FIGURES

© Richard B. McKenzie and Dwight E. Lee 2006

www.cambridge.org/mckenzie

Example of the demand shift

Figure 2.1 Market demand for tomatoesDemand, the assumed inverse relationship between price and quantity purchased, can be

represented by a curve that slopes down toward the right. Here, as the price falls from $11to zero, the number of bushels of tomatoes purchased per week rises from zero to 110,000.

Figure 2.2 Shifts in the demand curveAn increase in demand is represented by a rightward, outward, shift in the demand curve,from D1to D2. A decrease in demand is represented by a leftward, or inward, shift in the

demand curve, from D1 to D3.

Figure 2.3 Supply of tomatoesSupply, the assumed relationship between price and quantity produced, can be represented

by a curve that slopes up toward the right. Here, as the price rises from zero to $11, thenumber of bushels of tomatoes offered for sale during the course of a week rises from zero

to 110,000.

Figure 2.4 Shifts in the supply curveA rightward, or outward, shift in the supply curve, from S1 to S2, represents an increase in

supply. A leftward, or inward, shift in the supply curve, from S1 to S3, represents a decreasein supply.

Figure 2.5 Market surplusIf a price is higher than the intersection of the supply and demand curves, a marketsurplus – a greater quantity supplied, Q3, than demanded, Q1 – results. Competitivepressure will push the price down to the equilibrium price P1, the price at which the

quantity supplied equals the quantity demanded (Q2).

Figure 2.6 Market shortagesA price that is below the intersection of the supply and demand curves will create a

shortage – a greater quantity demanded, Q3, than supplied, Q1. Competitive pressure willpush the price up to the equilibrium price P2, the price at which the quantity supplied

equals the quantity demanded (Q2).

Figure 2.7 The effects of changes in supply and demandAn increase in demand – panel (a) – raises both the equilibrium price and the equilibrium

quantity. A decrease in demand – panel (b) – has the opposite effect: a decrease in theequilibrium price and quantity. An increase in supply – panel (c) – causes the equilibriumquantity to rise but the equilibrium price to fall. A decrease in supply – panel (d) – has the

opposite effect: a rise in the equilibrium price and a fall in the equilibrium quantity.

Figure 2.8 Price ceilings and floorsA price ceiling Pc – panel (a) – will create a market shortage equal to Q2 – Q1. A price floor

Pf – panel (b) – will create a market surplus equal to Q2 – Q1.

Figure 2.9 The efficiency of the competitive marketOnly those price–quantity combinations on or below the demand curve – panel (a) – are

acceptable to buyers. Only those price–quantity combinations on or above the supplycurve – panel (b) – are acceptable to producers. Those price–quantity combinations that areacceptable to both buyers and producers are shown in the darkest shaded area of panel (c).The competitive market is “efficient” in the sense that it results in output Q1, the maximum

output level acceptable to both buyers and producers.

Figure 2.10 Consumer preference in television sizeConsumers differ in their wants, but most desire a medium-sized television. Only a few

want a very small or a large television.

Figure 2.11 Long-run market for calculatorsWith supply and demand for calculators at D1 and S1, the short-run equilibrium price andquantity will be P2 and Q1. As existing firms expand production and new firms enter the

industry, the supply curve shifts to S2. Simultaneously, an increase in consumer awarenessof the product shifts the demand curve to D2. The resulting long-run equilibrium price and

quantity are P1 and Q2, respectively.

Figure 2.12 Prices in the long runIf demand increases more than supply, the price will rise along with the quantity sold –

panel (a). If supply keeps up with demand, however, the price will remain the same eventhough the quantity sold increases – panel (b).

Figure 2.13 Twisted pay scaleThe worker expects his productivity to rise along line A with years of service. If she startswork with less pay than she could earn elsewhere, then her career pay path could follow

line B, representing greater increases in pay with time and greater productivity.

Figure 3.1 Constrained choiceWith a given amount of time and other resources, you can produce any combination of

study and games along the curve E1 G1. The particular combination you choose will dependon your personal preferences for those two goods. You will not choose point x, because it

represents less than you are capable of achieving – and, as a rational person, you will striveto maximize your utility. Because of constraints on your time and resources, you cannot

achieve a point above E1 G1.

Figure 3.2 Change in constraintsIf your study skills improve and your ability at the game remains constant, your productionpossibilities curve will shift from E1G1 to E2G1. Both the number of chapters you can studyand the number of games you can play will increase. On your old curve, E1G1, you could

study two chapters and play four games (point a). On your new curve E2G1, you can studythree chapters and play five games (point b).

Figure 3.3 Policy trade-offs of a negative income taxWith a guaranteed income of SI1($5,000) and a break-even earned income level of

EI1($10,000), the implicit marginal tax rate on the poor is 50 percent. If policy makersattempt to reduce the implicit tax rate by raising the break-even income level, however,

the government’s poverty relief budget will rise by the shaded area SI1ab. A higher explicittax burden will fall on a smaller group of taxpaying workers.

Figure 3.4 Maslow’s hierarchy of needsThe pyramid orders human needs by broad categories from the most prepotent needs onthe bottom to lesser and lesser prepotent needs as an individual moves up the pyramid.According to Maslow, an individual can be expected to satisfy her needs in the order of

their prepotence, or will move from the bottom of the pyramid through the various levelsto the top, so long as the individual’s resources to satisfy her needs last.

Figure 3.5(a) Demand, price, and need satisfactionThe extent to which needs are satisfied depends, in the economists’ view of the world, onthe nature of the need’s demand and its price. Physiological needs may indeed be morecompletely satisfied than other needs, but that may only be because physiological needshave relatively low prices (panel (a)). But then, as shown in this figure (panel (b)), theprice of the means of satisfying physiological needs might be higher than the prices of themeans of satisfying safety and love needs.

