Economics I: Scarcity, Markets, Elasticity, Firms, and Market Structure

This is Unit Thirteen of Social Sciences and History, part two of two: microeconomics from utility to the four market structures. Part one closed on what is given up and who responds. This part carries one rule through every decision in it: compare the last unit's gain to the last unit's cost. A household buys until the last dollar earns the same utility everywhere. A firm reads its cost table row by row for the last unit's cost. A competitive firm produces where the last unit's revenue, which is the price, equals its cost, and a monopolist does the same with a revenue that falls below price. The rule never changes across the four market structures; what changes is the price the last unit fetches, and the capstone at the end lays those four structures on one line. By the end you will be able to find the best bundle. To read a cost table. To decide whether a competitive firm produces, exits, or shuts down. To say why a monopolist's marginal revenue falls below price. And to fill the four-structure table.

Four entries on elasticities and utility: the other elasticities, utility and its diminishing margin, the rule for the best bundle, and the two effects of a price change.

The other elasticities.

SSH 1224 Income, Cross-Price, Wage, Savings Elasticities

Elasticity is any percentage change over another. Income elasticity of demand is percentage change in quantity demanded over percentage change in income. Cross-price elasticity is one good's quantity change over another good's price change, positive for substitutes, negative for complements. Wage elasticity of labor supply and the elasticity of savings follow the same form. It applies in labor and financial markets too.

Utility.

SSH 1225 Total Utility, Marginal Utility, Diminishing

Households seek the highest utility, and each is the only judge of their own. Total utility is the satisfaction from a set of choices; marginal utility is the addition from one more unit, and marginal utility per dollar is that addition divided by price. Each added unit adds less: diminishing marginal utility. Utility is each person's own judgment.

The rule for the best bundle.

SSH 1226 The Rule MU/P = MU/P: Finding the Best Bundle

The exam gives prices and marginal utilities and asks the best bundle, and the anchor gives three routes to it, the third a rule. First, add up total utility for each affordable bundle on the budget line and take the highest. Second, start anywhere and move toward neighbors that raise utility until none does. Third, compare marginal utility per dollar: at the optimal choice the ratio of marginal utility to price is equal across goods, MU one over P one equals MU two over P two, the consumer equilibrium, where the ratio of prices equals the ratio of marginal utilities. If one good yields more utility per dollar, shift spending toward it; diminishing marginal utility lowers its ratio as you buy more, until the ratios meet. Coffee costs two and its next cup is worth eight; tea costs one and its next cup is worth three: coffee gives four per dollar, tea three, so buy more coffee. The ratios are equal: stop. A good's price falls: its utility per dollar rises, so buy more, which is the law of demand from the inside. Ask, for each good, how much satisfaction the last dollar bought. The trap is comparing marginal utilities without dividing by price. The second trap is expecting equal quantities; the rule equalizes utility per dollar, not units. The last dollar's gain is this lecture's rule, at the household.

The two effects.

SSH 1227 Income Effect, Substitution Effect, Loss Aversion

When a price rises, two effects always occur together. The substitution effect: buy less of the dearer good, more of the cheaper. The income effect: the buying power of income has fallen. Behavioral economics adds psychology: people value a dollar lost more than a dollar gained, over-withholding taxes to be sure of a refund. Fungible means units equally valued; behavior says otherwise.

Five entries on costs: two kinds of cost and profit, the short and long run, the cost family, scale, and reading a cost table for the last unit's cost.

Costs and profit.

SSH 1228 Explicit, Implicit, Accounting, Economic

Profit is revenue minus cost, but two costs exist. Explicit costs are out-of-pocket payments: wages, rent, materials. Implicit costs are the opportunity cost of resources the firm already owns and uses, an owner's forgone salary. Accounting profit subtracts only explicit costs; economic profit subtracts both. Zero economic profit still covers the owner's best alternative.

Production runs.

SSH 1229 Short Run, Long Run, Diminishing Marginal Product

In the short run at least one input, usually capital, is fixed, so output changes only through labor. Marginal product is the added output from one more worker, and eventually it declines, the tenth cook in a small kitchen: diminishing marginal productivity. In the long run all inputs vary. Diminishing returns come from the fixed input.

