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Learning Objectives
• Why do people spend so much money on things that aren’t much better than the cheap versions?
• Why do people who study ancient Greek get good jobs that don’t involve reading ancient Greek?
An interesting approach to solving informational problems involves signaling.Signaling was introduced by Nobel laureate Michael Spence in his dissertation, part of which was reprinted in “Job Market Signaling,” Quarterly Journal of Economics 87 (August 1973): 355–74. Signaling, in economic jargon, means expenditures of time or money whose purpose is to convince others of something. Thus, people signal wealth by wearing Rolex watches, driving expensive cars, or sailing in the America’s Cup. They signal erudition by tossing quotes from Kafka or Tacitus into conversations. They signal being chic by wearing the “right” clothes and listening to cool music. Signaling is also rampant in the animal world, from peacock feathers to elk battles, and it is the subject of a vibrant and related research program.
A university education serves not just to educate but also to signal the ability to learn. Businesses often desire employees who are able to adapt to changing circumstances and who can easily and readily learn new strategies and approaches. Education signals such abilities because it will be easier for quick learners to perform well at university. A simple model suffices to illustrate the point. Suppose there are two types of people. Type A has a low cost cA of learning, and type B has a higher cost cB of learning. It is difficult to determine from an interview whether someone is type A or type B. Type A is worth more to businesses, and the competitive wage wA (expressed as a present value of lifetime earnings) for type A’s is higher than the wage wB for type B’s.
A person can signal that she is a type A by pursuing a sufficient amount of education. Suppose the person devotes an amount of time x to learning at university, thus incurring the cost cA x. If x is large enough so that $$wA – cA x > wB > wA – cB x$$, it pays the type A to obtain the education, but not the type B, if education in fact signals that the student is type A. Thus, a level of education x in this case signals a trait (ease of learning) that is valued by business, and it does so by voluntary choice—those with a high cost of learning choose not to obtain the education, even though they could do it. This works as a signal because only type A would voluntarily obtain the education in return for being perceived to be a type A.
There are several interesting aspects to this kind of signaling. First, the education embodied in x need not be valuable in itself; the student could be studying astronomy or ancient Greek, neither of which are very useful in most businesses but are nevertheless strong signals of the ability to learn. Second, the best subject matter for signaling is that in which the difference in cost between the type desired by employers and the less desirable type is greatest—that is, where cB – cA is greatest. Practical knowledge is somewhat unlikely to make this difference great; instead, challenging and abstract problem solving may be a better separator. Clearly, it is desirable to have the subject matter be useful, if it can still do the signaling job. But interpreting long medieval poems could more readily signal the kind of flexible mind desired in management than studying accounting, not because the desirable type is good at it or that it is useful, but because the less desirable type is so much worse at it.
Third, one interprets signals by asking, “What kinds of people would make this choice?” while understanding that the person makes the choice hoping to send the signal. Successful law firms have very fine offices, generally much finer than the offices of their clients. Moreover, there are back rooms at most law firms, where much of the real work is done, that aren’t nearly so opulent. The purpose of the expensive offices is to signal success, essentially proclaiming, “We couldn’t afford to waste money on such expensive offices if we weren’t very successful. Thus, you should believe we are successful.”
The law firm example is similar to the education example. Here, the cost of the expenditures on fancy offices is different for different law firms because more successful firms earn more money and thus value the marginal dollar less. Consequently, more successful firms have a lower cost of a given level of office luxury. What is interesting about signaling is that it is potentially quite wasteful. A student spends 4 years studying boring poems and dead languages in order to demonstrate a love of learning, and a law firm pays \$75,000 for a conference table that it rarely uses and gets no pleasure out of in order to convince a client that the firm is extremely successful. In both cases, it seems like a less costly solution should be available. The student can take standardized tests, and the law firm could show its win-loss record to the potential client. But standardized tests may measure test-taking skills rather than learning ability, especially if what matters is the learning ability over a long time horizon. Win-loss records can be “massaged,” and in the majority of all legal disputes, the case settles and both sides consider themselves the winner. Consequently, statistics may not be a good indicator of success, and the expensive conference table may be a better guide.
Key Takeaways
• Signaling means expenditures of time or money whose purpose is to convince others of something.
• A university education signals the ability to learn. The education need not be useful in itself to be helpful in signaling. The best subject matter for signaling is something that is easy for fast learners and difficult for slower learners.
• Signals are interpreted by asking, “What kinds of people would make this choice?” while understanding that the person makes the choice hoping to send the signal. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/18%3A_Information/18.03%3A_Signaling.txt |
Learning Objectives
• Why do we see such random prices at the grocery store?
• Why are prices unpredictable?
Decades ago, economists used to make a big deal about the law of one price, which states that identical goods sell at the same price. The argument in favor of the law of one price is theoretical. Well-informed consumers will buy identical goods from the lowest-price seller. Consequently, the only seller to make any sales is the low-price seller. This kind of consumer behavior forces all sellers to sell at the same price.
There are few markets where the law of one price is actually observed to hold. Organized exchanges, like stock, bond, and commodity markets, will satisfy the law of one price. In addition, gas stations across the street from each other will often offer identical prices, but often is not always.
Many economists believed that the Internet would force prices of standardized goods—DVD players, digital cameras, MP3 players—to a uniform, and uniformly low, price. However, this has not occurred. Moreover, it probably can’t occur in the sense that pure price competition would put the firms out of business and hence can’t represent equilibrium behavior.
There are many markets where prices appear unpredictable to consumers. The price of airline tickets is notorious for unpredictability. The price of milk, soft drinks, paper towels, and canned tuna varies 50% or more depending on whether or not the store has an advertised sale of the item. Prices of goods sold on the Internet vary substantially from day to day.It is often very challenging to assess Internet prices because of variations in shipping charges. Such variation of price across stores is known as price dispersion by economists. It is different from price discrimination because price dispersion entails a given store quoting the same price to all customers; the variation is across stores, while price discrimination varies across customers.
Why are prices so unpredictable? We now develop a model that shows they have to be.
To understand price dispersion, we divide consumers into two types: shoppers and loyal customers. Loyal customers won’t pay more than a price pm for the good, but they consult a particular store. If that store has the good for less than the price pm, the loyal customer buys; otherwise, he or she does not. In contrast, the shoppers buy only from the store offering the lowest price; shoppers are informed about the prices offered by all stores. We let the proportion of shoppers be s. The loyal customers are allocated to the other stores equally so that if there are n stores, each store gets a fraction (1 – s)/n of the customers. Let the marginal cost of the good be c, and assume that c < pm. Both kinds of customers buy only one unit.
For the purposes of this analysis, we will assume that prices can be chosen from the continuum. This makes the analysis more straightforward, but there is an alternate version of the analysis (not developed here) that makes the more reasonable assumption of prices that are an integer number of pennies.
First note that there is no pure strategy equilibrium. To see this, consider the lowest price p charged by any firm. If that price is c, the firm makes no money, so it would do better by raising its price to pm and selling only to the loyal customers. Thus, the lowest price p exceeds c. If there is a tie at p, it pays to break the tie by charging a billionth of a cent less than p, and thereby capturing all the shoppers rather than sharing them with the other firm charging p. So there can’t be a tie.
But no tie at p means the next-lowest firm is charging something strictly greater than p, which means the lowest-price firm can increase price somewhat and not suffer any loss of sales. This contradicts profit maximization for that firm. The conclusion is that firms must randomize and that no pure strategy equilibrium exists.
But how do they randomize? We are going to look for a distribution of prices. Each firm will choose a price from the continuous distribution F, where F(x) is the probability the firm charges a price less than x. What must F look like? We use the logic of mixed strategies: the firm must get the same profits for all prices that might actually be charged under the mixed strategy; otherwise, it would not be willing to randomize.
A firm that charges price ppm always sells to its captive customers. In addition, it sells to the shoppers if the other firms have higher prices, which occurs with probability $$(1−F(p)) n−1$$. Thus, the firm’s profits are $π(p)=(p−c)( 1−s n +s $(1−F(p)) n−1$ ).$
On each sale, the firm earns pc. The firm always sells to its loyal customers and in addition captures the shoppers if the other firms price higher. Because no firm will exceed pm, the profits must be the same as the level arising from charging pm, and this gives $$π(p)=(p−c)( 1−s n +s (1−F(p)) n−1 )=( p m −c) 1−s n .$$
This equation is readily solved for F:
$F(p)=(1-(p m-p)(1-s) s(p-c) n) 1 n-1$
The lower bound of prices arises at the point L where F(L) = 0, or
$L=c+(p m-c) 1-s n 1-s n+s$
These two equations provide a continuous distribution of prices charged by each firm, which is an equilibrium to the pricing game. That is, each firm randomizes over the interval [L, pm], according to the continuous distribution F. Any price in the interval [L,pm] produces the same profits for each firm, so the firms are willing to randomize over this interval.
The loyal customers get a price chosen randomly from F, so we immediately see that the shoppers make life better for the loyal customers by pushing average price down. (An increase in s directly increases F, which means prices fall—recall that F gives the probability that prices are below a given level, so an increase in F is an increase in the probability of low prices.)
Similarly loyal customers make life worse for shoppers, increasing prices on average to shoppers. The distribution of prices facing shoppers is actually the distribution of the minimum price. Because all firms charge a price exceeding p with probability $$(1 – F (p))n$$, at least one charges a price less than p with probability $$1-(1-F(p))^{n}$$, and this is the distribution of prices facing shoppers. That is, the distribution of prices charged to shoppers is
$$1-(1-\mathrm{F}(\mathrm{p})) \mathrm{n}=1-((\mathrm{p} \mathrm{m}-\mathrm{p})(1-\mathrm{s}) \mathrm{s}(\mathrm{p}-\mathrm{c}) \mathrm{n}) \mathrm{n} \mathrm{n}-1$$
How does a price-dispersed industry perform? First, average industry profits are $$nπ(p)=( p m −c)(1−s).$$
An interesting aspect of this equation is that it doesn’t depend on the number of firms, only on the number of loyal customers. Essentially, the industry profits are the same that it would earn as if the shoppers paid marginal cost and the loyal customers paid the monopoly price, although that isn’t what happens in the industry, except in the limit as the number of firms goes to infinity. Note that this formula for industry profits does not work for a monopoly. To capture monopoly, one must set s = 0 because shoppers have no alternative under monopoly.
As the number of firms gets large, the price charged by any one firm converges to the monopoly price pm. However, the lowest price offered by any firm actually converges to c, marginal cost. Thus, in the limit as the number of firms gets large, shoppers obtain price equal to marginal cost and loyal firms pay the monopoly price.
Figure 18.1 Expected Prices in Search Equilibrium
Similarly, we can examine the average prices for loyal customers and shoppers when the proportion of shoppers varies. Increasing the proportion of shoppers has two effects. First, it makes low prices more attractive, thus encouraging price competition because capturing the shoppers is more valuable. Second, it lowers industry profits because the set of loyal customers is reduced. Figure 18.2 plots the average price for loyal customers and shoppers, as the proportion of shoppers ranges from zero to one, when there are five firms, pm = 1 and c = 0.
People who are price-sensitive and shop around convey a positive externality on other buyers by encouraging price competition. Similarly, people who are less price-sensitive and don’t shop around convey a negative externality on the other buyers. In markets with dispersed information about the best prices, where some buyers are informed and some are not, randomized prices are a natural outcome. That is, randomization of prices, and the failure of the law of one price, is just a reflection of the different willingness or ability to search on the part of consumers.
Figure 18.2 Expected Prices (s = Proportion of Shoppers)
This difference in the willingness to search could arise simply because search is itself costly. That is, the shoppers could be determined by their choice to shop in such a way that the cost of shopping just balances the expected gains from searching. The proportion of shoppers may adjust endogenously to ensure that the gains from searching exactly equal the costs of searching. In this way, a cost of shopping is translated into a randomized price equilibrium in which there is a benefit from shopping and all consumers get the same total cost of purchase on average.
Key Takeaways
• The law of one price, which states that identical goods sell at the same price, is unfortunately empirically false.
• There are many markets where prices appear unpredictable to consumers. Price variation over time or across stores is known as price dispersion.
• The basic price-dispersion model involves firms setting prices simultaneously and selling to two types of customers: one loyal to a particular store, the other (“shoppers”) buying from the cheapest store.
• There is no pure strategy equilibrium because firms either want to be just barely the cheapest or at the monopoly price. The only candidate for an equilibrium is a mixed strategy.
• There is a mixed strategy involving randomizing over an interval of prices.
• Industry profits in price dispersion arise from the number of loyal customers and are independent of the number of firms.
• An increase in the number of firms is good for shoppers and bad for loyal customers. In the limit as the number of firms goes to infinity, the shoppers pay marginal cost and loyal customers pay the monopoly price.
• Shoppers convey a positive externality on other buyers by encouraging price competition. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/18%3A_Information/18.04%3A_Search_and_Price_Dispersion.txt |
Learning Objectives
• What is an agency?
• How should a principal compensate an agent?
An agent is a person who works for, or on behalf of, another. Thus, an employee is an agent of a company. But agency extends beyond employee relationships. Independent contractors are also agents. Advertising firms, lawyers, and accountants are agents of their clients. The CEO of a company is an agent of the board of directors of the company. A grocery store is an agent of the manufacturer of corn chips sold in the store. Thus, the agency relationship extends beyond the employee into many different economic relationships. The entity—person or corporation—on whose behalf an agent works is called a principal.
Agency theory is the study of incentives provided to agents. Incentives are an issue because agents need not have the same interests and goals as the principal. Employees spend billions of hours every year browsing the Web, e-mailing friends, and playing computer games while they are supposedly working. Attorneys hired to defend a corporation in a lawsuit have an incentive not to settle, to keep the billing flowing. (Such behavior would violate the attorneys’ ethics requirements.) Automobile repair shops have been known to use substandard or used replacement parts and bill for new, high-quality parts. These are all examples of a conflict in the incentives of the agent and the goals of the principal.
Agency theory focuses on the cost of providing incentives. When you rent a car, an agency relationship is created. Even though a car rental company is called an agency, it is most useful to look at the renter as the agent because it is the renter’s behavior that is an issue. The company would like the agent to treat the car as if it were her own car. The renter, in contrast, knows it isn’t her own car and often drives accordingly.
rented P. J. O'Rourke, Republican Party Reptile (Boston: Atlantic Monthly, 1987), 242.
How can the car rental company ensure that you don’t put its car into reverse while going forward at a high rate of speed? It could monitor your behavior, perhaps by putting a company representative in the car with you. That would be a very expensive and unpleasant solution to the problem of incentives. Instead, the company uses outcomes—if damage is done, the driver has to pay for it. That is also an imperfect solution because some drivers who abuse the cars get off scot-free, and others who don’t abuse the car still have cars that break down and are then mired in paperwork while they try to prove their good behavior. That is, a rule that penalizes drivers based on outcomes imposes risk on the drivers. Modern technology is improving monitoring with GPS tracking.
To model the cost of provision of incentives, we consider an agent like a door-to-door encyclopedia salesperson. The agent will visit houses and sell encyclopedias to some proportion of the households; the more work the agent does, the more sales that are made. We let x represent the average dollar value of sales for a given level of effort; x is a choice the agent makes. However, x will come with risk to the agent, which we model using the variance δ2.
The firm will pay the agent a share s of the money generated by the sales. In addition, the firm will pay the agent a salary y, which is fixed independently of sales. This scheme—a combination of salary and commission—covers many different situations. Real estate agents receive a mix of salary and commission. Authors receive an advance and a royalty, which works like a salary and commission.
The monetary compensation of the agent is $$s x + y$$. In addition, the agent has a cost of effort, which we take to be x 2 2a . Here, a represents the ability of the agent: more able agents, who have a higher value of a, have a lower cost of effort. Finally, there is a cost of risk. The actual risk imposed on the agent is proportional to the degree he shares in the proceeds. If s is small, the agent faces almost no monetary risk, but if s is high, most of the risk is imposed on the agent. We use the linear cost of risk model, developed earlier, to impose a cost of risk, which is s $$\lambda $\delta^{2}$$$. Here, $$\delta^{2}$$ is the variance of the monetary risk, λ defines the agent’s attitude or cost of risk, and s is the share of the risk imposed on the agent. This results in a payoff to the agent of $$u=sx+y− x 2 2a −sλ σ 2$$.
The part of the equation represented by sx + y is the payments made to the agent. The next term is the cost of generating that level of x. The final term is the cost of risk imposed on the agent by the contract.
The agency game works as follows. First, the principal offers a contract, which involves a commission s and a salary y. The agent can either accept or reject the contract and accepts if he obtains at least u0 units of utility, the value of his next best offer. Then the agent decides how much effort to expend; that is, the agent chooses x.
As with all subgame perfect equilibria, we work backward to first figure out what x an agent would choose. Because our assumptions make u quadratic in x, this is a straightforward exercise, and we conclude x = sa. This can be embedded into u, and the agent’s optimized utility u* is
$u^{*}=s 2 a+y-(s a) 22 a-s \lambda \sigma 2=y+1 / 2 s 2 a-s \lambda \sigma 2$
The agent won’t accept employment unless u* ≥ u0, the reservation utility. The principal can minimize the cost of employing the agent by setting the salary such that u* = u0, which results in $y=u 0-1 / 2 s 2 a+s \lambda \sigma 2$ .
Observe that the higher the salary, the greater is the risk $$\delta^{2}$$. That is, the principal has to cover the cost of risk in the salary term.
Key Takeaways
• An agent is a person who works for, or on behalf of, another.
• An employee is an agent of a company. Independent contractors are also agents. The entity—person or corporation—on whose behalf an agent works is called a principal.
• Agency theory is the study of incentives provided to agents. In the basic agency model, a principal sets a salary and commission, and the agent chooses the effort to expend. The principal keeps the random output minus the salary and commission. Higher commissions increase the agent’s incentive but impose risk on the agent. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/19%3A_Agency_Theory/19.01%3A_Principals_and_Agents.txt |
Learning Objectives
• How much does it cost to motivate agents?
The principal obtains profits, which are the remainder of the value after paying the agent minus the salary:
$π=(1−s)x−y =(1−s)sa−( u 0 −½ s 2 a+sλ σ 2 ) =sa− u 0 −½ s 2 a−sλ σ 2$
Note that the principal gets the entire output x = sa minus all the costs—the reservation utility of the agent u0, the cost of providing effort, and the risk cost on the agent. That is, the principal obtains the full gains from trade—the value of production minus the total cost of production. However, the fact that the principal obtains the full gains from trade doesn’t mean the principal induces the agent to work extremely hard because there is no mechanism for the principal to induce the agent to work hard without imposing more risk on the agent, and this risk is costly to the principal. Agents are induced to work hard by tying their pay to their performance, and such a link necessarily imposes risk on the agent, and risk is costly.There is a technical requirement that the principal’s return π must be positive; otherwise, the principal would rather not contract at all. This amounts to an assumption that u0 is not too large. Moreover, if s comes out less than zero, the model falls apart, and in this case, the actual solution is s = 0.
We take the principal to be risk neutral. This is reasonable when the principal is economically large relative to the agent, so that the risks faced by the agent are small compared to those faced by the principal. For example, the risks associated with any one car are small to a car rental company. The principal who maximizes expected profits chooses s to maximize π, which yields $$s=1− λ a σ 2$$.
This formula is interesting for several reasons. First, if the agent is neutral to risk, which means λ = 0, then s is 1. That is, the agent gets 100% of the marginal return to effort, and the principal just collects a lump sum. This is reminiscent of some tenancy contracts used by landlords and peasants; the peasant paid a lump sum for the right to farm the land and then kept all of the crops grown. Because these peasants were unlikely to be risk neutral, while the landlord was relatively neutral to risk, such a contract was unlikely to be optimal. The contract with s = 1 is known as selling the agency because the principal sells the agency to the agent for a lump sum payment. (Here, y will generally be negative—the principal gets a payment rather than paying a salary.) The more common contract, however, had the landowner and the tenant farmer share the proceeds of farming, which gives rise to the name sharecropper.
Second, more risk or more risk aversion on the part of the agent decreases the share of the proceeds accruing to the agent. Thus, when the cost of risk or the amount of risk is high, the best contract imposes less risk on the agent. Total output sa falls as the costs of risk rise.
Third, more able agents (higher a) get higher commissions. That is, the principal imposes more risk on the more able agent because the returns to imposition of risk—in the form of higher output—are greater and thus worth the cost in terms of added risk.
Most real estate agencies operate on a mix of salary and commission, with commissions paid to agents averaging about 50%. The agency RE/MAX, however, pays commissions close to 100%, collecting a fixed monthly fee that covers agency expenses from the agents. RE/MAX claims that their formula is appropriate for better agents. The theory developed suggests that more able agents should obtain higher commissions. But in addition, RE/MAX’s formula also tends to attract more able agents because able agents earn a higher wage under the high commission formula. (There is a potential downside to the RE/MAX formula: it discourages agency-wide cooperation.)
Consider what contracts attract what kinds of agents. For a fixed salary y and commission s, the agent’s utility, optimizing over x, is $$u*=y+½ s 2 a−sλ σ 2$$.
The agent’s utility is increasing in a and decreasing in λ. Thus, more able agents get higher utility, and less risk-averse agents get higher utility.
How do the terms of the contract affect the pool of applicants? Let us suppose that two contracts are offered, one with a salary y1 and commission s1, the other with salary y2 and commission s2. We suppose $$y_{2}<y_{1}$$ and $$s_{2}>s_{1}$$. What kind of agent prefers Contract 2, the high-commission, low-salary contract, over Contract 1?
$y 2 +½ s 2 2 a− s 2 λ σ 2 ≥ y 1 +½ s 1 2 a− s 1 λ σ 2$
or the equivalent:
$½a( s 2 2 − s 1 2 )−( s 2 − s 1 )λ σ 2 ≥ y 1 − y 2$
Thus, agents with high ability a or low level of risk aversion λ prefer the high-commission, low-salary contract. A company that puts more of the compensation in the form of commission tends to attract more able agents and agents less averse to risk. The former is a desirable feature of the incentive scheme because more able agents produce more. The latter, the attraction of less risk-averse agents, may or may not be desirable but is probably neutral overall.
One important consideration is that agents who overestimate their ability will react the same as people who have higher ability. Thus, the contract equally attracts those with high ability and those who overestimate their ability.
Agency theory provides a characterization of the cost of providing incentives. The source of the cost is the link between incentives and risk. Incentives link pay and performance; when performance is subject to random fluctuations, linking pay and performance also links pay and the random fluctuations. Thus, the provision of incentives necessarily imposes risk on the agent, and if the agent is risk averse, this is costly.
In addition, the extent to which pay is linked to performance tends to affect the type of agent who is willing to work for the principal. Thus, a principal must not only consider the incentive to work hard created by the commission and salary structure but also the type of agent who would choose to accept such a contract.
Key Takeaways
• The principal chooses the salary to minimize the cost of the agent; thus, the principal nets the total output, minus the cost of the agent.
• The agent’s cost must be at least as large as what the agent would get in an alternative occupation and thus includes a risk adjustment.
• The optimal commission offered by the principal is decreasing in the risk aversion of the agent and the level of risk and increasing in the agent’s ability.
• If the agent is neutral to risk, the principal gets a lump sum, and “sells the agency.”
• Total output falls as the costs of risk rise.
• A company that puts more of the compensation in the form of commission tends to attract more able agents and agents less averse to risk. A principal must not only consider the incentive to work hard created by the commission and salary structure but also the type of agent who would choose to accept such a contract.
EXERCISE
1. Describe how a principal would go about hiring agents who are willing to take risks. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/19%3A_Agency_Theory/19.02%3A_Cost_of_Providing_Incentives.txt |
Learning Objectives
• How does an employer compensate an agent who performs several tasks of varying importance? What happens when the tasks conflict?
Multi-tasking refers to performing several activities simultaneously. All of us multitask. We study while drinking a caffeinated beverage; we think about things in the shower; we talk all too much on cell phones and eat french fries while driving. In the context of employees, an individual employee is assigned a variety of tasks and responsibilities, and the employee must divide her time and efforts among the tasks. Incentives provided to the employee must direct not only the total efforts of the employee, but also the allocation of time and effort across activities. An important aspect of multitasking is the interaction of incentives provided to an employee, and the effects of changes in one incentive on the behavior of the employee over many different dimensions. In this section, we will establish conditions under which the problem of an employer disaggregates; that is, the incentives for performing each individual task can be set independently of the incentives applied to the others.
This section is relatively challenging and involves a number of pieces. To simplify the presentation, some of the analyses are set aside as claims.
To begin the analysis, we consider a person who has n tasks or jobs. For convenience, we will index these activities with the natural numbers 1, 2, …, n. The level of activity, which may also be thought of as an action, in task i will be denoted by xi. It will prove convenient to denote the vector of actions by $$x=(x 1, \ldots, x n)$$. We suppose the agent bears a cost c (x) of undertaking the vector of actions x. We make four assumptions on c:
1. c is increasing in each xi.
2. c has a continuous second derivative.
3. c is strictly convex.
4. c is homogeneousHomogeneous functions were defined in Chapter 10. of degree r.
For example, if there are two tasks (n = 2), then all four of these assumptions are met by the cost function $$c(x 1, x 2)=x 12+x 22+1 / 2 \times 1 \times 2$$. This function is increasing in $$x_{1} \text { and } x_{2}$$, has continuous derivatives, is strictly convex (more about this below), and is homogeneous of degree 2.
It is assumed that c is increasing to identify the activities as costly. Continuity of derivatives is used for convenience. Convexity of c will ensure that a solution to the first-order conditions is actually an optimum for the employee. Formally, a function is a convex function such that, for any vectors xy and scalar α between zero and one
$(0 \leq a \leq 1), a c(x)+(1-a) c(y) \geq c(a x+(1-a) y)$
In other words, a convex function is any function that lies below the straight line segment connecting two points on the function, for any two points in the interval, when x is a scalor.
One way of interpreting this requirement is that it is less costly to do the average of two things than the average of the costs of the things. Intuitively, convexity requires that doing a medium thing is less costly than the average of two extremes. This is plausible when extremes tend to be very costly. It also means the set of vectors that cost less than a fixed amount, {x | c(x) ≤ b}, is a convex set. Thus, if two points cost less than a given budget, the line segment connecting them does, too. Convexity of the cost function ensures that the agent’s optimization problem is concave and thus that the first-order conditions describe a maximum. When the inequality is strict for α satisfying 0 < α < 1, we refer to convexity as strict convexity.
The assumption of homogeneity dictates that scale works in a particularly simple manner. Scaling up activities increases costs at a fixed rate r. Homogeneity has very strong implications that are probably unreasonable in many settings. Nevertheless, homogeneity leads to an elegant and useful theory, as we shall see. Recall the definition of a homogeneous function: c is homogeneous of degree r means that for any $$\lambda>0, c(\lambda x)=\lambda r c(x)$$.
Claim: Strict convexity implies that $$r>1$$.
Proof of Claim: Fix any x and consider the two points x and λ x. By convexity, for
$0<\mathrm{a}<1,(\mathrm{a}+(1-\mathrm{a}) \lambda \mathrm{r}) \mathrm{c}(\mathrm{x})=\mathrm{ac}(\mathrm{x})+(1-\mathrm{a}) \mathrm{c}(\lambda \mathrm{x})>\mathrm{c}(\mathrm{ax}+(1-\mathrm{a}) \lambda \mathrm{x}))=(\mathrm{a}+(1-\mathrm{a}) \lambda) \mathrm{r} \mathrm{c}(\mathrm{x})$
which implies $$(a+(1-a) \lambda r)>(a+(1-a) \lambda) r$$.
Define a function k that is the left-hand side minus the right-hand side:
$$\mathrm{k}(\mathrm{a})=\mathrm{a}+(1-\mathrm{a}) \lambda \mathrm{r}-(\mathrm{a}+(1-\mathrm{a}) \lambda) \mathrm{r}$$. Note that $$\mathrm{k}(0)=\mathrm{k}(1)=0$$. Moreover, $$k^{\prime \prime}(a)=-r(r-1)(a+(1-a) \lambda) r-2(1-\lambda) 2$$. It is readily checked that if a convex function of one variable is twice differentiable, then the second derivative is greater than zero. If
$$r \leq 1, k^{\prime \prime}(a) \geq 0$$, implying that k is convex, and hence, if $$0<a<1, k(a)=k((1-a) 0+a 1) \leq(1-a) k(0)+a k(1)=0$$.
Similarly, if r > 1, k is concave and k(α) > 0. This completes the proof, showing that r ≤ 1 is not compatible with the strict convexity of c.
How should our person behave? Consider linear incentives, which are also known as piece rates. With piece rates, the employee gets a payment pi for each unit of xi produced. The person then chooses x to maximize $$u=\sum i=1 n p i x i-c(x)=p \cdot x-c(x)$$.
Here • is the dot product, which is the sum of the products of the components.
The agent chooses x to maximize u, resulting in n first-order conditions $$\partial u \partial x i=p i-\partial c(x) \partial x i=p i-c i(x)$$, where ci is the partial derivative of c with respect to the ith argument xi. This first-order condition can be expressed more compactly as $$0=p-c^{\prime}(x)$$ where c ′ (x) is the vector of partial derivatives of c. Convexity of c ensures that any solution to this problem is a global utility maximum because the function u is concave, and strict convexity ensures that there is at most one solution to the first-order conditions.This description is slightly inadequate because we haven’t considered boundary conditions. Often a requirement like xi ≥ 0 is also needed. In this case, the first-order conditions may not hold with equality for those choices where xi = 0 is optimal.
One very useful implication of homogeneity is that incentives scale. Homogeneity has the effect of turning a very complicated optimization problem into a problem that is readily solved, thanks to this very scaling.
Claim: If all incentives rise by a scalar factor α, then x rises by α 1 r−1 .
Proof of Claim: Note that differentiating $$c(\lambda x)=\lambda r c(x)$$ with respect to xi yields $$$c^{\prime}(\lambda x)=\lambda r-1 c^{\prime}(x)$$$, and thus $$$c^{\prime}(\lambda x)=\lambda r-1 c^{\prime}(x)$$$. That is, if c is homogeneous of degree r, c ′ is homogeneous of degree r – 1. Consequently, if $$0=p-c^{\prime}(x), 0=a p-c^{\prime}(a 1 r-1 x)$$. Thus, if the incentives are scaled up by α, the efforts rise by the scalar factor α 1 r−1 .
Now consider an employer with an agent engaging in n activities. The employer values the ith activity at vi and thus wishes to maximize $$π= ∑ i=1 n ( v i − p i ) x i = ∑ i=1 n ( v i − c i (x)) x i$$.
This equation embodies a standard trick in agency theory. Think of the principal (employer) not as choosing the incentives p, but instead as choosing the effort levels x, with the incentives as a constraint. That is, the principal can be thought of as choosing x and then choosing the p that implements this x. The principal’s expected profit is readily differentiated with respect to each xj, yielding $$0= v j − c j (x)− ∑ i=1 n c ij (x)) x i$$.
However, because cj(x) is homogeneous of degree r – 1,
$∑ i=1 n c ij (x)) x i = d dλ c j (λx) | λ=1 = d dλ λ r−1 c j (x) | λ=1 =(r−1) c j (x),$
and thus
$$0=v j-c j(x)-\Sigma i=1 n c \text { ij }(x)) \times i=v j-r c j(x)$$
This expression proves the main result of this section. Under the maintained hypotheses (convexity and homogeneity), an employer of a multitasking agent uses incentives that are a constant proportion of value; that is, $$p j=v j r$$, where r is the degree of homogeneity of the agent’s costs. Recalling that r > 1, the principal uses a sharing rule, sharing a fixed proportion of value with the agent.
When agents have a homogeneous cost function, the principal has a very simple optimal incentive scheme, requiring quite limited knowledge of the agent’s cost function (just the degree of homogeneity). Moreover, the incentive scheme works through a somewhat surprising mechanism. Note that if the value of one activity, for example, Activity 1, rises, p1 rises and all the other payment rates stay constant. The agent responds by increasing x1, but the other activities may rise or fall depending on how complementary they are to Activity 1. Overall, the agent’s substitution across activities given the new incentive level on Activity 1 implements the desired effort levels on other activities. The remarkable implication of homogeneity is that, although the principal desires different effort levels for all activities, only the incentive on Activity 1 must change.
Key Takeaways
• Multi-tasking refers to performing several activities simultaneously.
• In the agency context, multitasking refers to the incentives of a principal to compensate different tasks.
• A simple model of multitasking provides a convex cost of a set of tasks that is homogeneous of degree r in the tasks. This means that scaling up activities increases costs at a fixed rate r.
• With piece rates, the employee gets a fixed payment for each unit produced.
• One very useful implication of homogeneity is that incentives scale. If all incentives rise by a scalar factor α, then x rises by α 1 r−1 , where r is the degree of homogeneity.
• Given convexity and homogeneity, an employer of a multitasking agent uses incentives that are a constant proportion of value; that is, $$p j=v j r$$. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/19%3A_Agency_Theory/19.03%3A_Multi-tasking_without_Homogeneity.txt |
Learning Objectives
• When will the incentives for performing tasks be related to each other, and how are they related?
In the previous section we saw, for example, that if the agent has quadratic costs, the principal pays the agent half the value of each activity. Moreover, the more rapidly costs rise in scale, the lower are the payments to the agent.
This remarkable theorem has several limitations. The requirement of homogeneity is itself an important limitation, although this assumption is reasonable in some settings. More serious is the assumption that all of the incentives are set optimally for the employer. Suppose, instead, that one of the incentives is set too high, at least from the employer’s perspective. This might arise if, for example, the agent acquired all the benefits of one of the activities. An increase in the power of one incentive will then tend to spill over to the other actions, increasing for complements and decreasing for substitutes. When the efforts are substitutes, an increase in the power of one incentive causes others to optimally rise, to compensate for the reduced supply of efforts of that type.Multi-tasking (and agency theory more generally) is a rich theory with many implications not discussed here. For a challenging and important analysis, see Bengt Holmstrom and Paul Milgrom, “The Firm as an Incentive System,” American Economic Review 84, no. 4 (September 1994): 972–991.
We can illustrate the effects of cost functions that aren’t homogeneous in a relatively straightforward way. Suppose the cost depends on the sum of the squared activity levels:
$c(x)=g( ∑ i=1 n x i 2 )=g(x•x) .$
This is a situation where vector notation (dot-products) dramatically simplifies the expressions. You may find it useful to work through the notation on a separate sheet, or in the margin, using summation notation to verify each step. At the moment, we won’t be concerned with the exact specification of g, but instead we will use the first-order conditions to characterize the solution.
The agent maximizes
$u=p \cdot x-g(x \cdot x)$
This gives a first-order condition
$0=p-2 q^{\prime}(x \cdot x) x$
It turns out that a sufficient condition for this equation to characterize the agent’s utility maximization is that g is both increasing and convex (increasing second derivative).
This is a particularly simple expression because the vector of efforts, x, points in the same direction as the incentive payments p. The scalar that gives the overall effort levels, however, is not necessarily a constant, as occurs with homogeneous cost functions. Indeed, we can readily see that xx is the solution to p•p= (2 g ′ (x•x)) 2 (x•x).
Because xx is a number, it is worth introducing notation for it: S = xx. Then S is the solution to $$p \cdot p=4 S\left(g^{\prime}(S)\right) 2$$.
The principal or employer chooses p to maximize $$π=v•x−p•x=v•x−2 g ′ (x•x)(x•x).$$
This gives the first-order condition $$0=v−4( g ′ (x•x)+(x•x) g ″ (x•x) )x.$$
Thus, the principal’s choice of p is such that x is proportional to v, with constant of proportionality $$g^{\prime}(x \cdot x)+x \cdot x g^{\prime \prime}(x \cdot x)$$. Using the same trick (dotting each side of the first-order condition $$v=4( g ′ (x•x)+x•x g ″ (x•x) )x$$ with itself), we obtain
$v \cdot v=16\left(g^{\prime}\left(S^{*}\right)+S^{*} g^{\prime \prime}\left(S^{*}\right)\right) 2 S^{*}$
which gives the level of $$x \cdot x=S^{*}$$ induced by the principal. Given S*, p is given by $$-p=2 g^{\prime}(x \cdot x) x=2 g^{\prime}\left(S^{*}\right) \vee 4\left(g^{\prime}\left(S^{*}\right)+S^{*} g^{\prime \prime}\left(S^{*}\right)\right)=12\left(11+S^{*} g^{\prime \prime}\left(S^{*}\right) g^{\prime}\left(S^{*}\right)\right) v$$
Note that this expression gives the right answer when costs are homogeneous. In this case, g (S ) must be in the form S r/2, and the formula gives
$$p= 1 2 ( 1 1+r−1 )v= v r$$ as we already established.
The natural assumption to impose on the function g is that $$\left(g^{\prime}(S)+S g^{\prime \prime}(S)\right) 2 S$$ is an increasing function of S. This assumption implies that as the value of effort rises, the total effort also rises.
Suppose S g ″ (S) g ′ (S) is increasing in S. Then an increase in vi increases S, decreasing pj for j ≠ i. That is, when one item becomes more valuable, the incentives for performing the others are reduced. Moreover, because $$p \cdot p=4 S\left(g^{\prime}(S)\right) 2$$, an increase in S only occurs if pp increases.
These equations together imply that an increase in any one vi increases the total effort (as measured by $$S^{*}=\mathbf{x} \cdot \mathbf{x}$)$, increases the total incentives as measured by pp, and decreases the incentives for performing all activities other than activity i. In contrast, if $$\mathrm{Sg}^{\prime \prime}(S) \mathrm{g}^{\prime}(\mathrm{S})$$ is a decreasing function of S, then an increase in any one vi causes all the incentives to rise. Intuitively, the increase in vi directly causes pi to rise because xi is more valuable. This causes the agent to substitute toward activity i. This causes the relative cost of total activity to fall (because $$\mathrm{Sg}^{\prime \prime}(\mathrm{S}) \mathrm{g}^{\prime}(\mathrm{S})$$ decreases), which induces a desire to increase the other activity levels. This is accomplished by an increase in the incentives for performing the other activities.
This conclusion generalizes readily and powerfully. Suppose that $$c(x)=g(h(x))$$, where h is homogeneous of degree r and g is increasing. In the case just considered, $$h(x)=x \cdot x$$. Then the same conclusion, that the sign of d p i d v j is determined by the derivative of $$\mathrm{Sg}^{\prime \prime}(S) \mathrm{g}^{\prime}(\mathrm{S})$$, holds. In the generalization, S now stands for h(x).
KEY TAKEAWAY
• In general, incentives can be substitutes or complements; that is, an increase in the importance of one activity may increase or decrease the incentives provided for performing the other activities. Homogeneity is the condition that causes such interactions to be zero. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/19%3A_Agency_Theory/19.04%3A_Multi-tasking_without_Homogeneity.txt |
Learning Objectives
• What is the most common auction form?
• How should I bid in an auction if I know my own value?
• When we share a value that none of us know, should I bid my estimate of value?
An English auction is the common auction form used for selling antiques, art, used cars, and cattle. The auctioneer starts low and calls out prices until no bidder is willing to bid higher than the current high price. The most common procedure is for a low price to be called out and a bidder to accept it. A higher price is called out, and a different bidder accepts it. When several accept simultaneously, the auctioneer accepts the first one spotted. This process continues until a price is called out that no one accepts. At that point, the auction ends, and the highest bidder wins.
Information plays a significant role in bidding in auctions. The two major extremes in information, which lead to distinct theories, are private values, which means bidders know their own value, and common values, in which bidders don’t know their own value but have some indication or signal about the value. In the private values situation, a bidder may be outbid by another bidder but doesn’t learn anything from another bidder’s willingness to pay. The case of private values arises when the good being sold has a quality apparent to all bidders, no hidden attributes, and no possibility of resale. In contrast, the case of common values arises when bidders don’t know the value of the item for sale, but that value is common to all. The quintessential example is an offshore oil lease. No one knows for sure how much oil can be extracted from an offshore lease, and companies have estimates of the amount of oil. The estimates are closely guarded because rivals could learn from them. Similarly, when antiques dealers bid on an antique, the value they place on it is primarily the resale value. Knowing rivals’ estimates of the resale value could influence the value each bidder placed on the item.
The private values environment is unrealistic in most settings because items for sale usually have some element of common value. However, some situations approximate the private values environment and these are the most easy to understand.
In a private values setting, a very simple bidding strategy is optimal for bidders: a bidder should keep bidding until the price exceeds the value a bidder places on it, at which point the bidder should stop. That is, bidders should drop out of the bidding when the price exceeds their value because at that point, winning the auction requires the bidder to take a loss. Every bidder should be willing to continue to bid to prevent someone else from winning the auction provided the price is less than the bidder’s value. If you have a value v and another bidder is about to win at a price pa < v, you might as well accept a price pb between the two, pa < pb < v because a purchase at this price would provide you with a profit. This strategy is a dominant strategy for each private values bidder because no matter what strategy the other bidders adopt, bidding up to value is the strategy that maximizes the profit for each bidder.
The presence of a dominant strategy makes it easy to bid in the private values environment. In addition, it simplifies the analysis of the English auction relatively simple.
Most auctioneers use a flexible system of bid increments. A bid increment is the difference between successive price requests. The theory is simplest when the bid increment, denoted by δ, is very small. In this case, the bidder with the highest value wins, and the price is no more than the second-highest value, but it is at least the second-highest value minus δ, because a lower price would induce the bidder with the second-highest value to submit a slightly higher bid. If we denote the second-highest value with the somewhat obscure (but standard) notation v(2), the final price p satisfies $$v (2) −Δ≤p≤ v (2)$$.
As the bid increment gets small, the price is nailed down. The conclusion is that, when bid increments are small and bidders have private values, the bidder with the highest value wins the bidding at a price equal to the second-highest value. The notation for the highest value is v(1), and thus the seller obtains v(2), and the winning bidder obtains profits of $$V_{(1)}-V_{(2)}$$.
Key Takeaways
• An auction is a trading mechanism where the highest bidder wins an object. Auctions are typically used when values are uncertain, and thus information is an important aspect of analyzing auctions.
• Private values mean bidders know their own value.
• Common values mean bidders share a common but unknown value, and they have some indication or signal about the value. With common values, willingness to pay by one bidder is informative for other bidders.
• In an English auction, the auctioneer starts low and calls out prices until no bidder is willing to bid higher than the current high price. At that point the auction ends, and the highest bidder wins.
• In a private values setting, the English auction has a dominant strategy: remain bidding until one’s value is reached.
• When bid increments are small and bidders have private values, the bidder with the highest value wins the bidding at a price equal to the second-highest value. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.01%3A_English_Auction.txt |
Learning Objectives
• How should I bid if I don’t get to see the bids of others?
In a sealed-bid auction, each bidder submits a bid in an envelope. These are opened simultaneously, and the highest bidder wins the item and pays his or her bid. Sealed-bid auctions are used to sell offshore oil leases, and they are used by governments to purchase a wide variety of items. In a purchase situation, known often as a tender, the lowest bidder wins the amount he bids.
The analysis of the sealed-bid auction is more challenging because the bidders don’t have a dominant strategy. Indeed, the best bid depends on what the other bidders are bidding. The bidder with the highest value would like to bid a penny more than the next highest bidder’s bid, whatever that might be.
To pursue an analysis of the sealed-bid auction, we are going to make a variety of simplifying assumptions. These assumptions aren’t necessary to the analysis, but we make them to simplify the mathematical presentation.
We suppose there are n bidders, and we label the bidders 1, …, n. Bidder i has a private value vi, which is a draw from the uniform distribution on the interval [0,1]. That is, if $$0 \leq a \leq b \leq 1$$, the probability that bidder i’s value is in the interval $$[a, b] \text { is } b-a$$. An important attribute of this assumption is symmetry—the bidders all have the same distribution. In addition, the formulation has assumed independence—the value one bidder places on the object for sale is statistically independent from the value placed by others. Each bidder knows his own value but he doesn’t know the other bidders’ values. Each bidder is assumed to bid in such a way as to maximize his expected profit (we will look for a Nash equilibrium of the bidding game). Bidders are permitted to submit any bid equal to or greater than zero.
To find an equilibrium, it is helpful to restrict attention to linear strategies, in which a bidder bids a proportion of her value. Thus, we suppose that each bidder bids λv when her value is v and λ is a positive constant, usually between zero and one. With this set up we shall examine under what conditions these strategies comprise a Nash equilibrium. An equilibrium exists when all other bidders bid λv when their value is v, and the remaining bidders bid the same.
So fix a bidder and suppose that bidder’s value is vi. What bid should the bidder choose? A bid of b wins the bidding if all other bidders bid less than b. Because the other bidders, by hypothesis, bid λv when their value is v, our bidder wins when b≥λ v j for each other bidder j. This occurs when b λ ≥ v j for each other bidder j, and this in turn occurs with probability b λ . If b>λ, then in fact the probability is 1. You can show that no bidder would ever bid more than λ. Thus, our bidder with value vi who bids b wins with probability ( b λ ) n−1 because the bidder must beat all n −1 other bidders. That creates expected profits for the bidder of $$n=(v i-b)(b \lambda) n-1$$.
The bidder chooses b to maximize expected profits. The first-order condition requires $$0=-(b \lambda) n-1+(v i-b)(n-1) b n-2 \lambda n-1$$.
The first-order condition solves for $$b=n-1 n v$$.
But this is a linear rule. Thus, if $$\lambda=n-1 n$$, we have a Nash equilibrium.
The nature of this equilibrium is that each bidder bids a fraction λ= n−1 n of his value, and the highest-value bidder wins at a price equal to that fraction of her value.
In some cases, the sealed-bid auction produces regret. Regret means that a bidder wishes she had bid differently. Recall our notation for values: v(1) is the highest value and v(2) is the second-highest value. Because the price in a sealed-bid auction is $$n-1 n \vee(1)$$, the second-highest bidder will regret her bid when $v(2)>$n-1 n \vee(1)$$. In this case, the bidder with the second-highest value could have bid higher and won, if the bidder had known the winning bidder’s bid. In contrast, the English auction is regret-free: the price rises to the point that the bidder with the second-highest value won’t pay.
How do the two auctions compare in prices? It turns out that statistical independence of private values implies revenue equivalence, which means the two auctions produce the same prices on average. Given the highest value v(1), the second-highest value has distribution $$(v(2) \vee(1)) n-1$$ because this is the probability that all n − 1 other bidders have values less than v(2). But this gives an expected value of $$v_{(2)} \text { of } \mathrm{E} v(2)=\int 0 \vee(1) \vee(2)(n-1) v(2) n-2 v(1) n-1 \text { d } v(2)=n-1 \text { n } v(1)$$.
Thus, the average price paid in the sealed-bid auction is the same as the average price in the English auction.
Key Takeaways
• In a sealed-bid auction, bids are opened simultaneously, and the highest bidder wins the item and pays his bid.
• The analysis of the sealed-bid auction is more challenging because the bidders don’t have a dominant strategy.
• When bidders have uniformly and independently distributed values, there is an equilibrium where they bid a constant fraction of value, n−1 n where n is the number of bidders.
• Statistical independence of private values implies revenue equivalence, which means English and sealed-bid auctions produce the same prices on average. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.02%3A_Sealed-bid_Auction.txt |
Learning Objectives
• Don’t the Dutch use a different kind of auction to sell tulips?
• How does the Dutch auction work?
The Dutch auction is like an English auction, except that prices start high and are successively dropped until a bidder accepts the going price, and the auction ends. The Dutch auction is so-named because it is used to sell cut flowers in Holland, in the enormous flower auctions.
A strategy in a Dutch auction is a price at which the bidder bids. Each bidder watches the price decline, until it reaches such a point that either the bidder bids or a rival bids, and the auction ends. Note that a bidder could revise his bid in the course of the auction, but there isn’t any reason to do so. For example, suppose the price starts at \$1,000, and a bidder decides to bid when the price reaches \$400. Once the price gets to \$450, the bidder could decide to revise and wait until \$350. However, no new information has become available and there is no reason to revise. In order for the price to reach the original planned bid of \$400, it had to reach \$450, meaning that no one bid prior to a price of \$450. In order for a bid of \$400 to win, the price had to reach \$450; if the price reaching \$450 means that a bid of \$350 is optimal, then the original bid of \$400 could not have been optimal.Of course, a bidder who thinks losing is likely may wait for a lower price to formulate the bid, a consideration ignored here. In addition, because the Dutch auction unfolds over time, bidders who discount the future will bid slightly higher in a Dutch auction as a way of speeding it along, another small effect that is ignored for simplicity.
What is interesting about the Dutch auction is that it has exactly the same possible strategies and outcomes as the sealed-bid auction. In both cases, a strategy for a bidder is a bid, no bidder sees the others’ bids until after her own bid is formulated, and the winning bidder is the one with the highest bid. This is called strategic equivalence. Both games—the Dutch auction and the sealed-bid auction—offer identical strategies to the bidders and, given the strategies chosen by all bidders, produce the same payoff. Such games should produce the same outcomes.
The strategic equivalence of the Dutch auction and the sealed-bid auction is a very general result that doesn’t depend on the nature of the values of the bidders (private vs. common) or the distribution of information (independent vs. correlated). Indeed, the prediction that the two games should produce the same outcome doesn’t even depend on risk aversion, although that is more challenging to demonstrate.
Key Takeaways
• The Dutch auction is like an English auction, except that prices start high and are successively dropped until a bidder accepts the going price, at which point the auction ends.
• The Dutch auction is so-named because it is used to sell cut flowers in Holland.
• The Dutch auction has exactly the same possible strategies and outcomes as the sealed-bid auction. This is called strategic equivalence. As a result, the Dutch and sealed-bid auctions have the same equilibria. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.03%3A_Dutch_Auction.txt |
Learning Objectives
• How should I bid in the auction used by eBay, assuming I don’t want to “buy it now.”
The strategic equivalence of the Dutch and sealed-bid auction suggests another fact: there may be more than one way of implementing a given kind of auction. Such logic led Nobel laureate William Vickrey (1914–1996) to design what has become known as the Vickrey auction, which is a second-price, sealed-bid auction. This auction is most familiar because it is the foundation of eBay’s auction design. The Vickrey auction is a sealed-bid auction, but with a twist: the high bidder wins but pays the second-highest bid. This is why the Vickrey auction is called a second-price auction: the price is not the highest bid, but the second-highest bid.
The Vickrey auction underlies the eBay outcome because when a bidder submits a bid in the eBay auction, the current “going” price is not the highest bid, but the second-highest bid plus a bid increment. Thus, up to the granularity of the bid increment, the basic eBay auction is a Vickrey auction run over time.
As in the English auction, bidders with private values in a Vickrey auction have a dominant strategy. Fix a bidder, with value v, and let p be the highest bid of the other bidders. If the bidder bids b, the bidder earns profits of { 0 if b<p v−p if b>p }.
It is profitable for the bidder to win if v > p and to lose if v < p. To win when v > p and to lose if v < p can be assured by bidding v. Essentially, there is no gain to bidding less than your value because your bid doesn’t affect the price, only the likelihood of winning. Bidding less than value causes the bidder to lose when the highest rival bid falls between the bid and the value, which is a circumstance that the bidder would like to win. Similarly, bidding more than value creates a chance of winning only when the price is higher than the bidder’s value, in which case the bidder would prefer to lose.
Thus, bidders in a Vickrey auction have a dominant strategy to bid their value. This produces the same outcome as in the English auction, however, because the payment made is the second-highest value, which was the price in the English auction. Thus, the Vickrey auction is a sealed-bid implementation of the English auction when bidders have private values, producing the same outcome, which is that the highest-value bidder wins but pays the second-highest value.
Because the Vickrey auction induces bidders to bid their value, it is said to be demand revealing. Unlike the English auction, in which the bidding stops when the price reaches the second-highest value and thus doesn’t reveal the highest value, the Vickrey auction reveals the highest value. In a controlled, laboratory setting, demand revelation is useful, especially when the goal is to identify buyer values. Despite its theoretical niceties, the Vickrey auction can be politically disastrous. Indeed, New Zealand sold radio spectrum with the Vickrey auction on the basis of advice by a naïve economist, and the Vickrey auction created a political nightmare when a nationwide cellular license received a high bid of \$110 million and a second-highest bid of \$11 million. The political problem was that the demand revelation showed that the government received only about 10% of the value of the license, making the public quite irate. The situation dominated news coverage at the time.The Vickrey auction generally produces higher prices than regular sealed-bid auctions if bidders are symmetric (that is, share the same distribution of values), but it is a poor choice of auction format when bidders are not symmetric. Because the incumbent telephone company was expected to have a higher value than others, the Vickrey auction was a poor choice for that reason as well. Some smaller licenses sold for tenths of 1% of the highest bid.
In a private values setting, the Vickrey auction and the English auction are much easier on bidders than a regular sealed-bid auction because of the dominant strategy. The sealed-bid auction requires bidders to forecast their rivals’ likely bids and produces the risks of either bidding more than necessary or losing the bidding. Thus, the regular sealed-bid auction has undesirable properties. Moreover, bidders in the sealed-bid auction have an incentive to bribe the auctioneer to reveal the best bid by rivals because that is useful information in formulating a bid. Such (illegal) bribery occurs from time to time in government contracting.
On the other hand, the regular sealed-bid auction has an advantage over the other two because it makes price fixing more difficult. A bidder can cheat on a conspiracy and not be detected until after the current auction is complete.
Another disadvantage of the sealed-bid auction is that it is easier to make certain kinds of bidding errors. In the U.S. PCS auctions, in which rights to use the radio spectrum for cellular phones was sold for around \$20 billion, one bidder, intending to bid \$200,000, inadvertently bid \$200,000,000. Such an error isn’t possible in an English auction because prices rise at a measured pace. And such an error has little consequence in a Vickrey auction because getting the price wrong by an order of magnitude requires two bidders to make such errors.
Key Takeaways
• There can be more than one way of implementing a given kind of auction.
• The Vickrey auction is a sealed-bid auction where the high bidder wins but pays the second-highest bid. The Vickrey auction is also called a second-price auction: the price is not the highest bid but the second-highest bid.
• The Vickrey auction underlies eBay because when a bidder submits a bid in the eBay auction, the current “going” price is not the highest bid, but the second-highest bid plus a bid increment. Thus, up to the granularity of the bid increment, the basic eBay auction is a Vickrey auction run over time.
• In the private values setting, bidders in a Vickrey auction have a dominant strategy to bid their value. The Vickrey auction is revenue equivalent to the other three auctions.
• Because the Vickrey auction induces bidders to bid their value, it is said to be demand revealing. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.04%3A_Vickrey_Auction.txt |
Learning Objectives
• How do I interpret the bids of others when other bidders may have relevant information about the value of the good?
I paid too much for it, but it's worth it.
-Sam Goldwyn
The analysis so far has been conducted under the restrictive assumption of private values. In most contexts, bidders are not sure of the actual value of the item being sold, and information held by others is relevant to the valuation of the item. If I estimate an antique to be worth $5,000, but no one else is willing to bid more than$1,000, I might revise my estimate of the value down. This revision leads bidders to learn from the auction itself what the item is worth.
The early bidders in the sale of oil lease rights in the Gulf of Mexico (the outer continental shelf) were often observed to pay more than the rights were worth. This phenomenon came to be known as the winner’s curse. The winner’s curse is the fact that the bidder who most overestimates the value of the object wins the bidding.
Naïve bidders who don’t adjust for the winner’s curse tend to lose money because they win the bidding only when they’ve bid too high.
Figure 20.1 Normally Distributed Estimates
A savvy bidder corrects for the winner’s curse. Such a correction is actually quite straightforward when a few facts are available, and here a simplified presentation is given. Suppose there are n bidders for a common value good, and the bidders receive normally distributed estimates that are correct on average. Let σ be the standard deviation of the estimates.The standard deviation is a measure of the dispersion of the distribution and is the square root of the average of the square of the difference of the random value and its mean. The estimates are also assumed to be independently distributed around the true value. Note that estimating the mean adds an additional layer of complexity. Finally, suppose that no prior information is given about the likely value of the good.
In this case, it is a straightforward matter to compute a correction for the winner’s curse. Because the winning bidder will generally be the bidder with the highest estimate of value, the winner’s curse correction should be the expected amount by which the highest value exceeds the average value. This can be looked up in a table for the normal distribution. The values are given for selected numbers n in Table 20.1. This table shows, as a function of the number of bidders, how much each bidder should reduce his estimate of value to correct for the fact that auctions select optimistic bidders. The units are standard deviations.
Table 20.1 Winner’s Curse Correction
n 1 2 3 4 5 10 15
WCC (σ) 0 .56 .85 1.03 1.16 1.54 1.74
n 20 25 50 100 500 1000 10,000
WCC (σ) 1.87 1.97 2.25 2.51 3.04 3.24 3.85
For example, with one bidder, there is no correction because it was supposed that the estimates are right on average. With two bidders, the winner’s curse correction is the amount that the higher of two will be above the mean, which turns out to be 0.56σ, a little more than half a standard deviation. This is the amount that should be subtracted from the estimate to ensure that, when the bidder wins, the estimated value is correct, on average. With four bidders, the highest is a bit over a whole standard deviation. As is apparent from the table, the winner’s curse correction increases relatively slowly after 10 or 15 bidders. With a million bidders, it is 4.86σ.
The standard deviation σ measures how much randomness or noise there is in the estimates. It is a measure of the average difference between the true value and the estimated value, and thus the average level of error. Oil companies know from their history of estimation how much error arises in the company estimates. Thus, they can correct their estimates to account for the winner’s curse using their historical inaccuracies.
Bidders who are imperfectly informed about the value of an item for sale are subject to losses arising from the way auctions select the winning bidder. The winning bidder is usually the bidder with the highest estimate, and that estimate is too high on average. The difference between the highest estimate and the average estimate is known as the winner’s curse correction. The size of the winner’s curse correction is larger the more bidders there are, but it tends to grow slowly beyond a dozen or so bidders.
If the bidders have the same information on a common value item, they will generally not earn profits on it. Indeed, there is a general principle that it is the privacy of information, rather than the accuracy of information, that leads to profits. Bidders earn profits on the information that they hold that is not available to others. Information held by others will be built into the bid price and therefore not lead to profits.
The U.S. Department of the Interior, when selling offshore oil leases, not only takes an up-front payment (the winning bid) but also takes one-sixth of the oil that is eventually pumped. Such a royalty scheme links the payment made to the outcome and, in a way, shares risk because the payment is higher when there is more oil. Similarly, a book contract provides an author with an upfront payment and a royalty. Many U.S. Department of Defense (DOD) purchases of major weapons systems involve cost-sharing, where the payments made pick up a portion of the cost. Purchases of ships, for example, generally involve 50%–70% cost sharing, which means the DOD pays a portion of cost overruns. The contract for U.S. television broadcast rights for the Summer Olympics in Seoul, South Korea, involved payments that depended on the size of the U.S. audience.
Royalties, cost-sharing, and contingent payments generally link the actual payment to the actual value, which is unknown at the time of the auction. Linkage shares risk, but linkage does something else, too. Linkage reduces the importance of estimates in the auction, replacing the estimates with actual values. That is, the price a bidder pays for an object, when fully linked to the true value, is just the true value. Thus, linkage reduces the importance of estimation in the auction by taking the price out of the bidder’s hands, at least partially.
The linkage principleThe linkage principle, and much of modern auction theory, was developed by Paul Milgrom (1948–). states that in auctions where bidders are buyers, the expected price rises the more the price is linked to the actual value. (In a parallel fashion, the expected price in an auction where bidders are selling falls.) Thus, linking price to value generally improves the performance of auctions. While this is a mathematically deep result, an extreme case is straightforward to understand. Suppose the government is purchasing by auction a contract for delivery of 10,000 gallons of gasoline each week for the next year. Suppliers face risk in the form of gasoline prices; if the government buys at a fixed price, the suppliers’ bids will build in a cushion to compensate for the risk and for the winner’s curse. In addition, because their estimates of future oil prices will generally vary, they will earn profits based on their private information about the value. In contrast, if the government buys only delivery and then pays for the cost of the gasoline, whatever it might be, any profits that the bidders earned based on their ability to estimate gasoline prices evaporate. The overall profit level of bidders falls, and the overall cost of the gasoline supply can fall. Of course, paying the cost of the gasoline reduces the incentive of the supplier to shop around for the best price, and that agency incentive effect must be balanced against the reduction in bidder profits from the auction to select a supplier.
Key Takeaways
• Auctions, by their nature, select optimistic bidders. This phenomenon—that auctions tend to select the bidder with the highest estimate, and the highest estimate is larger than the true value most of the time—is known as the winner’s curse.
• A savvy bidder corrects for the winner’s curse.
• The size of the winner’s curse correction is larger the more bidders there are, but it tends to grow slowly beyond a dozen or so bidders.
• There is a general principle that it is the privacy of information, rather than the accuracy of information, that leads to profits. Information held by others will be built into the bid price and therefore not lead to profits.
• The linkage principle states that in auctions where bidders are buyers, the expected price rises the more the price is linked to the actual value. Examples of linkage include English and Vickrey auctions, which link the price to the second bidder’s information, and the use of royalties or cost shares. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.05%3A_The_Winners_Curse_and_Linkage.txt |
Learning Objectives
• What kind of auction should I hold to sell something?
• Should I impose a minimum bid?
• Should I use an open- or sealed-bid auction?
We saw in Section 20.5 that the English auction tends to reduce regret relative to sealed-bid auctions and that the linkage principle suggests tying payments to value where possible. These are examples of auction design, in which auctions are designed to satisfy objectives of the auction designer. Proper auction design should match the rules of the auction to the circumstances of the bidders and the goal of the seller. Some of the principles of auction design include:
• Impose an appropriate reserve price or minimum bid
• Use ascending price (English) auctions rather than sealed-bid auctions
• Reveal information about the value of the item
• Conceal information about the extent of competition
• Handicap bidders with a known advantage
However, many of these principles change if the seller is facing a cartel. For example, it is easier for bidders to collude in a sealed-bid auction than in an English auction, and reserve prices should be made relatively high.
Reserve prices (minimum bids) have several effects. They tend to force marginal bidders to bid a bit higher, which increases the bids of all bidders and thus reduces bidder profits. However, reserve prices also lead to a failure to sell on occasion, and the optimal reserve trades off this failure to sell against the higher prices. In addition, reserve prices may reduce the incentive of bidders to investigate the sale, thus reducing participation, which is an additional negative consideration for a high reserve price.
Ascending price auctions like the English auction have several advantages. Such auctions reduce the complexity of the bidder’s problem because bidders can stretch their calculations out over time and because bidders can react to the behavior of others and not plan for every contingency in advance. In addition, because bidders in an English auction can see the behavior of others, there is a linkage created—the price paid by the winning bidder is influenced not just by that bidder’s information but also by the information held by others, tending to drive up the price, which is an advantage for the seller.
One caveat to the selection of the English auction is that risk aversion doesn’t affect the outcome in the private values case. In contrast, in a sealed-bid auction, risk aversion works to the advantage of the seller because bidders bid a little bit higher than they would have otherwise to reduce the risk of losing. Thus, in the private values case, risk-averse bidders will bid higher in the sealed-bid auction than in the English auction.
When considering the revelation of information, there is always an issue of lying and misleading. In the long run, lying and misleading are found out, and thus the standard approach is to ignore the possibility of lying. Making misleading statements is, in the long run, the same thing as silence because those who repeatedly lie or mislead are eventually discovered and then not believed. Thus, in the long run, a repeat seller has a choice of being truthful or silent. Because of the linkage principle, the policy of revealing truthful information about the value of the good for sale dominates the policy of concealing information because the revelation of information links the payment to the actual outcome.
In contrast, revealing information about the extent of competition may not increase the prices. Consider the case where occasionally there are three bidders, or the case where this is only one. If the extent of competition is concealed, bidders will bid without knowing the extent of competition. If the bidders are risk neutral, it turns out that the revelation doesn’t matter and the outcomes are the same on average. If, in contrast, bidders are risk averse, the concealment of information tends to increase the bid prices because the risk created by the uncertainty about the extent of competition works to the advantage of the seller. Of course, it may be difficult to conceal the extent of competition in the English auction, suggesting that a sealed-bid auction should be used instead.
Bidders with a large, known advantage have several deleterious effects. For example, incumbent telephone companies generally are willing to pay more for spectrum in their areas than outsiders are. Bidders bidding at an advantage discourage the participation of others because the others are likely to lose. This can result in a bidder with an advantage facing no competition and picking up the good cheaply. Second, rivals don’t present much competition to the advantaged bidder, even if the rivals do participate. Consequently, when a bidder has a large advantage over rivals, it is advantageous to handicap the advantaged bidder, thus favoring the rivals. This handicapping encourages participation and levels the playing field, forcing the advantaged bidder to bid more competitively to win.
A common means of favoring disadvantaged bidders is by the use of bidder credits. For example, with a 20% bidder credit for disadvantaged bidders, a disadvantaged bidder has to pay only 80% of the face amount of the bid. This lets such a bidder bid 25% more (because a \$100 payment corresponds to a \$125 bid) than she would have otherwise, which makes the bidder a more formidable competitor. Generally, the ideal bidder credit is less than the actual advantage of the advantaged bidder.
Auction design is an exciting development in applied industrial organization, in which economic theory and experience is used to improve the performance of markets. The U.S. Federal Communications auctions of spectrum were the first major instance of auction design in an important practical setting, and the auction design was credited with increasing substantially the revenue raised by the government.
Key Takeaways
• Some of the principles of auction design include:
• Impose an appropriate reserve price or minimum bid
• Use ascending price (English) auctions rather than sealed-bid auctions
• Reveal information about the value of the item
• Conceal information about the extent of competition
• Handicap bidders with a known advantage
• The optimal reserve trades off this failure to sell against the higher prices when sales arise.
• Ascending price auctions create linkage and reduce the complexity of the bidder’s problem.
• Consistent revelation of accurate information about the value of a good increases average prices through linkage, relative to the policy of concealing information.
• Revealing information about the extent of competition may not increase the prices.
• When a bidder has a large advantage over rivals, it is advantageous to handicap the advantaged bidder, favoring the rivals. This handicapping encourages participation and levels the playing field, forcing the advantaged bidder to bid more competitively to win.
• A common means of favoring disadvantaged bidders is by the use of bidder credits.
• Auction design is used to improve the performance of markets and is becoming a field in its own right. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/20%3A_Auctions/20.06%3A_Auction_Design.txt |
Learning Objectives
• What is the first U.S. antitrust law?
• What is antitrust anyway?
In archaic language, a trust (which is now known as a cartel) was a group of firms acting in concert. The antitrust laws that made such trusts illegal were intended to protect competition. In the United States, these laws are enforced by the U.S. Department of Justice’s (DOJ) Antitrust Division and by the Federal Trade Commission (FTC). The United States began passing laws during a time when some European nations were actually passing laws forcing firms to join industry cartels. By and large, however, the rest of the world has since copied the U.S. antitrust laws in one form or another.
The Sherman Act, passed in 1890, was the first significant piece of antitrust legislation. It has two main requirements.
Section 1. Trusts, etc., in restraint of trade illegal; penalty
Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal. Every person who shall make any contract or engage in any combination or conspiracy hereby declared to be illegal shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding \$10,000,000 if a corporation, or, if any other person, \$350,000, or by imprisonment not exceeding 3 years, or by both said punishments, in the discretion of the court.
Section 2. Monopolizing trade a felony; penalty
Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding \$10,000,000 if a corporation, or, if any other person, \$350,000, or by imprisonment not exceeding 3 years, or by both said punishments, in the discretion of the court.The current fines were instituted in 1974; the original fines were \$5,000, with a maximum imprisonment of one year. The Sherman Act is 15 U.S.C. § 1.
The phrase in restraint of trade is challenging to interpret. Early enforcement of the Sherman Act followed the Peckham Rule, named for noted Justice Rufus Peckham, which interpreted the Sherman Act to prohibit contracts that reduced output or raised prices while permitting contracts that would increase output or lower prices. In one of the most famous antitrust cases ever, the United States sued Standard Oil, which had monopolized the transportation of oil from Pennsylvania to the East Coast cities of the United States in 1911.
The exact meaning of the Sherman Act had not been settled at the time of the Standard Oil case. Indeed, Supreme Court Justice Edward White suggested that, because contracts by their nature set the terms of trade and thus restrain trade to those terms, and Section 1 makes contracts restraining trade illegal, one could read the Sherman Act to imply that all contracts were illegal. Chief Justice White concluded that, because Congress couldn’t have intended to make all contracts illegal, the intent must have been to make unreasonable contracts illegal, and he therefore concluded that judicial discretion is necessary in applying the antitrust laws. In addition, Chief Justice White noted that the act makes monopolizing illegal, but doesn’t make having a monopoly illegal. Thus, Chief Justice White interpreted the act to prohibit certain acts leading to monopoly, but not monopoly itself.
The legality of monopoly was further clarified through a series of cases, starting with the 1945 Alcoa case, in which the United States sued to break up the aluminum monopoly Alcoa. The modern approach involves a two-part test. First, does the firm have monopoly power in a market? If it does not, no monopolization has occurred and there is no issue for the court. Second, if it does, did the firm use illegal tactics to extend or maintain that monopoly power? In the language of a later decision, did the firm engage in “the willful acquisition or maintenance of that power as distinguished from growth or development as a consequence of superior product, business acumen or historic accident” (U.S. v. Grinnell, 1966)?
There are several important points that are widely misunderstood and even misreported in the press. First, the Sherman Act does not make having a monopoly illegal. Indeed, three legal ways of obtaining a monopoly—a better product, running a better business, or luck—are mentioned in one decision. It is illegal to leverage an existing monopoly into new products or services, or to engage in anticompetitive tactics to maintain the monopoly. Moreover, you must have monopoly power currently to be found guilty of illegal tactics.
When the DOJ sued Microsoft over the incorporation of the browser into the operating system and other acts (including contracts with manufacturers prohibiting the installation of Netscape), the allegation was not that Windows was an illegal monopoly. The DOJ alleged Microsoft was trying to use its Windows monopoly to monopolize another market, the Internet browser market. Microsoft’s defense was twofold. First, it claimed not to be a monopoly, citing the 5% share of Apple. (Linux had a negligible share at the time.) Second, it alleged that a browser was not a separate market but an integrated product necessary for the functioning of the operating system. This defense follows the standard two-part test.
Microsoft’s defense brings up the question, What is a monopoly? The simple answer to this question depends on whether there are good substitutes in the minds of consumers, so that they may substitute an alternate product in the event of bad behavior by the seller. By this test, Microsoft had an operating system monopoly; in spite of the fact that there was a rival product, Microsoft could increase the price, tie the browser and MP3 player to the operating system, or even disable Word Perfect, and most consumers would not switch to the competing operating system. However, Microsoft’s second defense, that the browser wasn’t a separate market, was a much more challenging defense to assess.
The Sherman Act provides criminal penalties, which are commonly applied in price-fixing cases—that is, when groups of firms join together and collude to raise prices. Seven executives of General Electric (GE) and Westinghouse, who colluded in the late 1950s to set the prices of electrical turbines, each spent several years in jail, and incurred over \$100 million in fines. In addition, Archer Daniels Midland executives went to jail after their 1996 conviction for fixing the price of lysine, which approximately doubled the price of this common additive to animal feed. When highway contractors are convicted of bid-rigging, the conviction is typically under the Sherman Act for monopolizing their market.
KEY TAKEAWAYS
• A trust (now known as a cartel) is a group of firms acting in concert. The antitrust laws made such trusts illegal and were intended to protect competition. In the United States, these laws are enforced by the Department of Justice’s (DOJ) Antitrust Division and by the Federal Trade Commission (FTC).
• The Sherman Act, passed in 1890, is the first significant piece of antitrust legislation. It prevents mergers and cartels that would increase prices.
• Having a monopoly is legal, provided it is obtained through legal means. Legal means include “superior product, business acumen or historic accident.”
• Modern antitrust investigations involve a two-part test. First, does the firm have monopoly power in a market? If it does not, no monopolization has occurred and there is no issue for the court. If it does, did the firm use illegal tactics to extend or maintain that monopoly power?
• The Sherman Act provides criminal penalties, which are commonly applied in price-fixing cases. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/21%3A_Antitrust/21.01%3A_Sherman_Act.txt |
Learning Objectives
• What other major antitrust legislation exists in the United States?
• What is predatory pricing and why is it illegal?
• Is price discrimination illegal?
Critics of the Sherman Act, including famous trust-buster President Teddy Roosevelt, felt the ambiguity of the Sherman Act was an impediment to its use and that the United States needed a more detailed law setting out a list of illegal activities. The Clayton Act, 15 U.S.C. §§ 12–27, was passed in 1914 and it adds detail to the Sherman Act. The same year, the FTC Act was passed, creating the Federal Trade Commission (FTC), which has authority to enforce the Clayton Act as well as to engage in other consumer protection activities.
The Clayton Act does not have criminal penalties, but it does allow for monetary penalties that are three times as large as the damage created by the illegal behavior. Consequently, a firm, motivated by the possibility of obtaining a large damage award, may sue another firm for infringement of the Clayton Act. A plaintiff must be directly harmed to bring such a suit. Thus, customers who paid higher prices or firms that were driven out of business by exclusionary practices are permitted to sue under the Clayton Act. When Archer Daniels Midland raised the price of lysine, pork producers who bought lysine would have standing to sue, but final pork consumers who paid higher prices for pork, but who didn’t directly buy lysine, would not.
Highlights of the Clayton Act include:
• Section 2, which prohibits price discrimination that would lessen competition
• Section 3, which prohibits exclusionary practices, such as tying, exclusive dealing, and predatory pricing, that lessen competition
• Section 7, which prohibits share acquisition or merger that would lessen competition or create a monopoly
The language lessen competition is generally understood to mean that a significant price increase becomes possible; that is, competition has been harmed if the firms in the industry can successfully increase prices.
Section 2 is also known as Robinson-Patman because of a 1936 amendment by that name. It prohibits price discrimination that lessens competition. Thus, price discrimination to final consumers is legal under the Clayton Act; the only way price discrimination can lessen competition is if one charges different prices to different businesses. The logic of the law was articulated in the 1948 Morton Salt decision, which concluded that lower prices to large chain stores gave an advantage to those stores, thus injuring competition in the grocery store market. The discounts in that case were not cost-based, and it is permissible to charge different prices based on costs.
Section 3 rules out practices that lessen competition. A manufacturer who also offers service for the goods it sells may be prohibited from favoring its own service organization. Generally manufacturers may not require the use of the manufacturer’s own service. For example, an automobile manufacturer can’t require the use of replacement parts made by the manufacturer, and many car manufacturers have lost lawsuits on this basis. In an entertaining example, Mercedes prohibited Mercedes dealers from buying Bosch parts directly from Bosch, even though Mercedes itself was selling Bosch parts to the dealers. This practice was ruled illegal because the quality of the parts was the same as Mercedes’s (indeed, identical), so Mercedes’s action lessened competition.
Predatory pricing involves pricing below cost in order to drive a rival out of business. It is relatively difficult for a firm to engage in predation simply because it only makes sense if, once the rival is eliminated, the predatory firm can then increase its prices and recoup the losses incurred. The problem is that once the prices go up, entry becomes attractive; so what keeps other potential entrants away? One answer is reputation: a reputation for a willingness to lose money in order to dominate the market could deter potential entrants. Like various rare diseases that happen more often on television shows than in the real world (e.g., Tourette’s syndrome), predatory pricing probably happens more often in textbooks than in the real world.Economists have argued that American Tobacco, Standard Oil, and AT&T each engaged in predation in their respective industries.
The FTC also has authority to regulate mergers that would lessen competition. As a practical matter, the DOJ and the FTC divide responsibility for evaluating mergers. In addition, other agencies may also have jurisdiction over mergers and business tactics. The Department of Defense has oversight of defense contractors, using a threat of “we’re your only customer.” The Federal Communications Commission has statutory authority over telephone and television companies. The Federal Reserve Bank has authority over national and most other banks.
Most states have antitrust laws as well, and they can challenge mergers that would affect commerce in the respective state. In addition, attorneys general of many states may join the DOJ or the FTC in suing to block a merger or in other antitrust actions, or they can sue independently. For example, many states joined the Department of Justice in its lawsuit against Microsoft. Forty-two states jointly sued the major record companies over their “minimum advertised prices (MAP)” policies, which the states argued resulted in higher compact disc prices. The MAP case settlement resulted in a modest payment to compact disc purchasers. The FTC had earlier extracted an agreement to stop the practice.
Key Takeaways
• The Clayton Act was passed in 1914 and adds detail to the Sherman Act. The FTC, which has authority to enforce the Clayton Act, as well as engage in other consumer protection activities, was created the same year.
• The Clayton Act does not have criminal penalties, but it does allow for monetary penalties that are three times as large as the damage created by the illegal behavior.
• Highlights of the Clayton Act include:
• Section 2, which prohibits price discrimination that would lessen competition
• Section 3, which prohibits exclusionary practices, such as tying, exclusive dealing, and predatory pricing, that lessen competition
• Section 7, which prohibits share acquisition or merger that would lessen competition or create a monopoly
• The language lessen competition is generally understood to mean that a significant price increase becomes possible; that is, competition has been harmed if the firms in the industry can successfully increase prices.
• Predatory pricing involves pricing below cost in order to drive a rival out of business.
• The DOJ and the FTC divide responsibility for evaluating mergers.
• Most states have antitrust laws as well, and they can challenge mergers that would affect commerce in the respective state. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/21%3A_Antitrust/21.02%3A_Clayton_Act.txt |
Learning Objectives
• What is price fixing and how does it work?
Price fixing, which is called bid-rigging in a bidding context, involves a group of firms agreeing to increase the prices they charge and restrict competition against each other. The most famous example of price fixing is probably the Great Electrical Conspiracy in which GE and Westinghouse (and a smaller firm, Allis-Chalmers) fixed the prices of turbines used for electricity generation. Generally these turbines were the subject of competitive (or, in this case, not-so-competitive) bidding, and the companies set the prices by designating a winner for each bidding situation and using a price book to provide identical bids by all companies. An amusing element of the price-fixing scheme was the means by which the companies identified the winner in any given competition: they used the phase of the moon. The phase of the moon determined the winner, and each company knew what to bid based on the phase of the moon. Executives from the companies met often to discuss the terms of the price-fixing arrangement, and the Department of Justice (DOJ) acquired a great deal of physical evidence in the process of preparing its 1960 case. Seven executives went to jail and hundreds of millions of dollars in fines were paid.
Most convicted price-fixers are from small firms. The turbine conspiracy and the Archer Daniels Midland lysine conspiracy are unusual. (There is evidence that large vitamin manufacturers conspired in fixing the price of vitamins in many nations of the world.) Far more common conspiracies involve highway and street construction firms, electricians, water and sewer construction companies, or other owner-operated businesses. Price fixing seems most common when owners are also managers and there are a small number of competitors in a given region.
As a theoretical matter, it should be difficult for a large firm to motivate a manager to engage in price fixing. The problem is that the firm can’t write a contract promising the manager extraordinary returns for successfully fixing prices because such a contract itself would be evidence and moreover implicate higher management. Indeed, Archer Daniels Midland executives paid personal fines of \$350,000, and each served 2 years in jail. Thus, it is difficult to offer a substantial portion of the rewards of price fixing to managers in exchange for the personal risks the managers would face from engaging in price fixing. Most of the gains of price fixing accrue to shareholders of large companies, while large risks and costs fall on executives. In contrast, for smaller businesses in which the owner is the manager, the risks and rewards are borne by the same person, and thus the personal risk is more likely to be justified by the personal return.
We developed earlier a simple theory of cooperation, in which the grim trigger strategy was used to induce cooperation. Let us apply that theory to price fixing. Suppose that there are n firms and that they share the monopoly profits πm equally if they collude. If one firm cheats, that firm can obtain the entire monopoly profits until the others react. This is clearly the most the firm could get from cheating. Once the others react, the collusion breaks down and the firms earn zero profits (the competitive level) from then on. The cartel is feasible if 1/n of the monopoly profits forever is better than the whole monopoly profits for a short period of time. Thus, cooperation is sustainable if $$\Pi m n(1-\delta)=\Pi m n(1+\delta+\delta 2+\ldots) \geq n m$$.
The left-hand side of the equation gives the profits from cooperating—the present value of the 1/n share of the monopoly profits. In contrast, if a firm chooses to cheat, it can take at most the monopoly profits, but only temporarily. How many firms will this sustain? The inequality simplifies to $$n \leq 11-\delta$$. Suppose the annual interest rate is 5% and the reaction time is 1 week—that is, a firm that cheats on the cooperative agreement sustains profits for a week, after which time prices fall to the competitive level. In this case, 1 − δ is a week’s worth of interest (δ is the value of money received in a week), and therefore $$\delta=0.95152=0.999014$$. According to standard theory, the industry with a weeklong reaction time should be able to support cooperation with up to a thousand firms.
There are numerous and varied reasons why this theory fails to work very well empirically, including that some people are actually honest and do not break the law, but we will focus on one game-theoretic reason here. The cooperative equilibrium is not the only equilibrium, and there are good reasons to think that full cooperation is unlikely to persist. The problem is the prisoner’s dilemma itself: generally the first participant to turn in the conspiracy can avoid jail. Thus, if one member of a cartel is uncertain whether the other members of a price-fixing conspiracy are contacting the DOJ, that member may race to the DOJ—the threat of one confession may cause them all to confess in a hurry. A majority of the conspiracies that are prosecuted arise because someone—a member who feels guilty, a disgruntled ex-spouse of a member, or perhaps a member who thinks another member is suffering pangs of conscience—turns them in. Lack of confidence in the other members creates a self-fulfilling prophecy. Moreover, cartel members should lack confidence in the other cartel members who are, after all, criminals.
On average, prosecuted conspiracies were about 7 years old when they were caught. Thus, there is about a 15% chance annually of a breakdown of a conspiracy, at least among those that are eventually caught.
Key Takeaways
• Price fixing, which is called bid rigging in a bidding context, involves a group of firms agreeing to increase the prices they charge and restrict competition against each other.
• The most famous example of price fixing is probably the Great Electrical Conspiracy in which GE and Westinghouse fixed the prices of turbines. The companies used the phase of the moon to determine the winner of government procurement auctions.
• Theoretically, collusions should be easy to sustain; in practice, it does not seem to be. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/21%3A_Antitrust/21.03%3A_Price_Fixing.txt |
Learning Objectives
• How does the government decide which mergers to block and which to permit?
The U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) share responsibility for evaluating mergers. Firms with more than \$50 million in assets are required under the Hart-Scott-Rodino Act to file with the government an intention to merge with another firm. The government then has a limited amount of time to either approve the merger or request more information (called a second request). Once the firms have complied with the second request, the government again has a limited amount of time before it either approves the merger or sues to block it. The government agencies themselves don’t stop the merger, but instead they sue to block the merger, asking a federal judge to prevent the merger as a violation of one of the antitrust laws. Mergers are distinct from other violations because they have not yet occurred at the time the lawsuit is brought, so there is no threat of damages or criminal penalties; the only potential penalty imposed on the merging parties is that the proposed merger may be blocked.
Many proposed mergers result in settlements. As part of the settlement associated with GE’s purchase of Radio Corporation of America (RCA) in 1986, a small appliance division of GE’s was sold to Black & Decker, thereby maintaining competition in the small kitchen appliance market. In the 1999 merger of oil companies Exxon and Mobil, a California refinery, shares in oil pipelines connecting the Gulf with the Northeast, and thousands of gas stations were sold to other companies. The 1996 merger of Kimberley-Clark and Scott Paper would have resulted in a single company with over 50% of the facial tissue and baby wipes markets, and in both cases divestitures of production capacity and the Scotties brand name preserved competition in the markets. Large bank mergers, oil company mergers, and other large companies usually present some competitive concerns, and the majority of these cases are solved by divestiture of business units to preserve competition.
A horizontal merger is a merger of competitors, such as Exxon and Mobil or two banks located in the same city. In contrast, a vertical merger is a merger between an input supplier and input buyer. The attempt by book retailer Barnes and Noble to purchase the intermediary Ingram, a company that buys books from publishers and sells to retailers but doesn’t directly sell to the public, would have resulted in a vertical merger. Similarly, Disney is a company that sells programs to television stations (among other activities), so its purchase of TV network ABC was a vertical merger. The AOL-Time Warner merger involved several vertical relationships. For example, Time Warner is a large cable company, and cable represents a way for AOL to offer broadband services. In addition, Time Warner is a content provider, and AOL delivers content to Internet subscribers.
Vertical mergers raise two related problems: foreclosure and raising rivals’ costs. Foreclosure refers to denying access to necessary inputs. Thus, the AOL-Time Warner merger threatened rivals to AOL Internet service (like EarthLink) with an inability to offer broadband services to consumers with Time Warner cable. This potentially injures competition in the Internet service market, forcing Time Warner customers to use AOL. In addition, by bundling Time Warner content and AOL Internet service, users could be forced to purchase AOL Internet service in order to have access to Time Warner content. Both of these threaten foreclosure of rivals, and both were resolved to the government’s satisfaction by promises that the merged firm would offer equal access to rivals.
Raising rivals’ costs is a softer version of foreclosure. Rather than deny access to content, AOL Time Warner could instead make the content available under disadvantageous terms. For example, American Airlines developed the Sabre computerized reservation system, which was used by about 40% of travel agents. This system charged airlines, rather than travel agents, for bookings. Consequently, American Airlines had a mechanism for increasing the costs of its rivals: by increasing the price of bookings on the Sabre system. The advantage to American Airlines was not just increased revenue of the Sabre system but also the hobbling of airline rivals. Similarly, banks offer free use of their own automated teller machines (ATMs), but they charge the customers of other banks. Such charges raise the costs of customers of other banks, thus making other banks less attractive and providing an advantage in the competition for bank customers.
The DOJ and the FTC periodically issue horizontal merger guidelines, which set out how mergers will be evaluated. This is a three-step procedure for each product that the merging companies have in common.
The procedure starts by identifying product markets. To identify a product market, start with a product or products produced by both companies. Then ask if the merged parties can profitably raise price by a small but significant and nontransitory increase in price, also known as a SSNIP (pronounced “snip”). A SSNIP is often taken to be a 5% price increase, which must prevail for several years. If the companies can profitably increase price by a SSNIP, then they are judged to have monopoly power and consumers will be directly harmed by the merger. (This is known as a unilateral effect because the merging parties will increase price unilaterally after the merger is consummated.) If they can’t increase prices, then an additional product has to be added to the group; generally the best substitute is added. Ask whether a hypothetical monopoly seller of these three products can profitably raise price. If it can, an antitrust market has been identified; if it cannot, yet another substitute product must be added. The process stops adding products when enough substitutes have been identified that, if controlled by a hypothetical monopoly, would have their prices significantly increased.
The logic of product market definition is that, if a monopoly wouldn’t increase price in a meaningful way, then there is no threat to consumers—any price increase won’t be large or won’t last. The market is defined by the smallest set of products for which consumers can be harmed. The test is also known as the hypothetical monopoly test.
The second step is to identify a geographic market. The process starts with an area in which both companies sell and asks if the merged company has an incentive to increase price by a SSNIP. If it does, that geographic area is a geographic market. If it does not, it is because buyers are substituting outside the area to buy cheaply, and the area must be expanded. For example, owning all the gas stations on a corner doesn’t let one increase price profitably because an increase in price leads to substitution to gas stations a few blocks away. If one company owned all the stations in a half-mile radius, would it be profitable to increase price? Probably not because there would still be significant substitution to more distant stations. Suppose, instead, that one owned all the stations for a 15-mile radius. Then an increase in price in the center of the area is not going to be thwarted by too much substitution outside the area, and the likely outcome is that prices would be increased by such a hypothetical monopoly. In this case, a geographic market has been identified. Again, parallel to the product market definition, a geographic market is the smallest area in which competitive concerns would be raised by a hypothetical monopoly. In any smaller area, attempts to increase price are defeated by substitution to sellers outside the area.
The product and geographic markets together are known as a relevant antitrust market (relevant for the purposes of analyzing the merger).
The third and last step of the procedure is to identify the level of concentration in each relevant antitrust market. The Hirschman-Herfindahl Index (HHI) is used for this purpose. The HHI is the sum of the squared market shares of the firms in the relevant antitrust market, and it is justified because it measures the price-cost margin in the Cournot model. Generally, in practice, the shares in percentage are used, which makes the scale range from 0 to 10,000. For example, if one firm has 40%, one has 30%, one has 20%, and the remaining firm has 10%, the HHI is $$40^{2}+30^{2}+20^{2}+10^{2}=3,000$$
Usually, anything over 1,800 is considered very concentrated, and anything over 1,000 is concentrated.
Suppose firms with shares x and y merge, and nothing in the industry changes besides the combining of those shares. Then the HHI goes up by $$(x+y)^{2}-x^{2}-y^{2}=2 x y$$. This is referred to as the change in the HHI. The merger guidelines suggest that the government will likely challenge mergers with (a) a change of 100 and a concentrated post-merger HHI, or (b) a change of 50 and a very concentrated post-merger HHI. It is more accurate in understanding the merger guidelines to say that the government likely won’t challenge unless either (a) or (b) is met. Even if the post-merger HHI suggests a very concentrated industry, the government is unlikely to challenge if the change in the HHI is less than 50.
Several additional factors affect the government’s decision. First, if the firms are already engaging in price discrimination, the government may define quite small geographic markets, possibly as small as a single customer. Second, if one firm is very small (less than 1%) and the other not too large (less than 35%), the merger may escape scrutiny because the effect on competition is likely small. Third, if one firm is going out of business, the merger may be allowed as a means of keeping the assets in the industry. Such was the case with Greyhound’s takeover of Trailways, a merger that produced a monopoly of the only intercity bus companies in the United States.
Antitrust originated in the United States, and the United States remains the most vigorous enforcer of antitrust laws. However, the European Union has recently taken a more aggressive antitrust stance, and in fact it has blocked mergers that obtained tentative U.S. approval, such as GE and Honeywell.
Antitrust is, in some sense, the applied arm of oligopoly theory. Because real situations are so complex, the application of oligopoly theory to antitrust analysis is often challenging, and we have only scratched the surface of many of the more subtle issues of law and economics in this text. For example, intellectual property, patents, and standards all have their own distinct antitrust issues.
Key Takeaways
• Firms with large assets are required to notify the government prior to merging.
• Many proposed mergers result in settlements.
• A horizontal merger is a merger of competitors. In contrast, a vertical merger is a merger between an input supplier and input buyer.
• Vertical mergers raise two problems: foreclosure and raising rivals’ costs. Foreclosure refers to denying access to necessary inputs. Raising rivals’ costs is a softer version of foreclosure because it charges more for inputs.
• Mergers are evaluated by a three-step procedure that involves looking at product market, geographic market, and effects.
• A product market is a set of products sufficiently extensive that a monopolist can profitably raise price by a small but significant and nontransitory increase in price, also known as a SSNIP (pronounced “snip”).
• The logic of product market definition is that, if a monopoly wouldn’t increase price in a meaningful way and there is no threat to consumers, any price increase won’t be large or won’t last. The market is defined by the smallest set of products for which consumers can be harmed. The test is also known as the hypothetical monopoly test.
• The second step is to identify a geographic market, which exactly parallels the product market, looking for an area large enough that a hypothetical monopolist over the product market in that geographic market would profitably raise price by a SSNIP.
• The product and geographic markets together are known as a relevant antitrust market (relevant for the purposes of analyzing the merger).
• The third and last step of the procedure is to identify the level of concentration in each relevant antitrust market. The Hirschman-Herfindahl Index (HHI) is used for this purpose.
• Several additional factors, including price discrimination and failing firms, affect the government’s decision to sue and thus block mergers.
• Antitrust is, in some sense, the applied arm of oligopoly theory. | textbooks/socialsci/Economics/Introduction_to_Economic_Analysis/21%3A_Antitrust/21.04%3A_Mergers.txt |
• 1.1: Why Managerial Economics is Relevent for Managers
We rely on others in the society to produce and distribute nearly all the goods and services we need. The sources of those goods and services are usually not other individuals but organizations created for the explicit purpose of producing and distributing goods and services. Nearly every organization in our society can be viewed as providing a set of goods, services, or both. The responsibility for overseeing and making decisions for these organizations is the role of executives and managers.
• 1.2: Managerial Economics is Applicable to Different Types of Organizations
• 1.3: The Focus of This Book
The intent of this book is to familiarize the reader with the key concepts, terminology, and principles from managerial economics. After reading the text, you should have a richer appreciation of your environment—your customers, your suppliers, your competitors, and your regulators. You will learn principles that should improve your intuition and your managerial decisions. You will also be able to communicate more effectively with your colleagues and with expert consultants.
• 1.4: How to Read This Book
Like any academic subject, economics can seem like an abstract pursuit that is of greatest interest to economists who want to communicate with other economists. However, while there is certainly a substantial body of written research that may reinforce that impression, this book is written with the belief that economics provides a language and a perspective that is useful for general managers.
01: Introduction to Managerial Economics
In a civilized society, we rely on others in the society to produce and distribute nearly all the goods and services we need. However, the sources of those goods and services are usually not other individuals but organizations created for the explicit purpose of producing and distributing goods and services. Nearly every organization in our society—whether it is a business, nonprofit entity, or governmental unit—can be viewed as providing a set of goods, services, or both. The responsibility for overseeing and making decisions for these organizations is the role of executives and managers.
