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1.2 WHAT IS A MARKET?

● market Collection of buyers and sellers that, through

their actual or potential interactions, determine the price of
a product or set of products.

● market definition Determination of the buyers, sellers,

and range of products that should be included in a
particular market.

● arbitrage Practice of buying at a low price at one

location and selling at a higher price in another.

What is the relation between market and industry?

Relevance of actual and potential interaction?

1.2 WHAT IS A MARKET?

Market Definition—The Extent of a Market

● extent of a market Boundaries of a market, both
geographical and in terms of range of products produced
and sold within it.

Market definition is important for two reasons:

A company must understand who its actual and potential

competitors are for the various products that it sells or
might sell in the future.

Market definition can be important for public policy decisions.

1.2 WHAT IS A MARKET?

Competitive versus Noncompetitive Markets

● perfectly competitive market Market with many buyers

and sellers, so that no single buyer or seller has a
significant impact on price.

Market Price

● market price Price prevailing in a competitive market.

Qs= 1800 + 240 P
Qd = 3550 – 266 P
 2.2 THE MARKET MECHANISM

Figure 2.3

Supply and Demand

The market clears at price P0

and quantity Q0.

At the higher price P1, a surplus

develops, so price falls.

At the lower price P2, there is a

shortage, so price is bid up.

What is dependent and what is

independent?
2.2 THE MARKET MECHANISM

Equilibrium

● equilibrium (or market clearing) price

Price that equates the quantity supplied
to the quantity demanded.

● market mechanism Tendency in a free

market for price to change until the market
clears.

● surplus Situation in which the quantity

supplied exceeds the quantity demanded.

● shortage Situation in which the quantity

demanded exceeds the quantity supplied.
2.4 ELASTICITIES OF SUPPLY AND DEMAND

● elasticity Percentage change in one variable resulting from

a 1-percent increase in another.

Price Elasticity of Demand

● price elasticity of demand Percentage change in quantity

demanded of a good resulting from a 1-percent increase in its
price.

(2.1)
2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

● linear demand curve Demand curve that is a straight line.

Figure 2.11

Linear Demand Curve

The price elasticity of demand

depends not only on the slope
of the demand curve but also
on the price and quantity.
The elasticity, therefore, varies
along the curve as price and
quantity change. Slope is
constant for this linear demand
curve.
Near the top, because price is
high and quantity is small, the
elasticity is large in magnitude.
The elasticity becomes smaller
as we move down the curve.
2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(a) Infinitely Elastic Demand

(a) For a horizontal demand

curve, ΔQ/ΔP is infinite.
Because a tiny change in price
leads to an enormous change
in demand, the elasticity of
demand is infinite.

● infinitely elastic demand Principle that consumers will buy as much

of a good as they can get at a single price, but for any higher price the
quantity demanded drops to zero, while for any lower price the
quantity demanded increases without limit.
2.4 ELASTICITIES OF SUPPLY AND DEMAND

Linear Demand Curve

Figure 2.12

(b) Completely Inelastic Demand

(b) For a vertical demand curve,

ΔQ/ΔP is zero. Because the
quantity demanded is the same
no matter what the price, the
elasticity of demand is zero.

● completely inelastic demand Principle that consumers will buy a

fixed quantity of a good regardless of its price.
Commodities with elastic and inelastic demand
Consumer Behavior

● theory of consumer behavior Description of how

consumers allocate incomes among different goods and
services to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences

2. Budget constraints

3. Consumer choices
3.1 CONSUMER PREFERENCES

• Indifference Curves

● indifference curve Curve representing all combinations of market

baskets that provide a consumer with the same level of satisfaction.

Figure 3.2

An Indifference Curve

The indifference curve U1 that

passes through market basket
A shows all baskets that give
the consumer the same level of
satisfaction as does market
basket A; these include
baskets B and D.

Our consumer prefers basket

E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.
 3.1 CONSUMER PREFERENCES

•The Marginal Rate of Substitution

● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.
Figure 3.5

The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two goods.
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
3.1 CONSUMER PREFERENCES

• Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right
angles.
Bads
● bad Good for which less is preferred rather than more.
3.2 BUDGET CONSTRAINTS
● budget constraints Constraints that consumers face
as a result of limited incomes.
• The Budget Line
● budget line All combinations of goods for which the total
amount of money spent is equal to income.

