13Producer Choices andConstraints.docx

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13
Producer Choices and
Constraints
Notes and teaching tips: 8, 16, 19, 37, 40, 44 and 66.
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After studying this chapter, you will be able to
Explain the firm’s economic problem and function
Explain the relationship between a firm’s output and its inputs
in the short run
Derive and explain a firm’s short-run cost curves
Explain the relationship between a firm’s output and costs in
the long run and derive a firm’s long-run average cost curve

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© 2013 Pearson Australia
What do a big electricity supplier, Origin Energy, and Sam’s T-
Shirts, a small (fictional) producer, have in common?
Like every firm, They must decide how much to produce.
How many people to employ. How much and what type of
capital equipment to use.
How do firms make these decisions?
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A firm is an institution that hires factors of production and
organises them to produce and sell goods and services.
The Firm’s Goal
A firm’s goal is to maximise profit.
If the firm fails to maximise its profit, the firm is either
eliminated or taken over by another firm that seeks to maximise
profit.
The Firm and Its Economic Problem
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Accounting Profit
Accountants measure a firm’s profit to ensure that the firm
pays the correct amount of tax and to show its investors how
their funds are being used.
Profit equals total revenue minus total cost.
Accountants use rules based on standards established by the
accounting profession.
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Economic Accounting
Economists measure a firm’s profit to enable them to predict the
firm’s decisions, and the goal of these decisions is to maximise
economic profit.
Economic profit is equal to total revenue minus total cost, with
total cost measured as the opportunity cost of production.
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A Firm’s Opportunity Cost of Production
A firm’s opportunity cost of production is the value of the best
alternative use of the resources that a firm uses in production.

A firm’s opportunity cost of production is the sum of the cost of
using resources
Bought in the market
Owned by the firm
Supplied by the firm's owner
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Another day; another dollar profit—or 15 cents, after implicit
costs. Emphasise the difference between accounting profit and
economic profit when a firm owner is using cost information to
make business decisions. Point out that only economic profit
reflects the full opportunity cost of making a business decision
and it is vital for assessing the true financial health of a firm.
Stress that accountants are limited in their ability to interpret
and report the costs of production: All accounting costs must
either be documented with a receipt or estimated according to
strict, generally accepted accounting procedures. Point out the
principal-agent problem that arises when firm managers can
exploit the limitations of accounting profit calculations to
under-report costs and over-report revenues to paint an
artificially rosy financial picture for the firm—to the detriment
of the firm owners.
Enron and Arthur Andersen: When is a cost really a cost? The
Enron fiasco brought the subject of accuracy and completeness
in cost assessment to the attention of investors everywhere.
Suddenly, the validity of financial information on any financial
statement issued by any publicly held company was under
scrutiny.
The implicit cost shuffle: Some subversive tools of the
accounting trade. A very useful news article, written by
financial reporter Ken Brown, appeared in the Wall Street
Journal on Feb. 2, 2002. He summarised many popular ways to
use accounting costs to understate opportunity costs on a
financial statement while technically satisfying generally

accepted accounting procedures: For example, his list includes:
i) Understating the capital asset depreciation by failing to
record recent declines in the true market valuation of the capital
(rather than from physical decay); ii) using off-the-books
agreements to hide debt and credit risk by partnering with
another company to share liabilities (which was a key element
of Enron’s ill-fated ploy); iii) capitalising operating expenses,
which allows current operating costs to be allocated over future
time periods as if it were a capital depreciation expense.
Resources Bought in the Market
The amount spent by a firm on resources bought in the market is
an opportunity cost of production because the firm could have
bought different resources to produce some other good or
service.
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Resources Owned by the Firm
If the firm owns capital and uses it to produce its output, then
the firm incurs an opportunity cost.
The firm incurs an opportunity cost of production because it
could have sold the capital and rented capital from another firm.
The firm implicitly rents the capital from itself.
The firm’s opportunity cost of using the capital it owns is called
the implicit rental rate of capital.

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The implicit rental rate of capital is made up of
1. Economic depreciation
2. Interest forgone
Economic depreciation is the change in the market value of
capital over a given period.
Interest forgone is the return on the funds used to acquire the
capital.
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Resources Supplied by the Firm’s Owner
The owner might supply both entrepreneurship and labour.
The return to entrepreneurship is profit.
The profit that an entrepreneur can expect to receive on average
is called normal profit.
Normal profit is the cost of entrepreneurship and is an
opportunity cost of production.
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In addition to supplying entrepreneurship, the owner might
supply labour but not take a wage.
The opportunity cost of the owner’s labour is the wage income
forgone by not taking the best alternative job.
Economic Accounting: A Summary
Economic profit equals a firm’s total revenue minus its total
opportunity cost of production.
The example in Table 13.1 on the next slide summarises the
economic accounting.
Figure
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The Firm’s Constraints
Two features of a firm’s environment impose constraints that
limit the profit that it can make.
They are:

Technology constraints
Market constraints
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Decision Time Frames
The firm makes many decisions to achieve its main objective:
profit maximisation.
Some decisions are critical to the survival of the firm.
Some decisions are irreversible (or very costly to reverse).
Other decisions are easily reversed and are less critical to the
survival of the firm, but still influence profit.
All decisions can be placed in two time frames:
The short run
The long run
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The big picture
Stand back from the details of this chapter and be sure that your
students learn two big ideas:
A firm’s production costs depend on the freedom to choose all
inputs.
1. Long-run flexibility enables firms to produce at a lower cost
than is possible in the short run when some inputs are fixed.
2. In the short run, with one or more fixed inputs, production
costs vary with output in a predictable way because they are
directly linked to input productivity.
Also, preview where we are heading. We want to be able to

predict firm’s decisions. To do so, we need to know about the
influences on their costs and revenues.
1. Cost conditions are similar for all firms. That’s what we
study here.
2. Revenue conditions depend on the market constraints. That’s
what we study in the three chapters that follow.
Emphasise that what the student learns here about cost is a vital
prerequisite for understanding firms in perfect competition,
monopoly, monopolistic competition, and oligopoly.
The Short Run
The short run is a time frame in which the quantity of one or
more resources used in production is fixed.
For most firms, the capital, called the firm’s plant, is fixed in
the short run.
Other resources used by the firm (such as labour, raw materials,
and energy) can be changed in the short run.
Short-run decisions are easily reversed.
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The Long Run
The long run is a time frame in which the quantities of all
resources—including the plant size—can be varied.
Long-run decisions are not easily reversed.
A sunk cost is a cost incurred by the firm and cannot be
changed.

