Chapter 8

Utility and Demand

Michael Parkin, Economics, Tenth Edition, Addison-

Wesley, 2012

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 1

 Consumption Possibilities
• Consumption possibilities are
all the things that a person
can afford to buy
• A person can afford many
different combinations of
goods and services, but they
are all limited by the person’s
income and by the prices that
the person must pay

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 2

 Changes in Consumption Possibilities
• Consumption possibilities change when
income or prices change
• A rise in income shifts the budget line
outward but leaves its slope unchanged
• A change in a price changes the slope of
the line

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 3

 • Utility - The benefit or satisfaction that
a person gets from the consumption of
goods and services
• Total utility - The total benefit that a
person gets from the consumption of
all the different goods and services
– more consumption generally gives
more total utility
• Marginal Utility - The change in total
utility that results from a one-unit
increase in the quantity of a good
consumed
Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 4
 • Positive Marginal Utility - All the things that
people enjoy and want more of have a
positive marginal utility
• Principle of diminishing marginal utility -
The tendency for marginal utility to
decrease as the consumption of a good
increases is so general and universal that
we give it the status of a principle

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 5

 Total Utility and Marginal Utility

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 6

 • Marginal utility per dollar is the marginal utility
from a good that results from spending one more
dollar on it
• Call the marginal utility from movies MUM and the
price of a movie PM. Then the marginal utility per
dollar from movies is
MUM/PM
• Call the marginal utility from soda MUS and the price
of a case of soda PS. Then the marginal utility per
dollar from soda is
MUS/PS
Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 7
 Utility-Maximizing Choice
• Consumers want to get the most utility Lisa’s Utility-Maximizing Choice
possible from their limited resources
• They make the choice that maximizes
utility
• A consumer equilibrium is a situation
in which a consumer has allocated all
of his or her available income in the
way that maximizes his or her total
utility, given the prices of goods and
services
• Lisa’s consumer equilibrium is 2
movies and 6 cases of soda
Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 8
 • Utility-Maximizing Rule A consumer’s total utility
is maximized by following the rule:
– Spend all the available income
• As more consumption brings more utility, only those
choices that exhaust income can maximize utility
– Equalize the marginal utility per dollar for all goods
• Move dollars from good A to good B if doing so
increases the utility from good A by more than it
decreases the utility from good B
• Such a utility-increasing move is possible if the
marginal utility per dollar from good A exceeds that
from good B
Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 9
Equalize the marginal utility per dollar for all goods
• Buying more of good A decreases its marginal utility and
buying less of good B increases its marginal utility.
• By moving dollars from good A to good B, total utility
rises, but the gap between the marginal utilities per
dollar gets smaller.
• As long as the marginal utility per dollar from good A
exceeds that from good B—total utility can be increased
by spending more on A and less on B
• But when enough dollars have been moved from B to A
to make the two marginal utilities per dollar equal, total
utility cannot be increased further. Total utility is
maximized.

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 10

 Marginal Calculation
Equalizing Marginal Utilities per Dollar

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 11

 A Fall in the Price of a Movie
When the price of a movie
falls and the price of soda
remains the same, the
quantity of movies
demanded by Lisa
increases, and in part (a),
Lisa moves along her
demand curve for movies.
Also, when the price of a
movie falls, Lisa’s demand
for soda decreases, and in
part (b), her demand curve
for soda shifts leftward. For
Lisa, soda and movies are
substitutes.
Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 12
 A Rise in the Price of Soda
• When the price of soda
rises and the price of a
movie and Lisa’s income
remain the same, the
quantity of soda
demanded by Lisa
decreases
• Lisa moves along her
demand curve for soda.

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 13

 The Effects of a Rise in Income

Michael Parkin, Economics, Tenth Edition, Addison-Wesley, 2012 14

 Independent University, Bangladesh
Lecture Note: 9
Chapter 9: Possibilities, Preferences and Choices
Consumption Possibilities
 A household’s budget line describes the limits to its
consumption choices.
 Divisible and Indivisible Goods
 Some goods – called divisible goods – can be bought in
any quantity desired.
 Examples are gasoline and electricity.
 When we think of goods as being divisible, then it
includes all the intermediate points between A to F along
with A to F on Lisa’s budget line. (Figure 9.1)
Consumption
Possibilities
Consumption Possibilities
 Budget Equation
 We can describe the budget line using a budget equation.
The budget equation starts with the fact
Expenditure = Income
 Using Lisa’s Example
 Expenditure = (Price of Soda * Quantity of Soda) + (Price of
Movie * Quantity of Movie)
 PSQS + PMQM = Y
 Or, $4QS + $8QM = $40
Consumption Possibilities
 After dividing both sides by PS and subtracting (PM/PS )*
QM , we get
 QS = Y/PS – PM/PS * QM
 Using figures
 QS = $40/$4 – $8/$4 * QM
 Or,
 QS = 10 – 2QM
 Consumption Possibilities
 The budget equation contains two variables, which the
household can choose. They are:
 QM & QS
 And two variables, which are given. They are:
 Y/PS & PM/PS
 We use these variables to understand Real Income and
Relative Price.
 Real Income
 A household’s real income is its income expressed as a quantity of
goods that the household can afford to buy.
 Consumption Possibilities
 In terms of soda, Lisa’s real income is Y/PS.
 This quantity is the maximum quantity of soda that she can
buy.
 Lisa’s money income is $40, price of soda is $4. So her real
income is 10 cases of soda.
 Relative Price
 A relative price is the price of one good divided by the price
of another good.
 In Lisa’s case PM/PS is the relative price of a movie in terms of
soda, which is 2 cases of soda.
 Consumption Possibilities
 That is, to see 1 movie Lisa must give away 2 cases of soda.
 This is also her opportunity cost.
 The relative price of a movie in terms of soda is the magnitude
of the slope of Lisa’s budget line.
 A Change in Prices
 When prices change, so does the budget line.
 The lower the price of the good measured on the x-axis, other
things remaining the same, the flatter is the budget line.
(Figure 9.2 a)
Consumption Possibilities
Consumption Possibilities
 If the price of movie falls from $8 to $4, then the budget line
rotates outward and becomes flatter.
 Real income in terms of soda does not change but the relative
price of a movie falls.
 A Change in Income
 A change in money income changes real income but does not
change the relative price.
 The budget line shifts but its slope does not change.
 A decrease in money income decreases real income and shifts the
budget line leftward. (figure 9.2 b)
Consumption Possibilities
Preferences and Indifference Curves
 A preference map is based on the intuitively appealing idea
that people can sort all the possible combinations of goods
into three groups: preferred, not preferred and indifferent.
 Figure 9.3 (a) shows the three groups.
 Indifference Curve
 An indifference curve is a line that shows combinations
of goods among which a consumer is indifferent.
Preferences and Indifference Curves
Preferences and Indifference Curves
 Four properties of indifference curves
• Higher indifference curves are preferred to lower ones
– Higher indifference curves – consume more
• Indifference curves are downward sloping
• Indifference curves do not cross
• Indifference curves are bowed inward toward the graph’s
origin
Preferences and Indifference Curves
The Impossibility of Intersecting Indifference
Curves
Quantity
of Pepsi
C
A

