources. A Pareto Superior allocation is that allocation where the benefit received by
one person is more than the harm inflicted on another. [cost - benefit approach]

Technical or productive efficiency is a somewhat easier concept. Technical

efficiency is defined as the minimization of cost for a given level of output or
(alternatively) for a given level of cost you maximize output. In other words, for an
economic system to be efficient, each firm in each industry must be technically efficient.
Again, a technically efficient operation is difficult to find in the real world. However,
most profit-maximizing firms (as well as government agencies and non-profit
organizations) will at least have technical efficiency as one of its operational goals.

For an economic system to be economically efficient then full employment is also

required. Due primarily to the business cycles, no economic system can consistently
achieve full employment. The U.S. economy typically has one (during recoveries) to
four percent (during recessions) unemployment above that associated with the natural
rate of unemployment. We will return to this topic in the discussions of market
structures in Chapters 8 and 9.

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 Allocative Efficiency

The Economics of Welfare, fourth edition (A. C. Pigou, London: Macmillan Publishing
Company, 1932, p. 89.)

. . . Any transference of income from a relatively rich man to a relatively poor man
of similar temperament, since it enables more intense wants to be satisfied at the
expense of less intense wants must increase the aggregate sum of satisfaction. The
old "law of diminishing utility" thus leads securely to the proposition: Any cause which
increases the absolute share of real income in the hands of the poor, provided that it
does not lead to a contraction in the size of the national dividend from any point of
view, will, in general, increase economic welfare.

Pigou states the basic proposition of Pareto Superiority in the real world; an
application of income re-distribution. The “transference of income from a relatively rich
man to a relatively poor man of similar temperament” making one less poor, and the
other less rich, results in an application of the principle of diminishing marginal utility
and, hence, allocative efficiency. In other words, the cost-benefit approach on the
margin. We take the last dollar from those with less value for that dollar and add that to
those more desperate for an additional dollar of income. Not only is this allocatively
efficient, but there are those who would argue that this is also fair.

Economic Cost

Economic cost consists of two distinct types of costs: (1) explicit (accounting)
costs, and (2) opportunity (implicit) costs. Explicit costs are direct expenditures in the
production process. These are the items of cost with which accountants are concerned.
An opportunity cost is the next best alternative that must be foregone as a result
of a particular decision. Rather than a direct expenditure, an opportunity cost is the
implicit loss of an alternative because of a decision. For example, reading this chapter
is costly, you have implicitly decided not to watch T.V. or spend time doing something
else by deciding to read this chapter. Every choice is costly; that is, there is an
opportunity cost. Economic costs are dealt with in greater detail in Chapter 7.

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Production Possibilities

The production possibilities frontier (or curve) is a simple model that can be used
to illustrate what a very simple economic system can produce under some restrictive
assumptions. The production possibilities model is used to illustrate the concepts of
opportunity cost, productive factors and their scarcity, economic efficiency
(unemployment etc.) and the economic choices an economy must make with respect to
what will be produced.

There are four assumptions necessary to represent the production possibilities in

a simple economic system. The assumption which underpin the production possibilities
curve model are: (1) the economy is economically efficient, (2) there are a fixed number
of productive resources, (3) the technology available to this economy is fixed, and (4) in
this economy we are going to produce only two commodities. With these four
assumption we can represent all the combinations of two commodities that can be
produced given the technology and resources available are efficiently used.

Consider the following diagram:

Beer

Pizza

Along the vertical axis we measure the number of units of beer we can produce
and along the horizontal axis we measure the number of units of pizza we can produce.
Where the solid line intersects the beer axis shows the amount of beer we can produce

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if all of our resources are allocated to beer production. Where the solid line intersects
the pizza axis indicates the amount of pizza we can produce if all of our resources are
allocated to pizza production. Along the solid line between the beer axis and the pizza
axis are the intermediate solutions where we have both beer and pizza being produced.

The reason the line is curved, rather than straight, is that the resources used to
produce beer are not perfectly useful in producing pizza and vice versa. The dashed
line represents a second production possibilities curve that is possible with additional
resources or an advancement in available technology.

Increasing Opportunity Costs is illustrated in the above production possibilities

curve. Notice as we obtain more pizza (move to the right along the pizza axis) we have
to give up large amounts of beer (downward move along beer axis). In other words, the
slope of the production possibilities curve is the marginal opportunity cost of the
production of one additional unit of one commodity, in terms of the other commodity.

Inefficiency, unemployment, and underemployment are illustrated by a point

inside the production possibilities curve, as shown above. A point consistent with
inefficiency, unemployment, or underemployment is identified by the symbol to
the inside of the curve.

Economic growth can also be illustrated with a production possibilities curve.

The dashed line in the above model shows a shift to the right of the curve. The only
way this can happen is for there to be more resources or better technology and this is
called economic growth. It is also possible that the curve could shift to the left (back
toward the origin -- the intersection of the beer axis with the pizza axis), this could result
from being forced to use less efficient technology (pollution controls) or the loss of
resources (racism or sexism).

Economic Systems

Production and the allocation of resources occur within economic systems.

Economic systems rarely exist in a pure form and the pure forms are assumed simply
for ease of illustration. The following classification of systems is based on the dominant
characteristics of those systems.

Pure capitalism is characterized by private ownership of productive capacity, very

limited government, and motivated by self-interest. Laissez faire means that
government keeps their hands-off and markets perform the allocative functions within
the economy. This type of system has the benefit of producing allocative efficiency if
there is no monopoly power, but this type of system tends towards heavy market
concentration left unregulated. There are substantial costs associated with pure
capitalism. These costs include significant loses of freedom, poverty, income inequity

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and several social ills associated with the lack of protections afforded by stronger
government. What is perhaps the saving grace, is that pure capitalism does not exist in
the course of economic history. Pure capitalism exists only in the tortured minds of
economists, and pages of the Wealth of Nations.

In the following box, Thorstein Veblen discusses his view of capitalism and the
“struggle” associated with the pursuit of self-interest in a system marked with private
interests.

The Struggle

The Theory of the Leisure Class, Thorstein Veblen, New York: Penguin Books, 1899,
pp. 24-25.

Wherever the institution of private property is found, even in a slightly developed

form, the economic process bears the character of a struggle between men for the
possession of goods. It has been customary in economic theory, and especially
among those economists who adhere with least faltering to the body of modernised
classical doctrines, to construe this struggle for wealth as being substantially a
struggle for subsistence. Such is, no doubt, its character in large part during the
earlier and less efficient phases of industry. Such is also its character in all cases
where the “niggardliness of nature” is so strict as to afford but a scanty livelihood to
the community in return for strenuous and unremitting application to the business of
getting the means of subsistence. But in all progressing communities an advance is
presently made beyond this early stage of technological development. Industrial
efficiency is presently carried to such a pitch as to afford something appreciably more
than a bare livelihood to those engaged in the industrial process. It has not been
unusual for economic theory to speak of the further struggle for wealth on this new
industrial basis as a competition for an increase in the physical comforts of life, –
primarily for an increase of the physical comforts which the consumption of goods
affords.

In command economies the government makes the allocative decisions. These

decisions are backed with the force of law (and sometimes martial force). Political
freedom is the antitheses of a command economy. Even though political and economic
freedom could result in a reasonable allocation, but rarely will command economies be
associated with democratic forms of government. Examples, of these types of systems
abound, Nazi Germany, Chile, the former Soviet Union are but a few examples.

Traditional economies base allocations on social mores or ethics or other non-

market, non-legislative bases. For example, Iran is an Islamic Republic and the
allocation of resources is heavily influenced by religious precepts. The purest forms of
traditional economies are typically observed in tribal societies. In the South Pacific and
certain South American Indian tribes, the allocation of resources is determined by

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traditions, only some of which are based in their religion. Many of these traditions
developed because of economic constraints. For example, the tradition that some
native tribes in the Arctic had of putting their elderly out of the community to starve or
freeze may seem barbaric, but because of the difficulty in obtaining the basic
requirements of life, those that could not contribute, could not be supported. Hence a
tradition that arose from economic constraints.

Socialism generally focuses on maximizing individual welfare for all persons

based on perceived needs, not necessarily on contributions. Socialist systems are
generally concerned more with perceived equity rather than efficiency. The basic idea
here is that when there is assurance of economic security then society in general is
better-off. Sweden, Denmark, Norway and Iceland have systems that have large
elements of socialism. Each of these three countries have been reasonably successful
in maintaining relatively high levels of productivity and standards of living.

Communism is a system where everyone shares equally in the output of society

(according to their needs), at least theoretically. Generally, there is no private holdings
of productive resources, and government is a trustee until such time as what is called
"Socialist Man" fully develops (where the individual is more concerned with aggregate
welfare than individual gain). The former Soviet Union was not a communist society as
perceived by Karl Marx in Das Kapital. However, examples of communist societies
exist on small community levels. Both New Harmony, Indiana and Amana, Iowa were
utopian communist systems that were probably more in keeping with Marxist ideals, but
without the political implications and in very limited scope.

Division of Labor – and possibly society

Class Warfare, Noam Chomsky, Monroe, Maine: Common Courage Press, 1996,
pp.19-20.

