Module 1: Introduction to Economics and
An economy in which
its Fundamentals
Key Terms
Allocative efficiency. A state of the
economy in which production is in
accordance with consumer preferences; in
particular, every good or service is produced
up to the point where the last unit provides a
marginal benefit to consumers equal to the
marginal cost of producing it.
Centrally planned economy. An economy
in which the government decides how
economic resources will be allocated.
Economic model. A simplified version of
reality used to analyze real-world economic
situations.
Economic variable. Something measurable
that can have different values, such as the
number of people employed in
manufacturing. 
Economics. The study of the choices people
make to attain their goals, given their scarce
resources.
Equity. The fair distribution of economic
benefits.
Macroeconomics. The study of the
economy as a whole, including topics such
as inflation, unemployment, and economic
growth.
Marginal analysis. Analysis that involves
comparing marginal benefits and marginal
costs.
Market. A group of buyers and sellers of a
good or service and the institution or
arrangement by which they come together to
trade.
Market economy.
the decisions of households and firms as
they interact in markets determine the
allocation of economic resources.
Microeconomics. The study of how
households and firms make choices, how
they interact in markets, and how the
government attempts to influence their
choices.
Mixed economy. An economy in which
most economic decisions result from the
interaction of buyers and sellers in markets
but in which the government plays a
significant role in the allocation of
resources.
Normative analysis. Analysis concerned
with what ought to be.
Opportunity cost. The highest-valued
alternative that must be given up to engage
in an activity.
Positive analysis. Analysis concerned with
what is.
Productive efficiency. A situation in which
a good or service is produced at the lowest
possible cost.
Scarcity. A situation in which unlimited
wants exceed the limited resources available
to fulfill those wants.
Trade-off. The idea that, because of
scarcity, producing more of one good or
service means producing less of another
good or service.
Voluntary exchange. A situation that
occurs in markets when both the buyer and
the seller of a product are made better off by
the transaction.
 Foundation and Models
 I. Key Economic Ideas
A market is a group of buyers and sellers of
a good or service and the institution or
arrangement by which they come together to
trade.
A. People Are Rational
Rational consumers and firms use all
available information as they act to achieve
their goals.  produced?
B. People Respond to Economic
Incentives
Economists emphasize that individuals and
firms consistently respond to economic
incentives.
C. Optimal Decisions Are Made at the
Margin
Economists use the word marginal to mean
an extra or additional benefit or cost from
making a decision. The optimal decision is
to continue any activity to the point where
the marginal benefit equals the marginal
cost. Marginal analysis is analysis that
involves comparing marginal benefits and
marginal costs.
II. The Economic Problem That Every
Society Must Solve  and services produced depends largely on
Every society faces the economic problem
that it has only a limited amount of
economic resources, so it can produce only a
limited amount of goods and services. Every
society faces trade-offs. A trade-off is the
idea that, because of scarcity, producing
more of one good or service means
producing less of another good or service.
Every activity has an opportunity cost: The
highest-valued alternative that must be given
up to engage in an activity.
Trade-offs force society to answer three
fundamental questions:
1.  What goods and services will be
produced?
2.  How will the goods and services be
produced?
3.  Who will receive the goods and services
A. What Goods and Services Will Be
Produced?
The answer to this question is determined by
the choices consumers, managers of firms,
and government policymakers make. Each
choice made has an opportunity cost.
B. How Will the Goods and Services Be
Produced?
Firms choose how to produce the goods and
services they sell. For example, firms often
face trade-offs between using more workers
or more machines.
C. Who Will Receive the Goods and
Services Produced?
In the United States, who receives the goods
how income is distributed. An important
policy question is whether the government
should intervene to make the distribution of
income more equal.
D. Centrally Planned Economies versus
Market Economies
Societies organize their economies in two
main ways. A centrally planned economy
is an economy in which the government
decides how economic resources will be
allocated. A market economy is an
economy in which the decisions of
households and firms interacting in markets
determine the allocation of economic
resources. Today, only North Korea has a
completely centrally planned economy. In a
market economy, the income of an
individual is determined by the payments he
or she receives for what he or she sells.
Generally, the more extensive the training a
person has received and the longer the hours
the person works, the higher his income will
be.
E.  The Modern “Mixed” Economy
The high rates of unemployment and
business bankruptcies during the Great
Depression of the 1930s caused a dramatic
increase in government intervention in the
economy in the United States and other
market economies. Some government
intervention is designed to raise the incomes
of the elderly, the sick, and people with
limited skills. In recent years, government
intervention has expanded to meet goals
such as protection of the environment,
promotion of civil rights, and increased
access to medical care.
Some economists argue that the extent of
government intervention makes it more
accurate to refer to the economies of the
United States, Canada, Japan and Western
Europe as mixed economies rather than
pure market economies. A mixed economy
is an economy in which most economic
decisions result from the interaction of
buyers and sellers in markets but in which
the government plays a significant role in
the allocation of resources.
F.  Efficiency and Equity
Market economies tend to be more efficient
than centrally planned economies. There are
two types of efficiency. Productive
efficiency is a situation in which a good or
service is produced at the lowest possible
cost. Allocative efficiency is a state of the
economy in which production is in
accordance with consumer preferences; in
particular, every good or service is produced
up to the point where the last unit provides a
marginal benefit to consumers equal to the
marginal cost of producing it. Voluntary
exchange is a situation that occurs in
markets when both the buyer and the seller
of a product are made better off by the
transaction.
Inefficiency arises from various sources.
Sometimes governments reduce efficiency
by interfering with voluntary exchange in
markets. The production of some goods
damages the environment when firms ignore
the costs of environmental damage. In this
case, government intervention can increase
efficiency.
Society may not find an efficient economic
outcome to be desirable. Many people prefer
economic outcomes they consider fair or
equitable even if these outcomes are less
efficient. Equity is the fair distribution of
economic benefits. There is often a trade-off
between efficiency and equity.
III. Economic Models 
An economic model is simplified version of
reality used to analyze real-world situations.
To develop a model, economists generally
follow five steps.
1.  Decide on the assumptions to use.
2.  Formulate a testable hypothesis.
 3.  Use economic data to test the
hypothesis.
4.  Revise the model if it fails to explain
the economic data well.
5.  Retain the revised model to help
answer similar economic questions in
the future.
A. The Role of Assumptions in Economic
Models
Models are based on making assumptions
because models must be simplified to be
useful. When using models, economists
make behavioral assumptions about the
motives of consumers and firms. Economists
assume consumers will buy goods and
services that will maximize their satisfaction
and firms will act to maximize their profits.
B. Forming and Testing Hypotheses in
Economic Models
An economic variable is something
measurable that can have different values,
such as the number of people employed in
manufacturing. A hypothesis in an economic
model is a statement that may be correct or
incorrect about an economic variable. To
test a hypothesis, we analyze statistics on
the relevant economic variables. Economists
accept and use an economic model if it leads
to hypotheses that are confirmed by
statistical analysis.
C. Positive and Normative Analysis
Positive analysis is analysis concerned with
what is. Normative analysis is analysis
concerned with what ought to be.
Economics is about positive analysis,
which measures the costs and benefits of
different courses of action.
D. Economics as a Social Science
Because economics studies the actions of
individuals, it is a social science. Economics
considers human behavior in every context,
not just in the context of business.
IV. Microeconomics and
Macroeconomics 
Microeconomics is the study of how
households and firms make choices, how
they interact in markets, and how the
government attempts to influence their
choices.
Macroeconomics is the study of the
economy as a whole, including topics such
as inflation, unemployment, and economic
growth. 
Economy – “oikonomos” (Greek)
“One who manages a household”
Household - many decisions
Allocate scarce resources
Ability, effort, and desire
Society - many decisions
Allocate resources
Allocate output
Resources are scarce
- Scarcity
- The limited nature of society’s
resources
Economics. Study of how society manages
its scarce resources
Economists study:
1. How people make decisions
2. How people interact with one
another
3. Analyze forces and trends that affect
the economy as a whole
Ten Principles of Economics
a. How People Make Decisions
Principle 1: People face trade-offs
- Making decisions
- Trade off one goal against another
Student – time
Parents – income
Society
National defense vs. consumer
goods
Clean environment vs. high level of
income
- Efficiency vs. equality
Efficiency
Society getting the most it can from its
scarce resources
- Size of the economic pie
Equality
Distributing economic prosperity uniformly
among the members of society
- How the pie is divided into
individual slices
Principle 2: The cost of something is what
you give up to get it
- People face trade-offs
- Make decisions
- Compare cost with benefits of
alternatives
- Opportunity cost- Whatever must
be given up to obtain one item
Principle 3: Rational people think at the
margin
- Rational people- Systematically &
purposefully do the best they can to
achieve their objectives
- Marginal changes. Incremental
changes to a plan of action
- Rational people take action only if
Marginal benefits > Marginal costs
Principle 4: People respond to incentives
- Incentive. Something that induces a
person to act
- Higher price
Buyers - consume less
Sellers - produce more
- Public policy
Change costs or benefits
Change people’s behavior
b. How People Interact
Principle 5: Trade can make everyone
better off
- Trade . Allows each person to
specialize in the activities he or she
does best
- Enjoy a greater variety of goods and
services at lower cost
Principle 6: Markets are usually a good
way to organize economic activity
- Communist countries – central
planning
- Government officials (central
planners) make all decisions
- Market economy - allocates
resources
- Through decentralized decisions of
many firms and households
- As they interact in markets for goods
and services
- Guided by prices and self interest
- Adam Smith’s “invisible hand”
Principle 7: Governments can sometimes
improve market outcomes
- We need government
Enforce rules and maintain
institutions
Enforce property rights
Promote efficiency
Avoid market failure
Promote equality
Avoid disparities in economic well-
being