PF F + PC C = I (3.1)

TABLE 3.2 Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
The table shows market baskets associated with the budget line
F + 2C = $80
3.3 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Figure 3.13

Maximizing Consumer Satisfaction

A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
No higher level of satisfaction (e.g.,
market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1] is
greater than the price ratio (1/2),
satisfaction is not maximized.
3.3 CONSUMER CHOICE

Satisfaction is maximized (given the budget constraint) at the

point where

MRS = PF / PC (3.3)

● marginal benefit Benefit from the consumption of one

additional unit of a good.
● marginal cost Cost of one additional unit of a good.

The condition given in equation (3.3) illustrates the kind of

optimization conditions that arise in economics. In this instnace,
satisfaction is maximized when the marginal benefit—the
benefit associated with the consumption of one additional unit of
food—is equal to the marginal cost—the cost of the additional
unit of food. The marginal benefit is measured by the MRS.
Draw demand curve
4.1 INDIVIDUAL DEMAND

The Individual Demand Curve

● price-consumption curve
Curve tracing the utility-maximizing
combinations of two goods as the
price of one changes.

● individual demand curve

Curve relating the quantity of a
good that a single consumer will
buy to its price.
4.1 INDIVIDUAL DEMAND

Normal versus Inferior Goods

Figure 4.3

An Inferior Good

An increase in a person’s
income can lead to less
consumption of one of the
two goods being
purchased.
Here, hamburger, though
a normal good between A
and B, becomes an
inferior good when the
income-consumption
curve bends backward
between B and C.
4.1 INDIVIDUAL DEMAND

Engel Curves

● Engel curve Curve relating the quantity of a good consumed to income.

Figure 4.4

Engel Curves

Engel curves relate the

quantity of a good
consumed to income.
In (a), food is a normal
good and the Engel curve
is upward sloping.
In (b), however,
hamburger is a normal
good for income less than
$20 per month and an
inferior good for income
greater than $20 per
month.
4.2 INCOME AND SUBSTITUTION EFFECTS

A Special Case: The Giffen Good

● Giffen good Good whose demand curve slopes upward
because the (negative) income effect is larger than the
substitution effect.
Figure 4.8
Upward-Sloping Demand Curve: The
Giffen Good
When food is an inferior good, and
when the income effect is large
enough to dominate the
substitution effect, the demand
curve will be upward-sloping.
The consumer is initially at point
A, but, after the price of food falls,
moves to B and consumes less
food.
Because the income effect EF2 is
larger than the substitution effect
F1E, the decrease in the price of
food leads to a lower quantity of
food demanded.
4.3 MARKET DEMAND

From Individual to Market Demand

Two points should be noted as a result of this analysis:
1. The market demand curve will shift to the right as more
consumers enter the market.
2. Factors that influence the demands of many consumers will also
affect market demand.
The aggregation of individual demands into market demands
becomes important in practice when market demands are built up
from the demands of different demographic groups or from
consumers located in different areas.
For example, we might obtain information about the demand for
home computers by adding independently obtained information about
the demands of the following groups:
• Households with children
• Households without children
• Single individuals
4.4 CONSUMER SURPLUS

● consumer surplus Difference between what a consumer is willing to

pay for a good and the amount actually paid.

Consumer Surplus and Demand

Figure 4.13

Consumer Surplus

Consumer surplus is the

total benefit from the
consumption of a product,
less the total cost of
purchasing it.

Here, the consumer surplus

associated with six concert
tickets (purchased at $14
per ticket) is given by the
yellow-shaded area.
Production

The theory of the firm describes how a firm makes cost-

minimizing production decisions and how the firm’s
resulting cost varies with its output.

• The Production Decisions of a Firm

The production decisions of firms are analogous to the

purchasing decisions of consumers, and can likewise be
understood in three steps:
1. Production Technology
2. Cost Constraints
3. Input Choices
6.1 THE TECHNOLOGY OF PRODUCTION

● factors of production Inputs into the production

process (e.g., labor, capital, and materials).

• The Production Function

q = F (K , L) (6.1)

● production function Function showing the highest

output that a firm can produce for every specified
combination of inputs.
Remember the following:

Inputs and outputs are flows.

Equation (6.1) applies to a given technology.

Production functions describe what is technically feasible

when the firm operates efficiently.
 6.1 THE TECHNOLOGY OF PRODUCTION

• The Short Run versus the Long Run

● short run Period of time in which quantities of one or

more production factors cannot be changed.

● fixed input Production factor that cannot be varied.

● long run Amount of time needed to make all

production inputs variable.

Industry specific variations

6.2 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

• The Law of Diminishing Marginal Returns

● law of diminishing marginal returns Principle that as the
use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.
6.2 PRODUCTION WITH ONE VARIABLE INPUT (LABOR)

• The Law of Diminishing Marginal Returns

● law of diminishing marginal returns Principle that as the
use of an input increases with other inputs fixed, the resulting
additions to output will eventually decrease.

