Praxis Study Guide Notes for Economics

Scarcity

Scarcity, the result of unlimited human wants coming face to face with the fact of limited resources to meet those wants, is one of the basic assumptions of economics. Most economists consider scarcity the central problem of economics. Once it is realized that resources are scarce, we see that there must be some mechanism for rationing these scarce resources among alternative uses: choices must be made.

If a choice must be made, then there is a cost involved. The economist's concept of cost, opportunity cost, is crucial to our understanding. Benefits given up are really what make up costs, not the dollars that we give up. Opportunity cost is the benefits given up of the most attractive alternative (doing one thing usually excludes other possibilities). Note that costs are measured as negative benefits, benefits given up. This way benefits and costs are always in the same units so that they can be compared. If doing one thing, call it X, involves giving up something else, Y, that is valuable, then X has a cost and involves scarcity, even if it the scarcity of our time.

Scarcity also implies competition. Some plant biologists discuss competition by plants. It is not that plants decide that they will get involved in some sort of competitive behavior with other plants. The biologists’ idea of plant competition is that plants grow and will continue to do so if there is enough water, sun, nutrients, and space. There are other plants that are also growing. With a limited amount of these resources (sun, water, nutrients, and space), some plants will eventually compete with each other for these scarce resources. There are not enough of these resources to satisfy all plants. If these resources are not scarce for the plants, plants will grow and reproduce until the basic resources upon which they rely are scarce. Scarcity, costs, and competition are inevitable, not just for plants, but especially for humans.

People deal with the problem of scarcity through markets and political institutions. If a good is scarce, people want more of that good than producers are willing to provide for free. So a good indication that a good is scarce is if you have to pay something to get it.

Markets ration goods and resources by placing prices on goods and resources. The goods are available for those willing and able to pay the price. If there are only a few of a certain type of good or resource available, but many buyers would be willing (and able) to give up a great deal of other things, those goods would have a high price. If buyers are not willing to pay much for a particular good, even if there are many available, the price would not be so high. Prices ration resources so that we do not “run out.”

Political responses to scarcity involve setting rules that restrict how much of something a person can take, who is able to take the good and when the good is available. The political response involves setting up a system of rationing. If prices aren't used as a rationing mechanism, some other method (that is no fairer than prices) must be employed, even if it is just first-come-first served. If we can't have all we want, we would like to have our desires realized as much as possible, given that we can't always get what we want. We want the rationing mechanism to be as efficient as possible in allocating resources to various uses that fulfill human desires. We have begun a study of how the price system works and how efficiently it works.

A simple activity for the first day of class in economics is to make sure that there are too few desks in the classroom for the number of students you expect (enrollment – normal first day absentees – another 4 desks). With this situation, you can discuss scarcity, rationing, fairness (or unfairness) of different rationing methods—someone will be without a desk no matter what.

Opportunity cost

“The cost of anything is what you have to give up to get it.”

Opportunity cost is THE cost concept in economics and it is THE cost concept that is relevant to decision making. Opportunity cost is about what an individual decision maker must give up to get something of value. Since there is scarcity is ubiquitous as we have noted above, to get almost anything of value, we have to give up something else that is valuable. Usually, to obtain a benefit some other beneficial possibility must be sacrificed. Opportunity cost is the benefit that must be given up of the next most attractive possibility. Suppose you have three choices, A, B, and C, and can do only one of these three possibilities. These are termed “mutually exclusive” choices—to do one, means none of the others can be done. You have the following values:

Choice	Willing to Pay
A	$30
B	$45
C	$17

Your first choice is obviously B. If you choose to do B, you cannot do A which you value at $30. You are giving up something worth $30 to get something worth $45. While you cannot do C if you choose B, you are not giving up the something worth $47, because you could not do both A and C—the opportunity cost, the value you are giving up, is the $30 value of A.

We see opportunity costs in many places and many ways. The cost of a mother of several children doing one thing for one child might be the next most beneficial task she could have performed for one of her other children. She cannot do everything. The cost of doing one thing is the benefit that could have been obtained of the thing left undone.

Anyone who has coached youth recreation soccer knows that few players want to play goalie, but that is probably the most crucial position of the team. Most players want to play forward so that they can score. Goalies feel the weight of the team—if a point is allowed they blame themselves and their teammates blame them as well. Often, the best goalies are also some of your best forwards (players in good positions to score). If you put a good forward in as goalie, it is less likely that you will score, but it is also less likely that you will be scored on. The cost of putting that player in at goalie is the points that are not scored by that player.

The real opportunity cost to society of a worker’s time and effort at work at one job is what that worker could have produced in some other work or some other job.

In this country, we used to draft a portion of our young men into military service, instead of providing them decent pay level. The draft forced these young men into the military service, so we did not have to pay them as much. This did reduce the costs to taxpayers, but it raised the opportunity costs to the society.

These young men had various opportunities in the job market, some could only get low paying jobs, but others could get rather good paying jobs. The reason jobs pay what they do is because those paying the wages and salaries value their work at least as high as what they are paying (or they would not pay so much). The reason an employer pays a particular wage or salary is because that employee adds enough to the output of the firm to more than pay for their wage or salary. Pay reflects the opportunity cost of the worker, but it also reflects the value of their output to members of society.

With the draft, young men were selected to serve, somewhat at random (many made the claim that the very wealthy and influential could use political ties to keep from being selected). Some men were drafted were not able to produce much of value in the workforce, while others were able to produce a lot of value. Think of how much society values the output of a young man drafted into the NBA out of high school, or the output of an actor, or the output of a computer genius. With these young people being selected somewhat at random, high-pay workers are drafted along with low-pay workers. If we just pay them, anyone who can get a better pay than the army will probably choose that other job. The ones selecting military service are seldom those who have the great opportunities elsewhere.

Take a look at the example in the table below. Suppose all of these young men are fit for military service and none has special connections to avoid a draft. Keep in mind that these young men make the pay they do because someone, and ultimately that means consumers, values

their output at least as much as they are getting paid. If one of them is removed from their job because of the draft, the output to the rest of us is cut by that amount. Their pay represents an opportunity cost to the rest of us in society.

Potential Soldier	Pay (Opportunity Cost) per year
Andy	$25,000
Ben	$15,000
Charlie	$20,000
Danny	$40,000
Eddy	$30,000
Frank	$35,000

Now suppose that the size of the army expected to be raised by the government is such that one out of every two fit young men is needed for the army. If we selected these men at random, we might come up with what amounts to drafting every other man on the list, drafting Andy, Charlie and Eddy for a cost to society of $25,000 + $20,000 + $30,000 or $75,000. If we paid enough to get the three lowest paid men to join the service, Andy, Ben and Charlie would serve and we would do without their output which we value at $60,000. Paying each $28,000 would get these three to join (this is simplifying and not counting much for the pay they would need to pay for the extra cost of the risk involved). Still, paying a certain level of pay gets those who have lower opportunity costs to join, leaving those with higher opportunity costs to do jobs we value more than soldiering. The cost to taxpayers of a volunteer or fully paid army is higher than the draft, but the cost to society is lower.

“Sunk costs”

Not all spending represents an opportunity cost. Suppose you buy a car and you paid 25% down and borrowed the rest. Now you have a monthly car note to pay, and suppose it is $300 per month. How much, per mile driven, is the cost of your monthly payment? Well, that is really not a very good question, because you pay $300 a month no matter how many miles you drive? The $300 expenditure is not a cost of driving your car. You pay that much every month whether you drive your car or not that month. It is an obligation from a past decision.

A sunk cost is really an expenditure that you make no matter what you decide. It is an expenditure that you make because of an obligation you made in the past. There is no opportunity for choice, so there is no real cost involved with a “sunk cost.”

Of course, not all of your monthly payment on your car represents a sunk cost. The $300 dollars monthly payment represents your cost to continue to own the car. You might be able to sell your car, but suppose you cannot sell the car for what you still owe on the car (this happens, particularly if you try to sell your car soon after purchasing it). Your sunk cost is your obligation minus what you could get for the car by selling it. Remember, just because you paid a particular amount for the car does not mean someone will give you anything near what you paid for it.

Suppose you buy a house and later find out that the property is on a landfill and that poisonous gasses from the landfill are seeping into your home and could result in serious health problems should you remain. You might not be able to sell the property at anything close to what you paid. You might be able to sue those who developed the property, but you might not be able to find them.

Suppose you lost a $20 bill and you look for the bill, and you value your time at $5 per hour. How long do you look for the bill? If you think that it will take longer than 4 hours to find the bill, don’t look. If you expect to find the bill within the next 4 hours, look for the bill. Here’s the clincher in applying the idea about opportunity cost and sunk cost. Suppose you have already looked for the bill for 3 ½ hours, but have not found the bill, but you fully expect to find the bill in the next 4 hours, you should continue to look. Actually, no matter how many hours you have already looked, if you fully expect to find the bill within the next 4 hours, continue to look. The hours you have already looked are sunk costs and cannot be retrieved. You no longer have those hours to give up, because they have already been given up. Those costs already incurred cannot be gotten back.