c. How the Economy as a Whole
Works
Principle 8: A country’s standard of
living depends on its ability to produce
goods and services
- Large differences in living standards
Among countries
- Over time
- Explanation: differences in
productivity
Principle 9: Prices rise when the
government prints too much money
- Inflation. An increase in the overall
level of prices in the economy
- Causes for large / persistent
inflation
1. Growth in quantity of money
2. Value of money falls
Principle 10: Society faces a short-run
trade-off between inflation and
unemployment
The Economist as a Scientist
Economists
 Devise theories
 Collect data
 Analyze these data
 Verify or
refute their theories
The role of assumptions
 Assumptions
o Can simplify the complex
world
 Make it easier to
understand
 Focus our thinking -
essence of the problem
 Different assumptions
 To answer different
questions
 Short-run or long-run
effects
 Economic models
o Diagrams & equations
o Omit many details
o Allow us to see what’s truly
important
o Built with assumptions
o Simplify reality to improve
our understanding of it
 Circular-flow diagram
o Visual model of the economy
o Shows how dollars flow
through markets among
households and firms
 Decision makers
o Firms & Households 
 Markets
o For goods and services
o For factors of production
 Firms
o Produce goods and services
o Use factors of production /
inputs
 Households
 o Own factors of production
o Consume goods and services
 Markets for goods and services
o Firms – sellers
o Households – buyers
 Markets for inputs
o Firms – buyers
o Households – sellers
Production possibilities frontier
o A graph
o Combinations of output that
the economy can possibly
produce
o Given the available
 Factors of production
 Production
technology
The production possibilities frontier shows
the combinations of output—in this case,
cars and computers—that the economy can
possibly produce. The economy can produce
any combination on or inside the frontier.
Points outside the frontier are not feasible
given the economy’s resources.
 Efficient levels of production
o The economy is getting all it
can from the scarce resources
available points on the
production possibilities
frontier
 Trade-off:
 The only way to
produce more of one
good Is to produce less
of the other good
 Inefficient levels of production
o Points inside production
possibilities frontier
 Opportunity cost of
producing one good
o Give up producing the other
good
o Slope of the production
possibilities frontier 
 Technological advance
o Outward shift of the
production possibilities
frontier
o Economic growth
o Produce more of both goods
A shift in the production
possibilities frontier
 A technological advance in
the computer industry enables
the economy to produce
more computers for any
given number of cars. As a
result, the production
possibilities frontier shifts
 outward. If the economy
moves from  point A to point
G, then the production of
both cars and computers
increases.
Positive vs. Normative analysis  is greater than the percentage change in
 Positive statements
o Attempt to describe the world
as it is
o Descriptive  economic variable responds to changes in
o Confirm or refute by
examining evidence
 Normative statements
o Attempt to prescribe how the
world should be
o Prescriptive  own it.
Module 2: Microeconomic Foundations:
Consumers & Firms
Absolute advantage. The ability of an
individual, a firm, or a country to produce
more of a good or service than competitors,
using the same amount of resources.
Behavioral economics. The study of
situations in which people make choices that
do not appear to be economically rational.
Budget constraint. The limited amount of
income available to consumers to spend on
goods and services.
Circular-flow diagram. A model that
illustrates how participants in markets are
linked.
Comparative advantage. The ability of an
individual, a firm, or a country to produce a
good or service at a lower opportunity cost
than competitors.
Economic growth. The ability of an
economy to produce increasing quantities of
goods and services.
Elastic demand. The case where the
percentage change in the quantity demanded
price, so the price elasticity is greater than 1
in absolute value.
Elasticity. A measure of how much one
another economic variable.
Endowment effect. The tendency of people
to be unwilling to sell a good they already
own even if they are offered a price that is
greater than the price they would be willing
to pay to buy the good if they didn’t already
Entrepreneur. Someone who operates a
business, bringing together the factors of
production—labor, capital, and natural
resources—to produce goods or services.
Factor market. A market for the factors of
production, such as labor, capital, natural
resources, and entrepreneurial ability.
Factors of production. Labor, capital,
natural resources, and other inputs used to
make goods and services.
Free Market. A market with few
government restrictions on how a good or
service can be produced or sold or on how a
factor of production can be employed.
Income effect. The change in the quantity
demanded of a good that results from the
effect of a change in price on consumer
purchasing power, holding all other factors
constant.
Inelastic demand. The case where the
percentage change in quantity demanded is
less than the percentage change in price, so
the price elasticity is less than 1 in absolute
value.
Law of diminishing marginal utility. The
principle that consumers experience
diminishing additional satisfaction as they
consume more of a good or service during a
given period of time.
Marginal utility (MU). The change in total
utility a person receives from consuming
one additional unit of a good or service.
Market. A group of buyers and sellers of a
good or service and the institution or
arrangement by which they come together to
trade.
Buyers. Determine the demand for the
product.
Sellers. Determine the supply of the product
Network externality. A situation in which
the usefulness of a product increases with
the number of consumers who use it.
Opportunity cost. The highest-valued
alternative that must be given up to engage
in an activity.
Perfectly elastic demand. The case where
the quantity demanded is infinitely
responsive to price and the price elasticity
of demand equals infinity.
Perfectly inelastic demand. The case where
the quantity demanded is completely
unresponsive to price and the price
elasticity of demand equals zero.
Price elasticity of demand. The
responsiveness of the quantity demanded to
a change in price, measured by dividing the
percentage change in the quantity demanded
of a product by the percentage change in the
product’s price.
Product market. A market for goods—such
as computers—or services—such as medical
treatment.
Production possibilities frontier (PPF). A
curve showing the maximum attainable
combinations of two goods that can be
produced with available resources and
current technology.
Property rights. The rights individuals or
businesses have to the exclusive use of their
property, including the right to buy or sell it.
Scarcity. A situation in which unlimited
wants exceed the limited resources available
to fulfill those wants.
Substitution effect. The change in the
quantity demanded of a good that results
from a change in price making the good
more or less expensive relative to other
goods, holding constant the effect of the
price change on consumer purchasing
power.
Sunk cost. A cost that has already been paid
and cannot be recovered.
Total revenue. The total amount of funds a
seller receives from selling of a good or
service, calculated by multiplying price per
unit by the number of units sold.
Trade. The act of buying and selling.
Unit-elastic demand. The case where the
percentage change in quantity demanded is
equal to the percentage change in price, so
the price elasticity is equal to 1 in absolute
value.
Utility. The enjoyment or satisfaction
people receive from consuming goods and
services.
I. Production Possibilities Frontiers and
Opportunity Costs
Scarcity is a situation in which unlimited
wants exceed the limited resources available
to fulfill those wants. Goods and services are
scarce, as are the resources used to make
goods and services.  greater increases in production for one good
A production possibilities frontier (PPF)
is a curve showing the maximum attainable
combinations of two goods that can be
produced with available resources and
current technology.
A. Graphing the Production Possibilities
Frontier
All combinations of products on a
production possibilities frontier are efficient
because all available resources are being
used. Combinations inside the frontier are
inefficient because maximum output is not
obtained from available resources. Points
outside the frontier are unattainable given
the firm’s current resources. Opportunity
cost is the highest-valued alternative that
must be given up to engage in an activity.
B. Increasing Marginal Opportunity
Costs
A production possibilities frontier that is
bowed outward illustrates increasing
marginal opportunity costs, which occur
because some workers, machines, and other
resources are better suited to one use than
to another. Increasing marginal
opportunity costs illustrate an important
concept: The more resources already
devoted to any activity, the smaller the
payoff to devoting additional resources to
that activity.
C. Economic Growth
Economic growth is the ability of an
economy to produce increasing quantities of
goods and services. Economic growth can
occur if more resources become available or
if a technological advance makes resources
more productive. Growth may lead to
than another. 
II. Comparative Advantage and Trade
Trade is the act of buying and selling. Trade
makes it possible for people to become
better off by increasing both their production
and their consumption.
A. Specialization and Gains from Trade
PPFs show the combinations of two goods
that can be produced if no trade occurs. We
can also use PPFs to show how someone
can benefit from trade even if she is better
than someone else at producing both goods.
B. Absolute Advantage versus
Comparative Advantage
Absolute advantage is the ability of an
individual, a firm, or a country to produce
more of a good or service than
competitors, using the same amount of
resources. If the two individuals have
different opportunity costs for producing
two goods, each individual will have a
comparative advantage in the production of
one of the goods. Comparative advantage
is the ability of an individual, a firm, or a
country to produce a good or service at a
lower opportunity cost than competitors.
Comparing the possible combinations of
production and consumption before and after
specialization and trade occur proves that
trade is mutually beneficial.
C. Comparative Advantage and the Gains
from Trade
The basis for trade is comparative
advantage, not absolute advantage.
Individuals, firms, and countries are better
off if they specialize in producing the goods
and services for which they have a
comparative advantage and obtain the other
goods and services they need by trading.
III. The Market System  D. The Role of the Entrepreneur in the
In the United States and most other
countries, trade is carried out in markets. A
market is a group of buyers and sellers of a
good or service and the institution or
arrangement by which they come together to
trade. A product market is a market for
goods—such as computers—or services—
such as medical treatment. A factor market
is a market for the factors of production,
such as labor, capital, natural resources, and
entrepreneurial ability. Factors of
production are labor, capital, natural
resources, and other inputs used to make
goods and services.
A. The Circular Flow of Income
A circular-flow diagram is a model that
illustrates how participants in markets are
linked. The diagram demonstrates the
interaction between firms and households in
both product and factor markets.
B. The Gains from Free Markets
A free market is a market with few
government restrictions on how a good or
service can be produced or sold or on how a
factor of production can be employed.
Adam Smith is considered the father of
modern economics. His book, An Inquiry
into the Nature and Causes of the Wealth of
Nations, published in 1776, was an
influential argument for the free market
system.
C. The Market Mechanism
A key to understanding Adam Smith’s
argument is the assumption that
individuals usually act in a rational, self-
interested way. This assumption underlies
nearly all economic analysis.
Market System
Entrepreneurs are an essential part of a
market economy. An entrepreneur is
someone who operates a business, bringing
together the factors of production—labor,
capital, and natural resources—to produce
goods or services. Entrepreneurs often risk
their own funds to start businesses and
organize factors of production to produce
those goods and services that consumers
want.
E.  The Legal Basis of a Successful
Market System
The absence of government intervention is
not enough for a market economy to work
well. Government has to provide a legal
environment that allows markets to operate
efficiently. Property rights are the rights
individuals or businesses have to the
exclusive use of their property, including the
right to buy or sell it. To protect intellectual
property rights, the federal government
grants inventors patents. A patent grants
the exclusive right to produce and sell a new
product for 20 years from the date the
patent is filed. Books, films, and software
receive copyright protection. Under U.S.
law, the creator of a book, film, or piece of
music has the exclusive right to use the
creation during the creator's lifetime. The
creator’s heirs retain this right for 70 years
after the death of the creator.
IV. Utility and Consumer Decision
Making
A. An Overview of the Economic Model
of Consumer Behavior
The economic model of consumer
behavior predicts that consumers will
choose to buy the combination of goods and