If a firm’s plant has no resale value, the amount paid for it is a
sunk cost.
Sunk costs are irrelevant to a firm’s current decisions.
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Short-Run Technology Constraint
To increase output in the short run, a firm must increase the
amount of labour employed.
Three concepts describe the relationship between output and the
quantity of labour employed:
1. Total product
2. Marginal product
3. Average product
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Lots of definitions and terminology can cloud the primary
message
Make good use of the glossary of productivity and cost terms
provided in Table 13.3 but don’t get mired down in reciting
productivity and cost measure definitions!
Emphasise to the students that they must learn these definitions.
But don’t spend a lot of class time on them.
Focus on why productivity measures and cost measures are vital
for decision making.
Managers must frequently make quick decisions with little
information. If managers have knowledge of a useful
relationship between input measures (which are relatively easy
to get) and production cost measures (which are much more

difficult to get—especially marginal cost figures) they can use
their understanding of this link to make inferences about how
production costs will change when the firm’s output changes.
Product Schedules
Total product is the total output produced in a given period.
The marginal product of labour is the change in total product
that results from a one-unit increase in the quantity of labour
employed, with all other inputs remaining the same.
The average product of labour is equal to total product divided
by the quantity of labour employed.
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Table 13.2 shows a firm’s product schedules.
As the quantity of labour employed increases:
Total product increases.
Marginal product increases initially but eventually
decreases.
Average product increases initially but eventually
decreases.
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Product Curves
Product curves show how the firm’s total product, marginal
product, and average product change as the firm varies the
quantity of labour employed.
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Total Product Curve
Figure 13.1 shows a total product curve.
The total product curve shows how total product changes with
the quantity of labour employed.
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The total product curve is similar to the PPF.
It separates attainable output levels from unattainable output
levels in the short run.
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Marginal Product Curve
Figure 13.2 shows the marginal product of labour curve and
how the marginal product curve relates to the total product
curve.
The first worker hired produces 4 units of output.
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The second worker hired produces 6 units of output and total
product becomes 10 units.
The third worker hired produces 3 units of output and total
product becomes 13 units.
And so on.
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The height of each bar measures the marginal product of labour.
For example, when labour increases from 2 to 3, total product
increases from 10 to 13, …
so the marginal product of the third worker is 3 units of output.
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To make a graph of the marginal product of labour, we can
stack the bars in the previous graph side by side.

The marginal product of labour curve passes through the
midpoints of these bars.
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Almost all production processes are like the one shown
here and have:
Increasing marginal returns initially
Diminishing marginal returns eventually
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Increasing Marginal Returns
Initially, the marginal product of a worker exceeds the marginal
product of the previous worker.
The firm experiences increasing marginal returns.

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Diminishing Marginal Returns
Eventually, the marginal product of a worker is less than the
marginal product of the previous worker.
The firm experiences diminishing marginal returns.
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Increasing marginal returns arise from increased specialisation
and division of labour.
Diminishing marginal returns arises because each additional
worker has less access to capital and less space in which to
work.
Diminishing marginal returns are so pervasive that they are
elevated to the status of a “law.”
The law of diminishing returns states that:
As a firm uses more of a variable input with a given quantity of
fixed inputs, the marginal product of the variable input
eventually diminishes.

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Average Product Curve
Figure 13.3 shows the average product curve and its
relationship with the marginal product curve.
When marginal product exceeds average product, average
product increases.
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The marginal pulls (but cannot not push) the average
Don’t let the students fall into the trap of thinking that if the
marginal measure rises (falls) with the level of an activity, then
the average measure must also rise (fall). This is a sloppy
statement of the relationship between marginal and average
measures. Use the tried-and-true average mark example used in
the text. Explain that if their average mark is a 60%, and their
next marginal mark is 80%, their average rises to 70%. But if
the next marginal market is 60%, this marginal grade will not
pull the average mark up. Conceptually, the students should
understand that the marginal value can’t “push” the average
measure higher when it is, itself, lower than the average
measure. The marginal measure must be higher (lower) than the
average value if the average value is to rise (fall) with the level
of activity, thereby “pulling” the average from its position of
either higher or lower than the average.

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When marginal product is below average product, average
product decreases.
When marginal product equals average product, average product
is at its maximum.
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Short-Run Cost
To produce more output in the short run, the firm must employ
more labour, which means that it must increase its costs.
Three cost concepts and three types of cost curves are:
Total cost
Marginal cost
Average cost
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Explain the intuition behind each cost measure. For example,
explain why the relationship between marginal product and
marginal cost is worth understanding.
Point out that although separating fixed and variable
components of cost help us understand why unit cost of
production is U-shaped in the short run and why fixed costs

don’t matter in a firm’s output decision.
Total Cost
A firm’s total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed inputs.
Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable
inputs. Variable costs do change with output.
Total cost equals total fixed cost plus total variable cost. That
is:
TC = TFC + TVC
Short-Run Cost
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Figure 13.4 shows a firm’s total cost curves.
Total fixed cost is the same at each output level.
Total variable cost increases as output increases.
Total cost, which is the sum of TFC and TVC also increases as
output increases.
Short-Run Cost
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The AVC curve gets its shape from the TP curve.
The TP curve becomes steeper at small output levels and then
less steep at larger output levels.
In contrast, the TVC curve becomes less steep at small output
levels and steeper at larger output levels.
Short-Run Cost
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Emphasise that the TP curve graph has labour on the x-axis and
output on the y- axis, while the TVC curve has output on the x-
axis and total variable cost on the y-axis. So, each graph has
output on one of the axes.
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To see the relationship between the TVC curve and the TP
curve, let’s look again at the TP curve.

But let us add a second
x-axis to measure total variable cost.
1 worker costs $25;
2 workers cost $50; and so on, so the two x-axes line up.
Short-Run Cost
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We can replace the quantity of labour on the
x-axis with total variable cost.
When we do that, we must change the name of the curve. It is
now the TVC curve.
But it is graphed with cost on the x-axis and output on the y-
axis.
Short-Run Cost
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Redraw the graph with cost on the y-axis and output on the x-
axis, and you’ve got the TVC curve drawn the usual way.
Put the TFC curve back in the figure, …
and add TFC to TVC, and you’ve got the TC curve.
Short-Run Cost
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Marginal Cost
Marginal cost (MC) is the increase in total cost that results from
a one-unit increase in total product.
Over the output range with increasing marginal returns,

marginal cost falls as output increases.
Over the output range with diminishing marginal returns,
marginal cost rises as output increases.
Short-Run Cost
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Average Cost
Average cost measures can be derived from each of the total
cost measures:
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of
output.
Average total cost (ATC) is total cost per unit of output.
ATC = AFC + AVC.
Short-Run Cost
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Figure 13.5 shows the MC, AFC, AVC and ATC curves.
The AFC curve shows that average fixed cost falls as output
increases.
The AVC curve is U-shaped. As output increases, average
variable cost falls to a minimum and then increases.
Short-Run Cost

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The ATC curve is also
U-shaped.
Short-Run Cost
The MC curve is very special.
For the output range over which AVC is falling, MC is below
AVC.
For the output range over which AVC is rising, MC is above
AVC.
At minimum AVC, MC equals AVC.
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Similarly, for the output range over which ATC is falling, MC
is below ATC.
For the output range over which ATC is rising, MC is above

ATC.
At the minimum ATC,
MC equals ATC.
Short-Run Cost
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The AVC curve is U-shaped because:
Initially, MP exceeds AP, which brings rising AP and falling
AVC.
Eventually, MP falls below AP, which brings falling AP and
rising AVC.
The ATC curve is U-shaped for the same reasons.
In addition, ATC falls at low output levels because AFC is
falling quickly.
Short-Run Cost
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Why the Average Total Cost Curve Is U-Shaped
The ATC curve is the vertical sum of the AFC curve and the
AVC curve.
The U-shape of the ATC curve arises from the influence of two
opposing forces:
Spreading total fixed cost over a larger output—AFC curve

slopes downward as output increases.
Eventually diminishing returns—the AVC curve slopes upward
and AVC increases more quickly than AFC is decreasing.
Short-Run Cost
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Cost Curves and Product Curves
The shapes of a firm’s cost curves are determined by the
technology it uses:
MC is at its minimum at the same output level at which
MP is at its maximum.
When MP is rising, MC is falling.
AVC is at its minimum at the same output level at which
AP is at its maximum.
When AP is rising, AVC is falling.
Short-Run Cost
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Figure 13.6 shows these relationships.
Short-Run Cost
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Shifts in the Cost Curves
The position of a firm’s cost curves depends on two factors:
Technology
Prices of factors of production
Short-Run Cost
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Technology
Technological change influences both the product curves and
the cost curves.
An increase in productivity shifts the product curves upward
and the cost curves downward.
If a technological advance results in the firm using more capital
and less labour, fixed costs increase and variable costs decrease.
In this case, average total cost increases at low output levels
and decreases at high output levels.
Short-Run Cost