Figure 3.5(b)

Figure 5.1 The economic effect of an excise taxAn excise tax of $0.25 will shift the supply curve for margarine to the left, from S1 to S2.

The quantity produced will fall from Q3 to Q2; the price will rise from P2 to P3. The increase,$0.20, however, will not cover the added cost to the producer, $0.25.

Figure 5.2 The effect of an excise tax when demand is more elastic than supplyIf demand is much more elastic than supply, the quantity purchased declines significantly

when supply decreases from S1 to S2 in response to the added cost of the excise tax.Producers will lose $0.20; consumers will pay only $0.05 more.

Figure 5.3 The effect of price controls on supplyIf the supply of gasoline is reduced from S1 to S2, but the price is controlled at P1, a

shortage equal to the difference between Q1 and Q2 will emerge.

Figure 5.4 The effect of rationing on demandPrice controls can create a shortage. For instance, at the controlled price P1, a shortage of

Q2 - Q1 gallons will develop. By issuing a limited number of coupons that must be used topurchase a product, the government can reduce demand and eliminate the shortage. Here,rationing reduces demand from D1 to D2, where demand intersects the supply curve at the

controlled price.

Figure 5.5 The conventional view of the impact of the minimum wageWhen the minimum wage is set at Wm (and the market clearing wage is Wo),

employment will fall from Q2 to Q1; simultaneously, the number of workers who arewilling to work in this labor market will expand from Q2 to Q3. The market surplus is then

Q3 - Q1.

Figure 5.6 An unconventional view of the impact of the minimum wageWhen the minimum wage is raised to Wm, a surplus is created equal to Q3 - Q1. As a

consequence, employers can be expected to respond to the surplus by reducing fringebenefits or increasing work demands on workers. The supply curve of labor contracts,reflecting the greater wage the workers will demand to compensate for the reduction in

fringe benefits or increase in work demands. The employers’ demand for labor increases,reflecting the higher wage they are willing to pay workers in terms of money wages who

get fewer fringe benefits or work harder and produce more.

Figure 5.7 Marginal benefit versus marginal costThe demand curve reflects the marginal benefits of each loaf of bread produced. The supplycurve reflects the marginal cost of producing each loaf. For each loaf of bread up to Q1, themarginal benefits exceed the marginal cost. The shaded area shows the maximum welfarethat can be gained from the production of bread. When the market is at equilibrium (when

supply equals demand), all those benefits will be realized.

Figure 5.8 External costsIgnoring the external costs associated with the manufacture of paper products, firms will

base their production and pricing decisions on the supply curve S1. If they consider externalcosts, such as the cost of pollution, they will operate on the basis of the supply curve S2,producing Q1 instead of Q2 units. The shaded area abc shows the amount by which the

marginal cost of production of Q2 – Q1 units exceeds the marginal benefits to consumers. Itindicates the inefficiency of the private market when external costs are not borne by

producers.

Figure 5.9 External benefitsIgnoring the external benefits of getting flu shots, consumers will base their purchases onthe demand curve D1 instead of D2. Fewer shots will be purchased than could be justifiedeconomically – Q1 instead of Q2. Because the marginal benefit of each shot between Q1 and Q2 (as shown by demand curve D2) exceeds its marginal cost of production, external

benefits are not being realized. The shaded area abc indicates market inefficiency.

Figure 5.10 Is government action justified?Because of external costs, the market illustrated produces more than the efficient output.

Market inefficiency, represented by the shaded triangular area abc, is quite small – so smallthat government intervention may not be justified on economic grounds alone.

Figure 5.11 Market for pollution rightsReducing pollution is costly (see table 5.1). It adds to the costs of production, increasingproduct prices and reducing the quantities of products demanded. Therefore firms have a

demand for the right to avoid pollution abatement costs. The lower the price of such rights,the greater the quantity of rights that firms will demand. If the government fixes the

supply of pollution rights at ten and sells those ten rights to the highest bidder, the price ofthe rights will settle at the intersection of the supply and demand curves – here, about

$1,500.

Figure 6.1 External and internal coordinating costsAs the firm expands, the internal coordinating costs increase as the external coordinating

costs fall. The optimum firm size is determined by summing these two cost structures,which is done in panel (b) of the figure.

Figure 6.A1 Fringe benefits and the labor marketIf fringe benefits are more valuable to workers and impose a cost on the employers, the

supply of labor will increase from S1 to S2 while the demand curve falls from D1 to D2. Thewage rate falls from W1 to W2, but the workers get fringe benefits that have a value of ac,

which means that their overall payment goes up from W1 to W3.

Figure 7.1 The law of demandPrice varies inversely with the quantity consumed, producing a downward sloping curvesuch as this one. If the price of Coke falls from $1 to $0.75, the consumer will buy three

Cokes instead of two.

Figure 7.2 Market demand curveThe market demand curve for Coke, DA+B, is obtained by summing the quantities that

individuals A and B are willing to buy at each and every price (shown by the individualdemand curves DA and DB).

Figure 7.3 Elastic and inelastic demandDemand curves differ in their relative elasticity. Curve D1 is more elastic than curve D2, inthe sense that consumers on curve D1 are more responsive to a given price change (P2 to

P1) than are consumers on curve D2.

Figure 7.4 Changes in the elasticity coefficientThe elasticity coefficient decreases as a firm moves down the demand curve. The upper half

of a linear demand curve is elastic, meaning that the elasticity coefficient is greater thanone. The lower half is inelastic, meaning that the elasticity coefficient is less than one. Thismeans that the middle of the linear demand curve has an elasticity coefficient equal to one.

Figure 7.5 Perfectly elastic demandA firm that has many competitors may lose all its sales if it increases its price even slightly.