services that makes them as well off as
possible from among all the combinations
that their budgets allow them to buy.
B. Utility
How much satisfaction you get from
consuming a particular combination of
goods and services depends on your tastes or
preferences. Utility is the enjoyment or
satisfaction people receive from consuming
goods and services. Although economists no
longer use the word util as an objective
measure of utility, the economic model of
consumer behavior is easier to understand if
we assume that utility, like temperature, is
directly measurable.
C. The Principle of Diminishing Marginal
Utility
Economists use the term marginal utility
(MU) to refer to the change in total utility a
person receives from consuming one
additional unit of a good or service. The law
of diminishing marginal utility is the
principle that consumers experience
diminishing additional satisfaction as they
consume more of a good or service during a
given period of time.
D. The Rule of Equal Marginal Utility per
Dollar Spent
The limited amount of income available to
consumers to spend on goods and services is
a budget constraint. A key principle to
remember is that optimal decisions are made
at the margin. The key to making the best
consumption decision is to follow the rule
of equal marginal utility per dollar spent:
As you decide how to spend your income,
you should consume additional units of each
good to the point where the last unit of each
good gives you the same utility per dollar.
This is the first condition necessary for
you to maximize your utility. The second
condition is that total spending on all
goods must equal the amount available to
be spent.
E.  What If the Rule of Equal Marginal
Utility per Dollar Does Not Hold?
Assume that you met your budget constraint,
but the marginal utility per dollar of one
good (Coke) was greater than the marginal
utility of another good (pizza). You could
raise your total utility by buying less pizza
and more Coke.
F.  The Income Effect and Substitution
Effect of a Price Change
A change in price has two effects on the
quantity demanded. The income effect is the
change in the quantity demanded of a good
that results from the effect of a change in
price on consumer purchasing power,
holding all other factors constant. The
substitution effect is the change in the
quantity demanded of a good that results
from a change in price making the good
more or less expensive relative to other
goods, holding constant the effect of the
price change on consumer purchasing
power.
IV. Where Demand Curves Come From  B. Network Externalities
A market demand curve is constructed by
adding horizontally the individual demand
curves of consumers of a particular good.
According to the law of demand, market
demand curves always slope downward.
This is because the income and substitution
effects of a fall in price cause consumers to
increase the quantity of the good they
demand. But there is a complicating factor.
Only for normal goods will the income
effect result in consumers increasing the
quantity of the good they demand when the
price falls. The income effect for an inferior
good leads consumers to decrease the
quantity of the good they demand. The
substitution effect results in consumers
increasing the quantity they demand of both
normal and inferior goods when the price
falls. When the price of an inferior good
falls, the income and substitution effects
work in opposite directions. The income
effect for an inferior good would have to
be greater than the substitution effect for
a demand curve to be upward sloping.
V. Social Influences on Decision-Making
Although economists have traditionally seen
such factors as culture, customs, and religion
as relatively unimportant, some economists
have begun to study how social factors
influence consumer choices.
A. The Effects of Celebrity Endorsements
If consumers believe that movie stars or
professional athletes use a product, then
demand for the product will often increase.
Demand increases partly because
consumers believe public figures are
particularly knowledgeable about certain
products, but also because they feel more
fashionable and closer to famous people if
they use the same products these people do.
A situation in which the usefulness of the
product increases with the number of
consumers who use it is a network
externality. Some economists raised the
possibility that network externalities might
result in consumers buying products that
contain inferior technologies because
network externalities can create switching
costs: Once a product becomes established,
consumers may find it too costly to switch to
a new product that contains a better
technology. The selection of products may
be path dependent; that is, because of
switching costs, the technology that was first
available may have advantages over better
technologies that were developed later.
Some economists have argued that because
of path dependence and switching costs,
network externalities can result in market
failure. If so, government intervention in
these markets might improve economic
efficiency. Other economists who have
studied cases of network externalities argue
that there is no good evidence that the
alternative technologies are superior.
C. Does Fairness Matter?
There is evidence that people like to be
treated fairly, and they usually attempt to
treat others fairly, even if doing so makes
them worse off financially. Economists have
used experiments to increase
their understanding of the role that fairness
plays in consumer decision-making. One
consequence of the importance of fairness to
consumers is that firms will sometimes not
raise the prices of their goods and services,
even when there is a large increase in
demand, because they are afraid customers
will consider the price increases unfair.
Sometimes firms will give up some profits
in the short run to keep their customers
happy and increase their profits in the long
run.
VI. Behavioral Economics: Do People
Make Rational Choices?  Many people in the United States are
Behavioral economics is the study of
situations in which people make choices that
do not appear to be economically rational.
The most obvious reason why people might
not act rationally is that they do not realize
that their actions are inconsistent with their
goals.
A. Pitfalls in Decision-Making
Consumers commonly commit the following
three mistakes when making decisions:
1.      They take into account monetary
costs but ignore nonmonetary opportunity
costs.
2.      They fail to ignore sunk costs.
3.      They are overly optimistic about their
future behavior.
Opportunity cost is the highest-value
alternative that must be given up to engage
in an activity. Behavioral economists believe
that consumers’ failure to take into account
the nonmonetary opportunity costs of their
decisions is related to the endowment effect.
The endowment effect is the tendency of
people to be unwilling to sell a good they
already own even if they are offered a price
that is greater than the price they would be
willing to pay to buy the good if they didn’t
already own it. Nonmonetary opportunity
costs are just as real as monetary costs, so
people should take them into account when
making decisions.
A sunk cost is a cost that has already been
paid and cannot be recovered. Once you
have paid money and can’t get it back, you
should ignore that money in any later
decisions you make.
overweight. One explanation for this is that
people eat a lot today because they expect to
eat less tomorrow. But they never do eat
less, and so they end up overweight.
Economists who have studied issues like
overeating and getting lung cancer from
smoking argue that many people have
preferences that are not consistent over time.
People can avoid these problems by
being realistic about their future behavior.
B. “Nudges”: Using Behavioral
Economics to Guide Behavior
Economist Richard Thaler has popularized
the idea of using “nudges” to lead people to
make better decisions. At the suggestion of
behavioral economists, many firms
automatically enroll employees in 401(k)
retirement plans. Although employees have
long-run plans to save for retirement, many
spend more – and save less – than is
consistent with this goal. Automatically
enrolling employees in a 401(k) plan means
that leaving the plan forces employees to
confront the inconsistency between their
short-run spending and their long-term
goal of a comfortable retirement. Rather
than confront their inconsistency, most
employees choose to remain in their plans.
Suggestions from behavioral economists
have also been used to improve health care.
C. The Behavioral Economics of
Shopping
A typical shopping trip for a family of four
could involve the purchase of 25 or more
products. Economists are divided in
deciding whether it matters if consumers do
not make optimal choices. Those who think
it does not matter believe that assumptions
in most scientific models are not literally
correct and unrealistic assumptions are
needed to simplify a complex reality. These
economists believe that models are judged
by the success of their predictions rather
than the realism of their assumptions.
Behavioral economists believe it does matter
that consumers don’t usually make optimal
choices. People often make choices based on
limited information and often use rules of
thumb that may not produce optimal
choices. Behavioral economists use the word
anchoring to describe one way consumers
assess whether a price is “high” or “low.”
When uncertain about the value of a
product they often relate—or anchor—
that value to another known value. Stores
can take advantage of consumers’ lack of
information about prices to anchor their
estimates by marking a high “regular price”
on a product which makes a discounted sales
price appear to be a bargain.  is less than the percentage change in price,
VII. The Price Elasticity of Demand and
Its Measurement 
Elasticity is a measure of how much one
economic variable responds to changes in
another economic variable. The price
elasticity of demand is the responsiveness
of the quantity demanded to a change in
price, measured by dividing the percentage
change in the quantity demanded of a
product by the percentage change in the
product’s price.
A. Measuring the Price Elasticity of
Demand
The slope of the demand curve is not used to
measure elasticity because the measurement
of slope is sensitive to the units chosen for
quantity and price.
The price elasticity of demand is always
negative. Because we are usually interested
in the relative sizes of elasticities, we often
compare their absolute values.
B. Elastic Demand and Inelastic Demand
Elastic demand refers to the case where the
percentage change in quantity demanded is
greater than the percentage change in
price, so the price elasticity is greater than
1 in absolute value.
Inelastic demand refers to the case where
the percentage change in quantity demanded
so the price elasticity is less than 1 in
absolute value.
Unit-elastic demand refers to the case
where the percentage change in quantity
demanded is equal to the percentage change
in price, so the price elasticity is equal to 1
in absolute value.
C. An Example of Computing Price
Elasticities
In calculating the price elasticity between
two points on a demand curve, we run into a
problem because we get a different value for
price increases than for price decreases.
D. The Midpoint Formula
We can use the midpoint formula to ensure
that we have only one value for the price
elasticity of demand between two points on
a demand curve. The midpoint formula uses
the average of the initial and final quantities
and the average of the initial and final
prices. If Q1 and P1 are the initial quantity
and price and Q2 and P2 are the final
quantity and price, then the midpoint
formula is:
E.  When Demand Curves Intersect, the
Flatter Curve Is More Elastic
When two demand curves intersect, the
curve with the smaller slope (in absolute
value) is more elastic, and the one with the
larger slope (in absolute value) is less
elastic.
F.  Polar Cases of Perfectly Inelastic and
Perfectly Elastic Demand
If a demand curve is a vertical line, then it
is perfectly inelastic. Perfectly inelastic
demand is the case where the quantity
demanded is completely unresponsive to
price and the price elasticity of demand
equals zero. If a demand curve is a
horizontal line, then it is perfectly elastic.
Perfectly elastic demand is the case where
the quantity demanded is infinitely
responsive to price and the price elasticity
of demand equals infinity.
VIII. The Determinants of the Price
Elasticity of Demand  in the average consumer’s budget.
There are five key determinants of the
price elasticity of demand.
1. Availability of Close Substitutes
2. Passage of Time
3. Luxuries vs. Necessities
4. Definition of Market
5. Share of a good in a consumer’s
budget
A. Availability of Close Substitutes
The availability of substitutes is the most
important determinant of the price
elasticity of demand. In general, if a product
has more substitutes, it will have a more
elastic demand. If a product has fewer
substitutes, it will have a less elastic
demand.
B. Passage of Time
The more time that passes, the more elastic
the demand for a product becomes.
C. Luxuries versus Necessities
The demand curve for a luxury is more
elastic than the demand curve for a
necessity.
D. Definition of the Market
The more narrowly we define a market, the
more elastic demand will be.
E.  Share of a Good in a Consumer’s
Budget
In general, the demand for a good will be
more elastic the larger the share of the good
IX. The Relationship between Price
Elasticity of Demand and Total Revenue 
Total revenue is the total amount of funds a
seller receives from selling a good or
service, calculated by multiplying price per
unit by the number of units sold.
When demand is inelastic, price and total Individual Demand. Demand of one
revenue move in the same direction: An individual
increase in price raises total revenue, and a
decrease in price reduces total revenue.