. . . People read snippets of Adam Smith, the few phrases they teach in school.
Everyone reads the first paragraph of The Wealth of Nations where he talks about
how wonderful the division of labor is. But not many people get to the point hundreds
of pages later, where he says that division of labor will destroy human beings and
turn them into creatures as stupid and ignorant as it is possible for a human being to
be. And therefore in any civilized society the government is going to have to take
some measures to prevent division of labor from proceeding to its limits.

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 Virtually all economic systems are mixed systems. A mixed system is one that
contains elements of more than one of the above pure systems. The U.S. economy is a
mixed system, with significant amounts of capitalism, command, and socialism. The
U.S. economy also has some very limited amounts of communism and tradition that
have helped shape our system. Much of the political controversies concerning the
budget deficit, social security, and the environment focuses on the what the appropriate
mix of systems should exist in our economic system.

Most developed economies are mixed systems. As a society grows and

becomes more complex, simple pure examples of economic systems are incapable of
handling the demands placed on them. Complexity generally requires elements of
command, socialism and capitalism to properly allocate resources and produce
commodities. This is no more evident in the troubles being experienced in the former
Soviet Union and in China. As these economies attempt to modernize and develop, the
policy makers have discovered the utility of market systems for many economic
decisions.

Estranged Worker

The Economic & Philosophic Manuscripts of 1844, Karl Marx, New York: International
Publishers, 1964, p. 107-8.

The worker become all the poorer the more wealth he produces, the more his
production increases in power and size. The worker becomes an even cheaper
commodity the more commodities he creates. With the increasing value of the world
of things proceeds in direct proportion the devaluation of the world of men. Labor
produces not only commodities: it produces itself and the worker as a commodity –
and this in the same general proportion in which it produces commodities.

This fact expresses merely that the object which labor produces – labor’s
product – confronts it as something alien, as a power independent of the producer.
The product of labor is labor which has been embodied in an object, which has
become material: it is the objectification of labor. Labor’s realization is its
objectification. In the sphere of political economy this realization of labor appears as
loss of realization for the workers; objectification as loss of the object and bondage to
it; appropriation as estrangement, as alienation.

Developed economies are generally high income economies, because the

production processes tend be capital intensive, and focused on high value-added
products. An economy that has a per capita GDP of $8000 or more is a high income
economy. Less developed economies fall into two categories, middle income $8000 to
$800, and low income economies or those below $800. Low income economies are
concentrated in South Asia, and Africa South of the Sahara. Middle income economies
are in the Middle East, Eastern Europe and Latin America. The majority of the world’s

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population, over half, live in low income economies.

Perhaps the greatest economic issue facing the current generation is what can
be done to bring the low income economies into meaningful participation in the global
economy. The poverty of the low income economies is a serious matter without any
other issue. AIDS, malaria, and a host of other health problems are associated with the
poverty in these nations. Perhaps more importantly, with rising incomes in these parts
of the world come several benefits globally. As income rise in low income countries,
cheap labor is no longer a cause for outsourcing from the high income, industrialized
parts of the world. Further, as income rise, so too does the demand for goods and
services. The often used cliché “a rise tide makes all boats float higher” is exactly the
case in these nations emergence into full participation in the global economy. More
concerning these issues will be offered later in this book.

KEY CONCEPTS

Economizing problem
Scarce Resources
Unlimited Wants

Resources and Factors Payments

Land - rent
Labor - wages
Capital - interest
Entrepreneurial Talent - profits

Full Employment
Underemployment

Economic Efficiency
Allocative Efficiency
Technological Efficiency
Full Employment

Opportunity Cost
Implicit vs. Explicit Costs

Production Possibilities Frontier (or Curve)

Growth
Inefficiency
Law of Increasing Opportunity Costs

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 CHAPTER 4

The Basics of Supply and Demand

The purpose of this chapter is to develop one of the most powerful methods of
analysis in the economist's tool kit. In this chapter we will develop the model of a simple
market – supply and demand (the industry in pure competition – discussed further in
Chapter 8). The demand schedule and supply schedule will be developed and put
together to form the analysis of a market. The market presented here is the starting
point for the analysis of all market structures.

Markets

A market is nothing more or less than the locus of exchange, it is not necessarily
a place, but simply buyers and sellers coming together for transactions. Transactions
occur because consumers and suppliers are able to purchase and sell at a price that is
determined through the free interaction of demand and supply.

Adam Smith, in the Wealth of Nations, described markets as almost mystical

things. He wrote that the interaction of supply and demand "as though moved by an
invisible hand" would determine the price and the quantity of a good exchanged. In fact,
there is nothing mystical about markets. If competitive, a market will always satisfy
those consumers willing and able to pay the market price and provide suppliers with the
opportunity to sell their wares at the market price. To understand the market, one need
only understand the ideas of supply and demand and how they interact.

Demand

The law of demand is a principle of economics because it has been consistently

observed and predicts consumers’ behavior accurately. The law of demand states
that as price increases (decreases) consumers will purchase less (more) of the
specific commodity, ceteris paribus. In other words, there is an inverse relationship
between the quantity demanded and the price of a particular commodity. This law of
demand is a general rule. Most people behave this way, they buy more the lower the
price. However, everyone knows of a specific individual who may not behave as
predicted by the law of demand, but remember the fallacy of composition -- because an
individual or small group behaves contrary to the law of demand does not negate it.

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 The demand schedule (demand curve) reflects the law of demand. The demand
curve is a downward sloping function (reflecting the inverse relationship of price to
quantity demanded) and is a schedule of the quantity demanded at each and every
price.

Price

P1

P2

Demand

Q1 Q2 Quantity

As price falls from P1 to P2 the quantity demanded increases from Q1 to Q2. This is a
negative relation between price and quantity, hence the negative slope of the demand
schedule; as predicted by the law of demand.

Consumers obtain utility (use, pleasure, jollies) from the consumption of

commodities. Economists have long recognized that past some point, the consumption
of additional units of a commodity bring consumers less and less utility. The change in
utility derived from the consumption of one more unit of a commodity is called marginal
utility. The idea that utility with the amount added to total utility will decline when
additional units are consumed past some point has also the status of principle. This
principle is called diminishing marginal utility.

Because consumers make rational choices, that is they act in their own self
interest, there are two effects that follow from their attempts to maximize their well-being
when the price of a commodity changes. These two effects are called the; (1) income
effect, and (2) the substitution effect. Together these effects guarantee a downward
sloping demand curve.

The income effect is the fact that as a person's income increases (or the
price of item goes down [which effectively increases command over goods] more
of everything will be demanded. The income effect suggest that as income goes
down (price increases) then less of the commodity will be purchased.

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 The substitution effect is the fact that as the price of a commodity
increases, consumers will buy less of it and more of other commodities. In other
words, a consumer will attempt to substitute other goods for the commodity that became
more expensive. The substitution effect simply reinforces the idea of a downward
sloping demand curve.

The demand schedule can be expressed as a table of price and quantity data, a
series of equations, or in a downward sloping graph. To this point, our discussion has
focused on individuals and their behavior. Assuming that at least a significant majority of
consumers are rational, it is a simple matter to obtain a market demand curve. One
needs only to sum all of the quantities demanded by individuals at each price to obtain
the market demand curve.

Changes in the price of a commodity causes movements along the demand

curve; such movements are called changes in the quantity demanded. If price
decreases, then we move down and to the right along the demand curve; this is an
increase in the quantity demanded. If price increases, then we move upward and to left
along the demand curve, this is a decrease in the quantity demanded. Remember, (it is
important) such changes are called changes in the quantity demanded because the
demand curve is a schedule of the quantities demanded at each price.

Movements of the demand curve itself, either to the left or right are called
changes in demand. A change in demand is caused by a change in one or more of
the nonprice determinants of demand. A shift to the right of the demand curve is called
an increase in demand; and a shift to the left of the demand curve is called a decrease
in demand.

The nonprice determinants of demand are; (1) tastes and preferences of

consumers, (2) the number of consumers, (3) the money incomes of consumers, (4)
the prices of related goods, and (5) consumers' expectations concerning future
availability or prices of the commodity.

If the tastes and preferences of consumers change they will shift the demand
curve. If consumers find a commodity more desirable, ceteris paribus, then an increase
in demand will be observed. If consumer tastes wane for a particular product then there
will be a shift to the left of the demand (a decrease in demand).

An increase in the number of consumers or their money income will result in a

shift to the right of the demand curve (an increase in demand). A decrease in the
number of consumers or their income will result in a shift of the demand curve toward
the origin (a decrease in demand). Consumers will also react to expectations
concerning future prices and availability. If consumers expect future prices to increase,
their present demand curve will shift to the right; if consumers expect prices to fall then
we will observe a decrease in current demand.

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 The prices of related commodities also effect the demand curve. There are two
classes of related commodities of importance in determining the position of the demand
curve, these are (1) substitutes, and (2) complements. A substitute is something that is
alternative commodity, i.e., Pepsi is a substitute for Coca-Cola. A complement is
something that is required to enjoy the commodity, i.e., gasoline and automobiles. If the
price of a substitute increases, then the demand for our commodity will increase. If the
price of a substitute decreases, so too will the demand for our commodity. In other
words, the price of a substitute and the demand for our commodity move in the same
direction. For complements, the price of the complement and the demand for our
commodity move in opposite directions. If the price of a complement increases, the
demand for our commodity will decrease. If the price of a complement decreases, the
demand for our commodity will increase.

