FIGURES © Richard B. McKenzie and Dwight E. Lee 2006 www.cambridge.org/mckenzie Figure 2.1 Market demand for tomatoes Demand, the assumed inverse relationship between price and quantity purchased, can be represented by a curve that slopes down toward the right. Here, as the price falls from $11 to zero, the number of bushels of tomatoes purchased per week rises from zero to 110,000. Figure 2.2 Shifts in the demand curve An increase in demand is represented by a rightward, outward, shift in the demand curve, from D1to D2. A decrease in demand is represented by a leftward, or inward, shift in the demand curve, from D1 to D3. Figure 2.3 Supply of tomatoes Supply, the assumed relationship between price and quantity produced, can be represented by a curve that slopes up toward the right. Here, as the price rises from zero to $11, the number of bushels of tomatoes offered for sale during the course of a week rises from zero to 110,000. Figure 2.4 Shifts in the supply curve A rightward, or outward, shift in the supply curve, from S1 to S2, represents an increase in supply. A leftward, or inward, shift in the supply curve, from S1 to S3, represents a decrease in supply. Figure 2.5 Market surplus If a price is higher than the intersection of the supply and demand curves, a market surplus – a greater quantity supplied, Q3, than demanded, Q1 – results. Competitive pressure will push the price down to the equilibrium price P1, the price at which the quantity supplied equals the quantity demanded (Q2). Figure 2.6 Market shortages A price that is below the intersection of the supply and demand curves will create a shortage – a greater quantity demanded, Q3, than supplied, Q1. Competitive pressure will push the price up to the equilibrium price P2, the price at which the quantity supplied equals the quantity demanded (Q2). Figure 2.7 The effects of changes in supply and demand An increase in demand – panel (a) – raises both the equilibrium price and the equilibrium quantity. A decrease in demand – panel (b) – has the opposite effect: a decrease in the equilibrium price and quantity. An increase in supply – panel (c) – causes the equilibrium quantity to rise but the equilibrium price to fall. A decrease in supply – panel (d) – has the opposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity. Figure 2.8 Price ceilings and floors A price ceiling Pc – panel (a) – will create a market shortage equal to Q2 – Q1. A price floor Pf – panel (b) – will create a market surplus equal to Q2 – Q1. Figure 2.9 The efficiency of the competitive market Only those price–quantity combinations on or below the demand curve – panel (a) – are acceptable to buyers. Only those price–quantity combinations on or above the supply curve – panel (b) – are acceptable to producers. Those price–quantity combinations that are acceptable to both buyers and producers are shown in the darkest shaded area of panel (c). The competitive market is “efficient” in the sense that it results in output Q1, the maximum output level acceptable to both buyers and producers. Figure 2.10 Consumer preference in television size Consumers differ in their wants, but most desire a medium-sized television. Only a few want a very small or a large television. Figure 2.11 Long-run market for calculators With supply and demand for calculators at D1 and S1, the short-run equilibrium price and quantity will be P2 and Q1. As existing firms expand production and new firms enter the industry, the supply curve shifts to S2. Simultaneously, an increase in consumer awareness of the product shifts the demand curve to D2. The resulting long-run equilibrium price and quantity are P1 and Q2, respectively. Figure 2.12 Prices in the long run If demand increases more than supply, the price will rise along with the quantity sold – panel (a). If supply keeps up with demand, however, the price will remain the same even though the quantity sold increases – panel (b). Figure 2.13 Twisted pay scale The worker expects his productivity to rise along line A with years of service. If she starts work with less pay than she could earn elsewhere, then her career pay path could follow line B, representing greater increases in pay with time and greater productivity. Figure 3.1 Constrained choice With a given amount of time and other resources, you can produce any combination of study and games along the curve E1 G1. The particular combination you choose will depend on your personal preferences for those two goods. You will not choose point x, because it represents less than you are capable of achieving – and, as a rational person, you will strive to maximize your utility. Because of constraints on your time and resources, you cannot achieve a point above E1 G1. Figure 3.2 Change in constraints If your study skills improve and your ability at the game remains constant, your production possibilities curve will shift from E1G1 to E2G1. Both the number of chapters you can study and the number of games you can play will increase. On your old curve, E1G1, you could study two chapters and play four games (point a). On your new curve E2G1, you can study three chapters and play five games (point b). Figure 3.3 Policy trade-offs of a negative income tax With a guaranteed income of SI1($5,000) and a break-even earned income level of EI1($10,000), the implicit marginal tax rate on the poor is 50 percent. If policy makers attempt to reduce the implicit tax rate by raising the break-even income level, however, the government’s poverty relief budget will rise by the shaded area SI1ab. A higher explicit tax burden will fall on a smaller group of taxpaying workers. Figure 3.4 Maslow’s hierarchy of needs The pyramid orders human needs by broad categories from the most prepotent needs on the bottom to lesser and lesser prepotent needs as an individual moves up the pyramid. According to Maslow, an individual can be expected to satisfy her needs in the order of their prepotence, or will move from the bottom of the pyramid through the various levels to the top, so long as the individual’s resources to satisfy her needs last. Figure 3.5(a) Demand, price, and need satisfaction The extent to which needs are satisfied depends, in the economists’ view of the world, on the nature of the need’s demand and its price. Physiological needs may indeed be more completely satisfied than other needs, but that may only be because physiological needs have relatively low prices (panel (a)). But then, as shown in this figure (panel (b)), the price of the means of satisfying physiological needs might be higher than the prices of the means of satisfying safety and