ECON101 Study Guide

Site: Saylor Academy
Course: ECON101: Principles of Microeconomics
Book: ECON101 Study Guide
Printed by: Guest user
Date: Wednesday, October 20, 2021, 11:57 AM

Navigating the Study Guide


Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

  • questions for you to answer independently;
  • a brief summary of the learning outcome topic;
  • and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

 

How to Use the Study Guide

  1. Review the entire course by reading the learning outcome summaries and suggested resources.
  2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Introduction to Economics

1a. Identify how individual economic agents make rational choices given scarce resources, and explain how to optimize the use of resources at hand

  • Define scarcity and market.
  • How does scarcity affect prices?
  • When a commodity becomes more scarce, how does its price change to reflect the scarcity?
  • How does the shortage or surplus of a commodity affect its price in the marketplace?

Scarcity is one of the most important concepts in economics. If resources are not scarce, there is no need to choose among alternatives. In a capitalist economy, when commodities and resources are scarce, the market distributes them in a way that is determined by the price system.

Review scarcity in the market in The Problem of Scarce Resources.

 

1b. Apply the concept of marginal analysis to make optimal choices, and identify whether the choices are efficient or equitable

  • Define the concepts of opportunity cost and marginal analysis.
  • Define economic model and the fallacy of false cause.
  • Define hypothesis testing in the context of economics.
  • How do economists use normative and positive statements?
  • Define sunk costs and budget constraints.

As you review microeconomics, you need to be sure you have mastered some important calculus concepts, such as graphs, variables, and constants. Economists use the scientific method in most economic analysis. Specifically, they examine the marginal benefits and marginal costs of a decision to determine the optimal choice for an individual or company.

Review marginal benefits and marginal costs in:

Review data representation and mathematics for economics in:

 

1c. Apply basic economic models related to production, trade, and the circular flow of resources

  • Define economic productionspecializationtrade, and the circular flow of resources.
  • Define the circular flow model of production, resources, and money.

Economists have created some basic models to illustrate how people deal with scarcity: specialization, trade, and the circular flow of resources. Individuals and societies specialize in certain products or activities to maximize productivity, to focus on the activities they are most productive in. Trade describes the way individuals and societies exchange goods and services, according to their needs, according to their specialization.

Think about the things or skills you personally specialize in and trade with others. For example, do you work in a certain profession because you have skills or talents your employer needs and is willing to pay you to perform? Do you use the income you earn from this specialization to buy goods and services you need from others?

Review specialization and trade models in What Economics Is and Why It's Important.

 

Unit 1 Vocabulary

  • Budget constraint
  • Circular flow of resources
  • Economics
  • Economic model
  • Economic production
  • Fallacy of false cause
  • Flow of resources
  • Hypothesis testing
  • Implied cost
  • Marginal analysis
  • Market
  • Microeconomics
  • Net benefit
  • Normative statement
  • Opportunity cost
  • Out-of-pocket choice
  • Positive statement
  • Profit margin
  • Scarcity
  • Scientific method
  • Specialization
  • Sunk costs
  • Trade

Unit 2: Supply and Demand

2a. Analyze and apply the mechanics of demand and supply for individuals, companies, and the market

  • Define the law of demand.
  • What is the relationship between the quantity consumers demand and the price of a good?
  • Do we consume fewer or more goods when prices increase or decrease?
  • How can we apply the law of demand to respond to these questions?

The Term Ceteris Paribus

The Latin term ceteris paribus means "all other things unchanged". When they study the relationship between two variables, researchers try to keep as many variables fixed as possible, so they can avoid confusing or complicating the effect of one variable on the other.

For example, suppose you want to explore the relationship between car prices and the number of cars sold. When car prices increase, people typically buy fewer cars assuming ceteris paribus or "all other things unchanged". If other variables are not fixed we cannot make this assumption. Let's say the potential buyer's income is not fixed, but increases during the time the car prices increase. We can no longer conclude higher prices will result in fewer car purchases. Customers might buy more cars than before, regardless of the higher prices, because their income increased and they could afford to buy more.

Review the concept of Ceteris Paribus.

 

Demand

  • Define and explain the difference between demand and quantity demanded.
  • Define a demand shifter.
  • Name two real-world examples of the following demand shifters: expectationsdemographic characteristicsincomepreferences, and the price of related goods and services.
  • How do changes in these variables affect the demand curve?
  • Explain why price is not a demand shifter.
  • Define and explain the difference between substitutes and complements.
  • How do substitutes and complements affect demand?
  • How do normal and inferior goods, and income affect demand for substitutes and complements?

The market includes buyers and sellers. Demand refers to how consumers behave in the marketplace, such as how much they want or need to buy a commodity.

Review this figure of a demand curve.

A Demand Schedule and a Demand Curve

Students often confuse the concept of demand with quantity demanded.

Think of the term demand as the overall appetite or desire consumers have for a good or product (for example, coffee), in a given area, during a given time.

The specific amount or quantity of coffee consumers want to buy (in other words, the quantity demanded) will change according to the price. Consumers will buy x amount at a certain price, y amount if the price is one dollar less, z amount if the price is one dollar more. This ratio, or line of progression which the demand curve represents, remains the same until a shift occurs.

Quantity demanded refers to a specific point on the demand curve: in the graph (Figure 3.1), a coffee shop will buy 20 million pounds of coffee at $7 per pound. The quantity demanded is 20 million pounds. When the price of a good changes, there is a movement along the demand curve – a change in quantity demanded (in the graph, the coffee shop buys 30 million pounds of coffee when the price falls to $5 per pound).

Demand determinants (also called demand shifters) describe the factors, other than price, that shift demand – changes in these variables cause the demand curve to shift to the right or to the left.

Remember that the demand curve is a ratio plotted on a graph that depicts the relationship between price (the y axis) and quantity demanded (the x axis), so a price fluctuation causes a movement along the demand curve (you can see that points on the demand curve refer to quantity demanded based on a given price). Price fluctuations do not shift the demand curve.