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Prices of Factors of Production
An increase in the price of a factor of production increases costs
and shifts the cost curves.
An increase in a fixed cost shifts the total cost (TC ) and
average total cost (ATC ) curves upward but does not shift the
marginal cost (MC ) curve.
An increase in a variable cost shifts the total cost (TC ),
average total cost (ATC ), and marginal cost (MC ) curves
upward.
Short-Run Cost
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Long-Run Cost
In the long run, all inputs are variable and all costs are variable.
The Production Function
The behaviour of long-run cost depends upon the firm’s
production function.
The firm’s production function is the relationship between the
maximum output attainable and the quantities of both capital
and labour.
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The firm’s transition between the short run and long run
revolves around the commitments made by the firm
Be sure the students realise that accurate forecasting of market
demand for a firm’s product is key to profitability, since it must
make the proper long-run commitment to a given plant size.
Show the students that if faulty market analysis causes a firm to
commit to a plant that is too small (too large) when the required
range of production is actually relatively high (relatively low),
the firm will suddenly be locked into a much less competitive
production cost situation with potentially dire consequences.
Long-Run Cost
Table 13.4 shows a firm’s production function.
As the size of the plant increases, the output that a given
quantity of labour can produce increases.
But for each plant, as the quantity of labour increases,
diminishing returns occur.
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Diminishing Marginal Product of Capital
The marginal product of capital is the increase in output
resulting from a one-unit increase in the amount of capital
employed, holding constant the amount of labour employed.
A firm’s production function exhibits diminishing marginal
returns to labour (for a given plant) as well as diminishing
marginal returns to capital (for a quantity of labour).
For each plant, diminishing marginal product of labour creates a
set of short run, U-shaped costs curves for MC, AVC, and ATC.
Long-Run Cost
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Short-Run Cost and Long-Run Cost
The average cost of producing a given output varies and
depends on the firm’s plant.
The larger the plant, the greater is the output at which ATC is at
a minimum.
The firm has 4 different plants: 1, 2, 3, or 4 sewing machines.
Each plant has a short-run ATC curve.
The firm can compare the ATC for each output at different
plants.
Long-Run Cost
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Long-Run Cost
ATC1 is the ATC curve for a plant with 1 sewing machine.
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Long-Run Cost
ATC2 is the ATC curve for a plant with 2 sewing machines.
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Long-Run Cost

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Long-Run Cost
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The long-run average cost curve is made up from the lowest
ATC for each output level.
So, we want to decide which plant has the lowest cost for
producing each output level.
Let’s find the least-cost way of producing a given output level.
Suppose that the firm wants to produce 13 T-shirts a day.
Long-Run Cost
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Long-Run Cost
13 T-shirts a day cost $7.69 each on ATC1.

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Long-Run Cost
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Long-Run Cost
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Long-Run Cost
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Long-Run Cost
The least-cost way of producing 13 T-shirts a day is to use 2
sewing machines, the fixed factor of ATC2.
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Long-Run Average Cost Curve
The long-run average cost curve is the relationship between the
lowest attainable average total cost and output when both the
plant and labour are varied.
The long-run average cost curve is a planning curve that tells
the firm the plant that minimises the cost of producing a given
output range.
Once the firm has chosen its plant, the firm incurs the costs that
correspond to the ATC curve for that plant.
Long-Run Cost

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Figure 13.8 illustrates the long-run average cost (LRAC) curve.
Long-Run Cost
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Economies and Diseconomies of Scale
Economies of scale are features of a firm’s technology that lead
to falling long-run average cost as output increases.
Diseconomies of scale are features of a firm’s technology that
lead to rising long-run average cost as output increases.
Constant returns to scale are features of a firm’s technology that
lead to constant long-run average cost as output increases.
Long-Run Cost

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Figure 13.8 illustrates economies and diseconomies of scale.
Long-Run Cost
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Minimum Efficient Scale
A firm experiences economies of scale up to some output level.
Beyond that output level, it moves into constant returns to scale
or diseconomies of scale.
Minimum efficient scale is the smallest quantity of output at
which the long-run average cost reaches its lowest level.
If the long-run average cost curve is U-shaped, the minimum
point identifies the minimum efficient scale output level.
Long-Run Cost
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12
Consumer Choices
and Constraints
Notes and teaching tips: 5, 18, 33, 38 and 42.
figure.
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After studying this chapter you will be able to
Describe a household’s budget line and show how it changes
when prices or income change
Use indifference curves to map preferences and explain the
principle of diminishing marginal rate of substitution
Predict the effects of changes in prices and income on
consumption choices
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As the prices of music downloads and e-books have fallen,
we’re downloading ever more songs and books.
But e-books have made a smaller inroad into the overall market
for books than downloads have in the market for recorded
music.
Why?
As the price of a DVD rental has fallen we’re renting ever more
of them, but we’re also going to movie theatres in ever-greater
numbers.
Why are we going to the movies more when it is so cheap and
easy to rent a DVD?
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Consumption Possibilities
A household’s consumption choices are constrained by its
income and the prices of the goods and services available.
The budget line describes the limits to the household’s
consumption choices.
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The budget line is like a restaurant menu. This example has
been well received: Emphasize that the consumer’s budget line
is like a menu showing what affordable combinations of food
and drink are available to the consumer. Ask them to compare
the relative prices between two goods: food and drink and
depict the affordable combinations a diner can purchase with a
set income.

Lisa has $40 to spend, the price of a movie is $8 and the price
of soft drink is $4 a case.
The rows of the table show combinations of soft drink and
movies that Lisa can buy with her $40.
The graph plots these six possible combinations.
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Lisa can afford any of the combinations at points A to F.
Some goods are indivisible goods and must be bought in whole
units at the points marked (such as movies).
Other goods are divisible goods and can be bought in any
quantity (such as petrol).
The line through points A to F is Lisa’s budget line.

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The budget line is a constraint on Lisa’s consumption choices.
Lisa can afford any point on her budget line or inside it.
Lisa cannot afford any point outside her budget line.
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The Budget Equation
We can describe the budget line by using a budget equation.
The budget equation states that
Expenditure = Income
Call the price of soft drink PS, the quantity of soft drink QS,
the price of a movie PM, the quantity of movies QM, and
income Y.
Lisa’s budget equation is:
PSQS + PMQM = Y.
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PSQS + PMQM = Y
Divide both sides of this equation by PS, to give:
QS + (PM/PS)QM = Y/PS
Then subtract (PM/PS)QM from both sides of the equation to
give:
QS = Y/PS – (PM/PS)QM
Y/PS is Lisa’s real income in terms of soft drink.
PM/PS is the relative price of a movie in terms of soft drink.
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A household’s real income is the income expressed as a quantity
of goods the household can afford to buy.
Lisa’s real income in terms of soft drink is the point on her
budget line where it meets the y-axis.
A relative price is the price of one good divided by the price of
another good.
Relative price is the magnitude of the slope of the budget line.
The relative price shows how many cases of soft drink must be
forgone to see an additional movie.
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A Change in Prices
A rise in the price of the good on the x-axis decreases the
affordable quantity of that good and increases the slope of the
budget line.
The budget line has become steeper because the relative price of
movies has increased.
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A fall in the price of the good on the x-axis increases the
affordable quantity of that good and decreases the slope of the
budget line.
The budget line has become flatter because the relative price of
movies has decreased.
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A Change in Income
An change in money income brings a parallel shift of the budget
line.
The slope of the budget line doesn’t change because the relative
price doesn’t change.
Figure 12.2(b) shows the effect of a fall in income.
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An indifference curve is a line that shows combinations of
goods among which a consumer is indifferent.
Figure 12.3(a) illustrates a consumer’s indifference curve.
At point C, Lisa sees
2 movies and drinks 6 cases of soft drink a month.
Preferences and Indifference Curves
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Decisions, decisions: Chardonnay or cheesecake? What
combination of food and drink will the diner select? It depends
upon the willingness to give up some food for additional drink.
Is the diner willing to forgo the appetiser in order to enjoy a
second glass of wine with dinner? Or will the diner have only
ice water in order to afford a dessert after the main course?
Have them construct a preference map reflecting the diner’s
indifference between exchanging a quantity of drink for a
quantity of food. (Be sure that the indifference curves for both
scenarios reflect diminishing marginal rate of substitution.)
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Lisa can sort all possible combinations of goods into three
groups: preferred, not preferred, and just as good as point C.
An indifference curve joins all those points that Lisa says are
just as good as C.
G is such a point. Lisa is indifferent between the combination at
point C and at point G.
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All the points on the indifference curve are preferred to all the
points below the indifference curve.
All the points above the indifference curve are preferred to all
the points on the indifference curve.
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A preference map is a series of indifference curves.
Call the indifference curve that we’ve just seen I1.
I0 is an indifference curve below I1.
Lisa prefers any point on I1 to any point on I0 .
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I2 is an indifference curve above I1.