Most readers will readily acknowledge that the subject matter of economics applies to their organizations and to their roles as managers. However, some readers may question whether their own understanding of economics is essential, just as they may recognize that physical sciences like chemistry and physics are at work in their lives but have determined they can function successfully without a deep understanding of those subjects.
Whether or not the readers are skeptical about the need to study and understand economics per se, most will recognize the value of studying applied business disciplines like marketing, production/operations management, finance, and business strategy. These subjects form the core of the curriculum for most academic business and management programs, and most managers can readily describe their role in their organization in terms of one or more of these applied subjects. A careful examination of the literature for any of these subjects will reveal that economics provides key terminology and a theoretical foundation. Although we can apply techniques from marketing, production/operations management, and finance without understanding the underlying economics, anyone who wants to understand the why and how behind the technique needs to appreciate the economic rationale for the technique.
We live in a world with scarce resources, which is why economics is a practical science. We cannot have everything we want. Further, others want the same scarce resources we want. Organizations that provide goods and services will survive and thrive only if they meet the needs for which they were created and do so effectively. Since the organization’s customers also have limited resources, they will not allocate their scarce resources to acquire something of little or no value. And even if the goods or services are of value, when another organization can meet the same need with a more favorable exchange for the customer, the customer will shift to the other supplier. Put another way, the organization must create value for their customers, which is the difference between what they acquire and what they produce. The thesis of this book is that those managers who understand economics have a competitive advantage in creating value. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/01%3A_Introduction_to_Managerial_Economics/1.01%3A_Why_Managerial_Economics_is_Relevent_for_Managers.txt |
In this book, the organization providing goods and services will often be called a “business” or a “firm,” terms that connote a for-profit organization. And in some portions of the book, we discuss principles that presume the underlying goal of the organization is to create profit. However, managerial economics is relevant to nonprofit organizations and government agencies as well as conventional, for-profit businesses. Although the underlying objective may change based on the type of organization, all these organizational types exist for the purpose of creating goods or services for persons or other organizations.
Managerial economics also addresses another class of manager: the regulator. As we will discuss in Chapter 8, the economic exchanges that result from organizations and persons trying to achieve their individual objectives may not result in the best overall pattern of exchange unless there is some regulatory guidance. Economics provides a framework for analyzing regulation, both the effect on decision making by the regulated entities and the policy decisions of the regulator.
1.03: The Focus of This Book
The intent of this book is to familiarize the reader with the key concepts, terminology, and principles from managerial economics. After reading the text, you should have a richer appreciation of your environment—your customers, your suppliers, your competitors, and your regulators. You will learn principles that should improve your intuition and your managerial decisions. You will also be able to communicate more effectively with your colleagues and with expert consultants.
As with much of microeconomic theory, many of the economic principles in this book were originally derived with the help of mathematics and abstract models based on logic and algebra. In this book, the focus is on the insights gained from these principles, not the derivation of the principles, so only a modest level of mathematics is employed here and an understanding of basic algebra will suffice. We will consider some key economic models of managerial decision making, but these will be presented either verbally, graphically, or with simple mathematical representations. For readers who are interested in a more rigorous treatment, the reference list at the conclusion of this text includes several books that will provide more detail. Alternatively, a web search using one of the terms from this book will generally yield several useful links for further exploration of a concept.
A note about economic models is that models are simplified representations of a real-world organization and its environment. Some aspects of the real-world setting are not addressed, and even those aspects that are addressed are simplifications of any actual setting being represented. The point of using models is not to match the actual setting in every detail, but to capture the essential aspects so determinations can be made quickly and with a modest cost. Models are effective when they help us understand the complex and uncertain environment and proceed to appropriate action.
1.04: How to Read This Book
Like any academic subject, economics can seem like an abstract pursuit that is of greatest interest to economists who want to communicate with other economists. However, while there is certainly a substantial body of written research that may reinforce that impression, this book is written with the belief that economics provides a language and a perspective that is useful for general managers.
All readers have a considerable experience base with the phenomena that economics tries to address, as managers, consumers, or citizens interested in what is happening in their world and why. As you read the book, I encourage you to try to apply the concepts and theories to economic phenomena you have experienced. By doing so, the content of the book will make more sense and you are more likely to apply what you will read here in your future activities as a player in the world of business and economics. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/01%3A_Introduction_to_Managerial_Economics/1.02%3A_Managerial_Economics_Is_Applicable_to_Different_Types_of_Organizations.txt |
• 2.1: Revenue, Cost, and Profit
Most businesses sell something—either a physical commodity like an ice cream bar or a service like a car repair. In a modern economy, that sale is made in return for money or at least is evaluated in monetary terms.
• 2.2: Economic Versus Accounting Measures of Cost and Profit
The discipline of accounting provides guidelines for the measurement of revenue, cost, and profit. Having analyses based on generally accepted principles is important for making exchanges in our economy. For example, corporations must produce financial statements to help investors and creditors assess the health of the corporation. Individuals and businesses must produce tax returns to determine a fair measurement of income for taxation purposes.
• 2.3: Revenue, Cost, and Profit Functions
There is a relationship between the volume or quantity created and sold and the resulting impact on revenue, cost, and profit. These relationships are called the revenue function, cost function, and profit function. These relationships can be expressed in terms of tables, graphs, or algebraic equations.
• 2.4: Breakeven Analysis
The volume level that separates the range with economic loss from the range with economic profit is called the breakeven point. From the graph we can see the breakeven point is slightly less than 35,000 units. If the students can sell above that level, which the prior operator did, it will be worthwhile to proceed with the venture. If they are doubtful of reaching that level, they should abandon the venture now, even if that means losing their nonrefundable deposit.
• 2.5: The Impact of Price Changes
In the preceding analyses of the ice cream venture, we assumed ice cream bars would be priced at \$1.50 per unit based on the price that was charged in the previous summer. The students can change the price and should evaluate whether there is a better price for them to charge. However, if the price is lowered, the breakeven level will increase and if the price is raised, the breakeven level will drop, but then so may the customer demand.
• 2.6: Marginal Analysis
Economists analyze relationships like revenue functions from the perspective of how the function changes in response to a small change in the quantity.
• 2.7: The Conclusion for Our Students
At first glance, a \$5000 profit does not seem like much. However, bear in mind that we already assigned an opportunity cost to the students’ time based on the income foregone by not accepting the corporate internships. So the students can expect to complete the summer with \$10,000 each to compensate for the lost internship income and still have an additional \$5000 to split between them.
• 2.8: The Shutdown Rule
Previously, we cited one condition for reaching a breakeven production level where revenue would equal or exceed costs as the point where average cost per unit is equal to the price. However, if some of the costs are already sunk, these should be disregarded in determining the relevant average cost. In a circumstance where a business regards all fixed costs as effectively sunk for the next production period, this condition becomes a statement of a principle known as the shutdown rule.
• 2.9: A Final Word on Business Objectives
In the example used in this chapter, we assumed the students’ goal in how to operate the ice cream business was to maximize their profit—more specifically, to maximize their economic profit. Is this an appropriate overall objective for most businesses? Generally speaking, the answer is yes. If a business is not able to generate enough revenue to at least cover their economic costs, the business is losing in the net.
02: Key Measures and Relationships
Most businesses sell something—either a physical commodity like an ice cream bar or a service like a car repair. In a modern economy, that sale is made in return for money or at least is evaluated in monetary terms. The total monetary value of the goods or services sold is called revenue.
Few businesses are able to sell something without incurring expenses to make the sale possible. The collective expenses incurred to generate revenue over a period of time, expressed in terms of monetary value, are the cost. Some cost elements are related to the volume of sales; that is, as sales go up, the expenses go up. These costs are called variable costs. The cost of raw materials used to make an item of clothing would be an example of a variable cost. Other costs are largely invariant to the volume of sales, at least within a certain range of sales volumes. These costs are called fixed costs. The cost of a machine for cutting cloth to make an item of clothing would be a fixed cost.
Businesses are viable on a sustained basis only when the revenue generated by the business generally exceeds the cost incurred in operating the business. The difference between the revenue and cost (found by subtracting the cost from the revenue) is called the profit. When costs exceed revenue, there is a negative profit, or loss.
The students in our simple venture realize they need to determine whether they can make a profit from a summer ice cream bar business. They met the person who operated an ice cream bar business in this building the previous summer. He told them last summer he charged \$1.50 per ice cream bar and sold 36,000 ice cream bars. He said the cost of the ice cream bars—wholesale purchase, delivery, storage, and so on—comes to about \$0.30 per bar. He indicated his other main costs—leasing the building, license, local business association fee, and insurance—came to about \$16,000.
Based on this limited information, the students could determine a rough estimate of the revenue, costs, and profit they would have if they were to repeat the outcomes for the prior operator. The revenue would be \$1.50 per ice cream bar times 36,000 ice cream bars, or \$54,000. The variable cost would be \$0.30 per ice cream bar times 36,000 ice cream bars, or \$10,800. The fixed cost would be \$16,000, making the total cost \$26,800. The profit would be \$54,000 minus \$26,800, or \$27,200.
Based on this analysis, the students are confident the summer business venture can make money. They approach the owner of the building and learn that if they want to reserve the right of first option to lease the building over the summer, they will need to make a nonrefundable \$6000 deposit that will be applied to the lease. They proceeded to make that deposit.
A few weeks later, all three students were unexpectedly offered summer business internships at a large corporation. Each student would earn \$10,000. However, the work site for the internships is far from the beach and they would be in an office all day. They now must decide whether to accept the internships and terminate their plan to run a business at the beach or turn down the internships. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.01%3A_Revenue_Cost_and_Profit.txt |
The discipline of accounting provides guidelines for the measurement of revenue, cost, and profit. Having analyses based on generally accepted principles is important for making exchanges in our economy. For example, corporations must produce financial statements to help investors and creditors assess the health of the corporation. Individuals and businesses must produce tax returns to determine a fair measurement of income for taxation purposes.
Costs as measured according to accounting principles are not necessarily the relevant measurements for decisions related to operating or acquiring a business. For example, accounting standards dictate that businesses depreciate long-lived assets, like buildings, by spreading the cost over the life of the asset.The particulars on depreciation can be found in any financial accounting text. However, from the perspective of the business, the entire expense was incurred when the asset was acquired, even if borrowing was necessary to make the purchase and there will be the opportunity to take increased tax deductions in future years.
Likewise, there are other business costs relevant to decision making that may not be considered as costs from the perspective of accounting standards. For example, the owner/operator of a proprietorship invests time and effort in operating a business. These would typically not be treated as expenses on the proprietorship’s tax return but are certainly relevant to the owner in deciding how to manage his self-run business.
Based on these differences in perspective, it is useful to distinguish accounting costs from economic costs. In turn, since profit is the residue of revenue minus costs, we also distinguish accounting profit from economic profit.
Consider our three students who are now in a quandary about whether to sell ice cream bars on the beach or accept the summer internships, and let us see how distinguishing the economic cost/profit from the accounting cost/profit helps to clarify their decision.
There is the matter of the students’ time and energy, which is not reflected in the projection of the \$27,200 profit based on last year’s operation. One way to measure that cost is based on how much they will forfeit by not using their time in the next best alternative, which in this case is the summer internship. We can consider this forfeited income as being equivalent to a charge against the operation of the ice cream business, a measurement commonly referred to as an opportunity cost. The students’ time has an opportunity cost of \$30,000. This should be added to the earlier fixed cost of \$16,000, making an economic fixed cost of \$46,000, a total economic cost of \$56,800, and an economic loss of \$2800. So maybe the ice cream business would not be a good idea after all.
However, recall that the students have already made a \$6000 nonrefundable deposit. This money is spent whether the students proceed to run the summer business or not. It is an example of what is called a sunk cost. Assuming the fixed cost of the business was the same as for the prior operator, the students would have a \$16,000 accounting fixed cost to report on a tax return. Yet, from the perspective of economic costs, only \$10,000 is really still avoidable by not operating the business. The remaining \$6000 is gone regardless of what the students decide. So, from an economic cost/profit perspective, viewed after the nonrefundable deposit but before the students declined the summer internships, if the students’ other costs and revenue were identical to the previous year, they would have economic costs of just \$50,800 and an economic profit of \$3200.
If a business properly measures costs from an economic perspective, ignoring sunk costs and including opportunity costs, you can conclude that a venture is worth pursuing if it results in an economic profit of zero or better. However, this is generally not a valid principle if you measure performance in terms of accounting profit. Most stockholders in a corporation would not be satisfied if the corporation only managed a zero accounting profit because this means there is no residual from the business to reward them with either dividends or increased stock value. From an economic cost perspective, stockholder capital is an asset that can be redeployed, and thus it has an opportunity cost—namely, what the investor could earn elsewhere with their share of the corporation in a different investment of equivalent risk.Readers interested in estimating the opportunity cost of investment capital are encouraged to consult a general text in financial analysis, such as Brigham and Ehrhardt (2010). This opportunity cost could be estimated and included in the economic cost. If the resulting profit is zero or positive after netting out the opportunity cost of capital, the investor’s participation is worthwhile. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.02%3A_Economic_Versus_Accounting_Measures_of_Cost_and_Profit.txt |
In the preceding projections for the proposed ice cream bar venture, the assumption was that 36,000 ice cream bars would be sold based on the volume in the prior summer. However, the actual volume for a future venture might be higher or lower. And with an economic profit so close to zero, our students should consider the impact of any such differences.
There is a relationship between the volume or quantity created and sold and the resulting impact on revenue, cost, and profit. These relationships are called the revenue function, cost function, and profit function. These relationships can be expressed in terms of tables, graphs, or algebraic equations.
In a case where a business sells one kind of product or service, revenue is the product of the price per unit times the number of units sold. If we assume ice cream bars will be sold for \$1.50 apiece, the equation for the revenue function will be
\[R = \$1.5 Q,\]
where \(R\) is the revenue and \(Q\) is the number of units sold.
The cost function for the ice cream bar venture has two components: the fixed cost component of \$40,000 that remains the same regardless of the volume of units and the variable cost component of \$0.30 times the number of items. The equation for the cost function is
\[C = \$40,000 + \$0.3 Q,\]
where \(C\) is the total cost. Note we are measuring economic cost, not accounting cost.
Since profit is the difference between revenue and cost, the profit functions will be
\[π = R − C = \$1.2 Q − \$40,000.\]
Here π is used as the symbol for profit. (The letter P is reserved for use later as a symbol for price.)
Table 2.1 provides actual values for revenue, cost, and profit for selected values of the volume quantity \(Q\).
Table 2.1 Revenue, Cost, and Profit for Selected Sales Volumes for Ice Cream Bar Venture
Units Revenue Cost Profit
0 \$0 \$40,000 –\$40,000
10,000 \$15,000 \$43,000 –\$28,000
20,000 \$30,000 \$46,000 –\$16,000
30,000 \$45,000 \$49,000 –\$4,000
40,000 \$60,000 \$52,000 \$8,000
50,000 \$75,000 \$55,000 \$20,000
60,000 \$90,000 \$58,000 \$32,000
Figure 2.1, provides graphs of the revenue, cost, and profit functions.
The average cost is another interesting measure to track. This is calculated by dividing the total cost by the quantity. The relationship between average cost and quantity is the average cost function. For the ice cream bar venture, the equation for this function would be
\[AC = C/Q = \dfrac{\$40,000 + \$0.3 Q}{Q} = \$0.3 + \$40,000/Q.\]
Figure 2.2 shows a graph of the average cost function. Note that the average cost function starts out very high but drops quickly and levels off.
Essentially the average cost function is the variable cost per unit of \$0.30 plus a portion of the fixed cost allocated across all units. For low volumes, there are few units to spread the fixed cost, so the average cost is very high. However, as the volume gets large, the fixed cost impact on average cost becomes small and is dominated by the variable cost component. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.03%3A_Revenue_Cost_and_Profit_Functions.txt |
A scan of Figure 2.1 shows that the ice cream bar venture could result in an economic profit or loss depending on the volume of business. As the sales volume increases, revenue and cost increase and profit becomes progressively less negative, turns positive, and then becomes increasingly positive. There is a zone of lower volume levels where economic costs exceed revenues and a zone on the higher volume levels where revenues exceed economic costs.
One important consideration for our three students is whether they are confident that the sales volume will be high enough to fall in the range of positive economic profits. The volume level that separates the range with economic loss from the range with economic profit is called the breakeven point. From the graph we can see the breakeven point is slightly less than 35,000 units. If the students can sell above that level, which the prior operator did, it will be worthwhile to proceed with the venture. If they are doubtful of reaching that level, they should abandon the venture now, even if that means losing their nonrefundable deposit.
There are a number of ways to determine a precise value for the breakeven level algebraically. One is to solve for the value of Q that makes the economic profit function equal to zero:
$0 = 1.2 Q − 40,000$
or
$Q = \dfrac{40,000}{1.2} = 33,334\, \text{units}.$
An equivalent approach is to find the value of Q where the revenue function and cost function have identical values.
Another way to assess the breakeven point is to find how large the volume must be before the average cost drops to the price level. In this case, we need to find the value of Q where AC is equal to $1.50. This occurs at the breakeven level calculated earlier. A fourth approach to solving for the breakeven level is to consider how profit changes as the volume level increases. Each additional item sold incurs a variable cost per unit of$0.30 and is sold for a price of $1.50. The difference, called the unit contribution margin, would be$1.20. For each additional unit of volume, the profit increases by $1.20. In order to make an overall economic profit, the business would need to accrue a sufficient number of unit contribution margins to cover the economic fixed cost of$40,000. So the breakeven level would be
$Q = \dfrac{\text{fixed cost}}{\text{price per unit} − \text{variable cost per unit}} = \dfrac{40,000}{1.50 − 0.30} = 33,333.3$
or $33,334\,\text{units}$.
Once the operating volume crosses the breakeven threshold, each additional unit contribution margin results in additional profit.
We get an interesting insight into the nature of a business by comparing the unit contribution margin with the price. In the case of the ice cream business, the unit contribution margin is 80% of the price. When the price and unit contribution margins are close, most of the revenue generated from additional sales turns into profit once you get above the breakeven level. However, if you fall below the breakeven level, the loss will grow equally dramatically as the volume level drops. Businesses like software providers, which tend have mostly fixed costs, see a close correlation between revenue and profit. Businesses of this type tend to be high risk and high reward.
On the other hand, businesses that have predominantly variable costs, such as a retail grocery outlet, tend to have relatively modest changes in profit relative to changes in revenue. If business level falls off, they can scale down their variable costs and profit will not decline so much. At the same time, large increases in volume levels beyond the breakeven level can achieve only modest profit gains because most of the additional revenue is offset by additional variable costs. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.04%3A_Breakeven_Analysis.txt |
In the preceding analyses of the ice cream venture, we assumed ice cream bars would be priced at \$1.50 per unit based on the price that was charged in the previous summer. The students can change the price and should evaluate whether there is a better price for them to charge. However, if the price is lowered, the breakeven level will increase and if the price is raised, the breakeven level will drop, but then so may the customer demand.
To examine the impact of price and determine a best price, we need to estimate the relationship between the price charged and the maximum unit quantity that could be sold. This relationship is called a demand curve. Demand curves generally follow a pattern called the law of demand, whereby increases in price result in decreases in the maximum quantity that can be sold.
We will consider a simple demand curve for the ice cream venture. We will assume that since the operator of the business last year sold 36,000 units at a price of \$1.50 that we could sell up to 36,000 units at the same price this coming summer. Next, suppose the students had asked the prior operator how many ice cream bars he believes he would have sold at a price of \$2.00 and the prior operator responds that he probably would have sold 10,000 fewer ice cream bars. In other words, he estimates his sales would have been 26,000 at a price of \$2.00 per ice cream bar.
To develop a demand curve from the prior operator’s estimates, the students assume that the relationship between price and quantity is linear, meaning that the change in quantity will be proportional to the change in price. Graphically, you can infer this relationship by plotting the two price-quantity pairs on a graph and connecting them with a straight line. Using intermediate algebra, you can derive an equation for the linear demand curve
\[P = 3.3 − 0.00005 Q\]
where \(P\) is price in dollars and \(Q\) is the maximum number of ice cream bars that will sell at this price. Figure 2.3 presents a graph of the demand curve.
It may seem awkward to express the demand curve in a manner that you use the quantity Q to solve for the price P. After all, in a fixed price market, the seller decides a price and the buyers respond with the volume of demand. Mathematically, the relationship for ice cream bars could be written
\[Q = 66,000 − 20,000 P.\]
However, in economics, the common practice is to describe the demand curve as the highest price that could be charged and still sell a quantity \(Q\).
The linear demand curve in Figure 2.3 probably stretches credibility as you move to points where either the price is zero or demand is zero. In actuality, demand curves are usually curved such that demand will get very high as the price approaches zero and small amounts would still sell at very high prices, similar to the pattern in Figure 2.4. However, linear demand curves can be reasonably good estimates of behavior if they are used within limited zone of possible prices.
We can use the stated relationship in the demand curve to examine the impact of price changes on the revenue and profit functions. (The cost function is unaffected by the demand curve.) Again, with a single type of product or service, revenue is equal to price times quantity. By using the expression for price in terms of quantity rather than a fixed price, we can find the resulting revenue function
\[R = P Q = (3.3 − 0.00005 Q) Q = 3.3 Q − 0.00005 Q^2.\]
By subtracting the expression for the cost function from the revenue function, we get the revised profit function
\[π = (3.3 Q − 0.00005 Q^2) − (40,000 + \$0.3 Q) = –0.00005 Q^2 + 3 Q − 40,000.\]
Graphs for the revised revenue, cost, and profit functions appear in Figure 2.5. Note that the revenue and profit functions are curved since they are quadratic functions. From the graph of the profit function, it can be seen that it is possible to earn an economic profit with a quantity as low as 20,000 units; however, the price would need to be increased according to the demand curve for this profit to materialize. Additionally, it appears a higher profit is possible than at the previously planned operation of 36,000 units at a price of \$1.50. The highest profitability appears to be at a volume of about 30,000 units. The presumed price at this volume based on the demand curve would be around \$1.80. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.05%3A_The_Impact_of_Price_Changes.txt |
Economists analyze relationships like revenue functions from the perspective of how the function changes in response to a small change in the quantity. These marginal measurements not only provide a numerical value to the responsiveness of the function to changes in the quantity but also can indicate whether the business would benefit from increasing or decreasing the planned production volume and in some cases can even help determine the optimal level of planned production.
The marginal revenue measures the change in revenue in response to a unit increase in production level or quantity. The marginal cost measures the change in cost corresponding to a unit increase in the production level. The marginal profit measures the change in profit resulting from a unit increase in the quantity. Marginal measures for economic functions are related to the operating volume and may change if assessed at a different operating volume level.
There are multiple computational techniques for actually calculating these marginal measures. If the relationships have been expressed in the form of algebraic equations, one approach is to evaluate the function at the quantity level of interest, evaluate the function if the quantity level is increased by one, and determine the change from the first value to the second.
Suppose we want to evaluate the marginal revenue for the revenue function derived in the previous section at last summer’s operating level of 36,000 ice cream bars. For a value of Q = 36,000, the revenue function returns a value of $54,000. For a value of Q = 36,001, the revenue function returns a value of$53,999.70. So, with this approach, the marginal revenue would be $53,999.70 −$54,000, or –$0.30. What does this tell us? First, it tells us that for a modest increase in production volume, if we adjust the price downward to compensate for the increase in quantity, the net change in revenue is a decrease of$0.30 for each additional unit of planned production.
Marginal measures often can be used to assess the change if quantity is decreased by changing sign on the marginal measure. Thus, if the marginal revenue is –$0.30 at Q = 36,000, we can estimate that for modest decreases in planned quantity level (and adjustment of the price upward based on the demand function), revenue will rise$0.30 per unit of decrease in Q.
At first glance, the fact that a higher production volume can result in lower revenue seems counterintuitive, if not flawed. After all, if you sell more and are still getting a positive price, how can more volume result in less revenue? What is happening in this illustrated instance is that the price drop, as a percentage of the price, exceeds the increase in quantity as a percentage of quantity. A glance back at Figure 2.5 confirms that Q = 36,000 is in the portion of the revenue function where the revenue function declines as quantity gets larger.
If you follow the same computational approach to calculate the marginal cost and marginal profit when Q = 36,000, you would find that the marginal cost is $0.30 and the marginal profit is –$0.60. Note that marginal profit is equal to marginal revenue minus marginal cost, which will always be the case.
The marginal cost of \$0.30 is the same as the variable cost of acquiring and stocking an ice cream bar. This is not just a coincidence. If you have a cost function that takes the form of a linear equation, marginal cost will always equal the variable cost per unit.
The fact that marginal profit is negative at Q = 36,000 indicates we can expect to find a more profitable value by decreasing the quantity and increasing the price, but not by increasing the quantity and decreasing the price. The marginal profit value does not provide enough information to tell us how much to lower the planned quantity, but like a compass, it points us in the right direction.
Since marginal measures are the rate of change in the function value corresponding to a modest change in Q, differential calculus provides another computational technique for deriving marginal measures. Differential calculus finds instantaneous rates of change, so the values computed are based on infinitesimal changes in Q rather than whole units of Q and thus can yield slightly different values. However, a great strength of using differential calculus is that whenever you have an economic function in the form of an algebraic equation, you can use differential calculus to derive an entire function that can be used to calculate the marginal value at any value of Q.
How to apply differential calculus is beyond the scope of this text; however, here are the functions that can be derived from the revenue, cost, and profit functions of the previous section (i.e., those that assume a variable price related to quantity):
$\text{marginal revenue at a volume }Q = 3.3 − 0.0001 Q,$
$\text{marginal cost at a volume }Q = 0.3,$
$\text{marginal profit at a volume }Q = 3 − 0.0001 Q.$
Substituting $Q = 36,000$ into these equations will produce the same values we found earlier. However, these marginal functions are capable of more.
Since the marginal change in the function is the rate of change in the function at a particular point, you can visualize this by looking at the graphs of the functions and drawing a tangent line on the graph at the quantity level of interest. A tangent line is a straight line that goes through the point on the graph, but does not cross the graph as it goes through the point. The slope of the tangent line is the marginal value of the function at that point. When the slope is upward (the tangent line rises as it goes to the right), the marginal measure will be positive. When the slope is downward, the marginal measure will be negative. If the line has a steep slope, the magnitude of the marginal measure will be large. When the line is fairly flat, the magnitude will be small.
Suppose we want to find where the profit function is at its highest value. If you look at that point (in the vicinity of Q = 30,000) on Figure 2.5, you see it is like being on the top of a hill. If you draw the tangent line, it will not be sloped upward or downward; it will be a flat line with a zero slope. This means the marginal profit at the quantity with the highest profit has a value of zero. So if you set the marginal profit function equal to zero and solve for Q you find
$0 = 3.00 − 0.0001 Q$
implies
$Q = \dfrac{3.00}{0.0001} = 30,000.$
This confirms our visual location of the optimum level and provides a precise value.
This example illustrates a general economic principle: Unless there is a constraint preventing a change to a more profitable production level, the most profitable production level will be at a level where marginal profit equals zero. Equivalently, in the absence of production level constraints, the most profitable production level is where marginal revenue is equal to marginal cost. If marginal revenue is greater than marginal cost at some production level and the level can be increased, profit will increase by doing so. If marginal cost is greater than marginal revenue and the production level can be decreased, again the profit can be increased. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.06%3A_Marginal_Analysis.txt |
Our students will look at this analysis and decide not only to go forward with the ice cream business on the beach but to charge \$1.80, since that is the price on the demand curve corresponding to a sales volume of 30,000 ice cream bars. Their expected revenue will be \$54,000, which coincidently is the same as in the original plan, but the economic costs will be only \$49,000, which is lower than in the original analysis, and their economic profit will be slightly higher, at \$5000.
At first glance, a \$5000 profit does not seem like much. However, bear in mind that we already assigned an opportunity cost to the students’ time based on the income foregone by not accepting the corporate internships. So the students can expect to complete the summer with \$10,000 each to compensate for the lost internship income and still have an additional \$5000 to split between them.
2.08: The Shutdown Rule
You may recall earlier in this chapter that, before deciding to disregard the \$6000 nonrefundable down payment (to hold the option to operate the ice cream business) as a relevant economic cost, the total cost of operating the business under a plan to sell 36,000 ice cream bars at a price of \$1.50 per item would have exceeded the expected revenue. Even after further analysis indicated that the students could improve profit by planning to sell 30,000 ice cream bars at a price of \$1.80 each, if the \$6000 deposit had not been a sunk cost, there would have been no planned production level and associated price on the demand curve that would have resulted in positive economic profit. So the students would have determined the ice cream venture to be not quite viable if they had known prior to making the deposit that they could instead each have a summer corporate internship. However, having committed the \$6000 deposit already, they will gain going forward by proceeding to run the ice cream bar business.
A similar situation can occur in ongoing business concerns. A struggling business may appear to generate insufficient revenue to cover costs yet continue to operate, at least for a while. Such a practice may be rational when a sizeable portion of the fixed costs in the near term are effectively sunk, and the revenue generated is enough to offset the remaining fixed costs and variable costs that are still not firmly committed.
Earlier in the chapter, we cited one condition for reaching a breakeven production level where revenue would equal or exceed costs as the point where average cost per unit is equal to the price. However, if some of the costs are already sunk, these should be disregarded in determining the relevant average cost. In a circumstance where a business regards all fixed costs as effectively sunk for the next production period, this condition becomes a statement of a principle known as the shutdown rule.
Definition: Shutdown Rule
If the selling price per unit is at least as large as the average variable cost per unit, the firm should continue to operate for at least a while; otherwise, the firm would be better to shut down operations immediately.
Two observations about the shutdown rule are in order: In a circumstance where a firm’s revenue is sufficient to meet variable costs but not total costs (including the sunk costs), although the firm may operate for a period of time because the additional revenue generated will cover the additional costs, eventually the fixed costs will need to be refreshed and those will be relevant economic costs prior to commitment to continue operating beyond the near term. If a business does not see circumstances changing whereby revenue will be getting better or costs will be going down, although it may be a net gain to operate for some additional time, such a firm should eventually decide to close down its business.
Sometimes, it is appropriate to shut down a business for a period of time, but not to close the business permanently. This may happen if temporary unfavorable circumstances mean even uncommitted costs cannot be covered by revenue in the near term, but the business expects favorable conditions to resume later. An example of this would be the owner of an oil drilling operation. If crude oil prices drop very low, the operator may be unable to cover variable costs and it would be best to shut down until petroleum prices climb back and operations will be profitable again. In other cases, the opportunity cost of resources may be temporarily high, so the economic profit is negative even if the accounting profit would be positive. An example would be a farmer selling his water rights for the upcoming season because he is offered more for the water rights than he could net using the water and farming. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.07%3A_The_Conclusion_for_Our_Students.txt |
In the example used in this chapter, we assumed the students’ goal in how to operate the ice cream business was to maximize their profit—more specifically, to maximize their economic profit. Is this an appropriate overall objective for most businesses?
Generally speaking, the answer is yes. If a business is not able to generate enough revenue to at least cover their economic costs, the business is losing in the net. In addition to the business owners having to cover the loss out of their wealth (or out of society’s largesse for a bankruptcy), there is an inefficiency from a societal perspective in that the resources used by the business could be more productive elsewhere.
The ice cream business analyzed here was simple in many respects, including that it was intended to operate for only a short period of time. Most businesses are intended to operate for long periods of time. Some businesses, especially newly formed businesses, will intentionally operate businesses at a loss or operate at volumes higher than would generate the maximum profit in the next production period. This decision is rational if the business expects to realize larger profits in future periods in exchange for enduring a loss in the near future. There are quantitative techniques, such as discounting,Many accounting and economics texts discuss the concept of discounting of profits over time. One good discussion can be found in an appendix in Hirschey and Pappas (1996). that allow a business decision maker to make these trade-offs between profit now and profit later. These techniques will not be covered in this text.
Economists refer to a measure called the value of the firm, which is the collective value of all economic profits into the future and approximately the amount the owners should expect to receive if they sold the business to a different set of owners. For a corporation, in theory this would roughly equate to the value of the equity on a company’s balance sheet, although due to several factors like sunk costs, is probably not really that value. Economists would say that a business should make decisions that maximize the value of the firm, meaning the best decisions will result in larger economic profits either now or later.
One response to the principle that the overall goal of a firm is to maximize its value is that, although that goal may be best for those who own the business, it is not the optimal objective for the overall society in which the business operates. One specific objection is that those who work for the business may not be the same as those who own the business and maximizing the value for the owners can mean exploiting the nonowner employees. The common response to this objection is that it will be in the owners’ best interest in the long run (several periods of operation) to treat their employees fairly. Businesses that exploit their employees will lose their good employees and fail to motivate those employees who remain. The collective result will be lower profits and a lower value of the firm.
A second objection to the appropriateness of operating a business to maximize the value for the owners is that this invites businesses to exploit their customers, suppliers, and the society in which they operate to make more money. Firms may be able to take advantage of outside parties for a while, but eventually the customers and suppliers will wise up and stop interacting with the business. With a high level of distrust, there will be a decline in profits in future periods that will more than offset any immediate gain. If a business tries to exploit the overall society by ruining the environment or causing an increase in costs to the public, the business can expect governmental authorities to take actions to punish the firm or limit its operations, again resulting in a net loss over time. So maximizing the value of the firm for the owners does not imply more profit for the owners at the expense of everyone else. Rather, a rational pursuit of maximal value will respect the other stakeholders of a business.
In the case of nonprofit organizations, maximizing the value of the organization will be different than with for-profit businesses like our ice cream example. A nonprofit organization may be given a budget that sets an upper limit on its costs and is expected to provide the most value to the people it serves. Since most nonprofit organizations do not charge their “customers” in the same way as for-profit businesses, the determination of value will be different than estimating sales revenue. Techniques such as cost-benefit analysis (a classic text in cost-benefit analysis was written by E. J. Mishan (1976)). have been developed for this purpose. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/02%3A_Key_Measures_and_Relationships/2.09%3A_A_Final_Word_on_Business_Objectives.txt |
• 3.1: Theory of the Consumer
Previously, we used a demand curve to represent the relationship between the price charged for ice cream bars and the maximum number of ice cream bars that customers would purchase. We will address how to create a demand curve later in this chapter, but we will begin our discussion with a brief review of microeconomic theory that endeavors to explain how consumers behave.
• 3.2: Is the Theory of the Consumer Realistic?
Strictly speaking, it would be difficult to make a case that the theory of the consumer conforms to our own experience of consumption decisions or what we observe of other consumers. We don’t consciously weigh the relative marginal utilities of tens of thousands of possible goods and services we might consume. We don’t know all the current prices and don’t even know of the existence of many goods and services.
• 3.3: Determinants of Demand
We can approach the challenge of modeling consumer behavior in a more practical manner that is informed by the theory of the consumer. To estimate demand and study the nature of consumer demand, we start by identifying a set of key factors that have a strong influence on consumer demand.
• 3.4: Modeling Consumer Demand
To develop a formal model of consumer demand, the first step is to identify the most important determinants of demand and define variables that measure those determinants. Ideally, we should use variables for which data exist so that statistical estimation techniques can be applied to develop an algebraic relationship between the units of a good consumed and the values of the key determinants.
• 3.5: Forecasting Demand
dentifying the key determinants of demand and developing demand functions gives a business manager a better understanding of his customers. A benefit of that understanding is an improved accuracy in forecasting the demand levels for their products and services in an upcoming period. Most businesses need to plan production activities well in advance of when the goods and services are actually provided to the consumer.
• 3.6: Elasticity of Demand
An alternative approach to measuring the sensitivity of demand to its determinant factors is to assess the ratio of percentage change in demand to the percentage change in its determinant factor. This type of measurement is called an elasticity of demand.
• 3.7: Consumption Decisions in the Short Run and the Long Run
Economists distinguish short-run decisions from long-run decisions. A consumer decision is considered short run when her consumption will occur soon enough to be constrained by existing household assets, personal commitments, and know-how. Given sufficient time to remove these constraints, the consumer can change her consumption patterns and make additional improvements in the utility of consumption.
• 3.8: Price Discrimination
In economics, the term for charging different prices to different customers is called price discrimination. Economists have actually defined multiple types of price discrimination, called first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination.
03: Demand and Pricing
Back in Chapter 2, we used a demand curve to represent the relationship between the price charged for ice cream bars and the maximum number of ice cream bars that customers would purchase. We will address how to create a demand curve later in this chapter, but we will begin our discussion with a brief review of microeconomic theory that endeavors to explain how consumers behave.
A consumer is someone who makes consumption decisions for herself or for her household unit. In a modern society, consumption is largely facilitated by purchases for goods and services. Some of these goods and services are essential to a consumer’s livelihood, but others are discretionary, perhaps even a luxury. Consumers are limited in how much they can consume by their wealth. A consumer’s wealth will change over time due to income and expenditures. She might be able to borrow against future income so as to increase her capacity to purchase now in exchange for diminished wealth and consumption later. Similarly, she may retain some of her current wealth as savings toward increased future consumption. Consumption decisions may be planned into the future, taking account of the expected changes in wealth over time.
The theory of the consumer posits that a consumer plans her purchases, the timing of those purchases, and borrowing and saving so as maximize the satisfaction she and her household unit will experience from consumption of goods and services. In this theory, consumers are able to compare any two patterns of consumption, borrowing, and saving and deem that either one is preferred to the second or they are indifferent between the two patterns. Based on the ability to do these comparisons, consumers look at the prices charged for various services now, and what they expect prices to be for goods and services in the future, and select the pattern of consumption, borrowing, and saving that generates the greatest satisfaction over their lifetime within the constraint of their wealth and expected future income.
Although the consumers may anticipate changes in prices over time, they may find that their guesses about future prices are incorrect. When this happens, the theory states that they will adjust their consumption, borrowing, and saving to restore the optimality under the newly revealed prices. In fact, the theory identifies two effects of price changes: the substitution effect and the income effect.
The substitution effect is based on an argument employing marginal reasoning like the marginal analysis discussed in Chapter 2. Economists often use the term utility as a hypothetical quantitative value for satisfaction that a consumer receives from a pattern of consumption. If a consumer were to receive one more unit of some good or service, the resulting increase in their utility is called the marginal utility of the good. As a consequence of maximizing their overall satisfaction from consumption, or equivalently maximizing their utility, it will be the case that if you take the marginal utility of one good or service and divide it by its price, you should get the same ratio for any other good or service. If they were not roughly equal, the consumer would be able to swap consumption of one good or service for another, keep within their wealth constraint, and have higher utility. The substitution effect is the consumer’s response to a changing price to restore balance in the ratios of marginal utility to price.
Just as a simple illustration, suppose a consumer likes bananas and peaches as a treat. For the sake of the illustration, let’s suppose an additional banana has a marginal utility of 2 and a peach has a marginal utility of 3. If a banana costs \$0.20 and a peach costs \$0.30, bananas and peaches have a ratio of the marginal utility to its price equal to 10. If the peach price increases to \$0.40, the ratio will become lower for peaches and the consumer may substitute some purchases of peaches with purchases of more bananas.
As the result of price changes and substitution, the consumer’s overall utility may increase or decrease. Consequently, the consumer may experience the equivalent of an increase or decrease in wealth, in the sense that it would have required a different level of wealth to just barely afford the new consumption pattern under the previous set of prices. This equivalent change in purchasing power is called the income effect.
Economists have precise techniques for separating the response to a price change into a substitution effect and an income effect.See Varian (1993) for a discussion of the substitution effect, income effect, and Giffen goods. This is beyond the scope of this text. For our purposes, it is sufficient to appreciate that price changes will affect the mix of goods and services that is best and change the consumer’s overall level of satisfaction.
In most cases, the primary response to a price change is a substitution effect, with a relatively modest income effect. However, for goods and services that a consumer cannot substitute easily, a sizeable price change may have a significant income effect. For example, when gasoline prices jumped dramatically in the United States, consumers may have reduced their driving somewhat but were unable to find a substitute for the essential needs served by driving their cars. As a result, consumers experienced a dramatic drop in wealth available for other goods and services and consumed generally less of all of those to compensate for the greater expenditure on gasoline.
Normally, price increases result in less consumption of the associated good or service, whereas price decreases results in more consumption. This typical pattern is usually supported by both the substitution effect and the income effect. An interesting exception is the case of Giffen goods, which is a situation where consumption of a good or service may increase in response to a price increase or decrease in response to a price decrease. This anomaly is explained by a strong income effect. An economist named Robert Giffen discovered that Irish consumers increased the use of potatoes in their diet during the Irish Potato Famine of the 1840s, even though the price of potatoes rose dramatically. Basically, because potatoes were a staple of the Irish diet, when the potato price increased, the wealth available to purchase other food items diminished and Irish consumers wanted to purchase more potatoes to compensate for the diminished purchases of other food items. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.01%3A_Theory_of_the_Consumer.txt |
Strictly speaking, it would be difficult to make a case that the theory of the consumer conforms to our own experience of consumption decisions or what we observe of other consumers. We don’t consciously weigh the relative marginal utilities of tens of thousands of possible goods and services we might consume. We don’t know all the current prices and don’t even know of the existence of many goods and services. Even if we did, the computational complexity to solve for optimal consumption would overwhelm our faculties, and probably even the fastest computers available.
Many times we and others don’t think of our consumption in terms of what gives us the greatest satisfaction but in terms of what it takes to get by. Consumers who are impoverished or suffer a major ailment are probably unable to do even a modest attempt at optimizing consumption. Others may simply consume as a matter of habit rather than conscious choice.
Although our consumption decisions may not fully conform to the theory of the consumer, there have been some attempts to argue that we do approximate it. Herbert Simon proposed a theory of bounded rationality (bounded rationality and satisficing are discussed in Simon (1997)). that states that humans do behave rationally with a limited range of options. So if consumers focus on a modest set of important goods and services, they may be able to achieve something close to the theoretical optimum in terms of overall utility. Simon also observed that human beings may not optimize so much as they “satisfice,” meaning that they work to meet a certain level of consumption satisfaction rather than the very best pattern of consumption. If the level of acceptability is reasonably close to the optimum level, again the results of consumption decisions may approximate what would occur if the consumers operated according to this theory.
Another argument suggesting that differences between the theory and actual behavior may not result in starkly different consumption is that we observe how others behave. If someone else, either by active choice or by accidental discovery, is experiencing greater satisfaction under similar circumstances of wealth and income, their friends and neighbors will detect it and start to emulate their consumption patterns. So our consumption may evolve in the direction of the optimal pattern.
Perhaps most importantly, the lack of face validity of the theory of the consumer does mean the theory is not useful in modeling consumer behavior. We do expect consumers to respond to price changes and we do expect consumers to respond to changes in their wealth, whether due to changes in their actual discretionary income or indirect impacts on wealth resulting from price changes.
3.03: Determinants of Demand
We can approach the challenge of modeling consumer behavior in a more practical manner that is informed by the theory of the consumer. To estimate demand and study the nature of consumer demand, we start by identifying a set of key factors that have a strong influence on consumer demand.
Probably the most important influencing factor is one we considered for the ice cream business in Chapter 2—the price of the item itself. Price is also the key determinant of demand in the theory of the consumer. In the simplest cases, there is a single price that applies to any item or unit of service being sold. However, as we will discuss later in the section on price discrimination, prices may vary depending on who is buying it and how much they are buying.
Businesses incur promotional costs to boost the consumption of their products. Promotion can be in the form of advertising, free samples, appearance in business directories, and so on. The theory of the consumer provides a supporting rationale for expenditure on promotion: If a consumer is regarded as deciding how to allocate his wealth across available goods and services, in order for your product to be included as a candidate in that choice, the consumer has to be aware that your product or service exists. However, as we will discuss in Chapter 7, large firms often engage in promotion at expenditure levels well beyond what is needed to make your firm and product known to the consumer, as a tactic of competition.
Consumer demand may vary depending on where and when the consumption is occurring. Being able to quantitatively assess how consumption changes by location or time is a powerful tool in deciding where and when to sell your product. Some businesses decide to serve broad geographical regions; others target specific locations. Some businesses sell most or all times of the day and days of the year; others limit their operations to a restricted number of hours or periods within a year. What strategy will work best will depend on the product and the company’s overall marketing strategy.
Businesses have a choice of channels for selling. They can operate their own commercial establishments or sell wholesale to other retailers. Goods can be sold directly at a retail site or via the Internet, telephone, or mail order. Understanding how the channels used will affect demand is important.
The selection of price, promotional activities, location, and channel are generally in the control of the business concern. In texts on marketing strategy,Kotler and Armstrong (2010) is a popular text on marketing principles. the composition of these decisions is called a marketing mix. For a marketing mix to be effective, the different elements need to be consistent.
However, there are other important determinants of consumption for a good or service that are largely out of the control of the providing firm. We will next consider some of these determinants.
As suggested by the substitution effect in the theory of the consumer, the consumer is able to alter his pattern of consumption to meet his needs as prices and wealth levels change. The most significant swaps are likely to be between goods and services that come close to meeting the same consumer need. For example, a banana can serve as a substitute for a peach in meeting the need for a piece of fruit. Usually the items that act as substitutes to the product of one firm will be sold by a different firm. Consequently, how that other firm elects to price, promote, locate, and channel its goods or services will have an impact on the consumption of substitutable goods or services sold by the first firm.
Different goods and services can be strongly related in another way called a complementary relationship. Consumption of some goods and services can necessitate greater consumption of other goods and services. For example, if more automobiles are sold, there will be increased demand for tires, oil, repair services, automobile financing, automobile insurance, and so on. Correctly monitoring and forecasting the demand of key complements can improve the ability of a firm to forecast its own consumer demand.
Most firms sell multiple products and services that are related. Within this collection, there are probably important substitute and complementary relationships. A car dealer that sells several models of vehicles has substitutable products that compete with each other. The car dealer may be offering services like repair service and financing that are complementary to vehicle sales. In situations with strong substitute and complementary product relationships, the firm needs to consider these in its demand forecasting and market strategy.
Earlier, we discussed the income effect caused by price changes and indicated that this is caused by the consumer realizing an increase or decrease in overall purchasing wealth. Probably a more significant cause of changes in wealth occurs from fluctuations in the economic activity, which will affect the demand for most goods and services. The relationship between demand quantities and economic indicators of economic activity or disposable income can improve business forecasting considerably.
Demand is also affected by the demographics of the population of eligible customers. How many people live in a region, their ethnic and socioeconomic composition, and age distribution can explain variations in demand across regions and the ability to forecast in the future as these demographics change. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.02%3A_Is_the_Theory_of_the_Consumer_Realistic.txt |
To develop a formal model of consumer demand, the first step is to identify the most important determinants of demand and define variables that measure those determinants. Ideally, we should use variables for which data exist so that statistical estimation techniques can be applied to develop an algebraic relationship between the units of a good consumed and the values of the key determinants. Techniques to derive these algebraic relationships from historical data are outside the scope of this text, but an interested reader may want to consult a text on econometrics. Stock and Watson (2007) is an established econometrics text.
We will examine a simple example of a model of consumer demand. Suppose a business is selling broadband services in a community. The managers of the business have identified four key determinants of demand: (a) the price they charge for the service, (b) their advertising expenditure, (c) the price charged by the competition, and (d) the disposable income of their potential customers. They define four variables to measure these determinants:
• $P$ = the price per month of their service, in dollars,
• $A$ = advertising expenditure per month, in dollars,
• $CP$ = the price per month of the competitor’s service, in dollars,
• $DIPC$ = the disposable income per capita, in dollars, as measured by the U.S. Department of Commerce for that month.
Using past data, they estimate the following equation to relate these variables to number of broadband subscribers to their service during a month, symbolized by $Q$:
$Q = 25,800 − 800 P + 4 A + 200 CP + 0.4 DIPC.$
This relationship is called a demand function.
One application of the demand function is to estimate the consumption quantity $Q$ for specific values of $P$, $CP$, and $DIPC$. Suppose $P$ = $30, A =$5000, CP = $25, and $DIPC$ =$33,000:
$Q = 25,800 − 800(30) + 4(5000) + 200(25) + 0.4(33,000) = 40,000 \,\text{subscribers}$
In Chapter 2, we introduced a demand curve to describe the relationship between the quantity of items sold and the price of the item. When there are multiple determinants of demand, the demand curve can be interpreted as a reduced view of the demand function where only the price of the product is allowed to vary. Any other variables are assumed to remain at a fixed level. For the previous demand function for broadband service, suppose we assume A is fixed at $5000, $CP$ is fixed at$25, and $DIPC$ is fixed at $33,000. If you substitute these values into the demand function and aggregate constant terms, the demand function becomes $Q = 64,000 − 800 P.$ Recall that demand curves are usually expressed with price as a function of quantity. With some basic algebra the equation of the demand curve can be written as $P = 80 − 0.00125 Q.$ What happens to the demand curve if one of the other variables is a different value? Well, in short, the demand curve would shift. Suppose the competitor decides to increase its price to$35. Repeating the preceding steps, the demand function simplifies to
$Q = 66,000 − 800 P$
or, expressed with $P$ as a function of Q,
$P = 82.50 − 0.00125 Q.$
Figure 3.1 shows a graph of the demand curve before and after the shift. Effectively, the result is that the broadband firm would see its demand increase by 2000 customers per month, or alternatively, the firm could raise its price to \$32.50 and still maintain 40,000 customers per month. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.04%3A_Modeling_Consumer_Demand.txt |
Identifying the key determinants of demand and developing demand functions gives a business manager a better understanding of his customers. A benefit of that understanding is an improved accuracy in forecasting the demand levels for their products and services in an upcoming period. Most businesses need to plan production activities well in advance of when the goods and services are actually provided to the consumer. Businesses need to have an adequately sized operation, have a sufficient staff in terms of size and training, and obtain any necessary resources for production. These capabilities are usually not possible to achieve overnight. For some goods, production is a process that takes significant time from initiation to completion, such as constructing apartments or office space that will be leased to customers. Even businesses that provide products or services “made to order,” where most of the direct organization or production activities occur after a purchase is made, usually need to have supplies, trained labor, and management structures in place in advance of the order to be in a position to negotiate a sale.Without some concrete estimate of what level of demand will result after these planning, designing, and production activities, a business may find itself with an excess of unused capacity or unable to serve the demand that follows. Excess capability is costly because idle resources have an opportunity cost but do not contribute to sales or revenue, especially when the unused resources spoil and cannot be used at a later time. When businesses set production targets too low, they discover missed opportunities for profit and unmet demand that is likely to discourage those consumers from being customers in the future.
To a limited extent, a business may be able to alter future demand to be more in line with its capacity because it has control over some determinants of demand, like pricing, promotion, and location. If the business is surprised by demand levels that are higher or lower than expected, these market strategy elements can be adjusted to either stimulate or diminish demand to conform to its production capabilities. Still, the financial performance of an enterprise is improved when the demand is consistent with the levels anticipated in the initial planning stages.
Further, most businesses are not in control of all the key determinants of demand. The business cannot control the direction of the overall economy and consumer incomes. The business may be able to guess at, but not control, actions by other companies that sell substitute and complementary goods and services. Anticipating the impact of these outside forces is critical.
Businesses can improve demand forecasting with their demand functions using the future values of determinant variables in those demand functions. Forecasts for widely followed economic indicators like disposable income are available from public releases or private forecasting services. If the business has a record of data for these uncontrollable variables, they can apply quantitative forecasting techniques like time series analysis or develop casual models that relate these factors to other variables that can be forecast. Readers are encouraged to look at a text in business forecasting for assistance in doing quantitative forecasts (one business forecasting text is a book authored by Hanke and Wichern (2009)).
For variables where past patterns may not continue into the future, like competitor actions on pricing and promotion or unexpected climate events, a business can construct scenarios in which management postulates settings for these factors and then develops a demand forecast for each scenario. Although the future will almost certainly not conform exactly to any single scenario, the exercise prepares them to monitor for changes in these factors and be ready to make a prompt response whenever a similar scenario emerges. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.05%3A_Forecasting_Demand.txt |
Another use of a mathematical demand function is measuring how sensitive demand is to changes in the level of one of the determinants. Suppose we would like to assess whether the demand for broadband service will change much in response to a change in its price. One indicator of the level of response to a price change is the coefficient of the price term in the demand function equation, –800 P. The interpretation of the coefficient –800 is that for each increase of $1 in the monthly subscriber price, the number of monthly subscribers will decrease by 800 subscribers. This observation provides some insight, particularly if the broadband firm is considering a price change and would like to know the impact on the number of subscribers. However, for someone who measures price in terms of a different currency, say Japanese yen, a conversion to U.S. dollars would be needed to appreciate whether the demand change implied by the coefficient value is large or modest. Another limitation of this approach to measuring the responsiveness of demand to a determinant of demand is that the observation may not apply readily to other communities that may have a larger or smaller population of potential customers. An alternative approach to measuring the sensitivity of demand to its determinant factors is to assess the ratio of percentage change in demand to the percentage change in its determinant factor. This type of measurement is called an elasticity of demand. Assessing the elasticity of demand relative to changes in the price of the good or service being consumed is called the own-price elasticity or usually just the price elasticity. As an illustration of this, suppose we want to measure the sensitivity of demand for broadband services corresponding to a modest change in its price. First, to determine the price elasticity, you need to clearly understand the settings for all the determinant factors because elasticity changes if you look at a different configuration of factor levels. Suppose we decide to find the price elasticity when P =$30, A = $5000, CP =$25, and DIPC = $33,000. Earlier we determined that the demand quantity at this setting was Q = 40,000 monthly subscribers. If we let the price increase by 10% from$30 to \$33 and repeat the calculation of Q in the demand function, the value of Q will decline to 37,600 subscribers, which is a decline of 2400 customers. As a percentage of 40,000 monthly customers, this would be a 6% decrease. So the price elasticity here would be
$\text{Price elasticity} = \dfrac{–6\%}{10\%} = –0.6. \nonumber$
Since the law of demand states that quantity demanded will drop when its price increases and quantity demanded will increase when its price decreases, price elasticities are usually negative numbers (other than special cases like Giffen goods, described earlier in this chapter).
Goods and services are categorized as being price elastic whenever the price elasticity is more negative than –1. In this category, the percentage change in quantity will be greater than the percentage change in price if you ignore the negative sign.
When the computed price elasticity is between 0 and –1, the good or service is considered to be price inelastic. This does not mean that demand does not respond to changes in price, but only that the response on a percentage basis is lower than the percentage change in price when the negative sign is ignored.
In those rare instances where price elasticities are positive, the product violates the law of demand. Again, these are similar to the Giffen goods discussed earlier.
By assessing sensitivity to changes on a percentage basis, it does not matter what units are used in the variable measurements. We could have constructed our demand function with a price measurement in cents or euros, and the price elasticity would have been the same. Also, if we wanted to compare the price elasticity of broadband service in this community with the price elasticity of broadband service in a larger community, we could compare the price elasticities directly without any need for further adjustment.
Another important class of elasticities is the response of demand to changes in income, or the income elasticity. For our broadband example, if we were to calculate the income elasticity at the same point where we calculated the price elasticity, we would have found an elasticity of 0.33. The interpretation of this value is as follows: For an increase of 1% in income levels, demand for broadband will increase by 0.33%.
When income elasticity of a product is greater than one, we call the product a cyclic good. The adjective “cyclic” suggests that this demand is sensitive to changes in the business cycle and will generally change more on a percentage basis than income levels. Luxury goods that customers can do without in hard economic times often fall in this category.
When income elasticity is between zero and one, we call the product a noncyclic good. Our broadband service falls in this category. The demand for noncyclic goods tends to move up and down with income levels, but not as strongly on a percentage basis. Most of the staple goods and services we need are noncyclic.
Normally we would expect demand for a good or service to increase when incomes increase and decrease when incomes decrease, other things being equal. However, there are arguably some exceptions that do not behave this way. Low-cost liquor, which might see increased use in hard economic times, is one of these possible exceptions. When income elasticity is negative, we call the product a countercyclic good.
When elasticities are calculated to measure the response of demand to price changes for a different good or service, say either a substitute product or complementary product, we call the calculated value a cross-price elasticity. Cross-price elasticities tend to be positive for substitute goods and negative for complementary goods. In our example, the competitor’s service is a substitute good. If we calculate the cross-price elasticity for changes in the competitor’s price on demand for broadband service at the point examined earlier, the result is 0.125.
Elasticities can be calculated for any factor on demand that can be expressed quantitatively. In our example, we could also calculate an advertising elasticity, which has a value of 0.5 at the given settings for the four factors in our demand function. This value indicates that an increase of 1% in our monthly advertising will result in a 0.5% increase in subscribers.
In interpreting and comparing elasticities, it is important to be clear whether the elasticity applies to a single business in a market or to all sellers in a market. Some elasticities, like price elasticities and advertising elasticities, tend to reflect greater sensitivity to changes in the factor when an elasticity is calculated for a single business than when assessed for the total demand for all sellers in a market. For example, we noted earlier that consumers will be unable to decrease gasoline consumption much, at least immediately, even if gasoline prices climb dramatically. This implies that gasoline is very price inelastic. However, this observation really applies to the gasoline industry as a whole. Suppose there was a street intersection in a city that has a gasoline station on every corner selling effectively the same product at about the same price, until one station increases its price dramatically (believing gasoline was highly inelastic to changes in price, so why not), but the other three stations leave their price where it was. If prices were clearly displayed, most customers would avoid the station that tried to increase the price and that station would see nearly all of its business disappear. In this situation where the competitors’ goods are highly substitutable, the price elasticity for a single gasoline station would be very price elastic.
3.07: Consumption Decisions in the Short Run and the Long Run
The main reason most consumers are unable to respond very quickly to an increase in gasoline prices is because there is not an effective substitute for automobile travel. However, if consumers were convinced that gasoline prices were going to continue to rise into the foreseeable future, they would gradually make changes to their lifestyles so that they are able to reduce gasoline consumption significantly. They could purchase more fuel-efficient cars or cars that use an alternative fuel, or they could change jobs or change residences so that they are closer to their places of employment, shopping, and such.
Economists distinguish short-run decisions from long-run decisions. A consumer decision is considered short run when her consumption will occur soon enough to be constrained by existing household assets, personal commitments, and know-how. Given sufficient time to remove these constraints, the consumer can change her consumption patterns and make additional improvements in the utility of consumption. Decisions affecting consumption far enough into the future so that any such adjustments can be made are called long-run decisions.
Demand functions and demand curves can be developed for short-run or long-run time horizons. Short-run demand curves are easier to develop because they estimate demand in the near future and generally do not require a long history of data on consumption and its determinant factors. Because long-run demand must account for changes in consumption styles, it requires longer histories of data and greater sophistication.
Elasticities of demand in the short run can differ substantially from elasticities in the long run. Long-run price elasticities for a product are generally of higher magnitude than their short-run counterparts because the consumer has sufficient time to change consumption styles.
There is so much uncertainty about long-run consumption that these analyses are usually limited to academic and government research. Short-run analyses, on the other hand, are feasible for many analysts working for the businesses that must estimate demand in order to make production decisions. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.06%3A_Elasticity_of_Demand.txt |
In the ice cream bar summer business in Chapter 2, we presumed that the student operators would decide on a price to charge. All ice cream bars would be sold at that price. We reasoned that more ice cream bars could be sold as the price is decreased. If the students decide to charge \$1.50 per ice cream bar, a potential customer will decide if the utility of the ice cream bar is sufficiently high for them to be willing to give up \$1.50 of their wealth. If not, they will walk away without making a purchase. If the students instead decide to charge \$1.80 per ice cream bar, the demand curve indicated that 6000 fewer unit purchases would occur, meaning 6000 of those purchases were not worth \$1.80 to the purchasers. However, some of the customers would have been willing to pay over \$2.00, and fewer even more than \$2.50 or \$3.00.
When all consumers pay the same price, some of them get a kind of surplus because they would have been willing to pay more for the ice cream bar. Sellers may wish they were able to charge customers the maximum amount they are willing to pay, which would result in more revenue and no added cost. In economics, the term for charging different prices to different customers is called price discrimination. Economists have actually defined multiple types of price discrimination, called first-degree price discrimination, second-degree price discrimination, and third-degree price discrimination.
First-degree price discrimination is an attempt by the seller to leave the price unannounced in advance and charge each customer the highest price they would be willing to pay for the purchase. If perfectly executed, this would meet the ideal of getting the greatest revenue possible from sales. Unfortunately, anything close to perfect execution of first-degree price discrimination is unrealistic because customers have an incentive to not reveal how much they would be willing to pay and instead try to pay as little as possible. Attempts to sell using first-degree price discrimination may be illegal as well, as it may be deemed discriminatory in the legal sense of the word.
Some commercial dealings resemble attempts at first-degree price discrimination. Sometimes there is no set price, and the buyer and seller negotiate a price. This is the customary way that automobiles have been sold in the United States. The process may start with a preannounced price, but one that is usually higher than the seller actually expects to receive. This falls short of pure first-degree discrimination because the buyer is probably able to negotiate down from the most he would pay, possibly quite a bit if the buyer is a good negotiator. In addition, there is time and effort expended in the negotiating, which is a kind of cost to the transaction that the buyer may see as part of the purchase cost and the seller may see as an added cost of business.
Goods and services are sometimes sold or purchased via an auction. This is usually an effective means when the seller has a limited number of items to sell. Run properly, an auction will distinguish those willing to pay more, although it probably will not manage to get a bid as high as the maximum the buyer would have paid. Again, the cost of operating an auction is expensive in comparison to selling using a set, preannounced price.
Businesses that sell a product that is in demand with no good substitute available will sometimes employ a sliding price, where they begin selling at a very high price that is attractive to relatively few consumers. After a time when presumably those high-value customers make their purchases, the business will drop the price somewhat and attract purchases from another group that was willing pay slightly less than the first group. Successive price drops can continue until it would be unprofitable for the seller to drop the price any lower. Sliding prices are sometimes used with products that employ new technologies, when the initial seller has the market to itself, at least for a while, and offers a got-to-have item for some customers. Of course, although these eager customers may be willing to pay more, they may be aware of this pricing strategy and delay their purchase, so this approach will not extract the full value customers would have been willing to pay.
When goods and services are sold according to a preannounced price, the customary arrangement is that the charge for multiple items is the price times the number of items. This is called linear pricing. However, customers differ in the volume they are interested in purchasing. A business may benefit by offering different prices to those who purchase in larger volumes because either they can increase their profit with the increased volume sales or their costs per unit decrease when items are purchased in volume. Businesses can create alternative pricing methods that distinguish high-volume buyers from low-volume buyers. This is second-degree price discrimination.
A donut shop might offer a free donut to anyone who purchases a whole dozen because the purchase requires less clerk time per donut sold and increases how many donuts get purchased. However, since only those who buy at least a dozen donuts get a free donut, the discount is limited to those people and not the customer who purchases just a donut or two. This would be second-degree price discrimination.
Another nonlinear pricing scheme to employ second-degree discrimination is a two-part price. A customer pays a flat charge to be a customer and then pays a per unit charge based on how much they consume. Some services like telephone service are primarily fixed cost and have a very small per unit variable cost. By charging telephone customers a flat monthly fee and low per unit charge, they encourage more use of the service than if they simply charged a linear price per unit and see more revenue in relation to costs. Membership stores that require customers to pay an entry fee before being allowed to shop, but offer lower prices than regular stores for purchased items, is another example of a two-part pricing.
Third-degree price discrimination is differential pricing to different groups of customers. One justification for this practice is that producing goods and services for sale to one identifiable group of customers is less than the cost of sales to another group of customers. For example, a publisher of music or books may be able to sell a music album or a book in electronic form for less cost than a physical form like a compact disc or printed text.
A second justification for charging different prices to different groups of customers is that one group may be more sensitive to price than the other group. Earlier we discussed elasticity of demand. If we separated the demand for the two groups into separate demand curves, at any given price the more price sensitive group will have stronger negative price elasticity. Sellers are able to increase economic profit by charging a lower price to the price-elastic group and a higher price to the more price-inelastic group. As an example, 25 years ago music was sold in two formats: cassette tapes and compact discs. The production cost of a cassette tape was roughly equivalent to a compact disc, but music on compact discs often retailed at a higher price because it was perceived that customers of compact discs were more demanding of quality and more price inelastic.
To apply third-degree price discrimination, the seller must be able to clearly identify and sort the customer by a salient characteristic. For example, a cable provider may be aware that existing subscribers are price inelastic relative to other households that are not existing customers. The cable provider will typically charge reduced rates to attract new customers and is able to execute the price discrimination because it knows whether a customer is an existing customer or not. A sports clothing retailer may know that fans of a team are more price inelastic in the purchase of apparel displaying the name or mascot of that team than customers who are not fans. However, if the clothing retailer were to attempt to charge differential prices, the customers who are fans would have the incentive to disguise that characteristic, so third-degree price discrimination would not work well in this case. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/03%3A_Demand_and_Pricing/3.08%3A_Price_Discrimination.txt |
In Chapter 2, we cited average cost as a key performance measure in producing a good or service. Average cost reflects the cost on a per unit basis. A portion of the average cost is the amount of variable costs that can be assigned to the production unit. The other portion is the allocation of fixed costs (specifically those fixed costs that are not sunk), apportioned to each production unit.
The average cost generally varies as a function of the production volume per period. Since fixed costs do not increase with quantity produced, at least in the short run where production capabilities are relatively set, the portion of the average cost attributable to fixed cost is very high for small production volume but declines rapidly and then levels off as the volume increases.
The portion of average cost related to the variable cost usually changes less dramatically in response to production volume than the average fixed cost. In fact, in the example of the ice cream bar business in Chapter 2, we assumed the average variable cost of an ice cream bar would remain \$0.30 per unit whether the operation sold a small volume or large volume of ice cream bars. However, in actual production environments, average variable cost may fluctuate with volume.
At very low production volumes, resources may not be used efficiently, so the variable cost per unit is higher. For example, suppose the ice cream bar venture operators purchase those bars wholesale from a vendor who delivers them in a truck with a freezer. Since the vendor’s charge for ice cream bars must cover the cost of the truck driver and truck operation, a large delivery that fills the truck is likely to cost less per ice cream bar than a very small delivery.
At the same time, pushing production levels to the upper limits of an operation’s capability can result in other inefficiencies and cause the average variable cost to increase. For example, in order to increase production volume in a factory, it may be necessary to pay workers to work overtime at a rate 1.5 times their normal pay rate. Another example is that machines may be overworked to drive higher volume but result in either less efficiency or higher maintenance cost, which translates into an increase in average variable cost.
Figure 4.1 shows a general breakdown of average cost into average fixed cost and average variable cost. The figure reflects the earlier situations of variable cost inefficiencies at very low and very high production volumes. Note that even with the continued decline in the average fixed cost, there is a production level (marked Q*) where the average total cost is at its lowest value. Economists called the production volume where average cost is at the lowest value the capacity of the operation.
In conversational language, we often think of capacity of a container as the maximum volume the container can hold. In that sense of the word, it seems awkward to call the production level Q* the capacity when the graph indicates that it is possible to produce at higher volume levels but just that the average cost per unit will be higher. However, even in physics, the volume in a container can be changed by the use of pressure or temperature, so volume is not limited by the capacity under normal pressures and temperatures.
The production level corresponding to the lowest point on the graph for average cost indicates the short-run capacity of the business operation.
In the economic sense of the word, we might think of capacity as the volume level where we have the most efficient operation in terms of average cost. Many businesses can operate over capacity, up to some effective physical limit, but in so doing will pay for that supplemental production volume in higher costs, due to needing to employ either more expensive resources or less productive resources, creating congestion that slows production, or overusing resources that results in higher maintenance costs per unit.
If the price earned by the business at these overcapacity volumes is sufficiently high, the firm may realize more profit by operating over capacity than at the capacity point where total average cost is at its lowest. Similarly, if demand is weak and customers will pay a price well in excess of average cost only at volumes lower than capacity, the firm will probably do better by operating below capacity. However, if a firm that is operating well above capacity or well below capacity does not see this as a temporary situation, the discrepancy suggests that the firm is sized either too small or too large. The firm may be able to improve profits in future production periods by resizing its operations, which will readjust the capacity point. If the firm operates in a very competitive market, there may even be little potential for profit for firms that are not operating near their capacity level. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.01%3A_Average_Cost_Curves.txt |
In the last chapter, we distinguished short-run demand from long-run demand to reflect the range of options for consumers. In the short run, consumers were limited in their choices by their current circumstances of lifestyles, consumption technologies, and understanding. A long-run time frame was of sufficient length that the consumer had the ability to alter her lifestyle and technology and to improve her understanding, so as to result in improved utility of consumption.
There is a similar dichotomy of short-run production decisions and long-run production decisions for businesses. In the short run, businesses are somewhat limited by their facilities, skill sets, and technology. In the long run, businesses have sufficient time to expand, contract, or modify facilities. Businesses can add employees, reduce employees, or retrain or redeploy employees. They can change technology and the equipment used to carry out their businesses.
The classification of short-run planning is more an indication of some temporary constraint on redefining the structure of a firm rather than a period of a specific length. In fact, there are varying degrees of short run. In a very brief period, say the coming week or month, there may be very little that most businesses can do. It will take at least that long to make changes in employees and they probably have contractual obligations to satisfy. Six months may be long enough to change employment structures and what supplies a firm uses, but the company is probably still limited to the facilities and technology they are using.
How long a period is needed until decisions are long term varies by the kind of organization or industry. A retail outlet might easily totally redefine itself in a matter of months, so for them any decisions going out a year or longer are effectively long-term decisions. For electricity power generators, it can take 20 years to plan, get approvals, and construct a new power generation facility, and their long-term period can be in terms of decades.
One important characteristic that distinguishes short-run production decisions and long-run production decisions is in the nature of costs. In the short run, there are fixed costs and variable costs. However, in the long run, since the firm has the flexibility to change anything about its operations (within the scope of what is technologically possible and they can afford), all costs in long-run production decisions can be regarded as variable costs.
Another important distinction between short-run production and long-run production is in the firm’s ability to alter its capacity. In a decidedly short-run time frame, the firm’s capacity or point of lowest average cost is effectively fixed. The firm may elect to operate either under or slightly over their capacity depending on the strength of market demand but cannot readily optimize production for that selected output level. In the long run, the firm is able to make decisions that alter its capacity point by resizing operations to where the firm expects to have the best stream of profits over time.
Because a business has the ability to redesign all of its operations to suit a targeted level of production, average cost curves for long-run planning are flatter than short-run average cost curves. If it appears that a low-volume operation would yield the best returns, the firm can be downsized to remove the cost of excess capacity and arrive at a lower average cost than would be achievable in the short run. By expanding its capacity, a firm would be able to perhaps even lower average cost, but certainly avoid the inefficiencies of being overcapacity, should higher production levels appear to be better.
One way to think of a long-run average cost curve is that each point on the curve reflects the lowest possible average cost of an operation resized to be optimal for that level of production. For example, in Figure 4.2, the long-run average cost on curve LRAC at a production rate of 1000 units per period is the lowest cost, or cost at the capacity point, for a cost structure reflected by short-run average cost curve SRAC1. The long-run average cost at a production rate of 2000 units per production period is the lowest cost for average cost curve SRAC2 (which has a capacity of 2000). The long-run average cost at a production rate of 3000 units per production would be the average cost at capacity for SRAC3.
Like short-run average cost curves, long-run average cost curves trend downward at low target production rates, although the rate of decline in the long-run average cost curve is somewhat flatter due to the ability to readjust all factors of production. The typical reason for this declining long-run average cost curve at low production levels is because there are efficiencies in cost or production that can be exploited for modest increases in quantity. For example, for a business that is manufacturing major appliances or vehicles that require several assembly steps, in a larger operation it is possible to assign different assembly steps to different workers and, via this specialization, speed up the rate of production over what would be possible if the firm hired the same workers with each worker performing all assembly steps. As we pointed out in the previous chapter, customers who buy in large quantities can sometimes buy at a lower per unit price. Since most firms are buyers as well as sellers, and larger firms will buy in larger quantities, they can reduce the contribution of acquired parts and materials to the average cost.
The ability to reduce long-run average cost due to increased efficiencies in production and cost will usually eventually subside. The production level at which the long-run average cost curve flattens out is called the minimum efficient scale. (Since the business is able to adjust all factors of production in the long run, it can effectively rescale the entire operation, so the target production level is sometimes called the scale of the business.) In competitive seller markets, the ability of a firm to achieve minimum efficient scale is crucial to its survival. If one firm is producing at minimum efficient scale and another firm is operating below minimum efficient scale, it is possible for the larger firm to push market prices below the cost of the smaller firm, while continuing to charge a price that exceeds its average cost. Facing the prospect of sustained losses, the smaller firm usually faces a choice between getting larger or dropping out of the market.
The increase in capacity needed to achieve minimum efficient scale varies by the type of business. A bicycle repair shop might achieve minimum efficient scale with a staff of four or five employees and be able to operate at an average cost that is no different than a shop of 40 to 50 repair persons. At the other extreme, electricity distribution services and telephone services that have very large fixed asset costs and low variable costs may see the long-run average cost curve decline even for large production levels and therefore would have a very high minimum efficient scale.
Most firms have a long-run average cost curve that declines and then flattens out; however, in some markets the long-run average cost may actually rise after some point. This phenomenon often indicates a limitation in some factors of production or a decline in quality in factors of production if the scale increases enough. For example, in agriculture some land is clearly better suited to certain crops than other land. In order to match the yield of the best acreage on land of lower quality, it may be necessary to spend more on fertilizer, water, or pest control, thereby increasing the average cost of production for all acreage used.
Businesses that are able to lower their average costs by increasing the scale of their operation are said to have economies of scale. Firms that will see their average costs increase if they further increase their scale will experience diseconomies of scale. Businesses that have achieved at least their minimum efficient scale and would see the long-run average cost remain about the same with continued increases in scale may be described as having constant economies of scale.
The impact of an increase of scale on production is sometimes interpreted in terms of “returns to scale.” The assessment of returns to scale is based on the response to the following question: If all factors of production (raw materials, labor, energy, equipment time, etc.) where increased by a set percentage (say all increased by 10%), would the percent increase in potential quantity of output created be greater, the same, or less than the percent increase in all factors of production? If potential output increases by a higher percent, operations are said to have increasing returns to scale. If output increases by the same percent, the operations show constant returns to scale. If the percent growth in outputs is less than the percent increase in inputs used, there are decreasing returns to scale.
Returns to scale are related to the concept of economies of scale, yet there is a subtle difference. The earlier example of gained productivity of labor specialization when the labor force is increased would contribute to increasing returns to scale. Often when there are increasing returns to scale there are economies of scale because the higher rate of growth in output translates to decrease in average cost per unit. However, economies of scale may occur even if there were constant returns to scale, such as if there were volume discounts for buying supplies in larger quantities. Economies of scale mean average cost decreases as the scale increases, whereas increasing returns to scale are restricted to the physical ratio between the increase in units of output relative to proportional increase in the number of inputs used.
Likewise, decreasing returns to scale often translate to diseconomies of scale. If increasing the acreage used for a particular crop by using less productive acreage results in a smaller increase in yield than increase in acreage, there are decreasing returns to scale. Unless the acreage costs less to use, there will be an increase in average cost per unit of crop output, indicating diseconomies of scale. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.02%3A_Long-Run_Average_Cost_and_Scale.txt |
Most businesses provide multiple goods and services; in some cases, the number of goods and services is quite large. Whereas the motivation for providing multiple products may be driven by consumer expectations, a common attraction is the opportunity to reduce per unit costs. When a venture can appreciate such cost savings, the opportunity is called an economy of scope.
Of course, not just any aggregation of goods and services will create economies of scope. For significant economies of scope, the goods and services need to be similar in nature or utilize similar raw materials, facilities, production processes, or knowledge.
One type of cost savings is the ability to share fixed costs across the product and service lines so that the total fixed costs are less than if the operations were organized separately. For example, suppose we have a company that expands from selling one product to two similar products. The administrative functions for procurement, receiving, accounts payable, inventory management, shipping, and accounts receivable in place for the first product can usually support the second product with just a modest increase in cost.
A second type of cost savings occurs from doing similar activities in larger volume and reducing per unit variable costs. If multiple goods and services require the same raw materials, the firm may be able to acquire the raw materials at a smaller per unit cost by purchasing in larger volume. Similarly, labor that is directly related to variable cost may not need to be increased proportionally for additional products due to the opportunity to exploit specialization or better use of idle time.
In some cases, two or more products may be natural by-products of a production process. For example, in refining crude oil to produce gasoline to fuel cars and trucks, the refining process will create lubricants, fertilizers, petrochemicals, and other kinds of fuels. Since the refining process requires heat, the excess heat can be used to create steam for electricity generation that more than meets the refinery’s needs and may be sold to an electric utility. When multiple products occur at the result of a combined process, they are called joint products and create a natural opportunity for an economy of scope.
As with economies of scale, the opportunities for economies of scope generally dissipate after exploiting the obvious combinations of goods and services. At some point, the complexity of trying to administer a firm with too many goods and services will offset any cost savings, particularly if the goods and services share little in terms of production resources or processes. However, sometimes firms discover scope economies that are not so obvious and can realize increased economic profits, at least for a time until the competition copies their discovery.
4.04: Cost Approach Versus Resource Approach to Production Planning
The conventional approach to planning production is to start with the goods and services that a firm intends to provide and then decide what production configuration will achieve the intended output at the lowest cost. This is the cost approach to production planning.Stevenson (1986) addresses this approach to production planning extensively. Once output goals are set, the expected revenue is essentially determined, so any remaining opportunity for profit requires reducing the cost as much as possible.
Although this principle of cost minimization is simple, actually achieving true minimization in practice is not feasible for most ventures of any complexity. Rather, minimization of costs is a target that is not fully realized because the range of production options is wide and the actual resulting costs may differ from what was expected in the planning phase.
Additionally, as we saw in Chapter 2, the decision about whether to provide a good or service and how much to provide requires an assessment of marginal cost. Due to scale effects, this marginal cost may vary with the output level, so firms may face a circular problem of needing to know the marginal cost to decide on the outputs, but the marginal cost may change depending on the output level selected. This dilemma may be addressed by iteration between output planning and production/procurement planning until there is consistency. Another option is to use sophisticated computer models that determine the optimal output levels and minimum cost production configurations simultaneously.
Among the range of procurement and production activities that a business conducts to create its goods and services, the firm may be more proficient or expert in some of the activities, at least relative to its competition. For example, a firm may be world class in factory production but only about average in the cost effectiveness of its marketing activities. In situations where a firm excels in some components of its operations, there may be an opportunity for improved profitability by recognizing these key areas, sometimes called core competencies in the business strategy literature, and then determining what kinds of goods or services would best exploit these capabilities. This is the resource approach to the planning of production.Wernerfelt (1984) wrote one of the key initial papers on the resource-based view of management.
Conceptually, either planning approach will lead to similar decisions about what goods and services to provide and how to arrange production to do that. However, given the wide ranges of possible outputs and organizations of production to provide them, firms are not likely to attain truly optimal organization, particularly after the fact. The cost approach is often easier to conduct, particularly for a firm that is already in a particular line of business and can make incremental improvements to reduce cost. However, in solving the problem of how to create the goods and services at minimal cost, there is some risk of myopic focus that dismisses opportunities to make the best use of core competencies. The resource approach encourages more out-of-the-box thinking that may lead a business toward a major restructuring. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.03%3A_Economies_of_Scope_and_Joint_Products.txt |
In Chapter 2, we discussed the principle for profit maximization stating that, absent constraints on production, the optimal output levels for the goods and services occur when marginal revenue equals marginal cost. This principle can be applied in determining the optimal level of any production resource input using the concepts of marginal product and marginal revenue product.
The marginal product of a production input is the amount of additional output that would be created if one more unit of the input were obtained and processed. For example, if an accounting firm sells accountant time as a service and each hired accountant is typically billed to clients 1500 hours per year, this quantity would be the marginal product of hiring an additional accountant.
The marginal revenue product of a production input is the marginal revenue created from the marginal product resulting from one additional unit of the input. The marginal revenue product would be the result of multiplying the marginal product of the input times the marginal revenue of the output. For the example in the previous paragraph, suppose that at the current output levels, the marginal revenue from an additional billed hour of accountant service is \$100. The marginal revenue product of an additional accountant would be 1500 times \$100, or \$150,000.
In determining if a firm is using the optimal level on an input, the marginal revenue product for an additional unit of input can be compared to the marginal cost of a unit of the input. If the marginal revenue product exceeds the marginal input cost, the firm can improve profitability by increasing the use of that input and the resulting increase in output. If the marginal cost of the input exceeds the marginal revenue product, profit will improve by decreasing the use of that input and the corresponding decrease in output. At the optimal level, the marginal revenue product and marginal cost of the input would be equal.
Suppose the marginal cost to hire an additional accountant in the previous example was \$120,000. The firm would improve its profit by \$30,000 by hiring one more accountant.
As noted earlier in the discussion of marginal revenue, the marginal revenue will change as output is increased, usually declining as output levels increase. Correspondingly, the marginal revenue product will generally decrease as the input and corresponding output continue to be increased. This phenomenon is called the law of diminishing marginal returns to an input. So, for the accounting firm, although they may realize an additional \$30,000 in profit by hiring one more accountant, that does not imply they would realize \$3,000,000 more in profits by hiring 100 more accountants.
If the marginal revenue product is measured at several possible input levels and graphed, the pattern suggests a relationship between quantity of input and marginal revenue product, as shown in Figure 4.3. Due to the law of diminishing marginal returns, this relationship will generally be negative. Thus the relationship looks much like the demand curve corresponding to output levels. In fact, this relationship is a transformation of the firm’s demand curve, expressed in terms of the equivalent marginal revenue product relative to number of units of input used. Due to the connection to the demand curve for output, the relationship depicted in Figure 4.3 is called a derived demand curve.
One difficulty in comparing marginal revenue product to the marginal cost of an input is that the mere increase in any single input is usually not enough in itself to create more units of output. For example, simply acquiring more bicycle frames will not result in the ability to make more bicycles, unless the manufacturer acquires more wheels, tires, brakes, seats, and such to turn those frames into bicycles. In cases like this, sometimes the principle needs to be applied to a fixed mix of inputs rather than a single input.
For the accounting firm in the earlier example, the cost to acquire an additional accountant is not merely the salary he is paid. The firm will pay for benefits like retirement contribution and health care for the new employee. Further, additional inputs in the form of an office, computer, secretarial support, and such will be incurred. So the fact that the marginal revenue product of an accountant is \$150,000 does not mean that the firm would benefit if the accountant were hired at any salary less than \$150,000. Rather, it would profit if the additional cost of salary, benefits, office expense, secretarial support, and so on is less than \$150,000. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.05%3A_Marginal_Revenue_Product_and_Derived_Demand.txt |
In cases where inputs are in high supply at the current market price and the market for inputs is competitive, the marginal cost of an input is roughly equal to the actual cost of acquiring it. So, in such a situation, the principle described earlier can be expressed in terms of comparing the marginal revenue product to price to acquire the input(s). If the number of accountants seeking a job were fairly substantial and competitive, the actual per unit costs involved in hiring one more accountant would be the marginal cost.
If the market of inputs is less competitive, a firm may have to pay a little higher than the prevailing market price to acquire more units because they will need to be hired away from another firm. In this situation, the marginal cost of inputs may be higher than the price to acquire an additional unit because the resulting price increase for the additional unit may carry over to a price increase of all units being purchased.
Suppose the salary required to hire a new accountant will be higher than what the firm is currently paying accountants with the same ability. Once the firm pays a higher salary to get a new accountant, they may need to raise the salaries of the other similar accountants they already hired just to retain them. In this instance, the marginal cost of hiring one more accountant could be substantially more than the cost directly associated with adding the new accountant. As a result of the impact on other salaries and associated costs of the hire, the firm may decide that the highest salary for a new accountant that the firm can justify may be on the order of \$50,000, even though the resulting marginal revenue product is substantially greater.
If inputs are available in a ready supply, or there are close substitutes available that are in ready supply, the price of an additional unit of input typically reflects either the opportunity cost related to the value of the next best use of that input or the minimum amount needed to induce a new unit to become available. However, there are some production inputs that may be in such limited supply that even further price increases will not attract new units to become available, at least not quickly. In these cases, the marginal revenue product for an input may still considerably exceed its marginal cost, even after all available inputs are in use. The sellers of these goods and services may be aware of this imbalance and insist on a price increase for the input up to a level that brings marginal cost in balance with marginal revenue product. The difference between the amount the provider of the limited input supply is able to charge and the minimum amount that would have been necessary to induce the provider to sell the unit to the firm is called economic rent.
Suppose a contracting firm was hired to do emergency repairs to a major bridge. Due to the time deadline, the firm will need to hire additional construction workers who are already in the area. Normally, these workers may have been willing to work for \$70 per hour. However, sensing the contracting firm is being paid a premium for the repairs, meaning the marginal revenue product of labor is high, and there are a limited number of qualified workers available, the workers can insist on being paid as much as \$200 per hour for the work. The difference of \$130 would be economic rent caused by the shortage of qualified workers available on short notice.
Economic rent can occur in agriculture when highly productive land is in limited supply or in some labor markets like professional sports or commercial entertainment where there is a limited supply of people who have the skills or name recognition needed to make the activity successful. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.06%3A_Marginal_Cost_of_Inputs_and_Economic_Rent.txt |
The resource view of production management is to make sure that all resources employed in the creation of goods and services are used as effectively as possible. Smart businesses assess the productivity of key production resources as a means of tracking improvements and in comparing their operations to those of other firms.
Earlier in this chapter we introduced the concept of marginal product. This measure reflects how productive an additional unit of that input would be in creating additional output. However, for some inputs, there are differences in marginal productivity across units. For example, in agriculture an acre of land in one location may be capable of better yields than an acre in another location. At any given input price, firms will seek to employ those units with the highest marginal product first.
In looking at the collective performance of a production operation, we need a measure of productivity that applies to all inputs being used rather than the last unit acquired. One means of doing this is using the measure of average productivity, which is a ratio of the total number of units of output divided by the total units of an input. An alternative measure of average productivity would be the total dollars in revenue or profit divided by the total units of an input.
Computations of average productivity make sense for key inputs around which production processes are designed. In the example of the accounting firm used in this chapter, the number of accountants is probably a good choice. Average productivity could be in the form of labor hours billed divided by accountants hired. If a firm managed to sell 1600 billable hours in 1 year, but only 1500 billable hours in another year, the earlier year indicated higher productivity.
In retail stores, a key resource is the amount of floor space. The productivity of a store could be measured by the total revenue over a period divided by the available square footage. This measure could be compared to the same measure for other stores in the retail chain or with similar competitor stores. Even sections within the store can be compared for which types of goods and services sold are most effective in generating sales, although given that costs vary too, a better productivity measure here may be profit contribution (revenue minus variable cost) per square foot.
The productivity of firms may change over time. In the case of labor, the productivity of individual workers will rise as they gain experience and new workers can be trained more effectively. There is also an improvement in overall productivity from the increased knowledge of management in how to employ productive resources better. These productivity gains from experience and improved knowledge are sometimes called learning by doingThe economics of learning by doing was introduced by Arrow (1962).
In addition to the increased profit potential of improved productivity, new firms or firms starting new operations need to anticipate these gains in deciding whether to engage in a new venture. Often a venture will not look attractive if the assumed costs of production are based on the costs that apply in the initial periods of production. Learning improvements need to be considered as well. In some sense, decreased profits and even losses in the initial production periods are necessary investments for a successful long-term operation.
Improvements due to productivity gains will usually result in decreased average costs. The relationship between cumulative production experience and average cost is called the learning curve. An example appears in Figure 4.4. One point to be emphasized is that the quantity on the horizontal axis is cumulative production, or total production to date, rather than production rate per production period. This is not a scale effect per se. Even if the firm continues to produce at the same rate each period, it will see declines in the average cost per unit of output, especially in the initial stages of operation.
One numerical measure of the impact of learning on average cost is called the doubling rate of reduction. The doubling rate is the reduction in average cost that occurs each time cumulativeproduction doubles. If the average cost declines by 15% each time cumulative production doubles, that would be its doubling rate. A learning curve with a doubling rate of 15% may be called an 85% learning curve to indicate the magnitude of the average cost compared to when cumulative production was only half as large.
Note that the number of units required to double cumulative production will get progressively higher. For example, if cumulative production now is 1000 units, the next doubling will occur at 2000 cumulative units, with the next doubling at 4000 cumulative units, and the following at 8000 cumulative units. Thus the rate of decline in average cost for each successive unit of production will diminish as cumulative production increases. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/04%3A_Cost_and_Production/4.07%3A_Productivity_and_the_Learning_Curve.txt |
Businesses usually sell multiple products or services, and they alter the collection of goods and services provided over time. Several factors motivate changes in this composition and can result in decisions either to expand an enterprise by increasing the range of goods and services offered or to contract the enterprise by suspending production and sale of some goods and services. In this section, we will list some key motivations for expanding the range of an enterprise. Bear in mind that when these motivations are absent or reversed, the same considerations can lead to decisions to contract the range of the enterprise.
1. Earlier, in Chapter 4, we discussed the concepts of economies of scale (cost per unit decreases as volume increases) and economies of scope (costs per unit of different goods can be reduced by producing multiple products using the same production resources). Businesses often expand to exploit these economies.
2. As we will see in Chapter 7, in markets with few sellers that each provide a large fraction of the goods or services available, the sellers possess an advantage over buyers in commanding higher prices. Businesses will often either buy out competitors or increase production with the intent to drive competitors out of the seller market in order to gain market power.
3. Many businesses sell products that are intermediate, rather than final, goods. Their customers are other businesses that take the goods or services they purchase and combine or enhance them to provide other goods and services. As a result, the profit that is earned in the production of a final product will be distributed across several firms that contributed to the creation of that good. However, the profit may not be evenly distributed across the contributing firms or proportional to their costs. Sometimes a firm will recognize the higher profit potential of the firms that supply them or the firms to which they are suppliers and will decide to participate in those more lucrative production stages.
4. Due to the considerable uncertainties of future costs, revenues, and profits and the need for firms to commit resources before these uncertainties are resolved, business is a risky prospect. Just as investors can mitigate the inherent risk of owning stocks by purchasing shares in different firms across somewhat unrelated industries, large firms can reduce some of their risk by producing unrelated products or services. Additionally, there may be increased efficiencies in movement of resources between different production operations when done by the same company.
5.02: Classifying Business Expansion in Terms of Value Chains
We noted earlier that many businesses sell goods or services that are intended to help other businesses in the creation of their goods and services. Many of the goods we consume as individuals are the result of a sequence of production operations that may involve several firms. If the final goods are traced backward through the intermediate goods that were acquired and utilized, we can usually envision the participant firms in a creation process as a network of production activities or a sequence of production stages.
For example, consider a loaf of bread purchased at a grocery store. The grocery store may purchase the loaf from a distributor of bakery products. The distributor likely purchased the loaf from a baking company. In order to produce the loaf of bread, the bakery would need flour and yeast, along with packaging material. These may be purchased from other businesses. The flour came from a grain grinding process that may have been done by a different business. The business that ground the grain would need grain that may have come from an agricultural cooperative, which in turn was the recipient of the grain from a farmer. In order to grow and harvest the grain, the farmer needs seed, tractors, and fuel, which are usually obtained from other sources.
Each of the firms or production operations that contributes to the creation of the final product can be considered as adding value to the resources they acquire in their completion of a stage of the creation process. Since the network of operations that account for the creation of a product can often be represented by a sequence of stages, the network is commonly called the value chain for the product.
Figure 5.1 shows a generic value chain for a manufactured good. This value chain begins with the raw materials that eventually go into the product that must be acquired, possibly by mining (e.g., metal) or harvesting (e.g., wood). Next, the raw material is processed into a material that can be used to create parts in the next stage. Using these parts, the next stage of the value chain is the assembly of the product. Once assembled, the product must be distributed to the point of sale. In the final stage, a retailer sells the finished product to the consumer.
Business expansions are classified based on the relationship of the newly integrated activity to prior activities engaged in by the firm. If the new activity is in the same stage of that value chain or a similar value chain, the expansion is called horizontal integration. If the new activity is in the same value chain but at a different stage, the expansion is called vertical integration. If the new activity is part of a quite different value chain, the new combined entity would be called a conglomerate merger.
5.03: Horizontal Integration
In horizontal integration, a firm either increases the volume of current production activities or expands to similar kinds of production activities. Consider a television manufacturer that operates at the assembly stage of its value chain. If that company bought out another manufacturer of television sets, this would be horizontal integration. If the company were to decide to assemble computer monitors, the product would be a form of horizontal integration due to the high similarity in the two products and type of activity within those value chains.
Cost efficiencies in the form of economies of scale from higher volumes or economies of scope from producing related products are primary driving factors in horizontal integration. When a firm expands to a new product that is similar to its current products, usually there is a transfer of knowledge and experience that allows the expanding firm to start with higher cost efficiency than a firm that is entering this market with no related experience. If an enterprise possesses core competencies in the form of production processes that it can perform as well or better than others in the market, and can identify other products that can employ those core competencies, the enterprise can enter new markets as a serious competitor.
Market power from holding a higher share of all sales in a market is the other major motivation for horizontal integration. As we will discuss in later chapters, the possible gains from increased market power are often so significant that the governments in charge of overseeing those markets may limit or forbid horizontal mergers where one company buys out or combines with a competitor.