Increase in Demand Decrease in Demand

Price Price

D2
D1 D2 D1
Quantity Quantity

An increase in demand is shown in the first panel, notice that at each price there is a
greater quantity demanded along D2 (the dotted line) than was demanded with D1 (the
solid line). The second panel shows a decrease in demand, notice that there is a lower
quantity demanded at each price along D2 (the dotted line) than was demanded with D1
(the solid line).

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 Changes in Quantity Demanded

Price

P1

P2
Demand

Q1 Q2 Quantity

Movement along a demand curve is called a change in the quantity demanded.

Changes in quantities demanded are caused by changes in price. When price
decreases from P1 to P2 the quantity demanded increases from Q1 to Q2; when price
increases from P2 to P1 the quantity demanded decreases from Q2 to Q1.

Supply

The law of supply is that producers will supply more the higher the price of the
commodity. The supply curve is an upward sloping function showing a direct
relationship between prices and the quantity supplied. In other words, the supply curve
has a positive slope that shows that as price increase (decreases) so too does quantity
supplied.

As with the demand curve a change in the price will result in a change in the
quantity supplied. An increase in price will result in an increase in the quantity
supplied, and a decrease in price will result in a decrease in the quantity supplied.
Again, this is because the supply curve is a schedule of the quantities supplied at each
price.

Changes in one or more of the nonprice determinants of supply cause the supply
curve to shift. A shift to the left of the supply curve is called a decrease in supply; a shift
to the right is called an increase in supply. The nonprice determinants of supply are; (1)
resource prices, (2) technology, (3) taxes and subsidies, (4) prices of other goods, (5)
expectations concerning future prices, and (6) the number of sellers.

When resource prices increase, supply decreases (shifts left); and when

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resource prices decrease, supply increases (shifts right). If a more cost effective
technology is discovered then supply increases, increases in taxes cause the supply
curve to shift left (decrease). An increase in a subsidy effects the supply curve in the
same way as a cut in taxes, an increase in supply.

If the price of other goods a producer can supply increases, the producer will
reallocate resources away from current production (decrease in supply) and to the
goods with a higher market price. For example, if the price of corn drops, a farmer will
supply more beans.

If producers expect future prices to increase, current supply will decline in favor
of selling inventories at higher prices later. In other words, supply will decrease (a shift
to the left, and exactly the opposite response will occur if producer expect future prices
to be lower. If the number of suppliers increases, so too will supply, but if the number of
producers declines, so too will supply.

Decrease in Supply Increase in Supply

Price Price
S2 S1
S1
S2

Quantity Quantity

A decrease in supply is shown in the first panel, notice that there is a lower quantity
supplied at each price with S2 (dotted line) than with S1 (solid line). The second panel
shows an increase in supply, notice that there is a larger quantity supplied at each price
with S2 (dotted line) than with S1 (solid line).

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 Changes in Quantity Supplied

Price Supply

P1

P2

Q2 Q1 Quantity

Changes in price cause changes in quantity supplied, an increase in price from P2 to P1

causes an increase in the quantity supplied from Q2 to Q1; a decrease in price from P1
to P2 causes a decrease in the quantity supplied from Q1 to Q2.

Market Equilibrium

Market equilibrium occurs where supply equals demand (supply curve intersects
demand curve). An equilibrium implies that there is no force that will cause further
changes in price, hence quantity exchanged in the market. This is analogous to a
cherry rolling down the side of a glass; the cherry falls due to gravity and rolls past the
bottom because of momentum, and continues rolling back and forth past the bottom
until all of its' energy is expended and it comes to rest at the bottom - this is equilibrium
[a rotten cherry in the bottom of a glass].

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 Price and Value

Principles of Economics, 8th edition (Alfred Marshall, London: Macmillan Publishing

Company, 1920, p. 348.)

. . . We might as reasonably dispute whether it is the upper or the under blade of a

pair of scissors that cuts a piece of paper, as whether value is governed by utility or
cost of production. It is true that when one blade is held still, and the cutting is
effected by moving the other, we may say with careless brevity that the cutting is
done by the second; but the statement is not strictly accurate, and is to be excused
only so long as it claims to be merely a popular and not a strictly scientific account of
what happens.

The following graphical analysis portrays a market in equilibrium. Where the

supply and demand curves intersect, equilibrium price is determined (Pe) and
equilibrium quantity is determined (Qe)

Price Supply

Pe

Demand

Qe Quantity

The graph of a market in equilibrium can also be expressed using a series of

equations. Both the demand and supply curve can be expressed as equations.

Demand Curve is Qd = 22 - P

(Notice the negative sign in front the price variable, indicating a downward sloping
function)

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 Supply Curve is Qs = 10 + P

(Notice the positive sign in front of the price variable, indicating an upward sloping
function)

The equilibrium condition is Qd = Qs

(For this market to obtain equilibrium, the quantity demanded must equal the quantity
supplied in this market)

Therefore:

22 - P = 10 + P

adding P to both sides of the equation yields:

22 = 10 + 2P

subtracting 10 from both sides of the equation yields:

12 = 2P or P = 6

To find the equilibrium quantity, we plug 6 (for P) into either the supply or
demand curve and get:

22 - 6 = 16 (Demand side) & 10 + 6 = 16 (Supply side)

The system of equations approach to solving for equilibrium gives a specific

number for price and for quantity. Unless the numbers are specified along the price
axis and the quantity axis, the graph does not yield a specific number for price and
quantity. However, the graph provides a visual demonstration of equilibrium which may
aid learning.

Changes in supply and demand in a market result in new equilibria. The

following graphs demonstrate what happens in a market when there are changes in
nonprice determinants of supply and demand.

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 Change in Demand

Price Supply

P1

P2

D2 D1

Q2 Q1 Quantity

Movement of the demand curve from D1 (solid line) to D2 (dashed line) is a

decrease in demand (as demonstrated in the above graph). Such decreases are
caused by a change in a nonprice determinant of demand (for example, the number of
consumers in the market declined or the price of a substitute declined). With a
decrease in demand there is a shift of the demand curve to the left along the supply
curve, therefore both equilibrium price and quantity decline. If we move from D2 to D1
that is called an increase in demand, possibly due to an increase in the price of a
substitute good or an increase in the number of consumers in the market. When
demand increases both equilibrium price and quantity increase as a result.

Considering the following graph, movement of the supply curve from S1 (solid
line) to S2 (dashed line) is an increase in supply. Such increases are caused by a
change in a nonprice determinant (for example, the number of suppliers in the market
increased or the cost of capital decreased). With an increase in supply there is a shift of
the supply curve to the right along the demand curve, therefore equilibrium price and
quantity move in opposite directions (price decreases, quantity increases). If we move
from S2 to S1 that is called an decrease in supply, possibly due to an increase in the
price of a productive resource (capital) or the number of suppliers decreased. When
supply decreases, equilibrium price increases and the quantity decreases as a result.
That is the result of the supply curve moving up along the negatively sloped demand
curve (which remains unchanged).

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 Changes in Supply
S1
Price
S2

P1

P2

Demand

Q1 Q2 Quantity

If both the demand curve and supply curve change at the same time the analysis
becomes more complicated. Consider the following graphs:

Increase in Demand Decrease in Demand

Decrease in Supply Increase in Supply
Price Price
D2 S2
D1 S1
S1
P2 S2
P1 P1

P2 D1
D2

Q Quantity Q Quantit

Notice that the quantity remains the same in both graphs. Therefore, the change
in the equilibrium quantity is indeterminant and its direction and size depends on the
relative strength of the changes between supply and demand. In both cases, the
equilibrium price changes. In the first case where demand increases, but supply
decreases the equilibrium price increases. In the second panel where demand
decreases and supply increases, the equilibrium price decreases.

In the event that demand and supply both increase then price remains the same

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(is indeterminant) and quantity increases, and if both decrease then price is
indeterminant and quantity decreases. These results are illustrated in the following
diagram
Increase in Supply Decrease in Supply s.
and in Demand and in Demand
Price Price

D2 D1
D1
D2
P P

S2
S1 S2 S1
Q1 Q2 Quantity Q2 Q1 Quantity

The graphs show that price remains the same (is indeterminant) but when supply
and demand both increase quantity increases to Q2. When both supply and demand
decrease quantity decreases to Q2.

Shortages and Surpluses

There is some rationale for limited government intervention in a free market

economy. Perhaps the most powerful rationale for limited government arises from the
effects of price controls in competitive markets. Shortages and surpluses can only
result because by having some sort of price controls in the market.

For example, the Former Soviet Union had a centrally planned economy and the
government decided what would be produced and for what price that production would
be sold. The government also was the sole employer and paid very low wages,
therefore prices were also controlled at below market equilibrium levels. The result was
that whenever any commodity was available in the market, there were long lines
observed at any store with anything to sell, prices were low but there was nothing to buy
(shortages). The popular Russian immigrant comedian, Yakov Simirnov, summed-up
the plight of the working class consumer in Russia prior to break-up of the Soviet Union.
He said, "In Russia we used to pretend to work, but that was alright, the government
only used to pretend to pay us!"

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 Shortage is caused by an effective price ceiling (the maximum price you can
charge for the product). Effective, in this sense, means that the government can and
does actively enforce the price ceiling. With the exception of the Second World War,
there is little evidence that the government can effectively enforce price ceilings.
Consider the following diagram that demonstrates the effect of a price ceiling in an
otherwise purely competitive industry.