0 Quantity of Pizza

A situation like this can never happen. According to these indifference curves, the
consumer would be equally satisfied at points A, B, and C, even though point C has more
of both goods than point A.

16
 Bowed Indifference Curves
 Indifference curves are usually bowed
Quantity of Pepsi inward. This shape implies that the
marginal rate of substitution (MRS)
depends on the quantity of the two goods
14
the consumer is currently consuming.
 At point A, the consumer has little pizza
and much Pepsi, so she requires a lot of
A extra Pepsi to induce her to give up one of
8 the pizzas: The MRS is 6 liters of Pepsi per
pizza.
4 B Indifference  At point B, the consumer has much pizza
3 curve and little Pepsi, so she requires only a little
extra Pepsi to induce her to give up one of
0 4 6 12 14 Quantity of Pizza the pizzas: The MRS is 1 liter of Pepsi per
pizza.
17
Preferences and Indifference Curves
 In figure 9.3 (b) Lisa is indifferent between points C and G
and prefers J over C and G.
 Among the 3 indifference curves combinations on I0 is
the least preferred and I2 is the most preferred.
 Marginal Rate of Substitution
 The marginal rate of substitution (MRS) is the rate at
which a person will give up good y (the good measured on
the y-axis) to get an additional unit of good x (the good
measured on the x-axis) while remaining indifferent.
Preferences and Indifference Curves
Preferences and Indifference Curves
 The magnitude of the slope of an indifference curve
measures the marginal rate of substitution.
 If the indifference curve is steep, MRS is high.
 If the Indifference curve is flat, MRS is low.
 In figure 9.4, at point C, Lisa is willing to give up more
soda to get 1 additional movie – MRS is high.
 At point G, Lisa is willing to give up less soda to get 1
additional movie – MRS is low.
Preferences and Indifference Curves
 Diminishing marginal rate of substitution
 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 remaining
indifferent as the quantity of x increases.
 Degree of Substitutability
 Movies and soda are not close substitutes but they are
substitutes.
 A person’s indifference curve for movies and soda will
look like the one for ordinary goods in figure 9.5 (a)
Preferences and Indifference Curves –Degree
of Substitutability
Preferences and Indifference Curves
 Close Substitutes
 These are goods which can be easily substituted for each other.
 Examples include different brands of marker pens and pencils.
 MRS is constant. (Figure 9.5 (b))

 Complements
 Some goods do not substitute for each other at all. Instead, they
are complements.
 In figure 9.5 (c) we see left and right running shoes are perfect
complements.
 Indifference curves of perfect complements are L-shaped.
Preferences and Indifference Curves
 Usually indifference curves are between the two
extreme cases.
 If two goods are closer to close substitutes, the
curves are close to straight line and MRS is closer to
constant.
 For poorer substitutes, the indifference curve is
tightly curved.
Predicting Consumer Choices
 We now predict the quantities of movies and soda Lisa chooses to buy.
 And how these quantities change when a price or income changes.
 Best Affordable Choice
 For best affordable choice, Lisa spends all her income and is on her highest
attainable indifference curve.
 The best affordable point is on the budget line and on the highest
attainable indifference curve.
Predicting Consumer Choices- Best Affordable
Choice
 Optimization, Part 1
 Optimum
 Point where indifference curve and budget constraint
touch
 Best combination of goods available to the consumer
 Slope of indifference curve
 Equals slope of budget constraint