Since most firms are buyers as well as sellers, horizontal integration can create an advantage for large firms in demanding lower prices for goods and services they purchase. For example, a national chain like Walmart may be the principal customer of one of its suppliers. If Walmart decides to use a different supplier, the former supplier may have difficulty remaining in business. Consequently, the supplier may have little choice about accepting reduced prices. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/05%3A_Economics_of_Organization/5.01%3A_Reasons_to_Expand_an_Enterprise.txt |
Vertical integration occurs when a firm expands into a different stage of a value chain in which it already operates. For example, suppose the television manufacturing firm had been purchasing the electronic circuit boards that it uses in its television set products but decides to either buy the supplier or start a new operation to make those parts for itself. This would be vertical integration.
Usually vertical integration will extend to a neighboring stage in the value chain. When a business expands into an earlier stage in the value chain, the business is said to be doing upstream integration. When the expansion is to a later stage of the value chain, the result is downstream integration.
A major motivation for vertical integration is the potential for improved profitability. As noted earlier, firms at some stages of the value chain may enjoy better market conditions in terms of profitability and stability. If two stages of the value chain are performed by two divisions of the same company rather than by two separate companies, there is less haggling over price and other conditions of sale. In some cases, through a process that economists call double marginalization. it is possible that a single vertically integrated firm can realize higher profit than the total of two independent firms operating at different stages and making exchanges. An independent partner may not conduct its business the way that the firm would prefer, and possibly the only means to make sure other stages of the value chain operate as a firm would like is for the firm to actually manage the operations in those stages.
Another possible motivation for vertical integration is risk reduction. If a firm is highly dependent on the goods and services of a particular supplier or purchases by a particular buyer, the firm may find itself in jeopardy if that supplier or buyer were to suddenly decide to switch to other clients or cease operations. For example, if the supplier of electronic circuit boards were to cancel future agreements to sell parts to the television manufacturer and instead sell to a competitor that assembles television sets, the television company may not be able to respond quickly to the loss of supply and may decide it needs to either buy out the supplier or start its own electronic parts division. From the circuit board supplier’s perspective, there is also risk to them if they invest in production capacity to meet the specific part designs for the television company and then the television company decides to get the circuit boards elsewhere. By having both operations within the boundaries of a single enterprise, there is little risk of unilateral action by one producer to the detriment of the other producer.
5.05: Alternatives to Vertical Integration
If the reduction of risk related to the actions of an independent supplier or buyer is a motivation for vertical integration, the firm may have alternatives to formally integrating into another stage of the value chain through use of a carefully constructed agreement with a supplier or buyer. Done correctly, these agreements can result in some of the gains a business might expect from formal integration of the other stage of value-adding activity.
If the concern is about the reliability of continued exchanges, the supplier firm can establish a long-term agreement to be the exclusive dealer to the buyer firm, or the buyer firm can contract to be the exclusive buyer from the seller firm. In the retail business, these sometimes take the form of franchise outlets, where the franchise enjoys the assurance that their product will not be sold by a competitor within a certain distance and the supplier is assured of having a retailer that features their goods exclusively.
In some cases, the concern may be about future prices. If the upstream firm is concerned that the downstream firm will charge too little and hurt their profitability, the upstream firm can insist on a resale price maintenance clause. If the downstream firm is concerned that the upstream firm will use their exchanges to build up a business and then seek additional business with other downstream clients at lower prices, the downstream firm can ask for a best price policy that guarantees them the lowest price charged to any of the upstream firm’s customers.
Some upstream suppliers may produce a variety of goods and rely on downstream distributors to sell these goods to consumers. However, the downstream firm may find that selling just a portion of the upstream firm’s product line is more lucrative and will not willingly distribute the upstream firm’s entire line of products. If this is a concern to the upstream firm, it can insist on the composition of products a distributor will offer as a condition of being a distributor of any of its products.
One way firms protect themselves from supply shortages is by maintaining sizeable inventories of parts. However, maintaining inventory costs money. Firms that exchange goods in a value chain can reduce the need for large inventories with coordinated schedules like just-in-time systems.The best-selling book by Womack, Jones, and Roos (1990) describes the just-in-time philosophy. In situations where quality of the good is of key concern, and not just the price, the downstream firm can require documentation of quality control processes in the upstream firm.
When upstream firms are concerned that they may not realize a sufficient volume of exchanges over time to justify the investment in fixed assets, the upstream firm can demand a take-or-pay contract that obligates the buyer to either fulfill its intended purchases or compensate the supplier to offset losses that will occur. This type of agreement is particularly important in the case of “specific assets” in economics, where the supplier would have no viable alternative for redeploying the fixed assets to another use.
Although some of these measures may obviate the need for a firm to expand vertically in a value chain, in some circumstances forming the necessary agreements is difficult to accomplish. This is especially the case when one party in a vertical arrangement maintains private information that can be used to its advantage to create a better deal for itself but potentially will be a bad arrangement for the party that does not have that information in advance. As a result, parties that are aware of their limited information about the other party will tend to be more conservative in their agreement terms by assuming pessimistic circumstances and will not be able to reach an agreement. This reaction is called adverse selection in economic literature.Nobel laureate George Akerlof (1970) wrote a seminal paper examining adverse selection in the context of used cars.
In some cases, one party in a vertical arrangement may have production or planning secrets that do not affect the agreement per se but risk being discovered by the other party as the result of any exchange transactions. These secrets may be the result of costly research and development but may pass to the other party at essentially no cost, and the other party may take advantage of that easily obtained information. This is a version of what economists call the free rider problem.See the text by Brickley, Smith, and Zimmerman (2001) for more about the free rider problem in economics of organizations.Due to the difficulty of protecting against problems of adverse selection and free riders, firms may conclude that vertical integration is the better option. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/05%3A_Economics_of_Organization/5.04%3A_Vertical_Integration.txt |
As stated earlier, a conglomerate is a business enterprise that participates in multiple value chains that are different in nature. An example of a conglomerate is General Electric, which engages in the manufacture of appliances, construction of energy facilities, financing of projects, and media ventures, just to name a portion of its product portfolio.
One attraction of conglomerates is the ability to diversify so that the firm can withstand difficult times in one industry by having a presence in other kinds of markets. Beyond diversification, a conglomerate can move capital from one of its businesses to another business without the cost and difficulties of using outside capital markets. Often conglomerates will have some divisions that are cash cows in being profitable operations in mature markets, and other businesses that have great potential but require sizeable investment that can be funded by profits from the cash-cow businesses.The concept of cash-cow businesses is an aspect of the Boston Consulting Group matrix for corporate strategy (1970).
Another argument for conglomerates is that companies with very talented management staffs may be capable of excelling in more than one type of business. For instance, the former chairman of General Electric, Jack Welch, was widely praised as providing superior senior management for the wide range of businesses in which General Electric participated.
5.07: Transaction Costs and Boundaries of the Firm
We have discussed several reasons a firm may decide to expand. At first glance, it may seem that expanding a business is often a good idea and has little downside risk if the larger enterprise is managed properly. In fact, during the last century successful businesses often engaged in horizontal and vertical integration and even became conglomerates due to such reasoning.
However, as many of these large corporations learned, it is possible to become too large, too complex, or too diversified. One consequence of a corporation growing large and complex is that it needs a management structure that is large and complex. There needs to be some specialization among managers, much as there is specialization in its labor force. Each manager only understands a small piece of the corporation’s operations, so there needs to be efficient communication between managers to be able to take advantage of the opportunities of integration and conglomeration. This requires additional management to manage the managers.
Large firms usually have some form of layered or pyramid management both to allow specialization of management and to facilitate communication. Still, as the number of layers increases, the complexity of communication grows faster than the size of the management staff. Information overload results in the failure of key information to arrive to the right person at the right time. In effect, at some point the firm can experience diseconomies of scale and diseconomies of scope as the result of management complexity increasing faster than the rate of growth in the overall enterprise.
Another problem with expansion, especially in the cases of vertical integration and conglomerates, is that different kinds of businesses may do better with different styles of management. The culture of a successful manufacturer of consumer goods is not necessarily the culture of a startup software company. When many kinds of businesses are part of the same corporation, it may be difficult to synchronize different business cultures.
Economists have developed a theory called transaction cost economics to try to explain when a firm should expand and when it should not, or even when the firm would do better to either break apart or sell off some of its business units. A transaction cost is the cost involved in making an exchange. An exchange can be external or internal. An external exchange occurs when two separate businesses are involved, like the television manufacturer and its parts supplier in the earlier example. Prior to the actual exchange of parts for cash, there is a period in which the companies need to come to agreement on price and other terms. The external transaction costs are the costs to create and monitor this agreement.
If a firm decides to expand its boundaries to handle the exchange internally, there are new internal transaction costs. These would be the costs to plan and coordinate these internal exchanges. If exchanges of this nature have not been done before, these internal transaction costs can be significant.
Nobel Prize laureate Ronald Coase introduced the concept of transaction costs and also proposed a principle for determining when to expand known as the Coase hypothesis.The initial article that stimulated later development of the transaction cost concept was by Ronald Coase (1937). Essentially, the principle states that firms should continue to expand as long as internal transaction costs are less than external transaction costs for the same kind of exchange.
5.08: Cost Centers Versus Profit Centers
One internal transaction cost in multiple-division companies is how to coordinate the divisions that make internal exchanges so they will achieve what is best for the overall corporation. This challenge is not merely a matter of communication but of providing proper motivation for the individual units.
Large vertically integrated companies often have at least one upstream division that creates a product and a downstream division that distributes it or sells it to consumers. One design for such companies is to have a central upper management that decides what activities and activity levels should be provided by each division. These instructions are given to the division managers. With the output goals of each division established, each division will best contribute to the overall profitability of the corporation by trying to meet its output goals at minimum cost. As such, divisions operating under this philosophy are called cost centers.
Although the cost center design may sound workable in principle, there is some risk in the division having an overall objective of minimizing cost and divisional management evaluated in terms of that objective. The response to this objective is that the firm may cut corners on quality as much as possible and avoid considering innovations that would incur higher initial costs but ultimately result in a better product for the long run. Unless the top-level management is aware of these issues and sets quality requirements properly, opportunities may be missed.
Another problem with cost centers, particularly in the nonprofit and public sectors, is that the compensation and prestige afforded to division managers may be related to the size of division operations. Consequently, the incentive for managers is to try to justify larger cost budgets rather than limit costs.
An alternative to the cost center approach is to treat a division as if it were like a business that had its own revenues and costs. The goal of each division is to create the most value in terms of the difference between its revenues and costs. This is known as a profit center. Division managers of profit centers not only have incentives to avoid waste and improve efficiencies like cost centers but also have an incentive to improve the product in ways that create better value. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/05%3A_Economics_of_Organization/5.06%3A_Conglomerates.txt |
One possibility for establishing a transfer price is for the two divisions to negotiate a price as they would if they were indeed independent businesses. Unfortunately, this approach sacrifices one of the benefits of vertical integration—namely, the avoidance of the transaction costs that are incurred on external changes—without avoiding all the internal transaction costs.
Another approach to the problem of pricing interdivision exchanges is to base prices on principles rather than negotiation. Academic research has concluded a number of principles for different kinds of situations. In this section, we will limit our consideration to two of these situations.
Suppose two divisions in an enterprise, Division A and Division B, exchange a good that is only produced by Division A. More specifically, there is no other division either inside or outside the enterprise that currently produces the good. Division B is the only user of this good, either inside or outside of the enterprise. Under these conditions, theoretically the best transfer price is the marginal cost of the good incurred by Division A.
No formal proof of this principle will be offered here, but a brief defense of this principle would be as follows: Suppose the price charged was less than the marginal cost. If Division A decides on the production volume that would maximize its internal divisional profit, then by reducing its volume somewhat, Division A would avoid more cost than it loses in forgone transfer revenue. So Division A would elect to provide fewer units than Division B would want.
On the other hand, suppose the transfer price was set at a level higher than the marginal cost. Since the transfer cost becomes a component of cost to receiving Division B, in determining its optimal volume of production, Division B will see a higher marginal cost than is actually the case (or would be the case if Divisions A and B functioned as a single unit). As a result, Division B may decide on a production level that is not optimal for the overall enterprise. By setting the transfer price equal to Division A’s marginal cost, the decision by Division B should be the same as it would be if the two divisions operated as one.
Although the principle is reasonably clear and defensible in theory, the participating divisions in an actual setting may raise objections. If the average cost of the item to Division A is less than the marginal cost, Division B may complain that they should not need to pay a transfer price above the average cost because that is what the actual cost per item is to Division A and the enterprise overall. If the average cost per item exceeds the marginal cost, Division A may complain that setting the transfer price to the marginal cost requires their division to operate at a loss for this item and they should be credited with at least the average cost. Nonetheless, the best decisions by Divisions A and B for the overall profit of the enterprise will occur when the transfer price is based on the marginal cost to Division A in this situation.
As a second case situation, suppose the good transferred from Division A to Division B is a good that is both produced and consumed outside the enterprise and there is a highly competitive market for both buyers and sellers. In this instance the best internal transfer price between Division A and Division B would be the external market price.
A supporting argument for this principle is this: If the transfer price were higher than the outside market price, Division B could reduce its costs by purchasing the good in the outside market rather than obtaining it from Division A. If the outside market price were higher than the set transfer price, Division A would make higher divisional profit by selling the good on the outside market than by transferring it to Division B. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/05%3A_Economics_of_Organization/5.09%3A_Transfer_Pricing.txt |
Earlier we considered how to motivate divisions within a large organization with appropriate transfer pricing. How about motivation within the divisions? As noted in the introduction to this chapter, in recent decades economists have addressed this matter from a new perspective.
The traditional approach to motivation inside a division or modest-sized business was typically regarded as matters of organizational design and organizational behavior. Once the employee agreed to employment in return for salary or wages and benefits, his services were subject to direction by management within the scope of human resource policies in terms of hours worked and work conditions. Ensuring good performance by employees was basically a matter of appropriate supervision, encouragement, and feedback. In cases where employees were not performing adequately, they would be notified of the problem, possibly disciplined, or even dismissed and replaced. From this perspective, managing employees is much like managing military troops, differing largely in terms of the degree of control on the individual’s free time and movements.
The new perspective on employee motivation is to consider the employee more like an individual contractor rather than an enlisted soldier. Just as microeconomics viewed each consumer as an entity trying to maximize the utility for his household, an individual employee is a decision-making unit who agrees to an employment relationship if he believes this is the best utilization of his productive abilities. The challenge for business management is to structure compensation, incentives, and personnel policies that induce employees to contribute near their productive capacities but not overreward employees beyond what makes economic sense for the business.
One contribution from this economic perspective is the notion of an efficiency wage (see Milgrom and Roberts (1992)). The classical approach to setting wages is that the wage paid to an employee should be no more than the marginal revenue product corresponding to her effort. However, if an employee is paid barely what her efforts are worth to the firm at the margin and if there is a competitive market for the employee’s services in other firms, the employee may not be motivated to work at maximum capacity or avoid engaging in behaviors that are detrimental to the firm because she can earn as much elsewhere if she is dismissed. An efficiency wage is a wage that is set somewhat above the marginal revenue product of the employee to give the employee an incentive to be productive and retain this job because the employee would sacrifice the difference between the efficiency wage and marginal revenue product if she sought employment elsewhere. This incentive is worthwhile to the firm because it avoids the transaction costs of finding and hiring a new employee.
Another contribution of this economic viewpoint of employee motivation is an examination of employee contracts to deal with what is called the principal-agent problem. In this context, the hiring business is a principal that hires an employee (agent) to act on its behalf. The problem occurs when the agent is motivated to take actions that are not necessarily what the employer would want, but the employer is not able to monitor all the activities of the employee and has insufficient information.
In the employment relationship the employer evaluates the employee on the basis of her contribution to profit or other objective of the firm. However, the employee evaluates her activities based on the amount of effort involved. To the degree that employees see their compensation and incentives connected to the intensity of effort, the more likely the employee will invest additional effort because there is reduced risk that her efforts will go unrewarded.
For example, if employee incentives are based on the overall performance of a team of employees without any discrimination between individual employees, there is an incentive for employees to shirk in performance of their jobs because they still benefit if others do the work and they do not risk putting in an extra effort to see the reward diminished by sharing the incentives with others who did not put in the same effort. The informativeness principle suggests that measures of performance that reflect individual employee effort be included in employee contracts.A good description of the informativeness principle appears in Samuelson and Marks (2010).
A third interesting contribution of this perspective on employee motivation is the concept of signaling. Nobel laureate Michael Spence (1974) introduced the economics of signaling. When employers hire, they face a pool of possible employees. Some employees will perform well, whereas others will not due to either lack of skills or lack of character. In the interview process, the employer will try to assess which applicants will be good employees, but these evaluation processes are imperfect. The real intentions of the applicant if and when he becomes an employee are largely private information until the person is actually hired and on the job for a while. As a result, employers face an adverse selection problem similar to what was discussed earlier in the context of vertical integration and will often protect against the risk by lowering the compensation offered, even though they would be willing to pay a motivated, qualified employee more.
One response to the adverse selection problem by the employee is to take actions on his own that will help distinguish him from others in the applicant pool, which are observable and serve as a signal to the employer. Seeking a college degree has been cited as a kind of signal. Even though much of what the employee learned as part of obtaining the college degree may be of little use in the prospective employment relationship, the fact that the applicant was willing to endure the cost and effort for a college degree, particularly a degree supported with good grades, is evidence that the applicant is more likely to be a dedicated and competent employee.
Applicants for employment or hire often have several employment relationships over time. By attaching importance to reputation, employers can both motivate employees to be more diligent in their current positions and establish a mechanism to help distinguish high-quality workers from low-quality workers in future hiring.
5.11: Manager Motivation and Executive Pay
In businesses where the manager is not the owner, there is another manifestation of the principal-agent problem. For example, in a typical corporation, the owners are stockholders, many of whom are not involved in the actual production activities. The board of directors hires executive management to act as the agents of the shareholders, who are the principals in this context. The intent of the arrangement is that the executives will manage the corporation in the best long-term interests of the shareholders. However, the executives, though they may own some of the corporation’s shares, are largely rewarded via salaries, bonuses, and other perquisites. Structuring executive contracts that both motivate the executive and represent the owners’ interests is a challenge.
The executives in corporations are often paid highly, certainly well above the opportunity cost of their labor in a nonexecutive setting. There are multiple theories for these high executive salaries. One argument is based on economic rent, namely, that talented executives are like star athletes and art performers, being in relatively short supply, so corporations must pay well above their opportunity cost to have their services.
Another argument for high executive pay is that they need to be not only compensated for their effort but rewarded for the value they create on behalf of the owners. So part of the higher salary is a share of the profits resulting from their execution of management duties.
A third argument for high executive salaries is that firms must often take significant risks to succeed in competitive markets and uncertain conditions. If the firm fails or falls short when its performance is assessed after the fact, the executive may lose his job. In response to this, the executive may avoid bold moves that have a significant risk of failure. In paying an executive highly, the executive is compensated for the additional personal risk he assumes by being willing to take reasonable chances that the corporation must tolerate.
Another interesting argument for high executive pay is called tournament theory (see Milgrom and Roberts (1992)). This applies to large enterprises with a sizeable team of executives, with a highly paid chief executive officer (CEO), along with several other vice presidents who are in line for consideration to become a future CEO. By paying the CEO generously and well beyond what is economically justifiable on the basis of the CEO’s contributions per se, there is a strong incentive for the other executives to put in extra effort so they will become that chief executive, with all the high pay and perquisites, in the future. From the perspective of the shareholders, the gain from those collective extra efforts is worth the high salary to the last winner of the CEO “tournament.” | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/05%3A_Economics_of_Organization/5.10%3A_Employee_Motivation.txt |
The perfect competition model is built on five assumptions:
1. The market consists of many buyers. Any single buyer represents a very small fraction of all the purchases in a market. Due to its insignificant impact on the market, the buyer acts as a price taker, meaning the buyer presumes her purchase decision has no impact on the price charged for the good. The buyer takes the price as given and decides the amount to purchase that best serves the utility of her household.
2. The market consists of many sellers. Any single seller represents a very small fraction of all the purchases in a market. Due to its insignificant impact on the market, the seller acts as a price taker, meaning the seller presumes its production decisions have no impact on the price charged for the good by other sellers. The seller takes the price as given and decides the amount to produce that will generate the greatest profit.
3. Firms that sell in the market are free to either enter or exit the market. Firms that are not currently sellers in the market may enter as sellers if they find the market attractive. Firms currently selling in the market may discontinue participation as sellers if they find the market unattractive. Existing firms may also continue to participate at different production levels as conditions change.
4. The good sold by all sellers in the market is assumed to be homogeneous. This means every seller sells the same good, or stated another way, the buyer does not care which seller he uses if all sellers charge the same price.
5. Buyers and sellers in the market are assumed to have perfect information. Producers understand the production capabilities known to other producers in the market and have immediate access to any resources used by other sellers in producing a good. Both buyers and sellers know all the prices being charged by other sellers.
6.02: Operation of a Perfectly Competitive Market in the Short Run
The consequence of the preceding assumptions is that all exchanges in a perfectly competitive market will quickly converge to a single price. Since the good is viewed as being of identical quality and utility, regardless of the seller, and the buyers have perfect information about seller prices, if one seller is charging less than another seller, no buyer will purchase from the higher priced seller. As a result, all sellers that elect to remain in the market will quickly settle at charging the same price.
In Chapter 2 and Chapter 3, we examined the demand curves seen by a firm. In the case of the perfect competition model, since sellers are price takers and their presence in the market is of small consequence, the demand curve they see is a flat curve, such that they can produce and sell any quantity between zero and their production limit for the next period, but the price will remain constant (see Figure 6.1).
It must be noted that although each firm in the market perceives a flat demand curve, the demand curve representing the behavior of all buyers in the market need not be a flat line. Since some buyers will value the item more than others and even individual buyers will have decreasing utility for additional units of the item, the total market demand curve will generally take the shape of a downward sloping curve, such as Figure 6.2.
Any amount the firm offers for sale during a production period (up to its maximum possible production level) will sell at the market price.
The downward sloping nature of the market demand curve in Figure 6.2 may seem to contradict the flat demand curve for a single firm depicted in Figure 6.1. This difference can be explained by the fact that any single seller is viewed as being a very small component of the market. Whether a single firm operated at its maximum possible level or dropped out entirely, the impact on the overall market price or total market quantity would be negligible.
Although all firms will be forced to charge the same price under perfect competition and firms have perfect information about the production technologies of other firms, firms may not be identical in the short run. Some may have lower costs or higher capacities. Consequently, not all firms will earn the same amount of profit.
Although one seller sees a fixed price for its supply, if all sellers were to increase production, the maximum price that customers would pay to buy all the units offered would drop.
As described in the description of the shutdown rule in Chapter 2, some firms only operate at an economic profit because they have considerable sunk costs that are not considered in determining whether it is profitable to operate in the short run. Thus not only are there differences in profits among firms in the short run, but even if the market price were to remain the same, not all the firms would be able to justify remaining in the market when their fixed costs need to be replenished, unless they were able to adapt their production to match the more successful operators. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.01%3A_Assumptions_of_the_Perfect_Competition_Model.txt |
As described in Chapter 4, a long-run time frame for a producer is enough time for the producer to implement any changes to its processes. In the short run, there may be differences in size and production processes of the firms selling in the market. Some sellers may be able to make a healthy economic profit, whereas others may only barely make enough to justify continued operation and, as noted earlier, may not have sustainable operations although they may continue to operate for a while since a substantial portion of their short-run costs are sunk costs.
Due to the assumption of perfect information, all sellers know the production techniques of their competitors. As a result, any firm that intends to remain in the market will revise its operations to mimic the operations of the most successful firms in the market. In theory, in the long run all firms would either have the most cost-efficient operations or abandon the market.
However, when all firms use the same processes, the possibility for firms to continue to earn positive economic profits will disappear. Suppose all firms are earning a positive profit at the going market price. One firm will see the opportunity to drop its price a small amount, still be able to earn an economic profit, and with the freedom to redefine itself in the long run, no longer be constrained by short-run production limits. Of course, when one firm succeeds in gaining greater profit by cutting its prices, the other firms will have no choice but to follow or exit the market, since buyers in perfect competition will only be willing to purchase the good from the seller who has the lowest price. Since the price has been lowered, all firms will have a lower economic profit than they had collectively before they lowered the price.
Some firms may realize they can even drive the price lower, again take sales from their competitors, and increase economic profit. Once again, all firms will be required to follow their lead or drop out of the market because firms that do not drop the price again will lose all their customers. And once again, as all firms match the lowered price, the economic profits are diminished.
In theory, due to competition, homogeneous goods, and perfect information, firms will continue to match and undercut other firms on the price, until the price drops to the point where all remaining firms make an economic profit of zero. As we explained earlier, an economic profit of zero is sufficient to sustain operations, but the firm will no longer be earning an accounting profit beyond the opportunity costs of the resources employed in their ventures.
Another necessary development in the long run under perfect competition is that all firms will need to be large enough to reach minimum efficient scale. Recall from Chapter 4 that minimum efficient scale is the minimum production rate necessary to get the average cost per item as low as possible. Firms operating at minimum efficient scale could charge a price equal to that minimum average cost and still be viable. Smaller firms with higher average costs will not be able to compete because they will have losses if they charge those prices yet will lose customers to the large firms with lower prices if they do not match their prices. So, in the long run, firms that have operations smaller than minimum efficient scale will need to either grow to at least minimum efficient scale or leave the market.
6.04: Firm Supply Curves and Market Supply Curves
The demand curve describes how either one consumer or a group of consumers would change the amount they would purchase if the price were to change. Producers may also adjust the amounts they sell if the market price changes.
Recall from Chapter 2 the principle that a firm should operate in the short run if they can achieve an economic profit; otherwise the firm should shut down in the short run. If the firm decides it is profitable to operate, another principle from Chapter 2 stated that the firm should increase production up to the level where marginal cost equals marginal revenue.
In the case of a flat demand curve, the marginal revenue to a firm is equal to the market price. Based on this principle, we can prescribe the best operating level for the firm in response to the market price as follows:
• If the price is too low to earn an economic profit at any possible operating level, shut down.
• If the price is higher than the marginal cost when production is at the maximum possible level in the short run, the firm should operate at that maximum level.
• Otherwise, the firm should operate at the level where price is equal to marginal cost.
Figure 6.3 shows a generic situation with average (economic) cost and marginal cost curves. Based on the preceding rule, a relationship between the market price and the optimal quantity supplied is the segment of the marginal cost curve that is above the shutdown price level and where the marginal cost curve is increasing, up to the point of maximum production. For prices higher than the marginal cost at maximum production, the firm would operate at maximum production.
This curve segment provides an analogue to the demand curve to describe the best response of sellers to market prices and is called the firm supply curve. As is done with demand curves, the convention in economics is to place the quantity on the horizontal axis and price on the vertical axis. Note that although demand curves are typically downward sloping to reflect that consumers’ utility for a good diminishes with increased consumption, firm supply curves are generally upward sloping. The upward sloping character reflects that firms will be willing to increase production in response to a higher market price because the higher price may make additional production profitable. Due to differences in capacities and production technologies, seller firms may have different firm supply curves.
If we were to examine all firm supply curves to determine the total quantity that sellers would provide at any given price and determined the relationship between the total quantity provided and the market price, the result would be the market supply curve. As with firm supply curves, market supply curves are generally upward sloping and reflect both the willingness of firms to push production higher in relation to improved profitability and the willingness of some firms to come out of a short-run shutdown when the price improves sufficiently. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.03%3A_Perfect_Competition_in_the_Long_Run.txt |
The market demand curve indicates the maximum price that buyers will pay to purchase a given quantity of the market product. The market supply curve indicates the minimum price that suppliers would accept to be willing to provide a given supply of the market product. In order to have buyers and sellers agree on the quantity that would be provided and purchased, the price needs to be a right level.
The market equilibrium is the quantity and associated price at which there is concurrence between sellers and buyers. If the market demand curve and market supply curve are displayed on the same graph, the market equilibrium occurs at the point where the two curves intersect (see Figure 6.4).
Recall that the perfect competition model assumes all buyers and sellers in the market are price takers. This raises an interesting question: If all the actors in the market take the price as given condition, how does the market get to an equilibrium price?
One answer to this question was provided by the person who is often described as the first economist, Adam Smith. Adam Smith lived in the late 18th century, many years before a formal field of economics was recognized. In his own time, Smith was probably regarded as a philosopher. He wrote a treatise called The Wealth of Nations,See Smith (1776). in which he attempted to explain the prosperity that erupted in Europe as the result of expanded commercial trade and the industrial revolution.
Smith ascribed the mechanism that moves a market to equilibrium as a force he called the invisible hand. In effect, if the price is not at the equilibrium level, sellers will detect an imbalance between supply and demand and some will be motivated to test other prices. If existing market price is below the equilibrium price, the provided supply will be insufficient to meet the demand. Sensing this, some suppliers will try a slightly higher price and learn that, despite perfect information among buyers, some buyers will be willing to pay the higher price if an additional amount would be supplied. Other sellers will see that the higher price has enough demand and raise their prices as well. The new price may still be below equilibrium, so a few sellers will test a higher price again, and the process will repeat until there is no longer a perception of excess demand beyond the amount buyers want at the current price.
If the market price is higher than the equilibrium price, sellers will initially respond with increased rates of production but will realize that buyers are not willing to purchase all the goods available. Some sellers will consider lowering the price slightly to make a sale of goods that would otherwise go unsold. Seeing this is successful in encouraging more demand, and due to buyers being able to shift their consumption to the lower priced sellers, all sellers will be forced to accept the lower price. As a result, some sellers will produce less based on the change in their firm supply curve and other sellers may shut down entirely, so the total market supply will contract. This process may be repeated until the price lowers to the level where the quantity supplied is in equilibrium with the quantity demanded.
In actual markets, equilibrium is probably more a target toward which prices and market quantity move rather than a state that is achieved. Further, the equilibrium itself is subject to change due to events that change the demand behavior of buyers and production economics of suppliers. Changes in climate, unexpected outages, and accidental events are examples of factors that can alter the market equilibrium. As a result, the market price and quantity is often in a constant state of flux, due to both usually being out of equilibrium and trying to reach an equilibrium that is itself a moving target. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.05%3A_Market_Equilibrium.txt |
In addition to the factors that cause fluctuations in the market equilibrium, some developments may lead to sustained changes in the market equilibrium. For example, if a new product becomes available that is a viable substitute for an existing product, there is likely to be either a persistent drop in the quantity consumed of the existing good or a reduction in the market price for the existing good.
The impact of these persistent changes can be viewed in the context of changes in the behavior of buyers or the operations of sellers that cause a shift in the demand curve or the supply curve, respectively. In the case of the new availability of a close substitute for an existing product, we would expect the demand curve to shift to the left, indicating that at any market price for the existing good, demand will be less than it was prior to introduction of the substitute. As another example, consider the supply curve for gasoline after an increase in the price of crude oil. Since the cost of producing a gallon of gasoline will increase, the marginal cost of gasoline will increase at any level of production and the result will be an upward shift in the supply curve.
It is often of interest to determine the impact of a changing factor on the market equilibrium. Will the equilibrium quantity increase or decrease? Will the equilibrium price increase or decrease? Will the shift in the equilibrium point be more of a change in price or a change in quantity? The examination of the impact of a change on the equilibrium point is known in economics as comparative statics.
In the case of a shifting demand curve, since the supply curve is generally upward sloping, a shift of the demand curve either upward or to the right will result in both a higher equilibrium price and equilibrium quantity. Likewise, a shift in the demand curve either downward or to the left will usually result in a lower equilibrium price and a lower equilibrium quantity. So in response to the introduction of a new substitute good where we would expect a leftward shift in the demand curve, both the equilibrium price and quantity for the existing good can be expected to decrease (see Figure 6.5).
Whether a shift in the demand curve results in a greater relative change in the equilibrium price or the equilibrium quantity depends on the shape of the supply curve. If the supply curve is fairly flat, or elastic, the change will be primarily in the equilibrium quantity (see Figure 6.6). An elastic supply curve means that a small change in price typically results in a greater response in the provided quantity. If the supply curve is fairly vertical, or inelastic, the change in equilibrium will be mostly seen as a price change (see Figure 6.7).
The shift is generally in terms of the quantity when the supply curve is elastic.
The shift is generally in terms of the price when the supply curve is inelastic.
A shift in the supply curve has a different effect on the equilibrium. Because the demand curve is generally downward sloping, a shift in the supply curve either upward or to the left will result in a higher equilibrium price and a lower equilibrium quantity. However, a shift in the supply either downward or to the right will result in a lower equilibrium price and a higher equilibrium quantity. So for the example of the gasoline market where the supply curve shifts upward, we can expect prices to rise and the quantity sold to decrease (see Figure 6.8).
The shape of the demand curve dictates whether a shift in the supply curve will result in more change in the equilibrium price or the equilibrium quantity. With a demand curve that is flat, or elastic, a shift in supply curve will change the equilibrium quantity more than the price (see Figure 6.9). With a demand curve that is vertical, or inelastic, a shift in the supply curve will change the equilibrium price more than the equilibrium quantity (see Figure 6.10).
The characterization of a demand curve as being elastic or inelastic corresponds to the measure of price elasticity that was discussed in Chapter 3. Recall from the discussion of short-run versus long-run demand that in the short run, customers are limited in their options by their consumption patterns and technologies. This is particularly true in the case of gasoline consumption. Consequently, short-run demand curves for gasoline tend to be very inelastic. As a result, if changing crude oil prices results in an upward shift in the supply curve for gasoline, we should expect the result to be a substantial increase in the price of gasoline and only a fairly modest decrease in the amount of gasoline consumed.
The shift is generally in terms of the quantity when the demand curve is elastic.
The shift is generally in terms of the price when the demand curve is inelastic. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.06%3A_Shifts_in_Supply_and_Demand_Curves.txt |
In a simple market under perfect competition, equilibrium occurs at a quantity and price where the marginal cost of attracting one more unit from one supplier is equal to the highest price that will attract the purchase of one more unit from a buyer. At the price charged at equilibrium, some buyers are getting a bargain of sorts because they would have been willing to purchase at least some units even if the price had been somewhat higher. The fact that market demand curves are downward sloping rather than perfectly flat reflects willingness of customers to make purchases at higher prices.
At least in theory, we could imagine taking all the units that would be purchased at the equilibrium price and using the location of each unit purchase on the demand curve to determine the maximum amount that the buyer would have been willing to pay to purchase that unit. The difference between what the customer would have paid to buy a unit and the lower equilibrium price he actually paid constitutes a kind of surplus that goes to the buyer. If we determined this surplus for each item purchased and accumulated the surplus, we would have a quantity called consumer surplus. Using a graph of a demand curve, we can view consumer surplus as the area under the demand curve down to the horizontal line corresponding to the price being charged, as shown in Figure 6.11.
On the supplier side, there is also a potential for a kind of surplus. Since market supply curves are usually upward sloping, there are some sellers who would have been willing to sell the product even if the price had been lower because the marginal cost of the item was below the market price, and in perfect competition, a producer will always sell another item if the price is at least as high as the marginal cost. If, as before, we assessed each item sold in terms of its marginal cost, calculated the difference between the price and the marginal cost, and then accumulated those differences, the sum would be a quantity called the producer surplus.
The producer surplus reflects the combined economic profit of all sellers in the short run. For a graph of the supply curve, the producer surplus corresponds to the area above the supply curve up to the horizontal line at the market price, again as shown in Figure 6.11.
Consumer surplus will increase as the price gets lower (assuming sellers are willing to supply at the level on the demand curve) and producer surplus will increase as the prices gets higher (assuming buyers are willing to purchase the added amount as you move up the supply curve). If we asked the question, at what price would the sum of consumer surplus plus producer surplus would be greatest, the answer is at the equilibrium price, where the demand curve and supply curve cross.
To support this claim, suppose sellers decided to increase the price above the equilibrium price. Since consumers would purchase fewer items, the quantity they could sell is dictated by the demand curve. The new producer surplus, as seen in Figure 6.12, might be higher than the producer surplus at the equilibrium price, but the consumer surplus would be decidedly lower. So any increase in producer surplus comes from what had been consumer surplus. However, there is a triangular area in Figure 6.12, between the supply and demand curve and to the right of the new quantity level, which represents former surplus that no longer goes to either consumers or producers. Economists call this lost surplus a deadweight loss.
If the price were lower than the equilibrium price, we encounter a situation where producer surplus decreases and at best only some of that decrease transfers to consumers. The rest of the lost producer surplus is again a deadweight loss, as seen in Figure 6.13.
The important point is that changing the price is worse than just a shift of surplus from consumers to producers, or vice versa. If the entire sum of consumer surplus and producer surplus could grow at a different price, it could be argued that the government could use a tax to take some of the excess received by one group and redistribute it to the other party so everyone was as well off or better off. Unfortunately, due to the deadweight loss, the gain to one of two parties will not offset the loss to the other party. So the equilibrium point is not only a price and quantity where we have agreement between the demand curve and supply curve, but also the point at which the greatest collective surplus is realized.
Note the creation of a deadweight loss that was formerly part of either consumer surplus or producer surplus when the market operated at the perfect competition equilibrium.
Note the creation of a deadweight loss that was formerly part of either consumer surplus or producer surplus when the market operated at the perfect competition equilibrium. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.07%3A_Why_Perfect_Competition_Is_Desirable.txt |
As an example, consider midsized passenger automobiles. Some firms may sell cars that are a different color or different shape, have different configurations of onboard electronics like GPS systems, and so on. Some firms may make the cars more reliable or built to last longer.
Variation in the product by sellers will only make sense if consumers are responsive to these differences and are willing to pay a slightly higher price for the variation they prefer. The reason that slightly higher prices will be necessary is that in order to support variation in product supplied, sellers may no longer be able to operate at the same minimum efficient scale that was possible when there was one version of the good that every seller produced in a manner that was indistinguishable from the good of other sellers.
The fact that firms may be able to charge a higher price may suggest that firms can now have sustained positive economic profits, particularly if they have a variation of the product that is preferred by a sizeable group of buyers. Unfortunately, even under monopolistic competition, firms can expect to do no better than a zero economic profit in the long run. The rationale for this is as follows: Suppose a firm has discovered a niche variation that is able to sustain a premium price and earn a positive economic profit. Another firm selling in the market or a new entrant in the market will be attracted to mimic the successful firm. Due to free entry and perfect information, the successful firm will not be able to stop the copycats. Once the copycats are selling a copy of this product variation, a process of price undercutting will commence as was described for perfect information, and prices will continue to drop until the price equals average cost and firms are earning only a zero economic profit.
6.09: Contestable Market Model
In the contestable market model, there can be a modest number of sellers, each of which represents a sizeable portion of overall market sales. However, the assumptions of free entry and exit and perfect information need to be retained and play a key role in the theory underlying this model. If buyers in the market know which seller has the lowest price and will promptly transfer their business to the lowest price seller, once again any firm trying to sell at a higher price will lose all its customers or will need to match the lowest price.
Of course, it may be argued that the selling firms, by virtue of their size and being of limited number, could all agree to keep prices above their average cost so they can sustain positive economic profits. However, here is where the assumption of free entry spoils the party. A new entrant could see the positive economic profits of the existing sellers, enter the market at a slightly lower price, and still earn an economic profit. Once it is clear that firms are unable to sustain a pact to maintain above cost prices, price competition will drive the price to where firms will get zero economic profits.
In the late 1970s, the U.S. government changed its policy on the passenger airline market from a tightly regulated market with few approved air carriers to a deregulated market open to new entrants. The belief that airlines could behave as a contestable market model was the basis for this change. Previously, the philosophy was that airline operations required too much capital to sustain more than a small number of companies, so it was better to limit the number of commercial passenger airlines and regulate them. The change in the 1970s was that consumers would benefit by allowing free entry and exit in the passenger air travel market. Initially, the change resulted in several new airlines and increases in the ranges of operations for existing airlines, as well as more flight options and lower airfares for consumers. After a time, however, some of the larger airlines were able to thwart free entry by dominating airport gates and controlling proprietary reservation systems, causing a departure from the contestable market model.A good account of airline industry deregulation is in chapter 9 of Brock (2009). | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.08%3A_Monopolistic_Competition.txt |
Markets that closely resemble the perfect competition model or its variants might be ideal from the standpoint of market customers and as a means of increasing social surplus. From the perspective of individual selling firms, highly competitive markets require that sellers carefully attend to cost and market conditions, while promising only modest returns on assets and invested capital for those firms that manage to survive. Despite the limited opportunity for profit in these markets over the long run, good and well-executed strategies can help firms in these markets be among the survivors and perhaps extend the period in which they can do better than sell products at average cost.
Michael Porter of Harvard University prepared a guidebook for firms to prevail in these competitive markets in his text Competitive Strategy (see Porter (1980)). Basically, he advises that firms adopt an aggressive program to either keep their costs below the costs of other sellers (called a cost leadership strategy) or keep their products distinguishable from the competition (called a product differentiation strategy). The logic of either of these strategies can be viewed as trying to delay the development of the assumed conditions of perfect competition, so as to delay its long-run conclusions of zero economic profit.
The perfect competition model allows that some firms will do better than others in the short run by being able to produce a good or service at lower cost, due to having better cost management, production technologies, or economies of scale or scope. However, the model assumption of perfect information means that any firms with cost advantages will soon be discovered and mimicked. The cost leadership strategy prescribes that firms need to continually look for ways to continue to drive costs down, so that by the time the competition copies their technology and practices, they have already progressed to an even lower average cost. To succeed, these programs need to be ongoing, not just done once.
The monopolistic competition model allows for some differentiation in a product and the opportunity to charge a higher price because buyers are willing to pay a premium for this. However, any short-run opportunity for increased economic profit from selling a unique version of the product will dissipate as the competition takes notice and copies the successful variant. Porter’s product differentiation strategy is basically a steady pursuit of new product variants that will be prized by the consumer, with the intent of extending the opportunity for above-normal profits. However, as with the cost leadership strategy, to be successful, a firm must commit itself to continued product differentiation with up-front investment in development and market research.
Porter suggests that each of his two strategies may be geared toward participation in a broader market or limited to a particular segment of the market, which he calls a focus strategy. A focus strategy endeavors to take advantage of market segmentation. As we discussed in Chapter 3, the population of buyers is not usually homogeneous; some are willing to pay a higher price (less price elastic) and some are willing to purchase in greater volume. By focusing on a particular segment, a firm may be able to maintain an advantage over other sellers and again forestall the onset of the long-run limitations on seller profits. The goal of the focus strategy is to be able to serve this segment either at lower cost or with product variations that are valued by the customer segment. Of course, by focusing on just one or a subset of buyer segments, a firm loses the opportunity for profits in other segments, so depending on the product, the circumstances of the market, and the assets of the firm, a broader application of cost leadership or product differentiation may be better.
The potential for success using a cost leadership strategy or a product differentiation strategy might suggest that a firm can do even better by practicing both cost leadership and product differentiation. Porter advises against this, saying that firms that try to use both strategies risk being “stuck in the middle.” A firm that tries to be a cost leader will typically try to take advantage of scale economies that favor volume over product features and attract customers who are sensitive to price. Product differentiation seeks to attract the less price sensitive customer who is willing to pay more, but the firm may need to spend more to create a product that does this. Firms that try to provide a good or service that costs less than the competition and yet is seen as better than the competition are endeavoring to achieve two somewhat opposing objectives at the same time. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/06%3A_Market_Equilibrium_and_the_Perfect_Competition_Model/6.10%3A_Firm_Strategies_in_Highly_Competitive_Markets.txt |
• 7.1: Why Perfect Competition Usually Does Not Happen
The perfect competition model (and its variants like monopolistic competition and contestable markets) represents an ideal operation of a market. As we noted in Chapter 6, not only do the conditions of these models encourage aggressive competition that keeps prices as low as possible for buyers, but the resulting dynamics create the greatest value for all participants in the market in terms of surplus for consumers and producers.
• 7.2: Monopoly
Often, the main deterrent to a highly competitive market is market power possessed by sellers. In this section, we will consider the strongest form of seller market power, called a monopoly. In a monopoly there is only one seller, called a monopolist.
• 7.3: Oligopoly and Cartels
Unless a monopoly is allowed to exist due to a government license or protection from a strong patent, markets have at least a few sellers. When a market has multiple sellers, at least some of which provide a significant portion of sales and recognize (like the monopolist) that their decisions on output volume will have an effect on market price, the arrangement is called an oligopoly.
• 7.4: Production Decisions in Noncartel Oligopolies
Oligopolies exist widely in modern economies. However, most do not function as cartels. Still, since these markets have relatively few sellers and each has a significant share of market sales, in many cases the total market production by oligopoly firms is less than would be expected if the market were perfectly competitive, and prices will be somewhat higher.
• 7.5: Seller Concentration
Although high seller concentration in itself is not sufficient for exercise of seller power, it is generally a necessary condition and constitutes a potential for the exercise of seller power in the future. In this section, we will consider two numerical measures of market concentration: concentration ratios and the Herfindahl-Hirschmann Index (HHI).
• 7.6: Competing in Tight Oligopolies- Pricing Strategies
Economists have employed the applied mathematical tools of game theory to try to capture the dynamics of oligopoly markets. Game theory is outside the scope of this text, but we will consider some of the insights gained from the application of game theory in discussions about strategy in this and the following sections.
• 7.7: Competing in Tight Oligopolies - Nonpricing Strategies
Oligopoly firms also use a number of strategies that involve measures other than pricing to compete and maintain market power. Some of these strategies try to build barriers to entry by new entrants, whereas the intention of other measures is to distinguish the firm from other existing competitors.
• 7.8: Buyer Power
The bulk of this chapter looked at facets of market power that is possessed and exploited by sellers. However, in markets with a few buyers that individually make a sizeable fraction of total market purchases, buyers can exercise power that will influence the market price and quantity.
07: Firm Competition and Market Structure
The perfect competition model (and its variants like monopolistic competition and contestable markets) represents an ideal operation of a market. As we noted in Chapter 6, not only do the conditions of these models encourage aggressive competition that keeps prices as low as possible for buyers, but the resulting dynamics create the greatest value for all participants in the market in terms of surplus for consumers and producers.
Some markets resemble perfect competition more than others. Agricultural markets, particularly up through the beginning of the 20th century, were viewed as being close to a real-world version of a perfectly competitive market. There were many farmers and many consumers. No farmer and no consumer individually constituted sizeable fractions of the market activity, and both groups acted as price takers. With a modest amount of capital, one could acquire land, equipment, and seed or breeding stock to begin farming, especially when the United States was expanding and large volumes of unused land were available for purchase or homesteading. Although some farmers had better land and climate or were better suited for farming, the key information about how to farm was not impossible to learn.
However, in recent decades circumstances have changed, even for farming, in a way that deviates from the assumptions of perfect competition. Now farmers are unlikely to sell directly to consumers. Instead, they sell to food processing companies, large distributors, or grocery store chains that are not small and often not price takers. Many farming operations have changed from small, family-run businesses to large corporate enterprises. Even in markets where farming operations are still relatively small, the farmers form cooperatives that have market power. Additionally, the government takes an active role in the agriculture market with price supports and subsidies that alter farm production decisions.
One reason so few markets are perfectly competitive is that minimum efficient scales are so high that eventually the market can support only a few sellers. Although the contestable market model suggests that this factor alone does not preclude aggressive price competition between sellers, in most cases there is not really free entry for new firms. A new entrant will often face enormous startup capital requirements that prohibit entry by most modest-sized companies or individual entrepreneurs. Many markets are now influenced by brand recognition, so a new firm that lacks brand recognition faces the prospect of large promotional expenses and several periods with losses before being able to turn a profit. To justify the losses in the startup period, new entrants must expect they will see positive economic profits later to justify these losses, so the market is not likely to reach the stage of zero economic profit even if the new entrants join.
Due to economies of scope, few sellers offer just one product or are organized internally such that production of that one product is largely independent of the other products sold by that business. Consequently, it will be very difficult for a competitor, especially a new entrant in the market, to readily copy the breadth of operations of the most profitable sellers and immediately benefit from potential economies of scope.
Sellers that are vertically integrated may have control of upstream or downstream markets that make competition difficult for firms that focus on one stage in the value chain. For example, one firm may have control of key resources required in the production process, in terms of either the overall market supply or those resources of superior quality, making it hard for other firms to match their product in both cost and quality. Alternatively, a firm may control a downstream stage in the value chain, making it difficult for competitors to expand their sales, even if they price their products competitively.
As we will discuss in the next chapter, markets are subject to regulation by government and related public agencies. In the process of dealing with some perceived issues in these markets, these agencies will often block free entry of new firms and free exit of existing firms.
In our complex technological world, perfect information among all sellers and buyers is not always a reasonable assumption. Some sellers may possess special knowledge that is not readily known by their competition. Some producers may have protection of patents and exclusive rights to technology that gives them a sustained advantage that cannot be readily copied. On the buyer side, consumers usually have a limited perspective on the prices and products of all sellers and may not always pay the lowest price available for a good or service (although the Internet may be changing this to some degree).
Finally, for the perfect competition model to play out according to theory, there needs to be a reasonable level of stability so that there is sufficient time for the long-run consequences of perfect competition to occur. However, in our fast-changing world, the choices of goods and services available to consumers, the technologies for producing those products and services, and the costs involved in production are increasingly subject to rapid change. Before market forces can begin to gel to create price competition and firms can modify their operations to copy the most successful sellers, changes in circumstances may stir enough such that the market formation process starts anew. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.01%3A_Why_Perfect_Competition_Usually_Does_Not_Happen.txt |
Often, the main deterrent to a highly competitive market is market power possessed by sellers. In this section, we will consider the strongest form of seller market power, called a monopoly. In a monopoly there is only one seller, called a monopolist.
Recall that in perfect competition, each firm sees the demand curve it faces as a flat line, so it presumes it can sell as much as it wants, up to its production limit, at the prevailing market price. Even though the overall market demand curve decreases with increased sales volume, the single firm in perfect competition has a different perception because it is a small participant in the market and takes prices as given. In the case of flat demand curves, price and marginal revenue are the same, and since a profit-maximizing producer decides whether to increase or decrease production volume by comparing its marginal cost to marginal revenue, in this case the producer in perfect competition will sell more (if it has the capability) up the point where marginal cost equals price.
In a monopoly, the demand curve seen by the single selling firm is the entire market demand curve. If the market demand curve is downward sloping, the monopolist knows that marginal revenue will not equal price. As we discussed in Chapter 2, when the demand curve is downward sloping, the marginal revenue corresponding to any quantity and price on the demand curve is less than the price (see Figure 7.1). Because the condition for optimal seller profit is where marginal revenue equals marginal cost, the monopolist will elect to operate at a quantity where those two quantities are in balance, which will be at volume marked QM in Figure 7.1.
Since the monopolist has complete control on sales, it will only sell at the quantity where marginal revenue equals marginal cost but will sell at the higher price associated with that quantity on the demand curve, PM, rather than the marginal cost at a quantity of QM.
If the marginal cost curve for the monopolist were instead the combined marginal cost curves of small firms in perfect competition, the marginal cost curve would correspond to the market supply curve. The perfect competition market equilibrium would occur at a volume QC, with a price PC. The monopolist could afford to function at this same volume and price and may even earn some economic profit. However, at this volume, marginal cost is greater than marginal revenue, indicating greater profit by operating at a lower volume at a higher price. The highest profit will result from selling QM units at a price of PM. Unfortunately, consumers do worse at the monopolist’s optimal operation as they pay a higher price and purchase fewer units. And as we noted in the previous chapter, the loss in consumer surplus will exceed the profit gain to the monopolist. This is the main reason monopolies are discouraged, if not outlawed, by governments.
7.03: Oligopoly and Cartels
Unless a monopoly is allowed to exist due to a government license or protection from a strong patent, markets have at least a few sellers. When a market has multiple sellers, at least some of which provide a significant portion of sales and recognize (like the monopolist) that their decisions on output volume will have an effect on market price, the arrangement is called an oligopoly.
At the extreme, sellers in an oligopoly could wield as much market power as a monopolist. This occurs in an oligopoly arrangement called a cartel, where the sellers coordinate their activities so well that they behave in effect like divisions of one enterprise, rather than as a competing business, that make independent decisions on quantity and price. (You may be familiar with the term cartel from the OPEC oil exporting group that is frequently described as a cartel. However, though OPEC has considerable market power and influence on prices, there are oil exporters that are not in OPEC, and internally OPEC only sets member targets rather than fully coordinating their operations.)
In theory, a cartel would operate at the same production volume and price as it would if its productive resources were all run by a monopolist. In a cartel, every member firm would sell at the same price and each firm would set its individual production volume such that every firm operates at the same marginal cost.
For the same reason that monopolies are considered harmful, cartels are usually not tolerated by governments for the regions in which those markets operate. Even the collusion that is a necessary component of a true cartel is illegal.
However, although cartels could theoretically function with the same power as a monopolist, if the cartel truly contains multiple members making independent decisions, there is a potential instability that can undo the cartel arrangement. Because monopolists gain added profit by reducing production volume and selling at a price above marginal cost, individual members may see an opportunity to defect, particularly if they can do so without being easily detected. Since the cartel price will be well above their marginal cost, they could profit individually by increasing their own production. Of course, if the defection is discovered and the other members retaliate by increasing their volumes as well, the result could be a substantially lower market price and lower economic profits for all cartel members.
Another problem for cartels is how to divide the profits. Suppose a cartel had two member firms, A and B. Firm A has more efficient facilities than Firm B, so the cartel solution will be to allow Firm A to provide the bulk of the production volume. However, if Firm A claims its share of the profits should be proportional to its share of the production volume, Firm B may object to voluntarily withholding its production only to allow to Firm A to grab most of the sales and profit, and the arrangement could end.
Also, since optimal cartel operation means that all firms set production so all have the same marginal cost, the firms need to share internal information for the cartel to determine the total volume where marginal revenue equals marginal cost and how that volume gets divided between firms. Again, some firms may have the incentive to keep the details of their operations private from other firms in the cartel. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.02%3A_Monopoly.txt |
Oligopolies exist widely in modern economies. However, due to the reasons just cited, most do not function as cartels. Still, since these markets have relatively few sellers and each has a significant share of market sales, in many cases the total market production by oligopoly firms is less than would be expected if the market were perfectly competitive, and prices will be somewhat higher.
From the point of theory, the expected operation of the firm in perfect competition or in monopoly/cartel is straightforward. Assuming the firm in the perfect competition sufficiently understands its production costs, it will increase volume up to the point where its marginal cost exceeds the price. For a monopolist or cartel, production should increase up to point where marginal cost equals marginal revenue.
Oligopolies fall somewhere in between perfect competition and a cartel. However, the prescription of how to set optimal production volume is considerably more complex than either of the extremes. Like the monopolist, the oligopoly firm is aware that significant changes in its production level will have a significant effect on the market supply quantity, requiring a change in the market price to be in agreement with a downward sloping demand curve. However, while the firm is aware its production decisions will affect the market price, it is difficult to forecast the actual impact on price, even if the firm knows the behavior of the market demand curve.
A major reason for the complexity in determining the optimal production level is that the firm does not know how its oligopoly competitors will respond to its production decisions. For example, suppose a firm looks at the current market price and decides based on the market demand curve that it could increase its production volume by 1000 units per day and make a greater profit, even if the price dropped according to the market demand curve. Other sellers in the market will see the action taken and may decide that if the price is dropping and market demand is increasing that they could benefit by increasing their production to take advantage. As a consequence, the total market volume may increase more than expected, prices will drop more than expected, and the resulting gain in profit will be less than what the initial firm expected when it did its analysis.
Trying to figure out how to deal with reactions of other sellers not only is a vexing problem for sellers in oligopolies but has been a difficult challenge for academic economists who try to develop theories of oligopoly. The scholarly literature of economics is filled with elaborate mathematical models that attempt to address oligopoly operation. Next we will consider some of the insights of these analyses without the mathematics.
One approach that economists have used to model the behavior of oligopoly firms, known as the Bertrand model or price competition, is to assume all firms can anticipate the prices that will be charged by their competitors. If firms can reasonably anticipate the prices that other firms will charge and have a reasonable understanding of market demand, each firm can determine how customers would react to its own price and decide what production level and price leads to highest profit. The soft drink market is an example of a market that could operate in this manner.
Another approach for modeling oligopoly behavior, known as the Cournot model or quantity competition, is to assume all firms can determine the upcoming production levels or operating capacities of their competitors. For example, in the airline industry, schedules and gate arrangements are made months in advance. In essence, the airlines have committed to a schedule, their flying capacities are somewhat fixed, and what remains is to make the necessary adjustments to price to use the committed capacity effectively.
In comparing models where firms anticipate price to those where firms anticipate production volume or capacity commitment, firms that anticipate quantity levels tend to operate at lower production levels and charge higher prices. This occurs because in a quantity competition model, firms subtract the planned operation of their rivals from the market demand curve and assume the residual is the demand curve they will face. This leads to the presumption that the price elasticity of their own demand is the same as the price elasticity of overall market demand, whereas in price competition models the elasticity of the firm’s own demand is seen as greater than the price elasticity of overall market demand (as was the case in the perfect competition model).
The number of selling firms also has an effect on the likely outcome of oligopoly competition. As the number of firms increases, the market equilibrium moves toward the equilibrium that would be expected in a perfectly competitive market of firms with the same aggregate production resources.
Another issue that can affect the prices and quantity volumes in an oligopoly market is the existence of a “leader” firm. A leader firm will make a decision on either its price or its volume/capacity commitment and then the remaining “follower firms” determine how they will react. An example of a leader firm in an industry might be Apple in the portable media player market. Apple decides on how it will price its iPod products and other manufacturers then decide how to price their products. Although the leader firm commits first in these models, in order to determine its own best course of action, it needs to anticipate how the follower firms will react to its decision. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.04%3A_Production_Decisions_in_Noncartel_Oligopolies.txt |
Sellers in oligopolies can limit competition by driving out competitors, blocking entry by new competitors, or cooperating with other sellers with market power to keep prices higher than would be the case in a market with strong price competition. In order for sellers to exercise market power, either the market will have fairly few selling firms or there will be some selling firms that account for a large portion of all the market sales. When this happens, the market is said to have high seller concentration. Although high seller concentration in itself is not sufficient for exercise of seller power, it is generally a necessary condition and constitutes a potential for the exercise of seller power in the future. In this section, we will consider two numerical measures of market concentration: concentration ratios and the Herfindahl-Hirschmann Index (HHI).
Both measures of seller concentration are based on seller market shares. A firm’s market share is the percentage of all market sales that are purchased from that firm. The highest possible market share is 100%, which is the market share of a monopolist. Market shares may be based either on the number of units sold or in terms of monetary value of sales. The latter use of monetary value is convenient when there are variations in the good or service sold and different prices are charged.
Concentration ratios are the result of sorting all sellers on the basis of market share, selecting a specified number of the firms with the highest market shares, and adding the market shares for those firms. For example, the concentration ratio CR4 is the sum of the market shares for the four largest firms in terms of volume in a market and CR8 is the sum of the eight largest firms in terms of volume. The U.S. Census Bureau periodically publishes concentration ratios for different industries in the United States.See U.S. Census Bureau (2010).
Suppose a market has 10 sellers with market shares (ranked from high to low) of 18%, 17%, 15%, 13%, 12%, 8%, 7%, 5%, 3%, and 2%. The CR4 ratio for this market would be 63 (18 + 17 + 15 + 13), and the CR8 ratio would be 95 (18 + 17 + 15 + 13 + 12 + 8 + 7 + 5).
Although concentration ratios are easy to calculate and easily understood, there are two shortcomings. First, the number of firms in the ratio is arbitrary. There is no reason that a four-firm concentration ratio indicates concentration potential any better than a three-firm or five-firm concentration ratio. Second, the ratio does not indicate whether there are one or two very large firms that clearly dominate all other firms in market share or the market shares for the firms included in the concentration ratio are about the same.
An alternative concentration measure that avoids these problems is the HHI. This index is computed by taking the market shares of all firms in the market, squaring the individual market shares, and finally summing them. The squaring has the effect of amplifying the larger market shares. The highest possible value of the HHI is 10,000, which occurs in the case of a monopoly (10,000 = 1002). If, on the other hand, you had a market that had 100 firms that each had a market share of 1%, the HHI would be 100 (1 = 12, summed 100 times). For the previous 10-firm example, the HHI would be 1302. Although there is no inherent reason for squaring market shares, the HHI includes all firms in the computation (avoiding the issue of how many firms to include) and reflects the variation in magnitude of market shares.
As far as interpreting these concentration measures, the following statements provide some guidance on the potential for market power by sellers:
• If CR4 is less than 40 or the HHI is less than 1000, the market has fairly low concentration and should be reasonably competitive.
• If CR4 is between 40 and 60 or the HHI is between 1000 and 2000, there is a loose oligopoly that probably will not result in significant exercise of market power by sellers.
• If CR4 is above 60 or the HHI is above 2000, then there is a tight oligopoly that has significant potential for exercise of seller power.
• If CR1 is above 90 or the HHI is above 8000, one firm will be a clear leader and may function effectively as a monopoly.
Again, a high concentration measure indicates a potential for exploitation of seller power but not proof it will actually happen. Another important caution about these measures is that the scope of the market needs to be considered. In the case of banking services, even with the mergers that have resulted in higher seller concentration, if you look at measures of bank concentration at the national level, there seems be a loose oligopoly. However, if you limit the scope to banking in a single city or region, it is very likely that only few banks serve those areas. There can be modest concentrations when examining national markets but high concentration at the local level. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.05%3A_Seller_Concentration.txt |
In recent decades, economists have employed the applied mathematical tools of game theory to try to capture the dynamics of oligopoly markets. The initial research papers are generally abstract and very technical, but the acquired insights of some of this research have been presented in textbooks geared to nontechnical readers (a text that applies game theory to management is Brandenburger and Nalebuff (1996)). Game theory is outside the scope of this text, but we will consider some of the insights gained from the application of game theory in discussions about strategy in this and the following sections.
In this section, we will consider the economics underlying some of pricing strategies used by firms in monopolies and tight oligopolies.
1. Deep discounting. One exercise of seller power is to try to drive out existing competition. Deep discounting attempts to achieve this by setting the firm’s price below cost, or at least below the average cost of a competitor. The intent is to attract customers from the competitor so that the competitor faces a dilemma of losses from either lost sales or being forced to follow suit and also set its price below cost. The firm initiating the deep discounting hopes that the competitor will decide that the best reaction is to exit the market. In a market with economies of scale, a large firm can better handle the lower price, and the technique may be especially effective in driving away a small competitor with a higher average cost. If and when the competitor is driven out of the market, the initiating firm will have a greater market share and increased market power that it can exploit in the form of higher prices and greater profits than before.
2. Limit pricing. A related technique for keeping out new firms is the technique of limit pricing. Again, the basic idea is to use a low price, but this time to ward off a new entrant rather than scare away an existing competitor. Existing firms typically have lower costs than a new entrant will initially, particularly if there are economies of scale and high volume needed for minimum efficient scale. A limit price is enough for the existing firm to make a small profit, but a new entrant that needs to match the price to compete in the market will lose money. Again, when the new entrant is no longer a threat, the existing firm can reassert its seller power and raise prices for a sustained period well above average cost. As a game of strategy, the new entrant may reason that if it is willing to enter anyway and incur an initial loss, once its presence is in the market is established, the existing firm will realize their use of limit pricing did not work and decide it would be better to let prices go higher so that profits will increase, even if that allows the new entrant to be able to remain in the market.
3. Yield management. Another method for taking advantage of the power to set prices is yield management, where the firm abandons the practice of setting a fixed price and instead changes prices frequently. One goal is to try to extract higher prices from customers who are willing to pay more for a product or service. Normally, with a fixed announced price, customers who would have been willing to pay a significantly higher price get the consumer surplus. Even if the firm employs third-degree price discrimination and charges different prices to different market segments, some customers realize a surplus from a price well below the maximum they would pay. Using sophisticated software to continuously readjust prices, it is possible to capture higher prices from some of these customers. Yield management can also make it more difficult for other firms to compete on the basis of price since it does not have a known, fixed price to work against.
A good example of yield management is the airline industry. Airlines have long employed price discrimination in forms of different classes of customers, different rates for flyers traveling over a weekend, and frequent flyer programs. However, in recent years, the price to buy a ticket can change daily, depending on the amount of time until the flight occurs and the degree to which the flight has already filled seats.
4. Durable goods. When firms in monopolies and oligopolies sell long-lived durable goods like cars and televisions, they have the option to sell to customers at different times and can attempt to do something similar to first-degree price discrimination by setting the price very high at first. When the subset of customers who are willing to pay the most have made their purchase, the firms can drop the price somewhat and attract another tier of customers who are willing to pay slightly less than the first group. Progressively, the price will be dropped over time to attract most customers at a price close to the maximum they would be willing to pay.
However, economists have pointed out that customers may sense this strategy, and if patient, the customer can wait and pay a much lower price than the perceived value of the item. Even if the firm has little competition from other firms, a firm may find itself in the interesting situation of competing with itself in other production periods. In theoretical analyses of monopolies that sold durable goods, it has been demonstrated that when durable goods last a long time and customers are patient, even a monopolist can be driven to price items at marginal cost.The durable goods problem is discussed in Kreps (2004).
One response to the durable goods dilemma is to sell goods with shorter product lives so that customers will need to return sooner to make a purchase. U.S. car manufacturers endeavored to do this in the middle of the 20th century but discovered that this opened the door for new entrants who sold cars that were designed to last longer.
Another response is to rent the use of the durable good rather than sell the good outright. This turns the good into a service that is sold for a specified period of time rather than a long-lived asset that is sold once to the customer (for at least a long time) and allows more standard oligopoly pricing that is applied for consumable goods and services. This arrangement is common with office equipment like copiers. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.06%3A_Competing_in_Tight_Oligopolies-_Pricing_Strategies.txt |
Oligopoly firms also use a number of strategies that involve measures other than pricing to compete and maintain market power. Some of these strategies try to build barriers to entry by new entrants, whereas the intention of other measures is to distinguish the firm from other existing competitors.
1. Advertising. As we noted in Chapter 3, most firms incur the expense of advertising. To some extent, advertising is probably necessary because buyers, particularly household consumers, face a plethora of goods and services and realistically can actively consider only a limited subset of what is available. Advertising is a means of increasing the likelihood a firm’s product or service is among those services actually considered.
When the firm is an upstream seller in a value chain with downstream markets, advertising may be directed at buyers in downstream markets. The intent is to encourage downstream buyers to look for products that incorporate the upstream firm’s output. An example of such advertising is in pharmaceuticals, where drug manufacturers advertise in mass media with the intent of encouraging consumers to request a particular drug from their physicians.
In tight oligopolies, firms may boost the intensity of advertising well beyond the amount needed to inform buyers of the existence of their goods and services. Firms may advertise almost extravagantly with the idea of not only establishing brand recognition but making strong brand recognition essential to successful competition in the market. Once strong brand recognition takes hold in the market, new firms will need to spend much more to establish brand recognition than existing firms spend to maintain brand recognition. Hence new entrants are discouraged by what is perceived as a high startup fee, which is a type of barrier to entry.
2. Excess capacity. Ordinarily a firm will plan for a capacity that is sufficient to support the production volume. Because capacity is often planned in advance and actual production volume may vary from period to period, the firm may have some excess capacity in some periods. And since there is inherent uncertainty in future demand, firms may even invest in capacity that is never fully utilized.
However, firms in oligopolies may invest, or partially invest, in capacity well beyond what is needed to cover fluctuations in volume and accommodation of uncertainty as a means of competing. If the sellers in an oligopoly have been successful in collectively holding back on quantity to drive up the price and profits, since the price is well above average cost, there is an opportunity for one firm to offer the product at a lower price, attract a sizeable fraction of the new customers attracted by the lower price, and make a sizeable individual gain in profit. This gambit may come from a new entrant or even an existing seller. This tactic may work, at least for a time, if the firm introducing the lower price does it by surprise and the other firms are not prepared to ramp up production rapidly to match the initiator’s move.
One way to protect against an attack of this nature is to have a significant amount of excess capacity, or at least some additional capacity that could be upgraded and brought online quickly. The firm doing this may even want to clearly reveal this to other sellers or potential sellers as a signal that if another firm were to try an attack of this nature, they are prepared to respond quickly and make sure they take advantage of the increased sales volume.
3. Reputation and warranties. As a result of fluctuations in cost or buyer demand, being a seller in a market may be more attractive in some periods than others. During periods that are lucrative for being a seller, some firms may be enticed to enter on a short-term basis, with minimal long-term commitments, enjoy a portion of the spoils of the favorable market, and then withdraw when demand declines or costs increase.
Firms that intend to remain in the market on an ongoing basis would prefer that these hit-and-run entrants not take away a share of the profits when the market is attractive. One measure to discourage this is to make an ongoing presence desired by the customer so as to distinguish the product of the ongoing firms from the product of the short-term sellers. As part of advertising, these firms may emphasize the importance of a firm’s reputation in providing a quality product that the firm will stand behind.
Another measure is to make warranties a part of the product, a feature that is only of value to the buyer if the seller is likely to be available when a warranty claim is made. Like high-cost advertising, even the scope of the warranty may become a means of competition, as is seen in the automobile industry where warranties may vary in time duration, number of driven miles, and systems covered.
4. Product bundling. In Chapter 3, we discussed the notion of complementary goods and services. This is a relationship in which purchasers of one good or service become more likely to purchase another good or service. Firms may take advantage of complementary relationships by selling products together in a bundle, where consumers have the option to purchase multiple products as a single item at lower total cost than if the items were purchased separately. This can be particularly effective if there are natural production economies of scope in these complementary goods. If competitors are unable to readily match the bundled product, the firm’s gain can be substantial.
A good example of successful product bundling is Microsoft Office. Microsoft had developed the word processing software Word, the spreadsheet software Excel, the presentation software PowerPoint, and the database software Access. Individually, each of these products was clearly outsold by other products in those specialized markets. For example, the favored spreadsheet software in the late 1980s was Lotus 1-2-3. When Microsoft decided to bundle the packages and sell them for a modest amount more than the price of a single software package, customers perceived a gain in value, even if they did not actively use some of the packages. Since all the components were software and distributed on floppy disks (and later on CDs and via web downloads), there was a strong economy of scope. However, when Microsoft introduced the bundle, the firms selling the leader products in the individual markets were not able to match the product bundling, even though some attempted to do so after Microsoft has usurped the market. Consequently, not only was the product bundle a success, but the individual components of Microsoft Office each became the dominant products.
5. Network effects and standards. In some markets, the value of a product to a buyer may be affected by the number of other buyers of the product. For example, a cell phone becomes more valuable if most of the people you would like to phone quickly also carry a cell phone. Products that increase in value when the adoption rate of the product increases, even if some units are sold by competitors, are said to have “network effects.”
One impact of network effects is that industry standards become important. Often network effects occur because the products purchased need to use compatible technologies with other products. In some markets, this may result in some level of cooperation between firms, such as when appliance manufacturers agree to sell units with similar dimensions or connections.
However, sometimes multiple standards emerge and firms may select to support one standard as a means of competing against a firm that uses another standard. Sellers may group into alliances to help improve their success via network effects. In the once-vibrant market for VCR tapes and tape players, the initial standard for producing tapes was called Betamax. This Betamax standard was developed by Sony and used in the VCR players that Sony produced. Soon after Betamax was introduced, the electronics manufacturer JVC introduced the VHS standard. Consumers first had to purchase the VCR player, but the value of the product was affected by the availability and variety of tapes they could acquire afterward, which was determined by whether their player used the Betamax standard or the VHS standard. Eventually the VHS standard prevailed, favoring JVC and the other firms that allied with JVC.
Up until the videotape was eclipsed by the DVD, the VCR industry moved to using the VHS standard almost exclusively. This illustrates a frequent development in a market with strong network effects: a winner-take-all contest. Another example of a winner-take-all situation can be seen with operating systems in personal computers. Although there were multiple operating systems available for PCs in the 1980s, eventually Microsoft’s MS-DOS and later Windows operating systems achieved a near monopoly in personal computer operating systems. Again, the driver is network effects. Companies that produced software saw different markets depending on the operating system used by the buyer. As MS-DOS/Windows increased its market share, companies were almost certain to sell a version of their product for this operating system, usually as their first version and perhaps as their only version. This, in turn, solidified Microsoft’s near monopoly. Although other operating systems still exist and the free operating system Linux and the Apple Macintosh OS have succeeded in some niches, Microsoft Windows remains the dominant operating system. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.07%3A_Competing_in_Tight_Oligopolies-_Nonpricing_Strategies.txt |
The bulk of this chapter looked at facets of market power that is possessed and exploited by sellers. However, in markets with a few buyers that individually make a sizeable fraction of total market purchases, buyers can exercise power that will influence the market price and quantity.
The most extreme form of buyer power is when there is a single buyer, called a monopsony. If there is no market power among the sellers, the buyer is in a position to push the price down to the minimum amount needed to induce a seller to produce the last unit. The supply curve for seller designates this price for any given level of quantity. Although the monopsonist could justify purchasing additional units up to the point where the supply curve crosses its demand curve, the monopsonist can usually get a higher value by purchasing a smaller amount at a lower price at another point on the supply curve.
Assuming the monopsonist is not able to discriminate in its purchases and buy each unit at the actual marginal cost of the unit, rather buying all units at the marginal cost of the last unit acquired, the monopsonist is aware that when it agrees to pay a slightly higher price to purchase an additional unit, the new price will apply to all units purchased. As such, the marginal cost of increasing its consumption will be higher than the price charged for an additional unit. The monopsonist will maximize its value gained from the purchases (amount paid plus consumer surplus) at the point where the marginal cost of added consumption equals the marginal value of that additional unit, as reflected in its demand curve. This optimal solution is depicted in Figure 7.2, with the quantity Qbeing the amount it will purchase and price PS being the price it can impose on the sellers. Note, as with the solution with a seller monopoly, the quantity is less than would occur if the market demand curve were the composite of small buyers with no market power. However, the monopsonist price is less than the monopoly price because the monopsonist can force the price down to the supply curve rather than to what a unit is worth on the demand curve.
When there are multiple large buyers, there will be increased competition that will generally result in movement along the supply curve toward the point where it crosses the market demand curve. However, unless these buyers are aggressively competitive, they are likely to pay less than under the perfect competition solution by either cooperating with other buyers to keep prices low or taking other actions intended to keep the other buyers out of the market.
An example of a monopsonist would be an employer in a small town with a single large business, like a mining company in a mountain community. The sellers in this case are the laborers. If laborers have only one place to sell their labor in the community, the employer possesses significant market power that it can use to drive down wages and even change the nature of the service provided by demanding more tiring or dangerous working conditions. When the industrial revolution created strong economies of scale that supported very large firms with strong employer purchasing power, laborers faced a difficult situation of low pay and poor working conditions. One of the reasons for the rise of the labor unions in the United States was as a way of creating power for the laborers by requiring a single transaction between the employer and all laborers represented by the union. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/07%3A_Firm_Competition_and_Market_Structure/7.08%3A_Buyer_Power.txt |
• 8.1: Free Market Economies Versus Collectivist Economies
Societies that primarily use centralized authorities to manage the creation and distribution of goods and services are called collectivist economies. The philosophy of communism is based on the prescription that centralized authority is the best means of meeting the needs and wants of its citizens.
• 8.2: Efficiency and Equity
There is a subfield of economics called “welfare economics” that focuses on evaluating the performance of markets. Two of the criteria used to assess markets are efficiency and equity.
• 8.3: Circumstances in Which Market Regulation May Be Desirable
When a market operates inefficiently, economists call the situation a market failure. In this chapter, we will address the generic types of market failure.
• 8.4: Regulation to Offset Market Power of Sellers or Buyers
In Chapter 7, we considered how monopolies and monopsonies would try to force changes in the price and quantity to move the market to their advantage, but at an even greater cost to the other side of the market. Again, this is not simply an equity concern that one party is getting most of the surplus created by the market (although that may be a legitimate concern) but rather the exertion of market power results in a net loss in total social surplus.
• 8.5: Natural Monopoly
In industries where the minimum efficient scale is very high, it may be that the lowest average cost is achieved if there is only one seller providing all the goods or services. Examples of such a service might be transmission and distribution of electric power or telephone service. This situation often occurs when total costs are very high but marginal costs are low. Economists call such markets natural monopolies.
• 8.6: Externalities
The second generic type of market failure is when parties other than the buyer and seller are significantly affected by the exchange between the buyer and seller. However, these other parties do not participate in the negotiation of the sale. Consequently, the quantities sold and prices charged do not reflect the impacts on these parties.
• 8.7: Externality Taxes
The most practiced economic instrument to address market externality is a tax. Those who purchase gasoline are likely to pay the sum of the price required by the gasoline station owner to cover his costs (and any economic profit he has the power to generate) plus a tax on each unit of gasoline that covers the externality cost of gasoline consumption such as air pollution, wear and tear on existing public roads, needs for expanding public roads to support more driving, and policing of roads.
• 8.8: Regulation of Externalities Through Property Rights
The economist Ronald Coase postulated that the problem of externalities is really a problem of unclear or inadequate property rights. If the imposition of negative externalities were considered to be a right owned by a firm, the firm would have the option to resell those rights to another firm that was willing to pay more than the original owner of the right would appreciate by keeping and exercising the privilege.
• 8.9: High Cost to Initial Entrant and the Risk of Free Rider Producers
Next, we will consider the third generic type of market failure, or the inability for a market to form or sustain operation due to free riders, by looking at two causes of this kind of failure in this section and the next section. Although the sources are different, both involve a situation where some party benefits from the market exchange without incurring the same cost as other sellers or buyers.
• 8.10: Public Goods and the Risk of Free Rider Consumers
In the case of rival goods, the party consuming the product is easily linked to the party that will purchase the product. Whether the party purchases the product depends on whether the value obtained is at least as high as the price. However, there are other goods that are largely nonrival. This means that several people might benefit from an item produced and sold in the market without diminishing the benefit to others, especially the party that actually made the purchase.
• 8.11: Market Failure Caused by Imperfect Information
Imperfect information can be due to ignorance or uncertainty. If the market participant is aware that better information is available, information becomes another need or want. Information may be acquired through an economic transaction and becomes a commodity that is a cost to the buyer or seller. Useful information is available as a market product in forms like books, media broadcasts, and consulting services.
• 8.12: Limitations of Market Regulation
Although regulation offers the possibility of addressing market failure and inefficiencies that would not resolve by themselves in an unregulated free market economy, regulation is not easy or cost free.
08: Market Regulation
The well-being and stability of any society depends on whether the members of that society are able to acquire the goods and services they need or want. In primitive societies, these issues were settled by either a recognized authority figure (e.g., a king or military leader) or use of force. In modern times, even though we still have kings and dictators, the source of authority is likely to be government laws and agencies. Societies that primarily use centralized authorities to manage the creation and distribution of goods and services are called collectivist economies. The philosophy of communism is based on the prescription that centralized authority is the best means of meeting the needs and wants of its citizens.
For millennia, even collectivist societies have included some level of commerce in the form of trade or purchases with currency. The use of the word “market” to describe the activities of buyers and sellers for goods and services derives from town gathering areas where such exchanges took place. Early markets were limited in terms of how much of the total goods and services in a society were negotiated, but in recent centuries, markets took an increasing role in the allocation of goods and services, starting in Europe. Today, most developed countries operate in a manner where exchange by markets is the rule rather than the exception. Societies that rely primarily on markets to determine the creation of goods and services are called free market economies.
Countries will lean toward being either more free market based or more collectivist, but no country is purely one or the other. In the United States, which is predominantly a free market economy, some services, like fire protection, are provided by public authorities. In China, which is a communist nation, free market activity has thrived in recent decades. As we will discuss in this chapter, even when markets are the main vehicle for allocation, there is some degree of regulation on their operation. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.01%3A_Free_Market_Economies_Versus_Collectivist_Economies.txt |
There is a subfield of economics called “welfare economics” that focuses on evaluating the performance of markets. Two of the criteria used to assess markets are efficiency and equity.
Efficiency is a shortened reference to what economists call Pareto efficiency. The outcome of a set of exchanges between decision-making units in a market or network of markets is called Pareto efficient if it would be impossible to modify how the exchanges occurred to make one party better off without making another party decidedly worse off. If there is a way to change the exchanges or conditions of the exchanges so that every party is at least as satisfied and there is at least one party that is more satisfied, the existing collection of exchanges is not Pareto efficient.
Pure Pareto efficiency is an ideal rather than a condition that is possible in the complex world in which we live. Still, in clear cases where some intervention in the market can result in significant overall improvement in the pattern of exchanges, regulation merits consideration.
One circumstance where this notion of efficiency is not fulfilled is when there is waste of resources that could have some productive value. When markets leave the useful resources stranded to spoil or be underutilized, there is probably a way to reconfigure exchanges to create improvement for some and at a loss to no one.
In the case of monopoly, which we examined in Chapter 7, the price and quantity selected by the monopolist is not efficient because it would be possible, at least in principle, to require the monopolist to set the price at the perfect competition equilibrium, reclaim the deadweight loss in consumer surplus and producer surplus, and redistribute enough of the surplus so the monopolist is as well off as it was at the monopoly price and the consumers are better off.
Equity corresponds to the issue of whether the distribution of goods and services to individuals and the profits to firms are fair. Unfortunately, there is no simple single principle, like Pareto efficiency, that has been adopted as the primary standard for equity. Although there is general support for the idea that the distribution of goods and services ought to favor those with greater talents or those who work harder, there are also those who view access to basic goods and services as reasonable expectations of all citizens. Despite the impossibility of developing a general consensus on what constitutes equity, when enough people become concerned that the distribution of goods and services is too inequitable, there are likely to be pressures on those in political power or political unrest.
Most microeconomists tend to view active regulation of individual markets as worthy of consideration when there are inefficiencies in the functioning of those markets. Since managerial economics (and this text) has a microeconomics focus, we will address the merit of market regulation from this perspective as well.
Problems of inequity are usually regarded as a problem of macroeconomics, best handled by wealth transfers, such as income taxes and welfare payments rather than intervention in the markets for goods and services. Still, there are instances where regulatory actions directed at specific markets reflect equity concerns, such as requiring companies to offer basic services at lifeline rates for low-income customers.
8.03: Circumstances in Which Market Regulation May Be Desirable
When a market operates inefficiently, economists call the situation a market failure. In this chapter, we will address the generic types of market failure:
• Market failure caused by seller or buyer concentration
• Market failure that occurs when parties other than buyers and sellers are affected by market transactions but do not participate in negotiating the transaction
• Market failure that occurs because an actual market will not emerge or cannot sustain operation due to the presence of free riders who benefit from, but do not bear the full costs of, market exchanges
• Market failure caused by poor seller or buyer decisions, due to a lack of sufficient information or understanding about the product or service
In all four situations, the case can be made that a significant degree of inefficiency results when the market is left to proceed without regulation.
Economists are fond of repeating the maxim “There is no free lunch.” Regulation is not free and is difficult to apply correctly. Regulation can create unexpected or undesirable effects in itself. At the conclusion of the chapter, we will consider some of the limitations of regulation. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.02%3A_Efficiency_and_Equity.txt |
In Chapter 7, we considered how monopolies and monopsonies would try to force changes in the price and quantity to move the market to their advantage, but at an even greater cost to the other side of the market. Again, this is not simply an equity concern that one party is getting most of the surplus created by the market (although that may be a legitimate concern) but rather the exertion of market power results in a net loss in total social surplus.
Seller competition is not only helpful in lowering prices and increasing volume and consumer surplus, but firms also compete in terms of product differentiation. When a monopoly or oligopoly emerges and the seller(s) have a sustainable arrangement that generates economic profits, the firms do not have the incentive to spend money in developing better products. The stagnation of the product sold represents another loss in potential value to the consumer.
Unfortunately, monopolies or tight oligopolies can readily develop in markets, especially when there are strong economies of scale and market power effects. For this reason, there are general antitrust laws that empower governments to prevent the emergence of monopolies and tight oligopolies. Some of these laws and regulations actually cite measures of market concentration that can be used as a basis for opposing any buyouts or mergers that will increase market concentration. Where market concentration has already advanced to high levels, firms can be instructed to break up into separate companies. About a century ago, monopolies had developed in important U.S. industries like petroleum, railroads, and electric power. Eventually, the U.S. federal government mandated these monopolies split apart.
As mentioned in earlier chapters, the fact that there are a few large sellers does not automatically constitute abusive use of market power if there is free entry and active competition between sellers. However, if those large sellers collude to hold back production volumes and raise prices, there is a loss in market surplus. The United States has laws that outlaw such collusion. While firms may be able to collude with indirect signals that are difficult for government antitrust units to identify at the time, courts will consider testimony that demonstrates that collusion has taken place.
In Chapter 7, we discussed the market power tactics of using low prices to drive out existing competitors and keep out new entrants. When the purpose of the price drop is merely to chase out competition, the practice is labeled predatory pricing and is considered illegal. Of course, the firms engaging in price decreases often take the position that they are in a competitive market and are simply competing on the basis of reduced profit margins, just as firms are expected to compete according to the theory of the perfect competition model. Courts are left to determine whether such actions are simply aggressive competition or are intended to create a more concentrated market that allows for greater profits in the long run.
As an alternative to taking actions to limit large firms from exploiting their size, another form of regulation is to encourage more competition by helping small or new competitors. Either subsidies or tax breaks may be offered to help these firms offset the disadvantages of being small in the market and to eventually emerge as an independent player in the market.
In cases where a concentrated seller market exists and the product or service is considered critical to the buyers and the overall economy, the government may decide to intervene strongly by setting a limit on prices or mandating that the product be provided at a minimum quantity and quality.
In situations where there is buyer power, the goal of regulation may be to push prices higher. For example, in agriculture crop markets where the seller farmers often have little market power, but there is concentration on the buyer side, the government will try to keep prices higher by mandating minimum prices or direct assistance to farmers in the form of price support programs.
Another response to market power on one side of the market is to support market power on the other side of the market. Using the crop market example again where there is buyer power, the government has sanctioned the creation of grower cooperatives that control the quantity of the amount sold to processors and thus keep the price higher. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.04%3A_Regulation_to_Offset_Market_Power_of_Sellers_or_Buyers.txt |
In industries where the minimum efficient scale is very high, it may be that the lowest average cost is achieved if there is only one seller providing all the goods or services. Examples of such a service might be transmission and distribution of electric power or telephone service. This situation often occurs when total costs are very high but marginal costs are low. Economists call such markets natural monopolies.
Unfortunately, if just one firm is allowed to serve the entire market, the firm will be tempted to exploit the monopoly position rather than pass its lower cost in the form of lower prices. One response to this situation is to conclude that the service should be provided by a public agency rather than a private company. In the case of telephone service, European countries often run the telephone system rather than a corporation like AT&T.
Another response is to go ahead and allow the private firm to be the sole seller but require regulatory approval for the prices to be charged. These regulated monopolies are often called public utilities, even though the operator may be a private corporation. In principle, this regulated monopoly could achieve the best of both worlds, letting a private company serve the market, while making sure the buyer is enjoying the benefits of the low average cost. In fact, this notion of a regulated monopoly was first proposed by AT&T when it feared that its near monopoly would be usurped by the government. Governments create agencies like state public utility commissions to review cost information with the public utility corporation in deciding on the prices or service rates that will be approved.
A potential concern when a single provider is allowed to operate as a regulated monopoly is that, without competition, the provider has little incentive for innovation or cost cutting. This could be the case whether the provider operated as a government agency or a public utility corporation. When a public utility corporation understands that it will be reimbursed for its costs plus an amount to cover the opportunity costs of assets or capital contributed by the corporation’s owners, the challenge is to be able to justify the costs rather than seek to trim its costs. Some regulatory agencies try to motivate regulated monopolies to be innovative or cut costs by allowing them to keep some of the surplus created in exchange for lower rates in the future. However, regulation is a game where the regulatory agency and the public utility corporation are both competing and cooperating. And the transaction costs of outside oversight of the regulatory monopoly are substantial. So, as noted earlier, there is no free lunch.
8.06: Externalities
The second generic type of market failure is when parties other than the buyer and seller are significantly affected by the exchange between the buyer and seller. However, these other parties do not participate in the negotiation of the sale. Consequently, the quantities sold and prices charged do not reflect the impacts on these parties.
Economists call the effects of market activity on the third parties externalities because they fall outside the considerations of buyer and seller. Although the concern with significant externalities is usually due to harm to the third party, externalities can be beneficial to third parties as well. Harmful externalities are called negative externalities; beneficial externalities are called positive externalities.
Some examples of negative externalities are pollution of air or water that is experienced by persons other than those directly related to the seller or buyer, injury or death to another person resulting from the market exchange, inconvenience and annoyances caused by loud noise or congestion, and spoiling of natural habitats. Some examples of positive externalities are spillover effects of research and development used for one product to other products or other firms, training of a worker by one firm and thereby creating a more valuable worker for a future employer, stimulation of additional economic activity outside the market, and outside benefactors of problem-solving services like pest control.
Negative externalities clearly create an inequity because the third parties are harmed without any compensation. However, significant negative externalities also create inefficiency. Recall that inefficiency means there is a way to make someone better off and no one worse off. Take the case of a negative externality like air pollution caused when an automobile owner purchases gasoline to use in his car. Hypothetically, if a representative for outside parties were present at the negotiation for the sale, she might be willing to pay an amount to the buyer and an amount to the seller in exchange for foregoing the sale by compensating the buyer with the consumer surplus they would have received and the producer with the economic profit they would have received, with the sum of those payments being worth the avoidance of the externality impact of the air pollution.
Even in the case of a positive externality, there is inefficiency. However, in this case, the third parties would actually benefit from more market exchanges than the sellers and buyers would be willing to transact. In principle, if third parties could participate in the market, they would be willing to pay the buyer or seller up to the value of the positive externality if it would induce more market activity.
Regulation of externalities usually takes two forms: legal and economic. Legal measures are sanctions that forbid market activity, restrict the volume of activity, or restrict those who are allowed to participate as buyers and sellers. As examples of these, if an appliance is prone to start fires that might burn an entire apartment complex and injure others besides the buyer, the sale of the appliance might be banned outright. If sales of water drawn from a river would threaten a wildlife habit, sales may be limited to a maximum amount. A firearms manufacturer might be allowed to sell firearms but would be restricted to sell only to people of at least a certain age who do not have a criminal record. Because legal measures require monitoring and enforcement by the government, there are transaction costs. When a legal measure is excessive, it may actually create a reverse form of inefficiency from denying surplus value to buyers and sellers that exceeds the benefit to other parties. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.05%3A_Natural_Monopoly.txt |
The most practiced economic instrument to address market externality is a tax. Those who purchase gasoline are likely to pay the sum of the price required by the gasoline station owner to cover his costs (and any economic profit he has the power to generate) plus a tax on each unit of gasoline that covers the externality cost of gasoline consumption such as air pollution, wear and tear on existing public roads, needs for expanding public roads to support more driving, and policing of roads.
Theoretically, there is an optimal level for setting a tax. The optimum tax is the value of the marginal externality damage created by consumption of an additional item from a market exchange. If each gallon of gasoline causes \$1.50 worth of externality damage, that would be the correct tax.
In the case of positive externalities, the optimum tax is negative. In other words, the government actually pays the seller an amount per unit in exchange for a reduction of an equal amount in the price. Theoretically, the optimum tax would be the negative of the marginal value of a unit of consumption to third parties. For example, if the positive externality from hiring an unemployed person and giving that person employment skills would be worth \$2.00 per hour, the employer could be subsidized \$2.00 per hour to make it more attractive for them to hire that kind of person.
Although the notion of an externality tax sounds straightforward, actual implementation is difficult. Even when there is general agreement that a significant externality exists, placing a dollar value on that externality can be extremely difficult and controversial. The optimal tax is the marginal impact on third parties; however, there is no guarantee that the total tax collected in this fashion will be the total amount needed to compensate for the total externality impact. The total collected may be either too little or too much.
Also, recall the impact of a tax from the earlier discussion of comparative statics in competitive markets in Chapter 6. A tax has the impact of either raising the supply curve upward (if the seller pays the tax) or moving the demand curve downward (if the buyer pays the tax). See Figure 8.1 for a graphic illustration of a tax charged to the buyer. To the extent that the supply and demand curves are price elastic, the tax will lower the amount consumed, thereby diminishing the externality somewhat and possibly changing the marginal externality cost. Consequently, actual externality taxes require considerable public transaction costs and may not be at the correct level for the best improvement of market efficiency.
Note the tax may cause a decrease in the equilibrium quantity, which may change the optimal externality tax.
8.08: Regulation of Externalities Through Property Rights
The economist Ronald Coase, whom we mentioned earlier in the context of the optimal boundaries of the firm and transaction costs, postulated that the problem of externalities is really a problem of unclear or inadequate property rights (see Coase (1960)). If the imposition of negative externalities were considered to be a right owned by a firm, the firm would have the option to resell those rights to another firm that was willing to pay more than the original owner of the right would appreciate by keeping and exercising the privilege.