Its customers can simply move to another producer. In that case, its demand curve ishorizontal, with an elasticity coefficient of infinity.

Figure 7.6 Increase in demandWhen consumer demand for low-rise pants increases, the demand curve shifts from D1 to

D2. Consumers are now willing to buy a larger quantity of low-rise pants at the same price,or the same quantity at a higher price. At price P1, for instance, they will buy Q3 instead of Q2. And they are now willing to pay P2 for Q2 low-rise pants, whereas before they would

pay only P1.

Figure 7.7 Decrease in demandA downward shift in demand, from D1 to D2, represents a decrease in the quantity of

low-rise pants consumers are willing to buy at each and every price. It also indicates adecrease in the price they are willing to pay for each and every quantity of low-rise pants.

At price P2, for instance, consumers will now buy only Q1 low-rise pants (not Q3, as before);and they will now pay only P2 for Q1 low-rise pants – not P3, as before.

Figure 7.8 Network effects and demandAs the price falls from P3 to P2, the quantity demanded in the short run rises from Q1 to Q2.However, sales build on sales, causing the demand in the future to expand outward to, say, D2. The lower the price in the current time period, the greater the expansion of demand in

the future. The more the demand expands over time in response to greater sales in thecurrent time period, the more elastic is the long-run demand.

Figure 7.9 Choosing between housing and bundles of other goodsThe budget line in Six Mile is A1H1 with an income of $100,000. The budget line in La Jolla

is A1H3 with the same income. If the employer were to offer the engineer a salary of$152,000, which covers the additional cost of housing, the engineer’s budget line would be

the thin line cutting A1H1 at a. Hence, the engineer could choose combination b and bebetter off than in Six Mile. This means that the employer can offer the engineer less than

$152,000.

Figure 7A.1 Derivation of an indifference curveBecause the consumer prefers more of a good to less, point a is preferable to point c, and

point b is preferable to point a. If a is preferable to d but e is preferable to a, then when wemove from point d to e, we must move from a combination that is less preferred to the onethat is more preferred. In doing so, we must cross a point – for example, f – that is equal invalue to a. Indifference curves are composed by connecting all those points – a, f, i, and so

on – that are of equal value to the consumer.

Figure 7A.2 Indifference curves for pens and booksAny combination of pens and books that falls along curve I1 will yield the same level of

utility as any other combination on that curve. The consumer is indifferent among them. Byextension, any combination on curve I2 will be preferable to any combination on curve I1.

Figure 7A.3 The budget line and consumer equilibriumConstrained by her budget, the consumer will seek to maximize her utility by consuming at

the point where her budget line is tangent to an indifference curve. Here the consumerchooses point a, where her budget line just touches indifference curve I1. All othercombinations on the consumer’s budget line will fall on a lower indifference curve,

providing less utility. Point c, for instance, falls on indifference curve I2.

Figure 7A.4 Effect of a change in price on consumer equilibriumIf the price of pens falls, the consumer’s budget line will pivot outward, from B1P1 to B1P2.As a result, the consumers can move to a higher indifference curve, I2 instead of I1. At the

new price, the consumer buys more pens, twenty-two packs as opposed to fifteen.

Figure 7A.5 Derivation of the demand curve for pensWhen the price of pens changes, shifting the consumer’s budget line from B1P1 to B1P2 infigure 7A.4, the consumer equilibrium point changes with it, from a to c. The consumer’sdemand curve for pens is obtained by plotting her equilibrium quantity of pens at variousprices. At $5 a pack, the consumer buys fifteen packs of pens (point a). At $3 a pack, she

buys twenty-two packages (point c).

Figure 7A.6 Budget line: cash grants vs. education subsidiesIf the price of education is reduced by an in-kind subsidy, a family’s budget line will pivot

from H3E3 to H3E5. The family will move from point a to point b, where it can consumemore food and housing. If the family is given the same subsidy in cash, its budget line will

move from H3E3 to H4E4. Because the relative price of housing is lower on H4E4 than on H3E5, the family will choose a point such as d over b. Because b was the family’s preferred

point on H3E5, but it prefers d to b on H4E4 which allows the purchase of b, we mustpresume that it also prefers cash to a food subsidy.

Figure 7B.1 Upward sloping demand?A good might have an upward sloping range, as described in panel (a), given that a priceincrease might convey greater value to consumers. However, there must be some higher

price that will cause sales to contract, since many consumers will no longer be able to buythe good. This means that the demand curve must go beyond some price, P3 in panel (b),must bend backwards and, thus, must have a downward sloping range. The downward

sloping range of the curve in panel (b) is the relevant range. If the seller is at combinationb, then there is some combination such as d in the downward sloping range of the entire

demand curve that is more profitable than combination b.

Figure 7B.2 Demand including irrational behaviorIf irrational consumers demand Q1 cigarettes no matter what the price, but rationalconsumers take price into consideration, market demand will be D1. The quantity

purchased will still vary inversely with the price.

Figure 7B.3 Random behavior, budget lines, and downward sloping demand curvesIf a number of buyers are faced initially with budget line A1B1 and behave randomly, they

will buy an average quantity of A2B2. If the price of A increases while the price of Bdecreases, the budget line pivots on a, causing buyers to purchase on average more of B(B4) and less of A (A4). Thus, quantity changes in the direction predicted by the law of

demand (in spite of the absence of rational behavior).

Figure 7B.4 Random behavior and the demand curve as a “band”If buyers randomly purchase anywhere from Q1 to Q2 when the price is P1 and anywherefrom Q2 to Q3 when the price is P2, then they will tend to increase their average quantity

purchased from Q4 to Q5 when the price falls from P1 to P2.