 Marginal rate of substitution, MRS

= Relative price 27
Figure 7 The Consumer’s Optimum

28
• Indifference curve II is the highest 13
indifference curve this individual can 12

reach with this budget constraint line. 11

10
• In order to reach equilibrium, this 9

consumer should spend $5 of his or her 8

7
income to purchase 5 units of Y and the 6
remaining $5 to purchase 5 units of X. 5 E I-3
• Equilibrium occurs where the budget 4
I-2
3
line is tangent to an indifference curve. 2
Budget constraint
• Thus, at point E, the slope of the budget 1
I-1
line is equal to the slope of indifference 0
1 2 3 4 5 6 7 8 9 10 11 12
curve II.
29
Predicting Consumer Choices
 That is, this point occurs when the highest attainable
indifference curve is tangent to the budget line.
 In figure 9.6, point C is the best affordable point.
 At this point MRS (slope of indifference curve) is equal to
relative price (slope of budget line).
 A Change in Price
 Price Effect: The effect of a change in the price of a good
on the quantity of the good consumed is called the price
effect.
Predicting
Consumer
Choices- A
Change in Price
Predicting Consumer Choices
 Figure 9.7 (a) shows price effect.
 Initially, Lisa’s best affordable point is C.
 When price of movies fall from $8 to $4, the budget line rotate
outwards and J becomes best affordable point.
 At point J, Lisa is at a higher indifference curve.
 Figure 9.7 (b) shows the demand curve, which is derived from
consumer’s budget line and indifference curve.
 Lisa’s demand curve is downward sloping- the lower the price
of movie, the more movies she sees.
Predicting Consumer Choices
 A Change in Income
 Income Effect: The effect of a change in income on buying
plans is called the income effect.
 Figure 9.8 shows the income effect when Lisa’s income falls.
 Lisa’s best affordable point changes from J to K as the budget
line shifts leftward.
 She buys less of both goods when her income falls, because
both are normal goods.
 A change in the income leads to a shift in the demand curve.
Shown in figure 9.8 (b).
Predicting
Consumer
Choices- A
Change in
Income
 Chapter 14

Firms in Competitive Markets

N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, 1
or posted to a publicly accessible website, in whole or in part.
 What is a Competitive Market, Part 1
• Competitive market
– Perfectly competitive market
– Market with many buyers and sellers
– Trading identical products
– Each buyer and seller is a price taker
– Firms can freely enter or exit the market

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 What is a Competitive Market, Part 2
• Firm in a competitive market
– Tries to maximize profit
• Profit
– Total revenue minus total cost
• Total revenue, TR = P ˣ Q
– Price times quantity
– Proportional to the amount of output

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 What is a Competitive Market, Part 3
• Average revenue, AR = TR / Q
– Total revenue divided by the quantity sold
• Marginal revenue, MR = ∆TR / ∆Q
– Change in total revenue from an additional
unit sold
• For competitive firms
– AR = P
– MR = P

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Table 1 Total, Average, and Marginal Revenue for
a Competitive Firm

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 Profit Maximization, Part 1
• Maximize profit
– Produce quantity where total revenue
minus total cost is greatest
– Compare marginal revenue with marginal
cost
• If MR > MC: increase production
• If MR < MC: decrease production
• Maximize profit where MR = MC

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Table 2 Profit Maximization: A Numerical Example

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 Profit Maximization, Part 2
• The marginal-cost curve and the firm’s
supply decision
– MC curve is upward sloping
– ATC curve is U-shaped
– MC curve crosses the ATC curve at the
minimum of ATC curve
– The price line is horizontal: P = AR = MR

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Figure 1 Profit Maximization for a Competitive Firm

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or posted to a publicly accessible website, in whole or in part. 9
 Profit Maximization, Part 3
• Rules for profit maximization:
– If MR > MC, firm should increase output
– If MC > MR, firm should decrease output
– If MR = MC, profit-maximizing level of
output
• Marginal-cost curve
– Determines the quantity of the good the
firm is willing to supply at any price
– Is the supply curve
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Figure 2 Marginal Cost as the Competitive Firm’s
Supply Curve

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 Profit Maximization, Part 4
• Shutdown
– Short-run decision not to produce anything
– During a specific period of time
– Because of current market conditions
– Firm still has to pay fixed costs
• Exit
– Long-run decision to leave the market
– Firm doesn’t have to pay any costs

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 Profit Maximization, Part 5
• The firm’s short-run decision to shut down
– TR = total revenue
– VC = variable costs
• Firm’s decision:
– Shut down if TR < VC (or P < AVC)
• Competitive firm’s short-run supply curve
– The portion of its marginal-cost curve
– That lies above average variable cost

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Figure 3 The Competitive Firm’s Short-Run
Supply Curve

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 Profit Maximization, Part 6
• Sunk cost
– A cost that has already been committed
and cannot be recovered
– Should be ignored when making decisions
– “Don’t cry over spilt milk”
– “Let bygones be bygones”
– In the short run, fixed costs are sunk costs

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 Near-empty Restaurants & Off-season Miniature Golf,
Part 1
• Restaurant – stay open for lunch?
– Fixed costs: not relevant; are sunk costs in
short run
– Variable costs, VC: relevant
• Shut down if revenue from lunch < VC
• Stay open if revenue from lunch > VC

Staying open can be profitable,

even with many tables empty.
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 Near-empty Restaurants & Off-season Miniature Golf,
Part 2
• Operator of a miniature-golf course
– Ignore fixed costs
– Shut down if
• Revenue < variable costs
– Stay open if
• Revenue > variable costs

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 Profit Maximization, Part 7
• Firm’s long-run decision
– Exit the market if
• Total revenue < total costs; TR < TC (same
as: P < ATC)
– Enter the market if
• Total revenue > total costs; TR > TC (same
as: P > ATC)
• Competitive firm’s long-run supply curve
– The portion of its marginal-cost curve that
lies above average total cost
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Figure 4 The Competitive Firm’s Long-Run
Supply Curve

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 Profit Maximization, Part 8
• Measuring profit
– If P > ATC
• Profit = TR – TC = (P – ATC) ˣ Q
– If P < ATC
• Loss = TC - TR = (ATC – P) ˣ Q
• = Negative profit

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Figure 5 Profit as the Area between Price and
Average Total Cost

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 Supply Curve, Part 1
• Short run: market supply with a fixed
number of firms
– Short run: number of firms is fixed
– Each firm supplies quantity where P = MC
• For P > AVC: supply curve is MC curve
– Market supply
• Add up quantity supplied by each firm