For those externalities that society is willing to tolerate at some level because the externality effects either are acceptable if limited (e.g., the extraction of water from rivers) or come from consumption that society does not have a sufficiently available alternative (e.g., air pollution caused by burning coal to generate electricity), the government representatives can decide how much of the externality to allow and who should get the initial rights. The initial rights might go to existing sellers in the markets currently creating the externalities or be sold by the government in an auction.
An example of this form of economic regulation is the use of “cap and trade” programs designed to limit greenhouse gas emissions. In cases where this has been implemented, new markets emerge for trading the rights. If the right is worth more to another firm than to the owner, the opportunity cost of retaining that right to the current owner will be high enough to justify selling some of those rights on the emissions market. If the opportunity cost is sufficiently high, the owner may decide to sell all its emissions rights and either shut down its operations or switch to a technology that generates no greenhouse gases.
If the value of emissions rights to any firm is less than the externality cost incurred if the right is exercised, the public can also purchase those externality rights and either retire them permanently or hold them until a buyer comes along that is willing to pay at least as much as the impact of the externality cost to parties outside the market exchange. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.07%3A_Externality_Taxes.txt |
Next, we will consider the third generic type of market failure, or the inability for a market to form or sustain operation due to free riders, by looking at two causes of this kind of failure in this section and the next section. Although the sources are different, both involve a situation where some party benefits from the market exchange without incurring the same cost as other sellers or buyers.
New products and services are expensive for the first firm to bring them to market. There may be initial failures in the development of a commercial product that add to the cost. The firm will start very high on the learning curve because there is no other firm to copy or hire away its talent. The nature of buyer demand for the product is uncertain, and the seller is likely to overcharge, undercharge, or alternatively set initial production targets that are too high or too low.
If the firm succeeds, it may initially have a monopoly, but unless there are barriers of entry, new entrant firms will be attracted by the potential profits. These firms will be able to enter the market with less uncertainty about how to make the product commercially viable and the nature of demand for the product. And these firms may be able to determine how the initial entrant solved the problems of designing the product or service and copy the process at far less initial cost than was borne by the initial entrant.
If the product sold by the initial firm and firms that enter the market later look equivalent to the buyer, the buyer will not pay one of these firms more than another just based on its higher cost. If the market becomes competitive for sellers, the price is likely to be driven by the marginal cost. New entrant firms may do well, but the initial entrant firm is not likely to get a sufficient return on the productive assets it had invested from startup. In effect, the other firms would be free riders that benefit from the startup costs of the initial entrant without having to contribute to that cost.
The market failure occurs here because, prior to even commencing with a startup, the would-be initial entrant may look ahead, see the potential for free riders and the inability to generate sufficient profits to justify the startup costs, and decide to scrap the idea. This market failure is a market inefficiency because it is hypothetically possible for the initial entrant, subsequent entrants, and buyers to sit at a negotiation and reach an arrangement where startup costs are shared by the firms or buyer prices are set higher to cover the startup costs, so that all firms and buyers decide they would be better off with that negotiated arrangement than if the market never materialized. Unfortunately, such negotiations are unlikely to emerge from the unregulated activities of individual sellers and buyers.
One of the main regulatory measures to address this problem is to guarantee the initial entrant a high enough price and sufficient volume of sales to justify the up-front investment. Patents are a means by which a product or service that incorporates a new idea or process gives the developer a monopoly, at least for production that uses that process or idea, for a certain period of time. Patents are an important element in the pharmaceutical industry in motivating the development of new drugs because there is a long period of development and testing and a high rate of failure. Companies selling patent-protected drugs will sell those products at monopoly prices. However, the process for manufacturing the drug is usually readily reproducible by other companies, even small “generic” manufacturers, so the price of the drug will drop precipitously when patent protection expires. In fact, patent-holding firms will usually drop the price shortly prior to patent expiration in an attempt to extract sales from the lower portion of the demand curve before other firms can enter.
In cases where there is not a patentable process, but nonetheless a high risk of market failure due to frightening away the initial entrant, government authorities may decide to give exclusive operating rights for at least a period of time. This tool was used to encourage the expansion of cable television to the initial entrant in a region to justify the high up-front expenses.
Other government interventions can be the provision of subsidies to the initial entrant to get them to market a new product. The government may decide to fund the up-front research and development and then make the acquired knowledge available to any firm that enters the market so there is not such a difference between being the initial entrant or a subsequent entrant. Another option is for the government itself to serve in the role of the initial entrant and then, when the commercial viability is demonstrated, privatize the product or service. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.09%3A_High_Cost_to_Initial_Entrant_and_the_Risk_of_Free_Rider_Producers.txt |
In the case of rival goods, the party consuming the product is easily linked to the party that will purchase the product. Whether the party purchases the product depends on whether the value obtained is at least as high as the price.
However, there are other goods that are largely nonrival. This means that several people might benefit from an item produced and sold in the market without diminishing the benefit to others, especially the party that actually made the purchase. For example, if a homeowner pays for eradication of mosquitoes around his house, he likely will exterminate mosquitoes that would have affected his neighbors. The benefit obtained by the neighbors does not detract from the benefit gained by the buyer. When benefits of a purchased good or service can benefit others without detracting from the party making the purchase, economists call the product a public good (public goods are discussed in Baye (2010)).
The difficulty with public goods is that the cost to create a public good by a seller may be substantially more than an individual buyer is willing to pay but less than the collective value to all who would benefit from the purchase. For example, take the cost of tracking down criminals. An individual citizen may benefit from the effort to locate and arrest a criminal, but the individual is not able or willing to hire a police force of the scale needed to conduct such operations. Even though the result of hiring a police force may be worth more to all citizens who benefit than what a company would charge to do it, since there are no individual buyers, the market will not be able to function and there is market failure.
As with the market failure for initial entrants with high startup cost, there is a potential agreement where all benefactors would be willing to pay an amount corresponding to their value that, if collected, would cover the cost of creating the good or service. The problem is that individuals would prefer to let someone else pay for it and be a free rider. So the inability of the market to function is a case of inefficiency.
In perfect competition, the optimal price to be charged is the marginal cost of serving another customer. However, in the case of public goods, the marginal cost of serving an additional benefactor can be essentially zero. This creates an interesting dilemma whereby the theoretical optimal pricing for the good is to charge a price of zero. Of course, that adds to the market failure problem because the cost of production of the good or service is not zero, so it is not feasible to operate a market of private sellers and buyers in this manner.
Usually the only way to deal with a public good of sufficient value is for the government to provide the good or service or pay a private organization to run the operation without charging users, or at least not fully charging users. This is how key services like the military, police protection, fire stations, and public roadways are handled. There may be some ability to charge users a modest fee for some services, but the revenue would not be sufficient to support a market served by private firms. For example, governments build dams as a means of flood control, irrigation, and water recreation. The agency that manages the dam may charge entry fees for boating on the lake or use of water released from the dam. However, the agency still needs to remain a public agency and likely needs additional finances from other public revenues like income or sales taxes to support its continued operations.
An interesting public good problem has emerged with the ability to make high-quality digital copies of books and music at very low marginal cost. When someone purchases a music CD (or downloads a file of commercial music) and then allows a copy to be made for someone else, the creation of the copy does not diminish the ability to enjoy the music by the person who made the initial purchase. Artists and producers claim that the recipients of the copies are enjoying the media products as free riders and denying the creators of the products full payment from all who enjoy their products, although there is some debate whether copying is a bona fide market failure concern.See Shapiro and Varian (1999).Nonetheless, publishers have pursued measures to discourage unauthorized copies, whether via legal prohibition or technology built into the media, or media players, to thwart the ability to make a clean copy. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.10%3A_Public_Goods_and_the_Risk_of_Free_Rider_Consumers.txt |
In the earlier discussion of the perfect competition model, we noted the assumption of perfect information of buyers and sellers. Theoretically, this means that buyers and sellers not only know the full array of prices being charged for goods and services, but they also know the production capabilities of sellers and the utility preferences of buyers. As part of that discussion, we noted that this assumption is not fully satisfied in real markets, yet sellers and buyers may have a reasonably complete understanding of market conditions, particularly within the limits of the types of products and geographic areas in which they normally participate.
Imperfect information can be due to ignorance or uncertainty. If the market participant is aware that better information is available, information becomes another need or want. Information may be acquired through an economic transaction and becomes a commodity that is a cost to the buyer or seller. Useful information is available as a market product in forms like books, media broadcasts, and consulting services.
In some cases, uncertainty can be transferred to another party as an economic exchange. Insurance is an example of product where the insurance company assumes the risk of defined uncertain outcomes for a fee.
Still, there remain circumstances where ignorance or risk is of considerable consequence and cannot be addressed by an economic transaction. One such instance is where one party in an economic exchange deliberately exploits the ignorance of another party in the transaction to its own advantage and to the disadvantage of the unknowing party. This type of situation is called a moral hazard. For example, if an entrepreneur is raising capital from outside investors, he may present a biased view of the prospects of the firm that only includes the good side of the venture to attract the capital, but the outside investors eventually lose their money due to potentially knowable problems that would have discouraged their investment if those problems had been known.
In some cases, the missing information is not technically hidden from the party, but the effective communication of the key information does not occur. For example, a consumer might decide to acquire a credit card from a financial institution and fail to note late payment provisions in the fine print that later become a negative surprise. Whether such communication constitutes proper disclosure or moral hazard is debatable, but the consequences of the bad decision occur nonetheless.
Exchanges with moral hazard create equity and efficiency concerns. If one party is taking advantage of another party’s ignorance, there is an arguable equity issue. However, the inadequate disclosure results in a market failure when the negative consequences to the ignorant party more than offset the gains to the parties that disguise key information. This is an inefficient market because the losing parties could compensate the other party for its gains and still suffer less than they did from the incidence of moral hazard.
Further, the impact of poor information may spread beyond the party that makes a poor decision out of ignorance. As we have seen with the financial transactions in mortgage financing in the first decade of this century, the consequences of moral hazard can be deep and widespread, resulting in a negative externality as well.
Market failures from imperfect information can occur even when there is no intended moral hazard. In Chapter 5, we discussed the concept of adverse selection, where inherent risk from uncertainty about the other party in an exchange causes a buyer or seller to assume a pessimistic outcome as a way of playing it safe and minimizing the consequences of risk. However, a consequence of playing it safe is that parties may decide to avoid agreements that actually could work. For example, a company might consider offering health insurance to individuals. An analysis might indicate that such insurance is feasible based on average incidences of medical claims and willingness of individuals to pay premiums. However, due to the risk that the insurance policies will be most attractive to those who expect to submit high claims, the insurance company may decide to set its premiums a little higher than average to protect itself. The higher premiums may scare away some potential clients who do not expect to receive enough benefits to justify the premium. As a result, the customer base for the policy will tend even more toward those individuals who will make high claims, and the company is likely to respond by charging even higher premiums. Eventually, as the customer base grows smaller and more risky, the insurance company may withdraw the health insurance product entirely.
Much of the regulation to offset problems caused by imperfect information is legal in nature. In cases where there is asymmetric information that is known to one party but not to another party in a transaction, laws can place responsibility on the first party to make sure the other party receives the information in an understandable format. For example, truth-in-lending laws require that those making loans clearly disclose key provisions of the loan, to the degree of requiring the borrower to put initials beside written statements. The Sarbanes-Oxley law, created following the Enron crisis, places requirements on the conduct of corporations and their auditing firms to try to limit the potential for moral hazard.
When one party in an exchange defrauds another party by providing a good or service that is not what was promised, the first party can be fined or sued for its failure to protect against the outcomes to the other party. For example, if a firm sells a defective product that causes harm to the buyer, the firm that either manufactured or sold the item to the buyer could be held liable.
A defective product may be produced and sold because the safety risk is either difficult for the buyer to understand or not anticipated because the buyer is unaware of the potential. Governments may impose safety standards and periodic inspections on producers even though those measures would not have been demanded by the buyer. In extreme cases, the government may direct a seller to stop selling a good or service.
Other regulatory options involve equipping the ignorant party with better information. Government agencies can offer guidance in print or on Internet websites. Public schools may be required to make sure citizens have basic financial skills and understand the risks created by consumption of goods and services to make prudent decisions.
Where adverse selection discourages the operations of markets, regulation may be created to limit the liability to the parties involved. Individuals and businesses may be required to purchase or sell a product like insurance to increase and diversify the pool of exchanges and, in turn, to reduce the risk of adverse selection and make a market operable.
8.12: Limitations of Market Regulation
Although regulation offers the possibility of addressing market failure and inefficiencies that would not resolve by themselves in an unregulated free market economy, regulation is not easy or cost free.
Regulation requires expertise and incurs expenses. Regulation incurs a social transaction cost for market exchanges that is borne by citizens and the affected parties. In some instances, the cost of the regulation may be higher than the net efficiency gains it creates. Just as there are diminishing returns for producers and consumers, there are diminishing returns to increased regulation, and at some point the regulation becomes too costly.
Regulators are agents who become part of market transactions representing the government and people the government serves. Just as market participants deal with imperfect information, so do regulators. As such, regulators can make errors.
In our discussions about economics of organization in Chapter 5, we noted that economics has approached the problem of motivating workers using the perspective that the workers’ primary goal is their own welfare, not the welfare of the business that hires them. Unfortunately, the same may be said about regulators. Regulators may be enticed to design regulatory actions that result in personal gain rather than what is best for society as a whole in readjusting the market. For example, a regulator may go soft on an industry in hope of getting a lucrative job after leaving public service. In essence, this is another case of moral hazard. One solution might be to create another layer of regulation to regulate the regulators, but this adds to the expense and is likely self-defeating.
When regulation assumes a major role in a market, powerful sellers or buyers are not likely to treat the regulatory authority as an outside force over which they have no control. Often, these powerful parties will try to influence the regulation via lobbying. Aside from diminishing the intent of outside regulation, these lobbying efforts constitute a type of social waste that economists call influence costs, which are economically inefficient because these efforts represent the use of resources that could otherwise be redirected for production of goods and services.
One theory about regulation, called the capture theory of regulation postulates that government regulation is actually executed so as to improve the conditions for the parties being regulated and not necessarily to promote the public’s interest in reducing market failure and market inefficiency (the capture theory of regulation was introduced by Stigler (1971)). For example, in recent years there has been a struggle between traditional telephone service providers and cable television service providers. Each side wants to enter the market of the other group yet expects to maintain near monopoly power in its traditional market, and both sides pressure regulators to support their positions. In some cases, it has been claimed that the actual language of regulatory laws was proposed by representatives for the very firms that would be subject to the regulation. | textbooks/socialsci/Economics/Managerial_Economics_Principles_(LibreTexts)/08%3A_Market_Regulation/8.11%3A_Market_Failure_Caused_by_Imperfect_Information.txt |
• 1.1: Defining Economics
Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.
• 1.2: The Field of Economics
We have examined the basic concepts of scarcity, choice, and opportunity cost in economics. In this section, we will look at economics as a field of study. We begin with the characteristics that distinguish economics from other social sciences.
• 1.3: The Economists’ Tool Kit
Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics.
• 1.4: Review and Practice
01: Economics: The Study of Choice
Learning Objective
1. Define economics.
2. Explain the concepts of scarcity and opportunity cost and how they relate to the definition of economics.
3. Understand the three fundamental economic questions: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
Economics is a social science that examines how people choose among the alternatives available to them. It is social because it involves people and their behavior. It is a science because it uses, as much as possible, a scientific approach in its investigation of choices.
Scarcity, Choice, and Cost
All choices mean that one alternative is selected over another. Selecting among alternatives involves three ideas central to economics: scarcity, choice, and opportunity cost.
Scarcity
Our resources are limited. At any one time, we have only so much land, so many factories, so much oil, so many people. But our wants, our desires for the things that we can produce with those resources, are unlimited. We would always like more and better housing, more and better education—more and better of practically everything.
If our resources were also unlimited, we could say yes to each of our wants—and there would be no economics. Because our resources are limited, we cannot say yes to everything. To say yes to one thing requires that we say no to another. Whether we like it or not, we must make choices.
Our unlimited wants are continually colliding with the limits of our resources, forcing us to pick some activities and to reject others. Scarcity is the condition of having to choose among alternatives. A scarce good is one for which the choice of one alternative requires that another be given up.
Consider a parcel of land. The parcel presents us with several alternative uses. We could build a house on it. We could put a gas station on it. We could create a small park on it. We could leave the land undeveloped in order to be able to make a decision later as to how it should be used.
Suppose we have decided the land should be used for housing. Should it be a large and expensive house or several modest ones? Suppose it is to be a large and expensive house. Who should live in the house? If the Lees live in it, the Nguyens cannot. There are alternative uses of the land both in the sense of the type of use and also in the sense of who gets to use it. The fact that land is scarce means that society must make choices concerning its use.
Virtually everything is scarce. Consider the air we breathe, which is available in huge quantity at no charge to us. Could it possibly be scarce?
The test of whether air is scarce is whether it has alternative uses. What uses can we make of the air? We breathe it. We pollute it when we drive our cars, heat our houses, or operate our factories. In effect, one use of the air is as a garbage dump. We certainly need the air to breathe. But just as certainly, we choose to dump garbage in it. Those two uses are clearly alternatives to each other. The more garbage we dump in the air, the less desirable—and healthy—it will be to breathe. If we decide we want to breathe cleaner air, we must limit the activities that generate pollution. Air is a scarce good because it has alternative uses.
Not all goods, however, confront us with such choices. A free good is one for which the choice of one use does not require that we give up another. One example of a free good is gravity. The fact that gravity is holding you to the earth does not mean that your neighbor is forced to drift up into space! One person’s use of gravity is not an alternative to another person’s use.
There are not many free goods. Outer space, for example, was a free good when the only use we made of it was to gaze at it. But now, our use of space has reached the point where one use can be an alternative to another. Conflicts have already arisen over the allocation of orbital slots for communications satellites. Thus, even parts of outer space are scarce. Space will surely become more scarce as we find new ways to use it. Scarcity characterizes virtually everything. Consequently, the scope of economics is wide indeed.
Scarcity and the Fundamental Economic Questions
The choices we confront as a result of scarcity raise three sets of issues. Every economy must answer the following questions:
1. What should be produced? Using the economy’s scarce resources to produce one thing requires giving up another. Producing better education, for example, may require cutting back on other services, such as health care. A decision to preserve a wilderness area requires giving up other uses of the land. Every society must decide what it will produce with its scarce resources.
2. How should goods and services be produced? There are all sorts of choices to be made in determining how goods and services should be produced. Should a firm employ a few skilled or a lot of unskilled workers? Should it produce in its own country or should it use foreign plants? Should manufacturing firms use new or recycled raw materials to make their products?
3. For whom should goods and services be produced? If a good or service is produced, a decision must be made about who will get it. A decision to have one person or group receive a good or service usually means it will not be available to someone else. For example, representatives of the poorest nations on earth often complain that energy consumption per person in the United States is 17 times greater than energy consumption per person in the world’s 62 poorest countries. Critics argue that the world’s energy should be more evenly allocated. Should it? That is a “for whom” question.
Every economy must determine what should be produced, how it should be produced, and for whom it should be produced. We shall return to these questions again and again.
Opportunity Cost
It is within the context of scarcity that economists define what is perhaps the most important concept in all of economics, the concept of opportunity cost. Opportunity cost is the value of the best alternative forgone in making any choice.
The opportunity cost to you of reading the remainder of this chapter will be the value of the best other use to which you could have put your time. If you choose to spend \$20 on a potted plant, you have simultaneously chosen to give up the benefits of spending the \$20 on pizzas or a paperback book or a night at the movies. If the book is the most valuable of those alternatives, then the opportunity cost of the plant is the value of the enjoyment you otherwise expected to receive from the book.
The concept of opportunity cost must not be confused with the purchase price of an item. Consider the cost of a college or university education. That includes the value of the best alternative use of money spent for tuition, fees, and books. But the most important cost of a college education is the value of the forgone alternative uses of time spent studying and attending class instead of using the time in some other endeavor. Students sacrifice that time in hopes of even greater earnings in the future or because they place a value on the opportunity to learn. Or consider the cost of going to the doctor. Part of that cost is the value of the best alternative use of the money required to see the doctor. But, the cost also includes the value of the best alternative use of the time required to see the doctor. The essential thing to see in the concept of opportunity cost is found in the name of the concept. Opportunity cost is the value of the best opportunity forgone in a particular choice. It is not simply the amount spent on that choice.
The concepts of scarcity, choice, and opportunity cost are at the heart of economics. A good is scarce if the choice of one alternative requires that another be given up. The existence of alternative uses forces us to make choices. The opportunity cost of any choice is the value of the best alternative forgone in making it.
Key Takeaways
• Economics is a social science that examines how people choose among the alternatives available to them.
• Scarcity implies that we must give up one alternative in selecting another. A good that is not scarce is a free good.
• The three fundamental economic questions are: What should be produced? How should goods and services be produced? For whom should goods and services be produced?
• Every choice has an opportunity cost and opportunity costs affect the choices people make. The opportunity cost of any choice is the value of the best alternative that had to be forgone in making that choice.
Try It!
Identify the elements of scarcity, choice, and opportunity cost in each of the following:
1. The Environmental Protection Agency is considering an order that a 500-acre area on the outskirts of a large city be preserved in its natural state, because the area is home to a rodent that is considered an endangered species. Developers had planned to build a housing development on the land.
2. The manager of an automobile assembly plant is considering whether to produce cars or sport utility vehicles (SUVs) next month. Assume that the quantities of labor and other materials required would be the same for either type of production.
3. A young man who went to work as a nurses’ aide after graduating from high school leaves his job to go to college, where he will obtain training as a registered nurse.
Case in Point: The Rising Cost of Energy
Oil is an exhaustible resource. The oil we burn today will not be available for use in the future. Part of the opportunity cost of our consumption of goods such as gasoline that are produced from oil includes the value people in the future might have placed on oil we use today.
It appears that the cost of our use of oil may be rising. We have been using “light crude,” the oil found in the ground in deposits that can be readily tapped. As light crude becomes more scarce, the world may need to turn to so-called “heavy crude,” the crude oil that is found in the sandy soil of places such as Canada and Venezuela. That oil exists in such abundance that it propels Venezuela to the top of the world list of available oil. Saudi Arabia moves to the second position; Canada is third.
The difficulty with the oil mixed in the sand is that extracting it is far more costly than light crude, both in terms of the expenditures required and in terms of the environmental damage that mining it creates. Northern Alberta, in Canada, boasts a Florida-sized area whose sandy soils are rich in crude oil. Some of that oil is 1,200 feet underground. Extracting it requires pumping steam into the oily sand and then pumping up the resultant oily syrup. That syrup is then placed into huge, industrial-sized washing machines that separate crude oil. What is left over is toxic and will be placed in huge lakes that are being created by digging pits in the ground 200 feet deep. The oil produced from these sands has become important—Alberta is the largest foreign supplier of oil to the United States.
Sands that are closer to the surface are removed by bulldozers and giant cranes; the forest over it is cleared away. The oily sand is then hauled off in two-story dump trucks which, when filled, weigh more than a Boeing 747. Total SA, a French company, is leading the race to develop Canada’s oil. Jean Luc-Guiziou, the president of Total SA’s Canadian operations, says that the extraordinarily costly process of extracting heavy crude is something the world is going to have to get used to. “The light crude undiscovered today is getting scarcer and scarcer,” he told The Wall Street Journal. “We have to accept the reality of geoscience, which is that the next generation of oil resources will be heavier.”
Already, Total SA has clear-cut thousands of acres of forest land in order to gain access to the oily sand below. The process of extracting heavy crude oil costs the company \$25 a barrel—compared to the \$6 per barrel cost of extracting and refining light crude. Extracting heavy crude generates three times as much greenhouse gas per barrel as does light crude. By 2015, Fort McMurray, the small (population 61,000) town that has become the headquarters of Northern Alberta’s crude oil boom, will emit more greenhouse gas than the entire country of Denmark (population 5.4 million). Canada will exceed its greenhouse gas quota set by the Kyoto Accords—an international treaty aimed at limiting global warming—largely as a result of developing its heavy crude deposits.
No one even considered the extraction of heavy crude when light crude was cheap. In the late 1990s, oil cost just \$12 per barrel, and deposits of heavy crude such as those in Canada attracted little attention. By mid-2006, oil sold for more than \$70 per barrel, and Canada’s heavy crude was suddenly a hot commodity. “It moved from being just an interesting experiment in northern Canada to really this is the future source of oil supply,” Greg Stringham of the Canadian Association of Petroleum Producers told Al Jazeera.
Alberta’s energy minister, Greg Melchin, defends the province’s decision to proceed with the exploitation of its oily sand. “There is a cost to it, but the benefits are substantially greater,” he insists.
Not everyone agrees. George Poitras, a member of the Mikisew Cree tribe, lives downstream from the oil sands development. “You see a lot of the land dug up, a lot of the boreal forest struck down and it’s upsetting, it fills me with rage,” he says. Diana Gibson of the Parkland Institute, an environmental advocacy group, says that you can see the environmental damage generated by the extraction of oil sands around Fort McMurray from the moon. “What we are going to be having is destruction of very, very valuable ecosystems, and permanent pollution,” she says.
Answers to Try It! Problems
1. The 500-acre area is scarce because it has alternative uses: preservation in its natural state or a site for homes. A choice must be made between these uses. The opportunity cost of preserving the land in its natural state is the forgone value of the land as a housing development. The opportunity cost of using the land as a housing development is the forgone value of preserving the land.
2. The scarce resources are the plant and the labor at the plant. The manager must choose between producing cars and producing SUVs. The opportunity cost of producing cars is the profit that could be earned from producing SUVs; the opportunity cost of producing SUVs is the profit that could be earned from producing cars.
3. The man can devote his time to his current career or to an education; his time is a scarce resource. He must choose between these alternatives. The opportunity cost of continuing as a nurses’ aide is the forgone benefit he expects from training as a registered nurse; the opportunity cost of going to college is the forgone income he could have earned working full-time as a nurses’ aide. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.1%3A_Defining_Economics.txt |
Learning Objective
1. Explain the distinguishing characteristics of the economic way of thinking.
2. Distinguish between microeconomics and macroeconomics.
We have examined the basic concepts of scarcity, choice, and opportunity cost in economics. In this section, we will look at economics as a field of study. We begin with the characteristics that distinguish economics from other social sciences.
The Economic Way of Thinking
Economists study choices that scarcity requires us to make. This fact is not what distinguishes economics from other social sciences; all social scientists are interested in choices. An anthropologist might study the choices of ancient peoples; a political scientist might study the choices of legislatures; a psychologist might study how people choose a mate; a sociologist might study the factors that have led to a rise in single-parent households. Economists study such questions as well. What is it about the study of choices by economists that makes economics different from these other social sciences?
Three features distinguish the economic approach to choice from the approaches taken in other social sciences:
1. Economists give special emphasis to the role of opportunity costs in their analysis of choices.
2. Economists assume that individuals make choices that seek to maximize the value of some objective, and that they define their objectives in terms of their own self-interest.
3. Individuals maximize by deciding whether to do a little more or a little less of something. Economists argue that individuals pay attention to the consequences of small changes in the levels of the activities they pursue.
The emphasis economists place on opportunity cost, the idea that people make choices that maximize the value of objectives that serve their self-interest, and a focus on the effects of small changes are ideas of great power. They constitute the core of economic thinking. The next three sections examine these ideas in greater detail.
Opportunity Costs Are Important
If doing one thing requires giving up another, then the expected benefits of the alternatives we face will affect the ones we choose. Economists argue that an understanding of opportunity cost is crucial to the examination of choices.
As the set of available alternatives changes, we expect that the choices individuals make will change. A rainy day could change the opportunity cost of reading a good book; we might expect more reading to get done in bad than in good weather. A high income can make it very costly to take a day off; we might expect highly paid individuals to work more hours than those who are not paid as well. If individuals are maximizing their level of satisfaction and firms are maximizing profits, then a change in the set of alternatives they face may affect their choices in a predictable way.
The emphasis on opportunity costs is an emphasis on the examination of alternatives. One benefit of the economic way of thinking is that it pushes us to think about the value of alternatives in each problem involving choice.
Individuals Maximize in Pursuing Self-Interest
What motivates people as they make choices? Perhaps more than anything else, it is the economist’s answer to this question that distinguishes economics from other fields.
Economists assume that individuals make choices that they expect will create the maximum value of some objective, given the constraints they face. Furthermore, economists assume that people’s objectives will be those that serve their own self-interest.
Economists assume, for example, that the owners of business firms seek to maximize profit. Given the assumed goal of profit maximization, economists can predict how firms in an industry will respond to changes in the markets in which they operate. As labor costs in the United States rise, for example, economists are not surprised to see firms moving some of their manufacturing operations overseas.
Similarly, economists assume that maximizing behavior is at work when they examine the behavior of consumers. In studying consumers, economists assume that individual consumers make choices aimed at maximizing their level of satisfaction. In the next chapter, we will look at the results of the shift from skiing to snowboarding; that is a shift that reflects the pursuit of self-interest by consumers and by manufacturers.
In assuming that people pursue their self-interest, economists are not assuming people are selfish. People clearly gain satisfaction by helping others, as suggested by the large charitable contributions people make. Pursuing one’s own self-interest means pursuing the things that give one satisfaction. It need not imply greed or selfishness.
Choices Are Made at the Margin
Economists argue that most choices are made “at the margin.” The margin is the current level of an activity. Think of it as the edge from which a choice is to be made. A choice at the margin is a decision to do a little more or a little less of something.
Assessing choices at the margin can lead to extremely useful insights. Consider, for example, the problem of curtailing water consumption when the amount of water available falls short of the amount people now use. Economists argue that one way to induce people to conserve water is to raise its price. A common response to this recommendation is that a higher price would have no effect on water consumption, because water is a necessity. Many people assert that prices do not affect water consumption because people “need” water.
But choices in water consumption, like virtually all choices, are made at the margin. Individuals do not make choices about whether they should or should not consume water. Rather, they decide whether to consume a little more or a little less water. Household water consumption in the United States totals about 105 gallons per person per day. Think of that starting point as the edge from which a choice at the margin in water consumption is made. Could a higher price cause you to use less water brushing your teeth, take shorter showers, or water your lawn less? Could a higher price cause people to reduce their use, say, to 104 gallons per person per day? To 103? When we examine the choice to consume water at the margin, the notion that a higher price would reduce consumption seems much more plausible. Prices affect our consumption of water because choices in water consumption, like other choices, are made at the margin.
The elements of opportunity cost, maximization, and choices at the margin can be found in each of two broad areas of economic analysis: microeconomics and macroeconomics. Your economics course, for example, may be designated as a “micro” or as a “macro” course. We will look at these two areas of economic thought in the next section.
Microeconomics and Macroeconomics
The field of economics is typically divided into two broad realms: microeconomics and macroeconomics. It is important to see the distinctions between these broad areas of study.
Microeconomics is the branch of economics that focuses on the choices made by individual decision-making units in the economy—typically consumers and firms—and the impacts those choices have on individual markets. Macroeconomics is the branch of economics that focuses on the impact of choices on the total, or aggregate, level of economic activity.
Why do tickets to the best concerts cost so much? How does the threat of global warming affect real estate prices in coastal areas? Why do women end up doing most of the housework? Why do senior citizens get discounts on public transit systems? These questions are generally regarded as microeconomic because they focus on individual units or markets in the economy.
Is the total level of economic activity rising or falling? Is the rate of inflation increasing or decreasing? What is happening to the unemployment rate? These are questions that deal with aggregates, or totals, in the economy; they are problems of macroeconomics. The question about the level of economic activity, for example, refers to the total value of all goods and services produced in the economy. Inflation is a measure of the rate of change in the average price level for the entire economy; it is a macroeconomic problem. The total levels of employment and unemployment in the economy represent the aggregate of all labor markets; unemployment is also a topic of macroeconomics.
Both microeconomics and macroeconomics give attention to individual markets. But in microeconomics that attention is an end in itself; in macroeconomics it is aimed at explaining the movement of major economic aggregates—the level of total output, the level of employment, and the price level.
We have now examined the characteristics that define the economic way of thinking and the two branches of this way of thinking: microeconomics and macroeconomics. In the next section, we will have a look at what one can do with training in economics.
Putting Economics to Work
Economics is one way of looking at the world. Because the economic way of thinking has proven quite useful, training in economics can be put to work in a wide range of fields. One, of course, is in work as an economist. Undergraduate work in economics can be applied to other careers as well.
Careers in Economics
Economists work in three types of organizations. About 58% of economists work for government agencies (Bureau of Labor Statistics). The remainder work for business firms or in colleges and universities.
Economists working for business firms and government agencies sometimes forecast economic activity to assist their employers in planning. They also apply economic analysis to the activities of the firms or agencies for which they work or consult. Economists employed at colleges and universities teach and conduct research.
Peruse the website of your college or university’s economics department. Chances are the department will discuss the wide variety of occupations that their economics majors enter. Unlike engineering and accounting majors, economics and other social science majors tend to be distributed over a broad range of occupations.
Applying Economics to Other Fields
Suppose that you are considering something other than a career in economics. Would choosing to study economics help you?
The evidence suggests it may. Suppose, for example, that you are considering law school. The study of law requires keen analytical skills; studying economics sharpens such skills. Economists have traditionally argued that undergraduate work in economics serves as excellent preparation for law school. Economist Michael Nieswiadomy of the University of North Texas collected data on Law School Admittance Test (LSAT) scores for undergraduate majors listed by 2,200 or more students taking the test in 2003. Table 1.1 “LSAT Scores and Undergraduate Majors” gives the scores, as well as the ranking for each of these majors, in 2003 and in two previous years in which the rankings were compiled. In rankings for all three years, economics majors recorded the highest scores.
Table 1.1: LSAT Scores and Undergraduate Majors
Major field LSAT average 2003–2004 2003–2004 Rank 1994–1995 Rank 1991–1992 Rank
Economics 156.6 1 1 1
Engineering 155.4 2 4 2
History 155.0 3 2 3
English 154.3 4 3 4
Finance 152.6 5 6 5
Political science 152.1 6 9 9
Psychology 152.1 7 7 8
Accounting 151.1 8 8 6
Communications 150.5 9 10 10
Sociology 150.2 10 12 13
Bus. Administration 149.6 11 13 12
Criminal Justice 144.7 12 14 14
Here are the average LSAT scores and rankings for the 12 undergraduate majors with more than 2200 students taking the test to enter law school in the 2003–2004 academic year.
Did the strong performance by economics, engineering, and history majors mean that training in those fields sharpens analytical skills tested in the LSAT, or that students with good analytical skills are more likely to major in them? Both factors were probably at work. Economics clearly attracts students with good analytical skills—and studying economics helps develop those skills.
Economics majors shine in other areas as well. According to the Bureau of Labor Statistics Occupational Outlook Handbook, a strong background in economic theory, mathematics, and statistics provides the basis for competing for the best job opportunities, particularly research assistant positions, in a broad range of fields. Many graduates with bachelor’s degrees will find good jobs in industry and business as management or sales trainees or as administrative assistants. Because economists are concerned with understanding and interpreting financial matters, among other subjects, they will also be attracted to and qualified for jobs as financial managers, financial analysts, underwriters, actuaries, securities and financial services sales workers, credit analysts, loan and budget officers, and urban and regional planners.
Table 1.2 “Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations” shows average yearly salary offers for bachelor degree candidates for May 2006 and the outlook for related occupations to 2014.
Table 1.2: Average Yearly Salary Offers, May 2006 and Occupational Outlook 2004–2014, Selected Majors/Occupations
Undergraduate major Average \$ Offer May, 2006 Projected % Change in Total Employment in Occupation 2004–2014
Computer Engineering \$54,200 10.1
Electrical/Electronic Engineering 54,053 11.8
Computer Science 50,892 25.6
Accounting 46,188 22.4
Economics and Finance 45,058 12.4
Management Information Systems 44,755 25.9
Logistics and Materials Management 43,426 13.2
Business Administration 40,976 17.0
Environmental Sciences (including forestry and conservation science) 39,750 6.3
Other Business Majors (e.g., Marketing) 37,446 20.8
Human Resources (incl. Labor Relations) 36,256 15.9
Geology and Geological Sciences 35,034 8.3
Sociology 33,752 4.7
Political Science/Government 33,151 7.3
Liberal Arts & Sciences (general studies) 32,627 na
Public Relations 32,623 21.7
Special Education 31,817 23.3
Elementary Education 31,778 18.2
Foreign Languages 31,364 na
Letters (incl. English) 31,204 20.4
Other Social Sciences (Including Criminal Justice and History) 30,788 12.3
Psychology 30,308 9.9
Pre-elementary Education 27,550 22.4
Social Work 25,865 19.6
Visual and Performing Arts 21,726 15.2
One’s choice of a major, or minor, is not likely to be based solely on considerations of potential earnings or the prospect of landing a spot in law school. You will also consider your interests and abilities in making a decision about whether to pursue further study in economics. And, of course, you will consider the expected benefits of alternative courses of study. What is your opportunity cost of pursuing study of economics? Does studying more economics serve your interests and will doing so maximize your satisfaction level? These considerations may be on your mind as you begin to study economics at the college level and obviously students will make many different choices. But, should you decide to pursue a major or minor in economics, you should know that a background in this field is likely to serve you well in a wide range of careers.
Key Takeaways
• Economists focus on the opportunity costs of choices, they assume that individuals make choices in a way that maximizes the value of an objective defined in terms of their own self-interest, and they assume that individuals make those choices at the margin.
• Economics is divided into two broad areas: microeconomics and macroeconomics.
• A wide range of career opportunities is open to economics majors. Empirical evidence suggests that students who enter the job market with a major in economics tend to earn more than do students in most other majors. Further, economics majors do particularly well on the LSAT.
Try It!
The Department of Agriculture estimated that the expenditures a middle-income, husband–wife family of three would incur to raise one additional child from birth in 2005 to age 17 would be \$250,530. In what way does this estimate illustrate the economic way of thinking? Would the Department’s estimate be an example of microeconomic or of macroeconomic analysis? Why?
Case in Point: The Financial Payoff to Studying Economics
College economics professors have long argued that studying economics is good preparation for a variety of careers. A recent study suggests they are right and that studying economics is even likely to make students more prosperous. Students who major in economics but did not pursue graduate work are likely to earn more than students in virtually every other college major. Students who major in economics and then go on to law school or an MBA program are likely to earn more than students who approach those areas of study having majored in most other areas.
Economists Dan A. Black, Seth Sanders, and Lowell Taylor used the 1993 National Survey of College Graduates, which included more than 86,000 college-educated workers between the ages of 25 and 55 that asked what field they had majored in. They then controlled for variables such as gender, race, and ethnicity. They found that students who had not done graduate work and had majored in economics earned more than students in any other major except engineering. Specifically, economics majors earned about 13% more than other social sciences majors, 11% more than business administration majors, and about the same as natural science and accounting majors. The economics majors in their survey, like those who majored in other social sciences and business administration and unlike those who majored in engineering or accounting, were spread out over a wide range of occupations but with many in management positions.
Based on the survey they used, over 40% of economics majors went on to earn graduate degrees, many in law and business. Economics majors ranked first in terms of wages, as compared to other law school graduates with the 12 most common pre-law majors (including such majors as business administration, finance, English, history, psychology, and political science). MBA graduates who had majored in economics earned more than those who had majored in any other field except chemical engineering. Specifically, undergraduate economics majors with MBAs earned about 15% more than those who had majored in other disciplines represented in the survey, including business-related majors.
It is remarkable that all of the business-related majors generated salaries much lower than those earned by economics majors with an MBA. One could argue that this reflects self-selection; that students who major in economics are simply brighter. But, students who major in physics have high SAT scores, yet they, too, earned wages that were about 20% lower than MBA students who had majored in economics. This finding lends some credence to the notion that the marketplace rewards training in the economic way of thinking.
Source: Dan A. Black, Seth Sanders, and Lowell Taylor, “The Economic Reward for Studying Economics,” Economic Inquiry, 41(3), July 2003, 365–377.
Answer to Try It! Problem
The information given suggests one element of the economic way of thinking: assessing the choice at the margin. The estimate reflects the cost of one more child for a family that already has one. It is not clear from the information given how close the estimate of cost comes to the economic concept of opportunity cost. The Department of Agriculture’s estimate included such costs as housing, food, transportation, clothing, health care, child care, and education. An economist would add the value of the best alternative use of the additional time that will be required for the child. If the couple is looking far ahead, it may want to consider the opportunity cost of sending a child to college. And, if it is looking very far ahead, it may want to consider the fact that nearly half of all parents over the age of 50 support at least one child over the age of 21. This is a problem in microeconomic analysis, because it focuses on the choices of individual households. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.2%3A_The_Field_of_Economics.txt |
Learning Objective
1. Explain how economists test hypotheses, develop economic theories, and use models in their analyses.
2. Explain how the all-other-things unchanged (ceteris paribus) problem and the fallacy of false cause affect the testing of economic hypotheses and how economists try to overcome these problems.
3. Distinguish between normative and positive statements.
Economics differs from other social sciences because of its emphasis on opportunity cost, the assumption of maximization in terms of one’s own self-interest, and the analysis of choices at the margin. But certainly much of the basic methodology of economics and many of its difficulties are common to every social science—indeed, to every science. This section explores the application of the scientific method to economics.
Researchers often examine relationships between variables. A variable is something whose value can change. By contrast, a constant is something whose value does not change. The speed at which a car is traveling is an example of a variable. The number of minutes in an hour is an example of a constant.
Research is generally conducted within a framework called the scientific method, a systematic set of procedures through which knowledge is created. In the scientific method, hypotheses are suggested and then tested. A hypothesis is an assertion of a relationship between two or more variables that could be proven to be false. A statement is not a hypothesis if no conceivable test could show it to be false. The statement “Plants like sunshine” is not a hypothesis; there is no way to test whether plants like sunshine or not, so it is impossible to prove the statement false. The statement “Increased solar radiation increases the rate of plant growth” is a hypothesis; experiments could be done to show the relationship between solar radiation and plant growth. If solar radiation were shown to be unrelated to plant growth or to retard plant growth, then the hypothesis would be demonstrated to be false.
If a test reveals that a particular hypothesis is false, then the hypothesis is rejected or modified. In the case of the hypothesis about solar radiation and plant growth, we would probably find that more sunlight increases plant growth over some range but that too much can actually retard plant growth. Such results would lead us to modify our hypothesis about the relationship between solar radiation and plant growth.
If the tests of a hypothesis yield results consistent with it, then further tests are conducted. A hypothesis that has not been rejected after widespread testing and that wins general acceptance is commonly called a theory. A theory that has been subjected to even more testing and that has won virtually universal acceptance becomes a law. We will examine two economic laws in the next two chapters.
Even a hypothesis that has achieved the status of a law cannot be proven true. There is always a possibility that someone may find a case that invalidates the hypothesis. That possibility means that nothing in economics, or in any other social science, or in any science, can ever be proven true. We can have great confidence in a particular proposition, but it is always a mistake to assert that it is “proven.”
Models in Economics
All scientific thought involves simplifications of reality. The real world is far too complex for the human mind—or the most powerful computer—to consider. Scientists use models instead. A model is a set of simplifying assumptions about some aspect of the real world. Models are always based on assumed conditions that are simpler than those of the real world, assumptions that are necessarily false. A model of the real world cannot be the real world.
We will encounter our first economic model in Chapter 35 “Appendix A: Graphs in Economics”. For that model, we will assume that an economy can produce only two goods. Then we will explore the model of demand and supply. One of the assumptions we will make there is that all the goods produced by firms in a particular market are identical. Of course, real economies and real markets are not that simple. Reality is never as simple as a model; one point of a model is to simplify the world to improve our understanding of it.
Economists often use graphs to represent economic models. The appendix to this chapter provides a quick, refresher course, if you think you need one, on understanding, building, and using graphs.
Models in economics also help us to generate hypotheses about the real world. In the next section, we will examine some of the problems we encounter in testing those hypotheses.
Testing Hypotheses in Economics
Here is a hypothesis suggested by the model of demand and supply: an increase in the price of gasoline will reduce the quantity of gasoline consumers demand. How might we test such a hypothesis?
Economists try to test hypotheses such as this one by observing actual behavior and using empirical (that is, real-world) data. The average retail price of gasoline in the United States rose from an average of \$2.12 per gallon on May 22, 2005 to \$2.88 per gallon on May 22, 2006. The number of gallons of gasoline consumed by U.S. motorists rose 0.3% during that period.
The small increase in the quantity of gasoline consumed by motorists as its price rose is inconsistent with the hypothesis that an increased price will lead to an reduction in the quantity demanded. Does that mean that we should dismiss the original hypothesis? On the contrary, we must be cautious in assessing this evidence. Several problems exist in interpreting any set of economic data. One problem is that several things may be changing at once; another is that the initial event may be unrelated to the event that follows. The next two sections examine these problems in detail.
The All-Other-Things-Unchanged Problem
The hypothesis that an increase in the price of gasoline produces a reduction in the quantity demanded by consumers carries with it the assumption that there are no other changes that might also affect consumer demand. A better statement of the hypothesis would be: An increase in the price of gasoline will reduce the quantity consumers demand, ceteris paribus. Ceteris paribus is a Latin phrase that means “all other things unchanged.”
But things changed between May 2005 and May 2006. Economic activity and incomes rose both in the United States and in many other countries, particularly China, and people with higher incomes are likely to buy more gasoline. Employment rose as well, and people with jobs use more gasoline as they drive to work. Population in the United States grew during the period. In short, many things happened during the period, all of which tended to increase the quantity of gasoline people purchased.
Our observation of the gasoline market between May 2005 and May 2006 did not offer a conclusive test of the hypothesis that an increase in the price of gasoline would lead to a reduction in the quantity demanded by consumers. Other things changed and affected gasoline consumption. Such problems are likely to affect any analysis of economic events. We cannot ask the world to stand still while we conduct experiments in economic phenomena. Economists employ a variety of statistical methods to allow them to isolate the impact of single events such as price changes, but they can never be certain that they have accurately isolated the impact of a single event in a world in which virtually everything is changing all the time.
In laboratory sciences such as chemistry and biology, it is relatively easy to conduct experiments in which only selected things change and all other factors are held constant. The economists’ laboratory is the real world; thus, economists do not generally have the luxury of conducting controlled experiments.
The Fallacy of False Cause
Hypotheses in economics typically specify a relationship in which a change in one variable causes another to change. We call the variable that responds to the change the dependent variable; the variable that induces a change is called the independent variable. Sometimes the fact that two variables move together can suggest the false conclusion that one of the variables has acted as an independent variable that has caused the change we observe in the dependent variable.
Consider the following hypothesis: People wearing shorts cause warm weather. Certainly, we observe that more people wear shorts when the weather is warm. Presumably, though, it is the warm weather that causes people to wear shorts rather than the wearing of shorts that causes warm weather; it would be incorrect to infer from this that people cause warm weather by wearing shorts.
Reaching the incorrect conclusion that one event causes another because the two events tend to occur together is called the fallacy of false cause. The accompanying essay on baldness and heart disease suggests an example of this fallacy.
Because of the danger of the fallacy of false cause, economists use special statistical tests that are designed to determine whether changes in one thing actually do cause changes observed in another. Given the inability to perform controlled experiments, however, these tests do not always offer convincing evidence that persuades all economists that one thing does, in fact, cause changes in another.
In the case of gasoline prices and consumption between May 2005 and May 2006, there is good theoretical reason to believe the price increase should lead to a reduction in the quantity consumers demand. And economists have tested the hypothesis about price and the quantity demanded quite extensively. They have developed elaborate statistical tests aimed at ruling out problems of the fallacy of false cause. While we cannot prove that an increase in price will, ceteris paribus, lead to a reduction in the quantity consumers demand, we can have considerable confidence in the proposition.
Normative and Positive Statements
Two kinds of assertions in economics can be subjected to testing. We have already examined one, the hypothesis. Another testable assertion is a statement of fact, such as “It is raining outside” or “Microsoft is the largest producer of operating systems for personal computers in the world.” Like hypotheses, such assertions can be demonstrated to be false. Unlike hypotheses, they can also be shown to be correct. A statement of fact or a hypothesis is a positive statement.
Although people often disagree about positive statements, such disagreements can ultimately be resolved through investigation. There is another category of assertions, however, for which investigation can never resolve differences. A normative statement is one that makes a value judgment. Such a judgment is the opinion of the speaker; no one can “prove” that the statement is or is not correct. Here are some examples of normative statements in economics: “We ought to do more to help the poor.” “People in the United States should save more.” “Corporate profits are too high.” The statements are based on the values of the person who makes them. They cannot be proven false.
Because people have different values, normative statements often provoke disagreement. An economist whose values lead him or her to conclude that we should provide more help for the poor will disagree with one whose values lead to a conclusion that we should not. Because no test exists for these values, these two economists will continue to disagree, unless one persuades the other to adopt a different set of values. Many of the disagreements among economists are based on such differences in values and therefore are unlikely to be resolved.
Key Takeaways
• Economists try to employ the scientific method in their research.
• Scientists cannot prove a hypothesis to be true; they can only fail to prove it false.
• Economists, like other social scientists and scientists, use models to assist them in their analyses.
• Two problems inherent in tests of hypotheses in economics are the all-other-things-unchanged problem and the fallacy of false cause.
• Positive statements are factual and can be tested. Normative statements are value judgments that cannot be tested. Many of the disagreements among economists stem from differences in values.
Try It!
Look again at the data in Table 1.1 “LSAT Scores and Undergraduate Majors”. Now consider the hypothesis: “Majoring in economics will result in a higher LSAT score.” Are the data given consistent with this hypothesis? Do the data prove that this hypothesis is correct? What fallacy might be involved in accepting the hypothesis?
Case in Point: Does Baldness Cause Heart Disease?
A website called embarrassingproblems.com received the following email:
“Dear Dr. Margaret,
“I seem to be going bald. According to your website, this means I’m more likely to have a heart attack. If I take a drug to prevent hair loss, will it reduce my risk of a heart attack?”
What did Dr. Margaret answer? Most importantly, she did not recommend that the questioner take drugs to treat his baldness, because doctors do not think that the baldness causes the heart disease. A more likely explanation for the association between baldness and heart disease is that both conditions are affected by an underlying factor. While noting that more research needs to be done, one hypothesis that Dr. Margaret offers is that higher testosterone levels might be triggering both the hair loss and the heart disease. The good news for people with early balding (which is really where the association with increased risk of heart disease has been observed) is that they have a signal that might lead them to be checked early on for heart disease.
Figure 1.3
Answer to Try It! Problem
The data are consistent with the hypothesis, but it is never possible to prove that a hypothesis is correct. Accepting the hypothesis could involve the fallacy of false cause; students who major in economics may already have the analytical skills needed to do well on the exam. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.3%3A_The_Economists_Tool_Kit.txt |
Summary
Choices are forced on us by scarcity; economists study the choices that people make. Scarce goods are those for which the choice of one alternative requires giving up another. The opportunity cost of any choice is the value of the best alternative forgone in making that choice.
Some key choices assessed by economists include what to produce, how to produce it, and for whom it should be produced. Economics is distinguished from other academic disciplines that also study choices by an emphasis on the central importance of opportunity costs in evaluating choices, the assumption of maximizing behavior that serves the interests of individual decision makers, and a focus on evaluating choices at the margin.
Economic analyses may be aimed at explaining individual choice or choices in an individual market; such investigations are largely the focus of microeconomics. The analysis of the impact of those individual choices on such aggregates as total output, the level of employment, and the price level is the concern of macroeconomics.
Working within the framework of the scientific method, economists formulate hypotheses and then test them. These tests can only refute a hypothesis; hypotheses in science cannot be proved. A hypothesis that has been widely tested often comes to be regarded as a theory; one that has won virtually universal acceptance is a law. Because of the complexity of the real world, economists rely on models that rest on a series of simplifying assumptions. The models are used to generate hypotheses about the economy that can be tested using real-world data.
Statements of fact and hypotheses are positive statements. Normative statements, unlike positive statements, cannot be tested and provide a source for potential disagreement.
Problems
1. Why does the fact that something is scarce require that we make choices?
2. Does the fact that something is abundant mean it is not scarce in the economic sense? Why or why not?
3. In some countries, such as Cuba and North Korea, the government makes most of the decisions about what will be produced, how it will be produced, and for whom. Does the fact that these choices are made by the government eliminate scarcity in these countries? Why or why not?
4. Explain what is meant by the opportunity cost of a choice.
5. What is the approximate dollar cost of the tuition and other fees associated with the economics course you are taking? Does this dollar cost fully reflect the opportunity cost to you of taking the course?
6. In the Case in Point essay “The Rising Cost of Energy,” what would be some of the things that would be included in an estimate of the opportunity cost of preserving part of northern Alberta Canada by prohibiting heavy crude oil extraction? Do you think that the increased extraction represents the best use of the land? Why or why not?
7. Indicate whether each of the following is a topic of microeconomics or macroeconomics:
1. The impact of higher oil prices on the production of steel
2. The increased demand in the last 15 years for exotic dietary supplements
3. The surge in aggregate economic activity that hit much of Asia late in the early 2000s
4. The sharp increases in U.S. employment and total output that occurred between 2003 and 2007
5. The impact of preservation of wilderness areas on the logging industry and on the price of lumber
8. Determine whether each of the following raises a “what,” “how,” or “for whom” issue. Are the statements normative or positive?
1. A requirement that aluminum used in cars be made from recycled materials will raise the price of automobiles.
2. The federal government does not spend enough for children.
3. An increase in police resources provided to the inner city will lower the crime rate.
4. Automation destroys jobs.
5. Efforts to improve the environment tend to reduce production and employment.
6. Japanese firms should be more willing to hire additional workers when production rises and to lay off workers when production falls.
7. Access to health care should not be limited by income.
9. Your time is a scarce resource. What if the quantity of time were increased, say to 48 hours per day, and everyone still lived as many days as before. Would time still be scarce?
10. Most college students are under age 25. Give two explanations for this—one based on the benefits people of different ages are likely to receive from higher education and one based on the opportunity costs of a college education to students of different ages.
11. Some municipal water companies charge customers a flat fee each month, regardless of the amount of water they consume. Others meter water use and charge according to the quantity of water customers use. Compare the way the two systems affect the cost of water use at the margin.
12. How might you test each of the following hypotheses? Suggest some problems that might arise in each test due to the ceteris paribus (all-other-things-unchanged) problem and the fallacy of false cause.
1. Reducing the quantity of heroin available will increase total spending on heroin and increase the crime rate.
2. Higher incomes make people happier.
3. Higher incomes make people live longer.
13. Many models in physics and in chemistry assume the existence of a perfect vacuum (that is, a space entirely empty of matter). Yet we know that a perfect vacuum cannot exist. Are such models valid? Why are models based on assumptions that are essentially incorrect?
14. Suppose you were asked to test the proposition that publishing students’ teacher evaluations causes grade inflation. What evidence might you want to consider? How would the inability to carry out controlled experiments make your analysis more difficult?
15. Referring to the Case in Point “Baldness and Heart Disease,” explain the possible fallacy of false cause in concluding that baldness makes a person more likely to have heart disease.
16. In 2005 the Food and Drug Administration ordered that Vioxx and other popular drugs for treating the pain of arthritis be withdrawn from the market. The order resulted from a finding that people taking the drugs had an increased risk of cardiovascular problems. Some researchers criticized the government’s action, arguing that concluding that the drugs caused the cardiovascular problems represented an example of the fallacy of false cause. Can you think of any reason why this might be the case? | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/01%3A_Economics%3A_The_Study_of_Choice/1.4%3A_Review_and_Practice.txt |
Learning Objective
1. Define the three factors of production—labor, capital, and natural resources.
2. Explain the role of technology and entrepreneurs in the utilization of the economy’s factors of production.
Choices concerning what goods and services to produce are choices about an economy’s use of its factors of production, the resources available to it for the production of goods and services. The value, or satisfaction, that people derive from the goods and services they consume and the activities they pursue is called utility. Ultimately, then, an economy’s factors of production create utility; they serve the interests of people.
The factors of production in an economy are its labor, capital, and natural resources. Labor is the human effort that can be applied to the production of goods and services. People who are employed or would like to be are considered part of the labor available to the economy. Capital is a factor of production that has been produced for use in the production of other goods and services. Office buildings, machinery, and tools are examples of capital. Natural resources are the resources of nature that can be used for the production of goods and services.
In the next three sections, we will take a closer look at the factors of production we use to produce the goods and services we consume. The three basic building blocks of labor, capital, and natural resources may be used in different ways to produce different goods and services, but they still lie at the core of production. We will then look at the roles played by technology and entrepreneurs in putting these factors of production to work. As economists began to grapple with the problems of scarcity, choice, and opportunity cost two centuries ago, they focused on these concepts, just as they are likely to do two centuries hence.
Labor
Labor is human effort that can be applied to production. People who work to repair tires, pilot airplanes, teach children, or enforce laws are all part of the economy’s labor. People who would like to work but have not found employment—who are unemployed—are also considered part of the labor available to the economy.
In some contexts, it is useful to distinguish two forms of labor. The first is the human equivalent of a natural resource. It is the natural ability an untrained, uneducated person brings to a particular production process. But most workers bring far more. The skills a worker has as a result of education, training, or experience that can be used in production are called human capital. Students who are attending a college or university are acquiring human capital. Workers who are gaining skills through experience or through training are acquiring human capital. Children who are learning to read are acquiring human capital.
The amount of labor available to an economy can be increased in two ways. One is to increase the total quantity of labor, either by increasing the number of people available to work or by increasing the average number of hours of work per week. The other is to increase the amount of human capital possessed by workers.
Capital
Long ago, when the first human beings walked the earth, they produced food by picking leaves or fruit off a plant or by catching an animal and eating it. We know that very early on, however, they began shaping stones into tools, apparently for use in butchering animals. Those tools were the first capital because they were produced for use in producing other goods—food and clothing.
Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all are used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also capital. Transportation equipment, such as cars and trucks, is capital. Facilities such as roads, bridges, ports, and airports are capital. Buildings, too, are capital; they help us to produce goods and services.
Capital does not consist solely of physical objects. The score for a new symphony is capital because it will be used to produce concerts. Computer software used by business firms or government agencies to produce goods and services is capital. Capital may thus include physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria:
1. The resource must have been produced.
2. The resource can be used to produce other goods and services.
One thing that is not considered capital is money. A firm cannot use money directly to produce other goods, so money does not satisfy the second criterion for capital. Firms can, however, use money to acquire capital. Money is a form of financial capital. Financial capital includes money and other “paper” assets (such as stocks and bonds) that represent claims on future payments. These financial assets are not capital, but they can be used directly or indirectly to purchase factors of production or goods and services.
Natural Resources
There are two essential characteristics of natural resources. The first is that they are found in nature—that no human effort has been used to make or alter them. The second is that they can be used for the production of goods and services. That requires knowledge; we must know how to use the things we find in nature before they become resources.
Consider oil. Oil in the ground is a natural resource because it is found (not manufactured) and can be used to produce goods and services. However, 250 years ago oil was a nuisance, not a natural resource. Pennsylvania farmers in the eighteenth century who found oil oozing up through their soil were dismayed, not delighted. No one knew what could be done with the oil. It was not until the mid-nineteenth century that a method was found for refining oil into kerosene that could be used to generate energy, transforming oil into a natural resource. Oil is now used to make all sorts of things, including clothing, drugs, gasoline, and plastic. It became a natural resource because people discovered and implemented a way to use it.
Defining something as a natural resource only if it can be used to produce goods and services does not mean that a tree has value only for its wood or that a mountain has value only for its minerals. If people gain utility from the existence of a beautiful wilderness area, then that wilderness provides a service. The wilderness is thus a natural resource.
The natural resources available to us can be expanded in three ways. One is the discovery of new natural resources, such as the discovery of a deposit of ore containing titanium. The second is the discovery of new uses for resources, as happened when new techniques allowed oil to be put to productive use or sand to be used in manufacturing computer chips. The third is the discovery of new ways to extract natural resources in order to use them. New methods of discovering and mapping oil deposits have increased the world’s supply of this important natural resource.
Technology and the Entrepreneur
Goods and services are produced using the factors of production available to the economy. Two things play a crucial role in putting these factors of production to work. The first is technology, the knowledge that can be applied to the production of goods and services. The second is an individual who plays a key role in a market economy: the entrepreneur. An entrepreneur is a person who, operating within the context of a market economy, seeks to earn profits by finding new ways to organize factors of production. In non-market economies the role of the entrepreneur is played by bureaucrats and other decision makers who respond to incentives other than profit to guide their choices about resource allocation decisions.
The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs put new technologies to work every day, changing the way factors of production are used. Farmers and factory workers, engineers and electricians, technicians and teachers all work differently than they did just a few years ago, using new technologies introduced by entrepreneurs. The music you enjoy, the books you read, the athletic equipment with which you play are produced differently than they were five years ago. The book you are reading was written and manufactured using technologies that did not exist ten years ago. We can dispute whether all the changes have made our lives better. What we cannot dispute is that they have made our lives different.
Key Takeaways
• Factors of production are the resources the economy has available to produce goods and services.
• Labor is the human effort that can be applied to the production of goods and services. Labor’s contribution to an economy’s output of goods and services can be increased either by increasing the quantity of labor or by increasing human capital.
• Capital is a factor of production that has been produced for use in the production of other goods and services.
• Natural resources are those things found in nature that can be used for the production of goods and services.
• Two keys to the utilization of an economy’s factors of production are technology and, in the case of a market economic system, the efforts of entrepreneurs.
Try It!
Explain whether each of the following is labor, capital, or a natural resource.
1. An unemployed factory worker
2. A college professor
3. The library building on your campus
4. Yellowstone National Park
5. An untapped deposit of natural gas
6. The White House
7. The local power plant
Case in Point: Technology Cuts Costs, Boosts Productivity and Profits
Figure 2.1
Technology can seem an abstract force in the economy—important, but invisible.
It is not invisible to the 130 people who work on a Shell Oil Company oil rig called Mars, located in the deep waters of the Gulf of Mexico, about 160 miles southwest of Pensacola, Florida. The name Mars reflects its otherworld appearance—it extends 300 feet above the water’s surface and has steel tendons that reach 3,000 feet to the floor of the gulf. This facility would not exist if it were not for the development of better oil discovery methods that include three-dimensional seismic mapping techniques, satellites that locate oil from space, and drills that can make turns as drilling foremen steer them by monitoring them on computer screens from the comfort of Mars. “We don’t hit as many dry holes,” commented Shell manager Miles Barrett. As a result of these new technologies, over the past two decades, the cost of discovering a barrel of oil dropped from \$20 to under \$5. And the technologies continue to improve. Three-dimensional surveys are being replaced with four-dimensional ones that allow geologists to see how the oil fields change over time.
The Mars project was destroyed by Hurricane Katrina in 2005. Royal Dutch Shell completed repairs in 2006—at a cost of \$200 million. But, the facility is again pumping 130,000 barrels of oil per day and 150 million cubic feet of natural gas—the energy equivalent of an additional 26,000 barrels of oil.
Technology is doing more than helping energy companies track oil deposits. It is changing the way soft drinks and other grocery items are delivered to retail stores. For example, when a PepsiCo delivery driver arrives at a 7-Eleven, the driver keys into a handheld computer the inventory of soft drinks, chips, and other PepsiCo products. The information is transmitted to a main computer at the warehouse that begins processing the next order for that store. The result is that the driver can visit more stores in a day and PepsiCo can cover a given territory with fewer drivers and trucks.
New technology is even helping to produce more milk from cows. Ed Larsen, who owns a 1,200-cow dairy farm in Wisconsin, never gets up before dawn to milk the cows, the way he did as a boy. Rather, the cows are hooked up to electronic milkers. Computers measure each cow’s output, and cows producing little milk are sent to a “hospital wing” for treatment. With the help of such technology, as well as better feed, today’s dairy cows produce 50% more milk than did cows 20 years ago. Even though the number of dairy cows in the United States in the last 20 years has fallen 17%, milk output has increased 25%.
Who benefits from technological progress? Consumers gain from lower prices and better service. Workers gain: Their greater ability to produce goods and services translates into higher wages. And firms gain: Lower production costs mean higher profits. Of course, some people lose as technology advances. Some jobs are eliminated, and some firms find their services are no longer needed. One can argue about whether particular technological changes have improved our lives, but they have clearly made—and will continue to make—them far different.
Answers to Try It! Problems
1. An unemployed factory worker could be put to work; he or she counts as labor.
2. A college professor is labor.
3. The library building on your campus is part of capital.
4. Yellowstone National Park. Those areas of the park left in their natural state are a natural resource. Facilities such as visitors’ centers, roads, and campgrounds are capital.
5. An untapped deposit of natural gas is a natural resource. Once extracted and put in a storage tank, natural gas is capital.
6. The White House is capital.
7. The local power plant is capital. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.1%3A_Factors_of_Production.txt |
Learning Objective
1. Explain the concept of the production possibilities curve and understand the implications of its downward slope and bowed-out shape.
2. Use the production possibilities model to distinguish between full employment and situations of idle factors of production and between efficient and inefficient production.
3. Understand specialization and its relationship to the production possibilities model and comparative advantage.
An economy’s factors of production are scarce; they cannot produce an unlimited quantity of goods and services. A production possibilities curve is a graphical representation of the alternative combinations of goods and services an economy can produce. It illustrates the production possibilities model. In drawing the production possibilities curve, we shall assume that the economy can produce only two goods and that the quantities of factors of production and the technology available to the economy are fixed.
Constructing a Production Possibilities Curve
To construct a production possibilities curve, we will begin with the case of a hypothetical firm, Alpine Sports, Inc., a specialized sports equipment manufacturer. Christie Ryder began the business 15 years ago with a single ski production facility near Killington ski resort in central Vermont. Ski sales grew, and she also saw demand for snowboards rising—particularly after snowboard competition events were included in the 2002 Winter Olympics in Salt Lake City. She added a second plant in a nearby town. The second plant, while smaller than the first, was designed to produce snowboards as well as skis. She also modified the first plant so that it could produce both snowboards and skis. Two years later she added a third plant in another town. While even smaller than the second plant, the third was primarily designed for snowboard production but could also produce skis.
We can think of each of Ms. Ryder’s three plants as a miniature economy and analyze them using the production possibilities model. We assume that the factors of production and technology available to each of the plants operated by Alpine Sports are unchanged.
Suppose the first plant, Plant 1, can produce 200 pairs of skis per month when it produces only skis. When devoted solely to snowboards, it produces 100 snowboards per month. It can produce skis and snowboards simultaneously as well.
The table in Figure 2.2 gives three combinations of skis and snowboards that Plant 1 can produce each month. Combination A involves devoting the plant entirely to ski production; combination C means shifting all of the plant’s resources to snowboard production; combination B involves the production of both goods. These values are plotted in a production possibilities curve for Plant 1. The curve is a downward-sloping straight line, indicating that there is a linear, negative relationship between the production of the two goods.
Neither skis nor snowboards is an independent or a dependent variable in the production possibilities model; we can assign either one to the vertical or to the horizontal axis. Here, we have placed the number of pairs of skis produced per month on the vertical axis and the number of snowboards produced per month on the horizontal axis.
The negative slope of the production possibilities curve reflects the scarcity of the plant’s capital and labor. Producing more snowboards requires shifting resources out of ski production and thus producing fewer skis. Producing more skis requires shifting resources out of snowboard production and thus producing fewer snowboards.
The slope of Plant 1’s production possibilities curve measures the rate at which Alpine Sports must give up ski production to produce additional snowboards. Because the production possibilities curve for Plant 1 is linear, we can compute the slope between any two points on the curve and get the same result. Between points A and B, for example, the slope equals −2 pairs of skis/snowboard (equals −100 pairs of skis/50 snowboards). (Many students are helped when told to read this result as “−2 pairs of skis per snowboard.”) We get the same value between points B and C, and between points A and C.
To see this relationship more clearly, examine Figure 2.3. Suppose Plant 1 is producing 100 pairs of skis and 50 snowboards per month at point B. Now consider what would happen if Ms. Ryder decided to produce 1 more snowboard per month. The segment of the curve around point B is magnified in Figure 2.3. The slope between points B and B′ is −2 pairs of skis/snowboard. Producing 1 additional snowboard at point B′ requires giving up 2 pairs of skis. We can think of this as the opportunity cost of producing an additional snowboard at Plant 1. This opportunity cost equals the absolute value of the slope of the production possibilities curve.
Figure 2.3 The Slope of a Production Possibilities Curve
The slope of the linear production possibilities curve in Figure 2.2 is constant; it is −2 pairs of skis/snowboard. In the section of the curve shown here, the slope can be calculated between points B and B′. Expanding snowboard production to 51 snowboards per month from 50 snowboards per month requires a reduction in ski production to 98 pairs of skis per month from 100 pairs. The slope equals −2 pairs of skis/snowboard (that is, it must give up two pairs of skis to free up the resources necessary to produce one additional snowboard). To shift from B′ to B″, Alpine Sports must give up two more pairs of skis per snowboard. The absolute value of the slope of a production possibilities curve measures the opportunity cost of an additional unit of the good on the horizontal axis measured in terms of the quantity of the good on the vertical axis that must be forgone.
The absolute value of the slope of any production possibilities curve equals the opportunity cost of an additional unit of the good on the horizontal axis. It is the amount of the good on the vertical axis that must be given up in order to free up the resources required to produce one more unit of the good on the horizontal axis. We will make use of this important fact as we continue our investigation of the production possibilities curve.
Figure 2.4 shows production possibilities curves for each of the firm’s three plants. Each of the plants, if devoted entirely to snowboards, could produce 100 snowboards. Plants 2 and 3, if devoted exclusively to ski production, can produce 100 and 50 pairs of skis per month, respectively. The exhibit gives the slopes of the production possibilities curves for each plant. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes (that is, the number of pairs of skis that must be given up per snowboard).
The exhibit gives the slopes of the production possibilities curves for each of the firm’s three plants. The opportunity cost of an additional snowboard at each plant equals the absolute values of these slopes. More generally, the absolute value of the slope of any production possibilities curve at any point gives the opportunity cost of an additional unit of the good on the horizontal axis, measured in terms of the number of units of the good on the vertical axis that must be forgone.
The greater the absolute value of the slope of the production possibilities curve, the greater the opportunity cost will be. The plant for which the opportunity cost of an additional snowboard is greatest is the plant with the steepest production possibilities curve; the plant for which the opportunity cost is lowest is the plant with the flattest production possibilities curve. The plant with the lowest opportunity cost of producing snowboards is Plant 3; its slope of −0.5 means that Ms. Ryder must give up half a pair of skis in that plant to produce an additional snowboard. In Plant 2, she must give up one pair of skis to gain one more snowboard. We have already seen that an additional snowboard requires giving up two pairs of skis in Plant 1.
Comparative Advantage and the Production Possibilities Curve
To construct a combined production possibilities curve for all three plants, we can begin by asking how many pairs of skis Alpine Sports could produce if it were producing only skis. To find this quantity, we add up the values at the vertical intercepts of each of the production possibilities curves in Figure 2.4. These intercepts tell us the maximum number of pairs of skis each plant can produce. Plant 1 can produce 200 pairs of skis per month, Plant 2 can produce 100 pairs of skis at per month, and Plant 3 can produce 50 pairs. Alpine Sports can thus produce 350 pairs of skis per month if it devotes its resources exclusively to ski production. In that case, it produces no snowboards.
Now suppose the firm decides to produce 100 snowboards. That will require shifting one of its plants out of ski production. Which one will it choose to shift? The sensible thing for it to do is to choose the plant in which snowboards have the lowest opportunity cost—Plant 3. It has an advantage not because it can produce more snowboards than the other plants (all the plants in this example are capable of producing up to 100 snowboards per month) but because it is the least productive plant for making skis. Producing a snowboard in Plant 3 requires giving up just half a pair of skis.
Economists say that an economy has a comparative advantage in producing a good or service if the opportunity cost of producing that good or service is lower for that economy than for any other. Plant 3 has a comparative advantage in snowboard production because it is the plant for which the opportunity cost of additional snowboards is lowest. To put this in terms of the production possibilities curve, Plant 3 has a comparative advantage in snowboard production (the good on the horizontal axis) because its production possibilities curve is the flattest of the three curves.
Plant 3’s comparative advantage in snowboard production makes a crucial point about the nature of comparative advantage. It need not imply that a particular plant is especially good at an activity. In our example, all three plants are equally good at snowboard production. Plant 3, though, is the least efficient of the three in ski production. Alpine thus gives up fewer skis when it produces snowboards in Plant 3. Comparative advantage thus can stem from a lack of efficiency in the production of an alternative good rather than a special proficiency in the production of the first good.
The combined production possibilities curve for the firm’s three plants is shown in Figure 2.5. We begin at point A, with all three plants producing only skis. Production totals 350 pairs of skis per month and zero snowboards. If the firm were to produce 100 snowboards at Plant 3, ski production would fall by 50 pairs per month (recall that the opportunity cost per snowboard at Plant 3 is half a pair of skis). That would bring ski production to 300 pairs, at point B. If Alpine Sports were to produce still more snowboards in a single month, it would shift production to Plant 2, the facility with the next-lowest opportunity cost. Producing 100 snowboards at Plant 2 would leave Alpine Sports producing 200 snowboards and 200 pairs of skis per month, at point C. If the firm were to switch entirely to snowboard production, Plant 1 would be the last to switch because the cost of each snowboard there is 2 pairs of skis. With all three plants producing only snowboards, the firm is at point D on the combined production possibilities curve, producing 300 snowboards per month and no skis.
Notice that this production possibilities curve, which is made up of linear segments from each assembly plant, has a bowed-out shape; the absolute value of its slope increases as Alpine Sports produces more and more snowboards. This is a result of transferring resources from the production of one good to another according to comparative advantage. We shall examine the significance of the bowed-out shape of the curve in the next section.
The Law of Increasing Opportunity Cost
We see in Figure 2.5 that, beginning at point A and producing only skis, Alpine Sports experiences higher and higher opportunity costs as it produces more snowboards. The fact that the opportunity cost of additional snowboards increases as the firm produces more of them is a reflection of an important economic law. The law of increasing opportunity cost holds that as an economy moves along its production possibilities curve in the direction of producing more of a particular good, the opportunity cost of additional units of that good will increase.
We have seen the law of increasing opportunity cost at work traveling from point A toward point D on the production possibilities curve in Figure 2.5. The opportunity cost of each of the first 100 snowboards equals half a pair of skis; each of the next 100 snowboards has an opportunity cost of 1 pair of skis, and each of the last 100 snowboards has an opportunity cost of 2 pairs of skis. The law also applies as the firm shifts from snowboards to skis. Suppose it begins at point D, producing 300 snowboards per month and no skis. It can shift to ski production at a relatively low cost at first. The opportunity cost of the first 200 pairs of skis is just 100 snowboards at Plant 1, a movement from point D to point C, or 0.5 snowboards per pair of skis. We would say that Plant 1 has a comparative advantage in ski production. The next 100 pairs of skis would be produced at Plant 2, where snowboard production would fall by 100 snowboards per month. The opportunity cost of skis at Plant 2 is 1 snowboard per pair of skis. Plant 3 would be the last plant converted to ski production. There, 50 pairs of skis could be produced per month at a cost of 100 snowboards, or an opportunity cost of 2 snowboards per pair of skis.
The bowed-out production possibilities curve for Alpine Sports illustrates the law of increasing opportunity cost. Scarcity implies that a production possibilities curve is downward sloping; the law of increasing opportunity cost implies that it will be bowed out, or concave, in shape.
The bowed-out curve of Figure 2.5 becomes smoother as we include more production facilities. Suppose Alpine Sports expands to 10 plants, each with a linear production possibilities curve. Panel (a) of Figure 2.6 shows the combined curve for the expanded firm, constructed as we did in Figure 2.5. This production possibilities curve includes 10 linear segments and is almost a smooth curve. As we include more and more production units, the curve will become smoother and smoother. In an actual economy, with a tremendous number of firms and workers, it is easy to see that the production possibilities curve will be smooth. We will generally draw production possibilities curves for the economy as smooth, bowed-out curves, like the one in Panel (b). This production possibilities curve shows an economy that produces only skis and snowboards. Notice the curve still has a bowed-out shape; it still has a negative slope. Notice also that this curve has no numbers. Economists often use models such as the production possibilities model with graphs that show the general shapes of curves but that do not include specific numbers.
Movements Along the Production Possibilities Curve
We can use the production possibilities model to examine choices in the production of goods and services. In applying the model, we assume that the economy can produce two goods, and we assume that technology and the factors of production available to the economy remain unchanged. In this section, we shall assume that the economy operates on its production possibilities curve so that an increase in the production of one good in the model implies a reduction in the production of the other.
We shall consider two goods and services: national security and a category we shall call “all other goods and services.” This second category includes the entire range of goods and services the economy can produce, aside from national defense and security. Clearly, the transfer of resources to the effort to enhance national security reduces the quantity of other goods and services that can be produced. In the wake of the 9/11 attacks in 2001, nations throughout the world increased their spending for national security. This spending took a variety of forms. One, of course, was increased defense spending. Local and state governments also increased spending in an effort to prevent terrorist attacks. Airports around the world hired additional agents to inspect luggage and passengers.
The increase in resources devoted to security meant fewer “other goods and services” could be produced. In terms of the production possibilities curve in Figure 2.7, the choice to produce more security and less of other goods and services means a movement from A to B. Of course, an economy cannot really produce security; it can only attempt to provide it. The attempt to provide it requires resources; it is in that sense that we shall speak of the economy as “producing” security.
At point A, the economy was producing SA units of security on the vertical axis—defense services and various forms of police protection—and OA units of other goods and services on the horizontal axis. The decision to devote more resources to security and less to other goods and services represents the choice we discussed in the chapter introduction. In this case we have categories of goods rather than specific goods. Thus, the economy chose to increase spending on security in the effort to defeat terrorism. Since we have assumed that the economy has a fixed quantity of available resources, the increased use of resources for security and national defense necessarily reduces the number of resources available for the production of other goods and services.
The law of increasing opportunity cost tells us that, as the economy moves along the production possibilities curve in the direction of more of one good, its opportunity cost will increase. We may conclude that, as the economy moved along this curve in the direction of greater production of security, the opportunity cost of the additional security began to increase. That is because the resources transferred from the production of other goods and services to the production of security had a greater and greater comparative advantage in producing things other than security.
The production possibilities model does not tell us where on the curve a particular economy will operate. Instead, it lays out the possibilities facing the economy. Many countries, for example, chose to move along their respective production possibilities curves to produce more security and national defense and less of all other goods in the wake of 9/11. We will see in the chapter on demand and supply how choices about what to produce are made in the marketplace.
Producing on Versus Producing Inside the Production Possibilities Curve
An economy that is operating inside its production possibilities curve could, by moving onto it, produce more of all the goods and services that people value, such as food, housing, education, medical care, and music. Increasing the availability of these goods would improve the standard of living. Economists conclude that it is better to be on the production possibilities curve than inside it.
Two things could leave an economy operating at a point inside its production possibilities curve. First, the economy might fail to use fully the resources available to it. Second, it might not allocate resources on the basis of comparative advantage. In either case, production within the production possibilities curve implies the economy could improve its performance.
Idle Factors of Production
Suppose an economy fails to put all its factors of production to work. Some workers are without jobs, some buildings are without occupants, some fields are without crops. Because an economy’s production possibilities curve assumes the full use of the factors of production available to it, the failure to use some factors results in a level of production that lies inside the production possibilities curve.
If all the factors of production that are available for use under current market conditions are being utilized, the economy has achieved full employment. An economy cannot operate on its production possibilities curve unless it has full employment.
Figure 2.8 shows an economy that can produce food and clothing. If it chooses to produce at point A, for example, it can produce FA units of food and CA units of clothing. Now suppose that a large fraction of the economy’s workers lose their jobs, so the economy no longer makes full use of one factor of production: labor. In this example, production moves to point B, where the economy produces less food (FB) and less clothing (CB) than at point A. We often think of the loss of jobs in terms of the workers; they have lost a chance to work and to earn income. But the production possibilities model points to another loss: goods and services the economy could have produced that are not being produced.
Inefficient Production
Now suppose Alpine Sports is fully employing its factors of production. Could it still operate inside its production possibilities curve? Could an economy that is using all its factors of production still produce less than it could? The answer is “Yes,” and the key lies in comparative advantage. An economy achieves a point on its production possibilities curve only if it allocates its factors of production on the basis of comparative advantage. If it fails to do that, it will operate inside the curve.
Suppose that, as before, Alpine Sports has been producing only skis. With all three of its plants producing skis, it can produce 350 pairs of skis per month (and no snowboards). The firm then starts producing snowboards. This time, however, imagine that Alpine Sports switches plants from skis to snowboards in numerical order: Plant 1 first, Plant 2 second, and then Plant 3. Figure 2.9 illustrates the result. Instead of the bowed-out production possibilities curve ABCD, we get a bowed-in curve, AB′C′D. Suppose that Alpine Sports is producing 100 snowboards and 150 pairs of skis at point B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it could have operated at a point such as C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. Had the firm based its production choices on comparative advantage, it would have switched Plant 3 to snowboards and then Plant 2, so it would have operated at point C. It would be producing more snowboards and more pairs of skis—and using the same quantities of factors of production it was using at B′. When an economy is operating on its production possibilities curve, we say that it is engaging in efficient production. If it is using the same quantities of factors of production but is operating inside its production possibilities curve, it is engaging in inefficient production. Inefficient production implies that the economy could be producing more goods without using any additional labor, capital, or natural resources.
Points on the production possibilities curve thus satisfy two conditions: the economy is making full use of its factors of production, and it is making efficient use of its factors of production. If there are idle or inefficiently allocated factors of production, the economy will operate inside the production possibilities curve. Thus, the production possibilities curve not only shows what can be produced; it provides insight into how goods and services should be produced. It suggests that to obtain efficiency in production, factors of production should be allocated on the basis of comparative advantage. Further, the economy must make full use of its factors of production if it is to produce the goods and services it is capable of producing.
Specialization
The production possibilities model suggests that specialization will occur. Specialization implies that an economy is producing the goods and services in which it has a comparative advantage. If Alpine Sports selects point C in Figure 2.9, for example, it will assign Plant 1 exclusively to ski production and Plants 2 and 3 exclusively to snowboard production.
Such specialization is typical in an economic system. Workers, for example, specialize in particular fields in which they have a comparative advantage. People work and use the income they earn to buy—perhaps import—goods and services from people who have a comparative advantage in doing other things. The result is a far greater quantity of goods and services than would be available without this specialization.
Think about what life would be like without specialization. Imagine that you are suddenly completely cut off from the rest of the economy. You must produce everything you consume; you obtain nothing from anyone else. Would you be able to consume what you consume now? Clearly not. It is hard to imagine that most of us could even survive in such a setting. The gains we achieve through specialization are enormous.
Nations specialize as well. Much of the land in the United States has a comparative advantage in agricultural production and is devoted to that activity. Hong Kong, with its huge population and tiny endowment of land, allocates virtually none of its land to agricultural use; that option would be too costly. Its land is devoted largely to nonagricultural use.
Key Takeaways
• A production possibilities curve shows the combinations of two goods an economy is capable of producing.
• The downward slope of the production possibilities curve is an implication of scarcity.
• The bowed-out shape of the production possibilities curve results from allocating resources based on comparative advantage. Such an allocation implies that the law of increasing opportunity cost will hold.
• An economy that fails to make full and efficient use of its factors of production will operate inside its production possibilities curve.
• Specialization means that an economy is producing the goods and services in which it has a comparative advantage.
Try It!
Suppose a manufacturing firm is equipped to produce radios or calculators. It has two plants, Plant R and Plant S, at which it can produce these goods. Given the labor and the capital available at both plants, it can produce the combinations of the two goods at the two plants shown.
Output per day, Plant S
Combination Calculators Radios
D 50 0
E 25 50
F 0 100
Put calculators on the vertical axis and radios on the horizontal axis. Draw the production possibilities curve for Plant R. On a separate graph, draw the production possibilities curve for Plant S. Which plant has a comparative advantage in calculators? In radios? Now draw the combined curves for the two plants. Suppose the firm decides to produce 100 radios. Where will it produce them? How many calculators will it be able to produce? Where will it produce the calculators?
Case in Point: The Cost of the Great Depression
Figure 2.10
The U.S. economy looked very healthy in the beginning of 1929. It had enjoyed seven years of dramatic growth and unprecedented prosperity. Its resources were fully employed; it was operating quite close to its production possibilities curve.
In the summer of 1929, however, things started going wrong. Production and employment fell. They continued to fall for several years. By 1933, more than 25% of the nation’s workers had lost their jobs. Production had plummeted by almost 30%. The economy had moved well within its production possibilities curve.
Output began to grow after 1933, but the economy continued to have vast numbers of idle workers, idle factories, and idle farms. These resources were not put back to work fully until 1942, after the U.S. entry into World War II demanded mobilization of the economy’s factors of production.
Between 1929 and 1942, the economy produced 25% fewer goods and services than it would have if its resources had been fully employed. That was a loss, measured in today’s dollars, of well over \$3 trillion. In material terms, the forgone output represented a greater cost than the United States would ultimately spend in World War II. The Great Depression was a costly experience indeed.
Answer to Try It! Problem
The production possibilities curves for the two plants are shown, along with the combined curve for both plants. Plant R has a comparative advantage in producing calculators. Plant S has a comparative advantage in producing radios, so, if the firm goes from producing 150 calculators and no radios to producing 100 radios, it will produce them at Plant S. In the production possibilities curve for both plants, the firm would be at M, producing 100 calculators at Plant R.
Figure 2.11 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.2%3A_The_Production_Possibilities_Curve.txt |
Learning Objective
1. Understand the argument for unrestricted international trade in terms of economic specialization and comparative advantage.
2. Define economic growth in terms of the production possibilities model and discuss factors that make such growth possible.
3. Explain the classification of economic systems, the role of government in different economic systems, and the strengths and weaknesses of different systems.
The production possibilities curve gives us a model of an economy. The model provides powerful insights about the real world, insights that help us to answer some important questions: How does trade between two countries affect the quantities of goods available to people? What determines the rate at which production will increase over time? What is the role of economic freedom in the economy? In this section we explore applications of the model to questions of international trade, economic growth, and the choice of an economic system.
Comparative Advantage and International Trade
One of the most important implications of the concepts of comparative advantage and the production possibilities curve relates to international trade. We can think of different nations as being equivalent to Christie Ryder’s plants. Each will have a comparative advantage in certain activities, and efficient world production requires that each nation specialize in those activities in which it has a comparative advantage. A failure to allocate resources in this way means that world production falls inside the production possibilities curve; more of each good could be produced by relying on comparative advantage.
If nations specialize, then they must rely on each other. They will sell the goods in which they specialize and purchase other goods from other nations. Suppose, for example, that the world consists of two continents that can each produce two goods: South America and Europe can produce food and computers. Suppose they can produce the two goods according to the tables in Panels (a) and (b) of Figure 2.12. We have simplified this example by assuming that each continent has a linear production possibilities curve; the curves are plotted below the tables in Panels (a) and (b). Each continent has a separate production possibilities curve; the two have been combined to illustrate a world production possibilities curve in Panel (c) of the exhibit.
Figure 2.12 Production Possibilities Curves and Trade
Suppose the world consists of two continents: South America and Europe. They can each produce two goods: food and computers. In this example, we assume that each continent has a linear production possibilities curve, as shown in Panels (a) and (b). South America has a comparative advantage in food production and Europe has a comparative advantage in computer production. With free trade, the world can operate on the bowed-out curve GHI, shown in Panel (c). If the continents refuse to trade, the world will operate inside its production possibilities curve. If, for example, each continent were to produce at the midpoint of its production possibilities curve, the world would produce 300 computers and 300 units of food per period at point Q. If each continent were to specialize in the good in which it has a comparative advantage, world production could move to a point such as H, with more of both goods produced.
The world production possibilities curve assumes that resources are allocated between computer and food production based on comparative advantage. Notice that, even with only two economies and the assumption of linear production possibilities curves for each, the combined curve still has a bowed-out shape. At point H, for example, South America specializes in food, while Europe produces only computers. World production equals 400 units of each good. In this situation, we would expect South America to export food to Europe while Europe exports computers to South America.
But suppose the regions refuse to trade; each insists on producing its own food and computers. Suppose further that each chooses to produce at the midpoint of its own production possibilities curve. South America produces 100 units of computers and 200 units of food per period, while Europe produces 200 units of computers and 100 units of food per period. World production thus totals 300 units of each good per period; the world operates at point Q in Figure 2.12. If the two continents were willing to move from isolation to trade, the world could achieve an increase in the production of both goods. Producing at point H requires no more resources, no more effort than production at Q. It does, however, require that the world’s resources be allocated on the basis of comparative advantage.
The implications of our model for trade are powerful indeed. First, we see that trade allows the production of more of all goods and services. Restrictions on trade thus reduce production of goods and services. Second, we see a lesson often missed in discussions of trade: a nation’s trade policy has nothing to do with its level of employment of its factors of production. In our example, when South America and Europe do not engage in trade and produce at the midpoints of each of their respective production possibilities curves, they each have full employment. With trade, the two nations still operate on their respective production possibilities curves: they each have full employment. Trade certainly redistributes employment in the two continents. In South America, employment shifts from computer production to food production. In Europe, it shifts from food production to computer production. Once the shift is made, though, there is no effect on employment in either continent.
Of course, this idealized example would have all of South America’s computer experts becoming farmers while all of Europe’s farmers become computer geeks! That is a bit much to swallow, but it is merely the result of assuming linear production possibilities curves and complete specialization. In the real world, production possibilities curves are concave, and the reallocation of resources required by trade is not nearly as dramatic. Still, free trade can require shifts in resources from one activity to another. These shifts produce enormous benefits, but they do not come without costs.
Nearly all economists agree that largely unrestricted trade between countries is desirable; restrictions on trade generally force the world to operate inside its production possibilities curve. In some cases restrictions on trade could be desirable, but in the main, free trade promotes greater production of goods and services for the world’s people. The role of international trade is explored in greater detail in subsequent chapters of this book.
Economic Growth
An increase in the physical quantity or in the quality of factors of production available to an economy or a technological gain will allow the economy to produce more goods and services; it will shift the economy’s production possibilities curve outward. The process through which an economy achieves an outward shift in its production possibilities curve is called economic growth. An outward shift in a production possibilities curve is illustrated in Figure 2.13. In Panel (a), a point such as N is not attainable; it lies outside the production possibilities curve. Growth shifts the curve outward, as in Panel (b), making previously unattainable levels of production possible.
The Sources of Economic Growth
Economic growth implies an outward shift in an economy’s production possibilities curve. Recall that when we draw such a curve, we assume that the quantity and quality of the economy’s factors of production and its technology are unchanged. Changing these will shift the curve. Anything that increases the quantity or quality of the factors of production available to the economy or that improves the technology available to the economy contributes to economic growth.
Consider, for example, the dramatic gains in human capital that have occurred in the United States since the beginning of the past century. In 1900, about 3.5% of U.S. workers had completed a high school education. By 2006, that percentage rose almost to 92. Fewer than 1% of the workers in 1900 had graduated from college; as late as 1940 only 3.5% had graduated from college. By 2006, nearly 32% had graduated from college. In addition to being better educated, today’s workers have received more and better training on the job. They bring far more economically useful knowledge and skills to their work than did workers a century ago.
Moreover, the technological changes that have occurred within the past 100 years have greatly reduced the time and effort required to produce most goods and services. Automated production has become commonplace. Innovations in transportation (automobiles, trucks, and airplanes) have made the movement of goods and people cheaper and faster. A dizzying array of new materials is available for manufacturing. And the development of modern information technology—including computers, software, and communications equipment—that seemed to proceed at breathtaking pace especially during the final years of the last century and continuing to the present has transformed the way we live and work.
Look again at the technological changes of the last few years described in the Case in Point on advances in technology. Those examples of technological progress through applications of computer technology—from new ways of mapping oil deposits to new methods of milking cows—helped propel the United States and other economies to dramatic gains in the ability to produce goods and services. They have helped shift the countries’ production possibilities curve outward. They have helped fuel economic growth.
Table 2.1 “Sources of U.S. Economic Growth, 1948–2002” summarizes the factors that have contributed to U.S. economic growth in the past half century. When looking at the period of 1948–2002 as a whole we see that about 60% of economic growth stems from increases in the quantities of capital and labor and 40% from increases in the qualities of the factors of production and improvements in technology. In the most recent period, 1995–2002, however, these percentages are essentially reversed, with a little less than 30% explained by increases in quantities of the factors of production and a whopping 70% explained by improvements in factor quality and technology.
Table 2.1 Sources of U.S. Economic Growth, 1948–2002
Year Percentage contribution to growth Period growth rate
Years 1948–2002 3.46%
Increase in quantity of labor 21%
Increase in quantity of capital 41%
Increase in quality of labor 10%
Increase in quality of capital 20%
Improved technology 25%
Years 1948–1973 3.99%
Increase in quantity of labor 15%
Increase in quantity of capital 44%
Increase in quality of labor 11%
Increase in quality of capital 5%
Improved technology 25%
Years 1973–1989 2.97%
Increase in quantity of labor 31%
Increase in quantity of capital 39%
Increase in quality of labor 7%
Increase in quality of capital 12%
Improved technology 10%
Years 1989–1995 2.43%
Increase in quantity of labor 26%
Increase in quantity of capital 33%
Increase in quality of labor 15%
Increase in quality of capital 17%
Improved technology 11%
Years 1995–2002 3.59%
Increase in quantity of labor 19%
Increase in quantity of capital 8%
Increase in quality of labor 5%
Increase in quality of capital 47%
Improved technology 20%
Total output during the period shown increased sixfold. The chart shows the percentage of this increase accounted for by increases in the quantity of labor and of capital and by increases in the quality of labor and of capital and improvements in technology. In the 1995–2002 period, the incorporation of information technology led to improvements in the quality of capital and technology that greatly contributed to growth.