Figure 8.1 Rising marginal costTo produce each new watercolor, Jan must give up an opportunity more valuable than the

last. Thus the marginal cost of her paintings rises with each new work.

Figure 8.2 The law of diminishing marginal returnsAs production expands with the addition of new workers, efficiencies of specialization

initially cause marginal cost to fall. At some point, however – here, just beyond two bushels– marginal cost will begin to rise again. At that point, marginal returns will begin to

diminish and marginal costs will begin to rise.

Figure 8.3 Costs and benefits of fishingFor each fish up to the fifth one, Gary receives more in benefits than he pays in costs. Thefirst fish gives him $4.67 in benefits (point a) and costs him only $1 (point b). The fifth

yields equal costs and benefits (point c), but the sixth costs more than it is worth. ThereforeGary will catch no more than five fish.

Figure 8.4 Accident preventionGiven the increasing marginal cost of preventing accidents and the decreasing marginal

value of preventing the accidents, c or 5 accidents will be prevented.

Figure 8.5 Total, average, and marginal product curves

The total product curve shows how output changes when the amount of the variable input, labor, changes. Total product rises first at an increasing rate (0–five workers), then at adecreasing rate (five–fifteen workers), before declining (beyond fifteen workers). Themarginal and average product curves reflect what is happening to total product. Marginalproduct rises when total product is rising at an increasing rate and falls when total productis rising at a decreasing rate. Marginal product is positive when total product is rising andnegative when total product is falling.

Figure 8.6 Marginal costs and maximization of profit

At price P1 (panel (a)), this firm’s marginal revenue, represented by the area under P1 up to Q1, exceeds its marginal cost up to the output level of Q1. At that point total profit, shown in panel (b), peaks (point a). At price P2, marginal revenue exceeds marginal cost up to an output level of Q2. The increase in price shifts the profit curve in panel (b) upward, from TP1 to TP2, and profits peak at b.

Figure 8.7 Market supply curveThe market supply curve (SA+B) is obtained by adding together the amount producers A

and B are willing to offer at each and every price, as shown by the individual supply curves SA and SB. (The individual supply curves are obtained from the upward sloping portions of

the firms’ marginal cost curve.)

Figure 9.1 Total fixed costs, total variable costs, and total costs in the short runTotal fixed cost does not vary with production; therefore, it is drawn as a horizontal line.Total variable cost does rise with production. Here it is represented by the shaded area

between the total cost and total fixed cost curves.

Figure 9.2 Marginal and average costs in the short runThe average fixed cost curve (AFC) slopes downward and approaches, but never touches,

the horizontal axis. The average variable cost curve (AVC) and the total variable cost curveare mathematically related to the marginal cost curve and both intersect with the marginalcost curve (MC) at its lowest point. The vertical distance between the average total cost

curve (ATC) and the average variable cost curve equals the average fixed cost at any givenoutput level. There is no relationship between the MC and AFC curves.

Figure 9.3 Economies of scaleEconomies of scale are cost savings associated with the expanded use of resources. To

realize such savings, however, a firm must expand its output. Here the firm can lower itscosts by expanding production from q1 to q2 – a scale of operation that places it on a lower

short-run average total cost curve (ATC2 instead of ATC1).

Figure 9.4 Diseconomies of scaleDiseconomies of scale may occur because of the communication problems of larger firms.

Here the firm realizes economies of scale through its first short-run average total costcurves. The long-run average cost curve begins to turn up at an output level of q1, beyond

which diseconomies of scale set in.

Figure 9.5 Marginal and average cost in the long runThe long-run marginal and average cost curves are mathematically related. The long-run

average cost curve slopes downward as long as it is above the long-run marginal costcurve. The two curves intersect at the low point of the long-run average cost curve.

Figure 9.6a Individual differences in long-run average cost curvesThe shape of the long-run average cost curve varies according to the extent and persistenceof economies and diseconomies of scale. Firms in industries with few economies of scalewill have a long-run average cost curve like the one in panel (a). Firms in industries with

persistent economies of scale will have a long-run average cost curve like the one inpanel (b), and firms in industries with extensive economies of scale may find that their

long-run average cost curve slopes continually downward, as in panel (c).

Figure 9.6b

Figure 9.6c

Figure 9.7 Shifts in average and marginal cost curvesAn increase in a firm’s variable cost (panel (a)) will shift the firm’s average total cost curve

up, from ATC1 to ATC2. It will also shift the marginal cost curve, from MC1 to MC2. Productionwill fall because of the increase in marginal cost. By contrast, an increase in a firm’s fixedcost (panel (b)) will shift the average total cost curve upward from ATC1 to ATC2, but will

not affect the marginal cost curve. (Marginal cost is unaffected by fixed cost.) Thus thefirm’s level of production will not change.

Figure 9A.1 Single isoquantA firm can produce 100 pairs of jeans a day using any of the various combinations of labor

and machinery shown on this curve. Because of diminishing marginal returns, more andmore machines must be substituted for each worker who is dropped.

Figure 9A.2 Several isoquantsDifferent output levels will have different isoquants. The higher the output level, the higher

the isoquant.

Figure 9A.3 Finding the most efficient combination of resourcesAssuming that the daily wage of each worker is $100, and the daily rental on each sewingmachine is $20, an expenditure of $600 per day will buy any combination of resources on

isocost curve IC1. The most cost-effective combination of labor and capital is point a, threeworkers and fifteen machines. At that point, the isocost curve is just tangent to isoquant IQ2, meaning that the firm can product 150 pairs of jeans a day. If the firm chooses any

other combination, it will move to a lower isoquant and a lower output level. At point b (onisoquant IQ1), it will be able to produce only 100 pairs of jeans a day.