Lisa prefers any point on I2 to any point on I1 .
For example, Lisa prefers the combination at point J to the
combination at either point C or point G.
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Marginal Rate of Substitution
The marginal rate of substitution, (MRS) measures the rate at
which a person is willing to give up good y to get an additional
unit of good x while at the same time remaining indifferent
(remaining on the same indifference curve).
The magnitude of the slope of the indifference curve measures
the marginal rate of substitution.
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If the indifference curve is relatively steep, the MRS is high.
In this case, the person is willing to give up a large
quantity of y to get a bit more x. If the indifference curve
is relatively flat, the MRS is low.
In this case, the person is willing to give up a small
quantity of y to get more x.

*
A diminishing marginal rate of substitution is the key
assumption of consumer theory.
A diminishing marginal rate of substitution is a general
tendency for a person to be willing to give up less of good y to
get one more unit of good x, while at the same time remain
indifferent as the quantity of good x increases.
*
Figure 12.4 shows the diminishing MRS of movies for soft
drink.
At point C, Lisa is willing to give up 2 cases of soft drink to see
one more movie—her MRS is 2.
At point G, Lisa is willing to give up 1/2 case of soft drink to
see one more movie—her MRS is 1/2.
*

*
Degree of Substitutability
The shape of the indifference curves reveals the degree of
substitutability between two goods. Figure 12.5 shows the
indifference curves for ordinary goods, perfect substitutes, and
perfect complements.
*
*
Predicting Consumer Choices
Best Affordable Choice
The consumer’s best affordable choice isOn the budget lineOn
the highest attainable indifference curveHas a marginal rate of
substitution between the two goods equal to the relative price of
the two goods

*
Here, the best affordable point is C.
Lisa can afford to consume more soft drink and see fewer
movies at point F.
And she can afford to see more movies and consume less soft
drink at point H.
But she is indifferent between F, I, and H and she prefers C to I.
*
Waiter? We’re ready to order now. Have the students identify
which combination of food and drink would equate the MRS to
the relative price ratio for a given budget. Have the students
show how a rise in the price of drinks would rotate the budget
line and push the diner away from drink and toward food. Show
how an increase in income shifts the budget line, allowing both
dessert and the second glass of wine.
The meaning of tangency. Emphasise to the student the meaning
behind the tangency point between the indifference curve and
the budget line.
The marginal rate of substitution (MRS) shows the consumer’s
willingness to give up one good to get more of the other good.
The relative price of the two goods shows what the consumer
must give up of one good to get more of the other good.
When a consumer equates the marginal rate of substitution
(MRS) with the relative price ratio, he or she leaves no
unrealised gains from substituting one good for another.
The consumer is just willing to give up what he or she must

give up, and there are no unrealised gains from substituting one
good for another.
*
At point F, Lisa’s MRS is greater than the relative price.
At point H, Lisa’s MRS is less than the relative price.
At point C, Lisa’s MRS is equal to the relative price.
*
Predicting …
A Change in Price
The effect of a change in the price of a good on the quantity of
the good consumed is called the price effect.
Figure 12.7 illustrates the price effect and shows how the
consumer’s demand curve is generated.
Initially, the price of a movie is $8 and Lisa consumes at point
C in part (a) and at point A in part (b).

*
*
The price of a movie then falls to $4.
The budget line rotates outward.
Lisa’s best affordable point is now J in part (a).
In part (b), Lisa moves to point B, which is a movement along
her demand curve for movies.
Predicting …
*
Explain that the fall in the price of a movie leads Lisa to
substitute away from soft drink and into movies. The change in
the relative price changes the best affordable point. She can
reach a higher indifference curve by substituting away from the
relatively more expensive good and towards the relatively
inexpensive good.
The new consumption bundle satisfies the three properties: it is
on the new budget line, it is on the highest attainable
indifference curve, and the MRS has changed, matching the
slope of the new budget line.
Also emphasise that tracking the change in the quantity of the
good for which the price falls reveals the demand curve for that
good.

A Change in Income
The effect of a change in income on the quantity of a good
consumed is called the income effect.
Figure 12.8 illustrates the effect of a decrease in Lisa’s income.
Initially, Lisa consumes at point J in part (a) and at point B on
demand curve D0 in part (b).
Predicting …
*
*
Lisa’s income decreases and her budget line shifts leftward in
part (a).
Her new best affordable point is K in part (a).
Her demand for movies decreases, shown by a leftward shift of
her demand curve for movies in part (b).
Predicting …
*

Substitution Effect and Income Effect
For a normal good, a fall in price always increases the quantity
consumed.
We can prove this assertion by dividing the price effect in two
parts: Substitution effect Income effect
*
Students find this topic hard. Take it slowly. Get the students to
tell you how it goes. That’s the best way of judging the pace
that will work for them.
Initially, Lisa has an income of $40, the price of a movie is $8,
and she consumes at point C.
Lisa’s best affordable point is now J.
The move from point C to point J is the price effect.
The price of a movie falls from $8 to $4 and her budget line
rotates outward.
*

*
We’re going to break the move from point C to point J into two
parts.
The first part is the substitution effect and the second is the
income effect.
*
Substitution Effect
The substitution effect is the effect of a change in price on the
quantity bought when the consumer remains on the same
indifference curve.
*

*
To isolate the substitution effect, we give Lisa a hypothetical
pay cut.
Lisa is now back on her original indifference curve but with a
lower price of movies and her best affordable point is K.
The move from C to K is the substitution effect.
*
The direction of the substitution effect never varies:
When the relative price falls, the consumer always substitutes
more of that good for other goods.
The substitution effect is the first reason why the demand curve
slopes downward.
*
Income Effect

To isolate the income effect, we reverse the hypothetical pay
cut and restore Lisa’s income to its original level (its actual
level).
Lisa is now back on indifference curve I2 and her best
affordable point is J.
The move from K to J is the income effect.
*
*
For Lisa, movies are a normal good.
With more income to spend, she sees more movies—the income
effect is positive.
For a normal good, the income effect reinforces the substitution
effect and is the second reason why the demand curve slopes
downward.
*