Another way of looking at these data for the most recent period is to notice that the increase in the rate of economic growth between the 1989 to 1995 period and the 1995 to 2002 period of more than one percentage point per year is largely explained by better-quality capital and better technology. The study by economist Dale Jorgenson on which the data shown in Table 2.1 “Sources of U.S. Economic Growth, 1948–2002” are derived notes that these two main contributors to higher economic growth can be largely attributed to the development of information technology and its incorporation in the workplace.
Waiting for Growth
One key to growth is, in effect, the willingness to wait, to postpone current consumption in order to enhance future productive capability. When Stone Age people fashioned the first tools, they were spending time building capital rather than engaging in consumption. They delayed current consumption to enhance their future consumption; the tools they made would make them more productive in the future.
Resources society could have used to produce consumer goods are being used to produce new capital goods and new knowledge for production instead—all to enhance future production. An even more important source of growth in many nations has been increased human capital. Increases in human capital often require the postponement of consumption. If you are a college student, you are engaged in precisely this effort. You are devoting time to study that could have been spent working, earning income, and thus engaging in a higher level of consumption. If you are like most students, you are making this choice to postpone consumption because you expect it will allow you to earn more income, and thus enjoy greater consumption, in the future.
Think of an economy as being able to produce two goods, capital and consumer goods (those destined for immediate use by consumers). By focusing on the production of consumer goods, the people in the economy will be able to enjoy a higher standard of living today. If they reduce their consumption—and their standard of living—today to enhance their ability to produce goods and services in the future, they will be able to shift their production possibilities curve outward. That may allow them to produce even more consumer goods. A decision for greater growth typically involves the sacrifice of present consumption.
Arenas for Choice: A Comparison of Economic Systems
Under what circumstances will a nation achieve efficiency in the use of its factors of production? The discussion above suggested that Christie Ryder would have an incentive to allocate her plants efficiently because by doing so she could achieve greater output of skis and snowboards than would be possible from inefficient production. But why would she want to produce more of these two goods—or of any goods? Why would decision makers throughout the economy want to achieve such efficiency?
Economists assume that privately owned firms seek to maximize their profits. The drive to maximize profits will lead firms such as Alpine Sports to allocate resources efficiently to gain as much production as possible from their factors of production. But whether firms will seek to maximize profits depends on the nature of the economic system within which they operate.
Classifying Economic Systems
Each of the world’s economies can be viewed as operating somewhere on a spectrum between market capitalism and command socialism. In a market capitalist economy, resources are generally owned by private individuals who have the power to make decisions about their use. A market capitalist system is often referred to as a free enterprise economic system. In a command socialist economy, the government is the primary owner of capital and natural resources and has broad power to allocate the use of factors of production. Between these two categories lie mixed economies that combine elements of market capitalist and of command socialist economic systems.
No economy represents a pure case of either market capitalism or command socialism. To determine where an economy lies between these two types of systems, we evaluate the extent of government ownership of capital and natural resources and the degree to which government is involved in decisions about the use of factors of production.
Figure 2.14 suggests the spectrum of economic systems. Market capitalist economies lie toward the left end of this spectrum; command socialist economies appear toward the right. Mixed economies lie in between. The market capitalist end of the spectrum includes countries such as the United States, the United Kingdom, and Chile. Hong Kong, though now part of China, has a long history as a market capitalist economy and is generally regarded as operating at the market capitalist end of the spectrum. Countries at the command socialist end of the spectrum include North Korea and Cuba.
Figure 2.14 Economic Systems
Some European economies, such as France, Germany, and Sweden, have a sufficiently high degree of regulation that we consider them as operating more toward the center of the spectrum. Russia and China, which long operated at the command socialist end of the spectrum, can now be considered mixed economies. Most economies in Latin America once operated toward the right end of the spectrum. While their governments did not exercise the extensive ownership of capital and natural resources that are one characteristic of command socialist systems, their governments did impose extensive regulations. Many of these nations are in the process of carrying out economic reforms that will move them further in the direction of market capitalism.
The global shift toward market capitalist economic systems that occurred in the 1980s and 1990s was in large part the result of three important features of such economies. First, the emphasis on individual ownership and decision-making power has generally yielded greater individual freedom than has been available under command socialist or some more heavily regulated mixed economic systems that lie toward the command socialist end of the spectrum. People seeking political, religious, and economic freedom have thus gravitated toward market capitalism. Second, market economies are more likely than other systems to allocate resources on the basis of comparative advantage. They thus tend to generate higher levels of production and income than do other economic systems. Third, market capitalist-type systems appear to be the most conducive to entrepreneurial activity.
Suppose Christie Ryder had the same three plants we considered earlier in this chapter but was operating in a mixed economic system with extensive government regulation. In such a system, she might be prohibited from transferring resources from one use to another to achieve the gains possible from comparative advantage. If she were operating under a command socialist system, she would not be the owner of the plants and thus would be unlikely to profit from their efficient use. If that were the case, there is no reason to believe she would make any effort to assure the efficient use of the three plants. Generally speaking, it is economies toward the market capitalist end of the spectrum that offer the greatest inducement to allocate resources on the basis of comparative advantage. They tend to be more productive and to deliver higher material standards of living than do economies that operate at or near the command socialist end of the spectrum.
Market capitalist economies rely on economic freedom. Indeed, one way we can assess the degree to which a country can be considered market capitalist is by the degree of economic freedom it permits. Several organizations have attempted to compare economic freedom in various countries. One of the most extensive comparisons is a joint annual effort by the Heritage Foundation and The Wall Street Journal. The 2008 rating was based on policies in effect in 162 nations early that year. The report ranks these nations on the basis of such things as the degree of regulation of firms, tax levels, and restrictions on international trade. Hong Kong ranked as the freest economy in the world. North Korea received the dubious distinction of being the least free.
It seems reasonable to expect that the greater the degree of economic freedom a country permits, the greater the amount of income per person it will generate. This proposition is illustrated in Figure 2.15. The group of countries categorized as “free” generated the highest incomes in the Heritage Foundation/Wall Street Journal study; those rated as “repressed” had the lowest. The study also found that countries that over the last decade have done the most to improve their positions in the economic freedom rankings have also had the highest rates of growth. We must be wary of slipping into the fallacy of false cause by concluding from this evidence that economic freedom generates higher incomes. It could be that higher incomes lead nations to opt for greater economic freedom. But in this case, it seems reasonable to conclude that, in general, economic freedom does lead to higher incomes.
Government in a Market Economy
The production possibilities model provides a menu of choices among alternative combinations of goods and services. Given those choices, which combinations will be produced?
In a market economy, this question is answered in large part through the interaction of individual buyers and sellers. As we have already seen, government plays a role as well. It may seek to encourage greater consumption of some goods and discourage consumption of others. In the United States, for example, taxes imposed on cigarettes discourage smoking, while special treatment of property taxes and mortgage interest in the federal income tax encourages home ownership. Government may try to stop the production and consumption of some goods altogether, as many governments do with drugs such as heroin and cocaine. Government may supplement the private consumption of some goods by producing more of them itself, as many U.S. cities do with golf courses and tennis courts. In other cases, there may be no private market for a good or service at all. In the choice between security and defense versus all other goods and services outlined at the beginning of this chapter, government agencies are virtually the sole providers of security and national defense.
All nations also rely on government to provide defense, enforce laws, and redistribute income. Even market economies rely on government to regulate the activities of private firms, to protect the environment, to provide education, and to produce a wide range of other goods and services. Government’s role may be limited in a market economy, but it remains fundamentally important.
Key Takeaways
• The ideas of comparative advantage and specialization suggest that restrictions on international trade are likely to reduce production of goods and services.
• Economic growth is the result of increasing the quantity or quality of an economy’s factors of production and of advances in technology.
• Policies to encourage growth generally involve postponing consumption to increase capital and human capital.
• Market capitalist economies have generally proved more productive than mixed or command socialist economies.
• Government plays a crucial role in any market economy.
Try It!
Draw a production possibilities curve for an economy that can produce two goods, CD players and jackets. You do not have numbers for this one—just draw a curve with the usual bowed-out shape. Put the quantity of CD players per period on the vertical axis and the quantity of jackets per period on the horizontal axis. Now mark a point A on the curve you have drawn; extend dotted lines from this point to the horizontal and vertical axes. Mark the initial quantities of the two goods as CDA and JA, respectively. Explain why, in the absence of economic growth, an increase in jacket production requires a reduction in the production of CD players. Now show how economic growth could lead to an increase in the production of both goods.
Case in Point: The European Union and the Production Possibilities Curve
Figure 2.16
Formed by the Maastricht Treaty of 1993, The European Union represents one of the boldest efforts of our time to exploit the theory of comparative advantage. The Treaty sought to eliminate all trade barriers between the European Union’s members. It established a European Parliament and a European Central Bank. The Bank introduced the euro in 1999, a currency that replaced national currencies such as the German deutsche mark and the French franc. At first, the euro was used only for transactions between banks. 320 million people in 15 EU nations (Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovenia, and Spain) used the euro by 2008. While the dollar continues to be more widely used, the total value of euros in circulation exceeds that of dollars.
The movement toward European integration can be dated back more than half a century. In 1950, just five years after a war that had devastated much of the world, Robert Schuman, the French Minister of Foreign Affairs, proposed a union between France and Germany to cooperate in the production of iron and steel. In the context of the time, Schuman’s proposal was a radical one. World War II had begun with Germany’s attempt to seize control of Europe—and ultimately the world. Japan and Italy joined Germany in this effort. Germany had captured France; France had been liberated in 1944 by the Allied invasion in Normandy. The proposal for cooperation between two countries that had been the most bitter of enemies was a revolutionary one. Schuman’s speech, delivered on May 9, 1950, is celebrated throughout Europe as “Europe Day.”
In effect, the European Union has created an entity very much like the United States. Countries within the European Union retain their own languages and cultural differences, but they have ceded a remarkable degree of sovereignty to the Union. Members of the European Union can trade as freely with each other as can states within the United States. Just as the U.S. Constitution prohibits states from restricting trade with other states, the European Union has dismantled all forms of restrictions that countries within the Union used to impose on one another. Just as restrictions on specialization among Ms. Ryder’s plants in Alpine Sports would have forced it to operate inside its production possibilities curve, restrictions that had existed among members of the European Union once put the members of the Union inside their collective production possibilities curve.
The experiment appears to have been a success. Trade among member nations has expanded sharply. A study by Carmen Diaz Mora, an economist at the University of Castilla-La Mancha in Spain, found that the bulk of the expanded trade within the Union was trade within industries and that it was driven by comparative advantage. In particular, she found that countries in the northern part of the Union, such as France and Germany, tended to specialize in relatively high-valued goods—office equipment and electrical goods—while countries in the southern part of the Union specialized in relatively low-valued goods such as food and textile products. In trade within the clothing industry, countries such as Italy tend to specialize in the production of higher-valued clothing, while lower-income countries such as Portugal specialize in the production of cheaper clothing. In sparkling wines, France specializes in the higher-quality end of the spectrum, while Spain specializes in the low-quality end. Similarly, Germany specializes in the production of higher-quality cars while Spain specializes in lower-quality vehicles. Similar exchanges occur across a wide range of goods and services.
Diaz Mora found that comparative advantage tended to correspond to income levels. Countries in the northern part of the European Union tend to have high per capita incomes and high levels of human capital and technology—these countries gained by specializing in the production of high-valued goods. Countries in the southern part of the Union also gained by specialization—in the production of low-valued goods. This specialization has increased the welfare of people throughout the Union.
Answer to Try It! Problem
Your first production possibilities curve should resemble the one in Panel (a). Starting at point A, an increase in jacket production requires a move down and to the right along the curve, as shown by the arrow, and thus a reduction in the production of CD players. Alternatively, if there is economic growth, it shifts the production possibilities curve outward, as in Panel (b). This shift allows an increase in production of both goods, as suggested by the arrow.
Figure 2.17 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.3%3A_Applications_of_the_Production_Possibilities_Model.txt |
Summary
Economics deals with choices. In this chapter we have examined more carefully the range of choices in production that must be made in any economy. In particular, we looked at choices involving the allocation of an economy’s factors of production: labor, capital, and natural resources.
In addition, in any economy, the level of technology plays a key role in determining how productive the factors of production will be. In a market economy, entrepreneurs organize factors of production and act to introduce technological change.
The production possibilities model is a device that assists us in thinking about many of the choices about resource allocation in an economy. The model assumes that the economy has factors of production that are fixed in both quantity and quality. When illustrated graphically, the production possibilities model typically limits our analysis to two goods. Given the economy’s factors of production and technology, the economy can produce various combinations of the two goods. If it uses its factors of production efficiently and has full employment, it will be operating on the production possibilities curve.
Two characteristics of the production possibilities curve are particularly important. First, it is downward sloping. This reflects the scarcity of the factors of production available to the economy; producing more of one good requires giving up some of the other. Second, the curve is bowed out. Another way of saying this is to say that the curve gets steeper as we move from left to right; the absolute value of its slope is increasing. Producing each additional unit of the good on the horizontal axis requires a greater sacrifice of the good on the vertical axis than did the previous units produced. This fact, called the law of increasing opportunity cost, is the inevitable result of efficient choices in production—choices based on comparative advantage.
The production possibilities model has important implications for international trade. It suggests that free trade will allow countries to specialize in the production of goods and services in which they have a comparative advantage. This specialization increases the production of all goods and services.
Increasing the quantity or quality of factors of production and/or improving technology will shift the production possibilities curve outward. This process is called economic growth. In the last 50 years, economic growth in the United States has resulted chiefly from increases in human capital and from technological advance.
Choices concerning the use of scarce resources take place within the context of a set of institutional arrangements that define an economic system. The principal distinctions between systems lie in the degree to which ownership of capital and natural resources and decision making authority over scarce resources are held by government or by private individuals. Economic systems include market capitalist, mixed, and command socialist economies. An increasing body of evidence suggests that market capitalist economies tend to be most productive; many command socialist and mixed economies are moving in the direction of market capitalist systems.
The presumption in favor of market-based systems does not preclude a role for government. Government is necessary to provide the system of laws on which market systems are founded. It may also be used to provide certain goods and services, to help individuals in need, and to regulate the actions of individuals and firms.
Concept Problems
1. How does a college education increase one’s human capital?
2. Why does the downward-sloping production possibilities curve imply that factors of production are scarce?
3. In what ways are the bowed-out shape of the production possibilities curve and the law of increasing opportunity cost related?
4. What is the relationship between the concept of comparative advantage and the law of increasing opportunity cost?
5. Suppose an economy can produce two goods, A and B. It is now operating at point E on production possibilities curve RT. An improvement in the technology available to produce good A shifts the curve to ST, and the economy selects point E′. How does this change affect the opportunity cost of producing an additional unit of good B?
Figure 2.18
1. Could a nation’s production possibilities curve ever shift inward? Explain what such a shift would mean, and discuss events that might cause such a shift to occur.
2. Suppose blue-eyed people were banned from working. How would this affect a nation’s production possibilities curve?
3. Evaluate this statement: “The U.S. economy could achieve greater growth by devoting fewer resources to consumption and more to investment; it follows that such a shift would be desirable.”
4. Two countries, Sportsland and Foodland, have similar total quantities of labor, capital, and natural resources. Both can produce two goods, figs and footballs. Sportsland’s resources are particularly well suited to the production of footballs but are not very productive in producing figs. Foodland’s resources are very productive when used for figs but are not capable of producing many footballs. In which country is the cost of additional footballs generally greater? Explain.
5. Suppose a country is committed to using its resources based on the reverse of comparative advantage doctrine: it first transfers those resources for which the cost is greatest, not lowest. Describe this country’s production possibilities curve.
6. The U.S. Constitution bans states from restricting imports of goods and services from other states. Suppose this restriction did not exist and that states were allowed to limit imports of goods and services produced in other states. How do you think this would affect U.S. output? Explain.
7. By 1993, nations in the European Union (EU) had eliminated all barriers to the flow of goods, services, labor, and capital across their borders. Even such things as consumer protection laws and the types of plugs required to plug in appliances have been standardized to ensure that there will be no barriers to trade. How do you think this elimination of trade barriers affected EU output?
8. How did the technological changes described in the Case in Point “Technology Cuts Costs, Boosts Productivity and Profits” affect the production possibilities curve for the United States?
Numerical Problems
1. Nathan can mow four lawns in a day or plant 20 trees in a day.
1. Draw Nathan’s production possibilities curve for mowing lawns and planting trees. Assume the production possibilities curve is linear and put the quantity of lawns mowed per day on the horizontal axis and the quantity of trees planted per day on the vertical axis.
2. What is Nathan’s opportunity cost of planting trees?
3. What is Nathan’s opportunity cost of mowing lawns?
2. David can mow four lawns in a day or plant four trees in a day.
1. Draw David’s production possibilities curve for mowing lawns and planting trees. Again, assume a linear production possibilities curve and put the quantity of lawns mowed per day on the horizontal axis.
2. What is David’s opportunity cost of planting trees?
3. What is David’s opportunity cost of mowing lawns?
3. Given the production information in problems 1 and 2 above, who has the comparative advantage in planting trees? Mowing lawns?
4. The exhibits below describe the production possibilities for Germany and Turkey.
Figure 2.19
Figure 2.20
1. What is the slope of Germany’s production possibilities curve?
2. What is the slope of Turkey’s production possibilities curve?
3. What is the opportunity cost of producing T-shirts in Germany?
4. What is the opportunity cost of producing T-shirts in Turkey?
5. What is the opportunity cost of producing optical instruments in Germany?
6. What is the opportunity cost of producing optical instruments in Turkey?
7. In which good does Germany have a comparative advantage?
8. In which good does Turkey have a comparative advantage? | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/02%3A_Confronting_Scarcity%3A_Choices_in_Production/2.4%3A_Review_and_Practice.txt |
Learning Objective
1. Define the quantity demanded of a good or service and illustrate it using a demand schedule and a demand curve.
2. Distinguish between the following pairs of concepts: demand and quantity demanded, demand schedule and demand curve, movement along and shift in a demand curve.
3. Identify demand shifters and determine whether a change in a demand shifter causes the demand curve to shift to the right or to the left.
How many pizzas will people eat this year? How many doctor visits will people make? How many houses will people buy?
Each good or service has its own special characteristics that determine the quantity people are willing and able to consume. One is the price of the good or service itself. Other independent variables that are important determinants of demand include consumer preferences, prices of related goods and services, income, demographic characteristics such as population size, and buyer expectations. The number of pizzas people will purchase, for example, depends very much on whether they like pizza. It also depends on the prices for alternatives such as hamburgers or spaghetti. The number of doctor visits is likely to vary with income—people with higher incomes are likely to see a doctor more often than people with lower incomes. The demands for pizza, for doctor visits, and for housing are certainly affected by the age distribution of the population and its size.
While different variables play different roles in influencing the demands for different goods and services, economists pay special attention to one: the price of the good or service. Given the values of all the other variables that affect demand, a higher price tends to reduce the quantity people demand, and a lower price tends to increase it. A medium pizza typically sells for \$5 to \$10. Suppose the price were \$30. Chances are, you would buy fewer pizzas at that price than you do now. Suppose pizzas typically sold for \$2 each. At that price, people would be likely to buy more pizzas than they do now.
We will discuss first how price affects the quantity demanded of a good or service and then how other variables affect demand.
Price and the Demand Curve
Because people will purchase different quantities of a good or service at different prices, economists must be careful when speaking of the “demand” for something. They have therefore developed some specific terms for expressing the general concept of demand.
The quantity demanded of a good or service is the quantity buyers are willing and able to buy at a particular price during a particular period, all other things unchanged. (As we learned, we can substitute the Latin phrase “ceteris paribus” for “all other things unchanged.”) Suppose, for example, that 100,000 movie tickets are sold each month in a particular town at a price of \$8 per ticket. That quantity—100,000—is the quantity of movie admissions demanded per month at a price of \$8. If the price were \$12, we would expect the quantity demanded to be less. If it were \$4, we would expect the quantity demanded to be greater. The quantity demanded at each price would be different if other things that might affect it, such as the population of the town, were to change. That is why we add the qualifier that other things have not changed to the definition of quantity demanded.
A demand schedule is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged. To introduce the concept of a demand schedule, let us consider the demand for coffee in the United States. We will ignore differences among types of coffee beans and roasts, and speak simply of coffee. The table in Figure 3.1 shows quantities of coffee that will be demanded each month at prices ranging from \$9 to \$4 per pound; the table is a demand schedule. We see that the higher the price, the lower the quantity demanded.
The information given in a demand schedule can be presented with a demand curve, which is a graphical representation of a demand schedule. A demand curve thus shows the relationship between the price and quantity demanded of a good or service during a particular period, all other things unchanged. The demand curve in Figure 3.1 shows the prices and quantities of coffee demanded that are given in the demand schedule. At point A, for example, we see that 25 million pounds of coffee per month are demanded at a price of \$6 per pound. By convention, economists graph price on the vertical axis and quantity on the horizontal axis.
Price alone does not determine the quantity of coffee or any other good that people buy. To isolate the effect of changes in price on the quantity of a good or service demanded, however, we show the quantity demanded at each price, assuming that those other variables remain unchanged. We do the same thing in drawing a graph of the relationship between any two variables; we assume that the values of other variables that may affect the variables shown in the graph (such as income or population) remain unchanged for the period under consideration.
A change in price, with no change in any of the other variables that affect demand, results in a movement along the demand curve. For example, if the price of coffee falls from \$6 to \$5 per pound, consumption rises from 25 million pounds to 30 million pounds per month. That is a movement from point A to point B along the demand curve in Figure 3.1. A movement along a demand curve that results from a change in price is called a change in quantity demanded. Note that a change in quantity demanded is not a change or shift in the demand curve; it is a movement along the demand curve.
The negative slope of the demand curve in Figure 3.1 suggests a key behavioral relationship of economics. All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price leads to a reduction in quantity demanded and a lower price leads to an increase in quantity demanded.
The law of demand is called a law because the results of countless studies are consistent with it. Undoubtedly, you have observed one manifestation of the law. When a store finds itself with an overstock of some item, such as running shoes or tomatoes, and needs to sell these items quickly, what does it do? It typically has a sale, expecting that a lower price will increase the quantity demanded. In general, we expect the law of demand to hold. Given the values of other variables that influence demand, a higher price reduces the quantity demanded. A lower price increases the quantity demanded. Demand curves, in short, slope downward.
Changes in Demand
Of course, price alone does not determine the quantity of a good or service that people consume. Coffee consumption, for example, will be affected by such variables as income and population. Preferences also play a role. The story at the beginning of the chapter illustrates as much. Starbucks “turned people on” to coffee. We also expect other prices to affect coffee consumption. People often eat doughnuts or bagels with their coffee, so a reduction in the price of doughnuts or bagels might induce people to drink more coffee. An alternative to coffee is tea, so a reduction in the price of tea might result in the consumption of more tea and less coffee. Thus, a change in any one of the variables held constant in constructing a demand schedule will change the quantities demanded at each price. The result will be a shift in the entire demand curve rather than a movement along the demand curve. A shift in a demand curve is called a change in demand.
Suppose, for example, that something happens to increase the quantity of coffee demanded at each price. Several events could produce such a change: an increase in incomes, an increase in population, or an increase in the price of tea would each be likely to increase the quantity of coffee demanded at each price. Any such change produces a new demand schedule. Figure 3.2 shows such a change in the demand schedule for coffee. We see that the quantity of coffee demanded per month is greater at each price than before. We show that graphically as a shift in the demand curve. The original curve, labeled D1, shifts to the right to D2. At a price of \$6 per pound, for example, the quantity demanded rises from 25 million pounds per month (point A) to 35 million pounds per month (point A′).
Just as demand can increase, it can decrease. In the case of coffee, demand might fall as a result of events such as a reduction in population, a reduction in the price of tea, or a change in preferences. For example, a definitive finding that the caffeine in coffee contributes to heart disease, which is currently being debated in the scientific community, could change preferences and reduce the demand for coffee.
A reduction in the demand for coffee is illustrated in Figure 3.3. The demand schedule shows that less coffee is demanded at each price than in Figure 3.1. The result is a shift in demand from the original curve D1 to D3. The quantity of coffee demanded at a price of \$6 per pound falls from 25 million pounds per month (point A) to 15 million pounds per month (point A″). Note, again, that a change in quantity demanded, ceteris paribus, refers to a movement along the demand curve, while a change in demand refers to a shift in the demand curve.
A variable that can change the quantity of a good or service demanded at each price is called a demand shifter. When these other variables change, the all-other-things-unchanged conditions behind the original demand curve no longer hold. Although different goods and services will have different demand shifters, the demand shifters are likely to include (1) consumer preferences, (2) the prices of related goods and services, (3) income, (4) demographic characteristics, and (5) buyer expectations. Next we look at each of these.
Preferences
Changes in preferences of buyers can have important consequences for demand. We have already seen how Starbucks supposedly increased the demand for coffee. Another example is reduced demand for cigarettes caused by concern about the effect of smoking on health. A change in preferences that makes one good or service more popular will shift the demand curve to the right. A change that makes it less popular will shift the demand curve to the left.
Prices of Related Goods and Services
Suppose the price of doughnuts were to fall. Many people who drink coffee enjoy dunking doughnuts in their coffee; the lower price of doughnuts might therefore increase the demand for coffee, shifting the demand curve for coffee to the right. A lower price for tea, however, would be likely to reduce coffee demand, shifting the demand curve for coffee to the left.
In general, if a reduction in the price of one good increases the demand for another, the two goods are called complements. If a reduction in the price of one good reduces the demand for another, the two goods are called substitutes. These definitions hold in reverse as well: two goods are complements if an increase in the price of one reduces the demand for the other, and they are substitutes if an increase in the price of one increases the demand for the other. Doughnuts and coffee are complements; tea and coffee are substitutes.
Complementary goods are goods used in conjunction with one another. Tennis rackets and tennis balls, eggs and bacon, and stationery and postage stamps are complementary goods. Substitute goods are goods used instead of one another. iPODs, for example, are likely to be substitutes for CD players. Breakfast cereal is a substitute for eggs. A file attachment to an e-mail is a substitute for both a fax machine and postage stamps.
Figure 3.4
Income
As incomes rise, people increase their consumption of many goods and services, and as incomes fall, their consumption of these goods and services falls. For example, an increase in income is likely to raise the demand for gasoline, ski trips, new cars, and jewelry. There are, however, goods and services for which consumption falls as income rises—and rises as income falls. As incomes rise, for example, people tend to consume more fresh fruit but less canned fruit.
A good for which demand increases when income increases is called a normal good. A good for which demand decreases when income increases is called an inferior good. An increase in income shifts the demand curve for fresh fruit (a normal good) to the right; it shifts the demand curve for canned fruit (an inferior good) to the left.
Demographic Characteristics
The number of buyers affects the total quantity of a good or service that will be bought; in general, the greater the population, the greater the demand. Other demographic characteristics can affect demand as well. As the share of the population over age 65 increases, the demand for medical services, ocean cruises, and motor homes increases. The birth rate in the United States fell sharply between 1955 and 1975 but has gradually increased since then. That increase has raised the demand for such things as infant supplies, elementary school teachers, soccer coaches, in-line skates, and college education. Demand can thus shift as a result of changes in both the number and characteristics of buyers.
Buyer Expectations
The consumption of goods that can be easily stored, or whose consumption can be postponed, is strongly affected by buyer expectations. The expectation of newer TV technologies, such as high-definition TV, could slow down sales of regular TVs. If people expect gasoline prices to rise tomorrow, they will fill up their tanks today to try to beat the price increase. The same will be true for goods such as automobiles and washing machines: an expectation of higher prices in the future will lead to more purchases today. If the price of a good is expected to fall, however, people are likely to reduce their purchases today and await tomorrow’s lower prices. The expectation that computer prices will fall, for example, can reduce current demand.
Heads Up!
Figure 3.5
It is crucial to distinguish between a change in quantity demanded, which is a movement along the demand curve caused by a change in price, and a change in demand, which implies a shift of the demand curve itself. A change in demand is caused by a change in a demand shifter. An increase in demand is a shift of the demand curve to the right. A decrease in demand is a shift in the demand curve to the left. This drawing of a demand curve highlights the difference.
Key Takeaways
• The quantity demanded of a good or service is the quantity buyers are willing and able to buy at a particular price during a particular period, all other things unchanged.
• A demand schedule is a table that shows the quantities of a good or service demanded at different prices during a particular period, all other things unchanged.
• A demand curve shows graphically the quantities of a good or service demanded at different prices during a particular period, all other things unchanged.
• All other things unchanged, the law of demand holds that, for virtually all goods and services, a higher price induces a reduction in quantity demanded and a lower price induces an increase in quantity demanded.
• A change in the price of a good or service causes a change in the quantity demanded—a movement along the demand curve.
• A change in a demand shifter causes a change in demand, which is shown as a shift of the demand curve. Demand shifters include preferences, the prices of related goods and services, income, demographic characteristics, and buyer expectations.
• Two goods are substitutes if an increase in the price of one causes an increase in the demand for the other. Two goods are complements if an increase in the price of one causes a decrease in the demand for the other.
• A good is a normal good if an increase in income causes an increase in demand. A good is an inferior good if an increase in income causes a decrease in demand.
Try It!
All other things unchanged, what happens to the demand curve for DVD rentals if there is (a) an increase in the price of movie theater tickets, (b) a decrease in family income, or (c) an increase in the price of DVD rentals? In answering this and other “Try It!” problems in this chapter, draw and carefully label a set of axes. On the horizontal axis of your graph, show the quantity of DVD rentals. It is necessary to specify the time period to which your quantity pertains (e.g., “per period,” “per week,” or “per year”). On the vertical axis show the price per DVD rental. Since you do not have specific data on prices and quantities demanded, make a “free-hand” drawing of the curve or curves you are asked to examine. Focus on the general shape and position of the curve(s) before and after events occur. Draw new curve(s) to show what happens in each of the circumstances given. The curves could shift to the left or to the right, or stay where they are.
Case in Point: Solving Campus Parking Problems Without Adding More Parking Spaces
Figure 3.6
Unless you attend a “virtual” campus, chances are you have engaged in more than one conversation about how hard it is to find a place to park on campus. Indeed, according to Clark Kerr, a former president of the University of California system, a university is best understood as a group of people “held together by a common grievance over parking.”
Clearly, the demand for campus parking spaces has grown substantially over the past few decades. In surveys conducted by Daniel Kenney, Ricardo Dumont, and Ginger Kenney, who work for the campus design company Sasaki and Associates, it was found that 7 out of 10 students own their own cars. They have interviewed “many students who confessed to driving from their dormitories to classes that were a five-minute walk away,” and they argue that the deterioration of college environments is largely attributable to the increased use of cars on campus and that colleges could better service their missions by not adding more parking spaces.
Since few universities charge enough for parking to even cover the cost of building and maintaining parking lots, the rest is paid for by all students as part of tuition. Their research shows that “for every 1,000 parking spaces, the median institution loses almost \$400,000 a year for surface parking, and more than \$1,200,000 for structural parking.” Fear of a backlash from students and their parents, as well as from faculty and staff, seems to explain why campus administrators do not simply raise the price of parking on campus.
While Kenney and his colleagues do advocate raising parking fees, if not all at once then over time, they also suggest some subtler, and perhaps politically more palatable, measures—in particular, shifting the demand for parking spaces to the left by lowering the prices of substitutes.
Two examples they noted were at the University of Washington and the University of Colorado at Boulder. At the University of Washington, car poolers may park for free. This innovation has reduced purchases of single-occupancy parking permits by 32% over a decade. According to University of Washington assistant director of transportation services Peter Dewey, “Without vigorously managing our parking and providing commuter alternatives, the university would have been faced with adding approximately 3,600 parking spaces, at a cost of over \$100 million…The university has created opportunities to make capital investments in buildings supporting education instead of structures for cars.” At the University of Colorado, free public transit has increased use of buses and light rail from 300,000 to 2 million trips per year over the last decade. The increased use of mass transit has allowed the university to avoid constructing nearly 2,000 parking spaces, which has saved about \$3.6 million annually.
Answer to Try It! Problem
Since going to the movies is a substitute for watching a DVD at home, an increase in the price of going to the movies should cause more people to switch from going to the movies to staying at home and renting DVDs. Thus, the demand curve for DVD rentals will shift to the right when the price of movie theater tickets increases [Panel (a)].
A decrease in family income will cause the demand curve to shift to the left if DVD rentals are a normal good but to the right if DVD rentals are an inferior good. The latter may be the case for some families, since staying at home and watching DVDs is a cheaper form of entertainment than taking the family to the movies. For most others, however, DVD rentals are probably a normal good [Panel (b)].
An increase in the price of DVD rentals does not shift the demand curve for DVD rentals at all; rather, an increase in price, say from P1 to P2, is a movement upward to the left along the demand curve. At a higher price, people will rent fewer DVDs, say Q2 instead of Q1, ceteris paribus [Panel (c)].
Figure 3.7 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/03%3A_Demand_and_Supply/3.1%3A_Demand.txt |
Learning Objective
1. Define the quantity supplied of a good or service and illustrate it using a supply schedule and a supply curve.
2. Distinguish between the following pairs of concepts: supply and quantity supplied, supply schedule and supply curve, movement along and shift in a supply curve.
3. Identify supply shifters and determine whether a change in a supply shifter causes the supply curve to shift to the right or to the left.
What determines the quantity of a good or service sellers are willing to offer for sale? Price is one factor; ceteris paribus, a higher price is likely to induce sellers to offer a greater quantity of a good or service. Production cost is another determinant of supply. Variables that affect production cost include the prices of factors used to produce the good or service, returns from alternative activities, technology, the expectations of sellers, and natural events such as weather changes. Still another factor affecting the quantity of a good that will be offered for sale is the number of sellers—the greater the number of sellers of a particular good or service, the greater will be the quantity offered at any price per time period.
Price and the Supply Curve
The quantity supplied of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged. Ceteris paribus, the receipt of a higher price increases profits and induces sellers to increase the quantity they supply.
In general, when there are many sellers of a good, an increase in price results in an increase in quantity supplied, and this relationship is often referred to as the law of supply. We will see, though, through our exploration of microeconomics, that there are a number of exceptions to this relationship. There are cases in which a higher price will not induce an increase in quantity supplied. Goods that cannot be produced, such as additional land on the corner of Park Avenue and 56th Street in Manhattan, are fixed in supply—a higher price cannot induce an increase in the quantity supplied. There are even cases, which we investigate in microeconomic analysis, in which a higher price induces a reduction in the quantity supplied.
Generally speaking, however, when there are many sellers of a good, an increase in price results in a greater quantity supplied. The relationship between price and quantity supplied is suggested in a supply schedule, a table that shows quantities supplied at different prices during a particular period, all other things unchanged. Figure 3.8 gives a supply schedule for the quantities of coffee that will be supplied per month at various prices, ceteris paribus. At a price of \$4 per pound, for example, producers are willing to supply 15 million pounds of coffee per month. A higher price, say \$6 per pound, induces sellers to supply a greater quantity—25 million pounds of coffee per month.
A supply curve is a graphical representation of a supply schedule. It shows the relationship between price and quantity supplied during a particular period, all other things unchanged. Because the relationship between price and quantity supplied is generally positive, supply curves are generally upward sloping. The supply curve for coffee in Figure 3.8 shows graphically the values given in the supply schedule.
A change in price causes a movement along the supply curve; such a movement is called a change in quantity supplied. As is the case with a change in quantity demanded, a change in quantity supplied does not shift the supply curve. By definition, it is a movement along the supply curve. For example, if the price rises from \$6 per pound to \$7 per pound, the quantity supplied rises from 25 million pounds per month to 30 million pounds per month. That’s a movement from point A to point B along the supply curve in Figure 3.8.
Changes in Supply
When we draw a supply curve, we assume that other variables that affect the willingness of sellers to supply a good or service are unchanged. It follows that a change in any of those variables will cause a change in supply, which is a shift in the supply curve. A change that increases the quantity of a good or service supplied at each price shifts the supply curve to the right. Suppose, for example, that the price of fertilizer falls. That will reduce the cost of producing coffee and thus increase the quantity of coffee producers will offer for sale at each price. The supply schedule in Figure 3.9 shows an increase in the quantity of coffee supplied at each price. We show that increase graphically as a shift in the supply curve from S1 to S2. We see that the quantity supplied at each price increases by 10 million pounds of coffee per month. At point A on the original supply curve S1, for example, 25 million pounds of coffee per month are supplied at a price of \$6 per pound. After the increase in supply, 35 million pounds per month are supplied at the same price (point A′ on curve S2).
An event that reduces the quantity supplied at each price shifts the supply curve to the left. An increase in production costs and excessive rain that reduces the yields from coffee plants are examples of events that might reduce supply. Figure 3.10 shows a reduction in the supply of coffee. We see in the supply schedule that the quantity of coffee supplied falls by 10 million pounds of coffee per month at each price. The supply curve thus shifts from S1 to S3.
A variable that can change the quantity of a good or service supplied at each price is called a supply shifter. Supply shifters include (1) prices of factors of production, (2) returns from alternative activities, (3) technology, (4) seller expectations, (5) natural events, and (6) the number of sellers. When these other variables change, the all-other-things-unchanged conditions behind the original supply curve no longer hold. Let us look at each of the supply shifters.
Prices of Factors of Production
A change in the price of labor or some other factor of production will change the cost of producing any given quantity of the good or service. This change in the cost of production will change the quantity that suppliers are willing to offer at any price. An increase in factor prices should decrease the quantity suppliers will offer at any price, shifting the supply curve to the left. A reduction in factor prices increases the quantity suppliers will offer at any price, shifting the supply curve to the right.
Suppose coffee growers must pay a higher wage to the workers they hire to harvest coffee or must pay more for fertilizer. Such increases in production cost will cause them to produce a smaller quantity at each price, shifting the supply curve for coffee to the left. A reduction in any of these costs increases supply, shifting the supply curve to the right.
Returns from Alternative Activities
To produce one good or service means forgoing the production of another. The concept of opportunity cost in economics suggests that the value of the activity forgone is the opportunity cost of the activity chosen; this cost should affect supply. For example, one opportunity cost of producing eggs is not selling chickens. An increase in the price people are willing to pay for fresh chicken would make it more profitable to sell chickens and would thus increase the opportunity cost of producing eggs. It would shift the supply curve for eggs to the left, reflecting a decrease in supply.
Technology
A change in technology alters the combinations of inputs or the types of inputs required in the production process. An improvement in technology usually means that fewer and/or less costly inputs are needed. If the cost of production is lower, the profits available at a given price will increase, and producers will produce more. With more produced at every price, the supply curve will shift to the right, meaning an increase in supply.
Impressive technological changes have occurred in the computer industry in recent years. Computers are much smaller and are far more powerful than they were only a few years ago—and they are much cheaper to produce. The result has been a huge increase in the supply of computers, shifting the supply curve to the right.
While we usually think of technology as enhancing production, declines in production due to problems in technology are also possible. Outlawing the use of certain equipment without pollution-control devices has increased the cost of production for many goods and services, thereby reducing profits available at any price and shifting these supply curves to the left.
Seller Expectations
All supply curves are based in part on seller expectations about future market conditions. Many decisions about production and selling are typically made long before a product is ready for sale. Those decisions necessarily depend on expectations. Changes in seller expectations can have important effects on price and quantity.
Consider, for example, the owners of oil deposits. Oil pumped out of the ground and used today will be unavailable in the future. If a change in the international political climate leads many owners to expect that oil prices will rise in the future, they may decide to leave their oil in the ground, planning to sell it later when the price is higher. Thus, there will be a decrease in supply; the supply curve for oil will shift to the left.
Natural Events
Storms, insect infestations, and drought affect agricultural production and thus the supply of agricultural goods. If something destroys a substantial part of an agricultural crop, the supply curve will shift to the left. The terrible cyclone that killed more than 50,000 people in Myanmar in 2008 also destroyed some of the country’s prime rice growing land. That shifted the supply curve for rice to the left. If there is an unusually good harvest, the supply curve will shift to the right.
The Number of Sellers
The supply curve for an industry, such as coffee, includes all the sellers in the industry. A change in the number of sellers in an industry changes the quantity available at each price and thus changes supply. An increase in the number of sellers supplying a good or service shifts the supply curve to the right; a reduction in the number of sellers shifts the supply curve to the left.
The market for cellular phone service has been affected by an increase in the number of firms offering the service. Over the past decade, new cellular phone companies emerged, shifting the supply curve for cellular phone service to the right.
Heads Up!
There are two special things to note about supply curves. The first is similar to the Heads Up! on demand curves: it is important to distinguish carefully between changes in supply and changes in quantity supplied. A change in supply results from a change in a supply shifter and implies a shift of the supply curve to the right or left. A change in price produces a change in quantity supplied and induces a movement along the supply curve. A change in price does not shift the supply curve.
The second caution relates to the interpretation of increases and decreases in supply. Notice that in Figure 3.9 an increase in supply is shown as a shift of the supply curve to the right; the curve shifts in the direction of increasing quantity with respect to the horizontal axis. In Figure 3.10 a reduction in supply is shown as a shift of the supply curve to the left; the curve shifts in the direction of decreasing quantity with respect to the horizontal axis.
Because the supply curve is upward sloping, a shift to the right produces a new curve that in a sense lies “below” the original curve. Students sometimes make the mistake of thinking of such a shift as a shift “down” and therefore as a reduction in supply. Similarly, it is easy to make the mistake of showing an increase in supply with a new curve that lies “above” the original curve. But that is a reduction in supply!
To avoid such errors, focus on the fact that an increase in supply is an increase in the quantity supplied at each price and shifts the supply curve in the direction of increased quantity on the horizontal axis. Similarly, a reduction in supply is a reduction in the quantity supplied at each price and shifts the supply curve in the direction of a lower quantity on the horizontal axis.
Figure 3.11
Key Takeaways
• The quantity supplied of a good or service is the quantity sellers are willing to sell at a particular price during a particular period, all other things unchanged.
• A supply schedule shows the quantities supplied at different prices during a particular period, all other things unchanged. A supply curve shows this same information graphically.
• A change in the price of a good or service causes a change in the quantity supplied—a movement along the supply curve.
• A change in a supply shifter causes a change in supply, which is shown as a shift of the supply curve. Supply shifters include prices of factors of production, returns from alternative activities, technology, seller expectations, natural events, and the number of sellers.
• An increase in supply is shown as a shift to the right of a supply curve; a decrease in supply is shown as a shift to the left.
Try It!
If all other things are unchanged, what happens to the supply curve for DVD rentals if there is (a) an increase in wages paid to DVD rental store clerks, (b) an increase in the price of DVD rentals, or (c) an increase in the number of DVD rental stores? Draw a graph that shows what happens to the supply curve in each circumstance. The supply curve can shift to the left or to the right, or stay where it is. Remember to label the axes and curves, and remember to specify the time period (e.g., “DVDs rented per week”).
Case in Point: The Monks of St. Benedict’s Get Out of the Egg Business
Figure 3.12
It was cookies that lured the monks of St. Benedict’s out of the egg business, and now private retreat sponsorship is luring them away from cookies.
St. Benedict’s is a Benedictine monastery, nestled on a ranch high in the Colorado Rockies, about 20 miles down the road from Aspen. The monastery’s 15 monks operate the ranch to support themselves and to provide help for poor people in the area. They lease out about 3,500 acres of their land to cattle and sheep grazers, produce cookies, and sponsor private retreats. They used to produce eggs.
Attracted by potential profits and the peaceful nature of the work, the monks went into the egg business in 1967. They had 10,000 chickens producing their Monastery Eggs brand. For a while, business was good. Very good. Then, in the late 1970s, the price of chicken feed started to rise rapidly.
“When we started in the business, we were paying \$60 to \$80 a ton for feed—delivered,” recalls the monastery’s abbot, Father Joseph Boyle. “By the late 1970s, our cost had more than doubled. We were paying \$160 to \$200 a ton. That really hurt, because feed represents a large part of the cost of producing eggs.”
The monks adjusted to the blow. “When grain prices were lower, we’d pull a hen off for a few weeks to molt, then return her to laying. After grain prices went up, it was 12 months of laying and into the soup pot,” Father Joseph says.
Grain prices continued to rise in the 1980s and increased the costs of production for all egg producers. It caused the supply of eggs to fall. Demand fell at the same time, as Americans worried about the cholesterol in eggs. Times got tougher in the egg business.
“We were still making money in the financial sense,” Father Joseph says. “But we tried an experiment in 1985 producing cookies, and it was a success. We finally decided that devoting our time and energy to the cookies would pay off better than the egg business, so we quit the egg business in 1986.”
The mail-order cookie business was good to the monks. They sold 200,000 ounces of Monastery Cookies in 1987.
By 1998, however, they had limited their production of cookies, selling only locally and to gift shops. Since 2000, they have switched to “providing private retreats for individuals and groups—about 40 people per month,” according to Brother Charles.
The monks’ calculation of their opportunity costs revealed that they would earn a higher return through sponsorship of private retreats than in either cookies or eggs. This projection has proved correct.
And there is another advantage as well.
“The chickens didn’t stop laying eggs on Sunday,” Father Joseph chuckles. “When we shifted to cookies we could take Sundays off. We weren’t hemmed in the way we were with the chickens.” The move to providing retreats is even better in this regard. Since guests provide their own meals, most of the monastery’s effort goes into planning and scheduling, which frees up even more of their time for other worldly as well as spiritual pursuits.
Answer to Try It! Problem
DVD rental store clerks are a factor of production in the DVD rental market. An increase in their wages raises the cost of production, thereby causing the supply curve of DVD rentals to shift to the left [Panel (a)]. (Caution: It is possible that you thought of the wage increase as an increase in income, a demand shifter, that would lead to an increase in demand, but this would be incorrect. The question refers only to wages of DVD rental store clerks. They may rent some DVD, but their impact on total demand would be negligible. Besides, we have no information on what has happened overall to incomes of people who rent DVDs. We do know, however, that the cost of a factor of production, which is a supply shifter, increased.)
An increase in the price of DVD rentals does not shift the supply curve at all; rather, it corresponds to a movement upward to the right along the supply curve. At a higher price of P2 instead of P1, a greater quantity of DVD rentals, say Q2 instead of Q1, will be supplied [Panel (b)].
An increase in the number of stores renting DVDs will cause the supply curve to shift to the right [Panel (c)].
Figure 3.13 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/03%3A_Demand_and_Supply/3.2%3A_Supply.txt |
Learning Objective
1. Use demand and supply to explain how equilibrium price and quantity are determined in a market.
2. Understand the concepts of surpluses and shortages and the pressures on price they generate.
3. Explain the impact of a change in demand or supply on equilibrium price and quantity.
4. Explain how the circular flow model provides an overview of demand and supply in product and factor markets and how the model suggests ways in which these markets are linked.
In this section we combine the demand and supply curves we have just studied into a new model. The model of demand and supply uses demand and supply curves to explain the determination of price and quantity in a market.
The Determination of Price and Quantity
The logic of the model of demand and supply is simple. The demand curve shows the quantities of a particular good or service that buyers will be willing and able to purchase at each price during a specified period. The supply curve shows the quantities that sellers will offer for sale at each price during that same period. By putting the two curves together, we should be able to find a price at which the quantity buyers are willing and able to purchase equals the quantity sellers will offer for sale.
Figure 3.14 combines the demand and supply data introduced in Figure 3.1 and Figure 3.8 Notice that the two curves intersect at a price of \$6 per pound—at this price the quantities demanded and supplied are equal. Buyers want to purchase, and sellers are willing to offer for sale, 25 million pounds of coffee per month. The market for coffee is in equilibrium. Unless the demand or supply curve shifts, there will be no tendency for price to change. The equilibrium price in any market is the price at which quantity demanded equals quantity supplied. The equilibrium price in the market for coffee is thus \$6 per pound. The equilibrium quantity is the quantity demanded and supplied at the equilibrium price.
With an upward-sloping supply curve and a downward-sloping demand curve, there is only a single price at which the two curves intersect. This means there is only one price at which equilibrium is achieved. It follows that at any price other than the equilibrium price, the market will not be in equilibrium. We next examine what happens at prices other than the equilibrium price.
Surpluses
Figure 3.15 shows the same demand and supply curves we have just examined, but this time the initial price is \$8 per pound of coffee. Because we no longer have a balance between quantity demanded and quantity supplied, this price is not the equilibrium price. At a price of \$8, we read over to the demand curve to determine the quantity of coffee consumers will be willing to buy—15 million pounds per month. The supply curve tells us what sellers will offer for sale—35 million pounds per month. The difference, 20 million pounds of coffee per month, is called a surplus. More generally, a surplus is the amount by which the quantity supplied exceeds the quantity demanded at the current price. There is, of course, no surplus at the equilibrium price; a surplus occurs only if the current price exceeds the equilibrium price.
A surplus in the market for coffee will not last long. With unsold coffee on the market, sellers will begin to reduce their prices to clear out unsold coffee. As the price of coffee begins to fall, the quantity of coffee supplied begins to decline. At the same time, the quantity of coffee demanded begins to rise. Remember that the reduction in quantity supplied is a movement along the supply curve—the curve itself does not shift in response to a reduction in price. Similarly, the increase in quantity demanded is a movement along the demand curve—the demand curve does not shift in response to a reduction in price. Price will continue to fall until it reaches its equilibrium level, at which the demand and supply curves intersect. At that point, there will be no tendency for price to fall further. In general, surpluses in the marketplace are short-lived. The prices of most goods and services adjust quickly, eliminating the surplus. Later on, we will discuss some markets in which adjustment of price to equilibrium may occur only very slowly or not at all.
Shortages
Just as a price above the equilibrium price will cause a surplus, a price below equilibrium will cause a shortage. A shortage is the amount by which the quantity demanded exceeds the quantity supplied at the current price.
Figure 3.16 shows a shortage in the market for coffee. Suppose the price is \$4 per pound. At that price, 15 million pounds of coffee would be supplied per month, and 35 million pounds would be demanded per month. When more coffee is demanded than supplied, there is a shortage.
In the face of a shortage, sellers are likely to begin to raise their prices. As the price rises, there will be an increase in the quantity supplied (but not a change in supply) and a reduction in the quantity demanded (but not a change in demand) until the equilibrium price is achieved.
Shifts in Demand and Supply
A change in one of the variables (shifters) held constant in any model of demand and supply will create a change in demand or supply. A shift in a demand or supply curve changes the equilibrium price and equilibrium quantity for a good or service. Figure 3.17 combines the information about changes in the demand and supply of coffee presented in Figure 3.2Figure 3.3Figure 3.9 and Figure 3.10 In each case, the original equilibrium price is \$6 per pound, and the corresponding equilibrium quantity is 25 million pounds of coffee per month. Figure 3.17 shows what happens with an increase in demand, a reduction in demand, an increase in supply, and a reduction in supply. We then look at what happens if both curves shift simultaneously. Each of these possibilities is discussed in turn below.
An Increase in Demand
An increase in demand for coffee shifts the demand curve to the right, as shown in Panel (a) of Figure 3.17. The equilibrium price rises to \$7 per pound. As the price rises to the new equilibrium level, the quantity supplied increases to 30 million pounds of coffee per month. Notice that the supply curve does not shift; rather, there is a movement along the supply curve.
Demand shifters that could cause an increase in demand include a shift in preferences that leads to greater coffee consumption; a lower price for a complement to coffee, such as doughnuts; a higher price for a substitute for coffee, such as tea; an increase in income; and an increase in population. A change in buyer expectations, perhaps due to predictions of bad weather lowering expected yields on coffee plants and increasing future coffee prices, could also increase current demand.
A Decrease in Demand
Panel (b) of Figure 3.17 shows that a decrease in demand shifts the demand curve to the left. The equilibrium price falls to \$5 per pound. As the price falls to the new equilibrium level, the quantity supplied decreases to 20 million pounds of coffee per month.
Demand shifters that could reduce the demand for coffee include a shift in preferences that makes people want to consume less coffee; an increase in the price of a complement, such as doughnuts; a reduction in the price of a substitute, such as tea; a reduction in income; a reduction in population; and a change in buyer expectations that leads people to expect lower prices for coffee in the future.
An Increase in Supply
An increase in the supply of coffee shifts the supply curve to the right, as shown in Panel (c) of Figure 3.17. The equilibrium price falls to \$5 per pound. As the price falls to the new equilibrium level, the quantity of coffee demanded increases to 30 million pounds of coffee per month. Notice that the demand curve does not shift; rather, there is movement along the demand curve.
Possible supply shifters that could increase supply include a reduction in the price of an input such as labor, a decline in the returns available from alternative uses of the inputs that produce coffee, an improvement in the technology of coffee production, good weather, and an increase in the number of coffee-producing firms.
A Decrease in Supply
Panel (d) of Figure 3.17 shows that a decrease in supply shifts the supply curve to the left. The equilibrium price rises to \$7 per pound. As the price rises to the new equilibrium level, the quantity demanded decreases to 20 million pounds of coffee per month.
Possible supply shifters that could reduce supply include an increase in the prices of inputs used in the production of coffee, an increase in the returns available from alternative uses of these inputs, a decline in production because of problems in technology (perhaps caused by a restriction on pesticides used to protect coffee beans), a reduction in the number of coffee-producing firms, or a natural event, such as excessive rain.
Heads Up!
Figure 3.18
You are likely to be given problems in which you will have to shift a demand or supply curve.
Suppose you are told that an invasion of pod-crunching insects has gobbled up half the crop of fresh peas, and you are asked to use demand and supply analysis to predict what will happen to the price and quantity of peas demanded and supplied. Here are some suggestions.
Put the quantity of the good you are asked to analyze on the horizontal axis and its price on the vertical axis. Draw a downward-sloping line for demand and an upward-sloping line for supply. The initial equilibrium price is determined by the intersection of the two curves. Label the equilibrium solution. You may find it helpful to use a number for the equilibrium price instead of the letter “P.” Pick a price that seems plausible, say, 79¢ per pound. Do not worry about the precise positions of the demand and supply curves; you cannot be expected to know what they are.
Step 2 can be the most difficult step; the problem is to decide which curve to shift. The key is to remember the difference between a change in demand or supply and a change in quantity demanded or supplied. At each price, ask yourself whether the given event would change the quantity demanded. Would the fact that a bug has attacked the pea crop change the quantity demanded at a price of, say, 79¢ per pound? Clearly not; none of the demand shifters have changed. The event would, however, reduce the quantity supplied at this price, and the supply curve would shift to the left. There is a change in supply and a reduction in the quantity demanded. There is no change in demand.
Next check to see whether the result you have obtained makes sense. The graph in Step 2 makes sense; it shows price rising and quantity demanded falling.
It is easy to make a mistake such as the one shown in the third figure of this Heads Up! One might, for example, reason that when fewer peas are available, fewer will be demanded, and therefore the demand curve will shift to the left. This suggests the price of peas will fall—but that does not make sense. If only half as many fresh peas were available, their price would surely rise. The error here lies in confusing a change in quantity demanded with a change in demand. Yes, buyers will end up buying fewer peas. But no, they will not demand fewer peas at each price than before; the demand curve does not shift.
Simultaneous Shifts
As we have seen, when either the demand or the supply curve shifts, the results are unambiguous; that is, we know what will happen to both equilibrium price and equilibrium quantity, so long as we know whether demand or supply increased or decreased. However, in practice, several events may occur at around the same time that cause both the demand and supply curves to shift. To figure out what happens to equilibrium price and equilibrium quantity, we must know not only in which direction the demand and supply curves have shifted but also the relative amount by which each curve shifts. Of course, the demand and supply curves could shift in the same direction or in opposite directions, depending on the specific events causing them to shift.
For example, all three panels of Figure 3.19 show a decrease in demand for coffee (caused perhaps by a decrease in the price of a substitute good, such as tea) and a simultaneous decrease in the supply of coffee (caused perhaps by bad weather). Since reductions in demand and supply, considered separately, each cause the equilibrium quantity to fall, the impact of both curves shifting simultaneously to the left means that the new equilibrium quantity of coffee is less than the old equilibrium quantity. The effect on the equilibrium price, though, is ambiguous. Whether the equilibrium price is higher, lower, or unchanged depends on the extent to which each curve shifts.
If the demand curve shifts farther to the left than does the supply curve, as shown in Panel (a) of Figure 3.19, then the equilibrium price will be lower than it was before the curves shifted. In this case the new equilibrium price falls from \$6 per pound to \$5 per pound. If the shift to the left of the supply curve is greater than that of the demand curve, the equilibrium price will be higher than it was before, as shown in Panel (b). In this case, the new equilibrium price rises to \$7 per pound. In Panel (c), since both curves shift to the left by the same amount, equilibrium price does not change; it remains \$6 per pound.
Regardless of the scenario, changes in equilibrium price and equilibrium quantity resulting from two different events need to be considered separately. If both events cause equilibrium price or quantity to move in the same direction, then clearly price or quantity can be expected to move in that direction. If one event causes price or quantity to rise while the other causes it to fall, the extent by which each curve shifts is critical to figuring out what happens. Figure 3.20 summarizes what may happen to equilibrium price and quantity when demand and supply both shift.
As demand and supply curves shift, prices adjust to maintain a balance between the quantity of a good demanded and the quantity supplied. If prices did not adjust, this balance could not be maintained.
Notice that the demand and supply curves that we have examined in this chapter have all been drawn as linear. This simplification of the real world makes the graphs a bit easier to read without sacrificing the essential point: whether the curves are linear or nonlinear, demand curves are downward sloping and supply curves are generally upward sloping. As circumstances that shift the demand curve or the supply curve change, we can analyze what will happen to price and what will happen to quantity.
An Overview of Demand and Supply: The Circular Flow Model
Implicit in the concepts of demand and supply is a constant interaction and adjustment that economists illustrate with the circular flow model. The circular flow model provides a look at how markets work and how they are related to each other. It shows flows of spending and income through the economy.
A great deal of economic activity can be thought of as a process of exchange between households and firms. Firms supply goods and services to households. Households buy these goods and services from firms. Households supply factors of production—labor, capital, and natural resources—that firms require. The payments firms make in exchange for these factors represent the incomes households earn.
The flow of goods and services, factors of production, and the payments they generate is illustrated in Figure 3.21. This circular flow model of the economy shows the interaction of households and firms as they exchange goods and services and factors of production. For simplicity, the model here shows only the private domestic economy; it omits the government and foreign sectors.
The circular flow model shows that goods and services that households demand are supplied by firms in product markets. The exchange for goods and services is shown in the top half of Figure 3.21. The bottom half of the exhibit illustrates the exchanges that take place in factor markets. factor markets are markets in which households supply factors of production—labor, capital, and natural resources—demanded by firms.
Our model is called a circular flow model because households use the income they receive from their supply of factors of production to buy goods and services from firms. Firms, in turn, use the payments they receive from households to pay for their factors of production.
The demand and supply model developed in this chapter gives us a basic tool for understanding what is happening in each of these product or factor markets and also allows us to see how these markets are interrelated. In Figure 3.21, markets for three goods and services that households want—blue jeans, haircuts, and apartments—create demands by firms for textile workers, barbers, and apartment buildings. The equilibrium of supply and demand in each market determines the price and quantity of that item. Moreover, a change in equilibrium in one market will affect equilibrium in related markets. For example, an increase in the demand for haircuts would lead to an increase in demand for barbers. Equilibrium price and quantity could rise in both markets. For some purposes, it will be adequate to simply look at a single market, whereas at other times we will want to look at what happens in related markets as well.
In either case, the model of demand and supply is one of the most widely used tools of economic analysis. That widespread use is no accident. The model yields results that are, in fact, broadly consistent with what we observe in the marketplace. Your mastery of this model will pay big dividends in your study of economics.
Key Takeaways
• The equilibrium price is the price at which the quantity demanded equals the quantity supplied. It is determined by the intersection of the demand and supply curves.
• A surplus exists if the quantity of a good or service supplied exceeds the quantity demanded at the current price; it causes downward pressure on price. A shortage exists if the quantity of a good or service demanded exceeds the quantity supplied at the current price; it causes upward pressure on price.
• An increase in demand, all other things unchanged, will cause the equilibrium price to rise; quantity supplied will increase. A decrease in demand will cause the equilibrium price to fall; quantity supplied will decrease.
• An increase in supply, all other things unchanged, will cause the equilibrium price to fall; quantity demanded will increase. A decrease in supply will cause the equilibrium price to rise; quantity demanded will decrease.
• To determine what happens to equilibrium price and equilibrium quantity when both the supply and demand curves shift, you must know in which direction each of the curves shifts and the extent to which each curve shifts.
• The circular flow model provides an overview of demand and supply in product and factor markets and suggests how these markets are linked to one another.
Try It!
What happens to the equilibrium price and the equilibrium quantity of DVD rentals if the price of movie theater tickets increases and wages paid to DVD rental store clerks increase, all other things unchanged? Be sure to show all possible scenarios, as was done in Figure 3.19. Again, you do not need actual numbers to arrive at an answer. Just focus on the general position of the curve(s) before and after events occurred.
Case in Point: Demand, Supply, and Obesity
Figure 3.22
Why are so many Americans fat? Put so crudely, the question may seem rude, but, indeed, the number of obese Americans has increased by more than 50% over the last generation, and obesity may now be the nation’s number one health problem. According to Sturm Roland in a recent RAND Corporation study, “Obesity appears to have a stronger association with the occurrence of chronic medical conditions, reduced physical health-related quality of life and increased health care and medication expenditures than smoking or problem drinking.”
Many explanations of rising obesity suggest higher demand for food. What more apt picture of our sedentary life style is there than spending the afternoon watching a ballgame on TV, while eating chips and salsa, followed by a dinner of a lavishly topped, take-out pizza? Higher income has also undoubtedly contributed to a rightward shift in the demand curve for food. Plus, any additional food intake translates into more weight increase because we spend so few calories preparing it, either directly or in the process of earning the income to buy it. A study by economists Darius Lakdawalla and Tomas Philipson suggests that about 60% of the recent growth in weight may be explained in this way—that is, demand has shifted to the right, leading to an increase in the equilibrium quantity of food consumed and, given our less strenuous life styles, even more weight gain than can be explained simply by the increased amount we are eating.
What accounts for the remaining 40% of the weight gain? Lakdawalla and Philipson further reason that a rightward shift in demand would by itself lead to an increase in the quantity of food as well as an increase in the price of food. The problem they have with this explanation is that over the post-World War II period, the relative price of food has declined by an average of 0.2 percentage points per year. They explain the fall in the price of food by arguing that agricultural innovation has led to a substantial rightward shift in the supply curve of food. As shown, lower food prices and a higher equilibrium quantity of food have resulted from simultaneous rightward shifts in demand and supply and that the rightward shift in the supply of food from S1 to S2 has been substantially larger than the rightward shift in the demand curve from D1 to D2.
Figure 3.23
Answer to Try It! Problem
An increase in the price of movie theater tickets (a substitute for DVD rentals) will cause the demand curve for DVD rentals to shift to the right. An increase in the wages paid to DVD rental store clerks (an increase in the cost of a factor of production) shifts the supply curve to the left. Each event taken separately causes equilibrium price to rise. Whether equilibrium quantity will be higher or lower depends on which curve shifted more.
If the demand curve shifted more, then the equilibrium quantity of DVD rentals will rise [Panel (a)].
If the supply curve shifted more, then the equilibrium quantity of DVD rentals will fall [Panel (b)].
If the curves shifted by the same amount, then the equilibrium quantity of DVD rentals would not change [Panel (c)].
Figure 3.24 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/03%3A_Demand_and_Supply/3.3%3A_Demand_Supply_and_Equilibrium.txt |
Summary
In this chapter we have examined the model of demand and supply. We found that a demand curve shows the quantity demanded at each price, all other things unchanged. The law of demand asserts that an increase in price reduces the quantity demanded and a decrease in price increases the quantity demanded, all other things unchanged. The supply curve shows the quantity of a good or service that sellers will offer at various prices, all other things unchanged. Supply curves are generally upward sloping: an increase in price generally increases the quantity supplied, all other things unchanged.
The equilibrium price occurs where the demand and supply curves intersect. At this price, the quantity demanded equals the quantity supplied. A price higher than the equilibrium price increases the quantity supplied and reduces the quantity demanded, causing a surplus. A price lower than the equilibrium price increases the quantity demanded and reduces the quantity supplied, causing a shortage. Usually, market surpluses and shortages are short-lived. Changes in demand or supply, caused by changes in the determinants of demand and supply otherwise held constant in the analysis, change the equilibrium price and output. The circular flow model allows us to see how demand and supply in various markets are related to one another.
Concept Problems
1. What do you think happens to the demand for pizzas during the Super Bowl? Why?
2. Which of the following goods are likely to be classified as normal goods or services? Inferior? Defend your answer.
1. Beans
2. Tuxedos
3. Used cars
4. Used clothing
5. Computers
6. Books reviewed in The New York Times
7. Macaroni and cheese
8. Calculators
9. Cigarettes
10. Caviar
11. Legal services
3. Which of the following pairs of goods are likely to be classified as substitutes? Complements? Defend your answer.
1. Peanut butter and jelly
2. Eggs and ham
3. Nike brand and Reebok brand sneakers
4. IBM and Apple Macintosh brand computers
5. Dress shirts and ties
6. Airline tickets and hotels
7. Gasoline and tires
8. Beer and wine
9. Faxes and first-class mail
10. Cereal and milk
11. Cereal and eggs
4. A study found that lower airfares led some people to substitute flying for driving to their vacation destinations. This reduced the demand for car travel and led to reduced traffic fatalities, since air travel is safer per passenger mile than car travel. Using the logic suggested by that study, suggest how each of the following events would affect the number of highway fatalities in any one year.
1. An increase in the price of gasoline
2. A large reduction in rental rates for passenger vans
3. An increase in airfares
5. Children under age 2 are now allowed to fly free on U.S. airlines; they usually sit in their parents’ laps. Some safety advocates have urged that they be required to be strapped in infant seats, which would mean their parents would have to purchase tickets for them. Some economists have argued that such a measure would actually increase infant fatalities. Can you say why?
6. The graphs below show four possible shifts in demand or in supply that could occur in particular markets. Relate each of the events described below to one of them.
Figure 3.25
1. How did the heavy rains in South America in 1997 affect the market for coffee?
2. The Surgeon General decides french fries are not bad for your health after all and issues a report endorsing their use. What happens to the market for french fries?
3. How do you think rising incomes affect the market for ski vacations?
4. A new technique is discovered for manufacturing computers that greatly lowers their production cost. What happens to the market for computers?
5. How would a ban on smoking in public affect the market for cigarettes?
7. As low-carb diets increased in popularity, egg prices rose sharply. How might this affect the monks’ supply of cookies or private retreats? (See the Case in Point on the Monks of St. Benedict’s.)
8. Gasoline prices typically rise during the summer, a time of heavy tourist traffic. A “street talk” feature on a radio station sought tourist reaction to higher gasoline prices. Here was one response: “I don’t like ’em [the higher prices] much. I think the gas companies just use any excuse to jack up prices, and they’re doing it again now.” How does this tourist’s perspective differ from that of economists who use the model of demand and supply?
9. The introduction to the chapter argues that preferences for coffee changed in the 1990s and that excessive rain hurt yields from coffee plants. Show and explain the effects of these two circumstances on the coffee market.
10. With preferences for coffee remaining strong in the early part of the century, Vietnam entered the market as a major exporter of coffee. Show and explain the effects of these two circumstances on the coffee market.
11. The study on the economics of obesity discussed in the Case in Point in this chapter on that topic also noted that another factor behind rising obesity is the decline in cigarette smoking as the price of cigarettes has risen. Show and explain the effect of higher cigarette prices on the market for food. What does this finding imply about the relationship between cigarettes and food?
12. In 2004, The New York Times reported that India might be losing its outsourcing edge due to rising wages (Scheiber, N., 2004) The reporter noted that a recent report “projected that if India continued to produce college graduates at the current rate, demand would exceed supply by 20% in the main outsourcing markets by 2008.” Using the terminology you learned in this chapter, explain what he meant to say was happening in the market for Indian workers in outsourcing jobs. In particular, is demand for Indian workers increasing or decreasing? Is the supply of Indian workers increasing or decreasing? Which is shifting faster? How do you know?
13. For more than a century, milk producers have produced skim milk, which contains virtually no fat, along with regular milk, which contains 4% fat. But a century ago, skim milk accounted for only about 1% of total production, and much of it was fed to hogs. Today, skim and other reduced-fat milks make up the bulk of milk sales. What curve shifted, and what factor shifted it?
14. Suppose firms in the economy were to produce fewer goods and services. How do you think this would affect household spending on goods and services? (Hint: Use the circular flow model to analyze this question.)
Numerical Problems
Problems 1–5 are based on the graph below.
Figure 3.26
1. At a price of \$1.50 per dozen, how many bagels are demanded per month?
2. At a price of \$1.50 per dozen, how many bagels are supplied per month?
3. At a price of \$3.00 per dozen, how many bagels are demanded per month?
4. At a price of \$3.00 per dozen, how many bagels are supplied per month?
5. What is the equilibrium price of bagels? What is the equilibrium quantity per month?
Problems 6–9 are based on the model of demand and supply for coffee as shown in Figure 3.17 You can graph the initial demand and supply curves by using the following values, with all quantities in millions of pounds of coffee per month:
Price Quantity demanded Quantity supplied
\$3 40 10
4 35 15
5 30 20
6 25 25
7 20 30
8 15 35
9 10 40
1. Suppose the quantity demanded rises by 20 million pounds of coffee per month at each price. Draw the initial demand and supply curves based on the values given in the table above. Then draw the new demand curve given by this change, and show the new equilibrium price and quantity.
2. Suppose the quantity demanded falls, relative to the values given in the above table, by 20 million pounds per month at prices between \$4 and \$6 per pound; at prices between \$7 and \$9 per pound, the quantity demanded becomes zero. Draw the new demand curve and show the new equilibrium price and quantity.
3. Suppose the quantity supplied rises by 20 million pounds per month at each price, while the quantities demanded retain the values shown in the table above. Draw the new supply curve and show the new equilibrium price and quantity.
4. Suppose the quantity supplied falls, relative to the values given in the table above, by 20 million pounds per month at prices above \$5; at a price of \$5 or less per pound, the quantity supplied becomes zero. Draw the new supply curve and show the new equilibrium price and quantity.
Problems 10–15 are based on the demand and supply schedules for gasoline below (all quantities are in thousands of gallons per week):
Price per gallon Quantity demanded Quantity supplied
\$1 8 0
2 7 1
3 6 2
4 5 3
5 4 4
6 3 5
7 2 6
8 1 7
1. Graph the demand and supply curves and show the equilibrium price and quantity.
2. At a price of \$3 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Indicate the surplus or shortage on the graph.
3. At a price of \$6 per gallon, would there be a surplus or shortage of gasoline? How much would the surplus or shortage be? Show the surplus or shortage on the graph.
4. Suppose the quantity demanded increased by 2,000 gallons per month at each price. At a price of \$3 per gallon, how much would the surplus or shortage be? Graph the demand and supply curves and show the surplus or shortage.
5. Suppose the quantity supplied decreased by 2,000 gallons per month at each price for prices between \$4 and \$8 per gallon. At prices less than \$4 per gallon the quantity supplied becomes zero, while the quantities demanded retain the values shown in the table. At a price of \$4 per gallon, how much would the surplus or shortage be? Graph the demand and supply curves and show the surplus or shortage.
6. If the demand curve shifts as in problem 13 and the supply curve shifts as in problem 14, without drawing a graph or consulting the data, can you predict whether equilibrium price increases or decreases? What about equilibrium quantity? Now draw a graph that shows what the new equilibrium price and quantity are. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/03%3A_Demand_and_Supply/3.4%3A_Review_and_Practice.txt |
Learning Objective
1. Learn how to apply the model of demand and supply to explaining the behavior of equilibrium prices and quantities in a variety of markets.
2. Explain how technological change can be represented using the model of demand and supply.
3. Explain how the model of demand and supply can be used to explain changes in prices of shares of stock.
A shift in either demand or supply, or in both, leads to a change in equilibrium price and equilibrium quantity. We begin this chapter by examining markets in which prices adjust quickly to changes in demand or supply: the market for personal computers, the markets for crude oil and gasoline, and the stock market. These markets are thus direct applications of the model of demand and supply.
The Personal Computer Market
In the 1960s, to speak of computers was to speak of IBM, the dominant maker of large mainframe computers used by business and government agencies. Then between 1976, when Apple Computer introduced its first desktop computer, and 1981, when IBM produced its first personal computers (PCs), the old world was turned upside down. In 1984, just 8.2% of U.S. households owned a personal computer. By 2007, Google estimates that 78% did. The tools of demand and supply tell the story from an economic perspective.
Technological change has been breathtakingly swift in the computer industry. Because personal computers have changed so dramatically in performance and in the range of the functions they perform, we shall speak of “quality-adjusted” personal computers. The price per unit of quality-adjusted desktop computers fell by about half every 50 months during the period 1976–1989. In the first half of the 1990s, those prices fell by half every 28 months. In the second half of the 1990s, the “halving time” fell to every 24 months (Tuomi, I).
Consider another indicator of the phenomenal change in computers. Between 1993 and 1998, the Bureau of Labor Statistics estimates that central processing unit (CPU) speed rose 1,263%, system memory increased 1,500%, hard drive capacity soared by 3,700%, and monitor size went up 13%. It seems safe to say that the dizzying pace of change recorded in the 1990s has increased in this century. A “computer” today is not the same good as a “computer” even five years ago. To make them comparable, we must adjust for these changes in quality.
Initially, most personal computers were manufactured by Apple or Compaq; both companies were very profitable. The potential for profits attracted IBM and other firms to the industry. Unlike large mainframe computers, personal computer clones turned out to be fairly easy things to manufacture. As shown in Table 4.1 “Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States”, the top five personal computer manufacturers produced only 48% of the personal computers sold in the world in 2005, and the largest manufacturer, Dell, sold only about 19% of the total in that year. This is a far cry from the more than 90% of the mainframe computer market that IBM once held. The market has become far more competitive.
Table 4.1 Personal Computer Shipments, Market Percentage Shares by Vendors, World and United States
Company % of World Shipments Company % of U.S. Shipments
Dell 18.9 Dell 34
Hewlett-Packard 15.4 Hewlett-Packard 18.2
IBM 5.1 Gateway 5.7
Fujitsu Seimens 4.6 IBM 4.3
Acer 4 Apple 3.9
Others 52 Others 34
Total 100.0 Total 100.0
Figure 4.1 illustrates the changes that have occurred in the computer market. The horizontal axis shows the quantity of quality-adjusted personal computers. Thus, the quantity axis can be thought of as a unit of computing power. Similarly, the price axis shows the price per unit of computing power. The rapid increase in the number of firms, together with dramatic technological improvements, led to an increase in supply, shifting the supply curve in Figure 4.1 to the right from S1 to S2.
Demand also shifted to the right from D1 to D2, as incomes rose and new uses for computers, from e-mail and social networking to Voice over Internet Protocol (VoIP) and Radio Frequency ID (RFID) tags (which allow wireless tracking of commercial shipments via desktop computers), altered the preferences of consumer and business users. Because we observe a fall in equilibrium price and an increase in equilibrium quantity, we conclude that the rightward shift in supply has outweighed the rightward shift in demand. The power of market forces has profoundly affected the way we live and work.
The Markets for Crude Oil and for Gasoline
The market for crude oil took a radical turn in 1973. The price per barrel of crude oil quadrupled in 1973 and 1974. Price remained high until the early 1980s but then fell back drastically and remained low for about two decades. In 2004, the price of oil began to move upward and by 2008 had reached \$147 per barrel.
What caused the dramatic increase in gasoline and oil prices in 2008? It appeared to be increasing worldwide demand outpacing producers’ ability—or willingness—to increase production much. This increase in demand is illustrated in Figure 4.2.
Higher oil prices also increase the cost of producing virtually every good or service, as at a minimum, the production of most goods requires transportation. These costs inevitably translate into higher prices for nearly all goods and services. Supply curves of the goods and services thus affected shift to the left, putting downward pressure on output and upward pressure on prices.
Graphically, the impact of higher gasoline prices on businesses that use gasoline is illustrated in Figure 4.3. Because higher gasoline prices increase the cost of doing business, they shift the supply curves for nearly all businesses to the left, putting upward pressure on prices and downward pressure on output. In the case shown here, the supply curve in a typical industry shifts from S1 to S2. This increases the equilibrium price from P1 to P2 and reduces the equilibrium quantity from Q1 to Q2.
Then, as the world economy slowed dramatically in the second half of 2008, the demand curve for oil shifted back to the left. By November 2008, the price per barrel had dropped back to below \$60 per barrel. As gas prices also subsided, so did the threat of higher prices in other industries.
The Stock Market
The circular flow model suggests that capital, like other factors of production, is supplied by households to firms. Firms, in turn, pay income to those households for the use of their capital. Generally speaking, however, capital is actually owned by firms themselves. General Motors owns its assembly plants, and Wal-Mart owns its stores; these firms therefore own their capital. But firms, in turn, are owned by people—and those people, of course, live in households. It is through their ownership of firms that households own capital.
A firm may be owned by one individual (a sole proprietorship), by several individuals (a partnership), or by shareholders who own stock in the firm (a corporation). Although most firms in the United States are sole proprietorships or partnerships, the bulk of the nation’s total output (about 90%) is produced by corporations. Corporations also own most of the capital (machines, plants, buildings, and the like).
This section describes how the prices of shares of corporate stock, shares in the ownership of a corporation, are determined by the interaction of demand and supply. Ultimately, the same forces that determine the value of a firm’s stock determine the value of a sole proprietorship or partnership.
When a corporation needs funds to increase its capital or for other reasons, one means at its disposal is to issue new stock in the corporation. (Other means include borrowing funds or using past profits.) Once the new shares have been sold in what is called an initial public offering (IPO), the corporation receives no further funding as shares of its stock are bought and sold on the secondary market. The secondary market is the market for stocks that have been issued in the past, and the daily news reports about stock prices almost always refer to activity in the secondary market. Generally, the corporations whose shares are traded are not involved in these transactions.
The stock market is the set of institutions in which shares of stock are bought and sold. The New York Stock Exchange (NYSE) is one such institution. There are many others all over the world, such as the DAX in Germany and the Bolsa in Mexico. To buy or sell a share of stock, one places an order with a stockbroker who relays the order to one of the traders at the NYSE or at some other exchange.
The process through which shares of stock are bought and sold can seem chaotic. At many exchanges, traders with orders from customers who want to buy stock shout out the prices those customers are willing to pay. Traders with orders from customers who want to sell shout out offers of prices at which their customers are willing to sell. Some exchanges use electronic trading, but the principle is the same: if the price someone is willing to pay matches the price at which someone else is willing to sell, the trade is made. The most recent price at which a stock has traded is reported almost instantaneously throughout the world.
Figure 4.4 applies the model of demand and supply to the determination of stock prices. Suppose the demand curve for shares in Intel Corporation is given by D1 and the supply by S1. (Even though the total number of shares outstanding is fixed at any point in time, the supply curve is not vertical. Rather, the supply curve is upward sloping because it represents how many shares current owners are prepared to sell at each price, and that number will be greater at higher prices.) Suppose that these curves intersect at a price of \$25, at which Q1 shares are traded each day. If the price were higher, more shares would be offered for sale than would be demanded, and the price would quickly fall. If the price were lower, more shares would be demanded than would be supplied, and the price would quickly rise. In general, we can expect the prices of shares of stock to move quickly to their equilibrium levels.
The intersection of the demand and supply curves for shares of stock in a particular company determines the equilibrium price for a share of stock. But what determines the demand and supply for shares of a company’s stock?
The owner of a share of a company’s stock owns a share of the company, and, hence, a share of its profits; typically, a corporation will retain and reinvest some of its profits to increase its future profitability. The profits kept by a company are called retained earnings. Profits distributed to shareholders are called dividends. Because a share of stock gives its owner a claim on part of a company’s future profits, it follows that the expected level of future profits plays a role in determining the value of its stock.
Of course, those future profits cannot be known with certainty; investors can only predict what they might be, based on information about future demand for the company’s products, future costs of production, information about the soundness of a company’s management, and so on. Stock prices in the real world thus reflect estimates of a company’s profits projected into the future.
The downward slope of the demand curve suggests that at lower prices for the stock, more people calculate that the firm’s future earnings will justify the stock’s purchase. The upward slope of the supply curve tells us that as the price of the stock rises, more people conclude that the firm’s future earnings do not justify holding the stock and therefore offer to sell it. At the equilibrium price, the number of shares supplied by people who think holding the stock no longer makes sense just balances the number of shares demanded by people who think it does.
What factors, then, cause the demand or supply curves for shares of stocks to shift? The most important factor is a change in the expectations of a company’s future profits. Suppose Intel announces a new generation of computer chips that will lead to faster computers with larger memories. Current owners of Intel stock would adjust upward their estimates of what the value of a share of Intel stock should be. At the old equilibrium price of \$25 fewer owners of Intel stock would be willing to sell. Since this would be true at every possible share price, the supply curve for Intel stock would shift to the left, as shown in Figure 4.5. Just as the expectation that a company will be more profitable shifts the supply curve for its stock to the left, that same change in expectations will cause more people to want to purchase the stock, shifting the demand curve to the right. In Figure 4.5, we see the supply curve shifting to the left, from S1 to S2, while the demand curve shifts to the right, from D1 to D2.
Other factors may alter the price of an individual corporation’s share of stock or the level of stock prices in general. For example, demographic change and rising incomes have affected the demand for stocks in recent years. For example, with a large proportion of the U.S. population nearing retirement age and beginning to think about and plan for their lives during retirement, the demand for stocks has risen.
Information on the economy as a whole is also likely to affect stock prices. If the economy overall is doing well and people expect that to continue, they may become more optimistic about how profitable companies will be in general, and thus the prices of stocks will rise. Conversely, expectations of a sluggish economy, as happened in the fall of 2008, could cause stock prices in general to fall.
The stock market is bombarded with new information every minute of every day. Firms announce their profits of the previous quarter. They announce that they plan to move into a new product line or sell their goods in another country. We learn that the price of Company A’s good, which is a substitute for one sold by Company B, has risen. We learn that countries sign trade agreements, launch wars, or make peace. All of this information may affect stock prices because any information can affect how buyers and sellers value companies.
Key Takeaways
• Technological change, which has caused the supply curve for computing power to shift to the right, is the main reason for the rapid increase in equilibrium quantity and decrease in equilibrium price of personal computers.
• The increase in crude oil and gasoline prices in 2008 was driven primarily by increased demand for crude oil, an increase that was created by economic growth throughout the world. Crude oil and gas prices fell markedly as world economic growth subsided later in the year.
• Higher gasoline prices increased the cost of producing virtually every good and service, shifting supply curves for most goods and services to the left. This tended to push prices up and output down.
• Demand and supply determine prices of shares of corporate stock. The equilibrium price of a share of stock strikes a balance between those who think the stock is worth more and those who think it is worth less than the current price.
• If a company’s profits are expected to increase, the demand curve for its stock shifts to the right and the supply curve shifts to the left, causing equilibrium price to rise. The opposite would occur if a company’s profits were expected to decrease.
• Other factors that influence the price of corporate stock include demographic and income changes and the overall health of the economy.
Try It!
Suppose an airline announces that its earnings this year are lower than expected due to reduced ticket sales. The airline spokesperson gives no information on how the company plans to turn things around. Use the model of demand and supply to show and explain what is likely to happen to the price of the airline’s stock.
Case in Point: 9/11 and the Stock Market
Figure 4.6
The hijacking of four airplanes and the steering of them into buildings is perhaps the only disaster that has become universally known by its date: September 11, 2001—hence, 9/11. “9/11” will remain etched in our collective memory for a great many generations.
Disasters such as 9/11 represent the kind of complete surprises that dramatically affect stock prices, if only temporarily. The New York Stock Exchange was closed on the day of the attack and remained closed for six days. On the day the market opened, the Dow Jones Industrial Average (the “DOW”, a widely used gauge of stock prices) fell nearly 685 points to 8,920. It was one of the biggest one-day decline in U.S. history.
Why did the attacks on September 11, 2001, have such a dramatic short-term impact on the stock market? The attacks of 9/11 plunged the United States and much of the rest of the world into a very frightening war against terrorism. The realization that terrorists could strike anytime and in any place sapped consumer and business confidence alike and affected both the demand and supply of most stocks. The attacks on 9/11 provoked fear and uncertainty—two things that are certain to bring stock prices down, at least until other events and more information cause expectations to change again in this very responsive market.
Answer to Try It! Problem
The information given in the problem suggests that the airline’s profits are likely to fall below expectations. Current owners of the airline’s stock and potential buyers of the stock would adjust downward their estimates of what the value of the corporation’s stock should be. As a result the supply curve for the stock would increase, shifting it to the right, while the demand curve for the stock would decrease, shifting it to the left. As a result, equilibrium price of the stock falls from P1 to P2. What happens to equilibrium quantity depends on the extent to which each curve shifts. In the diagram, equilibrium quantity is shown to decrease from Q1 to Q2.
Figure 4.7 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.1%3A_Putting_Demand_and_Supply_to_Work.txt |
Learning Objective
1. Use the model of demand and supply to explain what happens when the government imposes price floors or price ceilings.
2. Discuss the reasons why governments sometimes choose to control prices and the consequences of price control policies.
So far in this chapter and in the previous chapter, we have learned that markets tend to move toward their equilibrium prices and quantities. Surpluses and shortages of goods are short-lived as prices adjust to equate quantity demanded with quantity supplied.
In some markets, however, governments have been called on by groups of citizens to intervene to keep prices of certain items higher or lower than what would result from the market finding its own equilibrium price. In this section we will examine agricultural markets and apartment rental markets—two markets that have often been subject to price controls. Through these examples, we will identify the effects of controlling prices. In each case, we will look at reasons why governments have chosen to control prices in these markets and the consequences of these policies.
Agricultural Price Floors
Governments often seek to assist farmers by setting price floors in agricultural markets. A minimum allowable price set above the equilibrium price is a price floor. With a price floor, the government forbids a price below the minimum. (Notice that, if the price floor were for whatever reason set below the equilibrium price, it would be irrelevant to the determination of the price in the market since nothing would prohibit the price from rising to equilibrium.) A price floor that is set above the equilibrium price creates a surplus.
Figure 4.8 shows the market for wheat. Suppose the government sets the price of wheat at PF. Notice that PF is above the equilibrium price of PE. At PF, we read over to the demand curve to find that the quantity of wheat that buyers will be willing and able to purchase is W1 bushels. Reading over to the supply curve, we find that sellers will offer W2 bushels of wheat at the price floor of PF. Because PF is above the equilibrium price, there is a surplus of wheat equal to (W2W1) bushels. The surplus persists because the government does not allow the price to fall.
Why have many governments around the world set price floors in agricultural markets? Farming has changed dramatically over the past two centuries. Technological improvements in the form of new equipment, fertilizers, pesticides, and new varieties of crops have led to dramatic increases in crop output per acre. Worldwide production capacity has expanded markedly. As we have learned, technological improvements cause the supply curve to shift to the right, reducing the price of food. While such price reductions have been celebrated in computer markets, farmers have successfully lobbied for government programs aimed at keeping their prices from falling.
While the supply curve for agricultural goods has shifted to the right, the demand has increased with rising population and with rising income. But as incomes rise, people spend a smaller and smaller fraction of their incomes on food. While the demand for food has increased, that increase has not been nearly as great as the increase in supply. Figure 4.9 shows that the supply curve has shifted much farther to the right, from S1 to S2, than the demand curve has, from D1 to D2. As a result, equilibrium quantity has risen dramatically, from Q1 to Q2, and equilibrium price has fallen, from P1 to P2.
On top of this long-term historical trend in agriculture, agricultural prices are subject to wide swings over shorter periods. Droughts or freezes can sharply reduce supplies of particular crops, causing sudden increases in prices. Demand for agricultural goods of one country can suddenly dry up if the government of another country imposes trade restrictions against its products, and prices can fall. Such dramatic shifts in prices and quantities make incomes of farmers unstable.
The Great Depression of the 1930s led to a major federal role in agriculture. The Depression affected the entire economy, but it hit farmers particularly hard. Prices received by farmers plunged nearly two-thirds from 1930 to 1933. Many farmers had a tough time keeping up mortgage payments. By 1932, more than half of all farm loans were in default.
Farm legislation passed during the Great Depression has been modified many times, but the federal government has continued its direct involvement in agricultural markets. This has meant a variety of government programs that guarantee a minimum price for some types of agricultural products. These programs have been accompanied by government purchases of any surplus, by requirements to restrict acreage in order to limit those surpluses, by crop or production restrictions, and the like.
To see how such policies work, look back at Figure 4.8. At PF, W2 bushels of wheat will be supplied. With that much wheat on the market, there is market pressure on the price of wheat to fall. To prevent price from falling, the government buys the surplus of (W2W1) bushels of wheat, so that only W1 bushels are actually available to private consumers for purchase on the market. The government can store the surpluses or find special uses for them. For example, surpluses generated in the United States have been shipped to developing countries as grants-in-aid or distributed to local school lunch programs. As a variation on this program, the government can require farmers who want to participate in the price support program to reduce acreage in order to limit the size of the surpluses.
After 1973, the government stopped buying the surpluses (with some exceptions) and simply guaranteed farmers a “target price.” If the average market price for a crop fell below the crop’s target price, the government paid the difference. If, for example, a crop had a market price of \$3 per unit and a target price of \$4 per unit, the government would give farmers a payment of \$1 for each unit sold. Farmers would thus receive the market price of \$3 plus a government payment of \$1 per unit. For farmers to receive these payments, they had to agree to remove acres from production and to comply with certain conservation provisions. These restrictions sought to reduce the size of the surplus generated by the target price, which acted as a kind of price floor.
What are the effects of such farm support programs? The intention is to boost and stabilize farm incomes. But, with price floors, consumers pay more for food than they would otherwise, and governments spend heavily to finance the programs. With the target price approach, consumers pay less, but government financing of the program continues. U.S. federal spending for agriculture averaged well over \$22 billion per year between 2003 and 2007, roughly \$70 per person.
Help to farmers has sometimes been justified on the grounds that it boosts incomes of “small” farmers. However, since farm aid has generally been allotted on the basis of how much farms produce rather than on a per-farm basis, most federal farm support has gone to the largest farms. If the goal is to eliminate poverty among farmers, farm aid could be redesigned to supplement the incomes of small or poor farmers rather than to undermine the functioning of agricultural markets.
In 1996, the U.S. Congress passed the Federal Agriculture Improvement and Reform Act of 1996, or FAIR. The thrust of the new legislation was to do away with the various programs of price support for most crops and hence provide incentives for farmers to respond to market price signals. To protect farmers through a transition period, the act provided for continued payments that were scheduled to decline over a seven-year period. However, with prices for many crops falling in 1998, the U.S. Congress passed an emergency aid package that increased payments to farmers. In 2008, as farm prices reached record highs, Congress passed a farm bill that increased subsidy payments to \$40 billion. It did, however, for the first time limit payments to the wealthiest farmers. Individual farmers whose farm incomes exceed \$750,000 (or \$1.5 million for couples) would be ineligible for some subsidy programs.
Rental Price Ceilings
The purpose of rent control is to make rental units cheaper for tenants than they would otherwise be. Unlike agricultural price controls, rent control in the United States has been largely a local phenomenon, although there were national rent controls in effect during World War II. Currently, about 200 cities and counties have some type of rent control provisions, and about 10% of rental units in the United States are now subject to price controls. New York City’s rent control program, which began in 1943, is among the oldest in the country. Many other cities in the United States adopted some form of rent control in the 1970s. Rent controls have been pervasive in Europe since World War I, and many large cities in poorer countries have also adopted rent controls.
Rent controls in different cities differ in terms of their flexibility. Some cities allow rent increases for specified reasons, such as to make improvements in apartments or to allow rents to keep pace with price increases elsewhere in the economy. Often, rental housing constructed after the imposition of the rent control ordinances is exempted. Apartments that are vacated may also be decontrolled. For simplicity, the model presented here assumes that apartment rents are controlled at a price that does not change.
Figure 4.10 shows the market for rental apartments. Notice that the demand and supply curves are drawn to look like all the other demand and supply curves you have encountered so far in this text: the demand curve is downward-sloping and the supply curve is upward-sloping.
The demand curve shows that a higher price (rent) reduces the quantity of apartments demanded. For example, with higher rents, more young people will choose to live at home with their parents. With lower rents, more will choose to live in apartments. Higher rents may encourage more apartment sharing; lower rents would induce more people to live alone.
The supply curve is drawn to show that as rent increases, property owners will be encouraged to offer more apartments to rent. Even though an aerial photograph of a city would show apartments to be fixed at a point in time, owners of those properties will decide how many to rent depending on the amount of rent they anticipate. Higher rents may also induce some homeowners to rent out apartment space. In addition, renting out apartments implies a certain level of service to renters, so that low rents may lead some property owners to keep some apartments vacant.