SHORTAGE
Supply
Price

Pe
Price Ceiling

Demand

Qs Qe Qd Quantity

For a price ceiling to be effective it must be imposed below the competitive

equilibrium price. Note that the Qs is below the Qd, which means that there is an excess
demand for this commodity that is not being satisfied by suppliers at this artificially low
price. The distance between Qs and Qd is called a shortage.

It is interesting to consider the last time that wage and price controls were
attempted during the Carter administration. These short-lived price ceilings resulted in
producers technically complying with the price restrictions, but they frequently changed
the product. For example, warranties were no longer included in the sales price, service
was extra, delivery was extra, and where possible, the product was reduced in size. For
example, in the previous administration’s failed wage and price controls (Nixon) candy
bars were made smaller and they put fewer M & Ms in the package and the price for
these treats was not changed – effectively cutting costs, but not price, hence increasing
the profit margin without raising the price of the candy. The lesson is simple, if
government is going to control prices, they must be prepared to control virtually all other
aspects of doing business.

Surplus is caused by an effective price floor (minimum you can charge):

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 SURPLUS

Price Supply
Price Floor

Pe

Demand

Qd Qe Qs Quantity

For a price floor to be effective it must be above the competitive equilibrium price.
Notice that at the floor price Qd is less than Qs, the distance between Qd and Qs is the
amount of the surplus. Minimum wages are the best known examples of price floors
and will be discussed in greater detail in Chapter 11.

Implicit in these analyses is the fact that without government we could have
neither shortage or surplus. In large measure, the suspicion of government is because
it has the power to create these sorts of peculiar market situations. Even with the
power of government to enforce law, the only way that a shortage or surplus could
occur is if the price ceiling or the price floor were effective.

Markets and Reality

As intuitively pleasing as these analyses are, they are only models, and these
models are based on assumptions that are not very good approximations of reality. In
Chapter 8 the analysis of a purely competitive market is offered. What this chapter
presents is the industry in pure competition, which is based on assumptions that do not
exist in reality. The assumptions are (1) perfect information about all past, and future
prices, (2) no barriers to entry or exit from the market, (3) no non-price competition
(advertising etc.), (4) atomized competition (so many suppliers and consumers that
none can appreciably affect price or quantity), and (5) there is a standardized product
(corn is corn is corn). If all of these assumptions accurately represent reality, then the
firm must sell at whatever price is established in the industry. To sell at a lower price
denies the firm revenue it could have otherwise earned, and to sell at a higher price
would mean the firm could sell nothing. In other words, the competitive industry impose
price discipline on all of the firms that together comprise that competitive industry.

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 Part of the controversy in almost any discussion of microeconomic activity is
whether the results of policy can be predicted by the simple supply and demand model.
Often the results of the simple supply and demand diagram are not bad rough
approximations of reality – but remember that it is only a rough approximation – based
on assumptions that are not very accurate depictions of reality. However, more often
imperfect market models are more accurate approximations of reality – because one or
more the assumptions underpinning those models more accurately reflects reality. One
must be careful in applying these models, and in policy debates concerning these
models. To the extent that the assumptions are not fulfilled, then the results may not be
accurate.

The real value of the simple supply and demand model is to provide a beginning
point for coming to understand how markets really work. In most respects the simple
supply and demand model is little more than the beginning point for constructing one of
the more realistic market models. Pure monopoly, monopolistic competition and
oligopoly are, in some important respects, refinements from the purely competitive
market model.

KEY CONCEPTS

Market
Equilibrium

Law of Demand
Demand schedule
Utility
Marginal Utility
Diminishing Marginal Utility

Income Effect

Substitution Effect

Demand Curve
Determinants of Demand
Tastes & Preferences
Number of Consumers
Money Income of Consumers
Prices of Related Goods
Substitutes
Complements
Expectations

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 CHAPTER 5

Supply & Demand: Elasticities

The purpose of this chapter is to extend the supply and demand analysis
presented in the previous chapter. Specifically, this chapter will develop the methods
employed by economists to measure consumer responsiveness to price changes -- the
price elasticity of demand. Other topics examined in this chapter are the price elasticity
of supply, cross-elasticities, the income elasticity of demand and the interest elasticity of
demand.

Price Elasticity of Demand

The price elasticity of demand is how economists measure the responsiveness of

consumers to changes in prices for a commodity. In other words, as price increases
(decreases), the quantity demanded by consumers will decrease (increase). The
relative proportions of the changes in price and the respective quantities demanded are
the responses of consumers and are referred to as the price elasticity of demand. It is
this consumer responsiveness that is the subject of this chapter.

Business decisions concerning prices are not always a simple matter of adding
some margin to the cost of production of the commodity (cost-plus pricing). Suppliers
will wish to obtain the most revenue the market will bear from the sales of their products
– in other words, maximize their profits. It is therefore necessary for business to have
some idea of what the market will bear, and that is where the price elasticity of demand
enters the picture in business decision-making.

There are three methods that are used to measure the price elasticity of demand,
these are; (1) the price elasticity coefficient (midpoints formula), (2) the total revenue
test, and (3) a simple examination of the demand curve. Each of these will be
examined in turn, in the following paragraphs.

Elasticity Coefficient

The elasticity coefficient is a number calculated using price and quantity data
to determine how responsive consumers are to changes in the price of a commodity.
The elasticity coefficient may be calculated in two distinct ways. Point elasticity is

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measuring responsiveness at a specific point along a demand curve. The other
method is using the mid-point of the difference in the price and the mid-point in the
difference of the quantity numbers. Because the midpoints formula cuts down on the
confusion of which prices and quantities are to be used, it is the only coefficient we will
use in this course.

The price elasticity coefficient (midpoints) is calculated using the midpoints

formula:

Ed = Change in Qty ÷ Change in price

(Q1 + Q2)/2 (P1 + P2)/2

Calculating the elasticity coefficient will yield a specific number. The value of that
number provides the answer as to whether demand is price elastic or price inelastic.
Elastic demand means that the consumers' quantities demanded respond (more than
proportionately) to changes in price; with elastic demand the coefficient is more than
one. Inelastic demand means that the consumers' quantities demanded do not respond
very much to changes in price; with inelastic demand the coefficient is less than
one. Unit elastic demand means that the consumers' quantity demanded respond
proportionately to change in price; with unit elastic demand the coefficient is exactly
one.

What this equation states is illustrated in the graph below. The midpoint between
price one (P1) and price two (P2) is labeled Midpoint along the price axis and M on the
quantity axis.

Price

P1

Midpoint
P2

Demand

Quantity
Q1 M Q2

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 On the graph this number is the difference between Q1 and Q2 divided by the
distance between the origin and the point labeled M on the quantity axis for the
numerator and the difference between P1 and P2 divided the distance between the
origin and the point labeled midpoint on the price axis for denominator. The ratio of the
numerator to the denominator on this graph is the same number yielded by the
equation.

Examining the demand curve can also provide clues concerning the price
elasticity of demand. A perfectly vertical demand curve indicates that the quantity
demanded will be exactly the same, regardless of price. This type of demand curve is
called a perfectly inelastic demand curve. A perfectly horizontal demand curve
indicates that consumers will have almost any quantity demanded, but only at that price.
This is called a perfectly elastic demand curve. Perfectly unit elastic demand curves
are not linear, they have slopes that vary across ranges.

Perfectly elastic demand Perfectly inelastic demand

Price Price Demand

Demand

Quantity Quantity
Perfectly Elastic and Perfectly Inelastic Demand Curves
There is a trick to remembering inelastic and elastic demand. Notice in the
above graphs that the perfectly elastic demand curve is horizontal, (add one more
horizontal line at the top of the price axis and it will look like an E). The perfectly
inelastic demand curve is vertical (looks like an I). If you have problems remembering
the concept of inelastic or elastic demand you need only draw the curves above and
observe what happens to the quantity demanded when the price changes. In the case
of perfectly inelastic demand consumers will buy exactly the same quantity of a product
without regard for its price. In the case of a perfectly elastic demand curve, if producers
raise the price of the product, then they will sell nothing.
Slope and elasticity are two different concepts. With linear demand curves,
elasticity changes along the demand curve, however its slope does not. Elasticity is

136
concerned with responses in one variable to changes in the other variable. The slope
of the curve is concerned with values of the respective variables at each position along
the curve (i.e., its' shape and direction).

Demand Curve and Total Revenue (total revenue = P x Q) Curve

Price

Elastic Unit

Demand
Inelastic
Quantity
Total
Revenue

Total Revenue
Quantity

The total revenue curve in the bottom graph is plotted by multiplying price and quantity
to obtain total revenue and then plotting total revenue against quantity. In examining
the above graphs, notice that as total revenue is increasing, demand is elastic. When
the total revenue curve flattens-out at the top then demand becomes unit elastic, and
when total revenue falls demand is inelastic. In other words, moving from left to right on
the demand curve, as price and total revenue move in the opposite direction demand is
price elastic, and when price and total revenue move in the same direction demand is
price inelastic.

The total revenue test uses the relation between the total revenue curve and the
demand curve to determine the price elasticity of demand. In general, price and total
revenue will move in the same direction of the demand is price inelastic (hence
consumers are unresponsive in quantity purchased when price changes) and move in
opposite directions if price elastic (consumers’ quantities being responsive to price
changes).