It is, as they say, “water under the bridge.” The other applicable saying is “no use crying over spilt milk.” What’s done is done. A cost is an opportunity cost only up to the point where you have decided to take action incurring that cost. Once that point is reached, once that cost is incurred and cannot be undone, the cost is sunk. Opportunity costs are avoidable costs and “sunk costs” (not costs at all) are unavoidable. Once a $100 expenditure is incurred or “sunk” or invested, you face those costs no matter what you decide. Say, you have three possibilities after taking on an obligation to pay $100 (or actually paying the $100). You can choose action A and you face the additional costs of A along with your previous payment of $100. You could also choose B or C, which would entail the added costs of B or C, along with your previous $100. You have the $100 obligation no matter which way you turn, which choice you make—it is an unavoidable cost. Then, the only costs that matter to your decision are those additional costs of A or B or C.

Wants vs. Needs

Be careful with any distinction made between wants and needs. Psychologists use the term “needs” as drivers for human behavior. Economists prefer the term “wants.” It would be easy to slip into the idea that “human needs” are somehow objective, but wants are merely subjective. This is not the case at all. Psychologists’ “needs” are really just types of human “wants.” Our wants have biological and physiological roots as well as psychological and cultural roots.

The problem that economists have with the term “need” is that it has the connotation of absolute necessity, an imperative. Economists prefer the term “want” because we want students to think in terms of alternatives, substitutes and tradeoffs. When we think in terms of “needs” we stop thinking about alternatives or substitutes and then tradeoffs do not exist. The term “need” boxes our thinking in and blinds us to substitutes and alternatives. We want to think outside of the box that need connotes.

Rationality

In economics we assume that individuals act rationally. We must be careful about how we define this, however. It only means that individuals act with purpose. People, for the most part choose to do the things they do. Sometimes people may behave randomly, but random behavior is not predictable, only purposeful behavior is predictable. By rational we mean that people act with least cost, effort, and waste to achieve their goals, within their knowledge.

This does not mean that people are assumed to not make mistakes, only that they learn from their mistakes. If my goal is simply to go to New Orleans from Thibodaux, going there by mailing myself in a huge box, would be a most inefficient way to get there. Driving, hitchhiking, even biking, are all more efficient ways to get to New Orleans. [By the way, remember that the goal of getting to New Orleans is not questioned in the economist's view of rationality.]

Rationality in the way it is being used here does not mean that we have complete knowledge. In fact, economists use the idea of “rational ignorance.” Information is scarce, and so, costly, like anything else of value. Since it is costly to acquire information, people will only acquire information as long as the extra cost of gathering information is less than or equal to the extra benefit of more information.

Economists also think of rationality in terms of “bounded rationality.” People are not perfect calculators of benefits and costs, and the more complex the decision, the more difficult it is to make the best decision. There are limits to our brain power and so our rationality is limited or bounded.

The assumption of rational behavior does not rule out the behavior of the insane. Some people think that they are Napoleon, and so it would not be irrational (according to our definition) for them to act as they think Napoleon would, to have goals they think Napoleon would have.

Another key element to understanding rationality is that it is only an attribute of individuals and not an attribute of groups. People in groups do not do what is best for the group, necessarily, but what is best for someone of for some of the individuals in the group. The assumption of rationality is to assume that individuals are rational, but group choices, such as democratic choices, may not be.

Rationality, we must remember, is about the means we choose to achieve our goals, NOT about the goals we choose.

A final point about the assumption of rationality must be made. Rational behavior does not mean selfish behavior, it means self-interested behavior. The assumption is that people do things that they think are more important. Some people are selfish and do not consider the effects of their behavior on others, while others are more thoughtful and will do things for others without a reward for themselves. Still, the latter are pursuing goals that they find important. “Rational” does not mean “selfish.”

Factors of Production

Economists use the terms “factors of production,” “resources” and “inputs” interchangeably. These are the ingredients used in producing anything we make or grow. Economists classify factors of production into three or four basic categories: land, labor, capital, and some also mention entrepreneurship.

Land is really not just land, but all natural resources. These are all the resources that are provided by nature, those not produced by humans. These are necessary for producing any good, but not necessary for producing certain services.

Labor is any type of human effort (entrepreneurship might be classified as labor because it requires human effort). Management effort, under this classification, is also labor. Labor is any action involving time and effort by human beings.

Tools and equipment are called capital. Capital is defined as resources that help make other goods or services without becoming physically a part of the good being made—capital increases productivity of labor. Capital is a resource that lasts and can be used over and over. Capital is often referred to as a “roundabout means of production.” Instead of making something directly, just with our hands, we first make the tools or capital and then are better able to make whatever it is we are interested in making for consumption. The production of capital entails opportunity costs; because we cannot be producing the final consumption goods we are interested in consuming if we are busy producing the equipment or capital.

To produce capital, then, people will have to save, or consume less than they produce. If people consume everything they produce, they cannot be producing capital. To get people to save and invest in capital, then, people must be given a return to get them to forgo current consumption. People will not voluntarily invest in capital if they think that they will not get a return on their investment.

Capital is some labor saving device or tool. While it may reduce the number of workers required to produce the same amount of output, it increases the amount of output per worker. Any worker who is relieved of their work due to some labor saving machinery is available for work doing something else in the economy. Recall that scarcity means we never have enough. We have always found other jobs for those replaced by labor- saving machinery, because of scarcity—there is always something else that we can do because people as consumers have wants without end.

One type of capital related to labor is termed “human capital.” The idea of human capital is that people make investments in themselves when they acquire useful skills that enhance their productivity. To acquire those skills, they have to take time away from producing goods directly and using that time to acquire skills and abilities. Acquiring human capital is what people in school and in special training programs, or even with on-the-job training and experience. People will sometimes take lower paying jobs to learn things to become more employable later. Education is certainly one of the most important components of human capital investment.

Another important type of capital is public capital. Not only is private capital important, but so is investment in public capital, whether it is in roads, ports, airports, or police, security and defense equipment. Roads and other transportation capital, such as canals, ports and airports, reduce the costs of transporting goods from one place to another. Another essential type of public capital is a legal and court system to help us make and enforce contracts. Still another ingredient of public or social capital is some level of trust among parties to contracts.

Psychologists discuss the problem of “delayed gratification.” A reward delayed does not provide quite the incentive that an immediate reward of the same amount does. To save and invest in capital, people must receive a return sufficient to overcome this “delayed gratification” problem. They also must be given a return to overcome the risk involved in the sunk costs of an investment. Higher returns to capital owners provide them with incentives to produce the capital and risk the investment and wait for payment. Heavy taxes on the return to capital equipment reduce the incentive to invest and Heavy taxes on owning capital (through local property taxes) raise the cost of capital without increasing the return, reducing the incentive to invest, leaving workers with less machinery than they might otherwise have, and reducing their productivity.

Investment in capital is essential to productivity growth (and growth in income or the standard of living). Not only is private capital important, but so is investment in public capital, whether it is in roads, ports, airports, or police, security and defense equipment. Another essential part of public capital is a legal and court system to help us make and enforce contracts. Still another ingredient of public or social capital is some level of trust among parties to contracts.

Productivity is also enhanced by providing people with a bigger incentive to produce through reductions in the rate of taxation on income. This gives people a greater incentive to invest in human capital.

Entrepreneurship is the act of putting together the various factors of production in new ways or to produce new products; it is human creativity in our work life. Entrepreneurs are people who take the risks of organizing productive resources to make goods and services. Profit is an important incentive that leads entrepreneurs to accept the risks of business failure. Without profits, people have little incentive to create new and more efficient ways of doing things—we stagnate.

Production Possibilities Frontier

Our First Diagram

· Assumptions: technology and resources fixed

· Demonstrates Scarcity/Opportunity Cost

o Downward or Negative Slope

· Utilizes “Specialization” & “Law of Increasing Costs”

o PPF’s Bowed-out Shape

· Demonstrates Marginalism

· Demonstrates Efficiency, Inefficient, Not Feasible

· Shifting the PPF

Incentives

Monetary and non-monetary incentives are rewards and/or punishments. If the reward is worth more to someone than the cost they must endure to obtain that reward, then rewarded behavior is increased. Punished behavior gets people to reduce certain behaviors if the punishment is seen as costly enough that the punished behavior is no longer worth pursuing (the gains of that behavior are now less than the costs). Positive incentives (rewards) increase behavior and negative incentives (punishments) reduce that behavior.

One thing we know from psychology is that not all rewards are rewards to all people and not all punishments are punishments to all. The promise of an ice cream cone may be a good reward for good behavior for a small child, but it may not provide much of an incentive to a child with diabetes who knows that sweets can make them sick. Some children do not like to be scolded, and that is a punishment for them, but a few children like the attention, and what is meant to punish, actually for them is a reward and encourages inappropriate behavior. Non-monetary incentives may be rewards for some, but might be punishments for others, or just may not be of any value, positively or negatively, to some.

An important difference between monetary and non-monetary incentives is that monetary incentives are incentives to all. Can you think of someone who treats getting money as a punishment or someone who would increase some behavior in light of an increase in the monetary penalty? The reason money is a “generalized” reward or a reward to all is that we can exchange that money for anything (that is for sell) that we value, and there are so many choices available for monetary exchange, that we are all motivated by money.