A demand shifter causes a fluctuation in overall consumer demand, irrespective of price. Examples of demand shifters include changes in:

  • Consumer preferences: buyers read a report that states drinking one cup of coffee a day is healthy so demand for coffee soars.
  • Demographics: a new population moves into town that loves to drink coffee.
  • Income: the main employer in town lays off a large number of workers. They can no longer afford to buy expensive coffee drinks.
  • Prices of related goods and services: the price of tea drops precipitously and customers decide to switch to tea to save money. In this case, tea is a substitute.
  • Consumer or buyer expectations: consumers predict the price of coffee will increase because their government plans to impose a large tariff on coffee. Demand for coffee increases as people try to stock up on coffee at the lower price.

Review this figure, which highlights how a change in price can affect quantity demanded vs. a demand shifter.

An Increase in Demand


Review the concept of demand in:

 

Supply

  • What is the relationship between the quantity or amount of a good that a producer supplies and the price of a good?
  • Do producers have an incentive to produce and sell more or less of a good when its price increases or decreases?
  • Define and explain the difference between supply and quantity supplied.
  • Define a supply shifter.
  • Name real-world examples of the following demand shifters: natural events, number of sellers, prices of factors of production, returns from alternative activities, seller expectations; and, technology or innovative changes.
  • How do changes in these variables affect the supply curve?
  • Explain why price is not a supply shifter.

Supply refers to the amount of a good or product that is available in the marketplace for consumers to buy. Businesses, manufacturers, and sellers often respond to consumer demand by increasing or decreasing the supply of the products they provide them. For example, they may be able to sell off their inventory (their supply) at a higher price to make more money.

Review this figure, which depicts a supply curve.

A Supply Schedule and a Supply Curve

You will see a lot of correlation between the language and methods we use to analyze supply with how we analyze consumer demand. These two variables often work together and affect one another.

As with demand, students often confuse supply and quantity supplied. Think of the term supply as the overall supply of the good itself (coffee in our case), in a given area, during a given time. Supply remains constant unless a shift occurs. Businesses will supply x amount at a certain price, y amount for one more dollar, z amount for two more dollars. This ratio, or the line of progression the supply curve represents, remains the same until a shift occurs.

Quantity supplied is illustrated by a specific point on the supply curve (in the graph, a coffee grower will supply 20 million pounds of coffee at $5 per pound). When the price of a good changes, there is a movement along the supply curve – consider this a change in amount supplied. In the graph, the coffee grower supplies 30 million pounds of coffee when the price increases to $7 per pound.

Coffee growers have an incentive to produce more coffee to sell at the higher price. Perhaps the owner will give employees a small bonus if they work longer hours to harvest more coffee beans, the grower may buy extra beans from a neighboring farm to sell, or the grower knows they will be able to afford to buy a more expensive and effective fertilizer to grow more beans if they know they can sell them at a higher price.

As with the demand curve, remember that the supply curve is a ratio plotted on a graph that depicts the relationship between price (the x axis) and quantity businesses supply (the y axis), so a price fluctuation will cause a movement along the supply curve (you can see that points on the supply curve refer to quantity supplied based on a given price). Price fluctuations do not shift the supply curve.

Supply determinants (also called supply shifters) are factors, other than price, that shift supply – fluctuations in these variables will cause the supply curve to shift up or down.

Examples of supply shifters include:

  • Natural events: a nation-wide drought causes your coffee plants to die and supply plummets.
  • Number of sellers: a coffee conglomerate moves into your area and floods the market with coffee. Supply soars.
  • Prices of factors of production: the price of insecticide skyrockets and your coffee yield decreases because you cannot afford to buy enough insecticide to protect this year's crop.
  • Returns from alternative activities: you discover it is more profitable to incorporate organic farming techniques so you can sell your organic coffee a higher price.
  • Seller expectations: you predict coffee will be in high demand next year due to a recent trends report from the American Beverage Association.
  • Technology or innovative changes: a new model of tractor makes it easier to harvest more coffee beans in less time.

Review the drawing of a supply curve in Figure 3.5 which highlights the difference between supply and a supply shifter. An increase in supply shifts the supply curve to the right. A decrease in supply shifts the supply curve to the left.

An Increase in Supply

Review the concept of supply in:

 

2b. Determine equilibrium in the market under various situations that either cause movements or shifts in demand and supply

  • What will happen in a free market when a sudden change in demand or supply causes a shortage to occur at the original price? Think about the effect of a shortage on the price of the good.
  • What will happen in a free market after a sudden surplus?
  • Will sellers have an incentive to raise or lower the price to eliminate the surplus?
  • What happens to the equilibrium point if the government imposes a price control (such as a price ceiling or a price floor)? Note that government intervention means the market is no longer free and is unable to respond freely. Remember to distinguish between price controls that are binding or effective and those that are not.

In a free market, capitalist economic system, economists say that buyers and sellers will eventually achieve an equilibrium: the point where demand and supply intersect and create an equilibrium price and quantity in the market. Note that a free market will always reach an equilibrium.

As you review this material, it is helpful to draw graphs of demand and supply to analyze the changes in the equilibrium point that result from shifts in demand or supply.

Review the concept of market equilibrium in the following resources. Be sure to practice this section thoroughly by completing any accompanying exercises and practice problems.

 

2c. Apply the concept of elasticity as a measure of responsiveness to various variables

  • Define elasticinelastic, and unit elastic.
  • Will products with many substitutes have high or low elasticity?
  • What is the elasticity of luxury goods?
  • What about the elasticity of goods that people are addicted to (such as cigarettes)?
  • How do companies know whether they should raise or lower prices?

While demand and supply indicate what happens to quantity demanded and quantity supplied, with regard to price fluctuations, the concept of elasticity offers a deeper understanding of the exact level of consumer responsiveness. Do buyers and sellers change their behavior a little or a lot when prices fluctuate? It often depends on they type of good.

