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PRODUCT MARKETS
Elasticity, Consumer Surplus, and
Producer Surplus
Reference: McConnell, Campbell R. Economics: principles, problems, and
policies / Campbell R. McConnell, Stanley L. Brue,
Sean M. Flynn. 18th ed. p. cm. (The McGraw-Hill series in economics)
Inelastic demand
Small change in quantity
purchased for given price change
Ed =
6-3
Interpretations of Elasticity
Elastic Demand
Ed =
.04
.02
=2
.01
.02
= .5
.02
.02
=1
Inelastic Demand
Ed =
Unit Elasticity
Ed =
6-4
Elastic demand
P and TR change in opposite
direction
6-5
b
1
D1
10
20
30
40
Q
6-6
$4
d
1
D2
0
10
20
Q
6-7
$3
f
1
D3
10
20
30
Q
6-8
Elasticity on a Linear
Demand Curve
(1)
Total Quantity of
Tickets Demanded
Per Week, Thousands
1
2
3
4
5
6
7
8
(2)
Price Per Ticket
$8
]
7
]
6
]
5
]
4
]
3
]
2
]
1
(3)
Elasticity
Coefficient (Ed)
5.00
2.60
1.57
1.00
0.64
0.38
0.20
(4)
Total Revenue
(1) X (2)
$8,000
]
14,000
]
18,000
]
20,000
]
20,000
]
18,000
]
14,000
]
8,000
(5)
Total-Revenue
Test
Elastic
Elastic
Elastic
Unit Elastic
Inelastic
Inelastic
Inelastic
6-9
Price
Elastic
Ed > 1
Unit Elastic
Ed = 1
Inelastic
Ed < 1
h
0 1 2 3 4 5 6 7 8
Total Revenue
(Thousands of Dollars)
Quantity Demanded
$20
18
16
14
12
10
8
6
4
2
TR
0 1 2 3 4 5 6 7 8
Quantity Demanded
6-10
Determinants of Elasticity
Substitutability
More substitutes, more elastic
demand
Proportion of income
Price relative to income
Time
More elastic in the long run
6-11
Es =
Short run
Fixed plant size
Long run
Adjustable plant size
Supply more elastic
6-13
Greatest
Price
Impact
Sm
Pm
P0
D1 D2
Q0
Q
6-14
Lower
Price
Impact
Ss
Ps
P0
D1 D2
Q0 Qs
Q
6-15
P
Sl
Least
Price
Impact
Pl
P0
D1 D2
Q0 Ql
Q
6-16
Exy =
Complementary goods
Negative sign
The larger the negative cross elasticity coefficient, the greater is the
complementarity between the two goods.
Independent goods
Zero
6-18
Responsiveness of sales to
change in income
Normal goods positive sign
Inferior goods negative sign
6-19
Consumer Surplus
Consumer
Surplus
Equilibrium
Price = $8
P1
D
Q1
Quantity (Bags)
6-20
Producer Surplus
Producer
Surplus
Equilibrium
Price = $8
P1
Q1
Quantity (Bags)
6-21
Efficiency Revisited
Productive and allocative efficiency
S
Consumer
Surplus
Equilibrium
Price = $8
P1
Producer
Surplus
D
Q1
Quantity (Bags)
6-22
Efficiency Loss
Deadweight loss
S
Efficiency
Losses
P1
D
Q2
Q1
Q3
Quantity (Bags)
6-23
MICROECONOMICS OF
PRODUCT MARKETS
Consumer Behavior
Utility
Diminishing marginal utility
(states that beyond a certain quantity, additional units of a specific
good will yield declining amounts of extra satisfaction to a consumer)
Utility
Total utility
Marginal utility
7-27
Utility Graphically
(1)
(2)
(3)
Tacos
Total Marginal
Consumed Utility, Utility,
Per Meal Utils
Utils
2
3
4
5
6
7
0
10
18
]
]
]
24
]
28
]
30
]
30
]
28
10
8
4
2
0
-2
30
TU
20
10
0
6
Marginal Utility (Utils)
0
1
Total Utility
Marginal Utility
10
8
6
4
2
0
-2
MU
1
7-29
Algebraic Generalization
MU of product A
price of A
8 Utils
$1
=
=
MU of product B
price of B
16 Utils
$2
$2
Price of Product B
Income Effects
DB
0
Substitution Effects
Quantity Demanded of B
7-32
MICROECONOMICS OF
PRODUCT MARKETS
The Costs of Production
Economic Costs
Equal to opportunity costs
Explicit + implicit costs
Explicit costs
Monetary payments