Specialization and Comparative Advantage

Wealth – Exchange Value and Use Value

Material Wealth

Production Creates Wealth

So Does Trade

Trade and Absolute Advantage

Trade and Comparative Advantage

Total Production Possible

	Milk (gal.)	Fish (lbs.)
Bala	4	4
Mozella	5	10

Specialize traditional roles
Daily Output	8 hr day
	Milk (gal.)	Fish (lbs.)
Bala		32
Mozella	40
*total*	40	32

Specialize in Non-traditional roles
Daily Output	8 hr day
	Milk (gal.)	Fish (lbs.)
Bala	32
Mozella		80
*total*	32	80

Modified Comparative Advantage
Daily Output	8 hr day
	Milk (gal.)	Fish (lbs.)
Bala	32
Mozella	8	64
*total*	40	64

Opportunity Cost

	Cost of one	Cost of one
	gal. of milk	lb. of fish
Bala	1 lb. Fish	1 gal. Milk
Mozella	2 lb. Fish	1/2 gal. Milk
		Sources of Gains from Trade: Comparative Advantage and Multiculturism Gain or Advantage in Multicultural Society from Trade or trading across cultures and across countries

Comparative Advantage =Lowest Opportunity Cost

Earliest Modern Concept of Economic Efficiency

Comparative Economic Systems

Four Basic Questions for Economies

There are four basic questions that every economy must answer.

What should be produced?
How many should be produced?
What methods should be used?
How should the goods and services be distributed?

There are three kinds of economies: A traditional economy, command economy and a market economy. What separates these economy types is the answer or answers to a fifth question:

Who makes economic decisions, and by what process?

In a traditional economy, traditions answer these questions. A person follows in the footsteps of his or her parents. Still, most roles or jobs are not usually highly specialized in a traditional economy. Some of the questions might be answered by a chief or other tribal leader, such as the question of who gets what.

In a command economy, the government would answer all these questions. The political process in command economies is often dictatorial, but it could be democratic.

A way of thinking about this 5^th question is to examine what economists call “property rights.”

Production, Costs and Supply

Getting Behind the Supply Curve

Maximizing Profits

We begin with the assumption that firms try to maximize profits.

Profits are simply revenues minus costs. Revenues are the dollars received from the sales of the output of the firm. In the very simple analysis that follows, we assume that the firm sells just one type of good and, at least at first, that all units of the good are sold at the same price. Revenues, in this case, are then the price of the good times the number of units sold. This can be seen visually on the firm’s demand curve as the rectangle inside the demand curve, formed by the axes on the left and the bottom and the point on the demand curve at the price the firm charges and the quantity it sells at that price. That area is seen below as the shaded rectangle. The rectangle has a height of about $60 and a base of almost 10 units. The revenue is then about $600 ($60*10).

We have studied demand the factors that affect demand. Now let us turn our attention to the cost side of a firm’s profit equation.

In order to produce revenues, the firm has to have a product to sell. People do not just give the firm money without expecting something in return. The something that they expect requires some inputs, resources or factors of production. As they say, “you must spend money to make money.” Revenues come at some cost. The cost is has its roots in the inputs in the production process (which involves the marketing, as well).

Variable and fixed inputs—the short and the long run

(This section was written by Roger Adkins at Marshall University for his classes and is used with his permission.)

In order to better understand how economic units such as the firm adjust to changing circumstances, economists discuss two analytical time periods. These are the short‑run (SR) and the long‑run (LR). In microeconomics these periods are unrelated to calendar time; in other words, we do not say the SR is six months or nine months or a year, and the LR is then greater period of time. Rather, the SR and LR are defined in terms of how long it takes certain types of adjustments to occur.

We can think of these as planning periods or planning horizons. Some of our plans involve the here and now, immediate or tactical plans. Some of our plans deal with decisions that will affect things for a long time to come, strategic plans. Strategic plans are long-run plans, where as tactical plans are short-run plans.

The firm has two types of resources (inputs) for producing a good or service they are either fixed or variable. A fixed resource would be the buildings and equipment (machinery) of the firm. Examples of variable resources are labor, raw materials, and energy. The firm can easily expand production by quickly adding more or the variable resources, or the use of these inputs can be reduced with a drop in output. The firm can control the amount of variable resources used. Suppose the demand for the firm's product were to surge beyond the capacity of the firm's production facilities. How would the firm respond? While the firm can readily increase the amount of its variable inputs as demand expands it is unable to add to an existing structure or to put up a new building or to put in new equipment without the passage of some amount of time. A new firm seeking to enter this industry in response to the higher level of demand (and presumably higher profits) will also require time to build the new structures and install the equipment. We define the LR as the period of time it takes for an existing firm to expand capacity and/or for a new firm to enter the industry. (The LR is also the time it takes for an existing firm to expand capacity and/or for a new firm to enter the industry. (The LR is also the time it takes for an existing firm to reduce its capacity in response to lower demand or for that firm to leave the industry.)

In the LR the firms can vary the levels of all resources; this is an alternative definition. The firm looks to some time in the future and concludes that they can sell this amount of output which will require this size plant using this amount of labor. If the forecast is changed, the firm will chose a different size plant and a different level of employment. All resources are variable.

The SR is the length of time in which the response of the firm to changes in the market is limited. The fixed input(s) cannot be altered. The firm is free to add of reduce the amount of variable resources as the market dictates. So the SR is that period of time in which the firm has at least one fixed factor of production and one or more variable inputs. The consequence is that any drastic change in the market will be met by a limited response in the SR since only variable resources can be altered. But in the LR, a fuller response will occur because the firm will be free to change all inputs.

Before we look at a typical firm’s cost function (relationship), we need examine the relationship between inputs and outputs of a firm. We will call this relationship the “production function.” We will examine the production function in several ways, by looking at the relationship between input and total output, between input and average output (output/input) and between input and marginal output (the change in output due to having one more unit of the input. For now, we will assume that a firm’s production process involves one and only one variable input and only one fixed input. We will call the variable input “labor” and the fixed input “capital.”

Fixed costs are the costs associated with fixed inputs, and variable costs are those associated with variable inputs. In the short run, then, fixed costs, do not change as output changes, while variable costs do change with changes in output. While not all fixed costs are “sunk costs,” we will, treat fixed costs as “sunk costs.”

What will give the short-run production function its shape is the fact that we are changing the amount of the variable input, while leaving the amount of the fixed input constant. Imagine, for now, the production of school lunches. The cafeteria has a kitchen of a fixed size with a fixed amount of equipment. The room available and the equipment available is the capital, the fixed input. The cafeteria workers represent the variable input (for now, let us ignore the raw material food input, but recognize that this input varies directly with the output, number of lunches).

LAW OF DIMINISHING RETURNS

(This section was written by Roger Adkins at Marshall University for his classes and is used with his permission.)

The law of diminishing returns applies only to the short run. It examines the behavior of output as we add more inputs to the production process. In particular, since we are examining the firm in the short run there must be at least one factor of production (input) that is fixed and cannot be altered for a period of time. So to this (let us assume one) fixed factor we will add a variable input or we can think of this as a bundle of inputs. For instance our bundle would be so much labor, raw materials, and energy.

One further assumption is necessary. Each variable input (or bundle) is just like any other; they are homogeneous in the terminology of economics. The firm would be indifferent as to the order in which the variable inputs would be put to work.

The law of diminishing returns is best illustrated by a numerical example as in Table 8. Column one shows the increase in the homogeneous variable input (which we will call labor or L) that is being added to a fixed factor. The second column shows the behavior of output as more and more labor is added to the fixed factor. Output (total product or Q) increases for the first eight workers then levels off before declining with the 10th worker. The last column, marginal product, is of greatest interest. We will use the concept of marginal product often.

Table 8. Total and Marginal Product

(1)	(2)	(3)
Variable Input	Total Product	Marginal Product
(L)	(TP or Q)	(MP)
0	0	---
1	5	5
2	12	7
3	21	9
4	31	10
5	40	9
6	46	6
7	50	4
8	51	1
9	51	0
10	49	-2

Marginal Product: The increase in total product (output) that arises from the use of an additional unit of the variable input.

We formulate the law of diminishing returns based on the information found in column three.

The first worker when combined with the fixed factor produces five units. If we add a second worker, total production increases to 12 units. The second worker's marginal product (MP) is seven units. Notice MP has increased going from worker one to worker two. The MP of the second worker is not higher than the first because worker tow is a better worker. Recall that we have assumed that all labor inputs are identical. The rising marginal productivity of the first four workers is an indication that the fixed factor of production is not being efficiently utilized. Too little of the variable factor is being used with the fixed resource.

Another point ought to be made. By going from one to two workers total product goes from five to twelve units, and we conclude that the MP of the second worker is seven units. This does not mean the second worker actually produced seven units himself. Workers one and two together produced 12 units. The consequence of adding worker two to the efforts of worker one is a gain of seven units. The second worker works with the first worker in the production process.

