Survey of Economics: Principles, Applications and Tools Eighth Edition https://www.pearson.com/mylab Course ID: chakroun54908 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Survey of Economics: Principles, Applications and Tools Eighth Edition Chapter 1 Introduction: What Is Economics? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Chapter Outline 1.1 What Is Economics? 1.2 The three economic questions: What, How and Who? 1.3 The Economic Way of Thinking 1.4 Microeconomics Verus Macroeconomics Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1.1 What Is Economics? Economics: The study of choices when there is scarcity. Scarcity: The resources we use to produce goods and services are limited. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Some Examples of Scarcity and Tradeoffs • You have a limited amount of time. Each hour on the job means one less hour for study or play. • A city has a limited amount of land. If the city uses an acre of land for a park, it has one less acre for housing, retailers, or industry. • You have limited income this year. If you spend $17 on a music CD, that’s $17 less you have to spend on other products or to save. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Five Factors of Production (1 of 2) Factors of Production: The resources used to produce goods and services; also known as production inputs or resources. Natural Resources: Resources provided by nature and used to produce goods and services. Labor: Human effort, including both physical and mental, used to produce goods and services. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Five Factors of Production (2 of 2) Physical Capital: The stock of equipment, machines, structures, and infrastructure that is used to produce goods and services. Human Capital: The knowledge and skills acquired by a worker through education and experience and used to produce goods and services. Entrepreneurship: The effort used to coordinate the factors of production—natural resources, labor, physical capital, and human capital—to produce and sell products. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1.2 The Three Key Economic Questions: What, How, and Who? The choices made by individuals, firms, and governments answer three questions: 1. What products do we produce? 2. How do we produce the products? 3. Who consumes the products? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Economic Models Economists use economic models to explore the choices people make and the consequences of those choices. Economic model: A simplified representation of an economic environment, often employing a graph. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Positive versus Normative Analysis Most modern economics is based on positive analysis: Positive Analysis: Answers the question “What is?” or “What will be?” A second type of economic reasoning is normative in nature: Normative Analysis: Answers the question “What ought to be?” Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 1.1 Comparing Positive and Normative Questions Positive Questions Normative Questions • If the government increases the minimum wage, how many workers will lose their jobs? • Should the government increase the minimum wage? • If two office-supply firms merge, will the price of office supplies increase? • Should the government block the merger of two office-supply firms? • How does a college education affect • Should the government a person’s productivity and earnings? subsidize a college education? • How do consumers respond to a cut in income taxes? • Should the government cut taxes to stimulate the economy? • If a nation restricts shoe imports, who • Should the government restrict benefits and who bears the cost? imports? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1.3 The Economic Way of Thinking List the four elements of the economic way of thinking. “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor draw correct conclusions.” John Maynard Keynes, The Collected Writings of John Maynard Keynes, Volume 7 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Use Assumptions to Simplify Economists use assumptions to make things simpler and focus attention on what really matters. We have to be careful to make the right assumptions and simplifications. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Isolate Variables—Ceteris Paribus Economists often consider how one variable changes in isolation, in order to see how its changes affect other variables. Variable: A measure of something that can take on different values. Ceteris Paribus: The Latin expression meaning that other variables are held fixed. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Think at the Margin How will a small change in one variable affect another variable, and what impact will that have on people’s decision-making? Marginal Change: A small, one-unit change in value Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Rational People Respond to Incentives A key assumption of most economic analysis is that people act rationally, that is, in their own self-interest. This does not mean that people are only motivated by selfinterest, but instead that this is their primary motivation. Rationality implies that when the payoff (benefit) to doing something changes, people will change their behavior to make their payoff as large as possible. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1.4 Microeconomics Vs Macroeconomics The field of economics is divided into two categories: macroeconomics and microeconomics. Macroeconomics: The study of the nation’s economy as a whole; focuses on the issues of inflation, unemployment, and economic growth. Microeconomics: The study of the choices made by households, firms, and governments, and how these choices affect the markets for goods and services. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Macroeconomics to Understand Why Economies Grow The world economy has been growing in recent decades, averaging about 1.5 percent higher per capita income per year. Why do some countries grow much faster than others? Macroeconomics will help us understand why. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Macroeconomics to Understand Economic Fluctuations All countries, even those where per capita income is generally rising, experience economic fluctuations, including periods where the economy temporarily shrinks. What options do governments have to moderate these fluctuations? And should they do so? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Macroeconomics to Make Informed Business Decisions A manager who studies macroeconomics will be better equipped to understand the complexities of interest rates and inflation, and how they affect the firm. Should a firm borrow money now at a fixed interest rate? Or wait a while, hoping interest rates will fall? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Microeconomics to Understand Markets and Predict Changes One reason for studying microeconomics is to better understand how markets work and to predict how various events affect the prices and quantities of products in markets. For example, how would a tax on beer affect: 1. The price of beer? 2. How many people buy beer? 3. How many people are likely to drink and drive? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Microeconomics to Make Personal and Managerial Decisions On the personal level, we use economic analysis to decide how to spend our time, what career to pursue, and how to spend and save the money we earn. Managers use economic analysis to decide how to produce goods and services, how much to produce, and how much to charge for them. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Microeconomics to Evaluate Public Policies We can use economic analysis to determine how well the government performs its roles in the market economy. For example, prescription drugs are protected from being copied because of government patents. If we shortened patent lengths, we may get cheaper generic drugs sooner; but fewer drugs may get developed because of the decreased profitability of drug development. Microeconomics can help evaluate the best policy here. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Key Terms Ceteris paribus Marginal change Economic model Microeconomics Economics Natural resources Entrepreneurship Normative analysis Factors of production Physical capital Human capital Positive analysis Labor Scarcity Macroeconomics Variable Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1A.1 Using Graphs Economists use several types of graphs to present data, represent relationships between variables, and explain concepts. Although it is possible to do economics without graphs, it’s a lot easier with them in your toolbox. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.1 Graphs of Single Variables Left: Pie Graph for Types of Recorded Music Sold in the United States Right: Bar Graph for U.S. Export Sales of Copyrighted Products Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.2 Time Series Graph A time series graph shows how the value of a variable changes over time. In the right panel, the vertical axis is truncated, indicated by the double hash marks on the y-axis. This exaggerates the fluctuations in the data. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.3 Basic Elements of a TwoVariable Graph One variable is measured along the horizontal, or x, axis, while the other variable is measured along the vertical, or y, axis. The origin is defined as the intersection of the two axes, where the values of both variables are zero. The dashed lines show the values of the two variables at a particular point. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Graphing Two Variables The slope of a line relating two variables on a graph indicates whether they have a positive or negative relationship. Positive relationship: A relationship in which two variables move in the same direction. Negative relationship: A relationship in which two variables move in opposite directions. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.4 Relationship between Hours Worked and Income There is a positive relationship between work hours and income, so the income curve is positively sloped. The slope of the curve is $8: Each additional hour of work increases income by $8. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Computing the Slope Slope  Income Work hours Vertical difference between two points rise Slope   Horizontal difference between two points run Slope of a curve: The vertical difference between two points (the rise) divided by the horizontal difference (the run). In general, if the variable on the vertical axis is y and the variable on the horizontal axis is x, we can express the slope as: Slope  y x Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.5 Movement Along a Curve versus Shifting the Curve To draw a curve showing the relationship between hours worked and income, we fix the weekly allowance ($40) and the wage ($8 per hour). A change in the hours worked causes movement along the curve, for example, from point b to point c. A change in any other variable shifts the entire curve. For example, a $50 increase in the allowance (to $90) shifts the entire curve upward by $50. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.6 Negative Relationship between CD Purchases and Downloaded Songs There is a negative relationship between the number of CDs and downloaded songs that a consumer can afford with a budget of $360. The slope of the curve is −$12: Each additional CD (at a price of $12 each) decreases the number of downloadable songs (at $1 each) by 12 songs. Slope  Vertical difference Horizontal difference 120  240  120     12 20  10 10 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.7 Nonlinear Relationships (1 of 2) There is a positive and nonlinear relationship between study time and the grade on an exam. As study time increases, the exam grade increases at a decreasing rate. For example, the second hour of study increased the grade by 4 points (from 6 points to 10 points), but the ninth hour of study increases the grade by only 1 point (from 24 points to 25 points). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 1A.7 Nonlinear Relationships (2 of 2) There is a positive and nonlinear relationship between the quantity of grain produced and total production cost. As the quantity increases, the total cost increases at an increasing rate. For example, to increase production from 1 ton to 2 tons, production cost increases by $5 (from $10 to $15) but to increase the production from 10 to 11 tons, total cost increases by $25 (from $100 to $125). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 1A.2 Computing Percentage Changes and Using Equations To compute a percentage change, we divide the change in the variable by the initial value of the variable, and then multiply by 100: New value  initial value Percentage change   100 Initial value Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 3: The Perils of Percentages (1 of 2) In the 1970s, the government of Mexico City repainted the highway lane lines on the Viaducto to transform a four-lane highway into a six-lane highway. • The government announced that the highway capacity had increased by 50% (equal to 2 divided by 4). • Unfortunately, the number of collisions and traffic fatalities increased, and one year later the government restored the four-lane highway and announced that the capacity had decreased by 33% (equal to 2 divided by 6). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 3: The Perils of Percentages (2 of 2) This anecdote reveals a potential problem with using the simple approach to compute percentage changes. Because the initial value (the denominator) changes, the computation of percentage increases and decreases are not symmetric. There is a solution to this problem: using the midpoint method for percentage changes: Percentage change  New value  initial value  100 Average value Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Equations to Compute Missing Values (1 of 2) It will often be useful to compute the value of the numerator or the denominator of an equation. For example, if we know the change in work hours, and the slope of the line relating change in income and change in work hours: Income Slope  Work hours Work hours  Slope  Income Income  Work hours  Slope Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Equations to Compute Missing Values (2 of 2) Income  Work hours  Slope Then, if you work seven extra hours, and the slope of this line is $8 per hour, then your change in income is: Income  7 hours  $8per hour Income  $56 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Key Terms (Appendix) Negative relationship Positive relationship Slope of a curve Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Survey of Economics: Principles, Applications and Tools Eighth Edition Chapter 2 The Key Principles of Economics Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Chapter Outline 2.1 The Principle of Opportunity Cost 2.2 The Marginal Principle 2.3 The Principle of Voluntary Exchange 2.4 The Principle of Diminishing Returns 2.5 The Real-Nominal Principle Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 2.1 The Principle of Opportunity Cost Apply the principle of opportunity cost. Economics is all about making choices; to make good choices, we must compare the benefit of something to its cost. Opportunity Cost: What you sacrifice to get something. “There is no such thing as a free lunch” Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 1: The cost of doing business Jack left a job paying $60,000 per year to start his own florist shop in a building he owns. The market value of the building is $80,000. He pays $30,000 per year for flowers and other​ supplies, and has a bank account that pays 5 percent interest. What is the economic cost of​ Jack's business? Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Cost of Military Spending The war in Iraq cost the United States an estimated $1 trillion. Each $100 billion could: • Enroll 13 million preschool children in the Head Start program for one year. • Hire 1.8 million additional teachers for one year. • Immunize all the children in less-developed countries for the next 33 years. The true cost of the war was its opportunity cost: what the United States sacrificed for it. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 2.1 Scarcity and the Production Possibilities Curve (1 of 3) Production possibilities curve: A curve that shows the possible combinations of products that an economy can produce, given that its productive resources are fully employed and efficiently used. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 2.1 Scarcity and the Production Possibilities Curve (2 of 3) The production possibilities curve illustrates the principle of opportunity cost for an entire economy. An economy has a fixed amount of resources. If these resources are fully employed, an increase in the production of wheat comes at the expense of steel. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 2.1 Scarcity and the Production Possibilities Curve (3 of 3) Each additional 10 tons of wheat requires sacrificing progressively more steel— 50 tons from a to b, 180 tons from c to d. Some resources are better suited for steel production, and some are better suited to wheat production. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 2.2 Shifting the Production Possibilities Curve An increase in the quantity of resources or technological innovation in an economy shifts the production possibilities curve outward. Starting from point f, a nation could produce more steel (point g), more wheat (point h), or more of both goods (points between g and h). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 2.2 The Marginal Principle Apply the marginal principle. We rarely make all-or-nothing choices. Economists tend to think in marginal terms: the effect of a small or incremental change. Marginal benefit: The additional benefit resulting from a small increase in some activity. Marginal cost: The additional cost resulting from a small increase in some activity. The marginal principle: Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 2: Hiring people 1) The table below shows the marginal benefit that Khaled earns from keeping his store open one more hour. Khaled has a marginal cost of $40 per hour. Khaled stays open 20 hours. a) Do you think Khaled’s decision to stay open 20 hours is optimal? Why? (1 mark) b) How many hours do you advise Khaled to stay open? Why? (2 marks) 2.3 The Principle of Voluntary Exchange Apply the principle of voluntary exchange. Why would two people trade with one another? Because each believes that what they receive is worth more to them than what they give. The principle of voluntary exchange: A voluntary exchange between two people makes both better off. Example: When you work, you trade your time for money. The money is more valuable than the time to you, and your time is more valuable than the money to your employer. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 2.4 The Principle of Diminishing Returns Apply the principle of diminishing returns. You run a small copy shop with one copying machine and one worker, who can copy 500 pages per hour. You add another worker, but output increases to only 800 pages per hour, not doubling to 1,000. Why? They now share the copier, so each is less productive. The principle of diminishing returns: Suppose output is produced with two or more inputs, and we increase one input while holding the other input or inputs fixed. Beyond some point—called the point of diminishing returns—output will increase at a decreasing rate. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Why Do Diminishing Returns Occur? Diminishing returns occurs because one of the inputs to the production process is fixed. When a firm can vary all its inputs, including the size of the production facility, the principle of diminishing returns is not relevant. If you doubled both the number of workers and equipment, output ought to double also—or maybe more than double, if specialization is beneficial. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 4: Fertilizer and Crop Yields Adding fertilizer to a field increases its production; but this is subject to diminishing returns. Why? The other inputs to the production process are fixed, such as the field itself, the rain, the sunlight, etc. Each additional bag of fertilizer is progressively less productive. Some representative numbers are on the next slide. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 2.1 Fertilizer and Corn Yield Bags of Nitrogen Fertilizer Bushels of Corn per Acre 0 85 1 120 2 135 3 144 4 147 The first bag of fertilizer increases production by 35 bushels, but subsequent bags of fertilizer increase production by less and less. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 2.5 The Real-Nominal Principle Apply the real-nominal principle. Most modern money is not inherently valuable, but is valuable because of what it will buy. The real-nominal principle: What matters to people is the real value of money or income—its purchasing power—not its face value. Nominal value: The face value of an amount of money. Real value: The value of an amount of money in terms of what it can buy. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 2.2 The Real Value of the Minimum Wage, 1974–2015 Blank 1974 2015 Minimum wage per hour $2.00 $7.25 Weekly income from minimum wage 80 290 Cost of a standard basket of goods 47 236 1.70 1.23 Number of baskets per week Between 1974 and 2015, the federal minimum wage increased from $2.00 to $7.25. Was the typical minimum-wage worker better or worse off in 2015? We can apply the real-nominal principle to see that the value of the minimum wage has actually decreased over this time period. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 5: Repaying Student Loans Suppose you finish college with $40,000 in student loans and start a job that pays a salary of $50,000 in the first year. In 10 years, you must repay your college loans. Which would you prefer, stable prices, rising prices, or falling prices? Hint: The nominal value of the loans will not change, even as prices change. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Key Terms Marginal benefit Marginal cost Opportunity cost Production possibilities curve Nominal value Real value Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Survey of Economics: Principles, Applications and Tools Eighth Edition Chapter 3 Demand, Supply, and Market Equilibrium Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Chapter Outline 3.1 The Demand Curve 3.2 The Supply Curve 3.3 Market Equilibrium: Bringing Demand and Supply Together 3.4 Market Effects of Changes in Demand 3.5 Market Effects of Changes in Supply 3.6 Predicting and Explaining Market Changes Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.1 The Demand Curve Describe and explain the law of demand. In this chapter, we will develop the model of demand and supply—the most important tool of economic analysis. We will assume markets are perfectly competitive, implying that individual sellers are so small they cannot affect the market price. Perfectly competitive market: A market with many buyers and sellers of a homogeneous product and no barriers to entry. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Consumers and Demand How much of a particular product are consumers willing to buy during a particular period? We call this the quantity demanded. Quantity demanded: The amount of a product that consumers are willing and able to buy. What alters the amount consumers are willing to buy? We divide this into two categories: • The price of the product • Everything else! Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.1 The Individual Demand Curve (1 of 4) The table shows how many pizzas a consumer will buy at a selection of prices. This is a demand schedule. Demand schedule: A table that shows the relationship between the price of a product and the quantity demanded, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.1 The Individual Demand Curve (2 of 4) We plot each of the pricequantity pairs on the graph; joining those points gives the individual demand curve for pizza. Individual demand curve: A curve that shows the relationship between the price of a good and quantity demanded by an individual consumer, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.1 The Individual Demand Curve (3 of 4) The demand curve slopes downward; this is so typical, we call it the law of demand. Law of demand: There is a negative relationship between price and quantity demanded, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.1 The Individual Demand Curve (4 of 4) As price rises from $8 to $10, the consumer buys 3 fewer pizzas. This is a change in quantity demanded. Change in quantity demanded: A change in the quantity consumers are willing and able to buy when the price changes; represented graphically by movement along the demand curve. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.2 From Individual to Market Demand Adding quantity demanded by each consumer at each price gives us the market demand curve. Market demand curve: A curve showing the relationship between price and quantity demanded by all consumers, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 1: Young Smokers and the Law of Demand As price decreases, the quantity of cigarettes demanded increases for two reasons: • People who already smoke, choose to smoke more; and • Some (mostly young) people start smoking. Keeping cigarette prices high, or increasing them with taxes, is one way that governments try to discourage young people from starting smoking. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3.2 The Supply Curve Describe and explain the law of supply. How much of a particular product are firms willing to produce and sell during a particular period? We call this the quantity supplied. Quantity supplied: The amount of a product that firms are willing and able to sell. What alters the amount firms are willing to sell? We divide this into two categories: • The price of the product • Everything else! Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.3 The Individual Supply Curve (1 of 4) The table shows how many pizzas a firm will sell at a selection of prices. This is a supply schedule. Supply schedule: A table that shows the relationship between the price of a product and the quantity supplied, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.3 The Individual Supply Curve (2 of 4) We plot each of the pricequantity pairs on the graph; joining those points gives the individual supply curve for pizza. Individual demand curve: A curve that shows the relationship between the price of a good and quantity supplied by an individual firm, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.3 The Individual Supply Curve (3 of 4) The supply curve slopes upward; this is so typical, we call it the law of supply. Law of supply: There is a positive relationship between price and quantity supplied, ceteris paribus. There are some prices below which the firm would not provide any pizzas; for this firm, the minimum supply price appears to be $2. Minimum supply price: The lowest price at which a product will be supplied. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.3 The Individual Supply Curve (4 of 4) As price rises from $8 to $10, the firm is willing to provide 100 more pizzas. This is a change in quantity supplied. Change in quantity supplied: A change in the quantity firms are willing and able to sell when the price changes; represented graphically by movement along the supply curve. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Why Is the Individual Supply Curve Positively Sloped? A higher price encourages the firm to increase its output by purchasing more materials and hiring more workers. Even if the new materials are more expensive, or the new workers are more costly or less productive, the firm is willing to incur those higher marginal costs to sell at higher prices. • This is consistent with the marginal principle: increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. The price is the marginal benefit; the supply curve shows the firm’s marginal cost of production. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.4 From Individual to Market Supply Adding quantity supplied by each firm at each price gives us the market supply curve. Market supply curve: A curve showing the relationship between price and quantity supplied by all firms, ceteris paribus. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.5 The Market Supply Curve with Many Firms A perfectly competitive market has hundreds of firms rather than just two. In the case of many firms, the market supply curve will be smooth rather than kinked. In this graph, we assume there are 100 firms identical to Lola’s. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Why Is the Market Supply Curve Positively Sloped? There are two reasons why the market supply curve is positively sloped. As the market price increases, 1. Individual firms increase output by purchasing more materials and hiring more workers; and 2. New firms enter the market, encouraged by the higher price. As with the individual supply curve, the market supply curve shows the marginal cost of production, this time for the market as a whole. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 2: Sheep, Wool, and the Law of Supply In the 1990s, the world price of wool decreased by about 30%. The law of supply suggests wool output would decrease. It did; wool-exporting countries like New Zealand converted land to more profitable uses, like dairy farming, forestry, and wine production. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3.3 Market Equilibrium: Bringing Demand and Supply Together Explain the role of price in reaching a market equilibrium. A market is an arrangement that brings buyers and sellers together. These buyers and sellers jointly determine prices and quantities traded. Market equilibrium: A situation in which the quantity demanded equals the quantity supplied at the prevailing market price. When a market is in equilibrium, there is no pressure on the price to change. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.6 Market Equilibrium (1 of 3) At the market equilibrium (point a, with price = $8 and quantity = 30,000), the quantity supplied equals the quantity demanded. Everyone willing to pay $8 receives a pizza for that price; and every pizza firms are willing to produce at $8 gets sold. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.6 Market Equilibrium (2 of 3) At a price below the equilibrium price ($6), there is excess demand—the quantity demanded at point c exceeds the quantity supplied at point b. Excess demand: A situation in which, at the prevailing price, the quantity demanded exceeds the quantity supplied. This mismatch causes the price of pizza to rise; firms will realize they can raise the price and still sell all the pizzas they planned to sell. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.6 Market Equilibrium (3 of 3) At a price above the equilibrium price ($12), there is excess supply—the quantity supplied at point e exceeds the quantity demanded at point d. Excess supply: A situation in which the quantity supplied exceeds the quantity demanded at the prevailing price. This mismatch causes the price of pizza to fall; firms will realize they cannot sell all of their pizzas at the prevailing price, and will start undercutting one another. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 3: Shrinking Wine Lakes The European Union guarantees minimum prices for agricultural products like grapes. These above-equilibrium prices encourage overproduction, which the EU guarantees to buy. Recent reforms have reduced (and in some cases eliminated) these price guarantees, resulting in shrinking excess “wine lakes” and “butter mountains.” Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3.4 Market Effects of Changes in Demand Describe the effect of a change in demand on the equilibrium price. Market equilibrium occurs when the quantity supplied equals the quantity demanded. Changes in the demand side of the market can affect the equilibrium price and the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.7 Change in Quantity Demanded Versus Change in Demand (1 of 2) Panel (A) shows a change in price causing a change in quantity demanded, a movement along a single demand curve. A decrease in price causes a move from point a to point b, increasing the quantity demanded. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.7 Change in Quantity Demanded Versus Change in Demand (2 of 2) Panel (B) shows a change in demand caused by changes in a variable other than the price. This shifts the entire demand curve. An increase in demand shifts the demand curve from D1 to D2. Change in demand: A shift of the demand curve caused by a change in a variable other than the price of the product. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Increases in Demand Shift the Demand Curve (1 of 3) What could cause the demand curve to increase (shift to the right)? Anything other than a price decrease that makes consumers want to buy more of the good. Some examples: • An income change: Consumers buy more vacations and new cars when their income increases. We call these normal goods. But consumers buy less of some goods (like second-hand clothing, or ramen noodle packets) when their income increases: these are inferior goods. Normal good: A good for which an increase in income increases demand. Inferior good: A good for which an increase in income decreases demand. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Increases in Demand Shift the Demand Curve (2 of 3) More examples: • Increase in the price of a substitute good: Tacos and pizza are substitutes: when the price of tacos rise, some consumers switch to buying pizzas instead. • Decrease in the price of a complementary good: Pay-per-view sports events and pizza are complements: when the price of a pay-per-view event falls, more consumers watch it, and buy more pizza to consume with it. Substitutes: Two goods for which an increase in the price of one good increases the demand for the other good. Complements: Two goods for which a decrease in the price of one good increases the demand for the other good. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Increases in Demand Shift the Demand Curve (3 of 3) Even more examples: • Increase in population: More people means more potential pizza consumers. • Shift in consumer preferences: Consumers might decide the like for pizza more than they used to. A successful pizza advertising campaign might increase the demand for pizza. • Expectations of higher future prices: If consumers learn pizza prices will rise next week, they might buy more pizzas this week, and fewer next week. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 3.1 Increases in Demand Shift the Demand Curve to the Right Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.8 An Increase in Demand Increases the Equilibrium Price (1 of 2) An increase in demand shifts the demand curve to the right: At each price, the quantity demanded increases. At the initial price ($8), there is excess demand, with the quantity demanded (point b) exceeding the quantity supplied (point a). The excess demand causes the price to rise, and equilibrium is restored at point c. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.8 An Increase in Demand Increases the Equilibrium Price (2 of 2) The result of the increase in demand: the equilibrium price rises to $10, and the equilibrium quantity of pizzas rises to 40,000 pizzas per month. Generally, we predict an increase in demand will increase the equilibrium price and increase the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 3.2 Decreases in Demand Shift the Demand Curve to the Left Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.9 A Decrease in Demand Decreases the Equilibrium Price (1 of 2) A decrease in demand shifts the demand curve to the left: At each price, the quantity demanded decreases. At the initial price ($8), there is excess supply, with the quantity supplied (point a) exceeding the quantity demanded (point b). The excess supply causes the price to drop, and equilibrium is restored at point c. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.9 A Decrease in Demand Decreases the Equilibrium Price (2 of 2) The result of the decrease in demand: the equilibrium price falls to $6, and the equilibrium quantity of pizzas falls to 20,000 pizzas per month. Generally, we predict an decrease in demand will decrease the equilibrium price and decrease the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 4: Craft Beer and the Price of Hops Between 2012 and 2017, U.S. craft beer production increased more than 30%. Craft beer brewers increased their demand for ingredients, including hops. As a result of the demand increase, the equilibrium price of hops rose substantially: from $3.17 to $5.92 per pound. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3.5 Market Effects of Changes in Supply Describe the effect of a change in supply on the equilibrium price. Market equilibrium occurs when the quantity supplied equals the quantity demanded. Changes in the supply side of the market can affect the equilibrium price and the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.10 Change in Quantity Supplied versus Change in Supply (1 of 2) Panel (A) shows a change in price causing a change in quantity supplied, a movement along a single supply curve. An increase in price causes a move from point a to point b, increasing the quantity supplied. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.10 Change in Quantity Supplied versus Change in Supply (2 of 2) Panel (B) shows a change in supply caused by changes in a variable other than price. This shifts the entire supply curve. An increase in supply shifts the entire supply curve from S1 to S2. Change in supply: A shift of the supply curve caused by a change in a variable other than the price of the product. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Increases in Supply Shift the Supply Curve What could cause the supply curve to increase (shift to the right)? Anything other than a price increase that makes firms want to provide more of the good. Some examples: • A decrease in input costs: If wages or the cost of materials go down, production becomes more profitable, so firms expand. • Technological advance: New technologies can make production more profitable and hence encourage expansion. • Government subsidy: A payment from the government will also make production more profitable also. • Expected future prices falling: A firm that learns prices will fall next month will try to sell more at current higher prices. • Number of producers: More firms mean more production. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 3.3 Changes in Supply Shift the Supply Curve Downward and to the Right Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.11 An Increase in Supply Decreases the Equilibrium Price (1 of 2) An increase in supply shifts the supply curve to the right: At each price, the quantity supplied increases. At the initial price ($8), there is excess supply, with the quantity supplied (point b) exceeding the quantity demanded (point a). The excess supply causes the price to drop, and equilibrium is restored at point c. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.11 An Increase in Supply Decreases the Equilibrium Price (2 of 2) The result of the increase in supply: the equilibrium price falls to $6, and the equilibrium quantity of pizzas rises to 36,000 pizzas per month. Generally, we predict an increase in supply will decrease the equilibrium price and increase the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 3.4 Changes in Supply Shift the Supply Curve Upward and to the Left Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.12 A Decrease in Supply Increases the Equilibrium Price (1 of 2) A decrease in supply shifts the supply curve to the left. At each price, the quantity supplied decreases. At the initial price ($8), there is excess demand, with the quantity demanded (point a) exceeding the quantity supplied (point b). The excess demand causes the price to rise, and equilibrium is restored at point c. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.12 A Decrease in Supply Increases the Equilibrium Price (2 of 2) The result of the decrease in supply: the equilibrium price rises to $10, and the equilibrium quantity of pizzas rises to 24,000 pizzas per month. Generally, we predict a decrease in supply will increase the equilibrium price and decrease the equilibrium quantity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Simultaneous Changes in Demand and Supply What happens to the equilibrium price and quantity when both demand and supply increase? It depends on which change is larger. • If the effect on demand is larger, then the overall change will “look like” the change in demand. • If the effect on supply is larger, then the overall change will “look like” the change in supply. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 3.13 Market Effects of Simultaneous Changes in Demand and Supply Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 5: The Harmattan and the Price of Chocolate The harmattan is a dry, dusty wind from the Sahara desert. Each year it sweeps through cocoa plantations in Ghana and Ivory Coast, drying coca pods and decreasing yields. In 2015, the harmattan was longer than usual (14 days rather than the usual 5 days) so crop yields were lower than usual; the decrease in supply caused world cocoa prices to rise in 2015. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 3.6 Predicting and Explaining Market Changes Use information on price and quantity to determine what caused a change in price. Using our demand and supply model, we have shown how equilibrium prices are determined, and how changes in demand and supply affect equilibrium prices and quantities. When demand changes, both equilibrium price and quantity change in the same direction as demand changes: increasing or decreasing. When supply changes, the equilibrium quantity changes in the same direction as the supply change, but equilibrium price changes in the opposite direction. The table on the next slide summarizes this. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 3.5 Market Effects of Changes in Demand or Supply Change in Demand or Supply How does the equilibrium price change? How does the equilibrium quantity change? Increase in demand Increase Increase Decrease in demand Decrease Decrease Increase in supply Decrease Increase Decrease in supply Increase Decrease We can use this knowledge to predict how prices and quantities will change in response to a demand or supply change. We can also use this knowledge “in reverse”: if we know the price and quantity of a product both rose or fell, we should expect a change in demand caused the changes. Conversely, if the price and quantity of a product moved in opposite directions, we should infer a change in supply occurred. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 6: Why Did Drug Prices Fall? (1 of 2) “Do you know what’s happened to the price of drugs in the United States? The price of cocaine, way down, the price of marijuana, way down. You don’t have to be an expert in economics to know that when the price goes down, it means more stuff is coming in. That’s supply and demand.” Ted Koppel, host of the ABC news program Nightline Was Koppel right? That is, do falling drug prices prove the U.S. government’s “war on drugs” was failing, and the supply of illegal drugs was increasing Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 6: Why Did Drug Prices Fall? (2 of 2) There are two possible explanations: • Koppel’s hypothesis: supply rose, resulting in lower prices and higher quantities. • The alternative: demand fell, resulting in lower prices and lower quantities. According to the U.S. Department of Justice, during this time of falling prices, drug consumption actually decreased. • This suggests the alternative explanation is more likely to be correct. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Key Terms Change in demand Law of supply Change in quantity demanded Market demand curve Change in quantity supplied Market equilibrium Change in supply Market supply curve Complements Minimum supply price Demand schedule Normal good Excess demand Perfectly competitive market Excess supply Quantity demanded Individual demand curve Quantity supplied Individual supply curve Substitutes Inferior good Supply schedule Law of demand Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Survey of Economics: Principles, Applications and Tools Eighth Edition Chapter 4 Elasticity: A Measure of Responsiveness Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Chapter Outline 4.1 The Price Elasticity of Demand 4.2 Using Price Elasticity 4.3 Elasticity and Total Revenue for a Linear Demand Curve 4.4 Other Elasticities of Demand 4.5 The Price Elasticity of Supply 4.6 Using Elasticities to Predict Changes in Prices Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.1 The Price Elasticity of Demand List the determinants of the price elasticity of demand. Price elasticity of demand (Ed): A measure of the responsiveness of the quantity demanded to changes in price; equal to the absolute value of the percentage change in quantity demanded divided by the percentage change in price. percentage change in quantity demanded Ed  percentage change in price Suppose that when the price of milk increases by 10%, the quantity demanded of decreases by 15%: Ed  percentage change in quantity demanded 15%   1.5 percentage change in price 10% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Computing Percentage Changes and Elasticities Computing elasticities requires computing percentage changes. We can compute percentage changes via the initial-value method or the midpoint method. • The initial-value method is easier. • The midpoint method is more accurate. In this text, we use the initial-value approach in order to concentrate on the economic intuition rather than the math. A comparison of calculations using the two methods is on the next slide. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.1 Computing Price Elasticity with Initial Values and Midpoints Blank Blank Price Quantity Data Initial $20 100 Blank New 22 80 Blank Blank Price Quantity Computation with Initial-value method Percentage change $2 divided by $20, times 100 = 10% negative 20 divided by 100, times 100 = negative 20% Blank Price elasticity of demand Blank Blank Computation with midpoint method Percentage change Blank Price elasticity of demand $2 10%   100 $20 20%   20  100 100 the absolute value of, negative 20% divided by 10%, = 2.0 20% 2.0  10% Blank Price Quantity $2 divided by $21, times 100 = 9.52% negative 20 divided by 90, times 100 = negative 22.22% 9.52%  $2  100 $21 22.22% 9.52% the absolute value of negative 222.22% divided by 9.52% = 2.33 2.33  22.22%  20  100 90 Blank Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Price Elasticity and the Demand Curve Price elasticity of demand and the slope of the demand curve are related. percentage change in quantity demanded Ed  percentage change in price rise change in price Slope   run change in quantity Roughly, a greater price elasticity of demand means a shallower slope, and a smaller price elasticity of demand means a steeper-sloped demand curve. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.1 Elasticity and Demand Curves (Panel A) Elastic demand: The price elasticity of demand is greater than one, so the percentage change in quantity exceeds the percentage change in price. Example goods: restaurant meals, air travel, movies. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.1 Elasticity and Demand Curves (Panel B) Inelastic demand: The price elasticity of demand is less than one, so the percentage change in quantity is less than the percentage change in price. Example goods: milk, salt, eggs, coffee, cigarettes. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.1 Elasticity and Demand Curves (Panel C) Unit elastic demand: The price elasticity of demand is one, so the percentage change in quantity equals the percentage change in price. Example goods: housing, juice. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.1 Elasticity and Demand Curves (Panel D) Perfectly inelastic demand: The price elasticity of demand is zero. In this extreme case, the quantity demanded does not change when the price changes. This could only happen if there were no possible substitutes for the good, say insulin for diabetics. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.1 Elasticity and Demand Curves (Panel E) Perfectly elastic demand: The price elasticity of demand is infinite. In this extreme case, buyers will buy as much as sellers can offer at the given price. When a seller provides a tiny fraction of output for the market, this may be a good assumption. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Elasticity and the Availability of Substitutes The key factor in determining the price elasticity of demand for a particular product is the availability of substitute products. • For diabetics, there is no substitute for insulin, so the demand for insulin is inelastic. • For cereal-eaters, there are many substitutes for cornflakes, so the demand for cornflakes is elastic. Adjustment to price changes is easier over time. So the price elasticity of demand tends to be greater in the long run than in the short run. • If gasoline prices rise, you can do little about it in the short run. • In the long run, you can move, change cars, etc. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.2 Price Elasticities of Demand for Selected Products (1 of 2) Blank Inelastic Product Salt Food (wealthy countries) Weekend canoe trips Water Coffee Physician visits Sport fishing Gasoline (short run) Eggs Cigarettes Food (poor countries) Shoes and footwear Gasoline (long run) Price Elasticity of Demand 0.1 0.15 0.19 0.2 0.3 0.25 0.28 0.25 0.3 0.3 0.34 0.7 0.6 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.2 Price Elasticities of Demand for Selected Products (2 of 2) Blank Unit elastic Elastic Product Housing Fruit Juice Automobiles Foreign travel Motorboats Restaurant meals Air travel Movies Specific brands of coffee Price Elasticity of Demand 1.0 1.0 1.2 1.8 2.2 2.3 2.4 3.7 5.6 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Other Determinants of the Price Elasticity of Demand 1. Elasticity is higher for goods that take a relatively large part of a consumer’s budget. – A 10% increase in the price of gum is unlikely to change the quantity of gum demanded by much. – But a 10% increase in the price of cars would have a large effect. 2. Goods that are necessities have lower elasticities of demand; goods that are luxuries have higher elasticities of demand. – Food demand is inelastic in both rich and poor countries. – Demand for air travel is elastic (though for some it may be inelastic, say for travel to a funeral). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.3 Determinants of Elasticity Factor Demand is relatively Demand is relatively elastic if … inelastic if … Availability of substitutes There are many substitutes. There are few substitutes. Passage of time a long time passes. a short time passes. Fraction of consumer budget is large. is small. Necessity the product is a luxury. the product is a necessity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 1: The Elasticity of Demand for Public Transit When the price of a city bus or subway ride increases, what is the price elasticity of demand for public transit? • In the short run (one to two years) it is 0.40: relatively inelastic. • In the long run it is 0.80: close to unit elastic. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.2 Using Price Elasticity Use price elasticity of demand to predict changes in quantity and total revenue. If we have values for two of the three variables in the elasticity formula, we can compute the value of the third. The three variables are: • the price elasticity of demand itself, • percentage change in quantity, and • the percentage change in price. Specifically, we can rearrange the elasticity formula: Ed  percentage change in quantity demanded percentage change in price percentage change in quantity demanded  percentage change in price  Ed Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Predicting Changes in Quantity Suppose you are running a campus film series, and you know the price elasticity of demand for tickets is 2.0. If you raise prices by 15%, how many fewer tickets will you sell? percentage change in quantity demanded  percentage change in price  Ed  15%  2.0  30% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Price Elasticity and Total Revenue Firms use the concept of price elasticity to predict the effects of changing their prices. Total revenue: The money a firm generates from selling its product. Suppose a firm increases the price of its product. Two things happen: • Good news: it gets more money for each product sold. • Bad news: it sells fewer products. The extent of the “bad news” depends on the price elasticity of demand for the firm’s product. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.4 Price and Total Revenue with Different Elasticities of Demand Blank Elastic Demand: Ed = 2.0 Blank Price Quantity Sold Total Revenue $10 100 $1,000 11 80 880 Blank Inelastic Demand: Ed = 0.50 Blank Price Quantity Sold Total Revenue 100 10 $1,000 120 9 1,080 When elasticity is high, the “bad news” is large, and total revenue falls. When elasticity is low, the “bad news” is small, and total revenue rises. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.5 Price Elasticity and Total Revenue Blank Blank Elastic Demand: Ed > 1.0 If price … Total revenue … Because the percentage change in quantity is …   Larger than the percentage change in price.   Larger than the percentage change in price. Blank Blank If price … Total revenue …   Smaller than the percentage change in price.   Smaller than the percentage change in price. Inelastic Demand: Ed < 1.0 Because the percentage change in quantity is … Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Elasticity to Predict the Revenue Effects of Price Changes (1 of 2) 1. Market v s Brand Elasticity: The demand for a specific brand of a product is more elastic than the demand for the product. Raising the price of all coffees would increase coffee revenue; but raising the price of one brand would decrease revenue for that brand. ersu 2. Bus Fares and Deficits: Public bus systems almost always run a deficit. But demand is typically inelastic. If fares were raised, the “good news” (more revenue per rider) would dominate the “bad news” (fewer riders), so total fare revenue would increase, potentially eliminating the deficit. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Using Elasticity to Predict the Revenue Effects of Price Changes (2 of 2) 3. A Bumper Crop is Bad News for Farmers: An unusually large crop of soy beans increases the number of bushels of soy beans for sale (good news). But the price decreases, because of the increased supply (bad news). But demand is inelastic, so the bad news dominates the good news: a bumper crop results in lower overall revenues. 4. Antidrug Policies and Property Crime: Antidrug policies raise the price of drugs. But demand for drugs is inelastic, so total spending on drugs increases. This increases property crime, as drug addicts commit crime to obtain money for drugs. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 2: Vanity Plates and the Elasticity of Demand Virginia has the highest ratio of vanity license plates: over 10% of vehicles have them. Why? Because the price is so low, $10 per year. If Virginia wanted to raise more revenue from vanity license plates, it should raise its price: the price elasticity of demand is only 0.26. • A 100% increase in price would decrease quantity demanded only 26%. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.3 Elasticity and Total Revenue for a Linear Demand Curve Explain how the price elasticity of demand varies along a linear demand curve. It is often useful to represent the demand for a product with a linear demand curve. • A linear demand curve—a straight line—has a constant slope, but that does not mean that it has a constant elasticity of demand. In fact, the price elasticity of demand decreases as we move downward along a linear demand curve. • On the upper half of a linear demand curve, demand is elastic. • On the lower half of the curve, demand is inelastic. • At the midpoint of a linear demand curve, demand is unit elastic. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.2 Elasticity and Total Revenue along a Linear Demand Curve (Panel A) The slope of this demand curve is −$2 per unit quantity. We will use this in the table on the next slide to compute the elasticity at three points: e, u, and i (elastic, unit elastic, and inelastic). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.6 Elasticity of Demand along a Linear Demand Curve A B C D E F Starting Point Change in Price Percentage Change in Price Change in Quantity Percentage Change in Quantity Elasticity of Demand e: Elastic ‒$2 negative $2 $2 over $80 = negative 2.5%  2.5% +1 negative $2 over $50 = $2 negative 4%.  4% +1 negative $2 over $20 = $2 negative 10%  10% +1 $80 u: Unit elastic ‒$2 i: inelastic ‒$2 10  10% 1 over125 = 4%. 25 $50 $20 1 over110 = 10%  4% 1 over 40 = 2.5% 1  2.5% 40 absolute value of 10% over negative 2.5% = 4. 10% 4 2.5% absolute value of 4% over negative 4% = 1. 4% 1 4% absolute2.5% value of 2.5% over negative 10% = 0.25  0.25 10% The slope of −$2 per unit quantity means each increase in quantity of 1 (column D) is associated with the price decreasing by $2 (column B). The elasticity is lower at greater quantities (lower prices): a large percentage change in price induces a smaller quantity change. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.2 Elasticity and Total Revenue along a Linear Demand Curve (Both Panels) Since elasticity varies along the linear demand curve, so does the total revenue: • When demand is elastic, lowering price raises total revenue. • When demand is inelastic, raising price raises total revenue. • When demand is unit elastic, total revenue is maximized. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 3: Drones and the Lower Half of a Linear Demand Curve Suppose a firm that produces hobby drones (for civilian use) has a linear demand curve for its product, with a vertical intercept of $800. The firm currently charges a price of $300. Should the firm raise its price? Yes! 1. The price is below the midpoint of the linear demand curve, so raising price would increase revenue. 2. It would need to make fewer drones, so its costs would fall. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.4 Other Elasticities of Demand Define the income elasticity and cross-price elasticity of demand. Price elasticity of demand measures the responsiveness of consumers to changes in the price of a particular good. But demand depends on other variables too; we can obtain an elasticity for those variables, by seeing how quantity demanded responds to changes in those other variables. We will examine the effects of income and the prices of related goods. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Income Elasticity of Demand Income elasticity of demand: A measure of the responsiveness of demand to changes in consumer income; equal to the percentage change in the quantity demanded divided by the percentage change in income. percentage change in quantity demanded Ei  percentage change in income If a 10% increase in income increases the quantity of books demanded by 15%: percentage change in quantity demanded 15% Ei    1.5 percentage change in income 10% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Cross-Price Elasticity of Demand Cross-price elasticity of demand: A measure of the responsiveness of demand to changes in the price of another good; equal to the percentage change in the quantity demanded of one good (X) divided by the percentage change in the price of another good (Y). percentage change in quantity of X demanded E xy  percentage change in price of Y If a 20% increase in the price of bananas (B) increases the quantity of apples (A) demanded by 5%: E AB  percentage change in quantity of A demanded 5%   0.25 percentage change in price of B 20% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 4.7 Income and Cross-Price Elasticities for Different Types of Goods This elasticity Is Positive for … Is Negative for … Income elasticity Normal goods Inferior goods Cross-price elasticity Substitute goods Complementary goods Recall inferior goods are ones we buy less of as our income rises, resulting in a negative income elasticity of demand. • Normal goods—ones we buy more of as our income rises— have a positive income elasticity of demand. Substitutes are bought in place of one another: when the price of one rises, the demand for the other increases (a positive crossprice elasticity). • Complements work the other way: when the price of one rises, we buy less of the other—a negative cross-price elasticity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved How Are These Elasticities Useful? During a recession, incomes fall (or rise slowly). • If you operate a retail store and know the income elasticity of demand for your product and how incomes are changing, you can predict how sales of your product will change. A supermarket sells many products. When ordering for the produce department of a supermarket, suppose you know bananas will be on sale. • If you know the price change for the bananas, and the crossprice elasticities for other products, you can predict how much more or less you will sell of the other products, and order accordingly. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 4: I Can Find That Elasticity in Four Clicks! The USDA has a web site that provides estimates of demand elasticities (ownprice, income, or crossprice) for hundreds of food products, and for dozens of countries. Check it out: https://data.ers.usda.gov/ reports.aspx?ID=17825 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.5 The Price Elasticity of Supply List the determinants of the price elasticity of supply. We can also use elasticity do measure the responsiveness of firms to changes in prices. Price elasticity of supply: A measure of the responsiveness of the quantity supplied to changes in price; equal to the percentage change in quantity supplied divided by the percentage change in price. Es  percentage change in quantity supplied percentage change in price Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.3 The Slope of the Supply Curve and Supply Elasticity As with demand curves, a steeper slope means a smaller price elasticity of supply, and a shallower slope means a greater price elasticity of supply. For panel A, percentage change in quantity supplied 2% Es    0.10 percentage change in price 20% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved What Determines the Price Elasticity of Supply? The price elasticity of supply is determined by how rapidly production costs increase as the total output of the industry increases. • If the marginal cost increases rapidly, the supply curve is relatively steep and the price elasticity is relatively low. • Consider the pencil industry: increasing output is unlikely to increase input costs much, so the supply curve will be quite flat, with a high price elasticity of supply. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Role of Time: Short-Run versus Long-Run Supply Elasticity The supply curve is positively sloped because of two increases to an increase in price: • Short run: A higher price encourages existing firms to increase their output by purchasing more materials and hiring more workers. • Long run: New firms enter the market and existing firms expand their production facilities to produce more output. Greater quantity changes will result from a given price change in the long run: a greater price elasticity of supply. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Extreme Cases: Perfectly Inelastic Supply and Perfectly Elastic Supply For some goods and services, there is only a fixed amount of the good or service available: a perfectly inelastic supply. Perfectly inelastic supply: The price elasticity of supply equals zero. Land is a good example: as Will Rogers said, “The trouble with land is that they’re not making it anymore.” For other goods and services, the marginal cost of production may not change as we provide one more unit. These have a perfectly elastic supply. Perfectly elastic supply: The price elasticity of supply is equal to infinity. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.4 Perfectly Inelastic Supply and Perfectly Elastic Supply In Panel A, the quantity supplied is the same at every price, so the price elasticity of supply is zero. In Panel B, the quantity supplied is infinitely responsive to changes in price, so the price elasticity of supply is infinite. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Predicting Changes in Quantity Supplied We can rearrange the formula for price elasticity of supply as we did for price elasticity of demand: Es  percentage change in quantity supplied percentage change in price percentage change in quantity supplied  percentage change in price  Es If the elasticity of supply is 0.80 and price rises by 5%: percentage change in quantity supplied  percentage change in price  Es  5%  0.80  4% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 5: The Short-Run and LongRun Elasticity of Supply of Coffee Suppose the price of coffee beans rises. In the short run, farmers will use more fertilizer and water, and more labor, to obtain greater output per bush. In the long run, they will also plant more bushes, resulting in a greater output increase for the same size price increase—greater price elasticity of supply in the long run. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 4.6 Using Elasticities to Predict Changes in Prices Use demand and supply elasticities to predict changes in equilibrium prices. When demand or supply changes, we can use a simple demand-and-supply graph to predict whether the equilibrium price will increase or decrease. But we might want to do better: predicting how much the equilibrium price will change. • Demand and supply elasticities can help us to make this prediction. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Price Effects of a Change in Demand Suppose the demand for milk increases. Immediately, there is an excess demand for milk. We know the price will rise to eliminate the excess demand. What would make the resulting increase in price relatively small? 1. A small increase in demand (so the amount of excess demand is small). 2. Highly elastic demand (so the quantity demanded changes a lot in response to a price change). 3. Highly elastic supply (so the quantity supplied changes a lot in response to a price change). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.5 An Increase in Demand Increases the Equilibrium Price Demand increases by 35 million gallons; perhaps a new trade deal sends 35 million gallons overseas. The supply elasticity is 2.5 and the demand elasticity is 1.0. A 10% increase in price will increase quantity supplied by 25% (25 million) and decrease quantity demanded by 10% (10 million), eliminating the excess demand. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Predicting the Change In Equilibrium Price More generally, we can use the following formula: percentage change in equilibrium price  percentage change in demand Es  Ed In our example: percentage change in equilibrium price  35% 2.5  1.0 35% 3.5  10%  Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved The Price Effects of a Change in Supply Let’s work through a similar exercise for a change in supply. Suppose the supply of shoes decreases. Immediately, there is an excess demand for shoes. We know the price will rise to eliminate the excess demand. What would make the resulting increase in price relatively small? 1. A small decrease in supply (so the amount of excess demand is small). 2. Highly elastic demand (so the quantity demanded changes a lot in response to a price change). 3. Highly elastic supply (so the quantity supplied changes a lot in response to a price change). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 4.6 An Increase in Demand Increases the Equilibrium Price The supply of shoes falls by 30 million pairs; perhaps a protectionist government introduces import restrictions. The supply elasticity is 2.3 and the demand elasticity is 0.7. A 10% increase in price will increase quantity supplied by 23% (23 million) and decrease quantity demanded by 7% (7 million), eliminating the excess demand. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Finding the Change In Equilibrium Price More generally, we can use the following formula: percentage change in equilibrium price  percentage change in supply Es  Ed In our example:  30%  percentage change in equilibrium price      2.3  0.7   30%      3.0   10% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 6: A Broken Pipeline and the Price of Gasoline (1 of 2) In 2003, a pipeline break decreased the supply of gasoline to the city of Phoenix by 30%. The equilibrium price increased only 40%; with a short-run demand elasticity of demand for gasoline of 0.2, a price increase of 150% would have been necessary to eliminate the excess demand if there were not supply adjustment. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 6: A Broken Pipeline and the Price of Gasoline (2 of 2) What actually happened? Gasoline was diverted to Phoenix via a different pipeline: quantity supplied increased in response to the high prices. Suppose the price elasticity of supply was 0.55: percentage change in equilibrium price   percentage change in supply Es  Ed  30%      0.55  0.20  30%  0.75  40% Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Key Terms Cross-price elasticity of demand Perfectly inelastic demand Elastic demand Perfectly inelastic supply Income elasticity of demand Price elasticity of demand (Ed) Inelastic demand Price elasticity of supply Perfectly elastic demand Total revenue Perfectly elastic supply Unit elastic demand Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Survey of Economics: Principles, Applications and Tools Eighth Edition Chapter 5 Production Technology and Cost Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Chapter Outline 5.1 Economic Cost and Economic Profit 5.2 A Firm with a Fixed Production Facility: Short-Run Costs 5.3 Production and Cost in the Long Run 5.4 Examples of Production Cost Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 5.1 Economic Cost and Economic Profit Define economic cost and economic profit. A firm’s objective is to maximize its economic profit: economic profit  total revenue  economic cost Economic profit: Total revenue minus economic cost. Economic cost: The opportunity cost of the inputs used in the production process; equal to explicit cost plus implicit cost. The economic cost is the entire opportunity cost of production: whatever must be sacrificed in the course of production. Explicit cost: A monetary payment. Implicit cost: An opportunity cost that does not involve a monetary payment. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.1 Economic Cost versus Accounting Cost blank Economic Cost Explicit: monetary payments for labour, capital, materials $10,000 Accounting Cost $10,000 Implicit: opportunity cost of entrepreneur’s time 5,000 - Implicit: opportunity cost of funds 2,000 - Total 17,000 10,000 Accountants calculate profit and cost differently from economists. Their purpose is to account for flows of money. Economists are interested in questions like “should this firm continue to operate?” which require considering implicit costs as well as flows of money. Accounting cost: The explicit costs of production. Accounting profit: Total revenue minus accounting cost. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 1: Opportunity Cost and Entrepreneurship A homeowner is considering renting out his or her home through Airbnb, earning $90 for a typical two-night stay. While that may sound like a nice payoff, it fails to account for the opportunity cost of the homeowner’s time: • Emails to arrange the stay • Cleaning up after guests leave The economic profit will be much less than $90. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 5.2 A Firm with a Fixed Production Facility: Short-Run Costs Draw the short-run marginal-cost and average-cost curves. Consider first the case of a firm with a fixed production facility. Suppose you have decided to start a small firm to produce plastic paddles for rafts. Before we can discuss the cost of production, we need information about the nature of the production process. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.1 Total-Product Curve (1 of 2) Total-product curve: A curve showing the relationship between the quantity of labor and the quantity of output produced, ceteris paribus. For the first two workers, output increases at an increasing rate because of labor specialization. Marginal product of labor: The change in output from one additional unit of labor. Labor Quantity of Output Produced Marginal Product of Labor 1 1 1 2 5 4 3 8 3 4 10 2 5 11 1 6 11.5 0.5 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.1 Total-Product Curve (2 of 2) Diminishing returns occurs for three or more workers, so output increases at a decreasing rate. Diminishing returns: As one input increases while the other inputs are held fixed, output increases at a decreasing rate. Labor Quantity of Output Produced Marginal Product of Labor 1 1 1 2 5 4 3 8 3 4 10 2 5 11 1 6 11.5 0.5 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Short-Run Total Cost In the short-run analysis of costs, we divide production costs into two types, fixed cost and variable cost. Fixed cost (FC): Cost that does not vary with the quantity produced. Variable cost (VC): Cost that varies with the quantity produced. Short-run total cost (TC): The total cost of production when at least one input is fixed; equal to fixed cost plus variable cost. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.2 Short-Run Costs: Fixed Cost, Variable Cost, and Total Cost The short-run total-cost curve shows the relationship between the quantity of output and production costs, given a fixed production facility. Short-run total cost equals fixed cost (the cost that does not vary with the quantity produced) plus variable cost (the cost that varies with the quantity produced). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.2 Short-Run Costs (1 of 2) 1 Labor 2 Output 3 Fixed Cost (FC) 4 Variable Cost (V C) 5 Total Cost (TC) 6 Average Fixed Cost (AF C) 7 Average Variable Cost (AV C) 8 Average Total Cost (AT C) 9 Marginal Cost (M C) 0 0 $100 $0 $100 - - - - 1 1 100 50 150 $100.00 $50.00 $150.00 $50.00 2 5 100 100 200 20.00 20.00 40.00 12.50 3 8 100 150 250 12.50 18.75 31.25 16.67 4 10 100 200 300 10.00 20.00 30.00 25.00 5 11 100 250 350 9.09 22.73 31.82 50.00 6 11.5 100 300 400 8.70 26.09 34.78 100.00 The table shows a variety of measures of cost for the firm. Average fixed cost (AFC): Fixed cost divided by the quantity produced. Average variable cost (AVC): Variable cost divided by the quantity produced. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.2 Short-Run Costs (2 of 2) 1 Labor 2 Output 3 Fixed Cost (FC) 4 Variable Cost (V C) 5 Total Cost (TC) 6 Average Fixed Cost (AF C) 7 Average Variable Cost (AV C) 8 Average Total Cost (AT C) 9 Marginal Cost (M C) 0 0 $100 $0 $100 - - - - 1 1 100 50 150 $100.00 $50.00 $150.00 $50.00 2 5 100 100 200 20.00 20.00 40.00 12.50 3 8 100 150 250 12.50 18.75 31.25 16.67 4 10 100 200 300 10.00 20.00 30.00 25.00 5 11 100 250 350 9.09 22.73 31.82 50.00 6 11.5 100 300 400 8.70 26.09 34.78 100.00 Short-run average total cost (ATC): Short-run total cost divided by the quantity produced; equal to AFC plus AVC. ATC  TC FC VC    AFC  AVC Q Q Q Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.3 Short-Run Average Costs The short-run average-total-cost curve (ATC) is U-shaped. • As the quantity increases, fixed costs are spread over more units, pushing down the ATC. • As the quantity increases, diminishing returns eventually pull up the ATC. The gap between ATC and AVC is the average fixed cost (AFC). Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Short-Run Marginal Cost Short-run marginal cost (MC): The change in short-run total cost resulting from a one-unit increase in output. TC change in TC MC   Q change in output One worker produces 1 paddle, with total cost $150. Two workers produce 5 paddles, with total cost $200. TC $200  $150 $50 MC     $12.50 Q 5 1 4 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.4 Short-Run Marginal and Average Cost The marginal-cost curve (MC) is negatively sloped for small quantities of output, because of the benefits of labor specialization, and positively sloped for large quantities, because of diminishing returns. The MC curve intersects the average-cost curve (ATC) at the minimum point of the average curve. At this point ATC is neither falling nor rising. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.3 Marginal Grade and Average Grade Labor Marginal Grade Number of Courses Grade Points Grade Point Average Starting point - 9 27 3.0 = 27 over 9 Marginal grade < GPA D 10 28 = 27+1 2.8 = 28 over 10 Marginal grade = GPA B 10 30 = 27+3 3.0 = 30 over 10 Marginal grade > GPA A 10 31 = 27+4 3.0  27 / 9 2.8  28 / 10 3.0  30 / 10 3.1 = 31 3.1 over 31/1010 To illustrate the relationship between marginal and average, suppose you have a B (3.0) average after 9 classes, and are waiting for the grade for the 10th to come in. The 10th is your marginal grade; your GPA is your average grade. • If the 10th grade is less than your GPA, your GPA will fall. • If it is equal to your GPA, your GPA will stay the same. • If it is greater than your GPA, your GPA will rise. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 2: The Rising Marginal Cost of Crude Oil The first 40 million barrels of oil produced worldwide per day have a marginal cost less than $10 per barrel; oil costs little to extract in the Middle East and Russia. The next 25 million barrels cost about $20 per barrel, from more expensive offshore rigs and oil sands projects. Higher quantities see the marginal cost rise quickly, for Arctic drilling, biodiesel, etc. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 5.3 Production and Cost in the Long Run Draw the long-run marginal-cost and average cost curves. The long run is defined as the period of time over which a firm is perfectly flexible in its choice of all inputs. • In the long run, a firm can build or modify a production facility such as a factory, store, office, or restaurant. The key difference between the short run and the long run is that there are no diminishing returns in the long run. • Diminishing returns occur because workers share a fixed production facility. • In the long run, a firm can expand its production facility as its workforce grows. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Expansion and Replication Suppose our paddle-production firm was producing 10 paddles per day, with a total cost of $300 per day—an average cost of $30 per paddle. If we wanted to double production, we could do so in our old facility; but the workers would be cramped, and average costs would rise. Another option: build another identical workshop, to replicated our already successful production methods. The cost to produce, when we can flexibly change our facilities, is the long-run total cost. Long-run total cost (LTC): The total cost of production when a firm is perfectly flexible in choosing its inputs. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.5 Expansion and Replication (1 of 2) Initially (up to point b) the short-run and long-run total cost curves are the same; while average costs are falling, replication is not useful. Long-run average cost (LAC): The long-run cost divided by the quantity produced. Labor 1 Capital 2 Output 3 Labor Cost 4 Long-Run Total Cost (LTC) 5 Long-Run Average Cost (LAC) 1 $100 1 $ 50 $150 $150 2 100 5 100 200 40 4 100 10 200 300 30 8 200 20 400 600 30 12 300 30 600 900 30 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.5 Expansion and Replication (2 of 2) Once we exhaust our gains from specialization, we can replicate and achieve constant returns to scale. Constant returns to scale: A situation in which the long-run total cost increases proportionately with output, so average cost is constant. Labor 1 Capital 2 Output 3 Labor Cost 4 Long-Run Total Cost (LTC) 5 Long-Run Average Cost (LAC) 1 $100 1 $ 50 $150 $150 2 100 5 100 200 40 4 100 10 200 300 30 8 200 20 400 600 30 12 300 30 600 900 30 Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Long-Run Marginal Cost If we achieve constant returns to scale by replication, each additional batch of output costs the same as the ones before, so the long-run marginal cost is constant also. Long-run marginal cost (LMC): The change in long-run cost resulting from a one-unit increase in output. We may be able to do even better—say, by combining two workshops into a single larger workshop. Then the long-run marginal cost would be falling. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Reducing Output with Indivisible Inputs While replication will often allow us to increase production and keep average costs the same, we often cannot decrease production with the same result. Many inputs cannot be divided—they must be all-or-nothing. Indivisible input: An input that cannot be scaled down to produce a smaller quantity of output. • For example, to produce up to 10 paddles per day, perhaps we need one plastic mold; we cannot have half a mold. • Similarly, a hospital cannot buy half an MRI machine, and a railroad company can’t build half a set of tracks. • This helps to explain why long-run average costs are often high for small quantities. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Scaling Down and Labor Specialization Another problem with getting smaller is that we cannot benefit as much from labor specialization. • In our paddle-production example, if we cut down to just a couple of workers, each would have to perform many tasks. With more workers, they could specialize. • Similarly a large hospital benefits from size by having specialist surgeons, radiologists, etc. A small hospital could have one person perform multiple roles, but they would likely not be as productive; or it could contract some roles out, at higher cost. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Economies of Scale The foregoing examples help to explain why larger firms can enjoy economies of scale. Economies of scale: A situation in which the long-run average cost of production decreases as output increases. Eventually we will likely exhaust all possible economies of scale. Minimum efficient scale: The output at which scale economies are exhausted. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Diseconomies of Scale Could a firm get so big, its average cost actually starts to rise? Diseconomies of scale: A situation in which the long-run average cost of production increases as output increases. Diseconomies of scale could occur because of: • Coordination problems: Organizing a large operation with many layers of management may be difficult to do effectively. • Increasing input costs: A firm could get so big that it may be forced to pay higher prices for its inputs. For example, a large coal-fired power plant may have to source coal from far away, with higher delivery costs than a small power plant would face. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.6 Actual Long-Run Cost Curves for Aluminum, Truck Freight, and Hospital Services Different industries can have dramatically different long-run average cost curves. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Short-Run Versus Long-Run Average Cost Why is the firm’s short-run average-cost curve U-shaped, while the long-run average-cost curve is L-shaped? • The difference between the short run and long run is a firm’s flexibility in choosing inputs. In the long run, a firm can increase all of its inputs, scaling up its operation by building a larger production facility. • As a result, the firm will not suffer from diminishing returns. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Application 3: Indivisible Inputs and the Cost of Fake Killer Whales Sea lions off the Washington coast threaten some fish species with extinction and threaten commercial fisheries. One innovative idea: build big plastic killer whales, on rollercoaster-like rails, to scare off the sea lions. The cost for the first fake whale would be $16,000: $11,000 for the plastic mold, and $5,000 for labor and materials; each extra whale would cost only $5,000. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved 5.4 Examples of Production Cost Provide examples of production costs. In this section we will look at actual production costs for several products: • Electricity from wind turbines • Music videos • Solar and nuclear power Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.4 Wind Turbines and the Average Cost of Electricity blank Small Turbine (150 kilowatt) Large Turbine (600 kilowatt) Purchase price of turbine $150,000 $420,000 Installation cost $100,000 $100,000 Operating and maintenance cost $75,000 $126,000 Total Cost $325,000 $646,000 Electricity generated (kilowatt-hours) 5 million 20 million Average cost (per kilowatt-hour) $0.065 $0.032 A large wind turbine is more expensive, but also more cost-effective: installation and maintenance costs are relatively low for the large turbine, considering the much higher output of electricity. A wind turbine company would experience economies of scale as it moved from small to large turbines. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Figure 5.7 Average-Cost Curve for an Information Good A music video is an information good; almost all of its cost is in the initial production, and the marginal cost of reproduction is essentially zero. The average cost will fall for all reasonable quantities. A similar cost structure exists for other products distributed online. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Solar Versus Nuclear: The Crossover In 1998, the cost of electricity produced with solar technology was $0.32 per kilowatt-hour (Kwh), vs $0.07 per Kwh for nuclear. Over the last 20 years, the cost for electricity from nuclear power plants has increased to about $0.16 per Kwh, because the cost of building reactors has increased Meanwhile the cost from solar has decreased: $0.21 per Kwh in 2005, and $0.16 per Kwh in 2010. As further innovations happen in the solar industry, it is likely that solar energy costs will continue to fall: solar has crossed over to being more cost-effective than nuclear. Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.5 The Language and Mathematics of Costs (1 of 3) Type of Cost Definition Symbols and Equations Economic cost The opportunity cost of the inputs used in the production process; equal to explicit cost plus implicit cost - Explicit cost The actual monetary payment for inputs - Implicit cost The opportunity cost of inputs that do not involve a monetary payment - Accounting cost Explicit cost - Copyright © 2020, 2017, 2014 Pearson Education, Inc. All Rights Reserved Table 5.5 The Language and Mathematics of Costs (2 of 3) Type of Cost Definition Symbols and Equations Short-Run Costs blank blank Fixed cost Cost that does not vary with the quantity produced FC Variable cost Cost that varies with the qu...
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