Rent control is an example of a price ceiling, a maximum allowable price. With a price ceiling, the government forbids a price above the maximum. A price ceiling that is set below the equilibrium price creates a shortage that will persist.
Suppose the government sets the price of an apartment at PC in Figure 4.10. Notice that PC is below the equilibrium price of PE. At PC, we read over to the supply curve to find that sellers are willing to offer A1 apartments. Reading over to the demand curve, we find that consumers would like to rent A2 apartments at the price ceiling of PC. Because PC is below the equilibrium price, there is a shortage of apartments equal to (A2A1). (Notice that if the price ceiling were set above the equilibrium price it would have no effect on the market since the law would not prohibit the price from settling at an equilibrium price that is lower than the price ceiling.)
If rent control creates a shortage of apartments, why do some citizens nonetheless clamor for rent control and why do governments often give in to the demands? The reason generally given for rent control is to keep apartments affordable for low- and middle-income tenants.
But the reduced quantity of apartments supplied must be rationed in some way, since, at the price ceiling, the quantity demanded would exceed the quantity supplied. Current occupants may be reluctant to leave their dwellings because finding other apartments will be difficult. As apartments do become available, there will be a line of potential renters waiting to fill them, any of whom is willing to pay the controlled price of PC or more. In fact, reading up to the demand curve in Figure 4.11 from A1 apartments, the quantity available at PC, you can see that for A1 apartments, there are potential renters willing and able to pay PB. This often leads to various “backdoor” payments to apartment owners, such as large security deposits, payments for things renters may not want (such as furniture), so-called “key” payments (“The monthly rent is \$500 and the key price is \$3,000”), or simple bribes.
In the end, rent controls and other price ceilings often end up hurting some of the people they are intended to help. Many people will have trouble finding apartments to rent. Ironically, some of those who do find apartments may actually end up paying more than they would have paid in the absence of rent control. And many of the people that the rent controls do help (primarily current occupants, regardless of their income, and those lucky enough to find apartments) are not those they are intended to help (the poor). There are also costs in government administration and enforcement.
Because New York City has the longest history of rent controls of any city in the United States, its program has been widely studied. There is general agreement that the rent control program has reduced tenant mobility, led to a substantial gap between rents on controlled and uncontrolled units, and favored long-term residents at the expense of newcomers to the city (Arnott, R., 1995). These distortions have grown over time, another frequent consequence of price controls.
A more direct means of helping poor tenants, one that would avoid interfering with the functioning of the market, would be to subsidize their incomes. As with price floors, interfering with the market mechanism may solve one problem, but it creates many others at the same time.
Key Takeaways
• Price floors create surpluses by fixing the price above the equilibrium price. At the price set by the floor, the quantity supplied exceeds the quantity demanded.
• In agriculture, price floors have created persistent surpluses of a wide range of agricultural commodities. Governments typically purchase the amount of the surplus or impose production restrictions in an attempt to reduce the surplus.
• Price ceilings create shortages by setting the price below the equilibrium. At the ceiling price, the quantity demanded exceeds the quantity supplied.
• Rent controls are an example of a price ceiling, and thus they create shortages of rental housing.
• It is sometimes the case that rent controls create “backdoor” arrangements, ranging from requirements that tenants rent items that they do not want to outright bribes, that result in rents higher than would exist in the absence of the ceiling.
Try It!
A minimum wage law is another example of a price floor. Draw demand and supply curves for unskilled labor. The horizontal axis will show the quantity of unskilled labor per period and the vertical axis will show the hourly wage rate for unskilled workers, which is the price of unskilled labor. Show and explain the effect of a minimum wage that is above the equilibrium wage.
Case in Point: Corn: It Is Not Just Food Any More
Figure 4.12
Government support for corn dates back to the Agricultural Act of 1938 and, in one form or another, has been part of agricultural legislation ever since. Types of supports have ranged from government purchases of surpluses to target pricing, land set asides, and loan guarantees. According to one estimate, the U.S. government spent nearly \$42 billion to support corn between 1995 and 2004.
Then, during the period of rising oil prices of the late 1970s and mounting concerns about dependence on foreign oil from volatile regions in the world, support for corn, not as a food, but rather as an input into the production of ethanol—an alternative to oil-based fuel—began. Ethanol tax credits were part of the Energy Act of 1978. Since 1980, a tariff of 50¢ per gallon against imported ethanol, even higher today, has served to protect domestic corn-based ethanol from imported ethanol, in particular from sugar-cane-based ethanol from Brazil.
The Energy Policy Act of 2005 was another milestone in ethanol legislation. Through loan guarantees, support for research and development, and tax credits, it mandated that 4 billion gallons of ethanol be used by 2006 and 7.5 billion gallons by 2012. Ethanol production had already reached 6.5 billion gallons by 2007, so new legislation in 2007 upped the ante to 15 billion gallons by 2015.
Beyond the increased amount the government is spending to support corn and corn-based ethanol, criticism of the policy has three major prongs:
1. Corn-based ethanol does little to reduce U.S. dependence on foreign oil because the energy required to produce a gallon of corn-based ethanol is quite high. A 2006 National Academy of Sciences paper estimated that one gallon of ethanol is needed to bring 1.25 gallons of it to market. Other studies show an even less favorable ratio.
2. Biofuels, such as corn-based ethanol, are having detrimental effects on the environment, with increased deforestation, stemming from more land being used to grow fuel inputs, contributing to global warming.
3. The diversion of corn and other crops from food to fuel is contributing to rising food prices and an increase in world hunger. C. Ford Runge and Benjamin Senauer wrote in Foreign Affairs that even small increases in prices of food staples have severe consequences on the very poor of the world, and “Filling the 25-gallon tank of an SUV with pure ethanol requires over 450 pounds of corn—which contains enough calories to feed one person for a year.”
Some of these criticisms may be contested as exaggerated: Will the ratio of energy-in to energy-out improve as new technologies emerge for producing ethanol? Did not other factors, such as weather and rising food demand worldwide, contribute to higher grain prices? Nonetheless, it is clear that corn-based ethanol is no free lunch. It is also clear that the end of government support for corn is nowhere to be seen.
Answer to Try It! Problem
A minimum wage (Wmin) that is set above the equilibrium wage would create a surplus of unskilled labor equal to (L2L1). That is, L2 units of unskilled labor are offered at the minimum wage, but companies only want to use L1 units at that wage. Because unskilled workers are a substitute for a skilled workers, forcing the price of unskilled workers higher would increase the demand for skilled labor and thus increase their wages.
Figure 4.13 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.2%3A_Government_Intervention_in_Market_Prices_-_Price_Floors_and_Price_Ceilings.txt |
Learning Objective
1. Use the model of demand and supply to explain the effects of third-party payers on the health-care market and on health-care spending.
There has been much discussion over the past three decades about the health-care problem in the United States. Much of this discussion has focused on rising spending for health care. In this section, we will apply the model of demand and supply to health care to see what we can learn about some of the reasons behind rising spending in this important sector of the economy.
Figure 4.14 shows the share of U.S. output devoted to health care since 1960. In 1960, about 5% of total output was devoted to health care; by 2004 this share had risen to 15.4%. That has meant that we are devoting more of our spending to health care, and less to other goods and services, than we would be had health-care spending not risen so much.
Why were Americans willing to increase their spending on health care so dramatically? The model of demand and supply gives us part of the answer. As we apply the model to this problem, we will also gain a better understanding of the role of prices in a market economy.
The Demand and Supply for Health Care
When we speak of “health care,” we are speaking of the entire health-care industry. This industry produces services ranging from heart transplant operations to therapeutic massages; it produces goods ranging from X-ray machines to aspirin tablets. Clearly each of these goods and services is exchanged in a particular market. To assess the market forces affecting health care, we will focus first on just one of these markets: the market for physician office visits. When you go to the doctor, you are part of the demand for these visits. Your doctor, by seeing you, is part of the supply.
Figure 4.15 shows the market, assuming that it operates in a fashion similar to other markets. The demand curve D1 and the supply curve S1 intersect at point E, with an equilibrium price of \$30 per office visit. The equilibrium quantity of office visits per week is 1,000,000.
We can use the demand and supply graph to show total spending, which equals the price per unit (in this case, \$30 per visit) times the quantity consumed (in this case, 1,000,000 visits per week). Total spending for physician office visits thus equals \$30,000,000 per week (\$30 times 1,000,000 visits). We show total spending as the area of a rectangle bounded by the price and the quantity. It is the shaded region in Figure 4.15.
The picture in Figure 4.15 misses a crucial feature of the market. Most people in the United States have health insurance, provided either by private firms, by private purchases, or by the government. With health insurance, people agree to pay a fixed amount to the insurer in exchange for the insurer’s agreement to pay for most of the health-care expenses they incur. While insurance plans differ in their specific provisions, let us suppose that all individuals have plans that require them to pay \$10 for an office visit; the insurance company will pay the rest.
How will this insurance affect the market for physician office visits? If it costs only \$10 for a visit instead of \$30, people will visit their doctors more often. The quantity of office visits demanded will increase. In Figure 4.16, this is shown as a movement along the demand curve. Think about your own choices. When you get a cold, do you go to the doctor? Probably not, if it is a minor cold. But if you feel like you are dying, or wish you were, you probably head for the doctor. Clearly, there are lots of colds in between these two extremes. Whether you drag yourself to the doctor will depend on the severity of your cold and what you will pay for a visit. At a lower price, you are more likely to go to the doctor; at a higher price, you are less likely to go.
In the case shown, the quantity of office visits rises to 1,500,000 per week. But that suggests a potential problem. The quantity of visits supplied at a price of \$30 per visit was 1,000,000. According to supply curve S1, it will take a price of \$50 per visit to increase the quantity supplied to 1,500,000 visits (Point F on S1). But consumers—patients—pay only \$10.
Insurers make up the difference between the fees doctors receive and the price patients pay. In our example, insurers pay \$40 per visit of insured patients to supplement the \$10 that patients pay. When an agent other than the seller or the buyer pays part of the price of a good or service, we say that the agent is a third-party payer.
Notice how the presence of a third-party payer affects total spending on office visits. When people paid for their own visits, and the price equaled \$30 per visit, total spending equaled \$30 million per week. Now doctors receive \$50 per visit and provide 1,500,000 visits per week. Total spending has risen to \$75 million per week (\$50 times 1,500,000 visits, shown by the darkly shaded region plus the lightly shaded region).
The response described in Figure 4.16 holds for many different types of goods and services covered by insurance or otherwise paid for by third-party payers. For example, the availability of scholarships and subsidized tuition at public and private universities increases the quantity of education demanded and the total expenditures on higher education. In markets with third-party payers, an equilibrium is achieved, but it is not at the intersection of the demand and supply curves. The effect of third-party payers is to decrease the price that consumers directly pay for the goods and services they consume and to increase the price that suppliers receive. Consumers use more than they would in the absence of third-party payers, and providers are encouraged to supply more than they otherwise would. The result is increased total spending.
Key Takeaways
• The rising share of the output of the United States devoted to health care represents a rising opportunity cost. More spending on health care means less spending on other goods and services, compared to what would have transpired had health-care spending not risen so much.
• The model of demand and supply can be used to show the effect of third-party payers on total spending. With third-party payers (for example, health insurers), the quantity of services consumed rises, as does spending.
Try It!
The provision of university education through taxpayer-supported state universities is another example of a market with a third-party payer. Use the model of demand and supply to discuss the impact this has on the higher education market. Specifically, draw a graph similar to Figure 4.16. How would you label the axes? Show the equilibrium price and quantity in the absence of a third-party payer and indicate total spending on education. Now show the impact of lower tuition As a result of state support for education. How much education do students demand at the lower tuition? How much tuition must educational institutions receive to produce that much education? How much spending on education will occur? Compare total spending before and after a third-party payer enters this market.
Case in Point: The Oregon Plan
Figure 4.17
The health-care industry presents us with a dilemma. Clearly, it makes sense for people to have health insurance. Just as clearly, health insurance generates a substantial increase in spending for health care. If that spending is to be limited, some mechanism must be chosen to do it. One mechanism would be to require patients to pay a larger share of their own health-care consumption directly, reducing the payments made by third-party payers. Allowing people to accumulate tax-free private medical savings accounts is one way to do this. Another option is to continue the current trend to use insurance companies as the agents that limit spending. A third option is government regulation; this Case in Point describes how the state of Oregon tried to limit health-care spending by essentially refusing to be a third-party payer for certain services.
Like all other states, Oregon has wrestled with the problem of soaring Medicaid costs. Its solution to the problem illustrates some of the choices society might make in seeking to reduce health-care costs.
Oregon used to have a plan similar to plans in many other states. Households whose incomes were lower than 50% of the poverty line qualified for Medicaid. In 1987, the state began an effort to manage its Medicaid costs. It decided that it would no longer fund organ transplants and that it would use the money saved to give better care to pregnant women. The decision turned out to be a painful one; the first year, a seven-year-old boy with leukemia, who might have been saved with a bone marrow transplant, died. But state officials argued that the shift of expenditures to pregnant women would ultimately save more lives.
The state gradually expanded its concept of determining what services to fund and what services not to fund. It collapsed a list of 10,000 different diagnoses that had been submitted to its Medicaid program in the past into a list of more than 700 condition-treatment pairs. One such pair, for example, is appendicitis-appendectomy. Health-care officials then ranked these pairs in order of priority. The rankings were based on such factors as the seriousness of a particular condition and the cost and efficacy of treatments. The state announced that it would provide Medicaid to all households below the poverty line, but that it would not fund any procedure ranked below a certain level, initially number 588 on its list. The plan also set a budget limit for any one year; if spending rose above that limit, the legislature must appropriate additional money or drop additional procedures from the list of those covered by the plan. The Oregon Health Plan officially began operation in 1994.
While the Oregon plan has been applied only to households below the poverty line that are not covered by other programs, it suggests a means of reducing health-care spending. Clearly, if part of the health-care problem is excessive provision of services, a system designed to cut services must determine what treatments not to fund.
Professors Jonathan Oberlander, Theodore Marmor, and Lawrence Jacobs studied the impact of this plan in practice through the year 2000 and found that, in contrast to initial expectations, excluded procedures were generally ones of marginal medical value, so the “line in the sand” had little practical significance. In addition, they found that patients were often able to receive supposedly excluded services when physicians, for example, treated an uncovered illness in conjunction with a covered one. During the period of the study, the number of people covered by the plan expanded substantially and yet rationing of services essentially did not occur. How do they explain this seeming contradiction? Quite simply: state government increased revenues from various sources to support the plan. Indeed, they argue that, because treatments that might not be included were explicitly stated, political pressure made excluding them even more difficult and may have inadvertently increased the cost of the program.
In the early 2000s, Oregon, like many other states, confronted severe budgetary pressures. To limit spending, it chose the perhaps less visible strategy of reducing the number of people covered through the plan. Once serving more than 100,000 people, budget cuts reduced the number served to about 17,000. Whereas in 1996, 11% of Oregonians lacked health insurance, in 2008 16% did.
Trailblazing again, in 2008 Oregon realized that its budget allowed room for coverage for a few thousand additional people. But how to choose among the 130,000 eligibles? The solution: to hold a lottery. More than 90,000 people queued up, hoping to be lucky winners.
Answer to Try It! Problem
Without a third-party payer for education, the graph shows equilibrium tuition of P1 and equilibrium quantity of education of Q1. State support for education lowers tuition that students pay to P2. As a result, students demand Q2 courses per year. To provide that amount of education, educational institutions require tuition per course of P3. Without a third-party payer, spending on education is 0P1EQ1. With a third-party payer, spending rises to 0P3FQ2.
Figure 4.18 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.3%3A_The_Market_for_Health-Care_Services.txt |
Summary
In this chapter we used the tools of demand and supply to understand a wide variety of market outcomes. We learned that technological change and the entry of new sellers has caused the supply curve of personal computers to shift markedly to the right, thereby reducing equilibrium price and increasing equilibrium quantity. Market forces have made personal computers a common item in offices and homes.
Crude oil and gasoline prices soared in 2008 and then fell back. We looked at the causes of these increases as well as their impacts. Crude oil prices rose in large part As a result of increased demand, particularly from China. Higher prices for crude oil led to higher prices for gasoline. Those higher prices not only hurt consumers of gasoline, they also put upward pressure on the prices of a wide range of goods and services. Crude oil and gasoline prices then decreased dramatically in the last part of 2008, as world growth declined.
The model of demand and supply also explains the determination of stock prices. The price per share of corporate stock reflects the market’s estimate of the expected profitability of the firm. Any information about the firm that causes potential buyers or current owners of corporate stock to reevaluate how profitable they think the firm is, or will be, will cause the equilibrium price of the stock to change.
We then examined markets in which some form of government price control keeps price permanently above or below equilibrium. A price floor leads to persistent surpluses because it is set above the equilibrium price, whereas a price ceiling, because it is set below the equilibrium price, leads to persistent shortages. We saw that interfering with the market mechanism may solve one problem but often creates other problems at the same time. We discussed what some of these unintended consequences might be. For example, agricultural price floors aimed at boosting farm income have also raised prices for consumers and cost taxpayers dearly, and the bulk of government payments have gone to large farms. Rent controls have lowered rents, but they have also reduced the quantity of rental housing supplied, created shortages, and sometimes led to various forms of “backdoor” payments, which sometimes force the price of rental housing above what would exist in the absence of controls.
Finally, we looked at the market for health care and a special feature behind demand and supply in this market that helps to explain why the share of output of the United States that is devoted to health care has risen. Health care is an example of a market in which there are third-party payers (primarily private insurers and the government). With third-party payers the quantity of health-care services consumed rises, as does health-care spending.
Concept Problems
1. Like personal computers, digital cameras have become a common household item. Digital camera prices have plunged in the last 10 years. Use the model of demand and supply to explain the fall in price and increase in quantity.
2. Enron Corp. was one of several corporations convicted of fraud in its accounting practices during the early part of this decade. It had created dummy corporations to hide massive borrowing and to give it the appearance of extraordinary profitability. Use the model of demand and supply to explain the likely impact of such convictions on the stocks of other corporations.
3. During World War II there was a freeze on wages, and corporations found they could evade the freeze by providing other fringe benefits such as retirement funds for their employees. The Office of Price Administration, which administered the wage freeze, ruled that the offer of retirement funds was not a violation of the freeze. The Internal Revenue Service went along with this and ruled that employer-financed retirement plans were not taxable income. Was the wage freeze an example of a price floor or a price ceiling? Use the model of demand and supply to explain why employers began to offer such benefits to their employees.
4. The text argues that political instability in potential suppliers of oil such as Iraq and Venezuela accounts for a relatively steep supply curve for crude oil such as the one shown in Figure 4.2 Suppose that this instability eases considerably and that the world supply curve for crude oil becomes much flatter. Draw such a curve, and explain its implications for the world economy and for typical consumers.
5. Suppose that technological change affects the dairy industry in the same way it has affected the computer industry. However, suppose that dairy price supports remain in place. How would this affect government spending on the dairy program? Use the model of demand and supply to support your answer.
6. People often argue that there is a “shortage” of child care. Using the model of demand and supply, evaluate whether this argument is likely to be correct.
7. “During most of the past 50 years the United States has had a surplus of farmers, and this has been the root of the farm problem.” Comment.
8. Suppose the Department of Agriculture ordered all farmers to reduce the acreage they plant by 10%. Would you expect a 10% reduction in food production? Why or why not?
9. The text argues that the increase in gasoline prices had a particularly strong impact on low-income people. Name some other goods and services for which a sharp increase in price would have a similar impact on people with low incomes.
10. Suppose that the United States and the European Union impose a price ceiling on crude oil of \$25 per barrel. Explain, and illustrate graphically, how this would affect the markets for crude oil and for gasoline in the United States and in the European Union.
11. Given that rent controls can actually hurt low-income people, devise a housing strategy that would provide affordable housing for those whose incomes fall below the poverty line (in 2004, this was about \$19,000 for a family of four).
12. Using the model of demand and supply, show and explain how an increase in the share individuals must pay directly for medical care affects the quantity they consume. Explain how this would address the total amount of spending on health care.
13. Given that people pay premiums for their health insurance, how can we say that insurance lowers the prices people pay for health-care services?
14. Suppose that physicians now charge \$30 for an office visit and insurance policies require patients to pay 33 1/3% of the amount they pay the physicians, so the out-of-pocket cost to consumers is \$10 per visit. In an effort to control costs, the government imposes a price ceiling of \$27 per office visit. Using a demand and supply model, show how this policy would affect the market for health care.
15. Do you think the U.S. health-care system requires reform? Why or why not? If you think reform is in order, explain the approach to reform you advocate.
Numerical Problems
Problems 1–4 are based on the following demand and supply schedules for corn (all quantities are in millions of bushels per year).
Price per bushel Quantity demanded Quantity supplied
\$0 6 0
1 5 1
2 4 2
3 3 3
4 2 4
5 1 5
6 0 6
1. Draw the demand and supply curves for corn. What is the equilibrium price? The equilibrium quantity?
2. Suppose the government now imposes a price floor at \$4 per bushel. Show the effect of this program graphically. How large is the surplus of corn?
3. With the price floor, how much do farmers receive for their corn? How much would they have received if there were no price floor?
4. If the government buys all the surplus wheat, how much will it spend?
Problems 5–9 are based on the following hypothetical demand and supply curves for apartments
Rent/Month
Number of Apts.
Demanded/Month
Number of Apts.
Supplied/Month
\$0 120,000 0
200 100,000 20,000
400 80,000 40,000
600 60,000 60,000
800 40,000 80,000
1000 20,000 100,000
1200 0 120,000
1. Draw the demand and supply curves for apartments.
2. What is the equilibrium rent per month? At this rent, what is the number of apartments demanded and supplied per month?
3. Suppose a ceiling on rents is set at \$400 per month. Characterize the situation that results from this policy.
4. At the rent ceiling, how many apartments are demanded? How many are supplied?
5. How much are people willing to pay for the number of apartments supplied at the ceiling? Describe the arrangements to which this situation might lead. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/04%3A_Applications_of_Demand_and_Supply/4.4%3A_Review_and_Practice.txt |
Learning Objective
1. Explain the concept of price elasticity of demand and its calculation.
2. Explain what it means for demand to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic.
3. Explain how and why the value of the price elasticity of demand changes along a linear demand curve.
4. Understand the relationship between total revenue and price elasticity of demand.
5. Discuss the determinants of price elasticity of demand.
We know from the law of demand how the quantity demanded will respond to a price change: it will change in the opposite direction. But how much will it change? It seems reasonable to expect, for example, that a 10% change in the price charged for a visit to the doctor would yield a different percentage change in quantity demanded than a 10% change in the price of a Ford Mustang. But how much is this difference?
To show how responsive quantity demanded is to a change in price, we apply the concept of elasticity. The price elasticity of demand for a good or service, eD, is the percentage change in quantity demanded of a particular good or service divided by the percentage change in the price of that good or service, all other things unchanged. Thus we can write
Equation 5.2
Because the price elasticity of demand shows the responsiveness of quantity demanded to a price change, assuming that other factors that influence demand are unchanged, it reflects movements along a demand curve. With a downward-sloping demand curve, price and quantity demanded move in opposite directions, so the price elasticity of demand is always negative. A positive percentage change in price implies a negative percentage change in quantity demanded, and vice versa. Sometimes you will see the absolute value of the price elasticity measure reported. In essence, the minus sign is ignored because it is expected that there will be a negative (inverse) relationship between quantity demanded and price. In this text, however, we will retain the minus sign in reporting price elasticity of demand and will say “the absolute value of the price elasticity of demand” when that is what we are describing.
Heads Up!
Be careful not to confuse elasticity with slope. The slope of a line is the change in the value of the variable on the vertical axis divided by the change in the value of the variable on the horizontal axis between two points. Elasticity is the ratio of the percentage changes. The slope of a demand curve, for example, is the ratio of the change in price to the change in quantity between two points on the curve. The price elasticity of demand is the ratio of the percentage change in quantity to the percentage change in price. As we will see, when computing elasticity at different points on a linear demand curve, the slope is constant—that is, it does not change—but the value for elasticity will change.
Computing the Price Elasticity of Demand
Finding the price elasticity of demand requires that we first compute percentage changes in price and in quantity demanded. We calculate those changes between two points on a demand curve.
Figure 5.1 shows a particular demand curve, a linear demand curve for public transit rides. Suppose the initial price is $0.80, and the quantity demanded is 40,000 rides per day; we are at point A on the curve. Now suppose the price falls to$0.70, and we want to report the responsiveness of the quantity demanded. We see that at the new price, the quantity demanded rises to 60,000 rides per day (point B). To compute the elasticity, we need to compute the percentage changes in price and in quantity demanded between points A and B.
We measure the percentage change between two points as the change in the variable divided by the average value of the variable between the two points. Thus, the percentage change in quantity between points A and B in Figure 5.1 is computed relative to the average of the quantity values at points A and B: (60,000 + 40,000)/2 = 50,000. The percentage change in quantity, then, is 20,000/50,000, or 40%. Likewise, the percentage change in price between points A and B is based on the average of the two prices: ($0.80 +$0.70)/2 = $0.75, and so we have a percentage change of −0.10/0.75, or −13.33%. The price elasticity of demand between points A and B is thus 40%/(−13.33%) = −3.00. This measure of elasticity, which is based on percentage changes relative to the average value of each variable between two points, is called arc elasticity. The arc elasticity method has the advantage that it yields the same elasticity whether we go from point A to point B or from point B to point A. It is the method we shall use to compute elasticity. For the arc elasticity method, we calculate the price elasticity of demand using the average value of price, , and the average value of quantity demanded, . We shall use the Greek letter Δ to mean “change in,” so the change in quantity between two points is ΔQ and the change in price is ΔP. Now we can write the formula for the price elasticity of demand as Equation 5.3 $\bar{P}}$ The price elasticity of demand between points A and B is thus: $2}} = \frac{40 \% }{-13.33 \% } = -3.00$ With the arc elasticity formula, the elasticity is the same whether we move from point A to point B or from point B to point A. If we start at point B and move to point A, we have: $2}} = \frac{-40 \% }{13.33 \% } = -3.00$ The arc elasticity method gives us an estimate of elasticity. It gives the value of elasticity at the midpoint over a range of change, such as the movement between points A and B. For a precise computation of elasticity, we would need to consider the response of a dependent variable to an extremely small change in an independent variable. The fact that arc elasticities are approximate suggests an important practical rule in calculating arc elasticities: we should consider only small changes in independent variables. We cannot apply the concept of arc elasticity to large changes. Another argument for considering only small changes in computing price elasticities of demand will become evident in the next section. We will investigate what happens to price elasticities as we move from one point to another along a linear demand curve. Heads Up! Notice that in the arc elasticity formula, the method for computing a percentage change differs from the standard method with which you may be familiar. That method measures the percentage change in a variable relative to its original value. For example, using the standard method, when we go from point A to point B, we would compute the percentage change in quantity as 20,000/40,000 = 50%. The percentage change in price would be −$0.10/$0.80 = −12.5%. The price elasticity of demand would then be 50%/(−12.5%) = −4.00. Going from point B to point A, however, would yield a different elasticity. The percentage change in quantity would be −20,000/60,000, or −33.33%. The percentage change in price would be$0.10/$0.70 = 14.29%. The price elasticity of demand would thus be −33.33%/14.29% = −2.33. By using the average quantity and average price to calculate percentage changes, the arc elasticity approach avoids the necessity to specify the direction of the change and, thereby, gives us the same answer whether we go from A to B or from B to A. Price Elasticities Along a Linear Demand Curve What happens to the price elasticity of demand when we travel along the demand curve? The answer depends on the nature of the demand curve itself. On a linear demand curve, such as the one in Figure 5.2, elasticity becomes smaller (in absolute value) as we travel downward and to the right. Figure 5.2 Price Elasticities of Demand for a Linear Demand Curve The price elasticity of demand varies between different pairs of points along a linear demand curve. The lower the price and the greater the quantity demanded, the lower the absolute value of the price elasticity of demand. Figure 5.2 shows the same demand curve we saw in Figure 5.1. We have already calculated the price elasticity of demand between points A and B; it equals −3.00. Notice, however, that when we use the same method to compute the price elasticity of demand between other sets of points, our answer varies. For each of the pairs of points shown, the changes in price and quantity demanded are the same (a$0.10 decrease in price and 20,000 additional rides per day, respectively). But at the high prices and low quantities on the upper part of the demand curve, the percentage change in quantity is relatively large, whereas the percentage change in price is relatively small. The absolute value of the price elasticity of demand is thus relatively large. As we move down the demand curve, equal changes in quantity represent smaller and smaller percentage changes, whereas equal changes in price represent larger and larger percentage changes, and the absolute value of the elasticity measure declines. Between points C and D, for example, the price elasticity of demand is −1.00, and between points E and F the price elasticity of demand is −0.33.
On a linear demand curve, the price elasticity of demand varies depending on the interval over which we are measuring it. For any linear demand curve, the absolute value of the price elasticity of demand will fall as we move down and to the right along the curve.
The Price Elasticity of Demand and Changes in Total Revenue
Suppose the public transit authority is considering raising fares. Will its total revenues go up or down? Total revenue is the price per unit times the number of units sold1. In this case, it is the fare times the number of riders. The transit authority will certainly want to know whether a price increase will cause its total revenue to rise or fall. In fact, determining the impact of a price change on total revenue is crucial to the analysis of many problems in economics.
We will do two quick calculations before generalizing the principle involved. Given the demand curve shown in Figure 5.2, we see that at a price of $0.80, the transit authority will sell 40,000 rides per day. Total revenue would be$32,000 per day ($0.80 times 40,000). If the price were lowered by$0.10 to $0.70, quantity demanded would increase to 60,000 rides and total revenue would increase to$42,000 ($0.70 times 60,000). The reduction in fare increases total revenue. However, if the initial price had been$0.30 and the transit authority reduced it by $0.10 to$0.20, total revenue would decrease from $42,000 ($0.30 times 140,000) to $32,000 ($0.20 times 160,000). So it appears that the impact of a price change on total revenue depends on the initial price and, by implication, the original elasticity. We generalize this point in the remainder of this section.
The problem in assessing the impact of a price change on total revenue of a good or service is that a change in price always changes the quantity demanded in the opposite direction. An increase in price reduces the quantity demanded, and a reduction in price increases the quantity demanded. The question is how much. Because total revenue is found by multiplying the price per unit times the quantity demanded, it is not clear whether a change in price will cause total revenue to rise or fall.
We have already made this point in the context of the transit authority. Consider the following three examples of price increases for gasoline, pizza, and diet cola.
Suppose that 1,000 gallons of gasoline per day are demanded at a price of $4.00 per gallon. Total revenue for gasoline thus equals$4,000 per day (=1,000 gallons per day times $4.00 per gallon). If an increase in the price of gasoline to$4.25 reduces the quantity demanded to 950 gallons per day, total revenue rises to $4,037.50 per day (=950 gallons per day times$4.25 per gallon). Even though people consume less gasoline at $4.25 than at$4.00, total revenue rises because the higher price more than makes up for the drop in consumption.
Next consider pizza. Suppose 1,000 pizzas per week are demanded at a price of $9 per pizza. Total revenue for pizza equals$9,000 per week (=1,000 pizzas per week times $9 per pizza). If an increase in the price of pizza to$10 per pizza reduces quantity demanded to 900 pizzas per week, total revenue will still be $9,000 per week (=900 pizzas per week times$10 per pizza). Again, when price goes up, consumers buy less, but this time there is no change in total revenue.
Now consider diet cola. Suppose 1,000 cans of diet cola per day are demanded at a price of $0.50 per can. Total revenue for diet cola equals$500 per day (=1,000 cans per day times $0.50 per can). If an increase in the price of diet cola to$0.55 per can reduces quantity demanded to 880 cans per month, total revenue for diet cola falls to $484 per day (=880 cans per day times$0.55 per can). As in the case of gasoline, people will buy less diet cola when the price rises from $0.50 to$0.55, but in this example total revenue drops.
In our first example, an increase in price increased total revenue. In the second, a price increase left total revenue unchanged. In the third example, the price rise reduced total revenue. Is there a way to predict how a price change will affect total revenue? There is; the effect depends on the price elasticity of demand.
Elastic, Unit Elastic, and Inelastic Demand
To determine how a price change will affect total revenue, economists place price elasticities of demand in three categories, based on their absolute value. If the absolute value of the price elasticity of demand is greater than 1, demand is termed price elastic. If it is equal to 1, demand is unit price elastic. And if it is less than 1, demand is price inelastic.
Relating Elasticity to Changes in Total Revenue
When the price of a good or service changes, the quantity demanded changes in the opposite direction. Total revenue will move in the direction of the variable that changes by the larger percentage. If the variables move by the same percentage, total revenue stays the same. If quantity demanded changes by a larger percentage than price (i.e., if demand is price elastic), total revenue will change in the direction of the quantity change. If price changes by a larger percentage than quantity demanded (i.e., if demand is price inelastic), total revenue will move in the direction of the price change. If price and quantity demanded change by the same percentage (i.e., if demand is unit price elastic), then total revenue does not change.
When demand is price inelastic, a given percentage change in price results in a smaller percentage change in quantity demanded. That implies that total revenue will move in the direction of the price change: a reduction in price will reduce total revenue, and an increase in price will increase it.
Consider the price elasticity of demand for gasoline. In the example above, 1,000 gallons of gasoline were purchased each day at a price of $4.00 per gallon; an increase in price to$4.25 per gallon reduced the quantity demanded to 950 gallons per day. We thus had an average quantity of 975 gallons per day and an average price of $4.125. We can thus calculate the arc price elasticity of demand for gasoline: Percentage change in quantity demanded = -50/975 = -5.1% Percentage change in price=0.25/4.125=6.06% Price elasticity of demand = -5.1%/6.06% = -.084 The demand for gasoline is price inelastic, and total revenue moves in the direction of the price change. When price rises, total revenue rises. Recall that in our example above, total spending on gasoline (which equals total revenues to sellers) rose from$4,000 per day (=1,000 gallons per day times $4.00) to$4037.50 per day (=950 gallons per day times $4.25 per gallon). When demand is price inelastic, a given percentage change in price results in a smaller percentage change in quantity demanded. That implies that total revenue will move in the direction of the price change: an increase in price will increase total revenue, and a reduction in price will reduce it. Consider again the example of pizza that we examined above. At a price of$9 per pizza, 1,000 pizzas per week were demanded. Total revenue was $9,000 per week (=1,000 pizzas per week times$9 per pizza). When the price rose to $10, the quantity demanded fell to 900 pizzas per week. Total revenue remained$9,000 per week (=900 pizzas per week times $10 per pizza). Again, we have an average quantity of 950 pizzas per week and an average price of$9.50. Using the arc elasticity method, we can compute:
Percentage change in quantity demanded = -100/950 = -10.5%
Percentage change in price = $1.00/$9.50 = 10.5%
Price elasticity of demand = -10.5%/10.5% = -1.0
Demand is unit price elastic, and total revenue remains unchanged. Quantity demanded falls by the same percentage by which price increases.
Consider next the example of diet cola demand. At a price of $0.50 per can, 1,000 cans of diet cola were purchased each day. Total revenue was thus$500 per day (=$0.50 per can times 1,000 cans per day). An increase in price to$0.55 reduced the quantity demanded to 880 cans per day. We thus have an average quantity of 940 cans per day and an average price of $0.525 per can. Computing the price elasticity of demand for diet cola in this example, we have: Percentage change in quantity demanded = -120/940 = -12.8% Percentage change in price =$0.05/$0.525 = 9.5% Price elasticity of demand = -12.8%/9.5% = -1.3 The demand for diet cola is price elastic, so total revenue moves in the direction of the quantity change. It falls from$500 per day before the price increase to $484 per day after the price increase. A demand curve can also be used to show changes in total revenue. Figure 5.3 shows the demand curve from Figure 5.1 and Figure 5.2. At point A, total revenue from public transit rides is given by the area of a rectangle drawn with point A in the upper right-hand corner and the origin in the lower left-hand corner. The height of the rectangle is price; its width is quantity. We have already seen that total revenue at point A is$32,000 ($0.80 × 40,000). When we reduce the price and move to point B, the rectangle showing total revenue becomes shorter and wider. Notice that the area gained in moving to the rectangle at B is greater than the area lost; total revenue rises to$42,000 ($0.70 × 60,000). Recall from Figure 5.2 that demand is elastic between points A and B. In general, demand is elastic in the upper half of any linear demand curve, so total revenue moves in the direction of the quantity change. A movement from point E to point F also shows a reduction in price and an increase in quantity demanded. This time, however, we are in an inelastic region of the demand curve. Total revenue now moves in the direction of the price change—it falls. Notice that the rectangle drawn from point F is smaller in area than the rectangle drawn from point E, once again confirming our earlier calculation. Figure 5.4 We have noted that a linear demand curve is more elastic where prices are relatively high and quantities relatively low and less elastic where prices are relatively low and quantities relatively high. We can be even more specific. For any linear demand curve, demand will be price elastic in the upper half of the curve and price inelastic in its lower half. At the midpoint of a linear demand curve, demand is unit price elastic. Constant Price Elasticity of Demand Curves Figure 5.5 shows four demand curves over which price elasticity of demand is the same at all points. The demand curve in Panel (a) is vertical. This means that price changes have no effect on quantity demanded. The numerator of the formula given in Equation 5.2 for the price elasticity of demand (percentage change in quantity demanded) is zero. The price elasticity of demand in this case is therefore zero, and the demand curve is said to be perfectly inelastic. This is a theoretically extreme case, and no good that has been studied empirically exactly fits it. A good that comes close, at least over a specific price range, is insulin. A diabetic will not consume more insulin as its price falls but, over some price range, will consume the amount needed to control the disease. As illustrated in Figure 5.5, several other types of demand curves have the same elasticity at every point on them. The demand curve in Panel (b) is horizontal. This means that even the smallest price changes have enormous effects on quantity demanded. The denominator of the formula given in Equation 5.2 for the price elasticity of demand (percentage change in price) approaches zero. The price elasticity of demand in this case is therefore infinite, and the demand curve is said to be perfectly elastic. This is the type of demand curve faced by producers of standardized products such as wheat. If the wheat of other farms is selling at$4 per bushel, a typical farm can sell as much wheat as it wants to at $4 but nothing at a higher price and would have no reason to offer its wheat at a lower price. The nonlinear demand curves in Panels (c) and (d) have price elasticities of demand that are negative; but, unlike the linear demand curve discussed above, the value of the price elasticity is constant all along each demand curve. The demand curve in Panel (c) has price elasticity of demand equal to −1.00 throughout its range; in Panel (d) the price elasticity of demand is equal to −0.50 throughout its range. Empirical estimates of demand often show curves like those in Panels (c) and (d) that have the same elasticity at every point on the curve. Heads Up! Do not confuse price inelastic demand and perfectly inelastic demand. Perfectly inelastic demand means that the change in quantity is zero for any percentage change in price; the demand curve in this case is vertical. Price inelastic demand means only that the percentage change in quantity is less than the percentage change in price, not that the change in quantity is zero. With price inelastic (as opposed to perfectly inelastic) demand, the demand curve itself is still downward sloping. Determinants of the Price Elasticity of Demand The greater the absolute value of the price elasticity of demand, the greater the responsiveness of quantity demanded to a price change. What determines whether demand is more or less price elastic? The most important determinants of the price elasticity of demand for a good or service are the availability of substitutes, the importance of the item in household budgets, and time. Availability of Substitutes The price elasticity of demand for a good or service will be greater in absolute value if many close substitutes are available for it. If there are lots of substitutes for a particular good or service, then it is easy for consumers to switch to those substitutes when there is a price increase for that good or service. Suppose, for example, that the price of Ford automobiles goes up. There are many close substitutes for Fords—Chevrolets, Chryslers, Toyotas, and so on. The availability of close substitutes tends to make the demand for Fords more price elastic. If a good has no close substitutes, its demand is likely to be somewhat less price elastic. There are no close substitutes for gasoline, for example. The price elasticity of demand for gasoline in the intermediate term of, say, three–nine months is generally estimated to be about −0.5. Since the absolute value of price elasticity is less than 1, it is price inelastic. We would expect, though, that the demand for a particular brand of gasoline will be much more price elastic than the demand for gasoline in general. Importance in Household Budgets One reason price changes affect quantity demanded is that they change how much a consumer can buy; a change in the price of a good or service affects the purchasing power of a consumer’s income and thus affects the amount of a good the consumer will buy. This effect is stronger when a good or service is important in a typical household’s budget. A change in the price of jeans, for example, is probably more important in your budget than a change in the price of pencils. Suppose the prices of both were to double. You had planned to buy four pairs of jeans this year, but now you might decide to make do with two new pairs. A change in pencil prices, in contrast, might lead to very little reduction in quantity demanded simply because pencils are not likely to loom large in household budgets. The greater the importance of an item in household budgets, the greater the absolute value of the price elasticity of demand is likely to be. Time Suppose the price of electricity rises tomorrow morning. What will happen to the quantity demanded? The answer depends in large part on how much time we allow for a response. If we are interested in the reduction in quantity demanded by tomorrow afternoon, we can expect that the response will be very small. But if we give consumers a year to respond to the price change, we can expect the response to be much greater. We expect that the absolute value of the price elasticity of demand will be greater when more time is allowed for consumer responses. Consider the price elasticity of crude oil demand. Economist John C. B. Cooper estimated short- and long-run price elasticities of demand for crude oil for 23 industrialized nations for the period 1971–2000. Professor Cooper found that for virtually every country, the price elasticities were negative, and the long-run price elasticities were generally much greater (in absolute value) than were the short-run price elasticities. His results are reported in Table 5.1 “Short- and Long-Run Price Elasticities of the Demand for Crude Oil in 23 Countries”. As you can see, the research was reported in a journal published by OPEC (Organization of Petroleum Exporting Countries), an organization whose members have profited greatly from the inelasticity of demand for their product. By restricting supply, OPEC, which produces about 45% of the world’s crude oil, is able to put upward pressure on the price of crude. That increases OPEC’s (and all other oil producers’) total revenues and reduces total costs. Table 5.1 Short- and Long-Run Price Elasticities of the Demand for Crude Oil in 23 Countries Country Short-Run Price Elasticity of Demand Long-Run Price Elasticity of Demand Australia −0.034 −0.068 Austria −0.059 −0.092 Canada −0.041 −0.352 China 0.001 0.005 Denmark −0.026 −0.191 Finland −0.016 −0.033 France −0.069 −0.568 Germany −0.024 −0.279 Greece −0.055 −0.126 Iceland −0.109 −0.452 Ireland −0.082 −0.196 Italy −0.035 −0.208 Japan −0.071 −0.357 Korea −0.094 −0.178 Netherlands −0.057 −0.244 New Zealand −0.054 −0.326 Norway −0.026 −0.036 Portugal 0.023 0.038 Spain −0.087 −0.146 Sweden −0.043 −0.289 Switzerland −0.030 −0.056 United Kingdom −0.068 −0.182 United States −0.061 −0.453 For most countries, price elasticity of demand for crude oil tends to be greater (in absolute value) in the long run than in the short run. Key Takeaways • The price elasticity of demand measures the responsiveness of quantity demanded to changes in price; it is calculated by dividing the percentage change in quantity demanded by the percentage change in price. • Demand is price inelastic if the absolute value of the price elasticity of demand is less than 1; it is unit price elastic if the absolute value is equal to 1; and it is price elastic if the absolute value is greater than 1. • Demand is price elastic in the upper half of any linear demand curve and price inelastic in the lower half. It is unit price elastic at the midpoint. • When demand is price inelastic, total revenue moves in the direction of a price change. When demand is unit price elastic, total revenue does not change in response to a price change. When demand is price elastic, total revenue moves in the direction of a quantity change. • The absolute value of the price elasticity of demand is greater when substitutes are available, when the good is important in household budgets, and when buyers have more time to adjust to changes in the price of the good. Try It! You are now ready to play the part of the manager of the public transit system. Your finance officer has just advised you that the system faces a deficit. Your board does not want you to cut service, which means that you cannot cut costs. Your only hope is to increase revenue. Would a fare increase boost revenue? You consult the economist on your staff who has researched studies on public transportation elasticities. She reports that the estimated price elasticity of demand for the first few months after a price change is about −0.3, but that after several years, it will be about −1.5. 1. Explain why the estimated values for price elasticity of demand differ. 2. Compute what will happen to ridership and revenue over the next few months if you decide to raise fares by 5%. 3. Compute what will happen to ridership and revenue over the next few years if you decide to raise fares by 5%. 4. What happens to total revenue now and after several years if you choose to raise fares? Case in Point: Elasticity and Stop Lights Figure 5.6 We all face the situation every day. You are approaching an intersection. The yellow light comes on. You know that you are supposed to slow down, but you are in a bit of a hurry. So, you speed up a little to try to make the light. But the red light flashes on just before you get to the intersection. Should you risk it and go through? Many people faced with that situation take the risky choice. In 1998, 2,000 people in the United States died as a result of drivers running red lights at intersections. In an effort to reduce the number of drivers who make such choices, many areas have installed cameras at intersections. Drivers who run red lights have their pictures taken and receive citations in the mail. This enforcement method, together with recent increases in the fines for driving through red lights at intersections, has led to an intriguing application of the concept of elasticity. Economists Avner Bar-Ilan of the University of Haifa in Israel and Bruce Sacerdote of Dartmouth University have estimated what is, in effect, the price elasticity for driving through stoplights with respect to traffic fines at intersections in Israel and in San Francisco. In December 1996, Israel sharply increased the fine for driving through a red light. The old fine of 400 shekels (this was equal at that time to$122 in the United States) was increased to 1,000 shekels ($305). In January 1998, California raised its fine for the offense from$104 to \$271. The country of Israel and the city of San Francisco installed cameras at several intersections. Drivers who ignored stoplights got their pictures taken and automatically received citations imposing the new higher fines.
We can think of driving through red lights as an activity for which there is a demand—after all, ignoring a red light speeds up one’s trip. It may also generate satisfaction to people who enjoy disobeying traffic laws. The concept of elasticity gives us a way to show just how responsive drivers were to the increase in fines.
Professors Bar-Ilan and Sacerdote obtained information on all the drivers cited at 73 intersections in Israel and eight intersections in San Francisco. For Israel, for example, they defined the period January 1992 to June 1996 as the “before” period. They compared the number of violations during the before period to the number of violations from July 1996 to December 1999—the “after” period—and found there was a reduction in tickets per driver of 31.5 per cent. Specifically, the average number of tickets per driver was 0.073 during the period before the increase; it fell to 0.050 after the increase. The increase in the fine was 150 per cent. (Note that, because they were making a “before” and “after” calculation, the authors used the standard method described in the Heads Up! on computing a percentage change—i.e., they computed the percentage changes in comparison to the original values instead of the average value of the variables.) The elasticity of citations with respect to the fine was thus −0.21 (= −31.5%/150%).
The economists estimated elasticities for particular groups of people. For example, young people (age 17–30) had an elasticity of −0.36; people over the age of 30 had an elasticity of −0.16. In general, elasticities fell in absolute value as income rose. For San Francisco and Israel combined, the elasticity was between −0.26 and −0.33.
In general, the results showed that people responded rationally to the increases in fines. Increasing the price of a particular behavior reduced the frequency of that behavior. The study also points out the effectiveness of cameras as an enforcement technique. With cameras, violators can be certain they will be cited if they ignore a red light. And reducing the number of people running red lights clearly saves lives.
Answers to Try It! Problems
1. The absolute value of price elasticity of demand tends to be greater when more time is allowed for consumers to respond. Over time, riders of the commuter rail system can organize car pools, move, or otherwise adjust to the fare increase.
2. Using the formula for price elasticity of demand and plugging in values for the estimate of price elasticity (−0.5) and the percentage change in price (5%) and then rearranging terms, we can solve for the percentage change in quantity demanded as: eD = %Δ in Q/%Δ in P; −0.5 = %Δ in Q/5%; (−0.5)(5%) = %Δ in Q = −2.5%. Ridership falls by 2.5% in the first few months.
3. Using the formula for price elasticity of demand and plugging in values for the estimate of price elasticity over a few years (−1.5) and the percentage change in price (5%), we can solve for the percentage change in quantity demanded as eD = %Δ in Q/%Δ in P; −1.5 = %Δ in Q/5%; (−1.5)(5%) = %Δ in Q = −7.5%. Ridership falls by 7.5% over a few years.
4. Total revenue rises immediately after the fare increase, since demand over the immediate period is price inelastic. Total revenue falls after a few years, since demand changes and becomes price elastic.
1Notice that since the number of units sold of a good is the same as the number of units bought, the definition for total revenue could also be used to define total spending. Which term we use depends on the question at hand. If we are trying to determine what happens to revenues of sellers, then we are asking about total revenue. If we are trying to determine how much consumers spend, then we are asking about total spending.
2Division by zero results in an undefined solution. Saying that the price elasticity of demand is infinite requires that we say the denominator “approaches” zero. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/05%3A_Elasticity%3A_A_Measure_of_Response/5.1%3A_The_Price_Elasticity_of_Demand.txt |
Learning Objective
1. Explain the concept of income elasticity of demand and its calculation.
2. Classify goods as normal or inferior depending on their income elasticity of demand.
3. Explain the concept of cross price elasticity of demand and its calculation.
4. Classify goods as substitutes or complements depending on their cross price elasticity of demand.
Although the response of quantity demanded to changes in price is the most widely used measure of elasticity, economists are interested in the response to changes in the demand shifters as well. Two of the most important measures show how demand responds to changes in income and to changes in the prices of related goods and services.
Income Elasticity of Demand
We saw in the chapter that introduced the model of demand and supply that the demand for a good or service is affected by income. We measure the income elasticity of demand, eY, as the percentage change in quantity demanded at a specific price divided by the percentage change in income that produced the demand change, all other things unchanged:
Equation 5.4
The symbol Y is often used in economics to represent income. Because income elasticity of demand reports the responsiveness of quantity demanded to a change in income, all other things unchanged (including the price of the good), it reflects a shift in the demand curve at a given price. Remember that price elasticity of demand reflects movements along a demand curve in response to a change in price.
A positive income elasticity of demand means that income and demand move in the same direction—an increase in income increases demand, and a reduction in income reduces demand. As we learned, a good whose demand rises as income rises is called a normal good.
Studies show that most goods and services are normal, and thus their income elasticities are positive. Goods and services for which demand is likely to move in the same direction as income include housing, seafood, rock concerts, and medical services.
If a good or service is inferior, then an increase in income reduces demand for the good. That implies a negative income elasticity of demand. Goods and services for which the income elasticity of demand is likely to be negative include used clothing, beans, and urban public transit. For example, the studies we have already cited concerning the demands for urban public transit in France and in Madrid found the long-run income elasticities of demand to be negative (−0.23 in France and −0.25 in Madrid) (Bresson, G., et. al., 2004; Matas, A., 2004).
Figure 5.7
When we compute the income elasticity of demand, we are looking at the change in the quantity demanded at a specific price. We are thus dealing with a change that shifts the demand curve. An increase in income shifts the demand for a normal good to the right; it shifts the demand for an inferior good to the left.
Cross Price Elasticity of Demand
The demand for a good or service is affected by the prices of related goods or services. A reduction in the price of salsa, for example, would increase the demand for chips, suggesting that salsa is a complement of chips. A reduction in the price of chips, however, would reduce the demand for peanuts, suggesting that chips are a substitute for peanuts.
The measure economists use to describe the responsiveness of demand for a good or service to a change in the price of another good or service is called the cross price elasticity of demand, eA, B. It equals the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of a related good or service. We are varying the price of a related good when we consider the cross price elasticity of demand, so the response of quantity demanded is shown as a shift in the demand curve.
The cross price elasticity of the demand for good A with respect to the price of good B is given by:
Equation 5.5
Cross price elasticities of demand define whether two goods are substitutes, complements, or unrelated. If two goods are substitutes, an increase in the price of one will lead to an increase in the demand for the other—the cross price elasticity of demand is positive. If two goods are complements, an increase in the price of one will lead to a reduction in the demand for the other—the cross price elasticity of demand is negative. If two goods are unrelated, a change in the price of one will not affect the demand for the other—the cross price elasticity of demand is zero.
Figure 5.8
An examination of the demand for local television advertising with respect to the price of local radio advertising revealed that the two goods are clearly substitutes. A 10 per cent increase in the price of local radio advertising led to a 10 per cent increase in demand for local television advertising, so that the cross price elasticity of demand for local television advertising with respect to changes in the price of radio advertising was 1.0 (Ekelund, R. B., et. al., 2000).
Heads Up!
Notice that with income elasticity of demand and cross price elasticity of demand we are primarily concerned with whether the measured value of these elasticities is positive or negative. In the case of income elasticity of demand this tells us whether the good or service is normal or inferior. In the case of cross price elasticity of demand it tells us whether two goods are substitutes or complements. With price elasticity of demand we were concerned with whether the measured absolute value of this elasticity was greater than, less than, or equal to 1, because this gave us information about what happens to total revenue as price changes. The terms elastic and inelastic apply to price elasticity of demand. They are not used to describe income elasticity of demand or cross price elasticity of demand.
Key Takeaways
• The income elasticity of demand reflects the responsiveness of demand to changes in income. It is the percentage change in quantity demanded at a specific price divided by the percentage change in income, ceteris paribus.
• Income elasticity is positive for normal goods and negative for inferior goods.
• The cross price elasticity of demand measures the way demand for one good or service responds to changes in the price of another. It is the percentage change in the quantity demanded of one good or service at a specific price divided by the percentage change in the price of another good or service, all other things unchanged.
• Cross price elasticity is positive for substitutes, negative for complements, and zero for goods or services whose demands are unrelated.
Try It!
Suppose that when the price of bagels rises by 10%, the demand for cream cheese falls by 3% at the current price, and that when income rises by 10%, the demand for bagels increases by 1% at the current price. Calculate the cross price elasticity of demand for cream cheese with respect to the price of bagels and tell whether bagels and cream cheese are substitutes or complements. Calculate the income elasticity of demand and tell whether bagels are normal or inferior.
Case in Point: Teen Smoking and Elasticity
Figure 5.9
Tobacco kills more people than any other substance or disease. Worldwide, the annual death toll from tobacco is well over 3 million people per year. In the United States alone, 400,000 people die each year as a result of their use of tobacco.
More than two-thirds of smokers indicated in 1995 that they would prefer to quit smoking but were unable to do so, according to the Centers for Disease Control and Prevention. In fact, less than 2.5 per cent of smokers succeed in quitting each year.
Most smokers begin using tobacco as teenagers. Teens tend to underestimate the danger of smoking and to overestimate their likely ability to quit smoking when they choose to do so. One can, therefore, argue that the decision to smoke may not be a rational one, and it is one that imposes substantial costs on the rest of society. Because it raises health-care costs, it raises health insurance rates. And the evidence is mounting that secondhand smoke imposes serious health consequences on nonsmokers. Because smoking is such a serious problem for our society, and because the decision to smoke is typically made when one is a teenager, health economists tend to focus on measures to prevent young people from smoking.
One place to begin in limiting teen smoking is price. The price elasticity of demand for teenage smokers is greater (in absolute value) than that for the population in general because the cost of tobacco represents a greater percentage of teen incomes than of adult incomes. For all smokers, the price elasticity of demand was estimated by economists Matthew C. Farrelly, Terry F. Pechacek, and Frank J. Chaloupka to be −0.32. Health-care economists estimate that the price elasticity of demand for cigarettes for teenagers is between −0.9 and −1.5.
In 1998, the tobacco industry reached a settlement with 46 states that had filed lawsuits against the industry, charging that the tobacco industry had imposed huge health-care costs. The Master Settlement Agreement (MSA) called for a payment of \$205 billion over a period of 25 years (the other four states reached separate agreements with the industry in 1997 and 1998). The MSA led to an increase in the price of cigarettes by 48 per cent between 1997 and 1999. The percentage of high school students who smoked fell significantly by 2000, indicating a substantial responsiveness of teenagers to price changes.
The MSA also required that states use some of the money they receive from tobacco firms to carry out antismoking programs. The nature and scope of these programs vary widely. State excise taxes, also varying widely, range from 2.5¢ per pack in Virginia (a tobacco-producing state) to \$1.51 in Massachusetts. Given the greater responsiveness of teenagers to the price of cigarettes, excise taxes should prove an effective device.
One caveat, however, in evaluating the impact of a tax hike on teen smoking is that some teens might switch from cigarettes to smokeless tobacco, which is associated with a higher risk of oral cancer. It is estimated that for young males the cross price elasticity of smokeless tobacco with respect to the price of cigarettes is 1.2—a 10% increase in cigarette prices leads to a 12% increase in young males using smokeless tobacco.
Answer to Try It! Problem
Using the formula for cross price elasticity of demand, we find that eAB = (−3%)/(10%) = −0.3. Since the eAB is negative, bagels and cream cheese are complements. Using the formula for income elasticity of demand, we find that eY = (+1%)/(10%) = +0.1. Since eY is positive, bagels are a normal good. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/05%3A_Elasticity%3A_A_Measure_of_Response/5.2%3A_Responsiveness_of_Demand_to_Other_Factors.txt |
Learning Objective
1. Explain the concept of elasticity of supply and its calculation.
2. Explain what it means for supply to be price inelastic, unit price elastic, price elastic, perfectly price inelastic, and perfectly price elastic.
3. Explain why time is an important determinant of price elasticity of supply.
4. Apply the concept of price elasticity of supply to the labor supply curve.
The elasticity measures encountered so far in this chapter all relate to the demand side of the market. It is also useful to know how responsive quantity supplied is to a change in price.
Suppose the demand for apartments rises. There will be a shortage of apartments at the old level of apartment rents and pressure on rents to rise. All other things unchanged, the more responsive the quantity of apartments supplied is to changes in monthly rents, the lower the increase in rent required to eliminate the shortage and to bring the market back to equilibrium. Conversely, if quantity supplied is less responsive to price changes, price will have to rise more to eliminate a shortage caused by an increase in demand.
This is illustrated in Figure 5.10. Suppose the rent for a typical apartment had been R0 and the quantity Q0 when the demand curve was D1 and the supply curve was either S1 (a supply curve in which quantity supplied is less responsive to price changes) or S2 (a supply curve in which quantity supplied is more responsive to price changes). Note that with either supply curve, equilibrium price and quantity are initially the same. Now suppose that demand increases to D2, perhaps due to population growth. With supply curve S1, the price (rent in this case) will rise to R1 and the quantity of apartments will rise to Q1. If, however, the supply curve had been S2, the rent would only have to rise to R2 to bring the market back to equilibrium. In addition, the new equilibrium number of apartments would be higher at Q2. Supply curve S2 shows greater responsiveness of quantity supplied to price change than does supply curve S1.
We measure the price elasticity of supply (eS) as the ratio of the percentage change in quantity supplied of a good or service to the percentage change in its price, all other things unchanged:
Equation 5.6
Because price and quantity supplied usually move in the same direction, the price elasticity of supply is usually positive. The larger the price elasticity of supply, the more responsive the firms that supply the good or service are to a price change.
Supply is price elastic if the price elasticity of supply is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. A vertical supply curve, as shown in Panel (a) of Figure 5.11, is perfectly inelastic; its price elasticity of supply is zero. The supply of Beatles’ songs is perfectly inelastic because the band no longer exists. A horizontal supply curve, as shown in Panel (b) of Figure 5.11, is perfectly elastic; its price elasticity of supply is infinite. It means that suppliers are willing to supply any amount at a certain price.
Time: An Important Determinant of the Elasticity of Supply
Time plays a very important role in the determination of the price elasticity of supply. Look again at the effect of rent increases on the supply of apartments. Suppose apartment rents in a city rise. If we are looking at a supply curve of apartments over a period of a few months, the rent increase is likely to induce apartment owners to rent out a relatively small number of additional apartments. With the higher rents, apartment owners may be more vigorous in reducing their vacancy rates, and, indeed, with more people looking for apartments to rent, this should be fairly easy to accomplish. Attics and basements are easy to renovate and rent out as additional units. In a short period of time, however, the supply response is likely to be fairly modest, implying that the price elasticity of supply is fairly low. A supply curve corresponding to a short period of time would look like S1 in Figure 5.10. It is during such periods that there may be calls for rent controls.
If the period of time under consideration is a few years rather than a few months, the supply curve is likely to be much more price elastic. Over time, buildings can be converted from other uses and new apartment complexes can be built. A supply curve corresponding to a longer period of time would look like S2 in Figure 5.10.
Elasticity of Labor Supply: A Special Application
The concept of price elasticity of supply can be applied to labor to show how the quantity of labor supplied responds to changes in wages or salaries. What makes this case interesting is that it has sometimes been found that the measured elasticity is negative, that is, that an increase in the wage rate is associated with a reduction in the quantity of labor supplied.
In most cases, labor supply curves have their normal upward slope: higher wages induce people to work more. For them, having the additional income from working more is preferable to having more leisure time. However, wage increases may lead some people in very highly paid jobs to cut back on the number of hours they work because their incomes are already high and they would rather have more time for leisure activities. In this case, the labor supply curve would have a negative slope. The reasons for this phenomenon are explained more fully in a later chapter.
This chapter has covered a variety of elasticity measures. All report the degree to which a dependent variable responds to a change in an independent variable. As we have seen, the degree of this response can play a critically important role in determining the outcomes of a wide range of economic events. Table 5.2 “Selected Elasticity Estimates”1 provides examples of some estimates of elasticities.
Table 5.2 Selected Elasticity Estimates
Product Elasticity Product Elasticity Product Elasticity
Price Elasticity of Demand Cross Price Elasticity of Demand Income Elasticity of Demand
Crude oil (U.S.)* −0.06 Alcohol with respect to price of heroin −0.05 Speeding citations −0.26 to −0.33
Gasoline −0.1 Fuel with respect to price of transport −0.48 Urban Public Trust in France and Madrid (respectively) −0.23; −0.26
Speeding citations −0.21 Alcohol with respect to price of food −0.16 Ground beef −0.197
Cabbage −0.25 Marijuana with respect to price of heroin (similar for cocaine) −0.01 Lottery instant game sales in Colorado −0.06
Cocaine (two estimates) −0.28; −1.0 Beer with respect to price of wine distilled liquor (young drinkers) 0.0 Heroin −0.00
Alcohol −0.30 Beer with respect to price of distilled liquor (young drinkers) 0.0 Marijuana, alcohol, cocaine +0.00
Peaches −0.38 Pork with respect to price of poultry 0.06 Potatoes 0.15
Marijuana −0.4 Pork with respect to price of ground beef 0.23 Food** 0.2
Cigarettes (all smokers; two estimates) −0.4; −0.32 Ground beef with respect to price of poultry 0.24 Clothing*** 0.3
Crude oil (U.S.)** −0.45 Ground beef with respect to price of pork 0.35 Beer 0.4
Milk (two estimates) −0.49; −0.63 Coke with respect to price of Pepsi 0.61 Eggs 0.57
Gasoline (intermediate term) −0.5 Pepsi with respect to price of Coke 0.80 Coke 0.60
Soft drinks −0.55 Local television advertising with respect to price of radio advertising 1.0 Shelter** 0.7
Transportation* −0.6 Smokeless tobacco with respect to price of cigarettes (young males) 1.2 Beef (table cuts—not ground) 0.81
Food −0.7 Price Elasticity of Supply Oranges 0.83
Beer −0.7 to −0.9 Physicians (Specialist) −0.3 Apples 1.32
Cigarettes (teenagers; two estimates) −0.9 to −1.5 Physicians (Primary Care) 0.0 Leisure** 1.4
Heroin −0.94 Physicians (Young male) 0.2 Peaches 1.43
Ground beef −1.0 Physicians (Young female) 0.5 Health care** 1.6
Cottage cheese −1.1 Milk* 0.36 Higher education 1.67
Gasoline** −1.5 Milk** 0.5
Coke −1.71 Child care labor 2
Transportation −1.9
Pepsi −2.08
Fresh tomatoes −2.22
Food** −2.3
Lettuce −2.58
Note: *=short-run; **=long-run
Key Takeaways
• The price elasticity of supply measures the responsiveness of quantity supplied to changes in price. It is the percentage change in quantity supplied divided by the percentage change in price. It is usually positive.
• Supply is price inelastic if the price elasticity of supply is less than 1; it is unit price elastic if the price elasticity of supply is equal to 1; and it is price elastic if the price elasticity of supply is greater than 1. A vertical supply curve is said to be perfectly inelastic. A horizontal supply curve is said to be perfectly elastic.
• The price elasticity of supply is greater when the length of time under consideration is longer because over time producers have more options for adjusting to the change in price.
• When applied to labor supply, the price elasticity of supply is usually positive but can be negative. If higher wages induce people to work more, the labor supply curve is upward sloping and the price elasticity of supply is positive. In some very high-paying professions, the labor supply curve may have a negative slope, which leads to a negative price elasticity of supply.
Try It!
In the late 1990s, it was reported on the news that the high-tech industry was worried about being able to find enough workers with computer-related expertise. Job offers for recent college graduates with degrees in computer science went with high salaries. It was also reported that more undergraduates than ever were majoring in computer science. Compare the price elasticity of supply of computer scientists at that point in time to the price elasticity of supply of computer scientists over a longer period of, say, 1999 to 2009.
Case in Point: A Variety of Labor Supply Elasticities
Figure 5.12
Studies support the idea that labor supply is less elastic in high-paying jobs than in lower-paying ones.
For example, David M. Blau estimated the labor supply of child-care workers to be very price elastic, with estimated price elasticity of labor supply of about 2.0. This means that a 10% increase in wages leads to a 20% increase in the quantity of labor supplied. John Burkett estimated the labor supply of both nursing assistants and nurses to be price elastic, with that of nursing assistants to be 1.9 (very close to that of child-care workers) and of nurses to be 1.1. Note that the price elasticity of labor supply of the higher-paid nurses is a bit lower than that of lower-paid nursing assistants.
In contrast, John Rizzo and David Blumenthal estimated the price elasticity of labor supply for young physicians (under the age of 40) to be about 0.3. This means that a 10% increase in wages leads to an increase in the quantity of labor supplied of only about 3%. In addition, when Rizzo and Blumenthal looked at labor supply elasticities by gender, they found the female physicians’ labor supply price elasticity to be a bit higher (at about 0.5) than that of the males (at about 0.2) in the sample. Because earnings of female physicians in the sample were lower than earnings of the male physicians in the sample, this difference in labor supply elasticities was expected. Moreover, since the sample consisted of physicians in the early phases of their careers, the positive, though small, price elasticities were also expected. Many of the individuals in the sample also had high debt levels, often from educational loans. Thus, the chance to earn more by working more is an opportunity to repay educational and other loans.
In another study of physicians’ labor supply that was not restricted to young physicians, Douglas M. Brown found the labor supply price elasticity for primary care physicians to be close to zero and that of specialists to be negative, at about −0.3. Thus, for this sample of physicians, increases in wages have little or no effect on the amount the primary care doctors work, while a 10% increase in wages for specialists reduces their quantity of labor supplied by about 3%. Because the earnings of specialists exceed those of primary care doctors, this elasticity differential also makes sense.
Answer to Try It! Problem
While at a point in time the supply of people with degrees in computer science is very price inelastic, over time the elasticity should rise. That more students were majoring in computer science lends credence to this prediction. As supply becomes more price elastic, salaries in this field should rise more slowly.
1Although close to zero in all cases, the significant and positive signs of income elasticity for marijuana, alcohol, and cocaine suggest that they are normal goods, but significant and negative signs, in the case of heroin, suggest that heroin is an inferior good. Saffer and Chaloupka (cited below) suggest the effects of income for all four substances might be affected by education. [Other References listed below] | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/05%3A_Elasticity%3A_A_Measure_of_Response/5.3%3A_Price_Elasticity_of_Supply.txt |
Summary
This chapter introduced a new tool: the concept of elasticity. Elasticity is a measure of the degree to which a dependent variable responds to a change in an independent variable. It is the percentage change in the dependent variable divided by the percentage change in the independent variable, all other things unchanged.
The most widely used elasticity measure is the price elasticity of demand, which reflects the responsiveness of quantity demanded to changes in price. Demand is said to be price elastic if the absolute value of the price elasticity of demand is greater than 1, unit price elastic if it is equal to 1, and price inelastic if it is less than 1. The price elasticity of demand is useful in forecasting the response of quantity demanded to price changes; it is also useful for predicting the impact a price change will have on total revenue. Total revenue moves in the direction of the quantity change if demand is price elastic, it moves in the direction of the price change if demand is price inelastic, and it does not change if demand is unit price elastic. The most important determinants of the price elasticity of demand are the availability of substitutes, the importance of the item in household budgets, and time.
Two other elasticity measures commonly used in conjunction with demand are income elasticity and cross price elasticity. The signs of these elasticity measures play important roles. A positive income elasticity tells us that a good is normal; a negative income elasticity tells us the good is inferior. A positive cross price elasticity tells us that two goods are substitutes; a negative cross price elasticity tells us they are complements.
Elasticity of supply measures the responsiveness of quantity supplied to changes in price. The value of price elasticity of supply is generally positive. Supply is classified as being price elastic, unit price elastic, or price inelastic if price elasticity is greater than 1, equal to 1, or less than 1, respectively. The length of time over which supply is being considered is an important determinant of the price elasticity of supply.
Concept Problems
1. Explain why the price elasticity of demand is generally a negative number, except in the cases where the demand curve is perfectly elastic or perfectly inelastic. What would be implied by a positive price elasticity of demand?
2. Explain why the sign (positive or negative) of the cross price elasticity of demand is important.
3. Explain why the sign (positive or negative) of the income elasticity of demand is important.
4. Economists Dale Heien and Cathy Roheim Wessells found that the price elasticity of demand for fresh milk is −0.63 and the price elasticity of demand for cottage cheese is −1.1 (Heien, D. M. and Wessels, C. R., 1998). Why do you think the elasticity estimates differ?
5. The price elasticity of demand for health care has been estimated to be −0.2. Characterize this demand as price elastic, unit price elastic, or price inelastic. The text argues that the greater the importance of an item in consumer budgets, the greater its elasticity. Health-care costs account for a relatively large share of household budgets. How could the price elasticity of demand for health care be such a small number?
6. Suppose you are able to organize an alliance that includes all farmers. They agree to follow the group’s instructions with respect to the quantity of agricultural products they produce. What might the group seek to do? Why?
7. Suppose you are the chief executive officer of a firm, and you have been planning to reduce your prices. Your marketing manager reports that the price elasticity of demand for your product is −0.65. How will this news affect your plans?
8. Suppose the income elasticity of the demand for beans is −0.8. Interpret this number.
9. Transportation economists generally agree that the cross price elasticity of demand for automobile use with respect to the price of bus fares is about 0. Explain what this number means.
10. Suppose the price elasticity of supply of tomatoes as measured on a given day in July is 0. Interpret this number.
11. The price elasticity of supply for child-care workers was reported to be quite high, about 2. What will happen to the wages of child-care workers as demand for them increases, compared to what would happen if the measured price elasticity of supply were lower?
12. The Case in Point on cigarette taxes and teen smoking suggests that a higher tax on cigarettes would reduce teen smoking and premature deaths. Should cigarette taxes therefore be raised?
Numerical Problems
1. Economist David Romer found that in introductory economics classes a 10% increase in class attendance is associated with a 4% increase in course grade (Romer, D., 1993). What is the elasticity of course grade with respect to class attendance?
2. Refer to Figure 5.2 and
1. Using the arc elasticity of demand formula, compute the price elasticity of demand between points B and C.
2. Using the arc elasticity of demand formula, compute the price elasticity of demand between points D and E.
3. How do the values of price elasticity of demand compare? Why are they the same or different?
4. Compute the slope of the demand curve between points B and C.
5. Computer the slope of the demand curve between points D and E.
6. How do the slopes compare? Why are they the same or different?
3. Consider the following quote from The Wall Street Journal: “A bumper crop of oranges in Florida last year drove down orange prices. As juice marketers’ costs fell, they cut prices by as much as 15%. That was enough to tempt some value-oriented customers: unit volume of frozen juices actually rose about 6% during the quarter.”
1. Given these numbers, and assuming there were no changes in demand shifters for frozen orange juice, what was the price elasticity of demand for frozen orange juice?
2. What do you think happened to total spending on frozen orange juice? Why?
4. Suppose you are the manager of a restaurant that serves an average of 400 meals per day at an average price per meal of \$20. On the basis of a survey, you have determined that reducing the price of an average meal to \$18 would increase the quantity demanded to 450 per day.
1. Compute the price elasticity of demand between these two points.
2. Would you expect total revenues to rise or fall? Explain.
3. Suppose you have reduced the average price of a meal to \$18 and are considering a further reduction to \$16. Another survey shows that the quantity demanded of meals will increase from 450 to 500 per day. Compute the price elasticity of demand between these two points.
4. Would you expect total revenue to rise or fall as a result of this second price reduction? Explain.
5. Compute total revenue at the three meal prices. Do these totals confirm your answers in (b) and (d) above?
5. The text notes that, for any linear demand curve, demand is price elastic in the upper half and price inelastic in the lower half. Consider the following demand curves:
Figure 5.13
The table gives the prices and quantities corresponding to each of the points shown on the two demand curves.
Demand curve D1 [Panel (a)] Demand curve D2 [Panel (b)]
Price Quantity Price Quantity
A 80 2 E 8 20
B 70 3 F 7 30
C 30 7 G 3 70
D 20 8 H 2 80
1. Compute the price elasticity of demand between points A and B and between points C and D on demand curve D1 in Panel (a). Are your results consistent with the notion that a linear demand curve is price elastic in its upper half and price inelastic in its lower half?
2. Compute the price elasticity of demand between points E and F and between points G and H on demand curve D2 in Panel (b). Are your results consistent with the notion that a linear demand curve is price elastic in its upper half and price inelastic in its lower half?
3. Compare total spending at points A and B on D1 in Panel (a). Is your result consistent with your finding about the price elasticity of demand between those two points?
4. Compare total spending at points C and D on D1 in Panel (a). Is your result consistent with your finding about the price elasticity of demand between those two points?
5. Compare total spending at points E and F on D2 in Panel (b). Is your result consistent with your finding about the price elasticity of demand between those two points?
6. Compare total spending at points G and H on D2 in Panel (b). Is your result consistent with your finding about the price elasticity of demand between those two points? | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/05%3A_Elasticity%3A_A_Measure_of_Response/5.4%3A_Review_and_Practice.txt |
Learning Objective
1. Explain the maximization assumption that economists make in explaining the behavior of consumers and firms.
2. Explain and illustrate the concepts of marginal benefit and marginal cost and apply them to understanding the marginal decision rule.
To say that individuals maximize is to say that they pick some objective and then seek to maximize its value. A sprinter might want to maximize his or her speed; a politician might want to maximize the probability that he or she will win the next election. Economists pay special attention to two groups of maximizers: consumers and firms. We assume that consumers seek to maximize utility and that firms seek to maximize economic profit, which is the difference between total revenue and total cost. The costs involved in this concept of economic profit are computed in the economic sense—as the opportunity costs, or value of the best opportunity forgone.
The assumption of maximizing behavior lies at the heart of economic analysis. As we explore its implications, however, we must keep in mind the distinction between models and the real world. Our model assumes that individuals make choices in a way that achieves a maximum value for some clearly defined objective. In using such a model, economists do not assume that people actually go through the calculations we will describe. What economists do argue is that people’s behavior is broadly consistent with such a model. People may not consciously seek to maximize anything, but they behave as though they do.
The Analysis of Maximizing Behavior
The activities of consumers and firms have benefits, and they also have opportunity costs. We assume that given these benefits and costs, consumers and firms will make choices that maximize the net benefit of each activity—the total benefit of the activity minus its opportunity cost. The specific measures of benefit and cost vary with the kind of choice being made. In the case of a firm’s choices in production, for example, the total benefit of production is the revenue a firm receives from selling the product; the total cost is the opportunity cost the firm incurs by producing it. The net benefit is thus total revenue minus total opportunity cost, or economic profit.
Economists maintain that in order to maximize net benefit, consumers and firms evaluate each activity at the margin—they consider the additional benefit and the additional cost of another unit of the activity. Should you “supersize” your order at McDonald’s? Will the additional beverage and the additional french fries be worth the extra cost? Should a firm hire one more worker? Will the benefits to the firm of hiring this worker be worth the additional cost of hiring him or her?
The marginal benefit is the amount by which an additional unit of an activity increases its total benefit. It is the amount by which the extra french fries increase your satisfaction, or the extra revenue the firm expects to bring in by hiring another worker. The marginal cost is the amount by which an additional unit of an activity increases its total cost. You will pay more to supersize your McDonald’s order; the firm’s labor costs will rise when it hires another worker.
To determine the quantity of any activity that will maximize its net benefit, we apply the marginal decision rule: If the marginal benefit of an additional unit of an activity exceeds the marginal cost, the quantity of the activity should be increased. If the marginal benefit is less than the marginal cost, the quantity should be reduced. Net benefit is maximized at the point at which marginal benefit equals marginal cost. The marginal decision rule is at the heart of the economic way of thinking. The rule basically says this: If the additional benefit of one more unit exceeds the extra cost, do it; if not, do not. This simple logic gives us a powerful tool for the analysis of choice. Perhaps more than any other rule in economic analysis, the marginal decision rule typifies the way in which economists analyze problems. We shall apply it in every chapter that follows in the microeconomics portion of this text.
Maximizing choices must be made within the parameters imposed by some constraint, which is a boundary that limits the range of choices that can be made. We assume that a consumer seeks the greatest satisfaction possible within the limits of his or her income or budget. A firm cannot produce beyond the limits of its production capacity at a point in time.
The marginal decision rule forms the foundation for the structure economists use to analyze all choices. At first glance, it may seem that a consumer seeking satisfaction from, say, pizza has little in common with an entrepreneur seeking profit from the production of custom-designed semiconductors. But maximizing choices always follow the marginal decision rule—and that rule holds regardless of what is being maximized or who is doing the maximizing.
To see how the logic of maximizing choices works, we will examine a specific problem. We will then extend that problem to the general analysis of maximizing choices.
A Problem in Maximization
Suppose a college student, Laurie Phan, faces two midterms tomorrow, one in economics and another in accounting. She has already decided to spend 5 hours studying for the two examinations. This decision imposes a constraint on the problem. Suppose that Ms. Phan’s goal is to allocate her 5 hours of study so that she increases her total score for the two exams by as much as possible.
Ms. Phan expects the relationship between the time she spends studying for the economics exam and the total gain in her score to be as given by the second row of the table in Panel (a) of Figure 6.1. We interpret the expected total gain in her score as the total benefit of study. She expects that 1 hour of study will raise her score by 18 points; 2 hours will raise it by 32 points, and so on. These values are plotted in Panel (b). Notice that the total benefit curve rises, but by smaller and smaller amounts, as she studies more and more. The slope of the curve, which in this case tells us the rate at which her expected score rises with increased study time, falls as we travel up and to the right along the curve.
Now look at the third row in the table in Panel (a). It tells us the amount by which each additional hour of study increases her expected score; it gives the marginal benefit of studying for the economics exam. Marginal benefit equals the amount by which total benefit rises with each additional hour of study. Because these marginal benefits are given by the changes in total benefits from additional hours of study, they equal the slope of the total benefit curve. We see this in the relationship between Panels (b) and (c) of Figure 6.1. The decreasing slope of the total benefit curve in Panel (b) gives us the downward-sloping marginal benefit curve in Panel (c).
The marginal benefit curve tells us what happens when we pass from one point to another on the total benefit curve, so we have plotted marginal benefits at the midpoints of the hourly intervals in Panel (c). For example, the total benefit curve in Panel (b) tells us that, when Ms. Phan increases her time studying for the economics exam from 2 hours to 3 hours, her total benefit rises from 32 points to 42 points. The increase of 10 points is the marginal benefit of increasing study time for the economics exam from 2 hours to 3 hours. We mark the point for a marginal benefit of 10 points midway between 2 and 3 hours. Because marginal values tell us what happens as we pass from one quantity to the next, we shall always plot them at the midpoints of intervals of the variable on the horizontal axis.
We can perform the same kind of analysis to obtain the marginal benefit curve for studying for the accounting exam. Figure 6.2 presents this curve. Like the marginal benefit curve for studying economics, it slopes downward. Once again, we have plotted marginal values at the midpoints of the intervals. Increasing study time in accounting from 0 to 1 hour increases Ms. Phan’s expected accounting score by 14 points.
Ms. Phan’s marginal benefit curves for studying typify a general phenomenon in economics. Marginal benefit curves for virtually all activities, including the activities of consumers and of firms, slope downward. Think about your own experience with studying. On a given day, the first hour spent studying a certain subject probably generates a greater marginal benefit than the second, and the second hour probably generates a greater marginal benefit than the third. You may reach a point at which an extra hour of study is unlikely to yield any benefit at all. Of course, our example of Laurie Phan’s expected exam scores is a highly stylized one. One could hardly expect a student to have a precise set of numbers to guide him or her in allocating study time. But it is certainly the case that students have a rough idea of the likely payoff of study time in different subjects. If you were faced with exams in two subjects, it is likely that you would set aside a certain amount of study time, just as Ms. Phan did in our example. And it is likely that your own experience would serve as a guide in determining how to allocate that time. Economists do not assume that people have numerical scales in their heads with which to draw marginal benefit and marginal cost curves. They merely assume that people act as if they did.
The nature of marginal benefits can change with different applications. For a restaurant, the marginal benefit of serving one more meal can be defined as the revenue that meal produces. For a consumer, the marginal benefit of one more slice of pizza can be considered in terms of the additional satisfaction the pizza will create. But whatever the nature of the benefit, marginal benefits generally fall as quantities increase.
Ms. Phan’s falling marginal benefit from hours spent studying accounting has special significance for our analysis of her choice concerning how many hours to devote to economics. In our problem, she had decided to devote 5 hours to studying the two subjects. That means that the opportunity cost of an hour spent studying economics equals the benefit she would have gotten spending that hour studying accounting.
Suppose, for example, that she were to consider spending all 5 hours studying accounting. The marginal benefit curve for studying for her accounting exam tells us that she expects that the fifth hour will add nothing to her score. Shifting that hour to economics would cost nothing. We can say that the marginal cost of the first hour spent studying economics is zero. We obtained this value from the marginal benefit curve for studying accounting in Figure 6.2.
Similarly, we can find the marginal cost of the second hour studying economics. That requires giving up the fourth hour spent on accounting. Figure 6.2 tells us that the marginal benefit of that hour equals 2—that is the marginal cost of spending the second hour studying economics.
Figure 6.3 shows the marginal cost curve of studying economics. We see that at first, time devoted to studying economics has a low marginal cost. As time spent studying economics increases, however, it requires her to give up study time in accounting that she expects will be more and more productive. The marginal cost curve for studying economics can thus be derived from the marginal benefit curve for studying accounting. Figure 6.3 also shows the marginal benefit curve for studying economics that we derived in Panel (b) of Figure 6.1.
Just as marginal benefit curves generally slope downward, marginal cost curves generally slope upward, as does the one in Figure 6.3. In the case of allocating time, the phenomenon of rising marginal cost results from the simple fact that, the more time a person devotes to one activity, the less time is available for another. And the more one reduces the second activity, the greater the forgone marginal benefits are likely to be. That means the marginal cost curve for that first activity rises.
Because we now have marginal benefit and marginal cost curves for studying economics, we can apply the marginal decision rule. This rule says that, to maximize the net benefit of an activity, a decision maker should increase an activity up to the point at which marginal benefit equals marginal cost. That occurs where the marginal benefit and marginal cost curves intersect, with 3 hours spent studying economics and 2 hours spent studying accounting.
Using Marginal Benefit and Marginal Cost Curves to Find Net Benefits
We can use marginal benefit and marginal cost curves to show the total benefit, the total cost, and the net benefit of an activity. We will see that equating marginal benefit to marginal cost does, indeed, maximize net benefit. We will also develop another tool to use in interpreting marginal benefit and cost curves.
Panel (a) of Figure 6.4 shows the marginal benefit curve we derived in Panel (c) of Figure 6.1. The corresponding point on the marginal benefit curve gives the marginal benefit of the first hour of study for the economics exam, 18 points. This same value equals the area of the rectangle bounded by 0 and 1 hour of study and the marginal benefit of 18. Similarly, the marginal benefit of the second hour, 14 points, is shown by the corresponding point on the marginal benefit curve and by the area of the shaded rectangle bounded by 1 and 2 hours of study. The total benefit of 2 hours of study equals the sum of the areas of the first two rectangles, 32 points. We continue this procedure through the fifth hour of studying economics; the areas for each of the shaded rectangles are shown in the graph.
Two features of the curve in Panel (a) of Figure 6.4 are particularly important. First, note that the sum of the areas of the five rectangles, 50 points, equals the total benefit of 5 hours of study given in the table in Panel (a) of Figure 6.1. Second, notice that the shaded areas are approximately equal to the area under the marginal benefit curve between 0 and 5 hours of study. We can pick any quantity of study time, and the total benefit of that quantity equals the sum of the shaded rectangles between zero and that quantity. Thus, the total benefit of 2 hours of study equals 32 points, the sum of the areas of the first two rectangles.
Now consider the marginal cost curve in Panel (b) of Figure 6.4. The areas of the shaded rectangles equal the values of marginal cost. The marginal cost of the first hour of study equals zero; there is thus no rectangle under the curve. The marginal cost of the second hour of study equals 2 points; that is the area of the rectangle bounded by 1 and 2 hours of study and a marginal cost of 2. The marginal cost of the third hour of study is 6 points; this is the area of the shaded rectangle bounded by 2 and 3 hours of study and a marginal cost of 6.
Looking at the rectangles in Panel (b) over the range of 0 to 5 hours of study, we see that the areas of the five rectangles total 32, the total cost of spending all 5 hours studying economics. And looking at the rectangles, we see that their area is approximately equal to the area under the marginal cost curve between 0 and 5 hours of study.
We have seen that the areas of the rectangles drawn with Laurie Phan’s marginal benefit and marginal cost curves equal the total benefit and total cost of studying economics. We have also seen that these areas are roughly equal to the areas under the curves themselves. We can make this last statement much stronger. Suppose, instead of thinking in intervals of whole hours, we think in terms of smaller intervals, say, of 12 minutes. Then each rectangle would be only one-fifth as wide as the rectangles we drew in Figure 6.4. Their areas would still equal the total benefit and total cost of study, and the sum of those areas would be closer to the area under the curves. We have done this for Ms. Phan’s marginal benefit curve in Figure 6.5; notice that the areas of the rectangles closely approximate the area under the curve. They still “stick out” from either side of the curve as did the rectangles we drew in Figure 6.4, but you almost need a magnifying glass to see that. The smaller the interval we choose, the closer the areas under the marginal benefit and marginal cost curves will be to total benefit and total cost. For purposes of our model, we can imagine that the intervals are as small as we like. Over a particular range of quantity, the area under a marginal benefit curve equals the total benefit of that quantity, and the area under the marginal cost curve equals the total cost of that quantity.
Panel (a) of Figure 6.6 shows marginal benefit and marginal cost curves for studying economics, this time without numbers. We have the usual downward-sloping marginal benefit curve and upward-sloping marginal cost curve. The marginal decision rule tells us to choose D hours studying economics, the quantity at which marginal benefit equals marginal cost at point C. We know that the total benefit of study equals the area under the marginal benefit curve over the range from A to D hours of study, the area ABCD. Total cost equals the area under the marginal cost curve over the same range, or ACD. The difference between total benefit and total cost equals the area between marginal benefit and marginal cost between A and D hours of study; it is the green-shaded triangle ABC. This difference is the net benefit of time spent studying economics. Panel (b) of Figure 6.6 introduces another important concept. If an activity is carried out at a level less than the efficient level, then net benefits are forgone. The loss in net benefits resulting from a failure to carry out an activity at the efficient level is called a deadweight loss.
Now suppose a person increases study time from D to J hours as shown in Panel (c). The area under the marginal cost curve between D and J gives the total cost of increasing study time; it is DCHJ. The total benefit of increasing study time equals the area under the marginal benefit curve between D and J; it is DCIJ. The cost of increasing study time in economics from D hours to J hours exceeds the benefit. This gives us a deadweight loss of CHI. The net benefit of spending J hours studying economics equals the net benefit of studying for D hours less the deadweight loss, or ABC minus CHI. Only by studying up to the point at which marginal benefit equals marginal cost do we achieve the maximum net benefit shown in Panel (a).
We can apply the marginal decision rule to the problem in Figure 6.6 in another way. In Panel (b), a person studies economics for E hours. Reading up to the marginal benefit curve, we reach point G. Reading up to the marginal cost curve, we reach point F. Marginal benefit at G exceeds marginal cost at F; the marginal decision rule says economics study should be increased, which would take us toward the intersection of the marginal benefit and marginal cost curves. Spending J hours studying economics, as shown in Panel (c), is too much. Reading up to the marginal benefit and marginal cost curves, we see that marginal cost exceeds marginal benefit, suggesting that study time be reduced.
This completes our introduction to the marginal decision rule and the use of marginal benefit and marginal cost curves. We will spend the remainder of the chapter applying the model.
Heads Up!
It is easy to make the mistake of assuming that if an activity is carried out up to the point where marginal benefit equals marginal cost, then net benefits must be zero. Remember that following the marginal decision rule and equating marginal benefits and costs maximizes net benefits. It makes the difference between total benefits and total cost as large as possible.
Key Takeaways
• Economists assume that decision makers make choices in the way that maximizes the value of some objective.
• Maximization involves determining the change in total benefit and the change in total cost associated with each unit of an activity. These changes are called marginal benefit and marginal cost, respectively.
• If the marginal benefit of an activity exceeds the marginal cost, the decision maker will gain by increasing the activity.
• If the marginal cost of an activity exceeds the marginal benefit, the decision maker will gain by reducing the activity.
• The area under the marginal benefit curve for an activity gives its total benefit; the area under the marginal cost curve gives the activity’s total cost. Net benefit equals total benefit less total cost.
• The marginal benefit rule tells us that we can maximize the net benefit of any activity by choosing the quantity at which marginal benefit equals marginal cost. At this quantity, the net benefit of the activity is maximized.
Try It!
Suppose Ms. Phan still faces the exams in economics and in accounting, and she still plans to spend a total of 5 hours studying for the two exams. However, she revises her expectations about the degree to which studying economics and accounting will affect her scores on the two exams. She expects studying economics will add somewhat less to her score, and she expects studying accounting will add more. The result is the table below of expected total benefits and total costs of hours spent studying economics. Notice that several values in the table have been omitted. Fill in the missing values in the table. How many hours of study should Ms. Phan devote to economics to maximize her net benefit?
Hours studying economics 0 1 2 3 4 5
Total benefit 0 14 24 30 32
Total cost 0 2 8 32 50
Net benefit 0 12 12 0 −18
Now compute the marginal benefits and costs of hours devoted to studying economics, completing the table below.
Figure 6.7
Draw the marginal benefit and marginal cost curves for studying economics (remember to plot marginal values at the midpoints of the respective hourly intervals). Do your curves intersect at the “right” number of hours of study—the number that maximizes the net benefit of studying economics?
Case in Point: Preventing Oil Spills
Figure 6.8
Do we spill enough oil in our oceans and waterways? It is a question that perhaps only economists would ask—and, as economists, we should ask it.
There is, of course, no virtue in an oil spill. It destroys wildlife and fouls shorelines. Cleanup costs can be tremendous. However, Preventing oil spills has costs as well: greater enforcement expenditures and higher costs to shippers of oil and, therefore, higher costs of goods such as gasoline to customers. The only way to prevent oil spills completely is to stop shipping oil. That is a cost few people would accept. But what is the right balance between environmental protection and the satisfaction of consumer demand for oil?
Vanderbilt University economist Mark Cohen examined the U.S. Coast Guard’s efforts to reduce oil spills through its enforcement of shipping regulations in coastal waters and on rivers. He focused on the costs and benefits resulting from the Coast Guard’s enforcement efforts in 1981. On the basis of the frequency of oil spills before the Coast Guard began its enforcement, Mr. Cohen estimated that the Coast Guard prevented 1,159,352 gallons of oil from being spilled in 1981.
Given that there was a total of 824,921 gallons of oil actually spilled in 1981, should the Coast Guard have attempted to prevent even more spillage? Mr. Cohen estimated that the marginal benefit of preventing one more gallon from being spilled was \$7.27 (\$3.42 in cleanup costs, \$3 less in environmental damage, and \$0.85 worth of oil saved). The marginal cost of preventing one more gallon from being spilled was \$5.50. Mr. Cohen suggests that because the marginal benefit of more vigorous enforcement exceeded the marginal cost, more vigorous Coast Guard efforts would have been justified.
More vigorous efforts have, indeed, been pursued. In 1989, the Exxon oil tanker Exxon Valdez ran aground, spilling 10.8 million gallons of oil off the coast of Alaska. The spill damaged the shoreline of a national forest, four national wildlife refuges, three national parks, five state parks, four critical habitat areas, and a state game refuge. Exxon was ordered to pay \$900 million in damages; a federal jury found Exxon and the captain guilty of criminal negligence and imposed an additional \$5 billion in punitive damages. In 2008, The Supreme Court reduced the assessment of punitive damages to \$507 million, with the majority arguing that the original figure was too high in comparison to the compensatory damages for a case in which the actions of the defendant, Exxon, were “reprehensible” but not intentional.