Our interest is drawn to the fifth worker's MP. His MP is less than the MP of the worker who preceded him. We have entered the stage of diminishing returns. This phase is characterized by having the marginal product of each successive worker being less than the MP of the worker before him. In our example MP ceases to be positive and, in fact, becomes negative with the 10th worker.

Law Of Diminishing Returns: As equal units of a variable input are added to a fixed factor, beyond some point the marginal product of some unit of input will be less than the MP of the preceding input.

What is the major lesson to be learned from this? The supply response (desire to increase output) of the firm is limited in the short run. Given the fixed factor, only so many units of the variable factor can be added before MP approaches zero. A large supply response requires a long run adjustment. Also, it is important to understand that we do not have sufficient information to indicate how may workers ought to be hired in our example. A tentative guess might be that the firm would not operate beyond the fourth worker since each additional worker produces less and less. We do not know the selling price of the good being produced nor do we know the cost of hiring labor; all we have is a technical relationship but inputs and outputs when a fixed factor of production is present. We will not develop the argument now, but it can be demonstrated that the firm will operate somewhere in the range of diminishing returns. There is an intuitive argument for this point. If marginal product is rising per person, then cost per person must be falling. The firm does not worry about falling costs. Only when costs are increasing per person hired (output per person is falling) must the firm move ahead with care.

See if you can figure out the average product here. Does it follow the principle outlined in the section Marginal Versus Average Values?

Plot the total product curve on one diagram and the marginal product and average product below it on another.

XXI. SHORT RUN COSTS

(The first section of this note was written by Roger Adkins at Marshall University for his classes and is used with his permission.)

A. Introduction

In the short run, the costs associated with adding more capital (the fixed factor) are held constant, because we add no capital in the short run, by definition. Our total costs (TC) of production can be broken down into two classes at first (we will delineate more later on): 1) fixed costs (FC), a constant; and 2) variable costs (VC). We can think of these costs in several ways‑‑we may be concerned with the entire costs, we may be concerned with costs per unit, average costs (AC), or we may be concerned with the additional costs from producing one more unit marginal costs (MC).

B. From Total Product to Total Variable Cost, Total Average Cost, and Total Cost

For now, assume that there are only two factors of production required to produce some good "x", a fixed factor and a variable factor. Also, for sake of the example, assume that each unit of the variable factor adds one dollar to our costs (the price of the factor is one dollar per unit). Using TABLE VI in the previous section for our example, multiply one dollar times each unit of the variable factor. This gives us the total variable costs (VC) at each of the levels of output or total product listed in column (2). Plot these costs on the vertical axis of a diagram and the total product or output on the horizontal axis. What you have just plotted is the total variable cost curve. Plot a constant two dollars at each level of output and you have the total fixed costs (FC) if the capital you now have costs two dollars per year. If you add the total fixed costs to the total variable costs you have total costs. Plot this as well.

C. From Total Cost to Average Cost

To get the average costs, divide the associated total cost by output. Average fixed cost (AFC), or fixed cost per unit, is total fixed cost divided by output. Average variable cost (AVC), or variable cost per unit, is total variable cost divided by output. Average total cost (ATC), or total cost per unit, is total cost divided by output. Using the figures from TABLE VI and a two dollar fixed cost, compute these average costs for each unit of output given on the table.

D. Marginal Cost

To get marginal cost (MC), divide the change in total cost or the change in total variable cost by the change in output. Plot the marginal cost, average variable cost, and average fixed cost on one diagram. Do the average costs exhibit the relationship between averages and marginals we saw earlier (MARGINAL VERSUS AVERAGE VALUES)?

Classroom Example: (written by Morris Coats)

Costs and Firm Behavior

Some basic concepts:

· Production Functions and Costs Functions

· Average Variable Costs and Price

· Fixed Costs and the Irrelevance of Sunk Costs

· Fixed Costs in the Short Run and the Long Run

· Marginal Costs and Marginal Revenues and Maximizing Profits

Production Functions and Cost Functions

Starting with a simple relationship between Labor input (L) and output (Q) in Table 9, the rest of the values in the table can be derived (see definitions/formulas below).

Table 9. Production and Cost Relationships

L	Q	MPL	APL	VC	FC	TC	AVC	ATC	MC
0	0	---	---	0	25	25	---	---	---
1	10	10	10.000	5	25	30	0.500	3.000	0.500
2	25	15	12.500	10	25	35	0.400	1.400	0.333
3	42	17	14.000	15	25	40	0.357	0.952	0.294
4	57	15	14.250	20	25	45	0.351	0.789	0.333
5	71	14	14.200	25	25	50	0.352	0.704	0.357
6	84	13	14.000	30	25	55	0.357	0.655	0.385
7	95	11	13.571	35	25	60	0.368	0.632	0.455
8	105	10	13.125	40	25	65	0.381	0.619	0.500
9	114	9	12.667	45	25	70	0.395	0.614	0.556
10	122	8	12.200	50	25	75	0.410	0.615	0.625
11	129	7	11.727	55	25	80	0.426	0.620	0.714
12	135	6	11.250	60	25	85	0.444	0.630	0.833
13	140	5	10.769	65	25	90	0.464	0.643	1.000
14	144	4	10.286	70	25	95	0.486	0.660	1.250
15	147	3	9.800	75	25	100	0.510	0.680	1.667
16	149	2	9.313	80	25	105	0.537	0.705	2.500
17	150	1	8.824	85	25	110	0.567	0.733	5.000
18	150	0	8.333	90	25	115	0.600	0.767
19	149	-1	7.842	95	25	120	0.638	0.805
20	147	-2	7.350	100	25	125	0.680	0.850

Definitions, Relationships and Assumptions for Production Function Example Above:

L = Units of Labor Input in Person Hours (total number of hours worked by all workers)

Q = Quantity of Output of Some Good

K = the amount of capital = 5 units in this example

r = price of capital = $5 in this example

w = the hourly wage rate or price of an hour of labor = $5 in this example

MP_L = Marginal Product of Labor = ΔQ /Δ L

MP_K = Marginal Product of Capital (or Kapital) = ΔQ /Δ K

AP_L = Average Product of Labor = Q / L

AP_K = Average Product of Capital = Q / K

VC = Variable Cost = w*L, assuming labor and capital are the only inputs. Here w = $5 per hour.

FC = Fixed Cost = r*K (and for now, we will consider this a “sunk cost”)

TC = Total Cost = VC + FC = w*L + r*K

AVC = Average Variable Cost = VC/Q = w*L/Q = w/AP_L

AFC = Average Fixed Cost = FC/Q = r/AP_K

ATC = Average Total Cost = TC/Q = (VC+FC)/Q = w/AP_L + r/AP_K

MC = Marginal Cost = ΔVC /ΔQ = ΔwL/ΔQ = w* ΔL/ΔQ = w/MP_L

Figure XVII. Total Product

Figure XVIII. Average and Marginal Product

Figure XIX. Variable, Fixed and Total Costs

Figure XX. Average Total Costs, Average Variable Costs and Marginal Costs

XXII. THE LONG RUN AVERAGE COST CURVE

(This section was written by Roger Adkins at Marshall University for his principles of microeconomics classes and is used with his permission.)

A firm operating in the short run has at least one fixed factor of production that cannot be changed at that moment. We can draw a short run average cost curve (ATC) which shows how average cost per unit of output behaves as output increases. This curve is drawn as having a "U" shape as in Figure XX. Cost per unit of output is initially high, but then declines as output expands reaching a low before rising.

Our concern here is the development of the long run average cost curve (LRAC) and its relationship to the ATC curve. The LRAC curve is also called the firms planning curve. The important distinction here is that the ATC curve represents the behavior of average cost for a production facility that is either in existence or could be constructed. Input prices are assumed to remain unchanged. The LRAC curve does not represent any one physical production unit. It is more of a catalog of construction plants (ATC curves) for different size plants arranged from smallest to largest. If we were given a forecast of the expected average annual output our firm could sell and if this output were greater than our current capacity, we would need to make a long-run adjustment in the fixed resource (plant and equipment). We would go to an industrial engineer who would be able to indicate the most efficient size plant.

Figure XXI presents a graphical picture of this situation. Suppose current output is 4 units and the forecasted level of potential sales is 13, which is beyond the capacity of our existing plant (represented by ATC1). Output of 4 thousand units is produced at a cost per unit of $3.25. We have three ways of producing 13 units: ATC2_,ATC3, andATC4. Only one of these is efficient. We seek the size plant that will allow the product to be produced at the lowest average cost per unit. The plant size given by ATC3meets this condition where cost per unit is under $1.00. This same output could be produced by ATC2and ATC4. In the former, the plant is being operated near its physical capacity as the fixed factor is being fully utilized by being combined with large amounts of variable resources. Just the opposite occurs with the largest of the plants (ATC4); here the fixed factor is being under utilized as small amounts of the variable resource are employed. Cost per unit in both cases is over $2.