For example, people consider many goods, such as food, medicine, and water, to be necessities. Consumers will continue to buy them, in the same quantities as they did before, regardless of a price increase. These goods have a low responsiveness to price changes – they are inelastic. On the other hand, people will postpone buying something they do not really need when the price goes up just a little bit. These goods have a high responsiveness to price changes – they are elastic.

Business revenue is also related to elasticity of demand. Think about the company that sells the food, medicine, water, or luxury good. Raising the price may lead to an increase in revenues, but lowering the price may also generate more revenue if consumers buy more items. The company needs to do the math to see which option will generate more revenue. Elasticity of demand will play a role.

There are a number of different types of elasticities: price elasticity of demand, price elasticity of supply, income elasticity of demand, cross-price elasticity of related goods, and more.

Review elasticity in:

 

2d. Analyze how the market can be manipulated through price controls or quantity controls

  • Define price control and quantity control.
  • Define tariff.
  • What are the benefits of price controls? Who benefits?
  • What problems do price controls cause? Who is hurt?
  • Are price controls a good way to guide the market toward "desirable" price levels?

Remember that free markets create an equilibrium at the point where demand and supply intersect. What happens in a market when government or society deems the free market equilibrium price "too high" or "too low"?

For example, the mayors of many large cities are concerned that low-income residents are being forced to move to the suburbs because they cannot afford to rent an apartment downtown. The city suffers when these essential workers cannot afford to live or travel easily downtown; commuting is expensive and time consuming. Similarly, many consider the wage rate for many important jobs "too low", such as when workers do not earn enough to rise above the poverty level. City governments may require businesses to pay a minimum wage to their workers.

Review price and quantity controls in:

 

Unit 2 Vocabulary

  • Ceteris paribus
  • Change in demand
  • Change in quantity demanded
  • Change in quantity supplied
  • Change in supply
  • Complement
  • Demand
  • Demand determinant
  • Demand shifter
  • Elastic
  • Elasticity
  • Equilibrium
  • Expectation
  • Income
  • Inelastic
  • Inferior good
  • Law of demand
  • Law of supply
  • Luxury good
  • Minimum wage law
  • Natural event
  • Normal good
  • Preference
  • Price
  • Price ceilings
  • Price controls
  • Price floors
  • Quantity control
  • Quantity demanded
  • Quantity supplied
  • Shortage
  • Substitute
  • Supply
  • Supply shifter
  • Surplus
  • Tariff
  • Unit elastic

Unit 3: Markets and Individual Maximizing Behavior

3a. Identify the maximizing behavior of individuals in the market

The Marginal Decision Rule

  • Define net benefit.
  • Define marginal benefit and marginal cost.
  • Define the marginal decision rule.
  • What steps do economic agents follow to determine optimal outcomes?
  • What is the value of marginal benefit, with respect to marginal cost at the optimal level of consumption or production?

In this unit, we examine the process individuals and companies use to make decisions. We start with the basic assumption that market participants are driven by rational self-interest – individuals maximize their satisfaction (or utility) while companies maximize their profits.

According to the marginal decision rule, individuals and companies compare the marginal benefit or marginal cost of adding another unit to consumption or production. If the marginal benefit of the next unit exceeds the marginal cost, they should add more units.

The Benefits and Costs of Studying Economics

Review the optimal decision rule in:

 

Consumer and Producer Surplus

  • What is the graphical representation of consumer surplus?
  • What is the graphical representation of producer surplus?
  • How does demand represent marginal benefit and how does supply represent marginal cost?
  • How do we analyze market outcomes that optimize how much a society benefits from a sale or purchase, in terms of the total surplus in the market?

We can illustrate marginal benefit and marginal cost through the demand and supply curves. Consumer surplus illustrates the net benefit a buyer receives when they buy something for a price that is lower than the value they place on it.

For example, a happy restaurant patron might think, "I got a real bargain tonight, since I would have paid much more money for that delicious meal". Similarly, a producer surplus describes how a company profits when it is able to sell something for a price that is higher than what it cost to produce it.

The free market equilibrium represents the optimal and most efficient point in the market. Review our discussion of the demand and supply curves in the previous unit.

Review consumer and producer surplus in the following resources. Take the quiz in the last link to test your knowledge.

 

3b. Identify the behavior of individuals when markets fail

  • Name some examples of market failure.
  • Define and list some examples of deadweight loss.
  • Define and list some examples of a public good.
  • Define and list some examples of a free rider.
  • Define and list some examples of a negative externality.
  • Define and list some examples of a positive externality.
  • What government policies are used to correct negative externalities?
  • Define the concept of the tragedy of the commons.

The free-market equilibrium is the most efficient point in the market in terms of optimizing total surplus. However, from a society's point of view, the market equilibrium is not always best, depending on what you value and are interested in achieving in your community.

Sometimes externalities, asymmetric information, and market power generate additional costs or benefits that were not part of your initial analysis of consumer demand, producer supply, or cost curves.

Review market failure in:

 

3c. Analyze the causes and reasons for income inequality

  • Define income inequality and name some steps communities and governments have taken to alleviate it.
  • Is the market always fair? Why do some societal groups often experience a higher concentration of poverty?
  • Name some government programs aimed to help those in need and reduce poverty levels.
  • Define discrimination and name some examples of discrimination in the workplace.
  • Name some examples of some steps governments have taken to reduce or eliminate discrimination in the workplace?
  • Review the topic of discrimination that is banned in the workplace.

There is a common saying that income inequality causes "the rich to become richer and the poor to become poorer". Review income inequality and workplace discrimination in Inequality, Poverty, and Discrimination.