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Consider the following numerical example:
_____________________________________________________________________
_____________________________________________________________________

Table 1: Total Revenue Test

_____________________________________________________________________

Total Quantity Price per unit Total Revenue Elasticity

_____________________________________________________________________

1 7 7
>+5 Elastic
2 6 12
>+3 Elastic
3 5 15
>+1 Elastic
4 4 16
>-1 Inelastic
5 3 15
>-3 Inelastic
6 2 12
>-5 Inelastic
7 1 7
_____________________________________________________________________
_____________________________________________________________________

Marginal revenue is the change in total revenue due to the a change in

quantity demanded. The total revenue test relies on changes in total revenue
(marginal revenue) to determine elasticity. If the change in total revenue (marginal
revenue) is positive the demand is price elastic, if the change in total revenue is
negative the demand is price inelastic. If the marginal revenue is exactly zero
then demand is unit elastic.

The following determinants of the price elasticity of demand will determine how
responsive the quantity demanded by consumers is to changes in price. The
determinants of the price elasticity of demand are; (1) substitutability of other
commodities, (2) the proportion of income spent on the commodity, (3) whether
the commodity is a luxury or a necessity, and (4) the amount of time that a
consumer can postpone the purchase.

If there are no close substitutes then the demand for the commodity will be price
inelastic, ceteris paribus. If there are substitutes then consumers can switch their
purchasing habits in the case of a price increase, but if there are no substitutes then

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consumers are more likely to buy even if price goes up. For example, if the price of
Pepsi goes up, then certain consumers will buy Coke, if the price of Coke has not
increased, hence the demand for Pepsi is likely to be elastic.

All other things equal, the higher the proportion of income spent for the
commodity more price elastic will be the demand. Most home owners are familiar with
how this determinant works. The demand for single family dwellings is likely to be more
elastic than the demand for apartments, because a higher proportion of your income will
be spent on housing when you own your home.

Commodities that are viewed as luxuries typically have price elastic demand, and
commodities that are necessities have price inelastic demand. There is simply no
substitute for a insulin, if you are an insulin dependent diabetic. Because insulin is a
necessity for which there is no substitute, the demand will be price inelastic.

Time is an important determinant of price elasticity. If a price changes, it may

take consumers a certain amount of time to discover alternative lifestyles or
commodities to account for the price change. For example, if the price of cars
increases, a family that planned to buy a car may wait for their income or wealth to
increase to make buying a new car viable alternative to continuing to drive an older
vehicle. In other words, the longer the time frame for the decision to purchase the more
price elastic the demand for the commodity.

Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of suppliers to

changes in price. The price elasticity of supply is determined by the following time
frames; (1) market period, (2) short-run, and (3) long-run. The more time a producer
has to adjust output the more elastic is supply.

The time frames for producers will be discussed in more detail in Chapter 7 as
they pertain to a firm's cost structure. However, it is important to understand the basic
idea behind this classification of time as it relates to price elasticity. The market period
is defined to be that period in which the producer can vary nothing, therefore the supply
is perfectly inelastic. The long-run is the period in which the producer can vary
everything, therefore the supply is perfectly elastic. The short-run is the period in which
plant and equipment cannot be varied, but most other factors' usage can be varied,
therefore it depends on a producers capital - intensity as to how elastic supply is at any
particular point.

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Other Elasticities

There are three other standard applications of the elasticity of demand. The
cross elasticity of demand, the income elasticity of demand, and the interest rate
elasticity of demand. Each of these will be examined, in turn, in the remaining
paragraphs of this chapter.

The cross elasticity of demand measures the responsiveness of the

quantity demanded of one product to changes in the price of another product.
For example, the quantity demanded of Coca-Cola to changes in the price of Pepsi.
Cross elasticity of demand gives an indication of how close a substitute or complement
one commodity is for another. This concept has substantial practical value in
formulating marketing strategies for most products.

For example, as the price of coke increases, then consumers may purchase
proportionately more Pepsi products. In such a case, the cross elasticity of demand of
Pepsi to the price of coke would be termed elastic. The equation for the cross elasticity
of demand described here is presented below.

Ed = Change in Qty pepsi ÷ Change in price coke

(Q1 Pepsi + Q2 Pepsi)/2 (P1 coke + P2 coke)/2

The income elasticity of demand measures the responsiveness of the

quantity demanded of a commodity to changes in consumers' incomes. This is
typically measured by replacing the price variable with income (economists use the
letter Y to denote income) in the midpoints formula. Again, in business planning the
responsiveness of consumers to changes in their income may be very important.
Housing and automobiles, as well as, several big ticket luxury items have demand that
is sensitive to changes in income. The income elasticity formula is presented below.

Ed = Change in Qty ÷ Change in income

(Q1 + Q2)/2 (Y1 + Y2)/2

Often interest rates will also present a limitation on a consumer’s quantity of

demand for a particular commodity. As with income, often big ticket items are very
sensitive to interest rates on the loans necessary to make those purchases. With the
record low mortgage rates in the Spring of 2003 the quantity demanded for housing,
both new and existing homes, witnessed dramatic increases.

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 The automobile companies rarely reduce prices for their vehicles, but rather, GM,
Ford and Chrysler will offer incentives. Rebates, which are temporary reductions in
price, and attractive financing rates are the hooks offered to get the consumer in the
showroom and into the new car. In May of 2003 all of the American producers were
offering zero percent financing on all but a very few of their vehicles, and even some of
the European and Japanese producers were following suite with either very low rates,
or zero percent financing. The interest rate elasticity formula is (where interest rate is
“r”):

Ed = Change in Qty ÷ Change in interest rate

(Q1 + Q2)/2 (r1 + r2)/2

These analyses are important to businesses in determining what issues are

important to the successful sales of their products. There are industries that have not
been particularly good at understanding the notions of cross elasticity or price elasticity
– the airlines in particular, and many of these firms have suffered as a result. The
bankruptcies of United Airlines and US Air being excellent examples. The automobile
companies have been, in some measure, forced into the financing business because of
the interest rate sensitivity of consumers. By offering financing the car companies are,
essentially, maintaining some modicum of control over one important aspect of their
business.

Interest rate sensitivity can also be understood from another perspective. The
total cost of a commodity is not just its price, but also what must be paid to borrow
money to purchase that item. With modern views of instant gratification, it is rare for
someone to save to purchase a house, or any other big ticket item, what is more
common is to borrow the money, buy the item, and make installment payments.
Therefore the interest charges are a part of the total cost of acquiring that big ticket item
– hence consumer sensitivity to interest rates when buying a house or a car.

It is also noteworthy, that purely competitive firms are price takers, and it is the
imperfectly competitive firm that has a pricing policy. What is often referred to as
“pricing power” in the business press, means the ability to take advantage of the price
elasticity of demand or one of the other elasticities examined here – hence implying
some market structure, hence market power not otherwise identified in the model of
pure competition.

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 CHAPTER 7

Costs of Production

The purpose of this chapter is to examine the production costs of a firm. The first
section develops the economic concepts of production necessary for understanding the
cost structure of a firm. The second section presents the models of short-run costs.
The final section develops the long-run average total cost curve and discusses its
implications for the strategic management of a business.

Production and Costs

The reason that an entrepreneur assumes the risk of starting a business is to

earn profits. The fundamental assumption in the theory of production is that a rational
owner of a business will seek to maximize the profits (or minimize the losses) from the
operation of his business. However, before anything can be said about profits we must
first understand costs and revenues. This chapter will develop the basic concepts of
production costs.

An economist's view of costs includes both explicit and implicit costs. Explicit
costs are accounting costs, and implicit costs are the opportunity costs of an allocation
of resources (i.e., business decisions). Accountants subtract total cost from total
revenue and arrive a total accounting profits. An economist, however, would include in
the total costs of the firm the profits that could have been made in the next best
business opportunity (e.g., the opportunity cost). Therefore, there is a significant
difference in how accountants' and economists' view profits B economic profits versus
accounting profits.

For the purposes of economic analysis, a normal profit includes the cost of the
lost opportunity of the next best alternative allocation of the firm=s resources. In a purely
competitive world, a business should be able to cover their costs of production and the
opportunity cost of the next best alternative (and nothing more in the long-run). In an
accounting sense there is no benchmark to determine whether the resource allocation
was wise. Instead various financial ratios are used to determine how the firm has done
with respect to similarly situated companies.

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Time Periods Revisited

As was discussed briefly in the section of elasticity of supply in Chapter 5, time

periods for economic analysis are defined by the types of costs observed. These time
periods differ from industry to industry, and will differ by the technology employed
between firms. Again, these time periods are; (1) the market period, (2) the short-run,
and (3) the long-run.

In the market period, all costs are fixed costs (nothing can be varied). In the
short-run, there are both fixed and variable costs observed. Generally, plant,
equipment, and technology are fixed, and things like labor, electricity, and materials can
still be varied. In the long-run everything is variable. That is, the plant, equipment, and
even the business into which you put productive assets can all be changed. In the
long-run, even the country in which the business is located can be changed. Because
everything is fixed in the market period, this period is of little interest in economic
analysis. Therefore, economists typically begin their analysis of costs with the short-run
and proceed to examine the operation of the firm and the industry. The long-run is of
interest because it is also the planning horizon for the business.

Production

Another view of the short-run cost structure is that fixed costs are those that must
be paid whether the firm produces anything or not. Variable costs are called variable
because they increase or decrease with the level of production. Therefore to
understand short-run costs, you must first understand production.