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Figure 6 Short-Run Market Supply

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 Supply Curve, Part 2
• Long run
– Firms can enter and exit the market
– If P > ATC, firms make positive profit
• New firms enter the market
– If P < ATC, firms make negative profit
• Firms exit the market

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 Supply Curve, Part 3
• Long run
– Process of entry and exit ends when
• Firms still in market make zero economic
profit (P = ATC)
• Because MC = ATC: Efficient scale
– Long run supply curve is perfectly elastic
• Horizontal at minimum ATC

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or posted to a publicly accessible website, in whole or in part.
Figure 7 Long-Run Market Supply

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 Supply Curve, Part 4
• Why do competitive firms
stay in business if they make
zero profit?
– Profit = total revenue – total cost
– Total cost includes all
opportunity costs “We’re a nonprofit
organization - we don’t
– Zero-profit equilibrium intend to be, but we
are!”
• Economic profit is zero
• Accounting profit is positive

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or posted to a publicly accessible website, in whole or in part.
 Supply Curve, Part 5
• Market in long run equilibrium
– P = minimum ATC
– Zero economic profit
• Increase in demand
– Demand curve shifts outward
– Short run
• Higher quantity
• Higher price: P > ATC, positive economic
profit
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or posted to a publicly accessible website, in whole or in part.
 Supply Curve, Part 6
• Positive economic profit in short run
– Long run – firms enter the market
– Short run supply curve – shifts right
– Price – decreases back to minimum ATC
– Quantity – increases
• Because there are more firms in the market
– Efficient scale

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Figure 8 An Increase in Demand in the Short Run
and Long Run (a)

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Figure 8 An Increase in Demand in the Short Run
and Long Run (b)

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Figure 8 An Increase in Demand in the Short Run
and Long Run (c)

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 Supply Curve, Part 7
• Long-run supply curve might slope upward
– Some resource used in production may be
available only in limited quantities
• Increase in quantity supplied – increase in
costs – increase in price
– Firms may have different costs
• Some firms earn profit even in the long run
• Long-run supply curve
– More elastic than short-run supply curve
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 Chapter 15

Monopoly

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whole or in part.
 Why Monopolies Arise Part 1
• Market power
–Alters the relationship between a firm’s costs
and the selling price
• Monopoly
–Charges a price that exceeds marginal cost
–A high price reduces the quantity purchased
–Outcome: often not the best for society

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whole or in part.
 Why Monopolies Arise Part 2
• Governments
–Can sometimes improve market outcome
• Monopoly
–Firm that is the sole seller of a product
without close substitutes
–Price maker
–Cause: barriers to entry

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whole or in part.
 Why Monopolies Arise Part 3
• Barriers to entry
–A monopoly remains the only seller in the
market
• Because other firms cannot enter the market
and compete with it
1. Monopoly resources
2. Government regulation
3. The production process
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whole or in part.
 Why Monopolies Arise Part 4
• Monopoly resources
– A key resource required for
production is owned by a
single firm
– Higher price

“Rather than a monopoly, we

like to consider ourselves ‘the
only game in town.’”

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website, in
whole or in part.
 Why Monopolies Arise Part 5
• Government regulation
–Government gives a single firm the exclusive
right to produce some good or service
–Government-created monopolies
• Patent and copyright laws
• Higher prices
• Higher profits

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whole or in part.
 Why Monopolies Arise Part 6
• Natural monopoly
–A single firm can supply a good or service to an
entire market
• At a smaller cost than could two or more firms
–Economies of scale over the relevant range of
output
–Club goods
• Excludable but not rival in consumption

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whole or in part.
 Figure 1 Economies of Scale as a Cause of
Monopoly

When a firm’s average-total-cost curve continually declines, the firm has what is called a natural
monopoly. In this case, when production is divided among more firms, each firm produces less,
and average total cost rises. As a result, a single firm can produce any given amount at the
lowest cost.
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 Production and Pricing Decisions
Part 1
• Monopoly
– Price maker
– Sole producer
– Downward sloping demand: the market demand
curve
• Competitive firm
– Price taker
– One producer of many
– Demand is a horizontal line (Price)
9
N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in
whole or in part.
 Figure 2 Demand Curves for Competitive and
Monopoly Firms

Because competitive firms are price takers, they face horizontal demand curves, as in panel (a).
Because a monopoly firm is the sole producer in its market, it faces the downward-sloping market demand
curve, as in panel (b). As a result, the monopoly has to accept a lower price if it wants to sell more output.
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 Production and Pricing Decisions
Part 2
• A monopoly’s total revenue
–Total revenue = price times quantity
• A monopoly’s average revenue
–Revenue per unit sold
–Total revenue divided by quantity
–Always equals the price

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whole or in part.
 Production and Pricing Decisions
Part 3
• A monopoly’s marginal revenue
–Revenue per each additional unit of output
• Change in total revenue when output increases by 1 unit
–MR < P
• Downward-sloping demand
• To increase the amount sold, a monopoly firm must
lower the price it charges to all customers
–Can be negative
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whole or in part.
 Table 1 A Monopoly’s Total, Average, and Marginal
Revenue
(1) (2) (3) (4) (5)
Average Revenue Marginal
Quantity of Price (P) Total Revenue Revenue
Water Q) (AR = TR/Q) (MR= (∆TR/AQ)
(TR = P x Q)
0 gallons $11 $0 -
1 10 10 $10 $10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2
8 3 24 3 -4
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 Production and Pricing Decisions
Part 4
• Increase in quantity sold
–Output effect
• Q is higher: increase total revenue
–Price effect
• P is lower: decrease total revenue
• Because MR < P
–Marginal-revenue curve is below the demand
curve
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 Figure 3 Demand and Marginal-Revenue Curves for a Monopoly