When demand is elastic, price and total

revenue move inversely: An increase in
price reduces total revenue, while a decrease
in price raises total revenue.

If demand is unit elastic a change in price

is exactly offset by a proportional change
in quantity demanded, leaving revenue
unaffected.

A. Elasticity and Revenue with a Linear

Demand Curve
Along most demand curves, including linear
demand curves, elasticity is not constant at
every point.
Market demand curve. Sum the individual
demand curves horizontally
-Total quantity demanded of a good
varies, As the price of the good varies, Other
things constant

When the price is high and the quantity

demanded is low, demand is elastic.

When the price is low and the quantity

demanded is high, demand is inelastic.

Demand

Quantity Demanded. Amount of a good

that buyers are willing and able to purchase

Law of Demand Shifts in Demand Curve

Other things equal, when the price of the
good rises, quantity demanded of good falls
Demand Schedule. A table that shows
relationship between the price of a good and
quantity demanded
Demand Curve. A graph that shows
relationship between the price of a good and
quantity demanded
- Increase in demand
Any change that increases the
quantity demanded at every price
Demand curve shifts RIGHT
- Decrease in demand
Any change that decreases the
quantity demanded at every price
Demand curve shifts LEFT

Variables that can Shift the demand
curve
1. Income
2. Expectations about the future
3. Prices of related goods
4. Number of buyers-increase
5. Taste
Market supply curve. Sum the individual
supply curves horizontally
-Total quantity supplied of a good
varies, As the price of the good varies, all
other factors that affect how much suppliers
want to sell are hold constant

Supply

Quantity Supplied. Amount of a good

sellers are willing to sell

Law of Supply
Other things equal, when the price of the
good rises, quantity supplied of good rises

Supply Schedule. A table that shows

relationship between the price of a good and
quantity supplied
Demand Curve. A graph that shows
relationship between the price of a good and
quantity supplied
Individual supply. Supply of one seller
Shifts in Supply Curve
- Increase in supply
Any change that increases the
quantity supplied at every price
Supply curve shifts RIGHT
- Decrease in supply
Any change that decreases the
quantity supplied at every price
supply curve shifts LEFT

Variables that can Shift the demand
curve
1. Input Prices (costs)
- Supply- negatively related to prices
of inputs
- Higher input prices – decrease in
supply
2. Expectations about the future
- Affect current supply
- Expected higher prices – decrease in
current supply
3. Number of sellers-increase
- Market supply – increase
4. Technology
- Advance in technology- increase in
supply
Equilibrium.
- A situation wherein supply and
demand forces are in balance.
- Market price has reached the level
where quantity supplied = quantity
demanded
- Supply and demand curves intersect
Equilibrium Price
- Balances quantity supplied and
quantity demanded
- Market-clearing price
Equilibrium Quantity. Quantity supplied
and quantity demanded at the equilibrium
price
Surplus
- Quantity supplied > quantity
demanded
- Excess supply
- Downward pressure on price
- Movements along the demand and
supply curves
Increase in quantity demanded,
decrease in quantity supplied
Shortage
- Quantity demanded > quantity
supplied
- Excess demand
- Upward pressure on price
- Movements along the demand and
supply curves
Decrease in quantity demanded,
Increase in quantity supplied