Total product or total output is the total number of units of production obtained
from the productive resources employed. Average product is total product divided by
the number of units of the variable factor employed. Marginal product is the change in
total product associated with a change in units of a variable factor of production.

As a firm increases its output it normally makes more efficient use of its available
capital. However, with a fixed level of available capital as variable factors are added to
the production process, there is a point where the increases in total output begin to
diminish. The law of diminishing returns is the fact that as you add variable
factors of production to a fixed factor, at some point, the increases in total output
begin to become smaller. In fact, it is possible, at some point, that further additions in
the units variable factors to a fixed level of capital could actually reduce the total output
of the firm. This is called the uneconomic range of production. In reality, most firms
come to realize that their total additions to total output diminish, long before they begin
to experience negative returns to additions to their workforce or other variable factors.

155
 The following diagram provides a graphical presentation of total, average, and
marginal products for a hypothetical firm.

The top graph shows total product. After total product reaches its maximum
marginal product where marginal product changes from positive to negative (first
derivative is zero, second derivative is negative). When the total product curve reaches
its maximum, increased output results in negative marginal product. The maximum on
the marginal product curve is also associated with the first inflection point (the
acceleration or where the curve becomes steeper) on the total product curve. The
ranges of marginal returns are identified on the above graphs.

The beginning point in developing the cost structure of a firm is to examine total
costs in the short run. Total costs (TC) are equal to variable costs (VC) plus fixed costs
(FC).

TC = VC + FC
Variable costs are those costs that can be varied in the short-run, i.e., the cost of
hiring labor. Fixed costs are those costs that cannot be varied in the short-run, i.e.,
plant (interest). Therefore, total costs consist of a fixed component and a variable
component.

These relations are presented in a graphical form in the following diagram:

156
 The fixed cost curve is a horizontal line. These costs are illustrated with a
horizontal line because they do not vary with quantity of output. The variable cost curve
has a positive slope because it varies with output. Notice that the total cost curve has
the same shape as the variable cost curve, but is above the variable cost curve by a
distance equal to the amount of the fixed cost. This is because we added fixed cost
(the horizontal line) to variable cost (the positively sloped line).

From the total, variable and fixed cost curves we can obtain other relations.
These are the marginal cost, and the total, variable, and fixed costs relation to various
levels of output (averages).

Average total cost (ATC) is total cost (TC) divided by quantity of output (Q),
average variable cost (AVC) is variable cost (VC) divided by quantity of output (Q), and
average fixed cost (AFC) is fixed cost (FC) divided by quantity of output (Q). Marginal
cost (MC) is the change (denoted by the Greek symbol delta), in total cost (TC) divided
by the change in the quantity of output (Q).

157
 These relations are presented in equation form below:

ATC = TC/Q

AVC = VC/Q

AFC = FC/Q

MC = ÎTC/ÎQ; where Î stands for change in.

The following diagram presents the average costs and marginal cost curve in
graphical form.

Please notice that the average fixed cost approaches zero as quantity increases.
This occurs because a constant is being divided by increasingly large numbers.
Average total cost is the summation of the average fixed and average variable cost
curves. Because average fixed cost approaches zero, the difference between average
variable cost and average total cost also approaches zero (the difference between ATC
and AVC is AFC). The marginal cost curve intersects both the average total cost and
average variable cost curves at their respective minimums. In other words, as marginal
cost is below average total (and average variable) cost the average function is falling to
meet marginal cost. As marginal cost is rising above the average function then average

158
total (and average variable) cost are increasing.

The following graph relates average and marginal product to average variable

and marginal cost.

Notice that at the maximum point on the marginal product curve, marginal cost
reaches a minimum. Where marginal cost equals average variable cost, the marginal
product curve intersects the average product curve. In other words, the cost structure
of the firm mirrors the engineering principles giving rise to the firm=s production, hence
its costs.

This presents some interesting disconnects from how business is presently

evolving. The high compensation levels of executives seems to not reflect the actual
output of their labors. In other words, the costs of production seemingly fail to account
for the history of the 21st century thus far. As it turns out, these issues can be explained
by neo-classical economics, and will be in Chapters 10 and 11.

The Long Run Average Total Cost Curve

In the long-run all costs are variable. In other words, a firm can vary its plant,
equipment, technology and any of the factors that were either fixed or variable in the
short-run. Therefore, anything that is technologically feasible is available to this firm in
the long-run. Further, any short-run average total cost curve (consistent with any size of
operation) could be selected for use in the long-run.

159
 The long-run average total cost curve (LRATC) is therefore a mapping of all
minimum points of all possible short-run average total cost curves (allowing technology
and all factors of production (i.e., costs) to vary). The enveloping of these short-run
total cost curves map all potential scales of operation in the long-run. Therefore, the
LRATC is also called the planning horizon for the firm.

The following diagram illustrates a LRATC:

The shape of the LRATC is dependent upon the available resources and
technology that a firm can utilize to produce a given commodity. The downward sloping
range of the LRATC is due to economies of scale, the upward sloping range of the
LRATC is due to diseconomies of scale, and if there is a flat range at the minimum point
of the LRATC this is called a range of constant returns to scale.

Economies of scale are benefits obtained from a company becoming large and
diseconomies of scale are additional costs inflicted because a firm has become too
large. The causes of economies of scale are that as a firm becomes larger it may be
able to utilize labor and managerial specialization more effectively, capital more
effectively, and may be able to profitably use by-products from its operations.
Diseconomies of scale result from the organization becoming too large to effectively
manage and inefficiencies developing.

Constant returns to scale are large ranges of operations where the firm's size
matters little. In very capital intensive operations that must cover some peak demand,
the size of the firm may matter very little. Several public utilities, such as electric
generating companies, telephone company, and water and sewer service have

160
relatively large ranges of constant returns to scale.

Where the LRATC curve reaches its minimum, this is called the minimum
efficient scale (size of operation). Minimum efficient scale is the smallest size of
operations where the firm can minimize its long-run average costs. Minimum efficient
scale varies significantly by commodity produced and technology. For example, the
minimum efficient scale in agriculture in the Great Lakes area for dairy operations is
relatively small (in the $200,000 range). Minimum efficient scale for wheat farmers in
the Great Plains may be as large as $1,000,000.

There is an interesting implication of the LRATC analysis. There are instances

where competition may be an unrealistic waste of resources. A natural monopoly is a
market situation where per unit costs are minimized by having only one firm serve the
market.

Minimum efficient scale is the point on the LRATC where it reaches its minimum.
If that happens to be at the beginning of a long range of constant costs, it is the first
point (on the left of the range) where costs are at their minimum. Remember, that
technical efficiency requires that a firm produce at where it has attained minimum total
long-run costs.

Where minimum efficient scale is very large for capital intensive operations, it
may be more cost effective to permit one company to spread its fixed costs over a very
large number of consumers, rather than have several competing firms suffer the fixed
costs of a minimum efficient scale and have to share a customer base. There are
several industries that are very capital intensive and require large initial investments to
operate. These types of firms are frequently natural monopolies. Railroads, electric
generating companies, and air lines requires tens of millions of dollars in fixed costs.

KEY CONCEPTS

Explicit v. Implicit Costs

Opportunity Costs

Economic v. Accounting Costs

Normal Profit
Next Best Alternative

Time Periods of Analysis

Market Period
Short-run

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 CHAPTER 8

Pure Competition

Chapter 4 developed the supply and demand diagram. The simple supply and
demand diagram is the model of a perfectly competitive industry. That model will be
revisited and extended in this chapter.

The purpose of this chapter is to introduce models of the firm that are not purely
competitive. After a brief introduction to imperfectly competitive models we will turn our
attention to the purely competitive industry and firm. In particular, this chapter will
develop the model of the perfectly competitive firm, examine its relation to the industry,
and then offer some critical evaluation of this important paradigm.

Firms and Market Structure

There are several models of market structure. In the product market, the two
extremes are perfect competition and pure monopoly. This chapter will examine pure
competition and the following chapter examines monopoly. However, there are
intermediate market structures. These intermediate market structures are oligopoly and
monopolistic competition.

The assumptions in pure competition are:

(1) there is atomized competition (a large number of very small suppliers

and buyers relative to the market),

(2) there is complete freedom of entry and exit into and from this market,

(3) there is no nonprice competition,

(4) suppliers offer a standardized product, and

(5) firms in this industry must accept the price determined in the industry.

Purely competitive firms and industries do not exist in reality. Probably as close
as the real world comes to the competitive ideal is agriculture, during the period in which
this industry was dominated by the relatively small family farms prior to World War II.
165
 The assumptions in pure monopoly are:

(1) there is one seller that supplies a large number of independent buyers,

(2) entry and exit into this market is completely blocked,

(3) the firm offers unique product,

(4) there is nonprice competition (mostly public information advertising),

and

(5) this firm is a constrained price dictator.

Pure monopolies abound in reality, including public utilities and manufacturing

firms producing products protected from competition by patents or copyrights. A
monopolist will produce less than a competitive industry and charge a higher price,
ceteris paribus.

The assumptions underlying the model of a monopolistically competitive industry

are:

(1) a relatively small number of sellers compared to pure competition, but

this number can still be large, in some cases a few hundred
independent sellers,

(2) pricing policies exist in these firms,

(3) entry into this market is generally somewhat difficult,

(4) there is substantial nonprice competition, mostly designed to create

product differentiation, at least some of which is spurious.