Figure 6.2

The Effect of Technological

Improvement
Labor productivity (output
per unit of labor) can
increase if there are
improvements in technology,
even though any given
production process exhibits
diminishing returns to labor.
As we move from point A on
curve O1 to B on curve O2 to
C on curve O3 over time,
labor productivity increases.
6.3 PRODUCTION WITH TWO VARIABLE INPUTS

• Isoquants
● isoquant map Graph combining a number of
isoquants, used to describe a production function.
Figure 6.4

Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year at
points such as B) and
to isoquant q3 (90 units per year at
points such as C and E).
6.3 PRODUCTION WITH TWO VARIABLE INPUTS

• Isoquants
● isoquant map Graph combining a number of
isoquants, used to describe a production function.
Figure 6.4

Production with Two Variable Inputs

A set of isoquants, or isoquant

map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D),
to isoquant q2 (75 units per year at
points such as B) and
to isoquant q3 (90 units per year at
points such as C and E).
6.4 RETURNS TO SCALE

● returns to scale Rate at which output increases as

inputs are increased proportionately.

● increasing returns to scale Situation in which output

more than doubles when all inputs are doubled.

● constant returns to scale Situation in which output

doubles when all inputs are doubled.

● decreasing returns to scale Situation in which output

less than doubles when all inputs are doubled.
7.1 MEASURING COST: WHICH COSTS MATTER?

Economic Cost versus Accounting Cost

● accounting cost Actual expenses

plus depreciation charges for capital
equipment.

● economic cost Cost to a firm of

utilizing economic resources in
production, including opportunity cost.

Opportunity Cost
● opportunity cost Cost associated with
opportunities that are forgone when a
firm’s resources are not put to their best
alternative use.
7.1 MEASURING COST: WHICH COSTS MATTER?

Fixed Costs and Variable Costs

● total cost (TC or C) Total economic

cost of production, consisting of fixed
and variable costs.

● fixed cost (FC) Cost that does not

vary with the level of output and that
can be eliminated only by shutting
down.
● variable cost (VC) Cost that varies
as output varies.

The only way that a firm can eliminate its fixed costs is by
shutting down.
7.1 MEASURING COST: WHICH COSTS MATTER?

Fixed Costs and Variable Costs

● total cost (TC or C) Total economic

cost of production, consisting of fixed
and variable costs.

● fixed cost (FC) Cost that does not

vary with the level of output and that
can be eliminated only by shutting
down.
● variable cost (VC) Cost that varies
as output varies.

The only way that a firm can eliminate its fixed costs is by
shutting down.
7.1 MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost

Marginal Cost (MC)

● marginal cost (MC) Increase

in cost resulting from the
production of one extra unit of
output.

Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.
We can therefore write marginal cost as
7.1 MEASURING COST: WHICH COSTS MATTER?

Marginal and Average Cost

Average Total Cost (ATC)

● average total cost (ATC)

Firm’s total cost divided by its
level of output.

● average fixed cost (AFC)

Fixed cost divided by the level of
output.

● average variable cost (AVC)

Variable cost divided by the level of
output.
7.2 COST IN THE SHORT RUN

The Determinants of Short-Run Cost

The change in variable cost is the per-unit cost of the extra labor w times
the amount of extra labor needed to produce the extra output ΔL. Because
ΔVC = wΔL, it follows that

The extra labor needed to obtain an extra unit of output is ΔL/Δq = 1/MPL. As
a result,
(7.1)

Diminishing Marginal Returns and Marginal Cost

Diminishing marginal returns means that the marginal product of labor

declines as the quantity of labor employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.
7.2 COST IN THE SHORT RUN

The Shapes of the Cost Curves

Figure 7.1

Cost Curves for a Firm

In (a) total cost TC is the

vertical sum of fixed cost
FC and variable cost VC.
In (b) average total cost
ATC is the sum of
average variable cost
AVC and average fixed
cost AFC.
Marginal cost MC crosses
the average variable cost
and average total cost
curves at their minimum
points.
7.2 COST IN THE SHORT RUN

The Shapes of the Cost Curves

The Average-Marginal
Relationship
Consider the line drawn from
origin to point A in (a). The
slope of the line measures
average variable cost (a total
cost of $175 divided by an
output of 7, or a cost per unit
of $25).
Because the slope of the VC
curve is the marginal cost ,
the tangent to the VC curve
at A is the marginal cost of
production when output is 7.
At A, this marginal cost of
$25 is equal to the average
variable cost of $25 because
average variable cost is
minimized at this output.
7.3 COST IN THE LONG RUN