Figure 9A.4 The effect of increased expenditures on resourcesAn increase in the level of expenditures on resources shifts the isocost curve outward from

IC1 to IC2. The firm’s most efficient combination of resources shifts from point a to point c.

Figure 10.1 Demand curve faced by perfect competitorsThe market demand for a product (panel (a)) is always downward sloping. The perfect

competitor is on a horizontal, or perfectly elastic, demand curve (panel (b)). It cannot raiseits price above the market price even slightly without losing its customers to other

producers.

Figure 10.2 Demand curve faced by a monopolistic competitorBecause the product sold by the monopolistically competitive firm is slightly different fromthe products sold by competing producers, the firm faces a highly elastic, but not perfectly

elastic, demand curve.

Figure 10.3 The perfect competitor’s production decisionThe perfect competitor’s price is determined by market supply and demand (panel (a)). Aslong as marginal revenue (MR), which equals market price, exceeds marginal cost (MC),

the perfect competitor will expand production (panel (b)). The profit maximizingproduction level is the point at which marginal cost equals marginal revenue (price).

Figure 10.4 Change in the perfect competitor’s market priceIf the market demand rises from D1 to D3 (panel (a)), the price will rise with it, from P1 to P3. As a result, the perfectly competitive firm’s demand curve will rise, from d1 to d3

(panel (b)).

Figure 10.5 The profit maximizing perfect competitorThe perfect competitor’s demand curve is established by the market clearing price

(panel (a)). The profit maximizing perfect competitor will extend production up to the pointat which marginal cost equals marginal revenue (price), or point a in panel (b). At that

output level – q2 – the firm will earn a short-run economic profit equal to the shaded areaATC1P1 ab. If the perfect competitor were to minimize average total cost, it would produce

only q1, losing profits equal to the darker shaded area dca in the process.

Figure 10.6 The loss minimizing perfect competitorThe market clearing price (panel (a)) establishes the perfect competitor’s demand curve(panel (b)). Because the price is below the average total cost curve, this firm is losingmoney. As long as the price is above the low point of the average variable cost curve,

however, the firm should minimize its short-run losses by continuing to produce wheremarginal cost equals marginal revenue (price or point b in panel (b)). This perfect

competitor should produce q1 units, incurring losses equal to the shaded area P1ATC1ab.(The alternative would be to shut down, in which case the firm would lose all its fixed

costs.)

Figure 10.7 The long-run effects of short-run profitsIf perfect competitors are making short-run profits, other producers will enter the market,

increasing the market supply from S1 to S2 and lowering the market price from P2 to P1

(panel (a)). The individual firm’s demand curve, which is determined by market price, willshift down, from d1 to d2 (panel (b)). The firm will reduce its output from q2 to q1, the newintersection of marginal revenue (price) and marginal cost. Long-run equilibrium will be

achieved when the price falls to the low point of the firm’s average total cost curve,eliminating economic profit (price P1 in panel (b)).

Figure 10.8 The long-run effects of short-run lossesIf perfect competitors are suffering short-run losses, some firms will leave the industry,causing the market supply to shift back from S1 to S2 and the price to rise, from P1 to P2

(panel (a)). The individual firm’s demand curve will shift up with price, from d1 to d2 (panel (b)). The firm will expand from q1 to q2, and equilibrium will be reached when price

equals the low point of average total cost P2, eliminating the firm’s short-run losses.

Figure 10.9 The long-run effects of economies of scaleIf the market is in equilibrium at price P1 in panel (a) and the individual firm is producing q1 units on short-run average total cost curve ATC1 (panel (b)), firms will be just breakingeven. Because of the profit potential represented by the shaded area ATC1P2ab, firms canbe expected to expand production to q3, where the long-run marginal cost curve intersects

the demand curve (d1). As they expand production to take advantage of economies ofscale, however, supply will expand from S1 to S2 in panel (a), pushing the market price

down toward P1, the low point of the long-run average total cost curve (LRATC in panel(b)). Economic profit will fall to zero. Because of rising diseconomies of scale, firms will not

expand further.

Figure 10.10 The efficiency of the competitive market

– that is, the difference between cost and benefits – are shown by the shaded area in panel (a). The perfectly competitive market is also efficient in the sense that the marginal cost of production, P1, is the same for all firms (panels (b) and (c)). If firm X were toproduce fewer than its efficient number of units, qx, firm Y would have to produce more than its efficient number, qy, to meet market demand. Firm Y would be pushed up its marginal cost curve, to the point at which the cost of the last unit would exceed its benefits. But competition forces the two firms to produce to exactly the point at which marginal cost equals marginal benefit, thus minimizing the cost of production.

Perfectly competitive markets are efficient in the sense that they equate marginal benefit (shown by the demand curve in panel (a)) with marginal cost (shown by the supply curve in panel (a). At the market output level, Q1, the marginal benefit of the last unit produced equals the marginal cost of production. The gains generated by theproduction of Q1 units

Figure 10.11 Supply and demand cobwebMarkets do not always move smoothly toward equilibrium. If current production decisionsare based on past prices, price may adjust to supply in the “cobweb pattern” shown here.

Having received price P1 in the past, farmers will plan to supply only Q1 bushels of wheat.That amount will not meet market demand, so the price will rise to P4 – inducing farmers

to plan for a harvest of Q3 bushels. At price P4, however, Q3 bushels will not clear themarket. The price will fall to P2, encouraging farmers to cut production back to Q2. Only

after several tries do many farmers find the equilibrium price–quantity combination.

Figure 10A.1 A contestable marketThe market is composed of three firms, each producing output q*, which minimizes average

costs. Total industry output is Q* = 3q*. Any attempt by the three firms to reduce outputand increase market price will lead to entry by new firms and the dissipation of profits.