love needs. Figure 3.5(b) Figure 5.1 The economic effect of an excise tax An excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2. The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase, $0.20, however, will not cover the added cost to the producer, $0.25. Figure 5.2 The effect of an excise tax when demand is more elastic than supply If demand is much more elastic than supply, the quantity purchased declines significantly when supply decreases from S1 to S2 in response to the added cost of the excise tax. Producers will lose $0.20; consumers will pay only $0.05 more. Figure 5.3 The effect of price controls on supply If the supply of gasoline is reduced from S1 to S2, but the price is controlled at P1, a shortage equal to the difference between Q1 and Q2 will emerge. Figure 5.4 The effect of rationing on demand Price controls can create a shortage. For instance, at the controlled price P1, a shortage of Q2 - Q1 gallons will develop. By issuing a limited number of coupons that must be used to purchase a product, the government can reduce demand and eliminate the shortage. Here, rationing reduces demand from D1 to D2, where demand intersects the supply curve at the controlled price. Figure 5.5 The conventional view of the impact of the minimum wage When the minimum wage is set at Wm (and the market clearing wage is Wo), employment will fall from Q2 to Q1; simultaneously, the number of workers who are willing to work in this labor market will expand from Q2 to Q3. The market surplus is then Q3 - Q1. Figure 5.6 An unconventional view of the impact of the minimum wage When the minimum wage is raised to Wm, a surplus is created equal to Q3 - Q1. As a consequence, employers can be expected to respond to the surplus by reducing fringe benefits or increasing work demands on workers. The supply curve of labor contracts, reflecting the greater wage the workers will demand to compensate for the reduction in fringe benefits or increase in work demands. The employers’ demand for labor increases, reflecting the higher wage they are willing to pay workers in terms of money wages who get fewer fringe benefits or work harder and produce more. Figure 5.7 Marginal benefit versus marginal cost The demand curve reflects the marginal benefits of each loaf of bread produced. The supply curve reflects the marginal cost of producing each loaf. For each loaf of bread up to Q1, the marginal benefits exceed the marginal cost. The shaded area shows the maximum welfare that can be gained from the production of bread. When the market is at equilibrium (when supply equals demand), all those benefits will be realized. Figure 5.8 External costs Ignoring the external costs associated with the manufacture of paper products, firms will base their production and pricing decisions on the supply curve S1. If they consider external costs, such as the cost of pollution, they will operate on the basis of the supply curve S2, producing Q1 instead of Q2 units. The shaded area abc shows the amount by which the marginal cost of production of Q2 – Q1 units exceeds the marginal benefits to consumers. It indicates the inefficiency of the private market when external costs are not borne by producers. Figure 5.9 External benefits Ignoring the external benefits of getting flu shots, consumers will base their purchases on the demand curve D1 instead of D2. Fewer shots will be purchased than could be justified economically – Q1 instead of Q2. Because the marginal benefit of each shot between Q1 and Q2 (as shown by demand curve D2) exceeds its marginal cost of production, external benefits are not being realized. The shaded area abc indicates market inefficiency. Figure 5.10 Is government action justified? Because of external costs, the market illustrated produces more than the efficient output. Market inefficiency, represented by the shaded triangular area abc, is quite small – so small that government intervention may not be justified on economic grounds alone. Figure 5.11 Market for pollution rights Reducing pollution is costly (see table 5.1). It adds to the costs of production, increasing product prices and reducing the quantities of products demanded. Therefore firms have a demand for the right to avoid pollution abatement costs. The lower the price of such rights, the greater the quantity of rights that firms will demand. If the government fixes the supply of pollution rights at ten and sells those ten rights to the highest bidder, the price of the rights will settle at the intersection of the supply and demand curves – here, about $1,500. Figure 6.1 External and internal coordinating costs As the firm expands, the internal coordinating costs increase as the external coordinating costs fall. The optimum firm size is determined by summing these two cost structures, which is done in panel (b) of the figure. Figure 6.A1 Fringe benefits and the labor market If fringe benefits are more valuable to workers and impose a cost on the employers, the supply of labor will increase from S1 to S2 while the demand curve falls from D1 to D2. The wage rate falls from W1 to W2, but the workers get fringe benefits that have a value of ac, which means that their overall payment goes up from W1 to W3. Figure 7.1 The law of demand Price varies inversely with the quantity consumed, producing a downward sloping curve such as this one. If the price of Coke falls from $1 to $0.75, the consumer will buy three Cokes instead of two. Figure 7.2 Market demand curve The market demand curve for Coke, DA+B, is obtained by summing the quantities that individuals A and B are willing to buy at each and every price (shown by the individual demand curves DA and DB). Figure 7.3 Elastic and inelastic demand Demand curves differ in their relative elasticity. Curve D1 is more elastic than curve D2, in the sense that consumers on curve D1 are more responsive to a given price change (P2 to P1) than are consumers on curve D2. Figure 7.4 Changes in the elasticity coefficient The elasticity coefficient decreases as a firm moves down the demand curve. The upper half of a linear demand curve is elastic, meaning that the elasticity coefficient is greater than one. The lower half is inelastic, meaning that the elasticity coefficient is less than one. This means that the middle of the linear demand curve has an elasticity coefficient equal to one. Figure 7.5 Perfectly elastic demand A firm that has many competitors may lose all its sales if it increases its price even slightly. Its customers can simply move to another producer. In that case, its demand curve is horizontal, with an elasticity coefficient of infinity. Figure 