Inferior Goods
For an inferior good, when income increases, the quantity
bought decreases.
The income effect is negative and works against the substitution
effect.
So long as the substitution effect dominates, the demand curve
still slopes downward.
*
If the negative income effect is stronger than the substitution
effect, a lower price for inferior goods brings a decrease in the
quantity demanded—the demand curve slopes upward!
This case does not appear to occur in the real world.
*
*

4
Elasticity
Notes and teaching tips: 10, 28, 45, 46, 50 and 62.
figure.
*
After studying this chapter, you will be able to
Define, calculate and explain the factors that influence the price
elasticity of demand
Define, calculate and explain the factors that influence the cross
elasticity of demand and the income elasticity of demand
Define, calculate and explain the factors that influence the
elasticity of supply
*
When the price of petrol soars, you complain a lot but keep on
filling your tank and spending more on fuel.
Do you react the same way when a cyclone wipes out the banana
crop, driving the price of bananas to five times its normal level?
How can we compare the effects of price changes on buying

plans for different goods, such as petrol and bananas?
This chapter introduces you to elasticity: a tool that addresses
these quantitative questions.
*
In Figure 4.1(a), an increase in supply brings A large fall in
price A small increase in the quantity demanded
Price Elasticity of Demand
*
*
In Figure 4.1(b), an increase in supply brings A small fall in
price A large increase in the quantity demanded
*

*
The contrast between the two outcomes in Figure 4.1 highlights
the need for
A measure of the responsiveness of the quantity
demanded to a price change.
The price elasticity of demand is a units-free measure of the
responsiveness of the quantity demanded of a good to a change
in its price when all other influences on buying plans remain the
same.
*
Calculating Price Elasticity of Demand
The price elasticity of demand is calculated by using the
formula:
Percentage change in quantity demanded
Percentage change in price

*
Percentages and percentage changes. Many students need a
refresher and some practice at doing what seems too simple to
bother with, calculating percentages and percentage changes.
Don’t be afraid to start with this pre-elasticity warm up. Just
toss out some numbers. Suppose that the campus bookstore
increases the price of an economics text from $70 to $80. What
is the percentage increase in price? Suppose the campus
computer store lowers the price of an iMac from $1500 to
$1000. What is the percentage decrease in price?
Next, tell them the prices have moved in the opposite
directions: The campus book store cuts the price of an
economics text from $80 to $70. What is the percentage
decrease in price? And the campus computer store now raises
the price of an iMac from $1000 to $1500. What is the
percentage increase in price?
You’re now all set to get the students using the average of the
original and new price to calculate percentages that are
independent of the direction of change.
Many students have a hard time remembering whether quantity
or price goes in the numerator of the elasticity formulas. Have
the students create their own mnemonic. Suggest McDonald’s
Big Mac™ hamburgers. It’s silly, but it works, reminding the
student that Q (quantity) appears before P (price) in the ratio of
percentage changes.
For practice at calculating the price elasticity of demand, bring
out your demand schedule for Coke (or other drink) that you
sold in class when you covered demand. Get the students to
calculate the price elasticity of demand at various points along
that demand curve.

To calculate the price elasticity of demand:
We express the change in price as a percentage of the average
price—the average of the initial and new price,
and we express the change in the quantity demanded as a
percentage of the average quantity demanded—the average of
the initial and new quantity.
*
Figure 4.2 calculates the price elasticity of demand for pizza.
The price initially is $20.50 and the quantity demanded is 9
pizzas an hour.
*
*

The price falls to $19.50 and the quantity demanded increases to
11 pizzas an hour.
The price falls by $1 and the quantity demanded increases by 2
pizzas an hour.
*
The average price is $20 and the average quantity demanded is
10 pizzas an hour.
*
The percentage change in quantity demanded, %DQ, is
calculated as
DQ/Qave x 100, which is
(2/10) x 100 = 20%.
The percentage change in price, %DP, is calculated as DP/Pave
x 100, which is
($1/$20) x 100 = 5%.
*

The price elasticity of demand is
%DQ / %DP = 20% / 5%
= 4.
*
Average Price and Quantity
By using the average price and average quantity, we get the
same elasticity value regardless of whether the price rises or
falls.
Percentages and Proportions
The ratio of two proportionate changes is the same as the ratio
of two percentage changes.
%DQ / %DP = DQ / DP
*
A Units-Free Measure
Elasticity is a ratio of percentages, so a change in the units of

measurement of price or quantity leaves the elasticity value the
same.
Minus Sign and Elasticity
The formula yields a negative value, because price and quantity
move in opposite directions.
But it is the magnitude, or absolute value, that reveals how
responsive the quantity change has been to a price change.
*
Inelastic and Elastic Demand
Demand can be inelastic, unit elastic, or elastic, and can range
from zero to infinity.
If the quantity demanded doesn’t change when the price
changes, the price elasticity of demand is zero and the good has
a perfectly inelastic demand.
*
Figure 4.3(a) illustrates the case of a good that has a perfectly
inelastic demand.
The demand curve is vertical.

*
*
If the percentage change in the quantity demanded equals the
percentage change in price, …
the price elasticity of demand equals 1 and the good has unit
elastic demand.
Figure 4.3(b) illustrates this case—a demand curve with ever
declining slope.
*
*

If the percentage change in the quantity demanded is smaller
than the percentage change in price, the price elasticity of
demand is less than 1 and the good has inelastic demand.
If the percentage change in the quantity demanded is greater
than the percentage change in price, the price elasticity of
demand is greater than 1 and the good has elastic demand.
*
If the percentage change in the quantity demanded is infinitely
large when the price barely changes, …
the price elasticity of demand is infinite and the good has a
perfectly elastic demand.
Figure 4.3(c) illustrates the case of perfectly elastic demand—a
horizontal demand curve.
*
*

Elasticity Along a Linear Demand Curve
Figure 4.4 shows how the elasticity of demand changes along a
linear demand curve.
At the mid-point of the demand curve, demand is unit elastic.
*
Elasticity and slope along a linear demand curve. You can
provide solid intuition on why the elasticity of demand falls as
we move down a linear demand curve. Point out first that as the
quantity increases, the percentage change in quantity decreases
for equal changes in quantity. Do two calculations, one at a
small quantity and one at a large quantity. Then point out that
this same reasoning applies to the price. As the price falls, the
percentage change in price increases for equal changes in price.
Again, do two calculations, one at a high price and one at a low
price. Now put the two together. As we move downward along
the demand curve, the percentage change in quantity is getting
smaller and the percentage change in price is getting larger, so
the elasticity—the ratio of the percentage change in quantity to
the percentage change in price—is getting smaller.
*

At prices above the mid-point of the demand curve, demand is
elastic.
At prices below the mid-point of the demand curve, demand is
inelastic.
*
For example, if the price falls from $25 to $15, the quantity
demanded increases from 0 to 20 pizzas an hour.
The average price is $20 and the average quantity
is 10 pizzas.
The price elasticity of demand is (20/10)/(10/20), which equals
4.
*
If the price falls from
$10 to $0, the quantity demanded increases from 30 to 50 pizzas
an hour.
The average price is $5 and the average quantity is 40 pizzas.

