Example 185 Crawfish Fishing In Louisiana

In recent years, crawfish has become a popular restaurant item. In 1950, for example, the annual crawfish harvest in the Atchafalaya river basin in Louisiana was just over 1 million pounds. By 1990 it had grown to nearly 30 million pounds. Because most crawfish grow in ponds to which fishermen have unlimited access, a common property resource problem has arisen-too many crawfish have been trapped, causing the crawfish population to fall far below the efficient level. How serious is the problem...

Cost Minimization with Varying Output Levels

In the previous section we saw how a cost-minimizing firm selects a combination of inputs to produce a given level of output. Now we extend this analysis to see how the firm's costs depend on its output level. To do this we determine the firm's cost-minimizing input quantities for each output level, and then calculate the resulting cost. The cost-minimization exercise yields a result such as that shown in Figure 7.5. Each of the points A, B, C, D, and E represents a tangency between an isocost...

Utility and Satisfaction

Utility is the level of satisfaction that a person gets from consuming a good or undertaking an activity. Utility has an important psychological component because people obtain utility by getting things that give them pleasure and by avoiding things that give them pain. In economic analysis, however, utility is most often used to summarize the preference ranking of market baskets. If buying three books makes a person happier than the purchase of one shirt, then we say that the books give that...

Exercises

Assume a computer firm's marginal costs of production are constant at 1000 per computer. However, the fixed costs of production are equal to 10,000. a. Calculate the firm's average variable cost and average total cost curves. b. If the firm wanted to minimize the average total cost of production, would it choose to be very large or very small Explain. 2. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the worker's service is zero. Is this true Discuss. 3. a....

Example 31 Designing New Automobiles

If you were an automobile company executive, how would you decide when to introduce new models and how much money to invest in restyling You would probably know that two of the most important attributes of a car are its styling (e.g., design and interior features) and its performance (e.g., gas mileage and handling). Both styling and performance are desirable attributes the better the styling and the better the performance, the greater will be the demand for a car. However, it costs money to...

Capturing Consumer Surplus

All the pricing strategies that we will examine have one thing in common they are ways of capturing consumer surplus and transferring it to the producer. You can see this more clearly in Figure 11.1. Suppose the firm sold all its output at a single price. To maximize profit, it would pick a price P* and corresponding output Q* at the intersection of its marginal cost and marginal revenue curves. The firm would then be profitable, but its managers might wonder if they could make it even more...

Price Discrimination

Price discrimination can take three broad forms, which we call first, second-and third-degree price discrimination. We will examine them in turn. Ideally, a firm would like to charge a different price to each of its customers. If it could,it would charge each customer the maximum price that customer is willing to pay for each unit bought. We call this maximum price the customer's reservation price. The practice of charging each customer his or her reservation price is called perfect...

Transfer Pricing with a Noncompetitive Outside Market

Now suppose there is an outside market for the output of the upstream division, but that market is not competitive-the firm has monopoly power. The same principles apply, but we must be careful when measuring net marginal revenue. Suppose the engine produced by the upstream Engine Division is a special one that only Race Car Motors can make. There is an outside market for this engine, however, so Race Car Motors can be a monopoly supplier to that market and can also produce engines for its own...

Demand for a Factor Input When Only One Input Is Variable

Demand curves for factors of production are downward sloping, just like demand curves for the final goods that result from the production process. Unlike consumers' demands for goods and services, however, factor demands are derived demands-they depend on, and are derived from, the firm's level of output and the costs of inputs. For example, the demand of Microsoft Corporation for computer programmers is a derived demand that depends not only on the current salaries of programmers, but also on...

Summary

The theory of consumer choice is built on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services. 2. Consumer choice has two related parts the study of the consumer's preferences, and the analysis of the budget line, which constrains the choices a person can make. 3. Consumers make choices by comparing market baskets or bundles of commodities. Their preferences are assumed to be...

Questions for Review

How is an individual demand curve different from a market demand curve Which curve is likely to be more price elastic (Hint Assume that there are no network externalities.) 2. Is the demand for a particular brand of product, such as Head skis, likely to be more price elastic or price inelastic than the demand for the aggregate of all brands, such as downhill skis Explain. 3. Tickets to a rock concert sell for 10. But at that price, the demand is substantially greater than the available number...

Markets with Asymmetric Information

For most of this book, we have assumed that consumers and producers have complete information about the economic variables that are relevant for the choices they face. Now we will see what happens when some parties know more than others-i.e., when there is asymmetric information. Asymmetric information is characteristic of many business situations. Frequently, a seller of a product knows more about its quality than the buyer does. Workers usually know their own skills and abilities better than...

Investment Decisions by Consumers

We have seen how firms value future cash flows and thereby decide whether to invest in long-lived capital. Consumers face similar decisions when they purchase a durable good, such as a car or major appliance. Unlike the decision to purchase food, entertainment, or clothing, buying a durable good involves comparing a flow offuture benefits with the current purchase cost. Suppose you are deciding whether to buy a new car. If you keep the car for six or seven years, most of the benefits (and costs...

