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# MICROECONOMICS OF

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)

## Price Elasticity of Demand

Measuring responsiveness to
price changes
Elastic demand
Large change in quantity
purchased for given price change

Inelastic demand
Small change in quantity
purchased for given price change

## Price Elasticity of Demand

Price-elasticity coefficient
and formula

Ed =

## Percentage Change in Quantity

Demanded of Product X
Percentage Change in Price
of Product X

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

## The Total Revenue Test

Total Revenue = TR = PxQ
Inelastic demand
P and TR change in same direction

Elastic demand
P and TR change in opposite
direction
6-5

## The Total Revenue Test

Lower price and elastic demand
Blue gain exceeds gold loss
P
\$3

b
1

D1

10

20

30

40

Q
6-6

## The Total Revenue Test

Lower price and inelastic demand
Gold loss exceeds blue gain
P

\$4

d
1

D2
0

10

20

Q
6-7

## The Total Revenue Test

Lower price and unit-elastic demand
Blue gain equals yellow loss
P

\$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

## Elasticity and the TR Curve

\$8 a
7
b
6
c
5
d
4
e
3
f
2
g
1

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

## Luxuries versus necessities

Luxuries are more elastic

Time
More elastic in the long run
6-11

## Price Elasticity of Supply

Responsiveness to price
changes by producers

Es =

## Percentage Change in Quantity

Supplied of Product X
Percentage Change in Price
of Product X
6-12

## Price Elasticity of Supply

Market period
Perfectly inelastic supply

Short run
Fixed plant size

Long run
Supply more elastic
6-13

## Price Elasticity of Supply

The Market Period
Perfectly inelastic supply

Greatest
Price
Impact

Sm

Pm
P0

D1 D2

Q0

Q
6-14

Inelastic supply
P

Lower
Price
Impact

Ss

Ps
P0

D1 D2

Q0 Qs

Q
6-15

The Long Run
Elastic supply

P
Sl

Least
Price
Impact

Pl
P0

D1 D2

Q0 Ql

Q
6-16

## Cross Elasticity of Demand

Responsiveness of sales to
change in price of another good

Exy =

## Percentage Change in Quantity

Demanded of Product X
Percentage Change in Price
of Product Y
6-17

## Cross Elasticity of Demand

Substitute goods
Positive sign
The larger the positive cross-elasticity coefficient, the greater is the
substitutability between the two products.

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

Ei =

## Percentage Change in Quantity

Demanded
Percentage Change in Income

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

## Price (Per Bag)

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

S

Efficiency
Losses

P1

D
Q2

Q1

Q3

Quantity (Bags)
6-23

## Elasticity and Pricing Power

Competitive markets
No pricing power

## Firms with market power

Charge different prices

## Differences in group elasticities

Business (i) vs. leisure travelers (e)
Discounting for children
College tuition
6-24

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)

## Satisfaction obtained from

consumption
Three characteristics
Differs from usefulness
Subjective
Difficult to quantify
7-26

Utility
Total utility

quantity

Marginal utility

## Law of diminishing marginal

utility
Explains downward sloping
demand

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

7-28

## Theory of Consumer Behavior

Key dimensions of the consumer
problem
Rational behavior
Preferences
Budget constraint
Prices

7-29

## Find utility maximizing

combination of goods
Utility maximizing rule
Allocate income
Last dollar spent on each good
yields same marginal utility
Marginal utility per dollar
7-30

Algebraic Generalization
MU of product A
price of A
8 Utils
\$1

=
=

MU of product B
price of B
16 Utils
\$2

## Optimum Achieved Money income

is allocated so that the last dollar spent on
each product yields the same extra or
marginal utility
7-31

## Price Per Quantity

Unit of B Demanded

\$2

Price of Product B

Income Effects

DB
0

Substitution Effects

Quantity Demanded of B
7-32

## Applications and Extensions

New products increase utility
iPods

## The value of time

Medical care purchases
7-33

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

## Economic or pure profit

Total revenue less economic 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

## Short and Long Run

The short run
Fixed plant capacity
Variable intensity of plant use
Variable output