Figure XXI. Short Run Average Costs for Several Different Size Plants

When the firm is producing 4 units, utilizing plant size 1 (associated with ATC1) it is in the short run. When the firm begins to consider producing the larger output, 13 units, many options become available. Every resource can be adjusted to best produce the anticipated output ‑ a long run adjustment. Notice that after the firm constructs the new plant with per unit costs of ATC3, it has returned to the short run since it has a larger, but fixed, plant. As the firm moves from the old to the new structure, it moves from one short-run situation to another.

The long run average cost curve in Figure XXI is made up of portions of the four short run average cost curves (the portions with heavy lines). Any output up to 4 units should be produced with ATC1. From 4 to about 7 units, ATC2is the optimal size plant. Output levels of 7 to 18 are to be produced using ATC3and so on.

In theory each level of output would have a corresponding physical plant best suited to produce that output. This general case is shown in Figure XXII. The long run average cost curve has a "U" shape that is explained by what is termed the "economies of scale."

Figure XXII. The Long Run Average Cost Curve

Economies and Diseconomies of Scale

Notice that in the long run, both labor and capital can be varied. All combinations of labor and capital can be tried. Some combinations will cost more than others and produce the same amount of output. As the amount of capital available (plant size) increases different short-run total costs come into view. A large grocery store is able to achieve lower per unit costs than a small corner grocery store or convenience store. A large jet that can transport many more passengers per highly paid pilot, also achieves lower per unit costs. As the scale of production is increased, lower per-unit costs are achieved. This is called “economies of scale.” The economies of scale occur in the downward sloping portion of the Long-Run average cost curve.

It sometimes occurs that higher levels of output require increasing levels of coordination in the firm that are very difficult to achieve. Large-scale operations can become very difficult to coordinate, accounting for increasing per-unit costs in the long run. These increasing per-unit costs resulting from higher levels of production and higher coordination costs are called diseconomies of scale. The diseconomies of scale occur in the upward sloping portion of the Long-Run average cost curve.

A few definitions.

Total Product : the total output of all workers or units of input.

Average Product: the output per worker or output/input.

Marginal Product: the change in output from adding one more unit of an input.

Of course, if you have no cafeteria workers, there will be no lunches made. Suppose the first cafeteria worker produces about seven meals an hour by herself. The total production (or total product) is 7 meals, the average production (or average product) is 7 meals and the marginal (or added) product is 7 meals. If another worker were added to the first, perhaps each worker could specialize in different cafeteria tasks. Specialization in different tasks may allow the two workers, working cooperatively, to more than double the output of just one worker, perhaps increasing output to 17 meals. The total product is then 17 for two workers, the average product is 8.5 (17/2), and the marginal product is 10 (17 meals together minus the 7 meals produced by the first worker). At first, as you add cafeteria workers, specialization allows the Marginal Product of Labor to increase.

As more and more workers are added, however, to a fixed amount of capital, each worker has less equipment, on average, to work with and less space in the work area. There will come a point when adding more workers will result in a falling marginal product. This means that the extra worker adds to output, but not by as much as previous workers added to output.

Take a look at the following total product for labor function or curve. While the curve is rising, it eventually is rising but at a diminishing (falling) rate. The first 10 units of labor hours added about 125 units of output, but the next 5 only add about 25 units of output. Somewhere between about 16 units and 20 units of labor, there is no increase at all in output. The additional workers begin to crowd each other in terms of space and in terms of equipment, decreasing the additional output of the additional workers.

The average and marginal product curves are shown in the following diagram.

The Variable, Fixed and Total Costs

Based on the same production function that gives us the total average and marginal products of labor we see above, we have the variable, fixed and total costs in the following diagram, assuming that the fixed costs are $25 and the wage rate is $5 per hour.

Notice that the total cost curve, TC, is just the Variable Costs shifted up by the amount of the Fixed Costs: TC= FC+VC.

There are two short-run average cost concepts to consider. Average total costs are the total costs divided by the number of units of the output (TC/Q). Average variable costs are Variable Costs divided by output. Average fixed costs (not shown) are fixed costs divided by the output (FC/Q). Since dividing the constant fixed costs by an ever increasing quantity (output), average fixed costs decline from the start, continuing to fall and getting ever closer to the quantity axis without ever getting there. This curve is what mathematicians call a “hyperbola.” These short-run average total costs, average variable costs and marginal costs all have the characteristic U or parabolic shape, declining at first, reaching a bottom and then rising (the average total cost or ATC is actually a parabola plus a hyperbola).

The Law of Diminishing Marginal Returns

The eventual reduction in the marginal product is termed the “law of diminishing marginal returns,” or simply the “law of diminishing return,” which is also known as the “law of variable proportions.” As more and more of the variable input is added to the fixed input, the proportion of capital to worker declines, and so the marginal or added product of labor eventually falls, as the increased output from increased specialization is not enough to match the fall in output due to less capital per worker. The amount of output added (the return) by the added input eventually falls (diminishes).

Average and Marginal Costs

Costs are due to inputs (inputs could be used to make other things, and so have an opportunity cost). The cost of labor is the wage rate times the number of hours worked by the workers. Take a look at the following table. Suppose there are 100 workers each working a 40 hour week making $10 per hour. (For now, also assume that there are no other costs associated with labor other than their wages. Later on, we will look at wages as the total cost for a worker, including the cost of their fringe benefits.) The labor cost would $40,000 per week (40 hrs per worker times 100 workers times $10 per hour). Suppose that in a week, these 100 workers working 40 hours each can make 4,000 units of output. The first 4,000 person hours of labor added 4,000 units of output, so the marginal product at first averages to 1 unit of output for each extra unit of labor input. The variable costs are the $40,000 to make 4,000 units. The average variable cost is then $40,000/4,000 or $10 per unit. The marginal cost over these units is just the average variable cost of $10 per unit. Suppose an extra 10 workers working 40 hours per week caused output to increase to only 4,200 units. The marginal product of the extra workers would be 200 units added divided by the 400 labor hours added, which would be ½ unit per additional hour of labor. The average variable cost would then be $44,000/ 4,200 =$10.48. The marginal cost of adding 200 units of output would be $4,000/200=$20. The marginal cost than it had been because the extra workers did not add as much to output as the first 100 workers added. Costs increased the same for the extra workers ($10 per hour), but the output from these extra workers was less, so the added cost for the added output was higher. The falling marginal product of labor leads to an increasing marginal cost of the output. In the short run, the law of diminishing marginal returns leads to increasing or rising marginal costs. We will see later that the marginal cost concept is essential for understanding the supply of firms.

	Total				Average
Labor	Product	Average	Marginal	Variable	Variable	Marginal
Hours	Output	Product	Product	Cost	Cost	Cost
0	0	---	---	0	---	---
4,000	4,000	1	1	40000	10	10
4,400	4,200	0.954545	0.5	44000	10.47619	20

Long-run costs and Economies of Scale

n Production Functions and Costs Functions

n Average Variable Costs and Price

n Fixed Costs and the Irrelevance of Sunk Costs

n Fixed Costs in the Short Run and the Long Run

n Marginal Costs and Marginal Revenues and Maximizing Profits

Some preliminary distinctions

n Short Run vs. Long Run

n Sunk Costs vs. Non-sunk Costs

n Fixed Costs vs. Variable Costs

n Explicit Costs vs. Implicit Costs

n Normal Profits vs. Economic Profits vs. Accounting Profits

n Production Functions and Cost Functions

n Definitions, Relationships and Assumptions for Production Function Example Above:

n L = Units of Labor Input in Person Hours (total number of hours worked by all workers)

n Q = Quantity of Output of Some Good = Total Product = TP

n K = the amount of capital = 5 here

n r = price of capital = $5 here

n w = the hourly wage rate or price of an hour of labor = $5 here

n MPL = Marginal Product of Labor = ΔQ /Δ L

n MPK = Marginal Product of Capital = ΔQ /Δ K

n APL = Average Product of Labor = Q / L

n APK = Average Product of Capital = Q / K

Definitions, Relationships and Assumptions for Production Function Example Above:

n **VC = Variable Cost = w*L, assuming labor and capital are the only inputs. Here w = $5 per hour.**

n FC = Fixed Cost = r*K (and for now, we will consider this a “sunk cost”)

n TC = Total Cost = VC + FC = wL + rK

n AVC = Average Variable Cost = VC/Q = w*L/Q = w/APL

n AFC = Average Fixed Cost = FC/Q = r/APK

n ATC = Average Total Cost = TC/Q = (VC+FC)/Q = w/APL + r/APK

n MC = Marginal Cost = ΔVC /ΔQ = Δ(wL)/ΔQ = w* ΔL/ΔQ = w/MPL

Long-Run Costs

n Economies and Diseconomies of Scale (Increasing, Constant and Decreasing Returns to Scale)

n Reasons for Scale Economies

n Economies and Diseconomies of Scope

n Reasons for Economies (and dis~) of Scope

Marginal Costs and Supply

n Maximizing Profit: MR = MC, Why?

n Competitive Case: P = MR, Why?

n If Competitive Market, maximize profit where P = MC.

Shut Down Decision

n If P < AVC

n Profit max = Loss min

n Loss = TC – R

= FC + (VC – R)

P x Q=R, AVC x Q=VC,

so if P < AVC, then R<VC

What does VC, R equal if Q=0?