The demand curve shows how the quantity sold affects the price of the good.
The marginal-revenue curve shows how the firm’s revenue changes when the quantity increases by 1 unit.
Because the price on all units sold must fall if the monopoly increases production, marginal revenue is less than the
price.
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 Production and Pricing Decisions
Part 5
• Profit maximization
–If MR > MC: increase production
–If MC > MR: produce less
–Maximize profit
• Produce quantity where MR=MC
• Intersection of the marginal-revenue curve
and the marginal-cost curve
• Price: on the demand curve

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whole or in part.
Figure 4 Profit Maximization for a Monopoly

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 Production and Pricing Decisions
Part 6
• Profit maximization
–Perfect competition: P=MR=MC
• Price equals marginal cost
–Monopoly: P>MR=MC
• Price exceeds marginal cost
• A monopoly’s profit
–Profit = TR – TC = (P – ATC) ˣ Q
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Figure 5 The Monopolist’s Profit

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 Monopoly Drugs versus Generic Drugs
• Market for pharmaceutical drugs
– New drug, patent laws, monopoly
• Produce Q where MR=MC
• P>MC
– Generic drugs: competitive market
• Produce Q where MR=MC
• And P=MC
• Price of the competitively produced generic drug
– Below the monopolist’s price

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Figure 6 The Market for Drugs

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 The Welfare Cost of Monopolies Part 1

• Total surplus
–Economic well-being of buyers and sellers in a
market
–Sum of consumer surplus and producer surplus
• Consumer surplus
–Consumers’ willingness to pay for a good
–Minus the amount they actually pay for it

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whole or in part.
 The Welfare Cost of Monopolies Part 2

• Producer surplus
–Amount producers receive for a good
–Minus their costs of producing it
• Benevolent planner: maximize total surplus
–Socially efficient outcome
–Produce quantity where
• Marginal cost curve intersects demand curve
–Charge P=MC
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whole or in part.
Figure 7 The Efficient Level of Output

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whole or in part. 24
 The Welfare Cost of Monopolies Part 3

• Monopoly
–Produce quantity where MC = MR
–Produces less than the socially efficient quantity of
output
–Charge P > MC
–Deadweight loss
• Triangle between the demand curve and MC curve

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website, in
whole or in part.
Figure 8 The Inefficiency of Monopoly

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 The Welfare Cost of Monopolies Part 4

• The monopoly’s profit: a social cost?

–Monopoly - higher profit
• Not a reduction of economic welfare
–Bigger producer surplus
–Smaller consumer surplus
• Not a social problem
–Social loss = Deadweight loss
• From the inefficiently low quantity of output

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whole or in part.
 Price Discrimination Part 1
• Price discrimination
–Business practice
–Sell the same good at different prices to different
customers
–Rational strategy to increase profit
–Requires the ability to separate customers
according to their willingness to pay
–Can raise economic welfare
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 Price Discrimination Part 2
• Perfect price discrimination
–Charge each customer a different price
• Exactly his or her willingness to pay
–Monopoly firm gets the entire surplus
(Profit)
–No deadweight loss

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whole or in part.
 Price Discrimination Part 3

• Without price discrimination

–Single price > MC
–Consumer surplus
–Producer surplus (Profit)
–Deadweight loss

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whole or in part.
 Figure 9 Welfare with and without Price
Discrimination

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whole or in part. 31
 Price Discrimination Part 4
• Examples of price discrimination
– Movie tickets
• Lower price for children and seniors
– Airline prices
• Lower price for round-trip with Saturday night stay

“Would it bother you to

hear how little I paid for
this flight?”

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whole or in part.
 Price Discrimination Part 5
• Examples of price discrimination
– Discount coupons
• Not all customers are willing to spend time to clip coupons
– Financial aid
• High tuition and need-based financial aid
• Willingness to pay
– Quantity discounts
• Customer pays a higher price for the first unit bought than for
the last unit bought

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whole or in part.
 Public Policy Toward Monopolies Part 1

1. Increasing competition with

antitrust laws
– Sherman Antitrust Act, 1890
– Clayton Antitrust Act, 1914
– Prevent mergers
– Break up companies
“But if we do merge with
– Prevent companies from Amalgamated, we’ll have
coordinating their activities enough resources to fight
the anti-trust violation
to make markets less caused by the merger.”
competitive
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whole or in part.
 ASK THE EXPERTS
Airline Mergers
“If regulators had not approved mergers in
the past decade between major networked
airlines, travelers would be better off today.”

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whole or in part. 35
 Public Policy Toward Monopolies Part 2

2. Regulation
– Regulate the behavior of monopolists
• Price
– Common in case of natural monopolies
– Marginal-cost pricing
• May be less than ATC
• No incentive to reduce costs

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whole or in part.
 Figure 10 Marginal-Cost Pricing for a Natural
Monopoly

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whole or in part. 37
 Public Policy Toward Monopolies Part 3

3. Public ownership
–How the ownership of the firm affects the
costs of production
–Private owners
• Incentive to minimize costs
–Public owners (government)
• If it does a bad job, losers are the customers and
taxpayers
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whole or in part.
 Public Policy Toward Monopolies Part 4

4. Do nothing
–Some economists argue that it is often best for
the government not to try to remedy the
inefficiencies of monopoly pricing
–Determining the proper role of the government
in the economy requires judgments about
politics as well as economics

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whole or in part.
 Table 3 Competition versus Monopoly: A Summary
Comparison

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whole or in part. 40
 Chapter 16

Monopolistic Competition

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 Monopolistic Competition, Part 1
• Imperfect competition
–Between perfect competition and monopoly
–Oligopoly
–Monopolistic competition
• Oligopoly
–Few sellers
–Offer similar or identical products

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 Monopolistic Competition, Part 2
• Concentration ratio
– Percentage of total output in the market
supplied by the four largest firms
• Oligopolies, highly-concentrated industries
(concentration ratio %)
– Major household appliances (90%)
– Tires (91%), Light bulbs (92%)
– Soda (94%)
– Wireless telecommunications (95%)
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 Monopolistic Competition, Part 3
• Monopolistic competition
–Many sellers
–Product differentiation
• Not price takers
• Downward sloping demand curve
–Free entry and exit
• Zero economic profit in the long run
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Figure 1 The Four Types of Market Structure

Economists who study industrial organization divide markets into four types—monopoly,
oligopoly, monopolistic competition, and perfect competition.