The Analysis of Competitive Markets

In Chapter 2 we saw how supply and demand curves can help us describe and understand the behavior of competitive markets. In Chapters 3 to 8, we saw how these curves are derived and what determines their shapes. With this foundation, we return to supply-demand analysis and show how it can be applied to a wide variety of economic problems-problems that might concern a consumer faced with a purchasing decision, a firm faced with a long-range planning problem, or a government agency that has to...

The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) measures the risk premium for a capital investment by comparing the expected return on that investment with the expected return on the entire stock market. To understand the model, suppose, first, that you invest in the entire stock market (say, through a mutual fund). Then your investment would be completely diversified, and you would bear no diversifiable risk. You would, however, bear nondiversifiable risk because the stock market tends to move with the...

Choosing Inputs

Suppose we wish to produce output level Q . How can we do this at minimum cost Look at the firm's production isoquant, labeled Qi, in Figure 7.2. The problem is to choose the point on this isoquant that minimizes total costs. Figure 7.2 illustrates the solution to this problem. Suppose the firm were to spend Co on inputs. Unfortunately, no combination of inputs can be purchased for expenditure Co that will allow the firm to achieve output Qu Output Qi can be achieved with the expenditure of C2,...

Describing Risk

To describe risk quantitatively, we need to know all the possible outcomes of a particular action and the likelihood that each outcome will occur.1 Suppose, for example, that you are considering investing in a company that is exploring for offshore oil. If the exploration effort is successful, the company's stock will increase from 30 to 40 a share if not, it will fall to 20 a share. Thus, there are two possible future outcomes, a 40 per share price and a 20 per share price. Probability refers...

Chapter

The average product of labor, AP, is equal to Q L. The marginal product of labor, MP, is equraal to AQ AL. The relevant calculations are given in the following table. b. This production process exhibits diminishing returns to labor, which is characteristic of all production functions with one fixed input. Each additional unit of labor yields a smaller increase in output than the last unit of labor. c. Labor's negative marginal product can arise from congestion in the chair manufacturer's...

Income and Substitution Effects

A fall in the price of a good has two effects. First, consumers enjoy an increase in real purchasing power they are better off because they can buy the same amount of the good for less money and thus have money left over for additional purchases. Second, they will tend to consume more of the good that has become cheaper, and less of those goods that are now relatively more expensive. These two effects normally occur simultaneously, but it will be useful to distinguish between them in our...

The Inflexibility of Short Run Production

Recall that in the long run all inputs to the firm are variable, because its planning horizon is long enough to allow for a change in plant size. This added flexibility allows the firm to produce at a lower average cost than in the short run. To see why, we might compare the situation in which capital and labor are both flexible to the case in which capital is fixed in the short run. Figure 7.6 shows the firm's production isoquants. Suppose capital is fixed at a level K in the short run. To...

Titanium Dioxide Industry

Titanium dioxide is a whitener used in paints, paper, and other products. In the early 1970s, Du Pont and National Lead each accounted for about a third of U.S. titanium dioxide sales another seven firms produced the remainder. In 1972, Du Font was weighing whether to expand its capacity. The industry was changing, and with the right strategy, those changes might enable Du Font to capture more of the market and dominate the industry 22 21 Aid to Airbus Called Unfair in U.S. Study,New York...

Strategic Trade Policy and International Competition

We have seen how a preemptive investment can give a firm an advantage by creating a credible threat to potential competitors. In some situations a preemptive investment-subsidized or otherwise encouraged by the government-can give a country an advantage in international markets, and be an important instrument of trade policy. Does this conflict with what you have learned about the benefits of free trade In Chapter 9, for example,we saw how trade restrictions such as tariffs or quotas lead to...

Price Supports and Production Quotas

Besides imposing a minimum price, the government can increase the price of a good in other ways. Much of American agricultural policy is based on a system of price supports, often combined with incentives to reduce or restrict production. In this section we examine how these policies work and their impact on consumers, producers, and the federal budget. 6 Source Department of Commerce, U.S. Statistical Abstract, 1986, 1989, 1992. 7The benefit to consumers was somewhat smaller than this because...

Public Goods

We have seen that externalities, including common property resources, create market inefficiencies that sometimes warrant government regulation. When, if ever, should governments replace private firms as the producer of goods and services In this section we describe a set of conditions under which the private market either may not provide a good at all or may not price it properly once it is available. Public goods have two characteristics They are nonrival and nonexclusive. A good is nonrival...

Monopoly Power over the Wage Rate

Figure 14.15 shows a demand for labor curve in a market with no monopsony power-it aggregates the marginal revenue products of firms that compete to buy labor. The labor supply curve describes how union members would supply labor if the union exerted no monopoly power. Then the labor market would be competitive, and L* workers would be hired for a wage of w*. Because of its monppoly power, however, the union can choose any wage rate and the corresponding quantity of labor supplied (just as a...

Example A Linear Demand Curve

Let's work through an example-two identical firms facing a linear market demand curve. This will help clarify the meaning of a Cournot equilibrium and let us compare it with the competitive equilibrium and the equilibrium that results if the firms collude and choose their output levels cooperatively. Hence it is sometimes called a Cournot-Nash equilibrium. Suppose our duopolists face the following market demand curve where Q is the total production of both firms (i.e., Q Q + Q2). Also, suppose...