Implicit costs
Value of next best use
Self-owned resources
Self-employed resources
8-35
Profit
Accounting profit
Total revenue less explicit cost
Normal profit
Equal to implicit cost
8-36
Profits Compared
Economic
Implicit Costs
(Including a
Normal Profit)
Explicit
Costs
Total Revenue
Economic
(Opportunity)
Costs
Economic
Profit
Accounting
Accounting
Profit
Accounting
Costs (Explicit
Costs Only)
8-37
Production Relationships
Total product (TP)
Marginal product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input
Total Product
Units of Labor
8-39
Fixed technology
Add variable resource to fixed
resource
Marginal product will decline
Beyond some point
Rationale
8-40
Industry Structure
Minimum efficient scale (MES)
Natural monopoly
Applications and illustrations
Price of corn
Successful start-up firms
The Verson stamping machine
The daily newspaper
Aircraft and concrete plants
8-41
Sunk Costs
8-42
MICROECONOMICS OF
PRODUCT MARKETS
Pure Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Market Model
Characteristic
Pure Competition
Monopolistic
Competition
Number of firms
Many
Type of product
Standardized
Differentiated
Oligopoly
Pure Monopoly
Few
One
Standardized or
Unique; no close
differentiated
substitute
Limited by mutual
None
interdependence;
narrow limits
considerable with
Considerable
collusion
Condition of entry
Nonprice
None
competition
Examples
Agriculture
Relatively easy
Significant obstacles
Considerable emphasis
on advertising, brand
particularly with
names, trademarks
product differentiation
Blocked
Steel, automobiles,
farm implements, many
household appliances
Local utilities
Pure Competition
Very large numbers
Standardized product (identical)
Price takers
Free entry and exit
Perfectly elastic demand
Average revenue
Marginal revenue
Price
9-46
Profit Maximization
Two approaches
Total revenue and total cost
approach
Produce where TR-TC is greatest
0
1
2
3
4
5
6
7
8
9
10
(2)
Total Fixed
Cost (TFC)
(3)
Total Variable
Cost (TVC)
$100
100
100
100
100
100
100
100
100
100
100
$0
90
170
240
300
370
450
540
650
780
930
(4)
(5)
(6)
Total Cost Total Revenue Profit (+)
(TC)
(TR)
or Loss (-)
$100
190
270
340
400
470
550
640
750
880
1030
$0
131
262
393
524
655
786
917
1048
1179
1310
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Do
You
SeeGraph
Profit Maximization?
Now
Lets
The Results
9-48
Total Economic
Profit
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
Break-Even Point
(Normal Profit)
Total Revenue, (TR)
Maximum
Economic
Profit
$299
Total Cost,
(TC)
P=$131
Break-Even Point
(Normal Profit)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
$500
400
300
200
100
Total Economic
Profit
$299
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
9-49
0
1
2
3
4
5
6
7
8
9
10
(2)
Average
Fixed
Cost
(AFC)
$100.00
50.00
33.33
25.00
20.00
16.67
14.29
12.50
11.11
10.00
(3)
Average
Variable
Cost
(AVC)
(4)
Average
Total
Cost
(ATC)
$90.00 $190.00
85.00 135.00
80.00 113.33
75.00 100.00
74.00
94.00
75.00
91.67
77.14
91.43
81.25
93.75
86.67
97.78
93.00 103.00
(5)
Marginal
Cost
(MC)
$90
80
70
60
70
80
90
110
130
150
(6)
Marginal
Revenue
(MR)
(7)
Profit (+)
or Loss (-)
$131
131
131
131
131
131
131
131
131
131
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Surprise
- Now
Lets GraphNow?