The price elasticity is (20/40)/(10/5), which equals 1/4.
*
If the price falls from
$15 to $10, the quantity demanded increases from 20 to 30
pizzas an hour.
The average price is $12.50 and the average quantity is 25
pizzas.
The price elasticity is (10/25)/(5/12.5), which equals 1.
*
Total Revenue and Elasticity
The total revenue from the sale of a good or service equals the
price of the good multiplied by the quantity sold.
When the price changes, total revenue also changes.
But a rise in price doesn’t always increase total revenue.
*

The change in total revenue due to a change in price depends on
the elasticity of demand:If demand is elastic, a 1 percent price
cut increases the quantity sold by more than 1 percent, and
total revenue increases.If demand is inelastic, a 1 percent
price cut increases the quantity sold by less than 1 percent,
and total revenues decreases.If demand is unit elastic, a 1
percent price cut increases the quantity sold by 1 percent,
and total revenue remains unchanged.
*
The total revenue test is a method of estimating the price
elasticity of demand by observing the change in total revenue
that results from a price change (when all other influences on
the quantity sold remain the same).If a price cut increases total
revenue, demand is
elastic.If a price cut decreases total revenue, demand is
inelastic.If a price cut leaves total revenue unchanged, demand
is unit elastic.
*

Figure 4.5 shows the relationship between elasticity of demand
and the total revenue.
As the price falls from $25 to $12.50 a pizza, the quantity
demanded increases from 0 to 25 pizzas.
Demand for pizza is elastic, and total revenue increases.
*
*
In part (b), as the quantity increases from 0 to 25 pizzas, the
demand for pizza is elastic, and total revenue increases.
*

*
At $12.50 a pizza, the demand for pizza is unit elastic and total
revenue stops increasing.
*
At 25 pizzas, the demand for pizza is unit elastic, and total
revenue is at its maximum.
*
As the price falls from $12.50 to zero, the quantity demanded
increases from 25 to 50 pizzas.
The demand for pizza is inelastic, and total revenue decreases.

*
As the quantity increases from 25 to 50 pizzas, the demand for
pizza is inelastic, and total revenue decreases.
*
Your Expenditure and Your ElasticityIf your demand is elastic,
a 1 percent price cut increases the quantity you buy by more
than 1 percent and your expenditure on the item increases.If
your demand is inelastic, a 1 percent price cut increases the
quantity you buy by less than 1 percent and your expenditure on
the item decreases.If your demand is unit elastic, a 1 percent
price cut increases the quantity you buy by 1 percent and your
expenditure on the item does not change.
*
Encourage your students to use the total revenue test (total
expenditure) to check whether their demand for some item the
price of which has changed, is elastic or inelastic.

The Factors That Influence the Elasticity of Demand
The elasticity of demand for a good depends on:The closeness
of substitutesThe proportion of income spent on the goodThe
time elapsed since a price change
*
Fuel for thought: Getting some intuition on what determines
whether demand is inelastic or elastic
The demand for gasoline and junk food in general. Students
love their cars and junk food, and they know that the demand
for both in general is inelastic because there are no good
substitutes for personal transportation and a quick snack.
The demand for Joe’s quick-mart petrol. Ask your students if
Joe’s quick-mart (substitute your actual local one) convenience
store would lose much business and total revenues if he raised
the price of petrol more than a couple of cents compared to the
other three service stations at a intersection. When the students
conclude he’d lose much of his petrol sales ask them to
reconcile this large quantity decrease to a small increase in
price (elastic demand) with the fact that they earlier stated that
demand for petrol is very inelastic. They will recognise that
petrol from other service stations at the same intersection is a
very good substitute for Joe’s petrol.
The demand for Joe’s quick-mart junk food. After students
recognise that abundant substitute availability keeps elasticity
high, ask the students why Joe’s junk food (and all quick-mart
stores’ junk food) is priced so much higher than the near-by
supermarket’s junk food. Students will conclude that
“convenience” stores are well named. Most people aren’t
willing to wait in the supermarket check-out line behind the
frazzled mother of three screaming kids, each hanging on the
over-loaded basket that will take 15 minutes of coupon
validating and price checking to check out. The supermarket is
not a good substitute for people on the go looking for a fast

snack and a quick fill-up.
Closeness of Substitutes
The closer the substitutes for a good or service, the more elastic
is the demand for the good or service.
Necessities, such as food or housing, generally have inelastic
demand.
Luxuries, such as exotic vacations, generally have elastic
demand.
*
Proportion of Income Spent on the Good
The greater the proportion of income consumers spend on a
good, the larger is the elasticity of demand for that good.
Time Elapsed Since Price Change
The more time consumers have to adjust to a price change, or
the longer that a good can be stored without losing its value, the
more elastic is the demand for that good.
*

Cross Elasticity of Demand
The cross elasticity of demand is a measure of the
responsiveness of demand for a good to a change in the price of
a substitute or a complement, other things remaining the same.
The formula for calculating the cross elasticity is:
Percentage change in price of substitute or complement
More Elasticities of Demand
*
The cross elasticity of demand fora substitute is positive.a
complement is negative.
*
Emphasise the information content in the algebraic sign of the
cross elasticity and the income elasticity and contrast this
situation with the price elasticity for which we focus only on
the magnitude and not the sign.
Figure 4.6 shows an increase in the quantity of pizza demanded
when the price of a burger (a substitute for pizza) rises.
The figure also shows a decrease in the quantity of pizza
demanded when the price of a soft drink (a complement of
pizza) rises.

*
*
Income Elasticity of Demand
The income elasticity of demand measures how the quantity
demanded of a good responds to a change in income, other
things remaining the same.
The formula for calculating the income elasticity of demand is
Percentage change in income
*
If the income elasticity of demand is greater than 1, demand is
income elastic and the good is a normal good.
If the income elasticity of demand is greater than zero but less

than 1, demand is income inelastic and the good is a normal
good.
If the income elasticity of demand is less than zero (negative)
the good is an inferior good.
*
When demand increases, is the change in the quantity supplied
small or large?
In Figure 4.7(a), an increase in demand brings A large rise in
price A small increase in the quantity supplied
Elasticity of Supply
*
*
In Figure 4.7(b), an increase in demand brings A small rise in
price A large increase in the quantity supplied

*
*
The contrast between the two outcomes in Figure 4.7 highlights
the need for A measure of the responsiveness of the quantity
supplied to a price change.
The elasticity of supply measures the responsiveness of the
quantity supplied to a change in the price of a good when all
other influences on selling plans remain the same.
*
Calculating the Elasticity of Supply
The elasticity of supply is calculated by using the formula:
Percentage change in quantity supplied
Percentage change in price

*
Figure 4.8 on the next slide shows three cases of the elasticity
of supply.
Supply is perfectly inelastic if the supply curve is vertical and
the elasticity of supply is 0.
Supply is unit elastic if the supply curve is linear and passes
through the origin. (Note that slope is irrelevant.)
Supply is perfectly elastic if the supply curve is horizontal and
the elasticity of supply is infinite.
*
*
The unit elastic demand curve is a good example to use to
emphasise that elasticity and slope are not equal. Have the
students calculate the elasticity of supply on two linear demand
curves that pass through the origin, one with a slope of 0.5 and
the other with a slope of 2. They’ll get the message.

*
*
*
The Factors That Influence the Elasticity of Supply
The elasticity of supply depends on Resource substitution
possibilities Time frame for supply decision
Resource Substitution Possibilities
The easier it is to substitute among the resources used to
produce a good or service, the greater is its elasticity of supply.