Figure 11.1 The monopolist’s demand and marginal revenue curvesThe demand curve facing a monopolist slopes downward, for it is the same as market

demand. The monopolist’s marginal revenue curve is constructed from the informationcontained in the demand curve (see table 11.1).

Figure 11.2 Equating marginal cost with marginal revenueThe monopolist will move toward production level Q2, the level at which marginal costequals marginal revenue. At production levels below Q2, marginal revenue will exceed

marginal cost; the monopolist will miss the chance to increase profits. At production levelsgreater than Q2, marginal cost will exceed marginal revenue; the monopolist will lose

money on the extra units.

Figure 11.3 The monopolist’s profitsThe profit maximizing monopoly will produce at the level defined by the intersection of the

marginal cost and marginal revenue curves: Q1. It will charge a price of P1 – as high asmarket demand will bear – for that quantity. Because the average total cost of producing Q1

units is ATC1, the firm’s profit is the shaded area ATC1P1ab.

Figure 11.4 The monopolist’s short-run LossesNot all monopolists make a profit. With a demand curve that lies below its average total

cost curve, this monopoly will minimize its short-run losses by continuing to produce at thepoint where marginal cost equals marginal revenue (Q1 units). It will charge P1, a price thatcovers its fixed costs, and will sustain short-run losses equal to the shaded area P1ATC1ab.

Figure 11.5 Monopolistic production over the long run

In the long run, the monopolist will produce at the intersection of the marginal revenueand long-run marginal cost curves (panel (a)). In contrast to the perfect competitor, themonopolist does not have to minimize long-run average cost by expanding its scale ofoperation. It can make more profit by restricting production to Qa and charging price Pa. In panel (b), the monopolist produces at the low point of the long-run average cost curve only because that

happens to be the point at which marginal cost and marginal revenue curvesintersect. In panel (c), the monopolist produces on a scale beyond the low point of itslong-run average cost curve because demand is high enough to justify the cost. In eachcase, the monopolist charges a price higher than its long-run marginal cost.

Figure 11.6 The comparative efficiency of monopoly and competitionFirms in a competitive market will tend to produce at point b, the intersection of the

marginal cost and demand curves (with the price, or marginal benefit given by the heightof the demand curve). Monopolists will tend to produce at point c, the intersection of

marginal cost and marginal revenue, and to charge the highest price the market will bear: Pm. In a competitive market, therefore, the price will tend to be lower (Pc) and thequantity produced greater (Qc) than in a monopolistic market. The inefficiency of

monopoly is shown by the shaded triangular area abc, the amount by which the benefits ofproducing Qc - Qm units (shown by the demand curve) exceed their marginal cost of

production.

Figure 11.7 The costs and benefits of expanded productionIf the monopolist expands production from Qm to Qc in panel (a), consumers will receiveadditional benefits equal to the area bounded by QmabQc. They will pay an amount equalto the area QmcdQc for those benefits, leaving a net benefit equal to the shaded area abdc.To expand production, the monopoly must incur additional production costs equal to thearea QmcbQc in panel (b). It gains additional revenues equal to the area QmcdQc, leaving anet loss equal to the shaded area cbd. Thus, expanded production helps the consumer but

hurts the monopolist.

Figure 11.8 Price discriminationBy offering customers one can of beans for $0.30, two cans for $0.55, and three cans for

$0.75, a grocery store collects more revenues than if it offers three cans for $0.20 each. Ineither case, the consumer buys three cans. But by making the special offer, the store earns

$0.15 more in revenues per customer.

Figure 11.9 Perfect price discriminationThe perfect price-discriminating monopolist will produce at the point where marginal costand marginal revenue are equal (point a). Its output level, Qc is therefore the same as thatachieved under perfect competition. But because the monopolist charges as much as the

market will bear for each unit, its profits – the shaded area ATC1P1ab – are higher than thecompetitive firm’s.

Figure 11.10 Imperfect price discriminationThe monopolist that cannot perfectly price-discriminate may elect to charge a few different

prices by segmenting its market. To do so, it divides its market by income, location, orsome other factor and finds the demand and marginal revenue curves in each (panels (a)and (b)). Then it adds those marginal revenue curves horizontally to obtain its combinedmarginal revenue curve for all market segments, MRm (panel (c)). By equating marginalrevenue with marginal cost, it selects its output level, Qm. Then it divides that quantity

between the two market segments by equating the marginal cost of the last unit produced(panel (c)) with marginal revenue in each market (panels (a) and (b)). It sells Qa in marketA and Qb in market B, and charges different prices in each segment. Generally, the price

will be higher in the market segment with the less elastic demand (panel (b)).

Figure 11.11 The effect of price controls on the monopolistic production decisionIn an unregulated market, a monopolistic utility will produce Qm kilowatts and sell them forPm. If the firm’s price is controlled at P1, however, its marginal revenue curve will become

horizontal at P1. The firm will produce Q1 – more than the amount it would normallyproduce.

Figure 11.12 Taxing monopoly profitsTheoretically, a tax on the economic profit of monopoly will not be passed on to the

consumer – but taxes are levied on book profit, not economic profit. As a result, a tax shiftsthe first marginal cost curve up, from MC1 to MC2, raising the price to the consumer and

lowering the production level.

Figure 11A.1 Construction of the linear marginal revenue curveThe marginal revenue curve always starts at the intersection of the vertical axis and any

demand curve. However, for a linear demand curve, the marginal revenue curve must slopedownward under the demand curve, splitting the horizontal distance between the vertical

axis and every point on the demand curve. The marginal revenue curve must cut thehorizontal axis at the point below the middle of the linear demand curve, or where the

elasticity coefficient equals one.