Law of Supply and Demand
- The price of any goods adjusts
To bring the quantity supplied and
the quantity demanded for that good
into balance
- In most markets
Surpluses and shortages are
temporary
Steps in analyzing changes in equilibrium
1. Decide whether the event shifts the
supply curve, the demand curve or
both curves
2. Decide whether the curve shifts to
the right or to the left
3. Use the supply and demand diagram,
compare the initial and the new
equilibrium and effects on
equilibrium price and quantity
Case Analysis
1. A change in market equilibrium due to
SHIFT IN DEMAND
One summer – very hot weather
1. Hot weather – shift the demand
curve (taste)
2. Demand curve shifts to the right
3. Higher equilibrium price; higher
equilibrium quantity
2. A change in market equilibrium due to
SHIFT IN SUPPLY
One summer – a hurricane destroys part of
the sugarcane crop: higher price of sugar
1. Change in price of sugar – supply
curve
2. Supply curve shifts to the LEFT
3. Higher equilibrium price; lower
equilibrium quantity
How Prices Allocate Resources
PRICES
- Signals that guide the allocation of
resources
- Mechanism for rationing scarce
resources
- Determine who produces each good
and how much is produced
Module 3: Markets in Action: Policy &
Applications
Black market. A market in which buying
and selling take place at prices that violate
government price regulations.
Command-and-control approach. A
policy that involves the government
imposing quantitative limits on the amount
of pollution firms are allowed to emit or
requiring firms to install specific pollution
control devices.
Consumer surplus. The difference between
the highest price a consumer is willing to
pay for a good or service and the actual price
the consumer pays.
Deadweight loss. The reduction in
economic surplus resulting from a market
not being in competitive equilibrium.
Economic efficiency. A market outcome in
which the marginal benefit to consumers of
the last unit produced is equal to its
marginal cost of production and in which
the sum of consumer surplus and producer
surplus is at a maximum.
Economic surplus. The sum of consumer
surplus and producer surplus.
Externality. A benefit or cost that affects
someone who is not directly involved in the
production or consumption of a good or
service.
Marginal benefit. The additional benefit
to a consumer from consuming one more
unit of a good or service.
Marginal cost. The change in a firm’s total
cost from producing one more unit of a
good or service.
Market failure. A situation in which the
market fails to produce the efficient level of
output.
Pigovian taxes and subsidies. Government
taxes and subsidies intended to bring about
an efficient level of output in the presence
of externalities.
Price ceiling. A legally determined
maximum price that sellers may charge.
Price floor. A legally determined minimum
price that sellers may receive.
Private benefit. The benefit received by the
consumer of a good or service.
Private cost. The cost borne by the producer
of a good or service.
Producer surplus. The difference between
the lowest price a firm would be willing to
accept for a good or service and the price it
actually receives.
Property rights. The rights individuals or
businesses have to the exclusive use of their
property, including the right to buy or sell it.
Social benefit. The total benefit from
consuming a good or service, including both
the private benefit and any external benefit.
Social cost. The total cost of producing a
good or service, including both the private
cost and any external cost.
I. Consumer Surplus and Producer
Surplus 
A price ceiling is a legally determined
maximum price that sellers may charge. A
price floor is a legally determined minimum
price that sellers may receive.
A. Consumer Surplus
Consumer surplus is the difference
between the highest price a consumer is
willing to pay for a good or service and the
actual price the consumer pays. The demand
curve can be used to measure total consumer
surplus in a market. Consumers are willing
to purchase a product up to the point where
the marginal benefit of consuming a
product is equal to its price. Marginal
benefit is the additional benefit to a
consumer from consuming one more unit of
a good or service. The total amount of
consumer surplus in a market is equal to
the area below the demand curve and
above the market price. This area
represents the benefit to consumers in excess
of the price they paid for a product.
B. Producer Surplus
Supply curves show the willingness of firms
to supply a product at different prices. Firms
will supply an additional unit of a product
only if they receive a price equal to the
additional cost of producing that unit.
Marginal cost is the change in a firm’s total
cost from producing one more unit of a good
or service. Often, the marginal cost of
producing a good increases as more of the
good is produced during a given time period.
Producer surplus is the difference between
the lowest price a firm would be willing to
accept for a good or service and the price it
actually receives. The total amount of
producer surplus in a market is equal to
the area above the market supply curve
and below the market price.  Consumer surplus measures the benefit to
C. What Consumer Surplus and Producer
Surplus Measure
Consumer surplus measures the net benefit
to consumers from participating in a
market, rather than the total benefit.
Similarly, producer surplus measures the net
benefit received by producers from
participating in a market.  of the last unit produced is equal to its
II. The Efficiency of Competitive
Markets 
A competitive market is a market with many
buyers and sellers. An advantage of a market
system is that it results in efficient economic
outcomes.
A. Marginal Benefit Equals Marginal
Cost in Competitive Equilibrium
Equilibrium in a competitive market results
in the economically efficient level of output,
at which marginal benefit equals marginal
cost.
B. Economic Surplus
Economic surplus is the sum of consumer
surplus and producer surplus. In a
competitive market, with many buyers and
sellers and no government restrictions,
economic surplus is at a maximum when
the market is in equilibrium.
C. Deadweight Loss
Deadweight loss is the reduction in
economic surplus resulting from a market
not being in competitive equilibrium.
D. Economic Surplus and Economic
Efficiency
consumers from buying a particular product,
and producer surplus measures the benefit to
firms from selling a particular product.
Equilibrium in a competitive market
results in the greatest amount of economic
surplus, or total net benefit to society, from
the production of a good or service.
Economic efficiency is a market outcome in
which the marginal benefit to consumers
marginal cost of production and in which
the sum of consumer surplus and producer
surplus is at a maximum.  control, reduces economic efficiency.
III. Government Intervention in the
Market: Price Floors and Price Ceilings 
Not every individual is better off if a market
is at its competitive equilibrium. Any
producer would rather charge a higher price,
and any consumer would rather pay a lower
price than the equilibrium price. Producers
or consumers who are dissatisfied with the
competitive equilibrium price may lobby the
government to legally require that a different
price be charged.
A. Price Floors: Government Policy in
Agricultural Markets
During the Great Depression many farmers
were unable to sell their products or could
sell them only at very low prices. Farmers
convinced the federal government to
intervene to set price floors for agricultural
products. Government intervention in
agriculture has continued ever since. A price
floor reduces economic efficiency. The
federal government’s farm programs often
have resulted in large surpluses of wheat and
other agricultural products. The government
has usually bought surplus food or paid
farmers to restrict supply by taking some
land out of cultivation. In 2019, the
Congressional Budget Office estimated that
the farm program would result in federal
spending of more than $867 billion over the
following 10 years.
B. Price Ceilings: Government Rent
Control Policy in Housing Markets
Support for governments setting price
ceilings typically comes from consumers.
New York is one of the cities that impose
rent control, which puts a ceiling on the
maximum rent that landlords can charge for
an apartment. A price ceiling, such as rent
C. Black Markets and Peer-to-Peer Sites
Because rent control leads to a shortage of
apartments, renters who would otherwise not
be able to find apartments have an incentive
to offer landlords rents above the legal
maximum. This can result in a black
market, a market in which buying and
selling take place at prices that violate
government price regulations. Peer-to-peer
rental sites provide landlords and tenants a
way to avoid rent controls. Landlords use
these sites to convert a yearly rental into a
series of short-term rentals for which they
can charge rents that exceed the legal
maximum rent. Tenants can use peer-to-peer
sites to rent their apartments to others at
rents higher than the legal maximum they
pay.
D. The Results of Government Price
Controls: Winners, Losers, and
Inefficiency
When the government imposes price floors
or price ceilings, some people win, some
people lose, and there is a loss of economic
efficiency. The winners with rent control are
those who pay less for rent. Landlords may
gain if they break the law by charging rents
above the legal maximum and above what
the equilibrium rents would be. The losers
from rent control are the landlords who
abide by the law, and renters who are unable
to find apartments at the controlled price.
Rent control reduces economic efficiency
because fewer apartments are rented than
would be rented in a competitive market. 
E.  Positive and Normative Analysis of
Price Ceilings and Price Floors
Economists are generally skeptical of
government attempts to interfere with
competitive market equilibrium. Our
analysis of rent control and federal farm
programs is positive analysis. Whether
these programs are desirable or undesirable
is a normative question.  equilibrium.
IV. Externalities and Economic
Efficiency 
An externality is a benefit or cost that
affects someone who is not directly involved
in the production or consumption of a good
or service. An example of a negative
externality is the generation of electricity
by burning coal that generates carbon
dioxide. The price paid for electricity does
not include the cost of the damage carbon
dioxide does to the environment. College
educations are an example of a positive
externality because people who do not pay
for them benefit from the education others
receive.  Externalities and market failures result
A. The Effect of Externalities
A competitive market achieves economic
efficiency by maximizing the sum of
consumer and producer surpluses. But that
result holds only if there are no externalities
in production or consumption. An
externality causes a difference between the
private cost of production and the social
cost, or the private benefit from
consumption and the social benefit. A
private cost is a cost borne by the producer
of a good or service. A social cost is the
total cost of producing a good or service,
including both the private cost and any
external cost. A private benefit is a benefit
received by the consumer of a good or
service. A social benefit is the total benefit
from consuming a good or service,
including both the private benefit and any
external benefit. When there is a negative
externality in the production of a good or
service, too much of the good or service will
be produced at market equilibrium. When
there is a positive externality in consuming a
good or service, too little of the good or
service will be produced at market
B. Externalities and Market Failure
Market failure is a situation in which the
market fails to produce the efficient level of
output.
C. What Causes Externalities?
Governments need to guarantee property
rights for a market system to function well.
Property rights are the rights individuals or
businesses have to the exclusive use of their
property, including the right to buy or sell it.
In certain situations, property rights do not
exist or cannot be legally enforced.
from incomplete property rights or from the
difficulty of enforcing property rights in
certain situations. 
V. Government Policies to Deal with
Externalities 
British economist A.C. Pigou was the first to
analyze how governments should intervene
when private solutions to externalities are
not feasible.
A. Imposing a Tax When There Is a
Negative Externality
Pigou argued that to deal with a negative
externality in production, the government
should impose a tax equal to the cost of the
externality, which would cause a producer to
internalize the externality.
B. Providing a Subsidy When There Is a
Positive Externality
Pigou reasoned that the government can deal
with a positive externality in consumption
by giving consumers a subsidy equal to the
value of the externality. Payment of the
subsidy would allow consumers to
internalize the externality. Pigovian taxes
and subsidies are government taxes and
subsidies intended to bring about an efficient
level of output in the presence of
externalities. A Pigovian tax eliminates
deadweight loss and improves economic
efficiency.
C. Command-and-Control versus
Market-Based Approaches
A command-and-control approach to
pollution is a policy that involves the
government imposing quantitative limits
on the amount of pollution firms are allowed
to emit or requiring firms to install specific
pollution control devices. Instead of a
command-and-control approach, Congress
decided to use a cap-and-trade system of
tradeable emission allowances to deal with
the problem of acid rain. The objective was
to reduce emissions of sulfur dioxide to 8.5
million tons annually by 2010. The federal
government gave electric utilities, the major
sources of sulfur dioxide emissions that
cause acid rain, allowances equal to the total
amount of allowable emissions. The utilities
were then free to buy and sell the
allowances. Utilities that could reduce their
emissions at a low cost did so and sold some
or all of their allowances to utilities that
could only reduce their emissions at a high
cost. The program was successful not only
in reducing emissions but in doing so at a
much lower cost than had been expected.
D. The End of the Sulfur Dioxide Cap-
and-Trade System
Despite its success, the sulfur dioxide cap-
and-trade system effectively ended in 2013.
Research showed that illnesses caused by
sulfur dioxide emissions were greater than
previously had been thought. Although
President George W. Bush proposed
legislation to lower the cap on sulfur dioxide
emissions, Congress did not pass the
legislation. As a result, the Environmental
Protection Agency (EPA) reverted to setting
limits on sulfur dioxide emissions at the
state or power plant level.
E.  Are Tradable Emissions Allowances
Licenses to Pollute?
Some environmentalists have labeled
tradable emissions allowances “licenses to
pollute.” But this criticism ignores a central
economics lesson: resources are scarce and
trade-offs exist. Resources spent reducing
pollution are not available for any other use.
Because reducing acid rain using allowances
cost utilities $870 million, rather than $7.4
billion as originally estimated, society saved
more than $6.5 billion per year. 
Module 4: Market Structure and Firm
Strategy
Allocative efficiency. A state of the
economy in which production in accordance
with consumer preferences; in particular,
every good or service is produced up to the
point where the last unit provides a
marginal benefit to consumers equal to the
marginal cost of producing it.
Antitrust laws. Laws aimed at eliminating
collusion and promoting competition among
firms.
Average fixed cost. Fixed cost divided by
the quantity of output produced.
Average product of labor. The total output
produced by a firm divided by the quantity
of workers.
Average revenue (AR). Total revenue
divided by the quantity of the product sold.
Average total cost. Total cost divided by
the quantity of output produced.
Average variable cost. Variable cost
divided by the quantity of output produced.
Barrier to entry. Anything that keeps new
firms from entering an industry in which
firms are earning economic profits.
Business strategy. A set of actions that a
firm takes to achieve a goal, such as
maximizing profits.
Cartel. A group of firms that collude by
agreeing to restrict output to increase
prices and profits.
Collusion. An agreement among firms to
charge the same price or otherwise not to
compete.
Constant returns to scale. The situation in
which a firm’s long-run average costs
remain unchanged as it increases output.
Cooperative equilibrium. An equilibrium
in a game in which players cooperate to
increase their mutual payoff.
Copyright. A government-granted exclusive
right to produce and sell a creation.
Diseconomies of scale. The situation in
which a firm’s long-run average cost rises
as the firm increases output.
Dominant strategy. A strategy that is the
best for a firm, no matter what strategies
other firms use.
Economic loss. The situation in which a
firm’s total revenue is less than its total cost,
including all implicit costs.
Economic profit. A firm’s revenues minus
all of its implicit and explicit costs.
Economies of scale. The situation in which
a firm’s long-run average cost falls as it
increases the quantity of output it produces.
Explicit cost, . A cost that involves
spending money.
Fixed costs. Costs that remain constant as
output changes.
Game theory. The study of how people
make decisions in situations in which
attaining their goals depends on their
interactions with others; in economics, the
study of the decisions of firms in
industries where the profits of a firm
depend on its interactions with other
firms.
Horizontal merger. A merger between
firms in the same industry.
Implicit cost. A nonmonetary opportunity
cost.
Law of diminishing returns. The principle
that, at some point, adding more of a
variable input, such as labor, to the same
amount of a fixed input, such as capital,
will cause the marginal product of the
variable input to decline.
Long run. The period of time in which a
firm can vary all its inputs, adopt new
technology, and increase or decrease the size
of its physical plant.
Long-run average cost curve. A curve that
shows the lowest cost at which a firm is
able to produce a given quantity of output
in the long run, when no inputs are fixed.
Long-run competitive equilibrium. The
situation in which the entry and exit of
firms has resulted in the typical firm
breaking even.
Long-run supply curve. A curve that
shows the relationship in the long run
between the market price and the
quantity supplied.
Marginal cost. The change in a firm’s
total cost from producing one more unit
of a good or service.
Marginal product of labor. The additional
output a firm produces as a result of hiring
one more worker.
Marginal revenue (MR). The change in
total revenue from selling one more unit
of a product.
Market power. The ability of a firm to
charge a price greater than marginal cost.
Minimum efficient scale. The level of
output at which all economies of scale are
exhausted.
Monopolistic competition. A market
structure in which barriers to entry are low
and many firms compete by selling
similar, but not identical, products.
Monopoly. A firm that is the only seller of a
good or service for which there is not a close
substitute.
Nash equilibrium. A situation in which
each firm chooses the best strategy, given
the strategies chosen by other firms.
Natural monopoly. A situation in which
economies of scale are so large that one
firm can supply the entire market at a
lower average total cost than can two or
more firms.
Network externality. A situation in which
the usefulness of a product increases with
the number of consumers who use it.
Noncooperative equilibrium. An
equilibrium in a game in which players do
not cooperate but pursue their own self-
interest.
Oligopoly. A market structure in which a
small number of interdependent firms
compete.
Patent. The exclusive legal right to produce
a product for a period of 20 years from the
date the patent application is filed with the
government.
Payoff matrix. A table that shows the
payoffs that each firm earns from every
combination of strategies by the firms.
Perfectly competitive market. A market
that meets the conditions of having (1) many
buyers and sellers, (2) all firms selling
identical products, and (3) no barriers to
new firms entering the market.
Price Discrimination. The practice of
charging different prices to different
customers for the same good or service
when the price differences are not due to
differences in cost.
Price leadership. A form of implicit
collusion in which one firm in an oligopoly
announces a price change and the other
firms in the industry match the change.
Price taker. A buyer or seller that is unable
to affect the market price.
Prisoner’s dilemma. A game in which
pursuing dominant strategies results in
noncooperation that leaves everyone worse
off.
Production function. The relationship
between the inputs employed by a firm and
the maximum output the firm can
produce with those inputs.
Productive efficiency. The situation in
which a good or service is produced at the
lowest possible cost.
Profit. Total revenue minus total cost.
Public franchise. A government
designation that a firm is the only legal
provider of a good or service.
Short run. The period of time during which
at least one of a firm’s inputs is fixed.
Shutdown point. The minimum point on a
firm’s average variable cost curve; if the
price falls below this point, the firm shuts
down production in the short run.
Technological change. A positive or
negative change in the ability of a firm to
produce a given level of output with a
given quantity of inputs.
Technology. The processes a firm uses to
turn inputs into outputs of goods and
services.
Total cost. The cost of all the inputs a firm
uses in production.
Variable costs. Costs that change as output
changes.
Vertical merger. A merger between firms at
different stages in the production of a good.
I. Technology: An Economic Definition 
Technology refers to the processes a firm
uses to turn inputs into outputs of goods and
services. A firm’s technology depends on
many factors, including the skills of its
managers, the training of its workers, and
the speed and efficiency of its machinery
and equipment.
Technological change refers to a positive or
negative change in the ability of a firm to
produce a given level of output with a
given quantity of inputs. Positive
technological change allows a firm to
produce more output using the same
inputs or the same output using fewer
inputs. Positive technological change can
result from rearranging the layout of a store
or using faster or more reliable machinery,
among other things. A firm experiences
negative technological change if, for
example, it hires less-skilled workers or if a
hurricane damages its facilities. 
II. The Short Run and the Long Run in
Economics 
The short run is the period of time during
which at least one of a firm’s inputs is
fixed. The long run is the period of time in
which a firm can vary all its inputs, adopt
new technology, and increase or decrease
the size of its physical plant. The actual
length of calendar time for the short run and
the long run will vary from firm to firm.
A. The Difference between Fixed Costs
and Variable Costs
Total cost is the cost of all the inputs a firm
uses in production. Variable costs are costs
that change as output changes. Fixed costs
are costs that remain constant as output
changes. Since all of a firm’s short run
costs are either fixed or variable costs, we
can write:
Total cost (TC) = Fixed cost (FC) +
Variable cost (VC).
B. Implicit Costs versus Explicit Costs
Costs may be explicit or implicit. An
explicit cost is a cost that involves spending
money. An implicit cost is a nonmonetary
opportunity cost. Explicit costs are
sometimes called accounting costs.
Economic costs include both accounting
costs and implicit costs.
C. The Production Function
A production function is the relationship
between the inputs employed by a firm and
the maximum output the firm can produce
with those inputs. The production function
represents the firm’s technology.
D. A First Look at the Relationship
between Production and Cost
Average total cost (ATC) equals total cost
divided by the quantity of output
produced. In a graph, the ATC curve is U
shaped.
III. The Marginal Product of Labor and
the Average Product of Labor  the marginal and average values of any
The marginal product of labor is the
additional output a firm produces as a
result of hiring one more worker. Labor is
often considered a variable factor of
production. Capital—buildings and
equipment—is often considered a fixed
factor in the short run. As a firm hires its
first few workers, increases in marginal
product result from the implementation of a
division of labor and specialization.
A. The Law of Diminishing Returns
The law of diminishing returns is the
principle that, at some point, adding more
of a variable input, such as labor, to the
same amount of a fixed input, such as
capital, will cause the marginal product of
the variable input to decline. This result
occurs as the gains from specialization
lessen as more of the variable unit is used.
Although no firm would purposely do so,
the marginal product of the variable factor
could eventually become negative.
C. The Relationship between Marginal
Product and Average Product
The average product of labor is the total
output produced by a firm divided by the
quantity of workers. The average product
of labor is the average of the marginal
products of labor. The marginal product
of labor equals the average product of labor
for the quantity of workers for which the
average product of labor is at its maximum
value.
D. An Example of Marginal and Average
Values: College Grades
The relationship between the marginal
product of labor and the average product of
labor is the same as the relationship between
variable. For example, a student’s grade
point average (GPA) in one semester—the
marginal GPA—affects his cumulative GPA
—or average GPA. If the marginal GPA is
greater (less) than the average GPA, the
average GPA rises (falls).
IV. The Relationship between Short-Run
Production and Short-Run Cost 