Numerous industries are properly characterized as monopolistic competition.

These industries include computer manufacturers, software manufacturers, most retail
industries, and liquor distillers. In general, monopolistic competitors produce less than
pure competitors but more that pure monopolists, and charge prices that also fall
between competition and monopoly. In general, the graphical analysis of a monopolistic
competitive industry is identical to a monopoly, except the demand curve is somewhat
more elastic than the monopolists'.

166
 The assumptions upon which the model of oligopoly are founded are:

(1) that there are few sellers (generally a dozen or less), these firms often
collude or implicitly cooperate through such practices as price
leadership,

(2) entry into this market is generally difficult,

(3) there is normally very intensive non price competition in an attempt to

create product differentiation, often spurious.

Examples of oligopolies abound, the U.S. automobile industry, the soft-drink

industry, the brewing industry, segments of the fast-food industry, and airplane
manufacturers. Oligopoly will generally produce less than monopolistic competitors and
charge higher prices, if price leadership or other collusive arrangements exist an
oligopoly may be a close approximation to a pure monopoly.

All of these market structures also assume perfect knowledge concerning

present and future prices (by both producers and consumers) and all other information
relative to the operation of the market, i.e., product availability, quality etc. This perfect
knowledge assumption is not realistic, however, it does little violence to the models
because people typically learn very quickly in aggregate, and hence there expectations
approximate perfect knowledge over large numbers of persons.

The Purely Competitive Firm

Total, average and marginal product were developed with the various cost curves
in Chapter 7. The missing piece of the puzzle is revenue. Because a purely competitive
firm sells its output at the one price determined in the industry, price does not change as
the quantity sold increases. In other words, the demand curve is horizontal, or perfectly
elastic. The result is that average revenue is equal marginal revenue, and both of these
are equal to price. Further , total revenue is P x Q which is the total area under the
demand curve for the purely competitive firm.

A firm is assumed to be rationally managed and therefore it will attempt to

maximize its profits. The profit maximizing rule is that a firm will maximize profits where
marginal cost (MC) is equal to marginal revenue (MR). The reason for this is relatively
simple. There is still a positive amount of revenue that can be had in excess of costs of
the firm produces at a quantity less than where MC = MR. If a firm produces at a
quantity in excess of where MC = MR, the firm adds more to its costs than it receives in
revenues. Therefore the optimal, or profit maximizing level of output is exactly where
MC = MR.

167
 The model of the purely competitive industry is the simple supply and demand
diagram you mastered in Chapter 4. The simple supply and demand diagram is a
representation of the aggregation of a large number of independent firms and
consumers. This model is revisited below:

Supply
Price

Pe

Demand

Qe Quantity

The firm in perfect competition is just one of thousands that are summed to arrive
at the industry levels of output and price. Because of the atomized competition, it a firm
charges a higher price that the industry it will sell nothing because consumers can
obtain exactly the same commodity at a lower price elsewhere. If the firm charges a
price lower that the price established in the industry it is irrational and will lose revenue
it could have otherwise had. Therefore, a firm operating in a perfectly competitive
industry has no choice save to sell its output at the industry established price. Because
the firm sells at the single price established in the industry it has a perfectly elastic
demand curve. (In other words, it is horizontal and not downward sloping).

168
The demand curve for the perfectly competitive firm is illustrated below:

Price

D = MR = AR = P

Quantity

Because the firm is a price taker, meaning that it charges the same price across all
quantities of output, marginal revenue is always equal to price, and average revenue
will always be equal to price. Therefore the demand curve intersects the price axis and
is horizontal (perfectly elastic) at the price determined in the industry.

Establishing the price in the industry is simply setting the equilibrium in the
familiar supply and demand diagram, and that is the price at which the firm is obliged to
sell its output. The following diagram illustrates how this is done:

Industry Firm in Competition

P

Pe
D=MR=AR

Q Q

169
 Again, the price is established by the interaction of supply and demand in the
industry (Pe) and the quantity exchanged in the industry is the summation of all of the
quantities sold by the firms in the industry. However, this yields little information save
what price will be charged and what quantity the industry produce. To determine what
each firm will produce and what profits each firm will earn, we must add the cost
structure (developed in the previous chapter).

Economic profits are total revenues in excess of total costs. Remember from
Chapter 7, that profits from the next best alternative allocation of resources is included
in the total costs of the firm. In this short-run it plausible that some firms in pure
competition can exact an economic profit from consumers, but because of freedom of
entry, the economic profit will attract new firms to the industry, hence increasing supply,
and thereby lowering price and wiping out the short-run economic profits.

The following diagram adds the costs structure to the purely competitive firm’s
demand curve and with this information it is possible to determine the profits that this
firm makes:

MC
Price
ATC
AVC

Economic Profits D=MR

Qe Quantity

The firm produces at where MC = MR, this establishes Qe. At the point where
MC = MR the average total cost (ATC) is below the demand curve (AR) and therefore
costs are less than revenue, and an economic profit is made. The reason for this is that
the opportunity cost of the next best allocation of the firm's productive resources is
already added into the firm's ATC.

However, the firm cannot continue to operate at an economic profit because

those profits are a signal to other firms to enter the market (free entry). As firms enter
the market, the industry supply curve shifts to the right reducing price and thereby
eliminating economic profits. Because of the atomized competition assumption, the
number of firms that must enter the market to increase industry supply must be

170
substantial. The following diagram illustrates the purely competitive firm making a
normal profit:
MC
Price ATC
AVC

D=MR

Qe Quantity

The case where a firm is making a normal profit is illustrated above. Where MC
= MR is where the firm produces, and at that point ATC is exactly tangent to the
demand curve. Because the ATC includes the profits from the next best alternative
allocation of resources this firm is making a normal profit.

A firm in pure competition can also make an economic loss. The following
diagram shows a firm in pure competition that is making an economic loss:

MC
ATC
Price
AVC

Economic Losses
D=MR

Qe Quantity

The case of an economic loss is illustrated above. The firm produces where MC
= MR, however, at that level of production the ATC is above the demand curve, in other
words, costs exceed revenues and the firm is making a loss.

171
 Even though the firm is making a loss it may still operate. The relation of
average total cost with average revenue determines the amount of profit or loss, but we
to know what relation average revenue has with average variable cost to determine
whether the firm will continue in business. In the above case, the firm continues to
operate because it can cover all of its variable costs and have something left to pay at
least a part of its fixed costs. It is shuts down it would lose all of its fixed costs,
therefore the rational approach is to continue to operate to minimize losses. Therefore,
the profit maximizing rule of producing at where MC = MR is also the rule to determine
where a firm can minimize any losses it may suffer.

In sum, to determine whether a firm is making a loss or profit we must consider

the relation of average total cost with average revenue. To determine whether a firm
that is making a loss should continue in business we must consider the relation between
average variable cost and average revenue. The following diagram illustrates the shut-
down case for the firm making a loss:

MC ATC
Price AVC

AVC SAVED BY SHUT- DOWN

D=MR

Qe Quantity

In the case above you can see that the AVC is above the demand curve at where
MC=MR, therefore the firm cannot even cover its variable costs and will shut down to
minimize its losses. If the firm continues to operate it cannot cover its variable costs
and will accrue losses in excess of the fixed costs. If the firm shuts-down, all that is lost
is the fixed costs. Therefore the firm should shut-down in order to minimize its losses.

What may not be intuitively obvious is that this analysis determines the industry
supply curve. Because firms cannot operate along the marginal cost curve below the
average variable cost curve, the firm’s supply curve is its marginal cost curve above
average variable cost. To obtain the industry’s supply curve one needs only sum all of
the firms’ marginal cost curves about their average variable cost curves.

172
 CHAPTER 9

Pure Monopoly
The purpose of this chapter is to examine the pure monopoly model in the
product market. Because monopolies are price givers, there are significant differences
between monopolies and competitive firms, these differences will be examined in details
in this chapter. Once the monopoly model is mastered, it will be critically evaluated.
Further, the rate regulation of monopolies will be examined and critically evaluated.

The Assumptions of Monopoly Revisited

The assumptions upon which the monopoly model is based were presented in
Chapter 8. However, a quick review of those assumptions is worthwhile here. The
assumptions of the monopoly model are:

(1) there is a single seller (or a few sellers who collude, hence a cartel),

(2) the single seller offers a unique product,

(3) entry and generally exit are blocked,

(4) there is non-price competition, and

(5) the monopolist dictates price in the market.

As will become quickly apparent, the differences in the assumptions that

underpin the monopoly and purely competitive models make for very different analyses.
Further, the difference in assumptions also creates substantially different results in
price and output between the two models.

The Monopoly Model

In the purely competitive analysis, there were two different models, one model for
the industry, in which the interaction of supply and demand established the market price
and quantity. The second model was that of the firm, the firm faced a perfectly elastic
demand curve, in which demand, price, average revenue and marginal revenue were all
the same. However, in the analysis of a monopoly there is but one model. The firm, in
monopoly, is the industry (by definition). Because the firm is the industry it therefore

179
faces a downward sloping demand curve, which is also the average revenue curve for
the firm (hence the industry).
If the firm wants to sell more it must lower its price therefore marginal revenue is also
downward sloping, but has twice the slope of the demand curve. Remember when you
lower price the average revenue falls, but not as fast as the marginal, and if the average
revenue is a linear (as it is here, which is smooth, and continuously differentiable) the
there is a necessary relationship between the slope of the average and marginal
functions.