## The long run

Variable plant capacity
Firms enter and exit
8-38

Production Relationships
Total product (TP)
Marginal product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input

Average Product

Total Product
Units of Labor

8-39

## Law of Diminishing Returns

Fixed technology
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

## Irrelevant in decision making

Cannot be recovered
Do not affect marginal
benefit and marginal cost
Firm example:
R&D costs

8-42

MICROECONOMICS OF
PRODUCT MARKETS
Pure Competition

## Four Market Models

Pure competition
Pure monopoly
Monopolistic competition
Oligopoly
Imperfect Competition
Pure
Competition

Monopolistic
Competition

Oligopoly

Pure
Monopoly

9-44

Market Model

Characteristic

Pure Competition

Monopolistic
Competition

Number of firms

## A very large number

Many

Type of product

Standardized

Differentiated

Oligopoly

Pure Monopoly

Few

One

Standardized or

Unique; no close

differentiated

substitute

Limited by mutual

None

## Some, but within rather

interdependence;

narrow limits

considerable with

Considerable

collusion

Condition of entry

## Very easy, no obstacle

Nonprice
None

competition

Examples

Agriculture

Relatively easy

Significant obstacles

Considerable emphasis

## Typically a great deal,

particularly with

product differentiation

shoes

Blocked

## Mostly public relations

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

## Marginal revenue and marginal

cost approach
Produce where MR=MC
9-47

## Total Revenue Total Cost Approach

Price = \$131
(1)
Total Product
(Output) (Q)

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

## Total Revenue and Total Cost

\$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

Approach
(1)
Total
Product
(Output)

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

Approach

\$200

MR = MC

150

MC

P=\$131

MR = P
ATC

Economic Profit
100

AVC
A=\$97.78
50

10

Output
9-51

## Short Run Profit Maximization

Produce where MR (=P) = MC
Suffer loss, still produce?
Yes if loss is less than fixed cost
Cover variable cost

## Shut down if loss greater than fixed

cost
Produce if P > min AVC
9-52

\$200

## Lower the Price to \$81 and

Observe the Results!

150

MC

Loss
A=\$91.67

ATC
AVC

100
P=\$81

50

MR = P
V = \$75

10

Output
9-53

\$200

## Lower the Price Further to

\$71 and Observe the Results!
MC

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

## Long Run Profit Maximization

Assumptions
Entry and exit only
Identical costs
Constant-cost industry

## Goal of the analysis

In the long run, P = min ATC
Entry eliminates profits
Exit eliminates losses
9-55

Single Firm

Industry

S1

MC

ATC
\$60

\$60

50

50

S2

MR

D2

40

40

D1

100

80,000

90,000

100,000

## An increase in demand temporarily raises price

Higher prices draw in new competitors
Increased supply returns price to equilibrium

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

## A decrease in demand temporarily lowers price

Lower prices drive away some competitors
Decreased supply returns price to equilibrium

9-57

## Long Run Supply

Constant cost industry
Entry/exit does not affect LR ATC
Constant resource price
Special case

## Increasing cost industry

Most industries
LR ATC increases with expansion
Specialized resources

9-58

## Pure Competition and Efficiency

Productive efficiency
P = minimum ATC

Allocative efficiency
P = MC

## Maximum consumer and

producer surplus
Invisible Hand revisited
9-59

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

## Dual objectives of study

10-62

Barriers to Entry
Economies of scale
Legal barriers to entry
Patents

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

## Face down-sloping demand

Entire market demand
10-64

## Price and Marginal Revenue

Marginal revenue is less than price
A monopolist is
selling 3 units at
\$142
To sell 4, price must
be lowered to \$132
All customers
must pay the same
price
TR increases \$132
minus \$30 (3x\$10)
\$102 becomes a
point on the MR
curve
Try other prices to
determine other
MR points

\$142
132
122
112

Loss = \$30

102

Gain = \$132

92
82

MR
0

## The Constructed Marginal Revenue Curve

Must Always Be Less Than the Price

10-65

Down-Sloping Demand
Marginal revenue < price
To increase sales, must lower price

## Firm is a price maker

Choose P,Q combination

## Operate in the elastic region

Marginal revenue > 0
Total-revenue test (recall)
10-66

## Monopoly Revenue and Costs

Cost Data

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

10-67

## Price, Costs, and Revenue

\$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

## Not the highest price

The monopolist seeks maximum total profit, not
maximum price.