Marginal cost is the change in a firm’s total

cost from producing one more unit of a good Average fixed cost (AFC) equals fixed cost
or service. Marginal cost (MC) can be divided by the quantity of output produced:
expressed mathematically as

Average variable cost (AVC) equals

where Δ represents “change in,” TC is total
variable cost divided by the quantity of
cost, and Q is output
output produced:
B. Why Are the Marginal and Average
Cost Curves U Shaped?

When the marginal product of labor is

rising, the marginal cost of production
will be falling. When the marginal
product of labor is falling, the marginal
cost of production will be rising.
The relationship between marginal cost and
the average total cost is another example of
the relationship between marginal and
average values. As long as marginal cost is
below average total cost, average total
cost will fall. When marginal cost is above
average total cost, average total cost will
rise.
Marginal cost will equal average total cost
when average total cost is at its lowest
point.
The MC, ATC, and AVC curves are all U
shaped,
the MC curve intersects the AVC and ATC
curves at their minimum points.
When MC is above AVC or ATC, it causes
them to increase.
When MC equals AVC or ATC, AVC and
ATC must be at their minimum points.
AFC gets smaller and smaller as output
increases, and the difference between ATC
and AVC (this is equal to AFC) gets
smaller.

The average total cost curve has a U shape

because the marginal cost curve has a U
shape.

V. Graphing Cost Curves 

Several related average cost measures can

be described mathematically:

VI. Costs in the Long Run  cost rises as the firm increases output.
In the long run, all costs are variable;
there are no fixed costs in the long run.
Total cost equals variable cost and
average total cost equals average variable
cost.
A. Economies of Scale
A long-run average cost curve is a curve
that shows the lowest cost at which a firm
is able to produce a given quantity of
output in the long run, when no inputs are
fixed. Many firms experience economies of
scale, the situation in which a firm’s long-
run average cost fall as it increases the
quantity of output it produces. Managers
can use long-run average cost curves for
planning because they show the effect on
cost of expanding output by building a larger
or smaller factory or store.
B. Long-Run Average Cost Curves for
Automobile Factories
Firms may experience economies of scale
for several reasons. The (1) firm’s
technology may make it possible to increase
production with a smaller proportional
increase in at least one input. (2) Workers
and managers can become more specialized,
enabling them to become more productive.
Firms may be able to (3) purchase inputs at
lower costs than their smaller competitors.
Finally, as a firm expands, it (4) may be able
to borrow money at a lower interest rate. But
economies of scale do not continue forever.
The long-run average cost curve in most
industries has a flat segment. Constant
returns to scale is the situation in which a
firm’s long-run average costs remain
unchanged as it increases output. The level
of output at which all economies of scale are
exhausted is known as minimum efficient
scale. Diseconomies of scale refer to the
situation in which a firm’s long-run average
Diseconomies of scale may result when
managers have difficulty coordinating the
operation of a firm as it grows in scale. 
VII. Perfectly Competitive Markets 
A perfectly competitive market meets the
conditions of having (1) many buyers and
sellers, (2) all firms selling identical
products, and (3) no barriers to new firms
entering the market. Firms in
perfectly competitive markets are unable to
affect the prices of the goods they sell and
are unable earn economic profits in the long
run.
A. A Perfectly Competitive Firm Cannot
Affect the Market Price
Prices in perfectly competitive markets
are determined by the intersection of
market demand and supply curves.
Consumers and firms must accept the
market price if they want to buy and sell in a
competitive market. A price taker is a
buyer or seller that is unable to affect the
market price. Each buyer and seller in a
perfectly competitive market is too small to
affect the market price.
B. The Demand Curve for the Output of a
Perfectly Competitive Firm
Because the firm is a price taker, it can sell
as much output as it wants at the market
price. Although the market demand curve
has the normal downward shape, the
demand curve for a perfectly competitive
firm is horizontal at the market price.
output is also where the difference between
total revenue and total cost is greatest.
Because price is equal to marginal revenue
for a perfectly competitive firm, price
equals marginal cost at the profit-
maximizing level of output.

VIII. How a Firm Maximizes Profit in a IX. Illustrating Profit or Loss on the Cost
Perfectly Competitive Market  Curve Graph 

It is reasonable to assume that the objective Because profit equals total revenue (TR)
for most firms is to maximize profit, which minus total cost (TC), and TR equal price
is equal to total revenue minus total cost. multiplied by quantity, then:
To maximize profit, a firm must produce
that quantity of output where the difference
between total revenue (TR) and total cost
(TC) is as large as possible.
If we divide both sides of this equation by
A. Revenue for a Firm in a Perfectly
Q, we have:
Competitive Market

A firm’s average revenue (AR) is equal to

total revenue divided by the quantity of the
product sold. Average revenue is also
equal to the market price. Marginal
revenue (MR) is the change in total
revenue from selling one more unit of a
product. For a firm in a perfectly
competitive market, price is equal to both This equation tells us that profit per unit
average revenue and marginal revenue. equals price minus average total cost. We
obtain the expression for the relationship
B. Determining the Profit-Maximizing between total profit and average total cost by
Level of Output multiplying through by Q:
The marginal revenue curve for a
perfectly competitive firm is the same as
its demand curve.