It
DoNo
You
See Profit
Maximization
9-50
$200
MR = MC
150
MC
P=$131
MR = P
ATC
Economic Profit
100
AVC
A=$97.78
50
10
Output
9-51
$200
150
MC
Loss
A=$91.67
ATC
AVC
100
P=$81
50
MR = P
V = $75
10
Output
9-53
$200
150
ATC
V = $74
100
AVC
MR = P
P=$71
Short-Run
Shut Down Point
P < Minimum AVC
$71 < $74
50
10
Output
9-54
Assumptions
Entry and exit only
Identical costs
Constant-cost industry
Single Firm
Industry
S1
MC
ATC
$60
$60
50
50
S2
MR
D2
40
40
D1
100
80,000
90,000
100,000
9-56
Single Firm
Industry
S3
MC
ATC
$60
$60
50
50
S1
MR
D1
40
40
D3
100
80,000
90,000
100,000 P
9-57
9-58
Allocative efficiency
P = MC
MICROECONOMICS OF
PRODUCT MARKETS
Pure Monopoly
Characteristics of Monopoly
Single seller
No close substitutes
Price maker
Blocked entry
Nonprice competition
10-61
Examples of Monopoly
Regulated or natural monopolies
electricity
Near monopolies
Western Union
Frisbee
De Beers
Geographic monopolies
Professional sport teams
Barriers to Entry
Economies of scale
Legal barriers to entry
Patents
Licenses
Ownership or control of
essential resources
Pricing and other strategic
barriers to entry
10-63
Monopoly Demand
Assumptions:
Monopoly status is secure
No government regulation
Single-price monopolist
$142
132
122
112
Loss = $30
102
Gain = $132
92
82
MR
0
10-65
Down-Sloping Demand
Marginal revenue < price
To increase sales, must lower price
Revenue Data
(2)
Price
(1)
Quantity (Average
Of Output Revenue)
0
1
2
3
4
5
6
7
8
9
10
$172
162
152
142
132
122
112
102
92
82
72
(3)
Total
Revenue
(1) X (2)
$0 ]
162 ]
304 ]
426 ]
528 ]
610 ]
672 ]
714 ]
736 ]
738 ]
720
(4)
Marginal
Revenue
$162
142
122
102
82
62
42
22
2
-18
(5)
(6)
(7)
(8)
Average Total Cost Marginal Profit (+)
Total Cost (1) X (5)
Cost
or Loss (-)
$190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
103.00
$100 ]
190 ]
270 ]
340 ]
400 ]
470 ]
550 ]
640 ]
750 ]
880 ]
1030
$90
80
70
60
70
80
90
110
130
150
$-100
-28
+34
+86
+128
+140
+122
+74
-14
-142
-310
$200
175
Profit Maximization
MC
150
Pm=$122
125
100
75
Economic
Profit
ATC
A=$94
D
MR=MC
50
25
MR
1
10
Quantity
10-68
Misconceptions
Possibility of losses
10-69
Loss Minimization
A
Pm
MC
ATC
Loss
AVC
V
D
MR=MC
MR
0
Qm
Quantity
10-70
Economic Effects
Pure
Monopoly
Purely
Competitive
Market
S=MC
MC
Pm
P=MC=
Minimum
ATC
Pc
b
c
Pc
a
D
MR
Qc
Qm
Qc
Economic Effects
Pure competition is efficient
Productive efficiency
Allocative efficiency
CS+PS maximized
Monopoly is inefficient
Charge P>MC
Deadweight loss
Income transfer
10-72
Cost Complications
Economies of scale
Simultaneous consumption
A products ability to satisfy a large number of consumers at the same time
Network effects
are present if the value of a product to each user, including existing users,
increases as the total number of users rises.
X-inefficiency
Lowest ATC not achieved
Policy Options
Use antitrust laws
Divide the firm
Natural monopoly
Regulate price
Ignore
Unstable in long run
10-74
Price Discrimination
Three forms
Charge each customer max
willingness to pay
Charge one price for first unit
and a lower price for subsequent
units
Charge different customers
different prices
10-75
Price Discrimination
Conditions
Monopoly power
Market segregation
No resale
Examples
Airfares
Electric utilities
Theaters & golf courses
10-76
Regulated Monopoly
Natural monopolies
Rate regulation
Socially optimum price
P = MC
Regulated Monopoly
Dilemma of Regulation
Price and Costs (Dollars)
Monopoly
Price
Pm
Fair-Return
Price
f
Pf a
Socially
Optimal
Price
ATC
Pr
MR
0
MC
Qm
Qf
Qr
Quantity
10-78
MICROECONOMICS OF
PRODUCT MARKETS
Monopolistic Competition and
Oligopoly
Monopolistic Competition
Large number of sellers
Small market shares
No collusion
Independent action
Differentiated Products
Product attributes
Service
Location
Brand names and packaging
Some control over price
11-80
Monopolistic Competition
Easy entry and exit
Need for advertising
Nonprice Competition
Which industries?