*
Time Frame for Supply Decision
The more time that passes after a price change, the greater is the
elasticity of supply.
Momentary supply is perfectly inelastic. The quantity supplied
immediately following a price change is constant.
Short-run supply is somewhat elastic.
Long-run supply is the most elastic.
Table 4.1 in the textbook provides a glossary of all the
elasticity measures.
*
*
3
Demand and
Supply

Notes and teaching tips: 5, 7, 43 and 48.
figure.
*
After studying this chapter, you will be able toDescribe a
competitive market and think about a price as an opportunity
costExplain the influences on demandExplain the influences on
supplyExplain how demand and supply determine prices and
quantities bought and soldUse the demand and supply model to
make predictions about changes in prices and quantities
*
What causes the big swings in the prices of coffee and bananas?
Why does the price of oil keep rising?
You know that economics is about the choices people make to
cope with scarcity and how those choices respond to incentives.
Prices act as incentives. How do people respond to prices?
This chapter explains how markets determine prices and why
prices change.
*

A market is any arrangement that enables buyers and sellers to
get information and do business with each other.
A competitive market is a market that has many buyers and
many sellers so no single buyer or seller can influence the price.
The money price of a good is the amount of money needed to
buy it.
The relative price of a good—the ratio of its money price to the
money price of the next best alternative good—is its
opportunity cost.
Markets and Prices
*
Before you jump into the demand-supply model, be sure that
your students understand that a price in economics is a relative
price and that a relative price is an opportunity cost. Also spend
some class time ensuring that they appreciate the key lessons of
Chapter 2:
a) Prosperity comes from specialisation and exchange.
b) Specialisation and exchange requires the social institutions
of property rights and markets.
c) We must understand how markets work.
You might like to explain that the most competitive markets are
explicitly organised as auctions. An interesting market to
describe is that at Aalsmeer in Holland, which handles a large
percentage of the world’s fresh cut flowers. Roses grown in
Columbia are flown to Amsterdam, auctioned at Aalsmeer, and
are in vases in New York, London, and Tokyo all in less than a
day. If you have an Internet connection in your classroom, you
can participate in a simulation of an auction of flowers.
http://www.youtube.com/watch?v=O5V7USbDBwA.

If you demand something, then you
1. Want it,
2. Can afford it, and
3. Have made a definite plan to buy it.
Wants are the unlimited desires or wishes people have for goods
and services. Demand reflects a decision about which wants to
satisfy.
The quantity demanded of a good or service is the amount that
consumers plan to buy during a particular time period, and at a
particular price.
Demand
*
The Law of Demand
The law of demand states:
Other things remaining the same, the higher the price of a good,
the smaller is the quantity demanded; and
the lower the price of a good, the larger is the quantity
demanded.
The law of demand results from Substitution effect Income
effect
Demand
*
Estimating the demand for Coke (or bottled water) in the

classroom.
Of the hundreds of classroom experiments that are available
today, very few are worth the time they take to conduct. The
classic demand-revealing experiment is one of the most
productive and worthwhile ones.
Bring to class two bottles of ice-cold, ready-to-drink Coke,
bottled water, or sports drink. (If your class is very large, bring
six bottles).
Tell the students that you have these drinks and ask them to
indicate if they would like one. Most hands will go up and you
are now ready to make two points:
1. The students have just revealed a want but not a demand.
2. You don’t have enough bottles to satisfy their wants, so you
need an allocation mechanism.
Ask the students to suggest some allocation mechanisms. You
might get suggestions such as: give them to the oldest, the
youngest, the tallest, the shortest, the first-to-the-front-of-the-
class. For each one, point out the
difficulty/inefficiency/inequity.
If no one suggests selling them to the highest bidder, tell the
class that you are indeed going to do just that. Tell them that
this auction is real. The winner will get the drink and will pay.
Now ask for a show of hands of those who have some cash and
can afford to buy a drink. Explain that these indicate an ability
to buy but not a definite plan to buy.
Substitution Effect
When the relative price (opportunity cost) of a good or service
rises, people seek substitutes for it, so the quantity demanded of
the good or service decreases.
Income Effect

When the price of a good or service rises relative to income,
people cannot afford all the things they previously bought, so
the quantity demanded of the good or service decreases.
Demand
*
Demand Curve and Demand Schedule
The term demand refers to the entire relationship between the
price of the good and quantity demanded of the good.
A demand curve shows the relationship between the quantity
demanded of a good and its price when all other influences on
consumers’ planned purchases remain the same.
Demand
*
Figure 3.1 shows a demand curve for energy bars.
Demand
*

*
A rise in the price, other things remaining the same, brings a
decrease in the quantity demanded and a movement up along the
demand curve.
A fall in the price, other things remaining the same, brings an
increase in the quantity demanded and a movement down along
the demand curve.
Demand
*
Willingness and
Ability to Pay
A demand curve is also a willingness-and-ability-to-pay curve.
The smaller the quantity available, the higher is the price that
someone is willing to pay for another unit.
Willingness to pay measures marginal benefit.
Demand
*

A Change in Demand
When some influence on buying plans other than the price of
the good changes, there is a change in demand for that good.
The quantity of the good that people plan to buy changes at
each and every price, so there is a new demand curve.
When demand increases, the demand curve shifts rightward.
When demand decreases, the demand curve shifts leftward.
Demand
*
Six main factors that change demand are The prices of related
goods Expected future prices Income Expected future income
and credit Population Preferences
Demand
*
Prices of Related Goods
A substitute is a good that can be used in place of another good.
A complement is a good that is used in conjunction with another
good.

When the price of a substitute for an energy bar rises or when
the price of a complement of an energy bar falls, the demand for
energy bars increases.
Demand
*
Expected Future Prices
If the expected future price of a good rises, current demand for
the good increases and the demand curve shifts rightward.
Income
When income increases, consumers buy more of most goods and
the demand curve shifts rightward.
A normal good is one for which demand increases as income
increases.
An inferior good is a good for which demand decreases as
income increases.
Demand
*
Expected Future Income and Credit
When expected future income increases or when credit is easy
to obtain, the demand might increase now.
Population
The larger the population, the greater is the demand for all

goods.
Preferences
People with the same income have different demands if they
have different preferences.
Demand
*
Figure 3.2 shows an increase in demand.
Because an energy bar is a normal good, an increase in income
increases the demand for energy bars.
Demand
*
*
A Change in the Quantity Demanded Versus a Change in
Demand
Figure 3.3 illustrates the distinction between a change in

demand and a change in the quantity demanded.
Demand
*
*
Movement Along the Demand Curve
When the price of the good changes and everything else remains
the same, the quantity demanded changes and there is a
movement along the demand curve.
Demand
*
A Shift of the Demand Curve
If the price remains the same but one of the other influences on
buyers’ plans changes, demand changes and the demand curve
shifts.
Demand

*
If a firm supplies a good or service, then the firm
1. Has the resources and the technology to produce it,
2. Can profit from producing it, and
3. Has made a definite plan to produce and sell it.
Resources and technology determine what it is possible to
produce. Supply reflects a decision about which technologically
feasible items to produce.
The quantity supplied of a good or service is the amount that
producers plan to sell during a given time period at a particular
price.
Supply
*
The Law of Supply
The law of supply states:
Other things remaining the same, the higher the price of a good,
the greater is the quantity supplied; and
the lower the price of a good, the smaller is the quantity
supplied.
The law of supply results from the general tendency for the
marginal cost of producing a good or service to increase as the
quantity produced increases (Chapter 2, page 33).

Producers are willing to supply a good only if they can at least
cover their marginal cost of production.
Supply
*
Supply Curve and Supply Schedule
The term supply refers to the entire relationship between the
quantity supplied and the price of a good.
The supply curve shows the relationship between the quantity
supplied of a good and its price when all other influences on
producers’ planned sales remain the same.
Supply
*
Figure 3.4 shows a supply curve of energy bars.
Supply
A rise in the price of an energy bar, other things remaining the
same, brings an increase in the quantity supplied.
*

*
Minimum Supply Price
A supply curve is also a minimum-supply-price curve.
As the quantity produced increases, marginal cost increases.
The lowest price at which someone is willing to sell an
additional unit rises.
This lowest price is marginal cost.
Supply
*
A Change in Supply
When some influence on selling plans other than the price of the
good changes, there is a change in supply of that good.
The quantity of the good that producers plan to sell changes at
each and every price, so there is a new supply curve.
When supply increases, the supply curve shifts rightward.
When supply decreases, the supply curve shifts leftward.
Supply
*

The six main factors that change supply of a good areThe prices
of factors of productionThe prices of related goods produced
Expected future prices The number of suppliersTechnologyState
of nature
Supply
*
Prices of Factors of Production
If the price of a factor of production used to produce a good
rises, the minimum price that a supplier is willing to accept for
producing each quantity of that good rises.
So a rise in the price of a factor of production decreases supply
and shifts the supply curve leftward.
Supply
*
Prices of Related Goods Produced
A substitute in production for a good is another good that can
be produced using the same resources.