Consider the following diagram:

Price
El
as
ti c
Ra
ng
e

In
ela
st i
cR
an
ge

Marginal Demand
Revenue

Quantity

The point where the marginal revenue curve intersects the quantity axis is of
significance; this point is where total revenue is maximized. Further, the point on the
demand curve associated with where MR = Q is the point on the demand curve of unit
price elastic demand; to the left along the demand curve is the elastic range, and to the
right is the inelastic range (see Chapter 5 for a review of the relation between marginal
revenue and price elasticity of demand).

Unlike the purely competitive model here is no supply curve in an industry which
is a monopoly. The monopolist decides how much to produce using the profit
maximizing rule; or where MC = MR. In this sense, the monopolist is a price dictator,
in that it is the cost structure, together with the change in total revenue with respect to
change in quantity sold that directs the monopolist’s pricing behavior, rather than the
interaction of the monopolist’s supply schedule, with the demand schedule of
consumers (demand curve). With this information we can discover more about the
monopoly model.

A monopolist can make an economic profit. An economic profit is that margin

above average cost which is in excess of that necessary to cover the next best
alternative allocation of the firm’s assets. As you recall from Chapter 8, in pure

180
competition if there is an economic profit, that profit is a signal to other assets to enter
the market. Because there are no barriers to entry into a purely competitive industry,
the supply curve increase (shifts right) as these newly attracted resources enter the
market – hence driving down the market price in the industry, and eliminating the
economic profit.

One of the objections to pure monopoly is that there is closed entry. A

monopolist making an economic profit can do so as long as the cost and revenue
structure permit, perhaps permanently. The self-correcting advantages from pure
competition are lost because of these barriers to entry.

Price

Pe MC
Economic ATC
Profit

MR

Qe Quantity

The above diagram shows the economic profits that can be maintained in the long run
because of the barriers to entry into this industry. The monopolist produces where MC
= MR (where MC intersects MR), but the price charged is all the market will bear, that
is, the price on the demand curve that is immediately above the intersection of MC =
MR. The rectangle mapped out by the ATC, the indicator over the price index, the
origin, and Qm are the total costs, the rectangle mapped out by the demand curve, QM,
the origin, and Pm is the total revenue, and the difference between these rectangles is
economic profits.

On the other hand, there is nothing in the analysis that requires any given
monopolist will be profitable. In fact, a monopolist can operate at an economic loss, the
same as a competitive firm can.

The following diagram shows a monopolist that is unfortunate enough to be

operating at an economic loss.

181
 Price MC
ATC
Economic Loss AVC
Pe

MR

Qe Quantity

This monopolist is making an economic loss. The ATC is above the demand
curve (AR) at where MC = MR (the loss is the labeled rectangle). However, because
AVC is below the demand curve at where MC = MR the firm will not shut down so as to
minimize its losses. The firm can pay back a portion of its fixed costs by continuing to
operate at this level because the AVC is still below the demand curve. As you will
remember from the discussion in Chapter 8, when AVC is above the demand curve the
firm should shut down to prevent throwing good money after bad.

The Effects of Monopoly

There are several implications of the monopoly model; many of which lead to
criticisms of monopoly on issues of both technical and allocative efficiency. The prices
and output determined in the monopoly are not consistent with allocative efficiency
criteria. In monopoly there are too many resources allocated to production of this
product, for which we receive too little output as illustrated by comparison with the
competitive solution, the dotted line (discussed below). Consequently, because of the
barriers to entry, the price for this product is too high – hence allocatively inefficient.

Consider the following diagram of a pure monopoly making an economic profit, in

this case:

182
 Price

Pm MC
Economic ATC
Profit
Pc

MR

Qm Qc Quantity

The above graph shows the profit maximizing monopolist, Pm is the price the
monopoly commands in this market and Qm is the quantity exchanged in this market.
However, where MC = D is where a perfectly competitive industry produces and this is
associated with Pc and Qc. The monopolist therefore produces less and charges more
than a purely competitive industry.

A monopolist can also segment a market and engage in price discrimination.

Price discrimination is where you charge a different price to different customers
depending on their price elasticity of demand. Because the consumer has no
alternative source of supply price discrimination can be effective. This practice
enhances the allocative inefficiency. When a consumer must pay more for a product,
simply because of the monopoly power in the market, less of the consumers’ incomes
are available to purchase other commodities. The end result is even more resources
flow into the monopolist’s coffers, and out of other industries – hence even more
inefficient allocations of productive resources.

This does not mean that monopolists are pure evil – in an economic sense.
Sometimes a monopolist is in the best interests of society (besides the natural
monopoly situation). Often a company must expend substantial resources on research
and development (i.e., pharmaceutical firms). If these types of firms were forced to
permit free use of their technological developments (hence no monopoly power) then
the economic incentive to develop new technology and products would be eliminated –
hence economic irrationality would have to prevail for the technological progress we
have come to expect in the beginning of the twenty-first century.

183
Regulated Monopoly

Because there are natural monopoly market situations it is in the public interest
to permit monopolies, but traditionally in the United States they are regulated with
respect to price. The purpose of the rate regulation was to ensure that the public would
not suffer price gouging as a result of the monopoly position of the firms. Examples of
regulated natural monopolies are electric utilities, cable TV companies, and telephone
companies (local).

Throughout the 1980s and 1990s, up through 2002, there was substantial
deregulation of the power industry, cable TV industry, and telecom. In the 1980s ATT
was broken-up into several local telecom companies, i.e., Verizon, Southwestern Bell,
Ameritech, and US West, among other, the long lines company (ATT) and Bell Labs
(Lucent). The idea was to permit competition in long distance and local service. What
happened was far different. The local providers had much invested in microwave
towers, switches, and telephone lines – there would be charges permitted for the use of
these assets by competitors, and what resulted was poorer service, at higher prices in
most areas. In the summer of 2001, California consumers got a taste of what Enron
could do in selling power to local public utilities. Consumers were victims of
unscrupulous business practices that resulted in billions of dollars in overcharges that
cannot be recovered.

The problem with regulating the prices that monopolists can charge is that there
are several competing goals that can be accomplished through rate regulation. If
allocative efficiency is the goal, then the monopolist should be constrained to charge a
price where MC = D or the social optimum. If technical efficiency is the goal then
some argue that the monopolist’s minimum total cost should be the basis for the rate
regulation. If we are concerned about consistently and reliably having the product of the
monopolist available, at a reasonable price, then it might be more sensible to regulate
the monopolist to charge a price at where ATC = D, or the fair rate of return. So
regulatory agencies have alternatives as to where to regulate any monopolists within
their jurisdiction. The potential prices at which a monopolist could be regulated,
and the potential results of those price levels, is called the dilemma or regulation.
This dilemma has presented the opportunity for considerable debate about whether
rate regulation is appropriate, and if so, what sorts of regulation should occur.

Consider the following diagram, this is a monopolist that is being regulated at the
social optimum (MC = D):

184
 Price

MC
ATC
Pr

MR

Qr Quantity

This firm is being regulated at the social optimum, in other words, what the
industry would produce if it were a purely competitive industry. The price it is required
to charge is also the competitive solution. However, notice the ATC is below the
demand curve at the social optimum which means this firm is making an economic
profit. It is also possible with this solution that the firm could be making an economic
loss (if ATC is above demand) or even shut down (if AVC is above demand).

Consider the following diagram of a monopolist that is being regulated at the fair
rate of return:

Price

MC
ATC

Pr
D

MR

Qr Quantity

The fair rate of return enforces a normal profit because the firm must price its
output and produce where ATC is equal to demand. This eliminates economic profits
and the risk of loss or of even putting the monopolist out of business. Virtually every

185
 APPENDIX B

SELECTED BIBLIOGRAPHY
(BOOK LIST)

Becker, Gary, Human Capital: A Theoretical and Empirical Analysis. Chicago: University
of Chicago Press, 1993

Friedman, Milton, Essays in Positive Economics. Chicago: University of Chicago Press,

1994.*

Friedman, Milton and Rose D. Friedman, Capitalism and Freedom. Chicago: University
of Chicago Press, 1972.

Galbraith, John Kenneth, The Great Crash of 1929. New York: Houghton - Mifflin,
Company, 1997.*

Heilbroner, Robert L., The Worldly Philosophers, seventh edition. New York: Simon and
Schuster, 1999.*

Higham, Charles, Trading with the Enemy: The Nazi-American Money Plot - 1933-1949.
New York: Barnes and Nobel Books, 1983.

Hilgert, Raymond L. and David A. Dilts, Cases in Collective Bargaining and Industrial
Relations, tenth edition. New York: McGraw-Hill / Irwin, 2002.

Manchester, William, The Arms of Krupp: 1587-1968. New York: Bantam Books, 1970.*

Marx, Karl, Das Kapital, New York: International Publishers, Incorporated, 1982.*

McConnell, Campbell R. and Stanley Brue, Principles of Economics, sixteenth edition,

New York: McGraw-Hill / Irwin, 2004.

North, Douglas C. Economic Growth in the United States: 1790-1860. Seattle: DIANE
Publishing Co., 2003.

Rahnama-Moghadam, Mashaalah, Hedayeh Samavati and David A. Dilts, Doing

Business in Indebted Less Developed Countries. Westport, Conn: Greenwood
Publishing Group, 1995.

237