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 Short Run Equilibrium
• Profit maximization
–Produce the quantity where marginal
revenue = marginal cost
–Price: on the demand curve
–If P > ATC: profit
–If P < ATC: loss
–Similar to monopoly

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Figure 2 Monopolistic Competitors in the Short Run

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 Long Run Equilibrium, Part 1
• If firms are making profit in short run
–New firms - incentive to enter the market
–Increase number of products
–Reduces demand faced by each firm
• Demand curve shifts left
–Each firm’s profit declines until: zero
economic profit
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Figure 3 A Monopolistic Competitor in Long Run

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whole or in part. 9
 Long Run Equilibrium, Part 2

• Zero economic profit

–Demand curve
• Tangent to average total cost curve
• At quantity where marginal revenue = marginal
cost
–Price = average total cost
–Price exceeds marginal cost
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whole or in part.
 Long Run Equilibrium, Part 3

• Monopolistic versus perfect competition

–Monopolistic competition
• Quantity: not at minimum ATC (excess capacity)
• P > MC, markup over marginal cost
–Perfect competition
• Quantity: at minimum ATC (efficient scale)
• P = MC

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Figure 4 Monopolistic versus Perfect Competition

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whole or in part. 12
 Welfare of Society
• Sources of inefficiency
–Markup of price over marginal cost
• Deadweight loss of monopoly pricing
–Too much or too little entry
• Product-variety externality (positive externality
on consumers)
• Business-stealing externality (negative
externality on existing firms)
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website, in
whole or in part.
 Advertising, Part 1
• Incentive to advertise
– When firms sell differentiated products and charge
prices above marginal cost
– Advertise to attract more buyers
• Advertising spending
– Highly differentiated goods: 10-20% of revenue
– Industrial products: Little advertising
– Homogenous products: No advertising

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website, in
whole or in part.
 Advertising, Part 2
• Debate over advertising
–Wasting resources?
–Valuable purpose?
• The critique of advertising
–Firms advertise to manipulate people’s tastes
• Psychological rather than informational
• Creates a desire that otherwise might not exist
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 Advertising, Part 3
• The critique of advertising
–Impedes competition
–Increase perception of product
differentiation
• Foster brand loyalty
–Makes buyers less concerned with price
differences among similar goods
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 Advertising, Part 4
• The defense of advertising
–Provide information to customers
• Customers - make better choices
• Enhances the ability of markets to allocate resources
efficiently
–Fosters competition
• Customers - take advantage of price differences
–Allows new firms to enter more easily
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website, in
whole or in part.
 Advertising and the Price of Eyeglasses,
Part 1
• What effect does advertising have on the
price of a good?
–Consumers – view products as being
more different than they otherwise would
• Markets less competitive
• Firms’ demand curves less elastic
• Higher prices

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whole or in part. 18
 Advertising and the Price of Eyeglasses,
Part 2
• What effect does advertising have on the
price of a good?
–Consumers – easier to find firms with the
best prices
• Markets – more competitive
• Firms’ demand curves more elastic
• Lower prices
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 Advertising and the Price of Eyeglasses,
Part 3
• 1972, economist Lee Benham
• States that prohibited advertising
– Average price = $33 ($272 in 2018 dollars)
• States that did not restrict advertising
– Average price = $26 ($214 in 2018 dollars)
• Advertising
– Reduced average prices
– Fosters competition

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whole or in part. 20
 Advertising, Part 5
• Advertising as a signal of quality
–Little apparent information
–Real information offered – a signal
• Willingness to spend large
amount of money
Is it rational for
• = signal about quality of the product
consumers to be
–Content of advertising = irrelevant impressed that
George Clooney is
endorsing this product?
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website, in
whole or in part.
 Advertising, Part 6
• Brand names
–Spend more on advertising and charge higher
prices than generic substitutes

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website, in
whole or in part.
 Advertising, Part 7
• Critics of brand names
–Products – not differentiated
–Irrationality: consumers are willing to pay more
for brand names
• Defenders of brand names
–Consumers – information about quality
–Firms – incentive to maintain high quality

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website, in
whole or in part.
 Table 1 Monopolistic Competition: Between Perfect
Competition and Monopoly

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whole or in part. 24
 Chapter 17

Oligopoly

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whole or in part.
 Oligopoly
• Oligopoly
– Only a few sellers
– Offer similar or identical products
– Interdependent
• Game theory
– How people behave in strategic situations
• Choose among alternative courses of action
• Must consider how others might respond to the action he
takes
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whole or in part.
 Markets with Only a Few Sellers, Part 1

• A small group of sellers, oligopolists

–Tension between cooperation and self-interest
–Best off cooperating, acting like a monopolist
• Produce a small quantity of output
• Charge P >MC
–Each firm cares only about its own profit
• Powerful incentives not to cooperate

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whole or in part.
 Markets with Only a Few Sellers, Part 2