7.6 Increase in demand When consumer demand for low-rise pants increases, the demand curve shifts from D1 to D2. Consumers are now willing to buy a larger quantity of low-rise pants at the same price, or the same quantity at a higher price. At price P1, for instance, they will buy Q3 instead of Q2. And they are now willing to pay P2 for Q2 low-rise pants, whereas before they would pay only P1. Figure 7.7 Decrease in demand A downward shift in demand, from D1 to D2, represents a decrease in the quantity of low-rise pants consumers are willing to buy at each and every price. It also indicates a decrease in the price they are willing to pay for each and every quantity of low-rise pants. At price P2, for instance, consumers will now buy only Q1 low-rise pants (not Q3, as before); and they will now pay only P2 for Q1 low-rise pants – not P3, as before. Figure 7.8 Network effects and demand As the price falls from P3 to P2, the quantity demanded in the short run rises from Q1 to Q2. However, sales build on sales, causing the demand in the future to expand outward to, say, D2. The lower the price in the current time period, the greater the expansion of demand in the future. The more the demand expands over time in response to greater sales in the current time period, the more elastic is the long-run demand. Figure 7.9 Choosing between housing and bundles of other goods The budget line in Six Mile is A1H1 with an income of $100,000. The budget line in La Jolla is A1H3 with the same income. If the employer were to offer the engineer a salary of $152,000, which covers the additional cost of housing, the engineer’s budget line would be the thin line cutting A1H1 at a. Hence, the engineer could choose combination b and be better off than in Six Mile. This means that the employer can offer the engineer less than $152,000. Figure 7A.1 Derivation of an indifference curve Because the consumer prefers more of a good to less, point a is preferable to point c, and point b is preferable to point a. If a is preferable to d but e is preferable to a, then when we move from point d to e, we must move from a combination that is less preferred to the one that is more preferred. In doing so, we must cross a point – for example, f – that is equal in value to a. Indifference curves are composed by connecting all those points – a, f, i, and so on – that are of equal value to the consumer. Figure 7A.2 Indifference curves for pens and books Any combination of pens and books that falls along curve I1 will yield the same level of utility as any other combination on that curve. The consumer is indifferent among them. By extension, any combination on curve I2 will be preferable to any combination on curve I1. Figure 7A.3 The budget line and consumer equilibrium Constrained by her budget, the consumer will seek to maximize her utility by consuming at the point where her budget line is tangent to an indifference curve. Here the consumer chooses point a, where her budget line just touches indifference curve I1. All other combinations on the consumer’s budget line will fall on a lower indifference curve, providing less utility. Point c, for instance, falls on indifference curve I2. Figure 7A.4 Effect of a change in price on consumer equilibrium If the price of pens falls, the consumer’s budget line will pivot outward, from B1P1 to B1P2. As a result, the consumers can move to a higher indifference curve, I2 instead of I1. At the new price, the consumer buys more pens, twenty-two packs as opposed to fifteen. Figure 7A.5 Derivation of the demand curve for pens When the price of pens changes, shifting the consumer’s budget line from B1P1 to B1P2 in figure 7A.4, the consumer equilibrium point changes with it, from a to c. The consumer’s demand curve for pens is obtained by plotting her equilibrium quantity of pens at various prices. At $5 a pack, the consumer buys fifteen packs of pens (point a). At $3 a pack, she buys twenty-two packages (point c). Figure 7A.6 Budget line: cash grants vs. education subsidies If the price of education is reduced by an in-kind subsidy, a family’s budget line will pivot from H3E3 to H3E5. The family will move from point a to point b, where it can consume more food and housing. If the family is given the same subsidy in cash, its budget line will move from H3E3 to H4E4. Because the relative price of housing is lower on H4E4 than on H3E5, the family will choose a point such as d over b. Because b was the family’s preferred point on H3E5, but it prefers d to b on H4E4 which allows the purchase of b, we must presume that it also prefers cash to a food subsidy. Figure 7B.1 Upward sloping demand? A good might have an upward sloping range, as described in panel (a), given that a price increase might convey greater value to consumers. However, there must be some higher price that will cause sales to contract, since many consumers will no longer be able to buy the good. This means that the demand curve must go beyond some price, P3 in panel (b), must bend backwards and, thus, must have a downward sloping range. The downward sloping range of the curve in panel (b) is the relevant range. If the seller is at combination b, then there is some combination such as d in the downward sloping range of the entire demand curve that is more profitable than combination b. Figure 7B.2 Demand including irrational behavior If irrational consumers demand Q1 cigarettes no matter what the price, but rational consumers take price into consideration, market demand will be D1. The quantity purchased will still vary inversely with the price. Figure 7B.3 Random behavior, budget lines, and downward sloping demand curves If a number of buyers are faced initially with budget line A1B1 and behave randomly, they will buy an average quantity of A2B2. If the price of A increases while the price of B decreases, the budget line pivots on a, causing buyers to purchase on average more of B (B4) and less of A (A4). Thus, quantity changes in the direction predicted by the law of demand (in spite of the absence of rational behavior). Figure 7B.4 Random behavior and the demand curve as a “band” If buyers randomly purchase anywhere from Q1 to Q2 when the price is P1 and anywhere from Q2 to Q3 when the price is P2, then they will tend to increase their average quantity purchased from Q4 to Q5 when the price falls from P1 to P2. Figure 8.1 Rising marginal cost To produce each new watercolor, Jan must give up an opportunity more valuable than the last. Thus the marginal cost of her paintings rises with each new work. Figure 8.2 The law of diminishing marginal returns As production