Special Case The Giffen Good

The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. We call such a good a Giffen good, and Figure 4.7 shows the income and substitution effects. Initially, the consumer is at A, consuming relatively little clothing and much food. Now the price of food declines. The decline in the price of food frees enough income sc that the consumer desires to buy more clothing and fewer units of food, as illustrated by B. By revealed preference, the...

Regulation in Practice

Recall that the competitive price (Pc in Figure 10.10) is found where the firm's marginal cost and average revenue (demand) curves intersect. Likewise, for a natural monopoly, the minimum feasible price (Pr in Figure 10.11) is found where average cost and demand intersect. Unfortunately, it is often difficult to determine these prices accurately in practice because the firm's demand and cost curves may shift as market conditions evolve. As a result, the regulation of a monopoly is usually based...

Competition versus Collusion The Prisoners Dilemma

A Nash equilibrium is a noncooperative equilibrium-each firm makes the decisions that give it the highest possible profit, given the actions of its competitors. As we have seen, the resulting profit earned by each firm is higher than it would be under perfect competition, but lower than if the firms colluded. Collusion is, however, illegal, and most managers prefer to stay out of jail and not pay stiff fines. But if cooperation can lead to higher profits, why don't firms cooperate witho ut...

Example 52 Deterring Crime

Fines may deter certain types of crimes, such as speeding, double-parking, tax evasion, and air polluting, better than incarceration.8 The party choosing to violate the law in these ways has good information and can reasonably be assumed to be behaving rationally. Other things being equal, the greater the fine, the more a potential criminal will be discouraged from engaging in the crime. For example, if it were costless to catch criminals and if the crime imposed a calculable cost of 1000 on...

Intertemporal Production Decisions Depletable Resources

Firms' production decisions often have intertemporai aspects-production today affects sales or costs in the future. The learning curve, which we discussed in Chapter 7, is an example of this. By producing today, the firm gains experience that lowers its future costs. In this case production today is partly an investment in future cost reduction, and the value of this must be taken into account when comparing costs and benefits. Another example is the production of a depletable resource. When...

The Industrys Long Run Supply Curve

In our analysis of short-run supply, we first derived the firm's supply curve and then showed how the horizontal summation of individual firms' supply curves generated a market supply curve. We cannot analyze long-run supply in the same way, however, because in the long run firms enter and exit the market as the market price changes. This makes it impossible to sum up supply curves-we don't know which firms' supplies to add. To determine long-run supply, we assume all firms have access to the...

Example 91 Price Controls And The Natural Gas Shortage

In Example 2.8 in Chapter 2, we saw that during the 1970s price controls created a large excess demand for natural gas. But how much did consumers gain from those controls, how much did producers lose, and what was the deadweight loss to the country We can answer these questions by calculating the resulting changes in consumer and producer surplus. Again, we base our analysis on the numbers for 1975 and calculate the gains and losses that apply to that year. Refer to Example 2.8, where we...

Inuestment Time and Capital Markets

In Chapter 14 we saw that in competitive markets, firms compare the marginal revenue product of each factor to its cost to decide how much to purchase each month. The decisions of all firms determine the market demand for each factor, and the market price is the one that equates the quantity demanded with the quantity supplied. For factor inputs such as labor and raw materials, this picture is reasonably complete, but not so for capital. The reason is that capital is durable-it can last and...

The Two Part Tariff

The two-part tariff is related to price discrimination and provides another means of extracting consumer surplus. It requires consumers to pay a fee up front for the right to buy a product. Consumers then pay an additional fee for each unit of the product they wish to consume. The classic example of this is an amusement park 4 You pay an admission fee to enter, and you also pay a certain amount for each ride you go on. The owner of the park has to decide whether to charge a high entrance fee...

Designer Jeans

Three examples should help clarify the use of markup pricing. Consider a retail supermarket chain. Although the elasticity of market demand for food is small (about -1), several supermarkets usually serve most areas, so no single supermarket can raise its prices very much without losing many customers to other stores. As a result, the elasticity of demand for any one supermarket is often as large as -10. Substituting this number for Ed in equation (10.2), we find P MC (1 - 0.1) MC (0.9)...

Network Externalities

Bandwagon Effect

So far we have assumed that people's demands for a good are independent of one another. In other words, Tom's demand for coffee depends on Tom's tastes, his income, the price of coffee, and perhaps the price of tea, but it doesn't depend on Dick's or Harry's demands for coffee. This assumption enabled us to obtain the market demand curve by simply summing individuals' demands. For some goods, however, a person's demand also depends on the demands of other people. In particular, a person's...

Price Competition with Differentiated Products

Oligopolistic markets often have at least some degree of product differentiation.4 Market shares are determined not just by prices, but also by differences in the design, performance, and durability of each firm's product. Then it is natural for firms to compete by choosing prices rather than quantities. To see how price competition with differentiated products can work, let's go through the following simple example. Suppose each of two duopolists has fixed costs of 20 but zero variable costs,...

The Interaction Among Firms

How competing firms interact is also an important-and sometimes the most important-determinant or monopoly power. Suppose there are four firms in a market. They might compete aggressively, undercutting one another's prices to capture more market share. This would probably drive prices down to nearly competitive levels. Each firm, will be afraid to raise its price for fear of being undercut and losing its market share, and thus it will have little or no monopoly power. On. the other hand, the...