The Isocost Line

● isocost line Graph showing
all possible combinations of
labor and capital that can be
purchased for a given total cost.
To see what an isocost line looks like, recall that the total cost C of
producing any particular output is given by the sum of the firm’s labor
cost wL and its capital cost rK:
(7.2)

If we rewrite the total cost equation as an equation for a straight line,

we get

It follows that the isocost line has a slope of ΔK/ΔL = −(w/r), which is
the ratio of the wage rate to the rental cost of capital.
7.3 COST IN THE LONG RUN

The Isocost Line

Figure 7.3

Producing a Given Output at

Minimum Cost

Isocost curves describe the

combination of inputs to
production that cost the
same amount to the firm.
Isocost curve C1 is tangent
to isoquant q1 at A and
shows that output q1 can be
produced at minimum cost
with labor input L1 and
capital input K1.
Other input combinations–
L2, K2 and L3, K3–yield the
same output but at higher
cost.
7.3 COST IN THE LONG RUN

Choosing Inputs

Figure 7.4

Input Substitution When an

Input Price Changes

Facing an isocost curve

C1, the firm produces
output q1 at point A using
L1 units of labor and K1
units of capital.
When the price of labor
increases, the isocost
curves become steeper.
Output q1 is now
produced at point B on
isocost curve C2 by using
L2 units of labor and K2
units of capital.
7.3 COST IN THE LONG RUN

Choosing Inputs

Recall that in our analysis of production technology, we showed

that the marginal rate of technical substitution of labor for
capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and
capital:
(7.3)

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

We can rewrite this condition slightly as follows:

(7.4)
7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Long-Run Average Cost

● long-run average cost curve (LAC) Curve

relating average cost of production to output
when all inputs, including capital, are variable.

● short-run average cost curve (SAC) Curve

relating average cost of production to output when
level of capital is fixed.

● long-run marginal cost curve (LMC) Curve

showing the change in long-run total cost as
output is increased incrementally by 1 unit.
7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

As output increases, the firm’s average cost of producing that output

is likely to decline, at least to a point.
This can happen for the following reasons:
1. If the firm operates on a larger scale, workers can specialize
in the activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of
inputs utilized to produce the firm’s output, managers can
organize the production process more effectively.
3. The firm may be able to acquire some production inputs at
lower cost because it is buying them in large quantities and
can therefore negotiate better prices. The mix of inputs
might change with the scale of the firm’s operation if
managers take advantage of lower-cost inputs.
7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

At some point, however, it is likely that the average cost of

production will begin to increase with output.
There are three reasons for this shift:
1. At least in the short run, factory space and machinery may
make it more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and
inefficient as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared
once certain quantities are reached. At some point,
available supplies of key inputs may be limited, pushing
their costs up.
7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

● economies of scale Situation

in which output can be doubled
for less than a doubling of cost.

● diseconomies of scale
Situation in which a doubling of
output requires more than a
doubling of cost.

Increasing Returns to Scale: Output more than doubles when

the quantities of all inputs are
doubled.
Economies of Scale: A doubling of output requires less
than a doubling of cost.
7.4 LONG-RUN VERSUS SHORT-RUN COST CURVES

Economies and Diseconomies of Scale

Economies of scale are often measured in terms of a cost-output

elasticity, EC. EC is the percentage change in the cost of production
resulting from a 1-percent increase in output:

(7.5)

To see how EC relates to our traditional measures of cost, rewrite the

equation as follows:
(7.6)
7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

Product Transformation Curves

Figure 7.10

Product Transformation Curve

The product transformation

curve describes the different
combinations of two outputs
that can be produced with a
fixed amount of production
inputs.
The product transformation
curves O1 and O2 are bowed
out (or concave) because
there are economies of scope
in production.

● product transformation curve Curve showing the

various combinations of two different outputs (products)
that can be produced with a given set of inputs.
7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

Economies and Diseconomies of Scope

● economies of scope Situation in

which joint output of a single firm is
greater than output that could be
achieved by two different firms when
each produces a single product.

● diseconomies of scope Situation

in which joint output of a single firm
is less than could be achieved by
separate firms when each produces
a single product.
7.5 PRODUCTION WITH TWO OUTPUTS—
ECONOMIES OF SCOPE

The Degree of Economies of Scope

To measure the degree to which there are economies of scope, we

should ask what percentage of the cost of production is saved when
two (or more) products are produced jointly rather than individually.

(7.7)

● degree of economies of scope (SC)

Percentage of cost savings resulting
when two or more products are
produced jointly rather than
Individually.