The cost family.

SSH 1230 Fixed, Variable, Marginal, Average

Fixed costs come before any output and do not change with it, a bakery's rent; variable costs rise with output, its flour. Marginal cost is the change in total cost over the change in output. Average total cost and average variable cost divide by output, and both are usually U-shaped. Price above average cost means profit.

Scale.

SSH 1231 Economies, Constant Returns, Diseconomies of Scale

In the long run firms choose a production technology. The long-run average cost curve shows the lowest average cost at each output. Downward-sloping means economies of scale; flat, constant returns to scale; upward-sloping, diseconomies of scale. Demand against the curve's bottom sets the number of firms, and a flat bottom allows many firm sizes.

Reading a cost table.

SSH 1232 Reading a Cost Table for MC and ATC

The exam gives a table of output and total cost and asks for marginal cost, average total cost, or the profit-maximizing quantity, and the anchor's definitions are the arithmetic. Marginal cost is the change in total cost divided by the change in output, computed between rows. Average total cost is total cost divided by output at each row; average variable cost is variable cost divided by output; fixed cost is the total cost at zero output. Marginal cost typically rises because variable costs show diminishing marginal returns; average curves are U-shaped, and marginal cost crosses each average at its minimum. Total cost one hundred at zero units, one hundred forty at one, one hundred seventy at two, two hundred ten at three: fixed cost is one hundred; marginal costs are forty, thirty, forty; average total costs are one hundred forty, eighty-five, seventy. Price is sixty: the third unit's marginal cost of forty is below sixty, so produce it. Ask first for the fixed cost at zero, then difference the rows, then divide. The trap is dividing total cost by output and calling it marginal; marginal is a difference between rows. The second trap is the sunk fixed cost: it belongs in average total cost and nowhere in a decision about the next unit. The last unit's cost, read from the rows: the rule at the firm.

Three entries on the price taker: perfect competition's rule, the produce-or-shut-down decision, and the long run.

The price taker.

SSH 1233 The Price Taker and MR = MC

In perfect competition many sellers offer identical products with easy entry and exit, so each firm is a price taker: it accepts the market price, and total revenue rises at a constant rate. Profit is highest where marginal revenue, which equals price here, equals marginal cost. Market structure means sellers, entry and product type. Price above average cost, profit; below, loss.

Produce or shut down.

SSH 1234 Zero-Profit Point and Shutdown Point: Deciding What to Do

The exam gives a competitive firm's price against its average cost and average variable cost and asks what it should do, and the anchor's two points decide. The zero-profit point, or break-even point, is where the marginal cost curve crosses the average cost curve at the minimum of average cost; at that price the firm earns zero economic profit. The shutdown point is where marginal cost crosses average variable cost at its minimum. If price is below average variable cost at the profit-maximizing quantity, shut down immediately. If price is above average variable cost but below average cost, keep producing in the short run, because revenue covers variable cost and some of the sunk fixed cost, and exit in the long run. If price is above average cost, produce and profit. Price twelve, average cost ten, average variable cost seven: produce, profit. Price nine, average cost ten, average variable cost seven: produce now, exit later. Price six, average cost ten, average variable cost seven: shut down now. Ask two questions in order: does price cover variable cost, and does it cover all cost. The trap is shutting down at the first loss; a loss smaller than fixed cost is the better short-run choice. The second trap is calling zero profit failure; at the zero-profit point the owner earns the normal return.

The long run.

SSH 1235 Entry, Exit, and the Long-Run Supply Curve

In the long run firms respond to profits by entry and to losses by exit, and entry and exit push the market price toward the zero-profit point: long-run equilibrium is price equal to average cost, zero profit. The long-run supply curve shows the output firms supply in constant-cost, increasing-cost and decreasing-cost industries. Perfect competition meets both efficiencies, allocative and productive.

Five entries to close: barriers to entry, why a monopolist's marginal revenue falls, two inefficiencies, monopolistic competition, and the four structures on one line.

Monopoly's barriers.