Figure 11A.2 Construction of the nonlinear marginal revenue curveThe marginal revenue curve for a nonlinear demand curve is obtained by imagining linear

demand curves tangent to every point on the nonlinear demand curve and finding themidpoint between the vertical axis and the imagined linear demand curves.

Figure 12.1 Monopolistic competition in the short runAs do all profit maximizing firms, the monopolistic competitor will equate marginal

revenue with marginal cost. It will produce Qmc units and charge price Pmc, only slightlyhigher than the price under perfect competition. The monopolistic competitor makes ashort-run economic profit equal to the area ATC1Pmcab. The inefficiency of its slightly

restricted production level is represented by the shaded area.

Figure 12.2 Monopolistic competition in the long runIn the long run, firms seeking profits will enter the monopolistically competitive market,shifting the monopolistic competitor’s demand curve down from D1 to D2 and making it

more elastic. Equilibrium will be achieved when the firm’s demand curve becomes tangentto the downward sloping portion of the firm’s long-run average cost curve Qm. At that

point, price (shown by the demand curve) no longer exceeds average total cost; the firm ismaking zero economic profit. Unlike the perfect competitor, this firm is not producing at the

minimum of the long-run average total cost curve Qm. In that sense, it is underproducing,by Qm - Qmc2 units. This underproduction is also reflected in the fact that the price is

greater than the marginal revenue.

Figure 12.3 The oligopolist as monopolistWith fewer competitors than the monopolistic competitor deals with, the oligopolist faces aless elastic demand curve, Do. Each oligopolist can afford to produce significantly less (Qo)

and to charge significantly more Po than the perfect competitor, who produces Qc, at aprice of Pc. The shaded area representing inefficiency is larger than that of a monopolistic

competitor.

Figure 12.4 The oligopolist as price leaderThe dominant producer who acts as a price leader will attempt to undercut the market

price established by small producers (panel (a)). At price P1 the small producers will supplythe demand of the entire market, Q2. At a lower price – Pd or Pc – the market will demandmore than the small producers can supply. In panel (b), the dominant firm determines its

demand curve by plotting the quantity it can sell at each price in panel (a). Then itdetermines its profit maximizing output level, Qd, by equating marginal cost with marginalrevenue. It charges the highest price the market will bear for that quantity, Pd, forcing themarket price down to Pd in panel (a). The dominant producer sells Q3 – Q1 units, and the

smaller producers supply the rest.

Figure 12.5 A duopoly (two-member cartel)In an industry composed of two firms of equal size, firms may collude to restrict total

output to Qm and sell at a price of Pm. Having established that price–quantity combination,however, each has an incentive to chisel on the collusive agreement by lowering the priceslightly. For example, if one firm charges P1, it can take the entire market, increasing its

sales from Q1 to Q2. If the other firm follows suit to protect its market share, each will get alower price, and the cartel may collapse.

Figure 12.6 Long-run marginal and average costs in a natural monopolyIn a natural monopoly, long-run marginal cost and average costs decline continuously, over

the relevant range of production, because of economies of scale. Although the long-runmarginal and average cost curves may eventually turn upward because of diseconomies of

scale, the firm’s market is not large enough to support production in that cost range.

Figure 12.7 Creation of a natural monopolyEven with declining marginal costs, the firm with monopoly power will produce at the

point where marginal cost equals marginal revenue, making Qm units and charging a priceof Pm. Unless barriers to entry exist, however, other firms may enter the market, causing

the price to fall toward P1 and the quantity produced to rise toward Q1. At that price–quantity combination, only one firm can survive – but without barriers to entry, that firmcannot afford to charge monopoly prices. At a price of P1, its total revenues just cover its

total costs. Economic profit is zero.

Figure 12.8 Underproduction by a natural monopolyA natural monopolist that cannot price discriminate will produce only Q1 megawatts – lessthan Q2, the efficient output level – and will charge a price of P1. If the firm tries to produce Q2, it will make losses equal to the shaded area, for its price (P2) will not cover its average

cost (AC1).

Figure 12.9 Regulation and increasing costsIf a natural monopoly is compensated for the losses it incurs in operating at the efficientoutput level (the shaded area P1ATC1ba), it may monitor its costs less carefully. Its cost

curves may shift up, from LRMC1 to LRMC2 and from LRAC1 to LRAC2. Regulators will thenhave to raise the price from P1 to P2, and production will fall from Q1 to Q2. The firm will

still have to be subsidized (by an amount equal to the shaded area P2ATC2dc), and theconsumer will be paying more for less.

Figure 12.10 The effect of regulation on a cartelized industryThe profit maximizing cartel will equilibrate at point a and produce only Qm units and sell

at a price of Pm. In the sense that consumers want Qc units and are willing to pay morethan the marginal cost of production for them, Qm is an inefficient production level. Under

pure competition, the industry will produce at point b. Regulation can raise output andlower the price, ideally to Pc, thereby eliminating the dead-weight welfare loss that is

equal to the shaded triangle abc and which results from monopolistic behavior.

Figure 13.1 Shift in demand for laborThe demand for labor, as with all other demand curves, slopes downward. An increase inthe demand for labor will cause a rightward shift in the demand curve, from D1 to D2. A

decrease will cause the leftward shift, to D3.

Figure 13.2 Shift in the supply of laborThe supply curve for labor slopes upward. An increase in the supply of labor will cause a

rightward shift in the supply curve from S1 to S2. A decrease in the supply of labor willcause a leftward shift in the supply curve, from S1 to S3.

Figure 13.3 Equilibrium in the labor marketGiven the supply and demand curves for labor S and D, the equilibrium wage will be W1 and the equilibrium quantity of labor hired Q2. If the wage rate rises to W2, a surplus of

labor will develop, equal to the difference between Q3 and Q1.