expands with the addition of new workers, efficiencies of specialization initially cause marginal cost to fall. At some point, however – here, just beyond two bushels – marginal cost will begin to rise again. At that point, marginal returns will begin to diminish and marginal costs will begin to rise. Figure 8.3 Costs and benefits of fishing For each fish up to the fifth one, Gary receives more in benefits than he pays in costs. The first fish gives him $4.67 in benefits (point a) and costs him only $1 (point b). The fifth yields equal costs and benefits (point c), but the sixth costs more than it is worth. Therefore Gary will catch no more than five fish. Figure 8.4 Accident prevention Given the increasing marginal cost of preventing accidents and the decreasing marginal value of preventing the accidents, c or 5 accidents will be prevented. Figure 8.5 Total, average, and marginal product curves The total product curve shows how output changes when the amount of the variable input, labor, changes. Total product rises first at an increasing rate (0–five workers), then at a decreasing rate (five–fifteen workers), before declining (beyond fifteen workers). The marginal and average product curves reflect what is happening to total product. Marginal product rises when total product is rising at an increasing rate and falls when total product is rising at a decreasing rate. Marginal product is positive when total product is rising and negative when total product is falling. Figure 8.6 Marginal costs and maximization of profit At price P1 (panel (a)), this firm’s marginal revenue, represented by the area under P1 up to Q1, exceeds its marginal cost up to the output level of Q1. At that point total profit, shown in panel (b), peaks (point a). At price P2, marginal revenue exceeds marginal cost up to an output level of Q2. The increase in price shifts the profit curve in panel (b) upward, from TP1 to TP2, and profits peak at b. Figure 8.7 Market supply curve The market supply curve (SA+B) is obtained by adding together the amount producers A and B are willing to offer at each and every price, as shown by the individual supply curves SA and SB. (The individual supply curves are obtained from the upward sloping portions of the firms’ marginal cost curve.) Figure 9.1 Total fixed costs, total variable costs, and total costs in the short run Total fixed cost does not vary with production; therefore, it is drawn as a horizontal line. Total variable cost does rise with production. Here it is represented by the shaded area between the total cost and total fixed cost curves. Figure 9.2 Marginal and average costs in the short run The average fixed cost curve (AFC) slopes downward and approaches, but never touches, the horizontal axis. The average variable cost curve (AVC) and the total variable cost curve are mathematically related to the marginal cost curve and both intersect with the marginal cost curve (MC) at its lowest point. The vertical distance between the average total cost curve (ATC) and the average variable cost curve equals the average fixed cost at any given output level. There is no relationship between the MC and AFC curves. Figure 9.3 Economies of scale Economies of scale are cost savings associated with the expanded use of resources. To realize such savings, however, a firm must expand its output. Here the firm can lower its costs by expanding production from q1 to q2 – a scale of operation that places it on a lower short-run average total cost curve (ATC2 instead of ATC1). Figure 9.4 Diseconomies of scale Diseconomies of scale may occur because of the communication problems of larger firms. Here the firm realizes economies of scale through its first short-run average total cost curves. The long-run average cost curve begins to turn up at an output level of q1, beyond which diseconomies of scale set in. Figure 9.5 Marginal and average cost in the long run The long-run marginal and average cost curves are mathematically related. The long-run average cost curve slopes downward as long as it is above the long-run marginal cost curve. The two curves intersect at the low point of the long-run average cost curve. Figure 9.6a Individual differences in long-run average cost curves The shape of the long-run average cost curve varies according to the extent and persistence of economies and diseconomies of scale. Firms in industries with few economies of scale will have a long-run average cost curve like the one in panel (a). Firms in industries with persistent economies of scale will have a long-run average cost curve like the one in panel (b), and firms in industries with extensive economies of scale may find that their long-run average cost curve slopes continually downward, as in panel (c). Figure 9.6b Figure 9.6c Figure 9.7 Shifts in average and marginal cost curves An increase in a firm’s variable cost (panel (a)) will shift the firm’s average total cost curve up, from ATC1 to ATC2. It will also shift the marginal cost curve, from MC1 to MC2. Production will fall because of the increase in marginal cost. By contrast, an increase in a firm’s fixed cost (panel (b)) will shift the average total cost curve upward from ATC1 to ATC2, but will not affect the marginal cost curve. (Marginal cost is unaffected by fixed cost.) Thus the firm’s level of production will not change. Figure 9A.1 Single isoquant A firm can produce 100 pairs of jeans a day using any of the various combinations of labor and machinery shown on this curve. Because of diminishing marginal returns, more and more machines must be substituted for each worker who is dropped. Figure 9A.2 Several isoquants Different output levels will have different isoquants. The higher the output level, the higher the isoquant. Figure 9A.3 Finding the most efficient combination of resources Assuming that the daily wage of each worker is $100, and the daily rental on each sewing machine is $20, an expenditure of $600 per day will buy any combination of resources on isocost curve IC1. The most cost-effective combination of labor and capital is point a, three workers and fifteen machines. At that point, the isocost curve is just tangent to isoquant IQ2, meaning that the firm can product 150 pairs of jeans a day. If the firm chooses any other combination, it will move to a lower isoquant and a lower output level. At point b (on isoquant IQ1), it will be able to produce only 100 pairs of jeans a day. Figure 9A.4 The effect of increased expenditures on resources An increase in the level of expenditures on resources shifts the isocost curve outward from IC1 to IC2. The firm’s most efficient