Degree of concentration
Four-firm concentration ratio
Herfindahl index
11-81
Monopolistic Competition
Firms demand curve
Highly elastic
Inefficient
Product variety
11-82
Monopolistic Competition
Short-Run Profits
MC
ATC
P1
A1
Economic
Profit
D1
MR = MC
MR
0
Q1
Quantity
11-83
Monopolistic Competition
Short-Run Losses
MC
ATC
A2
P2
Loss
D2
MR = MC
MR
0
Q2
Quantity
will cause an exit of firms until normal profit is restored. After such entry and exit, the11-84
Monopolistic Competition
Long-Run Equilibrium
MC
ATC
P3= A3
D3
MR = MC
MR
0
Q3
Quantity
where it just equals average total cost at the MR MC output. At this price P 3 and output Q3 , the11-85
Oligopoly
A few large producers
Homogeneous or
differentiated products
Control over price
Mutual interdependence
Strategic behavior
Entry barriers
Mergers
11-86
Oligopoly
Four-firm concentration ratio
Needs to be more than 40%
Localized markets
Inter industry competition
World trade
Import Competition
Herfindahl index
11-87
2 competitors
2 price
strategies
Each strategy
has a payoff
matrix
Greatest
combined
profit
Independent
actions
stimulate a
response
Game Theory
High
$12
Low
$15
High
$12
$6
$6
$8
Low
$15
$8
11-88
Independently
lowered prices
in expectation
of greater profit
leads to the
worst
combined
outcome
Eventually low
outcomes make
firms return to
higher prices
Game Theory
High
$12
Low
$15
High
$12
$6
$6
$8
Low
$15
$8
11-89
Game Theory
Mutual interdependence
Pricing policy
Collusion
Enhances profit
Incentive to cheat
Prisoners dilemma
11-90
Kinked-demand curve
Collusive pricing
Price leadership
Why three models?
Diversity of oligopolies
Complications of interdependence
11-91
Kinked-Demand Curve
Noncollusive oligopoly
Strategies
Match price changes
Ignore price changes
Combined strategy
Price inflexibility
The kinked-demand curve
11-92
Kinked-Demand Curve
Competitor and rivals strategize versus each other
Consumers effectively have 2 partial demand curves
and each part has its own marginal revenue part
P0
f
D2
Rivals Match g
Price Decrease
0
Q0
MR1
Quantity
MR2
Price
Rivals Ignore
Price Increase
MC1
D2
P0
e
MR2
MC2
g
D1
D1
0
Q0
MR1
Quantity
MC
Effectively Sharing
The Monopoly Profit
P0
ATC
A0
MR=MC
Economic
Profit
MR
Q0
Quantity
11-94
(gentlemans agreement)
Obstacles to collusion
Demand and cost differences
Number of firms
Cheating
Recession
Potential entry
Legal obstacles: antitrust law
11-95
11-96
Advertising
Prevalent in monopolistic
competition and oligopoly
Capture market share
Better than a price cut
Information for consumers
Manipulation
11-97
MICROECONOMICS OF
PRODUCT MARKETS
Technology, R&D, and Efficiency
Technological Advance
Occurs in the very long run
11W-100
Invention-Innovation-Diffusion
Three step process
Invention
Patent
Innovation
Product innovation
Process innovation
Diffusion
Requires R&D expenditure
11W-101
$10
16
20
14
30
12
40
10
50
60
70
16
Expected Rate of Return, r
And Interest Rate, i (Percent)
18
20
12
r=i
80
20
40
60
80
100
11W-104
Increased Profits
Increased revenue via product
innovation
Importance of price
Unsuccessful new products
Product improvements
11W-106
Inverted-U Theory
Less Competition
R&D Expenditures as a
Percentage of Sales
More Competition
25
50
75
100
11W-108
Technological Advance
and Efficiency
Productive efficiency
Increasing productivity of inputs
Allocative efficiency
A more-preferred mix of goods and
services
Creative destruction
11W-109
Thank you