Shut down

Shut Down Decision

n Do you shut down if P>AVC?

Some Relevant Course Notes

n THE SHORT RUN VS. THE LONG RUN

n LAW OF DIMINISHING RETURNS

n SHORT RUN COSTS

n THE LONG RUN AVERAGE COST CURVE

n Coordinating Supply and Demand

n Example--Energy

n Individual Decisions

n Non-price coordination

n Price coordination

Market Participants and Incentives: Producer and Consumer Surplus

Accounting Profits, Normal Profits, and Economic Profits

As mentioned previously, opportunity cost is the fundamental cost concept in economics, as it is opportunity cost that is appropriate for decision making. One place we apply the idea of opportunity cost is to the investment decisions. Investors face opportunity costs when they decide where to invest their funds. One possible use of investment funds is to invest in a widely diversified stock portfolio in the stock market. The rate of return on such a widely diversified portfolio is what could be earned rather than investing in a single industry in the form of owning stock in just one firm, so these earnings in the stock market represent an alternative or opportunity cost of funds. This normal rate of return is a cost of stockholder capital. If we apply this normal rate of return over the stockholder capital in the firm, then we have what can be called “normal profits.” For debt capital, the interest payments to lenders or bond holders are part of the opportunity cost of operating the firm and are treated as costs. Accounting rules dictate that payments to stockholders in the form of retained earnings or dividends are all counted as profits. Part of the accounting profits of firms are profits that stockholders could have earned in a widely diversified portfolio. represents a “normal profit,” which, as we have seen is an opportunity cost of stockholder capital. If we subtract the normal profit from the accounting profit, we get the economic profit, revenues minus all opportunity costs. These opportunity costs are not only items such as wage expenses, but also normal profits.

II B. Market Structures

The competitive environments in which firms operate affect their supply decisions (both the price they charge and the quantity they supply in the market). The competitive environments are often referred to as market structures. Economists have four basic categories of seller competition in markets. The competition that plays out among buyers can also have profound affects on demand-side behavior. Here, we focus on competition among sellers.

There are really many market types, and the differences among market environments lie along three continuums, one having to do with the number of sellers, or the concentrations of market shares (market share is the percent the market’s sales going to a particular seller) of sellers being one major distinguishing dimension and the similarity of products of sellers (product differentiation) being another distinguishing dimension. A third continuum or dimension for competitive environments involves the ease with which firms are able to enter or leave the market, a long-run characteristic of seller competition.

Economists have classified competitive environments four basic market structures in which sellers compete. First, there are the two extreme environments of perfect competition and monopoly, and two intermediate environments of oligopoly and monopolistic competition.

“Monopoly” means “single seller” (mono – single, poly – seller). With a single seller, the one seller has a 100% market share. For the monopoly to be sustained, there must be some barriers to entry (high costs of entry), such as a patent, preventing competitors from coming into the market. Also, with just one firm, it makes little sense to discuss product differences among sellers, since there is only one seller. To sum up, monopoly is characterized by

Single seller
Barriers to entry so severe, no firms challenge the monopolist

Perfect competition is such a competitive environment that there are so many firms competing in the market that no single firm can raise its prices without losing all of its sales to competitors.

An example would be the market for unskilled labor (where the employees are the sellers). If a single worker demanded higher wages, that worker would price herself out of the market, with the employer just hiring someone else.

In perfect competition, consumers see the products of all sellers as perfectly interchangeable, with no product differentiation at all. Buyers see bars of a given weight of 24 k gold as perfectly interchangeable, unlike the market for fast food, where McDonalds and Burger King offer similar, but definitely different products.

In the long run firms are able to easily enter and leave perfectly competitive markets. There is really nothing to keep willing sellers out of the market. Summing up, perfect competition is characterized by

Many sellers
Low or no entry barriers
No product differences (“homogeneous” product)

“Monopolistic competition” gets its oxymoronic name from having some characteristics that in common with monopoly and some with perfect competition. Monopolistic competition is like monopoly in that each firm produces a distinctly different product, or has a monopoly on that exact product, that is, there is product differentiation in this type of market, making the rival sellers’ distinctly different. Making this type of market like perfect competition is the fact that there are very many firms in this market and the barriers to entry are very low or not existing. Even though there are many sellers in this market, the distinctness of the products makes a firms in monopolistically competitive markets behave like monopolists in the short run, but in the long run, the ease of entry and exit makes market participants act like competitors. Summing up, monopolisitically competitive markets have

Many sellers
Low or no entry barriers
Distinct product differences (“heterogeneous” products)

Oligopoly markets have a few sellers who may sell either homogeneous or heterogeneous products. “Oligo” (as in “oligarchy”) means “few” and “poly” means “sellers.” The reason for the fewness of rivals is that there are some high, but not prohibitive, barriers to entry, allowing some, but not many, rivals to compete in the market.

What is distinctive about oligopoly markets is that the fewness of the rivals in the market means that the behavior of one seller has a pronounced effect on the incentives, and so, the behavior, of other sellers. Since this is so, each firm must be concerned about how its rivals will respond to its actions. The expectation of the behavior of rivals plays a big part in oligopoly markets. Summing up, oligopolistic markets have

Few sellers
Moderately high entry barriers
Either homogeneous or heterogeneous products

Firm Behavior in Different Market Structures

Price makers and price takers

The main difference in firm behavior the short run in the different market structures is seen in a distinction made between firms that are “price takers” and firms that are “price makers.” Recall that a demand curve in a market is downward sloping because of the alternatives that people face. For a monopoly, the downward sloping market demand curve is the firm’s demand curve, as customers have nowhere else to turn (other than the alternatives that make the demand curve downward sloping in the first place). The firm sees its downward sloping demand curve as a menu of possibilities. The firm can sell more units, but must lower prices to do so, or it can raise prices, but will sell fewer units as a result. Monopolies have market power, or the ability to raise prices without losing all customers. This market power allows firms to make or set their own prices. Monopolies are price makers. Not only are monopolies price makers, but so are oligopolies and monopolistically competitive firms. Firms in each of these types of markets can independently raise their prices without losing all of their sales.

Firms in perfectly competitive markets (and markets that are nearly so) are price takers. While the market demand curve is downward sloping in the market, buyers face so many alternative sellers that any single seller’s demand curve is flat at the going market price. If one particular firm in this type of market were to raise its price above its rivals, consumers would rush to the rivals’ products, leaving the price raising firm to continue to hold onto its inventory, able to sell nothing, because its rivals are offering the buyers better deals. If a single cotton farmer tried to hold out for a price just a few cents per bale above her competitors’ price, the cotton buyers would simply buy from her competitors and she would only sell her cotton when she lowered her price to match her rivals.

The relationship between the market supply and demand (below, on the right), where price is set for the market in a competitive environment, and the demand for a price taker’s demand (below, on the left) is shown in the following diagrams.

Entry Barriers

Free or easy entry allows firms to respond to profits and losses in particular markets in the long run by entering into markets that appear to have higher profits than other markets and exiting markets that have lower profits than others the firm could enter.

If economic profits are greater than zero, profits in this industry or market are greater than their alternative profits, and firms will give up the smaller profits to achieve lower profits to enter this market. If economic profits are less than zero, firms will leave this industry as the profits in this industry are worse than the return from a diversified portfolio.

Entry barriers come in various forms or causes. Patents and copyright holders are given a special privilege of having a monopoly for a specified number of years.

If there are substantial economies of scale (falling long-run costs as quantity increases) coupled with a rather limited demand, such that the demand curve crosses the downward sloping portion of the long-run average cost curve, then having more than one seller would raise the cost of each seller. This is because each seller can only sell half of what is demanded in the market and must produce a smaller quantity than a monopolist, raising the average cost of output, so that one firm could sell at a price below what is required for two firms to survive in this market.

Licenses also serve as barriers to entry, especially when there are a limited number of licenses or licensees must pass exams that have little to do with performance or is highly subjective, leaving room for those in the industry to keep out new competitors. See the story about florist licensing in Louisiana at URL: http://dailycomet.com/apps/pbcs.dll/article?AID=/20040513/BUSINESS/405130302/1003.

The early exploration companies from England were given monopoly grants to certain trade by the crown.

Licenses, other governmental special privileges, patents, copyrights and economies of scale with small demand are all reasons for monopolies to persist over time.

If it were not for entry barriers, profits above the normal level will lead to firms entering the industry, causing prices to fall until both monopoly and higher than normal profits are a thing of the past.

Firm Behavior: Profit Maximization and Supply Decisions

We will begin our look at firm behavior and their supply decision by looking at profit maximization.

MAXIMIZING PROFITS (IN GENERAL)

We have seen that net benefits are maximized where marginal benefits are equal to marginal costs as long as marginal costs "cut" marginal benefits from below. Profit is one type of net benefit, revenues net of costs, that is, revenues minus costs. Marginal benefits that we use here are called marginal revenues. We need to see how we figure out marginal revenues, which we will do after we look at the rules from profit maximization.