combination of resources shifts from point a to point c. Figure 10.1 Demand curve faced by perfect competitors The market demand for a product (panel (a)) is always downward sloping. The perfect competitor is on a horizontal, or perfectly elastic, demand curve (panel (b)). It cannot raise its price above the market price even slightly without losing its customers to other producers. Figure 10.2 Demand curve faced by a monopolistic competitor Because the product sold by the monopolistically competitive firm is slightly different from the products sold by competing producers, the firm faces a highly elastic, but not perfectly elastic, demand curve. Figure 10.3 The perfect competitor’s production decision The perfect competitor’s price is determined by market supply and demand (panel (a)). As long as marginal revenue (MR), which equals market price, exceeds marginal cost (MC), the perfect competitor will expand production (panel (b)). The profit maximizing production level is the point at which marginal cost equals marginal revenue (price). Figure 10.4 Change in the perfect competitor’s market price If the market demand rises from D1 to D3 (panel (a)), the price will rise with it, from P1 to P3. As a result, the perfectly competitive firm’s demand curve will rise, from d1 to d3 (panel (b)). Figure 10.5 The profit maximizing perfect competitor The perfect competitor’s demand curve is established by the market clearing price (panel (a)). The profit maximizing perfect competitor will extend production up to the point at which marginal cost equals marginal revenue (price), or point a in panel (b). At that output level – q2 – the firm will earn a short-run economic profit equal to the shaded area ATC1P1 ab. If the perfect competitor were to minimize average total cost, it would produce only q1, losing profits equal to the darker shaded area dca in the process. Figure 10.6 The loss minimizing perfect competitor The market clearing price (panel (a)) establishes the perfect competitor’s demand curve (panel (b)). Because the price is below the average total cost curve, this firm is losing money. As long as the price is above the low point of the average variable cost curve, however, the firm should minimize its short-run losses by continuing to produce where marginal cost equals marginal revenue (price or point b in panel (b)). This perfect competitor should produce q1 units, incurring losses equal to the shaded area P1ATC1ab. (The alternative would be to shut down, in which case the firm would lose all its fixed costs.) Figure 10.7 The long-run effects of short-run profits If perfect competitors are making short-run profits, other producers will enter the market, increasing the market supply from S1 to S2 and lowering the market price from P2 to P1 (panel (a)). The individual firm’s demand curve, which is determined by market price, will shift down, from d1 to d2 (panel (b)). The firm will reduce its output from q2 to q1, the new intersection of marginal revenue (price) and marginal cost. Long-run equilibrium will be achieved when the price falls to the low point of the firm’s average total cost curve, eliminating economic profit (price P1 in panel (b)). Figure 10.8 The long-run effects of short-run losses If perfect competitors are suffering short-run losses, some firms will leave the industry, causing the market supply to shift back from S1 to S2 and the price to rise, from P1 to P2 (panel (a)). The individual firm’s demand curve will shift up with price, from d1 to d2 (panel (b)). The firm will expand from q1 to q2, and equilibrium will be reached when price equals the low point of average total cost P2, eliminating the firm’s short-run losses. Figure 10.9 The long-run effects of economies of scale If the market is in equilibrium at price P1 in panel (a) and the individual firm is producing q1 units on short-run average total cost curve ATC1 (panel (b)), firms will be just breaking even. Because of the profit potential represented by the shaded area ATC1P2ab, firms can be expected to expand production to q3, where the long-run marginal cost curve intersects the demand curve (d1). As they expand production to take advantage of economies of scale, however, supply will expand from S1 to S2 in panel (a), pushing the market price down toward P1, the low point of the long-run average total cost curve (LRATC in panel (b)). Economic profit will fall to zero. Because of rising diseconomies of scale, firms will not expand further. Figure 10.10 The efficiency of the competitive market Perfectly competitive markets are efficient in the sense that they equate marginal benefit (shown by the demand curve in panel (a)) with marginal cost (shown by the supply curve in panel (a). At the market output level, Q1, the marginal benefit of the last unit produced equals the marginal cost of production. The gains generated by the production of Q1 units – that is, the difference between cost and benefits – are shown by the shaded area in panel (a). The perfectly competitive market is also efficient in the sense that the marginal cost of production, P1, is the same for all firms (panels (b) and (c)). If firm X were to produce fewer than its efficient number of units, qx, firm Y would have to produce more than its efficient number, qy, to meet market demand. Firm Y would be pushed up its marginal cost curve, to the point at which the cost of the last unit would exceed its benefits. But competition forces the two firms to produce to exactly the point at which marginal cost equals marginal benefit, thus minimizing the cost of production. Figure 10.11 Supply and demand cobweb Markets do not always move smoothly toward equilibrium. If current production decisions are based on past prices, price may adjust to supply in the “cobweb pattern” shown here. Having received price P1 in the past, farmers will plan to supply only Q1 bushels of wheat. That amount will not meet market demand, so the price will rise to P4 – inducing farmers to plan for a harvest of Q3 bushels. At price P4, however, Q3 bushels will not clear the market. The price will fall to P2, encouraging farmers to cut production back to Q2. Only after several tries do many farmers find the equilibrium price–quantity combination. Figure 10A.1 A contestable market The market is composed of three firms, each producing output q*, which minimizes average costs. Total industry output is Q* = 3q*. Any attempt by the three firms to reduce output and increase market price will lead to entry by new firms and the dissipation of profits. Figure 11.1 The monopolist’s demand and marginal revenue curves The demand curve facing