SSH 1236 Barriers to Entry and Natural Monopoly

A monopoly is one firm producing all a market's output, sustained by barriers to entry: economies of scale that make a natural monopoly; control of a resource; legal restrictions, a legal monopoly being a legal prohibition on competition; intellectual property, patents, trademarks, copyrights, trade secrets, a patent being exclusive rights for a limited time; and predatory pricing, temporary price cuts to deter entrants.

The monopolist's revenue.

SSH 1237 Why a Monopolist's MR Falls Below Price

A monopolist is a price maker: choosing quantity sets the market price. Its total revenue starts low at small output, rises, then falls, since large quantities sell only cheaply. Marginal revenue declines with each unit, since the lower price applies to every unit: the tenth unit's price, minus the discount on the nine before it. Marginal profit is marginal revenue minus marginal cost.

Monopoly's inefficiency.

SSH 1238 Monopoly's Two Inefficiencies

The monopolist produces where marginal revenue equals marginal cost and charges the demand curve's price there. It is not productively efficient, since it does not produce at minimum average cost, and not allocatively efficient, since price exceeds marginal cost: less output, higher price, and a weak incentive to innovate with no entry to fear. Deregulation removes controls on prices and quantities.

Monopolistic competition.

SSH 1239 Monopolistic Competition: Differentiation and Zero Profit

Monopolistic competition is many firms selling differentiated products, distinct by features, location, intangibles or perception. Each faces a downward-sloping demand, more elastic than a monopolist's, and produces where marginal revenue equals marginal cost at its demand curve's price, above marginal cost, so inefficient. Entry and exit drive profit to zero. Variety is the benefit; too much is the anchor's open question.

Four structures on one line.

SSH 1240 Four Structures on One Line: Sellers, Products, Entry, Pricing Power, Efficiency

The exam's market-structure item is answered by one table, and the anchor's three chapters fill it column by column. Sellers: perfect competition has many, thousands; monopolistic competition many; oligopoly a few; monopoly one. Products: identical in perfect competition; differentiated by feature, location, intangible or perception in monopolistic competition; either in oligopoly; unique in monopoly. Entry: easy in the first two, so profits attract entrants and losses drive exit until economic profit is zero; blocked in oligopoly and monopoly by economies of scale, resource control, legal restriction, intellectual property or predatory pricing. Pricing power: the competitive firm is a price taker facing a horizontal demand, with marginal revenue equal to price; every other firm is a price maker facing a downward-sloping demand, with marginal revenue below price because each extra unit lowers the price on all units, the monopolistic competitor's demand the most elastic of the three because its rivals are close. The rule is the same for all four, produce where marginal revenue equals marginal cost, and the difference is what price that quantity fetches. Efficiency: only perfect competition reaches both, productive at minimum average cost and allocative at price equal to marginal cost; the others produce less at higher cost and price, and only monopolistic competition buys something with the loss, variety, which the anchor leaves as an open question. Oligopoly is where strategy enters: a few firms can collude as a cartel to act like one monopolist, but each gains by expanding output, so collusion tends to break down, and explicit collusion is illegal; the prisoner's dilemma models the bind, and the kinked demand curve, rivals matching cuts but not rises, models the stickiness. Two firms make a duopoly, and everything between the extremes the anchor calls imperfectly competitive. The line is the course's arrangement of the anchor's three chapters, and the Micro course carries each cell at depth. The variety controversy stays the anchor's open question, and oligopoly's game theory is stated as the anchor states it, a model of the bind rather than a prediction of its outcome. One rule, four prices: the idea this lecture opened with, on one line.

Look at what you can now do. You can find the best bundle by equalizing marginal utility per dollar, and name the substitution and income effects that a price change always brings together. You can read a cost table by taking the fixed cost at zero, differencing the rows for marginal cost and dividing for average, and tell accounting profit from economic. You can decide a competitive firm's fate by asking, in order, whether price covers variable cost and whether it covers all cost. You can say a monopolist's marginal revenue falls below price because the discount applies to every unit, and that monopoly is neither productively nor allocatively efficient. And you can fill the four-structure table, and you know the rule is the same in every column and only the price the last unit fetches changes, which is the idea this lecture was built on. Unit fourteen opens on labor markets and GDP.