 

Unit 3 Vocabulary

  • Consumer surplus
  • Deadweight loss
  • Discrimination
  • Equilibrium
  • Free rider
  • Income inequality
  • Marginal benefit
  • Marginal cost
  • Marginal decision rule
  • Market failure
  • Negative externality
  • Net benefit
  • Positive externality
  • Producer surplus
  • Public good
  • Tragedy of the commons

Unit 4: The Consumer

4a. Identify and describe the basic tenets of consumer theory through two alternate approaches: the utility analysis and the indifference analysis

Utility and Marginal Utility

  • Define utility analysis and marginal utility.
  • How do consumers choose between two goods?
  • Define the utility maximization rule using marginal utility per dollar.
  • What does the law of diminishing marginal utility indicate?

The theory of consumer choice relies on the concept of utility, which is another word for consumer satisfaction or happiness. As individuals seek to maximize their utility, specific behaviors often guide their choices. Concepts to help analyze choices are marginal utility and marginal utility per dollar.

Things are not always what they seem or what we expect. Review consumer theory and consumer equilibrium in:

 

Indifference Curves and Budget Lines

  • Define the indifference curve and describe how they measure utility.
  • Define a budget line and describe how it limits consumer choices.
  • How do you determine optimal consumer choice for an individual, when you put the indifference map and the budget line together?
  • Define and describe how you represent the income effect and substitution effect graphically.

The concepts of consumer preference and utility help us understand how individuals compare goods and services. For example, individuals have to consider their budget limitations and how much money they have available to spend to make an optimal choice. We put consumer preferences and budget on the same graph to analyze consumer choice.

During your review, pay particular attention to income and substitution effects that arise from changes in a consumer's income, and the price of one or both of the goods.

Review consumer choice and optimization subject to a budget constraint in:

 

4b. Correlate the derivation of the theory of demand to the theory of consumer behavior

  • How does a price increase affect the quantity a consumer can afford to buy?
  • How should we reflect a change in price in the indifference curve, budget line framework, and the choice an informed consumer will make regarding the optimal quantities of the goods?

The indifference curve and budget constraint provide the foundation for the demand curve, which represents the negative relationship between price and quantity demanded (i.e. as price increases, quantity demanded decreases). Consider how we can use the consumer optimization framework to derive this relationship.

You can translate and represent these changes on an individual's demand curve.

Review how to construct a demand curve in:

 

Unit 4 Vocabulary

  • Budget constraint line
  • Consumer equilibrium
  • Demand curve
  • Diminishing marginal utility
  • Income effect
  • Indifference curves
  • Indifference map
  • Law of diminishing marginal utility
  • Marginal utility
  • Marginal utility per dollar
  • Substitution effect
  • Total utility
  • Utility analysis
  • Utility maximization rule

Unit 5: The Producer

5a. Analyze the behavior of the producer

  • Define and explain the difference between accounting profit and economic profit.
  • Define opportunity costs and explain how they affect a company's production decisions?

In this unit, we analyze how businesses or producers make decisions. For example, businesses decide how much they should produce of the item they are selling, the price they should charge customers, and the number of hours they should operate. Costs and revenues are important considerations for companies that aim to maximize profit.

It is important to distinguish between accounting profit and economic profit. Companies make decisions based on their goal to maximize economic, not accounting, profit. For example, a company may be able to earn a positive accounting profit, but determine it is best to close its operations if economic profit remains negative.

Economic profits offer businesses a useful tool for making decisions. For example, consider an individual who quits their corporate job (earning $60,000 a year) to start a small business that earns $40,000 a year in accounting profits. The positive accounting profit indicates the business is able to cover its costs and earn positive profits. However, when the business owner considers an economic profit of -$20,000 (calculated as accounting profit minus the opportunity cost of the foregone salary) they determine it may be best to close the business and return to earning their previous corporate salary.

Review the decision making process companies face in:

 

5b. Compare the costs of production in the short run to costs of production in the long run

  • Define a short-run costlong-run cost, and respective cost.
  • Define and name some examples of fixed costsvariable costs, and total costs.
  • Define average total cost and explain how to compute it.
  • Define marginal cost and explain how to compute it.
  • How do costs change when we increase or decrease output?

Economics defines profits as the total revenues minus the total costs (which include opportunity costs). While revenues largely depend on demand and consumer behavior, businesses have direct control over their costs.

In this section, we analyze a company's cost structure and its effect on profitability and production decisions. Review how to distinguish between short-run and long-run costs, since they affect outcomes in different ways.

 

Short-Run Costs

The short-run describes a time period when many variables are fixed. In the long run, all variables are flexible.

Consider an ice cream shop that leases an ice cream machine and has contracted two employees to work on an hourly basis (at $10 per hour). The cost to rent the storefront and the cost to lease the ice cream machine is fixed: the ice cream shop must pay these fixed costs regardless of how many ice cream cones it produces or sells. How do fixed costs behave when we increase the number of ice cream cones produced?

Since the business manager has contracted its employees to work on an hourly basis, the number of work hours will vary with the level of production (number of ice cream cones produced and sold). This cost is variable not fixed. We can see in the table that larger quantities of production are associated with more hours worked.

 

Ice Cream Shop Costs

Ice Cream
Cones

Fixed Cost

Variable Cost

Total Cost

Average Total
Cost

Marginal Cost

0

$1,000

$0

$1,000

-

-

1

$1,000

$10

$1,010

$1,010

$10

5

$1,000

$10

$1,010

$202

$0

10

$1,000

$30

$1,030

$103

$20

15

$1,000

$60

$1,060

$71

$30

20

$1,000

$100

$1,100

$55

$40

Review the theory of costs and some visual examples in Production Choices and Costs: The Short Run from Principles of Microeconomics.

 

Long-Run Costs

  • How can we interpret the region of the long-run average cost (LRAC) where costs are falling (points A and B)?
  • How can we interpret the region of the long-run average cost (LRAC) where costs are rising (point D)?
  • What is the meaning of the lowest point on the long-run average cost (LRAC) curve (point C)?

The long-run describes a time period in which all costs are variable. For example, a production facility or factory may be a fixed variable in the short run, but with sufficient time in the long run, the business owner could build a new facility in a new location, close an existing operation, expand or reduce its production capacity. The factory itself becomes a variable resource in the long run.