Ways of Correcting Market Failure

How can the inefficiency resulting from an externality be remedied If the firm that generates the externality has a fixed-proportions production technology, the externality can be reduced only by encouraging the firm to produce less. This can be achieved through an output tax, as we saw in Chapter 8. Fortunately, most firms can substitute among inputs in the production process by altering their choice of technology. For example, a manufacturer can add a scrubber to its smokestack to reduce its...

Example 45 The Value Of Clean

Air is free in the sense that one need not pay to breathe it. Yet the absence of a market for air may help explain why the air quality in some cities has been deteriorating for decades. In 1970 Congress amended the Clean Air Act to tighten automobile emissions controls. Were these controls worth it Were the benefits of cleaning up the air sufficient to outweigh the costs that would be imposed directly on car producers and indirectly on car buyers To answer this question. Congress asked the...

Shifts in Supply and Demand

Supply and demand curves tell us how much competitive producers and consumers are willing to sell and buy as functions of the price they receive and pay. But supply and demand are also determined by other variables besides price. For example, the quantity that producers are willing to sell depends not only on the price they receive, but also on their production costs, including wages, interest charges, and costs of raw materials. And in addition to price, quantity demanded depends on the total...

Example 134 Walmart Stores Preemptive ii1

' , iu*-> *i v f . . < Wat-Mart Stores, Inc., is an enormously successful chain of discount retail stores started by Sam Walton in 1969. Its success was unusual in the industry. During the 1960s and 1970s, rapid expansion by existing firms and the entry and expansion of new firms made discount retailing increasingly competitive. During the 1970s and 1980s, industrywide profits fell and large discount chains-including such giants as King's, Korvette's, Mammoth Mart, W.T. Grant, and...

Example 27 The World Qil Market On The Back Of An Envelope

Since 1974, the world oil market has been dominated by the OPEC cartel. By collectively restraining output, OPEC succeeded in pushing world oil prices well above what they would have been in a competitive market. OPEC producers could do this because they accounted for a large fraction of world oil production (about two-thirds in 1974). We discuss OPEC's pricing strategy in more detail in Chapter 12 as part of our analysis of cartels and the behavior of cartelized markets. But for now, let's see...

Appendix To Chapter

Demand Theory-A Mathematical Treatment Thisappendixpresentsa mathematical treatment of the basics ofdemand theory. Our goal is to provide a short overview of the theory of demand for students who have some familiarity with the use of calculus. To do this, we will explain and then apply the concept of constrained optimization. Demand theory is based on the premise that consumers maximize utility subject to a budget constraint. Utility is assumed to be an increasing function of the quantities of...

Common Property Resources

Occasionally externalities arise when resources can be used without payment. Common property resources are those to which anyone has free access. As a result, they are likely to be overutilized. Air and water are the two most common examples of these resources. Other examples include fish, animal populations, mineral exploration, and extraction. Let's look at some of the inefficiencies that can occur when resources are common property rather than privately owned. Consider a large lake with...

Answers to Selected

If the Soviet Union had purchased an additional 200 million bushels, the new demand, Qd would have been equal to 200 + Qd 200 + Qd 2(X) + 2580 - 194P 2780 -194P. Equating quantity supplied with quantity demanded 1800 + 240P 2780 - 194P. P 2.26, an increase of 46 cents per bushel. 4. a. Total demand, Qd 3550 - 266P, equals domestic demand, Qdd, plus export demand, Qde, where Q m 1000 - 46P and Qde 2550 - 220P. If export demand decreases by 40 , Qd 1000 -45P +0.6 (2550 - 220P) 2530 - 178P...

Understanding and Predicting the Effects of Changing Market Conditions

We have discussed the meaning and characteristics of supply and demand, but our treatment has been largely qualitative. To use supply and demand curves to analyze and predict the effects of changing market conditions, we must begin to attach numbers to them. For example, to see how a 50 percent reduction in the supply of Brazilian coffee may affect the world price of coffee, we need to write down actual supply and demand curves and then calculate how those curves will shift, and how price will...

Efficiency in Exchange

In Chapter 9 we saw that an unregulated competitive market is efficient because it maximizes consumer and producer surplus. To examine the concept of economic efficiency in more detail, we begin with an exchange economy, analyzing the behavior of two consumers who can trade either of two goods between themselves. (The analysis also applies to trade between two countries.) Suppose the two goods are initially allocated so that both consumers can make themselves better off by trading with each...

Dynamic Changes in Costs The Learning Curve

Our discussion has suggested one reason a large firm may have a lower long-run average cost than a small firm-increasing returns to scale in production. It is tempting to conclude that firms that enjoy lower average cost over time are growing firms with increasing returns to scale. But this need not be true. In some firms, long-run average cost may decline over time because workers and managers absorb new technological information as they become more experienced at their jdbs. As management and...

Intertemporal Price Discrimination and Peak Load Pricing

Intertemporal price discrimination is an important and widely practiced pricing strategy closely related to third-degree price discrimination. Here consumers are separated into different groups with different demand functions by being charged different prices at different points in time. To see how intertemporal price discrimination works, think about how an electronics company might price new, technologically advanced equipment, such as videocassette recorders during the 1970s, compact disc...