As long as marginal revenue is greater A. Showing Profit on the Graph

than marginal cost, the firm’s profits are
increasing, and it will expand production.
When marginal revenue is equal to
marginal cost, the firm will make no
additional profit by increasing
production, so it will have maximized its
profits. The profit-maximizing level of
In a graph, the firm’s profit is equal to the
area of a rectangle with a height of (P –
ATC) and a base equal to Q.
B. Illustrating When a Firm Is Breaking
Even or Operating at a Loss
Whether a firm makes a profit depends on
the relationship of price to average total
cost. There are three possibilities:
(1) P > ATC, which means the firm makes
a profit;
(2) P = ATC, which means the firm breaks
even; and
(3) P < ATC, which means the firm
experiences a loss.
X. Deciding Whether to Produce or to
Shut Down in the Short Run  adding up the quantity supplied by each firm
In the short run, a firm suffering losses has
two choices: (1) Continue to produce, or (2)
Stop production by shutting down
temporarily.
During a temporary shutdown, a firm must
still pay its fixed costs. If by producing the
firm would lose an amount greater than its
fixed costs, it should shut down. We assume
that the firm’s fixed costs are sunk costs. A
sunk cost is a cost that has already been
paid and cannot be recovered. The firm
should treat its sunk costs as irrelevant to
its decision making. One option the firm
does not have is to raise its price. If a
perfectly competitive firm raises its price,
it would lose all its customers and sales
would drop to zero.
A. The Supply Curve of a Firm in the
Short Run
If the price the firm can charge drops
below average variable cost, the firm will
have a smaller loss if it shuts down and
produces no output. The firm’s marginal
cost curve is its supply curve for prices at
or above average variable cost. Because
the marginal cost curve intersects the
average variable cost curve where the
average cost curve is at its minimum point,
the firm’s supply curve is its marginal cost
curve above the minimum point of the
average variable cost curve. The shutdown
point is the minimum point on a firm’s
average variable cost curve; if the price falls
below this point, the firm shuts down
production in the short run.
B. The Market Supply Curve in a
Perfectly Competitive Industry
The market supply curve in a perfectly
competitive industry is determined by
in the market at each price.
XI. “If Everyone Can Do It, You Can’t
Make Money at It”: The Entry and Exit
of Firms in the Long Run 
A. Economic Profit and the Entry or Exit
Decision
Economic profit is equal to a firm’s
revenues minus all of its implicit and
explicit costs. A firm is unlikely to earn an
economic profit for very long. Other firms
that are just breaking even have an incentive
to enter the market so they also can earn
economic profits. The more firms there are
in an industry, the further to the right is the
market supply curve. Entry into the market
will continue until all firms are just breaking
even. Firms can suffer economic losses in
the short run. An economic loss is the
situation in which a firm’s total revenue is
less than its total cost, including all implicit
costs. As long as price is above average
variable cost, a firm suffering a loss will
continue to produce in the short run. But in
the long run, firms will exit an industry if
they are unable to cover all their costs.
B. Long-Run Equilibrium in a Perfectly
Competitive Market
Economic profits induce firms to enter an
industry. The entry of firms forces the
market price down until the typical firm is
breaking even. Economic losses cause some
firms to exit an industry. The exit of firms
raises the market price until the typical
firm is breaking even. This process results in
a long-run competitive equilibrium. Long-
run competitive equilibrium is the
situation in which the entry and exit of
firms has resulted in the typical firm
breaking even. The long-run equilibrium
price is at a level equal to the minimum
point on the typical firm’s average total
cost curve.
C. The Long-Run Supply Curve in a
Perfectly Competitive Market
The long-run supply curve is a curve that
shows the relationship in the long run
between the market price and the quantity
supplied. In the long run, a perfectly
competitive market will supply whatever
amount of a good consumers demand at a
price determined by the minimum point
on the typical firm’s average total cost
curve.
D. Increasing-Cost and Decreasing-Cost
Industries
Any industry in which the typical firm’s
average costs do not change as the
industry expands production will have a
horizontal long-run cost curve. Industries
where this result holds true are called
constant-cost industries.
If an input used in producing a good is
available in only limited quantities, the cost
of the input will rise as the industry
expands. In this case, the long-run supply
curve will slope upward. Industries with
upward-sloping long-run supply curves are
called increasing-cost industries.
In some cases, the typical firm’s average
costs fall as the industry expands, and the
long-run supply curve will slope
downward. Industries with downward-
sloping long-run supply curves are called
decreasing-cost industries.
XII. Perfect Competition and Efficiency 
A. Productive Efficiency
In a market system, the forces of
competition will drive the market price to
the minimum average cost of the typical
firm. Productive efficiency is a situation in
which a good or service is produced at the
lowest possible cost. Managers of firms
strive to earn an economic profit by reducing
costs. But in a perfectly competitive market,
other firms quickly copy ways of reducing
costs, so in the long run only consumers
benefit from cost reductions.
B. Allocative Efficiency
Competitive firms not only produce goods
and services at the lowest possible cost, but
they also produce the goods and services
that consumers value most. Perfect
competition achieves allocative efficiency, a
state of the economy in which production is
in accordance with consumer preferences; in
particular, every good or service is produced
up to the point where the last unit provides a
marginal benefit to consumers equal to the
marginal cost of producing it. Productive
efficiency and allocative efficiency are
useful benchmarks against which to compare
the actual performance of the economy.
XIII. Is Any Firm Ever Really a
Monopoly? 
A monopoly is a firm that is the only seller
of a good or service for which there is not a
close substitute. A narrow definition of
monopoly is that a firm is a monopoly if it
can ignore the actions of other firms. A
broader definition of monopoly is that a
firm is a monopoly if it can retain
economic profits in the long run
XIV. Where Do Monopolies Come From?  creator’s lifetime, and his or her heirs retain
A monopoly requires that barriers to
entering the market must be so high that
no other firms can enter.
There are four barriers high enough to
keep out competing firms:
(1) Government action blocks the entry of
more than one firm into a market; (
2) one firm has control over a key
resource necessary to produce a good;
(3) there are important network
externalities in supplying the good or
service; and
(4) economies of scale are so large that
one firm has a natural monopoly.
A. Government Action Blocks Entry
The U.S. government blocks entry by
granting a patent, copyright, or trademark
that gives an individual or firm the exclusive
right to produce a product, and by granting a
firm a public franchise, making it the
exclusive legal provider of a good or
service. A patent is the exclusive legal right
to produce a product for a period of 20 years
from the date the patent application is filed
with the government. Patents encourage
firms to spend money on research and
development necessary to produce new
products.
A trademark grants a firm legal protection
against other firms using its product’s name.
Books, films, and pieces of music can
receive copyright protection.
A copyright is a government-granted
exclusive right to produce and sell a
creation. The right is granted for the
this exclusive right for 70 years after the
creator’s death.
A public franchise is a government
designation that a firm is the only legal
provider of a good or service.
B. Control of a Key Resource
Controlling a key resource happens
infrequently; examples include the
Aluminum Company of America, which
until the 1940s had long-term contracts to
buy nearly all available bauxite. Another
example is the International Nickel
Company of Canada.
C. Network Externalities
A network externality refers to a situation
in which the usefulness of a product
increases with the number of consumers
who use it. Some economists argue that
network externalities can serve as barriers to
entry, but there is debate about the extent to
which they serve as barriers.
D. Natural Monopoly
A natural monopoly is a situation in which
economies of scale are so large that one firm
can supply the entire market at a lower
average total cost than can two or more
firms. In this case, there is room for only
one firm. Natural monopolies are likely to
occur in markets where fixed costs are very
large relative to variable costs.
XV. How Does a Monopoly Choose Price
and Output?  contrast to perfect competition, the
Like other firms, a monopoly maximizes
profit by producing where marginal
revenue equals marginal cost but, unlike
other firms, the monopoly’s demand curve
is the same as the demand curve for the
product.
A. Marginal Revenue Once Again
A monopolist is a price maker, rather than a
price taker. Its demand and marginal
revenue curves are downward sloping.
B. Profit Maximization for a Monopolist
Though a monopolist can earn economic
profits, new firms will not enter the
monopolist’s market. The firm can earn
economic profits even in the long run.
XVI. Does Monopoly Reduce Economic
Efficiency?   in economic efficiency would equal less
A. Comparing Monopoly and Perfect
Competition
A monopoly will produce a smaller
quantity and charge a higher price than
would a perfectly competitive industry
producing the same good.
B. Measuring the Efficiency Losses from
Monopoly
Because a monopoly raises the market
price, it reduces consumer surplus. The
increase in price due to monopoly
increases producer surplus compared with
perfect competition. By increasing price
and reducing the quantity produced, the
monopolist reduces economic surplus. The
reduction in economic surplus is a
deadweight loss and represents a loss of
economic efficiency due to monopoly. In
monopolist charges a price that is greater
than its marginal cost.
C. How Large Are the Efficiency Losses
Due to Monopoly?
Since there are few monopolies, the loss of
economic efficiency from monopoly is
small. But many firms have market power,
the ability of a firm to charge a price greater
than marginal cost. The only firms that
have no market power are firms in
perfectly competitive markets. Because
few markets are perfectly competitive, some
loss of economic efficiency occurs in the
market for nearly every good or service.
Arnold Harberger and other economists have
confirmed that the total loss of economic
efficiency in the U.S. economy from market
power is relatively small. According to
Harberger, if every industry in the United
States were perfectly competitive, the gain
than 1 percent of the value of total
production.
D. Market Power and Technological
Change
Joseph Schumpeter is closely associated
with the argument that the economy may
benefit from firms that have market power.
Schumpeter argued that economic progress
is dependent on technological change in
the form of new products. Those who
support Schumpeter’s view argue that the
introduction of new products requires
expenditures on research and development,
and firms with market power that can fund
research are more likely to earn economic
profits than perfectly competitive firms.
Others disagree with Schumpeter’s views
and point out that small firms develop many
new products.
XVII. Price Discrimination: Charging
Different Prices for the Same Product 
Price discrimination is the practice of
charging different prices to different
customers for the same good or service
when the price differences are not due to
differences in costs.
A.   The Requirements for Successful
Price Discrimination
To successfully practice price
discrimination a firm must: (a) possess
market power, (b) have some consumers
with a greater willingness to pay for a
product than other consumers and identify
which consumers have greater willingness to
pay, and (c) be able to segment the market.
Buying a product at a low price and reselling
it at a high price is called arbitrage.
B. An Example of Price Discrimination
Movie theaters know that many people are
willing to pay more to see a movie in the
evening than in the afternoon. Theaters
typically charge higher prices for evening
showings and make the tickets for afternoon
showings a different color to make it
difficult for someone to buy a lower-priced
ticket and use it to gain admission to an
evening showing.
C. Airlines: The Kings of Price
Discrimination
Since the late 1980s, airlines have used
computers to construct models of the market
for airline tickets. These models take into
account several factors that affect the
demand for tickets. The practice of
continually adjusting prices to take into
account fluctuations in demand is called
yield management.
D. Big Data and Dynamic Pricing
Firms use big data to determine consumers’
preferences. Although this is a form of price
discrimination, many firms prefer to call
their pricing strategies yield management,