a monopolist slopes downward, for it is the same as market demand. The monopolist’s marginal revenue curve is constructed from the information contained in the demand curve (see table 11.1). Figure 11.2 Equating marginal cost with marginal revenue The monopolist will move toward production level Q2, the level at which marginal cost equals marginal revenue. At production levels below Q2, marginal revenue will exceed marginal cost; the monopolist will miss the chance to increase profits. At production levels greater than Q2, marginal cost will exceed marginal revenue; the monopolist will lose money on the extra units. Figure 11.3 The monopolist’s profits The profit maximizing monopoly will produce at the level defined by the intersection of the marginal cost and marginal revenue curves: Q1. It will charge a price of P1 – as high as market demand will bear – for that quantity. Because the average total cost of producing Q1 units is ATC1, the firm’s profit is the shaded area ATC1P1ab. Figure 11.4 The monopolist’s short-run Losses Not all monopolists make a profit. With a demand curve that lies below its average total cost curve, this monopoly will minimize its short-run losses by continuing to produce at the point where marginal cost equals marginal revenue (Q1 units). It will charge P1, a price that covers its fixed costs, and will sustain short-run losses equal to the shaded area P1ATC1ab. Figure 11.5 Monopolistic production over the long run In the long run, the monopolist will produce at the intersection of the marginal revenue and long-run marginal cost curves (panel (a)). In contrast to the perfect competitor, the monopolist does not have to minimize long-run average cost by expanding its scale of operation. It can make more profit by restricting production to Qa and charging price Pa. In panel (b), the monopolist produces at the low point of the long-run average cost curve only because that happens to be the point at which marginal cost and marginal revenue curves intersect. In panel (c), the monopolist produces on a scale beyond the low point of its long-run average cost curve because demand is high enough to justify the cost. In each case, the monopolist charges a price higher than its long-run marginal cost. Figure 11.6 The comparative efficiency of monopoly and competition Firms in a competitive market will tend to produce at point b, the intersection of the marginal cost and demand curves (with the price, or marginal benefit given by the height of the demand curve). Monopolists will tend to produce at point c, the intersection of marginal cost and marginal revenue, and to charge the highest price the market will bear: Pm. In a competitive market, therefore, the price will tend to be lower (Pc) and the quantity produced greater (Qc) than in a monopolistic market. The inefficiency of monopoly is shown by the shaded triangular area abc, the amount by which the benefits of producing Qc - Qm units (shown by the demand curve) exceed their marginal cost of production. Figure 11.7 The costs and benefits of expanded production If the monopolist expands production from Qm to Qc in panel (a), consumers will receive additional benefits equal to the area bounded by QmabQc. They will pay an amount equal to the area QmcdQc for those benefits, leaving a net benefit equal to the shaded area abdc. To expand production, the monopoly must incur additional production costs equal to the area QmcbQc in panel (b). It gains additional revenues equal to the area QmcdQc, leaving a net loss equal to the shaded area cbd. Thus, expanded production helps the consumer but hurts the monopolist. Figure 11.8 Price discrimination By offering customers one can of beans for $0.30, two cans for $0.55, and three cans for $0.75, a grocery store collects more revenues than if it offers three cans for $0.20 each. In either case, the consumer buys three cans. But by making the special offer, the store earns $0.15 more in revenues per customer. Figure 11.9 Perfect price discrimination The perfect price-discriminating monopolist will produce at the point where marginal cost and marginal revenue are equal (point a). Its output level, Qc is therefore the same as that achieved under perfect competition. But because the monopolist charges as much as the market will bear for each unit, its profits – the shaded area ATC1P1ab – are higher than the competitive firm’s. Figure 11.10 Imperfect price discrimination The monopolist that cannot perfectly price-discriminate may elect to charge a few different prices by segmenting its market. To do so, it divides its market by income, location, or some other factor and finds the demand and marginal revenue curves in each (panels (a) and (b)). Then it adds those marginal revenue curves horizontally to obtain its combined marginal revenue curve for all market segments, MRm (panel (c)). By equating marginal revenue with marginal cost, it selects its output level, Qm. Then it divides that quantity between the two market segments by equating the marginal cost of the last unit produced (panel (c)) with marginal revenue in each market (panels (a) and (b)). It sells Qa in market A and Qb in market B, and charges different prices in each segment. Generally, the price will be higher in the market segment with the less elastic demand (panel (b)). Figure 11.11 The effect of price controls on the monopolistic production decision In an unregulated market, a monopolistic utility will produce Qm kilowatts and sell them for Pm. If the firm’s price is controlled at P1, however, its marginal revenue curve will become horizontal at P1. The firm will produce Q1 – more than the amount it would normally produce. Figure 11.12 Taxing monopoly profits Theoretically, a tax on the economic profit of monopoly will not be passed on to the consumer – but taxes are levied on book profit, not economic profit. As a result, a tax shifts the first marginal cost curve up, from MC1 to MC2, raising the price to the consumer and lowering the production level. Figure 11A.1 Construction of the linear marginal revenue curve The marginal revenue curve always starts at the intersection of the vertical axis and any demand curve. However, for a linear demand curve, the marginal revenue curve must slope downward under the demand curve, splitting the horizontal distance between the vertical axis and every point on the demand curve. The marginal revenue curve must cut the horizontal axis at the point below the middle of the linear demand curve, or where the elasticity coefficient equals one. Figure 11A.2 Construction of the nonlinear marginal revenue curve The marginal revenue