The Effective Yield on a Bond

Many corporate and most government bonds are traded in the bond market. The value of a traded bond can be determined directly by looking at its market price, since this is what buyers and sellers agree that the bond is worth.6 Thus, we usually know the value of a bond, but to compare the bond with other investment opportunities, we would like to determine the interest rate consistent with that value. Equations (15.1) and (15.2) show how the values of two different bonds depend on the interest...

Effects of Government Intervention Price Controls

In the United States and most other industrial countries, markets are rarely free of government intervention. Besides imposing taxes and granting subsidies, governments often regulate markets (even competitive markets) in a variety of ways. Here we will see how to use supply and demand curves to analyze the effects of one common form of government intervention price controls. Later, in Chapter 9, we examine the effects of price controls and other forms of government intervention and regulation...

General Equilibrium Analysis

So far our discussions of market behavior have been largely based on partial equilibrium analysis. When determining the equilibrium prices and quantities in a market, we presumed that the activity in that market had little or no effect on other markets. For example, in Chapters 2 and 9, we presumed that the wheat market was largely independent of the markets for related products, such as corn and soybeans. Often a partial equilibrium analysis of this sort is sufficient to understand market...

Estimating and Predicting Cost

A business that is expanding or contracting its operation needs to predict how costs will change as output changes. Estimates of future costs can be obtained from a cost function, which relates the cost of production to the level of output and other variables that the firm can control. Suppose we wanted to characterize the short-run cost of production in the automobile industry. We could obtain data on the number of automobiles Q produced by each car company and relate this information to the...

Mixed Strategies

In all of the games that we examined so far, we have considered strategies in which players make a specific choice or take a specific action advertise or don't advertise, set a price of 4 or a price of 6, and so on. Strategies of this kind are called pure strategies. There are games, however, in which pure strategies are not the best way to play. An example is the game of Matching Pennies. In this game, each player chooses heads or .tails, and the two players reveal their coins at the same...

Production with Two Outputs Economies of Scope

Many firms produce more than one product. Sometimes a firm's products are closely linked to one another-a chicken farm produces poultry and eggs, an automobile company produces automobiles and trucks, and a university produces teaching and research. Other times,firms produce products that are physically unrelated. In both cases, however, a firm is likely to enjoy production or cost advantages when it produces two or more products. These advantages could result from the joint use of inputs or...

Example 141 The Demand For Jet Fuel

Throughout the 1970s and the early 1980s fuel costs for U.S. airlines increased rapidly, in tandem with rising world oil prices. For example, whereas fuel costs made up 12.4 percent of total operating costs in 1971, fuel's share of operating costs rose to 24.6 percent in 1979. As we would expect, the amount of jet fuel used by airlines during this period fell as its price rose. Thus, the output of the airline industry, as measured by the number of ton-miles (one ton-mile is short for one ton of...

The Gains from Free Trade

That there are gains from international trade in an exchange economy is clear-we have seen that two persons or two countries can benefit by trading to reach a point on the contract curve. However, there are additional gains from trade when the economies of two countries differ so that one country has a comparative advantage in producing one good, while a second country has a comparative advantage in producing another. Country 1 has a comparative advantage over country 2 in producing a good if...

Preferences Toward Risk

We used a job example to describe how people might evaluate risky outcomes, but the principles apply equally well to other choices. In this section we concentrate on consumer choices generally, and on the utility that consumers obtain from choosing among risky alternatives. To simplify things, we'll consider the consumption of a single commodity-the consumer's income, or more appropriately, the market basket that the income can buy. We assume that consumers know all probabilities, and (for much...

The Cournot Model

We will begin with a simple model of duopoly-two firms competing with each other-first introduced by the French economist Augustin Cournot in 1838. Suppose the firms produce a homogeneous good and know the market demand curve. Each firm must decide how much to produce, and the two firms make their decisions at the same time. When making its production decision, each firm takes its competitor into account. It knows that its competitor is also deciding how much to produce, and the price it...

The Marginal Rate of Substitution

People face trade-offs when choosing among two or more goods, and indifference curves can help to clarify those trade-offs. The indifference curve in Figure 3.5 illustrates this. Starting at market basket A and moving to market basket B, we see that the consumer is willing to give up six units of clothing to obtain one extra unit of food. However, moving from B to D, he is willing to give up only four units of clothing to obtain an additional unit of food, and in moving from D to E, he will...

Example 72 The Opportunity Cost Of Waiting In A Gasoline Line

As a result of gasoline price controls in the spring of 1980, Chevron gasoline stations in California were required to lower their prices substantially below those of other major gasoline companies.2 This allowed an experiment to be conducted in which consumers revealed information about ihc opportunity cost of their time. In this experiment, 109 customers at one Chevron station and 61 customers at two competing stations nearby were surveyed The consumers could ei- 2 This special treatment for...