price optimization or dynamic pricing.
When firms adopt these pricing strategies,
typically some consumers gain by paying
lower prices while others lose by paying
higher prices. As a group, consumers lose
because, if successful, dynamic pricing
strategies increase firms’ revenues.
E.  Perfect Price Discrimination
Perfect discrimination, or first-degree
price discrimination, would occur if a firm
could charge each consumer a price equal to
the consumer’s willingness to pay and,
therefore, consumers would receive no
consumer surplus.  
F.  Price Discrimination across Time
Firms sometimes charge a higher price for a
product when it is first introduced and a
lower price later. Some consumers are early
adopters who will pay a high price to be
among the first to own certain new products.
G. Can Price Discrimination Be Illegal?
Price discrimination may be illegal if its
effect is to reduce competition in an
industry. 
XVIII. Government Policy toward
Monopoly 
Most governments have policies that
regulate the behavior of monopolies.
Collusion is an agreement among firms to
charge the same price or otherwise not to
compete. In the United States, antitrust laws
are designed to prevent monopolies or
collusion. Governments also regulate firms
that are natural monopolies.
A. Antitrust Laws and Antitrust
Enforcement
The first important law regulating
monopolies in the United States was the
Sherman Act (1890), which was designed to
promote competition and prevent the
formation of monopolies. The Sherman Act
targeted firms that had combined to form
trusts. Trusts enabled firms to collude.
Trusts disappeared after the Sherman Act
was passed, but the term antitrust laws
continues to be used to refer to laws aimed
at eliminating collusion and promoting
competition among firms. To address
loopholes in the Sherman Act, Congress
passed the Clayton Act (1914) and the
Federal Trade Commission Act (1914).
Under the Clayton Act, a merger was illegal
if its effect was “substantially to lessen
competition, or to tend to create a
monopoly.” The Federal Trade Commission
Act established the Federal Trade
Commission (FTC), which was given power
to police unfair business practices. Congress
divided the authority to police mergers
between the FTC and the Antitrust Division
of the U.S. Department of Justice.
B. Mergers: The Trade-off between
Market Power and Efficiency
The federal government regulates mergers
because if firms gain market power by
merging they may use this power to raise
prices and reduce output. The government is
most concerned with horizontal mergers. A
horizontal merger is a merger between
firms in the same industry. A vertical
merger is a merger between firms at
different stages of production of a good.
Two factors complicate regulating
horizontal mergers. First, the market that
firms are in is not always clear. Second,
there is a possibility that the newly merged
firm might be more efficient than the
merging firms were individually.
C. The Department of Justice and FTC
Merger Guidelines and the Herfindahl-
Hirschman Index of Concentration
In 1973, the Economics Section of the
Antitrust Division of the Department of
Justice was established and staffed with
economists entrusted with evaluating the
economic consequences of proposed
mergers. In 1982, the Department of Justice
and the FTC developed merger guidelines.
The guidelines have three main parts:
(1) Market definition.
(2) The measure of market concentration. A
merger between firms in a market that is
already highly concentrated is likely to
increase market power. The guidelines use
the Herfindahl-Hirschman Index (HHI) of
concentration, which squares the market
shares of each firm in the industry and adds
up the values of the squares.
(3) Merger standards. The Department of
Justice and the FTC use the HHI
calculations to evaluate proposed horizontal
mergers.
D. Regulating Natural Monopolies
If a firm is a natural monopoly,
competition will not play its role of forcing
prices down to the level where the company
earns zero economic profit. Local and state
regulatory commissions usually set prices
for natural monopolies. To achieve
economic efficiency, regulators should
require that the monopoly charge a price
equal to marginal cost. But this strategy has
a drawback when the firm’s average total
cost curve is still falling when it crosses the
demand curve. If the firm charges a price
equal to marginal cost, price will be less
than average total cost and the firm will
suffer an economic loss. Most regulators
will set the price equal to the level of
average total cost so that the firm can break
even.
XIX. Demand and Marginal Revenue for
a Firm in a Monopolistically Competitive
Market  MC.
Monopolistic competition is a market
structure in which barriers to entry are low
and many firms compete by selling similar,
but not identical, products. Oligopoly is a
market structure in which a small number of
interdependent firms compete.
A. The Demand Curve for a
Monopolistically Competitive Firm
An increase in the price of a
monopolistically competitive firm’s product
reduces the quantity sold.
B. Marginal Revenue for a Firm with a
Downward-Sloping Demand Curve
When a firm cuts its price, one good thing
happens: The firm will sell more, which is
called the output effect. But one bad thing
happens when price is cut: The firm will
receive less revenue for each unit of
output it could have sold at the higher
price, which is called the price effect.
When the firm lowers its price, marginal
revenue will be positive when the
additional revenue from selling one more
unit of output is greater than the revenue
lost from receiving a lower price.
Marginal revenue will be negative when the
additional revenue from selling one more
unit of output is less than the revenue lost
from receiving a lower price.
XX. How a Monopolistically Competitive
Firm Maximizes Profit in the Short Run
All firms maximize their profits by
producing where marginal revenue equals
marginal cost. Unlike a perfectly
competitive firm, a monopolistically
competitive firm will produce where P >
XXI. What Happens to Profits in the
Long Run? 
A. How Does the Entry of New Firms
Affect the Profits of Existing Firms?
When firms earn economic profits,
entrepreneurs have an incentive to enter the
market and establish new firms. The
demand curve of an established firm will
shift to the left and become more elastic.
Eventually, the demand curve will shift
until it is tangent to the firm’s average
total cost curve. A firm may suffer
economic losses in the short run. In the long
run, firms will exit an industry if they suffer
economic losses. The exit of some firms
will shift the demand curve for the output
of a remaining firm to the right.
Eventually, the representative firm will
charge a price equal to average total cost and
break even.
B. Is Zero Economic Profit Inevitable in
the Long Run?
Owners do not have to accept breaking even.
Firms try to continue earning a profit by
reducing their costs, providing exceptional
service, or by convincing consumers that
their products are different from their
competitors’ products.  preferable to the alternatives. Consumers,
XXII. Comparing Monopolistic
Competition and Perfect Competition  differentiated their products. Consumers
There are two important differences between
long-run equilibrium in monopolistic
competition and perfect competition.
Monopolistically competitive firms charge
a price greater than marginal cost and
they do not produce at minimum average
total cost.
A. Excess Capacity under Monopolistic
Competition
Because a monopolistically competitive firm
maximizes profit at an output level that is
not at the minimum point of its average total
cost curve, it has excess capacity. If the
firm increased its output, it could produce
at a lower average cost.
B. Is Monopolistic Competition
Inefficient?
In a monopolistically competitive market
neither productive efficiency nor
allocative efficiency are achieved.
Economists have debated whether this
results in a significant loss of well-being to
society in these markets compared with
perfectly competitive markets.
C. How Consumers Benefit from
Monopolistic Competition
The demand curve for a monopolistically
competitive firms slopes downward
because the good or service the firm is
selling is differentiated from the goods or
services sold by competing firms. Firms
differentiate their products to appeal to
consumers. When firms are successful in
differentiating their products, this indicates
that some consumers find these products
therefore, are better off than they would
have been had these companies not
face a trade-off when buying the product of
a monopolistically competitive firm:
Consumers pay a price greater than the
marginal cost, and the product is not
produced at minimum average cost, but they
benefit from being able to purchase a
product that is more closely suited to their
tastes.
 XXIII. Oligopoly and Barriers to Entry  
An oligopoly is a market structure in which
a small number of interdependent firms
compete. One measure of the extent of
competition in an industry is the
concentration ratio. Four-firm
concentration ratios measure the fraction
of an industry’s sales accounted for by its
four largest firms. Most economists believe
that a four-firm concentration ratio of 40
percent indicates an industry is an
oligopoly. The ratios do not include exports
to the United States by foreign firms and are
calculated for the national market, even
though competition in some markets is
mainly local. Concentration ratios provide a
general idea of the extent of competition in
an industry.
A. Barriers to Entry
New firms have difficulty entering an
oligopoly because of barriers to entry. A
barrier to entry is anything that keeps new
firms from entering an industry in which
firms are earning economic profits.
The most important barrier to entry is
economies of scale. Economies of scale
refer to the situation in which a firm’s long-
run average cost falls as it increases the
quantity of output it produces. Another
type of barrier to entry is ownership of a
key input. Examples of government-
imposed barriers are patents, licensing
requirements, and barriers to international
trade. A patent grants the exclusive legal
right to produce a product for a period of 20
years from the date the patent application is
filed with the government. The government
restricts competition through occupational
licensing, the justification for which is to
protect the public from incompetent
practitioners. But by restricting the number
of people who can enter licensed professions
the laws raise prices. Governments also
impose barriers through tariffs and quotas on
foreign competition.
 XXIV. Game Theory and Oligopoly  two firms is not satisfactory. Cooperation
Game theory is the study of how people
make decisions in situations in which
attaining their goals depends on their
interactions with others; in economics, the
study of the decisions of firms in industries
where the profits of a firm depend on its
interactions with other firms.
Games share three characteristics:
rules that determine what actions are
allowable;
strategies that players employ to attain
their objectives in the game; and
payoffs that are the results of the
interactions among the players’ strategies.
A business strategy is a set actions that a
firm takes to achieve a goal, such as
maximizing profits.
A. A Duopoly Game: Price Competition
between Two Firms
A payoff matrix is a table that shows the
payoffs that each firm earns from every
combination of strategies by the firms. One
strategy firms may use is to collude.
Collusion is an agreement among firms to
charge the same price or otherwise not to
compete. Collusion is against the law in the
United States. A dominant strategy is a
strategy that is the best for a firm, no matter
what strategies other firms use. A Nash
equilibrium is a situation in which each
firm chooses the best strategy, given the
strategies chosen by other firms.
B. Firm Behavior and the Prisoner’s
Dilemma
Sometimes an equilibrium reached between
may result in a better outcome. A
cooperative equilibrium is an equilibrium
in a game in which players cooperate to
increase their mutual payoff. A
noncooperative equilibrium is an
equilibrium in a game in which players do
not cooperate but pursue their own self-
interest. A prisoner’s dilemma is a game
in which pursuing dominant strategies
results in noncooperation that leaves
everyone worse off.
C. Can Firms Escape the Prisoner’s
Dilemma?
The prisoner’s dilemma seems to show that
cooperative behavior breaks down, but that
result assumes the game is played only once.
Most business situations are repeated; in a
repeated game, the losses from not
cooperating are greater than in a game
played only once, and players can employ
retaliation strategies against those who
don’t cooperate. As a result, cooperative
behavior is more likely. Price leadership is
a form of implicit collusion in which one
firm in an oligopoly announces a price
change and the other firms in the industry
match the change.

D. Cartels: The Case of OPEC

In the United States, firms cannot legally

meet to agree on what prices to charge and
how much to produce. The example of the
Organization of Petroleum Exporting
Countries (OPEC), a 14-member cartel,
suggests that collusion is not always
successful. A cartel is a group of firms
that collude by agreeing to restrict output
to increase prices and profits. OPEC has
had difficulty sustaining high oil prices.
Once the price has been driven up, each
OPEC member has an incentive to stop
cooperating and earn higher profits by
increasing output beyond its quota.