For example, consider Figure 8.9, which illustrates the long-run cost curve of a company producing CDs. Note that the long-run average total cost curve envelopes its short-run cost average total cost curves.

 

Relationship between Short-Run and Long-Run Average Total Costs

We derive the long-run average cost (LRAC) by taking the lowest average total cost curve at each level of output. The graph displays the average total cost curves for 20, 30, 40, and 50 units of capital (the four smaller yellow curves).

  • When the CD company produces 10,000 CDs per week, it can minimize the cost per CD by producing with 20 units of capital (point A).
  • When the CD company produces 20,000 CDs per week, with an expansion in plant size, it can minimize the cost per CD by producing with 30 units of capital (point B).
  • The CD company achieves the lowest cost per unit when it produces 30,000 CDs per week using 40 units of capital (point C).
  • If the CD company decides to produce 40,000 CDs per week, it will do so most cheaply with 50 units of capital (point D).

Review long-run costs in:

 

5c. Identify the production function in the short run as well as the long run

The Production Function

  • What are the goals of the company when choosing a specific combination of inputs and a production function?
  • What could cause an increase in labor productivity? Think about specialization and trade.
  • What could cause a decrease in labor productivity? Think about the effect of crowding out a small space with too many employees.
  • Define the law of diminishing marginal returns.

A production function is the relationship between a company's factors of production and its output. For example, the ice cream shop from the previous section uses inputs: fixed resources (the shop and the ice cream machine) and variable resources (employees, sugar, cream, cones) to produce output: ice cream cones.

As we examine the company's production choices, we consider factors that contribute to its profitability, such as the productivity of its resources.

This figure gives an example of a company that produces jackets. The table above the graph indicates output levels per day for Acme Clothing Company at various quantities of labor per day, assuming the company's capital is fixed.

Acme Clothing's Total Product Curve

We plot these values on the graph as a total product curve. As we move from points A, B, C to D, the slope of the production function rises, indicating increased worker productivity.

However, as we continue adding more employees past point D, labor productivity declines (diminishing marginal product) until it reaches point H. After point H, further additions of labor will actually lead to negative returns in production.

This type of outcome in production is so common, that economists define it as the law of diminishing marginal returns, which holds that the marginal product of any variable factor of production will eventually decline, assuming the quantities of other factors of production are unchanged.

Review the production function in:

 

The Company Shut-Down Decision

  • Define the company shut down decision.
  • How does its average total cost and average variable cost influence this decision in the short and long runs?

Have you been to a store or restaurant when you were the only customer? You may have wondered why the owner chose to keep the restaurant open at this time of the day or week. However, this decision to remain open during low customer traffic times may be a profit-maximizing (or loss-minimizing) choice.

The shutdown rule refers to the times when a company chooses to remain open during times of low activity, provided it can cover its variable costs with any revenue it generates. The company weighs whether it is better to incur a certain loss by staying open or incur an even bigger loss by closing during these times. Remember, it must pay its fixed costs regardless of whether it stays open or closes.

Review the shut-down rule in Understanding the Short-Run Shutdown.

 

5d. Compute the relationship between different cost functions

  • What specific calculations define each type of cost?
  • What does a graph of the respective cost curve look like?
  • How does the slope of each graph change in response to changes in output?
  • Why is the average fixed cost a downward sloping function?
  • Why are the marginal cost, average variable cost, and average total cost U-shaped?
  • Why does the marginal cost curve cross the average total cost and the average variable cost curve exactly at their minimum points? 

Make sure you can define each of the following cost functions, describe how each variable affects production choices, draw each cost curve on a graph, and analyze their shapes and interactions.

  • Fixed costs
  • Variable costs
  • Total costs
  • Marginal costs
  • Average fixed costs
  • Average variable costs
  • Average total costs

For our ice cream shop example, consider how fixed costs and average fixed costs behave as the shop produces more ice cream cones. Remember that fixed costs will remain the same regardless of how many ice cream cones are produced. Therefore, the average fixed cost must decline with each additional unit produced. The shop will lower per unit costs of production by raising output.

With respect to variable costs, note that average variable costs increase as production increases. What will that look like on a graph? Consider the effect on worker productivity, as you add additional employees in a crowded space and as you ask employees to work extra long hours.

How do you calculate marginal cost from total cost and what is the interpretation of an increasing marginal cost? Again, consider the effect on worker productivity, as you add additional employees in a crowded space and as you ask employees to work extra long hours.

 

Ice Cream Shop Costs

Ice Cream
Cones

Fixed Cost

Average Fixed
Cost

Variable Cost

Average Variable
Cost

Total Cost

Average Total
Cost

Marginal Cost

0

$1,000

-

$0

-

$1,000

-

-

1

$1,000

$200

$10

$10

$1,010

$1,010

$10

5

$1,000

$200

$10

$2

$1,010

$202

$0

10

$1,000

$100

$30

$3

$1,030

$103

$20

15

$1,000

$67

$60

$4

$1,060

$71

$30

20

$1,000

$50

$100

$5

$1,100

$55

$40


Once you master the definitions, you can put these costs together on the same graph and examine their interactions and dependencies.

 

Key Takeaways from Production Choices and Costs: The Short Run

In Panel (a), the total product curve for a variable factor in the short run shows that the firm experiences increasing marginal returns from zero to Fa units of the variable factor (zero to Qa units of output), diminishing marginal returns from Fa to Fb (Qa to Qb units of output), and negative marginal returns beyond Fb units of the variable factor.

Panel (b) shows that marginal product rises over the range of increasing marginal returns, falls over the range of diminishing marginal returns, and becomes negative over the range of negative marginal returns. Average product rises when marginal product is above it and falls when marginal product is below it.

In Panel (c), total cost rises at a decreasing rate over the range of output from zero to Qa. This was the range of output that was shown in Panel (a) to exhibit increasing marginal returns. Beyond Qa, the range of diminishing marginal returns, total cost rises at an increasing rate. The total cost at zero units of output (shown as the intercept on the vertical axis) is total fixed cost.