Rules for profit maximization

Profits are maximized where:

marginal revenues and marginal costs are equal (This is the PRIMARY RULE for profit maximization),

if:

1) marginal costs "cut" marginal revenue from below (Secondary Rule)

AND

2) revenues exceed the sum of all non-sunk costs. (Another Secondary Rule)

Here is the logic behind our “marginal revenue equals marginal cost” rule:

1) If MR>MC, another unit will add more to revenues than to costs, increasing profits, so the firm should increase output, Q

2) If MR<MC, the last unit produce added more to costs than to revenues, so cutting output will cut costs more than it will cut revenues, raising profits, so the firm should decrease output, Q

3) If MR=MC (and the two other conditions above hold), profits are maximized because neither increasing or decreasing output will raise profits.

Demand and Marginal Revenues

First, revenue is equal to price times quantity, assuming that we sell each unit for the same price. We get these from the demand for the firm's product (notice that the demand for the firm's product is the same as the industry or market demand for that product ONLY IF the firm is the only seller, that is, if the firm has a monopoly on that product, otherwise, the firm's demand curve is more elastic than the market demand). Revenue can easily be seen on a demand curve of FIGURE XIII as the area of the rectangle that has from zero to the quantity OQ sold as its base and from zero to the price OP as its height, or OP, the price, times OQ, the quantity, as seen below.

FIG XIII

Demand and Revenues

We can see that for us to sell one more unit, we must drop our price. If we sell one more unit we add the price that we sell one more unit for to our revenues, but we also have to sell the units before this at the same new price (perhaps you should recall now that quantity demanded is a FLOW variable, that is, we are dealing with units sold per week or per month or per year). Dropping the price on the units before this last one decreases our revenues on all of those units, so marginal revenue is less than price.

Perhaps a numerical example may help. In TABLE 4, we have a demand relation between price and quantity. Multiplying those two columns together gives us the revenue column. Finding the change in revenues divided by the change in quantity sold gives us marginal revenue. In this example we change quantity by only one unit each time. In this example, we make up a demand function and a cost function. We use "Prof" for profit.

We have seen the logic behind our primary rule for profit maximization, that marginal revenues and marginal costs must equal for profits to be maximized, in note 10, Marginal Analysis & Maximizing Net Benefits. As you recall, benefits, such as revenues, are additions to net benefits, or profits. Costs, on the other hand, reduce net benefits or profits and so, are subtracted from benefits or revenues. We also must recall that Marginal Revenues are the additions to total revenues, not the total of revenues. Also, Marginal Costs are the additions to total costs, not total costs.

If marginal revenues exceed marginal costs, then we are adding more to our revenues than to our costs. Profits must be rising. The profit function has a positive sloper here.

On the other hand, if marginal costs exceed marginal revenues, then we are adding more to our costs than to our revenues. Profits must be falling. The profit function has a negative slope here. The place where we go from profits rising to profits falling is where marginal revenues and marginal costs are equal. Here, total profits are neither rising nor falling. The slope of the profit function is defined as marginal revenues minus marginal costs and so it is zero where marginal revenues equal marginal costs. A zero slope is a necessary condition for a function to be maximized. To see this, draw a graph where the curve increases, comes to a peak or maximum, and then falls. What is the slope at the peak? So, for profits to be maximzed, marginal revenues must equal marginal costs.

Now let us examine our first subsidiary rule, that the equality of marginal revenues and marginal costs gives us maximum profits only if marginal costs cut marginal revenues from below. What this means is that for profits to be maxmized at the quantity where marginal revenues and marginal costs are equal, marginal costs must be below marginal revenues prior to their equality. If this were not true, if marginal costs intersected marginal revenues from above, then all the units produced before the point where marginal revenues and marginal costs are equal must have added more to costs than to revenues. This would continually push profits downward until that point where marginal costs = marginal revenue. After that profits would begin to rise, because after that point marginal revenues would exceed marginal costs. The point of equality between marginal costs and marginal revenues would then give us a profit minimum, not a profit maximum. A maximum of any function occurs where that function has a zero slope AND where the slope went from positive to negative, never where the slope goes from negative to positive.

Look back at the graph you were told to draw a moment ago. It rises, comes to a peak, and then falls. For profit to rise, come to a peak, and then fall, marginal costs must first be below marginal revenues, then cut, and then above marginal revenues.

TABLE 4

Firm Decision Making

Q	x P	= R	MR	TC	VC	MC	Prof
0	11	0	---	2	0	---	-2
1	10	10	10	3	1	1	7
2	9	18	8	5	3	2	13
3	8	24	6	8	5	3	16
4	7	28	4	12	10	4	16
5	6	30	2	18	16	6	12
6	5	30	0	26	24	8	4
7	4	28	-2	36	34	10	-8
8	3	24	-4	48	46	12	-24
9	2	18	-6	62	60	14	-44
10	1	10	-8	78	76	16	-68

VC=all non-sunk costs

TC=sunk plus non-sunk costs

We see two things in the numerical example in TABLE 4. First, marginal revenues are below price for a downward-sloping demand curve. Second, we see that profits are maximized where marginal costs equal marginal revenues and marginal costs cut marginal revenue from below.

We need to examine the second part of the IF of the rule above:

2) revenues exceed all non-sunk costs.

One way to show that this must also be true is to first suppose that it isn't. Suppose that VC > R. The firm is then making a loss of FC (we will treat this as sunk costs) + (VC - R). If the firm were to shut down completely, it would still have to pay the sunk costs, yet would have NO revenue, making a loss of FC. Where would losses be greater, where the only loss is FC or where the loss is FC + (VC - R). If VC > R then losses would be minimized by shutting down. This gives us our shutdown rule. Another version of this rule is "sunk costs are sunk costs" or even "don't cry over spilt milk". Again, we have the concept of opportunity cost staring us in the face! If the cost is changeable by your actions, it is a relevant cost, but if you can't change that cost, it is irrelevant for decision making purposes.

To sum things up, all firms will maximize profits where their marginal revenues equal their marginal costs, as long as marginal costs cut marginal revenues from below and the price charged provides enough revenue to pay for the variable costs of the firm (otherwise, the firm shuts down). For price maker firms, which includes monopolists, oligopolists, and monopolistic competitors, the downward sloping demand makes marginal revenues fall faster than price, so that marginal revenue lies beneath the demand curve. We will see that things are a little different for the firms in perfect competition.

Profit Maximization for Price Takers

Recall that firms operating in perfect competition are price takers. Price takers cannot affect their own price by their supply or output decisions. Suppose a firm in a perfectly competitive market faces a price of $25 for each unit that it sells, as we see in the diagram below. If the firm sells no units, it makes a revenue of $0. If it sells one unit for $25, its revenues are $25, and the change in revenues from selling the first unit is $25 (Marginal Revenues or MR = $25). If it sells two units at $25 each, the firm’s revenues will be $50 and its marginal revenues from the second unit are $25. As long as the firm does not have to change its price on any units it sells in order to sell more units, the firm’s price will be its marginal revenues. So, in a perfectly competitive market, the price is the firm’s demand and its marginal revenue.

Marginal Costs and the Competitive Firm’s Supply Curve

The blue line in the diagram is the firm’s marginal cost curve, while the red demand curve is its marginal revenue curve. Recall our rule, that profits are maximized where marginal revenues (MR) and marginal costs (MC) are equal. In perfect competition, this rule becomes P=MC, because we know that for perfectly competitive firms, P=MR. If the firm produces and supplies the quantity where P=MC, or 60 units in the diagram above, then those 60 units are the firm’s quantity supplied at a price of $25. If the price were to drop to $15, the Quantity Supplied would be a little less than 20 units. The competitive firm’s supply curve is its marginal cost curve!

Well, we do have to add to qualifiers to that, based on the two qualifiers we had for our MR=MC profit maximization rule that MR=MC. The first qualifier was that marginal cost had to cut marginal revenues from below. Since marginal revenue is flat, this rule limits our supply to just the upward sloping part of a marginal cost curve. If marginal costs fall before rising, we will not produce along the downward sloping part of marginal costs.

The other rule was that revenues had to equal or exceed variable costs. This means that only the upward sloping part of marginal costs that are above the average variable cost curve qualifies for the firm’s supply curve.

Profit Maximization by Price Searchers (Price Makers):

Monopoly, Oligopoly and Monopolistic Competition

They compete, too! But in different ways

Profit Maximization by Price Searchers

§Monopoly, Price Searchers and Barriers to Entry

§Price/Quantity Setting by a Price Searcher

§Why is Marginal Revenue below Demand for Price Searchers?

§Price Searcher’s Supply Curve?

§Economists’ Price Taker Fetish

Monopoly, Price Searchers and Barriers to Entry

§Monopoly—single seller

§Short Run:

–A Price Searcher (searches for most profitable price) or Price Maker, not a Price Taker

–Market Demand is Firm Demand

§Long Run—Barriers to Entry

–Licenses, County Franchise, Government Regulated Entry, Certificates of Need, Patents, ex. Single Land-Based Casino

–Economies of Scale with Small Demand—Natural Monopoly

Ownership of Key Resources Source of Profits?