• Duopoly
– Oligopoly with only two members
– Decide what quantity to sell
– Price is determined on the market by the
demand

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whole or in part.
Table 1 The Demand Schedule for Water
Quantity Price Total Revenue
(and total profit)
0 gallons $120 $0
10 110 1,100
20 100 2,000
30 90 2,700
40 80 3,200
50 70 3,500
60 60 3,600
70 50 3,500
80 40 3,200
90 30 2,700
100 20 2,000
110 10 1,100
120 0 0

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 Markets with Only a Few Sellers, Part 3

• For a perfectly competitive firm

–Price = marginal cost
–Quantity is efficient
• For a monopoly
–Price > marginal cost
–Quantity is lower than the efficient quantity

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 Markets with Only a Few Sellers, Part 4

• A duopoly can:
– Collude and form a cartel, act as a monopoly and
agree on:
• Total level of production
• Quantity produced by each member
– Don’t collude, act in self-interest
• Difficult to agree; Antitrust laws
• Higher quantity; lower price; lower profit
• Not competitive allocation
• Nash equilibrium
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 Markets with Only a Few Sellers, Part 5

• Collusion
–Agreement among firms in a market
• Quantities to produce or
• Prices to charge
• Cartel
–Group of firms acting in unison

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 Equilibrium for an Oligopoly, Part 1

• Nash equilibrium
–Economic actors interacting with one
another
–Each choose their best strategy
–Given the strategies that all the other
actors have chosen

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 Equilibrium for an Oligopoly, Part 2

• Oligopolists
– Better off cooperating and reaching the monopoly
outcome
– They pursue their own self-interest
• Do not end up reaching the monopoly outcome and
maximizing their joint profit
• Each is tempted to raise production and capture a larger
share of the market
• Total production rises and price falls

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whole or in part.
 Equilibrium for an Oligopoly, Part 3

• When firms in an oligopoly individually choose

production to maximize profit
– Produce a quantity of output
• Greater than the level produced by monopoly
• Less than the level produced by competition
– The price is
• Less than the monopoly price
• Greater than the competitive price (MC)

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whole or in part.
 Markets with Only a Few Sellers, Part 6

• If oligopolists form a cartel

–Maximize total profit
–Produce monopoly quantity
–Charge monopoly price
–Difficult to reach and enforce an
agreement as the size of the group
increases
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whole or in part.
 Markets with Only a Few Sellers, Part 7

• If oligopolists do not form a cartel, each firm has to

take into account:
–The output effect
• Because P > MC, selling one more unit increases
profit
–The price effect
• Increasing production increases total amount sold
• Decrease in price and lower the profit

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whole or in part.
 Markets with Only a Few Sellers, Part 8

• The size of an oligopoly affects the market outcome

–As the number of sellers in an oligopoly grows
larger
• Oligopolistic market looks more like a competitive
market
• Price approaches marginal cost
• Quantity produced approaches socially efficient level

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whole or in part.
 ASK THE EXPERTS
Nash Equilibrium

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whole or in part. 15
 The Economics of Cooperation, Part 1

• The prisoners’ dilemma

–Particular “game” between two captured prisoners
–Illustrates why cooperation is difficult to maintain
even when it is mutually beneficial
• Dominant strategy
–Strategy that is best for a player in a game
• Regardless of the strategies chosen by the other players

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whole or in part.
Figure 1 The Prisoners’ Dilemma

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 The Economics of Cooperation, Part 2

• The prisoners’ dilemma

–Because each pursues his or her own
interests
• The two prisoners together reach an outcome
that is worse for each of them
–Cooperation between the two prisoners is
difficult to maintain
• Because cooperation is individually irrational
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whole or in part.
 The Economics of Cooperation, Part 3

• Game oligopolists play

– In trying to reach the monopoly outcome
– Similar to the game that the two prisoners play in the
prisoners’ dilemma
• Firms are self-interested
– And do not cooperate
• Even though cooperation (cartel) would increase profits
– Each firm has incentive to cheat

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whole or in part.
Figure 2 Jack and Jill’s Oligopoly Game

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 OPEC and the World Oil Market, Part 1
• Organization of Petroleum Exporting Countries
(OPEC) is a cartel
–Formed in 1960: Iran, Iraq, Kuwait, Saudi Arabia,
Venezuela
–By 1973: Qatar, Indonesia, Libya, the United Arab
Emirates, Algeria, Nigeria, Ecuador, Gabon
–Control about 80 percent of the world’s oil
reserves

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whole or in part. 21
 OPEC and the World Oil Market, Part 2

• OPEC
–Tries to raise the price of its product
• Coordinated reduction in quantity produced
–Tries to set production levels for each of the
member countries
• Problem
–The countries want to maintain a high price of oil

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 OPEC and the World Oil Market, Part 3
• Problem
–Each member of the cartel
• Tempted to increase its production
• Get a larger share of the total profit
• Cheat on agreement
• OPEC – successful at maintaining cooperation and
high prices
–From 1973 to 1985: increase in price

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 OPEC and the World Oil Market, Part 4
• Mid-1980s — member countries began
arguing about production levels
– OPEC — ineffective at maintaining
cooperation
– Decrease in price
– Recent years: less successful at reaching
and enforcing agreements
• Fluctuations in oil prices
– Driven by supply and demand

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 The Economics of Cooperation, Part 4

• Arms races
– After World War II, United States and the
Soviet Union
• Engaged in a prolonged competition over
military power
– Strategies
• Build new weapons
• Disarm
– Dominant strategy: Arm

N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in 25
whole or in part.
Figure 3 An Arms-Race Game

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 The Economics of Cooperation, Part 5

• Common resources
– Two companies own a common pool of oil
– Strategies
• Each company drills one well
• Each company drills a second well and get
more oil
– Dominant strategy
• Each company drills two wells: lower profit