Production and Cost TheoryA Mathematical Treatment

This appendix presents a mathematical treatment of the basics of production and cost theory. As in the appendix to Chapter 4, we use the method of Lagrange multipliers to solve the firm's cost-miniinizing problem. The theory of the firm relies on the assumption that firms choose inputs to the production process that minimize the cost of producing output. If there are two inputs, capital K and labor L, the production function F K, L describes . the maximum output that can be produced for every...

Game Theory and Competitive Strategy

L nlike a pure monopoly or a perfectly competitive firm, most firms must consider the likely responses of competitors when they make strategic decisions about price, advertising expenditure, investment in new capital, and other variables. Although we began to explore some of these strategic decisions in the last chapter, there are many questions about market structure and firm behavior that we have not yet addressed. For example, why do firms tend to collude in some markets and compete...

Short Run Profit Maximization by a Competitive Firm

In the short run, a firm operates with a fixed amount of capital and must choose the levels of its variable inputs labor and materials to maximize profit. Figure 8.3 shows the firm's short-run decision. The average and marginal revenue FIGURE 8.3 A Competitive Firm Making Positive Profit. In the short run, the competitive firm maximizes its profit by choosing an output q at which its marginal cost MC is equal to the price P or marginal revenue MR of its product. The profit of the firm is...

Empirical Estimation of Demand

Later in Lhis book, we discuss how demand information is used as an input to firms' economic decision making. For example. General Motors needs to understand automobile demand to dccidc whether to offer rebates or below-market-interest-rate loans for new cars. Knowledge about demand is also important for public policy decisions-understanding Lhe demand for oil can help Congress dccidc whether to pass an oil import tax. Here, wc briefly ex- 3 See Gregory Chow, 'Technological Change and the...

Price Competition with Homogeneous Products The Bertrand Model

The Bertrand model was developed in 1883 by another French economist, Joseph Bertrand. As with the Cournot model, firms produce a homogeneous good. Now, however, they choose prices instead of quantities. As we will see, this can dramatically affect the outcome. Let's return to the duopoly example of the last section, in which the market demand curve is where Q Qi Q2 is again total production of a homogeneous good. This time, we will assume that both firms have a marginal cost of 3 As an...

Indifference Curves

We can show a consumer's preferences graphically with the use of indifference curves. An indifference curve represents all combinations of market baskets that provide the same level of satisfaction to a person. That person is therefore indifferent among the market baskets represented by the points on the curve. Given the three assumptions about preferences discussed above, we know that a consumer can always indicate a preference for one market basket over another or indifference between the...

Monopolistic Competition

In many industries the products that firms make are differentiated. For one reason or another, consumers view each firm's brand as different from those of other firms. Crest toothpaste, for example, is different from Colgate, Aim, and a dozen other toothpastes. The difference is partly flavor, partly consistency, and partly reputation-the consumer's image correct or incorrect of the relative decay-preventing efficacy of Crest. As a result, some consumers but not all will pay more for Crest....

Externalities

Externalities can arise between producers, between customers, or between consumers and producers. Externalities can be negative-when the action of one party imposes costs on another party-or positive-when the action of one party benefits another party. A negative externality occurs,for example, when a steel plant dumps its waste in a river that fishermen downstream depend on for their daily catch. The more waste the steel plant dumps in the river, the fewer fish will be supported. The firm,...

Example 136 Diaper Wars

For more than a decade, the disposable diaper industry in the United States has been dominated by just two firms Procter amp Gamble, with an approximately 50-60 percent market share, and Kimberly-Clark, with another 30 percent.2 How do these firms compete And why haven't other firms been able to enter and take a significant share of this 4 billion per year market Even though there are only two major firms, competition is intense. The competition occurs mostly in the form of cost-reducing...

Pricing with Market Power

As we explained in Chapter 10, market power is quite common. Many industries have only a few producers, so that each producer has some monopoly power. And many firms, as buyers of raw materials, labor, or specialized capital goods, have some monopsony power in the markets for these factor inputs. The problem the managers of these firms face is how to use their market power most effectively They must decide how to set prices, choose quantities of factor inputs, and determine output in both the...

The Law of Diminishing Returns

Marginal Product Curve

A diminishing marginal product of labor and a diminishing marginal product of other inputs holds for most production processes the phrase the law of diminishing returns is often used to describe this phenomenon. The law of diminishing returns states that as the use of an input increases with other inputs fixed , a point will eventually be reached at which the resulting additions to output decrease. When the labor input is small and capital is fixed , small increments in labor input add...

Returns to Scale

The measure of increased output associated with increases in all inputs is fundamental to the long-run nature of the firm's production process. How does the output of the firm change as its inputs are proportionately increased If output more than doubles when inputs are doubled, there are increasing returns to scale. This might arise because the larger scale of operation allows managers and workers to specialize in their tasks and make use of more sophisticated, large-scale factories and...

Cost in the Short

In the short run, some of the firm's inputs to production are fixed, while others can be varied as the firm changes its output. Various measures of the cost of production can be distinguished on this basis. Total Cost TQ The total cost of production has two components the fixed cost FC, which is borne by the firm whatever level of output it produces, and the variable cost VC, which varies with the level of output. Depending on circumstances, fixed cost may include expenditures for plant...