Panel (d) shows that marginal cost falls over the range of increasing marginal returns, then rises over the range of diminishing marginal returns. The marginal cost curve intersects the average total cost and average variable cost curves at their lowest points. Average fixed cost falls as output increases. Note that average total cost equals average variable cost plus average fixed cost.

Review this material in:

 

Unit 5 Vocabulary

  • Accounting profit
  • Average fixed costs
  • Average product
  • Average total costs
  • Average variable costs
  • Company shutdown rule
  • Cost function
  • Constant returns to scale
  • Diminishing marginal product
  • Diseconomies of scale
  • Economic profit
  • Economies of scale
  • Fixed costs
  • Labor productivity
  • Law of diminishing marginal returns
  • Long-run cost
  • Long-run average cost
  • Marginal cost
  • Marginal product
  • Marginal product of labor
  • Opportunity cost
  • Production function
  • Respective cost
  • Short-run cost
  • Short-run average cost
  • Total costs
  • Variable costs

Unit 6: Market Structure: Competitive and Non-Competitive Markets

6a. Identify the characteristic differences between various market structures, namely, perfectly competitive markets, non-competitive markets, and imperfectly competitive markets, and discuss differences in their operations

  • Define differentiated, and homogeneous products.
  • How many companies can exist in each of the four types of markets?
  • Do additional companies experience any barriers to entry?
  • Are products differentiated among different sellers?
  • Do companies have market power, which means they are able to control supply and prices?
  • Can companies sustain the amount of profit they receive for the long run?

Let's review different market structures and their characteristics. Monopolistic competition is the most common market structure, characterized by brand name and slightly differentiated products with many substitutes. The market structures perfect competition and monopoly offer theoretical extremes – they rarely exist in their purest forms, but we use these concepts as benchmarks to compare more common structures, such as monopolistic competition and oligopoly.

This table summarizes important distinctions among the four market structures. Note that mixed or hybrid structures, which encompass a mixture of characteristics, exist in addition to these four structures. For example, a market leader with a fringe of small competitors is a common market structure that combines monopoly and monopolistic competition.

Differentiated products means that each product is slightly or significantly different from the other and appeals to different customer wants or needs (think about different types of shoes, cars, or computer equipment). Undifferentiated or homogeneous means that all of the products are the same (think about a natural resource, such as oil, milk or sugar cane).

Market
Structure

Number of
Companies

Barriers to
Entry

Nature of
Product

Control over
Prices

Economic Profit
in the Long Run

Perfect
Competition

Many or
Infinite

No

Homogeneous

No

No

Monopoly

One

Yes

Unique

Yes

Yes

Oligopoly

Few

Yes

Differentiated

Some

Yes

Monopolistic
Competition

Many

Few

Differentiated

Little

No

 

Perfect Competition

  • Define perfect competition.
  • What sequence of events indicates a favorable market change that will cause existing companies to earn economic profit?
  • What sequence of events indicates an unfavorable market change that will cause existing companies to suffer an economic loss?
  • Why is it difficult for companies to sustain short-run profits or losses, causing them to make zero economic profits in the long run?

A perfectly competitive market assumes a large number of companies sell identical products and additional companies can enter and exit the industry freely. We call these companies "price takers" because they have no market power whatsoever, such as the ability to control prices.

Some students fail to recognize that zero economic profit is a reasonable and worthwhile outcome for a business. Remember the calculation for economic profit: accounting profit minus opportunity costs.

For example, an owner runs a business that earns $60,000 a year in accounting profit. However, the economic profit for the business is zero because the owner quit their corporate job where their salary was the same amount ($60,000). Accounting profit ($60,000) minus the opportunity cost of the owner's previous corporate job ($60,000) equals zero.

A company that makes zero economic profit is paying its bills and doing the best it can, without a better alternative use of its resources. In this situation, the company will remain in business.

Review these graphs from Competitive Markets for Goods and Services, which illustrate the dynamics that result from short-run economic profit or loss outcomes.

Eliminating Economic Profits in the Long Run

Figure 9.9 Eliminating Economic Profits in the Long Run

If companies in a particular industry are making an economic profit, other companies will join them in the long run. In Panel (b), a single company's profit is shown by the shaded area. Entry continues until companies in the industry are operating at the lowest point on their respective average total cost curves, and economic profits fall to zero.

Eliminating Economic Losses in the Long Run

Figure 9.10 Eliminating Economic Losses in the Long Run

Panel (b) shows that at the initial price P1, companies in the industry cannot cover average total cost (marginal revenue, MR1, is below average total cost, ATC). This induces some companies to leave the industry, shifting the supply curve in Panel (a) to supply, S2, reducing industry output to quantity, Q2, and raising price to P2. At this price (MR2), companies earn zero economic profit, and companies stop leaving the industry.

Panel (b) shows that when the company increases output from q1 to q2; total output in the market falls in Panel (a) because there are fewer companies. Notice that in Panel (a) quantity is designated by uppercase Q, while in Panel (b) quantity is designated by lowercase q. Note that in these graphs, (Q) is the quantity supplied in the market and (q) is the quantity supplied by one typical company.

Review the characteristics of a perfectly competitive market structure and company behavior in response to changes in market conditions in:

 

Monopoly

  • Define monopoly.
  • Define the profit maximizing rule.
  • Is this monopoly company making a positive economic profit?
  • Why are firms operating under monopolies less efficient than firms operating under perfect competition?
  • What are the effects of monopoly on consumer and producer surplus?
  • How does public policy attempt to resolve issues associated with monopoly?
  • Define price discrimination.
  • Define a natural monopoly.
  • Name some real-world examples of price discrimination and a natural monopoly.