The supply of a good increases if the price of a substitute in
production falls.
Goods are complements in production if they must be produced
together.
The supply of a good increases if the price of a complement in
production rises.
Supply
*
Expected Future Prices
If the expected future price of a good rises, the supply of the
good today decreases and the supply curve shifts leftward.
The Number of Suppliers
The larger the number of suppliers of a good, the greater is the
supply of the good. An increase in the number of suppliers
shifts the supply curve rightward.
Supply
*
Technology
Advances in technology create new products and lower the cost
of producing existing products.
So advances in technology increase supply and shift the supply
curve rightward.

The State of Nature
The state of nature includes all the natural forces that influence
production—for example, the weather.
A natural disaster decreases supply and shifts the supply curve
leftward.
Supply
*
Figure 3.5 shows an increase in supply.
An advance in the technology for producing energy bars
increases the supply of energy bars and shifts the supply curve
rightward.
Supply
*
*
A Change in the Quantity Supplied Versus a Change in Supply

Figure 3.6 illustrates the distinction between a change in
supply and a change in the quantity supplied.
Supply
*
*
Movement Along the Supply Curve
When the price of the good changes and other influences on
sellers’ plans remain the same, the quantity supplied changes
and there is a movement along the supply curve.
Supply
*
A Shift of the Supply Curve
If the price remains the same but some other influence on
sellers’ plans changes, supply changes and the supply curve
shifts.

Supply
*
Equilibrium is a situation in which opposing forces balance
each other. Equilibrium in a market occurs when the price
balances the plans of buyers and sellers.
The equilibrium price is the price at which the quantity
demanded equals the quantity supplied.
The equilibrium quantity is the quantity bought and sold at the
equilibrium price. Price regulates buying and selling plans.
Price adjusts when plans don’t match.
Market Equilibrium
*
The magic of market equilibrium and the forces that bring it
about and keep the market there need to be demonstrated with
the basic diagram, with intuition, and, if you’ve got the time,
with hard evidence in the form of further class activity.
You might want to begin with the demand curve experiment and
explain that in that market, the supply was fixed (vertical
supply curve) at the quantity of bottles that you brought to
class. The equilibrium occurred where the market demand curve
(demand by the students) intersected your supply curve.
Then you might use the supply curve experiment and explain
that in that market, demand was fixed (vertical demand curve)
at the quantity that you had decided to buy. The equilibrium
occurred where the market supply curve (supply by the
students) intersected your demand curve.
Point out that the trades you made in your little economy made

buyers and sellers better off.
If you want to devote a class to equilibrium and the gains from
trade in a market, you might want to run a double oral auction.
There are lots of descriptions of these and one of the best is at
Marcelo Clerici-Arias’s Web site at Stanford University—
http://www.stanford.edu/~marcelo/index.html?Teaching/Docs/E
xperiments/Auction/auction.htm~mainFrame
Price as a Regulator
Figure 3.7 illustrates the equilibrium price and equilibrium
quantity.
If the price is $2.00 a bar, the quantity supplied exceeds the
quantity demanded.
There is a surplus of
6 million energy bars.
Market Equilibrium
*
*

If the price is $1.00 a bar, the quantity demanded exceeds the
quantity supplied.
There is a shortage of
9 million energy bars.
If the price is $1.50 a bar, the quantity demanded equals the
quantity supplied.
There is neither a shortage nor a surplus of energy bars.
Market Equilibrium
*
Price Adjustments
At any price above the equilibrium price, a surplus forces the
price down.
At any price below the equilibrium price, a shortage forces the
price up.
At the equilibrium price, buyers’ plans and sellers’ plans agree
and the price doesn’t change until some event changes either
demand or supply.
Market Equilibrium
*
An Increase in Demand

Figure 3.8 shows that when demand increases the demand curve
shifts rightward.
At the original price, there is now a shortage.
The price rises, and the quantity supplied increases along the
supply curve.
Predicting Changes in Price and Quantity
*
The whole chapter builds up to this section, which now brings
all the elements of demand, supply, and equilibrium together to
make predictions.
Students are remarkably ready to guess the consequences of
some event that changes either demand or supply or both. They
must be encouraged to work out the answer and draw the
diagram.
Explain that the way to answer any question that seeks a
prediction about the effects of some events on a market has five
steps. Walk them through the steps and have one or two students
work some examples in front of the class. The five steps are:
1.Draw a demand-supply diagram and label the axes with the
price and quantity of the good or service in question.
2. Think about the events that you are told occur and decide
whether they change demand, supply, both demand and supply,
or neither demand nor supply.
3. Do the events that change demand or supply bring an increase
or a decrease?
4. Draw the new demand curve and supply curve on the
diagram. Be sure to shift the curves in the correct direction—
leftward for decrease and rightward for increase. (Lots of
students want to move the curves upward for increase and
downward for decrease—works ok for demand but exactly
wrong for supply. Emphasise the left-right shift.)
5. Find the new equilibrium and compare it with the original
one.
Walk them through the steps and have one or two students work

some examples in front of the class.
It is critical at this stage to return to the distinction between a
change in demand (supply) and a change in the quantity
demanded (supplied). You can now use these distinctions to
describe the effects of events that change market outcomes.
At this point, the students know enough for it to be worthwhile
emphasising the magic of the market’s ability to coordinate
plans and reallocate resources.
*
An Increase in Supply
Figure 3.9 shows that when supply increases the supply curve
shifts rightward.
At the original price, there is now a surplus.
The price falls, and the quantity demanded increases along the
demand curve.
*

*
All Possible Changes in Demand and Supply
A change in demand or supply or both demand and supply
changes the equilibrium price and the equilibrium quantity.
*
Change in Demand with No Change in Supply
When demand increases,
there is a movement up along the supply curve.
The equilibrium price rises and the equilibrium quantity
increases.
*

When demand decreases, the equilibrium price falls and the
equilibrium quantity decreases.
*
Change in Supply with
No Change in Demand
When supply increases,
there is a movement down along the demand curve.
The equilibrium price falls and the equilibrium quantity
increases.
*
When supply decreases,
the equilibrium price rises and the equilibrium quantity
decreases.

*
Increase in Both Demand and Supply
An increase in demand and an increase in supply increase the
equilibrium quantity.
The change in equilibrium price is uncertain because the
increase in demand raises the equilibrium price and the increase
in supply lowers it.
*
Decrease in Both Demand and Supply
A decrease in both demand and supply decreases the
equilibrium quantity.
The change in equilibrium price is uncertain because the
decrease in demand lowers the equilibrium price and the
decrease in supply raises it.
*

Decrease in Demand and Increase in Supply
A decrease in demand and an increase in supply lowers the
equilibrium price.
The change in equilibrium quantity is uncertain because the
decrease in demand decreases the equilibrium quantity and the
increase in supply increases it.
*
Increase in Demand and Decrease in Supply
An increase in demand and a decrease in supply raises the
equilibrium price.
The change in equilibrium quantity is uncertain because the
increase in demand increases the equilibrium quantity and the
decrease in supply decreases it.
*

*
*
*
*

*
*
*
*
*

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