Figure 13.4 The effect of nonmonetary rewards on wage ratesThe supply of labor is greater for jobs offering nonmonetary benefits – S2 rather than S1.

Given a constant demand for labor, the wage rate will be W2 for workers who do notreceive nonmonetary benefits and W1 for workers who do. Even though wages are lower

when nonmonetary benefits are offered, workers are still better off; they earn a total wageequal, according to their own values, to W3.

Figure 13.5 The effect of differences in supply and demand on wage ratesIn competitive labor markets, higher demand for labor (D2 in panel (a)) will bring a higher

wage rate. A higher supply of labor (S2 in panel (b)) will bring a lower wage rate.

Figure 13.6 The competitive labor marketIn a competitive market, the equilibrium wage rate will be W2. Lower wage rates, such as

W1, would create a shortage of labor, and employers would compete for the availablelaborers by offering a higher wage. In pushing up the wage rate to the equilibrium level,employers impose costs on one another. They must pay higher wages not only to new

employees but also to all current employees, in order to keep them.

Figure 13.7 The marginal cost of laborThe marginal cost of hiring additional workers is greater than the wages that must be paidto the new workers. Therefore the marginal cost of labor curve lies above the labor supply

curve.

Figure 13.8 The monopsonistThe monopsonist will hire up to the point at which the marginal value of the last worker,

shown by the demand curve for labor, equals his or her marginal cost. For thismonopsonistic employer, the optimum number of workers is Q2. The monopsonist must

pay only W1 for that number of workers – less than the competitive wage level, W2.

Figure 13.9 The employer cartelTo achieve the same results as a monopsonist, the employer cartel will devise restrictive

employment rules that artificially reduce market demand to D2. The reduced demandallows cartel members to hire only Q2 workers at wage W1 – significantly less than the

competitive wage, W2.

Figure 13.10 Menu of two-part pay packagesBy varying the base salary and the commission rate, employers can get salespeople to

reveal more accurately the sales potential of their districts. A salesperson who believes thatthe sales potential of his district is great will take the income path that starts at a base

salary of S3. The salesperson who doesn’t think the sales potential of his district is verygood will choose the income path that starts at S1.

Figure 14.1 The political spectrumA political candidate who takes a position in the “wings” of a voter distribution, such as D1

or R1, will win fewer votes than a candidate who moves toward the middle of thedistribution. In a two-party election, therefore, both candidates will take

middle-of-the-road positions, such as D and R.

Figure 14.2 Bureaucratic profit maximizationGiven the demand for police service, D, and the marginal cost of providing it, MC, the

optimum quantity of police service is Q2. A monopolistic police department interested inmaximizing its profits will supply only Q1 service at a price of P2, however. (A monopolistic

bureaucracy interested in maximizing its size would expand police service to Q3.)

Figure 15.1 Gains from the export tradeOpening up foreign markets to US producers increases the demand for their products, from D1 to D2. As a result, domestic producers can raise their price from P1 to P2 and sell a larger

quantity, Q3 instead of Q2. Revenues increase by the shaded area P2bQ3Q2aP1. The moreprice-elastic or flatter the supply function (S), the larger the change in quantity and the

smaller the change in price.

Figure 15.2 Losses from competition with imported productsOpening up the market to foreign trade increases the supply of textiles from S1 to S2. As a

result, the price of textiles falls from P2 to P1, and domestic producers sell a lower quantity, Q1 instead of Q2. Consumers benefit from the lower price and the higher quantity of

textiles they are able to buy, but domestic producers, workers, and suppliers lose.Producers’ revenues drop by an amount equal to the shaded area P2aQ2Q1bP1. Workers’and suppliers’ payments drop by an amount equal to the shaded area Q2abQ1. Starting atpoint c, a tariff or tax equal to ad is levied, shifting the supply curve from S2 to S1. In anindustry whose costs are increasing, the increase in price from P1 to P2 in the importingcountry is less than the increase in the tariff (ad), because a price fall in the exporting

country absorbs some of the burden of the duty.

Figure 15.3 Effects of tariff protection on individual industries: case 1If neither the textiles nor the automobile industry obtains tariff protection, the economy

will earn its highest possible collective income (cell I), but each industry has an incentive toobtain tariff protection for itself. If the textiles industry alone seeks protection (cell II), its

income will rise while the auto industry’s income falls. If the auto industry alone seeksprotection, its income will rise while that of the textiles industry falls. If both obtain

protection, the economy will end up in cell IV, its worst possible position. Income in bothsectors will fall.

Figure 15.4 Effects of tariff protection on individual industries: Case 2In this case, the auto industry gains from tariff protection, even if both sectors are

protected (cell IV). The textiles industry’s income falls from $20 (cell I) to $17 (cell IV), butthe auto industry’s income rises from $30 (cell I) to $31 (cell IV). Thus the auto industry has

no incentive to agree to the elimination of tariffs.

Figure 15.5 Supply and demand for euros on the international currency marketThe international exchange rate between the dollar and the euro is determined by theforces of supply and demand, with the equilibrium at E. If the exchange rate is below

equilibrium, say at ER1, the quantity of euros demanded, shown by the demand curve, willexceed the quantity supplied, shown by the supply curve. Competitive pressure will push

the exchange rate up. If the exchange rate is above equilibrium, say, ER3, the quantitysupplied will exceed the quantity demanded and competitive pressure will push the

exchange rate down. Thus the price of a foreign currency is determined in much the sameway as the price of any other commodity.

Figure 15.6 Effect of an increase in demand for eurosAn increase in the demand for euros will shift the demand curve from D1 to D2, pushing the

equilibrium from E1 to E2. At the initial equilibrium exchange rate ER1, a shortage willdevelop. Competition among buyers will push the exchange rate up to the new equilibrium

level, ER2.