The Shapes of the Cost Curves

Figure 7.1 shows two sets of continuous curves that approximate the cost data in Table 7.2. The fixed cost, variable cost, and total cost curves are shown in Figure 7.1a. Fixed cost FC does not vary with output and is shown as a horizontal line at 50. Variable cost VC is zero when output is zero, and then increases continuously as output increases. The total cost curve TC is determined by vertically adding the fixed cost curve to the variable cost curve. Because fixed cost is constant, the...

Average and Marginal Products

Total Marginal And Average Product

The contribution that labor makes to the production process can be described in terms of the average and marginal products of labor. The fourth column in Table 6.2 shows the average product of labor APl, which is the output per unit of labor input. The average product is calculated by dividing the total output Q by the total input of labor, L. In our example the average product increases initially but falls when the labor input becomes greater than 4. The fifth column shows the marginal product...

Monopsony Power

Monopsony Power

Much more common than pure monopsony are markets with only a few firms competing among themselves as buyers, so that each firm has some monopsony power. For example, the major U.S. automobile manufacturers compete with one another as buyers of tires. Because each of them accounts for a large share of the tire market, each has some monopsony power in that market. General Motors, the largest, might be able to exert considerable monopsony power when contracting for supplies of tires and other...

Glossary

Accounting Cost page 194 Actual expenses plus depreciation charges for capital equipment. These charges are determined by the Internal Revenue Service. Adverse Selection page 596 A form of market failure resulting from asymmetric information If insurance companies must charge a single premium because they cannot distinguish between high-risk and low-risk individuals, more high-risk individuals will insure, making it unprofitable to sell insurance. Agent page 608 An individual employed by a...

Evaluating the Gains and Losses from Government Policies Consumer and Producer Surplus

We saw at the end of Chapter 2 that a price ceiling causes the quantity of a good demanded to rise consumers want to buy more, given the lower price and the quantity supplied to fall producers are not willing to supply as much given the lower price , so that a shortage results. Of course, those consumers who can still buy the good will be better off because they will now pay less. Presumably, this was the objective of the policy in the first place. But if we also take into account those who...

Market Signaling

Education Signaling

We have seen that asymmetric information can sometimes lead to a lemons problem Because sellers know more about the quality of a good than buyers do, buyers may assume that quality is low, so that price falls, and only low-quality goods are sold. We also saw how government intervention in the market for health insurance, for example or the development of a reputation in service industries, for example can alleviate this problem. Now we will examine another important mechanism through which...

Bargaining Strategy

In looking at the Prisoners' Dilemma and related problems, we have assumed that collusion was limited by an inability to make an enforceable agreement. Clearly, alternative outcomes are possible and likely if firms or individuals can make promises that can be enforced. The Prisoners' Dilemma illustrated by the pricing problem shown in Table 13.8 is a good example of this. If there were no antitrust laws and both firms could make an enforceable agreement about pricing, they would both charge a...

Economies and Diseconomies of Scale

Lmc Microeconomics

In the long run, it may be in the firm's interest to change the input proportions as the level of output changes. When input proportions do change, the concept of returns to scale no longer applies. Rather, we say that a firm enjoys economies of scale when it can double its output for less than twice the cost. Correspondingly, there are diseconomies of scale when a doubling of output requires more than twice the cost. The term economies of scale includes increasing returns to scale as a special...

The Impact of a Tax or Subsidy

What would happen to the price of widgets if the government imposed a 1 tax on every widget sold Many people would answer that the price would increase by a dollar, with consumers now paying a dollar more per widget than they would have paid without the tax. But this answer is wrong. Or consider the following question. The government wants to impose a 50 cent per gallon tax on gasoline and is considering two methods of collecting the tax. Under Method 1, the owner of each gas station would...

What Is a Market

We can divide individual economic units into two broad groups according to function-buyers and sellers. Buyers include consumers, who purchase goods and services, and firms, which buy labor, capital, and raw materials that they use to produce goods and services. Sellers include firms, which sell their goods and services workers who sell their labor services and resource owners, who rent land or sell mineral resources to firms. Clearly, most people and most firms act as both buyers and sellers,...

Asymmetric Information in Labor Markets Efficiency Wage Theory

Efficient Wage Theory

When the labor market is competitive, all who wish to work will find jobs for a wage equal to their marginal product. Yet most countries have substantial unemployment even though many people are aggressively seeking work. 14 Any bonus of the form B PQ, ct Q Qt for Q gt Q and B 3Q, 7 Q, - QJ for Q lt Q with 7 gt 3 gt a gt 0 will work. See Martin L. Weitzman, The New Soviet Incentive Model, Bell Journal of Economics VII Spring 1976 251-256. There is a dynamic problem with this scheme that we have...

FjRegulating MuhfCiALSOEiD Wastes

By 1990 the average resident of Los Angeles was generating about 6.4 pounds of solid waste per day, and residents of other large American cities were not far behind. By contrast, residents of Tokyo, Paris, Hong Kong, and Rome generated 3 pounds, 2.4 pounds, 1.9 pounds, and 15 pounds, respectively.8 Some of these differences are due to variations in consumption levels, but most of the differences are due to the efforts that many other countries have made to encourage recycling. In the United...