## Total, not unit, profit

The monopolist seeks maximum total profit, not
maximum unit profit.

Possibility of losses
10-69

## Price, Costs, and Revenue

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

## Pure competition is efficient

Monopoly is inefficient
10-71

Economic Effects
Pure competition is efficient
Productive efficiency
Allocative efficiency
CS+PS maximized

Monopoly is inefficient
Charge P>MC

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

## Rent seeking behavior

More likely with monopoly?
10-73

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

## Fair return price

P = ATC
10-77

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
Nonprice Competition

Which industries?
Degree of concentration
Four-firm concentration ratio
Herfindahl index
11-81

Monopolistic Competition
Firms demand curve
Highly elastic

## Short run profit or loss

Produce where MR=MC

## Long run normal profit

Entry and exit

Inefficient
Product variety
11-82

Monopolistic Competition
Short-Run Profits

## Price and Costs

MC

ATC

P1
A1

Economic
Profit

D1
MR = MC

MR
0

Q1

Quantity
11-83

Monopolistic Competition
Short-Run Losses

## Price and Costs

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

## Price and Costs

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
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

## RareAirs Price Strategy

Independently
lowered prices
in expectation
of greater profit
worst
combined
outcome
Eventually low
outcomes make
higher prices

## Uptowns Price Strategy

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

## Three Oligopoly Models

Kinked-demand curve
Collusive pricing
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

## Resulting in a kinked-demand curve

to the consumer price and output
are optimized at the kink
11-93

## Cartels and Other Collusion

Price and output
Joint profit maximization

## Price and Costs

MC

Effectively Sharing
The Monopoly Profit

P0

ATC

A0
MR=MC

Economic
Profit

MR
Q0

Quantity
11-94

## Cartels and Other Collusion

Covert collusion
Tacit understandings

(gentlemans agreement)

Obstacles to collusion
Demand and cost differences
Number of firms
Cheating
Recession
Potential entry
Legal obstacles: antitrust law
11-95

Infrequent price changes
Communications
Limit pricing
Price wars

11-96

Prevalent in monopolistic
competition and oligopoly
Capture market share
Better than a price cut
Information for consumers
Manipulation
11-97

## Oligopoly and Efficiency

Not productively efficient
Not allocatively efficient
Tendency to share the monopoly
profit
Qualifications
Increased foreign competition
Limit pricing
11-98

MICROECONOMICS OF
PRODUCT MARKETS
Technology, R&D, and Efficiency

Occurs in the very long run

## Occurs in response to incentives

Arises from firm rivalry

## Firms seek new profit

opportunities

11W-100

Invention-Innovation-Diffusion
Three step process
Invention
Patent

Innovation
Product innovation
Process innovation

Diffusion
Requires R&D expenditure
11W-101

## Marginal benefit and marginal cost

Sources of funds
Bank loans
Bonds
Retained earnings
Venture capital
Personal savings

## Interest-rate cost of funds

Expected-rate-of-return
11W-102

## Firms Optimal R&D Amount

Interest
Expected
Rate
R&D
rate of
cost of
return, % millions funds, %

\$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

## Research and Development

Expenditures (Millions of Dollars)
11W-103

## Firms Optimal R&D Amount

Three important points
Optimal vs. affordable R&D

## Expected, not guaranteed,

returns

11W-104

Increased Profits
Increased revenue via product
innovation
Importance of price
Unsuccessful new products
Product improvements

innovation
11W-105

## Imitation and R&D Incentives

Imitation problem
Fast-second strategy
Benefits of being first
Patents
Brand-name recognition
doing
Time lags

11W-106

## Role of Market Structure

Which type of market structure
is best suited to technological
Pure competition
Monopolistic competition
Oligopoly
Pure monopoly
11W-107

Inverted-U Theory
Less Competition

R&D Expenditures as a
Percentage of Sales

More Competition

25

50

75

100

## A loose oligopoly supports

the optimum R&D spending

11W-108