§Cost advantage because of a superior input

§Competition for key input drives input price up

§No profit left, but key input has high price

§Firm owns key input, competition drives up input price, opportunity cost goes up, no profit left

Patents

§Ownership of key resource—same old story

§Patent value goes up, as firms compete for patent licensing

Profit Maximization Rule: MR= MC

Profit Maximization for a Price Searcher

§Where are revenues maximized?

§Where are profits maximized?

Revenue Maximized? Profit Maximized?

Profit Maximization for a Price Searcher

Why is Marginal Revenue below Demand?

§MR=D R / DQ, or change in revenue from one more Q

§To sell an extra unit, must reduce price on not just that extra or marginal unit but on non-marginal units (units before the marginal unit).

§MR = P – (D P / DQ)* Q Diagram it (set DQ =1)

§MR= P – (D P / DQ)* Q = P (1-1/e)

Why is Marginal Revenue below Demand?

§Demand and Marginal Revenue close at small quantities demanded—few non-marginal units to lower price over.

§Demand and Marginal Revenue far apart at larger quantities demanded—many non-marginal units to also lower price over.

Price Searcher’s Supply Curve?

§Supply not independent of Demand for Price Searchers.

§No Supply Curve, but there is a Quantity Supplied.

Economists’ Price Taker Fetish

§Price Taker Market Achieves Maximum Efficiency—maximum consumer and producer surplus

§Price Searcher Market has unrealized gains from trade—does not achieve maximum producer and consumer surplus

§Making silk purses from a sow’s ears

Efficiency Loss from Monopoly

§Deadweight Loss and Rent-Seeking Loss

EXTERNALITIES AND PUBLIC GOODSTHE MARKET AND THE INVISIBLE FOOT

A. Negative and Positive Externalities

Pareto optimality is a situation where no one can be made better off without making someone else worse off. Technical efficiency (producing all products at lowest cost) and allocative efficiency (producing the things consumers desire the most) taken together achieves Pareto optimality. An externality is a cost or benefit of the use of some resource that is not borne by the producers or consumers in that market. Examples of external costs (negative externalities) include: 1) the increased medical costs of others from the pollution from your car; 2) the increased costs of downstream water purification caused by the dumping of sewerage into streams by upstream communities; 3) the reduced value of the shrimp population from overfishing; 4) the increased costs of house maintenance (house painting) because of the smudge produced by agricultural burning; 5) the lower grade received by noncheating students in a class when a classmate cheats and the teacher grades on a curve; and 6) the increased medical costs to surrounding communities from the air pollution from certain refineries and chemical plants. Nonexamples would include: 1) the increased cost of medical care that a smoker must pay because of the ill effects of smoking on health (smokers pay part of the costs of smoking to doctors and so are less willing to pay for cigarettes); 2) the increased medical costs of a chemical plant worker from increased exposure to harmful chemicals (worker can negotiate higher pay for compensation); and 3) the increased costs of cleaning the clothes of garbage collectors (again, higher pay can be negotiated for compensation). Notice that the difference between the examples and the nonexamples hinges on whether the harmer and the harmed are related contractually; the workers and the product consumers are contractually related to the harmer.

The previous paragraph focused on external costs (often called "negative externalities"), but there is a flip side, external benefits (often called "positive externalities"). An example of an external benefit would be the increased housing values for neighbors when you buy and fix up an old abandoned house in the neighborhood. A nonexample would be the increase in value you receive by fixing the house up.

B. Public Goods

An extreme case of a positive externality is the "public good." A public good is one where one person's consumption does not reduce the amount available for others and it is too costly to prevent nonpayers from enjoying the benefits from the good. Examples of a public good would include: 1) national defense (if you are protected by our armed forces, I am also protected, and it would be difficult to protect only those who pay but withhold protection from those who do not); 2) environmental protection (if you breathe cleaner air outdoors, so does everyone in your community and it would be very hard to keep nonpayers from breathing the cleaner air); 3) aid to the poor (if you are made better off because the financial position of the poor is improved, others are also made better off, and this benefit of knowing the poor are better off cannot be withheld from someone who does not pay); and 4) civil liberty protection (if your constitutional rights are upheld, so are mine, and it is difficult to withhold this protection from nonpayers). Nonexamples would include: 1) public education (almost all of the benefits go to those who are educated by the process and we could, if we chose, withhold education from nonpayers); and 2) public housing (the benefits go to those housed and housing could be withheld from nonpayers). The differences between the examples and nonexamples are 1) whether the benefits are general or not, that is, whether we can identify consumers and nonconsumers of the good; and 2) whether benefits can be withheld from nonpayers. The non-examples here are all termed "private goods," not "public goods."

Private goods are like most goods, those who don't pay don't get, and those who don't get don't enjoy any appreciable benefits from consumption of the good by others. The more one person consumes of a private good means the less available for others. Notice that the difference between a public good and a private good has nothing to do with who pays for it, nothing to do with who owns it, and nothing to do with anything else except whether the good can be somehow kept from use by those who don't pay.

The market has a difficult time in getting public goods supplied because people receive benefits whether they pay or not. This problem is sometimes referred to as the "free-rider problem" and sometimes as the "prisoners' dilemma." The free-rider problem is that if you can "ride for free" why pay, so no one pays, and then there is nothing to ride. This is the "let Mikey try it" or "let Mikey (the other guy) pay for it" attitude. We can examine this choice situation better with the prisoners' dilemma example (click here for a link to Roger McCain's Strategy and Conflict: An Introductory Sketch of Game Theory and then click on "The Prisoners' Dilemma").

In the usual tale of the prisoners' dilemma, we have the example of two suspects in police custody who the cops are sure robbed a liquor store at gunpoint. Armed robbery is very serious, carrying a 10 year sentence. The cops caught the suspects "red-handed" on a lessor offense, carrying concealed weapons, which carries a two-year sentence. The cops place them in separate rooms and tell each suspect that if he turns state's evidence and confesses to the armed robbery, all charges will be dropped, if the other suspect does not confess. If both confess, they will get sevenyear sentences instead of tenyear sentences. The outcomes for the four possible combinations are shown in TABLE 5.

What is the likely result of this situation? They both confess. The reason is that no matter what the other one does, confessing gets a lighter sentence. If the other partner does not confess, the suspect in question goes free by confessing, instead of getting a twoyear sentence on the weapons charge. If the partner does confess, the suspect in question gets a sevenyear sentence instead of a tenyear sentence by confessing. Each is better off by confessing than by not confessing, yet together they could both be better off by keeping quiet and getting the twoyear sentence.

TABLE5

Jail Sentences in Years

(Crook #1's jail sentence listed first, then Crook #2's)

What does the prisoners' dilemma have to do with public goods? The incentive structure is set up similarly so that the incentives to individuals lead to results that are less desirable than other possible results. The choice is to contribute or not contribute, say $100, to the production of some public good, such as a less polluting sewerage system. The new sewerage costs $10,000 and is worth $300 to you. We can see the incentives in Table 6. Instead of getting a payoff of $200 if you and everyone else contributed to the project, neither you nor anyone else contributes. Public goods do not get funded on a voluntary basis, but generally require the compulsion of taxation with the threat of punishment for nonpayers. We will see later that democratic institutions also suffer from this public goods problem.

Click here to try out a prisoners' dilemma game, "Diamond Thief," a game developed by Mikhail Sabaev and Konstantin Lukin, two students at the State University of New York at Stony Brook (SUNY-Stony Brook) for a class project.

C. The "Commons" Problem

At the root of the externality and public goods problems is a lack of clearly defined property rights. To see this we will take up the classic example, the common-ground,

TABLE 6

Contribute or not to new Sewerage Project

or simply, the "commons," in 18th Century Britain. Each community had a plot of land for all in the community to use. Often, people used it for grazing their animals, most notably, for grazing sheep. Sheep can badly damage grazing land, as they eat grass, roots and all.

To illustrate the problem, imagine 100 shepherds who make up a community with a commons. Each sheep added to the commons damages the commons by reducing the value of the land by $100 dollars per year. The marginal benefits to the individual shepherd are declining as with MPB (marginal private benefits) in :FIGURE

XVI

. All of the benefits from the sheep grazing on the commons accrue to the individual shepherd, hence Marginal Private Benefits. If the only cost of adding a sheep to the commons is the cost of decreased land value, then the Marginal Private Costs (costs to the shepherd) will be only $1.00 ($100 damage to the land divided by 100 individuals in the sharing group comes to $1.00 per person). We saw above that individuals will keep doing some activity as long as the marginal benefit to them was greater than or equal to the marginal cost to them, as this is where net benefits are the highest. For society as a whole, net benefits are the highest where marginal social benefits are equal to marginal social costs, at far fewer sheep than the shepherd wants to put on the commons.

What is occurring is that the pattern of ownership of the land, the commons is common property, allows each shepherd to shift part of the cost his sheep onto others in the community, creating negative externalities. If each shepherd could only put sheep on his own land, or had to pay the owner of what was the commons rent, there would be no externality, as each shepherd would have to pay the full cost of the damage done by their sheep.

FIG XVI