A monopoly is at the opposite end of the market structure spectrum from perfect competition. A monopoly includes just one producer who is a "price maker", which has full control over the market price and quantity. There are no competitors and significant, strong barriers that restrict additional companies from entering this market. A monopoly can remain profitable during the long run since its position is unchallenged. Can you think of an example of a company that enjoys a monopoly?

We can determine a monopoly firm's profit-maximizing price and output by following three steps:

  1. Determine consumer demand, marginal revenue, and marginal cost curves.
  2. Choose the output level where the marginal revenue and marginal cost curves intersect.
  3. Determine the price from the consumer demand curve for the quantity found in step 2.

Once we have determined the monopoly company's price and output, we can determine its economic profit by calculating the area shaded in green in the below graph.

Computing Monopoly Profit

Figure 10.6 Computing Monopoly Profit

Read up from Qm to the demand curve to find the price Pm where the monopoly company can sell Qm units per period. Point E on the demand curve is the profit-maximizing price and output.

The average total cost (ATC) at an output of Qm units is ATCm. Consequently, the company's profit per unit is Pm minus ATCm. Determine the total profit by multiplying the company's output, Qm, by profit per unit. Total profit equals Qm(Pm minus ATCm): the area of the shaded rectangle.

A monopoly maximizes profit by producing an output Qm at point G, where the marginal revenue and marginal cost curves intersect. It sells this output at price Pm.

An important distinction between a monopoly and perfect competition is that the monopoly meets the demand of the entire industry, is free to charge customers more for what it produces, and is able to sell less product than it would if it were a perfectly competitive company.

Review the monopoly structure in:

 

Monopolistic Competition

  • What is the optimization rule for monopolistically competitive firms?
  • How do monopolistically competitive firms compare with perfectly competitive firms?
  • How do monopolistically competitive firms compare with monopoly firms?
  • Why and how is the economic profit of monopolistically competitive firms reduced to $0 in the long-run?

 

Monopolistic competition lies in the middle of the market structure spectrum: between perfect competition and a monopoly. In this type of structure, we see many producers, as in perfect competition, and fierce competition drives long-run economic profits to zero. However, companies in monopolistic competition produce differentiated products and have the ability to exert some market power. They have some control over prices, and limited barriers protect them from other companies that want to enter their market.

It is easy to point to examples of companies operating in monopolistically competitive market structure since they use brand names to differentiate their product, and each one typically has many close, but not identical, substitutes.

As with a monopoly, companies in monopolistic competition face the entire market demand for their product. Their demand curve slopes downward since consumers will buy fewer products as their price increases. The graphical analysis for a monopolistically competitive company resembles that of a monopoly company.

Short-Run Equilibrium in Monopolistic Competition

Figure 11.1 Short-Run Equilibrium in Monopolistic Competition

As you review this chart, examine the intersection of the marginal revenue curve MR1 and the marginal cost curve MC, to see that the profit-maximizing quantity is 2,150 units per week. Reading up to the average total cost curve ATC, we see the cost per unit equals $9.20. Price, given on the demand curve D1, is $10.40, so the profit per unit is $1.20. Total profit per week equals $1.20 times 2,150, or $2,580; it is shown by the shaded rectangle.

When companies in monopolistic competition make positive economic profits in the short-run, new companies enter the market to produce similar products. Eventually, profits decrease due to this fierce competition, and profits are eliminated in the long run.

Monopolistic Competition in the Long Run

Figure 11.2 Monopolistic Competition in the Long Run

 

As you review this chart, the existence of economic profits in a monopolistically competitive industry will induce entry in the long run. As new firms enter, the demand curve D1 and marginal revenue curve MR1 facing a typical firm will shift to the left, to D2 and MR2. Eventually, this shift produces a profit-maximizing solution at zero economic profit, where D2 is tangent to the average total cost curve ATC (point A). The long-run equilibrium solution here is an output of 2,000 units per week at a price of $10 per unit.

Review monopolistic competition in:

 

Oligopoly

  • Define oligopoly.
  • Define cartel and collusion.
  • Name some real-world examples of companies that fall under oligopoly structure.
  • How was OPEC able to inflate prices for oil and gas to enrich oil-producing countries in the Middle East?
  • How is game theory used to study strategic behavior in oligopolies?
  • Define dominant strategy.
  • Define what a Nash Equilibrium is and how it is determined.
  • What are some examples of the use of game theory to study oligopoly behavior?

An oligopoly lies between a monopoly and perfect competition on the market spectrum but leans more toward a monopoly since a group of companies work together to create monopoly-like conditions they can all profit from. By colluding, or cooperating among each other (either secretly or openly via a formal cartel), oligopoly companies "artificially" prop up prices to ensure they all maintain collective profitability. In an oligopoly, a few companies produce a differentiated product, enjoy significant market power, control prices, and are able to sustain positive economic profits in the long run.

Oligopoly companies have a tremendous impact on each other's operations: while they all benefit when they can work together, they are often fraught with discord and mistrust. They typically engage in strategic behavior, which involves constant vigilance, as they counteract any actions other cartel members might take to promote their market position.

Since they do not enjoy a complete monopoly, cartel members need to be sure to keep up with any product improvements other members make, match their advertising spending, and make sure their product is similarly placed among their customers, so no one member of the group obtains a competitive advantage above the others.

Additionally, one rogue member of the cartel may try to undercut the lowest price the group had agreed to charge, to attract all of the customers, because they are greedy or need the extra money. Another cartel member may try to secretly sell more product than the group had agreed to supply at the higher price. According to the laws of supply and demand, if one cartel member floods the market with their product, the price for the good will fall, and everyone in the cartel will suffer.

Oligopoly companies often work together to avoid public officials who aim to curtail the inflated prices on behalf of their political constituents and consumers. However, when cartel members can no longer agree to work together to limit their supply to inflate prices, their disputes run the risk of triggering a price war that will benefit public consumers, but damage the mutually-inflated profit margin the cartel members previously enjoyed.