Perhaps the most important impact of the Exxon Valdez disaster was the passage of the Oil Pollution Act of 1990. It increased shipper liability from \$14 million to \$100 million. It also required double-hulled tankers for shipping oil.
The European Union (EU) has also strengthened its standards for oil tankers. The 2002 breakup of the oil tanker Prestige off the coast of Spain resulted in the spillage of 3.2 million gallons of oil. The EU had planned to ban single-hulled tankers, phasing in the ban between 2003 and 2015. The sinking of the Prestige led the EU to move up that deadline.
Spill crises have led both the United States and the European Union to tighten up their regulations of oil tankers. The result has been a reduction in the quantity of oil spilled, which was precisely what economic research had concluded was needed. By 2002, the amount of oil spilled per barrel shipped had fallen 30% from the level three decades earlier.
Answer to Try It! Problem
Here are the completed data table and the table showing total and marginal benefit and cost.
Figure 6.9
Ms. Phan maximizes her net benefit by reducing her time studying economics to 2 hours. The change in her expectations reduced the benefit and increased the cost of studying economics. The completed graph of marginal benefit and marginal cost is at the far left. Notice that answering the question using the marginal decision rule gives the same answer. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/06%3A_Markets_Maximizers_and_Efficiency/6.1%3A_The_Logic_of_Maximizing_Behavior.txt |
Learning Objective
1. Explain what is meant by an efficient allocation of resources in an economy and describe the market conditions that must exist to achieve this goal.
2. Define consumer and producer surplus.
3. Discuss the relationship between efficiency and equity.
In perhaps the most influential book in economics ever written, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, Adam Smith argued that the pursuit of self-interest in a marketplace would promote the general interest. He said resources would be guided, as if by an “invisible hand,” to their best uses. That invisible hand was the marketplace.
Smith’s idea was radical for its time; he saw that the seemingly haphazard workings of the marketplace could promote the common good. In this section, we will use the tools we have developed thus far to see the power of Smith’s invisible hand. Efforts by individuals to maximize their own net benefit can maximize net benefit for the economy as a whole.
When the net benefits of all economic activities are maximized, economists say the allocation of resources is efficient. This concept of efficiency is broader than the notion of efficient production that we encountered when discussing the production possibilities curve. There, we saw that the economy’s factors of production would be efficient in production if they were allocated according to the principle of comparative advantage. That meant producing as much as possible with the factors of production available. The concept of an efficient allocation of resources incorporates production, as in that discussion, but it includes efficiency in the consumption of goods and services as well.
Achieving Efficiency
Imagine yourself arriving at the store to purchase some food. In your choice, you will weigh your own benefits and costs to maximize your net benefit. The farmers, the distributors, and the grocer have sought to maximize their net benefits as well. How can we expect that all those efforts will maximize net benefits for the economy as a whole? How can we expect the marketplace to achieve an efficient allocation of food, or of anything else?
One condition that must be met if the market’s allocation is to be efficient is that the marketplace must be competitive or function as if it were. We will have a great deal more to say about competitive markets versus less competitive ones in subsequent chapters. For now, we can simply note that a competitive market is one with many buyers and sellers in each market and in which entry and exit are fairly easy. No one controls the price; the forces of demand and supply determine price.
The second condition that must hold if the market is to achieve an efficient allocation concerns property rights. We turn to that topic in the next section.
The Role of Property Rights
A smoothly functioning market requires that producers possess property rights to the goods and services they produce and that consumers possess property rights to the goods and services they buy. Property rights are a set of rules that specify the ways in which an owner can use a resource.
Consider the tomato market. Farmers who grow tomatoes have clearly defined rights to their land and to the tomatoes they produce and sell. Distributors who purchase tomatoes from farmers and sell them to grocers have clear rights to the tomatoes until they sell them to grocers. The grocers who purchase the tomatoes retain rights to them until they sell them to consumers. When you buy a tomato, you have the exclusive right to its use.
A system of property rights forms the basis for all market exchange. Before exchange can begin, there must be a clear specification of who owns what. The system of property rights must also show what purchasers are acquiring when they buy rights to particular resources. Because property rights must exist if exchange is to occur, and because exchange is the process through which economic efficiency is achieved, a system of property rights is essential to the efficient allocation of resources.
Imagine what would happen in the market for tomatoes if property rights were not clearly defined. Suppose, for example, that grocers could not legally prevent someone from simply grabbing some tomatoes and leaving without paying for them. If that were the case, grocers would not be likely to offer tomatoes for sale. If it were the case for all grocery items, there would not be grocery stores at all.
Although property rights vary for different resources, two characteristics are required if the marketplace is to achieve an efficient allocation of resources:
1. Property rights must be exclusive. An exclusive property right is one that allows its owner to prevent others from using the resource. The owner of a house, for example, has the right to exclude others from the use of the house. If this right did not exist, ownership would have little value; it is not likely that the property could be exchanged in a market. And the inability to sell property would limit the incentive of owners to maintain it.
2. Property rights must be transferable. A transferable property right is one that allows the owner of a resource to sell or lease it to someone else. In the absence of transferability, no exchange could occur.
Markets and the Efficiency Condition
A competitive market with well-defined and transferable property rights satisfies the efficiency condition. If met, we can assume that the market’s allocation of resources will be efficient.
Consider again your purchase of tomatoes. Suppose the curves of demand and supply for tomatoes are those given in Figure 6.10; the equilibrium price equals \$1.50 per pound. Suppose further that the market satisfies the efficiency condition. With that assumption, we can relate the model of demand and supply to our analysis of marginal benefits and costs.
The demand curve tells us that the last pound of tomatoes was worth \$1.50; we can think of that as the marginal benefit of the last pound of tomatoes since that is how much consumers were willing to pay. We can say that about any price on a market demand curve; a demand curve can be considered as a marginal benefit curve. Similarly, the supply curve can be considered the marginal cost curve. In the case of the tomato market, for example, the price tells us that the marginal cost of producing the last pound of tomatoes is \$1.50. This marginal cost is considered in the economic sense—other goods and services worth \$1.50 were not produced in order to make an additional pound of tomatoes available.
On what basis can we presume that the price of a pound of tomatoes equals its marginal cost? The answer lies in our marginal decision rule. Profit-maximizing tomato producers will produce more tomatoes as long as their marginal benefit exceeds their marginal cost. What is the marginal benefit to a producer of an extra pound of tomatoes? It is the price that the producer will receive. What is the marginal cost? It is the value that must be given up to produce an extra pound of tomatoes.
Producers maximize profit by expanding their production up to the point at which their marginal cost equals their marginal benefit, which is the market price. The price of \$1.50 thus reflects the marginal cost to society of making an additional pound of tomatoes available.
At the equilibrium price and output of tomatoes, then, the marginal benefit of tomatoes to consumers, as reflected by the price they are willing to pay, equals the marginal cost of producing tomatoes. Where marginal benefit equals marginal cost, net benefit is maximized. The equilibrium quantity of tomatoes, as determined by demand and supply, is efficient.
Producer and Consumer Surplus
Think about the last thing you purchased. You bought it because you expected that its benefits would exceed its opportunity cost; you expected that the purchase would make you better off. The seller sold it to you because he or she expected that the money you paid would be worth more than the value of keeping the item. The seller expected to be better off as a result of the sale. Exchanges in the marketplace have a remarkable property: Both buyers and sellers expect to emerge from the transaction better off.
Panel (a) of Figure 6.11 shows a market demand curve for a particular good. Suppose the price equals OB and the quantity equals OE. The area under the demand curve over the range of quantities from the origin at O to the quantity at E equals the total benefit of consuming OE units of the good. It is the area OCDE. Consumers pay for this benefit; their total expenditures equal the rectangle OBDE, which is the dark shaded region in the graph. Because the total benefits exceed total expenditures, there is a consumer surplus given by the triangle BCD. Consumer surplus is the amount by which the total benefits to consumers from consuming a good exceed their total expenditures on the good.
Producer surplus [Panel b)] measures the difference between total revenue received by firms at a given quantity of output and the total cost of producing it. Here, total revenue is given by the rectangle OBDE, and total costs are given by the area OADE. The difference, shown by the triangle ABD is producer surplus.
Now consider the sellers’ side of transactions. Panel (b) of Figure 6.11 shows a market supply curve; recall that it gives us marginal cost. Suppose the market price equals OB and quantity supplied is OE; those are the same values we had in Panel (a). The price times the quantity equals the total revenue received by sellers. It is shown as the shaded rectangle OBDE. The total revenue received by sellers equals total expenditures by consumers.
The total cost to sellers is the area under the marginal cost curve; it is the area OADE. That cost is less than revenue. The difference between the total revenue received by sellers and their total cost is called producer surplus. In Panel (b) it is the light-shaded triangle ABD.
We put the demand and supply curves of Figure 6.11 Panels (a) and (b) together in Figure 6.12. The intersection of the two curves determines the equilibrium price, OB, and the equilibrium quantity, OE. The shaded regions give us consumer and producer surplus. The sum of these two surpluses is net benefit. This net benefit is maximized where the demand and supply curves intersect.
Efficiency and Equity
Consumer demands are affected by incomes. Demand, after all, reflects ability as well as willingness to pay for goods and services. The market will be more responsive to the preferences of people with high incomes than to those of people with low incomes.
In a market that satisfies the efficiency condition, an efficient allocation of resources will emerge from any particular distribution of income. Different income distributions will result in different, but still efficient, outcomes. For example, if 1% of the population controls virtually all the income, then the market will efficiently allocate virtually all its production to those same people.
What is a fair, or equitable, distribution of income? What is an unfair distribution? Should everyone have the same income? Is the current distribution fair? Should the rich have less and the poor have more? Should the middle class have more? Equity is very much in the mind of the observer. What may seem equitable to one person may seem inequitable to another. There is, however, no test we can apply to determine whether the distribution of income is or is not equitable. That question requires a normative judgment.
Determining whether the allocation of resources is or is not efficient is one problem. Determining whether the distribution of income is fair is another. The governments of all nations act in some way to redistribute income. That fact suggests that people generally have concluded that leaving the distribution of income solely to the market would not be fair and that some redistribution is desirable. This may take the form of higher taxes for people with higher incomes than for those with lower incomes. It may take the form of special programs, such as welfare programs, for low-income people.
Whatever distribution society chooses, an efficient allocation of resources is still preferred to an inefficient one. Because an efficient allocation maximizes net benefits, the gain in net benefits could be distributed in a way that leaves all people better off than they would be at any inefficient allocation. If an efficient allocation of resources seems unfair, it must be because the distribution of income is unfair.
Key Takeaways
• In a competitive system in which the interaction of demand and supply determine prices, the corresponding demand and supply curves can be considered marginal benefit and marginal cost curves, respectively.
• An efficient allocation of resources is one that maximizes the net benefit of each activity. We expect it to be achieved in markets that satisfy the efficiency condition, which requires a competitive market and well-defined, transferable property rights.
• Consumer surplus is the amount by which the total benefit to consumers from some activity exceeds their total expenditures for it.
• Producer surplus is the amount by which the total revenues of producers exceed their total costs.
• An inequitable allocation of resources implies that the distribution of income and wealth is inequitable. Judgments about equity are normative judgments.
Try It!
Draw hypothetical demand and supply curves for a typical product, say coffee. Now show the areas of consumer and producer surplus. Under what circumstances is the market likely to be efficient?
Case in Point: Saving the Elephant Through Property Rights
Figure 6.13
The African elephant, the world’s largest land mammal, seemed to be in danger of extinction in the 20th century. The population of African elephants fell from 1.3 million in 1979 to 543,000 in 1994. The most dramatic loss of elephants came in Kenya, where the population fell from 167,000 early in the 1970s to about 26,000 in 1997, according to the World Wildlife Fund. To combat the slaughter, an international agreement, the Convention on International Trade in Endangered Species of Wild Flora and Fauna (CITES), went into effect in 1989. It banned the sale of ivory.
Despite CITES and armed patrols with orders to shoot poachers on sight, the poachers continued to operate in Kenya, killing roughly 200 elephants per day. The elephants were killed for their ivory; the tusks from a single animal could be sold for \$2,000 in the black market—nearly double the annual per capita income in Kenya.
Several African nations, however, have taken a radically different approach. They have established exclusive, transferable property rights in licenses to hunt elephants. In each of these nations, elephant populations have increased. These nations include Botswana, Namibia, South Africa, Tanzania, Zambia, and Zimbabwe. In Botswana, for example, the elephant population increased from 20,000 in 1981 to 80,000 in 2000. Zimbabwe increased its elephant population from 30,000 in 1978 to nearly 90,000 in 2000.
Professors Michael A. McPherson and Michael L. Nieswiadomy of the University of North Texas have done a statistical analysis of the determinants of elephant populations in 35 African nations. They found that elephant populations increased in nations that had (a) established exclusive, transferable property rights in licenses to hunt elephants and (b) had stable political systems. Conversely, elephant populations declined in countries that had failed to establish property rights and that had unstable political systems.
The same appears to be true of the white rhinoceros, a creature whose horns are highly valued in Asia as an aphrodisiac. South Africa sells permits to hunt the creatures for \$25,000 per animal. Its rhinoceros herd has increased from 20 in 1900 to more than 7,000 by the late 1990s.
There is no “secret” to the preservation of species. Establishing clearly defined, transferable property rights virtually assures the preservation of species. Whether it be buffaloes, rhinoceroses, or elephants, property rights establish a market, and that market preserves species.
Answer to Try It! Problem
Figure 6.14
On the assumption that the coffee market is competitive and that it is characterized by well-defined exclusive and transferable property rights, the coffee market meets the efficiency condition. That means that the allocation of resources shown at the equilibrium will be the one that maximizes the net benefit of all activities. The net benefit is shared by coffee consumers (as measured by consumer surplus) and coffee producers (as measured by producer surplus). | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/06%3A_Markets_Maximizers_and_Efficiency/6.2%3A_Maximizing_in_the_Marketplace.txt |
Learning Objective
1. Explain what is meant by market failure and the conditions that may lead to it.
2. Distinguish between private goods and public goods and relate them to the free rider problem and the role of government.
3. Explain the concepts of external costs and benefits and the role of government intervention when they are present.
4. Explain why a common property resource is unlikely to be allocated efficiently in the marketplace.
Private decisions in the marketplace may not be consistent with the maximization of the net benefit of a particular activity. The failure of private decisions in the marketplace to achieve an efficient allocation of scarce resources is called market failure. Markets will not generate an efficient allocation of resources if they are not competitive or if property rights are not well defined and fully transferable. Either condition will mean that decision makers are not faced with the marginal benefits and costs of their choices.
Think about the drive that we had you take at the beginning of this chapter. You faced some, but not all, of the opportunity costs involved in that choice. In particular, your choice to go for a drive would increase air pollution and might increase traffic congestion. That means that, in weighing the marginal benefits and marginal costs of going for a drive, not all of the costs would be counted. As a result, the net benefit of the allocation of resources such as the air might not be maximized.
Noncompetitive Markets
The model of demand and supply assumes that markets are competitive. No one in these markets has any power over the equilibrium price; each consumer and producer takes the market price as given and responds to it. Under such conditions, price is determined by the intersection of demand and supply.
In some markets, however, individual buyers or sellers are powerful enough to influence the market price. In subsequent chapters, we will study cases in which producers or consumers are in a position to affect the prices they charge or must pay, respectively. We shall find that when individual firms or groups of firms have market power, which is the ability to change the market price, the price will be distorted—it will not equal marginal cost.
Public Goods
Some goods are unlikely to be produced and exchanged in a market because of special characteristics of the goods themselves. The benefits of these goods are such that exclusion is not feasible. Once they are produced, anyone can enjoy them; there is no practical way to exclude people who have not paid for them from consuming them. Furthermore, the marginal cost of adding one more consumer is zero. A good for which the cost of exclusion is prohibitive and for which the marginal cost of an additional user is zero is a public good. A good for which exclusion is possible and for which the marginal cost of another user is positive is a private good.
National defense is a public good. Once defense is provided, it is not possible to exclude people who have not paid for it from its consumption. Further, the cost of an additional user is zero—an army does not cost any more if there is one more person to be protected. Other examples of public goods include law enforcement, fire protection, and efforts to preserve species threatened with extinction.
Free Riders
Suppose a private firm, Terror Alert, Inc., develops a completely reliable system to identify and intercept 98% of any would-be terrorists that might attempt to enter the United States from anywhere in the world. This service is a public good. Once it is provided, no one can be excluded from the system’s protection on grounds that he or she has not paid for it, and the cost of adding one more person to the group protected is zero. Suppose that the system, by eliminating a potential threat to U.S. security, makes the average person in the United States better off; the benefit to each household from the added security is worth \$40 per month (about the same as an earthquake insurance premium). There are roughly 113 million households in the United States, so the total benefit of the system is \$4.5 billion per month. Assume that it will cost Terror Alert, Inc., \$1 billion per month to operate. The benefits of the system far outweigh the cost.
Suppose that Terror Alert installs its system and sends a bill to each household for \$20 for the first month of service—an amount equal to half of each household’s benefit. If each household pays its bill, Terror Alert will enjoy a tidy profit; it will receive revenues of more than \$2.25 billion per month.
But will each household pay? Once the system is in place, each household would recognize that it will benefit from the security provided by Terror Alert whether it pays its bill or not. Although some households will voluntarily pay their bills, it seems unlikely that very many will. Recognizing the opportunity to consume the good without paying for it, most would be free riders. Free riders are people or firms that consume a public good without paying for it. Even though the total benefit of the system is \$4.5 billion, Terror Alert will not be faced by the marketplace with a signal that suggests that the system is worthwhile. It is unlikely that it will recover its cost of \$1 billion per month. Terror Alert is not likely to get off the ground.
The bill for \$20 from Terror Alert sends the wrong signal, too. An efficient market requires a price equal to marginal cost. But the marginal cost of protecting one more household is zero; adding one more household adds nothing to the cost of the system. A household that decides not to pay Terror Alert anything for its service is paying a price equal to its marginal cost. But doing that, being a free rider, is precisely what prevents Terror Alert from operating.
Because no household can be excluded and because the cost of an extra household is zero, the efficiency condition will not be met in a private market. What is true of Terror Alert, Inc., is true of public goods in general: they simply do not lend themselves to private market provision.
Public Goods and the Government
Because many individuals who benefit from public goods will not pay for them, private firms will produce a smaller quantity of public goods than is efficient, if they produce them at all. In such cases, it may be desirable for government agencies to step in. Government can supply a greater quantity of the good by direct provision, by purchasing the public good from a private agency, or by subsidizing consumption. In any case, the cost is financed through taxation and thus avoids the free-rider problem.
Most public goods are provided directly by government agencies. Governments produce national defense and law enforcement, for example. Private firms under contract with government agencies produce some public goods. Park maintenance and fire services are public goods that are sometimes produced by private firms. In other cases, the government promotes the private consumption or production of public goods by subsidizing them. Private charitable contributions often support activities that are public goods; federal and state governments subsidize these by allowing taxpayers to reduce their tax payments by a fraction of the amount they contribute.
While the market will produce some level of public goods in the absence of government intervention, we do not expect that it will produce the quantity that maximizes net benefit. Figure 6.15 illustrates the problem. Suppose that provision of a public good such as national defense is left entirely to private firms. It is likely that some defense services would be produced; suppose that equals Q1 units per period. This level of national defense might be achieved through individual contributions. But it is very unlikely that contributions would achieve the correct level of defense services. The efficient quantity occurs where the demand, or marginal benefit, curve intersects the marginal cost curve, at Q*. The deadweight loss is the shaded area ABC; we can think of this as the net benefit of government intervention to increase the production of national defense from Q1 up to the efficient quantity, Q*.
Heads Up!
Note that the definitions of public and private goods are based on characteristics of the goods themselves, not on whether they are provided by the public or the private sector. Postal services are a private good provided by the public sector. The fact that these goods are produced by a government agency does not make them a public good.
External Costs and Benefits
Suppose that in the course of production, the firms in a particular industry generate air pollution. These firms thus impose costs on others, but they do so outside the context of any market exchange—no agreement has been made between the firms and the people affected by the pollution. The firms thus will not be faced with the costs of their action. A cost imposed on others outside of any market exchange is an external cost.
We saw an example of an external cost in our imaginary decision to go for a drive. Here is another: violence on television, in the movies, and in video games. Many critics argue that the violence that pervades these media fosters greater violence in the real world. By the time a child who spends the average amount of time watching television finishes elementary school, he or she will have seen 100,000 acts of violence, including 8,000 murders, according to the American Psychological Association. Thousands of studies of the relationship between violence in the media and behavior have concluded that there is a link between watching violence and violent behaviors. Video games are a major element of the problem, as young children now spend hours each week playing them. Fifty percent of fourth-grade graders say that their favorite video games are the “first person shooter” type1.
Any tendency of increased violence resulting from increased violence in the media constitutes an external cost of such media. The American Academy of Pediatrics reported in 2001 that homicides were the fourth leading cause of death among children between the ages of 10 and 14 and the second leading cause of death for people aged 15 to 24 and has recommended a reduction in exposure to media violence (Rosenberg, M., 2003). It seems reasonable to assume that at least some of these acts of violence can be considered an external cost of violence in the media.
An action taken by a person or firm can also create benefits for others, again in the absence of any market agreement; such a benefit is called an external benefit. A firm that builds a beautiful building generates benefits to everyone who admires it; such benefits are external.
External Costs and Efficiency
The case of the polluting firms is illustrated in Figure 6.16. The industry supply curve S1 reflects private marginal costs, MCp. The market price is Pp for a quantity Qp. This is the solution that would occur if firms generating external costs were not forced to pay those costs. If the external costs generated by the pollution were added, the new supply curve S2 would reflect higher marginal costs, MCe. Faced with those costs, the market would generate a lower equilibrium quantity, Qe. That quantity would command a higher price, Pe. The failure to confront producers with the cost of their pollution means that consumers do not pay the full cost of the good they are purchasing. The level of output and the level of pollution are therefore higher than would be economically efficient. If a way could be found to confront producers with the full cost of their choices, then consumers would be faced with a higher cost as well. Figure 6.16 shows that consumption would be reduced to the efficient level, Qe, at which demand and the full marginal cost curve (MCe) intersect. The deadweight loss generated by allowing the external cost to be generated with an output of Qp is given as the shaded region in the graph.
External Costs and Government Intervention
If an activity generates external costs, the decision makers generating the activity will not be faced with its full costs. Agents who impose these costs will carry out their activities beyond the efficient level; those who consume them, facing too low a price, will consume too much. As a result, producers and consumers will carry out an excessive quantity of the activity. In such cases, government may try to intervene to reduce the level of the activity toward the efficient quantity. In the case shown in Figure 6.16, for example, firms generating an external cost have a supply curve S1 that reflects their private marginal costs, MCp. A per-unit pollution fee imposed on the firms would increase their marginal costs to MCe, thus shifting the supply curve to S2, and the efficient level of production would emerge. Taxes or other restrictions may be imposed on the activity that generates the external cost in an effort to confront decision makers with the costs that they are imposing. In many areas, firms and consumers that pollute rivers and lakes are required to pay fees based on the amount they pollute. Firms in many areas are required to purchase permits in order to pollute the air; the requirement that permits be purchased serves to confront the firms with the costs of their choices.
Another approach to dealing with problems of external costs is direct regulation. For example, a firm may be ordered to reduce its pollution. A person who turns his or her front yard into a garbage dump may be ordered to clean it up. Participants at a raucous party may be told to be quiet. Alternative ways of dealing with external costs are discussed later in the text.
Common Property Resources
Common property resources are resources for which no property rights have been defined. The difficulty with common property resources is that individuals may not have adequate incentives to engage in efforts to preserve or protect them. Consider, for example, the relative fates of cattle and buffalo in the United States in the nineteenth century. Cattle populations increased throughout the century, while the buffalo nearly became extinct. The chief difference between the two animals was that exclusive property rights existed for cattle but not for buffalo.
Owners of cattle had an incentive to maintain herd sizes. A cattle owner who slaughtered all of his or her cattle without providing for replacement of the herd would not have a source of future income. Cattle owners not only maintained their herds but also engaged in extensive efforts to breed high-quality livestock. They invested time and effort in the efficient management of the resource on which their livelihoods depended.
Buffalo hunters surely had similar concerns about the maintenance of buffalo herds, but they had no individual stake in doing anything about them—the animals were a common property resource. Thousands of individuals hunted buffalo for a living. Anyone who cut back on hunting in order to help to preserve the herd would lose income—and face the likelihood that other hunters would go on hunting at the same rate as before.
Today, exclusive rights to buffalo have been widely established. The demand for buffalo meat, which is lower in fat than beef, has been increasing, but the number of buffalo in the United States is rising rapidly. If buffalo were still a common property resource, that increased demand, in the absence of other restrictions on hunting of the animals, would surely result in the elimination of the animal. Because there are exclusive, transferable property rights in buffalo and because a competitive market brings buyers and sellers of buffalo and buffalo products together, we can be reasonably confident in the efficient management of the animal.
When a species is threatened with extinction, it is likely that no one has exclusive property rights to it. Whales, condors, grizzly bears, elephants in Central Africa—whatever the animal that is threatened—are common property resources. In such cases a government agency may impose limits on the killing of the animal or destruction of its habitat. Such limits can prevent the excessive private use of a common property resource. Alternatively, as was done in the case of the buffalo, private rights can be established, giving resource owners the task of preservation.
Key Takeaways
• Public sector intervention to increase the level of provision of public goods may improve the efficiency of resource allocation by overcoming the problem of free riders.
• Activities that generate external costs are likely to be carried out at levels that exceed those that would be efficient; the public sector may seek to intervene to confront decision makers with the full costs of their choices.
• Some private activities generate external benefits.
• A common property resource is unlikely to be allocated efficiently in the marketplace.
Try It!
The manufacture of memory chips for computers generates pollutants that generally enter rivers and streams. Use the model of demand and supply to show the equilibrium price and output of chips. Assuming chip manufacturers do not have to pay the costs these pollutants impose, what can you say about the efficiency of the quantity of chips produced? Show the area of deadweight loss imposed by this external cost. Show how a requirement that firms pay these costs as they produce the chips would affect the equilibrium price and output of chips. Would such a requirement help to satisfy the efficiency condition? Explain.
Case in Point: Externalities and Smoking
Figure 6.17
Smokers impose tremendous costs on themselves. Based solely on the degree to which smoking shortens their life expectancy, which is by about six years, the cost per pack is \$35.64. That cost, of course, is a private cost. In addition to that private cost, smokers impose costs on others. Those external costs come in three ways. First, they increase health-care costs and thus increase health insurance premiums. Second, smoking causes fires that destroy more than \$300 million worth of property each year. Third, more than 2,000 people die each year as a result of “secondhand” smoke. A 1989 study by the RAND Corporation estimated these costs at \$0.53 per pack.
In an important way, however, smokers also generate external benefits. They contribute to retirement programs and to Social Security, then die sooner than nonsmokers. They thus subsidize the retirement programs of the rest of the population. According to the RAND study, that produces an external benefit of \$0.24 per pack, leaving a net external cost of \$0.29 per pack. Given that state and federal excise taxes averaged \$0.37 in 1989, the RAND researchers concluded that smokers more than paid their own way.
Economists Jonathan Gruber of the Massachusetts Institute of Technology and Botond Koszegi of the University of California at Berkeley have suggested that, in the case of people who consume “addictive bads” such as cigarettes, an excise tax on cigarettes of as much as \$4.76 per pack may improve the welfare of smokers.
They base their argument on the concept of “time inconsistency,” which is the theory that smokers seek the immediate gratification of a cigarette and then regret their decision later. Professors Gruber and Koszegi argue that higher taxes would serve to reduce the quantity of cigarettes demanded and thus reduce behavior that smokers would otherwise regret. Their argument is that smokers impose “internalities” on themselves and that higher taxes would reduce this.
Where does this lead us? If smokers are “rationally addicted” to smoking, i.e., they have weighed the benefits and costs of smoking and have chosen to smoke, then the only problem for public policy is to assure that smokers are confronted with the external costs they impose. In that case, the problem is solved: through excise taxes, smokers more than pay their own way. But, if the decision to smoke is an irrational one, it may be improved through higher excise taxes on smoking.
Answer to Try It! Problem
Figure 6.18
In the absence of any regulation, chip producers are not faced with the costs of the pollution their operations generate. The market price is thus P1 and the quantity Q1. The efficiency condition is not met; the price is lower and the quantity greater than would be efficient. If producers were forced to face the cost of their pollution as well as other production costs, the supply curve would shift to S2, the price would rise to P2, and the quantity would fall to Q2. The new solution satisfies the efficiency condition.
1See Report of the Committee on Commerce, Science, and Transportation, Children’s Protection From Violent Programming Act, Senate Report 106–509 (October 26, 2000), Washington, D.C.: U.S. Government Printing Office, 2000, and Michael Rich, “Violent Video Games Testimony,” Chicago City Council, October 30, 2000, at www.aap.org/advocacy/rich-videogameviolence.pdf.
2Common property resources are sometimes referred to as open access resources. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/06%3A_Markets_Maximizers_and_Efficiency/6.3%3A_Market_Failure.txt |
Summary
Economists insist that individuals do not make choices willy-nilly. Rather, economists assume that individuals make choices in a purposeful way, one that seeks the maximum value for some objective. We assume that consumers seek to maximize utility and that firms seek to maximize profits.
Whatever is being maximized, choices are based on the marginal decision rule. Following this rule results in an allocation that achieves the greatest degree of utility or profit possible.
If utility- and profit-maximizing choices are made in the context of a price system that confronts decision makers with all of the costs and all of the benefits of their choices, the allocation of resources will be efficient. An efficient allocation is one that maximizes the net benefit of every activity. The concepts of consumer and producer surplus show us how this net benefit is shared. Equity is a separate issue, one that calls for a normative evaluation of the fairness of the distribution of income.
The allocation of resources will be inefficient in the absence of competitive markets. It will also be inefficient if property rights are not exclusive and transferable. These two conditions break down when there are public goods, common property resources, or external benefits or costs. In each of these cases, public sector intervention may improve the efficiency of resource allocation. When a market fails to achieve the efficient solution, net benefit falls short of the maximum possible. Deadweight loss is the amount by which net benefit falls below the net benefit possible at the efficient solution.
Concept Problems
1. What is achieved by selecting the quantity of an activity at which marginal benefit equals marginal cost?
2. Suppose the marginal benefit of an activity exceeds the marginal cost. What does the marginal decision rule say a maximizing decision maker will do?
3. Suppose you are a discus hurler and your goal is to maximize the distance you achieve. You “produce” discus hurls by practicing. The total benefit of practice is distance achieved, and the input that achieves this distance is hours of practice. Describe the total benefit curve of practice. What point on the curve would you select?
4. This chapter argues that consumers maximize utility and firms maximize profits. What do you suppose each of the following might be presumed to maximize?
1. A minister or rabbi
2. A United States Senator
3. The manager of a major league baseball team
4. The owner of a major league baseball team
5. The director of a charitable organization
5. For each of the following goods, indicate whether exclusive, transferable property rights exist and whether the good poses a problem for public policy. If it does, does the problem relate to a problem of property rights?
1. Clean air
2. Tomatoes
3. Housing
4. Blue whales
6. The dry-cleaning industry is a major source of air pollution. What can you conclude about the price and output of dry-cleaning services?
7. Economists often recommend that polluters such as dry-cleaning establishments be charged fees for the pollution they emit. Critics of this idea respond that the establishments would simply respond by passing these charges on to their customers, leaving the level of pollution unchanged. Comment on this objection.
8. Government agencies often require that children be inoculated against communicable diseases such as polio and measles. From the standpoint of economic efficiency, is there any justification for such a requirement?
9. Which of the following goods or services are public? Why or why not?
1. Libraries
2. Fire protection
3. Television programs
4. Health care
5. Water for household consumption
10. If a village in Botswana is granted several licenses to kill elephants, how does this give it an incentive to preserve elephants and increase the size of the herd? How does the international ban on ivory sales affect the incentive in Botswana to preserve the elephant?
11. The number of fish caught in the ocean has fallen in recent years partly as a result of more intensive fishing efforts and the use of more sophisticated equipment. Fish in the ocean are a common property resource. How might this fact be related to declining fish catches? How do you think this drop in the catch affects the price of seafood?
Numerical Problems
1. Joe Higgins is thinking about how much time to spend studying for a biology exam tomorrow. Using “utility units” he measures the benefits and costs of study; his calculations are shown in the following table.
Figure 6.19
1. Fill in the fourth row for net benefit in the table. Use the midpoint convention to emphasize that the net benefit is a marginal value showing the gain as hours spent increase by one-hour increments.
2. Using a graph similar to Panel (a) of Figure 6.1 show the marginal benefit curve and verify that the area under the curve at 3 hours of study corresponds to the total benefit of that much study. (Hint: Remember that marginal values are plotted at the midpoints of the corresponding intervals on the horizontal axis.)
3. Use a graph similar to Panel (b) of Figure 6.1 to show the marginal cost curve and verify that the area under the curve at 3 hours of study corresponds to the total cost of that much study.
4. Use a graph similar to Panel (a) of Figure 6.6 to combine the marginal benefit and marginal cost curves you drew in parts (a) and (b).
5. Based on the marginal decision rule, how many hours should Joe spend studying for his biology exam? | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/06%3A_Markets_Maximizers_and_Efficiency/6.4%3A_Review_And_Practice.txt |
Learning Objective
1. Define what economists mean by utility.
2. Distinguish between the concepts of total utility and marginal utility.
3. State the law of diminishing marginal utility and illustrate it graphically.
4. State, explain, and illustrate algebraically the utility-maximizing condition.
Why do you buy the goods and services you do? It must be because they provide you with satisfaction—you feel better off because you have purchased them. Economists call this satisfaction utility.
The concept of utility is an elusive one. A person who consumes a good such as peaches gains utility from eating the peaches. But we cannot measure this utility the same way we can measure a peach’s weight or calorie content. There is no scale we can use to determine the quantity of utility a peach generates.
Francis Edgeworth, one of the most important contributors to the theory of consumer behavior, imagined a device he called a hedonimeter (after hedonism, the pursuit of pleasure):
“[L]et there be granted to the science of pleasure what is granted to the science of energy; to imagine an ideally perfect instrument, a psychophysical machine, continually registering the height of pleasure experienced by an individual…. From moment to moment the hedonimeter varies; the delicate index now flickering with the flutter of passions, now steadied by intellectual activity, now sunk whole hours in the neighborhood of zero, or momentarily springing up towards infinity” (Edgeworth, F. Y., 1967).
Perhaps some day a hedonimeter will be invented. The utility it measures will not be a characteristic of particular goods, but rather of each consumer’s reactions to those goods. The utility of a peach exists not in the peach itself, but in the preferences of the individual consuming the peach. One consumer may wax ecstatic about a peach; another may say it tastes OK.
When we speak of maximizing utility, then, we are speaking of the maximization of something we cannot measure. We assume, however, that each consumer acts as if he or she can measure utility and arranges consumption so that the utility gained is as high as possible.
Total Utility
If we could measure utility, total utility would be the number of units of utility that a consumer gains from consuming a given quantity of a good, service, or activity during a particular time period. The higher a consumer’s total utility, the greater that consumer’s level of satisfaction.
Panel (a) of Figure 7.1 shows the total utility Henry Higgins obtains from attending movies. In drawing his total utility curve, we are imagining that he can measure his total utility. The total utility curve shows that when Mr. Higgins attends no movies during a month, his total utility from attending movies is zero. As he increases the number of movies he sees, his total utility rises. When he consumes 1 movie, he obtains 36 units of utility. When he consumes 4 movies, his total utility is 101. He achieves the maximum level of utility possible, 115, by seeing 6 movies per month. Seeing a seventh movie adds nothing to his total utility.
Mr. Higgins’s total utility rises at a decreasing rate. The rate of increase is given by the slope of the total utility curve, which is reported in Panel (a) of Figure 7.1 as well. The slope of the curve between 0 movies and 1 movie is 36 because utility rises by this amount when Mr. Higgins sees his first movie in the month. It is 28 between 1 and 2 movies, 22 between 2 and 3, and so on. The slope between 6 and 7 movies is zero; the total utility curve between these two quantities is horizontal.
Marginal Utility
The amount by which total utility rises with consumption of an additional unit of a good, service, or activity, all other things unchanged, is marginal utility. The first movie Mr. Higgins sees increases his total utility by 36 units. Hence, the marginal utility of the first movie is 36. The second increases his total utility by 28 units; its marginal utility is 28. The seventh movie does not increase his total utility; its marginal utility is zero. Notice that in the table marginal utility is listed between the columns for total utility because, similar to other marginal concepts, marginal utility is the change in utility as we go from one quantity to the next. Mr. Higgins’s marginal utility curve is plotted in Panel (b) of Figure 7.1 The values for marginal utility are plotted midway between the numbers of movies attended. The marginal utility curve is downward sloping; it shows that Mr. Higgins’s marginal utility for movies declines as he consumes more of them.
Mr. Higgins’s marginal utility from movies is typical of all goods and services. Suppose that you are really thirsty and you decide to consume a soft drink. Consuming the drink increases your utility, probably by a lot. Suppose now you have another. That second drink probably increases your utility by less than the first. A third would increase your utility by still less. This tendency of marginal utility to decline beyond some level of consumption during a period is called the law of diminishing marginal utility. This law implies that all goods and services eventually will have downward-sloping marginal utility curves. It is the law that lies behind the negatively sloped marginal benefit curve for consumer choices that we examined in the chapter on markets, maximizers, and efficiency.
One way to think about this effect is to remember the last time you ate at an “all you can eat” cafeteria-style restaurant. Did you eat only one type of food? Did you consume food without limit? No, because of the law of diminishing marginal utility. As you consumed more of one kind of food, its marginal utility fell. You reached a point at which the marginal utility of another dish was greater, and you switched to that. Eventually, there was no food whose marginal utility was great enough to make it worth eating, and you stopped.
What if the law of diminishing marginal utility did not hold? That is, what would life be like in a world of constant or increasing marginal utility? In your mind go back to the cafeteria and imagine that you have rather unusual preferences: Your favorite food is creamed spinach. You start with that because its marginal utility is highest of all the choices before you in the cafeteria. As you eat more, however, its marginal utility does not fall; it remains higher than the marginal utility of any other option. Unless eating more creamed spinach somehow increases your marginal utility for some other food, you will eat only creamed spinach. And until you have reached the limit of your body’s capacity (or the restaurant manager’s patience), you will not stop. Failure of marginal utility to diminish would thus lead to extraordinary levels of consumption of a single good to the exclusion of all others. Since we do not observe that happening, it seems reasonable to assume that marginal utility falls beyond some level of consumption.
Maximizing Utility
Economists assume that consumers behave in a manner consistent with the maximization of utility. To see how consumers do that, we will put the marginal decision rule to work. First, however, we must reckon with the fact that the ability of consumers to purchase goods and services is limited by their budgets.
The Budget Constraint
The total utility curve in Figure 7.1 shows that Mr. Higgins achieves the maximum total utility possible from movies when he sees six of them each month. It is likely that his total utility curves for other goods and services will have much the same shape, reaching a maximum at some level of consumption. We assume that the goal of each consumer is to maximize total utility. Does that mean a person will consume each good at a level that yields the maximum utility possible?
The answer, in general, is no. Our consumption choices are constrained by the income available to us and by the prices we must pay. Suppose, for example, that Mr. Higgins can spend just \$25 per month for entertainment and that the price of going to see a movie is \$5. To achieve the maximum total utility from movies, Mr. Higgins would have to exceed his entertainment budget. Since we assume that he cannot do that, Mr. Higgins must arrange his consumption so that his total expenditures do not exceed his budget constraint: a restriction that total spending cannot exceed the budget available.
Suppose that in addition to movies, Mr. Higgins enjoys concerts, and the average price of a concert ticket is \$10. He must select the number of movies he sees and concerts he attends so that his monthly spending on the two goods does not exceed his budget.
Individuals may, of course, choose to save or to borrow. When we allow this possibility, we consider the budget constraint not just for a single period of time but for several periods. For example, economists often examine budget constraints over a consumer’s lifetime. A consumer may in some years save for future consumption and in other years borrow on future income for present consumption. Whatever the time period, a consumer’s spending will be constrained by his or her budget.
To simplify our analysis, we shall assume that a consumer’s spending in any one period is based on the budget available in that period. In this analysis consumers neither save nor borrow. We could extend the analysis to cover several periods and generate the same basic results that we shall establish using a single period. We will also carry out our analysis by looking at the consumer’s choices about buying only two goods. Again, the analysis could be extended to cover more goods and the basic results would still hold.
Applying the Marginal Decision Rule
Because consumers can be expected to spend the budget they have, utility maximization is a matter of arranging that spending to achieve the highest total utility possible. If a consumer decides to spend more on one good, he or she must spend less on another in order to satisfy the budget constraint.
The marginal decision rule states that an activity should be expanded if its marginal benefit exceeds its marginal cost. The marginal benefit of this activity is the utility gained by spending an additional \$1 on the good. The marginal cost is the utility lost by spending \$1 less on another good.
How much utility is gained by spending another \$1 on a good? It is the marginal utility of the good divided by its price. The utility gained by spending an additional dollar on good X, for example, is
This additional utility is the marginal benefit of spending another \$1 on the good.
Suppose that the marginal utility of good X is 4 and that its price is \$2. Then an extra \$1 spent on X buys 2 additional units of utility (MUX/PX=4/2=2). If the marginal utility of good X is 1 and its price is \$2, then an extra \$1 spent on X buys 0.5 additional units of utility (MUX/PX=1/2=0.5).
The loss in utility from spending \$1 less on another good or service is calculated the same way: as the marginal utility divided by the price. The marginal cost to the consumer of spending \$1 less on a good is the loss of the additional utility that could have been gained from spending that \$1 on the good.
Suppose a consumer derives more utility by spending an additional \$1 on good X rather than on good Y:
Equation 7.1
The marginal benefit of shifting \$1 from good Y to the consumption of good X exceeds the marginal cost. In terms of utility, the gain from spending an additional \$1 on good X exceeds the loss in utility from spending \$1 less on good Y. The consumer can increase utility by shifting spending from Y to X.
As the consumer buys more of good X and less of good Y, however, the marginal utilities of the two goods will change. The law of diminishing marginal utility tells us that the marginal utility of good X will fall as the consumer consumes more of it; the marginal utility of good Y will rise as the consumer consumes less of it. The result is that the value of the left-hand side of Equation 7.1 will fall and the value of the right-hand side will rise as the consumer shifts spending from Y to X. When the two sides are equal, total utility will be maximized. In terms of the marginal decision rule, the consumer will have achieved a solution at which the marginal benefit of the activity (spending more on good X) is equal to the marginal cost:
Equation 7.2
We can extend this result to all goods and services a consumer uses. Utility maximization requires that the ratio of marginal utility to price be equal for all of them, as suggested in Equation 7.3:
Equation 7.3
Equation 7.3 states the utility-maximizing condition: Utility is maximized when total outlays equal the budget available and when the ratios of marginal utilities to prices are equal for all goods and services.
Consider, for example, the shopper introduced in the opening of this chapter. In shifting from cookies to ice cream, the shopper must have felt that the marginal utility of spending an additional dollar on ice cream exceeded the marginal utility of spending an additional dollar on cookies. In terms of Equation 7.1, if good X is ice cream and good Y is cookies, the shopper will have lowered the value of the left-hand side of the equation and moved toward the utility-maximizing condition, as expressed by Equation 7.1.
The Problem of Divisibility
If we are to apply the marginal decision rule to utility maximization, goods must be divisible; that is, it must be possible to buy them in any amount. Otherwise we cannot meaningfully speak of spending \$1 more or \$1 less on them. Strictly speaking, however, few goods are completely divisible.
Even a small purchase, such as an ice cream bar, fails the strict test of being divisible; grocers generally frown on requests to purchase one-half of a \$2 ice cream bar if the consumer wants to spend an additional dollar on ice cream. Can a consumer buy a little more movie admission, to say nothing of a little more car?
In the case of a car, we can think of the quantity as depending on characteristics of the car itself. A car with a compact disc player could be regarded as containing “more car” than one that has only a cassette player. Stretching the concept of quantity in this manner does not entirely solve the problem. It is still difficult to imagine that one could purchase “more car” by spending \$1 more.
Remember, though, that we are dealing with a model. In the real world, consumers may not be able to satisfy Equation 7.3 precisely. The model predicts, however, that they will come as close to doing so as possible.
Key Takeaways
• The utility of a good or service is determined by how much satisfaction a particular consumer obtains from it. Utility is not a quality inherent in the good or service itself.
• Total utility is a conceptual measure of the number of units of utility a consumer gains from consuming a good, service, or activity. Marginal utility is the increase in total utility obtained by consuming one more unit of a good, service, or activity.
• As a consumer consumes more and more of a good or service, its marginal utility falls.
• Utility maximization requires seeking the greatest total utility from a given budget.
• Utility is maximized when total outlays equal the budget available and when the ratios of marginal utility to price are equal for all goods and services a consumer consumes; this is the utility-maximizing condition.
Try It!
A college student, Ramón Juárez, often purchases candy bars or bags of potato chips between classes; he tries to limit his spending on these snacks to \$8 per week. A bag of chips costs \$0.75 and a candy bar costs \$0.50 from the vending machines on campus. He has been purchasing an average of 6 bags of chips and 7 candy bars each week. Mr. Juárez is a careful maximizer of utility, and he estimates that the marginal utility of an additional bag of chips during a week is 6. In your answers use B to denote candy bars and C to denote potato chips.
1. How much is he spending on snacks? How does this amount compare to his budget constraint?
2. What is the marginal utility of an additional candy bar during the week?
Case in Point: Changing Lanes and Raising Utility
Figure 7.2
In preparation for sitting in the slow, crowded lanes for single-occupancy-vehicles, T. J. Zane used to stop at his favorite coffee kiosk to buy a \$2 cup of coffee as he headed off to work on Interstate 15 in the San Diego area. Since 1996, an experiment in road pricing has caused him and others to change their ways—and to raise their total utility.
Before 1996, only car-poolers could use the specially marked high-occupancy-vehicles lanes. With those lanes nearly empty, traffic authorities decided to allow drivers of single-occupancy-vehicles to use those lanes, so long as they paid a price. Now, electronic signs tell drivers how much it will cost them to drive on the special lanes. The price is recalculated every 6 minutes depending on the traffic. On one morning during rush hour, it varied from \$1.25 at 7:10 a.m., to \$1.50 at 7:16 a.m., to \$2.25 at 7:22 a.m., and to \$2.50 at 7:28 a.m. The increasing tolls over those few minutes caused some drivers to opt out and the toll fell back to \$1.75 and then increased to \$2 a few minutes later. Drivers do not have to stop to pay the toll since radio transmitters read their FasTrak transponders and charge them accordingly.
When first instituted, these lanes were nicknamed the “Lexus lanes,” on the assumption that only wealthy drivers would use them. Indeed, while the more affluent do tend to use them heavily, surveys have discovered that they are actually used by drivers of all income levels.
Mr. Zane, a driver of a 1997 Volkswagen Jetta, is one commuter who chooses to use the new option. He explains his decision by asking, “Isn’t it worth a couple of dollars to spend an extra half-hour with your family?” He continues, “That’s what I used to spend on a cup of coffee at Starbucks. Now I’ve started bringing my own coffee and using the money for the toll.”
We can explain his decision using the model of utility-maximizing behavior; Mr. Zane’s out-of-pocket commuting budget constraint is about \$2. His comment tells us that he realized that the marginal utility of spending an additional 30 minutes with his family divided by the \$2 toll was higher than the marginal utility of the store-bought coffee divided by its \$2 price. By reallocating his \$2 commuting budget, the gain in utility of having more time at home exceeds the loss in utility from not sipping premium coffee on the way to work.
From this one change in behavior, we do not know whether or not he is actually maximizing his utility, but his decision and explanation are certainly consistent with that goal.
Answers to Try It! Problems
1. He is spending \$4.50 (= \$0.75 × 6) on potato chips and \$3.50 (= \$0.50 × 7) on candy bars, for a total of \$8. His budget constraint is \$8.
2. In order for the ratios of marginal utility to price to be equal, the marginal utility of a candy bar must be 4. Let the marginal utility and price of candy bars be MUB and PB, respectively, and the marginal utility and price of a bag of potato chips be MUC and PC, respectively. Then we want
We know that PC is \$0.75 and PB equals \$0.50. We are told that MUC is 6. Thus
Solving the equation for MUB, we find that it must equal 4. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/07%3A_The_Analysis_of_Consumer_Choice/7.1%3A_The_Concept_of_Utility.txt |
Learning Objective
1. Derive an individual demand curve from utility-maximizing adjustments to changes in price.
2. Derive the market demand curve from the demand curves of individuals.
3. Explain the substitution and income effects of a price change.
4. Explain the concepts of normal and inferior goods in terms of the income effect.
Choices that maximize utility—that is, choices that follow the marginal decision rule—generally produce downward-sloping demand curves. This section shows how an individual’s utility-maximizing choices can lead to a demand curve.
Deriving an Individual’s Demand Curve
Suppose, for simplicity, that Mary Andrews consumes only apples, denoted by the letter A, and oranges, denoted by the letter O. Apples cost $2 per pound and oranges cost$1 per pound, and her budget allows her to spend $20 per month on the two goods. We assume that Ms. Andrews will adjust her consumption so that the utility-maximizing condition holds for the two goods: The ratio of marginal utility to price is the same for apples and oranges. That is, $\frac{M U_{A}}{\ 2}=\frac{M U_{O}}{\ 1} \label{7.4}$ Here MUA and MUO are the marginal utilities of apples and oranges, respectively. Her spending equals her budget of$20 per month; suppose she buys 5 pounds of apples and 10 of oranges.
Now suppose that an unusually large harvest of apples lowers their price to $1 per pound. The lower price of apples increases the marginal utility of each$1 Ms. Andrews spends on apples, so that at her current level of consumption of apples and oranges
$\frac{M U_{A}}{\ 1}>\frac{M U_{O}}{\ 1} \label{7.5}$
Ms. Andrews will respond by purchasing more apples. As she does so, the marginal utility she receives from apples will decline. If she regards apples and oranges as substitutes, she will also buy fewer oranges. That will cause the marginal utility of oranges to rise. She will continue to adjust her spending until the marginal utility per $1 spent is equal for both goods: $\frac{M U_{A}}{\ 1}=\frac{M U_{O}}{\ 1} \label{7.6}$ Suppose that at this new solution, she purchases 12 pounds of apples and 8 pounds of oranges. She is still spending all of her budget of$20 on the two goods [(12 x $1)+(8 x$1)=$20]. It is through a consumer’s reaction to different prices that we trace the consumer’s demand curve for a good. When the price of apples was$2 per pound, Ms. Andrews maximized her utility by purchasing 5 pounds of apples, as illustrated in Figure 7.3. When the price of apples fell, she increased the quantity of apples she purchased to 12 pounds.
Notice that, in this example, Ms. Andrews maximizes utility where not only the ratios of marginal utilities to price are equal, but also the marginal utilities of both goods are equal. But, the equal-marginal-utility outcome is only true here because the prices of the two goods are the same: each good is priced at $1 in this case. If the prices of apples and oranges were different, the marginal utilities at the utility maximizing solution would have been different. The condition for maximizing utility—consume where the ratios of marginal utility to price are equal—holds regardless. The utility-maximizing condition is not that consumers maximize utility by equating marginal utilities. Figure 7.4 Utility maximizing condition is: $\frac{M U_{X}}{P_{X}}=\frac{M U_{X}}{P_{Y}}$ Utility maximizing condition is not: $M U_{X}=M U_{Y}$ From Individual to Market Demand The market demand curves we studied in previous chapters are derived from individual demand curves such as the one depicted in Figure 7.3. Suppose that in addition to Ms. Andrews, there are two other consumers in the market for apples—Ellen Smith and Koy Keino. The quantities each consumes at various prices are given in Figure 7.5, along with the quantities that Ms. Andrews consumes at each price. The demand curves for each are shown in Panel (a). The market demand curve for all three consumers, shown in Panel (b), is then found by adding the quantities demanded at each price for all three consumers. At a price of$2 per pound, for example, Ms. Andrews demands 5 pounds of apples per month, Ms. Smith demands 3 pounds, and Mr. Keino demands 8 pounds. A total of 16 pounds of apples are demanded per month at this price. Adding the individual quantities demanded at $1 per pound yields market demand of 40 pounds per month. This method of adding amounts along the horizontal axis of a graph is referred to as summing horizontally. The market demand curve is thus the horizontal summation of all the individual demand curves. Individual demand curves, then, reflect utility-maximizing adjustment by consumers to various market prices. Once again, we see that as the price falls, consumers tend to buy more of a good. Demand curves are downward-sloping as the law of demand asserts. Substitution and Income Effects We saw that when the price of apples fell from$2 to $1 per pound, Mary Andrews increased the quantity of apples she demanded. Behind that adjustment, however, lie two distinct effects: the substitution effect and the income effect. It is important to distinguish these effects, because they can have quite different implications for the elasticity of the demand curve. First, the reduction in the price of apples made them cheaper relative to oranges. Before the price change, it cost the same amount to buy 2 pounds of oranges or 1 pound of apples. After the price change, it cost the same amount to buy 1 pound of either oranges or apples. In effect, 2 pounds of oranges would exchange for 1 pound of apples before the price change, and 1 pound of oranges would exchange for 1 pound of apples after the price change. Second, the price reduction essentially made consumers of apples richer. Before the price change, Ms. Andrews was purchasing 5 pounds of apples and 10 pounds of oranges at a total cost to her of$20. At the new lower price of apples, she could purchase this same combination for $15. In effect, the price reduction for apples was equivalent to handing her a$5 bill, thereby increasing her purchasing power. Purchasing power refers to the quantity of goods and services that can be purchased with a given budget.
To distinguish between the substitution and income effects, economists consider first the impact of a price change with no change in the consumer’s ability to purchase goods and services. An income-compensated price changeAn imaginary exercise in which we assume that when the price of a good or service changes, the consumers income is adjusted so that he or she has just enough to purchase the original combination of goods and services at the new set of prices. is an imaginary exercise in which we assume that when the price of a good or service changes, the consumer’s income is adjusted so that he or she has just enough to purchase the original combination of goods and services at the new set of prices. Ms. Andrews was purchasing 5 pounds of apples and 10 pounds of oranges before the price change. Buying that same combination after the price change would cost $15. The income-compensated price change thus requires us to take$5 from Ms. Andrews when the price of apples falls to $1 per pound. She can still buy 5 pounds of apples and 10 pounds of oranges. If, instead, the price of apples increased, we would give Ms. Andrews more money (i.e., we would “compensate” her) so that she could purchase the same combination of goods. With$15 and cheaper apples, Ms. Andrews could buy 5 pounds of apples and 10 pounds of oranges. But would she? The answer lies in comparing the marginal benefit of spending another $1 on apples to the marginal benefit of spending another$1 on oranges, as expressed in Equation 7.5. It shows that the extra utility per $1 she could obtain from apples now exceeds the extra utility per$1 from oranges. She will thus increase her consumption of apples. If she had only $15, any increase in her consumption of apples would require a reduction in her consumption of oranges. In effect, she responds to the income-compensated price change for apples by substituting apples for oranges. The change in a consumer’s consumption of a good in response to an income-compensated price change is called the substitution effectThe change in a consumers consumption of a good in response to an income-compensated price change.. Suppose that with an income-compensated reduction in the price of apples to$1 per pound, Ms. Andrews would increase her consumption of apples to 9 pounds per month and reduce her consumption of oranges to 6 pounds per month. The substitution effect of the price reduction is an increase in apple consumption of 4 pounds per month.
The substitution effect always involves a change in consumption in a direction opposite that of the price change. When a consumer is maximizing utility, the ratio of marginal utility to price is the same for all goods. An income-compensated price reduction increases the extra utility per dollar available from the good whose price has fallen; a consumer will thus purchase more of it. An income-compensated price increase reduces the extra utility per dollar from the good; the consumer will purchase less of it.
In other words, when the price of a good falls, people react to the lower price by substituting or switching toward that good, buying more of it and less of other goods, if we artificially hold the consumer’s ability to buy goods constant. When the price of a good goes up, people react to the higher price by substituting or switching away from that good, buying less of it and instead buying more of other goods. By examining the impact of consumer purchases of an income-compensated price change, we are looking at just the change in relative prices of goods and eliminating any impact on consumer buying that comes from the effective change in the consumer’s ability to purchase goods and services (that is, we hold the consumer’s purchasing power constant).
To complete our analysis of the impact of the price change, we must now consider the $5 that Ms. Andrews effectively gained from it. After the price reduction, it cost her just$15 to buy what cost her $20 before. She has, in effect,$5 more than she did before. Her additional income may also have an effect on the number of apples she consumes. The change in consumption of a good resulting from the implicit change in income because of a price change is called the income effectThe change in consumption of a good resulting from the implicit change in income because of a price change. of a price change. When the price of a good rises, there is an implicit reduction in income. When the price of a good falls, there is an implicit increase. When the price of apples fell, Ms. Andrews (who was consuming 5 pounds of apples per month) received an implicit increase in income of $5. Suppose Ms. Andrews uses her implicit increase in income to purchase 3 more pounds of apples and 2 more pounds of oranges per month. She has already increased her apple consumption to 9 pounds per month because of the substitution effect, so the added 3 pounds brings her consumption level to 12 pounds per month. That is precisely what we observed when we derived her demand curve; it is the change we would observe in the marketplace. We see now, however, that her increase in quantity demanded consists of a substitution effect and an income effect. Figure 7.6 shows the combined effects of the price change. The size of the substitution effect depends on the rate at which the marginal utilities of goods change as the consumer adjusts consumption to a price change. As Ms. Andrews buys more apples and fewer oranges, the marginal utility of apples will fall and the marginal utility of oranges will rise. If relatively small changes in quantities consumed produce large changes in marginal utilities, the substitution effect that is required to restore the equality of marginal-utility-to-price ratios will be small. If much larger changes in quantities consumed are needed to produce equivalent changes in marginal utilities, then the substitution effect will be large. The magnitude of the income effect of a price change depends on how responsive the demand for a good is to a change in income and on how important the good is in a consumer’s budget. When the price changes for a good that makes up a substantial fraction of a consumer’s budget, the change in the consumer’s ability to buy things is substantial. A change in the price of a good that makes up a trivial fraction of a consumer’s budget, however, has little effect on his or her purchasing power; the income effect of such a price change is small. Because each consumer’s response to a price change depends on the sizes of the substitution and income effects, these effects play a role in determining the price elasticity of demand. All other things unchanged, the larger the substitution effect, the greater the absolute value of the price elasticity of demand. When the income effect moves in the same direction as the substitution effect, a greater income effect contributes to a greater price elasticity of demand as well. There are, however, cases in which the substitution and income effects move in opposite directions. We shall explore these ideas in the next section. Normal and Inferior Goods The nature of the income effect of a price change depends on whether the good is normal or inferior. The income effect reinforces the substitution effect in the case of normal goods; it works in the opposite direction for inferior goods. Normal Goods A normal good is one whose consumption increases with an increase in income. When the price of a normal good falls, there are two identifying effects: 1. The substitution effect contributes to an increase in the quantity demanded because consumers substitute more of the good for other goods. 2. The reduction in price increases the consumer’s ability to buy goods. Because the good is normal, this increase in purchasing power further increases the quantity of the good demanded through the income effect. In the case of a normal good, then, the substitution and income effects reinforce each other. Ms. Andrews’s response to a price reduction for apples is a typical response to a lower price for a normal good. An increase in the price of a normal good works in an equivalent fashion. The higher price causes consumers to substitute more of other goods, whose prices are now relatively lower. The substitution effect thus reduces the quantity demanded. The higher price also reduces purchasing power, causing consumers to reduce consumption of the good via the income effect. Inferior Goods In the chapter that introduced the model of demand and supply, we saw that an inferior good is one for which demand falls when income rises. It is likely to be a good that people do not really like very much. When incomes are low, people consume the inferior good because it is what they can afford. As their incomes rise and they can afford something they like better, they consume less of the inferior good. When the price of an inferior good falls, two things happen: 1. Consumers will substitute more of the inferior good for other goods because its price has fallen relative to those goods. The quantity demanded increases as a result of the substitution effect. 2. The lower price effectively makes consumers richer. But, because the good is inferior, this reduces quantity demanded. The case of inferior goods is thus quite different from that of normal goods. The income effect of a price change works in a direction opposite to that of the substitution effect in the case of an inferior good, whereas it reinforces the substitution effect in the case of a normal good. Figure 7.7 illustrates the substitution and income effects of a price reduction for an inferior good. When the price falls from P1 to P2, the quantity demanded by a consumer increases from q1 to q2. The substitution effect increases quantity demanded from q1 to qs. But the income effect reduces quantity demanded from qs to q2; the substitution effect is stronger than the income effect. The result is consistent with the law of demand: A reduction in price increases the quantity demanded. The quantity demanded is smaller, however, than it would be if the good were normal. Inferior goods are therefore likely to have less elastic demand than normal goods. Key Takeaways • Individual demand curves reflect utility-maximizing adjustment by consumers to changes in price. • Market demand curves are found by summing horizontally the demand curves of all the consumers in the market. • The substitution effect of a price change changes consumption in a direction opposite to the price change. • The income effect of a price change reinforces the substitution effect if the good is normal; it moves consumption in the opposite direction if the good is inferior. Try It! Ilana Drakulic has an entertainment budget of$200 per semester, which she divides among purchasing CDs, going to concerts, eating in restaurants, and so forth. When the price of CDs fell from $20 to$10, her purchases rose from 5 per semester to 10 per semester. When asked how many she would have bought if her budget constraint were $150 (since with$150 she could continue to buy 5 CDs and as before still have \$100 for spending on other items), she said she would have bought 8 CDs. What is the size of her substitution effect? Her income effect? Are CDs normal or inferior for her? Which exhibit, Figure 7.6 or Figure 7.7, depicts more accurately her demand curve for CDs?
Case in Point: Found! An Upward-Sloping Demand Curve
The fact that income and substitution effects move in opposite directions in the case of inferior goods raises a tantalizing possibility: What if the income effect were the stronger of the two? Could demand curves be upward sloping?
The answer, from a theoretical point of view, is yes. If the income effect in Figure 7.7 were larger than the substitution effect, the decrease in price would reduce the quantity demanded below q1. The result would be a reduction in quantity demanded in response to a reduction in price. The demand curve would be upward sloping!
The suggestion that a good could have an upward-sloping demand curve is generally attributed to Robert Giffen, a British journalist who wrote widely on economic matters late in the nineteenth century. Such goods are thus called Giffen goods. To qualify as a Giffen good, a good must be inferior and must have an income effect strong enough to overcome the substitution effect. The example often cited of a possible Giffen good is the potato during the Irish famine of 1845–1849. Empirical analysis by economists using available data, however, has refuted the notion of the upward-sloping demand curve for potatoes at that time. The most convincing parts of the refutation were to point out that (a) given the famine, there were not more potatoes available for purchase then and (b) the price of potatoes may not have even increased during the period!
A recent study by Robert Jensen and Nolan Miller, though, suggests the possible discovery of a pair of Giffen goods. They began their search by thinking about the type of good that would be likely to exhibit Giffen behavior and argued that, like potatoes for the poor Irish, it would be a main dietary staple of a poor population. In such a situation, purchases of the item are such a large percentage of the diet of the poor that when the item’s price rises, the implicit income of the poor falls drastically. In order to subsist, the poor reduce consumption of other goods so they can buy more of the staple. In so doing, they are able to reach a caloric intake that is higher than what can be achieved by buying more of other preferred foods that unfortunately supply fewer calories.
Their preliminary empirical work shows that in southern China rice is a Giffen good for poor consumers while in northern China noodles are a Giffen good. In both cases, the basic good (rice or noodles) provides calories at a relatively low cost and dominates the diet, while meat is considered the tastier but higher cost-per-calorie food. Using detailed household data, they estimate that among the poor in southern China a 10% increase in the price of rice leads to a 10.4% increase in rice consumption. For wealthier households in the region, rice is inferior but not Giffen. For both groups of households, the income effect of a price change moves consumption in the opposite direction of the substitution effect. Only in the poorest households, however, does it swamp the substitution effect, leading to an upward-sloping demand curve for rice for poor households. In northern China, the net effect of a price increase on quantity demanded of noodles is smaller, though it still leads to higher noodle consumption in the poorest households of that region.
In a similar study, David McKenzie tested whether tortillas were a Giffen good for poor Mexicans. He found, however, that they were an inferior good but not a Giffen good. He speculated that the different result may stem from poor Mexicans having a wider range of substitutes available to them than do the poor in China.
Because the Jensen/Miller study is the first vindication of the existence of a Giffen good despite a very long search, the authors have avoided rushing to publication of their results. Rather, they have made available a preliminary version of the study reported on here while continuing to refine their estimation.
Answer to Try It! Problem
One hundred fifty dollars is the income that allows Ms. Drakulic to purchase the same items as before, and thus can be used to measure the substitution effect. Looking only at the income-compensated price change (that is, holding her to the same purchasing power as in the original relative price situation), we find that the substitution effect is 3 more CDs (from 5 to 8). The CDs that she buys beyond 8 constitute her income effect; it is 2 CDs. Because the income effect reinforces the substitution effect, CDs are a normal good for her and her demand curve is similar to that shown in Figure 7.6. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/07%3A_The_Analysis_of_Consumer_Choice/7.2%3A_Utility_Maximization_and_Demand.txt |
Learning Objective
1. Explain utility maximization using the concepts of indifference curves and budget lines.
2. Explain the notion of the marginal rate of substitution and how it relates to the utility-maximizing solution.
3. Derive a demand curve from an indifference map.
Economists typically use a different set of tools than those presented in the chapter up to this point to analyze consumer choices. While somewhat more complex, the tools presented in this section give us a powerful framework for assessing consumer choices.
We will begin our analysis with an algebraic and graphical presentation of the budget constraint. We will then examine a new concept that allows us to draw a map of a consumer’s preferences. Then we can draw some conclusions about the choices a utility-maximizing consumer could be expected to make.
The Budget Line
As we have already seen, a consumer’s choices are limited by the budget available. Total spending for goods and services can fall short of the budget constraint but may not exceed it.
Algebraically, we can write the budget constraint for two goods X and Y as:
$P_{X} Q_{X}+P_{Y} Q_{Y} \leq B \label{7.7}$
where PX and PY are the prices of goods X and Y and QX and QY are the quantities of goods X and Y chosen. The total income available to spend on the two goods is B, the consumer’s budget. Equation \ref{7.7} states that total expenditures on goods X and Y (the left-hand side of the equation) cannot exceed B.
Suppose a college student, Janet Bain, enjoys skiing and horseback riding. A day spent pursuing either activity costs $50. Suppose she has$250 available to spend on these two activities each semester. Ms. Bain’s budget constraint is illustrated in Figure 7.9.
For a consumer who buys only two goods, the budget constraint can be shown with a budget line. A budget line shows graphically the combinations of two goods a consumer can buy with a given budget.
The budget line shows all the combinations of skiing and horseback riding Ms. Bain can purchase with her budget of $250. She could also spend less than$250, purchasing combinations that lie below and to the left of the budget line in Figure 7.9. Combinations above and to the right of the budget line are beyond the reach of her budget.
The vertical intercept of the budget line (point D) is given by the number of days of skiing per month that Ms. Bain could enjoy, if she devoted all of her budget to skiing and none to horseback riding. She has $250, and the price of a day of skiing is$50. If she spent the entire amount on skiing, she could ski 5 days per semester. She would be meeting her budget constraint, since:
$50 x 0 +$50 x 5 = $250 The horizontal intercept of the budget line (point E) is the number of days she could spend horseback riding if she devoted her$250 entirely to that sport. She could purchase 5 days of either skiing or horseback riding per semester. Again, this is within her budget constraint, since:
$50 x 5 +$50 x 0 = $250 Because the budget line is linear, we can compute its slope between any two points. Between points D and E the vertical change is −5 days of skiing; the horizontal change is 5 days of horseback riding. The slope is thus −5/5=−1. More generally, we find the slope of the budget line by finding the vertical and horizontal intercepts and then computing the slope between those two points. The vertical intercept of the budget line is found by dividing Ms. Bain’s budget, B, by the price of skiing, the good on the vertical axis (PS). The horizontal intercept is found by dividing B by the price of horseback riding, the good on the horizontal axis (PH). The slope is thus: Equation 7.8 $P_H}$ Simplifying this equation, we obtain $S l o p e=-\frac{B}{P_{S}} \times \frac{P_{H}}{B}=-\frac{P_{H}}{P_{S}} \label{7.9}$ After canceling, Equation 7.9 shows that the slope of a budget line is the negative of the price of the good on the horizontal axis divided by the price of the good on the vertical axis. Heads Up! It is easy to go awry on the issue of the slope of the budget line: It is the negative of the price of the good on the horizontal axis divided by the price of the good on the vertical axis. But does not slope equal the change in the vertical axis divided by the change in the horizontal axis? The answer, of course, is that the definition of slope has not changed. Notice that Equation 7.8 gives the vertical change divided by the horizontal change between two points. We then manipulated Equation 7.8 a bit to get to Equation 7.9 and found that slope also equaled the negative of the price of the good on the horizontal axis divided by the price of the good on the vertical axis. Price is not the variable that is shown on the two axes. The axes show the quantities of the two goods. Indifference Curves Suppose Ms. Bain spends 2 days skiing and 3 days horseback riding per semester. She will derive some level of total utility from that combination of the two activities. There are other combinations of the two activities that would yield the same level of total utility. Combinations of two goods that yield equal levels of utility are shown on an indifference curve. Because all points along an indifference curve generate the same level of utility, economists say that a consumer is indifferent between them. Figure 7.10 shows an indifference curve for combinations of skiing and horseback riding that yield the same level of total utility. Point X marks Ms. Bain’s initial combination of 2 days skiing and 3 days horseback riding per semester. The indifference curve shows that she could obtain the same level of utility by moving to point W, skiing for 7 days and going horseback riding for 1 day. She could also get the same level of utility at point Y, skiing just 1 day and spending 5 days horseback riding. Ms. Bain is indifferent among combinations W, X, and Y. We assume that the two goods are divisible, so she is indifferent between any two points along an indifference curve. Now look at point T in Figure 7.10. It has the same amount of skiing as point X, but fewer days are spent horseback riding. Ms. Bain would thus prefer point X to point T. Similarly, she prefers X to U. What about a choice between the combinations at point W and point T? Because combinations X and W are equally satisfactory, and because Ms. Bain prefers X to T, she must prefer W to T. In general, any combination of two goods that lies below and to the left of an indifference curve for those goods yields less utility than any combination on the indifference curve. Such combinations are inferior to combinations on the indifference curve. Point Z, with 3 days of skiing and 4 days of horseback riding, provides more of both activities than point X; Z therefore yields a higher level of utility. It is also superior to point W. In general, any combination that lies above and to the right of an indifference curve is preferred to any point on the indifference curve. We can draw an indifference curve through any combination of two goods. Figure 7.11 shows indifference curves drawn through each of the points we have discussed. Indifference curve A from Figure 7.10 is inferior to indifference curve B. Ms. Bain prefers all the combinations on indifference curve B to those on curve A, and she regards each of the combinations on indifference curve C as inferior to those on curves A and B. Although only three indifference curves are shown in Figure 7.11, in principle an infinite number could be drawn. The collection of indifference curves for a consumer constitutes a kind of map illustrating a consumer’s preferences. Different consumers will have different maps. We have good reason to expect the indifference curves for all consumers to have the same basic shape as those shown here: They slope downward, and they become less steep as we travel down and to the right along them. The slope of an indifference curve shows the rate at which two goods can be exchanged without affecting the consumer’s utility. Figure 7.12 shows indifference curve C from Figure 7.11. Suppose Ms. Bain is at point S, consuming 4 days of skiing and 1 day of horseback riding per semester. Suppose she spends another day horseback riding. This additional day of horseback riding does not affect her utility if she gives up 2 days of skiing, moving to point T. She is thus willing to give up 2 days of skiing for a second day of horseback riding. The curve shows, however, that she would be willing to give up at most 1 day of skiing to obtain a third day of horseback riding (shown by point U). The maximum amount of one good a consumer would be willing to give up in order to obtain an additional unit of another is called the marginal rate of substitution (MRS), which is equal to the absolute value of the slope of the indifference curve between two points. Figure 7.12 shows that as Ms. Bain devotes more and more time to horseback riding, the rate at which she is willing to give up days of skiing for additional days of horseback riding—her marginal rate of substitution—diminishes. The Utility-Maximizing Solution We assume that each consumer seeks the highest indifference curve possible. The budget line gives the combinations of two goods that the consumer can purchase with a given budget. Utility maximization is therefore a matter of selecting a combination of two goods that satisfies two conditions: 1. The point at which utility is maximized must be within the attainable region defined by the budget line. 2. The point at which utility is maximized must be on the highest indifference curve consistent with condition 1. Figure 7.13 combines Janet Bain’s budget line from Figure 7.9 with her indifference curves from Figure 7.11. Our two conditions for utility maximization are satisfied at point X, where she skis 2 days per semester and spends 3 days horseback riding. The highest indifference curve possible for a given budget line is tangent to the line; the indifference curve and budget line have the same slope at that point. The absolute value of the slope of the indifference curve shows the MRS between two goods. The absolute value of the slope of the budget line gives the price ratio between the two goods; it is the rate at which one good exchanges for another in the market. At the point of utility maximization, then, the rate at which the consumer is willing to exchange one good for another equals the rate at which the goods can be exchanged in the market. For any two goods X and Y, with good X on the horizontal axis and good Y on the vertical axis, $M R S_{X . Y}=\frac{P_{X}}{P_{Y}} \label{7.10}$ Utility Maximization and the Marginal Decision Rule How does the achievement of The Utility Maximizing Solution in Figure 7.13 correspond to the marginal decision rule? That rule says that additional units of an activity should be pursued, if the marginal benefit of the activity exceeds the marginal cost. The observation of that rule would lead a consumer to the highest indifference curve possible for a given budget. Suppose Ms. Bain has chosen a combination of skiing and horseback riding at point S in Figure 7.14. She is now on indifference curve C. She is also on her budget line; she is spending all of the budget,$250, available for the purchase of the two goods.
An exchange of two days of skiing for one day of horseback riding would leave her at point T, and she would be as well off as she is at point S. Her marginal rate of substitution between points S and T is 2; her indifference curve is steeper than the budget line at point S. The fact that her indifference curve is steeper than her budget line tells us that the rate at which she is willing to exchange the two goods differs from the rate the market asks. She would be willing to give up as many as 2 days of skiing to gain an extra day of horseback riding; the market demands that she give up only one. The marginal decision rule says that if an additional unit of an activity yields greater benefit than its cost, it should be pursued. If the benefit to Ms. Bain of one more day of horseback riding equals the benefit of 2 days of skiing, yet she can get it by giving up only 1 day of skiing, then the benefit of that extra day of horseback riding is clearly greater than the cost.
Because the market asks that she give up less than she is willing to give up for an additional day of horseback riding, she will make the exchange. Beginning at point S, she will exchange a day of skiing for a day of horseback riding. That moves her along her budget line to point D. Recall that we can draw an indifference curve through any point; she is now on indifference curve E. It is above and to the right of indifference curve C, so Ms. Bain is clearly better off. And that should come as no surprise. When she was at point S, she was willing to give up 2 days of skiing to get an extra day of horseback riding. The market asked her to give up only one; she got her extra day of riding at a bargain! Her move along her budget line from point S to point D suggests a very important principle. If a consumer’s indifference curve intersects the budget line, then it will always be possible for the consumer to make exchanges along the budget line that move to a higher indifference curve. Ms. Bain’s new indifference curve at point D also intersects her budget line; she’s still willing to give up more skiing than the market asks for additional riding. She will make another exchange and move along her budget line to point X, at which she attains the highest indifference curve possible with her budget. Point X is on indifference curve A, which is tangent to the budget line.
Having reached point X, Ms. Bain clearly would not give up still more days of skiing for additional days of riding. Beyond point X, her indifference curve is flatter than the budget line—her marginal rate of substitution is less than the absolute value of the slope of the budget line. That means that the rate at which she would be willing to exchange skiing for horseback riding is less than the market asks. She cannot make herself better off than she is at point X by further rearranging her consumption. Point X, where the rate at which she is willing to exchange one good for another equals the rate the market asks, gives her the maximum utility possible.
Utility Maximization and Demand
Figure 7.14 showed Janet Bain’s utility-maximizing solution for skiing and horseback riding. She achieved it by selecting a point at which an indifference curve was tangent to her budget line. A change in the price of one of the goods, however, will shift her budget line. By observing what happens to the quantity of the good demanded, we can derive Ms. Bain’s demand curve.
Panel (a) of Figure 7.15 shows the original solution at point X, where Ms. Bain has $250 to spend and the price of a day of either skiing or horseback riding is$50. Now suppose the price of horseback riding falls by half, to $25. That changes the horizontal intercept of the budget line; if she spends all of her money on horseback riding, she can now ride 10 days per semester. Another way to think about the new budget line is to remember that its slope is equal to the negative of the price of the good on the horizontal axis divided by the price of the good on the vertical axis. When the price of horseback riding (the good on the horizontal axis) goes down, the budget line becomes flatter. Ms. Bain picks a new utility-maximizing solution at point Z. The solution at Z involves an increase in the number of days Ms. Bain spends horseback riding. Notice that only the price of horseback riding has changed; all other features of the utility-maximizing solution remain the same. Ms. Bain’s budget and the price of skiing are unchanged; this is reflected in the fact that the vertical intercept of the budget line remains fixed. Ms. Bain’s preferences are unchanged; they are reflected by her indifference curves. Because all other factors in the solution are unchanged, we can determine two points on Ms. Bain’s demand curve for horseback riding from her indifference curve diagram. At a price of$50, she maximized utility at point X, spending 3 days horseback riding per semester. When the price falls to $25, she maximizes utility at point Z, riding 4 days per semester. Those points are plotted as points X′ and Z′ on her demand curve for horseback riding in Panel (b) of Figure 7.15. Key Takeaways • A budget line shows combinations of two goods a consumer is able to consume, given a budget constraint. • An indifference curve shows combinations of two goods that yield equal satisfaction. • To maximize utility, a consumer chooses a combination of two goods at which an indifference curve is tangent to the budget line. • At the utility-maximizing solution, the consumer’s marginal rate of substitution (the absolute value of the slope of the indifference curve) is equal to the price ratio of the two goods. • We can derive a demand curve from an indifference map by observing the quantity of the good consumed at different prices. Try It! 1. Suppose a consumer has a budget for fast-food items of$20 per week and spends this money on two goods, hamburgers and pizzas. Suppose hamburgers cost $5 each and pizzas cost$10. Put the quantity of hamburgers purchased per week on the horizontal axis and the quantity of pizzas purchased per week on the vertical axis. Draw the budget line. What is its slope?
2. Suppose the consumer in part (a) is indifferent among the combinations of hamburgers and pizzas shown. In the grid you used to draw the budget lines, draw an indifference curve passing through the combinations shown, and label the corresponding points A, B, and C. Label this curve I.
Combination Hamburgers/week Pizzas/week
A 5 0
B 3 ½
C 0 3
3. The budget line is tangent to indifference curve I at B. Explain the meaning of this tangency.
Case in Point: Preferences Prevail in P.O.W. Camps
Economist R. A. Radford spent time in prisoner of war (P.O.W.) camps in Italy and Germany during World War II. He put this unpleasant experience to good use by testing a number of economic theories there. Relevant to this chapter, he consistently observed utility-maximizing behavior.
In the P.O.W. camps where he stayed, prisoners received rations, provided by their captors and the Red Cross, including tinned milk, tinned beef, jam, butter, biscuits, chocolate, tea, coffee, cigarettes, and other items. While all prisoners received approximately equal official rations (though some did manage to receive private care packages as well), their marginal rates of substitution between goods in the ration packages varied. To increase utility, prisoners began to engage in trade.
Prices of goods tended to be quoted in terms of cigarettes. Some camps had better organized markets than others but, in general, even though prisoners of each nationality were housed separately, so long as they could wander from bungalow to bungalow, the “cigarette” prices of goods were equal across bungalows. Trade allowed the prisoners to maximize their utility.
Consider coffee and tea. Panel (a) shows the indifference curves and budget line for typical British prisoners and Panel (b) shows the indifference curves and budget line for typical French prisoners. Suppose the price of an ounce of tea is 2 cigarettes and the price of an ounce of coffee is 1 cigarette. The slopes of the budget lines in each panel are identical; all prisoners faced the same prices. The price ratio is 1/2.
Suppose the ration packages given to all prisoners contained the same amounts of both coffee and tea. But notice that for typical British prisoners, given indifference curves which reflect their general preference for tea, the MRS at the initial allocation (point A) is less than the price ratio. For French prisoners, the MRS is greater than the price ratio (point B). By trading, both British and French prisoners can move to higher indifference curves. For the British prisoners, the utility-maximizing solution is at point E, with more tea and little coffee. For the French prisoners the utility-maximizing solution is at point E′, with more coffee and less tea. In equilibrium, both British and French prisoners consumed tea and coffee so that their MRS’s equal 1/2, the price ratio in the market.
Figure 7.17
Answers to Try It! Problems
1. The budget line is shown in Panel (a). Its slope is −$5/$10 = −0.5.
2. Panel (b) shows indifference curve I. The points A, B, and C on I have been labeled.
3. The tangency point at B shows the combinations of hamburgers and pizza that maximize the consumer’s utility, given the budget constraint. At the point of tangency, the marginal rate of substitution (MRS) between the two goods is equal to the ratio of prices of the two goods. This means that the rate at which the consumer is willing to exchange one good for another equals the rate at which the goods can be exchanged in the market.
Figure 7.18
1Limiting the situation to two goods allows us to show the problem graphically. By stating the problem of utility maximization with equations, we could extend the analysis to any number of goods and services. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/07%3A_The_Analysis_of_Consumer_Choice/7.3%3A_Indifference_Curve_Analysis%3A_An_Alternative_Approach_to_Understanding_Consumer_Choice.txt |
Summary
In this chapter we have examined the model of utility-maximizing behavior. Economists assume that consumers make choices consistent with the objective of achieving the maximum total utility possible for a given budget constraint.
Utility is a conceptual measure of satisfaction; it is not actually measurable. The theory of utility maximization allows us to ask how a utility-maximizing consumer would respond to a particular event.
By following the marginal decision rule, consumers will achieve the utility-maximizing condition: Expenditures equal consumers’ budgets, and ratios of marginal utility to price are equal for all pairs of goods and services. Thus, consumption is arranged so that the extra utility per dollar spent is equal for all goods and services. The marginal utility from a particular good or service eventually diminishes as consumers consume more of it during a period of time.
Utility maximization underlies consumer demand. The amount by which the quantity demanded changes in response to a change in price consists of a substitution effect and an income effect. The substitution effect always changes quantity demanded in a manner consistent with the law of demand. The income effect of a price change reinforces the substitution effect in the case of normal goods, but it affects consumption in an opposite direction in the case of inferior goods.
An alternative approach to utility maximization uses indifference curves. This approach does not rely on the concept of marginal utility, and it gives us a graphical representation of the utility-maximizing condition.
Concept Problems
1. Suppose you really, really like ice cream. You adore ice cream. Does the law of diminishing marginal utility apply to your ice cream consumption?
2. If two commodities that you purchase on a regular basis carry the same price, does that mean they both provide the same total utility? Marginal utility?
3. If a person goes to the bowling alley planning to spend \$15 but comes away with \$5, what, if anything, can you conclude about the marginal utility of the alternatives (for example, bowl another line, have a soda or a sandwich) available to the person at the time he or she leaves?
4. Which do you like more—going to the movies or watching rented DVDs at home? If you engage in both activities during the same period, say a week, explain why.
5. Do you tend to eat more at a fixed-price buffet or when ordering from an a la carte menu? Explain, using the marginal decision rule that guides your behavior.
6. Suppose there is a bill to increase the tax on cigarettes by \$1 per pack coupled with an income tax cut of \$500. Suppose a person smokes an average of 500 packs of cigarettes per year—and would thus face a tax increase of about \$500 per year from the cigarette tax at the person’s current level of consumption. The income tax measure would increase the person’s after-tax income by \$500. Would the combined measures be likely to have any effect on the person’s consumption of cigarettes? Why or why not?
7. How does an increase in income affect a consumer’s budget line? His or her total utility?
8. Why can Ms. Bain not consume at point Y in Figure 7.13?
9. Suppose Ms. Bain is now consuming at point V in Figure 7.13. Use the marginal decision rule to explain why a shift to X would increase her utility.
10. Suppose that you are a utility maximizer and so is your economics instructor. What can you conclude about your respective marginal rates of substitution for movies and concerts?
Numerical Problems
1. The table shows the total utility Joseph derives from eating pizza in the evening while studying.
Pieces of pizza/evening Total Utility
0 0
1 30
2 48
3 60
4 70
5 78
6 80
7 76
1. How much marginal utility does Joseph derive from the third piece of pizza?
2. After eating how many pieces of pizza does marginal utility start to decline?
3. If the pizza were free, what is the maximum number of pieces Joseph would eat in an evening?
4. On separate diagrams, construct Joseph’s total utility and marginal utility curves for pizza. Does the law of diminishing marginal utility hold? How do you know?
2. Suppose the marginal utility of good A is 20 and its price is \$4, and the marginal utility of good B is 50 and its price is \$5. The individual to whom this information applies is spending \$20 on each good. Is he or she maximizing satisfaction? If not, what should the individual do to increase total satisfaction? On the basis of this information, can you pick an optimum combination? Why or why not?
3. John and Marie settle down to watch the evening news. Marie is content to watch the entire program, while John continually switches channels in favor of possible alternatives. Draw the likely marginal utility curves for watching the evening news for the two individuals. Whose marginal utility curve is likely to be steeper?
4. Li, a very careful maximizer of utility, consumes two services, going to the movies and bowling. She has arranged her consumption of the two activities so that the marginal utility of going to a movie is 20 and the marginal utility of going bowling is 10. The price of going to a movie is \$10, and the price of going bowling is \$5. Show that she is satisfying the requirement for utility maximization. Now show what happens when the price of going bowling rises to \$10.
5. The table shows the total utility (TU) that Jeremy receives from consuming different amounts of two goods, X and Y, per month.
Quantity
TU
X
MU
X
MUX/PX
TU
Y
MU
Y
MUY/PY
0 0 0
1 50 75
2 88 117
3 121 153
4 150 181
5 175 206
6 196 225
7 214 243
8 229 260
9 241 276
1. Fill in the other columns of the table by calculating the marginal utilities for goods X and Y and the ratios of marginal utilities to price for the two goods. Assume that the price of both goods X and Y is \$3. Be sure to use the “midpoint convention” when you fill out the table.
2. If Jeremy allocates \$30 to spend on both goods, how many units will he buy of each?
3. How much will Jeremy spend on each good at the utility maximizing combination?
4. How much total utility will Jeremy experience by buying the utility-maximizing combination?
5. Suppose the price of good Y increases to \$6. How many units of X and Y will he buy to maximize his utility now?
6. Draw Jeremy’s demand curve for good Y between the prices of \$6 and \$3.
6. Sid is a commuter-student at his college. During the day, he snacks on cartons of yogurt and the “house special” sandwiches at the Student Center cafeteria. A carton of yogurt costs \$1.20; the Student Center often offers specials on the sandwiches, so their price varies a great deal. Sid has a budget of \$36 per week for food at the Center. Five of Sid’s indifference curves are given by the schedule below; the points listed in the tables correspond to the points shown in the graph.
Figure 7.19
1. Use the set of Sid’s indifference curves shown as a guide in drawing your own graph grid. Draw Sid’s indifference curves and budget line, assuming sandwiches cost \$3.60. Identify the point at which he maximizes utility. How many sandwiches will he consume? How many cartons of yogurt? (Hint: All of the answers in this exercise occur at one of the combinations given in the tables on this page.)
2. Now suppose the price of sandwiches is cut to \$1.20. Draw the new budget line. Identify the point at which Sid maximizes utility. How many sandwiches will he consume? How many cartons of yogurt?
3. Now draw the budget lines implied by a price of yogurt of \$1.20 and sandwich prices of \$0.90 and \$1.80. With the observations you’ve already made for sandwich prices of \$3.60 and \$1.20, draw the demand curve. Explain how this demand curve illustrates the law of demand. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/07%3A_The_Analysis_of_Consumer_Choice/7.4%3A_Review_and_Practice.txt |
Learning Objective
1. Understand the terms associated with the short-run production function—total product, average product, and marginal product—and explain and illustrate how they are related to each other.
2. Explain the concepts of increasing, diminishing, and negative marginal returns and explain the law of diminishing marginal returns.
3. Understand the terms associated with costs in the short run—total variable cost, total fixed cost, total cost, average variable cost, average fixed cost, average total cost, and marginal cost—and explain and illustrate how they are related to each other.
4. Explain and illustrate how the product and cost curves are related to each other and to determine in what ranges on these curves marginal returns are increasing, diminishing, or negative.
Our analysis of production and cost begins with a period economists call the short run. The short run in this microeconomic context is a planning period over which the managers of a firm must consider one or more of their factors of production as fixed in quantity. For example, a restaurant may regard its building as a fixed factor over a period of at least the next year. It would take at least that much time to find a new building or to expand or reduce the size of its present facility. Decisions concerning the operation of the restaurant during the next year must assume the building will remain unchanged. Other factors of production could be changed during the year, but the size of the building must be regarded as a constant.
When the quantity of a factor of production cannot be changed during a particular period, it is called a fixed factor of production. For the restaurant, its building is a fixed factor of production for at least a year. A factor of production whose quantity can be changed during a particular period is called a variable factor of production; factors such as labor and food are examples.
While the managers of the restaurant are making choices concerning its operation over the next year, they are also planning for longer periods. Over those periods, managers may contemplate alternatives such as modifying the building, building a new facility, or selling the building and leaving the restaurant business. The planning period over which a firm can consider all factors of production as variable is called the long run.
At any one time, a firm will be making both short-run and long-run choices. The managers may be planning what to do for the next few weeks and for the next few years. Their decisions over the next few weeks are likely to be short-run choices. Decisions that will affect operations over the next few years may be long-run choices, in which managers can consider changing every aspect of their operations. Our analysis in this section focuses on the short run. We examine long-run choices later in this chapter.
The Short-Run Production Function
A firm uses factors of production to produce a product. The relationship between factors of production and the output of a firm is called a production function Our first task is to explore the nature of the production function.
Consider a hypothetical firm, Acme Clothing, a shop that produces jackets. Suppose that Acme has a lease on its building and equipment. During the period of the lease, Acme’s capital is its fixed factor of production. Acme’s variable factors of production include things such as labor, cloth, and electricity. In the analysis that follows, we shall simplify by assuming that labor is Acme’s only variable factor of production.
Total, Marginal, and Average Products
Figure 8.1 shows the number of jackets Acme can obtain with varying amounts of labor (in this case, tailors) and its given level of capital. A total product curve shows the quantities of output that can be obtained from different amounts of a variable factor of production, assuming other factors of production are fixed.
Notice what happens to the slope of the total product curve in Figure 8.1. Between 0 and 3 units of labor per day, the curve becomes steeper. Between 3 and 7 workers, the curve continues to slope upward, but its slope diminishes. Beyond the seventh tailor, production begins to decline and the curve slopes downward.
We measure the slope of any curve as the vertical change between two points divided by the horizontal change between the same two points. The slope of the total product curve for labor equals the change in output (ΔQ) divided by the change in units of labor (ΔL):
Slope of the total product curve = ΔQL
The slope of a total product curve for any variable factor is a measure of the change in output associated with a change in the amount of the variable factor, with the quantities of all other factors held constant. The amount by which output rises with an additional unit of a variable factor is the marginal product of the variable factor. Mathematically, marginal product is the ratio of the change in output to the change in the amount of a variable factor. The marginal product of labor (MPL), for example, is the amount by which output rises with an additional unit of labor. It is thus the ratio of the change in output to the change in the quantity of labor (ΔQL), all other things unchanged. It is measured as the slope of the total product curve for labor.
Equation 8.1
$\Delta L$
In addition we can define the average product of a variable factor. It is the output per unit of variable factor. The average product of labor (APL), for example, is the ratio of output to the number of units of labor (Q/L).
Equation 8.2
$L$
The concept of average product is often used for comparing productivity levels over time or in comparing productivity levels among nations. When you read in the newspaper that productivity is rising or falling, or that productivity in the United States is nine times greater than productivity in China, the report is probably referring to some measure of the average product of labor.
The total product curve in Panel (a) of Figure 8.2 is repeated from Figure 8.1. Panel (b) shows the marginal product and average product curves. Notice that marginal product is the slope of the total product curve, and that marginal product rises as the slope of the total product curve increases, falls as the slope of the total product curve declines, reaches zero when the total product curve achieves its maximum value, and becomes negative as the total product curve slopes downward. As in other parts of this text, marginal values are plotted at the midpoint of each interval. The marginal product of the fifth unit of labor, for example, is plotted between 4 and 5 units of labor. Also notice that the marginal product curve intersects the average product curve at the maximum point on the average product curve. When marginal product is above average product, average product is rising. When marginal product is below average product, average product is falling.