Consumer Choice

Maximizing Consumer Satisfaction

Given preferences and budget constraints, we can now determine how individual consumers choose how much of each good to buy. We assume that consumers make this choice in a rational way-that they choose goods to maximize the satisfaction they can achieve, given the limited budget available to them. The maximizing market basket must satisfy two conditions. First, it must be located on the budget line. To see why, note that any market basket to the left of and below the. budget line leaves some...

Example 6 Declining Demand And The Behavior tf V r i Of Copper Prices

After reaching a level of about 1.00 per pound in 1980, the price of copper fell sharply to about 60 cents per pound in 1986. In real inflation-adjusted terms, this price was even lower than during the Great Depression 50 years earlier. Only in 1988-1989 did prices recover somewhat, as a result of strikes by miners in Peru and Canada that disrupted supplies. Figure 2.18 shows the behavior of copper prices in 1965-1993 in both real and nominal terms. The world-wide recessions of 1980 and 1982...

Bundling

You. have probably seen the 1939 film. Gone with the Wind. It is a classic that is nearly as popular now as it was then. Yet we would guess that you have not seen Getting Gertie's Garter, a flop that the same film company Loews also produced in 1939. And we would also guess that you didn't know that these two films were priced in what was then an unusual and innovative way.18 Movie theaters that leased Gone with the Wind also had to lease Getting Gertie's Garter, Movie theaters pay the film...

Monopoly Power

Markets in which several firms compete with one another are much more common. We say more about the forms this competition can take in Chapters 12 and 13. But we should explain here why in a market with several firms, each firm is likely to face a downward-sloping demand curve, and therefore will produce so that price exceeds marginal cost. Suppose, for example, that four firms produce toothbrushes, which have the market demand curve shown in Figure 10.7a. Let's assume...

Example 32 Designing New Automobiles

Our analysis of consumer choice allows us to see how the differing preferences of consumer groups for automobiles can affect their purchasing deci The result that the MRS equals the price ratio is deceptively powerful. Imagine two consumers who have just purchased various quantities of food and clothing. Without looking at their purchases, you can tell both persons if they arc maximizing the value of their MRS by looking at the prices of the two goods . What you cannot tell, however, is the...

Substitution Among Inputs

With two inputs that can be varied, a manager will want to consider substituting one input for another. The slope of each isoquant indicates how the quantity of one input can be traded off against the quantity of the other, while keeping output constant. When the negative sign is removed, we call the slope the marginal rate of technical substitution MRTS . The marginal rate of technical substitution of labor for capital is the amount by which the input of capital can be reduced when one extra...

The Budget Line

table 3.2 'Market Baskets arid the Budget Line FIGURE 3.8 A Budget Line. The consumer's budget line describes the combinations of goods that can be purchased given the consumer's income and the prices of the goods. Line AG shows the budget associated with an income of 80, a price of food of Pf 1 per unit, and a price of clothing of Pc 2 per unit. The slope of the budget line is in Table 3.2. Because giving up a unit of clothing saves 2 and buying a unit of food costs 1, the amount of clothing...

Sources of Monopoly Power

Why do some firms have considerable monopoly power, and other firms have little or none Remember that monopoly power is the ability to set price above marginal cost, and the amount by which price exceeds marginal cost depends inversely on the firm's elasticity of demand. As equation 10.3 shows, the less elastic its demand curve, the more monopoly power a firm has. The ultimate determinant of monopoly power is therefore the firm's elasticity of demand. The question is, why do some firms e.g., a...

Engel Curves

Income-consumption curves can be used to construct Engel curves, which relate the quantity of a good consumed to income. Figure 4.4 shows how such curves are constructed for two different goods. Figure 4.4a, which shows an upward-sloping Engel curve, is derived directly from Figure 4.2a. In both figures, as income increases from 10 to 20 to 30, the consumption of food increases from 4 to 10 to 16 units. The upward-sloping Engel curve like the upward-sloping income-consumption curve in Figure...

Market Demand

So far we have discussed the demand curve for an individual consumer. But where do market demand curves come from In this section we show how market demand curves can be derived as Lhe sum of the individual demand curves of all consumers in a particular market. To keep things simple, let's assume that only three consumers A, B, and C are in the markeL for coffee. Table 4.2 tabulates several points on each of these Of course, sottiL- consumers those who spend little on gasoline will be better...

Example 43 The Aggregate DemandfdR WHEAT

In Chapter 2 Example 2.2 , we discussed the two components of the demand for wheat-domestic demand by U.S. consumers and export demand by foreign consumers . Let us see how the world demand for wheat in 1981 can be obtained by aggregating the domestic and foreign demands. The domestic demand for wheat is given by the equation Qdd 1000 - 46P, where Qvm is the number of bushels in millions demanded domestically, and P is the price in dollars per bushel. Export demand is given by Qde 2550 - 220P,...

Marginal Revenue Exercise

Will an increase in the demand for a monopolist's product always result in a higher price Explain. Will an increase in the supply facing a monopsonist buyer always result in a lower price Explain. 2. Caterpillar Tractor is one of the largest producers of farm tractors in the world. They hire you to advise them on their pricing policy. One of the things the company would like to know is how much a 5 percent increase in price is likely to reduce sales. What would you need to know to help the...