Monopoly through Collusion

Figure 11.3 Monopoly through Collusion

Two identical firms have the same horizontal marginal cost curve MC. Their demand curves Dfirm and marginal revenue curves MRfirm are also identical. The combined demand curve is Dcombined; the combined marginal revenue curve is MRcombined. The profits of the two firms are maximized if each produces 1/2 Qm at point A. Industry output at point B is thus Qm and the price is Pm. At point C, the efficient solution output would be Qc, and the price would equal MC.

The Prisoner's Dilemma offers an interesting framework for analyzing strategic behavior among oligopoly companies. Companies engage in strategic behavior as they consider the actions of their competitors when making decisions, and intend to preempt or change final outcomes. For example, a company may want to outspend the advertising budget of its opponent when it decides how much money it should allocate to advertising next year. Another company may decide to preemptively invest in a large amount of capital to communicate a credible threat to its opponents of its intention to capture market share.

Figure 11.4 shows the decisions and outcomes available to players: two prisoners weigh "confessing" against "not confessing" to a crime. The four cells represent each possible outcome of the Prisoner's Game. Since the choice of the other prisoner will affect the final outcome on their prison sentence, what do the prisoners choose? Competitors often choose an option that is not mutually beneficial as they try to outplay each other.

Payoff Matrix for the Prisoner's Dilemma

 

Figure 11.4 Payoff Matrix for the Prisoner's Dilemma

 

Review the strategies of each player, note any dominant strategy, and the final outcome of the game, the Nash Equilibrium, if it exists. The Nash Equilibrium exists where each player's choice is the best response to what the other player has chosen and none of the players has an incentive to change their choice in equilibrium. Why do both players "confess" when "not confessing" is clearly a better outcome for them both?

Review the oligopoly market structure, game theory, the Prisoner's Dilemma, and the Nash Equilibrium in the following resources.

 

6b. Compare and contrast as well as discuss the three main kinds of economic systems

  • Define, compare, and contrast the three main kinds of economic systems: traditional economy, command economy, market economy.

Review this material in How Economies Can Be Organized: An Overview of Economic Systems.

 

Unit 6 Vocabulary

  • Cartel
  • Collusion
  • Command economy
  • Competitive advantage
  • Differentiated
  • Dominant strategy
  • Economic loss
  • Economic profit
  • Efficiency
  • Equitable
  • Game theory
  • Homogeneous
  • Marginal profit
  • Marginal revenue
  • Market economy
  • Monopolistic competition
  • Monopoly
  • Nash Equilibrium
  • Natural monopoly
  • Oligopoly
  • Perfect competition
  • Price discrimination
  • Price war
  • Prisoners' dilemma
  • Profit maximizing rule
  • Strategic choice
  • Traditional economy

Unit 7: Resource Markets

7a. Analyze how the demand and supply technique works for the resource markets

  • Define marginal revenue product and marginal factor cost.
  • What optimization rule do companies follow to decide how many employees to hire?
  • How can we reconcile this optimization rule with the rule we studied for profit optimization, Marginal Revenue = Marginal Cost?

How do companies decide how much of their resources to use (such as land, labor, capital, or entrepreneurial ability) to produce a final good, and at what price? Businesses calculate their demand for resources based on the demand consumers have for the final goods. For example, if consumer demand for cars (the final good) increases, demand for steel, parts, and other resources used to produce cars also increases.

Review supply and demand in resource markets in:

 

Labor Market

  • Define capital market and money market;
  • Define stock and bond;
  • Define primary market and secondary market;

When we talk about supply and demand in the labor market, we need to clearly identify the buyers and sellers of labor. If you are looking for a job, you are a supplier or seller of labor: you are represented in the labor supply curve. A business that wants to hire employees buys labor: the company is represented in the labor demand curve. The wage rate is the price or cost of labor.

As with our product market analysis of supply and demand, we can also identify shifters of labor demand. Note that a fluctuation in the wage rate leads to a change in the quantity of labor demanded, shown as a movement along the demand curve. A change in any other determinant of labor demand will shift the demand curve.

A labor demand shifter causes a fluctuation in overall labor demand, irrespective of price (wages). Examples of labor demand shifters include changes in:

  • Use of complementary or substitute factors of production: a new population of workers moves in the area or a local school closes which causes employees with children to leave.
  • Changes in product demand: local businesses begin outsourcing package fulfillment company when they cannot meet increased consumer demand for overnight shipping; and
  • Technology or innovation: a new robot is created to perform the repetitive tasks employees had been hired to perform;
  • The number of companies hiring: more package fulfillment businesses open their doors to meet the increased demand for overnight shipping.

Review the labor market in How Many People to Hire Given the MPR Curve. Review these factors and their impact on labor demand in Wages and Employment in Perfect Competition.

 

Financial Markets

Financial markets are important for firms and individuals as they provide financial resources for optimal decision making. In the United States, several formal marketplaces have formed where individuals and groups of corporate investors can trade shares or investment portfolios in various businesses or commodities. Note that economists examine financial markets in more detail in macroeconomics.

Review Types of Financial Markets, Stock (finance), and Bond (finance).

 

Land and Natural Resources

  • What is the optimal resource use?
  • How do economists derive the resource demand curve and what are the shifters of demand?

Economists use many of the same methods they use to analyze land and natural resources as they do for the labor market. As with labor, businesses consider land and natural resources as factors of production. The companies that need to use the land and resources as inputs for production are the primary buyers of resources: they drive demand. The sellers of resources are the landowners, corporations, local governments, or federal agencies that own them.

Review this material in Economic Resources and Labor Market Quiz.

 

Unit 7 Vocabulary

  • Bond market
  • Capital market
  • Complementary factors of production
  • Derived demand
  • Labor demand
  • Labor market
  • Marginal factor cost
  • Marginal revenue product
  • Money market
  • Natural resource
  • New York Stock Exchange (NYSE)
  • Optimization rule
  • Primary market
  • Product market
  • Secondary market
  • Stock market
  • Substitute factor of production