Figure 8.2 From Total Product to the Average and Marginal Product of Labor
The first two rows of the table give the values for quantities of labor and total product from Figure 8.1. Marginal product, given in the third row, is the change in output resulting from a one-unit increase in labor. Average product, given in the fourth row, is output per unit of labor. Panel (a) shows the total product curve. The slope of the total product curve is marginal product, which is plotted in Panel (b). Values for marginal product are plotted at the midpoints of the intervals. Average product rises and falls. Where marginal product is above average product, average product rises. Where marginal product is below average product, average product falls. The marginal product curve intersects the average product curve at the maximum point on the average product curve.
As a student you can use your own experience to understand the relationship between marginal and average values. Your grade point average (GPA) represents the average grade you have earned in all your course work so far. When you take an additional course, your grade in that course represents the marginal grade. What happens to your GPA when you get a grade that is higher than your previous average? It rises. What happens to your GPA when you get a grade that is lower than your previous average? It falls. If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains unchanged.
The relationship between average product and marginal product is similar. However, unlike your course grades, which may go up and down willy-nilly, marginal product always rises and then falls, for reasons we will explore shortly. As soon as marginal product falls below average product, the average product curve slopes downward. While marginal product is above average product, whether marginal product is increasing or decreasing, the average product curve slopes upward.
As we have learned, maximizing behavior requires focusing on making decisions at the margin. For this reason, we turn our attention now toward increasing our understanding of marginal product.
Increasing, Diminishing, and Negative Marginal Returns
Adding the first worker increases Acme’s output from 0 to 1 jacket per day. The second tailor adds 2 jackets to total output; the third adds 4. The marginal product goes up because when there are more workers, each one can specialize to a degree. One worker might cut the cloth, another might sew the seams, and another might sew the buttonholes. Their increasing marginal products are reflected by the increasing slope of the total product curve over the first 3 units of labor and by the upward slope of the marginal product curve over the same range. The range over which marginal products are increasing is called the range of increasing marginal returns. Increasing marginal returns exist in the context of a total product curve for labor, so we are holding the quantities of other factors constant. Increasing marginal returns may occur for any variable factor.
The fourth worker adds less to total output than the third; the marginal product of the fourth worker is 2 jackets. The data in Figure 8.2 show that marginal product continues to decline after the fourth worker as more and more workers are hired. The additional workers allow even greater opportunities for specialization, but because they are operating with a fixed amount of capital, each new worker adds less to total output. The fifth tailor adds only a single jacket to total output. When each additional unit of a variable factor adds less to total output, the firm is experiencing diminishing marginal returns. Over the range of diminishing marginal returns, the marginal product of the variable factor is positive but falling. Once again, we assume that the quantities of all other factors of production are fixed. Diminishing marginal returns may occur for any variable factor. Panel (b) shows that Acme experiences diminishing marginal returns between the third and seventh workers, or between 7 and 11 jackets per day.
After the seventh unit of labor, Acme’s fixed plant becomes so crowded that adding another worker actually reduces output. When additional units of a variable factor reduce total output, given constant quantities of all other factors, the company experiences negative marginal returns. Now the total product curve is downward sloping, and the marginal product curve falls below zero. Figure 8.3 shows the ranges of increasing, diminishing, and negative marginal returns. Clearly, a firm will never intentionally add so much of a variable factor of production that it enters a range of negative marginal returns.
The idea that the marginal product of a variable factor declines over some range is important enough, and general enough, that economists state it as a law. The law of diminishing marginal returns holds that the marginal product of any variable factor of production will eventually decline, assuming the quantities of other factors of production are unchanged.
Heads Up!
It is easy to confuse the concept of diminishing marginal returns with the idea of negative marginal returns. To say a firm is experiencing diminishing marginal returns is not to say its output is falling. Diminishing marginal returns mean that the marginal product of a variable factor is declining. Output is still increasing as the variable factor is increased, but it is increasing by smaller and smaller amounts. As we saw in Figure 8.2 and Figure 8.3, the range of diminishing marginal returns was between the third and seventh workers; over this range of workers, output rose from 7 to 11 jackets. Negative marginal returns started after the seventh worker.
To see the logic of the law of diminishing marginal returns, imagine a case in which it does not hold. Say that you have a small plot of land for a vegetable garden, 10 feet by 10 feet in size. The plot itself is a fixed factor in the production of vegetables. Suppose you are able to hold constant all other factors—water, sunshine, temperature, fertilizer, and seed—and vary the amount of labor devoted to the garden. How much food could the garden produce? Suppose the marginal product of labor kept increasing or was constant. Then you could grow an unlimited quantity of food on your small plot—enough to feed the entire world! You could add an unlimited number of workers to your plot and still increase output at a constant or increasing rate. If you did not get enough output with, say, 500 workers, you could use 5 million; the five-millionth worker would add at least as much to total output as the first. If diminishing marginal returns to labor did not occur, the total product curve would slope upward at a constant or increasing rate.
The shape of the total product curve and the shape of the resulting marginal product curve drawn in Figure 8.2 are typical of any firm for the short run. Given its fixed factors of production, increasing the use of a variable factor will generate increasing marginal returns at first; the total product curve for the variable factor becomes steeper and the marginal product rises. The opportunity to gain from increased specialization in the use of the variable factor accounts for this range of increasing marginal returns. Eventually, though, diminishing returns will set in. The total product curve will become flatter, and the marginal product curve will fall.
Costs in the Short Run
A firm’s costs of production depend on the quantities and prices of its factors of production. Because we expect a firm’s output to vary with the firm’s use of labor in a specific way, we can also expect the firm’s costs to vary with its output in a specific way. We shall put our information about Acme’s product curves to work to discover how a firm’s costs vary with its level of output.
We distinguish between the costs associated with the use of variable factors of production, which are called variable costs, and the costs associated with the use of fixed factors of production, which are called fixed costs. For most firms, variable costs includes costs for raw materials, salaries of production workers, and utilities. The salaries of top management may be fixed costs; any charges set by contract over a period of time, such as Acme’s one-year lease on its building and equipment, are likely to be fixed costs. A term commonly used for fixed costs is overhead. Notice that fixed costs exist only in the short run. In the long run, the quantities of all factors of production are variable, so that all long-run costs are variable.
Total variable cost (TVC) is cost that varies with the level of output. Total fixed cost (TFC) is cost that does not vary with output. Total cost (TC) is the sum of total variable cost and total fixed cost:
Equation 8.3
From Total Production to Total Cost
Next we illustrate the relationship between Acme’s total product curve and its total costs. Acme can vary the quantity of labor it uses each day, so the cost of this labor is a variable cost. We assume capital is a fixed factor of production in the short run, so its cost is a fixed cost.
Suppose that Acme pays a wage of \$100 per worker per day. If labor is the only variable factor, Acme’s total variable costs per day amount to \$100 times the number of workers it employs. We can use the information given by the total product curve, together with the wage, to compute Acme’s total variable costs.
We know from Figure 8.1 that Acme requires 1 worker working 1 day to produce 1 jacket. The total variable cost of a jacket thus equals \$100. Three units of labor produce 7 jackets per day; the total variable cost of 7 jackets equals \$300. Figure 8.4 shows Acme’s total variable costs for producing each of the output levels given in Figure 8.1
Figure 8.4 gives us costs for several quantities of jackets, but we need a bit more detail. We know, for example, that 7 jackets have a total variable cost of \$300. What is the total variable cost of 6 jackets?
We can estimate total variable costs for other quantities of jackets by inspecting the total product curve in Figure 8.1. Reading over from a quantity of 6 jackets to the total product curve and then down suggests that the Acme needs about 2.8 units of labor to produce 6 jackets per day. Acme needs 2 full-time and 1 part-time tailors to produce 6 jackets. Figure 8.5 gives the precise total variable costs for quantities of jackets ranging from 0 to 11 per day. The numbers in boldface type are taken from Figure 8.4; the other numbers are estimates we have assigned to produce a total variable cost curve that is consistent with our total product curve. You should, however, be certain that you understand how the numbers in boldface type were found.
Suppose Acme’s present plant, including the building and equipment, is the equivalent of 20 units of capital. Acme has signed a long-term lease for these 20 units of capital at a cost of \$200 per day. In the short run, Acme cannot increase or decrease its quantity of capital—it must pay the \$200 per day no matter what it does. Even if the firm cuts production to zero, it must still pay \$200 per day in the short run.
Acme’s total cost is its total fixed cost of \$200 plus its total variable cost. We add \$200 to the total variable cost curve in Figure 8.5 to get the total cost curve shown in Figure 8.6.
Notice something important about the shapes of the total cost and total variable cost curves in Figure 8.6. The total cost curve, for example, starts at \$200 when Acme produces 0 jackets—that is its total fixed cost. The curve rises, but at a decreasing rate, up to the seventh jacket. Beyond the seventh jacket, the curve becomes steeper and steeper. The slope of the total variable cost curve behaves in precisely the same way.
Recall that Acme experienced increasing marginal returns to labor for the first three units of labor—or the first seven jackets. Up to the third worker, each additional worker added more and more to Acme’s output. Over the range of increasing marginal returns, each additional jacket requires less and less additional labor. The first jacket required one tailor; the second required the addition of only a part-time tailor; the third required only that Acme boost that part-time tailor’s hours to a full day. Up to the seventh jacket, each additional jacket requires less and less additional labor, and thus costs rise at a decreasing rate; the total cost and total variable cost curves become flatter over the range of increasing marginal returns.
Acme experiences diminishing marginal returns beyond the third unit of labor—or the seventh jacket. Notice that the total cost and total variable cost curves become steeper and steeper beyond this level of output. In the range of diminishing marginal returns, each additional unit of a factor adds less and less to total output. That means each additional unit of output requires larger and larger increases in the variable factor, and larger and larger increases in costs.
Marginal and Average Costs
Marginal and average cost curves, which will play an important role in the analysis of the firm, can be derived from the total cost curve. Marginal cost shows the additional cost of each additional unit of output a firm produces. This is a specific application of the general concept of marginal cost presented earlier. Given the marginal decision rule’s focus on evaluating choices at the margin, the marginal cost curve takes on enormous importance in the analysis of a firm’s choices. The second curve we shall derive shows the firm’s average total cost at each level of output. Average total cost (ATC) is total cost divided by quantity; it is the firm’s total cost per unit of output:
Equation 8.4
$Q$
We shall also discuss average variable costs (AVC), which is the firm’s variable cost per unit of output; it is total variable cost divided by quantity:
Equation 8.5
$Q$
We are still assessing the choices facing the firm in the short run, so we assume that at least one factor of production is fixed. Finally, we will discuss average fixed cost(AFC), which is total fixed cost divided by quantity:
Equation 8.6
$Q$
Marginal cost (MC) is the amount by which total cost rises with an additional unit of output. It is the ratio of the change in total cost to the change in the quantity of output:
Equation 8.7
$\Delta Q$
It equals the slope of the total cost curve. Figure 8.7 shows the same total cost curve that was presented in Figure 8.6. This time the slopes of the total cost curve are shown; these slopes equal the marginal cost of each additional unit of output. For example, increasing output from 6 to 7 units (ΔQ=1) increases total cost from \$480 to \$500 (ΔTC=\$20). The seventh unit thus has a marginal cost of \$20 (ΔTC/ΔQ=\$20/1=\$20). Marginal cost falls over the range of increasing marginal returns and rises over the range of diminishing marginal returns.
Heads Up!
Notice that the various cost curves are drawn with the quantity of output on the horizontal axis. The various product curves are drawn with quantity of a factor of production on the horizontal axis. The reason is that the two sets of curves measure different relationships. Product curves show the relationship between output and the quantity of a factor; they therefore have the factor quantity on the horizontal axis. Cost curves show how costs vary with output and thus have output on the horizontal axis.
Figure 8.7 Total Cost and Marginal Cost
Marginal cost in Panel (b) is the slope of the total cost curve in Panel (a).
Figure 8.8 shows the computation of Acme’s short-run average total cost, average variable cost, and average fixed cost and graphs of these values. Notice that the curves for short-run average total cost and average variable cost fall, then rise. We say that these cost curves are U-shaped. Average fixed cost keeps falling as output increases. This is because the fixed costs are spread out more and more as output expands; by definition, they do not vary as labor is added. Since average total cost (ATC) is the sum of average variable cost (AVC) and average fixed cost (AFC), i.e.,
Equation 8.8
the distance between the ATC and AVC curves keeps getting smaller and smaller as the firm spreads its overhead costs over more and more output.
Figure 8.8 includes the marginal cost data and the marginal cost curve from Figure 8.7. The marginal cost curve intersects the average total cost and average variable cost curves at their lowest points. When marginal cost is below average total cost or average variable cost, the average total and average variable cost curves slope downward. When marginal cost is greater than short-run average total cost or average variable cost, these average cost curves slope upward. The logic behind the relationship between marginal cost and average total and variable costs is the same as it is for the relationship between marginal product and average product.
We turn next in this chapter to an examination of production and cost in the long run, a planning period in which the firm can consider changing the quantities of any or all factors.
Key Takeaways
Figure 8.9
• In Panel (a), the total product curve for a variable factor in the short run shows that the firm experiences increasing marginal returns from zero to Fa units of the variable factor (zero to Qa units of output), diminishing marginal returns from Fa to Fb (Qa to Qb units of output), and negative marginal returns beyond Fb units of the variable factor.
• Panel (b) shows that marginal product rises over the range of increasing marginal returns, falls over the range of diminishing marginal returns, and becomes negative over the range of negative marginal returns. Average product rises when marginal product is above it and falls when marginal product is below it.
• In Panel (c), total cost rises at a decreasing rate over the range of output from zero to Qa This was the range of output that was shown in Panel (a) to exhibit increasing marginal returns. Beyond Qa, the range of diminishing marginal returns, total cost rises at an increasing rate. The total cost at zero units of output (shown as the intercept on the vertical axis) is total fixed cost.
• Panel (d) shows that marginal cost falls over the range of increasing marginal returns, then rises over the range of diminishing marginal returns. The marginal cost curve intersects the average total cost and average variable cost curves at their lowest points. Average fixed cost falls as output increases. Note that average total cost equals average variable cost plus average fixed cost.
• Assuming labor is the variable factor of production, the following definitions and relations describe production and cost in the short run:
$\Delta L$
$Q$
$Q$
$Q$
$\Delta Q$
Try It!
1. Suppose Acme gets some new equipment for producing jackets. The table below gives its new production function. Compute marginal product and average product and fill in the bottom two rows of the table. Referring to Figure 8.2, draw a graph showing Acme’s new total product curve. On a second graph, below the one showing the total product curve you drew, sketch the marginal and average product curves. Remember to plot marginal product at the midpoint between each input level. On both graphs, shade the regions where Acme experiences increasing marginal returns, diminishing marginal returns, and negative marginal returns.
Figure 8.10 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/08%3A_Production_and_Cost/8.1%3A_Production_Choices_and_Costs%3A_The_Short_Run.txt |
Learning Objective
1. Apply the marginal decision rule to explain how a firm chooses its mix of factors of production in the long run.
2. Define the long-run average cost curve and explain how it relates to economies and diseconomies or scale.
In a long-run planning perspective, a firm can consider changing the quantities of all its factors of production. That gives the firm opportunities it does not have in the short run. First, the firm can select the mix of factors it wishes to use. Should it choose a production process with lots of labor and not much capital, like the street sweepers in China? Or should it select a process that uses a great deal of capital and relatively little labor, like street sweepers in the United States? The second thing the firm can select is the scale (or overall size) of its operations. In the short run, a firm can increase output only by increasing its use of a variable factor. But in the long run, all factors are variable, so the firm can expand the use of all of its factors of production. The question facing the firm in the long run is: How much of an expansion or contraction in the scale of its operations should it undertake? Alternatively, it could choose to go out of business.
In its long-run planning, the firm not only regards all factors as variable, but it regards all costs as variable as well. There are no fixed costs in the long run. Because all costs are variable, the structure of costs in the long run differs somewhat from what we saw in the short run.
Choosing the Factor Mix
How shall a firm decide what mix of capital, labor, and other factors to use? We can apply the marginal decision rule to answer this question.
Suppose a firm uses capital and labor to produce a particular good. It must determine how to produce the good and the quantity it should produce. We address the question of how much the firm should produce in subsequent chapters, but certainly the firm will want to produce whatever quantity it chooses at as low a cost as possible. Another way of putting that goal is to say that the firm seeks the maximum output possible at every level of total cost.
At any level of total cost, the firm can vary its factor mix. It could, for example, substitute labor for capital in a way that leaves its total cost unchanged. In terms of the marginal decision rule, we can think of the firm as considering whether to spend an additional \$1 on one factor, hence \$1 less on another. The marginal decision rule says that a firm will shift spending among factors as long as the marginal benefit of such a shift exceeds the marginal cost.
What is the marginal benefit, say, of an additional \$1 spent on capital? An additional unit of capital produces the marginal product of capital. To determine the marginal benefit of \$1 spent on capital, we divide capital’s marginal product by its price: MPK/PK. The price of capital is the “rent” paid for the use of a unit of capital for a given period. If the firm already owns the capital, then this rent is an opportunity cost; it represents the return the firm could get by renting the capital to another user or by selling it and earning interest on the money thus gained.
If capital and labor are the only factors, then spending an additional \$1 on capital while holding total cost constant means taking \$1 out of labor. The cost of that action will be the output lost from cutting back \$1 worth of labor. That cost equals the ratio of the marginal product of labor to the price of labor, MPL/PL, where the price of labor is the wage.
Suppose that a firm’s marginal product of labor is 15 and the price of labor is \$5 per unit; the firm gains 3 units of output by spending an additional \$1 on labor. Suppose further that the marginal product of capital is 50 and the price of capital is \$50 per unit, so the firm would lose 1 unit of output by spending \$1 less on capital.
The firm achieves a net gain of 2 units of output, without any change in cost, by transferring \$1 from capital to labor. It will continue to transfer funds from capital to labor as long as it gains more output from the additional labor than it loses in output by reducing capital. As the firm shifts spending in this fashion, however, the marginal product of labor will fall and the marginal product of capital will rise. At some point, the ratios of marginal product to price will be equal for the two factors. At this point, the firm will obtain the maximum output possible for a given total cost:
Equation 8.9
Suppose that a firm that uses capital and labor is satisfying Equation 8.9 when suddenly the price of labor rises. At the current usage levels of the factors, a higher price of labor (PL′) lowers the ratio of the marginal product of labor to the price of labor:
The firm will shift funds out of labor and into capital. It will continue to shift from labor to capital until the ratios of marginal product to price are equal for the two factors. In general, a profit-maximizing firm will seek a combination of factors such that
Equation 8.10
When a firm satisfies the condition given in Equation 8.10 for efficient use, it produces the greatest possible output for a given cost. To put it another way, the firm achieves the lowest possible cost for a given level of output.
As the price of labor rises, the firm will shift to a factor mix that uses relatively more capital and relatively less labor. As a firm increases its ratio of capital to labor, we say it is becoming more capital intensive. A lower price for labor will lead the firm to use relatively more labor and less capital, reducing its ratio of capital to labor. As a firm reduces its ratio of capital to labor, we say it is becoming more labor intensive. The notions of labor-intensive and capital-intensive production are purely relative; they imply only that a firm has a higher or lower ratio of capital to labor.
Sometimes economists speak of labor-intensive versus capital-intensive countries in the same manner. One implication of the marginal decision rule for factor use is that firms in countries where labor is relatively expensive, such as the United States, will use capital-intensive production methods. Less developed countries, where labor is relatively cheap, will use labor-intensive methods.
Now that we understand how to apply the marginal decision rule to the problem of choosing the mix of factors, we can answer the question that began this chapter: Why does the United States employ a capital-intensive production process to clean streets while China chooses a labor-intensive process? Given that the same technology—know-how—is available, both countries could, after all, use the same production process. Suppose for a moment that the relative prices of labor and capital are the same in China and the United States. In that case, China and the United States can be expected to use the same method to clean streets. But the price of labor relative to the price of capital is, in fact, far lower in China than in the United States. A lower relative price for labor increases the ratio of the marginal product of labor to its price, making it efficient to substitute labor for capital. China thus finds it cheaper to clean streets with lots of people using brooms, while the United States finds it efficient to clean streets with large machines and relatively less labor.
Maquiladoras, plants in Mexico where processing is done using low-cost workers and labor-intensive methods, allow some U.S. firms to have it both ways. They complete part of the production process in the United States, using capital-intensive methods. They then ship the unfinished goods to maquiladoras. For example, many U.S. clothing manufacturers produce cloth at U.S. plants on large high-speed looms. They then ship the cloth to Mexico, where it is fashioned into clothing by workers using sewing machines. Another example is plastic injection molding, which requires highly skilled labor and is made in the U.S. The parts are molded in Texas border towns and are then shipped to maquiladoras and used in cars and computers. The resulting items are shipped back to the United States, labeled “Assembled in Mexico from U.S. materials.” Overall maquiladoras import 97% of the components they use, of which 80 to 85% come from the U.S.
The maquiladoras have been a boon to workers in Mexico, who enjoy a higher demand for their services and receive higher wages as a result. The system also benefits the U.S. firms that participate and U.S. consumers who obtain less expensive goods than they would otherwise. It works because different factor prices imply different mixes of labor and capital. Companies are able to carry out the capital-intensive side of the production process in the United States and the labor-intensive side in Mexico (Vargas, L., 2001; Gruben, W. C., 2004).
Costs in the Long Run
As in the short run, costs in the long run depend on the firm’s level of output, the costs of factors, and the quantities of factors needed for each level of output. The chief difference between long- and short-run costs is there are no fixed factors in the long run. There are thus no fixed costs. All costs are variable, so we do not distinguish between total variable cost and total cost in the long run: total cost is total variable cost.
The long-run average cost (LRAC) curve shows the firm’s lowest cost per unit at each level of output, assuming that all factors of production are variable. The LRAC curve assumes that the firm has chosen the optimal factor mix, as described in the previous section, for producing any level of output. The costs it shows are therefore the lowest costs possible for each level of output. It is important to note, however, that this does not mean that the minimum points of each short-run ATC curves lie on the LRAC curve. This critical point is explained in the next paragraph and expanded upon even further in the next section.
Figure 8.14 shows how a firm’s LRAC curve is derived. Suppose Lifetime Disc Co. produces compact discs (CDs) using capital and labor. We have already seen how a firm’s average total cost curve can be drawn in the short run for a given quantity of a particular factor of production, such as capital. In the short run, Lifetime Disc might be limited to operating with a given amount of capital; it would face one of the short-run average total cost curves shown in Figure 8.14. If it has 30 units of capital, for example, its average total cost curve is ATC30. In the long run the firm can examine the average total cost curves associated with varying levels of capital. Four possible short-run average total cost curves for Lifetime Disc are shown in Figure 8.14 for quantities of capital of 20, 30, 40, and 50 units. The relevant curves are labeled ATC20, ATC30, ATC40, and ATC50 respectively. The LRAC curve is derived from this set of short-run curves by finding the lowest average total cost associated with each level of output. Again, notice that the U-shaped LRAC curve is an envelope curve that surrounds the various short-run ATC curves. With the exception of ATC40, in this example, the lowest cost per unit for a particular level of output in the long run is not the minimum point of the relevant short-run curve.
Economies and Diseconomies of Scale
Notice that the long-run average cost curve in Figure 8.14 first slopes downward and then slopes upward. The shape of this curve tells us what is happening to average cost as the firm changes its scale of operations. A firm is said to experience economies of scale when long-run average cost declines as the firm expands its output. A firm is said to experience diseconomies of scale when long-run average cost increases as the firm expands its output.Constant returns to scale occur when long-run average cost stays the same over an output range.
Why would a firm experience economies of scale? One source of economies of scale is gains from specialization. As the scale of a firm’s operation expands, it is able to use its factors in more specialized ways, increasing their productivity. Another source of economies of scale lies in the economies that can be gained from mass production methods. As the scale of a firm’s operation expands, the company can begin to utilize large-scale machines and production systems that can substantially reduce cost per unit.
Why would a firm experience diseconomies of scale? At first glance, it might seem that the answer lies in the law of diminishing marginal returns, but this is not the case. The law of diminishing marginal returns, after all, tells us how output changes as a single factor is increased, with all other factors of production held constant. In contrast, diseconomies of scale describe a situation of rising average cost even when the firm is free to vary any or all of its factors as it wishes. Diseconomies of scale are generally thought to be caused by management problems. As the scale of a firm’s operations expands, it becomes harder and harder for management to coordinate and guide the activities of individual units of the firm. Eventually, the diseconomies of management overwhelm any gains the firm might be achieving by operating with a larger scale of plant, and long-run average costs begin rising. Firms experience constant returns to scale at output levels where there are neither economies nor diseconomies of scale. For the range of output over which the firm experiences constant returns to scale, the long-run average cost curve is horizontal.
Firms are likely to experience all three situations, as shown in Figure 8.15. At very low levels of output, the firm is likely to experience economies of scale as it expands the scale of its operations. There may follow a range of output over which the firm experiences constant returns to scale—empirical studies suggest that the range over which firms experience constant returns to scale is often very large. And certainly there must be some range of output over which diseconomies of scale occur; this phenomenon is one factor that limits the size of firms. A firm operating on the upward-sloping part of its LRAC curve is likely to be undercut in the market by smaller firms operating with lower costs per unit of output.
The Size Distribution of Firms
Economies and diseconomies of scale have a powerful effect on the sizes of firms that will operate in any market. Suppose firms in a particular industry experience diseconomies of scale at relatively low levels of output. That industry will be characterized by a large number of fairly small firms. The restaurant market appears to be such an industry. Barbers and beauticians are another example.
If firms in an industry experience economies of scale over a very wide range of output, firms that expand to take advantage of lower cost will force out smaller firms that have higher costs. Such industries are likely to have a few large firms instead of many small ones. In the refrigerator industry, for example, the size of firm necessary to achieve the lowest possible cost per unit is large enough to limit the market to only a few firms. In most cities, economies of scale leave room for only a single newspaper.
One factor that can limit the achievement of economies of scale is the demand facing an individual firm. The scale of output required to achieve the lowest unit costs possible may require sales that exceed the demand facing a firm. A grocery store, for example, could minimize unit costs with a large store and a large volume of sales. But the demand for groceries in a small, isolated community may not be able to sustain such a volume of sales. The firm is thus limited to a small scale of operation even though this might involve higher unit costs.
Key Takeaways
• A firm chooses its factor mix in the long run on the basis of the marginal decision rule; it seeks to equate the ratio of marginal product to price for all factors of production. By doing so, it minimizes the cost of producing a given level of output.
• The long-run average cost (LRAC ) curve is derived from the average total cost curves associated with different quantities of the factor that is fixed in the short run. The LRAC curve shows the lowest cost per unit at which each quantity can be produced when all factors of production, including capital, are variable.
• A firm may experience economies of scale, constant returns to scale, or diseconomies of scale. Economies of scale imply a downward-sloping long-run average cost (LRAC ) curve. Constant returns to scale imply a horizontal LRAC curve. Diseconomies of scale imply an upward-sloping LRAC curve.
• A firm’s ability to exploit economies of scale is limited by the extent of market demand for its products.
• The range of output over which firms experience economies of scale, constant return to scale, or diseconomies of scale is an important determinant of how many firms will survive in a particular market.
Try It!
1. Suppose Acme Clothing is operating with 20 units of capital and producing 9 units of output at an average total cost of \$67, as shown in Figure 8.8. How much labor is it using?
2. Suppose it finds that, with this combination of capital and labor, MPK/PK > MPL/PL. What adjustment will the firm make in the long run? Why does it not make this same adjustment in the short run?
Case in Point: Telecommunications Equipment, Economies of Scale, and Outage Risk
Figure 8.16
How big should the call switching equipment a major telecommunications company uses be? Having bigger machines results in economies of scale but also raises the risk of larger outages that will affect more customers.
Verizon Laboratories economist Donald E. Smith examined both the economies of scale available from larger equipment and the greater danger of more widespread outages. He concluded that companies should not use the largest machines available because of the outage danger and that they should not use the smallest size because that would mean forgoing the potential gains from economies of scale of larger sizes.
Switching machines, the large computers that handle calls for telecommunications companies, come in four basic “port matrix sizes.” These are measured in terms of Digital Cross-Connects (DCS’s). The four DCS sizes available are 6,000; 12,000; 24,000; and 36,000 ports. Different machine sizes are made with the same components and thus have essentially the same probability of breaking down. Because larger machines serve more customers, however, a breakdown in a large machine has greater consequences for the company.
The costs of an outage have three elements. The first is lost revenue from calls that would otherwise have been completed. Second, the FCC requires companies to provide a credit of one month of free service after any outage that lasts longer than one minute. Finally, an outage damages a company’s reputation and inevitably results in dissatisfied customers—some of whom may switch to other companies.
But, there are advantages to larger machines. A company has a “portfolio” of switching machines. Having larger machines lowers costs in several ways. First, the initial acquisition of the machine generates lower cost per call completed the greater the size of the machine. When the company must make upgrades to the software, having fewer—and larger—machines means fewer upgrades and thus lower costs.
In deciding on matrix size companies should thus compare the cost advantages of a larger matrix with the disadvantages of the higher outage costs associated with those larger matrixes.
Mr. Smith concluded that the economies of scale outweigh the outage risks as a company expands beyond 6,000 ports but that 36,000 ports is “too big” in the sense that the outage costs outweigh the advantage of the economies of scale. The evidence thus suggests that a matrix size in the range of 12,000 to 24,000 ports is optimal.
Answers to Try It! Problems
1. To produce 9 jackets, Acme uses 4 units of labor.
2. In the long run, Acme will substitute capital for labor. It cannot make this adjustment in the short run, because its capital is fixed in the short run. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/08%3A_Production_and_Cost/8.2%3A_Production_Choices_and_Costs%3A_The_Long_Run.txt |
Summary
In this chapter we have concentrated on the production and cost relationships facing firms in the short run and in the long run.
In the short run, a firm has at least one factor of production that it cannot vary. This fixed factor limits the firm’s range of factor choices. As a firm uses more and more of a variable factor (with fixed quantities of other factors of production), it is likely to experience at first increasing, then diminishing, then negative marginal returns. Thus, the short-run total cost curve has a positive value at a zero level of output (the firm’s total fixed cost), then slopes upward at a decreasing rate (the range of increasing marginal returns), and then slopes upward at an increasing rate (the range of diminishing marginal returns).
In addition to short-run total product and total cost curves, we derived a firm’s marginal product, average product, average total cost, average variable cost, average fixed cost, and marginal cost curves.
If the firm is to maximize profit in the long run, it must select the cost-minimizing combination of factors for its chosen level of output. Thus, the firm must try to use factors of production in accordance with the marginal decision rule. That is, it will use factors so that the ratio of marginal product to factor price is equal for all factors of production.
A firm’s long-run average cost (LRAC) curve includes a range of economies of scale, over which the curve slopes downward, and a range of diseconomies of scale, over which the curve slopes upward. There may be an intervening range of output over which the firm experiences constant returns to scale; its LRAC curve will be horizontal over this range. The size of operations necessary to reach the lowest point on the LRAC curve has a great deal to do with determining the relative sizes of firms in an industry.
This chapter has focused on the nature of production processes and the costs associated with them. These ideas will prove useful in understanding the behavior of firms and the decisions they make concerning supply of goods and services.
Concept Problems
1. Which of the following would be considered long-run choices? Which are short-run choices?
1. A dentist hires a new part-time dental hygienist.
2. The local oil refinery plans a complete restructuring of its production processes, including relocating the plant.
3. A farmer increases the quantity of water applied to his or her fields.
4. A law partnership signs a 3-year lease for an office complex.
5. The university hires a new football coach on a 3-year contract.
2. “There are no fixed costs in the long run.” Explain.
3. Business is booming at the local McDonald’s restaurant. It is contemplating adding a new grill and french-fry machine, but the day supervisor suggests simply hiring more workers. How should the manager decide which alternative to pursue?
4. Suppose that the average age of students in your economics class is 23.7 years. If a new 19-year-old student enrolls in the class, will the average age in the class rise or fall? Explain how this relates to the relationship between average and marginal values.
5. Barry Bond’s career home run average in his first 15 years in major league baseball (through 1997) was 33 home runs per season. In 2001, he hit 73 home runs. What happened to his career home run average? What effect did his performance in 2001 have on his career home run average? Explain how this relates to the relationship between average and marginal values.
6. Suppose a firm is operating at the minimum point of its short-run average total cost curve, so that marginal cost equals average total cost. Under what circumstances would it choose to alter the size of its plant? Explain.
7. What happens to the difference between average total cost and average variable cost as a firm’s output expands? Explain.
8. How would each of the following affect average total cost, average variable cost, and marginal cost?
1. An increase in the cost of the lease of the firm’s building
2. A reduction in the price of electricity
3. A reduction in wages
4. A change in the salary of the president of the company
9. Consider the following types of firms. For each one, the long-run average cost curve eventually exhibits diseconomies of scale. For which firms would you expect diseconomies of scale to set in at relatively low levels of output? Why?
1. A copy shop
2. A hardware store
3. A dairy
4. A newspaper
5. An automobile manufacturer
6. A restaurant
10. As car manufacturers incorporate more sophisticated computer technology in their vehicles, auto-repair shops require more computerized testing equipment, which is quite expensive, in order to repair newer cars. How is this likely to affect the shape of these firms’ long-run average total cost curves? How is it likely to affect the number of auto-repair firms in any market?
Numerical Problems
1. The table below shows how the number of university classrooms cleaned in an evening varies with the number of janitors:
Janitors per evening 0 1 2 3 4 5 6 7
Classrooms cleaned per evening 0 3 7 12 16 17 17 16
1. What is the marginal product of the second janitor?
2. What is the average product of four janitors?
3. Is the addition of the third janitor associated with increasing, diminishing, or negative marginal returns? Explain.
4. Is the addition of the fourth janitor associated with increasing, diminishing, or negative marginal returns? Explain.
5. Is the addition of the seventh janitor associated with increasing, diminishing, or negative marginal returns? Explain.
6. Draw the total product, average product, and marginal product curves and shade the regions corresponding to increasing marginal returns, decreasing marginal returns, and negative marginal returns.
7. Calculate the slope of the total product curve as each janitor is added.
8. Characterize the nature of marginal returns in the region where
1. The slope of the total product curve is positive and increasing.
2. The slope of the total product curve is positive and decreasing.
3. The slope of the total product curve is negative.
2. Suppose a firm is producing 1,000 units of output. Its average fixed costs are \$100. Its average variable costs are \$50. What is the total cost of producing 1,000 units of output?
3. The director of a nonprofit foundation that sponsors 8-week summer institutes for graduate students analyzed the costs and expected revenues for the next summer institute and recommended that the session be canceled. In her analysis she included a share of the foundation’s overhead—the salaries of the director and staff and costs of maintaining the office—to the program. She estimated costs and revenues as follows:
Projected revenues (from tuition and fees) \$300,000
Projected costs
Overhead \$ 50,000
Room and board for students \$100,000
Costs for faculty and miscellaneous \$175,000
Total costs \$325,000
What was the error in the director’s recommendation?
4. The table below shows the total cost of cleaning classrooms:
Classrooms cleaned per evening 0 3 7 12 16 17
Total cost \$100 \$200 \$300 \$400 \$500 \$600
1. What is the average fixed cost of cleaning three classrooms?
2. What is the average variable cost of cleaning three classrooms?
3. What is the average fixed cost of cleaning seven classrooms?
4. What is the average variable cost of cleaning seven classrooms?
5. What is the marginal cost of cleaning the seventeenth classroom?
6. What is the average total cost of cleaning twelve classrooms?
5. The average total cost for printing 10,000 copies of an issue of a magazine is \$0.45 per copy. For 20,000 copies, the average total cost is \$0.35 apiece; for 30,000, the average total cost is \$0.30 per copy. The average total cost continues to decline slightly over every level of output that the publishers of the magazine have considered. Sketch the approximate shapes of the average and marginal cost curves. What are some variable costs of publishing magazines? Some fixed costs?
6. The information in the table explains the production of socks. Assume that the price per unit of the variable factor of production (L) is \$20 and the price per unit of the fixed factor of production (K) is \$5.
Units of Fixed Factor (K) Units of Variable Factor (L) Total Product (Q)
10 0 0
10 1 2
10 2 5
10 3 12
10 4 15
10 5 16
1. Add columns to the table and calculate the values for : Marginal Product of Labor (MPL), Total Variable Cost (TVC), Total Fixed Cost (TFC), Total Cost (TC), Average Variable Cost (AVC), Average Fixed Cost (AFC), Average Total Cost (ATC), and Marginal Cost (MC).
2. On two sets of axes, graph the Total Product and Marginal Product curves. Be sure to label curves and axes and remember to plot marginal product using the midpoint convention. Indicate the point on each graph at which diminishing marginal returns appears to begin.
3. Graph Total Variable Cost, Total Fixed Cost, and Total Cost on another set of axes. Indicate the point on the graph at which diminishing marginal returns appears to begin.
4. Graph the Average Fixed Cost, Average Variable Cost, Average Total Cost, and Marginal Cost curves on another set of axes. Indicate the point at which diminishing marginal returns appears to begin.
7. The table below shows the long-run average cost of producing knives:
Knives per hour 1,000 2,000 3,000 4,000 5,000 6,000
Cost per knife \$2 \$1.50 \$1.00 \$1.00 \$1.20 \$1.30
1. Draw the long-run average cost curve for knives.
2. Shade the regions corresponding to economies of scale, constant returns to scale, and diseconomies of scale.
3. In the region of the long-run average cost curve that corresponds to economies of scale, what is happening to the cost per knife?
4. In the region of the long-run average cost curve that corresponds to constant returns to scale, what is happening to the cost per knife?
5. In the region of the long-run average cost curve that corresponds to diseconomies of scale, what is happening to the cost per knife?
8. Suppose a firm finds that the marginal product of capital is 60 and the marginal product of labor is 20. If the price of capital is \$6 and the price of labor is \$2.50, how should the firm adjust its mix of capital and labor? What will be the result?
9. A firm minimizes its costs by using inputs such that the marginal product of labor is 10 and the marginal product of capital is 20. The price of capital is \$10 per unit. What must the price of labor be?
10. Suppose that the price of labor is \$10 per unit and the price of capital is \$20 per unit.
1. Assuming the firm is minimizing its cost, if the marginal product of labor is 50, what must the marginal product of capital be?
2. Suppose the price of capital increases to \$25 per unit, while the price of labor stays the same. To minimize the cost of producing the same level of output, would the firm become more capital-intensive or labor-intensive? Explain. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/08%3A_Production_and_Cost/8.3%3A_Review_and_Practice.txt |
Learning Objective
1. Explain what economists mean by perfect competition.
2. Identify the basic assumptions of the model of perfect competition and explain why they imply price-taking behavior.
Virtually all firms in a market economy face competition from other firms. In this chapter, we will be working with a model of a highly idealized form of competition called “perfect” by economists.
Perfect competition is a model of the market based on the assumption that a large number of firms produce identical goods consumed by a large number of buyers. The model of perfect competition also assumes that it is easy for new firms to enter the market and for existing ones to leave. And finally, it assumes that buyers and sellers have complete information about market conditions.
As we examine these assumptions in greater detail, we will see that they allow us to work with the model more easily. No market fully meets the conditions set out in these assumptions. As is always the case with models, our purpose is to understand the way things work, not to describe them. And the model of perfect competition will prove enormously useful in understanding the world of markets.
Assumptions of the Model
The assumptions of the model of perfect competition, taken together, imply that individual buyers and sellers in a perfectly competitive market accept the market price as given. No one buyer or seller has any influence over that price. Individuals or firms who must take the market price as given are called price takers. A consumer or firm that takes the market price as given has no ability to influence that price. A price-taking firm or consumer is like an individual who is buying or selling stocks. He or she looks up the market price and buys or sells at that price. The price is determined by demand and supply in the market—not by individual buyers or sellers. In a perfectly competitive market, each firm and each consumer is a price taker. A price-taking consumer assumes that he or she can purchase any quantity at the market price—without affecting that price. Similarly, a price-taking firm assumes it can sell whatever quantity it wishes at the market price without affecting the price.
You are a price taker when you go into a store. You observe the prices listed and make a choice to buy or not. Your choice will not affect that price. Should you sell a textbook back to your campus bookstore at the end of a course, you are a price-taking seller. You are confronted by a market price and you decide whether to sell or not. Your decision will not affect that price.
To see how the assumptions of the model of perfect competition imply price-taking behavior, let us examine each of them in turn.
Identical Goods
In a perfectly competitive market for a good or service, one unit of the good or service cannot be differentiated from any other on any basis. A bushel of, say, hard winter wheat is an example. A bushel produced by one farmer is identical to that produced by another. There are no brand preferences or consumer loyalties.
The assumption that goods are identical is necessary if firms are to be price takers. If one farmer’s wheat were perceived as having special properties that distinguished it from other wheat, then that farmer would have some power over its price. By assuming that all goods and services produced by firms in a perfectly competitive market are identical, we establish a necessary condition for price-taking behavior. Economists sometimes say that the goods or services in a perfectly competitive market are homogeneous, meaning that they are all alike. There are no brand differences in a perfectly competitive market.
A Large Number of Buyers and Sellers
How many buyers and sellers are in our market? The answer rests on our presumption of price-taking behavior. There are so many buyers and sellers that none of them has any influence on the market price regardless of how much any of them purchases or sells. A firm in a perfectly competitive market can react to prices, but cannot affect the prices it pays for the factors of production or the prices it receives for its output.
Ease of Entry and Exit
The assumption that it is easy for other firms to enter a perfectly competitive market implies an even greater degree of competition. Firms in a market must deal not only with the large number of competing firms but also with the possibility that still more firms might enter the market.
Later in this chapter, we will see how ease of entry is related to the sustainability of economic profits. If entry is easy, then the promise of high economic profits will quickly attract new firms. If entry is difficult, it won’t.
The model of perfect competition assumes easy exit as well as easy entry. The assumption of easy exit strengthens the assumption of easy entry. Suppose a firm is considering entering a particular market. Entry may be easy, but suppose that getting out is difficult. For example, suppliers of factors of production to firms in the industry might be happy to accommodate new firms but might require that they sign long-term contracts. Such contracts could make leaving the market difficult and costly. If that were the case, a firm might be hesitant to enter in the first place. Easy exit helps make entry easier.
Complete Information
We assume that all sellers have complete information about prices, technology, and all other knowledge relevant to the operation of the market. No one seller has any information about production methods that is not available to all other sellers. If one seller had an advantage over other sellers, perhaps special information about a lower-cost production method, then that seller could exert some control over market price—the seller would no longer be a price taker.
We assume also that buyers know the prices offered by every seller. If buyers did not know about prices offered by different firms in the market, then a firm might be able to sell a good or service for a price other than the market price and thus could avoid being a price taker.
The availability of information that is assumed in the model of perfect competition implies that information can be obtained at low cost. If consumers and firms can obtain information at low cost, they are likely to do so. Information about the marketplace may come over the internet, over the airways in a television commercial, or over a cup of coffee with a friend. Whatever its source, we assume that its low cost ensures that consumers and firms have enough of it so that everyone buys or sells goods and services at market prices determined by the intersection of demand and supply curves.
The assumptions of the perfectly competitive model ensure that each buyer or seller is a price taker. The market, not individual consumers or firms, determines price in the model of perfect competition. No individual has enough power in a perfectly competitive market to have any impact on that price.
Perfect Competition and the Real World
The assumptions of identical products, a large number of buyers, easy entry and exit, and perfect information are strong assumptions. The notion that firms must sit back and let the market determine price seems to fly in the face of what we know about most real firms, which is that firms customarily do set prices. Yet this is the basis for the model of demand and supply, the power of which you have already seen.
When we use the model of demand and supply, we assume that market forces determine prices. In this model, buyers and sellers respond to the market price. They are price takers. The assumptions of the model of perfect competition underlie the assumption of price-taking behavior. Thus we are using the model of perfect competition whenever we apply the model of demand and supply.
We can understand most markets by applying the model of demand and supply. Even though those markets do not fulfill all the assumptions of the model of perfect competition, the model allows us to understand some key features of these markets.
Changes within your lifetime have made many markets more competitive. Falling costs of transportation, together with dramatic advances in telecommunications, have opened the possibility of entering markets to firms all over the world. A company in South Korea can compete in the market for steel in the United States. A furniture maker in New Mexico can compete in the market for furniture in Japan. A firm can enter the world market simply by creating a web page to advertise its products and to take orders.
In the remaining sections of this chapter, we will learn more about the response of firms to market prices. We will see how firms respond, in the short run and in the long run, to changes in demand and to changes in production costs. In short, we will be examining the forces that constitute the supply side of the model of demand and supply.
We will also see how competitive markets work to serve consumer interests and how competition acts to push economic profits down, sometimes eliminating them entirely. When we have finished we will have a better understanding of the market conditions facing farmers and of the conditions that prevail in any competitive industry.
Key Takeaways
• The central characteristic of the model of perfect competition is the fact that price is determined by the interaction of demand and supply; buyers and sellers are price takers.
• The model assumes: a large number of firms producing identical (homogeneous) goods or services, a large number of buyers and sellers, easy entry and exit in the industry, and complete information about prices in the market.
• The model of perfect competition underlies the model of demand and supply.
Try It!
Which of the following goods and services are likely produced in a perfectly competitive industry? Relate your answer to the assumptions of the model of perfect competition.
1. International express mail service
2. Corn
3. Athletic shoes
Case in Point: Entering and Exiting the Burkha Industry
Figure 9.2
Muhammed Ibrahim Islamadin was driving a cab in Kabul, Afghanistan, when the Taliban took over the country. He foresaw the repression that would follow and sensed an opportunity.
He sold his taxicab and set up a shop for sewing and selling burkhas, the garments required of all women under the Taliban’s rule. Mr. Islamadin had an easy task selling, as women caught outdoors with exposed skin were routinely beaten by the Taliban’s religious police. He told The Wall Street Journal, “This was very bad for them, but it was good for me.”
Of course, Mr. Islamadin was not the only producer to get into the industry. Other Afghani merchants, as well as merchants from Pakistan and China, also jumped at the opportunity.
The entry of new firms exemplifies an important characteristic of perfect competition. Whenever there is an opportunity to earn economic profits—even an unexpected opportunity—new firms will enter, provided that entry is easy.
The model of perfect competition also assumes that exit will be easy if and when a firm experiences economic losses. When the Taliban rulers were ousted by the United States and its allies in 2001, Mr. Islamadin expected that the demand for burkhas would begin to fall. It did. The sales fell 50% almost immediately. Prices fell as well, generally by about 20%.
It was simple for Mr. Islamadin to leave the industry. He gave his remaining stock of burkhas to a brother who was producing them in the countryside where women continued to wear them. As for Mr. Islamadin, he has made plans to go into the glassware business. He expects the demand for glass teacups to be strong whatever happens in Afghanistan’s critical future.
Answers to Try It! Problems
1. Not perfectly competitive–There are few sellers in this market (Fedex, UPS, and the United States Postal Services are the main ones in the United States) probably because of the difficulty of entry and exit. To provide these services requires many outlets and a large transportation fleet, for example.
2. Perfectly competitive—There are many firms producing a largely homogeneous product and there is good information about prices. Entry and exit is also fairly easy as firms can switch among a variety of crops.
3. Not perfectly competitive—The main reason is that goods are not identical. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/09%3A_Competitive_Markets_for_Goods_and_Services/9.1%3A_Perfect_Competition%3A_A_Model.txt |
Learning Objective
1. Show graphically how an individual firm in a perfectly competitive market can use total revenue and total cost curves or marginal revenue and marginal cost curves to determine the level of output that will maximize its economic profit.
2. Explain when a firm will shut down in the short run and when it will operate even if it is incurring economic losses.
3. Derive the firm’s supply curve from the firm’s marginal cost curve and the industry supply curve from the supply curves of individual firms.
Our goal in this section is to see how a firm in a perfectly competitive market determines its output level in the short run—a planning period in which at least one factor of production is fixed in quantity. We shall see that the firm can maximize economic profit by applying the marginal decision rule and increasing output up to the point at which the marginal benefit of an additional unit of output is just equal to the marginal cost. This fact has an important implication: over a wide range of output, the firm’s marginal cost curve is its supply curve.
Price and Revenue
Each firm in a perfectly competitive market is a price taker; the equilibrium price and industry output are determined by demand and supply. Figure 9.3 shows how demand and supply in the market for radishes, which we shall assume are produced under conditions of perfect competition, determine total output and price. The equilibrium price is \$0.40 per pound; the equilibrium quantity is 10 million pounds per month.
Because it is a price taker, each firm in the radish industry assumes it can sell all the radishes it wants at a price of \$0.40 per pound. No matter how many or how few radishes it produces, the firm expects to sell them all at the market price.
The assumption that the firm expects to sell all the radishes it wants at the market price is crucial. If a firm did not expect to sell all of its radishes at the market price—if it had to lower the price to sell some quantities—the firm would not be a price taker. And price-taking behavior is central to the model of perfect competition.
Radish growers—and perfectly competitive firms in general—have no reason to charge a price lower than the market price. Because buyers have complete information and because we assume each firm’s product is identical to that of its rivals, firms are unable to charge a price higher than the market price. For perfectly competitive firms, the price is very much like the weather: they may complain about it, but in perfect competition there is nothing any of them can do about it.
Total Revenue
While a firm in a perfectly competitive market has no influence over its price, it does determine the output it will produce. In selecting the quantity of that output, one important consideration is the revenue the firm will gain by producing it.
A firm’s total revenue is found by multiplying its output by the price at which it sells that output. For a perfectly competitive firm, total revenue (TR) is the market price (P) times the quantity the firm produces (Q), or
Equation 9.1
The relationship between market price and the firm’s total revenue curve is a crucial one. Panel (a) of Figure 9.4 shows total revenue curves for a radish grower at three possible market prices: \$0.20, \$0.40, and \$0.60 per pound. Each total revenue curve is a linear, upward-sloping curve. At any price, the greater the quantity a perfectly competitive firm sells, the greater its total revenue. Notice that the greater the price, the steeper the total revenue curve is.
Price, Marginal Revenue, and Average Revenue
The slope of a total revenue curve is particularly important. It equals the change in the vertical axis (total revenue) divided by the change in the horizontal axis (quantity) between any two points. The slope measures the rate at which total revenue increases as output increases. We can think of it as the increase in total revenue associated with a 1-unit increase in output. The increase in total revenue from a 1-unit increase in quantity is marginal revenue. Thus marginal revenue (MR) equals the slope of the total revenue curve.
How much additional revenue does a radish producer gain from selling one more pound of radishes? The answer, of course, is the market price for 1 pound. Marginal revenue equals the market price. Because the market price is not affected by the output choice of a single firm, the marginal revenue the firm gains by producing one more unit is always the market price. The marginal revenue curve shows the relationship between marginal revenue and the quantity a firm produces. For a perfectly competitive firm, the marginal revenue curve is a horizontal line at the market price. If the market price of a pound of radishes is \$0.40, then the marginal revenue is \$0.40. Marginal revenue curves for prices of \$0.20, \$0.40, and \$0.60 are given in Panel (b) of Figure 9.4. In perfect competition, a firm’s marginal revenue curve is a horizontal line at the market price.
Price also equals average revenue, which is total revenue divided by quantity. Equation 9.1 gives total revenue, TR. To obtain average revenue (AR), we divide total revenue by quantity, Q. Because total revenue equals price (P) times quantity (Q), dividing by quantity leaves us with price.
Equation 9.2
The marginal revenue curve is a horizontal line at the market price, and average revenue equals the market price. The average and marginal revenue curves are given by the same horizontal line. This is consistent with what we have learned about the relationship between marginal and average values. When the marginal value exceeds the average value, the average value will be rising. When the marginal value is less than the average value, the average value will be falling. What happens when the average and marginal values do not change, as in the horizontal curves of Panel (b) of Figure 9.4? The marginal value must equal the average value; the two curves coincide.
Marginal Revenue, Price, and Demand for the Perfectly Competitive Firm
We have seen that a perfectly competitive firm’s marginal revenue curve is simply a horizontal line at the market price and that this same line is also the firm’s average revenue curve. For the perfectly competitive firm, MR=P=AR. The marginal revenue curve has another meaning as well. It is the demand curve facing a perfectly competitive firm.
Consider the case of a single radish producer, Tony Gortari. We assume that the radish market is perfectly competitive; Mr. Gortari runs a perfectly competitive firm. Suppose the market price of radishes is \$0.40 per pound. How many pounds of radishes can Mr. Gortari sell at this price? The answer comes from our assumption that he is a price taker: He can sell any quantity he wishes at this price. How many pounds of radishes will he sell if he charges a price that exceeds the market price? None. His radishes are identical to those of every other firm in the market, and everyone in the market has complete information. That means the demand curve facing Mr. Gortari is a horizontal line at the market price as illustrated in Figure 9.5. Notice that the curve is labeled d to distinguish it from the market demand curve, D, in Figure 9.3. The horizontal line in Figure 9.5 is also Mr. Gortari’s marginal revenue curve, MR, and his average revenue curve, AR. It is also the market price, P.
Of course, Mr. Gortari could charge a price below the market price, but why would he? We assume he can sell all the radishes he wants at the market price; there would be no reason to charge a lower price. Mr. Gortari faces a demand curve that is a horizontal line at the market price. In our subsequent analysis, we shall refer to the horizontal line at the market price simply as marginal revenue. We should remember, however, that this same line gives us the market price, average revenue, and the demand curve facing the firm.
More generally, we can say that any perfectly competitive firm faces a horizontal demand curve at the market price. We saw an example of a horizontal demand curve in the chapter on elasticity. Such a curve is perfectly elastic, meaning that any quantity is demanded at a given price.
Economic Profit in the Short Run
A firm’s economic profit is the difference between total revenue and total cost. Recall that total cost is the opportunity cost of producing a certain good or service. When we speak of economic profit we are speaking of a firm’s total revenue less the total opportunity cost of its operations.
As we learned, a firm’s total cost curve in the short run intersects the vertical axis at some positive value equal to the firm’s total fixed costs. Total cost then rises at a decreasing rate over the range of increasing marginal returns to the firm’s variable factors. It rises at an increasing rate over the range of diminishing marginal returns. Figure 9.6 shows the total cost curve for Mr. Gortari, as well as the total revenue curve for a price of \$0.40 per pound. Suppose that his total fixed cost is \$400 per month. For any given level of output, Mr. Gortari’s economic profit is the vertical distance between the total revenue curve and the total cost curve at that level.
Let us examine the total revenue and total cost curves in Figure 9.6 more carefully. At zero units of output, Mr. Gortari’s total cost is \$400 (his total fixed cost); total revenue is zero. Total cost continues to exceed total revenue up to an output of 1,500 pounds per month, at which point the two curves intersect. At this point, economic profit equals zero. As Mr. Gortari expands output above 1,500 pounds per month, total revenue becomes greater than total cost. We see that at a quantity of 1,500 pounds per month, the total revenue curve is steeper than the total cost curve. Because revenues are rising faster than costs, profits rise with increased output. As long as the total revenue curve is steeper than the total cost curve, profit increases as the firm increases its output.
The total revenue curve’s slope does not change as the firm increases its output. But the total cost curve becomes steeper and steeper as diminishing marginal returns set in. Eventually, the total cost and total revenue curves will have the same slope. That happens in Figure 9.6 at an output of 6,700 pounds of radishes per month. Notice that a line drawn tangent to the total cost curve at that quantity has the same slope as the total revenue curve.
As output increases beyond 6,700 pounds, the total cost curve continues to become steeper. It becomes steeper than the total revenue curve, and profits fall as costs rise faster than revenues. At an output slightly above 8,000 pounds per month, the total revenue and cost curves intersect again, and economic profit equals zero. Mr. Gortari achieves the greatest profit possible by producing 6,700 pounds of radishes per month, the quantity at which the total cost and total revenue curves have the same slope. More generally, we can conclude that a perfectly competitive firm maximizes economic profit at the output level at which the total revenue curve and the total cost curve have the same slope.
Applying the Marginal Decision Rule
The slope of the total revenue curve is marginal revenue; the slope of the total cost curve is marginal cost. Economic profit, the difference between total revenue and total cost, is maximized where marginal revenue equals marginal cost. This is consistent with the marginal decision rule, which holds that a profit-maximizing firm should increase output until the marginal benefit of an additional unit equals the marginal cost. The marginal benefit of selling an additional unit is measured as marginal revenue. Finding the output at which marginal revenue equals marginal cost is thus an application of our marginal decision rule.
Figure 9.7 shows how a firm can use the marginal decision rule to determine its profit-maximizing output. Panel (a) shows the market for radishes; the market demand curve (D), and supply curve (S) that we had in Figure 9.3; the market price is \$0.40 per pound. In Panel (b), the MR curve is given by a horizontal line at the market price. The firm’s marginal cost curve (MC) intersects the marginal revenue curve at the point where profit is maximized. Mr. Gortari maximizes profits by producing 6,700 pounds of radishes per month. That is, of course, the result we obtained in Figure 9.6, where we saw that the firm’s total revenue and total cost curves differ by the greatest amount at the point at which the slopes of the curves, which equal marginal revenue and marginal cost, respectively, are equal.
We can use the graph in Figure 9.7 to compute Mr. Gortari’s economic profit. Economic profit per unit is the difference between price and average total cost. At the profit-maximizing output of 6,700 pounds of radishes per month, average total cost (ATC) is \$0.26 per pound, as shown in Panel (b). Price is \$0.40 per pound, so economic profit per unit is \$0.14. Economic profit is found by multiplying economic profit per unit by the number of units produced; the firm’s economic profit is thus \$938 (\$0.14 × 6,700). It is shown graphically by the area of the shaded rectangle in Panel (b); this area equals the vertical distance between marginal revenue (MR) and average total cost (ATC) at an output of 6,700 pounds of radishes times the number of pounds of radishes produced, 6,700, in Figure 9.7.
Heads Up!
Look carefully at the rectangle that shows economic profit in Panel (b) of Figure 9.7. It is found by taking the profit-maximizing quantity, 6,700 pounds, then reading up to the ATC curve and the firm’s demand curve at the market price. Economic profit per unit equals price minus average total cost (PATC).
The firm’s economic profit equals economic profit per unit times the quantity produced. It is found by extending horizontal lines from the ATC and MR curve to the vertical axis and taking the area of the rectangle formed.
There is no reason for the profit-maximizing quantity to correspond to the lowest point on the ATC curve; it does not in this case. Students sometimes make the mistake of calculating economic profit as the difference between the price and the lowest point on the ATC curve. That gives us the maximum economic profit per unit, but we assume that firms maximize economic profit, not economic profit per unit. The firm’s economic profit equals economic profit per unit times quantity. The quantity that maximizes economic profit is determined by the intersection of ATC and MR.
Economic Losses in the Short Run
In the short run, a firm has one or more inputs whose quantities are fixed. That means that in the short run the firm cannot leave its industry. Even if it cannot cover all of its costs, including both its variable and fixed costs, going entirely out of business is not an option in the short run. The firm may close its doors, but it must continue to pay its fixed costs. It is forced to accept an economic loss, the amount by which its total cost exceeds its total revenue.
Suppose, for example, that a manufacturer has signed a 1-year lease on some equipment. It must make payments for this equipment during the term of its lease, whether it produces anything or not. During the period of the lease, the payments represent a fixed cost for the firm.
A firm that is experiencing economic losses—whose economic profits have become negative—in the short run may either continue to produce or shut down its operations, reducing its output to zero. It will choose the option that minimizes its losses. The crucial test of whether to operate or shut down lies in the relationship between price and average variable cost.
Producing to Minimize Economic Loss
Suppose the demand for radishes falls to D2, as shown in Panel (a) of Figure 9.8. The market price for radishes plunges to \$0.18 per pound, which is below average total cost. Consequently Mr. Gortari experiences negative economic profits—a loss. Although the new market price falls short of average total cost, it still exceeds average variable cost, shown in Panel (b) as AVC. Therefore, Mr. Gortari should continue to produce an output at which marginal cost equals marginal revenue. These curves (labeled MC and MR2) intersect in Panel (b) at an output of 4,444 pounds of radishes per month.
When producing 4,444 pounds of radishes per month, Mr. Gortari faces an average total cost of \$0.23 per pound. At a price of \$0.18 per pound, he loses a nickel on each pound produced. Total economic losses at an output of 4,444 pounds per month are thus \$222.20 per month (=4,444×\$0.05).
No producer likes a loss (that is, negative economic profit), but the loss solution shown in Figure 9.8 is the best Mr. Gortari can attain. Any level of production other than the one at which marginal cost equals marginal revenue would produce even greater losses.
Suppose Mr. Gortari were to shut down and produce no radishes. Ceasing production would reduce variable costs to zero, but he would still face fixed costs of \$400 per month (recall that \$400 was the vertical intercept of the total cost curve in Figure 9.6). By shutting down, Mr. Gortari would lose \$400 per month. By continuing to produce, he loses only \$222.20.
Mr. Gortari is better off producing where marginal cost equals marginal revenue because at that output price exceeds average variable cost. Average variable cost is \$0.14 per pound, so by continuing to produce he covers his variable costs, with \$0.04 per pound left over to apply to fixed costs. Whenever price is greater than average variable cost, the firm maximizes economic profit (or minimizes economic loss) by producing the output level at which marginal revenue and marginal cost curves intersect.
Shutting Down to Minimize Economic Loss
Suppose price drops below a firm’s average variable cost. Now the best strategy for the firm is to shut down, reducing its output to zero. The minimum level of average variable cost, which occurs at the intersection of the marginal cost curve and the average variable cost curve, is called the shutdown point. Any price below the minimum value of average variable cost will cause the firm to shut down. If the firm were to continue producing, not only would it lose its fixed costs, but it would also face an additional loss by not covering its variable costs.
Figure 9.9 shows a case where the price of radishes drops to \$0.10 per pound. Price is less than average variable cost, so Mr. Gortari not only would lose his fixed cost but would also incur additional losses by producing. Suppose, for example, he decided to operate where marginal cost equals marginal revenue, producing 1,700 pounds of radishes per month. Average variable cost equals \$0.14 per pound, so he would lose \$0.04 on each pound he produces (\$68) plus his fixed cost of \$400 per month. He would lose \$468 per month. If he shut down, he would lose only his fixed cost. Because the price of \$0.10 falls below his average variable cost, his best course would be to shut down.
Shutting down is not the same thing as going out of business. A firm shuts down by closing its doors; it can reopen them whenever it expects to cover its variable costs. We can even think of a firm’s decision to close at the end of the day as a kind of shutdown point; the firm makes this choice because it does not anticipate that it will be able to cover its variable cost overnight. It expects to cover those costs the next morning when it reopens its doors.
Marginal Cost and Supply
In the model of perfect competition, we assume that a firm determines its output by finding the point where the marginal revenue and marginal cost curves intersect. Provided that price exceeds average variable cost, the firm produces the quantity determined by the intersection of the two curves.
A supply curve tells us the quantity that will be produced at each price, and that is what the firm’s marginal cost curve tells us. The firm’s supply curve in the short run is its marginal cost curve for prices above the average variable cost. At prices below average variable cost, the firm’s output drops to zero.
Panel (a) of Figure 9.10 shows the average variable cost and marginal cost curves for a hypothetical astrologer, Madame LaFarge, who is in the business of providing astrological consultations over the telephone. We shall assume that this industry is perfectly competitive. At any price below \$10 per call, Madame LaFarge would shut down. If the price is \$10 or greater, however, she produces an output at which price equals marginal cost. The marginal cost curve is thus her supply curve at all prices greater than \$10.
Now suppose that the astrological forecast industry consists of Madame LaFarge and thousands of other firms similar to hers. The market supply curve is found by adding the outputs of each firm at each price, as shown in Panel (b) of Figure 9.10. At a price of \$10 per call, for example, Madame LaFarge supplies 14 calls per day. Adding the quantities supplied by all the other firms in the market, suppose we get a quantity supplied of 280,000. Notice that the market supply curve we have drawn is linear; throughout the book we have made the assumption that market demand and supply curves are linear in order to simplify our analysis.
Looking at Figure 9.10, we see that profit-maximizing choices by firms in a perfectly competitive market will generate a market supply curve that reflects marginal cost. Provided there are no external benefits or costs in producing a good or service, a perfectly competitive market satisfies the efficiency condition.
Key Takeaways
• Price in a perfectly competitive industry is determined by the interaction of demand and supply.
• In a perfectly competitive industry, a firm’s total revenue curve is a straight, upward-sloping line whose slope is the market price. Economic profit is maximized at the output level at which the slopes of the total revenue and total cost curves are equal, provided that the firm is covering its variable cost.
• To use the marginal decision rule in profit maximization, the firm produces the output at which marginal cost equals marginal revenue. Economic profit per unit is price minus average total cost; total economic profit equals economic profit per unit times quantity.
• If price falls below average total cost, but remains above average variable cost, the firm will continue to operate in the short run, producing the quantity where MR = MC doing so minimizes its losses.
• If price falls below average variable cost, the firm will shut down in the short run, reducing output to zero. The lowest point on the average variable cost curve is called the shutdown point.
• The firm’s supply curve in the short run is its marginal cost curve for prices greater than the minimum average variable cost.
Try It!
Assume that Acme Clothing, the firm introduced in the chapter on production and cost, produces jackets in a perfectly competitive market. Suppose the demand and supply curves for jackets intersect at a price of \$81. Now, using the marginal cost and average total cost curves for Acme shown here:
Estimate Acme’s profit-maximizing output per day (assume the firm selects a whole number). What are Acme’s economic profits per day?
Case in Point: Not Out of Business ’Til They Fall from the Sky
Figure 9.12
The 66 satellites were poised to start falling from the sky. The hope was that the pieces would burn to bits on their way down through the atmosphere, but there was the chance that a building or a person would take a direct hit.
The satellites were the primary communication devices of Iridium’s satellite phone system. Begun in 1998 as the first truly global satellite system for mobile phones—providing communications across deserts, in the middle of oceans, and at the poles—Iridium expected five million subscribers to pay \$7 a minute to talk on \$3,000 handsets. In the climate of the late 1990s, users opted for cheaper, though less secure and less comprehensive, cell phones. By the end of the decade, Iridium had declared bankruptcy, shut down operations, and was just waiting for the satellites to start plunging from their orbits around 2007.
The only offer for Iridium’s \$5 billion system came from an ex-CEO of a nuclear reactor business, Dan Colussy, and it was for a measly \$25 million. “It’s like picking up a \$150,000 Porsche 911 for \$750,” wrote USA Today reporter, Kevin Maney.
The purchase turned into a bonanza. In the wake of September 11, 2001, and then the wars in Afghanistan and Iraq, demand for secure communications in remote locations skyrocketed. New customers included the U.S. and British militaries, as well as reporters in Iraq, who, when traveling with the military have been barred from using less secure systems that are easier to track. The nonprofit organization Operation Call Home has bought time to allow members of the 81st Armor Brigade of the Washington National Guard to communicate with their families at home. Airlines and shipping lines have also signed up.
As the new Iridium became unburdened from the debt of the old one and technology improved, the lower fixed and variable costs have contributed to Iridium’s revival, but clearly a critical element in the turnaround has been increased demand. The launching of an additional seven spare satellites and other tinkering have extended the life of the system to at least 2014. The firm was temporarily shut down but, with its new owners and new demand for its services, has come roaring back.
Why did Colussy buy Iridium? A top executive in the new firm said that Colussy just found the elimination of the satellites a terrible waste. Perhaps he had some niche uses in mind, as even before September 11, 2001, he had begun to enroll some new customers, such as the Colombian national police, who no doubt found the system useful in the fighting drug lords. But it was in the aftermath of 9/11 that its subscriber list really began to grow and its re-opening was deemed a stroke of genius. Today Iridium’s customers include ships at sea (which account for about half of its business), airlines, military uses, and a variety of commercial and humanitarian applications.
Answer to Try It! Problem
At a price of \$81, Acme’s marginal revenue curve is a horizontal line at \$81. The firm produces the output at which marginal cost equals marginal revenue; the curves intersect at a quantity of 9 jackets per day. Acme’s average total cost at this level of output equals \$67, for an economic profit per jacket of \$14. Acme’s economic profit per day equals about \$126.
Figure 9.13 | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/09%3A_Competitive_Markets_for_Goods_and_Services/9.2%3A_Output_Determination_in_the_Short_Run.txt |
Learning Objective
1. Distinguish between economic profit and accounting profit.
2. Explain why in long-run equilibrium in a perfectly competitive industry firms will earn zero economic profit.
3. Describe the three possible effects on the costs of the factors of production that expansion or contraction of a perfectly competitive industry may have and illustrate the resulting long-run industry supply curve in each case.
4. Explain why under perfection competition output prices will change by less than the change in production cost in the short run, but by the full amount of the change in production cost in the long run.
5. Explain the effect of a change in fixed cost on price and output in the short run and in the long run under perfect competition.
In the long run, a firm is free to adjust all of its inputs. New firms can enter any market; existing firms can leave their markets. We shall see in this section that the model of perfect competition predicts that, at a long-run equilibrium, production takes place at the lowest possible cost per unit and that all economic profits and losses are eliminated.
Economic Profit and Economic Loss
Economic profits and losses play a crucial role in the model of perfect competition. The existence of economic profits in a particular industry attracts new firms to the industry in the long run. As new firms enter, the supply curve shifts to the right, price falls, and profits fall. Firms continue to enter the industry until economic profits fall to zero. If firms in an industry are experiencing economic losses, some will leave. The supply curve shifts to the left, increasing price and reducing losses. Firms continue to leave until the remaining firms are no longer suffering losses—until economic profits are zero.
Before examining the mechanism through which entry and exit eliminate economic profits and losses, we shall examine an important key to understanding it: the difference between the accounting and economic concepts of profit and loss.
Economic Versus Accounting Concepts of Profit and Loss
Economic profit equals total revenue minus total cost, where cost is measured in the economic sense as opportunity cost. An economic loss (negative economic profit) is incurred if total cost exceeds total revenue.
Accountants include only explicit costs in their computation of total cost. Explicit costs include charges that must be paid for factors of production such as labor and capital, together with an estimate of depreciation. Profit computed using only explicit costs is called accounting profit. It is the measure of profit firms typically report; firms pay taxes on their accounting profits, and a corporation reporting its profit for a particular period reports its accounting profits. To compute his accounting profits, Mr. Gortari, the radish farmer, would subtract explicit costs, such as charges for labor, equipment, and other supplies, from the revenue he receives.
Economists recognize costs in addition to the explicit costs listed by accountants. If Mr. Gortari were not growing radishes, he could be doing something else with the land and with his own efforts. Suppose the most valuable alternative use of his land would be to produce carrots, from which Mr. Gortari could earn \$250 per month in accounting profits. The income he forgoes by not producing carrots is an opportunity cost of producing radishes. This cost is not explicit; the return Mr. Gortari could get from producing carrots will not appear on a conventional accounting statement of his accounting profit. A cost that is included in the economic concept of opportunity cost, but that is not an explicit cost, is called an implicit cost.
The Long Run and Zero Economic Profits
Given our definition of economic profits, we can easily see why, in perfect competition, they must always equal zero in the long run. Suppose there are two industries in the economy, and that firms in Industry A are earning economic profits. By definition, firms in Industry A are earning a return greater than the return available in Industry B. That means that firms in Industry B are earning less than they could in Industry A. Firms in Industry B are experiencing economic losses.
Given easy entry and exit, some firms in Industry B will leave it and enter Industry A to earn the greater profits available there. As they do so, the supply curve in Industry B will shift to the left, increasing prices and profits there. As former Industry B firms enter Industry A, the supply curve in Industry A will shift to the right, lowering profits in A. The process of firms leaving Industry B and entering A will continue until firms in both industries are earning zero economic profit. That suggests an important long-run result: Economic profits in a system of perfectly competitive markets will, in the long run, be driven to zero in all industries.
Eliminating Economic Profit: The Role of Entry
The process through which entry will eliminate economic profits in the long run is illustrated in Figure 9.14, which is based on the situation presented in Figure 9.7. The price of radishes is \$0.40 per pound. Mr. Gortari’s average total cost at an output of 6,700 pounds of radishes per month is \$0.26 per pound. Profit per unit is \$0.14 (\$0.40 − \$0.26). Mr. Gortari thus earns a profit of \$938 per month (=\$0.14 × 6,700).
Profits in the radish industry attract entry in the long run. Panel (a) of Figure 9.14 shows that as firms enter, the supply curve shifts to the right and the price of radishes falls. New firms enter as long as there are economic profits to be made—as long as price exceeds ATC in Panel (b). As price falls, marginal revenue falls to MR2 and the firm reduces the quantity it supplies, moving along the marginal cost (MC) curve to the lowest point on the ATC curve, at \$0.22 per pound and an output of 5,000 pounds per month. Although the output of individual firms falls in response to falling prices, there are now more firms, so industry output rises to 13 million pounds per month in Panel (a).
Eliminating Losses: The Role of Exit
Just as entry eliminates economic profits in the long run, exit eliminates economic losses. In Figure 9.15, Panel (a) shows the case of an industry in which the market price P1 is below ATC. In Panel (b), at price P1 a single firm produces a quantity q1, assuming it is at least covering its average variable cost. The firm’s losses are shown by the shaded rectangle bounded by its average total cost C1 and price P1 and by output q1.
Because firms in the industry are losing money, some will exit. The supply curve in Panel (a) shifts to the left, and it continues shifting as long as firms are suffering losses. Eventually the supply curve shifts all the way to S2, price rises to P2, and economic profits return to zero.
Entry, Exit, and Production Costs
In our examination of entry and exit in response to economic profit or loss in a perfectly competitive industry, we assumed that the ATC curve of a single firm does not shift as new firms enter or existing firms leave the industry. That is the case when expansion or contraction does not affect prices for the factors of production used by firms in the industry. When expansion of the industry does not affect the prices of factors of production, it is a constant-cost industry. In some cases, however, the entry of new firms may affect input prices.
As new firms enter, they add to the demand for the factors of production used by the industry. If the industry is a significant user of those factors, the increase in demand could push up the market price of factors of production for all firms in the industry. If that occurs, then entry into an industry will boost average costs at the same time as it puts downward pressure on price. Long-run equilibrium will still occur at a zero level of economic profit and with firms operating on the lowest point on the ATC curve, but that cost curve will be somewhat higher than before entry occurred. Suppose, for example, that an increase in demand for new houses drives prices higher and induces entry. That will increase the demand for workers in the construction industry and is likely to result in higher wages in the industry, driving up costs.
An industry in which the entry of new firms bids up the prices of factors of production and thus increases production costs is called an increasing-cost industry. As such an industry expands in the long run, its price will rise.
Some industries may experience reductions in input prices as they expand with the entry of new firms. That may occur because firms supplying the industry experience economies of scale as they increase production, thus driving input prices down. Expansion may also induce technological changes that lower input costs. That is clearly the case of the computer industry, which has enjoyed falling input costs as it has expanded. An industry in which production costs fall as firms enter in the long run is a decreasing-cost industry.
Just as industries may expand with the entry of new firms, they may contract with the exit of existing firms. In a constant-cost industry, exit will not affect the input prices of remaining firms. In an increasing-cost industry, exit will reduce the input prices of remaining firms. And, in a decreasing-cost industry, input prices may rise with the exit of existing firms.
The behavior of production costs as firms in an industry expand or reduce their output has important implications for the long-run industry supply curve, a curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed. Every point on a long-run supply curve therefore shows a price and quantity supplied at which firms in the industry are earning zero economic profit. Unlike the short-run market supply curve, the long-run industry supply curve does not hold factor costs and the number of firms unchanged.
Figure 9.16 shows three long-run industry supply curves. In Panel (a), SCC is a long-run supply curve for a constant-cost industry. It is horizontal. Neither expansion nor contraction by itself affects market price. In Panel (b), SIC is a long-run supply curve for an increasing-cost industry. It rises as the industry expands. In Panel (c), SDC is a long-run supply curve for a decreasing-cost industry. Its downward slope suggests a falling price as the industry expands.
Changes in Demand and in Production Cost
The primary application of the model of perfect competition is in predicting how firms will respond to changes in demand and in production costs. To see how firms respond to a particular change, we determine how the change affects demand or cost conditions and then see how the profit-maximizing solution is affected in the short run and in the long run. Having determined how the profit-maximizing firms of the model would respond, we can then predict firms’ responses to similar changes in the real world.
In the examples that follow, we shall assume, for simplicity, that entry or exit do not affect the input prices facing firms in the industry. That is, we assume a constant-cost industry with a horizontal long-run industry supply curve similar to SCC in Figure 9.16. We shall assume that firms are covering their average variable costs, so we can ignore the possibility of shutting down.
Changes in Demand
Changes in demand can occur for a variety of reasons. There may be a change in preferences, incomes, the price of a related good, population, or consumer expectations. A change in demand causes a change in the market price, thus shifting the marginal revenue curves of firms in the industry.
Let us consider the impact of a change in demand for oats. Suppose new evidence suggests that eating oats not only helps to prevent heart disease, but also prevents baldness in males. This will, of course, increase the demand for oats. To assess the impact of this change, we assume that the industry is perfectly competitive and that it is initially in long-run equilibrium at a price of \$1.70 per bushel. Economic profits equal zero.
The initial situation is depicted in Figure 9.17. Panel (a) shows that at a price of \$1.70, industry output is Q1 (point A), while Panel (b) shows that the market price constitutes the marginal revenue, MR1, facing a single firm in the industry. The firm responds to that price by finding the output level at which the MC and MR1 curves intersect. That implies a level of output q1 at point A′.
The new medical evidence causes demand to increase to D2 in Panel (a). That increases the market price to \$2.30 (point B), so the marginal revenue curve for a single firm rises to MR2 in Panel (b). The firm responds by increasing its output to q2 in the short run (point B′). Notice that the firm’s average total cost is slightly higher than its original level of \$1.70; that is because of the U shape of the curve. The firm is making an economic profit shown by the shaded rectangle in Panel (b). Other firms in the industry will earn an economic profit as well, which, in the long run, will attract entry by new firms. New entry will shift the supply curve to the right; entry will continue as long as firms are making an economic profit. The supply curve in Panel (a) shifts to S2, driving the price down in the long run to the original level of \$1.70 per bushel and returning economic profits to zero in long-run equilibrium. A single firm will return to its original level of output, q1 (point A′) in Panel (b), but because there are more firms in the industry, industry output rises to Q3 (point C) in Panel (a).
A reduction in demand would lead to a reduction in price, shifting each firm’s marginal revenue curve downward. Firms would experience economic losses, thus causing exit in the long run and shifting the supply curve to the left. Eventually, the price would rise back to its original level, assuming changes in industry output did not lead to changes in input prices. There would be fewer firms in the industry, but each firm would end up producing the same output as before.
Changes in Production Cost
A firm’s costs change if the costs of its inputs change. They also change if the firm is able to take advantage of a change in technology. Changes in production cost shift the ATC curve. If a firm’s variable costs are affected, its marginal cost curves will shift as well. Any change in marginal cost produces a similar change in industry supply, since it is found by adding up marginal cost curves for individual firms.
Suppose a reduction in the price of oil reduces the cost of producing oil changes for automobiles. We shall assume that the oil-change industry is perfectly competitive and that it is initially in long-run equilibrium at a price of \$27 per oil change, as shown in Panel (a) of Figure 9.18. Suppose that the reduction in oil prices reduces the cost of an oil change by \$3.
A reduction in production cost shifts the firm’s cost curves down. The firm’s average total cost and marginal cost curves shift down, as shown in Panel (b). In Panel (a) the supply curve shifts from S1 to S2. The industry supply curve is made up of the marginal cost curves of individual firms; because each of them has shifted downward by \$3, the industry supply curve shifts downward by \$3.
Notice that price in the short run falls to \$26; it does not fall by the \$3 reduction in cost. That is because the supply and demand curves are sloped. While the supply curve shifts downward by \$3, its intersection with the demand curve falls by less than \$3. The firm in Panel (b) responds to the lower price and lower cost by increasing output to q2, where MC2 and MR2 intersect. That leaves firms in the industry with an economic profit; the economic profit for the firm is shown by the shaded rectangle in Panel (b). Profits attract entry in the long run, shifting the supply curve to the right to S3 in Panel (a) Entry will continue as long as firms are making an economic profit—it will thus continue until the price falls by the full amount of the \$3 reduction in cost. The price falls to \$24, industry output rises to Q3, and the firm’s output returns to its original level, q1.
An increase in variable costs would shift the average total, average variable, and marginal cost curves upward. It would shift the industry supply curve upward by the same amount. The result in the short run would be an increase in price, but by less than the increase in cost per unit. Firms would experience economic losses, causing exit in the long run. Eventually, price would increase by the full amount of the increase in production cost.
Some cost increases will not affect marginal cost. Suppose, for example, that an annual license fee of \$5,000 is imposed on firms in a particular industry. The fee is a fixed cost; it does not affect marginal cost. Imposing such a fee shifts the average total cost curve upward but causes no change in marginal cost. There is no change in price or output in the short run. Because firms are suffering economic losses, there will be exit in the long run. Prices ultimately rise by enough to cover the cost of the fee, leaving the remaining firms in the industry with zero economic profit.
Price will change to reflect whatever change we observe in production cost. A change in variable cost causes price to change in the short run. In the long run, any change in average total cost changes price by an equal amount.
The message of long-run equilibrium in a competitive market is a profound one. The ultimate beneficiaries of the innovative efforts of firms are consumers. Firms in a perfectly competitive world earn zero profit in the long-run. While firms can earn accounting profits in the long-run, they cannot earn economic profits.
Key Takeaways
• The economic concept of profit differs from accounting profit. The accounting concept deals only with explicit costs, while the economic concept of profit incorporates explicit and implicit costs.
• The existence of economic profits attracts entry, economic losses lead to exit, and in long-run equilibrium, firms in a perfectly competitive industry will earn zero economic profit.
• The long-run supply curve in an industry in which expansion does not change input prices (a constant-cost industry) is a horizontal line. The long-run supply curve for an industry in which production costs increase as output rises (an increasing-cost industry) is upward sloping. The long-run supply curve for an industry in which production costs decrease as output rises (a decreasing-cost industry) is downward sloping.
• In a perfectly competitive market in long-run equilibrium, an increase in demand creates economic profit in the short run and induces entry in the long run; a reduction in demand creates economic losses (negative economic profits) in the short run and forces some firms to exit the industry in the long run.
• When production costs change, price will change by less than the change in production cost in the short run. Price will adjust to reflect fully the change in production cost in the long run.
• A change in fixed cost will have no effect on price or output in the short run. It will induce entry or exit in the long run so that price will change by enough to leave firms earning zero economic profit.
Try It!
Consider Acme Clothing’s situation in the second Try It! in this chapter. Suppose this situation is typical of firms in the jacket market. Explain what will happen in the market for jackets in the long run, assuming nothing happens to the prices of factors of production used by firms in the industry. What will happen to the equilibrium price? What is the equilibrium level of economic profits?
Case in Point: Competition in the Market for Generic Prescription Drugs
Figure 9.19
Generic prescription drugs are essentially identical substitutes for more expensive brand-name prescription drugs. Since the passage of the Drug Competition and Patent Term Restoration Act of 1984 (commonly referred to as the Hatch-Waxman Act) made it easier for manufacturers to enter the market for generic drugs, the generic drug industry has taken off. Generic drugs represented 19% of the prescription drug industry in 1984 and today represent more than half of the industry. U.S. generic sales were \$15 billion in 2002 and soared to \$192 billion in 2006. In 2006, the average price of a branded prescription was \$111.02 compared to \$32.23 for a generic prescription.
A Congressional Budget Office study in the late 1990s showed that entry into the generic drug industry has been the key to this price differential. As shown in the table, when there are one to five manufacturers selling generic copies of a given branded drug, the ratio of the generic price to the branded price is about 60%. With more than 20 competitors, the ratio falls to about 40%.
The generic drug industry is largely characterized by the attributes of a perfectly competitive market. Competitors have good information about the product and sell identical products. The largest generic drug manufacturer in the CBO study had a 16% share of the generic drug manufacturing industry, but most generic manufacturers’ sales constituted only 1% to 5% of the market. The 1984 legislation eased entry into this market. And, as the model of perfect competition predicts, entry has driven prices down, benefiting consumers to the tune of tens of billions of dollars each year.
Table 9.1 Price Comparison of Generic and Innovator Drugs, by Number of Manufacturers
Number of Generic Manufacturers of a Given Innovator Drug Number of Innovator Drugs in Category Avg. Rx Price, All Generic Drugs in Category Avg. Rx Price, All Innovator Drugs in Category Avg. Ratio of the Generic Price to the Innovator Price for Same Drug
1 to 5 34 \$23.40 \$37.20 0.61
6 to 10 26 \$26.40 \$42.60 0.61
11 to 15 29 \$20.90 \$50.20 0.42
16 to 20 19 \$19.90 \$45.00 0.46
21 to 24 4 \$11.50 \$33.90 0.39
Average \$22.40 \$43.00 0.53
Answer to Try It! Problem
The availability of economic profits will attract new firms to the jacket industry in the long run, shifting the market supply curve to the right. Entry will continue until economic profits are eliminated. The price will fall; Acme’s marginal revenue curve shifts down. The equilibrium level of economic profits in the long run is zero. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/09%3A_Competitive_Markets_for_Goods_and_Services/9.3%3A_Perfect_Competition_in_the_Long_Run.txt |
Summary
The assumptions of the model of perfect competition ensure that every decision maker is a price taker—the interaction of demand and supply in the market determines price. Although most firms in real markets have some control over their prices, the model of perfect competition suggests how changes in demand or in production cost will affect price and output in a wide range of real-world cases.
A firm in perfect competition maximizes profit in the short run by producing an output level at which marginal revenue equals marginal cost, provided marginal revenue is at least as great as the minimum value of average variable cost. For a perfectly competitive firm, marginal revenue equals price and average revenue. This implies that the firm’s marginal cost curve is its short-run supply curve for values greater than average variable cost. If price drops below average variable cost, the firm shuts down.
If firms in an industry are earning economic profit, entry by new firms will drive price down until economic profit achieves its long-run equilibrium value of zero. If firms are suffering economic losses, exit by existing firms will continue until price rises to eliminate the losses and economic profits are zero. A long-run equilibrium may be changed by a change in demand or in production cost, which would affect supply. The adjustment to the change in the short run is likely to result in economic profits or losses; these will be eliminated in the long run by entry or by exit.
Concept Problems
1. Explain how each of the assumptions of perfect competition contributes to the fact that all decision makers in perfect competition are price takers.
2. If the assumptions of perfect competition are not likely to be met in the real world, how can the model be of any use?
3. Explain the difference between marginal revenue, average revenue, and price in perfect competition.
4. Suppose the only way a firm can increase its sales is to lower its price. Is this a perfectly competitive firm? Why or why not?
5. Consider the following goods and services. Which are the most likely to be produced in a perfectly competitive industry? Which are not? Explain why you made the choices you did, relating your answer to the assumptions of the model of perfect competition.
1. Coca-Cola and Pepsi
2. Potatoes
3. Private physicians in your local community
4. Government bonds and corporate stocks
5. Taxicabs in Lima, Peru—a city that does not restrict entry or the prices drivers can charge
6. Oats
6. Explain why an economic profit of zero is acceptable to a firm.
7. Explain why a perfectly competitive firm whose average total cost exceeds the market price may continue to operate in the short run. What about the long run?
8. You have decided to major in biology rather than computer science. A news report suggests that the salaries of computer science majors are increasing. How does this affect the opportunity cost of your choice?
9. Explain how each of the following events would affect the marginal cost curves of firms and thus the supply curve in a perfectly competitive market in the short run.
1. An increase in wages
2. A tax of \$1 per unit of output imposed on the seller
3. The introduction of cost-cutting technology
4. The imposition of an annual license fee of \$1,000
10. In a perfectly competitive market, who benefits from an event that lowers production costs for firms?
11. Dry-cleaning establishments generate a considerable amount of air pollution in producing cleaning services. Suppose these firms are allowed to pollute without restriction and that reducing their pollution would add significantly to their production costs. Who benefits from the fact that they pollute the air? Now suppose the government requires them to reduce their pollution. Who will pay for the cleanup? (Assume dry cleaning is a perfectly competitive industry, and answer these questions from a long-run perspective.)
12. The late columnist William F. Buckley, commenting on a strike by the Teamsters Union against UPS in 1997, offered this bit of economic analysis to explain how UPS had succeeded in reducing its average total cost: “UPS has done this by ‘economies of scale.’ Up to a point (where the marginal cost equals the price of the marginal unit), the larger the business, the less the per-unit cost.” Use the concept of economies of scale, together with the information presented in this chapter, to explain the error in Mr. Buckley’s statement (Buckley, W. F., 1997).
13. Suppose that a perfectly competitive industry is in long-run equilibrium and experiences an increase in production cost. Who will bear the burden of the increase? Is this fair?
14. Economists argue that the ultimate beneficiaries of the efforts of perfectly competitive firms are consumers. In what sense is this the case? Do the owners of perfectly competitive firms derive any long-run benefit from their efforts?
15. Explain carefully why a fixed license fee does not shift a firm’s marginal cost curve in the short run. What about the long run?
Numerical Problems
1. The graph below provides revenue and cost information for a perfectly competitive firm producing paper clips.
Output Total Revenue Total Variable Cost Total Fixed Cost
1 \$1,000 \$1,500 \$500
2 \$2,000 \$2,000 \$500
3 \$3,000 \$2,600 \$500
4 \$4,000 \$3,900 \$500
5 \$5,000 \$5,000 \$500
1. How much are total fixed costs?
2. About how much are total variable costs if 5,000 paper clips are produced?
3. What is the price of a paper clip?
4. What is the average revenue from producing paper clips?
5. What is the marginal revenue of producing paper clips?
6. Over what output range will this firm earn economic profits?
7. Over what output range will this firm incur economic losses?
8. What is the slope of the total revenue curve?
9. What is the slope of the total cost curve at the profit-maximizing number of paper clips per hour?
10. At about how many paper clips per hour do economic profits seem to be at a maximum?
2. Suppose rocking-chair manufacturing is a perfectly competitive industry in which there are 1,000 identical firms. Each firm’s total cost is related to output per day as follows:
Quantity Total cost Quantity Total cost
0 \$500 5 \$2,200
1 \$1,000 6 \$2,700
2 \$1,300 7 \$3,300
3 \$1,500 8 \$4,400
4 \$1,800
1. Prepare a table that shows total variable cost, average total cost, and marginal cost at each level of output.
2. Plot the average total cost, average variable cost, and marginal cost curves for a single firm (remember that values for marginal cost are plotted at the midpoint of the respective intervals).
3. What is the firm’s supply curve? How many chairs would the firm produce at prices of \$350, \$450, \$550, and \$650? (In computing quantities, assume that a firm produces a certain number of completed chairs each day; it does not produce fractions of a chair on any one day.)
4. Suppose the demand curve in the market for rocking chairs is given by the following table:
Price Quantity of chairs Demanded/day Price Quantity of chairs Demanded/day
\$650 5,000 \$450 7,000
\$550 6,000 \$350 8,000
Plot the market demand curve for chairs. Compute and plot the market supply curve, using the information you obtained for a single firm in part (c). What is the equilibrium price? The equilibrium quantity?
5. Given your solution in part (d), plot the total revenue and total cost curves for a single firm. Does your graph correspond to your solution in part (c)? Explain.
3. The following table shows the total output, total revenue, total variable cost, and total fixed cost of a firm. What level of output should the firm produce? Should it shut down? Should it exit the industry? Explain.
Output Total revenue Total variable cost Total fixed cost
1 \$1,000 \$1,500 \$500
2 \$2,000 \$2,000 \$500
3 \$3,000 \$2,600 \$500
4 \$4,000 \$3,900 \$500
5 \$5,000 \$5,000 \$500
4. Suppose a rise in fuel costs increases the cost of producing oats by \$0.50 per bushel. Illustrate graphically how this change will affect the oat market and a single firm in the market in the short run and in the long run.
5. Suppose the demand for car washes in Collegetown falls as a result of a cutback in college enrollment. Show graphically how the price and output for the market and for a single firm will be affected in the short run and in the long run. Assume the market is perfectly competitive and that it is initially in long-run equilibrium at a price of \$12 per car wash. Assume also that input prices don’t change as the market responds to the change in demand.
6. Suppose that the market for dry-erase pens is perfectly competitive and that the pens cost \$1 each. The industry is in long-run equilibrium. Now suppose that an increase in the cost of ink raises the production cost of the pens by \$.25 per pen.
1. Using a graph that shows the market as a whole and a typical firm in this market, illustrate the short run effects of the change.
2. Is the price likely to rise by \$.25? Why or why not?
3. If it doesn’t, are firms likely to continue to operate in the short run? Why or why not?
4. What is likely to happen in the long run? Illustrate your results with a large, clearly labeled graph. | textbooks/socialsci/Economics/Principles_of_Economics_(LibreTexts)/09%3A_Competitive_Markets_for_Goods_and_Services/9.4%3A_Review_and_Practice.txt |
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