N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in 27
whole or in part.
Figure 4 A Common-Resources Game

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 Welfare of Society
• Dominant strategy
–Noncooperative equilibrium may be bad for
society and the players
• Examples: Arms race game, Common resource
game
–Noncooperative equilibrium may be good for
society
• Oligopolists trying to obtain monopoly profits
• Quantity and price – closer to optimal level
N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in 29
whole or in part.
 Why People Sometimes Cooperate
• Game of repeated prisoners’ dilemma
–Repeat the game
–Agree on penalties if one cheats
–Both have incentive to cooperate
–As long as the players care enough about
future profits, they will choose to forgo the one-
time gain from defection

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whole or in part.
 The Prisoners’ Dilemma Tournament, Part 1

• Repeated prisoners’ dilemma

–The score at the end of the game is the total
number of years in jail
–Encourage cooperation
• Penalty for not cooperating
–Better strategy
• Return to cooperative outcome after a period of
noncooperation

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 The Prisoners’ Dilemma Tournament, Part 2
• Repeated prisoners’ dilemma
–Best strategy: tit-for-tat
–Player starts by cooperating, then do
whatever the other player did last time
–Starts out friendly
–Penalizes unfriendly players
–Forgives them if warranted
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whole or in part. 32
 Public Policy Toward Oligopolies, Part 1

• Governments
–Can sometimes improve market outcomes
• Policymakers
–Try to induce firms in an oligopoly to compete
rather than cooperate
–Move the allocation of resources closer to the
social optimum
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whole or in part.
 Public Policy Toward Oligopolies, Part 2

• Antitrust laws
– The Sherman Antitrust Act, 1890
• Elevated agreements among oligopolists from
an unenforceable contract to a criminal
conspiracy
– The Clayton Act, 1914
• Further strengthened the antitrust laws
– Used to prevent mergers
– Used to prevent oligopolists from colluding
N. Gregory Mankiw, Principles Of Micro Economics, 9th Edition © 2021 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in 34
whole or in part.
 An Illegal Phone Call, Part 1
• Robert Crandall — president of American
Airlines
• Howard Putnam — president of Braniff
Airways
– Crandall: I think it’s dumb as hell . . . to sit
here and pound the @#$% out of each other
and neither one of us making a #$%& dime.
– Putnam: Do you have a suggestion for me?
– Crandall: Yes, I have a suggestion for you.
Raise your $%*& fares 20 percent. I’ll raise
mine the next morning.
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 An Illegal Phone Call, Part 2
– Putnam: Robert, we . . .
– Crandall: You’ll make more money, and I
will, too.
– Putnam: We can’t talk about pricing!
– Crandall: Oh @#$%, Howard. We can talk
about any &*#@ thing we want to talk about.
• The Sherman Antitrust Act
– Prohibits competing executives from even
talking about fixing prices

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whole or in part. 36
 Public Policy Toward Oligopolies, Part 3

• Controversies over antitrust policies

– Used to condemn some business
practices whose effects are not obvious
– Resale price maintenance
– Predatory pricing
– Tying

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whole or in part.
 Public Policy Toward Oligopolies, Part 4

• Resale price maintenance (fair trade)

–Require retailers to charge customers a given price
–Might seem anticompetitive
• Prevents the retailers from competing on price
–Defenders:
• Not aimed at reducing competition
• Legitimate goal: some retailers offer service

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whole or in part.
 Public Policy Toward Oligopolies, Part 5

• Predatory pricing
–Charge prices that are too low
• Anticompetitive
• Price cuts may be intended to drive other firms out
of the market
–Skeptics
• Predatory pricing — not a profitable strategy
• Price war — to drive out a rival’ prices are driven
below cost
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whole or in part.
 Public Policy Toward Oligopolies, Part 6

• Tying
– Offer two goods together at a single price
• Expand market power
– Skeptics
• Cannot increase market power by binding two
goods together
– Form of price discrimination
• Tying may increase profit

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whole or in part.
 The Microsoft Case, Part 1
• U.S. government’s suit against the
Microsoft Corporation, 1998
– Central issue: tying
• Should Microsoft be allowed to integrate its
Internet browser into its Windows operating
system
– Bundling to expand market power into the
market of Internet browsers
• Would deter other software companies from
entering the market and offering new
products
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 The Microsoft Case, Part 2
• Microsoft responded
– New features into old products - natural
part of technological progress
• Cars — include CD players, air conditioners
• Cameras — built-in flashes
• Operating systems — added many features
to Windows
– Previously stand-alone products
– Computers - more reliable and easier to use
– Integration of Internet technology
• The next natural next step
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 The Microsoft Case, Part 3
• Disagreement
– Extent of Microsoft’s
market power
• The government
– More than 80% of
new personal
“Me? A monopolist?
computers Now just wait a
• Used a Microsoft minute . . .”
operating system
• Substantial monopoly
power
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 The Microsoft Case, Part 4
• Microsoft
– Software market is always changing
– Competitors: Apple Mac & Linux
operating systems
– Low price – limited market power
• November 1999 ruling
– Microsoft — great monopoly power
– Illegally abused that power

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 The Microsoft Case, Part 5
• June 2000
– Microsoft – to be broken up into two
companies
• Operating system & Applications software
• 2001, appeals court
– Overturned the breakup order
• September 2001
– Justice Department — wanted to settle
the case quickly

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whole or in part. 45
 The Microsoft Case, Part 6
• Settlement: November 2002
– Microsoft – some restrictions
– Government – browser would remain part
of the Windows operating system
• Private antitrust suits
• Suits brought by the European Union
– Alleging a variety of anticompetitive
behaviors

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