curve for a nonlinear demand curve is obtained by imagining linear demand curves tangent to every point on the nonlinear demand curve and finding the midpoint between the vertical axis and the imagined linear demand curves. Figure 12.1 Monopolistic competition in the short run As do all profit maximizing firms, the monopolistic competitor will equate marginal revenue with marginal cost. It will produce Qmc units and charge price Pmc, only slightly higher than the price under perfect competition. The monopolistic competitor makes a short-run economic profit equal to the area ATC1Pmcab. The inefficiency of its slightly restricted production level is represented by the shaded area. Figure 12.2 Monopolistic competition in the long run In the long run, firms seeking profits will enter the monopolistically competitive market, shifting the monopolistic competitor’s demand curve down from D1 to D2 and making it more elastic. Equilibrium will be achieved when the firm’s demand curve becomes tangent to the downward sloping portion of the firm’s long-run average cost curve Qm. At that point, price (shown by the demand curve) no longer exceeds average total cost; the firm is making zero economic profit. Unlike the perfect competitor, this firm is not producing at the minimum of the long-run average total cost curve Qm. In that sense, it is underproducing, by Qm - Qmc2 units. This underproduction is also reflected in the fact that the price is greater than the marginal revenue. Figure 12.3 The oligopolist as monopolist With fewer competitors than the monopolistic competitor deals with, the oligopolist faces a less elastic demand curve, Do. Each oligopolist can afford to produce significantly less (Qo) and to charge significantly more Po than the perfect competitor, who produces Qc, at a price of Pc. The shaded area representing inefficiency is larger than that of a monopolistic competitor. Figure 12.4 The oligopolist as price leader The dominant producer who acts as a price leader will attempt to undercut the market price established by small producers (panel (a)). At price P1 the small producers will supply the demand of the entire market, Q2. At a lower price – Pd or Pc – the market will demand more than the small producers can supply. In panel (b), the dominant firm determines its demand curve by plotting the quantity it can sell at each price in panel (a). Then it determines its profit maximizing output level, Qd, by equating marginal cost with marginal revenue. It charges the highest price the market will bear for that quantity, Pd, forcing the market price down to Pd in panel (a). The dominant producer sells Q3 – Q1 units, and the smaller producers supply the rest. Figure 12.5 A duopoly (two-member cartel) In an industry composed of two firms of equal size, firms may collude to restrict total output to Qm and sell at a price of Pm. Having established that price–quantity combination, however, each has an incentive to chisel on the collusive agreement by lowering the price slightly. For example, if one firm charges P1, it can take the entire market, increasing its sales from Q1 to Q2. If the other firm follows suit to protect its market share, each will get a lower price, and the cartel may collapse. Figure 12.6 Long-run marginal and average costs in a natural monopoly In a natural monopoly, long-run marginal cost and average costs decline continuously, over the relevant range of production, because of economies of scale. Although the long-run marginal and average cost curves may eventually turn upward because of diseconomies of scale, the firm’s market is not large enough to support production in that cost range. Figure 12.7 Creation of a natural monopoly Even with declining marginal costs, the firm with monopoly power will produce at the point where marginal cost equals marginal revenue, making Qm units and charging a price of Pm. Unless barriers to entry exist, however, other firms may enter the market, causing the price to fall toward P1 and the quantity produced to rise toward Q1. At that price– quantity combination, only one firm can survive – but without barriers to entry, that firm cannot afford to charge monopoly prices. At a price of P1, its total revenues just cover its total costs. Economic profit is zero. Figure 12.8 Underproduction by a natural monopoly A natural monopolist that cannot price discriminate will produce only Q1 megawatts – less than Q2, the efficient output level – and will charge a price of P1. If the firm tries to produce Q2, it will make losses equal to the shaded area, for its price (P2) will not cover its average cost (AC1). Figure 12.9 Regulation and increasing costs If a natural monopoly is compensated for the losses it incurs in operating at the efficient output level (the shaded area P1ATC1ba), it may monitor its costs less carefully. Its cost curves may shift up, from LRMC1 to LRMC2 and from LRAC1 to LRAC2. Regulators will then have to raise the price from P1 to P2, and production will fall from Q1 to Q2. The firm will still have to be subsidized (by an amount equal to the shaded area P2ATC2dc), and the consumer will be paying more for less. Figure 12.10 The effect of regulation on a cartelized industry The profit maximizing cartel will equilibrate at point a and produce only Qm units and sell at a price of Pm. In the sense that consumers want Qc units and are willing to pay more than the marginal cost of production for them, Qm is an inefficient production level. Under pure competition, the industry will produce at point b. Regulation can raise output and lower the price, ideally to Pc, thereby eliminating the dead-weight welfare loss that is equal to the shaded triangle abc and which results from monopolistic behavior. Figure 13.1 Shift in demand for labor The demand for labor, as with all other demand curves, slopes downward. An increase in the demand for labor will cause a rightward shift in the demand curve, from D1 to D2. A decrease will cause the leftward shift, to D3. Figure 13.2 Shift in the supply of labor The supply curve for labor slopes upward. An increase in the supply of labor will cause a rightward shift in the supply curve from S1 to S2. A decrease in the supply of labor will cause a leftward shift in the supply curve, from S1 to S3. Figure 13.3 Equilibrium in the labor market Given the supply and demand curves for labor S and D, the equilibrium wage will be W1 and the equilibrium quantity of labor hired Q2. If the wage rate rises to W2, a surplus of labor will develop, equal to the difference between Q3 and Q1. Figure 13.4 The effect of nonmonetary rewards on wage rates The supply of labor is greater for jobs offering nonmonetary benefits – S2 rather than S1. Given a constant demand for labor, the wage rate will be W2 for workers who do not receive nonmonetary benefits and W1 for workers who do. Even though wages are lower when nonmonetary benefits are offered, workers are still better off; they earn a total wage equal, according to their own values, to W3. Figure 13.5 The effect of differences in supply and demand on wage rates In competitive labor markets, higher demand for labor (D2 in panel (a)) will bring a higher wage rate. A higher supply of labor (S2 in panel (b)) will bring a lower wage rate. Figure 13.6 The competitive labor market In a competitive market, the equilibrium wage rate will be W2. Lower wage rates, such as W1, would create a shortage of labor, and employers would compete for the available laborers by offering a higher wage. In pushing up the wage rate to the equilibrium level, employers impose costs on one another. They must pay higher wages not only to new employees but also to all current employees, in order to keep them. Figure 13.7 The marginal cost of labor The marginal cost of hiring additional workers is greater than the wages that must be paid to the new workers. Therefore the marginal cost of labor curve lies above the labor supply curve. Figure 13.8 The monopsonist The monopsonist will hire up to the point at which the marginal value of the last worker, shown by the demand curve for labor, equals his or her marginal cost. For this monopsonistic employer, the optimum number of workers is Q2. The monopsonist must pay only W1 for that number of workers – less than the competitive wage level, W2. Figure 13.9 The employer cartel To achieve the same results as a monopsonist, the employer cartel will devise restrictive employment rules that artificially reduce market demand to D2. The reduced demand allows cartel members to hire only Q2 workers at wage W1 – significantly less than the competitive wage, W2. Figure 13.10 Menu of two-part pay packages By varying the base salary and the commission rate, employers can get salespeople to reveal more accurately the sales potential of their districts. A salesperson who believes that the sales potential of his district is great will take the income path that starts at a base salary of S3. The salesperson who doesn’t think the sales potential of his district is very good will choose the income path that starts at S1. Figure 14.1 The political spectrum A political candidate who takes a position in the “wings” of a voter distribution, such as D1 or R1, will win fewer votes than a candidate who moves toward the middle of the distribution. In a two-party election, therefore, both candidates will take middle-of-the-road positions, such as D and R. Figure 14.2 Bureaucratic profit maximization Given the demand for police service, D, and the marginal cost of providing it, MC, the optimum quantity of police service is Q2. A monopolistic police department interested in maximizing its profits will supply only Q1 service at a price of P2, however. (A monopolistic bureaucracy interested in maximizing its size would expand police service to Q3.) Figure 15.1 Gains from the export trade Opening up foreign markets to US producers increases the demand for their products, from D1 to D2. As a result, domestic producers can raise their price from P1 to P2 and sell a larger quantity, Q3 instead of Q2. Revenues increase by the shaded area P2bQ3Q2aP1. The more price-elastic or flatter the supply function (S), the larger the change in quantity and the smaller the change in price. Figure 15.2 Losses from competition with imported products Opening up the market to foreign trade increases the supply of textiles from S1 to S2. As a result, the price of textiles falls from P2 to P1, and domestic producers sell a lower quantity, Q1 instead of Q2. Consumers benefit from the lower price and the higher quantity of textiles they are able to buy, but domestic producers, workers, and suppliers lose. Producers’ revenues drop by an amount equal to the shaded area P2aQ2Q1bP1. Workers’ and suppliers’ payments drop by an amount equal to the shaded area Q2abQ1. Starting at point c, a tariff or tax equal to ad is levied, shifting the supply curve from S2 to S1. In an industry whose costs are increasing, the increase in price from P1 to P2 in the importing country is less than the increase in the tariff (ad), because a price fall in the exporting country absorbs some of the burden of the duty. Figure 15.3 Effects of tariff protection on individual industries: case 1 If neither the textiles nor the automobile industry obtains tariff protection, the economy will earn its highest possible collective income (cell I), but each industry has an incentive to obtain tariff protection for itself. If the textiles industry alone seeks protection (cell II), its income will rise while the auto industry’s income falls. If the auto industry alone seeks protection, its income will rise while that of the textiles industry falls. If both obtain protection, the economy will end up in cell IV, its worst possible position. Income in both sectors will fall. Figure 15.4 Effects of tariff protection on individual industries: Case 2 In this case, the auto industry gains from tariff protection, even if both sectors are protected (cell IV). The textiles industry’s income falls from $20 (cell I) to $17 (cell IV), but the auto industry’s income rises from $30 (cell I) to $31 (cell IV). Thus the auto industry has no incentive to agree to the elimination of tariffs. Figure 15.5 Supply and demand for euros on the international currency market The international exchange rate between the dollar and the euro is determined by the forces of supply and demand, with the equilibrium at E. If the exchange rate is below equilibrium, say at ER1, the quantity of euros demanded, shown by the demand curve, will exceed the quantity supplied, shown by the supply curve. Competitive pressure will push the exchange rate up. If the exchange rate is above equilibrium, say, ER3, the quantity supplied will exceed the quantity demanded and competitive pressure will push the exchange rate down. Thus the price of a foreign currency is determined in much the same way as the price of any other commodity. Figure 15.6 Effect of an increase in demand for euros An increase in the demand for euros will shift the demand curve from D1 to D2, pushing the equilibrium from E1 to E2. At the initial equilibrium exchange rate ER1, a shortage will develop. Competition among buyers will push the exchange rate up to the new equilibrium level, ER2.